Gannon Compilation 2005 2022

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 Boston-
Based 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
Short-Term 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
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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, “listing-like” 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-a-
company-down-revenue-line-by-revenue-line/
 Time: 2020
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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-or-
a-bad-thing-no-its-an-interesting-thing/
 Time: 2017
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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-over-
depreciation/
 Time: 2017
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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-to-
year “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 long-
term 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.”
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.”
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.”
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-the-
income-statemen/
 Time: 2017
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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-about-
stocks/
 Time: 2012
-----------------------------------------------------
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 price-
to-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/free-cash-flow-vs-owner-earnings-which-matters-more
 Time: 2012
-----------------------------------------------------
You’ve Crunched The Numbers – Now What?
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.
161475/youve-crunched-the-numbers--now-what
 Time: 2012
-----------------------------------------------------
Do Working Capital Reductions Count As Free Cash Flow?
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.
161522/do-working-capital-reductions-count-as-free-cash-flow
 Time: 2012
-----------------------------------------------------
GAAP Accounting: Restatements Vs. Realities
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.
161788/gaap-accounting-restatements-vs-realities
 Time: 2012
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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
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 double-
declining 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-depreciation-
archetypes/
 Time: 2011
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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
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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
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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-include-
changes-in-working-capital/
 Time: 2011
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How to Calculate Free Cash Flow – 5 Illustrated Examples From Actual 10-
Ks
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-illustrated-
examples-from-actual-10-ks/
 Time: 2010
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Net Current Asset Value Bargains: How Do You Screen For Them? –
Retained Earnings
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-you-
screen-for-them-retained-earnings/
 Time: 2010
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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-pleasant-
surprise/
 Time: 2006
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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
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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
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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% pre-
tax.
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-companys-
balance-sheet
 Time: 2018
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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 de-
emphasize 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 IsaacÂ 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-on-
capital-calculation
 Time: 2016
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Return on Capital Is the 'Cost of Growth'
“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
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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 anti-
cash. 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 one-
time 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-than-
normal 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-tomorrows-
returns
 Time: 2013
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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 Q-
Logic. 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 long-
term 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, Q-
Logic'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-buyback-
yield
 Time: 2013
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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 straight-
line 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-learn-
accounting
 Time: 2013
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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
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Is Negative Book Value Bad?
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: Net-
Net 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 6.2
AutoZone 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
-----------------------------------------------------
GAAP Accounting: Restatements vs. Realities
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
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-vs-
realities
 Time: 2012
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Do Working Capital Reductions Count as Free Cash Flow?
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-as-
free-cash-flow
 Time: 2012
-----------------------------------------------------
You've Crunched the Numbers: Now What?
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
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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-value-
investor-to-read/
 Time: 2017
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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 Z-
Score, 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-taking-
up-my-time/
 Time: 2017
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The Best Investing Book to Read if You’re Only Ever Going to Read One
“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-only-
ever-going-to-read-one/
 Time: 2016
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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
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What Books Should You Read About Ben Graham?
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.
161739/what-books-should-you-read-about-ben-graham
 Time: 2012
-----------------------------------------------------
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
-----------------------------------------------------
Investing 101 Toolbox: 12 Books, 3 Lectures, 4 Blogs, and 5 Interviews for

Investors
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. Cheap Stocks
2. SINLetter
3. Greenbackd
4. The Interactive Investor Blog
Interviews
1. Tariq Ali of Street Capitalist

2. George of Fat Pitch Financials
3. Toby Carlisle of Greenbackd
4. Asif Suria of SINLetter
5. 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-4-
blogs-and-5-interviews-for-investors/
 Time: 2010
-----------------------------------------------------
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
-----------------------------------------------------
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 customer-
oriented 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-for-
business-failure/
 Time: 2008
-----------------------------------------------------
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
-----------------------------------------------------
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
-----------------------------------------------------
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
-----------------------------------------------------
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:
***
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-crazy-
ideas-geoff-has-about-investing-in-efficiency-driven-businesses/
 Time: 2008
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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 ever-
rising 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
-----------------------------------------------------
What Books Should You Read About Ben Graham?

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)
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-ben-
graham
 Time: 2012
-----------------------------------------------------
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). Long-
term 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 pre-tax 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 2001-2016. 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-to-
use-it/
 Time: 2022
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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 non-
durable 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
long-term 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-non-
durable-businesses-altria-mo-vs-nacco-nc/
 Time: 2020
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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 8-10% 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-to-book 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-when-
retaining-earnings-is-the-key-to-compounding-and-when-it-isnt/
 Time: 2020
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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-of-
companies-not-keeping-enough-cash-on-hand/
 Time: 2020
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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
-----------------------------------------------------
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
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Free Cash Flow: Adjusting For Acquisitions, Capital Allocation And

Corporate Character
…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/
161328/free-cash-flow-adjusting-for-acquisitions-capital-allocation-and-corporate-
character
 Time: 2012
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How to Find Stocks With Good, Predictable Capital Allocation
“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 haveÂ the presence ofÂ 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 organizationÂ –Â 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)Â –Â and independent directorsÂ –Â 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
nowÂ –Â 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 long-
tenured 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-good-
predictable-capital-allocation-
 Time: 2017
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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-and-
growth
 Time: 2013
-----------------------------------------------------
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 initial-
initial 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 non-
sufficient 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 non-
interest 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 non-
interest 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 non-
interest 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.
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-to-
book 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 charged-
off. 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 one-
third 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-mortgage-
corporation-agm-the-freddie-mac-of-farms-and-ranches-has-a-p-e-below-9-and-an-roe-
above-most-banks/
 Time: 2019
-----------------------------------------------------
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 long-
term (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 5-
year 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-land-
paying-down-debt-and-focusing-on-its-core-business/
 Time: 2021
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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 write-
up 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 A-
Mark 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-and-
lender-in-physical-gold/
 Time: 2019
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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-apple-
bagel-stores-is-the-smallest-stock-i-know-of-thats-a-consistent-free-cash-flow-generator/
 Time: 2020
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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 Re-visit Price: $11.50/share
 URL: https://focusedcompounding.com/flanigans-bdl-a-cheap-complicated-restaurant-
chain-focused-on-south-florida/
 Time: 2020
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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 Meta-
Lax 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 sub-
harmonic 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 long-
term 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.
 URL: https://focusedcompounding.com/bonal-bonl-an-extremely-tiny-extremely-illiquid-
stock-that-earns-a-lot-but-doesnt-grow-at-all/
 Time: 2019
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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 Revisit Price: 1,200 GBP (down 27%)
 URL: https://focusedcompounding.com/bunzl-bnzl-a-distributor-with-20-straight-years-
of-eps-growth-and-27-straight-years-of-dividend-growth-facing-a-virus-thatll-break-at-
least-one-of-those-streaks/
 Time: 2020
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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-stock-
getting-activist-attention/
 Time: 2018
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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 “non-
GAAP 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.
 URL: https://focusedcompounding.com/bwx-technologies-bwxt-a-leveraged-speculative-
and-expensive-growth-stock-that-might-be-worth-it/
 Time: 2019
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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
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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 spun-
off 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 Re-visit Price: $11/share
 URL: https://focusedcompounding.com/carrier-carr-a-big-well-known-business-that-just-
spun-off-as-a-cheap-leveraged-stock/
 Time: 2020
-----------------------------------------------------
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 spun-
off 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-over-
year while growing its marketing spending by 22% and CarGurus grew its sales by 65% year-
over-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 re-
investing 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 ultra-
intense 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-a-
clear-catalyst-and-tons-of-rivals/
 Time: 2017
-----------------------------------------------------
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 co-
founder, 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.
Possible revisit price: $9/share (Down 28%)
 URL: https://focusedcompounding.com/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/
 Time: 2019
-----------------------------------------------------
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 Car-
Mart 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-the-
industry/
 Time: 2017
-----------------------------------------------------
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 90-
year 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 40-
minute 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 top-
level 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 re-
sanctioned 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 re-visit price: $1.10/share
 URL: https://focusedcompounding.com/dover-motorsports-dvd-two-racetracks-on-1770-
acres-and-65-of-the-tv-rights-to-2-nascar-cup-series-races-a-year-for-just-60-million/
 Time: 2020
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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 15-
25% 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 cap-
ex (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-real-
estate-some-dying-newspapers-and-a-growing-tech-company-with-minimal-disclosures/
 Time: 2019
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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-an-
utterly-average-price/
 Time: 2018
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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 6-
month 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 70-
75% 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 Revisit Price: $24/share (down 25%)
 URL: https://focusedcompounding.com/gainsco-gans-a-dark-nonstandard-auto-insurer-
thats-cheap-based-on-recent-underwriting-results/
 Time: 2020
-----------------------------------------------------
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 10-
K. 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 after-
tax 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-be-
able-to-value-this-thing/
 Time: 2018
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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.
 URL: https://focusedcompounding.com/gamehost-operator-of-3-local-monopoly-type-
casinos-in-alberta-canada-spending-the-minimum-on-cap-ex-and-paying-the-maximum-
in-dividends/
 Time: 2019
-----------------------------------------------------
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 non-
controlled (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: 22-
23% 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 non-
controlling 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.
 URL: https://focusedcompounding.com/green-brick-partners-grbk-a-cheap-complicated-
homebuilder-focused-on-dallas-and-atlanta/
 Time: 2019
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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 re-
opened 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 quarter-
century 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://focusedcompounding.com/grainger-gww-lower-prices-higher-volumes/
 Time: 2017
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Hanesbrands (HBI): A Very Cheap, Very Leveraged Stock That’s #1 in an

Industry that Changes So Little Even Warren Buffett Loves It
Hanesbrands (HBI) has gotten very cheap lately. In fact, the stock is back at prices that are
pretty close to where it was spun-off from Sara Lee back in 2006. I talked a little about the stock
back then. It was a spin-off I liked – I haven’t found many of those lately – and I’d assume the
business has become more valuable over the last 14 years, not less. We’ll see if that’s true.
The business hasn’t changed much in 14 years. Hanesbrands acquired other businesses. It has
grown in athleticwear. And it has grown internationally. However, a lot of this growth was
acquired with the free cash flow produced by the innerwear segment. Hanesbrands divides itself
into 3 parts: U.S. innerwear, U.S. activewear, and international. By my math, profit contribution
is roughly 55% from U.S. innerwear, 25% from U.S. athleticwear, and 20% from international.
All segments are profitable. And innerwear has seen shrinking profits over the last several years
while international has grown (mostly through acquisitions).
Hanesbrands has a very strong brand position in U.S. innerwear and a pretty strong position in
U.S. athleticwear. It also owns a lot of the top brands in various countries through acquisitions
made to build up its international business. There may be some synergies between international
and U.S. – but, they aren’t brand synergies. This gets into the issues I have with the company: 1)
Acquisitions, 2) Debt, and 3) Management / Guidance etc. I’m not necessarily opposed to
acquisitions, the use of debt, or management here. But, each of those 3 issues do complicate
things a bit. For example, I’m not sure I like what the company has done in terms of acquisitions
over the years – but, it’s hard to tell.
So, this is one area that changed over these 14 years. Originally, Hanesbrands seemed like it was
interested in taking its core brands: Hanes, Champion, Maidenform, Bali, Playtex, Wonderbra,
etc. and exporting them into other countries. This never seemed like a great strategy to me.
Underwear brands are sold mostly as “heritage” brands. They’re like chocolate bars and
breakfast cereal. There are countless countries around the world that have some very popular
chocolate bar or very popular breakfast cereal that they’ve been eating since about 1900 or 1950
or whenever. They love it. The rest of the world hates it. It’s successful in their country. It flops
everywhere else. Trying to convert someone who eats Cadbury to switch to Hershey – or trying
to get an American to start eating Weetabix instead of Kellogg’s Cornflakes just isn’t going to
work. These are commodity products. Do they taste a little different? Maybe. Is one brand of
underwear a bit cheaper, a bit higher quality, a bit more comfortable, a bit more stylish – maybe.
But, any of those things can and will be tweaked. Any company can invest in some different
synthetics or different cotton, can do a slight bit of R&D work combined with a lot of consumer
research – and they can copy what Fruit of the Loom is doing or Gildan is doing or Hanes is
doing. Any brand can shift itself a bit in terms of cost, raw material quality, adopting some
common innovations in the industry, shifting with some styles, etc. and get to basically the same
place.
Underwear brands aren’t like watch brands. There isn’t much “positioning”. Hanesbrands
estimates that the Hanes brand (its biggest brand) is in 90% of U.S. households. Sometimes this
is in the form of men’s underwear, sometimes it is in the form of socks, or children’s underwear,
or T-shirts, or women’s underwear. But, it’s in those households. That makes Hanesbrands
something like Heinz. Is it the cheapest? Gildan might be cheaper. Private label might be
cheaper. But, it could basically match anyone’s price if it wanted to. Heinz can make ketchup as
cheaply as anyone. Is it the best? At each price point – it’s pretty capable of having as good
quality as anyone else. I suspect Gildan can produce very low end men’s underwear at a better
price / quality mix than Hanes can. However, Gildan’s brand is less well-known and it has to pay
retailers to give it shelf space. The retailer buys Gildan underwear for less than Hanes underwear
and then prices them the same. The retailer pockets the difference. Gildan probably has better
production facilities and is more vertically integrated. It can certainly produce blank T-shirts for
printmaking at a lower price than anyone – including Hanes. So, as a pure commodity produce –
Gildan is the leader. It has the lowest cost.
But, it doesn’t have the brand. And being the lowest cost / highest quality producer of ketchup
would allow you to take some market share (for example, you’d be able to supply private label
ketchup) – but, it wouldn’t get you ahead of Heinz for #1 in the industry. It’s too late to unseat
Heinz, because their brand is time. That’s the same with Hanes. Hanes doesn’t have any
particular appeal to the athletic or unathletic, the rich or the poor, the young or the old. All it has
is that it’s something you probably bought before and your parents probably bought before you
were even making that purchase decision. All it has is that it’s literally everywhere. Hanes is
generally the most accessible brand anyplace you’d shop for underwear. You can find it online,
at Wal-Mart, at Target, at Kohl’s, in Dollar stores, in department stores, and even in sporting
goods stores, some specialty retail, etc. Hanes is even a big supplier to the U.S. military. It’s
everywhere. It’s good enough. It’s cheap enough. And you’ve heard of it before. You’ve
probably worn it before. So, it’s not just a pure commodity – it’s a branded commodity.
The business doesn’t grow over time. It might be shrinking a bit. I suspect Hanes is losing
market share in U.S. innerwear. It’s unclear where though. Gildan started selling men’s
underwear – so, presumably, there has been market share losses there. However, from how
Hanes describes growth trends each year – it actually seems like the losses in U.S. innerwear in
recent years have come more from things like women’s underwear, socks, etc. than men’s
underwear. Men’s underwear and socks are subject to less fashion risk than the various kinds of
women’s underwear – bras, panties, hosiery, “shapewear” – that Hanesbrands sells. The decline
in U.S. innerwear has been pretty slight. Sales were $2.5 billion in 2016 and declined to $2.4
billion by 2018. Profits went from $615 million to $530 million. That is definitely a decline. But,
it’s not the decline in U.S. innerwear that concerns me – it’s the acquisitions Hanes has been
making outside that area.
So, Hanes shifted strategies from trying to push its big brands in other countries to simply buying
out the #1 or #2 brand in Australia, France, etc. Why do this?
There is a logic to it. Hanes is different from most apparel companies. It is a true manufacturer. It
is focused on having low costs. In fact, 70% of all the physical unit volume put out by Hanes is
produced in either a Hanes operated factory or a factory that serves only Hanes. The company
doesn’t outsource most of its needs to companies that serve multiple manufacturers. To give you
some idea of how much Hanes has invested in production – consider this: Hanes employs 68,000
people and owns 8 million square feet of production and distribution space, and leases another 15
million square feet of production and distribution space. That’s very different from most apparel
companies. Hanes – also unlike most apparel companies – barely does any business with China.
Something like 97% of the company’s products come from countries other than China. A lot
comes from the company’s own factories in Southeast Asia (like Vietnam), Central America, and
the Caribbean. The company has done away with all of its U.S. manufacturing.
So, these acquisitions do potentially make a lot of sense. Here’s how they work. You already
own the #1 underwear brand in the U.S. But, the U.S. is only like 10% of worldwide underwear
sales. So, you find another country that’s maybe 1/10th or 1/5th the size of the U.S. market – a
country like Australia or France – and you buy the biggest brand there. You then shift how that
brand was sourcing its product. So, you leave everything intact with customers it was supplying,
the advertising it was doing, etc. But, now instead of buying from China or whatever they were
doing – you shift it all to being produced in the same factories you’ve been using. Many of those
factories are owned by you, staffed by your own employees, etc. You squeeze out economies of
scale at the plant level. You take advantage of economies of scale you have on the cost side. You
don’t really benefit from synergies on the revenue side – because, as I said, it’s tough to sell
Hanes into Australia or France or wherever or Bonds into the U.S. if those names are totally
unfamiliar in those countries. Hanes also licenses some fashion brands like Polo and DKNY for
probably much the same reason. You pay the license. It’s another thing you can sell alongside
Hanes in certain locations. And you’re producing all the stuff in the same factories.
Hanes’s accounting for these acquisitions is so messy it’s hard for me to know if they’ve gotten
their money’s worth. This is especially true because Hanes doesn’t break out organic growth
very well. The number is sometimes discussed. But, not consistently. So, I can see how much
Hanes paid. But, then there’s this really, really big number for a one-time integration cost. It’s
usually a huge number compared to the acquisition price. So, really, we should probably just add
the one-time acquisition cost to the actual acquisition price to get an all-in price to evaluate the
purchase. This doesn’t seem like just accounting gimmicks to me. The whole point of why these
acquisitions might make sense is how you change everything on the production side while
leaving a brand with a real national heritage in place. That obviously costs a ton. You are
constantly restructuring something if you’re doing this all the time.
Would Hanes just be better off buying back its own stock?
Maybe.
The stock hasn’t always been cheap. But, it still seems to me like a lot of the earnings Hanes has
is really coming from Hanes (and some other strong brands in innerwear) and Champion (which
is mostly U.S. athleticwear – but, also is a somewhat international brand). So, a lot of this
company really seems to be Hanes and Champion. It might have made sense to just buy back
more and more stock to own more and more – per share – of Hanes and Champion. The prices
paid for acquisitions when I add in the one-time costs seem high versus the market price at which
Hanes itself has often traded in the market.
Regardless, the stock is cheap. Free cash flow does not dry up fast in this business. Hanes was
loaded up with debt when it was spun-off. It’s loaded up with debt again (this time to make
acquisitions).
The debt is presenting a bit of a problem here. But, maybe not too much.
So, Hanes just came out with a press release (about a week ago) saying they had drawn over
$600 million on their credit line. They now have $1 billion in cash on hand. Hanes has
obligations in 2020 though. And 2021 as well. This isn’t an exhaustive list. But, I’d say they
have about $850 million in interest, rent, debt repayments, and minimum royalty payments due
in 2020. The number is more like $1.15 billion in 2021. They also generally commit to some
purchase minimums at the start of the year – almost no purchase obligations extend beyond the
year though.
The actual debt repayment schedule is quite forgiving.
December 2022: $750 million
May 2024: $900 million
June 2024: $600 million
December 2024: $500 million
May 2026: $900 million
That’s a ton of debt. And there’s a lot due in 2024. However, I’m not worried about years that far
out for Hanes. In fact, I’m not even very worried about 2021. Unlike most businesses, Hanes is
really just exposed to actual economic shutdowns due to coronavirus – not to any recessions that
follow. The business is largely replenishment. There is almost no change in U.S. innerwear
purchases in recessions, depressions, etc. Athleticwear is different. And international may differ
to the extent it’s not just innerwear. But, probably at least 50% of Hanesbrand’s free cash flow is
basically recession proof. The other 50% is less sensitive to economic conditions than most
businesses too.
What is free cash flow like?
This is the part that interests me. If we just take the 3-year average free cash flow – it’s $600
million. This is after interest payments, taxes, etc. That’s not bad for a company with $1 billion
in cash on hand and the first debt repayment being $750 million in about two and a half years
from now. Another way of doing it is taking today’s sales and applying the long-term average
free cash flow margin. That also gives us a free cash flow estimate of $600 million. Hanes has
withdrawn its guidance in the face of coronavirus. But, again, free cash flow guidance would
have given us a $600 million and up figure. The guidance had been for $700 million to $800
million in cash flow from operations and Hanes’s usual cap-ex of about $100 million. Let’s call
that $600 million in free cash flow.
So, just how much is that versus the enterprise value, the market cap, etc.?
Well, $600 million is just under one-tenth of the enterprise value of $6.3 billion. So, on an
unleveraged basis – and I’m using an after interest payments FCF figure here instead of EBIT –
we’d be talking about a “P/E” (really EV/FCF) of 11 or so. However, the stock is leveraged. So,
the situation is a bit different for a common stock buyer. There are 358 million shares
outstanding at a current price of $7.39 a share. So, the market cap portion of the enterprise value
is just $2.65 billion. Or, to put it another way, $600 million in free cash flow divided by 358
million shares is $1.68 a share in FCF. The stock price is $7.39 – so, on a leveraged basis we’re
talking about a price/free cash flow of 4-5 times. The leveraged P/E here is basically 4-5. One
other way to look at it is that if I think HBI’s normal free cash flow (in say 2021 – or more like
2022) would be $600 million, the company would be comfortable paying a dividend of 25% of
that amount. The company targets a dividend payout ratio of 25-30%. It could pay more if it
didn’t acquire, buyback stock, and have so much debt to pay down. So, let’s take 25% of $600
million in FCF. That’s $150 million. Well, $150 million divided by 358 million shares is $0.42 a
share. Let’s call that 40 cents a share. I feel pretty strongly that in a couple years HBI will be
paying a dividend of at least 40 cents a share and probably raising it from there. Once they get on
the other side of coronavirus shutdowns – a 40 cent a share dividend should be very secure. The
company’s actual dividend at the moment is 60 cents. But, I’d assume they suspend that for a
year or two (like a lot of companies will). Well, a 40-cent dividend on a $7.39 stock price is a
5.4% dividend yield. I really do feel that as long as Hanesbrands gets through the next 1-2 years,
it’s almost certain you’ll be paid more than a 5% dividend that will maybe increase over time
and certainly won’t decrease. That’d be a very manageable dividend for them.
Finally, I need to discuss the stock’s extreme volatility. This stock has had some pretty wild rides
up and down over the years. A lot of that could be debt. Some of it could be perceptions I don’t
agree with. This is not an overlooked stock at all. It has been written up at Value Investor’s club
5 times – 3 times as a long and 2 as a short. I read those write-ups. I disagree with all of them:
both the longs and the shorts. I don’t think this company was ever much of a compounding
machine. I’m not convinced the acquisitions done – mostly by the previous management – were
that effective. I do think the company focuses too much on adjusted EPS figures instead of just
reporting like organic growth and free cash flow. But, I also disagree with the write-ups (the
shorts) saying this is a bad business, subject to all these potential declines in things, etc. It has
really changed very little in the 14 years since the spin-off. The core business does not change
quickly and does produce a lot of free cash flow. That free cash flow is consistently generated
and pretty secure far into the future. It’ll be used for something: debt repayment, dividends, stock
buybacks, acquisitions, etc. But, it’ll be used. So, I’ve always fallen in the middle on this one. It
doesn’t grow organically. But, it’s also a timeless brand in a very unchanging business. There’s a
reason Warren Buffett owns Hanes’s closest peer and competitor (Fruit of the Loom). It’s a
business he has probably milked for cash without putting much of anything back into cap-ex,
R&D, and advertising. I tried to figure out the maximum amount Hanes could really spend on
those 3 things together – I think it’s never much more than 8% of sales and usually less.
The debt here is a concern. But, if you were going to put a lot of debt on anything – you’d put it
on something like Hanes and you’d space out the borrowing as they have. A lot of the debt is
fixed rate. I’m not sure if that’s a plus or a minus here.
There are covenants. And, like just about all businesses, Hanes will trip those covenants this
year.
This is not a risk-free stock. But, it is very cheap – especially on a leveraged basis. And it’s
definitely the kind of business Buffett would buy.
Geoff’s Revisit Price: $4.00/share (down 46%)
 URL: https://focusedcompounding.com/hanesbrands-hbi-a-very-cheap-very-leveraged-
stock-thats-1-in-an-industry-that-changes-so-little-even-warren-buffett-loves-it/
 Time: 2020
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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
Hilton Food Group (HFG) trades on the London Stock Exchange. It qualifies as an “overlooked
stock” because it has low share turnover (17% per year) and a low beta (0.28) despite having a
pretty high market cap (greater than $1 billion in USD terms).
On a purely statistical basis, Hilton Food is one of the most predictable – in fact, in one respect,
literally THE most predictable – companies I’m aware of. There’s a reason for this I’ll get into in
a second. But, first let me explain what I mean about the predictability here. Over the last 11-13
years, Hilton Food has shown very, very little variation in its operating margin. EBIT margin
variation can be measured in terms of ranges (this would be 2.2% to 2.9% in the case of Hilton
Food), standard deviations (this would be like 0.2% in the case of Hilton Food) or the coefficient
of variation (0.08 in the case of Hilton Food). When talking about margin variation – I almost
always am talking about this coefficient of variation, which is the standard deviation scaled to
the mean. So, if a company had 27% EBIT margins on average and a 2% standard deviation or a
2.7% average margin and a 0.2% standard deviation – I’d talk about those two situations as if
they were equally stable or unstable margins. Another way to look at it would be to think about
standard deviations. If you own a stock for any meaningful length of time, you’re going to see
one standard deviation and probably two standard deviation moves in margins. You may not see
a three standard deviation move. And it’s entirely possible – unless something major changes
with the business, which of course, it often does – you won’t see a 4 standard deviation move.
With Hilton Food, a move of 4-5 standard deviations to the downside would only be a 1% of
sales move in EBIT. Now, margins at Hilton Food are so low that 1% of sales is like 35% of
EBIT and awfully close to 50% of earnings. So, it’s a big move. But, 4-5 standard deviation
moves in margins are obviously unusual. And you’d be surprised how common 35% of EBIT to
50% of after-tax earnings swings are for many public companies. They happen all the time. I
don’t want to go too far into the statistical weeds here – but, I will say that margin fluctuations
that literally happen every 1-3 years for a normal company might only happen once in like 1-3
decades for Hilton Food. Now, Hilton Food has not been around for 3 decades (the original plant
started operating in 1994 and the company only went public like 12 or so years ago). And what
I’ve been discussing here is the predictability of earnings in cases where sales are fixed. Sales
fluctuate. So, Hilton Food’s earnings will move around. It’s just that earnings will move around
very, very little relative to sales compared to almost any other business on the planet.
For that reason, I’m just going to price Hilton Food off its sales. I think it makes no sense to pay
attention to the “noise” of any fluctuations from year-to-year in margins. These are unlikely to
last. It makes the most sense to just decide on the right price-to-sales ratio (or EV/Sales – at
Hilton Food these two are often close to the same thing) to pay for the stock. I’m going to
completely ignore topics like price-to-free-cash-flow, EV/EBITDA, P/E, etc. I don’t believe any
of these numbers are as good signals to buy, sell, or hold Hilton Food as the simple EV/Sales
ratio. So, that’s the only ratio I’ll be using in this write-up.
Before even discussing the business Hilton Food is in – I’m going to talk multiples. One easy
way to value Hilton Food is to think of the stock as just providing a total return – for however
long you own it – of dividend yield plus dividend growth. So, if you own the stock for 30 years
and pay 50 times dividends (a 2% dividend yield this year) and the stock grows dividends per
share by 6% a year for those 30 years, you’d have an 8% return over 30 years. This will only
happen if you enter and exit the stock at the same multiple. Obviously, the influence of entry and
exit multiples is amplified or muted depending on how short or long your holding period is. I
don’t actually analyze a stock like Hilton Food on a 30-year holding period myself (I assume a
10-year holding period), but just saying “30 years” makes it a lot easier for you to see what a
theoretically indefinite holding period would look like. Basically, a stock you hold forever that
pays dividends to you will return dividend yield plus dividend growth.
Keeping that in mind, we can look at the long-term average EBIT margin for Hilton Food (about
2.7%) and apply the current tax rate in many of the countries Hilton Food is in (about 20%, but
some of this may change a bit soon), and then round the resulting number (2.7 * 0.8 = 2.2%)
down to just 2%. This makes my math very easy and it borders on slight conservatism. Once I’ve
done that, I can find various equivalent levels between EV/Sales (which is how we’ll be pricing
the stock today) and P/E ratios at no net cash or debt. I’ll be rounding these numbers. I’m doing
all this to help frame the problem of how much is too much to pay for Hilton Food. I’m going to
be talking EV/Sales now. But, I want you to see what this would require in terms of an exit P/E
(I figure most readers are more comfortable working with P/E ratios of growth stocks than
EV/Sales ratios) however many years down the line to leave the total return equation as simply
dividend yield plus dividend growth.
Here’s the table…
EV/Sales of 0.6x = P/E of 30x
For me, some of these numbers are silly. We’ll get into the economics of Hilton Food soon – but,
the business model is basically this: plant level unleveraged cash returns on equity of like 20-
40% a year after-tax secured by 5-15 year “cost plus” type supply agreements with the biggest
supermarket retailer of meat in a given Western European (U.K., Netherlands, Sweden,
Denmark, Ireland, etc.) country. These are high returns on capital. These are long supply
agreement. These are extremely fixed agreements. And these are the bluest of blue chip
customers they are selling too. Retail packed meat is also a pretty stable demand sort of product
– especially in richer countries. Households will switch from beef to lamb to chicken to pork
depending on pricing differences in those commodities. They may trade down at economically
stressed times a bit. This isn’t quite like supplying chewing gum or cola or toothpaste or tissues.
But, it’s a lot more like supplying chewing gum, cola, toothpaste, or tissues than it’s like
supplying cars, washing machines, or computers.
So, personally, I think the 10x P/E is silly. Hilton Food might trade at 10 times earnings (with no
net debt) when everyone is worried that a major customer contract will be allowed to expire or
that a major customer is rapidly losing market share. But, as long as Hilton Food is expected to
grow sales over time – a P/E of 10 is not the level at which you’ll ever be selling this stock no
matter when you get out. Personally, I also think an EXIT P/E of 30 is silly. But, let me explain
this. I don’t think that the stock trading at 30 times earnings today would be silly. I think that’d
make perfect sense. There is some Australian business just now coming online. And the
company has shown a very good history of growth even without a big new expansion like this
Australian plant opening in Brisbane. For example, in every year since Hilton Food went public
it has grown the physical weight of meat packed for customers. Sales have dipped a couple times
in money terms. And earnings have dropped year over year at times too. But, not for long. And,
actually, the real output of this company hasn’t declined since it went public. There are strong
indications that the company’s “share of wallet” from its customers has grown, because we can
sometimes check sales figures for the company to a specific customer, country, etc. versus
supermarket market share data for that customer. Hilton sometimes confirms this fact too. For
example, there’s no doubt that Hilton has grown its sales of red meat to Tesco faster than Tesco
itself has grown red meat sales.
This leaves the reasonable exit P/E range for me as 15x to 25x. That would suggest that at an
EV/Sales ratio of 0.4x to 0.6x, my return in Hilton Food will end up being just the current
dividend yield plus the CAGR in dividends per share while I own the stock. The company
currently trades a bit above 0.5x EV/Sales. However, by my math – which involves a ton of
estimates and outright guesswork based on various triangulation of statements by management
about how big the Brisbane plant is and how big I think the company’s existing plants are and so
on – I wouldn’t be surprised if “sales capacity” or “already achievable earnings power” or
whatever you want to call it is 10-15% higher than last year’s sales. In reality, I think the
Australia and New Zealand business might be as much as 20-30% of what Hilton is now doing in
Western Europe (Western Europe accounts for all of Hilton’s profit, so I’m ignoring other
regions). However, this is a 50/50 joint venture. So, I’m cutting that number in half. The
Brisbane plant is running already. New Zealand is under construction. The customer
(Woolworths – one of the two biggest supermarkets in Australia) had been working with Hilton
Food for over 5 years already and then agreed to hand over operational control of the joint
venture to Hilton, shift production to a much bigger facility (cap-ex was probably like $100
million USD on this thing) and sign a 15-year supply agreement with Hilton. Also, the annual
report specifically mentions that the retiring CEO was asked to stay on as executive chairman
instead of non-executive chairman (which is the much more common U.K. practice) till the
Australian operations had transitioned to this new setup. So, while I don’t usually like to put a lot
of weight on company guidance, my near term predictions, “forward” earnings, etc. I really do
believe here – and these numbers are my own made up figures, not management’s – that we need
to price Hilton Food as if it’s already doing 10-15% more business than it did last year. This is a
$100 million dedicated factory built for a customer they have a joint venture with and have been
working with for several years already. It’s a 15-year supply agreement. This isn’t speculative.
The business has already been won. We need to count it as part of future earnings power even
though it didn’t show up in last year’s sales figures.
This doesn’t make a huge change to EV/Sales. It lowers today’s price to somewhere almost
midway between 0.4x EV/Sales and 0.5x EV/Sales. To put it another way, that means our return
in Hilton Food will be dividend yield plus dividend per share CAGR over the years we own the
stock IF we sell out at a P/E multiple of something like 20-25x. A lot of value investors are
reluctant to assume you can ever count on a sale price that high. So, they’d need to assume the
return in this stock will be LOWER than dividend yield plus dividend CAGR.
For the rest of us, the total return equation is simple. Today’s dividend yield is 2%. So, we
should only considering buying the stock to the extent that:
Hurdle Rate – 2% = Expected Growth Rate
Imagine your hurdle rate is a 10% annual return. Then, the equation becomes
10% – 2% = 8%
Do you expect Hilton Food to grow sales, earnings, and (thus) dividends per share by 8% or
more for however long you own the stock? Yes. Then, you can buy it and expect 10%+ return.
No. Then, you have to expect worse than 10% annual returns if you buy in at today’s price.
Which do I think is more likely? Dividend per share growth greater than or less than 8%?
Historically, the company’s lowest sales growth period ending today is if we look back 5-9
years. Measuring from 5-9 years ago to today (longer than 9 years and shorter than 5 years would
both give higher CAGRs) would give us an 8% sales growth rate. However, there has sometimes
been share dilution of a little over half a percent per year here. Let’s round that up and deduct it
from sales growth to get sales per share growth of as low as 7%. Based on past experience, we
wouldn’t expect Hilton Food to grow much less than 7% a year. So, we wouldn’t expect a total
return much less than 2% plus 7% equals 9% a year. That might beat the market. But, there are
risks. Of course, over time, I’d expect dividends (or buybacks if the company ever starts doing
those in earnest) to grow faster than sales. This is because of ROE type considerations. If Hilton
only grew 7% a year for the next 10 years, it’d get seriously overcapitalized and need to use the
cash on something. As a result, it’d probably increase dividends faster than it grew sales. So, it’s
possible you’d still get a 10% or better return in this stock even if sales per share only grew 7% a
year.
A different approach would be to measure the longest CAGR period instead of the lowest. Going
back like 12 years, sales have compounded at 10% a year. Assume as much as 1% dilution. That
leaves 9% sales per share growth long-term at Hilton historically. This would give you an
expected return of like 11% a year (2% dividend yield plus 9% dividend CAGR).
So, I’m coming up with expected returns – if there’s no multiple expansion or contraction while
you own this stock – of like 9-11% a year based on Hilton’s past growth rates.
But, should we be using past growth rates?
That’s a tricky question here. Normally, I would always want to assume a lower growth rate over
the next decade than a company had this past decade. That’s a basic “compounding gets harder
as you get bigger” way of thinking about it. The weird thing here is that Hilton’s growth has
obviously accelerated in the last few years, they obviously increased cap-ex, they keep talking
about much faster growth for the medium term than they had in much of the past half decade to a
decade. I don’t want to assume more growth over the next 10 years than they had over the last 10
years. But, I’m not as confident as I often am in assuming growth can’t be much faster.
There are geographic reasons for this too. Hilton Food has zero presence in the U.S. It just
ramped up its presence in Australia in a big way. The truth is that all of Hilton’s earnings really
come from like 5 European countries where it serves like 4 major supermarkets. One of Hilton’s
customers does have a meaningful presence in the U.S. The U.S. is potentially a bigger market
than the combined European countries they are in now. And I can think of a handful of U.S.
supermarkets that would be viable targets for a company like Hilton. In addition to the national
or nearly national chains familiar to most readers there are the leaders in specific states. I don’t
know enough about the industry and Hilton’s competitors to know if it’d ever be possible for
Hilton to win a contract like Publix in Florida or H-E-B in Texas or something like that. Yes,
those are just two states out of 50. But, it’s easy to forget that the economy of Florida on its own
or the economy of Texas on its own is roughly the same as the economy of Australia on its own.
There are probably like 5 individual U.S. states that would be on par with medium sized
developed national economies. And there are 45 other states that are on par with small developed
economies. I have no idea if Hilton Food will ever break into countries like the U.S. or other
continents besides Europe and Australia. But, I do know that Hilton Food does not yet have a
presence in at least half – and probably a lot more than half – of what the addressable market for
retail packed meat will be 10 or 20 years down the road. So, I can’t rule out future growth rates
being similar to past growth rates.
We can also look at two other indicators of possible growth. Historical dividend growth was at
its lowest over the past 6-10 years. It compounded at 10% a year. Over the time since Hilton
Food started paying a dividend, its dividend per share CAGR has been 14% a year. So, past sales
per share growth would suggest 7-9% a year type growth rates while past DIVIDEND per share
growth would suggest more like 10-14% a year growth rates.
What about the bonus plan?
Hilton Food has an incentive plan tied to earnings per share growth. The number used is always
the 3-year CAGR ending this year. The plan was changed so part of the incentive compensation
is now tied to the stock’s return. Most is still tied directly to EPS growth. And historically it was
all tied to EPS growth. My reading of the current incentive plan is that Hilton “expects” (that is,
its goal is) a range of like 5-15% a year EPS growth. They’d have to do like 6% a year to get any
incentive compensation from this plan. And they won’t get any added bonus from doing better
than 15% a year. How does this compare to what the targets had been in the past?
It seems pretty much in line with their long-term goals. The company fiddles with this number a
little, raising it a couple percent sometimes and dropping it a couple percent sometimes. But, the
middle of the range is often around 10% give or take 2-3%.
Does the company usually hit the target?
It seems like an “honest” target to me. What I mean by this is that if we look at like 10 years, the
company seems to hit more what I’d call the middle of this range around half the time and
seriously miss the range (hitting the high and low edges) about a quarter of the time. This isn’t a
situation where if the company sets a 5-15% range they are hitting 15% all the time. This is more
like if they set a 5-15% range, you should take that as aiming for 10% a year as realistic based on
what the board knows about the next 3 years. That’s how I’d take it.
So, the bonus plan would seem to suggest you can get 10% type returns in this stock with
slightly below target growth of like 8% a year (quite near the bottom the EPS range – executives
need 6% to get paid extra for the EPS growth).
However…
I am already counting on like 10-15% growth tied to Australia. And that’s part of what the board
knows and expects. So, I wouldn’t put a lot of faith in a 3-year EPS CAGR target. You don’t
want to go into a stock thinking as short-term as what EPS growth will be for just these next 3
years. You want to be thinking more like: will this company still be growing in 10 years?
I think a 10% type hurdle rate is totally hittable for Hilton Food stock given today’s price. You
could buy it today and clear that hurdle based on like 8% growth in sales, earnings, dividends,
etc. per share. I think the company could do that. This is a growth company. It may continue to
grow at those rates for the next 10+ years. You might get a chance to sell out of the stock at a
P/E of 25 or higher. Despite this looking like a very expensive stock – I think it can give you a
double digit annual percentage return if you buy in today.
But, that’s just the return. What about the risk?
Hilton Food isn’t a government bond. It has risks.
The biggest risk is customer concentration. Customer concentration here is absolutely extreme.
Here is my best guess of how much of Hilton’s business is done with each of its biggest
customers – excluding Woolworths (which would appear in this list at some point, but not yet)…
Tesco: 55%
Ahold: 19%
Coop Danmark: 13%
ICA Gruppen: 6%
You should probably view this like a stock portfolio. I believe Hilton Food is so decentralized
that each of these 4 customers are served on a dedicated basis as an individualized profit center
run on a long-term basis (these are 5-15 year supply agreements) by a manager who is effectively
like a CEO of that unit.
These are not new relationships. Hilton Food started out even more concentrated than it is to
Tesco, because the company’s origin is a plant built in the mid-1990s to retail pack meat for
Tesco.
In recent years, Hilton has branched out into seafood, vegetarian meals, sous vide, etc. My
impression is that profit comes disproportionately from retail packing red meat. I don’t have any
good insights into this. But, it’s just my impression that the highest value add least commodity
thing you can do in this industry is providing like 100% of the retail packing of red meat for one
supermarket.
Hilton Food does not break down contracts by customer, year they expire, whether they are done
on a “packing rate” or “cost plus” basis etc. I believe the company tends to make something like
the equivalent of 8 American cents per pound of meat it packs. I’m not confident in that number
being stable at all from year-to-year. But, if you told me it was a lot lower than 4 American cents
per pound or a lot higher than 16 American cents per pound – I’d be skeptical.
Compare this to the price of various store brand packaged meat cuts you can buy – and you can
see this is potentially a good deal for the customer. The biggest cost in the entire chain of
production is the commodity cost of the meat. After that, the biggest cost at the actual Hilton
plant is labor. I think the labor component is greater than 3 times the amount retained as profit by
Hilton (in other words, if they are marking 8 cents per pound – I think workers contributing to
that cut of meat are making 25 cents per pound). From what I’ve seen, Hilton is a lot more
aggressive in investing in labor saving automation (robots) than a lot of meat packers would be
and certainly than the customer would be if running a plant themselves. I just can’t imagine
many competitors running the plants in the U.K., Ireland, Netherlands, Australia, etc. (Central /
Eastern Europe is different) with less labor than Hilton does. Also, a dedicated plant should have
the lowest shipping costs of any solution I can think of. Any plant that serves multiple customers
can’t have lower shipping costs than a plant that is only delivering direct to your distribution
centers and your stores.
What do I think the customer cares about here?
My guess is that the customer wants continuously lower real costs per pound to the extent
possible. I think this largely means removing more and more of the labor component of each
pound of meat. I also think the customer cares about food safety, recalls, bad publicity, etc. (this
is all sold under their store brand – nothing is Hilton branded). Again, I think reducing the labor
component increases food safety. Robots don’t mind working in cold temperatures. Employees
do. And employees touching meat can increase the risk of contamination. As far as sourcing the
product – I believe the customer does this with Hilton or even directs Hilton how to source it. I
don’t believe Hilton is making any final and independent decisions on where to get this meat
from. I believe Hilton is packing meat where the supermarket has chosen or co-chosen the source
of the meat.
There are risks here. And possible returns look more like 10% returns not 20% returns. But, it’s a
very predictable company. And it’s very insulated from both competition and macroeconomic
ups and downs. The stock doesn’t look cheap on any of the usual measures (P/E, P/B, etc.).
Nonetheless, if this was a $10 billion company instead of a $1 billion company and someone
offered to sell it to Berkshire Hathaway – I think Warren Buffett would definitely take that call. I
don’t know if he’d buy it at today’s price. But, I’m sure he’d be very, very interested in this
business model.
Geoff’s Revisit Price: 600 pence (down 45%)
 URL: https://focusedcompounding.com/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-expensiv/
 Time: 2020
-----------------------------------------------------
Hingham Institution for Savings (HIFS): A Cheap, Fast Growing Boston-

Based Mortgage Bank with a P/E of 9 and a Growth Rate of 10%
This is the one “higher quality, more expensive” bank I mentioned in the podcast Andrew and I
did where we talked about like eight or so different U.S. banks. Hingham’s price-to-book (1.7x)
is very high compared to most U.S. banks. It is, however, quite cheap when compared to U.S.
stocks generally. This is typical for bank stocks in the U.S. They all look very cheap when
compared to non-bank stocks. There are many different ways to calculate price multiples: P/B,
P/E, dividend yield, etc. The easiest way to calculate a high quality, stable, growing bank’s
cheapness or pricey-ness is simply to take the most recent quarterly EPS and multiple it by 4.
You then divide the stock price into EPS that is 4 times the most recent quarterly result. The
reason for this is that bank’s aren’t very seasonal. But, sometimes events – like COVID – and
normal growth (HIFS is a fast grower) can cause the full past twelve month earnings figure to be
out of date So, how cheap is HIFS?
“Core” earnings per share in the most recent quarter – I’ll discuss what “core” means at Hingham
later, but for now trust me this is the right number to use – was $5.68. Multiply this by 4. We get
$22.72 a share. That’s our 12-month look ahead “core” earnings. The stock now trades at $206 a
share. So, $206 divided by $22.72 equals 9. Hingham is trading at a “forward” P/E of 9. The
“PEG” ratio (price-to-earnings / growth) here may be around 1 or lower. Hingham compounded
book value per share by 15% a year over the last 5 years. Growth rates in the 10-15% range have
been common since this bank’s management changed about 30 years ago. A lot of balance sheet
items – like total assets, loans, and deposits – all grew about 10%+ over the last 12 months. So, a
growth rate of about 10% and a P/E of about 9 seems likely here. One thing to point out is the
high return on equity. Core return on equity is running at about 18% here. If ROE is about 15-
18% while growth in loans and deposits and so on is in the 10-12% range, then the bank will
eventually need to pay out one-third of its earnings as dividends and buybacks. Historically, it
has not done this. It has found ways to grow much faster than the area (Boston) in which it
operates and much faster than the balance sheets of its existing clients. Usually, that kind of thing
can’t be kept up forever. Once that kind of growth can’t be kept up, the bank either becomes
overcapitalized or it pays out a lot more in dividends and in buybacks. This brings up the other
way we can look at a bank like Hingham. We can think in terms of dividend yield and growth.
So, let’s say the dividend yield is 1%. The question then becomes how much do we think that
dividend will grow? If we think the bank will grow earnings by 10% a year – the dividend will
need to grow faster than 10% a year. So, your total return looking at dividends plus growth (and
buying at a 1% dividend yield today) would be higher than 11%. However, this return would be
skewed almost entirely to growth (like 90% or more of your return would come from the rate at
which your dividend stream was growing, not from the initial dividends you received). It’s worth
mentioning that I suspect Hingham will pay more out in dividends (some will be special
dividends) than is suggested by the regular dividend yield you’ll see if you look up this stock.
So, I’m not sure the dividend yield you’ll get to start is really as low as 1%.
Okay. So, Hingham is cheap versus its annualized forward looking “core” earnings. But, what
are these core earnings?
Hingham has a stock portfolio. “Core earnings” are simply earnings excluding the quarterly
mark-to-market unrealized gains and losses that occur in the bank’s stock portfolio. Hingham
keeps about 20% of its book value in stocks. These are almost all individual stocks chosen by the
bank’s top management. Technically, the company holds a mutual fund. However, I believe this
is done because of how this mutual fund’s activities qualify and how that helps a bank. It’s a
point not worth getting into here. All you need to know is that the presence of that one mutual
fund is non-economic. It’s not on the books because the bank’s management likes it as an
investment. So, 100% of the bank’s stock portfolio (which is 20% of the bank’s equity) is
invested in specific stocks the management likes. We’re told these stocks are concentrated in
financial services, information technology, etc. and are thought of as long-term investments. In
particular, the investments seem to be in stocks where Hingham’s management likes the capital
allocation decisions of the management at the stocks they’ve invested in. This is because
Hingham mentions an added benefit of their equity portfolio is the ability to observe the capital
allocation decisions of the management teams at the companies they’re invested in. We don’t
have much information on whether Hingham’s portfolio is “Buffett like”. But, it’s possible it is.
How important is Hingham’s stock portfolio?

Not very. Hingham’s core banking business is 80% of book value. Furthermore, Hingham’s core
business is so profitable it’ll blow away returns in the stock portfolio. The bank can sometimes
make 18% a year. A stock portfolio can’t do that. So, assume the bank does 18% ROE and is
80% of book value. That’s 18% * 0.8 = 14.4% book value growth contribution. Then assume the
stock portfolio has a 10% CAGR and is 20% of book value. That’s 10% times 0.2 equals 2%
contribution to book value growth. Over time, book value – before dividends – could be capable
of growing like 16% here. However, only 2% of that growth would come from the stock
portfolio. In other words, Hingham is probably like 85% a bank and 15% a stock portfolio as far
as an investor in the company is concerned. Therefore, it’s fine to just ignore the stock portfolio
entirely.
What kind of bank is Hingham?
It’s not much of a deposit gathering operation. It’s basically a mortgage lender. And this is where
my discussion of the stock portfolio might be relevant. I think the presence of that portfolio is a
potential marker of how management thinks about capital allocation, compounding, etc. I don’t
think the portfolio itself matters much. But, it does fit the overall mix of assets we have here at
Hingham.
Hingham is a very efficient mortgage lender. It has an incredibly low – just about the lowest
you’ll see – efficiency ratio. The industry calculates the efficiency ratio as operating expenses
relative to revenue. I don’t like that measure so much (it is hard for most banks to control
revenue). I prefer operating expenses divided by earning assets. So does Hingham’s
management. For example, they’ll say something like operating expenses are now 0.8-0.9% of
our loans. At Hingham, loans make up almost all earning assets (the company really doesn’t own
debt instruments of any kind except to manage liquidity). For a bank, the “spread” they need to
earn is not the net interest margin quoted everywhere on financial websites. It is the yield (after
charge-offs) on the loans (and securities – which don’t matter at HIFS) vs. the total cost of
funding which is the non-interest expense (the 0.8-0.9% I mentioned earlier) plus the amount
paid in interest. So, imagine the bank is paying you 1.2% a year on your CD or whatever and
then it has an added 0.8% in operating expenses. It is digging the commodity called money out
of the ground at a price of 2%. If it then turns around and lends at 4%, it is making 2% a year.
Hingham really has just 3 advantages I can see in terms of how it achieves its higher ROE than
other banks.
One, Hingham has a lower non-interest expense (it’s more efficient) than other banks. So,
excepting interest, Hingham is a “low cost producer” of money.
Two, Hingham makes loans in two categories – mortgages on houses and mortgages on
apartment buildings – that have lower charge-offs than other forms of lending. This means the
yield on these loans NET of charge-offs is likely to be higher than it appears. For example, if you
make construction loans at 5% a year interest and mortgage loans at 4% a year interest – the
outcome is likely to be pretty similar (maybe 3.8% a year in both cases) net of how much you’d
need to charge-off each year. In fact, the relative position of mortgages versus construction loans
may be better than I just described. It’s likely construction loans default at a rate of like 5-6 times
mortgage loans. But, it may also be the case that defaulted mortgage loans can be collected on –
once the foreclosed property is sold, etc. – at a better rate than defaulted construction loans.
Three, Hingham’s mix of loans and securities is skewed almost completely to loans.
We can simplify these 3 points down to: 1) Hingham is a low cost producer of money (excepting
interest costs), 2) Hingham has lower charge-offs than other banks, 3) Hingham has a better
“asset mix” than other banks. Loans have higher yields than securities.
But, is what Hingham is doing dangerous?
It’s a highly, highly, highly non-diversified bank. I ran some estimates and came up with the
overall guess that between half and two-thirds of Hingham’s entire balance sheet is made up of
mortgages on housing in the Boston area. That’s it. Now, some of this housing is single-family
owner’s primary residence. Some of it is a vacation home. Some of it is a speculative investment
property. Some are small multi-family investment buildings. Some are bigger apartment
buildings. But, we are talking about a majority of this bank’s balance sheet being in a small
section of Massachusetts and being entirely tied to mortgages on buildings people live in.
The good news is that houses and apartment buildings are not correlated assets. They’re a little
correlated (almost everything in banking is a little correlated). But, if you were told that losses on
home mortgages jumped 6 times in a given period – this might only suggest that losses on
apartment building backed mortgages jumped 2-3 times. If you were looking for just two asset
groups that both have low full-cycle charge-offs and yet also are not that correlated with each
other – I can’t think of a better 50/50 mix to choose than mortgages on houses and mortgages on
apartment buildings.
Having said that, Hingham is not quite that evenly diversified. Over the last 5 years, they’ve
moved more and more into commercial (what I’m calling “apartment buildings”) and less and
less into houses. Recently, they reached 60% commercial and 30% residential. Also, you have to
throw in about 8% construction. Some of that construction is really of a residential nature. But,
for risk purposes it really belongs more with commercial in the sense it’s not a very good
diversifier in times of trouble.
So, it’s kind of like Hingham has let itself shift from a 50/50 mix to more like a 60/40 or even
70/30 mix.
It’s important to keep an eye on this, because Hingham is basically 100% loans. In fact, loans are
higher than deposits because the company is willing to borrow to fund loans.
An easy way to explain this is to look at construction lending at Hingham vs. energy lending at
Frost. A lot of investors got concerned when Frost was at around 16% energy as a loan category.
However, the bank was 50/50 between loans and securities. So, 16% of 50% is only 8% of the
balance sheet. Hingham may be only 8% construction. But, if that is 8% of 100% – that’s still
8% of the balance sheet. Hingham is also a tad more leveraged now than Frost was then (in terms
of assets/equity). So, I’d say the actual risk Hingham is taking in construction loans is a tiny bit
higher than Frost was taking in energy loans when that bubble burst. I don’t expect construction
in Massachusetts to burst. I’m just pointing out the fact that it is important for Hingham to
maintain adequate diversification among its two fairly low correlation types of loans. The bank
would become much riskier if it was ever 80% commercial and 20% residential or 20%
commercial and 80% residential. This is because it doesn’t mix securities with loans. It just does
loans.
Finally, although construction loans are often one-fifth or so the size of the next biggest loan
category – construction loans may account for a similar dollar amount of charge-offs at HIFS vs.
the other categories. Let’s say residential is 30% and construction is 8%. Well, if construction
loans have 4 times the charge-offs as a percent of principal as the residential mortgages (which is
very possible), then losses from construction and residential will be equal.
For these reasons, I think it’s important to watch Hingham’s construction lending percentage
(will it stay below 10%) and watch the difference between its commercial and residential
lending. The safest mix would probably be construction less than 10% and residential and
construction lending within about 10% of each other. For example: commercial (50%),
residential (40%), construction (10%).
There is a lot more to talk about with Hingham. For example, is the high ROE of this most recent
quarter sustainable? Short-term rates dropped to nothing while a lot of long-term loans are more
fixed for now. If rates stay this low for a long time – will Hingham’s margins and thus ROE
eventually come back down to Earth?
But, this is a long enough initial interest article as it is. So, I’ll re-visit Hingham another time.
For now, I haven’t learned enough about the bank to buy it. It is a cheap, fast grower though.
 URL: https://focusedcompounding.com/hingham-institution-for-savings-hifs-a-cheap-
fast-growing-boston-based-mortgage-bank-with-a-p-e-of-9-and-a-growth-rate-of-10/
 Time: 2020
-----------------------------------------------------
Hingham (HIFS): Good Yield Curve Now – But, Always Be Thinking About
the Risk of the Bad Yield Curve Years to Come
I’m writing again about Hingham (HIFS), because someone asked me this question:

I was wondering how long it would take Geoff to talk about Hingham savings, seems to tick all
his boxes – very low cost of funding on the operations side and a capital conscious manager
with Buffett fetish. What more could you want ?
It does have a very low operating cost. But, it doesn’t have a very low interest cost. It does now
that rates have been cut to nothing. But, it probably got down to about a 2% net interest margin
just before the end of the housing bubble about 13-14 years ago. It had a very rough 2006-2007.
So, the bank is set up very differently than most banks I would be interested in that I’d consider
very safe. Hingham is running some serious risks by being 100% real estate focused. This is
because you end up with almost no “self-funding” of your lending, because your borrowers are
going to be small to mid-sized (and maybe a couple big sized) relationships where they just want
a lot of money all the time to invest in more and more real estate. They aren’t going to deposit a
lot of money with you. Compare this to something like the C&I side of Frost where it is going to
be about 100% funded by an equal amount of deposits and borrowing coming from your
customers on the commercial and industrial side. So, something like Hingham is going to need to
use CDs and FHLB borrowing to operate. It is going to be very, very sensitive to cost of
liabilities on the very short-term. What it is basically doing is borrowing short wholesale and
then lending long against real estate. That’s very good right now. It’s just gotten to be a lot better
business, because the cost of its liabilities has dropped to close to 0% with Fed Fund Rate cuts in
the last year. But, that is going to be a temporary situation.
So, what more would I want to know?
Does the bank understand how it is running a unique business model that has unique risks in
terms of liquidity. Like, do they understand that they can have almost no credit losses and the
lowest operating expenses in the banking industry and STILL face some risks? If they said to
me: “Oh. We don’t really worry about that liquidity stuff. There’s always been funds available to
borrow. Etc.” Then, I might worry.
I kind of follow the Buffett approach that Alice Schroeder has talked about where I START with
asking “what’s the catastrophic risk here?” and then go from there. So, if I think there’s a
meaningful risk of catastrophe – then, I might pass on an idea right away that looks like it might
have good risk/return odds in most environments, but could go broke in unusual circumstances.

What are the unusual circumstances that are a risk here?
Inverted yield curve.
HIFS would have a very hard time dealing with an inverted yield curve that lasted for a long
time. Now, usually – at least, historically – inverted yield curves have not lasted very long. But,
HIFS has gone more and more in a direction that sets it apart from other banks.
So, if you look at their most recent quarter – I think they had about 8% of their balance sheet in
what I’d call “cash” and then about 2% in liquid equity securities. So, you have about 10% of the
bank’s balance sheet that is kept liquid. And then you have about 90% in a mix of residential and
commercial real estate loans. These aren’t liquid. They are long-term. The bank has basically
eliminated the presence of any sort of bond portfolio at all. Most banks have a meaningful bond
portfolio. This bank is primarily a lender – it doesn’t see itself as something that should have a
bond portfolio.
The simple way of looking at that is asking is it good or bad?
The answer to that simple question would be: “it’s good”.
A liquid equity portfolio of $50 million in common stocks is a better long-term asset (it will
compound at a higher rate) than a government / agency / municipal / etc. bond portfolio of $50
million. I mean, you could get capital gains / dividends of $2.5 million to $5 million a year (like
$1 to $2.50 a share in annual “comprehensive earnings”) coming from an equity portfolio and
much lower from a bond portfolio. So, over time, a bigger weighting to equities instead of
securities is better here.
And then, of course, the loan portfolio will have a higher yield (net of losses) than a bond
portfolio would have. However, the loan portfolio has to be seen as illiquid. So, this is a
leveraged and illiquid entity.

It also, because it’s 100% a real estate lending business, always going to be borrowing short and
lending long.
So, I look at the 25+ years this bank has been operating this way and think: has this been a good
time generally to be borrowing short and lending long?
And the answer is, with the exception of the housing boom – yes, it is.
So, does that mean the past record isn’t a good indicator of the future?
Well, for the immediate future: it’s fine. The immediate future at HIFS will be excellent. But,
what if short-term rates rise a lot vs. long-term rates and stay that way for a long time.
My feeling on that after analyzing the bank – by “analyzing” I just mean I read everything on
their IR page (so 25+ annual reports, presentations to shareholders, etc.) that the bank is in a
better position now than it was in 2006-2007.
ROE probably dropped to like 8% or so in 2006-2007.
That’s not a total deal breaker for a bank.
But, if you’re talking about paying 1.7 times book for something that will sometimes return 8%
on equity. That is a deal breaker if there are a lot of those years. If we divide 8% by 1.7 we get
about 5%. Now, do I think equities will do much better than 5% in terms of indexes and such
over the next 10 years?

Maybe not. But, indexes might do somewhat better.
Okay.
But, what if there’s a period where short-term rates are high and long-term rates are low relative
to short-term rates (not inverted for 10 years, but a “flat” curve).
Well, indexes and stocks generally probably won’t do too well. And they might not do better
than HIFS.
And then if you have a steeper curve – HIFS will do a lot better than index funds even if you buy
at 1.7 times book value.
When looking for a stock, I generally want two things:
1) A really low risk of “catastrophe”
2) A reasonable chance (always hard to define this in terms of probabilities) of getting a 10x
return in 15 years (that’s a 17% CAGR for 15 years)
We could simplify #2 for rounding purposes to basically asking:
– Can this stock (under some reasonable scenario) compound at about 15% a year for about 15
years?
It doesn’t all have to be from compounding of book value. Some could be from dividends. And
some could be from multiple expansion.

Let’s take a look at Hingham.
How close can it get to returning 17% a year over the next 15 years.
Dividends can add: 1% a year (based on recent dividend yield)
Multiple expansion (higher P/E at end of the 15 years) can add: 3-4% a year (P/E goes from
about 9x forward now to about 15x forward at the end of the period)
That gets me to just a 4-5% return.
Now, we need compounding of about 10% a year.
BV has compounded here at 15% a year for a long time. So, sounds okay.
But, the balance sheet has expanded to a pretty big size now. So, it could be harder to grow.
Can they keep dividend payout ratio at like 30-45% for the next 15 years?
Given their historical and current ROE and dividend payout and growth…the answer would be
basically yes.
If ROE is about 15-18% and dividend payout is about 30-45%, growth can be about 10% a year
in BV (that 10% a year is what’s left over if you do 1-dividend payout ratio).

Then, there’s the question of leverage.
Can the bank’s leverage ratio stay about even or rise over 15 years?
Seems as likely to rise as fall. Seems like a normal level.
So, answer is yes.
So, I’d say you can look at the past record and try to learn about the bank and talk with
management – and, yes, you get an answer where 15% a year return in the stock (but not the
actual business itself) is in line with expectations over 15 years.
It hits my return threshold.
But, does it clear the risk threshold?
We can’t predict the future. And I don’t start by saying: “What do I think the yield curve will
look like for the next 10 years?”.
Instead, we have to just weigh the possibilities of whether a damaging yield curve is likely for a
long time. And whether trouble accessing capital is an issue.
So, then, the questions generally end up being focused on things like:

– Can you cut costs further over time (if net interest margin got to 2% before, but you can take
another 0.4% out of your operating expenses that can make it like net interest margin is
equivalent of 2.4% now vs. then).
– Is the bank in any way reckless about liquidity risk
They aren’t reckless about credit risk. I know that from talking to them. I know that from the past
record more so than anything else.
But, they’ve had success being completely in real estate lending for 25+ years and getting a less
and less liquid balance sheet over time. So, it’s easy for inertia to set in and believe in your own
success and end up thinking: “We always run this kind of liquidity risk – it’s never a problem.”
So, the answer is what more can I know?
I can know: how serious are they about managing their liquidity risk. How vigilant will they be
even after many, many years when they run this risk and face no negative consequences from it.
And I can also ask about things like deposits. Can you grow deposits over time in your
“specialized deposit group” and things like that to do anything to lessen these risks.
What you want to hear is that they are vigilant. They know it’s a risk they are running that some
banks aren’t. You want to hear they are serious about growing the specialized deposit group.
And you want to know they are serious about continuing to take costs out of the business to
make the really, really flat yield curve years (and especially the periods where the curve is
inverted) survivable.
The risk that I see with Hingham is just that you could encounter a period with the yield curve
that is so bad for borrowing short and lending long and more importantly – lasts so long – that it
permanently alters their compounding rate. If every couple decades you hit two years where
ROE goes from 15% to 7.5% for two years – this is something that can be overcome. But, you go
much beyond that (if these moments occur more frequently, if they last longer, etc.) you have a
problem for long-term compounding.

Take costs out is an important part of that. If the next really tough period is 10 years from now
and they manage to lower operating expenses from 0.8% of assets today to 0.6% of assets in 10
years – then your ROE could go from 7-8% in those bad years to 9-10%. I can easily live with an
ROE close to 10% a year for several years in a row.
But, if it goes the opposite way – where they aren’t vigilant about costs and they allow operating
expenses as a % of assets to creep up from 0.8% to 1.1% or something – now, you are (other
things equal) at a sub 5% ROE. If you have to live through a period like that which last 3 years
or so on average – it makes a big difference whether the results are 15% ROE 15% ROE, then
5% and 5% and 5% and back to 15% vs. 15% ROE, 15% ROE, then 10% and 10% and 10%.
Connected to this.
What about dividends and share buybacks?
What I want to hear is that we don’t want to keep raising our “regular dividend payout ratio”
(HIFS does a special dividend too) and we want to add stock buybacks to our arsenal.
This is really important in bad yield curve years. Because what would happen if you had a 30-
50% regular dividend payout all the time you never were willing to get away from is that you’d
spike to like 65-100% dividend payout in the bad years.
If you’re willing to really keep the dividend payout low and to consider stock buybacks, then you
can buyback your stock in the bad years.
Aside from one-time events like COVID earlier this year – my guess is that the forward return
expectation on HIFS stock will exceed the returns in the business only in these inverted or flat
type yield curve situations.

So, it’s possible that you can do your best capital allocation in bad yield curve years in the form
of buying your own stock. This is because the decision of whether or not to buy the stock should
be based on solving for this inequality:
Long-Term ROE Average / (P/B) > Expected Return on Index?
For today, assume:
15% ROE
1.7x P/B
“x” expected return on index
15%/1.7 = 9%
It’s not as simple as I laid out. But, we can simplify to 9% in the sense that if 9% is greater than
return in the index and we buy – we haven’t made a mistake. The mistake we could make due to
our oversimplification is only NOT to buy HIFS when we should not the other way around.
So, for today – the inequality simplifies to 9% > S&P 500 forward return?
Yes or no?
My gut says yes. But, you can answer for yourself. I don’t really look behind 15 years when
thinking about a stock investment. So, when I say “forward return” on S&P 500 – I mean from
2020-2035 or so. Will it be 9% or higher (and will HIF’s geometric ROE – not arithmetic – be
15% or higher).
How does this influence the buyback math?
Say you expect an 8% return in the S&P 500 normally. Your stock has a normal ROE of 16%.
Then, your stock might be “fairly valued” around 2x P/B.
So, buybacks at small discounts to 2x P/B aren’t a big deal. Do them. Don’t do them. Who cares?
I mean buying back 2% of your stock at 1.8 times P/B isn’t going to move the needle for your
shareholders. But, having a chance to buyback 10% of your shares at 1x P/B really does move
the needle.
Will you ever get such a chance?
Right now, it seems like the answer would always be no with a stock as well thought of (in terms
of P/B multiple premium over other banks). But, let’s consider when this opportunity could
present itself…
…What if the market responds more to the CURRENT return on equity you have instead of your
long-term average. You ROE drops from 16% to 8% and the stock also drops by almost 50%.
This sounds crazy. But, it means the market would be keeping a constant P/E on the bank.
Personally, I think using a P/E from a non-representative year of ROE is crazy. But, I can
imagine it happening. Sometimes, even stocks see their P/Es contract in an especially low ROE
year – which means the “normalized P/E” has plummeted tremendously.
Well, now, your stock is very undervalued. Because the yield curve will change again and you’ll
again be making more like a 16% ROE than an 8% ROE.

You shouldn’t be paying dividends then. You should be buying back your stock.
So, the “more” I want to learn is:
– How seriously do they take liquidity risk?
– How low are they willing to keep dividend “commitments” to shareholders?
– How willing are they to do big share buybacks instead of dividends?
– How focused on growing the specialized deposit group are they?
– How focused on continuing to lower operating expenses even if they are the best of class in
this area already?
– Finally: how good are they are thinking about catastrophic risks when year-after-year they are
running risks that don’t show up in results at all
The hardest one is the last one. If a business has no ill-effects from some risk it is taking for like
10+ straight years – that risk becomes invisible to most managers. It takes very, very special
managers to remember they are running invisible risks that no one is thinking about or has
thought about for many years.
So, vigilance and honesty about something that can’t be seen in the actual past experience record
is really the #1 thing.
I can see how a bank like HIFS could be run well and have a great compounding record for a
long time and then be undone by a risk “no one saw coming” – even though everyone should
know it will come someday. It’s a super infrequent risk. But, it has a high magnitude of loss in
that moment when it does happen. So, you don’t want management at someplace like HIFS to
just wave off the idea of longer-term inverted yield curve than we’ve ever seen before. You don’t
run the business every day thinking about that. And you shouldn’t. But, it’s very easy to just
assume you will never face the one catastrophe that could undo everything you’ve done over a
lot of years.

So, I guess judging vigilance for a seemingly “invisible” risk is the more I want to know.
 URL: https://focusedcompounding.com/hingham-hifs-good-yield-curve-now-but-always-
be-thinking-about-the-risk-of-the-bad-yield-curve-years-to-come/
 Time: 2020
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IEH Corporation (IEHC): May Be a Good, Cheap Stock – But, Definitely in

the “Too Hard” Pile for Now
As this is an initial interest post, it’ll follow my usual approach of talking you through what I
saw in this stock that caught my eye and earned it a spot near the top of my research watch list –
and then what problems I saw that earned it a low initial interest score.
I’ll spoil it for you here. IEH Corporation (IEHC) is a stock I’m unlikely to follow up on
because of the difficulty of digging up the kind of info that would make me confident enough
about a couple key problem areas I’ll be discussing below.
I think I have a pretty biased view of this stock. Or, at least, some of what I’ll be discussing in
this article might give you a negative, biased impression of the stock. And there are actually a lot
of good things here. So, I’d like to start by linking to some bloggers who have discussed this
stock in-depth in a way that’s different from some of what I’ll be focusing on here.
I recommend you read theses posts:
“My Trip to the IEHC Annual Meeting” – Bull, Bear and Value (2014)
“Why I Bought IEHC” – Bull, Bear and Value (2013)
“IEH Corporation (IEHC)” – OTC Adventures
“IEH Corporation: A Tiny Company with the Potential for a Big Dividend” – Weighing
Machine (2013)
“Recent Numbers at this Company Say Buy, Hand over Fist” – Dylan Byrd (2015)
“IEH Corp (IEHC)” – Value Investors Club (2013)

In case you chose not to click those links, I’ll give you a quick explanation for why I might be
interested in this stock at first glance.
It’s Overlooked
The stock is overlooked. I manage accounts that focus on “overlooked” stocks.
This stock has a $40 million market cap – of which, probably close to 50% doesn’t actually trade
(it’s owned by insiders, etc.). So, we’re talking about a “float” of about $20 million or $25
million. Something quite small.
The company also does something quite boring. It makes connectors which go into products
assembled by defense contractors serving the military, space, and aerospace industries. Investors
would know the end products this company’s output goes into – Boeing 737, Airbus A380, F-35,
Apache AH-64, Hubble Telescope, etc. And investors would know the customers who buy
connectors from IEH – Raytheon, Northrup, Honeywell, Lockheed, NASA, etc. But, neither the
company itself nor the products it produces would be high visibility to investors. I find this tends
to make it more likely a stock is overlooked. For instance, in the movie industry – investors
would focus immediately on the theater owner, the studio producing the film they’re watching,
etc. and less on the companies that make the theater’s sound systems, digital projectors, etc. or
provide the ticketing kiosks or run the theater’s loyalty program.
In this way, IEH Corporation could be something like George Risk (RSKIA) – a company that
has a market cap of under $50 million, is about half owned by insiders (so, the float is even
lower), and makes a product that is far enough upstream in the chain of production that investors
have never thought about it.
Product Economics Could be Good
The product economics of something like what IEH makes can be good. Bear with me, because
this gets a little theoretical. But, if I haven’t seen a stock at all – read about its industry, what it
does, etc. in any detail – I can still form some very rough opinions about the basic
microeconomics of what it is involved in. Right off the bat, you get some ideas about how capital
intensive producing a certain product could be, how critical it is for the customers who buy it,
how big a cost item relative to the projects it is going into it is, how high-tech or low-tech it is,
how likely it is to face competition from imported products, how “sticky” the product could be
for its customers, etc.
A one sentence description of what IEH Corporation does is enough to give me the impression
that “hyperboloid” connectors could be a good product to make because they are a “high-
reliability contact system ideally suited for high stress environments” and that commercial
aerospace is 35% of total sales and military is 45% (space is another 10%). The relative size of
IEH and how fragmented its sales are by customer relative to the size of the projects it says these
connectors are being used in also suggested to me that the products IEH sells are a very small
part of the overall cost of the projects it is used in. These connectors are not a large part of the
cost of a helicopter, jumbo jet, fighter plane, or something you’re launching into space. So, I
immediately got the impression this could be a business that isn’t especially high tech nor
especially low cost driven. It’s the kind of business where reliability, compatibility, past
experience, etc. might be determining factors.
The company’s actual economics are not as good as something like George Risk, though. For
example, the gross margin of this business has never been that high for a manufacturer. You will
often see a gross margin in the 30% – 40% range for IEH. Something like George Risk probably
is 50%+ in its core product. There are lots of possible explanations for why this might be. For
example, George Risk has a completely non-unionized work force based in Nebraska whereas
IEH has a completely unionized work force based in Brooklyn, New York.
The Business Might Not Be Economically Sensitive
Demand for products in the military, commercial aviation, and space industries does bounce
around. It doesn’t have the stability of consumer non-cyclical products or something like that.
But, it’s also not tied to the same economic cycle that most stocks in a portfolio I put together
likely would be. For example, there is a stock in the managed accounts that depends in some part
on volume in stock market trading. That’s very tied to consumer confidence, a buoyant stock
market, etc. For most portfolios, adding a company that gets almost all of its profits from
customers in military, air, and space is going to be a diversifying selection. So, it’s usually a
plus.
The Business Might Be Scaling Up Nicely
Again, this gets a little theoretical. But, there’s a huge difference between growing sales from $2
billion to $20 billion and from $2 million to $20 million. There just aren’t many economies of
scale gained by going from $2 billion to $20 billion. There are a lot of economies of scale when
you go from doing $2 million in sales to $20 million. You probably don’t need 10 times the
number of top executives, 10 times the square footage, or 10 times the costs of being a public
company filing with the SEC when you go from $2 million to $20 million.
So, I get excited when I see a company growing sales a little but growing earnings a lot – if I
know that isn’t a cyclical expansion in earnings, but a result of continuous economies of scale as
a very small business becomes a much more middle sized business.
The EV/EBITDA Looked Reasonable

This one isn’t worth talking much about. I’ll just say the EV/EBITDA, P/E, etc. on this one was
about as low as you’d expect on a no-growth microcap stock in today’s high valuation stock
market. The past history here was good. It was growing. The business seemed to be getting better
over time.
Liabilities Were Nearly Nil
This is a big one. IEH showed $2.3 million in total liabilities against $1.4 million in cash and
$4.6 million in receivables. Cash and receivables covered all liabilities nearly 3 times. This
means whatever the inventory is worth or not worth, whatever the equipment is worth or not
worth – it doesn’t much matter in terms of the safety of the common stock here. The default risk
here should be very low. It could survive some small losses. I can’t overstate how helpful it is to
find a stock with very, very low liabilities relative to cash, receivables, “normal” earnings, etc. It
means the company could pay dividends, buy back stock, acquire things, etc. while you own it
through the use of debt instead of issuing stock. It also – just as importantly – means you could
misjudge the company’s future earnings badly and still never get close to a 100% loss in the
stock.
Share Count Stayed Exactly the Same For Close to 25 Years
This is another point I can’t overstate. Most public companies – and this is especially true of big
public companies – have a significant amount of drag on their annual per share growth caused by
an increasing share count. Some companies buy back stock. But – very, very few companies
simply never issue shares. Now, as I write this, IEH actually does have some stock options out
that will dilute shareholders. So, yes, they have now grown the share count to give more stock to
management. However – despite having a stock option grant plan that would’ve allowed them to
grow their share count – this company did not increase its share count one iota throughout the
1990s and 2000s. You can read the company’s 1995 10KSB (a form of the 10-K used by small
businesses) which shows the share count for 1994. You can then check the share count shown in
every 10-K thereafter – it is always 2.3 million shares. This is a big deal. Compared to most
stocks in your portfolio, you’ll find that a zero share issuance policy over time will add probably
a bit over 1% per year to your annual returns in a stock. In other words, your portfolio is
probably – before buybacks – transferring about 1% of your stock ownership to management
each year. When a company closely guards its own shares – I take notice. This is especially good
news if you’re looking at a high ROC stock. The worst thing a great business can do is use its
own shares to acquire other companies. That dilutes the good economics shareholders are buying
into. This company kept its share count steady for about a quarter century. That definitely got my
attention.
However, some other things got my attention in a bad way. We’ll deal with those now.

The Auditor Issue
I don’t short stocks. And I don’t talk about a company’s auditors in my write ups. I think
discussions of changes in auditors, who is auditing a firm, etc. tend to play towards the
conspiratorial mindset that some investors have. They’re afraid not just of losing money – but, of
being made to look foolish by a fraud.
Despite not talking about auditors with you – because, in almost all the stocks I’ve written up
whatever I know about the auditor is irrelevant or at most inconclusive when it comes to my final
appraisal of the stock – I am going to talk about IEH’s auditor.
In the company’s SEC filings, it just has the normal boilerplate language describing how the
company’s long-time auditor, Jerome Rosenberg, resigned as the company’s auditor and the
company subsequently chose Manuel Reina as the replacement auditor. The generic language
used in the SEC filing goes on to say that there was no disagreement with the auditor, etc. This is
exactly the language companies use when replacing one auditor with another.
However, in this case, it’s completely misleading.
Well, not completely. The company did mention that Reina was affiliated with the company’s
former auditor and had done auditing work on IEH before. But, this could make it sound like
Rosenberg was retiring or something and that’s why the change was made. As we’ll learn in a
second, Rosenberg’s resignation as auditor was not truly voluntary.
In a podcast that hasn’t aired yet I was asked about what typical “sleuthing” I do. While I don’t
focus much on auditors – I do always check four things. One, I check where the auditor is
located and where the company is located (the two are often close together – especially for small
companies – which makes sense). Two, I check how long the auditor has been auditing this
company (which is now disclosed in the auditor’s statement in the 10-K). Three, I google the
auditor and look at the firm’s website, find pictures of the key people involved in the firm, etc.
And four: I go to the Public Company Accounting Oversight Board (PCAOB) website and pull
past “inspections” of this auditor.
The way the PCAOB inspections normally work is that you’ll have the name of the auditor, the
number of public companies they audit, and some information about the size of the firm. Even
that little bit of information can be useful. For example, I’ve seen cases where the firm is listed
as auditing only one issuer. That’s useful information when you’re looking at that one issuer.
In most cases, all you really get that’s useful is an inspection of some number of issuers – often a
sample of about 5 issuer audits – where the PCAOB will refer to the issuers audited as just
“Issuer A”, “Issuer B”, etc. They will say something like out of the 5 audits sampled, the auditor
did not perform an adequate test of blah blah blah in the case of Issuer A and the auditor
responded with this letter to the PCAOB.
Lots of inspections have one or more mentions of some incorrect auditing in regard to at least
one of the five issuers. Often, this happens in one year and then is not present in another year.
Just because there is some issue discussed in an inspection – don’t jump to any big conclusions
about the auditor in general or certainly the specific company you are looking at.
Here, we have a totally different story though.
And, actually, I didn’t need to even go to the PCAOB website to notice it.
When I googled IEH’s new auditor’s name “Manuel Reina” one of the sites that popped up was
“Jerome Rosenberg”. Now, Jerome Rosenberg was the old auditor. So, Manuel Reina worked
with Jerome Rosenberg and yet the company accepted the resignation of Rosenberg to replace
him with Reina. They didn’t really switch auditors. They basically just used a different
accountant at the same firm.
Why?
The PCAOB website provides the answer (emphasis is mine):
By this Order, the Public Company Accounting Oversight Board (the “Board” or “PCAOB”) is
censuring Jerome Rosenberg CPA, P.C. (the “Firm”), revoking the Firm’s registration,1 and
imposing a civil money penalty in the amount of $10,000 upon the Firm; and censuring Jerome
Rosenberg, CPA (“Rosenberg”) and barring him from being an associated person of a
registered public accounting firm.2 The Board is imposing these sanctions on the basis of its
findings that the Firm and Rosenberg (collectively “Respondents”) violated PCAOB rules and
standards in connection with the Firm’s audits of an issuer audit client.
In this case – since it’s not an inspection, it’s an order – the PCAOB actually identifies what
company Rosenberg violated PCAOB rules when he audited it. That company is IEH (the stock
we’re talking about here).
In fact, I’m not 100% sure this violation didn’t involve the new auditor, Manuel Reina, in some
way. Reina and Rosenberg are the names that show up as people involved in the firm Jerome
Rosenberg. Both had been involved for a long time. The firm had been auditing IEH for a long
time. And now Rosenberg is barred from auditing IEH. And now, Reina is auditing IEH.
What does it mean?
From the PCAOB order, we know the violation specifically involved:

“Rosenberg served as the head of the assurance practice at the Firm …and he also served as the
engagement quality reviewer on the 2013, 2014 and 2016 IEH Audits. While serving as the
engagement quality reviewer for those years, Rosenberg assumed responsibilities of the
engagement team by performing audit procedures on revenue recognition, assets and inventory
in IEH’s financial statements. As a result, Rosenberg failed to maintain objectivity in his role as
engagement quality reviewer.”
Although I won’t quote from it. There’s a similar violation on the IEH 2015 audit – only, in that
case it involved a different person at the same firm. So, the violation is basically for the 2013-
2016 audits and then Rosenberg had to be removed as auditor in 2017.
Does this matter to us? We’re just investors looking at IEH stock.
I don’t know. But, it’s something that jumped out at me right away. And the accounting here
may actually be more important to the investment case than at many stocks I look at.
The Inventory Issue
One thing all of the write-ups on IEH seem to note is that the company hasn’t actually converted
a ton of its earnings into cash. What it has done is increased its inventory a lot.
What’s more concerning about this is that the company has a “factoring” arrangement whereby it
can borrow using current assets:
“The Company has an accounts receivable financing agreement with a non-bank lending
institution (“Factor”) whereby it can borrow up to 80 percent of its eligible receivables (as
defined in such financing agreement) at an interest rate of 2 ½% above JP Morgan Chase’s
publicly announced rate with a minimum interest rate of 6% per annum… funds advanced by the
Factor are secured by the Company’s accounts receivable and inventories.”
I won’t get into much detail about the factoring arrangement – except to say that if you read the
10-K very carefully, you can deduce that more than 30% of accounts receivable were due from a
single customer.
There is some circumstantial evidence – and I’m talking just how it appears to me, other analysts
may interpret things differently – that the company is not very conservative about how it
manages either receivables or inventory. For example, the company says it buys “raw materials”
in advance of expected demand for those materials to save money. Okay. But, there is also this
note on the company’s inventory accounting:
“…The Company based upon historical experience has determined that if a part has not been
used and purchased or an item of finished goods has not been sold in three years, it is deemed to
be obsolete.”
This company has $6.6 million in raw material inventory. Total inventory is $10.8 million.
That’s very significant for a company with an entire market cap of just $40 million.
To put this in perspective – the company’s entire balance sheet (all of its total assets) are less
than $20 million. So, you have about 50% of the entire balance sheet in assets and about a third
of total assets in “raw material” inventory. And we know the company purchases raw material
speculatively. We know that inventory is part of the security pledged to the receivables factoring
arrangement. And we know the company’s auditor of 25+ years was barred from public
company auditing work because of violations his firm committed while auditing IEH.
I don’t know. But, because the inventory build-up is such an issue in terms of determining the
actual cash returns this business is producing for me as a potential shareholder – this is just too
difficult a situation for me to untangle. Raw material that might be obsolete and is bought
speculatively is among the toughest assets for me to value. The fact that inventory build might be
seen as a good sign by investors – insofar as the company can report more earnings than actual
free cash flow – and by the company’s lender (who is secured by that inventory in addition to the
receivables) makes me think that it’s unusually important for me to understand IEH’s approach
to receivables and inventory management and accounting and the auditor’s as well.
I just don’t have as much faith that earnings which increased receivables and inventory are
equivalent to earnings that added to cash.
Nonetheless, the company did recently pay its first dividend since becoming an SEC reporting
company. So, the company had gone a long time without paying out any cash. And now it has
paid out some cash to investors. This might mark a turning point.
The 1990s Issue
My final concern has to do with the long-term history of this company. Some blog posts
discussed this. I created my usual Excel sheet using data I entered from the company’s SEC
filings (which cover the period back to 1994). What I discovered is that from 1994-2004, IEH
cumulatively produced essentially no earnings. It’s not just that it didn’t grow much during that
period. I’d say there was no meaningful profits. An owner could not have taken any cash out of
the business as a return during those 10 years. That’s an abysmal record.
But, it’s an old record. The company completely turned things around. Sales increased by 12% a
year over the next 14 years. Earnings increased even faster. EBIT margins went from essentially
zero in the 1990s and early 2000s to double-digits in every year from 2009-2018. Some say this
coincides with the increasing involvement of the son of the former CEO. He is now the
company’s current CEO.
That may be true. But, we have to remember that IEH has existed for a very, very long time. It
was founded in the 1940s. It has probably – I don’t have exact data on this – been public for
about half a century. And yet, it was only 15 years ago that all of the value creation here
happened. Based on the record we have – there just isn’t evidence of this company creating
meaningful value for its first 60 years or so of operation. Again, I don’t have details going back
before 1994. But, you can also look at a stock chart to see the value creation here is all in the last
15 years.
That means I need to understand the company’s strategy and what has been special about what it
has done these last 15 years. I need to know whether that will continue.
I’m not sure if I can know that here. There aren’t a lot of details about why the company’s results
exploded so positively in the last 15 years. There is some evidence of a lack of competition due
to Smiths Group (a U.K. company – ticker: SMIN) owning all of IEH’s competitors in a
subsidiary called “Smith Interconnect” and also that a U.S. government program favors sourcing
at least some of these parts from IEH instead of Smiths, because IEH meets some requirements
(as a small, U.S. business) that Smiths (as a large, U.K. company) can’t. I’m not sure how
important that was to the company’s improving results.
Conclusion
Overall, IEH has a lot of appealing quantitative features and possibly some hints of an appealing
competitive position. The microeconomics here might be good. The 15-year record is good. The
company looks super safe based on the usual credit risk metrics. And it looks cheap enough to be
a value stock despite having a 15-year record as a growth stock.
But, the amount of “sleuthing” that would have to go into me ever getting confident buying this
one seems too high to me.
I won’t give IEH a zero interest score – because, at very first glance this one looks excellent. So,
it does rank higher than something like my first look at Babcock & Wilcox Enterprises (BW).
But – it ranks far, far below almost any other stock I’ve looked at for this site.

Geoff’s Initial Interest Level: 20%
 URL: https://focusedcompounding.com/ieh-corporation-iehc-may-be-a-good-cheap-
stock-but-definitely-in-the-too-hard-pile-for-now/
 Time: 2019
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Interpublic (IPG): An Ad Agency Holding Company Trading at 10 times Free

Cash Flow and Paying a Nearly 7% Dividend Yield
Interpublic (IPG) is one of the big ad agency holding companies around the world. Other
examples include Omnicom (also a U.S. company), WPP (a U.K. company), Publicis (a French
company), and Dentsu (a Japanese company). There are countless other publicly traded
advertising stocks. Some are affiliated with one of those big groups. Others aren’t. Interpublic
might be the first real ad agency holding company. The name Interpublic dates back to 1961. If
you read the 10-K, you’ll notice PriceWaterhouse has been auditing Interpublic’s financials since
the 1950s. Before the name change in 1961, the company was called McCann-Erikson. Late in
the TV series Mad Men this is the agency that buys up the company all the main characters work
for. Mad Men ends with the “Hilltop ad” (I’d like to buy the world a Coke) for Coca-Cola.
That’s not made up just for the show. McCann-Erikson did make that ad. The McCann-Erikson
combination dates back to the 1930s. Each of those two agencies (McCann and Erikson) were
founded in the first decade of the 1900s. Omnicom and other advertising agency holding
companies that came later were probably based in part on Interpublic in the early 1960s. For
decades now, it’s been a common strategy for publicly traded advertising companies to own
different agencies and provide certain centralized functions (basic corporate functions, capital
allocation, setting compensation of top executives at the agencies, managing conflicts of interest
between agencies they own, etc.). To some extent the individual agencies are independent and
run sort of like Berkshire Hathaway runs its subsidiaries. But, in other ways they aren’t very
independent. For example, Interpublic explicitly says that corporate HQ provides guidance,
advice, etc. on both certain human relations stuff and on real estate. The cost structure of ad
agencies is very different from most companies. At Interpublic, close to 65% of revenues are
spent on base salaries, benefits, rent and office expenses. A huge proportion of the company’s
total cost structure is really just base salary and rent. These are both very fixed. This is a pure
service business. It’s largely “cost plus” – though how that works is a bit complicated.
So, the actual way ad agencies bill can be pretty complicated. Interpublic gets 50-60% of its
revenue from its top 100 clients. Usually, client retention rates among big accounts are incredibly
high. This is not due to contracts. The industry standard is for all contracts to allow either the
agency or the client to fire the other with 30-90 days’ notice. Each of the contracts are
customized. So, in theory, profits could vary a lot relative to the amount of revenue booked
depending on the client. But, in reality, this does not happen. The contract can be created to
involve a lot of cost plus, a lot of commission, flat fees, incentives for hitting certain quantitative
targets for the effectiveness of campaigns, etc. If you look at the long-term margins of all
different ad agencies around the world that once took very simple fees based on just two kinds of
work – fixed commissions on media buying and cost plus on creative work – and compare it to
margins with the various structures they operate under now, there’s no way to tell the difference.
The agreements are always made to work out – over a diversified client base – to a very
predictable return relative to sales. One thing to keep in mind though is that certain revenue
figures are overstated at a company like Interpublic because they are counting “pass through”
billable expenses. If Interpublic bills a client (when acting as a principal), the accounting will
show that as revenue. However, it is profitless revenue, because some billing of clients is just
reimbursement. Interpublic backs this out of its adjusted earnings figures. While we’re on the
topic of adjustments – note that ad companies like to use “EBITA” instead of “EBITDA”
because depreciation is a real expense (they’ll need to spend on cap-ex to make leasehold
improvements) but amortization of identified intangibles of agencies acquired in the past is a
non-cash charge. In general, I’d say the adjusted figures presented by companies like Interpublic
(and others in the industry) are a lot cleaner and more conservative than adjusted figures you find
in other industries. In normal times, ad companies like Interpublic convert a lot of their
“adjusted” earnings numbers into actual free cash flow. So, there’s very little gaming of those
reported figures. I think much of the accounting at Interpublic – and elsewhere in the industry –
was less conservative about 20 years ago. The adjustments I see now don’t worry me.
What does worry me?
In the 10-K, Interpublic makes it very clear they are economically sensitive. In fact, they make it
clear they are more economically sensitive than other industries. This is true. And I can’t
reiterate enough how cautious you have to be buying an ad agency at this economic moment.
Lately, you’ve probably heard the term “canary in the coal mine” used a lot about both public
health and economic data about some specific city, state, industry, company, etc. – well, ad
agencies are the “canaries in the coal mine” when it comes to business confidence. Ad spending
by the 100 biggest clients at Interpublic won’t drop off a cliff because clients don’t have money.
It won’t even necessarily drop off a cliff because GDP has declined by “x” percent. It’ll drop off
a cliff if “animal spirits” die down. In the long-run, ad spending – and other corporate
communications – track GDP awfully closely. You’d be amazed at how narrow the range of
advertising spend as a percent of GDP has been over the last 100 years. Things shift from direct
mail to newspapers to radio to magazines to TV to online at your computer to mobile on your
phone. But, these shifts don’t change the amount of spending advertisers do by very much at all.
Really, they can’t. Advertisers get a certain return on their ad spend. In some industries – if they
go more and more online – it may be possible to say shift high rent expense to more ad spending,
because high-profile locations are often just a form of advertising. But, other than that – it’s not
correct to think the ad pie can outgrow the GDP pie. So, in the long-run – GDP and ad spending
are closely tied. In the short-run, it’s business confidence and ad spending that are closely tied.
Interpublic does serve some clients that are shutdown, will be shutdown, etc. Usually, these big
ad agency holding companies have at least one big client in every industry you can imagine. The
same agency wouldn’t have more than one big client in the same industry, because that’s a
conflict of interest. Sometimes, the holding company can get around this by having multiple
agencies and multiple media buying groups to serve different clients in the same industry. But, in
part because of conflict of issue concerns and in part because there are only so many supersized
ad holding companies ready to serve supersized companies – you’ll see a pattern where every
holding company has “their” car company, “their” airline, “their” credit card company, etc. This
means they are somewhat exposed to all industries – but they’re very diversified. Interpublic’s
top 10 clients are just 17% of revenues. The number one client is 3% of revenues. And, although
I’ve been talking like Interpublic is just McCann-Erikson – that’s not true. It’s also things like
The Martin Agency (and countless others). The Martin Agency is probably best known for the
GEICO ads (the Gecko, the Cavemen, etc.) The level of diversification here is so extreme in
terms of number of agencies, number of clients of each agency, work done for the same client by
multiple parts of Interpublic, etc. – it’s just way too much to detail here. I’d just be throwing out
a bunch of names you don’t recognize. The same is true of clients. I could list a lot of clients
Interpublic has – but, all the major competitors of Interpublic also have impressive and diverse
client lists. Also, remember, it’s uncommon for one company to have all the business of its client
worldwide across all brands, demographics, etc. So, even when I name a client – that could just
mean Interpublic is handling all the mass advertising stuff in the U.S. like TV while others are
doing ads for that same company in other countries, targeting specific niches, for some new
product the company has come out with, etc.
So, the company is diverse – but, all ad spending is tied to business confidence and that will
plummet. Now, there’s a small part of Interpublic’s business that will be hurt for additional
reasons. Interpublic gets about 85% of its revenue, profits, etc. from what I’d call more of your
traditional “corporate communications” plus data. This is basically what you’re probably
thinking of when you’re thinking of an ad agency. Although, chances are you’re underestimating
two things: 1) The data aspect of what they do and 2) The actual media buying. Whenever I talk
about ad agencies, I feel like people get the creative side of what goes on just fine. But, I don’t
think they appreciate the fact that ad agencies are literally the client’s “agent” who goes out into
a marketplace and buys ad space on their behalf. This can be done in a variety of different ways.
A lot of it is more technical now than it used to be. But, it is a big part of the business for several
reasons. One, it’s a competitive advantage that a middleman has. Interpublic is more than 30
times the size of its biggest client and spends all day every day buying media. It’s very obvious
to investors that agencies – as middleman – take a commission on their buying on the client’s
behalf. It’s less obvious to investors that the middleman serves a very good purpose in this
industry. The commission is awfully small compared to the benefit the client can get. However,
there’s an extra embedded cost that the agency extracts – and it’s “float”.
This gets back into the risks that an ad company faces in an economic downturn. So, agencies are
theoretically on the hook for buying media that is way, way more than the entire revenues you
see in their 10-K. Those are revenues – not billings. The agency only converts a small part of
what it spends on a client’s behalf into actual revenue. So, the theoretical amount of promised
media purchases agencies have made at any one time is off the charts. If all clients said they
didn’t really want the media they said they wanted – no agency could ever pay for it. Luckily,
they often wouldn’t have to. Specific “outs” can be written into deals so that if a client fails to
perform, the agency doesn’t have to perform as promised to the media seller. On top of that, the
risks of this really happening in a big way are lower than they appear. One, the client has a close
relationship with their agency and knows it’s a bad idea to back out of taking media they wanted
bought. Two, the media outlet (the seller) is usually 100% dependent on ad revenue in their own
business. A lot of their revenue comes through a small number of big agencies. It’s not in the
interest of any media outlet to demand payment from agencies that can’t make it. So, although
this is theoretically a devastating off balance sheet liability – I don’t think it’s the biggest risk to
agencies.
Agencies do have some risks in a downturn though. Interpublic has debt. It’s fairly long-term,
well spaced out, and just all around manageable. They’re at about 2 times Net Debt to EBITDA.
That doesn’t worry me. They also have a commercial paper program. That worries me a bit
more. So, they can borrow up to $1.5 billion in the commercial paper market (the commercial
paper program is backed by a bank’s promise to backstop all the paper provided Interpublic
maintains certain financial ratios). At year end, Interpublic wasn’t using any paper. On an
average day during the year, they would be using about 20% of the potential size of the
commercial paper program.
Salaries are high and fixed. And this is a people business. If you cut pay, you have to figure out
other ways to keep people. I’d compare this to something like investment banking, big tech, etc.
Ad agencies don’t like to lose key people. If you look at the mean – remember, I said “mean” so
this vastly overstates the median (a better gauge of the average in this case) – base salary and
benefits for an Interpublic employee, it’s about $103,000 a year. There’s also incentive
compensation for some people. And there’s a pension plan (underfunded but manageable). Rent
is also especially fixed at ad agencies. Occupancy alone – this is the truly fixed part of office
expense – is more than 5% of total revenue. Given where these leases are, how long-term they
are, etc. that’s 5-6% of revenue that just can never be cut.
So, you’ve got fixed expenses. And then you have this reversal of “float”. In normal times, ad
agencies grow a bit and as their billings grow – remember, billings are to ad agencies what
premiums are to insurers – float grows too. When billings shrink, float shrinks. Ad agencies are
always in a deficit position in terms of current assets versus current liabilities on their balance
sheet. But, they are normally having additional cash flow from operations generated by changes
in working capital moving in their favor. In 2020, it’ll be working against them.
Nonetheless, there’s a ton of CFFO at Interpublic to take a blow like that. Over the last 3 years,
cash flow from operations has averaged $1 billion. Cap-ex has been like $200 million. That
leaves $800 million in free cash flow. Shares outstanding are 388 million. So, that’s $2.05 a
share in FCF. The company does have about $5.40 a share in debt, though. As I write this – IPG
stock is at $15.02. If we add the $5.40 a share in debt to the $15.02 in equity, we get a share
price of $20.42. That’s against $2.05 a share in average free cash flow. So, that’s a debt adjusted
“cash P/E” of 10.
Is that cheap?
Based on Interpublic’s recent performance – it’s very cheap. The company has been successful
in growing organic revenue in almost every country in each of the last 3 years or so. It’s often
grown as fast as GDP. There’s no sign Interpublic is losing share. The stock is cheap.
Is it safe?
Debt payments in 2020 – I’m not including leases since rent flows through the income statement
– are about $635 million. In 2021, it’s $617 million. It drops off after that. Basically all debt is
fixed. The company will have some real liquidity shifts this year. But, I’d say an ad company
with debt spaced out and fixed the way they’ve got it should be able to access debt markets if
needed. They might have to pay a bit more at times. But – this is a big, diverse, old, predictable
company. It’s not a risky thing to provide financing to. It’s a good credit. I’m not worried about
these ad giants the way I am about something like Hamilton Beach Brands. Interpublic has been
in the market plenty of times with various bonds that now trade every day. It has commercial
paper. It has banking relationships.
So, my concern in not that the company will fail. But, it will see a big decline in earnings. For
example, I stuck to just talking about the traditional part of the business here. That’s 85% of
Interpublic. The other 15% is stuff like events, sports marketing, etc. None of that is going to do
as well during a shutdown for the coronavirus as the 85% I’ve been talking about. And – in a
deep recession – the 85% will get hurt pretty hard too.
I don’t do macroeconomic projections. But, if you’re going to buy an ad company in 2020 based
on its 2019 earnings – you need to be prepared to wait till 2023 or so before you see a return to
(and eventually surpassing of) the 2019 earnings you based your purchase on.
So, Interpublic could effectively tread water for 3 years.
Unlike Omnicom, Interpublic will not buy back stock. It did an acquisition in 2018 that required
the use of a lot of debt. Historically, Interpublic has bought back stock. But, it hasn’t bought
back a single share since that acquisition – and I don’t expect it to till it pays that debt down
further. As I write this – the dividend yield is 6.8%. Is the dividend safe?
I don’t know. I don’t think it’s sacrosanct at Interpublic. But, I also think Interpublic is only
paying out about 50% of its free cash flow in dividends. So, the dividend is theoretically covered
about 2 to 1 in normal times. That coverage ratio will not hold up in 2020. But – if the dividend
is suspended, cut, etc. it’ll be reinstated a few years down the road and surpass the current
dividend rate (just as earnings will reach a new peak a couple years after we emerge from this
recession).
The question everyone will ask me is: do I like Interpublic more than Omnicom?
I have no answer for that yet.
But, at $15 a share – I do like Interpublic.
Geoff’s Revisit Price: $9/share

 URL: https://focusedcompounding.com/interpublic-ipg-an-ad-agency-holding-company-
trading-at-10-times-free-cash-flow-and-paying-a-nearly-7-dividend-yield/
 Time: 2020
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Investors Title Company (ITIC): A Strong, Consistently Profitable Regional

Title Insurer Trading at a Premium to Book Value
This stock was brought to me by Andrew. He wanted to know more about the title insurance
industry. ITIC is a publicly traded (it trades on NASDAQ) regional title insurer. There are four
large, national title insurers that account for 80-90% of all title insurance market share in the
U.S. However, in some states – the leading title insurer is a homegrown operation. These
companies are known as “regional” title insurers. ITIC was started by the Fine family in the
1970s (it became operational midway through 1976). By the 1980s, it became the largest title
insurer in North Carolina. It has since expanded into other states – mainly Texas, Georgia, and
South Carolina. Premiums in North Carolina, Texas, Georgia, and South Carolina account for
75-80% of the company’s premiums. ITIC writes mainly (but not totally) directly in North
Carolina and through “issuing agents” (lawyers, bankers, basically anyone originating a real
estate purchase or transfer or refinance) in other states. Generally, there is no commission
associated with title insurance premiums written directly and slightly under a 70% commission
rate for insurance written indirectly.
ITIC is a “primary” insurer. It does own a reinsurance subsidiary. And it both assumes and cedes
some insurance each year. However, this has never been a material part of its business. As far as
I can tell – and I only read the most recent 10-K from 2019 and the oldest 10-K from the mid-
1990s – reinsurance has been less than 1% of revenues. My guess is that the reinsurance business
is not for regulatory reasons. It probably has to do with the company’s choice to not retain
individual risks in excess of a certain amount. For example – and this is just a hypothetical
illustration, it may be close to the truth but is not something the company says explicitly – if
someone wants $900,000 of title insurance, the company may take the first $500,000 and retain
that risk in the usual insurance subsidiary and then pass the other $400,000 on to the reinsurance
subsidiary. As of the 1990s, we know that this was not a requirement that state regulators in
North Carolina put on the company. It was a choice the company was making.
ITIC’s financial position is strong. You can see it has an A.M. Best rating of “A” (there are only
two notches above this: A+ and A++). In a podcast I did recently with Andrew, I mentioned that
investors may want to look for an “A minus” or better rating from A.M. Best to know if there is
anything about the company’s financial position that might be a concern in terms of the strength
of an insurance subsidiary. Keep in mind that an A.M. Best rating is really an indication of
insurance subsidiary strength as an insurer (safety for policyholders, ability to reinsure others,
etc.) and not a credit rating. It’s certainly not a rating of the safety of the common stock or its
dividend.
Having said that, I wasn’t surprised when I saw the A.M. Best rating. There are several
indications in ITIC’s financials that suggest strength. One, the company uses effectively zero
underwriting leverage. When you look at the consolidated balance sheet and compare premiums
written, reserves for claims, etc. you can see that premiums are roughly in line with tangible
shareholder’s equity. In fact, they are often somewhat below. Sometimes, the company may only
be writing 80 cents to 90 cents of premiums for every $1 of tangible equity in its business.
Another way to look at this is the ratio of investments to equity. They are about the same. So,
when you are buying this company at a price-to-book of 1 – you’re getting about the stock price
in bonds and common stocks. Many insurers – though not necessarily many title insurers – have
far more dollars per share in investments than they do in book value. In other words, you pay
$100 a share for a stock with an investment portfolio of far more than $100. That’s not the case
here.
How would Buffett look at this company?
He’d think of the stock and bond portfolio as an investment portfolio he was buying. And then
he’d value the actual underwriting (and other income – ITIC’s fee-based businesses are
significant) as being priced for him at whatever premium he was paying above book. So, if you
are paying $300 million in market cap for the whole company and paying a 1.4x price-to-book,
you’re really buying a little over $200 million in a bond and stock portfolio and paying the other
$100 million or so for the ongoing operations.
What does the investment portfolio consist of? It’s mostly revenue backed municipal bonds. The
other one-third is in stocks. I’m not sure this 2/3rds bonds and 1/3rd stocks allocation is exactly
what the company consciously targets. You can see that the stock portion of the portfolio is
largely the result of unrealized gains in market value. At cost, the stock portfolio was smaller.
They just haven’t sold it down.
What are the economics of a title insurer? Do they justify paying a premium over book?
So, title insurance – at least as far as ITIC practices it – is partially an income on “float”
business. That’s difficult to see here, because the company has some off-balance sheet float that
is big. In fact, off balance sheet float is much, much bigger than on balance sheet float and is a
lot bigger than the company’s market cap.
ITIC reports deposits it holds in trust for others as a footnote to its financials. Actually, it appears
in two different categories in two different places. Income that appears to be fee-based for its
other businesses – the 10% of revenues that are not premiums – may be largely investment
income on float. The company holds several hundred million dollars (not shown on the balance
sheet) for others. Even at like a 1% average overnight interest rate, $500 million in average daily
balance held for others would produce like $5 million in EBIT. If we assume that actual fees
only cover actual expenses, the profit we are seeing for the other business units is probably
largely float. On the other hand, a lot of it could actually be additional fees for professional type
services associated with selling out of one piece of property and putting the proceeds in another.
The income on the actual insurance business is coming from the assets that are “on balance
sheet”. That’s the only investment portfolio we actually see. Title insurance generates a lot of
float. To explain how much, I’ll need to explain what title insurance is.
Title insurance – in the U.S., most other countries don’t need and don’t use title insurance –
comes in two flavors: 1) Protection for a lender against title defects and other risks where the
mortgage lenders lien could be made more junior (or be worthless) than they expected and 2)
Protection for the property owner.
I believe a major reason for the existence of title insurance has to do with the marketability of the
loan. In the U.S., there is a big secondary market for both residential mortgages (driven mostly
by the GSEs: Fannie and Freddie) and for commercial real estate. Lenders can make a loan and
then sell it. The entity they are selling to wants to know the loan conforms to certain standards
and also has title insurance. So, title insurance is like a one-time tacked on fee necessary to
ensure the marketability of the loan. There are other purposes to title insurance. But, the reason
the market is so big is probably what I just described.
Title insurance is paid as a one-time non-recurring lump sum premium at the time of closing.
Risks in writing title insurance involve: fraud, a title defect you could have found in your
database, and a title defect that you can’t find in your database.
There are large economies of scale in the business. Other than commissions, the business is
largely fixed cost in nature and yet premium volume – because premiums are paid once up front
at closing and not received monthly, annually, etc. – is highly variable. In fact, it’s cyclical (and
seasonal) in the same way mortgage loan originations are. Two, you need a database to consult
for determining who really has title to land. The bigger the database the better. Having done
business in North Carolina for over 40 years is probably a plus when it comes to having a good
database. The other major risk here is fraud of some sort. Incentives are high for the issuing
agent to close a deal and get you your premium – they keep most of the premium, and they get it
upfront. You may need to be somewhat careful – especially in speculative times – with who you
are getting your business sourced through.
Why is there so much float in this business? ITIC’s reserves are 90% incurred but not reported
(IBNR). Right now, the company has claims reserves of about $33 million with $4 million of
that being stuff actually reported to them – but not yet paid out – and $30 million being claims
that (based on their own past experience and that of the industry generally) ITIC expects to
already exist but be unknown to the insured and to themselves. In some insurance businesses,
IBNR is a small item. It’s usually a much, much smaller item than 90% of claims. For example,
auto insurers have IBNR (incurred but not reported) reserves that are small, because the time
between when an accident occurs and when someone reports the event is really short. Here, it’s
long. The title defect existed at the time the insurance was written. But, no one will discover it
and file a claim till some future event leads to its discovery.
About 40% of ITIC’s claims are expected to be paid out in 5 or more years from today. Only
about 20% are expected to be paid this year. I think that the “half-life” of the current reserves
might be in like the 4-year timeframe. In other words, if you set up a fund to pay claims and
invested all of the reserve to pay these claims in bonds where half the principal would turn to
cash within 4 years, you could probably pay claims just from that fund without ever selling a
bond (just letting them mature). This is a pretty substantial amount of “float” on your reserves.
ITIC is actually so liquid it doesn’t need to do that. It has very short-term investments –
basically, cash on hand – sufficient to meet all claims likely in the next 5 years or so right now.
In fact, the investment portfolio I’m describing – I exclude truly short-term bonds like very near-
term Treasuries from my calculation of “investments” – is really backed by shareholder money,
not money that’ll eventually be paid out in claims.
The “other” business generates a lot of float. It is tied to 1031 “like kind” exchanges and other
escrow type businesses. You can either think of this segment as float generating or not. Since the
assets associated with it are off balance sheet, I think analysts will tend to view this as a purely
fee based non-insurance business. However, one warning is that if the income really is coming
from some sort of float – and not just from fees – this doesn’t quite work like an actual fee-based
business. If overnight type lending rates are persistently negative, this business might not do
well. “Other” possibly adds up to a significant amount of profit – despite just being 10% of
revenue – for ITIC. It is difficult for me to know how much of this is really true fee-based
revenue that doesn’t depend at all on interest rates and how much is due to large amounts of float
being invested at very low short-term interest rates. Remember, the “investment income” that
comes off the “other” business is not booked as investment income. This is because the assets
associated with this business are off balance sheet. It just appears on the revenue line for that
segment. Everything else about it is described in footnotes.
Earnings per share are misleading in this business. They should be ignored. Starting a few years
ago, accounting rules changed for investments. This caused insurers to start passing unrealized
gains and losses on investments through the income statement and incorporating them in EPS.
What should you use instead to determine normal earnings?
The best way to analyze a company like this is usually to break it into 3 parts:
 Fee-based profits
 Underwriting profits
 Investment returns
You then value each of the three parts separately and add them up. Here, the “fee-based
businesses” are probably worth at least $25 a share. Again, I’m not sure if some of the stuff that
appears to be fees are really off-balance sheet sourced investment income. In normal times, it
wouldn’t matter. But, if rates were negative for a while – it would.
Underwriting profits can be analyzed based on past results. We have 35-40 years of underwriting
data for this company. You can go back through all the EDGAR filings and come up with what
you think is a normalized level of EBIT. Outside of a housing crash, this company has not had
meaningful and prolonged underwriting losses. Therefore, it should trade at some premium to the
value of its investment portfolio. If investment performance of an insurer is in line with
investment portfolios generally – then, the premium or discount to book the insurance stock
should trade it would be theoretically determined by the expected underwriting profits (premium
to book) or losses (discount to book). It does not make sense for an insurer to trade below the
value of its investment portfolio if that insurer normally reports underwriting profits (a combined
ratio below 100).
Like I said, the investment portfolio is similar to the book value here. So, this stock shouldn’t
trade below book. It has traded below book before. And some title insurers do. But, that’s
probably a mistake on the market’s part.
And then you would value the portfolio (which is by far the biggest part of this company) based
on expected future portfolio returns….
Or: you could value the portfolio on an asset basis.
The portfolio is carried on the books at the fair market value of the bonds and stocks. These are
marked-to-market and disclosed to investors in every quarterly earnings release. So, my guess is
that analysts value the portfolio based on its fair market value instead of trying to predict future
returns. I’m not sure if this is a good idea.
In fact, it’s here where I see the problem in liking this stock at today’s price.
What if the fair market value of the bonds and stocks this company owns is unusually high
today?
We know asset values are high today for financial assets. So, either way you analyze it – trying
to figure out the intrinsic value of the portfolio or trying to predict future returns – you get a low
number. The most dangerous way to evaluate this stock – the one most likely to make you think
it’s cheap when it’s really expensive – is the shortcut approach of assuming intrinsic value and
fair market value as of today are exactly the same.
But…
Personally: I wouldn’t want to pay 100 cents on the dollar for any 2/3rds bonds and 1/3rd stocks
mix of investment assets quoted at today’s prices.
For that reason, the premium to book value (about 40% in this case) might be fully justified in
times of low valuations for stocks and bonds but not be justified in today’s environment.
What about dividends, future earnings, etc.?
This company has grown nicely over time while paying dividends. Cumulatively, dividends have
often been as high as 50% of reported earnings. They’ve been uneven. This is due to special
dividends and cyclicality. But, you can expect like half of earnings will be paid as a dividend.
Growth has also been fine. Over the last 35 years, I think premiums have grown around 7% a
year. They moved into some other states. So, it’s unlikely they grew in any one state by much
more than the underlying nominal GDP of that state. Long-term, we should expect that real
estate values move about at nominal GDP. And the total market for title insurance should do the
same.
So, growth in the 5% to 9% a year range is okay for premiums. Double-digits might be
concerning. And less than 5% a year might suggest loss of market share.
Knowing if dividends will grow faster or slower than earnings and premiums is really a question
of whether the company is overcapitalized, undercapitalized, etc. and what it intends to do about
that. This company may be overcapitalized. But, I expect it to be run at about these capital levels.
So, dividends shouldn’t race ahead of earnings for the long-run. For that reason, premium growth
plus dividend yield might be a good proxy for your likely future return in this stock. The only
other variable of real significance would be the ratio of exit price multiple vs. entry price
multiple. So, your return in ITIC would likely be driven by 3 things:
 P/B (P/E, P/S, etc.) multiple expansion or contraction

 Premium volume CAGR
 Dividend yield
ITIC is a family company. The top 3 positions at the company are family members. So, it is
family run not just family controlled. The family here – the Fine family – seems to own at least
30% of the company divided equally between the 3 members of the family who are the CEO,
CFO, etc. The board is probably pretty cozy with the family. As you’d expect with a NASDAQ
listed stock, family members don’t sit on any of the board committees. But, many of the people
who do sit on these committees and the lead independent director have been with the company
from pretty much the start.
There is a poison pill. The board is also classified – meaning you only elect 1/3rd of the board
each year, thus delaying a takeover. There are also some change of control payments. It’s not an
obvious takeover target. It’s very well protected from any takeover the family doesn’t want.
Markel owns a bit over 11% of the stock. I believe they bought a bit less than 10% a long time
ago and then just keep holding indefinitely. There have been some share buybacks over time that
would’ve upped Markel’s percentage stake. Technically, the bought back shares are held by a
subsidiary (I assume an insurance subsidiary) and not the parent company. As a result, while
shares outstanding are listed in some places as 2.2 million – there are really only 1.9 million
shares out.
Some of the investment assets are held at the parent company (this is unusual for an insurance
company and again shows the insurance subsidiary is very well capitalized). I don’t think this is
relevant. I just mention it because the consolidated entity has significantly more capital than
would be required for regulatory reasons. If there were any concerns about capital levels, you’d
definitely keep all your investments at the insurance subsidiary level. Here, the consolidated
company is even a bit stronger than suggested by the regulatory capital situation at the subsidiary
(in some insurance holding companies, the reverse is true – the consolidated situation is a bit
weaker than the insurance subsidiary’s financial position).
Obviously, we’re in a boom time for real estate and therefore a boom time for title insurance.
Might next year’s earnings be amazing – especially if stock and bond prices continue to do well?
Yes. But, I don’t think a one year EPS pop is a good reason to own the stock for the long-term.
And if you’re not willing to own it for the long-term – you shouldn’t buy it just gambling on a
one-year EPS pop and then selling to someone else when that pop happens.
ITIC doesn’t look cheap versus publicly traded peers. I haven’t analyzed the other title insurers
you can buy shares in – so, I can’t get into why this is the case and whether it is justified. In fact,
by some measures, ITIC is actually a bit more expensive than some peers.
Could it be a better business than its peers?
That’s possible. It’s probably the leader in North Carolina even though the national title insurers
have the leading national share.
Of course, some people will wonder if this thing would be sold to a bigger title insurer when the
family decides to sell. That’s possible. As of now, it’s a founder led company.
Overall, this has been a consistent and profitable grower. It has shown it could move from a just
direct business in one state to a mostly agency business in several Southern states. The states the
company is in are good states to be in long-term.
I also have to stress that the capital position, low levels of underwriting leverage, etc. here are
really notable. Even just looking at a surface level at peers – the financial strength here vs. the
volume of business being done does stand out.
So, at the same price-to-book and P/E ratio and so on – would I rather buy the underleveraged
member of the group? Yes. I don’t get the feeling the family would shift to a very different level
of underwriting volume vs. capital. If they did, you could make more money as an investor. I
mean, we can do some comparisons with some other title insurers and see that the “earning
power” of ITIC at an equal level of leverage as these other title insurers would be quite a bit
higher.
Due to the past history here, the continuity provided by family management, and the financial
position versus amount of underwriting – I’d keep an eye on ITIC. This might be the title insurer
you’d choose to own if you could buy any title insurer at the same price multiple.
However, like I said, the company – although smaller and less well known – doesn’t trade at a
discount to peers. Adjusted for capitalization levels – it might be cheap. But, I’m not sure if a
potential shareholder should really adjust for capitalization ratios. What we have here might just
be a lower risk title insurer stock – not necessarily a higher return one.
Of course, when a potential buyer analyzes a company like ITIC – he thinks in terms of how
much leverage he’d be using, not how much it’s using now. To an acquirer, ITIC probably looks
a lot cheaper (and would be worth a lot more) than it does as a stand-alone public company. So,
maybe the “private market value” here is above the public market value. And maybe I should be
thinking of the value to an insurance company acquiring ITIC instead of thinking in terms of
ITIC staying independent indefinitely.
My next step in analyzing this one would be to do a comparison between ITIC and each of the
other more-or-less “pure play” title insurers with publicly traded shares. You can’t buy ITIC
without first analyzing the other title insurers as your opportunity cost.
 URL: https://focusedcompounding.com/investors-title-company-itic-a-strong-
consistently-profitable-regional-title-insurer-trading-at-a-premium-to-book-value/
 Time: 2021
-----------------------------------------------------
Keweenaw Land Association: Buy Timberland at Appraisal Value – Get a

Proxy Battle for Free
Keweenaw Land Association (KEWL) is an illiquid, unlisted stock. It trades something like
$15,000 to $20,000 worth of stock on an average day. The company does not file with the SEC.
However, you can find plenty of information – including investor presentations, annual reports,
quarterly reports, and other news – at the “company reports” section of Keweenaw’s website.
You can also find news about the company – including press releases from a 26% shareholder
who is trying to take control of the board – at Keweenaw’s OTCMarket.com “News” page.
Keweenaw Land Association owns timberland in Upper Michigan. It has 185,750 acres of
timberland and 401,841 acres of mineral rights. The difference between those numbers – 216,091
acres of mineral rights – is “severed” mineral rights where Keweenaw sold timberland without
selling the mineral rights on that land.
The company has 1.3 million shares outstanding. So, each shares of Keweenaw Land
Association is essentially made up of 0.14 acres of timberland, 0.31 acres of mineral rights, some
cash, some marketable securities, and some debt. Of those assets and liabilities – it’s the 0.14
acres of timberland that matters most. Unlike many of the big, publicly traded timber companies,
Keweenaw Land Association is not a REIT. However, the current board has said they plan to
convert to a REIT for tax year 2018.
First Let’s Deal with the Catalysts: 3 Weeks till a Contested Proxy Vote, REIT Conversion,
Copper, etc.
I say “current board”, because Keweenaw is in the middle of a proxy battle that will decide board
control at the April 12th vote. So, there is a catalyst here. Control of the board might flip 3 weeks
from today. The party contesting the election is Cornwall Capital. Cornwall has 2 of 8 board
seats right now. They are contesting 3 board seats at the April 12th election. If they win all 3
board seats, they will have a majority (5 of 8) board seats. Cornwall Capital is a long-term holder
of the stock. I believe they have held Keweenaw shares for about 10 years. The firm is run by
Jamie Mai (who already sits on Keweenaw’s board). Cornwall Capital owns 26% of
Keweenaw’s shares outstanding. Jamie Mai was mentioned in Michael Lewis’s “The Big Short”.
The Paul Sonkin that Cornwall is running on their ticket for the April 12th vote is the
nano-cap/micro-cap investor who used to run Hummingbird Value, works at Gabelli, and co-
wrote one of Bruce Greenwald’s value investing books. I don’t have much of an opinion on this
board vote, the nominees, etc. I just thought it was worth mentioning that if you – as a value
investor – are thinking the names Jamie Mai and Paul Sonkin sound familiar, it’s likely because
you read “The Big Short” and “Value Investing: From Graham to Buffett and Beyond”.
Another potential catalyst is that Keweenaw could convert to a REIT. The board had previously
said this was a bad idea. Now, they say they’ll do it for the 2018 tax year. A warning here: this
board explored selling the company and didn’t do that and explored setting up a timberland
management fund and didn’t do that either. Don’t assume there’s a 100% chance of a REIT
conversion happening this year.
There’s also a publicly traded Canadian company called Highland Copper Company interested in
mining on Keweenaw’s land. You can go to the mining company’s website and read about the
Copperwood project. Keweenaw Land Association says the mine should begin construction in
late 2018 and be online in 2020. Presumably, Keweenaw may start earning copper royalties in
2020 or 2021 if that schedule turns out to be true. Like I said, Highland Copper is a public
company in Canada. So, it files things regularly that allow you to keep track of what’s happening
with Keweenaw’s mineral rights. This isn’t a big lottery ticket. If you do the math on
Keweenaw’s potential royalties according to the company’s latest investor presentation – it
would be $20 to $25 a share in undiscounted royalties. Those royalties might never start at all.
And they might trickle in for a long time. The copper isn’t a game changer here.
Finally, the company did hire an investment bank to explore a sale of the company. They
ultimately decided not to sell the company. I suppose a sale of the company is still a potential
catalyst now. This might be more likely if Cornwall Capital took control of the board. That is
certainly the way the current board paints Cornwall’s proxy campaign. They say Cornwall owns
26% of an illiquid stock and has for many years – Cornwall wants out. The only way to do that
with such a big position in such an illiquid stock is to organize a sale of the whole company. That
may be true.
My own approach to analyzing Keweenaw Land Association is to just ignore all these potential
catalysts. Some of the outcomes from these catalysts could be as much good as bad. I’m not sure
a REIT conversion is a great idea. I’m not sure Cornwall will definitely do a better job running
the company. I have no idea if that planned copper mine will ever get up and running. So, I’m
going to just stick to valuing the timber.

Now Let’s Get The “Who to Vote For” Question Out of the Way
Before valuing that timberland, though, I guess I have to give my opinion on the April 12th board
election. If you put a gun to my head, I’d vote for the 3 Cornwall nominees. However, I don’t
think the current board or Cornwall is all good or all bad. Neither group has its interest perfectly
aligned with yours. Cornwall has a lot of skin in the game. But, you can sell your position in the
open market if you put in $10,000 or $100,000 or $1 million into this stock. No, you can’t sell it
instantly. But, you can sell your position in a perfectly orderly way. Cornwall can’t sell a $35
million position in a stock that trades less than $500,000 in many months. So, they may have an
incentive to sell the entire company at a worse price than you’d like. Also, Cornwall may be
more aggressive in harvesting timber than they should be. On the other hand, there’s the risk of
professional management – not owner/operator – type behavior from the board as it currently
exists. For example, this board has taken on debt to buy more timberland. My general impression
is that Cornwall’s policies when it comes to existing timber wouldn’t match mine if I was
running the company. And the current board’s policies when it comes to capital allocation
wouldn’t match mine. I don’t think a victory by either party would be a disaster for passive
shareholders though. In fact, I’m not sure my appraisal of the company would change at all
depending on who is in charge. The one caveat is that I’m not sure how leanly the organization
could be run. If Cornwall takes over, I may be surprised that expenses I assumed were legitimate
weren’t really necessary. Maybe. On the other hand, Cornwall could add expenses.
What’s important is keeping expenses as low as possible, harvesting the right amount of timber
to maximize long-term returns, minimizing and deferring taxes, and minimizing the use of
shareholder money when investing in more timberland. I don’t see one side or the other getting a
perfect score on all those points. So, I’m pretty neutral about the board election.
One of our members – and a frequent stock idea write-up author – Vetle Forsland sent me some
bullet points on why he’d vote for the incumbent board. He agreed to let me share his case for
the current board with you. Here it is…
Why Vetle Would Vote with the Board
 Cornwall, a NY Hedge fund, wants three additional members on the board

o Cornwall wants to sell the company
o If elected, they will make up 63% of the board, while owning 26% of
Keweenaw (Now they make up 25% of the board with 26% of the shares)
o Managing member states “The company intentionally under-harvests its
timber in favor of increasing biological growth, (…) and is perpetually cash
starved”

o
 In my opinion this sounds like a good decision by Keweenaw,
as inflation and housing starts have been low, hurting timber
prices
 Current Keweenaw board

o Plans to convert to REIT
o Sounds like the current board and management wants to continue
operations as the company stands today, instead of actively trying to sell the
company
 The company is extremely illiquid (days when it doesn’t trade at all) and peers are 10x+
bigger, which makes me think selling the company could be a good idea

o But Cornwall might just want out of the company, and could approve a
lower price than what’s fair
o Keweenaw explored a sale possibility in 2017, but the proposed offers were
too low, as acquirers were unwilling to pay for the capital gains created
over the past 25 years
 Converting to REIT will reduce taxes on dividends from 39.6% to 29.6% after the tax
cut, while eliminating built-in gains

o This of course could lead to better offers from bidders
o The current board have better timberland knowledge than Cornwell, knows
how to generate long-term value for shareholders, and are also actively
making Keweenaw more attractive to acquirers.
Therefore, I believe voting in line with the board recommendation is the right thing to do.

Okay. Now, I can talk to you about timberland. The key point is how much this timberland is
worth per acre and how many acres (0.14) there are per share. We’ll do that math in a bit. But,
first, I want to talk to you about timberland as an asset.
Timberland as an Asset
I wouldn’t be looking at this stock if I didn’t like timberland as an asset. Timberland is an

attractive asset because it has historically provided returns more similar to stocks than to bonds
or less productive land. The similarity between common stocks and timberland is that they both
have a harvested yield – timber cut and sold this year and a stock’s dividend yield – and they
both have retained yield (retained earnings for stocks and biological growth for timberland). If a
stock doesn’t pay a dividend, the earnings will build up in the form of corporate asset growth
(and often later earnings growth, dividend growth, etc.). If timberland isn’t heavily harvested, the
potential harvest in future years will build up in the form of more valuable trees (and often later
harvest growth). Timberland is also attractive as an inflation hedge.
The return in timberland is basically:
(Profit from the harvest / appraisal value) + biological growth rate post-harvest + the rate of
inflation
So, if a company has timberland appraised at $100 million and it produces $2 million of free
cash flow from timber operations and the volume of timber grows at 3% a year even without that
harvest and the rate of inflation is 3%, that’s actually a return of 8% on the appraised value of the
timber (2% + 3% + 3% = 8%). In the U.S., quite a lot of timber is used for housing construction.
So, the two key cyclical inputs for medium-term returns in timberland are: rate of housing
construction and rate of inflation. Well, for the last 10 years, the rate of housing construction and
the rate of inflation have been low. This makes timberland look like a terrible investment when
compared to the stock market for the period 2009-2018.
However, if we go back to the 1900s, you can see that my comparing timberland as an asset to
common stocks as an asset isn’t so far-fetched:
That’s from a biased source (a company that manages timberland). But, it shows that buying
timberland at its fair market value is not like buying a pile of cash, undeveloped land, etc. The
returns are much more like owning a stock market index. In fact, GMO (Jeremy Grantham’s
firm) had recently set 7-year projected returns for timberland above those of U.S. stocks
generally. And I’d agree with that. From 2018-2025, I’d expect holding timberland to offer better
returns than holding the S&P 500. However, this isn’t because timberland is a superior asset. It’s
because timberland hasn’t been increasing in price over the last 9 years the way the S&P 500 has
been. Investors should prefer stocks over timberland if they can get each asset at the same price
relative to its own historical price levels. Today, it’s hard to get stocks anywhere near the levels
they traded at in the past. It’s possible to get timberland at levels – in real prices – that are
somewhat similar to where it traded at in the past. Under the comparable sales approach – which
I’ll explain why I think is best – to appraising Keweenaw’s timberland, the nominal value per
acre has climbed consistently while the real price per acre hasn’t changed much since the
housing boom in 2006.
The company has an appraisal done of its own lands every 3 years. The appraisal they refer to is
an average of multiple different approaches. However, based on what I’ve read about why
appraisers use different methods and the information we have that Keweenaw misjudged the
amount of timber on their land by 25%, because it relied on flawed internal models – there’s
really no reason to use the income capitalization method. Appraisers like the income
capitalization method, because the land owner can provide them with all the information they
need to do the calculation and because appraisers are supposed to use more than one method. In
reality, the company’s modeling of its timber growth hasn’t been good. And an income
capitalization method uses a discount rate assumption – which I don’t have much faith in. The
comparable sales approach could be flawed. But, it’s the best method we have. So, I’d prefer
using the comparable sales approach when valuing Keweenaw. But…
The company says – in a recent press release criticizing Cornwall Capital – that the timberland
has most recently been appraised at $901 an acre. Again, this is probably using a combination of
appraisal methods. I actually think relying just on the comparable sales method alone is better.
But, we’ll use the $901 an acre appraisal.
If each share of Keweenaw Land Association stock has 0.14 acres of timberland worth $901 an
acre – then, the market value of the timberland per share is $126. The company says there’s a
$50 million gain embedded in the timberland that reduced the bids potential buyers made for the
company. That’s presumably a tax hit of $8 a share ($50 million / 1.3 million shares = $38 a
share in gains; $38 * 0.21 corporate tax rate = $8 a share). It’s impossible to judge this number
exactly. The tax hit could be higher than the 21% federal corporate tax rate. But, you’d think that
any sale of the company or its timberland would be something both the buyer and seller designed
with an eye toward minimizing taxes. The company says bidders took this embedded gain into
account and reduced what they bid for the company. However, there are ways to defer and avoid
gains like this. It’s not like Keweenaw is being forced to liquidate this instant. In reality, taxes
might reduce the value of Keweenaw Land shares by less than $8 a share. But, I’m going to use
$8 a share. So, that’s $126 in timberland minus $8 in taxes on that land equals $116 a share. Debt
is $18.5 million. That’s $14 a share. So, that bring the company’s value per share down from
$116 a share to $102 a share. The company has a little bit of cash, some marketable securities,
and mineral rights. I’ll assume those are all worthless. They’re not. But, they’re also irrelevant to
our conclusion.
The stock would then have an appraisal value of $102 a share. The stock last traded at $102.50 a
share.
So, the conclusion is that buying Keweenaw Land Association shares is a way to invest in
timberland without paying any more than it’s worth.
I think that’s a conservative appraisal value for the stock. And yet, I can’t get an appraisal value
for the stock that’s below the market price on the shares. In other words, you can buy into this
stock at a conservative appraisal of what it’s worth.
I’m sure that doesn’t sound exciting. But, in today’s stock market – that’s pretty rare. For most
stocks, I can come up with some appraisal method that is within the realm of reasonableness and
yet values the stock at less than where it trades. Here, I can’t find a reasonable method for
valuing Keweenaw that is less than its current stock price. That doesn’t mean there’s much
upside. It just means there’s no downside.
There are questions about whether timberland might be undervalued right now. Over the past 20
years, Kewanee grew the value per acre by about 5% a year. If we use more like the projected
return for timberland as an asset over the next 5-10 years, it’s possible we’d get closer to 8% a
year. But that’s a macro-call. This would happen if housing construction and inflation both
increased over the next 5-10 years.
I think we’re talking about an asset that will return 6% to 8% a year if bought at its appraisal
value.
I suspect Kewanee Land Association will outperform the S&P 500 over the next 5-10 years.
There’s some pretty conservative assumptions in my calculation that you might not have noticed.
For example, it’s very easy to get very long-term financing on timberland. It’s also very easy to
get biological growth that allows for quite a bit of deferred taxes. If a company isn’t cutting
down many trees and is using quite a bit of debt – returns could be good. There may be better
ways to run this company. Though I’m not sure either the current board or Conrwall is likely to
financially engineer this thing to perfection.
What are the risks?
This is a small company, so there are plenty of risks of high expenses. The current board claims
that expenses will rise if Cornwall Capital takes over, because Cornwall will add to travel
expenses for the board, exploring strategic alternatives costs money, etc. I think that’s a real risk.
A change in control at a company always presents risks of big changes to the board expenses,
expenses of top managers, etc.
The board also says that Cornwall doesn’t understand the timber industry and got an appraisal –
without notifying the board – that used satellite images and incorrectly gave a much higher value
for the land than it’s really worth. This is because Cornwall misidentified what land belonged to
Keweenaw.
So, it may be that Cornwall will take control of the company and seek to sell it quickly to make
up for this mistake. That’s the risk.
On the other hand, it’s possible that Keweenaw’s land is worth more than the current board
claims. The current board has timber experience and yet erred about as badly in determining how
much timber was on their land as Cornwall did in trying to get a satellite based independent
appraisal. In addition, if you read between the lines, it seems like Keweenaw’s lender was the
catalyst for doing a timber cruise to better determined the actual amount of timber on
Keweenaw’s land. In other words, if Keweenaw hadn’t sought to borrow money – it never would
have known how much timber it had.
So, it’s possible that Keweenaw’s tax situation isn’t as insurmountable as the current board says
and that their land is worth more than the current board says.
But, I wouldn’t count on it.

I’d count on $100 of Keweenaw stock being worth about $100 of timberland. Right now, I think
timberland is a better asset than the S&P 500. So, I’d say that switching money out of an S&P
500 index into Keweenaw Land would be a good diversifying move.
I’m also pretty confident that Keweenaw Land Association stock is not worth less than its market
value. I can’t say it’s cheap. But, I can say it’s definitely not expensive.
 URL: https://focusedcompounding.com/keweenaw-land-association-buy-timberland-at-
appraisal-value-get-a-proxy-battle-for-free/
 Time: 2018
-----------------------------------------------------
Why I’ve Passed on Keweenaw Land Association (so far)
Trey had a good question in response to my Keweenaw Land Association article:
“Are you willing to share your reason for not investing at this time?
My first pass analysis leads me to also not choose to invest at this time. For me, it’s a matter of
opportunity cost. Simply beating the S&P500 is insufficient. Since the S&P500 is projected to
return much lower than its historic rates of return, my current opportunity set is much better.
That’s really always been my hesitation with owning something like timberland. I’ve been
interested for diversification reasons, but in order to achieve double digit returns over long
periods of time, you have to really buy at a large discount.
While I agree with the analysis that downside looks limited here, I struggle to come up with a
scenario where a long-term owner (10+ years) could earn 10%+ returns. I understand though,
that if the company is sold in a shorter amount of time for a premium, you could earn that hurdle
rate over a shorter period of time. With that said, I think purchasing below $75-80 per share
would offer the additional 2%/year return that I need for a 10 year holding period.
Sure. So, it’s easy to imagine a scenario where a long-term holder of timberland makes 10% plus
returns. All you need is high inflation. Timberland’s long-term returns should be driven by: the
cash flow produced by the annual harvest, the biological growth, the rate of inflation, and then
also there tends to be some return – at least historically this has been true as countries develop –
of competing uses for the land. This last factor is not important in Upper Michigan. But, there are
places in the U.S. where it is. There’s nothing nominal about any of the factors driving returns in
timberland. All the factors driving returns are real factors. So, if you had 6% inflation or higher –
it’s likely timberland would return 10% or more a year for as long as that situation continued.
You can check the historical record for periods of high inflation in the U.S. and see how
timberland performed versus stocks, bonds, commodities, etc. during that period. The answer is
good.
Over periods as short as 5-10 years, the factors driving timberlands returns would really just be
the purchase price you were getting in at (if you’re buying a timber stock – this means both
where we are in terms of timberland pricing and where the share price is versus the appraisal
value of its timberland) and then whether demand for housing increases while you hold the
timber stock. There are other uses for timber, but the most cyclical use for the more profitable
trees is housing. So, when you see a low projected return for the S&P 500 versus a high
projected return for timberland over the next 5 or 10 years, what the forecaster is really saying is:
stocks are relatively more expensive than timberland right now, home construction is relatively
low right now versus what it’s going to be, and inflation is relatively low right now versus what
it’s going to be.
The reason I decided not to invest in Keweenaw has to do with the discount to my appraisal
value. In the article I wrote, I tried to be conservative. You’re right that if you’re buying
timberland at 100% of its market value your returns aren’t going to be impressive if you hold the
stock for long. However, it’s easy to underestimate the combination of buying a stock at a
discount to its asset value and those assets compounding in value while you own it.
Let’s say you were somehow 100% confident of two things: you were buying Keweenaw’s
timberland at a 20% discount to what it’s really worth and that timberland would return 6% a
year for as long as you owned it.
In that scenario, you would make 10.8% a year over a 5-year holding period or an 8.4% return
over a 10-year holding period or a 7.6% return over a 15-year holding period.
That may not sound impressive. But, consider a few things. One, I usually sell a stock within 5
years. So, if the value gap closed faster than 5 years – and it often does in value stocks even
without proxy battles, etc. – you’re talking about returns well above 11% a year.
Two, I can’t be 100% confident that timberland will return 6% a year as an asset class or that
Keweenaw’s timberland is really worth at least $125 a share (this is a 20% margin of safety if
you can get shares around $100 yourself). But, those are not high hurdles to clear. I couldn’t get
a value quite as low as $100 for the company even using the absolute most conservative
estimates I could come up with for the timberland (like an immediate tax hit). It really might be
worth $125 a share instead of $100 a share. I certainly wouldn’t be more sure of a $100 appraisal
than a $125 appraisal.
So, if you have a holding period of 5-15 years you’re expecting returns of 7.6% a year to 10.8%
a year. I’ve made good annual returns in stocks that only return 7% to 11% a year over 5-15
years, because I sold them sooner than 5 years.
It’s just difficult to find assets you have any kind of confidence will return 7% to 11% a year
right now. So, you can wait in cash till you find situations where you do have confidence. You
can wait in the stocks you already own but know won’t return that much (like I’m hanging on to
BWX Technologies despite it now being an expensive stock). Or, you can buy things that only
look likely to return 7% to 11% a year as long as those things seem safe and certain.
My reason for not buying Keweenaw Land Association isn’t that timberland is a low returning
asset. It’s a good asset. And I’d love to own it at a 35% discount to my appraisal value.
In the case of Keweenaw: maybe my optimistic appraisal value might have put the current stock
price at more like a 25% or 20% discount to appraisal value. And my pessimistic appraisal value
might have put it at more like a 0% discount to my appraisal value.
This is a moving target. The board gave us some information about the appraisal they got after
the timber cruise. But, it’s not as full as the information I’d normally like to see. And they were
using that information to score points in their proxy campaign. If you take the last appraisal
value we had 3 years ago and try to incorporate information about the results of the timber cruise
– you can easily end up with an estimate of the fair market value of this timberland (especially if
we’re not talking about selling the whole company right away) of well over $100 a share.
In other words, I felt Keweenaw really might only be worth $100 to $125 a share instead of $150
a share. If I felt sure it was worth $150 – I’d buy it. I have no problem buying an asset that might
only return 6% to 8% a year if I’m getting in at two-thirds of its face value so to speak and it’s a
solid asset in terms of inflation protection, the risk it’ll return less than 5%, etc. For example: I’d
be interested in a super predictable insurer with an 8% return on equity if I could get the stock at
0.65 times book value. If you hold such a stock forever you’re only going to make 8% a year. It’s
not an ideal long-term holding. But, if that 8% return is sure and the discount to book value is
sure – it’s a pretty good combination.
So, the issue here for me is that I just wasn’t sure I was buying in at anything like a 35% discount
to what the stock’s worth – and I try never to touch a stock unless I believe I have that margin of
safety.
In the article, I was very unfair to Keweenaw’s timberland in terms of what it might be worth. I
did this because this is how I think when analyzing a stock for myself. I start with some pretty
tough assumptions, and then if the stock still looks good given those assumptions – I start to get
more realistic. But, in the early stages of analyzing a stock, I’m looking for quick ways to
eliminate the idea.
I may have made it sound like I think Keweenaw is only worth $100 a share now in terms of the
value of the timberland. I don’t. What I think is that there’s no way the timberland is worth less
than $100 a share.
I’d recommend Focused Compounding members read what the board has said about the
timberland’s value, what Cornwall Capital has said, and then also read the annual reports (it’s
one report every 3 years that includes an appraisal of the timberland – I think the last annual
report that included an appraisal was 2015) to see the actual values given by the appraiser for the
timberland using different methods.
I don’t want to make it sound like the timberland is really worth $100 a share or $105 a share or
something like that. It’s not. I was just proving that the current share price can’t possibly be
higher than the underlying timberland.
However, the reason I passed on the stock is that the price is $100 or higher while I’m not
confident the timberland is worth $150 or more per share. So, there’s not the margin of safety
(35%) I like to see.
 URL: https://focusedcompounding.com/why-ive-passed-on-keweenaw-land-association-
so-far/
 Time: 2018
-----------------------------------------------------
Revisiting Keweenaw Land Association (KEWL): The Annual Report and the
Once Every 3-Year Appraisal of its Timberland Are Out
Accounts I manage hold shares of Keweenaw Land Association (KEWL). I’ve written about it
twice before:
Keweenaw Land Association: Buy Timberland at Appraisal Value – Get a Proxy Battle for
Free
And
Why I’ve Passed on Keweenaw Land Association – So Far
I didn’t continue to pass on Keweenaw Land Association. Like I said, the stock is now in
accounts I manage.
There are really two things worth updating you on. One is the annual report. The other is the
appraisal. The appraisal is something the old management team – the one that lost last year’s
proxy vote to Cornwall Capital – always did as well.
So, I can show you a summary of every appraisal from 2006 through 2018. The company
includes this in its annual report:
You can read the entire annual report here.
A full summary of this year’s appraisal and methods used by the appraiser can be found here.
In today’s article: I’ll focus on the appraisal, because valuation of the stock seems to be the thing
readers are most interested in. The annual report is also quite interesting though. The company’s
new management is disclosing far more than the previous management. Although Keweenaw
stock is “dark” (it doesn’t file with the SEC) – this latest annual report reads like a typical 10-K
filed with the SEC. The company also changed its auditor to a better known firm (Grant
Thornton) that audits plenty of other public companies.
As you can see in the table above, the value per acre of KEWL’s timberland was appraised at
$809 this year versus $901 in 2015. That’s a decline of 10% versus 3 years ago. It’s also
basically flat with an appraisal done in 2009 (so nearly 10 years ago). These are also nominal
numbers. So, that means that the real value of KEWL has declined on a per acre basis over the
last decade.
What’s tricky about this though is the last row you see “appraisal as a percent of standing
inventory”. As you can see, the effective gross timber value – this is the value of all of the wood
on Keweenaw’s land less the estimated gross costs of cutting and trucking that timber away – has
risen pretty consistently. It went from $728 an acre in 2009 to $1,130 an acre today. But, the
appraisal as a percent of that standing inventory went from 110% in 2009 – meaning the
appraiser was then valuing the timberland above the gross value of the timber itself – down to
just 72% this year. You can also see that the physical volume of timber – measured in cord
equivalents – has compounded at something like 4% a year over the last 12 years. So, physically
there is more timber on Keweenaw’s land every 3 years – and at least in the 2012, 2015, and
2018 appraisals this timber’s value has also increased per acre every time. However, the
property’s appraisal has not. In fact, it declined by 10% these last 3 years. That’s clearly due to
the change in the appraisal relative to the standing inventory.
Why has that happened?
Well, there’s some discussion of it in the appraisal summary. The appraiser notes that they would
normally put greater weight on the “comparable sales approach” rather than the “income
capitalization approach” (basically, a 10-year DCF). However, in this case they weighted the two
appraisal methods equally.
As I’ve mentioned in past articles on KEWL – I prefer the comparable sales method. I don’t like
the income capitalization approach. And you can read the details of the assumptions made to do
that DCF for the income capitalization approach in that appraiser’s summary report. It relies on
some solid assumptions like the growth – in fractions of a cord – per acre each year. But, then it
relies on assumptions I don’t like such as the use of a 5.5% real discount rate. This may be a
reason why the comparable sales approach gives a higher appraisal than the DCF based
approach. In today’s environment of 2% inflation, a 5.5% real discount rate is equivalent to a
7.5% nominal discount rate. The problem with that can be seen by applying such a discount rate
to the S&P 500 – it wouldn’t hold up well at its current price (in other words: I don’t expect the
stock market to return 7-8% a year in the decade ahead – and I certainly do expect it to be more
volatile than timberland). For comparison, inflation protected 30-Year U.S. Treasury bonds yield
1% right now. So, for appraisal purposes – the timberland here is being discounted at a 4.5
percentage point spread over U.S. Treasuries. This is what happens when you use DCFs. There
are other even more speculative assumptions built into this appraiser’s DCF such as a 10-year
holding period by any financial buyer, the decision by such a buyer to more aggressively harvest
the timber at first, etc.
Since I could do my own DCF just as well as an appraiser could – I prefer to look at the
comparable sales approach. An appraiser is much better able to judge the location of KEWL’s
land, the quality of its trees, road access, etc. than I possibly could. An appraiser also knows the
potential buyers much better than I do. So, this is the number I care about.
But, before I talk about the comparable sales approach – let’s do the math on the actual appraisal
put out in this report. The appraisal is for $148.9 million. KEWL has 1.3 million shares
outstanding. So, that gives a per-share appraisal of the timberland of about $114. KEWL has
about $10 a share in net debt – I’m deducting both cash and securities (these are stocks KEWL
holds) from gross debt. So, we have an appraisal net of debt of about $104 a share. In the annual
report, KEWL’s management gave a “fair value” disclosure of several assets. The only other one
that matters here is the mineral rights. This is a lottery ticket. If a mine is built soon and the price
of the copper extracted is high – KEWL would earn good royalties. I have no idea if this will
happen. KEWL’s management estimates the mineral right are worth a little over $5 million – or
about $5 a share. So, you could look at this appraisal as saying KEWL stock is worth either $104
a share or $109 a share. It last traded at $79.50 a share.
Like I said, I prefer the comparable sales approach. The difference between the comparable sales
approach and the income capitalization approach is large – it’s about $22 million (which is $17 a
share).
The sales comparison approach alone – not blended 50/50 with the income capitalization
approach as the appraiser did here – would give an appraisal of $160 million (instead of $148.9
million). If you divide $160 million by 1.3 million shares you get $123 a share. You then
subtract the $10 a share in net debt. You’re left with $113 a share. If you want to add the $5 per
share in mineral rights – you get $118 a share.
How would I do it?
I’d use the comparable sales approach alone. And I would assign no value to the mineral rights.
This gives an appraisal of $113 a share. I’d then apply the standard “Ben Graham margin of
safety” approach of buying only at 2/3rds of what you think something is worth. In this case,
that’s $113 * 0.67 = $75.71.
This leads to the following buy, sell, and hold suggestions.
When KEWL’s stock price is…
Under $75: BUY the stock
Between $75 and $113: HOLD the stock
Above $113: SELL the stock
The stock last traded at $79.50 a share. So, it’s a hold. But, it’s something to watch.
It’s also worth mentioning that the appraiser lays out 6 cases in that report. The lowest end of the
most conservative method is the low-end estimate using the income capitalization approach. It
would give a valuation of about $80 a share. So, about today’s stock price. The highest-end
estimate using the comparable sales approach would instead say there is about 95% upside in the
stock. So, it varies a lot.
Even though the lowest end of the least favorable appraisal method still gives you a valuation per
share of about $80 a share – without including mineral rights – which is right in line with today’s
stock price, KEWL is not risk free. The company does have a lot of debt relative to its actual
cash generating ability. This is supposedly considered safe for a timberland company. For
example, MetLife is basically extending credit to KEWL based on the safety provided by the
amount borrowed not exceeding about one-third of the value of the timberland. By that measure,
the company is not over indebted. Right now, the timberland might be valued at like 10 times the
net debt. But, timberland generates very little cash flow each year. So, this is definitely not a
company with as strong a balance sheet, liquidity position, etc. as something like NACCO (NC).
There is some financial risk here. So, even if there appears to be no “price risk” in the sense that
the appraiser didn’t consider any scenario where the timberland would be worth less per share
than where this stock currently trades – this stock is not risk free.
I wanted to focus on the appraisal here. The annual report was actually very encouraging. The
only two questions with this new board are:
 Will they issue too many stock options to insiders

 Will they cut down too many trees too fast
Within reason: neither #1 nor #2 is necessarily a bad thing. By volume, they increased the
harvest by more than 20% this year – and this board wasn’t even in charge all year. It was the
biggest harvest in the company’s history. The company didn’t use equity grants as an incentive
in the past. I have nothing against compensating management, the board, etc. in stock and based
on performance. However, stock grants dilute the percentage ownership of investors like us.
Basically, if you grant 1% of a company to insiders each year – you are lowering the total return
in the stock by 1% per year forever.
There are a lot of encouraging signs out of this management. There is a lot more talk of value
creation and eventual value realization. There is a ton more disclosure. And the plan to pay down
debt is a good one. Apparently, they will be doing an investor presentation and Q&A for
shareholders. This will also be made viewable by investors who don’t attend the annual meeting
in person.
With this new board, KEWL has gone from a “dark” stock that didn’t reveal as much to investors
as a typical SEC reporting company would to now being among the most communicative OTC
stocks I’ve seen.
It’s a big change. But, a bigger investor relations push makes sense when the board is controlled
by a hedge fund that owns a lot of shares.
Keweenaw mentioned that “now is not the time” for a sale of the company. They are open to
offers. But, it’s not a good market for timberland transactions. The appraiser said the same thing.
The appraisal report mentions a couple “no sales” including KEWL’s own attempt to sell all of
itself (under the previous board). Apparently, there has been very little activity in terms of
timberland transactions in the region within the last 2-3 years. This is a part of a bigger national
trend. Many institutional owners of timberland have gone from being net buyers to being net
sellers. I don’t know how much this has really affected prices at which transactions are done.
But, it’s clearly dried up volume.
In fact, this recent trend – of extremely few major timberland transactions – is why the appraiser
blended the income capitalization method and the comparable sales method 50/50 instead of
relying primarily on the comparable sales method.
So, I wouldn’t say there’s any catalyst in KEWL.

