GANNON COMPILATION, 2005-2022
Sections
Accounting
Books
Capital Allocation
Case Studies
Financials
Illiquid Stocks
Industries
Investing
Macro
Management
Moat and Durability
Valuation
Accounting
1. Why I’m Biased Against Stock Options
2. Go Beyond the Financial Statements: Break a Company Down Revenue
Line by Revenue Line
3. Is Negative Shareholder Equity a Good Thing or a Bad Thing? – No, It’s an
Interesting Thing
4. Looking for Cases of Over-Amortization and Over-Depreciation
5. EBITDA and Gross Profits: Learn to Move Up the Income Statement
6. Why We Can’t Use Owner Earnings to Talk about Stocks
7. Free Cash Flow Vs. Owner Earnings: Which Matters More?
8. You’ve Crunched The Numbers – Now What?
9. Do Working Capital Reductions Count As Free Cash Flow?
10. GAAP Accounting: Restatements Vs. Realities
11. Understanding Depreciation: 4 Depreciation Archetypes
12. Accounting Connections
13. The Accounting Equation
14. Calculating Free Cash Flow: Should You Include Changes in Working
Capital?
15. How to Calculate Free Cash Flow – 5 Illustrated Examples From Actual
10-Ks
16. Net Current Asset Value Bargains: How Do You Screen For Them? –
Retained Earnings
17. On Maintenance Cap-Ex and “The Pleasant Surprise”
18. On Pre-Tax Return on Non-Cash Assets
19. On Return on Assets
20. How to Take Notes on a Company's Balance Sheet
21. Exclude Intangibles From Return on Capital Calculation
22. Return on Capital Is the 'Cost of Growth'
23. How Today's Debt Lowers Tomorrow's Returns
24. How Do You Calculate a Stock's Buyback Yield?
25. What Is the Best Way to Learn Accounting?
26. How to Think About Retained Earnings
27. Is Negative Book Value Bad?
28. GAAP Accounting: Restatements vs. Realities
29. Do Working Capital Reductions Count as Free Cash Flow?
Books
1. The Best Investing Books for a Budding Value Investor to Read
2. Some Books and Websites That Have Been Taking Up My Time
3. The Best Investing Book to Read if You’re Only Ever Going to Read One
4. Books I’m Reading
5. What Books Should You Read About Ben Graham?
6. Build Your Own Ben Graham Library
7. Investing 101 Toolbox: 12 Books, 3 Lectures, 4 Blogs, and 5 Interviews for
Investors
8. On Buffett and Derivatives
9. Book Review: The Ten Commandments for Business Failure
10. On Ben Graham and Bank Stocks
11. Security Analysis: Introduction (Part 1)
12. Security Analysis: First and Second Preface
13. Reading Graham’s Security Analysis: Care to Join Me?
14. Book Review: Active Value Investing
15. What Books Should You Read About Ben Graham?
Capital Allocation
1. Warren Buffett’s “Market Value Test” – And How to Use It
2. Dividends and Buybacks at Potentially Non-Durable Businesses: Altria
(MO) vs. NACCO (NC)
3. The “Element of Compound Interest”: When Retaining Earnings is the Key
to Compounding and When it Isn’t
4. Surviving Once a Decade Disasters: The Cost of Companies Not Keeping
Enough Cash on Hand
5. Capital Allocation Discounts
6. If Dividends Don’t Matter – What Does?
7. Free Cash Flow: Adjusting For Acquisitions, Capital Allocation And
Corporate Character
8. How to Find Stocks With Good, Predictable Capital Allocation
9. Quality, Capital Allocation, Value and Growth
Case Studies
1. “Farmer Mac” A.K.A. Federal Agricultural Mortgage Corporation (AGM):
The Freddie Mac of Farms and Ranches Has a P/E Below 9 and an ROE Above
Most Banks
2. Alico (ALCO): A Florida Orange Grower Selling Land, Paying Down Debt,
and Focusing on its Core Business
3. A-Mark Precious Metals (AMRK): A Dealer and Lender in Physical Gold
4. BAB (BABB): This Nano-Cap Franchisor of “Big Apple Bagel” Stores is the
Smallest Stock I Know of That’s a Consistent Free Cash Flow Generator
5. Flanigan’s (BDL): A Cheap, Complicated Restaurant Chain Focused on
South Florida
6. Bonal (BONL): An Extremely Tiny, Extremely Illiquid Stock that Earns a
Lot But Doesn’t Grow at All
7. Bunzl (BNZL): A Distributor with 20 Straight Years of EPS Growth and 27
Straight Years of Dividend Growth – Facing a Virus That’ll Break At Least
One of Those Streaks
8. Babcock & Wilcox Enterprises (BW): A Risky Stock Getting Activist
Attention
9. BWX Technologies (BWXT): A Leveraged, Speculative, and Expensive
Growth Stock that Might be Worth It
10. Geoff’s Thoughts on Cheesecake Factory (CAKE)
11. Carrier (CARR): A Big, Well-Known Business that Just Spun-off as a
Cheap, Leveraged Stock
12. Cars.com (CARS): A Cheap Enough Stock with a Clear Catalyst and Tons
of Rivals
13. Canterbury Park (CPHC): A Stock Selling for Less than the Sum of Two
Parts – A Card Casino and 127-Acres of Land (Plus You Get a Horse Track for
Free)
14. Car-Mart (CRMT): Like the Company, Hate the Industry
15. Dover Motorsports (DVD): Two Racetracks on 1,770 Acres and 65% of the
TV Rights to 2 NASCAR Cup Series Races a Year for Just $60 million
16. Daily Journal (DJCO): A Stock Portfolio, Some Real Estate, Some Dying
Newspapers, and a Growing Tech Company with Minimal Disclosures
17. NIC (EGOV): A Far Above Average Business at an Utterly Average Price
18. Gainsco (GANS): A Dark Nonstandard Auto Insurer That’s Cheap Based
on Recent Underwriting Results
19. General Electric (GE): Step Zero – Will We Ever Be Able to Value This
Thing?
20. Gamehost: Operator of 3 “Local Monopoly” Type Casinos in Alberta,
Canada – Spending the Minimum on Cap-Ex and Paying the Maximum in
Dividends
21. Green Brick Partners (GRBK): A Cheap, Complicated Homebuilder
Focused on Dallas and Atlanta
22. Grainger (GWW): Lower Prices, Higher Volumes
23. Hanesbrands (HBI): A Very Cheap, Very Leveraged Stock That’s #1 in an
Industry that Changes So Little Even Warren Buffett Loves It
24. Hilton Food (HFG): A Super Predictable Meat Packer with Long-Term
“Cost Plus” Contracts and Extreme Customer Concentration at an Expensive
– But Actually Not Quite Too Expensive – Price
25. Hingham Institution for Savings (HIFS): A Cheap, Fast Growing BostonBased Mortgage Bank with a P/E of 9 and a Growth Rate of 10%
26. Hingham (HIFS): Good Yield Curve Now – But, Always Be Thinking About
the Risk of the Bad Yield Curve Years to Come
27. IEH Corporation (IEHC): May Be a Good, Cheap Stock – But, Definitely
in the “Too Hard” Pile for Now
28. Interpublic (IPG): An Ad Agency Holding Company Trading at 10 times
Free Cash Flow and Paying a Nearly 7% Dividend Yield
29. Investors Title Company (ITIC): A Strong, Consistently Profitable Regional
Title Insurer Trading at a Premium to Book Value
30. Keweenaw Land Association: Buy Timberland at Appraisal Value – Get a
Proxy Battle for Free
31. Why I’ve Passed on Keweenaw Land Association (so far)
32. Revisiting Keweenaw Land Association (KEWL): The Annual Report and
the Once Every 3-Year Appraisal of its Timberland Are Out
33. Libsyn (LSYN): A Pretty Cheap and Very Fast Growing Podcasting
Company in an Industry with a Ton of Competition
34. Libsyn (LSYN): CEO’s Departure Makes this Stock Even More Interesting
35. Luby’s (LUB): Luby’s is Liquidating – What’s the CAGR Math Behind
Possible Payouts and Timing?
36. Monarch Cement (MCEM): A Cement Company With 97 Straight Years of
Dividends Trading at 1.2 Times Book Value
37. Marcus (MCS): Per Share Value of the Hotel Assets
38. Marcus (MCS): A Movie Theater and Hotel Stock Trading for Less than
the Sum of Its Parts
39. Middleby (MIDD): A Serial Acquirer in the (Normally) Super Steady
Business of Supplying Big Restaurant Chains with Kitchen Equipment
40. Maui Land & Pineapple (MLP): 900 Acres of Hawaiian Resort Land for
$250,000 an Acre
41. Miller Industries: A Pretty Good, But Very Cyclical Business that Sells its
Car Wreckers and Car Carriers Through a Loyal Distributor Base
42. Mills Music Trust (MMTRS): A Pure Play Decades Long Stream of
Future Royalties on Old-Timey Songs Available at More Than an 8% Pre-Tax
Yield
43. NACCO (NC): The Stock Geoff Put 50% of His Portfolio Into
44. Does NACCO (NC) Have Any Peers?
45. What’s NACCO’s Margin of Safety?
46. NACCO (NC): First Earnings Report as a Standalone Company
47. Otis (OTIS): The World’s Largest Elevator Company Gets the Vast
Majority of Its Earnings From Maintenance Contracts With a 93% Retention
Rate
48. Pendrell (PCOA): A Company with Cash, a Tax Asset, and Almost No
Liabilities
49. Pendrell (PCOA) Follow-Up: Reading into a CEO’s Past and the Dangers
of “Dark” Stocks
50. Points International (PCOM): A 10%+ Growth Business That’s 100%
Funded by the Float from Simultaneously Buying and Selling Airline Miles
51. Psychemedics (PMD): A High Quality, Low Growth Business with a
Dividend Yield Over 7% – And A Third of the Business About to Disappear
52. Resideo: Honeywell’s Boring, No-Growth Spin-off Might Manage to
Actually Grow EPS for 3-5 Years
53. Resideo Technologies (REZI): A Somewhat Cheap, But Also Somewhat
Unsafe Spin-off from Honeywell
54. Follow-Up Interest Post: Resideo Technologies (REZI) – Stock Falls, My
Interest Rises
55. Silvercrest Asset Management (SAMG): A 4% Dividend Yield For an
Asset Manager Focused on Super Wealthy Families and Institutions
56. Stella-Jones: Long-Term Contracts Selling Utility Poles and Railroad Ties
Add Up to A Predictable, Consistent Compounder that Unfortunately Has to
Use Debt to Beat the Market
57. Sydney Airport: A Safe, Growing and Inflation Protected Asset That’s
Leveraged to the Hilt
58. F.W. Thorpe: A Good Business Making Durable Products that May Have
Already Peaked
59. Transcat (TRNS): A Business Shifting from Distribution to Services and a
Stock Shifting from Unknown and Unloved to Known and Loved
60. Truxton (TRUX): A One-Branch Nashville Private Bank and Wealth
Manager Growing 10% a Year and Trading at a P/E of 14
61. U.S. Lime (USLM): A High Longevity Stock in a Low Competition
Industry
62. Vitreous Glass: A Low-Growth, High Dividend Yield Stock with
Incredible Returns on Equity and Incredibly Frightening Supplier and
Customer Concentration Risks
63. Vertu Motors: A Cheap and Safe U.K. Car Dealer
64. Vertu Motors (VTU): A U.K. Car Dealer, “Davis Double Play”, and
Geoff’s Latest Purchase
65. Vulcan International (VULC): A Dark, Illiquid Company Planning to
Liquidate its Portfolio of Bank Stocks and Dissolve
66. Nekkar: Why We Bought It – And is It Cheap?
(Singular Diligence Archives)
67. America’s Car-Mart (CRMT)
68. Ark Restaurants (ARKR)
69. Babcock & Wilcox (BWC)
70. Bank of Hawaii (BOH)
71. BOK Financial (BOKF)
72. Breeze-Eastern (BZC)
73. Commerce Bancshares (CBSH)
74. Ekornes (OSLO: EKO)
75. Fossil (FOSL)
76. Frost (CFR)
77. W.W. Grainger (GWW)
78. Hunter Douglas (Amsterdam: HDG)
79. John Wiley & Sons (JW.A)
80. Life Time Fitness (LTM)
81. Luxottica (Borsa Italiana: LUX)
82. Movado (MOV)
83. MSC Industrial Direct (MSM)
84. Omnicom (OMC)
85. Progressive (PGR)
86. Prosperity Bancshares (PB)
87. Swatch (Swiss Exchange: UHR)
88. Tandy Leather Factory (TLF)
89. The Restaurant Group (London: RTN)
90. Town Sports (CLUB)
91. Village Supermarket (VLGEA)
92. Weight Watchers (WTW)
(end)
93. Cheesecake Factory vs. The Restaurant Group
94. He Who Has the Highest Opportunity Cost Wins (CAKE, NC, GRBK)
95. Frost (CFR): Interest Rate Expense and Cyclically Adjusted Earnings
96. Weight Watchers (WTW): Mistakes Made Over 4 Years of (Emotional)
Volatility
97. Constantly Concentrating: Why I Sold George Risk (RSKIA) and Weight
Watchers (WTW)
98. Sold George Risk (RSKIA)
99. Sold Weight Watchers (WTW) and B&W; Enterprises (BW)
100. MSC Industrial Direct (MSM): A Metalworking Supply Company
101. Commerce Bancshares (CBSH) is a Durable Family Run Bank
102. Distributors Like Grainger (GWW) Can Benefit From Their Biggest
Corporate Customers Wanting to Consolidate Suppliers for Decades to Come
103. Don’t Pick Between Prosperity (PB) and Frost (CFR) – Buy them Both
104. Closing the Book on Breeze-Eastern
105. UniFirst (UNF): Maybe Too Expensive; Maybe Just Right
106. Sold Town Sports (CLUB); Bought Babcock & Wilcox (BWC)
107. IMS Health (IMS): 4 Years Later
108. Geoff’s Avid Hog Watchlist: Catering International & Services
(CTRG:FP)
109. Armanino Foods of Distinction (AMNF)
110. Blind Stock Valuation #3 – Corticeira Amorim
111. Carnival (CCL): No Pricing Power – But Plenty of Value Created Over
Time
112. Western Digital (WDC): Ben Graham Bargain Or Mispriced Bet?
113. Vistaprint (VPRT): The Makings Of A Moat?
114. International Value Investing: Turbotec (TRBO:LN) – United Kingdom
115. International Value Investing: PaperlinX (PPX:AU) – Australia
116. Reed Hastings – CEO of Netflix (NFLX) – Responds to Whitney Tilson’s
Short Case
117. Sold My Barnes & Noble (BKS) Stock Today
118. Bill Ackman Tells Borders (BGP) to Bid $16 a Share for Barnes & Noble
(BKS)
119. Going Private Transactions: Should You Buy a Stock To Make 4% in 3
Months? – Bancinsurance
120. Case Study: Geoff’s Investment in Bancinsurance – Both His Letters to
the Board of Directors
121. Investing Ideas: 26 Things Geoff Looks for in a Stock
122. Case Study: Geoff’s Investment in Bancinsurance – 2 Failures and 1
Success
123. Case Study: Geoff’s Investment in Bancinsurance – Letter to the Board of
Directors
124. Barnes & Noble: What Happens Next? – Is This Yahoo and Microsoft All
Over Again?
125. Microsoft is Cheap
126. Against the Topps Deal
127. On Overstock’s Terrible Third Quarter
128. On Lenox
129. On Nintendo
130. On Blyth
131. On Pilgrim’s Pride and Gold Kist
132. On Homebuilders
133. On Wells Fargo & Company
134. On Fifth Third Bancorp
135. On Cascade Bancorp
136. On TCF Financial Corporation
137. On Valley National Bancorp
138. On Microsoft
139. On Pacific Sunwear
140. Google Price Target: $16,578.90
141. On Sherwin-Williams’ Profitability
142. On JRN vs. JRC
143. On Lexmark (Again)
144. On the Journal Register Company
145. On Journal Communications
146. On a Possible Cause for JRN’s Undervaluation
147. On Energizer
148. On Overstock (Again)
149. On Overstock
150. On Lexmark
151. On Google’s Franchise (and McCormick’s)
152. On American Eagle
153. NACCO: Why NACoal Is Inside My Circle of Competence and Hamilton
Beach Is Outside It
154. Which Product Categories Will Online Retailers Never Conquer?
155. What Does Warren Buffett See in Apple?
156. Can a Value Investor Buy Facebook (FB)?
157. Carbo Ceramics (CRR): Is It Ever Okay for a Company to Have No Free
Cash Flow?
158. A Stock Where Neither the Business nor the Price Matters
159. Why I'd Never Pay More Than Book Value for Nokia (NOK)
160. 5 Japanese Net-Nets: And How to Analyze Them
Financials
1. How is a Bank Like a Railroad? – And Other Crazy Ideas Geoff Has About
Investing In “Efficiency Driven Businesses”
2. How I Analyze Bank Stocks
3. Frost (CFR) in Barron’s: Read My Interview about Frost and My Report
on Frost
4. Valuing Financial Companies: ROIC, ROE, or ROA?
5. Warren Buffett and Western Insurance
6. On Ben Graham, Bank Stocks, and Tom Brown
7. Pompous Prognostication: Irish Banks
8. On Banks
9. How Fast Can a Big Bank Grow Its Deposits?
10. How to Value an Insurer Using the S&P 500 as a Yardstick
Illiquid Stocks
1. An Illiquid Lunch
2. Can You Build A Liquid Portfolio With Illiquid Stocks?
3. Illiquidity and You
Industries
1. Understanding An Industry - Is Simple Better Than Familiar?
2. How to Find Safe FCF Yields: Go Where the Competition Isn't
3. Buying a Good Business in a Bad Industry
4. How to Tell Which Company Will Survive an Industry Downturn
5. How to Research Obscure Industries
6. Should You Ever Invest in a Shrinking Industry?
7. How to Research an Industry
8. Talking to Competitors Is More Useful Than Talking to Management
Investing
1. Investing in Trusts: Why Andrew and I Don’t Own Them, Why You
Probably Won’t Want to Too – And How to Get Started if You’re Sure This is
Really an Area You Want to Explore
2. Hunting for Hundred Baggers: What Stocks Should – and Shouldn’t – Go in
a Coffee Can Portfolio
3. Is There a Difference Between Being a Good Investor and a Good Stock
Picker?
4. Was Peter Lynch Right? – Does Earnings Performance Drive Stock
Performance?
5. How Can Long-Term Value Investors Make the Most of This Week’s ShortTerm Volatility?
6. Is There a Difference Between Being a Good Investor and a Good Stock
Picker?
7. How Buffett Holds: The Incredible Importance of the “Contrasting
Trajectories” of Long-Term Winners and Losers
8. Ask Yourself: In What Year Would You Have Hopped Off the Warren
Buffett Compounding Train?
9. Outperformance Anxiety
10. Pre-Judging a Stock
11. Doubt as a Discount
12. Stylistic Skew
13. Relative Regret
14. Anything Times Zero
15. The Second Side of Focus
16. All About Edge
17. Insider Buying vs. Insider Incentives
18. So: Am I Keeping Stocks Forever Now – Or Not?
19. Why I Spend 95% of My Time Thinking About New Stocks
20. Why I Don’t Use WACC
21. Stocks You Can’t Buy
22. Why You Might Want to Stop Measuring Your Portfolio’s Performance
Against the S&P; 500
23. The Risk of Regret: NACCO (NC)
24. What Most Investors Are Trying to Do
25. Risk Habituation and Creeping Speculation
26. Why Smart Speculations Still Aren’t Investments
27. What is the Line Between Investment and Speculation?
28. My New 50% Stock Position is NACCO (NC)
29. Buy Unrecognized Wonder; Sell Recognized Wonder
30. Seeking Out Strange Stocks: How to Create a Value Investing Basket that
MIGHT Get Decent Returns Even When the Market Falls
31. How I “Screen” For Stocks – I Don’t
32. The Chains of Habit
33. Hostess Brands (TWNK) Warrants
34. Roam Free From the Value Investing Herd
35. My 4 Favorite Blogs
36. The Dangers of Holding on to Great Stocks
37. Bought a New Stock: 50% Position
38. NACCO (NC) Spin Off Article
39. Are You Buying Anything Now?
40. 5 Stocks Ben Graham Would Buy
41. Why Ad Agencies Should Always Buy Back Their Own Stock
42. Unleveraged Return on Net Tangible Assets: It Only Matters When
Coupled with Growth
43. My Investing Goal
44. The Two Things Every Stock Picker Needs to Learn: Independence and
Arrogance
45. How to Read Between the Lines of a 10-K
46. How to Judge a Company’s Bargaining Power With its Customers and
Suppliers
47. What My Portfolio Looks Like Right Now – July 3rd, 2017
48. All Supermarket Moats are Local
49. Can Howdens Joinery Expand to the European Mainland?
50. Do Supermarket Stocks Have Long-Term Staying Power?
51. The 3 Ways an Investor Can Compromise
52. Over the Last 17 Years: Have My Sell Decisions Really Added Anything?
53. I’ve Decided to Stop Deciding Which Stocks to Sell
54. The Fastest Way to Improve as an Investor
55. The First 8 Things to Look at When Researching a Stock
56. Analyzing Stocks With a Partner
57. How to Find the Most Persistently Profitable Companies
58. How to Invest When You Only Have an Hour a Day to Do It
59. Is Value Investing Broken?
60. The Moat Around Every Ad Agency is Client Retention
61. 26 Small Stocks
62. 14 Stocks For You To Look At
63. Boredom Is a Good Friend of Long-term Investors
64. You Can Afford to Hold Cash
65. You Can Always Come Up With a Reason For Why the Stock You Are
Researching is Actually About to Go Out of Business
66. Babcock & Wilcox Sets Spin-Off Dates
67. When Should You Diversify?
68. Babcock & Wilcox (BWC): Considering Separation into Two Companies
69. Adidas Announces Share Buyback
70. Barnes & Noble (BKS) Will Separate Retail from Nook
71. The Inevitables
72. (All) My Thoughts on The Avid Hog
73. Finding Enough Investment Ideas
74. How Did Mohnish Pabrai Not Make Money in Japanese Net-Nets?
75. Ben Graham Defines an Investment
76. How to Read a 10-K
77. Hint: Read the Oldest 10-K
78. Charlie Munger’s 3 Places to Find Stocks
79. 30 Obscure, Profitable Stocks
80. Catalysts Not Included
81. Rise of the Guardians Has DreamWorks’s Worst Opening Weekend
82. How to Lose Money in Stocks: Look Where Everyone Else Looks – Ignore
Stocks Like These 15
83. Why Capital Turns Matter – And What Warren Buffett Means When He
Talks About Them
84. How Today’s Profits Fuel Tomorrow’s Growth
85. How to Become a Better Analyst – One Hour at a Time
86. Why I Concentrate on Clear Favorites and Soggy Cigar Butts
87. One Good Idea a Year is All You Need to Beat the Market
88. Some Links You’ll Like
89. Best Place to Run Screens: StockScreen123 – Bloomberg.com Underrated
90. How My Investing Philosophy Has Changed Over Time
91. Can You Screen For Shareholder Composition? – 30 Strange Stocks
92. Notes On Warren Buffett’s 2011 Letter To Shareholders
93. What to Look for in Japanese Net-Nets
94. What Are The Minimum Requirements For A Good Net-Net?
95. Pain And Patience: Net-Nets, Magic Formulas, And Micro Caps
96. How To Read A 10-K: What Is The Most Important Part?
97. How Long Should You Hold A Net-Net?
98. Are Most Net-Nets “Uninvestable”?
99. Berkshire Hathaway’s New Buys – And One Really, Really Old One
100. David Einhorn’s Buys: More Tech And A Return To Yahoo (YHOO)
101. Glenn Greenberg’s New Buys: Growth Stocks For Value Investors
102. Walter Schloss: 1916 – 2012
103. What Stocks Would Phil Fisher Buy Today?
104. Faith in Net-Nets
105. Investor Questions Podcast: All Interviews and Episodes
106. Japanese Net-Nets: 6 Months Later
107. Investor Questions Podcast Episodes
108. 12 Stocks I’d Consider Buying
109. The 4 Questions to Ask Before Buying a Stock
110. Ted Weschler’s Portfolio
111. LEAPS – And a Lack of Good Ideas
112. Asset-Earnings Equivalence
113. My Investing Checklist
114. Stock Analysis Process – How Geoff Researches Stocks
115. Why Don’t You Write About Spin-offs? – Why “You Can Be a Stock
Market Genius” is So Great
116. Japanese Stocks: Now 34% of My Portfolio – Plan to Hold Them For At
Least 1 Year
117. Buy Japan
118. Barnes & Noble – The Human Element
119. Investing in Japan – Questions and Answers
120. 15 Japanese Net-Nets
121. Screening for Decent Businesses at Decent Prices – 7 U.K. Stocks
122. Return on Invested Assets
123. Coming Up With a List of U.S. Stocks
124. Investing in Turnarounds
125. What Broker to Use When Buying International Stocks
126. Warren Buffett and The Washington Post
127. How Warren Buffett Thinks About Micro Cap Stocks
128. Where to Find Micro Cap Stocks
129. How I Got Started In Value Investing
130. How to Get Started in International Value Investing
131. How to Come Up With Investing Ideas
132. Should You Learn Investing By Reading or Doing? – Geoff’s Advice to a
College Junior
133. What Jobs Prepare You for Running a Value Fund? – Geoff’s Advice to a
College Senior
134. Getting Started: What Should a New College Graduate Do to Get a Career
in Investing? – 2 Tips
135. Investing Ideas: Where Does Geoff Get His Investing Ideas? – Screens,
Blogs, and 4 Examples
136. Small Stocks: Should Value Investors Only Buy Microcap Stocks? – 4
Stocks People Ignore
137. Investment Returns: Home Runs and Strike Outs – What Kind of Hitter
is Geoff?
138. What are the 4 Most Important Numbers to Know About a Stock?
139. On Buffett’s Big Blunder
140. On Buffett Back Riding
141. Random Thoughts
142. On Ignorance Admitted
143. Is Warren Buffett’s Berkshire Hathaway Worth More Dead or Alive?
144. Gannon to Barron’s: Berkshire Fairly Valued…As a Buffettless Empire!
145. On Hanes
146. On the Northern Pipeline Contest
147. On Disney, Pixar, and Ratatouille
148. On the Dangers of Homogeneity
149. Berkshire Owns More Than 10% of Burlington Northern
150. On the Mueller Mispricing: “A” Shares vs. “B” Shares
151. On Buffett, Berkshire, and You
152. On Billionaires, Their Buys, and Buffett
153. On the Risk of Settling
154. On Corus, Fremont, and the Impairment Charge
155. On Rex Stores, Real Estate, and Ethanol
156. On Misreporting Warren Buffett
157. On Posco, Berkshire, and Buffett
158. On Freston, Redstone, and Viacom
159. On Google’s Non-Search Products
160. On Inflexible Enterprises
161. On Special Situations
162. On Confidence
163. On Buffett’s Big Bet
164. On Asymmetric Opportunities
165. On Contrarianism and Negativity
166. On Probability, Observation, and Investing
167. On Value Investing
168. On Some Lessons From Buffett’s Annual Letter
169. On the Physical Effects Fallacy
170. Against the Top Down Approach (Again)
171. On Financial Strength
172. What Would Buffett Do?
173. On The Two That Got Away
174. On Small Cap Value and Large Cap Growth
175. On The Great Chicken Debate
176. On Formulaic Investing
177. On Conviction and the Value Gap
178. A Two-Step Approach to Assessing 'Earnings Quality'
179. Risks You Can Remove and Risks You Can't
180. When Markets Drop, Turn Your Useless Emotions Into Useful Drudge
Work
181. Volatility Is the Value Investor's Friend
182. The Trouble With Taking Profits
183. Warren Buffett and the Art of Stock Picking
184. How to Find Great Businesses Without Resorting to Actual Math
185. 2 Ways to Get Super Selective About Stocks in the Bubble Year of 2018
186. How Warren Buffett Squeezes So Much Value Out of So Few Stock Ideas
187. Should You Buy a Cheap Stock That's at the Very Edge of Your Circle of
Competence?
188. Invest Like an Investigative Reporter: Stories From the Qualitative Side
189. Buy What You Know, Study What You Don't
190. To Research a Stock, Just Act Like an Investigative Reporter
191. Think of Your Circle of Competence as a Web of Familiarity
192. How to Zero In on Misunderstood Stocks
193. In the Long Run, a High-Growth Stock Has to Be a High Return on
Capital Stock
194. Why Money Managers Don't Own Net-Nets And Why You Should
195. Pick the Winners First Worry About Price Second
196. Why I Only Own 5 Stocks at a Time
197. Why Cyclical Stocks Make Tricky Long-Term Investments
198. How to Get the Most Out of a Great Idea
199. How to Benefit From Brokers, Screens and Web Sites Instead of Getting
Distracted by Them
200. How to Estimate Future Growth at a Predictable Company
201. Why Looking 5-15 Years Into a Stock's Future Makes the Most Sense
202. How Catalysts Can Boost Your Annual Returns
203. How to Get the Most Out of the Time You Spend Thinking About Stocks
204. What Makes a Stock Risky?
205. What Makes You Put a Stock in the 'Too Hard' Pile?
206. How to Brainstorm Stock Ideas
207. Can Snap Decisions Ever Be Good Decisions?
208. How I Research Stocks
209. How to Diversify Without Selling Stocks You Already Own and Love
210. How to Steal Another Investor's Style
211. Be Careful Learning From Your Own Mistakes
212. Should You Always Keep Stocks for a Full 5 Years?
213. Talking to Customers Is More Useful Than Talking to Management
214. What Does 'Understanding' a Business Really Mean?
215. Why I Concentrate
216. Should You Keep Idle Funds in Cash, an Index Fund or Berkshire
Hathaway?
217. Investing Overseas: Look for a Cheap Currency and Long History of
High Returns on Equity
218. Should You Buy Dividend Achievers or Intrinsic Value Achievers?
219. Should You Buy Net-Nets or 'Desert Island' Stocks?
220. Expanding Your Circle of Competence
221. How to Avoid the Same Mistakes Your Heroes Made
222. When Is a Company's Growth Repeatable?
223. Don't Buy the Business That Is; Buy the Business That Will Be
224. Read Financial Results for 30 Years Instead of 10
225. What to Do When Your Stock Doesn't Move
226. How to Be More of an Investor and Less of a Trader
227. Do You Need to Know Something the Market Doesn't?
228. Doing the (Focused) Work
229. 7 Areas I Look at Before Buying a Stock
230. How to Handle Stock Ideas
231. Great Investments Make Boring Write-Ups
232. How to Frame an Investment Problem
233. Microcaps: Should You Fear Controlled Companies?
234. Familiarity: Stretching Your Circle of Competence
235. Thinking in Alternatives: New Stock vs. Old Stock
236. Selectivity in Action
237. How to Learn Everything You Need to Know About a Stock
238. How to Pick Stocks That Always Grow EPS
239. Always Use Normal Numbers
240. How to Find Obscure Stocks
241. How Would Warren Buffett Invest If He Was Starting Over Today?
242. What's Your Investing Routine?
243. What's Your Research Process?
244. How Much Time Do You Spend Researching a Stock?
245. When to Sell a Stock
246. How to Analyze Net-Nets Undergoing Change
247. Free Cash Flow Isn't Everything
248. Picking Net-Nets: Don't Overfocus on the Balance Sheet
249. How to Find Cheap Foreign Stocks
250. How to Pick Stocks in Spain, Italy and Portugal
251. How to Invest a Lot of Money in Net-Nets
252. How to Combine Business Analysis with 10-Year Financial Data
253. Buying Funds Below NAV
254. Why I Don't Diversify
255. How Warren Buffett Thinks About Stocks
256. How Warren Buffett Made His First $100,000
257. Why Do Most Companies Stay Small?
258. How Long Does It Take to Develop an Investing Style?
259. How to Screen for Hidden Champions
260. Don't See Stocks Through Mr. Market's Eyes
261. What Ben Graham's Mr. Market Metaphor Really Means
262. If I Had to Pick Growth Stocks...
263. 3 Years of Mistakes and One Bit of Advice
264. How to Get the Most from an Annual Report
265. What Would Value Investing 101 Look Like?
266. Notes on Warren Buffett's 2011 Letter to Shareholders
267. How Should You Divide Your Research Time?
Macro
1. Are We in a Bubble? – Honestly: Yes
2. A U.S. Corporate Tax Cut is Not Priced into Stocks
3. Do I Think About Macro? Sometimes. Do I Write About Macro? Never.
4. The Possibility of Negative Interest Rates in the U.S.
5. Stocks Are Too Expensive
6. Rome: Civil Wars, Plague, Economics – And Paul Krugman
7. Bonds: Interest Rates and Asset Prices – What’s the Right Earnings
Multiplier?
8. On the President’s Address
9. On the Geithner Plan
10. On Keynes, the Stimulus, and Old Ideas
11. On a Return to Normalcy
12. An Email on Economic Catastrophe
13. On Tuesday’s Decline
14. In Defense of Extraordinary Claims
15. On the Dow’s Normalized Earnings Yields for 1935-2006
16. On Gold and Rome
17. On The Human Index
18. On Valuations
19. On Technical Analysis
20. Against The Top Down Approach
21. How to Get Extra Cautious About the Risks the Crowd Isn't Worried
About Yet
22. Why the Rise of Index Funds Makes It Easier to Be a Value Investor
23. Do Not Expect to Make More Than 7% a Year Passively Investing in
Stocks
24. Should Value Investors Hold Cash When the Market Is Overpriced?
25. Can You Be 100% in Stocks Even When the Market Is Overvalued?
26. Should You Wait for a Crash - Or Buy Today's Best Bargain?
Management
1. Why I Never Talk to Management
2. Corporate Governance: Do Microcap Stocks Do Wrong by Shareholders? –
Small vs. Young
3. On Barron’s Top 30 CEOs – Bob Simpson, XTO Energy
4. Can Overpaid CEOs Ever Be Worth It?
5. How to Tell Management Is Cost Conscious
Moat & Durability
1. How Do I Find a Company with a Moat?
2. Geoff’s Mental Model #1: “Market Power”
3. The Difference Between “Moat” and “Durability”
4. A Simple Way to Think about Moat
5. How to Judge a Business’s Durability
6. Swatch’s Moat
7. Driverless Cars and Progressive’s Durability
8. How to Quantify Quality
9. Unrepeatable Moats
10. Scuttlebutt: The Qualitative Way to Test for a Moat
11. Finding Moats: The Best Opportunities Require More Than a Surface
Scan
12. What Makes a Competitive Advantage Durable?
13. Why Businesses That Sell to Consumers Are the Most Durable
14. Is Quality as Good as Growth?
Valuation
1. Why I Wouldn’t Worry About Risk-Adjusted Discount Rates
2. Why Appraising a Stock Based on “Relative Valuation” vs. Peers Isn’t
Enough to Guarantee You’re Getting a Bargain
3. Since It’s One of Warren Buffett’s “Inevitables”: Is it Okay to Pay a High
P/E Ratio for Low Growth Coca-Cola (KO)?
4. A Question for Passive Investors: If You’d Buy 100% of the Business at
Today’s Price – Should You ALWAYS Buy the Shares?
5. Should I Really Just Automatically Ignore High P/E Growth Stocks Even if
they Are Amazing Businesses?
6. Business Momentum: When is a Value Stock a Value Trap?
7. How Much is Too Much to Pay for a Great Business?
8. You Don’t Need to Know What a Stock’s Worth to Know It’s Cheap
9. Hold Cash: Wait till You Get Offered 65 Cents on the Dollar
10. The Market is Overpriced: These 3 Stocks Aren’t
11. Finding the Right P/E Multiple – Or How to Handicap a Stock
12. The Two Sides of Total Investment Return
13. Should We Care Why the Stocks We Buy are Cheap?
14. Current Price/Appraisal Ratios for All Our Past Stock Picks (That We Still
Believe In)
15. Stock Price Guidelines
16. 2 Kinds of Cheap: Margin of Safety vs. Annual Return
17. How to Value a Stock: Is It Even Necessary If You Plan to Buy and Hold
Forever?
18. How to Value a Stock: The Power of Peer Comparisons
19. One Ratio to Rule Them All: EV/EBITDA
20. Warren Buffett’s (Modern Day) Margin Of Safety
21. How Do You Estimate A Stock's Intrinsic Value?
22. How Should You Value Journal Communications (JRN)?
23. How Does Warren Buffett Apply His Margin of Safety?
24. Warren Buffett’s Letter to Shareholders – Intrinsic Value
25. 15 Valuation Walkthroughs
26. How to Value a Business
27. Earning Power: Free Cash Flow Margin Variation – Price-to-Sales Ratio
28. On High Normalized P/E Years
29. On Normalized P/E Ratios Over Six Decades
30. On the Difference Between Actual Earnings and Normalized Earnings
31. On Calculating Normalized P/E Ratios
32. On Normalized P/E Effects Over Time
33. On Normalized P/E Ratios and the Election Cycle (Again)
34. On Paying a Fair Price
35. On the Free Cash Flow Margin Method
36. How to Identify Mispriced Stocks
37. DCFs and Probabilities: How to Apply Them in Practice Not Theory
38. When Historical Price Multiples Don't Matter Anymore
39. Buy Great Businesses When the PE Ratio Is Lying to You
40. How to Value a Stock Using Yacktman's Forward Rate of Return
41. Some Stocks Are Almost Always Underpriced
42. How to Value a Stock with No Public Peers
43. How to Practice Valuation
44. Is This Stock Conspicuously Cheap?
45. Should Buy and Hold Investors Worry About EV/EBITDA?
46. Where Does a Stock's Future Return Come From?
47. What Matters More: Today's Value or Tomorrow's Returns?
48. What to Do When Good Stocks Aren't Cheap
49. What Is Your Required Rate of Return?
50. The Most Time Efficient Way to Find Cheap Stocks
51. Value Investor Improvement Tip #1: Settle for Cheap Enough
52. Earnings Yield or Free Cash Flow Yield: Which Should You Use?
53. How to Know a Stock Is Cheap Enough to Buy
54. What's a No Growth Business Worth?
55. Intrinsic Value Estimates: Which P/E is the Right P/E?
56. How Does Warren Buffett Value Growth?
57. Which Price Ratio Is the Right Ratio?
58. How Do You Know When to Sell a Stock?
59. How Do You Estimate a Stock's Intrinsic Value?
60. Warren Buffett's (Modern Day) Margin of Safety
Accounting
Why I’m Biased Against Stock Options
Someone who listens to the podcast emailed this question:
“I’ve heard Geoff speak about not liking management with tons of stock options but preferring
they have raw equity. Could you elaborate on the reasons why? Is it because they have more skin
in the game by sharing the downside with raw equity? Thoughts on raw equity vs equity vesting
schedule?”
This is just a personal bias based on my own experience investing in companies. There is
theoretically nothing wrong with using stock options instead of granting shares to someone. And,
in practice, later hires are pretty much going to need to be given stock options or some other kind
of outright grants. Otherwise, they’ll never build up much equity in the company.
I basically have three concerns about stock options. One is simple enough to sum up in a sentence.
Obviously, CEOs and other insiders are very involved in setting the stock options they get. Other
things equal, the bigger the option grants the more likely insiders are especially greedy. I’m not
sure I want to own stock in a company run by especially greedy people. This might work if you
had active control of the company. But, you’re going to be a passive outside shareholder. You
don’t really have oversight powers as you would as a 100% private business owner. So, especially
greedy insiders are probably ones you don’t want running your company. Big option grants (and
low actual stock ownership) can be a symptom of unchecked insider greed.
Okay. We got the simple one out of the way. Now, let’s get into the more nuanced concerns about
stock options.
My second concern relates to the influence insiders have on the company’s long-term capital
allocation and strategy. The other is simply that I think that from a practical perspective more
wealth can be transferred from owners to operators without a shareholder backlash if done via
options than via cash.
Let’s talk about concern number one first. Concern number one is that insiders given a lot of
options tend not to end up being long-term holders of a lot of stock with a lot of votes attached to
it. Therefore, the incentives for insiders are not as long-term as I’d like and the stability of their
control over the company is not as secure as I’d like.
When I discuss compensation and stock ownership on the podcast – I’m not really talking about
employees. I’m talking about a super select group. My concern is people who are involved – or
could easily become involved – in major capital allocation decisions made at corporate. So,
basically: the board, C-level executives (especially the CEO and CFO), and major shareholders.
At most companies, it’s narrower than this. Most board members are relatively un-influential and
relatively passive. Most major shareholders are institutions that tend to be passive or are
shareholders where this stock alone is not large enough to be relevant to their overall performance.
So, for many companies, nobody outside of the CEO and CFO are even that important to worry
about share ownership. Also, many CEOs and CFOs are career executives (they may move
companies) who aren’t going to serve much more than a 5-year term. Again, this makes them less
relevant in an analysis of possible long-term capital allocation.
Who is more relevant? Any founder who is still around. Insiders who own a lot of stock (and have
a lot of votes). Former executives who are still on the board and still active in the business. And
long-tenured members of the management team. People like that.
Owning a lot of stock that someone is unlikely – or unable – to sell gives them a more long-term
focus. And owning a large proportion of (a voting class) of stock gives them a lot of influence. So,
I am focused on people who actually own stock in a company because these people will have the
greatest influence on major capital allocation decisions in the future. In particular, these people
will have a lot of influence over whether or not to sell the company, recapitalize the company, do
a transformative merger, keep or remove a CEO, etc.
Do I have anything against giving lot of options to people lower in the organization, people who
joined the company later, etc.? No. Especially not at larger organizations. At big companies, the
only people who could potentially have much influence are founders or people connected to
founders who got special classes of stock and kept that stock (so, members of the founding family).
Later hires will never have much voting power. And, any company that gets to a certain size and
lacks a founder who hangs on to his stock and lacks a dual-class share structure is going to be
limited in how much true control insiders of any kind have. If nobody inside a company owns
more than a couple percent of the stock and there is only one class of stock – that company can be
taken over whenever its stock price is weak. There is little insiders can do to stop that.
I am most concerned in situations where the board, top management, etc. have small stock
ownership relative to their compensation and where they have very few votes. These two things
usually go together. So, like a board where everyone is paid $300,000 a year and nobody owns
any stock. That’s concerning because $300,000 a year is definitely large enough to create bad
incentives where the director wants to keep their board seat more than they want to increase the
stock price in the long-run. Having few votes is also concerning, because it means current control
is in the hands of people who can’t necessarily count on continuing control. If the CEO, CFO,
board, etc. don’t own a lot of stock – they are basically just running things up to the point where
shareholders disagree with them. They seem to be in control. But, their control can be tested and
they have no stable support among the shareholder base other than the typical “status quo” bias
that you see in a lot of proxy voting.
More ownership by insiders helps ensure continuity of control and often continuity of capital
allocation, long-term strategy, etc. However: this doesn’t mean it’s good. It just amplifies the
innate goodness or badness the insiders bring to this company. It gives them a freer hand to act for
the long-term. So, if I like management – more ownership by management is better. And, if I don’t
like management – more ownership by management is worse.
There are companies where I’d buy into the stock if management didn’t own so much. But, because
I dislike management and management owns enough stock to have firm, long-term control of the
company – I ignore the stock. Many long-term “dead money” stocks fall into this situation. Value
investors and activist investors would buy into those companies and change management, capital
allocation, and maybe even long-term strategy if they could. But, they can’t. And, so the stocks
remain cheaper than they would be if there weren’t these ironclad takeover defenses combined
with incompetent, dishonest, or self-serving management.
I do want to clear one thing up about stock options though. I really don’t have a problem with a
company like Amazon (AMZN) or something where there is an insider with a large ownership
position who is happy to have a lot of stock options given to employees. This doesn’t concern me.
When it comes to dilution, an outside shareholder is in the same boat as the insider who owns a lot
of stock. If anything, the insider is more biased to being a long-term (almost permanent) holder of
the stock than you as an outside shareholder are. If he thinks he’s getting value for his dilution –
that’s really a business judgment you can agree with or not. But, it’s not a cause for concern in
terms of incentive mismatches between you and the insider.
I don’t want to go through a long list of naming every company where the reverse is true. But, in
the world of micro-caps that I invest in – I can think of cases where a CEO was granted more than
10% of a company and sold more than 10% of a company and still ended his tenure with more
shares than he started it with. In these cases, stock options are often a way to pay out larger bonuses
than shareholders would otherwise be willing to swallow.
The Chief Operating Officer of Meta recently decided to leave the company. Estimates are she
made stock sales of like $1.5 billion or more during her 14 years at the company. That averages
out to more than $100 million a year. It’s just unlikely shareholders would’ve been in favor of
$100 million a year in cash compensation (salary and bonuses). But, they’ll accept it if it’s done
in stock since that is very difficult to quantify.
One way of thinking about this is the market cap of the stock. If you have a $1 billion company
and say you are going to outright grant 1% to 2% a year to top executives – that doesn’t sound like
too much dilution. It sounds roughly right to investors. And they’ll accept it. But, that’s actually
$10 to $20 million a year. For a smaller company to pay that out directly in cash would get more
attention.
But, Berkshire probably does exactly that at some of its operating units. It uses huge cash bonuses
to compensate the heads of some business units with high paid executive type compensation – but,
without any share dilution (just a lot of cash).
There are a few industries where very large cash bonuses have been historically common
(investment banking, advertising, entertainment). I’m honestly less worried about huge cash
bonuses sneaking up on a shareholder versus huge share issuance. Share issuance (whether through
options or any other form) is easier to game in terms of timing and structuring in ways that can
make the wealth transfer from owners to operators especially big. Looking at the last 10-15 years
of a company’s history, I think I can account for large cash payments pretty well. But, if the
company sometimes issues a lot of stock to insiders – that’s something I’d be more worried might
happen in the future to a greater extent than I might predict on the day I buy the stock.



URL: https://focusedcompounding.com/why-im-biased-against-stock-options-2/
Time: 2022
Back to Sections
-----------------------------------------------------
Go Beyond the Financial Statements: Break a Company Down Revenue Line
by Revenue Line
One of the biggest issues I come across when talking with people about specific stocks is that while
we can have a good discussion of bottom-line numbers like earnings – the discussion of items
higher in the income statement is not so good. Andrew and I did a podcast about this recently. It’s
the one where we discussed gross profits. But, it’s not just an issue of gross profits. It’s also an
issue of what are the customer economics like, what are the store economics like, what are the
“unit” economics like. A lot of times, this information is given out by the company – if at all – in
ways that don’t guarantee an easy comparison between two companies. The bottom line figure is
probably comparable (though not always – note, for example, that different companies in the same
industry sometimes depreciate at different rates and so on). However, the way companies discuss
their projections for store level EBITDA of a “model” store or customer level economics are going
to be different. Does this make them less useful? It makes them more susceptible to fudging. You
have to rely more on whether management is being candid, realistic, etc. Is management
promotional? Are they always too optimistic? Are they always too pessimistic? Do the numbers
they give you as projections of how their business model should work line up nicely with reported
results? If not, why not?
These numbers are often more important for the long-term investor than the current earnings
results. Current earnings – and whether they miss or beat analyst estimates and market expectations
– are very important in determining short-term results in the stock. But, they are less important in
determining long-run results. This is because just knowing the bottom line result is less helpful in
projecting the future of the business than in having more detailed trend information.
The same stuff I’ve been saying about the “bottom line” also applies to the “top line”. For example,
OTCMarkets (OTCM) reported results recently. Both bottom line and top line numbers were right
in line with what I might expect. But, the mix of what areas of the business were up a lot and what
areas of the business were flat or down was different than I’d expect. So, it could’ve looked like a
typical quarter if you look only at: revenue, gross profit, operating profit, etc. But, it looked
atypical if you focused in on what specific product lines were up by what percentage amounts over
last year. They had a very bad showing – no growth, actually a bit of shrinkage (which is unusual
for this company) – in the actual number of companies that pay for “corporate services” (sort of
like being listed on OTCM – although, technically, OTCM is not an actual stock exchange).
Meanwhile, revenue that is driven by trading activity grew way more than you’d normally expect.
Now, none of this should’ve come as a huge surprise to me given the level of speculative activity
in U.S. common stocks – including small and more speculative stocks like might make up more
of the volume that benefits OTCM – during the quarter. But, here we have a combination of more
and less cyclical elements. If you had a very cyclical element like something driven by number of
trades done in the quarter up 20% while you had a less cyclical element – like number of stocks
paying for “listing-like” services – down 2%, that’s telling you different things than if those
revenue items were reversed in terms of growth. Imagine a quarter where the more stable, “listinglike” corporate services were up 20%. Well, that would be much more of a long-term positive for
the business than something that is driven by how active or inactive trading is during a given
quarter.
This is also true of price changes. Sometimes, companies give you this information directly. More
commonly, you have to find this information through backing out changes in volume. So, the
company might say that revenue in a certain segment was up 30% while unit growth was 20%. If
there are different products sold in this segment, then you don’t know exactly how much all the
different prices were raised. But, you can guess that the company pushed prices up something like
10% over last year. The importance of such a big price increase differs a lot depending on the type
of business. If Starbucks increases its prices by 6% year-over-year, that price increase is very likely
to stick. If a commodity type product sees a price increase of even 16%, this can be a lot less
meaningful. It’s not likely to last. The company just sells at the market price. And the market price
is volatile.
In some industries, major price increases accompanied by declining unit volume can actually be a
bit of a concern. I saw this recently with one insurer. It had been increasing revenue a bit over time
in a line of business it actually said it was shrinking over time – and had been for years – in terms
of number of policies. It was the company’s goal to reduce the number of policies over time. And
yet revenue wasn’t going down. When you looked a little deeper into this, you could see that the
company was probably increasing its rates for the same coverage by 15-20% a year for several
years in a row – and still, they were probably ending up with more policies than they really wanted.
Eventually, this company announced it was totally abandoning that line of business, because of
severe adverse claims development in that line of business. The fact it was constantly raising rates
in a line of business it kept saying it was trying to rely less and less on can be a hint – for an
insurance company – that it had mispriced these policies in the long ago past and didn’t feel it
could raise rates 100% all at once, and didn’t have the determination to abandon this business
earlier. That’s a rare example where dramatic price increases might not even be a sign of anything
good.
Insurers often give you information on both the revenue in a part of their business and the number
of policies. Again, this isn’t giving you exact information on rate increases. But, in broad strokes
– it’s giving you a lot of useful info. If revenue is rising 10% a year in most years and policies are
rising 12% a year in most years – it’s clear they aren’t really increasing or decreasing rates much
at all. So, the amount of risk they are taking in a given line of business is increasing rapidly through
actually having a lot more customers at much the same pricing. This is very useful information to
know. And it’s the reason why you want to read 10-Ks, 10-Qs, investor presentations, and even
other regulatory filings. You can get a better feel for the actual kind of growth the company is
experiencing.
What is the best kind of growth? Some ability to constantly raise prices on existing customers is
usually good. Some ability to increase the value of each order from a customer in terms of not just
pricing but also physical volume is usually good. And then growing the number of customers who
are similar to existing customers is also good. Getting entirely new kinds of customers can be very
good for the long-term, but it’s the kind of thing you need to analyze. Are these customers going
to be – over their entire lifetime – much better, much worse, etc. than existing customers? This can
show you how a company is likely to change for better or worse. It’s a leading indicator of what
things like returns on equity will be in the future.
Bottom line numbers are easiest to analyze for a couple different types of companies. One, very
diversified companies. If companies have a lot of very small customers paying them in a lot of
different ways – it’s unlikely things will change dramatically in enough segments to throw off the
earnings trend you’ve seen. But, be careful with this. This is why it’s difficult to analyze the
“quality of earnings” of companies like General Electric (GE). What is often happening is some
very bad stuff in one segment and some very good stuff in another segment. But, this doesn’t get
much discussion from the company, because the net effect of it doesn’t take the earnings trend for
the whole company very far off what was expected. It doesn’t draw analyst or investor attention.
So, there isn’t enough discussion of what is going well and what is going badly.
The other kind of company where focusing on just the top line and the bottom line is the exact
opposite of a diversified company – it’s a very focused company. The reason why it’s easy to
analyze these companies using just top line and bottom line is that the economics of the whole
company are very similar to the economics of any one product, one customer type, etc. So, it’s the
opposite situation from a diversified company. As soon as big successes or big failures happen in
a given line of business – because that line of business is nearly 100% of the company – investors
are instantly alerted to it. If a company relies on a small number of products, customers,
geographies, etc. – you’ll see some evidence of changes in any of the economics of those products
and places in the top and bottom line for the entire company.
Companies in transition that have say 3-4 major segments are the hardest to analyze using top and
bottom line information. It can be very deceptive. The best example I can give of this happening
is what Babcock & Wilcox (read my old report in the Focused Compounding Stocks A-Z section
for details) looked like before its spin-off. The company had a very successful and very
consistently growing nuclear business focused on the U.S. Navy, it had a much more cyclical and
slower growing (and sometimes much less successful) business focused largely on coal power
plants, and then it had what was basically a very big money-losing start-up betting on experimental
technology all housed in a single company. When you screened this stock, it didn’t show up as
super cheap as a stock or super successful as a business. It looked very mixed overall. It was mixed.
But, just “overall”. Not individually. Individually you had some very good parts and some very
bad parts. Eventually, they were separated out.
Much the same was true in the write-ups I did on Libsyn (LSYN) for the Focused Compounding
website (again, you can find these in the stocks A-Z section of the website). There, you have
essentially one business segment that has been a very consistent grower. That business is the
podcast hosting revenue that comes from fees charged to podcasts in the form of sort of flat
monthly fees and more variable (but still very predictable) bandwidth fees. Libsyn breaks its
business down into two segments. Pair is a website hosting company (which obviously grows
MUCH slower than podcast hosting). Libsyn is the podcast host. But, you actually have to break
things down one level further. Libsyn gets a revenue share on advertising inserted into the podcasts
it hosts. This ad-supported model is very different – and much more cyclical – than the flat fee and
bandwidth sales taken directly from podcast hosts. So, looking at numbers like the active number
of shows on the platform, the number of episodes, the total monthly audience size of all their
podcasts etc. can give you a better idea of the long-term trend in the company’s intrinsic value
than you’d get from including big up and down years from the ad business. If you separate out the
lines of business producing the actual free cash flow – you get a much better idea of the business’s
momentum (whether positive or negative) than you would from just looking at the statement of
cash flows for the whole company. That’s why you need to not just use QuickFS.net. Start with
QuickFS.net. But, then read the 10-Ks and 10-Qs and the investor presentations and the earnings
call transcripts and put them all together to analyze the company business line by business line.



URL: https://focusedcompounding.com/go-beyond-the-financial-statements-break-acompany-down-revenue-line-by-revenue-line/
Time: 2020
Back to Sections
-----------------------------------------------------
Is Negative Shareholder Equity a Good Thing or a Bad Thing? – No, It’s an
Interesting Thing
Someone emailed me this question:
“…how do you consider negative shareholder equity? Is this good, bad or other?”
Before I give my answer, I apologize to the roughly 60% of my audience that I know is made up
of non-Americans. I’m about to use a baseball analogy.
Like Warren Buffett has said: the best businesses in the world can be run with no equity now.
I’ve invested in companies with negative equity. Most notably, IMS Health in 2009.
I would always notice negative shareholder equity. It would make me more likely to want to
learn about the stock – because it’s odd.
Remember, you are looking for extraordinary investment opportunities.
We can break that search into two parts: “extra”+”ordinary”.
Sometimes, we know whether something is a “plus” or a “minus”. Other times, we only know
it’s an anomaly without knowing whether it’s “good odd” or “bad odd”.
As an investor, you always want to investigate anomalies. However, you don’t always want
to invest in anomalies. There’s a difference.
Say we’re searching for a good or even a “great” stock. The first thing we know for sure about
this hypothetical good or great stock we haven’t yet found is that it’s not ordinary.
Negative shareholder equity is very not ordinary.
In the past, I’ve compared negative shareholder equity to the number of strikeouts a Major
League batter has.
We know high strikeout rates are good for a pitcher.
However, there is considerable debate about whether high strikeout rates are good or bad for a
batter.
Theoretically, it’s better to have positive equity than negative equity. For example: if IMS Health
looked exactly like it did when I found it plus it had billions in extra cash on the balance sheet –
that’d be better.
But, that’s like saying it’s better to have a stock with a 17% growth rate and a P/E of 7 rather
than just a P/E of 7. In the real world: a P/E of 7 is plenty interesting all on its own.
And, using our baseball analogy: Theoretically, it’s always better to have not struck out rather
than struck out (excluding the possibility of double-plays).
Yes, if Babe Ruth had the same number of home runs plus some of his strike outs were instead
balls he put into play – he’d be an even better batter. But, let’s face it: if your job was picking the
right guy to have on your team – identifying the next Babe Ruth is all you need to do.
So, let’s forget theory for a second. Let’s look at the cold, hard facts.
What does the data say?
The data actually says that some of the best batters in Major League history had unusually high
strike out rates.
And the data says that some of the best stocks around have unusually low shareholder’s equity.
So, if I’m a general manager who sees a batter with an absurd number of strike outs, I know I
want to learn more. I don’t know I want to trade for this player. But, I know my eye is drawn to
this statistical anomaly.
And, if I’m a value investor who sees a stock with an absurdly low amount of shareholder equity,
I know I want to learn more. I don’t know I want to buy the stock though.
Why?
Because a batter with a high strikeout rate could just be an absurdly bad batter. It’s unlikely he’d
get this far if he was – but it’s possible.
And a public company with a low amount of shareholder equity could just be a distressed
company.
So, when you see a stock with negative shareholder equity, imagine it’s shouting “Research me!
Research me!”. Don’t imagine it’s shouting “Buy me! Buy me!”
I can’t say negative shareholder equity is always good or always bad. I can say it’s always worth
investigating.



URL: https://focusedcompounding.com/is-negative-shareholder-equity-a-good-thing-ora-bad-thing-no-its-an-interesting-thing/
Time: 2017
Back to Sections
-----------------------------------------------------
Looking for Cases of Over-Amortization and Over-Depreciation
A blog I read did a post on goodwill. The discussion there was about economic goodwill. I’d like
to talk today about accounting goodwill – that is, intangibles. Technically: accounting goodwill
applies only to intangible assets that can’t be separately identified. In other words, “goodwill” is
just the catch-all bucket accountants put what’s left of the premium paid over book value that
they can’t put somewhere else.
For our purposes though, accounting for specific intangible items is often more interesting than
accounting for general goodwill. That’s because specific intangibles can be amortized. And
amortization can cause reported earnings to come in lower than cash earnings.
Unequal Treatment
The first thing to do when confronting a “non-cash” charge is to figure out if it is being treated
equally or unequally with other economically equivalent items.
I’ll use a stock I own, NACCO (NC), as an example. As of last quarter, NACCO had a $44
million intangible asset on the books called “coal supply agreement”.
The description of this item (appearing as a footnote in the 10-K) reads:
“Coal Supply Agreement: The coal supply agreement represents a long-term supply agreement
with a NACoal customer and was recorded based on the fair value at the date of acquisition. The
coal supply agreement is amortized based on units of production over the terms of the
agreement, which is estimated to be 30 years.”
All of NACCO’s customers are supplied under long-term coal supply agreements which often
had an initial term of 30 years. These agreements are economically equivalent. However, one of
the agreements is being treated differently from the rest.
The amortization of this coal supply agreement is probably meaningless.
Why?
Because: if NACCO acquired a company that had a 29-year coal supply agreement in place, it
would record this item on its books as an intangible asset and it would amortize it over the life of
the contract. But, if NACCO itself simply signed a coal supply agreement with a new customer –
no intangible asset would be placed on the books. And there would be no amortization. What’s
the difference between creating a contract and acquiring a contract?
There is none.
Now, that doesn’t mean the economic reality is that NACCO’s earnings never need to be
replaced. Many of the contracts NACCO has in place only run for about 13-28 years now. And,
far more importantly, the power plants NACCO supplies with coal might close down long before
their contracts expire. So, earnings really will “expire” and need to be replaced. But, this has
nothing to do with whether a certain coal supply agreement is or is not being amortized. The
amortization charge is irrelevant. But, the limited remaining economic lifespan of NACCO’s
customers – which isn’t shown anywhere on NACCO’s books – is relevant.
Therefore, two adjustments need to be made. One, amortization has to be “added back” to
reported EPS to get the true EPS for this year. And, two, that EPS number has to be considered
impermanent.
Depreciation (Unlike Amortization) is Usually a “True” Expense
A depreciation charge is used to smooth out the expensing of an initial cash outlay (the purchase
of a long-lived asset) so that the timing of expenses and revenues match.
Depreciation charges are not used to pre-expense the purchase of a replacement asset.
Depreciation charges are only used to post-expense the purchase of an asset now in use.
Because of inflation, a replacement asset will almost always cost more than the original asset.
Therefore, depreciation expenses – unlike the amortization expense above – are not only
economically necessary, they are also almost always insufficient to fund the replacement.
As a rule, the annual depreciation expense you see at a company – like the Carnival
(CCL) example I will give below – “underfunds” the amount needed to replace the asset. In
other words, the more depreciable assets appear on a company’s balance sheet – the more that
company’s earnings are likely to be overstated.
Usual Assumptions
A change in the assumptions a company uses to calculate depreciation will change reported
earnings. Here is a cruise line, Carnival, explaining how a small change in depreciation
assumptions can cause a large change in reported earnings:
“Our 2015 ship depreciation expense would have increased by approximately $40 million
assuming we had reduced our estimated 30-year ship useful life estimate by one year at the time
we took delivery or acquired each of our ships. In addition, our 2015 ship depreciation expense
would have increased by approximately $210 million assuming we had estimated our ships to
have no residual value at the time of their delivery or acquisition.”
Carnival’s depreciation assumptions are generally reasonable. The company always overstates its
economic earnings, but only because of inflation. Management is not gaming either the estimated
useful life of a cruise ship to Carnival (30 years) or the fact that cruise ships have residual value
after the initial owner is done with them. There really are buyers for retired Carnival cruise ships.
So, each ship has a residual value. There is nothing unusual about these assumptions.
Can Depreciation Ever Be an Exaggerated Expense?
There are, however, company’s that make unusual assumptions. Gencor (GENC) is one such
company.
In the company’s 10-K, “Note #4” reads:
“Property and equipment includes approximately $10,645,000….of fully depreciated assets,
which remained in service during fiscal 2017…”
This is significant, because the total amount of “property and equipment, net” is shown to be
$5.7 million.
Move Up the Income Statement
Distortions caused by accounting assumptions usually appear lower down in the income
statement. So, an investor who is worried about misleading expenses can use an item like
EBITDA instead of net income. This takes out the complications of assumptions and one-time
items related to interest, taxes, depreciation, and amortization. If EBITDA seems high and net
income seems low – you want to investigate where that EBITDA is disappearing to. Are these
real depreciation charges? Are these irrelevant amortization charges?
The Earnings You Care About Come in the Form of Cash
The key question to ask about any accounting item is whether it will eventually become a cash
charge.
To an accountant: whether a company paid cash for the asset in the past matters. For an investor:
only whether a company will ever have to pay cash again in the future matters.
Carnival is going to buy more ships each year. It spends billions doing that. So, while you own
the stock, cash is going to be headed out the door and ships headed in the door.
The same thing would be true if NACCO’s business really consisted of buying existing coal
supply contracts. If, while you owned the stock, your expectation was that NACCO would be
using cash to purchase intangibles – then, that amortization charge would make a lot more sense
as an ongoing expense.
In reality, the company probably isn’t going to be buying more intangibles while you own the
stock. And: earnings from supplying coal to existing customers will “expire”, but it’ll be the shut
down of the power plants – not the expiration of the contracts – that causes this.
You always want to focus on economic reality rather than the accounting treatment. So, you
want to think in terms of how much cash Carnival will spend buying ships rather than how much
depreciation expense it will report.



URL: https://focusedcompounding.com/looking-for-cases-of-over-amortization-and-overdepreciation/
Time: 2017
Back to Sections
-----------------------------------------------------
EBITDA and Gross Profits: Learn to Move Up the Income Statement
“In lieu of (earnings per share), Malone emphasized cash flow…and in the process, invented a
new vocabulary…EBITDA in particular was a radically new concept, going further up the
income statement than anyone had gone before to arrive at a pure definition of the cash
generating ability of a business…”

William Thorndike, “The Outsiders”
“I think that, every time you (see) the word EBITDA you should substitute the word bullshit
earnings.”

Charlie Munger
The acronym “EBITDA” stands for Earnings Before Interest, Taxes, Depreciation,
and Amortization.
A company’s EPS (which is just net income divided by shares outstanding) is often referred to as
its “bottom line”. Technically, EPS is not the bottom line. Comprehensive income is the bottom
line. This may sound like a quibble on my part. But, let’s stop and think about it a second.
If EBITDA is “bullshit earnings” because it is earnings before:




Interest
Taxes
Depreciation and
Amortization
Then shouldn’t we call EPS “bullshit earnings”, because it is earnings before:



unrealized gains and losses on available for sale securities
unrealized currency gains and losses
and changes in the pension plan?
I think we should. I think both EBITDA and EPS are “bullshit earnings” when they are the only
numbers reported to shareholders.
Of course, EPS and EBITDA are literally never the only numbers reported to shareholders. There
is an entire income statement full of figures shown to investors each year.
Profit figures further down the income statement are always more complete – and therefore less
“bullshit” – than profit figures further up the income statement.
So:




EBITDA is always less bullshit than gross profit.
EBIT is always less bullshit than EBITDA.
EPS is always less bullshit than EBIT.
And comprehensive income is always less bullshit than EPS.
Maybe this is why Warren Buffett uses Berkshire’s change in per share book value (which is
basically comprehensive income per share) in place of Berkshire’s EPS (which is basically net
income per share). Buffett wants to report the least bullshit – most complete – profit figure
possible.
So, if profit figures further down the income statement are always more complete figures, why
would an investor ever focus on a profit figure higher up the income statement (like EBITDA)
instead of a profit figure further down the income statement (like net income)?
Senseless “Scatter”
At most companies, items further up the income statement are more stable than items further
down the income statement.
I’ll use the results at Grainger (GWW) from 1991 through 2014 to illustrate this point. The
measure of stability I am going to use is the “coefficient of variation” which is sometimes also
called the “relative standard deviation” of each series. It’s just a measure of how scattered a
group of points are around the central tendency of that group. Imagine one of those human
shaped targets at a police precinct shooting range. A bullet hole that’s dead center in the chest
would rate a 0.01. A bullet hole that winged the shoulder might rate a 0.50. The bullet holes here
are specific annual results.
Let’s look at the variation in Grainger’s margins from 1991 through 2014:



Gross margin: 0.10
EBITDA margin: 0.16
EBIT margin: 0.19
What do these numbers tell us?
Well, the annual bullet holes for EBIT are 19% more scattered (0.19/0.16 = 1.19) than the bullet
holes for EBITDA. The only difference between EBIT (Earnings Before Interest and Taxes) and
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is D&A
(Depreciation and Amortization). What we are seeing here is a meaningful amount of year-toyear “scatter” caused simply by accounting entries for depreciation and amortization.
As long-term investors, do we really want to focus on that kind of scatter in the year-to-year
results? Is the underlying (25-year) trend in Grainger’s EBITDA and EBIT really any different?
If not, should we even look at depreciation and amortization?
I don’t think so. I think including D&A in Grainger’s year-to-year results just makes the longterm trend in economic earnings more “noisy” and less clear.
And that “noise” I’m complaining about comes just from the difference between EBITDA and
EBIT. What if we move even further up the income statement?
Well, operating profit (EBIT) varied 90% more (0.19/0.10 = 1.9) than gross profit. So what?
Who cares about gross profit?
I do.
In fact, at Grainger, I believe it is more useful to focus on the trend in gross profit than the trend
in operating profit (EBIT). And there’s research to back me up on this.
Profit Persistence
“Gross profits is the cleanest accounting measure of true economic profitability.”

Robert Novy-Marx
A professor at the University of Rochester, Robert Novy-Marx, wrote a paper that showed
investing in companies with persistently high profitability is a winning investment strategy.
To prove his point, Novy-Marx didn’t use return on equity. Return on equity uses net income in
its numerator. Novy-Marx used gross profitability. That measures puts assets in the denominator
and gross profits (the profit line furthest up the income statement) in the numerator.
Here’s the reason Novy-Marx gave for using gross profits:
“Gross profits is the cleanest accounting measure of true economic profitability. The farther
down the income statement one goes, the more polluted profitability measures become, and the
less related they are to true economic profitability. For example, a firm that has both lower
production costs and higher sales than its competitors is unambiguously more profitable. Even
so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its
sales though aggressive advertising, or commissions to its sales force, these actions can, even if
optimal, reduce its bottom line income below that of its less profitable competitors. Similarly, if
the firm spends on research and development to further increase its production advantage, or
invests in organizational capital that will help it maintain its competitive advantage, these
actions result in lower current earnings.”
I’m sure the 8 CEOs profiled in William Thorndike’s “The Outsiders” would agree. All of these
CEOs focused on compounding the per share intrinsic value of their stock without regard to how
much of that added value they’d actually be able to report in earnings per share.
John Malone: Why EBITDA Matters
Let’s start with John Malone:
“Malone pioneered the active use of debt in the cable industry. He believed financial leverage
had two important attributes: it magnified financial returns, and it helped shelter TCI’s cash
flow from taxes through the deductibility of interest payments. Malone targeted a ratio of five
times debt to EBITDA and maintained it throughout most of the 1980s and 1990s.”

William Thorndike, “The Outsiders”
Here we see an “outsider” type CEO focusing on a profit line – EBITDA – further up the income
statement, because of two things he believed he could control:
1. How much his company pays in taxes and
2. How much shareholder money he has to use per dollar of corporate assets.
In other words, Malone believed that if he achieved the same EBITDA divided by assets as the
rest of the cable industry – his stock would outperform their stocks, because:
1. TCI would pay less of its EBITDA out in taxes and
2. TCI’s shareholders would control more assets per dollar of their own equity
In this way, Malone wouldn’t have to change the basic, inherent economics of the cable business
– EBITDA/Assets – to get a better compound result for his stock than the rest of the industry.
This story provides us with a warning. It would be fairly safe to assume that the rate of
EBITDA/Assets at TCI would be the same regardless of who controlled capital allocation at the
company. It would not be safe to assume that anything further down the income statement than
the EBITDA line would stay the same regardless of who was in charge. The same cable system
in someone else’s hands – not Malone’s – might earn the same EBITDA/Assets, but it would
definitely earn a lower return on equity (Net Income / Equity). TCI as a corporation would be
more financially efficient with Malone than without Malone even if the inherent efficiency of the
company’s cable assets (EBITDA/Assets) was something Malone could never change.
This can be stated as a general rule:
The further up the income statement you go, the more you learn about the inherent economics
of a business. The further down the income statement you go, the more you learn about the
people who run the business.
With that in mind, let’s take a look at Tom Murphy and Capital Cities.
Tom Murphy: Why Operating Expenses are Optional
“The core economic rationale for the deal was Murphy’s conviction that he could improve the
margins for ABC’s TV stations from the low thirties up to Capital Cities’ industry-leading levels
(50-plus percent)…the margin gap was closed in just two years.”

William Thorndike, “The Outsiders”
This is the same reason 3G is willing to bid such high multiples of earnings and EBITDA for the
companies it takes over. 3G doesn’t care what the current earnings and EBITDA of a company
are. 3G only cares what the current sales level is. There isn’t much 3G can do to grow unit
volumes in beer or ketchup or cheese. There is a lot 3G can do to cut costs at headquarters, in the
factories, and on the delivery routes.
“Murphy and Burke realized early on that while you couldn’t control your revenues at a TV
station, you could control your costs.”

William Thorndike, “The Outsiders”
The same is true at food and beverage companies. The market power of Budweiser and Heinz
and Kraft is what it is regardless of who controls those brands. But, the operating expenses at
Budweiser and Heinz and Kraft are lower under 3G’s control than they would be under anyone
else.
So, which earnings measure is the right measure?
1. Is comprehensive income a better measure than net income?
2. Is EBITDA really “bullshit earnings” the way Charlie Munger says it is?
3. And: does gross profit tell you more about a business’s competitive position than net
profit?
There is no “right” measure of earnings for all purposes. To get the full record of what exactly
the company you own stock in earned this year – comprehensive income is the best measure. To
know the “pure cash generating ability of a business” – EBITDA is the best measure.
And to measure the thing I care most about…
Market Power and Gross Profits
No line on an income statement can tell you what a business’s market power is. But, if there was
one such line – it would be gross profits.
If you’ve read my mental model post, you know I define market power as:
“… the ability to make demands on customers and suppliers free from the fear that those
customers and suppliers can credibly threaten to end their relationship with you.”
Market power generates gross profits. Market power doesn’t necessarily generate net profits. A
business with market power can be managed efficiently or inefficiently below the gross profit
line. As an example, Capital Cities’ local TV stations and ABC’s local TV stations had exactly
the same market power pre-merger. All of those stations were affiliates of a major network, were
part of a local oligopoly (with an ABC, NBC, and CBS affiliate controlling most of the local TV
ad market), and negotiated with the same advertisers when selling their air time. ABC’s local TV
stations had an EBITDA margin around 30%. Capital Cities’ local TV stations had an EBITDA
margin around 50%. After Capital Cities merged with ABC, the ABC stations went from a 30%
EBITDA margin to a 50% EBITDA margin.
Why?
Because those costs were all internal to the business. External prices and costs are determined
largely by market power (over customers and suppliers respectively). While internal expenses
are determined largely by managerial will.
Revenue is a much higher line on the income statement than EBITDA. And yet, revenue was the
right line to use in valuing ABC if you knew Capital Cities was going to buy ABC.
That’s the key to knowing which earnings measure to use. The inherent economics of a business
are what matters to an acquirer who is willing to slash costs. For Capital Cities and 3G, the
numbers that matter are revenue and gross profit. Reported earnings don’t matter in a takeover.
But, what about you?
You’re a passive, long-term investor. Which profit measure should you focus on?
As a long-term investor in a specific business in a specific industry – I think gross profitability
(Gross Profits / Assets) matters most.
And as a long-term investor in a specific capital allocator running a specific corporation – I think
EBITDA matters most.
The business’s long-term destiny is tied to its market power. The capital allocator’s long-term
destiny is tied to the capital he gets to deploy.
I’ll leave you with 3 key takeaways:
1. Gross profitability is the best indicator of market power
2. Profit figures higher in the income statement tell you about the economics of the
business; profit figures lower in the income statement tell you about the CEO’s skill
3. There is no “right” measure of profitability. Learn to use them all.
Finally, when betting on lasting business quality – think in terms of gross profitability. And
when betting on lasting managerial quality – think in terms of cash flow.
Everyone focuses on EPS. By moving up the income statement, you’ll be moving out of the
herd.



URL: https://focusedcompounding.com/ebitda-and-gross-profits-learn-to-move-up-theincome-statemen/
Time: 2017
Back to Sections
-----------------------------------------------------
Why We Can’t Use Owner Earnings to Talk about Stocks
Someone sent me an email asking about a post I did a while back called One Ratio to Rule Them
All: EV/EBITDA.
If I had to use an off the shelf ratio – EV/EBITDA is the one I’d use. Owner earnings matter
more. But owner earnings is a tough number to agree on. It’s not something you can screen for.
All price measures are flawed. None approximates the actual returns a business earns. What we
are always interested in is the value a company delivers over a year. That is the company’s real
earnings regardless of what is reported in terms of net income, EBITDA, free cash flow, book
value growth, etc.
It’s Not That EV/EBITDA is So Good – It’s that P/E is so Bad
My point about using EV/EBITDA is that no price measure actually works well in individual
cases. But if you are eliminating some stocks on the basis of a price ratio – for example, you are
saying a price-to-earnings ratio of 22 is too high so you won’t even start researching such a
stock, you can never actually calculate the value ratios that matter.
Let’s look at Carnival (CCL).
How Should Investors Define Earnings
What does this company earn?
For me, Carnival’s earnings are neither EBITDA nor net income. They are:
Cash Flow From Operations
– Maintenance Capital Spending
= Cash available to add passenger capacity, acquire other companies, pay down debt, buy back
stock, and pay dividends
That’s earnings. It’s the cash you collected in excess of what you need to spend in cash to collect
the same amount of cash next year. It’s a sustainable level of cash flowing through the business.
How is this different from EBITDA?
Carnival’s depreciation expense does not match its capital spending requirements. By my
estimates, about 20 years ago, the company was charging off less in depreciation than was
actually needed to maintain its competitive position in the industry, have the same number of
passenger nights, etc. In its most recent year, this was perhaps no longer true.
It’s a complicated issue. A lot of different facts go into deciding just how much CCL needs to
spend to maintain its competitive position and its passenger capacity.
But how do we know what Carnival’s maintenance cap-ex needs are?
We can’t know that until we start researching the company. In fact, it’s not that easy to know
until we read about current shipbuilding contracts from CCL, RCL, and NCL. Until we look at
what the average real cost per new berth (think of it as 2 cruise berths = 1 hotel room) for CCL,
RCL, etc.
Maintenance Cap-Ex is a Complicated Issue
At most companies, it’s very hard to determine maintenance cap-ex. I’m actually cheating by
talking about Carnival. Cruise ships are easily identifiable long-lived assets that change hands in
control transactions, etc. I’m pretty close to analyzing buildings here.
I mean, they give these ships names. I can trace their history from company to company. We
know who built them and what they charged. How the deal was financed.
A lot of companies have much more complicated cap-ex calculations. How do decide if a
grocery store, Chipotle location, movie theater, etc. You don’t always replace these things
because they’ve become deathtraps. And you often can’t sell them in the same form you own
them. To renovate an existing theather costs one thing. To sell the building to someone who
might use it for a totally different purposes costs something else.
An Unfairly Simple Example: How Much is the Maintenance Cap-Ex of a Cruise Ship?
How long have ships been in service in the past? This requires some basic knowledge of the
industry’s history. Especially knowledge of the history of these companies before they went
public. That means it helps to know some cruise history from before the 1987-1989 period when
Carnival went public, the Pritzkers invested in Royal Caribbean (and Richard Fain took over),
etc.
CCL was the most profitable cruise line by far at the time it went public. Royal Carribean and
Carnival look similar on the outside at the time. Inside, the numbers told a very different story. In
fact, Royal Caribbean’s management used Carnival’s proxy statement internally and tried to
figure out how they could mimic what CCL was doing. They used it to try to motivate changes
inside their own company under the idea that if CCL could achieve these margins, etc. so could
they. Over the next 25 years, that never really panned out.
To this day, analysts sometimes mention buying RCL as a better way to make money on a
rebound in the cruise business because RCL has more room for improvement than CCL. That’s
true. But it’s also been true for well over 25 years.
What does this have to do with maintenance cap-ex? It’s worth remembering that at the time
CCL went public, RCL had a newer fleet than CCL. Even today, RCL has the absolute best new
ships – and still earns less on the whole fleet. CCL has spent heavily on new ships at times in its
past. But even when it was operating older ships, it made a lot of money. There’s obviously a
competitive disadvantage if you fall far behind in terms of having enough great new ships. But
the evidence is that these ships can age a lot further – both CCL and RCL’s – without spending
at the rate these companies were spending on new capacity in the late 90s and early 2000s.
How old were some of the ships at the time Carnival went public?
How old are ships today?
What kind of returns do you earn on old and new ships? How much of a premium is there on
something like Oasis when it first comes out? Does this disappear within 10 years, within 5
years? Do you keep it in service for 15 years, 20 years, 30 years?
Do you sell it to a third rate cruise line once you are done with it? Are there enough minor cruise
lines left to buy ships from you? Or do you keep moving it into less and less mature brands? For
example, do you move a ship from Carnival over to Costa and then sell it to Pullmantur. This
actually happened with what was once a major new ship CCL had built. They moved it over
from Carnival which is an American line they own and the line the ship was actually built for
over to Costa when the ship was considered too old for Carnival and then it was sold by Costa to
Pullmantur which is a Spanish line. RCL eventually bought Pullmantur. And they didn’t stop
using that ship. So you can trace the life of a ship that was built decades ago as something big
and nice and new for Carnival into something very outdated but still operated by a Spanish cruise
line owned by one of the two big cruise companies.
This matters a great deal in the case of CCL and RCL.
Depreciation vs. Maintenance Cap-Ex
Once we’ve considered those issues we need to answer: How realistic is depreciation?
You need to check the note on property and equipment. But would you have even gotten to read
about the company, checked this note, etc. if you had been screening on the basis of something
like P/E ratios?
Probably not. For Carnival, neither a P/E screen nor an EV/EBITDA screen would’ve gotten you
interested in the company. So, once again, we see that all price ratios are flawed at least some of
the time.
Anyway, the note for CCL gives you the following key facts:





Existing ships had gross value of $39.764 billion
Ships under construction had gross value of $526 million
Everything else had gross value of about $1.9 billion
Accumulated depreciation was $10.15 billion
So book value of PP&E is about $32 billion
In other words, the vast majority (94%) of gross PP&E is existing ships. And this is really the
only number that matters in calculating maintenance cap-ex. So how much does CCL have to
spend on cap-ex on its existing fleet to keep its passenger capacity and competitive position
steady?
That’s a complex problem.
Let’s deal with a simple problem first. How does Carnival account for depreciation of its fleet?
We can get that info from the 10-K. It says they use a 30 year lifespan for ships and 15% residual
value.
So, for example, a ship that costs $1 billion to build today will have depreciation that looks
something like:


$28.33 million in depreciation every year for the next 30 years
$150 million in residual value in 2042
Carnival will obviously improve a $1 billion ship many times over its 30 year assumed life. And
these improvements will be depreciated differently.
Let’s look at how much CCL actually depreciates on a corporate basis. At the end of 2010,
PP&E was $30.967 billion. At the end of 2011, PP&E was $32.054 billion. So let’s call average
PP&E for the year $31.51 billion. Depreciation was $1.522 billion. That’s 4.8% of PP&E.
How accurate is that?
Setting aside inflation – which GAAP accounting doesn’t deal with – I actually think it’s fine. I
think they are pretty close to depreciating the right number of berths – if you want to think about
it that way – each year.
The idea that about 4% to 5% of the company’s property needs to be replaced each year is about
right. The idea that you can replace property carried at 1992 prices in 2012 is clearly wrong.
This can be fixed several ways. For CCL and RCL, my preferred way of treating maintenance
cap-ex is to take corporate passenger capacity (number of berths) and multiply that number by
1/estimated useful life of a berth.
So, if a new ship has a life of 25 years and 1,000 berths we take 1,000 times 1/25 = 1,000 * 4% =
40 berths. That is what maintenance cap-ex is. It’s the real cost of replacing 40 berths per year. If
we assume it costs $230,000 to replace one berth we then calculate economic – not accounting –
depreciation on the ship as $9.2 million a year. This is a real number. In future years, it will rise
with inflation. There is no tendency for new ship costs to rise faster than inflation for CCL or
RCL. Prices in real terms have been steady for decades if you exclude momentary global spikes
in input costs for the shipbuilders – these do happen, but 3 years later they have vanished, etc.
In essence, the first $9.2 million in cash flow this ship generates needs to be set aside to replace
the ship at the end of its life. Only after the ship generates more than $9.2 million in annual real
cash flow is it more than paying for itself.
Even EBITDA is Misleading Sometimes
Once we have this number for a cruise company’s entire fleet we can calculate free cash flow as:
Cash Flow From Operations
– Maintenance Cap-Ex
= Free Cash Flow
Why don’t we use EBITDA?
EBITDA is a bad proxy for economic earnings at a cruise company because cruise companies
have:


No tax expense
Negative working capital
What’s the Value of Cash That’s Been Collected – But Hasn’t Been Earned?
Cruise companies generate “float”. Deposits are collected long before ships sail. And this is
permanent money. In fact, it’s been a permanent source of funding for Carnival since before
Carnival was even Carnival.
The cruise company now known as Carnival was created by Ted Arison (Micky’s father) using
the float he had collected for Norwegian Cruise Lines. This float was the source of the dispute
that caused the separation between Arison and Norwegian and lead to the creation of Carnival.
It has always been very significant to the cruise industry that working capital needs are less than
zero. This means that growth is almost entirely dependent on the availability of ships, credit for
financing ships, etc. Because otherwise growth costs less than nothing – it actually produces cash
up front.
In fact, until Carnival was ready to go public, the company relied more on working capital
management – generating float and paying all bills as slowly as possible – to fuel growth.
Around the time the company went public – in 1987 – they realized they had reached the
stability of cash flows, size, etc. where it was just easier to focus on having an investment grade
credit rating and borrowing on a permanent bond basis instead.
In truth, even a company like Carnival – who can issue plenty of bonds if they want to – is
largely funded through generous ship financing guaranteed by European governments (Finland,
Germany, etc.) who subsidize their shipyards plus the float from Carnival’s own passengers to
be.
So, at the end of the day I get a number for CCL in terms of free cash flow that is very, very
different from what would be suggested by either EBITDA or net income.
In this example Carnival – which I believe to be selling for a low double digit ratio of price to
owner earnings – would appear on both EV/EBITDA screens and P/E screens as if it was trading
at a high teens to low 20s type P/E ratio. That’s because EV/EBITDA comparisons to other
companies don’t work because other companies pay taxes and Carnival does not. And neither net
income nor EBITDA take cash flow dynamics into account.
How Cash Flows Through a Business is Very Important
The way cash flows through Carnival is very favorable for shareholders. The fact it is not taxed
is even more favorable. This combination leads to a very reasonable owner earnings based P/E
ratio in my mind even while neither EV/EBITDA nor P/E captures this.
So why not use some standard calculation of owner earnings instead of either EV/EBITDA or
P/E?
Owner Earnings are the Most Relevant Number – And the Least Objective
Even now – I bet a lot of people disagree with my calculation of Carnival’s owner earnings.
Perfectly reasonable analysts, investors, etc. may calculate Carnival’s owner earnings divided by
price as being in the high teens to low 20s. Just like a simple P/E ratio.
I think they are wrong. But it’s a judgment call. Reasonable people can say the useful life of a
cruise ship is 20 years and that the ship has no residual value or that it’s useful life is 30 years
and the ship has a 15% residual value. Reasonable people can say the cost per berth used in
calculating what needs to be replaced should be what RCL is paying today, what NCL is paying
today, what CCL is paying today, the average real cost of what the whole industry has paid on
average over the last 20 years, etc. All of these are perfectly reasonable ways to model
maintenance cap-ex. But they’re different assumptions. And different assumptions result in
different estimates of owner earnings.
Reasonable people can disagree over whether “float” is permanent money that should be treated
just as if it was earned, money that should be treated as having some value but less value than if
it was earned, or money having no value at all – simply the same as adding debt to the balance
sheet on one side and cash on the other.
Can We Use Numbers We Don’t Agree On?
If my assumptions are:



Useful life of ship: 30 years; residual value: 15%
Replacement cost per berth:$190,000
Float: As good as earned
And your assumptions are:



Useful life of ship: 20 years; residual value: 0%
Replacement cost per berth: $240,000
Float: As bad as owed
We will get totally different calculations of owner earnings.
Normalizing Earnings is Even More Subjective
And this doesn’t even deal with truly contentious normalization questions like:



Taxes
Fuel costs
Demand
Is a tax rate of very nearly 0% really sustainable? Or is it fair to assume CCL, RCL, etc. will one
day pay corporate taxes like every other company.
Is Brent at more than $90 a barrel, spreads between crude oil and the fuel Carnival actually uses,
and the level of fuel consumption per passenger all normal or abnormal right now?
Is vacation demand less than 4 years from one of the greatest financial crisis of all times and
within a year of the worst deadly disaster in Carnival’s history normal or abnormal?
And so on.
Those 3 questions alone are huge. On earnings per share of $1.81 a share, answering all 3
questions pessimistically would probably reduce EPS from $1.80 today to $1.20 in “normal
times”.
While answering all 3 questions optimistically would probably increase EPS from $1.81 today to
$4.00 in “normal times”.
And those 3 questions are just about normalization of taxes, fuel, and demand. Thy have nothing
to do with the core issues of how to treat cap-ex, float, etc. which are the keys to Carnival’s
business model.
When we get into dealing with those things, we are really talking about a situation where a
uniformly bullish analyst can say normal owner earnings are 4 to 5 times what a uniformly
bearish analyst says they are.
One person can be saying CCL will earn about 4% to 5% on its tangible equity in normal times.
Another can say CCL will earn 16% to 20% on its tangible equity in normal times.
In a sense, both assertions are reasonable.
Personally, I think they are both wrong. But that’s just my opinion. And while I can argue that
16% to 20% is too high an estimated normal owner earnings return on tangible equity for CCL
and 4% to 5% is too low an estimate – there are definitely arguments to be made in favor of
either of those assertions and against my argument in favor of about a 10% to 15% normal range.
We can’t use an ideal measure like normal owner earnings – despite it clearly being the best way
to value a company – in our everyday discussions of a company. There would be no
comparability. I could say Carnival’s normal owner earnings are $3.60 a share. You could say its
$1.80 a share. And someone who believes cruise companies will certainly be taxed in the future
can say its $1.20 a share at best.
We Need a Number that Translates Well – Even if It’s a Rough Translation
Newspapers and analysts and blogs and Bloomberg can use P/E and EV/EBITDA. They can’t
use more relevant metrics like owner earnings because one data provider would say a stock is
trading for 10 times owner earnings and the other would say it’s trading at 30 times owner
earnings.
This is the problem we face with valuation ratios. But it’s just part of the larger problem of how
to account for things.
Accounting is Recording and Presenting – It’s Open to Interpretation
Should accounting stress:



Conservatism
Comparability
Comprehensiveness



Relevance
Past Records
Future Estimates
Is it an accountant’s job to put numbers into a form where I can compare Carnival’s results to
Colgate’s results.
But if the goal is to make Carnival and Colgate present financial statements that use the exact
same items, etc. then doesn’t that lose a lot of relevance. And comprehensiveness.
For example, I want detailed notes on how CCL accounts for depreciation, etc. Ideally,
Carnival’s financial statements would be restated to present maintenance cap-ex, etc. rather than
depreciation. But that kind of presentation of Colgate’s results would look pretty odd. And for
Colgate I want to know what the cost of goods sold was. For Carnival this number is mostly
meaningless unless it’s also disclosed that the company was sailing full.
What I really want to know with CCL are things like the cost of a cruise before and after fuel. At
Colgate, what oil prices were doing is pretty irrelevant to me. At Carnival, it’s critical.
It’s very hard to compare two different companies on the same metrics and have those metrics
matter equally. It’s easier to compare two different things on the same metrics without worrying
how relevant those metrics are. That allows us to have full comparability. But it may leave us
with an irrelevant comparison.
A huge part of what you do in any stock analysis is translate a company’s financial statements
further and further from GAAP and closer and closer to business reality.
The end result is low comparability but very high relevance.
In the end, what we want to compare is the return we expect on each stock. That’s the only
metric that is both truly comparable and truly relevant for all stocks.
One Ratio is Never Enough
My point is that you should never make an investment decision based on EV/EBITDA alone. But
that’s only because you should never make an investment decision based on P/E or P/B or P/S
alone. You should never make an investment decision based on only one metric.
Owner earnings matter more than EBITDA.
But we can’t report owner earnings. We can’t screen for owner earnings. So we really can’t talk
about stocks we haven’t analyzed yet in terms of owner earnings. It’s only after you’ve analyzed
a stock that you can move past net income and EBITDA and get to owner earnings.
Until we reach that point, we have to use numbers like net income, EBIT, EBITDA, etc.
And, for me, if we’re going to do that – we might as well use EBITDA.
But it’s just a placeholder. Once we can do an actual analysis of the company, we will replace
the general idea of EBITDA with our own special take on what owner earnings really are at the
company.
But that’s a private number. It’s not a number everyone can agree on. And it’s not something you
can screen for.



URL: https://focusedcompounding.com/why-we-cant-use-owner-earnings-to-talk-aboutstocks/
Time: 2012
Back to Sections
-----------------------------------------------------
Free Cash Flow Vs. Owner Earnings: Which Matters More?
Someone who reads my articles sent me this email:
Hi Geoff,
I've read most of your articles on GuruFocus and am going over lots on your website… I was
wondering if you can offer some insight into valuing a Canadian company, Tim Hortons (THI).
I have used your intrinsic value calculation based on average 10-year FCF and a Shiller P/E
multiplier. My guess is that there is more expected growth in the company's future and thus it
trades at a higher multiple to FCF. Is there something that is better suited to determining a
rough share price based on intrinsic value for this company other than FCF? If a company is
investing much of FCF into expansion and thus not lending itself to the intrinsic value analysis
based on FCF is there a better way? I'm not positive it is a growth company but it seems to make
sense given a higher valuation...
Thanks,
Tom
First of all, you’re right about there being a difference at Tim Hortons between free cash flow
and earnings. I’m looking at a 5-year comparison of the stock’s price-to-earnings and its priceto-free-cash-flow (you can graph this at GuruFocus). If you look at the P/E – around 12 –
everything looks wonderful. But the price-to-free-cash-flow – around 50 – looks pretty scary.
Last year, Tim Hortons’ depreciation and amortization charges were $118 million – all dollars
are Canadian – while cap-ex was $132 million. So cap-ex is higher than depreciation. And it has
been that way for years. In fact, the gap seems to be shrinking. Cap-ex beyond depreciation was
much higher a couple years back.
Finally, there are some non-operating items in Tim Hortons’ earnings. So anyone reading this
article should know they shouldn’t rely on the reported net income – or P/E numbers – they see
at most websites. Go to EDGAR and read the company’s 10-K for yourself.
Now, moving from the specific company you asked about – Tim Hortons – to the general issue
you raised…
Isn’t free cash flow – the way I calculate it – a crazy way to value a business?
Yep. You got me. It is crazy. Especially when it comes to valuing growth companies. Especially
companies that put out money today to make money tomorrow. Companies like Tim Hortons.
But is there a better number to use than free cash flow?
The right way to value a company is really "owner earnings" rather than free cash flow. This
is Warren Buffett's concept. And basically it means that a company is worth its cash flow from
operations minus the capital expenditures necessary to maintain the company's current level of
sales, profits, etc. This is the idea of "maintenance cap-ex" you hear so much about.
By the way, the same is true of changes in working capital. If a company is constantly growing
inventories, receivables, etc. by 15% a year because it is also growing sales by 15% a year this
increase in current assets is not a concern. If, however, the company is increasing inventories,
receivables, etc. by 15% a year while sales grow by only 10% a year you can rightly worry that
maybe not every dollar of reported earnings is being quickly turned into actual free cash flow.
With capital expenditures this is tricky.
How much is the right amount?
Your example of Tim Hortons is a tough one because it is a business like retail, restaurants, etc.
that depends somewhat on how the place looks to keep customers coming in. Even grocery stores
after 20 years of so-so upkeep start to look in need of a face lift. Maybe the aisles are too narrow
for the current style. Maybe there isn't enough light. The flooring is not what people have
become accustomed to nowadays. And so on. Over time this means that some of the cap-ex is
needed to reinvigorate the company and some is needed for growth.
I mention this because retail and restaurant chains sometimes have a period of very fast growth.
At the time, it seems like a lot of the cap-ex is going into growth. Because it's going into new
locations. But what if new locations start by looking great but say 10 years later they really start
looking out of date? They aren't in any way impaired physically. They've been properly up kept.
But there's a need for a new look. It's not as if every McDonald’s (MCD) has looked the same
for half a century. There are constant little adjustments at chains. Logo changes, color schemes,
etc. But also making a place airier or lighter or having exposed ductwork or whatever.
Why even bring this up?
Because it illustrates the problem of separating capital spending for future growth versus capital
spending for present maintenance. In a sense, capital spending on new locations is growth and
capital spending on old locations is upkeep. But is that sense right? What if the same level of
sales can be achieved using the same stores? Then we could definitely call that level of capital
spending “maintenance cap-ex”. But what if renovating old locations could lead to a jump in
sales? Well, then, that would be growth capital spending even though the cash is being spent on
an "old" location.
The way Warren Buffett likes to think about the cash flow question is to think about "owner
earnings". If a company produces a certain amount of cash during the year, how much would the
owner need to send back to that company's management for them to keep sales, profits, etc. the
same next year and next year and next year. Can we imagine a sort of "steady state" of capital
spending that would keep profits about the same in the future as they are today.
If so, that is the correct number to use. That's the number you subtract from cash flow from
operations to get free cash flow. You want "owner earnings" to make your intrinsic value
calculation. Not free cash flow the way I measure it.
So, why do I measure free cash flow as cash flow from operations minus capital expenditures?
Because it's an exact number. It's a number where I can point to the statement of cash flows and
show you how I got it.
It's not perfect. It's not even best. But the best number is owner earnings. And owner earnings is
necessarily an inexact amount. It's an estimate. Based on whether you think the current level of
capital spending is maintaining the earning power of – in this case – the entire chain at the same
level from year to year.
Use owner earnings. Make an estimate. That really is best. But, remember, when a company's
stores are all brand new and sparkling it's not just easy to achieve growth at new locations.
There's a halo of clean, new, stylishness that the entire chain enjoys. And so same store sales
benefit too.
When stores get old – the reverse is true. It’s not just a lack of spending on new stores that you’ll
start noticing. It’s a lot of outdated old stores – and possibly falling same store sales – that you’ll
see.
In other words, if a growing chain is really knocking it out of the park in terms of same store
growth and chain wide sales growth at the same time it is really spending big on its cap-ex – you
need to know that both of those numbers are probably higher now than they will be in the future
(per store). But remember that both are probably too high. Don't assume that a decade from now
same store sales growth of 6% a year will still be happening if today same store sales growth is
6% and the average store age is really, really young.
Just because you can't precisely quantify something doesn't mean you shouldn't think about it. It
is best to consider what industry, societal, economic, and company specific headwinds or
tailwinds a company faces today. And it's always a good idea to study past examples from the
same industry. So if you are studying a new, fast growing restaurant you should learn everything
you can about McDonalds, and Starbucks (SBUX), and Chipotle (CMG), and a thousand other
examples from both the long ago and quite recent past.
Generally, I would suggest trying to find an investment where a performance that is only average
compared to the way other companies in the same situation – in their own past – performed
would still give you good results. Ideally, the company would appear to be as well positioned or
better positioned than past examples of growth in that industry were in their heyday.
What you don't want is to think that a growing company can produce as much free cash flow as a
mature company or that a mature company can grow as fast as a young company. You need to be
realistic in the way you look at a company's cash flow needs and opportunities for growth.
Great companies can grow revenues without needing to use much cash to do it.
Good companies can grow revenues as long as they grow the amount of cash they're spending on
growth.
Bad companies need to increase cash spending even when they are not increasing sales.
The worst companies are those that have to spend more just to stay in place.
None of this is exactly quantifiable. All of it is important.
I recommend reading Phil Fisher's "Common Stocks and Uncommon Profits" along with some
of Warren Buffett's thoughts on the subject. I'd start with his shareholder letters. Especially those
from the 1980s. I think the letter where he talks about “owner earnings” is the 1987 letter to
shareholders. Combine that with Phil Fisher and you'll have a good idea of what matters for
growing companies. Sometimes what matters is hard to measure.
So we have to estimate things like owner earnings. That doesn't mean owner earnings is less
important than free cash flow. It isn't.
It's just less exact.



URL:
https://web.archive.org/web/20120714120327/http://www.gurufocus.com/news/161364/f
ree-cash-flow-vs-owner-earnings-which-matters-more
Time: 2012
Back to Sections
-----------------------------------------------------
You’ve Crunched The Numbers – Now What?
Someone who reads my articles sent me this email:
Dear Geoff,
I was looking at the fundamental of 18 stocks; I own 5 of them: Apple (AAPL), Abbott
Laboratories (ABT), Autodesk (ADSK), Cisco (CSCO) and Exelon (EXC). Others were ideas
collected from places like news, etc.
… The ranking exercise (is) based on growth and fundamental analysis. EXC ranks at the bottom
in both analyses…Top 4 results are Apple, BHP Billiton (BHP), Mosaic (MOS) and Rio Tinto
(RIO). MOS was eliminated as it has one year of negative FCF.
Since AAPL is listed as No. 1, I went back and looked at P/E when I bought it at $333 in April
and May 2011. The P/E was 11 - 13 times. It is currently 15 times… I think the iPhone 4s plus
Sprint network addition plus iPad plus enterprise adoption of Mac will provide an impressive
fabric of earning growth that is sustainable.
The other two on the list are basic materials, they could be… good long-term to my stock
portfolio. Assuming scarcity as their global trend (need to learn more here.)
From the fundamental analysis: Rio is cheaper than BHP. But, RIO is qualitatively inferior when
compared to BHP (ROIC, ROE, ROA). I have not looked at Vale (VALE), so maybe next
weekend I will continue this exercise with VALE.
I am not confident what the next step can be.
Should I do more work or buy AAPL or EXC?
Thank you very much.
Ning
(I should mention here that Ning included some very extensive Excel tables with this email.)
Those are some extensive tables you included there. They are thorough. But I think the next step
is not quantitative. It is qualitative. I would first look at the stocks you already own and feel you
know best.
This sounds like Apple (AAPL) and Exelon (EXC).
I may be wrong about that. But it sounded to me like you had a lot of basic materials stocks show
up for purely quantitative reasons, while you yourself didn’t have a strong feeling whether
buying basic materials was a good idea or not. It could be. But you didn’t seem to have any
special insight there. Am I right?
Where you did have some special insight – or at least a very clear opinion – was on Apple. Now,
normally I wouldn’t encourage anyone to start with one of the most talked about, written about,
gossiped about companies out there.
Everybody has an opinion on Apple. Everybody knows the company. It is hardly a hidden gem.
But it might be a gem in plain sight. And it sounds like you have some ideas about Apple beyond
the numbers. So, that’s where you should start.
The other company it sounds like you’re interested in is Exelon. Part of the reason why I’m
saying you sounded interested in doing more work on Exelon is that you talked about the stock
despite it finishing at the bottom of your purely quantitative comparison.
Is that really a good sign? Am I really saying you should spend more time studying a company
that finished at the bottom of a comparison you drew up?
Here’s what I’m saying. You did a wonderful quantitative comparison of some very different
stocks. A bunch of the stocks you’ve got there are basic materials stocks. This should tip you off
that something is – amiss. When you do a purely quantitative survey of stocks you’re casting a
net. When you get back a list of stocks that are all in the same industry, you need to take a good,
long pause.
You may not be measuring what you think you’re measuring. Or at least you may not be
catching what you wanted in that numerical net you threw.
I think Exelon and Apple are a good place to start.
They are very different companies. That's good. Apple is a very high profile company. While
Exelon is not. Both are potentially very interesting companies.
You could argue that either has a wide moat.
I wouldn't disparage the quality of either business relative to its peers. However, I think the next
step – for me at least – would be to look at the industries they operate in. Are Apple and Exelon
predictable? Do they have sustainable competitive advantages – especially in regards to
operating margins and return on equity. Look at the stocks found in GuruFocus’s Buffett-Munger
Screener. Compare the stocks you’re interested in with those companies. Not just quantitatively,
but qualitatively as well. Right now, it doesn’t look like either Apple or Exelon score very high
in terms of business predictability (as GuruFocus measures it). Again, that’s a purely quantitative
judgment – like your own Excel tables – but it’s worth keeping in mind.
I’ll tell you how I use quantitative measures. I don’t think of them as giving me the whole
picture. I like to think of them more like vital signs. They are alerts. They let me know what
areas of a stock I need to study more thoroughly. For example, Apple gets a 1-Star business
predictability rating. Does that mean it’s a bad, unpredictable company?
Absolutely not. It just means that the trajectory Apple has had these last 10 years hasn’t been
predictable. It has been phenomenal.
So you need to focus – this is always true, but it’s especially true with Apple – on whether or not
the current level of sales, earnings, etc., are sustainable for the long-term. In Apple’s case, this
means you need to do qualitative analysis. Probably competitive analysis.
The industry Apple operates in – consumer electronics – is not an especially predictable one. It is
not one where competitive advantages – “moats” – tend to be especially durable. That doesn’t
mean that Apple can’t maintain its terrific position. It doesn’t mean Apple lacks a moat. It just
means that you need to investigate that issue.
Okay. Another good question to ask is what the risks are. What happens if your assessment of a
company is wrong? What if you think Apple has a wide moat and it doesn’t? What if you think a
barrel of oil will be $150 in 2013 and it ends up being $50? Often, investors focus on the
probability of an event. That’s important. But it’s not more important than thinking about what
happens if your assessment is wrong. Maybe $150 a barrel oil is way more likely than $50 a
barrel oil. But – no matter how sure you felt about the future price of oil – would you really buy
a stock that could go to zero if oil stayed at $50 for any length of time? Probably not. Likewise,
however strongly you feel about Apple’s “moat” as of this moment – it’s important to be honest
about what would happen to the stock (and your portfolio) if Apple’s moat were breached.
I wrote about mean reversion in one of my net-net posts. My point was that when you buy a
company that's very cheap relative to its liquid and/or tangible assets any movement toward that
company doing "about average" relative to American business generally is a positive for you.
Well, these two stocks – Apple and Exelon – are far from net-nets. Any movement towards an
"about average" business performance for stocks like Apple and Exelon will be very, very bad
for you. That is because you are – in both cases – paying a high price to liquid and tangible
assets (relative to the price you could buy many of their peers at).
That doesn't mean they are bad businesses. An insurer or bank that trades at a premium to
tangible book value may be quite a bargain if it is something like Progressive (PGR) or Wells
Fargo (WFC).
The important thing is not to confuse a temporarily wonderful competitive position with a
competitive position like PGR or WFC that can probably be maintained for many, many years.
You may disagree with me here, but I think in the case of Apple you are really betting on the
organization. And in the case of Exelon you are betting on the assets. Basically, you are saying
that Apple's brand and people and culture working together are going to achieve things – like
higher returns on investment – than competitors who seek to do the same thing. In the case of
Exelon, I think you are saying that their assets are lower cost (higher margin) generators of
power than their competitors. In fact, you are saying they are so much more efficient that it is
worth paying a substantial premium to tangible book value.
I don't disagree with either claim. I think Apple has a superior organization. And Exelon has
superior assets.
Exelon's assets are clearly carried at far below their economic value. So the issue with Exelon is
how to value those assets.
Have you read Phil Fisher's "Common Stocks and Uncommon Profits?"
It is a good book to read if you are thinking about investing in Apple.
And "There's Always Something to Do" is a good book to read when thinking about Exelon.
After reading the information you sent me, I'd say that the most important thing for you to do
now is get some distance from comparative numbers. Think about what it is you are buying in
each case. What aspect of the business is providing you with your margin of safety?
It’s not the price.
These are not cheap stocks on an asset value basis if you consider only their tangible book value.
Therefore, either the tangible assets must be worth much more than they are carried for on the
books – or the intangibles must be very valuable for you to buy these stocks.
In your final analysis I think you should focus on one question:
How comfortable would you be if you had to hold this stock forever?
This is an important question because you may have in mind that you have a lot of faith in Apple
right now. That faith may be well founded. But if you have little faith in Apple four or five or six
years out – do you really think you will be the first to spot the company's loss of leadership?
Think about how quickly companies like Nokia (NOK) and Research In Motion (RIMM) saw
their P/E ratios contract when investors realized just how far they were behind the competition.
Do you really think you will be fast enough to spot a change in Apple's position? It’s not enough
to see the writing on the wall. You have to see it faster than everyone else. You have to sell
before they do.
That’s not the Phil Fisher way. The Phil Fisher way is to be very sure when buying a growth
company. Then, yes, you do monitor the situation. But it is not about understanding the situation
one or two years out. It is about understanding the qualities already present in the company that
will prove durable.
Even if you've read Phil Fisher and Peter Cundill's books, I'd suggest looking at them again as
they are good examples of the kind of investing you are trying to do in Apple (Fisher) and
Exelon (Cundill).
Also, you might want to read a bit about Marty Whitman's philosophy and Mario Gabelli's
philosophy. If you think Exelon is a buy, it is probably because you have reasons similar to the
reasons those two investors have when they buy a stock.
Basically, Marty Whitman and Mario Gabelli try to find out the value of a company's assets in a
private transaction. They don't try to figure out what public markets will pay for the stock. They
try to figure out what private owners would pay for the business and they work back from there
to figure out the stock's value.
So my advice is to step back from all the numbers. Zero in on just a couple companies. Don't
look at more than one stock in the same day. If you are thinking about Apple today then think
only about Apple for today. Exelon can wait until tomorrow. Think about what aspect of the
company makes the stock clearly worth more than its current price. Then study that aspect. And
don't add a dime to your investment in that stock until you are comfortable with betting on the
permanence of that aspect.
Make sure you understand the value in the company. And make sure that value is durable.
Understanding often requires more than just numbers. So, I think your next step will be a
qualitative analysis.