 URL: https://focusedcompounding.com/revisiting-keweenaw-land-association-kewl-the-
annual-report-and-the-once-every-3-year-appraisal-of-its-timberland-are-out/
 Time: 2010
-----------------------------------------------------
Libsyn (LSYN): A Pretty Cheap and Very Fast Growing Podcasting

Company in an Industry with a Ton of Competition
This is a complicated one. So, I’m going to do my best to boil it down to the things that really
matter. That’s a judgment call. And it means I may be focusing on the wrong things. I may not
be telling you enough about some things that do matter a lot and fixating instead on some stuff
that turns out not to matter as much as I think.
Libsyn is one of the biggest and oldest companies in podcasting. It has been there since the
beginning of podcasting basically. And unlike almost every other company in the industry – it’s
profitable. It’s been profitable for a while. And it’s likely to continue to stay profitable. This
company (Liberated Syndication – ticker LSYN) also owns another Pittsburgh, PA company
called “Pair”. Pair is a website host (and domain registrar) that is also very old and also
profitable. Pair has been around since the mid-1990s. Libsyn has been around since the mid-
2000s. Both have basically been there since the start of their respective industries. As I write this,
Libsyn (the podcasting company) accounts for maybe 60% of the gross profit, EBITDA, etc. of
the combined company and Pair for the other 40%. However, I’d personally appraise Libsyn as
much more than 60% of the combined company’s intrinsic value, because I think it’s likely to be
a fast grower.
Why?
Podcasting is a very, very fast growing industry. It’s hard for you to realize just how fast
growing it is. As investors, we’re used to thinking in dollar terms. We look at revenue and gross
profit and so on in terms of dollars. We aren’t managers and often don’t see the underlying unit
growth. Unit growth is the physical – of course, in this case it’s actually intangible – growth in
the industry. The number of podcasts, podcast episodes, monthly audience figures, etc. is the
“unit growth” in this industry. It’s the growth independent of pricing. Most industries in the U.S.
– if they are growing at about the same rate as the overall economy – only grow at a rate equal to
population growth plus output per person. So, before inflation, an industry that’s growing at a
healthy rate might be doing 3% unit growth a year. This means it will double in real size about
every 25 years. A fast growing industry – something more like electric vehicles and hybrids and
so on – might be growing at like 7% a year. This means it will double in real size about every 10
years. Podcasting is growing much, much faster than that. In recent years, most of the key
metrics that Libsyn tracks have been growing at about 20% a year. This means it doubles in real
terms about every 4 years. To put that in perspective, at the rate podcasting is growing in terms
of number of shows, number of episodes, number of monthly listenership, etc. we are talking
about something that will double in size by 2024, quadruple by 2028, and increase eight-fold by
2032. I like to look at 15 years max when analyzing a company. That’s hard to do here –
because, unless and until podcasting slows down a lot, you’d be looking at a company (Libsyn)
that would go from having about 110 million listeners a month (it’s actually higher than that
now, but that’s what it was last year) to about 1.7 billion listeners a month in 2035. Now, of
course, that doesn’t mean that 25% of the world’s population will be listening to a Libsyn hosted
show in 2035. Some people who listen to podcasts could listen to several Libsyn podcasts a
month. But, that’s the kind of growth we’re talking about here. We’re talking about the kind of
growth you saw in radio, movies, TV, etc. in their early decades. A business growing that fast
should be worth a high multiple of EBITDA if it will continue growing very long at all. Libsyn
doesn’t have a high EBITDA multiple.
Libsyn – the combined company – has about 30 million shares outstanding. The stock price is
$3.10 a share. So, that’s a market cap of $93 million. Net cash is about $9 million. Let’s round
off the enterprise value and call it $85 million. Recently, EBITDA was about $7.5 million. Other
than taxes – which Libsyn is now paying (in fact, an IRS audit showed it should’ve already been
paying taxes) – this company has very little (almost no) cash expenses below the EBITDA line.
As it grows, it also generates some float. So, free cash flow here should be roughly EBITDA
times one minus the tax rate. If taxes are 21% in the U.S., then 0.79 times (let’s call it 0.8 times)
EBITDA should be normal free cash flow. That’s $7.5 million times 0.8 equals $6 million. So,
you have a business valued by the market at $85 million doing about $6 million in “owner
earnings” in one of the fastest growing industries around. It’s trading at a P/FCF of like 14. Let’s
say 15 is normal. Let’s say Libsyn is trading at around 15x P/FCF. You are paying nothing here
for the fact earnings are going to grow much, much faster than stocks in other industries. This
looks like an amazing investment.
But, there are problems. The board is currently split 50/50 between an activist investor (Camac
Fund) and presumed supporters of the CEO (Chris Spencer). The SEC brought a complaint
against the CEO. If you read that complaint – I’m not going to link to it or talk about the details,
because I don’t know what is true and isn’t and don’t want to criticize someone by name (one of
Buffett’s best rules for life) – you’ll see that it’s a very, very serious complaint. Technically,
Libsyn is a spin-off of FAB. And this also presents problems, because there could one day be
legal issues due to what FAB did. Again, just look for the SEC complaint. Judge for yourself.
There are also some little things about how the company is run that are interesting. It’s a Nevada
corporation. It’s technically a spin-off of FAB. The former CFO and current CEO had a very
serious SEC complaint involving them. The company settled in a way that split its board. It had
tax problems related to that IRS examination I mentioned above. The current CEO seems like a
part-time or at least “remote” CEO from what I can tell. Not that that’s necessarily a negative if
you read the SEC complaint. The company also seems to keep almost all of its cash – at times,
this has been like $17 million – in basically just one bank account. There’s almost certainly
nothing nefarious about that. But, it is unusual for a company sitting on that much cash – and
adding more than $100,000 a week to the cash pile – to have the same “treasury management”
operations as like a tiny business. The company did just announce a new CFO hire. So, many of
these things may change. It’s also possible the split board is focused on more contentious stuff
than where the company parks its cash.
On the other hand, I kind of do like management here. Not top management. But, the
management one to two layers below. The company has a President who runs both Libsyn and
Pair. Andrew has spoken to her. She seems diligent, knows her stuff, and is on site in Pittsburgh.
A level below here you have a really excellent and knowledgeable podcasting pro who heads up
podcaster relations at Libsyn named Rob Walch. Listen to his podcast “the feed” (I’ve listened to
dozens of episodes) to get some good insight into how podcasting works. He’s very good. The
management bench here is deep with people who are perfectly good at what they do. The top
podcasting people at Libsyn are very involved in industry events, trade magazine type online
stuff, etc. They are long-tenured, industry veterans. They are active, well-connected, etc. If the
podcast industry is lobbying for or against something, doing some industry trade group type PR
stuff, etc. – expect people from Libsyn to be part of it.
The business has amazing economics. But, the industry has a really weird competitive situation.
Libsyn (now, I’m talking about the podcasting side) gets 64% of revenue from podcast hosting
fees and 17% from bandwidth charges. It also gets a few percent from apps. Ad revenue is less
than 15% of revenue. This is completely different from all its competitors. And the last time
there was an industry shake out – following the 2008 downturn in ad revenue, VC funding, etc. –
a lot of competitors died out.
The Libsyn model is durable. The model used by competitors – some of which have better user
interfaces, way better funding than Libsyn, and some pretty fast growth – is not very sustainable.
Competitors generally use a “freemium” model and burn lots of cash. They seem to hope to
eventually develop a big ad supported side to their network of podcasts or to sell out to a bigger
company.
Everyone interested in Libsyn seems to be interested in the company selling out to a bigger
player who wants a foothold in podcasting. That wouldn’t be expensive. You could spend $100
million to $200 million and suddenly be the host for maybe a fifth of the major podcasts out
there. But, personally, I think selling out would be a really bad way of monetizing this company.
If you look at Libsyn as a business, it will produce a ton of free cash flow that could be used year
after year to buyback its own stock. The company could support some debt (it certainly doesn’t
need excess cash). It could spin-off Pair. However, that’s unlikely at present as Pair was only
bought like a year ago.
Andrew and I use Libsyn for our podcast. It’s the way we’ll be delivering the new Focused
Compounding app we’re doing. Libsyn prides itself on its customer service. But, our experiences
with customer service at the lower levels of the organization – and this is just anecdotal info
about a sample size of one – have been extremely poor. On the other hand, any interactions with
the upper levels of the company – including just for help with the podcast – have been truly
excellent.
Libsyn’s technology, user interface, etc. are not cutting edge. It seems a bit behind the times in
user friendliness especially for podcasts just getting started out. The company has a very high
retention rate. I assume most podcast hosting companies also have very, very high retention rates
– we haven’t found many podcasters who have switched from one host to another. And we can’t
find anyone really who has switched between more than a couple hosts even if they’ve been
podcasting since pretty much the start of the industry.
Andrew and I went to Pittsburgh. Due to COVID, we were unable to meet with the management
there and see the offices on the inside and stuff. We did drive past the company’s locations in
Pittsburgh. This is a cost conscious company. It’s probably not a very innovative company. The
rent they are paying in Pittsburgh is very low on the office space they use (between $1 and $2
per square foot per month). Total rent here is like $550,000 a year. Items broken out specifically
as “technology” are not large expenses.
The economics of the business are excellent. Both website hosting and podcast hosting have high
retention rates. Gross profit margins are like 85% in these businesses. There is a misleading line
in Pair’s accounting which is amortization. So, EBIT is not accurate here. You need to use
EBITDA. For example, I’d estimate that in each of the next 5 years, Pair will take amortization
which – even after taxes – is equivalent to a charge of more than 3 cents per share. These are
non-cash charges applied to amortizing customer relationships, trade marks, and non-compete
agreements. If you use EBIT – you will vastly underestimate free cash flow. My advice is simply
to assume that about 80% of EBITDA will be free cash flow.
Bandwidth has economies of scale. The company gets lower and lower prices per unit of
bandwidth as it uses more and more bandwidth. It passes some of these savings on to heavy
consumers of bandwidth (the bigger your podcast, the less you pay per unit of bandwidth). But,
being a bandwidth “middle-man” is a good spread business that only gets better as you grow in
size.
This company has a ton of customers. It had 28,000 podcasts in 2015, 35,000 in 2016, 44,000 in
2017, 57,000 in 2018 and now probably a bit over 70,000 podcasts today. Listenership per
podcast doesn’t really grow that much over time. But, the rate of growth in the industry is
basically the same as the rate of growth in the number of podcasts.
The company is basically run with just 85 full-time employees across both Pair and Libsyn. It’s
run out of just one main office of about 35,000 square feet in Pittsburgh. There is a corporate
office and a back-up facility. But, we’re really talking about both sides of this company being
just 85 people working in 35,000 square feet in Pittsburgh.
Having used Libsyn ourselves for The Focused Compounding podcast – it feels like that. It feels
like a smaller, older operation. And I wouldn’t be surprised if a lot of new podcasters are
attracted to the “freemium” models of newer and cash burning competitors.
I’ve never invested in an industry with this much competition. And I’m not sure I’ll start now.
The very long-term upside here looks huge. This is a company that you could see being a ten-
bagger as a stock (the best way to do this would be to use almost all free cash flow to buy back
the stock and probably to divest Pair). But, it’s also an industry with a lot of competition. It is a
tech business. And Pair’s tech is not necessarily the best in the industry. It may not have a habit
of paying its people the most, spending the most on office space, etc.
A lot of that stuff worries me.
But, it’s the most stable and profitable and cost conscious company I know of in an industry that
is almost certain to grow over time. Libsyn isn’t focused much on the ad side of things. But,
advertising in podcasting is going to grow a ton over time. Ad rates for mid-roll host read ads –
imagine Andrew stopping at the fifteen minute mark in one of our shows and doing an ad in his
own voice and then going right back into the show – have some of the highest ad prices relative
to listenership of any ads I know of. This is because they are way more effective than any kind of
“broadcast” advertising on a per person who hears the ad basis. Podcasts are like special interest
magazines. They are a very lucrative form of media to insert highly targeted (by industry,
interest, etc.) ads into. I guess you could call the upside from ads the “lottery ticket” at Libsyn.
It’d still be a decent growth company even if it decided to stop running ads in all of its shows
tomorrow. Libsyn does make money from advertising (it shares with the podcast producer). But,
it’s just not a mainly ad supported business. So, I think you can analyze the company’s earning
power independent of ad spending on podcasts and then view any ad spending growth Libsyn
gets as unanticipated upside. Certainly, the stock’s price today wouldn’t be the least bit
expensive if ad revenue never grew at Libsyn. And everyone expects it will grow in the long-run.
This is a very, very hard one for me.
Of the stocks I’m seriously interested in, Libsyn is by far the business facing the most intense
competition. I like to find stocks where competition is low and getting lower. And I love to finds
stocks where competitors are rational, profit maximizing, etc. Competition in podcast hosting is
high and getting higher. And competitors are irrational and growth maximizing instead of profit
maximizing. A lot of competitors aren’t even interested in turning a profit anytime soon. They
just want to grow like crazy.
I’m undecided on this one. The growth runway is long and the compound upside over a decade
or more is tremendous. But, the competitive landscape worries me and the company’s
positioning in terms of its actual product, tech, customer service, etc. worries me too.
Still, industries with high retention rates tend to be very profitable for incumbents even when
competition appears very fierce. It’s usually the new entrants who burn through cash and leave
the incumbents in place.
Finally, I have to mention that Libsyn was the podcast host for the Joe Rogan Experience. That
show is moving to a Spotify exclusive. This was huge news in the business press and probably
the biggest thing the average investor has heard about podcasting. In the long-run, I think it’s not
a big deal for Libsyn. I’d expect a year of normal growth at Libsyn would make up for any loss
of Rogan’s show. Ten years from now, looking back on LSYN’s financials, I don’t think you’ll
be able to detect the year they lost Joe Rogan’s show. It’s just short-term noise. And it’s not bad
news of the magnitude that could possibly justify the current very low stock price.
The stock is undeniably cheap.
This is a value stock. And it’s a growth stock.

LSYN is one to keep an eye on. But, it’s not one I’m buying as of today.
 URL: https://focusedcompounding.com/libsyn-lsyn-a-pretty-cheap-and-very-fast-
growing-podcasting-company-in-an-industry-with-a-ton-of-competition/
 Time: 2020
-----------------------------------------------------
Libsyn (LSYN): CEO’s Departure Makes this Stock Even More Interesting
This is a follow-up article on Libsyn (LSYN). In my initial interest post on the company I talked
a little about the fact that company’s CEO was named in an SEC complaint. That complaint was
directed at the former CFO of the company and the current CEO of the company. I can now say
“former CEO” of the company. Libsyn announced that this CEO was resigning from his position
as CEO and also from the board. This was – to me – a very big deal. To the market, it wasn’t.
Libsyn stock barely moved on the news. That makes this stock a lot more interesting to me now.
However, the CEO was not the only issue I had with Libsyn. As discussed in my earlier article
on Libsyn, I do have some concerns about the company’s level of technological sophistication
versus some of its newer competitors. Libsyn has a business model that is probably – most of the
other companies in this industry don’t really release any sort of financial info that can give me
certainty on this – a lot more durable than competitors. Libsyn has two business segments. One is
“Pair”. This hosts websites – especially WordPress websites. It also does domain registration.
The other is the namesake Libsyn business. Libsyn’s business model consists almost entirely of
collecting revenue in 3 forms: 1) Fees paid by podcast producers (people like me and Andrew),
bandwidth fees (again paid by people like Andrew and me based on number and size of
downloads of a podcast each month), and premium subscriptions (Libsyn takes a cut of the
premium fee – for example the $7.95/month subscription service Andrew and I do – and the
podcast producers take the remaining amount). These 3 things taken together account for
virtually all of Libsyn’s revenue. It also has some ad revenue – but, this is small.
Competitors like Stitcher – which owns an ad company called Midroll – probably rely more
heavily on a combination of ad revenue and premium subscription revenue. Libsyn also does not
have a premium podcast network like some competitors. So, something like Stitcher – previously
owned by E.W. Scripps, but recently announced to be sold to Sirius/XM – brings in revenue sort
of like a hybrid TV broadcaster / cable channel. You pay a certain amount each month for a
subscription to Disney Plus, HBO Max, etc. People pay for a “Stitcher Premium” subscription
and get access to premium features (like behind a paywall episodes, etc.) of the various podcasts
on the network. Libsyn’s tiny amount of “app” revenue (it’s like 3% of recent revenue, maybe as
high as 5% in some quarters where ad revenue is real low) comes from specific show-by-show
revenue. It comes from taking a cut of people who signed up just for the specific premium
content of a podcast like Focused Compounding. So, it is single podcast specific revenue. There
are reasons why I think that makes more sense than a paid network. Ad revenue is potentially a
very big future source of earnings for any podcast host. However, it is the most economically
sensitive part of the podcasting industry. Things like fees paid by podcast producers, bandwidth
(basically podcast audience size), and even premium subscriptions are a lot more “sticky” forms
of revenue than ad revenue. Ad revenue depends on both the amount of ad spots sold and the
pricing of those ads. Recently, podcast listenership has not declined much due to COVID. It’s a
mix. Podcasts like the category Andrew and I do – finance / investing – haven’t declined at all. A
sports podcast or something like that may be down a bit. It’s category specific. But, it’s not like
audience numbers have dropped during COVID. Ad revenue has dropped. Probably by a lot. So,
if you are a mainly ad supported podcast hosting company that was already burning cash before
COVID – you could be a motivated seller of your whole company. Or, you could need to raise
capital in some way. This isn’t necessary for a company like Libsyn.
That’s all good for Libsyn. But, there are downsides to their approach to. One is that they are
diversified between two kinds of businesses – podcast hosting and website hosting – that I don’t
believe are equally attractive.
Libsyn as a whole is cheap. It hadn’t been paying taxes before. It will be now. But, as I laid out
in my earlier article – Libsyn’s EBITDA should convert to FCF very nicely. It’ll be at a really
high rate, maybe as high as like 75-80% after taxes. Why?
Libsyn (and sometimes maybe Pair too) is a growing business. It has minimal cap-ex needs. And
it generates float as it grows – payments are made to the company in advance of services
provided, bandwidth bills paid in cash, etc. As a result, if the business grows 10% or more in a
year – there’s a meaningful amount of float. The way EBITDA works is that it does not include
float generation. So, you can see that at like a manufacturer Cash Flow From Operations (CFFO)
can come in light versus EBITDA while at Libsyn CFFO can be extremely high relative to
EBITDA. In other words, every dollar of reported EBITDA at Libsyn is worth more than at a
manufacturer. People may overlook this. I’m not sure. Reported earnings suffer from
amortization of the Pair purchase. And then float drives CFFO (and FCF) higher versus EBITDA
than usual. Therefore, some investors may use either P/E or EV/EBITDA to value Libsyn while I
might favor Price/Free Cash Flow.
Of course, if the growth of the company reverses itself, float will run-off in the opposite direction
and shrinking FCF will become a much smaller portion of shrinking EBITDA. Basically, if
Libsyn grows 10% a year – FCF conversion will be extremely high versus reported EPS. But,
this is only if the company keeps growing year after year.
Podcasting itself will – putting ad revenue aside, and ad revenue is unimportant at Libsyn – grow
at a nice clip year after year after year. So, FCF conversion at the Libsyn segment of Libsyn
should be incredibly strong.
I would estimate that the company’s “true” P/E is about 15 times right now. That’s not really a
“forward” P/E either. If the company grows 10% a year, then obviously the forward P/E will be
more like 13 or so when the trailing P/E is 15 or so.
The stock is cheap.
Or, at least it would be cheap if Libsyn – the listed company – was 100% Libsyn the podcast
company. It’s not. Right now, you are getting a corporation that is about 50% a podcast host and
50% a website host. I have no reason to believe the website host will grow much (or at all) over
time.
In its last earnings press release, the company described revenue growth this way:
“Revenue for the full year of 2019 was $24,201,629, a 10% increase over revenues of
$22,010,132 for 2018. This reflects an increase in Libsyn4 hosting revenue as well as LibsynPro,
with a slight offset by a decrease in the dollars being spent on ad campaigns by advertisers.
Libsyn contributed $14,486,211 of revenue while Pair Networks contributed $9,715,418.”
This does not suggest anything good about Pair Networks. The two businesses should not be
seasonal. So, it should be possible to go mostly off the last quarter to get an idea of year-over-
year revenue growth. In the most recent quarter, the revenue line “podcast hosting” rose 22%
year-over-year. Meanwhile, the revenue line “website hosting” rose just 4%. Podcast hosting is
bringing in about 1.5 times as much revenue as website hosting. If the current growth rates –
22% a year at podcast hosting and 4% a year at website hosting – were to continue for 3 full
years from today, then podcasting will be almost 2.5 times larger than web hosting. To put it
another way, the company will have gone from being almost 50% podcasting and 50% web
hosting not too long ago to being 70% podcasting and 30% web hosting in 2023. This would
make the appraisal of the podcasting side of the business more and more important to the value
of the stock. There are two reasons for this. One, it will eventually just be the bigger business.
Two, it’ll be faster growing. For example, the company’s growth in 2023 would be coming 90%
from podcasting and only 10% from web hosting. Even now, the company’s growth is like 80%
podcast driven. Especially when the need for additional cash investment is near nil, the value of a
stock is driven primarily by the future growth of earnings. So, while this appears to be a mix of a
podcast business and a web host business – the valuation placed on the stock a few years down
the road will basically all be about the value of the podcast business. All of the “economic value
added” here will be in podcasting.
Is podcasting a good business to be in?
It’s a growth business. And Libsyn has a good business model in terms of profitability, returns
on capital, etc.
But, it’s a highly competitive business. This is where we get to one of the two big question marks
I have for this stock. The value of the podcasting business certainly appears to be very high
versus the current stock price. A business with these returns on capital growing at this rate could
easily be worth more than 30 times free cash flow. It probably should be worth more than that if
the growth can be sustained for a long time. So, you’re getting “Pair Networks” and the
company’s little bit of net cash for free in this stock. You’re really just paying a normal type of
growth multiple for a growing business like Libsyn and getting the rest thrown in for free.
But, will the growth continue and will profitability stay the same?
I’m not sure. Scuttlebutt suggests “no”. I mean, it suggests that Libsyn does not necessarily have
the best service, the cheapest service, etc. out there. And it suggests – even the company admits
this – that competition will only intensify in podcast hosting. Everyone wants to be in this
business. Companies with deeper pockets, higher paid employees, more tech, better brand
names, and just greater recognition among the podcast hosting public are willing to get into this
business offering much, much lower prices (you can’t get cheaper than free – and there will be a
lot of free services offered in this business) than Libsyn. So, it seems likely that competitors of
Libsyn will offer better services at lower prices.
On the other hand, retention rates are high in this industry. So, if just Libsyn’s existing group of
podcast producers stick with the company, give good word of mouth referrals, etc. – you’re
looking at a really good growth stock here. But, it’s an odd growth stock. It doesn’t seem to have
the lowest prices or the best service. That scares me.
The other issue, of course, is management. I know nothing about Camac (the fund that owns
some Libsyn stock and has 3 board seats). Andrew has spoken with the guy who runs that fund.
But, I have nothing to report one way or the other about my feelings regarding Camac. It’s an
activist fund. And a lot of the activism has now been completed with both the former CEO and
CFO gone.
I like the management currently running Pair and Libsyn just fine. And I like the next layer of
management down at Libsyn (which is the more important side of the company) a ton too. But,
there’s going to be a big need for capital allocation going forward. Libsyn could bring in about
$8 million a year in cash before it pays taxes. After paying taxes, it’ll still have like $6 million a
year coming in. It has net cash already. It could support a lot more debt than it does. I know
nothing about this board, about the new CEO they will bring in, etc.
Allocation of the free cash flow will be a huge factor in determining your return in this stock.
If Libsyn decided tomorrow to spin out Pair and to devote 100% of free cash flow to buying back
its own stock (in the remaining podcasting business) this would be a potentially spectacular long-
term investment.
That’s not typical capital allocation though. The more likely thing is that Libsyn keeps Pair
forever. And also that Libsyn uses its free cash flow to go out and buy other tech companies.
Still, I’m more interested in the stock today than I was early this week.
Andrew and I will continue to do scuttlebutt on this. As mentioned, we are Libsyn customers.
We have talked to some people at the company. We’ve put in work on this one. But, I’m not sure
we’ve come to a conclusion. I am, however, sure the stock really should have risen more on the
news of the CEO’s departure. That is one big hurdle already cleared in making this a more solid
investment candidate.
 URL: https://focusedcompounding.com/libsyn-lsyn-ceos-departure-makes-this-stock-
even-more-interesting/
 Time: 2020
-----------------------------------------------------
Luby’s (LUB): Luby’s is Liquidating – What’s the CAGR Math Behind

Possible Payouts and Timing?
This is a simple situation. But, you’ll want some background info before reading my take on it.
Information you might find useful about this one can be found at:
Clark Street Value
Hidden Value
Seeking Alpha
And my comments in this podcast (starts at 31 minutes)
The stock is Luby’s (LUB). It is liquidating. The company estimates it could make liquidating
distributions of between $3 to $4 a share. It doesn’t set a timetable for the distributions.
However, elsewhere in the proxy statement a period of 1-2 years is the estimate given for when
they will get an order for the Delaware court that would provide them the sort of safe harbor they
want to make distributions. As soon as they got that order, they might make the first of the
distributions. I suspect they will make no distributions before getting the order. So, the company
is saying it expects to pay out $3 to $4 per share no sooner than 1-2 years from now. The stock is
at $2.58 a share.
Let’s just do the math with those numbers: $2.58 price today, $3 distribution, or $4 distribution,
1 year, or 2 years from now. I don’t necessarily believe some of these numbers. But, let’s put that
aside for now, because these are the actual sort of company estimates we see in the proxy
statement instead of guesses made by me or others.
Buying at $2.58 and getting paid $3 in 2 years is an 8% annual return.
Buying at $2.58 and getting paid $3 in 1 year is a 16% annual return.
Buying at $2.58 and getting paid $4 in 2 years is a 25% annual return.
Buying at $2.58 and getting paid $4 in 1 year is a 55% annual return.

So, if you really expect to be distributed $3 to $4 per share within 1-2 years, you should buy the
stock. The expected return range is 8-55%. If we take the middle of both price and timeline – that
is, $3.50 in 18 months – that’s a 23% annual return. Which is really good. And if you assume the
downside here really is something like earning 8% a year for the next 2 years – there’s no reason
to assume you can do better than that in any index, any safe form of bond, etc. Stock pickers
might be able to do better than 8% a year over the next 2 years. Your opportunity cost could be a
lot higher than 8%. But, the certainty might be higher here.
Also, I have not presented the real upside here. The $3 to $4 estimate presented by the company
in its proxy statement is not the actual estimate of the liquidation distributions provided by the
company’s financial advisors. Like most companies considering “strategic alternatives”, Luby’s
formed a special committee which then hired a financial advisor. The financial advisor – Duff &
Phelps – came up with an estimated range for the liquidating distributions that would be paid to
shareholders.
The range was not $3 to $4 a share.
It was $4.15 to $5.62.
The special committee then took this estimate of $4.15 a share to $5.62 a share in liquidation
distributions and cut it down to $2.94 to $3.75 a share which it recommended the board adopt as
the number used in the proxy statement. The full board eventually chose $3 to $4. Which seems
like just a rounded off figure taken from what the special committee recommended. There is no
information in the proxy statement providing any support for using a $2.94 to $3.75 estimate
instead of a $4.15 to $5.62 estimate. Now, COVID did happen. But, the discussions about
liquidating distributions – and the efforts to sell part of the company and so on – were all
ongoing through COVID. There is language in the proxy statement giving the impression the
company made no attempt to re-estimate anything like liquidating distributions after COVID
happened. But, discussions were held during the period when the company’s stock price had
already been obliterated by COVID, the commercial real estate market for restaurant properties
was in an unusual state, etc. Legally, the company will say that it did not make any attempts to
update estimates for the impact of COVID, etc. But, some of the board are major shareholders.
It’s also impossible to believe they did not consider COVID – they just don’t want to take
responsibility for having to estimate the negative adjustment downwards to liquidating
distributions caused by COVID.
Let’s update the possible liquidating distributions to reflect the biggest range possible. The
minimum suggested by the special committee was $2.94. The maximum suggested by the
financial advisor was $5.62 a share. So, the range of estimates is $2.94 to $5.62. The proxy
statement suggests an order from the Delaware court could take 1-2 years. We’ll use that for now
(though, it’s likely an underestimate – because, the company would make THE FIRST
liquidating distribution shortly after getting the order instead of making ALL the liquidating
distributions quickly after getting the order).
So, the worst return possible would be buying at $2.58 today and getting cashed out at $2.94 in 2
years.
That’s a 7% annual return.
The best possible return would be buying at $2.58 today and getting cashed out at $5.62 in 1
year.
That’s a 120% return.
Let’s consider what happens to this very wide range – 7% to 120% – if we adjust the timeline for
distributions but keep the payments the same (a range of $2.94 to $5.62). I am assuming one
lump sum liquidating payment. The reality is more likely to be two or more liquidating payments
over time.
So, for buying at $2.58 today and getting cashed out at between $2.94 and $5.62 – the liquidation
timeline alters the CAGR range as follows:
1 year: 14% to 118%
2 years: 7% to 48%
3 years: 4% to 30%
4 years: 3% to 21%
5 years: 3% to 17%
10 years: 1% to 8%
There are a few things to consider here. Considering this is a “workout” – as Buffett would call it
– returns are borderline adequate across the entire timeline I’ve laid out. Even a 1% to 8% return
over 10 years or 3% to 17% return over 5 years is not out of line with where interest rates are
today. It also may not be out of line with 5-10 year returns in stock indexes. So, even if the
liquidation takes a long time to happen – returns would still pay you decently for your time. It
would be a mistake to invest in this if it is going to take 5-10 years. But, it wouldn’t be as costly
a mistake unless the range of values – not just the range of times till liquidation – is way off what
you expect.
“Way off” might be an exaggeration. By presenting these figures in per share numbers to be paid
out to equity holders – I am hiding the leverage in the appraisals here. See, the company has
debt. Relative to the appraised value of the properties – it is extremely small. Debt was about
20% of the property appraisal. You can check this by looking at the asset coverage ratio
covenant in the loan this company has. That’s not huge. If you imagine we marked up the assets
to be carried at the appraised value of the properties, the assets would be supported by about 80%
equity (at excess of market value of properties over liabilities) and 20% debt. There’s also the
actual assets and liabilities of the business excluding real estate. I’m not going to discuss that
here. The thing to focus on is the general rule that the assets here – as appraised – are being
converted into about 4 parts equity for every 1 part debt. If you halve your valuation of the
assets, the debtholder still gets paid in full. The haircut – in dollar terms, not just percentage
terms – is taken 100% by the proceeds you’ll get in liquidation.
Therefore, the margin of safety here is not as wide as it appears.
Let’s try to estimate what kind of length of time and what kind of reduction to the appraisal value
of these assets we could really handle and still do okay in the stock.
The bottom end of the range – $3 in proceeds – offers really no protection in terms of assets
being appraised lower than expected. If actual proceeds from property sales come in at like 90%
of what the $3 number assumes – you’ll lose money. So, no margin there. The actual range from
Duff & Phelps – $4.15 to $5.62 – does offer more of a margin of safety.
Now, let’s look at time based margin of safety.
Let’s start by assuming this liquidation will take 5 years.
I don’t think it’s a good idea to assume 3 years or less. It may very well happen within that time
frame. The first liquidating distribution – which could be the biggest, who knows – should
happen in 1-2 years. Maybe using a 3 year estimate is best. But, 5 years seems conservative
enough. Most people will assume the liquidation will be completed within 5 years – and
probably a lot sooner – so, this is a good timeframe to use.
If I use a 3-5 year estimate, the CAGR ranges I get at various price levels would be:
$2.94 (special committee minimum): 3% to 4%
$3.75 (special committee maximum): 8% to 13%
$4.15 (financial advisor minimum): 10% to 17%
$5.62 (financial advisor maximum): 17% to 30%
These ranges seem more reasonable to me. I don’t mean that in the sense the outcome is likely to
fall within this range. It’s easy to imagine some of the liquidating distributions coming much
sooner. But, if we are trying to think of a range of years from now during which more than 50%
of the eventual liquidating payments would’ve already been made – something like 1.5 to 2.5
years seems reasonable. That’s not that far different – half of distributions made in 1.5 to 2.5
years – from assuming ALL distributions are made as a single lump sum at the end of 3 to 5
years. It’s more conservative (and simpler) to assume it the way I did.
So, what we’re saying here is we expect more than half of liquidating distributions in the $2.94
to $5.62 a share range to have been made by early 2022 to early 2023.
Given today’s stock price, returns are really only acceptable if the $3.75 maximum suggested
figure from the special committee is the number taken. We need a minimum payout here of like
$3.75. And that’s only for an adequate return. And probably not a very good “risk-adjusted”
return when we consider the chance you could lose money on this thing.
The range that’s genuinely interesting as a workout is the $4.15 to $5.62 range.
Here’s why. Warren Buffett suggested that his unleveraged returns in workouts, arbitrage, etc.
were in the 20% a year type range. These are unleveraged returns. He liked to leverage them up
by paying for only 50% of his purchase of the stock in cash. The other 50% was margin debt.
The $4.15 to $5.62 range – when compared to today’s $2.58 share price – hits this 20% type
return target over the following timeframes.
$4.15: 2.5 years
$5.62: 4.5 years
Again, we can – somewhat conservatively – compare these lump sum timelines with “time-till-
half” timelines. So, 15 months to 27 months.
Is it reasonable to expect that distributions here will be $4.15 to $5.62 a share – the financial
advisor thought so – and at least half completed by 15-27 months from now (start of 2022 till
start of 2023)?
Maybe.
If so, it’s a Buffett style workout. And he’d leverage this thing up by using half debt to fund it.
The liquidation here might be uncorrelated with the market. I think it should be. But, it may not
be uncorrelated with the economy.
The thing that worries me here is that corporation has little cash, it has no access to credit, it is
burning cash, and the value of the assets could decrease over time.
So, I’m not worried about the timeline bringing down the CAGR. I’m worried that the longer the
liquidation takes the lower the net proceeds paid out to shareholders will be.
I didn’t discuss what is being liquidated here. The company operates cafeterias under the Luby’s
name – primarily in Texas – and Fuddrucker’s (both company owned and franchised) around the
country. There may be value in the Fuddrucker’s name and franchise agreements. The only value
in Luby’s is the real estate. They are large format locations with plenty of parking and visibility
and so on located around major Texan cities.
Andrew and I live in Texas. We could easily visit all the Luby locations in and around Houston,
Austin, San Antonio, and Dallas-Fort Worth – as well as many of the Texas locations sited
outside any real metro area. I estimate most of the relevant value in determining what liquidating
proceeds will be in this case comes down to just Luby’s and Luby’s/Fuddrucker combo locations
in Texas. That’s it. If you visit every Luby’s location in Texas – you have seen first hand nearly
all the assets you need to evaluate to appraise the liquidation value here.
Making such visits would be the logical next step.
 URL: https://focusedcompounding.com/lubys-lub-lubys-is-liquidating-whats-the-cagr-
math-behind-possible-payouts-and-timing/
 Time: 2020
-----------------------------------------------------
Monarch Cement (MCEM): A Cement Company With 97 Straight Years of

Dividends Trading at 1.2 Times Book Value
This is my initial interest post for Monarch Cement (MCEM). I’m going to do things a little
differently this time. My former Singular Diligence co-writer, Quan, emailed me asking my
thoughts on Monarch as a stock for his personal portfolio. I emailed him an answer back. I think
that answer will probably help you decide whether you’d want to buy this stock for your own
portfolio better than a more formal write-up. So, I’ll start by just giving you the email I sent
Quan on Monarch Cement and then I’ll transition into a more typical initial interest post.
EMAIL BEGINS
I think Monarch is a very, very, VERY safe company. Maybe one of the safest I’ve ever seen. If
you’re just looking for better than bond type REAL returns (cement prices inflate long-term as
well as anything), I think Monarch offers one of the surest like 30-year returns in a U.S. asset in
real dollars.
Having said that, I don’t think it’s as cheap or as high return as you or I like as long as the CEO
doesn’t sell it. And the CEO very clearly said: “Monarch is not for sale”.

I’m basing a lot of my comments in this email on historical financial data (provided by
Monarch’s management) for all years from 1970-2018.
In a couple senses: the stock is cheap. It would cost more than Monarch’s enterprise value to
build a replacement plant equal to the one in Humboldt, Kansas. And no one in the U.S. is
building cement plants when they could buy cement plants instead. The private owner value in
cement plants is even higher than the replacement value. An acquirer would pay more to buy an
existing plant than he would to build a new plant with equal capacity. The most logical reason
for why this is would be that an acquirer is an existing cement producer who wants to keep
regional, national, global, etc. supply in cement low because his long-term returns depend on
limiting long-term supply growth in the industry he is tied to – and, more importantly, anyone
seeking to enter a LOCAL cement market needs to keep supply down because taking Monarch’s
current sales level and cutting it into two (by building a new plant near Monarch’s plant) would
leave both plants in bad shape (too much local supply for the exact same level of local demand).
Fixed costs at a cement plant are too high to enter a local market like the ones Monarch serves by
building a new plant. You’d only get an adequate return on equity if you bought an existing
plant. Therefore, I believe that it’s usually the case that the price an acquirer would pay for a
cement plant – and certainly Monarch’s plant given its location far inland in the U.S. – is greater
than what it would cost to replace the existing plant. So: Acquisition Offer > Replacement Cost.
And, in this case, Replacement Cost > Enterprise Value. Therefore: Acquisition Offer >
Replacement Cost > Monarch’s Current Enterprise Value. In other word, Monarch’s current
enterprise value is less than what any acquisition offer would be. So, the stock is definitely
cheaper than what a 100% buyer would bid for the plant.
So, the stock is cheap. However…
This is where things get tricky.
Monarch’s stock price is around $60 a share. An acquirer would pay over $100 a share. Like
$100 at the low end and $120 at the high end. Replacement value is also quite high.
However, I don’t think YOU (or I) would necessarily want to pay more than about
$40. Maybe $50. Basically, close to book value. Why not?

Returns in the cement plant itself are good. But, management here: 1) Doesn’t use leverage
(Monarch only uses leverage to fund big cap-ex, then pays down the debt – most public
companies around the world borrow constantly to finance cement production). The business here
would benefit a lot from continual use of a reasonable amount of long-term, fixed cost debt. The
company should carry net debt. It actually carries net cash. You can see that in the results. While
Monarch would have reported a net loss if it had debt in the bottom of a deep recession – see
2010 or so as an example – the ROE over time would be higher, because this is a company where
you could predictably borrow at like 6% fixed and make 9%+ on whatever investment in the
plant you financed at 6%. You could keep doing this. The math is favorable and would drive up
after-tax ROE over a full cycle (though you would report losses at the bottom of deep recessions
because operating income wouldn’t cover fixed charges in those rare, terrible years). 2)
Management has bought ready mix concrete businesses. Without getting into how cement works,
basically the input for cement is lime (and other stuff) that is then produced at a cement plant and
shipped close to where it will be needed where it is then mixed with aggregates like rock to
become concrete. Concrete is then used to build roads, bridges, apartments, offices, warehouses,
etc. Anyway, the lime business is as good or better than anything (it is probably a bit more
competitive than cement, but it has lower cap-ex needs – so lime may be the best business
overall). Cement is the next best business (probably the least competitive, but very high cap-ex
spending – because of high economies of scale, desire to reduce labor cost component, and
meeting environmental regulations – cement is the most technical part of the chain of
production). Ready mix concrete is the worst part of the business. Honestly, I think Monarch just
bought out its customers in ready mix concrete in certain markets when they got themselves in
trouble. Owning ready mix concrete ensures demand for Monarch’s production. But, it’s not
needed. Cement plants only average 80-90% utilization normally, demand is so volatile (much
more volatile than price), that even owning the ready mix concrete businesses in an area doesn’t
insulate you from the cycle. So, the whole ready mix thing just sucks up a bunch of capital for no
return over time. The ready mix concrete business literally returns nothing sometimes. And it’s
not small. Finally, Monarch’s CEO just puts the rest of surplus funds into owning other cement
stocks (mostly). I think he has a policy of trying to keep roughly similar percents of Monarch’s
overall stock portfolio in each of the publicly traded cement companies he buys. He’s not a value
investor. He just keeps averaging into these stocks whenever Monarch has extra money after
paying the dividend.
The CEO said “The dividend is sacred”. And based on the 1970-2018 figures I have – I think
that’s true. Monarch will lower the dividend a lot in a total bust in the industry, but then start
raising it again the very next year. So, the ROE isn’t going to be leveraged and is going to
include investments in ready mix concrete (the CEO knows these are not good investments, but
I’m not confident he’ll swear off these purchases entirely) and publicly traded cement stocks.
Publicly traded cement stocks are much, much more expensive (usually) on like a P/B ratio
compared to Monarch. Some are good businesses long-term. But, Monarch will buy these
regardless of price. So, it’s not ideal capital allocation.

Because of these capital allocation decisions: I think Monarch as a company will have a long-
term ROE of like 8-12% a year. I think the underlying economics of Monarch’s actual cement
plant are at the top of that range (12% unleveraged returns on an accrual – not FCF – basis). And
I think actual cement plant returns – in the middle of the U.S. – will only be better over the next
30 years compared to the last 30 years (competition has decreased over time, there are fewer and
bigger locations, plants are much larger: Monarch’s capacity has probably quadrupled in 50
years at just that one plant, major players in U.S. cement are all bigger and more rational, it’s
very similar to what we saw in lime).
More accurately I should say: I think ROE will be 5-9% (or maybe like 6-10%) plus inflation.
It’s probably easier to calculate real returns and add inflation here.
You asked if cement economics are similar to lime as far as transport costs. The answer is yes.
You can move cement by ocean going ship, river barge, railroad, or truck. You’ll basically need
a cement terminal wherever you take delivery of it. So, if you are shipping across the ocean from
East Asia to the U.S. let’s say – you’d have to take delivery at a cement terminal in like Seattle
or Los Angeles. And then you could ship by truck. The last leg – shipping by truck – is by far the
most expensive per mile. So, the U.S. does import cement from other countries (imported cement
is the marginal supply, it can drop like 90% from boom to bust), but imported cement is
irrelevant to Monarch. Monarch’s plant is basically dead center in the middle of the country. It
can serve about half of each of several states (so, parts of Iowa and Kansas and so on). It’s near
the Eastern border of Kansas. So, it can ship to Oklahoma and Arkansas. Cement imports at U.S.
ports could never travel far enough inland – due to the high transportation costs per mile once
insider the U.S. versus the low value of the cement itself – to ever be worth worrying about
foreign competition influencing cement prices in Monarch’s market. Technically, the best way to
think of competition would be to imagine supply cascading into adjacent local markets sort of
like ripples that dissipate with distance. So, if you can import from Asia into Los Angeles, then
ripples of those imports could – through adding supply in the Los Angeles area – also be felt
hundred miles inland. But, they wouldn’t be felt a thousand miles inland. Looking at a map of
the world – it’s hard to imagine a location for a cement plant that would be more insulated from
the risk of chronic oversupply than someplace like Kansas. In fact, looking at margins from
1970-2018, I can see that despite being in the super cyclical industry of cement – Monarch’s
variation in margins (0.42 coefficient of variation) and pre-tax return on equity (0.37) is actually
lower than many companies experience over 50 years. The only way that can happen in an
industry where overall demand is so volatile and fixed costs are so high is if changes in
competitive position are much rarer than in less inherently cyclical industries. In other words,
you can’t have a lot of new entrants in a cyclical market and have variation that low and you
can’t have a lot of changes in who is the low cost producer in a cyclical market and have
variation that low. Monarch’s cost position relative to other cement producers in the region must
change very, very little over time.

When shipping direct to the customer, you don’t ship cement further than you’d ship lime. Lime
is an input for cement. Monarch owns lime deposits at its cement plant to supply it for 50+ years.
Lime isn’t a huge part of the cost of cement. But, it’s always a plus to have this low value/weight
resource without having to worry about transport costs. I think the plant and lime deposits are on
like 5,000 owned acres. However, I don’t think land in Humboldt, Kansas is worth much of
anything if it wasn’t being used to produce cement. In Iowa: they also own a 250 acre cement
terminal and a 400 acre (nearly depleted) quarry.
Nonetheless, the replacement cost and acquisition prices I suggested don’t explicitly include any
value for the land, the lime deposits, etc. For example, I don’t think someone in the U.S. – if they
were building new cement plants, which on a net basis they certainly aren’t – would really plan
to spend less than about $300 million. Less than that and the plant wouldn’t have sufficient
economies of scale. Monarch’s plant isn’t super small or anything. I’d say the plant is worth
more than $300 million but maybe not more than $450 million (the plant’s capacity is 1.3 million
tons a year). Remember, an acquirer depends on utilization to drive economics – so, the reason
you don’t build (you buy) is that the buyer is a cement industry participant (usually a huge global
cement company with big U.S. market share). They don’t want to add national capacity if
possible. And certainly don’t want to add local capacity. So, it’s almost always the case in
cement that acquisition prices look a lot higher than replacement cost. Also, I think I
underestimated Monarch’s replacement cost if I suggest it’s close to $300 million. It’s more than
that. I’m not sure how much more.
At tangible book value, you might like Monarch a lot.
At the current price – which is like 1.25 or 1.3 times book or something – it might be a little too
expensive, because the upside is so limited.
Long-term, I think you could hold MCEM indefinitely (literally forever) and do as well as the
S&P 500 did in the 1900s as a century. I think that’s possible. The S&P 500 is a lot more
expensive now than it was throughout the 1900s. So, maybe you’d outperform in MCEM if
bought today and held for 15, 30, or 45 years. Maybe. The volatility will probably be lower. It’s
a hugely cyclical industry in terms of demand. But MCEM’s margin volatility is actually lower
than most public companies (and I think this is typical for a leading cement plant in the U.S.
interior – coasts could be different, I’d avoid coastal cement plants). Also, as an illiquid stock
that doesn’t file with the SEC, etc. – I’m pretty sure the stock will always have a beta well below
1. Some websites say the stock has a beta of 0.3. That sounds about right. It’ll always pay a
dividend. The stock is almost certainly to be less volatile than the business and the business isn’t
really more volatile than most public companies. So, you should – even at today’s price – get
returns equal to or higher than the S&P 500 with volatility equal to or lower than the S&P 500 if
you buy the stock today and hold it forever.
But, I think you’re looking to outperform the S&P 500. That probably requires paying closer to
book value and selling the stock quicker – not holding it forever. Another reason you might
consider focusing on buying at book value…
Monarch will buy back its own stock below book value. One thing the CEO made clear is that he
knows the stock has historically traded around book and he thinks it’s never a good idea to buy
back stock above book – but, that it is a good idea to buy back stock below book. Even when
buying out members of the families that have owned a lot of Monarch for 50 plus years, the rule
has been to only buy back stock below book.
Monarch might be a stock that – especially if you could ever get it at book – you could just buy
and forget about pretty much forever. I can’t think of a more durable industry or industry
position than being a cement plant in the middle of the United States. You can see dividends
since 1970. That’s as far as my data goes back. However, I think they’ve paid a dividend for 100
years or so. I also think that most of the major shareholders are descendants of people who
bought the stock 60-100 years ago. It’s durable.
EMAIL ENDS
Monarch Cement (MCEM) is an illiquid microcap. The company does not file with the SEC.
But, it does report financials publicly.
There are two classes of stock. Many websites do not reflect this fact. So, a lot of sites show a
lower market cap for Monarch than it really has. For this reason, you should never rely on any
secondary data from financial websites when analyzing Monarch. Always make sure your
research on MCEM uses only the company’s own reports:
https://monarchcement.com/investors/
From these reports, we can see that Monarch had 3.86 million shares outstanding at the end of
last year. The class of stock you’d be interested in buying – the one that trades over-the-counter
under the ticker “MCEM” – has a last trade price of $60 a share. So, Monarch’s market cap is
$60 * 3.86 million = $232 million. Of course, this is not the price at which someone could
actually acquire all of Monarch. I believe descendants of 5 families – Monarch was founded 106
years ago – control around 50% of the company:
“Of the eleven members of our Board of Directors, nine are descendants of five families who
invested in and have guided our Company for over 60 years. Two of these five families’
ownerships date back to the purchase of the bankrupt Monarch Portland Cement Company and
its reorganization as The Monarch Cement Company in 1913. The descendants of these five
families continue to own a significant share of the outstanding stock of our Company.” (2019
Proxy)
And Monarch’s CEO is quite clear that “Monarch is not for sale”. Also, as I’ll explain later,
Monarch’s enterprise value is actually lower than its market cap.
But first…
…The business.
Monarch’s key asset is a cement plant in Humboldt, Kansas with the capacity to produce 1.3
million tons of cement per year. So, let’s start by talking about cement and that other word that’s
probably already on your mind: concrete.
Cement and Concrete
You are probably most familiar with cement through the product it’s an input for: concrete.
Basically, concrete is cement with stuff like gravel mixed into it. The cement part is the paste.
Concrete has been used as a building material for probably around 2,500 to 3,000 years. It’s best
known historical use is in major Roman building projects that survive to this day. If you’ve ever
visited sites like the Pantheon, the Baths of Caracalla, the Pont Du Gard aqueduct, the
Colosseum, etc. – the reason they’re still standing over 1,500 years later is because they were all
built from concrete. If we know Roman concrete structures are still standing nearly 2,000 years
later – we can probably guess that whatever technological innovations there have been in the
concrete (and thus cement) industry since then haven’t just been about making the material more
durable. In fact, Ancient Roman concrete could withstand compressive forces (“pushing” forces)
even better than modern concrete does. However, modern reinforced concrete has better tensile
strength (“pulling” force resistance) than Ancient Roman concrete – mainly because it often
includes something inside the concrete that the Romans didn’t know how to make: steel rebar.
Concrete is the world’s most important building material. Each year, the world uses more
concrete by weight than wood, plastic, aluminum, and steel combined. The “by weight” part is
super important – as we’ll see when we discuss the economics of the cement industry. For now:
just remember this – cement is cheap, heavy, and durable.
Using Andrew’s 4 Point Initial Checklist
The word “durable” brings me to our initial checklist.
My Focused Compounding co-founder, Andrew Kuhn, did a YouTube video where he outlined
the 4 things we look for in a stock when first sitting down to research it:
https://www.youtube.com/watch?v=rqw6KzhSvvE
Those 4 things are:
 Is the stock overlooked?

 Is the business high quality?
 Has the stock’s CAGR worked over time?
 Is it cheap?
Has Monarch’s CAGR Worked Over Time?
I’m going to give you the answer to #3 (what Monarch’s long-term CAGR has been) in a second.
But, before unveiling that number – I’d like to discuss why a publicly traded cement stock may
or may not have made its buy and hold owners rich.
Let’s start with the past. But, not just the 30 or 50 year past. Let’s start with the industry’s entire
past.
What does the history of cement (and concrete) tell us about the durability of Monarch as a
business?
Cement has been one of the key inputs – and certainly the key technological input (quarrying
aggregates is a low tech business) – in producing one of the most durable building products
(concrete) used in large scale public infrastructure (like roads), private homes (like apartment
blocks), and commercial and industrial buildings for around 2,000 years now. Technology in this
industry has progressed by making cement (and thus concrete) something that can be produced at
greater and greater scale using less and less labor. The Romans may have had the technology
needed to build the Colosseum out of concrete. But, they didn’t have the scale to produce 1.3
million tons of cement at a single plant (and there are cement plants much, much bigger than the
one Monarch owns in Humboldt, Kansas).
In other words: concrete – as a product – and cement (as an input) has perfect economic
durability. It isn’t going to be obsoleted. Someone is going to be producing a lot of cement each
year. The two questions we need to answer are: 1) Is this someone going to be making enough
money over an entire cycle to successfully compound their wealth over time? 2) Is Monarch
going to be in a position to stay in business forever and earn an acceptable rate of
return relative to its competitors.
Now we can look at Monarch’s long-term returns. I have actual stock returns for a shorter period
of time (about 25 years) and I have summary financials from Monarch for a longer period of
time (about 48 years). The summary financials don’t allow me to calculate the stock’s actual
return over close to 50 years. But, aside from price multiple expansion or contraction (changes in
the stock’s P/B ratio, P/E, ratio etc. from the 1970 start point till today’s 2019 end point) – I have
all the data I need to calculate what a buy and hold investor’s return would be. Over the last 25
years, the stock’s price has compounded at about 7% per year. Monarch also pays a dividend.
The dividend is usually quite meaningful (today it’s 3% of the stock price). It’s often been a 3-
6% yield on the stock’s book value (which is not necessarily the price at which an investor
actually bought the stock). The nearly 50-year history of the company shows a 2.6%
compounding of Monarch’s REAL book value per share. Nominal compounding of book value
has been about 6.1% a year (remember, inflation was quite high in the 1970s and 1980s). The
dividend has grown a bit slower at 4.8% a year for 50 years. This points to a nominal per share
growth rate somewhere between 4.8% and 6.1% a year. So, basically, 5.5% a year. On top of
this, you have a dividend yield on book value in like the 3-6% range. It started the period (back
in 1970) as a 6.8% dividend yield on book value and ended the period – in 2018 – at a 3.9%
dividend yield on book value. Keeping it simple enough to do here instead of in Excel – we
could just take the average of 3.9% and 6.8% and assume that the average dividend yield on
book value is about 5.4% of book value. Again, we’re close to 5.5% (meaning half your gains as
a buy and hold investor in Monarch cement would come from dividends and half from stock
price appreciation). If we added 5.5% and 5.4% – we’d get 10.9%. If we rounded both numbers
down we get 10%. If we rounded both number up, we get 12%. Is that really the kind of return
Monarch cement stock has produced: 10-12% a year?
Maybe.
Two issues here are stock multiples and inflation rates. The period from 1970-1995 (where I
have financial data from Monarch but not stock price data) was most likely a better period for a
cement stock (though not necessarily for a cement business). Why? Because inflation rates were
high throughout much of the period and yet interest rates – and therefore, stock price multiples –
ended the period in 1995 much higher than in 1970. In other words, I’m just warning you that if
you use the most recent 20-25 year CAGR you see for Monarch stock – I think it’s possible you
might be underestimating the 50-year record here. The stock has actually been around – and the
company claims, paying dividends – for over 100 years. Like I said, I can see the year-by-year
dividend record. And Monarch has certainly paid a dividend every year for the last 50 years (and,
I suspect more like every year for the last 100+ years). Monarch has sometimes lowered the
dividend in a recession. However, after any lowering of the dividend, Monarch has always
started annual dividend hikes again the very next year. For example, I can’t find any situation
where the dividend actually declined over a full 10-year period.
So, what does that ultimately mean for returns in Monarch cement?
Historically, I’d say the stock would have returned 8-12% a year if you bought it in some year
and held it till the day you died. The dividend would usually have been a big part of that return:
maybe 50/50 between the dividend and the capital gains. The S&P 500 obviously doesn’t return
more than 8-12% a year to buy and hold investors. So, yes: Monarch Cement’s CAGR works.
One caveat here: I expect Monarch’s REAL total return to be more reliable than most stocks. So,
it may be easier to predict that Monarch stock often returns 4% to 8% a year plus inflation than
to predict it will return 8% to 12% a year in plain old dollars. Investors aren’t used to thinking in
real terms. But, here it might be better to take a 4% to 8% real rate of return and then add your
expected rate of inflation to the returns to compare it with other stocks.
Checklist Item #3: Has the stock’s CAGR worked over time? Check.
Is the Business High Quality?
First of all, I want to explain something that should be obvious – but, that most investors
overlook. If a stock’s CAGR has worked over a really, really long period of time (like 50 years)
we pretty much know that the business at least was high quality during this period. Stock prices
can diverge from intrinsic value by a lot. And they can stay diverged for a long time. But,
because of the way compounding works – changes in the stock’s price multiples are unlikely to
overwhelm actual business performance over half a century. Basically, a good business makes a
good stock over a 50-year holding period almost regardless of the price you buy and sell at. And,
a bad business makes a bad stock over a 50-year holding period almost regardless of the price
you buy and sell at.
Consider this example. You pay 25 times earnings for a stock today. You hold the stock for 50
years. The stock compounds its earnings per share at 12% a year for those 50 years. You then
sell the stock at a P/E of 5. Obviously, paying 25 times earnings for a stock is a higher price than
an investor should ever be willing to buy at. Just as obviously, selling a stock at a P/E of 5 is a
lower price than an investor should ever be willing to sell at. Nonetheless, because the stock
compounded its earnings per share at 12% a year for 50 years – your total return over that half
century holding period would still be 8.5% a year. Basically, you could afford to over buy (P/E
of 25) to start and under sell (P/E of 5) to end your holding period and still match the 8-9% type
annual return you’d get in an index fund. Conversely, even if you buy a stock at a P/E of 5 and
then hold that stock for 50 years and sell at a P/E of 25 – if the stock only compounds its
earnings per share at 6% a year while you hold the stock, your CAGR over that half century
holding period will only be 9.5% a year. In both cases, we are talking about a 9% a year annual
return plus or minus 0.5% a year. And those are very, very extreme P/E buy and sell
assumptions. If you were just randomly picking when to buy and sell a stock – without basing
your decision on the P/E multiple at all – it’s likely the stock’s P/E when you bought and sold
would be somewhere between 5 and 25. So, I’m not exaggerating how small a factor buy and sell
prices are over a 50-year holding period. A good business – reinvesting 100% of its earnings at
12% a year – is pulling your returns up toward that 12% a year level while you own it. A bad
business – reinvesting 100% of its earnings at 6% a year – is dragging your returns down toward
that 6% a year level while you own it. I need to stress here that it isn’t the stock’s per share
growth rate alone that matters (and it’s definitely not the company’s overall growth rate). Three
factors matter. 1) How long is the stock held for? 2) How big a portion of earnings are being
reinvested in the business? 3) How high is the return on reinvestment? Monarch has often paid
out 40% to 75% of its earnings in dividends (40% in 2018 and 75% back in 1970). So, the
business’s return on equity is only driving the other portion (100% minus 40% equals 60% of
earnings in 2018) that the company is retaining. Whether a company has an ROE of 6% or 12%
– a dollar of dividends is worth a dollar of dividends. Who pays the dividend doesn’t matter. But,
a dollar of retained earnings driving a 6% ROE is worth less than a dollar of retained earnings
driving a 12% ROE. Most companies – and certainly a cap-ex heavy company like Monarch –
end up retaining a good portion of their earnings. So, their return on equity (really, their return on
retained earnings) drives about half of their total stock return.
Here’s my point. If you think an industry is a bad industry, or a business is a bad business – look
for a stock that performed well over the 50 years or so. If you find such a stock, chances are
you’ve just disproved your bad business theory. The same test – by the way – can be applied to
self-made millionaires and billionaires. Someone who is super rich today and who you know
founded a company and owes almost all their wealth to an ownership stake in that business is
pretty strong evidence for that business being a good one at least for many years in the past.
There are some fluke ways that a business owner can get rich (they could sell out in a massive
bubble, they could use massive amounts of debt, they could cheat their partners, they could pay
themselves a lot from the company’s till, they could have perfect market timing of when to start
up and when to sell a business). But, these fluke ways are rare. If someone entered a business
without being at least somewhat rich to start and then they ended up being famously rich – the
business they were in (and also probably the industry they were in) was almost certainly a “high
quality business” for many of the years they were invested in it. If you don’t know what the
long-term ROE of Carnival (CCL) was, but you do know that Micky Arison is worth $8 billion
and was CEO from Carnival from 1979-2013, odds are you’re going to find Carnival had a good
CAGR from 1979-2013. The same is true for long ago industrialists. Steel and railroads and oil
and so on could be low ROE industries whenever you started researching them. But, if you find
that some of the richest Americans of an era made their money in steel and railroads and oil and
so on – you’ll find that the companies they owned had good ROEs compared to other businesses
around at that time. This is sort of the iron rule of long-term compounding. If the owners of an
asset compounded their money at high rates while invested in an asset – for a long time – then,
the asset itself must have been high quality (at least while those people owned it). Over short
periods of time, this rule does not hold. If you buy a stock at 5 times earnings today and sell at 25
times earnings next year while your neighbor buys another stock at 25 times earnings today and
sells at 5 times earnings next year – you will get rich and your neighbor will get poor, almost
regardless of the underlying business performance of either of those stocks. In the short-run,
cheapness overwhelms quality. In the long-run, quality overwhelms cheapness.
We know Monarch Cement has had a 25-50 year record that suggests a buy and hold owner of
the stock wouldn’t have done much worse than if they’d owned the S&P 500, and (depending on
their timing) may have done better.
However, I know what an 8-12% long-term rate of compounding sounds like to most investors.
They hear that and they yawn. It sounds typical.
Actually, it’s not.
The overall stock market may return 8% a year over the long-term. However, fewer individual
stocks than you might imagine actually achieve this level of compounding over a period like 50
years. A small number of stocks start out very small and get very big by compounding at
incredibly high rates of returns. This small number of very successful compounders creates a lot
of the returns you see in the S&P 500. So, the average stock chosen from among U.S. public
companies is unlikely to still be around several decades from now and to have compounded at
around 10% a year.
Nonetheless, you could buy the index instead of Monarch. The index is able to capture the home
runs enough to offset the strike outs. So, it’s okay to have a high strike out rate in an index,
because the home runs more than offset the strikeouts. Therefore, it might not be a good idea to
prefer a stock like Monarch that is probably safer, more predictable, etc. in its very long-term
returns than the individual stocks that make up the index – because you could just use Vanguard
or something to buy the whole index and thus eliminate the risks of owning specific stocks.
In reality, I think Monarch will be less volatile than the S&P 500 over time. I think the beta of
Monarch will be below 1. And I think the alpha will be zilch or somewhat positive – not
negative. So, actually, I do believe that if Monarch is never sold to an acquirer – it stays public
forever, and you keep owning it forever – you will get the same or higher return as in the S&P
500 with lower volatility. But, that’s not a bet I really want to make in the accounts I manage. I
don’t want to target the same returns as the S&P 500 – just with lower volatility. The goal isn’t
to reduce volatility. It’s just to increase long-term compounding.
At today’s price, I’m not sure Monarch clears the threshold of the kind of future return potential
I’d like to see. Certainly, if the company is sold to an acquirer in the next 5, 10, or maybe even
15 years – it’ll hit that target. And it may even outperform the S&P 500 with less volatility. But,
I don’t like to buy a stock unless I see a realistic way to 10%+ returns over the next 10+ years.
I think I see that path for Monarch at tangible book value. I’m not sure I see it at today’s price. I
think this is a business that is very unlikely to give you inadequate returns if bought today and
held long-term. However, I also think it’s a business that’s unlikely to ever give you far above
market level returns if bought today and held forever. The stock is already selling for less than it
would be worth to an acquirer. It’s maybe somewhat cheap in today’s world of pretty high prices
for stocks, businesses, etc. I think it’d be decisively cheap at book value. Last I checked that was
about $49 a share.
Today, the stock is trading at $60 a share. You might not want to buy it above $50 a share – or
whatever book value has risen to by then.
The reason for that is you have to be very, very careful about price when you are buying a
business with a long-term return on retained earnings (while you own the stock) that you know
will be very close to the market’s own return. If Monarch reinvests a lot of its earnings at
between 8-12% a year, your long-term return in the stock will be dragged down closer and closer
to 8-12% a year over time even if you pay a low price today. So, it’s often important to not just
pay a low price – but, to pay a very low price. I think book value at Monarch would be a very
low price. So, that’s a good price to aim to buy it at.
 URL: https://focusedcompounding.com/monarch-cement-mcem-a-cement-company-
with-97-straight-years-of-dividends-trading-at-1-2-times-book-value/
 Time: 2019
-----------------------------------------------------
Marcus (MCS): Per Share Value of the Hotel Assets
I’m revisiting Marcus (MCS) with an attempt to appraise the hotel side of the business. Andrew
sent me some articles discussing property tax appraisal of Milwaukee hotels (including those
owned by Marcus). I looked at some other property tax records. I looked at Penn State’s hotel
value index. Andrew spoke with the CFO of Marcus. And I consulted a few other sources.
My best guess is that the pre-COVID fair value of Marcus’s hotel assets was around the $235
million to $400 million range. On a fully diluted basis (41 million shares) assuming that the
convertible is fully converted – this is inaccurate, because it ignores the “capped call” Marcus
entered into – that works out to between $6 and $10 a share from the hotel segment. Remember,
Marcus has like $5 a share in debt. It has cash, tax refunds due, other assets it isn’t using etc. that
might be worth around $2 a share. But, then this is a hotel and movie theater company. So, it’ll
burn through some cash in the quarters ahead. Maybe it’s best to ignore the cash, tax refunds,
excess land etc. and assume that Marcus will just need to use that stuff to fund cash burn through
2021. That leaves $6 to $10 in hotel value per share vs. debt of $5 a share. So, hotel value net of
debt is $1 to $5 a share. Marcus stock is at $11 a share right now. So, the stock is pricing the
theater chain at like $6 to $10 a share. In a normal year – like 2022, maybe (certainly not next
year) – I wouldn’t be surprised if Marcus could do $1 a share in free cash flow from its theaters
alone. So, that’d mean the stock is now priced at like 6-10x free cash flow from the theaters.
What’s MCS stock really worth? Probably more like twice that amount (14-20x free cash flow)
if it was priced like a normal business.
How solid is this $6 to $10 a share (after the conversion adds to Marcus’s shares outstanding) in
hotel segment valuation?
Not very. Hotels are pretty difficult to value in the sense that they bounce around a lot like stocks
do. Cap rates are important. If yields on other assets are very low, hotels will rise in price. If debt
is widely available, hotels will rise in price. And then these are cyclical assets. If you look at the
year-by-year figures for hotel values on a per room basis – each year is priced a lot like the
market is just extrapolating the present into the distant future. Hotels may have fallen like 30%
or something in value during COVID. But, this isn’t really relevant on an asset like this. And I’m
going to ignore 2020 values for hotels even though they are our most recent valuations. I’m not
going to value hotels in 2020 for the same reason I wouldn’t value a stock portfolio using early
2009 prices. They clearly crashed and they’ll recover.
How long will they take to recover?
I don’t know. I don’t think hotel cash flows will recover till at least 2023. Movie theaters should
recover much, much faster. This is because hotels – especially hotels like the bigger, urban, and
more upscale ones Marcus owns – depend a lot on business travel and conferences and
conventions and so on. That business will not be back in 2021 or 2022. I don’t know if it’ll be
back in 2023. It usually takes several years to see a full recovery in business travel. This is
obviously the worst decline in business travel ever. I can compare it to 2001 (September 11th),
and 2008 (the financial crisis) – but, I’m not sure either really captures how deep and long this
business travel recession could be. Businesses may permanently move some in person stuff to
online. Even if that shift is very small – hotels are a high “barrier to exit” business. Supply just
won’t disappear quickly even if demand declines. So, you’d have worse per room economics for
a while even if everyone stopped building new hotels for a bit.
On the other hand, might hotel values – as opposed to hotel earnings – recover far faster than
2023?
Yes.
In fact, this seems super likely.

Yields on almost all assets have dropped a ton. Hotels don’t look expensive right now on
cyclically normal earnings vs. any sort of comparable assets you could invest in. Basically,
hotels look cheap relative to other kinds of assets if you are using peak earnings of this most
recent cycle. Obviously, a lot of hotels are losing money right now. And it might take years to
get to the prior peak.
Finally, how accurate are these appraisals I’ve made?
Not very.
For the region of country where Marcus owns hotel (the Upper Midwest), the pre-COVID
valuation would be about $150,000 to $160,000 per room. For the class of hotel Marcus owns,
it’d be higher than this nationally. However, it may be that upscale hotel valuations nationally
are skewed too much to high valuations in New York, San Francisco, etc. whereas Marcus is
mostly in Wisconsin. However, Marcus owns especially strong properties in the places where it
does operate. So, if you knew what hotels sold for per room in Milwaukee – that’d probably
undervalue Marcus’s hotel rooms, because Marcus’s rooms are some of the best in that city. In
other words, valuations for upscale hotels nationally may overstate the value of upscale
Wisconsin (and other midwestern) hotels. But, valuations for upscale hotels in the Midwest may
underestimate Marcus hotels in the Midwest. This is because, in a couple cases, Marcus owns the
best asset in the area.
I have property tax appraisals from several different years. Keep in mind that these are tax
appraisals – not fair market values (though for the hotels I’m about to give you – the local
government claims the appraisal is supposed to be done aiming for tax appraisal to match fair
market value). Using 2006 property valuations and then adjusting for inflation between 2006 and
today, the per room valuations for the Hilton Milwaukee Center, the Saint Kate, and the Pfister
would be: $73k/room, $110k/room, and $163k/room respectively. The Saint Kate was a totally
different (branded) hotel at the time. It’s been closed, renovated, rebranded, etc. Marcus says it
expects it to make more money post rebranding than it had been – the rates it’s been charging
seem to reflect this. Also, interest rates were higher in 2006 than today. If those property tax
appraisals for 2006 were accurate indicators of fair market value – then, today’s values would
probably be higher because of the Saint Kate’s rebranding and the fall in cap rates (rise in
multiples) on hotels. As you can see, the median here is $110k/room. The mean is $115k. It’s
worth noting that the largest hotel by rooms had the lowest valuation per room. But, across all
hotels belonging to Marcus I’ve looked at – there is no pattern in this regard.
Okay. So, those are old tax appraisals from almost 15 years ago. I also have tax appraisal from
like a year ago. For those, I have 5 hotels (the 3 I mentioned plus Grand Geneva and Hilton
Madison Monona). The figures are similar. The mean is about $125k per room. The median is
$110k per room. However, the year-to-year valuation among appraisal per room is extreme. In
one case, the same hotel was appraised at $130k/room and $220k/room within a fairly short
period of time. So, these tax appraisals are often stale compared to fair market values and then
we see big one-time jumps.
I also have one appraisal of a non-city property that I believe to be seriously incorrect. I’m not
sure if the appraisal doesn’t cover all of the property or if appraisals are made at far different
valuations from fair market value on this particular property. This low end appraisal skews
things like the mean. Without it, the mean valuation would be over $140k per room. Since other
methods tend to indicate about $150k per room as the norm – it may be the tax appraisal method
(if you throw out this one property I suspect is an anomaly) – would actually be in line with other
methods of appraisal.
I also used another method. With this method, I ignore the tax appraisals and past sales and so on
of hotels and just look at average daily rates. I multiply the average daily rate by a figure that is
correlated with what I know of hotel values where we have both info on what they sold for and
what their average daily rate was. I then use the data given to us about average daily rates for
Marcus hotels and apply the multiplier. In any one case, this might be wrong. But, Marcus owns
8 hotels. The correlation between average daily rates per room and fair market value of a hotel
per room – when spread over 8 different hotels – should offer another reasonable enough method
of estimating value.
This method gives a valuation of $90k to $120k per room. But, I need to add a major caveat
having to do with cap rates. The valuation multiples I used was based on what hotels were selling
for versus their average daily rates as of the early 2010s. Not in recent years. In other words, the
“real” (inflation adjusted) value of Marcus owned hotel rooms may have been $90k to $120k at
the bottom of the last cycle – not at a “normal” point in this most recent cycle. The $90k figure I
got here is an outlier that I can’t reproduce using any other methods. No method of appraisal
gives me $90,000 values for Marcus hotels except this one. And, even in this case – the $90,000
is the low-end of a $90,000 to $120,000 range. It seems to me the bottom end of the range of
room values for Marcus is really more like $110,000. The top is maybe $160,000.
Rounding those down a bit, I’d say $100,000 to $150,000 per room is an appraisal range we can
use based on all the different methods I considered. Really, I did not find methods that
consistently gave me sub $100,000 per room estimates nor estimates that consistently came in
above $150,000 per room.
There are some other complications. I don’t know the details of a hotel that Marcus operates
under a long-term lease. This is the AC Chicago Downtown. In my minimum appraisal
($6/share), I threw out this hotel completely. In my maximum appraisal, I treated it as if the
company owned the hotel outright (both assumptions are wrong). In all my attempts at appraisal,
I allocated 60% of the rooms at the Skirvin (an Oklahoma City hotel) to Marcus. The company
owns 60% of that hotel. So, that was the easiest way to do that calculation.
Also: Marcus actually owns other stuff – besides typical hotel rooms – in the hotel segment that I
made no attempts to value. I don’t believe I have enough info about condo hotels, partially
owned parts of non-majority owned properties, etc. to make any guesses as to their values.
Okay. So, we’re just using Marcus’s number of rooms (about 2,100 to 2,500) across all 8 hotels
and then applying a single appraisal value per room.
What room value would it take for Marcus’s hotels to be worth more than its debt?
It’s under $100,000.
At the midpoint of a cycle, I’m not coming up with any method that values Marcus’s hotels at
less than $110,000 per room. So, it’s clear to me that – in normal times – Marcus hotels would
carry a fair market value greater than the company’s debt. This would mean the stock’s price in
terms of the theater’s FCF multiple is really no more than whatever the stock price is in dollars.
For example, if Marcus trades at $7/share – you’re not paying any more than about 7x normal
theater FCF per share (of $1 a share). If Marcus trades at $11/share – you’re not paying any more
than 11x and so on.
Could Marcus’s hotels be worth far more than $100,000 per room? Yes. They could definitely be
worth 50% more than that. An appraisal of $150,000 per room does not seem any less reasonable
than $100,000 per room. And…If cap rates go crazy low, Marcus’s hotel rooms could be worth
double the $100,000 a room amount I mentioned. They could be worth $200,000. It’s like any
kind of real estate that way. Everything from houses to apartment buildings to self-storage could
be worth more in the future than it was a few years ago if yields on other safe assets abnormally
low. Loose credit and low interest rates would tend to push up hotel values the same way it
would push up stock valuations.
Finally, are my share counts including convertibles accurate?
No.
I am exaggerating the amount of shares Marcus will have out. The company entered a “capped
call” transaction to lessen the amount of dilution. If I do another write-up on Marcus, I can get
into this topic. It’s been discussed in presentations, earnings calls, etc. There is also an 8-K that
discusses the transaction.
But, yes, I have written everything up about Marcus as if more shares will be out than may
actually be out.
And then: does the company have other assets?
Yes. I think Marcus has like $2 (just my best guess) per share in excess land it could sell in the
next couple years plus cash on hand plus taxes to be refunded in cash and so on. However, the
company is capable of burning through $2/share during COVID. So, these can be thought of as
“prepaid” losses.
I’m not counting this stuff despite my belief that Marcus’s theater segment has substantial real
estate assets (former locations, never developed locations, parking spots no longer needed, etc.)
that it may sell off in the next year or so. I can’t value that stuff. It’s not make or break for the
stock overall (though it is material to the valuation). And it may all end up being used to finance
cash burn. So, it’s kind of a wash where I can neither accurately value the “non-earning” assets
of the theater segment and I can’t accurately estimate how long the COVID cash burn will last –
so, I’m putting them both aside by assuming once cancels out the other.
Finally, what about leases in the theater segment?
This is a complicated topic. Marcus only owns about 2/3rds of its locations. It leases the other
third. Shouldn’t I add the capitalized value of these leases to debt?
Answer: yes.
But, other theater chains don’t do this. So, I believe these leases are debt. But, I also believe that
the free cash flow multiples I’ve used – which are LEVERAGED free cash flow multiples –
don’t overstate Marcus’s price vs. other theaters. The stock – like other theaters, retailers,
restaurants, etc. – is using leases to achieve the returns it is getting. But, investors routinely value
such lease using companies at multiples of free cash flow where Market Cap / FCF is in the 10-
20x range. You can compare Marcus’s 7-11x estimate I gave earlier to what other theaters (like
Cinemark – which leases almost everything) go for.
Since news of the vaccines came out, movie theater stocks like Marcus and Cinemark have risen
in price.
That has obviously lowered my interest level in them compared to when I first looked at these
stock.
Geoff’s follow-up interest level: 60%

Geoff’s re-visit price: $7/share
 URL: https://focusedcompounding.com/marcus-mcs-per-share-value-of-the-hotel-assets/
 Time: 2020
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Marcus (MCS): A Movie Theater and Hotel Stock Trading for Less than the
Sum of Its Parts
Marcus (MCS) is not an overlooked stock. Despite having a market cap of around $300 million
– the level usually defined as the cut-off between a “micro cap” and a “small cap” stock – well
over $10 million worth of this company’s stock trades on some days. The stock is liquid. And
most of that liquidity is probably highly speculative activity. This is typical for the industry. You
can see similar amounts of high share turnover, high beta, etc. at other publicly traded movie
theater companies like Reading (RDI) and Cinemark (CNK).
A major reason for that is COVID. I’m going to ignore COVID throughout this write-up. If
you’re a long-term investor looking to buy a stock and hold it for the long-term, COVID may
influence your appraisal of a company a bit in terms of cash burn over the next year or so. But,
aside from that, it matters very little in predicting where a hotel or movie theater stock will trade
within 3-5 years. Also, due to the value of the real estate Marcus owns, I don’t foresee
meaningful bankruptcy risk here compared to other hotel and movie theater stocks. Most
companies in the movie theater and hotel businesses own virtually none of their locations –
Marcus owns the majority of the properties they operate in both segments. In fact, Marcus is
remarkably overcapitalized compared to its peers in these industries.
And, despite not being overlooked, Marcus may actually be cheap. The company is made up of
two businesses. One business is the fourth largest movie theater chain in the U.S. The other
business is a collection of hotels. I’m most interested in the movie theater business. So, I’ll start
by trying to get the value of the hotel division out of the way.
Marcus manages around 20 hotels. However, it only has ownership stakes in less than half of
those. It owns 10% of one hotel. It owns 60% of another hotel. And then it owns 100% of a hotel
where the property is held under a long-term lease (instead of outright ownership). To simplify,
I’m going to ignore all the hotels Marcus only manages, the hotels where there is a different
majority owner, the hotels where there is a different minority owner, and the hotel where the
property is held under a long-term lease. In reality, some of these hotels have value. But, we’ll
ignore all that.
This simplifies the hotel division’s assets down to 6 fully owned hotels. Those 6 hotels are: the
Hilton Milwaukee Center (729 rooms), Grand Geneva Resort & Spa (355 hotels), Pfister (307),
Lincoln Marriott Cornhusker (297), Hilton Madison Monona Terrace (240 rooms), and Saint
Kate (219 rooms).
This adds up to a total of 2,147 rooms. Generally, these owned hotels are somewhat upscale and
somewhat urban (though they are in relatively less densely populated Midwestern states like
Wisconsin). I don’t know enough about hotels to be able to appraise these hotels accurately.
When I say they are upscale – they are certainly above the level of hotel in terms of rates charged
per night of the kind of place Andrew and I would ever stay while traveling on business. I can
look at their average rate per night, their reviews on sites like Booking, their AAA ratings etc.
and see that the owned hotels – as opposed to some of the managed hotels – are basically
city/resort hotels of the full-service / upscale variety. For example, my best guess is that Marcus
owns 2 of the 12 best hotels in the state of Wisconsin. The hotels I excluded – one is a 60%
owned hotel in Oklahoma City and the other is a 100% owned property in downtown Chicago
held under a long-term lease – also fall into the same category of like urban / upscale. We know
that the average room owned by Marcus is more valuable than a limited service / suburban hotel
room. Yet, as I’m about to show you – the current valuation on the hotel division is probably
below that of what you could (in normal, non-COVID times) sell more limited service, suburban
hotels for on a per room basis.
Since I don’t know the hotel industry well enough to have any confidence in my appraisal here,
I’m not going to try to actually appraise the hotels Marcus owns. Instead, I’m going to check to
see if Marcus’s hotel division has enough value to cover the entirety of the company’s debt. This
simplifies my calculation as to Marcus’s overall value, because it would mean that 100% of the
market cap of Marcus can be treated as valuing the movie theater chain alone.
My conclusion is that Marcus’s debts are fully covered by its hotel division. The hotel business
produced $30 – $35 million a year in EBITDA over the last 3 years. The company’s debt is
theoretically $300 million. However, $100 million of the debt is convertible into 9.1 million
shares of stock. Because Marcus is very undervalued, we can assume that 100% of the
convertible debt will be converted. It has 5 years till maturity. There is some complexity here in
that Marcus bought a “capped call” to deal with this dilution. But, really, we won’t be
overestimating the value of Marcus as a whole if we just reduce debt from $300 million to $200
million and increase share count from 32.1 million to 43.2 million shares. So, that’s what I’ll be
doing for the rest of this write-up. As far as I’m concerned: Marcus has $200 million in debt and
43 million shares outstanding.
So, is the hotel segment worth at least the company’s debt? Well, $200 million in debt divided
by $30 million to $35 million in hotel segment EBITDA equals 5.7 to 6.7 times EBITDA. Let’s
call that 6-7 times EBITDA. Prior to COVID, did full-service / urban hotels generally go for at
least 6-7 times EBITDA?
That’s one way of valuing the hotel segment.
The other way is on a per room basis. I excluded anything partially owned and any property
where there’s a lease. That leaves an overly conservative estimate of 2,147 rooms. We then
divide $200 million in debt by 2,147 rooms and get $93,153. In other words, an appraisal of less
than $100,000 per room for these hotels would cover the debt. I can find many different
measures of hotel appraisals on a per-room basis for the time period right before COVID.
Depending on type of hotel, location, etc. they tended to be in like the $90,000 to $230,000 per
room range. In terms of comparable properties, what Marcus owns was certainly closer to the
high end of that range than the low end. Also, although “replacement cost” is not something used
a lot in the hotel industry – I did my best to come up with some data on what that might look
like. Generally, I believe that a valuation of less than $100,000 per room for Marcus’s hotels
would be assigning a cost below what it would cost to actually reproduce these properties. In
other words, “cost” is somewhat more than $100,000 per room. Finally, we can look at the
amount of assets shown on the books of the hotel division. It’s about $300 million. This is fully
depreciated book value. Some of these assets are not actual land and property (though a lot are).
There are other ways for me to estimate book value. Overall, it does not appear that an appraisal
of less than $100,000 per room is especially high relative to segment EBITDA, book value,
replacement value, or market value of these hotels in normal times.
For that reason, I’m going to “cancel out” Marcus’s hotel segment’s positive value and the
overall corporation’s negative value from debt.
This leaves us with a movie theater segment and no debt (but 42 million shares).
How much is the movie theater segment worth?
We can do estimates based on number of screens and other stuff like that. But, I think that’s silly.
It’s best to use estimates of actual free cash flow generation. Marcus did a major acquisition
within the last couple years. So, an estimate of free cash flow generated by this segment over the
last 3 years is extra conservative. I estimate free cash flow here to be not less than $35 million a
year (and possibly more like $50 million a year). I’ll use the $35 million in FCF estimate. If we
divide $35 million in FCF by 42 million shares we get 83 cents a share in free cash flow.
Honestly, my best guess is that free cash flow from theaters would normally be between 80 cents
and $1.20 a share (using the new 42 million share count).
We’ll use 80 cents.
A normal P/E for a stock in normal times is 15. So, we’ll use a price-to-free-cash-flow multiple
of 15 here. That works out to 80 cents times 15 equals $12 a share.
Right now, the stock is trading at $9.75 a share. So, that’s 80% of appraisal value. Is that cheap
enough to risk buying into a stock in such troubled industries as movie theaters and hotels?
Honestly, I’d say yes. The appraisal methods I used here are very conservative. For example, the
likely value of the hotel segment as a whole is clearly not $200 million. It’s more than that. The
free cash flow from the theaters is really unlikely to be as low as $35 million in a normal year.
Now, 2021 won’t be normal. But, 2022 might be. Free cash flow could easily be 50% higher
than the estimate I’m using here. I need to do more work to make that estimate. But, there are
many reasons for thinking this. One, the company’s revenue is now higher after the acquisition.
Two, the company’s future cap-ex should be lower than past cap-ex. There just aren’t many
screens left in this chain that haven’t been upgraded to reclining seats, large format picture, etc.
These screens, on average, have far less room for additional cap-ex than what they did 5 or so
years ago. And I’m using the levels of cap-ex we’ve seen recently as if they are normal. So, cash
flow from operations will likely be higher in 2022, 2023, and 2024 than it was over the last 3
years. And cap-ex will likely be lower in 2022, 2023, and 2024. As a result, my estimate of $35
million a year in free cash flow from the theaters is just a really low estimate.
What are the risks with Marcus?
Capital allocation is a very big one. In fact, the biggest argument against buying a stock like
Marcus is why not just buy Cinemark. This company puts a lot of money into hotels. I’ve used a
“sum of the parts” approach here to value the company. That’s a somewhat dishonest approach.
If you put the company up for auction in its separate parts and I had the cash needed to bid on it
– I’d offer far more for the theater chain and far less for the hotels than my discussion above
suggests. This is not so much because the hotels aren’t really worth more than $200 million.
Rather, it’s because the potential for compounding free cash flow over time at the theater chain is
very high versus the low returns in the hotel business. Basically, I think the market tends to
overvalue hotel assets relative to theater assets. I’d rather be in the theater business. So, unless
you are getting a real big bargain buying a mix of hotel and theater assets here – why not make a
100% pure bet on a theater chain?
The easiest way to do that would be to buy Cinemark stock instead.
As a sum of the parts stock, Marcus looks attractive. The thing I like least about this stock
though is that you’re basically watering down a potential investment in a movie theater chain
with a partial investment in a hotel chain. Personally, that’s not a trade-off I want to make. So,
I’m a bit biased against this situation.
 URL: https://focusedcompounding.com/marcus-mcs-a-movie-theater-and-hotel-stock-
trading-for-less-than-the-sum-of-its-parts/
 Time: 2020
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Middleby (MIDD): A Serial Acquirer in the (Normally) Super Steady

Business of Supplying Big Restaurant Chains with Kitchen Equipment
Middleby (MIDD) is a stock I was excited to write-up, because it’s rarely been cheap. I’ve seen
10-year financial type data on the company. I’ve seen it show up on screens. And now the
government response to coronavirus – shutting down so many of the restaurants that Middleby
supplies – looked like a once in a lifetime opportunity to buy the stock. The company also has
quite a bit of debt. That can make a stock get cheap quickly in a time like this. So, I was looking
forward to writing up Middleby.
I’ll spoil this write-up for you now and tell you I didn’t like what I found. The company’s
investor presentation, 10-K, etc. was a disappointing read for me. And I won’t be buying
Middleby stock – or even looking into it further. Why not?
Middleby is in an industry I like. The company has 3 segments. The biggest profit contributor is
commercial foodservice – supplying restaurant chains like: Burger King, IHOP, Chili’s, etc. –
with kitchen equipment. The company sells equipment that cooks, bakes, warms, cools, freezes,
stores, dispenses, etc. It sells a very broad range of equipment. A lot of it is good equipment. A
lot of the brands the company carries are well known. Plenty of them are pretty innovative.
However, I think that innovation most likely happened before – not after – Middleby bought
those companies. Middleby talks a lot about innovation – but, it only spends about 1-2% of its
sales on research and development. That’s not a high number for a company in an industry like
this. Middleby is building this stuff itself – in the U.S. and around the world (in both owned and
leased facilities – and it’s making it for some pretty large scale orders. Plenty of the chains
Middleby serves have thousands of locations. Gross margins in the commercial foodservice
business are 40% or a bit better. Although most of this stuff is sold under just a one year
warranty – some is under warranty for up to 10 years. Plenty of these products do last longer
than 10 years. For a company making 40%+ gross margins on sales of key capital equipment to
big business customers – Middleby doesn’t do a lot of R&D. That fact bothered me a little. It
started to bother me a lot more when I looked closer at the company’s acquisitions.
Middleby has bought some leading brands. Chances are – if you’re reading this – you know
more about home kitchens than commercial and industrial kitchens. You may eat at Chipotle.
But, you don’t know what equipment Chipotle cooks on. You do – however – know brands you
might find in home kitchens. Several years ago, Middleby bought the Viking brand and later the
Aga brand (Aga is a big, premium brand in the U.K. – it’s less well known in the U.S.). In the
company’s investor presentation, they show the EBITDA margins for these acquisitions at the
time they were made and then as of the present (under Middleby’s restructured ownership). The
point of the presentation is to show the big earnings growth Middleby can squeeze out of these
brands. I wouldn’t be surprised to find improvements once Middleby owned these companies as
they are strong brands that probably share a lot of overlap in turns of where and how they can be
produced, what materials they are made from, how they can be distributed, etc. Middleby can
also take technology it already uses in commercial kitchens and adjust it to add some sort of new
feature, a brand extension, etc. to the home premium home kitchen brand. So, the fact there was
improvement in EBITDA margins didn’t bother me. What bothered me was the starting number
shown for both Viking and Aga. Middleby shows the before and after EBITDA margin
comparison for Aga going from 0% (previous) to 17% (current). And for Viking going from 0%
(previous) to 24% (current). I don’t believe these numbers. Or, at least, I don’t know what the
0% EBITDA margin number is supposed to mean exactly. Did Middleby buy two well-
established brands when they were producing no EBITDA? What’s weirder about this is that
Middleby gives information allowing me to see how much goodwill and identified intangibles it
booked when it made each acquisition. Middleby didn’t buy Viking – which it shows as having a
0% EBITDA margin – at some sort of discount to book value or something. Almost all of
Middleby’s acquisitions consist mostly of goodwill and intangibles. The acquired companies
have very little tangible assets relative to the price Middleby pays. And we know that Middleby
eventually wrote down some of Viking’s goodwill. So, how could Viking have been making no
money – a zero percent EBITDA margin is normally a loss in terms of both reported earnings
and free cash flow – when Middleby bought it and yet Middleby paid a lot more than book value
for it and then Middleby had to write down the price it paid? Did Middleby pay a high price for
an unprofitable business that it then turned around? I just don’t believe that Viking and Aga both
didn’t have positive EBITDA before Middleby bought them. So, I can’t really make sense of that
slide in the company’s presentation.
This bothers me, because the case for investing in Middleby is 100% a case for a serial acquirer.
The company would – in a steady state – produce free cash flow. I estimate it averaged a
traditional free cash flow figure of about $284 million over the last 3 years. That’s about $5 a
share. The stock trades at $48.71. So, the price is basically 10 times free cash flow. That sounds
fine till you consider debt. The company carries about $33 in debt per share. This presents two
problems for investors. One, the stock price isn’t really $50 a share – it’s more like $80 a share.
It’s just a leveraged $80 a share. Two, the free cash flow is about $5 per share while the debt is
about $33 a share. That means the ratio of free cash flow to debt is about 6 to 1. It would take
Middleby half a decade to earn enough in cash to pay down its debt.
This is the part that really bothers me – because, I’m not sure Middleby ever intends to pay down
its debt. By my math, Middleby makes about a 50% after-tax return on its net tangible assets. If
the company stopped acquiring stuff – it’d be a very high return business. A lot of this return
would be earned in cash. Middleby is a good business.
But, Middleby isn’t investing in itself. It isn’t spending on R&D – it’s spending on acquisitions.
And the return on acquisitions is not 50%. In fact, by my math, Middleby’s return on total capital
employed is more like 10% after-tax. Now, that’s still a lot higher than Middleby’s cost of debt.
The company borrows using a credit line that pays a reasonably small spread over the higher of
like the prime rate, LIBOR, Fed Funds Rate, etc. We don’t know what that will be in all years.
And we don’t know that lenders will continue to lend to Middleby on the exact same terms when
that revolver matures in 2021. But, I can do some quick math and – assuming the worst – am not
getting an estimated cost of borrowing of more than like 5% before tax for Middleby. After-tax,
it’d be under 4% in most situations I can think of. So, there’s a natural arbitrage here. Middleby
can borrow at less than 4% after-tax and make close to 10% after-tax on its acquisitions.
I’m not sure about that though. See, the 10% estimate is not an estimate of what Middleby is
actually earning on these acquisitions using the more recent acquisitions. I can see that Middleby
– which has been an acquirer for 20+ years and a rabid acquirer for about 10 years – does get
great returns on the really old acquisitions. It seems to get good enough (like 10% type returns)
on the entire company as it exists today. But, if the trend in returns on acquisitions is decreasing
over time – this is problematic. It’s a problem because the newer acquisitions have to be bigger
than the older acquisitions. This isn’t true for all serial acquirers – but, I honestly think it’s true
for Middleby.
The company’s growth record is fantastic. This is a stock that returned more than 20% a year for
more than 20 years. And it did it through continual growth in sales, EBITDA, earnings, etc.
without a ton of dilution for shareholders. However, the growth in profits per share in recent
years has been accompanied by high debt growth and low (sometimes shrinking) organic growth.
That is not a good combination. And it makes me less sure of the free cash flow number I
mentioned before.
I talked about how Hanesbrands has acquired things. But, the acquisitions made by Hanes just
weren’t big enough contributors to growth so as to confuse me about the underlying free cash
flow. I think the U.S. innerwear business at Hanes is declining a bit in sales and maybe more
than a bit in free cash flow. But, I have a lot more faith in the free cash flow Hanes will produce
if it stops buying things than I have in Middleby.
Over the last 10 years, Middleby has bought between 2 and 8 companies per year. Many of these
acquisitions are pretty small. But, some aren’t. The company includes a chart in its investor
presentation that is pretty disturbing. It shows that Middleby’s new acquisitions in a given year
as a percent of its total revenues in that year were: 23% in 2009, 8% (2010), 22% (2011), 9%
(2012), 23% (2013), 7% (2014), 31% (2015), 8% (2016), 12% (2017), 17% (2018), and 16%
(2019).
A lot of this has been funded by debt. In fact, from 2004 to 2018 – Middleby never took its
Debt/EBITDA ratio much below 1 or much above 3. It stayed in a constant state of 1-3 times
EBITDA in leverage.
Now, some people would say that’s a more optimized capital structure than most companies use.
It’s fairly safe – except in coronavirus years – for a company supplying restaurant chains with
kitchen equipment to always borrow something. And the company has not taken on any really
excessive amounts of debt.
But, the debt isn’t used to buyback stock or to expand the business organically. The debt is just
used to make additional acquisitions. That’s the part that worries me. If you have EBITDA of
$600 million now – you need to have debt of about $1.8 billion. That’s the situation Middleby
finds itself in. But, as you generate free cash of say $300 million and also keep growing your
EBITDA at the kind of rates Middleby has in the past (often 15%), you’d end up in a situation
where your Debt/EBITDA falls. And it falls in such a way that you need to find an acquisition
that’s pretty close to your existing EBITDA to go out and buy. Now, it can be a combination of
smaller deals. But, if you are growing 10-15% a year solely through acquisitions – then, you
need to be making 10-15% a year bigger acquisitions every year. I like to look at a ten year
holding period when analyzing stocks. I don’t feel comfortable with the idea Middleby will be
spending $1.5 billion or $2 billion or something on acquisitions in the year 2030. And,
remember, it will be spending many billions cumulatively over the 9 years before that. I just
don’t see evidence that these acquisitions have high returns. Right now, Middleby seems at the
edge of what it should be borrowing. It’ll have a bad 2020 and possibly 2021 as well. It’ll then
have too much debt coming out of this to acquire enough to keep the snowballing rolling.
I do like the existing businesses they own. For example, one of their biggest acquisitions was
Taylor. That equipment is very common in soft serve ice cream, frozen yogurt, etc. It’s a brand
that will probably be a leader in that area a decade or two from now. A lot of Middleby’s brands
will prove very durable. And they’ll be consistently profitable.
But, I don’t like the serial acquisition snowball I see here. And it’s not something I want to be
part of.
So, I like the industry. I like what Middleby already owns. And the stock price – on a leveraged
basis – is not expensive. But, I’m not okay with the capital allocation here. So, this one is a pass.
Revisit Price: Won’t Revisit at Any Price
 URL: https://focusedcompounding.com/middleby-midd-a-serial-acquirer-in-the-
normally-super-steady-business-of-supplying-big-restaurant-chains-with-kitchen-
equipment/
 Time: 2020
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Maui Land & Pineapple (MLP): 900 Acres of Hawaiian Resort Land for
$250,000 an Acre
Maui Land & Pineapple (MLP) owns real estate on the island of Maui (which is in Hawaii). The
company has 22,800 acres of land carried on its books at prices dating back to the 1911 to 1932
period. So, book value is meaningless here. The total size of the land holdings is also
meaningless here. Of the 22,800 acres, 9,000 acres are conservation land. That leaves only
13,800 acres of potentially productive land. Almost all of that (12,900 acres) is zoned for
agriculture.
That leaves 900 acres zoned for residential use.
Let’s compare those 900 acres of land to the company’s enterprise value to get a sense of just
how expensive this stock is on a price per acre basis. The company has 19.18 million shares
outstanding. As I write this, the stock price is $11.40 a share.
Since we’re talking shares outstanding, I’m going to pause to discuss liquidity. I may run
managed accounts focused on the most illiquid stocks out there (because I believe stocks with
wide bid/ask prices tend to be less efficiently priced than stocks that trade constantly at almost no
spread), but I know some members of Focused Compounding prefer more liquid investments.
MLP should be liquid enough for everyone. The stock trades about $300,000 worth of shares per
a day. It’s listed on the New York Stock Exchange.
Now, a bonus aside for those interested in ultra-illiquid stocks: if you’re interested in Maui Land
& Pineapple after reading this write-up, you should definitely check out is closest “peer” of sorts
– Kaanapali Land LLC (KANP). KANP is an illiquid (it trades about $2,000 worth of stock on
an average day) over-the-counter stock. I’m not going to discuss KANP here. However, what
land it owns – which I think is much more speculative and possibly worth much less than the
land I’m about to discuss owned by MLP – is only something like 4 miles from the land we’ll be
talking about here.
Now back to the enterprise value calculation. MLP stock is at $11.40 a share and there are 19.18
million shares outstanding. So, that’s $11.40 times 19.18 million equals $219 million. You can
find the company’s 10-Q on EDGAR and decide how much net cash or net debt to add to that
$219 million to get the correct enterprise value. There’s a tiny bit of cash, a tiny bit of debt, some
retirement benefit obligations, etc. For our purposes, all balance sheet items excluding the 900
acres of residential zoned land are a rounding error. So, I’m going to round the market cap up
from $219 million to $220 million and call that the enterprise value.
Now, we can calculate the price ratio that matters most here. It’s not price-to-book (meaningless
because the land is carried at at 1911 to 1932 values) or price-to-earnings (also meaningless
because it includes land sales which are very lumpy from year-to-year). It’s enterprise value per
acre. So, that’s $220 million in EV divided by 900 acres of residential land equals $244,444 an
acre. So, the market is valuing Maui Land & Pineapple at $244,444 an acre. Let’s round that up
to $250,000 an acre.
If you’re living anywhere in the continental U.S., you’re thinking this idea is a pass right here.
Raw land can’t be worth $250,000 an acre. However, in Hawaii it can be. I have a January 2018
(so only 6-month old) claim by the Realtors Association of Maui that the median home price on
that island is now $698,000. When combined with a few other facts, that figure becomes very
interesting. One, I have other data showing that the (arithmetic) mean home price in Hawaii is
significantly higher than the median. Two, I have data that gives the land value of home prices in
the entire state of Hawaii as a percent of the value of a home. In other words, it gives a
breakdown of land value and buildings and improvements for each year. This is important
because at different times and in different places the price of a home can consist mostly of the
cost of erecting a house (materials, labor, etc.) or it can consist mostly of the cost of the land you
are putting the house on. Back in the 1970s, there were some U.S. states where over 90% of the
cost of a home was literally the cost of the home. The land was only 10% of the purchase price.
Statewide in Hawaii, land’s share of a home’s value is often in the 70% to 75% range. Lately it’s
been 75%.
So, let’s start by trying to make some guesses about how much an acre of residential land on
Maui could be worth. We’ll use the median home price of $698,000 and a slightly lower value
for the land share of that home’s price (two-thirds instead of three-quarters). So, $698,000 times
0.67 equals $465,000. If you average one house per one acre on the island of Maui, that acre
should be worth around $465,000 before you put the house on it.
How good is that first stab at valuing Maui Land & Pineapple on a per acre basis?
Well, it’s slightly conservative in some ways. If you are developing 900 acres, the high-priced
units may skew the value of the entire project above the median. So, maybe we should’ve used a
mean home price but we used a median. And then we used a two-thirds land share of home value
instead of the actual three-quarters land share that’s common in Hawaii.
But, that’s a generic guess. We actually know something about the land Maui Land & Pineapple
owns. And we know something about the company’s development plans.
I will quote from the company’s 10-K. Everything I am valuing in this write-up comes from the
planned development discussed in these few paragraphs:
“Kapalua Mauka is a long-term expansion of the Kapalua Resort which is located directly
upslope of the existing resort development. As presently planned, it encompasses 800 acres and
includes up to 639 residential units…including up to 27 additional holes of golf…Kapalua
Central Resort is a commercial town center and residential community located in the core of the
Kapalua Resort. It is comprised of 46 acres and is planned to include up to 61,000 square feet of
commercial space and 188 condominium and multi-family residential units.”
This gives us something more specific to go on. We already know they are planning to develop
800-900 acres. But, here we have a figure for the number of residential units: 639 units in
Kapalua Mauka plus 188 condominium and multi-family residential units in Kapalua Central
Resort for a total of 827 housing units. To simplify, let’s say they are basically putting 800
housing units on 800 acres. It rounds things off and might be a touch conservative (though this is
a plan – so it may turn out to be overly aggressive if management is planning for more condos
than it’ll really build).
We also get information about the specific location of these units. One, they will be within the
Kapalua master planned community. Two, they will be “upslope” (I think “Mauka” means
something like toward the mountain). Three, they might be near a golf course (remember, they’re
adding another 27 holes).
Now, I have to talk about the existing Kapalua resort. The resort as it presently exists is about
2,100 acres. I haven’t talked about it, because Maui Land & Pineapple has sold most of this off.
Probably the two best known parts of it are the Ritz-Carlton Kapalua (as best I can tell, rooms go
for $800 to low $1,000s a night and the hotel itself was – in the recent past – listed for sale at
around $210 million). Then there are the existing golf courses. There’s the “Bay Course” and the
“Plantation Course”. The Plantation Course hosts a PGA event each January. I know nothing
about golf, but it’s possible based on some information I’ve found that the Plantation Course is
usually ranked one of the best if not the very best golf course in Hawaii.
That’s a lot of talk about three things Maui Land & Pineapple doesn’t actually own: The Ritz-
Carlton and the Plantation Course and Bay Course. I mention them here because this company
either has sold land to these entities before (which we’ll discuss) or some may speculate the
company will sell land to these entities in the future.
On the world “speculate” I’ll finally mention that there is a Value Investor’s Club post on this
company. Go to Value Investor’s Club, select “All Ideas (A-Z)” and then go alphabetically to
Maui Land & Pineapple (MLP). The write-up is about 6 months old. I think it’s too promotional
a discussion of the stock for me to seriously discuss here. But, it’s good to get a second opinion.
And the author of that post may be a lot better informed than me. He seems to have talked to
some people about the property. He mentions talking to management. I have not talked to
management. Nor have I talked to anyone more knowledgeable about property in Hawaii (a state
I have never visited).
That won’t stop me from trying to refine my estimate of the value of this land even further.
We’re going to use the information we have now: 800+ residential units, inside the Kapalua
master planned community, upslope (so let’s assume away from the ocean – mostly to be
conservative), and the word “golf” to find comparables for these planned units.
I went through all the condos listed for sale that are within the Kapalua resort. Obviously,
oceanfront condos sell for more. For example, here are the stats on the 19 “Kapalua Bay Villas”
(really condos) listed for sale at this moment. Remember, prices are list prices not sale prices (I
don’t have access to those). This is the “ask” price we’re talking about here not the “last trade”
price. Also, without going off on a statistical tangent – this is a sample of 19 of the 141 condos in
that community. I didn’t select this sample. It was selected by owners listing these properties. I
simply used all condos within the community that are currently listed for sale as the population
to calculate some of these stats for.
Here we go. For the “Kapalua Bay Villas” (so, oceanfront condos built in 1977) the range of
prices is $874,000 to $2 million. The median is $1.3 million. The mean is $1.29 million. The
standard deviation is $306,456 and the coefficient of variation (standard deviation scaled to the
mean) is 24%.
As you’d expect, there is less variation on a price per square foot basis than a price per unit basis.
The range for these oceanfront condos built in the 1970s is $740 to $1,456 per square foot. The
median price per square foot is $1,037. The mean is $1,014. The standard deviation is $151. And
the coefficient of variation is 15%.
These are not the best comparables. I just used them as an example to show you what some
condos in the Kapalua resort sell for. I’ll get to the community within the resort I am using as my
“peer” for the Kapalua Mauka planned development in a second. First, I want to discuss some of
those stats.
One, because this is a high-density condo type development – the mean is coming in at or below
the median. So, we can assume the median condo in a development is pretty representative of the
entire project valued cumulatively. In fact, even if we just use the unit basis we get a 24%
coefficient of variation and a mean and median that are basically the same. This is helpful,
because it’s often easier to eyeball the median in a group than the mean. Finally, let’s consider
the age of these condos. They’re 41 years old. Some reviews I’ve read online mention this resort
is a bit old and outdated in some ways considering the prices (these are renters vacationing in
one of the condos talking). The new development will obviously be new construction. And then
we have the amount of crowding. Because this is an oceanfront condo community, the crowding
is extreme. They put 27 buildings on 16.5 acres. We’re talking something like more than 5
condos per building and about 2 buildings per 3 acres. Some of the other communities are less
crowded. But, I can find several examples of at least one condo per acre to more like one condo
for every two-thirds of an acre. So, a plan to put 800+ residential units on 800+ acres of
developable land sounds right in line with this community overall.
Okay. I teased you with the condo community in the resort I think is an overpriced peer. Now,
we’re going to use the community I think is a true peer. This community has 20 listings. That
doesn’t sound like a huge sample. But, that’s part of the reason I showed you the range, median,
mean, and variation data on that oceanfront community first. You’ll see similar variation
(actually, even less) in this next community. By starting with the generic residential real estate
picture on the island of Maui as a whole and then moving down to the generic residential real
estate picture in this master planned community as a whole and then finally drilling down to this
one particular peer – I wanted to gradually establish the reasonableness of the appraisal figures
we’ll eventually come to.
The peer community I chose is called “Kapalua Golf Villas”. I chose it for a few reasons. One,
it’s not oceanfront. Two, it has golf course views. And three, it has the lowest average listing
price of any of the communities within the resort. So, it meets my two requirements of
comparability (location is next to a golf course not next to an ocean) and conservatism (it’s the
cheapest peer I could find).
Here are the stats for the 20 condos in the Kapalua Golf Villas currently listed for sale. The
minimum price is $598,000. The maximum is $970,000. The median is $788,000. The mean is
$825,679. The standard deviation is $111,327. And the coefficient of variation is 13%. Here, the
price per square foot doesn’t vary any less than the price per unit (many of the units are the exact
same size). It’s more convenient for us to use price per unit. So, let’s do that now.
The median was $788,000. And it was the lower of the two averages (the mean was $825,679).
There are a few ways to go from here. I like to keep things simple and be able to do more of the
math in my head. So, I’ll simplify some of the assumptions. The ratio of planned units (827) to
my rounded estimate of 800 units is actually greater than the ratio of $800,000 per unit to
$788,000 (the actual median price for the comparable community). So, I’m going to simplify –
via two separate roundings – the problem of 827 units times $788,000 to just 800 units times
$800,000. It’s a lot cleaner that way.
So, 800 planned units at a median sales price of $800,000 would be $640 million. The
company’s current market cap is $220 million. This means that if land’s share of the final condo
prices is about 35% of the sale price – the stock is priced at what the land is worth now. On the
other extreme end, if the land makes up 75% of the value of a residential unit (as it does
statewide in Hawaii) then the market cap should be $480 million. In that case, the stock price
should be $25 a share. Right now, it’s $11.40 a share. Let’s call that a double from here.
Do I think the land the company owns could be worth less than about 33% of the price of the
condos they will sell? Or, to put it another way, do I think there’s any way this company’s 900
acres of land inside the resort is worth less than $250,000 an acre (roughly what the stock is
selling for).
We can think of it this way: what’s the risk the stock is overpriced right now?
Well, if the company puts less than 1 condo per acre on the developable land and the land
component of each condo is worth less than $250,000 – that’s your risk right there. Based on the
information I’ve gathered so far, I don’t really think you would put less than about 1 unit per
acre on the land or that the unit would sell for much less than about $800,000. Even if we assume
land makes up only 50% (not more like three-quarters) of the value of a condo, we are talking
about a price per acre of more like $400,000 rather than the stock’s current market cap of about
$250,000 per acre. To assume the value is as low as $250,000 per acre you need to assume some
combination of condos per acre, sale price of a condo, and land share of that sale price that’s
low. For example, you can assume 1 condo per acre and $800,000 sale price per condo at a 30%
land share of the value equals $240,000 per acre. That basically gets you to today’s stock market
value. They do have agricultural land they lease, a water utility, a real estate brokerage, etc. But,
it doesn’t move the needle.
So, I can see a scenario where you get an appraisal value equal to today’s price if you assume a
really low value of land in proportion to the sale price of a condo. This seems unreasonable
though.
Why?
Look at it from a builder’s perspective. Assume the median house on Maui costs $700,000 and
three-quarters of that is land. That means the median cost of the structure $175,000. Let’s round
that up to $200,000. Let’s say you could build a condo for $200,000 and sell it for $800,000.
That leaves $600,000 for you to pay for the land you’re putting the condo on plus earn your
profit. On one extreme end, we might assume that some condo builders (like homebuilders)
could eke out a breakeven or profitable result on just a 20% margin. That assigns a very high
value to the land. Basically, if builders are willing to bid up the land to the point they only make
20% – the land has a lot of value.
The value of land that can be developed for condos should be determined by the bargaining
power of the land owner versus the bargaining power of the builder. If the builder can put a
condo on every acre and sell that condo for $800,000 – it just seems to me like they’d be paying
more like $400,000 to $500,000 per acre of land than $200,000 to $300,000. Otherwise, some
other builder would be willing to pay a higher price for the land. So, if I had to guess what
average price per acre someone would pay for all 800 acres right now if the land was really ready
to start putting 800 condos on it today – I’d guess it’s more like $500,000 an acre than $250,000
an acre. The stock is priced more like $250,000 an acre. So, the right appraisal price on the land
would put an appraisal on the stock of $25 a share not $11 a share.
We’re now ready to talk about monetization. How will Maui Land & Pineapple actually make
money on this land?
Here’s what the company has to say about the development in its 10-K. It says the approximate
number of acres are 900, the anticipated completion date is 2019-2039, and the projected costs to
complete are $500 million to $1 billion.
I held off talking to you about that development cost for a reason. Maui Land & Pineapple
doesn’t have liquid assets. It doesn’t have a lot of liabilities either. But, everything on this
balance sheet except for these 900 acres is basically peanuts compared to the value of this land.
The annual cash flows in and out from everything else are also basically peanuts compared to the
value of this land.
So, we’re talking about 900 acres that might be worth $450 million or something (in terms of the
land already there) once you put another $500 million to $1 billion into that land. But, this is a
company with no cash, productive assets, etc. that could ever finance something like that. The
value of the project is clearly 3 to 5 times the market cap. And the value of the land itself may be
2 times the market cap.
The development cost projection is also hinting at one of two things. Either, they’re going to get
a really low return on the actual investment in development – or, I may be underestimating the
final sale price per acre they’re going to get. I mean, the figure of $500 million to $1 billion in
development over 20 years did stand out to me considering this is closer to a $200 million
market cap stock. Notice this means your annual development investment – even if spaced out
evenly over 20 years – is like 10% to 20% of the entire starting market cap of your company
right now.
How do you finance this? Do you finance it yourself? Or do you sell it?
Obviously, there are lots of options. You can borrow and build. You can sell it all off. You can
sell part to finance building another part. Which is MLP going to do?
I can’t answer questions like that. I know those are the sorts of things people want modeled. But,
there’s just no useful information I can provide about future guesses on that stuff.
I can look at the estimated development costs, comparable condo sales in the community, etc.
and compare the scale of those things to the scale of this market cap. The market cap is small
relative to what this land might be worth and relative to what the cost of this development project
will eventually be.
That presents two possible risks here.
One, there’s the “dead money” risk. The company doesn’t have the resources to do this alone.
They haven’t always acted that fast in the past (this community began development over 40
years ago). So, maybe this stock is selling for 50% of my appraisal value of its land, but that gap
won’t close in 5 years, 10 years, or even 20 years. So, you have a 50-cent dollar that takes 25
years to become a 100 cent dollar.
How do we quantify that risk?
It’s hard to say. We can look at it two ways. One, how volatile is the stock? If the stock’s very
volatile and they don’t do anything it may work as a “cigar butt” stock. The stock may go from
$11 to $25 at some point even if they don’t get very far on this project.
This company is an $11.40 stock today. About 22 years ago, it was a $12 stock. That’s not a
great track record. However, as you’d expect with any stock – especially with an asset value play
stock like this – investors get greedy at times and fearful at others. In 2005, the stock hit $44 a
share. By 2013, it had dropped below $3 a share. In the long-run, it’s been plenty volatile. So, if
you are a “value trader” of sorts who wants to buy the stock whenever it reaches about 50% of
your appraisal value and sell the stock when it exceeds 100% of your appraisal value – you
might get the chance. It may still take years. But, it’s unlikely the stock would stay below your
appraisal value for something like 20 years. That’s the trader mentality.
What about the true buy and hold investor mentality? Well, then it becomes a question of annual
returns on raw land. Generally, raw land should have poor returns. However, all the data I have
for Hawaii going back about 40 years shows close to 6% annual compound growth in the
nominal price of residential housing units.
I haven’t really discussed the overhead here. The company has G&A costs that lower returns
compared to purely holding raw land inside a resort. It has other things that offset much of that
however (for example, it leases some of the agricultural land I gave no value to, it has a water
utility, and it gets commissions on resales of condos that use the company’s real estate agent).
It’s not impossible that raw land in a master planned community you do nothing with for 20
years and then build condos on in 2038 would have actually appreciated at like 5% plus a year.
Let’s call inflation 3% a year. I certainly think that even with corporate expenses you should be
able to see your appraisal value hold its real value. My best guess is that your appraisal value on
these 900 acres will compound at between 3% and 6% a year for as long as you hold the stock
and the company doesn’t develop the land. That’s not as good as timberland or farmland or
commercial real estate that has been developed. But it’s better than a random house in a random
state. Compounding could – in the long-run – be somewhere between a government bond
portfolio and a corporate bond portfolio. So, if you want to imagine the drag on this “dead
money” for long periods of time, I’d say it’s like allocating “x” percent of your portfolio
(whatever you choose to put into MLP) into a basket of bonds instead of a basket of stocks. It’s a
drag. But, it’s not the same drag as actually earning 0% on your money. And, if you’re willing to
adopt a trading mindset, the stock will be way more volatile than bonds. So, you might be able to
buy today and then sell out if the stock doubles or something on the anticipation of a
development that doesn’t actually get going yet.
The other risk is the scarier one. What if Maui Land & Pineapple tries to take on a lot of debt and
develop this property itself? What if it goes badly? The company ran into financial trouble about
a decade ago. And you can read this write-up by Nate Tobik of Oddball Stocks where he passed
on the company because of its poor liquidity position (that post was written just 2 and a half
years ago).
The company did sell off assets after that. For example, in February of 2017, it sold the Kapalua
Golf Academy practice course to the company that owns the Bay Course and Plantation course.
It has sold a lot off to this company recently. The practice course was 15 acres and sold for $7
million. So, that’s $467,000 an acre. They also sold the Kapalua Village Center which was 3.4
acres and a 26,000 square foot building for $18 million. I’m not going to calculate that on either
a per acre or per square foot basis as both give high valuations. It was a former golf clubhouse
and that buyer probably had strategic reasons for wanting it.
My point is simply that the company was able to sell off assets $15 million here, $3 million
there, $18 million here, $7 million there, etc. And some of the sales were of big chunks of land
I’ve classified as worthless. Is it possible a company could enter bankruptcy while sitting on
800+ acres of residential land and almost 13,000 acres of agricultural land? Maybe in a financial
crisis, or maybe through extreme ineptitude in the use of large borrowings. But, I don’t take the
credit risk here seriously at all. The only way I see the company getting into financial problems
is if it tries to finance the full $500 million to $1 billion of developing these 800+ acres itself and
the project goes badly.
I think the approach I’ve used is best. Don’t worry a lot about the monetization. Instead come up
with an appraisal value of the key asset (the residential land). Update your appraisal value per
acre whenever possible. Look at where the stock is pricing that land on a per acre basis. Right
now, the stock is pricing the residential land at under $250,000 an acre. The Ben Graham
investor type rule of thumb is usually to buy at a discount of at least one-third. So, if you think
those 800 acres at the resort are worth $400,000 an acre or more – this stock should be a buy. If
not, it’s a pass. I wouldn’t assign any value to the agricultural land. I didn’t mention that the
company is planning a development of 300 acres of that agricultural land (for a less valuable but
still residential / commercial use). Why didn’t I mention that planned development? They don’t
have all the approvals it’d need. So, it’s a lottery ticket.
You can do the math and see that if you have 13,000 acres of agricultural land and just 20% of
that land has a 20% chance of being approved for other uses that’s the same as having over 500
acres of land that you could develop at some point. Again, I didn’t mention that because it’s a
lottery ticket. It also wouldn’t be in as valuable a location as the resort land that has the needed
approvals and they’ve started work on. So, I’ve focused on the most valuable land, with the
needed approvals, that is being built on now or will be soon.
The only asset I think we can take a serious stab at trying to appraise is the 800 acres yet to be
developed at the Kapalua resort. And from a handicapping perspective we know that’s valued at
less than $250,000 an acre in the stock market. What would it be valued at in the Hawaiian real
estate market?
The question you have to ask yourself is whether you personally think that land is worth more in
the $200,000 to $300,000 an acre range or $400,000 to $600,000 an acre range. If you think it’s
worth $200,000 to $300,000 an acre – it’s a pass. If you think it’s worth $400,000 to $600,000 an
acre – it’s a buy.
What about the catalyst?
The 10-K has – for the last couple years at least – shown the planned completion of the
development as 2019-2039. If you assume the value of the land is about $400,000 per acre and it
takes 20 years to close the value gap and the land value increases just as the rate of inflation –
you can get a return as low as 5.5% over 20 years. If you assume the value of the land is more
like $600,000 per acre and it will take 10 years for the value gap to close and the land value
increases at 6% a year – you get a return of a bit over 15% a year.
So, if you’re right about the value of the land (and think it’s double what the stock is trading for
now) but get stuck in the stock for 10 or 20 years, your likely returns would be in the 5% to 15%
range.
If you are able to get your “puff” out of this cigar butt faster, because other investors get excited
about the stock at some point or because the company actually sells off a lot of the land within
10 years – you could make a lot more than 15% a year. For example, if the stock closes its value
gap in just 5 years (going from 50% of your appraisal value to 100% of your appraisal value)
while the land itself also grows in value by 5% a year – you’d make a 20% annual return over 5
years.
What’s the most likely scenario? I don’t know. You can read the company’s past history, its
current 10-K, etc. to get an idea.
I will add that this is a controlled company. The former CEO of America Online (Steve Case)
owns 60% of the stock. He’s from Hawaii originally. And he’s obviously a very wealthy man.
So, he may be as interested in the conservation land etc. as actually monetizing the resort’s
value. I have no insight on that.
Finally, one last point. I’ve been saying that they will put condos on this land. I don’t know that.
In fact, I know that’s not true. They clearly didn’t say “condos” in that first paragraph of the 10-
K. And we know that a developer is building some truly gigantic homes as part of the first phase
of this development.
So why did I use a condo based estimate? It’s just the best comparable data I have – so there’s no
point in trying to value it if it’s luxury homes.
We know in some cases it is luxury homes, because there’s an article about Mahana estates you
can read here. The actual Mahana Estates website is here. I’d caution you not to extrapolate from
the listings you see there. Big lots all along the ocean tend to go for incredibly high prices per
acre – but you’re going to have very few such lots to sell. There is some more detail about
Mahana estates at the developer’s website. Note this phase includes 125 acres of land and a
contract value of $300 million. Again, I’d strongly warn against extrapolating out that per acre
number across all 800+ acres of this development. However, you’ll note the article mentions that
“dirt” in some cases will go for $1 million or more per acre – meaning the homeowner will pay
more than $1 million per acre for the land portion of their home purchase. Overall, the
impression I get from reading about Mahana estates is that the stock market’s $250,000 per acre
valuation of MLP is below the per acre valuation the Hawaiian real estate market would set for
the same assets.
I want to make clear that throughout this post I’ve tried to come up with an estimated appraisal
range for this company. I haven’t tried to model the actual future. I haven’t tried to project
whether these will be condos or luxury homes on the 800 acres. I haven’t tried to project whether
they’ll mostly be delivered in 2025, 2030, 2035, or 2040. I don’t think that matters much. What
matters is the appraisal value of the 800 acres (as land) right now, whether that appraisal value
will compound in the future, and how high or low the stock market’s value per acre is versus that
appraisal value. I’m just trying to lay out whether this company is sitting on 800+ acres worth
something like $200,000 an acre or $600,000 acre or something in between. I’ve given you all
the data I have. It’s a matter of personal judgment from here.
So, will I be putting in a buy order for Maui Land & Pineapple tomorrow morning?
Overall, I think it’s difficult enough to appraise this land that I’m less sure of its value than I am
of Keweenaw’s timberland. However, it seems easy enough to value just the undeveloped land at
the resort to see that this stock’s market cap is not higher than the value of all of its land. The
stock isn’t expensive. It might underperform if it turns out to be a dead money stock or if it bites
off more than it can chew when it comes to developing the land it owns.
However, I think the odds are pretty high the company is worth twice its market cap. And I think
the odds are pretty low that it’s worth less than its market cap. The asset position is so strong that
even though the company doesn’t have much in the way of cash flow – I consider it financially
sound.
So, assessing the downside risk: I don’t think the land is worth any less than the market cap. And
I don’t think the financial position is weak.
The upside is harder to quantify because my appraisal is going to have to be some figure plus or
minus at least $100,000 per acre – maybe more. And, on top of that, I’m not sure how quickly
the land will be monetized.
So, I’m not at all sure I’ll be buying this stock. However, I am sure that I’ll be researching it
further.
 URL: https://focusedcompounding.com/maui-land-pineapple-mlp-900-acres-of-hawaiian-
resort-land-for-250000-an-acre/
 Time: 2018
-----------------------------------------------------
Miller Industries: A Pretty Good, But Very Cyclical Business that Sells its Car
Wreckers and Car Carriers Through a Loyal Distributor Base
Miller Industries (MLR) has a lot of things to like about it. But, the timing of buying this stock
now definitely isn’t one of them. Miller is in a very cyclical, highly durable capital good industry
– it produces “car wreckers” and “car carriers” – that depends heavily on business confidence
and especially access to capital. It is very easy to defer the purchase of a new wrecker or carrier.
And it is very hard – impossible, really – to sell wreckers or carriers without easily available
credit. To give you some idea of how important credit is in this industry – Miller Industries is
currently promising lenders to its distributors (these are all technically “independent
distributors”) that it will buy back up to $74 million of its own wreckers and carriers if the lender
repossess that collateral from the distributor. Miller makes this kind of promise all the time. In
recent years, it has not had to buy back any of its equipment. But, you see the problem. It might
have to do so. And, the fact that distributors are using financing that depends on the lender
getting a promise from Miller (the original equipment manufacturer) gives you some idea of how
important credit is in this industry. The distributors – there are 80 of them in the U.S., and Miller
estimates that about 68 of them don’t actually sell any wreckers or carriers other than Miller
products – rely heavily on floorplan financing.
The industry is also very cyclical. In the last economic cycle, Miller’s sales peaked at $409
million in 2006 and bottomed out at $238 million (down 42%) in 2009. Gross profit dropped by
the same percentage (42%). Operating profit – however – went from $33 million in 2006 to $7
million in 2008 (down 80%). Could the same thing happen in this recession?
Yes, it could.
So, Miller’s P/E, P/S, etc. ratios are all very suspect right now. Maybe price-to-tangible book
value would be a better guide to the company’s valuation. The good news is that the P/E and P/S
ratios here are low. But, that’s what you’d expect with a cyclical stock that everyone now knows
is at the very top of its cyclical (the recession has already started as I write this, and Miller
reported earnings less than a month ago that were its best ever – so, we can call this the official
peak). The P/E ratio on those peak earnings is between 7 and 8. The P/S ratio is about 0.4 times.
The company has a tangible book value of $21.60. As I write this – the stock is trading at $25.89.
So, the P/B ratio here is 1.2 times. That makes it pretty easy to compare this company’s long-
term history with its current stock price. Miller probably doesn’t convert all its reported earnings
into cash. So, if stocks generally return say 8-10% a year – and we use that as the hurdle rate
you, as an investor are looking for – then we need to see returns on equity from Miller (over a
full cycle) that are at least 8-10% times 1.2 = 9.6% to 12%. Let’s call that a requirement for a 10-
12% return on equity over a full cycle.
What has Miller actually done?

Over the last 16 years, Miller has averaged a 14.2% return on equity. That period starts right
after a (comparatively mild) recession in the early 2000s. On the other hand, it doesn’t include
the lower taxes Miller is paying now versus what it paid years ago. So, I’d say – yeah – Miller
hits about a 14% ROE over a full-cycle which adjusted for today’s taxes might even be more like
a 17% return on equity. Now, I do have to warn you about the word “average” here. I’m giving
you an arithmetic average which is the least conservative way of calculating an average for a
cyclical stock. The most conservative way would be to use the harmonic average. An arithmetic
average weights things toward the highest ROE years. A harmonic average weights things
toward the lowest average years. The harmonic average would be about 9%. However, taking
into account the change in taxes – I’d still say it’s a 10-11% average. And that’s unfairly low for
a cyclical company. The reality for Miller is somewhere between the harmonic and arithmetic
averages. What you should really use is the geometric average to be fair. But, honestly, I don’t
want to be fair. I want to look at the downside here. And the harmonic average tells me to expect
a downside of more like 10%. Again, though – we need to remember this period included The
Great Recession. So, over a full 15-years, I think we can say Miller should normally do better
than a 10% return on equity. However, we also need to remember that Miller may do worse than
ever in the next year or next few years. I showed you the drop in sales and earnings after the
financial crisis. Buyers of Miller shares today should be prepared for a 50% decline in sales and
an 80% decline in profits in this recession.
That does not, however, mean now is the wrong time to buy the stock. Sometimes, a cyclical
stock is attractive as we are headed into a recession, as we are in a recession, or when we are
almost about to emerge from a recession. That’s because it can get so cheap as people price in a
recession that the stock is cheap relative to its full cycle earnings. Is that the case here?
Well, I estimated Miller’s range of possible ROE outcomes over a full cycle was something like
10% to 17%. The price-to-tangible book ratio is now 1.2. So, that gives us an 8% (10%/1.2 =
8%) to 14% (17%/1.2 = 14%) kind of normalized earnings yield. To put this in P/E terms –
Miller might be trading at something like 7 to 12 times earnings. Basically, the “cyclically
adjusted” P/E on this stock could be as low as a P/E of 7 or as high as a P/E of 12. Both sound
reasonable enough. The long-term ROE on this stock is good enough too.
So, Miller might be cheap.
Is it safe?
Well, it’s in for a brutal time cyclically. And it does have some off balance sheet arrangements
that could cause problems. Miller has promised to buy like $50 million of what are basically raw
materials. I suspect, however, the company could get out of this. It’s not always the case that you
need to honor purchase obligations in a situation like this. In general, I wouldn’t assume that just
because a company has said it will buy $50 million of supplies it will always end up buying
those supplies when its factories are shut down by government order. There’s also the $74
million in promises to buy back equipment it produced for distributors if they default. I don’t
want to overstate that promise. Could it get triggered in 2020 or 2021? Absolutely. But, in
normal years, it’s never triggered at all. On top of that, the lender would be selling the equipment
back to Miller. So, Miller’s balance sheet would lose cash but gain finished equipment. That’s
not good. But, it’s not the same as burning cash. And, I doubt Miller agreed to – nor do I think
the lender even proposed the possibility of – Miller buying back repossessed equipment at rates
above what they could easily be re-sold for (given enough time and an orderly market). The
lender just doesn’t know how to dispose of car wreckers and car carriers. It’s not the kind of
thing they could repossess and sell as well as Miller can. So, I think it’s a real risk Miller might
actually have to buy some of its own equipment back in a bad recession. But, it’s not as big a risk
as I’m used to seeing at a lot of companies.
Okay. So, Miller has a couple off-balance sheet items that might cause it a bit of trouble. What
about on the balance sheet?
I can’t think of a better balance sheet you’d want to have than what Miller is going into this
recession with. It’s a thing of beauty. Current assets are double total liabilities. Quick assets –
cash and receivables – are 1.5 times total liabilities. Some inventory – which I didn’t include in
quick assets – is finished goods. And, we know, Miller produces almost everything to order. So,
that portion of inventory will get sold. The company also had a backlog of about 4 months as of
the end of the quarter. That backlog consists only of what Miller consider “firm” orders. They
could be a lot less firm in the face of coronavirus as it exists about a month since Miller talked
about its backlog. But, my point is that some of that inventory can get turned to cash. And it
doesn’t even need to. Miller has plenty of coverage of all of its liabilities using just its cash and
receivables. Cash is about $24 million while debt is $5 million. So, Miller has less than $20
million in actual cash on hand. But, the receivable balance is very big. Only one distributor
accounts for 16% of receivables. No other distributor accounts for even 10%. The company also
has a $50 million credit facility that it has not drawn on. I won’t get into all the PP&E and such.
But, that credit facility is unsecured. The PP&E consists of some land, a lot of plant assets, and
then a bunch of equipment. A lot of this PP&E is from very new cap-ex – the company spent
way more on cap-ex in the last 3 years than is required to maintain the business. So, overall, I
think liabilities are low, liquid assets are high, and there’s some additional owned assets that
aren’t mortgaged or anything. Plus, you’ve got a credit line. It’s also worth mentioning Miller’s
SG&A is like 5-6% of sales (though this may be overly flattering, because I think some “sales”
are pass through components at basically no gross profit). The U.S. workforce – which accounts
for about 85% of Miller’s sales – is non-union. The European workforce is also non-union – but,
probably a lot harder to lay off. Also, one of Miller’s European plants is in the U.K. and the U.K.
is offering some assistance to companies that might make the fixed costs of running a factory a
bit more sustainable.
I haven’t talked about the business. In normal times, I think I’d like but not love this business.
Miller is the leader in the field. Starting in the 1990s, they acquired the best known brands of car
wreckers, car carriers, and auto transports. Sales of these things are made to governments and the
like. But, the real customer base is professional towing companies. These are companies that
clear accidents on the road (using light duty wreckers), that move heavy equipment, that pick-up
overturned trucks and buses, that carry cars long-distances to dealerships, etc. Companies that
need these services include insurance companies, auto auction companies, rental car companies,
etc. But, the important thing to think about is towing companies buying these products through
distributors. Purchases are made on credit. And distributor inventory is owned using floorplan
financing. This industry is super sensitive to credit. It’s super cyclical.
But, as we saw, over a full cycle – ROE is acceptable. And, for the most part, that ROE was
achieved without use of much debt. Miller hasn’t given out any stock options in recent years. It
has invested super heavily in expanding its manufacturing base. A lot of this is modernization –
not just capacity increases. The vast majority of dealers have been selling Miller products for
over 10 years. Many dealers have been with the company for over 25 years. All the top
executives at Miller – including the Chairman and the Co-CEO have been with the company
since at least the 1990s (20-30 years). A few have been with the company even longer. Insider
ownership is not high here. The biggest shareholders are mutual fund owners (focused on small
caps). Miller claims it focuses on competing on relationship with its dealers, customer service,
quality, innovation, and having a known brand – not primarily on price. Their actions suggest
that. They spend a very low amount of R&D versus sales. But, it’s not terrible versus gross
profit. And they built a dedicated, free standing R&D facility. They employ 50 engineers out of
1,310 people total (engineers are 4% of the workforce). So, I do believe the things they say.
One final point – I mentioned a “pass through” of sales at like no gross profit. I’m very, very
suspicious that this company’s sales make it seem bigger than it is. Why is that? Well, the way
this business works is that Miller builds the body of a wrecker or a car carrier. However, what
distributor wants to hold inventory consisting of the body of a car carrier or the body of a
wrecker and tell the customer – we can put this together for you with a truck chassis later?
Nobody wants that. What they want is a wrecker or carrier affixed to a truck chassis already.
Miller doesn’t make that part of the product. But, it can just buy a truck chassis and combine it
with what it does make. So, that’s what Miller does. For a variety of reasons, I don’t believe
Miller can get better pricing on a truck chassis than others could and don’t think there’s room for
making profit on buying a chassis and selling it with a wrecker or carrier body. I think all the
gross profit is in the body. So, you’ll see things like a 15% gross margin at Miller and a 5%
SG&A as a percent of sales expense. I think all that stuff is a bit misleading. The chassis is a
meaningful part of the final cost – and Miller doesn’t make it and isn’t in a position to buy it at a
wide enough spread to make retail type margins. So, what I’m saying is that I think Miller’s
profits all come from just the body portion of the sales – but, accounting rules require sales be
shown as the combination of the body and the chassis. I think this overstates sales and causes the
gross margin at Miller to look oddly low. Again, what matters is really ROE. And, as we’ve
shown, Miller has achieved an acceptable ROE over a full cycle.
I’m not sure this company is cheap. I do think it’s safe. I’m really not sure now is a good time to
buy the stock – but, timing isn’t really my thing. It’s not an amazing business over a full cycle.
But, it’s good enough to be real interesting. For a cyclical stock and a manufacturer – I’m
surprised to say I kind of like this one.
But, I don’t like it nearly enough to suggest buying it anytime soon. Still, it’s one I’m willing to
revisit.
Geoff’s Revisit Price: $14/share

 URL: https://focusedcompounding.com/miller-industries-a-pretty-good-but-very-cyclical-
business-that-sells-its-car-wreckers-and-car-carriers-through-a-loyal-distributor-base/
 Time: 2020
-----------------------------------------------------
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
Mills Music Trust (MMTRS) is an illiquid, over-the-counter stock. In fact, it’s not a stock at all.
The security traded is a “trust certificate” that entitles the holder to quarterly distributions from
the trust. These “dividends” are not dividends. The trust has not paid taxes on the income. So,
you will be taxed on the income received. As a result, you’ll need to adjust the after-tax return on
Mills Music Trust as compared to other stocks you might own. Since I don’t know your tax
situation, I don’t have a way of doing that.
The trust was created in 1964. Its life may extend till something like 2088. The way it’s written
the trust will be dissolved at the end of the calendar year during which the last copyright expires
and can not be renewed. Based on a table of the 50 top performing copyrights in the Mills Music
Trust catalog – I believe this won’t happen before 2088. However, the trust renegotiated
something important with EMI (the publisher that collects royalties on behalf of Mills) that
makes the end date for the trust less important. The original trust arrangement required a
minimum royalty payment of $167,500 per quarter. This is not a small number when you
consider that there is a copyright that won’t expire till 2088. So, the contingent payment made to
Mills would presumably have been $670,000 a year in 2087 (and for many, many years before
that). Now, it’s likely the dollar will have depreciated quite a bit in the 67 years between today
and 2087 – but, $670,000 a year is still a ton more than the songs in the Mills Music Trust
catalog will be producing in royalties in that year. This is because the vast majority of the
copyrights on valuable songs will expire in about 25-30 years. Mills provides information on
when copyrights for songs may expire. But, as most of these songs are all governed by the same
copyright law, a pretty good guess is simply date of creation plus 95 years. So, these valuable
songs I expect to come off copyright (and go into the public domain) in the next 25-30 years
were created in like the 1920s. Almost all of the royalty streams you’ll be getting here are
derived from pre-1958 songs. And then, because of the general rule that a song will be off
copyright after 95 years (no matter what is done to try to renew it) – we can assume that these
songs don’t much pre-date the early 1900s. In fact, almost all the songs of value seem to date
from 1922-1958. There’s about a 30-year period where many of these more valuable copyrights
were created. And those were the roughly 30 years before the trust was created. Mills gives
details on what these songs are. Some of the biggest royalty producing songs for Mills right now
are:
Little Drummer Boy
Sleigh Ride
Lovesick Blues
Stardust
Hold Me, Thrill Me, Kiss Me
It Don’t Mean a Thing if It Ain’t Got That Swing
I’ve Got the World on a String
Mills had been entitled to 65% – 75% of gross royalty income prior to 2010. Mills then agreed to
a new deal under which the minimum royalty payment was removed and – Mills believes, but
EMI does not – all songs would now pay Mills 75% of gross royalty income. Do I believe what
Mills believes and not what EMI believes? Honestly, yes. But, I’ll put even odds on this dispute
– 50% chance that EMI is not underpaying Mills and 50% chance that EMI is underpaying Mills
– when I calculate the probability weighted earnings power (or, in this case, distribution power)
of the trust certificates. Right now, what you need to know is that there’s some chance that EMI
is now and has been – for each of the last 4-5 years I’ll be looking at to do this calculation –
underpaying Mills. As a result, there’s a chance that the distributions trust certificate holders
have been getting understates what they will get in the future. One exception to this is an
especially large distribution made in 2019. The 2019 distribution was especially large because
EMI agreed to a $1 million settlement. EMI paid the $1 million settlement after being presented
with an audit done by an auditor hired by Mills to investigate Mills’ claims of deficiencies on the
part of EMI in payments made from 2010 to 2015. The auditor got about $130,000 for its
trouble. So, Mills netted about $870,000 (remember, this is all “pre-tax”) over a period of 5
years. That works out to $174,000 per year. There are 277,712 trust certificates. So, that’s about
63 cents per trust certificate per year – net of auditor fees – that Mills was not distributing to
certificate holders from 2010-2015, because EMI wasn’t paying. Mills believes EMI is wrong
again. The settlement with EMI did not cover any period after 2015. Mills believes that it has
been underpaid by a cumulative amount of $600,000 during 2016, 2017, 2018, and 2019. That
works out – this time, before auditor fees – to about $150,000 in unpaid distributions due to EMI
deficiencies per year. That’s 54 cents per share.
Actually…
It’s a little more complicated than that. In a sense, buying Mills Music Trust certificates today is
like buying a cumulative preferred stock that is currently “in arrears.” If and when EMI settles up
or starts paying at the royalty rate that Mills believes it is owed – two things could happen. One,
you could get the accumulated deficiency less auditor fees, etc. In this case, let’s say that’s
$600,000 less a similar audit cost would be $470,000. The deficiency is constantly building up –
and the audit cost probably does not build at the same proportionate rate as the deficiency does.
If we take out $130,000 for an audit and then divide by the trust certificates outstanding: there is
at least $1.70/share (remember, these aren’t shares – they’re “certificates”) in cumulative arrears.
If EMI keeps paying the way it is – this cumulative arrears pile could grow by as much as 10 to
15 cents per share per quarter. So, by the time you are reading this, it may be bigger. In another
quarter or so it could be $2 a share. Should we lop this off the stock’s price? As I write this, the
last trade was $30.50. The bid was $31.25. The ask was $35. I’m not going to discuss how to
trade illiquid stocks here. But, please don’t look at the bid/ask spread of $31.25 / $35 and think
you should pay a price somewhere in between (or even worse, think you should pay the ask). If
you ever do buy a stock like this, don’t do more than beat the best bid. Unless you have reason to
believe a lot of certificates could come your way if you bid close to the ask – don’t do it. For that
reason, the last trade or the bid are the relevant bits of price info here. Normally, we use the last
trade when talking about stocks. So, I’ll do that here: $30.50/share. Given the “arrears” the stock
has built up – are you really paying more like $28.50 to $29 a share for the future distributions of
Mills Music Trust.
Like I said, I’ll be using a 50/50 approach here. I will assign a 50% chance the “arrears” are paid
in full to you as Mills claims they should be. And – far more importantly – I’ll be assuming that
there’s a 50/50 chance EMI will start paying in the future at the higher rate that Mills believes it
deserves. This second point is more debatable. One thing that will drive trust certificate holders
crazy here is the constant lag and uncertainty of payments. The 5-year average annual payment
per share – excluding the EMI settlement – was $2.55/share. Like I said, Mills believes that
they’ve been short-changed by about 54 cents per share these last several years. As a result, the
“dividend yield” of Mills Music Trust going forward is pretty open to interpretation. Is it
$2.55/$30.50 = 8.4%. Or, is it: $3.09/$28.80 = 10.7%. In fact, it could be even higher than that
last number. I’m using the 5-year average distributions. If I adjust for the EMI payment, the
actual cash distributions by year look like this:
2015: $2.69
2016: $2.19
2017: $2.14
2018: $2.85
2019: $2.90
Maybe you see a trend there. I wouldn’t stake my life on it. But, if you take the last year’s
distribution and add 54 cents in underpayments to it – you get $3.43 as the “earning power” here.
And when you deduct the “arrears” from the current stock price, that gives you a dividend yield
of 11.9% ($3.43/$28.80).
What’s the truth?
Well, the range is probably a payment of between 8% and 12% a year. I could give you the
probability weighted figures I calculated – but, I think that’s overly technical. You can guess at
the same result by saying the range is 8-12% and with 50/50 odds EMI is right and 50/50 odds
Mills is right – that gets you about a 10% yield. This yield is not taxed. However, it’s also not
contractually capped. It will hold up to inflation much better than long-term bonds.
What long-term bond should we compare Mills Music Trust to? This isn’t an easy comparison.
The risks here are different than corporate risks. The payments are more protected against
inflation. Upside is more possible here. But – most importantly – Mills Music Trust is effectively
a “stripped” side of a bond. It’s all coupon and no face value. There is no minimum royalty
agreement anymore. And Mills does not have to pay you back any sort of value at the
“maturation” of this bond. That’s because it’s not a bond. It’s just a series of payments probably
stretching over the next 25-30 years mostly.
The “yield” here is probably double a lower grade (but still investment grade) 30-year corporate
bond. The advantage in terms of basis points is enough to offset the fact you won’t get paid back
any lump sum at the end of this “bond’s” life. What I mean by that, is you’ll likely collect more
than 5% a year on your investment higher than just the amount you’d be getting in interest on a
long-term bond. So, if you think this is as safe as an investment grade bond – yes, it looks very
cheap.
Is it as safe?
I don’t know. But, I do know it’s a lot safer than I initially expected. It’s not difficult to see how
much of the royalties are backed by a handful of very durable songs. The “management” here is
also strongly on your side. So, theoretically this is just a trust with a bank (HSBC) acting as the
corporate trustee and then two individual trustees. However, the individual trustees are both
really “shareholders” here. One is the head of MPL Communications. He runs Paul McCartney’s
investments in music rights. The other runs Buttonwood Tree Value Partners. It owns a lot of
trust certificates too. So, you actually have two of the biggest “shareholders” as your trustees
here. First Eagle (the value investing shop) also owns a bunch of trust certificates. HSBC
(actually, its predecessor) has been the corporate trustee for over 50 years. The auditor has been
auditing the financials of Mills Music Trust for the last 17 years. Mills was the only public issuer
client it was auditing as of its last inspection report – and the PCAOB didn’t flag any issues with
that audit (which we know was the audit of Mills). Not bad for a tiny trust. But, remember, this
auditor doesn’t know anything about EMI’s books. And that’s what matters here. Overall, it
looks like a solid auditor, a solid – and active enough to pay to have EMI’s books audited –
couple of trustees with skin in the game. The set-up here looks a lot better than many trusts I see.
And the assets backing the trust are much more solid than what is backing a lot of publicly traded
trusts.
What’s the downside?
If you adjust for the probability EMI might not pay any of its past deficiencies, might not pay
more in the future, etc. and you consider that taxes to be paid on trust income could be high
versus dividends – this is nothing like a stock with a dividend yield of 8-12%.
In fact, I’m not sure that an unleveraged investment in Mills Music Trust will outperform an
unleveraged investment in a public company (even a much more expensive public company)
that’s re-investing most of its earnings. There are many banks that pay a good dividend yield but
still retain two-thirds of earnings and thereby grow book value while deferring additional
dividend taxes. There are growth companies that retain all earnings. There are stocks about as
cheap as Mills on a “P/E” basis (technically, Mills has no “e”) that buyback a lot of stock.
I said unleveraged a couple times there. The truth is that an investment in Mills – given the
relative safety (it’s a lot safer than other stuff yielding 8%+ a year) should be funded with debt.
Now, Mills itself is presumably not a purchase you can do on margin. It’s an OTC stock. It files
with the SEC. But, it’s not listed and it is illiquid. Of course, money is fungible. So, the fact you
can’t buy Mills on margin doesn’t mean you can’t offset however much Mills you do buy with
borrowed money elsewhere in your account. Buffett had a practice in his partnership days of
borrowing 100% of whatever amount of his portfolio he currently had in “workouts”. So, if 10%
of his portfolio was in these liquidations and such – he’d borrow 10% of his assets.
I never tell people they should use borrowed money in a brokerage account. I’m also not saying I
would buy Mills at this price. But, if I did buy Mills – I might look into borrowing money to
offset it.
 URL: https://focusedcompounding.com/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/
 Time: 2020
-----------------------------------------------------
NACCO (NC): The Stock Geoff Put 50% of His Portfolio Into
On October 2nd, Hamilton Beach Brands (HBB) was spun-off from NACCO Industries (NC).

That morning I put about 50% of my portfolio into NACCO at an average cost per share of
$32.50. Since that purchase was announced, several members of Focused Compounding have
sent in emails asking for a write-up that explains why I made this purchase.
Unfortunately, there just isn’t much to say about my NACCO purchase. So, this write-up will be
both brief and boring.
I bought NACCO, because the stock’s price after the Hamilton Beach spin-off seemed low
relative to the earning power of the coal business.