URL:
https://web.archive.org/web/20120311124047/http://www.gurufocus.com/news/161475/y
ouve-crunched-the-numbers--now-what
Time: 2012
Back to Sections
-----------------------------------------------------
Do Working Capital Reductions Count As Free Cash Flow?
Someone who reads my articles sent me this email:
Dear Mr. Gannon,
…In your calculation of free cash flow you mention investors should subtract increased
investments in working capital, as these represent unaccounted uses of cash for the business. I
was wondering what happens if this investment is negative? Do we add this onto our FCF
calculation, since mathematically two negatives make a positive? Has the company really gained
any cash? Moreover, what does a negative investment in working capital imply? (One of the
companies I’m analysing in Australia has been showing negative changes in working capital for
the last few years: after it began divesting from unprofitable operations, improving margins and
boosting return on equity. If I count the cash I know it’s a good thing since FCF has improved.
However, their working capital investment which is negative has me slightly worried as I don’t
know whether that’s a good or a bad thing, or even if it will be recurring).
Kind Regards,
Pratham
You seem to understand this issue well. The important thing is looking at how the cash flow is
being generated. It depends on the situation. There is no one rule to fit all companies. I could
take you through some specific company examples. But I don't want to waste your time right
now. If you have time – here are some companies you could look at for examples of companies
where constantly increasing working capital (in the very long run) has been a drag on the
business:
· Lakeland Industries (LAKE)
· ADDvantage Technologies (AEY)
Both companies tend to reinvest profits into additional inventory. This means that as long as they
are growing they can't afford to pay out any cash. Earnings must be retained. The upside is you
got growth for many years. The downside is they had little or no ability to buy back stock, pay
dividends, etc. Now for the other side – look at Taitron Components (TAIT). Here we see free
cash flow being generated by a slow motion liquidation. Current assets like inventory have been
falling over time. This has provided much of the cash.
Should you count this? Should you ignore the cash flow Taitron has generated over the last
decade or so because it is from reductions to working capital? And should you treat Lakeland
and ADDvantage as if they actually have little or no earnings simply because they have
reinvested these earnings in working capital growth instead of buying back stock, paying a
dividend, etc.?
Neither extreme is right.
Teledyne had a policy of crediting its subsidiaries with the average of that unit's free cash flow
(as in cash actually returned to shareholders) and its reported profits. If it reported profits of $10
million but kept all of its cash (adding to inventory, receivables, etc.) then Teledyne would say
that unit's earnings were $5 million (because $5 million is the average of $10 million in reported
profits and $0 in cash paid out).
A company's goal is to generate the most cash profits. But reduced investment in plant,
inventory, etc. could reduce cash profits in future periods. So could low spending on research,
advertising, etc. but these are expensed on the income statement in a more obvious way. Capital
spending and working capital growth are trickier. The answer is that neither measure is perfect. I
always look at both operating profit and free cash flow. And I look at operating profit and free
cash flow – both – relative to sales and invested tangible assets over at least a 10 year period.
This gives me some idea of the earning power of the business.
It is better to be roughly right than exactly wrong. Don't be foolish. If it is obvious a company is
reinvesting all of its cash flow into additional inventory to support growth – for instance sales
and inventory are both rising at 10% a year over each of the last 10 years – then clearly the
company is not producing cash now because it is instead growing the business. Likewise, if a
company is generating free cash flow merely through liquidation of inventory and receivables
running off – understand that for what it is. That kind of free cash flow is not sustainable.
These issues are common among net-nets. There is another issue relating to free cash flow. It has
to do with the business itself. Do the businesses in this industry tend to constantly produce more
free cash flow than expected relative to operating income or less?
For example, in the U.S. you would expect operating income times 0.65 to be roughly the
amount of "normal" free cash flow (after-tax) a company should generate in the long run. In
reality, inflation would normally cause this number to be lower than I just said even if cash
receipts were timed to match reported income. But it's not an issue we need to worry about in a
modest or reasonable inflation environment. Even at 4% inflation, it should be hardly noticeable
at most companies.
Now, the other big issue here is how cash is received in the business. And how it is used. This is
my advertising agency vs. railroad example. A railroad will tend to have free cash flow that is
low relative to reported operating earnings. An advertising agency will tend to have free cash
flow that is high relative to reported operating earnings. This is a different issue entirely. One is
an asset light business (the ad agency) that could – theoretically – pay out earnings in cash
almost from the first year it is open if it neither grows nor shrinks. The railroad is different. A
railroad will tend to need to always pay more in cash in the future to replace assets than it is
depreciating them at. With long-lived assets the difference can become substantial. This is even
more noticeable in a growth phase. There is a huge difference between a growing railroad and a
growing ad agency. The ad agency will produce cash with a higher present value because it will
arrive sooner than the railroad. Today, this is much less noticeable because growth in actual
physical assets is subdued at railroads in the U.S. Check out cruise lines for an example of a fast
growing asset heavy business. American railroads once looked like that – long, long ago.
Anyway, here's my answer to question #1. Use common sense. Don't ignore your intuition. Use
your entire understanding of the business and its uses of cash over the last decade. Understand if
it is growing, decaying, etc.
Separate businesses that are experiencing huge changes in working capital – like AEY vs. TAIT
– from companies that will continue to convert earnings into immediate cash at different rates
like Omnicom (OMC) vs. Carnival (CCL).
These are two different issues.
Also, keep in mind that the best business is one that receives cash early on relative to when it
records sales and needs little or no additional capital (plant, inventory, receivables, etc.) to grow
the business. The less cash investment needed and the quicker the cash return on additional
investment hits the coffers – the better the business is. If you are looking for long-term
investments, focus on cash flow mechanics that will be permanent. And never give full credit to
the cash flow reported by a company like TAIT. That kind of free cash flow is not sustainable.



URL:
https://web.archive.org/web/20120218025118/http://www.gurufocus.com/news/161522/d
o-working-capital-reductions-count-as-free-cash-flow
Time: 2012
Back to Sections
-----------------------------------------------------
GAAP Accounting: Restatements Vs. Realities
Someone who reads my articles sent me this email:
Hi Geoff,
...as concerns P/B and P/S with Birner Dental Management Services (BDMS), they trade at a
very high valuation to their P/B, and not in line with their average ROE, and that is before
taking out leverage. Is there an answer to the discrepancy between their high P/B with only
about 18% ROE and how P/S ties into that?
Tom
Wow. This is going to be a complicated answer. Actually – yes – there’s an answer to the
discrepancy. In fact, there are two answers. Birner has very high amortization charges. And
Birner had a different definition of revenue.
This is an accounting article. So here comes the footnote…
“….(Birner Dental Management Services) restated its audited consolidated statements of income
for the years ended December 31, 2007 and 2008 and its unaudited consolidated statements of
income for each of the quarters of the years ended December 31, 2008 and 2009. The
restatements affects (Birner’s) previously reported revenue and expenses for clinical salaries
and benefits paid to dentists, dental hygienists and dental assistants. (Birner’s) reported revenue
increased by the amounts paid to dentists, dental hygienists and dental assistants. Clinical
salaries and benefits increased by the same dollar amounts as the increase in revenue. The
restatements have no impact on (Birner’s) contribution from dental offices, operating income,
net income, earnings per share, consolidated balance sheets, consolidated statements of
shareholders equity and comprehensive income or consolidated statements of cash flows, or the
calculation of Adjusted EBITDA.”
Ready to dig into this?
With BDMS, there are several accounting complications you need to understand. Most
importantly, there’s an unusually huge and persistent gap between EBITDA per share and
earnings per share. Basically, Birner constantly understates its economic earnings. So, any metric
that uses net income is going to give you a misleading take on the company.
Before we go any further with BDMS, you probably want to get someone else’s take on the
company – not just mine. I’m sure there are some bearish folks out there. And it would be good
to Google around and try to find their blogs. Because any explanation I give you of how
BDMS’s business works, how its accounting works, and what it means for an investor could be
accused of being overly bullish.
Remember: We’re talking about a $33 million market cap stock here. So, the mere fact that I
frequently use BDMS as an example should tip you off to the fact that I obviously like the
company enough to research a pretty obscure stock. So be warned – I’m not providing the
consensus opinion here (if there is one on a $33 million stock). I’m just giving you my take.
Okay. Now let me explain the discrepancy between what I think BDMS’s “owner earnings” are
and what kind of net income, ROE, operating margin, etc. you are seeing.
Go to GuruFocus’s 10-year financials page for BDMS. Notice anything odd? Look at EBITDA.
That’s earnings before interest, taxes, depreciation, and amortization. Notice how stable
EBITDA is. Let’s take EBITDA per share.
2001: $1.20
2002: $1.58
2003: $1.90
2004: $1.92
2005: $2.17
2006: $3.08
2007: $3.50
2008: $3.19
2009: $3.19
2010: $3.05
Okay. So, it’s a boring, stable company. BDMS has a business predictability ranking of 3 stars
according to GuruFocus. Not bad for a company with a $33 million market cap. What’s weird
about all this is that the stability of EBITDA is not shared by the stability of other numbers. Most
notably, the revenue numbers are all over the map. Especially notice how revenue leaps from
$18.26 a share in 2008 to $31.86 a share in 2009. Do you really think BDMS’s sales grew 75%
in one year while adding exactly zero EBITDA that same year?
That doesn’t sound likely.
So what does sound likely?
An accounting change. Go to gross margin and operating margin. Notice how they both fall off a
cliff – in almost the exact same ratio – at the same time sales spikes while EBITDA stays steady.
You know what’s coming here. If you check EDGAR for that time period, there’s a good chance
you’ll find that BDMS changed what counts as revenue. By changing the revenue line they
changed their gross margins, operating margins, etc. However, changing revenue recognition
doesn’t change EBITDA.
Think of advertising companies. In fact, think of Groupon (GRPN). Remember, Groupon’s
revenue controversy? Groupon counted as revenue cash that was paid out to its merchant
partners. Is that really revenue? Or is that just handling cash? They aren’t the same thing.
Otherwise: banks, brokers, etc. would report trillions of dollars in revenues.
This was a big deal because it was Groupon. People were talking about valuing the stock – which
had no earnings – on a price-to-sales ratio. The problem with using price-to-sales is that sales can
be a very squishy number. It’s easy for a company to exaggerate its revenue. It’s harder for a
company to exaggerate its free cash flow, EBITDA, etc.
Okay. Now remember how Groupon’s revenue numbers suddenly changed by a huge amount?
That didn’t mean the business actually changed. The only thing that changed was the way
Groupon described its business to shareholders.
Same story here.
In our BDMS example, it’s not like patients paid any more for their visit to the dentist. Nothing
that substantial happened. All that happened is BDMS changed what it counted as revenue
received from the offices that form its cash conduit. Basically, people pay offices. And then
offices pay Birner. By changing what is revenue and expenses for the offices you can change
what is revenue and expenses for Birner. This has no real impact on Birner’s economic reality. In
fact, Birner had been reporting their own non-GAAP number for years. So, in reality, Birner was
– if shareholders read the whole 10-Q, 10-K, etc. rather than just the audited financial statements
– always reporting all these numbers.
They always reported what the revenues and expenses of both their offices and the corporation
itself were. I think they used terms like “contribution from dental offices” and “contribution
margin”. Anyway, I remember reading the 8-K where Birner explained the change they were
making – and restated their financial statements. It was utterly inconsequential. However, it does
affect any metric that uses sales as either the numerator or the denominator.
This is a good example of why you always need to read a company’s actual 10-K, 10-Q, and
14A. Never invest in a company until you’ve done that.
Also, you need to read the notes to the financial statements. The same kinds of notes are often
important at different companies. For example, you always read what the definition
of “revenue” is. You always read the inventory note. It tells you whether inventory is finished
and waiting to be sold or just raw materials waiting for an order to come in. Together, notes like
these often give insight into how a company works. Inventory is a particularly important note.
You also have to read notes that have a big impact on reported earnings. So, the key note in
Birner’s SEC reports is the note about amortization. Actually, Birner has a whole big section
about how the business is structured financially. So you need to read and understand the part
about “management agreements”. I’ll give you a quick taste – this is not the full explanation –
from part of Birner’s 10-K:
“With each Office acquisition, the Company enters into a contractual arrangement, including a
Management Agreement, which has a term of 40 years. Pursuant to these contractual
arrangements, the Company provides all business and marketing services at the Offices, other
than the provision of dental services, and it has long-term and unilateral control over the assets
and business operations of each Office. Accordingly, acquisitions are considered business
combinations and are accounted as such.”
Often, one accounting note will lead you to another. This is why you always read a 10-K – or
any SEC report – with a pen in hand. For example, once you know that Birner’s management
agreements last 40 years, a bell should ring in your head to go check the length of time over
which the agreement is amortized.
That trail would lead you to this note:
“The Company's dental practice acquisitions involve the purchase of tangible and intangible
assets and the assumption of certain liabilities of the acquired Offices. As part of the purchase
price allocation, the Company allocates the purchase price to the tangible and identifiable
intangible assets acquired and liabilities assumed, based on estimated fair market values.
Identifiable intangible assets include the Management Agreement. The Management Agreement
represents the Company's right to manage the Offices during the 40-year term of the agreement.
The assigned value of the Management Agreement is amortized using the straight-line method
over a period of 25 years.”
Okay. So, what those two notes together tell you is that BDMS writes off 4% of the purchase
price – in excess of tangible assets acquired – each year. Finally, I included the bit about the
inability of the acquired offices to terminate the agreement except under extreme circumstances
because that is such a critical issue with a company like this. If the agreements were easy to
terminate, then these acquisitions would really be more like management agreements. In reality,
these so-called management agreements are actual acquisitions in all but name.
This reinforces the most important idea in reading SEC reports. When you research a company
you aren’t looking for some mystical “right” number in terms of earnings, sales, book value, etc.
The economic reality of sales, earnings, assets, etc. is always squishy. It’s always inexact.
How much is your house worth?
I’m sure you can give me a number right now. But I’m also sure it’s probably not the exact price
you would sell it at if you put up a for sale sign today. It’s the same thing with business. And that
means it’s the same thing with accounting. You don’t read SEC reports looking for little things.
You look for big things. You look for an understanding of the economic reality.
In the case of BDMS, I believe – and I’m sure other folks might not agree with me – that the
economic reality of the company is that their “owner earnings” are some form of the cash flow
generated from operations less their capital expenditures on existing offices. And the
management agreements are really outright purchases of dentist offices. Therefore, when I think
of BDMS I don’t see the GAAP statements shown in the SEC reports. I see something more like
a company that simply buys dentist offices and produces EBITDA.
Now, of course, EBITDA is not earnings. What shareholders get is really just the free cash flow.
But when I look at BDMS, what I care about is the overall revenue of the offices – not
necessarily what BDMS recognizes as their own corporate revenue – and the amount of
EBITDA, free cash flow etc., that leads to on a per share basis. That – plus capital allocation – is
what matters most at BDMS.
As far as the idea that BDMS has a low return on equity, I just checked the latest 10-Q. They had
$5.72 a share in tangible assets at the end of last quarter. Let’s pretend that’s usually what they
have. EBITDA has been in the $2.50 to $3.50 a share range in the last couple years. Free cash
flow has been in the $1 to $2 per share range. You can run those numbers yourself and see that
the economic reality of BDMS for the last few years has been that the 18% ROE number you cite
is pretty much the bottom end of their owner earnings divided by their invested tangible assets.
In other words, even without leverage BDMS’s returns on tangible invested assets are good.
You’re obviously including intangibles. Which is fine. But it’s not something I would do.
There’s no way that Birner’s reported return on equity – including intangibles – is a meaningful
figure in any economic sense. Dentist offices don’t produce earnings in line with their book
value. And those amortization charges really affect reported earnings. Just look at Birner
Dental’s 10-year Financial Summary and compare earnings per share with free cash flow per
share.
So, I’d look at the price-to-sales ratio and some form of a margin – maybe the free cash flow
margin – for a company like BDMS. However, in this case, you need to go back to past years
and make sure you adjust for the new definition of sales. Like I said, this is actually pretty easy.
All you have to do is read some of Birner’s old 10-Ks. They provided this data. Just not as part
of the audited financial statements.
Finally, I want to talk a bit about how noticeable all this is. It’s not like you have to go to
EDGAR to figure all this out. Just by looking at Birner Dental’s 10-year Financial Summary you
can see that free cash flow per share has been higher than earnings per share every year for the
last decade.
You have to keep your eyes open. And whenever possible you need to look at a company’s
financial data in context. Ideally, over a 10 year period. And you always want to look at more
than just one metric at a time. Return on equity is important, free cash flow is important,
operating margin is important.
But more important than any one number is the overall picture that emerges when you step back
and look at the relationship between all these metrics over a full decade. That’s when you start to
really understand a company.



URL:
https://web.archive.org/web/20120220004022/http://www.gurufocus.com/news/161788/g
aap-accounting-restatements-vs-realities
Time: 2012
Back to Sections
-----------------------------------------------------
Understanding Depreciation: 4 Depreciation Archetypes
A lot of investors don’t give depreciation enough thought. Whenever you compare P/E ratios,
you are – to some extent – counting on depreciation between companies being totally
comparable.
It’s not.
Forget loans for a second. And forget the idea of “appreciation” and “depreciation” in the sense
of a rise or fall in value. Instead, we’re just going to talk about depreciation and amortization as
they are used in financial statements.
We’re talking 10-Ks and 10-Qs. We’re talking balance sheets and income statements.
We’re talking accounting.
For our purposes, the words depreciation and amortization mean the same thing. It’s just that
we’re going to say depreciation when we’re talking about something we can touch – like a cruise
ship. And we’re going to say amortization when we’re talking about something we can’t touch –
like a management agreement.
Otherwise, depreciation and amortization are synonyms.
You sometimes hear it said that depreciation is a reserve for the replacement of an asset. That’s
wrong. Depreciation is a method used by accountants to spread the cost of an asset over the
period in which the asset provides a benefit to its owner.
Basically, we’re talking about matching the costs and benefits – the revenues and expenses – of
an asset so they appear on the income statement at the same time.
The basic idea you need to get from reading this article is that no one is attempting to account for
the replacement cost of the asset when they determine the depreciation expense. Replacement
cost has nothing to do with depreciation.
Instead, they are taking the cost – the expense – of what you are buying today, and then chopping
it up and spreading it out over the time you use it.
If you want to think of the difference between buying a car and renting a car to understand
depreciation, that’s fine. If you rent a car, you get charged every day. If you buy a car, you get
charged once (but it’s a big charge). In a sense, depreciation is about providing the folks who
read financial reports with a picture of a business’s performance that shows the car buyer in
much the same way it would show the car renter. Each day we’re asking: what did it cost the
driver to use his car today?
That analogy is far from perfect. And I’ve made things sound simpler than they really are. But,
now, I’d like to move past talking abstractly about depreciation and amortization and move to
talking about specific examples you will see in your investing adventures.
I’ve singled out these 4 stocks because they are examples – in fact, rather extreme examples – of
4 types of important depreciation situations you’ll come across when you research stocks.
In a sense, these 4 stocks are archetypes of situations in which depreciation and amortization can
be important in picking stocks.
Although I said depreciation is used to match the timing of the expense of owning an asset with
the benefits the owner receives, the timing doesn’t always work out that neatly in practice.
The time period over which the asset is depreciated doesn’t always match the period over which
the asset provides its benefit.
Here is an actual example of amortization from the 10-K of Birner Dental Management
Services (BDMS, Financial):
“The Company’s dental practice acquisitions involve the purchase of tangible and intangible
assets and the assumption of certain liabilities of the acquired Offices. As part of the purchase
price allocation, the Company allocates the purchase price to the tangible and identifiable
intangible assets acquired and liabilities assumed, based on estimated fair market values.
Identifiable intangible assets include the Management Agreement. The Management Agreement
represents the Company’s right to manage the Offices during the 40-year term of the agreement.
The assigned value of the Management Agreement is amortized using the straight-line method
over a period of 25 years.”
You should notice 3 things here:
1) Because Birner takes these amortization charges, its net income and free cash flow may be
very far apart. You can’t just look at reported earnings in this situation. That would be especially
true if Birner once bought many more dentist offices than it does today. If that happened,
amortization expenses could be very large and yet cash outflows for new acquisitions could be
very small.
2) The term of the agreement and the period over which it is amortized don’t match. Birner takes
a 4% amortization charge every year for 25 years. However, the agreement gives Birner the right
to manage the offices for 40 years. Birner will still have the management right for 15 years after
it has charged off the management agreement to $0.
3) The accounting treatment here is different from what Birner would do if it bought the dentist
offices outright instead of signing a management agreement. Yet is the economic reality much
different? If Birner bought the dentist offices, it would check the goodwill for impairment
instead of charging it off evenly over 25 years. So, Birner’s income statement is not comparable
to the income statements of other businesses that grow through acquisitions.
Here is another example of amortization. This time it’s from the 10-K of a publisher, John
Wiley & Sons (JW.A, Financial):
“Product development assets consist of composition costs and royalty advances to authors.
Costs associated with developing any publication are expensed until the product is determined to
be commercially viable. Composition costs represent the costs incurred to bring an edited
commercial manuscript to publication, which include typesetting, proofreading, design and
illustration costs. Composition costs are capitalized and are generally amortized on a doubledeclining basis over their estimated useful lives, ranging from 1 to 3 years. Royalty advances to
authors are capitalized and, upon publication, are recovered as royalties earned by the authors
based on sales of the published works. Royalty advances are reviewed for recoverability and a
reserve for loss is maintained, if appropriate.”
This note to the financial statements makes much more sense if you read it with copies of the
balance sheet, the income statement, and – most importantly – the statement of cash flows in
front of you. It explains why I’ve mentioned that publishers have an extra line in their cash flow
statements right by the more usual “additions to property, plant, & equipment” that’s very
important to look at. This added line – which in Wiley’s case is called “additions to product
development assets” – is critical to understanding a publisher.
Now, this cash flow item appears under “investing activities”. However, it’s clearly an operating
activity in the sense that it’s a regular part of Wiley’s day-to-day operations. In fact, it’s the core
part of Wiley’s operations. The company spent an average of $130 million annually on this item.
So, although it appears under investing activities, and although it is an investment in the sense
that the asset will be used over more than 1 year, it’s really part of the day-to-day business of
publishing.
So – in my mind – I move that line up to operating cash flows. When I look at a publisher, I only
see their operating cash flows after you subtract the annual cash outlay for product development.
If I didn’t do that, I’d be looking at a publisher as if it was in run-off. As if I was going to buy the
publisher and immediately put an end to the actual business of publishing new stuff.
And that’s no way to analyze a publisher.
Depreciation and amortization can get very complicated. And they can be very important to
evaluating the business. Usually, depreciation isn’t as important as in the case of Birner Dental
Management Services or John Wiley & Sons.
But it can be.
Depreciation is important at Union Pacific (UNP, Financial). Union Pacific’s free cash flow is
usually about 50% less than its reported earnings. Some of the difference is caused by
investments in future growth. But most of the difference is caused by the gap between the
original cost of the asset – which is what they’re depreciating – and the replacement cost of the
asset. Whenever Union Pacific replaces something it pays more to replace the asset than it
charged off in depreciation expense over the years it used the asset.
The reason for this is inflation. The influence of inflation on railroads is explained fully in my
article on inflation and depreciation at railroads.
This huge difference between free cash flow and net income at railroads is why it’s so crucial to
remember that depreciation is not a provision for the future replacement of assets.
Depreciation has nothing to do with the future.
Depreciation just spreads out the past cost that occurred in one cash downpour and turns it into
more of an accrual trickle.
Amortization is important at Netflix (NFLX, Financial). If you’ve never seen Netflix’s cash
flow statement, boy you’re in for a surprise.
It’s impossible to understand Netflix without looking at the cash flow statement.
Netflix is like an intangible railroad. It spends huge amounts of cash on buying intangible assets.
And those intangible assets – the content library – are every bit as important to Netflix as
tangible rails and engines are to a railroad.
I’ve given you some extreme examples here. At most companies, depreciation and amortization
are not as important to a potential shareholder as they are at Birner Dental Management, John
Wiley & Sons, Union Pacific, or Netflix.
But each of those 4 companies can act as a blueprint in your head for how to think about
depreciation in similar situations you come across.
These are 4 archetypes of depreciation.
Hopefully, they’ll stick in your brain and set off a bell whenever you come across a company
where depreciation is really important to understanding the value of the business.
Once again, the 4 depreciation archetypes are:
1) The pseudo-acquisition charge offs at Birner
2) The pre-publication expenses at Wiley
3) The inflation induced original cost/replacement cost mismatch at Union Pacific
4) The intangible asset intensive content library at Netflix
You’ll find variations on these depreciation archetypes in lots of places.
For example, cruise lines are quite similar to railroads. The big difference is that cruise lines are
not a mature industry. So they look a lot like railroads did back in their growth days. But the
basic issue of inflation and depreciation is still an important problem to tackle when
analyzing Carnival (CCL) or Royal Caribbean (RCL).
To understand depreciation you should look at the income statement and the cash flow statement
at the same time. Print them out and put the two pages on the desk in front of you. Also, you
need to read the note on depreciation in the company’s notes to its financial statements.
I can’t stress this last point enough.
Always read the notes to the financial statements.



URL: https://focusedcompounding.com/understanding-depreciation-4-depreciationarchetypes/
Time: 2011
Back to Sections
-----------------------------------------------------
Accounting Connections
I just wrote an article over at GuruFocus that I think is worth reading. I get a lot of questions
asking what’s a good accounting book to learn from. Right now, I’m reading John Tracy’s How
to Read a Financial Report.
The point of the book is seeing the connections between the financial statements. That’s so
important. And it’s really the only thing I have to say about accounting. It’s about fluency. It’s
not about knowing in detail how this or that is calculated. It’s about knowing how things on the
income statement and the balance sheet and the statement of cash flows work together to tell the
story of a business.
Recently, I’ve written 3 articles that show how investors can use accounting:
DuPont Analysis for Value Investors
Warren Buffett: Berkshire Hathaway, Leverage, and You
Warren Buffett: Inflation, Depreciation, and the Earnings Mirage
If you want to see how I think about accounting, you should start with those articles.



URL: https://focusedcompounding.com/accounting-connections/
Time: 2011
Back to Sections
-----------------------------------------------------
The Accounting Equation
This is something that’s come up in emails readers and I have exchanged. If I was teaching an
Investing 101 course, when students walked in on the first day this would be on the board:
Assets = Liabilities + Equity
Which means…
Assets – Liabilities = Equity
and…
Assets – Equity = Liabilities
This is taught in accounting classes to show how every transaction affects at least two of a
company’s accounts and the equation always stays balanced.
I mention it just because it’s useful in situations like the blind stock valuation where I didn’t
show the mystery company’s liabilities. Some folks mentioned that I didn’t show the liabilities.
Of course, I did show the mystery company’s liabilities because:
Assets – Equity = Liabilities
For balance sheets found in 10-Qs and 10-Ks filed with the SEC, it’s pretty common to just show
the total assets and shareholder’s equity at the bottom of the balance sheet without totaling the
liabilities.
The reason for this is that for the sheet to “balance” you can’t literally show assets on one side
and liabilities on the other. You actually show assets on one side and liabilities plus equity on the
other.
If you watched my eyes run down a balance sheet, the first thing I actually do – by force of habit
– is race to the assets and equity at the bottom of the page to instantly see how leveraged the
company is. Sometimes that’s all it takes to eliminate a stock from further consideration.
In theory, that bottom most number is liabilities plus shareholder’s equity (which is on the line
above it). But, since you know the accounting equation, you know that liabilities plus
shareholder’s equity is always equal to assets (Assets = Liabilities + Equity) so the two bottom
most numbers are effectively a company’s equity and assets. The difference between them is
total liabilities.
So, the two bottom most lines of a balance sheet actually tell you a company’s assets, liabilities,
and equity in just one glance.
That one glance also tells you how leveraged the company is. If you see a lot of assets sitting
below a little equity, that’s a highly leveraged company. If the two numbers are close together,
that’s an unleveraged company.
It can also be helpful to think in terms of leverage ratios.
Like I do in my latest GuruFocus article about how Berkshire Hathaway uses leverage.



URL: https://focusedcompounding.com/the-accounting-equation/
Time: 2011
Back to Sections
-----------------------------------------------------
Calculating Free Cash Flow: Should You Include Changes in Working
Capital?
A reader sent me this email:
Geoff,
I have just recently started to use discounted cash flow analysis with owners earnings. You have
stated that changes in working capital should be included in owners earnings calculation.
However, a lot of value investors on the web seem to think that changes in working capital
should not be included…Up until now, I have excluded changes in working capital. But your
articles have made me think that I should include it. If you don’t mind, please clarify this for me.
I just want to use the right data for my discount cash flow analysis.
Geoff, if changes in working capital is included in owners earnings then would the owner’s
earnings formula simply be: cash from operations – maintenance capex? I sure hope so, because
having to exclude working capital is very confusing because not all financial sites list it the same
way.
Also, what free financial site has the most accurate cash flow statements? I personally have been
using MSN MoneyCentral, but I (am) starting (to notice) that sometimes their figures are
different than the company’s 10K filing. Any suggestions?
Thanks,
Chad
Yes.
You should include changes in working capital. So, when I say free cash flow I simply mean
“cash flow from operations” less “capital expenditures”. Some people talk about separating
growth capital spending from maintenance capital spending (including Warren Buffett). They’re
obviously smarter than I am or have access to financial statements I don’t. The statements
prepared for outside investors – not management – don’t provide enough detail to separate
growth capital spending from maintenance capital spending in more than 90% of the
cases. Birner Dental Management Services (BDMS) is a rare exception.
Warren Buffett was explicit on the issue of including working capital in his 1986 letter to
shareholders:
If we think through these questions, we can gain some insights about what may be called “owner
earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization,
and certain other non-cash charges…( c) the average annual amount of capitalized expenditures
for plant and equipment, etc. that the business requires to fully maintain its long-term
competitive position and its unit volume. (If the business requires additional working capital to
maintain its competitive position and unit volume, the increment also should be included…)
I don’t do discounted cash flow calculations. Charlie Munger says Warren Buffett doesn’t either.
A lot of people do discounted cash flow calculations. And a lot of people don’t wear seat belts.
Discounted cash flow calculations are the most misused tool in investment analysis. I think
they’re insanely risky. But, again, most people disagree.
I read the statements at EDGAR. The figures I cite here are always taken from EDGAR and then
adjusted as necessary by me.
You can use GuruFocus, Morningstar, or MSN Money for a first glance at the ten year numbers.
None of them are accurate enough to replace EDGAR.
Obviously, some companies decrease working capital year after year because sales are
permanently decreasing and they are effectively self-liquidating. This is how returns on capital
return to normal for many net/nets. They don’t necessarily grow earnings. They cut capital.
Competitors exit the industry. Returns on the capital that remains in the industry rise.
You don’t want to assume a decaying business will continue to produce the same level of free
cash flow in future years.
Decay – like growth – is usually easier to look at qualitatively rather than quantitatively. So
some folks should just ignore all businesses in permanent decay when looking for stocks to buy.



URL: https://focusedcompounding.com/calculating-free-cash-flow-should-you-includechanges-in-working-capital/
Time: 2011
Back to Sections
-----------------------------------------------------
How to Calculate Free Cash Flow – 5 Illustrated Examples From Actual 10Ks
Some readers have emailed me with questions about exactly how to calculate free cash flow. Do
you include changes in working capital? Do you really have to use SEC reports instead of
finance websites? Things like that.
Yes. You really do have to use EDGAR. Finance sites can’t parse a free cash flow statement the
way a trained human like you can. As you know, I’m not a big believer in abstract theories. I
think you learn by doing. By working on problems. By looking at examples.
Here are 5 examples of real cash flow statements taken from EDGAR.
We start with Carnival (CCL).
Notice the simplicity of this cash flow statement. It starts with “net income” (top of page) and
then adjusts that number to get to the “net cash provided by operating activities” (yellow). To
calculate free cash flow in this case you just take “net cash provided by operating activities”
(yellow) and subtract “additions to property and equipment” (green). The result is free cash flow.
As you can see, Carnival produces very little free cash flow. Free cash flow is always lower than
net income. That’s because cruise lines are asset heavy businesses like railroads. They have to
spend a lot of cash to grow. Carnival’s reported earnings tend to overstate the amount of cash
owners could actually withdraw from the business in any one year.
Carnival is our example of a “typical” cash flow statement. There’s really no such thing. But this
one is simple in the sense that you only have to subtract one line “additions to property and
equipment” from “net cash provided by operating activities” to get Carnival’s free cash flow.
Next up is Birner Dental Management Services (BDMS).
Notice how Birner separates capital spending into two lines called “capital expenditures” and
“development of new dental centers”. This is unusual. And it is not required
under GAAP (Generally Accepted Accounting Principles). However, it’s very helpful in
figuring out maintenance capital spending. If you believe the existing dentist offices will
maintain or grow revenues over the years, you only need to subtract the “capital expenditures”
line from “net cash provided by operating activities.” But remember, any cash Birner uses to
develop new dental centers is cash they can’t use to pay dividends and buy back stock.
Now for two cash flow statements from the same industry. Here’s McGraw-Hill
(MHP) and Scholastic (SCHL).
These are both publishers. And like most publishers they include a line called “prepublication
and production expenditures” or “investment in prepublication cost”. Despite the fact that these
expenses aren’t called “capital expenditures”, you absolutely must deduct them from operating
cash flow to get your free cash flow number. In fact, these are really cash operating expenses.
For investors, this kind of spending isn’t discretionary at all. It’s part of the day-to-day business
of publishing. I reduce operating cash flow by the amounts shown here. At the very least, you
need to lump it in with capital expenditures. The important thing is that you don’t overestimate
free cash flow by leaving out prepublication expenses. They’re real expenses. And they’re paid
in cash. Look for this line whenever you’re analyzing a publisher.
Finally, we have Netflix (NFLX).
I’ve included Netflix to give you some idea of just how complex a cash flow statement can get.
This doesn’t look much like Carnival’s cash flow statement, does it?
The key to understanding any cash flow statement is to come in asking the question you care
most about: “How much cash is left over for owners?”
For me, the test is simple. If I owned but did not operate the business – imagine it’s a family
owned business with an outsider hired to head up operations – would final authority for this
spending rest with me or the general manager?
Decisions on acquisitions, debt repayments, dividends, and stock buybacks would rest with me.
Changes in working capital? That’s the general manager’s job. Capital spending?
Capital spending’s a little more complicated. Maintenance cap-ex is definitely up to the general
manager. What about expansion cap-ex?
The problem with most cash flow statements – Birner is a rare exception – is that they don’t
separate maintenance cap-ex from expansion cap-ex.
So, usually you have to lump everything together as non-discretionary cap-ex.
This test of whether the decision on spending the cash or not is up to the general manager or the
owner works well when it comes to lines you may not see all the time like “prepublication
expense” or “additions to database” or “purchase of intangibles”. All those decisions rest with
the general manager. Not the owner.
For me, free cash flow is the stream of cash the general manager is letting flow out of the
business and into the owner’s control. In public businesses, the general manager and owner are
often the same person, or the same group. Stockholders may own the company, but they don’t
actually direct the free cash flow at the end of each month, quarter, or year the way someone like
Warren Buffett does.
That means past records on capital allocation at places like Birner and FICO (FICO) become
very important. If the board uses the money to buy back stock, you’ll become very rich. If they
pay out dividends, you’ll do okay. If they make acquisitions, they might just squander a sure
thing.
So, eventually, we have to move beyond the cash flow statement to evaluate how each year’s
cash flow will be directed. This is especially important because cash flow snowballs.
And snowballing is how investors grow fortunes.



URL: https://focusedcompounding.com/how-to-calculate-free-cash-flow-5-illustratedexamples-from-actual-10-ks/
Time: 2010
Back to Sections
-----------------------------------------------------
Net Current Asset Value Bargains: How Do You Screen For Them? –
Retained Earnings
A reader sent me this email:
I’m…curious how you start your searches for new ideas and what methods you use. Is there a
starting parameter you choose to look at first, like 52wk. low or stocks trading below 50% of
book value, etc.?
No.
But I do keep lists.
I keep a list of stocks trading below net current asset value.
Net Current Asset Value = Current Assets – Total Liabilities
When you buy a stock where the net current asset value is more than the stock price: you get the
customer relationships, brands, and factories for free.
Benjamin Graham bought stocks at 2/3 of net current asset value and sold them when the stock
price hit its net current asset value. If the net current asset value didn’t change: Benjamin
Graham made 50% on his investment.
Most net current asset value screens are bad. You need human eyes. Two good blogs that cover
net current asset value bargains are: Greenbackd and Cheap Stocks.
I only keep track of stocks priced less than net current asset value if they:
a) Have more past profits than past losses or
b) Are planning to liquidate
The quickest way to check if a stock has more past profits than past losses is to look at retained
earnings. Retained earnings are on the balance sheet. If retained earnings are positive: the
business has more past profits than past losses. If retained earnings are negative: the business has
more past losses than past profits.
This retained earnings trick can backfire. Spin-offs screw it up. It’s not perfect. But it’s quick. In
seconds: retained earnings show you the net current asset value bargains worth studying.



URL: https://focusedcompounding.com/net-current-asset-value-bargains-how-do-youscreen-for-them-retained-earnings/
Time: 2010
Back to Sections
-----------------------------------------------------
On Maintenance Cap-Ex and “The Pleasant Surprise”
There was an interesting comment posted in response to last Thursday’s podcast. I gave three
replies. I’ve reproduced them below, with questions interspersed:
Maintenance Cap-Ex
The nice thing about having low capital spending, is the pleasant surprise it creates. You find a
company that is earning more (economically) than other companies with the same GAAP
numbers. So, the P/E ratio tends to exaggerate how expensive the business is.
This is kind of like finding a business with excess cash. While it’s true that a business can
have too much cash from an efficiency point of view, finding more cash on the balance sheet
than you expected is always a good thing, right? The point in each case is that the headline
numbers (EPS, P/E, etc.) sometimes lie – and an inordinate number of bargains are found where
such “lies” exist – simply, because others aren’t looking there (it’s a less conspicuous bargain).
“Wouldn’t it mean the company wasn’t reinvesting in P&E;?”
Some businesses have a very strong relationship between the value of the assets in the business
and earnings.
Others have almost no correlation between the two. For an example of a business that will likely
have very different ROAs from year to year (and longer-term) look at Forward Industries
(FORD). A less extreme example is Craftmade International (CRFT), further down the
spectrum (but still very asset light) you have companies like Timberland (TBL) and K-Swiss
(KSWS).
For an example of a business, that long-term at least, has to add to assets to add to earnings look
at Village Supermarket (VLGEA). In this case (as in the case of most retailers), the long-term
correlation between assets and earnings is somewhat obscured by operating leverage; however,
logically at least, you do recognize that a supermarket’s earnings will be determined in large part
by the number (and size) of the stores being operated.
Also on this side of the spectrum (businesses with a strong long-term correlation between assets
and earnings) you have various businesses that own distinct, identifiable assets such as: theme
parks, pipelines, parking lots, bowling alleys, golf courses, hotels, etc. Of course, you also have
asset-heavy manufacturing businesses, especially in price sensitive, commodity-like products.
Both of these types of businesses tend to have more predictable returns on assets (at least on the
margins). I add the qualifier, because it’s a rare business that is both capital intensive and highly
profitable – although I’m sure you could name a handful of such conglomerates.
Some asset-light businesses have predictable returns on assets – not so much because there is a
strong correlation between assets and earnings, but rather because there is the absence of
disruptive change and some real protection from price competition. An example from this
podcast would be McCormick (MKC) – a business that has a fairly predictable ROA largely
because it’s simply a great business (albeit a slow growth business).
One of the greatest investing conundrums is the fact that it is usually easiest to reinvest retained
earnings at past rates of return in a poor business and hardest to reinvest retained earnings at past
rates of return in a good business.
In other words, many of the least limited businesses tend to be the least profitable, and many of
the most profitable tend to be the most limited. That’s why you hear me talk so much about
“franchises” and “niches”.
I may not have played this point up as much as I should have. But, if I were forced to invest
every dime I had in a single business and hold it for the rest of my life, the first characteristic I
would look for is a business with virtually no need for maintenance cap-ex.
The Pleasant Surprise
The pleasant surprise is finding that the GAAP earnings are lower than the actual amount of cash
a 100% owner would be able to extract from the business, if he chose not to expand it (via
additional spending).
A lot of companies have depreciation charges that adequately mirror maintenance cap-ex
requirements. That isn’t to say the two items are necessarily the same amount; but, the extent to
which they diverge from each other is not terribly specific to the business. The most obvious
reason for a major divergence is inflation. Regardless, stocks with similar P/E ratios generally
also have similar “owners’ earnings” multiples.
This isn’t true if the assets on the book don’t really need to be replaced to maintain the
same earnings power. Some businesses do have assets that need to be maintained (brand,
technology, etc.) – but, these assets are maintained as a part of daily operations and are not
broken out as a separate item (it would be nearly impossible to separate “brand maintenance”
from other expenses anyway).
The most conspicuous examples of such brand maintenance are all the ads you see for GEICO,
1-800-PetMeds, etc. At least in these two cases, there is no doubt such advertising creates an
economic asset that helps generate earnings in future periods.
Such spending is not treated as a capital investment. Therefore, GAAP accounting tends to
exaggerate the actual cost of day-to-day operations for these businesses and understate the
amount of additional investment in the business (both GEICO and 1-800-PetMeds are heavily
investing in future growth – it’s just that those investments aren’t in the form of tangible assets
such as a new plant).
I’m sure it sounds like I’m taking quite a leap here. After all, there have been businesses that
argued for the amortization of certain operating expenses that clearly did not have much of a
useful life. You may remember a few such instances from the late 90s. However, a review of the
past financials for PetMeds Express (PETS) illustrates my point. Since 2000, the company’s
revenues have increased roughly tenfold while net Property, Plant, and Equipment has been cut
by two-thirds.
The reason? Advertising. The majority of the company’s operating expenses are advertising
expenses. Let me put the difference between the intangible asset of the 1-800-PetMeds brand and
all of the company’s tangible assets into perspective. In 2005, depreciation expenses totaled less
than 0.5% of sales while advertising expenses totaled more than 15% of sales. In previous years,
advertising expenses were even greater as a percentage of sales.
My point is simply that some of this advertising spending (and I’m guessing a whole lot) creates
economic benefits in future periods. In other words, economically, part of that advertising
spending is an investment, not an expense. I’m not saying GAAP accounting should treat the
advertising as an investment in an intangible asset, I’m just saying, the advertising is such an
investment.
So, the pleasant surprise is the phantom investment. GAAP earnings in previous years were
lower than economic earnings, because an investment in future growth was treated as an
operating expense.
Again, I think this is, in fact, how the item should be treated by accountants. However, investors
need to recognize the distinction and adjust their expectations accordingly.
To better explain what all this talk of accounting for advertising is about, I’ll provide an excerpt
from the company’s 10-K:
The Company’s advertising expense consists primarily of television advertising, internet
marketing, and direct mail/print advertising. Television costs are expensed as the advertisements
are televised. Internet costs are expensed in the month incurred and direct mail/print advertising
costs are expensed when the related catalog and postcards are produced, distributed or
superseded.
Simply put, the hit to earnings is immediate, while the full economic benefits are only realized
over a period of many years.
That’s what I meant when I said the EPS number (and thus the P/E ratio) “sometimes lie”. This
is one of those times. An owner would see the advertising spending differently than the GAAP
portrayal. Therefore, he would believe the true P/E ratio was lower than it appeared to be.
The Value of Intangibles
Intangible assets are often harder to reproduce than tangible assets.
There is a nearly infinite potential supply of new plants and stores if a competitor wants to build
them – and they can usually be built at the same cost regardless of who builds them.
Already, if a competitor wanted to reproduce the 1-800-PetMeds or GEICO brands, they would
have to spend considerably more than those companies did, because both brands are fairly
entrenched within our minds – they’ve staked a claim to the territory in our mind where we think
“pet meds” or “auto insurance”.
You can’t reproduce those brands at the same cost. Furthermore, in both of these cases, you’d
have to lose money or accept a much narrower margin while you did build the brand up. So,
while the barriers to entry may not be obvious, the barriers to profitability and dominance are
quite clear.
Both companies already own a little piece of your mind. That’s valuable real estate – even if it
doesn’t show up on the books.
Hidden Bargains
How does one parse the numbers to find these hidden bargains?
There is no purely quantitative way of doing this. Qualitative considerations loom large in any
estimate of cap-ex requirements, because the nature of the business and the competitive position
of the firm are key determinants of how effective new cap-ex spending is.
If you can’t explain why one company spends less on cap-ex than its competitors, you have to
assume the current skimping on cap-ex is not sustainable.
One important caveat though: many companies in the same industry are not competitors, and
therefore cap-ex comparisons between them are of little use. For example, Strattec
(STRT) and Lear (LEA) both make auto parts. However, they aren’t competitors. Lear makes
interiors; Strattec makes locks.
The lock business is not the same as the interior business. The industries aren’t equally profitable
and they aren’t equally competitive. You have to analyze each business separately – just as you
can’t lump Amazon.com (AMZN) and 1-800-PetMeds together, even though they both sell a lot
of stuff on the web.
Any consideration of cap-ex spending and how it’s really divided between “maintenance” and
“investment” has to begin with your assessment of the nature of the industry in general and the
specific competitive position of the company you’re looking at.
Then, you can start making cap-ex comparisons. But, don’t allow yourself to become unduly
wed to the numbers. Bring your understanding of what’s needed to maintain and expand the
particular business and what competitors are likely to do (and the unintended consequences those
likely actions will produce).
Some industries are easy. Unless you have a very special case, a steel company’s cap-ex will be
determined by the long-term economics of the steel industry (which is not extraordinarily
profitable). You aren’t going to find one company that can skimp on capital spending – they all
have to ante up each round.
At any one time, the numbers for the last few years may not make this fact obvious, but you’ll
know it, because of the qualitative judgments you bring to your analysis of any particular steel
company. Just as your qualitative judgments about 1-800-PetMeds would have helped you
realize the low cap-ex spending there was perfectly fine, because the real investment was the
advertising. These are the things the numbers alone can’t tell you.
Related Reading
On Inflexible Enterprises (for more on the unintended consequences of competing capital
expenditures)



URL: https://focusedcompounding.com/on-maintenance-cap-ex-and-the-pleasantsurprise/
Time: 2006
Back to Sections
-----------------------------------------------------
On Pre-Tax Return on Non-Cash Assets
This post was prompted by a comment to yesterday’s post on Sherwin-Williams.
PTRONCA = Earnings Before Taxes / (Total Assets – Cash & Equivalents)
Pre-tax return on non-cash assets is intended to eliminate any need for human judgment.
I understand why you might want to adjust for other assets, but you must not do this in
calculating PTRONCA. I only intend the pre-tax return on non-cash assets as a quick first
measure of profitability. There is no human judgment involved – that’s the idea. You can
calculate PTRONCA in seconds and repeat the process over scores of businesses.
Obviously, there’s a lot you could adjust. You mentioned goodwill; there’s also excess working
capital, marketable securities that you may believe are not really “available for sale” even though
they may be so classified, etc.
The idea behind PTRONCA is to quickly measure the profitability of the business
operations of both public and private companies. I think after-tax measures are not
meaningful for most companies; because, except for the very largest American businesses, public
companies can be taken private, financed with debt or equity, merged with other companies,
move their HQs overseas, etc. Furthermore, companies like Journal Communications
(JRN) could be broken up.
The pre-tax return on non-cash assets is often less variable for similarly profitable companies
than the various profitability margins (e.g., net income / sales or FCF / sales). PTRONCA is very
useful when there are differences in gross margins.
For instance, Village Supermarket (VLGEA) is an unusually profitable grocer that appears on the
basis of its profit margin to be less profitable than many other grocers. Fixed costs and sales
volume are important considerations in the groceries business. Obviously, you could look at
sales per square foot and other industry specific measures, but I believe that’s more appropriate
as a second step. It isn’t something you want to do until you’re starting to learn about the
economics of the industry.
PTRONCA is not very useful if you already know something about the company or the
industry. I agree sales are often more important. I’ve often cited sales numbers such as
price/sales and the FCF margin. Both are essentially ways of valuing companies based on the
belief that current sales are largely sustainable and a certain (minimum) normalized free cash
flow margin is expected. For instance, with Overstock (OSTK), I was simply valuing a money
losing business on the basis of expected free cash flow. That’s why sales numbers can be very
important. If you’re convinced they can be sustained, or will grow at some minimum rate, you
can even value loss–making businesses once you address the solvency issue.
Finally, the pre-tax return on non-cash assets obviously doesn’t consider the premium an
investor is paying over the book value of the assets. It’s not intended to. Think of it like you
would the return on capital half of Joel Greenblatt’s “magic formula”, it only provides part of the
picture. You need to know both how good a business is and how cheap it is, before you buy.
I think return on equity, return on capital, return on retained earnings, the gross margin, the profit
margin, and the FCF margin are all useful measures of profitability.
I understand why you might want to use enterprise value-to-EBITDA ratio, especially because it
is a widely available metric. Personally, I use normalized pre-tax owner’s earnings for valuing a
predictable, slow-growing business that is not a consumer monopoly. In some cases, an
appropriate EV/Sales ratio based on a normalized FCF margin might work even better.
I mentioned VLGEA before. That’s an example of a company I would value on the basis of
normalized pre-tax owner’s earnings. Energizer Holdings (ENR) is the kind of company I would
value on the basis of a normalized free cash flow margin and the current level of sales (adjusted
for a conservative annual revenue growth rate). So, for Energizer, EV/Revenue is more
appropriate than it would be for Village.



URL: https://focusedcompounding.com/on-pre-tax-return-on-non-cash-assets/
Time: 2006
Back to Sections
-----------------------------------------------------
On Return on Assets
Despite all appearances to the contrary, this is a post about investing – not baseball. So, to those
of you who love reading about investing but hate reading about baseball: don’t be deterred. It’s
worth reading all the way through.
Return on assets is the hit by pitch of investing. Common sense suggests it isn’t a very
important measure. Why would any investor care about return on assets when return on
equity and return on capital tell you so much more?
You don’t have to know a lot about baseball to know that the number of times a batter is hit by a
pitch shouldn’t tell you much about his value to the team. After all, getting hit by a pitch is a
fairly rare occurrence. Even if some players are truly talented when it comes to getting plunked,
they still won’t get hit enough to make a huge difference, right?
That’s true. In and of itself, the act of getting hit by a pitch is not particularly productive. But
(and here’s where things get interesting), as a general rule, a simple screen for the batters who
get hit most often will yield a list of good, underrated players.
Why? The most likely explanation is that a hit by pitch (HBP) screen returns a list of players
who are similar in other, more important ways. Perhaps batters who get hit more often also tend
to walk, double, homer, and fly out more often – while grounding into double plays less often.
Even a casual baseball fan might suspect this.
Since this blog is about investing rather than baseball, there’s no reason for me to discuss
whether such a correlation really does exist. I’ll just provide a list of the top ten active leaders for
HBP: Craig Biggio, Jason Kendall, Fernando Vina, Carlos Delgado, Larry Walker, Jeff Bagwell,
Gary Sheffield, Damion Easley, Jason Giambi, and Jeff Kent.
After the top ten, the list is no less impressive. #11 – 15 are: Derek Jeter, Luis Gonzalez, Alex
Rodriguez, Matt Lawton, and Barry Bonds. Since this list is based on career totals for active
players, it’s biased towards players who remain in the majors and who get a lot of plate
appearances. That fact alone means the guys on this list are likely going to be above average
players. However, even if you look at the single season HBP list, which includes a few young
players (e.g., Jonny Gomes), the guys with high HBP totals still tend to be extraordinarily
productive offensively.
Simply put, screening for HBP tends to return a much higher number of “bargain” batters than
you’d expect. One explanation for this is that the good things players with high HBP totals do
tend to be less conspicuous than the good things other players tend to do.
Might there be a parallel in the world of investing? You bet. So, again I say –
Return on assets is the hit by pitch of investing.
Return on assets is a good screen for high – quality, low – profile businesses. A high return
on equity does not go unnoticed for long. Sometimes, a high return on assets does. Jakks Pacific
(JAKK) is one good example of a high ROA stock. Its returns have basically been what you’d
expect from a toy company. That may not sound like great news to owners of Jakks; but, it is.
Jakks sells at a price – to – earnings ratio of about 12 and a price – to – sales ratio of about
1. The company has grown quickly. Over the past five years, revenue has grown at an annual rate
of about 25%. Shareholders haven’t enjoyed the full benefits of that growth, because of share
dilution – but, that’s something best left to a longer discussion of Jakks. The point here is simple.
Jakks may not be anything special as a toy company, but it is a toy company. Jakks’ past
return on assets proves that simply being a toy company is something special. Jakks’ “normal”
ROA of around 5 – 12% may be nothing extraordinary in the toy business; but, it is far more than
what most businesses earn. If there will be any future growth at Jakks, the current P/E of 12 will
be shown to have been utterly ridiculous.
If you screen for high returns on equity, you might have missed Jakks. But, if you screen for high
returns on assets, you’d have caught this apparent bargain. By the way, I believe Joel
Greenblatt’s magic formula would have lead you to Jakks as well.
Village Supermarket (VLGEA) is another stock I’ve mentioned before that has often earned a
good return on assets, but has failed to ever earn a high enough return on equity to get much
attention. This business is not as cheap as it once was; but, it isn’t exactly expensive at these
prices either. For at least five years now, Village has looked quite clearly like it should be valued
as a mediocre business. That’s saying something, because the market has continually valued
VLGEA as a sub – par business; which it isn’t.
In 2000, you could have bought VLGEA at a 50% discount to book value. In 2001, the
average buyer still obtained shares at a greater than 25% discount to book value. By then, anyone
who had been monitoring Village’s return on assets for the previous five years would have
known the stock was cheap.
For the last ten years, Village’s return on equity has been nothing more than average; however,
the performance of the stock has been anything but average. An investor with one eye on
Village’s price – to – book ratio and the other eye on Village’s return on assets would have
enjoyed the decade long climb without breaking a sweat.
Another one of my favorite high ROA stocks is CEC Entertainment (CEC) – better known
as Chuck E. Cheese. Recently, the stock has earned a good return on equity. However, a simple
screen based on ROE would have brought a lot of less than wonderful businesses to your
attention along with Chuck E. Cheese.
Return on assets told a different story. Chuck E. Cheese has consistently earned an extraordinary
return on assets for the last decade.
Now, it’s true that Chuck E. Cheese has earned a very nice return on equity as well. But, if
you’re an investor who knows what normal ROA numbers look like, one look at CEC’s return on
assets will blow you away.
Debt can play the role of the fairy godmother. So, an investor needs to look beyond the veil of
current performance. Return on assets can often provide a glimpse of what the stroke of midnight
will bring. ROA is just one piece of the puzzle. But, it’s an important piece nonetheless.
A high return on assets doesn’t guarantee quality. However, I’ve found that Mr. Market has
usually offered many more small, growing companies with extraordinary returns on assets than
he has offered small, growing companies with extraordinary returns on equity.
Therefore, just as a general manager might want to run a quick screen for a high HBP number,
you may want to run a quick screen for a high ROA number. I know it’s not supposed to be the
best indicator of a bargain. But, in my experience, it tends to turn up a lot of neat ideas.
Obviously, a high return on equity is important. I’m not saying it isn’t. I’m just saying a high
return on assets is more important than you think.



URL: https://focusedcompounding.com/on-return-on-assets/
Time: 2006
Back to Sections
-----------------------------------------------------
How to Take Notes on a Company's Balance Sheet
Someone emailed me a question about how to take notes when reading a 10-K:
Geoff,
When you're reading a 10-K, how do you initially read the balance sheet, the income statement
and the cash flow statement? I'm thinking about the balance sheet in general.
Is it cluttered with notes and calculations from your part, and if so, what are you usually
writing? Do you look for something in particular?
Since you asked specifically about the balance sheet, let’s tackle that statement in this article. For
most stocks I am looking at buying these days – the balance sheet isn’t terribly important. Most
of the stocks I’ve bought recently get most of their appraisal value (my best guess as to “intrinsic
value”) from my expectation of future free cash flows. So, asset values aren’t as important. The
balance sheet isn’t as important.
What am I taking notes on even in those cases?
My notes are almost always simplifications. So, I’m crossing out lines that don’t matter using
little “cheats” to focus on what does matter.
What’s an example of a balance sheet “cheat"?
Well, there’s checking the level of total liabilities against the levels of cash specifically and
current assets generally.
Total liabilities may understate a company’s liabilities if there are post-retirement obligations or
something like that with incorrect assumptions being made. But, generally, you aren’t going to
go wrong by assuming a stock is safe if:


It’s profitable. (This is a given. I almost never look at stocks that are either net income
negative or free cash flow negative in the past year.)
It has liquid assets greater than total liabilities.
What’s a liquid asset?
Cash, marketable securities and receivables all qualify.
There are other assets – not all liquid – worth considering though. So, let’s go through all of the
asset lines that you might want to care about. If I don’t mention it here – for example, “other
current assets & prepaid expenses” – it’s usually safe to completely ignore it. You don’t need to
know what’s in that line.
There are usually five sorts of assets worth caring about at almost any company. Let’s start with
the No. 1 most predictable and most “valuable” in the sense that it's a "definitely telling you
something useful right now" kind of asset.
It’s cash.
Actual cash is the easiest asset to value. It’s the single most important line on the balance sheet.
So, if we look at “cash & cash equivalents” and see it’s $101 million while total liabilities are
$100 million – that’s all we need to know. The stock is safe. Later, we can come back and check
for more “hidden” assets with extra value. But, just knowing cash is greater than total liabilities
would immediately put this stock in the “safe” category. I can now focus on the business.
The No. 2 most important asset line is “securities” of some kind. These might appear in “cash &
equivalents” if they are very short-term U.S. Treasury Bills or something like that. They could –
if they are mutual funds, individual stocks, etc. – appear on a line called “marketable securities.”
Or the accounting could get a little complicated. If you’re in another country – like Japan – these
securities might not show up where you expect. And you might need to do some digging to try to
figure out exactly what these assets consist of. In the U.S., if you are looking at a 10-K, it’ll be
pretty simple. They will go into detail in the footnotes somewhere discussing whether these are
bonds, equities, mutual funds and so forth. What was their original cost? What is their fair value?
How did the company estimate fair value (for example, did it check the last market price)? If you
see any marketable securities listed on the balance sheet, you want to go to the section discussing
these marketable securities and read it and take notes very carefully. Do your best to reconstruct
a sort of table of the company’s holdings.
Sometimes, there will be marketable securities held at odd values. This is most likely to happen
in the U.S. where a company owns a large percentage of the outstanding shares of another
company. So, if you own like 21-49% of another company, that would potentially cause the
accounting for that position to look different than if you owned 19% or 9%. That doesn’t make a
ton of sense. In many cases, owning even 4% of a publicly traded stock and owning 28% of a
publicly traded stock should really be similar economically (the 28% stake is just worth seven
times the 4% stake). It’s true the 28% stake could be a little harder to sell and could command
more of a premium in a block trade But, to me, owning 4% of a company or 28% of a company
should be valued the same way. So, if it’s a publicly traded company that these shares are in –
you can hopefully find that out and do your best to adjust the stake from however it is carried on
the books to what it would be worth at today’s market value. In other words, you find something
valued using the "equity method” and you adjust it to “fair market value” using today’s last trade
price.
Even bigger (like controlling) stakes are more complicated. If a company owns 51-79% of a
stock, this may or may not be so different from owning 4%, 49%, etc. But, it will be accounted
for differently. The company’s financial results will be adjusted to (most likely, there are
exceptions – NACCO, which I own, is an exception) take the subsidiary’s results and put it on
the parent’s books and then back out the minority ownership as a liability. This is quite
confusing. You probably want to see if any subsidiary is publicly traded. For example, in a report
on my member site (Focused Compounding), I wrote about a stock called Grainger (GWW). It
has a majority stake in a Japanese company called MonotaRO. MonotaRO is actually publicly
traded in Japan and quite an expensive stock. So, you could look at the value of Grainger
excluding MonotaRO as being Grainger’s market cap less Grainger’s share of MonotaRO’s
market cap. We made that calculation. We took notes on that point. However, we ultimately did
a sum of the parts analysis where we looked more at how we’d value MonotaRO than how the
Japanese investing public was valuing MonotaRO. Other investors, however, would probably
just use the market value of Grainger’s stake in MonotaRO. In all these cases, you need to adjust
reported results at the parent to avoid double counting.
Always use the approach that makes the most sense to you. Keep it simple. But, most
importantly: Make sure you never double count. You can either count the earnings of a
subsidiary as belonging to the parent – or, you can treat the value of the subsidiary (like its fair
market value) as belonging to the parent. But you can’t count both. If a subsidiary is appraised
by you at 10 times EBIT, you can either make a note that the parent owns something worth $1
billion or that it makes another $100 million in EBIT. You can’t do both. If you value the stake
in the subsidiary at $1 billion – you have to adjust EBIT down by $100 million. You can never
count the earnings from something and count that same something as an asset at the same time.
You either take the earnings stream or you value it as an asset. Don’t do both.
The No. 3 most interesting asset is receivables. Receivables are usually – especially under GAAP
(U.S.) accounting – close to being as good as cash except they’re “restricted.” Cash is surplus.
You don’t need to keep cash in a business to run it day-to-day. Receivables are something you
can borrow against. But, you can’t take the receivables themselves out of the business. However,
for purposes of safety receivables can be included in the current assets versus total liabilities type
safety calculation. If you are looking at a company where cash plus marketable securities plus
receivables is greater than total liabilities – it’s a safe stock. What I mean is: If it’s consistently
profitable – it’s a safe stock. The balance sheet is solid. There’s no need to keep digging.
Economically, receivables are bad insofar as they are a use of cash. It’s an asset that ties up
owner’s capital in the business. But, you can safely borrow against receivables. So, they are
another “quick” asset that adds to a stock’s safety.
Inventory I mostly ignore. Theoretically, people would rank this as the No. 4 most interesting
asset. I don’t. I mostly consider inventory a cost of doing business and don’t expect it to protect
my investment in a doomsday scenario. After all, if a company has solvency troubles – it usually
has sales trouble. And if a business is having trouble selling its inventory – what would that
inventory fetch in a sudden fire sale?
Not much.
So, I mostly ignore inventory except insofar as it is one of items that adds to net tangible assets.
We’ll discuss NTA in a second.
It’s worth noting inventory has some features that might make it interesting. One, if the company
is using something like “LIFO” (last-in, first out) accounting. Two, if the inventory is mostly a
commodity. This means either that inventory is something like a raw material: steel, leather, etc.,
that hasn’t been “finished” yet, or the company actually sells a product that is mostly just a
commodity like gold jewelry or diamond engagement rings. These considerations are irrelevant
in today’s low inflation environment. But, if you had high inflation, quickly rising commodity
prices and so forth, there would be a big disconnect from the carrying value of inventory and its
market value in some cases. I think almost all investors can almost always ignore the inventory
line of the balance sheet. But it is something I look at checking for things like LIFO whether it is
a commodity. You don’t have to do that. So, don’t worry about inventory.
And then, if you want to get super technical: Under non-GAAP accounting systems there are
some complexities especially having to do with biological assets. This is a very obscure point.
You’ll rarely run across it. But it is going to be important in the few cases where you encounter
it. So, it you’re analyzing a French vineyard or something – the accounting would matter versus
analyzing a vineyard in California.
The second to last balance sheet item I care about as a plus is land. Buildings and land both have
value. Land – again, going by U.S. GAAP for this article – can be an especially good source of
hidden value. Land is recorded at cost and then it is not depreciated, but neither is the value
adjusted upwards. I try to always figure out what the original cost of the land was and when it
was bought. You can then use a site like “Measuring Worth” to do a quick inflation adjustment.
This is a conservative way of valuing the land.
So, if a company is carrying $1 million of land on the books bought in 1950, we can assume that
is worth no less than $10 million (I just used the CPI for that one). Land is useful mostly as a sort
of potential source of hidden value. Be careful though if the company really needs this land for
day-to-day operations.
Let me give you two examples. Copart (CPRT, Financial) owns land as part of its business. The
company’s business is running auctions of totaled cars at salvage yards. It needs these junkyards
and it needs to site the junkyards in or around major cities. We know from some digging – you
can use the 10-K as a starting point to look up the oldest 10-Ks or to check property records
online – that some of the junkyards Copart runs (like in its original home of California) are
carried on the books at well below what these properties could be sold for today.
Does that matter?
I don’t think so. Copart has a high return on capital. The highest and best use much of the
property could be put to is being a Copart junkyard.
The situation is different with something like Ingles Market (IMKTA). That company owns a lot
of property. It is worth more than what it is carried for on the company’s books. And, in some
cases, I suspect the company may not be putting the property to its highest and best use. We can
see this in the low return on assets at the company. So, that’s a stock where you want to look
carefully at the footnotes on land and other property.
There is a section of the 10-K (quite early on) called “properties.” Always read that. And, also,
always read the footnotes on depreciation of property, plant and equipment.
Sometimes the address of the property is a dead giveaway. In a report on my member site
(Focused Compounding) I wrote about a stock called Town Sports International
(CLUB, Financial). This company runs gyms in places like Manhattan. It leases almost all of its
gyms. But it owned the building one gym was in. It didn’t need to do this. When I started looking
at this stock, I knew only the building was likely valuable (I had the address of the building).
Later, the company sold the property for $82 million. That was more than 5% of the company’s
market cap at the time. That’s what you’re looking for. You want to find land that is worth 5% or
more of the company’s market cap/enterprise value and is carried on the books for much less.
Other than that, it’s not worth spending a lot of time worrying about land.
Finally, there are tax related items. The only one really worth thinking about – because it could
really change your appraisal of a company – is net operating loss carryforwards. A good example
of this right now is Green Brick Partners (GRBK, Financial). That’s a homebuilder that we know
has operating loss carryforwards that will reduce taxes and yet we know those tax savings will
get used up in full pretty quickly. So, it’s valuable. It’s valuable to know a stock will pay, say,
0% in taxes instead of around 20% for the next three years versus its peers. Many companies
with net operating loss carryforwards are on shakier footing when it comes to being sure they’ll
have enough profits soon enough to use up the carryforwards. Generally, I only adjust my
appraisal value based on tax savings when it’s clear the company is making enough money fast
enough to definitely use up the tax savings and to do it fairly soon.
While we’re on the topic of Green Brick Partners – a homebuilder – we need to make a
distinction between the accounting treatment and economic treatment of some item.
Homebuilders account for land as “inventory.” However, land is land. So, when I say you can
“ignore inventory” but “pay attention to land” – I don’t mean you can ignore the “inventory” line
on a homebuilder’s 10-K. Why not?
Because it’s land. A homebuilder’s inventory is land. You need to always exercise that kind of
common sense. Land values matter. Homebuilders use land as inventory. So, you need to pay
careful attention to a homebuilders inventory and what you’d appraise it at.
As far as liabilities, I mostly focus on post-retirement obligations (pensions) and environmental
liabilities (site clean-ups and so forth). I try to learn about these things and the assumptions the
company is making.
In all cases, you only have to worry about asset lines or liability lines that are going to “move the
needle.” If the company has a market cap of $500 million and a $50 million pension obligation
shown on the balance sheet – pay attention to that. If it has a $1 million pension obligation, just
cross it out. Likewise, if land is $25 million – look at it. If it’s $2.5 million – don’t.
Anything that immediately looks like it’s less than around 5% of the value the market is putting
on the whole company – just move on from that for now. You only want to start with the items
that are 5%, 10%, 20% or more of the value the market is putting on a company.
This is even true of cash. If the market cap is $500 million and there’s a $10 million net cash
position – who cares? Just use the market cap in place of enterprise value. There’s no point being
so exact you care about a 2% difference in your estimate of the “price” of a company. If a 2%
change in a stock’s price would determine whether or not you buy the stock – you aren’t doing
appraisals right. If something would change the value of a company by 10% or more – then, you
can start caring.
So, mostly you cross things out. You simplify. There is some investigating. Mostly, you want to
investigate marketable securities and land on the asset side and environmental and pension
obligations on the liabilities side.
Finally, there’s “NTA.” Remember: this stands for “net tangible assets.” I use NTA as an
estimate of the amount of owner’s capital needed to run a business. How do I estimate NTA?
I take inventory plus receivables plus property, plant and equipment (PP&E).
Then I subtract accounts payable and accrued expenses from that.
If there’s “deferred revenue” you should also subtract that. But that’s a discussion for another
day.
Finally, I take EBIT and divide it by NTA to get a return on capital figure.
Again, it’s not important to be precise.
What’s a good number?
Anything that is clearly 30% or higher passes with flying colors.
Anything that is clearly less than 15% fails.
At least, those are the figures I used when U.S. tax rates were around one-third. Now, they will
be around one-fifth. So, I suppose that means you can lower that to around 25% or more being a
perfectly good pre-tax return on net tangible assets and 12% or lower being an unacceptable
level.
I’d say avoid any business that seems to earns less than 12% pre-tax on its invested capital.
And then don’t worry about how high return on capital is once you know it’s at least 25% pretax.
Any business with an unleveraged ROE below 10% is one to avoid staying in long-term. And
any business with an unleveraged ROE above 20% is fine to stay in long-term.
Once you’ve done these things, move on from the balance sheet. Usually, it’s not worth spending
a lot of time with the balance sheet. If a stock is trading well above book value – as almost all
U.S. stocks are these days – the balance sheet isn’t that informative. It’s earning power that
matters.
So, check to make sure the stock is safe. And check to make sure it’s earning definitely more
than 10% a year after-tax on owner money and hopefully more like 20% a year.
If it’s earning 10%, 20% or more and it’s safe – move away from the balance sheet and toward
your assessment of the company’s competitive position as soon as possible.
You probably want to spend 90% of your time researching a stock thinking about the business
model and 10% of your time thinking about the balance sheet.
The exception is Ben Graham-type stocks. But, unless you are looking at stocks trading below
book value – you shouldn’t fixate on the balance sheet.



URL: https://www.gurufocus.com/news/633166/how-to-take-notes-on-a-companysbalance-sheet
Time: 2018
Back to Sections
-----------------------------------------------------
Exclude Intangibles From Return on Capital Calculation
Someone who reads my blog emailed me this question:
“I had a question regarding return on capital employed. So I have read various views on what
should and should not be included. I believe that Buffett believes you should look at return on
tangible capital employed. I struggle with the exclusion of intangibles because some of them are
very relevant. For example, if you have a company that is a serial acquirer surely goodwill
should be included as a means by which management’s capital allocation is evaluated? What is
the counterargument to my question? Also, what do you think should and should not be
included?”
I agree with Buffett. It’s important to exclude intangibles. Capital allocation needs to be
evaluated. But it needs to be evaluated separately from the business. The day-to-day managers of
the business – as it exists today – have no control over the level of intangibles. In fact,
intangibles are mostly just the amount that a company has “overpaid” for something in the past.
The company could have really overpaid in an economic sense.
For example, if Newscorp buys Myspace it will pay above book value. This will be listed as
goodwill. If Myspace declines in popularity in the future, that goodwill is then written off. But,
the accounting goodwill added to the books when Newscorp bought Myspace was immediately
irrelevant to both the managers of Myspace specifically and Newscorp generally. It’s unfair to
judge the profitability of the business based on the price one person agreed to pay for it once.
You should evaluate capital allocation. I spend a lot of time doing that, but I separate capital
allocation from the economics of the business. For example, I’ve written about ad
agencies. Omnicom (OMC, Financial), Interpublic (IPG, Financial), Publicis (XPAR:PUB, Fin
ancial), WPP (LSE:WPP, Financial) and Dentsu (TSE:4324, Financial) have similar economic
measures of return on capital employed. They have very different figures in terms of return on
their retained earnings.
Capital allocation has been best at Omnicom (it mostly buys back stock), second best at WPP (it
mostly acquires good enough companies at good enough prices), then it gets worse at the other
companies. As an example, Interpublic made a series of mistakes in the late 1990s to maybe very
early 2000s. We shouldn’t penalize Interpublic as it exists today for the level of goodwill it built
up through overpaying for stuff back then. In many of these cases, the company writes off the
goodwill. These aren’t the best examples, but they are the examples that come to my mind first.
What we want to know about is the incremental return on investment. If Interpublic was to grow
5% next year, how much of its earnings would it need to retain? The answer is not much. If we
included goodwill, we might think that a company needs to retain more earnings to support
organic growth than it really does. Now, yes, if Interpublic keeps making the same kind of
acquisitions it did in the past, then the return on those acquisitions will be poor.
But it’s easy to test for capital allocation apart from return on capital. Here’s the simplest way to
do it. Go to Google Finance. Type in “OMC,” then check the “IPG” box over the chart to add
Interpublic stock to the chart. Then set the stock chart to “ALL.” Google Finance will give you
its (not always entirely accurate) estimate of stock returns in Omnicom and Interpublic from
1978 to 2016. That’s 38 years of returns.
I can give the compound figures for each stock based on the Google Finance figures. According
to Google Finance, Interpublic stock has returned 10% per year over the last 38 years.
Meanwhile, Omnicom stock has returned 13% per year over the same 38 years. That doesn’t
sound like much of a difference. Just three percentage points. But over four decades those three
percentage points translate into about a tripling of your money in Omnicom versus Interpublic.
You can make these stock return comparisons over shorter periods of time. I use a test like this
all the time to see if the high returns on unleveraged net tangible assets that I see in my Excel
history for the company have translated into actual solid returns for the stock.
In the short run, the stock price performance is not relevant to a value investor, but a company
that is successfully earning returns on equity of 20% or more per year decade after decade really
can’t post bad stock market returns over 30 to 40 years. It is hard for a stock to post even 25-year
returns that are different from the underlying business. I can’t really think of any examples where
this has happened. Right now, about the longest I can come up with is that some darlings of the
tech boom in the late 1990s have had not-so-great stock performances over 15 to 18 years or so
even when the underlying business did fine. It is almost impossible to find stock market returns
of 25 years or more that diverge sharply from the performance of the underlying business.
I’ll give you another example. Right now, I’m reading the annual reports for Southwest
Airlines (LUV, Financial). On its website, Southwest has annual reports (in PDF form) going
back to the 1970s. It is a good stock for me to analyze. Obviously, I got interested in the stock
when I heard that Berkshire Hathaway (BRK.A, Financial)(BRK.B) had bought shares in the
four biggest domestic airlines. Of those four, Southwest has the best long-term performance. It
has the best financial strength. There are a lot of reasons why – if I was interested in an airline –
I’d be interested in Southwest.
I entered data from those annual reports into a big, giant Excel sheet running from the 1970s
through today. The purpose of this Excel sheet is to measure things like sales, assets, equity,
return on sales (margin) and return on equity. An especially important part of the calculation is
looking at the variation in these figures. How much does Southwest’s operating margin
fluctuate? How much does Southwest’s return on equity fluctuate? These are important things to
know. If I ever did buy Southwest, it would be on the basis of EV/Sales or EV/Tangible Equity –
not on the basis of this year’s most recently reported earnings. In the Excel sheet, Southwest has
a long and unusually profitable history. Not just for an airline. It has a long history of high
profitability for any kind of business. But is that true? Are we missing something?
Well, what we can do is go to Google Finance and look for the long-term stock performance. We
can’t really compare Southwest to peers. There aren’t other long-lasting public companies in the
airline business. They tend to enter bankruptcy a lot. They don’t stay public the way giant ad
companies do. We can compare Southwest to the Standard & Poor's 500 though. Google Finance
gives the compound rate of growth in the index as 8.7% per year over the last 38 years. So the
S&P 500 did 8.7%. It gives the compound annual return for Southwest Airlines stock as 11.9%
per year over the last 38 years. Southwest appears in my Excel sheet to be a more profitable
business than most in the stock market.
Then when we look at the long-term record of Southwest Airlines stock versus the S&P 500, we
again see Southwest creating more value. In fact, Southwest’s long-term stock market returns fall
somewhere between Interpublic and Omnicom. The airline hasn’t done as well as Omnicom. But
it has done better than Interpublic. That’s impressive.
It probably has to do with capital allocation. Southwest probably allocated more capital for its
successful domestic airline business and didn’t use much of its free cash flow to do anything
else. Meanwhile, Interpublic didn’t just buy back its own stock. The company couldn’t reallocate
capital to growing its business organically. That’s not possible in the ad agency business because
– unlike airlines – ad agencies don’t require any capital to grow. An ad agency can’t reinvest in
its own business. Actually, it can, but it has to buy back its stock to do so.
That’s what Omnicom has chosen to do. Omnicom has allocated far more free cash flow to
buying back its own shares than other ad agencies have. In fact, that’s the reason Omnicom has
outperformed some other ad agencies' stocks over the years. It didn’t buy back as much of its
own stock as Omnicom did. And – for an ad agency – buying back your own stock is almost
always the best possible use of your capital.
So, yes, I do use net tangible assets. I never include goodwill, intangibles or any idle cash and
cash equivalents. I only include what is needed to run the business this year.
When I wrote the newsletter, I included a whole section on capital allocation. I don’t mean to deemphasize capital allocation by ignoring goodwill. Instead, I want to separate capital allocation
decisions from business decisions. I’ll use another example from the past –Â Fair
Isaac (FICO, Financial). I bought this stock just after the financial crisis. I had been aware of the
stock for a long time. I like the core credit scoring business.
But the company had done an acquisition of which I wasn’t especially fond. That’s not because it
bought something bad. It’s because Fair Isaac used stock to do the deal. Now, Fair Isaac was at
that time a monopoly business. It had near infinite returns on capital. And it could grow at least a
little. It’s a very bad idea for a company like Moody’s (MCO), Dun & Bradstreet (DNB), IMS
Health (IMS), etc., to ever sell off a part of the business. The economics of those businesses are
so superior to the economics of any businesses they’d acquire that it’s difficult to get any value
from issuing your shares in a swap for some other business. Companies like that should simply
never use stock in acquisitions and never issue shares. I don’t even like the idea of compensating
employees using shares. This sounds extreme.
But if you start looking at the math from a long-term buy-and-hold-forever shareholder of one of
these companies, you’ll see it’s really not that extreme a position. Omnicom was able to do
probably 3% per year better than some of its peers simply because it devoted most of its capital
to buying back stock while some of its competitors made acquisitions. Some of those
acquisitions were smart. But you’d have to be very, very smart to make up for the loss of any
shares of a business that can raise prices faster than its expenses and doesn’t have to increase
assets at all to do it. If you have a business that can raise real prices and not lose customers, you
shouldn’t issue stock in that business for any reason.
Here’s my point about Fair Isaac. The stock was cheap on a normalized free cash flow basis
coming out of the financial crisis. But that’s not the reason I bought the stock –Â or, at least, it is
not the only reason I bought the stock. I bought Fair Isaac because I believed free cash flow
would be high relative to its market cap, and I believed the company would use that free cash
flow to reduce its share count. I felt that if, say, I knew I’d be getting at least a 10% return in the
stock, I also knew the company would be getting at least a 10% return on its purchases of its own
stock.
In early 2009, it was possible to find lots of companies at 10% free cash flow yields. But I didn’t
think most of them would take that free cash flow and use it to just buy more and more of the
same company at that same 10% yield. For most stocks, I thought the 10% free cash flow yield
was a ceiling of sorts. They’d probably allocate the rest at rates below that level. At Fair Isaac, I
felt management was going to reinvest the free cash flow exactly the way I would if the decision
was left to me.
That’s capital allocation, and it’s critical. It’s also why I’ve mentioned Bank of Hawaii (BOH)
before. I believe that company will use more of its earnings to buy back its own stock than most
other banks do. For me, that doesn’t make Bank of Hawaii a better or worse business. It just
makes the stock a better investment. I separate the concept of goodwill form the concept of
capital allocation. There are good businesses that don’t make good capital allocation decisions. I
don’t want to confuse the issues because one day that good business might have a different
management team that makes different capital allocation decisions.



URL: https://www.gurufocus.com/news/461351/exclude-intangibles-from-return-oncapital-calculation
Time: 2016
Back to Sections
-----------------------------------------------------
Return on Capital Is the 'Cost of Growth'
Someone who reads my blog emailed me this question:
“I'd love to hear how you think about return on invested capital. It seems every investor has their
own definition.
How do you calculate it, what do you consider bad, average, good, exceptional, etc.?”
I use the pre-tax return on net tangible assets. When I’m looking at a non-financial company, I
remove cash and other securities from total assets. I also remove intangibles such as goodwill
and other intangible assets. The number that is important to me isn’t the return on net tangible
assets. It’s the flipped figure. Let me explain. Let’s say a business can generate a 30% pre-tax
return on net tangible assets. At a 35% corporate tax rate – like the U.S. has – that’s about a 20%
after-tax return on net tangible assets. I don’t spend much time thinking in those terms. I don’t
look at the company as earning 20 cents per dollar of net tangible assets. Instead, I think of the
company as needing to retain one dollar of earnings to grow earnings by 20 cents – or, if you’d
like to put it in even simpler terms, the company must retain 5 cents of earnings to grow EPS by
one cent. This is the most useful number for me to consider, because I already know what the
company is earning now. Return on capital matters to me as a long-term investor, because it
determines the value of the growth I’m going to get.
Let’s look at an example like Bank of Hawaii (BOH, Financial). Bank of Hawaii is a financial
stock. So, we don’t have to break out cash or anything like that. We can just talk in terms of
return on equity. In a normal interest rate environment (something like a 3% Fed Funds
Rate), Bank of Hawaii could earn an after-tax ROE in the 20% to 30% range. But how fast can it
grow? Historically, the bank grew deposits a little faster than 5% a year. The bank has as high a
level of tangible equity relative to total assets as it is ever likely to want to have. So, it doesn’t
need to retain more earnings than usual. It can pay out anything it doesn’t have to retain to
grow. Bank of Hawaii needs to retain 5 cents of EPS for every 1 cent of EPS growth. BOH is
now making about $4.20 a share in earnings per share. It’ll make a lot more in a normal interest
rate environment. So, it can grow EPS faster than it grows deposits while the Fed Funds Rate is
being hiked. But, let’s pretend $4.20 was a normal level of EPS given the deposits the bank has.
In that case, BOH growing at 5% a year for the next 10 years would be able to grow EPS from
$4.20 to $6.84 ($4.20 * 1.05^10 = $6.84). So, the bank could be earning $6.84 a share in 2026.
How much would it need to retain to do that? Over the next 10 years, the bank would grow EPS
by $2.64 ($6.84 - $4.20 = $2.64). And if the incremental after-tax return on equity was 20% a
year (which is very doable for Bank of Hawaii in a normal interest rate environment) then the
bank would need to retain $13.20 a share in cumulative EPS over the next 10 years. It could pay
the rest out in dividends and share buybacks. I don’t have a calculator in front of me, so I can’t
figure out the exact cumulative EPS that Bank of Hawaii would have over those 10 years. But I
can estimate it’s probably not much less than $55 a share over 10 years. In other words, it’s not
that different than if the stock had an EPS of $5.50 a year for 10 years. In reality, the stock’s EPS
would start at $4.20 today and end up at $6.84 in 2026. But, we can approximate this situation by
acting like the bank was going to earn $5.50 a year for all 10 years. So, you have about $55 in
cumulative earnings expected over 10 years and you have the need to retain about $13 over those
10 years to support this growth in EPS. You can check this by doing $13/$55 = 24%. And,
yes, Bank of Hawaii could earn 20% to 25% after-tax if the Fed Funds Rate was about 3% or so.
So, we have a cumulative payout potential for the stock of about $55-$13 = $42 over ten years.
The bank can pay out about $4.20 as if it grows 5% a year. When Quan and I wrote about Bank
of Hawaii for the newsletter, what we said is that Bank of Hawaii would pay out no less than
80% of its EPS in stock buybacks and dividends and it would pay out no more than 100% of its
EPS. Before the financial crisis, it paid out a little more than 100% of earnings. After the
financial crisis – while it was deleveraging – it paid out closer to 80% of EPS. But even during
that time of de-leveraging it didn’t pay out less than 80% of EPS on average. So, it’s easy to
estimate that if the bank is already earning $4.20 a share and it isn’t going to pay out less than
80% of earnings in any year – you’re never going to get less than about $3.35 a share (roughly
$4.20 * 0.8) in a combination of stock buybacks and dividends. The bank pays out just under 50
cents a quarter in dividends. So, let’s say $2 a year in dividends. So, share buybacks should be
about $1.35 a share at a minimum in any given year. They should also grow in line with the
growth in EPS. So, if we expect EPS to grow 5% a year over the next 10 years – we’d also
expect the amount spent on share buybacks (per share) to start out at $1.35 a share and grow by
5% a year over the next 10 years. This means the company should be – in 10 years – spending
about $3.25 a year in dividends in 2026 ($2 * 1.05^10) and about $2.20 a year in share buybacks.
The stock now trades for $85 a share. So, you’d expect the stock to appreciate in price to keep
the dividend yield in 2026 from being too high or the stock buyback rate to cause EPS growth
that is too fast.
So, what we are talking about here is a return on retained earnings. That is how I think about
return on capital. Because Bank of Hawaii can’t spend very much on its actual business. But
then, it can grow without spending very much on its business. Some companies can grow
without having to retain any earnings at all. The example I always give is Omnicom. Because of
the way payment cycles work for ad agencies – they get paid by clients a couple weeks on
average before they pay for the services they purchase on behalf of clients – an ad agency’s free
cash flow increases as its billings increase. The same thing is true for companies that collect
money up front and then provide services later. So, if John Wiley (JW.A) is growing 3% a year,
it can do that while paying out all of the earnings from its academic journal business in dividends
and stock buybacks. It has no need to retain earnings. In that sense, growth is free.
So, that’s how I prefer to think about return on capital. I don’t look at how much capital a
business has and how much earnings it has and decide that a 50% return on capital is better than
a 15% return on capital. That’s not actually true. Let’s think about pre-tax return on capital. I
own George Risk (RSKIA, Financial). I’d say that George Risk has probably gotten close to a
50% pre-tax return on capital in some years. But, George Risk doesn’t really grow. Now, let’s
compare that to a company like LifeTime Fitness (now private). LifeTime Fitness can keep
building new gyms across the country for a long time to come. What if LifeTime Fitness could
get a 15% pre-tax return on capital. That would be a 10% after-tax return on capital. I can’t make
10% a year in the S&P 500. And I can’t take out a mortgage when investing in the S&P 500.
But, LifeTime Fitness certainly can borrow about 50% of the cost of the land and building
needed to create a new gym. Let’s be conservative and say LifeTime Fitness can earn a 10%
after-tax return on capital when it builds a gym and it can get a long-term mortgage at 7.5%.
Now, a mortgage at 7.5% would be 5% after-tax (because you deduct the interest cost and pay a
35% corporate tax rate). So, LifeTime Fitness would be financing a new gym in two parts. One
part would be with equity. And it would be earning a 10% return on equity. The other part would
be with debt. Basically, the company could earn 10% to 15% a year on a new gym for its
shareholders. And it could do this while being pretty conservative. A mortgage with a loan to
value of 50% on the kind of locations where LifeTime Fitness puts its gyms is not aggressive.
And the earnings from the gym itself should do a good job of covering the interest cost. It should
also be possible to have a very long-term mortgage even at a rate that isn’t remotely close to the
return you are getting on your capital. In the example I gave, a 7.5% pre-tax yield isn’t low. And
yet it’s far below the nearly 15% pre-tax return we’d expect LifeTime could make on a new
location.
So, George Risk can’t create value for me despite its nearly 50% pre-tax return on net tangible
assets. Meanwhile, LifeTime Fitness could have created value for me despite its measly 15%
pre-tax return on unleveraged net tangible assets. Why? Two reasons. One, it could reinvest at a
10% unleveraged after-tax return. I don’t expect the stock market to do anywhere near 10% a
year. In fact, I expect it to do more like 6% a year. So, a 10% unleveraged return on retained
earnings is attractive compared to owning the S&P 500 at today’s high price for the index. And,
two, LifeTime will use leverage when it builds its gyms whereas I will not use leverage when I
buy a stock market index. This adds an element of risk. But, people won’t lend to me on the
same terms to buy stocks that they will lend against land occupied by a brand new, large gym.
You can’t get low cost, long-term financing to buy stocks. Warren Buffett (Trades, Portfolio)
can. He can get no cost float. But even if we wanted to use leverage – the leverage we’d use
would be very dangerous. It would be something like margin debt which is an extremely unstable
source of funding compared to a long-term fixed mortgage. If land falls 50% in value but the
gym keeps producing enough income to cover its interest payments – nothing changes about the
mortgage debt. It doesn’t become due sooner. It doesn’t become more expensive. So, it’s easy to
finance this kind of growth with less than 100% equity.
In principle, this is the way I think of return on capital. I think in terms of unleveraged return on
net tangible assets. And I think in terms of the cost of growth. To me, Omnicom doesn’t have an
infinite ROE – what it has is free growth. The question then is just whether Omnicom will grow
2% a year, 4% a year, or 6% a year. But, I know that growth will be free. What matters to me is
the return on retained earnings.
For purposes of standardization, I always use the unleveraged return on net tangible assets. So, I
take total assets. And then I remove cash and cash equivalents, goodwill, and other intangibles. I
then divide EBIT by those net tangible assets.
In reality, the figure shown on the books may not be an accurate measure of economic value.
EBIT isn’t free cash flow. And, of course, the assets have a fair market value different from what
is shown on the balance sheet. For example, LifeTime Fitness’s actual return on net tangible
assets is lower than what I described here. That’s because when LifeTime was a public company,
the fair market value of the land it controlled was higher than the book value of that land. I’ve
mentioned this before with other companies. For example, Copart (CPRT) carries land at less
than its fair market value. This doesn’t much matter. The company gets a higher return out of
using the land for its operations than another owner would get from putting the land to a different
use. So, you don’t want to “count” the land as an asset in addition to the company’s operations.
That would be double counting. But, you should be aware that it might cost Copart more to buy
the same sort of land today. So, Copart’s actual return on earnings it retains today might be lower
than the ROC of its older sties.
This just means you must use your best estimates. There is no perfect number. But, I think what
you want to start with is the concept of the “cost of growth”. I think in terms of how much
earnings a company would have to retain to support EPS growth of 1 cent. So, if you have a 20%
unleveraged return on net tangible assets – you need to retain 5 cents of shareholder money to
produce one extra cent of earnings.
An acceptable return on net tangible assets is 15% pre-tax. A good return on net tangible assets
would be something like 22% (about 15% after-tax). Anything in the 30% pre-tax range or
higher is more than you will ever need. In the long-run, no company is going to keep retaining all
its earnings while earning an after-tax ROE of 20% a year. Companies just can’t grow that fast
for that long. So, a lot of a high ROE company’s earnings are just going to be paid out in
dividends and buybacks. What matters most is the difference between a company eking out a
10% after-tax ROE and a company doing a 20% ROE without the use of leverage. The first
company is nothing special. The second company is really attractive if it can grow.



URL: https://www.gurufocus.com/news/458286/return-on-capital-is-the-cost-of-growth
Time: 2016
Back to Sections
-----------------------------------------------------
How Today's Debt Lowers Tomorrow's Returns
It's not just an increase in risk that happens once a company has a lot of debt. It is also a decrease
in stock buying back ability and dividend paying ability. This is one reason why EV/EBITDA is
important in all cases, but especially important to private equity buyers.
Let’s use the word “excess” to mean a more than normal amount – a more than “right” and
“sustainable” amount in our opinion – of something. Well then excess cash is cash a company
should pay out. And excess debt is debt a company should pay down. In this sense, debt is anticash. And cash is anti-debt. A stock can swing from negative $5 of cash (which we call $5 of
debt) to positive $5 of cash. Often, we would just say that positive $5 of cash adds $5 of value.
But, what if the “right” amount of debt for a certain stock to have was almost certainly $5 of debt
per share – and yet it had $5 of cash. Does it really have $5 of cash? Yes. But can’t we also say it
has $10 of excess cash?
That’s a weird way of putting it. But it’s not an entirely wrong way of putting it. And it’s a very
helpful way of thinking about a stock.
From the time you buy a stock till the time you sell it you want three things to happen:
1. You want the P/E to rise
2. You want earnings to grow
3. You want as much cash as possible to be paid out to you
As a rule, buying a company with a low price and spare debt capacity – a low EV/EBITDA – is a
blessing on those three fronts. Meanwhile, buying a company with a high price and a heavy debt
load – a high EV/EBITDA – is a curse on those three fronts.
It’s important to think about returns in time and over time. Debt can be good. But it is the change
in debt that we want. We do not benefit from buying a company that already has a lot of debt.
We benefit from buying a company that can add a lot of debt in the future.
In this article, I’ll set aside the critical issue of what a company actual plans to do with its cash
and debt. Here, I’m just going to talk about what a company could plan to do. This is where
EV/EBITDA is helpful.
Imagine a company has $20 a share of cash and $5 a share in free cash flow. Many people will
see this company as being worth either $75 a share (15 times free cash flow) or $90 a share (15
times free cash flow plus net cash). But the reality of your return in the investment is actually a
little different from that.
If you hold the stock for let's say 10 years and the stock can be sold for 15 times free cash flow at
the end of that period then you can earn a return based on that sale. But, you can also earn a
return based on the free cash flow you harvest in the meantime. That is, you can have your cake
and eat it too. You can consume the free cash flow for the 10 years you hold the stock. Then you
can sell the future free cash flow – year 11 and beyond – to somebody else for 15 times a single
year's free cash flow.
Now, imagine a company is safe enough - like a food, beverage, tobacco, etc.-type company - to
be loaded up with 4 times free cash flow in debt.
This is what that same stock would look like under those circumstances:
$20 a share of debt
$4.50 a share in free cash flow
Now, let's look at what this stock might sell for in 2023. A share price of 15 times (very
leveraged) free cash flow still seems reasonable for a dependable business. That would be $67.50
a share. However, we now have an extra $40 a share to use. That is the money that came from
taking the $20 in cash off the balance sheet and adding $20 of debt.
We can use the $40 a share to buy back stock. In fact, if the price of the stock stayed around 15
times free cash flow, we could buy back 60% of the shares. We would also have annual free cash
flow over the 10 years of $4.50 a share. The result would look something like this:
FCF per share growth caused by buying back 60% of shares over 10 years: 9.6% a year.
So we have manufactured nearly 10% a year in annual growth just from a stock buyback. And,
really, just from a one-time recapitalization. In fact, there would still be the $4.50 a share in free
cash flow - if the company never paid down its debt. This free cash flow could be used to buy
back even more stock, pay out a dividend, etc. Depending on whether you bought back stock in a
big gulp at the start of the investment period, evenly over time, etc. the dividend you could pay
on the original purchase price would vary. If used entirely as a buyback, this company could theoretically, it would be very hard to do practically - increase its EPS by 18% a year over 10
years just through going from $20 a share of net cash to $20 a share of net debt once at the start
of the decade and then always using every penny of free cash flow to buy back stock.
Notice, however, that if the debt level is kept steady the whole time the buyback can only create
about 9% annual growth. It is the original recapitalization from $20 of net cash to $20 of net debt
that creates the other 9% to 10% a year of EPS growth potential through buybacks. This is a onetime occurrence caused by an underleveraged balance sheet moving to an overleveraged
position. It's basically equivalent to an LBO of a company that stays public.
Next, what is the risk that a company with $20 a share in cash will deleverage in the future?
And what is the risk that a company with $20 a share in debt will deleverage?
I think the risk of the $20 a share in net debt company deleveraging is higher. If the company
chooses to deleverage completely, you - the new buyer at the end of 10 years - will have to
forfeit five years of having your cake and eating it too. You will have your cake. But for four to
five years, while the $4.50 to $5 in free cash flow is used to pay down the $20 in debt - you will
not be able to eat your cake too.
Yes, risk rises when a company has debt. But return also decreases. The company has already
spent the leveraging up ammo it had. It can't do that twice. It can maintain its current position –
giving you the same free cash flow yield – but so can a company with net cash. And it can go
back from a high leverage position to a neutral position. That could cost you several years of free
cash flow. Years will pass but there will be no harvests for shareholders. Only the bondholders
will get fed. We don’t want to own a stock during those years.
For this reason - just like with dividends - it is often better to look for a company with the
capacity to leverage up rather than look for a company that is now leveraged up. After a
company has leveraged up and bought back stock - if the market rewards this - is the worst time
to buy the stock. It may be a good stock to buy. But if we were trying to time the purchase of that
stock, it would be best to buy when the stock is cheap on an unleveraged P/E basis. The very best
purchase to make is one where the P/E is 8 today, the company has net cash, etc., but the P/E will
one day be 16, the company will have net debt, etc.
Some investors - and I know Warren Buffett is this way - are looking ahead 5 to 15 years or so
and asking what kind of returns they will get in the stock. Paying down debt is a very low-return
activity.
Right now, the average stock buyback may return anywhere from 4% at the very worst to a little
over 10% in the very best stocks. For many U.S. companies, paying down debt actually returns
less than 4% a year. Remember, the company is doing something that has negative tax
implications. So, a 4% pre-tax cost is actually an exaggeration of what the company is paying
after tax. It is very hard for me to find any companies today where paying down debt seems to
create more value for shareholders than buying back stock. In some cases, the differences are
huge.
I am looking at Weight Watchers (WTW, Financial) right now. The question of what they will
do in terms of leveraging, deleveraging, etc., over the 3 to 15-year holding period I imagine is
key to understanding what I think the stock will return. There could be a huge difference
between what the company grows by and what the stock returns.
You can see this in the history of Weight Watchers since the 1999 takeover by Artal (buying
from Heinz). The company's sales - including acquisitions - have grown 12% a year over the last
14 years. Meanwhile, Artal (the private equity owner) has earned way more than 25% a year.
The reason is the low amount of cash Artal put in and the constant releveraging and stock
buybacks.
So it is not just a question of risk. Leverage increases risk. But it also increases return. When you
have a lot of debt right now, you have both a higher-than-normal risk today and a lower-thannormal return in the future.
Of course, that is assuming normal (leveraged) prices. In other words, this would be true if the
market were leverage agnostic in how it awarded P/E ratios. That's not exactly true. The market
tends to recognize a very high-debt company may need a lower P/E and a company with a lot of
cash may need a higher P/E. But very often the market undercompensates for this.
The real issue for the investor - in terms of returns during her holding period - is not the level of
debt or cash itself. Rather, it is the change in debt and cash. Cash on the balance sheet is cash
that can be paid out without being produced in free cash flow. If I buy a stock with $1 of free
cash flow and $12 of cash and hold it for 10 years, I can receive cash payments of $22 during
that time not just $10. Unfortunately, the reverse is also true, if I buy a stock with $1 of free cash
flow and $12 of debt, I can receive cash payments of zilch during that time, not the $10 you
might think I'm entitled too. It depends on where the company puts the cash. A DCF should be a
discounted calculation of all cash flows through the stock - not just a record of the company's
recorded earnings, free cash flow, etc.
I think Eddie Lampert and John Malone's behavior may make more sense when seen in this way.
John Malone would like to pay down as little debt as possible and pay as few taxes as possible
while he owns a business. He - like a private equity owner - wants to take cash out of the
business, buy back stock, make smart acquisitions, etc. Then he would like to sell it to someone
else with debt attached. He would also like someone else to have to pay the taxes. So he wants an
approach that maximizes his ability to add leverage while he holds a stock while minimizing the
need to pay taxes today. The best way to do that is to target high EBITDA and low reported
earnings. In fact, he wanted to avoid reporting earnings at TCI. Once that business becomes
mature enough that it has a good EPS appearance, it is no longer a strong investment candidate
because it is now more taxed in the present. So John Malone often looked at a business in terms
of its debt capacity. How much debt can I add? He didn't want to be the debt owner. He wanted
to be the equity owner who would benefit from all this debt.
Value investors outside of private equity often overlook the potential of an underleveraged
business becoming a leveraged business while you own it. In fact, the best way to make money
in stocks is not 100% from growth, 100% from payouts, etc. It is from having your cake, eating
your cake and growing your cake all at the same time. The best business is something that can
grow 5% a year without needing any more capital, that can pay out all its free cash flow (or use it
all to buy back stock) while you hold the company, and then can be sold for 15 times free cash
flow when you're done with it.
Thinking this way will help you in both your Buffett-style investments and your Graham-style
investments. For example, it will help you understand why buying a profitable company at a
negative enterprise value is a good investment. It is not just a guarantee of a bargain. It is also the
possibility of a better return. A negative enterprise value is the best indicator of an
underleveraged company. All value investors see the bargain nature of such a purchase. But
some do not see the upside potential. These same investors are unlikely to see the downside
potential – to return rather than risks – in a company that already has a lot of debt.
Cash and debt are not just numbers to consider in a liquidation analysis. They are not just static
figures. They can be changed. Often, they will be changed while you hold the stock.
There may come a time when an underleveraged company pays out cash, buys back stock, makes
an acquisition, etc. When this happens the P/E ratio will tell you what the EV/EBITDA ratio
always told you.
Nothing lasts forever. If a company has too much cash or too much debt you need to do more
than compliment or criticize management for their past decisions. You can’t earn returns on the
past.
Current levels of cash and debt – and how they can determine the amount of future free cash
flow that goes your way – are important points for investors to consider. They are most
important in the context of time.
If you look only at free cash flow now you are assuming that the accumulated past of a company
need never be dealt with. That is true only to the extent the balance sheet you are buying into is
“normal” now and will be “normal” forever.
If you are buying into an underleveraged company, you may get more than your fair share of free
cash flow while you hold the company – because you bought the stock at the right time in terms
of the balance sheet. When you buy into an overleveraged company, you may get less than your
fair share of free cash flow while you hold the company – because you bought the stock at the
wrong time in terms of the balance sheet.
There is nothing wrong with capital allocation timing a stock. Timing your purchase to get the
best future capital allocation is as sensible as timing your purchase to get the best price.
In both cases, we can’t know what the absolute turning point will be. But we can certainly buy
into stocks that are more likely than not to be at unusually low prices and more likely than not to
have unusually good capital allocation in their future.



URL: https://www.gurufocus.com/news/213732/how-todays-debt-lowers-tomorrowsreturns
Time: 2013
Back to Sections
-----------------------------------------------------
How Do You Calculate a Stock's Buyback Yield?
A lot of people talk about buyback yield or total shareholder yield or something like that as
amount spent on buybacks/market cap equal buyback yield. In the next couple paragraphs, I’ll
lay out the basics of how you can decide whether a buyback is big or small, good or bad. Then
I’ll spend the next 6,000 words – way more than most people need to read – getting into the nitty
gritty of exactly how you can calculate the buyback yield and even more importantly how you
can calculate a company’s return on its buyback. This is important stuff for buyback obsessed
investors – people like me and Warren Buffett . But it is much more than most investors need to
know.
One principle to keep in mind is asset-earnings equivalence. An asset is not just worth what it
appears as an asset to be worth. An asset is worth its future earnings. If a company pays a $1
dividend, that dividend is taxed and reduced to at least 85 cents. In cases where using $1 to buy a
stock only gets you 85 cents of intrinsic value, the dividend payment still makes more sense. In
cases where a stock is at least as good a purchase as the rest of the market, a buyback – rather
than a dividend – can create value. It is not unusual for $1 spent on a buyback to be worth more
than $1.25 in dividend form. It happens all the time. For example, if a stock buyback is both not
taxed and is used to buy back stock at a discount of at least 10% of intrinsic value – it will
always create at least $1.25 in value versus a $1 cash dividend. That’s because a $1 buyback
done at 90 cents on the (intrinsic value) dollar creates 11 cents of value, while a dividend
destroys 15 cents of value. This is the critical concept to keep in mind whenever you think about
buybacks. It works in reverse too. Once a stock is 20% overvalued, the tax benefits of a buyback
versus a dividend are insufficient to overcome the loss created by paying $1.20 to get only $1 of
intrinsic value. At this point, buybacks start to destroy value.
If we look at a case like Berkshire Hathaway (BRK.A)(BRK.B, Financial) – where I believe the
stock is trading at 80 cents on the intrinsic value dollar – a buyback creates a lot of value. In fact,
a buyback is almost 50% more effective in returning value to Berkshire shareholders – at today’s
price – than a dividend would be. That’s because $1 spent on a buyback buys $1.25 of intrinsic
value. Meanwhile, $1 paid out in dividends becomes no more than 85 cents after-tax.
Of course, the buyback does not eliminate the tax. It only defers it. But very long-time holders
can get enormous benefits from such buybacks.
We should be careful to overstate the tax aspect of buybacks. For example, Q-Logic has a lot of
cash overseas (almost all of its $500 million). The company could – in theory – make several
tender offers for close to 50% of its market cap with that cash. This is the Teledyne (TDY)
approach. Q-Logic doesn’t do that for several reasons. One, it likes having some cash on hand at
all time. But, more importantly, it doesn’t want to pay the tax.
The actual intrinsic value math here does not support the company’s position. No one is
complaining because Q-Logic already buys back a lot of stock. But, even paying an extra 35%
tax (the most possible) on bringing back cash to the U.S. to buy stock would not destroy value.
That’s true because the stock is so cheap that a buyback at around today’s prices would result in
anywhere from an 8% to 15% return on the cash used to make that buyback. This is higher than
shareholders can make on their own. The company’s argument for keeping the cash is valid only
if they can find a way to earn more than 8% a year overseas. Perhaps they can. But it seems more
like a knee jerk desire to avoid taxes rather than a careful look at how much value could be
created even after paying taxes versus keeping cash idle.
These are the kinds of complexities you deal with when you start talking about stock buybacks.
You need to think about the buyback yield, the taxes that would be paid (or not paid versus
dividends), and the return the company would get on the buyback.
Companies rarely talk about the return on their buyback. But that is a critical element of the
decision to buyback stock sense the higher the price at which stock is bought back the less the
intrinsic value of the “capital returned” to shareholders and the lower the stock price at which the
buyback is done the more intrinsic value is created. It is never a 1 to 1 comparison between a
dollar of buybacks in price terms leading to a dollar of buybacks in value terms. They are always
different.
But there are two parts that matter when looking at the difference between a stock’s buyback
yield and its dividend yield. A dividend yield is simply the stock’s annual dividend per share
divided by the stock price. Keep in mind, dividends are taxed. So, a 6% dividend yield is only
worth about 5% after-tax in the best circumstances.
The value of a buyback is more complicated. The tax is deferred – for now – but the value added
or destroyed relative to a dividend payment depends on the return the company is getting on its
buyback versus the return you could get by going out an buying another stock. For example, if a
company with a P/E of 10 is buying back its stock, that company is probably going to earn at
least 10% a year on its purchase. It is unlikely to can buy stocks for yourself right now that return
11.75% which is what you would need to offset a 15% dividend tax and earn what the company
can earn through a buyback.
A simple rule of thumb is that when a company’s stock price is below the P/E at which you
could buy other stocks, a buyback probably helps you. When a company’s stock price is above
the P/E at which you could buy other – equally good – stocks, you’d probably be better off with
a dividend. When the stock’s P/E is close to the P/E you would pay for other stocks – it’s
probably better to have a buyback because:
1. You don’t have to pay an extra tax right now
2. You already know you like this particular stock. That’s why you already own it.
That’s the simple way to think about buybacks. Now, let’s get into exactly how you can calculate
a stock’s buyback yield and a stock’s return on that buyback. Both numbers matter. A high
buyback yield with a low return on that buyback is not good. In that case, a dividend would be
better. Meanwhile, a low buyback yield with a high return on the buyback is good – but it means
you are either paying too high a price for the stock, or the company isn’t buying back enough
stock.
I’ll focus on a particularly interesting case here: Q-Logic (QLGC, Financial). Q-Logic has a
high buyback yield (around 12%). And it has a very, very high return on its buyback (about
25%). However, there is a complication with Q-Logic. It is using what I call “anti-leverage.”
This makes the buyback less effective – because it’s actually much smaller – than it first appears
to be.
What they seem to be using is the cash spent on buybacks last year divided by today's market
cap. That's what I see most often. So, assume a company - we'll use Q-Logic who pays no
dividend but does buyback stock - spent $127 million buying back stock last year. In fact, they
actually did spend $127 million buying back stock (as you can see on their 2012 cash flow
statement for the year ended April 2012). The company's market cap is $1.05 billion today. So, a
buyback of $127 million divided by $1.05 billion gives Q-Logic a buyback yield of 12%. In a
sense, that is true. But I would argue it is clearly wrong. Why?
Because Q-Logic spent $127 million gross on share buybacks. It did not spend $127 million net.
The company also issued stock. We need to adjust for that. The company issued $30 million of
stock last year and bought back $127 million. So, the net buyback was $97 million. That leads to
a buyback yield of 9.24% on today's market cap of $1.05 billion. That number is probably about
right as a backward looking number.
A buyback is effectively a free cash flow type number. In no sense is a company required to have
earned its buyback in GAAP income. The same is theoretically true of dividends - but rather rare.
I have seen companies pay dividends they did not earn in GAAP terms but did earn (in their
minds) as free cash flow. It's very rare. And it only happens when a company manages for free
cash flow. Dividends tend to be stated as a percent of income earned, etc.
You want to look back at least three years to get any free cash flow number. Let's do that for QLogic. Their cash flow statement for the fiscal years ended 2012, 2011, and 2010 gives us both
the buyback amount and the stock issued amount. By netting treasury stock purchases (share
buybacks) against proceeds from issuance of common stock and options exercised (stock
issuance) we get a net share repurchase in dollars for each of those three years. They were: $129
million in 2010, $153 million in 2011, and $97 million in 2012. That gives us a three-year
average of $126 million. The market cap right now is $1.05 billion. So, $126 million divided by
$1.05 billion gives a buyback yield of 12%.
Is that right? And if so, is it equivalent to a 12% dividend yield?
I'd say it's pretty much right. In my view, Q-Logic's stock buyback yield - based on the past
record alone - is around 12% on today's price. If the stock stays at the same price and free cash
flow stays at the same level as it has in the past, Q-Logic will buy back about 12% of its shares
over the next year. In that sense, a new Q-Logic shareholder who buys 1,000 shares of Q-Logic
today will - in one year - be the owner of the equivalent of 1,120 shares of Q-Logic. That's
because the share count will shrink. And this shrinkage will be effectively the same for that
shareholder as if the share count did not shrink but the shareholder was given an extra 120 shares
of Q-Logic at the end of the year. In that sense, it's exactly like a 12% cash dividend being paid
in stock rather than cash to the shareholder.
The actual reality of course is different. What really happens is that the shareholder's account
shows the same number of shares and yet his percentage ownership of the company rises. What's
important to take away here is that 12% of his original purchase price was generated in free cash
flow and that 12% was reinvested in the company's stock. He did not receive cash. And he did
not pay taxes on dividends. Instead, his stake in the company increased and his deferred gain on
the company increased. This means he was able to avoid taxes for now - in fact, he can avoid
them until the moment he sells since Q-Logic has never paid a dividend. And he will get longterm capital gain treatment when he does sell. This is the tax part everyone talks about. The more
reliable part of the tax situation - it's not really an issue that's debated in the U.S. from year to
year - is the deferring of the tax. It's a pretty basic principle that income is taxed when received
but that an increase in market value without any transaction does not constitute income yet. So,
while the favorability or unfavorability of dividends versus capital gains etc. bounces around
over time depending on who is writing the tax laws - it's unlikely that putting off paying a tax
will ever become a negative.
Okay. Now, the issue is the return on the buyback. This is what you were getting at. I don't think
book value is a good measure for most companies. I think earnings yield - or free cash flow
yield, it depends on the company - is the best measure for most operating businesses. You can
look at the P/E ratio, EV/EBITDA, Market Cap/Free Cash Flow, and EV/Free Cash Flow as
good indicators of what a company's return on its buyback is.
Here, you want to compare the return on the company's buyback with the return you could
achieve. However, you want to keep in mind that while you would pay a tax on the dividend the
company does not pay a tax on the buyback. Let's say I imagine John Wiley
(JW.A, Financial) will get a 10% return on its buyback. Likewise, I think I can go out and
return 10% a year myself picking my own stocks. In this case, which should I prefer? Should I
prefer John Wiley paid a dividend or used all of its free cash flow to buyback stock?
If my assumptions - that John WIley will get a 10% return on their buyback and I can make 10%
a year picking stocks in my brokerage account - are true, then John Wiley creates more
shareholder value for me when they don't pay a dividend and instead just buyback stock. In fact,
that is the actual case with the company right now. If anything, I've understated the return JW.A
can get buying back their own stock (it's probably closer to 13% than 10% right now - I'd
estimate 12% to 15% if I had to pick a range) and most investors will have a hard time earning
more than about 7% picking stocks right now. This just goes to show you that I think John Wiley
is - on an admittedly leveraged basis - a cheap stock.
But, what if the reality was that JW.A really would earn 10% on their buyback and I really could
make 10% picking new stocks?
It doesn't matter. That would still suggest the capital allocation should be 100% buyback and 0%
dividend because even under the best circumstances a dividend will be taxed at 15%. Under the
worst circumstances, it could be almost 40%. But taking the best case of 15%, we see that for
every $1 John Wiley pays me in dividends I only keep 85 cents after-tax. The company however
pays no extra tax on a stock buyback. So, if they earmark $1 for buybacks they actually buy $1
worth of stock on my behalf. Therefore the choice is - excluding the factor of timing between
when I receive cash and when I pay the IRS - a matter of me getting to keep 85 cents in cash or
$1 in stock. Obviously, if the stock is at all undervalued, it's better to have the stock.
Let's look at real-life for a John Wiley shareholder. I would estimate the return you can get by
owning more John Wiley stock to be 12% a year. This is based on a roughly 10% free cash flow
yield (which again, is leveraged and assumes JW.A does not pay down debt over time relative to
equity) and a 2% long-term growth rate. That growth rate is simply an assumption about
academic journal pricing. I expect it to rise over time. Like I said, the reality might be more in
the 2% to 5% annual growth range. But, I am going to assume a 10% free cash flow yield today
plus 2% growth each year forever. Meanwhile, at today's - in my view - high stock prices I think
the average individual investor will have a hard time earning more than 7% a year in stocks over
the next 5 to 15 years.
Assuming a 15% dividend tax, every $1,000 that John Wiley uses to buyback stock would
become $5,474 by the end of a 15-year holding period. If John Wiley instead paid its shareholder
$1,000 in a dividend which the shareholder then put in an index fund, etc. I would estimate they
would have about $2,345 at the end of 15 years. Therefore, over a 15 year holding period the
difference between John Wiley buying back $1,000 worth of stock on your behalf this year and
paying you $1,000 in a cash dividend is the difference between $5,474 and $2,345.
In the case of John Wiley - at today's price - I think it is very clear that a long-term investor
would be made much better off through a buyback rather than a dividend. However, I don't think
the market recognizes this. In fact, I think many investors would prefer seeing a dividend to a
buyback. They'd be wrong unless they can earn a tax equivalent return greater than the company
can earn buying back stock. In the case of John Wiley, shareholders who can earn over 14% a
year in the stock market (or elsewhere) are the only shareholders who should prefer a dividend to
a buyback. I believe there are very, very few John Wiley shareholders who can make 14% a year
on their own long-term - therefore, it would be to the benefit of almost all long-term shareholders
of JW.A to use all free cash flow to buy back stock rather than paying any dividend.
The argument some will make against a buyback and in favor of a dividend is that a buyback is
essentially a doubling down on the company. That's true. John Wiley is a higher quality company
- with a wider moat - than the S&P generally and the median hypothetical stock certainly. It's
also cheaper right now. So there's no valid argument against John WIley buying back stock at
this time in favor of paying a dividend.
But what if you had doubts about the long-term viability of the business? (I should point out, I
have no such doubts with John Wiley. The most important part of their business - academic
journal publishing has a durable moat that will be around for however long you choose to own
the stock.)
That is a legitimate concern. But it's a legitimate concern at the corporate capital allocation level
regardless of dividend policy. Charlie Munger has pointed this out. General Motors ruined its
shareholders. Berkshire Hathaway did not. General Motors was a failing business. Berkshire
Hathaway was a failing business. Neither company could do anything to fix that problem. But
only one company saved its shareholders.
If a company has an at risk business, it can allocate capital to other areas. Many successful
companies no longer engage in the business they started in. If American Express (AXP) stayed
in its original business, it wouldn't be around today. The same is true of IBM, MMM, and
BRK.B. Some companies choose to pay large dividends or buy back stock while the business is
failing rather than allocating capital into a different industry. Let's look at Value Line
(VALU, Financial). Over the last 10 years, Value Line has paid out about 85% of the company's
current market cap. It's a dying business. It had a decision to make. It could allocate capital to
new areas inside the corporation, it could pay dividends, or it could buyback stock. It chose to
pay dividends.
Now, let's compare this to Q-Logic. The company spent about $1.32 billion on stock buybacks
over the last 10 years. The company's market cap today is only $1.05 billion. So, the company
has spent more buying back stock than the company is worth now. Is that a good outcome or a
bad outcome?
It sounds like a pretty terrible outcome.
But there's always the issue of valuation here. Is Q-Logic valued right. Enterprise value is even
lower. It's about $555 million. Of course, when a company buys back stock - and now we're
getting really meta here - it also buys back more of the cash it keeps. In other words, Q-Logic
buying back stock today is not really valuing its continuing operations at $1.05 billion. It's only
assigning them a value of $555 million. That's because continuing shareholders - those who don't
sell into the buyback - get an increase in the company's free cash flow as well as in increase in
the cash left on the balance sheet after the buyback. Q-Logic may be spending $11 to buy back a
share of stock, but that share they buy back comes with something like $5 of added cash
attached. So, if you start out as a shareholder of 1,000 shares of Q-Logic you end the year with a
greater ownership in Q-Logic's ongoing business plus an effective "cash back" on the stock
repurchased. Basically, if Q-Logic pays $11 for stock right now, it's paying $11 and then getting
$5 back. The reverse is true for a company like John Wiley that uses debt - they effectively
increase debt as they buy back stock because they decrease cash relative to debt. This isn't
necessarily negative - in fact, this leveraging is a reason why buybacks work over time - but it's
making a clear decision to avoid paying down debt and instead buying back stock. It's an active
choice not to deleverage.
Q-Logic already uses "anti-leverage". Their return on equity is lower than their return on
invested capital because much of the shareholder equity is not invested in the business.
Shareholder's equity is $716 million and $115 million of that is goodwill. So, tangible equity is
$601 million. However, the company has $495 million in net cash. So, unleveraged tangible
equity would be only $106 million. That's the part they are using in the business. Obviously, QLogic's returns on invested capital are extraordinarily high. In fact, the numbers they report in
ROE etc. are still acceptable looking despite Q-Logic using a huge amount of "anti-leverage".
They only have $106 million in tangible net worth tied up in the business and yet the balance
sheet has $601 million in tangible shareholder's equity. That's equivalent to having a "leverage
ratio" of 0.18. Obviously, a 100% buyer of Q-Logic would simply remove the $495 million in
cash - it's overseas and will have to be taxed if brought to the U.S. - and keep only the $106
million in tangible equity that is tied up in the business.
And this is where we get to a really important concept. Let's imagine Q-Logic is - on average buying back about $126 million worth of stock. What is the return on this repurchase?
Let's start by assuming future earning power is simply Q-Logic's 10-year average free cash flow.
Average free cash flow over the last decade has been $141 million a year. The company's market
cap today is $1.05 billion. So, the return on repurchase under those circumstances (assuming
neither earnings growth or decay) would be 13.4%. But there's a problem here. The company's
enterprise value is not $1.05 billion. It's $555 million. So, if Q-Logic were really delivering free
cash flow of $141 million a year - that free cash flow only costs the company $555 million to
buy (you don't pay for the cash you keep on the balance sheet - it's still there, in fact in a higher
proportion for continuing shareholders).
So, isn't the real return on repurchase more like $141 million / $555 million = 25.4%.
Yes, it is. Q-Logic is earning about a 25% on its repurchase. However - and this is critical - the
repurchase is not as large as it appears. If Q-Logic spends $126 million this year to buy back
stock, it's not actually buying back as much of the operating business as it would be if the
company was not anti-leveraged. Basically, about 47 cents of every dollar Q-Logic spends on
repurchases is going to actually buy back the company's operations. The other 53% is just being
refunded in surplus cash. I know that's a confusing concept. But it's important. Q-Logic has no
method for focusing buybacks only on the operating business the way a 100% private buyer
could do. If you buy back stock in the open market you get more ownership of the income/cash
flow statement and more ownership of the balance sheet.
So, really what's happening when Q-Logic buys back stock?
Well, they earmark $126 million - again, this is just a three-year average of what they've actually
spent buying back stock - for buybacks. However, only $59 million of this is being used to
buyback the operating business at an enterprise value of $555 million. So, they are buying back
about 10.6% of the operating business when they spend $126 million. The remainder of that
$126 million - about $67 million - is just swapping cash for cash. This is a very important
concept. And it has major implications for stockpicking. It is actually possible for John Wiley which trades at twice the EV/EBITDA of Q-Logic - to buy back roughly the same amount of the
operating business each year (around 10%) as Q-Logic is doing despite Q-Logic having much
higher cash flow relative to enterprise value. How is that possible?
Leverage.
The ability of a company to increase earning power through buybacks depends on the percentage
of shares it buys back. For example, Q-Logic can buy back about 10% of its shares outstanding
each year - at today's stock price - using its normal free cash flow. This would cause earnings to
rise 11% a year (1/0.9 = 1.11). So, Q-Logic can grow earnings per share 11% a year without
increasing the capital invested in the business. And without the business actually growing the
topline. If the company's business neither grows nor shrinks, the stock price stays the same, and
all free cash flow is used to buyback stock - Q-Logic's earnings per share will rise 11% a year.
That's significant considering Q-Logic is not priced like a growth stock and yet it has a pretty
foolproof method for achieving EPS growth of 11% a year. After all, if the stock price goes up
the return on buybacks goes down - but then, shareholders get the consolation of a higher stock
price which they can take advantage of and sell their shares. It's a win-win if the business is
stable.
But John Wiley can also increase EPS each year through buybacks.
So what's the difference?
The difference is one between theory and practice. Q-Logic has demonstrated an extremely
unusual willingness to buy back as much stock as possible - and pay no dividends despite having
the cash flow to pay large dividends - and to do it every year. John Wiley has bought back stock
at times. But they've also increased share count and also left it pretty flat at times. Sometimes
that's good. If your stock is overpriced, it's good to not issue shares.
A few companies - very, very few - may in fact practice Henry Singleton like attitudes toward
buybacks. Most companies aren't even common sense using enough to mention the fact that
buybacks are a good idea below 15 times earnings and a bad idea above 25 times earnings. If
most companies simply adhered to that strategy - buy below 15x earnings and stop buying above
25x earnings - they'd have more success with their return on buybacks. Most can't do even that.
Personally, I do not look for "smart" buybacks. I look for an admission of stupidity on the part of
the company. I look for a company that just always buys back stock regardless of stock prices,
future expectations, etc.
Why?
Because I already know the stock price when I buy into the company. I know if the company is
trading at 5 or 10 or 15 or 25 times free cash flow. I know what return on my stock purchase I
expect. The company is simply making the same investment - albeit in its own stock - that I
made in the company. All I care about that I don't already know is whether or not they will buy
back stock. And how much will they buy back. I do, however, want to make sure they won't stop
buying back when the stock tanks. That is a major concern, because a lot of companies do that.
This is the simplest part of the buyback question. If you as an investor have just purchased the
stock at today's price the question of whether you would prefer a stock buyback or a dividend is
a no brainer. You would prefer a stock buyback. A company's investment in its own shares can
never be less attractive than your investment in that same company's shares. Never.
So if you are putting new money to work today in DirecTV (DTV, Financial) or Q-Logic or
John Wiley and you are correct in that purchase - then the company is correct in devoting 100%
of free cash flow to buybacks and 0% to dividends. There can be no question about this. The
question only arises in situations where you would no longer be willing to put new money to
work in the stock.
As an example, Berkshire Hathaway would be in favor of Coke using all of its free cash flow to
buyback stock in 1989 because Berkshire was buying Coke then. Berkshire would not
necessarily be in favor of Coke putting all its free cash flow into buybacks today because
Berkshire has the opportunity to put new money to work in Coke at today's prices and instead
prefers to buy Heinz, Wells Fargo, IBM, etc. The 1980s care is clear, Berkshire had to prefer
buybacks because Berkshire was buying the stock itself. The 2013 situation is different.
Berkshire is no longer a buyer of Coca-Cola. Berkshire is a holder of Coca-Cola.
A lot of people overlook this simple rule. If you are a buyer of a stock, you ought rationally to be
in favor of that company paying no dividend and using all that cash to buy back stock. There is
no good argument against this. If you are a holder of the stock, the story is different. It's complex
and it may sometimes be indeterminable whether you want a dividend or a buyback.
It depends a lot on your own return potential. Historically, I've been able to earn 15% a year in
the stocks I bought. So, I am a bit biased in favor of dividends over buybacks at stocks I hold but
am no longer buying. I figure I can make 15% a year on my own. So unless the company can
make more than 12% to 13% (due to taxes), it isn't clear that a buyback is better for me. But,
again, that's based on making 15% a year annualized since 1998-1999. The stock market
performance since 1998-1999 has not been as good as my personal performance. So, it's a
question of whether you believe your performance will or will not be better than the market,
whether your future performance will be like your past performance, etc.
I doubt I can do 15% a year in the future. So, if I feel good a company I own can earn 10% on a
stock buyback - I'd tell them to go all out and skip the dividend.
Sometimes this is not practical. I own George Risk (RSKIA, Financial) and Ark Restaurants
(ARKR, Financial). When I bought them - and even now - I think their return on buyback
would be high and I'd be in favor of it. However, the stocks are illiquid and their free cash flow
relative to the dollar value of freely traded shares is not high. As a result, I'm always in favor of
RSKIA and ARKR buying back stock. But, I understand it's very hard for them to do in practice
unless there is a meaningful holder who signals he wants out of the stock.
My approach to buybacks is pretty simple. One, I prefer them. Two, I look at the share count
history over the last 10 to 20 years as my guide to what the company might do in the future - I
want a pattern of predictable behavior. Generally, that means a continuously shrinking share
count that shrinks in bull markets and bear markets, panics and recessions and booms and busts
and so on. Three, if I'm a buyer of the stock - then the company should be a buyer of its own
stock. No questions asked on that one. If the stock is good enough for me to buy it's clearly good
enough for the company to buy. Finally, I look for the return on buyback. I tend to focus on the
earning power the company is buying relative to the net cash it is spending. If a company has
cash on its balance sheet, the amount of net cash consumed by a buyback will be less than it
appears because I will end up with a greater percentage ownership of the resulting balance sheet
as well as the income statement.
I want the return on buyback to always be at least 10%. As a rule, the average company will only
get returns on its buybacks of 10% or higher if it pays less than 15 times normal earnings. In
special cases - fast growing companies, companies where free cash flow vastly exceeds reported
income, etc. - it is possible that buybacks above 15 times earnings will return more than 10%. It
almost never makes sense for a company to buy back stock at over 25 times earnings. So, for
most companies, under 15 times earnings is the green zone for buybacks - 15 to 25 times
earnings is the yellow zone, and over 25 times earnings is the red zone.
You mentioned book value, etc. You can't value most companies on book value. You need to
look at owner earnings. Basically, what do you think the right leverage level for DirecTV is?
Feel free to use debt to free cash flow or Debt/EBITDA or whatever you think is an appropriate
metric. The question is - at that leverage level - is FCF/Purchase Price acceptable? Is the extra
free cash flow (owner earnings) the company gets in the buyback worth at least the price paid? Is
it more than you can get in the stock market?
You probably don't want any buybacks where FCF/Market Cap 10%. So, as long as the price
paid is between 10 and 15 times owner earnings, it's a murky situation. If the company is paying
less than 10 times owner earnings it's either a good purchase or the business is headed into
oblivion. A flat or growing business is worth at least 10 times earnings as long as it's a durable
business. Once a company is paying 15 times owner earnings or more for its own stock, the
question becomes growth. Some companies probably are worth 15 times earnings while other
probably are worth 25 times earnings. The perfect business might be - might be - worth
something like 33 times earnings. But it would have to be a business with complete certainty for
the future and that future would have to involve growth equal to or greater than nominal GDP. I
can't think of many companies where GDP or greater growth is literally guaranteed. To the
extent they exist, they are probably worth close to 30 times earnings. Of, course I’d never pay 30
times earnings for a stock even if it were worth 30 times earnings.
For that reason, it's clear that buybacks are best at higher quality and more durable companies.
They are simply safer there. If Coca-Cola or Omnicom chooses to always buy back stock, it'll
tend not to destroy much value because the stock will usually be trading at a reasonable level
versus long-term prospects. As a business's future becomes less certain - and its P/E higher - this
is more problematic. Sometimes even a company I like can trade at a silly price. It is hard for me
to argue in favor of Netflix, Under Armour, etc. buying back stock at some of the prices where
those stocks have traded regardless of what I think about the businesses because the P/Es were
simply too high at times.
For this reason, I think it's best to focus on companies that:
1. Have a wide and durable moat
2. Lower their share count every year
3. Are trading at a reasonable price right now
Those are the kinds of buybacks you want. And always prefer the past record to buyback
announcements, etc. I don't pay much attention to recent announcements. I pay attention to past
actions.



URL: https://www.gurufocus.com/news/212095/how-do-you-calculate-a-stocks-buybackyield
Time: 2013
Back to Sections
-----------------------------------------------------
What Is the Best Way to Learn Accounting?
The best way to learn accounting is not by reading books. The best way to learn accounting is by
reading 10-Ks. This gives you real-world examples of accounting concepts. Today I’m going to
talk about some of those concepts. And try to use examples of real companies.
Let’s start with depreciation. Depreciation is one of the most important concepts you will deal
with as an investor. Depreciation causes much of the difference between reported earnings and
cash flow. What matters in investing is not reported earnings. What matters is cash flow.
Cash flow is defined in many different ways. You will hear a lot of talk about EBITDA. That is a
measure of pretax and pre-interest cash flow. EBITDA is most often compared to enterprise
value. Enterprise value includes the value of the company’s equity and its debt. It is an estimate
of how much it would cost to buy the entire company without paying any premium.
A lot of studies have shown that enterprise value to EBITDA is one of the best price metrics to
use when picking stocks. It is probably the best gauge of how cheap or expensive a stock is.
Control owners often use EBITDA as a better measure of earnings.
They do this because EBITDA reflects cash flow rather than reported earnings. And because
EBITDA reflects cash flow before interest and taxes. Control owners can add debt to a
company’s balance sheet. This changes the amount of interest and taxes owed.
Many investors believe using EBITDA is wrong. They are right in that EBITDA greatly
overstates economic earnings. However, the solution is not to use reported earnings. For some
companies reported earnings are not a good estimate of owner earnings. Owner earnings are
equal to free cash flow after paying to maintain a company’s competitive position.
That is the key concept to keep in mind as an investor. Your focus should always be on owner
earnings. Owner earnings means cash flow. It does not mean reported earnings. And it does not
mean EBITDA. It means free cash flow. But it does not mean free cash flow as you see it
reported on many financial websites.
The free cash flow number you see reported is often cash flow from operations minus capital
expenditures. Why is this not the best measure of owner earnings?
When a company is not growing but it is maintaining its competitive position free cash flow,
owner earnings will basically be equal. But when a company is growing very quickly, free cash
flow may be very low and yet owner earnings may be high. A good example of this is CARBO
Ceramics (CRR, Financial). Over the last 30 years or so CARBO Ceramics produced very little
free cash flow. However, the value of the company has increased in the high double-digit
percentage over those decades.
As a result, investors in CARBO Ceramics have made a lot of money. That means owner
earnings have been big. And it means owner earnings have been positive. And yet free cash flow
has often been close to zero.
How can that be? The answer is that CARBO Ceramics' competitive position has improved over
the years. The company’s market share has increased. The amount of the overall proppant market
that goes to CARBO Ceramics products has probably quadrupled within the last 20 years or so.
So owner earnings have been positive because the company has grown. If the company had not
been growing and free cash flow had been close to zero, then owner earnings would be zero.
Owner earnings should be considered a hypothetical number.
The best way to think about owner earnings is to imagine what free cash flow would be if the
company stayed in place. Free cash flow shows you what the company actually produced in free
cash last year. That’s not really the number you want. The number you want is the economic
profit of the business that would be available to owners. Many companies reinvest much of their
earnings. Not just much of the reported earnings. But much of their owner earnings.
When looking at owner earnings you want to consider what form those earnings come in. In the
case of CARBO Ceramics they do not come in the form of free cash flow. What does that mean?
It means CARBO Ceramics increases its sales every year. The increase comes in the form of
bigger receivables, bigger inventories and more property, plant and equipment. In other words
comes in the form of asset growth. That is common for growing companies.
A few companies produce lots of free cash flow even when they grow. A good example of this is
a software business like Microsoft (MSFT, Financial). Other good examples are advertising
agencies like Omnicom (OMC, Financial). And database companies like Dun & Bradstreet
(DNB, Financial). Many companies with intangible assets that are produced internally have high
free cash flow. So you should not be surprised to find that a company like Dolby
(DLB, Financial) has a lot of free cash flow. But there are other kinds of companies that also
produce a lot of free cash flow.
One company that produces a lot of free cash flow that I’ve been looking at recently is Western
Union (WU, Financial). Western Union is a financial services company. For most financial
services companies the idea of free cash flow is meaningless. Many people write to me in emails
talking about the free cash flow a bank or insurer produces. That is a bad thing to focus on.
Why? It is bad to focus on the free cash flow produced by banks and insurers because those
companies can increase free cash flow today by making mistakes they will pay for tomorrow. An
insurer can increase free cash flow today as it is shown on the cash flow statement by making
promises that will cost a lot in the future. Both banks and insurers have reported earnings that
depend heavily on the assumptions those companies are making. Other kinds of companies do
some of the same assumption making.
A good example of a non-financial company that has to make assumptions is a movie studio.
Let’s talk about DreamWorks. DreamWorks Animation (DWA, Financial) produces movies.
DreamWorks Animation does not distribute movies. The movie distribution business is shorter
term. The movie production business is longer term. And the movie production business depends
a lot on assumptions. It depends on assumptions when making the movie. And it even depends
on assumptions when reporting earnings after a movie has been released.
You can see this in the accounting rules used by these companies. DreamWorks explains that it
carries film inventory on its books. Inventory at most companies consists of products that will be
sold within the next year. There are some exceptions. But inventory is normally a liquid asset.
Inventory at a film studio is not a liquid asset.
DreamWorks accounts for film inventory much the way most companies account for inventory.
But that is only true when inventories are put on the books. Film inventories are put on the books
at cost. The one difference is that the inventory can include capitalized interest. This is not an
important factor for DreamWorks because the company does not borrow.
Inventory is normally recorded at cost. This is true whether the inventory is bread on a grocery
store shelf, a diamond in a jewelry store, or a movie that is entirely intangible. Now the question
becomes how the company accounts for the value of that inventory over time.
Ideally inventory is sold at a much higher price than cost. It’s important to remember that the
inventory that is shown on company’s books at least under GAAP accounting which is what is
used in the U.S. will be the cost of that inventory. Let’s take the example of a grocery store. A
grocery store might spend $1 to buy and shelve some product. That product will probably be sold
for about $1.33. When you look at the store shelf you see $1.33. However, when you look at the
company’s balance sheet you see $1. When the product is sold the company records gross profit
to the extent that the retail price of the product exceeded the cost.
Gross profit is an important concept at many companies. I want to stress that inventory is
recorded at cost. A normal profitable business should routinely sell inventory for much higher
than the value shown on its balance sheet. In fact many companies go year after year after year
without having negative gross profit. The company that has a gross loss is usually in very serious
trouble. It is normal for a company to have a gross loss only in the very early stages of the
business. And even then only in the case of companies that are going to rely on a huge scale to
make a profit in the future.
From the perspective of understanding a business rather than a company and its financial
structure the key numbers you want to focus on are sales, gross profit and EBITDA.
You always want to compare these numbers to something else. A lot of people compare gross
profit and EBITDA. In other words they take gross profit and divide by sales to get the gross
margin. And they take EBITDA and divide by sales to get the EBITDA margin. Those are both
important numbers. But they’re not the most important numbers. The most important number is a
return on capital measure.
How should you measure return on capital? If we put aside the issue of how companies are
financed and focus on the business itself the number that will matter most to you is EBITDA
divided by invested tangible assets. What are invested tangible assets?
Different companies will have different quirks. I mentioned DreamWorks. That is an unusual
company. And it can be hard to measure return on capital there. Likewise companies like
Microsoft and Dun & Bradstreet will have deferred revenue. This complicates things because if
you ignore deferred revenue you underestimate the return on capital of the businesses.
But for most companies the key balance sheet items are receivables, inventory and property.
Those are the assets. The liabilities are accounts payable and accrued expenses. You want to net
the sum of receivables, inventory and property against the sum of accounts payable and accrued
expenses. This will give you an idea of how much capital is in the business.
You then want to look at gross profit divided by the difference between those invested assets and
liabilities. And most importantly you want to look at EBITDA relative to the difference between
those assets and liabilities.
Why do we net out the difference between the assets and liabilities of the operating business?
A business has owners. And it has creditors. We usually think about financial creditors. But
when we look at a company independent of its debt, what we need to focus on are creditors that
are owed money as part of the day-to-day business.
Most companies owe money to their employees. They owe this money at all times. Employees
do work first and are paid later. They also owe money to suppliers. Supplies are shipped first and
paid for later. These creditors provide some of the capital the business needs to operate. That is
capital that owners like shareholders do not have to provide.
What if the accounts payable and accrued expenses are less than receivables, inventory, and
property. Then the business will need capital from owners. Or it will need capital from banks. Or
it will need capital from bond investors. In other words it will need financial capital.
It is best to start studying a company without leverage. Some companies use leverage all the
time. A utility like a power company or a water company will not earn enough for its
shareholders without issuing bonds. That is true. But investors first starting out in understanding
accounting should focus on businesses before considering how they are financed. They should
start with how business is run regardless of whether capital is coming from bond investors or
stock investors.
They should also focus on cash flow rather than reported earnings. That is why I want to talk
about sales, gross profit and EBITDA relative to invest capital.
What is a good return on investment? That is one of the biggest reasons investors look at
accounting. They want to find a business that earns a good return on capital.
It is important that the return on be good in most or all years. You need to go back at least 10
years to understand a business. With EDGAR you can often go back 15 years. You should do
that.
Important numbers to consider are sales relative to receivables, inventory and property. And
sales relative to net tangible assets. The net tangible assets are approximated at most companies
by receivables plus inventory plus property minus accounts payable minus accrued expenses.
The higher sales are relative to net tangible assets the lower margins can be in the company can
still make money. The reason a company like Costco (COST, Financial) can operate with such
low margins is because it has high sales relative to net tangible assets.
If a company has low sales relative to net tangible assets like Amorim Cork does in Portugal or
many jewelry stores do it will need to have very high margins. Some companies that have a lot
of assets always have high margins even when they have poor returns on capital. A cruise
company like Carnival (CCL, Financial) has very high EBITDA margins even in bad years.
The same is true of a railroad. That is not what you should focus on. It is not important that they
get a good return on sales. It is important that they get a good return on assets.
When can you be sure that a company has a good return on assets? Here is a rule of thumb. If a
company routinely earns a 20% EBITDA return on net tangible assets, the business is good
enough for you to invest in for the long run. But it is critical that you remember that a company
which earns more than 20% in most years but lost money in any year may have a mediocre
performance over the long run. In other words you want to see median returns and minimum
returns that are as close to your ideal of 20% or higher in terms of EBIT up. Where does the
number 20% come from?
An unleveraged company with a 20% EBITDA return is likely to be able to deliver double-digit
returns to shareholders. That is why a 20% EBITDA of return is a good cut off.
But it is most useful for companies that have consistent EBITDA returns.
That’s where you start. You start with the EBITDA returns. Then you can think about how
closely EBITDA is related to owner earnings.
At a company like Western Union EBITDA translates into free cash flow at a very high rate. The
only depreciation and amortization at Western Union has to do with write offs of bad past
acquisitions. Or with signing bonuses. Western Union capitalizes signing bonuses.
Some companies build new stores and new factories. Western Union does not do that. Western
Union has a network of agents. Those agents already have bank branches and post offices and
convenience stores and the physical stuff you need to be a Western Union agent. So all Western
Union needs to do is sign them up. The investment that Western Union makes is a signing bonus.
So if Western Union pays $800 as a signing bonus to get a new location for the next five or
seven years they will amortize that signing bonus over those five or seven years. That means
they take $800 and instead of expensing it in year one they spread it out at a rate of anywhere
from say $200 to $100 a year depending on how close it is to, say, a four-year contract or how
close it is to being, say, an eight-year contract.
That is amortization. You may see it described differently at different companies. The truth is
that amortization, depreciation and depletion are all really the same thing. They are just different
terms for the same idea. Do not get hung up on which word is used. You often see amortization
used for intangibles like movies. And you will see depreciation used for tangible things like
machines. Depletion may be used for natural resources. They all amount to the same thing.
Whether we are talking about depreciation, or amortization, or depletion we’re talking about
taking a one-time cash outlay and spreading it over many years as an expense. The classic
example that I use over and over again is a cruise ship. A cruise ship may last 20 or 25 years.
And even after it has been used for 20 or 25 years it will not simply be scrapped. It will be sold.
So a cruise ship has a residual value. And it has a useful life of many, many years.
Those are the key concepts to understand with depreciation. You want to look in the accounting
notes for a description of useful life and residual value. There are also different methods for how
to spread the expense over the years.
An example is the difference between how Carnival accounts for depreciation and how
DreamWorks handles film amortization. Carnival spreads the expense evenly. It uses a straightline method. DreamWorks uses the ultimate revenue approach. They match revenue against
expenses. That works except when they have a flop. When they have flops they have to write off
immediately. So expect to see a write down of Rise of the Guardians real soon.
Why does this matter? It doesn’t really matter that much. You shouldn’t focus on reported
earnings. Analysts tend to focus on reported earnings. The media definitely focuses on reported
earnings. Don’t do that. I want you to focus on cash flow. So you need to look at the ways that
reported earnings masks cash flow. You don’t want to have an estimate of what earnings will be
next year. That’s not necessary.
Carnival and Royal Caribbean (RCL) are similar businesses. And yet if you read their
explanation of how they handle depreciation carefully you will see it is not identical. You will
also see this with companies like railroads. Not every railroad has to use the same approach to
depreciating assets. And not every cruise company has the same approach to depreciating their
assets. They will even disagree on issues like useful life.
This is important. It means that Royal Caribbean may sometimes be depreciating 4% of their
ships each year while Carnival may be depreciating 5%. If each company is generating sales of
only about 40% of the value of their ships we are talking about ships with a book value of about
2 ½ times sales. In other words a 1% difference in depreciation per dollar of book value of
property each year would correspond to a 2.5% difference in margin each year.
So if you focus on reported earnings a tiny difference in depreciation of say a 20-year useful life
versus a 25-year useful life could cause you to miss a 2.5% difference in margin. You could look
at the two companies and see one company has a margin of 12.5% and the other company has a
margin of 10%, and you would think the company with a 12.5% margin is more profitable. But if
the company with a 12.5% margin has estimated useful life for their ships that is just five years
greater then actually there is no difference in cash flow. There is only a difference in reported
earnings. And that difference is based on an arbitrary decision about useful life.
In other words, if you do not understand accounting you will not understand that you are giving
credit to one company over another simply on the basis of trusting managements' estimates of
how long they can use a ship.
This kind of thing is common in many situations. And that is the way to use accounting. You
want to use it not as a guide to exactly what is right and wrong. You want to understand it as you
would understand a written language.
In other words you don’t want to have some exact idea what depreciation is or should be in every
situation. Instead you want to understand how the depreciation affects reported earnings and cash
flow. And you want to understand the difference between economic reality and management
estimates. Most importantly you want to take nothing for granted. You want to understand where
every part of your own estimates of a company’s value comes from.
The danger in not understanding accounting is that you will incorporate ideas without analyzing
them critically. You will incorporate ideas like the useful life of a ship without ever thinking
about the useful life of a ship. You may never read that note on depreciation. But you will take
those margins and make assumptions based on them. But those margins themselves make
assumptions based on the useful life. So you need to go and look for what data makes up the data
you are using.
That is the most important part of accounting. It is not about right or wrong. I can’t tell you
exactly what the earnings-per-share of Royal Caribbean should be. And I can’t tell you exactly
what the earnings-per-share of Carnival should be. I can look at why the earnings are what they
are. I can look at how they would be different if they made different assumptions. And I can give
you my take on what assumptions I think are reasonable. More importantly, I can make
conservative estimates of economic reality and I can restate reported earnings in terms of a
conservative economic reality as I see it.
That is what you are really looking to do. You don’t need to know what reported earnings will
be. You need to know what a conservative estimate of future owner earnings will be. And the
way to do that is to break down the headline numbers you find in a company’s earnings.
How do you do that? Try to be like an investigator. Write down questions you have. If a
company’s receivables look particularly high or low, go and read the note on receivables. The
notes to the financial statements are critical. I can’t stress this enough. You always need to read
the notes to the financial statements. You always want to read the entire 10-K. And you need to
take notes. The notes you take should mostly be questions.
In other words, when you are looking at the depreciation line you should be thinking what
assumptions are they making about useful life? And you should be thinking how does that match
what actually happened in the past. For example, you can go back into the past annual reports for
Royal Caribbean and see the age of their ships. You can see what they sold ships for when they
were done with them. You can test estimates of the future against the past.
If you listen to conference calls you hear a lot of estimates. You should ignore this. You should
instead go back into the past to make estimates about the future. If you want to consider what
kind of capital spending will be needed to keep a fleet in a certain shape you should go back to
what they spent on ships in the past. You should adjust it for inflation. You should consider that
as the average life of the fleet gets older its earning power may be worse. Certainly its
attractiveness will be lower to customers. You should think the way an investigator or journalist
would think.
The metaphor of a reporter is a good one. That is really the way to tackle accounting. It is very
important that you not get hung up on right and wrong. That’s the mistake most people make
when they look at accounting. They try to decide what is correct and incorrect. That’s not really
the way to use accounting. The way to use accounting is to literally think of it as a language. It is
to analyze a financial statement the way you would analyze a written statement. You would not
be focused on some ideal. You should be focused on the gist of what was being said and how it
was being said and what wasn’t being said.
There are good books on accounting. But they will not help most people who need help with
accounting. Because they are theoretical. And at best they will give you some idea of what you’ll
face the real world. But it is much better to simply go out and read a 10-K every day. You can’t
help but learn accounting if you read a 10-K every day. If you read 10-K every day and read it
critically taking notes and especially asking questions you will become much better at
understanding accounting than most investors.
It is that simple. You should stop looking for books on accounting. And you should start learning
accounting the way you would learn a language by immersing yourself in it.



URL: https://www.gurufocus.com/news/201254/what-is-the-best-way-to-learnaccounting
Time: 2013
Back to Sections
-----------------------------------------------------
How to Think About Retained Earnings
Someone who reads my articles asked me this question:
Hi Geoff,
I'm assembling the financial statements for various companies that have done well over the past
years to try and learn and actually see their characteristics for myself. Other than understanding
the business economics and making the calculations, I'm trying to follow the money through the
statements but I'm having trouble seeing the redeployed capital from retained earnings when
other items cloud the picture.
In your article "How Does Warren Buffett Value Growth?" you approximated the reinvested
capital, $1.35. Is there a specific way to determine this? I can calculate the various return
formulas now, but I need to see how capital gets redeployed as well as the rates earned on that
capital. If there is no capital stock purchased then the increase in retained earnings works out,
but if there is, the numbers don't. I have attached the Fastenal Company financials (its 10-K has
an error in the 2006 fiscal year data that the auditor did not pick out, but this is not important
because the error resulted in an understatement). I also have the book "How to Read a Financial
Report" by John Tracy to help with the flows, but at the moment, I can't see it and would be
grateful for some guidance.
Sincerely,
Kevin
You ask a great question. It’s not easy to answer. I track receivables, inventory, PP&E, accounts
payable, and accrued expenses for every year of the last 15 years (if I can get 15-year data). I use
an Excel sheet to compare these numbers to sales, EBITDA, etc. So, if receivables have risen
faster than sales – then that could be where the “reinvestment” is going.
If you have, say, 15 years of data – and you can get this on EDGAR if you’re willing to directly
type stuff from EDGAR into Excel by hand – you can do a better comparison. But if you want it
to be easy – you can use GuruFocus, Morningstar, etc., to do a shorter comparison.
Just look at:
· Net Income
· Free Cash Flow
· (Buybacks + Dividends)
Some companies – like Omnicom, Dun & Bradstreet, etc. – will say “we’ve returned 95% or
90% or 80%” or whatever of earnings to shareholders over the last 10 years. This is often an
overstatement of sorts. Because they’ve increased debt. I can pay you back 500% of earnings if
someone is willing to lend me $5 for every $1 I earned this year. Usually, we don’t want to count
stuff like this.
So...
Let’s look at Dun & Bradstreet (DNB, Financial). Share buybacks and dividends were $2.93
billion versus $2.43 billion in reported earnings over the last 10 years. Obviously, they increased
debt. I’ll lump debt and pension shortfall together here. Net financial obligations (that is, debt
and pension gap minus cash) was $637 million in 2002. And it was $1.68 billion today. (These
are approximations – I’m not looking at EDGAR right now, I’m using the GuruFocus page. If
you really do this yourself, check EDGAR. Because I’m using the “other long-term liabilities”
line as pension gap here – and I don’t think all of it is really the pension fund. Anyway...) So
debt increased by $1.04 billion. Let’s take that out of the $2.93 billion payback (because it was
debt financed, not business financed). That leaves $1.89 billion that was paid out to shareholders
without using debt. And reported earnings were $2.43 billion. So, $1.89 billion divided by $2.43
billion equals 78%. DNB pays out around 78 cents of each dollar.
They retained about 22 cents of each dollar. And these 22 cents that were retained – remember,
they really weren’t retained at DNB, they just borrowed money – were able to grow net income
by 6.9% a year (from $143 million to $260 million over nine years). Sales grew slower. Just
3.6%. The sustainable rate is probably closer to 3.6%.
But let’s think about earnings. Say, you had a dollar of earnings at DNB. Next year – if they
grow net income by 6.9% a year – you’ll have about $1.07 in earnings next year. And DNB will
pay you 78 cents in stock buybacks and dividends. So, that 7 cent increase came from 22 cents of
retained earnings. That’s about a 32% return on retained earnings. If we assume the sales number
is more accurate – we don’t give them credit for margin expansion in earnings growth – then
return on retained earnings is just 18%. Either number is good.
For comparison, let’s look at Omnicom (OMC, Financial). Over the last 10 years, they’ve had
cumulative dividends and buybacks of $7.94 billion. Cumulative net income was $8.25 billion.
Net debt increased by something like $1.8 billion. Again, this probably isn’t right. Check
EDGAR. I just treated all long-term liabilities as debt – which is probably wrong. Anyway, that
means that we had 74 cents of each dollar paid out without the use of debt. Again, the actual
payout was higher – but if they borrowed from the bank and paid me a dividend, I don’t count
that. So, 74 cents a year is what Omnicom pays out to shareholders without increasing debt. That
leaves 26 cents in retained earnings.
Net income rose by 4.4% a year. Sales rose by 7.2%. I think net income is a little depressed right
now. And the real number is somewhere between 4.4% a year growth and 7.2% a year growth in
normal earning power. But we’ll use 4.4%.
So, same idea, for every $1 of EPS OMC has today we assume they will have $1.04 in EPS next
year. And they need to retain 26 cents to do that. Well, 4 cents divided by 26 cents is 15%. So
they are earning about a 15% return on retained earnings. Again, this is a guess. But it gives you
an idea of what they are earning over time.
Look at the change in net income and sales over 10 years and then the ratio of cumulative
buybacks and dividends to cumulative reported earnings.
We’ll try this for a totally different company – Carbo Ceramics (CRR, Financial).
They had cumulative net income of $568 million over the last 10 years. And they paid out $152
million in stock buybacks and dividends. That means they are paying out 27 cents for every $1
they earn. Or looking at it the other way – they are retaining 73 cents for every $1 they earn.
Net income rose by 23% a year over the last nine years. Sales rose by 20% a year. We won’t
assume any margin expansion – so let’s take the 20% sales number as normal.
This means that Carbo tends to earn $1.20 next year for every $1 it earned this year. And for
every $1 Carbo earned this year, they tend to pay out 27 cents. On the part they retain, their
return is 20 cents divided by 73 cents. Which is a 27% return on retained earnings.
Again, this is an estimate. Not a calculation. I’m not looking for a specific formula. I’m looking
for what the central tendency of return on retained earnings has been. And I’m not worried about
whether it is 23% or 21%. I’m worried about whether it is 5% or 15% or 30%. Is it a bad
business, a good business or a great business.
Carbo (CRR, Financial) is good verging on great. Omnicom is good – definitely not verging on
great. But Omnicom buys other agencies. Acquisitions like that give you more room to deploy
capital – Omnicom has a lot more runway than DNB – but it also means you are unlikely to get
spectacular returns on capital. At some price, the sellers simply won’t sell. One product
companies have a much easier time of achieving very high returns on retained earnings – but
they also have a tough time expanding indefinitely.



URL: https://www.gurufocus.com/news/178532/how-to-think-about-retained-earnings
Time: 2012
Back to Sections
-----------------------------------------------------
Is Negative Book Value Bad?
Someone who reads my articles asked me this question:
Geoff,
Dun & Bradstreet Corp (DNB, Financial) is a great buy in my opinion. I have been considering
it myself since it dropped to the mid-$60 range last week. I have one concern about it and this
holds true for a few other stocks that have this same characteristic. Several very successful
companies have been buying back stock at a rapid pace and this has caused shareholders equity
to go negative. Direct TV (DTV, Financial), AutoZone (AZO, Financial) and Dun and
Bradstreet (DNB, Financial) are examples. All have great track records for business and stock
price growth long term so this appears to be a strategic decision to finance through debt rather
than equity. My question is at what point can an investor judge that this practice is no longer
creating value but adding risk to the investment? There can obviously be too much leverage.
However when money is cheap to borrow and ROIC is high this seems like a great way to create
value for shareholders, to just borrow at 3% and buy stock with an ROIC over 20%, but how
much is too much?
Thank you,
Jeff
It’ll take me a while to answer. And I’m afraid my answer may really go off on some tangents
here.
So, I want to make a few key points right away:
· Negative equity itself is meaningless (could be good or bad).
· Operating liabilities and financial liabilities should be analyzed separately.
· You will often have to restate the value of assets from book value if you want the balance sheet
to reflect reality.
· In special cases – like with pensions – you may have to restate liabilities as well.
· Liquidating safety and operating safety are two different things.
· Compare net financial obligations to EBITDA.
· Compare net financial obligations to free cash flow – think of borrowed money as the price of
time (a good business can always wait a few years and do the same things without any debt, ask
yourself which you’d rather they do – borrow money or spend time).
· Look at EV/EBITDA – not just the P/E ratio.
Finally, remember you can always learn from someone who invests in debt.
Stock investors can learn a lot from people who analyze debt. Here is a good blog to give you a
taste of what I mean.
Reading about investing in debt – and especially about companies in bankruptcies – can give you
a new perspective on situations like these.
I just wrote an article about how free cash flow isn’t everything. Well neither are earnings. And
neither is book value.
If you look at the stocks in my portfolio, you’ll find I must value free cash flow very highly
because as a group they tend to:
· Always have positive free cash flow
· Have unusually high ratios of free cash flow to reported earnings
· Buy back shares
· Pay dividends
· And still have excess cash
Dun & Bradstreet sure doesn’t meet the last criterion (it has a lot more debt than cash). But it
checks the other boxes. This is something both my “wide moat” investments and my “net-nets”
have in common. Free cash flow.
And yet, I wrote a whole article about how free cash flow isn’t everything.
That’s because it’s really looking at the space between the three key statements:
· Balance sheet
· Income statement
· Cash flow statement
Where you do your most important work.
Investing isn’t about the balance sheet or the income statement or the cash flow statement. It’s
about how the balance sheet, income statement and cash flow statement interact through time.
Never be myopically focused on one financial statement or myopically focused on one time
period.
Each statement reveals just one aspect of the same object: a business. And it does it for just one
time period (in fact, the balance sheet does it for just one moment in time).
As an investor, you need to be able to see all aspects of the business in motion.
Because we are seeing just one aspect of a business when we see something like negative equity
– that fact alone means almost nothing.
It would be like if we were analyzing football players and we knew somebody weighed 300
pounds. Is that good or bad?
For a quarterback?
Bad.
On the line?
If he’s good enough in other ways – he could weigh even more and nobody would mind.
If we were drafting a football player we’d want to know the combination of age, size, weight,
agility, skill, personality, etc. Just knowing weight isn’t going to help without having more
context of how that one aspect relates to the whole player.
Same thing with a business. Same thing with an investment.
So negative shareholder’s equity alone doesn’t matter. In fact, like you said, it can be something
you find with stocks that perform perfectly fine over time.
Now, about Dun & Bradstreet...
I wish I had bought more Dun & Bradstreet (DNB, Financial). On the morning of the big drop,
I only had 6% of my portfolio in cash and ready to buy. I’m doing a bit of selling of something
else – over in Japan – right now. It’s a cheap stock. And will probably perform wonderfully for
whoever buys it from me. But the risk of catastrophic loss rose since I first bought the stock. The
risk/reward may still be good. But the reliability is not as high. That’s usually my cue to go. So I
would be selling that Japanese stock anyway. Even if DNB hadn’t dropped.
But I do hope it sells a little faster – now that I have someplace to put the cash.
I hate having only 6% of my portfolio in a position. I have a pretty strong dislike – almost a rule
against – any position less than 10% in my portfolio. I have found I do not make good decisions
when I have to juggle 10 or more opportunities in my head at once.
That shows you how much I like DNB. For most stocks, I would wait until I knew I had enough
cash to put more than 10% into the stock. For DNB, I immediately used all the cash I had
available. Even before I worried about how I could get more. If the price of DNB gets away from
me – and I get stuck with just a 6% position – I will be disappointed. But I won’t sell the
position. I’ll hold it. Probably for a long time. You don’t get many opportunities to buy a
business with the super wide moat and essentially non-existent tangible investment requirements
of something like DNB very often.
There are some companies where – if I feel the business is still as I remember it, economically –
I will buy the stock whenever it gets to an acceptable owner earnings yield. There is not much
more to it than that. “Acceptable” in my book is better than my next best alternative or 10% a
year – whichever is higher. If nothing seems priced to return about 10% a year, I hold cash.
I don’t believe in market timing. But I don’t believe in taking a risk where I think if everything
goes perfectly the upside is still going to be in the single digits.
Well, after the big drop – I thought DNB was just about exactly priced to deliver 10% a year. I
don’t mean that I know what the stock will do. But I think the normal economic earnings of the
business – after they pay interest and all that – that could be passed on to owners will be about 10
cents a year for every $1 I paid for the stock last week.
Plenty of other stocks are priced in a similar way. But they are not reliable in the same way I
think DNB is. Trading at a P/E of 10 is not the same thing as being priced like a 10% perpetual
bond.
In most cases, it is very different. In DNB’s case I don’t think that’s true.
That was the rationale for the purchase.
Now, on to your concern. The share buybacks. And the negative equity.
So, negative equity alone has no meaning. It’s a non-issue.
I buy stocks all the time – most stocks I buy in fact – that have positive tangible equity in excess
of my purchase price (that is, they trade below tangible book value). But I also buy stocks with
negative book value. I owned IMS Health before it was bought out. They had the same practice
as DNB. They borrowed and bought back stock. Year after year.
Different people have different ways of measuring how much debt is too much debt. This is a
separate issue from whether the debt is being used productively.
Obviously, if you have to borrow at 9% and you can only earn 6% on what you borrow – that’s
not a recipe for success. So, in that case, even if you are borrowing a “safe” amount of debt –
you may still be doing wrong for shareholders.
But, here we are talking about companies that tend to use borrowed money to buy back shares –
not buy equipment, develop land, dig for gold, etc. So the calculation should be a bit easier.
If the company is able to grow at least as fast as inflation and the stock trades at a price to owner
earnings of say 10 – and you think it’s worth every penny – then obviously borrowing at
anything less than 10% a year should theoretically be fine if all of the money borrowed is used to
buy back stock.
Generally, I’d want to make sure that a company that is buying back stock while simultaneously
owing money is always borrowing at – hopefully, longer fixed rates – that are lower than the
return I’d expect on the stock if the company stopped growing today and never started growing
again.
That would be my test. If a company can pass that test – it can go ahead and borrow and buy
back stock. As long as the level of debt is also safe. We’ll deal with that issue in a minute.
So, if I think DNB stock could return close to 10% a year even if it was a truly no-growth
company from this moment forward – then it’s okay that they borrow money at a much lower
rate.
How much lower?
In their 10-K, DNB says that in November 2010, they borrowed $300 million at 2.9%. The $300
million is due in November 2015. So they borrowed for five years at under 3%. Buying back
stock will return more than 3%. That was true even when the stock was a lot more expensive.
They also have an $800 million credit facility. They owed $260 million on that facility at the end
of last year. They currently pay 1.6% a year in interest on that $260 million.
Again, 1.6% a year is much lower than the return DNB’s shareholders can expect from share
buybacks.
So, borrowing money and buying back stock is okay from a return on investment perspective.
What about a safety perspective? Is the amount of debt DNB is carrying safe? Can they handle
it?
Here, we don’t care that they are buying back stock. And as strange as it sounds – we don’t care
that they have negative equity.
I know I write about net-nets all the time. I’m the guy who writes GuruFocus’ Ben Graham: NetNet Newsletter. By definition, a net-net trades below book value. So you’d think I’d be a big
believer in the importance of book value.
I’m not. Book value alone means nothing. It can hint at something big though.
Tangible book value is a useful screening tool. So is EV/EBITDA. Neither measure is perfect.
They are more useful when you are soaring over the entire market trying to spot bargains. They
are less useful when you are trying to analyze specific companies. If an entire country’s stock
market has a low price-to-tangible book ratio or low EV/EBITDA this is very important info to
know. In fact, it’s decisive. You can buy indexes on that knowledge alone. But you probably
shouldn’t buy specific companies on that knowledge alone.
Ultimately, things like:
· Liquidation Value
· Market Value
· Replacement Value
· And Owner Earnings
Matter more. These things trump:
· Book Value
· EV/EBITDA
But you’ve got to calculate them yourself. You’ve got to move beyond being a record keeper –
an accountant – and become an appraiser.
We’ve talked about this kind of thing before. DreamWorks Animation
(DWA, Financial) carries a library of animated movies on its books. For about $13.5 million a
movie.
You can find all this for yourself by reading the company’s balance sheet and the notes to its
financial statements in its 10-K. I can’t stress this enough. You always have to read the notes. In
many ways, the notes are the 10-K.
If you could separate DreamWorks’ employees, property, technology, management and
production pipeline from the movies they’ve already made – and their rights in those franchises –
would you be willing to pay more than $14 million a movie for that intellectual property stub?
Some (old movies, and a couple flops) are carried at zero. A couple new ones are carried for a
lot. All of them together are carried for about $310 million.
Would you pay $310 million for the movies DreamWorks has already released plus the rights to
keep making movies in those franchises?
If so, then that balance sheet item is probably worth even more than $310 million. And
DreamWorks’ book value – as intangible and full of intellectual property as it may be – is
actually understated.
If not, then that balance sheet item is worth less than $310 million. And DreamWorks’ book
value is overstated.
This is because the way DreamWorks treats their other inventory – the stuff that hasn’t been
released yet – is pretty similar to how the accounting works at other companies in other
industries (they make it and as they do – they carry it on their books at their cost). Once a movie
is released, this gets trickier though. Because DreamWorks starts amortizing the movie at what
may or may not be an economically accurate way of recording long-term revenue generating
potential and residual value.
And so you have an asset that might not be carried on the books at what it could be sold for. And
yet it might be quite possible to sell that asset.
You have a similar situation with land. Sometimes companies accumulate land over the years at
prices that do not reflect what that land could be sold
for. Generally Accepted Accounting Principles (GAAP) does not allow companies to mark up
the value of this land over time. This is particularly important to note when changes in the
business make the land less integral to the business than it once was. In other words, some
companies end up with valuable land they could sell without radically changing how they run
their business day-to-day.
And then you have the very tricky concepts of receivables and inventory. They are good in
liquidation – yes. You can borrow against them – yes.
But, generally, they are not a very good asset to own because they are utterly integral to the
business and they need to be constantly replenished – essentially they become an obligation.
You’d rather have less working capital than more working capital if you could.
So some assets on the balance sheet matter a lot more than other assets. And their book value
may not reflect their market value.
The assets that matter most are usually:
· Cash
· Investments
· Land
· Intellectual Property
· Tax Savings
· Legal Claims
If you have these things, you can support less debt. If you don’t have these things, you can’t
support debt – except to the extent you are generating cash flow from your business.
Cash flow from the business is always best. But if you’re focused on a static snapshot of a
business – like a balance sheet – it helps to restate the cash, investments, land, intellectual
property, etc., to reflect what they could be sold for.
Things that can be sold can sometimes be borrowed against. And selling things can help save
shareholders when there is debt and no cash flow to pay for it.
But that is not a good situation. Cash flow protection is much better than asset protection.
Strong, reliable free cash flow is usually a surer sign of a company’s safety than anything you’ll
find on the balance sheet.
But why those specific assets?
Why not include inventory, receivables, etc.? Why talk about land – and stuff you can sue over?
These assets matter most because they are in some sense separable from the operating business
itself. You convert these assets into other things. There are different ways of doing it. Not all of
those things can be sold. But if you want to exit a certain line of business – you can usually keep
those things.
They become corporate assets more than business assets.
Inventory and receivables are different. They are important. But they are most important as an
acid test of cheapness and overcapitalization.
A net-net is almost always cheap and overcapitalized.
That’s why you screen for them. But, like I’ve said before, don’t fixate on a net-net’s assets. Just
use those assets to prove the company is cheap. Then pivot and start analyzing the operating
business – its profitability, reliability, future prospects, etc.
When it comes to an operating business – don’t think of assets as assets. Assets in a continuing
business are not necessarily good. Liabilities in a continuing business are not necessarily bad.
In liquidation, assets are good. And in liquidation, liabilities are bad.
But we’re not talking about liquidation.
Liquidation should not be your first line of defense.
So, when deciding whether a company like Dun & Bradstreet, DirecTV, AutoZone, etc. is
carrying a safe amount of debt – whether the balance sheet shown at book value’s verdict of
negative net worth is economically accurate – you want to break the company down into:
· Cash
· Investments
· Land
· Intellectual Property
· Tax Savings
· Legal Claims
· Owner Earnings
While the right measure to use is owner earnings, I’m going to talk about these stocks you
mentioned in terms of EBITDA. It’s a number we can all agree on. Yes. It is too generous. If
people use EBITDA like it means EPS – they are trying to fool you. But EBITDA is not evil. It
is a tool. As useful for analysts as for promoters.
We’ll try to use it responsibly here.
EBITDA saves us from debating the exact amount of maintenance cap-ex, working capital
changes, etc. that would be needed to support a no-growth DNB, DTV, AZN, etc.
How much is EBITDA worth?
If you had to capitalize EBITDA like it was the rent on an apartment building to figure out the
value of that apartment building – what number would you use?
It’s unlikely U.S. companies generate much more than 33 cents of EBITDA for every dollar of
book value they have. I don’t have data on this. It may be a smidgeon higher at the moment. But
that’s only because we live in odd times. Right now, returns on equity – however you measure
them – are really high in the U.S.
So, a normal number would be even lower. And remember, U.S. stocks trade way above book
value – so even if a company is generating 33 cents of EBITDA on its book value – investors
only be getting more like 15 cents of EBITDA on every dollar of their cost in the stock.
That number may sound wonderfully high – but 15 cents is less than you think after you pay for
physical depreciation (a real expense) and taxes (another real expense). Even without interest
payments of any kind, you can easily go from 15 cents of EBITDA to about 7 cents of net
income.
What I just described isn’t far from the current reality in the U.S.
Okay. So I think it’s fair to say that at a normal company you would need at least $3 of book
value to generate $1 of EBITDA. Maybe more. But not less.
Here’s where I want to talk about asset-earnings equivalence.
I’ve mentioned before that assets generate earnings. And then earnings are used to buy (or build)
assets. And then those assets create more earnings.
And so you have this cycle of investment. You have a stock of assets. You have a flow of
earnings. You turn the flow into the stock. And you turn the stock into the flow.
Well, the truth is that when you have a flow of earnings on the income statement – and yes, the
cash flow statement – but no assets (or very few assets) on the balance sheet, this doesn’t mean
you have a negative economic net worth.
It means something different.
It usually means you have a special asset. An asset that is worth its flow. Not an asset that can be
easily appraised perhaps. And certainly not an asset that can be easily compared to other assets.
This is not like owning a single family home on a street with 20 others.
This is like owning a highway rest stop. There is nothing else for 30 miles. Maybe you can build
a restaurant here as cheaply as a restaurant anywhere. But the cash flows are going to be
different. And so the market value of that rest stop location will be different regardless of what
your original cost was – this is if and only if folks can’t put up a thousand other restaurants all
around yours.
Well, Dun & Bradstreet is like that highway rest stop. DirecTV is like that. And Autozone is like
that. To some extent. They all own special assets. Assets that are not separable from the
operating business.
The business is the valuable asset. And it’s valuable in ways the balance sheet may not reflect.
Well, what if we just approximately applied this idea to $1 of EBITDA is similar to $3 of equity?
It’s a strange concept. But let’s see where it takes us.
DNB had EBITDA in 2011 of $506 million.
How much did it take to produce that $506 million in EBITDA?
The truth is that it took nothing. If you look at what I normally consider the core invested assets
of an operating business:
· Receivables
· Inventory
· Property, plant, and equipment
And you net them against what I consider to be the core liabilities of an operating business:
· Accounts payable
· Accrued expenses
· Deferred revenue
You don’t get a positive number. You get a negative number.
What does this mean?
If you liquidated Dun & Bradstreet’s business – it would cost you money. There’s a reason that
revenue is deferred – you’ve been pay, your customers haven’t been served – they won’t
appreciate a sudden shut down. If you try to flip a switch and shut it down – you would not be
able to take more cash out of it.
In fact, since you’ve been paid for services you haven’t provided – you’d actually have to put
more money into DNB to shut it down. If you don’t provide the service – they’ll want their
money back.
This is the opposite of a net-net. If you shut a net-net down – no one would need to inject more
money into the company to liquidate it. Instead, it could be shut down and a surplus from the sale
of inventory and the running off or sale of receivables could be paid out to owners.
It’s important to note that being in a strong, safe liquidating position does not necessarily mean
you are in a strong, safe operating position.
Most net-nets have a higher risk of bankruptcy than Dun & Bradstreet. (Understatement of the
century.) But all net-nets have a lower risk of failing to survive a forced liquidation than Dun &
Bradstreet.
Does that matter?
Does it really matter to you how a stock like Dun & Bradstreet would fair in a liquidation?
I don’t think it does. In fact, if Dun & Bradstreet ended up in bankruptcy – what would happen to
the operating business would be a much bigger concern than say the $118 million or so they have
in cash. Yes – cash, receivables, etc., matter. But if you have a business producing $500 million
in EBITDA, people want to preserve that asset. And a business that produces cash flow really is
an asset. In fact, the operating business would be the key asset if a company like:
· Dun & Bradstreet
· DirecTV
· Or AutoZone
Couldn’t pay its creditors on time.
Let’s look back at that very theoretical mention of EBITDA I made. I said that an American
public company with $1 of EBITDA might also have $3 of equity.
Now, equity is not the same as assets. Companies use leverage. But imagine for a moment what
this would mean if a company with $500 of EBITDA followed the same sort of pattern as other
companies.
Well, it would have at least $1.5 billion in net assets.
As I pointed out, Dun & Bradstreet – the core operations of the company, what we’ll call the
business rather than the corporation – really doesn’t have any net assets. Its assets are less than
its liabilities.
So we’ve got at least a $1.5 billion hole here.
In my book, that’s economic goodwill. Not accounting goodwill.
It’s the investment shareholders need to normally put into the business. And – in this case – it’s
simply not there. The stock of invested assets is missing. But the cash flow is there. And the cash
flow is what has value.
Now, if you take out all the assets and liabilities related to operations from DNB’s balance sheet
you’re basically left with
Financial Assets
· Cash: $118 million
Financial Liabilities
· Debt: $843 million
· Pensions: $595 million
Let’s net them out. You get net financial liabilities of $1.32 billion.
So we’ve got an asset – this operating business with (what I think is conservatively calculated)
economic goodwill of $1.5 billion – and we’ve got this $1.32 billion liability.
Is that different from buying a house for investment purposes and borrowing 88% of its
appraised value?
I don’t think so. I think – if you need to look at it from an asset/liability perspective – that’s the
right way to look at it.
Yes. It’s borrowing a lot of money. But it’s borrowing against the appraised value of the business
– really what the market would pay for DNB’s cash flows. Not the book value of DNB’s
business.
DNB has an operating business that would normally need $1.5 billion in net assets to support it.
And it borrowed $1.32 billion.
This has very little to do with what the business is worth to a stockholder.
For that, you’d need to start talking about what EV/EBITDA is at DNB.
But you didn’t ask whether DNB was a good investment. You asked whether it was safe.
The real answer to whether companies like DNB, DTV and AZO are safe has to do with the
kinds of measures people who look at debt worry about.
It usually involves EBITDA. Which I know is a dirty word among some value investors – and
Charlie Munger in particular. But it isn’t easy to compare companies with different businesses
and different financial structures.
For one thing, DNB – and some of these other companies – are already unusual from an
operating perspective. And even EBITDA does not “solve” this problem.
Over the last 10 years, DNB has turned 68 cents of every dollar of EBITDA into free cash flow.
This is rather remarkable when we consider that corporate taxes in the U.S. are 35%. Interest
rates – while low – are still higher than zero. And DNB grew nominal sales by 3.5% a year over
the last 10 years.
EBITDA should be reduced by:
· Interest
· Taxes
· Additions to property
· And additions to working capital
We’d expect that to cause free cash flow to come in closer to half of EBITDA than two-thirds in
the kind of circumstances I described.
It didn’t at DNB because:
· Working capital is negative
· Capital spending needs are minimal
These aren’t financial aspects. They’re operational aspects of the business. In fact, they are core
and usually quite difficult to change aspects of the business.
I usually find that working capital needs and capital spending needs are part of the DNA of a
business. They are there from birth. They are – in broad strokes – something that’s very hard to
change. You can improve discipline. But you can’t turn a railroad into an ad agency. Their
property requirements are what they are. And they’ve always been that way.
An exceptionally cash-generative business is often an exceptionally cash generative business for
reasons that have nothing to do with the current management team or their policies.
So even EBITDA doesn’t help us separate a company that converts one dollar of EBITDA into
50 cents of free cash flow over a decade from a company that converts one dollar of EBITDA
into 68 cents of EBITDA over a decade.
So, no measure is perfect. When in doubt, creditors and shareholders would both prefer to see
free cash flow come in higher. Free cash flow is the best protection.
But we’ll look at EBITDA because that is a customarily used measure – and it allows us to
compare different companies without having me constantly talking about why free cash flow is
high here but low here. EBITDA just causes fewer problems than either a net income or free cash
flow based discussion would.
So, I mentioned that financial liabilities at DNB – basically debt and pensions – are $1.3 billion.
And EBITDA is $500 million.
That means debt – we’ll lump pensions in with debt here – is 2.6 times EBITDA. Can you live
with that?
Is debt of 2.6 times EBITDA okay?
That’s the question to ask. Not whether it’s okay to have negative equity. Negative equity itself
is not a risk. Poor interest coverage is.
You can also measure the ability to repay debt by looking at free cash flow. For free cash flow –
because of working capital swings – never use a one year number. Take a three-year average. In
DNB’s case that three-year average is $325 million.
So, if DNB continued to produce free cash flow at the same rate – and used every penny of free
cash flow to pay down its debt and fund its pension liabilities – it would take the company
exactly four years to scrub its balance sheet spotless.
This is probably closer to the kind of number Warren Buffett would use. He’d probably say:
“The company can pay everything off in four years.”
There is an additional problem with DNB. The pension plan. I said pensions were about $600
million. But that’s only the unfunded portion. The actual obligation is $1.7 billion. This is then
reduced by the value of pension plan assets.
The calculation of the unfunded portion that appears on the balance sheet depends on
assumptions DNB makes. Some of which are too aggressive:
· Expected Long-Term Return on Plan Assets: 8.25%
They are cutting it to 7.75% going forward. That is still too high.
The plan’s target allocation is:
· 55% stocks
· 43% bonds
· 2% real estate
We’ll call that:
· 55% stocks
· 45% bonds
Which is awfully close to 50/50 between stocks and bonds. So the math is pretty easy.
What would I say the expected return on a 50/50 stock and bond portfolio should be?
6.25%.
I think 50/50 stock and bond pension plans that are assuming more than 6.25% a year are
assuming too much. And that obviously means they are understating their liabilities.
Of course, some people disagree with me. And some of them are a lot smarter than me. Berkshire
Hathaway assumes a 7% a year return on their pension plans. At year end, stocks were 60% of
Berkshire’s pension assets.
I think assumptions more aggressive than about:
· 8% for stocks
· 4% for bonds
Are too aggressive.
Berkshire may be right to use 7% for their pension plan return assumptions.
But, if it was up to me, I’d use 6%. Of course, nobody uses 6%.
The average expected return on pension assets is 7.8% at the 100 largest U.S. public companies.
So, DNB is right in line with them with its 7.75% expectation.
But Dun & Bradstreet’s funded status is worse than most big U.S. companies. On average,
companies have funded between 75% and 80% of their pension obligations.
Here is a comparison of expect return and actual returns for the 100 public companies with the
largest defined benefit plans:
Expected Actual
2000 9.4%
4.5%
2001 9.3%
(6.4%)
2002 9.2%
(8.7%)
2003 8.5%
19.2%
2004 8.4%
12.4%
2005 8.3%
11.2%
2006 8.3%
12.9%
2007 8.2%
9.9%
2008 8.1%
(18.7%)
2009 8.1%
13.9%
2010 8.0%
12.8%
2011 7.8%
5.9%
As you can see, expectations make no sense. They are very sticky. They didn’t increase at all
when there was a huge drop in stock prices. And they were at their highest in 2000 – when no
combination of assets was going to earn you 9.4% a year.
Unfortunately, the asset allocation of these funds is really bad too. They had 60% on average in
stocks in 2006 – when the market was clearly overvalued – but just 38% today when stocks are
by far the best investment available to them.
At least on this measure, DNB does better. They have 52% of their plan assets in stocks.
So I would expect them to earn about 6% a year on their pension investments.
They expect 7.75% a year. That 1.75% a year gap is equivalent to $22 million a year in earnings
they expect to have – that I think they won’t.
It shaves about 7% a year off their earnings. In other words, when DNBS says it earned $6 a
share – my ears hear it earned $5.60 a share.
It cuts into my valuation of the company. But it doesn’t make me think there is the potential for
financial peril because of the pension plan.
Ultimately, we are talking about a plan with $1.7 billion in obligations that has almost $1.3
billion in assets at a company with $300 million a year in free cash flow that could be devoted to
closing that gap if they need to.
Finally, Dun & Bradstreet’s 6.3%-a-year compensation increase assumption is something I
highlighted when I read the 10-K. Berkshire assumes 3.7%. I don’t have any data on this. But I
can’t remember seeing many public companies who assume a greater than 6% compensation
increase.
Finally, let’s look at the companies you talked about – Dun & Bradstreet, DirecTV and
AutoZone – from a perspective that incorporates their debt into their prices.
I’m using Bloomberg numbers here.
EV/EBITDA
Dun & Bradstreet 7.8
DirecTV
AutoZone
6.2
10.3
If you’re not used to looking at EV/EBITDA – one thing that might help you is to assume that a
truly unleveraged company would have a P/E ratio that was double its EV/EBITDA ratio. This is
not exactly right. It can vary a lot by industry. But it may help you think about the numbers.
So, Dun & Bradstreet might sell for about 15 to 16 times earnings if it used no debt. For reasons
I explained earlier – Dun & Bradstreet tends to convert EBITDA into free cash flow much better
than most companies – a 7.8 times EV/EBITDA ratio at DNB would probably be equivalent to a
P/E of about 11.5.
In other words, if you’re not worried the debt poses a risk of bankruptcy – you can imagine 7.8
times EBITDA with debt is really the same price as 11.5 times EBITDA with no debt.
I think that’s the best way to think about Dun & Bradstreet’s negative equity and whether the
debt they have and the share buybacks they’ve done make sense.
The questions to ask are:
1. Is the earnings yield of the stock they are buying back higher than the interest rate of the
money they are borrowing?
2. Do you need to adjust any financial obligations – like an unfunded pension liability – to
determine the true extent of what the company owes?
3. Are net financial obligations (debt and pensions minus cash) a low enough multiple of their
EBITDA?
4. How many years of free cash flow would it take to completely pay off all their financial
liabilities?
5. Is the price of the entire company – in terms of EV/EBITDA, not just P/E – still low enough to
justify your investment?
6. And most importantly: How reliable is the company’s EBITDA, free cash flow, etc?
This last question is something I didn’t spend any time on in this article. But it’s the reason I
bought DNB.
If I thought the company:
· Did not have a wide moat
· Did have a high risk of technological obsolescence
· And didn’t have the pricing power (and places to cut costs) to keep margins up
I would definitely feel differently about DNB as a stock. And I might even feel differently about
it in terms of its ability to carry debt.
So the long-term reliability of the business should be a critical part of your analysis of any
company with negative equity.
But the fact that a company has negative equity is really not a big deal. The right company can
have negative equity and still be worth buying.
The “right company” tends to be a wide moat business with almost no need for tangible
investment in day-to-day operations.
In other words:
· Negative working capital
· Minimal property, plant, and equipment
· A wide moat
Those are what you want to see in any company with negative equity.



URL: https://www.gurufocus.com/news/176639/is-negative-book-value-bad
Time: 2012
Back to Sections
-----------------------------------------------------
GAAP Accounting: Restatements vs. Realities
Someone who reads my articles sent me this email:
Hi Geoff,
...as concerns P/B and P/S with Birner Dental Management Services (BDMS, Financial), they
trade at a very high valuation to their P/B, and not in line with their average ROE, and that is
before taking out leverage. Is there an answer to the discrepancy between their high P/B with
only about 18% ROE and how P/S ties into that?
Tom
Wow. This is going to be a complicated answer. Actually – yes – there’s an answer to the
discrepancy. In fact, there are two answers. Birner has very high amortization charges. And
Birner had a different definition of revenue.
This is an accounting article. So here comes the footnote…
“….(Birner Dental Management Services) restated its audited consolidated statements of income
for the years ended December 31, 2007 and 2008 and its unaudited consolidated statements of
income for each of the quarters of the years ended December 31, 2008 and 2009. The
restatements affects (Birner’s) previously reported revenue and expenses for clinical salaries
and benefits paid to dentists, dental hygienists and dental assistants. (Birner’s) reported revenue
increased by the amounts paid to dentists, dental hygienists and dental assistants. Clinical
salaries and benefits increased by the same dollar amounts as the increase in revenue. The
restatements have no impact on (Birner’s) contribution from dental offices, operating income,
net income, earnings per share, consolidated balance sheets, consolidated statements of
shareholders equity and comprehensive income or consolidated statements of cash flows, or the
calculation of Adjusted EBITDA.”
Ready to dig into this?
With BDMS, there are several accounting complications you need to understand. Most
importantly, there’s an unusually huge and persistent gap between EBITDA per share and
earnings per share. Basically, Birner constantly understates its economic earnings. So, any metric
that uses net income is going to give you a misleading take on the company.
Before we go any further with BDMS, you probably want to get someone else’s take on the
company – not just mine. I’m sure there are some bearish folks out there. And it would be good
to Google around and try to find their blogs. Because any explanation I give you of how
BDMS’s business works, how its accounting works, and what it means for an investor could be
accused of being overly bullish.
Remember: We’re talking about a $33 million market cap stock here. So, the mere fact that I
frequently use BDMS as an example should tip you off to the fact that I obviously like the
company enough to research a pretty obscure stock. So be warned – I’m not providing the
consensus opinion here (if there is one on a $33 million stock). I’m just giving you my take.
Okay. Now let me explain the discrepancy between what I think BDMS’s “owner earnings” are
and what kind of net income, ROE, operating margin, etc. you are seeing.
Go to GuruFocus’s 10-year financials page for BDMS. Notice anything odd? Look at EBITDA.
That’s earnings before interest, taxes, depreciation, and amortization. Notice how stable
EBITDA is. Let’s take EBITDA per share.
2001: $1.20
2002: $1.58
2003: $1.90
2004: $1.92
2005: $2.17
2006: $3.08
2007: $3.50
2008: $3.19
2009: $3.19
2010: $3.05
Okay. So, it’s a boring, stable company. BDMS has a business predictability ranking of 3 stars
according to GuruFocus. Not bad for a company with a $33 million market cap. What’s weird
about all this is that the stability of EBITDA is not shared by the stability of other numbers. Most
notably, the revenue numbers are all over the map. Especially notice how revenue leaps from
$18.26 a share in 2008 to $31.86 a share in 2009. Do you really think BDMS’s sales grew 75%
in one year while adding exactly zero EBITDA that same year?
That doesn’t sound likely.
So what does sound likely?
An accounting change. Go to gross margin and operating margin. Notice how they both fall off a
cliff – in almost the exact same ratio – at the same time sales spikes while EBITDA stays steady.
You know what’s coming here. If you check EDGAR for that time period, there’s a good chance
you’ll find that BDMS changed what counts as revenue. By changing the revenue line they
changed their gross margins, operating margins, etc. However, changing revenue recognition
doesn’t change EBITDA.
Think of advertising companies. In fact, think of Groupon (GRPN). Remember, Groupon’s
revenue controversy? Groupon counted as revenue cash that was paid out to its merchant
partners. Is that really revenue? Or is that just handling cash? They aren’t the same thing.
Otherwise: banks, brokers, etc. would report trillions of dollars in revenues.
This was a big deal because it was Groupon. People were talking about valuing the stock – which
had no earnings – on a price-to-sales ratio. The problem with using price-to-sales is that sales can
be a very squishy number. It’s easy for a company to exaggerate its revenue. It’s harder for a
company to exaggerate its free cash flow, EBITDA, etc.
Okay. Now remember how Groupon’s revenue numbers suddenly changed by a huge amount?
That didn’t mean the business actually changed. The only thing that changed was the way
Groupon described its business to shareholders.
Same story here.
In our BDMS example, it’s not like patients paid any more for their visit to the dentist. Nothing
that substantial happened. All that happened is BDMS changed what it counted as revenue
received from the offices that form its cash conduit. Basically, people pay offices. And then
offices pay Birner. By changing what is revenue and expenses for the offices you can change
what is revenue and expenses for Birner. This has no real impact on Birner’s economic reality. In
fact, Birner had been reporting their own non-GAAP number for years. So, in reality, Birner was
– if shareholders read the whole 10-Q, 10-K, etc. rather than just the audited financial statements
– always reporting all these numbers.
They always reported what the revenues and expenses of both their offices and the corporation
itself were. I think they used terms like “contribution from dental offices” and “contribution
margin”. Anyway, I remember reading the 8-K where Birner explained the change they were
making – and restated their financial statements. It was utterly inconsequential. However, it does
affect any metric that uses sales as either the numerator or the denominator.
This is a good example of why you always need to read a company’s actual 10-K, 10-Q, and
14A. Never invest in a company until you’ve done that.
Also, you need to read the notes to the financial statements. The same kinds of notes are often
important at different companies. For example, you always read what the definition
of “revenue” is. You always read the inventory note. It tells you whether inventory is finished
and waiting to be sold or just raw materials waiting for an order to come in. Together, notes like
these often give insight into how a company works. Inventory is a particularly important note.
You also have to read notes that have a big impact on reported earnings. So, the key note in
Birner’s SEC reports is the note about amortization. Actually, Birner has a whole big section
about how the business is structured financially. So you need to read and understand the part
about “management agreements”. I’ll give you a quick taste – this is not the full explanation –
from part of Birner’s 10-K:
“With each Office acquisition, the Company enters into a contractual arrangement, including a
Management Agreement, which has a term of 40 years. Pursuant to these contractual
arrangements, the Company provides all business and marketing services at the Offices, other
than the provision of dental services, and it has long-term and unilateral control over the assets
and business operations of each Office. Accordingly, acquisitions are considered business
combinations and are accounted as such.”
Often, one accounting note will lead you to another. This is why you always read a 10-K – or
any SEC report – with a pen in hand. For example, once you know that Birner’s management
agreements last 40 years, a bell should ring in your head to go check the length of time over
which the agreement is amortized.
That trail would lead you to this note:
“The Company's dental practice acquisitions involve the purchase of tangible and intangible
assets and the assumption of certain liabilities of the acquired Offices. As part of the purchase
price allocation, the Company allocates the purchase price to the tangible and identifiable
intangible assets acquired and liabilities assumed, based on estimated fair market values.
Identifiable intangible assets include the Management Agreement. The Management Agreement
represents the Company's right to manage the Offices during the 40-year term of the agreement.
The assigned value of the Management Agreement is amortized using the straight-line method
over a period of 25 years.”
Okay. So, what those two notes together tell you is that BDMS writes off 4% of the purchase
price – in excess of tangible assets acquired – each year. Finally, I included the bit about the
inability of the acquired offices to terminate the agreement except under extreme circumstances
because that is such a critical issue with a company like this. If the agreements were easy to
terminate, then these acquisitions would really be more like management agreements. In reality,
these so-called management agreements are actual acquisitions in all but name.
This reinforces the most important idea in reading SEC reports. When you research a company
you aren’t looking for some mystical “right” number in terms of earnings, sales, book value, etc.
The economic reality of sales, earnings, assets, etc. is always squishy. It’s always inexact.
How much is your house worth?
I’m sure you can give me a number right now. But I’m also sure it’s probably not the exact price
you would sell it at if you put up a for sale sign today. It’s the same thing with business. And that
means it’s the same thing with accounting. You don’t read SEC reports looking for little things.
You look for big things. You look for an understanding of the economic reality.
In the case of BDMS, I believe – and I’m sure other folks might not agree with me – that the
economic reality of the company is that their “owner earnings” are some form of the cash flow
generated from operations less their capital expenditures on existing offices. And the
management agreements are really outright purchases of dentist offices. Therefore, when I think
of BDMS I don’t see the GAAP statements shown in the SEC reports. I see something more like
a company that simply buys dentist offices and produces EBITDA.
Now, of course, EBITDA is not earnings. What shareholders get is really just the free cash flow.
But when I look at BDMS, what I care about is the overall revenue of the offices – not
necessarily what BDMS recognizes as their own corporate revenue – and the amount of
EBITDA, free cash flow etc., that leads to on a per share basis. That – plus capital allocation – is
what matters most at BDMS.
As far as the idea that BDMS has a low return on equity, I just checked the latest 10-Q. They had
$5.72 a share in tangible assets at the end of last quarter. Let’s pretend that’s usually what they
have. EBITDA has been in the $2.50 to $3.50 a share range in the last couple years. Free cash
flow has been in the $1 to $2 per share range. You can run those numbers yourself and see that
the economic reality of BDMS for the last few years has been that the 18% ROE number you cite
is pretty much the bottom end of their owner earnings divided by their invested tangible assets.
In other words, even without leverage BDMS’s returns on tangible invested assets are good.
You’re obviously including intangibles. Which is fine. But it’s not something I would do.
There’s no way that Birner’s reported return on equity – including intangibles – is a meaningful
figure in any economic sense. Dentist offices don’t produce earnings in line with their book
value. And those amortization charges really affect reported earnings. Just look at Birner
Dental’s 10-year Financial Summary and compare earnings per share with free cash flow per
share.
So, I’d look at the price-to-sales ratio and some form of a margin – maybe the free cash flow
margin – for a company like BDMS. However, in this case, you need to go back to past years
and make sure you adjust for the new definition of sales. Like I said, this is actually pretty easy.
All you have to do is read some of Birner’s old 10-Ks. They provided this data. Just not as part
of the audited financial statements.
Finally, I want to talk a bit about how noticeable all this is. It’s not like you have to go to
EDGAR to figure all this out. Just by looking at Birner Dental’s 10-year Financial Summary you
can see that free cash flow per share has been higher than earnings per share every year for the
last decade.
You have to keep your eyes open. And whenever possible you need to look at a company’s
financial data in context. Ideally, over a 10 year period. And you always want to look at more
than just one metric at a time. Return on equity is important, free cash flow is important,
operating margin is important.
But more important than any one number is the overall picture that emerges when you step back
and look at the relationship between all these metrics over a full decade. That’s when you start to
really understand a company.



URL: https://www.gurufocus.com/news/161788/gaap-accounting-restatements-vsrealities
Time: 2012
Back to Sections
-----------------------------------------------------
Do Working Capital Reductions Count as Free Cash Flow?
Someone who reads my articles sent me this email:
Dear Mr. Gannon,
…In your calculation of free cash flow you mention investors should subtract increased
investments in working capital, as these represent unaccounted uses of cash for the business. I
was wondering what happens if this investment is negative? Do we add this onto our FCF
calculation, since mathematically two negatives make a positive? Has the company really gained
any cash? Moreover, what does a negative investment in working capital imply? (One of the
companies I’m analysing in Australia has been showing negative changes in working capital for
the last few years: after it began divesting from unprofitable operations, improving margins and
boosting return on equity. If I count the cash I know it’s a good thing since FCF has improved.
However, their working capital investment which is negative has me slightly worried as I don’t
know whether that’s a good or a bad thing, or even if it will be recurring).
Kind Regards,
Pratham
You seem to understand this issue well. The important thing is looking at how the cash flow is
being generated. It depends on the situation. There is no one rule to fit all companies. I could
take you through some specific company examples. But I don't want to waste your time right
now. If you have time – here are some companies you could look at for examples of companies
where constantly increasing working capital (in the very long run) has been a drag on the
business:
· Lakeland Industries (LAKE, Financial)
· ADDvantage Technologies (AEY, Financial)
Both companies tend to reinvest profits into additional inventory. This means that as long as they
are growing they can't afford to pay out any cash. Earnings must be retained. The upside is you
got growth for many years. The downside is they had little or no ability to buy back stock, pay
dividends, etc. Now for the other side – look at Taitron Components (TAIT, Financial). Here
we see free cash flow being generated by a slow motion liquidation. Current assets like inventory
have been falling over time. This has provided much of the cash.
Should you count this? Should you ignore the cash flow Taitron has generated over the last
decade or so because it is from reductions to working capital? And should you treat Lakeland
and ADDvantage as if they actually have little or no earnings simply because they have
reinvested these earnings in working capital growth instead of buying back stock, paying a
dividend, etc.?
Neither extreme is right.
Teledyne had a policy of crediting its subsidiaries with the average of that unit's free cash flow
(as in cash actually returned to shareholders) and its reported profits. If it reported profits of $10
million but kept all of its cash (adding to inventory, receivables, etc.) then Teledyne would say
that unit's earnings were $5 million (because $5 million is the average of $10 million in reported
profits and $0 in cash paid out).
A company's goal is to generate the most cash profits. But reduced investment in plant,
inventory, etc. could reduce cash profits in future periods. So could low spending on research,
advertising, etc. but these are expensed on the income statement in a more obvious way. Capital
spending and working capital growth are trickier. The answer is that neither measure is perfect. I
always look at both operating profit and free cash flow. And I look at operating profit and free
cash flow – both – relative to sales and invested tangible assets over at least a 10 year period.
This gives me some idea of the earning power of the business.
It is better to be roughly right than exactly wrong. Don't be foolish. If it is obvious a company is
reinvesting all of its cash flow into additional inventory to support growth – for instance sales
and inventory are both rising at 10% a year over each of the last 10 years – then clearly the
company is not producing cash now because it is instead growing the business. Likewise, if a
company is generating free cash flow merely through liquidation of inventory and receivables
running off – understand that for what it is. That kind of free cash flow is not sustainable.
These issues are common among net-nets. There is another issue relating to free cash flow. It has
to do with the business itself. Do the businesses in this industry tend to constantly produce more
free cash flow than expected relative to operating income or less?
For example, in the U.S. you would expect operating income times 0.65 to be roughly the
amount of "normal" free cash flow (after-tax) a company should generate in the long run. In
reality, inflation would normally cause this number to be lower than I just said even if cash
receipts were timed to match reported income. But it's not an issue we need to worry about in a
modest or reasonable inflation environment. Even at 4% inflation, it should be hardly noticeable
at most companies.
Now, the other big issue here is how cash is received in the business. And how it is used. This is
my advertising agency vs. railroad example. A railroad will tend to have free cash flow that is
low relative to reported operating earnings. An advertising agency will tend to have free cash
flow that is high relative to reported operating earnings. This is a different issue entirely. One is
an asset light business (the ad agency) that could – theoretically – pay out earnings in cash
almost from the first year it is open if it neither grows nor shrinks. The railroad is different. A
railroad will tend to need to always pay more in cash in the future to replace assets than it is
depreciating them at. With long-lived assets the difference can become substantial. This is even
more noticeable in a growth phase. There is a huge difference between a growing railroad and a
growing ad agency. The ad agency will produce cash with a higher present value because it will
arrive sooner than the railroad. Today, this is much less noticeable because growth in actual
physical assets is subdued at railroads in the U.S. Check out cruise lines for an example of a fast
growing asset heavy business. American railroads once looked like that – long, long ago.
Anyway, here's my answer to question #1. Use common sense. Don't ignore your intuition. Use
your entire understanding of the business and its uses of cash over the last decade. Understand if
it is growing, decaying, etc.
Separate businesses that are experiencing huge changes in working capital – like AEY vs. TAIT
– from companies that will continue to convert earnings into immediate cash at different rates
like Omnicom (OMC, Financial) vs. Carnival (CCL, Financial).
These are two different issues.
Also, keep in mind that the best business is one that receives cash early on relative to when it
records sales and needs little or no additional capital (plant, inventory, receivables, etc.) to grow
the business. The less cash investment needed and the quicker the cash return on additional
investment hits the coffers – the better the business is. If you are looking for long-term
investments, focus on cash flow mechanics that will be permanent. And never give full credit to
the cash flow reported by a company like TAIT. That kind of free cash flow is not sustainable.



URL: https://www.gurufocus.com/news/161522/do-working-capital-reductions-count-asfree-cash-flow
Time: 2012
Back to Sections
-----------------------------------------------------
You've Crunched the Numbers: Now What?
Someone who reads my articles sent me this email:
Dear Geoff,
I was looking at the fundamental of 18 stocks; I own 5 of them: Apple
(AAPL, Financial), Abbott Laboratories (ABT), Autodesk (ADSK), Cisco (CSCO) and Exelon
(EXC, Financial). Others were ideas collected from places like news, etc.
… The ranking exercise (is) based on growth and fundamental analysis. EXC ranks at the bottom
in both analyses…Top 4 results are Apple, BHP Billiton (BHP), Mosaic (MOS) and Rio Tinto
(RIO). MOS was eliminated as it has one year of negative FCF.
Since AAPL is listed as No. 1, I went back and looked at P/E when I bought it at $333 in April
and May 2011. The P/E was 11 - 13 times. It is currently 15 times… I think the iPhone 4s plus
Sprint network addition plus iPad plus enterprise adoption of Mac will provide an impressive
fabric of earning growth that is sustainable.
The other two on the list are basic materials, they could be… good long-term to my stock
portfolio. Assuming scarcity as their global trend (need to learn more here.)
From the fundamental analysis: Rio is cheaper than BHP. But, RIO is qualitatively inferior when
compared to BHP (ROIC, ROE, ROA). I have not looked at Vale (VALE), so maybe next
weekend I will continue this exercise with VALE.
I am not confident what the next step can be.
Should I do more work or buy AAPL or EXC?
Thank you very much.
Ning
(I should mention here that Ning included some very extensive Excel tables with this email.)
Those are some extensive tables you included there. They are thorough. But I think the next step
is not quantitative. It is qualitative. I would first look at the stocks you already own and feel you
know best.
This sounds like Apple (AAPL, Financial) and Exelon (EXC, Financial).
I may be wrong about that. But it sounded to me like you had a lot of basic materials stocks show
up for purely quantitative reasons, while you yourself didn’t have a strong feeling whether
buying basic materials was a good idea or not. It could be. But you didn’t seem to have any
special insight there. Am I right?
Where you did have some special insight – or at least a very clear opinion – was on Apple. Now,
normally I wouldn’t encourage anyone to start with one of the most talked about, written about,
gossiped about companies out there.
Everybody has an opinion on Apple. Everybody knows the company. It is hardly a hidden gem.
But it might be a gem in plain sight. And it sounds like you have some ideas about Apple beyond
the numbers. So, that’s where you should start.
The other company it sounds like you’re interested in is Exelon. Part of the reason why I’m
saying you sounded interested in doing more work on Exelon is that you talked about the stock
despite it finishing at the bottom of your purely quantitative comparison.
Is that really a good sign? Am I really saying you should spend more time studying a company
that finished at the bottom of a comparison you drew up?
Here’s what I’m saying. You did a wonderful quantitative comparison of some very different
stocks. A bunch of the stocks you’ve got there are basic materials stocks. This should tip you off
that something is – amiss. When you do a purely quantitative survey of stocks you’re casting a
net. When you get back a list of stocks that are all in the same industry, you need to take a good,
long pause.
You may not be measuring what you think you’re measuring. Or at least you may not be
catching what you wanted in that numerical net you threw.
I think Exelon and Apple are a good place to start.
They are very different companies. That's good. Apple is a very high profile company. While
Exelon is not. Both are potentially very interesting companies.
You could argue that either has a wide moat.
I wouldn't disparage the quality of either business relative to its peers. However, I think the next
step – for me at least – would be to look at the industries they operate in. Are Apple and Exelon
predictable? Do they have sustainable competitive advantages – especially in regards to
operating margins and return on equity. Look at the stocks found in GuruFocus’s Buffett-Munger
Screener. Compare the stocks you’re interested in with those companies. Not just quantitatively,
but qualitatively as well. Right now, it doesn’t look like either Apple or Exelon score very high
in terms of business predictability (as GuruFocus measures it). Again, that’s a purely quantitative
judgment – like your own Excel tables – but it’s worth keeping in mind.
I’ll tell you how I use quantitative measures. I don’t think of them as giving me the whole
picture. I like to think of them more like vital signs. They are alerts. They let me know what
areas of a stock I need to study more thoroughly. For example, Apple gets a 1-Star business
predictability rating. Does that mean it’s a bad, unpredictable company?
Absolutely not. It just means that the trajectory Apple has had these last 10 years hasn’t been
predictable. It has been phenomenal.
So you need to focus – this is always true, but it’s especially true with Apple – on whether or not
the current level of sales, earnings, etc., are sustainable for the long-term. In Apple’s case, this
means you need to do qualitative analysis. Probably competitive analysis.
The industry Apple operates in – consumer electronics – is not an especially predictable one. It is
not one where competitive advantages – “moats” – tend to be especially durable. That doesn’t
mean that Apple can’t maintain its terrific position. It doesn’t mean Apple lacks a moat. It just
means that you need to investigate that issue.
Okay. Another good question to ask is what the risks are. What happens if your assessment of a
company is wrong? What if you think Apple has a wide moat and it doesn’t? What if you think a
barrel of oil will be $150 in 2013 and it ends up being $50? Often, investors focus on the
probability of an event. That’s important. But it’s not more important than thinking about what
happens if your assessment is wrong. Maybe $150 a barrel oil is way more likely than $50 a
barrel oil. But – no matter how sure you felt about the future price of oil – would you really buy
a stock that could go to zero if oil stayed at $50 for any length of time? Probably not. Likewise,
however strongly you feel about Apple’s “moat” as of this moment – it’s important to be honest
about what would happen to the stock (and your portfolio) if Apple’s moat were breached.
I wrote about mean reversion in one of my net-net posts. My point was that when you buy a
company that's very cheap relative to its liquid and/or tangible assets any movement toward that
company doing "about average" relative to American business generally is a positive for you.
Well, these two stocks – Apple and Exelon – are far from net-nets. Any movement towards an
"about average" business performance for stocks like Apple and Exelon will be very, very bad
for you. That is because you are – in both cases – paying a high price to liquid and tangible
assets (relative to the price you could buy many of their peers at).
That doesn't mean they are bad businesses. An insurer or bank that trades at a premium to
tangible book value may be quite a bargain if it is something like Progressive (PGR) or Wells
Fargo (WFC).
The important thing is not to confuse a temporarily wonderful competitive position with a
competitive position like PGR or WFC that can probably be maintained for many, many years.
You may disagree with me here, but I think in the case of Apple you are really betting on the
organization. And in the case of Exelon you are betting on the assets. Basically, you are saying
that Apple's brand and people and culture working together are going to achieve things – like
higher returns on investment – than competitors who seek to do the same thing. In the case of
Exelon, I think you are saying that their assets are lower cost (higher margin) generators of
power than their competitors. In fact, you are saying they are so much more efficient that it is
worth paying a substantial premium to tangible book value.
I don't disagree with either claim. I think Apple has a superior organization. And Exelon has
superior assets.
Exelon's assets are clearly carried at far below their economic value. So the issue with Exelon is
how to value those assets.
Have you read Phil Fisher's "Common Stocks and Uncommon Profits?"
It is a good book to read if you are thinking about investing in Apple.
And "There's Always Something to Do" is a good book to read when thinking about Exelon.
After reading the information you sent me, I'd say that the most important thing for you to do
now is get some distance from comparative numbers. Think about what it is you are buying in
each case. What aspect of the business is providing you with your margin of safety?
It’s not the price.
These are not cheap stocks on an asset value basis if you consider only their tangible book value.
Therefore, either the tangible assets must be worth much more than they are carried for on the
books – or the intangibles must be very valuable for you to buy these stocks.
In your final analysis I think you should focus on one question:
How comfortable would you be if you had to hold this stock forever?
This is an important question because you may have in mind that you have a lot of faith in Apple
right now. That faith may be well founded. But if you have little faith in Apple four or five or six
years out – do you really think you will be the first to spot the company's loss of leadership?
Think about how quickly companies like Nokia (NOK) and Research In Motion (RIMM) saw
their P/E ratios contract when investors realized just how far they were behind the competition.
Do you really think you will be fast enough to spot a change in Apple's position? It’s not enough
to see the writing on the wall. You have to see it faster than everyone else. You have to sell
before they do.
That’s not the Phil Fisher way. The Phil Fisher way is to be very sure when buying a growth
company. Then, yes, you do monitor the situation. But it is not about understanding the situation
one or two years out. It is about understanding the qualities already present in the company that
will prove durable.
Even if you've read Phil Fisher and Peter Cundill's books, I'd suggest looking at them again as
they are good examples of the kind of investing you are trying to do in Apple (Fisher) and
Exelon (Cundill).
Also, you might want to read a bit about Marty Whitman's philosophy and Mario Gabelli 's
philosophy. If you think Exelon is a buy, it is probably because you have reasons similar to the
reasons those two investors have when they buy a stock.
Basically, Marty Whitman and Mario Gabelli try to find out the value of a company's assets in a
private transaction. They don't try to figure out what public markets will pay for the stock. They
try to figure out what private owners would pay for the business and they work back from there
to figure out the stock's value.
So my advice is to step back from all the numbers. Zero in on just a couple companies. Don't
look at more than one stock in the same day. If you are thinking about Apple today then think
only about Apple for today. Exelon can wait until tomorrow. Think about what aspect of the
company makes the stock clearly worth more than its current price. Then study that aspect. And
don't add a dime to your investment in that stock until you are comfortable with betting on the
permanence of that aspect.
Make sure you understand the value in the company. And make sure that value is durable.
Understanding often requires more than just numbers. So, I think your next step will be a
qualitative analysis.