All Value Comes from the Unconsolidated Mines
After the Hamilton Beach spin-off, the earning power of NACCO comes entirely from its
“unconsolidated mines”. NACCO – through NACoal – owns 100% of the equity in these mines
and receives 100% of the cash dividends they pay out (which is almost always equal to 100% of
reported earnings). However, the liabilities of these mines are non-recourse to NACoal (and thus
NACCO). Each mine’s customer (the power plant) is really supplying all the capital to operate
the mine. This is why NACCO doesn’t consolidate the mines on its financial statements (because
it isn’t the one risking its capital – the utility that owns the power plant is taking the risk).
You can see the financial statements for the unconsolidated mines here.
(It is very important that you click the above link and read through it carefully).
There Are Risks
NACCO also owns one consolidated mine (MLMC) which could potentially destroy value. And
at the parent company level – so NACCO rather than NACoal – the company has legacy coal
mining liabilities (“Bellaire”) and losses related to general corporate overhead.
NACCO’s customers are almost all “mine-mouth” coal power plants. They sit on top of coal
deposits that NACCO mines and delivers to the plants to be used as fuel.
Coal power plants throughout the U.S. have been closing. The power plants NACCO supplies
could close at any moment. And it would only take one such closure to seriously dent NACCO’s
earning power.
NACCO’s largest customer accounts for probably 35% of the company’s earning power.
NACCO’s two largest customers account for probably 50% of earning power. And NACCO’s
three largest customers account for probably 65% of earning power.
NACCO’s Business Model
NACCO sells coal to its customers under long-term (most contracts expire in 13-28 years)
supply agreements. The agreements are “cost-plus” and indexed to inflation.
Each Share of NACCO is Backed by 5 tons of Annual Coal Production

As you can see in this investor presentation, NACCO delivered 35.5 million tons of coal over the
last twelve months. The company has 6.84 million shares outstanding, so each share of NACCO
is now backed by 5.19 tons (35.5 million / 6.84 million = 5.19) of coal sold under a cost-plus
contract indexed to inflation. I paid an average of $32.50 a share for my stake in NACCO. This
means I paid about $6.26 ($32.50 / 5.19 tons = $6.26) per ton of annual coal production sold
under these cost-plus contracts indexed to inflation.
How much is a ton of annual coal production worth at NACCO?
NACCO Makes Anywhere From 57 cents to $1.75 (After-Tax) Per Ton of Coal It Supplies
NACCO owned a couple consolidated mines (Centennial and Reed Minerals) that it wrote off.
The various charges related to these mines muddied results for 2014, 2015, and 2016 so badly it
seems best to just ignore these most recent years and rely only on the “clean” financials from
years before 2014.
NACCO’s important mines have been supplying the same power plants under the same contracts
for a long time. So, it makes sense to simply use long-term historical data for the years 1991-
2013 instead of trying to re-state more recent results.
Because coal miners receive a tax benefit (“depletion”) as part of their day-to-day operations, it
also makes sense to use estimated after-tax results instead of operating income. In its investor
presentation, NACCO estimates it will pay a tax rate of 20% to 25% in the future. The
company’s estimate is supported by the historical tax information for the unconsolidated mines
(they file their returns as part of NACCO’s returns) which show those mines have paid taxes
ranging from 21% to 27% a year and averaging 23%. In the estimates that follow, I have
assumed NACCO will pay a 23% tax rate from now on.
NACCO operates under cost plus supply agreements indexed to inflation. So, the best way to
estimate today’s earning power is to calculate the historical real after-tax profit per ton of coal
supplied and then multiply that figure by the amount of coal being produced per share over the
last 12 months (5.19 tons).
From 1991-2013, NACCO’s real after-tax profit per ton of coal supplied ranged from 57 cents
(2005) to $1.75 (1991, 1992, and 1993). The median real after-tax profit per ton was $1.06. The
arithmetic mean was $1.15. And the standard deviation in this series was 39 cents. Finally, the
real after-tax profit per ton for the five most recent “clean” years was: $0.85 (2009), $1.06
(2010), $0.82 (2011), $1.02 (2012), and $0.83 (2013). The average after-tax real profit per ton of
these last 5 years is 92 cents.
Using these real after-tax profit per ton figures, we can come up with a series of earnings
“estimates” using current production of 5.19 tons per share.
At the minimum real profit per ton: $2.96/share ($0.57 * 5.19 = $2.96)
At the maximum real profit per ton: $9.08/share ($1.75 * 5.19 = $9.08)
At the median real profit per ton: $5.50/share ($1.06 * 5.19 = $5.50)
At the mean real profit per ton: $5.97/share ($1.15 * 5.19 = $5.97)
At the last 5-year mean real profit per ton: $4.77 ($0.92 * 5.19 = $4.77)
So, our estimate of earnings power would be somewhere in the range of $3 to $9 a share with a
central tendency around $5.50 to $6 a share. If we use the last 5 years, we might put earning
power at more like $4.75 a share.
At my average purchase price of $32.50 a share, the important figures are really the three more
conservative “P/Es”. At the minimum real profit per ton we have a P/E of 11 ($32.50 / $2.96 =
10.98). At the median real profit per ton we have a P/E of 6 ($32.50 / $5.50 = 5.91). And if we
use the average figure over the 5 more recent years of 2009-2013 we get a “P/E” of 7 ($32.50 /
$4.77 = 6.81).
These estimates (which I created) made it appear that I was buying the stock at a high single digit
P/E if I paid $32.50 a share. In other words, the estimates made it look certain that normal cash
earnings for the “new” NACCO (free from Hamilton Beach and Kitchen Collection) would be
greater than $3.25 a share.
I also checked the company’s figures. In the investor presentation, the graph showing “cash flow
before financing” (essentially a measure of free cash flow) puts that figure at $41 million in
2015, $31 million in 2016, and $50 million over the last 12 months. With 6.84 million shares
outstanding, that would give a per share free cash flow figure of between $4.53 ($31 million /
6.84 million shares = $4.53) and $7.31 ($50 million / 6.84 million shares = $7.31).
Also, you can now double check these earnings power estimates in a way I couldn’t before I
bought the stock.
After I bought the stock, NACCO released pro-forma EPS for the first 6 months of 2017. The
company shows the “new” NACCO earned $1.74 per share in the first 6 months of 2017.
NACCO may earn less in the last 6 months of 2017 than it did in the first 6 months. However, it
still appears to me from all these different approaches that NACCO’s earning power is not less
than $3.25 a share. And I bought the stock at $32.50 a share. So, I did not pay more than a P/E of
10 for my shares.
Side Note: Amortization of Coal Supply Agreements
For the sake of simplicity, I haven’t discussed the fact that all these EPS numbers don’t “add
back” a constant non-cash charge for the amortization of coal supply agreements. For example,
when NACCO says it earned $1.74 pro-forma for the first 6 months of this year – you’ll notice it
shows $1.2 million (18 cents a share) in “amortization of intangibles”. Basically, NACCO
amortizes a little bit of its coal supply agreements with each ton of coal produced. In a normal
year, I expect NACCO to have close to $3 million in amortization that will reduce reported
earnings but not free cash flow. Overall, I expect NACCO – aside from the one consolidated
mine (and that’s a huge caveat) – to produce very high free cash flow relative to reported
earnings.
NACCO vs. NACoal
Also, when I made my calculations (which you’ll be able to see in a second if you squint real
hard at an Excel sheet) I was conservative in how I calculated NACCO’s past earnings. NACCO
is the name of the parent company. NACoal is the coal mining subsidiary. For all my
calculations, I took just the operating profit from NACoal and then subtracted ALL of the
operating loss from NACCO (the parent). Realistically, some corporate expenses have always
been attributable to Hamilton Beach, Kitchen Collection, and Hyster-Yale (back before NACCO
spun off that company). For the sake of conservatism, I always calculated the “new” NACCO’s
historical after-tax earnings for a year as: (Operating Profit From NACoal – Operating Loss from
NACCO) * 0.77. Basically, I took the coal mining business and allocated all corporate overhead
to that business and then taxed the resulting profit at 23%.
(Note: The reality is a little more complicated than what I just said because NACCO – the
parent – had been charging a management fee to its subsidiaries. However, this management fee
was probably less than the actual corporate expenses the subsidiaries were responsible for. So,
my general point still stands. If I erred in allocating corporate overhead, I erred on the side of
overcharging NACCO’s coal mining operations.)
Quality of Earnings
It’s difficult to prove this, but I consider the quality of NACCO’s earnings to be high. There are
several features of the company’s accounting that should cause reported EPS to be low relative
to free cash flow. And then all of the earnings are tied to long-term cost-plus agreements that are
indexed to inflation. Most other businesses with the same P/E as NACCO will convert less EPS
into FCF and would struggle under inflation.
Risk of Catastrophic Loss

The big risk with NACCO is that it loses key customers as coal power plants in the U.S. shut
down. Each mine is dependent on a nearby customer. The mine has no value once the power
plant has shut down. The coal we are talking about here is lignite (“brown”) coal. It isn’t
economical to ship. In the case of a coal power plant shutting down, I believe NACCO is in a
better position to survive – albeit at a much lower earning power – the loss of its biggest
customers than most public companies are. NACCO is organized so that the unconsolidated
mines have debts which are non-recourse to NACoal and then NACoal has debts which are non-
recourse to NACCO. When you buy shares of NC, you’re buying stock in the ultimate parent
“NACCO”. Although NACCO’s earning power all comes from the unconsolidated mines (which
are heavily indebted), those mines distribute 100% of their earnings in cash to NACoal each
year. With the exception of its one consolidated mine (MLMC), NACCO won’t be stuck with
“bad” coal mining assets of any kind. The company’s earnings come in the form of cash.
How I “Frame” NACCO
I think of each share of NACCO as an inflation adjusted stream of free cash flow. As I’ve shown,
I think the stream has a “coupon” of greater than $3.25 and I bought it at $32.50. So, the yield is
10% or more and that’s effectively a “real” yield.
The average U.S. stock has a free cash flow yield in the 4% to 5% range and that yield is not as
well protected against inflation.
It’s true that NACCO’s yield will eventually decline as coal power plants shut down (although,
in recent years, the tons of coal supplied has risen rather than fallen). However, I think of my
“margin of safety” as being the fact that it isn’t 100% certain these plants will shut down and
they haven’t shut down yet. Till they do, cash will build up on the balance sheet of NACCO (the
parent company) or it will pay out dividends, buy back stock, or acquire businesses unrelated to
coal mining (as it did in the past).
Why I Don’t Recommend NACCO Shares
I put 50% of my portfolio into NACCO. But, I think people reading this should put 0% of their
portfolio into NACCO. As long as electricity demand in the U.S. is declining and natural gas
production is rising, coal power plants will shut down. As a shareholder of NACCO, you could
wake up any morning to the news that the company has lost 35% of its earnings overnight. I
don’t think this is a risk most investors can handle.
Therefore, I don’t recommend anyone invests in NACCO even though it’s now my biggest
position.
Let me be clear: I’m not just saying this is a “perceived” risk you may want to avoid.
It’s a real risk.
NACCO is a risky stock.
I absolutely can’t prove that all of the power plants NACCO supplies won’t shut down real soon.
This means I can’t prove NACCO won’t lose literally all of its business in the very near future.
End Note: Get Out Your Magnifying Glass
For those interested, here is a snapshot of an Excel sheet where I did some of the “earning
power” calculations mentioned in this article.
 URL: https://focusedcompounding.com/nacco-nc-the-stock-geoff-put-50-of-his-portfolio-
into/
 Time: 2017
-----------------------------------------------------
Does NACCO (NC) Have Any Peers?
A Focused Compounding member who analyzed and bought NACCO himself read my write-up
on NC and was curious if I did a “peer analysis” for NACCO:
“Did you consider looking at any potential peers with your analysis? I was quite simplistic with
my approach. Omnicom splits cash out year in year out. Its current EV to free cash flow is
around 10x whereas I looked at NACCO and thought its EV to free cash flow was around 5x
(NOTE: At the much lower spin-off price he bought at) and appeared very undervalued as it
should at least be 7 to 10x even though Omnicom is a higher quality business. My hurdle for any
new position is Omnicom.”
I tried to keep it simple. Really, I asked myself 3 questions early one:
1. After the spin-off, will the balance sheet be pretty close to net no debt/no cash (you did
something similar seeing there would be the $35 million dividend but then there’s the
asset retirement obligation and the pension).
2. Would NACCO produce its earnings mostly in the form of free cash flow?
3. Would “earning power” be 10% or higher as a percent of my purchase price.
In the end, the decision is really just whether you would buy a stock or wouldn’t buy a stock. To
me it didn’t matter if the stock’s earnings would be $3.25 a share or $6.50 a share if I was buying
at $32.50. What mattered was how certain I was of the $3.25 number. Once I think I have a 10%
yield, I don’t spend a lot of time wondering if I have a 13% yield, 15% yield, or 20% yield. So, I
didn’t spend time worrying about this. If the stock was pretty much unleveraged, the earnings
pretty much came in the form of free cash flow, and the earnings yield was greater than 10%,
that would be enough.
As far as growth, it’s difficult to value that. The company has a goal of growing earnings from
unconsolidated mines by 50% within the next 5 years or so. However, they had the same goal
about 5 years ago. Because the Kemper project was cancelled, they won’t achieve this. However,
they will achieve growth of say 15% or so over last year due to newer mines producing closer to
the tons they were eventually expected to produce.

I don’t know what they’ll use free cash flow on. I know that the two businesses I like are the
unconsolidated contracted coal production and the lime rock draglines. But, neither of those
businesses absorbs capital. So, they will grow through signing new deals in that area but they
shrink through losing existing customers. I couldn’t judge one way or the other on this.
I feel they have no peer. Omnicom (OMC) is not a good peer, because OMC is permanently
durable in my view. I think advertising agencies will be around in 2047 and even 2067. It’s very
possible lignite coal will not be mined for use in power plants by 2047.
However, you can’t really compare NACCO to something like a trust, because the contracts are
long-dated and the mines can last longer than the contracts. It’s really the life of the power plants
that matters.
You could, I suppose compare NACCO to some other companies tied to coal. However, I am not
sure this is that informative.
In terms of valuing a stream of cash flow, junk bonds yield 5.5% right now. The yield peaked at
around 22% during the financial crisis. The prior peak had been 12% to 13% in the 2002
recession.
https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY
However, this is not that useful in comparing due to the re-investment risk (the bonds may not
last as long as NACCO will) and taxes (NACCO may pay a 23% tax rate and then if it pays
dividends there are taxes on that, but if it buys back stock that defers taxes which are then taxed
at capital gains, etc.). More importantly, bond yields are nominal – not indexed to inflation. The
free cash flow yield on NACCO is real.
It would make sense to compare NACCO to the free cash flow yield on something as troubled as
coal.

However, coal miners have commodity price risk and are therefore not a good comparison.
NACCO stock is at $37.40 right now. If you read the write-up I did before (and based on the
work you did yourself) you’d come to conclusion that a free cash flow “coupon” of $4 to $5 a
share is about what NC will average. This may be conservative (actual free cash flow had been
closer to the $5 to $7 range in some recent years – though that was with almost no cap-ex for the
consolidated mine). Let’s use a price of $37.40 on the stock and a FCF coupon of $4 to $5 a
share.
That’s a yield of 10.7% to 13.4%. This yield has two advantages over a junk bond. All the FCF
is driven by long-term supply agreements that are cost-plus and indexed to inflation. So, these
are “real” yield of like 11% to 13%. The upside is also uncapped. Instead of the FCF coupon
being $4 to $5, it can also be $5 to $7. The disadvantage versus a junk bond is you have no
contractual protection. There may be years where NACCO doesn’t earn this coupon and in all
years it isn’t paid out to you. The free cash flow will be used at the parent company level
(“NACCO”) to pay dividends (then it would be paid to you), buy back stock (which is kind of
like payment in kind with just giving you additional “junk bonds”), or acquire businesses.
You could try to compare NACCO common stock to coal miner bonds. For example, people
wrote about Peabody Energy bonds in 2015 due in 2020 and things like that. So, I can see where
investors thought there was value and at what yields.
Again, I’m not sure that’s helpful. The only similarity between NACCO and Peabody is they are
both existentially tied to coal. But, their business models have nothing in common and they don’t
share any risks except “coal going away” completely. NACCO’s risk is coal power plants
shutting down. Coal prices, capital costs of coal mines, etc. aren’t the risks for NACCO.
There is a company I analyzed previously called Babcock & Wilcox Enterprises (BW) that is

tied to U.S. coal power plants and whether they shut down. Originally, the company’s cash flow
was largely from maintenance on U.S. coal power plant boilers and related equipment. That’s
similar to NACCO. BW is in serious financial trouble. But, that’s not purely because it was
involved in coal power plant maintenance. Instead, it tried to shift to other kinds of work and ran
into the kinds of problems that can bankrupt any engineering firm. I’m not sure the company is
comparable and it doesn’t produce free cash flow to value it on. So, BW is a dead end.

We know who NACCO’s customers are, but they are more diversified than just coal power plant
operators (in the cases where they are publicly traded) and so it’s difficult to value NACCO
against companies who are their customers or are similar to their customers. If we went this
route, we’d chose companies like Southern Company (SO) and Vistra Energy (VST). Vistra is
a utility that is shutting down some “mine-mouth” operations in Texas.
But, utilities are the customer taking the other side of risk/reward bet from NACCO in these
deals. Utilities are taking the capital risk, not producing any free cash flow, etc. NACCO isn’t
taking the capital risk. NACCO is getting the cash dividends. They’re not peers. They’re
opposites.
Utilities are really the opposite of NACCO’s business in that they are leveraged, convert little
reported earnings into free cash flow, and use up lots of capital. Utilities may need to issue
bonds, issue stock, not buy back stock, etc. NACCO doesn’t need to issue stock or bonds and is
in a good position to pay a lot in dividends or buy back stock in the years ahead.
Utility yields are probably about 4% in terms of their dividends right now. Their reported
earnings yield may be closer to 5%. Those are leveraged figures though. Debt/Equity is high at
these companies. It’s probably the case that utilities’ FCF yields are about one-third as much as
NC right now (that is: NC’s FCF yield is about 3x the FCF yield on of a basket of utilities).
What are other people using for peers?
In the write-up on NACCO, Clark Street Value uses peers like Vistra:
http://clarkstreetvalue.blogspot.com/2017/09/nacco-industries-hamilton-beach-spinoff.html
He uses EV/EBITDA. And says reorganized coal miners trade at 4-5 times EBITDA and
something like the reorganized Vistra Energy trades at 7-8 times EBITDA.

NACCO’s most recent adjusted EBITDA figures were about $33 million on a 3-year average of
2015, 2016, and the last twelve months (June of 2016 to June of 2017). I used that figure since
it’s more conservative than taking the $44.4 million in last twelve months of EBITDA.
Post spin-off, NACCO is essentially unleveraged at the parent company level (it has long-term
liabilities for pensions and mine shutdowns but it also has cash on hand from Hamilton Beach).
So, instead of EV we can just do EBITDA per share.
Here we go: $33 million in EBITDA is $4.82 a share and $44.4 million in EBITDA is $6.49 a
share (NACCO has about 6.84 million shares outstanding). That gives you two different bands of
peer valuations if you’re using 4-5 times (coal miners) or 7-8 times (utilities) of:
4-5 times EBITDA appraisal value: $19.28 to $32.45 a share
7-8 times EBITDA appraisal value: $33.74 to $51.92 a share
If you look at these figures, I think this is what some special situations type individual investors
are looking at. You can read the comments under the post at Clark Street Value, read the forum
posts at Corner of Berkshire and Fairfax, read the 3 old write-ups at Value Investors club
(written in 2012, 2015, and 2017), etc. and come to a conclusion that the company was very
cheap at about $20 a share (where it traded the moment it spun off Hamilton Beach) and fairly
valued where I bought it ($32.50 a share) and would be overpriced at anything much over $50 a
share.
However, I think using EV/EBITDA is extremely misleading here. It goes against all common
sense.
What investors care about ultimately is “owner earnings” or free cash flow in the sense of the
actual annual build up of cash per share. There’s a huge difference between a company that
converts 40% to 60% of EBITDA into free cash flow (like some possible peers we’re using here)
and a company that converts 80% to 100% of EBITDA into free cash flow (like NACCO).
We also have about a 26-year record at NACCO to use in estimating normal free cash flow. I’d
rather count on my 26-year estimates of FCF rather than trying to do some sort of last twelve
months of EBITDA approach.

If you assume NACCO – if it pays no dividends, buys back no stock, and makes no acquisitions
– would build up $4 to $5 per share a year (about $27 million to $34 million) in free cash you’re
going to have to value the company differently from what you’d get using EBITDA.
Absent plant shutdowns: by 2022, you’d expect NACCO to have maybe $20 a share in net cash
on its balance sheet. Today’s stock price is $37.85. Imagine the stock price grows 10% a year for
the next 5 years. That would give you a stock price of $61 a share. A value investor would “back
out” $20 in net cash to get a share price of $41 a share in 2022. NACCO will – if it doesn’t lose
coal power plant customers to shut downs (a huge if) – still be producing $4.10 a share (or more)
in free cash flow. So, the stock could return 10% a year for 5 years and still be priced at an
EV/FCF of 10x.
It’s difficult to find a peer that would look anything like that. Utilities don’t. Coal miners don’t.
In terms of capital light, high free cash flow…
Yes, you can compare NACCO to a stock you mentioned (Omnicom) or a stock I own (BWX
Technologies). However, I think that’s even more misleading that using peers like utilities and
coal miners.
NACCO has a finite and risky future.
Omnicom and BWX Technologies have very certain futures. In 2047, it’s likely advertising
needs profitability and U.S. Navy needs for nuclear aircraft carriers, attack subs, and ballistic
missile subs will be pretty much the same as they are now.
Omnicom and BWXT deserve to trade at some of the lowest FCF yields (highest prices-to-free
cash flow) of any mature business because their cash flows are predictable decades into the
future. Most public companies can’t be counted on to have positive free cash flow 30 years from
now. Those two can.
NACCO can’t. It’s not going to exist doing this kind of work (mining coal) in 30 years. It’s not
clear anyone will be mining coal in the U.S. in 2047.
So, perhaps the right “peer” for NACCO is to reverse this and look at what other kinds of stocks
currently have a free cash flow yield similar to NC.
If we base our earnings estimates off profit per ton in 2009-2013, you get about $4.75 in my
estimate of “reportable” EPS going forward. However, there’s amortization of coal supply
agreements that would take you over $5 in cash terms. That’s probably about NC’s normal free
cash flow level.
The best estimate – not in the sense of most conservative, but simply most honest – would be to
expect free cash flow of $5 a share on average. A $5 FCF divided by today’s stock price of
$37.85 gives you a free cash flow yield of 13%. Again, this is a real yield in the sense the coupon
would rise with inflation.
What other public companies have free cash flow yields of about 13%?
Limiting it to public companies most people have heard of, you get a lot of stocks like:
* Discovery Communications (DISCA)
* Dick’s Sporting Goods (DKS)
* Kohl’s (KSS)
* Brinker (EAT)
* Gannett (GCI)
* MSG Network (MSGN)
* Office Depot (ODP)
* Pitney Bowes (PBI)

I pulled that list off a screen. I didn’t clean-up free cash flow to reflect my estimates of “normal”
for those companies. That’s not important. This article isn’t about those companies. It’s just
getting a sense of what the market values NACCO like.
Right now, the market values NACCO’s shares like it values the shares of newspapers, cable TV
channels, retailers, etc. Although we should keep in mind that almost all of those companies have
a lot more leverage (they certainly have more leases) than NACCO does at the parent company
level. Remember, the mines are non-recourse to NACCO.
Many of those companies are seen as being in businesses that will be obsolete soon. So, it’s
possible the market may correctly value NACCO (another company in a business that may be
obsolete soon) as being a peer of companies in newspapers, cable TV channels, retailers, etc.
One difference with NACCO is that it operates under exclusive long-term “cost-plus” supply
contracts indexed to inflation. So, it faces no price competition and really no competition at all.
These other companies are mostly at risk of being obsoleted by competition from the internet.
NACCO’s survival doesn’t depend on withstanding competition. Its survival and whether it can
keep generating that high free cash flow yield is based on whether the coal power plants it serves
stay open.
I thought that was a big difference from the risks faced by the other companies on that “peer” list
of high free cash flow yield stock. I like NACCO better than the stocks on that list there. But, it’s
possible that others would view those businesses as being NACCO’s peers. And I can’t say
they’re wrong.
NACCO faces an existential threat. That’s why – even though I bought the stock myself – I don’t
recommend others buy the stock.
 URL: https://focusedcompounding.com/does-nacco-nc-have-any-peers/
 Time: 2017
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What’s NACCO’s Margin of Safety?
After reading my write-up, a member asked me about the margin of safety in NACCO (NC):
“…why would someone put half of their portfolio weight in a stock like this where there is
customer concentration risk plus a real risk that one of the customers may close shop? Agree
that its FCF yield is 10% or so but does it deserve that kind of weight?”
I don’t want to exaggerate the safety of this stock. I didn’t write it up for a newsletter. This isn’t
a recommendation for anyone else to buy it. I put 50% into it knowing I would have future
control over decisions to sell that 50%. I don’t think I’d recommend this stock to anyone else
because the headlines will all be negative and that is very tough for people to hold through.
Having said that, let me take you through how I might have seen the potential margin of safety
when I bought the stock at under $33 a share on October 2nd. The way I framed it, the margin of
safety in NACCO was a lot higher than what I can get in other stocks. That’s despite the
customer concentration and the possibility those concentrated customers are coal power plants
about to be shut down.
When I bought the stock, I believed it was then trading at something like a 10% to 15% free cash
flow yield. I also believed that the company’s balance sheet will be essentially unleveraged
pretty soon (taking into account build up of cash during this year, the expected $35 million cash
dividend from Hamilton Beach just before the spin, etc.). The parent company has liabilities but
these are not immediately payable in full. Meanwhile, the unconsolidated mines pay cash
dividends immediately each year. So, what I’m saying here is that I don’t believe the parent
company is more leveraged, more short of cash relative to potential liabilities, etc. than an
average stock.
So, the balance sheet is like an average stock.
But, a normal, unleveraged stock usually trades at about a 5% free cash flow yield.
So, NACCO’s free cash flow yield is 5% to 10% higher than an average stock while the balance
sheet is similar.
Now, if it is true that when NACCO loses a big contract this means it mostly loses an equal
percentage proportion of both revenues and expenses (this is an exaggeration – but I don’t think
it’s a huge exaggeration because the mines really are administered very independently and are
non-recourse to NACCO), you can kind of think about your margin of safety and the value in
this stock as follows…
NACCO has a free cash flow yield no lower than 10% to 15%.
A normal stock has a free cash flow yield no higher than 5%.
5% is 0.50 to 0.67 times less than 10% to 15%. Therefore, NACCO would decline to a normal
valuation after it has lost about 50% to 65% of its earnings. Let’s say this is basically after it has
lost something like its biggest or even two biggest contracts.
So, your margin of safety in NACCO stock is that it’s priced like it has already lost its two
biggest contracts. However, it hasn’t lost its two biggest contracts.
Logically, even if we assume that it is probable that NACCO will lose its 2 biggest contracts and
that loss will happen reasonably soon…
The probability that NACCO will lose these contracts is less than 100%.
The likely time till NACCO loses these contracts is greater than tomorrow.
A normal stock is priced like it is 100% certain that it has a 5% free cash flow yield starting this
second.
To get NACCO to have that same yield/discounted cash flow situation, you’d need to know it
was close to 100% certain they’d lose their 1-2 biggest customers pretty close to right now.
Three things seem true to me about NAACO:
1. Till some contracts are cancelled, I’m getting no less than a 10% to 15% cash return on
my purchase price ($32.50)
2. The probability that the coal power plants NAACO serves will be shut down can’t
literally be 100%
3. The time till the coal power plants NACCO serves shut down can’t literally be one day
The way I look at it is this:
Investors who pass on buying NACCO probably believe there is a real chance that the coal
power plants NACCO serves may be shut down sometime in the near future. I too believe there
is a real chance that the coal power plants NACCO serves may be shut down sometime in the
near future.
Most investors, seeing this possibility, don’t want to own the stock while it seems probable to
them that power plants which are customers of NACCO will be shut down and NACCO’s
earnings will drop a lot.
I, seeing that NACCO is offering a 5% to 10% cash yield advantage over other stocks till some
plants do shut down, am happy to hold the stock while these negative headlines hit.
In other words, I’m taking higher cash flow now and risking that I will have to endure bad
headlines and lower cash flow in the future. I’m doing this not because I believe my 10% to 15%
free cash flow yield is secure, but because I think a free cash flow yield greater than 5% is secure
because I am starting with a 10% to 15% free cash flow yield that can afford to be eroded some
and still leave me with a 5% yield.
A normal stock can’t have its free cash flow yield eroded at all and stay safe. NACCO can.
I don’t have any precise guesses about probabilities of coal plant shutdowns, when they will
happen, etc.
But, let’s model two possible futures for NACCO.
Let’s say free cash flow per share is in the $3 to $5 range with the contracts they have now. The
stock price is $33 (close to where I bought it). And then let’s say that some important contracts
will be lost resulting in a loss of 50% of the company’s earnings in 3-5 years from now.
Well, $3 a year in free cash flow times 3 years is $9 of cash build up per share.
And: $5 a year in free cash flow times 5 years is $25 of cash build up per share.
And then, a 50% reduction in cash earning power is $3 * 0.5 = $1.50 a share or $5 * 0.50 = $2.50
a share.
So, if the scenario I laid out here is true (NACCO earns about $3-$5 a share now but earnings
will permanently fall 50% within 3-5 years) this is what a buyer of NACCO stock today should
be getting in 2021-2023 for his $33:
* A stock holding between $9 and $25 of net cash in 2021-2023
* A stock earning between $1.50 and $2.50 a share in FCF between 2021-2023
Net cash is often valued at net cash. And stocks often trade at 10-15 times earnings. So, the sum
of these parts would be:
* $9 + $15 ($1.50 * 10) = $24 a share
* $25 + $37.50 ($2.50 * 15) = $62.50 a share
So, you see right there that one of the estimates I came up with predicts a loss. If FCF is $3 a
share, stays the same for 3 years, then NC loses 50% of its earnings and the stock trades at a P/E
of 10 that gives you a loss of $9 on a $33 stock, so 27% of your capital. That would demolish
14% of my total portfolio right there.
And, of course, this isn’t the worst case scenario.

Power plants could close down before 3 years. NACCO could lose more than 50% of its
earnings. The market might never value NC at a P/E as high as 10. You can always imagine a lot
of bad things that might happen to a stock. And some of them will happen.
On the other hand, some of what I laid out just there was conservative. For example, I believe
NACCO’s “owner earnings” are much closer to $5 a share than $3 a share. And, I did a
calculation which assumes NACCO’s cash earning power has a 100% chance of dropping 50%
within 3-5 years.
Does it?
First of all, NACCO might win contracts as well as lose them. It might win lime rock contracts.
It might take the cash flow from its coal operations and buy businesses unrelated to coal mining
(it used to own Hyseter-Yale and Hamilton Beach). Also, the contracts are indexed to inflation.
We’re acting like inflation is 0% and NACCO can only make money from coal mining contracts
it already has. It can’t have new contracts, acquire other businesses, etc. This is a simplifying
assumption. But, it’s obviously a conservative one.
Let’s ignore all that and simply ask: will NACCO lose 50% of the coal supply contracts it now
has? And, if so, when?
This is a macro call. And I’m not qualified to make it. But, I can tell you why coal power plants
have been closing for the last 10 years. Since the financial crisis, electricity demand per person in
the U.S. has declined. Meanwhile, natural gas production has increased.
Coal power plants will definitely close down if:
 Natural gas production keeps increasing

 Electricity consumption keeps decreasing
For the last 7-10 years now, the U.S. has needed less and less power and has simultaneously had
more and more natural gas to burn. If these trends persist, it makes sense to keep closing power
plants (because electricity demand is decreasing) and it makes sense for those closures to be coal
power plants (since the alternative fuel, natural gas, keeps getting more abundant).
A bet on the certainty that coal power plants will close relatively soon is a bet on:
 Declines in electricity consumption

 Increases in natural gas production
That’s what has happened for the last 10 years. However, it’s not what happened for the previous
30 years. Natural gas production is up about 4% a year over the last 10 years. That’s probably in
part because companies were looking for oil (not necessarily gas) in the U.S. when oil prices
were high. Prior to this 10-year boom, U.S. natural gas production grew 0% a year for 30 years.
The need for electricity has been decreasing recently. However, electricity demand had been
flatter to up over the 30 years prior to the financial crisis.
So, both increasing natural gas production and decreasing electricity generation needs are 10-
year trends rather than 40-year trends.
I can’t predict future natural gas production or future electricity needs in the U.S. However, I can
see that the reason coal power plants have shut down has had more to do with low need for new
electricity generation and high supply of natural gas rather than other societal factors.
We can try to speculate on macro factors like this.
Like we can ask: what if electric cars become widely used?
Well, that would tend to reverse both those trends. Electric cars would increase demand for
electricity and decrease demand for gasoline. Gasoline demand helps drive the demand for
finding and developing oil reserves which tends to have a byproduct type influence on natural
gas that increases its production.
But, what’s the point of knowing that electric cars would help extend the life of coal power
plants? I can’t make predictions about electric cars, oil, natural gas, etc. better than anyone else.
What I’m saying is that it’s all speculative. If instead of trying to answer the question “What do I
need to assume to buy NACCO at $32.50 a share?” you ask “What do I need to assume to bet
against NACCO at $32.50 a share?” – you come up with a chain of speculative assumptions.
When I flipped the question and said: “How will NACCO end up being worth less than $32.50 a
share?” I got a series of speculative assumptions that seemed shaky on the probabilities and the
timing.
There’s a big difference between a 99% probability that NACCO will lose more than half its
earnings in 6 months and a 51% probability that NACCO will lose more than half its earnings in
6 years. The first case can justify NACCO’s then price of $32.50 (when I bought it). The second
case doesn’t come close.
So, when I flipped the question and asked: how can NACCO be worth less than $32.50 – I had
such a hard time coming up with a justification for that assertion that I bought the stock instead.
Finally, I want to stress something. I have 50% of my portfolio in NACCO. That doesn’t make
me an expert on NACCO. Even though you have 0% of your portfolio in NACCO, you can
easily know as much as I do and judge the situation as well or better than I have.
Someone recently wrote me an email asking a lot of questions about NACCO. My response was
short:
“I don’t plan to write anything more about NACCO. I only wrote it up because I got a lot of
emails from members requesting a write-up when they saw I bought the stock.
Anyone who goes through the filings like you did can know as much about NC as I do and come
to their own conclusions. I really don’t have anything to add. I was reluctant to write as much as
I did.”
Because this was a spin-off with an investor presentation and because NACCO puts out such a
detailed 10-K (and has since the early 1990s) and includes exhibit 99 to the 10-K which is the
financial statements for the unconsolidated mines – there’s really not much I can tell you that’s a
unique take.
Everything you need to form your own opinion is in those filings.
I’m not recommending anyone buy NACCO shares. I am – however – strongly

recommending everyone read the investor presentation, the past 10-Ks, and the financial
statements for the unconsolidated mines and then come to their own conclusion.
 URL: https://focusedcompounding.com/whats-naccos-margin-of-safety/
 Time: 2017
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NACCO (NC): First Earnings Report as a Standalone Company
Two days ago, NACCO (NC) released its first quarterly results as a standalone company.
Yesterday morning, the company had its first earnings call as a standalone company. The stock
dropped 10% following these events. I’m not going to write about NACCO each quarter. But,
some people asked for my thoughts on the quarter and the stock drop. So, I’ll do it this once.
Overall, the earnings call and the stock drop reinforced my belief that it could take a year or
more of NACCO trading “cleanly” as a separate company before it’s well understood by
investors. More on that at the end of this post.
First, the earnings release. Here, everything was as expected.
You can – and should – read NACCO’s full earnings release here. These are the items I
highlighted:
 “After the completion of the spin-off, NACCO ended the third quarter with consolidated
cash on hand of $93.9 million, debt of $58.7 million and net cash of $35.2 million. The
cash on hand included a $35 million dividend received from the housewares business
prior to the completion of the spin-off.” So, the company now has $5.13 in net cash per
share.
 “NACCO’s board of directors will evaluate and determine an ongoing dividend payout
rate at its next regularly scheduled meeting in November. When doing so, the board will
consider the financial conditions and prospects of NACCO and North American Coal
following the spin-off of the housewares-related business.” We’ll see what they decide to
start the dividend at. The “financial conditions” are strong. The “prospects” are bleak.
 Not a highlight, but a note: The after-tax numbers are meaningless here because of a very
unusual tax timing situation. The company had a 44% tax rate on continuing operations.
In the future, I expect the normal tax rate for NACCO as a standalone company will be
23%. So, ignore all after-tax numbers.
 Centennial is NACCO’s consolidated (so NACCO bears all the risk) failed
mine: “Centennial will continue to evaluate strategies to optimize cash flow, including
the continued assessment of a range of strategies for its remaining Alabama mineral
reserves, including holding reserves with substantial unmined coal tons for sale or
contract mining when conditions permit. Cash expenditures related to mine reclamation
will continue until reclamation is complete, or ownership of, or responsibility for, the
remaining mines is transferred.”
 NACCO confirmed that the customer will bear the risks related to the Kemper plant /
Liberty mine failure and NACCO will be paid to do the mine closure work: “The terms
of the contract specify that Mississippi Power is responsible for all mine closure costs,
should that be required, with the Liberty Mine specified as the contractor to complete
final mine closure. Should the decision to suspend operations of the gasifier and mine
become permanent, it will unfavorably affect North American Coal’s long-term earnings
under its contract with Mississippi Power.”
 “…capital expenditures are expected to be approximately $21 million in 2018.”
 “While the current regulatory environment for development of new coal projects has
improved, continued low natural gas prices and growth in renewable energy sources,
such as solar and wind, could unfavorably affect the amount of electricity generation
attributable to coal-fired power plants over the longer term. North American Coal
expects to continue efforts to develop opportunities for new or expanded coal mining
projects, although future opportunities are likely to be very limited. In addition, North
American Coal continues to pursue additional non-coal mining opportunities, principally
related to its North American Mining business and elsewhere where it might provide
other value-added services.”
Then there was the earnings call. You can listen to the earnings call here. There were only two
questions. One was from an investor. Neither was informative.
The first question was about how low NACCO could get SG&A over time. I think there was
some confusion here. The “NACCO and Other” part of the company includes ongoing losses
related to “Bellaire”. This is the company’s legacy underground mining liabilities.
A brief aside. NACCO in the sense of “North American Coal Company” (this is now actually a
subsidiary of NACCO and its debt is non-recourse to the parent) was founded in 1913 as a coal
broker and evolved into a typical coal mining company. It did things like underground mining of
metallurgical coal – so “black”, commodity coal you ship via rail to steel mills and stuff – and
then only in the 1950s started making the first steps in transitioning to focus on providing coal to
power plants under long-term supply contracts (“steam coal”). By the 1980s, this transition was
complete. But the company never entered bankruptcy or anything. So, NACCO has a continuous
104-year corporate history in the coal business. There are legacy liabilities they simply can’t get
rid of. For example, they had to put money in a trust to clean up water in Pennsylvania. The cash
outflows related to these liabilities should be small but perpetual. So, there will always be losses
at “NACCO and Other”.
Then, on top of this, you had some salaries before the spin-off – like for the Chairman / CEO –
that will go away. They said that on the earnings call.
So, I think there’s confusion about 3 different issues here. One, you have to wait a full year after
a spin-off before you have truly clean SG&A numbers. Two, NACCO includes legacy liabilities
that will always be there. In my past write-ups on NACCO, I always accounted for this using the
past 20 plus years of data on losses from that parent company. And then, beyond that, SG&A
isn’t going to go down if it’s actually related to the coal business or the expense of being a public
company. For example, in the earnings call they mentioned that there has to be corporate
management of a public company and that can either happen in Cleveland or Dallas and it’s
probably cheaper to keep it in Cleveland.
The second question was from an investor who said he made a lot of money on the stock. I think
he meant he bought NACCO before the spin-off and has since sold about 95% of his position in
NACCO and may or may not have kept his Hamilton Beach (HBB) shares. He asked a question
management obviously can’t answer: why did the stock go from like $20 at the moment of the
spin-off to as high as $44? And he said that $44 was something like double the price of peers.
Obviously, management didn’t answer that question.
The one interesting part is that the investor mentioned coal prices and peers. Now, you can use
multiples of other coal miners to value NACCO on the belief that the durability of coal for
generating electricity is limited and NACCO’s customers will eventually shut down the power
plants that NACCO is selling to. That’s reasonable. But, NACCO does not benefit in any way
from higher coal prices. And this investor mentioned that coal prices hadn’t gone up and yet the
stock had gone up. Management said NACCO’s business model has nothing to do with coal
prices.
This just reinforced for me that it may take a year or more of NACCO trading on its own for
even the shareholders of the company to understand what it does and what drives its free cash
flow.
The 10% drop in the stock also reinforced this belief that it’ll take a while for NC to be well
understood. Reasonable people can argue over whether the stock is worth $20 or $40. But, there
was no new information in that earnings release or the earnings call that could possibly change
the value of the company by 10%. It was a very boring quarter.
Two final notes on NACCO. Someone asked me what would cause me to sell my NACCO
shares. If the company bought another consolidated coal mine, I’d almost certainly sell my
shares regardless of their price.
Two, there’s a book called “Getting the Coal Out: A Centennial History of the North American
Coal Company and NACCO Industries, Inc.: 1913-2013”. You can apparently order it from the
company’s website. I know you can buy it used at places like Amazon, because I own a copy.
If you’re interested in NACCO stock, invest in the book before you invest in the shares.
 URL: https://focusedcompounding.com/nacco-nc-first-earnings-report-as-a-standalone-
company/
 Time: 2017
-----------------------------------------------------
Otis (OTIS): The World’s Largest Elevator Company Gets the Vast Majority
of Its Earnings From Maintenance Contracts With a 93% Retention Rate
Otis Worldwide (OTIS) is the world’s biggest elevator and escalator company. Like Carrier
(CARR) – which I wrote up two days ago – it was spun-off from United Technologies. However,
shareholders of United Technologies received one share of Carrier for each share of United
Technologies they had while they only received half a share of Otis for every one share of
United Technologies they owned. As a result, the market caps of Carrier and Otis would be the
same if the share price of Otis was twice the share price of Carrier. Otis isn’t trading at double
Carrier’s stock price though. It’s at $47.85 versus $16.25 for Carrier. So, closer to three times the
price of Carrier than two. Carrier, however, does have more debt than Otis. Nonetheless, as I’ll
explain in this article – the bad news is that while I like Otis as a business a lot better than
Carrier: Otis is the more expensive stock.
Reported revenues are unimportant at Otis. The company did $13 billion in sales. But, only about
$7.4 billion of this comes from service revenue. Service revenue makes up 80% of EBIT while
new equipment sales are just 20%. Service revenue is also less lumpy. A major reason for this is
that more than $6 billion of the total service revenue is under maintenance contracts. This more
than $6 billion in maintenance contracts has a 93% retention rate. The contracts don’t actually
require much notice or much in the way of penalties to cancel. However, cancellation is rare. So,
a very big portion of the economic value in Otis comes from the roughly 2 million elevators
covered by maintenance contracts that bring in about $6 billon in revenue per year. My estimate
is that the after-tax free cash flow contribution from these 2 million elevators under contract is
anywhere from $1 billion to even as much as $1.2 billion. Basically, if we set aside these
maintenance contracts – there is almost no free cash flow beyond the corporate costs etc. that
need to be covered at Otis. There is an argument to be made that as much as 20% of the
company’s economic value comes from new equipment sales. However, I think it’s trickier to
value the company if you count those sales in the period in which they occur. Rather, I think it
makes sense to look at the business the way you might a movie studio, book publisher, etc. with
a substantial library. Or – if you’d prefer – the way you’d look at an insurer that usually has a
combined ratio a bit below 100, but basically makes its money off the return on its “float”. Otis’s
service business has very stable revenue, EBIT, and free cash flow from year-to-year. I expect it
to rise at least in line with inflation (the company expects better than that). And there are some
possible productivity gains here from digital initiatives. Smart elevators, technicians using
iPhones, etc. could cut down on the number of visits and the amount of time spent per visit.
While wages of these technicians would still rise over time – the gains in productivity combined
with inflation like increases in the price of maintenance contracts could expand margins. This
part of the business is a very, very good business. And I would put a high multiple on the EBIT
generated from this business. I’ll talk about EBIT here. But, what I really care about is free cash
flow. And Otis’s service business generates plenty of that. The company pays fairly high tax
rates (it’s been as high as 35% recently) for a U.S. company. This is because a lot of earnings are
from countries outside the U.S. (especially Europe). That’s the biggest factor reducing
conversion of EBIT into free cash flow. However, reported after-tax earnings understate free
cash flow. If Otis had no net debt – it does have quite a bit, as we’ll see – it would probably
convert EBIT into free cash flow at like a 70-75% rate. So, revenue of around $7.5 billion would
convert at about a 21% EBIT margin into EBIT of $1.6 billion and free cash flow of like $1.1
billion to $1.2 billion. This is a business that will rarely every shrink. It’s extremely predictable.
It has a retention rate over 90% and uses very little in the way of net tangible assets to produce
excellent returns. It deserves a very high multiple of free cash flow. If we assume the stock
market might return 8-10% a year and Otis’s service business might grow as little as 3% a year
(again, the company thinks it’ll grow quite a bit faster) – that’d tell us the right free cash flow
multiple here should be about 15-20 times. That should be applied to enterprise value – not
market cap. However…
I actually think the profit on new equipment can basically cover the debt. I want to be careful
about how I say this. I think profit on new equipment will offset the interest on the debt – not
allow for a lot of repayments of debt. However, Otis has less debt than Carrier. And Otis’s
presentations and filings with the SEC are clear about the company’s intentions in terms of its
debt levels. Otis only intends to pay down about half a billon of debt. It then seems to be saying
it’ll maintain a steady Net Debt/EBITDA ratio of about 2 times. I believe the company can stay
at this level with the new equipment business basically being worth about what the debt is worth
and the service business being basically what shareholder own “free and clear”. I won’t talk a lot
about Otis’s debt situation here. It’s meaningful. But, I think it’s fairly safe, cheap, and well-
spaced out debt. I also think the service side of an elevator business is very capable of carrying a
lot of debt. There are some risks as far as capital allocation. Otis is targeting a 40% payout in
terms of EPS (this could be in the 90 cent to $1 range eventually – maybe not in a coronavirus
year) combined with stock buybacks and possible acquisitions. I don’t think acquisitions will be
big here. The industry leaders are basically an oligopoly controlling about three-quarters (or
maybe even more) of the service contracts with big building owners, property managers, etc. By
units, something like 50% of all elevators in the world are serviced by the little guys. But, I think
that’s misleading. It’s similar to the ad agency business. The biggest brand owners in the world
heavily use the biggest ad agencies. And the biggest property owners heavily use the biggest
elevator companies.
Let’s use China as an example. Otis does okay in China for maintenance contracts among big
property developers. But, it doesn’t do so well with smaller owners. And, overall, I don’t like
China as an elevator market. The conversion rate of new equipment into a maintenance contract
in China is poor. The Chinese new equipment market hasn’t grown in 5 years (while the rest of
the world has). And Otis doesn’t expect China to grow for another 5 years. The economics also
seem inferior as Otis sells through distributors more and much of its business is spaced out in a
way where it is using more branches and more employees to serve fewer elevators.
This brings me to “the Americas”. There’s clearly a big difference in the productivity levels of
servicing elevators in the U.S., Europe, and then the rest of the world. I’m assuming American
elevators are more likely to be offices and malls and less likely to be low-rise residential and
stuff like that. The number of branches and number of technicians used in the U.S. relative to the
service revenue brough in is much, much lower. By some measures, “the Americas” segment is
up to 3.5 times more efficient by number of branch locations and it’s about 2.5 times more
efficient by number of technicians. It’s possible technicians in Asia and even Europe are paid
less than U.S. technicians. But, it just seems like the U.S. business is better, the China business is
worse, and the European (and Middle East) business is in between. Europe is really the biggest
segment. There’s a publicly traded company in Spain that Otis owns the majority of. It’s called
Zardoya Otis. That company might offer more insights into Otis’s European business. But,
similar to what I’ve seen with country-by-country variation in companies that do armored cars,
pest control, etc. where things like fixed branch costs, driver productivity, and route density
matter – there look to be meaningful differences between countries based on both the type of
elevators in those countries and perhaps the company’s historic position in that industry.
What is Otis worth?
I think it’d make sense to pay about 3 times service revenue. We could do enterprise value equals
3 times service revenue. That might be an attractive point to buy. But, it could be slightly unfair
in the sense of undervaluing Otis because it doesn’t give credit to the new equipment business
always bringing in some profits. Probably a fairer approach is to assume that the new equipment
business and the debt basically cancel out. I want to be careful doing this – because, it means I’m
assuming Otis will always maintain a fair amount of leverage. But, that is what the company says
it plans to do.
So, the more aggressive assumption here would be to just use 3 times service revenue as the right
market cap for Otis given current debt levels. Three times service revenue is about $22.5 billion.
The company has 433 million shares outstanding. So, $22.5 billion / 433 million equals $52 a
share. The stock now trades at $47.85. So, is it cheap?
No. I did a variety of different methods to value the company. I used service revenue alone. I
used EBIT from everything. I used sales. I used some normalized approaches. Otis used to be a
better business than it is today. The company’s 10-year average EBIT under United
Technologies actually compares favorably to today. I made some different estimates
incorporating more of management’s guidance about margin expansion and so on. These 5 or
more different methods didn’t give me dramatically different valuations. The very lowest came
in around $30 a share. The very highest came in around $65 a share. Today’s stock price is
$47.85. That’s exactly smack dab in the middle of that intrinsic value range.
There’s nothing to see here. Not for a value investor. The business might be exciting. It’s an
excellent business. It may be capable of improvement. And, if it does improve – EPS will really
move here. In a couple years, Otis could start doing buybacks. I’ve seen companies like this that
spin-off and then lap a couple years of messy financials while buying back stock, raising the
dividend, etc. eventually get rewarded with a high P/E. This is a big business. The market cap is
already $20 billion. It’ll be a consistent dividend payer. I assume it’ll be a consistent buyer of its
owns stock. The business is really not as cyclical as people think it is. About 80% of earnings are
tied to low-cyclicality service revenue. This is a business that – if well managed – will have
slightly higher EPS and a slightly higher dividend year after year after year.
I don’t think it’s expensive at the price it’s at now. But, I’m not looking to pay a very full price
for a big, well-known business like this. If you had to manage billions of dollars – there are much
worse places to put it than Otis. The advantage investors like you and me have is that we don’t
have to buy $20 billion market cap stocks if they’re not cheap. I can’t see any definitive proof
that Otis is cheap. If you believe management’s medium-term guidance – maybe it is. But, there
are a lot of cheaper stocks out there. There aren’t a lot of better businesses out there though.
Open a file on Otis. Keep track of the price. Study it now in case it ever gets cheap later.
 URL: https://focusedcompounding.com/otis-otis-the-worlds-largest-elevator-company-
gets-the-vast-majority-of-its-earnings-from-maintenance-contracts-with-a-93-retention-
rate/
 Time: 2020
-----------------------------------------------------
Pendrell (PCOA): A Company with Cash, a Tax Asset, and Almost No
Liabilities
Pendrell is essentially a non-operating company with two assets: cash and net operating loss
carryforwards. The cash appears on the balance sheet. The net operating loss carryforwards do
not.
The most recent balance sheet is dated December 31st, 2017. It is found in the 10-K. Total
liabilities are $9 million while accounts receivable are $17 million. Since accounts receivable
alone can cover all liabilities – I’ll assume that all cash is surplus cash.
Cash is $184 million. The company has 242,769 shares outstanding (there are both “A” and “B”
shares). That means cash is about $758 a share. Let’s call it $750 a share in cash. As I write this,
the stock is trading at $645 a share. So, let’s call that $650 a share.
Let’s try to simplify the situation.
The stock price is about $650. The net cash is about $750 a share. So, if you buy the stock you
are more than 100% covered by cash. Liabilities are almost nothing. And there’s no cash burn.
So, you’re getting more in cash than you’re putting into the stock. That’s your downside
protection.
Where’s the upside?
The company’s net operating loss carryforwards are not listed on the balance sheet. There is a
legitimate accounting reason for this. However, the accounting treatment doesn’t reflect
economic reality. Let me explain.
Pendrell presents a table (in a note in its 10-K) that shows the net operating loss carryforwards
would be $625 million (this includes California) but then shows a “valuation allowance” for the
full amount. This means the company has this tax asset on the books for zero dollars.
Why?
The company is taking an allowance for the full amount, because there is nothing in its past
history or current operations that would suggest it can use these net operating loss carryforwards.
Here’s the quote:
“For all years presented, the Company has considered all available evidence, including the
history of tax losses and the uncertainty around future taxable income. Based on the weight
of the evidence available at December 31, 2017, a valuation allowance has been recorded to
reduce the value of the Company’s deferred tax assets, including the deferred tax
assets associated with the NOLs, to an amount that is more likely than not to be realized.”
That amount is essentially zero.

And that’s the right way to account for the net operating loss carryforwards. However, it’s not
the right way for an investor to look at their value. How should we look at their value?
Pendrell has federal and state (California) net operating loss carryforwards.
California Net Operating Loss Carryforwards
The state net operating loss carryforwards are for past losses of $1.3 billion suffered in
California. They begin to expire in 2028. I’ll just assume these state net operating loss
carryforwards are worthless.
Federal Net Operating Loss Carryforwards
These net operating loss carryforwards begin to expire in 2025 with “a significant portion”
expiring in 2032. Pendrell has $2.5 billion in federal net operating loss carryforwards. The
corporate tax rate in the U.S. is now 21%. So, $2.5 billion times 0.21 equals $525 million. If
Pendrell could somehow report $2.5 billion in taxable income right now – it could save itself
$525 million.
“Bounding” The Problem: Discounting the Tax Savings
I’m going to establish two “bounds” for this problem. This one is the most optimistic
presentation. I will assume that somehow Pendrell is able to produce $2.5 billion in taxable
income in 2032. This is a fantasy in two ways. One, how could a company with only $184
million right now ever control $2.5 billion of taxable income? Two, some of the net operating
loss carryforwards expire as early as 2025. However, there are some offsetting factors. I’m
assuming the California net operating loss carryforwards are worthless and I’m assuming there
will be no federal tax savings from 2018 through 2031. As you’ll see when I “discount” the value
of this tax asset – the assumption that there are no tax savings for well over a decade gets you a
much lower value.
I’m not interested in what other people would value these tax savings at. I just want to look
at my own opportunity cost of waiting a really long time for some asset to be monetized. So,
what I’m going to do here is apply my own hurdle rate of 10% a year – this is basically the
expected return rate below which I wouldn’t touch a stock – to the problem. To have $525
million in 2032, how much money would I have to start with in 2018 if I compounded my initial
sum at 10% a year?
The answer is $135 million. So, if we were really sure that Pendrell would have no tax savings
between 2018 and 2031 and then suddenly save $525 million on taxable income of $2.5 billion
in 2032 – that would be as valuable to us as having another $135 million in cash right now. This
hypothetical asset works out to another $550 a share in value.
Don’t get too excited. This isn’t really a stock with $1,300 ($750 in cash plus $550 in tax
savings) of assets selling for $645 a share.
We’ve handled the discounting approach. But, the question we haven’t answered is how much
taxable income can Pendrell really produce?
Now, let’s move on to the way I would really think about this stock. Personally, I don’t think the
appraisal value for the tax asset I showed you above makes a lick of sense. But, I think the
method I’m about to show you below is reasonable.
“Bounding” The Problem: What Would an Acquisition Look Like?
Let’s assume Pendrell will buy something. It will pay roughly what a private equity firm would.
However, it will only use its cash – no debt. The company has over $180 million in cash. Last
year, private equity firms tended to pay about 8 times EBITDA for acquisitions. They paid more
for companies over $250 million in enterprise value than for companies under that amount.
Historically – for unleveraged public companies – 8 times EBITDA had been very close to about
10 times EBIT and about 15 times earnings. However, the corporate tax rate declined from 35%
to 21%. Most data I have on private equity multiples and the relationships between EBITDA,
EBIT, and P/E are from a 35% tax rate world.
Today, an acquisition price of about 12 times EBIT is equivalent – in after-tax terms – to what an
acquisition at 10 times EBIT was in 2017 and before.
What if Pendrell Buys a Business at 12 times EBIT?
So, let’s assume Pendrell does an acquisition all in cash where the purchase price is $180 million
and the target is producing $15 million a year in EBIT. We’ll assume the acquisition is done this
second.
Pendrell has over 13 years to produce taxable income. Nonetheless, $15 million a year in EBIT
growing at 0% a year for 13 years only gets you to $195 million in cumulative EBIT. Even if the
acquired company grew at 6% a year and even if the free cash flow it produced was plowed back
into buying more companies at 12 times EBIT – it doesn’t look like you are going to ever get to
use up all these net operating loss carryforwards.
That simplifies things for us. It means whatever Pendrell buys isn’t going to pay taxes for a long,
long time.
It Only Matters What a Stock Looks Like When You Sell It
There’s a quote I repeat often – an odd one for a value investor – that goes something like this:
“It doesn’t matter what a stock looks like when you buy it. It only matters what a stock looks like
when you sell it.”
Today: Pendrell is a cash box with some net operating loss carryforwards. But, the cash is going
to be used to buy a business with taxable income. And the net operating loss carryforwards are
going to expire (mostly) and get used up (somewhat). We know that in about 14 years, Pendrell
will have neither cash nor net operating loss carryforwards. So, should you – as a long-term
investor – really think of Pendrell as a cash pile with net operating loss carryforwards?
Or, should you think of Pendrell as what it will become?
What Pendrell Will Become
Pendrell isn’t going to use up all of its net operating loss carryforwards. That means, whatever
Pendrell buys isn’t going to be paying U.S. corporate income tax. We could do a DCF to try to
see how much of the tax savings will ever get used, when they’ll get used, and how much you
should pay for those tax savings today.
But, there’s a much easier way to value Pendrell.
Whatever the company buys will probably grow a bit. It may also throw off some cash that can
be used to make more acquisitions. Let’s pretend neither of these things will happen. That’s
being unfair to Pendrell. But, we’re going to offset this with another assumption. We’re going to
pretend a company that doesn’t pay taxes for the next 14 years should have the same P/E ratio as
a company that will never pay taxes. We know this is untrue. But, I’d say that we also know
assuming 0% growth for a business, assuming free cash flow is not used for more acquisitions,
etc. is also untrue and probably offsets most of the value in any difference between an untaxed
company for the next 14 years versus an untaxed company for eternity.
If you agree with me on this assumption, we can really simplify the Pendrell situation down to
this…
Pendrell will acquire something with $15 million in EBIT. That something will pay no taxes. So,
Pendrell will have $15 million in after-tax income. Pendrell has 242,769 shares outstanding. So,
the company will be earning $62 a share after-tax. Pendrell stock now sells for $645 a share.
Therefore, Pendrell is now being valued at a P/E of 10.4. That’s a P/E of 10.4 with no net debt or
net cash. It’s an unleveraged P/E of 10.4. We can also assume that a business purchased in a
roughly $200 million transaction at an EV/EBIT of 12 will be a pretty middle of the road,
average “microcap” (though an awfully big microcap) sort of stock.
So, I think there’s the potential here investing in Pendrell at about $650 a share today to be like
buying an average public company with a $200 million market cap with a clean balance sheet at
a P/E of 10.
Is this really what Pendrell will become?
I don’t know. It could buy many different things. It could buy something in a more complex deal
where the seller wants a buyer with net operating loss carryforwards.
Pendrell has an uncertain future. But, it seems like you can get in a little cheap on that future.
Nothing is certain. But, I don’t think you should pay less for something that’s less certain but no
more risky. Pendrell can’t be called risky right now. You could say that there’s a risk the
company will overpay or make a bad acquisition. That’s true. Management has actually avoided
making an acquisition for now, because they say prices are too high. There’s also uncertainty the
other way. There may be some more complex deal – rather than just buying any old business at
12 times EBIT – that could make better use of the net operating loss carryforwards. The
company could buy back stock at below net cash (it’s done that before). Current operations –
basically they have some patents they license – could produce some free cash flow. I’ve assumed
all assets that aren’t cash or tax assets are worthless and operations neither add nor detract value.
Uncertain vs. Bad
I’d also add that while Pendrell does have more uncertainty than public companies at this size
and price normally do – it doesn’t have more bad features. This cash will eventually be freshly
allocated to a new acquisition. There is no troubled business here, no large amount of liabilities,
etc. So, it might be easy to underestimate what Pendrell would be worth after it buys an
operating business, changes its name to reflect the business it acquires, and then starts reporting
earnings produced by that business and improved in EPS terms by the net operating loss
carryforwards. I think it’s very possible an investor looking at the stock right now would
underestimate just how attractive this kind of stock would be 5 years down the road when things
look more certain.
Quibbles
There are a ton of assumptions in what I just laid out. And, I think you could argue that some of
those assumptions are more likely to be wrong than right. On the other hand, if you look through
the different assumptions favorable to Pendrell that I didn’t make – I’m not sure that trying to
adjust my assumptions one-by-one would lead you to assume Pendrell is worth less than a stock
with a clean balance sheet and a P/E of 10 as of today.
What the quibbles do is point out the uncertainty on both sides of the situation here. There’s no
clear story here as to what will actually happen.
In my experience, that tends to be the number one reason investors ignore a stock. Investors
don’t like stocks where it will take time for value to be clearly present. They either want earnings
today, cash today, or hard assets today. They don’t want to invest in something that will probably
turn into something that will – on an earnings basis – likely be valued higher than this thing is
today.
Today, I think value investors may be valuing Pendrell on its cash. So, they are willing to buy
the stock up to the point where it trades at net cash. But, they aren’t willing to pay anything
above net cash.
Once Pendrell acquires an operating business and that business doesn’t pay taxes – value
investors may look at the stock in terms of P/E instead of in terms of net cash per share.
What about the Wait?
Of course, Pendrell (with the current CEO in place – he joined in late 2014) was clearly on the
hunt for a business to acquire in 2015, 2016, and 2017 and found none. So, even if Pendrell does
eventually make a good acquisition the upside could be limited compared to other stocks you
might buy today because you will own a stock without knowing if it will produce meaningful
free cash flow relative to your purchase price within the next few years.
Technically, free cash flow versus purchase price (FCF yield) was actually good as of last year.
But, this depends on patents I can’t judge the value of. So, I’ve ignored the fact that the existing
business is currently cash generative. I’m not saying these patents are worthless. I’m just saying
that this post is all about making conservative, simplifying assumptions to do a first check of
whether this is a stock I should research further. So, right now, I’m pretending the patents are
worthless.
What about the “Qualitative” Issues Here?
Most posts you read about Pendrell will talk about the people involved, the satellite business that
lost all this money in the first place, etc.
I think that’s all important. But, I think it’s too early to talk about that. First, you need to know
the price is right to buy into this corporation. Then, you can worry about who is running the
corporation and what they want to turn it into.
I could go into who controls Pendrell, what incentives they have, how the company has being
allocating capital so far, what they say about the future, etc. – and I may, in a later write-up.
But, I don’t think that’s a good first step. The first step is to figure out how cheap or expensive
the stock is versus net cash as it stands now and – more importantly – how cheap or expensive
the stock would be once it converted the cash pile into a tax-advantaged earnings stream.
I’m almost certain to write about Pendrell again.
 URL: https://focusedcompounding.com/pendrell-pcoa-a-company-with-cash-a-tax-asset-
and-almost-no-liabilities/
 Time: 2018
-----------------------------------------------------
Pendrell (PCOA) Follow-Up: Reading into a CEO’s Past and the Dangers of
“Dark” Stocks
A member commented to the write-up I did yesterday on Pendrell. I think the comment and my
response are worth making into a full follow-up “memo”.
So, here they are:
“Geoff,
This company definitely seems promising. I saw the blog post from Hidden Value that you
retweeted and ended up buying a small starter position in the company after reading the 10k.
That was before even seeing that you ended up writing a post on it.
I’m struggling to decide how to size the position right now, but really I have two open questions
I’m working on.
1. How big of a cash flow business can Pendrell reasonably acquire using their current
cash position?
2. How will the experience of being a “private” shareholder in Pendrell differ from
owning stock in a more public position that files with the SEC?
Some further development of those two points:
1. I know you assumed that they’d purchase the company with 100% cash equity. That
seems like a very conservative assumption. If they’re going to behave and operate as a
private corporation, there is no reason we can’t view PCOA as basically a private equity
investment without the 2% management fee.
In that situation, wouldn’t they be likely to use leverage in an LBO like purchase? They could
use somewhere between 30-50% cash with the rest being debt. That could change your EBIT
target from 15 million per year, to something like $30-40 million per year. Therefore, the
unleveraged 10.4 P/E could be something like a leveraged P/E of 4-6.
While management hasn’t guided to the use of debt versus all-cash transactions, I don’t see why
they would choose to use all cash. By using leverage, they can better take advantage of their
deferred tax NOL asset.
Obviously, this is purely an upside discussion, but you’ve already discussed the downside.
(minimal)
2. Although the company won’t file financial reports with the SEC, do private companies
still usually prepare financial statements but not issue them publicly? Perhaps only to
shareholders? Or should I assume I’ll not receive any regular updates at all about the
financial condition of the underlying company while I hold this stock?
Geoff, any insight you can provide on those points would be most appreciated. Thank you for
bringing the stock to my attention through your tweet.”
First of all, this is a reminder to all the members reading this to follow me on
Twitter (@GeoffGannon). You can sometimes – if you pay attention to what I re-tweet, tweet,
etc. – get an idea of what sort of things I’m reading about and even sometimes which particular
company I’m current analyzing. Many times, nothing will come of it. This time, a stock write-up
came of it.
Is an Unlisted, “Dark” Company Public or Private?
Just to be clear on the terminology, Pendrell is now an over the counter stock that doesn’t file
with the SEC. It says it “went private” and that’s true in a sense. You need to get under a certain
shareholder of record number to achieve this – but, it’s a pretty loose requirement for a microcap
stock in today’s market. If a microcap really wants to “go private” this way – that is, stop filing
with the SEC – it’s not that hard to pull off if you do big reverse splits (Pendrell went from
basically a penny stock to a $600 stock through these reverse splits) and cashing out very small
shareholders. The threat of a listed stock becoming unlisted and of an SEC filing stock become a
non-SEC filing stock can also help drive out small shareholders – especially those who don’t
understand that a stock could still be quite liquid even after it’s “gone private” this way.
Why did Pendrell does this? It has saved over $1 million of costs by doing so. However, all it has
really done so far is remove its listing from a major exchange and remove the need to file with
the SEC. This doesn’t necessarily mean the company won’t release annual reports, audited
financial statements, etc. to the public (if they choose to do so: you should be able to find these
via OTCMarkets.com under the ticker “PCOA”). They can do that if they choose. They can also
choose not to do it. If you want to call it a private company, you’d have to call it a pretty liquid
private company as small investors are able to get in and out of the stock much more easily than
in the least liquid listed stocks out there. There are days where I think Pendrell has had $100,000
of trading volume. I have accounted for 100% of the daily volume in stocks I’ve bought and sold
sometimes. So, $100,000 of volume on some days is plenty for most individual investors. Even
“dark”, Pendrell is likely to be more liquid than several stocks I’ve owned that were filing with
the SEC.
What Are the Dangers of Investing in a Dark Company?
I have invested in “dark” companies before. In fact, the stock I am now considering buying is not
listed on an exchange and doesn’t file with the SEC. It does, however, release quarterly and
annual “reports” (only a few pages, but with financial statements) as well as information about
the annual meeting. That stock is much less liquid than Pendrell is. Its annual report is maybe 5%
to 10% the size of the 10-K a company would file with the SEC. On the other hand, it sometimes
provides additional – and quite useful – non-GAAP information that its fully public peers don’t
release.
One concern that investors have with “dark” companies is that a company may go dark to allow
management to loot it. It’s possible. All companies have some related party transactions. I’ve
seen public companies file 10-Ks that fully disclose these related party transactions and still
manage to allocate say 1-2% a year of the company in share form to insiders per year and maybe
10% to 20% of what annual income would be without paying for probably unneeded services of
these insiders. So, the protection you have with a company that files with the SEC isn’t that
management can’t loot the company – it’s just that management has to disclose it’s looting the
company.
Pendrell was already – whether listed or not – a company with a pile of cash, a lot of net
operating loss carryforwards, and a very rich controlling share (the controlling shareholder here
may have a net worth 10 times the size of this company’s market cap). Whatever the IRS’s
opinion on this – Pendrell is effectively a holding company for a few insiders. In such situations,
you have to either trust the controlling shareholder, the CEO, etc. or not.
At the risk of offending lawyers here, I’d say your 3 key protections as an outside shareholder in
any public company are usually:
 Alignment of interests between you and insiders

 The personal honor and integrity of insiders – their sense of shame AND
 The ability of outsiders to “raid” the company
If a company with a professional management team is poorly run – some activist investor,
private equity firm, or competitor will make some sort of offer to the board. That’s not going to
happen with small, controlled companies. So, your protections are really how honorable insiders
are and how closely your interests are aligned with their interests. I don’t think the “motive” to
loot changes here whether the company is dark or not. It’s true “opportunity” does change. So, if
you feel management’s interests aren’t aligned with you and management isn’t trustworthy –
then, yes, going dark is bad.
There’s also a risk that management might sort of intentionally use going dark, de-listing, etc. to
dry up liquidity, inconspicuously improve the value of the company, etc. and then eventually
offer to buyout outsiders. A lack of liquidity has a sort of drip, drip, drip water torture kind of
way on working on the minds of many investors. Outsiders can be pretty quick to give up on a
“dead money” stock. If a stock is illiquid and there isn’t any news coming out of the company,
some investors will sell out and won’t be too picky about price.
Pendrell has bought back stock from shareholders – though they’re limited in their ability to do
huge buybacks. It’s clear that Pendrell’s management is aware that outside shareholders are
undervaluing the company and they may be considering ways they can take advantage of that. I
mean, buying back stock below net cash is a way of enriching continuing shareholders at the
expense of selling shareholders. If you’re a continuing outside shareholder, these buybacks are
good for you. But, I’m sure the fact outsiders aren’t valuing the company correctly isn’t lost on
management when they do these buybacks. Eventually, management is trained to think outsiders
don’t know how to value the company and can be taken advantage. What I’m saying is: insiders
know the market for this stock isn’t efficient. What they do without that knowledge is a matter of
their personal ethics.
I Don’t Know What Disclosures Will or Won’t Be
Will Pendrell continue to provide information to shareholders along the lines of annual reports?
It doesn’t have to. I have seen dark companies that try very hard to hide literally everything
about their business from their own “outside” shareholders including such basic information as
what land they own, what stocks they hold, etc. In some cases, outside shareholders have only
gotten information by making a legal request for it.
In other cases, there isn’t much difference between a closely held, publicly traded over-the-
counter but still filing with the SEC stock like George Risk (RSKIA), OPT-Sciences (OPST),
etc. and a company like Pendrell. But, it depends. For example, I owned OPT-Sciences when it
was filing with the SEC. About 3 years ago, the company finally went dark (it’s a tiny company
controlled by a trust) and I don’t think it’s filed any reports since then. I can guess what it looks
like. But, I can’t be sure.
So, it’s possible investors would know nothing about Pendrell while it was dark. The company
could change quite a bit without you – as a shareholder – knowing how it had changed.
If Pendrell does go truly and completely dark – are their ways of getting information about the
business once you’re a shareholder? Yes. A dark company is still preparing plenty of financial
statements, etc. and shareholders can contact the company to gain access to it. The blog to read
for information on all this is “Oddball Stocks”. Go through all the archives and especially the
comments to see how Nate and some people commenting on that blog got information on
companies that were completely dark to non-shareholders. Often, investors who specialize in
truly obscure companies will buy some shares of an ultra-obscure company just for informational
purposes.
My Best Guess as To What Will Happen at Pendrell
What do I think is most likely to happen over the next few years at Pendrell? Well, if you look at
the way the CEO is compensated and things like that – I’d say the most likely scenario is that
Pendrell doesn’t necessarily disclose a lot till it buys something. It then announces it made a big
acquisition, it prepares to file with the SEC again, it eventually up-lists to a major exchange and
by then the name Pendrell has been changed to the name of whatever it acquired.
FutureFuel
One thing I didn’t mention in my original write-up is that years ago I analyzed a public company
Lee Mikles (Pendrell’s current CEO) ran. I never bought the stock. But, I recognized the name
Lee Mikles and what he had done at FutureFuel. FutureFuel was really Eastman Chemical. It just
used the corporate name FutureFuel, but it was actually Eastman Chemical. Eastman Chemical
had a biofuels business. But, its legacy business was supplying custom ingredients in large
volumes to a couple big companies under long-term contracts. I’m working from memory here,
so I could be way off – but, I want to say their two key customers were P&G (Tide) and
Monsanto (RoundUp).
Anyway, the history of FutureFuel was basically this:
2005: Company is formed as a vehicle for acquiring a company “in the oil and gas industry”
2006: Company acquires Eastman Chemical and becomes known as “FutureFuel”
2008: FutureFuel starts trading on the OTC Bulletin Board (“pink sheets”)
2011: FutureFuel lists on the NYSE
Lee Mikles was a member of the board, the CEO, etc. from the time the company started (2005)
through all these name changes, etc. I think he owned something like 5% of FutureFuels. The
Chairman of FutureFuels (who may have also become CEO when Mikles left) owned more like
40% of the company. If you check the address of the Eastman business, the executive offices of
FutureFuel, and the addresses of the various board members it looks like the company’s
executive offices were basically the Chairman’s location. I remember that the company used a
Missouri address for its executive offices even though it owned a couple thousand acres in
Arkansas for its chemical business. You can also see that the company was formed to make
acquisitions in the “oil and gas” industry and the Chairman had background in that business. On
top of all this, there’s an OTC stock – I’m familiar with it, they make gloves and safety
equipment – called Boss Holdings where both Mikles and the Chairman of FutureFuel served as
directors.
Anyway, that’s a long story to make a short point. If you’re asking how will Lee Mikles do
working with taking a cash pile with a controlling shareholder, having it traded over-the-counter,
acquiring something, listing on a major exchange, etc…
Well, that’s exactly what he did at FutureFuels for maybe something like 7 years. I mean, I think
his key involvement with the company as a real operating business was between 2006-2013.
How was his record? Well, you can check the stock price and so on. I don’t think it’ll look very
impressive on that measure. On the other hand, you could dig more into the history to see
whether the underlying acquisition and its subsequent operating results were good or bad.
Regardless, I wouldn’t be surprised if the future of Pendrell looks somewhat like the past of
FuturFuel.
The Trouble with Speculating
I have no reason to believe that will happen beyond the stuff you know too. It’s just my guess of
which of a bunch of different scenarios is most likely. I think it’s most likely that within 5 years
or whatever: Pendrell eventually acquires “ACME Widgets” and then lists on the NASDAQ as
ACME Widgets and there is just a brief mention in the 10-K that the company used to be called
Pendrell and explaining where the net operating loss carryforwards came from, etc.
As far as how big an acquisition Pendrell could do…

It could be big. I didn’t want to get into all the tax questions. That’s stuff you can explore
yourself. I’m no more of an expert on corporate taxes, net operating loss carryforwards, etc. than
you are.
There is a bunch of potential upside I didn’t discuss. I mean, if John Malone controlled Pendrell
– it would be worth a lot. Because we know he’d use as little owner’s equity as possible and pay
as little taxes as possible. I know of companies – publicly traded, but I assume there are some
private ones too – that have been reluctant to sell the company because whoever buys them
would apply a discount to the fact there is embedded within what they are buying an unusually
big need to pay taxes in the future. But, I think it gets very speculative to talk about those sorts of
things. It gets very speculative to talk about the absolute best way to take advantage of net
operating loss carryforwards, because we don’t know enough about the capital allocation ideas
management has. How committed are they to minimizing taxes, maximizing the earnings bang
they get for their acquisition buck, and doing it sooner rather than later?
I don’t know. I can speculate. But, I’m not sure it’d be helpful to do so.
But, yes, there is – if the buyer and seller are working together to minimize taxes for everyone –
some ways to structure a deal that might mean the seller would get a better bid from a buyer with
net operating loss carryforwards than a buyer without any.
What My First Pendrell Write-Up Was All About
As usual, what I tried to do in that “memo” is lay out some conservative assumptions that might
work here. I think I was very conservative with Pendrell. I think the upside – if run by the right
capital allocator – is potentially very big in this stock. So, far, Pendrell’s management has done
mostly the right things. But, so far, the right things have mostly been getting smaller and doing
nothing. When it’s time to get bigger and do more – will their decisions be just as good?
Obviously, there is the potential for a bigger acquisition, there is the potential for plowing back
free cash flow into acquiring more taxable operating businesses and snowballing like that over
time so that a lot of the net operating loss carryforwards could be used in later years, there is the
potential for the acquired business (or businesses) to grow organically, etc.
But, I’m not sure we should ever count on optimal capital allocation at a company we invest in.
It’s very easy to confuse what you would do if you controlled the company with what the
management of the company will actually do. They’re rarely the same thing.
What I did in that post is lay out the two sort of extreme boundaries of what Pendrell should – if
managed right – be worth. I don’t think you should strongly prefer a $200 million stock with a
P/E of 10 over Pendrell. You might look at the two at being roughly equal. But, you shouldn’t
much prefer one over the other. I do, however, think you should prefer a stock trading at 50% of
your appraisal value to Pendrell though. As I laid out in the extreme example of what would
happen if Pendrell eventually uses up all the net operating loss carryforwards by 2032 – I still
didn’t get a value for the stock (to me personally) of over $1,300 as of today. I think that shows
pretty clearly that Pendrell is not worth more than double was it now trades for.
Pendrell is definitely worth more than its current stock price. But, I also think it’s definitely
worth no more than double that stock price. Those are the “bounds” I sketched out.
So, I’m just saying that I see Pendrell initially as being something that’s probably trading at more
than 50% but maybe less than say 75% of its appraisal value. That’s pretty good for a stock with
cash on hand, no liabilities, etc.
Right now, I think value investors see it as a stock trading at 90% of cash. That’s true. But, I
don’t think that’s an accurate gauge of appraisal value, because the net operating loss
carryforwards here are very big relative to the market cap and the company is not currently
burning cash or saddled with a lot of liabilities. It’s rare to find a very clean balance sheet, lack
of cash burn, etc. accompanied by such large net operating loss carryforwards. So, I think there’s
a lot of flexibility here.
Why Most Value Investors Won’t Make Much Money on This One
What do I think can go wrong with this investment?
I think a lot of value investors buying this stock will end up losing a little money, breaking even,
or making a little money over the next couple years. I think, eventually, most value investors
who buy this stock will come around to seeing it as “dead money” and decide to recycle the
capital from Pendrell into a better, livelier idea. That’s usually what happens with these kinds of
stocks. Value investors who get in under net cash don’t actually stick it out for the
transformation. It’s very tiring to watch a stock go nowhere, hear no news about it, etc. for a few
years while you are buying and selling other stocks, making profits and – above all else, simply
“doing things”. If Pendrell takes a while to buy something, most of the value investors who buy
in today will have sold out before that acquisition is ever announced.
As always, feel free to comment below. Sometimes, I’ll do a full follow-up memo like this one
where a comment calls for that.
 URL: https://focusedcompounding.com/pendrell-pcoa-follow-up-reading-into-a-ceos-
past-and-the-dangers-of-dark-stocks/
 Time: 2018
-----------------------------------------------------
Points International (PCOM): A 10%+ Growth Business That’s 100%
Funded by the Float from Simultaneously Buying and Selling Airline Miles
Points International (PCOM) is a stock Andrew brought to me a couple weeks ago. It always
looked like a potentially interesting stock – I’ll discuss why when I get to management’s
guidance for what it hopes to achieve by 2022 – but, I wasn’t sure it’s a business model I could
understand. After some more research into the business, I feel like I can at least guess at what
this company is really doing and at how this helps airlines. My interpretation of what the
company is doing is sometimes a bit different than what I’ve read about in write-ups of this stock
on Value Investor’s Club, Seeking Alpha, etc. The company’s own investor presentation doesn’t
lay things out quite the way I will here. So, everything you read in this initial interest post should
be consumed with the understanding that it’s my best guess of how this business works – and
that guess could be far off the mark.
Points International has 3 segments. One of these is “Loyalty Currency Retailing”. That segment
produces more than 100% of the company’s economic profit because the other 2 segments
together add up to a slight loss, break even result, etc. depending on the exact year or quarter. At
this point, I see no reason to assign any value – positive or negative – to the other two business
segments. Points International also says it serves a lot of different clients. It mentions a total of
60 clients who it does some work for. However, only 30 use even one of the company’s “Loyalty
Currency Retailing” functions. As a side note: in a YouTube video I saw, the company’s
President seems to mention the number 36 in reference to Loyalty Currency Retailing – so, when
I say “30” going by the company’s reports to regulators and so on, the actual number may now
be 36 but I’m not 100% sure that’s what the President was referencing. So, I’m going to keep
saying they have about 30 out of 60 clients actually allowing them to do any Loyalty Currency
Retailing. Loyalty Currency Retailing is the only business that produces value here. So, all
profits are from only 30 (or so) “partners”. Customer concentration seems extreme here if you
read the note that 70-75% of revenue comes from 3 partners. However, gross profit is the more
meaningful measure here. I would just cross out revenue and replace it with gross profit for most
discussions of this company. The one exception would be “float”. I’ll discuss that later. It’s
possibly best to treat gross profit as this company’s top line revenue and to treat the reported
revenue as a form of “billings” as other marketing companies might put it. So, gross profit
concentration is such that 80% of gross profits comes from 12 partners. Based on other things the
company says, I would assume these partners are airlines based in the U.S. and Europe. I think
the concentration here is really that almost all profits probably come from “Loyalty Currency
Retailing” operations done for about a dozen airlines in the U.S. and Europe.
What is Loyalty Currency Retailing? Here is where I’m going to describe the business slightly
differently than I’ve seen it described by others. I think this company runs marketing promotions
to sell airline miles on a “retail” basis (that is, to individual people who fly with the airline). For
accounting purpose – whenever Points International is acting as a “principal” instead of as an
“agent” – this is treated as Points International buying airline miles at a wholesale cost from its
airline partner and selling the miles to the flier who will eventually use these miles. I think
describing the business that way could be somewhat misleading to an investor. First of all, you
might assume that if Points is buying from airlines at wholesale and selling to fliers at retail that
it is first buying and then selling. However, that’s not the case. Points International doesn’t
normally go “long” airline miles at all. You can see this by checking the company’s balance
sheet. It usually carries truly minimal amounts of airline miles on the balance sheet. And the
company explains what causes it to ever carry any miles at all. This explanation – that it only has
airline miles on its balance sheet when it fails to sell as many miles in a year as it has promised
to buy under the guaranteed purchase obligation it has contractually with an airline – implies that
in all other circumstances, Points International is not buying airline miles before selling them. It
buys them as it sells them. In fact, on a cash basis – it really buys them long after it sells them.
Points sells airline miles to people who pay with their credit cards. The payment processor then
deposits money in a Points International bank account about 2 days later. However, Points
International doesn’t pay its airline partners anything in cash for the miles it buys till 30 days
after the end of the calendar month in which Points International bought the miles. If we assume
that Points International has an equal chance of selling miles on all days of a given calendar
month, then we’d assume that at the end of a given month they have already gone about 15 days
on average (half a month) since selling the points before the clock starts ticking to pay the airline
partner in 30 days. Therefore, I would assume that Points International is paying cash for the
points it sells about 45 days after selling those points. It’s collecting cash for the points it is
selling about 2 days after selling them. So, in a very rough way, it should have about 43 days
worth of points in cash. That’s about 12% of a year. So, if you take the annual revenue of this
company – you’d expect it could (on an average day) have about annual revenue times 0.12
equals cash on hand. This is if the company was not piling up any earned cash. And, recently, it
hasn’t been doing that. It’s been using the cash in excess of this float to buy back its own stock.
It seems to be on pace to reduce share count by about 5% this year. Because of the nature of the
float I’ve been discussing – Points International seems to have an excellent financial position.
There is one meaningful financial risk they have. I’ll discuss that in a second. But, normally they
are borrowing literally nothing from any bank while having a very large cash position – it’s been
over $50 million in cash for a company with a market cap of $170 million – with the only
meaningful liability being payables due to airlines for the miles the company has already sold.
Generally, airlines tend to renew with Points International (they claim a 95% renewal rate, initial
contract terms are 3-5 years, but it seems that annual renewals after the first contract term ends
are common) . And, at least in recent years, it’s very clear that existing airlines have been selling
more and more points through Points International. This means the amount of sales increases
over time. This means the size of the roughly 1.5 months of sales increases over time. This
means float increases over time. This means cash on hand increases over time. So, it’s a very
liquid and very safe balance sheet.
There is, however, a large off-balance sheet obligation. I don’t think it’s especially large relative
to Points International’s business. However, the last I checked – the company had around $400
million in minimum purchase guarantees. This is spread out over several years. It’s usually very
low for the current calendar year – this is because Points is getting closer and closer to reaching
the annual requirement as the year progresses, thus causing the remainder of the guarantee (not
the original promise) to appear smaller in the company’s footnotes as the year gets closer to the
end of December. The minimum purchase guarantee is usually going to be biggest for next year.
I think Points has promised to buy like $150 million worth of airline miles in 2020, for example.
This doesn’t really concern me much, because I don’t see the size of these promises as being
especially large versus sales. Right now, it seems like Points International has promised – over
the next 5 years – to buy about 1.5 years of normal revenue for the company. This isn’t a big
promise compared to companies that invest in stuff like the rights to show movies, TV shows,
sports, etc. And it’s only airline miles that can’t be sold at year end that present much of a
problem. And, honestly, because of the working capital cycle here – it’s really only a major
concern to me if it becomes difficult for Points to sell airline miles on behalf of any of its clients.
It’s not a big deal if a couple airlines have miles that can’t be sold that Points has to buy, because
this will be a modest amount of “make good” that Points has to buy versus the float on hand
from all the other airlines where it could sell the miles. For example, it was recently at like $1.5
million in points it had to buy for failing to reach the minimum purchase requirement versus float
of closer to $60 million. Even like a 10 or 20 times increase in the amount of shortfall in terms of
points sold versus points promised to be sold wouldn’t be a huge concern versus the cash
position. To put it another way, imagine that the company is selling around $350 million a year
in airline miles. It is promising to sell $150 million. That means it’d have to sell nearly 60% less
miles to – across all its airline partners – have a deficit it has to buy up. Now, each contract is
separate. So, it’ll have deficits with one airline and not another. But, that’s not a concern as long
as there is float from the other airlines. For example, it doesn’t matter much if they have to make
up $5 million in purchases with one airline if they have $50 million in float giving them cash on
hand of $50 million with which they could buy up those airline miles if needed. The concern is
much more what I described above with promising to buy $150 million and averaging sales of
$350 million. A huge plunge in sales – relative to minimum purchase guarantees – would cause
two things to happen at once. One, the company would need to buy up airline miles using cash.
And two, the dollar amount of float would fall along with the failure to sell miles. So, the
company would basically have additional cash obligations at the same time it had a declining
cash balance.
How big a risk is this?
Honestly, I think it’s small because of what we’re talking about here. Points International is a
marketing partner for airlines targeting members of these frequent flier programs. To promise to
buy a lot more miles than they can sell – Points International (and probably the airline partner
too) would need to be miscalculating the effectiveness of a planned marketing promotion by
quite a bit. This miscalculation would probably be about 1-year out. But, in theory, it could be
longer. Points has promised to buy $100 million worth of miles in like 2024 and beyond. So, it’s
possible you could miscalculate badly in something like that kind of further out purchase
obligation especially if you had a huge recession or more likely a serious terrorist attack
involving planes. Points International was only founded in 2000. The influence of September
11th, 2001 just don’t show up in a way that’s helpful for us to gauge how this company would
perform in a future year with a terrorist attack of that size or greater. The financial crisis and
Great Recession also don’t help much here because I feel the company has just changed too
much in the last 10-12 years. The 5-year record is probably a more accurate predictor of the
company’s future. But, unfortunately, we don’t have anything in the last 5 years that really helps
us see what would happen in a big turndown for airlines. It’s also a little complicated by the fact
this company is selling airline miles. You can’t just remove all planes from service when demand
plummets – so, the amount of empty seats goes up when the airline industry hits a downturn in
demand. It’s hard for me to know exactly how this influences marketing of airline miles, because
on the one hand airlines would obviously want more redemption of miles when they are flying
relatively empty than when they are flying relatively full. On the other hand, they might be less
likely to spend on marketing. And marketing effectiveness might be lower in a bad economy.
But, this kind of marketing does actually guarantee cash flow for airlines. The one thing I do feel
pretty sure of is that contract renewals and renegotiations that happened at a bad time for the
airline industry would be more likely to include concessions on Points International’s behalf to
its airline partners. They’d want them. And I think Points would grant them.
What makes the stock attractive?
Management is guiding for 2022 growth that suggests like 13-17% annual increases in gross
profit. The increase in their favorite measure – adjusted EBITDA (which excludes some stuff I’d
want included, but on a CAGR basis should be a decent measure of earnings power growth)
would be up like 30% a year for the next 3 years. The stock isn’t expensive right now on a
market cap basis. It’s very cheap if you use enterprise value. I wouldn’t use enterprise value. But,
I would consider the presence of float to mean growth costs nothing here. So, if you have a stable
multiple over the next 3 years, you’d get a stock price increase of close to 30% a year in Points.
The stock pays no dividend. But, that brings up another point. If management really is going to
hit the 3-year growth goals and it’s going to do it primarily with money coming in from the core
“Legacy Currency Retailing” business, I’d expect cash flows that need to be sopped up by
something. The most likely something would be buying back like 5% of shares per year for the
next few years. I don’t know if the company will do this. But, it should have the cash available to
buy back stock as it grows.
I don’t have a good feel for management here and whether they are realistic enough. From what I
can tell of the recent growth performance of the Legacy Currency Retailing business this
guidance on the growth profit line isn’t actually aggressive. The company has now been growing
pretty quickly for quite a while. They aren’t predicting a dramatically different trajectory. They
do now have a partnership with Amadeus. However, I think the guidance is probably related
more to expected organic increases in sales to their biggest existing airline partners. This seems
to have been the source of a lot of the profit growth recently.
Management here may be too aggressive in their estimates. They own very little stock. I don’t
see any insider really owning more than about 2% of this stock.
I don’t like relying on management’s guidance when valuing a stock. And I don’t like betting on
a management that has put out the kind of presentations, reports, etc. this one has. They’re not
extremely promotional exactly. But, I don’t get any sort of vibe of extreme conservatism and
candor in anything I’m reading in stuff prepared by the company and intended as communication
with investors. So, management and the realism of their expectations for the next 3 years is by
far my biggest concern here.
Nonetheless, this is a business that seems safe, high quality, and capable of growth without
needing any cash to finance it. On top of that, the stock is also super cheap today versus what
management says it’ll make in 3 years.
This one goes to the top of the list.
Reconsider Price: Already interested at today’s price
 URL: https://focusedcompounding.com/points-international-pcom-a-10-growth-business-
thats-100-funded-by-the-float-from-simultaneously-buying-and-selling-airline-miles/
 Time: 2019
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Psychemedics (PMD): A High Quality, Low Growth Business with a Dividend

Yield Over 7% – And A Third of the Business About to Disappear
Psychemedics (PMD) is a micro-cap stock (market cap around $50 million right now) that
trades on the NASDAQ. It is not – by my usual definitions – a particularly overlooked stock. The
beta is about 0.53 (low, but many stocks I’ve written about have much lower betas). The share
turnover rate – taking recent volume in the stock and multiplying it to see how much of a
company’s total shares outstanding would turn over in a given year at this recent rate of trading –
is 102%. Again, that’s not an especially high number for the market overall. It might not be high
compared to the stocks in most people’s portfolios. But, it’s very high for any sort of truly
“overlooked” stock. There are some possible explanations here. Some recent events have caused
Psychemedics stock to be especially volatile (this suggests the low-ish beta of 0.53 is more the
result of very low correlation with the overall market than of actual low volatility in the stock)
and insiders own very few shares of this company. In fact, there’s a ton of float and very few
long-term investors in this stock. To give you some idea: insiders all own about 3% or less of the
stock individually (and less than 10% taken all together) and Renaissance Technologies (a quant
fund) was the largest holder of the stock as of the last proxy statement. This points to a stock that
is not closely held by insiders, not generally held by long-term investors, etc. So, it trades a lot. It
may not be overlooked. But, it’s still a micro-cap stock. And there’s a decent chance you haven’t
seen a longer write-up of this particular stock. So, I do consider it overlooked enough to at least
do an “initial interest post”. This is that post.
Psychemedics is in one line of business: hair testing for drugs. Actual testing services make up
over 90% of revenue in any given year. The rest of revenue is all very closely related revenue
such as charging for the actual collection and shipping of hair samples (in some cases). This is
really just a drug testing company that uses hair to do the tests. That’s all you need to know.
Historically, almost all revenue and earnings and so on came from the United States. Almost all
costs still do come from the U.S. The company is headquartered in Massachusetts and rents
about 4,000 square feet there, the actual lab is a rented facility in Culver City, California.
Although the lab facility is rented – the equipment is owned. Psychemedics in an asset light
business with one exception: it owns a lot of lab equipment. The company depreciates the
equipment over 5-7 years. If you do the math on what the equipment was valued at gross, what
cap-ex on the equipment is, etc. – this is the one asset heavy part of the business. The company’s
assets really consist of technical know-how and a bunch of lab equipment for drug testing.
A few years ago – Psychemedics expanded into the Brazilian market to do testing of professional
truck drivers there. I expect this business may disappear entirely in the next year or so. I mean
Psychemedics may lose the business. And I am going to analyze Psychemedics as if it has
already lost the Brazilian business. The market for drug testing via hair will continue in Brazil.
It’ll just be dominated by someone else. This is a good place to pause and explain what drug
testing using hair is.
Most drug testing around the world – and that includes in the U.S., which does also test truck
drivers (like Brazil does, but using urine instead) – is done using urine testing instead of hair
testing. Why? Is urine testing a better method of detecting drugs? No. It’s worse. It’s a lot worse.
Psychemedics goes into some details about how much more effective hair testing for drugs is
than urine testing for drugs. But, the truth is that – before opening Psychemedics’ 10-K – I was
aware of a lot of this data. It’s relatively easy for employees, job applicants, students, criminals,
prisoners, etc. to trick a urine test. The test only detects drug use in the last few days tops. So, the
easiest way is to simply abstain from drugs immediately before you expect to be tested. It is also
relatively easy to get false positives from some other things – for example, eating poppy bagels
could cause a false positive on an opium test – that the threshold amounts used to define failing a
urine test sometimes have to be set high (to eliminate these possible false positives). Then, there
are more active methods of avoiding a positive on a urine test such as consuming abnormally
high quantities of water – this combined with the need to set a higher threshold to define failing a
drug test could be enough to pass some drug tests even with recent drug use – on to much more
involved processes like obtaining clean urine. Obviously, it’s possible to combat many of these
tricks used to avoid drug detection. Surprise drug testing would help. Using an observer to
witness the actual urine collection process would help. And so on. However, many of these
methods have downsides. If what an employer really wanted was to be 100% sure they had
detected as many drug users as possible – they’d simply use a hair test. But, most don’t. Why
not?
One possible theory – and the one I personally lean towards – is that not all entities that perform
drug tests are really that eager to: 1) Pay more for hair testing than urine esting AND 2) Actually
detect the maximum number of true drug users. Psychemedics gives the example of a prison
where urine testing gave a 0% positive rate and then hair testing gave about a 7% positive rate.
Measures were then put in place to reduce drug use – that’s a lot easier to do in a prison than
with employees – and the rate was reduced to closer to 2% with further hair testing. Urine testing
showed 0% positive both before and after the drug reduction methods were used. I think this –
coupled with higher pricing on hair tests – is a pretty good example of what an employer or other
entity using drug tests might not be that excited to find. Some organizations may want to test for
drugs, say they test for drugs, make it clear they intend their workplace to be a drug free
environment etc. – but, then, not actually eliminate 7% of their workforce, potential job
applicants, etc. I think this is supported by the research Psychemedics includes on what HR
executives say they are trying to eliminate with drug testing. The number one thing they care
most about is people missing work. They believe that employees on drugs are more likely to
miss work. That’s probably true. But, I’m not sure it’s necessary to do accurate drug testing to
lower a lot of job absences. HR may be quite capable of screening out the less well functioning
drug users from those who are quite capable of attending work regularly despite their drug use.
In some industries, there are other concerns about safety and trustworthiness and so on.
Anecdotally, from knowing managers who have supervised employees with drug problems – this
fits. I know of a couple cases where employers knew they were retaining employees with serious
drug problems and yet did kept the employee on indefinitely. In these cases, the desire was to
avoid union problems, litigation, etc. In those cases, the employer specifically instructed the
employee’s supervisor to use special procedures to make sure the drug user did not have access
to things like cash handling that others in the position might normally have. I’m relying on that
HR executive survey, anecdotes, etc. here to make an important point. If you’re reading this and
you know urine testing is common and hair testing isn’t common – you’re probably thinking
Psychemedics is exaggerating the effectiveness of hair testing versus urine testing.
I’m not convinced they are.
In some cases where establishing a clear history of past drug use is critical – such as in a custody
dispute – the very same agency that might rely on urine testing normally for its own workforce
will use hair testing instead. As Psychemedics explains, hair testing can give you a good 90-day
record of drug use including more information on the frequency and severity of the drug use.
There are cases where urine testing is clearly better, of course. The moment after an accident – a
urine test can detect drugs. Hair testing can’t detect drug use in the very recent past – like this
past week – because you’re collecting a hair sample from above the scalp. Hair growth starts
under the scalp. But, most employers don’t need to know if someone used drugs within a week
of their interview, start date, etc. They just need to know how often and how heavily they used
drugs in the last 3 months. I think Psychemedics is right and hair testing is the best way of
knowing that. But, I don’t think most companies using drug tests need that kind of information at
any cost. There may be some very special positions involving safety, risk of liability coming
back to the company, certain risks involving children, etc. where an employer would care so
much about quality and so little about price that they’d use hair testing exclusively. But, I’m
convinced the market for hair testing will always be small versus urine testing. I think sensitivity
to price here is pretty high. And I think very few employers would prioritize really needing to be
100% sure about someone’s drug use.
So, Psychemedics is a niche business. It seems to have a good technology. Other companies –
especially bigger labs as part of their services – do offer hair tests. But, these competitors rely on
other people’s tests. They don’t design the testing methods themselves like Psychemedics does.
R&D spending at Psychemedics is not high. It’s over $1 million but less than $2 million in any
year. There are 6 R&D employees. That’s not big in absolute terms. Nor is it big relative to
Psychemedics’ own revenue line. It’s just a few percent of sales. The company has continued to
develop additional tests, get additional patents, etc. I don’t want to say Psychemedics doesn’t
innovate. But, it doesn’t spend a ton on research. If you look at salary and other information –
it’s clear that the head of laboratory operations is the second most important executive (behind
the Chairman & CEO). The Chairman/CEO and the head of the laboratory have been with the
company a long time. What you see in Psychemedics’ past history is the record built by the
current management team.
It’s a high quality, low growth record. Over the last 20 years – and including the expansion into
Brazil – Psychemedics has only managed to grow revenue by about 4% a year. Some of this may
be due to difficulty raising prices (because this would hurt volumes versus the cheaper urine
testing method). I’m giving you per share numbers. If I gave you pure companywide numbers, it
wouldn’t change much. In recent years, there has been some share dilution causing a drag of
maybe 0.5% a year on shareholder returns. The company doesn’t buy back stock. What it does is
pay a big dividend.
Psychemedics basically pays out 100% of its owner earnings (free cash flow) in dividends.
You’ll notice today’s dividend yield is 7.8% despite a P/E of 18. Those two don’t sound like they
could both be correct. But, they roughly are. If I calculate out my own guess of recent “normal”
free cash flow at Psychemedics, I get a payout ratio in the 80-85% range. The company has been
paying out more than 80% but less than 100% of its cash earnings. It might be trading as cheaply
as about 10 times its recently normal free cash flow. Psychemedics has net cash – not net debt.
So, it sounds cheap. But….
Brazil is now one-third of total sales. The company pays a very high tax rate in Brazil – this is
because the tax is based on sales not income and Psychemedics has very fat profit margins, so it
seems like the company is paying around 50% of Brazilian income in taxes. All of Psychemedics
business in Brazil has been done through a single distributor. That distributor had an agreement
to exclusively market Psychemedics test in the country. This was an attractive deal, because
Brazil recently added a rule that truck drivers in the country had to submit to drug testing via hair
quite frequently. Psychemedics put a lot into this business. And it paid off. But, now the
company’s distributor has sold more than 50% of its shares to a competitor of Psychemedics.
The updated agreement between Psychemedics and the distributor is non-exclusive. The
distributor can now sell its parent company’s drug tests as well. It likely will. Psychemedics
warns that the competitor may not have the scale immediately to handle this volume of business.
So, Psychemedics may retain some Brazil business for a little while. Longer-term, my
expectation would be that 100% of this distributor’s purchases eventually shift away from
Psychemedics and Psychemedics tries – but, who knows if they’ll succeed – to get another
distributor in Brazil, enter the country directly, etc. Direct entrance would be out of character for
Psychemedics. This company is generally a lab that performs drug tests. It does sell direct to
parents online. But, that’s not a big part of its business. Marketing consists more of signing up
big organizations and then collecting revenue on a price per test performed basis. So, it makes
money based on the volume of drug testing of new applicants, employees being tested, etc.
Psychemedics has minimal costs associated with Brazil. It has almost no assets in the country
and lists just one employee as being dedicated to Brazil. The company did pay a board member
about $150,000 a year to handle corporate governance and other issues in Brazil. I suspect the
director’s job was mainly to handle relations with the distributor and secondarily – perhaps – to
avoid things like any foreign corrupt practices act (U.S. bribery law) violations in the country.
So, if we plug in a 35% to – because there will be negative impact due to operating leverage
going the wrong way – like a 50% decline in normal earnings, FCF, etc., we’d be talking about
paying more like 15-20 times future FCF (without Brazil) for the stock. That 4% historical
growth rate was achieved including the new Brazil business.
That leaves a free cash flow yield of maybe 5-7% a year or something on today’s price. Growth
might be 4% or less. We’re getting numbers that don’t add up to much above 10% a year. And
then this isn’t a “Davis Double Play”. The P/E is already in the teens. I’m saying the Price/FCF
might be 15-20 times future FCF. We shouldn’t expect multiple expansion here.
If all goes badly in Brazil, this looks like it might be fairly priced – not much underpriced. It’s a
high quality business. I think it’s likely – but not certain – to outperform the S&P 500.
Psychemedics has paid a dividend for over 23 years now. The dividend yield is over 7%. Even
after losing Brazil, this company can – and almost certainly will – pay big dividends in the
future.
This isn’t a stock where you are at risk of losing money, getting low single digit returns, etc. But,
so far, I don’t see a very certain path to returns over 10% a year.
For now, I think the stock is probably a pass. But, it’s one I’ll keep a file on for future
investigation.
 URL: https://focusedcompounding.com/psychemedics-pmd-a-high-quality-low-growth-
business-with-a-dividend-yield-over-7-and-a-third-of-the-business-about-to-disappear/
 Time: 2019
-----------------------------------------------------
Resideo: Honeywell’s Boring, No-Growth Spin-off Might Manage to Actually

Grow EPS for 3-5 Years
Yesterday, Honeywell set the distribution date for the spin-off of its home comfort and security
business “Resideo”. So, I thought now would be a good time to do an “initial interest post” on
Resideo. In this article, I’ll give my first impressions of the stock and then I’ll conclude by
giving you an idea of how interested I am in following up with this stock idea. As always, I’ll
grade the idea on a scale ranging from of 0% interest to 100% interest.
To give you some context, let’s start with a review of how interested I was in the five other
stocks I looked at.
Keweenaw Land Association (KEWL): 90% initial interest level

Pendrell: 90%
Maui Land & Pineapple (MLP): 80%
U.S. Lime & Minerals (USLM): 50%
Babcock & Wilcox Enterprises (BW): 10%
The details for the ratio of shares of Resideo to Honeywell (1-for-6), record date (October 16th),
and distribution date (October 29th) can be found here:
https://www.sec.gov/Archives/edgar/data/773840/000119312518290912/d528228dex992.htm
The notes I took when reading the Resideo spin-off document can be found here:
https://secureservercdn.net/198.71.233.172/575.8f7.myftpupload.com/wp-content/uploads/
2017/06/Focused_Compounding_Resideo_Notes_by_Geoff_Gannon.pdf
Resideo includes a products business (“Honeywell Home” or “Products”) and a distribution

business (“ADI global distribution” or “Distribution”). Resideo will operate in multiple
countries. And it will spin off with about $1.23 billion of debt from Honeywell and liabilities
related to over 200 environmental clean-up sites. We’re interested in valuing the stock (the
equity portion, not the debt). So, it’s easy to get lost in the complexities of this situation. The first
thing we need to do, then, is to focus on those aspects of this spin-off that could drive returns in
the stock. In other words, we need to start simplifying things right from the start.
Here are some of the first questions we need to ask:
How much debt will Resideo have when it spins off?
How big will Resideo’s environmental liabilities be when it spins off?
How expensive will the stock be when it spins off?
Where will most of Resideo’s “owner earnings” (“free cash flow”) come from?
Let’s start with the last question first. In recent years, Resideo has gotten about 75-80% of its
profits from the “products” business rather than the distribution business. There’s a lot of
information in the spin-off document – and therefore, in my notes – about ADI. However, ADI
only accounts for about one-fifth of profits (about half of revenue) at Resideo. It’s easy to get
sidetracked by spending as much time on ADI as we would on Honeywell Home (“products”).
On a sales basis, the two businesses are equal in size. But, sales aren’t what matters to a
shareholder. Profits are what matters. Gross margins at Honeywell Home (the products business)
are about 4 times higher than gross profits at ADI (the distribution business). Therefore, the same
amount of sales at each business translates into roughly 4 times more profit (80% of profits
versus 20% of profits) at Honeywell Home.
In this initial interest post, I really want to set ADI aside and focus on the main profit driver here
which is the products business. That’s difficult to do. I honestly feel I understand the distribution
business better than the products business. For example, I invested in a company – George Risk
(RSKIA) – that supplied its products largely through ADI (30-40% of its sales were made to ADI
in many years). Nonetheless, we need to focus on what matters most – not just what we can
understand best. In this case, Honeywell Home is what matters most. It is 3-4 times more
important to Resideo shareholders than ADI is. So, for now, let’s chuck ADI aside and turn our
focus entirely to Honeywell Home.
Next, we have the question of domestic sales versus foreign sales. About two-thirds of sales are
made in the U.S. The company provides several breakdowns by geography at various points in
the spin-off document. But, the simplest rule of thumb to follow here is that probably no less
than 2 out of every 3 dollars of profit at Resideo comes from the U.S.
This means the single biggest determinant of Resideo’s profits is sales of Honeywell Home
products inside the United States. The domestic products business probably makes up about half
of Resideo’s value as a stock. So, when we think about the competitive situation this company is
facing – we should start by looking at products and the United States.
What kind of products does Resideo make? Who does Resideo make them for? Who are they
sold to? And who eventually uses them?
Let’s start with the last question first. Resideo’s Honeywell Home products in the U.S. are
primarily used by American homeowners.
What products does Honeywell make?
Honeywell Home makes products like: security panels, security cameras, sound detection,
thermostats, whole house humidifiers and de-humidifiers, water filters, furnace and boiler
controls, freeze detectors, leak detectors, etc. The company’s oldest product category is
thermostats. It has relationships with original equipment manufacturers like ADT (security),
Carrier (air conditioners), and A.O. Smith (water heaters). Honeywell Home is bigger in
“comfort” than it is in security. So, we’ve now moved on to “who” Honeywell makes these
products for. The company makes these products for home security companies, HVAC
companies, etc.
The decision makers are professionals. Most of the Honeywell products going into U.S. homes
are not being bought by homeowners. They are instead being bought by companies like ADT,
Carrier, and A.O. Smith and then incorporated into their products. Or, they are products that are
being installed by professional contractors of some sort. Honeywell does make some products –
including some “connected” products – that homeowners can buy themselves and install (“do-it-
yourself”). Again, I think this is a tangent an investor could get distracted by. It’s easy to think
that whatever Honeywell product you see being sold at Best Buy is the key to this company’s
success or failure. In reality, do-it-yourself sales of products through a retailer like Best Buy are
not driving a big portion of this company’s profits. That’s not the sales channel this company is
focused on. It’s just the channel that is most conspicuous for you as a homeowner.
Where is Honeywell making these products?
Here, we get to one of the risk factors. Honeywell manufactures products for the U.S. market in
Mexico (as well as in the U.S. itself). A change in the North American Free Trade Agreement
(NAFTA) that disadvantages Mexican imports of these products into the U.S. relative to how
they are treated now would be bad for Honeywell. Generally, Honeywell does not produce a lot
of products in categories where you manufacture on the other side of the world and then ship the
products in to the market you want to sell in. For example, Honeywell has manufacturing in
Scotland, the Netherlands, and Mexico. It does not have any manufacturing in the Far East.
Those kinds of manufacturing locations are typical for a company that needs to be close to
customers in the U.K., E.U., and U.S. You see this kind of manufacturing set up a lot with things
that go into new homes, renovated homes, etc. Products may be sourced across the border. But,
they’re usually not sourced from the other continents.
We could spend time talking about the Honeywell brand, its patents, etc. But, I think that stuff is
self-explanatory. Honeywell has been involved in home comfort such as climate control for over
100 years. It’s been one of the best known names in that area for just as long. The brand is as
good, well-known, etc. as anything in that space. It has long made stuff in that product category
for some of the best known equipment manufacturers in each of the areas of home comfort and
security. Do we have enough information to determine it’s a wide moat business? Probably not.
Does it seem to have as good, as long, and as durable a position in this industry as anyone else in
the U.S.? Yes.
What are the economics of this business like?
They’re good. Gross margins are high. Resideo has about 50% gross margins in its product
business. Net tangible assets are low. So, the after-tax returns on equity – and this is without
leverage, Resideo will actually be leveraged when it spins off – are excellent. Again, I don’t
think it’s worth carefully quantifying this. If you find a business you’re sure will earn better than
30% after-tax returns on tangible owner’s equity – it’s not really worth arguing about whether
it’s 30% or 60%. Instead, you should focus on the prospects for re-investment. Remember,
you’re not going to be sold this business at book value. So, even if it is earning 30%+ returns on
equity – if you’re paying several times book value and then the company doesn’t grow, how are
you benefiting from these really high returns?
I don’t see good signs that Resideo can grow a lot. I did some quick checks of the size of
Honeywell’s Home business 20 years ago, I checked the size of George Risk 20 years ago, I
looked at the size of ADI 20 years ago. These things haven’t really grown much. They’re very
stagnant. And that’s not a huge surprise. One, we’re cyclically at a not very high point in the
housing market. Two, the U.S. population growth between 1998 and 2018 hasn’t been very high.
Household formation hasn’t been that high. It’s a slow growth country that way. And then the
U.S. already had very high penetration rates for some of these technologies 20 years ago. A lot of
people already had water heaters, central air, central heating, humidifiers, de-humidifiers, etc.
who needed those things. When you compare certain residential and commercial climate stuff in
the U.S. to Europe, Asia, etc. the U.S. seems very well along in those things. It’s one of the most
developed markets for this stuff. In fact, it may literally be the very most developed market of
all. Finally, some of these things can be deflationary in terms of costs. There are some signs of
that – especially earlier in the 20-year period I looked at – so, a company may not have been
making much more in sales but this did not stop profits from being just as high. I think the real
unit costs of some of these things declined. But, I don’t have enough information on that. There
are definitely economies of scale in matching large parts suppliers with large original equipment
manufacturers and things like that. Shifting manufacturing from the U.S. to Mexico may have
reduced costs too. Overall, I would rate this as a “no REAL growth” business long-term.
However, it will grow cyclically. I think Resideo’s product sales could be as much as 20% higher
in the future than they are today. This is due to where we are in the housing cycle. The normal
level is probably 20% higher than today’s level. And, like any cycle, the U.S. housing cycle will
overshoot normal at some point.
Now, let’s get down to price.
Honeywell stock isn’t cheap. We have no reason to believe this spin-off will be done at an
especially low price. Resideo stock might trade down over time if Honeywell’s shareholders sell
it off. They aren’t opting in to this spin-off. And no Honeywell shareholder bought that stock to
get this business. The spin-off is quite small compared to the overall size of Honeywell. It’s
worth watching the stock in the say 1 month to 1 year period following this spin-off to see if
there’s indiscriminate selling of Resideo.
Debt will be about $1.25 billion. That’s a manageable debt load for this company. The 3-year
average operating profit from Honeywell Home was about $380 million. Debt isn’t much more
than 3 times the EBITDA of this unit alone. And there’s profit from the distribution business too
(which adds at least another $100 million). We don’t have cash flow data. But, based on some
information about expected cap-ex, the balance sheets for past years, etc. I can tell this is a very
cash flow generative business. Also, there are two somewhat separate businesses here. That
diversifies earnings available to cover debt payments a little. I don’t see the debt alone as an
insurmountable burden. However, I do expect investors will take this $1.25 billion parting gift
from Resideo to Honeywell into account. Investors are usually pretty knowledgeable about how
to calculate enterprise value and adjust a stock’s price for its debt level. Spin-offs with a lot of
debt are common. Investors who focus on spin-offs know to look for this.
What might they not know to look for though?
Well…
The $140 million a year environmental liability payment is the interesting part. So, Resideo is
doing a deal with Honeywell where it will be responsible for paying Honeywell up to $140
million a year. This amount is capped. It can, however, decline over time if the annual
environmental payments Honeywell makes on some 200+ clean-up sites declines. Also, it’s
important to note that Resideo can NOT deduct this $140 million payment for income tax
purposes. Therefore, the potential improvement in Resideo’s future earnings from that $140
million declining to $0 at some point is equivalent to more like $180 million in added EBIT. This
is because you’d usually need to earn about $180 million more before taxes in the U.S. to keep
another $140 million in free cash flow. And that’s a conservative assumption. For most
companies, $180 million in added EBIT would – through a combination of taxes and non-cash
forms of earnings – end up producing less than $140 million in free cash flow. Here, this is a
pure after-tax cash outlay. The company is just giving Honeywell $140 million a year in actual
cash. That amount can never go up. But, it can go down. I know environmental clean-up sites
don’t sound like a benefit. But, here, the presence of those sites and the Honeywell agreement
could be an advantage for investors who are focusing in on Resideo and trying to model earnings
out.
I’m not going to value Resideo yet. This is an initial interest post. But, if I did value the company
– I’d do it over a 5-year period. I’d model out these things:
 Projected earnings of Honeywell Home in 2023

 Projected earnings of ADI distribution in 2023
 Projected cash outflow for environmental liabilities in 2023
 Remaining net debt balance in 2023
And then I’d simply put a multiple on Resideo’s FCF.
Resideo might grow earnings faster than you think here. For example, if the housing cycle is at
or above its long-term trend in 5 years, this could add 3-4% a year to earnings over the next 4
years. Inflation could add 2-3% a year to earnings over the next 4 years. And then, if
environmental payments halved over the next 5 years – you’d get another 3% a year increase in
EPS.
The company will also be leveraged in terms of debt. EV/EBITDA takes that into account. But,
P/E doesn’t. It’s easy to imagine – a year from now – that some investors look at this business
trading at a low teens P/E or something and think it’s not cheap because that’s a normal P/E for a
no growth business.
However, we know a few things about the business. One, it can grow due to the housing cycle
improving. Two, it might – this is very speculative – be able to grow due to inflation. Three, it
might – this is even more speculative – be able to grow due to declining environmental
payments.
I can imagine this company growing EPS by up to 10% a year over the next 5 years. I can’t say it
will. Because, I can also imagining EPS growing closer to 3% a year. But, the important thing to
keep in mind, is that I can see Resideo being in a “no-growth” industry and yet still growing EPS
by a percentage – just for the next 5 years, not beyond that – of really high single digits.
That’s interesting because we know cash needs here are low. So, assume the company pays a
dividend (it says it plans to). Or, assume the company buys back stock (it might). Add that on to
your expected annual growth rate in company-wide free cash flow.
There are a lot of ways where if this company spins off at a “no-growth” type P/E ratio – and
that’s a big if – I could see a path of 10-20% annual returns over the next 3-5 years. A lot of this
has to do with things – capital allocation, the housing cycle, and environmental liabilities – that I
don’t have predictions about.
But, at the right price, things could be shifted into your favor here.
I’ll be curious to see what kind of multiple this spins off at. I’ll watch it from time-to-time in the
first month to year of trading.
At first glance: the competitive position and the financial position here seem sufficient for me to
not immediately cross Resideo off my watch list.
It all depends on the price it spins off at and the earnings model you come up with for the next 3-
5 years.
I’m interested. But, till I see a price on this one – I’m only slightly interested.
 URL: https://focusedcompounding.com/resideo-honeywells-boring-no-growth-spin-off-
might-manage-to-actually-grow-eps-for-3-5-years/
 Time: 2018
-----------------------------------------------------
Resideo Technologies (REZI): A Somewhat Cheap, But Also Somewhat

Unsafe Spin-off from Honeywell
This is a revisit of Resideo Technologies (REZI). My initial write-up of Resideo was done
before the stock was spun off from Honeywell. Three things have changed since that initial
interest post.
One: Honeywell spun-off Resideo. So, we now have a price on Resideo.
Two: I’ve created a five part scoring system – a checklist of sorts – for the stocks I write up here
at Focused Compounding. This helps me more systematically order what stocks I should be
writing up for the first time, re-visiting, etc. and what stock ideas I should make less of a priority.
I’ll score Resideo using this 5-point checklist later in this article.
Three: Resideo released its first quarterly earnings as a public company. Management hosted an
earnings call where they took analyst questions. They put out some earnings slides with that call
as well. So, we have a bit of an update since last time.
I can tell you now that this third event is the least interesting. It’s the one I’ll spend the least time
talking about. What matters most here is that we now have a price on Resideo stock and I can
now score Resideo on my 5-point checklist. Let’s start with the checklist.
The 5 questions I’ll be asking are:
1) Is Resideo stock overlooked?
2) Do I understand the business?
3) Is this a safe stock?
4) Is this a good business?
5) Is this a cheap stock?
I score each question on a scale that goes: -1 (“no), 0 (“maybe”), +1 (“yes”).
Is Resideo stock overlooked? – Maybe (0). The answer can’t be a straight “no”, because this
is a spin-off. Spin-offs, in general, lead to stocks being overlooked – at least at first – because
shareholders of the bigger company (in this case, the very big company Honeywell) get shares in
this much smaller company without doing anything. They may sell the stock without giving it a
lot of thought. Also, this spin-off didn’t seem to be a huge focus for value investors and what I
did read online from value investors often treated it as something of a throwaway by Honeywell.
Basically, not a lot of people are writing about how this is a high quality business. They are
writing about how this company is slow growing, fully mature, and includes the burden of
paying Honeywell indefinitely to cover environmental liabilities. So, this isn’t a particularly
focused on spin-off. But, it’s still a stock with a market cap over $2 billion. It’s listed on a major
exchange. It did an earnings call with analysts. I didn’t hear questions from analysts at
especially big firms. This is probably a pretty overlooked stock for a $2 billion to $3 billion
market cap. But, in the world of the kind of stocks I often look at – it wouldn’t count as
overlooked at all. I’ll split the difference and say Resideo “maybe” overlooked (0 points).
Do I understand the business? – Yes (+1). I owned a stock – George Risk Industries
(RSKIA) – for about 7 years that sold a lot (often more than 30% of its total sales) to this
company’s ADI distribution business. I have researched three of this company’s biggest
customers in the business-to-business part of the “Products” business. I know a little about most
of the products this company produces. I was able to gather information on the companies that
eventually went on to make up Resideo over a period going back like 20+ years. This industry,
this company, and its competitive position aren’t much of a mystery. I wouldn’t say I understand
the environmental liabilities – but, I do understand they are capped (remember, Honeywell still
has these liabilities – Resideo just pays Honeywell to fund the liabilities up to a capped level). I
would say that, yes, I understand the business.
Is this a safe stock? – No (-1). Resideo’s management mentions their debt is rated “BB+”. And
I’ve read the explanation of why the debt is rated that way. The company has said it is targeting
a “modest” dividend in 2019 and 2 times gross financial leverage. The adjusted EBITDA
number they put out would suggest the company can cover the environmental payments about 3
times over (Adjusted EBITDA of $470 million or more AFTER paying $140 million in
environmental obligations). On top of that, the liabilities are capped. And the terms of the deal
with Honeywell would not be quite as strict – in terms of payments while the company was
distressed – as payments to a bank or bondholder would be. So, it would be wrong to simply
capitalize the $140 million at 17 times or something (as if the Honeywell payments were really
bonds that had a 5.9% after-tax yield) and pretend the company had like an extra $2.4 billion in
debt. It doesn’t really have an extra $2.4 billion in debt. Resideo is safer than a company with 4-
5 times EBITDA in long-term bonds (which is what the company would have if I capitalized the
environmental obligations and then divided that capitalized obligation plus other debt by the
hypothetical EBITDA the company would have before making those payments to Honeywell). I
don’t think this stock is as risky as it would be if it really had 4 plus times EBITDA in debt. But,
it’s also far from debt free. What about the actual debt? I said in my notes that Resideo would
have debt/EBITDA of about 3 times if we assume EBITDA will be $400 million a year. Resideo
is now saying that EBITDA will be greater than $470 million in EBITDA (the top end of their
range). This is a company with a strong competitive position in a mature – and not very cyclical
– industry with Debt/EBITDA of less than 3 times. But, it’s not that simple. In reality, they have
to pay that $140 million each year. But, we’re also not counting that in the EBITDA. So, does
that make the company safer or more dangerous than if it had neither that EBITDA nor that
obligation? The payments to Honeywell are capped at $140 million a year in nominal dollars.
The actual EBITDA of this business isn’t. So, if you assume that there is like $180 million of
EBITDA being eaten up by that $140 million of obligation right now – the $180 million may well
grow at a rate of 3% a year for the next 15 years leaving $280 million in 2034. Meanwhile, the
$140 million can’t grow. It’s capped. It can only shrink if Honeywell’s environmental liabilities
shrink. So, I’d say that right now Resideo is not especially safe. But, it should get progressively
safer as a stock with every year that passes. It’s hard to bring myself to definitely say that such a
well-established company in such a mature industry is not safe when the debt load is at a level
that’s high but still at the high end of manageable for a typical U.S. public company. In fact, on
a podcast where Andrew asked me about Reisdeo’s safety I said I would consider it a “maybe”
in terms of safety – but just barely. As I write this, I would say I’m leaning a little more to the
“not safe” side. This stock is “no”, not safe. But, it was a close call rating it. So: no, Resideo is
not safe (-1).
Is this a good business? – Maybe (0 points). This is the question I find hardest to answer. The
returns on capital, the gross profits divided by tangible assets, the margins – everything here
says “yes”. Both sides of the business – products and distribution – are leaders. And the product
economics of each business is above average. The gross margins on the product side are very
high. But, this is a totally mature market in terms of the physical volume demanded. And then,
perhaps because a lot of this manufacturing has moved out of the U.S. and to places like Mexico
– I don’t see much evidence of product price inflation over the last couple decades.
Unfortunately, the only periods I can compare with are shortly after NAFTA started till today.
It’s very possible that this is leading me to underestimate how much these products can keep
their prices rising with inflation. I’m going to score Reisdeo’s business quality as a “maybe”
good business, because it seems to be a combination of 1) A definitely good business with 2)
Seemingly no room to grow. Of course, the company will have growth cyclically, it might have
growth in non-U.S. markets, and it might grow enough to keep pace with inflation. But, I see the
odds of this business growing in real terms long-term as being very, very low. The existing
business is undeniably a high return business. So, the return on capital will be great. But, how
much capital can be reinvested in the business may be very low. Unlike the safety question where
I was leaning towards “no”, here I am leaning towards “yes”. This is a good business. But, a
good business with no growth prospects gets a “maybe” from me.
Is this a cheap stock? – Yes (+1). There are a few ways of looking at this. Let’s start with the
fully leveraged basis. I said free cash flow – after all payments to Honeywell, interest payments
on debt, etc. – might be around $200 million a year. The company has a market cap of about
$2.6 billion (123 million shares outstanding at $20.85 a share) So, that would be equivalent to a
P/E of 13 ($2.6 billion / $200 million in FCF = 12). A P/E of 13 is probably only about 2/3 of
what a lot of stocks are priced at now. It’s only about 85% of what an average stock has been
priced at in the past – however, stocks have been priced higher in the 21st century than they were
in the 20th. So, it’s unclear whether we should say Resideo is trading at around 65% or around
85% of the “owner earnings” multiple a normal company would trade at. On a leveraged basis,
I’d say you’re getting something like a 15% to 35% discount here. However, Resideo has debt.
So, you shouldn’t just divide market cap by free cash flow. That may be an accurate assessment
of your upside potential – if Resideo doesn’t pay down debt – but, it would underestimate the
risk you’re taking as a common stockholder. The stock is cheap. It’s certainly leveraged. But, it
is cheap. So, this stock may not be safe. But, it is cheap.
What about attempting to calculate an EV/EBITDA that adjusts for this leverage? In other
words, can we try to come up with a single ratio that captures both the safety and cheapness of
this company?
Sure.
So, EBITDA right now is projected to be $475 million for this fiscal years AFTER the
environmental obligations. Resideo also gives guidance for BEFORE those payments. That
guidance is for $615 million. As you can see from that, environmental payments are $140
million. We can capitalize these – roughly – as if they were 6% bonds, in which case we’d have
$140 million times 17 (1/17 is about 6%) equals $2.38 billion. Let’s call it $2.4 billion. So, the
capped annual environmental payments of up to $140 million a year to Honeywell can be treated
as being equivalent to $2.4 billion in long-term debt. Really, this is probably penalizing Resideo
too much. However, it’s a convenient line in the sand. Not many people are going to argue
Resideo’s actual payments to Honeywell have a net present value greater than $2.4 billion. It’s
probably some number much greater than zero but also much less than $2.4 billion. We’ll call it
$2.4 billion here. Resideo took on $1.4 billion in debt after the spin-off. So, we can calculate the
enterprise value – again, this is an OVER calculation of the true enterprise value – as being $2.6
billion market cap plus $1.4 billion in debt plus $2.4 billion in capitalized environmental
payment equals $6.4 billion in “enterprise value”. Against this we have adjusted EBITDA –
before environmental payments – of $615 million (which is the guidance for this year). That
gives an EV/EBITDA of $6.4 billion / $615 million = 10.4 times. An EV/EBITDA of 10 doesn’t
sound low. But, in this case it is. To illustrate, watch what happens if we include the market cap
and debt – but not the capitalized environmental payments. We get $2.6 billion market cap plus
$1.4 billion in debt equals $4 billion. EBITDA – AFTER environmental obligations – is
projected to be $475 million. And, $4 billion divided by $475 million equals 8.4 times.
Especially considering the recent corporate tax rate cut – and the low need for cap-ex at this
business – an EV/EBITDA of 8 is very low. What’s the true EV/EBITDA here? It’s in the 8-10
times range. This is a cheap stock. It’s not a deep value stock or anything. But, the equity is
certainly trading a bit below where I’d appraise it. There is, however, the issue of risk. The
upside here is bigger – because of the leverage provided by the environmental obligations – than
you’d normally have with a stock trading at 8 times EBITDA. However, the financial risk –
again, because of the environmental obligations – is also higher here than it would be with a
stock that has debt/EBITDA of $1.4 billion/$475 million = 2.9 times.
Really, this company is cheap but may not be safe.
Is Resideo better than most public companies? Probably. But, is Resideo riskier than most public
companies? Also, probably. It’s possible Resideo is trading at about two-thirds of what I might
appraise it at. It’s also possible Resideo is trading at closer to 90% of what I’d appraise it at. It
depends on which method you use to appraise it. Probably, the best way to explain it is this:
Resideo’s equity is trading at perhaps as little as 2/3 of what I’d appraise it at – but, Resideo’s
equity is also sitting behind more debt than I’d be comfortable having in front of me as a
shareholder. So, the equity is probably above average in terms of cheapness but below average in
terms of safety.
I’ll increase my interest level in the stock from an interest level of 60% to a level of 70%. This is
mainly due to information the company gave in the analyst call and to a lesser extent the
earnings release. However, I still have no plans to buy Resideo for the accounts I manage. It is,
however, worth mentioning that this is a stock I first rated at a 30% interest level, then increased
to 60% on my first re-visit, and have now increased to 70% on my second re-visit. There are still
plenty of stocks that interest me more than Resideo. But, each time I’ve re-visited Resideo, I’ve
gotten a little more interested in the stock as a potential investment.
It’s still a pass for me.
Re-visit checklist score: 1 out of 5
Re-visit interest level: 70%
 URL: https://focusedcompounding.com/resideo-technologies-rezi-a-somewhat-cheap-but-
also-somewhat-unsafe-spin-off-from-honeywell/
 Time: 2019
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Follow-Up Interest Post: Resideo Technologies (REZI) – Stock Falls, My

Interest Rises
The Resideo spin-off has taken place. And the stock has traded on its own for a bit now. So, I
thought I would very quickly re-visit the stock here.
You can check the ticker REZI (Resideo Technologies). It’s $19.56 a share as I write this. Here
is a link to the press release announcing the completion of the spin-off:
https://www.otcmarkets.com/stock/REZI/news/story?e&id=1207602
“Honeywell distributed one share of Resideo common stock for every six shares of Honeywell
common stock held as of 5:00 p.m. Eastern Time on October 16, 2018, the record date for the
distribution.”
Honeywell had 740 million shares outstanding about 17 days before that date. So, let’s assume
Resideo now has 740 million / 6 = 123 million shares outstanding (actually, slightly more – but
I’m simplifying).
Actual quote from a recent 8-K: “Immediately following the Spin-Off, we estimate that
approximately 123,451,420 shares of our common stock will be issued and outstanding.”
Before we re-visit my initial interest post, you may want to read it.
Here’s my initial interest post (where I give Resideo a 30% likelihood of me following up further
with it):
https://focusedcompounding.com/resideo-honeywells-boring-no-growth-spin-off-might-manage-
to-actually-grow-eps-for-3-5-years/#comment-293
And here are the notes I took when reading the company’s spin-off document:
https://secureservercdn.net/198.71.233.172/575.8f7.myftpupload.com/wp-content/uploads/
2017/06/Focused_Compounding_Resideo_Notes_by_Geoff_Gannon.pdf
Now that you have that background. Let’s talk about why I’m upgrading my interest level in
Resideo.
So, as I write this…
Resideo Technologies (REZI)

Price: $19.56 / share
Shares Outstanding: 123 million
Market Cap = $19.56 * 123 million

Market Cap = $2.41 billion
Net Debt = $1.15 billion
Taken from this recent investor presentation:
https://www.sec.gov/Archives/edgar/data/1740332/000119312518296364/d617866dex991.htm
(Slide 45)
So…
Enterprise Value = Market Cap + Debt

Enterprise Value = $2.41 billion + $1.15 billion
Enterprise Value = $3.56 billion
Let’s call it $3.6 billion in enterprise value
Now, there are two ways of doing this. One: we can capitalize the environmental obligations and
add that capitalized value to the EV and add-back the $140 million a year payment to Honeywell
to arrive at some sort of “adjusted EBITDA” figure.
Or, we can just use $3.6 billion in EV and we can fully include $140 million a year payment as
an annual expense. We then have to understand that the expense can go down from $140 million
toward zero over time.
The easiest way to do this is to assume the $140 million annual payment is a perpetual obligation
that will never be less than $140 million a year and will never go away.
In that case…
Enterprise Value = $3.6 billion

Last 12 months EBITDA = $475 million
Enterprise Value / LTM EBITDA = $3.6 billion / $475 million

Enterprise Value / EBITDA = 7.58x
Let’s round that up…
EV/EBITDA = 8x
Is that cheap?
It seems like it. Historically, an EV/EBITDA of 8 was pretty normal for a U.S. stock – paying a
35% tax rate at the federal level – because an EV/EBITDA of 8 translated into about an
unleveraged P/E equivalent of 15 or 16. Basically, what I’m saying is that if a company had zero
debt and traded at a P/E of 16 (the long-term historical average for big U.S. stocks) that company
would also often have an EV/EBITDA of 8.
But, is that true anymore? And is Resideo an average company?
Today, an EV/EBITDA of 8 would translate into well under a P/E of 16 (because the federal tax
rate dropped form 35% to 21%). The new normal EV/EBITDA ratio is probably more like 9-10x
to get a P/E equivalent of around 16. Resideo also probably converts more EBITDA into pre-tax
cash flow than other companies. So, I’d say you need an EBITDA of 10 times to get a “normal”
P/E on this one.
This implies the stock price should be around $29.16 a share. You could probably appraise the
stock at around $30 a share.
In fact, because of the way we did this calculation – there’s a risk we underestimated the intrinsic
value of the stock. It might be higher than $30, because environmental obligations may decline.
On the other hand, the company has a fixed charge of $140 million a year it can’t do anything
about. It also owes $1.15 billion in debt. In a sense, the company is probably capitalized with
about an equal amount of equity (at today’s prices) and debt (if you capitalized the
environmental obligations and added them to the financial debt).
My best guess is that the stock is “worth” $30 a share.
However, the margin of safety is NOT 33% ($20/$30 = 0.67x). It’s smaller than that.
And the upside is NOT 50% ($30/$20 = 1.5x). It’s bigger than that.
If I had to put a number on it: I’d say the stock is trading at about two-thirds of what it’s worth.
But, this isn’t an especially low risk stock. It has debt and fixed costs it has to cover.
However, it also has the possibility of the fixed costs one day decreasing.
If you were agnostic about risk (basically, you didn’t care how much of EV was debt and how
much was market cap – you just bought whatever was cheap on an EV/EBITDA basis) I’d say
the stock is priced at about two-thirds of what it’s worth and has an obvious way to like 50%
upside.
I would also upgrade my interest level from about 30% to about 60%. This is purely due to the
price at which the stock now trades.
If you look at my notes, Resideo now trades at less than the market cap I guessed it would have.
However, the debt is the debt. It hasn’t changed. Only the market cap is different than I expected.
So, I’ll upgrade my interest level from 30% to 60% based on the price of the stock.
Geoff’s follow-up interest level: 60%
 URL: https://focusedcompounding.com/follow-up-interest-post-resideo-technologies-
rezi-stock-falls-my-interest-rises/
 Time: 2018
-----------------------------------------------------
Silvercrest Asset Management (SAMG): A 4% Dividend Yield For an Asset

Manager Focused on Super Wealthy Families and Institutions
Silvercrest Asset Management (SAMG) is an investment manager. It looks cheap if you expect
it – as has been the case in the past – to do a good job of keeping its clients and keeping those
clients keeping about as much money with them as before. However, most publicly traded asset
managers are cheap stocks, because they have experienced – and investors probably expect them
to continue to experience – redemptions. In some ways, Silvercrest looks a bit closer to Truxton
(TRUX) – another stock I wrote-up – than it does to some of the asset managers that just run
mutual funds for the general investing public. Silvercrest’s client base is a mix of ultra-wealthy –
their top 50 clients average $290 million in assets each at Silvercrest – families (2/3rds of the
business) and institutions (1/3rd of the business). These clients are put into a mix of homegrown
investment options and outsourced investments. For all clients, the average is closer to about $30
million. However, as you’d expect – most of the assets under management are with their top 50
clients (who, again, each average close to $300 million in assets with Silvercrest).
Silvercrest charges mostly asset-based fees. These average a bit less than 0.6% of assets under
management. Unlike Truxton, Silvercrest is not a private bank. It offers other services. But, these
are a small part of the business, aren’t growing very fast, and aren’t something I’m going to
discuss much here. So, Silvercrest might sit midway between the kind of publicly traded asset
managers you’re more familiar with (say GAMCO) and a private bank / trust business like
Truxton. I don’t think it’s entirely comparable to one or the other.
There’s a write-up over at Value Investors Club on this stock. It’ll be a little different from what
I discuss here. So, I recommend reading that. But, there’s not going to be a ton of information in
there that I don’t also cover. This is because both my write-up of Silvercrest and that Value
Investors Club write-up look like they’re nearly 100% based on reading the company’s 10-K.
The company does earnings calls. You should read the transcripts. It might give you a little bit
better feel for the sales process and things like that. The company also puts out an annual report
(on its website) that includes a shareholder letter not found in the 10-K (the rest of the annual
report is just the 10-K).
As of the last 10-Q (September 30th, 2020) the company had $24 billion in asset under
management. However, that is for the consolidated entity Silvercrest L.P. which is 35% owned
by employees of the company and only 65% owned by public shareholders in the entity I’m
writing about here.
So, as a stockholder, you really only have an interest in $16 billion of that AUM.
Silvercrest has a diagram to explain this. But, it’s worth going over here. The publicly traded
company owns about 2/3rds of the L.P. So, outside shareholders get 2/3rds of the economics of
this business and 1/3rd goes to employees who have a stake in the L.P. The company manages
$24 billion and charges 0.6% of AUM on average – so, that’s $16 billion times 0.60 equals
“look-through” AUM of $16 billion for outside shareholders on which fees of 0.6% of $10
billion work out to be $96 million. Reported revenue is higher, because it’s the consolidated
revenue you are seeing (which means it includes revenue attributable to the “B” shares held by
employees). The fees tend to be a bit below 0.6% on average. And then there are about 9.5
million “A” shares. So, the A shares are each backed by about $10 of sales and about $1,600 to
$1,700 of AUM per share. The stock price is around $15 right now.
So, SAMG’s Class “A” shares (what you can buy) trade at about 1.5 times sales and about 1% of
AUM.
Is that a good deal? That number (price/AUM) is why I said this thing looks cheap on the
surface. Whether it really is or isn’t cheap depends on how AUM grows or shrinks over time.
But, given the economics of this business – a price/AUM of at least 2% would normally be
justified. And, if it’s a sticky and predictably growing base of AUM, prices well over 2% of
AUM could still work out well for owners.
Growth is very valuable here.
That makes appraising the stock more difficult. Even 1% of AUM is too much to pay for an asset
base about to be headed out the door. But, even 3% of AUM isn’t too much to pay for an asset
base sure to compound for many years to come. The reason for this is that growth is basically
free from an earnings retention perspective. All earnings at an asset manager can be paid out in
cash dividends. Growth is just your return on top of that. At most companies, earnings retention
is the “cost of capital” used to fund growth. There is no cost of capital for growth at an asset
manager, because no additional capital investment is needed to grow assets. So, if you knew an
asset manager would grow for many years to come – it’d be silly to pass on the opportunity to
buy it at 1% of AUM. In that sense, Silvercrest is cheap.
But, is that the right way to look at this asset manager? Obviously, the market does not look at
many asset managers that way. There are a ton of low-priced asset management stocks out there.
What makes Silvercrest different?
The company’s in-house offerings skew towards stocks and in particular value stocks. Their
largest single strategy (at 30% of assets in the company’s own strategies – it’d be less in terms of
total assets under management) is small cap value. Some of these strategies may be size
constrained. That one is. The company can’t keep growing that small-cap value strategy and
keep getting good returns.
There are several concerns here.
One, the company could be run to benefit its employees instead of its owners. A lot of
compensation (about 50% of the employee compensation you see in the income statement) is
variable stuff tied to incentive bonuses and the like. This may decrease in times of poor
performance. But, it’s also subject to increase if the folks running the company feel
compensation hikes are needed. So, your effective ownership of the assets under management
can get diluted in percentage terms over time. This will be a drag on stock returns. The only
question is how big a drag. Right now, I’m presenting things to you in a static view – employees
get one-third and you get two-thirds of the company – but, this may not always be the case.
Two, you’re effectively investing in a stock and (to a lesser extent) bond and hedge fund and
private equity portfolio. While you don’t directly own the underlying assets under management –
the revenue of the public company is nearly 100% tied to the AUM of the asset manager. So, a
10% decrease in the stock portfolio of clients will translate into like a 10% decrease in the
earning power of the public company. Basically, if you buy an asset manager when the
underlying assets clients are invested in are cheap – you benefit from the eventual rise in market
value. When you buy an asset manager when the underlying assets clients are invested in are
expensive – you suffer from the eventual decline in market value.
Fees track AUM. Earnings track fees. And the price of the stock you’re buying tracks earnings.
So, the market risk you’re taking here is really the same as the clients themselves.
The economics are better for you – because, you’re using other people’s money to make your
profit. But, really, that is no different from an insurance company. So, the same risk applies here
as it did to Investors Title Company (ITIC). If you’re buying into an overvalued investment
portfolio today – you’ll see a drag on future results. The only way to offset this is to insist on
paying a lower price/AUM for a company where AUM consists of overvalued stocks. In other
words, pay lower price-to-AUMs for an asset manager when stocks are expensive and be willing
to pay higher price-to-AUMs for an asset manager when stocks are cheap. I know this goes
against everyone’s instincts. But, it is theoretically the correct way to buy and hold these things.
Still, if you are paying half the price you should pay for an asset manager today – you’ll do fine
even if stocks are generally twice as expensive as they’d normally be. The greatest danger in a
stock like this would be doing the reverse. You could get very bad results if you pay an
especially high multiple of fees, AUM, etc. at the same time that stocks and bonds are trading at
especially high multiples. So, be extra careful not to overpay for an asset manager when the
overall market is expensive.
There’s another risk here. It’s an odd one. I’m not sure how much this company can grow
organically. And I’m not sure how much it’d shrink in bad times.
This is because the performance record of their investment strategies has been too good.
That might sound like a high-class problem to have – but, it means that we’re looking at
strategies that have outperformed their benchmarks (admittedly, often “value” benchmarks) over
the last 3-years, 7-years, etc. and since inception. That’s not a very good test of an asset manager.
The stickiness of clients isn’t tested in good times. It’s tested when you underperform. Every
strategy underperforms sometimes. So, building a long-term compounding machine for the
public company can’t be solely based on outperformance of the investment strategy. You really
want other things making clients sticky. Maybe Silvercrest has those other things. But, it’s hard
to tell – because, it’s easy to keep clients when you’re outperforming your benchmarks.
Like I said, some of those other “sticky” factors may be present here. Silvercrest does provide
family office type services. And they claim that 5 of their top 10 clients make some (but not
always total) use of these services. The company charges relatively low direct fees (about 0.6%
or less) on average.
However, those low fees are to be expected for two reasons. One, the client sizes are very large.
So, big clients expect volume type discounts. Silvercrest gets discounts itself when it puts some
client money with outside managers. Two, there are usually other fees the client is being charged
besides what Silvercrest is charging. For example, Silvercrest does put some money (not most,
but some) with outside managers – especially for things it doesn’t specialize in (so, not stocks).
Another example is the institutional money that Silvercrest manages. The company’s AUM is
now about one-third institutional. These institutions come with consultants, etc. There are other
fees clients may be paying – so, the 0.6% number is not comparable to what you as a much lower
net worth individual investor might be used to seeing on mutual funds, index funds, and the like.
Also, a portion of Silvercrest’s AUM is indirectly sourced. Over 80% is direct. But, some isn’t. I
don’t know if these indirectly sourced assets, assets of the nine companies it has acquired over
the years, and assets supplied by institutional investors are as sticky as original family money
from some of the company’s earlier clients. It may be. But, in a period of outperformance for the
strategies Silvercrest runs – we really have no way of knowing.
Obviously, bad investment performance is a big risk here. If the company’s strategies badly
underperform benchmarks for a time this could cause a reduction in winning new institutional
clients, a reduction in assets under management with existing clients, and even the loss of
existing clients.
Silvercrest claims it has had a 98% client retention rate over a lot of years now.
Also, this is a people business. Silvercrest – the public company – is, poorly protected against
key people at the company just up and leaving. As outsiders, we have little insight into whether
this is a realistic risk. There could be little chance it’ll happen. I have no way of knowing.
Silvercrest mentions it has had people leave to go to competitors.