URL: https://www.gurufocus.com/news/161475/youve-crunched-the-numbers-now-what
Time: 2012
Back to Sections
-----------------------------------------------------
Books
The Best Investing Books for a Budding Value Investor to Read
Value and Opportunity just reviewed a book “100 Baggers” that I’ve read (and didn’t
particularly like) which is basically an update of another book I own called “100 to 1 In the
Stock Market” (which is outdated, not available on Kindle, but I probably like better). The fact
that I’ve read both these books reminded me that I actually do read a lot of investing books and
yet I don’t write much about books on this blog.
There’s a reason for that.
I get a lot of questions about what investing books people should read. My advice to most is to
stop reading books and start doing the practical work of slogging your way through 10-Ks,
annual reports, etc. There seems to be a tremendous appetite for passive reading among those
who email me and no appetite for active research. It’s better to read a 10-K a day than an
investing book a day.
But, there are good investing books out there. And, yes, I read a lot of books. Still, I’m going to
give you a simple test to apply to yourself: if you’re reading more investing books than 10-Ks,
you’re doing something wrong.
Assume you’re reading your fair share of 10-Ks. Then you can read some investing books on the
side. Which should you read?
Practical ones.
How to Read a Book
A book is only as good as what you get out of it. And there’s no rule that says you have to get
out of a book what the author intended. The best investing books give you plenty of case studies,
examples, histories, and above all else – names of public companies. While you read a book,
highlight company names, names of other investors, and the dates of any case studies. You can
look into these more on your own later. Also, always read the “works cited” or “bibliography” at
the back of any book you read. This will give you a list of related books you can read next. Since
I was a teen, I’ve always read the works cited or bibliography to come up with a list of related
titles. And I’ve realized talking to other people as an adult, that most people ignore those pages.
They’re very useful. Read them.
My Personal Favorite: “You Can Be a Stock Market Genius”
If you follow my Twitter, you know I re-tweeted a picture of ”You Can Be a Stock Market
Genius” that my website co-founder, Andrew Kuhn, posted. It’s one of his favorite books. And
it’s my favorite. If you’re only going to read one book on investing – read “You Can Be a Stock
Market Genius”. The subject is special situations. So, spin-offs, stub stocks, rights offering,
companies coming out of bankruptcy, merger arbitrage (as a warning), warrants, corporate
restructurings, etc. The real appeal of this book is the case studies. It’s a book that tells you to
look where others aren’t looking and to do your own work. It’s maybe the most practical book on
investing I’ve ever read.
My Partial Favorite: “The Snowball” – The 1950 through 1970 Chapters
I said “You Can Be a Stock Market Genius” was my favorite book. If we’re counting books in
their entirety, that’s true. I like “You Can Be a Stock Market Genius” better than the Warren
Buffet biography “The Snowball”. However, I might actually like some chapters of “The
Snowball” more than any other investing book out there. The key period is from the time Warren
Buffett reads “The Intelligent Investor” till the time he closes down his partnership. So, this
period covers Buffett’s time in Ben Graham’s class at Columbia, his time investing his personal
money while a stockbroker in Omaha, his time working as an analyst at Graham-Newman, and
then his time running the Buffett Partnership. These chapters give you more detailed insights into
the actual process through which he researched companies, tracked down shares, etc. than you
normally find in case studies. That’s because this is a biography. The whole book is good. But,
I’d say if you had to choose: just re-read these chapters 5 times instead of reading the whole
book once. Following Buffett’s behavior from the time he read The Intelligent Investor till the
time he took over Berkshire Hathaway is an amazing education for an individual investor to
have.
Often Overlooked: John Neff on Investing
I’m going to mention this book because it’s a solid example of the kind of investing book people
should be reading. And yet, I don’t see it mentioned as much as other books. John Neff ran a
mutual fund for over 3 decades and outperformed the market by over 3 percent a year. That’s a
good record. And this book is mostly an investment diary of sorts. You’re given the names of
companies he bought, the year he bought them, the price he bought them at (and the P/E, because
Neff was a low P/E investor), and then when he sold and for what gain. This kind of book can be
tedious to some. But, it’s the kind of book that offers variable returns for its readers. Passive
readers will get next to nothing out of it. But, active readers who are really thinking about what
each situation looked like, what they might have done in that situation, what the market might
have been thinking valuing a stock like that, what analogs they can see between that stock then
and some stock today, etc. can get a ton out of a book like this. Remember: highlight the names
of companies, the years Neff bought and sold them, and the P/E or price he bought and sold at.
You can find stock charts at Google Finance that go back to the 1980s. You can find Wikipedia
pages on these companies and their histories. A book like this can be a launching point into
market history.
A More Modern Example: Investing Against the Tide (Anthony Bolton)
There are fewer examples in Bolton’s book than in Neff’s book. But, when I read Bolton’s book,
it reminded me of Neff’s. A lot of Neff’s examples are a little older. Younger value investors
will read some of the P/E ratios and dividend yields Neff gives in his 1970s and 1980s examples
and say “Not fair. I’ll never get a chance to buy bargains like that.” As an example, Neff had a
chance to buy TV networks and ad agencies at a P/E of 5, 6, or 7 more than once. They were
probably somewhat better businesses 30-40 years ago and yet their P/Es are a lot higher today
than they were back then. Bolton’s book is more recent. You get more talk of the 1990s and early
2000s in it. So, it might be more palatable than Neff’s book. But, this is another example of the
kind of book I recommend.
Best Title: There’s Always Something to Do (Peter Cundill)
This is one of two books about Peter Cundill that are based on the journals he wrote during his
life. The other book is “Routines and Orgies”. That book is about Cundill’s personal life much
more so than his investing life. This book (“There’s Always Something to Do”) is the one that
will appeal to value investors. It’s literally an investment diary in sections, because the author
quotes Cundill’s journal directly where possible. Neff was an earnings based investor (low P/E).
Cundill was an assets based investor (low P/B). He was also very international in his approach.
This is one of my favorites. But, again, it’s a book you should read actively. When you come
across the name of a public company, another investor, etc. note that in some way and look into
the ones that interest you. Use each book you read as a node in a web that you can spin out from
along different strands to different books, case studies, famous investors, periods of market
history, etc.
You’re Never Too Advanced for Peter Lynch: One Up On Wall Street and Beating the
Street
Peter Lynch had a great track record as a fund manager. And he worked harder than just about
anyone else. He also retired sooner. Those two facts might be related. But if the two themes I
keep harping on are finding stocks other people aren’t looking at and doing your own work –
how can I not recommend Peter Lynch. He’s all about turning over more rocks than the other
guy. And he’s all about visiting the companies, calling people up on the phone, hoping for a
scoop Wall Street doesn’t have yet. The odd thing about Peter Lynch’s books is that most people
I talk to think these books are too basic for their needs. Whenever I re-read Lynch’s books, I’m
surprised at how much practical advice is in there for even really advanced stock pickers. These
are not personal finance books. These are books written by a stock picker for other stock pickers.
The categories he breaks investment opportunities into, the little earnings vs. price graphs he
uses, and the stories he tells are all practical, useful stuff that isn’t below anyone’s expertise
levels. These books try to be simple and accessible. They aren’t academic in the way something
like “Value Investing from Graham to Buffett and Beyond” is. But, even for the most advanced
investor, I would definitely recommend Peter Lynch’s books over Bruce Greenwald’s books.
An Investing Book That’s Not an Investing Book: Hidden Champions of the 21st Century
I’m going to recommend this book for the simple reason that the two sort of categories I’ve read
about in books that have actually helped me as an investor are “special situations” (from “You
Can Be a Stock Market Genius”) and “Hidden Champions” (from “Hidden Champions of the
21st Century”). It’s rare for a book to put a name to a category and then for me to find that
category out there in my own investing and find it a useful tool for categorization. But, that’s
true for hidden champions. There are tons of books that use great, big blue-chip stocks as their
examples for “wonderful companies” of the kind Buffett likes. This book uses examples of
“wonderful companies” you haven’t heard of. In the stock market, it’s the wonderful companies
you haven’t heard of that make you money. Not because they’re better than the wonderful
companies you have heard of. But, because they are sometimes available at a bargain price. As
an example, Corticeira Amorim (Amorim Cork) was available at 1.50 Euros just 5 years ago (in
2012). That was 3 years after this second edition of the book was published. Amorim is now at
11.50 Euros. So, it’s a “seven-bagger” in 5 years. More importantly, if you go back to look at
Amorim’s price about 5 years ago versus things like earnings, book value, dividend yield, etc. –
it was truly cheap. And yet it was a global leader in cork wine stoppers. Amorim is not as great a
business as Coca-Cola. It doesn’t earn amazing returns on equity. But, it’s a decent enough
business with a strong competitive position. And it was being valued like a buggy whip business.
That’s why learning about “hidden champions” and thinking in terms of “hidden champions” can
be so useful. There are stocks out there that are leaders in their little niches and yet sometimes
get priced like laggards. As an investor, those are the kinds of companies you want to have listed
on a yellow pad on your desk.
The Canon: Security Analysis (1940) and The Intelligent Investor (1949)
Do you have to read Ben Graham’s books? No. If you’re reading this blog, visiting value
investing forums, etc. you’re sick and tired of hearing about Mr. Market and margin of safety.
Those concepts were original and useful when Ben Graham coined them. I’ve read all the
editions of these books. People always ask me my favorite. So, for the record: I like the 1940
edition of Security Analysis best and the 1949 edition of The Intelligent Investor. I recommend
reading Graham’s other work as well. Fewer people have read “The Interpretation of Financial
Statements” and collections of Graham’s journal articles that can be found in titles like
“Benjamin Graham on Investing: Enduring Lessons from the Father of Value Investing”. Don’t
read any books about Ben Graham but not written by him. Instead look for any collections of his
writing on any topics you can find. He was a very good teacher. I especially like his side-by-side
comparative technique of presenting one stock not in isolation but compared to another stock
which is either a peer, a stock trading at the same price, or even something taken simply because
it is alphabetically next in line. It’s a beautiful way of teaching about “Mr. Market’s” moods.
Out of Print: Ben Graham’s Memoirs, “Distant Force” (A Book About Teledyne), and 100
to 1
I own all these books and like all these books. Do I recommend them? Not really. You have to
buy them in print. The price on some of them (even heavily used) is not cheap. And they aren’t
as good as the books I’ve mentioned above which you can get cheaper (and on your Kindle).
Still, if you don’t own these books, you’re probably wondering: what am I missing?
Well…
You can replace 100 to 1 with “100 Baggers”. That’s probably why “100 Baggers” was
published in the first place.
Ben Graham’s memoirs include only a few discussions of investing limited to a couple chapters.
I found them interesting, especially when I combined the information Graham gives in his
memoirs with historical newspaper articles I dug up. Some of the main stories he tells relate to
operations he did in: 1) the Missouri, Kansas, and Texas railroad, 2) Guggenheim Exploration, 3)
DuPont / General Motors, and 4) Northern Pipeline. The Northern Pipeline story has been told
elsewhere. In some cases, I’ve seen borderline plagiarizing of Graham’s account in his memoirs.
But, if you’ve ever read a detailed description of Graham’s proxy battle at Northern Pipeline, it
was probably lifted from this book.
What about “Distant Force”? Some people find this book extraordinarily boring. I found it
interesting more as a “source” for putting together a picture of how Teledyne worked rather than
just a book to be read in isolation. There are old business magazine articles you can find on
Teledyne and there’s a chapter length description of Teledyne in “The Outsiders”.
Although I’m not going to recommend you dig up expensive, out of print, used, and often boring
books – I am going to warn you about the “copy of a copy of a copy” syndrome. A lot of value
investors will cite something about habits, or checklists, or Ben Graham, or Teledyne that is from
a more popular / more recent book. That book is “popularizing” a primary (or in some cases
actually a secondary) source. Like popular science, the author is making certain tweaks to the
presentation of the idea to better fit the concept their book is about and to simplify the ideas they
present. Some authors do this in a way that shows they probably understand the original material
really well but are just presenting it simplified for your benefit. Other authors give some hints
that they may not really understand the primary source that well. Something like “The Snowball”
simplifies certain ideas because it’s not an investing book. It’s a biography. However, the
simplification in that book is done really well. Sure, I’d love to have more detail. Alice
Schroeder gave a talk about Mid-Continent Tab Card Company that would’ve been a great
addition to the book. But, I’m not worried that Alice Schroeder is really garbling what she’s
reporting even when she’s presenting it for a general audience whose main interest might not
even be value investing.
I’m not going to name names. But, there are value investing books out there that aren’t as good.
Wherever possible, try to read the primary sources.
If you find a book with good concepts in it, but find the detail lacking – read through the works
cited for the sources that book is using.
And if you really want to know what Ben Graham thought, read the 1940 edition of Security
Analysis and the 1949 Edition of The Intelligent Investor. Don’t read a modern book that just has
Ben Graham’s name in the title.



URL: https://focusedcompounding.com/the-best-investing-books-for-a-budding-valueinvestor-to-read/
Time: 2017
Back to Sections
-----------------------------------------------------
Some Books and Websites That Have Been Taking Up My Time
I get a lot of questions from readers about what investing sites I use, what books I’m reading, etc.
So, here are two sites and four books I’ve been spending time with lately.
Websites
GuruFocus: Buffett/Munger Screener
I write articles for GuruFocus (click the “Articles” link at the top of the page to see all of them).
So, it’s a conflict of interest to recommend premium membership to the site. What I will say is
that if you are a premium member – I think the most useful part of the premium membership is
the various predictable companies screens. There’s a Buffett/Munger screen, an undervalued
predictable companies screen, and you can also just filter companies by predictability score
(GuruFocus assigns companies 1-5 stars of predictability in 0.5 star increments). I think the best
thing GuruFocus ever developed is the predictability score. And it’s a good use of your time to
type in some ticker symbols and see which of those companies are high predictability, which are
low, etc. Do I personally invest based on predictability? No. GuruFocus doesn’t rate BWX
Technologies (BWXT) and it assigns predictability scores of 1 (the minimum) to both Frost
(CFR) and George Risk (RSKIA). I have about 85% of my portfolio in those 3 companies. So, I
have almost all my money in non-predictable companies according to GuruFocus. The
predictability score isn’t perfect. But, for non-cyclical and non-financial stocks that have been
public for 10 years or more – I think it’s a pretty good indicator. Use it like you would the ZScore, F-Score, etc. It’s just a vital sign to check. Don’t just buy a stock because it’s predictable
or eliminate it because it’s unpredictable according to GuruFocus’s automated formula.
Quickfs.net
I can’t vouch for the accuracy of the data on this site. But, that’s true for summary financial
statements at all websites. Once I’m actually researching a stock, I do my own calculations using
the company’s financial statements as shown in their past 10-Ks on EDGAR (the SEC website).
What I like about Quickfs.net is that it’s simple and clean. Most websites that show you
historical financial data give you way too much to look at. When you’re just typing in a ticker
you heard of for the first time – which is what I use these sites for mainly – what you need is a
“Value Line” type summary of the last 10 years. It shouldn’t be something you need to scroll
down to see. As sites age, they get more and more complicated showing more and more financial
info. You don’t need more than what Quickfs.net shows you. If you like what you see of a
company at Quickfs.net then you should go to EDGAR yourself and do the work. Quickfs.net is
for the first 5 minutes of research. The next hours should be done manually by you – not relying
on secondary sources like Quickfs.net, GuruFocus, Morningstar, etc. None of them are a
substitute for EDGAR.
Books
Deep Work: Rules for Success in a Distracted World
This is a great concept. It’s not a great book though. I recommend reading the book only because
focus is probably the most important concept in all of investing. If you can focus the way the
author of this book talks about – you can become an above average investor. If you can’t focus
the way this author talks about – I’m not sure you can ever become an above average investor. In
fact, I actually think you can’t. Focus is the foundational skill for an investor. You can teach
most everything else. I’m not sure you can teach focus. But, this book tries to teach focus. So, I
do recommend it. Value and Opportunity reviewed this book last year.
By the way, Value and Opportunity is a great blog. You should read it.
Tao of Charlie Munger
I just said “Deep Work” wasn’t a great book. That’s true. But, it’s not a bad book. This book is
really, really not a good book. However, it has some great quotes from Charlie Munger in it.
And, although I was disappointed by the book as I read it – I did find myself quoting the book
quoting Munger in the weeks after I read it. So, the author did actually imprint some of Munger’s
quotes on my psyche. I guess it’s worth $12 on Kindle for that. Don’t expect much out of this
book though. Just think of it as a collection of quotes from Charlie Munger.
The Founder’s Mentality
This is a Chris Zook book. You might know that I’ve read all of Zook’s books. They’re basically
about profitable growth. How can a business grow for a long time in a way that compounds
wealth for the business’s owners at an above average rate? I’m sure that’s not how Zook would
phrase it exactly. But, that’s how I approach his books. This is a good book. It’s probably my
least favorite Zook book so far. But, I do recommend it to all value investors. This kind of book
is very useful for buy and hold investors. For example, I was just talking to someone about
Howden Joinery and I mentioned that in about 6 years the company will have fully saturated the
U.K. with its namesake concept (the concept is a chain of depots for local, small builders who
are renovating kitchens). The founder/CEO is also about 61 now. So, I told this person I was
talking to that while I thought Howden would likely return something like 12% a year as a stock
– I was only interested in viewing the stock as a 6-year commitment. In 6 years, the founder
would be about retirement age and the company would be producing a lot of free cash flow it
could no longer put back into its core concept (Howden depots) in its core country (the U.K.).
So, I just felt that it’s possible the company’s phase of value creating growth would be over at
that point. I think it’ll continue to be a durable business. But, most companies start to stray once
their original concept is mature and once they move on to the second generation, third
generation, etc. of management. When I invest in a growth company, I want it to be run by the
founder and to still have room to roll out its core concept in its core country. I think Howden has
about 6 more years of that period left in it. I’m not sure I would be able to so clearly explain my
thinking on Howden if I hadn’t read this book and Zook’s other books. So, I recommend them
all.
Global Shocks: An Investment Guide for Turbulent Markets
Now, this is actually a great book. Though I’m not sure it’s a great topic. And it’s a topic I’d
recommend most value investors avoid. Full disclosure, a member of my extended family knows
the author of this book. So, I actually heard about the book before it came out. It’s not a topic I
would have found searching through Amazon. The topic is basically financial crises. However,
it’s really focused on financial crises through the lens of monetary policy meaning especially
foreign exchange and asset bubbles. It’s very useful for value investors to hunt in countries that
have been devastated by these sorts of crises. It’s also useful to avoid countries that may be in
bubbles. I would recommend this book with a caveat. Most value investors I talk to are already
way too worried about things like the overall price of the stock market, whether a country is in
an asset bubble, foreign exchange rate levels, etc. I started investing as a teenager in the late
1990s. So, I went through years like 1999-2001 and 2007-2009. Even when the stock market is
overvalued, you can find stuff to do. The market is clearly overvalued now. And yet I hope to
add a new stock to my portfolio later this year. I think it’s good to understand these things. But, I
also think it’s good to be practical about it. If you’re a value investor and a stock picker – you
should be capable of both believing that a market is overvalued and also believing that it isn’t
pointless to keep reading 10-Ks, looking through spin-offs, etc. day after day. Hope is having
something to do. And there’s always something for a stock picker to do. So, I recommend the
book. But, I also recommend staying focused on individual stocks rather than macro-concerns. If
you know you’re the kind of person who tends to get overwhelmed – don’t read this book. For
everyone else, it’s an interesting read. Some people think it’s dry. I don’t. It helps if you’re
interested in financial history. There’s a lot of (recent) financial history in this book.



URL: https://focusedcompounding.com/some-books-and-websites-that-have-been-takingup-my-time/
Time: 2017
Back to Sections
-----------------------------------------------------
The Best Investing Book to Read if You’re Only Ever Going to Read One
Someone who reads my blog emailed me this question:
“Imagine you’re giving advice to a young person (early twenties) who just got their first job and
has a 401k match program or has decided to set aside part of their paycheck each month for a
tax advantaged investment account. They want to learn enough about investing to not get into
trouble while managing their account, but they don’t want to turn this into a hobby or a part
time job.
Is there one book or resource they should study to learn how to select suitable investments and
manage them within a portfolio over time that you’d recommend? Imagine they’ll never read or
think about the subject again, this is your one shot to set them on a good path. What do you
recommend for the everyman investor?”
That’s a good question. And a tough one to answer. I can quickly come up with a list of books
I’d recommend as a group. Everyone should read Peter Lynch’s “One Up on Wall Street” and
“Beating the Street”. Joel Greenblatt’s “You Can Be a Stock Market Genius” and “The Little
Book that Beats the Market”. Ben Graham’s “The Intelligent Investor” (the 1949 edition is best).
And then Phil Fisher’s “Common Stocks and Uncommon Profits”. Just writing this I’d say that
maybe the number one book I’d recommend – if I was only recommending one – is Phil Fisher’s
“Conservative Investors Sleep Well.” Now, technically, “Conservative Investors Sleep Well” is
included in “Common Stocks and Uncommon Profits”. It was originally published as a separate
book. So, if you’re willing to count it as a separate book – even though it’s only available as a
really old, used book in that form – I might say “Conservative Investors Sleep Well” is the one
book I’d recommend.
Why wouldn’t I make the Lynch books, the Greenblatt books, or the Graham book the one and
only book to read? A few of them are too specialized. I’m a big Ben Graham fan. But, Ben
Graham is not a good choice for someone who doesn’t want to spend a lot of time picking
stocks. His approach takes a lot of time to implement. And it can be dangerous if done wrong.
Greenblatt’s best book is “You Can Be a Stock Market Genius”. I think that’s the single best
book on investing. But, it’s not the one I’d recommend for someone who isn’t going to focus on
investing all the time. His other book “The Little Book That Beats the Market” is the easier one
to implement. But, it’s not that different from indexing. That is what Warren Buffett would
recommend – the John Bogle approach. If an investor isn’t willing to put in the time to research
stocks in depth, he should just buy the S&P 500. I don’t know if I agree with that. There is
another way you could make things work I think.
Let’s say you only picked one stock a year. And let’s say you never sold stocks. So, there was no
question of Graham’s “group operations” like net-nets and there would be no question of Peter
Lynch’s higher turnover approach. Greenblatt’s best book focuses a lot on spin-offs and such.
It’s a high turnover approach. And his other book (the Magic Formula one) suggests flipping the
stocks each year. You obviously don’t have to do that. But, I’d suggest that an investor who
doesn’t want to think too much – or doesn’t want to think too long at least – should follow the
Phil Fisher approach as much as possible.
So, if we’re committed to the idea that an investor who doesn’t want to spend a lot of time
tending his portfolio should focus on Phil Fisher’s writings – we’re left with a choice between
“Common Stocks and Uncommon Profits” and “Conservative Investors Sleep Well”. Like I said
before, you can buy these two together in one book now. So, if we’re counting them as one book
– that’s the book I’d recommend.
This means I’m suggesting a growth investor approach instead of a value investor approach. My
second choice wouldn’t be a value investor either. I’d say the single best investing book to read
if you’re only going to read one is Phil Fisher’s “Common Stocks and Uncommon Profits” and
the second-best choice is Peter Lynch’s “One Up on Wall Street”. These books are the most
approachable for the new investor. Ben Graham’s 1949 Intelligent Investor would probably be
my third choice. So, there you have a Fisher, a Lynch, and a Graham to choose from. Fisher is
the ultimate buy and hold growth investor. Graham is the ultimate value investor. And Lynch is
somewhere in between. If this new investor had any idea temperamentally which author he lined
up with most, he could read that guy’s book. But, if I had to recommend just one I’d recommend
the Fisher.
Why? Phil Fisher was a buy and hold investor. And I don’t see any way to invest successfully
without putting in a lot of time unless you’re a true buy and hold investor. So, if someone said
they don’t want to make investing a profession or a hobby – but they do want to put money away
for the rest of their life in stocks they themselves choose, then that person must commit to buy
and hold. There’s no other way for this to work.
Committing to a buy and hold approach solves a lot of problems. The average investor probably
spends half their time worrying what they should sell and when they should sell it. If you simply
commit to the idea that you will literally never sell – then you can double the amount of time you
spend thinking about which stock to pick in the first place. Ben Graham’s approach would work
fine in a buy and hold sort of way. You can buy low price-to-book stocks and the like and hold
them for 5 years without any problem. But it’s a group approach. Graham wanted the
“defensive” investor to have something like 20 stocks in his portfolio. Even for the individual
investor, his idea of diversification was 10 to 30 stocks – never a handful like Fisher was willing
to focus on. So, I don’t think you can go with the Graham approach unless you are willing to put
in the time. If you aren’t willing to put in the time – your two choices are Bogle (indexing) or
Fisher (buy and hold forever).
The next thing I’d recommend to someone who wanted to pick his own stocks but didn’t want to
spend much time picking those stocks is to only buy one stock a year. I think that would – when
combined with the commandment to never sell – be a big help. Why?
How selective you can be in your stock picking is the result of how many decisions you make
and how much time you have. The less time you have – the fewer decisions you should make.
Now, the Fisher approach solves part of the problem for us. Fisher was a buy and hold investor.
He felt that if you picked the right stock to start with the right time to sell that stock was never. I
agree. Not for all investors. But for an investor who doesn’t want to make this his profession or
his hobby. For that investor, you never want to waste a second thinking about selling. So, you
buy and literally hold forever. That cuts the amount of decisions you have to make in half. But,
unless you also make a decision about how often you are going to buy a stock – you’ll have a
problem. There will still be the problem of portfolio allocation. What if you have 5 good ideas
one year? Should you put 20% of your savings for that year in each? Or should you focus on the
best idea to the tune of 50% of that year’s savings? There’s an easier answer. Always put
everything you add to your 401k in a given year into just one stock. For a trader, this would lead
to a lack of diversification. But for a true buy and hold forever investor – the level of
diversification will be big. You mentioned an early 20s investor. Let’s take a 25-year-old. He
picks one stock a year and puts all he adds to his savings into just one stock. By the time he’s 40
years old he owns 15 different stocks. Now, some of these stocks could go bankrupt. Some could
be sold out for cash. So, maybe the number isn’t 15. But even if one company takes over another
in an all-stock deal – he’ll just keep his shares in the new, merged company. Likewise, if there’s
a spin-off, he’ll keep his shares in that too. Because, remember, he’ll never sell. So, he will end
up more diversified than Phil Fisher was. Because Phil Fisher didn’t keep close to equal amounts
in 15 different stocks.
The other benefit to needing to pick only one stock a year is that this investor – who doesn’t
want to spend too much thinking on his own, remember – can do a lot of copycatting. The press
covers what Warren Buffett bought this year. It covers spin-offs and scandals and IPOs and
mergers and so on. So, there will often be a stock in the news that could catch this investor’s
interest without a lot of him having to do background searching. For example, let’s say this
investor eats at Chipotle (CMG). Well, Chipotle is having a hard time. I don’t have an opinion
about the stock. But, this investor certainly could see the stock mentioned in the news. He could
focus on that stock because he eats there. And it might be the one he decides to buy and hold
forever. Or, he could read in the news about a possible merger. For example, you have the whole
Viacom drama with Sumner Redstone and whether it will merge with CBS. If this investor is in
his early 20s right now, he’d have grown up with MTV and Nickelodeon. He’d have seen plenty
of Comedy Central. He might have a view on Viacom. Or, he might be reading about Brexit
online somewhere. And it is just this political drama on another continent. But, then, he reads
something about how much the Pound has dropped or how much some of the stocks over there
have gone down. And so he focuses – for this year, and this year only – on U.K. stocks. He only
has to find one. He knows that going in. Looking through the carnage like that is more of a Peter
Lynch approach than a Phil Fisher approach. In fact, what it’s like is Peter Cundill. There’s a
good book that draws from Cundill’s journals. It’s called “There’s Always Something to Do”. I
didn’t list the top 5 books I might recommend to the kind of investor you talked about – but I
think that Cundill book would make the list. It’s a good book for telling you about the
psychology of investing. The psychology of holding especially.
The most important thing this investor will need to learn from these books is the need to hold
when others are selling. Not just the need to be contrarian. But the need to hold during those
times when others would sell. So, maybe “There’s Always Something to Do” would be a good
choice. Those would be my top 4 I think. Number 4: “There’s Always Something to Do”,
Number 3: “The Intelligent Investor (1949)”, Number 2: “One Up on Wall Street”, and Number
1: “Conservative Investors Sleep Well”. If I’m allowed to cheat – because it is now packaged as
one book – I’d choose Phil Fisher’s “Common Stocks and Uncommon Profits and Other
Writings” as the one book for this new investor to read. My one recommendation though would
be that while it’s enough to read this book and only this book – it’s not enough to read it only
once. If this investor would commit to re-reading “Common Stocks and Uncommon Profits and
Other Writings” every year, buying only one stock a year, and never selling – I think he could do
okay. That’s not much of a commitment. Re-read (the same) one book a year and buy one stock a
year. But I don’t know many people who would actually stick to it.



URL: https://focusedcompounding.com/the-best-investing-book-to-read-if-youre-onlyever-going-to-read-one/
Time: 2016
Back to Sections
-----------------------------------------------------
Books I’m Reading
I just finished reading Pat Dorsey’s The Little Book That Builds Wealth. This was recommended
to me by the blogger who writes Neat Value. It was a good recommendation. The book is short.
And simple. And all about moats.
I’m now reading William Thorndike’s The Outsiders: Eight Unconventional CEOs and Their
Radically Rational Blueprint for Success. This one’s even better. Every buy and hold investor
should read it.



URL: https://focusedcompounding.com/books-im-reading/
Time: 2012
Back to Sections
-----------------------------------------------------
What Books Should You Read About Ben Graham?
Someone who reads my articles sent me this email:
Hey Gannon,
…do you have any suggestions on books to read about Ben Graham, Warren Buffett early days,
and Walter Schloss? I feel like I've read 90% of them (the only popular one I can think of that I
haven't finished is Of Permanent Value, but I'm slowly making my way through it), but I'm
always surprised to find quotes or stories about them in your articles that I've never seen before.
Any suggestions (especially off the wall ones!) will be appreciated…
Hope all is well,
Andrew
Most books about Warren Buffett, Ben Graham, etc. are just rehashing info you can find
elsewhere. You’re right that there are references in my articles that might be a little obscure.
I’ll be honest with you.
I have kind of a collection of – mostly hardcover, printed – books on the topic of Warren
Buffett (and Ben Graham and others). So, usually what happens is I know the reference roughly
in my head and then I have to go digging into the books to find it. Sometimes, I’m not even sure
which book it’s from.
Sad but true.
Okay, on to Ben Graham book suggestions…
Many people don’t have all the editions of "The Intelligent Investor," etc. So they will only be
quoting from things you can find in the Zweig edition. Some of the most interesting stuff Ben
Graham wrote was taken out of later editions. There’s very interesting valuation stuff in the 1949
edition – I think it’s around chapter 10 – that isn’t in the 1970s edition. Partly, this is because the
techniques had become more common place. This is one of the issues with "Security Analysis."
Analysts now do many of the things Ben Graham suggested. So, some of that work isn’t really
unique to Graham any more. And that stuff has been de-emphasized.
Anyway, here are the books on Ben Graham you need to own:
The Intelligent Investor (Look for the 1949 Edition if you can find it – I could’ve sworn they
reprinted it with a Jack Bogle foreword. But I can’t find the link now.)
Security Analysis (1934, 1940, 1951, and the Recent One)
The Interpretation of Financial Statements
Benjamin Graham: The Memoirs of the Dean of Wall Street (Yes, I own it – and no, I won’t sell
it).
Benjamin Graham On Investing: Enduring Lessons from the Father of Value Investing
Benjamin Graham, Building a Profession: The Early Writings of the Father of Security Analysis
Also, yes, you should read Of Permanent Value. And – yes – I buy it every time a new edition
comes out. Expensive. And heavy. But worth it. It’s more of an information resource than
pleasure reading material.
But what a resource it is.
The Buffett Partnership Letters are here.
The Graham-Newman Letters (From 1946-1958) are here.
All but one of those letters is just a list of Graham-Newman’s portfolio positions.
Sounds pretty useless, right?
Not exactly. Here’s what you do…
Use a newspaper archive to match Graham-Newman’s positions to contemporary articles. You
can do this with Ben Graham’s memoirs too. There are tons of articles about stocks. Sometimes,
you can even find earnings numbers from around the time Graham was buying. And rumors.
Boy, did newspapers have different standards about printing market gossip in Ben Graham’s day.
Searching for Ben Graham’s name is less helpful. Instead, search for the name of the company
whose stock Graham-Newman owned. Set the search criteria to between January 1 and
December 31 of the year in which Graham-Newman first bought the stock. After that, widen the
search one year in each direction. Start with the year before Graham bought his shares. Graham
was often buying shares as part of a special situation (like an announced liquidation). So news
stories pre-dating his purchase are often worth reading.
The New York Times Article Archives are here.
Obviously, you have to have all of the shareholder letters from Berkshire Hathaway (here). And
Wesco (here).
You’ll also want to own "Poor Charlie’s Almanack"
And you need to read both "Buffett: The Making of an American Capitalist" and "The
Snowball."
There isn’t much academic writing about any of these guys. Although you can try
searching JSTOR from somewhere with access. Ben Graham’s name appears a few times. But
rarely for investment stuff. If I remember right I think it’s economics (his commodity reserve
plan) and a calculus paper he wrote as a student.
I can’t think of other sources that weren’t from some other blog or something like that. I think
several of the times I mentioned Walter Schloss would’ve been from things I found on various
blogs – obviously including this one.
My other tips are just general research tips. If you find a person’s name, company name, date,
anecdote, etc., write the identifying details down. An index card is perfect for this.
Then search for those people, companies, publications, dates, etc., online.
Especially in newspapers.
Newspaper archives are very helpful for researching investors since the companies they are
investing in are public companies. And public companies get written about a lot in newspapers.
Also – always, always, always – read the footnotes, bibliography, works cited, etc., of anything
Ben Graham-related you get your hands on. The author is usually getting their info from another
written source. Usually, another fuller written source.
Biographies of Warren Buffett like Lowenstein and Schroeder wrote involved way more research
than what ends up being printed in the book that hits shelves. Often the stories that are cut would
be very, very interesting to investors. But less interesting to the general public.
Also, authors – and their editors – hate to present the same thing over and over again. So – for
example – they’ll tell one story about Buffett’s coattail riding and then throw out the other
episodes to avoid boring readers with a “been there, done that” feel.
That’s all I can think of right now. I’m sure I’m forgetting a lot.
But I’m also sure there’s a lot in there that folks haven’t read and would really enjoy.
So check out those links.



URL:
https://web.archive.org/web/20120623132053/http://www.gurufocus.com/news/161739/
what-books-should-you-read-about-ben-graham
Time: 2012
Back to Sections
-----------------------------------------------------
Build Your Own Ben Graham Library
If you want to fully understand Ben Graham, you should own the following Ben Graham library:
In Print
1. Benjamin Graham on Investing (1917-1927) – $20.76
2. The Rediscovered Benjamin Graham (1932-1977) – $29.70
3. The Interpretation of Financial Statements (1937) – $17.84
4. Security Analysis (1940) – $34.71
5. Benjamin Graham: Building a Profession (1945-1977) – $20.82
6. The Intelligent Investor (1949) – $19.39
Out of Print
1. Benjamin Graham: The Memoirs of the Dean of Wall Street ($44.99 Used)
That’s a total cost of $143.22 to build a complete – for our purposes – Ben Graham library
counting only books in print. And $188.21 if you include a used copy of the memoirs.
So you can buy a complete library of Ben Graham’s investment writing for about $200
at Amazon.
A couple ex-library copies of the memoirs have passed through my hands over the years, and
they’re usually in good shape. Ben Graham’s memoirs appeal to such a niche audience, it’s
likely no one actually read the library’s copy.
The memoirs only touch on investing in spots. But if you’re really into Ben Graham, you should
get them. Buying these books is only worthwhile if you both have an appetite for Ben Graham’s
stuff and you’re a voracious reader.
I read old books, papers, etc. It’s something I like doing. If you don’t like reading stuff that’s 60
to 90 years old, you probably aren’t going to like reading these books.
Some people can’t get through Graham. I don’t know why. But you might be one of those
people. Sample some of Graham’s actual writing first to find out.
If you just want the core “how to invest” stuff by Ben Graham, it’s simply:
1. The Interpretation of Financial Statements (1937) – $17.84
2. Security Analysis (1940) – $34.71
3. The Intelligent Investor (1949) – $19.39
So we’re talking a $75 set.
The usual caveats for any decades old academic / technical writing applies to these books.
All the information in them is dated. This isn’t what Graham would write today. It’s like reading
Keynes or something. It’s a classic. But it’s definitely not the way today’s students are
introduced to the field.
I get asked which editions of The Intelligent Investor and Security Analysis I prefer. The answer
is the 1940 edition of Security Analysis and the 1949 edition of The Intelligent Investor.
Different people have different preferences. Those are mine.
The book I’m giving away in this month’s blind stock valuation contest is the 1949 edition of the
Intelligent Investor. To be clear, these are all modern reprints. I don’t own – and am not giving
away – collector’s pieces. Although, obviously, copies of the memoirs are “collectible” in the
sense that they’ve appreciated in value. I think new copies retailed for $28 in 1996.
Regardless, you should only buy these books if you intend to read them – repeatedly.



URL: https://focusedcompounding.com/build-your-own-ben-graham-library/
Time: 2011
Back to Sections
-----------------------------------------------------
Investing 101 Toolbox: 12 Books, 3 Lectures, 4 Blogs, and 5 Interviews for
Investors
A reader sent me this email:
I saw…that you are more or less self-taught. Do you have any other sources for information you
could recommend for me?
– Brian
I’m going to interpret this email as if Brian asked: “How would you teach Investing 101?”. I
don’t believe in formulas and definitions. I believe in examples and patterns. I believe you teach
Buffett, Greenblatt, Fisher, Graham, Lynch, Pabrai, Burry, etc. You don’t say who is right and
who is wrong. You teach the toolbox.
I don’t like everything in the box. Frankly: I’m not a Pabrai fan. Seems like a decent guy. But we
don’t invest the same way. I’m still obligated to learn Pabrai’s model and be able to teach it the
same way someone who writes about the U.S. Constitution needs to know Calhoun’s model.
Here’s my Investing 101 Toolbox:
Books
1. You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market
Profits
2. The Little Book That Still Beats the Market
3. Common Stocks and Uncommon Profits and Other Writings
4. The Intelligent Investor: A Book of Practical Counsel
5. One Up On Wall Street : How To Use What You Already Know To Make Money In The
Market
6. Beating the Street
7. Contrarian Investment Strategies – The Next Generation
8. John Neff on Investing
9. Money Masters of Our Time
10. Investing the Templeton Way
11. Benjamin Graham on Investing: Enduring Lessons from the Father of Value Investing
12. The Dhandho Investor: The Low – Risk Value Method to High Returns
Lectures
1. Thomas Russo
2. Li Lu
3. Mohnish Pabrai
Blogs
1.
2.
3.
4.
Cheap Stocks
SINLetter
Greenbackd
The Interactive Investor Blog
Interviews
1.
2.
3.
4.
5.
Tariq Ali of Street Capitalist
George of Fat Pitch Financials
Toby Carlisle of Greenbackd
Asif Suria of SINLetter
Jon Heller of Cheap Stocks
Other
Warren Buffett’s Partnership Letters
Michael Burry’s Message Board Posts
Michael Burry’s Partnership Letters



URL: https://focusedcompounding.com/investing-101-toolbox-12-books-3-lectures-4blogs-and-5-interviews-for-investors/
Time: 2010
Back to Sections
-----------------------------------------------------
On Buffett and Derivatives
Janet Tavakoli’s Dear Mr. Buffett is an unusual amalgam of a simple, personal story and a
complex, public one.
The personal story begins with an invitation from the Oracle himself:
“Be sure to stop by if you are ever in Omaha and want to talk credit derivatives…”
Buffett had just re-read Tavakoli’s Credit Derivatives & Synthetic Structures and noticed a letter
from the author tucked between the book’s pages. With a quick apology and the above invitation,
Buffett unknowingly set in motion a process that would give the public a rare glimpse inside his
inner sanctum.
Tavakoli took Buffett up on his offer and recorded the ensuing encounter in Chapter 2 of Dear
Mr. Buffett.
The promise of this tantalizing morsel will draw buyers in. But readers will find much more than
another book on Warren Buffett.
The real story begins in 1998. That’s when Buffett’s Berkshire Hathaway bought General Re.
Berkshire was a major insurer with a home-grown reinsurance business. General Re was
considered the crème de la crème of reinsurers.
I say “considered”, because unbeknownst to Buffett there was a lot of crap among the crème.
That crap came in the form of derivatives.
Meta-Bets
Derivatives are exactly what they sound like. The value of a plain vanilla security like a stock or
bond is derived from the underlying business – its assets, earnings, and capacity to meet
obligations. These are simple, straight bets.
Derivatives are meta-bets. Like an ironic narrator, they stand a level above the action. Instead of
betting on a business, they bet on the betting on that business. Instead of betting on a borrower’s
future income and collateral they bet on the bet a banker made on that borrower’s future income
and collateral.
If the investment banks that created these derivatives used the same ad agency as BASF, their
slogan would be: “We don’t make a lot of the securities you buy; we make a lot of the securities
you buy riskier”.
Theory of Everything
Tavakoli has her own Theory of Everything in Finance:
“The value of any financial transaction is based on the timing of cash flows, the frequency of
cash flows, the magnitude of cash flows, and the probability of receipt of those cash flows.”
It’s a simple theory. Derivatives are complex. But no amount of complexity can free a security
from this iron clad rule.
“In finance, we make up a lot of fancy and difficult to pronounce names and create complicated
models to erect a barrier to entry that keeps out lay people. High barriers tend to protect high
pay. I’ve written about some of these esoteric products: credit derivatives, CDOs, and more, but
before I look at the latest hot label dreamt up, I look at the cash to find out what is really going
on.”
So does Warren Buffett.
Buffett Bets
As Tavakoli points out, financial journalists seized on Buffett’s description of derivatives as
“financial weapons of mass destruction” while completely ignoring another passage in his 2002
letter to shareholders:
“Many people argue that derivatives reduce systemic problems, in that participants who can’t
bear certain risks are able to transfer them to stronger hands. These people believe that
derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual
participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes
engage in large-scale derivatives transactions in order to facilitate certain investment
strategies.”
Although Buffett was concerned with the macro-risk presented by derivatives – especially the
risk of a collateral requirement death spiral – he was still open to engaging in large-scale
derivative transactions when it made sense for Berkshire.
Buffett takes risk from Wall Street firms willing to pay Berkshire well. For instance, Berkshire
has assumed the risks of owning certain junk bonds.
But he sets the ground rules:
“He chooses the specific corporate names; he refuses ‘diversified’ portfolios containing a large
number of corporations. He does trades in massive size – $100 million or more, if possible.”
Buffett applies the same principles he uses in common stock investing. He likes to be greedy
when others are fearful and fearful when others are greedy. He likes opportunities where there is
a perception gap – an inappropriate quantitative relationship between price and value that arises
from some qualitative bias. And he likes to focus on what he knows. When he bets, he bets big.
When he’s unwilling to bet big, he doesn’t bet.
Margin of Safety
Buffett is occasionally willing to assume first-to-default risk on a basket of junk bonds:
“Normally, first to default trades are viewed as the riskiest trades, and junk debt is viewed as the
riskiest kind of asset; but Warren builds in a margin of safety that makes this a wise investment
as long as Wall Street misprices the risk.”
Market participants who focus entirely on conventional indicators of quality – like triple-A
ratings – miss opportunities to get great returns in “bad” assets and open themselves up to the
danger of buying supposedly “good” assets at prices that provide no margin of safety – and when
levered – provide a real risk of catastrophic loss.
Remember, Buffett bought into Moody’s common stock. He didn’t buy into their ratings system.
With lots of leverage and little value relative to price, you can go broke betting on good assets.
Conversely, with little leverage and lots of value relative to price, you can get good returns from
bad assets.
Buffett knows that. And he preaches what he practices:
“Investing in junk bonds and investing in stocks are alike in certain ways: Both activities require
us to make a price-value calculation and also to scan hundreds of securities to find the very few
that have attractive reward/risk ratios. But there are important differences between the two
disciplines…Purchasing junk bonds, we are dealing with enterprises that are far more marginal.
These businesses are usually overloaded with debt and often operate in industries characterized
by low returns on capital. Additionally, the quality of management is sometimes questionable.
Management may even have interests that are directly counter to those of debtholders.
Therefore, we expect that we will have occasional large losses in junk issues.”
(2002 Letter to Shareholders)
A man famous for stressing the importance of buying into good businesses with high returns on
capital run by able and honest management is willing to buy junk bonds of bad businesses with
low returns on capital run by incompetent and “questionable” management – when the price is
right.
Buffett is always focused on the relationship between price and value.
Tavakoli’s book chronicles the words and deeds of people who dealt in derivatives without
knowing – and often without caring – what that relationship was.
Some will call her book a morality tale. I call it a rationality tale.



URL: https://focusedcompounding.com/on-buffett-and-derivatives/
Time: 2009
Back to Sections
-----------------------------------------------------
Book Review: The Ten Commandments for Business Failure
Yesterday, I scampered off (virtually) to Amazon.com, found Don Keough’s new book, and
clicked the “Buy Now” button.
Through the sorcery of modern book selling – one minute, nine dollars and ninety-nine cents
later – Don Keough’s words were in my hands.
I froze.
Seeing the big, bold print of that title page on my Kindle, I froze. Here was a business book by
Don Keough. Yet for some reason I expected the worst. The title was not encouraging: “The Ten
Commandments for Business Failure”. It sounded like a book I’d read a few hundred times
before.
Would this be a saccharine sleigh ride through Coca-Cola’s golden (Goizueta) years? Or just
another listless list of managerial platitudes?
Evenly divided between anticipation, trepidation, and vacillation I pressed the “NEXT PAGE”
button and embarked on my journey with Mr. Keough.
At least, I thought it was to be with Mr. Keough, until I read the first few words of the foreword:
“It has been an article of faith for me that I should always try to hang out with people who are
better than I. There is no question that by doing so you move yourself up. It worked for me in
marriage and it’s worked for me with Don Keough.”
That voice, of course, is Mr. Buffett’s. Warren’s cameo will be appreciated by all business
readers, but those of the investing ilk will savor it most. And this is a worthwhile book for
investors – though only indirectly so.
Don Keough has written a general business book, not a managerial handbook. As he writes in his
introduction:
“…there has never been a shortage of speakers and writers willing to dispense tried and true
advice on how to succeed in business without really trying.”
This is not that book.
Nor is this the book for the starry-eyed entrepreneur, the middle manager looking to get ahead, or
the executive who wants to become a “leader”. This is not a self-help book.
It’s a business book – and a damn good one. The lessons within provide insights into businesses
both good and bad and are as useful to the investor as they are to the executive.
Keough knows the kind of book he’s writing and tells us at the outset who his audience is:
“While these commandments can be applied to any business at any stage in its development, they
are mainly intended for businesses and business leaders who have already attained a measure of
success. In fact, the more you have achieved the more the commandments apply to you.”
His years at Coke made Keough extremely well-qualified to write a book on how to screw up a
sure thing.
Keough’s advice is simple, maybe even trite:
“You will fail if you quit taking risks, are inflexible, isolated, assume infallibility, play the game
close to the line, don’t take time to think, put all your faith in outside experts, love your
bureaucracy, send mixed messages, and fear the future.”
That’s the whole book right there. Sorry to spoil it for you.
But what I haven’t spoiled for you is the fun of seeing how Keough takes these trite little dictums
and develops them through anecdotes. He makes passing reference to many of the most familiar
business failures; Xerox, Ford, and IBM are all taken to task.
However, Keough’s best stories are his Coke stories. Even his best IBM story is really a Coke
story:
“After the opening of the meeting, Akers made a speech on the supremacy of the customer in the
IBM world, and in order to highlight how important this new paradigm was, he said that as the
centerpiece of this meeting I was to be the speaker at the first session.”
Before letting Keough (then President of The Coca-Cola Company) speak, Akers told the
audience: “I want you all to get the flavor of some of the in-depth discussions we have been
carrying out here at headquarters to explore ways we can better serve our customers and
reaffirm our dedication to those customers.”
“He then showed a video of senior executives including him with their coats off and sleeves
rolled up in some clearly serious meetings on customers and customer service. There were
charts and graphs and a professional facilitator who kept reminding everyone of the importance
of the new paradigm…I watched this video along with everyone else. Of course I couldn’t help
but notice that on the conference table in front of every executive taking part in the customeroriented discussion was a can of Pepsi-Cola.”
Keough heaps one anecdote on top of another. I won’t ruin it for you by cherry picking the best
bits and reprinting them here. Like a comedy, this book is best approached without having
already been exposed to all the good material.
“The Ten Commandments for Business Failure” is a lightening fast read. I read it twice
yesterday. The first half of the book flies by.
It loses some momentum near the end, where Keough, who majored in philosophy, gets a bit too
philosophical for a bit too long. Even here, what he does he does well, but I’m not sure it needed
doing – at least not in the same book that cuts quickly to the heart of so many bone-headed
business mistakes. Keough’s slight meandering near the end of the book is far from a fatal flaw;
it is, for instance, nothing like the two-book format of Alan Greenspan’s “The Age of
Turbulence” which subtracted from one good book by adding another.
There is one other flaw: the chapter on bureaucracy is too long. While I’d love the book to be
twice as long if we got twice as many of Keough’s well-told tales, the chapter on bureaucracy
and Keough’s brief foray into Malthusian thought (and other equally dismal topics) are either
longer than they need to be or altogether unnecessary.
These small missteps are but a pebble on the scales when compared to Keough’s honest
assessment of just about everything in business:
“Now annual reports of most companies are page after page of full color, featuring people of all
races, creeds, and cultures plus a double-page spread of a pristine forest in Maine that
was not cut down to produce the report. Somewhere in all this green beauty you’ll find the
numbers.”
I wish Keough were embellishing the truth to make a point. Sad to say, I once read an annual
report where the financial data literally appeared among those trees – the great upward trend of
earnings causing each year’s EPS to rise like a redwood – higher and higher – ‘til it scraped the
azure sky.
Yes, there are a few hairline fractures on Keough’s little gem, but a gem it remains.
I have no doubt Don Keough’s “The Ten Commandments for Business Failure” will go down as
one of the best business books of 2008. I also have no reservation recommending it.
Verdict: BUY



URL: https://focusedcompounding.com/book-review-the-ten-commandments-forbusiness-failure/
Time: 2008
Back to Sections
-----------------------------------------------------
On Ben Graham and Bank Stocks
Jason Zweig writes the Intelligent Investor column for The Wall Street Journal. I’m sorry to say
this week’s column is especially unintelligent.
When asked whether Graham would be buying financial stocks today, Zweig says no, and gives
the following reason:
You cannot even pretend to be protected against loss while real estate prices – – the wobbly
foundation for most financial stocks – – are still crumbling.
False.
You can do more than pretend to be protected – and Graham would have. Crumbling real estate
prices alone would not have deterred Graham. He liked to use long-term averages and estimates
of what normal conditions would bring. He relied heavily on the past as an indicator of the
future. Real estate prices will recover at some point. Even if they don’t anytime soon, land still
has value and Graham would have done his best to conservatively estimate that value. He
could’ve used estimates based on prices from many years ago, replacement costs, rents, or the
value of unimproved land. Then he would have lopped off some of that price and – voila –
there’s your margin of safety.
No. The crumbling real estate market wouldn’t have fazed Graham.
Graham wouldn’t have bought financial stocks for a very different reason: they simply aren’t
cheap enough.
I know it’s hard to believe, but as Zweig points out, on average, financial stocks are still
trading above book value.
Remember, 1.1 times book is still 110% of a bank’s equity. Graham bought net current asset
value stocks at less than 67% of their net current asset value (NCAV).
A lot of people think NCAV stocks (or “net/nets”) are risky. Some may be. However, there was
one study showing that net/nets sought bankruptcy protection less frequently than non-net/nets.
That’s not as shocking as it sounds. Unlike low price to book stocks, low price to NCAV stocks
have a built in tendency to be overcapitalized.
Why?
Because there’s no need to have a positive net current asset value at all. Many public companies
don’t.
Take Anheuser-Busch. It has about $3.1 billion in book value and NEGATIVE $12.1 billion in
net current asset value. Even if BUD’s stock price fell to two bucks a share tomorrow, it would
not trade below its net current asset value, because it has no net current asset value. To have a
net current asset value, the company would have to be overcapitalized.
Other companies, especially companies with very high inventory needs and rapidly declining
sales, can trade below NCAV without actually having much financial wiggle room. However,
most companies end up in NCAV territory with strong balance sheets and weak statements of
income and cash flow.
The NCAV stocks that fail tend to do so in slow motion and through extreme pig-headedness.
Had management wished to, they could have exited unprofitable businesses, stopped treating the
company as their own personal piggy bank, or wound down the business at some point without
ever facing insolvency. A bankrupt (former) NCAV stock is usually the direct result of a
determined and dimwitted management.
I made this detour into the land of net/nets for a good reason. Graham liked to combine both safe
and cheap. He didn’t necessarily look for a high-quality, low-price stock – he looked for
businesses that could perform worse than expected and still see their share prices rise. When
taken as a group, net/nets are both safe and cheap. Their current earnings and cash flow are
usually very bad, their future prospects are usually abysmal – however, even the slightest
improvement in their performance will lead to excellent results.
Graham was betting on stocks with extraordinarily low expectations; if he were betting on a
horse race, the nearest equivalent would be betting that the worst horse in a race wouldn’t place
dead last every time. He didn’t bet on long-shots (he wasn’t betting the horse to win), and he
didn’t expect to make more than 50% from any one stock. But, he did expect to beat very low
expectations.
The problem with financial stocks is that today’s expectations still aren’t as low as Graham liked.
Buying a basket of bank stocks just above book value may be an excellent speculation, but it
wasn’t Graham’s idea of an investment.
Given the right price, you could carry out an investment operation in financial stocks by relying
on their past records (many banks have very long public histories) and diversifying. Zweig
finally gets Graham right when he says:
If you are still tempted to bottom-fish for financial flounder, at least diversify.
Unfortunately, he goes on to say:
Consider Vanguard Financials or iShares Dow Jones U.S. Financial Sector. Each of these
exchange-traded funds holds hundreds of financial and real-estate stocks.
You are to do no such thing. If you’re going to buy financials, don’t buy them indiscriminately
above book value. You need a margin of safety – and you can’t diversify your way to safety.
That means you either have to buy banks that are a cut above the rest or you have to buy banks
well below book value.
An example of a bank that’s a cut above (from a Grahamian safety perspective) is Valley
National (VLY).
Unfortunately, it ain’t cheap. I nearly posted on Valley recently when the company’s declining
stock price brought its dividend yield over 5% and its price-to-book ratio under two. Of course,
that means the company (briefly) traded at just under 200% of its book value – not exactly Ben
Graham cheap.
And that’s the problem. Many of the banks trading below book value don’t have long histories of
safety, solidity, and reliability. While many of the banks that do have such records (the kind of
records Graham would look for) aren’t trading anywhere near Ben Graham bargain territory.
If financial stocks fell another 40%, Graham would consider buying a basket regardless of the
economic climate. Even if we’re heading into a depression, buying the 20 best financial stocks at
2/3 of book value would be intelligent investing. However, even if we’re heading into the broad,
sunlit uplands of permanent peace and prosperity, buying a hodge-podge of financial stocks at
110% of book is unthinking investing.
Graham wouldn’t do it and you shouldn’t either.
So Zweig gets the answer right: No. If Ben Graham were alive today he wouldn’t be buying bank
stocks.
However, Zweig’s reasoning is all wrong. Graham wouldn’t be deterred by real estate prices;
he’d be deterred by stock prices. Bank stocks just aren’t cheap enough to provide a margin of
safety – unless you’re sure most banks are worth much more than book – and Ben Graham
wouldn’t be.
Zweig concludes with this indulgent advice:
Whatever you do, use only the money you were salting away for that trip to Las Vegas.
No.
Invest or don’t invest. But, don’t play games. Don’t dip a toe in the water. Don’t fool yourself
into thinking you’re being prudent when you’re simply being indecisive. It’s one thing to make a
single bad investment; it’s quite another to indulge yourself in a bout of sloppy thinking and
indecisive decision making. Better to burn the money now than lose it in a way that will
undermine your confidence in yourself or the seriousness with which you approach your
investments.
Here is the matter before you: Is an adequate margin of safety provided by the purchase of a
basket of bank stocks at an average of 110% of book value?
Yes? No? Maybe?
If yes, then invest.
If anything else, then forget about bank stocks altogether.



URL: https://focusedcompounding.com/on-ben-graham-and-bank-stocks/
Time: 2008
Back to Sections
-----------------------------------------------------
Security Analysis: Introduction (Part 1)
The introduction to Security Analysis is a treasure trove of Grahamian thought. It is impossible to
fully plumb the depths of this Grahamian gold mine in a single post. Therefore, I have separated
my comments into two posts. This post explores the opening paragraph of the introduction with
special attention to Graham’s style.
We should begin with the most general point made in Graham’s introduction: It is impossible to
completely separate analysis and action, theory and practice. Therefore, while the title of
Graham’s book is Security Analysis, the scope is necessarily wider:
Although, strictly speaking, security analysis may be carried on without reference to any definite
program or standards of investment, such specialization of functions would be quite unrealistic.
Critical examination of balance sheets and income accounts, comparisons of related or similar
issues, studies of the terms and protective covenants behind bonds and preferred stocks – these
typical activities of the securities analyst are invariably carried on with some practical idea of
purchase or sale in mind, and they must be viewed against a broader background of investment
principles, or perhaps of speculative principles.
This is vintage Graham. In many ways, it is a sort of cold open into the book and the mind of the
man who wrote it. He begins with a logical and overly literal opening sentence; to Graham,
“strictly speaking” means speaking strictly – nothing more or less. He adds a word we wouldn’t
think necessary – “definite” – but in Graham’s mind it is a necessary and meaningful modifier.
Finally, he interjects his personality with the word “quite”, which we will see repeated again and
again throughout Security Analysis (Graham was born in Britain).
Next, we have a catalogue. The activities Graham lists are all activities he’ll cover in Security
Analysis. If you wonder what Graham means by security analysis, look no further than these
lines. He lists three main activities: “critical examination” of corporate financial statements,
“comparisons of related or similar issues”, and finally “studies of the terms” of senior securities.
This is an especially excellent introduction for the modern reader, because we learn just how
different Graham and his book are from what we might expect – and we learn our lesson well
within the first few sentences.
What is the most unusual feature of this paragraph? Can you find the words almost no other
writer would have included?
I’ll give you a hint. In Graham’s list of activities undertaken by the security analyst, there are
two words that stick out like a sore thumb – a seemingly redundant sore thumb – can you find
them?
Here they are:
“Critical examination of balance sheets and income accounts, comparisons of related or
similar issues, studies of the terms…”
These two words tell you more about Graham and Security Analysis than anything else in that
opening paragraph.
Why?
Because they are peculiar. What tells most is often what is said least. The appearance of these
extra words in this sentence is something almost no one but Graham would ever insist upon.
Graham thinks these words are necessary; otherwise, he wouldn’t have included them. Related
and similar are not synonyms. Similar means “alike”; related means “connected”. Connections
do not necessitate similarities or vice versa.
For instance, there can be no doubt that airlines and railroads are related (as transports). But are
they similar? In some ways yes; but, other industries that are not closely related are at least as
similar to one or the other when we drill down into the micro-economics of each.
Graham knows this.
He loves comparisons. Comparing two or more different stocks or bonds was always one of his
favorite activities; he did it over and over again in class after class. He used comparisons in his
teaching and in his writing. Sometimes these comparisons used similar issues, sometimes related
issues, and sometimes random issues (as in the Intelligent Investor).
Choosing random issues (e.g., by taking stocks that are listed together in alphabetical order)
allows the security analyst the greatest opportunity to see each stock in the sharpest relief.
Looking only at related issues can be very useful (and is a common practice, especially when
putting a valuation on a stock or a company); however, such comparisons can cause tunnel
vision.
One phrase in this introduction will come back to haunt many readers – as it foreshadows what
will quickly become their least favorite part of Security Analysis – “studies of the terms and
protective covenants behind bonds and preferred stocks”.
Oh how some of you will come to hate that phrase!
There are a lot of reasons for Graham’s focus on senior securities. Some are peculiar to the time
he was writing; most are not. Graham’s own personal history made him a sucker for a good, long
exploration of every aspect of senior securities.
Here is a passage from Graham’s memoirs, describing his activities when he first arrived on Wall
Street:
Even in my spare time I took the job of self-education very seriously. I got myself a small
looseleaf notebook, and on each page I wrote the salient data about a given bond issue in
convenient form to be memorized. After all these years I can still remember the appearance of
that black notebook and some of the entries in it. The first was: “Atchison, Topeka, & Santa Fe,
General 4s, due 1995: 150 mil.” There must have been a hundred different issues entered; I
memorized their size, interest rate, maturity date, and order of lien. Why I wanted to memorize
facts that could be readily obtained from manuals or my notebook I am at a loss to
explain…After making what I thought was wonderful progress with these studies, I found all the
different issues hopelessly mixed up in my mind, and I gave up the exercise as a bad job. But I
was surprised to realize some months later that the figures had somehow straightened
themselves out. I had becoming something of a walking Railroad Bond Manual.
Some would prefer to skip everything Graham wrote about senior securities. You can
read Security Analysis without reading Graham’s views of bonds and preferred stocks and still
get something out of it. But, I wouldn’t recommend it. In a later commentary, I’ll defend the
value of the parts of Security Analysis that deal with bonds and preferred stocks. For now, just
know that they are there – and that you may not like them as much as those parts of the book that
deal exclusively with common stocks.
Tough.
Graham wrote about both for a reason. Luckily, much of what he says about senior securities will
help us better understand his thinking on common stocks. But, for now, just brace yourself for
reading (and reading and reading) about bonds.
Those of you with book in hand – or more likely, hands – know that Security Analysis is quite
literally heavy reading.
There’s no getting around it: Security Analysis is one big book. It’s long. Too long for some
modern readers – or at least long enough to give modern readers an excuse for eschewing
Graham.
There are two kinds of long. There’s little-thing long and big-thing long.
The best illustration of the difference between little-thing long and big-thing long is Alfred
Hitchcock’s The Man Who Knew Too Much (1956). This Jimmy Stewart movie features a climax
many have seen even if they haven’t seen the movie (hint: it involves cymbals). This climactic
sequence is little-thing long. It is a long, long sequence. It seems to get longer as you watch it.
Every little thing is noted and adds to the suspense. Unfortunately, this climax is not near the end
of the movie. In fact, it isn’t even the last climax of the movie. There’s another climax: a
perfectly good one involving a song, a kidnapped child, and a gun. These two climactic
sequences make The Man Who Knew Too Much big-thing long as well as little-thing long. The
movie has a lot of big building blocks strung together – several different exotic locales, two
climaxes, etc. Being big-thing long is very different from being little-thing long. A little-thing
long movie is exhilarating and exhausting for the audience; a big-thing long movie can be either
satisfying or sleep inducing depending on how it’s handled.
Security Analysis is big-thing long. It has lots of parts and chapters, sections and subsections. It
covers a huge amount of material. It touches on a lot of different ideas and explores a lot of
different arguments. But, when it does, it doesn’t do so in extraordinary depth. Graham doesn’t
circle round a subject; he cuts right to the heart. Therefore, he can pick up and dispose of a
subject or argument within a relatively short time. If you miss a paragraph of Graham, you may
have missed a lot. There are nuggets in there – great scenes, real gems – but they aren’t
especially long and Graham doesn’t make a big fuss about each and every one of them.
No where is this more obvious than in the introduction. In my next post, I’ll try to discuss some
of the subjects Graham takes up in more detail. For now, just note how many different topics he
picks up, scrutinizes, and then disposes of in a single introduction. Then, open up any other
investment book and read that book’s introduction. Even if the number of words are equal, the
number of ideas is likely to be less. Most investment writers circle more and cut less.
Finally, there’s the matter of Graham’s subversive style. In Security Analysis, the author is
ubiquitous but not conspicuous. In one of my podcasts, I compared Graham to Tacitus. If that
strikes you as a totally insane comparison, consider the close of Graham’s first paragraph:
“…they must be viewed against a broader background of investment principles, or perhaps of
speculative principles.”
This kind of sentence is more common in Graham (and Tacitus) than in most writing. It
maintains an objective tone, while injecting the author’s personality – or more accurately – his
personal judgment. Using “or perhaps” and placing it after a complete thought that includes the
word “must” suggests not so much uncertainty as deceit. In this case, Graham is honestly saying
security analysis may be used either for investment or speculation.
However, he’s also saying – without really having to say it – that we often speculate and call it
investment. We practice self-deceit. The way he’s constructed his sentence allows us to read
either objective uncertainty (i.e., could be “a”, could be “b”, who knows?) or subjective
subversion (we say it’s “a”, but you and I both know it’s often “b”).
Graham – like Tacitus – tends to subvert his own sentences.
His presentation of the facts and his willingness to explore all the facts – and all the possible
explanations – is exceedingly honest and objective. However, he concomitantly conveys his own
views to the reader, regardless of the objective textbook format in which he operates.
You get a real sense of Graham without his ever taking off the textbook writer’s mask, just as
you get a real sense of Tacitus without his ever taking off the historian’s mask. In both cases, you
feel you’re reading a very disinterested account written by a very interested party.
It’s an unusual experience.
I hope you enjoy it.



URL: https://focusedcompounding.com/security-analysis-introduction-part-1-2/
Time: 2008
Back to Sections
-----------------------------------------------------
Security Analysis: First and Second Preface
This book is intended for all those who have a serious interest in security values. It is not
addressed to the complete novice, however, for it presupposes some acquaintance with the
terminology and the simpler concepts of finance. The scope of the work is wider than its title may
suggest. It deals not only with the methods of analyzing individual issues, but also with the
establishment of general principles of selection and protection of security holdings. Hence much
emphasis has been laid upon distinguishing the investment from the speculative approach, upon
setting up sound and workable tests of safety, and upon an understanding of the rights and true
interests of investors in senior securities and owners of common stocks.
(Preface to the First Edition)
And so Graham begins his magnum opus – or at least the preface to its first edition. Here we
have a full introduction to the entire work – much fuller than a first-time reader might suspect.
First, we are introduced to Graham’s ideal reader (“…have a serious interest in security
values…not…a complete novice…some acquaintance with the terminology and the simpler
concepts of finance.”) Next, the scope of the work is delimited. We are told that it shall
encompass not only analysis proper, but the related issues of “selection” and “protection”.
Finally, Graham informs us of his own special concerns: the distinction between investment and
speculation, practical methods, and shareholder rights.
This last – and in 1940, most peculiar – concern of Graham’s will be explored in two
ways: 1) through an exhaustive – and for some readers exhausting – discussion of senior
securities (e.g., corporate debt) and 2) through glimpses of shareholder activism.
Graham was an early pioneer of shareholder activism. For more information, see On the
Northern Pipeline Contest.
The two prefaces also introduce us to Graham’s idiosyncratic – and to some readers intimidating
– writing style. I’ll take up this subject in my next commentary post. For now, just read over the
two prefaces (or the passage above) and note how the writing is neither confused nor convoluted.
It may be stylistically unfamiliar, but it is very easy to follow. Graham’s sentences are not
especially long and they are syntactically streamlined for the modern American reader. Words
and clauses appear exactly where you would expect them to appear to perform their standard
functions.
Therefore, you’re unlikely to get lost in one of Graham’s sentences. However, you may get lost
in one of his paragraphs.
As a general rule, you should not back-track when reading Graham, because his prose is strung
together more logically than most people’s. If you don’t think you understand something
perfectly, just keep reading. However, if you find you’re truly lost, go back to the first sentence
in the paragraph. Even back up another entire paragraph if you must, but don’t try to back-track
within a paragraph, because Graham’s paragraphs are threaded together with a logical strand
that’s hard to pick up without a good reference point.
Again, my best advice is to keep reading without ever stopping, back-tracking, etc. The best way
to read Graham (and probably the best way to read anyone) is to read entire sections straight
through and then re-read them if necessary, but never stop and hack them up just to make
yourself more confident in your comprehension.
The next commentary post will discuss Graham’s writing style in greater depth. Next Monday’s
post will cover the Introduction (pg. 1 – 17). So, please read that for Monday.
Now, who has questions or comments about this first commentary post or either preface?



URL: https://focusedcompounding.com/security-analysis-first-and-second-preface/
Time: 2008
Back to Sections
-----------------------------------------------------
Reading Graham’s Security Analysis: Care to Join Me?
Reading a thread over at GuruFocus reminded me of a common problem people have:
Have you actually read Security Analysis cover-to-cover? Has anyone on here?
I have. Several editions, several times.
A lot of people haven’t. I don’t think it’s a matter of dedication, enthusiasm, intellectual
curiosity, etc. I think it’s a matter of being or not being a certain kind of reader.
I’m sure many, many people read a lot more than I do. But, I’m also sure I’m well-suited to
reading Security Analysis on my own, because:
1) I never stop reading a book I enjoy
2) I’m a binge reader
3) I routinely read books written by dead guys
If this doesn’t describe you and you’ve never read Security Analysis cover-to-cover and you’d
really, really like to – I have an idea.
I’m willing to do a weekly post on Security Analysis, taking anyone who wants to go on the
journey through every chapter of the book. I’ll give you my best commentary on the text, and I’ll
answer any questions you have. In return, I ask that you get the book and read a chapter a week.
Is anyone up for this?
If you’d like to join me, this is the required text:
Security Analysis: The Classic 1940 Edition
If you’ve neither taken a financial accounting course nor read Graham before, you’ll need this
one as well:
The Interpretation of Financial Statements
***
To whet your appetite, here’s a previous comment I made about a passage in Security Analysis,
in a post On Technical Analysis:
“…the influence of what we call analytical factors over the market price is both partial and
indirect – partial, because it frequently competes with purely speculative factors which influence
the price in the opposite direction; and indirect, because it acts through the intermediary of
people’s sentiments and decisions. In other words, the market is not a weighing machine, on
which the value of each issue is recorded by an exact and impersonal mechanism, in accordance
with its specific qualities. Rather should we say that the market is a voting machine, whereon
countless individuals register choices which are the product partly of reason and partly of
emotion.”
I’ve seen a lot of people cite this quote, without bothering to notice what’s really being said.
Graham had a very broad mind, much broader than say someone like Buffett. That’s both a
blessing and a curse. At several points in Security Analysis (and to a lesser extent in his other
works), Graham can not help but explore an interesting topic more deeply than is strictly
necessary for his primary purpose. In this case, Graham could have said what many have since
interpreted him as saying: in the short run, stock prices often get out of whack; in the long run,
they are governed by the intrinsic value of the underlying business. Of course, Graham didn’t say
that. Instead he chose to describe the stock market in a way that should have been of great
interest to economists as well as investors.
Data affects prices indirectly. The market is a lot like a fun house mirror. The resulting reflection
is caused in part by the original data, but that does not mean the reflection is an accurate
representation of the original data. To take this metaphor a step further, the Efficient Market
Hypothesis is based on the idea that the original image acts on the mirror to create the reflection.
It does not recognize the unpleasant truth that one can interpret the same process in a very
different way. One could say it is the mirror that acts on the original image to create the
reflection. In fact, that is often how we interpret the process.



URL: https://focusedcompounding.com/how-is-a-bank-like-a-railroad-and-other-crazyideas-geoff-has-about-investing-in-efficiency-driven-businesses/
Time: 2008
Back to Sections
-----------------------------------------------------
Book Review: Active Value Investing
Vitaliy Katsenelson’s “Active Value Investing” is one of the best investing books published in
the last few years. The book is both readable and teachable. It focuses on general principles
rather than specific strictures. Although “Active Value Investing” is written in an easily
approachable manner, it is structured much like a good textbook ought to be. In this way,
Katsenelson’s 282-page book captures much of the spirit of Graham and Dodd’s magnum opus
without ever losing sight of our modern day market and the unique challenges it presents.
Katsenelson’s thesis is that the U.S. stock market won’t soon return to its old ways, the everrising crescendo of the 1982-2000 bull market on which many of today’s investors were weaned:
For the next dozen years or so the U.S. broad stock markets will be a wild roller-coaster ride.
The Dow Jones Industrial Average and the S&P; 500 index will go up and down (and in the
process will set all-time highs and multi-year lows), stagnate, and trade in a tight range. They’ll
do all that, and at the end of this wild ride, when the excitement subsides and the dust settles,
index investors and buy-and-hold stock collectors will find themselves not far from where they
started in the first decade of this new century.
With this opening salvo, the reader might well expect the book to devolve into a barrage of
unabashed bearishness.
Thankfully, it does not.
Instead the book argues that the bull/bear dichotomy is a false one. True, there are long-term bull
markets – but, there are really very few long-term bear markets in the sense in which most
people understand the term. Rather, unfavorable long-term market trends tend to be of the
“cowardly lion” variety, “whose bursts of occasional bravery lead to stock appreciation, but are
ultimately overrun by fear that leads to a subsequent descent“.
That’s the crux of Katsenelson’s book – and quite a crux it is. He has the data to support it – and
anyone who has spent any time looking at long-term market trends knows that it doesn’t take
much to demolish the bull/bear dichotomy which seems to fascinate Wall Street (and infect its
literary output). Terms which may make a good deal of sense in the short-term are used as if they
applied to long-term trends, when almost all of market history shows they don’t.
I’m sure it’s more fun to be unabashedly bearish – especially when writing a book – than it is to
be realistic. But, the facts are the facts – and the facts say that the word “bear” doesn’t really
belong in our long-term market vocabulary.
Katsenelson provides a great service when he demolishes the bull/bear dichotomy and shows his
readers the truth – the boring, honest truth – that in the long-run, sometimes markets go up and
sometimes markets go sideways; sometimes P/E ratios expand and sometimes P/E ratios
contract. These trends can last a long time. It’s easy for investors to become so accustomed to the
market they knew that they can no longer see the market they are being asked to invest in with
the honest eyes of an unconditioned mind.
Katsenelson demolishes myths, opens eyes, and then instills the basic tenets of value investing.
While this process may sound abstract, the text itself is not. Katsenelson combines concrete data
with abstract principles to illustrate important points like P/E expansion and contraction – and
what that means for the buyers of high and low P/E stocks respectively:
…I wanted to see what would happen to the average P/E of each quintile if I bought each
quintile in the beginning of the range-bound market (January 1966) and sold it at the end in
December 1982…The highest-P/E quintile exhibited a P/E compression of 50.3 percent. The P/E
of the average stock dropped from 29.3 in 1966 to 14.6 in 1982. That portfolio generated a total
annual return of 8.6 percent. The lowest-P/E quintile to my surprise had a P/E expansion of 34.8
percent. Yes, you read it right. The P/E of the average stock in my lowest-P/E quintile actually
went up from 11.8 to 15.8 throughout the range-bound market. That portfolio produced a nice
bull market-like total annual return of 14.16 percent…
This book will teach you about our markets and their past. More importantly, it will teach you
how to invest with an eye towards value at a time when a sound value orientation can do the
most good.
This is an excellent book. I highly recommend it.



URL: https://focusedcompounding.com/book-review-active-value-investing/
Time: 2007
Back to Sections
-----------------------------------------------------
What Books Should You Read About Ben Graham?
Someone who reads my articles sent me this email:
Hey Gannon,
…do you have any suggestions on books to read about Ben Graham, Warren Buffett early days,
and Walter Schloss? I feel like I've read 90% of them (the only popular one I can think of that I
haven't finished is Of Permanent Value, but I'm slowly making my way through it), but I'm
always surprised to find quotes or stories about them in your articles that I've never seen before.
Any suggestions (especially off the wall ones!) will be appreciated…
Hope all is well,
Andrew
Most books about Warren Buffett , Ben Graham, etc. are just rehashing info you can find
elsewhere. You’re right that there are references in my articles that might be a little obscure.
I’ll be honest with you.
I have kind of a collection of – mostly hardcover, printed – books on the topic of Warren
Buffett (and Ben Graham and others). So, usually what happens is I know the reference roughly
in my head and then I have to go digging into the books to find it. Sometimes, I’m not even sure
which book it’s from.
Sad but true.
Okay, on to Ben Graham book suggestions…
Many people don’t have all the editions of "The Intelligent Investor," etc. So they will only be
quoting from things you can find in the Zweig edition. Some of the most interesting stuff Ben
Graham wrote was taken out of later editions. There’s very interesting valuation stuff in the 1949
edition – I think it’s around chapter 10 – that isn’t in the 1970s edition. Partly, this is because the
techniques had become more common place. This is one of the issues with "Security Analysis."
Analysts now do many of the things Ben Graham suggested. So, some of that work isn’t really
unique to Graham any more. And that stuff has been de-emphasized.
Anyway, here are the books on Ben Graham you need to own:
The Intelligent Investor (Look for the 1949 Edition if you can find it – I could’ve sworn they
reprinted it with a Jack Bogle foreword. But I can’t find the link now.)
Security Analysis (1934, 1940, 1951, and the Recent One)
The Interpretation of Financial Statements
Benjamin Graham: The Memoirs of the Dean of Wall Street (Yes, I own it – and no, I won’t sell
it).
Benjamin Graham On Investing: Enduring Lessons from the Father of Value Investing
Benjamin Graham, Building a Profession: The Early Writings of the Father of Security Analysis
Also, yes, you should read Of Permanent Value. And – yes – I buy it every time a new edition
comes out. Expensive. And heavy. But worth it. It’s more of an information resource than
pleasure reading material.
But what a resource it is.
The Buffett Partnership Letters are here.
The Graham-Newman Letters (From 1946-1958) are here.
All but one of those letters is just a list of Graham-Newman’s portfolio positions.
Sounds pretty useless, right?
Not exactly. Here’s what you do…
Use a newspaper archive to match Graham-Newman’s positions to contemporary articles. You
can do this with Ben Graham’s memoirs too. There are tons of articles about stocks. Sometimes,
you can even find earnings numbers from around the time Graham was buying. And rumors.
Boy, did newspapers have different standards about printing market gossip in Ben Graham’s day.
Searching for Ben Graham’s name is less helpful. Instead, search for the name of the company
whose stock Graham-Newman owned. Set the search criteria to between January 1 and
December 31 of the year in which Graham-Newman first bought the stock. After that, widen the
search one year in each direction. Start with the year before Graham bought his shares. Graham
was often buying shares as part of a special situation (like an announced liquidation). So news
stories pre-dating his purchase are often worth reading.
The New York Times Article Archives are here.
Obviously, you have to have all of the shareholder letters from Berkshire Hathaway (here). And
Wesco (here).
You’ll also want to own "Poor Charlie’s Almanack"
And you need to read both "Buffett: The Making of an American Capitalist" and "The
Snowball."
There isn’t much academic writing about any of these guys. Although you can try
searching JSTOR from somewhere with access. Ben Graham’s name appears a few times. But
rarely for investment stuff. If I remember right I think it’s economics (his commodity reserve
plan) and a calculus paper he wrote as a student.
I can’t think of other sources that weren’t from some other blog or something like that. I think
several of the times I mentioned Walter Schloss would’ve been from things I found on various
blogs – obviously including this one.
My other tips are just general research tips. If you find a person’s name, company name, date,
anecdote, etc., write the identifying details down. An index card is perfect for this.
Then search for those people, companies, publications, dates, etc., online.
Especially in newspapers.
Newspaper archives are very helpful for researching investors since the companies they are
investing in are public companies. And public companies get written about a lot in newspapers.
Also – always, always, always – read the footnotes, bibliography, works cited, etc., of anything
Ben Graham-related you get your hands on. The author is usually getting their info from another
written source. Usually, another fuller written source.
Biographies of Warren Buffett like Lowenstein and Schroeder wrote involved way more research
than what ends up being printed in the book that hits shelves. Often the stories that are cut would
be very, very interesting to investors. But less interesting to the general public.
Also, authors – and their editors – hate to present the same thing over and over again. So – for
example – they’ll tell one story about Buffett’s coattail riding and then throw out the other
episodes to avoid boring readers with a “been there, done that” feel.
That’s all I can think of right now. I’m sure I’m forgetting a lot.
But I’m also sure there’s a lot in there that folks haven’t read and would really enjoy.
So check out those links.



URL: https://www.gurufocus.com/news/161739/what-books-should-you-read-about-bengraham
Time: 2012
Back to Sections
-----------------------------------------------------
Capital Allocation
Warren Buffett’s “Market Value Test” – And How to Use It
Someone who listens to the podcast wrote in with this question:
“…(in a recent episode) you mention that you want to know if the capital allocation has created
value or not. I was wondering how you do this kind of exercise practically? Do you look at the
increase in book value/equity over time and compare that to the average ROE? When book value
increased far less over a certain period of time compared with the historical average ROE I
suppose that is a sign of bad capital allocation, right? Or do you have a different approach?”
There’s no one right approach that is going to work in every situation. The simpler the company
and its business model, the easier it will be to see if capital allocation is working. For example, the
stock price may tend to follow the earnings per share and the earnings per share may be driven in
part by the capital allocation. That would be the case at a company that acquires other businesses
for their reported earnings, issues stock, and/or buys back stock. Earnings per share captures all of
that.
But, what if you were trying to analyze Berkshire Hathaway (BRK.B) or Biglari Holdings
(BH)? In these cases, management might be allocating capital at times to increase earnings per
share and at other times in ways where the value received for the capital outlay is not going to
appear in the income statement. If capital is allocated to buying stock, land, etc. EPS may not be
helpful in evaluating capital allocation. Now, book value would be a good way to analyze those
capital allocation decisions. However, at companies like Berkshire Hathaway and Biglari Holdings
you have a mix of operating businesses and investments. The operating businesses are held at
unrealistic values for accounting purposes – so, an EPS approach works for judging them, but a
book value approach doesn’t. And the investments may be held at realistic values for accounting
purposes (they’re marked to market) – however, the underlying (“look-through”) earnings won’t
show up when judging the EPS growth of the business. As a result, a pure EPS based approach to
judging capital allocation will work for part of these conglomerates and fail for the other part. And
a pure book value approach will work for judging capital allocation for part of these conglomerates
and fail for another part. You need a mixed approach.
Buffett basically suggests this when he used the “bucket” approach for analyzing Berkshire
Hathaway. He did this in some past annual letters. You take operating earnings per share (which
excludes investment earnings and insurance underwriting). And you take investments per share.
Operating earnings per share is a “flow” number. It needs to be capitalized to translate it into a
figure that can be combined with investments per share. Investments per share is a “stock” number.
You can either look at it as a “stock” number (which makes sense when trying to come up with an
intrinsic value) or you can convert it into a “flow” number (by using look through earnings). For
our purposes, it’s easier to assume you capitalize operating earnings per share and keep
investments per share in the same form.
U.S. corporate tax rate is around 25% (I’m assuming some income is taxed at state level). Longterm average P/E ratio (Shiller, etc.) is something like 16 times. So, 16 times 0.75 (100%-25% =
0.75) equals 12. That’s a good enough number to use when capitalizing pre-tax operating income
to turn it from a “flow” number to a “stock” number. So, $1 million of pre-tax operating income
is the same as a stock position with a marked to market value of $12 million. In other words, selling
$12 million worth of assets (at market value) and buying a business producing $1 million of pretax operating income leaves you in about the same place.
One final point specific to Berkshire before I get back to the more general point you’re asking
about. The “bucket” approach ignores underwriting profit and loss from insurance. But, it also
ignores the liabilities associated with the insurance businesses. I think this is a simplification that
works better for judging capital allocation, valuation, etc. at Berkshire better than most analyst
models. The value in the insurance operations will be captured by what they allow Berkshire to
carry (stocks, cash, operating businesses, etc.) using their float. The negative value (the liabilities)
are just an accounting liability which has more meaning in run-off and liquidation than it does for
a growing business like Berkshire. If underwriting can approach a combined ratio of 100 over time
and float can stay stable or grow over time – then, the value created at Berkshire should all show
up in the operating earnings per share and the investments per share with no need to assign a
positive or negative value to insurance. In this approach, insurance is used as a source of funding
for the productive assets (investments and operating businesses) that Berkshire owns.
Getting back to judging capital allocation, Buffett’s other contribution to the subject is the idea of
the “market value test”. The market value test is the idea that one dollar of retained earnings needs
to add at least one dollar to the share price of the stock to be justified as a good decision. Basically,
stocks go up because each dollar kept inside the business adds more than one dollar to the share
price. And, stocks go down because each dollar kept inside the business does not add more than
one dollar to the share price. This is also a useful and important concept in valuing a business. If a
business is expected to pass the market value test in the future – then, it can be bought whenever
the P/E is low enough. If a business fails the market value test – then, it might not be a good
purchase even if it has a low P/E ratio. Generally, any stock with a P/E below 13 that passes the
market value test should be worth considering adding to your portfolio. This is because 1/13 =
7.7%. That’s the stock’s earnings yield. Assuming the P/E we just cited is the trailing P/E and the
stock is able to grow in line with inflation (or better), the actual earnings yield is more like 8-10%.
This is in line with the long-term return in stock market indexes in the U.S. generally. So, any
stock that currently has a P/E of 13 or less and is going to pass the market value test going forward
shouldn’t drag down your returns relative to what the index tends to do. Whether it helps you beat
the market or not depends on how much it passes the market value test by and how much below
13 the P/E ratio is. But, this is sort of a dividing line. Look for a stock that passes Buffett’s market
value test and that sells at a P/E of 13 or less.
So, the market value test is a sound idea theoretically. And it’s a useful idea for a stock picker to
apply when hunting for stocks. They don’t have to be all that cheap as long as you have a high
degree of confidence the business will pass the market value test going forward. The problem is
applying the market value test. One, you can only apply it to the past record. And it’s the future
capital allocation record – not the past capital allocation record – that’s going to determine your
returns in the stock. Two, price multiples are a huge part of stock returns. So, a business that retains
$1 when trading at a P/E of 5 and then ends up at a P/E of 15 just 5 years later is going to look like
it created value even if it destroyed it. If the $1 of retained earnings added just 40 cents of “intrinsic
value” – that’s still going to show up as having created value because: 15 divided by 5 equals 3.
And 3 times 40 cents is $1.20. It’ll look like the stock created $1.20 in value for just $1 of retained
earnings. However, this increase in the stock price was due to a multiple expansion that was big
enough to overwhelm poor capital allocation. Multiple expansions and contractions of this size are
very common. So, attempts to apply the “market value test” over short periods of time aren’t able
to differentiate good capital allocation from bad capital allocation.
What about over a 15-year time period? It’s still a problem. A multiple expansion of 3-5 times
over 15 years can be as much as like an 8-12% annual return contribution. So, capital allocation
that added no value at all (but also didn’t destroy any) can look like a decent business (an 8-12%
a year performer in terms of share price) over even as long as 15 years. Therefore, you have to
apply some common sense. If a stock started at a P/E of 5 and went to 15 or 25 – you need to adjust
for this in your mind. The same would be true if the P/B went from 1 to 3 or 1 to 5. This would be
obvious when using something like QuickFS.net. I recommend using a site like that. Try to use a
15-year record when possible (QuickFS.net has some 10 year info available for free and full 20
year info available if you subscribe).
I think a 15-year numerical record when combined with your common sense overlay is enough.
Some would say 10 years is enough. It’s possible. If the industry is clearly non-cyclical – 10 years
would be enough. However, long-cycle businesses can run in the 15-20 year range. So, a 10-year
record is short enough that you could be capturing purely a cyclical effect where the business was
early cycle on the start date you’re using and is now late cycle. I think 15 years is a decent
compromise for companies that have been public for a long time. It’s also a good idea to always
use moving comparisons. So, don’t just use 2007-2022. Also, take a look at 2004-2019 and 20012016. A few observations (3 at a minimum) taken some years apart is best. The market value test
is very sensitive to strange readings caused by unintentionally unrepresentative start and end dates.
None of this is necessary if you understand the business model, the industry, etc. well and the
company is a lot simpler than a Berkshire Hathaway or a Biglari Holdings. On the podcast I
mentioned CBIZ (CBIZ). Operating margins in that industry are stable enough that simply asking
whether $1 of retained earnings has created 1 divided by “x” dollars of additional sales where “x”
is the P/S multiple you think is appropriate would work as a good enough market value test. It’s
not an exact science. For ad agencies, I’ve always suggested that 1.5 is a fine P/S multiple to use.
So, an ad agency that pays $100 million to buy something and gets $67 million ($100 million /1.5
= $67 million) isn’t far from neither creating nor destroying value. Of course, this isn’t as simple
as saying that any acquisition done at 1.4 times P/S is a value add and anything done at 1.6 times
destroys value. The issue is the long-term trend in sales for the total company. If you acquire at
1.4 times and growth in the acquired business is poor over time – the acquisition might’ve been a
mistake. If you acquire at 1.6 times and it grows nicely – the acquisition was a success.
So, why use P/S instead of just the share price? For companies like CBIZ (or the ad agencies
example I gave), the advantage would be cutting down on noise. During a business cycle, operating
margins might vary a bit. And then during a stock market cycle, the multiples put on earnings per
share might vary a bit. By tracking just sales per share you can filter out both these sources of
noise and get closer to what intrinsic value creation might be. However, this requires your belief
that there is a strong long-term relationship between sales per share and intrinsic value. Basically,
that requires a stable free cash flow margin over time.
For banks and insurers, you can use P/B where you believe the return on equity can be stable over
time. It won’t be exactly stable. But, if you believe you can assume some sort of “normal” return
on equity over a full cycle – this will work. Again, this might work better than using the actual
share price. You can look at changes in book value over time just as you can look at change in
sales per share over time.
Another way to use these metrics is to look at the trajectory of rates of change to see if the capital
allocation machine has been speeding up, staying the same, or slowing down. A sign that the
capital allocation “flywheel” could be stalling out (or the runway shorter than you anticipated) is
an increase in retained earnings intensity. Basically, is the company having to retain more and
more earnings to drive the same increases in equity per share, sales per share, earnings per share,
etc.? An even worse issue would if debt per share is having to accelerate more and more vs. your
“intrinsic value proxies” like sales per share or book value per share. So, if debt per share had
always been growing at 15% a year and sales per share was also growing at 15% a year – that’s
business as usual. But, if you notice that debt is continuing to grow at 15% a year this decade (same
as last decade) but sales per share is only growing at 10% a year, that could be a problem. Actually,
a more common problem for a management intent on continuing the compounding is the reverse.
The sales (and EPS) growth stays the same, but the use of additional capital rises. So, maybe sales
per share has always grown at 10% a year while debt per share has too – but, now you notice debt
per share growing at 15% a year while sales per share is still growing at just 10% a year. More
debt is being used to drive the same growth as before. This might mean capital allocation is getting
worse.
When that happens, it doesn’t automatically mean management is to blame. As Warren Buffett has
said – his returns (which are the result of his capital allocation) have gotten worse every decade
since he started in the 1950s. That’s because opportunities have become scarcer as the capital he’s
needed to allocate has grown bigger. The same thing will happen with a lot of businesses. As more
capital has to be allocated, returns are poorer on the marginal unit of allocated capital relative to
the past average unit of allocated capital. This will show up in long-term averages – but, only
gradually. A business that was once a compounding machine can boast of very high CAGRs since
inception for a long time after the capital allocation engine starts sputtering and even stalls out.
The way CAGR math works, you’re going to still have a very high CAGR over the lifetime of a
company if you had amazing returns upfront and then mediocre returns in the most recent years.
However, as an investor – you only benefit from future returns.
This is the main point I’d make about analyzing the capital allocation record. I don’t think it’s as
important as other investors do. The past track record – even if very long – is only of use to you to
the extent you can project it into the future. Understanding the philosophy of management toward
capital allocation, the broad strokes of what capital will be used for (is the company a cannibal that
buys back stock, does it never issue stock, does it use debt for financial engineering purposes, is it
a serial acquirer within its industry, is it some sort of conglomerate, etc.) and the runway left for
additional capital allocation is what I’d be focused on. A great track record is fine. But, it doesn’t
necessarily mean much. If you had a fund manager who started with a $10 million fund and ran it
for 15 years and now it’s a $10 billion fund – how much should you care that his CAGR has been
30% since inception? That would be an amazing track record. But, there’s no similarity in available
opportunities to allocate cash towards when you have a $10 million AUM versus when you have
a $10 billion AUM. So, it’d matter how the record was created. Was it all done in big cap stocks
even when the fund had $10 million under management? Well, that’s repeatable.
The past capital allocation record – no matter how good – only matters to an investor to the extent
it’s repeatable. But, it doesn’t have to be exactly repeatedly. That’s where the philosophy of
management, incentives, etc. would come into play. Management won’t be able to use the exact
same playbook that determined capital allocation in the past. Eventually, the cycle will turn or the
company will get too big or the opportunities it took advantage of will get arbitraged away by copy
cats. But, the style of capital allocation can stay the same from a philosophical perspective. If
management is focused on free cash flow per share – they can keep that focus as a $100 million
company and a $100 billion company. If they have a strong bias toward never issuing shares or
never paying a dividend or never buying back stock – those kinds of bias tend to be maintained for
a really long time. A good example is just a total aversion to issuing shares, options, etc. This is
such a small thing, but it can easily add 1% a year to your returns versus what you’d get in other
stocks. And this tends to be something that is maintained over time. If a company kept the share
count flat for the last 10 years – it’ll probably keep it flat for the next 10 years. If it bought back
stock aggressively in the last couple downturns, it may do so in the next one. These are things you
can observe and use in your stock selection even though they aren’t directly a part of the track
record of the company’s capital allocation. For example, if a company in an entertainment or
restaurant business aggressively bought back stock during COVID – that actually may not have
added much to the track record you can judge them on in terms of share price results. Some of
these companies are still quite cheap. And some have taken longer to recover from the COVID
shutdown then they expected. But, this information is still really useful. They may have misjudged
how long COVID would last. But, they were willing to buy into a crashing stock price. If they did
it then, they’d probably be willing to do it under different circumstances. And those different
circumstances might offer a much better payoff. The next crash won’t be due to a pandemic. It’ll
be due to something else. So, the same action taken at different times will have different payoffs.
It’s not always possible to judge management on the payoffs their capital allocation got in the past.
But, it usually is possible to judge their past actions and get some idea what their future actions
will be. For this reason, I’d focus more on how the past track record was created than on how to
measure the past track record.



URL: https://focusedcompounding.com/warren-buffetts-market-value-test-and-how-touse-it/
Time: 2022
Back to Sections
-----------------------------------------------------
Dividends and Buybacks at Potentially Non-Durable Businesses: Altria (MO)
vs. NACCO (NC)
A Focused Compounding App subscriber had a question about something I said in a recent
podcast:
“In your recent podcast you said you thought a tobacco firm should buy back its own stock rather
than pay dividends – you said you don’t think it should pay a dividend at all and instead should
avoid acquisitions and buy back its stock.
Could you expand on that?
This is somewhat similar to NC, actually, and why this stood out to me. You’ve told me before
why you don’t want to see NC buy back stock (although now that we’re in the upper teen price
range you may feel differently), because the coal business is challenged and shrinking. I think we
may be able to agree that US lignite coal has a shorter life than cigarettes. But still, it seems
directionally the same sort of situation with a dying cash generative business.”
I feel cigarettes are a much safer business than lignite coal. Much more durable.
I could be very wrong about this. But, it’s about the extent to which it is integrated into society
and the difficulty of removing that. Decades ago, I would have had much more serious doubts.
But, the fact people keep smoking cigarettes in the numbers they do even when there are plenty of
other methods of getting nicotine widely available now, strong inconveniences to the actual
smoking of cigarettes, higher pricing (including taxes) on the people buying the cigarettes relative
to their income, etc. It just shows me the durability of cigarettes specifically – as opposed to just
nicotine consumption generally – is much higher than I might have guessed decades ago.
This isn’t true with lignite. You are depending on a few corporations as customers instead of
millions of consumers. They are eager to substitute to other kinds of power if it is roughly
equalized. The customers are probably more rational – more open to considering alternatives. With
cigarettes, we’ve seen continued use of cigarettes even when people could substitute to smokeless
tobacco, vaping, etc. and even with increasing laws making life less convenient for smokers and
rising prices. So, clearly, the degree to which there is seen as being “no substitute” to cigarettes is
really high vs. the extent to which there is seen as being “no substitutes” to lignite. Lignite is seen
as easily substitute-able. Cigarettes are seen by many customers as having absolutely no
substitutes.
Now, it is true that I may have exaggerated the idea of just buying back stock – not paying any
dividends – in a cigarette company, because if they never diversify at all by product (at least into
other tobacco products) or by geography they could have a meaningful risk of losing everything.
There is some risk that cigarettes could actually be outlawed in a single jurisdiction like the U.S.
So, you can never have a 0% risk of losing everything if you don’t borrow, don’t pay dividends,
but just buy back your stock. I think the risk is much lower than the risk of competition in a growing
industry wiping out a company entirely. But, it’s certainly not 0%. So, should a cigarette company
like just buy back its own stock AND diversify into owning at least minority stakes or something
in differently regulated businesses – non-cigarette tobacco, alcohol, cannabis, gambling, etc. – or
like just at least holding some marketable securities and such? Maybe. It’s a hard question to
answer, because it’s unlikely anyone is putting 100% of their savings into a single cigarette
company. So, rationally, should the actual investors that own a cigarette company just keep their
ownership in the stock from getting excessive and let the company stay 100% non-diversified.
Probably.
It’s a really interesting question. I mean, I wouldn’t personally want to own/control etc. a cigarette
company just because that’s not what I’d like to do with my life – it does kill a fair number of
people over time.
So, I’d never actually get in a situation where I was controlling person in a single cigarette
company.
But, if I was – and if all of my own net worth was in it — what, would I do?
I’d probably diversify slightly. That is, I’d make opportunistic purchases of businesses in part or
whole that were somehow regulation-wise diversified away from sharing the exact same risks. So,
companies in other countries and companies in businesses that face different legal risks. But, it’s
hard. It’s hard to find businesses as good as cigarettes. And presumably you wouldn’t know about
other kinds of industries that well. So, diversifying is risky.
You would only be able to buy companies in industries that are in some sense “vice” industries.
Otherwise, you would risk harming the brands of the cereal companies, soft drinks companies, etc.
that these companies had once diversified into. It would be hard to own Dr. Pepper or Oreos or
something today and be a cigarette producing parent company. You could do that 40 years ago –
but, I don’t think today.
You could definitely invest easily in alcohol, cannabis, gambling, and guns. I’m not sure those are
necessarily good industries. But, they have enough stigma attached to them that no one would be
horrified if they were owned by a cigarette maker.
You could diversify into buying something like Turning Point Brands since that is rolling paper
and smokeless tobacco. It diversifies you a bit. There’s also European based businesses that are
big in cigars and smokeless products – but, those don’t have the same economics exactly.
I’m not really sure what I’d do. In the case of both NC and something like MO – I am sure I
wouldn’t pay any dividends at all. I also wouldn’t do REGULAR stock buybacks or borrow short
(or as heavily as cigarette companies do). I might keep a portfolio of stocks, bonds, cash, etc. on
hand at least to the extent the SEC would allow without threatening to make me an investment
company. I think the opportunity to do big buybacks when you want, diversifying acquisitions if
you get a chance, etc. might make sense. I also don’t think it’d be important these be control deals
if the purpose is just diversifying. But, I really wouldn’t want to risk giving away most of my cash
flows in regular dividends, interest and principal payments, etc. If you are in a business where
there’s a lot of risk to the durability of the business – you want to have a ton of free cash flow each
year that isn’t automatically allocated for you.
There are examples of companies that successfully diversified away from a non-durable or seemingly nondurable business. Berkshire took all the cash from textiles and re-deployed it. Atlantic Tele-Network (ATNI) –
I think the corporate name’s been changed, but that was its old name – was originally a company with a
monopoly on the long-distance business in a country they always feared would just pull the plug on their deal.
So, they took all the free cash flow from that and bought up other telecom stuff in other small island nations,
rural U.S., etc. over time. You’re right that they could have – instead – just pay out like all the free cash flow
from that originally at risk monopoly to shareholders and that would’ve protected the family’s wealth as well.
So, you could do it either way. You could pay out high dividends. Or you could diversify into
something else.
NACCO went the diversification route decades ago in the totally unrelated business way.
Now, NACCO is trying to diversify into related businesses.
I’d be really cautious about borrowing in amounts that are meaningful in terms of annual debt
payments in cash and any sort of regular dividends at companies like this. I know regular dividends
have worked really, really well for big cigarette companies. But, I’m not at all sure that regular
stock buybacks would’ve done worse for them. And it would’ve left them with more financial
flexibility. I haven’t checked their filings – but, going off what is in websites that show these states
– it seems like Altria has been paying out around 75% of their cash flow from operations in
dividends. NACCO is paying out more like 10%. I think I’d be worried if they had been doing
anything like 75% in dividends the way Altria has, because then you wouldn’t have fast FCF build.
I do think it’s much more critical to the long-term survival of NC that they diversify away from
lignite in the next 5 years than that Altria diversify away from cigarettes in the next 5 years. I think
cigarettes are a much, much safer product in terms of durability than lignite is. So, I think longterm business survival – putting financial position aside – is so much higher at Altria than NACCO.
I don’t see the two as comparable that way. Really, more like complete opposite sides of the
durability spectrum.
But, this might be a misjudgment on my part. It’s just based on observing cigarette smoker
behavior in the face of alternatives they could try out, switch to, etc. and don’t despite increasing
social restrictions, increasing price differentials between cigarettes and other sources of nicotine,
and more widely distributed choices for nicotine substitutes that they aren’t adopting. When I
compare this to like wind adoption by utilities – I see the two as completely different.
But, whether a company should do like 100% stock buybacks when in a business like cigarettes.
That’s hard to answer.
Realistically, too, it’d be hard for a company of Altria’s size to do a transaction that works well as
a diversifier at a good price in anything except super troubled times. The company is just so big. I
mean, you’d need a multi-tens of billions of dollars acquisition in something completely unrelated
to cigarettes to move the needle long-term in getting you diversified to preserve your net worth if
cigarettes are outlawed in the U.S. or something so catastrophic. NACCO is of a size where it’d
be very easy for them to make a diversifying deal that makes sense price-wise and totally shifts
their business mix away from lignite. Those deals are hard to do because management might know
nothing about the business it’s getting into etc. But, for a micro-cap company, it’s easy to diversify.
For a mega-cap it’s a lot harder.
But, yeah, if they both traded at like the same EV/FCF etc. – I’d be more comfortable with big
share buybacks at Altria than at NACCO. As you know, though, NC is many times cheaper than
Altria – so, I’m not saying buybacks at NC wouldn’t be better. They might work out very well
simply because the stock is so cheap. But, other than cheapness – I wouldn’t want them to devote
100% of FCF to buybacks.



URL: https://focusedcompounding.com/dividends-and-buybacks-at-potentially-nondurable-businesses-altria-mo-vs-nacco-nc/
Time: 2020
Back to Sections
-----------------------------------------------------
The “Element of Compound Interest”: When Retaining Earnings is the Key to
Compounding and When it Isn’t
In my first two articles about Warren Buffett’s letter to Berkshire Hathaway shareholders, I talked
about Berkshire’s year-by-year results as a stock and about Warren Buffett’s approach to holding
both stocks and businesses. Today, I want to talk about a very interesting section of Buffett’s letter
that doesn’t (directly) seem to have all that much to do with either Berkshire or Buffett. This
section starts with the name of a man Buffett has mentioned before “Edgar Lawrence Smith”. It
also mentions a book review Buffett has mentioned before. In 1924, Smith wrote a book called
“Common Stocks as Long Term Investments”. Keynes reviewed that book. He said two very
interesting things in that review. The one Buffett quotes from this year goes:
“Well-managed industrial companies, do not, as a rule distribute to the shareholders the whole of
their earned profits. In good years, if not in all years, they retain a part of their profits and put
them back into the business. Thus there is an element of compound interest operating in favor of
the sound industrial investment. Over a period of years, the real value of the property of a sound
industrial is increasing at compound interest, quite apart from the dividends paid out to the
shareholders.”
This is obviously the most important concept in stock investing. It is the entire reason why stocks
outperform bonds over time. Investors – even after this book was published – tend to overvalue
bonds and undervalue stocks. Academics call this a “risk premium” for stocks. But, on a diversified
basis – it doesn’t make a lot of sense to say it represents long-term risk. It does represent volatility.
It also represents uncertainty as to the exact size of performance and the timing of that
performance. But, in most years, there really hasn’t been a lot of uncertainty that a 25-50 year old
putting his money 100% into stocks will end up with more value when he’s 55-80 than the 25-50
year old putting his money 100% into bonds. The market doesn’t usually undervalue the dividend
portion of stocks. Sometimes it does. There have been times – most a very, very long time ago –
where you could buy a nice group of high quality stocks yielding more than government bonds
(and even less commonly, corporate bonds). To this day, individual stocks sometimes do yield
more than bonds. I can think of a few countries (a very few) where you can buy perfectly decent,
growing businesses yielding more than the government bonds in those countries (though this is
usually due to very low bond yields, not very high dividend yields). And I could think of a few
stocks that yield more than some junk bonds right now. But, there’s an important caveat here. The
stocks that seem safe and high yielding retain very, very little of their earnings and grow by very,
very low amounts. In other words, the element of compound interest is often smallest in the stocks
with the highest dividend yields. For example, I happen to know of a perfectly safe seeming super
illiquid stock that has often been priced to yield between 8-10% a year. That’s wonderful. But, it
doesn’t retain any earnings. And it doesn’t normally grow any faster than the overall rate of
inflation. So, your total return in such a stock might be like 10-12% a year if you bought it on an
average trading day and held it forever. Well, that’s good. Since Buffett took over Berkshire
Hathaway, the S&P 500 has compounded – with dividends included – at 10% a year. So, something
that seems very certain to return 10-12% is obviously an adequate substitute for the S&P 500. It
belongs in the mix of a stock portfolio. But, while it is clearly a better alternative to bonds – it’s
not so clear it’s a better alternative to stocks. A return in the 8-12% range is really about what you
could expect historically in stocks that pay out far, far less in dividends than anything like an 810% yield.
Investors tend to have a preference for a regular, quantifiable amount of income paid out today
instead of a far more irregular, and far less precisely quantifiable amount of much greater income
paid out way down the road. This tendency isn’t universal. There are plenty of times – 1929, 1965,
1999, and today – when it pretty much disappears. For example, many of the biggest stocks in the
S&P 500 don’t pay out dividends and do have very, very high P/E ratios for stocks so large. There
is more pricing in of far distant expected cash flows into the biggest U.S. stocks than has normally
been the case. Normally, investors – especially value investors – prefer a certain dividend yield,
book value, earnings per share, etc. over something that hasn’t quite hit those numbers.
Are they right to prefer this?
We can do some math on the compounding and see. Although there are some complications, the
easiest way to sketch out our expectations in any stock we buy is that our return will be somewhere
BETWEEN the earnings yield and the return on equity. Now, I mean this in a “spirit of the law”
not “letter of the law” sort of way. You can’t assume that $1 of reported earnings at an ad agency
and a cruise line are equally valuable. The cruise line will tend to have less than $1 of cash free to
be paid out in dividends, buybacks, etc. when it reports $1 of EPS. The ad agency will tend to have
a bit more than $1 of cash actually free to be paid out than the $1 it reports. The earnings of most
banks, insurers, and perhaps some real estate companies and such should be thought of in a
“comprehensive” sense. Basically, how much is their book value per share (or better yet, if you
can calculate it, how much is the fair market value of their assets less liabilities) growing each year
– not necessarily how much are they reporting in earnings. But, you get the point. How much richer
are shareholders at the end of 2019 than they were at the start of 2019? That is the earnings of the
stock. I like to adjust it for how much dilution I expect the company to have due to issuing stock
options and granting shares and all that. For S&P 500 companies, that’s running at like 1-2% a
year right now.
Given where stock prices usually are – most stocks you buy will have a lower earnings yield than
a return on equity. This means you should expect your return in the stock to rise over the years to
the extent that: 1) The company retains a lot of its earnings and 2) You hold the stock for a long
time. For example, if a company has a 20% return on equity, it reinvests 100% of its earnings (so
that the business is actually growing at 20% a year), and you hold the stock for your entire lifetime
– you’re going to end up with a return much, much closer to 20% a year than to whatever the
earnings yield was when you bought the stock. Right now, it’s probably typical for an investor to
buy a stock at about a 5% earnings yield (P/E of 20) and an ROE of 15% and then hope that – over
time – the initial 5% return will drift upwards toward the 15% a year ROE limit.
If I’m being honest – I don’t think that will happen for a lot of the S&P 500 going forward. The
ROE of the index is probably the least meaningful it’s ever been right now, because the index as a
whole has been using all of its reported earnings to pay dividends and buyback shares. You can
calculate the value of dividends paid to you (it depends on the tax rate you pay and the rate at
which you can reinvest the dividends – that is, your stock picking prowess if you’re 100% in
individual stocks). The return on buybacks depends on the price at which the purchase is made. If
a company buys back its own stock at a 5% earnings yield and a 15% return on equity – the return
on that investment will (like you own return in the stock) be bounded by 5% in the short-run and
15% in the long-run.
There are two really interesting aspects to what Buffett said about this element of compound
interest in common stocks. Both have to do with how investors think about compounding in stocks.
Here’s the best of what Buffett had to say about that book:
“It’s difficult to understand why retained earnings were underappreciated by investors before
Smith’s book was published. After all, it was no secret that mind-boggling wealth had earlier been
amassed by such titans as Carnegie, Rockefeller, and Ford, all of whom had retained a huge
portion of their business earnings to fund growth and produce ever greater profits. Throughout
America, also, there had long been small-time capitalists who became rich following the same
playbook.”
What Buffett says is totally true. No one was getting rich in the 1800s and early 1900s in the U.S.
simply through clipping coupons or collecting dividends. The richest Americans got that way by
retaining extremely high proportions of their earnings in the same enterprise and growing it bigger
and bigger. Sometimes, this was commented on. Buffett mentions Rockefeller. Standard Oil’s
dividend policy was often questioned and criticized. And the company was believed to be too
conservatively run financially. Eventually, there may have been truth to this. But, early on, the
retaining of huge amounts of earnings was very useful in being able to take advantage of
competitors who did not retain much in earnings and did use a lot of debt. What’s interesting to
me, is that in most discussions I’ve ever seen of the dividend policy, cash position, borrowing, etc.
of companies like Standard Oil – there’s little or no discussion of the concept of compounding. If
I looked through newspapers from the time, I’d probably be able to find such references. But, just
working from my memories of books I’ve read of the corporations run by the men Buffett mentions
there – the concept of retaining earnings as opposed to paying dividends in order to compound the
size of the overall enterprise just isn’t something I remember reading about. Complaints that the
dividend policy of these corporations was unusual, stingy, etc. is something I remember reading.
Discussion of the concept of compounding isn’t.
Today, the reverse is true. The biggest companies in the U.S. – with a couple exceptions – focus
on retaining earnings instead of buying back stock and paying dividends. The investors in them
keep talking about compounding despite their size.
This brings us to the last point regarding your long-term return in a stock.
It’s obviously determined by the return on INCREMENTAL retained earnings – not the past
return. For example, Berkshire Hathaway’s rate of compounding – both in terms of book value
and stock market value – peaked around the late 1990s. It was roughly around the time of the
transformative General Re merger that shifted Berkshire’s overall asset allocation out of stocks
and into bonds. Berkshire’s best years were from 1965-1998. For some of those years, the rate of
incremental return on retained earnings was probably higher than 25%. Today, it’s probably lower
than 10%. You could argue that maybe Berkshire’s stock portfolio tended to be overvalued in the
1990s and undervalued now. That Berkshire as a stock was overvalued then and undervalued now.
And that book value was more meaningful then and less meaningful now. Even if you assume all
those things – I still think you don’t get a tendency to compound incremental retained earnings at
any less than 20% a year from 1965-1998. And I don’t think you get a tendency to compound
incremental retained earnings for the last ten years, for what the next ten years will likely be, etc.
at better than 10% a year.
For that reason, any dividends paid by Berkshire during the 1960s, 1970s, and 1980s would’ve
had a disastrous influence on Berkshire’s long-term compound record. If you reduce the weighting
you are putting into a higher returning asset (Berkshire in the 1960s, 1970s, and 1980s) and put it
into a much lower returning asset (something like the S&P 500 after you’ve paid a tax on your
dividends) – your compound result will get much worse. Berkshire’s advantage over the S&P 500
was once something like 15% a year during Buffett’s first 15 years or so. Dividends would be paid
regularly over time, so it’s not quite like shifting out of something returning 20-25% a year into
something returning 5-10% a year – but, it’s pretty close. It’s worse than making a portfolio
allocation decision to shift from stocks to bonds. And, honestly – during Berkshire’s best years –
paying a dividend would have the same size impact as like an individual investor shifting from a
100% allocation to the S&P 500 to a 100% allocation to T-Bills. In fact, the difference between
those two asset classes has usually NOT been as high as 10-15% a year in lost compounding.
Berkshire would’ve destroyed immense amounts of potential shareholder wealth by paying a
dividend.
That was true for the first 30+ years of Berkshire’s history under Buffett.
It’s not true today.
There just can’t – mathematically – be much of a difference between Berkshire retaining 100% of
its earnings or paying 100% of its earnings out in dividends. Even if you assume Berkshire will
compound at as high as 10% a year over the next 10 years (which, honestly, I consider to be on
the very aggressive side of what’s humanly possible), most investors don’t think the S&P 500 will
do much worse than like a 6% or so return over the next 10 years. Obviously, a lot of them think
10% a year is possible (though I don’t think it is possible from today’s prices).
To use that analogy I made earlier – at worst, we’re talking about a capital allocation decision akin
to going from 100% stocks to 100% long-term bonds (a difference of like 5% a year or less). More
likely, we’re talking about the difference between a portfolio that’s like 100% stocks and 0% bonds
to one that is 60% stocks and 40% bonds. In the long-run, it’s a mistake. In a long enough run,
being less than 100% in stocks is almost always a mistake. Over your investment lifetime, any
allocation to anything other than stocks is probably dragging down your eventual ending net worth
unless you are expertly skilled in timing (you’re a good trader).
Given how expensive stocks are, I still think it’s likely that Berkshire is better off retaining 100%
of its earnings than paying 100% out in dividends. However, it’s getting awfully close to a coin
flip. And, a few years down the road – because of the anchor on performance created by
compounded asset levels – I think it will be a coin flip and stay that way.
There’s one big exception though.
The more earnings Berkshire retains – the more of its own stock it could buy back if it wanted to.
Berkshire works a little like a closed-end fund. Less so than it did before 1998. But, it still does to
some extent. Berkshire owns listed stocks and reports their changing market value. But, Berkshire
is also itself a listed stock. What tends to happen with any listed company that owns other listed
companies is similar to what can happen when investors misjudge a cycle. In a misjudged cycle,
investors put the lowest price-to-earnings ratio on a stock at the moment where earnings are most
depressed and the highest price-to-earnings ratio on a stock at the moment where earnings are at
their peak. Something like this did actually happen with Berkshire before the General Re deal.
Berkshire’s stock portfolio – things like Coca-Cola – were trading at very high multiples of their
earnings, sales, etc. and then Berkshire (which was carrying those investments at those high
multiples) also traded at a high price-to-book ratio. This tends to lead to wild distortions in the
“look through” earnings multiple. Basically, Berkshire is likely to have an especially low price-tobook ratio at the same moment that its book is likely to be UNDERSTATED relative to intrinsic
value (due to carrying stocks at their market values – not at their intrinsic values).
As a result, Buffett might get the opportunity to spend a lot of Berkshire’s retained earnings buying
back the company’s own stock when its price-to-book ratio is low and its stock portfolio is
undervalued in the market.
The math on that works well. It’d be fairly easy for Berkshire to generate high returns on the
portion of cash it uses to buy back its own stock in a market downturn. The catch here wouldn’t
be the return on incremental capital deployed in this way. The catch would be the weighting. It’s
usually pretty hard for companies to continually devote large amounts of capital to buying back
their own stock. One, the buy back can help push up the stock price – and so, be self-defeating as
a use of capital. Two, the stock can simply fail to stay cheap enough for long enough. This is more
of a problem for illiquid stocks than for stocks on an exchange. Big, listed stocks like Berkshire
tend to have pretty high share turnover – so, if they devote as much capital as they can to buying
back the maximum allowable or prudent level of volume each month, they can buy back a
meaningful part of the market cap. Illiquid stocks don’t turn over enough to make this possible.
So, this is a rare case where size is oddly helpful. Having to spend billions on buybacks to move
the compounding needle is unhelpful. But, the advantage of size as a stock is that you have a lot
of passive owners, short-term owners, computers, etc. basically trading your stock. It’s a lot easier
to find shares to buyback in the open market. There just isn’t much of a long-term, active
shareholder base hoarding your stocks when it’s cheap. Instead there are more shareholders who
are shorter-term oriented and less sensitive to the price you’re offering. The fact they think they
can get out and back in again becomes an advantage to you in buying back stock – because you
only need to perform half the operation they do. You’re just buying the stock. You never need to
sell it again.
Finally, there is one obvious problem Berkshire might face in trying to commit enough capital to
a buyback – Buffett. Berkshire’s best chance to buy back a ton of stock would obviously be if the
decision was made by someone other than Buffett. That’s not going to happen while Buffett is
running the company. So, there is the potential problem that a Berkshire buyback ordered by
Warren Buffett would act as a signal that he believes the stock is cheap. Buffett is considered to
have very good investment judgment. He knows more about the value of Berkshire than anyone.
And, historically, he’s been very reluctant to buy back stock. A really big buyback could quickly
defeat any chance of continuing to allocate a lot of capital to Berkshire shares, because Buffett
isn’t Singleton. At Teledyne, Singleton wasn’t really all that famous. And the idea of buybacks
was very poorly understood. Buffett is incredibly famous and buybacks are now very, very
common. Buffett has a huge disadvantage versus Singleton. So, he’s unlikely to be able to commit
as much capital as he’d like to any buyback, because the simple act of Buffett aggressively buying
back shares could actually move the market in the wrong direction for him to continue getting a
good return on his investment.



URL: https://focusedcompounding.com/the-element-of-compound-interest-whenretaining-earnings-is-the-key-to-compounding-and-when-it-isnt/
Time: 2020
Back to Sections
-----------------------------------------------------
Surviving Once a Decade Disasters: The Cost of Companies Not Keeping
Enough Cash on Hand
A couple days back, I read Tilman Fertitta’s book “Shut Up and Listen”. The book is short. And
it’s full of a lot of basic, good advice especially for someone looking to build a big hospitality
business (which is what Fertitta did). What stood out to me is how practical the book is about stuff
I see all the time in investing, but rarely gets covered in business books. The best example of this
is a chapter on “working capital”. Value investors know the concept of working capital well,
because Ben Graham’s net-net strategy is built on it. But, working capital is also important as a
measure of liquidity.
A lot of value investors focus on the amount of leverage a company is using. The most common
metric used is Debt/EBITDA. Certain Debt/EBITDA ratios are considered safe for certain
industries. It might be considered fine to leverage a diversified group of apartment buildings at
Debt/EBITDA of 6 to 1 but risky to leverage a single cement plant at Debt/EBITDA of 3 to 1.
There is a logic to this. And some companies do simply take on too much debt relative to EBITDA.
But, that’s not usually the problem that is going to risk massive dilution of your shares, sales of
assets at bad prices, bankruptcy etc. in some investment. The usual issue is liquidity. If you borrow
3 times Debt/EBITDA and keep zero cash on hand and all your debt can be called at any time
within 1-2 years from now – that’s potentially a lot riskier than if you have borrowed 4 times
Debt/EBITDA and are keeping a year of EBITDA on hand in cash at all times and your debt is
due in 3 equal amounts 3, 6, and 9 years from today. The difference between these two set-ups is
meaningless in good times. As long as credit is available, investors who focus only on
Debt/EBITDA will never have to worry about when that debt is due and how much cash is on hand
now. However, at a time like COVID – they will. Times like COVID happen more often than
you’d think. Fertitta is in the restaurant business. He’s seen 3 liquidity crunches for restaurants in
the last 20 years. There was September 11th, the collapse of Lehman Brothers, and now COVID.
He got his start in the Houston area. Not much more than a decade before the first 3 of those events
I listed above – there was a collapse of the Texas banking system that resulted in a lot of Texas
banks (and all but one of the big ones) closing down. That was also a possible extinction level
event for restaurants in the state. So, using Fertitta’s 30-40 years in the restaurant business as an
example, extinction level risks that depend on a restaurant company maintaining some liquidity to
survive seem to happen as frequently as once every 10 years. When looking at a stock’s record
over 30 years – the difference between a stock with a 10% chance of going to zero happening once
every 10 years versus a stock with a 0% chance of going to zero for the full 30 years is pretty
meaningful. In fact, if you find a stock you expect to compound at like 12% a year while the market
compounds at 8% a year – but, you neglect to notice it has a 10% chance of complete failure once
every 10 years, your above average investment will be reduced to basically an average investment.
A 70-75% chance of compounding at 12% a year combined with a 25-30% chance of losing
everything in a stock is not very different from a 100% chance of getting an 8% annual return. We
can see this in the restaurant business. Over a sufficiently long investment timeline, a surprising
number of restaurant companies – I mean here full-service restaurant concepts, not fast food –
would have stocks that ended up going to zero. Loss of popularity of the concept in the face of
changing customer tastes and especially competition that is better suited to those tastes is one
explanation. But, liquidity problems are often a big factor too. If a restaurant business has borrowed
3 times Debt/EBITDA (or is renting space to create much the same fixed charges in cash as they’d
have if borrowing that much), then it doesn’t take a very large decline in sales to create a very big
problem in terms of cash generation beyond meeting debt payments and refunding that debt. A
restaurant can have a 50% decline in EBITDA on a much lower than 50% decline in sales. It is not
hard to imagine just a 20-30% decline in sales causing your Debt/EBITDA to jump from less than
3 times to more than 6 times. This becomes a problem, because access to funding will become
worse for the company if sales are headed in the wrong direction. You can’t issue a lot of stock,
borrow a lot more from banks, etc. when your sales are 20-30% off their all-time peak. You can
when you are setting new revenue records every year. But, of course, if your sales are growing
every year, so is your EBITDA – and so, you probably don’t need to increase your Debt/EBITDA
ratio anyway.
That’s why Fertitta gives the same advice as Buffett – borrow when money is available, not when
you need it. A big reason why a lot of stocks in industries very badly hit by COVID dropped to
such lows in late March and have risen to such highs now is because of the availability of funding.
If you were a cruise line, a restaurant, a theme park, etc. – you couldn’t access more credit in
March. Once your cash ran out, you were going to be in a very bad position that was definitely
going to destroy a lot of shareholder value. A few months later – in fact, in some cases it was just
a few weeks later – these companies were able to access a lot of capital. That, more than anything
else, changed the likely value of their stocks as long-term investment. So, if there was a real chance
the lack of access to capital was going to stay permanent back in March and there’s a real chance
the access to capital is going to stay permanent now – those crazy swings in some of those stock
prices could actually have been fully justified. Without access to capital, some of these companies
would’ve run out of cash pretty quickly. If you have no cash and do have debt – that is usually a
very bad position for protecting the value of your business for shareholders. The assets of the
business – the actual parks and cruise ships and so on – will recover operationally at some point.
But, your shareholders are unlikely to own the same proportion of them when earnings do rebound.
But, what if access to capital for COVID hit industries hadn’t loosened up? What if it stayed like
it was in March? Or what if it happens again? Then, it would’ve made a very big difference if a
company was sitting on cash and had its debts spread out over many years versus a company with
little cash and a lot of debt due soon. None of this is captured by the Debt/EBITDA ratio. It’s not
just measures of leverage that matter. It’s also measures of liquidity.
How much do they matter?
Well, if you assume that – because of likely government policy you could’ve guessed about in
advance – the chance of COVID hit industries being completely starved of capital for months or
years was very unlikely (say a 20% chance of no access and 80% chance of access returning to
where it was before COVID), each company’s liquidity position would’ve mattered a lot. A 20%
chance of a 50% destruction of shareholder value – since the equity is the most junior position in
the capital structure and these companies use leverage, a 50% decline in a stock’s intrinsic value
could happen even when the intrinsic value of the entire enterprise contracts much less – would be
a 10% difference in the value of the business. A one-time 10% difference may not sound very big
– stocks moved by more than that on a daily basis during the worst part of the market’s COVID
related drop. But, consider that if it’s pretty realistic that there could be at least a 20% chance of a
50% destruction of shareholder value due to these “once a decade” events, this is a 1% annual
performance difference between a stock that runs this risk and a stock that doesn’t. This is true for
long-term holdings that are not entered into at periods where risks are especially elevated.
Obviously, right now, the risk of more immediate adverse consequences to holding too little cash
and having too much debt due too soon presents an even bigger risk. Your expected return in a
stock with a strong liquidity position versus a weak liquidity position may only be 1% different
over 30 years or something. But, it’s obviously a lot more than a 1% annual difference in expected
return when you are in or near an actual or potential liquidity crisis. If there is the same risk of
damage as in other periods, but the possible occurrence of the damage is a lot sooner – the odds of
liquidity problems in the next year or so after you buy the stock today are higher than usual – then
the difference in expected return for you is going to be a lot worse in the stock with less liquidity.
For investors, the important thing is to try to worry most about liquidity when the market is not.
This allows you to get out of stocks with bad liquidity positions while their prices are still good. If
you wait till times like this March to get out of stocks with poor liquidity positions – you’ll pay an
absurd premium for insurance against insolvency. If a stock is down 50-90% due to concerns about
insolvency, selling that stock because you share those concerns is not likely to make a lot of sense.
It would only make sense if you felt pretty confident you were buying insurance – limiting your
loss by selling now – on an event (like actual bankruptcy) that was probably going to occur. That’s
not a good bet to take. The best bet to take is to find two similarly situated companies during good
times, normal times, etc. where there is not much of a difference in price between the two stocks
despite one stock having plenty of cash and debt that isn’t due for a while and the other having
very little cash and debt due much sooner. That’s the time to avoid the company that is worse
positioned for that one every decade extinction level liquidity event.



URL: https://focusedcompounding.com/surviving-once-a-decade-disasters-the-cost-ofcompanies-not-keeping-enough-cash-on-hand/
Time: 2020
Back to Sections
-----------------------------------------------------
Capital Allocation Discounts
Value and Opportunity has an excellent post on holding company discounts. The key point of the
post is the division of holding companies into 3 types: value adding, value neutral, and value
destroying.
Excellent point. I would take it a step further. The issue with the discount that should or
shouldn’t be applied to holding companies is capital allocation. Capital allocation has a huge
influence on long term returns in a stock.
But not just holding company stocks. All stocks. A company that buys back stock when it’s
cheap deserves to trade at a premium to other stocks. A company that issues stock when it’s
cheap deserves to trade at a discount.
I recently looked at a list of good, cheap U.K. businesses. I passed on most of them. Not because
they were too expensive. Most were cheaper than similar quality U.S. companies. I passed on the
U.K. companies because they tended to issue shares over the last 10 years.
Some of these U.K. share issuers traded around enterprise values of 6 times EBITDA for much
of the last decade. Interest rates were not high during the last 10 years. Issuing stock at 6 times
EBITDA is criminal. I don’t care what you were acquiring. You can’t make money doing it by
issuing such cheap currency.
Capital allocation at non-holding companies is critical. And often overlooked. Because it’s
complicated. Take Western Union (WU). Western Union made several acquisitions over the last
few years. They overpaid.
That’s the bad news. The good news is that Western Union never stopped buying back its stock.
And when they needed money – they borrowed. They didn’t issue stock.
Let’s take a look at CEC Entertainment (CEC). This is Chuck E. Cheese. The stock has
returned 8% a year over the last 15 years – versus 4% for the S&P 500. That’s impressive for 2
reasons. For most of the last 15 years, Chuck E. Cheese’s operations have been getting worse –
not better. Margins have dropped virtually every year for the last decade. And the stock is cheap
right now. EV/EBITDA is about 5. It’s hard for any stock that cheap to show good past returns –
an incredibly low end point is incredibly hard to overcome.
I doubt anyone is applauding CEC’s board. But they should be. It would’ve been very easy to
deliver returns of zero percent a year over the last 15 years.
Operating income peaked 8 years ago. Earnings per share kept rising for the next 7 years. Shares
outstanding decreased 57% over the last 10 years. Those are Teledyne like number.
Some might argue the return on those buybacks has been poor. And they would have been better
off paying out dividends. Maybe. But let’s consider another alternative – the one most companies
actually take. CEC could’ve invested that cash – not in buybacks or dividends – but in expanding
the business.
Investors make an arbitrary distinction between operating companies and holding companies.
They blame CEC for bad operations. And don’t applaud them for good capital allocation. The
truth is that your return in a stock is the product of both those factors – how operations are
managed and how capital is allocated.
There should be a discount applied to many conglomerates, holding companies, etc. But it has
nothing to do with their structure. I apply a discount to most large tech companies based on the
dumb acquisitions they will make in the future.
Should you apply a discount to Google (GOOG) the corporation that you wouldn’t apply to
Google the search engine?
I think so. I’d be willing to pay more for outright ownership of the search engine if I could
allocate the free cash flow it generates. The rest of the company is likely to be value destructive.
Finally, I would caution every long term investor about assuming standard discounts for holding
companies, conglomerates, etc. Historically, there is no such thing. It’s a matter of taste.
A half century ago, there was a conglomerate premium. In the early part of the 20th century,
some insurance companies traded at discounts to book value simply because they were valued on
the dividends they paid. If you didn’t pay big dividends and you were a bank, insurer, etc. – it
didn’t matter how much book value you had – Wall Street marked you down. Financials were
supposed to be priced on yield.
This leads to a related issue. And it’s a big one for modern investors. Can we drop “dividend
yield” from our lexicon.
When most companies didn’t use buybacks the idea of a dividend yield had some validity. When
companies followed unorthodox capital allocation policies – it was a poor measure. But for
companies following the accepted payout policies, it made sense.
Does dividend yield make any sense today? Some companies pay dividends. Some companies
buy back stock. Some companies do both.
Why is it that when I type in a ticker symbol I’m immediately shown the dividend yield? And
there’s no mention of stock buybacks?
Because of tradition. That’s the only reason. It’s become customary to show the P/E ratio and
dividend yield for a stock. Neither measure is as important as its prominence on stock websites
suggests. But tradition says it belongs there.
I want investors to think for themselves when it comes to things like holding companies. A
standard discount is just a tradition. In the 1960s, conglomerates traded at a premium, stocks paid
dividends, and men wore hats.
Those were historical facts. Not immutable laws.



URL: https://focusedcompounding.com/capital-allocation-discounts/
Time: 2012
Back to Sections
-----------------------------------------------------
If Dividends Don’t Matter – What Does?
There’s a good blog post over at The Interactive Investor Blog by Richard Beddard. It talks
about how divdends are both everything and nothing in investing.
Dividends, Value, and Growth Can all Be Sources of Long-Term Returns
The point is that you don’t need to get a return on your investment from dividends. You can get
it from someone else – in the form of capital gains – when you sell the stock. You can get it from
the company directly – in the form of dividends – when they pay you cash.
For me, there are two extreme views of how investors make money in stocks.
The Pure Value Approach
You buy a stock at a discount to its value and expect to sell it when the stock price reaches that
static intrinsic value sometime in the future. Your return is therefore the compound annual rate
required to close the gap between price and value over the time you hold the stock.
Illustration: You pay a third of what a stock is worth today. Intrinsic value stays the same. Over
the next 15 years, the stock price rises to meet intrinsic value. You sell. And make 7.6% a year
over 15 years.
The Pure Growth Approach
You buy a stock and expect to sell it sometime in the future. The stock has a dynamic intrinsic
value. So you hope it will be worth more in the future than it is today. Your return comes from
the interaction of the price-to-value ratio you paid today and the intrinsic value growth over the
time you own the stock.
Illustration: You pay three times what a stock is worth today. It grows intrinsic value 20% a year
for the next 15 years. You sell. And make 11.5% a year over 15 years.
It’s worth mentioning that the item of interest to most academics, society at large, etc. should be
the pure growth approach. The value approach is of most interest to practitioners. The entire
investing public can benefit from holding growing companies. They can’t benefit (together) from
buying businesses at one-third of their value. We can.
These are pure approaches.
Where you buy a stock at a deep discount to its value, the company’s growth can be very poor –
and you can still make money.
And when you buy a stock with very fast growth, the price you pay can be very high – and you
can still make money.
Most investments fall in between. Value and growth both matter. If instead of getting a stock at
one-third of its intrinsic value, a value investor buys a stock at four-fifths – he now has to worry
a lot about growth.
Likewise, if a growth investor buys a stock growing 10% a year instead of 20% a year – he now
has to be very careful about the price he pays for the stock.
How do we deal with stocks that fall in this gray area? They are neither deep value stocks nor
incredibly fast growers. But we think they might be mispriced. And we think they might be good
businesses. And we might be able to hold them for the long-term.
You Don’t Need a Present Day Dividend to Predict Future Returns
I have a pet formula of sorts I like to use. It’s not meant to be an exact calculation. It’s meant to
be more of a reality check and a decomposition of a stock’s long-term return potential. Sort of
like a DuPont analysis for an investment you haven’t made yet – but would like to hold for the
long-term.
It goes like this…
Forever Return Potential = Cube Root of (Earnings Yield * Sales Growth * ROI)
Let me give you an illustration using Boston Beer (SAM).
Morningstar tells me Boston Beer’s 10-year average return on capital is 19%.
My rule of thumb is that if we put aside the capital structure, the normal ROI of a business is
probably not far from:
0.5 * EBITDA/((Receivables + Inventory + PP&E)-(Payables + Accrued Expenses))
This is similar to Joel Greenblatt’s Magic Formula. He uses EBIT instead of EBITDA.
For Boston Beer, this approach yields a much higher estimated ROI of almost 30% for the last
year or so. Capital turns at Boston Beer improved dramatically over the last decade – they more
than doubled sales while holding working capital steady. My guess is that ROI really is greater
than 25%. And that my little rule of thumb is probably about right here.
However, we’ll stick with a longer-term average. Which is something like 19%.
There are a lot of ways to measure sales growth. Most people use the compound rate between
two points. I prefer median year-over-year sales growth over the long-term. For the last 10 years
at Boston Beer this has been about 11% a year.
Bloomberg says Boston Beer’s EV/EBITDA is 13. Again, we’ll assume economically real
depreciation expenses, taxes, etc. will take half of that EBITDA before it ever becomes “owner
earnings”. That means Boston Beer probably trades around 26 times owner earnings. Yes, that
happens to be very close to their actual P/E ratio.
One divided by 26 is 3.85%. We’ll use that as Boston Beer’s owner earnings yield.
And now our forever return potential equation looks something like:
Forever Return Potential = Cube Root of (4 * 11 * 19)
Well, 4 times 11 times 19 is 836. And the cube root of 836 is 9.42.
A buy and hold forever return potential for Boston Beer of 9% sounds right to me.
The stock is overpriced. But it’s also a much better than average business. It will earn very high
returns on capital over the next decade or so. Any growth it has will be very profitable. So, it will
probably grow into its P/E of 28 times earnings and give a market matching or slightly market
beating performance for truly long-term investors.
Stock Fail at Their Weakest Link – Look at the Limits on Your Returns
What’s the point of a formula like this?
An investment tends to break down at its weakest point. Boston Beer’s weakest point is price –
but that’s precisely quantifiable in this case.
Growth is the variable that is hardest to predict. Remember, Boston Beer’s overall industry is not
growing. Its product segment might be. But overall Beer sales are down in volume terms over the
last decade.
The formula also highlights a big issue Boston Beer will face. And it’s one of critical importance
to buy and hold investors.
Boston Beer grew about 11% a year in the past. It won’t grow faster than that in the future. The
company’s long-term average ROI was around 20%. More recently, it’s around 30%.
There’s a gap there. A big gap. Boston Beer is currently investing in a fresh beer initiative that
could require it to hold more working capital. That could help bring sales growth and returns into
closer alignment. In a bad way – short-term – for shareholders but a good way for customers. A
little while back, they bought a brewery. These long-term investments have masked the true
extent of normal cash build at SAM.
Unless something is done, capital would grow a lot faster than sales. And I don’t think there is
any way to plug this gap year after year. So assets will simply grow faster than sales – and those
assets will come in cash form.
I don’t think this is an organization that wants to branch out into other things. So that means the
company will probably pay a dividend in the future, or buyback stock.
Sure, it matters which option Boston Beer chooses. It matters whether they let cash pile up for a
while before they start doing those things.
But, ultimately it doesn’t make a lot of sense worrying about today’s dividend yield (which is
zero) when we know this is the kind of company that will one day have to pay out most of its
earnings in dividends and buybacks.
It makes more sense to worry about the low earnings yield (4%) and the uses it can be put to.
Sometimes, even when a company is paying no dividend today, you can buy it with the
knowledge that return of capital will be as important as return on capital over the next couple
decades.
That’s the case with Boston Beer.
And a good way to look at investments like this is to focus on:



Earnings Yield
Sales Growth
Return on Investment
And not just dividend yield.
Because the capacity to pay a dividend is almost as important as actual payment of that dividend.
In fact, in a high return business – there’s no good reason to prefer a dividend.



URL: https://focusedcompounding.com/if-dividends-dont-matter-what-does/
Time: 2012
Back to Sections
-----------------------------------------------------
Free Cash Flow: Adjusting For Acquisitions, Capital Allocation And
Corporate Character
Someone who reads my articles sent me this email:
…I would appreciate your thoughts on three questions of mine:

When calculating the free cash flow of serial acquirers, should the acquisition costs be
factored in?
 What are your thoughts on using pre-tax earnings, FCF, etc., yields to evaluate the
attractiveness of securities. Intuitively, post-tax is all that matters, but pre-tax numbers
allow for a more straightforward comparison between equities and fixed-income
securities.
 Now for a more company-specific question. Sotheby's (BID) is inherently a very good
business, but management owns only a small sliver of equity and in the past has failed to
act prudently in the use of the balance sheet (impairment charges show up on cash flow
statement following downturn in art market). The language in the SEC filings since that
point is encouraging… which brings me to my question. How can an investor evaluate if
management has learned from past missteps? Or is it so time consuming that a more
efficient use of time would be to move on to other ideas?
Thanks again,
Patrick
Great questions. I get similar questions a lot. Especially about how to treat cash flows used for
acquisitions. Is it really free cash flow? Or is it basically just another form of capital
expenditure?
And questions about management changing their stripes are very, very common. That’s a tough
question. But since these two questions are connected, I’ll start with the acquisition issue first.
When calculating the free cash flow of serial acquirers, should the acquisition costs be factored
in?
Yes. If the company really is a serial acquirer, acquisition costs should be considered equivalent
to cap-ex. The issue of acquisitions is always one that can be considered part of cap-ex or not
part of cap-ex. If spending on acquisitions is treated as if it is part of cap-ex, then your
expectations for that company's growth would be higher (because they would be growing
through acquisitions). If it is not counted as part of cap-ex, then your expectations for that
company's growth should be lower (because you are not treating acquisition spending as a
normal part of the company's year-to-year progress).
Sometimes it may be easier to estimate growth before acquisitions.
For example, a company involved in a mundane business like running hair salons – like Regis
(RGS), dentist offices – like Birner Dental (BDMS), grocery stores – like Village
Supermarket (VLGEA), or garbage dumps – like Waste Management (WM), may be easy to
estimate as essentially a no-growth business.
Sotheby’s would be harder. Because there is not a steady, year-in-year-out kind of demand for
their products. And a growth company like Facebook would also be impossibly hard to evaluate
this way. There is no normal industry wide rate of growth at those kinds of businesses. You
simply have to evaluate them on a company-specific basis. You have to dig into their growth
stories the way someone like Phil Fisher would.
But what about companies in industries with very steady demand? Industries like hair salons,
dentist offices, groceries and garbage.
You can think of such businesses in two ways. One way would be to assume roughly zero
percent real growth (although the company's nominal revenues might grow in line with inflation)
and then to treat acquisitions as one-time both in terms of costs and the growth they provide.
The other way would be to assume the company will spend a certain amount of its free cash flow
on acquisitions each year. In that case, free cash flow might fall to nearly zero (because
acquisition costs are so high). But then you would analyze the business as if it grows by 3%, 5%,
8%, 10%, or whatever the acquisition-fueled sales growth tends to be.
So there are two ways to analyze a business that grows by acquisition. It is up to you to either
pick which way works best for your understanding of the business — or to use both approaches
in parallel. What you must never do is assume acquisition growth is real but acquisition costs
aren't. Or — more conservatively — that acquisition costs are real but the growth they provide is
not. If acquisitions are a normal part of the business, so is the sales growth they provide. If
acquisitions aren’t a normal part of the business, then neither is the sales growth they provide.
What are your thoughts on using pre-tax earnings, FCF, etc. yields to evaluate the attractiveness
of securities? Intuitively, post-tax is all that matters, but pre-tax numbers allow for a more
straightforward comparison between equities and fixed-income securities?
If you are analyzing the company as a potential control buyer — asking yourself what this
company would be worth to private equity, a competitor, Berkshire Hathaway
(BRK.A)(BRK.B), etc. — use pre-tax numbers. And use enterprise value instead of the stock
price. Analyze the business like you are buying the whole thing — equity and debt — and you
are getting all of their EBIT.
But if you are analyzing the company merely as a passive minority investor, use free cash flow
or after-tax income. This second calculation is important in situations where you imagine being
invested for a long time under the same management team or corporate culture. These are not
situations where you imagine a change of control. They are not something you are looking to buy
today and sell next year.
These are long-term holdings.
When you are looking at that kind of business — Berkshire Hathaway is certainly one, but CEC
Entertainment (CEC), Birner Dental, Oracle (ORCL) etc. may also count — you are
imagining yourself as a shareholder and silent partner in a business that will continue to be
controlled by the current management team — or similar successors — and in which they will
decide what your dividends are each year, they will decide how much stock is issued or bought
back, etc.
Buy and hold investments should be analyzed on a free cash flow basis. Not an EV/EBIT basis.
"Value" investments in the Ben Graham sense of the word — think cigar butts — should be
analyzed on an enterprise value.
Simply put, make your Ben Graham investments on an EV/EBIT basis. And make your Warren
Buffett investments on a price-to-free-cash-flow basis.
We can think of this as a public owner versus private owner choice. Are you buying the company
because you think it is cheap relative to its intrinsic value and you expect to receive your
investment gain in the forms of capital gains caused by a rising share price that will close the gap
between price and value — some sort of merger, takeover, etc. — or do you imagine being
invested in the company the way Warren Buffett is invested in Wells Fargo (WFC), Coca-Cola
(KO), the Washington Post (WPO), etc.?
Enterprise value and operating income (“EBIT”) should be used when analyzing an investment
as a private owner. This is how Joel Greenblatt seems to work. At least that is how he talks in
"You Can Be a Stock Market Genius" and how he designed the magic formula (enterprise value
and pre-tax earnings). If you are looking to buy a company on a public owner basis — like
Berkshire Hathaway’s long-term investment mentioned above — then you need to look at the
investment on an after-tax basis. Probably on a free cash flow basis. And you certainly need to
make sure you are comfortable with current leverage, management and capital allocation
policies. Because you are betting on those things continuing.
I know this sounds confusing. It sounds like I’m saying there are two different ways of analyzing
a company. Do you really have to decide if you are buying a Ben Graham stock or a Warren
Buffett stock? That just doesn’t sound right.
But think about the way Warren Buffett described the stocks Ben Graham bought in the 1950s
and before. He called them used cigar butts. Stocks that were pretty much free. But that had only
one puff left in them. The puff was all profit. But once you took that puff, you had to get out of
the stock fast.
And Buffett has repeatedly said that he made a big mistake by buying control of Berkshire
Hathaway. Everything he did after buying the dying textile mills was genius. Buying insurance
companies, See’s Candies, etc. Brilliant. Buying Berkshire? Dumb.
How can that be?
It wasn’t because buying a net-net like Berkshire Hathaway was actually a mistake. It wasn’t.
Buffett was right to buy Berkshire Hathaway stock at first. He was wrong to hang onto it. He was
wrong to hold that kind of company — a bad one — year after year.
If you expect to buy a stock the way Ben Graham did — using a static intrinsic value estimate as
your expected sell price — you can use enterprise value and EBIT as your valuation tools.
But if you start thinking about stocks the way Warren Buffett does today, you are moving into
another area. Another way of thinking. This area of investment is not static. It’s not about getting
one profitable puff and then selling out. It’s not about looking for a stock to rise 30% or 50% or
100% in one or two or three years. It’s about owning something for, well, forever.
That’s a different game entirely. It’s a different approach. It comes from Ben Graham’s
principles. From his core beliefs. But it’s a different approach. It’s very close to Phil Fisher. And
it’s an approach that depends more on management, capital allocation and the free cash flow they
have to allocate rather than measures like enterprise value and EBIT.
Where capital allocation is important, you need to move beyond EV/EBIT. You need to start
thinking dynamically. Start thinking about the future. The uses free cash flow will be put to. You
need to start thinking about dividends and stock buybacks and acquisitions and all that.
Warren Buffett clearly does. If you listened to Buffett talk about why he bought IBM (IBM) —
this was when he was talking to the folks over at CNBC — you could tell he was very excited
about the idea that IBM had reduced its share count over time. He had no problem at all with
modest sales growth if it was accompanied by constant share buybacks. That gives you a rising
earnings per share number the same way much stronger sales growth — through acquisitions —
would. Buybacks are just another form of capital allocation.
For stocks like IBM, don’t use enterprise value and EBIT. Use free cash flow. And really dig
into the company’s history of capital allocation. Do you think they will have a higher or lower
share count 10 years from now? Those are the questions that matter when analyzing something
like IBM. Something where the uses free cash flow is put to are key.
Finally...
Now for a more company-specific question. Sotheby's is inherently a very good business, but
management owns only a small sliver of equity and in the past has failed to act prudently in the
use of the balance sheet (impairment charges show up on cash flow statement following
downturn in art market). The language in the SEC filings since that point is encouraging…
which brings me to my question. How can an investor evaluate if management has learned from
past missteps? Or it is so time consuming that a more efficient use of time would be to move on
to other ideas?
My advice here is simple. Words don't matter. Behavior does. Character is behavior. And
behavior is character. When looking to assess a person, look at their past record. The pattern that
emerges is a portrait of that person. Don't listen so much to what others say about them, or even
what they say about themselves.
Look at what they did.
Talking about buybacks tells you nothing. Actually doing 10 straight years of buybacks tells you
something. There are companies like CEC Entertainment (CEC) and Sherwin Williams
(SHW) that practice buybacks like that pretty consistently. Then there are Internet companies
and tech giants that dilute their shareholders year after year. Finally, there are companies that
raise their dividend every year.
Some companies overpay chasing instant growth through acquisitions. Companies will always
tell you their latest purchase is a good idea, and then when they spin the unit off or sell it, they'll
tell you they've learned focus matters. Five years later they'll be talking about diversification
again. Today they may talk about unlocking shareholder value. But if the economy is really
pumping and the stock market is really frothy in 5 or 10 years, you can bet they’ll be talking
about the importance of growth again.
Focus on past behavior. Look at what people really did. Not just people. But institutions too.
Understand the temptations all companies face. But don’t trust words. Trust deeds.
As far as I’m concerned, management's character is equivalent to their pattern of past behavior.
Nothing more. Nothing less.



URL:https://web.archive.org/web/20120424191310/http://www.gurufocus.com/news/161
328/free-cash-flow-adjusting-for-acquisitions-capital-allocation-and-corporate-character
Time: 2012
Back to Sections
-----------------------------------------------------
How to Find Stocks With Good, Predictable Capital Allocation
Someone emailed me this question:
“How do you evaluate the capital allocation skill by the management? I do so by looking at the
FCF yields for the acquisitions and share repurchases or ROIC for internal investments.”
I want to focus on what will have the most influence on my investment in the company going
forward. For this reason, I’m less interested in knowing quantitatively what the past return on
investment of management’s actions were – and more in simply how management will allocate
capital going forward.
Let’s start with who the manager is. If the manager is the founder, that’s the easiest situation. We
can assume the founder will stay with the company for a long time. The average tenure of a
professional manager – nonfounder – CEO at a Standard & Poor's 500 type company is short.
It’s maybe five years. If you think about that, it means odds are that the CEO you now see at the
company you are thinking of investing in will be gone within two to three years (because
chances are he’s already been running the company for two to three years by the time you buy
the stock). It’s just not worth thinking about such a manager. In this case you’d want to focus on
the board of directors or the chairman. Ideally, you want to find situations where the founder is
still the CEO, the chairman or has some position in the company. This will make figuring out
future capital allocation plans easier.
In situations where you don’t have a founder present, ongoing participation by a family is useful.
In situations where you don’t have the presence of either a founder or his family at the
company, you may still have first-generation managers who worked with the founders before
they became CEOs.
Those three situations will make future capital allocation easier to predict. One, the founder
influences capital allocation. Two, the controlling family influences capital allocation. Three, a
manager who worked directly for the founder early in his career now influences capital
allocation. If you don’t have any of those three scenarios, there are still two others that can lead
to some predictability. You can have a long-tenured CEO. For example, the big ad agency
holding companies are usually run by a CEO who has been at the company forever. I
know Omnicom (OMC, Financial) best. The CEO there – John Wren – has been at the top
position for 20 years. For most of those 20 years, the chairman of the company and the chief
financial officer (CFO) were also the same.
In terms of capital allocation, if you have a lot of consistency in the offices of chairman, CEO
and CFO, you’re able to more easily count on future capital allocation looking like past capital
allocation. The last of the five scenarios that can lead to predictable capital allocation is the
presence of a “refounder.” This is someone who comes in and reshapes an existing business
through some sort of crisis. Again, this is an extraordinarily powerful figure. Not just a
professional manager who will probably be replaced within the next two to three years.
Before worrying about whether capital allocation has been good or bad, worry about whether the
future will be like the past. You can only count on future capital allocation looking like past
capital allocation in five scenarios: 1) The founder influences capital allocation, 2) a controlling
family influences capital allocation, 3) a former top lieutenant of the founder influences capital
allocation, 4) a long-tenured CEO influences capital allocation or 5) a “refounder” influences
capital allocation. You can look for some other signs beyond just these five scenarios, but first
let’s take a moment to identify actual real-life examples of what I’m talking about.
I’ll go through some of the stocks I’ve talked about in the past. I just mentioned Omnicom.
Omnicom meets a couple of these criteria. For a long time, the CFO, the CEO and the chairman
positions didn’t turn over. The CFO eventually changed, but the CEO and chairman are long
tenured. Omnicom as it exists today is pretty closely tied to the personal histories of the current
CEO and the current chairman. You can argue about whether they are really founders – they
didn’t found the agencies that form the organization – but they really determined the way
capital was allocated from the very beginning.
Omnicom, as a holding company that allocates the free cash flow produced by the agencies that
were merged to form it, was pretty much founded by people who still have roles at the company.
This isn’t unusual among ad agencies. Both WPP (LSE:WPP, Financial)
and Publicis (XPAR:PUB, Financial) also have people involved in capital allocation who have
been at the companies forever. You can predict that future capital allocation at Omnicom,
Publicis and WPP will be similar to past capital allocation.
In one of my most recent articles – on index funds – I mentioned three companies whose stocks I
owned in the late 1990s: Village Super Market (VLGEA, Financial), J&J Snack
Foods (JJSF, Financial) and Activision (ATVI, Financial). Village is controlled by the founding
Sumas family. The family runs it day to day. There are something like five family members with
top positions in the company. Historically, only some financial functions (CFO) and legal
functions (general counsel) – and independent directors – have ever been held by
nonfamily members, but that’s about as family controlled and family run as a public company
can get.
J&J Snack Foods is still run by the founder. He’s been running the company for about 46 years
now – most of his life and all of the company’s life. Capital allocation there should be the
same in the future as it was in the past. Activision is an interesting case. Basically, the founder is
still running the company. That company has a pair of people – President and CEO Bobby
Kotick and Chairman Brian Kelly – who have been involved for a long time.
I’m giving you these examples because my advice to look for a founder, a refounder, a longtenured CEO, etc., might seem overly restrictive. It’s not. I know a lot of S&P 500 type
companies are now run by brief-tenured professional managers, some of whom were even hired
from outside the company. In general, these aren’t the best companies to buy. It’s not hard to
find companies that have a cleaner line of descent from founder to current CEO.
For example, I’ve written about three
watchmakers: Swatch (XSWX:UHRN, Financial), Fossil (FOSL) and Movado (MOV). All
three of these companies meet one of the criteria I mentioned. They also have different capital
allocation from each other. Movado is conservative. Fossil is aggressive. It’s true, though, that
over time most companies drift away from founder control, family control, etc. Of companies
I’ve written about, the oldest family controlled example would be John Wiley & Sons (JW.A).
That company is now probably something like 210 years old. Members of the Wiley family still
have board seats and own a special class of voting stock. The family exerted some operational
control for probably the first 190 years of that company’s history. That’s the most extreme
example I can think of.
What if the stock you are looking at doesn’t fit into any of these five situations I’ve described?
You are looking at a board, a CEO, a CFO, etc., who aren’t especially long tenured. They have
no connection to the firm’s founder. They have no connection to the founder’s family. They may
have been hired from outside the company. They haven’t spent their whole careers at the
company.
Honestly, this usually means you can’t count on predicting how they will allocate capital, but
there could be exceptions. I bought into Fair Isaac (FICO) just after the financial crisis. A big
reason why I did so was the capital allocation I expected. I honestly believed that FICO was
going to buy back a lot of its own stock. If I didn’t believe that, I might have been less inclined
to buy the stock. The company was trading at a low price-to-free-cash-flow. This meant I could
“double-dip” if the company – instead of paying free cash flow out in a dividend – used it to buy
back its very cheap stock. The CEO was an outsider who had worked at IBM (IBM) before
taking the position at Fair Isaac.
There were some clues that Fair Isaac would be buying back its own stock. Shares had peaked at
78 million in 2004. They then fell to 74 million (2005), 65 million (2006), 58 million (2007) and
then 49 million (2008). It’s not common for a company to reduce share count by about 10% per
year. The company also didn’t really talk about dividends as something it planned to increase
despite having a ton of free cash flow to spend on it. As it turns out, Fair Isaac went on to reduce
share count by about 6% per year from the time I bought it to today. That’s a rapid rate of share
reduction, especially considering the stock became more expensive over time. It’s much easier
for a cheap stock to reduce its share count than an expensive stock. Here, the unorthodox and
repetitive nature of what Fair Isaac was doing is important.
Companies do buy back stock from time to time. What very few companies do is buy back stock
each and every year while paying out close to nothing in dividends. Fair Isaac was doing that.
There were years when it probably bought back $200 million in stock while paying less than $50
million in dividends. In other words, it was using more than 80% of the cash it “returned” to
shareholders for stock buybacks. This is unorthodox because it’s not balanced the way most
companies like to use both buybacks and dividends. I was willing to trust Fair Isaac’s capital
allocation more than I would trust the capital allocation at other companies.
Finally, you can look at incentives instead of past actions. I focus on three predictors of future
capital allocation: 1) The personalities involved, 2) the past actions of the corporation as a whole,
and 3) the incentives of the decision makers. Copart (CPRT) is a good example of this. The key
decision makers here were a founder and a long-tenured manager (and total corporate “insider”).
Copart hadn’t bought back much stock when I first looked at the business. This was a little over
five years ago. It had only carried out one buyback, but I knew two things from reading about the
company. One, the people who ran Copart only cared about the narrow business Copart was in.
They were very knowledgeable about the business, but they didn’t seem to have any interest in
diversification.
Copart wasn’t going to be able to use all its free cash flow to grow the business. If it wasn’t
going to make acquisitions, it would have to decide on piling up cash, paying out dividends or
buying back stock. My bet was that the company would aggressively buy back stock from now
on. Why? One, it had just done some buybacks. That was a big tipoff. Two, the top people in the
company had signed an unusual compensation agreement that suggested they’d focus on
buybacks. This is why you always read the proxy filings for a company in which you’re
interested. The proxy document has info on bonus plans, etc. If you’re using EDGAR (the SEC
website) the document you are looking for will be called the “14D.” Here is a description of the
compensation agreement I was talking about (Willis Johnson is the founder of Copart):
From April 2009 to April 2014, Willis J. Johnson, our chairman, received no cash compensation
in consideration of his services to Copart (other than a $1.00 annual payment). Instead, in April
2009, we granted Mr. Johnson (our CEO at the time) an option to acquire shares of our common
stock, vesting over five years. This option became fully vested in April 2014.
Basically, both the current CEO and the former CEO (and now chairman) were given long-term
options to acquire stock instead of being given any cash compensation. The company didn’t have
a history of paying a dividend. It had started buying back some stock recently, and it granted the
two people who were most important to the company – the CEO and the chairman/founder –
five-year stock options instead of any other kind of compensation. Based on that, I was confident
that the company was going to buy back a lot of stock. I was also confident that – whether they
were right or not – the two people who knew the most about Copart were convinced its share
price would be a lot higher in five years than it was at the time. Otherwise, they would have
taken at least some cash rather than all stock.
This was an unorthodox compensation arrangement. It’s unlikely the board thought of it
independent of the two executives. It’s also completely unthinkable that the two executives
would feel obligated to accept zero cash compensation unless they were confident in the stock’s
prospects over the next five years. As it turned out, Copart bought back about 5% of its stock per
year over each of the next five years. The stock returned about 20% per year. You couldn’t have
predicted these exact figures, but reading the proxy statement would be helpful.
I had also read some past interviews with the current CEO and the founder/chairman. Reading
between the lines, I felt strongly that they were more interested in buying back stock than paying
dividends. They just seemed parochial about their business compared to the way a professional
manager at a big, bureaucratic S&P 500 type company thinks.
You can find other incentive systems in proxy filings and annual reports. For example, I have
researched some companies that rely heavily on either total stock return (TSR) or economic
value added (EVA) as the way they determine almost their entire bonus pool for employees from
the very top to the very bottom of the organization. Companies that pay bonuses based on TSR
or EVA aren’t going to issue stock that adds to equity if it depresses ROE. Companies that pay
bonuses out of either total stock return or economic value added are basically targeting either
return on equity (leveraged) or return on capital (unleveraged). They can be counted on to
minimize the growth of assets generally and owner’s equity specifically.
So far, I’ve lectured you on how to figure out what I think really matters: How will the company
allocate capital in the future? You asked how to judge past capital allocation decisions.
I judge each acquisition independently, but I’m most interested in the strategy of why they did
what they did. I don’t necessarily care whether they got lucky. For example, I think Frost (CFR)
has only so-so capital allocation. Frost’s strategy is good when it comes to the cultural fit of the
acquisitions it makes. Frost mainly buys good, Texan banks that fit easily into their organization.
They stay within their circle of competence. Frost is unlikely to make major capital allocation
mistakes, but I don’t think Frost’s acquisitions will add value. Why not? The company sometime
uses shares to make acquisitions. Other banks just aren’t as high quality as Frost. I’d rather Frost
never issued shares.
I extend the same rule to other businesses I consider “great.” I own shares in BWX
Technologies (BWXT). I would never want BWX to issue shares to make an acquisition. This is
even more true at Omnicom. It’s extraordinarily true at Fair Isaac. Frankly, Fair Isaac’s business
is so good that in the long run it would be hard for the company to ever come out ahead when
giving up shares in itself to acquire anything else. If the stock is overvalued, it might be possible,
but I doubt it. Capital allocation decisions that are simple, predictable and yet good are the best
ones.
In the newsletter issue I wrote about ad agency holding companies, I compared capital allocation
at Omnicom, WPP and Publicis. Publicis has a history of making poor capital allocation
decisions. It overpays for things. WPP has a history of making good capital allocation decisions.
It pays fair value or less for what it buys. Omnicom has a history of basically just buying back its
own stock.
The truth is that as good as WPP’s capital allocation has been – and it’s been good – it’s hard to
negotiate purchases of entire advertising-related companies at prices that are lower than these
companies would trade for in noncontrol situations as public companies. In other words, control
buyers are at a disadvantage to noncontrol buyers when it comes to ad agencies. You, the
individual investor, can get a better price on a share of an ad agency you buy than WPP can get
on a merger it has to negotiate with the seller’s board of directors. As a result, Omnicom has
been able to match or top WPP’s return on its allocated capital while really doing nothing but
dollar cost-averaging into its own stock. This is typical of the kind of capital allocation program
that actually works.
You can even see this at Berkshire Hathaway (BRK.B). Warren Buffett (Trades, Portfolio) has
sometimes used stock to make acquisitions. Berkshire’s shareholders would be as well off or
better – and would sleep much more soundly – if Berkshire’s board of directors passed a rule
banning Buffett from ever increasing Berkshire’s share count. Buffett is a great capital allocator.
He’s the best of all time, and yet his record in using stock to acquire Dexter Shoe, General Re
and Burlington Northern using Berkshire shares is mixed.
Burlington was a good acquisition, but considering where long-term interest rates were, how
much debt Burlington itself can safely carry and Berkshire’s own financial strength, I’m not sure
using stock worked that well. I’m sure he used stock because some of Burlington’s sellers were
only willing to do the deal if it wasn’t all cash, but Berkshire could have borrowed and bought
back its own stock to eliminate any dilution. In fact, I’m not convinced that Berkshire has ever
added value by allowing its share count to rise, and I can point to cases where Berkshire
destroyed value by increasing its share count.
When evaluating capital allocation, I mainly use long-term rates of return on things like retained
earnings. I also try – whenever possible – to compare capital allocation at peers. For example, in
the ad agency business, you’d think all companies were decent capital allocators if you just
looked at their returns on capital or even return on retained earnings. The ad agency business is
very forgiving. Even if you overpay to buy an agency, you’ll end up with a pretty value-neutral
to value-enhancing purchase if you hold the acquired company forever. The economics of the ad
business are good especially if you can borrow money to buy an ad agency you’re going to get a
decent long-term return on your money, but the test is how good your acquisition is versus just
buying back your own company’s stock. A return of 8% per year might look OK, but if you
could have bought back your own stock at a return of 12% per year on the same day, it’s a bad
capital allocation decision.
The real test of any capital allocation decision is the opportunity cost. We can always measure
capital allocation decisions versus two very easy to measure alternatives: 1) Paying a cash
dividend and 2) buying back stock. If you’re a good stock picker, you should prefer dividends.
For example, if I really believe I can always make 10% per year or more on any money a
company pays out to me, then the opportunity cost of them doing anything but paying out a
dividend is never going to be less than 10% times one minus the current dividend tax rate.
Let’s say my dividend tax rate is 20%. In that situation, the opportunity cost for any capital
allocation decision by a company I own can never be less than 8% per year. Remember, what
matters for me is the cost of the capital allocation decision to me, not the cost to the company.
From the company’s perspective, an 8% after-tax return on investment may seem like a perfectly
good decision. To me, an 8% after-tax return on investment is never better than a cash dividend –
and it is often worse. That’s because, over a long enough time period, I can almost always be
assured a 10% annual return or better from my own stock picking.
The opportunity cost hurdle of not paying a dividend is actually pretty high. Right now, it’s not
that easy to make more than 8% per year after-tax out of any merger unless you are funding that
merger entirely with borrowed money. Of course, for great businesses (and especially great
businesses with stock prices that are temporarily low), the real opportunity cost of any capital
allocation decision is not buying back their stock.
I mentioned Omnicom. Let’s say Omnicom stock is trading at something like a 7% leveraged
free cash flow yield. And let’s say the company can grow revenues – and free cash flow – by
about 3% per year without additional investment. I’m not sure if those numbers are exactly right.
They may be 1% to 2% too aggressive combined. I would guess Omnicom stock is now priced to
return no less than 8% per year and no more than 10% per year. In this case, it’s possible the
opportunity cost of Omnicom doing anything is the up to 10% return it could get from buying
back its own stock. If I was advising the company on how to allocate capital, I’d say that any use
of cash has to be expected to return 11% per year or more. Otherwise, the company should just
buy back its stock.
There is no evidence that dividends can provide more value to shareholders than buybacks at
Omnicom. The company should use all its free cash flow to buy back stock and not pay any
dividend at all. I know that it will pay a dividend. Unfortunately, it will probably pay something
like one-third of free cash flow out in dividends and two-thirds out in share buybacks. That’s just
a guess. Theoretically, I’d prefer all free cash flow at Omnicom be used to buy back stock and
none used to pay dividends. That’s because it’s hard to prove that the average individual investor
would be better off getting a dividend from Omnicom than simply having their ownership stake
in the company raised over time. And then, like I said, the hurdle you would need to hit for the
use of cash inside the company would be 11% a year. That’s after-tax. And that’s pretty hard to
hit. It’s hard to negotiate a control purchase of a private company or a public one at an 11%
annual return, even in cases where there’s a lot of synergy.
The more the company spends on buying back stock the happier I’d be. Of course, there are
cases where one company acquiring another can really add value. The two examples that come to
mind are 3G’s acquisitions at companies like Kraft Heinz (KHC) and the acquisitions
that Prosperity (PB) has done in Texas, but mergers at these companies haven’t been effective
because the prices paid were low – they’ve been effective because you have a cost-conscious
culture acquiring a business that hasn’t been run efficiently.
I’m sure you know 3G’s approach already. Prosperity’s approach is to remove a lot of office
expenses at the branches it takes over. It also gets rid of a lot of the loan book. Basically it is
acquiring deposits from the acquired company and then changing its cost and lending culture to
reflect Prosperity’s.
Since Prosperity has lower office expenses and lower loan losses than the banks it acquires, it
achieves cost “synergies” that aren’t really synergies at all. They’re just management-led
improvements. I’m always in favor of using cash on these kinds of mergers. The catch here is
that the management of the acquirer has to be better than the management of the acquired
company. To benefit from this, you need to be invested in a company with an above-average
management team that you know is going to stay in place for the long term.
Generally, Wall Street tends to notice above-average management teams and eventually bids up
the prices of their stocks to above market price-earnings (P/E) multiples. It’s tough to profit from
this approach unless you go looking for less well-known managers who are as good as the
already famous ones.



URL: https://www.gurufocus.com/news/491156/how-to-find-stocks-with-goodpredictable-capital-allocationTime: 2017
Back to Sections
-----------------------------------------------------
Quality, Capital Allocation, Value and Growth
In my last article I talked about the first 3 of the 7 things I look for before buying a stock –
understanding, durability and moat. Today, I’ll talk about the other four areas I focus on.
First up is quality. We can look at quality a couple ways. One way – which I remember from
reading Greenbackd and the book Quantitative Value Investing (which cites an article on the
subject) – is using a metric from high up the income statement. Something like gross profits
divided by NTA.
This is a good first check. A business should have high gross profitability. Most of the
companies I look at have fairly high gross margins. However, all of these subjects are a little
tricky because of the accounting definition of sales. Sales are defined in accounting terms for a
company in ways that might not make sense from an economic perspective.
For example, Omnicom (OMC, Financial) doesn’t record billings as sales. Nor
does DreamWorks (DWA) record box office as sales. However, some companies that buy and
quickly resell – at very, very low margins – do count the transaction as a purchase and sale rather
than a contracted service. I’m not knocking any of these approaches to accounting – we need one
definite way of measuring sales. But it’s important to keep in mind that you can sometimes
restate sales without restating anything – like earnings, cash flow, etc. – that actually matters.
What matters is the economic profits a company earns. Sales can be very useful comparisons
between companies that use similar accounting. But, I’m not sure gross profitability means the
same thing across all industries. For example, I would not be concerned with gross profits at ad
agencies, defense contractors, or drug distribution. This is just common sense. For
example, AmerisourceBergen (ABC, Financial) hasn’t posted a gross margin above 5% at any
point in the last 10 years. Yet, return on equity has rarely been below 10%. That’s unusual. And
it reinforces the need for using common – human – sense rather than relying on a screen.
When looking at a company economically – rather than as an accounting entity – we often want
to ask what spending at the end of the chain is on these products, what sales by others dependent
or controlled by the company etc.
Economically, a DreamWorks movie should be broken down from the ticket price collected from
the moviegoer, then we look at the take for the theater, the agreement with the distributor, and
then finally DWA’s revenue number comes into play.
In other words, we can – using widely available data that isn’t in the financial statements – easily
create a picture of how a movie makes money. We should do that. Just as we should consider the
quality of an auto parts maker in terms of the price of their product relative to the price of the
product it’s going into and what it adds.
But I’m sure you also want hard and fast rules – things you can screen by. Math.
I use a couple little bits of arithmetic. One, I do actually use gross profits divided by net tangible
assets. In fact, I always look at gross profits divided by net tangible assets, EBITDA divided by
net tangible assets, and EBIT divided by net tangible assets. In many cases, it hardly matters
which you use. Focus on the exceptions.
For example, a microcap that lacks a lot of scale but already had high gross profitability relative
to assets may be interesting. A giant company that has mediocre gross profitability – and always
has – is something you may want to avoid. That’s hard to overcome.
The next thing I look at is the return on capital. However, I do this a little different. I invert it.
I actually don’t focus on whether a company can earn a 15% ROE. Instead I focus on the idea
that to grow earnings by $1 the company will need to get $6 from somewhere (usually retained
earnings – but sometimes always increasing debt).
What number should you focus on? You can look at anything. If you’ve read The Outsiders, you
can guess that many of those CEOs would probably focus on something like how much
increasing EBITDA by $1 per share would take in terms of assets – and how could they finance
those assets.
My reason for inverting return on capital, is that I’m not usually investing in very fast growth
companies. Even then, I’m not sure how important knowing the return on equity is – because it’ll
usually be very close to the growth rate (since they’re retaining everything in those situations).
My reasons for focusing on the lack of needed capital as a good thing rather than the return on
capital is obvious in the stocks I own.
Right now, I own three stocks: George Risk (RSKIA), Weight Watchers (WTW, Financial),
and Ark Restaurants (ARKR).
(I bought Weight Watchers yesterday).
In each case, you can probably guess – if you run Joel Greenblatt style ROC numbers – that my
reason for buying those companies is that I thought they traded at low or average multiples and
ought to trade at average or above multiples. Why? Because, they can pay out all their earnings.
Of course, it may be better to buy a company with better growth prospects than those companies.
For me, quality is a question of profitability. Profitability generally means good pricing power
and low capital needs. I tend to think in terms of capital needed rather than return on that capital.
This is different from most investors. I find it very helpful. And I recommend you try it out and
see if that little inversion – looking at a 20% ROC as actually a $5 capital requirement to grow
$1 – is helpful in tackling old problems from new angles.
Capital Allocation
This is a huge one for me. In part, that’s because I tend to buy companies with high free cash
flow relative to their market cap. Free cash flow is discretionary spending. The board gets to
decide what to do with it. What they choose to do is incredibly important to me.
I always prefer buy backs. This is common sense. If you are – at this very moment – putting your
own money into a stock, then you obviously want the company to do the same.
But if the stock is your best investment opportunity right now, then it’s hard to come up with a
good argument for why you wouldn’t want the company to buy back its own stock.
I like dividends less. And I like piling up cash less. I differ from a lot of value investors in how
much less I like piling up cash.
The worst way to spend money is to lock yourself into a low return. Interest rates are low right
now. It’s fine to pile up cash. It would be worse – in many cases – to make a permanent
investment in something (new ventures, acquisitions, etc.) that might realistically offer 9% a year
as a good outcome and carry some risk. In scenarios like that – or worse – I’d rather you just
keep the cash on the balance sheet.
Some capital allocation can also have negatives beyond just the simple return math. I don’t want
management to split their attention. I don’t want a lot of big new projects going on at once. A lot
of tiny projects are often fine – but they won’t make any difference to capital allocation.
It sounds simple, but overwhelmingly I’m looking for stock buybacks. Again, this isn’t because
they make sense for most companies (they don’t). It’s because I’ve already decided this stock –
at this price – is the best place for my money. Therefore, I want the company to double down for
me. When that stops being the case, I might want to consider selling the stock.
That’s a good test to give yourself. If you don’t want the company to use all its free cash flow to
buy back stock – why do you still own the stock? What does preferring a dividend really mean?
Does it mean you wouldn’t put new money into this stock? And if a stock isn’t worthy of new
money, is it really worthy of old money? Should you still be in it?
I’d ask those questions. Generally, I only sell a stock to replace it with a better stock. I don’t sell
because of valuation.
Value
Let’s talk value. This one is simple. I look for a clear line in the sand. If there is a number I feel
sure the company is worth more than, I want to pay that price.
I mentioned one times sales for Omnicom. I mentioned one times book for DreamWorks. I’d
also use one times tangible book for something like Carnival (CCL). There is a simple, logical
argument you can make for why the company is certainly worth more than this.
That’s very different than intrinsic value. I have a hard time putting a precise intrinsic value on
stocks. Comparing the stock to others is often a shortcut. It’s not an actual valuation method. It’s
just another way of trying to prove the stock is undervalued.
I’d use about two-thirds of your favorite measure. Stocks often trade at 15 times earnings. Free
cash flow should be worth more than earnings (because most companies have less free cash flow
than reported earnings). Therefore, if you have a good company – it should trade at 15 times free
cash flow.
I would try to buy it around 10 times free cash flow. It’s not worth that. But that’s what I’d like
to pay.
Likewise, using an EV/EBITDA screen – 8x EBITDA would be pretty normal (since it’s
equivalent to about a P/E of 15). I’d try to pay 5x EBITDA. That’s a common screen I use in the
U.S. and U.K. I just look for a list of every company that makes money year in and year out that
trades for 5x EBITDA or less.
It’s not a big list right now.
Keep in mind a couple points specific to my approach. One, I’m looking at companies that
generally make money every year. This has two huge implications. One, I’m not looking for
major mean reversion in margins, EPS, etc. I’m not assuming they can earn more in the future
than they do now. I’m assuming now is pretty normal.
Two, I don’t have to – if you assume the future will be like the past – be as conservative in using
any one year’s earnings numbers. If a company routinely loses money a couple times in a decade
– boy, you need to bring those multiples down a lot.
The compounding you get from always having positive earnings – never taking a step back – and
for having all of those earnings be available to be distributed to shareholders (in cash) is huge. I
tend to focus on companies that do both. They tend to be profitable every year. And their profits
tend to understate their free cash flow.
Most companies lose money occasionally. Almost all companies have less free cash flow than
earnings. So, adjust your own approach if you’re looking at other kinds of businesses.
Growth
This is a subject I know nothing about. Chance are, if you’re reading this, you know more than
me. Or you at least have more definite views on the subject.
I’m bad at estimating future growth. I don’t pay for growth. When I make an investment, it needs
to be justified even if the business doesn’t grow. It doesn’t need to be a home run if it doesn’t
grow – I certainly benefit from growth – but it needs to be a base hit without growth.
I generally ask these questions:
· Can earnings grow faster than sales?
· Can unit volume grow faster than population growth?
· Can prices grow faster than inflation?
· Can this product grow as a share of GDP?
Spending on food in the U.S. is not going to grow faster than GDP. Therefore, you need market
share gains at a grocer to increase sales more than 5% to 6% a year. Operating leverage in the
business can be huge though. So, a grocer that’s getting better – competitively – can easily grow
EPS 10% a year on 5% a year in sales growth.
Generally, the surer you are the industry will grow, the less sure you are of future market share.
I can’t think of many situations where I really made an investment believing I was going to get
growth greater than nominal GDP.
Of course, if you don’t need capital to get that growth, you’ll often do fine with such “low”
growth. Most big caps, only grow like 6% a year over the decades.
Let’s say you could get 6% a year growth. And let’s say it was in a company that needed very
little added capital to support that growth. In the most extreme case – where you need no added
capital – you could see the company supporting a P/E of something like 25 even while growing
no faster than the economy. That’s because it could have a 4% dividend yield and a 6% growth
rate. A stock with those attributes would look good in some interest rate environments.
That’s an extreme example. I would never assume a company could support a P/E of 25. Let’s
use a P/E of 15 as a better example.
Assume a company could grow 6% a year. In theory, my most recent purchase of Weight
Watchers fits this description because weight loss spending can grow as a share of GDP over
time. At a price of 15 times free cash flow – and truly no capital needed for growth – you would
have an attractive investment. For example, the company could use the 6% FCF yield to buy
back 6% of its outstanding shares and then sales could grow 6% on average. In that case, sales
per share – and presumably earnings per share – would grow more than 12% a year.
Still, I’d want to pay 10 times free cash flow rather than 15. At 15 times free cash flow, if the
growth doesn’t materialize – you won’t make any money.
Finally, it’s important to consider growth over the long-term in sales rather than just cyclical
rises and falls. For example, WTW’s sales will be down over 10% this next year. That’s a
marketing miss. It’s equivalent to a same-store sales decline at a retailer. We don’t assume the
weight loss industry or restaurant spending or apparel sales or whatever actually changes 10% in
a year. We assume the company just overachieved or underachieved.
It could turn out to be a bad investment because they’ll keeping having years like that. But, if
they rebound at some point – that will not be growth. That will be a marketing success. It has
nothing to do with the long-term trajectory of the business.
That’s what I mean when I say growth. I’m talking about the “earning power” of the company.
What it’s capable of earning in a neutral year for the company, the industry, and the economy.
Mostly, I’m imagining the past 10 years and the future 10 years and wondering what a trend line
through that would look like. Is that trend line rising 6% a year.
That’s growth.
But, I’m the last person to listen to about growth. I know so little about growth that I’m
unwilling to pay for it.
I just treat the lack of growth as a negative. I consider growth qualitatively. Decay is terrible.
Stagnation is bad. Average growth is okay. Better than average growth is good.
I’ve never been successful making finer distinctions than that.

URL: https://www.gurufocus.com/news/225303/quality-capital-allocation-value-andgrowth


Time: 2013
Back to Sections
-----------------------------------------------------
Case Studies
Farmer Mac” A.K.A. Federal Agricultural Mortgage Corporation (AGM): The
Freddie Mac of Farms and Ranches Has a P/E Below 9 and an ROE Above
Most Banks
This is one of my “initial interest posts”. But, in this case it’s going to be more of an initialinitial interest post. I am in the early stages of learning about this company. And it’s likely to
take me some time to get to the point where I can give as definitive a verdict on whether or not
I’d follow up on the stock as I normally give in these posts.
First, let’s start with the obvious. As you probably guessed from the name, “Farmer Mac” is a
government sponsored enterprise like Freddie Mac and Fannie Mae – except it operates in the
agricultural instead of the residential market. The company has two main lines of business –
again, this is just like the Freddie Mac business model except transplanted into the agricultural
mortgage market – of 1) Buying agricultural (that is, farm and ranch) mortgages and 2)
Guaranteeing agricultural (that is, farm and ranch) mortgages.
As a government sponsored enterprise operating in the secondary market for mortgages – the
company has the two competitive advantages you’d expect. One, it has a lower cost of funds (on
non-deposit money) because it issues debt that bond buyers treat as being ultimately akin to
government debt. The same bond buyer might be willing to accept a 2.45% yield on a 10-Year
U.S. Treasury bond and just a 3% yield on a Farmer Mac bond. This cost above the rate the U.S.
government borrows at is much narrower for Farmer Mac than it is for most banks that make
agricultural loans.
The other cost advantage is scale. Yes, there are banks – like Frost (CFR) – that have very low
financial funding costs. But, these banks usually have to invest in hiring a lot of employees to
build a lot of relationships, to provide customer service to retain customers, etc. that leads to a
“total cost of funding” that is higher than what Farmer Mac has to pay. To put this in perspective,
Frost’s deposits are basically the same as its earning assets (loans it makes plus bonds it buys).
Frost has about $200 million in deposits per branch. This isn’t a bad number – it’s 1.5 times the
deposits per branch of Wells Fargo and 2 times the deposits per branch of U.S. Bancorp (and
more like 3-4 times the entire U.S. banking industry’s deposits per branch). Frost’s deposits per
branch are pretty close to industry leading for a big bank. So, we can use that $200 million in
deposits they have and assume a bank will almost never have more than $200 million in assets –
because it doesn’t have more than $200 million in deposits – per branch. Farmer Mac has $200
million in assets per employee.
As a rule, one employee is going to cost you a lot less than one branch.
To put this in perspective, most banks spend more on rent relative to their assets than Farmer
Mac spends on everything relative to its assets.
Last year, Farmer Mac spent between one-quarter (0.25%) and one third (0.33%) of one percent
of its total assets on all of its non-interest expense. This is extraordinarily low relative to even the
most efficient banks in the United States.
As an aside: there are a few U.S. banks – a very, very few – that charge so much in fees for nonsufficient funds, monthly charges on checking accounts, ATM fees, debit card fees, wealth
management fees, etc. that they can offset so much of their non-interest expense with noninterest income that their NET non-interest expense is similar to Farmer Mac’s roughly 0.3% of
assets.
You’re probably familiar with the DuPont analysis approach to breaking down the return on
equity of an industrial company. You can take apart an industrial company’s ROE by breaking it
down into margin (profit/sales), turns (sales/assets) and leverage (assets/equity).
A financial institution works pretty much the same way. You can break a bank’s efficiency down
into 3 parts:



How much does the bank pay in interest on the funds it has?
How much does the bank pay in non-interest expense on the funds it has?
How much equity does the bank use relative to its total funds?
There are some other factors – like charge-offs – which matter too. We can discuss those in a
second. But, I’m going to spoil that discussion a bit here. I’m not so confident that we can know
what Farmer Mac’s long-term charge-off rate will be. Because of the kind of loans it holds –
largely first-lien mortgages on farms and ranches – Farmer Mac may have no losses in some
years and then more losses in a single year than it has had in a whole decade. Although Farmer
Mac was chartered several decades ago – it has a somewhat limited history relative to the length
of agricultural cycles. The big determinant of losses in something like agricultural mortgages is
really whether there has been a large build up in debt (especially borrowing against land values)
in previous years. The last time there was a clear debt bubble in U.S. agriculture – the early
1980s – predates Farmer Mac’s existence. So, looking at Farmer Mac’s likely future charge-offs
is a lot like looking at a bank that makes residential mortgages. Other than in the 2008 financial
crisis – residential mortgages had very low charge-offs. But, there were then enough charge-offs
in the years around 2008 to wipe out some banks (these charge-offs were sometimes more in one
year than the bank had charged-off in the entire decade prior to that year). So, again, we find
Farmer Mac is a lot like Freddie Mac.
So, let’s put aside likely charge-offs at Farmer Mac for a second. Instead, we’ll do that sort of
DuPont analysis for banks I suggested above. Will Farmer Mac have a higher or lower return on
equity than U.S. banks?
Higher.
Here’s how we know that.
1. How much does the bank pay in interest on the funds it has?
Last year, Farmer Mac’s total interest expense was less than 2.1% of its average assets. Looking
at the same question from a different angle – we can see that depending on how short-term or
long-term a Farmer Mac bond is, it pays anywhere from 1.2% to 3.3%. For example, a Farmer
Mac bond due in about 4 years yielded about 2.9% when issued. Right now, a U.S. Treasury
bond maturing at the same time, yields about 2.1%. That example is somewhat misleading – it
overstates Farmer Mac’s cost of borrowing – because U.S. Treasury yields are lower now than
when those Farmer Mac bonds were issued. Regardless, you can see that Farmer Mac’s cost of
borrowing is less than 1% above the U.S. government’s own cost of borrowing. The company’s
cost of funding from an interest expense perspective alone is not lower than many larger,
successful banks. It is lower than some small, less successful banks.
2. How much does the bank pay in non-interest expense on the funds it has?
This – rather than some interest advantage – is what makes Farmer Mac better positioned in
terms of ROE than U.S. banks. Banks can pay so very little interest on certain deposits –
basically none on checking accounts of households, for example – such that they could certainly
match or beat Farmer Mac on that score. Where they can’t beat Farmer Mac is on the noninterest expense. Banks normally have low interest expense precisely because they offer a lot of
services to their depositors. Farmer Mac doesn’t have depositors. It just issues bonds and buys
mortgages (and does a few other things like guaranteeing mortgages). So, it has very low noninterest expense. This means Farmer Mac’s combined cost of funding compares well to many
(though not all) banks. Let’s say Farmer Mac has a 2.1% financial expense on its total assets.
And let’s also say Farmer Mac has a 0.3% non-interest expense on its total assets. The
company’s “all-in” cost of funding is 2.4%. Let’s round that up to 2.5%. Okay, so Farmer Mac
can fund itself at 2.5% and then buy assets that yield more than that.
3. How much equity does the bank use relative to its total assets?
This is leverage. And it’s the biggest advantage Farmer Mac has over a bank in terms of ROE
achievement. There are a few ways to measure how leveraged Farmer Mac common stock is.
The method I’m going to use is definitely not the one the company’s management would use.
But, I’d say the company ended last quarter leveraged about 35 to 1.
What I mean by this is that total assets at Farmer Mac are about 35 times the tangible equity
attributable to the common stock. Banks – and Farmer Mac – count other equity (such as
preferred stock) in their capital structure when measuring leverage. As a potential holder of the
common stock – this isn’t relevant to you. What matters is the risk from leverage and the return
from leverage in terms of assets/common stock equity. At Farmer Mac, that ratio is about 35 to
1.
What does this mean?
Let’s assume Farmer Mac can borrow at 2.5% a year “all-in” (this includes both the interest cost
and the non-interest cost of their operation) and buy loans that yield 3.2%. This would give the
company a 0.7% pre-tax return on its assets (3.2% – 2.5% = 0.7%). The company would then
pay a 21% tax rate leaving it with a 0.55% return on its assets. Let’s call that 0.5%. So, if Farmer
Mac could make a 0.5% after-tax return on its assets – what would you, the common stock
holder, earn on your equity?
About 18%. We take 0.5% and multiply it by the 35 times leverage and get 17.5%. Again, let’s
round that down. We’re left with a 17% return on equity.
How close is the situation I just described to Farmer Mac’s actual returns?
Pretty close. The official results for last year were an ROA of 0.5% and an ROE of 14.8%.
Farmer Mac likes to report “core” earnings and “core” ROE. I’ll give you those numbers here –
though, I have some problems with the fact they use these figures. From 2015-2018, Farmer
Mac’s “core” ROE was 13-17% a year. Let’s call that an average ROE of 15%.
We also know Farmer Mac’s dividend payout ratio. Farmer Mac pays about one-third of its
earnings out in dividends. It uses the other two-thirds to compound book value. This suggests
that Farmer Mac’s returns – relative to book value per share, NOT stock price per share – will be
a 10% growth rate and a 5% dividend yield.
To calculate your own likely return – and the form it will come in – when buying AGM, you
would just divide that 10% + 5% = 15% expected return on BOOK value by the ratio of price-tobook you will be paying.
Farmer Mac ended last year with a book value of $49 per share. As I write this, the stock is
trading at $71 a share. So, the price-to-book value is $71/$49 = 1.45 times book value. Again,
let’s just round that up to 1.5 times. So, let’s say Farmer Mac will cost you about 1.5 times its
book value.
This implies your return in the stock should be 15%/1.5 = 10% a year.
The current dividend yield is 3.66%. The rest of your 10% a year return will have to come from
growth. Historically, Farmer Mac has grown its balance sheet by about 10% a year. And Farmer
Mac is currently retaining enough earnings to keep growing at 10% a year while maintaining the
same 35 to 1 leverage ratio I mentioned earlier.
Let’s talk about loan losses.
This is part of the complication with a bank’s reported earnings versus what it is actually earning
– in cash – each year. A bank makes adjustments to its allowance for loan losses. This change in
allowances may not match actual charge-off ratios, delinquencies, etc. In theory, allowances are
supposed to be higher than charge-offs in good times and this will smooth out reported results. In
practice, allowances tend to get raised higher after charge-offs start becoming a problem. So,
allowances are less helpful in highly cyclical forms of lending than you’d think.
How high are Farmer Mac’s charge-offs in agricultural lending?
Nearly nil. The company often shows a graph going back 20 years. This isn’t very helpful.
Agricultural loan losses in the U.S. have been very low for the last 20 years. Farmer Mac’s loan
losses have been about 0.02% a year over the last 20 years. That’s not a typo. It’s lower than the
agricultural lending other banks do. The publicly traded banks you’d be looking at tend to do less
mortgage based agricultural lending and more for financing working capital and things like that.
But, even U.S. banks generally have only charged-off about 10 times what Farmer Mac has
(0.2% a year) over the last 20 years. We can, of course, assume that Farmer Mac will charge-off
0.2% a year (10 times what it actually has) in the next 20 years versus the last 20 years.
But, I don’t think that’s all that helpful as a guide.
Ninety-day delinquencies on Farmer Mac’s loans are actually quite high. This isn’t unique to
Farmer Mac. One thing I noticed when reading Bill Ackman’s old short report on Farmer Mac is
that he assumed high delinquencies in agricultural loans relative to allowances (and charge-offs)
must be unsustainable. It’s actually proven to be totally sustainable. The industry’s delinquencies
relative to charge-offs have often been about 5-10 times higher. In other words, a bank that has
$50 million in 90-day delinquent agricultural loans is likely to charge-off only $10 million or
less of those loans this year.
There are a lot of reasons why agricultural loans may often be delinquent but rarely be chargedoff. The most likely explanations are: 1) that cash income for a farmer or rancher is much more
variable than wages paid to a homeowner, 2) payments on agricultural loans are due far less
frequently (often only once or twice per year – instead of 12 times per year for a homeowner), so
a 90-day+ delinquency may indicate missing only one or two payments (as opposed to more than
3 for a homeowner), 3) agricultural borrowers often have better balance sheets – because they are
businesses not consumers – than households (farmers and ranchers tend to have more short-term
assets than short-term debt; while households can be quite illiquid) 4) for the last 50 years:
farmer and ranchers have seen their income rise faster than other types of workers (they’ve
become progressively higher-income relative to U.S. workers generally), and 5) farmland is a
better investment than a single-family home, so the collateral is safer long-term (though this does
not necessarily mean the collateral is safer in the short-term).
I think all 5 of those points are true. But, I don’t think that makes Farmer Mac any safer than
Freddie Mac. The stock may move a lot with rising and falling projections for farmer income –
so, crop prices and yields and so on – expected in the next year or two. But, I don’t think that’s
what could kill this company. What could kill Farmer Mac is the same thing as what killed
Freddie Mac – rapidly rising borrowing against rapidly rising asset values. Without big increases
in debt – which almost certainly have to both cause and be supported by – rapidly rising land
values, the stock should be safe. But, in a big enough farmland bubble, I don’t see any way the
stock could be safe even if management intends to be quite conservative. In this case, I’m not
sure management intends to be conservative. They have certain targets, guidance ranges, etc. that
aren’t especially conservative.
So, is Farmer Mac an especially safe stock?
No.
But, is it so un-safe you can’t buy it today?
I wouldn’t say that. Yes, it’s leveraged 35 to 1. But, as long as you don’t see meaningful upticks
in the debt/asset ratio of the entire agricultural sector – charge-offs in farm and ranch loans will
be very, very low compared to almost any other kind of lending. Outside of a bubble, these are
very safe loans.
Inside a bubble, I think you’d have to sell the stock. It seems entirely possible the company’s
equity would be completely annihilated in the bursting of any farmland bubble. We had one
close to 40 years ago now. At some point, we’ll have another. When we do, Farmer Mac stock
could go to zero.
A lot of people reading this will say that it’s the leverage ratio of 35 to 1 (by my calculation – not
the company’s) that makes this stock uninvestable. I think that’s misleading. It’s very possible to
go broke when leveraged 2 to 1. There are banks leveraged just 10 to 1 that are riskier than
Farmer Mac. No, I won’t give you their names. But, I’ve looked at them. And I know that being
70% less leveraged than another financial institution does not mean you’re safer.
What does determine whether a financial institution is safe or not?
If your focus shouldn’t be on leverage alone – what should you focus on?
How should you evaluate the riskiness at Farmer Mac?
Ask yourself these 4 questions:




How certain is the company’s access to credit in even the worst market environments?
How certain is it that the company’s borrowing cost will stay exceptionally low?
How certain is it that the company’s expense ratio will stay exceptionally low?
How certain is it that the company’s charge-offs will stay exceptionally low?
Uncertainty about any of those 4 things is the risk in Farmer Mac – not the leverage ratio in
itself.
To put this another way, yes Farmer Mac has so much leverage it could quickly demolish a lot of
book value if something went wrong. But, if the company’s business model remained intact – it
also has so much leverage it would quickly earn its way out of the hole created by that loss.
The thing to focus on is the earnings engine and whether it remains intact. Is that spread – we’re
talking yield on the assets less borrowing costs, expenses, and charge-offs combined – almost
certain to stay positive?
If so, you’re almost certain to do well in Farmer Mac stock. If not – there’s a real chance of the
stock going to zero at some point.
An investor interested in Farmer Mac should spend 95%+ of his time worrying about the risks.
Ninety-five percent of your time thinking about risks. That leaves only 5% to think about
everything else.
Don’t you need to worry about valuation, future growth, etc.?
No. You don’t. And we can see why with some numbers here…
Dividend Yield: 3.7%
P/E ratio: 8.2
Payout ratio: 30%
Long-term asset growth (historical): About 10% a year
Long-term asset growth (management’s plan): About 10% a year
There are two ways of thinking about this. One, let’s assume you are intending to buy and hold
Farmer Mac forever. Okay. We can cross out the P/E ratio then. What you are getting is a 3.7%
dividend yield that will grow at 10% a year. That’s too cheap. It’s far too cheap. You’ll beat the
stock market, bonds, etc. if that turns out to be true.
Let’s look at it another way. You’re not a true buy and hold investor. You are just going to buy
today at an 8.2 times P/E and sell in 10 years. In 10 years, the stock will be priced at a “normal”
(for stocks generally) P/E of 15. Take today’s EPS of $8.76 a share, compound it at 10% a year
for 10 years, capitalize it at a 15 times multiple – you get a 2029 stock price of $341 versus
today’s $75 stock price. That would give you a compound annual return from capital gains of
16.4% a year. The dividend yield adds 3.7% a year (and that would actually grow – but, let’s
pretend it won’t here). That’s a 20% total return over 10 years. If we’re wrong and the company
grows 5% instead of 10% – honestly, that can’t change the buy decision. Lower growth would
mean a higher payout ratio. And even without a higher payout ratio – if the stock did reach a P/E
of 15 after 10 years, you’d still have a 15% a year annual return. When you find a stock where
you can be wrong for 10 years and still make 15% a year – you should buy it.
So, how can we come up with a scenario where Farmer Mac stock returns less than 10% a year
over the next 10 years?
It’s actually pretty hard to think of a reasonable scenario. Here’s why. The P/E is 8.2. If the P/E –
without any earnings growth – ever just goes from 8.2 to 15 over 10 years, that’s a 6% annual
return from the multiple expansion. The dividend is nearly 4%. The nominal value of the
agricultural mortgage market grows over most 10-year periods. It’s possible this stock could
return about 10% a year over 10 years without growth. And yet it’s almost certain Farmer Mac
will grow.
My point is that it’s not worth thinking about whether this thing will return 10%, 15%, or 20% a
year over 5 years, 10 years, or 15 years. If the stock survives the risks inherent in this business
model – it’ll keep doing something like that. And something like that will beat the market.
The risk here is not that Farmer Mac stock returns 7% a year while you own it. The risk here is
that Farmer Mac stock one day goes to zero.
It won’t be tomorrow. But, Freddie and Fannie were good businesses that made investors –
Warren Buffett included – very, very rich up through the 1990s. If – however – you held the
stocks through the financial crisis – you lost everything.
There’s certainly nothing inherent in being a government sponsored enterprise with a mortgage
portfolio that means you will fail. There shouldn’t even be anything in that business model that
means you will be a high risk stock. The actual idea behind the business is not high risk.
But…
Having the ability to borrow at nearly the same rate as the U.S. government means you will have
access to low cost funds you can use to achieve high returns on equity by buying low yielding
assets. This is the risk. And it’s not unique to companies with some sort of implied government
support. Any public company with a triple-A credit rating or near triple-A credit rating could fall
into the same trap. A couple did. AIG’s credit rating contributed to its mistakes. And GE’s credit
rating allowed it to – from almost the moment Jack Welch became CEO till today – keep
increasing the financial risk it was taking.
Ironically, anything that is perceived as so safe it won’t default on its bonds can become risky
from shareholders precisely because it can borrow so cheaply. It’s not that these kinds of
companies have anything special about them that makes them risky. It’s that anyone who is
given nearly unlimited access to low cost funding for a very, very long time will eventually
stretch to do slightly less and less safe things.
Now we can talk about the real risks I see with Farmer Mac.
The company has a long-term plan to grow EPS at an above average clip. Whenever a financial
institution does that – you need to be worried. Trying to reach that goal – especially trying to
reach it consistently – can lead to making numbers up, doing this outside your circle of
competence, and basically just incrementally taking on a little more risk each year. I don’t like
the long-term financial goals here. I’d rather they not share any growth goals with investors.
None of the people at the top of the company have been with Farmer Mac very long. Some have
been in the industry. And I didn’t talk about what the “industry” is here. But, basically there are
other entities quite similar to Farmer Mac in terms of what they do. Farmer Mac does not have a
big share of the agricultural mortgage market. It’s maybe like 10% right now. Top executives
have been with Farmer Mac for only like 1-6 years. The CEO is very, very new.
I really don’t like seeing a lot of outsiders at a financial company.
Finally, nothing about the company’s management makes me think they are all that conservative.
They definitely want to do well for shareholders and get the stock price moving. They are aware
they trade at a big P/E discount (like 30-50% probably) to other mortgage type companies. They
even talked about how part of the reason they raised their dividend payout ratio to about onethird is to better match other bank stocks.
I don’t like any of this.
It’s not the business model that bothers me. It’s having no real long-term insight into the culture,
the people, the degree of conservatism etc.
I’m going to wrap up this initial-initial interest post here. It’s very, very early in my look at
Farmer Mac.
I haven’t gotten into actually describing this business very much. I did that on purpose. I think
breaking down exactly what Farmer Mac does – rural utility loans versus USDA loan guarantees
versus outright purchases of first lien farm and ranch mortgages, etc. – is far too complicated and
far too distracting to get into in a first post on this company.
The general idea of unbelievably high leverage used to borrow cheaply and lend a little less
cheaply with virtually no charge-offs and virtually no day-to-day expenses while matching the
length of the borrowings and the length of the lending against each other is what we need to
focus on here. And the fact that Farmer Mac is like Freddie Mac. And that Freddie Mac is both a
company that made people like Warren Buffett and Peter Lynch a lot of money and cost many
more investors all that and more a couple decades later. The situation here is similar to that.
Farmer Mac is priced way, way too cheap if it doesn’t do risky things. The company’s return on
retained earnings is going to be much, much higher than at other banks. It should trade at a
higher P/E than banks do – not a lower P/E.
But…
It could also go to zero eventually. The “eventually” part is key. You have to watch something
like this for drift in strategy, risk-taking, etc.
To sum up: Farmer Mac is clearly an above average business at a below average price.
But, it might turn out – in the long-run – to be a lot more risky than most businesses.
For now I’d rate my initial interest level at 50%.
Personally, I will not be researching this stock any further.
Why not?
Is it the riskiness?
No. It’s the visibility of the stock. I manage accounts that follow an “overlooked stock”
approach. I only buy stocks I think are overlooked. I buy the best businesses I can find. But, I
only buy the best businesses I can find that I truly believe are “overlooked stocks”. I don’t look
at Apple, Amazon, Facebook, Netflix, etc. no matter how good I think those businesses might be.
Stocks in the accounts I manage currently have annual share turnover ratios – basically, the
number of shares they trade in a year relative to their total shares outstanding – of between 2%
and 65%. Put another way, their shares “churn” somewhere in the 18 month to 50 year range.
Obviously, a stock with a 50-year “churn” is something almost entirely owned by founders who
never sell the stock. Individual investors never hold something that long. But, some patient
outside investors in overlooked stock do hang on to shares for an average of 18 months or so.
This is not true of most U.S. companies. And it’s not true of Farmer Mac. The stock has churned
about 100% this last year. On average, shares are being flipped once per year. That’s not the
highest churn rate out there. The stocks I mentioned before – the Apples and Facebooks and such
of the world – get traded even more rapidly than that.
So, for me, something like Farmer Mac is a pass.
I focus on overlooked stocks. And I’m not interested in putting managed account money into
stocks where there’s an active market of traders flipping the stock frequently. As a rule – that’s
not a good way to find inefficiently priced stocks. The market cap here – at about $750 million –
is also far from a micro-cap.
So, this one is a pass for me. The stock is too big and too actively traded.
This is not an especially overlooked stock. Considering what it does, its size, etc. – yes, it’s
overlooked. I think only one analyst covers it.
For an $800 million market cap stock on the NYSE – yes, Farmer Mac is “overlooked”.
But, compared to the stocks I own in the managed accounts – no, Farmer Mac isn’t an
overlooked stock.
Geoff’s initial interest: 50%



URL: https://focusedcompounding.com/farmer-mac-a-k-a-federal-agricultural-mortgagecorporation-agm-the-freddie-mac-of-farms-and-ranches-has-a-p-e-below-9-and-an-roeabove-most-banks/
Time: 2019
Back to Sections
-----------------------------------------------------
Alico (ALCO): A Florida Orange Grower Selling Land, Paying Down Debt,
and Focusing on its Core Business
Alico (ALCO) is a landowner in Florida. The company is – or is quickly becoming – basically
just an owner of citrus groves that produce oranges for use in Tropicana orange juice. The
majority of the land Alico owns is still ranch land. The company has about 100,000 acres in
Florida. Of this about 55,000 acres are ranch land and 45,000 acres are orange groves. The book
value consists almost entirely of the actual capitalized cost of the orange trees on the land. The
land itself – with a few exceptions caused by recent purchases – is held at unrealistic values on
the balance sheet. For example, the company has sold ranch land at more than $2,500 per acre
that was carried on the books at less than $150 an acre. So, the situation here is similar to two
other stocks I’ve written up in the past: Keweenaw Land Association (KEWL) and Maui Land
& Pineapple (MLP).
There is one write-up of the stock over at Value Investors Club. You can go over to VIC and
read that write-up. It gives background on the history of the company that Alico itself doesn’t
really talk about in either its 10-Ks or its investor presentation. The company has recently tried to
get its story out to investors. There is now an investor presentation. There have also been a
couple quarters of earnings calls.
The investor presentation has a slide that includes the company’s estimate of the fair value of the
land it owns versus the enterprise value. On this basis, the stock looks cheap. However, it doesn’t
look incredibly cheap. And I’m somewhat unsure whether a value investor should look at the
stock as just a matter of enterprise value versus likely market value of the land. But, I’ll start
there, because other write-ups of the stock will almost certainly be focused around that investor
presentation slide that lays out the company’s enterprise value versus the likely fair market value
of the land.
ALICO owns 55,000 acres of ranch land. (For the purposes of this write-up, I’m using some out
of date numbers not updated for land sales and cash receipts – however, they basically would just
net out: less land, more cash / less debt). The company puts an estimate for fair value of that land
at $2,000 to $3,000 an acre. Ranch land I’ve known of in other places goes for similar amounts
to that. About $1,000 to $3,000 an acre. The company has sold plenty of ranch land recently.
And much of it has been sold in the $2,000 to $3,000 range. So, that implies a pre-tax value of
$110 million to $165 million for the ranch land. However, almost all of any land sales not put
into a “like kind” asset to defer taxation will end up taxed at very, very high amounts because
nearly 100% of the sale will be a capital gain. Also, some of this land seems to me to be
encumbered with debt. Alico isn’t totally explicit about what land is encumbered with debt and
what land isn’t. The company does give the total amount of debt that has land as collateral
backing it. It gives this number in both acres and in dollar amount (of the loan). However, it does
not break out what lending is backed by citrus groves and what lending is backed by ranch land.
So, it’s possible – this is just me guessing – that in some cases, Alico may not be allowed to use
proceeds from certain land sales for anything but debt repayment and possibly the purchase of
additional land (that the lender agrees to).
My interpretation of the borrowing / asset situation here is a little different. I think, basically, the
ranch land and the debt are “non-core” and they basically cancel out. Alico sees itself as an
orange grower and is moving in that direction. It is selling off ranch land at the same time it is
buying orange groves. It also did a deal in the last year to start managing an orange grove (7,000
acres – I believe these are “net” acres that actually produce oranges, there are probably support
acres not counted in this) on behalf of another landowner in Florida.
Why do I say the ranch land and the borrowing offset? One, they are probably pretty close in
terms of net debt versus value of the ranch land. Both could be around $150 million. Two, it is
not difficult to borrow long-term against orange groves. The company is already borrowing longterm (it’s about 2/3rds fixed rate borrowing and 1/3rd variable rate borrowing) from Met and
Prudential. Based on other “permanent crop” agricultural loans I’ve seen and what this company
has historically borrowed at – I think the fully leveraged “cost of capital” for the orange groves
would potentially be long-term fixed rate borrowing at 3-4% after-tax (so, a bit higher pre-tax)
equal to about one-third of the fair market value of the groves. I think you’ve definitely got
additional borrowing capacity whenever your total debt / fair market value of orange groves is
under 30%. The company says the groves are worth $8,000 to $10,000 an acre. So, it’s probably
possible to borrow like $2,500 to $3,000 per orange grove acre at like 3-4% after-tax on a
continuing, long-term (and effectively permanent) basis. One warning: when you re-borrow,
you’ll be paying whatever long-term rates of interest are at that moment.
I mention this because it’s unclear the company intends to operate with like no leverage if it sells
off the ranch land. I think a lot of people looking at the situation would say the company is
selling off ranch land and paying down debt. This is true. But, I don’t think it’s a liquidation. We
can see some sold land is encumbered (that’s mentioned at times). And the company sometimes
has “restricted cash” that seems to be tied to the land sales. I think a realistic long-term view of
the company’s future progression would be to assume ranch land is sold off over time and the
proceeds are put into citrus grove purchases where possible and then to debt repayment to the
extent no tax-deferrable “like kind” purchase can soak up the capital freed up in the land sale.
This could take a very long time. But, for a long-term investor, the state the company will
probably get to is one in which it has sold off the ranch land and paid off the debt.
Having said that, I don’t assume that an orange grove operator would use no leverage. But, I also
don’t think it’s safe and cheap to operate with more leverage than about 1/3rd of the value of the
groves. After that, you’re just like any other corporate borrower. At low loan-to-vale ratios, you
have a lot of collateral to borrow against even if you’re an otherwise weak credit. So, over time,
it may be that not all the debt is ever paid off. However, the debt will eventually be repaid and
re-borrowed in a way that shifts the ranch land off the books and shifts whatever debt remains to
being tied to the orange groves.
So, I don’t think a liquidation analysis shows you what you’re really buying here.
Another point to mention is the dividend. Alico has paid a dividend for close to 50 years now. It
started upping that dividend a bit in recent years. And then it upped it a lot recently. Alico isn’t
doing special dividends, buybacks (except for one really big tender it did a couple years ago),
etc. So, the decision on the regular dividend rate is probably tied to the cash flow from the
orange groves. The ranch land produces essentially no income. My best estimate based on
looking at segment reporting is that ranch land produced $1 million to $2 million in EBIT at
times. However, the company discloses one aggregates lease, one oil lease (it owns the mineral
rights under its land for about 90% of its acreage) and some grazing rights leasing. I don’t think
the grazing rights leasing contributed any real income. The company says the mining royalties
aren’t “material”. But, something did produce some cash flow which might be immaterial at the
corporate level but explain the small production of income from ranch and other non-citrus land
we’ve seen at times. As best I can tell, whatever recurring income was coming in from the land
subsidiary (as opposed to the citrus subsidiary) has been due to some other leases – probably
“mineral rights” which may be aggregate mining or something else like oil, etc. There had been
plans for a water project. However, the company abandoned those and sold the land it would’ve
needed to complete that project. So, forget the water stuff you’ll read about in the Value
Investors Club write-up of Alico. That’s dead.
As a result: I think we can basically remove whatever EBIT we’ve seen from the ranch land
(again, it’s minimal) and remove the debt and remove the ranch land.
This leaves just an orange growing operation on the “value” side of the equation and just the
market cap (forget the debt, so EV doesn’t matter) on the “price side”. Market cap is $230
million. There’s 45,000 acres of orange groves. So, $230 million / 45,000 acres = $5,100 an acre.
This is less than the company says the land is worth ($8,000 – $10,000 an acre). The market cap /
fair market value of the citrus land is therefore theoretically 50-65%. There’s Ben Graham’s
famous “one third margin of safety”. And that’s why value investors might get interested in this
as an “asset play”.
But, let’s talk about it as an actual business.
Customer concentration is extreme. However, I don’t think it’s relevant. The company sells 90%
of its output to Tropicana under 5-year type contracts. These contracts aren’t very meaningful in
my analysis, because I’m assuming Tropicana is the most logical customer for Alico and Alico is
one of the most logical suppliers for Tropicana. These are commodities. And the contracts are
not very fixed. The contracts probably just codify the likely microeconomic situation anyway.
The way these contracts work is that a market price (at the time the contract is signed) for
oranges sold per pound of useable material (pounds solid soluble) establishes a price range that is
fixed. Outside of this price range, Tropicana and Alico are basically sharing 50% of the rise or
fall in the market price of oranges per pound.
You can find current and historical pricing, production, estimates for next season, etc. at the
USDA. You can calculate Alico’s cost structure for yourself using cost of goods sold and pounds
sold from the company’s 10-K. I’m not going to go over those numbers here. Instead, I’ll focus
on something you might miss under GAAP accounting.
What’s more important is the way Alico’s cost structure differs from the contract structure. The
variable cost of producing oranges for orange juice is low. My best guess is that no more than
30% of the cost of Alico’s product is actually tied to factors like production levels. About 70% of
the “cost” Alico shows in its per pound numbers, cost of goods sold, etc. is really a fixed cost of
operating the groves. The 10-K has a line that is super explicit about this point. The groves cost
what the groves cost. It is only costs like hauling that vary with production levels. So, if no
oranges were sold in any one year (which will never happen, but bear with me), the company
would still show an expense equal to about 70% of its cost structure. So, the variability of pricing
and production levels of oranges is greater than the variability built into the contract. In other
words, Alico’s earnings are cyclical and are tied to the amount of revenue it can generate at
market prices for its oranges each year. The revenue depends on quantity of output (which varies
a lot depending on weather conditions during the year) and the market price of oranges. The
market price of the oranges depends on inventory levels for oranges, exports of oranges from
Brazil to the U.S., exports of oranges from Mexico to the U.S., and the level of oranges produced
in the U.S. (basically in Florida, though California and Texas probably produce some oranges
too).
Due to COVID, not from concentrate (the type of orange juice Tropicana produces and Alico is
an input for) demand rose and orange juice demand continues to be at an elevated level. COVID
didn’t disrupt the orange harvest. But, production declined a bit for weather reasons. Obviously,
production can’t be increased for oranges the way it can be for commodities planted each year.
An orange tree has to be planted about 4 years in advance of producing any fruit. Production then
peaks around 8 years after planting. The tree continues to produce. Based on the way Alico
depreciates its groves, it seems like groves have up to a 25-year producing life (and almost 5year non-producing life). As a result, increases in demand and decreases due to weather move
the price for the oranges. Demand moves instantly. But, there can’t be any immediate adjustment
in supply.
The one thing I would worry about here more than contracts with Tropicana is tariffs. The U.S.
has tariffs on orange juice imports from other countries. So, the competitive position of oranges
grown in Florida versus oranges grown in Brazil does depend in part on political decisions inside
the U.S., trade negotiations, etc. This is not a totally free market.
Alico has done a couple things recently that might increase earnings of the groves. It cut
operating expenses a few years ago. It also started planting more than a normal amount of trees.
So, the cap-ex you’re seeing is not all maintenance cap-ex – some of it is growth cap-ex. This
started a couple years ago and is going to continue for another year or so. This cap-ex – the
GAAP element to this is capitalized and then depreciated over many years – will only drive
additional production 4 years after the planting. And the impact of the additional plantings will
peak about 8 years after the original investment.
With any real estate backed stock like this you want to ask how much “owner earnings” really
are absent capital appreciation. Sure, if there’s a lot of inflation and the groves are worth $8,000
an acre – at 10% inflation, the land value is producing $800 an acre in capital gains. You’ll do
fine. But, what if there isn’t much inflation in land values. Or, what if you have to compare an
asset play like Alcio to a good business you could buy instead.
Then, the question becomes…
Are you really earning a decent cash “rent” while you own the land?
What is the cash owner earnings value of the crop itself?
This is hard to tell. EBITDA is not low. It’s been around $25 million at times. It could be higher
once recent plantings mature. However, the “depreciation” part of this expense is somewhat real.
The groves – this includes roads and water infrastructure and other stuff needed to support the
actual productive acreage – has an original cost on the books of $300 million. Even if you
depreciate $300 million at a 30 year lifespan, that’s $10 million of annual depreciation. And,
with some inflation, the cost of replacing groves is actually higher in future years than the
original (nominal) cost you’re depreciating. So, EBITDA here is not like EBITDA on an
apartment or even – I’d say – on timberland. It’s more real than that.
You could try to measure free cash flow. But, that’s very cyclical. Both pricing and production
move by 20% or more in a given year. And cap-ex is very discretionary. You can under-plant or
over-plant for a few years and not see the full impact of that for 4-8 years. You could trust
management. You could look at plantings in one year versus another. But, really, if you’re not an
expert on this – and I’m not – it’s going to be hard to calculate normal, average, “full cycle”
annual free cash flow.
There are some hints about the productive value of groves in cash terms. If you look at the deal
Alico signed just to manage orange grove acreage for a competitor – the management fee
charged is like $170 per acre per year. That’s my estimate. Alico just says it is reimbursed for all
costs and then gets a management fee. But, we can see EBIT from this operation is $300,000 per
quarter and they are managing 7,000 acres – so, $300,000 / 7,000 acres = $43/quarter which is
the same as $172 a year.
If you’re willing to pay someone $170/year to manage your apartment building, your hotel, your
timberland, your farmland, etc. – then, the underlying asset is probably capable of producing
quite a bit more than that. This suggests – and the warning here is AT CURRENT INTEREST
RATE LEVELS – that a value of $8,000 to $10,000 per acre may be consistent with the actual
underlying cash flows over a full cycle. However, it’s certainly not clearly cheap. I mean a
management fee – basically guaranteed profit – of $170 on something valued at $8,000 or more
is just 2% of the asset’s value. Is a 2% of asset value management fee reasonable – yeah, it might
be. The land might be worth $8,000 – $10,000 and also be capable of producing a decent yield at
that market price. For example, if the owner is making a 60/40 split with the manager here –
that’s a 6% annual pre-tax yield, an 80/20 split is even better, and so on. I mean, the management
fee does seem somewhat in line with the market values Alico is claiming.
However, “somewhat in line to me” doesn’t really afford any precision sufficient to promise we
can tell the difference between the land being worth $10,000 or $5,000. And that’s your entire
margin of safety in the stock right there. Also, I do need to make the warning that Alico has
bought some orange acres at less than $8,000. Some acres have gone for closer to $5,000. I don’t
know if those were smaller and less efficient acres, if they were less dense groves, etc. But, it’s
not like we’ve never seen evidence of a purchase price below $8,000 per acre for orange groves
in the area – we have.
So: is the stock cheap?
It doesn’t look especially cheap now. It may be cheap versus earnings in a good earnings year.
We might see a good earnings year next year. It is cheap versus the company provided fair
market value of the land. But, I don’t think this thing is liquidating. So, this isn’t like buying a
dollar for 65 cents.
Is the business good?
Depends. I think the business is getting better here. The company – there’s a whole past history
with a group of investors, lawsuits, a dissolution of a partnership that controlled a lot of the
stock, changes in the board, etc. I’m not getting into – has a strategy it’s executing on that seems
much smarter than what Alico had been doing historically.
Is the asset good?
In times of inflation, yes. In times of no inflation, maybe not. I don’t know if the orange business
here can match returns in more asset light and better situated “franchise” type operating
companies. Things with moats. Things with good returns on capital. Actual free cash flow
producers.
But, is it a better investment than a lot of real estate?
That’s possible. This could be a better way to own real estate than a lot of publicly traded
vehicles. There’s a real cash generative business on top of the land. The company is narrowing
its operations and focusing on operational efficiency in one product in one small part of the
country. It is managing as well as owning. It’s a real operator.
Alico doesn’t look super cheap. But, for a publicly traded land play, it’s not expensive relative to
your other options. And capital allocation is moving in the right direction.
The company is doing a big investor relations type push. The management – you can listen to the
calls – is really talking up the company, giving guidance, etc.
The stock is kind of under the radar now. It might not be in the future.
At present, I have no real view one way or the other on management. I have looked into the
history of the people involved in this one. But, that’s not a topic I feel I know enough about to
talk intelligently on.
Alico might be a stock to keep an eye on. Like I said, it’s very cyclical. And investors might get
overly excited or depressed in years where both pricing and production happen to move in the
same direction.