The other difficulty here is assessing the brand, the organization, etc. That’s hard to do.
Silvercrest operates in areas of the investment management business about which Andrew and I
know next to nothing. It is a less visible portion of the investment business.
And we can only analyze the past record for the years we have it.
The problem is that we have a combination of trends in the market for family offices,
institutional investors, etc., overall market conditions, performance of value vs. other strategies,
and relative performance of Silvercrest vs. its (mostly value) benchmarks that are all happening
in the same year. Some of these would be headwinds for the company. Some of these would be
tailwinds. For example, the kind of offerings the company has weren’t very well suited for the
last decade in the market. But, the other items I named were mostly tailwinds. I wouldn’t say we
can see a period of serious testing for this company since it went public.
Growth here has been okay but not great. I’ve seen a lot better in this industry. If you look at
how the company has grown AUM, a lot of it has been through market appreciation. Net client
inflows have been small. Over the last few years, this company maybe would grow 3-4% a year
if the market had been flat. Unless it brings in a lot more institutional money, I’m not sure
organic growth – apart from appreciation of AUM in the market – will add up to much here. This
isn’t a tiny company anymore.
Now, the general rise in the market over time is a benefit to using other people’s money. Having
a royalty stream tied to assets under management where those assets are stocks that rise 8-10% a
year on average is what makes this a good business to be in. However, there will be periods –
sometimes, 15-year periods possibly – where the nominal value of a stock portfolio will not
increase at all. There is such a thing as a bear market, a sideways market, etc. In such markets,
this could be a very low growth company.
It doesn’t make sense to assume growth here will be tied to anything other than organic growth
in net existing client inflows, new client wins net of client losses, and market return of the
underlying portfolios. The portfolios here are – compared to most of these kinds of super high
net worth asset managers – skewed more towards stocks and skewed more toward value. I’d
certainly rather be invested in a value stock manager than a bond manager. But, can we really
expect market appreciation to add more than 5% a year to AUM over time measured from
today’s market prices forward?
I’d say no.
So, if all goes well, maybe you get growth of 5% a year in the market plus 3% a year or so from
a combination of new client wins and net inflows from existing clients (getting more of their
business, Silvercrest often doesn’t manage all of a client’s money).
That’s a decent growth stock (8% a year). But, that’s if everything goes well. With companies
like this, you also have to assume that a lot of that growth is going to be diluted away with these
B shares being issued to employees of the firm. Like I say with investment banks, ad agencies,
etc. – these things are run for employees first and shareholders second. You just have to accept
that if you’re going to invest in any asset manager.
Based on the stock price and the past growth of this company – it’s attractive. You have
something priced at a level that is equal to or less than the overall market (remember, the overall
market is pricey). And yet it has historically grown much faster than the market. This is also a
business – and an industry – where returns on capital are so high that growth is effectively free.
As a result, growth (when combined with high returns on capital – that is, low earnings retention
needs) creates a lot of value. So, if this company turns out to be a much bigger grower than I
expect – it’ll turn out to be a terrific stock to own.
Another way of analyzing this thing could be to look at the dividend. For a variety of reasons, I
think the dividend can give you some feel of management’s idea of what long-term normal
earnings are. There isn’t a need to retain a lot of earnings. They do acquire things from time-to-
time. But, that’s about it. Right now, the dividend is running at an annual rate of $0.64 a share.
That’s a yield of 4.3%.
That’s probably about the yield you could get on junk bonds right now. It’s a really good yield.
And there is no indication to me that it’s an especially onerous dividend given the company’s
cash and debt position, the rents it has to pay, fixed compensation expense, and likely AUM tied
fees. If this is as sticky a business as it has appeared to be in the past – that’s actually a pretty
high dividend that is likely to grow over time. If I was to value this one just based on the
dividend, I’d have to admit there aren’t many – in fact, I don’t know if there are any – stocks
with a dividend yield that high where the business prospects look as good as they do here. This
may be one of the best businesses you can find today with a yield of 4% or higher.
Also, the dividend yield shows you don’t need a lot of growth here. Even if they could just
manage 3-4% a year growth over time, that growth plus the dividend yield would be very
competitive with the returns you can get in the market going forward. If they can get some
market appreciation too – this could perform well. I’ve seen cheaper asset managers. But, I don’t
know I’ve seen asset managers I liked better.
I don’t have a clear opinion on management here. Again, because of the client base this company
serves – this isn’t a company I can get much scuttlebutt type information on.
And without some scuttlebutt, Silvercrest would be a hard stock purchase to ever pull the trigger
on in a big way.
 URL: https://focusedcompounding.com/silvercrest-asset-management-samg-a-4-
dividend-yield-for-an-asset-manager-focused-on-super-wealthy-families-and-institutions/
 Time: 2021
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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
Stella-Jones mainly provides large customers with pressure treated wood under contractually
decided terms. The customers are mainly: U.S. and Canadian railroads, U.S. and Canadian
electric companies, U.S. and Canadian phone companies, and U.S. and Canadian big box
retailers. Stella-Jones has some other sources of revenue – like selling untreated lumber and logs
– that provide revenue but no value for shareholders. The company also has some more niche
customers – probably buyers for using wood in things like bridges, piers, etc. – that probably do
provide some profit, but not profit meaningful in scale to the categories of customers I mentioned
above. The company also sells some stuff that I’d consider more or less byproducts of their main
business. Everything they do is clearly tied to either wood or the treatment of wood. Because
there is less information about the smallest product categories the company sells and because
those categories are either low or no margin or are probably too small to move the needle for
making a decision about whether or not to buy this stock – I’m going to pretend Stella-Jones
sells only 3 things: 1) Ties to U.S. and Canadian railroads, 2) Poles to U.S. and Canadian electric
and phone companies, and 3) Pressure treated wood (for outdoor decking, etc.) to U.S. and
Canadian big box retailers.
First, let’s discuss the economics of this business. One: the first two categories – railroad ties and
utility poles – are super predictable, because the U.S. and Canada already have basically all the
railroad ties and utility poles they’re ever going to need. What these countries need is simply
annual replacement of those products. These are long-lived assets. On average: a utility pole can
go 65 years before needing to be replaced. Railroads and utilities can defer replacement due
purely to age. But, why would they? This isn’t the most expensive form of cap-ex to spend on.
Eventually, network performance will degrade if they don’t maintain this stuff. And these are
usually very, very creditworthy customers. They don’t have to rely on short-term borrowing
from banks. Stella-Jones’s most important customers can all issue long-term bonds to raise the
capital needed to fund not only normal maintenance projects but even growth cap-ex. So, there
could be some cyclicality here. But, it’s probably a lot less than you’d think. It’s going to be far,
far less cyclical than companies like suppliers of newer technology products to utility and
telecom customers. It’s going to be a lot less cyclical than suppliers of locomotives to railroads.
Although technically Stella-Jones is clearly selling a physical (and pretty much commodity)
product to these customers – the economics here are going to look a lot more like they are being
paid to maintain something on behalf of their customers. They’re providing a constant supply of
replacement parts.
The physical scale of Stella-Jones and their customers is possibly a lot bigger than you might be
thinking. What I mean by this is that the company moves a large physical volume of actual wood
being sold compared to what you might guess from a company with market cap, revenues, etc. of
this size.
I did some back of the envelope type estimating of what a utility pole (basically, what you’d call
a “telephone pole”) costs and what a railway tie costs. My best guess was that a utility pole can’t
cost more than about $700 to $750 on average and a railroad tie probably does not cost more
than $50 on average. If a utility pole costs $700 to $750 on average and lasts 65 year, then the
annual spending by a utility on replacing its poles works out to just $11-$12 a pole. For
accounting purposes, the Union Pacific (UNP) railroad assumes a 34-year lifespan for its ties. If
we assume railroads pay something like $50 to $55 (at most) per tie, we’re talking about $1.47 to
$1.62 spent per year per tie. Let’s call that $1 to $2 per tie per year. Of course, I think railroads
spend more per tie than that and I think utilities spend more per pole than that – I just think they
spend it on stuff like the labor used to remove, replace, maintain, dispose of, etc. the poles and
ties.
It’s also worth mentioning that this stuff has to be moved. And it’s not light. So, the location of
the wood has to be important in terms of how close the timber is from where it’s going to be
treated and then how close the treated wood is from where the customer needs to replace a pole,
tie, etc. Stela-Jones includes a map of their facilities. The map looks like what you’d expect to
see if a company was siting its facilities near where it was sourcing the timber from. The value of
this stuff has got to be low compared to the distances it is traveling. I also think it can’t be all that
high versus the labor used by the customer to actually replace its poles and ties once the wood
product is on site. So, I don’t think that the cost of what Stella-Jones is charging – setting aside
all the freight costs involved – is necessarily as high versus the true cost to the customer as you’d
expect with a commodity. The actual “all-in” cost to the customer probably depends mostly on
just generally what fuel costs are at the moment (this is the cyclical element of transport costs),
the distance the replacement wood has to travel, and the labor and other related costs of
removing the old pole, tie, etc. and replacing it with the new pole, tie, etc. The economics for
Stella-Jones are a little different. Let’s get into what I think matters most to them.
One, I think it’s important that Stella-Jones be able to pass on inflation to their customers. This is
easiest if they have long-term contracts with purchase prices indexed to inflation and where unit
demand doesn’t vary much from year-to-year. I think they have this in both utility poles and
railway ties. Utility poles are 34% of the company’s sales (and probably more of their profits)
and railway ties are 32% of their sales (and, again, probably more of their profits). I don’t think
they have this in residential lumber sales (this is selling pressure treated wood to big box
retailers). That’s 22% of their sales. It has grown over time. The contracts in that business are
short-term (like one year, so not much of a contract at all). And unit demand in that business is
more cyclical. Even if it consisted purely of homeowners replacing an existing deck or
something – which it doesn’t – homeowners don’t have the balance sheets and rational, long-
term outlook that utilities and railroads have. Homeowners are more likely to carry out
replacement projects when their confidence is high, their income is rising, home values are
rising, they have easy access to credit, etc. It’s a more cyclical business. And, of course, no
matter the creditworthiness of the big box retailers – they have no interest in buying a lot of
wood inventory they can’t sell this year.
This brings me to what I think are the biggest two determinants of Stella-Jones’s future returns
on equity, value creation in the stock, etc. Number one is how much inventory of unseasoned
wood the company keeps on hand. Number two is the company’s cost of financing that
inventory. It can take up to 9-months to air season the wood Stella-Jones is treating and selling to
its customers. This time lag is unavoidable. And the company isn’t going to be able to get its
suppliers to extend it more than 9-months of credit to purchase this wood. I say “more than 9-
months”, because you have to remember that big utilities, railroads, and big box retailers are
going to expect their suppliers – like Stella-Jones here – to extend them some credit. These
customers don’t pay in cash upfront. You can see the problem here. It’s entirely possible a
company like Stella-Jones could end up owning inventory for as long as 3-4 quarters. That can
be very rough from a free cash flow perspective. You need to generate cash to cheaply finance
your business. And shareholders need good cash returns on invested tangible assets to drive
compounding of the per share value of the stock over time. Stella-Jones has a clear record of
compounding its share value, its dividends per share, etc. over time. So, something is working
here. But, how?
Stella-Jones borrows money. And I think they have to. They don’t literally have to. The business
does generate free cash flow that is perfectly sufficient to finance the company’s growth at rates
even faster than the organic growth in the industries they serve. So, Stella-Jones could grow its
market share over time and produce a profit for its shareholders every year without ever
borrowing. But, I’m not sure Stella-Jones stock can convincingly beat something like the S&P
500 index over time unless the company borrows a bit. Right now, it is borrowing about 2 times
EBITDA in net debt. That’s a little on the low side compared to what it’s done in the past. The
company has often operated with 2-3 times net debt to EBITDA. Just reading about this
company’s business – before getting into how much they are actually borrowing and on what
terms – I would’ve told you the right debt load for this company was probably 3 times net debt to
EBITDA. I still think that’s true. I have one caveat: the larger the residential lumber business
gets, the less comfortable I am with Stella-Jones constantly operating with that much debt. But, if
the business was purely one of selling utility poles and railway ties – I’d say permanently
targeting a leverage ratio of 3 times net debt to EBITDA would make the most sense.
I’m not sure I’d want to buy this stock if I thought management would operate it without debt.
Clearly, management has no plans to operate without debt. But, I just want to make that point
here – because, normally, I am writing up a stock where I’d be perfectly happy to own the
business if it never used a penny of debt. Here, I think I’d need to feel sure management will use
debt. Otherwise, I just don’t think the business will generate enough free cash flow versus the
amount of money shareholders have put into the stock to be assured of a good outcome here
versus the market. I don’t think you can buy and hold this stock forever and meaningfully beat
the market without Stella-Jones using some debt. Which it will. So, this isn’t something to worry
about.
But, it does bring me to price. When a company earns relatively low unleveraged cash returns on
its tangible invested capital – I think a prospective stock owner needs to be very, very careful
about the price he is willing to pay for the stock. Right now, the stock trades at nearly 2 times
book value. And some of that book value is goodwill and intangibles from all the acquisitions
this company has done. Could it be worth 2 times book value? Or: more than 2 times tangible
book value?
Sure. I think it could. In fact, I think that optimally run from a financial engineering perspective
– Stella-Jones is worth 2 times tangible book value or more. Still: I’m not sure how comfortable I
am paying more than tangible book value for a business that doesn’t actually generate very high
returns on its tangible invested capital.
Why am I cautious about that?
Well, Stella-Jones is certainly less cyclical than Monarch Cement (MCEM). They are both
extremely durable. Monarch might be a little more durable. But, Stella-Jones might be a little
less risky. It faces much less price risk. I didn’t get into that here, but the company is making
most of its money under 3-10 year contracts that include automatic price escalations such that
close to two-thirds of the company’s business is more like a “cost plus” business except insofar
as it has to actually carry inventory. I don’t think a cost plus type business where you have to
hold all that inventory is ever going to be as good as a pure cost-plus service business. But, it’s
still very good. I think the economics of Stella-Jones are probably better than the overall
economics of Monarch Cement. However, I actually don’t know that the economics of Stella-
Jones are better than the economics of just the cement plant in Humboldt, Kansas that Monarch
owns. I actually think that over a full cycle, the cement plant alone may be a better investment
than Stella-Jones. But, I could definitely see how an investor would prefer Stella-Jones over
Monarch Cement. And, honestly, at the exact same price-to-tangible book value ratio – I think
I’d prefer Stella-Jones to Monarch Cement.
But, we have to ask why? Why would I prefer Stella-Jones to Monarch Cement?
The answer is financial engineering. Which is a fine answer. But, it’s not usually the bet I like to
make. I don’t usually like to bet on management achieving good corporate level results for
shareholders through making smart decisions about getting a low cost of capital and then making
smart capital allocation decisions.
There are really just 2 reasons for preferring a stock like Stella-Jones to Monarch Cement. One:
Stella-Jones will use leverage while you own the stock – Monarch won’t. Two: Stella-Jones will
continue to acquire more companies in its industry – Monarch Cement won’t. Stella-Jones is
obviously the better perpetual motion machine here. The stock is likely to be a better
compounder over time than Monarch Cement. However, I don’t think that has as much to do
with the actual assets of the business as it does with who is running the business. The strategy at
Monarch is extreme conservatism and no expansion. The strategy at Stella-Jones is constant use
of debt and constant expansion. In the long-run, I expect Stella-Jones stock to outperform a stock
like Monarch Cement. However, I just can’t pay a premium purely on the basis of someone
leveraging up a business and acquiring stuff on my behalf. I said this in the Sydney Airport
write-up. But, I’ll say it again here. I don’t recommend it. But, if you have a stock portfolio
consisting mostly of liquid S&P 500 type stocks and you’re worried Monarch Cement isn’t using
enough leverage – you could always borrow against the blue chip stocks you have to finance a
stock purchase of Monarch Cement that is done on terms (for you, the shareholder) that aren’t all
that different than if you bought the stock outright using cash but it was leveraged at 3 times debt
to EBITDA. What I mean is: I think investors tend to ignore the fact one business isn’t using
debt and another is in a way they wouldn’t ignore if they were buying one stock on margin and
another without using margin.
At the same price-to-book, I’d definitely prefer Stella-Jones over Monarch Cement. At the big
premium at which Stella-Jones now trades, I think I’d pass on the stock for now. I’m not sure if
that’s wise. But, I think I can find other businesses that will produce similar returns – as stocks –
to Stella-Jones while using zero debt to do it.
Possible Revisit Price: 19 CAD (down 52%)
 URL: https://focusedcompounding.com/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/
 Time: 2019
-----------------------------------------------------
Sydney Airport: A Safe, Growing and Inflation Protected Asset That’s

Leveraged to the Hilt
Today’s initial interest post really stretches the definition of “overlooked stock”. I’m going to be
talking about Sydney Airport. This is one of the 20 to 25 biggest public companies in Australia.
It has a market cap – in U.S. dollar terms (the stock trades in Australian Dollars) – of about $13
billion. It also has a lot of debt – including publicly traded bonds. So, not what you’d normally
consider “overlooked”. On the other hand, Andrew and I have a couple standard criteria we use
(low beta and low share turnover) to judge whether a stock might be overlooked. And Sydney
Airport happened to score just barely well enough on these two measures of “overlooked-ness”
that it wasn’t automatically eliminated by our screens. For this reason, I left the stock on a
watchlist that went out on our email list. While a lot of people mentioned the stock definitely
wasn’t overlooked – a lot of other people also mentioned they’d like to hear my thoughts on the
stock. So, here they are.
Sydney Airport was suggested to me by my former newsletter co-writer Quan Hoang. He’s from
Vietnam originally. And he’s now spent time in Australia. He was looking at stocks and sent me
over some financial data of Sydney Airport. A few things jump out about this company
immediately. One: it pays out basically everything it can afford to in dividends. Two: it uses a
high amount of debt (close to 7 times Net Debt/EBITDA – at one time that number was closer to
11 times Net Debt/EBITDA). However, this isn’t a distressed company in any way. The debt is
spaced out – about half of it matures within the next 5 years and the other half after the next 5
years. The bonds are rated by Moody’s and S&P. Sydney Airport intends to maintain an
investment grade rating. That’s usually not easy when you have well over 6 times Net Debt /
EBITDA. But, this is an airport.
The problem with the debt here is not solvency risk. It’s that the stock price with the debt added
– so, the enterprise value relative to various earnings power measures – creates a pretty high
future growth hurdle that needs to be cleared. On a dividend yield basis, the stock looks cheap. It
yields 4.3%. However, you need to be careful with that number. Consider, for example, Vertu
Motors in the U.K. It also yields 4.2%. But, instead of having more than 6 times Net Debt /
EBITDA – it has basically no net debt. It also pays out only about 1/3rd of its earnings as
dividends. I’m not saying Vertu Motors is a better stock than Sydney Airport – though, at this
point, I do own Vertu and don’t own Sydney Airport – but, I am saying that it’s a lot easier for
Vertu to cover its dividend and grow it over time than it is for Sydney Airport. Basically, if
Sydney Airport doesn’t want to increase its Net Debt / EBITDA ratio above 7, it can only grow
its dividend at the same rate as it grows its cash flows per share. It also has the risk of failing to
grow the dividend as fast as shareholders might like if the interest rate Sydney Airport has to pay
on its debt rises, if the taxes Sydney Airport has to pay increases (which it will in a couple
years), etc. So, Sydney Airport might be cheap enough to buy. But, you can’t tell that by looking
at the dividend yield only. If Sydney Airport was already a full tax payer (it doesn’t yet pay cash
taxes) and had no net debt at all – it’d be very easy to predict high growth in the dividend for a
long time to come.
One way I like to talk about stocks is by working backward from how much they are paying you
today and figure out how much they’d need to grow to beat the market. A lot of people reading
this are going to want 10% or better returns from a stock. Certainly, if you’re buying something
where the debt is rated as pretty low investment grade and there is more than 6 times Debt /
EBITDA – you want to be compensated for the financial risks you’re taking. It seems logical that
– given how leveraged the common stock is – you’d expect double-digit type returns. What
would it take for Sydney Airport to deliver that?
If the dividend yield is 4.3%, then just taking 10% minus 4.3% equals 5.7% a year growth in the
dividend is a pretty good guess. If Sydney Airport can pay you a 4.3% dividend yield while
growing that dividend by about 6% a year, the stock price should also be able to grow by about
6% a year. The result would be a better than 10% return for a shareholder buying today and
holding for the long-term. How realistic is a 6% or better growth rate in cash flow available for
dividend payout per share?
Based on Sydney Airport’s past record, it’s achievable. It’s also achievable based on the targets
set in the company’s bonus program. Executives receive some additional compensation once
Sydney Airport increases cash flow per share by 8% a year. The bonus – for this part of the
program that’s tied to cash flows – maxes out at a 12% annual growth rate in cash flow per share.
The measurement period is over 3 years. Sydney Airport admits these are aggressive goals in
fitting with the company’s “high performance culture”. So, I wouldn’t take those numbers as
some sort of easily achievable guidance. But, it’s entirely possible that the price of Sydney
Airport stock will grow by about the same rate as the cash flow per share will grow by. So, if
they do hit 8-12% cash flow per share growth while you own the stock – you might make 12% to
16% a year in total return, because you get stock price appreciation of around 8-12% plus a
dividend of more than 4%. Remember, because Sydney Airport targets what is basically a 100%
payout ratio of truly free cash flow – you’re going to see the dividend yield rise along with the
stock price to the extent the stock price doesn’t grow faster than the underlying cash flows per
share.
We can also look at the company’s past. Over the last 30 years, passenger numbers grew by
more than 3% a year. Sydney Airport has a 20-year plan in place to help guide its long-term
capital spending needs. That plan envisions 2% a year growth in passenger numbers over the
next 20 years. Inflation in Australia has often been around 2% a year recently. If you assume that
Sydney Airport’s revenues tied directly and indirectly to passenger traffic pretty much
automatically escalate with inflation – the company strongly suggests this at several points in its
annual report – then, we’ve already hit a 4% expected growth rate in revenues for the next 20
years. Actually, the plan suggests better than 4% revenue growth. This is due to a shift in
passenger mix. Sydney Airport currently gets a lot of domestic passengers. The airport serves
more domestic passengers than international passengers. However, the international passengers
produce more revenue (and more profit) per person. So, Sydney Airport already gets about half
its revenue, earnings, etc. from things tied to international passengers despite the company
mainly serving domestic passengers. Over the next 20 years, the company expects that
international passenger growth will be higher than domestic passenger growth. By the end of the
20 years, the airport will be serving at least as many international passengers as domestic
passengers. If the relative contribution from each additional domestic passenger and each
international passenger stays the same over these 20 years – REAL revenue would actually grow
faster than the growth rate in passengers. For example, it’d be possible for Sydney Airport to
grow passengers by 2% a year, have 2% inflation and yet actually have 5% or greater nominal
revenue growth because more and more of the passengers moving through the airport were
international passengers.
Why do international passengers contribute more to Sydney Airport’s earnings than domestic
passengers? There are a few possible reasons. One is retail. The company’s international
terminal has a lot of high end shopping. The “dwell time” for international passengers is
significant at 2 hours and 13 minutes. International passengers have a lot of time to kill and can
do so by shopping, buying gifts, eating, etc. They may also be more likely to use the company’s
hotels. Sydney Airport only has a little over 300 hotel rooms. However, occupancy is very high
(recently 88%). And the average stay is very short (0.8 days). The airport wants to more than
double its available rooms. These are “non-aeronautical” reasons why international passengers
would be more profitable. It’s also possible that Sydney Airport directly makes more money off
international passengers than it does domestic passengers. The company has contracts with
airlines that usually provide for a payment per passenger using the terminal, airport
infrastructure, etc. Some contracts instead require payment based on the maximum weight of an
aircraft using the airport. This brings me to a side point. It’s clear that at least in the most recent
year, Sydney Airport handled more passengers without handling more planes. My best estimate
was that the number of passengers per plane actually increased about 3%. Again, it’s possible
that the number of passengers per plane on an international route could be higher than the
number of passengers per plane on a domestic route. If true, this would mean revenue per plane
would be higher on international than domestic. It’s also likely that the profit per plane
discrepancy might be even greater too. Calculating marginal “profit” versus marginal “revenue”
for Sydney Airport is tough. A lot of times – I think marginal revenue basically falls to the
bottom line. Expenses are often fixed. Cap-ex is the big cash expense. The company actually
employs very few people. My estimate was that between 98% and 99% of the people working at
Sydney Airport are employees of others – airlines, government, retailers, restaurant operators,
outside contractors, etc. – rather than Sydney Airport’s own employees. The company makes
about half of its money fairly directly from “aeronautical” sources. These are more direct fees
paid by airlines. The other half is “non-aeronautical.” However, I still think non-aeronautical
sources of profit are basically driven by passenger volumes – just a bit less directly. At several
points, the company makes it clear that things like hotel revenue, parking, etc. are ultimately
driven by passenger numbers. There are things you can do to tweak the dining, shopping,
advertising, etc. sources of revenue to extract a bit more profit per passenger (perhaps especially
by optimizing for international passengers). However, all of these things are ultimately tied to
traffic figures too. Advertisers want a certain number of eyeballs. Restaurants, retailers, etc. want
a certain amount of foot traffic. This is what drives rents. So, even where – as is often the case –
Sydney Airport gets minimum guarantees from tenants that ensures the airport will collect a
certain amount of rent even if the sales of the tenant are disappointing, I still think long-term
minimum guarantee levels will tend to track passenger traffic trends. Tenants will accept higher
minimum guarantees when they feel they know they can count on a minimum level of traffic
passing right by their stores, restaurants, etc.
So, it all comes down to passenger levels primarily. Secondarily, there’s the mix of domestic
versus international – with international being preferable. But, then there’s the big question of
operating leverage (and financial leverage too). If Sydney Airport’s costs are relatively fixed
whether passenger traffic grows 1% a year, 2% a year, or 3% a year – then, hitting 3% instead of
1% would make a very big difference to the company’s cash flow per share growth. Except to
the extent the company’s bond ratings change or interest rates rise or fall – we know debt service
will be fixed. So, as a common shareholder who is only entitled to the payment of dividends after
the bondholders get their interest – it matters a great deal whether passenger traffic grows 1%,
2%, or 3%.
Basically, Sydney Airport looks like a very highly leveraged – both operationally and financially
– bet on international passenger growth in Sydney. This might be a good bet. But, we have to
rely on expectations formed based on what the company is telling us. The company is using an 8-
12% cash flow per share growth rate for its incentive compensation targets. The 20-year plan is
for 2% annual growth in passengers with more new passengers being international than
domestic. I can easily imagine that – after inflation, benefits of passenger mix, etc. – Sydney
Airport experiences 5% or better annual revenue growth for the next two decades. Expenses –
other than financial expenses like additional interest payments and taxes – won’t grow as fast as
5% a year. So, cash flow per share should compound at a greater rate than any revenue growth
expectations I have.
If I assume the company can maintain its multiple (of 23 times dividends) and its debt load (of
almost 7 times Debt/EBITDA), I’m already projecting numbers here that will give shareholders
10% or better returns over the next 20 years. That sounds like a great stock to buy.
But…
I do have concerns. I don’t think I can easily predict what interest costs will be for the next 20
years. I don’t think I can easily predict what cash taxes will be for the next 20 years. And I do
think there’s a real risk both can be higher than they are now. I also think that under tighter credit
conditions globally, there’d be more pushback by ratings agencies and bond investors against
something even as stable as an airport carrying nearly 7 times EBITDA in debt. So, I’m not sure
Sydney Airport bonds won’t be junk rated at some points in the next couple decades. They might
be.
So, let’s talk about the price here on an unleveraged basis. I’m going to do something strange
here and use U.S. dollars, because it’s a lot easier for most readers of this article to think in USD
than in AUD. At the moment, one Australian Dollar is equivalent to about 68 American cents.
Sydney Airport has about $6.5 billion (USD equivalent) in debt. It has around $13.5 billion
(again, USD equivalent) in market cap. That’s an enterprise value of a little over $20 billion
(USD). What are passenger numbers today? What are passenger numbers expected to be in 20
years?
Sydney Airport currently has passenger traffic of about 44.4 million a year. It expects to have
65.6 million passengers in 2039. This is a 2% annual CAGR in passenger volumes. But, what I
want to look at here is the price you’re paying – on an UNLEVERAGED BASIS – for an annuity
on passenger traffic at Sydney Airport.
We can think of this as paying about $20 billion (USD) divided by 44.4 million passengers
equals a purchase price of about $450. Now, about $300 of that price is paid by the shareholder.
The other $150 is paid by borrowing. But, still – let’s just look at this as paying $450 today for a
perpetual profit annuity on each passenger passing through Sydney Airport forever. You can
check my math by seeing that Sydney Airport has a price in AUD of about 9 right now – which
is around $6 a share in USD. Shares outstanding are 2.26 BILLION (in a recent Instagram, I
misspoke and did some math as if Sydney Airport had 2.2 MILLION shares outstanding – it’s
2.2 billion). So, the number of passengers you get per share you buy is 44.4 million / 2.26 billion
= 0.02 passengers. You need to buy 50 shares of Sydney Airport stock to buy just one full
passenger. That’s 9 AUD times 50 equals 450 AUD (which equals about $300 USD). But, that’s
just the equity portion of the purchase price. The company also has over 9 billion AUD in debt
(which is over $6 billion USD in debt). This is about another $150 USD per passenger in
borrowed price. So, you are buying a passenger at Sydney Airport by putting up $300 USD of
your own money and assuming $150 USD of debt on top of your shares.
Is this worth it? Is it worth paying $450 USD for a single airport passenger? Maybe. It’s possible
an airport could make around $15 (USD) per passenger right now. And I really do think that a
passenger passing through an airport can be viewed as an annuity that will grow by at least
inflation. Then, the actual real volume of passengers is also growing. So, you’re paying $450 for
a current passenger that is growing their nominal coupon paid to you at more than 4% a year. I
think this is a very well protected number inflation wise too. If inflation goes from 2% to 10% a
year by the end of the next 20 years, I think the amount Sydney Airport makes per passenger
passing through the airport will be growing at a lot closer to 10% a year than 2% a year.
Still, what I just laid out there is obviously a very, very high price. When you count the debt as
part of the purchase price – you’re valuing this perpetual passenger annuity that might be starting
around $15 and then rising from there at a very, very high price ($300 of equity plus $150 of
debt).
Absent my concerns about higher interest costs and higher taxes in the future – this stock looks
fine on a leveraged basis. As long as Sydney Airport doesn’t keep deleveraging, I think the
common stock could – even at today’s price – beat other stocks you might buy. I think it can
keep doing that even over a 20-year holding period. But…
I think there are risks with things like interest rates that need to be considered. As safe as this
asset is, I don’t think that something expected to return 10%+ as a stock for the next 20 years
while having nearly 7 times EBITDA in debt for all those years is really the same thing as a
stock priced to return 10% a year for the next 20 years while never having any debt.
One way to think about this is simply to consider the level of debt here versus the price of the
stock. At the moment, we’re talking about a stock price I consider to be about priced right to
deliver adequate returns that will beat the market. We can sort of treat the stock as being very
closely to fairly valued. If that’s true, you are buying into this company using 2 parts equity (at
the current market value of the equity) and 1 part debt.
I can’t deny Sydney Airport is a super safe asset, business, etc. when compared to other stocks
that are priced to deliver 10% or so returns for the next 10-20 years. But…
Think of it this way. What if you put $100,000 into a stock you considered very, very safe using
$65,000 of your own money and $35,000 worth of a loan from a broker. Could you – given
where interest rates are now – leverage up that position to the point where a safe underlying asset
was returning about the same as Sydney Airport stock is priced to now?
I think the answer to that is yes. So, I’m not going to say Sydney Airport is too risky. I’m just
going to say it seems as risky to me as buying a very safe stock using $2 of your own capital and
$1 borrowed from a broker. There are people who do that successfully long-term. And you may
be very successful simply buying Sydney Airport stock now – without adding any margin of
your own – and holding it long-term.
I just think the attraction here for people is in large part the amount of debt the company is using
on your behalf. It’s true the company is borrowing for an average of 5 years (not a margin loan
that can run into collateral problems through daily marks to market) but I just see this as being
too similar to buying a safe asset using margin to get a market beating return.
I like the business. And I’m actually okay with this amount of debt – though, as always, I’d
rather they were spacing it out further than just 1-10 years mostly – if the common stock behind
the debt is very cheap. Here, I think the common stock is neither shockingly cheap nor
expensive. And I think there’s a lot of debt ahead of it.
It’s probably a mistake to pass on Sydney Airport stock. If I was managing billions of dollars –
maybe I wouldn’t. But, I’d just rather find things that offer similar returns without using so much
leverage to do it. This reminds me too much of buying a safe asset on margin to beat somewhat
less safe assets bought without leverage (the index).
So, it’s a pass for now.

Possible Revisit Price: 4.50 AUD (50% lower)
 URL: https://focusedcompounding.com/sydney-airport-a-safe-growing-and-inflation-
protected-asset-thats-leveraged-to-the-hilt/
 Time: 2019
-----------------------------------------------------
F.W. Thorpe: A Good Business Making Durable Products that May Have
Already Peaked
Today’s initial interest post is a company I like a lot. It’s trading at a price that could be
justifiable – possibly – based on that company’s past performance. But, it’s not a stock I’m going
to give a very high initial interest level too. The reason for that is uncertainty about the future.
I’ll get to that uncertainty in a second. First, I want to describe what FW Thorpe does. The
company makes lights. I won’t go into too much detail here. You can always read a company’s
annual report for yourself. So, I hate to go into analysis free re-hashes of a company’s basic
business model. I’ll do that a little here, though, because I don’t want you to think FW Thorpe
makes light bulbs for your house.
The company’s focus in on professional lighting with the lowest cost of total ownership. It
makes lights for everything from clean rooms to warehouses to retail shops. FW Thorpe’s
products are used for street lights, in tunnels, up on the ceiling of the office you may be working
in now (though, if you’re not in the U.K. or the Netherlands – it’s a lot less likely that’s an FW
Thorpe product). The company also makes lighting for emergency signs. It has a business unit
that seems to me to be focused on making emergency sign lighting that complies with
regulations while looking aesthetically pleasing (the customers all seem like locations that care
about the look of the interior of their building). Some lighting is used to illuminate
advertisements and things like that. It’s a whole variety of professional lighting where the main
focus is not having the cheapest initial purchase price. It’s about what the lighting does and how
little it’ll cost you in electricity bills, replacement, etc. over many years into the future.
Basically: FW Thorpe makes lights. Decades ago, lighting was not a very durable product. But,
that changed in recent years. Unfortunately, not so recent that we’re still in the middle of this
shift from more disposal lighting to more durable lighting. What was once often fluorescent (and
incandescent) lighting became LED. As you probably know, a lot of governments put in rules
phasing out incandescent lighting. Many of these rules were put in place anywhere from 5-15
years ago. So, again – we’re talking about a tailwind that was stronger in the past than it will be
in the future.
I’m sure there are people reading this who know more about the lifespans of incandescent,
fluorescent, and LED lights. But, from what checks I could make – it seems that a typical LED
light can have a life as much as 10 times that of a typical fluorescent lamp. I was, however, able
to find references to some fluorescent lamps designed to have similar lifespans to LED lights.
So, companies have probably always been working on extending the lifespan of any of these
types of lighting. For us as investors here – the problem is that Thorpe’s results show an upgrade
cycle where they went from having like 3% of their lighting be LED to now having more than
90% of the lighting be LED. The company also says we’ve reached “peak LED” in the sense of
new sales. Sure, the installed base of LED lights may grow over time. But, given the long
lifetime of LED lights and the young age of many of the newly installed ones – there will no
longer be a need for the world to buy as many LED lights in any one year. This is the familiar
problems faced by all sorts of consumer innovations from radios to TVs to flat screen TVs to
smartphones to even things like memory foam mattresses. If a large number of people adopt
these things for the first time – sales spike. But, these products aren’t like energy drinks. There’s
no need to keep buying them each year. So, for companies – like Thorpe – that produce a durable
“new” product, annual sales may peak long before there’s 100% adoption. In essence, the
lifespan of LED lights may be so long that although the population of LED lights will grow each
year – the number of new “births” will decline. In fact, Thorpe has already said it has. This
doesn’t necessarily mean that Thorpe’s sales will decline. Their annual report is sort of hopeful
about possible record sales being hit again sometime soon. However, that record would be hit
through market share gains, a business they acquired recently, product line extension, additional
innovations, some sort of “smart” non-lighting stuff being added to their lights, etc. Nothing the
company has said suggests that actual demand for LED lights as providers of light will increase
overall in the years ahead. So, Thorpe may be an excellent organization. In fact, I think it is. But,
the past record and the current stock price don’t really add up to something you’d want to buy if
the industry overall is so mature that it may continually decline in the future.
Let’s walk through some of those numbers. We’ll start with the one that concerns me the most.
Thorpe’s valuation has risen at the same time the LED market has matured. Basically, the stock
has been recognized as having a growth stock past at a time when it may not have a growth stock
future. Before the fallout from the financial crisis – in fiscal years ended during the calendar
years of 2006, 2007, and 2008 – the company was growing EPS at more than 15% a year with a
P/E of less than 13. Sometimes it was growing quite a bit faster than 15% a year. And sometimes
the P/E ratio got far below 10. But, that’s cherry picking certain years. If we just go with the
general tendency: it’s clear you could’ve often bought this stock on any random day with a year-
over-year EPS growth rate of 15% or better and a P/E of 13 or lower. Basically, Thorpe was an
unrecognized growth stock. The record over the last 10 years is not as clearly that of a growth
stock. It’s fine. At times, it’s good. Growth in 2015-2017 or so looks very solid, for example.
But, things like the P/E ratio are as high as ever now. The P/E has been 20-30 times for much of
the last 3 years. Now, there are stocks that deserve P/E ratios of 20-30 times. For example, I’ve
talked about OTCMarkets (OTCM) before. But, Thorpe is not that kind of company.
OTCMarkets converts a huge amount of its reported EPS into free cash flow. The company has
float. And it has almost no tangible assets. This leads to extremely high returns on equity. And
the returns I really care about – the actual amount of cash generated for shareholders this year
versus the amount of equity in the business – is sky high. That’s not the case at Thorpe. It has
had free cash flow conversion over the last 10-15 years in a range of like 50% to 100%. I’m
excluding some outliers. What’s important though is the timing of the high conversion years.
Thorpe generally can’t have a series of years where it converts a high amount of EPS into free
cash flow while also growing EPS. That makes sense. It’s true for most companies. The more
you need to grow next year and the year after that – the more you need to retain and invest in
additional inventory, receivables, property, etc. instead of taking out of the business in cash.
There’s nothing wrong with this. But, it’s very important to understand the kind of difference
this makes to valuation. If one company can grow 4-5% a year while having a 4-5% free cash
flow yield – it can match the market (return 8-10% a year) even while trading at 20-25 times
earnings. This is true if – like at OTCMarkets – free cash flow and earnings are (when growing
that fast) awfully close to each other. This is not possible at a company like Thorpe. So, if
Thorpe has a P/E ratio of 20-25 and is growing EPS by 4-5% a year, it can’t also be converting
nearly 100% of EPS into free cash flow. I know this sounds like sort of a personal preference of
mine for companies that convert a huge amount of EPS into free cash flow. But, it’s a lot more
than that. It’s critical to understanding the appropriate valuation level for certain companies that
do both grow – but that have differing returns on equity. Thorpe’s return on equity is fine. But,
it’s nothing like OTCM’s return on equity. Historically, it has been about 13-21% a year (over
the last 10-15 years). That obviously adds value over time. But, it also means that growth is
costly enough that the company has to trade at a much higher price to free cash flow ratio than
price to earnings ratio. To put it the way I like to think: if Thorpe trades at like a 6% earnings
yield – it might only be trading at a 4% free cash flow yield. As I write this, the stock trades at 23
times earnings. That’s a 4.3% earnings yield. In an average year – that’d translate to less than a
3% free cash flow yield. This is where my concerns about “peak LED” comes in.
If Thorpe really is trading at a level that’s around a 3% normalized free cash flow yield – then, it
would need to grow about 7% a year to give a return of around 10% a year in the stock. This
isn’t exactly true if we’re thinking perpetually about a buy and hold forever stock. But, if we’re
thinking more realistically about say a 10-year investment case here – what I said is roughly
right. Thorpe’s P/E is 23. We can’t expect multiple expansion from here while we own the stock.
The multiple might even contract. So, the only return we’ll get is from cash generated by the
business and not reinvested in that business (true free cash flow that can be used to pile up cash,
pay dividends, acquire growth, etc.) and then Thorpe’s growth rate in that free cash flow. If the
stock’s price multiple is the same the day we buy and sell the stock and it also pays out, buys
back stock, etc. equal to 3% of our purchase price, we need 7% a year growth to get a 10% return
here. Now, it’s possible I’m being unfair to Thorpe here and the earnings yield and free cash
flow yield are actually more similar. So, Thorpe might have a 4.3% free cash flow yield. The
company’s 6-year growth rate in sales is like 12% a year. So, the past record easily suggests this
stock is a buy. If it keeps growing 12% a year and has a 4% free cash flow yield, it could return
16% a year while you own it without multiple expansion. And it’s not impossible – though I still
don’t like betting on it – that a stock growing 12% a year will have a P/E over 30 when you sell
it. So, the multiple could expand. But, Thorpe is warning us that LED lighting sales have peaked
and that growth at the company has to come from figuring out how to take market share, expand
into other countries (65% of sales are in the U.K. and another 10% in the Netherlands), add other
features to the lighting, etc. Overall, the impression the company gives is that the upgrade cycle
will be longer than in the past. The other concern is environmental. A lot of companies made the
switch to various Thorpe LED offerings for two reasons. One, they wanted the lowest total cost
of ownership (low electricity costs, less replacement costs, less maintenance, etc.). Two, they
wanted to go “greener”. This second part is a bit of a problem. It’s less purely rational than the
first part. It may be harder to successfully push for faster upgrades of existing products when
arguing only that a company can lower its total cost of ownership of the lighting. Companies that
weren’t using LEDs and now are using LEDs made a very visible switch to a greener product.
They saved on energy, yes. But, they also showed their commitment to environmental values in a
way they really can’t again. Thorpe talks a little about this in the annual report. And I think it’s a
valid concern. It may be something that better marketing on Thorpe’s part can overcome. They
may have to come up with better ways to explain the value of other benefits their newer products
can offer. Thorpe talks a lot about additional features – sensors basically – of some newer
lighting which can monitor the movement of people in the areas being lit, can monitor air
quality, etc. This is useful stuff. In some countries and some locations, it’s conceivable that
lighting could actually save a really big amount of dollars versus its cost if it did anything to help
better utilize labor. In developed countries – and Thorpe’s biggest market is the U.K. – labor
costs are very high versus electricity costs. So, reducing man hours even a little bit can be as
good as reducing megawatt hours by a lot. But, this is stuff that customers have to be sold on
through marketing in a way saving electricity and eliminating certain types of lighting didn’t
have to be. Customers were pre-sold on green. FW Thorpe needs to sell them on other kinds of
improvements. This is a very superficial judgment here – but, just reading about how Thorpe
presents itself, I was impressed by the company’s innovations based on knowledge of the
customer. I was less impressed by the company’s sales efforts. Compared to other companies
I’ve seen, Thorpe looks strong in tweaking products to meet very specific end user needs
(making things safer, simpler, easier, etc. for the organization actually using the lights). There
was a lot less information about how the company explained the benefits of its products in a way
that might stimulate additional upgrades and things like that.
Overall, FW Thorpe is an organization I like a lot. It’s something of a Phil Fisher company in a
few ways. It is overlooked (especially for a company of this quality). The company has been
around for more than 80 years and public for more than 50 years, but it actually went from the
London Stock Exchange to AIM many years ago. It’s largely family held. I think there is now
one great grandson of the founder involved with the company. The current co-CEOs (one has a
technical background, the other a financial background) seem to be the first non-family people at
the top here. There are a couple older Thorpe brothers with major shareholdings. The board is
quite simple too. The only committee they use is for remuneration (which is probably
unavoidable, because the co-CEOs are part of the full board). The full board takes care of other
issues without use of committees. It’s family controlled and simple. It de-listed from a major
exchange many years ago. Yet, it produces a great annual report. It uses a reputable auditor. I’m
not concerned about anything like that here.
I’m just concerned that this is too durable a product. There’s nothing wrong with a durable
product that has been mature for a long time. Cars are durable. But, almost everyone – as a
percent of the population – who wants a car has had a car for many, many decades. There just
hasn’t been much of an increase in the saturation of cars in the total population over the last 20
years. There has been in LED lighting. So, original equipment sales here would worry me in
much the same way they would with smartphones and memory foam mattresses and so on.
That’s not a problem if the stock is cheap, the ROE is sky high, etc.
I think FW Thorpe is a great organization. But, I also think it’ll take a great organization to grow
anywhere like 7% a year indefinitely in lighting now that so many LEDs have already been sold.
And I think that a stock as expensive as this one would require a growth rate of like 7% a year
far into the future to you give you market beating returns.
So, the current stock price is too high and the future growth trends for the overall industry too
low for me to consider this stock. Thorpe could grow through market share gains. It has a nice
looking collection of specialist businesses. It has a philosophy of not duplicating itself
competitively in the businesses it’s in. So, it basically buys stuff it wants to expand into and then
does its best to apply its expertise to those areas. It’s hard to be so positive on the organization –
and, it’s a great annual report I recommend everyone read – while at the same time being so
negative on the stock.
But, FW Thorpe is a pass for me.
 URL: https://focusedcompounding.com/f-w-thorpe-a-good-business-making-durable-
products-that-may-have-already-peaked/
 Time: 2019
-----------------------------------------------------
Transcat (TRNS): A Business Shifting from Distribution to Services and a

Stock Shifting from Unknown and Unloved to Known and Loved
Transcat is an interesting stock for me to write-up, because I probably have a bias here. Quan
and I considered this stock – and researched it quite a bit – several years back. We were going to
write it up for a monthly newsletter I did called Singular Diligence. All the old issues of this
newsletter are in the stocks “A-Z” section of Focused Compounding. And – you’ll notice, if you
go to that stocks A-Z section of Focused Compounding – that there’s no write up of Transcat
there. I’ve never written about the stock. Why not? Back then, Transcat was a somewhat smaller
company with a much, much smaller market cap. It didn’t do the kind of investor relations stuff
it does now. Quan and I could read what management was saying and see the company was
trying to move from being a distributor of test equipment to being a service company focused on
calibration. Quan and I MIGHT have bought the stock for our own personal accounts (I’m not
sure we would have, but I am sure we would’ve had an open mind about Transcat). But, those
Singular Diligence newsletters were 10,000+ words long. I didn’t see how we could gather
enough info on Transcat to write something that long. So, maybe it was a good stock. But, it
probably wasn’t a good newsletter issue.
How does that make me biased now?

Well, in the years since I chose NOT to write it up for Singular Diligence – Transcat’s
management did what they said they were going to do. The company has now transformed itself
from mainly a distributor of handheld measuring equipment to mainly a calibration service
provider. I don’t want to overstate this “mainly” part. If you look at each of the last two full
years, I think Transcat got something like 48% and then 50% of its revenue, operating profit,
EBITDA, etc. from the service segment and about the same amount from the distribution
segment. However, looking at this fiscal year – Transcat is only 6 months into it in terms of what
it’s reported so far – I’m getting a number for “adjusted EBITDA” (basically, EBITDA with
stock compensation added back – Transcat has a lot of stock compensation) that tells me about
60% of the company’s profit is now coming from the service segment. The other 40% is coming
from the distribution segment. That didn’t happen entirely due to a revenue spike in services and
a decline in distribution. Part of what has happened this fiscal year is something Transcat’s
management has been talking about for a very, very long time and only now really started to
deliver on: margin expansion.
Margin expansion is probably the key to deciding whether or not to invest in Transcat. Right
now, it’s a good and growing business. But, it’s not a great business. The company has never had
amazing returns on capital. It does now use some debt (though usually closer to 1.5 times
EBITDA in debt than 3 times EBITDA in debt – which is pretty manageable for a company as
predictable as this). Gross margins in both the service segment and distribution segment are
pretty low (25% is common). Operating margins aren’t super high either (5% was common till
recently). The odd part is that the calibration service segment has usually had both gross and
operating margins right in line with the distribution segment. How can that be?
I don’t think the calibration service business actually has similar economics to the distribution
segment. However, there are definitely some scale issues with calibration. The company operates
more than 20 service centers. It operates some on-site calibration centers (that is, inside a
customer’s plant). And then it also has “mobile calibration centers” (basically trucks you can
park outside a customer site that doesn’t have the room in the plant needed to do calibrations).
This business segment has been growing very fast. They must be hiring a lot of new employees
all the time. New employees may not be as productive as employees the company has had for a
while. Likewise, there may be start-up costs associated with bringing on new customers, putting
sites inside their plants, servicing them for the first time, etc. All the things I’m saying are things
the company says in its 10-K, press releases, etc. I think they make sense as an explanation for
why the service segment’s margins haven’t looked that different from the distribution segment’s
margins. A long time ago, they did. When the service segment was clearly subscale, it had very
poor margins. That was to be expected. But, it also gives a hint that today’s margins may not be
the top margins this company can achieve in the service segment. That’s important, because as
the service segment becomes the majority of Transcat’s overall business – and because it is
growing faster than the distribution segment, it’ll keep getting to be a bigger and bigger piece of
the overall pie – the future economics of Transcat are going to look more like the future
economics of the service business than the distribution business. The service segment has pretty
considerable depreciation and amortization expense. They do acquire things above book value all
the time. And then they have leased sites full of some leasehold improvements and equipment
and so on. There’s also capitalized software that was developed internally by Transcat. Why does
this matter? Well, Transcat is making more of an investor relations push than it has in the past. I
wouldn’t be surprised if investors in the company started focusing more and more on the
company’s figure for “adjusted EBITDA” (this always seems to be the number investors in most
stocks where management does a lot of presentations use when talking with me about the value
of the company). I wouldn’t be surprised if Transcat’s “adjusted EBITDA” growth rate was
really strong in the years ahead. I think the service segment can grow adjusted EBITDA – and
especially adjusted EBITDA margins – quickly through both organic growth and some debt
financed acquisitions. And then I think that the service segment has now reached the point where
it is providing the majority of Transcat’s adjusted EBITDA and growing faster than the legacy
business. Whenever a company has two or more business segments in it and investors start to
focus exclusively on the good, growing business – you’re a lot more likely to have expanded
price multiples on the stock.
Which brings me to Transcat’s price multiple. It isn’t cheap. The P/E is 27. The price-to-book is
between 3 and 4. However, price-to-book is honestly meaningless here. Transcat’s book value is
mostly goodwill and intangibles from acquisitions of other distributors and calibration service
providers. Actual investment in this business is just receivables and inventory and some PP&E
offset by some (much lower) current liabilities. I calculate the net tangible assets of this business
to be very, very low compared to the market cap. I’d ignore book value. We could use enterprise
value to sales. That ratio stands at 1.5. The long-term average operating margins here have been
around 5%. We’ll assume a tax rate of 21% (the statutory federal rate). Reality is probably
between 21% and 25% (the company does pay some state taxes). So, that’d be about a 5% EBIT
margin turns into about a 4% after-tax margin. So, you are paying $1.50 (including debt) for ever
$1 of sales. And every $1 of sales is producing 4 cents of after-tax earnings. So, you are paying
150 cents for 4 cents of annual earnings. That’s 150/4 = 37.5. Paying almost 38 times earnings
(to be fair, we’re using enterprise value compared to after-tax earnings here) is not something
value investors like to do.
But, there are a bunch of reasons why that might seriously overstate Transcat’s price. Let’s look
at this fiscal year alone. The “adjusted EBITDA” of the service segment was $5.2 million in the
first two quarters of the current fiscal year. The business is somewhat seasonal. It usually makes
more money in the back half of the year than the front half. It’s also growing. And fast. So, it’s
very conservative to assume that just doubling the first 6 months of EBITDA will give us the
likely full year 2020 results for the service segment. That would be $10.4 million of “adjusted”
EBITDA. What is that worth on its own?
On a trailing twelve month basis, service segment revenue is up 13-14%. Its adjusted EBITDA
margin also expanded. That segment made about 2% more per dollar of sales this year than last
year. That’s a huge improvement. It means that 13-14% growth in segment revenue could really
understate future growth in earnings from this segment. However, some of the 13-14% growth in
segment revenue was from acquisitions. Still, the organic growth rate in the service segment has
rarely been below 6%. The segment has grown – year-over-year – in each of the last 40 plus
quarters. It has 10 straight years now of growing. And it’s usually been growing the top line by
more than 6% per year organically. Acquisitions have bumped growth in this segment up to
double-digit type annual rates. And now we’re seeing margin expansion. So, what could that like
$10 million or more in adjusted EBITDA be worth on its own?
The company has a market cap of about $230 million. Net debt is about $25 million. That’s
about $255 million in enterprise value. Compare that to $10 million of “adjusted EBITDA” in
the service segment – could this business really be worth 25x EBITDA?
That seems hard to believe. It’s not impossible though. To see if it’s impossible we need to look
at enterprise value relative to sales in the service segment. I think service segment sales could be
close to $100 million by the end of this year. That’d make the enterprise value to sales – of JUST
the service segment – 2.5 times. Is that an impossibly high price?
It might not be. The adjusted EBITDA margin for the service segment already rose above 13%
this quarter. Now, this is not an EBIT number. It’s EBITDA. And there’s the stock comp
problem I’ll talk about in a second. But, could this margin eventually exceed 15%? Sure. I think
it could. Could it exceed 20%? That’s harder. Gross margins are only like 25%. But, gross
margins could expand in a widely scattered service business like this. So, it’s kind of difficult to
tell how high margins could get in this business.
It’s not impossible that the service segment alone could justify the current enterprise value of
like $250 million on Transcat. Then you are getting the distribution business for free.
What’s this “stock comp” issue I keep talking about. It’s the issue that I believe – based on past
use of stock options, restricted stock awards, etc. – that Transcat may dilute its shares
outstanding by as much as a 1-2% growth rate indefinitely into the future. The way I like to think
of this is not as an expense the company has to pay in cash (because it doesn’t). But, rather, as an
expense borne by the shareholder in the form of 1-2% lower returns every year I own the stock.
Transcat has never paid a dividend and has no plans to pay a dividend. The company has debt. It
could certainly double and maybe eventually triple the amount it’s borrowing. It doesn’t have to
deleverage while you own the stock.
However, the 3 things I pointed out just now are a bit of a problem in owning a stock long-term.
One, you’re going to get diluted. Two, you’re not going to get a dividend yield. To put this in
perspective, it’s not hard to find stocks that PAY YOU a 2% annual dividend without increasing
their share count. If, instead, Transcat both doesn’t pay you any dividend and does increase the
number of shares out by 2% a year – you’d then be 4% a year behind where you’d be in a stock
that pays a dividend and doesn’t dilute. This isn’t an impossible drag to overcome. I don’t think
it’d be hard for Transcat to grow earnings 4% a year faster than most stocks while you own the
business. But, keep in mind it’d have to do that to get you to the same place as a more traditional
value stock.
Finally, there’s the debt issue. It’s not dangerous. But, Transcat owes $25 million. If the
company chose to pay this debt off while you owned the stock, that’d eat up earnings that could
otherwise be used to pay you dividends, buy back stock, acquire other companies, etc. Now,
Transcat could go the other way and increase leverage while you own the stock. My own
impression of management and their plans is that Transcat is as likely to INCREASE leverage
while you own the stock as to DECREASE leverage. Nonetheless, it’s always easier to be certain
a company will not de-lever while you own it, if there’s nothing to de-lever.
I like Transcat’s service segment business. I’m not sure the stock is too expensive. But, I am sure
the hurdle it has to clear given today’s stock price, the fact it pays no dividend, and the fact it
might dilute me means I’d be betting on that service segment hitting a specific growth rate.
It’s possible.
The business quality here is high. I didn’t get into it in this write-up. But, Transcat focuses on
calibrating instruments for companies regulated by the FDA (life sciences, biotech, etc.) and the
FAA (aerospace, defense, etc.). It does work for oil and gas companies and things like that. But,
a lot of the business is very non-cyclical. The distribution business is selling durable instruments.
A typical order Transcat fills is in the $2,000 to $2,500 range. The company sells used
equipment. It also rents equipment. So, distribution is more cyclical because you can put off new
testing equipment purchases but can’t put off calibration. We can see this in past results. So,
Transcat’s future earnings won’t just be marching steadily higher – they’ll also become more
predictable.
I wouldn’t be surprised if this company eventually becomes a small cap (it’s still a micro-cap at
present) darling of those looking for “compounders”. The bigger the service business gets
relative to the distribution business, the more people will be attracted to this stock.
I like the business. I expect good things for it. The price seems like a pretty big hurdle for me to
clear right now. So, I’m not as confident in an investment in this company as I am in its business
model.
 URL: https://focusedcompounding.com/transcat-trns-a-business-shifting-from-
distribution-to-services-and-a-stock-shifting-from-unknown-and-unloved-to-known-and-
loved/
 Time: 2010
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Truxton (TRUX): A One-Branch Nashville Private Bank and Wealth

Manager Growing 10% a Year and Trading at a P/E of 14
Truxton (TRUX) is an illiquid, micro-cap bank stock. TRUX is not listed on any stock exchange. It
trades “over-the-counter”. And it does not file with the SEC.
The bank has two locations (one in Nashville, Tennessee and one in Athens, Georgia). However,
only one location (the Nashville HQ) is actually a bank branch. So, I’m going to be calling Truxton
a “one branch” bank despite it having two wealth management locations.
The company doesn’t file with the SEC. But, it is not a true “dark” stock. It has a perfectly nice
website with an “investor information” section that includes quarterly earnings releases.
Still, if Truxton doesn’t file with the SEC – how can I find enough information to write an article
about it?
Truxton – as a U.S. bank – does file reports with the FDIC even though it doesn’t file with the
SEC. So, some of the information in this article will be taken from the company’s own – very
brief – releases to shareholders (which are not filed with the SEC) while other information is
taken from the company’s reports to the FDIC. Truxton also puts out a quarterly newsletter that
sometimes provides information I might talk about here. Those 3 sources taken together add
up to the portrait of the company I’ll be painting here. Some other info is taken from Glassdoor,
local press reports, etc. But, that’s mostly just color.
So, it is possible to research Truxton despite it being a stock that doesn’t file with the SEC.
But, is it possible to actually buy enough Truxton shares to make a difference to your portfolio?
It depends. Are you an individual investor or a fund manager? Do you have a big portfolio or a
small portfolio? And – most importantly – are you willing to take a long time to build up a
position in a stock and then hold that stock pretty much forever?
No shareholder of any size would have an easy time getting out of Truxton stock quickly. But, if
you intended to stick with the company for the long haul – it is possible, if you take your time
buying up the position, for individual investors to get enough TRUX shares.
The math works like this…
Truxton shares are illiquid but not un-investable. In an average month, there might be around
$300,000 worth of shares trading hands. Let’s round that down to $250,000 to be conservative.
Let’s say you can buy 20% of the total volume of shares traded in a stock without much
disturbing the price. That’s one-fifth of $250,000 equals $50,000. So, let’s say you can put
$50,000 a month into Truxton stock without anyone noticing. That’s $150,000 per quarter,
$300,000 every six months, and $600,000 over a year. Most investors don’t put much more than
10% of their portfolio in a single stock. So, if you’re willing to take up to a year to buy it –
Truxton is investable for anyone with an account of $6 million or less ($600,000/10% = $6
million).
Now that we know it’s possible for an individual investor to buy enough shares of this bank – if
he intends to hold the stock for the long-term – the obvious question is whether this is a good
stock to hold for the long-term?
It is.
Truxton is an exceptionally small and fast growing bank with very high returns on assets and
equity. These things often go hand-in-hand in banking. The very smallest banks enjoy the
fastest improving economies of scale as they get bigger. This means that a dollar of extra
deposits taken in at a one branch bank will tend to increase EPS faster in percentage terms
than it increases deposits in a way that is much less likely to be true at a bank with a thousand
branches. We can see this clearly at Truxton. The bank’s return on equity has more than tripled
in the last decade. It won’t triple again in the next decade – or likely ever. The reason ROE could
grow so quickly in the last 10 years is because it started from such a low level. A new one
branch bank is very inefficient compared to an older, multi-branch bank. And then we have the
relationship between quick growth in loans, assets under management, book value, etc. and
high returns on assets and equity.
A bank’s return on assets drives its return on equity with the only other factor being leverage. If
two banks use the same amount of leverage, the bank with the higher ROA will have the higher
ROE. And then a bank’s ROE is a necessary – though not sufficient – driver of that bank’s growth
in deposits, earning assets (like loans and bonds), etc. A bank’s growth is limited by its return on
equity and the demand for deposits and loans. For a bank to make a loan, it generally needs to
have deposits to lend (though some banks may borrow to make loans – this is only a temporary
solution). How quickly can a bank grow its deposits? That depends on two things. One, how
many new clients it can bring in to deposit money with the bank. That’s demand for deposits.
But, then there’s also the bank’s ability to take the extra deposits. A bank can’t – for example –
double its deposits if it has an ROE of 1%. Deposits – while an economic asset if they are low
cost enough – are an accounting liability. So, if a bank increases deposits any faster than it
increases equity – the bank will have increased its leverage ratio. Assuming a bank wants to
keep its leverage ratio stable – and in the very long-run this is always a safe assumption – the
bank shouldn’t increase its deposits faster than it increases its equity. Bank’s can increase
equity by issuing preferred stock, issuing common stock, or retaining earnings. There can be
some benefit to common shareholders from a bank issuing preferred stock. But, it’s similar to
the benefit common shareholders get from any company issuing debt. If the debt is low cost – it
can benefit shareholders. But, there’s a limit to how much leverage you can take on. So, it’s
always best to assume that any company you are investing in will attempt to keep its leverage
stable while you own it. In other words, don’t assume a bank you invest in well fund future
deposit growth through preferred stock issuance. That would be like assuming that the
supermarket chain you are investing in will fund all future store sites by issuing bonds. It might
do that. But, it’s not good for a long-term investor seeking a safe investment to assume that’s
where the company will get its funds from. Issuing new common stock hurts existing common
stockholders. It dilutes your ownership of the company. There are cases where a stock can be
so overpriced that issuing more shares benefits the existing shareholders because the price at
which the new shares are sold is so high. However, the only shareholders who really benefit
from this are “stuck” shareholders – usually insiders and major holders – who can’t easily sell
most their shares in the open market. The truth is that for you – an outside, passive minority
shareholder – if it ever makes sense for a company you own stock in to issue more common
stock, it makes even more sense for you to just sell your own stock in the company yourself. So,
it’s not a good idea to count on either preferred stock issuance or common stock issuance as
the source of funding deposit growth. That leaves only one source of funding: retained
earnings. A bank’s retained earnings will grow in relation to its equity through the return on
equity ratio. If a bank has $40 of book value and earns a 10% return on equity it has $4 of
earnings available to retain. Almost all banks will choose to pay some of these earnings out in
dividends. Some banks may also choose to use some of these earnings to buy back stock.
Whatever is left after the company pays dividends and buys back stock is added to equity. This
is the company’s addition to both retained earnings and book value.
Over time, a bank can sustainably grow its deposits (and thus loans and bonds) at the same
rate it grows its tangible book value. Basically, the company’s earning power (which comes from
the interest received on loans and bonds) can grow as fast the company’s retained earnings.
This is how the return on equity at a bank drives growth at that bank. Return on equity is the
maximum sustainable growth rate at the bank. Most banks – in fact, almost all U.S. banks – will
grow quite a bit slower than their ROE, because they will pay dividends or buy back stock. You
can find examples of banks with a 20% ROE and only a 3% growth rate in deposits, loans, etc.
This means the bank is using almost every penny it earns to pay dividends and buy back stock.
For an example of such a bank see Bank of Hawaii (BOH). For a long time, that bank has earned
far more on its equity than there is enough demand in the Hawaiian economy to soak up. The
bank has enough fuel to grow 10% or 20% a year. But, the Hawaiian economy is growing only
about a tenth as fast as that. And a bank that already has a big market share in Hawaii can’t
really grow much faster than the Hawaiian economy as a whole. So, BOH has the fuel. But, it
doesn’t have enough demand for growth to use up that fuel. So, it must pay that fuel out to
shareholders. If BOH didn’t do this, it’d become less and less leveraged every year.
Truxton has both a lot of fuel (a high ROE caused by a very high ROA) and a lot of demand in its
local Nashville market. Nashville is a fast growing city. And the richer population in Nashville –
which is what Truxton, as a private bank and wealth management company is focused on – is
an even faster growing part of that city.
So, we know how Truxton has been growing. It started with a low ROE. But, as the economies of
scale of a one branch bank with a rapidly growing client base kicked in, that ROE rose and rose
and rose. This high ROE translated into a lot of fuel – a lot of retained earnings growth – that
allowed the bank to maintain the same leverage ratio each year even while taking in a lot more
deposits and making a lot more loans. And then the local high-end Nashville market provided a
lot of demand – unlike the Hawaiian market for BOH – where TRUX could burn its retained
earnings fuel. In other words, Truxton is a growth story. Or, at least, it had been a growth story
over the last 10 years.
Let’s put some exact figures on this growth. Just how fast did Truxton grow in its early years?
Truxton was founded in the early 2000s. But, it has only been public for a little over 9 years.
During those 9 years, the company compounded its earnings per share at 29% a year. While
EPS would seem to be the best kind of growth for shareholders to worry about – there’s an
issue here. Ten years ago, companies paid higher taxes than they do today. So, the one-time
federal corporate tax rate cut from 35% to 21% would skew compound growth figures higher.
Even over as long as a 9 year period, that one-time tax cut could add between 2% and 3% a year
to your EPS growth calculation. What I mean here is that if you take the period from 2009-2018
using 2009 EPS as your start point and 2018 as your end point and do a CAGR calculation, your
annual compound growth rate will be higher by over 2% a year over those 9 years simply
because your end point (2018) has a lower corporate tax rate (21%) than your 2009 start point
(35%). These growth figures would be distorted even higher on an annual basis if we were to
use short-term – that is, more recent – EPS growth numbers like asking how quickly did Truxton
compound EPS over the last 5 years.
In other words: all of Truxton’s EPS growth rates – whether we are talking 15 years, 10 years, 5
years, or 3 years – are exaggerated higher by the tax cut. The exaggeration is quite small over
say a 15-year period, quite huge over a 3-year period, but present in all periods.
To avoid this problem, we can simply calculate the growth in Truxton’s earnings power using
pre-tax numbers. The only outside force that has changed is the company’s tax rate. So, we can
create a sort of alternative history where the tax rate is either still 35% today or one where the
tax rate was always 21% – even going back to the day Truxton was founded. The easiest way to
do this is just to pick pre-tax metrics that we know end up driving post-tax earnings at a bank.
The two big ones are assets under management and loans. In the long-run, assets under
management and loans are two very good gauges of pre-tax earning power at a combined
private bank / wealth manager. One is assets under management at the wealth management
business. The other is total loans at the private bank. Because Truxton has gained scale going
from a tiny bank to a somewhat less tiny bank – growth in loans and assets under management
would understate the growth in true earning power. So, it’s a somewhat conservative measure.
However, as a bank grows – the benefits of economies of scale tend to decrease. Size is still
helpful going from a $1 billion in assets bank to $10 billion or even $10 billion to $100 billion –
but, it’s less useful than the initial jump from a bank with $100 million in assets to $1 billion in
assets. So, don’t expect Truxton’s returns on assets and equity to increase the way they have in
the past. But, do expect that Truxton’s EPS will not grow any slower than its assets under
management and its loans.
I should pause here to discuss why I am simply using “loans” at Truxton instead of “earning
assets” or deposits. Generally, a bank will use all of its deposits to fund earning assets. Earning
assets are a combination of loans and bonds. Some banks may make very few loans and buy a
lot of bonds. Other banks may make a lot of loans and own very few bonds. Truxton is an
example of the second kind of bank. It makes a lot of loans. It doesn’t own a lot of bonds.
However, Truxton is a much more extreme example of this second kind of bank than most.
Many banks own loans that are fairly standardized or even “conforming” in the sense that they
meet the underwriting standards of a government sponsored entity (like Freddie and Fannie in
home mortgages or Farmer Mac in farm and ranch mortgages). What you’ll find if you dig into
Truxton’s loan book is that it’s not standardized in any way. These are customized loans. And
this is notable in some very unusual kinds of loans appearing on Truxton’s balance sheet you
almost never see on other bank balance sheets. The most obvious example of this is a “closed-
end” mortgage. Many banks make “open-end” mortgages to clients of the bank and then quickly
– pretty much instantly – sell those loans to someone else. They are not in the business of
holding a 15-year mortgage for 15 years. These loans can often be refinanced as the appraisal
value of the home increases or interest rates decrease without penalties to the borrower.
Basically, the features of these standard mortgage loans strongly favor the borrower over the
lender. However, the interest rates – to compensate for the advantages in optionality the
borrower is getting – may not be as low as they could be. On top of this, the loans have to be
fairly small. It wouldn’t be possible, for example, to borrow $4 million against a house appraised
at $5 million in any sort of conforming way. Truxton, however, makes loans like that. And they
may make those loans at lower interest rates than you’d expect. They also keep the loan on
their own books instead of selling it. So, Truxton would make a 15-year closed-end mortgage
loan on a very expensive house or a similar loan on non-owner-occupied real estate like an
office building. These are more customized loans though than what you would see at most
banks. And the terms of the loan – other than the interest rate – are more favorable to the
bank. Using the closed-end mortgage example, you may have a home equity loan where you
can borrow more money as the value of your house increases or as the balance of the loan is
paid down. Likewise, you may have a fixed-rate mortgage lasting 15 or 30 years that you can
pay early without penalty. The unusual loans that Truxton makes don’t work like that. Instead,
the borrower would get $4 million today and could never again take more money out against
the home using that same loan. They also could not pre-pay the loan without penalty. It is, in
reality, a much more fixed loan in terms of the what the actual length of the loan will turn out to
be, what the interest rate will be, and also what the safety of the loan will be over its entire life.
Because Truxton makes so many loans relative to its deposits (that is, it buys very few bonds)
and because many of these loans are not directly comparable to loans bought and sold by
other banks – I want to stress lending as a key function of Truxton when discussing it with you. I
think that lending at Truxton matters a lot more in terms of deciding whether or not to buy the
stock than lending would matter at say Frost (CFR).
With that discussion of Truxton’s lending out of the way – we can now talk about the historical
growth rates in both Truxton’s loan book and its assets under management.
What we want here is the “central tendency” as Ben Graham would put it. If you look at the
graph above, you can see that over the last 3-8 years Truxton has grown assets under
management by 6-9% a year. We can use that as the historical growth rate in the asset
management business. Note that the S&P 500 has obviously grown a lot during this period.
However, as I’ll show you later – the relationship between the S&P 500’s growth in any one year
and Truxton’s assets under management growth in that same year is very, very low. There’s not
much of a correlation. So, it’s unlikely Truxton’s asset growth has come largely from increasing
stock portfolio values for clients.
The growth in loans has been steadier than the assets under management growth. If we look at
this same chart again you’ll see that loans have compounded at about 11% a year regardless of
what years we measure from (the last 3 years, last 6 years, last 9 years, etc. all give us this same
11% a year growth rate). It’s interesting to note that loan growth in the U.S. – though perhaps
not in Nashville where Truxton is located – has been quite low throughout this period. So, it’s
possible that the 11% a year compound growth rate in loans would have been even higher if
not for cyclical factors. I don’t think that’s true – because, there’s a big difference between loan
growth and loan demand growth. A bank is limited in making loans by the amount of deposits it
has and the leverage ratio (how much equity it is keeping relative to total assets) it wants to
have. Basically, the higher a bank’s return on equity and the lower its dividend payout ratio –
the higher loan growth can be. Conversely, the lower a bank’s return on equity and the higher
its dividend payout ratio – the lower loan growth has to be. Here, I think Truxton has seen
ample demand for loans to make all the loans they wanted. This is one reason why the
compound annual growth in loans has been so stable. It’s not a measure of loan demand. It’s a
measure of the actual loans Truxton makes. So, all we are really seeing is that Truxton hasn’t
had any shortage of loan demand over the last decade – and Truxton is capable of growing
loans by 11% a year given its level of profitability. In some years, there was probably enough
loan demand for Truxton to grow 30% a year and in other years, maybe there was only enough
loan demand to grow loans 15% a year. However, this kind of fluctuation wouldn’t show up in
Truxton’s actual loan growth – because a bank’s actual loan growth would always be effectively
capped by the sustainable rate of growth at the bank. In the long-run, a bank’s sustainable rate
of growth is: ROE * (1-Dividend Payout Ratio). So, a bank with a roughly 18% return on equity
and a roughly 33% dividend payout ratio would have a sustainable growth rate of 18% * (1-0.33)
= 18% * 0.67 = 12%. Now, the actual rate of growth in loans would be limited by the rate of
growth in deposits. But, the leverage neutral growth in deposits would be the growth in equity.
So, what I’m saying is that if a bank earns 18% on its book value and pays 6% of book value as a
dividend – that bank probably only wants to grow deposits by 12% a year and thus can only
grow loans by 12% a year. In the long-run – though this will not hold true in any one particular
year – a bank’s sustainable growth rate in loans is simply ROE times one minus dividend payout
ratio. Or, to put it in the simplest terms – a bank’s loans shouldn’t grow faster than a bank’s
retained earnings.
Based on that graph, you could say that Truxton’s past history would suggest that earnings will
increase by some blended rate of assets under management growth (historically 5-9% a year)
and loan growth (historically 11% a year). Long-term, Truxton’s earnings per share should – due
to growing economies of scale – grow somewhat faster than the underlying growth in assets
under management and loans. So, if you expected the future growth rates at Truxton in those
things to be the same as the past rates – you’d expect EPS growth somewhat greater than 5-
11% a year. This matches other ways of trying to adjust for the tax cut at Truxton. If we look at
what the bank probably would’ve compounded EPS by over the last 3-6 years if there had been
no reduction in the corporate tax rate – I’d say it would’ve been in the 8-12% a year range. What
we are seeing here over and over again is above nominal GDP growth rates – so Truxton can
grow faster than the U.S. economy – but, not much above 10% growth rates. Historically, the
bank has grown by more than nominal GDP but no more than about 10% a year. If you assume
nominal GDP growth in the future will be 5% a year, you could assume Truxton will grow
between 5-10% a year for a very, very long time.
You can check this math yourself. Look at Truxton’s current ROE. And look at Truxton’s current
dividend payout ratio. Is ROE * (1-Dividend Payout Ratio) greater than the top end of that
growth range I discussed above (10%). If so, than Truxton can – if it keeps its ROE this high or
higher in future years – grow at 10% a year without needing to cut its dividend. In fact, as you’ll
see by doing that math, it might be possible for the bank to grow loans (and thus EPS) a bit
faster than 10% and/or increase its dividend payout ratio a bit beyond where it is now.
As a shareholder, there’s a pretty simple way of thinking about this. You can view the dividend
yield of the stock as all you are getting in value this year. However, you are also getting the
growth in the dividend yield over time. So, let’s say you are buying at a 2.4% dividend yield
today. That’s the same as buying a stock with a P/D (not P/E) ratio of 42. That sounds like a very
high price to pay for any stock. But, let’s consider the math I’ve laid out here. It seems that
Truxton’s dividend could grow by more than 10% a year – in the past, loans have grown at 11%
a year – in the future. In fact, we know that EPS should grow a bit faster than actual loans
because this is still a very small bank that will benefit from a lot of improving economies of
scale over time as it grows. We also know that if the bank doesn’t grow loans as fast as it has in
the past – the high ROE at the bank means it would need to increase its dividend payout ratio to
keep its leverage ratio from dropping. Another way of putting this is that dividends per share
will rise faster than earnings per share. In fact, this is often what happens at banks with slowing
deposit growth, loan growth, etc. As the bank grows slower, ROE does not decline. Therefore –
using the formula we discussed above – the bank ends up increasing its dividend payout ratio.
If a bank pays out more of its earnings to you as those earnings grow – dividends will grow
faster than earnings. All of this suggests we are looking at a stock where dividends per share
could rise by more than 10% a year while you own the stock.
How much is that kind of growth worth?
It depends. Really, it depends on 4 things. One, are you willing to own this stock pretty much
forever? If the answer to that is no – then, you can’t pay much for growth. It’s only safe to pay a
high price for growth if you are willing to own the stock while it experiences that high growth. It
may not turn out to be necessary to stick with the stock for a long time. It’s possible you won’t
need to own it for that long. But, you need to be willing to. Because there is no guarantee the
stock’s multiple expansion will provide your needed profit here as it often does in a value stock.
Two, the quality of the growth – that is, the profitability of the business – has to be high. Here, it
is. There are a lot of ways to measure how profitable growth is. But, the best way is to think of
the needed addition to retained earnings – how much more actual cash a company has to put
down today to fund future earnings growth – versus the increase in earnings. At a bank,
inflation is relatively unimportant. The ROE you see is pretty close to the cash-on-cash
economic return the business is getting. So, if a bank has an ROE of 20%, it only needs to retain
about 5 cents per share of earnings to increase EPS by 1 cent next year. The rule of thumb to
keep in mind is that you need the (cash) return on retained (cash) earnings at the business you
are invested in to exceed the return in the S&P 500. If the stock market is going to return 9% a
year – you don’t want to hold any stock that is retaining earnings of more than 10 cents per
share to generate 1 cent per share in additional EPS. You need to get a 10%+ ROE in a world
with a 9% stock market return to know that growth at the company you are invested in is
actually adding value. Another way to think of this is that each dollar of retained earnings has to
add more than one dollar of market value to the stock. In the short-term, this isn’t a reliable
test. In the long-term, it is. Here, we know Truxton’s ROE is safely far, far above 10% a year. As
long as it stays far, far above 10% a year – this is good growth we want to participate in (at the
right price). The third thing that matters for growth is how reliable it is. How sure are we of this
growth? Bank growth tends to be very, very certain compared to growth at some tech company,
retailer, etc. So, Truxton scores well on that. Finally, we have perhaps the most important – and
most difficult to answer – question: how long will this growth last?
A stock that is going to grow 10% a year for the next 30 years is worth a lot more than a stock
that is going to grow 10% a year for the next 3 years. Which one is Truxton?
I gave the example of Frost. Frost is one of the biggest banks in Texas (it is the biggest
headquartered there). But, it is only in Texas. Just one state. There are many banks bigger than
Frost. So, the theoretical limit of possible size for a tiny bank in the U.S. is certainly no smaller
than the current size of Frost. We can then ask the question: if Truxton grew 10% a year each
and every year – how long would it take for Truxton to reach the size Frost is now?
The answer is about 40 years. This doesn’t take inflation into account. And it certainly doesn’t
take size versus GDP into account. Over time, the banking industry in Nashville, in Texas, in the
U.S, etc. should grow about as fast as the GDP of those places. This means that if Truxton were
to grow 10% a year for the next 40 years – it’d actually still be much, much smaller than Frost is
today when adjusted for inflation, bank’s size versus total size of the U.S. banking market, etc.
Obviously, Frost is also an arbitrary choice. I could’ve picked Wells Fargo which is many, many
times bigger. My point here is just that there’s no reason why a bank the size of Truxton would
be limited in its growth any time within the next 30 years. Even if it grows at 10% a year – it
could keep growing that fast for the next 50 years and still be nowhere near one of the biggest
banks in the country. Will Truxton ever get that big? No. It almost certainly won’t. But, the
reason for that will be internal rather than external. The market is big enough for a tiny bank
like Truxton to grow 10% a year for the next half century. Most tiny banks won’t grow that fast.
That’s because most banks won’t have the right business model, culture, strategy, and
management to grow that fast. It’s not because the market isn’t big enough to allow that kind of
growth. So, at a rate of 10% annual EPS growth – I see no external limit to Truxton’s growth
prospects within an investor’s lifetime.
Here I need to pause and talk about growth in assets under management. You may have
noticed in that graph that Truxton’s assets under management have often grown in like the 5-
10% a year range. That sounds good. Sounds fine compared to GDP or something like that. But,
it’s actually not very fine compared to the S&P 500. Over the last 10 years, the S&P 500 has
grown nearly 15% a year. Meanwhile, Truxton’s 9-year growth rate in assets under
management has been just 11% a year. Does that mean Truxton hasn’t added any clients over
time – and instead clients have been withdrawing their assets at a rate of like 4% a year?
No. The correlation between Truxton’s growth in assets under management and the growth in
the S&P 500 has been very, very low. For example, in a year (2014) when the S&P 500 didn’t
grow at all – Truxton’s AUM grew 14%. The same thing happened in 2011 (no growth in the S&P
500, but 17% growth in Truxton’s AUM) and in 2018 (S&P 500 down 6%, Truxton’s AUM up 8%).
There’s no indication that Truxton’s AUM growth is closely tied to the S&P 500. In years when
the S&P 500 does well, Truxton’s AUM growth lags the market. In years where the market is flat
or down – Truxton still grows AUM at about the same rate as it does in years that are good for
the market. There’s just no meaningful relationship between the return in the S&P 500 and
Truxton’s assets under management. There are many possible reasons why this is. The biggest
is simply that Truxton’s clients may have a lot of money in real estate, private equity, hedge
funds, municipal bonds, corporate bonds, and government bonds as well as in the S&P 500. The
other factor is that client decisions to increase or decrease the amount of money they have
Truxton manage may be a bigger factor than the return Truxton gets on the assets entrusted to
it. Finally, remember that the bank is called “Truxton Trust” and not just Truxton. It’s a lot more
likely that Truxton’s AUM on which it charges fees includes kinds of assets – in the trust – that
would not be a normal part of an asset manager’s (in the sense of a pure stock or bond picker’s)
assets under management.
So, I think we have to say Truxton – like any wealth manager – must have benefited from the
rise in the value of the S&P 500 over these last 10 years. This must have helped Truxton grows
its assets under management. However, the rise in the S&P 500 probably helped Truxton a lot
less than it helped most wealth managers. So, it may be easier for Truxton to keep AUM
growing even in a down stock market than it is for many other wealth managers.
Now, we need to consider how this past growth record of double-digit annual EPS gains was
achieved. Was Truxton’s past growth record achieved during a time of cyclical headwinds,
cyclical tailwinds, or cyclically typical times in banking?
Certainly, the period from 2009-2018 was not cyclically typical. It was one of the most atypical
times in banking in the last 30 years or so.
So, we know cyclical factors played a part in Truxton’s past record. But, the part they played isn’t
as easy to quantify as you might think. In fact, cyclical factors in U.S. banking may have
exaggerated Truxton’s good record in one respect and held back its record in another. So, we
need to consider cyclicality in two respects here. One, we know that Truxton’s past growth is
actually a lot more impressive than it appears because the credit expansion from 2009-2019
was very mild in the U.S. It wasn’t much of a banking boom. Secondly, we have to consider
interest rates. There are two ways to think about interest rates at Truxton. One – as I write this –
the Federal Reserve is expected to cut the Fed Funds Rate at its next meeting. Regardless of
how much and how often the Fed cuts rates this year, longer-term yields on many securities
and loans have already fallen. This could pressure Truxton’s net interest margin next year
versus last year. Compared to many banks, I don’t think this is a big issue at Truxton. It’s not a
very interest rate sensitive bank. I’ll discuss why that is later. But, trust me for now when I say
that predicting future interest rates is not as important in figuring out Truxton’s earning power
as it would be at a bank like Frost that has a lot of non-interest paying deposits funding a lot of
municipal (and other) bond purchases. Truxton pays more interest on its deposits and loans
more of its deposits out than Frost does. So, it’s less interest rate sensitive. That brings us to the
second way in which interest rate cyclicality needs to be considered here. The decade of results
we see at Truxton is pretty impressive for any time period. But, it’s especially impressive for a
period in which most U.S. banks have had trouble delivering good returns on assets. Truxton’s
current ROA of 1.8% is extremely high for a U.S. bank. It’s especially high for such a tiny bank.
Because Truxton isn’t especially interest rate sensitive – but still benefits a bit from lower short-
term rates and higher long-term rates like basically all U.S. banks do – Truxton’s relative
profitability versus other bank’s has probably been cyclically overstated these last 10 years.
However, the bank’s absolute profitability has been a bit understated. Other banks would
benefit more from higher interest rates. But, Truxton would have been more profitable this
past decade if rates had been higher for more of that period. So, is Truxton as much better than
Frost as it appears based on the ROAs of each bank during these last 10 years? No. But, would
Truxton be likely to earn as high or higher an ROA during a period of higher interest rates? Yes.
Again, this makes it look as if the bank could either: continue to grow at 10% a year for a long
time while paying its current dividend – or, raise its dividend payout ratio while growing slower.
We may not be able to break out exactly how sensitive Truxton was to the cycle these past 10
years. But, we have enough evidence that it probably didn’t – on a net basis – benefit a lot over
the last 10 years from economic conditions that won’t exist in most periods. The future may be
a lot different than the recent past. But, there’s no reason to believe the recent past was a lot
kinder to Truxton than the average of future years will be.
So, we could do a DCF with Truxton using a 10% growth rate and apply that to the current 2.4%
dividend yield. Imagine you pay $100 today for a stream of cash that starts at $2.40 a year
today and grows at 10% a year far out into the future. This year’s payment is $2.40, 2020’s
payment is $2.64, 2021’s payment is $2.90 and so on.
We don’t actually have to do such a calculation. There’s a much easier way to decide whether
Truxton is a bargain or not. We can just look at the very long-term history of U.S. stocks. We
have data on the Dow Jones, the S&P 500, etc. If we take the Dow Jones over the last century or
so – we’re talking about a group of stocks that have averaged about a 3% dividend yield and a
6% sales (per share) growth rate. We know that stocks today are more expensive than stocks
were in the past. In other words, the Dow Jones today is unlikely to offer a 3% dividend yield
and a 6% sales growth rate. The dividend yield may be lower. And the sales growth rate may be
lower as well. Because the stock market has – on average – been cheaper in the past than it is
today, we can use the long-term past average of the market as an especially conservative sort
of opportunity cost test here. We know you can’t – through buying an index today – get as good
a deal as investors got on average over the last century.
The long-term past average was for a 3% dividend yield growing 6% a year. Truxton today is
offering you a 2.4% dividend yield growing 10% a year. It’s probably already a better deal than
the Dow has tended to be in the past. But, that’s not immediately certain for two reasons. One –
we know the Dow’s sales growth (because it’s a basket that gets re-shuffled) is pretty much a
perpetual growth rate. If it can grow 6% a year for the next 5 years, it can probably grow 6% a
year for the next 50 years too. We don’t know that about a single stock like Truxton. So, the
length of time during which you’ll have growth could be longer with the Dow than at Truxton
(though I don’t much believe this – there’s little reason for the Dow to grow faster than a bank).
The other thing to consider is that Truxton’s dividend yield (at 2.4%) is below the long-term
historical dividend yield of 3% on the Dow. Of course, Truxton’s growth rate is much higher than
the Dow’s historical growth rate. But, you’d need to know what discount rate to apply to the
stock today to see how much lower a dividend yield you can have now to buy greater growth
(that is, a higher future dividend). I think most readers can see – without doing a DCF – that
something yielding 2.4% and growing 10% a year is probably a better deal than something
yielding 3% a year and growing 6% a year.
There is, however, a simpler solution. You could just wait till the point where Truxton would be
yielding the same as the Dow has historically while also growing faster than the Dow. If Truxton
stock paid the same dividend per share it does now but had a stock price 20% lower – it would
have a 3% dividend yield. If the company’s growth hadn’t slowed you’d then be comparing
something yielding 3% a year and growing 10% a year against something – stocks generally as
represented by the Dow – yielding 3% a year and growing only 6% a year.
In other words, Truxton would clearly be a good investment at a price 20% lower than today’s
price.
That is, if – and only if – you believe the company’s higher than average ROE, higher than
average growth rate, etc. is sustainable far into the future.
That brings us to a description of Truxton’s business model. What makes Truxton unique? What
is the culture like? What is this bank’s philosophy? Does the business model make sense? Can it
endure for decades? And – more importantly – can Truxton be an above average bank for
decades to come?
So far I’ve really only talked about Truxton as a bank generally. Now, I need to talk about what
specifics about this bank make it different from other U.S. banks you’ve probably analyzed.
Truxton does two things: 1) it’s a “private bank” and 2) it’s a wealth manager.
The company has two locations. One is a combined bank branch, wealth management office,
and headquarters in Nashville, Tennessee. The other is just a wealth management office in
Athens, Georgia.
Deposits are about $400 million. Assets under management are about $1 billion.
Truxton’s return on assets (1.8%) is high compared to U.S. banks, because it has greater
economies of scale. Truxton gets more dollar volume of business from each client, each branch,
etc. Obviously, it does not cost twice as much to serve a client who deposits twice as much with
a bank. Nor does it cost twice as much to run a branch with double the number of clients as
another branch. A fair amount of branch expenses are fixed regardless of the number of clients
served by that branch. And a fair amount of per client expenses are fixed regardless of how rich
or poor that client is. As a result, it’s more profitable for a bank to have fewer clients and fewer
branches while having the same total AUM, deposits, loans, etc. as a bank with more clients and
more branches.
U.S. banks as a group have about $50 million in deposits per branch. One of my favorite banks
– and a good deposit gatherer, Frost (CFR), – has about $200 million in deposits per branch.
Truxton has $400 million at one branch. As a result, the company’s occupancy cost (rent) as a
percent of deposits is lower than banks 10, 100, and even 1,000 times its size.
Likewise, the company has only one dedicated wealth management location and two wealth
management locations in total – yet, it has $1 billion in assets under management (so, $500
million in assets per office). Some of these assets belong to insiders. My best guess is that
insiders account for a little over $50 million of assets under management.
How does Truxton gather so much money in so few locations?
Truxton is a “private bank”. In other words, it has rich clients.
Truxton gets more than half of its funding from large accounts. My definition of a “large
account” is a single bank account with more than a $250,000 balance. I use this number
because the FDIC doesn’t break down accounts by size once they exceed the $250,000 limit. The
average (mean) size of a “large account” at Truxton is $1 million. So, I would say more than half
of Truxton’s deposits are kept in large accounts that average about $1 million in size. Note that
the same client – or closely related entities like a household, a business owned by the head of
that household, a foundation created by the head of that household, etc. – may have multiple
accounts. So, it’s possible that many individual relationships at Truxton result in average
deposits at the bank of greater than $1 million.
Of course, Truxton’s average size for all accounts – not just large accounts – is much, much
lower. But, I don’t think this is meaningful to our discussion. I think it’s more meaningful to say
that a small group – of less than three hundred clients – provides most of the funding ($300
million) to Truxton’s bank.
I said earlier that I’d explain why Truxton isn’t as interest rate sensitive as a bank like Frost.
These deposits are why. If you have a small number of big deposits from some very rich clients
– those deposits are going to be in the form of money market accounts. Truxton is basically
funded entirely by money market accounts. These pay interest. And they will pay more interest
the higher short-term interest rates are. No one is going to leave $1 million on deposit at a bank
and not expect to receive some interest for it. A commercial bank – like Frost – often provides a
lot of services for a business and then allows that business to earn credits on its deposits that
can be used to offset what the depositor would otherwise pay for in fees. Basically, the
depositor gets paid in services – not cash interest. At Truxton, depositors are going to get paid
in cash interest. As a result, higher interest rates won’t just mean higher yields on the loans
Truxton makes – they’ll also mean higher interest payments from Truxton to its depositors.
These two factors will offset much more so at a bank like Truxton than at a bank like Frost. So,
Truxton will be less interest rate sensitive – that is, the bank’s earnings will be more similar
regardless of where interest rates are – than a bank like Frost (which benefits more from higher
rates).
So, now we know what a private bank looks like. It’s a lot of deposits at one branch supplied by
a small group of very rich clients.
What does a wealth manager look like?

The answer to this is a little tricky. As a Focused Compounding member reading this – your
mind really goes to a portfolio manager, a mutual fund, a hedge fund, etc. focused on buying
stocks in hopes of outperforming the market. That is a wealth manager. But, that’s not really
the game most wealth managers are playing. And I think it would be very, very misleading to go
into an analysis of Truxton stock imagining that its wealth management clients chose Truxton
because they think the folks at Truxton have a good shot of beating the S&P500. Truxton isn’t
that kind of wealth manager.
Here a wealth manager is basically a customer service representative who focuses on serving a
small group of rich clients. Using my own business – Focused Compounding Capital
Management – as an example, a wealth manager is the person who calls up my partner Andrew
and says he would like to put a portion of some (or all) of his clients’ money in accounts I
manage. The wealth manager has the relationship with the client (we, Focused Compounding
Capital Management, don’t). He knows the client well. And he knows accountants, lawyers, and
portfolio managers who can help the client well too. But, he’s a generalist. What he doesn’t have
is expertise in a specialized area like picking specific stocks. So, he often outsources this task.
Truxton also employs more specialized employees. They have some of their own accountants,
lawyers, and insurance agents. And there are people at Truxton with the job title “portfolio
manager”. They don’t outsource all their investment decisions. But, it’s very important to
remember that Truxton has literally zero proprietary products. It doesn’t have any mutual
funds. I don’t think of the business as being comparable to Hennessey Advisors, Pzena
Investment, and other stocks you might look at when imaging a peer for an “asset manager.”
I believe Truxton charges clients about 0.08% of assets under management each month (1% per
year). So, for every $1 million you have under management at Truxton, you probably pay about
$800 a month.
I’ve been calling the company “Truxton”. The official name is “Truxton Corporation” for the
parent company and “Truxton Trust” for the bank. There’s a reason the bank is called “Truxton
Trust”. This bank has a huge trust business compared to other banks. If you look at everything
the bank says, the FDIC reports, etc. – you’ll come away with the impressions that a lot of this
bank’s overall business is probably related to its trust business. For example, the bank has very
low amounts of retirement type investment accounts compared to other asset managers. And
it has a lot of trust accounts. It also has a low compared to its overall size, but still quite high
compared to most banks (which usually have almost no) foundation business. By going through
the FDIC report, I could try to quantify the importance of trusts here – but, based on the
corporate communications I’ve read, I think that’d be misleading. Trusts are probably especially
important for Truxton in terms of leading to additional accounts, revenue streams, etc. Like I’ve
said before that the general operating account of a business is key to Frost getting other
deposit accounts and making loans to a specific business – having a trust relationship with a
family is probably disproportionately important to Truxton’s long-term earnings compared to
what the percentage of assets in trusts actually is.
As far as the culture and all of that – the company was created to focus on high-touch service to
rich clients in the Nashville area. Most of the hiring the company has done – the exception
would be the many hires of entry level people directly out of college – reflects this. The overall
impression I get from everything I’ve read about Truxton is that it’s a customer service
organization first and a sales organization – meaning in large part providing additional services
to the same clients – second. At times, the company has said that most new clients come from
referrals either from existing clients or from professionals – lawyers and accountants – of
existing clients. Truxton has also mentioned that employees do not receive commissions. Again,
this suggests a relationship (deposits, assets, etc.) focus instead of a products (transactions)
focus. Incentives are probably to grow the total size of client relationships rather than to sell
clients things.
While there is a lot of anecdotal information about Truxton’s culture – it’s pretty much all PR
type stuff from the company itself. I’ve read corporate communications from the company,
Glassdoor (employee) reviews, and local press reports. All of these have a heavy corporate PR
element. What the company has communicated over the last decade is very consistent though.
My impression formed from the limited sources available is that Truxton is focused on
customer service almost purely of the “relationship building” variety. A lot of the employees
probably aren’t so much wealth managers or bankers as they are relationship managers.
On the investment side, there is nothing of note to report. I can’t find anything unique about
Truxton’s approach to investing. I can’t find anything particularly wrong or right with it.
The lending side is also unclear. My guess is that it’s conservative. The bank has not written off
any loans in the past. It has maintained a normal – for other banks making similar categories of
loans – loan loss allowance despite not writing off loans. And the bank has also classified loans
(meaning the bank is aware of reasons why loan payments wouldn’t be made and also –
perhaps especially – why the collateral would be insufficient to recover the loan balance) that
have then not been written off. From a purely quantitative perspective, it looks like a very safe
loan book. It is overwhelmingly tied to real estate. And it’s probably tied to pretty big (relative to
the bank) real estate loans. The biggest category is commercial real estate (not occupied by the
owner). The second biggest category is home loans. These are probably for quite expensive
homes. Some of them may be vacation homes or quasi-investment properties. Certainly, the
residential mortgages Truxton has don’t match the kind of loans that GSEs buy. However, like I
said, Truxton makes closed-end mortgage loans which shouldn’t be a riskier way (in fact, it’s
theoretically a less risky way) to lend against homes that wouldn’t be appropriate for a
conforming mortgage. Finally, the bank does have a bigger portfolio of consumer loans to rich
people than is common. Some of these loans are probably for quite typical things like
automobiles. But, other loans are probably for things like art. That’s not a category most banks
do any meaningful amount of lending against. Far, far more of Truxton’s loans are some kind of
“secured” loan than you’ll see at most banks. Basically, there is some kind of collateral (an office
building, an apartment building, a full-time home, a vacation home, a car, a painting, etc.)
backing the loan than at most banks. Truxton doesn’t do as much “commercial and industrial”
lending to businesses as the more commercial banks around the country do and it doesn’t do
as much credit card lending (it doesn’t do credit card lending at all) as the more consumer
oriented banks do. Overall, it’s a lot of real estate lending. The unusual risks in the portfolio are
a big concentration in commercial real estate (presumably in the Nashville area) and a big
concentration in mortgages on high priced homes. Since Truxton hasn’t written off a loan in a
long time, its historical loss record is obviously much better than virtually all U.S. banks. It hasn’t
had losses yet. While that’s an important data point, I don’t want to overstate it. Truxton has
served rich clients in the Nashville area during a decade long economic expansion. The city
Truxton is in, the type of clients Truxton serves, and the nationwide macro-economic situation
all say this is a time when you shouldn’t be writing off loans. So, I think the fact Truxton hasn’t
had loan losses in the past is likely to leave too strong an impression of an ultra-conservative,
ultra-skilled lender in your mind. A record of no losses can’t be beat. So, there’s nothing
negative here. Personally, I feel sure the lending here has – so far – been at least average and
almost certainly better than average in terms of conservativism. But, I’m not willing to go
further than that. There will be loan losses in the future. The past record won’t last.
There are some indications that Nashville is a hot lending market for construction and real
estate. I don’t know anything about that. It would be something to look into further. If true, it
could mean that Truxton’s yields on its loans and its likely future losses will be different in
future years than they have been in the past. This is something to keep an eye on.
The quantitative record at Truxton is excellent. The culture looks good. They say all the right
things. A bank this small has an investor’s lifetime of potential growth ahead of it. The stock
price isn’t high now. And there’s no way you could argue the bank isn’t cheap enough if the
stock was to drop 20% in price (that is, trade at a 3% dividend yield).
This is one to watch.
Truxton goes straight to the top – or at least very, very near the top – of my idea pile.
 URL: https://focusedcompounding.com/truxton-trux-a-one-branch-nashville-private-
bank-and-wealth-manager-growing-10-a-year-and-trading-at-a-p-e-of-14/
 Time: 2019
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U.S. Lime (USLM): A High Longevity Stock in a Low Competition Industry
This is the second article in my new approach to writing for Focused Compounding each week. I
will give you a look into my initial thoughts on a stock that I may then research further. At the
end of this article, I will tell you my interest level (0% means there’s no chance I will follow-up
with additional research on this stock; 100% means it’s already at the top of my research
pipeline). This is my first article on U.S. Lime & Minerals (USLM). So, the question I have to
answer here is not “should I buy the stock”, “what is the stock worth”, etc. Right now, the
question is simply: should I research USLM further.
Charlie Munger is a fan of flipping how you frame a problem by “inverting”. If everyone is
looking at a problem the same way – maybe looking at it upside down will give you a different
but equally correct way of seeing things. Today, I’m going to “invert” the problem of finding a
company with a high return on capital. Actually, what matters for us investors is a company’s
incremental return on capital while we own it. What the stock earned on its capital before we
invested in it and what it earns after we sell the stock isn’t what we care about. We care about the
return on money put to work while we own the stock.
That’s a more difficult question to answer, though. So, let’s just start by asking if we think U.S.
Lime will can earn an adequate unleveraged return on equity for a long-time into the future.
Here, I am focusing on the “long-time into the future” part.
First, a confession. I personally don’t think in terms of return on equity when making my own
investing decisions. Instead, I always “invert” ROE. I think of capital not as something you earn
a return on but something which is a bit of a “tax” on growth. The reason I wrote about a stock
like NIC (EGOV) is that if it does grow – that growth will have a very low owner’s equity tax.
Maybe the stock will grow and maybe it won’t. But, if it does grow, it isn’t going to need to
retain earnings to do it.
With a commodity like lime, it’s possible that the “inflation” part of any growth won’t require
much capital investment. If you already own plenty of lime deposits, then it shouldn’t cost you
much more to produce the same tons of lime each year – and yet, if the dollar gets 3% less
valuable each year, you may be able to charge 3% more for your same quantity of lime
produced.
This is the aspect of a commodity producer that’s attractive. There are other less attractive
aspects to commodity producers that often make me shy away from them. But, maybe we’ll learn
lime doesn’t share those qualities.
My interest in U.S. Lime is a little odd. On the one hand – as we’ll see – running lime quarries is
an asset heavy business. On the other hand, U.S. Lime already has more reserves than it needs to
produce earnings for a long time. And, as I said at the start of this article – it’s the return on
incremental capital while we own a stock that matters. As investors, we don’t want to pick a
stock that is going to buy many tons of proven lime reserves the day after we buy the stock. We
want to pick a stock that already owns lime reserves and then exploits them – without buying
new ones – while we hold the stock. We want high cash flow from operations and low cap-ex.
Can U.S. Lime deliver that for us?
Let’s start by inverting the “return on capital” problem. Instead of asking what allows a company
to earn a high return on capital – like it’s abnormal to earn a high return – let’s ask what stops a
company. Every company out there is managed in a way that’s supposed to deliver high returns
on capital for the long-term – that’s the goal. But, most businesses fail.
Why?
I think five “birth defects” explain why most businesses naturally fail to earn very high returns
on capital:
1. Their business requires a lot of capital investment (asset levels are too high)
2. They face a lot of rivalry from competitors (prices are too low)
3. They get a lot of pushback from suppliers (costs are too high)
4. They get a lot of pushback from customers (prices are too low)
5. The government confiscates a lot of their profits (taxes are too high)
So, what we want to do is find a company with “market power” as I defined it in my article on
that topic:
“Market power is 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.”
I think every lime quarry in the U.S. – not just the ones U.S. Lime owns – has market power.
There is no market for the supply of lime outside of buying it from a local (usually within 400
miles) quarry. You can produce it yourself – and some big consumer do that – or you can buy it
from your local (usually within 400 miles) quarry. But, there aren’t stockpiles kept in inventory
and traded by wholesalers. So, sellers of lime must secure a deposit and mine it. Imports and
exports of lime are immaterial. And it is believed – there is no data on this – that annual
production and annual consumption of lime are nearly equal. Lime is short-lived and reactive
with water, so all reports I’ve seen on lime assume no one would store meaningful quantities of
it.
I’m going to spend a lot of time talking about the lack of price competition (“rivalry”) in the lime
industry. I hope this doesn’t bore you, because it is the main attraction here for me. If you can be
very sure that some business you buy won’t face price competition for a very, very long –
perhaps perpetual – period of time, you can be secure paying a much higher price for that asset.
This is less obvious today when we are in the midst of about 10 straight years of low inflation.
But, it’s always useful to own a business that can maintain the same real price per quantity far
into the future without causing any decline in unit volume.
Let’s start our discussion of how competitive the lime industry is with a quote from U.S. Lime’s
10-K. I have bolded words that I highlighted on my hard copy of the 10-K:
“The lime industry is highly regionalized and competitive, with price, quality, ability to meet
customer demands and specifications, proximity to customers, personal relationships
and timeliness of deliveries being the prime competitive factors. The Company’s competitors
are predominantly private companies.
The lime industry is characterized by high barriers to entry, including: the scarcity of
high-quality limestone deposits on which the required zoning and permitting for extraction can
be obtained; the need for lime plants and facilities to be located close to markets, paved roads
and railroad networks to enable cost-effective production and distribution; clean air and
anti-pollution regulations, including those related to greenhouse gas emissions, which make it
more difficult to obtain permitting for new sources of emissions, such as lime kilns; and
the high capital cost of the plants and facilities. These considerations reinforce the premium
value of operations having permitted, long- term, high- quality limestone reserves and good
locations and transportation relative to markets. Lime producers tend to be concentrated on
known high-quality limestone formations where competition takes place principally on a
regional basis.”
That part of the 10-K’s description of competition is concerned with competition on a local or
regional basis. In the last part of U.S. Lime’s “competition” section, we get some info about the
structure of the industry nationally:
“Consolidation in the lime industry has left the three largest companies accounting for more
than two- thirds of North American production capacity. In addition to the consolidations, and
often in conjunction with them, many lime producers have undergone modernization and
expansion and development projects to upgrade their processing equipment in an effort to
improve operating efficiency.”
I included the last sentence, because of a trend I seem to detect in the industry long-term. It may
be uncertain, difficult, time-consuming, or expensive to acquire and develop truly new quarries.
For example, kilns pollute. So, it may be easier to upgrade an existing kiln than get government
approval for a new kiln. In addition, if competition is localized, exploiting a new quarry near an
existing one – within sort of the “circle of competitiveness” for an existing quarry would have
negative long-term consequence for the industry. Basically, return on capital would be lowered,
because you would either introduce price competition between two local players or you would
need to invest heavily in capital at first to get up to the production cost economics of the existing
quarry or you would shrink the local market the existing quarry (and the new quarry) each had to
themselves. If the 3 largest companies in the U.S. lime industry are long-term, private players in
this industry – they might seek to make more rational long-term decisions than a lot of little
players would. For example, they might favor committing capital spending to the expansion and
modernization of larger, successful existing quarries and not opening – or even shutting down –
some of the more marginal sites. A trend like that would be a very good sign. In fact, once you
have a trend like that things like environmental regulations, permitting processes, etc. can
become a benefit to the industry because it raises the bar for what a truly new competitor would
have to attain in terms of how much time and capital they’d need to start a new site. What I’m
saying is: fewer and fewer production sites is always better for an investor than more and more
production sites. And it’s possible that fewer and fewer big players on the national scale would
try to shape the industry toward fewer and fewer sites on the regional level.
Our next source of information about the competitiveness of the lime industry in the U.S. is the
USGS. The USGS is the Unites States Geological Survey. It’s referred to as a “scientific agency”
of the U.S. government. However, when it comes to commodities, some of the work the USGS
does is really economic in nature. The USGS prepares annual reports on commodities like lime.
Here is the opening to the 2018 yearbook on lime.
Again, I am showing you what I highlighted on my hard copy of the PDF:
“In 2017, an estimated 18 million tons (20 million short tons) of quicklime and hydrate was
produced (excluding independent commercial hydrators), valued at about $2.3 billion. At
yearend, 28 companies were producing lime, which included 18 companies with commercial
sales and 10 companies that produced lime strictly for internal use (for example, sugar
companies). These companies had 74 primary lime plants (plants operating quicklime kilns) in
28 States and Puerto Rico. Three of these 28 companies operated only hydrating plants in five
States. In 2017, the five leading U.S. lime companies produced quicklime or hydrate in 21
States and accounted for 76% of U.S. lime production. Principal producing States were, in
descending order of production, Missouri, Alabama, Ohio, Texas, and Kentucky. Major
markets for lime were, in descending order of consumption, steelmaking, flue gas treatment,
construction, chemical and industrial applications (such as the manufacture of fertilizer, glass,
paper and pulp, precipitated calcium carbonate (PCC), and in sugar refining), water treatment,
and nonferrous mining.”
We can now make some estimates about the size of the lime industry, the degree of
concentration of market share, and U.S. Lime’s relative position. There are only 18 companies
with commercial sales of lime. To me, that means there are only 18 true lime producers in the
U.S. We know the top 5 of these 18 control 76% of lime production. So, the market share
breakdown is that something like 3 players probably have at least 65% of the market, the next
two might have as much as 10% of the market, and then 13 others have the remaining 24% of the
market. In other words, there are probably 3 producers with around 20% of the market and about
13 producers with about 2% of the market. So, the relative size difference between the 3 biggest
and 13 smallest producers is something like 10 to 1. I am, you’ll notice, combining info from
U.S. Lime’s 10-K with info from the USGS. And I’m rounding numbers off and making some
guesses. But, I think what I laid out here is a pretty good summary of what the level of
consolidation may be here. You have 3 companies with at least 67% of the industry and 5
companies with 76% of the industry. I think we can say that the number of “big” players here is
somewhere in the 3-5 range and the amount of market share in the hands of the big players is
two-thirds to three-quarters. On top of that, a “big player” is probably about 10 times the size of
a small player. Also, it is often stated that the top 10 producers have about 90% of production.
So, it’s likely that the 8 smallest producers have market share of 1% or less each. Concentration
might look roughly like this.
Three biggest producers: >= 65% of the market
Five biggest producers: >= 75% of the market
Ten biggest producers: >= 90% of the market
Eighteen biggest producers: 100% of the market
Because the USGS provides the number of lime plants – including non-commercial plants – in
the U.S. in each year’s report, I can paint a picture of whether the number of plants and number
of tons produced has been growing or shrinking over time.
Here are snapshots of the U.S. lime industry taken at 5-year intervals (except for the last
snapshot which is today):
1994: 18 million tons produced by 64 companies at 114 plants in 33 states.
1999: 19.6 million tons produced by 45 companies at 115 plants in 33 states.
2004: 20 million tons…at 94 plants in 32 states.
2009: 15.8 million tons…at 90 plants in 29 states.
2014: 19.5 million tons produced by 29 companies at 77 plants in 29 states.
Today: 18 million tons produced by 28 companies at 74 plants in 28 states.
The above numbers overstate how widespread and fragmented the production of lime is because
I included: 1) Companies and plants engaged in lime production for their own “non-commercial”
uses 2) Lime plants incapable of certain types of lime production and 3) Plants that did not
produce any lime during the year.
The best piece of information about the reasons for the trend toward consolidation and potential
lack of competitiveness in the lime industry is laid out in the 2014 report from the USGS:
“The U.S. lime industry is characterized by high barriers to entry, which include an industry
dominated by a few large-scale producers with nationwide supply and distribution networks, a
scarcity of high-quality limestone deposits on which the required zoning and mining permits can
be obtained, the need for lime plants and facilities to be located close to markets with access to
suitable transportation networks to allow for cost effective production and distribution,
environmental regulations making it difficult to permit new lime kilns, and the high capital cost
of the plants and facilities. Production capacity increases are usually met by retiring older
kilns and using the existing air quality permits for new, more efficient, higher capacity kilns
that have reduced air emissions. In 2014, the U.S. lime industry consisted of 29 companies…Of
the 29 companies, 14 companies produced lime products for sale, 10 companies produced lime
that was used entirely for internal company purposes, and 5 companies did both. Owing to its
reactivity and short shelf life, lime is not stockpiled in large amounts and data on stocks are
not collected.”
I think we can say that the trend in the lime industry is toward fewer and fewer producing sites
controlled by fewer and fewer companies. This means capital allocation must be focused on
upgrading and modernizing existing sites and acquiring other lime producers.
Finally, in that same USGS report (for 2014), U.S. Lime is listed as the sixth largest producer of
lime in the U.S. The other companies listed ahead of U.S. Lime are either private or are a small
part of a public company that produces other commodities as well. The only public peer of any
kind shown ahead of U.S. Lime is a subsidiary of Martin Marietta Materials (MLM).
Martin Marietta trades for 18 times EBITDA while Vulcan Materials (VMC) trades for 19
times EBITDA. USLM trades for 9 times EBITDA. I wouldn’t call Martin Marietta or Vulcan
peers. Limestone production is – I suppose – quite similar to aggregate (gravel) production. But,
the main uses of lime are not in construction. Lime is used in everything from steel mills, to coal
power plants, to water treatment – all of which have nothing to do with construction. It’s also
worth mentioning that – over the last 25 years – U.S. Lime stock has far outperformed both
Martin Marietta and Vulcan Materials. So, the stock’s history points to this being at least as good
a business as the more expensive Martin Marietta and Vulcan.
Overall, I would say that USLM appears to be cheap enough to consider researching the stock
further. The competitive position of a lime producer might have some similarities to aggregate
producers. And yet, U.S. Lime is probably half the price of some construction related quarry
owners.
Finally, what does U.S. Lime actually own? What are you getting when you buy this stock?
Here are the company’s key assets:
 $82 million in cash (against no debt)

 Texas Lime: 33 million proven tons plus 53 million probable tons. Estimated life of
reserves at current production level: 70 years.
 Arkansas Lime: 13 million proven tons plus 76 million probable tons. Estimated life of
reserves at current production level: 60 years.
 Clair: 12 million probable tons. Estimated life of reserves at current production level: 20
years.
 Land ownership: The land is being used to produce lime, so it’s important not to double
count this. However, U.S. Lime owns 3,450 acres at Texas Lime and 3,550 acres at
Arkansas Lime. St. Clair is an underground mine and some of that land is leased. U.S.
Lime has some mineral rights on land it doesn’t own.
Let’s assume the land has no value. That’s not a very extreme assumption. Although we’re
talking 7,000 to 8,000 acres here, we need to keep some things in mind. One, it’s being
extensively mined and will be for a long time. There will be costs to closing any lime quarry and
using any of the land for anything else. Any non-lime monetization of land would be very, very
far-off. So, let’s cross “land ownership” off the list. But, it’s an asset that might be enough to
offset unexpected future liabilities that can be associated with mining operations. For example,
U.S. Lime has earned royalties for the extraction of natural gas on some of its land.
The $82 million in net cash works out to more than $14 a share.
As far as reserves, let’s say the proven reserves are to be counted at 100% and the probable
reserves are to be counted at 50%. This is arbitrary. If we blend that together we get 33 million
tons plus 13 million tons equals 46 million tons to be counted at 100%. Then we have 53 million
tons plus 76 million tons plus 12 million tons equals 141 million tons to be counted at 50%.
That’s 70 million more tons. So, that’s about 116 million tons of reserves (assuming proven
means 100% certainty and probable mean 50% certainty).
We know two other facts about U.S. Lime. One, it used up about 3 million tons of lime from its
reserves last year. And, two, the company was producing at about 62% of its capacity last year.
Let’s assume capacity is 5 million tons of lime and – for the sake of argument – U.S. Lime starts
producing at 100% of capacity and keeps producing at that level forever.
At that rate, U.S. Lime would deplete all its proven reserves in 9 years. It would deplete all its
proven and probable reserves (assuming probable reserves turn out to be 50% real and 50% not)
in 23 years.
So, that would say that U.S. Lime doesn’t need to acquire more limestone deposits for 10-25
years even if it produces at close to 100% capacity and even if probable reserves turn out to be
only 50% real.
Those are extremely aggressive depletion assumes. You need to make kind of outlandish
assumptions to get to the point where U.S. Lime would be out of reserves in 10-20 years.
The reality here is that U.S. Lime isn’t going to produce at 100% capacity. The stock is priced
like it’s going to produce at about 60% capacity forever. And, at this rate, U.S. Lime won’t need
to acquire more deposits for something much closer to 15 – 45 years. It would be 15 years if
100% of probable reserves turn out to be non-recoverable and 45 years if 50% are recoverable
and 50% aren’t. If 100% of probable reserves are eventually exploited and U.S. Lime only
produces at its current annual unit volume in tons – the company would have 60 years of
production left in it without acquiring new deposits.
I think we can pretty safely guess U.S. Lime won’t run out of deposits sooner than 15 years from
now and its deposits won’t last more than 60 years. Between those two numbers, your guess is as
good as mine. But, my guess is that the company has ample reserves compared to many
commodity producers.
So, the attraction here is pretty simple.
One, I think the lime industry isn’t very competitive and isn’t going to get more competitive in
the years ahead.
Two, I think the thing that is the most expensive part of getting into this business – acquiring a
working lime quarry – is something U.S. Lime won’t have to pay for in the foreseeable future.
It’s entirely possible you could buy this stock and hold it for 10 or 15 years without the company
using its cash to acquire another quarry.
And then, the price looks okay right now. It’s hard to know what normal free cash flow looks
like, because the company will go for years without spending much of anything on cap-ex and
then it’ll suddenly invest in a new kiln or something. But, if we use the free cash flow figures
from the years after the financial crisis (lime production plunged more than 20% in tons in
2009), we have free cash flow being pretty steady in the $20 million to $25 million range. Let’s
call it $23 million in average free cash flow.
That gives the company a market cap to free cash flow of 18. The enterprise value to free cash
flow is 15. This is before the tax cut. So, I’m fine assuming the stock is not trading for more than
a cash P/E of 15 to 18.
The important question here is re-investment. So, normally a typical U.S. public company grows
about 5% a year to 6% a year (at around the rate of nominal GDP growth) while retaining about
half its earnings. So, if you buy a normal stock at a P/E of 15, you are really paying something
like 30 times the payout from the company (cash piling up, stock being bought back, and
dividends being paid out). The other half of your reported earnings are funding the 5% to 6%
growth rate. You never see that part of the cash – you only enjoy the growth it funds.
The question here is whether we might be paying closer to 15 times the actual distributable cash
flow. U.S. Lime’s balance sheet is mostly cash and equipment. Land and mineral rights are held
at a low valuation on the books – but then, we don’t expect more investment in that. What we
expect USLM to invest in is upgrading and modernizing the existing sites it controls.
Imagine production in tons is held steady. Meanwhile, the price of each ton of lime rises 3% a
year. How much of the company’s earnings are really cash that doesn’t need to be put back into
the business?
If the number really is around $23 million – that is, about $4 a share – this stock is a buy. It has
net cash on hand. It has more reserves than it needs. And then you have a $4 cash coupon
coming off the stock. It’s a real yield (the price per ton of lime won’t fall due to inflation). So,
what is the right fairly certain, very long-term real yield on a security these days?
If we’re talking appraisal value – what it’s worth, not what I’d pay – it’s probably 25 to 33 times
the real cash coupon. If you know competition is limited and you know you’ll keep earning the
same real profit regardless of inflation – that’s worth a lot. Furthermore, if you know the lifespan
of this security is of the same sort of lifespan as say a 30-year government bond – that’s worth
even more. For example, the 30-year U.S. Treasury Bond yields 3.13% right now. So, could
something that is producing at two-thirds of capacity (it might produce more one day) and
indexed to inflation (this is basically a TIPS not a normal 30-year bond) be worth a starting yield
of something close to that 3% nominal yield on a government bond (like 33 times free cash
flow)?
The right yield on something like this is probably 3% to 4%. A 5% yield (P/FCF of 20) seems
too high for something with such a wide moat and such ample reserves relative to production
levels.
So, does that mean U.S. Lime shares are worth something like 25 to 33 times free cash flow?
Maybe.
Assume free cash flow is $4 a share. Assume a 25 to 33 times multiple. That gets you to an
appraisal value of $100 to $132 a share. There’s also just under $15 in net cash. That would give
an appraisal value of $115 to $147 a share.
That could be too high.
But, the stock’s at $76.30 a share as I write this. That’s about two-thirds of the bottom end of this
appraisal range (where I used a P/FCF of 25).
Is the stock worth a P/FCF of 25?
Probably. I mean, it’s difficult to find things with as long-term and safe as U.S. Lime with a
REAL yield of 4% or higher. Many stocks that face serious competition and definitely wouldn’t
be able to pass on 100% of inflation trade at 25 times reported earnings – not free cash flow –
already.
My guess is that the stock won’t underperform the S&P 500 even if bought at about 25 times free
cash flow. Would I consider buying it at 15 times free cash flow or less?
Yes.
Right now, I rate my interest level in U.S. Lime at a 5 out of 10.
If the stock dropped even 5% to 10% in price, down to say a $70 price – I’d bump up my interest
level to at least a 6 out of 10 here.
As it is, I’m about as likely as not to put this stock at the top of my research pipeline.
Geoff’s interest level: 50%
 URL: https://focusedcompounding.com/u-s-lime-uslm-a-high-longevity-stock-in-a-low-
competition-industry/
 Time: 2018
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Vitreous Glass: A Low-Growth, High Dividend Yield Stock with Incredible

Returns on Equity and Incredibly Frightening Supplier and Customer
Concentration Risks
Vitreous Glass is a stock with some similarities to businesses I’ve liked in the past – NACCO,
cement producers, lime producers, Ball (BLL), etc. It has a single plant located close enough to a
couple customers (fiberglass producers) and with an exclusive source of supply (glass beverage
bottles from the Canadian province of Alberta that need to be recycled) and – most importantly –
the commodity (glass) can’t be shipped very far because the value to weight ratio is so low that
the price of transportation quickly exceeds the price being charged for the glass itself (absent
those shipping costs). The stock is also overlooked. It’s a microcap with fairly low float, beta,
etc. It’s also a simple business. And capital allocation is as simple as it gets. The company pays
out basically all the free cash flow it generates as dividends. And operating cash flow converts to
free cash flow at a very high rate, because the company spends very little on cap-ex.
That’s most of the good news. The one other bit of good news is the stock’s price. As I write
this, the stock trades at about 3.60 Canadian Dollars. I did a quick calculation of what seemed to
be the normal trend in dividends these past few years. The company pays out a quarterly
dividend that pretty much varies with quarterly cash flow from operations. So, it’s not a perfectly
even dividend from quarter-to-quarter. But, it seems fairly stable when averaged over 4, 8, 12,
etc. quarters and compared to cash flow from operations. If we do that – I’d say the current pace
of dividends seems to be right around 0.36 cents per share each year. In other words, the
dividend yield is 10%. There are other ways to estimate this. For example, we can use the price-
to-sales ratio (EV/Sales would be similar, the company has some cash and no debt) and compare
it to the free cash flow margin we’d expect. Then assume that all FCF will be paid out in
dividends. Again, we get numbers suggesting future annual dividends are likely to be a lot closer
to 10% of today’s stock price than say 5%.
There is some bad news though. One bit of bad news is the difficulty I’ve had in this initial
interest post verifying certain important facts about the business. In preparation for this write-up,
I read 3-4 different write-ups of this stock at various blogs, Value Investors Club, etc. I read the
company’s filings on SEDAR (the Canadian version of America’s EDGAR). While I believe the
information in the blog posts to be true -they’re getting those facts from somewhere, I can’t
independently verify certain things about the supply agreement, the specific customers buying
from Vitreous Glass, etc. Having said that, nothing I found in the accounting and in the filing
overall really seemed to contradict what I read in the blog posts. And I did notice some stuff in
the accounting that matches up pretty strongly with the way the business is described in some of
those blog posts. Let’s start with some of the things that match up well.
Vitreous Glass has an exclusive supply agreement with what is essentially a part of the Canadian
government in Alberta (it’s the province’s mandatory glass recycling program). Vitreous Glass
has to take whatever it is supplied. So, it’s not that Viterous Glass is choosing to buy how much
waste glass its customers need. Instead, Vitreous Glass has to buy ALL of the waste glass
collected in Alberta. And then Vitreous turns that waste glass into material that can be used by
fiberglass producers within a couple hundred miles of the company’s waste glass processing
plant. There’s some stuff mentioned in these write-ups that jives well with unusual accounting
items I noticed. I’ll mention those that may help to explain the company’s business model.
So, one logical question would be why don’t customers just “in-house” the conversion from post
consumer waste glass to a fiberglass input. The answer may be that Vitreous Glass is really
operating a staging area as much as a manufacturing plant. The company’s accounts strongly
suggest this fact. It sometimes holds a lot of inventory. And the inventory is almost all raw
materials. This makes perfect sense if two things are happening here: one on the supply side and
one of the demand side. Let’s say hypothetically that waste glass is produced at a fairly stable
level each year. This would make sense. I don’t think the people of Alberta are using vastly
different amounts of glass beverage bottles each year. Supply could then be very, very stable.
Like, Vitreous could be getting 2% more or 2% less waste glass sold to them each year. But, it
wouldn’t vary by like 20% in any year. However, the demand from fiberglass manufacturers
would vary a lot. This is because demand for things like housing starts – this fiberglass is being
used in insulation – can swing 20% or more a year quite frequently. Well, if Vitreous glass is
required to accept all the waste glass offered by the region – then, it will sometimes have its
factory increase supply by 2% in a year where demand drops by 20% (or a lot more). This would
increase inventory levels by more than 20% obviously. The reverse could also happen as well. If
the market for waste glass was competitive – others were bidding against Vitreous Glass to buy
the used beverage bottles – then, financial results would be quite variable. However, if Vitreous
Glass is the only one taking waste glass in the region (which is what all write ups of the stock
claim) then this changes the volatility of results a lot. In fact, I would expect that both the input
cost of actual waste glass arriving at the plant and the output price – excluding certain
transportation costs which probably would vary more – could be remarkably stable. In fact, they
might actually be surprisingly stable on a non-unit but rather plant wide basis. Let me explain
why.
So, if there is a competitive market for the supply of something – which is the situation all of us
investors are most used to seeing – then, microeconomic analysis on a per unit of volume basis
makes a ton of sense. It makes sense to imagine that the average retailer of soda makes a gross
profit of 6 cents a can or whatever. But, does it make quite as much sense to assume that Ball – a
company that provides ALL the supply of cans to certain beverage plants – always makes a gross
profit of 3 cents a can or whatever? Well, it does and it doesn’t. Obviously, what matters to both
Ball and the bottling plant sited near Ball’s beverage container factory is really the return on
investment of those entire plants as projects. If volume assumptions were very different, then
supply agreements on a per unit basis would have to be very different too. The more a plant
supplies, the less it’d have to charge per unit. The less it supplies, the more it’d have to charge
per unit to justify the investment. And because of the co-dependence, this calculation matters to
both the company and its customer. Ball doesn’t want to build a plant to supply a customer
unless it can get an adequate return on its investment. And the customer isn’t really making the
decision of producing just one more can of Coke or not. The important decision is the entire
planning of a bottling plant including who to use as the supplier of beverage cans to the plant.
The critical microeconomic factors here are the expected returns on investment of each of the
plants – the beverage can plant and the bottling plant – on a factory wide (rather than per can of
soda) basis. But – and this might not be the best example, because the market for soda is super
non-cyclical – it’s still true that after you output these cans, price and quantity is responding to
demand for soda along with competitive factors and such on a per can basis. If people want to
consume 5% less soda this year and 5% more healthier alternatives or whatever, this does have a
meaningful impact on the economics of the bottling plant and that can pass through to the
beverage can plant as well.
My guess would be that the situation with Vitreous Glass is – if anything – less variable in terms
of the profitability as opposed to the volume of business being done. Whereas I think it’d be
easier for the profitability of some things – like cans of soda – to vary for the entire plant, I think
the situation at Vitreous Glass is more likely to be far bigger variations in physical quantities of
stuff passing through the plant than we’ll see in terms of plantwide profit and losses. There are
some indications of this in the footnotes to the financial statements I’ve read. It certainly seems
like what’s happening is that Vitreous Glass is taking all of the variability in the chain of
production of waste glass to fiberglass. It’s basically freeing its supplier (the waste glass
collection program) and its customers (the fiberglass producers) from ever having to think about
inventory levels. Vitreous Glass simply takes everything the collection program wants to get rid
of (which, obviously, is all the glass bottles used in the region each year) and then only supplies
its customers on a just-in-time basis. The company shows extremely minimal levels of finished
inventory. If we were to visit the Vitreous Glass plant, I think we’d find that on each of our visits
the amount of stockpiled waste glass would vary. Like, I think it might be possible to literally
eyeball some extreme variations in physical inventory levels. And this variation should be based
on the demand for fiberglass. When housing demand increases, demand for fiberglass insulation
would spike. When demand for fiberglass insulation spiked, demand for fiberglass inputs (waste
glass) would spike. However, the supply of waste glass can’t spike. That’s because waste glass is
a byproduct of the amount people are drinking. And people in Alberta aren’t going to drink more
or less simply because a lot more new homes are being built. So, production levels at the
Vitreous Glass plant would spike along with housing activity. The company would be depleting
inventory. This is because Vitreous can’t buy more or less waste glass depending on the demand
for waste glass. It always has to buy whatever is on sale. And whatever is on sale is probably
pretty inflexible because the amount of drinking done each year is probably pretty inflexible.
This would have some strange results for Vitreous Glass. One, cash flows would depend a lot on
inventory levels – raw material piles – being increased or decreased. However, the economics on
the supplier and customer sides really could be stable on like a plant wide basis. This is – sort of
– what the historical numbers show. I say “sort of” because the results do show some variability
in earnings. However, I can’t see how the variability in earnings is actually as high as what I
assume the variability in demand for fiberglass insulation would look like. So, profit seems to
vary less than the demand from customers here. This is believable in co-dependent economic
relationships. The two parties share the volatility more than you are used to seeing in supplier-
customer relationships that are more purely transactional and competitive.
One supplier and two customers account for like 90% of Vitreous Glass’s sales. By the way,
because there are big fixed costs at any plant, this means that 1 supplier and 2 customers account
for more than 100% of profits here in the sense that Vitreous’s profits are completely dependent
on one supply agreement and two customer relationships. The loss of that supplier or of those
customers would send Vitreous into the red. That’s obviously the risk here. There’s supplier
concentration and customer concentration.
Though, to be fair, it’s bi-lateral. The recycling program is only using Vitreous Glass as its way
of getting rid of this waste. And the customers are – possibly (I can’t confirm this based on just
the report I’ve read so far) – relying on Vitreous Glass for even more (like 100%) of their source
of waste glass than Vitreous is depending on them (more like 35% to 50%) of its total sales.
This kind of bilateral dependency can cause some weird “moat” stuff. So, Vitreous already has
the customer relationships, the supply agreement, and the plant. Although it might seem logical
for a customer to “in-house” waste glass conversion – there are reasons they wouldn’t do this.
One, the cost savings wouldn’t be high. Let’s pretend waste glass as an input is 80% of the cost
of fiberglass insulation (I have no reason to believe it’s that high, but such a high number helps
demonstrate my point). Now, let’s assume that – as some blog posts say – the cost of transport is
3 times the cost of the waste glass. That means 60% of the cost of the final product is transport
costs and only 20% is the pre-transport cost of the waste glass. On top of that, Vitreous Glass
would have some economies of scale by having two customers instead of one. It’s unlikely
competing fiberglass manufacturers would agree to a co-venture of producing waste glass
themselves. So, what’s left here in cost savings? 20% of the cost of the insulation? Not really.
Because you’d lose the economies of scale. I have no idea how big those would be. Fixed costs
at the plant seem quite significant to me. On top of that, Vitreous Glass has been in this business
for like 20 plus years at the same location. There are clear indications of deflation here. The most
likely explanation for deflation on the cost side is experience gains at the plant. These could be
significant. Could they be 2% a year. 1%? I don’t know. But, it’s very likely that a newly built
plant by an operator who hasn’t done this before would take several years to lower costs to the
point the incumbent is at. And then we have the capital costs. These fiberglass manufacturers are
offloading the speculative inventory needs on to Vitreous Glass. Right now, it seems to be a just-
in-time process for the plants. It wouldn’t be if you were dealing directly with the waste glass
collector. You’d also need to invest in the plant. It’s very likely that the capital costs of building
a new plant are really high versus the tiny amount of needed future cap-ex at an old plant.
I’m not saying Vitreous can’t lose one or both customers to in-housing overnight. It could. But,
this plant clearly has tremendous returns on equity. So, any observer would say the logical thing
is to cut out the middleman. However, I’m seeing a lot of reasons not to do that. And the reasons
I’ve talked about here are the hard reasons. I think there are also “soft” reasons not to do this.
One, it’s hard to cooperate with a competitor. Two, it’s usually undesirable to complicate the
running of your plant by taking a streamlined just in time process and making it one where
you’re holding inventory. Three, cutting out the middleman would require some sort of
negotiations (with the supplier of glass bottles for recycle). Four, the supplier is not a for profit
entity and you (the customer) are. Five, it’s just easier to bid for your supplier and buy their
entire old plant, existing supply agreement, long tenured manager and plant manager, employees,
etc. You’d get whatever experience there is from doing that. But, six, if one customer bid to buy
Vitreous – you’d have the risk of the other customer wanting to bid. The incentives would
actually be doubled, because Vitreous is supplying competing local plants. So, a bidder would
want any cost savings for themselves plus they’d want to deny any cost savings to a competitor if
they believed such cost savings of cutting out the middleman really did exist.
I have no idea if Vitreous Glass’s customers have ever considered bidding for the company, have
ever considered a co-venture with other possible users of waste glass, etc. But, it just doesn’t
look like a situation where it definitely makes sense to cut out the middleman. I also don’t know
if they could. Vitreous does not – at least in the report I read – go into the kind of detail on the
length and terms of its contracts with customers, suppliers, etc. the same way that a company like
NACCO does.
Vitreous Glass has some of the same risks that NACCO has. The customer concentration is more
extreme. And NACCO owns the coal deposits. Vitreous Glass relies on a supply agreement. On
the other hand, Vitreous Glass is in a business – providing a fiberglass insulation input – that
could last a lot longer than coal. Vitreous Glass also has clearer capital allocation than NACCO
does. Incentives here are good – as they are at NACCO, but probably even better here – with the
CEO and his wife owning close to 40% of the company and the CEO being compensated
primarily via a bonus tied directly to the level of cash flow from operations. Vitreous Glass also
will have higher returns on equity, because it doesn’t need much reinvestment (while NACCO
expands one consolidated mine, buys expensive equipment for its limerock business, etc.).
For these reasons, Vitreous Glass looks a lot like a bond that yields 10%. But, is it as safe as a
bond? No. Definitely not. And the upside doesn’t much compensate for the lower safety. The
company might – primarily through cost savings at the plant – increase dividends by like 2% or
more a year indefinitely. But, that’d just make it a 10% real yield. That does compare favorably
to what like a 2% real yield (assuming 2% inflation) on very long-term investment grade
corporate bonds. Would I rather own Vitreous Glass than a 30-year corporate bond? Yes. Would
I rather own it than the S&P 500? Maybe. But, unless I learn more – NOT at like a 100% S&P
500 allocation versus 100% Vitreous Glass. There are real risks here. However, one good thing
for investors is that Vitreous Glass has pure “business risk”. If it fails, it’ll fail for reasons that
won’t cause any problems for the rest of your portfolio.
The risks at Vitreous Glass have zero correlation with whatever risks are already in your
portfolio.
So, right now, Vitreous Glass does seem like a really good diversifier. It might add some returns
to your portfolio. And it won’t add any general market risk at all. So, it’s a totally idiosyncratic
add to any portfolio. If you could find a basket of 10 stocks just like Vitreous Glass – you’d have
yourself a solid portfolio that wouldn’t move with the market. Unfortunately, I can’t even think
of like 4 stocks that are similar to Vitreous Glass in price, customer concentration risks, etc.
Given the risks here, I’m not yet completely sure a dividend yield of like 10% or so is high
enough. But, I am sure I’d like to do more research on Vitreous Glass.
Initial Interest: 80%
 URL: https://focusedcompounding.com/vitreous-glass-a-low-growth-high-dividend-
yield-stock-with-incredible-returns-on-equity-and-incredibly-frightening-supplier-and-
customer-concentration-risks/
 Time: 2019
-----------------------------------------------------
Vertu Motors: A Cheap and Safe U.K. Car Dealer
Vertu Motors owns more than a hundred car dealerships in the United Kingdom. About half of
the time – so, at 50+ locations – Vertu Motors also owns the land on which the dealership is
built. They lease the other half of their locations. The stock trades on the London Stock
Exchange (the AIM market, specifically) under the ticker “VTU”.
Back on November 14th, 2017 Focused Compounding member Kevin Wilde sort of wrote up
Vertu Motors. He did an idea exchange post on U.K. car dealers. The stock he focused most on
was Vertu Motors.
Why?
Why focus on Vertu Motors specifically?
And why focus on U.K. car dealers generally?
Publicly traded U.K. car dealers seem to trade at lower prices than their U.S. peers. In the U.S.,
car dealerships are usually sold at a premium to tangible book value. Car dealer stocks tend to
trade at a premium to tangible book value. In the U.K., some publicly traded car dealers – like
Vertu Motors – have shares that can be bought below tangible book value.
We can try to come up with arguments for why U.S. car dealers should be more expensive than
U.K. car dealers. But, the math isn’t very convincing. For example, if we look at the rate of
growth in Vertu Motors’ tangible net assets per share over the last 5 years – it isn’t lower than
what U.S. car dealers would be able to achieve. At times, Vertu Motors stock has grown net
tangible assets per share by 10% or more a year while also paying a dividend. The company was
not very successful growing PER SHARE asset values in the years immediately after its
founding (though it did increase the size of the company and improve its economics during this
time). Since scaling up, the company seems capable of getting a 10% growth rate in net tangible
assets without using leverage. Car dealers often use some leverage. And – as I said earlier –
Vertu Motors stock can sometimes be bought below its tangible net assets. The company’s
management includes their own 10-year calculation of free cash flow generated versus assets
employed and comes up with a number around 10% a year. If I take the most recent half of the
company’s existence and use the rate of compounding in net assets per share (instead of FCF like
the company uses) I’d get a similar rate of value creation. Basically, I’m going to assume here
that Vertu Motors can generate about 10% worth of “owner earnings” relative to its net tangible
assets.
We can use that information to answer the question: “Is it cheap?”
When first looking at a stock, I often ask 5 questions: 1) Is this stock overlooked? 2) Can I
understand this business? 3) Is the business safe? 4) Is the business good? 5) Is the stock cheap?
Because I started today’s discussion with the company’s ability to generate earnings relative to
tangible equity – let’s start with #5.
Is Vertu Motors stock cheap?

Yes. As I write this, Vertu Motors stock trades below 40 pence. On October 10th, 2018 the
company provided balance sheet information as of August 31st, 2018. At the end of last August,
net tangible assets per share were 46 pence. The company has reduced the number of shares
outstanding since last August. And the purchases of stock the company made between the end of
last August and the time I’m writing this were done at prices below net tangible asset value. So,
we can assume the market price of this stock is somewhat below 40 pence and the tangible asset
value per share is somewhat above 46 pence. If we assume your annual total return as a
shareholder will be roughly equal to 10% of starting net asset value – then, the company’s
normal “earning power” right now should be about 4.6 pence (0.10 * 46 pence). The stock price
is 40 pence. So, 4.6 pence divided by 40 pence is 11.5%. If you bought at today’s price, you
might expect a return of between 11% and 12% a year from this stock.
That’s for U.K. based investors. They have Pounds right now they want to use to buy this stock
and get Pounds back in dividends received, proceeds from the stock sale, etc.
For U.S. (and other non-U.K. investors), an investment in VTU would work differently. First, the
buyer would convert their currency – in this case, I’ll assume U.S. dollars – into Pounds and then
they’d buy VTU stock. Any dividends received would be paid in Pounds (not dollars). And then
the stock would – perhaps many years from now – eventually be sold in Pounds. Finally, the
investor would convert these Pounds back into U.S. dollars.
For this reason, it matters what the exchange rate is between Pounds and dollars right now. In
fact, it matters in much the same way that VTU’s own price to net asset value matters.
Let me explain.
VTU’s internal rate of return – the company’s own Pounds generated on Pounds tied up in the
business – might be 10%. However, an investor – even a buy and hold forever investor – will
make a somewhat different return on their shares than VTU makes on its business, because this
investor is not paying 1 Pound for every 1 Pound of tangible net assets tied up in this business.
You – the U.K. based shareholder – are getting your shares of VTU at a 13% discount (0.87x net
tangible asset value), because you are paying 40 pence today to get an interest in 46 pence of net
assets inside the company. You can see how this 0.87 modifier wraps around the company’s own
operations. The company is generating a 10% – we’re assuming for the sake of illustration –
return on its money. But, you are buying in at 0.87 times tangible book value. So, your initial
investment return here would be more like 10% / 0.87 = 11.5%. Now, it’s worth mentioning that
as the company reinvests money in its own operations, your return would trend closer to the
company’s own returns on capital. So, you’d start with an expectation of 11.5% a year but this
would trend down toward 10% a year as you held the stock forever. There is another aspect – the
“trading return” – to this that I’ll discuss later. Right now, I’m only discussing the “hold return”.
This means that buying at a slightly lower price-to-book ratio than 1 (in this case, 0.87) will
make a difference – but not a huge difference – for a buy and hold investor. And, the cheapness
of the stock will matter most the shorter your holding period while the quality of the business
will matter most the longer you hold the stock.
For an investor, the VTU price-to-book ratio here works the same way as the Pounds-to-Dollar
exchange ratio. If the Pound trades above purchasing power parity versus the dollar – this will
negatively influence long-term returns for American investors the same way buying above book
value would. If the Pound trades below purchasing power parity versus the dollar – this will
positively influence long-term returns for American investors.
Right now, the Pound trades below purchasing power parity with the U.S. dollar.
In fact, we have 3 speculative “timing” type issues here going for a U.S. investor buying stock in
VTU and holding it.
Vertu itself may earn only a 10% unleveraged return on its investment. However…
1) The company’s leverage ratio is lower than many companies (it has close to no net debt)
2) The company’s price-to-book ratio is below 1
3) The Pound’s exchange rate with the U.S. Dollar is below purchasing power parity
This means, that while a U.S. investor owns shares in Vertu Motors, they might experience 3
tailwinds:
1) The company increases leverage
2) The stock’s price-to-book ratio rises
3) The Pound rises versus the dollar
All 3 factors would increase returns for American investors. Moving in the opposite direction –
declining leverage, a falling price-to-book ratio, and a weakening Pound would hurt returns.
In the long-run, the odds are definitely stacked in favor of higher leverage, a higher price-to-
book ratio, and a stronger Pound.
But, trends could go the other way for a few years. Three years from now, you might have
leverage just as low or lower. You might have the price-to-book ratio of the stock even lower
than it is today. And, you might have an even weaker Pound.
We don’t know. We can’t predict the future. So, why buy Vertu Motors stock?
The basic reason is that you have 3 speculative one-time potential upside events combined with
one investment long-term trend that is – on its own – sufficient to hold the stock.
You can bet on currencies directly. But, you aren’t paid 10% a year to make that bet. Here, you
are. You can buy a ton of stocks with price-to-book ratios less than 1. However, very few stocks
that trade below 1 times tangible book value are expected to generate as much as a 10% annual
return relative to that book value. And you can bet on stocks that have surplus cash, no debt, etc.
hoping they will add debt over time. But, many of those stocks are not the shares of companies
with capital allocation plans that would generate returns any time soon.
Vertu has bought back stock recently. It has long said it will start generating more free cash flow
starting in the second quarter of 2019. It’s likely to use this free cash flow – whenever it can’t
buy other car dealerships – to simply buy back its own stock. The company’s stock trades below
book value. And the company seems capable of earning 10% on its book value. This means that
any stock buy backs should generate returns above 10% a year (because, they’d generate 10% a
year if done at book value – but these will be done below book value).
Should – especially American – investors buy Vertu Motors stock?
Probably. A good rule of thumb would be to simply buy VTU shares at prices below the last
announced net tangible asset per share figure. The last announcement – from last year – was 45.9
pence. Just truncate that number for the sake of simplicity – to make sure you aren’t buying
above tangible book. That’s 45 pence. Whenever the stock is below 45 pence, buy shares. If you
do this – you’d also get the benefit of any buy backs done while you own the stock having to be
done at less than tangible book value. Of course, if the stock rises above 46 pence – those buy
backs wouldn’t be generating as much value. You might consider selling the stock only when it
surpasses tangible book value. Till that happens, just hold the stock indefinitely.
But, is the stock a huge bargain? Is there a big margin of safety?
No. If you consider all these dealerships to be worth only tangible book value – then, it would
make sense to set your bid price for this stock at a level that is some level below tangible book
value. Ben Graham often talked of buying at two-thirds of intrinsic value. Here, intrinsic value –
conservatively calculated – might be tangible book value. So, you could decide to buy the stock
whenever it traded at 2/3 of tangible book value. Right now, that’s about 30 pence. If you were
really a Ben Graham type investor – you might even set your buy point at about 30 pence and
your sell point at tangible book value. In other words, buy the stock at 30 pence or less. Sell the
stock at 46 pence or higher.
What if you’re a longer-term investor?
This should work fine as a buy and hold stock. While you own the stock, it might compound at
10% before we take any increase in leverage, increase in price-to-book, and increase in the value
of the Pound into consideration.
If the company really can generate about a 10% return on tangible book value year-after-year,
then the stock should be considered as good or better than the S&P 500, the FTSE, etc. whenever
it trades around tangible book value. This is because market indexes do not return more than
10% a year. So, if given the choice between owning an index at its current price or owning a car
dealer at tangible book value – you shouldn’t be any worse off picking the car dealer.
Is the stock safe? Is the business good? Etc.
The industry should be safe enough and good enough. VTU’s record so far has very little
volatility in results. Margins, returns on capital, etc. have all been very stable. A lot of the
company’s value come from after market revenues (servicing cars the company sold). About 70-
75% of the company’s profits come from service revenue and used car sales combined. New cars
drive a lot of revenue, but have much less influence over profits.
It’s hard to speculate about the long-term future of cars. Certainly the safety and quality here
both seem adequate. The quality – especially if the company never leverages up – may never be
above average. But, it could be average. Safety may be above average. Historically, this
company’s results haven’t varied much. And, historically, car dealers have had above average
business safety. Right now, the business is not leveraged. Half of locations are owned. It’s
definitely a safe stock for now.
If VTU stock was trading at or below 30 pence a share, this stock would already be getting
something like a 90% initial interest from me. But, today VTU is at more like a 15% discount to
tangible book value than a 35% discount. This means there isn’t much of a margin of safety. If I
was very certain about the company, the industry, etc. that might be acceptable. Right now, that’s
the issue.
Someone recommended I look at another U.K. car dealer – Cambria Automobiles (CAMB) –
and I’ll certainly do so. It’s always a good idea to look at a few peers at the same time. We’re
probably in the early days of my research into VTU. I’ll look more at this stock for the managed
accounts. And there’s a good chance I’ll write it up again here on Focused Compounding.
I’ve started scoring stocks on how well they do on my 5 initial interest questions combined. A
clear “yes” to any question gets you a plus one (+1). An iffy “maybe” to any questions gets you a
zero (0). And a clear “no” to any question gets you a negative one (-1). I sum up the five figures
to get a more objective assessment of how the stock looks on my 5 initial interest criteria. My
“initial interest level”, however, remains completely subjective.
 Is the stock overlooked? – Maybe (0). Vertu Motors has a market cap of less than 150
million Pounds. This puts it slightly less than $200 million U.S. Dollars. That’s often
used as a cut-off for what defines a “micro-cap”. However, Vertu has been public for a
long time, it’s not a spin-off, etc. And it’s part of a well-known industry group (car
dealers) with publicly traded peers. The company does quite a bit of investor outreach. I
can’t call this one overlooked. But, it is a borderline micro-cap.
 Do I understand the business? – Yes (+1). I didn’t talk about the business in this
particular write-up. But, car dealers are fairly easy to understand. I’ve looked at others
before – both in the U.S. and U.K. Margins, returns on capital, etc. are more stable in
this industry than in most. This particular company has been getting more and more
earnings from service revenue. The industry changes pretty slowly. Market share is
extremely fragmented. Car dealers as a business model are probably easier to
understand than 90% of the industries out there.
 Is it safe? – Yes (+1). Car dealers are pretty durable. This company doesn’t have a lot of
debt. It does have hard assets – land and car inventory – that are easy to borrow against.
Compared to other car dealers, VTU appears safer than most.
 Is it good? – No (-1). Car dealers don’t have especially high returns on capital. And
neither does Vertu. Car dealers aren’t bad businesses. But, unleveraged returns on
capital are no better than you could get just by buying into the stock market as a whole.
In other words, if you put equal portions of your savings into a collection of car
dealerships at tangible book value and an S&P 500 index fund on your 45th birthday, I’m
not sure – without the use of leverage – which of the two piles would be larger on your
75th birthday. Car dealers do have increasing returns with scale. VTU can get bigger and
maybe more profitable than it had been in the past. But, we could also have been in an
especially good part of the cycle for these 5-10 years. Much of my data is skewed toward
looking at the last 5 years at the shortest and last 8 years at the longest. The car business
in the U.K. had been getting a bit better each year for much of that period. I’m not sure
this company can generate returns on capital much above 10% a year. It’s an okay
business. It’s not a good business.
 Is it cheap? – Yes (+1). An established collection of car dealers with scale – Vertu is
bigger than all but a handful of competitors in the U.K. – should trade at a premium to
tangible book value, never at a discount. Vertu’s definitely a cheap stock.
“Objective” initial interest scorecard: 2 out of 5
Geoff’s “subjective” initial interest level: 70%
 URL: https://focusedcompounding.com/vertu-motors-a-cheap-and-safe-u-k-car-dealer/
 Time: 2019
-----------------------------------------------------
Vertu Motors (VTU): A U.K. Car Dealer, “Davis Double Play”, and Geoff’s
Latest Purchase
Accounts I manage own some shares of Vertu Motors (VTU) – bought last week – but, far less
than a normal position. Whether we end up owning a full position – that is, having something
like 20% of the portfolio in Vertu – or not depends mostly on whether the stock’s price comes
down and stays down for a while. As I write this, shares of Vertu trade for about 40 pence. They
were as low as 31 pence not too long ago.
I wrote the stock up last year. For my initial thoughts on Vertu, read that post. For a good
overview of the entire U.K. auto industry and the various publicly traded companies in it – read
Kevin Wilde’s post.
I’m going to spend most of this post talking about whether Vertu is cheap enough to buy now.
Before I do that, I should talk a little about Cambria Automobiles (CAMB). I had planned to do
a write-up of Cambria before writing up Vertu. I decided not to. My reason for skipping a write-
up of Cambria is that I realized I just didn’t have much to say about the stock. Cambria has
somewhat better margins and inventory turns than Vertu. So, the actual business provides a bit
higher returns on tangible invested capital. On top of this, Cambria has not issued more shares
over time while Vertu has. Vertu did two very costly capital raises – both many years ago – that
severely diluted existing shareholders at low values versus tangible book. This has had a big
influence on the outperformance of Cambria as a stock over Vertu. One possible explanation of
this is that top insiders at Cambria own between 40% and 50% of that company. At Vertu, the
two biggest insiders combined own something closer to 5% of the stock. Management’s
incentives for compounding PER SHARE wealth at Cambria are greater than they are at Vertu.
Until recently, Cambria’s management talked a lot more about the kind of metrics shareholders
care about than Vertu did. In the last couple years, this seems to have changed – with Vertu’s
management using a lot of the usual buzzwords about shareholder value. And then – in the very
recent past – Vertu’s actions followed those words. The company bought back over 2% of its
shares outstanding in the first 6 months of this year. Those purchases were done at very big
discounts to tangible book.
That explains my increased interest in Vertu today versus years ago. It doesn’t explain my
reasons for preferring Vertu over Cambria. I should be clear here. I don’t really think of it as
preferring Vertu over Cambria. Ultimately, I didn’t decide Cambria wouldn’t outperform Vertu –
it may FAR outperform Vertu for all I know – I just decided to pass on Cambria. In a recent
podcast, I told Andrew “We almost never bet on change.” I suppose you could argue a bet on
Vertu is a bet on a change in its capital allocation. Management is the same. But, I’m betting the
company won’t do as dilutive capital raises as it did in the period about 5-10 years ago. If it goes
back to doing those while I’m a shareholder – then, clearly I was wrong to buy the stock now.
But, putting aside capital allocation – and I should say that it’s only ever been the capital raising
(not the capital deploying) part of Vertu’s actions that bothered me – Vertu is undergoing much
less change than Cambria. Cambria is investing very heavily in new dealerships, upgrades, etc.
right now. As a rule, a company with above average returns on capital versus peers, versus
businesses generally, etc. that suddenly grows assets a lot is one you want to be careful about.
The easiest way for return on capital to decline is for a business to rapidly grow its capital base.
Vertu is already generating a lot more free cash flow this year and last than Cambria was (I’m
talking relative to reported earnings and things like that) and Vertu’s guidance is for much, much
lower capital outlays in the next two years than it had in the previous two. Meanwhile, Cambria
has shifted its business more than I like to see. It might be a really smart shift. But, it’s still a
shift. Cambria has gotten rid of some dealerships it had. And it has added very high end
dealerships – like McLaren, Lamborghini, and Bentley – that I just don’t want to bet on. These
franchises are very exclusive. They usually have much higher returns on capital – they have both
higher margins and higher turns than a Ford dealership would, for example – than mass market
type brands. But, it’s just the part of car dealers I least want to be involved with. It may be a
great business. But, I’m less confident I know where in the cycle we are with super luxury stuff.
And, some of these brands sell very, very few cars in the U.K. In the long-run, I am most
confident in the earning power of car dealers that get a lot of parts and service revenue from the
cars they sell. Brands like Lamborghini – and, to be fair to Cambria they are combining some of
these super luxury franchises in the same big locations in part probably to deal with this issue –
sell so few cars that I worry drivers are far distant from service centers. I’m not sure that’s true.
Cambria is much more skewed in terms of geography to the London area. And extremely
wealthy people in the U.K. are disproportionately in that part of the country. In fact, I’ve called
Cambria a “United Kingdom” car dealer group – but, if I’m reading the map right, I think they’re
really just an “England” car dealer group. I don’t see any clusters of locations much outside
England itself. In the long-run, I’d be more worried about direct selling of very expensive cars
than things like Ford. I don’t want to overstate the difference between Cambria and Vertu in
terms of brands here. Vertu does have Land Rover and Jaguar dealerships which – while not in
the class of McLaren, Lamborghini, and Bentley – are luxury cars. And Cambria has some of the
same mass market brands that Vertu has. It’s just that when I look at the capital allocation plans
of Vertu and Cambria – I feel like I see a pivot at Cambria towards more of these extremely
pricey cars and towards investing a lot in building the best dealerships in the best locations.
Finally – and this last point is subjective, you can read both companies’ earnings releases from
the last year or so – I think Vertu’s recent results look better and more stable to me. It’s harder
for me to tell if Cambria’s older, non-luxury dealerships are holding up well at all. Some of the
same store sales (“like-for-like”) numbers look poor to me. Vertu’s numbers look solid. I have
no reason to believe Vertu stock will outperform Cambria stock. But, I don’t think it’s really a
critical part of my job to pick between the two stocks. All I need to do is find one I’m
comfortable enough with at a cheap enough price. I think I found that in Vertu. Cambria checks
the right boxes as a stock. It looks better than Vertu on many measures. But, my confidence level
in Cambria is just lower than it is in Vertu. So, for me – Cambria was definitely a pass. And then
it was just a question of whether I’d buy Vertu and at what price.
I recently re-read “The David Dynasty” which is about 3 generations of investors in the Davis

family. The first owned insurance stocks on margin. A term repeated over and over again in that
book is “The Davis Double Play” which means: 1) The stock’s EPS rises while you own it and 2)
The stock’s P/E multiple expands while you own it. It’s the combination of these two things that
drives really good results in stocks that are neither deep value stocks nor super fast growers.
Although I don’t think I’ve ever used the term “Davis Double Play” on the podcast – it’s clear
that the combo of EPS growth and P/E multiple expansion is a big part of the winning stocks I’ve
had. The first Davis generation focused on insurers. And that was a particularly good group – as
compared to say technology companies – to focus on when trying to find a “Davis Double Play”.
The advantage of insurers is that as long as they survive, they don’t become obsolete. So, there
will usually be a high point in the cycle again where investors put a high enough P/E on an
insurer. Insurers aren’t fads.
Neither are car dealers. I think U.K. car dealer stocks can give investors a “Davis Double Play”. I
have no idea what will happen with Brexit and its immediate aftermath. There could be some
terrible recession that eats into auto sales for 3 or 4 or 5 years. But, putting that short-term to
medium-term risk aside, I’d say we appear to be at roughly the mid-point of the car sales cycle in
the U.K. Basically, I think today’s earnings at a company like Vertu are roughly “normalized
earnings”. Over the next couple years, Vertu will probably convert a lot of EPS into free cash
flow. But, normally, I’d expect car dealers could convert as little as 2/3rds of EPS into free cash
flow. I use normalized FCF ratios rather than P/E ratios when analyzing a stock. So, let’s start
with that assumption. Vertu’s current P/E is 8. That would translate into perhaps a Price/Free
Cash Flow as bad as 12 (or 8.33% FCF yield). Vertu has basically no net debt. It leases half its
locations. And it finances its inventory. It has some cash. Overall, I’d say it does have some debt.
But, it uses less leverage than almost all car dealers in the U.K. or U.S. would consider normal
and prudent. It’s basically unleveraged.
There are other ways to try to come up with the current price. The one I just gave you says the
normalized FCF yield would be greater than 8%. Another approach is to use EV/Sales. In recent
years Vertu has had operating margins of 1.1%. EV/Sales is 0.05 right now. Eventually, the U.K.
tax rate is expected to decline to 17%. Taking these 3 figures together we get 1.1%/0.05 = 22%
pre-tax yield on the stock times 0.83 equals 18% after-tax yield. Then we once again assume
EPS converts to FCF at 2/3rds rate. This brings us down to a 12% FCF yield assumption. So far
we have one method telling us it’s an 8% FCF yield and another saying 12%.
We can also use the price to tangible book approach. Vertu now trades at 0.9x tangible book.
Adequately performing dealerships – even single locations – tend not to go for less than tangible
book in negotiated sales. I would assume a sale of all of Vertu’s dealerships together to some
competitor bigger than Vertu would be done at closer to 1.2 times tangible book than 0.9 times
tangible book. In recent years – I used the last 4 years for this one – Vertu’s EPS divided by its
STARTING net TANGIBLE assets per share for the year was in the 12-17% range. In other
words, if returns on tangible assets were the same going forward – they’d be about 12/0.9 =
13.3% to 18.8% (17/0.9).
I don’t expect Vertu’s actual returns to be that high. It has a lot of goodwill and intangibles.
These don’t matter if the company doesn’t buy more dealerships at above tangible book value in
the future. But, I expect it will. So, returns will not be as good as like teens returns on reinvested
earnings.
The stock pays a 4% dividend yield which it covers about 3 times (company guidance is to pay a
dividend it can cover at least 3 times).
If we are in a normal point in the cycle and dealerships can grow in line with nominal GDP and
U.K. nominal GDP grows at about 5% a year for the next 10 years – then, we can assume things
like EPS, dividends, etc. will grows about 5% a year before adjusting for share issuance and
buybacks.
Let’s just assume 4% annual growth. Population growth is quite low in the U.K. Inflation is not
terribly high. And the entire car industry doesn’t grow faster than the economy (though I suspect
big dealers like Vertu will take share from small dealers either organically or through buying
them).
Let’s assume Vertu is trading for somewhere between 5 (that is, an 18% FCF yield) and 12 times
normalized FCF (that is an 8% FCF yield). You can check the methods above for trying to
determine normal earnings. I’m going to go with 10%. That may be low compared to what FCF
will be these next couple years. But, in the long-run, I’m not sure car dealer EPS converts to FCF
very well. Still, I do think the stock is trading at about 10 times its normal FCF.
Normally, I’d expect to sell a stock at around 15 times free cash flow. That is, I’d expect a
durable business – like a car dealer – to eventually trade for 15 times free cash flow.
So, let’s assume normal free cash flow here is 4 pence a share. It compounds at 4% a year for the
next 10 years. That’s 5.92 pence. I’m going to call that 6 pence in free cash flow expected in
2029. That’s an expected share price of 90 pence. The capital gain over 10 years going from a 40
pence share price to 90 pence share price would be 8.5% a year. The dividend yield is 4% right
now. Presumably, the dividend would grow along with EPS – but I’ll ignore that. You add the
dividend yield to the 8.5% a year capital gain and get a 10-year expected return of 12.5% a year.
This assumes the stock eventually trades at 15 times free cash flow. Vertu hasn’t traded at that in
the past. But, it’s been my experience in investing that if you are right about what the company
will look like down the road – the market will award the multiple you expect regardless of what
past multiple it assigned the stock. In other words, if Vertu doesn’t issue more shares at low
prices, if it does buy back stock, if it does keep raising its dividend, if it does earn a teens type
ROE excluding acquisitions – it’ll eventually trade for a “normal” stock price of like 15 times
free cash flow (which, remember, is not a very high P/E if conversion from EPS to FCF is as
poor as I think it can be). In this calculation, we’ve also omitted the other 6% of the current
purchase price that I expect to be normal FCF that isn’t paid out in a dividend. Ideally, Vertu
would use this to buy back stock. But, I’m skeptical. At best, they’ll buy back like 4% of their
shares this year. At worst, more like 2%. Some U.S. car dealers – most notable AutoNation
(AN) – have been way, way more aggressive with buybacks. I don’t think Vertu will ever get
that aggressive. But, if the stock stays cheap – you’ll get a very good return on any buybacks
done with that extra free cash flow. I don’t know what Vertu will do with the extra free cash.
But, it’ll be something. Maybe acquiring stuff. Maybe buybacks. Maybe higher dividends. But,
the company is already a bit overcapitalized by car dealer standards. It won’t just pile up the
cash. So, something will be done that should add on to the already expected 12.5% a year return
discussed above.
In this way, Vertu is a “Davis Double Play”. It can grow 4% a year or something without any
buybacks. It might buyback a couple percent a year so EPS grows more like 6% a year. And then
the multiple is likely to expand from a P/E of 8 to something closer to a P/E of 12 or more. Just
an expansion to a P/E of 12 would add more than 4% a year to your return over 10 years. There’s
also a dividend. Anyway I crunch it, I’m getting expected 10-year returns in like the 12-15%
range.
In my experience, if you’re right that the return for a 10-year holder of the stock will be in the
10-15% a year range – you’ll end up making a better CAGR than that, because the stock will rise
a lot faster than you expect and you’ll end up turning over the shares to someone else a lot
quicker than 10 years from now. So, a stock that seems very likely to do better than 10% a year
often gives you really good results over like a 3-year holding period instead.
Like I said, accounts I manage own some shares of Vertu. But, the number of shares they own
right now is a lot les than what I’d like to own. I’m certain to bid for more shares in the future.
But, it’s uncertain how many shares I’ll get at the prices I’m willing to bid at.
 URL: https://focusedcompounding.com/vertu-motors-vtu-a-u-k-car-dealer-davis-double-
play-and-geoffs-latest-purchase/
 Time: 2019
-----------------------------------------------------
Vulcan International (VULC): A Dark, Illiquid Company Planning to

Liquidate its Portfolio of Bank Stocks and Dissolve
This is another “initial interest post”. I was looking at Vulcan International for the managed
accounts I run. As a first step, I write up the company here and rate my interest in following up
on the stock – as a candidate for purchase in those managed accounts – on a scale from 0%
interest to 100% interest. I’ll reveal my interest level at the end of the post. Now, that I’ve got
you hooked with suspense, let’s start the post off with a discussion of just what “dark” means
here.
Vulcan International (VULC) is a dark stock. And here when I say “dark” I don’t just mean it
doesn’t file with the SEC. I’ve mentioned Keweenaw Land Association (KEWL), Computer
Services (CSVI), and OTC Markets (OTCM) before as “dark” stocks. In those cases, all the
word “dark” means is that they don’t file with the SEC.
Those dark stocks present less information about some things than SEC filing companies. But,
about other things – like appraisals of their land in the case of KEWL and long-term historical
financials in the case of Computer Services – they sometimes provide as much or more
information. For example, Maui Land & Pineapple (MLP) is listed on the New York Stock
Exchange and files with the SEC while Keweenaw Land trades over-the-counter and does not
file with the SEC. MLP isn’t really more forthcoming about the likely market value of their land,
their plans to develop or sell land, etc. than KEWL is.
Vulcan International though is a truly dark stock. It usually tells the public nothing. In fact, some
investors have only gotten information on the company after signing a non-disclosure agreement.
There are two reasons why a company might be extremely secretive. One, management is using
being a “dark” stock and not reporting any information to outside shareholders as a way to strip
the company bare. It could be that the CEO or controlling family is siphoning off assets and
slowly converting shareholder wealth into management wealth. I’ve seen this before.
But, I’ve also seen a second reason for a company to be extremely secretive. Management knows
they are valued in the stock market but they have no self-interest in their stock price getting more
expensive. They are simply running the company for the long-term. As controlling shareholders,
a board, etc. they can always realize the value of the business in a way minority shareholders
can’t. Basically, insiders at a very valuable business can always elect to liquidate the business or
sell it off to a 100% buyer. Unlike passive minority shareholders, the day-to-day trading in the
stock isn’t the way they are going to get out of the business. So, the bid and ask prices you see in
that public market just don’t matter to them.
Vulcan International is an example of reason #2. The company was sitting on assets that were
very valuable and very underpriced by the market. However, in the last year or so – the market
has greatly increased the value it put on Vulcan International. So, when I tell you the news that
Vulcan has announced its plan to liquidate – this doesn’t necessarily mean there’s a lot of upside
left.
Here is the most important part of this article. Read it carefully. Read it twice. This is the catalyst
that investors have long been looking for in this stock. It’s the press release where Vulcan
announced its intention to liquidate the company and distribute its assets to shareholders:
“…the Board intends to liquidate all corporate assets, and distribute all available proceeds to
the stockholders, as far in advance of the expiration of the three-year winding-up period as
possible. The Company intends to make such stockholder distributions as tax efficient to the
stockholders and the Company as possible…”
As I’m writing this article – on Sunday, October 14th 2018 – Vulcan’s last trade price was $120 a
share. The highest anyone is bidding is $118 a share and the lowest anyone is asking is $140 a
share. So, we can say the stock’s “price” is somewhere in the $118 to $140 range.
Is the value of the stock in liquidation around that same level of $118 to $140 a share?
Before I try to add up the company’s likely value in liquidation – which others have done before
me, I’ll be linking to their attempts in a minute – I thought we should stop a second and make
sure we understand where exactly that value resides. It makes a big difference if this company
has $100 million in cash, $100 million in 100 different stocks, $100 million in one single risky
stock, etc. It may take them some time to liquidate. Or, they may be doing it already. We’ll deal
with the timeline in a second. But, first I want to give you some idea of what proportion of the
value we’re talking about is in what assets.
So, what assets does Vulcan own?
You can see the company’s balance sheet ending 2016 (so, almost 2 years ago). Marketable
securities are 94% of total assets. Cash is 2% of assets. So, marketable securities and cash are
96% of total assets. Liabilities are very close to nil. There is a large liability item shown in that
2016 balance sheet. However, almost all of total liabilities on that balance sheet are deferred
taxes. These are taxes that would be paid on realized gains in the marketable securities. That
balance sheet – because it’s for the year 2016 – has about 35% of the unrealized gains in
marketable securities shown as “deferred income taxes”. We can assume that if the company was
applying the statutory federal corporate tax rate of 35% in 2016, we should now apply the new
statutory federal corporate tax rate of 21%. So, the liability figure should be a haircut of about
21% of the unrealized gain in the marketable securities.
There are other aspects of that balance sheet that might be misleading in the sense that book
value does not represent fair market value. Two items immediately jump out at me. One, we can
see the company owns timberland. Marketable securities are carried on the balance sheet at their
market value. However, timberland is not re-valued over time. And the same number of acres of
timberland become more and more valuable in nominal dollars as time goes on. Therefore, the
book value of timberland is almost always understated. So, timberland might be a meaningful
asset here. But, meaningful in the sense it could be worth anywhere from like $1 to $10 a share
on a stock we said is trading in the $118 to $140 range. In other words, timberland is a single
digit percentage of the stock’s market value here. The company has also depreciated most of the
value of its property other than land. You can see that the contra asset account under property,
plant, and equipment equals a little over 90% of the asset line “gross property, plant, and
equipment”. Basically, the company has completely depreciated any property they are allowed to
depreciate. All that is left on the balance sheet undepreciated is stuff like timberland and other
forms of land – not buildings – which can’t be depreciated.
So, what do we make of all this? I’d just say that the company owns some timberland, some
land, some buildings, etc. But, I can’t see it making way more than a $10 or so per share
difference on a $118 to $140 stock. In other words, everything other than the marketable
securities portfolio is just a matter of whether the stock is worth 10% more or 10% less than what
you estimate it is. Because of these items, two equally reasonable people looking at this stock
with the same amount of diligence might vary in their estimates of liquidation value by 20%.
Because of this fact, it would be risky to invest in Vulcan at 90% of your estimate of liquidation
value. That’s even putting aside the question of how fast this liquidation happens. And, there’s
always a risk something will come up to stop the liquidation from happening. So, you can’t have
100% confidence the liquidation will happen, you can’t know how quickly the liquidation will
happen, and you have to assume your estimate of liquidation value might be off by 20%. As a
result, all of the assets other than the marketable securities would be nice to have – but, all they
give you is more of a margin of safety than a lot more upside you can count on. So, as a potential
investor, I wouldn’t bother spending time trying to value any kind of land, property, or really any
other kind of assets but the stocks.
Let’s get to those stocks then.
The way we’ll value this company is by simply totaling up all of the stocks the company owns
and all the cash it has – or had on hand as of the end of 2016.
Before I go on, I’ll mention that I’m relying on the financial statement for the year ending 2016
quite a lot here. You can read that document here. Although this is a truly dark stock and I have
no information between that 2016 year-end financial document and the press release put out
announcing the liquidation – it’s a perfectly normal document that I’m seeing for the year 2016.
It’s audited. The auditor is small, but they’ve been inspected by the PCAOB (Public Company
Accounting Oversight Board) and while the sample size of that inspection was quite small, there
weren’t important deficiencies detected in that inspection. What I’m saying – because I know a
lot of people reading this are a bit scared of stocks that don’t file with the SEC – is that if all I
knew about this company was those 2016 financials, those financials wouldn’t look questionable
to me, overly aggressive, etc. That 2016 financial report doesn’t concern me as much as some
documents I’ve read that were filed with the SEC by small companies on major exchanges. So,
the darkness of this company is a concern. We don’t know a lot – and that’s the way
management likes to keep it. But, what we do know isn’t especially concerning.
Okay. Now, it’s time to actually value this company. Here’s how we’re going to do it.
I’m going to apply a roughly 20% haircut (the corporate tax rate is now 21%) to the entire value
of the stock portfolio. Why? There’s information in those 2016 financials that suggests that
almost all of the value of the stocks is unrealized gains that haven’t been taxed yet because they
haven’t been sold. There may be ways for the company to do this liquidation in a more tax
efficient way than at 80% of the market value of the company’s securities portfolio. But, it’s
unlikely that the liquidation would be done at a level – after taxes – that’s much worse than that.
So, having me just total everything up and then multiply that figure by 0.8 to get the liquidation
value seems like a conservative enough way of doing it. It’s not overly conservative though. It’s
pretty close to what may turn out to be correct.
Let’s start with the market value of the securities at the end of 2016. Cash and marketable
securities taken together were about $143 million. The company had a couple million in
liabilities (other than deferred taxes). But, these were more than offset – at the end of 2016 – by
assets (like buildings) held for sale and other property we now know the company will liquidate.
So, $143 million sounds like a good number. At the end of 2016, the company had 911,534
shares outstanding. I’m not 100% sure that number is still correct, because the company has a
program that allows directors to buy treasury shares owned by the company for themselves. This
would move shares from “treasury” to “outstanding”. I have no reason to believe directors used
this program to buy a lot of shares. And, of course, the company would then have cash added to
its balance sheet for those treasury shares. So, let’s go with 911,534 shares.
Our first estimate of the liquidation value of Vulcan International is now $143 million times 0.8
equals $114.4 million divided by 911,534 shares equals $125.50.
Now, let’s assume the bid price of $118 is how much you can pay to get shares. If you pay $118
now and receive $125.50 in one year – how much have you made?
About 6%.
The liquidation could happen a lot quicker than one year. Or, it could take as long as almost 3
years. Under Delaware law, the company must complete its liquidation payments within 3 years
now that it’s given notice of its plan.
What’s the upside potential here?