URL: https://focusedcompounding.com/alico-alco-a-florida-orange-grower-selling-landpaying-down-debt-and-focusing-on-its-core-business/
Time: 2021
Back to Sections
-----------------------------------------------------
A-Mark Precious Metals (AMRK): A Dealer and Lender in Physical Gold
A-Mark Precious Metals (AMRK) has been written up twice at Value Investor’s Club. The most
recent time was this year. You can read those write-ups over there. It was this most recent writeup at Value Investor’s Club that got me interested in the stock. However, it was for different
reasons than that write-up itself lays out as the case for buying the stock. The VIC write-up
focuses on how low volatility in the price of gold (and silver and other precious metals) in recent
years means that A-Mark has under-earned in each of the last 5 years or so. Having looked at the
company now – I’d say that’s possibly true. A-Mark says many times in its SEC filings that it
benefits from increased volatility in the physical markets for precious metals. The company also
says that the price of gold – rather than how much that price bounces around – doesn’t much
matter to the company’s results. I’m less sure of this second point. There is one activity that the
company engages in where I feel high (and continually rising) gold prices would be a benefit and
low (and continually falling) gold prices would harm the company. Since I mentioned
“activities” – let’s talk about what acts A-Mark actually engages in.
The best way I can describe this company is as an investment bank (really, a “trading house”)
focused on physical precious metals. That word “physical” is important. We are talking about the
buying, selling, storing, shipping, minting, lending, and many other things of actual physical bars
and coins of gold, silver, etc. The business is almost completely U.S. It seems 90% of profits
probably come from the U.S. I say “seems” and “probably” because of some difficulty in using
traditional accounting measures when looking at a company like this. A-Mark is a financial
company. It really is a highly leveraged and fully hedged – or as near as fully hedged as it can
get – trader in a market. As a result, an accounting line like “revenue” is meaningless. The
company reports revenue. But, revenue doesn’t matter. The first line on the income statement
that is worth paying attention to is “gross profit”. Gross profit at A-Mark is always less than 1%
of revenue. Usually it’s quite a bit less than 1%. This makes typical SEC requirements to
disclose revenue stuff useless. For example, does A-Mark have high customer concentration? We
don’t know from the 10-K, 10-Q, etc. There’s a line in the 10-Q that says about 50% of revenue
comes from two companies: HSBC and Mitsubishi. However, this is just hedging activity.
Because of how A-Mark’s accounting works, you could list big “customers” as just entities they
are making sales to in the form of hedging activity that will never be settled with physical gold
and will never result in any gross cash profits for A-Mark (on their own). So, it may be that
around half of the revenue line you are seeing is hedging done with HSBC and Mitsubishi. But,
that doesn’t help us understand A-Mark’s business. The amount of sales they make – and,
remember, I think these particular sales to those big banks would never result in physical
delivery of any gold or other metals – are just the end result of how much business they are
doing with their actual customers. We’re seeing the other – hedging – side of their real business.
This bit about HSBC and Mitsubishi isn’t important. It’s just a digression I’ve included here to
make very clear that you can’t rely on comparability between A-Mark and any other public
company financials you’ve ever seen. You can’t go to a site like quickfs.net and look at the last 5
years of financial results and think you really know what happened with revenue, margins,
returns, etc. It’s a lot more complicated than that. And you have to break the company down
yourself.
I think A-Mark can be broken into 3 parts. One part is “GoldLine”. This is probably the part
anyone reading this is most likely to be familiar with. GoldLine has historically run a lot of
cheap TV ads, radio ads, etc. trying to sell gold directly to American households. The business
was supposedly EBITDA positive almost all the time before being bought by A-Mark. It’s
currently losing money. The consolidated results you see for A-Mark include losses at GoldLine.
The business was acquired recently by A-Mark. It may be disguising some of the earning power
of A-Mark overall. I generally like to see stocks where there is one business segment losing
money. This sounds counterintuitive. But, it’s usually the easiest thing a company can fix. If you
stop putting money into the loss making business, you sell it, you liquidate it, or you turn it
around – profits suddenly jump. A lot of investors screen for low P/E, low EV/EBITDA, etc. and
for high ROIC, ROE, margins, etc. Well, screeners combine all business segments in a
corporation when showing you results. So, a stock with 2 great businesses and one terrible
business can sometimes keep it off screens. I had success buying into Babcock & Wilcox –
which later became BWX Technologies – when it had one great business, one mediocre
business, and one speculative money losing start-up. The company shut down the start-up and
broke the rest of the company in half. The result was a very rapidly rising share price at the great
business. Very little changed. It was really the same business before and after. But, people
actually valued the great business alone higher than they had been valuing all the parts together.
Is A-Mark going to break up? No. But, it has already started slashing operating expenses at
GoldLine. We’ll see if GoldLine was a dumb acquisition or not. But, overall – a lot of what the
company has been doing in terms of what they’ve acquired does make a lot of strategic sense to
me. Whether or not it was done at good prices is hard for me to tell at this point. But, the
company does seem to stick very, very much in the center of its “circle of competence”.
Everything it does is focused in some way on being a dealer in physical precious metals.
So, GoldLine is the money losing business. What are the 2 money making businesses? One is
what I’ll call the trading business and the other is what I’ll call the lending business. A-Mark
calls them “trading and wholesale” and “secured lending” (or something like that). For this part,
I’m not going to go into a lot of detail about what I personally would pay for A-Mark. I’m just
going to trty to take a stab at what the company might be valued at in a more general sense.
Given today’s corporate tax rates – up to 79% of pre-tax income can convert into after-tax profit
at a U.S. corporation – I’m going to assume that a business could be worth 12 times pre-tax
profits. This is equivalent to a P/E a bit over 15. Of course, a company could deserve a P/E as
low as like 10-12 or as high as 30-35 depending on other factors like what the return on
shareholder’s money is, whether it’s growing, etc. For me, these are difficult to calculate for AMark right away. Knowing what normal leverage and normal profitability is – given the fact that
volatility in precious metals markets influences the company’s profitability – would be tough for
me to figure out this early in the research process. So, I’ll start by just describing these
businesses as best as I can understand them and then slapping some very rough multiples on
them and seeing if that is anywhere near the current stock price.
Okay. So, secured lending. This is the business that interested me the most when I read about it. I
compare it to margin loans on physical gold. The company has not had any loan losses in this
business segment, and – given how they describe the loans – I don’t see any reason why A-Mark
should ever have meaningful loan losses in this business absent something like fraud, employee
misconduct, etc. These loans yielded 9-10% in the last year or so. You can see why I focused my
attention on this segment first. A business that can lend at 9-10% with theoretically close to zero
risk of loan losses should be an attractive business.
A-Mark buys (60% of the loans in this segment were acquired from other lenders) or originates
(40% of loans were made by A-Mark itself) short-term loans backed by gold bars and gold coins.
These loans are made at a loan-to-value ratio that’s low compared to the marketability of the
collateral (hence the lack of loan losses). The company often makes loans that amount to 50% to
85% of the value of the gold. A-Mark claims it is using the liquidation value of the collateral
when making this calculation. If so, it’s possible that the loan-to-“retail” value for the coins is
quite a bit lower than the bars. A-Mark has physical custody of all the collateral. Margin calls
usually occur at 85% loan-to-value ratios. These loans vary in length from 3 months to 1 year
and vary in size from $15,000 to $10 million. If you look at the results A-Mark puts out about
growth in various business segments – it’s clear that a lot of these loans end up getting closed out
through liquidation of the underlying collateral. There are a lot of margin calls. This is the
segment I think may be more tied to higher and rising gold prices than A-Mark claims. As gold
prices fall – a lot of collateral calls occur, A-Mark closes out more loans than clients open, etc.
As gold prices rise, there is more and more collateral value to borrow against. Basically, the
borrowing capacity of A-Mark clients should widen as gold prices rise and shrink as gold prices
fall. This is the one long-term aspect of A-Mark’s business that seems unhedged to me. My
thinking right now is that one business segment – trading – is influenced by volatility. Another
business segment – lending – is influenced by gold prices and nominal interest rates. Very high
nominal interest rates, very high inflation, very high gold prices, etc. would probably be good for
the “secured lending” business at A-Mark. The reverse – low nominal interest rates, deflation,
low gold prices, etc. – would be bad. A-Mark has about 7 million shares outstanding. Recently,
“lending” has made about $2.2 million or so on average in net interest income. If we capitalize
that at 12 times, we’d get $26.4 million in value. Divide $26 million in value by 7 million shares
and you have $3.70 a share in value from lending. Even if we said – okay – it might be worth $4
a share, we have a problem. The stock is trading at $11 a share. If the business segment I like
most is only worth $4 – that means at least two-thirds of the business value (just to get me a 0%
margin of safety) is in a business segment I have less confidence in.
That business is “trading”. This is the part of the business that might benefit a lot from higher
volatility. I’ve now read a lot about this segment. I know what it does. But, I don’t know how to
decide what “normal” earning power is here. If I had an extremely long record of financial data
for the business unit I could compare it to volatility in gold prices in any given year and come up
with estimates. It’s easy to get gold price data for all years. So, I can easily calculate normal gold
price volatility myself. But, I can’t correlate it with A-Mark’s trading unit profitability without a
longer record. For that reason, I’m just going to take the most optimistic look at the last 2 years
of results. If I exclude interest income and interest expense as well as “other” items and just take
the last 2 years of gross profit less the last 2 years of SG&A and then average them – I get a
figure of about $6 million per year. That’s probably an overly optimistic estimate of the earning
power of this trading unit in years like 2017 and 2018. There is enough data to calculate
EBITDA for this business unit – but, I’m not sure the D&A should be fully excluded. Cap-ex is
similar to “D&A”. For that reason, I’m just going to say the operating profit at this segment was
about $6 million – on average – over the past 2 years. These were non-volatile years for gold. So,
perhaps “normal” earning power is a lot higher. The per share amount that translates into is $6
million * 12 = $72 million. We then divide by 7 million shares and get $10.28 a share. We got
something like $3.70 for the lending business. So, we add them up and get around $14 a share
for an $11 stock. Not much of a margin of safety. And, unfortunately – 2/3rds of the business
value is in the segment I understand least.
There’s a long corporate history here, a spin-off, a past of some bad corporate governance, etc.
I’m going to skip all that. At this point, A-Mark is a pass for me. It looks fine as a speculative
bet. I tend not to make those. It isn’t correlated at all with stocks generally. If someone really
wanted to own something gold related – maybe this is what they should own instead of the metal
itself. I don’t know. It’s not obviously expensive in any way. It seems cheap enough based on
earnings that are probably lower than average. I don’t have evidence one way or the other of
whether it’s especially safe or dangerous. So, I can’t bring myself to give it my lowest rating.
But, it’s definitely a pass. I’m not going to re-visit this one.
Geoff’s Initial interest: 20%



URL: https://focusedcompounding.com/a-mark-precious-metals-amrk-a-dealer-andlender-in-physical-gold/
Time: 2019
Back to Sections
-----------------------------------------------------
BAB (BABB): This Nano-Cap Franchisor of “Big Apple Bagel” Stores is the
Smallest Stock I Know of That’s a Consistent Free Cash Flow Generator
This might turn out to be a shorter initial interest write-up than some, because there isn’t as much
to talk about with this company. It’s pretty simple. The company is BAB (BABB). The “BAB”
stands for Big Apple Bagel. This is the entity that franchises the actual stores (there are no
company owned stores). Big Apple Bagel is a chain of bagel stores – mostly in the Midwest –
that compete (generally unfavorably) with companies like Einstein Bros Bagels, Panera Bread,
and Dunkin’ Donuts. The company owns certain other intellectual properties like: a brand of
coffee (Brewster’s) served in its stores (which Andrew tells me is terrible, I haven’t had a chance
to taste the coffee myself), “My Favorite Muffin” (a muffin concept similar to Big Apple Bagel),
etc. But, the cash flows seem to come mainly from royalties paid to BABB by franchisees in
proportion to the sales they make. Like other franchised businesses, the company also maintains
a marketing fund that is paid for by franchisee contributions.
Why am I writing about this business? Because I think it may be literally the smallest stock I’m
aware of that is a legitimate and decent business. The market cap is closer to $4 million than $5
million. Insiders own some stock. So, the float is even less. And the investment opportunity is
limited no matter how willing you are to accumulate shares because there is a poison pill. No one
can acquire more than 15% of the company’s shares no matter how patient they are. So, as of the
time I’m writing this, that would mean that the biggest potential investment any outsider could
make in this company would be about $650,000. Realistically, it’s unlikely any fund or outside
investor could manage to put much more than half a million dollars into this stock. And it’s
entirely possible management would not be happy to see even that much being put into this stock
(since that’d be more than 10% of the share count).
So, this is a very, very limited investment opportunity. And yet: it is a real investment
opportunity. This is a real business. You can travel the country eating at each of these franchised
locations. You can call up the owners of the franchised stores and talk with them about the
business. You can read 10-Ks on this company going back a couple decades. The company is an
“over-the-counter” stock. But, it isn’t dark. It files with the SEC. That’s very unusual for a
company with a market cap of less than $5 million. Public company costs are significant. This
company would be making more money if it was private. Management costs are also significant
here too. The CEO, general counsel, and CFO were paid: $250,000, $175,000, and $120,000
(respectively) last year. That adds up to $550,000.
They own 33% of the stock. I mention this because if we compare the value of the stock they
own to the value of the salaries they draw – it’s true they are owners, but their position as
managers may be more valuable to them. Take the CEO. He owns 20% of a stock with a total
market cap of less than $5 million. So, he has wealth of less than $1 million in stock in the
company. Meanwhile, he is paid $250,000 a year by the company. If we capitalize his salary at
say 8 times – so, $2 million – his incentives should be titled a bit more toward keeping his job
than compounding his wealth. And he is the biggest shareholder at the company.
This is also very, very unusual for a very, very small company. Tiny companies usually have
very big shareholders who have way more invested in the future success of the business than
they could reasonably get back in yearly salaries. That’s not the case here.
The business is obviously very free cash flow generative before we get to this corporate layer
where you have public company costs, compensation of people who are also major shareholders,
etc. It’s important to separate this stuff out to get a better feel for things like what a management
led leveraged buyout would look like. What are the core economics of this business?
The company’s “cash flow from operations” basically converts directly to free cash flow. This is
not unusual for a company like this. It’s basically just an entity that collects a perpetual royalty
on already franchised stores. They do license (or franchise) additional stores sometimes. But,
they don’t build company owned stores. They lease their headquarters. And they don’t have
much in the way of equipment needs, etc. at HQ. So, CFFO basically equals FCF. Last year’s
CFFO was $430,000. The year before was $390,000. Let’s call that $400,000.
At the end of last quarter, the company had 7.3 million shares outstanding. So, $400,000 in FCF
divided by 7.3 million shares equals 5 cents a share in free cash flow. The stock trades at 60
cents a share. So, 12 times free cash flow. For a fast food franchisor – that’s cheap. It’s a little
cheap for any stock really. You don’t find many stocks trading below 15 times truly free cash
flow. To illustrate, 5 cents divided by 60 cents is an 8.3% free cash flow yield. The company’s
current assets exceed its liabilities. A constant royalty stream on what’s basically a fast food
business is a pretty safe form of free cash flow. And there are no securities senior to the common
stock. So, getting a yield of more than 8% a year in BABB common stock seems a lot better
protected than other ways of earning 8% a year.
Now, the actual dividend yield does not perfectly match the free cash flow yield as I’ve
calculated it. But, it’s very close. BAB paid out about $360,000 in dividends in 2018 and about
$440,000 in dividends in 2019. If we average the two, we get about $400,000 a year in
dividends. If we divide that into the 7.3 million shares outstanding – we get an expected dividend
of about 5 cents. A 5 cent dividend on a 60 cent stock is an 8% yield.
Again, this yield is well protected in some sense. It’s certainly not rock solid. But, compared to
other things you can buy that will pay you 8% in cash on your purchase price this year – this is a
financially solid entity you’re buying into. For example, cash on hand is $1.1 million using
unrestricted cash only and $1.5 million including restricted cash. That’s 15 cents to 21 cents a
share in cash. That is not – however – what I’d call net cash necessarily. The company does have
some liabilities. But, current assets exceed total liabilities by $400,000. There is, therefore, no
reasonable argument to be made that the company has less than 5 cents a share in truly surplus
cash. And it probably has a lot closer to 15 cents a share.
Why?
Because the company’s liabilities are really cheap, safe, and slow to run-off forms of liabilities.
The single biggest liability is the marketing fund. The company has received cash from
franchisees to be put toward marketing that it hasn’t yet put toward marketing. This is a liability.
And we could take the restricted cash and net it against this number. I’d consider that fair. That
would leave just the unrestricted cash of 15 cents a share. The only other forms of liabilities are
an operating lease liability and accrued expenses. These are normal expenses that are paid in
cash from each year’s cash flows before we get to the “cash flows from operations” number.
So, if I’m being honest, here’s what I think we have here.
Stock price is 60 cents a share.
Net cash is 15 cents a share.
Free cash flow is 5 cents a share.
So, when you buy this security – you have 25% of the price you are paying immediately backed
by cash on hand. Plus, you get an 8% annual yield paid out to you in dividends. Or, if you prefer
using the “enterprise value” approach – we have free cash flow / enterprise value of 11%. It’s
actually 12%, because I rounded down the free cash flow figure I’ve been giving you. Whatever
it is, we’re talking about a free cash flow yield / dividend yield of over 8% on the market cap and
over 10% on the enterprise value. If you prefer using EV/EBIT – it’s about 5 times.
We are also talking about a business that is very, very small relative to the costs of being a public
company. For example, the company paid $60,000 for its audit last year. I know of a few public
companies that pay $40,000 or less. And this company is an SEC filing stock even though it’s
very, very small even by OTC standards. I don’t know how much could be saved in total by not
being a public company.
I think it’s difficult to model out what this company would look like if its 20% owner (the CEO)
simply became a 100% owner. But, it’d look different. My guess is that he could – in the long
run – extract far more cash from BAB, if he borrowed enough money (like $3-4 million or more)
to take the company private and then eliminated public company costs, etc. and drew his
earnings as an owner (paid himself out 100% of the company’s dividends) rather than drawing a
salary and being just a 20% owner.
However, there would be risks with doing something like that. One, I don’t know that you could
borrow enough money to buy outsider shareholders out. Two, there are enough outside
shareholders to present reputational problems, etc. if you did this. You might actually have to
pay a decent premium to take the company private. Three, this business could deteriorate – and
you might not want to put debt on it.
However, I do want to point out that taking this company private is probably easier than it looks.
Take the market cap. Yes, it’s $4.4 million. However, two insiders – the CEO and the general
counsel – own a third of the shares. So, the real “float” needed to buy out everyone other than the
CEO and general counsel (if they were the team-up taking the company private) is only $2.9
million. Call it $3 million. The company definitely has $1 million in truly surplus cash on hand.
It actually has $1.5 million in the bank. You can borrow dollar for dollar against truly surplus
cash. That leaves $2 million you have to borrow. Free cash flow has been $400,000 lately. So,
that’s borrowing 5 times debt to free cash flow (not EBITDA). And, remember, that’s without
injecting any more equity. The top people at the company have been drawing $150,000 to
$250,000 a year. Presumably, they have some savings. Now, yes, you’d have to pay a premium
to get agreement from shareholders overall. But, this thing does seem to be trading at a price
below where a going private transaction would make sense.
So, am I excited about this opportunity?
Not really.
Why not?
Well, it’s really only going to pay me dividends. I would never be able to influence capital
allocation – there’s a poison pill with 15% threshold – so, you can’t keep cash in the entity. A
franchise system that built up cash inside it and eventually did other stuff with that (while being
publicly traded) could be more efficient than almost any other vehicle for the right capital
allocators. Is current management the right capital allocators?
I don’t think so. I think they’ll just pay out the free cash flow in dividends. Receiving all cash in
dividends is a very sure way of making money. But, it’s not the most efficient way.
If this thing gets recapitalized at some point – borrowing against its stream of future royalites – I
suspect it’ll be to go private, not to reward the outside shareholders with more dividends or some
buybacks or acquisitions of other stuff. So, the fact there is net cash here and no leverage is
definitely a big plus for the value of the corporation. But, it may not be something outside
shareholders can ever benefit from given management is entrenched with the poison pill.
This leaves just a dividend stream.
And while it’s a good dividend stream – this is not something like Pinelawn Cemetery (PLWN)
or even something like Mills Music Trust (MMTRS). This company is subject to intense
competition.
Big Apple Bagel locations face much rougher competition now than they did 20 years ago.
Einstein Bagel and Panera are much more likely to be sited close to some of the franchisees that
are producing a lot of the free cash flow here.
If we assume the median franchised location does about $350,000 a year in sales and the
company gets a 5% of sales royalty fee – that’s a little less than $18,000 from the median
franchised store. The mean sales from a store has to be more like $450,000 and up. But, it’s very
possible the mean could be that high while the median was more along the lines I suggested if
the very top stores do over $1 million a year in sales.
The cushion here for the franchisee – if they only own/operate one location – is very slim. When
I add together the marketing fund, the royalties taken by corporate, and then factor in what’s
likely to be left for the franchisee to draw as a salary, it doesn’t leave more than they’d make
working a full-time job managing someone else’s store or doing a lot of other jobs. And that’s
more along the lines of the “median” franchisee. It’s likely that the bottom half of franchisees are
closer to the edge financially than that.
That’s typical of franchise systems. And I don’t see anything here to suggest that the resiliency
of the remaining Big Apple Bagel locations is a lot worse than other franchised businesses.
However, in places where Big Apple Bagel is up against the likes of Einstein Brothers and
Panera – it’s very clear that franchisees aren’t putting in as much capital as those companies do.
So, the Big Apple Bagel locations are older than the locations of competing chains in the same
area. They don’t get much support or direction from BAB Inc. I didn’t hear negative things from
franchisees. But, I did hear they have a lot of freedom compared to other franchise systems and
they’re mostly on their own. Some are successful. Others less so. But, the way these stores work
– franchisees really don’t have the capital on hand to refurbish and upgrade stores. And it shows.
Stores look old. Equipment tends to be cheaper. This is a small system. The entire Big Apple
Bagel franchise system generates only $33 million a year. Think about that. That’s less than
$650,000 a week spread over 72 franchised locations. We’re talking an average (mean) of $9,000
a week in sales per store. It’s enough to make a living. But, it’s not enough – at the franchisee
level – to actually retain capital and compound wealth through reinvestment.
So, my concern is not that BAB Inc. isn’t doing well financially. It is. My concern also isn’t that
franchisees are doing all that badly. I’ve seen much, much worse economics for the franchisees
than what I’m seeing with a Big Apple Bagel. My concern is that if and when competition
intensifies from the siting of locations of better known, more national, and better funded
competitors – these Big Apple Bagel franchisees won’t be able to put more money into their
stores.
The stores will age further over time. They will fall further behind.
Is this risk more than offset by the high dividend yield, the excellent balance sheet, the surplus
cash, etc.?
Maybe.
There’s a reason other franchise systems trade for many, many times higher multiples than BAB
does. I can’t deny the stock is cheap. But, I am not sure of the long-term competitive position of
the franchised locations that provide all the free cash flow here.
Geoff’s Initial Interest: 50%
Geoff’s Re-visit Price: 35 cents a share



URL: https://focusedcompounding.com/bab-babb-this-nano-cap-franchisor-of-big-applebagel-stores-is-the-smallest-stock-i-know-of-thats-a-consistent-free-cash-flow-generator/
Time: 2020
Back to Sections
-----------------------------------------------------
Flanigan’s (BDL): A Cheap, Complicated Restaurant Chain Focused on South
Florida
Flanigan’s (BDL) is a nano-cap full service restaurant and discount liquor store company. All of
its locations are in Florida. And all but one of the locations are in South Florida. The company’s
ticker – “BDL” – comes from the name of its liquor stores: Big Daddy’s Liquor. Meanwhile, the
company’s name – Flanigan’s – comes from the name of its founding and still controlling family.
One family member is directly involved in the business – as the Chairman and CEO for the last
18 years – and his brothers who serve on the board and also own entities connected to the
company. There is a family trust as well. Altogether, insiders of some sort own about 50% of the
company. Although I referred to this company as being both a full service restaurant chain and a
chain of discount liquor stores – the discount liquor stores mean very little in an appraisal of the
company. About 90% of the company’s EBIT comes from the restaurants. So, less than 10% of
earning power comes from the liquor stores. Also, the returns on capital in the restaurant
business are much higher than in the liquor stores. If you don’t adjust for leases – which changes
the calculation of ROC with the new accounting rules adopted in the last few years – the
restaurant chain’s returns on capital are probably around 25% pre-tax (so, high teens after-tax)
while the liquor stores are more like 7% or so pre-tax and maybe 5% or worse after-tax and in
cash. Restaurants are often valued on EBITDA or EBITDAR (EBITDA before rent) instead of
EBIT. So, if anything, I’ve used a somewhat more conservative measure. Most importantly,
though, is that the company says it doesn’t intend to open more liquor stores. It is going to use
some space that had been planned for a restaurant expansion to instead do an additional liquor
store. But, overall, the company doesn’t intend to put more capital into the liquor store business.
Since the liquor store business is less than 10% of earning power here already and the company
intends to re-invest free cash flow in additional restaurants, but not additional liquor stores –
there’s really no point in an analyst wasting their time worrying about the value of the liquor
stores, their competitive position, etc. I will just mention two synergies here. The liquor stores
are often co-located with the restaurants. Not always. But, often enough to make it worth
mentioning. And then the other synergy would be liquor sales at the restaurant. Flanigan’s
restaurants get about 75% of revenue from food sales and about 25% from bar sales. Gross
margins at the restaurants are very high (compared to other restaurants) at around 65%. The fact
the company is buying so much alcohol so frequently from the same distributors in the same
region of the same state suggests that ownership of the liquor stores may help increase buying
power, lower costs, and thereby achieve higher margins at the bar. It’s also worth mentioning the
difference between revenue and gross profit. I said that 25% of revenue was from the bar. But,
note that if gross margins at a bar are meaningfully higher than on food – this would result in a
much greater share of gross profit (relative to revenue) coming from the bar. For example, the
company could be getting 25% of revenue from its bars, but more like a third or four-tenths
(40%) of gross profits from bar. Imagine they do get 40% of gross profits at each restaurant from
the bar. The restaurants as a whole are nine-tenths of earning power. So, as much as like 35% of
the company’s reported earnings could really be coming from the bars. Regardless of how you
look at it, the bars taken as a whole are more important profit contributors than the actual liquor
stores. So, I think the bars are worth thinking about as a business and the restaurants (excluding
bar sales) are also worth thinking about. But, I don’t think the liquor stores are worth worrying
about. As a result, I’ll be talking about the restaurants and bars at those restaurants – but, not
about the liquor stores.
Flanigan’s is a casual concept with restaurants located in South Florida. The restaurants are
nautical themed – they have pictures of boats and fish and stuff like that – and focus on selling a
good amount of alcohol. Some of the restaurants don’t close till 1 a.m. to 5 a.m. depending on
local laws. This, along with the company’s liquor store business, suggests a strong focus on
drinking. In fact, Flanigan’s started out as an operator of cocktail lounges that did not serve much
in the way of food. Over time, though, it repositioned itself. The company traces its roots to
1958. It is still headquartered and incorporated in Florida. It once operated locations outside
Florida – but, no longer does. It also managed – it didn’t own – a strip club in Atlanta. It is no
longer involved in that business. Laws were changed causing the club to be closed down. It
wasn’t a major contributor to earnings recently anyway. A somewhat meaningful contributor is a
restaurant called “The Whale’s Rib” which Flanigan’s runs but does not own. That restaurant
probably brings in about $750,000 a year of which around $375,000 goes to Flanigan’s and
$375,000 to the restaurant’s owners. All other locations – so, really everything I’ll be talking
about in this article – are “Flanigan’s” branded restaurant locations only. They’re standardized.
It’s a true chain. Purchasing is done at HQ for both food and liquor. The company has a fixed
supply agreement, invested in half ownership of a fish importing company, etc. to secure low
cost supplies. I already mentioned the liquor supply. There doesn’t seem to be an unusual
amount of autonomy at the restaurant level here. The company uses supervisors over the GM
level who focus on a small number of restaurants. Considering these restaurants are all fairly
closely clustered in South Florida – the degree of oversight from the supervisors is probably
high. It wouldn’t take much work to be visiting individual restaurant locations frequently. So,
this is not a company like Ark Restaurants (ARKR). It’s a chain. I know it’s unusual to look at
chain restaurants with market caps this low. But, that’s happening here for two reasons. One, the
stock is cheap. Normally, a restaurant stock would be about 3 times more expensive than this
one. So, a market cap of like $30 million here should really be more like $90 million. Secondly,
this chain is very regionally focused on South Florida. So, it’s not known around the country.
And, finally, systemwide numbers here are actually like double the numbers we see for
EBITDA, because the way the company has structured its franchises, limited partnerships, and
incentive program for executives means that insiders and investors in each of the various
restaurant projects end up keeping about 50% of the cash earning power with the other 50%
going to shareholders of Flanigan’s. If you factor in those two things, the actual chain of
restaurants like this one would have a market cap closer to $200 million than $30 million. It’s
$30 million in this case because EBITDA for the public company is only like 50% of EBITDA
for the whole chain and then the stock trades below 3 times prior peak EBITDA.
The accounting here is complicated. And this would definitely be the first worry of most
investors looking at this stock. Related party transactions are extensive. In fact, most investors
have probably never analyzed a company with as many related party transactions as this one.
However, the related party transactions here – and the bonuses, which I’ll get to in a second – are
extraordinarily simple affairs. Whether or not you as a shareholder like the arrangements – you
can easily understand them.
Flanigan’s used to franchise locations and still has franchised locations. The franchisees are
members of the Flanigan family (among others). However, this is not real relevant to our
discussion here, because Flanigan’s hasn’t franchised a location in like 35 years and says it
doesn’t intend to franchise more locations. As a side note, the fact that these locations are still
producing positive cash flow 35 years later is pretty impressive. A lot of individual restaurants
locations don’t survive 35 years. The Flanigan chain is made up of some pretty old restaurant
locations. A lot of them were opened under the current CEO. About 9 of the locations (the
majority of the chain) were founded between 8 and 23 years ago. Of those, 8 were founded
between 12 and 23 years ago. About half of those were founded in the 13-15 year range and the
other half in the 19-23 year range. These are old, continuously profitable locations.
One reason we know about the profitability and age of specific locations is the way they are set
up. As I said, Flanigan’s hasn’t franchised locations for 35 years. So, how do you create a chain
without franchising? The company does not have much net debt – it does, however have a lot of
gross debt offset by a lot of cash on hand. So, the start-up costs of the restaurants and any initial
losses would have to be shouldered by the company itself. Most chains of restaurants are: 1)
Franchised or 2) Have better access to capital (debt raises, stock issuance, etc.) or 3) Spread
quickly through leasing locations at malls across the country. Flanigan’s leases some locations
but actually owns some others. I’m not going to delve deeply into the stuff they own – but, it’s
actually significant compared to most restaurant chains. They own a collection of like 9 small
buildings throughout South Florida – often acquired a while ago – which includes their
headquarters as well as liquor stores and restaurants. The cap-ex here also looks very high in
many years for a restaurant chain. So, compared to publicly traded restaurant companies –
Flanigan’s has plowed a lot more of their free cash flow into capital investment whether through
ownership of land or through improving the building they are leasing. Where do they get the
funds?
Insiders and family members mostly. When Flanigan’s wants to open a new restaurant it sets up
a limited partnership. The company takes an LP stake – (always between 5% and 49%, most
commonly between 25% and 45%) and takes the entire GP stake. The LPs are structured along a
“return of capital” approach. So, entities other than Flanigan’s – it looks like a lot of insiders,
family members, and other affiliates – put in between 55% and 75% or so of the cost of the new
restaurant. They then get paid back over a period of about 4 years (if the restaurant is
immediately successful). They only get paid back 25% of what they put in per year provided
there are distributable cash flows from the restaurant. So, this would mean a payback period no
shorter than 4 years. In theory, the payback period could be anyt number of years (beyond four)–
but, Flanigan’s doesn’t have any restaurant that hasn’t fully paid back its LPs. Once the LPs are
repaid – and remember, Flanigan’s the company is also an LP to some extent in each of these
restaurants – the GP starts getting paid. The general partner collects 50% of distributable cash
flow from the restaurant and the LPs collect the other 50%. This would suggest that if Flanigan’s
owns between 25% and 45% of the LP interests and 100% of the GP interests they’d be getting
like 63% to 73% of the “free cash flow” from the restaurant. Let’s not be that precise – say, 60%
to 75% on average.
Now, in reality, it’s quite a bit less. That’s because of the bonus scheme here. A further 20% of
the restaurant’s cash flow will end up going to the top 3 executives at Flanigan’s, because the
bonus scheme is basically 20% split about 15%, 2.5%, 2.5% between the CEO, the COO, and the
CFO. As a result, you can think of Flanigan shares as being part of a structure where you – kind
of like an LP in a hedge fund – get 80% of profits but management takes 20% of profits. There is
a threshold amount and some other complicating factors. But, there is also – normally, not in this
COVID year – meaningful (but not remotely excessive) base salary payments to management as
well.
As a result, I think the best way to think of this is a system where – on average – Flanigan
shareholders get somewhere between 60% and 75% of restaurant free cash flow less 20% paid to
management equals 48% to 60% of free cash flow.
There’s also those franchises and more normal SG&A expenses etc. But, it’s unlikely to be much
less (or much more) than about one-half of the actual free cash flow of the restaurants.
In exchange for this, you have a company that isn’t using a lot of net debt, doesn’t have a lot of
SG&A that’s inflexible, etc. – but, can still expand.
Is it a good trade-off?
I think most investors will say no. It’s a lot of related party transactions. It’s a controlled
company. The auditor – Marcum – has been censured by the PCAOB In the past and has been
this company’s auditor for 21 years. Marcum is, however, a pretty normal choice for an auditor
for a company like this. It’s not a small auditor. It’s not cheap.
Disclosures here also seem to me to be very, very good versus what a company could get away
with. For example, I’m pretty sure they are disclosing legal issues that other restaurant
companies have and just don’t disclose. The explanations, disclosures, etc. of the LP structures
and who is a partner of each and how much they receive from the LPs and so on is good. I also
liked the disclosures on properties, insurance, and subsidiaries of the company. In general, I
found the level of disclosure of many things to be much higher than I’m accustomed to even with
much, much bigger public companies. I don’t know the COO, CFO etc. here. I don’t know if
everyone involved in the LPs is honest and careful not to take advantage of public shareholders
of Flanigan’s. But, I can see that the finance and legal people at this company aren’t amateurs
and do understand this company and the structures it is using well.
Also, and this is more subjective, I’m not as bothered by the related party transactions as other
investors are likely to be because of the incentives. I went through the filings comparing things
like the amount of compensation coming from the bonuses, the payouts from the LPs, the value
of the common stock people at the company hold, etc. – and I can come to only one conclusion.
The incentives are strongly skewed for insiders to worry about maximizing EBITDA at BDL. If
they want to get rich, they should definitely do that. It’s easy to see why this is. Insiders already
own plenty of BDL. Increasing EBITDA will – over time – increase the value of the shares they
own. It pays a small dividend. This is funded through EBITDA and will rise along with it over
time. But, most importantly, they – and by, “they” I especially mean the Chairman and CEO –
also have a large bonus paid out based directly on EBITDA at BDL. If you think about it, the
stock price of BDL moves with EBITDA and the bonus moves with EBITDA. So, if you are
getting a bonus equal to 15% of EBITDA and own 20% of the company, your incentives (when
you have a small base salary and small distributions received as a result of being an LP) are
strongly directed at growing EBITDA at the BDL level.
Also, BDL isn’t really on the other side of the table from insiders invested in other restaurants all
that often. How the LP is financed and how quickly LPs are paid back and stuff like that is where
I see possible conflicts. These get into issues of advancing money to the LPs and stuff like that.
There are also obviously tax differences between what a corporation and what an individual LP
might like to see and stuff like that. But, overall – BDL is usually a major LP as well as the GP,
and the GP and LP both are getting all payments based on the same metric: distributable cash
flow. To me, it looks like BDL and insiders at BDL whether as management looking for
bonuses, shareholders looking for stock price appreciation, or LPs looking for payouts – all are
aiming at increasing EBITDA.
However, ownership of LP interests and being paid in a large bonus does skew some incentives
for management. But, not in a way I mind. You’ll notice that management would be more
incentivized to worry about the stock price if they had to sell stock to fund their lifestyle, etc.
They don’t. They get some small distributions as LPs (based on EBITDA) and they get big
bonuses based on EBITDA of the company. This leaves the question of how much management
cares about the EV/EBITDA multiple of the stock. Honestly, they own stock and should care a
bit. But, it’s probably a bit less than at your more typical public company.
I haven’t talked much about the underlying business fundamentals here. Lately – before COIVID
– they had been good. Comparable sales at both the restaurants and the bars were strong year
after year. This is probably due to price increases on both menus and also to unusually heavy
cap-ex at existing restaurants compared to what a lot of chains do. Returns on capital are good.
Comparable store sales excellent. And the expansion of this concept has been slow and focused
on a small part of the country. It’s all the stuff you usually want to see with a restaurant
company.
It’s also an undeniably cheap stock. Market cap is only like 3 times actual “cash flow from
operations”. It’s maybe 7 times free cash flow. But, that FCF actually includes a bit of expansion
cap-ex and heavier cap-ex in general than I think most restaurant stocks would be doing. The
quality of earnings here seems really high in the sense that if we are pricing off actual CFFO
minus cap-ex these last three years – that FCF number is a really solid and conservative one.
It’s also possible this stock is kind of cheap versus book value. That’s not something I’d usually
think of with a restaurant stock. But, book value here is unusually “hard”. You can look at the
note on depreciation yourself to see how much of book value is in land, building, etc. You can
see for yourself that the stock has a market price of around $17 a share and book value is more
like $24 a share. I don’t know how significant this is. One day, the company might choose to
unwind some of its liquor operations. If it ever chooses to do that, it might have some book value
associated with that which can be liquidated and re-invested in restaurants or something. More
likely, it will keep piling up a little bit of real estate along with a lot of leased properties
throughout South Florida.
Finally, I didn’t discuss leases. There are some risks here. In theory, something like 20% of the
company’s restaurants come off lease in the next 6 years or so. By this I mean there is neither a
unilateral option to purchase the location or a unilateral option to extend the lease. For most
restaurant companies, this isn’t an issue. It can be an issue if you are focused on extremely high
traffic and desirable locations. It has – for example – been a real problem for Ark over the years.
But, it’s almost never a problem for most restaurant stocks.
Rent here is a significant expense. EBIT has been $6 million to $7 million recently while rent has
been $4 million. About $3.2 million of that is fixed regardless of sales while $800,000 is tied to
sales performance.
Finally, there is an added risk here: hurricanes. The company warns that it might not be able to
obtain adequate insurance at reasonable prices. All bars can have trouble with liability insurance
due to “dram shop” laws which mean you could be responsible for harm done to others by
drunks you illegally served. There are special caps and higher deductibles and things on some of
this insurance – it’s all disclosed in the 10-K and none of that worries me. However, discussion
of the coverage for windstorm (that is, hurricane) damage does concern me more. Remember,
basically 100% of this company’s locations are in South Florida. It’s easy for a restaurant to be
damaged such that it can’t be open for a time. And having locations shut for a time can mean a
permanent hit to loyalty and difficulty re-opening. The company pays over $500,000 a year in
premiums for this kind of coverage. I don’t know if that’s sufficient. And I’m not sure I’d be able
to evaluate this even if there was more disclosure about the amount of coverage the company
has. If you look at the company’s balance sheet and then also look at its locations – this is
potential a pretty big insurance risk for someone to take on. An insurer could have to pay out a
large amount from a single hurricane that hits South Florida.
It’s something to keep in mind both in the sense of a risk I can’t quantify and also as a possible
buying opportunity to evaluate if a major hurricane does a ton of damage to the company’s
properties and they have a big loss beyond what they are uninsured for.
From a balance sheet perspective, I think they could handle it. I don’t think hurricane losses over
insured limits is likely to bankrupt this company. But, it might hurt the stock a lot if people
assume there is adequate insurance and there isn’t.
Overall, I think this is one of the cheapest and most interesting restaurant stocks I’ve come
across.
Geoff’s Initial Interest: 80%
Geoff’s Re-visit Price: $11.50/share



URL: https://focusedcompounding.com/flanigans-bdl-a-cheap-complicated-restaurantchain-focused-on-south-florida/
Time: 2020
Back to Sections
-----------------------------------------------------
Bonal (BONL): An Extremely Tiny, Extremely Illiquid Stock that Earns a Lot
But Doesn’t Grow at All
Bonal isn’t worth my time. It might be worth your time. It depends on the size of your brokerage
account and the extent of your patience.
So, why isn’t Bonal worth my time?
I manage accounts that invest in “overlooked” stocks. Bonal is certainly an overlooked stock. It
has a market cap under $3 million and a float under $1 million (insiders own the rest of the
company). It often trades no shares in a given day. When it does trade, the amounts bought and
sold are sometimes in the hundreds of dollars – not the thousands of dollars – for the entire day.
It’s also a “dark” stock. It doesn’t file with the SEC. However, it does provide annual reports for
the years 2014 through 2018 on the investor relations page of its website. In the past, the stock
has also been written up by value investing blogs. Most notable is the write-up by OTC
Adventures (the author of that blog runs Alluvial Capital – sort of another “overlooked stock”
fund). That post was written back in 2013. So, it includes financial data from 2008-2013. I
strongly suggest you read OTC Adventure’s post on Bonal:
Bonal International: Boring Products and Amazing Margins – BONL
The company has also gotten some coverage in a local newspaper. For example, I’ve read
articles discussing Bonal’s attempt to sell itself at a below market price. Shareholders rejected
this. So, the stock isn’t a complete enigma. You have write-ups like OTC Adventures, you have
some old press coverage, and you have annual reports (complete with letters to shareholders) on
the company’s investor relations page. At the right price, it’s definitely an analyze-able and
presumably invest-able stock.
But, not for me. Because I run managed accounts focused on overlooked stocks, I try never to
eliminate a stock simply because it’s very, very small or trades almost no shares on most days.
Even stocks that appear to have zero volume are sometimes investable. In my personal
experience, I can point to cases where I bought up to 10,000 shares of a stock in a single trade
that had a history of trading less than 500 shares on average. And that’s not a one-off fluke. It’s
happened to me more than once. So, if the shares are out there – your best bet is to bid for the
stock you like best regardless of what the past volume of that stock has been. Often, it may be
easier to get into – and even out of a stock – in a few big trades than it appears on the surface.
This is due in part to people trading much smaller amounts of the stock than you – and a few
other bigger, or simply more concentrated investors – will want.
However, in the case of Bonal – there simply aren’t enough shares held by non-insiders to make
it worth my while. The accounts I manage are not big. But, the investment strategy I practice is
not one where you go out looking for 1% positions. It’s the kind of strategy where you always
want to put 10% or more of the portfolio into any stock you buy. Sometimes, because of
illiquidity – or the price moving up on you – the position size you end up with might be far short
of 10%. But, to start bidding for something – you have to believe it’s possible to put 10% into
this stock. Here, because of the extraordinarily small float, it’s just not possible. Even if
everyone but the controlling family was willing to sell me shares – this would still end up being a
smaller position than I want.
So, for me Bonal is a pass. But, those are trading concerns that some readers won’t have. Since I
did look at the stock – I’m going to go ahead and write it up here without worrying about the fact
that it’s “un-investable” for the accounts I manage. It might not be un-investable for your
personal account. Maybe because your account is smaller. But, also maybe because you like to
be much more diversified than I do. If you don’t mind single-digit percentage position sizes –
maybe, Bonal is investable for you.
What jumped out to me about Bonal?
Two things. One, the company’s size and the fact it was often profitable. This is unusual. There
are very, very few companies with sales of just a couple million dollars that manage to eke out a
profit. Yes, there are some private companies – often, more like sole proprietor type businesses –
that are consistently profitable on such a small level of sales. But, it’s extremely unusual to find a
public company turning a profit at such low sales levels. This has important implications. It
means the company must have strong product-level economics – gross profitability has to be
amazing here – to allow anything to exceed the SG&A line. It also means that if the company
can ever increase its sales by a few million dollars – the bottom line, the dividends paid, etc. are
likely to absolutely explode.
Let’s talk “economies of scale”. The economies of scale gained by going from $2 million of
sales to $10 million of sales are greater than the economies of scale gained by going from $2
billion of sales to $10 billion of sales. Investors underestimate this. We’re all used to using
ratios, percentages, etc. to analyze the stocks we look at. This puts them on equal footing. It
makes it appear that a group of 100 different wineries making 1,000 different wines has as good
a chance of improving its operating margins as a company making 1 type of wine at a single
vineyard. That’s wrong. The single vineyard has a much, much greater chance of expanding
operating margins on even small increases in sales, because true fixed costs are a much greater
percentage of the company’s current cost base and what I’ll call “semi-fixed costs” are also big.
Semi-fixed costs are things that if the company quadrupled in size would be considered a
“variable” cost because you would have to scale them up at the same rate. But, there is no scaling
up of the cost – or very little scaling up of the cost – at small incremental sales gains till you hit a
certain level of utilization. Basically, you might have a vineyard that could do $5 million in
sales, but it is now doing just $2 million in sales. This doesn’t mean you need to more than
double assets to get to $5 million in sales. It means you are operating inefficiently at 40%
utilization of your current capacity. This is very, very common for very, very tiny companies.
Everything about them from the premises they rent, to the sales team that markets their product,
to the CEO’s time may be underutilized. The further down the income statement you go – the
truer this is. Every company – even a “dark” company – has some “corporate costs” that eat up a
lot of profit. It needs a CEO, it needs a board, and it needs an auditor. And every company – no
matter how small – needs a location to use. Often, the location being used can handle more
volume than a couple million in sales, production, etc. So, the administration of a very small
public company and certain other general costs – as well as some costs that might end up in the
“gross costs” line – have a ton of operating leverage built into them. Often, if sales go from $2.5
million to $1.25 million – the company goes from solidly profitable to being on the verge of
bankruptcy. While a sales increase from $2.5 million to $5 million would make earnings
explode.
Is that the case here with Bonal?
Well, the way to analyze that is to focus in on gross profitability. We’ll start with gross margins.
For financial reporting purposes – which is the only thing we, as potential investors, are given a
clear view of – gross profitability is a sort of stand-in for basic, variable profitability. A company
with very, very low gross margins combined with very, very low sales turns (Sales / Assets)
should always be incapable of earnings high returns on capital no matter how big it gets. There
are some exceptions to this. A big brewery fully utilized probably has much lower unit costs than
a small brewery mostly underutilized does. A production line being used intermittently to
produce orders on a case-by-case basis might have super high gross costs compared to the same
line being run 24/7 on stable demand. But, as investors, it’s very hard to see those things.
Managers may understand the cost accounting and technical situation well enough to know that
something with bad gross profitability today could actually achieve good gross profitability on
10 or 100 times the volume. But, we as outsider investors can rarely know this. What we can
know is the financial accounting. We can know the gross profitability.
By the way, the reverse argument is easier to prove. Sometimes a small business with bad gross
profitability might have a case to be made it can become a huge business with good gross
profitability. But, the opposite is almost never true. Why would a company with high gross
profitability on low volume ever become a company with low gross profitability on high
volume? The only cases I can think of are very special ones like intentionally undersupplied high
status or collectible products. Yes. If you are selling a bottle of wine for $150 – it’s unlikely you
could increase production ten times and still maintain the $150 sales price, because the extreme
rarity of the product on the low volumes you now produce is causing the perception of scarcity,
high quality, a niche label, etc. that couldn’t be maintained if you produced more bottles and
marketed them more widely. The scarce and hidden nature of the product may help gross
margins. But, that’s just one example of the very, very few special cases where high gross
profitability wouldn’t lead to higher and higher operating profitability when a small business
scales up. In the vast majority of cases, a small business with gross margins that make early
investors salivate will – if it ever grows – become a big business with operating margins that
will make later investors bid up the share price.
So, let’s take a look at Bonal’s gross margins.
Manufacturers often have lower gross margins than what I’ve used as a “typical” gross margin
above. However, keep in mind that gross margins alone don’t matter much to a manufacturer.
What matters is profitability. And profitability is always the product of margins AND turns. So,
you need to look at both Sales/Assets and Profit/Sales to figure out the number you care most
about: profit/assets.
Still, there can’t be a lot of price competition in a business that looks like this…
Gross Margins: 2008-2018
2008: 79%
2009: 74%
2010: 73%
2011: 78%
2012: 77%
2013: 77%
2014: 74%
2015: 77%
2016: 74%
2017: 73%
2018: 74%
The very low change in gross margins during the financial crisis, suggests that Bonal’s
profitability isn’t constrained by how much it can charge (Gross Profit/Sales) – it’s more likely
the company is constrained by a lack of orders. Orders – rather than prices – probably drop most
in a bad year. You can judge orders somewhat – I haven’t done this here for you – by using the
pre-markup figure of COGS/Assets. That’s “cost of goods sold” – NOT sales – divided by assets.
So, it is turns on a cost rather than sales price basis. Why do that? A huge markup interferes with
understanding the relationship between volume demanded and the willingness of a customer to
pay a high price. If you look at gross margins and “cost NOT sales” turns, I think you’ll see that
Bonal is unconstrained in terms of how much it can charge for what it makes – but, is quite
constrained in terms of how much of what it makes it can actually sell at any price. Basically,
this is a small niche that allows for a big price mark-up.
That’s an 11-year period. Luckily, it also includes the “bust” years of 2009-2010 (when the U.S.
– and much of the rest of the world – was coming out of the 2008 financial crisis). Without
knowing much about Bonal’s industry – about all I know is it sells to metalworking businesses –
I’d say that period from 2008-2018 is a good test of what gross margins would like look under
just about any economic circumstances. The company sells its products at more than a 70 cent
per dollar gross profit and less than an 80 cent per dollar gross profit. Gross margins are 70-80%.
To put this in perspective, 70 to 80% gross margins are equivalent to a 230% to 400% mark-up.
In other words, if a widget costs the company $1 to produce – it’s turning around and pricing that
widget at $3.30 to $5.
Of course, that’s misleading if sales volume in this line of business is so small that asset “turns”
(Sales/Assets) are insufficient to earn an acceptable return on capital. Is that true here?
Because Bonal holds excess cash that is small in absolute terms – like $1 million – but gigantic
in relation to the size of this firm (which does about $2 million a year in sales) I’ll base “turns”
on stockholder’s equity less cash. This is a proxy for the amount of money owners have tied up
in the business’s actual operations rather than just sitting idle in a corporate bank account.
Sales / Equity Less Cash
2013: 6x
2014: 6x
2015: 5x
2016: 4x
2017: 3x
2018: 4x
This translates into excellent cash returns on starting equity excluding cash:
2014: 28%
2015: 110%
2016: 7%
2017: 2%
2018: 23%
And merely “average-ish” cash returns on starting equity including cash:
2014: 8%
2015: 27%
2016: 7%
2017: 2%
2018: 23%
The above is somewhat unfair to BONL – as it’s likely that anyplace the company put its roughly
$1 million in cash earned essentially zero interest in the period 2014-2018. If interest rates were
several percentage points higher during that period and the company kept the same dividend
policy in place – it might inch ever so much closer to a perfectly solid cash return on total
starting equity (including idle cash) of more like 15%. The corporate tax rate cut in the U.S. can’t
hurt either. So, while the record is for a very lumpy 13% cash return on starting book value – I
could be persuaded to say the company is set up (even with idle cash) to generate more like a
15% after-tax cash return on its stated book value per share.
What is book value per share?
It’s 89 cents per share. So, at a stock price of 89 cents per share, Bonal would be a good buy…if
and only if the company can deliver 10%+ cash returns on book value – that’d be equivalent to
about 14 cents a share in annual cash earnings – at its current sales volume and would have much
higher returns if sales grew at all, if it could re-invest a lot in its operating business, etc.
Unfortunately, the stock last traded at $1.40. That’s 1.57 times book value. Paying that kind of
premium over book value would – if the company never disgorges its excess cash – bring down
your total return in the stock to a less acceptable level. You don’t want to take any unusual risks
– much less huge liquidity risk, the risk of owning a “dark” stock, etc. – to make less than 10% a
year. You probably only want to take those kind of risks when you see a path to 15% a year type
returns. Or, maybe when you have a lot of faith – like with a company reinvesting in its own
growth – that 10%+ annual returns can be sustained for a particularly long holding period.
Especially given today’s generally high stock prices, low bond yields, etc. – some might argue
that buying into a solid, predictable stock at just a 10% expected annual return is the right
decision. But, there are more solid, more predictable businesses than Bonal out there. Here, we
have what amounts to a “silent partner” type investment – it’d be incredibly illiquid once you
built a sizeable position in this stock – in a small business that promises to return just 10% a
year. People buying into small business they don’t control definitely want to make more than
10% a year.
So, is Bonal a pass?
I can’t answer that one yet. Because there’s an easier way to value this stock. It is – perhaps – too
aggressive a way of valuing it. But, the approach I used above is probably too conservative.
After all, Bonal isn’t really a stock with 89 cents in book value. It’s more like a stock with 56
cents in cash and 33 cents invested in an absolutely amazing business (one that earns 18% to
34% after-tax cash returns on invested capital).
Let’s say the cash is worth the cash. In other words, the 56 cents in cash should be valued at
exactly 56 cents. This reduces the stock’s “price” from $1.40 to 84 cents a share. Is Bonal’s
operating business worth 84 cents a share?
There’s an easy way to check this. Bonal has paid a dividend every year for the last 13 years.
The most recent dividend was 10 cents per share (for a 7% dividend yield on the $1.40 last trade
price). And we know Bonal has not added debt, run down its cash balance, etc. over time. The
operating business seems to be the source of funding for both the excess cash on the company’s
balance sheet and the annual dividend paid to shareholders.
The most aggressive way to value Bonal would be to divide it into two buckets. The cash bucket
is worth 56 cents per share (because the company has 56 cents per share in cash). The business
bucket is worth the present value of 10 cents per share paid in dividends in perpetuity. At an 8%
discount rate – basically, what we’d expect the S&P 500 to return if bought now and held forever
– a perpetual dividend of 10 cents per share is worth $1.25. This is like saying the “cap rate” is
8%. In reality, I don’t think investors would capitalize a non-contractually obligated payment –
this is a dividend paid at the discretion of the board, not the yield on a bond or a bank loan – at
anything like 12.5 times. Nonetheless, the company could grow cash earnings. That’s not
impossible.
Here we need to move into a bit of a theoretical “investment philosophy” type discussion. Let’s
talk risk-adjusted discount rates. Whenever analysts, portfolio managers, CFOs, etc. talk about a
company’s “cost of capital” or do a DCF or something – they talk about discount rates as if they
should be used to capture the “risk” in a cash flow. This makes perfect sense for any cash flow
with a hard cap on its possible return. For example, if I buy a 30-year investment grade corporate
bond that yields 4.8% – I need to be thinking of part of that yield as being the result of the risk
I’m taking. Right now, the 30-year U.S. Treasury yields 2.9%. So, here I’d be getting about 1.9%
more per year – let’s call it 2% – to take the added risk in the corporate bond. We’ve matched the
maturities of these two bonds here. So, we know it’s not reinvestment risk or something I’m
taking here. These are also both nominal yields. Neither is inflation adjusted. So, we also know
that this isn’t inflation risk I’m taking here. The added 2% a year I’m getting when I buy
corporate long-term debt instead of government long-term debt is due to the “business risk” (the
corporate credit risk) I’m assuming.
So, naturally, you can apply the same idea to common stocks.
Except you clearly can’t. I mean – you can do the math, and many people do. But, the exercise is
flawed. It wouldn’t make sense to apply higher discount risks to “riskier” stocks because the risk
of a stock with uncertain future earnings isn’t one-sided. In a stock, my potential dividend isn’t
capped. See, as a bondholder, if I don’t know if a company’s earnings will rise by 50% next year
or fall by 50% next year – I can take that as a single input in my analysis. The 50% rise doesn’t
help me. It might make the bond be perceived as less risky and might give me a nice capital gain
if I flip the bond in the next 12 months. But, as long as the bond keeps paying me my interest for
these next 30 years and as long as the principal is repaid as scheduled – then, a 50% rise in
earnings isn’t relevant to me. Only a 50% decline in earnings is relevant to me. So, a bondholder
can afford to think of earnings volatility as being pretty close to the risk of not recouping some of
my investment.
Common stocks don’t work that way. Think about it. A basket of micro-cap stocks bought at 15
times earnings certainly will have more earnings volatility than a basket of mega cap stocks
bought at 15 times earnings. The price of the micro-cap stock basket will also be more volatile.
A micro-cap stock fund is more likely to see a 50% decline in its NAV than a mega cap stock
fund.
But, that’s the “trade” return in the two baskets. It’s not the “hold” return. In the case of bonds,
we might ask: “Sure, the price of any basket of bonds will move around from year-to-year – but,
what if I hold all these bonds till they mature?” That simplifies things from an exercise in
predicting what “the crowd” will offer for my bonds in any given year and instead boils down a
valuation of any set of bonds into just the question of credit risk. Sure, there’s reinvestment risk
and inflation risk and all that – but, we can use things like the U.S. Treasury to benchmark those
levels.
We can really say that the 2% I get paid in the corporate bond over the government bond with
the same maturity date, is the discount in the price of the corporate bond (that is, the premium in
the yield of the corporate bond) to compensate me for this risk. So, it becomes a simple question
of a trade-off between a perfectly safe 2.9% a year or a somewhat less safe 4.8% a year. I
evaluate that trade-off and I choose the corporate bond or the government bond depending on
how much more yield I’m getting for how little risk I’m taking or vice versa.
In other words, a corporate bond is only going to outperform a government bond if I buy it at a
higher yield.
Is that true of common stocks?
Of course not. You can make more money in stocks with the same dividend yield, same P/E
ratio, etc. as other stocks. How can you do this?
If the “coupon” grows faster in one set of stocks than in the other.
This presents a really big problem for the idea of using a higher discount rate to value small
stocks with unstable dividends versus large stocks with stable dividends. What if the odds
actually favor the small stocks growing their dividends faster than the big stocks?
More importantly for stock pickers like us – what if you could have more actionable information
about the odds in a small stock than a big stock. This isn’t as crazy as it sounds. Starbucks
(SBUX) will definitely have less earnings volatility than Bonal. But, Starbucks is also likely to
have more information about likely future dividends priced into the stock than Bonal is. Using a
higher discount rate for more volatile dividends is equivalent to assuming you have no way of
knowing better than the crowd whether the long-term volatility in the stock’s dividend – the
trend – will be towards growth or decay.
For example, Bonal paid a 15 cent dividend in 2016, a 4 cent dividend in 2017, and a 10 cent
dividend this year. Any of those 3 dividend levels could be the “normal” level to expect over the
next many decades.
Because we know Bonal has excess cash and I also know – though I haven’t discussed it with
you here – that cap-ex at Bonal is almost always non-existent, we can use EPS as a good proxy
for dividend paying power.
Here is the 11-year EPS history at Bonal.
2008: 30 cents
2009: 2 cents
2010: Nil
2011: 29 cents
2012: 19 cents
2013: 13 cents
2014: 8 cents
2015: 25 cents
2016: 12 cents
2017: 3 cents
2018: 16 cents
The 11-year average is 14 cents. The stock last traded at $1.40 a share. So, if Bonal’s future
looks like its 11-year past and it pays out all earnings in dividends – you’d expect a 10%
dividend yield on today’s stock price (not a 7% yield). By the way, on a free cash flow basis –
the expected dividend would be also be exactly 14 cents a share. There is close to zero difference
– over an 11-year cumulative record – of any difference between reported earnings and “cash”
earnings. So, that’s still a 10% dividend yield on today’s stock price.
So, we have a stock here that – based on its 11-year past record – is probably priced to yield
anywhere from 7% to 10% a year. If we use the past 11 years of free cash flow per share – or
reported EPS – as our guide, the expected dividend yield would be 10%.
But wait. Bonal’s tax rate has changed. Changes in a company’s tax rate are difficult to perfectly
model from a microeconomic perspective. Depending on the bargaining power of the business,
the asset intensity, etc. a corporate tax cut can vary from 100% retained by the company’s
shareholders all the way down to 0% retained by the company’s shareholders (passed on to
customers, suppliers, lenders, employees, etc.). Bonal checks all the boxes from the kind of
business that would experience the biggest boost from a corporate tax cut. It has extraordinary
pricing power. And it makes minimal capital expenditures.
However, the company’s actual tax rate paid in the past seems quite low. There is some
information on certain tax benefits that reduce the rate actually paid. As a result, I would guess
that Bonal might pay a bit less in taxes – and, therefore, have more after-tax cash to pay
shareholders – but, I’m unwilling to attempt a precise calculation. I can’t see how it would pay
more in taxes than before the corporate tax cut. Therefore, I would say that – if Bonal produces
the same pre-tax earnings over the next 11 years as it did over the past 11 years – the stock
should be capable of yielding more than 10% a year on its last trade price of $1.40 a share.
Basically, I’m saying this is a stock that can pay an average dividend of 15 cents a share going
forward.
So, taxes aren’t a question worth spending much time thinking about here. The more important
question is to judge which way earnings volatility might occur. At Bonal, gross margins are both
extraordinarily high and extraordinarily stable. As a result, the volatility in the company’s
earnings comes entirely from the physical volume of its output. Basically, it is sales volatility not
sales profitability that matters at Bonal. If we knew what the company’s future sales would be –
we could know whether this stock is a risky high dividend yield stock – or, a super cheap stock
that might pay a lot more out in future dividends than anyone expects.
Unfortunately, the company’s sales are a lot more volatile than its margins.
Sales: 2008-2018
2008: $2.5 million
2009: $1.7 million
2010: $1.8 million
2011: $2.6 million
2012: $2.3 million
2013: $2.5 million
2014: $2.1 million
2015: $2.4 million
2016: $2.1 million
2017: $1.6 million
2018: $2.3 million
For one thing, you can see there is no clear sales growth trend there at all. Luckily, there’s also
no noticeable sales decay either. Those are nominal figures. But, inflation has been quite low
over the last 11 years. So, it’s impossible to find any trend in either nominal or real sales there.
The company looks like it should have about the same “earnings power” – as Ben Graham likes
to call it – in 2019 as it did in 2008.
Again, this points to a stock that can be split into two buckets.
The “cash bucket”: $0.56/share
The “dividend bucket”: $0.15/share per year
Now, we could easily estimate what those things should be worth. In theory, cash should be
worth cash. So, 56 cents a share. And the average expected dividend should be capitalized at the
expected return on the S&P 500 from this point forward. Let’s call that 8% a year. Well, $0.15
divided by 0.08 equals $1.88/share. We sum the two buckets and get $2.44 a share.
Do I really think Bonal is worth $2.44 a share?
It last traded at $1.40 a share. So, that kind of appraisal would put the stock at a 57%
price/appraisal value ratio.
I think – without being able to predict how likely it is the company can grow sales – that I would
say Bonal is not worth more than $2.44 a share. Let’s call $2.50 a share a hard cap on the upside
here. I could imagine that a 100% acquirer with plans to allocate capital differently, better insight
into the business than I have, etc. might not lose money acquiring this thing at a price as high as
$2.50 a share. I could see someone paying that much for the whole company and being able to
look back on the decision and say it wasn’t an error.
Would I pay that price?
No. And, honestly, I wouldn’t be surprised if the family was happy to sell out at a much lower
price than that. Years ago, they planned – presumably this was the former Chairman’s idea – to
sell the company at a fraction of that value (86 cents a share back in 2013). I actually don’t know
the history of that offer and the family’s disagreements about it. I assume there was some sort of
disagreement within the family on whether or not to take the deal (after all, the deal was
rejected). And the new Chairman – while a family member – is not the same Chairman under
whom that merger was planned. So, it’s the same controlling family. But, it might not be a good
idea to use a rejected offer from 8 years ago as the basis on which to value the company today
(especially with a different Chairman).
Because I don’t know anything about the actual background of the attempt to take the company
private – all any blog post, comment, newspaper article, etc. I’ve ever seen is using as a source is
the company’s own press release – I don’t want to speculate too much on what happened. But, I
will say there is some slightly misleading information in the little bit I’ve read where other
investors talk about that going private attempt.
One thing always mentioned about this offer is that it must have been a going private transaction
where the family tried to force out the non-family minority shareholders (folks like you and me)
at a below market price.
You can still find the press releases – they are at OTCMarkets.com under the “BONL” news tab
– that include the original letter of intent announcement (where the company claims a majority of
shares were held by shareholders who agreed to the deal), the amended letter of intent (which
amends the original deal from an offer to buy a majority of the company from selling
shareholders – named as mostly family members and family trusts – to an offer to buy the
ENTIRE company), and finally the acceptance of that merger by the board (sort of – I’ll get to
the sort of in a second).
This last part is important. In the press release announcing a merger – so, this would force the
outside shareholders to sell if a majority supported the deal (unlike the original offer, which
presumably was just an offer to buy the family’s stake in Bonal) – some other events occurred:
“Separately, Thomas E. Hebel and Paul Y. Hebel have resigned from the board of directors of
Bonal International, Inc. The company’s board of directors has also relieved Thomas E. Hebel
from his duties as acting Interim President. Mr. Hebel remains an employee of the company,
serving as the Vice-President of Marketing. Mr. A. George Hebel III, past president and chief
executive officer and current chairman of the board of directors, has been appointed Interim
President, effective immediately.”
Note the use of the word “separately” and not “unrelated”. Two family members resigned when
the merger was agreed to. And the board relieved one “Thomas E. Hebel” from a job they had –
when accepting the original letter of intent to buy a majority – not all – shares of the company,
specifically requested stay on in that position.
Why is this important?
A few things. First, we know Thomas Hebel resigned as a director and left – was “relieved” but
quite possibly after he resigned as a director (which is kind of like firing someone after they quit)
– as interim President. Two, A. George Hebel III is the one who replaced him. Well, “A. George
Hebel” died the next year. And he was replaced by “Thomas E. Hebel”. George Hebel was
Chairman from 1992 to 2010. It looks like he attempted to sell the company in 2012 through
2013. Then, he died in 2014. Meanwhile –Thomas E. Hebel resigned during the attempt to sell
the company and then took over in 2014 (after his George died). Thomas E. Hebel is the
Chairman who writes all of the annual letters from 2014-2018 you can read on the company’s
website. We have no reason to believe that the current Chairman (Thomas E. Hebel) supported
the idea of selling the company, forcing out non-family shareholders at a below market price, etc.
And we have some evidence that he didn’t support the idea of selling the company (he’s very
clearly NOT listed in the original announcement where the majority of shares were to be sold –
in fact, all that’s said about him in that press release is that he “has been asked to stay with the
company”). We also have very strong evidence he definitely opposed the merger that would sell
the entire company: he resigned from the board and was relieved as interim president the same
moment the merger was announced. He was re-appointed to the board (as was Paul Hebel) about
six months after the merger was rejected. Because he’s not named among the original selling
shareholders, is mentioned as being “asked to stay with the company”, then left as both a director
and as President of the company at the same time the merger was announced, the merger failed,
then he returned to the board after the merger’s failure, and finally he took over the company
again from his (I assume) brother – I think it’s misleading to say that the current management of
this company tried to push out minority shareholders at a below market price. Actually – as best I
can tell – the current management seems to have actively opposed the attempt to sell the
company. That’s very different.
Okay. Let’s really get into the weeds of Hebel family speculation here.
Because of the way some people are referred to – I’m not 100% sure that I know the family
connections between board members. My assumption – which could be very wrong – is that Gus
Hebel was the founder and George, Thomas, and Paul were sons of his. George was Chairman
from 1992 to 2010. Then he retired leaving his (my best guess is) brother, Thomas, as President.
George then tried to sell the company in 2012. Paul (again, I think, George’s brother) is listed as
a seller in the original plan for a buyer to acquire majority control of – but not actually merge
with – Bonal. Thomas was never listed as a seller. Then, when the offer changed to a merger –
which would include buying out minority shareholders – indications are that George still
supported the merger, but that both his (again, I’m guessing) brother Paul and his (guessing
again) brother Thomas opposed the deal (since we know they both resigned). Since then:
Thomas and Paul rejoined the board. George died. Thomas is the current Chairman & CEO.
I went into all this about separating George from Thomas from Paul for a good reason. We talk
about “the Hebel family” wanting to sell the company in 2012 at a terrible deal for outsiders and
now “the same Hebel family” running the company in 2019. But, I did just explain that George
tried to do the merger and then both Thomas and Paul resigned from the board and the
shareholder vote failed.
Today: Bonal lists its board members, their positions with the company, etc. in the back of their
annual report. Remember, the two Hebel family members we know resigned the same moment
that merger was announced are…
Thomas E. Hebel: Current Chairman, President, and CEO
Paul Y. Hebel: Current Vice Chairman
So, the Chairman & CEO and the Vice Chairman are the two Hebel family members who
resigned over that bad merger offer. We don’t know a lot here. But, I think it mischaracterizes
the situation to say that the people currently in control of this company tried to swindle outside
shareholders. Actually, the two top people on this board resigned in some sort of intra-family
dispute over that unfair deal.
With a family controlled, dark stock like this – any sale process of a company is very murky. For
example, nothing is said about the merger being voted down except that because the motion
failed at the meeting – negotiations with the buyer were terminated. We can know very little for
sure without talking to someone connected to the family. So, I don’t want to say that you should
or shouldn’t have confidence that the current Chairman is especially shareholder friendly or not.
But, I will say that based on the press releases I read – the idea that the current management
tried to force a “take under” on outside shareholders is false. We have no evidence of that. In
fact, we have quite a lot of circumstantial evidence against it. And the family member we most
clearly do know tried to sell the company is dead. So, we really can’t say there’s a high
likelihood of outside shareholders being abused here going forward. The opportunity to abuse
outside shareholders is high. There’s no doubt of that. But, that’s true at any dark, family
controlled company.
There’s a very high risk of a family controlled, tiny company running things with only the family
in mind. You have to accept that if you’re going to buy a stock like this. But, that’s about all I
see for sure here.
Okay. So, I think the price at which the family planned to sell the company – at 86 cents plus a
20 to 30 cent dividend (so, $1.06 to $1.16) back in late 2012 – is not especially useful. But, we’ll
note it as one indicator of value. In late 2012: there was a deal struck to sell the company at
$1.06 to $1.16 a share. You’ll hear some people say it was an 86 cent a share offer. However,
that’s incorrect. The company planned to pay a 20 to 30 cent dividend before the sale and then
another 86 cents when the deal closed. That adds up to a $1.06 to $1.16 offer in late 2012.
We know what some of the family was willing to sell at – and a buyer was willing to buy at – in
2012.
But, what price would I pay in 2019?
Again, there’s a fairly simple way to answer that question. Let’s assume I want some sort of
“compartmented defense” here. In other words, I want a value redundancy where one
compartment of my intrinsic value “ship” can flood and yet the stock can stay afloat above the
price I paid.
The way to do this is look at cash per share as first thing keeping the stock price afloat and look
at the likely dividend per share as the second thing keeping the stock afloat.
Imagine there’s no dividend. Can the stock stay afloat at $0.56/share? Sure. They have that much
cash. In most years, the business is profitable on an earnings and free cash flow basis. So, yes. It
shouldn’t trade below cash per share. Bonal should stay above 56 cents a share as long as it has
more than 56 cents a share in cash.
Now, let’s perform the reverse exercise. Imagine there is a dividend. But, imagine there’s no
longer any cash on that balance sheet. It gets blown on a bad acquisition, etc. Of course, it could
be used in a way that doesn’t just destroy 56 cents per share in value. In theory, you could buy
something money losing. Remember, we’re talking about only $1 million in cash. So, I’m not
sure what you could really buy with that. It seems more likely the cash is worth something
between 56 cents a share (they pay it all out as a special dividend tomorrow) and zero cents a
share (it never earnings interest, is never paid out in dividends – etc. It just sits there forever and
ever). I’m comfortable using that range. The worst case scenario is that cash is worth nothing.
The best case scenario is that it’s worth 56 cents a share. For valuing the “dividend
compartment” alone – let’s assume the cash already on the balance sheet is worth nothing. But,
that the company will continue to pay dividends as it has for the last 13 years in a row.
Okay. So, what kind of stock price can be supported by the dividend alone?
Well, at this moment: the highest potentially sustainable dividend yield I know of among U.S.
public companies is 9.4% a year. The company that pays that dividend is National CineMedia
(NCMI). I’m not going to get into the details of NCMI here except to say it’s a company with a
market cap over $1.2 billion and highly leveraged (with debt between 4 and 5 times EBITDA).
The company’s EBITDA is very safe (it basically has 18-year contractually guaranteed rights to
sell ads on movie screens right before the previews start) – but, the high leverage means the
dividends to investors are less secure. Moody’s rates the company’s bonds “non-investment
grade”. And the dividends obviously sit behind the bonds. The company’s policy is to literally
keep almost no cash on hand (all cash is basically pushed out of the company every single
quarter). This is a good comparison in the sense that a completely unleveraged business that has
paid dividends for 13 straight years, has not lost meaningful amounts of money in any of those
13 years, has virtually no liabilities, and keeps several years’ worth of dividends on its balance
sheet at all times shouldn’t have a higher dividend yield than National CineMedia. That’d be
crazy. Bonal’s dividend yield should always be equal to or less than NCMI’s. Never more than.
Okay. So, we said NCMI yields 9.4% right now. For the sake of simplicity, let’s round that up to
10%. And then we can just capitalize Bonal’s likely average future dividend at 10 times. That’s
the stock price it is “safe” to pay based on the dividend alone.
I have dividend per share data for Bonal from 2012 through 2018. Here are those dividends.
2012: $0.14
2013: $0.30
2014: $0.05
2015: $0.20
2016: $0.15
2017: $0.04
2018: $0.10
That’s a range of 4 cents to 30 cents per share. The average is 14 cents a share. If you capitalize
14 cents per share at 10 times you get $1.40 a share. That’s the share price level I’d say is
supported by the likely future dividend yield alone – assuming no meaningful future earnings
growth, no use of the already existing cash pile, etc. In reality, because of the tax cut – you’d
have to say the likely future dividend is probably no less than 15 cents per share and the stock
price supported by the likely future dividend alone is $1.50 a share.
Because Bonal doesn’t trade frequently – there’s often a bid/ask spread. For example, as I write
this…
Last trade = $1.40
Highest Bid = $1.38
Lowest Ask = $1.72
To be sure you get shares right away – you’d need to bid $1.72 a share. Obviously, don’t do that.
In this case, the highest bid is close enough to the last trade that the last trade is a good enough
proxy for what you should actually bid. Logically, you’d either bid $1.39 a share (topping the
$1.38 a share highest bid) right now – or, you’d put in a bigger order at a much lower bid. It’s
possible someone wanting to sell quite a lot of shares might sell them to you below $1.38 a
share, because you’d be bidding for a lot more shares than whoever if bidding $1.38. In all
honesty, that’s what I usually do in illiquid stocks. I start by making a pretty big volume bid at a
lower than “market” price. There’s no reason to believe that the current bid/ask is necessarily
indicative of where the stock would sell “on heavy volume”.
You’ve gotten this far. Now, the question is: should you bid for shares of Bonal?
Well, normally, I’d stop my “initial interest post” right here. Later, I’d write a follow-up post
where I discuss the business, its durability, its future growth prospects, etc.
We’ve already covered everything that “initially” interested me in Bonal. It’s a dividend payer
that – based on past experience – might already be yielding 10% a year for long-term buy and
hold shareholders who get in today and average something like a 15 cent dividend over their
holding period in the stock. It’s also got more than a third of its market price in cash on the
balance sheet. Liabilities are close to nil. And the company’s gross profitability is truly
extraordinary.
That’s all I’d need to know that “yes, I’m initially interested” in Bonal.
However, I started this article by telling you I’d probably pass on Bonal simply because there
isn’t enough “float” to make buying it for the managed accounts an investment that could
possible “move the needle”. Bonal is such a small stock – that we can all get a taste of the
“Warren Buffett problem” here. Warren Buffett’s problem – managing a $100 billion+ stock
portfolio – is that he can mostly only consider $100 billion+ market cap companies. And you
certainly can’t invest meaningful amounts of his portfolio in any sub $10 billion market cap
stock. He has to focus on stocks with over $100 billion market caps. And he can’t afford to waste
even a second consider stocks below $10 billion (these could never be more than 1% positions
for him).
That’s my problem here with Bonal. So, I’m pretty sure this is a stock I will never follow-up on.
Despite that, some of you might be diversified enough in your personal accounts for Bonal to be
a potential investment. It’d still have to be an incredibly illiquid investment. But, hey, if it’s
going to yield 10% while you hold it – you can afford to get in with no idea if you could ever get
out. You could just buy this thing and hold it indefinitely. So, it will be worth some readers’
time.
Therefore, I’ll wrap this up with a brief discussion of the business Bonal is in.
Bonal describes itself as:
“…the world’s leading provider of sub-harmonic vibratory metal stress relief technology and the
manufacturer of Meta-Lax stress relieving, Black Magic Distort on Control and Pulse Puddle
Arc Welding equipment. Headquartered in Royal Oak, Michigan, Bonal also provides a
complete variety of consulting, training, program design and metal stress relief services to
several industries including: automotive, aerospace, shipbuilding, machine tool, plastic molding
and die casting, to mention a few. Bonal’s patented products and services are sold throughout
the U.S. and in over 61 foreign countries.”
What does that really mean? We know from other parts of annual reports – which I’m not going
to quote here, you can read them yourself (none run more than a few pages) – that Meta-Lax is
used in a variety of metalworking applications. The company’s founder and his son (who later
went on to run the business) were co-inventors of the technology. The first Meta-Lax patent was
in 1971. All I can tell from reading about the technology is that it’s an alternative to the “heat
trace method” of stress relief.
What about the way this technology is monetized?
Sales to “machine and fabrication shops” were 50% of last year’s sales. Aerospace was 12%.
The company has sold in 60 countries overall. But, it only sold in 12 different countries last year.
So, customers are machine shops. Three years ago, repeat customers accounted for 42% of sales.
Two years ago, repeat customers accounted for 54% of sales. And, this past year, they accounted
for 63% of sales. Given how high gross margins are at Bonal – even this most recent year’s
figures are actually a surprisingly low rate of repeat customer purchases. It’s much more
common for a business selling spare parts, doing repairs, servicing an existing installed base, etc.
to have high gross margins than it is for a company that sells to a lot of brand new customers
each year.
The demand for Meta-Lax has to be really, really low. So, what is Meta-Lax?
We know its equipment that is sold to metalworking companies. The equipment’s supposed
benefits are to “control machining and welding distortion, improve product quality, and increase
service life”.
In a past shareholder letter, the CEO wrote:
“Yet our loyal Bonal customer base, not only ordered more Meta-Lax equipment, they also
referred and required their suppliers to use our Meta-Lax technology. Companies that invested in
Meta-Lax equipment this year overwhelmingly selected our top model for its capability to
graphically certify stress relief results.”
So, we know a lot of the sales are for the company’s top model. And we know the top model is
some sort of metalworking equipment that can “graphically certify stress relief results.”
The company’s sales are probably done in pretty large part through trade shows. A letter to
shareholders mentions trade shows. And based on my very limited knowledge of private
companies that have a just a few million dollars in sales (despite selling globally) of capital
equipment – trade shows are a common way of getting on the radar of new customers.
In addition to machining and welding – Bonal mentions customers in the die casting, mining, and
motorsports industries. Two customers mentioned by name are TigerCat (forestry equipment)
and Bombardier (airplanes).
How much of sales are foreign and how much domestic? I assume most are domestic. Bonal
doesn’t break this out each year. However, when they did mention it – they gave a breakdown of
20% to 25% foreign and 75% to 80% U.S. Also, when the company mentions countries they sell
to (and, I’m generalizing because they have sold this equipment in 60 countries) – they seem to
share certain economic traits with the U.S. manufacturing sector. Basically, they’re Northern
European countries and such. Also supporting the “mostly pretty domestic” argument here is that
Bonal did say in one annual report that Canada is the company’s biggest source of foreign sales.
That suggests a very North American centric business. Globally, Canada’s a pretty big economy.
But, if Canada is your second biggest market – you’re probably a very U.S. focused company.
And when Bonal talked about trade shows it only mentioned shows in the U.S. and U.K. On the
other hand, the equipment’s specs do say it can run on like 5 other languages besides English.
The company mentions – in its 2016 annual report – a specific model. It’s the model 2800. I
haven’t found images of that. But, I have seen images of series 2000, 2400, 2700, etc. You can
find these by visiting the company’s website or doing text or image Google searches.
For a description of the Meta-Lax technology, you can visit this page of the company’s website:
http://www.bonal.com/tech/tech.html
All I can tell you is that Bonal’s equipment is meant to relieve thermal stress. As you can see on
that page, the technology is named as a combination of “metal” and “relaxation”. Since I don’t
know anything about welding, etc. – this information isn’t very helpful to me. For example, why
is this process so rarely used (if the $2 million a years in Bonal’s sales worldwide are any
indication)? Are there very niche applications that find this technology beneficial? A couple
times, Bonal mentions aerospace customers and things like that. But, it seems that half of sales
are coming for much more general customers (though, I don’t know if those customers are using
the equipment for very specific jobs or more generally). Saying that a customer is a “machine
shop” isn’t really helpful in knowing the actual way in which that customer is using the MetaLax equipment. We know the customers are metalworkers. But, we don’t know how small a part
of their overall business is done using anything Bonal sells.
Obviously, Bonal touts its own technology. The argument it makes in favor of Meta-Lax is:
“Meta-Lax continues to achieve the same effectiveness and consistency as heat treat stress
relief yet without the expense, time delays, huge energy consumption, and the many other
negative side effects that are common with the heat treat method.”
Since I don’t know anything about metalworking – all this really tells me is that Bonal’s subharmonic vibration approach is an alternative to the standard heat treat method. But, which is
better for what applications? That’s way outside my circle of competence. And it’s dangerous to
base any conclusions on what the company that markets the technology is telling you. This
would be an area where you might be able to do some scuttlebutt – especially if you know
anything about metalworking.
If you look at images of Bonal’s equipment – it seems we’re really talking about different
iterations in the same product line. The company said – back in 2015 – that 80% of revenue was
from equipment sales. So, you can probably guess that about 80% of the company’s sales are for
whatever images you can pull up for “Meta-Lax” equipment (this is the series 2000-whatever
stuff I’m talking about).
In Bonal’s 2014 letter to shareholders, there is a little more information about the founding of the
company and the creation of its Meta-Lax technology:
“…the founder of Bonal…was the owner of a machine shop. He knew that the metalworking
industry needed a low-cost and energy-efficient method of stress relief that was as consistent as
the traditional, but expensive, heat-treat stress relief method. Gus made it his mission to fill that
need. Gus created the Meta-Lax process and, building on its initial success, continued to
improve and perfect the process as Bonal Technologies introduced 14 stress-relief models. In
1988, the U.S. Department of Energy took notice and, following their own research, began to
promote Meta-Lax as an energy savings invention, showing that Meta-Lax stress relief was 98%
more energy efficient than the traditional heat-treat method. When Bonal became a public
company in 1990…Gus became its first chairman of the board.”
So, what’s the conclusion here?
Bonal is basically a one tech and one product line – the equipment based on this tech – company.
It’s mostly a domestic company. So, it’s probably tied more than anything else to U.S. machine
shops. The technology is an alternative that the company believes is superior to the traditional –
and presumably, more commonly used to this day – method.
Is this a good technology that has just been under marketed by the inventor and his family?
Or, is there some reason it will never be widely adopted?
I don’t know the answer to that. It’s entirely possible this is perfectly good technology,
equipment, etc. But, this is a really small company. It can’t spend on R&D, marketing, etc. the
way a big company does. It’s entirely possible that the marketing done by this company is not as
sophisticated at what bigger, public companies do.
So, this may never be a growth story. But, if the technology is solid – which I have no way of
knowing one way or the other – then, this company could be solid.
Bonal is a $1.40 a share stock with more than 50 cents a share in cash and the potential to pay
more than a 10% dividend yield in the future. The fact that Bonal does not follow a policy of
paying the exact same regular dividend each year – but, instead, pays a lot one year and then a
little the next as business ebbs and flows cyclically could actually be a huge blessing for longterm investors. If this thing had a history of paying 15 cents a share in dividends for 10 straight
years – it’d never be this cheap. Because dividends are lumpy – they’re may be a chance to buy
stock in Bonal in low dividend per share year and then hold those shares indefinitely.
Due to the extreme illiquidity here – you have to view any investment in Bonal as being a
permanent investment. Whatever shares you are successful in buying should be seen as forming
a “permanent position” in the stock. Basically, this stock is so small and so illiquid that you have
to take the Warren Buffett approach if you want to invest in this. This is truly a buy and hold
forever situation. In some future year – you might get to sell it with a nice capital gain. But, that
can’t be part of the investment case for buying it today. This investment has to work as a buy and
hold forever stock. With the potential to have a 10% dividend yield on today’s price – the math
here works as a buy and hold forever investment.
If Bonal had a bigger supply of “share float” – I’d definitely be 100% sure this is a stock I’d
follow up on. And, odds are, it’d be a stock I’d actually buy for the managed accounts.
Because I like more concentrated positions – and this thing is simply too small to “move the
needle” for the accounts I manage, I’m undecided about whether to follow up on it or consider
buying whatever teensy amount I can get for the managed accounts.
As a result, I’m going to give Bonal an “initial interest level” of just 50%. I’m sure it’s an
interesting stock. I’m just not sure it’s worth my time given the miniscule float.
Bonal last reported earnings on February 15th. The company’s sales – over the last 9 months –
are down 30%. Earnings are down more like 90%. If you look at Bonal’s long-term history, this
kind of thing does happen. Year-to-year variation in sales and earnings is big. So, I’d still focus
on the long-term average earnings per share, dividend per share, etc. when looking at this stock.
Paying a low price relative to the average EPS, DPS, etc. of the last 10 years or so seems the
right approach here. A bad year for earnings might be a good year to buy the stock. I’m not sure
if that’s the case this year. But, in the last 12 months, Bonal’s stock price has probably dropped
about in line with the sales decline.
Geoff’s Initial Interest: 50%



URL: https://focusedcompounding.com/bonal-bonl-an-extremely-tiny-extremely-illiquidstock-that-earns-a-lot-but-doesnt-grow-at-all/
Time: 2019
Back to Sections
-----------------------------------------------------
Bunzl (BNZL): A Distributor with 20 Straight Years of EPS Growth and 27
Straight Years of Dividend Growth – Facing a Virus That’ll Break At Least
One of Those Streaks
Bunzl (BNZL) is a business I’ve known about for a long time. However, it’s not a stock I’ve
thought I’d get the chance to write about. The stock is not overlooked. And it rarely gets cheap.
EV/EBITDA is usually in the double-digits. It had a few years – the first few years of the
recovery coming out of the financial crisis – where the EV/EBITDA ratio might’ve been around
8 sometimes. It’s back at levels like that now. Unfortunately, the risks to Bunzl are a lot greater
this time around than in the last recession. Why is that?
First, let me explain what Bunzl does. This is actually why I like the business. The company is
essentially like an MRO (maintenance, repair, and overhaul) business. It’s a little different from
them. In fact, I think it’s a little better than businesses like Grainger, MSC Industrial, and
Fastenal. But, it offers its customers the same basic value proposition: we’ll take the hidden costs
out of you procuring the stuff you buy that isn’t really what your business is about. What do I
mean by that? Well, with Bunzl – the company is basically a broadline distributor of non-food,
not for resale consumables. So, you go to a supermarket. You get a bagel out of the little bagel
basket, glass case, whatever in your supermarket – you throw it in a brown paper bag. Bunzl
doesn’t supply the bagel. It supplies the brown paper bag. You pick out some tomatoes and put
them in a plastic bag and add a little green wrapper to the top to seal off the bag – Bunzl might
supply the clear bag and the twist thing, it won’t supply the tomatoes. Obviously, I’m using
examples of stuff the customer might come into contact with. Bunzl actually supplies a lot of
stuff you wouldn’t come into contact with that also gets used up. But, the point is that Bunzl is
neither a manufacturer of anything nor a seller of anything that goes on to be re-sold. It’s a pure
middleman. It buys from companies that produce products that businesses will use – but won’t
sell. It does bid for these contracts (like Grainger does with its big accounts). But, it’s unlikely
that the price of the items is the most important part of the deal. Stuff like whether the company
can do category management, deliver direct to your door (or, in some cases, beyond your door
and into your stores and factories and so on), order fill accuracy, order delivery speed,
consolidating orders, consolidating everything on one invoice, etc. is important. The case for
using a company like this is usually not that you save a penny on some product they buy in bulk
– instead, it’s that you eliminate the work that would be done inhouse by finding a bunch of
different suppliers, comparing prices, tracking inventory, etc. That’s why I say Bunzl is like an
MRO.
However, Bunzl would normally be probably more resilient than an MRO – in fact, Bunzl’s
annual report uses the word “resilient” a lot – in any year other than a coronavirus year. MROs
are usually more exposed to industrial stuff. Bunzl isn’t. Here’s the company’s breakdown (the
first industry served is the biggest problem):
Foodservice: 29%
Grocery: 26%
Safety: 13%
Cleaning / Hygiene: 12%
Retail: 11%
Healthcare: 7%
A lot of that stuff will get disrupted this year. Two categories stand out as very negatively
affected – foodservice and retail. They add up to 40% of the company’s sales. Bunzl has
increased both its earnings per share every single year for at least the last 20 years (I don’t have
data past that). Sales have grown for more than 15 straight years. And the company has increased
its dividend for 27 straight years. The increase in the dividend over 27 years has been done at a
10% CAGR. Generally, the company tries to increase the dividend in line with EPS. It’s very
possible – based on that fact – that intrinsic value per share has compounded at close to 10% a
year for close to 30 years. Shareholders also got a dividend on top of that. The company is super
resilient in normal years. It won’t be resilient this year though. And it does use debt. Bunzl had 2
times net debt to EBITDA going into this. If you add in leases – I guess it’d be closer to 3 times.
But, that’s misleading, because I didn’t add back rent. I think a level of about 2 times net debt
EBITDA – keeping in mind they also have leases – is the best way to look at this company.
Based on the most recent annual report, Bunzl had about 1 billion Pounds undrawn on a credit
line and was rated BBB+ by S&P. The company’s goal is to maintain an investment grade rating.
There is some discussion of coronavirus in the annual report. However, the risk section on
coronavirus – even when speculating about it spreading in the future – does not discuss any
impact outside of China. Bunzl sources a lot of its stuff from an office in China. It talks about
this a lot. It talks about how sourcing could be disrupted. It doesn’t talk about the possibility of
customers being hurt.
There’s a good reason for that. Bunzl is a U.K. listed company. However, its biggest market is
the U.S. Operating profit comes about 53% from the U.S., 28% from the E.U., and about 13%
from the U.K. At the time the company’s annual report was prepared – the idea of shutdowns of
restaurants in the U.S, U.K., and E.U. would not have seemed possible. Coronavirus was then
only a Chinese phenomenon.
The annual report is not very informative. The company seems pretty big and bureaucratic. It
does seem very disciplined though. The metrics they talk about in the annual report are the ones
shareholders would care about. For example, Bunzl focuses on return on invested capital –
including goodwill. That’s what you’d want a serial acquirer to focus on. Bunzl buys smaller
companies all the time. So, it’s good that the company discloses the 13-14% type returns it has
on capital including intangible assets instead of just focusing on the more like 30-50% returns it
has on tangible capital. This is a great business. But, you always have to acquire things at far
above book value. To give you some idea of the “goodwill” in this business – Bunzl amortizes its
acquired customer relationships on a straight line basis over 10-19 years. Amortization is just a
non-cash accounting charge. The fact the accountants chose 10-19 years doesn’t prove anything
important about the business – and it does flatter reported earnings to take longer to amortize
stuff. But, it also suggests high customer retention. You don’t normally choose a 10-19 year
amortization period if your customer churn is like 30% a year.
Bunzl describes “a one stop shop” as being “the very essence of the Bunzl business model”. It
talks about its approach as being: “one order, one delivery, one invoice”. The company also
mentions – as I discussed earlier – the importance of “beyond the back door” service for some
customers. Bunzl doesn’t disclose a lot about specific customers. The annual report included
some pictures where I knew who the customer was based on the picture. I also recognized some
brands from stuff in pictures. Bunzl supplies both brand name and private label stuff. I believe –
but can’t prove – that Bunzl often (but not always) serves at least one of the biggest
supermarkets in a given market. This is just a guess based on some stuff the company said and
on the materiality to specific segments of the loss of a single supermarket customer or winning
that customer back. The company mentions situations like this twice in ways that – by my math –
wouldn’t make sense unless the customer was a very big market share player.
Bunzl mentions something in its acquisition criteria which is probably core to its business
approach – and is usually a defining characteristic of the “MRO” type businesses to which I’m
comparing Bunzl – and that’s the requirement that a customer’s purchases from the acquired
company must represent a small percentage of the customer’s total spend. A key to this business
is that Bunzl is not a supplier of anything you re-sell – so, you aren’t obsessed about your margin
on the product. And secondly, Bunzl is not a very high cost service provider either. The level of
diversification here is meant to be more like MROs, big ad agencies, etc. Although Bunzl does
discuss key customer losses and wins – they’re mostly noticeable because the existing customers
change their purchase levels so little. So, a big customer win or loss could swing one of the
countries I discussed by maybe like 6% or something and more like 2% or 3% for the entire
company. I don’t see a really high level of growth potential or of risk of lost business due to a
single customer coming to or moving away from Bunzl.
This is a “survival of the fattest” business as Buffett would say. The economies of scale in a
broad, middleman business like this are pretty awesome. They aren’t noticeable at first. But, they
snowball. One, you probably get the best returns on your acquisitions. Bunzl has a lower cost of
capital than the companies it acquires. It buys several small companies every year. Bunzl uses
debt to finance these purchases. It’d be hard for companies that are sometimes less than 1% of
Bunzl’s size to access capital at the rates Bunzl can borrow. And, of course, these companies
aren’t public. Bunzl is. On top of this, the return on the acquisitions is largely from synergies.
Bunzl intends to sell more through the same system to the same customers by making these
purchases. It’s difficult to get lower purchase prices on supplies than Bunzl, because you’ll often
be buying less than they are. And it’s easier to make money on the customer side of things if you
can get more of the spend of each location at each customer. This increases gross profit per order
and stuff like that. Bunzl rents warehouses and employs truck drivers. It also has more than
3,000 sales people and more than 2,000 customer support people. I’m sure smaller competitors
can compete with Bunzl just fine – the industry is very fragmented – on an “also” basis. But, not
on a consolidated basis. What I mean is that it’s typical for smaller companies to be able to
supply a narrower line of products and make good money as long as they have high customer
retention, a strong position in a specific region, or a strong position in a specific industry (and
often a specific industry in a specific region). However, the risk to smaller companies is that
customers will simplify their purchasing by consolidating their supplier list into fewer, bigger,
and more entwined relationships. That seems to always be the pattern in industries like this. And
that’s why I say this is a survival of the fattest business.
Bunzl will have a bad year in 2020. It may have a bad year in 2021. All this coronavirus and
recession talk is speculative. Bad stuff will happen. But how bad and for how long – I don’t
know. And I definitely don’t know how to price that into a stock like Bunzl.
How cheap is Bunzl?
The P/E ratio is about 13. The dividend yield is about 3%. Both of those are really attractive for a
company that had grown EPS for 20 straight years and dividends per share for 27 straight years.
The company is super resilient outside of freak years like this one. EV/Sales is 0.77. I think the
company can normally have an operating margin of 7%. Cash conversion is good. Returns on
mergers is adequate (13%+). Returns on organic growth would be amazing – but, organic growth
is awfully close to nil in an industry like this.
So, I think I’d like to pay less than 0.7 times sales for the company. I’d like to get it at less than
10 times pre-tax earnings. It might be cheap enough now. But, I’m not in a buying mood yet.
And, as with almost all businesses this year, things will get worse for Bunzl before they get
better.
Still, this could be a buying opportunity.
Geoff’s Initial Interest: 70%
Geoff’s Revisit Price: 1,200 GBP (down 27%)



URL: https://focusedcompounding.com/bunzl-bnzl-a-distributor-with-20-straight-yearsof-eps-growth-and-27-straight-years-of-dividend-growth-facing-a-virus-thatll-break-atleast-one-of-those-streaks/
Time: 2020
Back to Sections
-----------------------------------------------------
Babcock & Wilcox Enterprises (BW): A Risky Stock Getting Activist
Attention
I’m trying something different this week. In an effort to share more ideas with members, I’ve
decided I’ll write about whatever stock I’m looking at – even if I don’t like what I see. This will
give you some insight into my stock selection process at the earliest stages. It will also let me
give you more regular, stock-specific content. The downside, of course, is that it’s risky. I’m
risking getting you interested in a stock you shouldn’t be interested in. So, I’ll rate the initial
stock ideas I write up here with an interest level (from zero to ten) at the end of the article.
This week I’m writing about Babcock & Wilcox Enterprises (BW). I once owned this stock,
because I bought the pre spin-off Babcock & Wilcox and kept my shares of BWX Technologies
(BWXT) through to today. I sold my shares of Babcock & Wilcox Enterprises about 11 months
ago at $15.48 a share.
Where is the stock today?
It’s at $5.80 a share.
Your first step in researching Babcock & Wilcox Enterprises should be to read the old report on
Babcock & Wilcox in the “reports” section of this website. That report describes what would
become BWXT and BW in great detail. I’m not going to spend time here discussing what it is
that Babcock does, because you have a report available to you that describes that in greater detail
than probably any public information on Babcock that’s out there.
However, that report describes what those businesses looked like as of about two and a half years
ago.
Some things have changed since then with BW.
Let’s start with the recent news items that might get a value investor interested in the stock. The
company has attracted two major investors.
One is Vintage Capital Management. It owns 14.9% of the company and now has two board
seats. You can read Babcock’s announcement of the deal with Vintage here. You can also visit
Vintage’s website for yourself and see what other companies are in their portfolio.
The second – and more recent – investor in Babcock is one you’re more likely to have heard of:
Steel Partners.
The details I’m going to give you now come from Steel Partners’ 13D on Babcock filed February
5th. Steel Partners owns 11.8% of Babcock & Wilcox shares. These shares were bought between
January 26th and February 5th at prices between $5.99 and $6.58. The stock now trades at $5.80.
So, you can get your shares a bit cheaper than Steel Partners got their shares. That’s one reason
for writing this up obviously.
Another reason is that the stock trades at $5.80 a share and Steel Partners apparently wanted to
buy all of Babcock for $6 a share. This quote is from the 13D:
“On December 15, 2017, Steel Holdings made a proposal to the Issuer to acquire all of the
Shares not owned by Steel Holdings or its subsidiaries for $6.00 per share in cash, representing
a premium of approximately 33% over the then 30-day volume-weighted average price of the
Shares. However, the Issuer has been unwilling to engage in any meaningful discussions with the
Reporting Persons regarding this proposal. The Reporting Persons intend to continue to
communicate with the Issuer’s management and board of directors about a broad range of
strategic and operational matters…”
It’s worth noting the timeline there. Apparently, Steel Partners made a proposal to buy all of
Babcock on December 15th for $6 a share. Steel Partners was rejected. A little over a month later,
it started buying Babcock shares at prices about even with its original proposal. So, it has been
creating a minority stake in Babcock at about what it wanted to buy the whole company for.
The final recent piece of news is that Babcock has also announced a new CEO. That
announcement was made at the start of February. So, you have a lot of news items with this
company. Recently, the company has gotten two big, new shareholders – one owns 15% of the
company and has a deal for board seats and the other owns 12% of the company and had its $6
buyout proposal rejected out-of-hand. You also have a new CEO.
Babcock & Wilcox is not just a troubled stock (at one point in the past year, it had fallen from
over $17 to under $2). It is also a troubled company. The financial position is weak.
The company violated its debt covenants earlier this year.
Also, in 2017, Lightship Capital had bought 9.9% of Babcock & Wilcox Enterprises stock.
Lightship is affiliated with American Industrial Partners and Babcock took out a loan from
American Industrial Partners to buy out Lightship Capital’s equity stake.
When Babcock released earnings results on November 8th of 2017, they said they “…ended third
quarter in compliance with our financial covenants and forecast that we will remain in
compliance going forward.”
However, they still talked about strategic alternatives for some of the company’s businesses.
This is potentially interesting to us – or at least, me, as an investor – because Babcock may
dispose of businesses I was unsure of how to evaluate and keep the ones I was more sure of.
Here, I will finally touch on what it is Babcock does (remember: read the report). But, first let’s
take a look at how Babcock breaks its business into segments and what outlook it gives for each
segment for next year.
The company has 3 segments: renewable, industrial, and power. I am least interested in
renewable and most interested in power.
The 2017 guidance is for renewable to generate $350 million in revenue and have “positive”
gross margins in the second half of 2017. We may have to consider that business worthless for
any analysis we do of what Babcock’s value is. Guidance for industrial is that it will be at the
“low end” of the previous guidance of $400 to $500 million in revenue. Let’s call that $400
million. And the gross margin will be “in the mid-teens”. If we assume “mid-teens” means 15%,
that would be $400 million * 0.15 = $60 million in gross profit contribution. Then we have the
“power” segment which is said to be at the “low end” of the previous range of $825 million to
$875 million in revenue. Gross margin is said to be in the “low 20% range”. Let’s say this means
$825 million in revenue times a 20% gross margin equals $165 million in gross profit
contribution.
My point here is that – as of now – whatever value there is in Babcock & Wilcox Enterprises
seems to be lopsided in favor of the “power” segment. Roughly speaking, we may have to
consider renewables inappropriate for a sum of the parts analysis and then assume industrial is
25% to 33% of the value of Babcock and power is more like 67% to 75%. In any case, power
could provide as much as two-thirds to three-quarters of all the value in Babcock. So, we need to
check if the power segment of Babcock is potentially worth as much as the company’s current
enterprise value. The logic behind that approach is that if power is possibly 65% or more of the
total company’s value and we – as value investors – want at least a 35% “margin of safety” (that
is, we want to buy a dollar for 65 cents) – we can’t buy into a stock where the enterprise value is
higher than something that represents 65% of the overall company’s value.
So, in this case, our first sort of valuation check is simply to put “industrial” and “renewable” to
one side and compare our appraisal value of Babcock’s power segment to the current enterprise
value.
Let’s start with enterprise value. If we calculate net debt by adding the (very big) pension
obligations shown on the balance sheet and the second-lien loan (this is the American Industrial
Partners loan) and the revolving credit balance and then we subtract out both restricted and
unrestricted cash – we get right around $400 million in “net debt”. Market cap is only $255
million right now. So, this business basically has a $650 million price-tag that is 60% debt and
only 40% equity. As value investors – who want a margin of safety – we can’t just use the
leveraged part of that. We have to count the debt. So, the overall price tag is $650 million for this
business.
Is the power segment of Babcock & Wilcox Enterprises worth $650 million?
We wrote about the power segment of Babcock and how to appraise it in our report. First, I
should say something that might worry you here about how difficult it is to appraise this asset…
The closest peer to Babcock’s power segment is Alstom. That’s the company GE acquired and
has definitely hurt the business results – and stock price – of GE since then. Alstom is more
dependent on capital spending at natural gas plants and on capital spending on power plants
outside the U.S. Babcock is more dependent on capital spending at coal power plants and on
power plants inside the U.S. I should point out though that we never considered “new build” an
important part of the value in Babcock’s power segment. So, if the U.S. doesn’t build another
coal power plant in the future – that really doesn’t have much to do with the appraisal of
Babcock’s power segment. Without new build, the amount of coal power plants will trend down
and Babcock’s maintenance revenue with it. But, as you can see from the results at Alstom – and
from Babcock’s recent experiences in everything but U.S. coal – a buggy whip business like
maintenance on coal power plants is a lot less likely to threaten a company’s existence than
expanding into other types of projects (however fast growing you may think long-term demand is
for those projects).
Basically, we assumed that the profit contribution from Babcock’s power segment would be
maintenance work on the U.S. coal power plants where Babcock built the original boiler. So,
what we’re talking about here is maintenance work on U.S. coal power plants.
The original appraisal we put on Babcock’s power generation business was just under $1.3
billion. That was only two and a half years ago. All of Babcock & Wilcox now trades for a $650
million enterprise value. So, if Babcock’s power business was only worth 50% of what we
assumed it was – the power segment alone could still justify B&W’s present-day enterprise
value.
So, the stock might be cheap. Recent results are very messy and trying to calculate normal
earnings based on performance since the spin-off probably doesn’t make much sense.
Am I interested in this stock?
No.
There are two reasons why I’m not interested in Babcock & Wilcox Enterprises and am unlikely
to continue to follow the stock.
One: the company’s financial strength is weak. It has a big pension obligation and now has big
loans as well. I don’t want to go into an analysis of B&W as a credit risk – you can look at the
balance sheet yourself and try to work out the future cash flows. But, when you get to the point
where you need to do a detailed credit analysis to decide whether you want to buy the equity –
you probably should drop the stock right there.
Two: the company’s capital allocation has been the opposite of what I wanted to see before the
spin-off. I though there was value – free cash flow that could be milked for a while – in doing
maintenance on U.S. coal power plants. The cash flows from that could be used to fund pension
obligations, eliminate debt, build up cash and lead over time to a smaller, safer company.
Instead, Babcock has tried to diversify away from coal (and, in so doing, away from the U.S.).
In our report on Babcock we felt their competitive strengths were tied to coal power plants and
the United States. It’s not just that acquisitions of higher growth businesses may be made at too
high a price. It’s actually that none of these new and international power projects may ever have
the kind of economics U.S. coal does. It’s very dangerous to invest in an engineering company
that is doing projects it hasn’t done before and is changing the mix of its business.
This stock has become both risky (in terms of insolvency) and too hard for me to understand (in
terms of diversification).
Right now, I rate my interest level in Babcock & Wilcox Enterprises a 1 out of 10.
It does, however, look like the stock could be cheap on a business value to enterprise value basis.
And, because of the leverage in the stock, B&W shares could rise a lot in price if the business
was turned around. Obviously, there are big shareholders in the stock who may work for such a
turnaround.
Geoff’s Interest Level: 10%