Well, things like timberland could be worth something. I don’t have information on the exact
amount of timberland the company owns. And I don’t want to repeat claims I have heard given
without any supporting evidence. If the claims I’ve heard about what timberland the company
owns are true – the sale of this timberland at what timberland in the same area is appraised at
might potentially bring in up to another $12 in value for this stock. So, let’s pretend that’s true.
Let’s pretend you could pay $118 today (the bid) and get $137.50 in a year. What kind of return
would that be?
About 17%.
We are now talking about annual returns in the 6% to 17% range. And, of course, if the
liquidation happens – or the first bulk of the payment happens – in closer to 6 months than 1
year, you’ve got a market beating type annualized return.
Is it risk free though?
No. The company owns stocks. And, in fact, most of the value of the marketable securities
portfolio – and therefore most of the value in the company – is probably in just a few stocks. I
say “probably” because I am going off old information about what shares the company owned.
We can use Nate Tobik’s post over at Oddball Stocks about what shares the company owned and
combine it with that 2016 balance sheet and see from those facts that the assumption Nate made
that the company never sold these stocks is probably correct. Almost the entire portfolio shown
in that 2016 balance sheet consists of unrealized capital gains. That wouldn’t be the case if they
sold stocks and bought others. We have every reason to believe this is a total “buy and hold”
type situation.
If that’s the case, then what assets does Vulcan International own?
At the time Nate wrote up the company’s stock holdings – earlier in 2018 – the portfolio looked
something like this:
PNC Financial (PNC): 59%
U.S. Bancorp (USB): 24%
There’s really no point in going on beyond that. The #3 and #4 stock on that list accounted for
something like 5% each. And, actually, we don’t know if assets like timberland and other real
estate holdings the company has are worth less than stocks #3, #4, and beyond. So, in terms of
“major” assets I would only say that PNC common stock and U.S. Bancorp stock are worth our
time.
In fact, it’s likely that most of the assets that need to be sold off and/or distributed to
shareholders are: PNC stock, U.S. Bancorp stock, timberland, other real estate, and cash.
PNC stock has declined since Nate wrote that post. But, let’s start by going with the marketable
securities value he laid out and then adjust it downward as needed.
First, here’s Nate’s 2018 post on Vulcan International.
He gives a value on that stock portfolio of $163 million. If we apply a 20% tax haircut to that
number we get $163 million times 0.8 equals $130.4 million divided by 911,534 shares equals
$143. So, the upside there would be bidding like $118 for the stock now and getting $143 in the
next 3 months, 6 months, a year, 3 years, etc. Let’s assume you can get the stock by bidding
$118 and that you’ll receive $143 in liquidating distributions within 1 year. What would you
annual return be?
It’d be a 21% annual return. And, if we assume the timberland, other real estate, cash, etc. adds
another $12 or so after-tax you’d get a value of $155 in possible liquidating payments. Again,
assume you can pay $118 and get back $155 at some point.
If you pay $118 and receive liquidating payments of $155 within one year, you’ve made more
than 30% a year in this stock. If it takes 2 years, you’ve made about 15% a year. If it takes 3
years, you’ve made about 10% a year.
However, I do need to pause here and mention that PNC stock – which was believed to be
Vulcan International’s largest holding – has dropped in price since Nate wrote that post. PNC
stock is down 15% since Nate wrote that post. The drop in PNC stock would trim about $12 a
share off the likely liquidation value of Vulcan International. That would bring us down to a
liquidation value of around $143 if real estate, timberland, etc. is worth what I think it might be
worth. You might be able to get down to a liquidating value of around $130 if those things aren’t
worth anything.
But, it’s hard to get much below $130 in liquidating value. And it’s quite possible to get values
of $150 a share or higher. Also, the vast majority of this company’s value is in the stock of very,
very liquid banks. You could easily sell off $100 million worth of PNC bank stock – or, you
could just distribute the stock to shareholders directly.
There are a lot of upsides I haven’t considered. Maybe there is a more tax efficient way – than
simply selling the stock this company owns for cash and paying the federal government 20% of
that sale price. And maybe – because you could just sell these shares in the open market
tomorrow, or you could distribute the shares within a matter of months – the liquidation will
happen faster than in one year.
Here’s one way of looking at it. This stock’s last trade price was $120. Most of the approaches I
used to try to guess what the after-tax liquidating payments would be here were over $130. The
liquidation could be mostly done in under a year (the company could make a really big payment
very early on and then decide on the final, smaller payments much later). So, let’s take the
bottom end of each of those estimates. Let’s say the liquidating payment isn’t more than $130 –
it just is $130. And let’s say the liquidating payment doesn’t happen sooner than in one year.
Let’s say it does happen in exactly one year.
Putting out $120 today to get $130 a year from now is an 8.3% investment return. That might not
sound sexy. Maybe you have better ways to make more than 8% a year. But, the truth is that I
don’t expect bonds, stocks, etc. generally to have a high probability of returning well over 8% a
year. A small increase in the eventual liquidating payment or a small increase in the speed of
when this liquidation will happen could get you higher returns. So, the reality may be that you
could make anywhere from 8% to 30% annualized in this stock.
Would I assume it’ll be anywhere close to 30% annualized?
No.
But, would I assume that Vulcan has a better chance of being an 8% or greater return than any
stocks, bonds, etc. I could buy with the planned commitment being a matter of months to 3 years
top?
No.
This is a short-term “workout” as Buffett would say. Compared to interest rates and other
opportunity costs – it looks like a reasonable place to park money for a few months to a few
years.
If you want to learn more about Vulcan, these write-ups go into much more detail about the
business, the people, and the past story:
Oddball Stock’s Original Write-Up (2015)
Oddball Stock’s Follow-Up (2018)
Jan Svenda’s Seeking Alpha article (2018)
So, what’s my verdict?
I can’t tell you what Vulcan will return.
But, at its last trade – $120 a share – Vulcan looks priced to return as much or more than the
stock market with as little or less risk than the stock market. Remember, a 1-3 year bet on the
stock market isn’t anywhere near a riskless proposition. And bonds maturing in 1-3 years don’t
yield 8% or more.
That makes Vulcan a serious contender for my next stock purchase. This one goes to the very top
of the pile of stocks I don’t yet own.
Geoff’s Interest Level: 90%
 URL: https://focusedcompounding.com/vulcan-international-vulc-a-dark-illiquid-
company-planning-to-liquidate-its-portfolio-of-bank-stocks-and-dissolve/
 Time: 2018
-----------------------------------------------------
Nekkar: Why We Bought It – And is It Cheap?
Someone emailed me a question about Nekkar:
“I was just curious to understand your thesis on Nekkar. Although they quite correctly have a net
cash position of MNOK 0,3bn, they also have close to 0,2 in negative WC (95 in
receivables/inventory minus current liabilities of MNOK 274), and I believe most of the cash in
Syncrolift (0,2) comes from pre-payments, which over the course of the project will be used for
buying raw materials, paying sub-suppliers etc. I am not sure of the percentage but according to
the annual filings in 2018 Syncrolift had MNOK 135 in cash and 130 in pre-payments, so I
would guess it is a meaningful amount.
EBITDA for Syncrolift was MNOK 30 and 40 in 2017/18. However, if we take out corporate
costs of MNOK ~5 which was the average level for the two years, we arrive at a normalized
EBITDA of MNOK 35-45. If we slap on a multiple of 6-7x we arrive at a range of MNOK 200-
300, so lets use MNOK 250 a midpoint.
With these assumptions I get the following break-up-value of Nekkar ASA:
Net cash Nekkar: MNOK 100
Negative WC Nekkar: -180
Cash (non-restricted) Syncrolift: 25 (?)
EV Syncrolift: 250
= ~200, which is considerably less than today’s market value.”
We don’t value Nekkar on a liquidation basis. Obviously, like an insurer – or anyone with “float”
– they would be worth quite a lot less if they ran down their business and closed than if they
continued. Syncrolift is quite cyclical. So, this complicates things. If backlog rises over time –
the negative working capital position will get more negative (cash will come in the door). If it
falls, then cash will end up being used on the project.
So, you’re absolutely right that Nekkar wouldn’t be worth anywhere near what we think it is if it
stopped bringing in new orders. The reason for buying the company would be that any new
orders would also generate float to the extent that new orders exceed completion on existing
orders (backlog rises). They’d always have the same cash on hand (basically) if the backlog
stayed essentially flat. Again, this is similar to an insurer. Whenever premiums written today at
an insurer drop versus last year, a portion of their balance sheet has to be liquidated and cash
flows out the door. They have less customer cash on hand. Nekkar would work the same way.
Whenever new orders fall the amount of pre-payments will fall. Whenever new order rise, then
pre-payments would rise.
We would never have considered the company unless it was on an ongoing basis. So, the fact
that cash isn’t earned isn’t as much of a negative to us looking at this as other people I think. I
think other people look at it and say – rightly – that Nekkar can’t (unless they always have this
long a backlog) count on having that cash on hand. It’ll flow out of the business in the future.
We look at it and think that any new orders they get will be on similar terms. Therefore, if
Nekkar grows revenue much at all over the long-run, they’ll create a lot of value because that
growth will be funded with customer money (not retained shareholder money).
I looked at all the long-term business unit data I could get on Syncrolift. I do have concerns
about Nekkar. But, they aren’t at the Syncrolift level. Basically, Nekkar may mis-allocate capital
at the corporate level. And I’m not at all convinced they will cut corporate costs enough so that a
lot of Syncrolift’s earnings at the business unit level will really flow to shareholders. This was a
much bigger company. Syncrolift is very small. It can’t support a lot of overhead at HQ and be a
good business.
So, really, I would just say that we bought Syncrolift because we think it’s a good business that –
if it grows – would create a lot of money for shareholders (because return on incremental
invested capital would be very, very high).
You’re right that Syncrolift wouldn’t be worth anything like what we paid in liquidation. The
entire value of “float” (cash received in advance of services provided) exists only in an ongoing
business. It is a bad thing to have in liquidation – but, a good thing to have if you’re going to
grow the business.
Without getting into my exact estimates, if you assume I thought that the company could grow
5% or more a year in terms of new orders, backlog, eventual earnings etc. over time from one
cycle to the next (with huge cyclical variations within any few years in that period) then, I’d get
a number for the company’s value 10 years from now or something that’d be very high. This
happens whenever there is growth with very little shareholder money being used. A company
that grows 5-6% a year using almost no shareholder money is going to tend to create more value
than a company growing say 8-9% a year while using every dime of shareholder money to do it.
Andrew and I just did a podcast on this subject. I think it’ll go up today. It’s called something
like “The Only Way Buy and Hold Ever Works”. So, you might want to search for Focused
Compounding Podcast “The Only Way Buy and Hold Ever Works” or follow my partner,
Andrew Kuhn, on Twitter (@FocusedCompound) and you’ll see it. Although that’s not a podcast
about Nekkar – I think it explains why we’d own something that has cash and owes deliveries.
Over time, we think a business model of getting paid in part upfront by customers and then
completing their orders over time can be a very good one if we think orders will continue –
adjusted for the cycle, we’re nowhere near a low point in Nekkar’s backlog right now, so it’s
important to be conservative about volume of business expected in the near future.
Basically, I’d be willing to pay a much higher multiple of EBITDA for a business that uses
primarily customer money than a business that uses primarily shareholder money. However, this
only makes sense if you look at the business as something to be owned for a while. Not sold
soon.
I’ve talked with some people about Nekkar. Generally, they are more excited about the cash on
hand, near term prospects, etc. and would put a lower EBITDA multiple on Nekkar than I would.
Conversely, I’d value the ongoing business higher and care less about the cash and near term
future.
I wouldn’t say Nekkar is a value investment. I don’t think we paid a very low price for it. I do
think we got a good business model from it.
 URL: https://focusedcompounding.com/nekkar-why-we-bought-it-and-is-it-cheap/
 Time: 2019
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Cheesecake Factory vs. The Restaurant Group
A blog reader emailed me these questions:
“With respect to CAKE and its same-restaurant sales decline, do you have any thoughts on the
following:
1. The strength / source of its economic moat?
2. Will the cost spread between eating at home and eating away from home narrow, and if
so, what will cause it to do so?
3. Are you worried about declining foot traffic at malls, and brick and mortar stores in
general, as it pertains to CAKE?
I’m also wondering if you still feel The Restaurant Group is a potentially attractive idea?”
First, an aside: For those who don’t know, what he’s talking about in #2 is the fact that food
prices in U.S. supermarkets have been falling for about 2 years even while food prices in U.S.
restaurants have been rising. That’s historically rare. In fact, the recent rate of change in
the relative price of food in supermarkets versus food in restaurants may be historically
unprecedented. Other things equal, such a relative price change obviously causes restaurant
traffic to fall and supermarket traffic to rise.
Back to the questions…
1) I don’t think Cheesecake Factory (CAKE) has a moat. Everyone goes to multiple

restaurants. The most successful restaurant chains do a good job of compounding wealth for
shareholders and earning high returns on capital. But, no restaurant is insulated from competition
with others. So: no moat.
2) Yes. At some point, prices of food in supermarkets will rise faster than prices of food in
restaurants. Several publicly traded supermarkets had EPS declines of 10% to 20% this year.
That won’t continue indefinitely. At some point, they will have to open fewer new stores, close
some existing stores, and raise prices. Food at home prices have fallen because retailers have
accepted pricing that earns them less money. What’s happened is not that food costs are down.
It’s that supermarket profits are down. The cycle will get worse as long as rivalry in food retail
gets more intense and then it will get better only once rivalry in food retail gets less intense.
Right now, food retailers are more intense rivals than restaurants. I haven’t seen anything that
changes costs in food. I’ve just seen supermarkets and other retailers lowering prices without
lowering costs – and thereby lowering profits for themselves and their competitors.
3) Yes. Declining traffic to malls is the biggest risk for Cheesecake Factory. Management thinks
it can grow from about 200 locations in the U.S. to about 300 locations. That means finding
another 100 good locations for a Cheesecake Factory where there isn’t already a Cheesecake
Factory. If there is a societal shift away from visiting malls, I’m not sure it’ll ever be possible to
add 100 more Cheesecake locations in the U.S. It’s true that Cheesecake is in better malls and
what I’ve seen anecdotally is the very best malls I’ve been to in New Jersey and Texas show no
signs of any traffic decline while the very worst malls I’ve been to in New Jersey and Texas
show signs that they are on the verge of being totally abandoned.
I don’t like The Restaurant Group as much as Cheesecake Factory. The Restaurant Group is a
fairly typical operator of fairly typical casual dining restaurants in the U.K. Basically, The
Restaurant Group does in the U.K. today what plenty of U.S. casual dining operators started
doing a couple decades ago. The problem is that the U.K. is behind the U.S. in terms of the
development of casual dining restaurant chains. Chains have been expanding faster over there.
This means that the pace of expansion of casual dining concepts and the starting of new casual
dining concepts in the U.K. is intense compared to the U.S. I don’t like investing in an
“unsettled” industry. In the next 5 years, I believe more competing restaurants are going to open
near a Restaurant Group location (Franky & Benny’s, Chiquito, etc.) than are going to open near
a Cheesecake Factory location.
Cheesecake is a more differentiated concept (it can go in places that make sense for Cheesecake,
Maggiano’s, or a higher end restaurant but don’t make sense for your average Chili’s, Olive
Garden, Texas Roadhouse, etc.) Cheesecake has a well-known brand (the mindshare is
abnormally high for a casual dining restaurant chain). And then Cheesecake is just in places (the
U.S., “A” malls, etc.) that aren’t going to add as many restaurants within a drivable radius as
what you’re going to see with The Restaurant Group in the U.K.
I’m not saying The Cheesecake Factory stock is better priced probabilistically versus The
Restaurant Group stock. Cheesecake may not be a better investment. I’m just saying Cheesecake
Factory has a more certain future. And I’m the kind of investor who prefers to put my money
into the business with the more certain future.
Just as one indicator of what I mean: The Restaurant Group closed something like 30 locations in
just one year recently. By comparison, Cheesecake Factory has rarely ever closed a location with
the exceptions of: A) moving to a different nearby location or B) Not renewing a lease after
there’s been a change to the mall in some way. In fact, I think they still opened one net new store
in 2008-2009.
I am speaking only about The Cheesecake Factory concept. I have no opinion on Grand Lux and
Rock Sugar. In my appraisal of the stock, I assume those concepts are worthless and only the
company’s namesake concept has value.
For those who don’t know The Restaurant Group, it’s a collection of U.K. casual dining
restaurant chains. I wrote a 10,000+ word report on the stock maybe a year or so ago (it’s up on
the member site). The company has had problems recently. For a description of what those
problems are and what management is doing to fix them, I recommend reading the latest Interim
Results press release.
 URL: https://focusedcompounding.com/cheesecake-factory-vs-the-restaurant-group/
 Time: 2017
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He Who Has the Highest Opportunity Cost Wins (CAKE, NC, GRBK)
Someone who reads the blog emailed me about Cheesecake Factory (CAKE):
“Why are you not buying CAKE – it is around 66 cents on the dollar – at 40 dollars (a share)?”
When I answered that to his satisfaction, he asked:
“…So your options right now are most likely OMC, Howden and CAKE? You said in your OMC
(stock report) that it was the best business you’ve ever analyzed. Is that still the case, especially
compared to CAKE etc.?”
Omnicom is a better business than Cheesecake. However, Cheesecake may have more room to
deploy capital within the business for the next 5, 10, 15 years. Apparently, Cheesecake
management still thinks they can grow the concept from 200 locations to 300 locations. It’s not
unheard of for them to open 8 new restaurants a year. So, that’s probably equivalent to 3%
compound annual growth in the number of Cheesecake locations over a period of 10-15 years.
Each location may be capable of earning a 10% to 15% after-tax return on the company’s cash
investment of say $8 million to $12 million (they also sign a lease, but this does not tie up any
shareholder money). Let’s call it $10 million per location in cash the company puts in and they
can repeat that same $10 million bet at each of another 100 new locations – that’s $1 billion
more in reinvestment done at rates of 10% plus.
To put this in perspective: Cheesecake may be able to re-invest 50% of its current market cap
over the next 10 years at rates of return equal to or greater than 10% a year. It can also buy back
its own stock. Both companies can do that and I expect both will do that aggressively. But,
Cheesecake may have this additional opportunity to invest about 50% of its market cap over the
next 10 years in the actual business at good rates of return. For Omnicom to reinvest 50% of its
market cap on those same terms, there would need to be something in the $8 billion to $9 billion
price range that will earn a year one 10% plus cash return on your investment.
I don’t see how Omnicom can find something like that. Right now, Omnicom can only compete
with that kind of value creating capital allocation by buying back its own stock. Omnicom’s
stock would have to stay cheap for a long time while the company gobbled up its own shares for
OMC’s capital allocation to add as much value as Cheesecake’s capital allocation. So,
Cheesecake may grow intrinsic value per share faster than Omnicom. Omnicom’s still the safer
bet if you had to own one stock forever. But, if you have to own one stock for the next 10 years –
I can’t promise that OMC has a way to deploy as much cash as profitably as Cheesecake might.
Again, I stress might (CAKE needs to find good mall type locations to do this).
My options other than Cheesecake are not limited to Omnicom and Howden Joinery.
I look at a lot of stocks.
Yes. The ones recently that stand out as the kind of businesses I would normally buy at the kind
of price I normally like are: Cheesecake Factory, Howden Joinery, and Omnicom. Those are the
most stereotypical me type stocks.
However, there are other stocks I look at that also seem potentially attractive. I just may not be
done researching them enough to know them as well as I know things like Cheesecake, Howden,
and Omnicom (all of which I originally researched at least a year ago and in one case –
Omnicom – more than 8 years ago.)
Right now, two stocks that stand out as deserving a lot more study are: NAACO
(NC) and Greenbrick Partners (GRBK).
NAACO is splitting into what should be a pretty capital light, non-cyclical, and non-competitive
coal mining business and the Hamilton Beach small appliances business.
Green Brick Partners is a homebuilder that is split close to evenly between Dallas Fort-Worth (it
builds homes in places like Frisco, which is right by where I live in Plano) and Atlanta. I don’t
know the Atlanta housing market. But, I do know the Dallas housing market. The stock trades at
about 1.1 times book value. However, in the homebuilding industry, land is usually held for 2-5
years from the time a homebuilder buys it to the time they sell the finished house on that land.
Land prices in Dallas Fort-Worth have risen, so the fair value of their holdings would actually
somewhat exceed 110% of book value – meaning, the market value of the company’s assets is
slightly greater than the market cap of the company. They have enough net operating loss
carryforwards to not pay taxes for another 3-5 years depending on how much they grow
earnings. The decision maker (Jim Brickman) is a good homebuilding guy and has a meaningful
personal stake in the company. Together with David Einhorn’s Greenlight capital (about a 50%
owner) and Dan Loeb’s Third Point (about a 17% owner) people who are insiders/long-term
investors of some kind hold about 75% of Green Brick Partners. So, the float is probably no
more than $125 million. The stock was, in recent memory, a speculative ethanol type company
that was used as the public entity to take this Einhorn/Brickman homebuilding entity public. In
investors’ minds, the company is probably not “seasoned” as much as it’s going to get in the
sense that if I say “Green Brick Partners” today – you may not have recognized the name and if
you did you may not have immediately remembered it’s a homebuilder and even if you did
remember that you still might not have remembered where it builds home (Dallas and Atlanta).
It’s underrecognized. If you buy the stock in 2017 and plan to sell it in 2022, you’ll probably be
selling a bigger, more recognized stock with a higher price-to-book multiple that is then starting
to pay taxes.
A homebuilder is not the kind of stock I’d usually buy. Green Brick isn’t a capital light pure
homebuilder like NVR (NVR). Nor is it more of a marketing machine like LGI Homes (LGIH).
It’s something that buys up land, holds it for up to five years, puts a house on it, and then sells
the land plus the house. There’s no cash flow that doesn’t go back into buying up more land.
Everything it does is tied to residential land values where it operates. So, this is purely an
investment in residential land in Dallas and Atlanta. However, the combination
of UNTAXED (for now) cash flow from homebuilding activities going back into buying
additional land plus the annual appreciation of land while it’s on the balance sheet gets you to a
good growth in Market Value of Land Per Share which is what the intrinsic value of the
company obviously is.
Green Brick Partners is clearly very attractive relative to the market. The S&P 500 is trading at
probably twice what it normally does. One times book is not above normal for a homebuilder
that operates only in good metro areas. And then I feel sure that on a per share basis Green Brick
Partners will grow its book value faster over the next 5 years than the S&P 500 will grow its
EPS. So, Green Brick definitely has higher growth and a lower price multiple than the overall
market.
It’s an attractive potential investment. And I’d have to compare something like Green Brick to
something like Cheesecake to something like Omnicom to decide which to buy.
Most investors would just buy Howden and buy Omnicom and buy Cheesecake Factory and buy

Green Brick Partners and buy AutoZone if they felt the way about those stocks that I do.
But then they’d eventually end up with a portfolio of like 20 stocks with 5% in each instead of a
portfolio with 5 stocks and 20% in each like I want.
If you’ve read “The Snowball” and looked carefully at how Warren Buffett sized positions in his
own portfolio and the partnership in the 1950s and 1960s – that’s more how I operate.
Right now, my portfolio is basically:
40% Frost (CFR)
25% BWX Technologies (BWXT)
35% Cash
I’m very concentrated and very patient. I’m so slow to buy a stock. I mention my high selectivity
/ concentration in posts all the time, but I don’t think readers really understand how different that
makes my decision making from their decision making.
I haven’t bought a stock in 2 years.
Chances are that if I do buy Omnicom, Howden, Cheesecake, AutoZone, Green Brick Partners,
or NAACO it will only be one of those stocks. It could be two if I like one best now and then
another one absolutely plummets in price.
But, because I buy so few stocks and buy them so rarely – my hurdle is very high. If you see me
buy Cheesecake, it means that ultimately I decided I felt more comfortable with Cheesecake as a
business and at this price than I did with EACH AND EVERY ONE OF: Omnicom, Howden,
AutoZone, Green Brick, NAACO, etc. That’s a high hurdle to clear.
One of the best ways to improve your investment returns is simply to raise your opportunity cost.
If the best idea you DON’T buy is better than most the ideas other investors DO buy – then,
you’ll win over time.
 URL: https://focusedcompounding.com/he-who-has-the-highest-opportunity-cost-wins-
cake-nc-grbk/
 Time: 2017
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Frost (CFR): Interest Rate Expense and Cyclically Adjusted Earnings
A reminder: 40% of my portfolio is in Frost. It’s the stock I like best.
Someone wrote me to ask about Frost’s interest expense:
“Hi Geoff,
I have not read your report on Frost…but right now I am looking at the latest balance sheet and
(am) very surprised…the average interest expense is…paltry…the cost of funding is 0.032%.
That’s extremely low, almost free. Am I right on this calculation? Or is it a mistake?”
My response goes into way more arithmetic than anyone wants to read. But, if you want the full
picture of how I personally value Frost – read on…
First of all, a bit more than half of Frost’s deposits are in accounts that pay pretty close to 0%
interest because they provide a lot of services and these customers are not hunting for yield.
Frost pays “credits” to reduce the fees customers are charged for banking services. I think when
we wrote our report it was about 1.5% combined interest and non-interest expense. Frost
generally has the lowest non-interest expense of a bank I know of. They’re always a little lower
than Wells Fargo (WFC).
Anyway, I did the calculation for last year’s interest expense that you did using average interest
bearing deposits and annual interest paid on those deposits (the information is in the 2016 10-K
at EDGAR). They paid 0.03% on average in interest (3 basis points). Which is what you said.
However, remember, the Fed Funds Rate started 2016 at 0.25% to 0.50%. So, the 2016 interest
rate expense for any bank is very misleading.
In the long-run, I expect Frost to pay 0.5 times what the Federal Reserve pays for the same
amount of money. So, if we end this year at say a 1.5% Fed Funds Rate and then it just stayed
there, I’d expect Frost’s interest expense to rise to 0.75% eventually.
The formula:
FFR * 0.5 = Frost’s interest expense is pretty accurate.
That’s only the cash interest rate though.
On some accounts, Frost also pays an “earnings credit rate” that customers use to offset fees for
services the bank would otherwise charge for. So, back in 2016, Frost might have been paying
0.03% on an account in cash interest but then 0.25% in credits you can use to offset bank fees.
Of course, it’s the total expense that matters for a bank. You have to count both the interest
expense and the net non-interest expense when calculating cost of funds. Frost pays maybe 1.4%
of deposits in net non-interest expense and then you have the interest expense.
So, the bank’s total economic cost of funding would really be:
FFR * 0.5 + 1.4% = Frost’s total cost of funding.
So, if we end 2017 at a 1.5% Fed Funds rate and the rate stayed there, Frost should be getting
their money at about 0.75% (interest expense) + 1.40% (net non-interest expense) = 2.15%.
If the Fed Funds Rate was a more “normal” 3% to 4%, then Frost’s total cost of funding would
be 1.5% + 1.4% equals 2.9% to 2% + 1.4% equals 3.4%. So, at a 3-4% Fed Funds Rate, Frost’s
total cost of funding would be like 3% to 3.5%. Frost would basically have the same cost of
funding as the Fed.
The way interest rates drive Frost’s earnings is that:
· Frost has a constant 1.4% net non-interest expense regardless of where rates are
· The relationship between interest expense and Fed Funds Rate
is multiplicative (0.5 times the Fed Funds Rate)
· The relationship between yield on loans and securities and the Fed Funds Rate
is additive (FFR plus 3.3%)
So, what Frost actually earns before loan loss provisions and taxes on each dollar of deposits
works like this:
(FFR + 3.3%) – (0.5 times FFR + 1.4%).
So, if the Fed Funds Rate ends 2017 at 1.5%, you’d expect Frost’s pre-tax and pre-provision
earnings per dollar of deposits to be:
4.8% (1.50% + 3.30%) – 2.15% (0.75% + 1.40%) = 2.65%.
And, if the Fed Funds Rate eventually hits a more “normal” 3% to 4%, you’d expect Frost’s pre-
tax and pre-loan loss provision earnings per dollar of deposits to be:
6.80% (3.50% + 3.30%) – 3.15% (1.75% + 1.40%) = 3.65%
Based on past experience, they’ll charge-off about 0.50% of loans per year. So, let’s call after-
provision earnings 3% and then you pay a third of that in taxes and so you’ve got earnings of 2%
after taxes for every dollar of deposits you have.
In other words, in a 3% to 4% Fed Funds Rate world, Frost should report $1 of EPS for every
$50 of deposits. Right now, they have $400 a share in deposits. So, if the Fed Funds Rate was
3% to 4% right now, they’d probably have $8 a share in EPS.
That’s what I mean when I say Frost is interest rate sensitive. EPS should be about $5.50 a share
when the Fed Funds Rate is 1.5% and about $8 a share when the Fed Funds Rate is 3.5%.
Those numbers won’t be exactly right, because I overstated what the combination of loan losses
and taxes will really be. But, the pre-tax and pre-provision formula I gave you is an excellent
estimate for all interest rate environments.
If you want to go through all the details of how (my newsletter co-writer) Quan and I got these
figures, you have to read the “Value” section of the notes in this PDF report on Frost. It starts on
page N56 (that’s page 81 of the PDF).
Full Report on Frost (CFR)
I don’t recommend reading that though. I went into way more arithmetic here in this post than I
think most people want to get hit with at once. The notes section is much more detailed in
providing evidence for why the Fed Funds Rate based earnings model shown here should
correctly predict (with some lag) what EPS for Frost will be in any future year as long as you
know just 2 things:
· Frost’s deposits per share
· The Fed Funds Rate
We know Frost’s deposits per share are about $400 now. And I think I know that in the very
long-run, the Fed Funds Rate has the same or better odds of being above 3% in any year as it
does being below 3%. Most people disagree with me on that assumption. If you assume today’s
Fed Funds Rate is normal, then you’d assume normalized EPS on Frost is now about $5.50 or so.
If you assume a 3% to 4% Fed Funds Rate is normal (like I do), then you’d assume normalized
EPS on Frost is now about $8 or so. Obviously, that means if most people believe the Fed Funds
Rate is normal now, then most people are going to value Frost stock about 30% lower than I do.
Personally, I value Frost at about 0.40 times deposits. That’s about $160 a share. If you think a
Fed Funds Rate of 1.5% is normal, you should value Frost at about 0.28 times deposits. That’s
about $110 a share. The stock now trades at just under $90 a share. So, if you think a normal Fed
Funds Rate is 1.5%, you shouldn’t buy the stock. It’s a terrible idea to pay $90 for something
you think is only worth $110.
 URL: https://focusedcompounding.com/frost-cfr-interest-rate-expense-and-cyclically-
adjusted-earnings/
 Time: 2017
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Weight Watchers (WTW): Mistakes Made Over 4 Years of (Emotional)

Volatility
I lost a lot of money in Weight Watchers. Let’s look at why that was.
As I write this article, Weight Watchers (WTW) stock is at $44.30 a share.
I bought my shares at $37.68 a share in 2013 and sold them (in March of 2017) at $19.40. So, I
realized a loss of 49%. I also tied up money for about 3.5 years. During this same time period,
the S&P 500 returned about 12% a year. I probably could have found something else to buy that
would have returned 10% to 15% a year like the overall market did.
So, we have two types of losses here. One, is the lost money. That was about 50% of my
investment which in turn was about 25% of my total portfolio – so, a loss of about 12.5% of my
portfolio. The other loss is time. Over 3.5 years (the length of my Weight Watchers holding
period), an investment that moved about in line with the overall market would have grown to
about $1.50 for every $1 I invested. This means my decision to invest in Weight Watchers
instead of something else wasn’t really a loss of 49 cents for every dollar I invested. It was more
like a loss of 99 cents for every dollar I invested (49 cents in capital losses plus the 50 cents in
forfeited compounding).
So, that was the cost of my mistake. For each dollar I could have invested in something else and
thereby ended up with $1.50 at the end of 3.5 years, I instead put that money into Weight
Watchers and only got 51 cents back. The difference between a $10,000 investment in a
hypothetical “something else” (like an index fund) and a $10,000 investment in Weight Watchers
would be: $15,000 in the something else or $5,100 in Weight Watchers. So, about a $10,000
difference on a use of $10,000. Talking in terms of $10,000 isn’t hyperbole. Remember, I put
25% of my portfolio into this stock to start.
This may sound like an odd way of looking at the loss, but the fact this investment tied up money
for 3.5 years is also important.
Now, we know what my losses were. But, what were my mistakes? I want to separate the
evaluation of my investment into two parts. Did I make a mistake in my stock selection? And if
so, how bad was that mistake? And then, did I make a mistake in my “hold” approach? And, if
so, how bad was that mistake.
In an earlier article, I talked about how my sell decisions haven’t added any value over time. My
stock selection over the last 17 years has been good. My actual investment performance has been
no better than my stock selection though. None of my performance advantage over the stock
market as a whole has come from selling at the right time. All of my outperformance has come
from picking the right stock at the right time when buying.
My experience in Weight Watchers fits this pattern.
My timing was bad.

Let’s start with my buy timing. I bought Weight Watchers at $37.68 a share. When I put out my
report on the stock – recommending it to subscribers – the price was $32.12. The timing of the
report was based on factors like how long it took me to research and write about the company in
enough depth to publish a 10,000 word analysis. This means the report dates couldn’t be
precisely “timed” by me for price reasons. It often took about a month between the time my
newsletter co-writer (Quan) and I decided we wanted to pick a certain stock and when we
released the report. Here, we can see that my own sense of timing didn’t help. I paid $37.68 a
share for my stock while subscribers could have followed me into the stock at $32.12. So, right
there my sense of timing made me pay about 17% more for the stock.
This isn’t always true. I can find reports where I bought a stock I also recommended for the
newsletter and yet I got a lower price for my shares than the price shown on the report sent out to
subscribers. The best example of this is Frost (CFR). It’s a stock I still own now.
I’ve looked at all my past trades. And, it’s true that the exact timing of my buys may add value.
However, the exact timing of my sells definitely does not add value as we’ll see right now.
I sold my Weight Watchers shares at $19.40 in March. We are now six months later (in
September), and the stock is at $44.30. So, I missed out on a gain of 128% in half a year. That’s
terrible timing.
I don’t want to cherry pick here. So, I have to go on a bit of a tangent and mention I sold
something else (B&W Enterprises, which is the “rump” spin-off of my BWXT position) at
$10.22 a share at the same time I sold Weight Watchers. That stock plunged from $10.22 in
March to $2.63 a share now. So, that’s a 74% loss in 6 months that I managed to miss out on by
selling.
Here, I want to sidestep a discussion of luck with a simplification. We could pick certain days on
which Weight Watchers was very cheap or very expensive and imagine I might have bought
more at that moment or sold out at that moment. This is backward looking and really all it tells
you is how lucky I might have been.

There’s one way to do this without any consideration of lucky timing. It’s the simplest approach.
I did a whole report on Weight Watchers (Focused Compounding members can read the report in
the Library). That report wasn’t released on some specific day because I felt the price was
perfect at that moment. I only had control over picking the stock. I didn’t have control over the
exact price at the time we released that report. In fact, I know Quan and I were working on that
report for well over a month before we released it. So, we can use the not precisely timed price
of $32.12 a share that subscribers would have seen when I picked Weight Watchers stock in
2013. And then we can just assume these subscribers did the simplest thing possible: they held
every share of the stock they bought from the day I released that report right up to the present
day. That means they bought at $32.12 a share 4 years ago and they are still holding at $44.30 a
share today.
How much of the my own loss could these subscribers have avoided? An investment of about
$1,000 needed to – over the last 4 years – have grown to about $1,480 today to keep pace with
the market. An investment in Weight Watchers didn’t do that. If you bought the stock the day I
released my report on it and held it till today, you would now have about $1,380 instead of
$1,480. So, again, there was some opportunity cost here. If you bought Weight Watchers when I
released the report and held it till today, you’d be looking at an 8.4% annual return over the last 4
years. The market did better than that. So, Weight Watchers would’ve still been a loser. But, it
would’ve been a very small loser.
Instead, I lost a lot by buying at over $37 a share and selling at around $19 a share.
It was a wild ride. So, my result could have been even worse. Weight Watchers dropped as low
as $4 a share in 2015. That low point was reached about midway through my investment. So, the
first half of my investment in Weight Watchers was a roughly 18 month decline from $37 to $4.
That’s enough to scare most people out of any stock.
Not everyone. Here is one blog reader who emailed me to say he was sticking with the stock:
“I have great faith in your analysis of Weight Watchers. I (also have) experience in
the weight loss industry myself and can really see the efficacy of its system as well as the
trajectory.

I have also made considerable personal investments of a large portion (of my) personal savings
in WTW, and was in for a real roller coaster ride… But…I held firm to my beliefs that it is a
great company (albeit with a lot of debt ).
I know the metrics have changed greatly since your last article (and Punchcard’s article) on it,
but also know that you held on to your guns despite market irrationality in 2015 when it got sold
down just before the Oprah announcement.”
This reader attached a table showing the value of his shares in Weight Watchers. That table
shows the price starting at $32 a share when he bought in and then declining to $4 a share before
rising to about $11 a share when he sent me that email saying he had “great faith” in my analysis
of Weight Watchers. I sold out at $19 a share. When I announced that sale, this reader emailed
me saying:
“I am just curious about the WTW sale, since WTW has announced growing subscription
numbers and has Oprah as a Board Member, so things look rosier than last year.”
Presumably, this “avid follower of my site” (feeling things were looking so rosy) has held on to
his shares to this day. If so, the “avid follower” has done much better than the gutless leader (me)
who came up with the idea but did not have the stomach to see it through.
If so, he would not be the only person who followed me into Weight Watchers and did better
than me.
On January 7th, 2017 “Munger Fan” wrote an article on Seeking Alpha entitled “Weight
Watchers Provided a Valuable Lesson in Stock Watching”. It’s a good article. I recommend you
read it.
The brilliance of this article is in its simplicity.
It’s not really about doing a detailed analysis of Weight Watchers from scratch. It’s more about
reading what I wrote – at a much different price – and then checking what is still true about the
company. This allowed the author to make a turnaround bet – with much better odds – than my
original (faulty) “wide moat” investment.

When I made my investment in 2013, I paid what I thought was a reasonable price for Weight
Watchers. It was about 8 times EBITDA when the EBITDA margin was near a high level. So,
this is a lot like paying an unleveraged P/E of 15 for the stock. The actual P/E on Weight
Watchers was around 8 when I bought it. But, that’s misleading because the stock was very
leveraged. In truth, I paid an average (debt adjusted) price for what I believed was an above
average business.
At a later date, someone like “Munger Fan” could buy into the stock in a higher leveraged
situation, but at a much better price. On a normalized basis, Weight Watchers was really cheap in
January of this year.
Let’s take a look at this Seeking Alpha article:
“The best known recommendation a few years ago was given by Geoff Gannon and Quan
Hoang…The report in itself was extremely well-researched…”
I’m not including that quote to toot my own horn. I’m including it to make a point. My well
researched report on Weight Watchers got me a big loss. Someone else who was braver in the
application of the investment could piggy back on existing research without needing to reinvent
the wheel for himself.
There’s a lesson in there for you. The right research isn’t worth anything unless backed up by the
right actions. Over the years, I’ve corresponded with a lot of excellent analysts. Very few of
them are excellent investors.
Now, I want to tackle a bigger quote from this excellent article. And I think it really gets to the
heart of whether you are the kind of person who loses a lot of money in Weight Watchers (as I
did) or makes a lot of money in Weight Watchers (as some others did):

“One particular trait I’ve noticed about Geoff and Quan in their recommendations for their
newsletters is that they rarely like to get into very hairy situations in which the price of a stock
has tanked due to some unforeseen troubles. I think it’s safe to say that they prefer to find great
businesses at fair prices rather than decent or even mediocre businesses at bargain prices…”
That’s true.
I’m not a turnaround investor.
And this was especially true when I was picking stocks for the newsletter between 2013 and
2016. Generally, I had a list of about 10 candidates in a “pipeline” of ideas. These were usually
the 10 best businesses I could come up with that were close enough to a fair price that Quan and
I – as value investors – could consider buying them. In other words, we weren’t looking through
lists of stocks with P/Es of 5-10 and asking which among them might be decent businesses.
Instead, we were looking through a list of stocks with P/Es of 10-20 and asking which was the
one we’d feel best owning for the long-run. And, often, if we loved the stock with the P/E of 15
and only liked the stock with the P/E of 11 – then we’d pick the business we liked best.
Now, you’re not going to find picks where we paid much more than about a normalized P/E of
15. We are still value investors.
But we usually picked stocks that were great businesses even when they weren’t going through a
temporary, fixable problem. Buffett says the best thing to buy is a great business going through a
temporary problem. Quan and I often looked for the great business part. But, we kept putting out
one new issue a month – so, we really weren’t waiting for the temporary problem part. If you
waited till Weight Watchers hit its problem patch, you got a much better price than we did.
I will take a brief tangent here to mention that Weight Watchers stock had already fallen from
$80 to $32 when we picked the stock for the newsletter. So, although people who bought into
this stock later would see my initial investment as being made before things went REALLY bad
– Quan and I (and Mr. Market) could already see what direction results would be headed in for
the next couple years. It’s just that none of us knew the stock would go from $32 to $4.

Having said that, it’s true I didn’t analyze Weight Watchers as a turnaround in 2013. In 2017,
Munger Fan did.
The 3 bullet points at the top of Munger Fan’s January 2017 Seeking Alpha article are really all
about seeing this stock as a great business facing a temporary, fixable problem:
“1) The market focused only on the negative story on the way down and no longer remembers
that Weight Watchers is actually a good business.
2) There is a material possibility of capital loss and even potential bankruptcy, but I believe the
probabilistic expected payoff is positive.
3) The shareholder structure is absolutely incentivized to make Weight Watchers work for other
common equity holders.”
This sounds a lot like Warren Buffett’s investment in GEICO in the 1970s. He knew GEICO was
still a great business. He liked the new management and thought they could turn it around. But,
he saw a “material possibility of capital loss and even bankruptcy”. That’s very different from
the kind of picks Quan and I made for our newsletter.
However, having said that, I don’t want to downplay just how bad the situation was at Weight
Watchers when we first invested. Because the situation got worse later, people looking back on it
now can imagine we bought into Weight Watchers when it was business as usual.
Nope.
I bought into Weight Watchers in the early stages of things going wrong. I knew they were going
wrong and I knew each quarter’s earnings release would get worse before it got better.
Let me quote some of the headlines from my 2013 report on Weight Watchers (where remember,
I was picking the stock as a buy).
Some Headlines from My Report

 “Weight Watchers Has Fired its CEO, Suspended its Dividend, and Announced $150
Million in Cost Cuts”
 “Artal Treats Weight Watchers Like a Publicly Traded Leveraged Buyout”
Quan and I also explained two key risks to Weight Watchers. One, the business momentum was
going to be bad for a while no matter what happened. Headlines would be ugly for a time. And
two, free apps (for mobile phones) were a potential problem. Now, we did not expect apps to
continue to be a problem for new recruitment at Weight Watchers for as long as ended up being
the case. But, we knew both these risks.
This is what we said in 2013 about free apps:
“The biggest risk of misjudging Weight Watchers is the risk of underestimating competition from
free apps. The entire investment case for Weight Watchers is based on consumer psychology.
The difference between an investor who is long Weight Watchers and an investor who is short
Weight Watchers is probably their view of how much lasting harm they expect free apps to cause
Weight Watchers. Geoff expects very little lasting harm: ‘Two of the most powerful words in
marketing are: new and free. Right now, free apps are both new and free. In a couple years, they
will still be free. To most people, they will no longer be new. The novelty will have worn off. So,
the question is whether Weight Watchers is being harmed by the newness of these apps or the
freeness of these apps. The folks who are short Weight Watchers believe it is the freeness of the
apps. I don’t think free is very important to Weight Watchers’s customers. That means they don’t
pose a risk to Weight Watchers’s durability.’ “
At the time we picked the stock, we also laid out the inevitability of poor earnings releases for
the next few years:
“Things will get worse before they get better. With a lower subscriber base, revenue at Weight
Watchers will decline for at least the next couple years. Although the company will cut $150
million in costs over the next 3 years, it will still have lower operating income in the next few
years than it has had at any point in the recent past. There is no way to predict what will change
this trend or when it will happen.
Unless an investor believes this pressure from free apps will be temporary it is impossible for
him to come up with an owner earnings estimate and to value the stock. The only basis on which
to invest in Weight Watchers is the belief that the company’s results will normalize. Many
investors do not expect Weight Watchers to return to its past record.”
What’s notable to me looking back at what I wrote then is how little any of the essential analysis
changed. Emotions changed. Owning the stock for over 3 years, you might get worn down by the
constant barrage of bad news. But, with few exceptions, we laid out what the grim future would
be for Weight Watchers over the next couple years and that’s not that different from the grim
future that actually materialized. Now, in a moment, I will explain where the difference comes
in. Because, I did make some projections out about 5 years to ask what the business would need
to look like by then to make my investment decision a good one. I’ll re-visit that point at the end
of this article.
But, what you really notice is simply two things:
1. Some things I thought would “turn” in about 3 years instead will probably “turn” in about
5 years (that is, results will be solid in 2018 instead of 2016)
2. And: the stock reacted far more violently than I ever expected
In late 2015, before Oprah Winfrey made her investment the stock reaction was especially
extreme. I talked with some readers who asked me that since I thought I made a mistake in
Weight Watchers why not sell the stock at $4, or $6, or $8 or whatever it was at in that moment.
They said basically “well, you must be sure the company won’t end up in bankruptcy or you
wouldn’t be hanging on to the stock.”
Not at all.
In 2015, I thought Weight Watchers might end up in bankruptcy. But, even treating that “might”
as a high probability couldn’t make the math work to justify selling the stock.
At $4 a share to $8 a share – I saw no way probabilistically speaking that the chance of

bankruptcy could justify the stock’s price. In other words, if there was a chance the stock could
go to zero and it was now at $16 a share, I could understand why it was at $16 a share and not
$32 a share even if I thought the most likely scenario was a more normalized business situation
where the stock was clearly worth $32 a share or better. After all, there might be a 50% chance
of bankruptcy and a 50% chance of recovery to $32 and beyond. But, at $4 and $6 and $8 a share
– I simply felt I couldn’t sell the stock, because it was cheaper on the probabilities than anything
else I owned. Honestly, I couldn’t come up with odds of bankruptcy that could justify those
prices. You can see why when you consider that Weight Watchers is now – and this company is
still far from its prior peak – reporting $1.50 a share in earnings. Given what Weight Watchers
earning power would be if it survived, a price of $4 a share didn’t make any sense unless you had
advance knowledge the company was preparing to file for bankruptcy. The only way to justify a
single digit stock price on something with that much earning power in its past is to have a high
degree of confidence that it’s definitely going to file for bankruptcy. So, I held on to the stock
even when I thought there was some chance it could go to zero. However, I sold at just $19 a
share. Which – as the stock trades at $44 a share now – was clearly a mistake.
Enough about my investment.
I want to take us through the journey one of my subscribers had. This subscriber read the report
on Weight Watchers. I’m going to quote his email to me in full to give you an idea of what this
kind of investment journey really feels like:

“Hi Geoff,
I found WTW through (the newsletter) and bought the stock over a couple of years. I bought my
first shares in December 2013 at $32.45 a share. Then I doubled my position in February 2014
at $21.71 a share. I finally doubled my share count once again in February 2015 both at $17.40
and $11.90, making my average purchase price $19.30 a share.
What drove my first sell decision was that the business thesis had changed since I first bought
the stock back in December 2013. I thought the company (was) a franchise type of investment.
However, it turned out to be more of a turnaround. So, when Oprah bought her shares I thought
it was time to (take) some chips off the table as it now was more of a turnaround, and I did not
want to concentrate more than 10% of my capital in this type of high risk / high reward stock.
So, I thought in November 2015 that if I sell half my position and the company fails, I would still
have lost something like 1/3rd of the investment…
…I was wrong in my original thesis. I thought it to be a franchise and a long-term compounder

and made a 10% position and constantly adding, while it turned out to be a turnaround. I think
this was the major mistake, because if I had framed it to be a turnaround and not a franchise, I
would have made the position smaller. It is not as good as a buy and hold investment as I
thought it to be. So, it was a bad investment because my original thesis was wrong. The customer
is fickle and demand cyclical and WTW is really providing something that people don’t really
want to buy and spend money on…
…I continued to keep the stock, (because) I thought (of) it as more of an option than a stock in
the end. If WTW was successful, I would probably make a nice gain on my remaining capital,
while I would not lose all my invested capital if it went bust. So, I was more positioned for a
turnaround type of investment thesis with my remaining capital. However, I got tired of the stock
and decided to sell in July 2016. I still have this money in cash. What still frustrates me was that
I was not (able) to wait out the thesis a full 5 years, until 2018. With a part of the remaining
position I should’ve waited until the end of 2018 and to let the thesis play out for a full five
years. I was wrong in my initial positioning, but I was also wrong in the way I sold. At least I
was looking at it in retrospect. I got impatient and to some degree let my emotions drive the sell
decision. However, when I reanalyzed and positioned (it) like it was a turnaround, WTW still
had 4 or 5 attempts (years) until the debt was due in 2020 and I thought it still could turnaround
the business, but at the same time I was (skeptical) as turnarounds seldom turn. But, WTW had a
history of recovering from such crises and without the debt load I would probably have been
more confident in the thesis.
For me it raises a fundamental, but important decision: when should you revise and admit a
mistake? When is your original investment thesis wrong?
Like you, my sell decisions add little value. I sold BWXT at an early stage, at $30 after the spin-
off and I also sold Progressive at an early stage, at $35 a share (Geoff’s note: these are two
other stocks I picked for the newsletter). The proceeds from the first was used to increase my
position in Frost, while the proceeds from Progressive were used to add Prosperity to my
portfolio. However, I can see that I should have kept all of them in my portfolio.
What I have learned from this, is that I’ve tended to turn over my portfolio faster than I really
want, and that I should definitely hold my investments longer. I have to discipline myself to keep
my holdings for longer. The first step is to be aware of it. The second is to act on it…
(Weight Watchers) also (taught) me a lesson in the challenges of investing in a cyclical business
combined with a lot of leverage. One should be very careful in such instances and maybe avoid
them altogether. At least one has to be mentally prepared for the volatility in the business in
such cases.”
That’s a great email. I know I wasn’t prepared for the volatility in the business and in the stock.
And I wasn’t prepared for how long the wait would be with that volatility. In the report, I really
laid out a five year thesis – as I pretty much always do – and yet I sold the stock after not much
more than 3 years.
Why didn’t I wait another 2 years?
You get tired of sitting through all the volatility in both the business and the stock.

For me, there is also an added difficulty. I don’t just pick stocks for myself. I write about the
stocks I pick.
And I get tired of answering emails about the stock. By the time I sold Weight Watchers it was
not one of my biggest positions at all, and yet it accounted for probably more email questions
from readers than all of my other stock picks combined. BWX Technologies is a pretty big
position for me (about 25% of my portfolio right now) and yet I never get any emails about the
stock. It’s a wonderful business. I think it’s got the widest moat of any company around. And
yet, it bores readers. It bored them at $27 a share and bores them at $54 a share. Weight
Watchers always provided entertainment value. It was something to argue about. It’s the only
stock I ever wrote about where several potential subscribers specifically asked to get a different
free sample than WTW (they didn’t even want to read a free issue on such a company). And it’s
the only company I picked that got as long a rebuttal as this anti-WTW article from Punch Card
Research.
It is very unpleasant to write about a volatile stock, a controversial stock, a heavily shorted stock,
etc. Sometimes the best things to invest in are not the best things to write about. I don’t short
stocks. And there are a few reasons for that. But, I’ll tell you the biggest reason: it’s because I
write about stocks. Over the years, I’ve found Chinese companies listed in the U.S. that I
believed to be frauds. Would I ever want to short them? That’s not the question. I write about
everything I invest in. So, the real question is: do I want to write about frauds? Do I want to
debate whether something is a legitimate business or not with a reader who is long that stock?
No.
So, I have a rule that I don’t short stocks because I’d never want to write about shorting stocks.
Would I have held my Weight Watchers stock till now if I hadn’t made my investment in the
company public?
I don’t know.

But, I do know I’m more likely to sell a controversial stock because I have to write about what I
own and talk to people about what I own.
The truth is that there isn’t really that much to say about Weight Watchers other than what I said
in that 2013 report. I recommend everyone read that report. Because, there’s been big changes in
my emotions and in the stock price and there’s been some changes with the business – most
notably, Oprah’s investment – but if I was going to make a decision to buy, sell, or hold Weight
Watchers today I would still base 90% of my decision on what I wrote in 2013.
What I’ve tried to do with this article is give you a taste of the actual experience of owning a
volatile stock. What does it feel like to own a stock that goes from $37 to $4 to $44 in less than 4
years? And what mistakes do people make when a stock does that?
I’ll leave you with a tiny bit of actual analysis. No emotions. Just numbers.
This is how I ended my 2013 report on Weight Watchers:
“So, I look out to 2018 and ask whether Weight Watchers will be making $650 million in
operating proﬁt. And I ask whether the share count will be lower. I think it will be making $650
million (assuming a normal economic climate). And I am certain there will be fewer than 50
million shares outstanding. Unless you assume Weight Watchers will trade at a single digit P/E
ratio forever, that will result in a higher stock price 3 to 5 years from now.”
This is the part where we can see I’m wrong. I was right about the P/E multiple expanding. But,
Weight Watchers issued shares to Oprah. There are now more shares outstanding than there were
in 2013. And there are going to be more shares outstanding at the end of 2018 than there were
when I wrote that. So, each share of Weight Watchers is worth less to the extent there are now
more shares. Also, I said I thought EBIT would be $650 million at the end of 2018. It’s now
about $240 million and last peaked at just $550 million.
So, I was wrong on the two variables that mattered most.
In five years:
 Weight Watchers will have at least $650 million of operating income – WRONG
 Weight Watchers will have fewer than 50 million shares outstanding – WRONG
I appraised the stock at $63 a share back in 2013. To get as high an intrinsic value estimate as
$63 on the stock now, you’d need to believe those two things I talked about (for the end of 2022
this time, not 2018). I’m not sure I do believe that. So, I’m not sure I believe Weight Watchers is
worth more $63 a share.
It trades at $44 a share which is 70% of my original appraisal value. For that reason, I would not
buy the stock today. To buy a stock, I generally want at least a 35% discount to an appraisal
value I still believe in. Here, we have a 30% discount to an appraisal value I don’t have any
confidence in.
Weight Watchers may be fairly valued.
I don’t think it’s meaningfully undervalued at today’s price.
It is, however, leveraged. So, if I’m wrong by being too pessimistic this time around – the stock
will eventually zoom past $63 a share.
Of course, leverage works both ways.
The point of this article isn’t to give you a good idea of the value of Weight Watchers. The point
of this article is to let you live vicariously through me and some others who invested in Weight
Watchers.
“It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.”
 Warren Buffett
Learn from mine.
 URL: https://focusedcompounding.com/weight-watchers-wtw-mistakes-made-over-4-
years-of-emotional-volatility/
 Time: 2017
-----------------------------------------------------
Constantly Concentrating: Why I Sold George Risk (RSKIA) and Weight

Watchers (WTW)
I’ve gotten a lot of questions regarding my sales of Weight Watchers (WTW) and George Risk
(RSKIA).

Interestingly, literally no one emailed me about selling Babcock & Wilcox Enterprises (BW).
I’ve picked out two questions as representatives of the larger group.
Question #1: George Risk
“Really interested in why you decided to suddenly sell RSKIA.
I mean it’s still obviously undervalued. You could have sold it in the beginning of 2014 for a
better price than $8.40. Stocks in general were obviously cheaper at that time than they are now.
So logically it means you’ve found a better opportunity now than you could find in 2014 relative
to the current price of RSKIA. That just seems really surprising to me.
The only logical conclusions are that you either lost patience with RSKIA, now have a different
view on the risk of the markets, or really did find something better than what you could in
2013/2014.
If it’s the latter, I can’t wait to hear what it is when you decide to post it…”
I sold George Risk, because I am planning to buy Howden Joinery.

I don’t like to take positions that are smaller than 20% of my portfolio. The total amount I had
available in cash, Natoco, and Weight Watchers combined was less than 20% of my portfolio.
So, I sold George Risk to make room for Howden Joinery.
I try to only sell one stock to make room for another. The reason I hadn’t sold George Risk
before is that I hadn’t found a stock I liked better than George Risk. I’ve now decided I like
Howden Joinery better than George Risk.
Yes, I could have and should have realized this a couple years ago. I’ve known about Howden
for years. Howden shares were cheaper in the past than they are now. George Risk shares were
more expensive in the past than they are now. I’d have been better off if I made the swap sooner.
But, it took me a while to come to this decision. I don’t own Howden yet. But, I expect to buy it
soon.
Question #2: Weight Watchers
“With regards to your long term stake in WTW, I am just curious about the WTW sale, since
WTW has announced growing subscription numbers and has Oprah as a Board Member, so
things look rosier than last year.”
Yes. Weight Watchers is doing better now than it was in the past. Oprah Winfrey is a great
spokeswoman and a good board member for WTW.
I didn’t sell my shares in Weight Watchers because I like the stock less now than I did last year. I
sold my shares of Weight Watchers because I looked at what percent of my portfolio the stock
made up and then considered whether or not I’d like to buy more.
Here’s what I said in a previous post:

“Weight Watchers, B&W Enterprises, and Natoco combined were now only about 10% of my
portfolio. I had no intention of buying more of these stocks. I like individual positions to be
about 20% of my portfolio. So, both Weight Watchers and B&W Enterprises had become
distractions I wanted to eliminate at some point.”
Honestly, once I come to the realization that I’m never going to buy enough of a stock to get it
up to 20% of my portfolio – I start thinking about selling that stock. I still own Natoco. It’s only
about 5% of my portfolio. And I plan to sell it at some point. When I do sell Natoco, it won’t be
because I don’t like the stock. It’ll be because I don’t like the stock enough to bring it up to 20%
of my portfolio.
That’s really just how I think. If I wouldn’t want a stock to be 20% of my portfolio – then why
would I want it to be any percent of my portfolio?
From time to time, I do own stocks that are less than 20% of my portfolio. Natoco was bought as
part of a roughly 25% to 50% of my portfolio basket of Japanese stocks. When I sold out of
those Japanese net-nets, nobody was willing to take the price I was asking for some of my
Natoco shares. So, I kept the leftover shares rather than compromise on price. Later on, I kept
holding Natoco, because I didn’t have anything I wanted to buy more of at the moment. So, it
was a choice between either doing nothing and staying in Natoco or doing something and adding
5% of my portfolio to my cash balance. My bias is usually toward: 1) Inaction and 2) Holding
stocks instead of cash. So, I just stayed with Natoco.
Once I decided I was probably going to buy Howden Joinery, I started thinking about selling
George Risk, Weight Watchers, Babcock & Wilcox Enterprises, and Natoco because these
positions combined were about 30% of my portfolio. I knew I’d want to put at least 20% of my
portfolio into a new stock idea like Howden.
And I knew I don’t like holding “distractions”. I consider any stock that makes up less than 10%
of my portfolio to be a distraction. When I look at a distraction, I ask myself a simple question.
Would I rather have 20% of my portfolio in this stock or 0% of my portfolio in this stock? And
then, I either buy more to get the stock up to 20%. Or (much more likely) I eliminate the position
entirely.

This is something I really do. With both Weight Watchers and Babcock & Wilcox Enterprises –
which are two stocks that dropped 50% or more at one point to become small positions for me –
I really did ask myself whether I wanted to more than “double down” on these positions. In both
case, I decided I’d rather buy a completely new stock than take positions like these from less
than 10% of my portfolio up to more like 20% of my portfolio.
So, I sold George Risk because I decided I liked Howden Joinery more than George Risk. And I
sold Weight Watchers and Babcock & Wilcox Enterprises because – in both cases – I decided I’d
rather have 0% of my portfolio in each of those stocks than 20% of my portfolio in each of those
stocks.
I could have kept them at 10% or less. But, that always feels to me like a half measure that
doesn’t make much sense. I never want to “water down” a future good idea I’ll have – like
Howden – because I’m still holding some ideas I maybe half-like and half-don’t like so much
anymore. I’d rather ask myself: do you really want to buy more of this stock to bring it up to
20% of your portfolio? No. Then why own it at all?
I know that’s an unorthodox approach. I’ll also admit that on a strictly rational single case basis,
it’s an incorrect approach. It’s not rational to sell something just because you aren’t willing to
make it 20% of your portfolio. However, I’m always trying to find the strategy that works best
for me over the long-term. And I think a habit of focusing all my efforts on holding no more than
5 ideas is one that makes sense. If I’m going to implement that policy long-term, I need to
constantly eliminate positions of less than 20% in the short-term.
 URL: https://focusedcompounding.com/onstantly-concentrating-why-i-sold-george-risk-
rskia-and-weight-watchers-wtw/
 Time: 2017
-----------------------------------------------------
Sold George Risk (RSKIA)
Last week, I eliminated my entire position in George Risk (RSKIA).
This position was about 20% of my portfolio. It is now 0%.

My average sale price was $8.40 a share.
My average purchase price had been $4.66 a share (back in 2010).
I held the stock for about 6.5 years. So, the stock price compounded at about 9.5% a year while I
held it.
George Risk also paid a dividend. The yield was rarely less than 4% a year. So, my total return in
the stock was about 13% a year over my entire holding period.
My return in George Risk was not better than the return I could have gotten by simply holding
the S&P 500 for the same 6.5 years.
However, the stock was cheaper than the S&P 500 when I bought it. I believe it remains cheaper
than the S&P 500 today.
Right now, George Risk’s dividend yield is about 4.2%. And the stock has $6.36 a share in cash
and investments versus a share price of $8.40 a share.
I didn’t sell George Risk because I no longer like the stock. Rather, I sold George Risk to make
room in my portfolio for a totally new position.
I try to only buy one new stock a year. So, when I do finally buy this new position – it’ll be a big
moment for me.
I’ll let you know once I’ve added the new position.
 URL: https://focusedcompounding.com/sold-george-risk-rskia/
 Time: 2017
-----------------------------------------------------
Sold Weight Watchers (WTW) and B&W; Enterprises (BW)
Today, I sold my entire positions in Weight Watchers (WTW) and B&W Enterprises (BW).
My Weight Watchers position was eliminated at an average sale price of $19.40 a share.
My B&W Enterprises position was eliminated at an average sale price of $10.22 a share.
My Weight Watchers position had an average cost of $37.68 a share. So, I realized a loss of 49%
on Weight Watchers.
My B&W Enterprises position had an average cost of $15.48 a share. So, I realized a loss of 34%
on B&W Enterprises.
Note: I got my shares of B&W Enterprises as part of the Babcock & Wilcox spin-off. I bought
that stock ahead of the spin-off. I still retain my shares in BWX Technologies (BWXT). My
BWXT position is about 10 times the size (in market value) of the BW position I just eliminated.
My portfolio is now:
Frost (CFR)
BWX Technologies (BWXT)
George Risk (RSKIA)
Natoco (a Japanese stock)
and
Cash
In rough terms, Frost is about 40% of my portfolio, BWX Technologies is about 25%, and
George Risk is about 20%. Natoco is less than 5%. The rest is cash.
So, about two-thirds of the portfolio is just Frost and BWX Technologies and more than six out
of every seven dollars is in just three stocks.
Why did I sell WTW and BW?
Weight Watchers, B&W Enterprises, and Natoco combined were now only about 10% of my
portfolio. I had no intention of buying more of these stocks. I like individual positions to be
about 20% of my portfolio. So, both Weight Watchers and B&W Enterprises had become
distractions I wanted to eliminate at some point.
Also, this portfolio is taxable. Three stocks account for 85% of the value of my portfolio and
those three stocks are anywhere from 80% to 150% higher than where I bought them. I hope to
buy a new stock sometime this year. To make room for that stock, I’ll have to trim some
positions with large capital gains.
Today’s sales provide me with capital losses.
As a side note, you may have noticed WTW stock was up over 30% today and B&W Enterprises
was down over 30% today. My Weight Watchers position was several times the size of my
B&W Enterprises position, so today’s rise in WTW’s stock price may have had some influence
on my decision to sell right now. However, I could have opted to eliminate just WTW and keep
BW – and I didn’t. So, I’d still say the sale is mostly not due to short-term price movements.
I really just wanted to:
1. Eliminate positions that were less than 10% of my account
2. Realize capital losses
3. Raise cash for a future stock purchase
 URL: https://focusedcompounding.com/sold-weight-watchers-wtw-and-b-enterprises-bw/
 Time: 2017
-----------------------------------------------------
MSC Industrial Direct (MSM): A Metalworking Supply Company
MSC Industrial Direct is an MRO (maintenance, repair, and overhaul) distributor focused on the
metalworking industry. The company’s initials originally stood for Manhattan Supply Company.
This is a company MSC’s predecessor acquired many years ago. MSC can trace its roots to
Sidney Jacobson’s Sid Tool Company. Sid Tool was founded in 1941 in Manhattan. Sid Tool’s
store sold cutting tools and accessories to New York City machine shops. The company moved
to Long Island in the 50s. Business grew rapidly after World War Two. But Sid Tool soon
became dependent on two key customers. Grumman Corporation and Republic Aircraft made up
90% of Sid Tool’s sales. To diversify its sales, Sid Jacobson started a catalog business. The
catalog offered discount prices on imported cutting tools. Since it was a catalog instead of a
store, the book was able to offer a wider range of products. Sid Tool’s catalog was launched in
1961. By 1964, it had over 150 pages. Today, MSC’s catalog – known as the “Big Book” has
over 4,000 pages.
Within a few years, Sid Tool’s catalog sales were greater than the sales it had been making to
those two key customers. Sid Tool was selling products it found at trade shows. Jacobson would
visit trade shows and make up lists of the products he wanted to sell. Or manufacturers who saw
Sid Tool’s catalog would contact him and ask to be put in the catalog. This allowed the catalog
to have a wide range of products. But, it created a problem in the late 1960s. An imported item
was out of stock. Sid Tool didn’t have the product on hand – though it was in the catalog – and
was told it would take 6 months to fill the order. Jacobson wanted to make sure this would never
happen again. So, in 1969, he installed a computerized inventory control system. MSC has been
quick to adopt technology to manage inventory and fill orders quickly and accurately ever since.
In 1970, Sid Tool acquired Manhattan Supply Company. This is where the MSC name comes
from. MSC opened its first distribution center in 1978. In the 1970s, Sidney Jacobson’s son,
Mitchell Jacobson, joined the company and soon took over day-to-day management. Mitchell
Jacobson was very young when he took over the company. So, he is actually still with MSC
today. He serves as the company’s Chairman. Members of the extended Jacobson family control
much of the economic interest – and a majority of the voting power – of MSC to this day.
Under Mitchell Jacobson, MSC started a geographic expansion. It went from 3 branches in the
mid-1980s to 26 branches in 1990. That same year, MSC opened a second distribution center in
Atlanta. This gave the New York based company better geographic coverage. The company also
made same day shipping a priority. By 1991, MSC was shipping 98% of orders the same day it
received them. This was several years before e-commerce became a reality in the U.S. So, same
day shipping under almost all circumstances was not yet common. MSC’s management decided
same day shipping helped differentiate the company from its competition. So, it pressed this
advantage. For orders placed by 4:30 p.m., MSC said it would either ship the order that day or it
would send the customer a check for $50. In the first 3 years of the program, MSC had a 99.99%
same day shipping rate.
MSC went public in 1996. Revenue was $305 million at that time. We know what MSC’s sales
were in the mid-1970s. So, we know that MSC had achieved a 20% annual sales growth rate
from 1976 through 1996. It was a growth company. But, it was determined to invest in additional
infrastructure. From 1996 through 2004, MSC opened 3 new distribution centers, added 60
branches, and increased its catalog by 400,000 stock keeping units. In the 20 years since its 1996
IPO, MSC has grown sales by 12.6% a year and earnings per share by 13.3%. The stock price
has compounded at 11% a year while the company stuck to a 30% to 50% dividend payout rate
throughout those two decades.
There are two ways to look at MSC today. The first is to see it as one of the big MROs like
Grainger and Fastenal. By this measure, MSC has 2% of the North American MRO market. It
has 1.1 million stock keeping units available online. And it actually stocks 880,000 of these
items. Orders placed by 8 p.m. have a 99% chance of being shipped that same day. If you think
of MSC as just another broad line MRO distributor like Grainger and Fastenal – it appears more
centralized. MSC ships almost everything out of just 5 distribution centers. The company still
has 100 branches. But, these branches should not be thought of as stores like the small ones
Fastenal operates or the large ones Grainger runs. MSC’s 100 branches are really just sales
offices. They carry very little inventory.
So where is the inventory? It’s in MSC’s 5 distribution centers. And it’s in vending machines.
MSC is mostly an e-commerce company. MSC has sales of $3 billion. About 57% of those sales
come from electronic sources. Metalworking revenue is 50% of all sales. So, actually, MSC is
almost 30% a pure online metalworking supply company. It can be thought of as about half
online and half offline and it can be thought of as about half metalworking and half non-
metalworking. MSC’s relative market share within metalworking supplies is big. The company
has 10% market share in metalworking. This is several times the size of its nearest competitor.
The Jacobson family has 82% of MSC’s voting power and 49% of its economic interest. We’ve
included shares owned by the Chairman (Mitchell Jacobson), a Jacobson family trust, shares held
by Mitchell’s sister, and shares held by his niece and nephew. Calculated this way, the Jacobson
family controls MSC. It is a family controlled company despite being public for 20 years now.
MSC has $3 billion in sales. It just completed a major expansion of its infrastructure which
included a second headquarters and a fifth distribution center. The company will not be running
“at capacity” till it hits $4 billion in sales. The EBIT margin is 13% now. But, Quan estimates
the EBIT margin will peak in the 16% to 18% range when MSC once again operates at capacity.
This is an important point to keep in mind throughout the issue. MSC might look like it is trading
at a P/E of 19. But, over the next 5 years, MSC can increase sales, increase margin, and pay out
free cash flow without additional investment in infrastructure. So, 2016 earnings are very low
compared to what we expect 2021 earnings to be. When a buy and hold investor looks at a stock,
it isn’t this year’s earnings they should price the stock off of. It’s earnings five years down the
road. MSC is not cheap compared to what it is earning if you buy it today. But, today’s stock
price is cheap compared to what MSC will be earning when you sell it in 2021.
 URL: https://focusedcompounding.com/msc-industrial-direct-msm-a-metalworking-
supply-company/
 Time: 2016
-----------------------------------------------------
Commerce Bancshares (CBSH) is a Durable Family Run Bank
Commerce has been controlled by the same family – the Kemper family – for over 100 years. In
the 113 years since the Panic of 1903, Commerce has survived several financial crises. In 2008,
it did not accept TARP money from the U.S. government. Commerce’s net charge off rate
peaked at just 1.31% in 2009. Even in that crisis year, loan losses at Commerce were quite low
(well less than half a percentage point) in all areas except credit cards, real estate construction,
and consumer credit. These 3 areas are high risk loan categories. Right now, about 13% of
Commerce’s total loans are in areas Quan and I consider high risk. Credit cards are 7% of total
loans, real estate construction (and land) is 4% of total loans, and boat and recreational vehicle
loans are 2% of total loans. So, 13% of Commerce’s loans are in areas that would be severely
stressed by a financial crisis like the one seen in 2008. The next financial crisis probably won’t
look like the last one though. They never do. So, it doesn’t make sense to focus too much on
loans that go bad with the housing market and household finances. Just know that about 87% of
Commerce’s total loan portfolio is in fairly safe and traditional types of lending. None of these
types of loans had charge-off rates above 0.41% in 2009. Those are very low charge-off rates.
So, any risk to the durability of Commerce comes from the other 13% of loans that are in credit
cards, real estate construction, and marine and RV lending.
Overall, Commerce makes all types of loans. Consumer and mortgage loans are 41% of total
loans. Real estate is 47% of total loans. Real estate is diversified among: business real estate
(20% of total loans), personal real estate (16%), home equity (7%), and construction (4%). There
are many ways to break down a bank’s loan portfolio. In Commerce’s case we can look at some
big and fairly traditional forms of lending and see what they add up to. Business loans (non-real
estate – so commercial loans) are 35% of all loans. Business mortgages are 20%. Personal
mortgages are 16%. So, right there, you have 71% of loans from those 3 categories. These loans
are very typical of what banks we’ve talked about before make. Then, we get down to some
categories of loans that Commerce makes which are less important at other banks – or even non-
existent. We have 8.5% car and motorcycle loans, plus 1.3% RV loans, plus 0.4% boat loans
equals 10.2% vehicle loans of some kind. We have 7% credit card loans. And we have 6.6%
home equity loans. Home equity loans are fairly common at other banks. Auto loans and credit
card loans are often a lot smaller at the banks we’ve talked about then at Commerce though.
Commerce’s charge-off rate tends to be much lower than the industry. This isn’t just overall. It’s
also within each category. Commerce did have higher charge-offs in 2009 than Frost. A lot
higher, in fact. But, this was due to Commerce making types of loans that Frost does not. So, in
2009, Commerce peaked at a 1.31% charge off rate. Frost peaked at 0.58%. As you know from
reading our bank issues – Frost and BOK Financial and Prosperity all had very low charge-offs
right through the crisis. Commerce did not have an extraordinarily low charge-off rate. But, the
crisis was a much tougher test of the types of loans Commerce makes than it was at Frost. Frost
makes a lot of business loans in Texas. Businesses in Texas just weren’t very stressed by the
crisis. Real estate in parts of the country was stressed. Households around the country were
stressed. But, businesses in Texas were stressed much less by the 2008 financial crisis than by
the early 1990s recession or the early 1980s oil bust. So, 2008 was not the toughest moment for
Frost’s borrowers. It was certainly the toughest moment in 30 or more years for some of the
consumer type loans that Commerce makes.
For example, Commerce made construction loans. These are very risky in a housing bubble. In
2008, 2009, 2010, and 2011 Commerce charged off 0.89%, 4.61%, 2.69% and 1.66% of its
construction loans. That sounds high. But, now, let’s do a comparison of Commerce versus the
industry in that loan category. In 2008, Commerce charged off 0.89% of its construction loans
versus 2.63% for the industry. In 2009, it was 4.61% vs. 5.40%. In 2010, it was 2.69% versus
5.45%. And in 2011, it was 1.66% versus 3.33%. In 2012, 2013, and 2014 – Commerce then had
a negative charge-off rate (it actually recovered on some written off loans) while the industry as
a whole never did. For the entire period of 2008 through 2014, Commerce wrote off far less of its
construction loans than the industry did.
Over the last 24 years, Commerce has only charged off an average of 0.63% a year of its
consumer loans (these are passenger vehicles, boats, and recreational vehicles – probably they
are mostly cars). In each year from 2008 through 2014, Commerce charged off less than the
industry did within the category. It’s also worth mentioning that the composition of this category
is now different. In 2009, boat and recreational vehicle loans were 50% of all consumer loans at
Commerce. Today, boat and RV combined are just 12% of all consumer loans at Commerce. So,
Commerce is making far more car loans in this category relative to boat and RV loans.
Charge-offs in credit card lending are always high. Over the last 24 years, Commerce has
averaged a charge-off rate of 3.5% a year in this category. Commerce’s charge-offs peaked in
2009 at 6.77% of all its credit card loans. The industry peaked in 2010 at 10.08% of all of its
credit card loans. Again, Commerce’s charge-off rate in this category was lower than the
industry’s charge-off rate in every single year from 2008 through 2012.
I focused on these riskier categories even though they are not Commerce’s biggest categories –
because they are the only categories where charge-offs have ever been high enough to cause any
concern. Commerce’s biggest loan categories are actually real estate loans. Missouri and Kansas
didn’t have a housing bubble. So, Commerce’s record in these areas is pristine. Net charge-offs
in business loans averaged 0.07% a year. They peaked at 0.70% in 1991. Charge-offs were a lot
lower in the 2008 crisis than in the early 1990s recession. The same pattern is true for residential
real estate loans. The very worst charge-off rate for residential real estate was just 0.19%. The
industry average was 9 times higher at 1.72% in 2009. Commerce probably had low losses
because Missouri and Kansas didn’t have a real estate bubble, Commerce generally originated
the loans on its books (it didn’t acquire them), it never made subprime loans, and it generally
required at least a 20% down payment. To illustrate, in the year 2006 (a bubble year in the U.S.),
87% of all Commerce’s residential real estate loans had a loan-to-value ratio of 80% or less. And
98% of loans required principal payments be made – not just interest payments.
Commerce’s commercial and industrial loans actually have even lower charge-off rates than
Frost’s C&I loans. So, by category, Commerce is a more conservative lender than Frost. To be
fair to Frost, that bank specializes in commercial lending and avoids things like credit card and
home mortgage loans entirely.
Commerce – like Frost – also has a lot of cultural continuity. If the bank didn’t make risky loans
in a category in the past – it’s very unlikely to start making risky loans in that category, because
the same people are making the loans. Commerce has been run by the same family for over 110
years. It is the slowest growing bank among those we’ve profiled. It is in the slowest growing
region. And it isn’t a serial acquirer. BOK Financial, Frost, and Prosperity all grow faster and
either make acquisitions or have to hire new employees more frequently than Commerce. In
2013, the company’s CFO said: “Somebody that’s been with us for 10 years is a short-timer. We
still look at them kind of as a newbie and that’s just sort of the culture at Commerce.” Commerce
made it safely through the 2008 financial crisis without accepting TARP money. There is no
reason to believe another 2008 type crisis is imminent. When another crisis like 2008 does
happen though, Commerce should be in the same position to survive it. Commerce’s durability
should be equal to or greater than the durability at BOK Financial, Frost, and Prosperity. Cultural
continuity is probably even higher at Commerce than at those banks. And the bank doesn’t grow
as quickly as those banks do. So, the pace of change in risk taking is probably slower at
Commerce than at those banks. It’s a durable bank.
 URL: https://focusedcompounding.com/commerce-bancshares-cbsh-is-a-durable-family-
run-bank/
 Time: 2016
-----------------------------------------------------
Distributors Like Grainger (GWW) Can Benefit From Their Biggest

Corporate Customers Wanting to Consolidate Suppliers for Decades to Come
Grainger distributes the products needed to keep a large business running smoothly. It sells light
bulbs, motors, gloves, screwdrivers, mops, buckets, brooms, and literally thousands of other
products. About 70% of the orders customers place with Grainger are unplanned purchases. By
unplanned we mean things like the filter in an air condition system, the up / down button on an
elevator’s control panel, the motor for a restaurant kitchen’s exhaust fan. The customer knows
these things break eventually. But, they don’t know when they will break. These aren’t cap-ex
purchases made when the place first opens. And they aren’t frequent, predictable purchases.
Things like light bulbs, safety gloves, and fasteners – a key part of Fastenal’s business – are
bought more frequently in greater quantities as part of planned orders. Grainger sells to both
large customers and small customers. And customer orders are sometimes planned and more
frequent, sometimes unplanned and less frequent. But, the biggest part of Grainger’s business is
unplanned purchases made by large business customers who have a contract with the company.
Almost all of the company’s profit comes from the U.S. So, when you think about what Grainger
does – think unplanned purchases by big U.S. businesses.
Grainger was founded by William W. Grainger (hence the W.W. in the company’s name) in
1927 in Chicago. The company is still headquartered in Illinois. It started as a wholesale electric
motor distributor. At the time, manufacturers were switching their assembly lines from a central
DC driven line to separate work stations each with their own AC motor. Grainger focused its
business on customers with high volume electric motor needs. It was a catalog retailer. The
original “Motorbook” catalog was just 8 pages. Today, Grainger’s “Red Book” catalog is over
4,000 pages. It features more than 1.4 million stock keeping units. Grainger started opening
branches in the 1930s. From Chicago, it expanded into Philadelphia, Atlanta, Dallas, and San
Francisco. By 1937, it had 16 branches. In 1953, Grainger started a regional warehousing
system. The company added distribution centers to both replenish stock at the branch level and to
fill very large customer orders. The company eventually added distribution centers in Atlanta,
Oakland, Fort Worth, Memphis, and New Jersey. As alternating current became standard
throughout the U.S., Grainger focused on doing more than just selling motors to American
manufacturers. It sought out smaller scale manufacturing customers, service businesses, and
other parts of the economy. Today, Grainger’s customer list is very diversified. It is much less
dependent on the manufacturing sector than publicly traded peers like MSC Industrial and
Fastenal. Grainger basically sells to any U.S. business customer who makes a lot of small orders.
So, high frequency combined with low volume per order. Grainger is best at dealing with big
customers. The company’s competitive position is strongest where the customer has a contract
with Grainger and is served by a specific account representative. These customers make
purchases at their different sites across the country under the same overarching agreement that
provides steep discounts to the list price shown in Grainger’s catalog.
Grainger went public in 1967. At the time, sales were $80 million. Those sales have since
compounded at 10% a year over the last 39 years. Grainger has changed its logistical footprint
several different times. It eliminated its regional distribution centers by the mid-1970s. But, it
brought them back in a different – heavily automated form – starting with a distribution center in
Kansas City in 1983. Grainger rapidly increased its branch system during the late 1980s. It was
opening about one branch a week by the end of that decade. In 1995, the last Grainger family
CEO – David Grainger – retired. In that same year, the company launched its first website.
Online became a huge part of Grainger’s business. Today, Grainger is the 13th biggest online
retailer in the U.S. It is one of UPS’s top 10 customers. And it gets 40% of all U.S. revenue
through the internet.
Over time, Grainger also expanded a little internationally. It acquired a Canadian company in
1996. And it entered a few different countries – like Mexico, Japan, Brazil, and China – in recent
years. Some of these attempts succeeded. Others failed. The U.S. business provides most of the
company’s profits. The Canadian business is big and successful. The Mexican business is small
but profitable. Brazil and China were failures. However, Grainger is still in China. But, we don’t
expect them to invest any further there. Japan was a huge, huge, huge success. We’ll talk more
about Grainger’s model in Japan and how it brought that over to the U.S. later. For now, we’ll
just let you know that Grainger is the majority (53%) owner of a publicly traded Japanese
company called MonotaRO. The stock – which is a wildly expensive, Japanese growth stock –
has a market cap of $2.4 billion (that’s U.S. dollars). That gives Grainger’s stake a $1.3 billion
value at market. I’m not sure that’s the correct value. The P/E on the stock is astronomical. But,
so is the growth rate.
The reason for Grainger’s success in the U.S. is supplier consolidation. Big customers want to
consolidate purchases across their various sites. In high GDP per capita countries – places where
labor cost per hour worked is expensive – there is a lot of interest in reducing complexity. For
example, Grainger’s business in China was unsuccessful in part because in China employers will
just send an employee out to a big open market to browse through various parts for the one
replacement part the company needs. This kind of set up is not reasonable in countries where an
employee’s time is more valuable. Customers in the U.S. like using one supplier for more and
more of their maintenance supply needs. They like that Grainger can install vending machines,
provide inventory management by re-stocking inventory, and give a discount below the list price
on a wide variety of the products the company might need to buy however infrequently.
The most important thing to understand about Grainger is the nature of the orders customers are
placing with the company. The orders can be fairly random looking – almost every business
needs a mop, a screwdriver, a small motor, a light bulb, etc. sometime even if it’s far from the
core of what they do. The average order size is small. However, it needs to be filled fairly
rapidly. Customers are often satisfied with next day shipping on most items. They’re unlikely to
be satisfied with next week shipping. This means Grainger has to keep a lot of inventory on
hand. They also have to offer credit terms to customers. Business customers are used to buying
on credit. They don’t want to have to pay their bills any faster than 30 days. So, Grainger has a
lot of inventory and a lot of receivables. It has low turns. But, it has high margins. This surprises
some people. Investors and analysts see 40% gross margins and wonder how that can be. Can a
middleman really mark-up basic, boring products like we’ve talked about here – mops, buttons,
motors, light bulbs, etc. – by 50% to 70% over the price they paid for that product? The answer
is yes. But, it’s yes because of issues of quantity and timing. Grainger is willing to go to a maker
of let’s say mops and order a thousand of them. It’s willing to hold those mops. And it’s willing
to pay the mop maker before it collects payment from the eventual mop user. Grainger’s
customer can buy one mop – just one mop – as part of an order with completely unrelated
products. And that customer can buy on credit. They don’t need to buy more mops than they
need. They don’t need to keep spares around. And they can get better credit terms – a longer time
to pay – and a lower price than you could get from sending an employee to Wal-Mart looking for
just one mop. This is why the gross margin is so high. The end user of the mop has no interest in
dealing with the maker of the mop on terms the two would find acceptable. In some cases, a
customer is buying a product they’ve never bought before. Using the example of a motor in an
HVAC system. The plant manager or store manager or branch manager of some customer of
Grainger’s may never have bought an HVAC motor before in his life nor may he ever have to
again. He knows he needs a motor. But, he doesn’t know much about pricing, availability, etc.
Having a main supplier of most replacement needs gives him a place to turn to for a consistently
decent price, delivery time, and credit terms – even for products he knows little about. This is
Grainger’s strength. It’s facility maintenance. Grainger isn’t as strong as MSC Industrial and
Fastenal when it comes to the manufacturing floor. Those companies are better at selling cutting
tools and fasteners and lots of related products to customers who have consistently high needs
for some specialty products.
Like I said, Grainger is the most diversified company in its industry. The client list is extremely
diversified. Manufacturing (18% heavy, 11% light) is just 30% of revenue. Commercial
customers are 14%. Government is 13%. Contractors are 11%. Sellers – wholesale, retail, and
resellers combined – are 10%. Transportation is 6%. And natural resources is 5%. It’s not quite
as diversified as U.S. GDP. For example, manufacturing at nearly 30% of Grainger’s sales is
clearly over-represented relative to the U.S. economy. But, it’s pretty close.
The products Grainger sells are so extraordinarily varied that I’ve had trouble talking to you
about them so far. I’m sure that will continue to be the case. Grainger sells everything a business
facility needs to keep running smoothly. Product categories include: Safety and security (18%),
material handling (12%), metalworking (12%), cleaning and maintenance (9%), plumbing and
test equipment (8%), hand tools (7%), electrical (6%), HVAC (6%), lighting (5%), fluid power
(3%), power tools (3%), motors (2%), and power transmission (2%). So, concentrations in any
one area are very low. For example, metalworking is a big, specialty category – but it’s still only
9% of the company’s total sales. A 10% drop in metal working sales would be less than a 1% hit
to overall revenue.
Grainger has 1.4 million stock keeping units. About 500,000 SKUs are kept in inventory. Most
orders ship same-day or next day. Grainger keeps products in inventory at 19 distribution centers
and 350 branches across the country. Branches average 22,000 square feet.
Grainger divides customers into large customers, medium customers, and small customers. Quan
and I think the real distinction is between customers covered by a specific Grainger sales
representative (and attached to a corporate contract) and customers covered by a territory sales
representative. Our best guess is that Grainger gets 85% or more of all revenue from customers
covered by a specific sales rep under an attached account. Grainger says it has 14% market share
in large customers. Large customers are customers with over 100 employees per location that
buy over $100,000 worth of facility maintenance supplies each year. Grainger is very weak in
small customers. These customers have fewer than 20 employees per site and buy facility
maintenance supplies just once or twice a month. Almost all of Grainger’s growth has come from
increasing sales to its biggest customers. Since 2009, sales to large customers have grown 8.6% a
year. This is much, much faster than nominal GDP growth. Grainger has been increasing its
share of wallet among these customers.
The company now has something called Zoro in the U.S. This company is modeled after
Grainger’s joint venture in Japan. The Japanese joint venture – MonotaRO – was wildly
successful in terms of revenue growth. So far, Zoro has been a fast grower too. The online only
distributor had sales of $80 million in 2013, $180 million in 2014, and $300 million in 2015.
Grainger hopes to copy Zoro’s success in both the U.K. and Germany. So, Grainger has several
business units following this model. There is MonotaRO in Japan – which now has over $500
million in sales. There is Zoro in the U.S. – which now has $300 million in sales. And then
Grainger hopes to use its U.K. acquisition to build a U.K. online only business. There is also
Zoro Germany. So, one day, Grainger could have a meaningful online business in the U.S.,
Japan, the U.K., and Germany. These businesses compete directly with Amazon Supply. The rest
of Grainger really doesn’t. Grainger sales reps always say that their largest competitors are other
local or regional MRO companies. They say they rarely find themselves competing directly with
Fastenal, MSC Industrial, or Amazon Supply – despite those being the competitors investors and
analysts ask most about. Quan and I found in talking to people at the publicly traded MROs, that
they are quite knowledgeable about each other’s business models, but actually don’t believe they
compete very directly with each other or even do business in the same way. They all have
different theories on which model is best. Part of the explanation for this can be that they each
have different customer populations. Grainger’s success has really been on the least frequently
purchased items by the biggest American companies. When it comes to frequently purchased
items, smaller customers, or foreign countries – they’ve had a very mixed record. But, when it
comes to large businesses, they are actually even more successful than the past record makes
them seem. Sales growth looks mild in recent years due to the huge decline in sales to Grainger’s
smallest customers. As we said, Grainger actually grew 10% a year since going public 40 years
ago. And, it has grown sales to large businesses by more than 8% a year since the financial crisis.
Earnings grow even faster than sales. So, Grainger is definitely a growth stock. In fact, it’s a
growth at a reasonable price stock.
 URL: https://focusedcompounding.com/distributors-like-grainger-gww-can-benefit-from-
their-biggest-corporate-customers-wanting-to-consolidate-suppliers-for-decades-to-come/
 Time: 2016
-----------------------------------------------------
Don’t Pick Between Prosperity (PB) and Frost (CFR) – Buy them Both
An investor interested in Texas banks should simply buy both Prosperity and Frost. These two
biggest Texas based banks are among the best banks in the U.S. They each have their risks. Frost
makes energy loans. And Prosperity does not have especially high capital levels. But, these risks
should be small because of the conservative attitudes toward lending and acquisitions at each
bank. Frost doesn’t make big, transformative acquisitions. And Prosperity is a serial acquirer that
has never had high loan losses despite acquiring many different Texas banks.
We can certainly compare Prosperity and Frost. But, my advice and Quan’s advice would be not
to buy Prosperity without also buying Frost and not to buy Frost without also buying Prosperity.
Unless you have a very, very concentrated portfolio – there is little reason to focus on buying
only one bank and not the other.
Prosperity is less interest rate sensitive than Frost. And Prosperity doesn’t make energy loans.
So, if your two big concerns are that oil prices will stay low for many, many years to come and
the Federal Reserve will keep interest rates at or below zero for many, many years to come – it
makes sense to buy Prosperity instead of Frost. I understand some investors may have a feeling
about where oil prices or interest rates are headed in the next few years. And they may want to
bet on that feeling. But, oil below $30 a barrel is cheap long-term. And a Fed Funds Rate under
1% is low in normal times. So, it doesn’t make much sense to bet against either an increase in oil
prices or an increase in the Fed Funds Rate. Buying both Prosperity and Frost can diversify
whatever risks Frost has in terms of energy loans and low interest rates. But, I can’t suggest
picking Prosperity over Frost. Because, actually, it’s reasonable for rates to rise over the next 5
years and for Frost to benefit far more from that than Prosperity. As for energy loans, the truth is
that while Frost might have to write-off a lot of energy loans if oil stays below $30 for years –
those losses would not bring Frost’s tangible equity levels lower than Prosperity’s. In other
words, Frost can charge-off a lot of its energy loan portfolio and still have higher tangible equity
to total assets after doing so than Prosperity does now. So, it’s not logical to prefer a bank with
lower tangible equity levels over a bank with higher tangible equity levels just because the bank
with higher tangible equity might charge-off loans that would still leave it more highly
capitalized than the bank that doesn’t charge-off any loans. So, again, I see no reason to prefer
Prosperity over Frost because of energy loans. Low oil prices will cause bad headlines at Frost
and not at Prosperity. But, bad headlines don’t necessarily make for a bad stock.
What about interest rates? This one is speculative. But, it’s also a meaningful difference between
Prosperity and Frost. If you really did know what the Fed Funds Rate would be at various points
in the future – you could discriminate between Prosperity and Frost on that basis. For example,
Quan and I estimate that based on today’s interest rates, Prosperity is more than 10% cheaper
than Frost. However, based on a 3% Fed Funds rate – which we consider normal – Prosperity
would actually be about 20% more expensive than Frost. So, is Prosperity cheaper than Frost or
more expensive? In my opinion, Prosperity is more expensive than Frost. I always look at normal
earnings. If you’re analyzing an oil company while oil is $27 a barrel and you expect oil to be
$55 a barrel in 2021, then you would estimate 2021 earnings based on $55 a barrel. And if you’re
a long-term investor, it doesn’t matter what earnings are in 2016 when you buy the stock. It
matters what earnings will be in 2021 when you sell the stock. I think the same rule applies to
interest rates – except only more so. Central banks have implemented negative interest rates in
other parts of the world. It’s technically possible the Fed could do that in the U.S. But, is it
important to consider? There are real problems with having interest rates very close to zero and
even bigger problems when interest rates are below zero. It’s not reasonable to believe that a
negative 3% Fed Funds Rate in 2021 is as likely as a positive 3% Fed Funds Rate in 2021. And
yet we know that Frost will benefit more from higher rates than Prosperity. So, with interest rates
as close to zero as they are – we would expect higher rates to be a more likely event in 5 years’
time than lower rates. This is speculative. But, it’s not speculative in quite the same way as
looking at $38 a barrel oil today and wondering whether oil is more likely to be at $76 a barrel in
2021 or $19 a barrel in 2021. Long-term costs would suggest $76 a barrel might be a little more
likely than $19 a barrel. But, $19 a barrel is not an unreasonable price for oil in quite the same
way that a negative yield on money is an unreasonable price for a loan. Oil at $19 a barrel in
2021 would not be as odd an occurrence as a meaningfully negative Fed Funds rate in 2021. So,
Prosperity is cheaper than Frost now because interest rates are abnormally low now. But, Frost is
cheaper under any reasonable “normal” interest rate scenario. That’s why I consider Frost the
cheaper stock. You shouldn’t price a stock based on what it’s earning in an abnormal present.
You should price it against what it will earn in a normal future.
Prosperity might have more upside. Quan believes Prosperity’s organic growth has a 20% or
better after-tax return on equity. He also thinks any acquisitions Prosperity does should have a
13% or better after-tax return on equity. The stock has a 2.5% dividend yield. So, the only part of
the future return equation that could be sub-standard is the reinvestment of that dividend.
Prosperity may be able to earn between 13% and 20% on the earnings it retains. It’s unlikely you
can earn that much on the dividends it pays you. But, as long as the dividend payout ratio is low,
it’s unlikely your total return will be pulled below 10% a year.
Prosperity has a P/E around 11 today. Historically, it has traded at between 13 and 20 times
earnings. So, the stock is cheap relative to its own past. It’s not clear why this is. Prosperity is a
Texas bank. Some investors may worry that Texas real estate will perform poorly in an oil bust.
They may worry about Prosperity’s real estate loans in areas like Houston where energy
companies are large employers and large office tenants. Energy loans are only 5.5% of
Prosperity’s loan portfolio. That’s 2.7% of earning assets. Losses on those loans can’t
meaningfully increase risk at all for shareholders. To put this in perspective, if every energy loan
Prosperity made defaulted and Prosperity recovered zero cents on the dollar in all these defaults
– Prosperity could cover all of the losses out of roughly one year’s earnings. Investors may also
dislike all regional banks because of interest rate sensitivity. But, Prosperity is fine with low
rates. The Fed Funds rate declined from over 5% to less than 0.25% from 2007 to 2014. During
that time, Prosperity grew earnings per share by 12% a year. At worst, the risk that investors are
worried about for the next 7 years is that the Fed Funds Rate is fairly flat near zero – not that it
declines by five full percentage points. So, Prosperity was a growth stock over the last 7 years
when rates were falling rapidly. No one expects rapidly falling interest rates. So, the next 7 years
should present Prosperity with interest rates that are easier to cope with than the last 7 years.
Right now, Prosperity’s net interest margin is in line with the bank’s long-term historical average
net interest margin. Honestly, Prosperity’s net interest margin doesn’t vary much with the Fed
Funds rate. So, concerns about the Fed not raising rates as fast or at all as expected are an
argument against buying Frost right now. They aren’t an argument against buying Prosperity. It’s
also worth mentioning that we are really only debating the upside here. Even if interest rates
don’t rise, Frost is a cheap stock that will deliver good returns. It just won’t deliver great returns
quickly if rates stay near zero. Prosperity’s upside is pretty similar regardless of what happens
with interest rates.
So, if you are concerned about energy loans and believe the Fed will not raise rates – you might
prefer Prosperity over Frost. Quan and I aren’t that worried about energy loans. And we expect
the Fed Funds rate to be a lot higher in 5 years than it is today. So, if you’re a long-term buy and
hold investor, we suggest putting equal amounts of your money into the two biggest Texas based
banks: Frost and Prosperity
 URL: https://focusedcompounding.com/dont-pick-between-prosperity-pb-and-frost-cfr-
buy-them-both/
 Time: 2016
-----------------------------------------------------
Closing the Book on Breeze-Eastern
Quan and I did an issue on Breeze-Eastern last year. The stock has since been acquired
by TransDigm (TDG). When we did the issue Breeze-Eastern was priced at $11.38 a share. We
appraised the stock at $15.02 a share. TransDigm would later pay $19.61 a share for all of
Breeze-Eastern.
What lesson can we learn from our Breeze-Eastern experience?
Here’s what we said about Breeze-Eastern’s stock price at the end of our issue:
“Breeze should – based on the merits of the business alone – trade for between 10 and 15 times
EBIT. It is unlikely the stock market will ever put such a high value on Breeze…It is a small
company. And 3 long-term shareholders own 70% of the stock. That doesn’t leave a lot of shares
for everyone else to trade…Some investors may not like that kind of illiquidity…Breeze is not a
fast growing company. And it’s not in an exciting industry. So, it is unlikely to get attention
based on anything but its numbers. This might cause investors to underappreciate the qualitative
aspects of the company…It is possible that the investment funds that hold most of Breeze’s stock
will not hold it for the long-term. They may want to sell the company.”
(Breeze-Eastern Issue – PDF)
Last year, Value and Opportunity did a blog post called “Cheap for a Reason”:
“Every ‘cheap’ stock you will find has problems. Some of those problems might be individual
(bad management, too much debt etc.), some of those problems might be more sector specific
(oil&gas, emerging markets exposure) or a combination of both.
The most important thing is to be really aware what the real problem is. If you don’t find the
problem, then the chance is very high that you are missing something.”
So, why was Breeze-Eastern cheap?
Quan and I thought it was that the company had been spending on developing new projects in the
recent past that wouldn’t pay off till the future:
“Between 2007 and 2011, Breeze-Eastern’s EBIT margin was depressed by 5 full percentage
points as a result of development spending on projects like the Airbus A400M…Breeze-Eastern’s
gross margin and operating margin will be higher in the future than they were in the last 10
years.”
The merger document for the acquisition includes a projection by the company’s management to
its financial advisors that suggests the reason TransDigm – or any other 100% buyer – would pay
more for Breeze than the stock market had often valued the company at was because:
1. Breeze will have lower costs as it spends less on development projects

2. AND Breeze will have higher sales as a result of the development projects it spent on in
the recent past
The projections show EBIT going from $12.9 million in 2015 to $29.3 million in 2021. This is a
15% annual earnings growth rate. The projected growth is largely due to management’s belief
that revenue from platforms under development will go from $0 in 2016 to $28 million in 2021.
This would seem to suggest that we were right about two things:
1. The stock’s illiquidity made its shares more attractive to a 100% buyer than to individual
investors buying just a small, tradeable piece of the company
2. Breeze was cheap today versus its likely future value, because the company’s reported
results included present day expenses as incurred but did not include the expected long-
term payoff from supplying new helicopter and airplane projects that won’t be launched
for several years
So, maybe the two lessons we should learn from the Breeze takeover being done at a much
higher price than the stock traded at or than we valued the company at are:
1. Always value a stock based on what a control buyer would pay for it as a permanent,
illiquid investment – never value a stock based on what traders will pay for small,
tradeable pieces of the business (Ben Graham’s Mr. Market rule)
2. Look for businesses that have to report bad results today even though you know they will
report better results in the future
Quan and I weren’t sure if Breeze would have higher revenue from these projects one day. The
acquirer here is counting on future projections for revenue. However, we were sure that Breeze
would spend less in the future than it did in the past. That was a sure thing.
There is one problem with this analysis of the learning experience we got from Breeze. Mr.
Market actually did re-value the company upwards before the acquisition – not after. Breeze
went from like $12 a share in the summer of 2015 to $20 a share in the fall of 2015. You didn’t
have to hold the stock through the acquisition to make money. We were wrong that Mr. Market
would never pay up for such a boring, obscure, and illiquid little stock.
It’s worth mentioning here that Breeze’s enterprise value had been $160 million in 2009. We
even mentioned in the issue we wrote that Breeze fell in EV from $160 million in 2009 to $95
million in 2015. Yet, we didn’t speculate that Mr. Market would once again assign Breeze a
$160 million enterprise value. It seemed more reasonable to us that someone would buy the
whole company. So, again we proved we are really bad at guessing what Mr. Market will do.
And maybe it is better to assume we know nothing about how a stock will be valued by anyone
other than a control buyer.
Also, we were clearly too conservative in our appraisal of Breeze. At about 7 times what we
considered normal EBIT to be, it was a cheap stock when we picked it. And we probably
presented it as too much of a value investment and not enough of a quality investment. I think we
were biased against Breeze – we ticked off its extraordinary virtues in the text of our issue but
still slapped an utterly ordinary EBIT multiple of 10 on the company – due to its small size as a
stock and its low growth in recent years. We may have pigeonholed it as “microcap” value. In
fact, we knew that based on signs like market structure, relative market share, and the bargaining
power Breeze had when dealing with spare parts buyers that its “market power” was among the
strongest of any company we’ve covered. Probably John Wiley and Tandy Leather are as strong.
Hunter Douglas also has an excellent competitive position.
Since Breeze is a small company in a very small industry, we didn’t have precise data to give on
market share the way we often do. All we could say was that Breeze had “a greater than 50%
global market share” in a “true duopoly” and that “the only reason customers ever seem to switch
from Breeze-Eastern to UTC or vice versa is when they get annoyed that a critical spare part is
taking too long to arrive.”
This last sentence is probably the most important sentence in our issue. We rarely come across
companies to analyze where the customers tell us flat out that they just aren’t going to switch
providers. The two clearest examples of this are Breeze and John Wiley.
Finally, Breeze is a classic example of a “Hidden Champion”. We’ve only done a few truly
dominant companies for the newsletter. Tandy and Hunter Douglas are probably the closest to
Breeze in terms of market leadership. They’re also similar in that they have no real peers. We try
to present “comparable” peers in each issue. We said flat out in the issue that “Breeze has no
good peers.” The same thing is true of Tandy and Hunter Douglas.
There’s a lesson in here. Look for companies with no publicly traded peers. Analysts cover entire
industry groups. And investors like to pick from the top down too. If you started from the top
down would you ever get to the “helicopter rescue hoist industry”? Where does that fit in a
portfolio? What about leathercrafting? Most people don’t even know that’s a real hobby. Or
shades and blinds? Is that housing related?
For me, the biggest lessons from Breeze-Eastern are both about timing.
We can time normal earnings. For example, we could see Breeze was under earning now. This
isn’t hard. We know Hunter Douglas will make more in the future than it did in the recent past
(since U.S. housing was lower than normal). We know Frost will make more in the future than it
did in the past (since interest rates are lower than normal). Often, you don’t know “when” this
“normal future” is. But, it’s not hard to notice when the present is abnormal in some way.
We can’t time the stock market. Quan and I never would have predicted that Breeze-Eastern’s
stock would rise on its own – without a buyout offer – to anything like the level it did. And we
never would have expected it’d do it so fast.
I think it’s a lot easier to figure out what an acquirer will eventually pay for a company than what
the stock market will eventually pay for a stock.
So, how do we combine the ideas of finding companies that are under earning today compared to
a normal future year with the idea of ignoring Mr. Market entirely and simply valuing a stock
based on what an acquirer would pay for the entire company?
I guess we could distill that down to a simple investment recipe:
Step One: Fast forward 5 years.
Step Two: How much would an acquirer pay for this company (in 2021 not 2016)?
Last Step: Work backwards to decide how much you should pay for one share of the stock today
assuming the whole company is bought 5 years from today.
 URL: https://focusedcompounding.com/closing-the-book-on-breeze-eastern/
 Time: 2016
-----------------------------------------------------
UniFirst (UNF): Maybe Too Expensive; Maybe Just Right
Here’s a stock trading for 1.4 times sales. We’re sure of that. What we can’t be sure of is whether
it’s trading at 10 times normal pre-tax profits or 14 times normal pre-tax profits.
That word “normal” is the problem.
UniFirst provides uniforms and protective clothing to American and Canadian businesses of all
sizes. These businesses typically sign a 3 to 5 year contract. UniFirst then personalizes, cleans,
and delivers whatever uniforms the business needs. The ongoing task is basically showing up at a
customer location once a week to deliver fresh uniforms and collect the dirty ones.
Quan and I have probably talked about most publicly traded uniform and textile rental companies
in the U.S., U.K., and E.U. at some point. Sadly, they haven’t been cheap enough for us to buy.
We like the industry.
If capital allocation is good and the stock is not clearly selling at a premium price – we’d be
willing to consider buying almost any of them.
At the right price.
We’ve decided that “right price” is 10 times pre-tax profits.
Luckily, UniFirst does trade for about 10 times pre-tax profit. However, the price is closer to 14
times pre-tax profit if normalized a certain way. I’ll explain that “certain way” in a second – but
first an aside.
When we investigate a business in depth we come up with a unique way of normalizing earnings
that is appropriate to that company. For example, Hunter Douglas made $200 million last year
but we think it can make $300 million in a normal year and $350 million in a good year for
housing. That’s not surprising because its sales are lower in both the U.S. and Europe than they
were in 2006 and 2007. Its market share isn’t. The U.S. market for blinds and shades should in a
cyclically normal year – assuming the same real prices per window covering and the same
demand for window covering per person – be more than 25% higher now than it was 10 years
ago. That’s because of population growth and inflation. It’s an easy estimate to calculate. And
I’m confident in it. America isn’t going to have a lot fewer windows per person. And blinds and
shades aren’t going to cost a lot less in real terms. So, in the case of Hunter Douglas we were
aggressive in saying that future earnings will be much, much higher than any year from 2008-
2014. That’s a no brainer.
UniFirst’s earnings are not as simple to normalize.
Our standard way of normalizing the earnings of a company we know nothing about is to simply
take the most recent year’s sales and multiply that by the median EBIT margin over as many
years of history as we have for the company. This is far from perfect. But, it’s also very good at
eliminating cyclically overearning stocks from our list. In recent years, UniFirst has had a 13%
return on sales. Today, it’s up to a 14% EBIT margin. However, if you study the company’s
long-term past (for about the last 20 years) you’ll find that the median return on sales for those
years is just 10%. So, current earnings might overstate normal earning power by up to 40%.
That’s a big mistake for an investor to make.
In this case, it’s basically the difference between paying a P/E of 15 or a P/E of almost 22. We
like the industry. But, uniform rental isn’t the ad agency business or something. You don’t want
to pay 20 times earnings for one of these companies.
To be fair to UniFirst, the S&P 500 shows a pretty similar spike in return on sales. Starting in
2009, UniFirst’s operating margin jumped from around 10% to about 13%. Gross margin moved
– but not as decisively or consistently. This is exactly what has happened at a lot of big public
companies in the U.S. Taking the S&P 500 as a whole – there has been a reduction in selling,
general, and administrative expenses. Gross costs are not lower than in the past. It’s entirely
possible that companies got bloated during the 1990s and 2000s. When the crisis hit, these public
companies were most concerned with growing EPS and shareholder value and therefore slashed
operating expenses – like employees working at corporate – to the bone. That’s a theory. There
could be other explanations. But, stopping cap-ex can reduce depreciation a little. Firing people
reduces SG&A. And not increasing salaries as quickly as your sales increase, also reduces
SG&A. So, lower cap-ex and lower employment and lower salaries than are normal can all
reduce SG&A relative to sales. These could all be reactions to low demand.
Since 2010, UniFirst’s operating expenses have grown much slower than sales.
To give you some idea of what I mean, UniFirst’s SG&A as a percent of sales was 24.6% last
year. Ten years earlier, it had been 27.1%. So, we have an improvement in return on sales of
2.5% due to a reduction in SG&A. That may sound small. But, consider that UniFirst has $1.44
billion in sales now. So, we are talking about $36 million of cost savings. If the stock normally
trades for 10 times pre-tax profits (about a P/E of 15), that is $360 million of value created
through getting lean. That’s $18 per share of added value. Again, this isn’t unique to UniFirst.
You can find a lot of public companies in America with this same pattern of reducing operating –
not gross – expenses faster than sales since the financial crisis hit.
A lot of people email me saying that corporate profits don’t have to “mean revert”. Companies
can have higher operating margins than they did in past decades. It’s possible. But, I think we
should remember that American workers don’t really make much more money than they used to.
And yet they do output quite a bit more than they used to. That obviously benefits employers. In
industries that were historically unionized or closed to foreign competition – I don’t disagree
with the idea that employers can be in a permanently stronger position when bargaining with
employees than they used to be. But a great many companies Quan and I look at were never
unionized and don’t really compete much with companies using labor outside the U.S.
There is one other very good reason for why SG&A could be permanently lower. Companies
could use information technology to lower the amount of people they need in staff type
functions. This invests in capital and economizes on labor. Certainly, a lot of tasks performed by
humans in past decades can be performed by computers now.
However, I think it’s difficult to separate cyclical cost savings due to cutting fat from your
organization during a crisis from permanent cost savings due to technology. I would caution that
in the U.S. you have businesses making unusually good profits while workers are not. Since
businesses are the ones who pay workers – I think it’s really important to stress the cake cutting
between employers and employees is part of what determines profit margins.
This is why we need to be especially careful when looking at companies that have higher EBIT
margins now than they did before 2008. UniFirst is one such company. And whether it is
overearning or not is the key to deciding whether or not the stock is worth buying at anywhere
near today’s price.
UniFirst is not a stock you want to pay more than 10 times normal pre-tax profits for. The right
multiple for a business is determined by the cash profitability of that business. Companies that
can both grow and pay out a lot of cash are worth a lot. Companies that can’t are not worth more
than the average business.
As a long-term buy and hold, UniFirst has two things going against it. One, it needs to invest in
working capital as it grows. Two, it makes acquisitions. As a result, UniFirst does not pay out
much in dividends or buy back any stock. The company has a wonderfully stable EBIT margin
from year to year. Sales are also stable. So, EBIT is predictable.
UniFirst is a very consistent business – as are most companies in this industry. It has the kind of
consistency in profits that you see at John Wiley (JW.A) or Omnicom (OMC). What it doesn’t
have is the free cash flow generating ability of those businesses. John Wiley and Omnicom can
have P/Es of 20 and yet their annual returns can match an index fund with a P/E of 15 – because
they can grow organically while also paying dividends and buying back stock. Since the early
1990s, Omnicom grew sales per share by 11% a year. It didn’t grow its net tangible assets at all.
In fact, they shrank from a deficit of $200 million to a deficit of $2 billion.
As an ad agency, Omnicom can get its customers to finance its growth. As a uniform rental
company, UniFirst can’t.
And so while UniFirst is a very consistent and adequate performer – it doesn’t have especially
desirable cash flow dynamics. It can provide a 10% type return on equity year after year which
can lead to 10% type returns in the stock for the long-run. It’s outperformed the S&P 500 over
the last 30 years. So, I can’t say it’s not an above average business. But, I am going to say it’s
not worth an above average price.
Imagine we can’t settle the question of whether the normal EBIT margin for UniFirst is 10% or
14%. If that’s true, then we can’t be entirely sure if we’re paying something like 10 times pre-tax
profits (a P/E of 15) or something like 14 times pre-tax profits (a P/E of 22). And it’s very
important in this case not to pay a premium to 10 times pre-tax earnings.
Also, UniFirst does some uniform business in areas with oil drilling. It’s possible drilling activity
in North America over the last 5 years has skewed UniFirst’s results in a way we can’t
appreciate.
In defense of the stock, it is unleveraged and this is the kind of business you can leverage up.
Based on the stability of UniFirst’s EBIT, it can support a lot of debt. Cash flow is not very
stable versus reported results. However, peers with less stable earnings have a bit more debt.
UniFirst is definitely a stock worth keeping an eye on. But, I’m not sure it’s possible to have
confidence the stock is cheap enough to provide anywhere near the 11% a year annual returns it
delivered over the last three decades. With stock prices so high right now, it might make sense to
settle for buying a maybe 40% overvalued UniFirst or maybe not overvalued at all UniFirst.
Even if you are overpaying by 40%, I would expect long-term holders of UniFirst to do better
than the overall stock market.
Quan and I will consider UniFirst if it gets cheaper. We’d love to buy the stock at one times
sales. Today, it sells for 1.4 times sales.
At today’s price, we’re not interested.
 URL: https://focusedcompounding.com/unifirst-unf-maybe-too-expensive-maybe-just-
right/
 Time: 2015
-----------------------------------------------------
Sold Town Sports (CLUB); Bought Babcock & Wilcox (BWC)
Today, I sold my shares of Town Sports (CLUB) and put the proceeds of that sale – plus some
other cash – into buying Babcock & Wilcox (BWC).
My average cost in Town Sports was $8.84 a share. My average sale price was $6.85. This is a
realized loss of 23% over an 11 month holding period.
My average cost in Babcock & Wilcox is $27.06 a share. Babcock now represents 18% of my
portfolio. The company will split into two separate stocks later this year. I will hold on to both of
those stocks.
I may increase my position in Babcock to about 25% of my portfolio. This depends on whether:
1) I am successful in selling the last of my Japanese net-nets 2) Babcock’s share price does not
rise too much.
The four non-Japanese net-nets in my portfolio right now are:
1. George Risk
2. Ark Restaurants
3. Weight Watchers
4. Babcock & Wilcox
These four stocks account for more than 90% of my portfolio.
Toby handles the Singular Diligence model portfolio. This sale has no impact on the model
portfolio. Quan also owns Town Sports in his portfolio. Quan did not sell Town Sports and buy
Babcock & Wilcox today. If and when Quan makes a change to his portfolio it will be posted
here.
The timing of my sale of Town Sports and purchase of Babcock has to do with Babcock – not
with Town Sports. Town Sports is the target of an activist campaign. Activist investors control
about a quarter of the company’s shares. The board recently adopted a “poison pill” defense and
the activists nominated their ticket for this year’s board election. None of these events make it a
particularly good time to sell Town Sports. However, we just put out the Babcock & Wilcox
issue of Singular Diligence. The publication of that issue freed me up to buy the stock. Quan and
I start research on a stock far in advance of the date when that stock appears in Singular
Diligence. So, I have been waiting for months to buy Babcock & Wilcox.
It is worth mentioning that I did not – and would not – have sold Town Sports merely to hold
cash. I sold Town Sports to buy Babcock. This tells you 3 things:
1. I prefer Babcock over Town Sports

2. I believed Babcock was the strongest stock I did not already own
3. I believed Town Sports was the weakest stock I did own
For example, my sale of Town Sports obviously tells you that I think Weight Watchers is – at
today’s price – a stronger stock than Town Sports. Otherwise, I would have sold Weight
Watchers instead of Town Sports.
If you subscribe to Singular Diligence you can now read the full issues on both Town Sports and
Babcock & Wilcox.
 URL: https://focusedcompounding.com/sold-town-sports-club-bought-babcock-wilcox-
bwc/
 Time: 2015
-----------------------------------------------------
IMS Health (IMS): 4 Years Later
I bought shares of IMS Health (IMS) in early 2009. The company went private in 2010. That
buyout (involuntarily) ended my investment in the stock. Now in 2014, IMS Health is going
public again. I don’t invest in IPOs. So, I’m not interested in the stock. But, I am interested in
what has happened with the company. Some things have changed. Others have not.
Here is the S-1.
While under TPG’s control, IMS Health bought a lot of stuff. In 3 years (2011 through 2013),
IMS Health spent $900 million on 22 acquisitions, “internal development programs”, and
“capital expenditures”.
I’m not sure if they are including “additions to computer software” in that number. I treat it as a
capital expenditure when analyzing IMS Health (or any database company) but it is reported on a
separate line of the cash flow statement. Additions to computer software is always a bigger
number for IMS Health than other capital expenditures. Over the last 3 years, software capital
spending has averaged $73 million a year while other capital expenditures have been just $38
million a year. You will notice that capital spending (which we just said was $111 million a year
plus acquisitions) and depreciation are totally unrelated. This is a good place to mention that
GAAP numbers are irrelevant at IMS Health. You always want to focus on your expectations of
normal future free cash flow. The business is very stable, so there’s little need to “normalize”
anything on the customer side.
This quote from the S-1 sums up what interested me in the stock originally:
The average length of our relationships with our top 25 clients, as measured by 2013 revenue, is
over 25 years and our retention rate for our top 1,000 clients from 2012 to 2013 was
approximately 99%.
This is IMS Health’s moat. It is the one thing about the company you want never to change if
you’re going to hold the stock for the long-term.
The new owners churned through the workforce astoundingly fast:

Since the Merger…we added approximately 7,600 employees…and oversaw the departure of
approximately 5,200 employees…We estimate that about 60% of our approximately 9,500
employees have joined us since the Merger…

So, IMS Health – a 60-year old company with an average customer relationship of 25 years – is
now mostly made up of employees who have been with the company for less than 3 years.
I can’t recommend looking at IMS Health as a possible investment. However, I do recommend

reading the S-1. It offers some insight into both a company with a competitive position I really
like and what a private equity owner does to a once and future public company.
 URL: https://focusedcompounding.com/ims-health-ims-4-years-later/
 Time: 2014
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Geoff’s Avid Hog Watchlist: Catering International & Services (CTRG:FP)
Catering International & Services trades in Paris under the ticker “CTRG”. The company was
founded in Marseilles, France in 1992. Two families control 71% of the shares. The founder,
Regis Arnoux, controls the majority of the company’s shares. He still runs the company.
Catering International provides remote site services (mainly catering) in extreme conditions.
Revenue is about evenly divided between serving mining customers (51%) and oil & gas
customers (47%). Operating profit – but not revenue (more on that later) – is about evenly
divided between Asia/Pacific (54%) and Africa (46%). So, we’re basically talking about a
company that caters for mines and oil fields in Asia and Africa.
Let’s start with how I found the company.
I ran a screen at Stockopedia looking for E.U. stocks sorted by their gross profits relative to net
tangible assets. I then eliminated companies that either had lost money in one of the last few
years or that now traded above 8 times EBITDA. I also eliminated companies where the business
description suggested they were far from all 3 rings of my circle of competence: 1) consumer
habits, 2) business support services, and 3) industry standards. This left a little over 40 stocks. I
then looked for English language information on all 40 stocks. About 14 of these stocks had
multiple annual reports in English. Catering International was one of them.
A few things appealed to me immediately about Catering International. The business sounded
both mundane (catering) and niche (extreme conditions). It’s a business support services
provider. Gross profitability was adequate.
A few things also concerned me right away. Catering International serves mining and oil & gas
customers. That means the commodities these companies are extracting – their reasons for being
at these sites – are at bubble levels. I’m not saying they are in a bubble. The supply of oil and gas
is finite. So you can argue that bubble prices relative to the past could be justified throughout the
future. But there is no long-term history of prices being this high. Therefore, we don’t have a
relevant record of consumer or producer behavior to go on. We don’t know how marginal – high
cost and high risk – some of these sites are. Catering International has been a very fast growing
company. Some of that growth was driven by customer interest in more extreme conditions
which high prices for commodities like oil and gold have to encourage.
The good news is that you don’t have to expect a lot of future growth to invest in Catering
International. Using the most aggressive estimates of EBIT and enterprise value you get a price
of 6.5 times EBIT for the company. Using the most conservative estimates of EV and EBIT you
get a ratio of 8.2 times. Any price less than 10 times EBIT seems quite fair for a company like
this – even without a lot of growth.
I need to explain the “estimates” issue for both EV and EBIT. The company has two noteworthy
items. First, it has money losing operations in South America. Today, that is Peru and Brazil.
South America contributes 18% of the company’s revenue. However, those operations actually
cost the company 3 million Euros in losses. We need to consider those losses in our analysis.
But, we certainly should not capitalize them. For example, if we assume Catering International is
worth 10 times pre-tax profit – we should not lop 30 million Euros off our valuation for contracts
the company can simply stop bidding for in the future. So, this raises the question of whether
EBIT is 21 million Euros (companywide) or 24 million Euro (profitable segments only).
And now the cash question. Catering International has 16 million Euros of cash in Algeria. The
Algerian government does not want Catering International to transfer that money to a subsidiary
that would allow us to consider it net cash at the corporate level. If you count all Catering
International’s cash around the world – it comes to 38 million Euros of net cash. If you count all
the cash except what’s in Algeria – it comes to 22 million Euros.
So, if you value the company at 10 times pre-tax profit, your decisions on how to treat South
American operating losses and the Algerian cash could change your valuation of the company by
46 million Euros. Catering International’s market cap is 192 million Euros. So, the questions are
significant. But, an analysis for The Avid Hog, could simply present the best and worst cases. It
would almost certainly write-off the Algerian cash entirely because we have no ability to predict
court cases in Algeria.
All this talk of Algeria – which is Catering International’s largest market at 22% of revenue – is
a good place to tangent toward the special headline risks present in owning Catering
International. These risk (mostly) don’t concern me. However, they greatly increase the risk of
negative publicity for the company. And some of the potential headlines could make investors –
especially investors far from both France and the sites where the company operates – quite
uncomfortable.
First, there is the special risk that Catering International’s employees could be violently killed.
The company’s largest single subsidiary is Cieptal in Algeria. Over 130 local workers – and one
French citizen – of this subsidiary were among the 800 hostages taken at the In Amenas gas
facility when it was attacked in January. None of Cieptal’s employees were executed. However,
the French employee was hidden and presumably would have been killed if found. About 39
foreigners were killed. They worked for or with Cieptal’s customers at the site: Sonatrach
(Algeria’s oil company), Statoil, and BP.
This brings up another risk. Catering International works with companies like Sonatrach that are
controlled by governments like Algeria. In fact, local investors have minority stakes in some of
Catering International’s subsidiaries. The countries Catering International operates in are often
corrupt. Catering International is run from France by French citizens who – in very small
numbers – rotate through these countries for short periods of time. So there is a risk Catering
International’s French employees will bribe people in these countries. When you consider that
Catering International bids for contracts and that they have a stated goal of 500 million Euros in
revenue by 2015 (up from 316 million Euros in 2012) the incentive to bribe is high. Furthermore,
these are French – not local – employees dealing with local (not French) decision makers in a
country where bribery is more common than in France and where the French employee will not
be living permanently. This is a good recipe for justifying your own bad behavior.
Of course, as I’ll explain in a moment, many of Catering International’s direct customers are
multinational oil and mining companies. But in all cases, Catering International has to set up
local subsidiaries in these countries. They may sometimes have to take on local investors in these
subsidiaries. And there will always be issues like whether they can access their Algerian cash. So
there will be constant temptations to bribe.
Finally, there is simply the public relations problem of a French company doing business in very
different parts of the world from where it is headquartered. About 9 out of 10 Catering
International employees are local men. In France, the company employees equal numbers of men
and women. In the rest of the world, it’s about 9 to 1 men versus women. French employees are
paid anywhere from about 4 to 11 times more than local employees. They receive plenty of
benefits. They work less. And their employment is more secure. Local employees have a very
different situation. To a large extent, this just reflects the relative power position of workers in
each country. Workers in France have a lot of power. Workers in the countries where Catering
International does its catering have very little power. And women are excluded from much of
public life.
On an annual – which is not how local workers are employed – basis, wages are about 3,816
Euros a year in Africa, 5,256 Euros a year in Asia/Pacific, and about 10,284 Euros a year in
South America. Catering International makes all its profit in Africa and Asia/Pacific. These are
places where employees make less than 6,000 Euros a year.
So, you have the special headline risks of terrorism, bribery, and exploitation. Any coverage of
these – or any topic about Catering International – are as likely to have a political angle as a
financial angle. So, the experience of holding Catering International may feel a little different
than other stocks you own.
With that out of the way, let’s get some basic information about the company. They have 11,600
employees (of which about 88% are local, low-paid men). The company operates at 170 sites in
41 countries. They serve about 120,200 meals a day. Their biggest single market (22% of sales)
is Algeria. The subsidiary that now handles all Algerian operations is called Cieptal. It has a
website (in French) that you can see here.
Catering International was founded in 1992. It went public in 1998. It has compounded revenue
at 40% a year since its founding. Growth in recent years has continued in sales. However, the
operating profit picture is fairly mixed (losses in South America have widened). In the latest
annual report, the company mentions a sales target of 500 million Euros in 2015. With sales of
316 million in 2012, that would require sales growth of more than 15% a year. If profit growth
was anything like that, you’d obviously be paying a very low multiple of 2015 EBIT. Enterprise
value – excluding the Algerian cash – is 172 million. EBIT – including losses in South America
– is about 21 million Euros. If operating profit grew 15% a year, you’d be paying 5.4 times 2015
EBIT. That’s a very good deal. The reality – because of the South American losses and Algerian
cash – might be even better than that. Of course, we don’t know that operating profit will track
sales or that sales will grow as expected. However, you can see that by any growth at a
reasonable price measure – this is a very, very cheap stock.
Business is conducted in the local currency. Most customers are excellent credits. In fact, legal
risk (like the Algerian cash) are probably as meaningful as the risk that a customer would fail to
pay due to insolvency. Catering International paid 1.4 million Euros to settle a customer’s claim
last year. I imagine this is a company where you will be seeing a lot of items like that from time
to time. Last I checked, the company’s Algerian subsidiary was still being prevented from
transferring a dividend (of 16 million Euros) out of the country. They filed a claim with the
Algerian Supreme Court.
Catering International has a huge list of its subsidiaries. Many are inactive. In the annual report,
there is a couple sentence business commentary for many of the active ones. If you’re interested
in the company, you should read this list of subsidiaries in the annual report. It’s the highlight of
that document.
Instead of reproducing it here, I’ll just focus on a few examples where we know both the name of
a Catering International customer and the country where they serve that customer. For a full list
of customers, see the back of the 2012 annual report. Almost all are multinational companies
active in mining or oil & gas. There are a few exceptions (Nestle is on the list). The exceptions
aren’t meaningful contributors to sales.
Examples of customers and countries where Catering International operates are Bechtel in
Guinea Conakry, Kinross Gold in Mauritania, Total in Yemen, and Avocet Mining in Burkina
Faso.
I think the Yemen business is small. It sounds like they just want to work with Total and show
off what they can do outside of catering. Catering International has almost no business in the
Middle East. Although they hope to one day do meaningful business in Iraq. Like I said, all
profit really comes from mining and oil and gas sites in Asia/Pacific and Africa. None of the
other stuff is meaningful.
The company has money losing businesses in both South America (meaningful at 3.8 million
Euros in operating losses) and the former Soviet Union (not meaningful). South American
operations seem to be ongoing in Brazil and Peru and pretty much just inactive subsidiaries
elsewhere. The former Soviet Union includes subsidiaries in Kazakhstan, Turkmenistan, and
Russia (the arctic).
The company refers to its employees in New Caledonia (part of France near Australia) in a way
that makes it sound like they may be organized. It’s unclear to me whether this “dialogue” has to
do with New Caledonia’s special status (and Catering International being a French company) or
some past problem with these employees. Generally, my impression of the worldwide workforce
is that they are local, low paid men who are not unionized.
So what’s the verdict?
It’s unlikely Catering International will make it into The Avid Hog. The stock is statistically
attractive in both a “magic formula” and “growth at a reasonable price” way. It will probably
perform well. And it would make an excellent addition to a diversified value portfolio.
However, there is not enough information on how a customer decides to go with Catering
International. The company’s customers are very large multinationals who do not provide details
on such information in their own reports. The business is far from the consumer. And I do not
know a lot of people in this industry or these countries.
This is a research problem. I don’t have – and am unlikely to get – enough info about the actual
purchase decision. I don’t see a way to gain enough confidence in the future behavior of
customers when it comes to their catering needs. And I know nothing about Catering
International’s competitors.
Basically, the annual report wasn’t informative enough about what I most need to know. So,
unless someone emails me after reading this to tell me they know a lot about Catering
International specifically or catering at these sites generally – I just don’t see a path forward for
this company.
So, I’m suggesting Catering International as a stock blog readers should be interested in. But I’m
also passing on it for The Avid Hog. This one is a “no”.
 URL: https://focusedcompounding.com/geoffs-avid-hog-watchlist-catering-international-
services-ctrgfp/
 Time: 2013
-----------------------------------------------------
Armanino Foods of Distinction (AMNF)
A few people have emailed me asking for my thoughts about Armanino Foods of

Distinction (AMNF). I don’t have any right now. But Whopper Investments does:
I think Armanino is undervalued at today’s prices. It’s growing pretty fast and creating tons of
value from that growth, so that value gap should (hopefully) grow over time. And, as an added
kicker, there’s the potential for a merger at a huge premium, which would be easily supported by
the synergy potential, and/or a big special dividend to lever the company up.
I lied. I do have one thought. At one point, Whopper says:
I tend to think that their frozen products fall more into the “commodity” segment than the
“branded” segment, but their returns on capital actually suggest other wise. Pre-tax returns on
capital are well over 50% and gross margins are in the 35% range. Those tend returns tend to
indicate some form of brand strength or competitive advantage.

That’s true. However, it is imperative that when you find empirical evidence of a competitive
advantage you back it up with a rational explanation for that competitive advantage.
You always want to combine abstract reason with concrete evidence to prove something’s
practical existence.
If you fail to do this, you will end up taking the magic formula approach. Many companies earn
excess returns. Some have durable moats. Others do not. It may work out on average to
simply assume moats based on high returns on capital. In fact, the historical data Greenblatt used
says that the approach did work in the past.
But you must never beg the question. You must never argue that this company has a moat
because only a company with a moat could earn the returns this company is now earning.
Instead we must look for both a rational theory and empirical data that are reasonable when
considered separately and agree when put together.
 URL: https://focusedcompounding.com/armanino-foods-of-distinction-amnf/
 Time: 2013
-----------------------------------------------------
Blind Stock Valuation #3 – Corticeira Amorim
About a week ago I posted a blind stock valuation. That’s where I give you some financial data
from a public company without revealing the company’s name. Then you try to value it.
Here are the numbers I provided:
The company is Corticeira Amorim. It’s a public company. It trades in Portugal.
Nate Tobik of Oddball Stocks did a great 2 part series about Corticeira Amorim.
Corticeira Amorim
It’s a cork company. Amorim is the name of the family that runs the company. Corticeira is
Portuguese for cork. Corticeira Amorim was briefly mentioned in my favorite business
book: Hidden Champions of the 21st Century.
Amorim has 25% of the worldwide cork stopper market. Cork stoppers are used to bottle wine.
Amorim’s share of other cork products is even bigger. It has 55% of the composite cork market,
65% of the cork floor market, and 80% of the cork insulation business.
As I mentioned when I posted this blind stock valuation – the company uses debt. It has bank
debt and commercial paper.
Your Thoughts
I got a lot of emails from readers giving their intrinsic value estimates for the company based
solely on the financial data.
Here are my 3 favorite responses.
Response #1: Low Quality Business – Probably Using 1 to 1 Leverage
(Estimated Market Cap: 163 million Euros; Enterprise Value: 327 million Euros)
This is a low quality business: assume a 30% tax rate and it is earning an average of just 5.4%
on its operating capital.
Its only strengths, such as they are, seem to be an (i) an ability to avoid significant gross profit
erosion in the 2007-2009 cycle; and (ii) either a reluctance, or an inability, to grow.
I suspect it is the latter, because the very large swings in EBIT/GP ratio for an otherwise stable
business indicates managers with very little discipline. And undisciplined managers generally
want to grow, if they can.
(I assume that these swings are either related to marketing and/or SGA bloat in good times, and
retrenchment in bad times; foresighted, intelligent managers generally do it the other way
around).
So why can’t it grow? Niche market played out? Local market saturated? Or it’s a supplier to
one or two big clients who have these problems?
In any case, the managers of this business will want to take on significant debt to (a) make its
ROE look better and (b) to reduce its cost of capital. How much debt? Probably 1:1 with equity
– in order to get the ROE above 10%.
So, estimating the EV and market cap should be logical and straightforward:
ROC = 5.4%,
 average operating capital = $429m

 cost of capital (assuming half the capital is debt) = 7%
And, following from that, market cap = ½ x 327 = $163

Or, put another way: $163m in debt will generate $5m in after-tax interest expense which
implies equity earnings of approx $20m which, in turn, implies a yield of 20/163 = 12.25% on
normal earnings, which sounds appropriate…

Response #2: Unimpressive Returns – But Impressive Resilience
(Estimated Market Cap: 250 million to 350 million Euros; Enterprise Value: 300 million to 500
million Euros)
Sales are growing at 2-3% annually, corresponding to normal GDP growth of developed
countries. By this measure, the company looks like a mature business. It is somewhat
disconcerting that receivables have risen at a faster pace than sales. This requires further
study.
The 50% gross margin suggests that the company probably has some sort of competitive
advantage – being able to sell its product at a relatively high price or obtain resources at a
relatively low cost. It has also managed to grow income from operations at a faster rate than
sales.
Nevertheless, the operating margin is average at best. A large part of the 50 cents gross gets
used up in operations. Five cents goes for maintenance capex as the depreciation rate and
PP&E are pretty constant through the years. Where does the rest go?
You mentioned the company uses debt. This means, after interest charges and taxes, the
company will net 5-6 cents on a dollar of sales, maybe less. At this rate, I would value the
equity at 250,000-350,000, considering the company’s exceptional resilience in the difficult
conditions of the past 3-4 years, the steady growth in operating income and EBITDA, and the
low capital intensity.

Return on invested capital has averaged 13% and has reached record (for the time frame) levels
in the last 2 years. Again, I find the persistent results and the swift recovery after 2009 more
impressive than the level of the returns. Thus, I’d say the total company is worth 300,000-
500,000.
Response #3: Attractiveness of the Stock Depends on the Company’s Use of Debt
(Would buy at Market Cap of 160 million Euros; Enterprise Value of 400 million Euros).
Invested capital has been approximately 400M over the 7 year history. Sales have roughly
tracked inflation, I would assume the company is paying out the majority of its profits in
dividends/share buybacks. Since it’s still grown from 25 to 51 M in profit without any real
increase in invested capital, it probably has something of a “See’s Candy” type business model,
where prices are raised annually, but the company doesn’t have any real good reinvestment
outlets. It is economically sensitive though, which means I would give it a lower multiple than
See’s, especially due to the fact that they have less opportunity to invest as much capital when
there are large downturns. Since it’s more of a mediocre predictable business I would expect to
pay approximately (51 pretax * 8) or about 408 M for a boring predictable business that pays
out its earnings.
Let’s talk about leverage though, since it’s a relatively boring predictable company, I would
expect you could lever it up to 3x 2009 depressed after tax operating profit plus current
liabilities minus payables and accrued expenses. You could sell the bonds for 7 or 8%. That’s an
after-tax cost of ~ 5%. You could even do it by doing sale leasebacks on the PP&E. Since you
are earning ~ 9-12% after-tax on invested capital and since you can expect your average
shareholder to earn 7-12% over the long run it makes sense to lever up to somewhere in that
ballpark. So let’s say you have 120M of debt financing those assets at 5% after tax. That’s 6M of
after-tax interest bringing the 51 M of pretax operating profit down to ~43 M of operating profit.
I find it interesting now that I think about it. Even though the company becomes more risky with
more debt, I would hold less of it in my portfolio, but up to a certain point I would give
management kudos for using it appropriately which would reflect in my valuation. In fact if it
wasn’t prudent I would probably throw this company out. If it was levered appropriately as
above, I would probably be expecting a reasonable market valuation to be 9 or 10 x (pretax
operating profit minus interest) minus the amount of debt.
Right now the average company in my portfolio has a simple-boring-statistically expected return
of about 18%. In order to get added to my portfolio it would have to in that ballpark. We’ll give
management and the industry the benefit of the doubt because I’m not privy to that information
for this stock pick, and I’d say that the price I would pay to earn approximately the same rate of
return would be:
if the company used no leverage, approximately 300 M
if the company used 120 M of leverage, approximately 220 M (market cap..) (EV defined as
mcap + debt/nonoperatingspecific liabilities minus non-necessary cash of ~ 340 M)
if the company used 240 M of leverage, which they probably could get away with due to their
high inventory/receivables/pp&e to current liabilities and if they had consistent highly
predictable enough earning power to keep interest rates near above,
I’d buy it at 160 M market cap (EV 400 M)

Actual Market Value of Corticeira Amorim
Corticeira Amorim’s actual market cap is 185 million Euros. The actual enterprise value is 312
million Euros.
The stock is up about 50% over the last year. The market cap has ranged from about 120 million
Euros at the low to 185 million Euros at the high. So, the company’s enterprise value hasn’t been
consistently below 250 million Euros at any point.
 URL: https://focusedcompounding.com/blind-stock-valuation-3-corticeira-amorim/
 Time: 2012
-----------------------------------------------------
Carnival (CCL): No Pricing Power – But Plenty of Value Created Over Time
Geoff here.
Since Quan started writing about Carnival (CCL) here on the blog, we’ve gotten a lot of emails
from people saying the cruise business is a bad business – even for the leader – and that these
companies only destroy value.
It’s perfectly valid for people to have a different view of the future than Quan and I do. But when
it comes to the past – it’s really not possible to argue Carnival has destroyed value.
This may sound obvious to some. But I’m going to take a moment to explain it – because it’s a
really important concept.
Carnival Has Zero Pricing Power
Carnival has no pricing power. The product economics of the business are not good. They can’t
raise prices relative to competitors and still fill their ships. This is not Wrigley. This is not Coca-
Cola (KO). This is not See’s.
But Wal-Mart (WMT) never had a dime of pricing power. Neither did Southwest (LUV). I

don’t care if my PC has Intel inside or AMD inside. If Intel doesn’t maintain an advantage in
terms of cost, performance or both – which requires constant improvement – it also has zero
pricing power.
Return on Capital is Driven by Both Product Economics and Competitive Position
Most companies that earn economic profits do not earn them because they are in an inherently
better business. Chris Zook’s series – he works for Bain consulting – estimated that two-thirds of
economic profits are due to a superior competitive position. Only one-third is due to superior
product economics.
I love superior product economics where I can find them. It is better to sell candy than cruises.
But even in candy – it is better to be See’s than Russell Stover.
Most companies earn economic profits because they are – at the moment – in a better
competitive position. Unfortunately, it is difficult to know whether the competitive position of
most companies will get better, worse, or stay the same over the next 5 years, 10 years, 20 years,
etc.
But some corporate records – and family fortunes – are built on maintaining a constant
competitive lead in an otherwise unimpressive industry.
In no sense can it be said that Wal-Mart, Southwest, or Intel were ever in an industry with good
product economics. But in those periods where they earned good returns on capital – they had a
competitive lead on the completion.
If You Built a Fortune – You Created Value
This is kind of obvious. But it’s worth mentioning. Anyone you see on a list of billionaires either
created or inherited a fortune. You can always trace those kinds of fortunes back to some sort of
shareholder value creation. No one earns a billion dollars in wages. They earn it from owning
something and having that something increase in value.
That obviously doesn’t mean Rupert Murdoch – simply because he’s a billionaire – necessarily
created value in the last 10 or 15 years. It doesn’t mean his unleveraged returns were terrific.
You’ll have to look into the past of News Corp (NWSA) to figure that out.
But it does mean he created shareholder value at some point.
Micky Arison, Carnival’s Chairman and CEO, is ranked #75 on Forbes list of American
billionaires. He has a net worth over $4 billion. That comes from owning Carnival stock.
Slow and Steady Value Creation – With the Use of Debt
Carnival’s stock price has compounded at a rate of 9% a year over the last 25 years. They’ve also
paid dividends in every year throughout that period except for when the dividend was suspended
during the financial crisis.
For example, since 1991, Carnival has returned $8.7 billion through cash dividends and share
repurchases – netted against share issuance. Today, the company has about $9.3 billion in debt.
Some people have emailed me and Quan about the fact that Carnival borrows money to build
new ships that have a poor return on capital.
This is a legitimate concern. But it’s not supported by the past record. The issue of Carnival’s
returns on incremental investment are complicated by a tripling of oil prices over the last decade
or so.
If you look at returns separate from fuel costs, there has been no deterioration in Carnival’s
return on investment. It has actually risen a small amount over the last decade.
If you look at Carnival’s returns on capital after fuel costs – which is obviously what the
company reports – returns have been more than cut in half.
Which is the right way to look at the company’s returns?
Let me put it this way. If I’m analyzing an oil company, I do not assume that today’s oil prices
should be the basis of long-term investment decisions. Likewise, I hope that Carnival decides
whether or not to contract for new ships with more in mind than what oil prices have been in the
last few years.
It’s worth mentioning that the period where there was deterioration in Carnival’s ROI was just in
the last 5 years. During this time, real oil prices were as high as they have ever been.
Nonetheless, Carnival’s return on net tangible assets – basically the company’s unleveraged
return on equity – has not been below 8%. What worries people – and justifiably so – is that this
8% number is the present number.
Before 2002, Carnival almost never earned less than 15% on its net tangible assets. From 2002
through 2007, Carnival earned about 13%. It is the returns from 2008 through today that concern
people. They now average about 8%.
Carnival’s Capital Costs in Perspective
Carnival aims to have a credit rating of Baa or higher. Moody’s recently rated them higher than
that. Today, the long-term Baa yield is about 5%. Again, I’d estimate Carnival’s return on net
tangible assets has been about 8% since the crisis. And much, much higher in the past. I’d also
estimate that excluding fuel costs – Carnival’s return on capital today would be very similar to
what it had been in the past. This is not to say fuel costs aren’t real. They are totally real –
Carnival does not hedge in any way. It’s only to say that the decline in Carnival’s return on
capital is due to rising fuel costs rather than deteriorating competitiveness.
Carnival’s two big competitors – Royal Caribbean (RCL) and Norwegian – use a lot more debt
relative to their size than Carnival does. In fact, Carnival and RCL have very similar amounts of
debt in total dollars. Yet, Carnival has twice the market share of RCL. And every point of market
share at Carnival tends to convert into more EBITDA than over at RCL.
Carnival is not an especially reckless borrower by general standards. And they are actually a
conservative borrower by cruise industry standards.
Carnival’s Return on Net Tangible Assets Are Good Relative to Other Asset Heavy
Businesses
I like an asset light business as much as the next guy. Probably more. At the same price-to-
normal earnings I am much more excited by an advertising agency than a cruise line, railroad,
etc.
But let’s be honest here. There is a reason Carnival borrows. They borrow to contract for new
ships.
So, let’s compare Carnival’s return on capital to the returns on capital of other well-known asset
heavy businesses.
200 200 200 200 200 200 200 200 201 201
2 3 4 5 6 7 8 9 0 1
Southw 4% 7% 4% 7% 6% 8% 2% 1% 5% 2%
est
(LUV)
Norfol 3% 4% 6% 8% 9% 9% 11 6% 9% 11
k % %
Southe
rn
(NSC)
Exelon 7% 4% 9% 4% 7% 12 12 11 10 9%
(EXC) % % % %
Aqua 7% 6% 6% 6% 5% 5% 4% 4% 5% 5%
Americ
a
(WTR)
Carniv 10 8% 8% 9% 9% 9% 8% 6% 6% 6%
al %
(CCL)
Those numbers include intangibles. As I mentioned before, Carnival’s return on net tangible
assets are higher. They have intangibles on the balance sheet. For example, they overpaid for
Princess.
Since Carnival’s numbers are so comparable to the other four companies there – the question is:
If Carnival has destroyed value over the last 10 years and you expect them to destroy value over
the next 10 years, do you think the same about:
 Southwest
 Norfolk Southern
 Exelon
 Aqua America
I don’t. And I don’t see how Carnival’s future is obviously much worse than those companies in
terms of future returns on capital. I just think that we have seen a trend in the last half of the last
decade – high oil prices, bad economy – that if extrapolated into the distant future makes
Carnival look terrible.
But I’m not sure why any macroeconomic trend of the recent past should continue in the future.
And I don’t see any evidence of a competitive trend in the data.
Carnival’s Return on Capital Has Never Been Great – It’s Always Been Adequate
I’ve said before that Warren Buffett talks about return on capital of Berkshire subsidiaries using
something similar to Joel Greenblatt’s ROC calculation.
Basically, Buffett uses a return on unleveraged net tangible assets.

Carnival has intangible assets. They’ve bought cruise lines in the past. And, yes, they overpaid
for Princess.
How has Carnival’s return on net tangible assets looked in the past?
The worst year was 8%. The best year was 20%. Carnival’s return on net tangible assets has
generally been very steady. In fact, by any statistical measure of variation you throw at it
Carnival’s ROI generally will rank among the least variable of any publicly traded company
outside of regulated monopolies.
Carnival Has No Pricing Power – But It Holds Real Costs Down
I think the best explanation of how Carnival tries to create value over time – despite having zero
pricing power – comes from something Micky Arison said in a 2008 earnings call:
We were able to offset inflation during the year through economies of scale and increased
efficiencies; however, as I’ve indicated on previous calls, our long-term track record of flat
cruise costs per available berth day dating back to 1990 is getting harder to maintain in the face
of moderate capacity growth. As a result, our goal for future cruise costs per available lower
berth day is in the range of flat to one-half the rate of inflation.

It’s important to understand that Carnival has been pushing down real costs per person per night.
That is their strategy.
How do they do this?
What Do I Mean When I Say Carnival Has Economies of Scale?
Carnival now serves about 9.6 million passengers a year. Carnival has some premium lines
where passengers stay for over a week. So, on average, those 9.6 million passengers are each
spending 7 to 8 nights with Carnival.
I understand why many people think things like food costs are something Carnival can’t control
– but that’s not true. Carnival can control food costs. That’s actually one of the key parts of their
business. If you are serving hundreds of millions of meals a year, who knows how many drinks,
etc. there are economies of scale when you are purchasing and providing that much food, drink,
live entertainment, etc.
If there were no economies of scale – we’d see real costs rising. After all, the stuff Carnival is
purchasing – food, drinks, etc. – is not getting cheaper on retail shelves. It’s getting more
expensive in nominal terms. In most industries, that’s exactly what happens. But even now,
Carnival still tries to target cost growth per passenger below the rate of inflation.
This is what I’m talking about when I say “economies of scale”. I actually don’t mean combining
corporate offices. In fact, Carnival does not move their subsidiaries’ main offices to their
corporate HQ. Analysts always ask that question. And Carnival’s management always says that’s
a bad way to save on costs because it disrupts that line too much. They’d rather try to save
money on the actual cost of each voyage.
So, as silly as it sounds – when I say Carnival aims for economies of scale – I really do mean
they aim to buy incredible quantities of shrimp for less than you ever could, put on live shows
for less than others could stage them, buy lots of booze at rock bottom prices, get the best deals
to drive volume without driving up travel agent commissions and transportation costs to the ship,
etc.
This is very boring stuff, but this is the profit pool for cruise lines. This is where you make your
money.
Why Carnival is a Company That Interests Me
Why I’m interested in Carnival can be stated simply in terms of 4 long-term qualities:
 Long history of adequate (8% to 20%) return on net tangible assets

 Strong competitive position
 Favorable long-term prospects (low competitive risks, tech risks, etc.)
 Management focused on the key metrics – costs – that drive economic profits in the
industry
Why Now is a Time When Carnival Interests Me
For me, these 4 qualities make Carnival an interesting company. What makes now an interesting
time to look at Carnival?
Looking at the last half decade or so:
 Returns – excluding fuel costs – have not deteriorated

 Fuel costs are as high in real terms as they’ve ever been
 Interest rates are as low as they’ve ever been
 The macro economy is as poor as it’s ever been
 Cruise industry capacity growth is as low as it’s ever been
To put capacity growth in perspective, over the last 20 years Carnival has tended to grow
capacity in the high single digits. Right now, they are expecting capacity growth to be a little less
than 3%.
This obviously hurts their efforts to reduce per passenger costs. But it helps their expected future
returns on capital. The slower supply increases in relation to demand, the more likely it is that
future ROI will be greater than today’s ROI.
Is Now Normal?
And yet, Carnival trades at a completely normal P/E of 16. To me, it seems much more likely
than not that Carnival’s current earnings understate Carnival’s normal earning power. And that
the stock could rise quite a bit over the next – say – 5 years without any multiple expansion. This
is simply because a lot of things can cause today’s earnings to rise:
 Tomorrow’s fuel costs being lower than today’s

 New borrowing being done at lower interest rates than old borrowings
 Supply and demand being more favorable in the future than today
So raher than seeing Carnival’s next 10 years as an inevitable continuation of the last 10 years, I
think the future is most likely to be brighter than the last few years. That’s because the last few
years featured so many macro headwinds that will eventually even out over time.
 URL: https://focusedcompounding.com/carnival-ccl-no-pricing-power-but-plenty-of-
value-created-over-time/
 Time: 2012
-----------------------------------------------------
Western Digital (WDC): Ben Graham Bargain Or Mispriced Bet?

Someone who reads my articles sent me this
geoff@gurufocus.com:
Geoff,
…I want to ask your opinion about Western Digital (WDC). WDC is a computer hard drive
maker, essentially in a commodity business in an industry which in time has exhibited bad
competition and irrational price behavior. Nevertheless, the company has maintained
reasonable profitability and ROE over the last 10 years. It's now traded around 30. After
adjusting for net cash of close to 10-15 dollars, you are paying 15 - 20 dollars for a business
that I think have earnings power of at least 3 dollars in a normal year, with a range of 1 - 6
dollars, give or take. That seems cheap. With the flooding in Thailand, WDC was briefly trading
lower around 25. That seemed extremely cheap since no one really expected the damage to last
more than a few quarters. Some might say the cash of $3.5 billion is already spoken for with the
pending purchase of Hitachi’s hard drive business, and as is normally the case, WDC is likely to
have overpaid. But we could account for that in 2 ways, either reduce the cash value from $15 to
$10, or not account for the cash, but instead give WDC more earning power due to that
purchase and the resulting reduced industry competition, say $4 to $5.
Their largest competitor, Seagate Technology (STX), is also purchasing another industry

competitor. After the completion of these deals, WDC and STX will be largely what's left and
enjoy much better pricing power. In any case, I thought WDC was very cheap at 25, and still do
around 30.
Apparently the market thinks otherwise. Perhaps they think the PC market is going to the dead
and WDC/STX will soon follow the way of Research in Motion (RIMM). That might be.
Anything could happen in the investment world, but the odds of that outcome are low, in my
opinion. I feel the market is mispricing the risk/reward in this case, especially when it was
trading at 25. I'm wondering if you have any opinion here and care to share.
Regards,
Chaoran
(I should note – so far – Chaoran has been proven right. WDC now trades at $39. Today’s price
is about 30% higher than where WDC traded when that email was written.)
I can't disagree with your take on Western Digital. But I'm not the best person to ask about this
kind of stock. Other people have mentioned it before. It's obvious why value investors would be
attracted to it.
But as you can probably guess from somebody who includes operating margin variation
coefficients in his net-net newsletter, I focus a lot on predictability. The business Western Digital
is in is a business I would normally not buy into unless it traded for around net cash. Margins
have been extremely variable.
Also, if you look at 10-year average operating margins you'd have operating margins which after
taxes would lead to earnings of about $2.27 a share on the current sales level. This is lower than
your estimate of a $3 a share earning power. Now, I have no confidence in taking 10-year
operating margins, multiplying them by 0.65 (1 minus the 35% corporate tax rate), and then
applying that net margin estimate to current sales. I have no reason to believe that is a remotely
good gauge of earnings power. But, like I said, it comes in below $2.50 a share.
The other issue here is the way Western Digital is not insanely cheap on either an asset value
measure or an earning power measure. What it seems to be is insanely cheap when you combine
the two. In other words, a measure like EV/EBITDA makes it look very, very attractive. And
that's fine. Because as a recent study shows yet again - EV/EBITDA is a very good value
indicator. One of the best.
Anyway, I have two concerns:
1) How important is surplus cash to the company's cheapness – is the earning power to
stock price (not EV) cheap enough?
2) When you apply long-term averages in terms of margins to today's sales and long-term
average return on invested tangible assets to today's book value is the company still very
cheap?
The picture is mixed here.
Western Digital’s upside on a price-to-sales basis is not that high. Maybe 50%. In other words,
you could expect maybe a 50% increase in the stock price to get it to an appropriate price-to-
sales ratio. Book value is more complicated. Past returns on equity suggest a very high price-to-
book ratio would be appropriate. I like to only consider what the right price-to-book ratio would
be if the company were unleveraged. In that case, you'd still expect a price close to 2 times book
value would be appropriate for a company with Western Digital’s kind of past returns.
I’m getting this from a return on assets range of about 7% to 25% over the last 10 years. Western
Digital’s 10-year average ROA has been about 15%. So, even without the use of leverage –
Western Digital’s return on equity suggest it could be worth two times book value.
So on a historical basis, it's cheap. But what if the company's history tells us nothing here? After
all, when we buy a stock – we’re buying future earnings. Not past earnings.
We need to check and see if Western Digital is cheap on generic price ratios. In other words, it
should be cheap relative to sales, tangible book value, net current assets, etc. for an average
company – not just the above average company it was in the past.
On a stock price – not enterprise value – basis Western Digital isn't cheap enough to be a
screaming buy. If we consider enterprise value, it's a different story.
And so that's what it comes down to for me. While the stock price may be reasonable even
without any cash – it’s not insanely cheap by any means. So this only really qualifies as a
bargain investment when we factor in the cash.
This raises the issue of the company's size. This is a big stock. The market cap is around $9
billion. I'm going to let you in on a little secret. In a back test of net-nets – which WDC isn’t, but
bear with me – I found that one of the best (if not the very best) method of ordering net-nets to
know which would perform best and which would perform worst was simply to take the amount
of insider ownership and divide it by the amount of institutional ownership.
The worst decile of net-nets in terms of insider vs. institutional ownership underperformed the
best decile by – I’m not making this up – about 30% a year. The highest insider to institutional
ownership decile returned 40% a year. The lowest returned 10%. Randomly chosen net-nets
returned around 21% over the same time period. In other words, you can shave 10% a year off a
net-net portfolio's returns just by picking those net-nets with the very highest institutional
ownership relative to insider ownership.
This is important because of the kind of net-nets Graham bought. As Walter Schloss said later –
many of the companies Ben Graham bought in the 1940s were family controlled companies.
There was no way to take them over. This is one of the reasons people neglected these stocks
even when they got super cheap. No one expected them to liquidate. Or to be bought out. They
were assumed to be stuck in place because of family ownership.
Now there's no rule that says a family owned net-net is better than a professionally managed net-
net. But it's interesting to consider the problem surplus cash presents. Families are likely to hoard
cash. They tend not to blow cash. At least not families that control net-nets. If they were risk
takers, they wouldn't have current assets greater than total liabilities.
We see this at a company like Imation (IMN). I picked Imation for the Ben Graham Net-Net
Newsletter. That was earlier in the year. And I have to admit one factor I did not pay enough
attention to was management. I didn't think enough about how likely they were to spend cash on
acquiring other companies. I didn't consider whether they'd try to preserve the size of the
company as best they could.
I've gone on too long about this. It's just something to keep in mind. I do worry about stocks with
lots of cash that are really, really big stocks. I worry they are more likely to do something
proactive and unintelligent with their money. If you're buying a pure earnings power bargain
where – absent the cash – you are very confident in the long-term earning power of the business
to more than justify your purchase price, this isn't a big deal.
With Western Digital it is a big deal.
According to Western Digital's 14A officers and directors of the company own just 1.2% of the
company's shares.
That's not the kind of insider ownership I like to see. Now, that doesn't mean Western Digital
won't do good things with its cash. And obviously there's a lot of room for error here. You are
buying at an EV/EBIT (based on the past) that means WDC can do worse in the future than it did
in the past – some cash can get blown on stupid things – and you can still have an investment
that works out okay or even better than okay.
You mention the market mispricing the risk/reward. That's very possible. For me, that's only part
of the question. As you know, I look for comfort. How comfortable am I owning this stock?
There are some stocks where I think the market made odds are wrong but I'm unlikely to buy,
because I'm not comfortable. Western Digital might be one of those stocks.
As far as the technology, I really can't say. Personally, I've gotten to a place in my own use of
media where I don't want to have much storage of my own. I want to use Amazon, Netflix, etc.
to store things for me. So I guess I'm kind of a symptom of what's happening to stocks like
WDC, IMN, etc. where I'm not interested in personal physical storage. I actually consider it
hassle I'd rather avoid. But I'm not good at knowing how technology will shake out, when people
will change their habits, etc. So don’t listen to me on the issue of technological change.
But even if you knew how customer behavior would change, it's unclear what this would mean.
Western Digital is in a commodity type business. Loss of demand is easier to chart out in a
business that is different from this one. In WDC's industry, margins are not just driven by
customer behavior and company behavior.
Competitor behavior is very important. And obviously WDC is far from the weakest competitor.
This was something I had to think about with Barnes & Noble (BKS). I knew Borders was in a
much weaker position. I knew there would be industry consolidation. There would be fewer
players in the future. You have the same situation now with Western Digital. This complicates
the analysis.
Which is a fancy way of saying…
I don't know.
I'm not the best person to ask about WDC, because it's just not the kind of situation I'm normally
drawn to. I think it is about handicapping a risk/reward situation rather than buying a stock you
feel comfortable is worth more than you are paying. Instead, you are saying it could be worth
more or less but the probabilities and the payoffs clearly favor a positive outcome.
I tend to agree with that. Western Digital certainly looks interesting.
Charlie Munger has talked about how picking stocks is like picking horses – you can think of it
as a form of pari-mutuel betting. In both cases, there are frictional costs you have to
overcome (“trading costs”). But beyond that you are betting against others. So you are
handicapping the situation. It’s not necessarily about picking the best company.
It’s about picking the stock with the most mispriced odds.
Of course, that isn’t the way Ben Graham thought about stocks. He wanted to find stocks
he knew were worth more than they were selling for.
I don’t think Western Digital falls into that category. It’s not a Ben Graham bargain.
But it may be a mispriced bet.

161482/western-digital-wdc-ben-graham-bargain-or-mispriced-bet
 Time: 2012
-----------------------------------------------------
Vistaprint (VPRT): The Makings Of A Moat?
Hi Geoff,
I am doing my quarterly 13-F review and the first thing I stumbled onto when looking for info
on Vistaprint (VPRT) was your article on Glenn Greenberg.
I didn't realize that you also look at this type of company.
Looking through some investor presentations, I’m not really convinced that they can maintain
current growth rates of 20%.
Their production facilities are all based in high cost developed nations.
Why could this not be copied in Asia?
I just don't see the moat.
Current valuation assumes double digit performance for several years, one small dip and the
stock dives, no margin of safety here...
Regards,
Rijk
You bring up an interesting point about cost. But I’m not sure how much a small price
differential matters to customers in this kind of business. I would have to look into that. Any
logistical problems would lose you a customer. Also, that assumes the lowest labor costs lead to
the lowest production costs – I’m not sure that’s true in the printing industry.
I’ve had business cards printed. And screwed up (not by Vistaprint). As long as the price was
reasonable, I would’ve gone with “the best”. And I would’ve had no way to know who “the
best” was other than the most recognized name. Actually, I remember that being the problem
when I needed some business cards, company stationary, etc., printed. I had to visit a couple
websites. Look at them. Try to guess which was the best. Or at least decent. It was like getting a
plumber or something. I had very little ability to separate the good guys from the bad guys. I
wasn’t spending time thinking about price – many printers had prices that seemed awfully
similar to me. Instead I was just overwhelmed how frustratingly identical all the choices were.
I had no way to make an informed decision.
I can certainly imagine ways of saving money. But I really doubt labor is a good place to try to
find those savings. Small orders to small customers that need to be timely are the thing low-cost
Asian countries don’t do well.
Take George Risk (RSKIA). All of their competitors moved overseas. They’re still in Nebraska.
Management doesn’t really claim they can either be better or cheaper than their competitors.
They know they can’t be cheaper. And as far as better – this isn’t dark chocolate they’re selling.
Beyond customization, timeliness, and reliability – I’m not sure the idea of “quality” has much
meaning in that business. It’s either frustration-free or it’s not. The two things George Risk can
be are timely and customized. Both of those things are easier to be – for American customers – if
you are manufacturing in the U.S.
The easiest thing to offshore seems to be mass-produced copies.
I know someone who works in the (high end) shoe business who is constantly traveling to China.
He tells me that if you bring an actual new shoe over to a factory in China you can start mass
producing it in no time. But if you try to make the slightest alteration after the fact – telling your
guys in China to tweak some little thing with the design – the results are disastrous. His company
experienced some production fiascoes at first. So now they never try to tweak anything. They
always make sure there’s an exact copy on site. And they don’t change any detail – ever.
Everything has to be perfect on their end before it goes to China. If changes need to be made –
they get made in the U.S. without suggestions from over there. Apparently, this had not been the
normal procedure for production in the U.S., Italy, Brazil, etc.
Not sure why this is. But I think the companies that had trouble with moving production to Asia
have been businesses that needed at least a modicum of customization. Standardization is what
Asia does really well right now.
Overall though I don’t think costs are going to be the most important part of this a printing
business. Certainly not labor costs.
It’s an image business. If you screw something up that has to do with your customer’s image –
which is a lot of Vistaprint’s business – you alienate that customer.
Costs are important. But what’s the trade-off between dollar costs to the customer and costs that
come in the form of a lack of customization. Can a printer really try to cut costs by sacrificing
customization?
That doesn’t sound right to me.
Also, I think the business scales really well. It’s really expensive to compete for new business.
Repeat business is easier for little, local guys to do well. But this is a business – because of the
huge number of small businesses, their failure rate, etc. – where you constantly have first time
customers who are doing their first ever product search. This is an industry with churn. Old
businesses fail – new ones start up. Every year. Won’t people use the service they’ve heard of?
I’m not sure how you get your name out there. How you get to the top of Google, etc. if you are
a competitor of Vistaprint.
None of the individual orders – or customers – are very valuable. Being the go-to source for
some totally new business is key. Basically, you want to be the first guy a new business owner
orders from for the first time. I think that’s the key to this business. If you get that first look –
you’ll have success. If you don’t – you won’t. So if the economics of the orders works for you at
the same time you have the kind of profile that gets you that first look – I think you’ve got a
recipe for long-term profitable growth.
As far as the rate of growth, I don’t know how sustainable it is. That’s a really high growth rate.
Vistaprint has talked about 20%. It’s hard to predict how achievable that kind of growth is. They
probably aren’t going to have the same growth rate they had in the past. We certainly can’t
assume they will.
But I don’t know if the price really is factoring in a huge growth rate. It’s definitely factoring in
growth. But the current stock price isn’t assuming blistering growth.
Predictable, profitable companies are worth a high multiple even if they are pretty slow growers.
Vistaprint is the kind of company that could be very stable and very predictable at some point.
Even when the growth stops – Vistaprint could end up a very steady business. And it could end
up with the kind of multiple very steady businesses get. That sort of multiple isn’t much lower
than where Vistaprint’s stock is trading right now. Today, there’s maybe a 50% “growth
premium” in the stock. In other words – Vistaprint shares might be about 33% lower if its
growth prospects were no better than anybody else’s.
Does that mean there’s a margin of safety?
Absolutely not. There’s no quantitative margin of safety in Vistaprint’s shares. But Glenn

Greenberg likes businesses he can buy and hold that are trading at a fair price. Greenberg’s
margin of safety is always the business. It’s rarely the price. I don’t think he wants to own an
average business trading at a great price. I think he wants to buy a great business at an average
price. In this case – I’d say it’s an above average price. I mean, there are certainly good
companies trading for less right now.
But highly fragmented businesses where competition is from local small businesses are the
easiest to grow for a long, long time. It’s the Starbucks (SBUX), Barnes & Noble (BKS), etc.
formula. It’s really easy to grow against local competition. It gets hard when you start facing the
same (large) competitor across all geographies.
I think there’s the potential for a durable moat in this kind of business. I’d have to study
Vistaprint. But this kind of business has an immediate appeal to me.
The more I read about Vistaprint the more of a moat I see. I think the idea that you could use
cheaper labor actually illustrates a point here. That’s not what matters. It isn’t the labor that
matters. It’s applying the principles of mass production to small orders. Vistaprint is really about
reconciling those two things. Getting small orders to work smoothly for the customer and large
production to work smoothly for Vistaprint.
I think I'm getting an idea of the importance of reconciling the taking of small orders from the
customer with the use of huge production facilities. Printers really need both. So the printers with
the lowest costs – historically – couldn’t take small orders. And the folks who could take small
orders couldn't be world class when it came to production costs.
The internet solves this.
Vistaprint may be an example of Warren Buffett's idea that sometimes it's better to invest in the
company that benefits from some technology (like GEICO) than to invest in the company that
pioneers that technology (phone, internet, etc.).
I haven't had enough time to really delve into Vistaprint as a possible investment. I hope to this
weekend. But I am intrigued by the possibility of a moat here. I've been reading about their
production facilities. And the centralized way orders are handled. These are some really tiny
orders going to really huge production facilities. Reading about the facilities orders are routed to
has got me extremely interested in the stock.
Vistaprint has the kind of business strategy I look for.
This one goes to the top of my research pile.
161898/vistaprint-vprt-the-makings-of-a-moat
 Time: 2012
-----------------------------------------------------
International Value Investing: Turbotec (TRBO:LN) – United Kingdom
Richard Beddard of the Interactive Investor Blog brought this company to my attention

through Twitter. Here’s a short blog post about Turbotec.
This is actually an American company listed in London. A few years back, its sole shareholder
unloaded half the company by floating it in the U.K. There’s since been a dispute with the
shareholder, Thermodynetics, which is discussed below.
The company has a market cap of $6 million. The stock price in U.S. dollars is 47 cents per
share.
That’s 29.5 pence.
Although the shares are priced in pence – the sales, assets, earnings, and cash flows are all in
U.S. dollars. So, you really need to translate pence to cents every time you check the price on
this stock.
That’s regardless of whether you are in the U.K. or not. To British investors, this is effectively an
American stock. The stock may be quoted in pence, but the business is run in dollars. So British
investors are still exchanging their pence for cents when they buy and their cents for pence when
they sell.
For non-U.K. investors: “GBP” means Great British Pounds; “GBp” means Great British pence.
A pence is 1/100 of a pound. So watch your shift key.
The company is moving to a new manufacturing facility in North Carolina. This had been a New
England company. The new location makes a lot more sense.
Regardless, the mortgage associated with the North Carolina property more or less wipes out the
company’s net current assets.
However, the company still has about $0.86 a share in tangible book value versus a $0.47 share
price. Check the latest quote and the GBP to USD exchange rate when you read this.
So we’re talking about a profitable company selling at a 45% discount to its tangible book value.
Interesting.
Turbotec (TRBO:LN) – Reports
Below, I’ve quoted from the subsequent events section of the annual report. These are the two
material events you might miss out on if you just read the 2010 financial statements. I’ve also
translated the court award into U.S. dollars, because again, that’s how you should value a
company that keeps its assets and earnings in U.S. dollars.
In April 2010, the Company completed the purchase of an approximately 100,000 square foot
facility and an adjacent 5.46 acre parcel of undeveloped land in Hickory, North Carolina for
$2,768,750. The company plans to relocate its manufacturing operations to this facility
commencing in late fiscal year 2011. The purchase was financed in part with a mortgage from
the Company’s existing bank in the amount of $2,215,000. The mortgage has a twenty five year
amortization schedule with equal monthly payments of principal with a five year term and bears
interest at a floating rate linked to the bank’s prime rate.

And there was also a court case:
“On 10 May 2010 the Company was notified that it was successful in its defence of the claim
brought by Thermodynetics, Inc. in relation to the payment of administration fees under the
Relationship Agreement entered into at the time of its admission to AIM. The company was
awarded substantial costs, including an order of payment on account of ($560,000) by
Thermodynetics, Inc. with an additional amount to be determined by the court. The initial
payment was received by the Company in May 2010 and will be reflected in the fiscal year 2011
accounts.”
 URL: https://focusedcompounding.com/international-value-investing-turbotec-trboln-
united-kingdom/
 Time: 2011
-----------------------------------------------------
International Value Investing: PaperlinX (PPX:AU) – Australia
A reader responded to my post asking for stock ideas from other countries, with this email:
Hi Geoff,
Below is a quick and simple analysis of one of the stocks in my portfolio which your readers
might be interested in.
Regards,
Danny
PaperlinX (PPX:AU) – Reports
Below is Danny’s write-up on PaperlinX…
***
PaperlinX is the world’s largest paper merchant. It sources and distributes fine paper ranges,
specialty paper, sign and display and graphics solutions and industrial packaging materials
worldwide. PaperlinX is based in Melbourne, Australia and listed on the Australian Stock
Exchange with a market capitalization of A$253m. The current share price is A$0.42 which is
close to its all-time low and compares with a peak share price of approximately A$5.85 in 2003.
PaperlinX is a deep value idea trading at 0.9x net tangible assets with a 49% margin of safety to
my intrinsic value of $0.82.
The paper industry is highly competitive and PaperlinX has undergone significant transformation
over the years, closing and selling its manufacturing facilities. Volumes in the paper industry
have been impacted by the weakening global economy and the structural decline in paper use
with increased use of electronic communication. Industry participants have responded to the
industry downturn by cutting capacity which has mitigated the fall in prices. As you can see
below, PPX price/tonne increase in 2009 although dropping again in 2010. I have ignored the
impact of the rising A$ which has a negative impact on PPX earnings.
PaperlinX’s very low margins are evidence of the highly competitive industry and its business
model has significant operating leverage (a 25% decline in volume from 2006-10 led to a 70%
decline in EBIT/sales margin). Increased volumes from current depressed levels will generate
significant earnings growth. I have only shown the operating earnings from the Merchant
business above which excludes the discontinued manufacturing business, various asset sales and
restructuring costs.
An estimate of normalized earnings would be to take an average of the trading EBIT for the last
four years which is A$126.1m. This is of course very simplistic and ignores price forecasts,
foreign exchange, the benefit of the cost reduction programs etc which have both negative and
positive impacts of earnings. If we assume that corporate costs are A$30m (in line with historical
numbers), interest expense is A$20m (estimate from company) and corporate tax is 35%,
applying a 10x PE multiple, the implied valuation is A$0.82 which represents a 49% margin of
safety to the last share price of A$0.41.
The main catalyst for PaperlinX is an improvement in the economy. The Company’s most recent
results announcement shows that leading indicators are improving however remain volatile.
I believe that at the current price level, downside risk is limited. The EBIT implied by the
current share price, applying the assumptions above and a 10x PE is approximately A$89m
which is half FY2008 EBIT. In addition, at the current share price, PPX is trading at 0.9x net
tangible assets.
The risk is a prolonged delay in the recovery of the economy. Furthermore PaperlinX has a
significant amount of net debt at A$440m (cash A$137m, debt A$557m) compared to its market
capitalization. The debt was refinanced earlier this year and consists of a number of regional
asset backed facilities.
 URL: https://focusedcompounding.com/international-value-investing-paperlinx-ppxau-
australia/
 Time: 2011
-----------------------------------------------------
Reed Hastings – CEO of Netflix (NFLX) – Responds to Whitney Tilson’s

Short Case
Reed Hastings, the CEO of Netflix (NFLX), wrote a response to Whitney Tilson’s article on

why he’s shorting Netflix at $180 a share.
I was working on an article about Tilson’s short position in Netflix for GuruFocus when I

saw Reed Hastings’s response.
I’ll probably end up writing an article that talks about both their points.
I don’t short stocks. Never have. Probably never will. There are a few reasons for this. One, I’ve
looked at value investors who do short – and in most cases – they could have done at least as
well if they never shorted a single stock. That was certainly true for Benjamin Graham. It wasn’t
worth the trouble.
And that’s point number two. There are some things I can do in investing that I don’t do simply
because the trouble of doing them isn’t worth the reward they bring. Once in a very long while I
arbitrage an all cash deal. So far, the success rate has been great. But I haven’t had much fun
doing it. It’s an oddly unenjoyable experience, buying into something for a small profit and then
following it through a minefield of problems till it comes out the other side. Even when it works,
it just makes me want to curl up with the annual report of some quality company I can buy and
hold for a bit.
There’s a little of that in why I don’t short. Maybe a lot. I’ve seen people short stocks. And what
they go through isn’t something I want to go through.
I would never short Netflix. I think it’s an amazing company. I might be biased here since I’m a
long-term customer. I’ve basically switched over to instant only – I keep a one DVD plan just so
I have that option – but mostly I just watch instantly. And it’s amazing how it’s changed my life.
Amazon (AMZN) is the only other company that comes close. The way they both deal with
their customers actually conditions their customers to behave differently. Netflix and Amazon
have molded my habits in ways no other company has.
It’s hard to explain. But I know Netflix and Amazon are the two stickiest relationships I have as
a customer. They will keep getting my money for a long, long time.
Hastings and Bezos are also the two businessmen that impress me most. That’s outside of the
usual suspects – guys like Warren Buffett who are really just investors. I have to admit I’ve gone
through the archives and watched both Hastings and Bezos on Charlie Rose.
A few years back, Netflix was trading pretty cheap. It was clearly a Charlie Munger bargain. But
it wasn’t trading at a Ben Graham price. And, as you know, I don’t pay up for growth. I don’t
pay up for quality. I’ll buy the best stuff that’s quantitatively cheap based on its past numbers
and current assets. But I don’t like paying for tomorrow. So I didn’t buy the stock.
But I was very impressed by the company. I’ve come across a handful of companies like that
where I knew at the time an investment would work out really well long-term. But I just couldn’t
justify it on the past record alone. I’m still more Ben Graham than Charlie Munger.
Is that a mistake? In the individual cases, yes, absolutely. But, overall, I still don’t think so.
There’s some danger in the quality at a fair price approach. And there are some phenomenal
returns – especially in micro caps – in the Ben Graham approach.
Still, that experience researching Netflix really made me think whether I was being irrational in
sticking so close to Graham and staying so far from Munger. I knew it was a mistake not to buy
Netflix at the time. And I did it anyway.
I’m not quite at the point where I actually believe that was a mistake. I’m always worried about
letting new ideas into my process that could really screw things up. Being right on general
process is more important than being right on a single stock. And I’m still cautious enough to
think that it’s better to stick to a Ben Graham approach, because the process seems less likely to
lead to me fooling myself on some investment and taking a really big loss.
Anyway, it’s an interesting little saga to watch. Makes me think about shorting. About shorting
good companies. And about Netflix as a business.
Of course, none of that’s real useful to me, because I don’t short stocks and I don’t buy
expensive stocks.
So I’m not going to short Netflix and I’m not going to buy it.
But it’s fun watching.
 URL: https://focusedcompounding.com/reed-hastings-ceo-of-netflix-nflx-responds-to-
whitney-tilsons-short-case/
 Time: 2010
-----------------------------------------------------
Sold My Barnes & Noble (BKS) Stock Today
I sold my Barnes & Noble (BKS) stock today. The average sale price was $14.82. I bought
Barnes & Noble back in August at an average cost of $15.36 a share. In the meantime, I received
$0.50 a share in dividends. The round trip was a loss of 4 cents a share – or 0.26% – while the
S&P 500 was up more than 10%.
The reason I sold out of Barnes & Noble is to buy a stock I like better. Since I’m not done
buying that stock – and it’s a lot less liquid than BKS – I won’t be telling you about the new
stock today.
I’ll let you know the name when I’m done buying the stock.
But, for now, just know that I have sold out of Barnes & Noble.
 URL: https://focusedcompounding.com/sold-my-barnes-noble-bks-stock-today/
 Time: 2010
-----------------------------------------------------
Bill Ackman Tells Borders (BGP) to Bid $16 a Share for Barnes & Noble
(BKS)
Just wrote an article for GuruFocus, so you may want to read that first.
Bill Ackman – the hedge fund manager who runs Pershing Square – just filed a 13D with the
SEC saying he wants Borders (BGP) to buy Barnes & Noble (BKS) for $16 a share. Ackman
would provide the cash. Borders itself could never pull off this kind of deal. They are in much
worse shape than Barnes & Noble.
These are the two biggest booksellers in the U.S. The third place player – Books-a-Million
(BAMM) – is a very distant third. There are a couple interesting angles to this story. Obviously,
as a Barnes & Noble shareholder I tend to focus on that side. Barnes & Noble is auctioning itself
off right now. And Ackman’s offer will let us see if there are any other bidders. It will certainly
encourage Riggio and Burkle to get off the fence.
If it looks like such a combination really was going to happen, it would also mean some soul
searching for companies like Bertelsmann. Do we really want a single customer that big? Do we
really want only two real retail paths – Barnes & Noble and Amazon – to our readers. And, of
course, those two paths would be both print and digital.
I think we can say that if Borders merged with Barnes & Noble the idea of any serious e-reader
other than Kindle and Nook is dead. I’m talking from the publisher’s perspective here. I’m sure
we’ll see other devices. But as a realistic distribution system, it would only be Amazon and
Barnes & Noble. It’s a scale business. And you need both the content and the relationship with
the reader. I’m sure other folks will engineer e-readers of exquisite technical excellence. It won’t
matter.
I have a gold coffee filter at home. I put a paper filter in it. Gold is pretty. Paper does the job I
ask.
Anyway, this has me thinking about the likely and immediate scenarios and the less likely more
long-term scenarios. Obviously, actually consummating a marriage between Borders and Barnes
& Noble for $16 a share in cash is an unlikely and distant scenario. The immediate issues are the
reactions from others at Borders and the reaction from Barnes & Noble. Barnes & Noble is
tenuously controlled by Riggio – he had a narrow majority of the September vote and since then
the stock price has gone down with a lot of Nook spending and little news on the buyout front.
There was also a report in the New York Post that Riggio wasn’t very interested in buying the
whole company. If that’s true, coming out at the very beginning and making a big show of the
fact that he might be a bidder is unlikely to have endeared him to the few outside shareholders
who supported him.
And, obviously, if Barnes & Noble is in play, then basically no one has control of the company.
You need a huge stake to confidently block a bid without offering a counter bid once the board
decides the company is in play and their duty is just to get the highest price.
I’ll have much more on this story when I hear more and think more.
The other angle – which I really haven’t considered yet – is what this would mean for Borders.
That’s such a strange situation. But it’s possible that if this deal did happen at terms close to
what Ackman is talking about you could be left with some shares of the combined company in
public hands. And those shares would be held by people who thought they were buying a second
place bookseller on the verge of bankruptcy. Instead they end up shareholders in a much, much
bigger business.
But it’s way too early to think about that part. However, one thing that might be different here is
how Borders’s stock reacts. Usually, the potential acquirer’s stock drops. There’s absolutely no
reason for that to happen here. I’d be surprised if it did. There’d just be no sense in Borders
shares trading down on this news. None at all.
Both stocks probably pop.
So this is definitely a unique situation.
 URL: https://focusedcompounding.com/bill-ackman-tells-borders-bgp-to-bid-16-a-share-
for-barnes-noble-bks/
 Time: 2010
-----------------------------------------------------
Going Private Transactions: Should You Buy a Stock To Make 4% in 3

Months? – Bancinsurance
Hi Geoff,
I read about your investing experience with BCIS. Congratulations with the success. I am
considering buying Bancinsurance (BCIS) at $8.14 in order to make $8.50 when the deal
closes for a 4% gain in a few months. Not a very high return but it looks like the deal is going
through. Could you give me your opinion on the deal?
Regards,
Walter
I think the deal will happen.
The annualized return is good if you buy at $8.14. We’re talking about 21% annualized. The
non-annualized return is low: about 4.4%.
I don’t buy anything where the non-annualized return is less than 10%. Because:
a) There is always a small chance the deal won’t happen and

b) There is always a big chance the deal will take longer than you expect.
In this case: the buyer is the CEO and the buyout price is low.
The low price – 89% of book value – makes the CEO want to get the deal done. Also:
Bancinsurance will save money by stopping its reports to the Securities and Exchange
Commission (SEC). On the other hand: Bancinsurance is a controlled company.
If the CEO runs into trouble with financing – or something like that – he won’t worry about
taking a long time or bailing. There’s no one competing with him. Bancinsurance’s CEO doesn’t
want to sell the company. And he owns most of the stock. That means it’s his bid or no bid.
The big risk is a delay. That happens a lot.
In this kind of investing: all the surprises are bad surprises. I don’t expect a higher offer. That’s
why I sold. I had other opportunities. I didn’t want to wait for the last 4%.
I’m all about the first 30% to 50%. I don’t wait around for the last 10%.
But – yes – I expect the deal will happen. Most likely: you will make a 4% profit in 3 months or
less.
However: a delay is always possible.
When a board says 3 months: I calculate the annualized return as if they said 6 months. When
they say 6 months: I act like they said a year.
And I pass on deals where the non-annualized return is less than 10%. Sometimes a 3 month deal
closes in 1 year. I have better places to be.
In terms of pure odds: Yes. The deal will probably get done at $8.50 a share in cash by January
1st, 2011.
 URL: https://focusedcompounding.com/going-private-transactions-should-you-buy-a-
stock-to-make-4-in-3-months-bancinsurance/
 Time: 2010
-----------------------------------------------------
Case Study: Geoff’s Investment in Bancinsurance – Both His Letters to the
Board of Directors
In an earlier post about Bancinsurance (BCIS), I answered a reader’s email that asked:
I came across your Barnes and Noble write up on GuruFocus. I noticed in the comments section
you mentioned two letters you sent to the board of directors of an insurance company you
owned. Would I be able to get those off of you?
I only included my first letter to the board in that post. This post – at the bottom – includes both
my letters to the board of directors.
I’m not showing you these letters because they influenced the board. They didn’t. The CEO first
offered $6 a share. The board finally agreed to $8.50. I had nothing to do with that.
I’m showing you these letters, because readers ask about my own investments. What kind of
stocks do I pick? And how do I value them? These 2 letters give you an idea.
Obviously: they were written for a specific audience.
So – yes – I went out of my way to use conservative estimates of Bancinsurance’s value in these
letters. I asked the board to reject any offer less than book value. Does that mean I thought
Bancinsurance was worth book value?
Hell no.
I thought Bancinsurance was worth more than book value. Still do. And – in private – I would’ve
told you that. I talked about book value in the letters, because I was asking for something. I
wasn’t being rational. I was being reasonable.
I only owned 0.5% of Bancinsurance. As I said in an earlier post: I would’ve liked to own a lot
more. I didn’t have the time and volume I needed to get the shares I wanted. That’s life.
I wasn’t a big shareholder. The board didn’t care what I wrote.
They eventually settled on an arbitrary number: $8.50. Book value had risen to $9.50. There’s no
logical reason for the $8.50 a share number. They outline reasons in the going private transaction
report. None of them are logical.
If you want to learn about the $8.50 a share Bancinsurance deal and how it values the company,
read my 2 letters to the board, Raymond James’s presentation, and the going private report to the
SEC.
Here are my letters to the Bancinsurance board of directors. The first letter was sent in April and
argues against the CEO’s original $6 a share offer. The second letter was sent in July and argues
against the CEO’s raised $7.25 a share offer. The board later agreed to the CEO’s re-raised $8.50
offer.
Geoff Gannon’s 1st Letter to Bancinsurance’s Board of Directors
Geoffs 2nd Letter to Bancinsurance’s Board of Directors
 URL: https://focusedcompounding.com/case-study-geoffs-investment-in-bancinsurance-
both-his-letters-to-the-board-of-directors/
 Time: 2010
-----------------------------------------------------
Investing Ideas: 26 Things Geoff Looks for in a Stock
Hey Geoff
Just curious, where do you get your investing ideas?

Blogs are the best source. Screens are good too. Certain things catch my eye.
Here’s what I look for in a stock:
1. Market capitalization under $100 million

2. Low float
3. Foreign – especially from a small country
4. Not listed in home country
5. Controlling shareholder (maybe owns 30% – 70%) runs company
6. Long history of free cash flow
7. Share buybacks that reduce the share count – especially if done every year
8. A Dutch auction to buy back a lot of stock at once
9. Delisted
10. Just spun-off
11. Huge, one-time problem (think American Express Salad Oil scandal)
12. Bankruptcy in past caused by legal trouble
13. Hostile takeover attempt by someone who owns good chunk of company’s shares
14. Mismatch between reported earnings and free cash flow – FCF is much higher
15. Accounting quirk – amortization, carrying at cost, owns part of another public
company
16. Selling for less than cash and investments
17. Selling for less than net current asset value
18. No analyst coverage
19. Niche business
20. Lack of price competition – or the price leader
21. One of a kind business
22. Wrong time in cycle to buy this kind of stock: advertising, credit, homes, autos
23. Goodwill write-downs and restructurings cause reported losses when making money
24. “Too much uncertainty”
25. Nowhere near a 52-week high
26. Stock once traded at several times today’s price
 URL: https://focusedcompounding.com/investing-ideas-26-things-geoff-looks-for-in-a-
stock/
 Time: 2010
-----------------------------------------------------
Case Study: Geoff’s Investment in Bancinsurance – 2 Failures and 1 Success
Two days ago: I wrote about my investment in Bancinsurance (BCIS). My investment was a

success in one way and a failure in two ways.
It was a success in terms of return. My cost was $5.82 a share. Bancinsurance’s board agreed to
an $8.50 a share buyout. I sold my shares between $8.00 and $8.20, because I saw opportunities
elsewhere where good things could happen fast. One example is Barnes & Noble (BKS).
Success #1: That’s a better than 38% return in less than 7 months. If I’d held Bancinsurance
through the buyout I would’ve done better with a 46% return in less than 10 months.
So how was my investment in Bancinsurance a failure?
In two ways:
1. I didn’t buy enough stock
2. The board didn’t get a fair buyout price
Failure #1: I only bought 25,000 shares. Some of that was my own clumsiness. I would’ve
gotten 35,000 shares if I was a better buyer. My mistake was bad timing. I started buying right
before the CEO’s $6 bid was announced. I should’ve started buying in February.
Failure #2: Bancinsurance’s book value was $8.52 a share in March. It’s $9.50 today. $9.50
would’ve been a fair buyout price. The board agreed to $8.50. That cheats shareholders out of
12% in extra returns. It’s not fair. That’s life.
And that’s value investing. You can fail at two things and still make 38% in 7 months as long as
you buy at the right price.
2-failures-and-1-success/
 Time: 2010
-----------------------------------------------------
Case Study: Geoff’s Investment in Bancinsurance – Letter to the Board of

Directors
I came across your Barnes and Noble write up on GuruFocus. I noticed in the comments section
you mentioned two letters you sent to the board of directors of an insurance company you
owned. Would I be able to get those off of you?

Sure. Here’s the case study. Read what I did. And think about what you would have done.
Background: Years ago, a microcap specialty insurance company, Bancinsurance (BCIS), was

involved in a bail bond reinsurance program that caused a 29% loss of shareholder’s equity.
Bancinsurance’s auditors resigned. A.M. Best cut Bancinsurance’s financial strength rating.

NASDAQ delisted the stock. And the SEC sent a Wells Notice telling Bancinsurance the SEC
was investigating the company’s executives.
At this time – 2005 – I began following the stock. On February 3rd, 2010, the SEC told
Bancinsurance it was not going to act against the executives. I decided to buy Bancinsurance
stock.
I started selling other stocks I owned to round up cash. In March, Bancinsurance’s bid and ask
prices were below $5. I started buying at $4.75.
On March 23, 2010, the Bancinsurance board announced the CEO – who owned 74.17% of all
Bancinsurance shares – was offering to buy out other shareholders at $6 a share. I bid for all
stock at or below $6 a share throughout this period. I probably accounted for the majority of
Bancinsurance’s trading volume from this point on.
On April 7th, 2010, I sent a letter to Bancinsurance’s board of directors.
Geoff Gannon’s 1st Letter to Bancinsurance’s Board of Directors
letter-to-the-board-of-directors/
 Time: 2010
-----------------------------------------------------
Barnes & Noble: What Happens Next? – Is This Yahoo and Microsoft All
Over Again?
I believe your thesis was to be long because of a proxy battle and buyout of either Riggio or
Burkle…It reminds me a bit of the YHOO MSFT situation where…MSFT would pay whatever,
but the deal never got done and YHOO went in half. You may be right that Burkle wants the
company for $20, but at what point does he…walk away? What do you think happens next
here?
There are differences between Barnes & Noble (BKS) and Yahoo (YHOO). The biggest are:
 BKS is cheap; YHOO wasn’t

 Len Riggio owns 30% of BKS; Jerry Yang owned 4% of YHOO
 Ron Burkle owns 19% of BKS; Carl Icahn owned 6% of YHOO
Microsoft didn’t own Yahoo stock. So the positions of Microsoft, Yang, and Icahn were different
from those of Riggio and Burkle.
Riggio, Burkle, and Aletheia own most of Barnes & Noble. They have money at risk. They can
only get it out by selling in the market and driving down the stock price or selling in a deal.
Burkle is different from Microsoft or Icahn. Burkle didn’t start out wanting control of Barnes &
Noble. He just wanted to be a big investor. He’s an influence investor not an activist like Icahn.
Burkle wants the best price. He doesn’t think he’ll get it from Riggio.
What’s next?
I expect Burkle and Riggio will argue about the Barnes & Noble sale process in court and in the
press for the next 3 months.
 URL: https://focusedcompounding.com/barnes-noble-what-happens-next-is-this-yahoo-
and-microsoft-all-over-again/
 Time: 2010
-----------------------------------------------------
Microsoft is Cheap
Go to 24/7 Wall St. and read great coverage of the Microsoft (MSFT) earnings call.
Here is what I wrote about Microsoft in May of 2006:
What price would I be buying Microsoft at? Like I said, this isn’t normally the kind of company I
would be buying. It is definitely in an industry where there is a lot of uncertainty – at least
beyond the Windows franchise (which I do think is completely secure).
For the most part, this is a stock I wouldn’t be able to value well enough to buy, because of the
future and my lack of understanding of the business.
Having said that, I would certainly buy shares if they reached $17. Before that, I would have
some trouble making a decision. The margin of safety simply wouldn’t be wide enough in an
area I don’t understand that well. Maybe I will get a better feel for the company and its
competitive position as I look into the stock some more (and write about it here). But, unless and
until that happens, it would be hard for me to buy at a price much greater than $17 (where I
think it would pretty much be a sure thing).

Because of share buybacks and other changes since 2006, my sure thing price would now be
more like $17.50.
Earnings power in terms of free cash flow is probably around $1.75 a share.
No entrenched, wide-moat business this size trades for 10 times its cash earnings power.
Is Microsoft a growth stock?
No.
Is it cheap?
Yes.
If you need to buy a big cap stock, buy Microsoft at $17.50 or less.
 URL: https://focusedcompounding.com/microsoft-is-cheap/
 Time: 2009
-----------------------------------------------------
Against the Topps Deal
In my earlier post entitled “Topps to be Acquired by Eisner and Others“, I said that I would look
over the company’s financials. I did and what I found is quite interesting.
Actual Offer
First, you need to forget the $9.75 a share number you’ve seen reported as the offer from
Tornante and Madison Dearborn. Topps (TOPP) has $84.87 million in cash and no debt. So, the
$9.75 a share offer from Eisner et al. includes the acquisition of $2.19 per share in cash.
The offer for Topps’ operating business is $7.56 a share not $9.75 a share. When investors
calculate standard valuation ratios such as price-to-earnings, price-to-sales, and price-to-book,
they need to use the $7.56 a share number rather than the $9.75 a share number, because the
utility of these ratios is in comparing an operating business to the price paid for that business.
For instance, although it first appears that Eisner et al. are making an offer that values Topps at
over 100% of sales, this is an illusion. The offer values Topps at almost exactly one times sales –
in fact, slightly less than one times sales.
Furthermore, Topps is expected to increase sales in the years ahead, because of certain favorable
developments (brought on in part by management’s recent actions) that seem to have improved
the outlook for the industry. I’ll address the issue of a “turnaround” later.
For now, it’s important to note that Topps’ current sales levels are not especially high – in fact,
sales are roughly where they were in 2001.
Use of Cash
In that year, Topps spent close to $30 million to repurchase 2.81 million shares at $10.39 a share.
Six years later, the entire company is set to be sold for $9.75 a share.
To be fair, Topps had more cash in 2001 than it has today. The difference in cash and
investments is theoretically large enough to account for the $0.64 a share gap between the price
at which Topps was enthusiastically buying in 2001 and the price at which Topps is now
planning to sell itself. Regardless, this repurchase record betrays the fact that Topps’ board
accepted an offer even they don’t believe to be substantially greater than what long-term
shareholders will (eventually) be able to sell their shares for in the open market.
If that last statement is untrue, then either the 2001 repurchases were a negligent misuse of
almost $30 million of company cash or unforeseeable events that occurred during the intervening
years have permanently impaired the value of the business.
Which is more likely? Is management wrong now? Was it wrong then? Or, have circumstances
conspired against the company?
If the 2001 repurchases were the error, perhaps they were an excusable error.
However, Topps’ long history of squandering cash is inexcusable. Almost exactly six years ago,
Topps had $158.74 million in cash. Today, the entire company is being sold for $385.4 million
dollars.
Over the last several years, Topps has spent far more cash on share buybacks than it has paid out
in dividends. In fact, despite a nearly $75 million reduction in cash on the balance sheet, Topps
has paid out less than $25 million in dividends.
Why doesn’t the company pay out a special dividend?
It’s hard to imagine a company better suited for the payment of a special dividend. Topps is
paying a regular dividend of just $0.16 per share while holding $2.19 per share in cash.
This miserly attitude makes even less sense when you realize what a consistent cash generating
business Topps is. By my admittedly hasty calculations, I can find only one year among the last
seventeen in which Topps failed to produce distributable cash.
In 1997, there was no cash for a theoretical 100% owner to withdraw from the business. In every
other year since 1990, Topps has produced “owner earnings” at least in the sense that a 100%
owner could pay himself a healthy cash dividend without negatively affecting continuing
operations.
Reported Earnings vs. Owner Earnings
I hesitate to call this distributable cash “owner earnings” in the sense that Buffett intended the
term, because Topps has seen its earnings power diminish over the years. However, this
diminishment appears to be due to industry conditions and Topps’ own failure to develop new hit
products. The company’s competitive position has not been weakened through underinvestment.
I’ve done my best to estimate Topps’ per-share owner earnings for each year from 1990 – 2005.
While my estimates aren’t perfect, they undoubtedly reflect economic reality better than the
earnings per share numbers reported on the income statement.
Topps’ economic earnings are consistently higher than the company’s reported net income. In
other words, the company consistently underreports its true economic earnings.
There’s nothing nefarious about this. It happens to some other public companies as well. It’s a
natural result of accrual accounting – and is more or less unavoidable within any system of
accounting that applies general rules to a wide range of inherently different businesses.
If you think about the business Topps is in, this underreporting isn’t surprising. It’s the result of
non-cash charges that have no economic importance. Don’t let these charges fool you.
Although the reported earnings per share numbers bear the auditor’s imprimatur, the estimated
per share owner earnings below better reflect economic reality.
Per Share Owner Earnings
1990 – $1.49
1991 – $1.51
1992 – $0.52
1993 – $0.71
1994 – $0.42
1995 – $0.30
1996 – $0.36
1997 – $0.00
1998 – $0.46
1999 – $1.56
2000 – $2.31
2001 – $0.75
2002 – $0.47
2003 – $0.43
2004 – $0.42
2005 – $0.22
The above numbers have been adjusted to reflect today’s lower share count. This is a necessary
adjustment that investors should always perform when considering historical earnings per share
numbers.
A few things immediately jump out from the above numbers. The first is the sad realization that
Topps’ current sixteen cent annual dividend is lower than what the company’s owner earnings
had been in sixteen of the last seventeen years.
In other words, despite already having a whopping $2.19 a share in cash, the company’s dividend
payment is not working down the cash hoard at all. In fact, if Topps performs much as it has in
the past, it will continue to add cash to the balance sheet each and every year. Topps has
managed to obscure this fact through share repurchases – some of which look ill considered now
that the company is planning to sell itself for $9.75 a share.
If Topps is sold for $385.4 million, the decision to buy back shares would be demonstrably
inferior to the decision to disburse the cash to owners through a special dividend. Until Topps is
sold, it might be argued that the share repurchases created value that has not yet been realized in
the market for the company’s stock.
But, once the company is sold (at such a low price), the share repurchases of years past will be
exposed as value destroying measures. After all, the company could have simply returned that
cash to its rightful owners.
I call them “rightful” owners, because Topps’ financials clearly show that the business had no
use for this cash. A business that has generated positive owner earnings in sixteen of the last
seventeen years and had never in that period had a year in which operations caused a material
consumption of cash is hardly a business that requires a cash cushion.
Inherent Economics
I’ve seen businesses that could benefit from a cash cushion. Topps isn’t one of them. In fact,
Topps is their polar opposite. The kind of businesses that can benefit from a cash cushion are
dependent upon a few large customers who are themselves exposed to the full fury of a
capricious economy. They are businesses that can not insulate themselves from short-term trends
within their industry – and thus must endure down years even when they do everything right.
Above all else, they are businesses that can not outrun the ill effects of their dumbest
competitor’s dumbest move.
Topps is about as far from that somber scenario as you can get. It is a consistent cash generator –
not because it’s brilliantly run or because it has outsmarted its wily competition, but because
it has very little competition. It is fully insulated from the whipsaw whims of the general
economy for a simple reason – it sells a simple product.
That may sound like a silly thing to say. But, it’s true. The ideal product, from a business
perspective, is a relatively cheap discretionary item that its purchasers are passionate about.
Some people are passionate about their cars. But, even then, they tend to be too reasonable at the
time of purchase. A great product is one that is sold in a fit of unreasonableness. It can’t be too
expensive, because that leads to the twin sins of comparison and hesitation. Ideally, it is a
product that can not be evaluated point by point, aspect by aspect, but must be assessed in its
entirety. Above all else, it must be a product with positive associations for the prospective buyer.
Topps meets these criteria quite nicely. If you use the above paragraph as a checklist to run
against each of Topps’ products, you will find that the company occupies a competitive space
where profits are likely to be plentiful and destructive competition is likely to be scarce.
Just as importantly, Topps has minimal capital spending requirements. For more on this topic,
please see my post entitled “On Maintenance Cap-Ex and the Pleasant Surprise“. In that post, I
made this important point:
“… 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.”
That’s a strange statement to make. But, it’s one I’m happy to stick by. I wrote another post “On
Inflexible Enterprises” discussing a related topic. That post outlined the perils of businesses that
put down roots. Inflexible enterprises are tied to a particular line of business, mode of
production, or labor force in such a way that extricating themselves from a dying or unprofitable
operation becomes exceedingly difficult – often to the permanent detriment of investors.
But, that’s only half the story. A business with minimal maintenance cap-ex requirements isn’t
merely a less risky business. It also tends to be a highly profitable business – or, at least it tends
to have the potential to become a highly profitable business. Given the kind of business it is,
Topps has the potential to do a lot with very little capital. Private equity buyers see this. Many
current shareholders don’t appreciate this point fully.
That’s understandable given Topps’ past record. For years, the company left piles of cash sitting
idle while the operating business dithered along under an uneasy malaise. The performance was
poor; but, the strength inherent in the business provided an air of adequacy to an otherwise
inadequate performance.
This is not an inherently bad business; in fact, it’s an inherently good business. Topps is blessed
with an enviable competitive position in more ways than one.
Beyond the minimal capital spending requirements and the type of product the company sells, it
is also fortunate enough to be involved in businesses where there is little incentive to allow
excessive competition.
The sports card business is, in a sense, a regulated business. The companies that market sports
cards need licenses from the professional sports leagues that have established themselves as clear
monopolies.
Although it may seem nonsensical at first, the leagues have little incentive to allow a large
number of market participants. The dynamics of the sports card business are such that you would
expect a lower number of suppliers would not (after a brief adjustment period) lead to a large
decline in total sales. Furthermore, the long-term benefits of reduced competition are substantial.
This is not an industry in which innovation is particularly important. If it were, a large number of
competing suppliers might improve the industry from the league’s perspective.
It’s an industry in which familiarity is especially important – perhaps more important than in
almost any other industry. For that reason, second-tier competition is detrimental to the long-
term health of the industry. It merely serves to reduce familiarity with specific products while
offering little benefit in terms of higher overall sales. Essentially, a smaller number of
competitors can successfully supply roughly the same number of cards while fostering greater
long-term product loyalty.
For this reason, a league can establish a satisfactory market structure with the use of only a
couple licenses. In the case of Major League Baseball, the number of licenses is now literally “a
couple” – as in two. In one year, the number of licenses was cut in half. These important changes
were engineered by Topps. If the less crowded market structure is sustained, it will undoubtedly
benefit the company in the long-run. Similar arrangements have been made (or likely will be
made) between other leagues and their licensees.
Turnaround
These licensing changes made at Topps’ instigation bring us to an important yet imprecise
discussion – is Topps successfully implementing a turnaround?
The sports card industry has been in decline for several years. Why? I don’t know. I could
vaguely blame it on the internet, the pace of change in all things media, a generation growing up
with MTV, etc. Since I don’t actually know, let’s go with that explanation. It sounds
superficially plausible, even though the actual answer is undoubtedly more complex and more
industry specific.
Regardless of why the sports card industry was shrinking, it’s worth noting that it isn’t shrinking
at present. It’s growing. How much? How fast? I don’t know. In fact, no one knows. Believe it or
not, there are actually a lot of little industries like this where no one really knows the exact
figures. But, it is growing.
If you listen to Topps’ third quarter conference call, you’ll hear mention of a survey that
suggested the incidence of card collecting tripled in the last year. As a rule, any survey that
claims something tripled in a year is highly suspect. That’s probably why the survey was
downplayed in the conference call. I’d be skeptical too. Whatever the merits of the survey, it
certainly does suggest the last year was a good one for the sports card industry – and something
meaningful has changed.
As for Topps itself, the company has said it is on track to meet or exceed its full year earnings
guidance of $0.25 to $0.30 per diluted share (before special charges) for fiscal year 2007. The
company constantly throws around the word turnaround; so, you can forgive me for bringing up
that oft used, hopeful phrase “turnaround story”.
A summary of the changes the company has made in this turnaround effort is provided on the
first page of the 2006 annual report. These changes include:
Restructuring the Business to Focus on Operating Profit: Topps has greatly increased the
number of employees reporting to someone with direct profit and loss responsibility. Previously,
this number had been very low (20%). Financial reporting changes for the two business units
(Confectionary and Entertainment) accompanied this restructuring.
Cut Costs: The company reduced the headcount at HQ, froze the pension plan, made changes to
medical insurance, etc. Supposedly, these cuts will provide savings of about $4.5 million.
Market Structure Changes: These are the licensing agreement changes I mentioned earlier.
They effectively cut a large portion of the competition out of several of the company’s sports
card markets.
As a result of all this, Topps is expected to deliver a much greater operating performance
improvement than it has in years. The business had seen essentially no improvement for some
time. These changes are real and shouldn’t be overlooked when evaluating the $9.75 a share
offer.
Valuation
Now, to the hard part. How much is Topps worth?
There are a few different metrics we can use to evaluate the offer price. For the fiscal year ended
February 25, 2006 Topps had $293.84 million in sales. Right now, it’s on pace to top that
number. But, we’ll use total sales of $293.84 million for our calculations.
Here is what the company’s share price would look like if it traded at 0.5 times sales, 1 times
sales, 1.5 times sales, 2 times sales, and 2.5 times sales (cash has been added back because it’s
independent of the value assigned to operations):
50% of sales: $5.99
100% of sales: $9.78
150% of sales: $13.58
200% of sales: $17.38
250% of sales: $21.17
As you can see, the offer from Eisner et al. values the company at almost exactly 100% of sales –
no more, no less. Is that a fair multiple? You decide.
Next, we could look at Topps’ price-to-book ratio. But, there’s no reason to; really, we would
just be counting the cash. Nothing else is recorded at a value that’s indicative of its earnings
power. Topps is an intangible business and book value is a tangible measure. So, it’s useless in
this case.
The next common valuation measure is the price-to-earnings ratio. But, as we’ve seen, accrual
accounting obscures Topps’ true economic earnings. For that reason, we would be better off
looking at the owner earnings estimates I provided for the last seventeen years.
Owner earnings over the last five years averaged $0.46 a share. Over the last ten years, owner
earnings averaged $0.66 a share. Over the last fifteen years, they averaged $0.70 a share. These
numbers don’t exclude interest earned on Topps’ sizeable cash hoard. The diminishment in
average operating earnings is actually worse than it first appears, because interest helped some of
the recent years look better than they really were.
Overall, even if we assumed the fifteen year average is the most accurate (and considering the
decline in the card business, that’s a bit of a stretch), Topps doesn’t look terribly undervalued on
an owner earnings basis. At $9.75 a share, the offer values Topps at 13.93 times its estimated
owner earnings over the last fifteen years.
That’s cheaper than it first appears, because many low P/E stocks tend to have higher accrual
earnings than economic earnings. In other words, an owner earnings multiple of 13.93 is quite
reasonable (one might even say cheap). Of course, my estimates for owner earnings in more
recent years were much lower. For 2005, the estimate fell all the way to $0.22 a share. That
would give the $9.75 a share offer an outrageous owner earnings multiple of 44.32.
Here, we have to consider two factors. Was 2005 a representative year? Has the company’s
earnings power diminished over time?
Topps has certainly earned less over time. So, the answer to the second question would seem to
be “yes”. Let’s leave it at that for now. The company’s potential is a different issue. As for 2005
being a representative year – if, by that we mean that future years will see similar owner earnings
numbers, I doubt it. Topps will probably earn more in future years than it did in 2005.
It’s important to remember that these estimates work well over time (when multiple years are
averaged together). My estimate for any single year will tend to be way off. I haven’t tried to
smooth the numbers unnecessarily, because that would make the averages of multiple years less
useful. As a result, while the figure for any single year is open to interpretation, we can be quite
confident that for the full period from 1990 through 2005, Topps produced around $460 million
in distributable cash. The average amount of distributable cash generated in a year was close to
$30 million. That’s after taxes on a business that is now set to be bought for $385.4 million –
including $84.87 million in cash.
So, we’re talking about a roughly $300 million purchase price for a business that has thrown off
about $30 million a year in cash since 1990. Again, that’s after taxes. With the use of debt, the
math gets a lot more enticing. Before taxes, it would be closer to $45 million on a $300 million
purchase price. Remember, this does include interest income over the years – which has been a
much larger item for Topps than it is at many public companies, because Topps has held a lot of
cash. The interest income shouldn’t be included. So, you need to keep that in mind here.
Still, we’re talking about a pre-tax yield on the purchase price that is somewhere between 10%
and 15% based on average distributable cash generation since 1990. So, if you wanted to think of
the buyout as a bond (and you wanted to use an average “coupon” going all the way back to
1990), you’d be looking at a bond yielding somewhere between ten and fifteen percent. It would
be closer to fifteen percent. There’s another tax complication in here; but, for the sake of brevity,
I’m going to ignore it entirely. Just know that the tax treatment makes me even more confident in
estimating the yield on our imaginary buyout bond to be 15%.
Of course, there’s an obvious argument against asserting a buyout at this price is equivalent to
the purchase of a 15% bond. Topps hasn’t generated that much distributable cash for quite some
time. In fact, it’s been five years since Topps has provided the kind of free cash flow you would
need to mimic a bond with a fifteen percent yield.
On the other hand, a bond has no upside – ownership of a business does. If Topps improves its
operating performance either as a result of actions it has already taken or as a result of actions
that will be taken after the buyout, the yield on our imaginary bond would go through the roof.
So, we’ve come full circle. The price-to-sales ratio is probably the best way to evaluate the $9.75
a share offer. It’s an offer made at 100% of sales. Every dollar in sales is being translated into a
dollar of market value at the offer price of $9.75 a share.
Should a deal be done at just 100% of sales? Is that fair?
That doesn’t sound like the right multiple to me – and I certainly don’t see a premium here. The
offer is for the entire company, not the tiny pieces of the company that trade every day. An offer
of 100% of sales doesn’t sound like a particularly high price to pay for a non-controlling, passive
stake in a business like Topps – much less complete ownership of the entire company.
Thoughts from Shareowners
I ended my first post on Topps by asking for thoughts from actual owners of Topps shares (as
I don’t own shares). I was surprised by how quickly the responses came. They ranged from
emails from money managers to emails from individual investors with small, long-held positions
in the company.
Many of them had questions. Sadly, some of the Topps shareholders who found their way to my
site did not realize the buyout would leave them without any interest in the company. It wasn’t
fun breaking the news. Here is one such email:
I am a long time owner of Topps, perhaps close to ten years. Call me crazy, but I was raised a
buy and hold guy. I’m a little saddened by the price that Mr. Shorin has decided to sell the
company because I’m quite certain with the cash position it is worth more. Still, it has been
frustrating with Mr. Shorin at the helm, for I feel he was an old school guy who struggled
keeping up with the changes of the world. Recently over the past year, I believe they have really
begun to take the company in a new direction and to start to innovate value into the brand. So, it
seems selling to Eisner is not a bad thing at all, but I’m not sure if I will still be an owner to see
if he can take the company somewhere to which Shorin was unable, because I’m not sure when a
company goes private if the shareholders are bought out. Still, besides all that, I’m disappointed
in the price and I’m hopeful someone else will step in and white-knight us.
Here we have a tragic twist on the term “white knight”. Its narrow meaning is a subsequent
bidder who comes to rescue (management) from a hostile bid. Of course, it also has the broader
sense of a savior and a champion. There’s no hostile bid here. For this shareholder it’s the
Chairman and CEO, Arthur Shorin, who is the black knight.
Every one of the responses I received was critical of the deal. But, that’s to be expected. The post
I wrote wasn’t a positive one and it’s always the people with a problem who are most likely to
voice their opinion. So, it’s far from a random sample.
Still, I was surprised by the number of emails along the lines of: “I wish I understood this
situation.“, “Why are they doing this?“, etc.
The most telling comment may have been: “I thought that when a company got bought out, the
stockholders benefited.” In my experience, investors are often quite pleased with the pop in a
stock the day a company announces it’s being acquired. In fact, they usually don’t worry too
much about whether the deal is fair, because the stock is suddenly well above where it’s been. In
this case, the deal’s very poor reception from shareholders may have been exacerbated by the
small premium over the (then) current stock price and the fact that the offer was actually a bit
below the high for the year. Shareholders didn’t see a pop and they certainly didn’t feel any
richer the day the deal was announced.
Conclusion
So, what should shareholders do? What is the right course of action for Topps?
The simplest answer is that private equity doesn’t have a monopoly on value enhancing
activities. Nothing but institutional inertia and investor apathy prevents the undertaking of
serious capital restructurings without a change in ownership. A public company can attempt its
own do-it-yourself buyout. Or, rather, it can adopt the best aspects of some buyouts while
charting a sustainable course all its own.
Topps already has a lot of cash and it will continue to generate more each and every year. The
cash has nothing to do with its operations. It’s surplus cash. It needs to be returned to owners one
way or the other. There are two good options here. Topps can either pay out a special dividend;
or, it can engage in a major share buyback with the aim of recapitalizing the business to provide
better returns for owners.
When I say a share buyback, I do not mean the kind of much publicized buyback programs many
companies have these days. Topps is well situated for a large one-time share repurchase. It could
be done through an auction or through a fixed price tender offer. Obviously, the $9.75 a share
offer provides a convenient level at which the company could buy back potentially large amounts
of its own stock and in so doing provide investors the opportunity to opt out of the company’s
uncertain future by taking a cash offer equal to that made by Eisner. The shareholders who
wanted to leave would get their cash; those who wanted to stay would see their piece of the pie
grow.
At $9.75 a share, there might not be nearly enough stock offered for sale as the company would
like to repurchase. However, $9.75 would be a good starting point, considering that it’s both the
actual offer price and yet still a price that an objective observer (or at least this observer,
objective or otherwise) would say adds sufficient value to warrant an attempt to bring in as much
stock as possible.
Then, there’s the issue of debt. Topps is a consistent, relatively strong cash generator (at least
relative to its accrual earnings). You can do your own math to determine what kind of interest
payments you’d be comfortable seeing the company burdened with. I’m not advocating an
absurdly high debt load here. But, some debt would make sense for this kind of company –
especially if it could be used to buy back shares.
It’s clear that Topps needs to return at least $85 million to its shareholders through share
buybacks, special dividends, or some combination thereof. If the company were to take on debt
(and I think that would be advisable provided the debt burden is reasonable) it could and should
return more than $85 million to shareholders.
The best course for Topps (and thus the plan that shareholders need to be advocating loudly and
unceasingly) is as follows:
1. Reject the Eisner Offer
2. Remove Mr. Shorin
3. Solicit Bids For the Company and its Constituent Segments for a Set, Limited Time Period
4. Engage in Major Share Repurchases and/or Pay Out a Large Special Dividend
5. Take on an Appropriate Amount of Debt (in conjunction with #4 above)
It’s important to note that while now is an appropriate time to entertain other bids, shareholders
must not resign themselves to selling the company at any marginally better price. Instead, it is
likely the company will have to make changes – certainly to its capital structure and quite likely
to operations as well. Ultimately, the goal is to create value for shareholders. That end might be
achieved with or without a sale. For this reason, it may be appropriate to consider bids while
simultaneously developing a plan for a complete overhaul of the company’s capital structure.
But, at some point (relatively soon) the company needs to move forward with an executable plan
to create value on its own.
Of course, all of this is predicated on rejecting the Eisner deal and removing Mr. Shorin.
Many people have asked me what Topps is really worth. I don’t know anything with certainty
and I don’t want to suggest a false precision here. However, I don’t see how reasonable people
could disagree about any offer of less than $12.00 a share. Offers below that amount are clearly
inadequate. There is no reason to prefer them to an energetic effort to create value through
improving the capital structure and removing the current CEO.
Removing Shorin is an absolute necessity. After accepting this deal, he can never be trusted
again. This is not merely a problem of ineffective management. It has clearly gone beyond that.
The problem now is not ineffectiveness; it’s faithlessness.
Related Reading
Topps Removes Dissident Directors from “Go Shop” Process
Topps to be Acquired By Eisner and Others
Cheap Stocks
Disappointing Offer for Topps: Why This Deal is $7.55 per share, Not $9.75
StreetInsider.com 13D Tracker
Ajdler Calls Board Moves at Topps “A New Low in Corporate Governance”
SEC Investor
Shareholders Concerned Over Topps Board Action
 URL: https://focusedcompounding.com/against-the-topps-deal/
 Time: 2007
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On Overstock’s Terrible Third Quarter
I did not expect to learn anything significant about Overstock.com (OSTK) until the fourth
quarter results were in, because the Christmas season is so critical to the company’s success.
However, Monday’s announcement of a year-over-year decline in revenue was completely
unexpected.
Based on Byrne’s remarks and the reported results, it looks like Overstock got everything right
except conversions. I was pleasantly surprised with how well the company managed its IT
systems and its inventory. In the past, management had made mistakes in these areas and
Overstock paid the price. This quarter they did a great job on both fronts.
Unfortunately, the fantastic growth that had allowed Overstock to move forward despite serious
missteps (in previous quarters), was totally absent this quarter.
In his letter to owners, Byrne wrote:

“In the past we ran at an A- and regularly generated 100% growth: now I think we are running
at an A+ but seeing no growth. I am not entirely sure what to make of that.”

I agree. That’s the real story. The company gave its best performance – and posted its worst
results. The CEO can’t explain it and I can’t either.
At the beginning of this year, I thought Overstock could grow sales at 10-15% for the year.
I expected to see total sales for 2006 of between $875 million – $925 million. In the first three
quarters of 2006, the company only generated about $500 million in sales. So, Overstock would
need $375 million to $425 million in sales during Q4 to get to where I expected them to be at the
end of the year. To put that in perspective, the company had sales of $318 million in Q4 of ’05.
So, Overstock would need to post year-over-year growth of 18 – 34% during the fourth quarter
of this year just to reach a target I thought was sufficiently conservative when I set it about a year
ago.
Then, there’s the issue of cash. Like I said, Overstock did everything right this quarter and still
posted very poor results.
In February, I wrote that “Insolvency could only occur through gross managerial ineptitude”.
Clearly, I was wrong. Overstock’s management is not inept; in fact, they’ve made meaningful
improvements to the business in the first nine months of 2006. Overstock is a much more
efficient operation today than it was a year ago.
However, there is a real risk of insolvency. If Overstock’s fourth quarter results don’t show
year over year growth of at least 15-20%, it seems nearly certain they will have to raise cash in
2007.
Even if the fourth quarter looks great, there may be a need to raise cash. If the company has
to raise cash while its prospects appear terribly dim, the terms on which the cash is raised are
likely to be extremely detrimental to current shareholders.
Overstock has a solid business model. Unfortunately, the logic of that model is predicated upon
sales volume growth. The business simply can’t operate profitability on such a small volume. If
Overstock can’t grow sales, it can’t survive.
If we see really poor sales growth in the fourth quarter, despite Overstock’s excellent name
recognition, I would have to question the firm’s viability. If the company reports year-over-year
growth in the single digits for Q4, I’d have to seriously question whether this is a viable
business.
The third quarter results (themselves) are unimportant. But, the fact that revenue declined
going into the critically important fourth quarter is both surprising and unsettling. I never
imagined a quarter could be this bad. Clearly, I don’t understand the business, because I really
did believe a year-over-year decline in sales was unthinkable. These results shake the
foundations of my case for Overstock.
Now, the natural question is whether the stock is (in my opinion) a buy, sell, or hold. That’s not
the way I usually discuss stocks on this blog – and it’s certainly not the way I’m going to discuss
this stock. I’ve already demonstrated I don’t understand the business; if I did, I would have been
able to see that Overstock could experience a year-over-year decline in revenue despite strong
brand recognition. I didn’t recognize that possibility; so, clearly I don’t understand the business.
Having said that, I am aware of the dangers of announcing my lack of confidence in Overstock
(and thereby reversing my earlier pronouncements) at precisely the time the stock is making new
lows. On the basis of price-to-sales this remains a very cheap stock, if the company’s growth
prospects are reasonably good.
Based on the site’s traffic and customer awareness, I was convinced Overstock’s growth
prospects were good enough to justify purchasing the stock. Now, I’m not sure, because any
failure to grow sales will result in insolvency. I thought the likelihood of such a failure was
extremely low; now, it looks like a real possibility.
It’s clear I don’t understand this business. So, personally, I’m unwilling to own it. I can’t
assess the risks of owning shares in Overstock.com. If I can’t assess the risks, I can’t own the
stock – it’s that simple.
However, I can’t, in good conscience, encourage others to sell at levels that present the
possibility of great rewards if Overstock achieves merely mediocre business results.
Furthermore, I had no intention of writing about this stock until the fourth quarter results were in,
because I believed those results would be the only ones I could learn anything meaningful from.
I still believe the fourth quarter results will be the most important piece of information we
receive. But, that would mean a long wait.
There is certainly no assurance that Overstock’s share price will decline. In fact, being short
the stock (today) presents greater risks than being long the stock.
If some evil omnipotent were to force me to choose between being short the stock by x dollars or
being long the stock by x dollars, I would certainly choose the latter. It’s a lot easier to sleep
when your liability is limited. A short stake creates an unlimited liability (in dollar terms). So,
where a huge price movement in some direction is almost certain (as it is in the case of
Overstock), it’s safer to take the long side. Here, my point has nothing to do with short-term
price movements. It has to do with Overstock’s precarious position.
Overstock will either survive or it will fail. If it survives, it would be nearly impossible for the
stock to trade much below this level. In fact, if the business survives, the stock price will very
likely have to rise by several hundred percent in any market. Obviously, if the business fails, the
stock will be worthless.
Is Overstock a good bet? I don’t know. Is it a safe bet? No.
Related Reading
Overstock.com (OSTK)
An Analysis of Overstock (OSTK)
On the Rationale for the Overstock Post
On Overstock’s Fourth Quarter
 URL: https://focusedcompounding.com/on-overstocks-terrible-third-quarter/
 Time: 2006
-----------------------------------------------------
On Lenox
Below is a letter from Mr. John L. Morgan, beneficial owner of approximately 7% of Lenox
(LNX), to Ms. Susan E. Engel, Chairwoman and CEO of Lenox.
Dear Susan,
When your board offered me a directorship on September 18, 2006, we discussed the reasons
that made it unacceptable. At that time, I reiterated that I could best serve the shareholders of
Lenox Group by assuming a leadership role on the Board of Directors and playing an active
role in formulating and guiding the strategic direction of the Company. Furthermore, I
expressed my intention to not make changes in the management or Board of Directors. My views
were based on information I had at that time.

The Board’s rejection of my offer to help the Company create a successful strategy has given me
a different perspective. I now feel that the Board has decided to pursue a course of action that is
not in the best interests of the shareholders and is a continuation of the strategies that have
failed to create value over the past ten years.
The management team and Board of Directors continue to behave like the Company is a large,
successful Company that has margin for making more mistakes. I do not agree. My offer to assist
the Company in changing its strategy to benefit shareholders has been rejected although I
proposed to work with the existing management and Board of Directors. You have made your
position clear and I hope this letter will do the same for me and other likeminded shareholders.
Very truly yours,
John L. Morgan
The Ownership Situation
First, let me explain the ownership situation. The reporting persons are John L. Morgan, Kirk A.
MacKenzie, Jack A. Norqual, and Rush River Group. Rush River Group is a limited liability
corporation (LLC) of which Morgan, MacKenzie, and Norqual are members.
Rush River was formed in December 1998 in Minnesota and “its principal business activities
involve investing in equity securities of privately owned and publicly traded companies, as well
as other types of securities.” As far as I can tell, the only members of Rush River are the three
aforementioned men: Morgan, MacKenzie, and Norqual.
According to a recent SEC filing, Morgan beneficially owned 6.1% of the outstanding shares of
common stock in Lenox, Rush River owned 0.79%, MacKenzie owned 0.07%, and Norqual
owned 0.07%.
Please keep in mind that this 7% stake in Lenox is controlled by Mr. Morgan; but, not Winmark
Corporation (WINA), a publicly-held franchisor of retail stores. This is an important distinction
to keep in mind (especially since Winmark is a public company).
Morgan is the Chairman and CEO of Winmark; MacKenzie is the Vice Chairman. However,
their stake in Lenox has nothing to do with Winmark. In fact, last time I checked, Winmark did
not have any material investments in marketable securities.
The reported position amounts to 989,300 shares of Lenox. Shares of Lenox last closed at $6.23
a share. So, the position would be worth a little over $6.16 million. Since Winmark only has a
market cap of $126 million, I want to make it clear Winmark does not have a position in Lenox –
Morgan does. He just happens to be the Chairman and CEO of Winmark. I hope this clears up
any possible confusion about Winmark.
Lenox
Now, I can move on to discussing the truly interesting aspect of this news, Lenox itself.
Lenox is the result of a September 2005 merger between Department 56 and Lenox
Incorporated. Prior to the merger, Department 56 was known for its “Village Series of
collectible, handcrafted, lighted ceramic and porcelain houses, buildings and related accessories
that depict nostalgic scenes”. That last sentence was taken directly from the company’s 10-K,
simply because I couldn’t write a better description myself. I assume most of you have seen the
series. Even if you haven’t, I’m sure you can imagine the concept of a little porcelain Christmas
scene.
Obviously, the Lenox name is much better known than the Department 56 name. Therefore,
when Department 56 acquired Lenox, it changed its name to Lenox.
In its 10-K, the company calls the Lenox acquisition a “transformational event”. This term is too
often applied to mergers that are far from transformational. In this case, however, it’s a perfectly
accurate description.
Whether the transformation is for better or worse is debatable; however, the fact that the merger
has transformed the company is not debatable. To put the size of this transaction in perspective,
consider this: Today, Lenox (the combined company) has a market cap of $88 million. In
September 2005, Department 56 paid $204 million to acquire Lenox Group. Immediately, this
should tell you two things. One, the acquisition was probably quite large relative to the existing
business. Two, the combined company’s stock price has tanked.
Both of these statements are true. Even when shares of Department 56 were a lot more
expensive, the Lenox acquisition was very large relative to the existing business when
considered from the perspective of market cap, enterprise value, sales, and just about any other
meaningful measure of the size of a business.
Obviously, the combined company’s stock price has been falling hard since the merger. After all,
the enterprise value of the entire company is not much greater than the amount Department 56
paid for the Lenox business.
The market is assigning a value of close to zero to the newly acquired Lenox business. This
is remarkable considering the fact that Department 56 rarely traded at a lofty multiple when it
was a stand alone business. In fact, the company’s shares often traded at a P/E multiple in the
high single digits or low double digits throughout the past decade.
The New Business
You probably already know what Lenox does. If you don’t, a quote from the company’s 10-K
does a good job of explaining what the newly acquired business does:
“The company sells dinnerware, crystal stemware and giftware, stainless steel flatware, and
silver-plated and metal giftware under the Lenox and Gorham brands. Dansk is the company’s
contemporary tabletop, houseware and giftware brand. The company sells premium causal
dinnerware and fine china dinnerware, giftware and collectibles under the Lenox trademark,
and sterling silver flatware and sterling silver giftware under the Gorham and Kirk Stieff
trademarks. The company believes that it is the largest domestic marketer of fine tabletop
products.”
I’m sure you noticed a bad omen in the above paragraph. One of the company’s brands (Dansk)
is described as the company’s “contemporary” brand to differentiate it from the other two
brands. Obviously, having fine products that are not considered contemporary is a bit of a
problem.
In fact, it may be a very large problem in the years ahead. Overall, it seems the market is moving
away from formal dinning and towards more upscale casual dinning. This is not a new
phenomenon; nor, is it likely to be a short-lived one.
On the other side of the scales, you do have the simple, undeniable fact that the company has one
of the best brand names in its industry. It is also a big player in a very small industry. Those are
both advantages that are difficult (if not impossible) to duplicate. For a $200 million business,
Lenox has a lot of history – and perhaps, a lot of potential.
The Old Business
A big part of the problem with the performance of the company’s shares (both over the short-
term and the long-term) has been the performance of Department 56. In 2005, sales from
Department 56’s Village Series declined 21%, “which was consistent with the longer term trend”
according to the company’s 10-K. In fact, sales had clearly been declining each and every year
from 1999-2005. Furthermore, sales in 2004 were substantially less than sales in 1996. So, even
though there wasn’t a continuous, straight-line decline in sales over the past ten years, the
general trend for sales of the Village series has been decidedly negative for a full decade now.
To combat the “substantial attrition of the Gift and Specialty channel” the company has settled
on two strategies intended to both “offset the decline of the Village business” and “to grow
revenues long term”. Those strategies are “expanding the company’s channels of distribution
outside its traditional Gift and Specialty channel” and “expanding the company’s product
offering to include year-round gift products.” The former strategy sounds promising; the latter
strategy sounds implausible.
Lenox is already moving to implement both strategies. In fact, the company made a small
acquisition that should help expand Lenox’s year-round product offerings. But, I remain highly
skeptical of attempts to transform the gift products business into anything other than a highly
seasonal business.
The Acquisition
At the time it was announced, I thought the Lenox acquisition sounded like an interesting move
for the company. Department 56’s operations looked lean; the operations at Lenox did not.
Furthermore, the price paid for Lenox didn’t look unreasonable, especially when compared to the
kinds of prices many public companies have often paid to make such large (“transformational”)
acquisitions.
In September 2005, Department 56 acquired Lenox in a $204 million deal (including $7.6
million in transaction costs). Department 56 funded the acquisition “through a $275 million
senior secured credit facility consisting of a $175 million revolving credit facility and a $100
million term loan”.
As mentioned earlier, the combined company adopted the more recognizable Lenox name.
Restructuring
As a result of the merger, the company closed approximately half of the stores belonging to
its new Lenox subsidiary. In total, the company closed 31 Lenox retail stores. As of February
1st, 2006, this left the company with only 36 retail stores. Six stores were operated under the
Department 56 name; the remaining 30 stores were operated under the Lenox name.
After the merger, the company consolidated some of its operations. For instance, Lenox sold its
Langhorne, Pennsylvannia facility when it moved certain operations to Bristol, Pennsylvannia.
The company has used the cash proceeds of such sales to pay down debt incurred in the Lenox
acquisition.
New Concept Stores
Lenox plans to launch a new mall-based chain of stores that will sell all of the company’s brands
(Department 56, Lenox, Gorham, and Dansk). The company plans to open three “All The
Hoopla” stores during 2006. A fourth store will be opened in 2007.
Opportunities
The combination of Department 56 and Lenox presents several interesting opportunities. Perhaps
most importantly, there’s the hope that Lenox will become a leaner operation. Aside from any
cost-savings made possible by the merger, there is also the simple fact that Department 56 was
always a leaner operation than Lenox, and that the management at the new company might be
more adept (or more determined) to keep costs down.
There is also some promise to the idea of selling all of the company’s brands together. To a large
extent, the distribution channels are similar. The “All The Hoopla” concept proves the company
is committed to this bundling of its products. However, it’s hard to see how the company’s
products are going to be much of a draw on their own. Is there really enough demand for these
Lenox operated retail stores? The company’s current plans call for a very limited launch. So, the
price of failure would not be very great. Obviously, a success here would greatly benefit the
company in the long run.
Conclusion
Lenox is an interesting opportunity. The business looks very cheap based on averages of past
sales, EBIT, pre-tax earnings, etc. However, Lenox is now an entirely different company. The
old Department 56 business faces rapidly declining sales. Neither Lenox nor Department 56
looked like a very promising business at the time of the merger. Today, they don’t look a whole
lot more promising together.
On the other hand, it’s important to look past the company’s recent results (which include a large
write-off). It will take time to see the full effects of the merger. At present, it’s difficult to judge
either company independently, because of the acquisition.
Still, this is clearly a cheap business by most measures. There are problems at Lenox (as there
were problems at Department 56). But, if the business can be run right, it should reward
shareholders who buy at today’s extraordinarily low levels.
Morgan’s letter presents both the hope that there will be change and the realization that such
change will not be easy. Clearly, the company’s past performance has been unacceptable. The
stock has never been as cheap as it is today; but, the problems have been just as bad.
Lenox offers an interesting opportunity for patient investors. Nonetheless, being a Lenox
shareholder is certain to frustrate you even if it does eventually reward you.
There are several good sources for stories like this. One such source is the StreetInsider.com
13D tracker (which reported this story yesterday).
 URL: https://focusedcompounding.com/on-lenox/
 Time: 2006
-----------------------------------------------------
On Nintendo
Even before last week’s announcement from Sony (SNE), it seemed nearly certain that
company’s dominance in the PlayStation 2 generation of video game consoles would give way to
a much more level playing field for the PS3 generation. This time around, Sony faces much
stiffer competition from both Microsoft (MSFT) and Nintendo (NTDOY).
While the Nintendo name is most closely associated with a video game platform (the NES), the
company’s real focus has always been the games rather than the platform. Herein lies the true
distinction between Nintendo and its two larger rivals. Nintendo seeks to make good games.
Microsoft and Sony seek to control a distribution channel.
Nintendo is the only company among the three console makers that began life as an
entertainment company – and it shows. Microsoft is known for software; Sony is known for
hardware; and Nintendo is known for games.
American gamers are well acquainted with the Nintendo brand; but, American investors
generally know very little about the company. That’s unfortunate, because despite all the
attention given to Sony and Microsoft’s video game operations, Nintendo is the ultimate pure
play video game company.
Nintendo is big. The company surpasses U.S. video game publishing giant Electronic Arts
(ERTS) in sales, earnings, and market cap. On the last count, some may argue that Nintendo
only has a larger market cap than EA, because its stock price has risen sharply over the past year,
while EA’s share price has actually declined. However, there’s a much simpler explanation.
Nintendo has a larger market cap than Electronic Arts, because Nintendo (the business) is worth
more than EA (the business). The run-up in Nintendo’s stock price may be entirely due to
improved investor perceptions of the company’s future prospects as a result of the good press
surrounding Nintendo’s soon to be launched console, the Nintendo Wii.
Regardless, such an increase in the price of Nintendo’s shares was justified by the rather low
value the market had previously placed on Nintendo’s business. The same can’t be said of
Electronic Arts. Even after underperforming the S&P; 500 over the last three years, EA’s stock
price remains at levels that are nearly impossible to justify using any form of rational thought.
So, Nintendo really is the world’s largest pure play video game company.
Nintendo is an interesting business to write about from an investor’s perspective for several
reasons. The company operates in an exciting industry with excellent long-term prospects. It’s
more reasonably priced than many public companies in that industry (although that’s not saying
much). It’s a truly unique business (with a unique past), and it has a clear vision of what it is and
what it isn’t. Obviously, Nintendo’s tremendous intellectual properties add to its appeal both as a
subject of a post and as the object of an investor’s interest.
Nintendo has been a good steward of its intellectual properties. It’s been very careful to
protect the image of its most beloved characters. In fact, some would say the company has
occasionally been too protective of its strongest franchises.
For instance, between 1994 and 2002 there were no new Metroid games, despite the popularity
of that franchise. The benefit of such a strategy is that when Metroid Prime was released in 2002,
it received extraordinary reviews and sold over a million units. The downside to this approach is
obvious. Nintendo effectively surrendered the revenue (almost certainly more than $100 million)
that could have been milked from the franchise throughout the latter half of the 1990s.
It’s a rare and valuable property that can benefit from spending some time “in the vault”.
Nintendo has several such properties. For this reason, Nintendo has more in common with
companies like Disney (DIS) and Lucasfilm than it does with manufacturers of consumer
electronics.
Nintendo is an entertainment company; not an electronics company. Console sales are

inextricably intertwined with games sales. Hardware sales account for a large portion of
Nintendo’s total sales; however, hardware sales don’t drive a large portion of Nintendo’s total
sales.
At Nintendo, the games sell the consoles. Of course, the console itself can affect the gameplay
experience in its role as a platform. For instance, the Wii is expected to be a differentiating
gameplay factor when it launches later this year. Whether it’s a positive or negative
differentiating factor, we don’t yet know. But, the Wii will certainly help set Nintendo’s games
apart from their competition.
Third party publisher support for the Wii has been the subject of much debate and speculation.
Nintendo’s consoles have enjoyed less support from third parties than the competing consoles,
because Nintendo has been less willing to work with third parties on their terms.
While many publishers are now interested in releasing titles for the Wii, there is a new and
substantial impediment to successful third party titles. Games will have to be designed around
the Wii. In the past, it was easier for third parties to offer titles for Nintendo’s consoles, without
targeting that console in particular. Now, it will be a lot harder to do that. Expect a few botched
attempts early on.
A Long, Slow Decline
Nintendo’s position in hardware has been declining for well over a decade now. In fact, the
zenith of Nintendo’s fortunes in the console business was the NES itself (launched in 1985). It’s
been downhill since then. Nintendo launched the Nintendo Entertainment System (NES) in 1985,
the Super Nintendo Entertainment System (SNES) in 1991, the Nintendo 64 (N64) in 1996, and
the GameCube in 2001.
Here are the worldwide unit sales for these four systems as of March 31st of this year:
NES: 61.9 million
SNES: 49.1 million
N64: 32.9 million

GameCube: 20.9 million
That’s not a pretty trend. To add injury to injury, the number of games sold per console had been
steadily declining until the GameCube dramatically reversed that trend.
Here are the number of games sold per console for each of the four systems:
NES: 8.08 games
SNES: 7.72 games
N64: 6.84 games
GameCube: 9.05 games
GameCube
The above GameCube number is especially interesting, because sales of GameCube games in the
Americas have been extraordinarily strong considering that console’s modest installed base
relative to what previous Nintendo consoles had enjoyed.
The GameCube has performed much better in the U.S. than it has elsewhere. The Americas
account for 58.37% of worldwide GameCube unit sales while Japan accounts for merely 19.14%
of worldwide sales. In the Americas, the number of games sold per GameCube is approximately
10; while in Japan it is only 7.
While a difference of 10 games per system to 7 games per system may not sound that important,
it is a far greater difference in the number of games sold per system between geographic regions
than exists with any other current Nintendo platform. As a result, the Americas account for
nearly two out of every three games sold for the GameCube.
Nintendo DS
At first, it appears the situation is reversed with the Nintendo DS. Japan accounts for more than 4
out of every 10 sales of both DS games and the handheld platform itself. However, at the
beginning of this year, the ratio of software to hardware sales was still a bit higher in the
Americas than it was in Japan. That’s the case for all of Nintendo’s platforms, although the
games per platform gap varies from very wide (GameCube) to quite narrow (DS).
Game Boy Advance
Nintendo’s Game Boy sales have always been impressive. The Game Boy Advance, which
launched in 2001, has sold more than 75 million units and more than 325 million games. That
doesn’t include sales of the various Game Boys of the 20th century (the original launched in
1989) which have sold well over 100 million units and 500 million games.
The Game Boy has helped Nintendo’s financial results, because it has been a much more
consistent performer. Taking part in the “console wars” is expensive, time-consuming, and risky.
The risks are incurred upfront; the rewards come on the back half of the journey. Having the
support of regular revenues derived from the Game Boy certainly doesn’t hurt when you’re
involved in such an uncertain undertaking as launching a new console every half decade or so.
Financial Performance
Considering the industry it operates in, Nintendo has been a solid performer. The company
consistently turns a profit, which isn’t easy when there aren’t other divisions to smooth out any
of the bumps brought on by launching new consoles and essentially launching new products
constantly.
After all, that is the greatest difference between the video game business and almost every other
business around. All your sales are coming from “new” products, even if they are variations on
the same theme or sequels within an established franchise. The lifecycle of each product is
unnervingly similar to the lifecycle of a fruit fly.
So, the business depends upon doing an adequate job a great many times. As a general rule,
businesses where you only have to do one really smart thing every couple of decades are better
bets.
Conclusion
Apparently, most Japanese gamers now believe the Nintendo Wii will come out on top in this
round of the console wars. That’s a surprising and somewhat disturbing finding. If the Wii really
is a revolution in the making, I suppose they’ll be right. But, I still think this is Sony’s race to
lose.
What will the price of a PS3 be in December of 2007? Until I know that, I can’t predict anything
other than a much tighter race this time around.
What about Nintendo as an investment? The stock isn’t expensive, if you expect Nintendo
will win the next round of the console wars. Otherwise, it’s difficult to value. There are two big
issues: the Wii and handheld gaming.
I’m not convinced there are going to be serious competitive threats to Nintendo’s position in
handheld gaming coming from high-tech cell phones that are quickly becoming the Swiss Army
Knife of the 21st century. I just don’t think the three great obstacles of clumsy controls, a lack of
focus from the manufacturer, and a lack of interest from the user are going to be easy to
overcome.
Nintendo is in the best position of any company to profit from handheld gaming in the
future. They will face competition; but, they will start with the advantage of knowing what their
product is (a game machine).
So, if you are comfortable with Nintendo’s position in handheld gaming and you truly believe in
both the company and the Wii, shares of Nintendo would be a reasonable long-term investment
at this price. However, even considering the large amount of cash and securities on the balance
sheet relative to Nintendo’s market cap, Nintendo isn’t a “value” style purchase based on past
performance alone. Buying shares at the current price is a bet on a brighter future.
While I like Nintendo’s future prospects, it’s usually safer to bet against a revolution. So, I’d
have to say Nintendo is a very interesting business that’s priced a bit too high to be a very
interesting investment.
Related Reading
On the PlayStation 3 Delay
 URL: https://focusedcompounding.com/on-nintendo/
 Time: 2006
-----------------------------------------------------
On Blyth
Blyth (BTH) calls itself a “home expressions company”. Most people call it a candle company.
Neither description is entirely accurate.
Blyth can rightly be called the world’s largest scented candle company, because larger
competitors like S.C. Johnson and Sara Lee (SLE) are primarily engaged in other businesses.
Like its smaller rival The Yankee Candle Company (YCC), Blyth is primarily a scented candle
company. However, unlike the Yankee Candle Company, Blyth has substantial non-candle
related operations – hence the “home expressions” designation.
I’m not sure what a home expression is; but I’m pretty sure coffee doesn’t qualify. From that fact
alone we can safely say Blyth isn’t really a home expressions company (last year, Blyth acquired
Boca Java, an online retailer of coffee, tea, and hot chocolate). Blyth may not be a pure play
scented candle company or a pure play “home expressions” company; but, that doesn’t mean it’s
merely a hodgepodge of unrelated businesses.
There is a method to Blyth’s madness. From the manufacturer’s perspective, candles,

ceramics, frames, vases, coffee, and gourmet food are very different products. But, from the
customer’s perspective, they serve a similar purpose. Essentially, Blyth sells personal
indulgences to women at affordable prices. That’s a big business in the U.S., Canada, and
Europe. It also happens to be a good business.
Profitability
Since 1998, Blyth has had an average return on assets of 10.33% and an average return on
equity of 18.55%. Regular readers of this blog know that I like to use a third profitability metric
from time to time. One of the best ways to measure the inherent profitability of a business
(independent of its current capitalization structure) is to use the pre-tax return on non-cash assets
(PTRONCA). Over the past decade, Blyth has had a PTRONCA of about 19.21%, which is very
good – although far from great.
To put that 19.21% PTRONCA into perspective, think of it this way: independent of its
capitalization structure, Blyth generated a little over nineteen cents for every dollar invested in
the business (before taxes).
Essentially, this means that if Blyth hadn’t utilized any debt whatsoever it would have had a
return on equity of roughly 12% (after taxes). Although a 12% return on equity doesn’t sound all
that impressive, achieving a 12% ROE without using any debt would actually represent a solid
performance for most public companies under most economic conditions.
Of course, over the last decade Blyth actually averaged a much higher return on equity (18.55%).
During this period, Blyth utilized a material (but far from egregious) amount of debt. As a result,
the company surpassed its own stated goal of achieving a 15% annual return on equity.
Based on Blyth’s past ROA and PTRONCA, it appears to be a good business. If we put aside
GAAP accounting for a moment and look at the economic earnings of the business, we’ll see that
Blyth has actually performed a bit better than its reported net income figures suggest.
Cash Flow
Blyth’s free cash flow margin was excellent in each of the last several years. For the past five
years, the company’s FCF margin has ranged from 5% to 12%. Many businesses would be
satisfied with a 5% free cash flow margin. So, even when Blyth was at the bottom of this range,
it was generating plenty of free cash flow.
Blyth’s free cash flow has been very high relative to its reported net income. Over the past
ten years, Blyth had an average reported net income of $70.2 million versus an average free cash
flow of $79.5 million.
Unfortunately, this gap would be entirely erased if free cash flow was reduced by the
amount Blyth has spent on acquisitions. From a shareholder’s perspective, such a reduction is
appropriate. Acquisitions eat up cash in exactly the same way an investment in a new plant does.
However, it’s worth considering the two lines separately, because it’s much easier to match cash
outflows with specific acquisitions than it is to match cash outflows with specific investments in
an existing business. This is especially true when looking at a company like Blyth, because some
of the acquisitions are in different businesses (and different geographic locations).
Blyth has been able to consistently generate quite a bit of free cash flow. Over the past ten
years, cash flow from operations (CFFO) has averaged $93.65 million. The latter half of the past
decade has been even better as a result of sales growth. During the past five years, Blyth’s CFFO
has averaged $142.64 million.
During that same period, free cash flow averaged $125.18 million before acquisitions but only
$60.52 million after acquisitions – which is even less than the company’s average reported net
income of $72.16 million during the same period.
What does all this mean? For one, it means Blyth’s free cash flow has grown far more than its
net income over the past ten years. This isn’t surprising, considering Blyth invested much more
heavily in cap-ex from 1997-2001 than it did from 2002-2006. That’s normally a good sign, but
there are a few problems here.
Slowing Sales
Blyth’s sales growth has slowed considerably during the last five years. Before 2001, the
company had been growing sales at 20% or more a year – without a lot of spending on
acquisitions. After 2001, sales growth slowed to the mid single digits, despite an increase in the
amount of cash being used for acquisitions. Slowing sales growth is clearly a concern. However,
it may not be entirely specific to Blyth.
During the early and mid 1990s, the growth in scented candles within the United States was
tremendous. By 2000, more than 75% of all candles sold in the U.S. were scented. At that time,
Blyth estimated that only 5% of all candles sold in Europe were scented. So, a very large part of
the growth in scented candles within the U.S. was simply a one-time migration from non-scented
candles to scented candles.
In an August 1999 interview with The Wall Street Transcript, Blyth’s Chairman & CEO,
Robert Goergen, illustrated the degree of penetration within the U.S. by citing a study conducted
by his company:
“Blyth has done research the last two years that indicates that when asked of women ‘have you
purchased candles in the last six months?’ 67% of a random sample will say that yes they have.
That percentage ranks with women’s purchases in the last six months very close to lipstick and
face makeup, which means that candles are a fairly broad and relatively routine part of
everyday life.”
(Interview)
Once a product has achieved such penetration, it is inevitable that the rate of sales growth
will slow. Sales of candles are limited by the number of women in the United States, because
men will not buy scented candles (except perhaps as gifts for women).
So, once more than two-thirds of American women say they’ve recently bought a candle and
more than three-fourths of all candles sold in the U.S. are scented, the fact that the growth in
sales of scented candles is slowing should be seen as inevitable rather than remarkable.
It’s hard to track total sales of scented candles, because they account for a very small part of a
great many different retailers’ sales. Also, while Blyth and Yankee Candle are public companies,
many of their competitors are privately held. The rate of sales growth at both Blyth and Yankee
Candle has slowed noticeably in the last few years. So, Blyth’s recent experience is clearly not
unique.
Troubled Times
Morningstar’s website lists Blyth’s stock type as “distressed” – which strikes me as a tad
extreme. However, there’s no denying Blyth is now facing some of the toughest challenges it has
had to contend with in many years.
Blyth’s Chairman and CEO began his most recent letter to shareholders as follows:
“Fiscal 2006 was a very challenging year for Blyth – in many ways, the most challenging in our
nearly 30 year history. Sales growth across North America and Europe was difficult to achieve
as consumers, faced with record energy prices, had fewer discretionary dollars than in years
past. Moreover, the impact of double-digit cost increases in all of our major purchased
commodities and freight had a dramatic impact on our financial performance.”

Later in his 2006 letter to shareholders, Mr. Goergen put the increased commodities cost into
perspective:
“Let me offer some context on what the doubling in price of a barrel of oil means to Blyth. The
cost of paraffin wax, a byproduct of the petroleum refining process, increased approximately
20% over the past year, as strong demand continued while capacity declined following the
impact of hurricanes on Gulf refineries. Approximately 100 basis points of Blyth’s fiscal year
2006 gross margin decline resulted from higher paraffin, freight, and other commodity costs.”
Blyth has three stated long-term corporate goals:
– 5-10% annual sales and earnings growth

– 10-12% operating margins
– 15%+ return on equity
For the year, Blyth experienced a slight decline in sales and a steep decline in earnings. The
company’s operating margin was 3.6% (well shy of the 10-12% goal). Blyth’s return on equity
also plunged, falling from 17.42% to 4.90%. In other words, the company fell far short of each of
its three stated goals during fiscal year 2005.
Second Quarter
During the current fiscal year, Blyth’s results have only worsened. On August 31, 2006, the
company reported a second quarter operating loss of $27.7 million compared to a $16.9 million
operating profit in the year ago period. All of last quarter’s operating loss (and most of the
difference between this year’s results and last year’s) was attributable to a non-cash goodwill
impairment charge of $36.8 million.
Last year’s second quarter was also helped by a $5.5 million reserve reversal. Excluding these
items, second quarter operating profit was $9.0 million in the second quarter of this year versus
$11.4 million in the second quarter of last year.
Blyth also took a $68.6 million loss on the discontinued operations of its European wholesale
business. In all, Blyth reported a net loss of $89.4 million during the second quarter of this year
versus net income of $4.2 million during the year ago period.
Net sales for the last six months were essentially flat. Sales for the first half of the fiscal year fell
by 0.40%, dropping from $545.1 million a year ago to $542.9 million this year.
The Good News
The company is in much better shape than these recent earnings reports suggest. Blyth’s
restructuring efforts have obscured its relatively normal operating results. Excluding the
restructuring, Blyth’s performance has still been far weaker recently than it had been from 1997-
2001.
However, the company will not continue to report losses for years to come. Even over the last
twelve months, Blyth has generated nearly $100 million in cash from operations and over $80
million in free cash flow. So, the net loss is actually somewhat deceptive when considering the
company on a continuing basis. These losses will not continue.
The Bad News
Blyth does face real challenges – and not just the short-term challenges presented by higher
commodity costs.
Blyth also faces the prospect of declining direct selling revenue within the U.S. Over the last
year, the number of independent sales consultants in the company’s U.S. PartyLite business fell
by more than 7%. There were approximately 24,000 independent consultants this year versus
26,000 a year ago.
This decline in the number of active independent sales consultants caused a 5% decline in sales
for the company’s U.S. direct selling operations. While the number of consultants in Canada was
flat and the number of consultants in Europe was actually up this year, no one would be surprised
by a continuing trend towards fewer active independent consultants and thus lower sales within
the direct selling business as a whole and the U.S. segment in particular.
Direct Selling
Blyth has long been involved in the direct selling business. The company acquired PartyLite in
1990. That was four years before Blyth’s 1994 IPO; so, PartyLite has been a part of Blyth for the
entirety of that company’s history as a public company.
Direct Selling accounts for approximately 44.7% of Blyth’s total revenues. The company’s
PartyLite subsidiary has more than 45,000 active independent consultants selling in the U.S.,
Germany, Canada, the U.K, Austria, France, Switzerland, Finland, Australia, and Mexico.
Approximately 24,000 of these 45,000 consultants sell within the United States. These
consultants sell scented candles and other accessories via the party plan method of in-home
selling.
In addition to its PartyLite subsidiary, Blyth now owns two other party plan marketers: Two
Sisters Gourmet and Purple Tree. Two Sisters Gourmet is a gourmet food company. Purple Tree
is a crafts oriented business. At present, these businesses incur multi-million dollar operating
losses as Blyth invests to grow them into larger, more profitable businesses.
Regardless of their current operating performance, these businesses do seem to be a good fit with
Blyth’s existing PartyLite business and appropriate new ventures for the company to pursue. Of
course, only time will tell if any of these ventures develops into the kind of larger, more
profitable direct selling business Blyth is hoping for.
Valuation
Blyth’s current price-to-earnings, EV/EBIT, and other such ratios are meaningless, because of
the company’s recent losses.
During the last ten years, Blyth has had an average EBIT of $113.47 million. During the last five
years, Blyth’s EBIT has averaged $113.77 million – essentially the same as the company’s ten
year average EBIT.
Blyth’s current enterprise value-to-EBIT ratio is very high, because the company only reported
$32.03 million in earnings before interest and taxes during fiscal 2006.
Blyth’s EV/EBIT ratio would be much more reasonable if computed using the average
EBIT from past years. Depending on exactly how you calculate both the company’s
current enterprise value and its average EBIT from past years the ratio will vary slightly.
Regardless, this “normalized” EV/EBIT ratio would be around 8.7.
That’s a fairly low EV/EBIT ratio, but not an absurdly low one. To put it in perspective,
invert the ratio to get the EBIT/EV yield (essentially a pre-tax earnings yield comparable to the
yield on a taxable bond). An EV/EBIT ratio of 8.7 translates into an EBIT/EV yield of 11.49%.
Obviously, that’s a good yield – especially in the current low yield investment environment.
However, there are better yields out there.
To be fair, the average EBIT numbers I gave may be unduly conservative as normalized
numbers, because they include Blyth’s abysmal EBIT of $32.03 million in 2006.
A better normalized figure would probably be Blyth’s average EBIT from 1999 – 2005.
Those seven years may be the most representative, because they neither penalize Blyth for its
extraordinarily poor 2006 performance nor for its far lower total sales prior to 1999 (remember,
Blyth had once been quite the growth story).
During the seven year period beginning in fiscal year 1999 and continuing through fiscal year
2005, Blyth’s average EBIT was $134.40 million. If this average were used as Blyth’s
normalized EBIT, Blyth’s EV/EBIT ratio would come in a bit lower at 7.34. That translates into
an EBIT/EV yield of approximately 13.63%.
Buying a Company vs. Buying a Stock
As a business, Blyth is clearly underpriced. If I were drawing up a list of businesses selling for
less than they’re worth, Blyth would be near the top.
If you could buy the entire business by merely paying the current enterprise value, you’d have
yourself a very nice deal. But, you can’t. You can only buy small pieces of the business via the
stock market.
No one could buy the entire business at the price at which each piece is selling in the open
market. So, in that respect, you’re actually getting a better bargain than you would if you had to
acquire the entire business.
Unfortunately, there’s a downside. Buying the entire business is an attractive opportunity,

because the acquirer could use the company’s cash flow as he saw fit. Buying a small piece of
Blyth in the stock market doesn’t offer this kind of control over the allocation of capital. That’s
potentially a very big problem, because cash can be squandered.
Has Blyth squandered cash in the past? Not really. While it has acquired other companies (and so
far has little to show for some of those acquisitions), it has generally made these deals at
reasonable if not rock bottom prices. There are many other public companies guilty of paying far
more for far less.
On the other hand, from the perspective of a 100% owner, Blyth’s free cash flow has not been
successfully reinvested in the business during the last several years. The returns produced by
additional capital (in the form of acquisitions financed with free cash flow) have been meager at
best – at least in terms of creating additional free cash flow.
Over the last five years, Blyth spent $323 million on acquisitions, $230 million on share
repurchases, $86 million on dividends, and $66 million on capital expenditures.
Right now, the best use of cash would be to buy back stock. At these prices, investing in
Blyth makes a lot more sense than investing in another business via an acquisition. Hopefully,
Blyth’s management recognizes that fact and will act accordingly.
Conclusion
But, should you invest in Blyth? As always, that’s ultimately a personal decision. A lot of people
don’t want to invest in companies in the midst of such upheaval. That’s fine.
However, failing to see the value in Blyth, simply because of its most recent reported results is
not fine. In fact, it’s a very common and very costly mistake.
You will always overweight the last datum in a series. It’s nearly impossible not to. Just as it’s
nearly impossible not to believe the current economic cycle will be different from all the rest.
If Blyth’s most recent results occurred five years ago, you would see them for what they are
– an aberration. But, because they are the company’s most recent results (and the very last bit
of information you have to go on) you’ll likely see them as the beginning of a new and terrible
trend.
Human history favors the interpretation that years of past data are more informative than a single
year of “current” data. Unfortunately, human history also favors the interpretation that this fact
will only be obvious in hindsight.
Future operating results will determine whether Blyth is a good buy today. I don’t know
what those operating results will be. However, I do know that they don’t have to be particularly
good to justify buying the stock at its current price.
Considering how great Blyth’s cash generating ability is relative to its current enterprise value,
an average operating performance from Blyth will lead to above-average returns for the
company’s shares.
 URL: https://focusedcompounding.com/on-blyth/
 Time: 2006
-----------------------------------------------------
On Pilgrim’s Pride and Gold Kist
On Friday, integrated poultry producer Pilgrim’s Pride (PPC) publicized its offer to acquire

smaller rival Gold Kist (GKIS) for $20 per share. The offer values Gold Kist at roughly $1.16
billion including the assumption of $144 million in debt. The $20 a share cash offer represented
a nearly 55% premium over Friday’s closing price of $12.93.
Since the offer was made public, the market price of Gold Kist’s shares has risen to $19.88.
Going Public
On Friday, Pilgrim’s Pride put out a press release that included the text of a letter delivered to
Gold Kist’s board (that same day). In the release, Pilgrim’s Pride claimed it has “substantial
current liquidity” and that its financial advisors have given the company “further assurances”
that Pilgrim’s Pride has the ability to finance the transaction.
The release also suggested the transaction would be accretive to EPS in the first full year
following the merger; the combined company would enjoy approximately $50 million in
anticipated synergies. During 2005, Gold Kist had sales of over $2.3 billion while incurring
Selling, General, and Administrative costs (SG&A;) of just $112.2 million. So, these anticipated
synergies would likely come from the cost of goods sold line. Pilgrim’s Pride suggested as much
in the release by stating such synergies were “expected to come primarily from the optimization
of production and distribution facilities and cost savings in purchasing, production, logistics, and
SG&A;”.
A Fair Price?
The letter to Gold Kist’s board is generally unremarkable, being full of the usual platitudes such
as “value creation for our respective shareholders, employees, business partners and other
constituencies”. Considering the price at which Gold Kist currently trades, the limited expected
synergies, and the fact that the current proposal is for an all cash deal, it seems far more likely
Pilgrim’s Pride is looking to create value for its shareholders by capturing the wide spread
between the market price of Gold Kist and the company’s value to a 100% owner.
Pilgrim’s Pride shouldn’t be faulted for trying to exploit such an opportunity. However,
investors shouldn’t view the deal as a value creating combination when it is clearly an
opportunistic attempt to buy something for less than its worth.
The letter did state that Pilgrim’s Pride is “willing to discuss alternative forms of consideration,
including a mix of cash and Pilgrim’s Pride common stock”. We’ll see what this means in the
days ahead.
I suspect it means some small amount of stock as a sweetener rather than a radically
different mix of cash and stock. The reason for this is obvious. Shares of Pilgrim’s Pride are
probably worth a lot more than their quoted price; so, a deal consisting of a large amount of
stock in place of cash would actually be a big step up in the true amount of economic
consideration given in exchange for Gold Kist’s operations.
Valuation
Now, some may argue that this deal is aimed in large part at capturing synergies rather than
exploiting a difference between the price and value of a competitor. If you look at chicken
producers Pilgrim’s Pride, Gold Kist, and Sanderson Farms (SAFM), you’ll see that the current
price-to-sales and price-to-book ratios aren’t that low relative to where these stocks have traded
in the past.
That’s true. But, they’ve been quite cheap in the past. Over the last ten years, these stocks have
strongly outperformed the S&P; 500. For the most part, this outperformance has not been the
result of multiple expansion in terms of either price-to-sales or price-to-book. Today, both
Pilgrim’s Pride and Sanderson Farms trade at roughly the same price-to-sales and price-to-book
ratios as they did from 1996-1998. Yet, they’ve strongly outperformed the S&P; 500 since then.
There’s a case to be made that the chicken producers actually deserve to trade at higher
price-to-sales and price-to-book ratios than they have in the past. If you buy that argument,
then the fact that Gold Kist is already trading at or above the kind of price-to-book and price-to-
sales multiples chicken stocks have often traded at, doesn’t mean Pilgrim’s Pride isn’t getting a
bargain at $20 a share.
Cash vs. Stock
For Gold Kist shareholders there’s a simple solution to the problem of getting a raw deal. While
Gold Kist may be cheap, it’s no longer cheap relative to the other chicken stocks – including
Pilgrim’s Pride.
So, the easiest way to ensure a good deal would be to insist Pilgrim’s Pride puts its stock where
its mouth is. If both Pilgrim’s Pride and Gold Kist are undervalued, paying for Gold Kist in stock
would require the swapping of one undervalued asset for another. That would make for a true
combination. Of course, it also might make the deal a lot less attractive for Pilgrim’s Pride.
If I were a Gold Kist shareholder, I’d want the deal to be all stock. There’s nothing wrong
with swapping part ownership of one poultry producer for part ownership of a new, larger
poultry producer. But, there is potentially something very wrong with swapping part ownership
of a poultry producer for cash.
Related Reading
Pilgrim’s Pride
Proposal to Acquire Gold Kist
Friday’s Press Release
Gold Kist
Press Release in Reponse to Proposal
 URL: https://focusedcompounding.com/on-pilgrims-pride-and-gold-kist/
 Time: 2006
-----------------------------------------------------
On Homebuilders
Bill of Absolutely No DooDahs began his May 31st post entitled “My Homeys” by writing the
following:
“Rarely has there been a single segment or industry as universally loathed as the one I’m
writing about today. Almost every stock I’ve screened from this industry has double-digit
negative 52-week returns and short ratios over a week to cover. This industry’s P/E is below 5.5
on average, and its PEG and Price/Sales are 0.4 and 0.5 respectively. This industry’s
Price/Book ratio is hovering close to 1.3, a rarity for a set of businesses with double-digit Return
on Assets. I’m talking about, of course, the homebuilders.”

Bill has written three excellent posts about homebuilders. I highly recommend reading them,
especially because you will find I’ve sprinkled quotes from those three posts throughout the post
you’re reading now. There’s no need to re-invent the wheel. If Bill said it better first, why
shouldn’t I quote him instead of struggling to find a different way to say the same thing?
Here are Bill’s three posts (in chronological order):
My Homeys
I Value My Homeys
DHI – One of My Homeys
A Contentious Topic
Although nearly three months have passed since Bill wrote that paragraph, it remains an
appropriate introduction to a contentious topic. I’ll try to take the discussion in a slightly
different direction by presenting some questions (and hopefully a few answers) that seem most
likely to help investors form actionable judgments about the homebuilders.
Naturally, the first question is why housing in general and homebuilding stocks in particular are
such a contentious topic. Two culprits immediately spring to mind: self-interest (enlightened or
otherwise) and the financial media (almost certainly otherwise). These two forces have a hand in
the forming and fomenting of a great many controversies. So, it’s hardly surprising to find them
at work here.
The self-interest is genuine. Many Americans own a house. Some Americans own more than
one house. This second group is probably somewhat more likely to watch CNBC, read The Wall
Street Journal, etc. So, the financial media takes that kernel of genuine self-interest and blows it
ups.
The manner in which it does this is particularly interesting, because it affects the way Americans
in general and investors in particular think about the subject.
Discussions of the housing market often involve talking heads and statistics. The talking heads
naturally present opposing views. The statistics are, of course, meaningless without a point of
reference.
Obviously, a series of historical data could provide such a point of reference; however, a series
of historical data is complex, backward-looking, and above all else not a good way to keep an
audience’s attention. In contrast, estimates are simple, forward-looking, and a bit more exciting.
So, estimates win out. Not just in the reporting on the housing market, but in financial reporting
as a whole. Estimates pervade the financial media.
While they can be very useful, estimates do carry the unfortunate side effect of turning shades of
gray into either black or white, simply because every number has to end up on one side or the
other of a precise estimate. This provides a kind of win or lose moment that usually leads to both
more excitement and less perspective.
Perspective
Much of the reporting and commentary regarding the homebuilders centers around expectations
for near-term operating results. Where are earnings headed? How far will they fall? How weak
will the U.S. housing market become?
These are important questions for investors to ask. However, they aren’t the only important
questions. A successful investment is made by exploiting the difference between the price and
the value of some asset. The health of the U.S. housing market in general and the future earnings
of specific homebuilders only address the value side of the price/value inequality investors seek
to exploit.
The price side of the inequality is of equal importance. At some price, the future for
homebuilders may be quite poor and yet their shares may be an excellent investment. Have we
reached that price yet?
That’s the way investors need to think about the problem. We need a little perspective. How far
will the homebuilders’ earnings have to fall during the next few years before the value of their
shares falls below the current market prices? Simply knowing whether (and how far) earnings
will fall is not enough. We need to consider future earnings relative to the current price.
Bill took up this problem in his post entitled “I Value My Homeys”. In that post, he discusses
discount rates and valuation methods. The discussion is clear and worth reading even if you have
no interest in valuing the homebuilders, because the same valuation methods can be applied in
countless other situations.
At one point in the post, Bill illustrates how to find an appropriate P/E ratio for a stock with an
expected near-term earnings decline followed by some renewed earnings growth (obviously, this
is an entirely different matter from valuing a stock with earnings that will continue to decline for
many years to come). After going through this hypothetical illustration, Bill writes:
“Does this mean they’re cheap? Yes, it means they’re dirt cheap, at least, by this methodology
they’re trading at a 33% discount. However, a lot can go wrong with those analysts’s
assumptions, the earnings might fall more, or for longer, than expected, and a whole holy host of
other things could go SNAFU on us. And don’t forget that dirt cheap stocks…usually keep
getting cheaper for a while.”

Let me take the last point first. Such stocks may continue to decline for a time. I differ from Bill
in that he utilizes technical analysis while I do not (see “On Technical Analysis”).
I only mention this because some people will say that while the homebuilders may be truly
cheap, you shouldn’t buy them if the stock prices will keep falling. I can’t argue with the logic of
buying a stock as cheaply as possible. But, as I don’t know the day on which the lowest quoted
price will appear, I’m willing to take Mr. Market’s offer when I think there’s a good deal in it for
me – without worrying about whether he’ll be making an even better offer tomorrow.
Some people think such an attitude is foolish. Certainly, it may prevent achieving the optimal
result in some investment operation. However, it shouldn’t prevent achieving an adequate result.
After all, if you aren’t going to sell your shares when the stock price falls (and the gap between
price and value widens) you will still reap the rewards of your original investment when that gap
is closed.
So, if you have the stomach to ride out whatever price swings may occur and you believe the gap
between price and value will eventually be closed, you simply need to find a sufficiently wide
gap between price and value to ensure an adequate result.
Value
Now, I can get to Bill’s other excellent point: while the homebuilders look dirt cheap based on
the assumptions outlined in his hypothetical illustration, those assumptions may prove to be
wrong. That’s always a risk for investors.
An unjustified assumption can justify any stock price. If you’re willing to project a blistering
earnings growth rate into the distant future, you can justify almost any P/E ratio. Likewise, if you
ignore an inevitable near-term earnings decline, you will see bargains where none exist.
To give you some idea of what it would take to justify these absurdly low P/E ratios, I looked
at Comstock Homebuilding (CHCI). This isn’t in any way a suggestion that you buy Comstock
– or that it looks particularly attractive.
There are real issues with the company: debt, the markets it operates in, its most recent
financial results, etc. It’s also a very small cap stock – it has a market cap under $100 million,
although the low P/E ratio makes the business appear smaller than it really is by more than
halving the kind of market cap you’d expect a similar business would have. If you really were
looking at Comstock as an investment, there would be a lot of company specific issues to
consider and weigh in your final analysis.
This post isn’t about Comstock. It’s about the homebuilders in general. I’m just using one name
as an example, because it clearly illustrates the difference a very low P/E ratio makes. In 2005,
Comstock reported net income of $27.6 million. The company has a market cap of $63 million;
so, the stock is trading for less than 2.5 times 2005 earnings.
Obviously, the company is quite capable of reporting a net loss sometime during the next
few years. But, for the sake of simplicity, let’s assume Comstock’s 2005 earnings will decline by
20% a year for each of the next five years and then increase by 3% a year thereafter.
In other words, let’s assume the company will earn $22.1 million in 2006, $17.7 million in 2007,
$14.1 million in 2008, $11.3 million in 2009, and $9.0 million in 2010. These numbers are for
the purposes of illustration only.
It seems reasonable to expect the company will actually earn much less than $22.1 million in
2006 and $17.7 million in 2007 and much more than $9.0 million in 2010. I’m just using these
hypothetical numbers to better illustrate what modeling a 20% annual decline in earnings for the
next five years really looks like.
We assume that in 2011 earnings will increase by 3% to reach $9.27 million and will continue to
increase at an annual rate of 3% thereafter. To put this in perspective, the assumption is that the
“peak” earnings of 2005 will have turned out to be a veritable Everest – it will take the
company 40 years to complete the second ascent.
That’s obviously a ridiculous assumption. I have little doubt 2005 was a peak that will remain
the high water mark for several years to come. However, I sincerely doubt it will take four
decades to recover from the bursting of the housing bubble.
Anyway, what if it did? What if this absurd model was an accurate representation of reality?
Would Comstock be a good investment?
Yes. Despite the earnings decline and the four decades of anemic growth, an investment in
Comstock would work out well at today’s price. At a price-to-earnings ratio of well under 3, the
company doesn’t have to do much for the stock to take off. If the scenario really did play out as
outlined above, today’s buyer of Comstock shares would have no problem beating the market. In
fact, a 15% annual return would be a near certainty.
So, what would justify a P/E ratio of less than 3? Bankruptcy. Seriously, that’s about it.
Obviously, the company could simply fail to earn anything ever again. Some businesses can go
years and years without earning a dime or declaring bankruptcy. So, I suppose I should say a
failure to report any earnings whatsoever would justify a P/E ratio of less than 3 (in fact, it would
justify a P/E ratio of zero).
Although it’s obvious, I should mention that a P/E ratio of 3 translates into an earnings yield of
33.33% – which is a very high yield. This is an important point, because most homebuilders
actually have an earnings yield considerably lower than Comstock’s (i.e., their P/E ratios are
higher). For instance, a P/E ratio of 5 translates into an earnings yield of 20%, which is a full
thirteen points below the earnings yield on a stock with a P/E of 3.
A 20% yield is still good. But, many investors don’t realize just how large the differences in
various single digit P/E ratios really are. The closer you get to the low single-digits the more
absurd the worst case scenario has to become to justify the market price.
At some point, it seems everything can go wrong and the stock can still turn out to be a
great investment. Of course, if the “e” half of the P/E ratio disappears entirely (and never
reappears) you stand to lose your entire investment regardless of how low the P/E ratio was when
you bought the stock.
Worst Case Scenario
In no other industry is the imagining of a worst case scenario more important than in the
homebuilding industry. Why? Because the homebuilders are currently priced in a way that
would make them bargains under any circumstances that existed during the last decade and a
half. But, isn’t it conceivable the housing market will, for quite some time, be far, far worse than
anything we’ve seen in a decade and a half?
It’s possible. If you removed the “for quite some time” part, I’d say it’s highly probable. The
next few years will be very bad years in the U.S. housing market. But, the homebuilders aren’t
going the way of the dodo.
That’s an important point to keep in mind, because some otherwise decent businesses that trade
at low price-to-book ratios do so precisely because they are expected to wither away. Here I’m
thinking of companies like USA Mobility (USMO) and Handleman (HDL).
Whatever you might think of these businesses and their stocks, you have to admit they operate in
industries that are threatened by the sort of pervasive and pernicious changes that can never
threaten the homebuilders. This simple fact may not offer much comfort now, when the near-
term outlook for the housing industry is so poor; but, the fact that the long-term viability of the
industry is not in question is actually a very important matter when a high ROA business trades
at or near book value.
If the future is going to be anything like the past, a high ROA business shouldn’t trade at
or near book value. A handful of homebuilders currently trade below book, and quite a few
trade for less than 1.5 times book.
Considering their record of strong profitability, it is hard to imagine the homebuilders should, in
the aggregate, sell for much less than about 1.33 times book value. If you had to pick a
necessarily arbitrary price-to-book ratio at which homebuilders should prominently appear on
you value radar, 1.33 would probably be my choice.
It’s certainly not an overly optimistic assessment considering the strong returns on assets posted
by the group during the past decade and a half. It allows for a period of much lower returns on
assets, without assuming some sort of long-term industry wide problem – a scenario which
seems highly unlikely to me.
Of course, that’s a question you’ll have to answer for yourself. Personally, I find it difficult to
imagine the profitability of the homebuilders will look historically low six years or more from
today. In other words, I don’t see much chance of a lingering problem, if lingering is defined as
lasting more than five years. Why?
Once again, I’ll quote from Bill: “Interest rates are rising and easy money is long gone? Sorry,
I’m too cynical to think the powers that be can ‘allow’ easy money to go away for very long. It’ll
be back, and sooner than you think.”
I agree with Bill’s assessment. Despite all the time we spend talking about interest rates, the Fed,
and the macro environment, we rarely step back and consider the larger (post war) picture.
Inflation is a governmental phenomenon. Whatever the intentions of individual policymakers,

where you have both a strong central government and an aversion to deflation, it is difficult to
imagine anything other than “easy money” being the norm. There will be aberrations; but,
inflation will only be dormant – never dead.
That’s bad news for investors. However, it’s good news for homebuilders and other capital
intensive businesses that disproportionately benefit from such easy money policies.
This time won’t be different. Interest rates will rise and fall. But, the trends we see today will
look a lot more cyclical and a lot more “normal” when viewed from a couple decades down the
road. Reversions are rarely evident to the participants.
There is always a lot of extreme sentiment that seems silly in retrospect, though perfectly logical
at the time. The near-term housing picture is grim, but the long-term will probably look a lot
more familiar than the market seems to believe. The prices at which the homebuilders currently
sell will look very foolish a decade from now.
You can’t wait a decade? I don’t think you’ll have to. Considering the P/E ratios at which the
homebuilders trade, operating results would have to be consistently and extraordinarily poor to
allow these stocks to remain at such low levels for more than a few years.
I never make predictions about stock price movements over a period of less than a few years –
which is probably a good thing considering what Bill Miller wrote about the homebuilders in his
latest letter to shareholders:
“While the statistics in the space have come in roughly as expected, the stocks have moved down
significantly more than we expected. We have witnessed p/e multiples contract from roughly 6-
7x a year ago, to, in some extreme cases, 3-5x earnings. Although estimates came down as we
expected, multiples contracted on the lower estimates, which we did not expect.”
A week ago, a breakingviews column appearing in The Wall Street Journal passed judgment on
Miller’s investments in homebuilders as follows:
“As the housing market slows further, there will be more bad news. New home sales are still
running at 50% above their level of four years ago…Even after their recent decline, the share
prices of homebuilders have doubled. During the housing bust of the early 1990s, housing stocks
sold for half book value. It’s conceivable that could happen again.”
It could happen again. Of course, homebuilders were a bargain at half of book then and they
would be a bargain at half of book now.
Decent businesses shouldn’t sell for half of book value. I don’t know what stock prices will do
this month, this quarter, or this year. But, I do know that if you can buy a decent business at half
of book value you don’t need to know what the market will do, because you’ll be doing quite a
bit better.
I hope we do see the homebuilders sell for half of book value once again. It would certainly
make stock picking a lot easier – just point to a homebuilder.
Visit Absolutely No DooDahs
Related Reading
Absolutely No DooDahs
My Homeys
I Value My Homeys
DHI – One of My Homeys
Morningstar
Bill Miller’s Letter to Shareholders
 URL: https://focusedcompounding.com/on-homebuilders/
 Time: 2006
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On Wells Fargo & Company
Wells Fargo & Company (WFC) is a huge Western and Midwestern bank that provides a
diverse array of financial services to its more than 23 million customers. The company employs
more than 150,000 people at its over 6,000 locations nationwide. Wells Fargo has about $500
billion in assets.
While the company continues to derive more than half its revenues from interest income (about
$26 billion), its activities are not limited to collecting deposits and lending money. Wells Fargo
engages in other businesses such as brokerage services, asset management, and investment
banking. The company also makes venture capital investments.
Over the last ten years, Wells Fargo has averaged a 1.57% return on assets and an 18.19% return
on equity.
Location
Wells Fargo is closely associated with California in the minds of most investors. The company
now operates in 23 different states. However, the concentration in California remains.
Mortgage lending in California accounts for approximately 14% of Wells Fargo’s total
loan portfolio. Commercial real estate loans in California account for another 5% of the
company’s total loans. No other single state accounts for a similarly sized portion of total loans.
In fact, neither mortgage lending nor commercial real estate lending in any other state accounts
for more than 2% of Wells Fargo’s total loans.
Cross-Selling
Wells Fargo’s focus on cross-selling is well known. The company has a stated goal of doubling
the number of products the average consumer and business customer has with Wells Fargo to
eight products per customer (from the current four products per customer).
Cross-selling increases customer stickiness. It also helps increase profitability by decreasing

expenses relative to revenues. The need for a large physical footprint is reduced – as is the need
for a large number of bankers. Instead, the existing infrastructure is able to provide additional
revenue from the same customers.
Wells Fargo’s Chairman & CEO, Richard Kovacevich, explains the importance of the
company’s cross-selling in the “Vision & Values” section of the corporate website:
Cross-selling — or what we call “needs-based” selling — is our most important strategy. Why?
Because it is an “increasing returns” business model. It’s like the “network effect” of e-
commerce. It multiplies opportunities geometrically. The more you sell customers the more you
know about them. The more you know about them the easier it is to sell them more products. The
more products customers have with you the better value they receive and the more loyal they
are. The longer they stay with you the more opportunities you have to meet even more of their
financial needs. The more you sell them the higher the profit because the added cost of selling
another product to an existing customer is often only about ten percent of the cost of selling that
same product to a new customer. This gives us—as an aggregator — a significant cost
advantage over one product or one channel companies. Cross-selling re-invents how financial
services are aggregated and sold to customers — just like other aggregators such as Wal-Mart
(general merchandise), Home Depot (home improvement products) and Staples (office supplies).
(Vision and Values)
Mr. Kovacevich’s enthusiasm for the cross-selling model is well justified. It is difficult to
quantify the importance of meeting all the varied needs of your customers, because you can not
measure the opportunities you missed. However, it is obvious that reducing each customer’s
interest in considering a competitor’s services will greatly increase long-term profitability for
any company engaged in any line of business – not just for a bank.
Later, in the same website section, Mr. Kovacevich addresses the importance of customer
stickiness:
(Cross-selling) is our most important customer-related sales metric. We want to earn 100
percent of our customers’ business. The more products customers have with Wells Fargo the
better deal they get, the more loyal they are, and the longer they stay with the company,
improving retention. Eighty percent of our revenue growth comes from selling more products to
existing customers.
(Vision and Values)
This focus on retention is an important part of a long-term plan to maintain Wells Fargo’s above-
average returns on assets and equity. Extraordinary profitability comes from differentiating your
product or service from those of your competitors. Increasing customer stickiness and reducing
“comparison shopping” is a key part of maintaining extraordinary profitability.
Some businesses are blessed with enviable economics because of their product’s natural
prominence in the minds of their customers. Most businesses are obsessed with market share.
But, how many really think about “mind share”? Obviously, a product like Coke (KO), Hershey
(HSY), or Snickers is going to have a positive association in the minds of consumers.
For many people, these products will also have a prominent place in each customer’s mind
(relative to other products and services on which money can be spent). A few other businesses
have a healthy mind share without the positive association; GEICO is the most obvious example.
The company’s brand conjures up nothing but the words “auto insurance”. Of course, that’s all
the GEICO brand has to do.
So, what does all this have to do with Wells Fargo? Mind share isn’t just the result of exposure to
advertising. In fact, in most cases, exposure to advertising can not duplicate the kind of results
that a direct, differentiated experience creates. Entertainment properties are by far the leaders in
mind share. People who saw and loved Star Wars remember the film. In fact, they don’t just
remember the film, they actually file it away (or, more precisely, cross reference it) in countless
ways within their mind.
The evidence for this particular example is abundant. There are countless references to Star Wars
in other media. The name, the music, the opening text and countless other elements are
immediately recognizable. Even the films Star Wars fans hated made more money than almost
any other movies in the history of cinema – and this was decades after the original came out. So,
obviously Star Wars has the kind of lasting mind share any business should aspire to if it hopes
to continuously earn extraordinary profits.
Unfortunately, most businesses, however well run, can not attain this kind of mind share. The
products and services they provide can never be as differentiated and memorable as a motion
picture. Just as importantly, the positive associations will not be present, simply because the
product or service is not inherently exciting, entertaining, or pleasant. This is clearly the case in
financial services.
So, what can a financial services company do to improve its mind share? The most obvious tactic
is simply to “wow” its customers. In fact, Wells Fargo’s CEO discusses this particular option in
the “Vision and Values” section of the company’s website:
We have to “wow!” them. We know what that feels like because we’re all customers. We go to
the cleaners, the grocery store, a restaurant or whatever, and we find a situation where we’re
“wowed!” We walk out and we say, those people really listened to me and helped me get what I
need. All of us hear stories about customers, say, who pick a certain line at the supermarket
because they know the person who bags the groceries connects with customers — smiles, greets
regular customers by name, asks how their families are doing. When a personal banker helps a
customer in one of our stores, or when a customer gets help from one of our phone bankers or
does transactions on wellsfargo.com we want them to say, “That was great. I can’t wait to tell
someone.”
(Vision & Values)
Another option worth pursuing is widening the associations present in the customer’s
mind. Financial services is a business where associations tend to be more conscious, categorized,
and hierarchical than the associations formed in more heavily branded businesses. Put simply,
the (potential) customer usually thinks of a “set” before thinking of an “element” within that set.
Like many mental associations, the information can be returned in either direction. For example,
the customer may normally think “banks” and then think “Wells Fargo”, but will also be able to
return the word “bank” if prompted by the name “Wells Fargo”. This categorization is important,
because it provides (limited) permission for Wells Fargo to expand its mind share horizontally
(across service categories).
In other words, providing a diverse range of financial services doesn’t just make sense from the
provider’s perspective, it also makes sense from the user’s perspective, because the user of
financial services has already grouped deposits, borrowing, credit cards, insurance, brokerage
services, asset management, etc. together in a very loose way within his mind. As a result of this
mental network, one positive experience with Wells Fargo will greatly affect a customer’s desire
to pay for an additional service, even if the two services are not really all that similar.
The three key elements here are: a broader definition of what Wells Fargo is (a place that does
“money things”, not just a bank), a positive experience, and some sense of trust that the quality
of service will be consistent. The last requirement is the easiest to meet, because it’s natural for a
customer to assume that the positive experience was not a fluke, much the way a diner assumes
the good meal he had at a particular restaurant was not caused by his picking the best offering
from the menu. The diner usually assumes the overall quality of the restaurant’s various entrees
is superior. Likewise, a good experience with one of Wells Fargo’s products or services will
likely rub off on its other offerings.
Valuation
Shares of Wells Fargo currently yield just over 3%. The stock trades at a price-to-book ratio of
just under 2.75 and a price-to-earnings ratio of less than 15.
Conclusion
Over the last 5, 10, 15, and 20 years shareholders of Wells Fargo & Company have fared better
than the S&P; 500. As of the end of last year, WFC’s total return over the last ten years was 17%
vs. 9% for the S&P.; Over the last 20 years, WFC outpaced the S&P; 500 by an even wider
margin: 21% vs. 12%.
Wells Fargo has a stellar reputation with investors. The company is the only U.S. bank to
earn Moody’s highest credit rating. Wells Fargo also boasts a well-known major shareholder.
The largest owner of the company’s common stock is Berkshire Hathaway. Warren Buffett’s
holding company has a roughly 5.5% stake in Wells Fargo. Berkshire’s last reported purchase
occurred during the first quarter of this year.
Wells Fargo has a stated goal of achieving double-digit growth in earnings and revenue while
managing a return on assets over 1.75% and a return on equity over 20%. Those are both very
ambitious goals. The company has achieved some of the highest returns on assets and equity of
any major U.S. bank. However, Wells Fargo will probably need to increase the percentage of
revenue it derives from fee businesses if it is to achieve these goals.
In the years ahead, the company may well become more of a diversified financial services
business. In fact, that’s what I expect will happen. The company’s commitment to cross-selling
is not some fad. Eventually, this commitment will change the way investors think about Wells
Fargo. Soon, it may be considered much more than a bank.
Wells Fargo’s CEO makes the case that his company’s P/E is simply too low. Wells Fargo has a
solid history of strong growth and profitability. So, why should it be valued similarly to most
other banks? Shouldn’t it be awarded a multiple more in line with a growth company?
There’s actually some merit to this argument. Wells Fargo is unusually well positioned for a
bank. Often, those banks that seem certain to earn very high returns on assets and equity for
many years to come are poorly positioned for future growth. These banks are often smaller than
their competitors and focused on a specific geographic niche. Any acquisitions would dilute the
exceptional profitability of the bank’s niche.
Of course, there are also many consolidators in the banking industry. Unfortunately, many of
these banks do not have a history of earning the kind of returns on assets and equity that Wells
Fargo has achieved. Even more importantly, there is little differentiation between these titans of
the banking industry and their national competitors. Therefore, their moats are highly suspect.
Wells Fargo is a different kind of bank. It has a history of extraordinary

growth and profitability. There are two obvious opportunities for future growth: geographic
expansion and cross-selling. Of these two opportunities, it’s clear I’m more enamored with the
latter. An eastward push is not necessary, and certainly not via an ill-advised acquisition.
There is a lot of value in the Wells Fargo franchise and there is plenty of room within that
franchise for future growth. That’s one of the great advantages of the financial services
industry. With the right model, limits to growth are almost non-existent. In other highly-
profitable industries, there is often nowhere to reinvest new capital at a similar rate of return.
If Wells Fargo is a growth stock, it is a peculiar sort of growth stock. Maybe that is what
attracted Buffett to the company in the first place. Here is a business with a strong franchise that
can grow for many years to come. Perhaps most importantly, it is a growth business that
frequently trades in the market at value like multiples, simply because it’s a bank.
At the current market price, Wells Fargo is the sort of investment you make once and
forget. The valuation is not so cheap as to promise a good return if the business falters. But, the
business is not so suspect as to require the margin of safety be provided by a low P/E ratio.
Sometimes, near certain growth is the margin of safety.
On a separate topic, I’d like to encourage anyone with an interest in competitive advantages to
read the entire “Vision and Values” section of the Wells Fargo site.
Superficially, it looks like any other online presentation to investors. In truth, it is nothing like
those hollow, sugary slide shows. It’s actually an engaging exploration of competitive
advantages within an industry that seems totally unlike the sort of branded, consumer-oriented
businesses one normally associates with strong franchises. Even if you aren’t interested in the
banking industry in particular, I recommend reading this section for its insights into customer
psychology and behavior.
Read Wells Fargo’s “Vision and Values”
This post is the fifth and final post in a week long series of posts on specific banks earning above
average returns. The idea is to look at the bank’s business and ask why it is capable of earning
above average returns. For a discussion of why banks, on average, earn returns above those of
many other public companies, see my earlier post: “On Banks”. The fact that any particular
bank is profiled this week should not be viewed as an indication that the bank’s shares are
attractive at the current price.
 URL: https://focusedcompounding.com/on-wells-fargo-company/
 Time: 2006
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On Fifth Third Bancorp
Fifth Third Bancorp (FITB) is a large, decentralized Midwestern bank with a strong history of
focusing on cost controls. The company operates over 1,100 branches spread across ten different
states: Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia,
Pennsylvania, and Missouri. Fifth Third has over $100 billion in assets.
In addition to its banking operations, Fifth Third also operates one of the Midwest’s largest
money managers and one of the nation’s largest EFT processors.
Over the last ten years, the company has averaged a 1.68% return on assets and an 18.34% return
on equity.
Location
The vast majority of Fifth Third’s total assets are provided by affiliates in five states: Ohio,
Michigan, Illinois, Indiana, and Kentucky.
Fifth Third focuses on smaller markets with below average population growth. The
company seeks to operate more efficiently than its local competitors and thereby obtain a
dominant share of each market.
The unattractive demographics of the largely Midwestern markets in which Fifth Third operates
partially insulates the company from the ravages of competition. Many banks seek out pockets of
above average population growth and high concentrations of wealth instead of expanding into
one of Fifth Third’s markets.
Decentralization
Fifth Third consists of nineteen affiliates operating in ten different states. The company’s
three largest affiliates account for approximately a third of the company’s total assets. These
three largest affiliates are located in Cincinnati, Chicago, and Western Michigan. None of the
other sixteen affiliates accounts for more than 7% of Fifth Third’s total assets.
The company is well-known for its highly decentralized affiliate banking model. Fifth Third’s
President and CEO, George Schaefer explained this model in a May 22nd, 2000 interview
with The Wall Street Transcript:
All of our lines of business, for example, in Indianapolis, Indiana, report into our CEO in that
market. He’s in charge of the commercial business, he’s in charge of the retail business, he’s in
charge of the trust business, the investment business and the processing business in his area.
(Interview)
This decentralized approach has helped Fifth Third compete in each local market, despite the
very real differences between the various communities in which the company operates.
Fifth Third now has branches in larger markets as well as the small, slow-growing markets the
company is normally associated with. Those smaller markets remain an important part of Fifth
Third’s business; but, if the company hopes to continue its strong growth, it will need to increase
its rather small share of some of these larger markets.
The autonomy granted to the CEOs of the various affiliates should better position Fifth
Third for growth in both types of markets. Such autonomy frees local branches from any sort
of institutional uniformity imposed upon them by some distant corporate office. This allows for
the development of different solutions to similar problems based on the specific circumstances of
each particular profit center.
Costs
Despite its decentralized operations, Fifth Third is more efficient than its peers. The
company has consistently had a better efficiency ratio than its rivals.
Fifth Third’s management has always stressed low-cost operations. This focus is reinforced by
the monthly profit and loss statements issued for even the smallest segments of the business. At
Fifth Third, responsibility for expenses rests with those who can best control the expenses.
Incentives
Fifth Third’s cost conscious culture is a direct result of its highly incentivized employees.
The company issues thousands of monthly profit and loss statements that allow costs to be
tracked at each individual profit center. The widespread use of stock options reinforces Fifth
Third’s cost conscious culture. Mr. Schaefer explained the importance of stock options in the
same interview with The Wall Street Transcript:
Every one of our branch managers, all of our officers, receive stock options. We give them all
options and we give them all profit/loss statements. So each month they know right where they
stand. We keep score very well and they understand that the better they do, the higher the value
of these options that we’ve given them.