URL: https://focusedcompounding.com/babcock-wilcox-enterprises-bw-a-risky-stockgetting-activist-attention/
Time: 2018
Back to Sections
-----------------------------------------------------
BWX Technologies (BWXT): A Leveraged, Speculative, and Expensive
Growth Stock that Might be Worth It
BWX Technologies (BWXT) has been at the top of my research pipeline for a while now. I
wrote about the company – when it was the combined company that is now split into BWXT and
Babcock & Wilcox Enterprises (BW) – a few years back. You can read my report on the
combined Babcock & Wilcox in the Singular Diligence archives. Today, I’m not going to talk
about the business – which is described in great detail in that report (see the “Stocks A-Z” tab).
Instead, I’m going to talk about price.
I’ve talked before about how I need to check off 4 points about a stock. One: do I understand it?
Two: is it safe? Three: is it good? And four: is it cheap? If a stock clearly and definitively fails
any of these 4 criteria – it’s not something I’m going to want to buy. Since I wrote a report on
Babcock a few years back – and since BWXT is the part of the old, combined Babcock I felt I
understood best – I definitely think BWXT is something I can understand. I also think it’s a high
enough quality business. The big concern with safety is debt. The company does not have an
investment grade credit rating. However, the business itself is very safe and very predictable. So,
analyzing the debt load is really just a matter of arithmetic. You can judge that part as well as I
can. The more interesting question is price. On the surface, BWXT does not look cheap. It has
almost never looked cheap. And so: the quickest way to disqualify this stock would be to show
that it is, in fact, too expensive to consider at $53 a share.
BWXT had a missile tube issue last year. The stock price declined. And it hit a low around the
start of this year. The stock has since rebounded though. We can look at the year-to-date return
in the stock as an indicator of how much more expensive it’s gotten. The stock started 2019
around $39 a share. As I write this, BWXT is at $53 a share. So, it’s 36% more expensive.
Obviously, the market as a whole has done well in January and February. But, it hasn’t done
anywhere near as well as that. So, we’re talking about a substantial rebound in the stock price
here. I had put BWXT on my research pipeline before that rebound. So, the question is: at $53 a
share, is BWXT too expensive for a value investor to even consider?
The company has debt. And, normally, I’d start with an enterprise value based price metric (like
EV/EBITDA or Enterprise Value / Free Cash Flow). However, I’m trying to eliminate BWXT
from consideration here. I strongly believe the business is a good, safe (when debt is kept
manageable), predictable business. It might be worth a very high multiple of EBITDA, free cash
flow, etc. So, starting with something like EV/EBITDA might give us an inconclusive answer.
Instead I’ll start with a measure that is most favorable to the possibility that BWXT might be
cheap. Remember, if we prove it’s clearly far too expensive a stock for a value investor to
consider – we can eliminate it from the research pipeline right here and now. But, if the answer
we get is that the stock looks pricey but also looks a lot better than most businesses – that’s not a
definitive answer at all. So, we have to start by giving BWXT the benefit of every doubt we
might have. We can then work our way back from that extremely favorable calculation to
something more reasonable. And, if BWXT passes the most favorable test – that is, the lowest
possible price hurdle I can think for a stock to clear – then, I should keep it on my research
pipeline and re-visit the stock at some future date. But, if BWXT seems clearly overpriced even
when I give it the benefit of every doubt I might have – then, we can eliminate it right now.
So, I’m going to use EPS. Using a P/E type measure instead of something like Enterprise Value /
Free Cash Flow is very favorable to BWX Technologies, because the company has quite a lot of
debt.
So, let’s stick to a P/E calculation. BWX is guiding for pretty fast growth. And we want to take
that into account. It might have a high P/E ratio this year – but, if it’ll be growing EPS by 10% a
year while the S&P 500 returns only 5% a year (I’m using that just for the purpose of illustration
here) – then, it could still be a good investment. For that reason, I’m not going to talk about the
stock’s P/E ratio in 2018. Instead, I’m going to try my best to look out about 5 years and see
what the stock’s current price divided by the EPS it may have in 2024 would be.
As of the last quarterly press release, BWXT’s management said its 2018 guidance was for “nonGAAP EPS in a range of $2.23 to $2.27”. Because this article is just a first hurdle for BWXT to
clear – we’ll assume the number is $2.27 a share and that this number is effectively equivalent to
a GAAP number. BWXT also reiterated its long-term guidance. This is something the company
has been saying for a long time. The exact quote is: “…the company anticipates an EPS
compound annual growth rate in the low-double digits over a three to five year period based on a
robust organic growth strategy and balance sheet capacity.”
Note that last bit: “balance sheet capacity”. BWXT already has about $700 million in net debt.
That’s about $7 a share in net debt (since the company has a little under 100 million shares
outstanding and a little over $700 million in net debt). This doesn’t include pension liabilities
(which the company also has). So, the $7 a share in net debt figure is a bit conservative. We’re
talking about a company where debt is already 3 times expected EPS and they expect to borrow
more to buyback more shares. That’s clearly what “balance sheet capacity” means in the EPS
growth guidance. In other words, BWX’s debt adjusted stock price would be more like $60 a
share – not the $53 a share market price I’m using. We’re giving the company the benefit of the
doubt as if it can always keep this much debt. And then management is actually going beyond
that and saying that part of its EPS growth over the next 3 to 5 years will be fueled by additional
debt growth.
Okay. So, we’re being extremely easy on the company by using a $53 stock price here and by
including all of management’s EPS growth expectations – even the part that will be supported by
additional debt. What does “low double-digits over a three to five year period” mean?
Again, we want to be favorable to the stock in this first article where we decide if BWXT makes
the cut and deserves additional consideration. So, I’m going to assume that low double digit
growth in EPS over 3 to 5 years translates into a 10% growth rates in EPS sustained for 5 full
years.
Let’s do the math on that. We start with $2.27 in EPS guidance for this year. We then compound
that $2.27 at 10% a year for 5 years. That gives us $3.66 a share five years from now ($2.27 *
1.10 ^ 5 = $3.66).
We can then use the $3.66 a share estimate for 2024 and capitalize it at some P/E ratio. Today,
the S&P 500 is pretty pricey. Historically, a normal P/E had been around 16. BWXT is a better
than average business. Let’s us a P/E ratio of 20 as fair. That’s actually more than fair, because
BWXT has debt today and might have even more debt in 5 years. So, $3.66 a share times 20
equals $73.20 a share.
So, how much of a capital gain would you have if you bought BWXT stock today and sold it in 5
years at 20 times an expected EPS of $3.66 a share? That is, you buy at $53 and that becomes
$73 in 5 years. That’s a 6.7% compound rate of growth in the stock price. The dividend yield
would add another 1% to the stock return. Add 1% to 6.7% and you get 7.7%. Round it up: it’s
8%. So, there you have it. That’s a pretty average – historically – return in a stock. And that’s
counting on management’s guidance of (as I translate it) 10% EPS growth for 5 years coupled
with an ending P/E ratio of 20. Adjusting the P/E ratio for debt would make it more like 22 or
higher (probably higher, since BWXT seems to be planning to use debt to buyback stock).
BWXT is such a predictable stock that we could actually go further than this. For example, the
company has given us 30-year guidance – it doesn’t call it that, but that’s kind of what it is – for
the U.S. Navy’s expected orders for both submarines and aircraft carriers through the 2040s.
Those are real expected orders. We’d have to add inflation on top of that. If we were to do that
and extend our EPS estimate out beyond the next 5 years for another decade on top of that –
we’d actually get a very, very similar answer. In fact, it looks to me to be an almost identical
answer. If you assume something like 3% inflation and include the dividend yield BWXT now
has – you’d again get something more than 6% but less than 8% as your annual return in this
stock all the way out through 15 years or so instead of just the 5 the company gives guidance for.
You can go out a full 30 years – but, that makes the starting stock price less and less important. If
you really can predict 30 year growth, ROE, etc. and find it all very satisfactory – then, today’s
starting price on the stock is relatively unimportant. Basically, value investing doesn’t work as
well as pure “quality” / “growth” investing if you have a holding period of more like 30 years
than 15 years. It just doesn’t make sense to think much about value when holding a stock for
over 15 years. That fact doesn’t worry me here though – because, I doubt anyone reading this
would really buy BWXT today and hold it without ever selling for 15-30 years.
This suggests that – if everything goes right – you might get a return that matches (a pricey) S&P
500 over 15 years or so. But, you’re not going to beat the S&P 500 by buying and holding
BWXT at today’s price of $53 a share (as long as we don’t go crazy in assuming Warren Buffett
type holding periods of 30 years or something).
Unless…
The company does have other potential avenues for growth. These could matter a lot. Probably
not within 5 years. But, it would matter a lot within a 15 year holding period. And this is where
the calculation gets tricky. For a company with a low return on net tangible assets – such
additional growth avenues wouldn’t change the calculation much. If you have a 10% annual
return on equity and a 10% EPS growth rate in the first 5 years and 6% growth rate after that
with that same 10% ROE – it doesn’t make a huge difference if the company pays dividends,
buys back stock, makes acquisitions, or grows organically. In the long run, your return on equity
becomes the stock’s destiny.
But, what if a stock has a pre-tax return on net tangible assets closer to 100% than 10%? Then,
the financial engineering – like debt fueled stock buybacks – and the various growth avenues
start to matter. See, if BWXT can deliver all those reactors for all those subs and carriers without
retaining much of what it earns – then, it can grow EPS faster than what I’ve just laid out. It’s not
going to grow faster than “low double digits” since that is only what the company is guiding for
even over 5 years. However, I could be quite wrong about the growth rate being as low as 6%
(nominal) and more like 3% real over the following 10 years. Or, if the company doesn’t grow
very fast – the dividend will grow very fast. The issue here is the company’s very, very high
ROE within its core business. BWXT could grow a lot without retaining a lot of earnings. That’s
actually the recipe for a successful Warren Buffett type 30 year plus holding period. But, that
complication doesn’t just kick in for years 15-30. If a company’s ROE is high enough and it
raises its dividend, buys back stock, acquires things, grows in new ways, etc. – you can get
surprisingly high 15 year returns despite a high starting price in the stock.
In fact, we know about a couple possible ways BWXT could grow much more than I’ve
anticipated over 15 years. There’s a very small contract they have for working on testing the
possibility of a nuclear propulsion system for a manned mission to Mars. This is absolutely
irrelevant at present. But, if there was a Mars mission planned for 10 to 20 years from now and
the propulsion system chosen was nuclear – then, that would become meaningful to BWXT. I
have no clue what the odds are of that happening. It’s probably closer to a 5% chance than a 50%
chance. But, I can’t say whether it’s closer to a 1% chance or a 10% chance.
It’s so speculative – I just can’t account for it.
There’s another much less speculative – but, still way more speculative than what I usually
consider – program that could drive meaningful growth over the next 15 years. This is the
Nordion medical isotopes business. BWXT has a plan to produce technetium-99m generators.
Technetium-99m is the world’s most commonly used medical isotope. Its used in tens of
millions of diagnostic procedures each year and BWXT gives some information on the likely
market size (it’s a close to $3 billion global market for the actual end product – the generator
market is estimated to be $400 million). The speculative aspects are marketing related. I just
don’t know how good BWXT would be at getting this stuff to market and taking share. However,
on the technical aspects – we’re talking about a product that is produced from another product (I
don’t want to get into all the technical aspects of the chain of production here) that is the result of
the fission of highly enriched uranium. Certainly, BWXT is as knowledgeable as anyone when it
comes to working with highly enriched uranium.
Highly enriched uranium is anything over 20% concentration of uranium-235. Naturally
occurring uranium is less than 1% uranium-235. Commercial reactors for the sort of thing
BWXT is now looking into with the medical isotopes would be 25% or so concentrations. The
most common civilian nuclear reactor design runs on uranium at less than 5% uranium-235.
Naval reactors are probably 50%+ concentrations. While early U.S. nuclear weapons were
sometimes 85%. Certainly, BWXT has a ton of experience in highly enriched uranium (BWXT’s
work is probably been mostly 50-90%) as compared to other companies that have more
experience with low enriched uranium (like 3-5%).
Another question I don’t know the answer to is the fact that BWXT’s planned process might be
considered safer from a nuclear non-proliferation perspective. The company claims that’s true.
They may be right. Certainly, the concentrations we are talking about here (25%+) would be
sufficient to build a nuclear weapon. It would just have to be a very, very big bomb. Historically,
weapons grade enrichment has been 80%+ (that’s the concentration the U.S. had enriched to at
the time it bombed Japan). So, we’re talking about a number far off from that. But, unlike say
nuclear reactors operated by utilities the limitation here is practical rather than theoretical. It’s
true that, in theory, highly enriched uranium (though nowhere near weapons grade) could – if
you built a weapon massive enough – be used in a nuclear weapon. So, there’s definitely a
proliferation concern with greater than 25% enriched uranium (what we’re talking about for the
production of medical isotopes) that there isn’t with less than 5% enriched uranium (what we’re
normally talking about with nuclear power plants operated by utilities). So, could BWXT
develop a process that a government – like the United States – prefers and even privileges legally
over competing sources of molybdenum-99 (the product used to produce technetium-99m)?
Maybe.
But, other people are already producing all of the needed supply. They may be doing it less
efficiently than the process BWXT plans. But, as far as a proliferation risk – if it exists, it already
exists and has existed for a very long time (I think these medical isotopes have been in existence
since the 1950s).
What I’m saying is this: the whole medical isotope thing is still very, very speculative. But, it
certainly sounds like a very smart long-term strategic move into an adjacent area of competence
for BWXT.
The reason why I spent so much time talking about the medical isotopes business is because – if
successful – it won’t produce meaningful amounts of earnings during the 3-5 year guidance
period BWXT has laid out. In other words, BWXT is predicting 10%+ EPS growth without this
business kicking in. Therefore, my prediction of 6% growth in the Navy business from 2024 and
beyond wouldn’t be a good long-term prediction for the total BWXT if this isotope business
takes off.
For this reason, I can’t 100% rule out BWXT as being too expensive. If you think about how
much repurchases, dividends, acquisitions, etc. it could have while also growing 6% a year for
about as far as the eye can see (you can look at the company’s investor presentation in June of
2018 for a slide that includes a 30-year U.S. Navy plan that runs through the 2040s) – I can’t rule
out 10% long-term returns in this stock even at today’s high price.
But, I think expecting anything beyond about 8% annual returns in this stock is speculative. It
might happen. But, at today’s price – I’m not sure that even if you buy and hold for 15 years,
you’d really do better than 8% or so.
Nothing I see in the price tells me that this is a safe way to do better than the S&P 500. The
company is more leveraged and growth is somewhat speculative. This may be a safe way to
expect 6-8% returns over the next 5-15 years. But, I don’t see it as something likely to produce
10%+ returns. I certainly don’t know enough about medical isotopes to bet on strong growth
beyond the next 5 years here.
I can’t fully eliminate it today. But, at $53 a share – this is definitely a pass for now.
Also, because it has been several years since BWXT spun-off BW – I don’t really think this
stock qualifies as an “overlooked stock” in the sense that it’s eligible for inclusion in the
accounts I manage. For that reason, I’m less likely to re-visit this one. But, I think it’s a stock
you may want to keep watching. At over $50 a share – I think it’s too expensive. At under $40 a
share, it’s a stock you might want to add to your portfolio and hold for the next 5 years.
Geoff’s initial interest: 40%



URL: https://focusedcompounding.com/bwx-technologies-bwxt-a-leveraged-speculativeand-expensive-growth-stock-that-might-be-worth-it/
Time: 2019
Back to Sections
-----------------------------------------------------
Geoff’s Thoughts on Cheesecake Factory (CAKE)
Someone asked me my thoughts on Cheesecake Factory. It’s a stock we’ve looked at before. But,
I have written about it recently. The stock hasn’t done well lately. It looks fairly cheap. Here was
my answer:
“I haven’t followed it lately. I know the stock hasn’t done that well. I did a very quick check of
the stock price just now looking at the long-term average operating margin, today’s sales, today’s
tax rates, etc. It seems that on an earnings basis (normalized for a normal margin on today’s
sales) it would be about 13x P/E. That seems like a good price for a stock like this that has grown
EPS almost every year. By the numbers alone, it reminds me of a Buffett stock. I was recently
reading what I think is one of the best books on Warren Buffett. It’s called “Inside the
Investments of Warren Buffett: Twenty Cases”. And one thing that stands out in each case study
is his looking at the last 10-years or more of historical data. In time after time, the increase in
revenue and net income and EPS year-over-year is positive in almost 10 out of 10 years.
Sometimes it’s 9 out of 10 or something. But it’s very consistently positive compared to most
stocks. Also, while people talk a lot about moats and high ROE – I’m not sure that’s as much as
a focus for him. I think he looks more to find something that is already consistently showing
good results year over year almost every year. Then, if the ROE is 20% or 30% – that’s enough
for him. Because the stock is unlikely to be able to grow that fast anyway – it’s just a question of
whether it can get a higher return on retained earnings than he can. ROE at Cheesecake Factory
is generally adequate. It’s high enough that you could buy it based on its growth rate and P/E
ratio. Now, I do notice that the 10-year results in terms of the top line really aren’t that strong.
However, this has been true for a lot of restaurants in the U.S. I think Cheesecake also has the
added problem that it doesn’t grow same-store real sales after the first year. These restaurants
open VERY full compared to the industry. So, some companies have restaurants that do better in
year 2 than year 1. That’s not the case here. But, the growth in things like earnings per share
versus assets has been good. So, the economics have been – if anything – improving in terms of
free cash generation versus the tangible assets used in the business. I’m not, however so sure it’s
a growth stock anymore. But, in the company’s defense I think these last 10 years have been
some of the toughest for restaurants. Inflation has been very low. Food inflation at supermarkets
has been incredibly low to the point where eating in has been much more attractive than eating
out. I don’t think that’s a permanent trend. And then you have increases in wages due to things
like minimum wage laws and low unemployment. I would imagine that the combination of low
inflation and low unemployment with some increases in minimum wages is very bad for
restaurants like this. I know that some casual dining and fast food results have been substantially
worse than Cheesecake’s results.
If I take the 3-year average free cash flow and ignore acquisitions – which I maybe shouldn’t – I
get something like $3.80 a share in average FCF. Like I said, normalized earnings are like $3 in
EPS. So, we have earning power of like $3-$3.80 a share versus stock price of like $39 a share.
Maybe 10-13x P/E. Seems good. But, I like to look at the 10-year forward return expected from
holding the stock. I think the company has only grown revenue by like 4% a year over the last 10
years. If they can’t get any economies of scale, etc. – then, that’s not a great number. However,
dividends are running like 3% yield on today’s price and buybacks like 2%+ most every year
(sometimes a lot higher). Even if we just assume dividends of 3%, buybacks of 2%, and top line
growth of 4% over the next 10 years that’d be an increase in FCF per share of 9% a year.
Multiple expansion (from like 10-13x earnings to 15-16x earnings) could easily account for
another 1.5% to 4% a year. I could see returns of let’s say 10-13% a year possible in this stock
even if the 10-year future growth is closer to the 10-year past revenue growth than the growth in
things like earnings, FCF, etc.
How low could growth in sales be and yet the stock return 10%+ over the next 10 years?
By my math, it’d be about 4% a year sales growth needed here. I think you can get no less than
about 5% a year right now through a combination of buybacks and dividends and I think you’ll
get another 1% a year or more from multiple expansion. That leaves a required sales growth rate
of just 4% a year. I’m pretty sure the overall eat-in dining business in the U.S. won’t grow
SLOWER than 4% a year nominal over the next 10 years Population growth is expected to be
0.7% a year from 2020 to 2030. Inflation / inflation expectations in the U.S. is about 2%. Lowest
I can find is 1.8%. Highest is like 2.5%. Let’s call that something in the 2.5-3% range for
population growth plus inflation. That means you need 1% to 1.5% in REAL growth in sales
BEYOND growth of inflation plus population. I’m not sure this is faster than likely nominal
GDP growth, because real output per capita can increase 1% to 1.5% in some decades. Maybe
1% is more likely than 1.5%, but still very possible. Also, I feel like eating out is a more likely
use of people’s disposable income than additional amounts going to clothing, food at home, etc.
So, I feel like entertainment and food and such outside experiences could increase AT LEAST as
fast as nominal GDP and maybe faster. Nominal GDP might grow as fast as 6% or as slow as
4%. But, I doubt nominal GDP will grow much slower than 4%.
So, I see a path to 10%+ returns in Cheesecake Factory if the company can clear the hurdle of
simply MAINTAINING ITS MARKET SHARE in the restaurant industry. Can it do that? I’m
not sure. But, compared to most restaurant companies I think I’d be pretty optimistic. I think it’s
a great model. Buffett doesn’t really buy restaurant stocks – but, I think it’s an area he could buy
into. They often have predictable earnings actually. If I was managing unlimited amounts of
capital – it’s something I’d consider.
It’s not overlooked enough for Andrew and I. But, it is a stock I think would be a good choice for
any investors who:
1) Like restaurant stocks – feel they are in their circle of competence
2) Have eaten at Cheesecake Factory, feel they understand it
3) Would buy and hold the stock for a long time without worrying about where it trades
I feel most restaurant stocks over-respond to economic results, same store sales, etc. They tend to
attract short interest for macroeconomic reasons. I think they’re actually pretty predictable when
in a strong position competitively. As long as Cheesecake Factory’s competitive position doesn’t
worsen over the next 10 years, I think you’ll make 10% a year. It’s something I’d definitely
consider personally.”



URL: https://focusedcompounding.com/geoffs-thoughts-on-cheesecake-factory-cake/
Time: 2020
Back to Sections
-----------------------------------------------------
Carrier (CARR): A Big, Well-Known Business that Just Spun-off as a Cheap,
Leveraged Stock
Carrier (CARR) is a recent spin-off from United Technologies. The company has leading brands
in Heating, Ventilation, and Air Conditioning (HVAC), fire & safety, and refrigeration. The best
known brand is the company’s namesake: “Carrier”. About 60% of profits come from HVAC.
About 30% of profits come from fire/safety. And about 20% of sales and profits come from
refrigeration. Although you may be familiar with the Carrier name in terms of residential air
conditioning – there are just under 30 million residential Carrier units in the U.S. right now – the
company is skewed much more toward commercial, industrial, and transportation uses than some
of its competitors. Carrier’s market position is strongest in “the Americas” where it gets over half
of all sales (55%). About three-quarters (72%) of sales are for new equipment and the rest (28%)
are some form of parts, maintenance, or other “after-market”. Gross margins for both sales and
services are basically the same at around 29%. Gross margin variability seems very, very low
here. Return on capital is high. If we use only tangible assets excluding joint ventures accounted
for under the equity method of accounting – more on this later – Carrier’s pre-tax return on net
tangible assets invested in the business would be greater than 100%. After fully taxing these
results and then adjusting for a slightly less than 100% conversion (I’ll assume 90% conversion
as the possible low-end of a normal 90-100% of EPS converting to FCF range for the company)
you’d still be left with unleveraged cash returns on net tangible assets employed greater than
50%. By any measure, the business is incredibly profitable. But, does that matter?
Does Carrier grow?
The company’s investor relations team thinks it does. They explicitly model faster than the
market organic growth. There is, however, no proof of this in the five years of financial data
included in the spin-off documents. After adjusting for changes in currency, acquisitions, and
one-time pick-ups and drop offs of big business in various units – I really can’t tell if this
business was or wasn’t growing under United Technologies. Organically, it looks like it was
flattish over the last 5 years. Earnings Before Interest and Taxes (EBIT) ranged from about $2.5
billion to $3.7 billion. The central tendency – to the extent there is one – seems like about $3
billion in EBIT. Just to keep us dealing with nice, round numbers I’ll assume Carrier as a spunoff entity will average about $3 billion in EBIT. Obviously, you shouldn’t expect $3 billion in
EBIT during 2020 or 2021, because of the virus. Purchases of everything Carrier makes are very
easy to defer. This is all cap-ex. If you don’t need a new refrigerated truck – you don’t need to
buy from the refrigeration business unit this year. If you aren’t building new stand alone homes,
new townhomes, etc. – you don’t need to put in residential Carrier units. Commercial customers
who run everything from retail to office and so on may also be husbanding their cash. A good
way to keep more cash on hand for a while is to avoid any cap-ex that would have to be done
using cash. The businesses Carrier sells through often use credit as an important part of their
dealings. In a recession, availability of credit may be scarcer. So, overall, I’ll just stick to talking
about what Carrier might be averaging in earnings in let’s say 2022-2026 or something like that
as opposed to what it’ll actual earn this year or next year.
My initial impressions of this spin-off were not good. However, I followed my usual spin-off
practice of analyzing the company before checking the stock price. A cheap price can offset a lot
of issues with an investment. And Carrier stock spun-off cheap. In fact, the stock portion of the
market cap isn’t very different from the debt portion of the market cap. And the company is
actually rated investment grade by both Moody’s and S&P.
Carrier paid a dividend of about $11 billion (all funded through new borrowings) to its former
parent, United Technologies. So, $11 billion in debt / $3 billion in EBIT = 3.7 times Debt/EBIT.
That’s close to 4 times Debt/EBIT. And I expect the company will sometimes be at 4 times
Debt/EBIT. The debt is beautifully spaced. There’s bank debt in addition to bonds. But, the
bonds make up most of the debt. Carrier has notes maturing in 2023, 2025, 2027, 2030, 2040,
and 2050. About 75% of the company’s debt is due in 5 or more years. Cash on hand is
meaningful. I don’t know the exact number. But, as of the spin-off documents – it would’ve been
close to $1 billion. The company’s cap-ex needs are minimal: about 1% to 1.5% of sales a year
on average. R&D is higher at 2% to 2.5% of sales. Like I said, gross margins are very stable. So,
the main fixed costs uses of cash for the company will be interest on its debt, repayments of its
debt (only in certain well-spaced years), and payment on leases.
Carrier is actually pretty complicated and not very well explained in its SEC filings. For
example, the company does lease a lot of property. But, it actually owns a ton of property. My
best guess is something like 25 million square feet. It’s a big company with 53,000 employees. A
little under 50,000 of them are non-engineers – the rest are engineers. A meaningful portion of
the U.S. workforce is unionized – and there are collective bargaining agreements that expire all
the time. There’s a pension plan, environmental liabilities (potentially quite extensive), and
litigation risks. The company also has joint ventures all around the world – some of these are
presumably dodgy. For example, Carrier mentions that it identified $380 million (in U.S. dollar
terms) of payments made from an affiliated company in dealing in countries that were formerly
members of the Soviet Union. It does not say if these payments were merely improper or illegal.
However, $380 million over 10 years is a material amount of money to have a poor grasp of. It’s
not clear to me that Carrier had a poor grasp on what this money was being used for – or, if the
company just accepts that as the cost of doing business in some countries around the world. The
company may not be directly responsible for the actions of companies it owns only 20-49% of.
However, doing business in these countries and with such poor control over where large
payments are being sent does expose the company to risks associated with U.S. anti-corruption
laws. Carrier does bid for business. This can include government business. It seems likely that
some companies associated with Carrier engage in bribery. And it’s not out of the question that
Carrier will have to pay anti-corruption fines in the U.S. for actions it or others took around the
world.
The company also has litigation associated with two different substances: one is asbestos (this
was included in installations of the company’s products though Carrier itself didn’t produce the
asbestos), and a firefighting foam (“aqueous film-forming foam”). Both of these things have
been the subject of lawsuits alleging long-term health effects. So, lawsuits in these areas could
linger for a long time. The company doesn’t provide much legal disclosure compared to the risks
it may face. In fact, it doesn’t provide a lot of disclosure in several important areas such as
“properties”. I think the company owns a lot of properties that may be worth a lot more than they
are carried on the books for. But, the company’s own filings are little help in this regard. In terms
of the number of sites – environmental liabilities are also not low here. There are a number of
superfund sites, other clean-up sites, etc. The companies Carrier owns have a long history of
manufacturing inside the U.S. – often dating back more than 100 years – and, so, there’s little
doubt the company has heavily polluted all around the country. There are estimated amounts for
all of these liabilities carried on the balance sheet. As estimated, this stuff is not worrying. It is
very small compared to the $10-$11 billion in net debt.
I don’t like the corporate governance here. The board is made up of a lot of people who don’t
own much stock in the company. They seem to be generally overpaid. They also seem to have a
lot of outside commitments. It’s a very standard board for a huge U.S. company. They have little
skin in the game. They will be compensated with plenty of stock. But, if you look at what the
bonuses are tied to – it’s really just being awarded based on hitting earnings levels. The company
expects to pay a dividend of about 65 cents a share. That’s a 4.4% dividend yield on the current
stock price ($14.67). The idea this stock is going to spin-off with a yield of like 4-5% really
surprises me. Everything about the price at which this thing spun-off surprises me.
Management’s “medium-term” plan is pretty simple. They expect sales to grow faster than the
markets they are in. They expect profits to grow faster than sales. They expect adjusted EPS to
grow faster than profits. And then they expect free cash flow per share to grow faster than
adjusted EPS per share. The result of this would be that very mid-single digit growth in sales
could drive double-digit returns in the stock. In fact, given the price at which this thing spun-off
– it’d have to drive double-digit growth in the stock.
While most people prefer using approaches like EV/EBITDA or EV/EBIT – I’m okay with the
less correct (in fact, technically, it’s wrong) approach of just using what free cash flow I think
the company (if unleveraged) would produce and then what enterprise value that deserves. It
seems to me that if this thing was capitalized with 100% equity and 0% debt – we’d expect it to
have no problem doing $1.75 billion a year in actual free cash flow. In other words – without
debt – your buybacks and dividends could be $1.75 billion a year. If that’s true – we need to
consider the debt. The net debt is between $10 billion and $11 billion. Let’s call it $11 billion.
And then we need to ask how much free cash flow generating ability has to go to covering the
debt. We’ll just use 7%. That’s what I’ll assume you need to make interest payments and retire
debt. That works out to about $770 million a year earmarked for the $11 billion in debt. The
remainder over that – about $1 billion a year – goes to the shareholders. The stock spun-off with
866 million shares. A steady, reliable free cash flow of about $1 billion a year should be worth
no less than about $15 billion. Take $15 billion and divide by 866 million shares. You get $17.32
a share. And yet the stock trades at only $14.58 a share. It’s cheap.
That doesn’t sound astoundingly cheap. But, the estimates I made above are not very aggressive.
I am assuming that 7% of the face value of debt in actual free cash flow has to go to servicing
that debt. It doesn’t. The company isn’t borrowing at anywhere near 7% a year. And it’s
borrowing pre-tax – not after-tax. Actual free cash flow could be more like $2 billion than $1.75
billion. Blue chip industrial companies often trade above 15 times free cash flow.
If we do a calculation using EV/EBIT – the cheapness of Carrier may be more obvious. Market
cap is 866 million times $14.58 a share equals $12.6 billion. Debt on a gross basis is $11.4
billion. The company has cash – but let’s ignore that. So, $12.6 billion plus $11.4 billion equals
$24 billion. The company’s 5-year average EBIT had been about $2.9 billion. But, its worst
EBIT in the last 5 years was $2.5 billion. So, let’s use $2.5 billion. That gives an EV/EBIT of
$24 billion / $2.5 billion equals 9.6 times. Most of the company’s business is in “the Americas”
with the U.S. being a very big part of that. I’ll use a 25% tax rate instead of the U.S. federal rate
of 21%. So, that’s 9.6 / 0.75 = 12.8.
In other words, the most conservative methods I could use for checking to see if the stock is
overpriced still gave me a P/E less than 13 times. And – you’re effectively buying the company
on margin: 50% debt and 50% cash when looking at that 13 times P/E. The bondholders are
providing half the financing here. And – what’s a lot better than buying on margin – is that the
financing is mostly in place for over 5 years.
Nothing stood out to me as especially good about Carrier.
I didn’t get a good feeling about the company, its management, etc.
But the company is big and old.
And the stock is cheap on a unleveraged basis.
And yet it’s actually leveraged – very, very economically and for a very, very long time.
Carrier looks like a good spin-off.
Geoff’s Initial Interest: 70%
Geoff’s Re-visit Price: $11/share



URL: https://focusedcompounding.com/carrier-carr-a-big-well-known-business-that-justspun-off-as-a-cheap-leveraged-stock/
Time: 2020
Back to Sections
-----------------------------------------------------
Cars.com (CARS): A Cheap Enough Stock with a Clear Catalyst and Tons of
Rivals
About a week ago, Starboard Value disclosed a 9.9% position in Cars.com (CARS). Starboard
Value is an activist hedge fund. It is probably best known for its 294-page presentation
on Darden Restaurants (DRI) back in 2014. You can read that presentation here (PDF).
Cars.com is a 2017 spin-off from Tegna (TGNA). Tegna is the rump of the old Gannett. It
consists mostly of local TV stations. The public company now called Gannett (GCI) was spunoff from Tegna (then known as Gannett) in 2016. It consists mostly of USA Today (a national
newspaper in the U.S.) and about 100 local newspapers.
So, in a sense, the public company Cars.com was formed as a break-up of a break-up.
Cars.com is a research website for car shoppers. Publicly traded competitors include CarGurus
(CARG) and TrueCar (TRUE). TrueCar went public in 2015. You can read its IPO prospectus
here. CarGurus went public in October of this year. You can read its IPO prospectus here.
Because Cars.com was a spin-off instead of an IPO, the SEC document it filed is different. You
can read Cars.com’s 2017 spinoff document (its S-1) here. The company has yet to file a 10-K.
You can read the most recent 10-Q here.
I’m not going to describe what Cars.com does, because you can visit the website or download the
app (today, most people use the app) and play the role of customer for yourself. No description I
can give you will explain the company better than having you just give the website a whirl.
So, I’m not going to explain Cars.com’s business. What am I going to do?
I’m going to explain why I’m writing to you about the stock.
I’m writing to you about Cars.com stock for 3 reasons:
1. An activist hedge fund, Starboard Value, now owns just under 10% of the company
2. The stock’s history is that Cars.com was bought by Gannett (then a TV and newspaper
company) in 2014 and then Gannett broke into two parts in 2016 (Cars.com went with the
TV part) and finally Cars.com was broken off of an already broken-off company. So,
there are no long-time owners/analysts/etc. of Cars.com stock and many of the investors
who have held the company’s – or its predecessor’s – shares were not originally
interested in owning a website.
3. Some competitors of Cars.com trade at much higher multiples of sales, earnings, etc.
than Cars.com does.
In other words: this is a Joel Greenblatt “You Can Be a Stock Market Genius” type situation. The
company is the end result of a fairly recent (2014) acquisition and two very recent (2016 and
2017) spin-offs. Most importantly, the stock appears to be a relative value.
Is it a good business?
Quality
The business model is theoretically a good one. And the company’s current financial results are
very solid. A website like this has economics similar to a local TV station. For full-year 2017,
management is guiding for an adjusted EBITDA margin of 38% of sales. The business requires
minimal tangible capital to run (receivables are the biggest use of capital). I’d estimate the
business has – over the last 9 months – produced about $120 million of free cash flow while
tying up maybe $60 million of net tangible assets. A triple digit after-tax return on net tangible
assets seems certain. It’s really not important to know whether a business has an 80% return on
capital, a 160% return on capital, or a 320% return on capital. Once you hit ROC numbers like
that – growth is good and you don’t need to retain much capital to fund it. By the numbers, it’s a
great business. That’s all you need to know.
Growth
Here’s our first problem. Cars.com isn’t growing. The most recent earnings release had sales
down 1% (which is what’s expected for the full year). The number of visitors was up 3%.
However, the number of visits was down 1%. This means the people who are visiting the website
are doing it less often. Is this a good result or a bad result?
It’s hard to say. Here’s the most remarkable fact you’re going to read about Cars.com. During
the first 9 months of this year, Cars.com spent exactly the same amount on marketing as it did
over the first 9 months of last year.
Cars.com spent $160 million on marketing during the first 9 months of the year. That annualizes
out to about $213 million spent on marketing.
Let’s compare this to some competitors.
2017 increase in Cars.com marketing spend: +0%
2017 increase in TrueCar’s marketing spend: +22%
2017 increase in CarGurus’s marketing spend: +55%
So, is a 1% decline in website traffic and a 1% decline in overall revenue a good or bad result
when you increase marketing spend by 0% and your competitors increase it by 22% and 55%?
It sounds good. But, there’s a difference between losing barely any sales in dollars and losing
barely any sales in points of market share. Is Cars.com losing market share without losing sales
simply because the online car shopping industry is growing so fast?
Let’s compare Cars.com’s sales growth to sales growth at its competitors.
2017 decrease in Cars.com sales: -1%
2017 increase in TrueCar’s sales: +18%
2017 increase in CarGurus’s sales: +65%
It looks like TrueCar and CarGurus are doing better. It looks like they will grow faster than
Cars.com and overtake it, thereby achieving the kinds of economies of scale and “winner takes
all” victory that the internet is known for.
But, there’s a catch. And again, it’s marketing we need to talk about.
Let’s compare Cars.com’s marketing spending as a percent of sales to its competitors.
Marketing spend at Cars.com: 34% of sales
Marketing spend at TrueCar: 57% of sales
Marketing spend at CarGurus: 74% of sales
Finally, let’s compare the current scale of the 3 companies in terms of sales:
Year-to-date Cars.com sales: $470 million
Year-to-date TrueCar sales: $240 million
Year-to-date CarGurus sales: $226 million
So, Cars.com is about double the size of TrueCar and CarGurus. However, TrueCar and
CarGurus spend about the same amount on sales and marketing as Cars.com does. This must
mean that while Cars.com is already highly profitable – TrueCar and CarGurus aren’t.
Let’s check 2017 operating profit at the 3 companies.
Year-to-date operating profit at Cars.com: $95 million
Year-to-date operating loss at TrueCar: ($23 million)
Year-to-date operating profit at CarGurus: $15 million
So, Cars.com has about double the sales and 6 times the profits of TrueCar and CarGurus. How
do the enterprise values of these 3 companies compare?
Relative Value
As I write this (on Christmas Eve 2017), Cars.com has a market cap of $2.12 billion and about
$590 million in net debt. Let’s call the enterprise value $2.7 billion.
TrueCar has a market cap of $1.13 billion and about $196 million in cash (with no debt). Let’s
call the enterprise value $930 million.
CarGurus has a market cap of $3.17 billion and about $85 million of cash (again, no debt). Let’s
call the enterprise value $3.2 billion.
Using those numbers – which I won’t promise are anything but a quick back of the envelope by
me – we get EV/Sales ratios of 4.3 for Cars.com, 2.9 for TrueCar, and 10.3 for CarGurus. Those
are annualized numbers where we just assume sales in the fourth quarter will be one-third of
sales in the first 9 months of the year. That’s probably unfair to the faster growing companies.
What’s interesting here is that the already highly profitable company – Cars.com – is not trading
at a much higher multiple of sales than its much less profitable competitors. These competitors
are growing much faster. However, the competitors are buying this growth with very high
marketing spending as a percent of sales. Remember: TrueCar grew its sales by 18% year-overyear while growing its marketing spending by 22% and CarGurus grew its sales by 65% yearover-year while growing its marketing spending by 55%. Cars.com shrank its sales by 1% while
growing its market spending by 0%. All 3 companies saw rates of sales growth that were close to
their rates of marketing spending growth.
Why the Starboard Value Investment Makes Cars.com Interesting
What’s interesting here is that Cars.com is the bigger and more profitable company. However,
the market is awarding the highest multiple to the company that is growing its sales the fastest.
This company (CarGurus) is probably growing its sales the fastest because it is growing its
marketing spending the fastest.
Basically, investors are saying that $1 of sales at CarGurus is worth more than 2 times more than
the same $1 of sales at Cars.com (EV/Sales of 10.3 vs. EV/Sales of 4.3) because CarGurus is reinvesting more than 2 times more of each $1 of sales in marketing than Cars.com is (marketing
as a percent of sales of 74% vs. marketing as a percent of sales of 34%).
In other words, it may not be that investors like CarGurus’s competitive position better than
Cars.com’s competitive position. It may just be that investors like CarGurus’s strategy (and
management) better than Cars.com’s strategy (and management).
An activist investor can’t fix a poor competitive position. But, an activist investor can shake-up
strategy and management.
In fact, while doing my original research on Cars.com (this was months before Starboard’s
investment), the only complaint I really came across from investors, analysts, etc. explaining
why Cars.com should trade at a lower multiple than its peers was that Cars.com had a less
entrepreneurial culture and was a less sales growth oriented company.
Those are issues an activist can address.
Absolute Value
Cars.com is not overpriced on an absolute basis. Media properties often sell for 10 times
EBITDA or more. On a leveraged basis (free cash flow divided by market cap) the stock is
definitely cheap.
Rivalry
Warren Buffett’s big test of “moat” is how much damage a competitor can do through
overzealous rivalry. In other words, how hard is it for a competitor to take ten percent of Coke’s
market share if they’re willing to do aggressive – maybe even irrationally aggressive – things?
Some competitors of Cars.com are willing to spend 50% to 75% of sales on marketing while
making little or no profit. Several of these competitors have gone public. Many are well-funded
with large market caps and plenty of cash – and no debt – on their balance sheet.
Cars.com is facing some dot-com boom type competitors. They’re aggressive. They are seeking
scale. And investors are willing to provide them with cheap equity capital (that is, the market
will give them a high P/E ratio or even tolerate losses).
Will all this last?
Probably not. At some point, competitors will be less aggressive about marketing. At some point,
investors will be less rewarding of growth and more rewarding of earnings in this industry.
But, until that’s the case, competitors of Cars.com may be able to do a ton of damage to the
company through extremely intense rivalry – especially in the form of high marketing spending.
Verdict
Cars.com is a relatively cheap stock with a clear catalyst. It isn’t expensive on an absolute basis.
And it is already proven. However, the industry is not settled yet. I see signs of intense rivalry. I
prefer to invest where competition is getting less intense rather than more intense.
Right now: this just isn’t the industry for me.
The car shopping website industry reminds me a lot of the hotel shopping website industry. I like
the growth prospects of both these industries. I like the business model of some of the players in
both these industries. And I know that the winner in each of these industries will one day be
raking in a lot of cash. But, in both these industries, I’m too afraid of the prospects for ultraintense rivalry especially in the form of heavy ad spending.
So, I won’t be buying Cars.com today. However, I do recommend that Focused Compounding
members look at the stock from a Joel Greenblatt “You Can Be a Stock Market Genius” type
perspective. The business model is great. The relative valuation is good. And there’s a clear
catalyst in the form of Starboard Value.
I recommend you research the stock and come to your own conclusion.
I plan to research Cars.com more in the future. For now: it’s a pass for me.
P.S. – A Technical Note on “Affiliate Revenue Share”
I told you I wouldn’t waste time describing Cars.com as a business. However, there is one point I
want to make. Cars.com has an expense line called “affiliate revenue share”.
The explanation of this expense is: “Affiliate revenue share primarily represents payments made
to affiliates for major account customers we service directly that are located in the affiliates’
market territory. Revenue recognized for these sales is recorded as retail revenues.”
That description makes no sense unless you understand that Cars.com used to be owned by a
bunch of newspapers who all bought advertising packages from Cars.com at wholesale rates and
then re-sold these packages to local car dealers (in the paper’s market area) at marked-up prices.
The important thing to note is a bargaining power issue here. These newspapers were – at one
point – both owners and customers of Cars.com. That kind of relationship tends to lead to
agreements that favor the owner/customer. Once a company with these agreements is freed from
the ownership grip of these customers, it’s likely to transition into agreements made when its
bargaining power is greater (and its incentives – to maximize profits – are clearer). In other
words, Cars.com’s margins might go up.
Some of these agreements expire in the years ahead. And I believe some investors expect
Cars.com to get better terms in the future. Once Cars.com is fully disentangled from its previous
owners – in other words, once the wholesale agreements expire – Cars.com may be able to either
get better pricing on selling wholesale advertising packages through these former owners or
Cars.com may just have no agreement and sell directly in these territories.
There is a 2014 article on the economics of Cars.com and its relationship with these
newspapers that explains the issue better than I ever could. I strongly recommend you read this
article.



URL: https://focusedcompounding.com/cars-com-cars-a-cheap-enough-stock-with-aclear-catalyst-and-tons-of-rivals/
Time: 2017
Back to Sections
-----------------------------------------------------
Canterbury Park (CPHC): A Stock Selling for Less than the Sum of Two Parts
– A Card Casino and 127-Acres of Land (Plus You Get a Horse Track for Free)
Canterbury Park (CPHC) is a sum of the parts stock.
After our experiences – and when I say “our”, I mean my decisions to buy – Maui Land &
Pineapple, Keweenaw Land Association, and Nekkar – Andrew has a sticky note on his desk that
says: “When thinking about SOTP, think STOP”.
Canterbury Park (CPHC) is a sum of the parts (SOTP) stock. Since we’re thinking “SOTP”
should we also be thinking “STOP”?
Yes, Canterbury Park is a sum of the parts stock. But…
That doesn’t mean it is primarily an asset play. Though it might be. I’ll talk about the company’s
horse track and card casino in a second. But, first let’s get the hardest part for me to value out of
the way.
I find it difficult to value the real estate assets of this business. So, I will be judging them based
in large part on the range of per acre transaction prices – for both sales of land and purchases of
land – I found in the company’s filings. Amounts paid or received per acre seem to range from
about $180,000 to $385,000. Some of these deals are a bit more complex – for example, it’s
difficult to determine what the price per acre the company received was when it exchanged land
for an equity stake in an apartment complex or something like that. In one specific example of
this – I would say the company exchanged about 1 acre of land for every 8 apartment units (I
mean here the equivalent of owning 100% of 8 units, actual ownership is a minority stake in a
greater number of units). Well, what exactly are 8 apartment units worth in the area? I don’t
know. Could 8 apartment units be worth something in that same $180,000 to $385,000 range?
Could it be more? I’d have to do a lot more research – and be a lot better at understanding real
estate investments – to get definitive answers to how much Canterbury Park’s real estate is
worth. It’s an important part of the investment case here. But, it’s not one I can evaluate well.
The real estate not being used by the business is 127 acres. Total real estate ownership is more
like 370 acres. But, most of it is tied up in the horse track – so, I’ll limit discussion to the 127
acres that is planned to be developed into apartments, townhomes, extended stay hotels, etc. The
lowest values I found for actual transactions the company has engaged in were around $180,000
per acre. If we assume the company receives the equivalent of $180,000 in value – sometimes in
cash from sales of land, sometimes from equity stakes in joint ventures that rent out apartments
for years to come, etc. – we’d place a value of about $23 million on all this real estate. It might
be worth $25 million.
It could be worth a lot more than that depending on how it’s developed. For example, the amount
of infrastructure Canterbury Park expects to put into this development – and then be repaid by
the city through the additions to tax revenue created by these infrastructure investments – is
around the full amount I’m discussing as the value of all the land. I don’t know enough about
real estate development projects to know if that makes sense. Would you put $20 million to $25
million into public infrastructure improvements in an area – and expect enough incremental tax
revenue from the new development to eventually recoup those costs – and then only value the
underlying acres at that same $20 to $25 million? I don’t know. This just isn’t an asset I
understand well enough.
So, I’m going to arbitrarily assign all the developable land Canterbury Park owns a value of $25
million and just move on with my analysis. I should point out that – unlike some stocks I’ve
looked at in the past with a lot of empty acres – Canterbury Park is really far along in the
development process here. Their other operations produce cash flow. They have good access to
credit. They have a partner lined up for the two phases of the planned apartments. It’ll be 300
units (phase one) plus 300 units (phase two) equals 600 units and CPHC will own about a quarter
of the equity – so, that’s like owning 150 apartment units outright. And this is just one of the
assets Canterbury Park can get out of all this development. So, I don’t doubt there could be a lot
of upside here. I just am not going to assign a present value of more than $20 million to $25
million to the land they own today. I’ve decided – for the purposes of this write-up – to just use
$25 million. There are about 4.6 million shares outstanding. That’s about $4.50 to $5.50 per
share in yet to be developed real estate value. In other words, we can just take $5 off the stock’s
current price of $12.49 a share and then check to see if the rest of the company’s businesses are
worth more than $7.40 a share.
What are the company’s other businesses? Canterbury Park lists 3 other segments: horse racing,
food and beverage, and the card casino. I’m only going to assign a positive value to the card
casino. Let me explain why. The way Canterbury Park breaks out its segments allows us to see
the segment level assets and earnings of each segment. We know food and beverage pays – this
is within the company – a large part of its gross revenue (on days on which there are live horse
races) to the horse racing segment. We also know that food and beverage’s segment assets as
shown in the 10-K don’t include facilities it uses that are listed as either assets of the card casino
(which are minimal) or the horse racing segment (which is a huge amount of the total assets of
the business). Even with what I’ve discussed above – the return on assets at the horse racing
segment is very low. First of all, we’re talking about segment level results – without certain
corporate overhead applied to it. Secondly, a lot of the assets of the horse racing track have
already been somewhat depreciated on the books. So, the segment level book value of the assets
may be lower than the replacement cost of the assets if you had to build a new track today. Third,
there’s what I’ll call “a lobbying alliance” between Canterbury Park and a local Indian tribe (that
operates the nearby Mystic Lake Casino) which results in about $10 million per year of indirect
benefit to Canterbury Park generally and primarily to Canterbury Park’s horse racing segment
specifically. The Shakopee Mdewakanton Sioux pay over $7 million a year in purse
enhancements that allow races at the horse track to pay out more to the winners than would be
the case without these enhancements. Bigger purses mean a race track can attract both better
quality horses and also simply more horses (“a bigger field”). Higher quality competition and
larger fields increase the amount of betting on a race, the number of spectators in attendance, etc.
Without this co-marketing agreement (as the company calls it – I really consider it a lobbying
alliance) the live races would be more costly to run and/or produce less revenue from wagers and
other sources. As a horse track hosting live races, Canterbury Park also can make money by
“simulcasting” other races around the country. They get a meaningful (relative to the total
amount of revenue brought in by all their horse racing activities) amount of revenue from bets
made on these simulcasts. Even with counting all assets at their somewhat depreciated levels,
including the benefits of the Shakopee purse enhancements, counting the simulcast revenue the
same as the live race revenue, etc. I sometimes see returns in this segment as low as about a 4%
EBITDA (and cap-ex requirements in this segment are very real – so, I think EBITDA flatters
returns here) return on assets. Even if I include food and beverage returns as if they belong to
horse racing – when, really some of that return is tied more to the card casino – I get no better
than 8% EBITDA returns on that side of things. If horse racing was a separately traded entity – I
don’t see how it could have reported after-tax earnings greater than 5% of its assets. I think
returns would be lower than that. And unleveraged cash returns here could be quite a bit poorer
than 5%. This segment doesn’t earn its cost of capital. Growth here won’t create value. And I
have serious doubts about whether using the acreage they do for a horse racing track is anywhere
near the highest and best use you could get for this land. But, it’s a necessary use – because of
the next segment we’ll be talking about.
Canterbury Park has gaming licenses because it is a horse racing track. This kind of thing
happens a lot where a location that was originally used for one kind of gambling is eventually
allowed to conduct other kinds of gambling at the same site. Horse tracks originally ran live
races spectators could bet on. Then they were allowed to televise other horse races around the
country (year round, instead of only during their own limited race seasons) and take a cut of bets
made on those races through their locations. And then – at least in the case of Canterbury Park –
other forms of gambling beside horse racing were allowed. Here it is a card casino. Canterbury
Park has permission to run an 80 table card casino. The company can run either banked (the
house puts up its own money) or unbanked games. They choose to run only “unbanked” games.
Winnings come from player pools – a lot like the way betting on a horse race works – and the
house does not risk any of its own money. Technically, Canterbury Park does kind of use some
of its own money in the sense that some of what it is allowed to take on games it then recycles
back into potential winnings – often things like a “progressive jackpot” – as a sort of marketing
enhancement. This isn’t really all that different than like player loyalty programs that casinos run
which include cash vouchers. Canterbury Park has one of those too. If you look at the company’s
balance sheet, it includes some of the stuff I’m talking about (the limited form of “banking” it
does – which really is just a rebate / bonus type system) under “restricted cash”. The card games
Canterbury Park runs are of two types. One is poker. This accounts for about one-third of the
card casino’s revenue. The other is table games. The games we are talking about are things like:
blackjack, baccarat, pai gow, etc.
The card casino is quite profitable. It uses minimal assets. It’s not a very big space. Segment
level EBIT at the card casino averaged $7 million in 2017 and 2018. Some renovations were
done and there was a regulatory change – both potentially a bit positive – between the time those
results were reported and today. Also, if I am understanding Minnesota’s minimum wage law
correctly, I believe all aspects of this company’s labor expenses will look better over the next 4
years than the past 4 years. I think Minnesota raised the minimum wage by 8% a year in each of
the last 4 years and is likely to raise it no more than 2.5% per year for each of the next 4 years.
This company employs a very large number of workers at minimum wage, seasonal workers,
college students, part time workers, etc. So, expense control and customer service is likely to be
easier over the next few years than the last few years. Anyway, we’ll just call Card Casino
earnings before taxes $7 million. I’m going to assume a 30% tax rate here (federal taxes are 21%
and Minnesota corporate taxes can be close to 10%) which may be overly conservative, but is a
nice round number. That gives me an estimated after-tax earning power for the card casino of
$4.9 million. There’s really no assets directly attributed to this segment, minimal depreciation,
it’s a cash business, etc. So, I’m going to just round that up and assume this thing generates
about $5 million a year in after-tax free cash flow.
What’s that worth?
Historically, stocks have often traded above 15 times P/E ratios. So, the card casino might be
worth $5 million times 15 equals $75 million. The company has 4.63 million shares outstanding.
So, $75 million divided by 4.63 million equals $16.20 a share. As I’m writing this, the stock is
trading for $12.50 a share. And I just said the card casino might be worth $16.20 and the real
estate might be worth another $5. So, you have a stock trading for less than $13 a share that
might be worth more than $21 a share. Or, to put it another way – if the real estate is worth $25
million and the card casino is worth $75 million, then CPHC’s enterprise value should be $100
million while it’s actually just $60 million.
Are their risks?
Yes. The card casino appraisal I gave was just $75 million versus $60 million for the whole
stock. That’s without corporate costs, etc. attached. If the real estate development doesn’t add
value and this company dilutes shareholders at the rate it has in the past – shares outstanding
have sometimes risen as fast as 2% a year, that’s a big drag on your future returns in this stock –
this could easily be a mediocre investment.
New competition from other gambling in the area could be a problem. The agreement between
the Shakopee (who operate Mystic Lake Casino just 4 miles from Canterbury Park) and
Canterbury Park runs through 2022 and includes requirements for Canterbury Park not to expand
into other gambling and to oppose the expansion of gambling elsewhere in Minnesota. But, this
is always a risk with any gaming stock.
I didn’t go into much detail here – but, this company’s facilities are very different from those of
Gamehost. The Alberta casinos Gamehost runs are pretty rough and rundown compared to the
state Canterbury Park has kept its facilities in. I’ve looked at reviews of the casino and race
track, what the company says about its own facilities, cap-ex spending, etc. and compared it to
what I know about horse tracks in the U.S. and regional casinos. I think this company is
maintaining its site very well by industry standards. There are many horse tracks in worse shape
than this one. And the development around the track could be synergistic. When I say the track
isn’t really worth assigning a value to – I don’t mean to suggest it isn’t bringing in traffic
(attendance averages 6,500 people on the nearly 70 live racing days a year, for example). The
renovation of the card casino included a change to provide a “grand entrance” from the live
racing and event space to the card casino. Some of the development plans around the track do
suggest to me – and, again, I’m not an expert on real estate developments – that the company
may have wanted to develop some of the nearby land in a way where that fit well with a card
casino / horse track in the same neighborhood. Some of the other planned stuff just sounds like
what any developer would want to put in that area though. So, it’s a mix. But, I don’t want to
make it sound like Canterbury Park is planning to just sell off these 100+ acres to get some cash.
They’re not. They will be left with more people in the immediate vicinity of the card casino and
track and with some equity stakes in entities that will provide cash flows for a long time to come.
So, while I looked at this as a “sum of the parts” – I don’t expect Canterbury to just take a lump
sum of cash for a development that won’t benefit the race track and card casino at all. I expect
the track and casino will benefit from the development and Canterbury Park will have an
ongoing interest in some of the stuff that’s developed.
Which brings me to capital allocation. This company has increased its share count more than I’d
like. Till recently, they had not paid much of a dividend. I think they’re now likely to regularly
increase the dividend. But, I could be wrong about that. I see no indication they intend to buy
back stock (though they have authorization to do so). Unfortunately, I expect the share count to
rise and for this to be somewhere between a minor and major drag on future returns in the stock.
This is basically a family controlled company. The current CEO is the co-founder and son of the
chairman. Together they own around 30% of the company. A third co-founder (this company
dates back about 25 years) owns another 10%+ chunk. For corporate governance purposes, the
third co-founder is treated as independent – though I don’t see it that way. Gabelli is a major
shareholder (though not major enough to upset any plans of those 3 insiders). It’s a 5-person
board. So, the 3 people who are not the father and son are the ones who make up every
committee you’d imagine (compensation, audit, and nominating). The audit isn’t cheap for a
company this size. Nor do I have any concerns about the auditor this company uses (they have a
local office, they audit other public company issuers, their most recent PCAOB report is clean,
etc.). Compared to other gambling companies, closely controlled companies with $50 million
market caps, etc. – I really don’t see a lot of problems here. For the most part, the non-founding
board members don’t have a ton of ownership in the company. But, I don’t think they’re likely to
matter that much in terms of long term capital allocation decisions. The only people I’d expect to
have any voice at all are definitely the 2 founding family members, probably the third cofounder, and possibly (as the voice of all the outsiders) Gabelli if they ever want to make a fuss.
Otherwise, I find corporate governance and such here pretty typical of a public company. It’s
possible I am underestimating the long-term view with this being a family company embarking
on a major real estate development that’ll transform the business quite a bit.
My problems here are: 1) They may dilute me more than I want, 2) I know nothing about
Minnesota state politics, and 3) I know nothing about Minnesota real estate. Those 3 things could
be major factors here. So, while this is a business – the card casino – I like trading at a price I’m
fine with, I don’t know if I’d revisit this one or not.
If I was to research this further, my 3 next steps would be:




Talk to people more knowledgeable about real estate in the area
Talk to people who follow this stock / Minnesota gaming more than I do
Talk to management
Visit the race track, card casino, area to be developed, and competing gambling venues in
the area
Those are probably the 4 things I’d want to do before buying this stock.
Geoff’s Initial Interest: 50%
Possible revisit price: $9/share (Down 28%)



URL: https://focusedcompounding.com/canterbury-park-cphc-a-stock-selling-for-lessthan-the-sum-of-two-parts-a-card-casino-and-127-acres-of-land-plus-you-get-a-horsetrack-for-free/
Time: 2019
Back to Sections
-----------------------------------------------------
Car-Mart (CRMT): Like the Company, Hate the Industry
Car-Mart (CRMT) now trades for $35 a share. I picked the stock for my old newsletter, The
Avid Hog (you can read all 27 past issues of that newsletter here), when it was trading at $38 a
share back in June of 2014. So, it’s now three years later. And the stock is now 8% cheaper. Do I
like Car-Mart more today than I did in 2014?
No.
Ideally, a stock should be:
1. Cheap
2. Good
3. Safe
I’m not sure Car-Mart meets all 3 of those criteria. And I am sure it has a harder time meeting
those 3 criteria today than it did back in June of 2014. But, let’s start with the criterion that CarMart clearly passes.
Receivables Per Share: The Right Way to Value Car-Mart?
Buy and hold investors value a business on its future cash earning power.
So, the correct way to value a business is usually to begin by finding the key determinant – the
ultimate source – of a company’s future cash earnings and multiply that number by a second
figure. For a timber producer, you’d use the acres of timberland. You might look at a company
owning 500,000 acres of timberland and see that buyers normally pay $600 an acre for such land.
Based on that, you’d say the business is worth $300 million. If this corporation currently had
$120 million in debt on its books, you’d then say all the common stock combined was only
worth $180 million. If there were 9 million shares outstanding, you’d say each share of stock was
worth $20 a share. In this way, you’ve done an entire calculation for a single share of stock based
on something that is:



Constant
Calculable
and consequential
The amount of timberland a company owns varies much less from year-to-year than reported
earnings. It’s a “constant” figure. It’s also a very easily “calculable” number. The company states
the number of acres it owns in the 10-K each year. Finally, the quality and quantity of acres of
timberland owned is clearly the most “consequential” number there is for such a business.
Different owners, different managers, different ways of running the business could squeeze a
little more profit or a little less profit from the business from year-to-year. But, how much land
the company owns and where it owns that land can’t be changed. Clearly, the quality and
quantity of acres of timberland owned is the key determinant – the ultimate source – of this
company’s future cash earnings.
What is the ultimate source of Car-Mart’s future cash earnings?
What one number can we find that is: 1) constant, 2) calculable, and 3) consequential? We need
to find the “essential earnings engine” for Car-Mart.
It’s receivables per share.
Here’s how I explained the right way to value Car-Mart, back in 2014:
“Car-Mart’s value over time should mirror its per share loan balance. This loan balance is what
creates value for Car-Mart. So, it is receivables – net of the provision for credit loss – per share
that will matter most to long-term investors. (In June of 2014), Car-Mart (had) $310 million in
net receivables and 8.75 million shares outstanding. That means the company (had) $35.42 in
net receivables per share (versus a $38 stock price).”
So, when I picked it for the newsletter, Car-Mart had $35 a share in net receivables per share and
a $38 share price. I thought that price (an 8% discount to net receivables) was a good one to buy
Car-Mart at. So, let’s run those same numbers as of today and see if Car-Mart is a better bargain
or a worse one than it was back in 2014.
We can see on the company’s 10-Q (over at EDGAR) that as of the quarter ended January of
2017, Car-Mart had $364 million in net receivables and 7.8 million shares outstanding. That
means the company has a little under $47 a share in net receivables. Where’s the stock price?
$35 a share. So, Car-Mart is trading at 75% of its receivables per share. The stock was trading at
an 8% discount to its receivables when I first wrote about it in 2014. Three years later, it is now
trading at a 25% discount to its receivables. The stock market is also about 25% more expensive
now than when I first picked Car-Mart. So, the company is absolutely cheaper (trading at 75% of
receivables now versus 92% of receivables when I first picked it). The stock is also relatively
cheaper too. Car-Mart’s stock price has dropped about 16% relative to how I calculate intrinsic
value. The stock market overall has risen 25%. The intrinsic value of the market has not risen at
anything like 25% over the last 3 years. So, the stock market’s price rose faster than its intrinsic
value while Car-Mart’s intrinsic value rose faster than its stock price. Normally, that would mean
Car-Mart is more attractive now than it was in 2014.
Is that true?
There’s a catch. I wrote something very, very important in that 2014 report:
“The $396 million in car sales that Car-Mart made in 2013 is what determines the company’s
receivable balance for the next couple years. Using retail sales as a yardstick against which free
cash flow can be compared provides an opportunity to construct an owner earnings margin for
Car-Mart. This is also helpful because receivable balance increases that come from sources
other than additional sales – basically longer loan terms – are not desirable from Car-Mart’s
perspective. Car-Mart’s owner earnings decrease versus sales when loan terms increase. Over
time, Car-Mart (along with everyone else in the buy here pay here industry) has tended to
increase the length of its loans.”
Let me repeat the key portion here:
“…receivable balance increases that come from sources other than additional sales –
basically longer loan terms – are not desirable from Car-Mart’s perspective.”
Or, to put it even more simply:
Longer loans are bad for Car-Mart
For this reason, we shouldn’t be tricked into believing Car-Mart’s intrinsic value has grown
when receivables go up but sales don’t. Car-Mart can always increase its receivables per share by
simply making longer and longer loans. But, remember the most important thing you’ll read in
this memo is:
Longer loans are bad for Car-Mart
That’s why I suggested valuing Car-Mart based on its sales instead of its receivables. If you
don’t do that, you’ll be tricked into buying more and more shares of the stock at the exact
moment in the cycle when things are getting worse and worse.
We can measure how bad the cycle is right now in a few ways. A really lagging indicator is
actual loan charge-offs. Two other lagging indicators are Car-Mart’s provision for loan losses
and then the amount of non-current loans. Those are all lagging indicators, though. We need a
leading indicator to know where we are in the cycle.
I’d suggest loan length.
Let me explain this logically. If a borrower is as poor as ever – that borrower can only ever make
the same regular loan payment. If you have a $200 payment due every two weeks on your loan
and your income doesn’t go up and you don’t have any money left in your bank account after
making that payment – there’s no way for you to ever make a bigger loan payment. But, can you
buy a bigger car?
Yes, you can. There are two ways a borrower who is as poor as ever can spend like he’s richer
than he really is. One, he can make a bigger down payment. A bigger down payment reduces the
amount he’s borrowing. This works if you have savings. Car-Mart’s borrowers are bad credit
risks. They’re generally poor people living in small, southern cities. They don’t have savings. So,
that’s not a realistic option. What’s the other option?
You can extend the term of the loan. Let’s say a borrower takes out a $5,000 loan and pays a
15% interest rate. That borrow needs to pay $750 a year in interest (I’m simplifying here, they
pay less as the balance declines). That’s $63 a month in interest. If the borrower is repaying the
entire loan over 30 months, they also need to pay $167 a month to reduce the loan balance. So,
this borrower would be paying $230 a month. Let’s say the borrower is tapped out at this point.
They are left with nothing after paying $230 a month out of their monthly cash flow. How can
that borrower – in the loosest part of the credit cycle – get an $8,000 loan instead of a $5,000
loan? You simply extend the loan term from 30 months to 48 months. The monthly payment in
both cases is $230 a month. From the buyer’s perspective, both loans are equally manageable.
So, the way “buy here pay here” car lenders compete with each other in the loose part of the
credit cycle is by extending the length of the loans they make. Increasing a loan’s length is really
the only way lenders like Car-Mart can reach more and more marginal buyers and/or make
bigger loans to their existing customers.
Longer loans are more dangerous loans.
So, we need to know what’s happened to Car-Mart’s loan length in the 3 years since I wrote that
report.
Here are the vital stats for the average loan Car-Mart is making when selling a car off its lot
today.
Car-Mart’s Average Sales Terms in 2017
Down Payment: $620
Interest Rate: 15.7%
Bi-Weekly Payment: $ 177
Term: 31.9 months
The one problem area here is “term”. It was 29.8 months on average in 2014 and it is now 31.9
months on average in 2017. That might not sound like much of an increase. But, it’s 2.3% a year.
If you kept lengthening your loan terms at that rate, you’d go from making 2 and a half year
loans now to making 3 and a half year loans in 15 years from now. Can you keep doing this?
Sure. I can imagine Car-Mart making 3.5 year loans in 2032. But, is it as safe to make loans that
take 3-4 years to pay off as it is to make loans that take 2-3 years to pay off?
No. It’s definitely riskier. And Car-Mart is already making very risky loans. At any point in time,
about 20% of Car-Mart’s loans are non-current and Car-Mart is usually provisioning for credit
losses of about 25 cents on the dollar. So, this isn’t your typical lender. The fact Car-Mart lends
very short is an important part of how it manages to lend to these kinds of borrowers at all. A
short loan length is critical to this business model.
Here’s what Car-Mart’s CFO had to say about loan length in the company’s most recent earnings
call:
“…Our weighted average contract term for the entire portfolio, including modifications, was
31.9 months, which was up from 30.9 at this time last year and basically flat sequentially. The
weighted average age of our portfolio was 8.9 months, that’s up from 8.6 at this time last year
and up from 8.5 months sequentially. Due to the slightly increasing (average selling price) and
for competitive reasons, our average term lengths may continue to increase some into the future,
but we remain committed to minimizing any increases. If competitive offerings get more
conservative, we will have room to keep terms down.”
The other indicator of competitive pressure is that Car-Mart has seen more people visiting its lots
but fewer people actually closing a deal:
“…lot traffic was actually up a little bit. The quality of that traffic was a little spotty but the
traffic was up. And it just seems like going into several years of excess lending and excess
offerings to our customer, it just seems like there is a little fatigue out there with the consumer
at this point.”
Those bold and underlines are mine. But, when you hear a company’s CFO say that competitors
have engaged in “several years of excess lending and excess offerings to our customer”, you
have to worry about the quality of the loans being made in this industry right now.
Car-Mart tries to be a disciplined underwriter. Each lot is run independently. And the managers
of those lots are compensated with low base pay and a potentially high bonus based on the
performance of the loans they make. This incentivizes managers to make good loans. But, it also
incentives them to make loans period.
Car-Mart has continued to buy back stock. I like that a lot. I like this company a lot. But, I don’t
like the industry it’s in.
So, what about the timing of buying this stock now?
On the one hand, I think that some of the worst auto loans you’re ever going to see be made were
the ones made in the last year or two.
On the other hand, I think Car-Mart is trading at about a 25% discount to its receivables per
share and it had historically compounded those receivables at about 13% a year. Realistically,
this is a stock that should trade at more than one times receivables – not less.
I like the business and I like the price. But, I don’t like the industry. And I’m really worried the
industry will – over the next few years – pay the price for loans it is making now.
So, I’ll be watching for two things. One, what is Car-Mart’s share price relative to its receivables
per share. Two, when will shrinking loan lengths tell us the loose part of the auto lending cycle is
finally over.
Verdict



Geoff will NOT buy shares of Car-Mart at this time
Geoff WILL add Car-Mart to his watchlist at a price of $34.50
Car-Mart will move to #3 on Geoff’s new idea pipeline behind Grainger
(Read Geoff’s original report on Car-Mart in the library)



URL: https://focusedcompounding.com/car-mart-crmt-like-the-company-hate-theindustry/
Time: 2017
Back to Sections
-----------------------------------------------------
Dover Motorsports (DVD): Two Racetracks on 1,770 Acres and 65% of the
TV Rights to 2 NASCAR Cup Series Races a Year for Just $60 million
I mentioned this stock on a recent podcast. This is more of an initial interest post than usual. It’s
likely I’ll follow this post up with one that goes into more detail. Two things I don’t analyze in
this write-up are: 1) What this company will look like now that it is once again hosting races at
Nashville (in 2021) and cutting back races at Dover. 2) What the normal level of free cash flow
is here. I discuss EBITDA. But, I think normalized free cash flow is the far better measure. And I
don’t discuss that at all here. Finally, I haven’t dug deeply into NASCAR as a sport to get
enough of a feel for whether it is durable and likely to increase or decrease in popularity in the
years ahead. This is critical to analyzing the investment. And it’s the next logical step. But, this
write-up was already getting long. So, better to do a deeper follow-up later and stay at the more
superficial level for this first analysis.
Dover Motorsports is a $60 million market cap New York Stock Exchange listed company. It has
two classes of stock. The super voting shares are owned by Henry B. Tippie (the now over 90year old chairman). That leaves about $30 million worth of float in the common stock. Enterprise
value is similar to – maybe a bit lower than – the $60 million market cap. As of March 31st, 2020
– the company had $5 million in cash on hand. Liabilities are generally stuff like deferred
revenue (cash received that’ll be earned when a race is hosted later this year). The one exception
is a bond issue I’ll discuss in a minute. The balance sheet shows about $4 million in liability
related to that bond issue. The reality is that there could be another $10 million owed on those
bonds. Or – as seems more likely now – the company could invest in some cap-ex instead and
even that $4 million liability might go away. Why is that?
The liability is tied to bonds issued by the Sports Authority of Wilson County, TN. These bonds
were issued as part of the funding of the Nashville Superspeedway. It’s a racetrack about a 40minute drive from Nashville that was built by Dover Motorsports 20 years ago. The racetrack is
big. It was originally on 1,400 acres of owned land, now down to 1,000 acres of land that hasn’t
been sold off. It’s also – if you look at a list of where NASCAR and non-NASCAR races are
held – much more in line with NASCAR type tracks in terms of the construction of the track
(concrete), its length (1.33 miles), and the amount of seating. However, the track had never held
a NASCAR Cup Series (think of this as the “major leagues” of U.S. auto racing) race. Without
hosting such a race, it never made money. And, in fact, it hasn’t been operated in any way for
close to 10 years now. However, I did just say “had” not held a race instead of “has” not held a
race. There’s a reason for that. While I was researching Dover Motorsports, the company
announced it would be holding one of its two NASCAR Cup Series races at Nashville in each of
the years 2021, 2022, 2023, and 2024 instead of the usual two weekends of racing at its Dover
International Speedway location. This complicates valuing the company quite a bit. Nashville
had never hosted a NASCAR Cup Series race (another track in the area, not owned by Dover
Motorsports, had hosted races in the Nashville area long ago – but not this track). Meanwhile,
Dover had hosted two NASCAR Cup Series races each year for close to 50 straight years now.
On the podcast, the way I talked about valuing this stock was by treating Nashville as a closed
down property of 1,000 acres left to sell off and counting Dover merely for its earning power
(not its asset value). Now, we have to look at 3 assets (one intangible and two tangible).
A buyer of Dover Motorsports stock today is paying about $60 million for 3 assets:



2 NASCAR Cup Series races per year
Nashville Superspeedway (1,000 acres in Wilson County, TN)
Dover International Speedway (770 acres in Dover, DE)
Now, it’s important not to double count these assets. A race promoter needs to combine a track
and a NASCAR Cup Series race to get the economic benefit of each. Tracks that don’t host toplevel NASCAR events aren’t very profitable. Dover Motorsports used to own several other
tracks. It closed them all down and sold them off when it couldn’t get NASCAR Cup Series
dates for them. Likewise, you obviously won’t get a NASCAR sanctioned racing date if you
don’t have a NASCAR caliber track to host it at. This is why I said earlier that Nashville will
probably be doing some cap-ex. You can’t not host a race at your track for a decade and then
host a NASCAR Cup Series race without putting in millions of dollars.
On the other hand, it’s important to think of each asset’s “highest and best use”. Is Nashville’s
best use hosting one NASCAR Cup Series race a year. Or is its best use being sold off.
How much would Dover get in after-tax cash if they sold all 1,000 acres at Nashville?
There were two different deals to sell all of the Nashville property. Both fell through. Pieces of
the property have been sold off over time. The property seems like it MAY be held at a slightly
low valuation if sold piece by piece over time in an orderly fashion. But, I’m not knowledgeable
about real estate in the area or about the costs an owner would have to shoulder when actually
taking the racetrack portion of the property. Here’s what we know. The company carries
Nashville on its books at about $21,000 per acre. The property was marked down from an
original cost of about $68,000 an acre with all improvements etc. Obviously, that cost was for a
brand new racing track. It has depreciated over time. And any new owner would not use the
property for racing. So, the value is likely to be closer to raw land than anything else. Various
offers and options and so on for the property have been done between $35,000 and $68,000 an
acre. I believe the value of land in the area has gone up over the last 10 years or so. There are
other complications though. The company could have to pay taxes. And the company would
have to assume payment on the bonds that have been paid through property taxes and
incremental revenue from the Nashville property. My best estimate is that Dover Motorsports has
about $10 million in additional “off balance sheet” maximum liabilities (this is undiscounted –
it’s the actual amount that would need to be paid over a long period of time, not tomorrow) from
the Wilson County bonds. There’s more than that in face value on the bonds. But, Dover
Motorsports already shows that on its balance sheet (I netted the $5 million in cash against the on
balance sheet liability when I told you the enterprise value here was about $60 million). The off
balance sheet portion of the debt works out to about $10,000 an acre. I don’t know enough about
the tax situation to judge how much could be due. But, there’s a simplification we can make
here. If Dover only sells the property for about its current book value plus $10,000 an acre (to
cover the Wilson County bonds), we can guess that taxes on gains on the land would be minimal.
Yes, the company would be reporting major gains to shareholders on the land sales. But, we
know the property would still be sold at big discounts to what it was originally put on the books
at.
So, let’s ask the question: could the Nashville property be worth $25 million after taxes. Well,
it’s 1,000 acres of property. That’d be $25 million / 1,000 = $25,000. But, it would need to be
sold at $10,000 per acre more than that to cover liabilities associated with any bonds. That’d be
$35,000 an acre. There could be taxes on some parcels of land. And some acres could be worth a
lot less – if there are significant costs associated with repurposing the land. However, there were
offers for the entire property – but, remember, these offers were eventually abandoned – that did
value the total property about that highly. So, the book value of the Nashville property – about
$21 million – seems solid to me even in cash, after taxes, and accounting for the off balance
sheet liability. In other words, it seems like the valuation on the Nashville property is a bit low.
And sales of pieces of the property will result in gains. This means you are probably paying more
like $40 million for 2 assets:


2 NASCAR Cup Series races each year
Dover International Speedway (770 acres in Dover, DE)
However, it now appears Nashville will not be sold over time. It will host a race. New cap-ex
will go into it – instead of cash from the sales of property coming out of it. And – if Nashville
really does host events in each of the next 5 years – those bonds aren’t going to need to be paid
off by Dover Motorsports. The property taxes and incremental revenue from the Nashville
property will cover more of those bonds than I expected.
On a present value basis, these factors DON’T offset. However, on a plain dollars to dollars basis
– ignoring when cash flows happen – they probably do. I’d expect that Nashville will put about
$10 million into getting ready for its first NASCAR Cup Series race in 2021. And I’d expect that
hosting races in each of the next 5 years will take care of all liabilities not on the balance sheet. It
may, in fact, remove those liabilities we now see on the balance sheet. However, I’m not sure
when Dover Motorsports will make that determination from an accounting perspective.
Certainly, the decision to put the present value of the contingent liability on the balance sheet
was made at a time when the company was looking to sell the Nashville Superspeedway and
believed its chances of hosting a NASCAR Cup Series event there were basically nil.
So, the last question we have to answer is what is a NASCAR Cup Series date worth? Here we
are talking about a race when attached to a track that can host such a race. You can read this
Value Investor’s Club write-up (from about 8 years ago ago) where the author thought that – in
acquisitions – each NASCAR series date was going for about $150 million back then.
Remember, the market is valuing 2 NASACAR series dates here at $40-$60 million (that’s $20$30 million per racing date – depending on whether you assume both dates are Dover and
Nashville is sold, or Nashville is kept and dates split between Dover and Nashville from now
on). Do I really think Dover Motorsports with its two dates and two tracks is worth $300
million?
No. I don’t.
But, I’m equally unsure it’s only worth something like $60 million. Both a $300 million
valuation and $60 million valuation seem outside the range of reasonableness I’d come up with
for this stock’s appraisal.
And – as absurd as a $300 million valuation sounds now – I do have to admit the author was not
off in terms of what was then being paid for NASCAR promoters (including Dover Motorsports
itself). About 10 years ago, Dover Motorsports only had 2 racing dates. It had a ton more debt
than it has now. And it had some bad properties with little hope of attracting additional
NASCAR races. It seems very likely that any offers made for the company back then were really
just for the 2 NASCAR Cup Series weekends hosted at Dover. If I do the math, the enterprise
value at which the highest of those offers – it was $6 a share – would value the company at
around $300 million. I don’t think NASCAR Cup Series races are valued at $150 million each
now by private owners. However, I do think that Dover Motorsports is actually a more attractive
asset in all other ways (other than the huge decline in NASCAR’s popularity) than it was 10+
years ago when it rejected that $6 a share bid.
This brings us to valuing that asset as it exists today. How much are those 2 NASCAR Cup
Series each year worth?
Well, there’s a few ways to look at this. Let’s start with the going private transactions involving
the last two other publicly traded NASCAR promoters. One was International Speedway and the
other was Speedway Motorsports. Both went private – they were both taking out by a
controlling, super voting shareholder – at 8 times EBITDA. We can assume – because of who
took them out in each case – that insiders believed the stock was worth more than 8 times
EBITDA. Tax rates have also been lowered since then. While applying tax rate adjustments to
EBITDA is an imperfect process – it’s definitely safe to say that 8 times EBITDA under 35%
taxes becomes at least equivalent to 9 times EBITDA under 21% taxes. What owners care about
is after-tax free cash flow. Not EBITDA. Also, we have the economies of scale issue here. Dover
is a publicly traded, NYSE listed entity that holds only 2 NASCAR Cup Series events a year. It
also has had a drag from a track not hosting a NASCAR Cup Series race in every single year of
its past history (long ago, it had multiple money losing tracks). Honestly, I think this company
would be worth at least 10 times corporate level EBITDA to a buyer, because “track level”
EBITDA here is a lot higher. Until you unpack past financial statements, it’s very easy not to see
how much free cash flow has been generated year in and year out by Dover. That’s because
everything this company has done other than Dover has been a money loser for a very long time.
So, everything from the performance of the stock long-term to the dividends you’ve been paid to
figures like return on equity – even all the way up to the EBITDA line (the other tracks were
EBITDA negative) are messy at the corporate level in a way that disguises the fact that if JUST
the Dover track had been all that was publicly traded for the last 25 years or so, this stock
wouldn’t be thought of as quite such a terrible performer. There has always been one good,
consistent and free cash flow generative asset (Dover International Speedway) at the core of this
company. So, it’s not at all unbelievable to me that someone would pay 10 times corporate level
EBITDA for Dover International Speedway on its own (if it was still hosting 2 NASCAR Cup
Series races per year). However, what an acquirer might pay may not be a relevant measure here
– because Tippie has never agreed to sell the stock. This company has two classes of stock, a
poison pill, it doesn’t do Q&As with analysts. For an NYSE listed company – it’s extremely
unfriendly to outsiders. So, you shouldn’t expect a sale.
But, if you were one day going to get a bid for the whole company – what might that bid be?
EBITDA has been about $10 million recently. All of that has been from Dover. At 10 times
EBITDA that’d be $100 million for 2 NASCAR Cup Series races. That works out to $50 million
per race. Nashville could probably be sold for about $20 million in cash receipts after taxes and
liabilities and so on. That would be $120 million. This would equate to an offer of about $3.30 a
share for the company. I think a bidder would offer at least $3 per share in cash. And yet the
stock trades at about a 50% discount to that.
Why?
There are a bunch of factors here. This is now the only publicly traded NASCAR stock left. So,
it doesn’t get attention the way it might have when International Speedway and Speedway
Motorsports were covered by analysts. The stock has performed abysmally since it went public.
That turns some people off. There are reasons for this. It went public during a bubble for
NASCAR as a sport and for NASCAR related assets. It has also only slimmed down and restored
its financial position in the last 10 years. It looks like the stock has gone nowhere in 10 years or
so. The reality is that the company has gotten much, much cheaper – and also, in many ways,
much better. It paid off over $40 million in debt. It started paying a dividend (the current annual
dividend is 10 cents, which is a 5-6% yield on tangible book value – so, quite a healthy
dividend). The biggest factors here are probably: 1) NASCAR’s popularity is at a 20-year low
and 2) The controlling shareholder.
What’s wrong with the controlling shareholder?
Well, this company refused to sell out at prices much higher than today’s stock price. It also
spun-off and then later tried to re-merge Dover Motorsports and Dover Downs Gaming. Dover
Downs has now been sold to an unrelated company. But, the price Dover Motorsports
shareholders would’ve gotten for merging with Dover Downs wasn’t going to be good. Having
said that, this is what you need to expect with controlling shareholders. The same complaints
could be made about the two other, bigger (and usually better liked by investors) NASCAR race
promoters. Those families were never going to sell out. But, they were willing to go private at
advantageous times and to simplify their investment holdings. For example, NASCAR itself
(which is 100% owned by the France family) bought out International Speedway (which was
only partially owned by the France family – the rest was held by public shareholders). Investing
in NASCAR companies as an outside, minority shareholder is like investing in family controlled
media companies. You are investing in a family controlled business. The business will never be
sold except when the family wants to sell. And, since public ownership is fragmented – the
family has the option of taking you out at a price you don’t like. In fact, that’s even more certain
here since this company actually has a poison pill with a 10% threshold. That’s remarkable
because the two classes of stock ensure that the chairman has 50% of the votes. There’s little
need to restrict anyone else to holding less than 10% of votes when you have more than 50%.
And yet this company still did it. There’s also a big ($8 to $10 million) golden parachute here.
So, an acquirer would really be paying about $130 million (for example) just to give
shareholders $120 million for this company. A $10 million golden parachute on a $60 million
stock is a pretty big deal. A poison pill on a company controlled through super voting shares is
completely unnecessary. And this company has rejected offers made at many, many times
today’s share price. That, more than anything else, is what I would guess has kept the stock
performing poorly versus fundamentals and keeps most investors away.
What are these “fundamentals” though? The stock looks somewhat cheap – though not
amazingly cheap – when valued on things like P/B, P/E, and EV/EBITDA.
It looks a lot cheaper when you think in terms of free cash flow and where it comes from.
Dover Motorsports gets basically all of its “owner earnings” from two TV broadcasts a year of a
NASCAR Cup Series race. The company does other things: it owns Nashville Superspeeday
(which hasn’t produced revenue in nearly a decade), it hosts an annual music festival (which
accounts for less than 4% of revenue), it has tens of thousands of fans pay for tickets to the
event, it gets sponsors for the event, it sells concessions, and it hosts other lower level NASCAR
sanctioned events (think minor league games in baseball, the undercard in boxing, etc. for an
analogy) and so on. But, really, those things – when they go well – are all just a wash. They
cover expenses. But, they don’t generate the free cash flow we see being used to pay dividends
and pay down debt and buy back stock and pile up a little cash.
What does?
The TV rights to a NASCAR race are paid out as follows…
Promoter: 65%
Drivers: 25%
NASCAR: 10%
There are 36 NASCAR Cup Series races a year. They don’t get the same TV viewership versus
each other or anything like that. But, let’s pretend for a second they do. One hundred divided by
36 equals 2.78. And then 0.65 times 2.78 equals 1.8. So, the stream of “owner earnings” at Dover
Motorsports is basically tied to a small (1-2%) royalty on all NASCAR TV rights. That’s really
where all the free cash flow comes from here.
NBC and Fox have TV deals with NASCAR that will increase this stream of free cash flow for
Dover Motorsports by 3-4% a year in 2020, 2021, 2022, 2023, and 2024. The exact deal is for a
4% a year increase in broadcast revenue more than offset by a 4.3% increase in payments to
drivers. The net annual growth in free cash flow from broadcasting will be 3-4% a year.
After that, the deals will be re-negotiated. And that’s the really big question mark for this
company. TV ratings for NASCAR races have declined a lot during the 10 years NBC and Fox
have been broadcasting the races. However, the broadcast rights to sports have definitely gone up
a lot per rating point. There’s no doubt about that. Even if a sport (like the NFL) has sometimes,
in some years managed to increase its ratings a bit – the increase in the price paid to broadcast a
game has increased way more than the number of likely viewers of that game. So, NASCAR
ratings have declined. But, the price paid per rating point has increased.
What is likely to happen when NASCAR broadcast rights come up for renewal in a little under 5
years?
That’s a question I can’t answer yet. I don’t know if the market for sports broadcast rights will be
as good in 2024 as it is now. And I don’t know if NASCAR’s popularity will be as low. There
can be cyclical factors at play in both things. Eventually, cable channels will pay too much for
TV rights to sports and a bubble will form. And, eventually, many sports that lose some
popularity relative to other sports over 10 or 20 years do regain some. A few don’t. And that may
be the other reason this stock is not so popular. If it had all of the same economics it has now but
free cash flow came from an NFL, NBA, or MLB based broadcasting rights stream of cash flows
– investors might like it better.
Buying this stock is a bet on the durability of NASCAR.
It’s also a bet on the durability of the company keeping these 2 NASCAR Cup Series dates. How
realistic is that?
So, in the future, it’s expected that NASCAR will sanction races on a year-by-year basis.
Investors won’t like that. It means that we’ll only know in 2025 that Dover will host a racing
date in 2026. And we won’t have any visibility beyond that. There are no contracts here. There is
no requirement to keep giving dates to the same promoters and in the same proportions.
Furthermore, two companies / families control the vast majority of racing dates each year. Only a
very small number of tracks are owned by smaller players like Dover. NASCAR also now owns
International Speedway. So, effectively NASCAR owns tracks where it can host things. Why not
take dates from independent tracks and move them to NASCAR owned tracks. It’d increase
earnings a lot for NASCAR.
As far as I can tell, they haven’t in the past. Of course, NASCAR and International Speedway
were only recently merged (though they’ve both been controlled by the France family forever). I
can find examples of tracks losing races – Dover is going to lose a race to Nashville next year.
But, I can’t find past examples of well-capitalized, legitimate, etc. promoters who weren’t
involved in some sort of problems that would’ve hurt their chances of promoting successfully
having a racing date yanked from them. For those who know NASCAR, let me know of
historical examples where a promoter who had been hosting a race for many years didn’t get resanctioned despite lobbying for it. I’d be very interested in knowing when this happened, to
whom, and why NASCAR took the race away from them. Dover Motorsports has had 2 top level
NASCAR racing weekends a year for about half a century. It wasn’t able to win more even when
it owned a lot more tracks. It wasn’t able to win one for Nashville even when it purpose built that
track and lobbied for it. And yet it was now able to move one of its two dates to Nashville
instead of Dover.
These two questions of durability – of NASCAR and of having the same number of races
awarded to a promoter every year – would account for big differences in appraisal of the
company. If you put aside the controlling shareholder here and just look at the stream of free
cash flow – it’s potentially a very, very valuable and very, very high quality stream. But, it’s also
potentially not. Some people will believe it’s actually at high risk of declining or disappearing
entirely if they don’t trust NASCAR to keep sanctioning the same races for the same promoters
regardless of conflicts of interest. And some people will believe this is not a high quality stream
of cash flows if they believe that NASCAR is in terminal decline in terms of popularity in a way
sports like baseball, basketball, and football aren’t.
So, a good understanding of NASCAR is critical to evaluating Dover Motorsports. And very,
very few investors have a good understanding of NASCAR.
That makes this one outside of most people’s circle of competence.
It may make it outside my circle of competence. But, I’ll try to keep learning about NASCAR
generally and Dover specifically and see if I can come to a firmer conclusion on this one.
Geoff’s initial interest: 70%
Geoff’s re-visit price: $1.10/share



URL: https://focusedcompounding.com/dover-motorsports-dvd-two-racetracks-on-1770acres-and-65-of-the-tv-rights-to-2-nascar-cup-series-races-a-year-for-just-60-million/
Time: 2020
Back to Sections
-----------------------------------------------------
Daily Journal (DJCO): A Stock Portfolio, Some Real Estate, Some Dying
Newspapers, and a Growing Tech Company with Minimal Disclosures
This was going to be one of my initial interest posts. Then, I started reading Daily Journal’s SEC
filings for myself. At that point, I realized there just isn’t enough information being put out by
Daily Journal to possibly value the company. There just isn’t enough information to even gauge
my initial interest in the stock. I’ll still try at the end of this post. But, my look at Daily Journal
will be a quicker glance than most.
Daily Journal is a Los Angeles based company (it’s incorporated in South Carolina, however)
with 4 parts.
Part one is a stock portfolio consisting mainly of – we’re sure of this part – Wells Fargo (WFC)
and Bank of America (BAC) shares. The third part of the portfolio is probably (my guess) mostly
shares of the South Korean steelmaker POSCO. Yes, Daily Journal does put out a 13F – this is
where sites like GuruFocus, Dataroma, etc. are getting the “Charlie Munger” portfolio to show
you. However, the way that kind of filing works is that it would entirely omit certain securities.
For example, it’d include POSCO shares held as ADRs in the U.S. (which is probably a small
number) while not counting any POSCO shares held in Korea (which is probably a bigger
number). Daily Journal does have a disclosure about foreign currency that includes discussion of
the Korean Won. We can also see by looking at the 13F for periods that are very close to the
balance sheet date on some Daily Journal 10-Qs that the actual amount of securities held by
Daily Journal is greater than the amount shown in the 13F. There would be other differences too.
For example, we know Daily Journal sold some bonds at a gain. Those bonds would not be
included in the table filed with the SEC that websites use to tell you what Charlie Munger owns.
Everyone can agree on the two big stock positions though. Daily Journal has a lot invested in
Wells Fargo and Bank of America shares.
The value of these stakes are offset to some extent by two items.
One, Daily Journal would be liable to pay taxes if it sold shares of these companies. As long as
Charlie Munger is Chairman of the company (he’s 95 now, though) I don’t expect Daily Journal
to ever sell its shares of these banks. Therefore, I don’t expect a tax to be paid. If a tax was to be
paid – you should, perhaps, trim the value of these stakes by over 15%. A very big part of the
holdings are simply capital gains. If a stock has increased in value by 4 times while a corporation
has held the shares – then, the final amount of taxes paid will seem very large relative to the size
of the stake. This is because most of the stake is capital gains that would be taxed on a sale.
The other offset is margin borrowing. Daily Journal borrows using a margin account. The
company doesn’t borrow to amplify returns. It borrows against its shares in companies like Bank
of America, Wells Fargo, and (presumably) POSCO to buy technology companies that can help
the company grow in a new direction. That direction is providing services to governments –
basically courts and other justice related government agencies (like the traffic ticket payment
processing part of a city government, for example) – using software. This is what drew me to
write about the company. I read an interview in Columbia Business School’s “Graham and
Doddsville” newsletter that talked about Daily Journal. The investor being interviewed had some
very interesting things to say about how Daily Journal recognized revenue and things like that.
We’ll discuss this when I get to the “Journal Technologies” part of Daily Journal. For now, we
just need to know that Daily Journal borrows in a margin account against stocks like Wells Fargo
and Bank of America to fund the acquisition of legal software companies serving governments in
the U.S. and abroad. Margin borrowing is a cheap form of borrowing. There are a lot of reasons
to like it. The margin loans are done at Fed Funds Rate plus a premium. They never mature.
Daily Journal just has to keep sufficient collateral to protect the loans adequately. That’s not
difficult considering I expect Daily Journal has no intention of ever selling these stocks anyway
while Charlie Munger is in charge. The margin loans are also – at least for now – at rates well
below the expected returns in the stocks they are collateralizing. So, to fund an acquisition by
selling Wells Fargo stock, you’d trigger a major tax. Instead, you avoid triggering the tax. You
keep compounding at 8% or 10% or whatever in Wells. You pay 3% or whatever (actually, the
Fed Funds Rate has declined since the reports I’m using to write about Daily Journal here and so
has the margin loan rate). This means shareholder wealth is still compounding nicely at 5% to
7% (instead of 8-10%) on the portion of the stock that you otherwise would have sold but now
just borrow against. The tax continues to be deferred. Daily Journal gets to make an acquisition.
It works out well for shareholders from both a tax and return perspective. And it uses leverage
that is both low cost and doesn’t come with solvency risk involving when it matures. It does – of
course – come with the market risk that a huge decline in Bank of America, Wells Fargo, etc.
stock would require Daily Journal to post more collateral, sell stock, etc. Given the amounts
involved here – the amount borrowed versus the other assets Daily Journal has – I think the risk
is low. I think Daily Journal is very smart to borrow in a margin account against its shares
instead of resorting to more traditional bank loans.
Daily Journal’s financial strategy is interesting. It’s very unusual. This brings me to part two.
After you figure out how much the stock portfolio should be valued at – subtracting whatever
amounts for margin loans, taxes, etc. you think is appropriate – you then can move on to real
estate. Daily Journal owns several buildings it occupies. In fact, the company recently switched
from leasing to owning one of its buildings. It owns property it uses in Los Angeles as well. The
“properties” section of the 10-K gives exact details on years when buildings were built or
bought, square footage, what the buildings are used for, etc. A next step would be to look for
more accurate appraisals of the value of these properties. Is this a meaningful part of the value of
Daily Journal?
Maybe.
I don’t think it’s worth writing a lot about real estate here. But, it is an unusually large number
relative to things like market cap and enterprise value compared to what percent of value real
estate makes up at most operating businesses. Here, again, Daily Journal is borrowing.
Borrowing against real estate – like borrowing against stocks – can be a smart move for creating
shareholder value. You don’t want a company tying up money in both acquiring tech companies
and in holding its own real estate, stock portfolio, etc. You’d rather that shareholder money only
be put to uses that are likely to compound. The equity left above a real estate loan is likely to
compound fine. The stock net of a margin loan is very, very likely to compound fine. And the
purchases of tech companies is a necessary part of Daily Journal’s long-term term strategy. So,
here – in the real estate part of Daily Journal – we’d just want to get a better appraisal of the real
estate and then subtract out the real estate loans. That would be my next step here on returning to
analyze the company in detail.
As I’ve hinted earlier though – I don’t have plans to revisit Daily Journal in-depth. The reason is
that, so far, I’ve been unable to find information that would help me value some of the most
important parts of Daily Journal. I’ll get to that in a second. Let’s now deal with – what is, to me
– the least important part of Daily Journal.
Part 3 of Daily Journal’s value comes in the form of the “Legacy Business” which is also known
as “The Daily Journals” (and some other related publications). These are old, originally print
only newspapers (they now also have websites) that charge annual subscriptions to those getting
the paper delivered to their home, office, etc. and that also charge advertisers to run ads in the
papers. The papers are targeted at lawyers, judges, etc. Historically, the company had run a lot of
public notice advertising. These are things like foreclosure notices that have to be run – they’re
required by state law – in a newspaper of record in some particular county, town, etc. by such
and such a date or for so long to meet some legal requirements. In the past, more popular
newspapers – the kind average people read for enjoyment, not because they are lawyers or judges
– did not run much of this kind of advertising. One risk here is that bigger papers will run those
kinds of ads. Big papers have lost some of their most valuable forms of advertising – like
classified ads – to things like Google, Facebook, and Craigslist. They are failing. And they may
eventually accept any kinds of ads that pay much of anything. I suppose Daily Journal would still
have advantages in being able to charge less, having a history of running these kinds of ads (so
better known by the advertisers), and also through ownership of an agency that specializes in
placing these kinds of ads – usually in non-Daily Journal owned newspapers – while taking a 1525% commission. Still, as an industry shrinks – once protected niches may get generalized. This
legacy business has some costs that might not get slashed fast enough. It could produce some
cash profits for a while. But, the offset in terms of value would be any period where the legacy
business is burning cash and yet hasn’t been shut down. The 10-K includes some language that
makes it sound like Daily Journal sees some of its reporting as a duty here beyond just a profit
seeking motive. Once they are actually burning meaningful amounts of cash in this business –
they may be willing to forget about that duty. It’s never said in the 10-K that the duty extends to
running money losing papers. It’s just mentioned that they pursue objective reporting even in
cases where that might not be the ideal profit maximizing decision. Still, that kind of language
and focus on service to the local communities instead of just to shareholders is always worrying
when it is being used to describe a business that will soon be in need of permanent shutting
down. I’d value this business at nothing. It might be worth slightly more than nothing. But, it
could – if the company refuses to shut things down fast enough – also have a real negative value
for shareholders here. So, I don’t think valuing it at nothing is as conservative as it seems.
Then we get to “part 4”. This is “Journal Technologies”. Here, the Daily Journal acts as a
competitor and peer of sorts to publicly traded companies like Tyler Technologies (TYL) and
NIC (EGOV). This is the part of Daily Journal that originally attracted me. It’s also the part I’ll
be spending the least time on now. The disclosures in this section are inadequate. There is no
way to value the business. We know the CEO (79 and recently suffered a stroke) who runs
almost all aspects of this business is entitled to a percentage of the pre-tax income of this
business unit. However, at present, the business unit has no pre-tax income. We can also see that
Daily Journal’s accounting is very, very conservative. For example, they don’t recognize a lot of
the revenue till the system they installed has gone live and the customer is satisfied. They’re able
to do this – which results in massive mis-matching of revenue and expenses, so very anti-GAAP
in spirit – by not invoicing the customer till the system goes live. Without an invoice, they can
claim that the revenue is not certain enough in amount, whether it will be paid, etc. Still, this
creates a huge problem for any analyst.
It’s possible that – as the Graham and Doddsville interview suggests – Daily Journal’s Journal
Technologies business will grow into a free cash flow juggernaut within a decade or so. Maybe.
But, I have no way to gauge the size or profitability of this business. The revenues shown
understate the amount of billing the company is likely to do in the future. However…
There are two problems that make this one nearly impossible for me to analyze. I’m not even
sure if Journal Technologies will or won’t create a ton of value in the future. One is that in many
years the company has been growing its salaries and benefits line as fast as its revenue line.
Now, if the amount of revenue the company will EVENTUALLY book is running ahead of
revenue in percentage terms each year – that’s fine. Basically, if you are growing expenses by
10% a year and revenue by 11% a year, but you’re actually growing the eventually invoice-able
amount of future billings expected by 16% a year, you have a good business. Since I can’t know
whether revenues are or aren’t a good proxy for growth in Journal Technologies’ future business
value, it’s hard for me to see if there’s going to be future business value here. You could say it’s
necessary to trust the business judgment of the CEO here, of Charlie Munger (the chairman), J.P.
Guerin (Vice Chairman and big shareholder), etc. and just accept the idea that they wouldn’t
allow operating expenses at Journal Technologies to grow as fast or faster than what they expect
to eventually bill. But, if you aren’t willing to make that assumption – I’m not yet seeing
percentage growth in revenue exceeding percentage expense growth by enough to get me
interested. If this was a growth company without Charlie Munger’s name attached – I’d pass on
it.
Finally, Journal Technologies remains free cash flow negative. It doesn’t have meaningful capex (at all). And it does – or did, I think it’ll be just about done with this when you’re reading this
part – amortize a lot of intangibles that depress earnings. So, it wouldn’t be hard for Journal
Technologies to very soon flip into a free cash flow generator. But, in past years, the segment has
consumed cash flow in its operations. I can’t remember the last time I invested in a company that
had negative cash flow from operations. This could change soon. And a big period of investment
of cash followed by years of FCF generation may be the right way to run a growing software
business as it gets to scale.
But, again, it’s a pass for me.
Even with Charlie Munger’s name attached to this one – my interest level is low. I don’t think
it’s a bad stock. Some information in how it accounts for things combined with that interview I
read does suggest that Daily Journal could be more of a growth company than it appears. But,
it’s not the kind of investment for me. There’s just too little disclosure of the stuff I need to see
to value a company.
In this case: too little information leads to a low interest level.
Geoff’s initial interest level: 30%