(Interview)
Acquisitions
Although much of Fifth Third’s past growth has come from organic sources, the company does
engage in acquisitions. Some of these acquisitions have allowed the company entry into an
otherwise impenetrable local market. As most banks have learned, the easiest way to gain share
in some new market is to acquire existing branches within that market.
Within the last few years, Fifth Third has greatly expanded its exposure to new markets. The
company has begun to venture beyond the three core states of Ohio, Kentucky, and Indiana.
Despite the company’s highly decentralized affiliate banking model, newly acquired branches
are not simply assimilated as is. In that same May 2000 interview with The Wall Street
Transcript, Fifth Third’s President and CEO explained the company’s approach to new
acquisitions:
When we make an acquisition, we buy a set of branches and then bring in our commercial loan
people, our trust officers and our merchant processing people and grow the franchise there. We
pick up the geography in an acquisition, but then we fill that with our own people.
(Interview)
Recent Results
Fifth Third’s recent results have been disappointing. Wall Street had very high expectations
for this fast growing bank. Over the last few years, those expectations have not been met. Fifth
Third’s growth has slowed considerably.
Returns on both assets and equity have fallen to levels closer to those achieved by the
average U.S. bank. In 2005, Fifth Third’s return on assets fell to 1.50% while its return on
equity fell to 16.60%. Both figures are well below the company’s average returns over the past
ten years. In fact, judged solely by ROA and ROE, 2005 was one of Fifth Third’s worst
performances in over a decade.
Disappointment and dissatisfaction were clearly evident in Mr. Schaefer’s most recent letter to
shareholders:
Unfortunately, we have learned that challenges can also increase with size and even the most
highly regarded companies and strongest cultures are not immune to difficulties. Our
performance over the last two years has not matched our historical success. And while
disappointing and below our potential, I believe these results are best understood within the
context of the many things we accomplished this year to improve our competitive position and
drive revenue and earnings growth in the years to come – progress that will ultimately be
reflected in our performance.

This honest assessment is encouraging. Mr. Schaefer is an able and long-serving Chief
Executive who deserves much of the credit for Fifth Third’s past success. He has served as
President and CEO for over fifteen years. During much of that time, Fifth Third was a Wall
Street darling. The company’s recent performance has relegated it to the Street’s dog house.
Mr. Schaefer could easily have dismissed the company’s recent performance as being purely the
result of outside factors such as a difficult interest rate environment. The fact that he did not do
so, despite clear evidence that Fifth Third’s real problem was a twenty-five basis point
contraction in its net interest margin, suggests he is well aware of the very real difficulties facing
his company as it seeks to maintain its past record of above-average growth and profitability.
Below the surface, Fifth Third’s 2005 numbers actually remained fairly strong. Total loan
growth came in at 18% for the year. Deposit growth was in the low double digits.
The company’s processing solutions division continues to enjoy strong revenue growth that is
largely independent of the overall interest rate environment. Americans seem determined to
increase their use of plastic and electronic payments of all kinds each year. This powerful trend
is unlikely to abate within the next few years.
Valuation
Shares of Fifth Third currently yield just under 4%. The stock trades at a price-to-book ratio
of about 2.25. FITB’s price-to-earnings ratio is a little over 14. It’s worth noting that the earnings
in the current P/E ratio represent Fifth Third’s lowest return on equity in some time. For most of
the past ten years, the company has earned closer to an 18% ROE.
Conclusion
Wall Street has soured on Fifth Third. The once beloved bank is now viewed as nothing
special. During the closing years of the second millennium, Fifth Third was awarded high price-
to-book and price-to-earnings ratios. The company’s shares regularly traded at 5-6 times book
and 30-40 times earnings. Obviously, these lofty multiples assumed future growth would be both
fast and profitable.
While the company’s performance was actually quite strong over the past half-decade, Fifth
Third has been unable to deliver the kind of results that would justify such multiples. The stock
fell victim to irrational expectations. It is a rare bank that can trade at 5-6 times book for any
length of time without ultimately disappointing investors in a big way.
Over the last five years, Fifth Third has managed to double in size. Unfortunately, even that
was not enough to protect investors who got in at the top. Like many otherwise excellent
businesses, Fifth Third’s shares are essentially no higher today than they were at the opening of
the great bull market’s final stage.
The bank’s shares had already been climbing (justifiably) throughout most of the 1990s. By
1997, a logical ascent based on strong operating results had become an irrational surge based on
little more than hope, faith, and a pretty looking stock chart.
A great business became a god awful stock and the inevitable result of all the excessive
enthusiasm came shortly after the overall market crested. In the five years since, shares of FITB
have steadily decreased as the value of the business has steadily increased. Since 2000, the
bank’s earnings per share have compounded at 8.64% annually; book value per share has
compounded at 10.09% a year.
The recent decline in Fifth Third’s shares gives long-term investors the opportunity to seriously
consider an investment in this first-rate bank. At the moment, Fifth Third is perhaps the most
attractive of the five banks profiled this week.
Investors who believe in Fifth Third’s decentralized, cost conscious culture should seriously
consider acquiring shares at the current market price of less than $40 a share.
This post is the fourth in a week long series of five posts on specific banks earning above
 URL: https://focusedcompounding.com/on-fifth-third-bancorp/
 Time: 2006
-----------------------------------------------------
On Cascade Bancorp
Cascade Bancorp (CACB) operates branches under the Bank of the Cascades name in Oregon
and the Farmers and Merchants name in Idaho. The company has 21 branches in Oregon and 11
branches in Idaho. Cascade Bancorp has total assets of $1.35 billion and deposits of $1.16
billion.
Over the last ten years, the company has averaged a 2.08% return on assets and a 22.89% return
on equity.
Location
Over a third of Cascade Bancorp’s total deposits are in the company’s six Bend, Oregon
branches. Cascade has a 31% market share in Bend. Several larger banks have much smaller
positions within the town. No other bank has a share of the market equal to more than half of
Cascade’s share.
Cascade’s CFO, Gregory Newton, explained the attraction of Bend in an October 10th, 2005
interview with The Wall Street Transcript:
The economy in Central Oregon has been quite strong, mainly because of in-migration of baby
boomers and active retirees. Central Oregon has better weather than most of the Northwest and
has an abundance of recreational opportunities that draw quality of life seekers from large
metros along the West Coast and increasingly from other parts of the country.
(Interview)
Cascade has a strong position both in the city of Bend itself (population: 50,000) and Deschutes
County as a whole. Over half of Cascade’s deposits come from the company’s ten branches in
Deschutes County. Cascade has a 33% market share within the county. The two nearest
competitors each have a market share that is well under half of Cascade’s.
Despite Cascade’s strong penetration in Deschutes County, the company has a less than 2.5%
share of the statewide market. The company earns above-average returns on both assets and
equity by dominating a very small (and very lucrative) geographic niche.
People
Cascade’s limited geographic reach (and strong penetration within its territory) allows the
company to focus on attracting the best employees. The company recently completed a large
acquisition relative to its small size. However, Cascade has usually focused on de novo
expansion within its chosen geographic niche (central Oregon).
In the same interview with The Wall Street Transcript, Mr. Newton explained the importance of
Cascade’s staff:
People are our biggest asset and differentiating factor. Quality bankers are hard to come by
these days and their prices are being bid up. So we are investing in developing skill levels of
existing staff. In addition, we believe we are an attractive alternative to bankers who are with
big banks where they have less ownership interest.

(Interview)
Executives at some local banks, including Cascade, have expressed concern that there are not
enough good loan officers in Central Oregon. Part of the problem seems to be demographics. An
increase in retirees does nothing to improve the quality of the labor pool these banks draw from.
At the same time, the growing retiree population greatly increases the demand for loan officers.
As a result, some local banks have had to extensively train people from within the organization
or look outside the local market to fill these positions. For this reason, Mr. Newton’s comment
about people being Cascade’s “biggest asset” may have more truth to it than similar sentiments
expressed by other executives. Staffing is a real issue in Central Oregon.
Growth
Cascade is poised for strong earnings growth over the next decade due to favorable
demographic trends. The company’s branches are located in areas where near-term population
growth is expected to be very rapid. In fact, all of the markets Cascade serves rank well above
average in terms of expected future population growth. Such growth is a boon for a bank with
Cascade’s strong penetration. A strong local market position tends to be self-perpetuating.
Valuation
Shares of Cascade Bancorp currently trade at a rather lofty 21 times earnings. That’s
almost 4.5 times book! Generally speaking, you aren’t going to make much money buying a
bank at a price of more than 400% of book. However, Cascade does have a recent record of
earning extraordinary returns on both assets and equity while also achieving a peer leading
efficiency ratio.
Conclusion
Shares of Cascade Bancorp yield a paltry 1.3%. There is no margin of safety in paying more
than four times book for any bank – even a great one. While Cascade’s past record is promising,
the current price already assumes a very sunny future. At these lofty levels, any surprises are
likely to be unpleasant. Investors should pass over these shares, despite the excellent underlying
business. The price is simply too high.
This post is the third in a week long series of five posts on specific banks earning above average
returns. The idea is to look at the bank’s business and ask why it is capable of earning above
average returns. For a discussion of why banks, on average, earn returns above those of many
other public companies, see my earlier post: “On Banks”. The fact that any particular bank is
profiled this week should not be viewed as an indication that the bank’s shares are attractive at
the current price.
 URL: https://focusedcompounding.com/on-cascade-bancorp/
 Time: 2006
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On TCF Financial Corporation
TCF Financial Corporation (TCB) operates branches in Illinois, Minnesota, Michigan,

Wisconsin, Colorado, and Indiana. The majority of the bank’s branches are located in Illinois,
Minnesota, and Michigan. The bank, founded as a mutual thrift in 1923 with $500, now has
almost $14 billion in assets and more than 1.6 million checking accounts.
Over the last ten years, TCF has averaged a 1.77% return on assets and a 21.93% return on
equity.
Strategy
TCF collects low cost deposits by banking to the common man. Fee income accounts for an
unusually large portion of the bank’s earnings. These fees greatly reduce TCF’s cost of funds,
because they offset much of the interest paid on the deposits. To the extent that loans are made
from deposits, this greatly increases profitability.
Unfortunately, TCF has a very high loan/deposit ratio (more than 110%), so not all of the bank’s
loans are made from low cost deposits. However, TCF continues to grow, so the loan/deposit
ratio should come down in the natural course of future expansion.
TCF’s growth strategy is simple and unorthodox. William Cooper, TCF’s Chairman and then
CEO, outlined the bank’s strategy in a March 15th, 2004 interview with The Wall Street
Transcript:
We are different because we tend to bank to the everyday person. We don’t have an emphasis on
banking the rich. We have a product structure and a service convenience level. We’re open
seven days a week, 364 days a year.

(Interview)
Supermarkets
TCF has one of the country’s largest supermarket branch systems. These tend to be the
bank’s most profitable branches. One of the differences between TCF and other banks is the
nature of their supermarket branches.
TCF actively seeks small deposits and structures their supermarket branches so that they can act
as full service branches. In effect, TCF brings the bank to its customers. It’s a different approach
entirely, as Mr. Cooper explained in the same interview:
In the supermarket you have to get out there and sell things to people who weren’t there
particularly to buy a banking service. So you need people, for instance, who have worked at The
Limited or sold shoes or whatever who can get out and really sell in a much more aggressive
manner.
(Interview)
Expansion
While many other banks have been closing their branches in favor of doing more online banking,
TCF has been growing its bricks and mortar presence. Much of that growth has come in urban
areas like Detroit, where some of TCF’s competitors have been less interested in doing business.
Many of the company’s competitors look to the suburbs – where the greatest concentration of
wealth is. TCF looks for population density first. The company aims to make a small amount of
money on each customer and multiply that over a huge number of customers.
TCF’s approach to expansion is essentially the same as many retailers. The company goes
where potential customers already are (including supermarkets), fosters a recognizable image,
and employs true salespeople to deal directly with customers.
Probably the biggest difference between TCF and its competition is the bank’s reliance on de
novo expansion. Many of the bank’s branches are fairly new, having been built within the last
decade. TCF focuses on de novo expansion, because new locations provide growth through
greater penetration of the local area. Slowly, but surely, new branches increase business long
after they’ve been established.
Banks that rely on growth through acquisitions tend to end up with a much older collection
of branches. The hunt for growth becomes something of a treadmill, as acquisitions provide
only a one time boost to revenues. Banks that use the same approach as successful retailers
(expanding through new store openings) tend to also enjoy the benefits of growth as the new
locations mature.
Mr. Cooper made TCF’s commitment to this approach clear with his concluding remarks to The
Wall Street Transcript:
Our strategy is going to stay pretty much the same. And if you look around the world at the
successful retailers, such as Wal-Mart or Target or Starbucks and so forth, most of those
companies have grown de novo, opening new stores. Not through acquisitions and that’s the way
we plan to do it.
(Interview)
Valuation
TCF currently trades at well over 3 times book. The shares yield less than 3.5%. This is not a
cheap stock.
Conclusion
TCF is an interesting, innovative bank trading at a premium to its peers. Ultimately, a

bank’s value is derived from its assets. The extent to which a bank can develop significant
economic assets that don’t appear on the books is quite limited.
TCF has a solid recent record of earning great returns on assets and equity. However, this record
has to be maintained in the face of tough competition in the years ahead. The odds are stacked
against maintaining such stellar returns on equity in such a largely undifferentiated industry.
TCF’s advantage is cultural. Can that advantage be maintained? It’s hard to say, but there is
certainly no margin of safety at these prices, despite the seemingly reasonable P/E ratio.
There’s a reason banks don’t normally trade at high price-to-book ratios (for long).
Investors should be absolutely certain TCF’s moat is wide and its competitive advantage truly
durable, before considering purchasing shares at anywhere near today’s prices.
This post is the second in a week long series of five posts on specific banks earning above
 URL: https://focusedcompounding.com/on-tcf-financial-corporation/
 Time: 2006
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On Valley National Bancorp
Valley National Bancorp (VLY) is a conservative bank with a strong position in northern New
Jersey and a presence in Manhattan. The bank, founded in 1927, has about $12 billion in assets.
Valley has consistently earned extraordinary returns on assets and equity. Over the last
twenty years, Valley has averaged a 1.74% return on assets and a 21.12% return on equity.
Valley’s worst two-year performance occurred in 1990 and 1991. During that period,
Valley’s return on equity dropped as low as 14.54% and its ROA dropped as low as 1.29%. Even
in Valley’s worst year (1991), the company still managed to roughly match the average long-
term performance of most of its peers. In other words, Valley’s worst year was a close to typical
year for many other banks.
It was at this low-point in 1991 that the board of directors decided not to increase the cash
dividend. That was the only year in the last 37 that Valley did not increase its dividend.
The company has 79 consecutive years of profitable operations. That’s over 300 quarters (Valley
has yet to post a quarterly loss). More importantly, Valley has a record of earning great returns
on both assets and equity over long periods of time. So, what’s the company’s secret?
Location
Northern New Jersey is about the best place in the world to situate a bank. This isn’t
hyperbole; if there’s a better location, I’ve yet to hear of it. As you know, American banks are
unusually profitable. The market is large and highly fragmented. So, naturally the best place to
situate a bank would be in the United States. But, why north Jersey in particular?
In a September 20th, 2001 interview with The Wall Street Transcript, Valley’s chairman,
Gerald Lipkin, explained why northern New Jersey is such an attractive market:
Northern New Jersey is the single most densely populated area on earth. There are more people
per square mile in northern New Jersey than there are in India, China, Japan or anyplace else.
We have the highest median family income in the United States in that area. So, we serve a very
densely populated and affluent area, which is not dominated by any single industry.
(Interview)
Focus
Valley maintains a narrow focus both in terms of geography and services. The company’s offices
are kept within one hour of the bank’s headquarters in Wayne, NJ. In the same interview, Mr.
Lipkin explained why this geographic concentration is important: “We like to make it very
convenient for our client base to meet with senior management as well as the other members of
our staff.” (Interview)
Valley focuses on relationship banking. The company has residency requirements for its
directors. The majority of directors are to live within 100 miles of the corporate headquarters.
Furthermore, each board member is required to use Valley for both business and personal
accounts. Theoretically, these two requirements ensure board members are familiar with the
bank’s services and are best able to understand the needs of local businesses.
Discipline
Valley has a history of highly disciplined lending. Charge-offs are immaterial. Current
reserves are adequate to cover many years of future charge-offs with little difficulty. The
company’s asset quality ratios and loan to value ratios both indicate Valley has a more
conservative approach to lending than many of its peers.
Undoubtedly, the local economy is helpful in this regard. Valley does not need to make
questionable loans, because there is an abundance of opportunity in the local area. It is possible
for the bank to remain fairly selective without forfeiting growth entirely. For instance, despite
having $12 billion in assets, Valley only has about a 6% market share in northern New Jersey.
Management
Banking, like insurance, is a business where a particularly good or particularly poor

management can greatly affect long-term results. The current Chairman, President, and CEO,
Gerald Lipkin, has served for just over thirty years now. His record is unblemished.
Of course, the real responsibility for avoiding mistakes lies with others in the organization. There
are few businesses where individual employees can do as much harm as they can within a bank.
Valley’s past record and the level of experience of its top managers suggests investors should
encounter very few unpleasant surprises resulting from human error.
Mr. Lipkin made his management philosophy quite clear with his concluding remarks in the
aforementioned 2001 interview with The Wall Street Transcript:
We never bet the ranch – we never put the bank in harms way on any single issue that could
really harm it. Lending money is a risk taking business. So, obviously we at times have problems,
situations with individual loans, but we try to avoid concentrations that could create major
problems.
(Interview)
Valuation
Valley National Bancorp is a solid, well-run bank operating in a geographic area with
excellent economics. The company’s physical footprint and its existing relationships give it a
narrow moat in a highly profitable (and increasingly competitive) region.
Unfortunately, the company is trading at more than three times book. Three times book is a
lot to pay for any bank. Valley’s future growth will likely be somewhat restrained by the
company’s conservative approach. Therefore, dividends are going to make up a significant
portion of an investor’s total returns.
Conclusion
Valley is a good bank. It has a real moat, albeit a narrow one. Competition is increasing within
Valley’s territory. However, the company has been able to compete successfully with new
entrants (who tend to take on far less profitable business).
The stock isn’t cheap today, but there is one wrinkle worth keeping in mind. Valley is more
dependent upon interest rate spreads than most banks. If the yield curve was to become
significantly steeper, Valley would reap outsized rewards.
The current dividend yield on a share of Valley National Bancorp is a little less than 3.5%.
Considering the company’s limited growth prospects, this is an unattractive yield. If, during a
period of general uncertainty within the banking industry, shares of VLY were to trade closer to
two times book, investors would have an opportunity to make a long-term commitment in a
quality bank.
This post is the first in a week long series of five posts on specific banks earning above average
returns. The idea is to look at the bank’s business and ask why it is capable of earning above
average returns. For a discussion of why banks, on average, earn returns above those of many
other public companies, see my earlier post: “On Banks”. The fact that any particular bank is
profiled this week should not be viewed as an indication that the bank’s shares are attractive at
the current price.
 URL: https://focusedcompounding.com/on-valley-national-bancorp/
 Time: 2006
-----------------------------------------------------
On Microsoft
As a result of recent price declines, shares of Microsoft (MSFT) look more attractive now than
they have in years. I hope to write more about the company and the stock in the weeks ahead.
For now, however, I am simply going to reprint my response to an email asking for my take on
Microsoft.
At the time I wrote the response I did not intend to post it. Therefore, a few clarifications are in
order. Throughout the response I am focusing on long-term trends. Viewed as a discussion about
the next few years, my response could be badly misinterpreted. I took a longer view of
Microsoft’s prospects than just the next few years.
It’s also worth noting that I omitted a few relevant points, because I was writing to a single
individual, not a large audience. For instance, my remark that Microsoft did not use its cash pile
to buy up an established player in the games business seems out of place. The company has, in
fact, acquired a few developers (most recently, Peter Molyneux’s Lionhead Studios). These were
small deals. I was thinking about something much larger.
My comments regarding the PlayStation 3 may also be confusing, because they seem to indicate
I believe PS3 sales will be weak. Actually, I only meant to suggest that Sony’s competitive
position would be considerably weaker at the end of this round than it had been at the time of the
PS2’s dominance.
This email has been edited. Irrelevant passages have been omitted, and the text has been
reformatted to match the appearance of other posts to this blog:
Microsoft is a difficult situation for me to evaluate. I think the company still has a lot of
growth ahead in some areas. But, that depends on where management wants to take it.
There are three core businesses that are already well developed: Windows, Office, and Servers.
The moat in the first two are wide. The Windows moat is huge.
The business model in operating systems is great. You keep upgrading every few years; the
hardware needn’t progress for you to find things to tweak and get people to buy the next step up.
It’s insanely profitable.
I think the new launch (Vista) will be bigger than people expect (eventually) in how it allows for
cross selling other Microsoft products (but we’ll see about that). I expect the press to be very
negative at least until well after the launch, because there will always be some bugs and delays.
Games
Eventually, video games will be a big business for Microsoft. I hate the economics of the
console business, but love the economics of the publishing (and development) side of things.
I’m sorry to see that Microsoft didn’t use its cash pile to buy up an established business here
(publishers were cheap in the market a few years ago; an all cash deal would have worked well.
Now, everyone thinks video games will be the next big thing).
The console wars are going well for Microsoft. The two keys to establishing a dominant console
are launching first and getting good games on your platform. We’ll see how Sony (SNE) does
this round, but I expect them to be the big loser.
Nintendo may surprise here. I think the Xbox 360 and Nintendo’s new console (Wii) will do
very well. It’ll be interesting to see the breakdown of the consoles in both the domestic and
foreign markets. I think Sony may still be strong overseas, but could be in a much poorer
position at the end of this round than they were with the PS2.
Search
Long-term I am optimistic about search. I think Google’s position is much weaker than most
people think. I don’t think Microsoft will be the only one to benefit here.
Search is a very natural cross sell with Windows. That’s the direction everything seems to be
headed in (combining online and desktop search). For future growth in terms of market share I
think Microsoft is in a better position than either Yahoo (YHOO) or Google (GOOG).
I also think we might see a couple other (largely unknown) search engines gain some share.
I think Google’s strength is its brand. Its dominance helps with advertisers more than users. I
don’t think it has a lock on users. Also, I think Google has been poorly positioned for doing
much of anything outside of keyword search.
I expect to see a lot more in the way of intelligent, social search inspired stuff. Years from now,
much of search will have to be helping you find what you didn’t know you wanted to find.
Google is dominant in a different business: helping you find what you know you want to find
(but don’t know the name / location). The two types of search are very different. Both will be
important, but the growth in other forms of search will be coming off a smaller base and will
likely integrate with keyword search. Google has the most to lose here.
Other Devices
Microsoft wants to perform well on mobile devices and on your TV. Compared to competitors it
is very strong in these respects.
The strategy seems to be the one I would favor – to control the point of initial contact wherever
software is used and then to only venture into the actual application or content side of the
business where it is highly profitable to do so. In video games it will be highly profitable. In
other areas it is less likely to be very profitable.
I expect to see more generic, web-based applications. These will be less profitable for everyone.
Office should hold up well, but not as well as Windows. Basically, Microsoft needs to take what
it has in PCs and import that to TVs, Handheld Devices, Consoles, and the Web.
That should be the strategy. I think that is the strategy. These aren’t unrelated businesses that
need to be broken up to unlock creativity (as some have suggested). Rather, the profit potential
for each is greatly enhanced by being part of Microsoft. If you take these pieces apart they are
worth very little. There would only be the three businesses I started off talking about and the
console / games business.
Internationally, there is going to be natural growth for Microsoft’s dominant businesses. It won’t
be a tremendous growth rate, but it will be strong and will require virtually no additional
investment to secure.
Obsolescence Issues
Overall, I like the future for software a lot more than hardware, because the marginal gains in the
quality of hardware will slow greatly in the years ahead.
The question isn’t what can be done mathematically in terms of increasing specs; it’s what
that translates to for the user. We are reaching a point where the individual user will not
directly see the benefits of increased hardware performance as clearly as he did in the past.
Much of the research that goes in to this area will only serve to bring down prices and benefit
memory intensive businesses – it will not provide as much of a “wow” factor for the user
anymore.
This is especially true in games. The situation in desktop applications is already such that
improving the software design is where most gains will come from.
Computing power is simply not a scarce resource for most individuals sitting at home or in
a cubicle. Advances will benefit some users a lot and will trickle down to the end user (often via
the web) through fast responses and cheap services. But, that’s a barely noticeable change.
You’ll see something here akin to the kind of thing you see in the brokerage business. It won’t be
obvious, because price competition will never be as great in software.
Generally, you’ll just see the prices for doing anything electronically come down. That’s very
different from what we’ve seen over the last few decades, where you also had advancements that
attracted new users, because they allowed developers to do something differently, not just more
cheaply.
This is a very long-term trend I’m worried about. It could weigh heavily on a business like Dell
(DELL), because PCs are actually quite durable; once the rate of obsolescence slows, sales will
have to slow as the cycle lengthens.
Management
I think Microsoft’s management is absolutely the best in the business. In fact, I think it’s one of
the best in any business.
It would be hard for me to find more than a handful of people I’d rather have managing a
business I was part owner of. I also think the current arrangement is a good one.
There is enough of a line between current operations and future investments in the Chairman /
CEO split that investors will probably get the greatest benefit from the brilliance of the Chairman
this way.
Everyone underestimates Bill Gates. It’s easy, because his great triumph came some time ago
now. But, he’s interested in building something lasting. I trust him more than anyone in tech
without a question. He always impresses me whether he’s talking about his own industry or some
other topic. He has exactly the right kind of mind for someone running a business where the
long-run is such a concern.
Qualitatively, I think Microsoft scores close to perfectly. I could cite the profitability stats, but I
won’t, because you know they’re better than almost any other business on the planet – and that’s
with a huge siphoning off of resources to investments in the future that aren’t required to
maintain the cash cow, wide-moat Windows franchise.
Valuation
Valuation is a bit more troubling. Microsoft is not at the point on an EV/EBIT basis where I’d be
buying the stock if there was a risk of no extraordinarily profitable growth in the future. In other
words, at the current price, it clearly makes for a bad bond.
The key is earnings growth. I think you have to believe MSFT will have a real future in search,
games, and non-PC devices that will fuel future, highly profitable growth.
I think that future is there. As far as a truly large cap stock (say $10 billion or more) it’s about as
attractive as anything on the planet right now – and certainly it’s the most attractive stock of any
very large U.S. business. Even though Intel (INTC) and Dell are cheap looking, I don’t like
them nearly as much. Dell is an interesting situation, but I don’t understand the business well
enough.
I have a better idea of where MSFT is headed – and I like it.
Conclusion
I don’t own shares of MSFT. I won’t be buying any either. I don’t normally own such large
stocks. I prefer much smaller businesses, because the mispricings tend to get more out of whack.
You aren’t going to see MSFT trade at an EV/EBIT of 7.5 or something like that, but you do
sometimes get those chances in small (high quality) businesses.
There are a lot of chances to find wild mispricings without much of the future being a concern.
Those are the situations I prefer to invest in, because businesses like MSFT have an awfully
large anchor with the amount of capital they’ve got – plus, they tend to be less likely to be wildly
mispriced.
However, if I had to own one business with a market cap of more than $10 billion and hold it for
a lifetime I would buy Microsoft here without hesitation.
 URL: https://focusedcompounding.com/on-microsoft/
 Time: 2006
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On Pacific Sunwear
Pacific Sunwear (PSUN) operates two mall based retail chains: PacSun and d.e.mo. PacSun
is a nationwide surf and skate themed chain with about 900 locations comprising approximately
3.25 million square feet. d.e.m.o. is a hip hop themed chain with about 200 stores comprising
approximately 500,000 square feet. Both chains target the “teen” market (specifically, guys and
girls ages 12-24).
Note: When discussing Pacific Sunwear (PSUN), all uses of the term “Pacific Sunwear” will be
references to the company; all uses of the term “PacSun” will be references to the skate and surf
themed chain. This practice is intended to avoid confusion as to whether a particular statement
applies to the PacSun chain alone or to the PacSun, d.e.m.o., (and soon) One Thousand Steps
chains collectively.
Locations
PacSun has expanded from 11 stores in California at the end of fiscal 1986 to almost 900 stores
spread across all 50 states and Puerto Rico.
For the most part, the stores are distributed among the states roughly in line with
population. The largest exceptions are the usual suspects: Pennsylvannia, New Jersey, and
Connecticut. However, the chain also operates more stores in Florida, Georgia, North Carolina,
and Arizona than would be expected on the basis of population alone. Despite the company’s
California roots, its presence in California is roughly proportional to California’s population, if
PacSun Outlets are excluded.
Nationwide, PacSun operates approximately 800 PacSun stores and 100 PacSun Outlets.
Unlike PacSun stores, which are very evenly distributed on the basis of population, PacSun
Outlets are skewed towards highly populous states with large areas of extraordinarily high
population density (“suburban sprawl”). The only exceptions are Virginia, North Carolina, and
Louisiana. While the number of stores in any one state is small enough that the disproportionate
concentration of PacSun Outlets in these states may be purely coincidental, I doubt it.
More likely, PacSun Outlets in these states are meant to benefit from the expected population
growth in their surrounding communities, and were developed because of the danger of
saturation in states such as New York, New Jersey, Maryland, Michigan, Illinois, and California.
I have not heard management discuss this matter. So, it is pure conjecture on my part. It will be
interesting to see where the new PacSun and PacSun Outlets are located.
For the most part, PacSun stores are not unusually concentrated in any state or region. In fact,
they are eerily evenly distributed relative to state populations. It is likely management has
intentionally acted to ensure an even distribution of PacSun stores across the U.S. As a result,
regional economic and demographic trends will have no material effect on PacSun’s operations.
d.e.m.o. stores are not (yet) as evenly distributed. They are disproportionately located in
Northeastern states, Southeastern states, and California. There are relatively few d.e.m.o. stores
west of the Appalachians and east of the Sierra Nevadas. The number of stores in the d.e.m.o.
chain is still growing at about 20-25% a year; so, a more even distribution may be achieved in
the future. Among teens, hip hop clothing is not limited to the Northeast, Southeast, and
California. Therefore, it is unlikely the d.e.m.o. chain will be permanently limited to these
regions.
Strategy
Pacific Sunwear’s strategy is to operate two separate, non-cannibalizing chains.

Management claims each chain is focused on a different teen “subculture”. I would say
subculture is too strong a term (and academics are as guilty as retail executives for stretching the
term to the point where it loses its meaning). However, it is true that the two styles, and indeed,
the two sets of customers are distinct. There is virtually no overlap between PacSun customers
and d.e.m.o. customers.
Although there are some similarities between guys’ skate and hip hop apparel, these similarities
are purely superficial. There is no reason to believe PacSun sales affect d.e.m.o. sales and vice
versa. Pacific Sunwear has successfully created “two completely independent sources of sales
and growth.”
In April, the company plans to introduce One Thousand Steps, a new mall-based footwear and
accessories chain targeting 18-24 year olds. It is very unlikely this chain will prove to be
cannibalizing.
Tactics
Pacific Sunwear locates stores in high-traffic malls. The company actively seeks to locate its
stores in malls frequented by large numbers of teens, despite the fact that this puts the company
in direct competition with rivals such as Abercrombie & Fitch (ANF), American Eagle
(AEOS), Aeropostale (ARO), Hot Topic (HOTT), and Gap (GPS). There are malls in which
one can find PacSun, Abercrombie & Fitch, Aeropostale, and Hot Topic stores all under the
same roof.
PacSun also operates stores in malls where some of the branded merchandise it sells is being sold
in other stores besides those of its main competitors. Some brands carried by PacSun are sold in
department stores; but, the selection is usually far shallower in such stores.
However, there are places where PacSun does face deep direct competition. For instance, VF
Corporation’s (recently acquired) Vans subsidiary operates stores in some of the same malls as
PacSun. Vans is a well-known maker of skateboarding footwear and apparel (it is much better
known for the footwear). Direct competition from Vans is limited; the company only operates
about 150 stores.
Pacific Sunwear offers name brands complemented by private brands:
In each of our store formats, we offer a carefully edited selection of popular name brands
supplemented by our own proprietary brands, with the goal being seen by our teenage and
young adult customers as the source for wardrobe choices appropriate to their lifestyle. We
believe that our merchandising strategy differentiates our stores from competitors who may offer
100% proprietary brands, greater than 80% name brands, or seek to serve a wider customer
base and age range.

There is some truth to this statement (pulled from the company’s 10-K). It is difficult to assess
the d.e.m.o stores in this respect. I believe d.e.m.o. has not been as successful as PacSun in
differentiating itself and creating some kind of stickiness with the male customer.
PacSun’s footwear offerings have been particularly effective in keeping young men coming
back. Shoes, particularly the kind PacSun sells, are a good lure for young men, because men
tend to frequent their favorite stores far less often than women do. Even where there are no
fashion concerns, shoes must be regularly replaced. Furthermore, males between the ages of 12-
24 must buy new shoes, even if there are no aesthetic considerations involved, because old shoes
will simply stop fitting their feet.
There is anecdotal evidence for this; but, unfortunately I could not find a study describing the
annual change in shoe size for different segments of this age group. There is plenty of data on
changes in height for males within this age group. However, it is very unlikely changes in height
are concurrent with changes in shoe size. Anecdotal evidence suggests changes in shoe size are
more common and more pronounced among males than among females within this age group.
It also suggests changes in shoe size would be more common and more pronounced within the
youngest segment of this group. This has important psychological implications, because, if true,
selling footwear would tend to cause young men to frequent a particular store at a time when
they are more likely to form a habit of shopping there regularly. For instance, one would expect
that a male shopper has formed more attachments and stronger attachments to particular stores
by the time he is 17 than he had by the time he was 13.
Pacific Sunwear’s stores offer a broad selection of items within each brand. In fact, the
company has been responsible for the expansion of some of the brands it carries into new
products (particularly footwear and accessories). Pacific Sunwear has encouraged the owners of
some of its best known brands to expand beyond their original product and leverage the
prominence their brand enjoys within Pacific Sunwear’s stores into nationwide sales of new
products.
Pacific Sunwear is able to effect such changes, because the company is usually one of the
largest customers for each of its vendors. In several cases, Pacific Sunwear is the largest
customer. The company has more influence over vendors than would be suggested by the size of
its total sales, because the products it sells tend to have a more limited distribution than the
products carried by some of Pacific Sunwear’s larger competitors.
The brands carried in PacSun and d.e.m.o. stores benefit from a greatly enhanced image
among the “subculture” they target. These are niche brands that become even more closely
associated with their particular niche when they are featured prominently in PacSun and d.e.m.o.
stores.
There is anecdotal evidence that a few of the name brands carried in PacSun stores have
become so closely associated with the chain, that, within the customer’s mind, the brand’s
image and the store’s image have fused. Where a brand carried in PacSun stores is also carried
elsewhere, it is almost always much more visible in the PacSun stores, because the target market
for PacSun and the target market for the brands it carries are very similar – and the image
PacSun projects is relatively undiluted. Other retailers run a greater risk of striking a discordant
note.
Merchandise
Pacific Sunwear’s total sales consist of approximately 67% name brand sales and 33%
proprietary brand sales. Pacific Sunwear’s two largest individual branded vendors
are Quiksilver (ZQK) and Billabong. Both companies are probably still best known for their
surf wear; however, they have branched out into other merchandise such as skateboarding and
snowboarding apparel and various accessories. Quiksilver is responsible for sales of the
Quiksilver, Roxy, and DC Shoes brands; Billabong is responsible for sales of both the Billabong
and Element brands.
Each company’s merchandise accounts for about 10% of Pacific Sunwear’s total sales or
about 15% of total name brand sales. In other words, about twenty cents of every dollar spent
at Pacific Sunwear stores is spent on Quiksilver or Billabong products. These percentages are
based on Pacific Sunwear’s company wide total sales numbers; therefore, it is safe to say sales of
Quiksilver and Billabong products make up well over one-fourth of all sales at PacSun stores.
Pacific Sunwear’s total sales consist of approximately 65% apparel, 20% accessories, and
15% footwear. Pacific Sunwear has always sold more guys’ apparel than girls’ apparel. In
recent years, the gap has narrowed slightly. Currently, apparel sales consist of approximately
55% guys’ apparel and 45% girls’ apparel.
Apparel sales account for a smaller percentage of Pacific Sunwear’s total sales than they had in
previous years, because sales of footwear have been growing much faster than sales of apparel.
Sales of accessories have grown faster than apparel sales, but slower than footwear sales. Only
relative growth is being discussed here; absolute growth has been positive in all categories. Of
course, this is not surprising considering the growth in the number of stores operated.
Trends
Recently, growth in the number of total transactions per comparable store at both PacSun
and d.e.m.o. has been anemic. However, growth in the average sales transaction was up
significantly, allowing Pacific Sunwear to post strong same store sales numbers. Over the last
two years, the number of total transaction per comparable store has been virtually flat. Recently,
growth in the average sales transaction has been as high as 7-8%.
This is a disconcerting trend. I do not doubt that PacSun has a greater ability to raise prices than
most teen retailers have. However, that does not mean I would like to see growth come primarily
from such price increases (as it has for the last two years or so).
This may be a short-term trend. Unfortunately, I am not convinced it is. Pacific Sunwear’s
performance in terms of growth in the number of total transactions and growth in sales per
square foot has not been as strong as the headline numbers suggest. These are two metrics to
watch closely in the years ahead.
The general impression given by these metrics (and by much of the other available data) is
that the PacSun chain is more mature than Pacific Sunwear’s impressive growth rates
suggest. The store count alone might lead some to the conclusion that PacSun’s past growth rates
are unsustainable. Of course, every retailer must face this dilemma at some point – and specialty
retailers like PacSun must confront the problem sooner than most.
At times, comparable store sales growth at PacSun has outpaced comparable store sales
growth at d.e.m.o. The difference has often been small, but that does not make it immaterial. In
the most recent period, same store sales were stronger at d.e.m.o. than at PacSun. Still, d.e.m.o.
does not have the same potential PacSun did. However, management is intent upon adding new
d.e.m.o. stores – and, at present, there is no good reason not to.
Both PacSun and d.e.m.o. have some room for expansion left – and Pacific Sunwear is
generating more than enough free cash flow to fund their expansion. The company already
has plenty of cash on hand. In fact, it probably has more cash than it can effectively deploy,
considering how much free cash flow Pacific Sunwear will generate next year.
Growth
There is still some growth potential at both PacSun and d.e.m.o. However, the attention of
most Pacific Sunwear shareholders will likely be fixed on One Thousand Steps, the company’s
new mall-based footwear and accessories chain scheduled to launch in April. One Thousand
Steps will target 18-24 year olds.
I have mixed feelings about One Thousand Steps. The concept could be a good growth vehicle.
Pacific Sunwear needs someplace to put all the cash it’s generating, and a new concept may be a
better long-term bet than continuing to expand the PacSun chain.
There is a real danger of overexpansion at PacSun. If things turn negative, Pacific Sunwear
will suffer mightily. But, that’s the nature of retail. Between the operating leases and the fixed
costs associated with each store, specialty retailers are highly leveraged.
Sales increases produce spectacular profit growth; sales decreases cause a rapid erosion of
those profits. It is not realistic to assume that a retailer can get out from under the burden of its
stores in the same way marketers and manufacturers can exit a particular line of business. The
biggest difference is the speed at which profits evaporate. A specialty retailer has little time to
adjust course.
One Thousand Steps has promise. Pacific Sunwear has demonstrated its ability to manage the
growth of mall-based chains. The target audience for One Thousand Steps is part of the same age
group targeted by Pacific Sunwear’s other two chains. Like d.e.m.o., One Thousand Steps will
target a very different segment from existing Pacific Sunwear stores. One Thousand Steps is
unlikely to attract the same customers who frequent PacSun or d.e.m.o. Therefore, it should be
another non-cannibalizing growth vehicle.
Footwear is a good choice for a new mall-based chain. Generally, most malls have
underserved the teen footwear market. Although there are some notable footwear chains, a
nationwide comparison by store count suggests there is plenty of room for a new mall-based teen
footwear retailer. Teen footwear stores are very scarce relative to teen apparel stores.
The margins on both shoes and accessories are good. Just as important, Pacific Sunwear has
demonstrated its ability to successfully sell both types of merchandise. One particularly
appealing aspect of selling footwear is the strong appeal of name brands. Obviously, customers
form stronger attachments to footwear brands than to apparel brand. This is not surprising given
the limited number of footwear items purchased relative to apparel items and the frequency with
which any one shoe is worn.
There are important differences between Pacific Sunwear’s two existing chains and the
One Thousand Steps concept. Both PacSun and d.e.m.o. sell entire outfits. They offer
everything needed to dress in the style of the particular “subculture” they serve. One Thousand
Steps will not sell entire outfits. So, the new chain is unlikely to enjoy the same kind of customer
stickiness that PacSun and d.e.m.o. enjoy.
One Thousand Steps will not be as distinctive as PacSun and d.e.m.o. For now, it is difficult
to say how distinctive One Thousand Steps will be. However, it is safe to say the new chain will
be less distinct in the minds of customers than either PacSun or d.e.m.o. That isn’t surprising.
Very few stores are as distinct as PacSun or d.e.m.o. None of Pacific Sunwear’s major
competitors operates stores that have as well defined an image as PacSun or d.e.m.o.
Pacific Sunwear will manage the One Thousand Steps chain better than any other company
possible could. If you first described the One Thousand Steps concept and then asked what
company would be best suited to manage it, I would need only a fraction of a second to say
Pacific Sunwear. No company is more knowledgeable about selling footwear to young
customers.
The PacSun chain has done a tremendous job selling name brand footwear to teens. PacSun
is directly responsible for the lasting success of several of the brands it carries. Although brand
name footwear was already an important part of many skaters’ lives (and more importantly their
spending habits), PacSun greatly magnified that importance. Without PacSun, the value of the
major skate shoe brands would be significantly less than it is today. Very few retailers have had
this kind of positive influence on the brands they carry.
It is impossible to evaluate the One Thousand Steps concept at this point. I will be watching
the chain carefully to see how it distinguishes itself from its competition, how it increases
customer stickiness, and how it selects the brands it carries. The more different One Thousand
Steps is, the more successful it will be.
One obvious mark against the chain is the name. One Thousand Steps is a terrible name. A store
name should be short, simple, distinct, and memorable. PacSun and d.e.m.o. both succeed in that
respect. Actually, those two names are much better than most, because they happen to be (in
spoken form at least) made up of actual words.
Of course, if the chain does succeed, it’s unlikely Pacific Sunwear will have any shot at
preventing it from being widely known as “Steps”. There may be some reason why the chain
couldn’t be operated under that name. If not, I’d say management made a mistake. One
Thousand Steps sounds like something that came out of marketing meeting. It’s far too cute for
use in real world.
Pacific Sunwear plans to open 8-10 One Thousand Steps stores during the first half of
2006. Management believes the chain could grow to 600 – 800 stores. At an average size of
2,500 square feet, that would mean the chain could grow to between 1.5 million and 2 million
square feet.
Upon announcing the new concept (last year), Pacific Sunwear CEO Seth Johnson made the
following statement:
Footwear has been a highly successful part of our assortment in PacSun stores. One Thousand
Steps will enable us to leverage our brand management skills in what we believe is an
underserved market. This new concept gives us an exciting growth vehicle that adds a new and
distinct customer base to our business. Combined with out existing PacSun and d.e.m.o.
businesses, we will have the opportunity to achieve significant sales and profit growth in the
future.
I am cautiously optimistic about One Thousand Steps. The concept is more promising than
d.e.m.o. However, I will have to wait until I see an actual store before I can offer any assessment
of the chain’s profit potential.
Estimates
Analysts are optimistic about Pacific Sunwear’s future earnings, but pessimistic about Pacific
Sunwear’s shares. Wall Street is estimating 16-17% earnings growth over the next five years.
That’s lower than the growth rate Pacific Sunwear achieved over the last ten years. However, it’s
higher than the growth rate I would predict.
The average 5-year earnings estimate from analysts is in the 16-17% range; but, the
average recommendation is a hold. These two opinions are mutually exclusive. They are
utterly incompatible. You can not predict a 16-17% earnings growth rate for Pacific Sunwear
without also predicting the company’s shares will outperform the S&P.; Well, actually you can,
because a great many analysts have done exactly that. But, you shouldn’t.
PSUN is trading at a P/E of about 14. The argument for a significant multiple contraction is
very weak. What company is going to grow earnings at 16-17% a year and sport a P/E well
below 12? The obvious answer would be a company weighed down by a tremendous debt
burden. So, how much debt does Pacific Sunwear have? None.
The company’s total liabilities are about equal to current inventory levels. Current assets (ex
other) are about $350 million; total liabilities are about $250 million. The company has about
$125 million in cash and marketable securities. Pacific Sunwear can probably generate over $150
million in cash from operations each year.
It is unlikely the company can open new stores fast enough to keep free cash flow from reaching
50 – $75 million a year. This is a fast growing company that is generating cash much faster than
it can spend it.
There is a good chance that, five years from now, there will be fewer shares outstanding
than there are today. Therefore, whatever multiple contraction these analyst are expecting
would have to bring Pacific Sunwear’s stock down to a P/E rarely seen by healthy, growing U.S.
companies.
The company’s PEG ratio is well below 1, and its forward P/E is about 12. I don’t pay any
attention to these numbers, but analysts seem to. So, why don’t they rate PSUN a buy? I don’t
know and I don’t care. It probably has something to do with the industry.
Compared to analysts, I’m less optimistic about Pacific Sunwear’s earnings growth, but more
optimistic about the company’s shares.
Profitability
Pacific Sunwear has consistently earned high returns on equity while employing very little
debt. Over the past 10 years, the company has achieved returns on equity of about 17%. Returns
in recent years have been higher than returns at the beginning of the ten year period. However,
the company’s return on equity has been above average throughout the period, and the difference
between the ROE of recent years and the ROE of the more distant past is not particularly
significant. Basically, this has been a business with a 17% return on equity for some time.
Pacific Sunwear scores well on every profitability metric. The company has a high free cash
flow margin – and an even higher owner’s earnings margin, because the company has invested
much more in capital expenditures than required for maintenance alone.
Pacific Sunwear’s return on retained earnings has ranged from 25-50% and its pre-tax return on
non-cash assets has ranged from 20-30%. Both of these numbers are quite healthy, especially
considering the consistency with which they have been achieved.
Pacific Sunwear, like most of its rivals, leases its retail stores under long-term operating
leases. The initial term of each lease is usually ten years. The use of operating leases makes it
difficult to compare the profitability of companies like Pacific Sunwear with the profitability of
companies that do not have any such long-term obligations.
Pacific Sunwear has about $700 million in minimum future rental commitments. The present
value of these commitments should be estimated at well under $500 million for purposes of
comparison. So, even if one were to compare Pacific Sunwear’s capital structure with that of
non-retailers, PSUN would not appear to be unduly leveraged.
Price
Shares of Pacific Sunwear currently sell at a relatively modest price-to-sales ratio of 1.2.
The stock’s (trailing) P/E ratio is about 14. The stock’s price-to-book ratio is not all that different
from the P/B of the general market, despite the fact that PSUN is expected to grow earnings
faster and achieve a higher return on equity than the general market.
The price-to-book ratio is not a particularly useful measure for an operator of leased retail stores.
The price-to-sales ratio is somewhat more useful, but still questionable, because Pacific Sunwear
has a different merchandising mix than many of its rivals.
Pacific Sunwear has an enterprise value-to-EBITDA ratio of under 6 and an EV/sales ratio of
just over 1. This is a bit cheaper than comparable peers. A few of Pacific Sunwear’s more
troubled rivals trade at lower EBITDA multiples, but they have much poorer growth prospects
and more of a mixed record of sustaining high returns on equity.
Most of Pacific Sunwear’s rivals are selling at much more reasonable prices than they had once
traded at. The group does not appear overvalued relative to the market.
Conclusions
I don’t like owning retailers, and I don’t like valuing retailers. If I had to pick an expected 10-
year annual return for the investor who buys shares of PSUN at tomorrow’s opening price, I
would pick 12-13%. This rate of return should be enough to beat the market, but is short of the
magical 15% rate of return that I believe will lead to a 3-5% real after-tax return for the buy and
hold investor.
It is quite conceivable Pacific Sunwear will perform much better than I expect. If everything
goes the way management hopes, and each of the three chains is expanded to the stated goals, the
10-year return could be closer to 15-17%. However, I believe such a high rate of return is
unlikely. I’m sticking with 13%.
If I had to choose between being 100% invested in the S&P; 500 or being 100% invested in
PSUN, I would probably choose PSUN. If I had to choose between being 25-50% invested in
S&P; 500 or 25-50% invested in PSUN, I would definitely choose PSUN. Regardless, I expect
shares of Pacific Sunwear will beat the market over the next ten years.
If you own more than a handful of stocks, PSUN would probably make a fine addition to your
portfolio (if acquired at the $22.50 or so at which the stock last traded).
 URL: https://focusedcompounding.com/on-pacific-sunwear/
 Time: 2006
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Google Price Target: $16,578.90
Regular readers of this blog will immediately recognize this headline is a joke. For the rest of
you, I was kind of hoping the ninety cents part would give it away.
If you’re reading this because you’re interested in what I have to say about Google (GOOG),
you can stop now. I’m not going to say anything interesting about Google. Rather, I’m going to
say something (that I hope is) very interesting about the wonders of compounding.
Warren Buffett’s annual letter to shareholders was released today; I’ll write a lot more about
it tomorrow. For now, I’m just going to pull out one little nugget:
Between December 31, 1899 and December 31, 1999, to give a really long-term example, the
Dow rose from 66 to 11,497 (Guess what annual growth rate is required to produce this result;
the surprising answer is at the end of this section.)

I knew what Warren was up to, and had some idea of the historical growth rate for the Dow, so I
guessed 6%.
Here’s the answer to the question posted at the beginning of this section: To get very specific the
Dow increased from 65.73 to 11,497.12 in the 20th century, and that amounts to a gain of 5.3%
compounded annually. (Investors would also have received dividends, of course). To achieve an
equal rate of gain in the 21st century, the Dow will have to rise by December 31, 2099 to –
brace yourself – precisely 2,011,011.23. But I’m willing to settle for 2,000,000; six years into
this century, the Dow has gained not at all.

I wish I could tell you that my guess was close. But, it wasn’t even in the right ballpark. The
difference between a 5.3% annual gain and a 6% annual gain may look relatively small. In fact,
the difference is not small. If, during the 20th century, the Dow had achieved a gain of 6%
compounded annually rather than a gain of 5.3% compounded annually, on the eve of Y2K, the
index would have been sitting at 22,302.33.
The rallying cry of the bubble years would have been Dow 20,000. And what of Dow 10,000?
The index would have added its fifth figure in 1987. That’s right, if the Dow had achieved a gain
of 6% compounded annually during the 20th century, the index would have broken the 10,000
mark while the Berlin Wall was still standing.
Over a century, that extra 0.7% really adds up. I recently wrote an email to a member of my
family who had just had her first child. You would think that blathering on as I do here each day,
I would have a sea of investing advice to offer. In fact, I provided only a single drop: Time
trumps money.
If you want to have more money than you will ever need, your best bet is to find a few places
where you can deploy large sums of money that will earn good returns for a great many years,
and will not require you to share any of the spoils with Uncle Sam until you are done
accumulating said spoils. To do this, you will have to own a business either in part or in whole.
I’m an investor, not an entrepreneur; so, let’s stick to the economics of becoming part owner of a
business.
It’s time to discuss Google. I have a price target of $16,578.90 on Google. Does that sound
reasonable? No. Well, I may have forgotten to mention this is a 50-year price target? So, does it
sound reasonable now?
Don’t answer. First, we need to see what it would take for Google’s share price to reach
$16,578.90. Last I checked, each share of Google had a book value of $31.87. Everyone says
Google’s a great business. They may be right. But, I like all my surprises to be of the pleasant
variety. So, I’m going to start by chucking the idea of Google being an extraordinary business.
For now, let’s just call it average.
Who would want stock options in an average business? Let’s pretend no one would. Since
there’s no downside, I think everyone would; but, let’s just ignore that inconvenient fact. We’re
going to pretend Google won’t be diluting its shares at all. For the next fifty years, there will be
no new shares and no stock splits.
As a public company, Google has earned an above average return on equity. It hasn’t been an
earth shattering return on equity (it’s no Timberland), but it’s been better than most. Of course,
with Google, you’re not paying up for the current return on equity – you’re paying up for all the
ridiculously profitable growth to come. I’m willing to meet the Google bulls halfway on this one.
I’ll give you growth, but no unusual profitability. You’re going to get a 12% return on equity, but
there will be no limit to your growth. In my model, Google can literally conquer the world.
With something like $9 billion in equity to start with, a 12% return on equity, and the
reinvestment of all earnings in the business, Google would get awfully big.
Don’t believe me? I know a 12% return on equity looks ridiculously low, but watch what
happens. In 2056, Google will be a $312 billion company. Of course, the big question is: do I
mean market cap or revenue?
I mean profits! At a P/E of 15, Google would have a market cap of $4.68 trillion. Yes, with a
“t”. That same Google share that was quoted on Friday at $378.18 would be worth $16,578.90.
Google’s EPS would be $1,105.26. You read that last part right. Each Google share would be
earning three times its current (lofty) price.
So, what’s the catch? There are two problems with this scenario. One, in 2056, it’s more likely
Britney Spears and Kevin Federline will be celebrating 50+ years of marital bliss together than it
is that Larry Page and Sergey Brin will be celebrating 50+ years of 100% retained earnings at
Google. For that matter, I’d say it’s more likely Larry Page and Sergey Brin will be celebrating
50 years of marital bliss together in 2056 – which is to say it isn’t very likely Google will be able
to retain all of its earnings for the next half century (unless you know something about Larry and
Sergey that I don’t).
The second problem is much less amusing. You see, if on Monday, you were to shell out the
$378.18 for a share of Google, when the stock reached $16,578.90 in 2056, you’d be able to brag
to Britney and K-Fed about your annual compound gain of…drum roll please…7.85%. And
that’s before taxes and inflation.
Google would have a $4.68 trillion empire, and you’d have an annual return of 7.85% – how can
that be?
Time turns molehills into mountains and mountains into molehills. In the very long-term,
growth that only earns ordinary profits leads to stocks that only yield ordinary gains.
But, isn’t Google’s (lofty) price the problem? It’s part of the problem.
However, it’s probably a smaller part than you think. Right now, Google is trading at about
twelve times book. What would your return be if you bought Google at book value? 13.32%.
That’s a good return (fifty years from now, it’ll probably be considered a great return). Still, it’s
somewhat unsatisfying. I mean, if you had the prescience to buy a $4.68 trillion behemoth when
it was just a $10 billion company (remember, you’re paying book this time) all you’d get for
your trouble is 13.32%.
Think of it this way. At $31.87 a share, 85% of your purchase price would be backed by cold,
hard cash and you’d be buying a stock with a P/E of 6.3. A P/E of 6.3 is insanely cheap. So, why
would buying a stock trading at a P/E of 6.3 and growing earnings per share at 11.4% a year for
fifty years only yield a 13.32% return? Where are the insane gains?
Return on equity is the puppet master here. Take another look at the numbers. They’re doing
something strange; they’re converging. Everything is getting closer and closer to 12%. Why?
Because that’s your destiny. If you buy a business that earns 12% a year and you hold it long
enough, guess where your returns are headed?
Here’s one last excerpt from Buffett’s letter. He’s writing about all businesses, but a long-term
holding in a single business works in much the same way:
True, by buying and selling that is clever or lucky, investor A may take more than his share of
the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an
owner can exit only by having someone take his place. If one investor sells high, another must
buy high. For owners as a whole, there is simply no magic – no shower of money from outer
space – that will enable them to extract wealth from their companies beyond that created by the
companies themselves.

It is now obvious I picked Google just to get your attention. Google may very well earn a return
on equity much greater than 12% for the next fifty years. It has already earned “extraordinary
profits”.
Even if it does grow at a phenomenal rate, it will, during the next half century, likely shed excess
equity by paying dividends, buying back stock, or transforming itself into a holding company. I
don’t see a way the company could possibly put more than $2.5 trillion in equity to good use in
search and related businesses. In nominal terms, that’s well more than California’s GSP (Gross
State Product). In 2006 dollars, it would still be something like $600 billion. Armies have been
raised for less. So, if Google really does want to conquer the world, it could just try doing it the
old fashioned way.
I had an important message to get across on the wonders (and horrors) of compounding. I hope
(despite how strange this post was) that message came through clearly. I’ll write about Buffett’s
letter tomorrow. For now, you might want to check out my Value Investing Encyclopedia;
there’s a relevant entry entitled “growth factor“. You may also want to read up on Joel
Greenblatt and the Magic Formula. If you’re looking for insights on return on equity and the
power of compounding, Buffett and Greenblatt are your two best sources.
Since this was my silliest post to date, I will attempt to provide some semblance of sobriety by
letting Ovid express in three words what has taken me more than seventeen hundred.
 URL: https://focusedcompounding.com/google-price-target-16578-90/
 Time: 2006
-----------------------------------------------------
On Sherwin-Williams’ Profitability
Sherwin Williams (SHW) scores well on just about every profitability measure. Some
companies I’ve mentioned in the past are more profitable than Sherwin-Williams. For
instance, Timberland (TBL) scores much higher than SHW on just about every measure of
profitability. The clearest difference between the two businesses is their pre-tax returns on non-
cash assets (PTRONCA).
This is one of my favorite profitability measures. For the last five years, Timberland has
consistently had a PTRONCA of 35 – 55%; Sherwin-Williams’ PTRONCA has been in the 12 –
16% range. This post isn’t intended to be a comparison between Timberland and Sherwin-
Williams. I wanted to introduce you to my preferred method of calculating return on assets, and
Timberland is the obvious choice for a PTRONCA comparison. Very few businesses earn a pre-
tax return on non-cash assets greater than 25%.
The easiest way to earn a very high pre-tax return on non-cash assets is to have very few
tangible assets. Businesses with very high PTRONCAs can grow without retaining earnings.
Generally, maintenance cap ex is minimal, and little investment is required beyond additions to
working capital.
Sherwin-Williams’ pre-tax return on non-cash assets of 12-16% is very good. The company
has not kept much cash on hand during the last few years, so SHW’s PTRONCA of 12-16%
translates almost perfectly into the expected (traditional) ROA of 7.2 – 9.6%. I say “expected”,
because a pre-tax ROA of 12-16% translates into an after-tax ROA of 7.2-9.6% at an effective
tax rate of 40%.
In other words, my adjustments to the return on assets computation make little difference in this
case. It’s clear Sherwin-Williams consistently earns an above average return on assets whether
you use the traditional ROA measure or the pre-tax measure with the cash adjustment.
Sherwin-Williams’ has consistently earned a good return on equity while employing little
debt. Over the last ten years, the company’s ROE has usually been in the 15-25% range.
Sherwin-Williams has regularly bought back stock. The number of shares outstanding is about
20% less than it was a decade ago. Share repurchases and dividend payments have helped
Sherwin-Williams increase its ROE year after year. For several years, the company’s ROE has
been following a clear upward trend.
Sherwin-Williams has also been putting retained earnings to good use. Obviously, there is a
correlation between a company’s return on retained earnings and its return on equity, because
retained earnings increase shareholder’s equity. Looking at the amount of retained earnings in
relation to EPS growth over various time periods can sometimes provide clues regarding the
relationship between a company’s return on capital and its return on incremental capital.
Sherwin-Williams’ returns on retained earnings match the company’s returns on equity very
closely. Both the range (15-25%) and the trend (upward) of SHW’s return on retained earnings
serve to confirm the company’s return on equity data.
Finally, as Rick of Value Discipline noted, Sherwin-Williams has regularly increased its
dividend. I believe this year will be the 27th consecutive year in which the company raised the
dividend. It is interesting to note that while the company has always increased its dividend
payment per share of common stock, the actual dollar amount of dividends paid by the company
has not always increased. Some of the dividend increases are attributable to share buybacks.
I’ve decided to stop providing intrinsic value estimates for the businesses I discuss, because
some readers seemed a bit confused by these estimates. It can sometimes be difficult to explain
that while I may say a company is worth x that does not mean I would consider purchasing it at
100% of x. While I think most readers fully understood both the discounted cash flow concept
and the margin of safety concept, I’m afraid a few couldn’t get the intrinsic value number out of
their head.
I also know most readers would prefer any estimates be provided in terms of share prices rather
than enterprise values. Therefore, I am making a slight adjustment. I will sometimes provide my
best estimate of the compound annual growth rate (CAGR) to be realized by an investor who
buys shares today and holds them for 10 years.
If it were not for the lawsuit, I would be fairly confident that a holder of Sherwin-Williams
common stock could expect a CAGR of no less than 12% and no more than 17.5%, over
the next ten years. This is a very wide range. But, it is not so wide as to be meaningless. I am
not at all confident that the holder of an U.S. index can expect a CAGR of 12% over the next five
years.
It seems Sherwin-Williams is right on the cusp of being a very attractive long-term

investment. The likely 10 year CAGR looks to be very close to the magic 15% number. If you
are as pessimistic about the long term risks of higher inflation and higher taxes as I am, fifteen
percent is a hurdle that must be cleared to give you any shot at the 3-5% after-tax real return that
I’m looking for.
Right now, I have nothing to say about the lawsuit, except to say that even a very large adverse
judgment is unlikely to substantially reduce Sherwin-Williams’ earnings power, because the
business does not require much reinvestment. However, there would still be the issue of (at least)
a one-time destruction of equity and the costs of any debt that had to be raised.
 URL: https://focusedcompounding.com/on-sherwin-williams-profitabilit/
 Time: 2006
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On JRN vs. JRC
A few days ago, a reader told me my post on Journal Communications had left him a bit
confused. About midway through the article, he was starting to think this might be a good stock
to buy. Then, my conclusion caught him a little off guard:
JRN has almost no downside. Sadly, it doesn’t seem to have a lot of upside either. There is a real
danger investors will see their returns wither away as the time it takes to realize the value in
Journal Communications proves costly. Time is the enemy of the investor who buys this kind of
business at this kind of price. Objectively, I have to admit JRN is undervalued. But, I’m not sure
it’s grossly undervalued – and I am sure there are better long term investments.
I did not do a very good job of explaining my position.
Journal Communications is undervalued. As I stated, I believe the constituent parts are worth
somewhere between $1.25 billion and $2 billion. The $1.25 billion estimate is very low. I think it
may be too low.
However, I am very pessimistic about the outlook for the kind of properties Journal
Communications (JRN) owns. The company’s earnings power is largely derived from
newspapers, network TV affiliates, and terrestrial radio stations. None of these businesses
provides a very good value to its customers. I hate to say that, but I believe it’s true.
Although the web’s most conspicuous growth has already come and gone (in the United States),
the utility of the web continues to improve. I believe online content will continue to improve in
quality and approachability. Local newspapers will operate online sites; but, the economics of
such sites will be far less favorable than the monopolies they now enjoy.
Network television has already been weakened tremendously. Its importance to mass
audiences will continue to diminish. There is little reason for network television. More
fragmented cable and online sources can better exploit niches, whether those niches consist of a
certain subject or a certain geographic area. The current network TV model of focusing on
programs that can bring in large audiences is a very poor model. I know it has been the model for
years. But, it’s flawed. It doesn’t offer value to audiences or advertisers.
Some of today’s most successful advertisers eschew the networks entirely. I don’t think they’re
wrong to do so. No network television program is large enough to justly claim a mass audience.
So, if it is only possible to advertise to tiny fragments of the public anyway, why not target
specific segments yourself?
Networks have an even greater problem with viewers. The great advantage they should have is
the cross – selling of their programs and the increased stickiness of their viewers. Unfortunately,
they tend to adopt a model that mitigates these advantages. How many networks fill an adequate
amount of prime viewing time with interesting, ongoing programming? Look at the schedule for
these networks. You’ll notice some big holes in the schedule. The churn rate for network
programming is way too high. They turn off viewers in the search for hits. The value of stability
and familiarity is given no consideration at all.
The networks are playing on a much more level playing field than they should be. They
have a huge advantage, a legacy inherited from a bygone era. But, they also have the advantages
of customer complacency, deep pockets, and free publicity. Some network programming like the
morning shows, the late night shows, national newscasts, and local newscasts do benefit from
customer complacency. Viewers stick with something that they wouldn’t tolerate if it was
unfamiliar.
People will still watch network television. It’s just that the playing field is becoming more and
more level everyday. I’m not sure most investors appreciate the extent to which network
television profits from its past. The same is certainly true of newspapers. Both newspapers and
network television will lose this advantage. To the upcoming generation, these media are less
distinct.
It’s hard to understand just how economically damaging a lack of distinction is for a media
outlet. It destroys the franchise. Newspapers and network television will both look a lot like they
have in the past. They will change with the times like everyone else. But, that’s precisely the
problem. They will become more and more like the rest of the media.
My point here is the same one I made about Energizer Holdings (ENR). A shift from alkaline
batteries to lithium batteries will not do much to change the way many investors perceive
Energizer’s business. However, it will cause a seismic shift in the profitability of the battery
business.
Journal Communications will become a less profitable business. All of its properties have
rapidly narrowing moats. Radio has, perhaps, the bleakest future of them all. But, so much has
already been said about the future of terrestrial radio, that I have nothing to add to the debate.
So, what’s the bottom line? Journal Communications is a much better bargain than the Journal
Register Company (JRC) – which may not even be a bargain at all (though Bruce
Sherman believes it is. Last I checked, Private Capital Management held about 10% of JRC’s
shares). The problem with the Journal Register Company is that it isn’t all that cheap. Journal
Communications is cheap. It generates tons of free cash flow relative to its price.
If you hold twenty – five or thirty stocks, Journal Communications will make a fine
addition to your portfolio. However, if you hold a more concentrated portfolio, I think there are
better long term bargains out there.
I believe both JRN and JRC would make better buys than the S&P; 500. However, I
wouldn’t particularly enjoy being an owner of a business that will be in decline for many years to
come. They may both be bargains, but there is no reason for you to hold both. If you want to own
a stock that’s this cheap relative to free cash flow, buy Journal Communications alone. JRN is
selling at a much steeper discount to intrinsic value than JRC.
Related Reading
On the Journal Register Company
On a Possible Cause for JRN’s Undervaluation
On Journal Communications
On Newspaper Stocks (Again)
On Newspaper Stocks
Journal Communications (JRN)
Journal Register Company (JRC)
Bruce Sherman
Value Discipline
Terrestrial Radio-Down to Earth Valuations
 URL: https://focusedcompounding.com/on-jrn-vs-jrc/
 Time: 2006
-----------------------------------------------------
On Lexmark (Again)
This completes a day of posting follow ups on companies I had previously discussed. I hope you
didn’t mind these quick little reviews. I promise to bring you something new very soon.
Guru Focus is reporting Berkshire Hathaway tripled its stake in Lexmark International
(LXK) during the fourth quarter of 2005. Berkshire increased its holdings from one million
shares in the third quarter to three million shares in the fourth quarter.
As I mentioned in my earlier post on Lexmark, I believe the shares were purchased by Geico’s
Lou Simpson. Lexmark shares currently trade at $46.79; so, the market value of Berkshire’s
position is likely less than $150 million. That’s a rather small amount relative to Berkshire’s total
common stock holdings.
Lexmark looks like a typical Lou Simpson purchase. However, I have not seen confirmation
that this is a Lou Simpson purchase. If anyone has more information on the matter, please
comment below or send me an email.
The important question is not who’s buying Lexmark; it’s whether you should be buying
Lexmark. I think the answer to that question is yes.
Lexmark has a price – to – earnings ratio of 16, a price – to – sales ratio of 1.04, and a price – to
– book value ratio of 3.49. If we knew nothing about the stock, we would probably say the price
– to – earnings ratio doesn’t suggest Lexmark is anything special, the price – to – sales ratio hints
at a bargain (but only hints), and the price – to – book value suggests the stock is most definitely
not underpriced.
Of course, we do know something about Lexmark. We know the company’s free cash flow
margin has usually been extraordinary. In 1996 and 2001, Lexmark had a (just barely) negative
free cash flow margin. In every other year, Lexmark’s free cash flow margin has been truly
remarkable. From 1997 – 2000, the company’s free cash flow margin ranged from 4.71% to
8.24%. From 2002 – 2004 the free cash flow margin ranged from 10.86% to 16.16%. So, we
know Lexmark is a special business (or was a special business).
Even over the last twelve months, Lexmark’s free cash flow margin has been much greater than
that of the average business. But, we can’t evaluate the company by using the free cash flow
margin alone.
For much of the 90s, Lexmark had an average revenue growth rate in the high single digits or
low double digits. However, during this past year, revenue has declined for the first time in a
long time. What does this mean?
The explanation usually given is that competition has increased in the consumer printer
market. HP, Dell, and Canon are the most frequently cited competitors. Will these worthy
competitors crush Lexmark?
I doubt it. Lexmark’s expertise in printing is unsurpassed. Only about 50% of Lexmark’s sales
and 25% of its profits come from the consumer segment. The Lexmark brand is not well –
known to consumers, and those who do know it don’t particularly like it. Now, I’m not an expert
on printers. But, having read what bad things people have to say about Lexmark printers and
what good things they have to say about Dell printers, I think it’s safe to say brands play a large
role in people’s perception of the quality of their printer. For a lot of these people, a Lexmark
built printer with the Dell name on it becomes a different printer.
Lexmark has the weakest brand in the printer business. It also has the strongest technical
position. The company can provide good hardware and excellent interfaces. It will do more of
both in the years ahead.
There is an opportunity here for Lexmark to build a strong brand in the printer business.
That’s a nice bonus, because even if I didn’t think Lexmark had the strongest technical position
of any printer company, the stock is still cheap.
Lexmark has a great balance sheet. The company has only $1.9 billion in total liabilities and
about $2 billion in current assets (ex –other). Lexmark has nearly a billion dollars in cash and
short – term investments.
Finally, when it comes to the price, you can see why I think the Journal Register Company
(JRC) isn’t your best bet. Lexmark’s enterprise value – to – revenue ratio is just under 1, and its
enterprise value – to – EBITDA ratio is just under 7. Compare that to the numbers for JRC; then,
ask yourself which company you’d rather own.
Lexmark continues to generate lots of free cash flow. Management has responded
aggressively to the company’s problems. The company has launched new products and is
undergoing a restructuring.
I would say now is an ideal time to make a long term investment in a good company selling at a
very good price. You will have to stomach a lot of bad news, but that’s not too much to ask, is it?
Related Reading
On Lexmark
Lexmark (LXK)
Information Week
Lexmark Rolls Out Multifunction Devices
Guru Focus
Warren Buffett Triples Lexmark, Sold Shaw Communications, Reveals Holdings in Wells
Fargo
 URL: https://focusedcompounding.com/on-lexmark-again/
 Time: 2006
-----------------------------------------------------
On the Journal Register Company
Let me begin with some of the eye – catching metrics that might lead an investor to consider
purchasing shares of the Journal Register Company (JRC). This newspaper company has a price
– to – earnings ratio of 11.3, a price – to – sales ratio of 0.93, a 5 year average return on
capital of 17.6%, and a five year average pre-tax profit margin of 27.4%.
Now, for the bad news. The Journal Register Company has an enterprise value – to
– EBITDA ratio of 9.07 and an enterprise value – to – revenue ratio of 2.24. Obviously, this
company is carrying a lot of debt. So, perhaps the multiples on the common stock price are
deceptive.
How should an investor value the Journal Register Company? Should he use JRC’s market
cap or its enterprise value? I have usually encouraged a full and careful consideration of all debt
when making any investment. In the case of JRC, such debt makes up a large portion of the
company’s enterprise value. Is it really best to lump the debt and equity together to determine the
true price Journal Register is selling for?
I think it is.
There are situations in which the leverage inherent in a debt – heavy capital

structure works to the benefit of the common stock holder. The most obvious example is a
highly leveraged, growing company selling at a bargain price.
The increase in earnings is amplified by the fixed debt, because the debt creates a sort of break
even point, much like a traditional fixed cost. Just as greater production can give tremendous
benefits to the owner of a large plant, or greater sales can give tremendous benefits to the owner
of a large store, greater pre-tax earnings before interest charges can give tremendous benefits to
the owners of common stock.
Does this scenario apply to Journal Register? Perhaps, but I don’t think so. Long – term, the
economics of the newspaper business will likely be quite poor. Even for Journal Register’s
properties, I am projecting a fall in circulation with no end in sight. Some may disagree with this
assessment. However, I believe they are being overly optimistic.
Past performance is only a good estimate of future performance insofar as the future
resembles the past. I believe the future of newspaper publishing will be sufficiently different
from the past to render any estimate of Journal Register’s future performance based solely on its
past performance quite inaccurate. So, for the most part, the leverage inherent to Journal
Register’s capital structure will be working against the long – term investor.
For all practical purposes, the Journal Register Company’s assets are encumbered. The
legal reality is immaterial to the shareholder. The company can not sell off its assets without
either paying off its debt or maintaining control over sufficient free cash flow to meet its
obligations. Today, money is cheap. It may not be so cheap in the future. Journal Register is
insulated from interest rate changes on its current borrowings. However, the company can not
guarantee that, if it were to refinance its debt as it came due, interest charges would remain as
low as they are today. This is true for every business, but it takes on greater importance in the
case of the Journal Register Company, because of the company’s debt heavy capital structure,
today’s historically low interest rates, and the likely future trend of declining newspaper
circulation numbers.
Together, these three factors form a kind of perfect storm. But, it is important that the facts
be assessed calmly. There is no need for exaggeration. The Journal Register Company is not in
any grave peril. There would be no risk of insolvency, if the company did not borrow further,
and committed its substantial free cash flow to paying down its debt. A look to the recent past
suggests the company is unlikely to follow such a conservative course. That is not necessarily a
bad thing.
There may be value in future acquisitions. In fact, the current climate is perfect for making
acquisitions that truly add value to the company. But, other companies with operations capable
of regularly generating lots of free cash flow have sometimes found themselves in financial
difficulties, because of an overly ambitious capital structure and reduced profitability within their
chosen industry. I am not suggesting the Journal Register Company will find itself in such a
position. If it is well – managed, there is no reason for Journal Register to face such peril. But, it
is rarely wise to assume a company will be well – managed.
The problem with the Journal Register Company as an investment is not the risk created
by its debt. It is easy to overstate that risk. The problem is the price. The Journal Register
Company is not as cheap as it appears to be. Newspapers will not be going the way of the Dodo
anytime soon, but they are already in decline. That decline will not be reversed.
Investors need to remember the importance of growth. Newspapers are not growing. There is
no need to chase stocks with lofty multiples merely to accquire some short – lived hyper growth.
But, there is a need to avoid companies that will not grow their earnings. There are many stocks
trading at higher P/E ratios than JRC that are, in fact, better bargains, because of their growth
factor. I have mentioned Timberland (TBL) before, and I will mention it again.
At today’s price, Timberland is a better bargain than the Journal Register Company. This is true,
despite Timberland’s higher price – to – earnings, price – to – sales, and price – to – book ratios.
Remember the passage from Warren Buffett’s 1992 letter to shareholders that I never tire of
quoting:
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one
that the investor should purchase – irrespective of whether the business grows or doesn’t,
displays volatility or smoothness in its earnings, or carries a high price or low in relation to its
current earnings and book value.

Incidentally, Journal Communications (JRN) and Lexmark (LXK) are also more attractive than
Journal Register, despite their higher P/E ratios. I will be writing about both companies (again)
in the very near future.
Let me know if you would have preferred a discussion of Journal Register that more closely
resembled the post on Journal Communications. I would be happy to provide such a summary of
the business if that would be helpful.
Please feel free to provide your thoughts and/or analysis regarding the Journal Register
Company by leaving your comments below. If you would prefer, you may discuss the Journal
Register Company with me privately via email.
 URL: https://focusedcompounding.com/on-the-journal-register-company/
 Time: 2006
-----------------------------------------------------
On Journal Communications
Journal Communications (JRN) consists of seven essentially separate businesses: The

Milwaukee Sentinel, Community Newspapers, Television Stations, Radio Stations,
Telecommunications, Printing Services, and Direct Marketing. The company’s five
reportable segments do not exactly match these seven businesses; however, I believe an investor
should analyze JRN on the basis of these seven businesses and their constituent properties, rather
than as a single going concern with five reportable business segments.
Additional reasons for this belief will be outlined below. For now, it is sufficient to say that if
Journal Communications were to split into seven separate public companies, the combined
market value of those companies would be substantially greater than JRN’s current enterprise
value. Simply put, the sum of the parts would be valued more highly than the whole.
Journal Communications has an enterprise value of just under $1 billion. Pre-tax owner’s
earnings are probably around $125 million. So, JRN trades at eight times pre-tax owner’s
earnings. That’s cheap.
Journal’s effective tax rate is 40%. That is an unusually high rate. Journal’s media properties
would likely generate more after-tax income under different ownership. The difference would be
material; but, for anyone other than a highly leveraged buyer, tax savings would not be a primary
consideration. When evaluating Journal as a going concern, it is perfectly appropriate to treat the
full 40% tax burden as a reality. These taxes reduce owner’s earnings by $50 million.
With after-tax owner’s earnings of $75 million and an enterprise value of $1 billion,
Journal’s owner’s earnings yield is 7.5%. Remember, this is the after-tax yield. The pre-tax
yield is 12.5%. When evaluating a company, it’s best to use the pre-tax yield for purposes of
comparison. Last I checked, the 30 – year Treasury bond was yielding 4.63%. So, looking at
JRN’s current earnings alone, the stock appears to offer a large margin of safety.
This is especially true if you consider the fact that earnings yields offer more protection against
inflation than bond yields. They don’t offer perfect protection. But, with stocks, there is at least
the possibility that nominal cash flows will increase along with inflation. The cash flows
generated by bonds are fixed in nominal terms, and therefore offer no protection against
inflation.
When evaluating a long-term investment, such as a stock, I do not use a discount rate of less than
8%. This reduces JRN’s margin of safety considerably. Instead of being the difference between
12.5% and 4.63%, Journal’s margin of safety is the difference between 12.5% and 8%. Is such a
margin of safety sufficient? Maybe.
When evaluating a prospective investment, I first look at the risk of a catastrophic loss.
What is the magnitude? And what is the probability? For my purposes, a catastrophic loss is
defined as any permanent loss of principal. The risk that I’ve overvalued a business is always
greater than my risk of catastrophic loss, because I insist upon a margin of safety. A catastrophic
loss is one that wipes out the entire margin of safety.
I can make a bad investment without suffering a catastrophic loss. For instance, most mutual
funds are bad investments, because they underperform alternatives. However, mutual funds do
not usually carry a high risk of catastrophic loss. In fact, they generally have a low risk of
catastrophic loss, because they are highly correlated to the overall market.
It’s easiest to understand this concept if you think of valuing companies as being a lot like
writing insurance. Even if reality exceeds your expectations in nine out of every ten cases, a
terrible misjudgment in the tenth case can cause you great harm. It isn’t just how many mistake
you make. It’s also how big they are.
Some stocks, like Google (GOOG), trade at prices that allow for catastrophic losses of
considerable magnitude. Other stocks, like Journal Communications, trade at prices that only
allow for very small losses to principal. However, there is also the matter of probability. How
likely is it that a Google shareholder will suffer a catastrophic loss? I don’t know. I’m not even
willing to hazard a guess.
In the case of Journal Communications, I am willing to stick my neck out.
I believe an investment in JRN carries a very low risk to principal. Why? Because Journal
Communications is trading at a very modest owner’s earnings multiple. But, that isn’t the only
reason. You shouldn’t look at Journal solely from a going concern perspective. JRN mainly
consists of readily saleable properties. The assets backing shares of JRN are quite substantial:
Publishing
The Milwaukee Journal Sentinel: Milwaukee’s only major daily and Sunday newspaper. The
Sunday edition has the highest penetration rate (72%) of any Sunday newspaper in the top 50
U.S. markets. The daily edition has the third highest penetration rate (49%) of any daily
newspaper in the top 50 U.S. markets. The paper has a daily circulation of 240,000 and a Sunday
circulation of 425,000.
The Milwaukee Journal Sentinel also operates three websites. JSOnline.com and
OnWisconsin.com generate advertising revenue. PackerInsider.com is a subscription – based
website.
Over the last three years, both daily circulation and Sunday circulation have decreased by about
1% annually. Full run advertising linage has also fallen by a similar amount; however, after
accounting for increases in part run advertising and preprint pieces, it appears there has been no
real decrease in total advertising.
The Journal Sentinel generates approximately $230 million in revenue. Advertising accounts for
80% of the Journal Sentinel’s revenue (the other 20% is circulation revenue). Advertising
revenue is somewhat cyclical, and may currently be above “normal” levels.
It’s difficult to value the Journal Sentinel, because JRN groups the Journal Sentinel and its
community newspapers under one reportable segment. Even if the numbers for the Journal
Sentinel were broken out, I would still have some difficulty coming up with an exact figure,
because I’m not an expert on newspapers.
Having said that, I can’t see how the Journal Sentinel could be worth less than $250 million or
more than $500 million. If I had to put a dollar figure on the Journal Sentinel, it would probably
be in the 250 – $300 million range. I’d like to think this is a conservative estimate, but I don’t
know enough about newspapers to be sure. JRN’s failure to break out the numbers for the
Journal Sentinel apart from the community newspapers complicates the issue. However, I am
quite confident the Journal Sentinel is worth no less than $250 million.
It’s even more difficult to value JRN’s Journal Community Publishing Group. It consists of 43
community newspapers, 41 shoppers, and 9 niche publications (automotive, boating, etc.). The
group generates about $100 million in revenue. I can’t value this group apart from the Journal
Sentinel, because of the aforementioned lack of disclosure (combining the group with the Journal
Sentinel for reporting purposes), my inability to find enough public information on community
newspaper businesses, and other such factors.
The best I can do is offer an educated guess as to the combined value of JRN’s publishing
business. My best guess is that, taken together, the Journal Sentinel and the community
newspapers are probably worth somewhere between $300 million and $500 million.
Broadcasting
Journal Communications owns 38 radio stations. The most important of which are: WTMJ-AM
Milwaukee, KMXZ-FM Tucson, KFDI-FM Wichita, and KTTS – FM Springfield (MO). All
four of these stations are number one in their market. JRN’s radio stations generate about $80
million in revenue.
Journal Communications owns seven television stations. Almost all of these stations are ranked
as one of the top three in their market. Three are NBC affiliates, three are ABC affiliates, and
one is a Fox affiliate. JRN owns two stations in Wisconsin, two in Idaho, one in California, one
in Michigan, and one in Nevada. Journal’s TV stations generate about $90 million in revenue.
Again, it’s too hard for me to value JRN’s TV stations and radio stations separately. Taken
together, I believe they’re worth somewhere between $250 and $450 million.
Telecommunications
JRN owns a 3,800 mile network in the Great Lakes region. Norlight Telecommunications
generates about $150 million in revenue. I’m very hesitant to make any attempts to value this
division, because I don’t understand the telecom business well enough. Having said that, I don’t
see how JRN’s telecom business could be worth much less than $350 million.
Miscellaneous
I don’t like the printing services and direct marketing businesses at all. I have no idea how to
value them. They do have revenues though; so, they are probably worth something to someone.
Revenues from these two businesses exceed $100 million, but they are not very profitable.
Real Estate
JRN owns a surprising amount of unencumbered real estate. For the most part, such
properties are closely tied to one of JRN’s operating businesses. As long as JRN continues as a
going concern, much of the real estate can’t be sold. Just to give you some idea of the extent of
these properties, it appears JRN owns a little less than two million square feet – much of which is
in or around Milwaukee. I can not accurately value such real estate. As I said, much of it is
closely tied to operating activities. However, buildings in urban areas can sometimes be
converted to other uses.
It hardly matters though. Journal Communications is likely to remain a going concern for some
time, and as long as it does, it is unlikely to dispose of such assets.
Valuation
So, what is JRN worth? It’s hard to say. The current enterprise value is around $1 billion, which
is clearly too low. My most conservative estimates for the publishing, broadcasting, and telecom
businesses alone add up to $900 million. I think those are very conservative estimates. Using
more reasonable estimates, I can not arrive at a value of less than $1.25 billion for JRN’s
constituent parts. This is true whether I perform an intrinsic value analysis on the entire
company, or apply some sort of earnings, sales, or EBITDA multiple to each business separately.
Journal Communications is probably worth somewhere between $1.25 billion and $2
billion. I’m quite pessimistic about the newspaper business; therefore, I would lean towards the
$1.25 billion figure (which assumes slightly declining revenues). Any sort of revenue growth
would dramatically change the valuation. If such growth does occur, JRN is extremely
undervalued at these levels. However, I’m not sure there will be any growth at all.
Journal Communications’ voting structure will probably discourage the best course of action:
breaking up the company. JRN should spin off the community newspapers, the TV stations, the
radio stations, and the telecom business. The printing services and direct marketing businesses
should also be disposed of in some way. These are really very different businesses. There are few
good reasons for keeping them together, and many good reasons for separating them.
Newspapers, radio, and TV all face different challenges. They need different managers who have
complete control over capital allocation and who are compensated based on the performance of
their business, not on the performance of a hodge-podge of various media properties. Breaking
JRN up will make it easier to manage and will make it easier for current owners to dispose of
their shares at more favorable prices should they wish to.
If these businesses traded as five or six different public companies, it is very unlikely their
combined market cap would be less than $1 billion. It may not even be necessary for them to be
publicly traded. There might be buyers for such properties, if JRN’s properties were separated
into common sense collections.
But, none of this is likely to happen. Employees control JRN (they maintain control through the
ownership of shares with disproportionate voting rights). No one interested in shaking things up
will take a stake in this company, because he would be unable to impose his will. I can’t imagine
management ever embarking on such a sweeping venture without some prodding from the
outside.
JRN has almost no downside. Sadly, it doesn’t seem to have a lot of upside either. There is a
real danger investors will see their returns wither away as the time it takes to realize the value in
Journal Communications proves costly. Time is the enemy of the investor who buys this kind of
business at this kind of price.
Objectively, I have to admit JRN is undervalued. But, I’m not sure it’s grossly undervalued – and
I am sure there are better long term investments.
 URL: https://focusedcompounding.com/on-journal-communications/
 Time: 2006
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On a Possible Cause for JRN’s Undervaluation
I thought a discussion of the possible causes of Journal Communications’ undervaluation by the

market might help us find other similarly undervalued stocks. In the Gannon on Investing
Podcast: “Why Small Caps” I stated that undervalued stocks usually suffer from either contempt
or neglect. JRN suffers from both.
Journal Communications (JRN) is a relatively small company, despite the diversity of its media
assets. The company owns a collection of low profile media assets. The same size company with
a well known flagship would not go as unnoticed by investors. Although the Journal Sentinel is a
big paper, I don’t believe most investors know the name. Of course, most daily newspapers are
only known in and around the city in which they are published. That brings up another possible
cause of JRN’s undervaluation. Perhaps the location of the company’s assets has helped it fly
under the investing public’s radar.
Maybe. But, I’m not so sure. All of those factors could contribute to the lack of interest in JRN.
However, I doubt they are the primary cause.
One of the best possible explanations for JRN’s undervaluation is the company’s lack of
debt. Journal Communications is not debt free; however, for a media company, it is very lightly
encumbered. Actually, the company also has a low debt load relative to the S&P; 500. But, I
want to focus on the company’s debt relative to other media companies, particularly other
newspaper publishers, because I believe that is a key cause of the undervaluation.
The stock market doesn’t totally ignore debt. However, it sometimes fails to fully account for the
differences in debt levels between companies. In general, unduly leveraged companies are
punished by the market. All other things being equal, the stock of such companies trades at a
lower P/E ratio. In this way, the stock market does account for debt.
However, punishing companies with a lot of debt is not quite the same thing as rewarding
companies with very little debt. That’s where mispricings can occur. Some businesses in
exceptional financial condition are not awarded the premiums they deserve. Such businesses are
better able to make acquisitions, buy back stock, increase dividend payments, and weather tough
times. Just as importantly, they also have the capacity to take on more debt.
On occasion, I have read the argument that excess cash on the balance sheet may be a bad sign,
because it suggests management is not running the business in the way that would best
maximize returns on equity. It is true that some companies have more cash and less debt than
would be best for the maximization of shareholder returns. However, from this, it does not
necessarily follow that such companies are less desirable investments.
I have touched on enterprise value a few times before. There is a reason for this. A business’
enterprise value is a better measure of price than its market capitalization. Generally speaking, a
company’s cash can be treated as a reduction to the price paid for the operating business, and a
company’s debt can be treated as an increase in the price paid for the operating business. Now,
some people have argued, quite correctly, that the debt itself does not really increase the
purchase price for the buyer of the common stock.
After all, a company could continually refinance its debt. It is even possible for a company to
pay out a hefty dividend despite a fair amount of debt. An investor does not really intend to hold
a company’s stock forever. Therefore, he needn’t worry about debt levels that do not rise to
alarming heights. Obviously, he must consider the matter of interest payments. But, the debt
itself is not his concern.
I don’t particularly care for this argument. The world is an uncertain place. An investor can not
be sure a company’s debt will be refinanced on equally favorable terms in the future. At least as
importantly, an investor can not be sure his returns will come in the form of dividends. It is quite
possible the company will be acquired. Then, the debt assumed by the acquirer will be his
concern.
I believe investors will do best to always take a full and careful account of a company’s
debt. This does not necessarily mean that they must always use enterprise values in their
analyses. It simply means they can not ignore a company’s debt. An investor who evaluates a
company solely on metrics such as after-tax earnings, P/E ratios, and returns on equity is
effectively ignoring that company’s debt.
A high return on assets coupled with a low debt/equity ratio is a surprisingly effective screen for
undervalued stocks. I don’t think is merely a quality issue. I think it is also an issue of price.
Businesses that earn good returns on capital while employing a lot of debt will be more
conspicuous when they fall well below their intrinsic value. They will tend to have low P/E
ratios and high returns on equity.
Businesses that earn good returns on capital while employing little or no debt will
sometimes go unnoticed when they fall well below their intrinsic value. Their P/E ratios may
be a bit higher and their returns on equity may be quite a bit lower. However, they will be, in
many respects, no different from the businesses with high returns on equity and low P/E ratios.
Don’t let a bargain pass unnoticed just because a company’s capital structure doesn’t perfectly
adhere to the norm.
After all, it’s often best to fish where others aren’t.
Happy Hunting
 URL: https://focusedcompounding.com/on-a-possible-cause-for-jrns-undervaluation/
 Time: 2006
-----------------------------------------------------
On Energizer
Energizer Holdings (ENR) owns two of the world’s great brands: Energizer and Schick.
Currently, about 70% of the company’s sales come from the battery business and 30% come
from the razor and blades business. International sales (from both businesses) account for almost
exactly half of all sales.
Energizer’s acquisition of Schick was a steal. In 2003, the company bought Schick –
Wilkinson Sword from Pfizer (PFE) for just under $1 billion. In 2005, Schick contributed just
under $120 million in profit. This figure does not properly allocate certain shared costs to
Schick; but, it does include depreciation expense in excess of maintenance cap ex. Therefore, I
believe $125 million is a good estimate of the true economic benefit provided by Schick in 2005.
Over the next few years, further margin improvements are likely at Schick; because, between
product launches, fewer razors and more blades will be sold. Energizer’s cost of capital for the
Schick acquisition was very low. Most of the purchase price has been refinanced as fixed debt
carrying an interest rate of less than 5%.
Over the next thirty years, Energizer will become primarily a razor business and primarily
an international business. When looking at Energizer today, this fact is difficult to see;
however, it is an important truth. Here, I disagree with many other commentators on Energizer’s
business. They are far more optimistic about the battery business and far more pessimistic about
the razor blade business than I am. We both have access to the same information, so why the
disagreement?
I believe Energizer’s highly profitable battery business will slowly wither away. It will
remain in some form. Even decades from now, there will still be Energizer batteries sold all over
the world. But, how many will be alkaline batteries?
A lot of analysts note that Energizer is particularly well positioned in the markets for lithium and
rechargeable batteries, and therefore believe a transition to such batteries would not necessarily
spell doom for the little pink bunny. Energizer’s sales of these products has recently been
growing at a 20% clip. With so many personal entertainment devices finding their way into
consumers’ hands (and under their Christmas tress), it looks like Energizer has a wonderful
growth opportunity to exploit.
Unfortunately, that’s not how I see it. Energizer will look to grow its sales of lithium batteries –
as it should. But, don’t let the flashy growth fool you. There are two parts to the growth
factor equation: growth and profitability.
Lithium batteries are unlikely to be anywhere near as profitable as alkaline batteries. They
are more durable and less visible. This is a deadly combination for the likes of Energizer and
Duracell. A battery that is bought by the manufacturer rather than the consumer is not something
these companies look forward to. There is very little price competition in alkaline batteries.
Energizer’s brand name and its distribution system is the key to its ability to charge high prices
on alkaline batteries. Those advantages are mitigated in the market for lithium batteries.
Alkaline batteries won’t be going the way of the Dodo anytime soon. It’s important to note
alkaline battery sales have not yet decreased by volume. This is as true in the U.S. as it is
overseas. In fact, unit sales of alkaline batteries have consistently increased over the past few
years.
This fact has been obscured by changes in the retail business. More and more customers are
buying batteries in bulk. Some analysts have expressed concern. They believe this means brand
loyalty is eroding. Despite being generally pessimistic about the battery business, I disagree with
that sentiment.
Brand loyalty is not eroding. More people are shopping at retailers that sell in bulk. Therefore,
more people are buying larger packages of batteries. There is no evidence to suggest there is a
trend toward cheaper, less prominent brands. In fact, there is no real evidence to support the idea
that consumers actually want larger packages of batteries.
It’s clear they want to shop at the stores that sell larger packages of batteries, but that isn’t
necessarily the same thing. Most consumers would be happy to buy batteries in smaller
packages. That’s exactly what they’d be doing, if they weren’t shopping at superstores and the
like. Consumers have not suddenly taken to buying their batteries via in – depth comparison
shopping. Falling unit prices in the battery business have been caused by changes in retail
methods, not changes in consumer tastes.
The strength of the major brands was evidenced last year when Energizer raised battery prices
and Duracell followed suit. For the most part, Energizer has not been hurt by rising materials
costs, because it has simply raised prices. Many investors haven’t really noticed the rise in
materials costs, because these costs haven’t affected Energizer’s bottom line. Energizer’s pricing
power has made this blissful ignorance possible. True, Energizer’s battery business doesn’t have
as much pricing power as its razor business; however, it still has far more pricing power than the
vast majority of American businesses.
Energizer’s battery business will produce a ton of free cash flow for years to come. The
company will likely remain in the battery business even after alkaline batteries account for a
much smaller part of the market. As a result, the profitability of Energizer’s battery business will
decline.
This won’t happen today or tomorrow. There are still tons of products that are far too cheap to
take more expensive, more durable batteries. There are also opportunities for Energizer to gain
market share in developing countries (who will likely be moving away from super cheap carbon
zinc batteries). The combined distribution infrastructure of Energizer and Schick will help both
businesses gain market share overseas. But, there is far less opportunity for growth in the battery
business than there is in the razor business.
An investor should value Energizer Holdings’ battery unit as a no growth business. This
isn’t quite as bad as it sounds. First of all, the battery business is not truly a no growth business.
Both unit sales and dollar sales have increased in the recent past. Whatever growth does occur
will add value to Energizer, because the battery business will continue to earn a very good return
on incremental capital.
Unfortunately, the trend of rising unit sales of alkaline batteries will not last forever. Some
alkaline batteries will be replaced by rechargeable and lithium batteries. Energizer will be hurt
by such replacements. Even if the company does establish a strong position in the lithium battery
market, its pricing power will be far less than it is in alkaline batteries.
It is important to note that unit sales of batteries, taken in the aggregate, will still grow. Although
some rechargeable and lithium batteries will replace alkaline batteries, other rechargeable and
lithium batteries will be used in completely new products.
Even thirty years from now, it is hard to imagine a world with lower unit sales of batteries than
the levels of 2005. However, it is the mix of those batteries sales that will ultimately determine
Energizer’s profitability. I am far less optimistic than most about the profitability of that mix.
There is a very real risk that selling lithium batteries will prove to be an inherently less
profitable business. Most analysts have not yet addressed this issue. I can not say whether their
silence on this matter is caused by a lack of concern or by a lack of interest. Regardless, I believe
such silence is dangerous, because the future profitability of the battery business is an important
part of any valuation of Energizer Holdings.
Increased durability and reduced visibility generally lead to lower brand awareness, less
customer stickiness, and greater price competition. Therefore, the economics of the alkaline
battery business and the lithium battery business are not as similar as they first appear to be. It
may be sometime before the economics of the lithium battery business become clear.
In the meantime, investors would be best advised to view any migration from alkaline batteries
to lithium batteries as a net negative for Energizer Holdings. Shareholders will want to follow
this trend closely; however, it may be several years before a full understanding of the economics
of the nascent lithium battery business is possible.
Energizer’s future growth will come from its razor business – especially international sales
of its Schick products. In the recent past, the razor and blade business hasn’t experienced
tremendous growth. This has lead analysts and investors to overlook the great long term growth
potential in this business. Schick is a very strong international brand supported by Energizer’s
already established worldwide distribution infrastructure.
Over the next thirty years, the worldwide razor business will become even less fragmented.
Gillette and Schick will make large gains in their share of total unit volume, and even larger
gains in their share of total sales dollars. Their brands already have worldwide reach. In the long
run, far greater penetration is inevitable. There are no other similarly positioned competitors. No
one will be able to compete with their distribution infrastructure, their R&D;, and their
advertising.
The razor business will be dominated by near continuous new product launches for a very
long time to come. Don’t be fooled by those who downplay any increase in sales at Energizer or
Gillette that is the result of a new product launch. Getting consumers to trade up for pricier
models will be the real engine of growth in the razor business.
I believe it is a sustainable business model. Long term economic and demographic trends are
favorable to such a model. As segments of overseas populations become more prosperous,
increased spending on pricey, branded consumer products is sure to follow.
The two major competitors’ brands and their new products have a strong hold over men. It
is likely their grip will only tighten. For a man, there is an important psychology attachment to
his razor. A man’s experience with his razor is regular and ritualistic. He also uses very few
other personal care products of any consequence. Therefore, he is likely to develop the kind of
relationship with his trusted razor that will make him a super sticky customer.
This psychological attachment to a razor is not as strong for women. However, both Schick and
Gillette are working to increase customer stickiness among women. So far, their efforts seem to
be fairly productive. If successful, high end razor sales to women will provide an even greater
source of growth for both businesses, because they are coming off a much lower base.
Societal trends in much of the world will also favor high growth among sales to women for this
sort of pricey, branded personal care product. As a result, the strong international brands of these
two razor companies should become even more valuable in the years to come – and those brands
can not be replicated.
Schick is a true franchise. This fact often goes unnoticed, because Schick’s market share is
dwarfed by Gillette’s. Both companies will grow their share of the international market, but
Schick may very well grow its share more rapidly. There is nothing particularly surprising about
this. Schick is starting from a smaller base, and is, in many ways comparable to Gillette.
What real advantages does Gillette have over Schick?
True, Gillette has a greater market share, but where is the actionable advantage in that? Can’t
Schick achieve similar economies of scale at each of its production facilities? Doesn’t Schick
posses a similar distribution system (largely provided by Energizer)? Doesn’t Schick have at
least some brand recognition in most of the same countries as Gillette? Won’t Schick be able to
match Gillette’s spending in both promotion and innovation?
Simply put, what can Gillette do that Schick can’t? Or, what can Gillette do better or more
cheaply than Schick can?
One could argue Gillette’s absorption by Procter & Gamble (PG) gives it some superiority in
distribution, advertising, and R&D.; But, whatever advantages exist in these areas are slim.
There is no evidence Gillette has an advantage in new product development over Schick. True,
no one can match Procter & Gamble’s distribution system or its economies in advertising; but,
Energizer comes awfully close. The combined Energizer Holdings has great enough resources to
make Gillette’s advantages in these areas little more than academic. Once a company enjoys
these advantages on the scale of an Energizer or Gillette, what real difference do they make?
Gillette’s competitive advantages over Schick are greatly exaggerated. Schick will not wrest
control of the razor market from Gillette. But, that isn’t the important question. The important
question is this: will Schick grow its international business profitably for many years to come?
The answer to that question is an emphatic yes.
In fact, while I concede the fact that Gillette is a tough competitor and a first rate business, I
believe the probabilities favor faster long term growth at Schick than at Gillette. The
combination of the razor business and the battery business makes sense. Schick will continue to
benefit from this combination.
More importantly, being the second player in a business like razors isn’t a bad racket. Look at
the records of other companies who found themselves in the same situation. An investor would
be just as foolish to dismiss an investment in Energizer on account of Gillette’s dominant
position in the razor business as he would have been to dismiss an investment in Pepsi (PEP) on
account of Coke’s (KO) dominant position in the cola business. As an investor, you aren’t
looking for the biggest business – you’re looking for the best bargain.
Energizer’s management is shrewd and shareholder oriented. I have to refute the claims I
have heard (reported in several places) that Energizer’s management has been anything less than
superb in its stewardship of the owners’ capital. There are several complaints; none of them have
any merit.
The most frequent complaint is that Energizer doesn’t hold quarterly conference calls. Good for
them. If you’re part owner in a battery and razor blade business in which a quarterly conference
call is necessary, you’re in the wrong battery and razor blade business. Energizer’s disclosures
are absolutely first rate. Management just chooses to make those disclosures on paper. Anyway,
the conference call is really more of an issue for analysts than it is for shareholders – and
Energizer has no obligation to pander to analysts.
The company’s annual report is a good model for others to emulate. It reports comprehensive
income within the income statement, instead of opting for a separate disclosure. This should be
standard practice. Several footnotes in the report lead to tables instead of long lists of numbers in
tiny print. This should be a standard reporting practice as well.
Energizer breaks its business down into three common sense business segments: North American
Battery, International Battery, and Razors and Blades. It reports all items for these segments in
the body of the report. This means cash flow and balance sheet items are provided right next to
income items. That allows anyone with third grade math skills to calculate returns for each
business segment and to judge each unit on its cash flows instead of relying solely on the income
statement.
Within the body of the report, the company breaks down sales across all business segments by
geography. This means, with just a little subtraction, one can break each unit (batteries and
razors) down into North American and International sales. Battery sales are also divided into
three common sense product categories: alkaline batteries, carbon zinc batteries, and other
batteries. This is another really useful disclosure.
The company even volunteers exact estimates on event – driven sales of batteries (e.g.,
hurricanes) and benefits from the timing of production at certain plants. In both cases, the
information is provided so the reader can lower his estimate of normalized earnings, not raise
them.
Very few companies will prominently mention how an unusual number of hurricanes helped
them, or how the same volume of output in the next calendar year would not result in equally
high earnings. Energizer volunteers both pieces of information without resorting to the use of
footnotes.
The one crucial fact that isn’t explicitly provided is the sales mix between razors and blades
within Schick. That would be a nice touch. Energizer isn’t alone in not providing this
breakdown. Most public companies in refill/repair businesses don’t provide this particular detail,
despite its great economic importance.
If you want to see evidence of the misunderstandings that can result from this lack of disclosure,
look no farther than the market’s reaction to Lexmark’s (LXK) recent announcement that its
earnings were better, because its printer sales were worse.
Energizer’s share repurchases enhanced shareholder value. A lot of analysts would rather
see a dividend. They’re wrong. Once a company starts paying a dividend, it effectively promises
to keep doing so. On Wall Street, cutting a dividend is viewed as a mortal sin. Healthy
companies just don’t do it. Even unhealthy companies go to ridiculous lengths to maintain
regular dividend payments (e.g., GM). By not paying a dividend, Energizer maintains its
flexibility. It can make an acquisition, it can buy back stock, or it can pay down debt. In this way,
the company is able to put its capital to the best possible use.
To date, that’s exactly what it has done. All share repurchases were made at discounts to intrinsic
value. The acquisition of Schick is a rare example of a large corporate acquisition that was well
worth the price. In both cases, the money borrowed was cheap.
Of course, it remains to be seen if Energizer will continue to put its capital to the best possible
use, or whether low interest rates and a low stock price were just happy coincidences and
Energizer will continue to borrow heavily and buy back stock regardless of its cost of capital and
the stock’s discount to intrinsic value. Past actions and statements from management lead me to
believe Energizer will continue to allocate capital wisely – but, one can never be sure of
management’s intentions.
Energizer has proven to be more shareholder oriented than most companies, not less. So, ignore
the occasional uneducated complaints made about Energizer’s corporate governance. Energizer’s
actions prove the company’s commitment to enhancing shareholder value. Those actions back up
the words with which the annual report begins:
“Going forward, we are focused on two clearly defined financial objectives – to generate
consistent annual earnings per share growth and to maximize free cash flow. We fully intend to
achieve those objectives by successfully executing our ongoing business strategies – investing in
our brands for future growth, using cash flow to acquire operating earnings and
opportunistically repurchasing our shares.”

While I believe Energizer is a suitable investment on qualitative grounds, every investment
decision ultimately comes down to price. At a steep discount to its intrinsic value, Energizer
would make an excellent long term holding. So, what is its intrinsic value?
Energizer is worth at least $7.5 billion. The company’s current enterprise value is about $5
billion. So, at today’s price, the margin of safety is not much greater than 33%. I consider this to
be an insufficient margin of safety. As an individual investor, not restricted by having a large
amount of money to invest, there is no reason to accept a margin of safety of less than 50%, if
you are willing to hold a concentrated portfolio. Of course, if you want to be widely diversified
across 30 or more stocks at all times, you will often have to accept a margin of safety of less than
50%. For such widely diversified investors, Energizer provides an attractive investment
opportunity at the current price.
To come up with this $7.5 billion figure, I performed a DFCF calculation using the free cash
flow margin method. Of course, estimates of intrinsic value will differ from person to person.
That’s normal. In this case, the two key (and potentially controversial) assumptions are the
decline of the battery business and the growth of the razor business.
To give you some idea of the importance of these assumptions, I came up with an estimate based
on the worst case scenario of a relatively rapid decline in the battery business as well as an
estimate based on the best case scenario of strong, sustained growth in the razor business. The
worst case scenario yielded an intrinsic value of $5.25 billion; the best case scenario yielded an
intrinsic value of $12 billion. Both of these estimates are within the realm of possibility. In
neither case did I make any obviously unreasonable assumptions.
For instance, a very rapid decline in the battery business would yield a much lower intrinsic
value than $5.25 billion. However, I do not believe such a rapid decline is a reasonable
assumption.
On the other side of the scales, very strong growth in the razor business would yield an intrinsic
value much higher than $12 billion. I believe such growth is unlikely, unless there is some
catalyst I am unaware of. If you believe there will be sustained, strong growth in the demand for
high priced razors among large populations overseas, $12 billion becomes a low end estimate.
Personally, I believe $12 billion is very much a high end estimate.
I always try to err on the side of caution. So, I’m sticking with $7.5 billion as my
best conservative intrinsic value estimate for Energizer Holdings.

Please feel free to provide your thoughts and/or analysis regarding Energizer Holdings by
leaving your comments below. If you would prefer, you may discuss Energizer with me privately
by sending an email to: geoff@gannononinvesting.com
 URL: https://focusedcompounding.com/on-energizer/
 Time: 2006
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On Overstock (Again)
There is a good post over at The New Wall Street entitled: “Overpriced Overstock”. The post
makes the case that Overstock.com (OSTK) is headed towards bankruptcy. I encourage you to
read it.
Of course, I also disagree with it. Actually, I disagree with the conclusion reached. I don’t
disagree with some of the reasoning used to reach that conclusion. For instance, I have
visited Overstock’s website, and I do view it as poorly designed, intimidating, and just downright
overcrowded.
I also agree that Mr. Byrne’s time could be better spent. However, I don’t agree with one
statement:
“I would immediately sell any company whose President spends his time making excuses rather
than seeing through the execution of his business plan”

There are two problems here. One, most CEOs of public companies make excuses in their public
statements. I was just reading the annual report of a consumer products company that gave
“electoral uncertainty” as one of the reasons for a “challenging environment” in the U.S. in 2004.
Apparently, a close Presidential election keeps people from shopping.
Two, I don’t see evidence that Dr. Byrne has been doing any of this rather than seeing through
the execution of his business plan. I think Overstock has been run according to that plan, and I
think that plan is working, as I will explain below. All in all, I can think of candidates for the top
job who are a lot worse than Dr. Byrne. In fact, I have had the pleasure of investing in businesses
run by such men. My experience was rewarding enough, whenever their stock was cheap
enough.
I don’t believe Overstock’s business plan is flawed. In fact, over the past two years or so, I
believe Overstock has generated sales in excess of necessary associated costs. Most people will
dispute this assertion. It is not borne out by GAAP. Even management’s own financial data
suggests sales were below necessary associated costs in a few of these quarters. I think that has
to do with the timing of certain expenses more than anything else. I believe sales are already
ahead of variable costs, and are growing fast. That’s the formula for future profitability.
It will be interesting to see what Overstock reports for the fourth quarter, because, for Overstock,
the Christmas shopping season is a little different from the rest of the year (as it is for many
retailers).
The post at The New Wall Street also argues that Overstock is competing with eBay. I don’t
believe this is true in any economically meaningful sense. I’ve discussed this kind of competition
before, and will be discussing it in my upcoming podcast.
Overstock and eBay (EBAY) are listed in the same industry. I’m sure the management of each
company thinks of the other company as a competitor. Still, I’m not convinced there’s much
competition going on. The real sales potential for Overstock has nothing to do with eBay. The
online retailing market is big enough to accommodate several large, profitable businesses. As
outlined in my four assumptions, Overstock does not need to gain much market share in the
industry to achieve profitability, or to be a bargain at these prices.
Most of Overstock’s future sales are likely to come from customers who do not use eBay,
and would not seriously consider using eBay for what they do on Overstock. eBay has a
great racket and a very wide moat. It is also a very expensive stock. Overstock isn’t. Just as there
is room in the discount superstore universe for several profitable companies, I think there is room
for several profitable companies in online retailing.
“Overstock has tried to take upon too much, it is not going to become an online Wal-Mart. They
should have concentrated on finding a niche market and tailoring to them before taking on a
product line as vast as they have. This has led to excess capacities, thus driving down margins.”
I have to disagree with this as well.
Overstock wants to become the Costco (COST) of online retailing. I think that’s an
achievable goal. However, to achieve that goal, Overstock has to offer a wide range of products
at deep discounts. Customers need to associate Overstock with the cheapest prices on earth for
just about everything on earth. That doesn’t mean Overstock actually needs to have the cheapest
prices or the widest selection. It just means Overstock has to appear to have those things. I think,
right now, in the eyes of many, it does appear to have those things.
Of course, it also has the best name of any online retailer. Even that name suggests Overstock is
not competing directly with eBay for many of its customers. Overstock is an offline name. The
company has pursued an offline marketing strategy. I’m not sure that strategy has always paid
off. However, I do think it gives us some idea of where management believes new sales will be.
It sees new sales coming from people who have no interest in eBay.
“When taking into account all four of these points, I strongly advise against investing in
Overstock. I do not believe that this company will ever generate sustainable profits. At the
moment their business plan is flawed, and their President is more concerned with arguing with
journalists, than fixing this problem. If you don’t currently own shares of Overstock, good. If you
do, than sell them as soon as possible.”

I have to admire the strength of conviction present in this post; but, I also have to disagree with
it.
Despite almost universal press coverage to the contrary, Overstock’s business plan is not
flawed. It’s a very simple, very effective plan. There are already signs it will prove highly
profitable. If you break out the quarterly numbers, you will see the profit potential in Overstock’s
strategy. You will also see the progress it has made. If Overstock had sufficient financing for the
next few years, there would be no doubt the company would survive. If you look at the
financials, you see this isn’t an ailing business; it’s a young business.
There is a real financing problem. No one wants to back this company. At present, the
company’s financial position is decent. It does not have a lot of liabilities. It has some cash. I do
not foresee large negative cash flows in the years ahead, but I may be wrong. A lot of people are
betting that I am wrong.
I think Overstock.com is one of the best bargains being offered today, and certainly the best
bargain among internet companies. If you hold 5 – 12 stocks or more, Overstock should be one
of them.
If you hold fewer than five stocks, you should probably limit yourself to more Grahamian plays.
In a portfolio of four or fewer stocks, you need to eradicate business risks.
There are business risks associated with owning Overstock.Therefore, I do not believe
Overstock is appropriate for such concentrated portfolios – unless, of course, you know more
about the situation than I do.
The New Wall Street’s post is the best anti – Overstock argument to date. It’s a good post and
definitely worth reading. The blog itself is also worth reading regularly, especially because it
discusses companies that are rarely mentioned in this blog – and discusses them in an intelligent
manner.
Read The New Wall Street’s “Overpriced Overstock”

 URL: https://focusedcompounding.com/on-overstock-again/
 Time: 2006
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On Overstock
Why am I writing about an unprofitable internet company on a value investing blog? Because
this blog is about finding dollars that trade for fifty cents; with a market cap of less than 75% of
sales, Overstock.com (OSTK) looks like it may be exactly that.
But isn’t it too risky?
The greatest risk in any investment is the risk of overpaying. So, the real question is: what is
Overstock worth? I think it’s worth at least $1.5 billion. With Overstock’s market cap currently
sitting around $500 million, my valuation certainly looks far fetched. But, there’s only one way
to know for sure. Let’s take apart my argument piece by piece, and see if any of my assumptions
are unreasonable.
First Assumption: Over the next five years, Overstock will neither generate truly free cash flow
nor consume cash. In other words, its free cash flow margin will average 0%. Cash generation in
some years will exactly offset cash consumption in other years. Obviously, this assumption is
unreasonable, because there is almost no chance the cash flows will exactly offset.
That’s not a problem if it turns out Overstock does generate some free cash flow over the next
five years. In that case, my assumption simply errs on the side of caution. If, however, it turns
out Overstock actually consumes cash over the next five years, there is a problem – possibly a
very big problem. So, which scenario is more likely?
Overstock’s revenues are growing quickly. Gross margins look solid at 13.3% in 2004 and
14.9% over the last twelve months. Overstock’s unprofitability is the result of its selling, general,
and administrative expenses (SG&A;) which have been growing exponentially. Will these
expenses continue to grow? Yes, but not as fast as revenues. Over the last twelve months,
Overstock’s spending on cap ex has been 5.6% of sales. That number is an aberration. In the long
run, spending on cap ex should not exceed 3% of sales. Considering the business Overstock is in
and the expected sales growth, the company will, more likely than not, generate some free cash
flow over the next five years. Therefore, the assumption that Overstock will be cash flow neutral
over the next five years is not overly optimistic.
Second Assumption: Over the next five years, Overstock’s sales will grow by 15% annually. Is
this an unreasonable assumption? Again, I don’t think it is. Very few industries are expected to
grow as fast as eCommerce. Overstock’s revenue growth in 2003 and 2004 was over 100%. In
the past year, that growth has slowed. However, it is still closer to 50% than it is to 15%.
Overstock isn’t in a cyclical business. So, there is no reason to believe current sales are
abnormally high.
Also, all that spending on advertising is increasing consumers’ awareness of Overstock. A
review of Overstock’s traffic data shows it has not only been gaining more visitors; it has also
been climbing the ranks of the most popular web sites. While it is a long, long way from the
Amazons, Yahoos, and eBays of the world (and will never reach those heights) Overstock is
becoming a well known internet destination. This fact was most clearly evident in the weeks
leading up to Christmas. Shoppers who visited Overstock during the holiday season obviously
know it exists, and may very well return at some other point in the year. Analysts are predicting
very high growth rates for Overstock; however, they are also recommending you sell the stock. I
don’t put any weight in their estimates. But, for the other reasons given, I believe the assumption
that Overstock will grow sales at 15% a year for the next five years is not unreasonable.
Third Assumption: Six to ten years from today, Overstock will have a free cash flow margin of
3%. Ten years from today, Overstock’s free cash flow margin will rise to 4% and remain at that
level. Now, of all the assumptions I’ve made, this one is the most questionable. Sure, Amazon
has that kind of free cash flow margin, but Overstock isn’t Amazon, and it never will be
Amazon. Overstock’s gross margins are less than Amazon’s. In fact, Overstock’s gross margins
are less than Wal – Mart’s. However, Overstock’s fixed costs will eat up a much smaller portion
of its sales than is the case over at Wal – Mart.
If you compare Overstock to other online retailers, you will see that if Overstock does experience
strong sales growth, a 3% free cash flow margin six years from now is not unreasonable. I
assumed Overstock’s sustainable free cash flow margin will be 4%. There’s a case to be made
that 4% is too high. I won’t make that case, because I don’t believe in it. Remember, that 4%
number comes ten years out. That gives Overstock plenty of time to grow sales and thus reduce
SG&A; as a percentage of sales.
Fourth Assumption: Six to ten years from today, Overstock will be growing sales by 12% a
year; eleven to fifteen years from today, Overstock will be growing sales by 8% a year;
thereafter, Overstock will grow sales by 4% a year. Let’s see what this really means. According
to these assumptions, Overstock’s sales will be as follows:
Today: $707 million
2011: $1.59 billion
2016: $2.71 billion
2021: $3.83 billion
2026: $4.66 billion
2031: $5.67 billion
2036: $6.90 billion
Seven billion dollars is not an unreasonable target – if you have thirty years to achieve it. To put
that figure in perspective, Amazon.com currently has sales of about $8 billion. So, even after
thirty years, these assumptions don’t lead to Overstock reaching the same size as today’s
Amazon. Don’t forget these numbers assume some inflation. For instance, if inflation averages
3% a year over the next thirty years, Overstock’s projected $6.90 billion in sales only translates
to $2.84 billion in today’s dollars. So, these assumptions only lead to a fourfold increase in
Overstock’s real sales over a period of thirty years. I think that’s pretty reasonable.
If you take these four assumptions together, you get a value of $1.5 billion for Overstock. Today,
Mr. Market is offering it for $500 million – that’s why I’m writing about an unprofitable internet
company.
 URL: https://focusedcompounding.com/on-overstock/
 Time: 2006
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On Lexmark
At the end of my very first podcast, I mentioned my positive experience with the investor
relations people over at Lexmark (LXK). They sent me the company’s annual reports for 1995 –
2004 as well as the accompanying 10-Ks. This happened over two weeks ago; so, I’ve had plenty
of time to review the material. But, until now, I haven’t written a word about Lexmark. Why?
In 2005, Berkshire Hathaway bought about a million shares of Lexmark. I haven’t followed
this story closely, but I assume the stock was purchased by Lou Simpson rather than Warren
Buffett. I have only two reasons for believing this: the total purchase was small relative to
Berkshire’s investable assets and the Lexmark purchase is typical of Simpson’s investment
philosophy (or at least, what little I can glean about his investment philosophy from his past
purchases). Regardless of who actually makes the purchases, a new Berkshire holding always
draws a lot of commentary.
The commentary on Lexmark has been almost uniformly negative. Even many value
investors have a very dim view of Lexmark at these prices. Now, I am not a contrarian investor.
Psychology and sentiment do not enter into my considerations at all. I’ve bought stocks trading
near five year lows, and I’ve bought stocks trading near five year highs. I just try to be rational.
I’m not afraid to agree with the consensus, if it’s an accurate representation of reality. Here, it
isn’t. The model of Lexmark that has emerged in my mind over the past few weeks bears little
resemblance to the Lexmark I’ve seen described elsewhere.
Most of the negative comments about Lexmark have focused on the consumer segment.
Yet, more than 75% of Lexmark’s profits come from the business segment. The business
segment is Lexmark’s franchise. There, the company has managed to build a moat, not a very
wide moat, but a moat nonetheless. Lexmark is the only focused, integrated printing company of
any consequence. It understands its business customers’ needs, and provides specially tailored
solutions that none of its competitors can offer.
Worldwide, some very large companies use Lexmark’s products for some very specialized tasks.
Among these are retailers, banks, and pharmacies. Lexmark has complete control of their product
including the printing technology itself and the software used to manage its printers (i.e., to
interface with the user’s computer). Businesses that care about getting these specialized tasks
done right (and getting them done cheap) use Lexmark.
Even Lexmark’s competitors have to concede the fact that Lexmark knows printing better
than anyone else. Lexmark is the only company that develops its own ink – jet, monochrome,
and color laser technologies. It is a vertically integrated printer business like no other. The two
competitors most often mentioned as threats to Lexmark are HP and Dell. While everyone will
suffer from deep price cuts; I think it’s HP and Dell who should be scared.
Lexmark has the much stronger competitive position. For years to come, it will be launching the
best printing products for high ink consumption tasks. Lexmark hasn’t been focused on
competing directly with these companies in the consumer segment; that’s going to change
because of the emerging photo printing market.
Lexmark isn’t interested in selling hardware. It’s interested in selling ink. Now that there is
real demand emerging for high quality printing within the home, Lexmark is going to start going
after the consumer market. Over the next few years, Lexmark will be selling more printers in this
segment. A few years after that, the company will see strong recurring revenues from ink sales.
Generic ink cartridges are the biggest threat to the high margin printing business.
However, I believe, of all the players in this industry, Lexmark will be the least affected. Its
highest margin sales are its most insulated sales. Its lowest margin sales, in its least dominant
businesses, are where generic ink will hurt the most.
There is also some concern that Dell could always move away from using Lexmark printers. Let
them. From what I can see, sales to Dell will not be a particularly significant high free cash flow
margin business. There’s no benefit to the Lexmark brand either. That brand is going to become
stronger over the next decade, because the quality is already there. Lexmark simply hasn’t been
that visible to consumers. The Dell deal doesn’t help build the Lexmark brand. Honestly, I
wouldn’t be terribly troubled if Lexmark’s sales to Dell dropped to zero tomorrow. Such an
occurrence would not materially affect my valuation of Lexmark.
As far as I can tell, Lexmark’s management is excellent. They understand the printer business
better than anyone (they also happen to understand the science of printing better than anyone –
CEO Paul Curlander has a PhD in electrical engineering from MIT). Lexmark’s management
also sees highly profitable opportunities in printing long – term, despite a very competitive
situation short – term. I agree with that assessment.
Within the printer business, there is a real danger of ferocious price competition. However,
I do not believe there is a real danger of prolonged ferocious price competition. Lexmark is the
company best positioned to weather the storm. It will generate tons of free cash flow, none of
which has to be siphoned off to other lines of business, as it does at all of Lexmark’s
competitors. Lexmark’s high free cash flow margin recurring revenue stream will supply it with
more than enough ammunition to outlast its competitors. They may be deep pocketed, but
eventually, they will have to answer to Wall Street. Long – term, they can’t compete with
Lexmark. It will take them some time to realize that. But, Lexmark has the time.
That’s my assessment of Lexmark on qualitative grounds. How does the stock look
quantitatively?
The stock is selling for about 15 times earnings and 10 times cash flow. Right now, a dollar
of Lexmark’s stock buys you a dollar of sales. I think that’s a bargain. Not many companies of
this caliber sell at a price – to – sales ratio of one.
For the last ten years, Lexmark’s return on equity has not fallen below 20%. During the
same period, the company’s return on assets never fell below 10%. The free cash flow margin
has generally been in the 5 – 10% range.
I wouldn’t be surprised to see Lexmark’s ROE and free cash flow fall substantially in the
next few years. However, long – term, I believe a return on equity of 15 – 20% and a free cash
flow margin of 8 – 10% are sustainable. In fact, if I was forced to pick an exact ROE that
Lexmark could sustain I would pick 20%. But, I would also caution you not to expect that for the
next five years or so.
The important estimate is the 8 – 10% free cash flow margin. That’s the best way to value
Lexmark. At one times sales, you have an 8 – 10% yield, if you think sales can be sustained. If
you think sales can grow, you have to factor that into your analysis. At present, a discount rate of
8% seems appropriate.
You can clearly see how I’d value Lexmark. I gave you what I think Lexmark’s free cash flow
margin will be (8-10%), you know what Lexmark’s sales are ($5.4 billion), and I gave you the
discount rate I thought was most appropriate (8%). The only necessary variable I haven’t
provided is a sales growth estimate, and I’m not going to provide that, because I don’t want you
to think it has anything to do with the next five years.
It doesn’t. I’m looking at this company well beyond that point, and I like what I see. Lexmark
will strengthen its brand (with consumers), and people will still be printing. So, yes, I am
projecting revenue growth for Lexmark; and yes, it is enough to suggest Lexmark is worth
substantially more than $5.5 billion.
 URL: https://focusedcompounding.com/on-lexmark/
 Time: 2006
-----------------------------------------------------
On Google’s Franchise (and McCormick’s)
I thought I’d end this year the way everyone else is: by writing about Google (GOOG). Just
Google “the year of Google” and you’ll get some sense of the hype around this stock. Of course,
if you’ve ever watched Jim Cramer’s “Mad Money”, you’ve already had a heaping spoonful of
said hype.
So, why is a value investing blog even mentioning a stock that’s not far from having a triple digit
P/E ratio?
I count seeking businesses with a competitive advantage among the tenets of good value
investing. Google has a competitive advantage. In fact, one might even say its franchise is web
search. I wouldn’t say that. I mean, Google does have a franchise; but, it doesn’t have a
monopoly on web search and never will. There are real problems with Google’s model that are
often overlooked. It does a poor job of finding certain sites that are difficult to describe in
keywords. For this reason, there may still be a market for web search in the form of specialized
niche directories and in some of these “social search engines” (e.g., Stumble Upon) for many
years to come.
I’m not suggesting any of these services will be as successful as Google; I’m sure they won’t
be. I am simply pointing out that there is a difference between a need and the means by which
that need is satisfied. Even as the dominant search player, Google will only have a franchise on
the means (keyword search); it will not have a franchise on the need (finding stuff on the web).
Also, Google can not, at present, rightly be called the dominant search player. There is no
dominant player in search. Google is the leading search player. It is also the catalyst for many
changes in search. But, it is not yet the dominant player in search the way McCormick
(MKC) is the dominant U.S. spice producer.
Looking at McCormick’s franchise is actually a pretty good way of evaluating Google’s. Why do
I say McCormick is the dominant player (domestically) in spice, but Google is not yet the
dominant player in search?
McCormick has a 45% share of the U.S. retail spice market. Its closest competitor has a 12%
market share. We may differ about exactly how the web search pie is carved up. But, I think we
can agree that Google’s share of the search market is no greater than 45%, and that at least two
of its competitors have a share of the market greater than 12%. So, Google’s position differs
from McCormick’s in that the domestic search market is less fragmented than the domestic spice
market.
The spice market is an upside down funnel. The few producers are at the top. They feed their
products through three distribution paths: retail, industry, and restaurants. In each case, the shape
of the upside down funnel remains intact, because the widening happens at the very end. The
ultimate consumer of McCormick’s product doesn’t get to choose from all available spices. His
choice is always indirect. He picks a grocery store, a food product, or a restaurant. Then, he must
choose from the spices that particular supermarket chooses to carry, or the restaurant he
frequents chooses to use (and/or make available).
In search, the story’s a little different. There is still something of an upside down funnel shape
in search. Although, it is less pronounced than it was a few years ago. Search results are fed
through dependent sites that searchers visit. But, it is the searcher who chooses the dependent
sites. A few of these dependent sites account for a large part of all searches. That is very different
from the spice market, where no supermarket or restaurant chain accounts for a large part of all
spice consumption – none even comes close.
So, the searcher has a much bigger role in choosing his search provider than the spice
consumer has in choosing his spice provider. Even though it is true you are sometimes
searching without knowing Google is the search provider, the situation is nothing like it is at
McCormick. When eating a meal you aren’t thinking about McCormick. Quite often, however,
you are using a McCormick product. Whether it was in that package of spices you used to cook a
meal at home, or in that manufactured food product, or in the dish you ordered at the restaurant,
you are a consuming a McCormick product.
What matters as far as the investor is concerned is that the ultimate consumer of
McCormick’s product rarely makes an active, unfettered choice to consume that product
over all other competing products (or even many competing products). The closest he comes
to making such a choice is at the supermarket; though even there, the decision of how much shelf
space to allocate to each company’s products was made for him. To use Google, the first time
searcher must make an active, unfettered choice.
Finally, there is the matter of infrastructure. This consists of two parts: production and
distribution. McCormick has an existing production infrastructure which is helpful as far as costs
are concerned, but isn’t especially valuable. It could be duplicated by a new entrant with deep
pockets. McCormick’s distribution infrastructure is almost impossible to duplicate. It is worth far
more than it cost McCormick to create it. Prying McCormick’s customers (situated at the narrow
of that inverted funnel) away from the company’s products would not be easy. This distribution
infrastructure gives solidity to McCormick’s spice franchise in the U.S. In some instances, it will
also help McCormick abroad (as some of the company’s customers are expanding globally and
will be inclined to stick with McCormick in their overseas operations).
Google’s production infrastructure (the algorithm and the index) is easy to duplicate and
will become even easier to duplicate in the future. There isn’t much of a barrier to entry here.
Google may currently offer the best search service around, but there is no reason to believe this
will always be the case. Distribution is very often the most valuable part of any franchise (it is
usually the part that is hardest to duplicate).
So, the natural question is: in the world of search, if you build it will they come? Will the best
search engine always attract the most searchers? Probably not. That’s good for Google, because
it won’t always be the best search engine. Google has a great brand. Whatever value is in Google
comes from that brand. That brand is what will keep searchers from flocking to the inevitable
newer, better search engine.
All of Google’s revenues are ultimately dependant upon attracting searches. Getting those
searches requires two things. First, millions of people must make the active, unfettered choice to
search Google. Then, those millions of people must keep searching with Google. The brand is
the key to step one. The service is the key to step two. Search customers are sticky. But, they
probably aren’t as sticky as we think. It’s very easy to take immediate action on the web (just
click a link). Switching away from Google isn’t like switching away from Windows.
That leaves the brand. True, when you think search, you think Google. But, is that brand worth
$120 billion? No – and neither is Google.
Happy New Year. See you in ’06.
 URL: https://focusedcompounding.com/on-googles-franchise-and-mccormicks/
 Time: 2006
-----------------------------------------------------
On American Eagle
Generally, I don’t like investing in retailers, because it is nearly impossible to find one with a
durable competitive advantage. I do, however, like to invest in companies generating tons of
truly free cash flow and consistently earning good returns on invested capital while maintaining a
pristine balance sheet. When one such company is priced at less than a dozen times earnings (and
a part of that price is attributable to the cash in its coffers) my heart begins to patter.
The object of my affection: preppy teen retailer American Eagle (AEO). AE recently reported
dismal numbers, and there is no reason to believe things will get better; in fact, they’ll probably
get worse. But, at this price, the issue is not whether sales growth is slowing. In fact, at this price,
the issue is not even whether sales are declining. Even If AE’s sales do decline, the stock could
still be cheap. The issue is whether AE can, on a continuing basis, generate enough truly free
cash flow to justify the current price. If, in the long – run, AE can throw off cash at a rate similar
to that of the recent past, its shares are cheap. Of course, if AE’s ability to generate free cash has
been permanently and materially impaired, its shares are wildly overpriced. Which is it? If you
know, tell us by commenting below.
Otherwise: start your homework by reading another blogger’s take on American Eagle , and a
fool’s take. Requesting an investor’s kit , and/or by checking out AE’s last 10-K right now. You
can also hear more of my thoughts on American Eagle Outfitters on Thursday’s upcoming value
investing podcast.
Until then, happy hunting!
 URL: https://focusedcompounding.com/on-american-eagle-2/
 Time: 2006
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NACCO: Why NACoal Is Inside My Circle of Competence and Hamilton

Beach Is Outside It
I’ve often talked about the importance of focusing on those businesses you – personally – can
understand. Today, I want to use my research into NACCO (NC, Financial) as an example of
that. NACCO is a holding company – it used to own the forklift company Hyster-
Yale (HY, Financial) till it spun that off in 2012 – that now owns two major businesses: NACoal
and Hamilton Beach Brands (expected to trade under the ticker “HBB”). This is a controlled
company (it has super voting class “B” shares that are owned by descendants of the founding
family) that has been diversifying away from coal for a long time.
I believe the company stopped the underground mining of bituminous coal (“black coal”) in the
1980s. However, the company is still involved in surface mining of lignite coal (“brown coal”).
Brown coal is the poorest quality coal with the lowest heat content. For this reason, it’s not
something you ship far. This makes it less of a nationwide or worldwide commodity and more of
something that you would only want to produce in quantity for one or more big, local customer
under a long-term supply contract. Hamilton Beach Brands mostly consists of the range of
Hamilton Beach small appliances (blenders, toasters, slow cookers, coffeemakers, etc.)
Americans are familiar with (you may not remember the brand, but you’ve definitely seen it)
from shopping at Walmart (WMT, Financial) and Amazon (AMZN, Financial). A while back, I
heard that NACCO was planning a spinoff to be completed some time in the third quarter of
2017 (so basically now). This fact wasn’t surprising. I had some slight familiarity with NACCO
because I had researched Hyster-Yale as a stand-alone stock.
The thing that first drew me to NACCO was simply that it was a spinoff. I’ve had two good
experiences with spinoffs: Hanesbrands (HBI, Financial) in 2006 and BWX
Technologies (BWXT, Financial) in 2015. I still own BWX Technologies. It’s about 25% of my
portfolio right now. I also had a good indirect experience with another spinoff: Energizer
Holdings (ENR, Financial). I didn’t buy that stock as a spinoff. But reading about the spinoff
once the company was trading on its own got me interested in the company, its history, etc. So I
am always looking for the possibility that a business I like will be spun off. It doesn’t happen
that often. And sometimes a planned spinoff never occurs. NACCO had planned to spin off
Hamilton Beach twice before (this was about 10 years ago) and didn’t complete the spinoff on
either occasion.
I’ve sometimes looked hard at a potential spinoff (or breakup of some kind) that never happened.
For example, I’ve studied Hawaiian Electric (HE, Financial) for years in the hope that they
would somehow separate their utility business (which I’m not interested in) from their bank
(which I am interested in). I wrote a report about Bank of Hawaii (BOH, Financial). So I know
the Hawaiian banking market. I like the Hawaiian banking market. And I’m always looking for a
way to get a piece of the Hawaiian banking market at a good price. Hawaiian Electric has come
close to splitting the bank from the utility – but, so far, it’s never happened. So all my research
into that stock has been for nothing. This can happen with spinoffs. You want to be prepared. So
you just have to accept that sometimes you research a situation that never materializes.
I said I wanted to get into the Hawaiian banking market “at a good price.” Obviously, I could just
buy Bank of Hawaii. But the market knows that bank’s a good bank, and it tends to trade like it’s
a good bank. I don’t want to pay a high price for a great business. I still want a good price even if
the business I’m buying is a great one.
That “at a good price” part is why you look at spinoffs. The kinds of companies I like best tend
to be “predictable” companies even if they don’t meet GuruFocus’ statistical definition of that
title. For example, I own Frost (CFR, Financial), which I think is a predictable bank if you look
under the hood and ignore the fluctuations in the Fed Funds Rate. It’s the Fed Funds Rate that is
unpredictable. The bank itself is predictable. And I think BWX Technologies is predictable, too.
It’s just that BWXT hasn’t traded as a stand-alone company for very long yet. Once BWXT has
been trading for five or 10 years as a stand-alone business – everyone will recognize what a high
quality, predictable business it is. It’ll be too late to buy the stock at that point. That’s the
attraction of spinoffs.
It’s not just spinoffs. Sometimes other corporate events pull back the curtain on a previously
hidden good, predictable business. A few years ago, I wrote a report on Breeze-Eastern (since
acquired by Transdigm [TDG]). Breeze-Eastern had a wonderful core business of selling the
original equipment (and more importantly, the replacement parts and maintenance) on search and
rescue hoists for helicopters. That business had always been a pretty predictable one. But Breeze
had bought a bunch of other things, loaded up with a lot of debt and then unwound all that
buying and paid off all that debt. This made the company’s past history look murky. That’s good.
That’s actually what you want if you’re a value investor who likes a good, predictable business.
You want something to be obscuring the qualities you see in the business. I find this is better
than betting on turnarounds. Instead of finding a business that has tended to be good in the past
but is now facing some problem and needs to be put back on course – you find a business that is
already good but can’t be recognized as such just yet.
I’m looking at NACCO now. NACCO is spinning off Hamilton Beach. So does that mean
Hamilton Beach fits that description?
It might. Hamilton Beach is a known “name” brand in the U.S. I wouldn’t say it has any
particular positioning as a premium brand of small appliances or as standing for something in
particular. I haven’t met anyone yet who believed Hamilton Beach has mindshare. But it has one
of the broadest arrays of small appliances, and it has some of the most shelf space at Walmart of
any small appliance maker. And yet the business is capital light (the manufacturing is all
outsourced to China basically). The Hamilton Beach name hasn’t had a ticker of its own. Instead
– to buy the business – you’d need to buy into something called NACCO. If you picked up
NACCO’s 10-K, you get a very long description of NACoal and all of its risks and such before
you ever get to hearing about Hamilton Beach. Investors interested in a consumer products
company might not want to invest an equal amount of their capital in a coal company. And going
back further, you’d have been investing in Hyster-Yale too. So Hamilton Beach wouldn’t be an
easy business to invest in. It was public. But, unless you wanted to own some forklifts and coal
mines – it wasn’t something you were going to buy.
What is Hamilton Beach worth?
I’m honestly not that sure because I pretty quickly eliminated Hamilton Beach from
consideration for my own portfolio. This isn’t because Hamilton Beach is a bad brand or will be
a bad stock when it trades on its own. It’s simply that Hamilton Beach is outside my “circle of
competence,” as Warren Buffett would say.
How do you know your circle of competence?
You start by asking two questions.
What do I know well? What have I researched before?
Many of my good investments have been in companies with little or no competition. I am terrible
at evaluating retail companies. The average analyst who covers consumer products companies
will understand Hamilton Beach better than I will. I don’t follow Walmart or Amazon as closely
– nor do I feel I understand them as well – as many investors do.
NACoal is different. The company is involved in operating lignite (again that’s “brown”) coal
mines for a few major customers. These customers are usually power plants of some kind. They
sit very, very near (in some cases, basically on top of) the coal deposit that NACoal is working. I
was able to confirm this to my satisfaction by going online and getting satellite images of
NACoal’s five biggest mines. Using those images, I can see where the customer’s plant is in
relation to the surface mining activity.
I’ve never researched a coal miner before. However, I have researched two companies related to
coal mining. Brink’s (BCO, Financial) is the armored car company. What you may not know
unless you’ve read that company’s 10-K is that the corporation that is now Brink’s was once
involved in coal mining. It has obligations related to its former coal mining operations. There is a
retirement plan related to union workers (which Brink’s expects to have to pay into 10 years
from now), and there is a fund for black lung victims. That fund involves lifetime benefits. So
it’s definitely a long-term obligation.
The company I researched that is more directly related to coal is Babcock & Wilcox. I told you I
own shares in BWX Technologies. That is the nuclear side of the old Babcock & Wilcox. It
mostly builds nuclear reactors for U.S. Navy submarines and aircraft carriers. It also maintains
nuclear power plants in Canada and provides a bunch of nuclear-related services (often related to
America’s nuclear weapons program) for the U.S. government. The other side of Babcock was
the coal part. Babcock & Wilcox’s expertise was in steam. They were historically the best
around at doing steam on a very, very big scale. Two kinds of projects tend to involve steam on a
big scale: nuclear power plants and coal power plants. Most other ways of generating power
don’t involve much steam.
A huge risk for Babcock & Wilcox (pre-spinoff) was that coal power plants in the U.S. would
close as environmental regulations required them to invest in capex right now (so pony up more
cash) while natural gas prices were cheap. Some plants can switch from coal to natural gas. And
even when that isn’t possible, coal power plants and natural gas power plants may be in
competition in a local area. This is different than say nuclear. A nuclear power plant – once
construction is complete (this phrase is key) – is going be a lower ongoing cost way of producing
electricity than either coal or natural gas. Nuclear power plants don’t experience downtime for
economic reasons. They have downtime for maintenance. Coal and natural gas is different. At
one price for natural gas, you’d operate the plant. At another price, you wouldn’t. So natural gas
is often your marginal source of electricity supply. It gets turned on and off, built or shut down
first.
After the spinoff of Babcock & Wilcox Enterprises (BW, Financial) from BWX Technologies
(the renamed Babcock & Wilcox that was left over), I sold my shares in BW and kept my shares
in BWXT.
Was this because of concerns about U.S. coal power plants?
Actually, no. I sold because I was concerned Babcock was concerned. Not because I, myself,
was as concerned.
Let me explain that.
Babcock’s coal business in the U.S. was largely maintaining boilers it had built. That’s a good,
repeatable business. Over time, the amount of maintenance work was going to decline. But you
aren’t going to go out of business quickly by relying on a shrinking base of maintenance
contracts. How do you go out of business quickly?
As an engineering company, it’s pursuing business you shouldn’t. And I was really worried
about Babcock expanding into things like waste-to-energy projects and doing more work in other
countries. Babcock had done things other than coal before. And it had done work outside the
U.S. But when I looked at the company, the part I felt most sure of was coal in the U.S. After the
spinoff, BW seemed to be moving aggressively in the direction that I wasn’t sure of. It’s not that
going into different kinds of energy and more emerging markets is necessarily worse than coal in
the U.S. – it’s just unproven. And if an engineering company makes mistakes like giving a quote
that turns out to be way less than what the project will cost to deliver – things can go very bad.
So I haven’t talked about this before, but that’s really why I was looking for an opportunity to
sell that part of the Babcock breakup. I could see that business turning into something less
predictable that I didn’t want to be a part of.
In the case of NACCO, I think I do – at the right price – want to be a part of NACoal. I just don’t
know if I want to be a part of Hamilton Beach.
NACoal’s value comes mostly from the earnings of unconsolidated mines. These mines are fully
owned by NACoal but are not consolidated on the books (their revenue, costs, etc., don’t appear
on NACCO’s statements). The mines are funded with nonrecourse debt. The mines sell their
production on a cost-plus basis per ton. If the plants they sell to demand less coal, the mines
make less money. Otherwise, there is no commodity risk, macroeconomic risk, etc. The mines
make the same profit per ton of coal delivered, and that profit adjusts for inflation over time. The
contracts are supposed to expire anywhere from about 13 years from now till about 28 years
from now.
Risks include the possibility that the customer will not have much demand for coal. If the
customer terminates the agreement or defaults, they would be obligated to pay book value to buy
out the unconsolidated mine. Remember, NACoal owns 100% of the mine. So the customer
would be paying NACoal a termination fee of sorts. I’ve tried to do research into this, but I just
don’t know how substantial this would be in some cases. NACoal’s own capital contribution to
these mines is tiny. But since it isn’t consolidating the equity interest of its balance sheet, it’s
possible I’m not seeing book value that’s actually significant. Also worth mentioning is that I
would be buying stock in NC (that’s NACCO) which is not the same thing as NACoal which in
turn is not the same thing as the various unconsolidated mines.
All of the unconsolidated mines have debt that is nonrecourse to NACoal, and NACoal itself has
debt which is nonrecourse to NACCO. After the spinoff, NACCO will mostly be just NACoal
and an additional subsidiary called Bellaire, which is really just old mining liabilities. Bellaire
detracts value from NACCO. Anyone looking at NACCO stock would have to take this into
account. I dug up some legal documents on Bellaire but am not knowledgeable enough on the
issues to quantify how much the legacy liabilities housed in Bellaire will ultimately cost NACCO
shareholders. So although I’ve read documents you haven’t (if you’ve only read the 10-K), the
end result is the same as if I’d just read NACCO’s disclosure on Bellaire in the 10-K.
The other huge risk in NACCO is that one of the mines is consolidated. NACoal actually puts up
the capital for this mine. This mine still has the same sort of cost plus contract. But actually
owning the mine is different from operating a mine someone else owns. There’s also a guarantee
the company gave related to another mine. In that case, the company could be on the hook if a
customer fails to meet certain obligations to its lenders. So there are three unusual risks: Bellaire
(legacy liabilities), the consolidated mine and this one guarantee NACoal made.
The other risk is the more normal business risk that customers will shut down plants and
terminate their agreements. In other words, you’ll lose customers. It’s a risk. But that’s business.
Hamilton Beach has a risk of losing Walmart. NACoal’s biggest customer isn’t bigger relative to
NACoal as a whole than Walmart is to Hamilton Beach as a whole. So, yes, a customer’s plant
shutting down is a risk. But it’s a risk I’m used to seeing with any sort of business that has big
customers. If a customer terminates, they’ll be buying out the mine associated with the contract.
So it’ll be like shrinking the company. It’s bad. But it’s not the same thing as having a mine you
actually own and no demand for your coal. And NACoal can win new contracts. In fact, it has a
five-year plan that envisions a large increase in earnings from unconsolidated mines. I don’t
know if the company will hit this target. But it’s entirely possible that NACoal could win as
much business as it loses over time. I’m more comfortable with cost-plus contracts that can be
terminated if the customer buys you out than I would be investing in a company that owned a
higher quality (“black”) coal mine and sold it as a commodity that could be shipped.
Finally, NACoal has diversified into operating draglines for lime rock quarries in Florida. I once
owned stock in an aggregate company called Florida Rock (it was acquired by Vulcan
Materials), and I did a lot of research on U.S. Lime (USLM) and continue to follow that stock
and the lime industry in the U.S. It’s an industry I like a lot.
What makes NACoal easier for me to analyze than Hamilton Beach?
I’ve had experience researching companies with long-term contracts, cost-plus contracts and
limited competition due to location. Basically, NACoal’s mines and the plants they supply
should be mutually dependent. So, yes, if these plants fail the mines will fail, too. But as long as
the plants stay in business and keep needing coal, they should always get that coal from the
associated mine at pretty much a guaranteed real profit per ton of coal delivered. NACoal should
be free from price competition.
For these reason, NACoal looks to me like the business I can understand and Hamilton Beach
like the business I can’t. This is, of course, subjective. One, I could be wrong. And two, other
investors – like you – might have way more experience researching retailers, consumer products,
small appliances, etc. You may know a lot about Walmart and Amazon. I know next to nothing
about those businesses.
I’ve had more experience researching businesses that take stuff out of the ground and don’t move
it very far because it’s heavy and not worth much per pound. So NACoal is inside my “circle of
competence” and Hamilton Brands is outside my circle of competence.
Right now, I don’t own shares of NACCO. I might buy shares of NACCO after the Hamilton
Beach spinoff. Depending on the price of each of the two separately traded stocks, I might do
anything from buying NACCO to buying Hamilton Beach to doing nothing. My decision will
come down to price. But, putting price aside, the piece I’d be interested in owning is NACoal not
Hamilton Beach.
 URL: https://www.gurufocus.com/news/571537/nacco-why-nacoal-is-inside-my-circle-
of-competence-and-hamilton-beach-is-outside-it
 Time: 2017
-----------------------------------------------------
Which Product Categories Will Online Retailers Never Conquer?
Since I researched PetSmart when it was public, someone asked for my thoughts about online
retailers of pet supplies (including dog food – which tends to be a key profit source):
"(You) mentioned that the biggest threat to PetSmart was the online competition. In the notes
(your co-writer) wrote that it’s hard to make money selling pet foods online because it's
expensive to ship it. So the logistical challenges and the prices may be the bottleneck of the
business.
"I think zooplus (XSWX:ZO1, Financial) has an interesting story. In many ways they have taken
the Amazon (AMZN, Financial) way, focusing on building scale and customer satisfaction at
the expense of short-term profit. Amazon also (has) a meaningful market share but is only bigger
than zooplus in the U.K. As it is in brick and mortar, I think there will be both room for a
generalist like Amazon and a specialist like zooplus. The question is if zooplus can build the
sufficient scale to become profitable.
"Are you familiar with zooplus? Did you look at it when you worked on the issue on PetSmart?”
I don't know zooplus.
And I haven't revisited PetSmart since it went private (the company bought Chewy.com after I
did my report). However, I can talk a little bit in extremely broad strokes about online retail
concepts as business models vs. their offline counterparts. What I'm going to talk about here is
what I've seen in doing company-specific research versus what I see hypothesized by the press,
analysts, etc., about online retail generally. If I don't mention an industry, then I probably haven't
researched how selling online vs. selling offline works. Like shoes, I know nothing about the
economics of online vs. offline. The last time I researched a shoe company almost no shoes were
sold online. So I can’t say a single word about shoes. What I can talk about is human food, pet
food, auto insurance, pet medication, diamonds, office supplies, etc., only because in each case
I've researched a company involved in the offline sale of the product and a company involved in
the online sale of that same product.
There is often a belief that online retailing involves less marketing expense than offline.
I haven't seen much evidence to support this. And with specific companies we've looked at, I
have seen evidence to support the idea that online retailing involves more advertising expense
than offline retailing. After all, these are startups. So they have no name recognition at first.
Many companies that run into problems online do so because they once had lower customer
acquisition costs than they do now. Online customer acquisition costs aren't as stable as
something like rent in a mall – so the marketing aspect of a retailer online can have risks you
might not think of.
Customer acquisition costs are often high online. This means industries where the lifetime gross
profit from a customer is high are good candidates for going online while industries where the
lifetime gross profit from a customer is low are poor candidates.
People talk a lot about razor blades. Razor blades went from like 0% outside the top few players
to maybe 10% pretty quickly. It's not an accident that razor blades had success being sold online.
However, we should pause here and consider that Dollar Shave Club and Harry’s spent an
enormous amount buying online ads relative to the actual amount of sales those ads have so far
generated. The huge ad spending could easily be worth it for them as I’ll explain. But they
certainly didn’t advertise less than an offline razor blade company – in fact, they advertised a
heck of a lot more.
Gillette actually researched the possibility of doing something like Dollar Shave Club before
Dollar Shave Club existed; they just didn't act on the idea. I’m not surprised they considered it
internally. Razor blades are the most obvious (tangible) consumer product to sell online.
The reason it makes sense to sell things like auto insurance, razor blades, etc., online is because
the expected lifetime gross profit from a customer is extraordinarily high. If you have a
"seasoned" loyal user of Gillette or Schick who has been shaving with that product say since he
graduated high school and started doing all his own shopping till he's now a junior in college or
something – that's about as valuable a customer as a consumer product company can ever have.
If you look at it from a DCF perspective, razor blade companies could offer to give you a signing
bonus of $100 just to have you agree to use their blades for a couple years. It's not unreasonable
to believe that even when adjusting for customer attrition a man who is currently shaving with
Gillette or Schick is worth in excess of $50 a year in incremental cash profit to the company that
has that man's business. If you do some quick math on what the gross profit on an incremental
blade is, what percent of customers stay loyal to a brand each year and then discount the cash
flows for the next best use of the company's money – honestly, I can't come up with a number
less than $180 for the net present value of a razor blade customer.
That's not my estimate by the way. That's just the NPV I believe a premium (that is, Gillette or
Schick – not Dollar Shave Club) razor blade customer can't be worth less than if he's really
loyally using your product this year. I have no special insights into this topic of customer NPV
and didn't try looking anything up to find out. I just made estimates for gross profit, customer
attrition, etc., that I know are conservative based on my knowledge of Schick’s business (since I
researched that brand’s parent company years ago). My point is that if Schick really thinks that
buying $180 of ad time gets them one additional truly new shaving customer (like a kid going off
to college for instance) then they aren't destroying value by spending to do that. And, of course,
advertising is known to increase frequency of purchase with any existing customers who are
exposed to it.
But even if we imagine they were just doing direct mail or something, you can come up with an
estimate where they could still probably be justified spending $180 just to get a new shaving
customer to "trial" their product for like a year. Now, they're not a wireless carrier or a printer
maker or something; they can't really get you under contract or have a high sunk cost up front.
So the biggest danger is you try Gillette this week and Schick next week. Till they get you
consistently using one it wouldn't be worth much. But if you could build a habit – that habit has
to be worth more than $180 to the company. Obviously, a value-oriented customer who goes
with Dollar Shave Club is less valuable because: 1) They pay less per blade for your brand, and
2) they showed they were willing to switch brands for a lower price.
So just because this is a problem for Schick and Gillette does not necessarily make Dollar Shave
Club a good business for Unilever (UN, Financial) (its parent company). There is definitely a
risk that Dollar Shave Club could overestimate the lifetime value of the lower quality customers
they are poaching from Gillette and Schick. Logically, a Dollar Shave Club customer can never
be as valuable as a Gillette or Schick customer. So Dollar Shave Club shouldn’t be willing to
spend as much to acquire customers as Gillette or Schick would. The risk here is that Dollar
Shave Club could spend too much on advertising.
The economics of razor blades sold online are very similar to the economics of auto insurance
sold online.
In auto insurance, we have ideas of how high retention rates are. We know what rates are. And
we know that new business both has a high customer acquisition cost and also has higher loss
rates and lower renewal rates in the first year than a policyholder who has been with you a few
years. What I'm saying is that a "Year 3" type policyholder – someone who has renewed for a
couple cycles now –Â is very, very valuable to GEICO or Progressive (PGR, Financial) or
USAA. It makes a ton of sense to spend a lot of money and hurt EPS for a couple years to grow
the number of seasoned policyholders you have. However, every time you do this you hurt EPS
for the current calendar year.
Most consumer product categories where the lifetime value of a customer is high involve
frequent purchases out of loyalty. However, there are a few businesses that have very high
marginal cash profit from just one online sale. Most notable are room rentals and airline tickets.
There's a big factor with each of those, too, which is that you can sell a seat or a room online to
someone who is searching for it without announcing this lower price to the world. TV
advertising is problematic for airlines and especially hotels because the price they are willing to
offer right now to sell an unoccupied seat/room is very low. Rooms are perishable. They expire
worthless every night. So hotel room pricing has to be very, very opaque.
As a room seller, you never want transparent pricing. You don't want to list the same price per
night for the guy who walks into your lobby at 11 p.m. unannounced, the person searching online
for a vacation in five months, and anyone watching TV in a city that sends tourists your way. No
one should know the true price you are selling your rooms for on average (because you are
actually willing to make that price quite low as long as you hit higher occupancy). A hotel's
willingness to sell an empty room is so high that they need to keep the general public in the dark
about just how low they'd go on price. So it's in the interest of cruise lines, airlines, hotels, etc.,
to sell either through travel agents or online instead of naming prices the general public can see
(which would cheapen the "normal" rate people expect).
I see amazing long-term futures online for the selling of razor blades, auto insurance, airline
tickets and hotel rooms. There's no reason these products and services shouldn't be sold primarily
online and in greater and greater numbers for many years to come. But notice, none of these
things cost much of anything to sell online.
Dog food does. And that's a problem. There are some successful online retailers of stuff with low
value-weight ratios like Walmart (WMT, Financial), Staples and Amazon. But these companies
own distribution centers. They ship a lot. If you read their 10-Ks, you'll realize just how good
their systems are for getting things to places at low prices. Other sellers lack these advantages.
They often need to pay someone else to store and/or handle their product, and they aren't going
to be able to pay different prices for shipping than any other business.
When researching PetSmart, we found those problems close to insurmountable for an online pet
supply startup.
Can Amazon sell dog food?
Yes. The research I did for that report I never published did convince me that Amazon can sell
dog food on a subscribe-and-save basis to certain Prime customers. But the economics of this are
more like Costco (COST, Financial) electing to sell a certain brand of dog food to its customers
than they are like what a dog food only / online only competitor would face.
Amazon's Prime members are loyal. And they are probably looking for a convenient way to get
dog food shipped from Amazon rather than price comparison shopping a lot of different dog
foods. Amazon is perceived by a lot of people in the press as winning on price. But I've just
never seen that as a main factor for their success. The factor I do see is that for a certain subset of
customers Amazon has become the Google of Things. If you need information, you search
Google. If you need a product, you search Amazon. I've seen this a million times in person. For
loyal Amazon customers, they do not Google things you can buy. They only Amazon things you
can buy. Now, once something isn't available on Amazon, won't ship fast enough, seems too
expensive, etc., they start looking around online and offline. But Amazon customers aren't
starting at Google. They aren't even using Google at all when searching for physical stuff.
I think the economics of having someone typing in "Hill's Science Diet" or whatever into Google
are very different from someone typing "Hill's Science Diet" into Amazon – especially if they
are an Amazon Prime member.
The cost structure that Amazon has for both acquiring that customer as a regular buyer of dog
food (assuming they are already a Prime member buying other stuff from Amazon) and then
storing, handling and shipping that product are very different from what other websites would
face.
In some of our figures for costs, we ran numbers that we know companies like Costco, 1-800-
PetMeds and Blue Nile have for what they sell. For the actual getting of the product from point
A to point B you're not going to beat Costco or Amazon's cost structure. You also aren't going to
have lower G&A expense than any of the companies I mentioned. There's a reason businesses
like 1-800-Contacts, 1-800-PetMeds, Blue Nile, etc., got started and successful online quickly
just as there's a reason auto insurance and razor blades can be sold effectively online.
I don't want to sound too pessimistic here. The market is going to get segmented over time. So
online may steal 20% or 40% of the share of the market in some products that don't particularly
make any more sense being sold online than they do being sold in stores.
I'm just saying that it makes way more economic sense to sell auto insurance, razor blades, pet
medication, diamonds, etc., online than offline.
What about dog food?
You know, if you value convenience and you are a Walmart customer or an Amazon
customer – yes, I think you will end up getting your regular shipments of dog food online.
Pet food is certainly less protected from online competition than the selling of human food.
Supermarkets are safer from online competition. There's a selection and convenience problem for
supermarkets – at least in the suburban U.S. – that is close to insurmountable for online. Amazon
might design a whole elaborate system of pick-up / delivery sites that overcomes this. But the
infrastructure they are going to need to build, the systems they are going to need to put in
place – these have to be intelligently designed as big bets made from the very top of Amazon's
management to sink a lot of capital into winning in groceries. It's not something that can develop
organically where we are going to see a lot of online grocery concepts operating as efficiently as
supermarkets. U.S. supermarkets are very efficient in terms of selection and convenience when
you consider households are made up of several people. Online is a viable option for some single
people, some couples, etc., especially in very rural or very urban places. U.S. supermarkets can't
really serve either rural areas or urban areas. But the idea of online being a superior business
model to a supermarket for meeting the needs of a suburban family doesn’t sound right to me. I
just can't come up with a new, online model that works better than a supermarket within driving
distance. This could be a failure of imagination on my part.
But I do believe online can be successful selling groceries in Kansas and in Brooklyn. And there
are parts of the world that have more in common with either the urban U.S. or the rural U.S. than
the suburban U.S.
Pet food is different than what supermarkets are selling because a household is basically just re-
ordering the exact same item for their cat or dog for the life of that animal. There are similarities
here to 1-800-PetMeds which has been a successful business.
The thing I would watch out for is the customer acquisition cost versus the lifetime value of the
customer. If I had to break down confidence in continuing to hold the stock of some online
retailer to just one formula/trend it would be:
Customer acquisition cost / lifetime value of the customer
If you can do some back-of-the-envelope math on zooplus that convinces you they were able to
lower customer acquisition cost by 5% a year the last couple years while raising lifetime value of
the customer (so probably better retention rate and higher cross-selling) by 5% – then I'm excited
for you that you're looking at this idea. Because that's an amazing trend if it's going in the right
direction. Scale can solve most of the other problems over time. But if customer acquisition cost
and lifetime value of the customer are trending in the wrong direction – I'd seriously consider
getting out of even a high-growth internet stock that was facing that trend.
This can be a trend that eventually undermines the company's growth.
If you have a novel value proposition for customers – like shipping something they used to have
to buy in stores –Â you can quickly get some customers really cheap just on the basis of them
being biased toward what you do best. So if 20% of all pet food buyers really value convenience
more than price, selection, etc., you can win those people over quickly. But, then like any other
business, you're going to get a response from the existing players that can copy a lot of what you
do.
Over time, there's obviously going to be a tendency in retail for offline retailers to become
progressively more like online retailers and online retailers to progressively become more like
offline retailers. In 15 years, I don't expect us as investors to be able to as neatly divide online
and offline retailers into two buckets. More and more retailers will be selling through both
channels despite starting in one or the other.
The company you mentioned is zooplus, and they specifically mention that:
“Pet supplies are ideally suited for online retail:
 Standardized products.
 Regular and repeat demand patterns.
 High-convenience home delivery.”
I agree with all of that.
I don't know European pet supply markets at all. In the U.S., the difficulty in doing pet supplies
online is that you are competing with PetSmart generally, and you also need to bargain with
branded suppliers of dog food for their product.
Some sellers of dog food use selective distribution of their product. For example, some sell only
to:
 Independent pet supply stores (highest selectivity).