URL: https://focusedcompounding.com/daily-journal-djco-a-stock-portfolio-some-realestate-some-dying-newspapers-and-a-growing-tech-company-with-minimal-disclosures/
Time: 2019
Back to Sections
-----------------------------------------------------
NIC (EGOV): A Far Above Average Business at an Utterly Average Price
NIC (EGOV) is a company that’s – as the ticker suggests – focused on eGovernment. In
particular, NIC is focused on providing internet based interactions with state governments in the
United States.
This is not a truly huge market. EGOV is by far the market leader and yet it only has $331
million in revenue, $78 million in pre-tax profit, and $59 million in after-tax free cash flow. The
company is valued at $1 billion (the market cap is greater, but the company has net cash). To put
this in perspective, EGOV has about half the addressable market for state government portals in
the U.S. So, the stock market is saying that the entire potential state government portal industry
– for all 50 states – is worth no more than $2 billion.
To me, that sounds a lot like a niche. And that’s what got me interested in EGOV. Actually, my
co-founder, Andrew, got me interested in EGOV. But, I think my interest in the stock quickly
outstripped his own.
In the U.S., government clients can be broken down into: 1) school districts, 2) cities / towns /
municipalities, 3) counties, 4) states, and 5) the federal government (including military branches
and various agencies). The biggest available government contracts are at the federal level. And
the greatest number of available contracts are at the local level. For example, a Department of
Defense contract would be a deal serving just one client, but the client would be very big. The
Department of Defense has an annual budget of $534 billion. Meanwhile, the largest state
government in the U.S. (California) only has an annual budget of $183 billion. Keep in mind, the
median U.S. state by population (Louisiana) is about one-eighth the size of California. So, the
average state’s budget might be 5% of the Department of Defense’s budget.
The biggest state with which NIC does business is Texas. It is the second most populous state in
the U.S. (behind California) and yet we know that the revenues from providing eGovernment
services through the Texas.org portal are only about $64 million a year (EGOV’s 10-K tells us
that Texas is 20% of NIC’s total revenues and NIC’s total revenues were $318 million last year).
It may seem like I’m throwing a lot of numbers about market size at you here for no reason. But,
I think there’s a very important reason that goes to the core of whether you should or shouldn’t
invest in EGOV.
How niche is this business?
How competitive is this “industry” now?
And how competitive is it likely to get?
My guess – as long as EGOV stays in its niche of providing individual online portals for the 50
U.S. states – is that isn’t not very competitive now and it’s not likely to get much more
competitive in the future. However, if EGOV strays from operating “dot gov” sites for the states
into trying to win business with federal agencies, city governments, etc. (which it is already now
doing a little of) I think competition could be a lot more intense.
So, how dominant is EGOV in its niche? And how competitive is that niche?
The U.S. consists of 50 states. There are also some state-like entities. Most importantly: the
District of Columbia (a.k.a. “Washington D.C.”), Puerto Rico (a territory), and over 500
American Indian tribes (considered “domestic dependent nations”). Some of those entities are as
big as the smallest U.S. states. However, their needs wouldn’t be exactly the same as states
because of the division of power between the federal government and the state government in the
U.S. Each of the 50 states can choose to put some things online – that is, use eGovernment or not
use eGovernment – for all sorts of different needs. But, what each state does – either online or
offline – is exactly the same for all 50 states. All 50 states have the power to grant the same
licenses, collect the same records, etc. Basically, there’s a set customer group of 50 potential
clients. That’s the addressable market here.
Right now, NIC operates a “dot gov” internet portal for 27 of the 50 states. So, NIC has roughly
54% of the addressable market.
How competitive is this market?
I will quote from EGOV’s 2016 10-K:
“Historically, we have not faced significant competition from companies vying to provide
enterprise-wide outsourced portal services to governments; however, we face intense
competition from companies providing solutions to individual government agencies…In most
cases, the principal alternative for our enterprise-wide services is a government-designed and
managed service that integrates multiple vendors’ technologies, products and services.”
The impression I get is that there is very little competition for outsourced portal services for state
governments (the “dot gov” sites such as Texas.gov). This impression is backed up by several
facts mentioned in EGOV’s 10-K.
One, in cases where EGOV wins a new government contract, that state has usually written a law
(presumably at the request of lobbyists from NIC) to allow for outsourcing the state’s website
and requesting proposals from private sector companies to run the site. In other words, EGOV is
not taking business from competitors. Instead, it is getting U.S. states to switch from an in-house
website to an outsourced website.
Two, in cases where EGOV loses an existing government contract, the company has usually
chosen not to respond to a “request for proposal”. These seem to be money losing contracts. For
example, NIC recently lost 3 state contracts and these 3 losses combined had no material impact
on profit.
Three, although some states operate under agreements that they can terminate (without cause) on
short notice – few do. When my Focused Compounding co-founder, Andrew, and I discussed
EGOV the terms of these agreements were a major concern for him. For example, Texas is 20%
of EGOV’s business and the state can simply terminate the deal and force NIC to hand the
existing site over to a competitor. Texas does not need “cause” to do this. And Texas does not
need to compensate NIC for the loss of the contract.
The idea that 20% of a company’s revenue – and even more of its earnings – could disappear
overnight is a scary one for investors. But, this is not the part of EGOV’s business model I’m
worried about.
Why not?
Sure, EGOV could lose state contracts. It has the contracts for about as many states (27) as it
doesn’t have (23). So, EGOV can always lose an existing contract. But, it can also always win a
contract it doesn’t yet have. I can’t say it won’t lose Texas. But, no one can say it won’t win
California (a contract it doesn’t have) either.
As for having contracts the client can easily terminate…
First, many service businesses work this way. In my report on Omnicom, I showed that client
retention at the world’s biggest ad agencies is often 95% to 99% even though clients could
terminate these agreements without cause and hand over all the intellectual property the agency
created for them to a competitor. Ad agencies don’t have contractual protections. However, they
have historically done better at keeping clients than many business models that include a
contractual lockup for the client.
Second, we can look at companies that are doing something different – like selling off the shelf
hardware and software – but for similar clients. Tyler Technologies (TYL) serves mostly local
governments. Here is what Tyler Technologies says about its retention rate:
“We have a large recurring revenue base from maintenance and support and subscription-based
services, which generated…62% of total revenues, in 2016. We have historically experienced
very low customer turnover (approximately 2% annually) and recurring revenues continue to
grow as the installed customer base increases.”
While TYL’s recurring revenues are 62% of its business, EGOV’s recurring revenues are 90% of
its total revenues (and 95% of “portal” revenue is recurring).
Finally, we can look at how many states have had NIC operating their “dot gov” portal for over
10 years (note that Tennessee is no longer a client):
26 years: Kansas
23 years: Nebraska and Indiana
21 years: Arkansas
19 years: Maine and Utah
18 years: Idaho, Hawaii, and Tennessee
17 years: Montana, Oklahoma, and Rhode Island
16 years: Alabama
15 years: Kentucky
13 years: South Carolina and Colorado
12 years: Vermont
It’s true that several large states – like Texas (9 years) and Pensylvannia (6 years) – haven’t been
with EGOV for nearly as long as the states listed above. However, it’s worth stopping to think
about just how long ago in the history of the internet some of these states were first signed up. Of
state that still do business with the company, EGOV signed up a total of 6 states in the 1990s
when the idea of doing much of anything through a statewide website was very new. Kansas,
Nebraska, Indiana, Arkansas, Maine, and Utah were all signed up before the year 2000 and are
all still with NIC.
If we look at old 10-Ks, we can see that some states used to be clients and are no longer clients.
For example, by 2001, EGOV had signed up Georgia, Virginia, and Iowa. Iowa is a recent lost
client for EGOV. None of these states are clients of EGOV anymore. Despite some states leaving
EGOV, the total number of state portals operated by NIC rose from 17 of the 50 states (34%) in
2001 to 27 of the 50 states (54%) today.
The other issue to consider in terms of competition is scale. If EGOV has 54% of the state
portals out there and the biggest other operator of state portals are the states themselves – there
aren’t a lot of big state portal contracts available for a competitor to use as a steeping stone to
bidding on more of this kind of business. EGOV mostly just operates state portals (that’s about
91% of their business) and yet they have 1 employee at headquarters for every 3 employees in
the field. NIC is organized with 27 different state subsidiaries. These are like 27 field offices
(one office in the capital of each state). If you read reviews of the company by employees and
ex-employees, you get the general sense that working in these field offices – once EGOV has the
master contract for the state portal – is not grueling work compared to life at most tech
companies. Life is probably more hectic at headquarters. My point here is that even with half the
addressable market – EGOV is carrying overhead of about 1 employee at the home office for
every 3 employees in the field. Presumably, potential competitors would have much worse ratios
of home office staff to field staff. The other issue for new entrants is scale at the state level. A
new portal isn’t immediately profitable. And some of EGOV’s portals probably never become
profitable. This has to due with the level of fixed expenses versus variable expenses and the
ability to cross-sell other government services on the portal.
Let’s start by discussing “start-up” costs and fixed expenses. EGOV has to start its “sales cycle”
by lobbying the governor’s office and legislature (often two different houses) in a state capital.
Once a bill is passed allowing the state portal to be outsourced and EGOV is chosen as the
provider of that portal, it then needs to create a subsidiary in the state capital that does the
decentralized work of providing a “dot gov” portal for that particular state.
EGOV’s business model is to have zero dollars allocated to it in the state budget. Normally, the
state does not “pay” EGOV anything in that way (through legislatively appropriated
funds). Instead, EGOV processes fees that would otherwise be collected by the state on the
portal and a portion of these fees are used to compensate EGOV. So, if you sign up for a hunting
license in the state of Oklahoma – you’re using an EGOV site to do that (Oklahoma.gov) and the
state of Oklahoma is using the license fees collected from hunters to pay EGOV for providing
eGovernment services on the portal such as issuing hunting licenses.
I gave an example that I thought would be clearer and easier for the folks reading this article to
understand. Something like a hunting license is easy for a citizen to understand. In reality,
EGOV gets about 72% of its revenue from businesses and only 28% from citizens. However,
citizens sometimes generate the information source that EGOV sells to businesses. In fact, this is
true of EGOV’s single largest source of revenue.
EGOV sells “driver history records” to insurers or re-sellers like LexisNexis. In fact, EGOV’s
single biggest revenue source is payments from LexisNexis for driver history records which
insurers then access via LexisNexis.
This is another example of revenue concentration that might worry some investors. About 20%
of all payments to EGOV come from LexisNexis and about 20% of all revenue at EGOV comes
from Texas. This means that EGOV could lose close to 40% of all revenue if just two parties –
the State of Texas and LexisNexis – stopped doing business with EGOV.
How realistic a concern is this?
Texas could leave. But, LexisNexis wants to sell driver history records to car insurers – and in 27
of 50 states, you have to go through EGOV to get those driver history records.
EGOV’s business model is to get the master contract for operating the portal (which makes it
little or no revenue and almost certainly loses money at first) and then quickly start selling driver
history records. It then tries to get more and more “interactive government services” done
through the website it operates.
The sales cycle takes years. Even after EGOV wins the contract for a portal, it’s unlikely to make
any money within the first 18 months of the deal. And, as I said, in most cases there had to be
lobbying ahead of time before a contract could be won.
My assumption is that large states that have had EGOV operating their portal for a long time and
that have added more and more interactive government services through the portal over time are
probably the biggest contributor to EGOV’s profits. Meanwhile, small states that are new
contract wins for EGOV and which are reluctant to add more interactive government services to
their portal (beyond driver history records) are less profitable or even unprofitable.
Yes, this would mean that the loss of a state like Texas would cost EGOV more than 20% of its
profits even though it only accounts for 20% of revenue.
Keep in mind what I just said about adding services over time to the site as the years go by. It’s
an important point. But, I want to first talk a little about fixed expenses and variable expenses.
Again, I want to look at this more from the competitive (qualitative) side than from the operating
leverage (quantitative side). Things like a small addressable market, a lot of already locked up
customers, a long sales cycle, start-up losses, and high fixed expenses relative to variable
expenses often mean you can expect few new entrants.
At the state level, fixed costs are 61% of EGOV’s costs. This is important because same-state
revenue growth usually exceeds fixed cost growth while often growing no more than variable
costs. For example, state level revenue grew about 9% in 2016 while state-level fixed costs grew
3% and state-level variable costs grew 15%. The easiest way for EGOV to grow returns for
shareholders while making government clients feel they are getting at least as much for their
money each year is to grow same-state revenue much faster than same-state fixed expenses.
Historically, EGOV has had a very impressive rate of same-state revenue growth. And in the
company’s last 10-K it included an aggressive goal:
“Our long-term goal is to grow same state revenues at our historical average of approximately
8-10% per year. Same state portal revenues grew 9% in 2016 compared to 8% in 2015.
Revenues from interactive government services…primarily consist of transaction fees generated
by means other than from providing electronic access to motor vehicle driver history
records…As (interactive government services) revenues continue to become a larger component
of overall portal revenues, our growth in same state (interactive government services) revenues
becomes more important to our overall growth as a company. Same state (interactive
government services) revenues grew 12% in 2016 compared to 11% in 2015. “
My personal long-term concern with EGOV is that this goal might not be achievable. The
company can’t realistically grow same-state revenue for driver history records very fast. This
past year, it grew 1%. And I expect 0% to 3% to be the norm going forward (that’s without
considering the long-term impact of driverless cars). EGOV can mostly just implement pricing
increases on those. Growth in drivers is no greater than population growth these days. So, the
eventual long-term growth in driver history records would at best be inflation plus 1% and due to
factors like low population growth and the possibility of driverless cars – it’s likely to be lower
than that.
Now, interactive government services revenue can grow a lot faster. States still do a tremendous
amount of things offline. But, if we look at states where we have some hints of revenue levels –
we see that same-state interactive government services growth is very fast in early years and then
slows as more and more services are already done via the website. In other words, a new state
contract might be able to grow at 20% a year in its fist 3 years. But, by it 8th, 9th, and 10th year it
might be growing more like 5% a year. We don’t have exact numbers on this. But the broad
strokes of what I just laid out there are consistent with the disclosures on a state like Texas.
Here is what EGOV said in its most recent earnings release:
“Quarterly portal revenues were $76.4 million, a 2 percent increase over the third quarter of
2016. On a same-state basis, portal revenues were $76.4 million in the current quarter, a 5
percent increase over the third quarter of 2016. Same-state, transaction-based revenues from
Interactive Government Services (IGS) rose 10 percent over the third quarter of 2016, due
primarily to higher volumes from a variety of services including motor vehicle registrations and
business registration filings, among others. Same-state, transaction-based revenues from Driver
History Records (DHR) were up 1 percent…”
This is actually very impressive compared to what I would expect in the long-term. Think about
it: same-state interactive government services are rising 10% a year at a time when nominal GDP
in these states likely rose about 5% or less. In the last 10-K, a goal of 8% to 10% was mentioned.
These are aggressive targets. If the company achieves them going out 5, 10, or 15 years, it’s
going to make today’s buy and hold shareholders in the stock very rich. I’m not sure the targets
are achievable though – at least not for that long.
If EGOV’s only business was driver history records, I don’t think the company would grow
revenue by more than about inflation each year.
However, the same-state growth in interactive government services has always been strong and it
continues to be strong this year.
Obviously, if EGOV really can deliver 8% to 10% truly long-term same-state revenue growth in
its interactive government services while keeping fixed cost growth closer to half that level – it’s
a dirt cheap buy and hold forever stock even right now (when the P/E is 21).
If the stock can grow at nominal GDP type rates, it’s a good stock to buy and hold even now
when this stock – and the overall market – has a pretty high P/E.
What if it only grows at about the rate of inflation plus population growth?
Well, even then, I’d expect EGOV – if you really bought it today and held it forever – to
outperform the overall market. This isn’t obvious right now because EGOV is operating in a low
inflation environment – as are all U.S. stocks.
EGOV could do well in high inflation environments because it has:


Almost no tangible capital invested in the business
Revenue sources that are completely non-discretionary
Now, it is true that the state governments have to approve increases in the fees EGOV collects.
So, there’s no guarantee that revenue won’t lag in a high inflation environment. But, I promise
you that EGOV’s growth looks pretty high right now instead of exceptionally high mostly
because inflation is low. This is the kind of company that would have good EPS growth
compared to more asset heavy businesses in a high inflation environment. It should be possible
for EGOV to have earnings grow faster than sales and sales to grow faster than invested capital.
That’s a recipe for success during times of inflation. And most times have higher inflation than
the recent past we’re using as “normal” here.
How cheap is EGOV now?
A little cheap.
So, EGOV trades at about a 5% earnings yield using last year’s after-tax EPS. EPS always
understates free cash flow at a business like this. And then the corporate tax rate has been
reduced from 35% to 21% in the U.S. EGOV is the kind of business that should benefit
tremendously from this sort of tax break. It does business 100% within the U.S. and in fact must
pay pretty high taxes every year. Before last year, EGOV had a tax rate in the high 30s to low
40s just about every year. This is not surprising for a business that is so decentralized it has 27
different state subsidiaries. A business like this can avoid neither state nor federal taxes.
The savings from the federal tax cut are unlikely to get “bargained away” by the parties on the
other side of EGOV’s negotiations. The state governments mostly set fees on citizens and
businesses. State governments could negotiate down EGOV’s take – but state governments
aren’t for profit businesses. So, it’s less likely than in tough negotiations between suppliers and
retailers or something like that. EGOV’s bargaining position for keeping the tax cut to itself is
stronger than it is at most public companies.
I expect EGOV to benefit a lot from the tax cut. It should be one of the biggest beneficiaries of
the corporate tax reduction.
As a result, we should probably immediately assume that EGOV has a P/E of something closer
to 18 than 21. On top of this, free cash flow is actually higher than EPS. So, we should assume
that as of this moment – EGOV has a price-to-owner earnings of less than 18. The true economic
P/E is under 18. That’s cheap compared to the market.
EGOV is also a much higher quality business than most stocks in the S&P 500. For example, the
business uses almost no capital. Joel Greenblatt would calculate the ROIC of EGOV as being
way into the triple digits. It’s effectively infinite. More importantly, EGOV doesn’t use its free
cash flow to make expensive acquisitions. Instead, it basically keeps share count constant and
pays a dividend.
That dividend is one of two possible catalysts for EGOV.
Assume EGOV’s actual business doesn’t change much this year. Could the stock price rise for
non-business reasons?
Yes.
One, the company just switched from declaring a special dividend each year to now declaring a
regular dividend. Given EGOV’s high free cash flow relative to EPS and its high historical
growth rate in EPS (18% over the last ten and five years and then 8% over the last year), it would
be very easy for EGOV to start with a low dividend yield like 2% and then raise that dividend
per share at a double-digit percent rate for a very long time. As I write this (with the stock at
$17.45 a share) the dividend yield is 1.83%.
I don’t know if EGOV’s plan really is to raise that dividend by 10% or so annually. But, I do
know that EGOV is pretty much the perfect stereotype of what a consistent dividend increasing
company looks like before it gets noticed as a consistent dividend grower. The payout ratio is
low. The company doesn’t buy back stock, it doesn’t make acquisitions, it doesn’t use capital in
the business as it grows, and it does get almost all its earnings from recurring revenues. This is a
dividend grower in the making.
The other catalyst is the tax cut. EGOV’s earnings per share could grow 10% to 15% next year
simply as a result of the tax cut. This is a one-time boost. But, remember: the stock fell about
30% in price last year. I’d estimate that 30% decline in the stock’s price was accompanied by
probably a 20% increase in the stock’s after-tax earning power.
Think about that. EGOV’s price went down 30% over the last year while it’s value went up
about 20% last year. That’s the kind of year that gets a value investor’s attention.
So, am I buying EGOV today?
No.
Is it near the very top of the stock I’m considering buying list?
Yes.
Will I write about it again?
Probably.
I’m going to do some more research on this company. And I’d love to get emails – or comments
(below) – from Focused Compounding members interested in this stock.
EGOV isn’t a clear “value” stock yet. But it’s a “quality” stock that is no longer trading at a
premium to the market. In fact, EGOV is now quite cheap compared to the average P/E it used to
trade at.
I know some people prefer a stock like Tyler Technologies (TYL) which I mentioned above.
Tyler is not really a competitor. It is a fast-growing stock and I have nothing bad to say about
Tyler except that it’s priced at almost 3 times EGOV’s price and yet it doesn’t have better returns
on capital, better financial strength, etc. What it has is a higher growth rate and a much higher
price. Both companies are impeccable according to most quality metrics – growth, return on
capital, predictability, financial strength, etc. Tyler is a faster grower. But, it’s priced like a
much, much faster grower.
From a pure handicapping perspective: I’m a lot more comfortable digging deeper into EGOV
than digging deeper into Tyler Technologies.
So, that’s what I’ll be doing this week – digging deeper into EGOV.
I suggest you guys do the same.



URL: https://focusedcompounding.com/nic-egov-a-far-above-average-business-at-anutterly-average-price/
Time: 2018
Back to Sections
-----------------------------------------------------
Gainsco (GANS): A Dark Nonstandard Auto Insurer That’s Cheap Based on
Recent Underwriting Results
Gainsco (GANS) is a dark stock. It does not file with the SEC. However, it does provide both
statutory (Gainsco is an insurer) and GAAP financial reports on its website. These reports go
back to 2012 (so, covering the period from 2011 on). Not long before 2011, Gainsco had been an
SEC reporting company. Full 10-Ks are available on the SEC’s EDGAR site. Anything I’ll be
talking about with you here today about Gainsco’s historical financial performance has been
cobbled together through a combination of GAAP financials for the holding company (Gainsco),
statutory financials for the key insurance subsidiary (MGA), and old 10-Ks.
Before I even describe what Gainsco does, let’s start with the company’s combined ratio.
An insurer’s combined ratio is the flipside of its profit margin. However, it covers only the
underwriting side of the business. It ignores investment gains on the float generated by
underwriting. A combined ratio of 100 means that economically the insurer is getting use of its
float at no cost. A combined ratio above 100 means the float costs the insurer something. A
combined ratio below 100 means the insurer is making a profit even before it invests the float.
The combined ratio has two parts. One is the loss ratio. The other is the expense ratio. These
ratios are calculated as fractions of the premium revenue the insurer takes in. So, the loss ratio
gives us some idea of how much higher the insurer is pricing its premiums than actual losses will
be. For example, a loss ratio of 75% would indicate the insurer priced premiums at about $1.33
for every $1 it lost (100%/75% = 1.33x). The expense ratio gives you an idea of how much of
premiums are eaten up immediately by things like commissions, marketing, and a lot of the fixed
costs of running an insurance operation. It’s everything other than the stuff that relates to losses.
Here is Gainsco’s combined ratio from 1998-2018 (excluding 2010):
1998: 134%
1999: 99%
2000: 124%
2001: 163%
2002: 143%
2003: 105%
2004: 97%
2005: 95%
2006: 108%
2007: 98%
2008: 99%
2009: 100%
EXCLUDED
2011: 99%
2012: 103%
2013: 99%
2014: 96%
2015: 99%
2016: 99%
2017: 94%
2018: 94%
Something obviously changed there. Till about 2004, Gainsco did other things besides
“nonstandard” auto insurance. For the last 15 years, it’s stuck to just writing nonstandard auto
insurance in a few (mostly Southern) states.
My guess is that about 80% of drivers seeking coverage in the total U.S. auto insurance market –
this might be a bit different in the states Gainsco is in – would be considered standard or
preferred risks. So, Gainsco only writes coverage for the bottom 20% of drivers. Gainsco is more
of a niche business than just that though. A lot of Gainsco’s policyholders are Spanish speaking.
And most are drivers in the states of Texas and South Carolina. My best guess is that Gainsco’s
policyholder base is disproportionately made up of: 1) Spanish speaking drivers, 2) In the states
of Texas, South Carolina, Florida, and Georgia, 3) Seeking the minimum legally required
coverage in that state.
Most (but not quite all) of the coverage Gainsco writes is for the minimum liability and damage
coverage required by law in that state. For example, Gainsco’s biggest market is Texas. Texas
requires all drivers have liability coverage of $30,000 per person up to $60,000 per accident and
$25,000 of property damage.
Because Gainsco covers non-standard drivers, the average Gainsco driver’s premium cost would
be higher than the cost paid by most drivers seeking the same low level of coverage.
Based on SEC filings, I would guess that about 10 years ago, the average Gainsco driver was
paying around $100 a month in premiums. I don’t know what they’re paying today. And the
calculation would be complicated by how the premiums are paid. Gainsco’s drivers would tend
to use payment plans, fail to make payments, make late payments, seek to have lapsed insurance
(due to non-payment of premiums) reinstated, etc. which would all come with additional fees and
such.
Also, an insurer like Gainsco would need to charge more in premiums to take the same level of
actual auto risk, because the risk of cancellation by the policyholder is higher. There are auto
insurers with retention rates of like 90%. About 10 years ago, I would calculate Gainsco’s
retention rate at maybe 40%. About 10 years ago, half of Gainsco’s policyholders would cancel
their policies during the term – before the policy even came up for renewal at the end of the 6month or 12-month term. Cancellation was almost always due to a failure to pay premiums.
Given the low retention rate, etc. – what’s attractive about this stock?
Well, based on recent past results it’s cheap. It also has – again, based on recent results – a solid
ROE. And it’s been growing fast. Let’s look at the last 3 years. (I have incomplete 2019 data –
results weren’t as good in 2019 as 2018, but the combined ratio, etc. was still fine):
Combined Ratio
2016: 97%
2017: 94%
2018: 94%
Return on Equity
2016: 13%
2017: 17%
2018: 22%
Premium Growth
2016: 9%
2017: 16%
2018: 19%
Dividends Per Share
2016: $2.50
2017: $1.50
2018: $2.00
The stock is trading at $32 a share right now. So, that’s a dividend yield of about 4.7% to 7.8%
based on those 3 years of dividends. On a P/E basis, it’d be something like 8 times earnings. On
a price-to-book basis, it’d be something like 1.3 times book. A stock growing by 9-19% a year,
shouldn’t trade at a P/E of 8. And a stock with an ROE of 13-22%, shouldn’t trade at a price to
book of 1.3. Nor should an insurance stock be priced to yield 5-8% a year in dividends when the
longest investment grade corporate bonds out there yield less than 4%. Two warnings: 1)
Gainsco didn’t pay a dividend last year (2019). And 2) those dividends in 2016, 2017, and 2018
were special dividends – not regular diviends.
Nonetheless, if you had complete faith that Gainsco’s future performance will match its
performance these last 3 years – you should stop reading this article and just go out and buy the
stock now.
I have doubts.
It’s an insurer. So, the business is very, very cyclical. We are also – for 2017 and 2018 – looking
at literally the lowest combined ratio this company has achieved in more than 20 years. So, it’s a
cyclical business showing wider profit margins than ever before. Also, the low combined ratio is
completely a result of a low loss ratio – not a low expense ratio. Gainsco’s expense ratio has
been 25-29% of premiums since it changed its business model entirely around 2004 (more on
this later). The expense ratio hasn’t been what’s fluctuated. It’s been the loss ratio bouncing
around. The loss ratio in 2017 and 2018 was the lowest loss ratio Gainsco has ever achieved
(65% and 64% respectively). Even after changing its business model, Gainsco had experienced
loss ratios as high as 78% in 2012 and 82% in 2007. In fact, from 2006 though 2016 – Gainsco’s
loss ratio was NEVER below 70%. The last two years, it has plunged to 64-65%. To put this in
perspective, a loss ratio of 64% versus a loss ratio of 70% is the difference between a combined
ratio of 94 or 100. For Gainsco it’s the difference between an underwriting loss or an
underwriting profit. And, during the last two years, Gainsco’s underwriting accounted for 7075% of earnings (the other 20-25% came from the bond portfolio funded by float). So, Gainsco
stock is cheap if you assume results for the last couple years are a good guide to future results.
But, it would only take a return to Gainsco’s past loss ratios to wipe out 75% of earnings and
make this stock jump from a P/E of about 8 to a P/E of about 30. Buying a cyclical stock when it
has a low P/E (like 8) that could skyrocket to a high P/E (30) the moment the cycle turns is
usually a bad idea.
But, I might be overstating Gainsco’s cyclicality. The stock may be a lot less likely to return to
bad underwriting results than I’m assuming. Let’s look at the combined ratio for the years since
Gainsco stopped filing with the SEC.
2011: 99%
2012: 103%
2013: 99%
2014: 96%
2015: 99%
2016: 99%
2017: 94%
2018: 94%
2019 (first 9 months): 94%
If we go far back, we also see a premium growth pattern that matches nicely with the improving
combined ratio. Premium growth increased quite a lot during strings of consecutive years of
strong underwriting profit and premium growth – this is going back a long way – and then was
basically nothing during periods where the combined ratio was poor. For example, take that
103% combined ratio. In the two years following that 103 number, Gainsco grew premiums by
just 3% and 2%. After that, the combined ratio hit 96 and would only rise as high as 99. It has
now been at 94 for 3 consecutive years. Well, during that time period, Gainsco’s premium
growth by year was: 12%, 9%, 16%, 19%, and now 7%. Of course, it’s possible that premium
growth is due to premium price increases causing a reduction in the loss ratio and keeping the
combined ratio below 100. Without these price increases, premiums wouldn’t be growing and
the combined ratio wouldn’t be under 100. That’s possible, however it’s worth mentioning that
Gainsco’s expense ratio has been a poor predictor of its combined ratio. The expense ratio has
tended to be low in bad years (it was 25% in 2012) and high in good years (it’s been 29% for the
last 3 years). Especially considering Gainsco’s retention rate is likely very low – it’s difficult to
believe high premium growth and low combined ratios are being caused largely by increasing
premiums on existing policyholders. It’s more likely the improvement in Gainsco’s combined
ratio has something to do with the losses it has been experiencing.
So, let’s look at the loss ratio since Gainsco changed its business model. This was roughly 2004.
2004: 69%
2005: 67%
2006: 71%
2007: 82%
2008: 73%
2009: 74%
EXCLUDED
2011: 72%
2012: 78%
2013: 72%
2014: 70%
2015: 72%
2016: 70%
2017: 65%
2018: 64%
We basically have two very bad year (2007 and 2012) out of the last 15 or so years. Maybe we
are seeing a rate of 1-2 bad years out of 10. None of the last 6 years (actually, 7 – I’ve seen 2019
results for the first 9 months) could count as any sort of test of what Gainsco would look like in a
bad year.
Since this is an “initial interest post” I am really simplifying things by ignoring Gainsco’s
reserves for losses. Like any insurer, Gainsco also faces a timing issue due to ultimate losses
being determined and paid out quite a bit after the event that Gainsco is insuring actually
happens. My guess is that 60% of Gainsco’s ultimate losses are paid out in the same calendar
year as the event and about 90% within 3 years. About 10% of ultimate losses may not be
determined and paid till 4 or more years after the event. Gainsco would only be able to reprice its
policies on – I’m assuming – usually like a 6-month lag. In reality, Gainsco has policies that
renew monthly, once every 6 months, and once every 12 months. I’m just assuming 6 months is
the norm for most of its policies.
Finally, Gainsco isn’t a one-man organization. The company has a Dallas HQ and a pretty big
office in Miami too. It can’t turn on a dime. So, even if someone in the organization realizes that
something is amiss with their reserves, their premiums are too low, their expansion into a
particular state or through some agent or something is resulting in different losses than expected
– the company isn’t going to make a change instantly. So, the lags here are serious. It takes time
before anyone in the organization realizes an issue, it takes time for the organization to decide to
do something about that issue, policy pricing can’t be changed till months after the organization
wants to change them, and the company is still paying for past mistakes years after making them.
This shows up in things like the reserves by accident year tables. We can see periods where
ultimate losses were consistently higher than Gainsco originally estimated – meaning the
combined ratios I showed you were too optimistic – and we can see periods where ultimate
losses were consistently lower than Gainsco originally estimated. Often, these are not one-off
years. The insurer keeps overestimating or underestimating for a few years in a row.
Part of this can be due to competitive factors and herding. If it starts to be common in the
industry to underprice or overprice risk, two things will happen: 1) Insurers are aware of how
their competitors are pricing similar risks and may become less sure of their own judgment and
more inclined to assume the herd must know something – even if it doesn’t, and 2) Incentives to
win business and make the most underwriting profit possible mean that copying the moves of
others in the industry may help the company achieve its short-term objectives of growth and
profitability even when the herd believes differently than the organization. If competitors cut
rates when you believe rates shouldn’t be cut, there’s still an incentive to avoid losing too much
business and so to cut rates as far as you’re comfortable. Likewise, if competitors raise rates,
there’s little incentive to deeply underprice them – you might as well raise rates as far as you
think is appropriate on a relative pricing difference between you and them. In other words,
Gainsco’s combined ratio would naturally fluctuate due to actions taken by competitors even if
Gainsco does not become any more or less accurate in pricing risk. It may be that the company
has to run pretty fast to stay in place (in terms of underwriting profit) if the average competitor
shifts to a worse position in terms of profitability.
For these reasons, it’s hard to know whether the low P/E or pretty reasonable P/B ratio here
indicate the stock is really a good buy. It depends on whether the company maintains good
profitability over a full cycle.
On the other hand, it’s very easy to underestimate how great a stock Gainsco could turn out to be
if the recent past is a good indicator of its underwriting results far into the future. Given VERY
recent ROE, premium growth, etc. – Gainsco would be capable of paying a dividend of like 5%,
while growing EPS like 10%, and the P/E multiple would likely double at some point before you
sold the stock. It’s not impossible for a stock like this to return 20-25% a year for the next
decade. I know that’s hard to see by looking at this dark, illiquid, nonstandard micro-cap insurer.
But, that’s just the way the math works for a small insurer that is growing a very small market
share position while achieving high returns on equity. If an insurer like that really does have a
better mousetrap and it proves durable for a decade or more, you end up with a huge winner in
the stock market.
I haven’t discussed some of the specific issues I see with Gainsco. One, it is a dark stock. On the
other hand, it provides statutory reports – so, I can see far more detail on the exact investments it
holds, the exact lines it writes, how much it writes in each state, what losses it has been having
each year in each state, etc. than you’d ever get from a 10-K. I didn’t discuss these specifics in
here. But, I’ve read both the GAAP and statutory reports. So, I’ve seen all this stuff itemized to
an incredible extent.
But, that’s really just numbers. There’s no info from the company on their business strategy, the
people involved, how the business changes from year to year, and how sustainable anything is.
And some things have changed about Gainsco at times for reasons I don’t fully understand.
They recapitalized the business about 15 years ago. It needed to be recapitalized. And it needed a
strategy shift. It got both. It also ended up with 3 major shareholders – who all seem connected to
me – named John Goff, Bob Stallings, and Jim Reis. I can find some info on some of these
people. They’re local to the area I live in (Dallas-Fort Worth). There have been insider deals
before. Bob Stallings sold a Hyundai dealership to Gainsco. John Goff – or employees at his firm
– were originally managing Gainsco’s bond portfolio as a condition of a recapitalization. The
condition was removed eventually. Historically, it didn’t seem like the board granted themselves
a lot of shares. But, then, in the last 2 years or so – something incredible like 8% of the company
was given to directors. It’s hard to overcome a 4% a year drag on the stock returns caused by
share issuance. But, I’m not convinced the company will keep issuing much stock every year to
these big shareholders.
Finally, the financial strength of Gainsco isn’t that amazing. The company’s A.M. Best Rating is
“B+”. It had been increased from the time the company switched its approach around 2005 till
around 2012 or so. But, it has not had its rating increased meaningfully since then. An “A-“ or
something is more along the lines of what plenty of competitors of Gainsco have.
The company’s bond portfolio is higher risk than you might expect. It has very, very little in
higher quality investment grade corporate bonds. The securities portfolio is disproportionately in
shorter-term, higher risk corporate bonds. We’re talking lower end of investment grade due in
less than 5 years. Because I don’t have management discussions after they stopped filing with the
SEC – there’s no explanation for why they shifted the investment strategy. It’s very possible the
shift was simply done for 2 reasons: 1) They wanted an adequate (3%+) type yield on their
money and 2) They didn’t want to take interest rate risk, be in stuff that wouldn’t turn to cash
relatively quickly. A decade or more ago, it would’ve been possible to have a portfolio of like 3
year bonds paying decent yields with little credit risk. Now, it’s not. So, maybe they are just
taking more credit risk to avoid getting no yield at all.
The bond portfolio doesn’t deeply concern me or anything. But, it’s another cyclical issue you
need to pay attention to. If you are at a cyclical high point for returns in these kinds of bonds and
a cyclical high point in terms of underwriting profits for nonstandard auto insurers – it’d be very
easy to think you’re buying at a P/E of less than 10 when you’re really buying in at a P/E of
more than 30. All of this company’s earnings come from a combination of underwriting profit in
nonstandard auto (which is cyclical) and returns in short-term corporate bonds with some credit
risk (which is also cyclical). It’s just something to be aware of.
Without doing some scuttlebutt on this company, learning more about the people involved,
trying to figure out what changed here and why and how likely it is to stay changed – Gainsco is
probably too hard for me to come to a conclusion on.
It looks like a potentially attractive stock though.
I just don’t know if you can do enough research on this one to get comfortable.
Geoff’s Initial Interest: 50%
Geoff’s Revisit Price: $24/share (down 25%)



URL: https://focusedcompounding.com/gainsco-gans-a-dark-nonstandard-auto-insurerthats-cheap-based-on-recent-underwriting-results/
Time: 2020
Back to Sections
-----------------------------------------------------
General Electric (GE): Step Zero – Will We Ever Be Able to Value This
Thing?
I apologize in advance for the disorganized and inconclusive nature of this write-up. By this
point, I’ve read a little about GE. It’s a stock many of you have said you’d like to hear about.
And yet, I’m not sure I have anything worthwhile to say about it quite yet. This piece is the best I
can do for now.
So, this isn’t even an “initial interest” post. This isn’t step one of my analysis of GE. This is step
zero. The company is that difficult to understand, value, and analyze. I’m writing this piece
about GE now to sort of lay out what I would need to know later to be able to start analyzing this
thing.
In preparation for this piece: I read GE’s shareholder letter, 10-K, the most recent earnings call
transcript, and an investor presentation.
Of those: the shareholder letter is the easiest read. So, I recommend you read it now.
GE’s Letter to Shareholders
I’m going to walk you through the notes I took while reading this letter.
“While most of our businesses delivered solid – and in the case of Aviation and Healthcare,
world-class – performances, our cash flow was challenging.”
This is our first hint that I’m not going to be able to value this thing. As an investor, I tend to
limit myself to free cash flow generating businesses. It’s not real clear GE generates a lot of free
cash flow. And the difference between free cash flow and reported earnings in some of the
businesses GE is in – like power, aviation, and transportation – can be big. Power and aviation
are two of GE’s biggest businesses and they involve the sale (usually financed) of extremely
long-lived equipment. I’m ignorant of most of the businesses GE competes in. But, I have
researched a couple companies related to GE’s power business: the combined Babcock &
Wilcox (see the “report” section of Focused Compounding) and Aggreko. Aggreko is a stock
I’ve never written about. But, I have researched it. As part of my research into Aggreko, I
actually looked at a competitor that was renting out GE turbines as a source of temporary, mobile
power. I don’t mean to suggest these businesses are true peers. For example, the core
competency at Babcock was working with steam. GE’s power business is like 95% not steam.
But, there are some similarities. And the point I’m trying to get to here is that the cash
profitability of these customer relationships can be really uneven in terms of timing. You can
make nothing upfront and then have very high cash profits on maintenance work you do many
years later. The important figure to focus on is the lifetime value of the customer in terms of
something like a DCF. Whether GE is focusing on that or not is kind of tough to tell from the 10K. And it’s extra complicated in the case of GE, because there’s sometimes also the involvement
of GE Capital. The press reports I had read about GE made GE capital sound like some separate
business that doesn’t fit naturally into what GE does. But, actually, the financing of sales of
long-lived equipment on which GE will have long-term maintenance contracts is very
synergistic. I don’t know if it’s synergistic in a good way or a bad way though for two reasons.
One, there are some risks of bad incentives here. There’s always a temptation in a business that
gets maintenance work to underprice the original equipment. And there’s always a temptation in
a business that sells equipment to finance those sales more aggressively when it’s your
equipment being financed than if you were financing someone else’s sale. And then, finally, GE
has an excellent credit rating. So, there’s always this fear in the back of my head that GE is using
its strong corporate credit rating to have easy access to capital to finance the sales of equipment
to get long-term maintenance contracts. That sounds like a wonderful business model to me if the
company is internally being really, really honest about the lifetime value of what it’s doing
including the financing risks, its returns on capital, etc. From what I’ve seen though, GE hadn’t
really been that transparent or focused on discussing either returns on capital or free cash flow
with investors. Maybe it’s more focused on these things internally. And the CEO is definitely
saying the right things now about shifting to a focus on free cash flow. But, I’m very worried this
can be the kind of business where the incentives were not to maximize the generation of the most
free cash flow possible as soon as possible while minimizing the amount of assets that have to be
tied up to do that.
What I’ve just described is the kind of business I normally like. I want to know how much
capital is being tied up to generate how much free cash flow this year. I can tell you right now
that I can’t answer that question with GE. And I don’t just mean at the corporate level. I’m not
confident I can come up with any numbers I’d be comfortable with at the segment level when
modeling a hypothetical break-up of GE.
“The power and oil and gas markets were tough. Our metrics were too focused on EPS and
operating profits and not enough on cash.”
What the CEO is saying here is exactly what I saw when I read the investor presentation. I was
really surprised at how poor GE’s cash conversion was at the business unit level. These are big
businesses. And there are public peers I can compare them to. So, there were certain cash
conversion numbers I expected to see at specific business segments. And I didn’t see what I was
expecting. So, obviously, this pivot to a focus on free cash flow is something I like to hear. But,
it may be a discipline the market imposed on GE.
”When we talk about running our businesses better, we really mean four things – customer
outcomes, our business units as the center of gravity, running the business for cash, and driving
a new culture for the future.”
I can only talk about two of those four things. I don’t know what to make of “customer
outcomes” or “a new culture”. But, I do like to hear about running the business for cash and the
business units as the center of gravity.
“We have identified more than $20 billion of assets for potential exit and currently have more
than 20 dispositions in active discussion.”
This is the line that really gets me interested in researching GE. Maybe they will spin some
things off. If they don’t spin them off – but sell them instead – maybe what will be left of GE
will be interesting. Change and complexity are often good from a stock picker’s perspective. So,
is the market’s contempt. GE seems to be ticking all of those boxes right now. It might become a
mispriced stock. And it has at least a couple businesses with really strong market share. If run
right, there should be some value I can understand at a couple of these units. And the overall GE
might be so disliked, so quickly changing, and so complex through it all – that a lot of investors
might stay away. This could be a messy overall corporate situation with some gems in there.
That’s often the best kind of stock to look for.
“We are narrowing our focus to three key industries where our impact is greatest: aviation,
health, and energy”.
When we combine that quote with the business units GE says it’s in now (further on in the
shareholder letter): “aviation, healthcare, renewable energy, transportation, oil & gas, lighting,
capital, and power” – that suggests transportation and lighting will be disposed of definitely and
the company might exit some other stuff too. I don’t have enough detail on GE’s lighting
business to know if it would be interesting.
“Capital enabled $14.4 billion of industrial orders…”
This relates to my point about the interdependence of GE Capital – which is shown as a financial
business – and aviation, power, and transportation (which are shown as industrial businesses). If
you’re financing industrial orders – that’s really an activity of the industrial group not just a
separate finance business.
“….we are planning to reduce energy capacity by 30% or more…we are actually working to
double our current inventory-turn performance…starting with a $1 billion inventory
reduction…”
Power is potentially an interesting part of GE. You’ll remember I did a little write-up on
Babcock & Wilcox Enterprises (BW) and how hard a time it’s having as a power business. This
is the part of GE that could most lead to a mispricing of the stock. I’d be very excited if this
business was ever spun-off. But, I’m not sure it’d be easy for GE to break-up something like
Power from something like Capital and especially do it in a way where it was well-financed
standing on its own. GE has a big installed base in power. In fact, they might be a little too
aggressive on pricing to maintain market share. GE mentions market share a lot in this business.
For example, it says it maintained 50% market share in heavy duty turbines despite pressure on
margins and prices. The problem with that is, of course, that if you’re 50% of the market the
reason prices are bad is in large part you. Of course, there’s no denying that a big installed base
is a nice economic engine for the years ahead. And this is something that could be undervalued
by investors – especially if there are both cyclical and long-term societal trends going on at the
same time. Investors have a hard time telling one from the other. More than that: this industry
isn’t expected to turn around anytime soon. GE’s hopes for the power industry getting better start
around 2019 or so I think – so this is the kind of business unit investors might just give up on if it
performs badly for that long. So, it’s a big part of GE that investors might not assign much value
to.
“We are focusing on simpler reporting metrics like revenue, operating profit, and free cash flow.
Compensation for our senior executives now includes a higher mix of equity, and our annual
bonus program will be more closely tied to each business’ performance. These changes are
designed to motivate our teams and lead to focus on execution and cash.”
It’s hard to judge how effective this will be. What you monitor and what you reward are very
important in driving behavior. GE really neither monitored nor rewarded free cash flow
generation. So, this is obviously a good sign. But, I’ve seen companies say a lot of things about
compensation changes and then they weren’t really as extreme or as focused as the kind of
incentives I’d put in place if it was up to me.
“The reality, though, is that most of the company’s capital is already allocated before getting to
these kinds of topics.”
This is my big concern with GE. I’ve seen a lot of people on Twitter, blogs, etc. talk about GE’s
share repurchases or acquisitions as being the problem. But, whether or not GE gets good returns
on capital – and whether or not shareholders get a good return in this stock – is decided at least
as much at the business unit level. It’s issues like how slow inventory and receivables turn.
That’s all I have to say about the shareholder letter. Overall, I was impressed. It was far better
than I ever expected and focused in pretty plain English on some of the topics I’d be focused on
as an investor. There was a lot of talk about cash, some talk on incentives, some talk of
transparency, and some talk of slimming down and focusing on the businesses where GE is best
positioned. I can’t imagine a letter getting me even 10% of the way to investing in some stock.
But, if I had to grade this thing it’d definitely get an “A”.
Now, on to the 10-K. The CEO letter is a quick and easy read. The 10-K is not. I don’t expect
most of you to tackle it. So, I’ll be brief.
First, I will point out two things. One, GE’s business is very broad. It’s diverse. So, you get lines
like this one:
“The mortgage portfolio in Poland comprises floating rate residential mortgages, of which
approximately 85% are denominated in Swiss Francs…”
That puts a lot of people off. You sit down expecting to read about a company that makes jet
engines, gas turbines, and CT scanners, and suddenly you’re reading about Polish mortgages
denominated in Swiss Francs. It’s a discontinued operation (as is a lot of what you read about in
this 10-K). But, it’s the kind of thing that will get some investors to put this 10-K down.
And, then, GE’s 10-K is not just broad – it’s also complex. It’s not what I’d call transparent. And
I think this passage is a good illustration of that:
“Cash used for contract assets was $4.0 billion in 2017 compared with $3.9 billion in 2016.
Cash used for contract assets in 2017 was primarily due to cumulative catch up adjustments
driven by lower forecasted cost to complete the contracts as well as increased forecasted
revenue on our long-term service agreements and the timing of revenue recognized relative to
the timing of billings and collections on both our long-term service agreements and long-term
equipment contracts.”
I don’t have much to say about items that are specifically found in the 10-K but which I hadn’t
seen discussed much in the shareholder letter, an investor presentation, an earnings call, etc.
Really, the only thing I’d like to single out is the relationship between GE’s financial and
industrial activities.
Quote #1
“In order to manage short-term liquidity and credit exposure, GE sells current receivables to
GE Capital and other third parties in part to fund the growth of our industrial businesses.”
Quote #2
“In certain circumstances, GE provides customers primarily within our Power, Renewable
Energy and Aviation businesses with extended payment terms for the purchase of new equipment,
purchases of significant upgrades and for fixed billings within our long-term service contracts.
Similar to current receivables, GE may sell these long-term receivables to GE Capital to manage
short-term liquidity and fund growth.”
Quote #3
“Enabled orders represent the act of introducing, elevating and influencing customers and
prospects that result in industrial sales, potentially coupled with captive financing or
incremental products or services. During the years ended December 31, 2017and 2016, GE
Capital enabled $14.4 billion and $13.4 billion of GE industrial orders,
respectively. 2017 orders are primarily with our Power ($5.9 billion), Renewable Energy
($4.6 billion), Healthcare ($1.9 billion) and Oil & Gas ($0.7 billion) businesses. Most of these
enabled orders were financed by third-parties including export credit agencies and financial
institutions.”
Quote #4
“During the years ended December 31, 2017 and 2016, GE Capital acquired 50 aircraft (list
price totaling $6.6 billion) and 44 aircraft (list price totaling $6.5 billion), respectively, from
third parties that will be leased to others, which are powered by engines that were manufactured
by GE Aviation and affiliates.”
So, I’ve taken you as far as I can go for now. I can’t assign GE an interest level yet. I can’t
imagine buying the stock now. However, I know I will definitely follow-up with this company. If
I had to value GE, I’d use a sum of the parts analysis. So, let’s consider what parts contributed
the most profit over the last 5 years.
If we sort GE’s business units by their cumulative contribution to industrial profit over the last 5
years, the order is: #1) Aviation (33%), #2) Power (26%), #3) Healthcare (18%), #4) Oil & Gas
(11%), #5) Transportation (6%), #6) Renewables (3%), and #7) Lighting (2%).
As value investors, we insist on a margin of safety before buying a stock. So, there’s a little
shortcut built into how we can analyze GE. We only need to know if GE is cheap enough to
promise a big enough margin of safety. While there’s some chance that Healthcare, Oil & Gas,
Transportation, Renewables, and Lighting could be worth far more than we’d imagine – that’s
not a big concern for us. The big concern for us is that Aviation, Power, and Healthcare aren’t
worth enough to give us a margin of safety.
If you look at profit contribution, Aviation plus Power plus Healthcare is 77% of GE. And just
Aviation plus Power is 59% of GE.
So, if we do a sum of the parts analysis – all we need to know is whether those 3 business units
together are worth more than what the market values all of GE at. Now, there’s the risk of some
negative value being attached to GE Capital and there’s the pension issue and all that. But, we
don’t need to start with that.
The simplest way to start is to ask two questions.
One: How much is Aviation plus Power worth compared to GE’s market cap?
Two: How much is Aviation plus Power plus Healthcare worth compared to GE’s market cap?
I don’t like to buy a stock unless I feel I have at least a 35% margin of safety (that is, I’m buying
a dollar for 65 cents). Based on the past 5 years, Aviation plus Power has been 59% of GE. So,
the obvious time to buy GE would be when the sum of my individual appraisal values for
Aviation plus Power is greater than the company’s market cap. In that moment, my margin of
safety would be the combined value of healthcare, oil & gas, transportation, renewables, and
lighting. All of that stuff taken together would then have to make up for any negative value that
GE Capital would have as well as GE’s pension problems.
So, that would be my next step in analyzing GE. I’d limit myself to first considering only
Aviation and Power. What are each of those business units worth? Only after I had appraisal
values for each of those businesses would I sum them up and compare that sum to GE’s market
cap.
Right now, if you take the best operating profit years for each of those business segments –
Aviation and Power – and slap an EBIT multiple of 12 on those peak years (basically, an aftertax P/E of 16) you would actually get a total slightly above GE’s market cap. Of course, on the
Power side that’s incredibly aggressive as we know the near term future will be much, much
worse than the best year for that unit.
But, there is a hint in the numbers that GE might already be trading within spitting distance of its
sum of the parts value. In today’s market, it’s pretty rare to find any company that is trading near
where I’d expect private buyers – in a normal market environment – to bid for each part of the
company if it was auctioned off.
Here, we see the possibility that GE’s not expensive right now. So, it’s definitely a stock I’ll
follow up on. But, I’m not at all confident I’ll be able to understand this stock well enough to
buy it.



URL: https://focusedcompounding.com/general-electric-ge-step-zero-will-we-ever-beable-to-value-this-thing/
Time: 2018
Back to Sections
-----------------------------------------------------
Gamehost: Operator of 3 “Local Monopoly” Type Casinos in Alberta, Canada
– Spending the Minimum on Cap-Ex and Paying the Maximum in Dividends
Today’s initial interest write-up is a lot like yesterday’s. Yesterday, I wrote about an Alberta
based company paying out roughly 100% of its free cash flow as dividends. In fact, that
company was paying almost nothing in cap-ex. Today’s company is doing the same. It pays
almost everything out in dividends. And it doesn’t spend much on cap-ex. So, cash flow from
operations translates pretty cleanly into dividends. And like yesterday’s stock being written up
(Vitreous Glass) – today’s stock being written-up (Gamehost) probably attracts a lot of investors
with its high dividend yield. As I write this, Gamehost’s dividend yield is a bit over 8%. Like the
dividend yield on Vitreous Glass – that sounds high. But, you need to be careful. If a stock is
paying almost all of its free cash flow – and, in fact, almost all of its cash flow from operations in
this case – out as a dividend, then you might need a much higher dividend yield than you’d think.
There are three reasons for this. One, if the company pays everything out in dividends then it’s
obviously not paying down debt or buying back stock or piling up cash. So, the free cash flow
yield is no higher than the dividend yield. A dividend yield of 8% sounds amazing. But, a stock
trading at 12.5 times free cash flow (for an 8% free cash flow yield) isn’t unheard of. It’s still
cheap. But, you need to do some research to make sure there aren’t good reasons for it being that
cheap. Two, the dividend coverage ratio is obviously 1 to 1 on a stock that has a dividend payout
ratio of roughly 100%. A stock paying out just one-third of its earnings as dividends can see its
earnings drop by 65% and still cover the dividend from that year’s earnings. Any decrease in the
earnings of a stock with a 100% payout ratio would threaten the dividend. Three, it’s usually
hard for a company to grow it sales, earnings, free cash flow, etc. over time if it retains literally
no earnings in any period. For some companies, it’s not impossible. But, for a stock like
Gamehost – which does have a fair amount of tangible assets – it’s impossible to organically
grow those things aside from just capacity utilization increases. Luckily, Gamehost’s properties
are currently operating far below capacity. When I describe what these properties are and – most
importantly – WHERE they are, you’ll see why.
Gamehost’s EBITDA and other measures of earning power peaked about 5 years ago. The
company operates both hotels and casinos in Alberta. It also provides food and beverage services
in those hotels and casinos. The company claims to have 3 segments – casinos, hotels, and food
and beverage. It also owns a strip mall. However, the only real source of profit we’ll be talking
about here is the first segment: casinos. The other segments don’t lose money. They make a
slight profit. And they do deliver some returns on an EBITDA basis. However, the primary
economic purpose of the hotels is to provide a captive source of traffic for the casinos. The food
and beverage business is more of a necessary evil than a profit source. For the most part,
Gamehost does not even provide the food service itself. Gamehost outsources the preparation of
food and keeps the liquor business. The liquor business at hotels and casinos is a higher margin
business than actual food anyway. Actual gaming revenue is a very high margin source of profit.
If you look at what segments use what assets and what segments produce what EBITDA at
Gamehost – I think it’s easier just to discard everything other than gaming and treat them as
somewhat better than break-even businesses that support the core profits from gaming.
Gamehost operates 3 casinos. All are in the Canadian province of Alberta. One is the Boomtown
Casino in Fort McMurray. Another is the Great Northern Casino in Grand Prairie. The third is
the Deerfoot Casino in Calgary. Gamehost only owns 91% of the Deerfoot casino. It owns 100%
of the Boomtown and Great Northern casinos. The size and competitive positions of these
casinos is a little different too. Calgary is a big city. The Deerfoot casino is not a destination
casino like you might see in Las Vegas, Macau, etc. We’re not even talking what you’d see in
Atlantic City. However, the descriptions of that casino’s property, the reviews I read, etc. suggest
that if any of these casinos are in a more competitive market, if any of them are better upkept,
etc. it’d be the Deerfoot in Calgary. The other two casinos are local to the point of being
monopolies. Calgary is a city of 1.3 million people. With the exception of the Great Depression,
the city has seen pretty much constant growth for the last 120 years. It’s a stable, growing major
city. It has a diversified economy. Meanwhile, Fort McMurray has a population of just 65,000
people. The city’s population growth has historically been very, very uneven. It goes through a
boom and bust cycle of bringing in outsiders and then losing population to the outside world.
Almost no one lived there 70 years ago. The population surged throughout much of the last half
century or so. However, it showed at least two major population declines. These look to me as if
they coincide with the two major oil price collapses of the last few decades. The city’s economy
is not diversified like Calgary, It’s dependent on oil sands, pipelines, etc. It is more cyclical. It
also has far fewer gambling venues. In fact, Gamehost’s SEDAR (like EDGAR, but for
Canadian companies instead of U.S. companies) filing specifically says both that “Boomtown
Casino in Fort McMurray operates without any gaming-related competition in the trading area”
and that “gaming demand is well served by the company’s current capacity.” Reading between
the lines, Gamehost is telling us: 1) Boomtown casino is a monopoly and 2) The Boomtown
casino has excess capacity. This makes sense if I divide certain population figures of the number
of people who could realistically visit the Boomtown casino and compare them to the number of
casinos in Fort McMurray (one), the number of slots, table games, square footage of the venue,
etc. This is a local casino that can handle all the demand in town.
The Great Northern is in Grande Prairie. Gamehost says this about competition there: “The Great
Northern Casino is Grand Prairie is the only full-service casino in the city.” This means there is
some other kind of gaming choice in the city. I don’t know what it is. The population of Grand
Prairie is about the same (63,000) as the population of Fort McMurray. I don’t know enough
about Grand Prairie to know if it is as dependent on oil as Fort McMurray. However, I can see
that the major industries in both cities are much the same (oil, forestry, tourism, etc.). They are
also both likely to be the kind of places where a casino would serve the local population well and
operate as a monopoly.
Reviews of the Great Northern casino in Grand Prairie and the Boomtown casino in Fort
McMurray are consistent with what I expected after reading about those cities, looking at the
financial statements of Gamehost, etc. These seem to be local monopolies that do not spend on
cap-ex. Reviews are very middle of the road. And complaints are about a lack of capital spending
to keep the casinos looking up to date, poor food service (which is outsourced and not a profit
center) as compared to liquor sales (which aren’t outsourced and do contribute to profits), etc.
I’ve read reviews of small casinos that operate as local monopolies in various smaller and more
remote U.S. cities – and the reviews I see of Gamehost’s casinos look very, very similar to
reviews of those kind of establishments. I suspect that – since oil prices declined years ago –
these casinos do operate at well below capacity, they don’t spend as much on cap-ex as larger
casinos in more competitive markets would, and they put a very low priority on food. Reviews
also indicate that guests of the hotels do frequent the casinos. This would be consistent with
synergies between owning the hotels and casinos being mainly about providing a consistent
traffic source to the casinos rather than capturing additional revenue from people who’d be
staying in the area to visit the casinos anyway. In other words, this is probably a reverse “Disney
World” situation here. Disney added more hotel capacity within its parks after decades where it
would attract people to the area from all around the world and then lose out on most of the hotel
revenue to companies that built hotels just outside the park. Here, it seems much more likely that
people would be staying in Fort McMurray and Grand Prairie regardless of whether or not the
casinos were there. But, putting hotels and casinos next to each other (or literally together in one
place) increases the revenue the company can capture versus what an operator of just a hotel
would make. Again, I don’t think these casinos are destinations people seek out. I think they are
local gambling monopolies.
This brings us to regulation. I’m obviously not knowledgeable about this situation. I’m an
American. I don’t know Canadian politics generally or Alberta politics specifically. I can only go
on what Gamehost itself says. There are a couple hopeful bits of information the company gives
here. There’s also two risks. The two risks are much the same risks faced by U.S. casinos. One,
there are sometimes more favorable terms given to First Nations (descendants of people who
lived in Canada prior to the arrival of Europeans). Two, governments can unilaterally set the
revenue share for gambling. In theory, this means governments can simply raise more revenue by
lowering the amount existing casinos get to keep and increasing the amount that goes to the
government. Since existing casinos are very profitable on a cash return on incremental tangible
investment basis – this kind of move would be unlikely to reduce total gambling much. Yes, it
would reduce the likelihood of for-profit companies wanting to build totally new locations. But,
once the location exists – it’d be in the government’s interest to shift more and more of the
profits from gambling away from casino operators and towards governments. This is a risk. But,
it’s a similar risk to the U.S. Canada is not generally a country that worries me in terms of
legislative risk of governments shifting profits like this. It can happen. But, the reverse can
happen too. It’s like the risk – more generally – of a country greatly increasing corporate tax
rates. It’s just something we investors have to live with.
I’m not sure either of these risks are big right now. If one is big – it’d probably be the risk that a
government trying to balance its budget in hard economic times might try to raise more money
through shifting agreements on gambling to favor the government more. The First Nations risk
does not seem big here, because this hasn’t been a growing market for a long time.
Gamehost says that Alberta has not granted any additional gambling licenses since 2008. It also
says that Alberta has not revoked the license of an existing operator. Once granted, the license
has stayed in place. If both of these things were to stay true in the future – Alberta never again
issues another license for a casino and it never revokes the license of an existing casino operator
– this would be a very, very good form of regulatory protection. It’d be similar to the history of
local TV station licenses in the U.S. While those are theoretically risky because they have to be
renewed, there are some requirements on the station owner, the government could theoretically
grant a lot more licenses etc. – in reality, they act as a high barrier to entry that helps create
monopolies, duopolies, and oligopolies and keeps returns for anyone granted a license higher
than they would be in an unregulated market. So, I don’t want to ignore regulatory risk here. But,
the truth is that a regulated local casino monopoly is probably one of the safer kinds of business
out there in terms of avoiding competition.
I can’t evaluate the competitive situation of the Calgary casino (Deerfoot) as well as the casinos
in Fort McMurray and Grand Prairie. The company claims that the casinos in Calgary are far
enough away from each other so that there is limited true competition between them. However,
the distances given between the casinos seems close enough to me to suggest the Calgary casino
market could be a lot more competitive than the markets in Fort McMurray and Grand Prairie.
All the write-ups of this stock focus on the cyclicality of the economy of Alberta generally and
oil sands specifically. I can’t bet one way or the other on that. Obviously, I’d rather – other
things equal – buy a stock with an 8% free cash flow yield in a bad economic year than one with
an 8% free cash flow yield in a good economic year.
Return on tangible capital here is quite good. It looks to me like recent free cash flow can get as
high as 25% of the tangible capital invested in the business. This probably overstates returns on
these casinos over their entire lifetimes. However, a shareholder buying into the stock today is
not responsible for building the casinos in the first place. If you buy a toll bridge a decade after
it’s built, the original cost of the toll bridge doesn’t matter. It’s just the very low future cap-ex
and the rate at which you can raise tolls that matters. The situation is the same here. And, in fact,
if there is any increase in the traffic to these casinos due to an improving economy – this would
be a very high return form of growth. Management does mention asking for approval to make
some changes to these casinos to update them, expand them (it doesn’t sound like much of an
expansion), etc. So, cap-ex could certainly be higher in the future than in the past. But, even
growth driven by cap-ex would probably be pretty high return. The risky and expensive part is
planning, getting approval, opening, and marketing the casino to the local population initially.
Once a casino is long-established, my main concern would just be what’s the chance another
casino is opened nearby. Here, the chance of that happening seems lower than at most casinos.
Debt here isn’t very high. But, it’s not nothing. Compared to “peers” – and I’m not sure there
really are many peers with as few, as local, as old, as remote, etc. casinos as this company
operates – the stock looks cheap. It might be attractive to a private buyer. It definitely seems
much, much safer than most casino stocks I’ve looked at. Risk of new competition seems lower.
Risk the area is presently in a boom seems to be completely nil. And risk of debt is extremely
minimal compared to the debt loads carried by most casino operators. The stock’s price seems
very reasonable versus other casino operators. If I had to buy a casino operator, I’d definitely
consider Gamehost.
But, without betting on a recovery in the Alberta economy – I’m not sure it’s cheap enough to
guarantee market beating returns. You might not really do much better than just collecting the
8% or so dividend yield. Multiple expansion from say 12 times to 15 times earnings (free cash
flow, etc.) might provide another 2% a year in returns over as long as 10 years. If growth due to
a recovery in the local economy could provide let’s say 2-5% type annual returns over as long as
10 years, this would make a good long-term investment. The company could also increase its
debt load if it did ever want to acquire anything.
Management’s incentives are generally good. Two people – Darcy and David Will (I assume
they are son and father) – own a lot of stock. There are related party transactions. For example,
“the Wills” are entitled to sort of management fee type deals that give them additional revenue /
profit share off the top at some casinos. Even these incentives mostly align with what would
benefit shareholders too. It’s just an additional way of extracting more value for management.
But, I didn’t see examples of stuff where management would make a lot of money without at
least indirectly causing minority shareholders also to do well. I don’t really have an opinion one
way or the other about most of what I read about management’s ownership stake, incentives, side
deals, etc. I’d definitely consider this a controlled company. It’s pretty much founder led. I’ve
seen casino stocks run by professional managers who owned a lot less stock and extracted at
least as much value as this. So, nothing in the little bit I’ve read so far seems egregious. But, my
initial attitude on management is just neutral – not necessarily positive.
I’d be a lot more interested in Gamehost stock if it was about 30% cheaper (for a free cash flow
yield of closer to 12% than 8%), or if I was very sure of an eventual recovery in the economies
of cities that depend on the oil industry.
Right now, I don’t think I like Gamehost as much as I like Vitreous Glass. But, I do think I like it
more than a lot of casino stocks I’ve seen.
Geoff’s Initial Interest: 60%



URL: https://focusedcompounding.com/gamehost-operator-of-3-local-monopoly-typecasinos-in-alberta-canada-spending-the-minimum-on-cap-ex-and-paying-the-maximumin-dividends/
Time: 2019
Back to Sections
-----------------------------------------------------
Green Brick Partners (GRBK): A Cheap, Complicated Homebuilder Focused
on Dallas and Atlanta
I chose to write-up Green Brick Partners (GRBK) this week for a couple reasons. The first is
the company’s headquarters: Plano, Texas. I live in Plano. And the company gets about half of
its value from its Dallas-Fort Worth homebuilding operations. My “initial interest post” checklist
goes something like this:




Do I understand the business?
Is it safe?
Is it good?
Is it cheap?
The single most important questions is number zero: “Do I understand the business?” Since I’ve
lived for about seven years right by this company’s lots – I should understand it better than most
homebuilders. The other half of the company, however, is in the Atlanta area. That is a place I
know nothing about. So, the answer to question zero would be that I understand half the business
here well.
The next easiest question to answer – after “do I understand the business?” – would be #3 “is it
cheap?”.
So, we’ll skip right to that one. It is, after all, the other reason that put Green Brick Partners at
the top of my research pipeline.
I have in front of me the balance sheet for Green Brick Partners dated September 30th, 2018. This
is the last day of the most recent quarter the company has provided results for. Under
“inventory” we see $648 million. Under “cash” we have $33 million. There’s another $12
million under “restricted cash”. The unrestricted part of cash is offset almost exactly with
customer deposits. The restricted part of cash is just $12 million. Debt is about $200 million
gross. So, that leaves about $188 million in net debt. If we netted out that inventory less that net
debt we’d be left with $648 million in inventory less $188 million in net debt equals $460
million. The company has a little less than 51 million shares outstanding. So, $460 million in real
estate free from debt divided by 51 million shares outstanding equals $9.02 a share. Let’s call
that $9 a share. That’s very close to the company’s officially stated net tangible book value of
$8.97 a share. Again, that’s basically $9 a share. We can compare this to the market price of
$8.06 a share at which GRBK stock closed today. So, we have a stock with tangible book value –
almost all land (about 50% in Dallas Fort-Worth and about 50% in the Atlanta area) – of $9 a
share against a market price of $8 a share. Green Brick Partners is trading at about 90% of book
value. So, a price-to-tangible-book ratio of 0.9 looks cheap.
However, this is where we start getting into the more complex aspects of Green Brick Partners.
The company’s balance sheet shows only $15 million (about 29 cents a share) in
“noncontrolling” interests. Green Brick, however, has only a 50% economic interest in its Dallas
Fort-Worth and Atlanta homebuilders. The fair market value of the 50% owned by its partners –
basically, the top management of these “controlled builders” – would be far more than $15
million. We know this because on the income statement we can see that the 50% of these
homebuilders that Green Brick doesn’t own will probably report after-tax earnings of between
$10 and $12 million for fiscal 2018. If we put a 15 times P/E on that half of those builders Green
Brick Partners doesn’t own – the “noncontrolling interests” would be carried on the balance
sheet at more like $150 million to $180 million than $15 million. That’s a big difference (it’s
over $3 per share). So, does Green Brick Partners common stock have a tangible book value of
more like $9 a share or $6 a share? This makes a big difference when the stock trades at $8 a
share.
To answer this question, we’ll need to talk about Green Brick Partners’ accounting. And, to do
that, we’ll need to talk about the way the company is set up. Let’s start with the owners.
As of the company’s proxy statement for the 2018 annual meeting, Green Brick Partners had 3
important owners: 1) Greenlight Capital, an investment company controlled by David Einhorn
(the company’s chairman) owned 48% of the company, 2) Third Point Funds (which are Dan
Loeb controlled funds) owned 16% of the company, and 3) Jim Brickman, Green Brick Partners
founder and CEO, owned 4% of the company. During 2018, Third Point sold its shares of Green
Brick Partners in a public offering.
How did Third Point get those shares?
This brings me to the other reason I’m doing an initial interest post on Green Brick Partners this
week. I run an “overlooked stocks” portfolio for the accounts Andrew and I manage for Focused
Compounding Capital Management. To count as “overlooked” a stock must meet at least one of
several criteria. One of the boxes it can check is a “reverse merger”. Another box it can check is
a micro-cap. Green Brick Partners is not quite a micro-cap stock (the company has a market
capitalization of just under $400 million; though insiders – including Einhorn’s Greenlight
Capital – eat up about $200 million of that market cap). But, it is a reverse merger.
Green Brick Partners was formed out of a former publicly traded ethanol company. That
company sold its ethanol operations and became a public shell. Green Brick Partners was then
merged into that public shell. This is how both Third Point and Greenlight ended up getting
involved with Green Brick. First, there was a loan – from Greenlight – to finance the purchase of
the homebuilding business. And then Greenlight and Third Point bought shares in Green Brick
Partners to raise the cash used to eliminate that debt. Later – in 2018 – Third Point sold its shares
to the public. From the time Green Brick announced Third Point’s intention to sell its stock till
today, the stock’s price declined from more than $12 a share to less than $8 a share.
So, is this an “overlooked stock”? The reverse merger was 3 plus years ago. The stock is not a
micro-cap stock (it’s around $400 million) but it is a mico-float stock (the float is less than $200
million). Did the company have an IPO? The closest thing to an IPO was Third Point’s sale of
about $100 million (originally) worth of stock to the public. That “IPO” (really, a secondary
offering – but, in this case, the first time shares were being widely sold to the public all at once)
may have helped depress the stock’s price. This is debateable. The initial announcement
certainly did cause the stock price to plummet (it dropped like 25% in a single day). But, the
longer term decline in the company’s stock price over the past 6 months or more may be due as
much to a something like 10% decline in the overall stock market coupled with industry specific
(the homebuilding industry, that is) concerns about rising interest rates. Overall, Green Brick has
some of the features that may make a stock count as “overlooked” or just plain disliked. So, early
2019 might be a good time to check it out.
What, then, is Green Brick Partners really? What do you – as a buyer of GRBK shares – get for
your money?
The value in Green Brick Partners comes from its controlling stake in captive homebuilders in
the Dallas Fort-Worth and Atlanta markets. Green Brick has some other assets: a 100% owned
homebuilder (in the start-up stages) in DFW, an 80% owned homebuilder in Florida, a noncontrolled (and thus unconsolidated) 49% owned homebuilder in Colorado, and a mortgage
business. However, none of these other holdings contribute meaningfully to the value of the
company. A couple of these other assets may contribute meaningfully starting in 2019 or 2020.
But, for now, we will discuss only one type of arrangement in one type of asset. We’re talking
about the half-ownership / full control arrangements Green Brick has with homebuilders in
Dallas Fort-Worth and Atlanta.
Here is how this arrangement works:




Green Brick has a 50% economic interest in the homebuilder
Green Brick has 51% of the voting rights in the homebuilder
Green Brick appoints 2/3 of the board of the homebuilder
Liabilities of the homebuilder are non-recourse to Green Brick
As I mentioned earlier, this complicates the accounting for Green Brick. It also changes the
economics a bit too. Green Brick is more of a land developer and less of a homebuilder – though
it’s important not to overstate this distinction – than you might think.
Why?
Green Brick – the corporate parent you are buying shares in when you purchase GRBK stock –
has a 100% interest in the capital related activities of providing land and financing to controlled
homebuilders. However, Green Brick only has a 50% economic interest in the actual
homebuilding activities of these builders.
Technically, to make money: Green Brick can either transfer its land from the parent to a 50%
owned homebuilding subsidiary or it can sell the land to an unrelated party (usually to a
homebuilder in Dallas or Atlanta that it has no stake in). In practice, Green Brick almost always
transfers the land to a 50% owned homebuilding subsidiary.
Most of Green Brick’s land inventory is not finished homes. If you look at a breakdown of Green
Brick’s inventory it is about 50% held in the “land development” division and about 75% of the
company’s inventory is classified as either “land held for development” or “work in process”.
Only 25% of the inventory – by dollar volume – consists of finished lots held for sale to
customers. Furthermore, we need to consider the distinction between the accounting presentation
and the economic reality here. The inventory shown as lots held for sale are only really 50%
owned by Green Brick. However, the land held for development starts out as 100% owned by
Green Brick. For accounting purposes, Green Brick consolidates the accounts of its 50% owned
subsidiaries. This means that if you see a 50/50 break down between land held by the “land
development” division and land held by a homebuilding subsidiary – the land division assets are
100% owned by you (the GRBK shareholder) but the homebuilding land is only 50% owned by
you. This land is, of course, ultimately going to be the exact same land. At an early stage it is
100% owned by you and then at a later stage – probably anywhere from 2-6 years down the road
– it is only 50% owned by you (and 50% owned by the managers of the homebuilding
subsidiary).
So, let’s look at Green Brick’s inventory again. As of last quarter, the company has about $650
million in land on its books. This land is carried at cost unless marked down for impairments.
Green Brick hasn’t really marked anything down in the last 4 years or so (the markets Green
Brick builds homes in have been rising in price for about 7 straight years or so). The cost shown
is not just the price Green Brick paid for the land. Green Brick capitalizes its interest and adds
this to the cost of the land it holds. Development costs are also added to the land. This can
include all sorts of costs related to getting permission to develop the land and things like that.
Nonetheless, you would expect that – at least as of today – the $650 million at which the land is
held on Green Brick’s books is an understatement of the fair market value of the land.
Why?
Well, for one, Green Brick hasn’t written down land recently. If the value of the land declined
below the cost on the books – Green Brick would have some impairments. Two, Green Brick
consolidates its 50% owned homebuilders that eventually build on these lots and receive cash
from customers. The homebuilding subsidiaries have recently had the following margins: 2223% gross margins, 12-13% operating margins, and (adjusted for certain one-time tax law
changes and use of net operating loss carryforwards) 9-10% after-tax margins. In other words,
these homebuilders have recently been selling the land for about 30% more than their cost
(0.3/1.3 = 23% gross margin). So, on a fully consolidated basis, Green Brick’s inventory is
eventually monetized at about 1.3 times its book value.
The inventory is – again, we’re talking the consolidated accounting treatment here – split almost
exactly evenly between land held by the land development division (which is 100% owned by
GRBK shareholders) and land held by the homebuilding subsidiaries (which is only 50% owned
by GRBK shareholders).
Let’s think of it this way. Green Brick shows $650 million in land inventory on its books. In
reality, this land might be worth something like $850 million ($650 * 1.3 = $845 million). That
means the company might consolidate about $650 million in land at cost and about $850 million
in land at its likely fair market value. However, this accounting consolidation doesn’t match the
economic reality. The economic reality – for a GRBK shareholder – is that you own 50% of
$325 million of land at cost (and 50% of $425 million of land at its likely fair market value) and
then 100% of the other $325 million of land at cost (and 100% of the $425 million of land at its
likely fair market value).
So, $325 million times 0.5 equals $163 million. And $163 million plus $325 million equals $488
million. That’s at cost.
At our admittedly arbitrary valuation of about 1.3 times cost – the fair market value calculation
would then be $325 million times 1.3 equals $423 million times 0.5 equals $211 million. And
then $211 million plus $325 million times 1.3 ($423 million) equals $634 million.
That is, however, the gross value of the inventory. It doesn’t take into account the company’s
debt. GRBK borrows about $200 million and has about $45 million in cash. Much of the cash is
offset with customer deposits. However, it’s probably best to think of these customer deposits as
being secured by homes soon to be delivered rather than by the company’s cash. This is because
80-85% of the orders for homes will not be cancelled. So, even if every order that is cancelled
results in the customer getting back 100% of their deposit (which seems unlikely), over 80% of
the deposits will be kept and a home delivered to satisfy the obligation caused by taking the
deposit.
For this reason, I’m going to treat the company’s net financial debt as being just $155 million
($200 million in debt less $45 million in cash). I don’t see customer deposits as a financial
liability. It’s really just a reduction in the amount of net assets that have to be tied up in
homebuilding operations.
Okay. So, we have $155 million in net debt. And we – as shareholders of GRBK – have a “look
through” interest in about $488 million in land at cost and about $634 million in fair market
value of the land. We can subtract the net debt from the “look through” land. So, at cost, that
would be $488 million less $155 million equals $333 million. We then divide $333 million by 51
million shares outstanding to get $6.53 a share in “book value”. I think – restated for the 100%
ownership at the land development level and 50% ownership at the homebuilding level – this
roughly $6.50 is an accurate enough estimate of the economic (as opposed to accounting) net
tangible assets of GRBK. This stock really has a tangible book value of $6.50 a share.
That’s at cost. What’s the likely fair market value of these assets? That would be $634 million of
land minus $155 million of net debt equals $479 million. Then we divide $479 million by 51
million shares outstanding. We get $9.39 a share. That’s a decent estimate of the fair market
value of what a GRBK shareholder really owns.
The stock closed today at $8.06 a share. So, GRBK is probably trading at about 1.23 times
tangible book value ($8.06/$6.53) and about 0.86 times appraisal value ($8.06/$9.39).
Is it possible that I have overstated or understated the fair market value – the $9.39 “appraisal
value” – of the stock here by a meaningful amount?
Yeah. It’s possible. The issue here is really in the land development division. This is the 100%
owned business. The homebuilding division is less of a concern for a few reasons. One, it only
takes about 5 months to 9 months to build a house. Two, the land being sold has been transferred
by GRBK from the land development division to the homebuilding subsidiary to generate a
targeted rate of return at the parent company level. Three, we can see from an accounting
breakdown of net income attributable to non-controlling interests that the homebuilding division
creates less income than the land development division. For example, over the last 9 months,
GRBK reported $52 million in operating profit and yet only $9 million in net income attributable
to the non-controlling interests. This means the non-controlling interest account for about 20% of
normalized after-tax profit (here, I’ve normalized the tax rate as if it was 21%). If the land
development division and the homebuilding division produced exactly equal profits, the noncontrolling interest should be 25% of normalized after-tax profit (because that’s 50% of 50%).
Since the non-controlling interest is 20% of after-tax profits, this suggests that land development
is more like 60% of GRBK’s profits and homebuilding is more like 40%. But, this could easily
be the result of cyclicality. In an up market, GRBK may make more money from land
development and in a down market it might make more from homebuilding. I just don’t know.
There’s also evidence from the returns that GRBK targets and some information I have about the
rate of land price appreciation in Dallas and Atlanta and the length of time between when GRBK
contracts to option land and when that land is finally developed enough to be transferred to the
homebuilding division that suggests to me that the inventory in the land development division
(which is 100% owned by GRBK) is carried at a lower value relative to its likely fair market
value than the land that has already been transferred to the homebuilding division. Here, I used a
1.3 times multiple as if all of the land would – if sold today in whatever state it is in – generate
the same gross margins as the 22-23% gross margins in the homebuilding division.
In other words, GRBK might deserve an appraisal value of more than $9.50 a share. But, I think
it’s reasonable to use roughly $6.50 a share as “cost” and roughly $9.50 a share as “appraisal
value” for this stock. The market value is about $8 a share on the NASDAQ right now.
Why haven’t I talked about earnings?
I just don’t think that’s a meaningful way to look at the business. One, the company does not pay
dividends and has no plans to ever pay dividends. Two, it has not historically bought back stock
and has only authorized a small (less than 10% of the company’s market cap) plan over several
years to allow stock buybacks. Generally, all cash generated by this business will immediately be
put back into buying more land. Therefore, “earnings” in GRBK are just the growth in per share
land inventory. That’s it. You get paid in land in this company. Land will beget more land.
Buying GRBK is an all-in bet on residential land in Dallas Fort-Worth and Atlanta where you
will constantly let your bet ride on more and more land. You’ll never get cash from this stock.
You’ll only get more and more land.
The other issue is debt. Homebuilders use debt. GRBK uses debt. It uses less debt than some
other homebuilders. And, if the company was to quickly grow EPS, it would do it by increasing
its debt/capital ratio from something like 20% to something like 40%. This boosts earnings, but it
wouldn’t distort my calculation of land at cost and appraisal value. I think my approach is better,
because it normalizes the cyclical distortions of leveraging and de-leveraging to fund growth
faster than the sustainable rate of growth the company can support during boom years and to
fund slower than the maximum sustainable rate of growth the company can support during bust
years. Basically, I like my asset value approach better because it is less likely to overvalue this
stock during a housing expansion and undervalue it during a housing contraction.
Finally, there is a tax issue at GRBK. This distorts earnings. And it’s easier than normal here for
an analyst to be fooled by after-tax earnings. Income attributable to non-controlling interests
appears below the tax line. Interest appears in the cost of goods sold line (because – as a
homebuilder – GRBK capitalizes interests and assigns it to specific lots it sells). Two things have
happened with taxes at GRBK. One, the company had – but, going forward, soon will not have –
net operating loss carryforwards. Two, the corporate tax rate was cut from 35% to 21%. This tax
cut caused a huge one-time tax distortion at GRBK (like it did at many public companies).
GRBK also has a short history since the reverse merger. The reported EPS here just hasn’t been
very meaningful. The company provides adjusted numbers like the EBITDA return on average
equity.
A more useful figure is to look at things like the return on capital at GRBK and at other
homebuilders. And then to look at the leverage normally used at GRBK and at other
homebuilders. Overall – and I may be being ever so slightly conservative here – I think the likely
long-term return on equity here is similar to the likely long-term return in the stock market.
Specifically, I would say that if you use my appraisal value (of almost $9.50) which is basically
equivalent to a sort of “mark-to-market” approach to the company’s assets – the compound
annual growth rate in this company’s appraisal value per share, book value per share, etc.
shouldn’t be much greater than the return in the S&P 500. It might be as fast as 10% a year. It’s
not – over a full cycle – going to be something like 20% a year.
So, GRBK might be an adequate investment at a price equal to my “appraisal value” of $9.39 a
share. I would want a margin of safety. So, a good price to buy the stock would be something
like two-thirds of appraisal value. The formula for this – at present – would be $9.39 * 0.65
equals $6.10 a share. The cost approach gives you an adjusted book value of about $6.53 a share.
This would be about 70% of my initial appraisal value per share. That would be another logical
line in the sand. So, let’s use $6.50 – as of this past quarter – as a good price at which to buy
GRBK.
I didn’t talk much about the kinds of returns GRBK generates. We only have data for the
expansion years. Atlanta and Dallas have both been expanding – homes have been rising in price
– for the last seven years. GRBK does have better margins, returns on capital, lower leverage,
etc. than other homebuilders. However, GRBK (the stock) is about two-thirds economic profits
from land development and one-third homebuilding. It’s only in the hot housing markets of
Dallas and Atlanta. And we only have data from the recent housing expansion. I don’t want to
assume the company’s quality is higher than the average homebuilder.
So, how would I answer the 4 questions that matter most in an initial interest post?




Do I understand the business? – I understand the Texas part of the business fine (a lot
of the company’s lots it will develop over the next 5 years or so are in locations very
close to where I live – not just in DFW generally, but specifically in the towns and parts
of towns I know well). So, 50% I understand well and 50% (Atlanta) I know nothing
about.
Is it safe? – Homebuilders are cyclical, sensitive to interest rates, and use debt. GRBK
uses less debt than many homebuilders. We are very far from the past peaks in
homebuilding. The time to be least concerned about a housing bubble is when people still
remember the last one. The long-term economics of supply/demand etc. in the DFW
market are good (I don’t know Atlanta). Homebuilders aren’t very cash generative. The
company has very big theoretical off balance sheet obligations (basically, options on
land) I didn’t discuss – but, it’d be easy to back out of these at a fraction of the value of
the land they have options on. Overall, safety here is – at this point in the cycle –
adequate but not excellent.
Is it good? – GRBK is a homebuilder. That’s a cyclical industry that is capital intensive.
It’s not an especially bad industry. But, it’s definitely not an especially good industry. So
far, GRBK’s returns on capital are better than homebuilders generally. Land
development returns as an asset class of sorts though aren’t really better than the stock
market generally, especially when you adjust for the use of leverage. GRBK’s quality is
adequate but not excellent. I’m not sure I’d call it a “good” business. But, I don’t have
evidence it’s a “bad” business either. It’s okay.
Is it cheap? – GRBK stock is cheap. The adjusted book value is about $6.50. My
appraisal value is about $9.50. The stock trades at about $8. So, the stock trades at about
125% of book value and about 85% of appraisal value. Today, most stocks trade above
my appraisal value of the stock. Certainly, most stocks trade at much higher ratios of
book value than 1.25x. GRBK is cheap.
Overall: GRBK is a cheap stock that I understand somewhat well enough and is of average
quality and safety. It’s a value stock. And it’s a value stock where half of the value is in locations
I am very, very familiar with. But, that’s about it. I’d first consider buying GRBK at $6.50 a
share – and start to get serious about the stock at $6 a share – but, I’m not interested at prices
above that.
Geoff’s initial interest level: 60%



URL: https://focusedcompounding.com/green-brick-partners-grbk-a-cheap-complicatedhomebuilder-focused-on-dallas-and-atlanta/
Time: 2019
Back to Sections
-----------------------------------------------------
Grainger (GWW): Lower Prices, Higher Volumes
The Original Pick
I picked Grainger (GWW) for a newsletter I used to write. The pick was made in April of 2016.
Grainger traded at $229 a share when I picked it. Today, the stock trades for $188 a share. That’s
one reason to look at the stock now.
Reason #1 for considering GWW:
I picked the stock when the price was 22% higher than it is now.
There’s another. Over the last twelve months, here’s how Grainger’s stock performed versus the
shares of is two closest peers.



Grainger: (16%)
Fastenal (FAST): (2%)
MSC Industrial (MSM): +19%
I picked MSC Industrial for the newsletter too. Last year, one of the questions I had to ask
myself was which stock I liked better: Grainger or MSC Industrial? Back then, it was a tough
question. Today, it should be a lot easier to answer.
Reason #2 for considering GWW:
Grainger is now 14% cheaper relative to Fastenal and 29% cheaper relative to MSC
Industrial than it was a year ago.
So, is Mr. Market right? Does Grainger really deserve a downward re-valuation of 14% versus
Fastenal and 29% versus MSC?
Before we can answer that question, we need to know why I picked Grainger in the first place.
Reason for Picking Grainger in the First Place
I thought Grainger was a Growth At a Reasonable Price (GARP) stock. Here’s what I wrote a
year ago:
“…Grainger can grow sales by at least 5% a year. Profit growth should be more than 5% and
less than 8% a year. At that pace of growth in sales, Grainger would return two-thirds of its
earnings each year. So, if you bought Grainger at around a P/E of 16 or 17, the company would
pay out 4% of your purchase price each year in buybacks and dividends while companywide
profit would grow 5% to 8% a year. Your return in the stock would be in the 9% to 12% a year
range. This is far better than you’ll get long-term in the S&P 500. So, Grainger is a ‘growth at a
reasonable price’ stock even when priced as high as 17 times earnings and when growing sales
as slowly as 5% a year. The combination of margin expansion and share buybacks mean the
company could grow sales as slow as 5% a year and yet grow earnings per share at close to
10% a year. The ‘growth’ in ‘growth at a reasonable price’ that an investor should care about is
only earnings growth and only in per share terms. It doesn’t matter whether companywide sales
grow 10% a year or 5% a year if EPS growth is 10% a year in both scenarios, the stock is no
more or less valuable due to the difference in sales growth. Companywide sales growth doesn’t
benefit shareholders. Only growth in earnings per share makes any difference to an investor. So,
by that measure, a stock with a P/E of 15 or 20 and a growth rate of 8% or 10% a year is
actually a reasonably priced growth stock. Grainger fits that description.”
Let’s break down my year-old argument into its 3 key assumptions:
1. Grainger will grow sales at least 5% a year
2. Grainger will grow net income between 5% and 8% a year
3. Grainger will pay out two-third of its earnings in dividends and buybacks
These are the 3 assumptions that need defending if I’m to prove my case for Grainger. But,
before we hear my defense of Grainger, let’s listen to the bear case.
The April 18th Earnings Release: Why Grainger’s Stock Dropped
Most of the decline in Grainger’s stock price over the last year took place in just one day.
Grainger shares closed trading on April 17th, 2017 at $223 a share (just 3% below where I’d
picked the stock a year before). The company then reported its quarterly results. Shares reopened the following day at $200 a share. So, you had a decline of 10% on a single earnings
report.
How bad was that earnings report?
Let’s start with the actual quarterly results:
“…sales of $2.5 billion increased 1 percent versus $2.5 billion in the first quarter of
2016….earnings for the quarter of $175 million were down 6 percent versus $187 million in
2016. Earnings per share of $2.93 declined 2 percent versus $2.98 in 2016.”
So:



Sales rose 1%
Earnings per share fell 2%
And net income fell 6%
Obviously, the company bought back a lot of stock during the year. This, however, is only part
of the problem. The bigger problem for the stock price was the change in guidance:
“…(Grainger) now expects sales growth of 1 to 4 percent and earnings per share of $10.00 to
$11.30, which incorporates the effect of the pricing acceleration…The company’s previous 2017
guidance, communicated on January 25, 2017, was sales growth of 2 to 6 percent and earnings
per share of $11.30 to $12.40.”
So, Grainger lowered its projected sales growth from a 2% to 6% range down to a 1% to 4%
range. It also added a new low-end to its EPS guidance. The company is now guiding for as low
as $10 a share in earnings. Let’s take Grainger’s new sales growth and new EPS guidance and
compare it to my year-old assumptions.
Sales Growth
My year-old sales growth assumption:
Grainger will grow sales by at least 5% a year.
Versus the company’s present-day sales growth guidance:
Grainger will grow sales by 1% to 4% in 2017.
Obviously, in 2017, Grainger isn’t going to grow its sales as fast as I expected. Actually, it will
grow unit sales almost as fast as I expected (for the quarter, volume growth was 5%). It’s dollar
sales that will come in below what I expected. More on that in a moment. But, first…
We’ve discussed the “growth” part of my year-old “Growth At a Reasonable Price” argument in
favor of buying Grainger stock. Now, we need to talk about that “reasonable” price part.
Earnings Per Share
My year-old earnings per share assumption:
“The company has 63 million shares outstanding. So, that puts ‘normal’ earnings per share –
without any leverage – at $14.76.”
Versus the company’s present-day earnings per share guidance:
Grainger will earn between $10 and $11.30 a share in 2017.
That puts the top-end of Grainger’s EPS guidance range 23% below my estimate of normal
earnings and the low-end of Grainger’s range ($10 a share) at 32% below my estimate of normal
earnings.
The “Right” P/E: What Me and Mr. Market Agree On
We should pause here and note something. When I picked Grainger in April of 2016, I pegged
normal earnings per share at $14.76 a share and appraised the stock at an intrinsic value of
$268.94. That means I assigned Grainger a P/E of 18.
Now, let’s look at where Mr. Market has Grainger priced and where the company is guiding for
2017 earnings. Grainger’s share price is now $193 a share. The company has provided guidance
of $10 to $11.30 for 2017 EPS. That translates into a P/E of 17 to 19. So, the market is putting a
P/E of 17 to 19 on Grainger’s current earnings and I’m putting a P/E of 18 on Grainger’s
“normal” earnings.
There is no disagreement here about valuation. The only disagreement between Mr. Market and
me is whether Grainger should trade at 18 times an EPS of about $10 or 18 times an EPS of
about $15. Mr. Market says earnings of $10 a share are normal. I say earnings of $15 a share are
normal. If Mr. Market is right, the stock should be priced around $180 a share. If I’m right, the
stock should be priced around $270 a share. That’s the crux of the argument.
So, let’s focus on that one simple question:
Is Grainger’s normal earning power now $10 a share or $15 a share?
There are a few checks we can perform. We can look at past history. We can look at the
company’s predictions for the future. And we can look at my predictions for the future. Let’s
start with past history.
This is what Grainger reported in EPS over each of the last 5 years:
2012: $9.52
2013: $11.13
2014: $11.45
2015: $11.58
2016: $9.87
So, we have a range of $9.52 (in 2012) to $11.58 (in 2015). The median is $11.13 (2013) and the
mean is $10.71. Till last year, the trend was – as it always had been at Grainger – one of
consistently higher EPS year-after-year. Normally, Mr. Market would use peak earnings for a
constant EPS grower like Grainger.
So, normally the market would treat $11.58 as the “normal” EPS for Grainger. If you slap a P/E
of 18 on an EPS of $11.58, you get a stock price of $208 a share. Grainger trades at $193 a share.
So, the market probably isn’t using Grainger’s prior peak earnings of $11.58 a share.
Why not?
Probably because of the company’s own guidance. But, before we get to Grainger’s own
predictions about the future – we need to make one adjustment.
The figures I just gave you were earnings per share figures – not net income figures. Here is the
trend in Grainger’s number of shares outstanding:
2012: 71.2 million
2013: 70.6 million
2014: 69.6 million
2015: 65.8 million
2016: 60.8 million
Now: 59.2 million
Grainger is what Charlie Munger calls a “cannibal”. It’s a stock that gobbles up its own shares
year-after-year.
If I adjusted Grainger’s old EPS figures to reflect what the company would earn if it reported the
same corporate net income it had in that year but instead had the number of shares outstanding
(59.2 million) it does now, the totals would look a little different.
Here are Grainger’s past 5 years of earnings adjusted for the company’s current share count:
2012: $11.45
2013: $13.27
2014: $13.38
2015: $12.87
2016: $10.14
At the risk of overkill, I want to pause now and present a table. The left-hand column shows
Grainger’s EPS as originally reported for the years 2012-2016. The right-hand column shows
Grainger’s EPS for the years 2012-2016 adjusted to reflect today’s share count:
As Originally Reported
Adjusted for Today’s Share Count
2012
$9.52
$11.45
2013
$11.13
$13.27
2014
$11.45
$13.38
2015
$11.58
$12.87
2016
$9.87
$10.14
Now, I hope we can all agree that only the right-hand column has any relevance. Grainger may
have had 71 million shares outstanding in 2012. But, it’s not 2012 anymore. It’s 2017. And
Grainger only has 59 million shares outstanding in 2017. So, any historical figure that is based
on an outdated share count won’t help us predict the future.
What will help us predict the future?
The Consistency That Had Been, The Uncertainty That Now Is
Grainger grew EPS year-over-year in 21 of the 24 years leading up to 2016. On top of this,
Grainger never recorded back-to-back EPS declines. The company’s record over the last quartercentury is about as consistent an EPS growth record as you’re going to find. Almost without
exception, Mr. Market tends to use one of 3 numbers when valuing a consistent EPS grower:
1. The most recent year’s EPS
2. The company’s guidance for next year’s EPS, or
3. The stock’s prior peak EPS
In probably 9 out of 10 years, it doesn’t matter which figure Mr. Market picks as “normal” for a
company like Grainger. Such a consistent grower only registers a single EPS decline about once
a decade – and usually right as the economy heads into a recession. So, a company like Grainger
is almost always at a point where it is currently reporting record EPS for last year and
simultaneously guiding for a (new) record level of EPS next year.
However, Grainger’s net income peaked in 2014 and its EPS peaked in 2015. Since then, the
company’s net income and EPS has been falling. Grainger has also been lowering its guidance
for future EPS.
Simplifying Assumption: Grainger Will Earn $13.38 a Share Eventually
I’m going to stop here and make a statement that might be counter-intuitive, but isn’t really up
for debate. I view Grainger as a GARP (growth at a reasonable price) stock. The company’s
highest ever net income was recorded in 2014. Taking Grainger’s 2014 net income and dividing
that figure by today’s share count gives you a peak EPS of $13.38. If I think Grainger is still a
growth stock, I think it’ll surpass that prior peak. Therefore, let’s simplify this discussion. I’m
going to assume Grainger’s “normal” earning power is no less than $13.38 a share, because
either:
13. Grainger will earn more than $13.38 a share in the future, or
14. Grainger isn’t a growth stock anymore
If Grainger isn’t a growth stock anymore, I’m not interested in buying it. And, if Grainger is a
growth stock, it’ll earn more than $13.38 a share in a normal, future year.
Therefore, let’s just assume Grainger will – if it’s still a growth stock – earn at least $13.38 a
share in a normal year. And then, let’s address the one key question left:
Is Grainger still a growth stock?
Grainger has given EPS guidance of $10 to $11.30 a share in 2017. I’m a long-term investor. So,
I don’t care what Grainger is going to earn in 2017. I want to know what Grainger is going to
earn in 2022. Grainger’s management team doesn’t give guidance quite that far out. But, it’s
come close.
In 2015, Grainger’s CFO said this about growth:
“And as we look forward five years…what should our growth be and what do you have to
believe to think that it can grow organically (at) high single digits, so 6% to 10%?
You need to believe that the share gains with our larger customers will ramp back up like we’ve
been seeing the last five years…That the market will grow 2% to 3% as it’s been growing for
some time except this year.
And that price — well, we are kind of weighting it down probably heavily by our current
experience, but — because historically it has been 1% to 2%, we are saying zero to 1% growth
each year over the next five years. And that is how we get to the 6% to 10%.”

Ron Jardin, CFO of Grainger (May 2015)
Let’s break down the 3 key drivers Jardin said Grainger needs to grow over the next 5 years:
1. Share gains with the company’s largest customers
2. The overall market growing 2% to 3% a year
3. Price growing 0% to 1%
Grainger’s growth targets are above the growth I projected for the stock. So, we can take the low
end of each of those ranges and ask:
1. Will Grainger still grow its share with the company’s largest customers?
2. Will the overall market still grow 2% a year?
3. Will prices stay stable in nominal terms?
The answer to question #1 is yes. Nothing that happened recently will threaten Grainger’s market
share with its existing big, corporate clients.
Grainger’s earnings declined because of across the board price cuts it made combined with
greater online price transparency. There are real risks to doing what Grainger just did. But none
of those risks involve Grainger’s volume share with large customers.
The changes Grainger made to the level of its prices and how those prices are shown make 3
things more likely:
1. Lower, more competitive prices in the future
2. Greater weighting toward the kind of smaller business customers that consumer focused
retailers like Amazon can also compete for
3. Greater weighting toward smaller, less frequent orders for “one-off” items
This all sounds very, very bad. And it might be. But, we need to stop and talk a little about the
truly weird way Grainger has grown over the last 10 years or more:
Grainger hasn’t really added new customers for at least a decade.
That’s not an exaggeration. I think it’s possible the “Grainger” brand in the U.S. almost never
wins truly new customers. Management has said things that back up this belief:
“The reality is we have not been able to acquire a customer into the Grainger brand for years
and we are now going to start acquiring customers for the Grainger brand starting in the third
quarter. And so that’s a big shift for us and one that we’re really excited about and we’re
confident we are going to get the results.”

Donald Macpherson, CEO of Grainger (April 2017)
In fact, I think Grainger actually has tended to have fewer customers over time. Price increases
that Grainger passes on to its customers are very small. Over the last 10 years, Grainger’s catalog
has increased in price by something like 0% to 2% a year. So, almost all of Grainger’s earnings
have come from volume gains rather than price gains. Also, like I said, Grainger hasn’t added
new customers over time. Now, it also tends not to lose its big customers. But, still, we’re talking
about a company with almost no:
1. Price growth
2. Customer growth
So, almost all of Grainger’s growth comes from actual unit volume growth with existing, large
customers. The real amount of stuff that a big corporate client buys from Grainger tends to go
up, up, up over time.
Actually, Grainger has had one other source of growth:
Grainger Owns Two Very Fast Growing E-Commerce Businesses
Grainger owns 53% of MonotaRO. MonotaRO is a high-flying Japanese stock. It’s incredibly
expensive. Grainger also owns all of Zoro. Zoro is basically just the MonotaRO business model
transplanted to the U.S. Both MonotaRO and Zoro tend to grow sales at something like 20% to
25% a year. They are online only businesses.
So, those are the two sources of Grainger’s growth:
1. Volume gains with existing large, corporate customers
2. E-commerce websites that are still in their fast growth phase
Everything else at Grainger has shrunk over time. The Grainger brand in the U.S. used to serve a
lot of small and medium sized customers. It lost those customers over the last decade.
So, the three questions we need to focus on are:
1. Will Grainger’s online only businesses – Zoro and MonotaRO – keep growing?
2. Will Grainger keep growing its volumes with existing large, corporate customers
3. And: Will Grainger’s prices with existing large, corporate customers stay flat?
Let’s answer those questions one by one.
Question #1 is the least important. Grainger’s U.S. business – which is both online and offline –
made up 80% of the appraisal value I gave the stock in 2016. I might have been overly
conservative in my valuation of the fast-growing online only businesses, MonotaRO and Zoro.
However, there’s just no way that Grainger’s U.S. business could ever count for less than 50% to
75% of the stock’s total value. So, we should really focus all our discussion on growth in the
Grainger branded business in the United States.
So, as far as the online businesses are concerned – I think it’s enough just to quote what Grainger
said about them in its most recent earnings release:
“…23 percent sales growth for the single channel online businesses. Operating earnings for the
Other Businesses were $32 million in the 2017 first quarter versus $22 million in the prior year.
This performance included strong results from Zoro in the United States and MonotaRO in
Japan.”
So, MonotaRO and Zoro are doing fine. Let’s deal with the only two questions left:
1. Will Grainger keep growing its volumes with existing large, corporate customers
2. And: Will Grainger’s prices with existing, large corporate customers stay flat?
The first of those questions is easier to answer:
“Sales for the U.S. segment were down 1 percent versus the 2016 first quarter. The decrease was
driven by a 4 percentage point decline in price and a 1 percentage point decline from lower
sales of seasonal products, partially offset by a 4 percentage point increase from volume
growth.”
Putting aside the seasonal products, we have a 4% price decline and 4% volume growth. Last
fall, Grainger announced its plans to lower prices and especially make its online prices clearer
and more competitive. So, both customers and competitors knew this was coming. Grainger has
now announced it will fully implement these price cuts faster than planned:
“…the first quarter clearly fell short of our expectations, driven primarily by the stronger than
anticipated customer response to our U.S. strategic pricing actions, with a greater volume of
products sold at more competitive prices…Based on the positive customer response thus far, we
are pulling forward the remaining pricing actions originally scheduled for 2018 into the third
quarter of this year. This decision requires a significant change to our earnings per share
guidance for the year but should enable us to accelerate growth with existing customers and
attract new customers sooner than planned.”
Basically, Grainger’s customers turned out to be more “price-elastic” than planned. Grainger
simultaneously raised the prices of some of its Stock Keeping Units (SKUs) and lowered the
prices of other SKUs. On SKUs where the price was lowered, volume increased more than
expected. And then on SKUs where the price was raised, volume decreased more than expected.
Grainger had price declines of about 4% and volume gains of about 4% year-over-year.
However, it’s accelerating the pace it was making these changes at. So, they are looking more for
about a 6% price decline over 2017 as a whole.
That’s a huge change. It’s also a complex change. I think Grainger already implemented price
changes on about 450,000 SKUs. The company has over 1.4 million SKUs. However, it only
keeps about 500,00 SKUs in inventory, because most SKUs are very slow moving.
Grainger’s profits come mostly from its large customer accounts. So, the pricing of individual
SKUs isn’t something the company really needs to target from a source of profit perspective. For
example, it’s fine if Grainger gives its corporate clients especially competitive prices on slow
moving SKUs and then less competitive prices on fast moving SKUs. Grainger only needs to
make money on the entire customer relationship.
For these reasons, I think it’s too complicated to answer the question:
Will Grainger’s prices with existing large, corporate customers stay flat?
And that’s the key question. You need to be able to answer that question in the affirmative if
you’re going to buy Grainger shares.
We know Grainger can grow volume with these customers. And higher volume leads to lower
cost of goods sold on a unit basis. However, Grainger is essentially implementing a 6% price cut
this year. That will immediately lower gross margins. The question is whether Grainger will ever
return to its previous operating margins.
Right now, I don’t know the answer to that question. I’ll watch the company closely. Grainger
should report continued bad results throughout 2017. So, the stock price might decline further.
And, as we all know, Warren Buffett has said:
“The best thing that happens to us is when a great company gets into temporary trouble…we
want to buy them when they’re on the operating table.”
Grainger is definitely on the operating table now. And, over the last 25 years,
Grainger had definitely been a great company. But, is this trouble temporary?
I’ll be watching the business closely in 2017 to find out.
The key question is whether – starting in 2018 – Grainger will be able to keep the average selling
price of its SKUs flat in nominal terms. If Grainger can do that, it will be a great company and a
great compounder once again.
If it can’t, I’ll permanently eliminate Grainger from consideration as a long-term investment.
Verdict


Geoff will NOT buy shares of Grainger at this time
Geoff WILL add Grainger to his watchlist at a price of $187.84
Grainger move to #2 on Geoff’s new idea pipeline behind Howden Joinery



URL: https://focusedcompound