Others also sell to:
 PetSmart and its largest competitor (second-highest selectivity).
While others also sell to:
 Supermarkets, etc.
There are a lot of pet food brands that don't want to be in Walmart. This is something I think is
misunderstood by some reporters and analysts. They assume that Walmart can sell any pet food
they want.
Many brands don’t want to sell through Walmart.
If you think about it,Â this makes sense. The cost of shipping dog food is always going to be the
same per pound no matter what the dog food is made of. The amount of dog food – in
pounds – that a given household can buy each month is always going to be the same no matter
what the dog food is made of.
So some costs are always going to be stable per pound instead of per dollar of revenue. And then
demand per household will definitely be stable in terms of pounds rather than dollars. You can
convince a pet owner to pay $3 per pound instead of $1 per pound for their dog food. You can't
convince them to feed their dog 90 pounds a month instead of 30 pounds a month.
So there is an economic case to trying to take your brand as premium as possible. The easiest
way to do that is usually:
1. Sell your brand in fewer places.

2. Spend more on advertising your brand.
So online sale of dog food does present certain problems for the dog food brand owner. There's a
trade-off if you are getting a lower price per pound for what you're selling. And they want a high
price per pound both when selling wholesale but also they want households to see a high price
per pound whenever they encounter the brand. Otherwise, you are doing long-term damage to the
brand.
I think there's a ton of room for a company like zooplus to grow. There's plenty of room for
PetSmart to exist in the U.S. and for there to be big online sellers of the same stuff PetSmart
sells.
Do I believe that selling pet food online versus offline offers something clearly superior for most
customers?
No. I don't think it's a better business. But I think online and offline sellers of dog food can
coexist long term. Industries often have more than one business model.
I mean, I think worldwide right now, you have something like 40% of hotel rooms being booked
online. I expect that number to be 80% to 100% in 2032 (so 15 years from now).
In 2032, do I think 80% to 100% of dog food will be sold online?
No. I don't think that, worldwide, 80% to 100% of dog food will ever be sold online.
Over the last 15 years, we've seen a lot of product categories go from about 0% online to much
closer to 50% online. I think that has caused some people to believe that even product categories
that are now not much better than 0% online will one day be 80% online or something like that.
And that's just not going to happen. We really could see auto insurance and razor blades and
hotel rooms go to 80% online all over the world. Neither dog food nor human food is going to be
sold 80% online.
But that doesn't mean I'm saying to avoid investing in online retailers of pet supplies. Online
retailers of pet supplies are going to live or die based on whether they can grow customers
rapidly while showing an improving trend in customer acquisition cost versus the likely lifetime
value of a customer.
Everyone else in the stock market world who looks at these things is going to be focused on
customer growth, revenue growth, etc., quarter by quarter.
My advice to you is to focus instead on your best estimate of customer acquisition cost and
lifetime value of the customer (which is mostly driven by retention rate and cross-selling). If that
trend is positive, I like your odds in the stock. If that trend is negative, I'd be worried.
But the market is huge. So as long as the actual economics of what it costs to get a new customer
and what that customer is worth to you are in your favor – the amount of available market share
out there can easily accommodate you making a lot of money holding zooplus stock and
PetSmart staying in business too.
The other thing I would look at is private label. If zooplus can get customers to transition to
private label – that's huge.
We can invert this and look at things from the dog food brand owner's perspective instead of
from the dog food buyer's perspective. I don't think investors flip things that way nearly enough.
So imagine my entire family's fortune is tied up in one dog food brand. Where would I sell my
family's dog food?
There are three places I would never let it be sold: Amazon, Walmart and Costco.
You don't want to get into bed with any of those retailers if your goal is maximizing the long-
term value of your brand. If some of the stats you told me about zooplus are indicative of the
business' overall quality, I'd say that as a dog food brand owner that may be a retailer I'd want to
avoid selling to as well. You don't want to lose bargaining power over time by depending on
some retailer that is going to squeeze you, cheapen the brand, etc.
The goal of any retailer like Amazon, Walmart or Costco – and, in this case, zooplus – should be
to transition customers to the store brand. But if you are selling private label stuff in your store,
you're probably not someplace a strong brand wants to be sold through. That's if the brand owner
is thinking long term. I've seen a lot of brand owners think shorter term and believe that getting
into Walmart, on Amazon, etc., is clearly a good thing. In the short term it always will be. But, in
the long run, I wouldn't be surprised if some dog food brands always avoid selling through some
big retailers both online and offline. It's in the brand owner's long-term interest to maximize the
price per pound of their product wherever it's sold.
 URL: https://www.gurufocus.com/news/569766/which-product-categories-will-online-
retailers-never-conquer
 Time: 2017
-----------------------------------------------------
What Does Warren Buffett See in Apple?
Since Warren Buffett (Trades, Portfolio)’s annual letter came out and he followed up with a

lengthy interview on CNBC where he talked about how much more Apple (AAPL, Financial)
stock Berkshire now owned – and how he was the one who bought most of it – I have gotten a
lot of email questions asking about his purchase.
This is not the first time I have received a slew of emails questioning the logic of one of Buffett’s
investments. Since I have been writing articles about investing, he has made four investments
that really got a reaction from value investors who doubted the logic of what he was doing.
These include: Buffett’s initial purchase of railroad stocks and his subsequent purchase of all of
Burlington Northern, his investment in IBM (IBM, Financial) despite him having said he does
not invest in tech stocks, his investment in the four major U.S. airlines despite the fact he has
said the airline industry is a terrible one for investors and now his investment in Apple.
Berkshire Hathaway's (BRK.A, Financial)(BRK.B, Financial) investment in Apple is far from

the most controversial of these cases. A bunch of other value investors like the stock. It is a
reasonably priced stock on an enterprise value basis – Apple has a lot of net cash, so its market
cap exaggerates the valuation being put on the company. But, each of these investments by
Buffett is an example of him moving into an area he had not previously touched. I am not sure
Buffett ever invested in a railroad stock despite the fact that when he started his career – in the
early 1950s – railroad stocks were a much bigger part of the investment landscape than they are
today. Buffett may not have bought tech stocks before IBM – but it is, in most every other
respect, the kind of stock Buffett would normally buy.
Also, Buffett previously said the reason he never owned Microsoft (MSFT, Financial) was

because no matter whether it was true or not – people would assume the purchase was the result
of inside information from his friend, Bill Gates (Trades, Portfolio). He also said, however, that
at one point Microsoft stock got to a price – presumably, this is sometime after the 2008 financial
crisis – that seemed low to him. Buffett rarely talks about whether the price of a stock seems low,
high, etc. unless he understands something about that business and that industry. So, it is not
unreasonable to think Buffett believes he understands some things about Microsoft. And those
things might allow him to – within a very wide value range – know whether even a tech stock
like Microsoft is cheap or not.
Now, let’s look at Apple. What does Buffett see in that stock? The number one thing that appeals
to Buffett about Apple is something that should not matter at all to you. Buffett is attracted to
Apple’s size. It is a huge stock. Buffett said on that same CNBC interview I mentioned that
Berkshire was unlikely to take a bigger than 10% stake in a company because of the problems
that presents. Berkshire has ended up with more than 10% of a company’s stock, but that has
often been helped along by share repurchases on the part of the company itself.
Right now, Ted Weschler and Todd Combs are each running $10 billion portfolios at Berkshire.
Those are the small portfolios. Buffett is investing at a whole order of magnitude more in size.
But, let’s start with just the kind of ideas Weschler and Combs need to come up with.
Assume you are running a $10 billion portfolio that is fully invested in common stocks. Further
assume you want to avoid buying more than 10% of a company’s stock. Now, assume you are a
concentrated type investor the way BuffettÂ is. As I write, my own portfolio is 65% invested in
just two stocks: Frost (CFR, Financial) and BWX Technologies (BWXT, Financial). It is 85%
invested in just three stocks. The third stock, however, is a micro-cap. Managers investing
billions of dollars cannot even look at a micro-cap. The very smallest stocks they can possibly
buy are things like Frost and BWX Technologies. So, how much of their portfolio could they put
in those two stocks? Remember, I have 65% of my portfolio in those stocks.
Well, if you are managing $10 billion, and you are buying stock in a company with a market cap
of about $6 billion (which is about the size of Frost and BWX), you can put just under $600
million into the company without crossing the 10% ownership threshold. So, say you have two
good ideas that are each $6 billion companies – put them both together and you get just 12% of
your portfolio in those stocks. Now, for me personally, I do not want to spend time worrying
about a stock that is much less than 20% of my portfolio. Here, we are talking about stocks that
are 6% of your portfolio if you buy absolutely as much of them as possible. You see the problem.
And I have understated it.
Buffett is running about 10 times what Weschler and Combs are running individually. And
neither Frost nor BWX Technologies is a small company. Within its niche of Texan banks, Frost
is the biggest. And within its niche of nuclear work for governments rather than civilians, BWX
Technologies is the biggest. So, Buffett cannot be looking for companies that have market caps
of $6 billion. He wants companies with market caps of $60 billion or even $600 billion. Apple
has a market cap of even more than $600 billion. So, here we have a company where instead of
putting just 5% of your portfolio into the stock at the very most, you might get the chance to put
10%, 20% or even 50% of your portfolio into the stock. When Buffett was running his
partnership, he liked to put 25% into his best idea. In the case of American
Express (AXP, Financial), he even went beyond that. If we do a little math with the amount of
money Buffett manages at Berkshire, we can see that ideas in the $100 billion to $700 billion
market cap range are really, really useful to him because he can potentially deploy $10 billion to
$70 billion (10% of the value of these kinds of companies) into such gigantic public companies.
Think about what kinds of companies you have in the $100 billion to $700 billion range. It is
pretty limited. Buffett likes focused companies. He likes brands. A great idea for Buffett is
something like Coca-Cola (KO, Financial), American Express, Wells
Fargo (WFC, Financial), Moody’s (MCO, Financial), or Gillette. Those were great ideas
because they were not just big companies. They did very few things in a very big way. Buffett’s
stake in Gillette got swapped into Procter & Gamble (PG) stock. He eventually did a deal to get
out of P&G by taking control of Duracell. Duracell is a big brand like Gillette. P&G is an even
bigger company, but only a few of its brands are huge in a way that is useful to Buffett. P&G as
a whole is more diversified into things that are not really as good as Gillette is on a standalone
basis.
Not only is Apple a huge company, it is a hugely focused company, which is attractive to
Buffett. Apple’s fortunes are now tied to one brand (as they really always have been) and largely
to one product (the iPhone). When you listen to what Buffett said about Apple, you realize how
important this is. Buffett said he likes Apple. He said he sees how integral the iPhone is to the
lives of people – especially young people – who now have it. And he says that he sees – at places
like the Nebraska Furniture Mart stores he owns – that people upgrade from one iPhone to
another instead of considering competing brands. So, the investment thesis is surprisingly
focused for a giant company. It really has to do with one brand and one product, the iPhone. That
is it. Buffett can evaluate the stickiness of one consumer product and one brand. That makes
Apple easier to understand than Procter & Gamble or Disney (DIS) or other giant consumer-
oriented businesses that are actually much more diversified. Apple is not diversified. That is the
potential attraction.
Moving on, Buffett thinks Apple, like IBM, is not going to do a lot of big acquisitions. He thinks
the company is going to buy back a lot of its own stock. This is a very common theme in a lot of
his investments. One of the surest signs you can find for a “catalyst” that might change his
thinking about a company is that company turning inward and focusing on the things it does best
while dedicating its free cash flow toward reducing its share count year after year instead of
expanding into other areas.
Buffett is not an activist investor, but if you look at those areas where he has been most vocal –
either while on a board, in the way he abstained from a vote or what he said to the press – it is
almost always a capital allocation decision. It is usually related to the issuance of company stock.
Sometimes it is related to overpaying. Nonetheless, he is constantly urging the management of
the companies he invests in to focus on widening their moat, doing what they do best and
investing in themselves at a reasonable price (by buying back their own stock) rather than
investing in somebody else by overpaying.
The only times I can think of Buffett having any complaints about Coca-Cola had to do with an
acquisition the company wanted to do (at too high a price) or with giving stock to top executives.
The stock grants to executives incident at Coke was reported in the press as Buffett complaining
about executives being overpaid. I think the reason he abstained on that vote had more to do with
the fact the company would be permitted to cause a lot of dilution if it used the program to the
full extent it was asking shareholder approval for. So, it was probably more about Buffett
wanting Coca-Cola to shrink its share count rather than grow it.
When Buffett was asked on CNBC about the growth prospects of both IBM and Apple, he
answered by talking about share buybacks. Before Buffett bought it, IBM had one of the longest
and most aggressive histories of buying back its own stock you can find at any public company.
A lot of Berkshire’s investments have this feature. Look at how much American Express has
shrunk its share count since Buffett bought that position. Or look at how much Coca-Cola has
bought back of its own stock. In both cases, I’m pretty sure Berkshire’s investments are worth at
least 33% more than they otherwise would be because these companies have shrunk their share
count by more than 25% while Berkshire owned them. Buffett mentioned in the CNBC interview
that Apple had bought back almost 5% of its stock in a year. That is unlikely to be a one-time
thing. Apple will have problems with where its cash is located – it will end up with a lot of cash
that would be taxed if brought back to the U.S. – but it does not need cash to grow, it cannot
grow that fast anymore organically and it does not do big acquisitions.
For a tech company its size, Apple has historically been especially averse to acquisitions. A
company as profitable as Apple that does not use money on high-priced, transformative
acquisitions is eventually going to have to use that cash to buy back its own stock. There just are
not any other realistic options. It could pay dividends; and because of Berkshire’s own tax status,
Buffett would benefit at least as much from dividends as from (fairly or overpriced) buybacks.
He does not mind dividends, and he certainly does not mind buybacks at stocks he chose in the
first place.
What about Apple’s lack of future growth? I think this actually attracts Buffett. That sounds
counterintuitive. But, let me explain. Apple is a tech stock and a consumer product company.
The most dangerous time to invest in tech stocks and consumer product stocks is when they sell
a high-priced product to a small pool of customers. The reason for this is that it allows market
entry at the low end. If you are selling $1,000 watches or $10,000 computers, someone can come
in selling a cheaper and more basic version of the product to a large group of people who have
never owned the product. All sorts of market leaders run into this problem. They have the biggest
dollar share of the industry, but economies of scale – and certainly gains in experience – are
driven in large by the unit volume you do. The leader is in an awkward position because trying to
expand the market cuts into their profitability on a per-customer basis.
If you are selling computers to corporate customers – you are not dreaming of the day when
every living room in America can have a cheap, basic desktop. That future is potentially bad for
you in several ways. One, it teaches whoever you are competing with a lot about many of the
things you do. Two, it cheapens the image of what you are selling. Three, it changes the way you
will have to sell what you are selling. Almost all technology, especially any sort of consumer
tech, follows this pattern. It can be very tough for investors because it leads to a two-stage
adoption of the technology.
In phase one, one leader establishes their dominance in the “pro” market and the stock looks
great. But, in phase two, another – and usually different – leader establishes their dominance in
the “consumer” market. Then that stock looks great at the expense of the first leader. We could
be talking about computers or cell phones here. But if you go back further in history, TVs and
radios followed the same pattern too. These things are always invented long, long before you
remember them being invented, but were not adopted quickly. People tend to remember when
they started seeing cell phones everywhere, when they started using the internet in their own
home and so on. Those years have nothing to do with when these products were first invented,
commercialized and so forth. Often, there was a company you have completely forgotten about
that made and lost a fortune before the time period you even think of the new consumer tech as
being suddenly important to society.
What does this have to do with Apple? It is part of a broader question. Just how “moaty” are
consumer technology companies? At least on one side of the economic value equation,
companies like Apple, Facebook (FB) and Alphabet's Google (GOOG)(GOOGL) depend
entirely on the mass appeal of their product. We call them technology companies. Internally, I
am sure they seem very technical to those inside the organization. But how much does
technology drive the economic returns at these companies? And, at this point, how easy is it to
attack any of these business models on some technical difference between your product and
theirs? How much of what makes the iPhone successful is the Apple brand, the fact a customer
already owns an iPhone and is used to using it, the fact a customer’s friends, family and peers
already own an iPhone and, as a consequence, the fact other entrepreneurs and organizations
have invested time money and effort in trying to reach people by designing products to be used
on an iPhone?
In other words, has the iPhone become the default choice for customers because the Apple brand
is good enough, the status quo is good enough, people are not all going to jump on another
bandwagon together and the suppliers are going to be where the demand is? Is the iPhone always
going to be the easiest choice? This is exactly the same question for Facebook and Google. A
very long time ago, I wrote that while I did not own Google stock and did not know how the
organization would develop over time as a company, I did know that understanding anything
technical about a search engine no longer mattered. Google does not need to be the world’s best
search engine to be the world’s most popular search engine. The advantages it has are too
entrenched and the differences between one set of search results and another are so small –
Google does not really have to compete on quality anymore. Google is enough of a brand and
search is enough of a commodity that it does not matter.
The things that got Apple to the position it is now in are not necessarily the things that will keep
it there. A lot of readers emailed me asking about Apple’s brand and whether it would last. The
answer to that is yes and no. It will be a recognizable brand that is seen as good enough in a
decade or two. I would be very surprised if that changed. On the other hand, I would be surprised
if the Apple brand was seen as being particularly innovative or standing for very specific design
choices or anything like that in a decade or two. Coca-Cola is a great brand, but it is not a very
specific brand. It cannot be anymore. When people think cola they think Coca-Cola. And when
people think phone – they think Apple. But, Apple will not need to convince anyone to try a
smartphone for the first time anymore. They do not really even have to convince anyone to try an
Apple product for the first time anymore.
Apple has very high returns on the money it actually ties up in its business. The numbers look
lower because they have excess cash. Likewise, the stock looks more expensive than it is
because it has a lot of excess cash. If Apple’s sales grow somewhere between nominal GDP and
the rate of inflation in the countries where it operates in and the company dedicates every cent it
makes – or more, since Apple already has net cash – to buying back its own shares, it will still be
a “growth” stock on an EPS basis. For an example of this, see BWX Technologies. It is not
really a growth company at all in terms of what it does. It does not gain new customers (outside
of the U.S. Navy). It does not win totally new projects (outside of the carriers and subs it has
long provided reactors for). And it does not even get many more orders for a higher build rate for
the number of those ships now than it did in the recent past. Despite all that, the company just
put out a press release saying it expected a “low double-digit” EPS growth rate for the next three
to five years. That is a growth stock, but it is one because it is doing something very, very
profitable on a return on capital basis. It is retaining all the business it already has and growing
the business it retains a tiny but consistent bit, and then it is taking all the money it makes and
buying back its own stock. When a super high-quality business buys back its own stock, it is not
impossible to turn an underlying 5% type growth rate in how much more your customers actually
want into more like a 10% growth rate in the earnings you report per share.
IBM is another good example of that. In the 10 years before Buffett bought the stock, it was not
very good at company-wide revenue growth. Over the last decade, IBM had close to 9% annual
EPS growth at the same time it had close to zero percent revenue growth. A lot of that is
accomplished simply by not growing the assets you tie up in the business at all (IBM’s net
tangible assets actually shrank over the last decade) and then taking all your free cash flow and –
instead of growing assets like most companies do – use it to reduce your share count.
What Warren Buffett (Trades, Portfolio) sees in Apple is probably a slow growth, wide moat

consumer brand that can use all its free cash flow to buy back its own stock and thereby be a
high-growth stock in terms of EPS, even while it is slow growth in terms of additional units sold.
Apple may not be a growth company anymore, but that does not mean it cannot be a growth
stock. All Buffett cares about is the growth in earnings per share. So, he is not necessarily betting
Apple can sell a lot more iPhones over the next five to 10 years. What Buffett’s betting on is
Apple’s ability to report a lot more in earnings per share over the next five to 10 years.
 URL: https://www.gurufocus.com/news/488832/what-does-warren-buffett-see-in-apple
 Time: 2017
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Can a Value Investor Buy Facebook (FB)?
Even if (Michael Wolff) is overblowing things in his criticism of Facebook, he poses an

interesting idea: that the value of advertising in general may be falling because advertising is
generally less effective.
This is where I have to disagree with the criticism of Facebook (FB, Financial). For me, there is
one valid criticism – and only one valid criticism – of Facebook stock:
It’s too expensive
Way too expensive.
Fine. But a lot of stocks are too expensive.
People are talking about the dot-com bubble. This is nothing like the dot-com bubble. This is like
the Nifty Fifty. And it could end for Facebook investors the way it did for investors who bought
into any of the Nifty Fifty – you’ll lose a lot of money over the next few years – but the company
itself will still be a solid competitive enterprise chugging away many, many years from now.
That’s very different from the dot-com insanity. It’s the difference between speculative
businesses and speculative prices. Facebook is not a speculative business. It’s definitely an
investment quality business. There is nothing wrong with a company like this being offered to
the public. (There was a lot wrong with the companies offered to the public in the late 1990s.)
There’s nothing wrong with sticking something like Facebook in a college endowment.
Other than the price.
There is something wrong with the price. But there are two parts to what makes a stock purchase
an intelligent investment:
· The business bought
· The price paid
Facebook is a perfectly good investment if we’re talking about the business you’re buying. But
it’s also a complete speculation if we’re talking about the price paid.
But let’s not broaden the discussion into some grander theme. It really comes down to too high a
price for the stock.
Just because an IPO flops, doesn’t mean there’s something wrong with the business model.
I don’t see any reason why advertising would be less effective in the future than it has been in
the past. Or why it would be less effective online than offline. If you mean a certain kind of
advertising – yes, a certain kind of advertising will be less effective online than offline.
But a certain kind of story has always been less effective on movie screens.
I live a block from an Angelika theater here in Plano. The movies I see tend not to play real big
in most of the country. Why? Because they aren’t the right kinds of stories to tell on a big screen
where people are going to go out as a couple or a group and plunk down 10 bucks and spend two
hours in the dark. Seeing old, decrepit English people staying in an old, decrepit hotel in India; or
an old woman looking for her lost (not especially young) dog; or a mortician killing an old lady –
these are not effective kinds of movies. The movies themselves may or may not be effective. But
the kind of movie most definitely is less effective in attracting people’s attention.
They don’t have the right appeal. For one, they are about characters. And if you want to focus on
characters – why not do that on TV where folks don’t need to spend a full two hours with you,
don’t have to pay for the experience, and can stick with the same character week after week.
You get the point.
Some stuff doesn’t work that well in movie form. But just because we can’t make American
Idol: The Movie doesn’t mean movies are an ineffective medium for telling stories. It just means
you can’t put stuff made for free TV into paid theaters and expect the same results.
The same is true with ads.
Just as what makes an effective TV story may not also make an effective movie story – an
effective offline ad may not make an effective online ad. And vice versa.
For one thing, I click stuff online. I don’t click stuff on my TV.
So, TV has some serious limitations. In fact, it’s hard to imagine a more limited advertising
medium than TV. Even advertising directly in a book would have permanence. I don’t freeze my
TV. And yet I also don’t give it my undivided attention. I can and do: change the channel, mute
it, walk away from it and even talk to other people while watching it.
Oh, and I can’t interact with it directly – I can’t follow a link to your website on my TV screen.
And I usually don’t have a pen on me to write anything down – who would want to advertise on
something like that? Without showing me the same ad half a dozen times on TV, I won’t even
remember the ad much less act on it.
These are all valid criticisms of TV advertising. Companies still use it.
There is no reason advertising spending has to be used in a certain way. Advertising as a

percentage of U.S. GDP has not decreased in any meaningful way in over 90 years. It was
basically the same in 1920 as it was in 2000. And, in that time, companies have been advertising
in everything from:
· Radio
· Mail
· TV
· Magazine
· Newspapers
· Billboards
· Etc.
It has been sold in 30-second spots and 2-minute spots – and in certain settings even much, much
longer. It has been very targeted, and it has been very general.
Different businesses have used very different ad supported models.
Newspapers made a huge percentage of their operating profit from classified ads. Today, there’s
actual classified sites – that look much the same as newspaper classified – like Craiglist. And
then there’s Google (GOOG, Financial). Google is essentially a classified ads company.
Google has a way wider moat than local newspapers did though. Because the habit is more
strongly ingrained. It’s an active search. Not passive. It’s hard to imagine a better business than
Google. It’s a company that stumbled into the marriage of habits and advertising.
Facebook is a terrific business. Absolutely amazing economics. Not in the future. Today. Right
now. It is already a great business. Whether or not it is a durable great business is another
question. But look at its operating margins. Look at its working capital requirements. Facebook
has the economics of a local TV station. It just happens to have the potential to reach much of the
world.
Facebook’s long-term future is entirely a question of two things:
· Habits
· Experience
The question of experience is the question of an “experience curve.” I’m not a big fan of that
term. But finance people like using it. So, we’ll use it here.
What I mean is that if an army – like the Roman army – gets in the habit of campaigning every
year and marching every day and building a defendable camp every night – they get good at
those things. Not just any one Roman. But the collected wisdom of the group – even when they
don’t know exactly why they do the things they do – leads them to automatically make
somewhat smarter decisions without thinking. And over time, the institution figures out the
logistics of moving tens of thousands of people and keeping them fed and dysentery free and so
on just through doing that day after day when a lot of other folks are not doing it. And very often
a single academy or one great genius really can’t push enough experience through the whole
organization as years of seemingly mindless practice will.
Well Facebook is going to get a lot of practice. So the issue is the potential of how much you can
make in the kind of advertising there will be on Facebook – and then how good they will get at
selling that advertising. This is key. Because the advertisers are going to need help. They evolved
in a different ecosystem of sorts. And they are not well adapted to Facebook. And they have
some old habits that will need to change.
But unless the folks at Facebook are idiots they will soon know more about advertising to people
through social media than anyone on the planet – much more than any ad agency does now. They
will have a tremendous amount of data on people.
This is one of the big reasons why I think retailers are in a bad position versus someone
like Amazon (AMZN, Financial). Amazon has the potential to assemble the same sort of
advantages – informationally – that every grocery store out there has and yet it also has a
pleasant shopping experience with the ability to cross sell you things you didn’t even know you
needed.
That is the trifecta of retail:
· Get all the customer’s info
· Sell them stuff they don’t know they need
· Have them leave happy
This is very hard to do offline. But it happens all the time at Amazon. And so I would not want
to have to compete with a company like that. Because the model of an online store is just so
superior to the model of an offline store.
Facebook is theoretically a much, much better way of advertising than television advertising.
Television is one of the world’s worst ways of advertising. The only reason TV advertising
became so important is because TV is one of the best ways of entertaining people.
Advertising goes where people’s attention is.

The eyeballs went to TV. Because TV is the best way to entertain people in their own homes. So
if you wanted to sell things to a mass audience – but talk to one person at a time – TV was the
way to do it.
The article is right of course that Facebook – and let’s face it, Google – are not deriving their
economic value from being tech companies. They are both advertising-supported media
companies from a profit perspective. From an employee perspective it’s different. And that’s
important to keep in mind. You want to know how a company sees itself. But you also want to
know where it makes its money. What does it eat? What fuels the business?
It’s not tech for either Facebook or Google. They are both pretty simple media companies in
terms of where they make their money.
Facebook is not a tech company. It’s a media company. There is a risk in the company – the
same risk is present in Google, but probably to a much greater extent there – that the folks inside
the company do not have a clear idea of what their golden goose is and instead will go off and do
very stupid things.
According to Facebook’s SEC reports, the price paid for its advertising per user has been
increasing rather than decreasing.
Overall, I think the idea that Facebook needs to grow users a lot to justify its valuation gets
talked about too much. Growth in users is not the first thing I would look at when analyzing
Facebook. It is the habitual use of Facebook that is important. You want to have a product that is
used the way a local newspaper, local morning show, and local even news were once used. For
some people, Facebook is already used that way.
So how much money can Facebook make advertising to each of its users?
There is a lot of growth potential right there. Even before you talk about growing the audience.
Maybe because it’s an Internet company people think users matter more than they do. Use
matters. The thing I want to know more about Facebook is how people use it. Not who will be
using it in five years. That really is much less important than some people are making it out to
be. You’ve got enough valuable folks spending valuable time on the site now. If they’re using it
the right way – it’s a very valuable media property.
Let’s think about that $100 billion IPO price.
If Facebook ever had 5% of worldwide advertising spending it would justify the $100 billion
IPO valuation.
As a no-growth business Facebook should trade around five times revenue.
Look at the company’s operating margins. In 2011, Facebook had revenue of $3.71 billion and
operating income of $1.76 billion. That’s a 47% operating margin. At a 35% tax rate, that would
put net margins around 30%. It’s pointless to talk about free cash flow right now because of
Facebook’s rapid growth. But the owner earnings picture at Facebook is probably in line with
something like Moody’s (MCO).
Basically every $1 of revenue turns into about 30 cents of after-tax cash. Divide that 30 cents of
owner earnings by 5 and you get 6 cents. A free cash flow yield of 6% would not be odd for a
big public company. Basically, that’s a P/E of 15. So that’s why I say Facebook would be worth
five times revenue without adding any growth premium. (Of course an advertising supported
media business with a wide moat should be able to manage 5% to 6% growth in nominal terms –
basically it should match GDP over time.)
Every 1% of global advertising spending is $5 billion. So, with an enterprise value of five times
revenue, a company with a 1% share of global advertising would be valued at $25 billion. This is
only true if you have Facebook’s economics. Outside of local media (most of which is decaying),
very few companies have anything like Facebook’s economics. Revenue is worth a lot less to
them. I don’t want you to think five times revenue is the right value for all media companies –
it’s not.
Facebook doesn’t really need working capital. And won’t use debt (media companies don’t need
debt – they usually just use it when they buy each other up). So, that’s basically $25 billion in
market cap per 1% share of the worldwide ad market you think Facebook will have.
Facebook went public with a $104 billion market cap. If 1% of worldwide advertising is worth
$25 billion in market cap in the hands of Facebook, that valuation implies a 4.2% share of
worldwide advertising spending.
In other words, people who bought the stock at its IPO price were betting Facebook will account
for 1 of every 25 dollars spent on advertising worldwide.
Unless they think Facebook will get profits from someplace else. From someplace other than
advertising.
That required 4% share of worldwide advertising gave no credit to possibilities of other revenue
sources – like payment processing. Consider all other revenue sources a lottery ticket. Because of
the nature of Facebook there will be more happy accidents than at other media companies.
Revenue sources will appear the company didn’t really plan for. It’s a more valuable lottery
ticket than at most companies. There is a much greater possibility of payoff because of the
amount of experimentation that will happen without the company really having to do much.
As far as the effectiveness of advertising specifically regarding Facebook – the potential is

clearly there for much more effective organizing via Facebook than any other advertising
medium. This is supported by basic principles of social momentum that have been proven in
research time and again. I have no doubt the potential exists to get more momentum for an idea,
brand, person, act, etc., on Facebook than through any other medium on which a company can
advertise. Whether this is something companies and agencies know how to do or want to do is
another question.
You had 483 million daily active users when Facebook filed the original S-1. Of those, probably
80% at least are pure followers of no great import to advertisers beyond the traditional way you
advertise to folks through TV, etc. In other words, more than 80% of Facebook users are just
worth their eyeballs. Nothing more. It is not like talking to a crowd. But a small number of
Facebook users – I’m not sure if it’s 100 million, 50 million, or 25 million – but it’s at least 25
million people are really much more valuable. Or potentially more valuable. If you know which
25 million people to try to influence you will end up getting a lot more bang for your buck.
This is one of the big problems advertisers have. Advertisers are a bad messenger for their own
message. The same message delivered by somebody else would be way more effective than
delivered directly from the company. Advertisers try different ways of solving this problem. But
they can rarely get to the people that would be most helpful in promoting their brand simply
through advertising. Some companies obviously have a ton of success influencing the
influencers, but this is often through other means than advertising.
When you are advertising on TV or in a newspaper or even giving someone a coupon you may
know some demographic info and some buying behavior. But you generally don’t know their
influencing behavior. You don’t know to what extent they can help you beyond just getting you
one sale. Facebook has that info. They have the most valuable information about the exercise of
influence by individuals that anyone has anywhere. Whether they know how to use it, etc., is a
different question. Whether they will share it is a different question. But they have it.
A brief detour about FICO (FICO, Financial) will explain why this matters.
You leave some behavioral breadcrumbs in your financial life that FICO can use to predict your
likelihood of paying your bills in full and on time. In fact, your FICO score tells you much more
than that. If anything, FICO and others have downplayed the predictive value of the FICO score
outside of lending for fear of a public backlash against just what that info tells you. The truth is
that the FICO score is really not just some measure of creditworthiness. It is a measure of
character. It is a measure of behavior. You could duplicate a lot of the same score – you could
really guess someone’s FICO score much better than you think – by gathering stuff that’s
(seemingly) totaled unrelated to borrowing money.
If you knew someone’s:
· Driving record
· Sexual history
· Substance (ab)use record
· Criminal record
· Employment record
· Etc.
It wouldn’t be very hard to tell if they are more or less likely to default on a loan. A group of
people who present as quite boring in terms of driving, sex, drugs, crimes and jobs are people
you should lend to.
A group of people who present as quite exciting in terms of driving, sex, drugs, crimes and jobs
are people you shouldn’t lend to.
This is common sense. But when you can aggregate it and use it on a large scale it becomes
economically meaningful.
It’s probably less important than people think which data someone gathers about your behavior –
if it’s financial or non-financial. What matters is the insight into your behavior. Risk taking is
both a basic and pervasive trait. It shows up in all different actions throughout your life. What
FICO can give you is a measure of risk taking. People with low FICO scores are people who
misuse risk. What credit bureaus have is very valuable because no one is going to submit to the
best way of evaluating creditworthiness which would be some sort of multi-hour, detailed, taped,
polygraph interrogation of all aspects of your risk taking history including quite personal
questions. No one will do that. But the credit bureaus’ data combined with predictive analytics
(the FICO score) can counterfeit that experience. It’s a short cut.
Influence is pervasive too. And it’s possible to figure out how influential somebody is.
Facebook is going to know more about influence than anyone on the planet over time. And
advertising is applied influence. So it seems to me that if Facebook does reasonably intelligent
things over time it’s going to learn more about influence – have more practical knowledge about
how people really influence each other – than anyone knows now.
That will just be a side effect of the company going about its business. So, it seems hard to me to
believe that a business like Facebook is going to fail because it can’t figure out how to monetize
eyeballs.
Charlie Munger says stocks are valued partly like bonds and partly like Rembrandts.
I tend to think the failure of the Facebook IPO was a failure of its Rembrandt value. I never buy
into IPOs. But on the numbers, I really can’t say Facebook looked especially overvalued as a
new public company. IPOs aren’t known for being done at sensible prices. And certainly not at
prices value investors like.
Yes, Facebook was offered at something like five or six times what the company would be worth
if it had no future growth potential. If it was only going to grown in line with worldwide GDP. In
that case, it’s probably worth about 80% less than what it was offered to the public at.
But Facebook obviously does have some growth potential.
I would not take the bet that the S&P 500 will outperform Facebook shares over say the next 5 or
10 years. That isn’t a bet I would feel comfortable making.
Facebook’s operating margins are much more defensible than those of the S&P 500 as a whole.
I think value investors have been too dogmatic about Facebook. I’m not sure most have even
seriously looked at the situation. Thought through the business or the valuation. They’ve just had
this knee jerk reaction against an IPO and an internet company and an insanely high P/E ratio.
I’m not especially fond of any of those three things.
But we shouldn’t let one bad mark – price – cloud our judgment on other aspects of the situation.
Facebook is obviously a great business. It has a huge competitive advantage. If it is

a durable competitive advantage, Facebook will justify the price at which it went public – over
time.
As far as the idea that digital/web advertising is useless...
If you pitch the right product to the right person in the right way, you can run an effective ad on
the inside of a pudding cup. Technology will never change that.
I understand when people say the economics of movies will change in a way that makes a $150
million computer-animated movie unprofitable to make. That’s perfectly valid. But that’s not the
same thing as saying stories won’t work because of some tech change.
Ads really are as basic as stories. They work in much the same way.
You’ve got to get us interested in getting some sort of info.
Outside of needing to eat and drink and sleep – I’m not sure there’s anything as basic as stories.
And I put advertising in that same category. We may tell ourselves we go about our day thinking
about what we need and don’t need – but that’s not exactly true. We go about our day flitting
from one thing that catches our attention – that interests us.
And a good ad will get our interest. It’ll catch our attention. It really isn’t medium specific.
I ride a bus every day. And I’ve seen some very effective advertising on buses. I don’t mean the
sides of buses. I mean on the bus. They have these square cards no bigger than a single poster.
Some of those ads work. And I’ve seen effective ads run before a movie in a theater too. And
we’ve all seen TV ads – probably very expensive TV ads – that don’t work at all. I remember
one ad where it took me four viewings to realize they weren’t advertising their competitor’s
product.
And I can definitely tell you I’ve seen effective online advertising – because I know I’ve made
purchases based on online advertising. Last week I spent $100 because I was exposed to a
display ad for probably five seconds before clicking it.
It was a very effective ad. It singled me out as part of a special group, told me I’d save money,
and that I had a limited time to act. It worked. And you probably could’ve run it in print half a
century ago using the same exact appeal and it would’ve worked there too.
So I wouldn’t worry about the ineffectiveness of online advertising.
I would be more worried about some lab testing a pill you pop in your mouth that tastes great in
your brain – bypasses the buds on your tongue entirely – and nourishes you thus putting Coca-
Cola and Kraft and Chipotle out of business than I would be worried about ads not working on
the net.
(For the record, I’m not especially worried about either. But food we actually chew has a higher
risk of obsolescence than advertising.)
An ad where you are the target and the aim of the ad is right – it’s very hard not to be intrigued
by that.
Now, that doesn’t mean advertisers always know the right target, aim for that target in the right
way – or have a good way of paying for the right advertising.
Probably the best advertising I was ever exposed to in my life was when a friend said to me –
about the movie Memento, which I’d never even heard of: “You are going to love this.” With the
emphasis on you. That’s the right appeal. It works better than a trailer, better than a poster, better
than a critic’s review. But only a friend can make it.
I make my livingwriting on the Internet. If I can’t succeed writing on the Internet in the future, it
won’t be technology’s fault. It’ll be mine. Writing for any medium is really just about the
connection between the teller’s mind and the target’s mind.
And that’s all advertising is too. I don’t see any reason why – with practice – the tellers can’t get
good enough to figure Facebook out. If you’ve ever seen some of the first stuff that was written
for movies or TV – it’s really, really bad.
Astonishingly bad. They basically just threw a play up there. But then things changed – to the
point where 100 years later, most of what you see on a movie screen is stuff that wouldn’t play
that well in other media. Some people may wish it was otherwise. But the point is that the folks
who create movies got better at knowing specifically what works differently in movies than – say
– on a stage.
Advertisers will go through the same learning process online.
People take time to learn. Facebook will take time to learn its business. And advertisers will take
time to learn how to advertise on Facebook.
I’m not worried about that.
I’d only be worried about three things at Facebook:
1. User habits
2. Management behavior
3. Price
Before investing in Facebook, I’d like a lower price. This is a typical value investor complaint.
And it’s definitely true here. Facebook stock is (still) too expensive for me. That doesn’t mean
it’s overvalued – just that I’m not willing to pay the current price
Second, I wouldn’t buy any stock in an IPO. That’s just a basic psychological thing. You don’t
want to buy under the illusion of time scarcity. So I can’t imagine any scenario where I would
ever buy a stock when it is first offered to the public.
But what if the price was right? What if Facebook were trading at – let’s say – 5 or 10 times
revenue. That would be cheap enough that I’d have to really consider the business.
What would I focus on?
User habits are key. I don’t use Facebook. So I don’t know enough about this. If I was
considering an investment in the company, I’d spend about 90% of my research time on studying
user habits.
Management behavior. I’d like to know more about how Facebook sees itself. If we’re talking
about Zuckerberg, this doesn’t seem like a tough task. He’s definitely easier to “read” than 99%
of the CEOs you’ll come across.
I wouldn’t spend much time on this.
There are so many sensationalized secondary sources about Facebook and Zuckerberg that I
think it’s pretty hopeless to try getting info out of a narrative that’s become so contaminated by
storytelling by now.
Basically, I’d just focus on the durability of Facebook’s moat.
I’ll be interested to see when long-term options on Facebook start trading. In the long-run, you’re
not going to either make a little money on Facebook or lose a lot. You’ll either lose a lot (pretty
fast) or you’ll do well over time. It’ll either be something that blows up in a couple years or is a
good buy and hold forever stock.
It is, however, worth mentioning that this is a stock where literally everyone knows more about
the product than I do. Like I said, I don’t use Facebook. So this is never a stock where I could
never “buy what I know.”
The bottom line for value investors is that the stock is way too expensive – as almost all IPOs are
– to consider right now. But I think the negativity on this stock (especially from value investors)
has been way over done.
One neat thing about an IPO is that you get to read a nice, long description of the business filed
with the SEC. It’s called an S-1. And you can have great fun reading it. It’s window shopping for
value investors.
You can find Facebook’s S-1 here.
 URL: https://www.gurufocus.com/news/177739/can-a-value-investor-buy-facebook-fb
 Time: 2012
-----------------------------------------------------
Carbo Ceramics (CRR): Is It Ever Okay for a Company to Have No Free

Cash Flow?
Hi Geoff,
A German blogger just posted about this site. It is a list of the most shorted stocks in the USA...
Iwassurprised that ITT Educational (ESI), Carbo Ceramics (CRR, Financial), and Boston

Beer (SAM, Financial) are on this list...
ITT has some law problems.
SAM has a "high" P/E ratio but is high quality.
But I have a problem with Carbo. Carbo shows a high EPS but the cash flow is much lower most
of the time, and is even negative in five years. This makes me think of Enron. So do you have an
idea why the cash flow at Carbo is much lower than earnings?
Kind regards,
Alex
It depends on what you mean by cash flow. There are really three or four cash flow measures to
talk about. The most important one is Warren Buffett ’s owner earnings. That is a more
subjective measure though. So, I’m going to focus on three measures where we can agree on the
actual numbers:
· EBITDA
· Cash Flow From Operations
· Free Cash Flow
Let’s look at Carbo Ceramics (CRR, Financial) using each of them.
And let’s compare each of these to net income. That way we can see why EPS is so much higher
than “cash flow.”
I’ll use 10-year cumulative numbers. So, that’s the ratio of 10 years (Year 1 + Year 2 + Year
3....+ Year 10) of net income and the same of EBITDA, cash flow from operations, etc.
The 10-year ratio of EBITDA to net income is 1.87. In other words, Carbo tends to have $1.87 in
EBITDA for every $1 of net income. This is almost exactly normal. While I don’t have data on
what constitutes a normal relationship between net income and EBITDA in the U.S. today – I
can tell you I see plenty of good companies that turn every $1 of EBITDA into 50 to 55 cents of
net income. That’s what CARBO is reporting. And that looks normal.
So that’s our first hint of why Carbo’s cash flow is so much lower than EPS. It’s something that
earnings and EBITDA both fail to capture. They are losing cash somewhere else along the way.
Well the hunt for answers continues. Next up is cash flow from operations.
Cash flow from operations has totaled about $595 million over the last 10 years. That compares
to $570 million in cumulative net income. That’s definitely close. Too close. Something is going
on there.
And it suggests Carbo doesn’t produce a lot of free cash each year. If you don’t produce a lot of
cash flow from operations relative to net income – there’s no way you can produce a lot of free
cash flow relative to net income.
Now, free cash flow. When you said cash flow was sometimes negative – I think this is what you
were talking about.
Over the last 10 years, Carbo has only produced $65 million in free cash flow. That’s only about
11% of what they reported in net income.
And, yes, it’s sometimes been negative. But, again, that’s free cash flow that’s been negative.
· EBITDA has never been negative
· Cash flow from operations has never been negative
· And net income has never been negative
Just free cash flow. This is a huge hint as to where Carbo is slipping up from earning money to
actually delivering cash to shareholders.
Let’s look at what each of these numbers measure:
EBITDA measures the capitalization independent cash flow of the business. So it takes out
interest and taxes. That doesn’t matter in Carbo’s case. The company tends not to borrow.
Okay. So what else does EBITDA do?
Well, it excludes spending on depreciation and amortization. That’s a meaningful expense at

Carbo. Depreciation was about 6% of sales last year. Of course, depreciation only takes into
account Carbo’s existing assets. Depreciation is an expense used to spread out the past cost of an
asset providing benefits now. It doesn’t take into account spending today for benefits that won’t
be realized until next year and beyond.
What else doesn’t EBITDA take into account?
Working capital changes.
A lot of folks forget about working capital changes. They’re important. And just looking at free
cash flow without considering what’s going on with working capital can cause
misunderstandings.
Sometimes a company produces a lot of free cash flow because – like Dun & Bradstreet
(DNB, Financial) – it really doesn’t need working capital even when it grows say 3% a year or
so. And some companies always need a ton of working capital like Lakeland
(LAKE, Financial) or ADDvantage (AEY, Financial). How you feel about how those
companies use working capital has a lot to do with whether or not you like those stocks long-
term.
Then there are companies that have increased working capital very, very fast over the last decade
or so – but they’ve also increased sales at a startling clip.
That’s Carbo.
Let’s look at where the difference between EBITDA and operating cash flow is coming from.
Cash flow from others as shown on GuruFocus’s 10-year financials page for Carbo – I’ll use this
as a proxy for working capital changes – was positive in only two years. And not by much.
Usually, it’s been negative. Over the 10 years, that single line has added up to a negative $173
million. Wow.
Okay. Then there’s the difference between free cash flow and owner earnings. Owner earnings as
you’ll remember is Warren Buffett ’s calculation of what a business could pay out to owners in
cash at the end of the year – if it stopped growing. But didn’t shrink. More on that later. For now,
let’s look at the difference between Carbo’s depreciation and Carbo’s spending on property,
plant and equipment.
Over the last 10 years, cap-ex has been: $546 million (or $425 million if you allow cap-ex to
provide cash flow in certain years, this is a weird issue I don’t want to touch right now)
And over the last 10 years, depreciation has been: $201.52 million
That’s a big gap. We’ve got some combination of Carbo underreporting economic depreciation
by anywhere from $225 million to $350 million or so – or we’ve got Carbo investing something
like $225 million to $350 million in growth.
Which is it?
Let’s check the growth angle first.
Over the last 10 years, Carbo has grown total sales by just under 18% a year. Now, I happen to
know their new product development record had not been so hot during the 1990s or earlier part
of the 2000s. For about 15 years they spent on R&D without launching a single successful new
product. Finally, they did have some product success but mostly just by providing options to
customers that allowed for more of a tiering of Carbo products where you can use lower end
stuff for your lower end applications. They’ve gone even more in this direction with their resin
coated sand. Whether you want to call that a big R&D success or not – I don’t know – but I
wouldn’t say technological breakthrough is what’s driving Carbo’s sales growth.
My point is – it’s not like they are Apple (AAPL) or something. They didn’t release some hit
products and – zoom – sales shot up 18% a year. They probably gained market share with an
existing product. In fact, that’s been pretty much Carbo’s whole history.
Carbo is really at its core a one trick pony. There’s nothing wrong with this. It’s better to know
one great trick than 100 mediocre ones.
Carbo has differentiated the products a bit to give you this idea that there are all these different
products. And they acquired some companies I rather they hadn’t bought.
That’s about it.
Basically, Carbo’s grown for like 30 years because the percentage of hydraulic fractures using a
ceramic proppant has been going up, up, up. In the last 25 years, it’s probably quadrupled or
quintupled or something. The percentage of hydraulic fractures using ceramic proppants was
very deep in the single digits in terms of the number of hydraulic fractures in say 1987 or
however far back you want to go. Now it’s a lot higher. So they’ve ridden that wave. You could
say they created that wave. But that’s what they’ve done. They’ve manufactured a lot more little
clay balls.
What does that take?
I’d love to tell you Carbo Ceramics has the economics of Coca-Cola’s syrup business or
something. But it doesn’t. When Carbo grows – it has to invest in growth. It can’t outsource that
growth to somebody else. They don’t just design stuff and outsource all the ugly manufacturing
aspects to somebody else. They do the manufacturing. And the distributing.
I know this is a long quote. But I want you to read it. It paints a picture of Carbo’s business that
will help you imagine how the company really works – and especially what it takes to expand:
“The Company maintains finished goods inventories at each of its manufacturing facilities and
at remote stocking facilities. The North American remote stocking facilities consist of bulk
storage silos with truck trailer loading facilities, as well as rail yards for direct transloading
from rail car to tank trucks. International remote stocking sites are duty-free warehouses
operated by independent owners. North American sites are typically supplied by rail, and
international sites are typically supplied by container ship. In total, the Company leases
approximately 2,000 rail cars for use in the distribution of its products and has contracted for
the delivery of an additional 650 railcars by the end of 2012. The price of the Company’s
products sold for delivery in the lower 48 United States and Canada includes just-in-time
delivery of proppant to the operator’s well site, which eliminates the need for customers to
maintain an inventory of ceramic proppant. The Company expands its distribution network as
needed to support production capacity additions at the Company’s manufacturing facilities.
During 2011, the Company expanded its distribution network. The expansion, which continues
into 2012, includes rail car additions as well as increasing finished goods storage capacity at
stocking locations in the key unconventional plays the Company serves.”
By the way, they’re always expanding. If you go back and read old earnings call transcripts, old
10-Ks, etc. it’s just expand, expand, expand. And all the sales growth – and the headaches – that
comes along with that.
This is the polar opposite of something like DNB. Carbo grows and invests everything it earns in
that growth. DNB doesn’t grow. And it doesn’t need to invest a penny in its core operations.
If you noticed, Carbo is talking about having 2,650 rail cars in 2012. This gives you some idea of
the logistics of this business. Just one other imagine I’d like to paint: their production capacity is
about 2.1 billion pounds of product. While the cost of their product is small relative to the
economic investment their customers have made in the wells – it’s not like this is an asset light
business. There are a lot of physical assets involved in the business. Physical assets that have to
be expanded. So expansion costs Carbo a lot of money.
Also, Carbo has ownership rights in Georgia clay – kaolin if you want to be fancy about it – that
should last 15 years. Remember, this is supposed to be a ceramic company. Not a clay company.
This is like an airline buying an oil refinery. Also, it’s obvious from some of the things Carbo
says in its filings that it has some facilities located where they are in part because of raw material
availability.
Again, I think it’s important to consider the scale here. For example, Carbo owns “4,000 acres
of land and leasehold interests” near plants in Georgia and Alabama. That’s a lot of property.
And they’ve got another 500 acres up in Wisconsin. So right there you have rights in 4,500 acres
of property that they have just as a source of raw materials.
Does this explain the cap-ex?
I think so.
Net PP&E – which means net of accumulated depreciation – rose from $112 million in 2002 to
$411 million today. So, that’s a $300 million increase in property. Sounds awful. But that’s only
about a 14% a year increase in property versus an 18% a year increase in sales. I’m not saying I
like property increasing that fast. But I’m saying it makes sense when you’re not an asset light
business and you are growing sales in the high teens each year.
What about working capital?
That’s where cash flow from operations falls short.
Inventory has increased 24% a year over the last 10 years. Receivables have increased 17% a
year. Sales – remember – have increased 18% a year. I’m just spewing compound rates here, so
be careful – compound rates depend a lot on the start and end numbers. And Carbo ran into a big
logistical problem recently. They couldn’t move some stuff by rail that they wanted to.
Let’s recap the cash drain for Carbo’s growth.
The increase in inventories over 10 years has been: $116 million
The increase in receivables over 10 years has been $89 million
And the increase in property has been: $299 million

So that’s additional investment in inventory, receivables, and property of: $504 million
Over half a billion dollars. What you’re doing with that money is that you’re taking your
winnings from one bet and you’re immediately betting it on the next hand. You aren’t taking it
home. So the question is whether the return on that investment is:
· High enough
· Reliable enough
Is it high enough?
Yes. Carbo doesn’t use leverage. By any measure I can come up with its unleveraged returns are
lovely. This is a good business. You can do the math for yourself. You’ve seen other articles
where I look at returns on investment and especially unleveraged returns on tangible net assets.
You can check those numbers for Carbo. But I’m telling you now – they’ll look good. And
they’ve gotten better over time – not worse.
So return on investment is high enough.
But is it reliable enough?
This one’s tougher. If Carbo was the only player in the industry – if they had some way to keep
other competitors out, I’d say yes. Mostly because I think the inherent characteristics of the
business – the value of what you are giving customers versus the cost of providing that service –
is really, really good. I think it’s inherently a business with a lot of pricing power between the
seller of the proppant and the user of the proppant.
But how much pricing power would Coke have if you’re willing to switch to Pepsi if they
undercut Coke on price by just a penny?
I mean, even if you were theoretically willing to pay $10 for a can of cola – if Coke and Pepsi
are both right there in front of you and Pepsi is priced at $1.50 a can and you have no allegiance
to Coke, well Coke isn’t going to get your $10 are they?
That’s the problem we have here. And it’s compounded by growth. There is no unique
distribution here. You are moving things by rail. Anyone can do that.
Carbo certainly does not have the marketing advantages that someone else you mentioned
– Boston Beer (SAM, Financial) – has. Boston Beer has a way of selling the product that is
better than other craft brewers can do. Because they have a better sales force.
And because of the number of accounts they have to call on. Over half of Boston Beer’s business
is away from home. And then over half of that away from home business is actually selling to
some pretty small businesses.
So when I say anything about marketing at Boston Beer people always fixate on the Sam Adams
brand. It’s good to have that brand. But marketing isn’t a synonym for ads.
A strong brand is good. Having that sign out there and people recognize it is helpful. I’d rather
own shares of a company where you can put their beer out there and people have seen the logo
before. But to think that the words “Samuel Adams” is all there is – no – it’s the sales force. It’s
how the product is sold. It’s where the product is consumed. It’s how annoying it is to have to
duplicate that from scratch even when you’ve got a killer new product.
And, most importantly, it’s the combination of a nice marketing ability with a product whose
image is something the guys with the best marketing capabilities (the giant beer companies) can’t
easily match. On the one side of Boston Beer you have really little guys who have the right
image – but now they’ve got to get it into restaurants and stores and such. And then you’ve got
the big guys on the other side. Who could distribute the stuff. They’d do a great job. But they
need to distribute it while basically hiding who they are. Because they have the wrong corporate
image for the product. They need to disassociate it from their other products.
Anyway...
You’ve got nothing like that at Carbo. You don’t have distribution advantages like at Boston
Beer. This is something you can move by rail. Ultimately, it feels a lot like a manufacturing
business where the overall supply and demand of the industry is very important. And that’s not a
recipe for as reliable long-term results in terms of return on investment.
What’s nice about Boston Beer is that ultimately it’s a Peter Lynch stock. It has grown quickly in
an industry that isn’t growing at all. That’s something you want to look for.
Carbo Ceramics is different. It’s a fast growing business – yes. But it’s a fast growing business
in a fast growing industry. That’s the worst kind. You want a fast growing business in a slow
growing industry.
Otherwise, you attract attention.
A fast growing business in a fast growing industry is going to face more competition every year.
Ceramic proppant has grown quickly. And everybody has heard about hydraulic fracturing – so I
won’t even go there. But the perception is that those things have grown alarmingly fast.
And I wouldn’t disagree with that. For me, the fast growth of Carbo Ceramics is problematic.
Because growing assets that fast is not usually good. Asset growth is something you want to
watch out for. I don’t like looking at stocks that have grown all sorts of assets by 15% to 25% a
year. Unless you can insulate yourself entirely from competition that kind of asset growth is
going to end badly.
So that would be my concern with Carbo. Which is different from the concern you have. Totally
different. You said it reminds you of Enron. I wouldn’t worry about that. In fact, I wouldn’t
worry about the past or present at all with Carbo. I think the past and present look lovely. All I’d
worry about it being too much of a growing commodity business in the future. That too much
new investment would be made too fast.
Now, the product itself is not very commodity like in terms of prices. Commodities rarely have
the kind of psychological advantages this particular product has. As I said about Carbo before,
it’s a pixie dust business. You don’t want to bet against a pixie dust business normally. Because
something where sprinkling a relatively low cost item on your relatively high cost item causes a
big improvement in that expensive item – that’s a recipe for long-term pricing power.
Again, when I say a pixie dust business I want you to think of BASF’s slogan: “At BASF, we
don’t make a lot of the products you buy. We make a lot of the products you buy better.”
That’s a pixie dust business.
If you can choose between owning Sanderson Farms (SAFM) and McCormick

(MKC, Financial) – pick McCormick. Spice is just a better product than chicken. Well, ceramic
proppant is a really, really good product. It’s the spice of the oil industry.
But McCormick isn’t just any spice company. They’ve been around for like 130 years or
something now. They’ve got like 40% or more of the spice aisle in your local supermarket.
Their position in the industry is much more settled than Carbo’s position. And Carbo is in a fast
growing industry. Spice is not a fast growing industry. So McCormick and Carbo are similar in
terms of some of the inherent advantages of the product as a product – they’re both selling pixie
dust. But one company is very settled with a very clear future. The other is less settled. Carbo’s
industry is less settled.
So, Carbo is selling the spice of the oil business. Which I love.
But growth attracts competition. And that is the danger here. Especially if you have too much
growth in hydraulic fracturing. I’m less concerned about too much growth in ceramics vs. other
proppants. That attracts competition. But it’s less likely to cause too much capacity to be built
too fast and then have several years of excess capacity. Because I don’t think that once market
share is taken by ceramics it will be given back over time. I think that’s sustainable.
I don’t know enough to know how much hydraulic fracturing is sustainable.
Ultimately, demand for Carbo’s product is based on something – oil and gas production – that is
way outside my circle of competence. And that’s where I’d be worried.
The long-term risk with any company that reinvests as heavily as Carbo does comes from the
fact that you absolutely need the company to keep earning good returns in future periods. You
aren’t betting on what the company’s ROI is today. You’re betting on what it will be in 15 years.
Why is that the bet?
Because Carbo reinvests really every penny they earn. So, it is a constant betting of your
winnings on yet another hand.
If you have a really good business with a durable competitive advantage – that’s what you want.
That’s actually much better than not being able to reinvest the money. You want a high ROI
business to keep investing everything it can in the business. Over and over. Betting one hand
after the next after the next.
So there’s nothing wrong with their cash flow in the past. It’s fine. If the future ROI is fine.
But how do you know what the future ROI will be?
In Carbo’s case – because of how good the economics inherent to the product are – it’s just a
matter of competition.
· Will they be competitive?
· Will competitors over expand?
· And do they have a moat?
I know those aren’t the questions you asked. But they’re key. You may have started by asking
about fraud – I assume that’s what you meant when you mentioned Enron – but really it’s not
about fraud it’s about reinvesting as far as the eye can see.
When a company spends so much on growth for so long, you really are betting on what the ROI
will be way out in the future. And you need to be comfortable with that when you buy CRR.
As far as why people are shorting it – I don’t short stocks, so I’m not the person to ask about
that. And there are lots of dumb longs and lots of dumb shorts.
One blog I really like is Distressed Debt Investing. There's a post over there that talks about
shorting. You should read it.
I lost money when I was long Barnes & Noble (BKS, Financial). But if you shorted the stock
when I bought it – you would’ve lost more than 25% by now, and a lot of time (when the market
was rising), and shorting isn’t free. So, it would’ve gone very, very badly for you unless you
really had the timing right.
Actually, if you literally shorted it when I went long you'd also have the issue of a couple
dividend payments too. When you factor in dividends, I lost a tiny amount on BKS. But the
opportunity cost was big. And the risks taken were very, very big. So it was a terrible long. But,
it also might not have been as good a short as you'd think - unless you timed it right (the same
could be said of the long, at one point you could've made 50% buying when I did and selling at
the right time, needless to say I didn't time that right).
My point is just that people are making a bet either way. And they could be right or wrong. If
you wanted to bet against hydraulic fracturing – you might short Carbo.
To be honest, if I had to short something, I’d rather short Barnes & Noble than Carbo Ceramics.
Because BKS had a worse balance sheet. They’ve got technological obsolescence. And the
inherent economics of their business – retail – frankly suck. They just managed to out compete
everybody else and become the low cost operator. But that was in a different environment. They
are not well adapted to the present. Of course, most of their competition – almost all of it – has
already been annihilated. But there isn’t necessarily a prize for being the last one to succumb to
the inevitable. It’s usually more of a moral victory than an economic one.
I said Carbo’s product itself has some similarities to something like McCormick. And that’s true.
And I wouldn’t short a stock that sells a product like that at any price.
There are a lot of very price competitive businesses out there. I’m not sure why you would want
to short something where the economics of the product are so good. I would not short a great
brand.
If you want to short something, short something with:
· A product that has inherently poor economics
· A bad balance sheet
· And deteriorating competitiveness
I’d also rather it be in an industry with a high mortality rate.
I think shorting things like Carbo and Boston Beer is a mistake. First of all, they’re definitely not
going to zero. They may be overpriced. But there is a huge risk they can work through being
overpriced over time.
But, I think a lot of people are much more short-term oriented than that. So, if you’re shorting
the stock for this quarter – well, then that’s a whole different story. I don’t know how to think
something like that through.
You probably start with a top down conviction about hydraulic fracturing or something. And
then you say, well, it would make sense if Carbo dropped to a normal P/E for the market (that’s
quite conceivable). And if you shorted it a while back then maybe you saw a lot of upside just
from the possibility of a one-time multiple contraction.
I don’t know if as many people would short the stock if they had to stay short for three or five or
ten years. I think, if you made people stay short a stock for five or ten years, you’d have a
different set of stocks up there on that list.
Some of them would be up there either way. But I can also see three or four stocks where I think
very few people would be willing to short the stock if they had to stay short for five years.
But if you’re buying the stock – even if you don’t intend to stick around for the next decade – the
expected ROI in a decade really does matter. When a company reinvests everything, you need to
worry about what they’ll earn on their capital many years out.
 URL: https://www.gurufocus.com/news/176930/carbo-ceramics-crr-is-it-ever-okay-for-a-
company-to-have-no-free-cash-flow
 Time: 2012
-----------------------------------------------------
A Stock Where Neither the Business nor the Price Matters
Geoff,
Emerson Radio (MSN, Financial).
I haven't looked too deeply at the company yet. They've discontinued certain businesses and I
haven't adjusted any of these numbers for any of that. There is some issue with the holding
company being restructured and there was talk of the company itself reorganizing its operations,
but I haven't read further yet to be able to comment intelligently on that. The good thing is the
mgmt doesn't seem to think it's a keen acquirer of other businesses and doesn't seem bent on
blowing the cash on something stupid. The bad thing is, they don't seem to care for distributing it
to shareholders, either.
It's not a NCAV, as with most NCAVs, that I'd be excited to hold in my portfolio. And I have no
idea what good things could happen to it (and I'm still trying to sort out what bad things could
happen to it)... but it doesn't seem terribly risky, especially if it could be bought even closer to
net cash. I'm almost tempted to hang a bid out there around $1.41/share even if there's little
chance of it being filled at the moment.
I am curious if you've read up on the company at all and could quickly tell me if I am wasting my
time considering it, and why?
- Taylor
Yeah. You’re wasting your time.
And, no, this isn’t going to be quick. It’s going to be very, very slow. You’ll see why in a
minute. Anyone who isn’t up for 4,000 words of old magazine articles, SEC reports, lawsuits,
etc. should turn back now.
Look, I’m not saying Emerson Radio’s stock couldn’t return 400% sometime soon. It could
totally do that. You could easily make a $2 or $4 or $8 profit on this $2 stock. I can see that
happening. Maybe the odds even say you should make the bet. But I would never do it.
So I'm not saying it's a bad bet. It's so cheap that I can't say that.
What I can say is that Emerson Radio is not what you think it is. Nobody is concerned about the
business. It may not be a great business. But business risk is the least of your problems here.
I’m familiar with the company. It has been a net-net in the past. But I never bought it. There’s a
good reason for this. More on that later.
I’m also familiar with the products. There are a lot of them at Wal-Mart (WMT), Target
(TGT), etc. Maybe most of what you see in the microwave aisle of a Target is Emerson.
As far as investors are concerned, Emerson Radio is effectively a Chinese company. Not an
American company. The stock price reflects this.
The Emerson brand is old. And people do know it. Maybe not people who are as young as you.
But my parents and their parents know Emerson. And now people who shop at Target know
Emerson. It’s similar to using Zenith as the name of a TV or something like that. Emerson was
once a well-known American brand.
The concern here is that you get wiped out completely because of management.
I remember it being talked about on one of The Value Guys shows – I think it was near the end
of last year. And they said it best when they noted the company was selling at an EV/EBITDA of
something like 1 or less than 1 at the time.
So the question is: Will this company be around in one year?
And, then, if the cash that’s reducing the EBITDA might not be around – the question becomes
what is the company’s earnings relative to its market cap? And can the company stick around for
at least that many years.
Anyway, The Value Guys – like you – talked a lot about the business and people’s concerns
about that business and so on.
(They’re older than you. So they recognized the Emerson name. And they knew it was a really
old brand.)
They focused on that.
But this stock has traded at an EV that is about 1 times EBITDA (and 3 to 4 times market cap).
So, nobody is concerned primarily about the business. They are concerned about fraud and
business failure.
I should quickly note that you can find companies without these problems with an EV/EBITDA
that low. I’m definitely not saying you should pass on a company with an EV/EBITDA around 1.
Sometimes you can even find perfectly decent little companies with a negative EV. I found five
in Japan with negative enterprise values in 2011. And I found a perfectly decent, perfectly safe –
in my opinion – American stock with a negative enterprise value in 2010 and another one in
2012.
But it’s a bit of a needle in a haystack situation. There are probably 60 U.S. companies with a
negative enterprise value right now. Maybe six of them are perfectly safe companies. Most are
unprofitable. And there are as many Chinese reverse merger frauds on the list of negative EV
stocks right now as there are American companies I’d call perfectly decent.
The rest of the negative EV group is a mix of businesses – many of them have never turned a
profit. A few may never turn a profit in the future.
Emerson doesn’t have a negative EV. But it’s awfully close. It’s really in the same category as
those stocks. And it’s reason for trading this low are very similar to why those reverse merger
Chinese stocks trade so low.
There are a lot of warning flags with Emerson Radio. Not in the 10-year financials. Not
anywhere you’ll see on websites. But in the actually filings.
The SEC reports are chock full of some eye-popping paragraphs.
Like this one from the 14A:
“..The Grande Holdings Limited (Provisional Liquidators Appointed) (“Grande”) had advised
the Company that one of its indirect subsidiaries held beneficially 15,243,283 shares or
approximately 56.2% of the outstanding common stock of Emerson. That number of shares
includes 3,391,967 shares (the “Pledged Shares”) which, according to public filings made by
Deutsche Bank AG (“Deutsche Bank”) in March 2010 had previously been pledged to Deutsche
Bank to secure indebtedness owed to it. In February 2011, Deutsche Bank filed a Schedule 13G
with the U.S. Securities and Exchange Commission (“SEC”) stating that Deutsche Bank had
sole voting and sole dispositive power over the Pledged Shares (which represent approximately
12.5% of the Company’s outstanding common stock). The Company believes that both Grande
and Deutsche Bank have claimed beneficial ownership of the Pledged Shares. As of October 14,
2011, the Company has not been able to verify independently the beneficial ownership of the
Pledged Shares.”
And this description of the Chairman:

“Christopher Ho has served as the Company’s Chairman since July 2006. Mr. Ho is presently
the Chairman of Grande, a Hong Kong based group of companies engaged principally in
the distribution of household appliances and consumer electronic products and licensing of
trademarks. Grande indirectly, through a wholly-owned subsidiary, owns the controlling
interest in the Company’s outstanding common stock. Mr. Ho also currently serves as
Chairman of Lafe Corporation Limited, a company listed on the Singapore Exchange.”
You can look up Lafe to find out more about that company and Ho. It is a publicly traded
company.
But Lafe is only the start of this story.
Then there is this description of their CEO:
“Duncan Hon, a director of the Company since February 2009, has been the Company’s Chief
Executive Officer since August 2011 and, prior to that, was the Company’s Deputy Chief
Executive Officer since November 2009. In addition, Mr. Hon was appointed as a director of
Grande in January 2011. Mr. Hon also serves as Chief Executive Officer of the Branded
Distribution Division of Grande. Mr. Hon currently serves as a director and Vice Chairman of
the board of directors of Sansui Electric Co. Ltd., which is listed on the Tokyo Stock Exchange,
and also serves as a director of several of Grande’s non-listed subsidiaries.”
Remember those names: Ho, Grande, Lafe, Sansui. We might be Googling them later.
If you look at the amount of beneficial ownership, you see there is 56.2% of the company owned
by Grande. Several people have relationships with Grande and so are shown as if they control
56% of the company or 12.5% in Deutsche Bank’s case. All of the shares shown except for the
50,000 shares owned by Eduard Will are owned by Grande. So, this is a controlled company.
Again, there is the note about Deutsche Bank and Grande:
Grande has advised the Company that, as of October 14, 2011, one of its indirect subsidiaries,
S&T International Distribution Ltd. (“S&T”), held beneficially 15,243,283 shares, or
approximately 56.2% of the outstanding common stock of Emerson (the “Shares”). As the sole
stockholder of S&T, Grande N.A.K.S. Ltd. (“N.A.K.S.”) may be deemed to own beneficially the
Shares. As the sole stockholder of N.A.K.S., Grande may be deemed to own beneficially the
Shares. Mr. Ho is one of the beneficiaries under a discretionary trust which owns approximately
70% of the capital stock of Grande...Deutsche Bank filed a Schedule 13G with the SEC stating
that Deutsche Bank had sole voting and sole dispositive power over the Pledged Shares (which
represent approximately 12.5% of the Company’s outstanding common stock)... The Company
believes that both Grande and Deutsche Bank have claimed beneficial ownership of the Pledged
Shares. As of October 14, 2011, the Company has not been able to verify independently the
beneficial ownership of the Pledged Shares.”
Ho owns 70% of Grande and Grande owns 53% of Emerson. So, Ho controls Grande and Ho
controls Emerson. However, Grande had pledged shares of Emerson to Deutsche Bank which
Deutsche bank claims it has sole power over. Ho’s economic interest in Emerson is about 37%.
Which certainly aligns his interests with shareholders.
Or does it?
Hold that though. First let’s just note that three of the seven board members of Emerson are
employees of Grande. And the chairman and CEO of Emerson are both employees of Grande.
So what is the story with Grande?
First of all, the company says it has not been able to verify independently the beneficial
ownership of the pledged shares. However, Emerson basically is Grande. The company is
Grande. Ho and Hon and Fok work for Grande.
Even more than that Hon “also serves as chief executive office of the Branded Distribution
Division of Grande.” Well, Grande owns 53% of Emerson and Grande describes its business as:
“The distribution of household appliances and consumer electronic products and licensing
trademarks.”
But that’s Emerson’s business!
So Emerson’s business is Grande’s business. And Emerson’s CEO is Grande’s “Branded

Distribution Division” CEO.
Sounds a lot like they are the same company.
On corporate governance Emerson says this:

“In March 2011, after final court approval and associated appeal and implementation periods
of the settlement agreement that the Company entered into to bring to a close a shareholder
derivative lawsuit, the Company updated its policy regarding the review and approval of
transactions with related parties...”
Last year, their CEO – Adrian Ma – resigned. The press release came out on Aug. 11, 2011. He
resigned from the CEO job and board effective August 8. So, I guess he resigned effective
immediately. This is how they dealt with that:
“...as of August 31, 2011, Duncan Hon, age 50, was appointed as Chief Executive Officer of
Emerson Radio Corp....Mr. Hon has served as the Company’s Deputy Chief Executive Officer
since November 2009 and as a director since February 2009. He continues in his role as a
director of the Company. Concurrent with Mr. Hon’s appointment as Chief Executive Officer of
the Company, the position of Deputy Chief Executive Officer was eliminated.”
“The Company also announced that its Board of Directors appointed Mr. Vincent Fok, age 41,
as a director of the Company, to fill a vacancy on the Board. Mr. Fok is a senior managing
director of FTI Consulting (Hong Kong) Limited, a global advisory firm assisting companies to
protect and enhance enterprise value, and was appointed by the High Court of Hong Kong on
May 31, 2011 as one of two Joint and Several Liquidators over The Grande Holdings Limited
(Provisional Liquidators Appointed), which indirectly, through a wholly-owned subsidiary, is
a controlling shareholder of the Company.”
Grande Holdings has a website. They also have a Wikipedia page. Wikipedia info isn’t always
reliable. So I’m not going to link to it. But I can’t stop you from Googling the name Grande
Holdings and clicking on that Wikipedia link, can I?
It was once a pretty big company. They have a history of cross ownership, repeated bankruptcies,
last second changes in corporate ownership, and shifting assets away from creditors.
In 2002, Business Week wrote an article about James Henry Ting’s business empire, its collapse,
and the shifting of assets to Grande.
Here is a quote:
“Officers at one company may know how Ting's empire fell: Grande Holdings Ltd., founded by
none other than Ting's old associates, billionaire Stanley Ho and Christopher Ho. In November,
1999, control of many of Akai's remaining assets mysteriously shifted to Grande--and without
any notification to the Hong Kong Stock Exchange, creditors, the courts, or other regulatory
authorities. The deal was done through a simple, seemingly hastily prepared four-page
management agreement. Creditors say they only learned of the change in corporate ownership
in September, 2000, when Grande presented 54 boxes of Akai records to liquidators. Grande
Holdings executive director Samuel K. Yuen denied in a brief telephone interview that Grande
had taken over Akai, saying that the management agreement had been "misunderstood."
Whatever the case, Grande now does control key Akai assets, including the Zhongshan Tomei
TV factory. In fact, Ting, in conversations two years ago, asserted that Grande was in control of
his former empire.”
For the relationship between Grande and Emerson – and especially their history – you can read
this article posted at NJ.com (Emerson is a New Jersey company):
The latest chapter in the Emerson saga began nearly three years ago, when Grande Holdings, a
Hong Kong-based group of businesses founded by the Chinese gambling magnate Stanley Ho,
started buying Emerson stock.
By August 2006, Grande had bought up more than 50 percent of Emerson's shares, and its
chairman, Christopher Ho -- no relation to Stanley Ho -- was named Emerson's chairman. Then,
Emerson started cutting deals with Grande subsidiaries.
That's when the trouble began.
During the past year, Emerson has been subject to an internal probe of some $50 million in off-
the-book loans it made to Grande affiliates. Those dealings have made the company the target of
a shareholder lawsuit, which accuses Emerson of breaching its fiduciary duty through "unfair,
self-dealing transactions." And the flap has led to the exit of four board members -- three in
the past month.
Emerson, headquartered on the second floor of a nondescript office building in Parsippany, now
faces delisting by the American Stock Exchange for a lack of independent directors on the
board's audit committee. Its stock has fallen below $1, down 70 percent from its 52-week high of
$3.15. And the company has had to pay monetary penalties to its lender, Wachovia, for
breaching its loan covenants.
Troubles continue. While the company has said in filings with the Securities and Exchange
Commission that Grande subsidiaries have repaid tens of millions of dollars, a former director
said money is still owed and alleges the questionable conduct continues.
"Emerson was exploited as a financial resource by Grande," W. Michael Driscoll, a former
director and chair of the board's audit committee, wrote in his July 14 resignation letter.
"Emerson's losses from past related-party transactions have not yet been fully compensated,"
said the letter, included in company filings with the SEC. "More recent problematic transactions
have occurred, but have not yet been fully reviewed, much less redressed. I lack confidence that
the highest levels of Emerson management can be trusted to police themselves."
As mentioned in the article, Michael Driscoll was the chairman of the company’s audit
committee. He resigned in July 2008. And wrote this letter of resignation:
“This letter provides notice to the Emerson Radio Corp. of my resignation from its Board of
Directors, effective immediately. I regret that this has become necessary, and I provide here a
summary of my rationale.
Upon joining the Board, I was optimistic regarding prospects for Emerson under its new
management... Those positive impressions were disabused upon my discovery of egregious
related party transactions that were planned and executed by Grande-affiliated directors and
employees, to Emerson’s terrible detriment. Rather than gaining opportunities from Grande,
Emerson was exploited as a financial resource by Grande in ways both large and small, direct
and insidious. The issues are developed well in the April 4, 2008 Report to the Audit Committee
of the Emerson Radio Corp. Board of Directors Regarding Certain Related Party Transactions
by the law firm of Pinnisi & Anderson, LLP (“RPT Report”), which was copied to all members
of this Board. Other questionable conduct of Grande-affiliated parties has occurred since the
RPT Report was delivered.”
He goes on to describe the financial reforms he was able to achieve while chairman of the audit
committee and then says:
...Although the Board’s cooperation in these matters has been reluctant, it ultimately was
obtained, and that is positive. However, considerable additional work remains to be done.
Emerson’s losses from past related party transactions have not yet been fully
compensated. More recent problematic transactions have occurred but have not yet been fully
reviewed, much less redressed. Certain of the financial reforms described above have not yet
been fully put into operation. Persuasive recommendations set forth in the RPT Report have not
yet been adopted. All control enhancements, past and future, will need to be monitored diligently
and enforced aggressively, as I lack confidence that the highest levels of Emerson
management can be trusted to police themselves in these matters. On the contrary, I am
concerned that their intention is to circumvent or subvert the important reforms of the recent
past to the greatest extent they can. Oversight and action by Emerson’s independent directors,
perhaps led by the Audit Committee as in the past, may be an essential safeguard against
reversion.
There are other problems with the company. It filed a NT 10-K notice inability to timely file a
10-K. That isn’t necessarily a problem. I’ve invested in companies that have failed to timely file
a 10-K. But you don’t want to see this. They are vague in explaining why they couldn’t file:
“The delay in filing is principally attributable to the Company’s need to analyze certain
transactions and additional non-financial information in order to complete the disclosure in the
Company’s financial statements and the Form 10-K.”
Compare this to something like the NT 10-K for a company I did invest in. They go on for three
paragraphs explaining what the problem is and how they plan to fix it.
Other issues include the fact that Emerson settled a shareholder lawsuit (see 10-K):
“...in which it was alleged that the named defendants violated their fiduciary duties to the
Company in connection with a number of related party transactions with affiliates of The
Grande Holdings Limited (Provisional Liquidators Appointed), the Company’s controlling
shareholder. As approved, the settlement calls for the payment to the Company by or on behalf
of the defendants of the sum of $3.0 million, which was paid to the Company in full by the
named defendants in March 2011, and the continuation of a number of previously adopted
corporate governance reforms. On March 28, 2011, the Court approved an award to plaintiff’s
attorneys payable out of the settlement proceeds of $875,000 on account of legal services
rendered and costs and expenses incurred, which the Company paid to the plaintiff’s attorneys
in April 2011.”
There is also a second item:
“...On July 7, 2011, the Company was served with a complaint filed in the Federal District
Court for the Central District of California alleging that it, certain of its present and former
directors and other entities or individuals now or previously associated with Grande,
intentionally interfered with the ability of the plaintiffs to collect on a judgment (now
approximately $47 million) it had against Grande by engaging in transactions (such as the
dividend paid to all shareholders in March 2010) which transferred assets out of the United
States. The complaint also asserts claims under the civil RICO statute. In the Company’s
opinion, based on an initial review, the claims appear to be devoid of merit. Emerson intends to
defend the action vigorously.”
I’ve read some documents connected with the case. I will quote from the opinion affirming the
original decision to impose sanctions on Grande for the inappropriate way they turned over
evidence in the case.
The original lawsuit involved MTC Electronic Technologies. MTC was sued in 1995. In 2005,
there was a judgment of $37.56 million against MTC. The “plaintiffs (alleged) that MTC which
ceased doing business in 2003, was Grande’s alter ego, and that Grande misused or converted
MTC’s assets over a period of several years before leaving it a judgment-proof shell.”
You see the problem. This is awfully similar to Grande’s behavior alleged to have happened in
Asia in the late 1990s and early 2000s. And it’s awfully similar to what we saw the head of
Emerson’s audit committee resigned over.
For the trial, Grande turned over 30,600 pages of documents. The plaintiff complained that
literally 99.99% of these were documents Grande knew the plaintiffs already had. They went
back and forth. Grande finally turned over 60,000 more pages of accounting and banking records
– which the plaintiff said were unlabeled, unordered, and undated. The judge said: “On the bell
curve of document production, this one is very near the end of the bell curve.” Grande was
forced to pay $75,000.
Here is another court document. I will quote the parts that an investor might be interested in:
“Plaintiffs allege that ultimately Grande siphoned all of MTC’s funds rendering MTC a
judgment proof shell and advised MTC’s counsel to withdraw from the Kayne action.”
If you read the footnotes to this document – it’s titled Fred Kayne v. Christopher Ho and dated
November 15, 2010 – you’ll find a description of how Christopher Ho controls Grande. More
importantly, for our purposes looking at Emerson Radio, you’ll have an idea of how he controls
that company too (because Grande owns 53% of Emerson).
The dealings are incredibly complex. Start on page 4. You’ll be lost by page 5. But the key
points are this. Ho takes over a company. He distributes its assets to other companies. When
someone tries to collect from the now bankrupt shell – the funds are elsewhere. Like another
company. In another country. That he also controls. He then claims that the companies are
separate. While the people trying to collect the debts they are owed claim the companies are the
same.. And that the last minute payment of the special dividend, transfer of assets, etc. was
designed to keep them from getting to the money they are owed.
Putting aside what various judges said – it’s quite obvious to me that those claims are true.
Grande and Ho’s other controlled companies do transfer assets among each other causing them
to enter businesses they were never in before. The reason for these transfers is obviously to keep
valuable assets away from creditors. Transfers such as moving office buildings between
companies have no other purpose.
Most importantly of all though, in 2010 a judge agreed that almost half a dozen other companies
are alter egos of Grande and Ho. Grande owns 53% of Emerson. Grande and Emerson have
related party transactions. Emerson’s head of the audit committee resigned over these. It is not
out of the question that Emerson will be forced to pay for Ho’s fraud.
So the two main risks at Emerson – and why investors are staying away from the stock – are that
Emerson will be forced to pay for actions taken by Grande, Ho, etc. Or that Ho will move assets
out of Emerson at some point as he has done with other controlled companies in the past.
So people might be shying away from the stock because they figure at some point either a judge
or Ho is going to grab Emerson’s cash – leaving shareholders with nothing.
For this reason, I’ve never considered buying Emerson Radio for the Ben Graham: Net-Net
Newsletter.
Emerson Radio is a very cheap stock. You can consider it if you want to. But the questions to
start with are not questions about the company. They are questions about management.
By the way, while you might not have been able to turn up all this information about Ho,
Grande, etc. yourself using your normal routine for researching a stock – the key clue that either
should have led you to drop your research entirely or focus on management was in both the 14A
and the 10-K. You always want to read the latest 10-Q, 10-K and 14A when you research a
stock. Have a highlighter ready. And a pen for taking notes.
Here are the first three business risks as titled in the 10-K:
· Uncertain Impact of Appointment of Provisional Liquidators for Grande, Emerson’s

Controlling Shareholder.
· The majority ownership of the company’s stock by an indirect subsidiary of Grande, which
is listed and based in Hong Kong, substantially reduces the influence of other stockholders, and
the interests of Grande may conflict with the interest of the company’s other stockholders.
· A number of the company’s directors and senior executive officers also are managing directors
or senior officers of Grande and have loyalties and fiduciary obligations to both Grande and
the Company.
These are huge clues about what to focus on with this company. But the oddest bit of information
is that on in the 14A:
“As of October 14, 2011, Grande had advised the Company that one of its indirect subsidiaries
held beneficially 15,243,283 shares or approximately 56.2% of the outstanding common stock of
Emerson. That number of shares includes the 3,391,967 Pledged Shares which, according to
public filings made by Deutsche Bank in March 2010 had previously been pledged to Deutsche
Bank to secure indebtedness owed to it. In February 2011, Deutsche Bank filed a Schedule 13G
with the SEC stating that Deutsche Bank had sole voting and sole dispositive power over the
Pledged Shares (which represent approximately 12.5% of the Company’s outstanding common
stock). The Company believes that both Grande and Deutsche Bank have claimed beneficial
ownership of the Pledged Shares. As of October 14, 2011, the Company has not been able to
verify independently the beneficial ownership of the Pledged Shares.”
It’s hard to overstate how weird that paragraph is. If you are looking for a simple company to
invest in and you find something like that – just drop it. If you are still interested in the company
focus on the ownership structure and the management.
It’s not worth analyzing Emerson as a business until you first analyze the people controlling the
company.
Personally, I would pass on Emerson Radio at any price.
Either way, it’s a bad idea to dive right into analyzing the business when the biggest risks at
Emerson Radio are human rather than economic.
Analyze the human element first.
Then worry about the business and the price.

 URL: https://www.gurufocus.com/news/172206/a-stock-where-neither-the-business-nor-
the-price-matters
 Time: 2012
-----------------------------------------------------
Why I'd Never Pay More Than Book Value for Nokia (NOK)
Someone who reads my articles sent me this question:
Hi Geoff,
This isn't your kind of company, but what are your thoughts on Nokia (NOK, Financial)? I have
been tracking it for a while and wonder if you had ever thought about it?
Thanks,
Sivaram
Sivaram is a contrarian investor. He writes a great blog called Can Turtles Fly?
He’s also right about Nokia not being my kind of company. It’s not a stock I’d consider.
I have thought about Nokia. But not for long. I think about anything that drops a lot. I think
about Bank of America (BAC, Financial), and AIG (AIG, Financial), and Hewlett-Packard
(HPQ, Financial) – and honestly I’d probably pick any of those over Nokia. Because there are a
couple questions I ask myself before really digging into a stock. The first three are closely
related – some might say essentially identical:
1. What’s my risk of catastrophic loss?
2. What’s the chance this company doesn’t exist in 10 years?
3. What’s the chance I’ll misunderstand this business?
If the answers are: high, high, high – I’m out.

My answers for Nokia to those three questions are: high, high, high.
So I’m out. Now, I’m not saying there’s a better than 50/50 chance Nokia doesn’t exist in ten
years. I don’t know that. When I say the risk of catastrophic loss is high, the chance the company
won’t exist in ten years is high, and the chance I misunderstand the business is high – I simply
mean each of these risks are too high for an investment.
A 25% risk of losing everything in a stock is low in the sense that the event is unlikely to
happen. But it’s very high in the sense that you would need a super bargain price to compensate
you for a one-in-four chance of losing every dime you put into a stock.
Honestly, I don’t even do a risk/return calculation like that. If the risk of total loss is too high I
end the analysis there – before my research even begins.
So why is the risk of loss in Nokia too high for me?
It’s in the cell phone business. And I have no interest in owning a cell phone manufacturer. It’s
not a good business to be in. Sure. It looks like a good business for the leader. Until 2009, Nokia
usually had returns on investment of 20% to 25% a year.
But, remember, Nokia is the global market-share leader in mobile phones:
Market Share
Nokia 24%
Samsung 18%
LG 5%
Apple 4%
ZTE 3%
RIM 3%
HTC 3%
Motorola 3%
Huawei 2%
Sony Ericsson 2%
Also Rans 33%
There are some serious problems with that market share picture. First of all, one-third (33%) of
all mobile phones are made by someone other than Nokia, Samsung, LG, Apple, ZTE, RIM,
HTC, Motorola, Huawei and Sony Ericsson.
How many other cell phone manufacturers can you even name besides those ten? And – be
honest – didn’t you forget one or two of those top-ten companies still even made cell phones?
Second, companies other than the top two manufacturers – Nokia and Samsung – account for
58% of the mobile phones sold in the world. Now, controlling 42% of the world’s market share
for a product between two companies doesn’t sound too bad.
But let’s think about this. Are Nokia and Samsung strongly differentiated from the other
companies on that list?
Or are they just lucky? Are they just flavors of the decade?
I vote for flavor of the decade. I’m not sure what makes Nokia or Samsung different from RCA
or Zenith. And if you check a list of today’s biggest TV manufacturers you’ll notice Zenith and
RCA aren’t on the list. In 20 years, will Nokia and Samsung make a list of the world’s biggest
mobile phone makers?
It’s a little disconcerting to see 42% of an industry in the hands of two companies that don’t
strike me as very different from the other names on that list. That’s really troubling. The fact,
that they are headquartered in two completely different parts of the world is also troubling.
Having world leaders located in different places is normally fine. If there’s a reason. But it’s
important that there be legitimate geographical reasons why you should have a market leader in
Finland and a market leader in Korea.
In general, you don’t want to see market leaders founded in totally disparate times and places.
The best industries usually involve several leaders who were founded under similar
circumstances. For example, Company A can trace its origins to Company B. You want them to
be founded in the same town, region, country, by the same person, etc.
Obviously, having market leaders who entered the business around the same time is a very good
sign. It’s one of the best signs of a self-sealing market-entry industry. An industry where the door
shuts behind you.
You hate to see a group of the top five companies in your industry where No. 1 entered the
business in 1920, No. 2 entered the business in 1990, No. 3 entered the business in 1970, etc.
That’s a terrible sign. It means companies are coming and going as they please.
I like an industry with a common origin. I’ve talked about DreamWorks (DWA) in the past.
Think about the three brands in the animation you know best – Pixar, DreamWorks and Disney
(DIS) – they can all trace their roots to a single company and a single relationship. Pixar and
DreamWorks were both founded by ex-Disney people.
We want to see something like the cruise business. Whatever the problems with profitability in
that industry – returns on investment are not impressive – we know companies will definitely not
be coming and going as they please:
Market Share
Carnival (CCL): 52%
Royal Caribbean (RCL): 26%
Norwegian: 8%
MSC: 5%
Disney: 2%
Also Rans: 8%
Let’s look at the top three cruise companies:
· Carnival (founded 1972 by Ted Arison)
· Royal Caribbean (founded 1968 by several companies)
· Norwegian (founded 1966 by Knut Kloster and Ted Arison)
None of those companies was founded more recently than 40 years ago. They were all founded
within about half a decade of each other. Two of them share a founder (Arison). Together, these
three companies control over 85% of the global cruise business. The largest (Carnival) has about
half the market to itself. And the two largest (Carnival and Royal Caribbean) together have three-
quarters of the market.
That’s what I like to see.
So what do I look for when I see market share statistics for an industry?
First, you’d like the company you are looking at to have a high relative market share. So, the
company’s market share – if it is the leader in its industry – divided by the next closest
competitor is high. Often, 1.5 is considered high. But a relative market share of 2 or more is
always nice to see.
A company like McCormick (MKC) has a high relative market share in addition to a high

absolute market share. They have anywhere from 40% to 60% of the consumer spice business in
the U.S. This is more than double the market share of their nearest competitor.
You want to look at this from a customer perspective – not a corporate perspective. We want to
compare actual alternatives. Although different spices are used for different things – and some
are sold in grinders and some in pouches and some in flip tops, etc. – they are all just alternatives
for the same thing. They are things you buy in a grocery store and add to a dish. Group them
together. Likewise, every cruise is an alternative to cruising with another company. They are
actual alternatives as well.
For some products, the market we are measuring their share of is very, very small. It’s very
specific. Go to a drugstore. Look for wart remover. It’s not a big industry. But the only products
that are alternatives to each other are the ones that actually remove warts.
Competitively, it’s more important to know a company owns the No. 1 wart remover in America
than that it has 7% of all drug store aisle sales spread across a lot of different products. You can
have less than 1% and have a good business if that 1% is being the leader in wart remover, ear
wax softener, etc. There’s actually a company like this. It’s called Prestige Brands
(PBH, Financial). And, yes, it reports market share for all its major brands – even though these
are products like Compound W and Murine.
There are advantages to huge scale. Of course, most of these advantages disappear if your
competitors also have huge scale. And there are some very frightening competitive tendencies
that appear in industries with a lot of scale and very little differentiation.
In businesses like the one Nokia is in – you don’t control your own destiny. In the long-run you
are at the mercy of your competition. Not just one competitor. But the collective stupidity of the
group. That’s what determines your long-term returns on investment.
The first line of defense in any industry is not selling the most products to customers. The first
line of defense is having the most customers relative to alternatives. It’s being
the preferred product.
Nokia has market share. But it’s not a big market share in absolute terms. And it’s definitely not
a stable market share. What’s worse is that a couple rungs down from Nokia we see companies
with laughably small market share. The cell phone industry has a lot of scale and very little
preference.
Complete dominance by a single company is fine. This would mean the company is either
a Hidden Champion serving a tiny niche or a multinational monopoly like Microsoft
(MSFT, Financial).
But an oligopoly-type business is also fine. Look at the four leading advertising companies:
· Omnicom (OMC, Financial)
· Interpublic (IPG, Financial)
· Publicis
· WPP
And now look at the four leading mobile phone companies:
· Nokia
· Samsung
· LG
· Apple (AAPL, Financial)
Which group has the more stable position? Which group is more likely to earn consistent profits
– as a group? And which list of names is less likely to change in the next ten years?
Likewise, let’s look at the flavors and fragrances industry:
· International Flavors and Fragrances (IFF)
· Firmenrich
· Givaudan
· Symrise
· Takasago
Like the advertising business these world leaders are spread around a bit – one is in the U.S., one
is in Japan, one is in Germany and two are in Switzerland.
Again, we have a lack of change in this business like we do in the advertising business. IFF was
created out of a merger in the 1950s. It has been public for almost 50 years.
Even in industries where competition is hard to measure, I like to see a company with a strong
position that isn’t new. I like to see a lack of change.
I’ve talked about FICO (FICO) before. The company was founded in 1956.
I’ve talked about Dun & Bradstreet (DNB, Financial) too. Their history goes back to the
1800s. They were formed through a merger in the 1930s. And their key product – DUNS – was
created almost 50 years ago.
Obviously, there is nothing wrong with a new world leader in some business. Facebook may turn
out to be a splendid investment. If you understand their moat and you are absolutely sure it’s
durable – you have my blessing to buy that company’s shares when you can. The same is true
of Google (GOOG, Financial).
As long as you believe their competitive positions are lasting, you can buy those stocks on a P/E
ratio basis.
That’s not true of a company like Nokia. I wouldn’t buy a cell phone company because it had a
low P/E.
To me, the cell phone business looks exactly like the TV business. And I expect it will end just
as badly for the companies involved.
There have been something like 220 U.S. TV manufacturers over the years. Ninety percent of
them have either abandoned the business or gone belly up themselves.
Some of the old American TV brands have been preserved or dug up from the dead and are now
used by foreign companies.
The world leaders in the TV business have not been constant. They’ve changed a lot over time.
And they have changed a lot in geography. Countries that had a lot of leading TV companies in
the early years now have almost none.
Is this just a manufacturing issue? When television was first successfully commercialized (we’ll
call that 1948 when the percentage of Americans with TVs was around 1%) the U.S. did a lot
more manufacturing than it does today.
Of course, that’s no excuse for why U.S. companies don’t still produce a lot of TVs. Obviously,
they could make the sets in other countries if they wanted to. There have to be other reasons why
U.S. TV manufacturers aren’t still among the world leaders.
Why are so many foreign companies now selling TVs in the U.S. while foreign companies are
not selling a lot of underwear, soda, spices, etc. in this country?
The TV business is not a business you stay in. It’s a business you enter and exit and hope to
make some profits by riding a societal wave for a while and getting out before your margins hit
zero.
I don’t see any reason why the cell phone business will be different.
They seem remarkably similar to me.
In both cases, the technology was developed long before it became an important feature of our
day-to-day lives. The TV was invented sometime in the 1928 to 1934 time period – depending
on what exactly you call a TV. It couldn’t really be commercialized until 1938. And it wasn’t
really successfully commercialized until almost 1948. The cell phone was invented in – let’s call
it – 1978.
So, we’re about as far into the cell phone era – 44 years – as we were into the TV era back in
1972.
In the U.S., it took about 34 years (if we say the TV was invented in 1928) for the TV to reach
what we’ll call virtually complete penetration (90% of all American households). That happened
in 1962. Depending on which sources you look at, we are either at that level now or a little bit
lower than that level with cell phones. And we are also exactly 34 years from the product’s
launch. Cell phones aren’t directly comparable to TVs because the percentage of American
adults with cell phones will probably never reach 90% - it’s maybe 80% right now. But the
number of households with cell phones is higher than 80%. It’s probably about 90%. And, like
TVs, the number of devices divided by the number of households in the U.S. is actually greater
than 100% because households average more than one device.
The key point here is scale. And that’s the problem. These are widespread devices used as part of
our daily lives. But they are the hardware part.
The TV broadcasting business was a very good business for a very long time. The TV set
manufacturing business was not.
There may very well be carriers who make a lot of money on cell phones for a very long time.
But I doubt cell phone manufacturers will consistently earn economic profits making cell phones.
We are talking about a global business of enormous scale. Yes, when something like smart
phones come around – everyone gets excited, and some folks (like Apple) even make some great
returns on capital – for a while..
But how is this different from high definition TVs? Companies wanted to leave the TV
manufacturing business in the 1970s – companies like Zenith branched out into any related
products (like cable) to try to stay on the edge of a societal wave.
But the TV business was bad in the 1970s and 1980s. That’s why companies abandoned the
industry.
The TV industry changed again. It’ll always change. They’ll be glimmers of hope.
Flat panels were a lot more exciting. But it’s not like anyone is going to make lasting money in
flat panels. It’s a terrible business.
Ultimately, a cell phone is nothing that a TV or a toaster isn’t. And the history of the industry is
going to play out like TVs and toasters. This isn’t a business companies stay in. And if they do
stay in the business, investors should get out.
There are going to be bursts of innovation and change in the business. And someone like Apple
will capitalize on that for a few years. And then everyone will make a phone just like that. And
no one will make any money.
In his book, “Security Analysis”, Ben Graham opened with a quote from the Roman poet
Horace:
“Many shall be restored that are now fallen and many shall fall that are now in honor.”
That’s the cell phone business. That’s the TV business.
I would never buy a cell phone stock for its earning power. I would never buy a cell phone stock
for its market share.
Why would I think that what a company earned last year in an industry like this has anything to
do with what it will earn over the next decade or two?
Would I buy a cell phone company on a Ben Graham basis?
As a net-net?
Sure.
But last I checked, Nokia had tangible shareholder’s equity of 7.67 billion euros. The company’s
market cap is 11.37 billion euros. So we aren’t even talking about a company that’s trading
below tangible book value.
If Nokia falls another 35% from here – without losing any money in the meantime – I’d take a
look at the stock. I could make a case for investing in a cell phone company when it trades below
tangible book, as a net-net, etc.
But, no, I would never consider buying a cell phone stock above tangible book value.
I just won’t even look at a company in this industry unless it trades below tangible book.
I have no way of valuing a cell phone stock on its earning power. So, I really don’t care what it
once earned.
That sounds harsh. But it only sounds harsh because some people believe the cell phone is a tech
business. And tech is sometimes worth a lot more than book.
Yes, the right kind of tech stock is worth many, many times its book value.
But, honestly, there’s no reason a cell phone company should sell for a higher ratio to its tangible
book value than a company that slaughters pigs – like Smithfield Foods (SFD) or Seaboard
(SEB) – or a company that produces eggs – like Cal-Maine (CALM) – or a company that grows
fruit – like Chiquita (CQB), Dole (DOLE), and Fresh Del Monte (FDP).
At a deep enough discount to book value I’d consider any of those companies. And I’d consider
Nokia. But – as an investor – Nokia really does look a lot like those companies to me. Cell
phones may be more exciting than pigs and pineapples. But I don’t see why the economics are
different.
Nokia had its moment in the sun. It was in honor. It fell. And now it’s a global commodity
company in an industry with ungodly scale and lots of hungry, desperate competitors.
It doesn’t really matter to me that they’re selling phones instead of pork or bananas. I think the
long-term realities of the industry are the same.
Now, you can do things in the cell phone business that maybe would get me interested in your
competitive position. But you can do that in pork and fruit too. It’s very tough. But with the right
management team and the right decisions in terms of how to control the product and get the very
best price for it – gain some degree of pricing power – I could be interested in any of these
companies.
But not above tangible book value. I would never pay more than tangible book value for Nokia
or any other cell phone company.
 URL: https://www.gurufocus.com/news/171692/why-id-never-pay-more-than-book-
value-for-nokia-nok
 Time: 2012
-----------------------------------------------------
5 Japanese Net-Nets: And How to Analyze Them
Hi Geoff,
Have you ever run a back-test for net-nets in Japan? Buying profitable companies selling for
less than cash and paying a dividend would make Graham's mouth water, it seems like a no-
brainer. But given the continued depressed state of the Nikkei, has net-net investing worked
there over a 10-year period? It's hard to come to terms with a poor macro environment like
Japan — but on the same hand, the screaming deals would not exist if it were not for the
problematic environment. How do you come to terms with that? I know net-net investing isn't a
strategy based on macroeconomic timing or considerations, but doesn't it still make you question
the viability of the strategy? Local evidence (i.e., backtesting) could help assuage that.
Thanks,
Tom
No. I haven’t backtested a net-net strategy in Japan. I don’t have access to good historical data in
foreign countries.
No. It doesn’t make me question the viability of the strategy.
Net-net investing worked in actual practice (always better than a backtest) in the 1930s and
1940s in the U.S. The situation in Japan is similar, though worse (for investors).
I’m going to take some time to explain how bad Japan’s economic growth has been for the past
two decades. People know it is bad. I think they underestimate just how bad it is – because they
don’t realize how unusual a long-term poor performance like this is. A short-term poor
performance – The Long Depression, The Great Depression, The Great Recession, etc. – is
common. And for long-term investors, depressions are pretty forgettable. From a bird’s eye view
showing a period of decades, these economic catastrophes barely register.
Japan’s economy has had it worse these last 20 years than the U.S. did from 1929-1949. You can
see this in their much lower real GDP per capita growth rate. I think real GDP per capita growth
in Japan has been about 0.9% a year over the last 20 years. The entire period from 1929 to 1949
was actually not bad for the U.S. Real GDP per capita rose about 2.2% a year. The last 20 years
you just lived through was worse. Real GDP per capita only grew 1.5% a year from 1991 to
2011. So, the 1930s and 1940s were better than the 1990s and 2000s if you’re willing to put
aside mass unemployment, genocide, world war, atomic bombs, etc.
Those things take center stage when you are writing world history. They are not that important
when discussing the kind of returns investors will realize over a couple decades in the stock
market. Only two things matter there: the price you pay and the value you get. We can break
down the way price and value determine your returns by looking at four factors:
· Earnings yield (price)
· Return on investment (profitability)
· Sales growth (growth)

· Dividend yield (dividends)
From a long-term investment perspective, any period of a couple decades taken together doesn’t
stand out much. We can’t look at the long-term performance of the economy starting from the
most recent financial panic (since it's only been a short time since 2008). But we can take a look
at a couple past economic catastrophes.
· The Great Depression (20-year real annual GDP per capita growth: 2.2%)
· The Long Depression (20-year real annual GDP per capita growth: 2.0%)
As you can see, measuring real GDP per capita for a full 20 years after starting in the supposedly
peak years of 1929 and 1873 doesn’t do much to the long-term growth picture. It certainly
doesn’t get us anywhere near Japan’s dismal last two decades.
Buying net-nets after the 1929 crash and before the 1950s certainly worked. We know that. And
we have a very complete record of the kinds of things Ben Graham bought in the 1930s and
1940s. But, again, we need to remember that real GDP per capita growth was 2.2% a year over
those two decades. In Japan, real GDP per capita hasn’t grown even half as fast.
And, of course, the rate of growth in capitas is even worse in Japan. Let’s take another look at
The Great Depression and The Long Depression. But this time let’s look at the rate of growth in
people rather than GDP per person:
· The Great Depression (20-Year annual population growth: 1.0%)
· The Long Depression (20-Year annual population growth: 2.3%)
And now Japan’s last two decades:
20-Year annual population growth: 0.2%.
So, the long-term growth numbers – before we even think about inflation – look something like
this:
(Real GDP Per Capita + Population Growth = Real GDP Growth)
· The Long Depression (2.0% + 2.3% = 4.3%)
· The Great Depression (2.2% + 1.0% = 3.2%)
· The Lost Decades (0.9% + 0.2% = 1.1%)
So, yes, the business situation in Japan – over the last two decades – has been much, much worse
than it ever was in the U.S. The U.S. never experienced a long-term slowdown as bad as Japan
has experienced these last 20 years.
No growth habits have formed. There was never time for these to form in American depressions.
Things got very bad. But they never stayed very bad for very long.
In Japan, perhaps things never got as bad. But they stayed much, much worse. The net result was
obviously much worse for anyone young enough to live through the next couple decades.
So, Japan is stagnant in a way the U.S. was never stagnant.
That creates a problem. Remember, the return you get on a stock is going to be constrained by
four things:
Of these four things, dividends are the least necessary. A stock that pays no dividends can give
you very good returns. And a stock that doesn’t grow – but pays a lot of dividends – can give
you very good returns too. But a dividend is a return. So, the amount of value you need the
retained earnings to add – through a combination of the initial earnings yield you buy the stock
at, the sales growth and the return on investment – is lower to the extent a stock’s dividend is
higher. And vice versa (the lower the yield on the stock – the higher its earnings yield, growth
and ROI need to be).
It’s important to keep these four things in mind. But it’s also important to remember that it is the
future of these items that really matters. I’ll be talking about today’s P/E ratio, today’s dividend
yield, today’s return on investment, etc. But if earnings, dividends or growth is unsustainable, the
numbers will give you a misleading impression of what the stock can return tomorrow.
Okay, let’s look at a group of five Japanese net-nets.
I’m going to just use Bloomberg data for this. So, the numbers may not be exactly right. But they
will be consistent. The important thing is to look at these stocks as a group.
Natoco (4627)
Earnings Yield: 9.84%
Excel (7591)
Kitakei (9872)

Chuokeizai-Sha (9476)
Otec (1736)
Now, the average earnings yield for these five Japanese net-nets is 10.62%. That’s a P/E of 9.42.
The average dividend yield is 3.07%.
Japan’s inflation rate is negative 0.7%. The U.S.'s inflation rate is positive 2.9%. So, you need to
add 3.6% to all Japanese yields to get the equivalent (in real terms) yields in the U.S.
In other words, for a group of U.S. stocks to have the same real dividend yield as Natoco, Excel,
Kitakei, Chuokeizai-Sha and Otec, they would need to have dividend yields of 5.82%, 7.52%,
6.43%, 7.37% and 6.22%, respectively. The average real dividend yield of these five Japanese
net-nets is 3.77%. For a U.S. stock to have a real dividend yield of 3.77% it would need to yield
6.67%.
Very few U.S. stocks currently yield 6.67%. And those that do are much more heavily indebted
than these Japanese net-nets. Remember, some of these net-nets have negative enterprise values
despite paying dividends. That means they don’t just have more cash than debt. They have so
much more cash than debt that the surplus of their cash over their debt is greater than their stock
price.
Okay. So, to deliver an equivalent real value to investors through its dividends as these Japanese
net-nets do, a U.S. stock would need a dividend yield of 6.67%.
What would its P/E ratio need to look like?
The average earnings yield of these five Japanese net-nets is 10.62%. Again, Japan’s inflation
rate is negative 0.7%. So, the real earnings yield of this group is actually 11.32%. The U.S. has a
positive inflation rate of 2.9%. So, a U.S. stock would need an earnings yield of 14.22% to
achieve a real earnings yield of 11.32%. Or to put it another way, a Japanese stock with a P/E of
9.42 has the same real earnings yield as a U.S. stock with a P/E of 7.03.
So, when we imagine what these Japanese net-nets would look like if we could move them to the
U.S. while keeping the exact same real returns from dividends and earnings – we find that they
would have a P/E of 7 and a dividend yield of 6% to 7%.
Does that sound impossible?
Only three or four decades ago, there were lots of U.S. stocks trading at those prices.
If you read “There’s Always Something to Do” about Peter Cundill you’ll remember that he
loved magic six stocks: P/E of 6, dividend yield of 6% and 60% or less of book value.
In nominal terms, you won’t find a lot of Japanese stocks – even net-nets – fitting this formula.
But, in real terms, you can find stocks in Japan that hit those numbers. Some of them are net-
nets.
Of course, Peter Cundill was dealing with a period of much higher inflation. So his magic six-
stock criteria was not nearly as demanding as it is today – when interest rates are so much lower.
Let’s look again at the four factors I mentioned as determining your return in a stock:

A company’s real dividend yield is effectively a reduction in your hurdle rate. Think of it this
way. If you are demanding 6.5%-a-year real returns before you buy a stock and that stock’s real
dividend yield is 3.5%, you only need the earnings retained by the company to grow the value of
your stock by another 3% (real) a year to provide you with the returns you want. Dividends are
neither necessary nor are they some kind of bonus. They are a substitution. To the extent you get
paid in cash you don’t need share price appreciation and vice versa.
The average dividend yield of the five Japanese net-nets I mentioned is 3.07%. Since Japanese
inflation is negative 0.7%, this is a 3.77% real return.
Historically, U.S. stocks have returned 6.5% a year in real terms. I’m just using Shiller’s data
here. It says real returns in U.S. stocks were 6.5% a year over the last 140 years.
So, if we want that kind of return in Japanese net-nets – today a 6.5% return would be about a
9.4% return in nominal U.S. dollars – we need to have share price appreciation in our Japanese
net-nets that is at least equal to 6.5% minus the 3.77% real dividend yield we are getting.
That leaves a 2.73% a year gap that needs to be filled through share price appreciation. Can our
Japanese net-net provide this?
Let’s look at our “retained earnings yield.” This is a stock’s earnings yield minus its dividend
yield. These 5 Japanese net-nets are only paying out about one-third of their dividends in
earnings. Over two-thirds of their earnings are being retained. For these net-nets that retention
tends to be a buildup of cash not a reinvestment in receivables, inventory and property.
On average, these companies are retaining 7.55% of their stock price each year. So, if one yen
retained by these stocks adds one yen in value to these stocks – we would expect nominal share
price growth of around 7% to 8% a year.
But how likely is that? How likely is it that these Japanese net-nets actually get full value for
their retained earnings?
Not very.
How low can the value of each dollar – they’re yen, but we’ll pretend they’re dollars here – fall
in value when it is retained by the company instead of being paid out?
Well, we need share price appreciation of 2.73% a year to make up for the gap between these
stocks’ dividend yields and the kind of returns we want. They are retaining 7.55% of the stock
price. So, we need each dollar of retained earnings to add at least 36 cents to the stock’s intrinsic
value. Anything less than that – and the value destruction will be too great to deliver a 6.5% real
return in our Japanese net-nets.
Do I think 100 yen retained by a Japanese net-net – or more accurately these five Japanese net-
nets – will eventually add at least 36 yen to the share price?
Actually, yes.
If you look at these net-nets, they are adding to cash more than they are adding to property. You
have miniscule growth in Japan’s economy. But it is not negative. Maybe we can assume 1% a
year in real growth. So, reinvestment possibilities in Japan are very low. And the return on any
reinvestment is low.
In that situation, it makes sense to either pay out earnings as dividends or retain earnings as cash.
For the most part, those are the best net-nets to buy. The net-nets that:
· Have high dividend yields
· Have high earnings yield
· And keep their retained earnings in cash
Keeping retained earnings in cash avoids the risk of getting stuck in very low-return, long-term
investment like additions to property, plant and equipment.
Let’s break down the issues surrounding our investment in Japanese net-nets – and really any
investment – by ticking off each of the four factors that decide our annual returns in a stock.
Because we are comparing stocks in two countries – the U.S. and Japan – with very different
inflation rates, I’m going to talk in real terms. Remember, that inflation is 2.9% in the U.S. So,
when I say a 6.5% real return is our hurdle rate, that’s like saying a 9.4% nominal return is our
hurdle rate.
Let’s look at each factor of these Japanese net-nets and how it compares to the rate of return we
want to see:
Desired Real Rate of Return vs. Real Dividend Yield: 6.5% - 3.77% = 2.73%
So, we need our other factors – our return on retained earnings – to be at least 2.73% a year in
real terms.
Real Retained Earnings Yield: 8.25% / 2.73% = 3.02 (Pass)
Real Return on Investment: ? / 2.73% = ?
Real Sales Per Share Growth: 1%/2.73% = 0.37 (Fail)
So, the amount of retained earnings we have being added to the company’s balance sheet is three
times larger than it needs to be to deliver the kind of returns we want. But the real sales per share
growth is only about a third of what we want here (it would have to be much higher, but low
sales growth is okay when the dividend yield is high).
It seems to come down to the real return on investment. I’m not sure what that will be. I think
4% a year is possible. Not much more than that. In the U.S., real return on investment is much
higher at many companies. It’s not unusual to see numbers in the 10% to 12% range right now.
How can I have any confidence in the returns on investment that will be achieved by Japanese
net-nets?
I can’t. But two numbers make the ROI/growth hurdles very low. Low enough that I’m pretty
sure even Japanese companies can clear them.
If you look at these five Japanese net-nets – they are paying you a dividend yield of 3.07% a
year. And then they are retaining another 7.55% of your purchase price on their balance sheet.
So, for every 100 yen you use to buy these stocks, you’re getting paid three yen a year in cash.
And you’re getting seven to eight yen added to the balance sheet.
The issue of growth and return on investment only arises to the extent these things are necessary
to provide you with a high enough return on your purchase price. If the purchasing power of the
yen is stable, we are talking about a 10.6% real return in a combination of retained earnings and
dividends.
That’s much higher than the real returns investors normally get in stocks.
Now, yes, the 7.5% part of that 10.6% real return is vulnerable to value destruction through
reinvestment at very low rates of return.
If these low rates of return are, say, 4% a year – we’re fine. You’d still end up with real total
returns in the stock that are higher than what investors in stocks have usually earned.
You can see this by assuming that each part of the return on retained earnings must be the same
number. For example, a 6.5% earnings yield that is invested at a 6.5% return on investment and
achieves 6.5% growth in sales per share will hit a target of growing intrinsic value by 6.5% a
year.
A 4% ROI is low. But it’s enough to clear the less than 3% hurdle that’s left after we take these
stocks’ dividends into account.
Let’s put dividends aside and just talk about why ROI, growth and a stock’s earnings yield all
matter. But they don’t matter individually. They matter together.
So what if one of those numbers is lower than your hurdle rate?
The others have to be higher than your hurdle rate to offset this.
The margin of safety in Japanese net-nets is that the dividend yield is a payback unrelated to
ROI. This reduces the hurdle you have to clear with retained earnings.
Think of it this way. The dividend yield on these Japanese net-nets is 3.07%. And
the retained earnings yield is 7.55%. A stock with an earnings yield of 7.55% trades at a P/E just
over 13.
So, when you buy a Japanese net-net you get two very bad features vs. U.S. stocks:
· Low growth
· Low return on investment
And you get three good features to offset those bad features:
· Dividend yield
· Deflation
· Excess cash
A Japanese net-net is retaining enough earnings that it would trade at a P/E of 13 even if you
didn’t count the dividend as part of earnings. In that sense, you are buying a stock with a P/E of
13 and getting a 3% dividend yield for free. The purchasing power of the yen has risen 0.7%
while the purchasing power of the dollar has fallen 2.9%. So, in a sense, you’re getting 3.6%
there. (Of course, that’s the rear view mirror. Future purchasing power is what really matters.)
U.S. stocks do not normally have a lot of surplus cash. Almost no profitable U.S. companies
have so much more cash than debt that they actually have more net cash than their share price.
Well, that happens in Japan. Some of these net-nets are proof.
So, the growth and return on investment picture is pathetic. That means retained earnings have
less value in Japan than they do in the U.S.
But you don’t just buy a stream of retained earnings when you buy a Japanese net-net. You also
get:
· A pile of cash
· A stream of dividends
· The change in purchasing power
In the U.S., it is not uncommon for a company to have more cash than debt. But it’s also not
uncommon for a company to have more debt than cash. So, the first factor – the cash pile – is
sometimes positive, sometimes negative and sometimes a wash in the U.S. The stream of
dividends in the U.S. is nice on some stocks – but how often is it higher than the change in
purchasing power?
Real dividend yields in the U.S. are pretty low right now. We’re talking 0% to 2% on what some
people consider high-yielding stocks.
In Japan, you can find companies with net cash that have real dividend yields in the 3% to 4%
range.
So, you get a dividend defense and a balance sheet defense in Japan that is often lacking in the
U.S
In fact, you can find Japanese net-nets that sell for less than their net cash. That fact alone is not
impressive. Bad companies sometimes sell for less than net cash.
But you can actually find Japanese net-nets that are priced to give adequate returns without their
cash piles that also have really big cash piles.
A stock with no net cash, a P/E of 10 and a dividend yield of 3% is often going to do just fine.
In Japan, you can find stocks that have a P/E around 10, a dividend yield around 3% and a net
cash position right around their market cap.
This splits your investment into three bets:
· A bet on the value of the stock’s future retained earnings stream

· A bet on the value of the stock’s future dividend stream
· A bet on the value of the stock’s future cash pile deployment
When you take these three bets together, I like the odds.
If anything is going to derail these Japanese net-net investments, it won’t be a bad economic
environment in the sense that you mean it. It won’t be a continuation of the past. That’s baked
into the cake. Stagnation as far as the eye can see is fine – you can still make money in Japan if
that happens.
So what can derail Japanese net-nets?
A decline in the value of the yen.
A country that is accustomed to deflation could have poor-performing stocks if they were hit
with a lot of sustained inflation. Remember, the nominal rates we are talking about here are not
that impressive. They’re okay. They become very impressive when you realize they are being
paid in a currency that has held its value for a while now.
Investors in the U.S. are rightly concerned about this. Many people tell me they won’t buy
Japanese net-nets because they don’t know what the yen will do against the dollar.
That’s fine. In fact, I think it’s the best reason for passing on Japanese net-nets.
My own policy is that I’m always willing to put 50% of my money outside of U.S. dollars. I
don’t have a view one way or another on currencies. But I feel that if half my money is in dollars
and half is in something else and all 100% of my portfolio is in some of the cheapest stuff on
earth – my results will be fine.
Over time.
I’m not concerned about the fact that I have never backtested Japanese net-nets. Although I’ve
talked about backtests of net-nets before, I’ve always really meant those backtests to be
illustrations rather than evidence.
I think the U.S. in the 1930s is the best illustration of what net-net investing in Japan is like.
Obviously there are differences between the U.S. and Japan. But it’s not like changes of control
were common in the U.S. in the 1930s. And many of the stocks Ben Graham bought were
controlled net-nets that were not interested in selling the company at any price.
Also, one of the Japanese net-nets I bought in 2011 (Sanjo Machine Works) was bought out. So
it’s hard for me to say Japan totally lacks a certain kind of catalyst that’s important in the U.S. I
think net-net investors focus a bit too much on the whole idea of a catalyst. I prefer a lot of
uncertain opportunities to make money over time to one seemingly certain exit strategy.
When stocks are as cheap as the five stocks mentioned in this article – there are a lot of different
ways to get paid at some point in the future.
A lack of buyouts in Japan is definitely not a plus. But it’s hard to quantify how that changes net-
net performance vs. the U.S.
Anyway, the answer is no, I haven’t backtested net-nets in Japan. And I don’t question the
viability of the strategy.
If anything, the strategy seems a lot more viable to me in Japan than in the U.S. today – because
the quality of net-nets in the U.S. is not as good as it is in Japan. Most U.S. net-nets are
extremely unsafe. There are a couple dozen worth considering. The Ben Graham: Net-Net
Newsletter probably owns half of them.
The American stock market isn’t exactly teeming with good net-nets right now.
That’s what happens after a few good years. After a few bad years, lists of net-nets look more
like what you see in Japan right now.
Actually, in terms of the quality of the net-nets you can find in Japan, I’ve never seen anything
like that here. Net-nets like the ones you can find in Japan just haven’t existed in the U.S. in the
last couple decades.
 URL: https://www.gurufocus.com/news/171604/5-japanese-netnets-and-how-to-analyze-
them
 Time: 2012
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Financials
How is a Bank Like a Railroad? – And Other Crazy Ideas Geoff Has About
Investing In “Efficiency Driven Businesses”
Someone sent in this question:
When deciding to look for a bank, where do you start? What is your initial approach when
finding a bank?
So, I don’t really have one specific thing I look for in a bank stock. The way it usually works is
that I read about a bank somewhere. I’ve gotten a couple good bank stock ideas off the Corner of
Berkshire and Fairfax “investment ideas” thread (I read every post in that thread). Now, the truth
is that it’s never been a very long thread about the bank. In fact, there are like 3 banks in all the
time I’ve been reading Corner of Berkshire and Fairfax’s “investment ideas” thread that jumped
out at me. The numbers someone cited just jumped out at me immediately as unusual. Now,
unusual doesn’t necessarily mean good. But, it does mean do more research on it. So, the basic
numbers where being especially high or low or whatever for the bank would make it really,
really interesting would probably be:
– ROE (higher is better)

– ROA (higher is better)
– Efficiency ratio (lower is better)
– Deposits/branches (higher is better)
– Leverage (lower is better)
– Dividend payout ratio (lower is better)
Many banks are going to look awfully similar on these measures. That’s because banking is in
some sense a commodity business. To me, banking is most similar to insurance. It also – in some
ways – can be a little similar to things like railroads too. I know that’s hard to believe. But, I
would say that there can be potentially some similarities between things like: banking, insurance,
telecom, power, water, and railroads. Why?
These businesses work really, really differently from most businesses investors are used to
analyzing. Most investors are used to analyzing big tech, media, restaurants, retailers, consumer
brands, etc. Capital is relatively unimportant in those industries. Intangibles are important.
Competition is fierce. The industry changes quickly. So, competitive position can be very, very
important in those industries. Whereas capital is less important. And then oddly efficiency is less
important as a differentiator. Efficiency becomes very important as a differentiator if you are in a
more capital intensive and less competitive business. Like, a monopoly cable company can have
all sorts of different returns depending on who is running it. John Malone runs it – it’s a great
business. Average family running it in the early days of cable – it was an okay business. It grew
fast and such, but it may not have been very highly leveraged (so it paid taxes) and it was
probably spending more than it needed to in terms of expenses (so EBITDA margins were
worse) and so on. Businesses like banking, insurance, railroads etc. are very efficiency driven
because the return accruing to owners is further removed from the value you can extract from the
customer. If you have a great brand – it’s going to either be a good business or bad business
primarily based on the product economics rather than the operational efficiencies. Basically, how
many units can you sell at the same sort of prices as your competitors and then also how much
pricing power do you have. So, I don’t think it makes a huge difference who is running a
company once a brand like Tide or Reese’s or Tabasco is established.
I think it makes a huge difference in businesses like banking and insurance. In fact, when I’ve
been asked about like how important the “jockey” is – I would say I’d only ever make a pure
jockey bet in 3 situations: M&A roll-up business, insurer, or bank. That’s it. So, if you have a
guy run a bank or an insurer or roll-up an industry for 20 years and then he leaves to start or
takeover a brand new business in the same industry – if the price was right, I’d be willing to
follow him. In fact, in one case of the banks mentioned at Corner of Berkshire and Fairfax –
that’s what happened. I noticed that one of the banks mentioned was run by a guy who had like a
long-term record at another bank that he left (“left” is putting it politely, they fired him) where
you could analyze the past record.
So, my #1 thought when looking at an efficiency driven business (an “efficiency” driven
business to me is one where capital requirements and fixed expenses are high and competition is
low) is the management. Sometimes, “management” could mean culture. Like, if the business
was founded by penny pinchers and all top management since then have been insiders promoted
from the bottom up through to the top of the company – management is probably cheap. This
would honestly be my focus for banks, for insurers, for telecom, for power companies, for water
companies, and for railroads. Who is running the place? Who is the CEO? Who is the M&A
guy? Who is the CFO? What is the culture? You want the key people and the culture to be one
focused on compounding shareholder value and on keeping operating expenses very low. At
different companies, the key person can sometimes be different. I know a bank where the CFO
was probably more key than the CEO. Another where the Chairman (he’s a huge shareholder
who basically bailed out the bank personally and took it over decades ago) is the key person.
And obviously there are many where it’s the CEO. You can also think of situations – the
building up of Citigroup is the most famous example, but I’ve seen other modern ones – where
it’s really like a two person team. And then sometimes it’s the culture. Like, I know of one bank
where everyone is from the same town and went to the same college and all that and basically
was hand picked by the same guy who founded the bank. So, whoever ends up running that bank
years from now – they probably have the culture created by that founder. Then there’s another
one I know of where basically everyone who matters was taken from another bigger bank. So,
like a bank got very big and successful and then some of the more independent minded people at
that bank got tired of it getting slower moving and more committee driven over time and they
joined another bank that was kind of like a re-founding of that successful big bank. You see this
sometimes.
So, what is it that I want to see in terms of management/culture?
I think you want a very, very stingy management team. And stinginess to me can be scored on
two points:
1) You want them to be super stingy when it comes to operating expenses. Do they talk about
things like “other” expenses (postage and letterhead and other waste) and “occupancy cost”
(rent) and headcount growth relative to asset growth and stuff like that.
2) You want them to be super stingy when it comes to using owner’s capital. Owner’s capital is
equity. So, you don’t want a bank to think it’s okay to operate at 6x assets/equity or 12x
assets/equity. At 6x assets/equity – they need to start talking about how they need to find an
acquisition to do, or a share buyback to start, or a regular dividend to raise, or a special dividend
to pay or something like that. Some bankers will say they have a “fortress balance sheet” and
stuff like that when saying they are glad to be operating at half the leverage of other banks. But,
this is wrong. Talking about ROA but not ROE when you have lower than normal leverage is a
bad sign. Now, the reverse – if a bank says we have 1% ROA and 12% ROE but some of our
competitors have 1.1% ROA and 11% ROE (using less leverage than us) so don’t give us too
much credit for just using more leverage – that’s fine. I’m not saying a bank should only focus
on ROE instead of ROA. It shouldn’t. But, it should be reluctant to issue shares. It should be
reluctant to allow itself to operate permanently at lower leverage than it knows to be safe and so
on. What is safe is going to vary by bank and management team. Some will say 15x assets/equity
is correct and some will say 10x assets/equity is correct. Either answer could be right. I don’t
think 5x or 25x is going to be right though. Actually, 25x should be basically impossible for a
normal bank to do now. But, you get my point. You don’t want someone to do the equivalent of
taking your money as a mutual fund manager and going 100% into short-term bonds. They’ll
never lose you money. But, they’ll never make you any either. If you wanted to invest long-term
with someone in stock and bond markets, you’d probably want them to invest as close to 100%
in stock whenever they could find decent stocks at decent prices. But, you wouldn’t want them to
use leverage. And you might be okay with them holding some bonds in like 1929, 1965, 1999, or
today. In other words, if a banker says – our leverage has dropped from 12x to 8x over the last 5
years, because we just can’t find loans in areas we understand at decent rates – then, that’s fine.
They just need to have a very clear understanding that it costs something to let owner capital sit
idle and not be leveraged up fully as the laws and such allow. Saying we can’t find intelligent
things to do right now is a good excuse.
The idea here is similar to insurance. I have no problem if an insurer normally writes at 2x
premiums / statutory surplus (usually but not always similar to equity) when a regulator / A.M.
Best would be fine with 3x premiums / statutory surplus – if they explain why. I’ve seen insurers
that write 1x premiums / surplus and give no explanation as to why it’s not 2x premiums /
surplus. They need to explain their leaving owner’s capital unleveraged in terms of betting of
some kind. Like they have such small betting because the market is too loose and pricing is
wrong and so on. They can’t just be so conservative that they don’t use appropriate leverage.
Leverage is a normal part of banking.
So, I would want a management team obsessed with keeping expenses low and keeping the
amount of owner’s money in the business low. This doesn’t mean I want them overleveraged. I
wouldn’t necessarily complain if a bank operated at 10x assets/equity if it was always 10x
assets/equity. They might have an ROA of 1.5% and ROE of 15%. I’m not sure that needs to be
pushed to get the ROE to 22.5% or whatever if you leverage as much as some peers. But, I need
some sense that there is a point where you are just hurting your shareholders by using less
leverage than you know would be safe.
Then, I’d like a “niche”.
So, banks are “network” businesses in a sense. But, many banks don’t possess strengths on both
sides of the network. So, a bank works like a money middleman. It takes money on the deposit
side and lends it out on the loan side. What you’ll find is that the vast majority of banks are
commodity like on both sides. They have no competitive advantage worth talking about as either
a source of money (deposits) or a supplier of money (loans). Then, there’s a smaller subset of
banks (less than half) that have some competitive advantage on either the deposit side or lending
side. Very few banks have an advantage on both. Usually, if a bank has a double-sided true
network advantage it’s going to be: a private bank, a business bank, or a specialized bank. In
fact, specialization toward like one industry for a business bank or toward clients at a private
bank that are also more focused on one industry is going to be more likely. Most banks I’ve
found that are like this are not very big. So, it’d be hard to give examples people have heard of.
I’d say that SVB Financial (SIVB) and First Republic (FRC) are two examples of size people
have heard of. But, there are lots of bigger banks that have some segment of their bank that
might have network type advantages tied to some specific industries. SIVB is somewhat tailored
to venture capitalists and FRC is somewhat tailored to hedge fund managers. If you just look at
the 10-year financials of those banks – you wouldn’t see that. But, if you go browse their
websites, read their investor presentations, etc. – you’ll see their strategies involve more of a
focus on some specific individuals / entities (often in banking, you’re going to find the bank does
some stuff both on behalf of a firm and also for the key people at the firm – this is a good way to
get sticky business and referrals).
But, this doesn’t happen much. Most banks you’ll find will not have strengths on both sides of
the deposit taking / loan making side of things. For example, I’ve talked about Frost before. Frost
has strengths in deposit gathering. It doesn’t really have strengths in lending. They aren’t stupid,
reckless, etc. Which you need to watch out for. But, an investment in Frost would basically be a
bet they can do smart things on the deposit gathering side and then just not dumb things on the
lending side.
A reverse situation is Hingham (HIFS). This bank doesn’t have strengths historically in deposit
taking. In fact, this is very obvious by the fact they are lending > 100% of their deposits and they
have a group called “specialized deposit group” inside the bank. Everything about HIFS gives
you the impression they find it easier to make loans than to have deposits to fund those loans.
Everything about Frost gives you the impression they find it easier to take in deposits than to
have loans to make with those deposits.
Does that make HIFS a bad bank?
I don’t think so. And I know this confuses people, because I talk about the importance of having
a low cost of funding (like at Frost) and then I turn around and write-up a stock like Hingham
that does not have especially low interest costs and does not fund itself entirely with sticky
customer deposits. Hingham uses borrowings. It uses what I’d call wholesale money (some is
officially wholesale, but also just any money coming in for the rates is really hotter money than
non-interest type deposits).
So, what does Hingham do right?
First of all, I don’t care what a bank’s non-interest expenses are. This is irrelevant. I also don’t
care what a bank’s interest expenses are. These too are irrelevant.
There’s only ever one cost that matters.
It’s non-interest costs PLUS interest costs.
If you could build a bank that paid ZERO INTEREST to any of your depositors but provided
concierge levels of service, no fees for anything, blah, blah, blah – you may actually have built a
good bank. If you can go and lend money at 3.5%+ and leverage it up 10x+ – then, honestly you
can afford to spend 2-2.5% or your assets each year providing amazing customer service as long
as (in exchange) your depositors are happy to receive no interest.
The reverse is also true. If you could operate a bank – let’s say over the internet or something
like that – which took in only massive deposits that were always happy to stick around, you
could pay interest at like 2-2.5%.
The above was just for illustration. There are two realities to keep in mind.
One, all banks will have some non-interest expense and some interest expense. So, Hingham is
efficient enough to be running at 0.8-0.9% of assets in terms of non-interest expense. Some
banks can operate about that efficiently on a NET non-interest basis, but they do this through
charging high fees. HIFS has like almost no fees at all. So, it is just exceptionally low expense
versus the size of its assets. Frost, meanwhile, has a lot of non-interest paying deposits. But, on
an interest plus net non-interest expense basis it is only very good – it doesn’t come in a lot
lower than a super low expense bank that has almost all interest bearing accounts.
So, it’s always the combination of these two things. The cost of funding for a bank should only
ever be evaluated on an “all in” basis. The “combined ratio” for a bank is the non-interest
expense and the interest expense taken together. Never separately. Don’t let a bank fool you by
stressing how low their non-interest expenses are and then never talking interest costs or by
stressing how they pay almost nothing in interest but never admit they are a very high non-
interest expense bank. This would be like listening to an insurer talk about their low expense
ratio without mentioning their high loss ratio or vice versa.
The goal for any bank should be the same. It has to be to aim to become the lowest cost producer
of money around. The low cost producer is the guy with the lowest combination of non-interest
and interest expenses relative to assets.
And then secondly, I excluded charge-offs from the above. So, spreads have to be wider before
charge-offs than I talked about above. For some banks, this matters very little. For others, it
matters a lot. If you are making loans at 5.5% and charging off 1.5% per year on average over a
full cycle – this is no different than making loans yielding 4% with zero charge-offs.
I can’t stress this enough. A wide net interest margin is not necessarily a sign of a great bank.
Often, it’s going to be the combination of two factors that’ll work better:
1) A low “all in” cost of funding (non-interest expense plus interest expense divided by total
deposits is very low)
2) An almost non-existent charge-off rate
Why does this pattern work well?
If you have a low cost of funding, you can make low interest loans and still turn a profit.
If you have low charge offs, you can make low interest loans and still turn a profit.
Low interest loans are often going to be easier to make, easier to monitor, get you repeat
business, etc.
A bank that has to make high interest loans all the time is just going to have a tougher time in a
lot of ways.
So, say our goal was to survive on making 4% loans.
Well, if our “all-in” cost of capital is 2.5% or less and our charge-offs are basically zero percent
we could have a spread there of like 4-2.5% = 1.5%. If we could make a huge amount of these
4% loans, we could have almost our entire balance sheet in loans instead of securities. With
normal leverage a bank might use, we’d have a double-digit ROE despite investing in what are
really quite low interest and presumably safe loans.
This brings me to the last point I’d look for in a bank.
I definitely like a specialty.

This isn’t required. I mean, a bank with a very low cost of capital could – in some interest rate
environments – park money at the Fed, hold municipal bonds, etc. and get results that were
anywhere from somewhat profitable to higher ROE than most other banks. If money costs you
almost nothing on an “all in” basis – you really don’t need to actually lend it out except as
required by your regulators and such.
But, most banks are going to lend out their deposits. And almost all bank failures are going to be
the result of lending mistakes. So, the lending side of a bank is important.
I would not focus on finding banks that can get higher yields on their loans than their peers can. I
think that’s too difficult for an outside investor to evaluate.
Instead, I’d look for banks that do 3 things:
1) Aim to have very low charge-offs on their loans (I think it’s more achievable to eke out an
extra 1% from charge-off reduction to basically nil than it is to eke out 1% by making 5.5% yield
loans instead of 4.5% yield loans)
2) Specialize
3) Diversify
I know #2 and #3 sound like they are at odds.
Personally, I want as high a proportion of loans as is prudent to be made in as narrow a specialty

as possible. This may sound like I’m suggesting making 50% credit card loans or 50% energy
loans or 50% art loans or something. But, I’m really not. What I’m saying is that it is best to
focus on making loans in your area of expertise. You might call this your circle of competence.
You might call it loans where you have an edge. Whatever it is – you don’t want to make loans
where you don’t believe you aren’t at least somewhat more skilled than other lenders. So, the
average bank should not be making 5% energy loans and think this is safe. Banks that specialize
in energy loans should be making 15% of their loans in that area. For a half dozen or so banks in
the country – a 15% allocation to energy loans is appropriate. For 1,000 banks in the country: a
1.5% allocation would be inappropriate. Investors understand this idea better in insurance. In
insurance, you want to invest in “niche” insurers whenever possible. You want to buy into the
insurer that has the most past experience with losses in the industry, that has the most data, that
has the most trained people in terms of the risks they’re covering. You want to avoid insurers
that are writing some line of business for the first time. Investors in insurers get this wrong all
the time. They buy into an insurer with a ton of growth in premiums, a low price-to-book, etc. –
but that “book” is literally a book of business which is fairly recently written risks that the
company has no prior experience writing and that was obtained on the basis of sometimes
quoting a lower rate than a competitor who had been writing those risks for the last 30 years.
Generally, I’ll admit, the risks in lending for banks are going to be really muted versus the risks
in insurance. If your lenders are really level-headed emotionally and risk averse – I don’t think
they’ll blow up a bank just because they don’t have any experience or data making these kinds of
loans. I think that will happen more frequently in insurance. But, it’s still an analogy I’m
comfortable with. Think of a lender like an insurer. You’d prefer they have a niche.
But, they have to be somewhat diversified.
The best way to do this is through having a low correlation between the two or more risks you
are taking. I talked about Hingham in my write-up (on the Focused Compounding premium site).
In that case, the bank is lending a lot against two different kinds of collateral (both in the Boston
area). One is single-family houses. The other is multi-family buildings. The good news is these
are both fairly low risk categories. The better news is they aren’t that closely correlated. In a
housing bubble, you rarely have an apartment bubble. In an apartment bubble, you rarely have a
housing bubble. The thing you’d want to avoid is like having two equal categories: housing and
construction. That’s bad because housing is fairly low risk. Construction is fairly high risk. But,
construction and housing are too highly correlated. The moment when you could end up
foreclosing on some land bank that’s totally undeveloped by some now bankrupt homebuilder is
the same moment when your loans on existing homes are also going bad.
So, you want two or more specialized loan categories that aren’t overly correlated with each
other.
Will you find this?
Very rarely.
Banks just aren’t run that way very much. In my experience, you’ll be more likely to find a good
bank that is just very strong on the deposit side and then totally mediocre and generic on the
lending side. I’ve found it very hard to identify banks with strong lending side attributes, because
almost all banks are run conventionally on the lending side. They are diversified beyond their
points of potential specialization. As a result, they tend to take fairly broad and normal cyclical
charge-offs based on the area of the country they are in and a mixed loan portfolio.
Unfortunately, they are sometimes overweight enough to some high risk loan category to manage
unusual losses in that area during something like a bubble.
So, generally, you aren’t really looking for “good” lenders. You’re just looking for “not bad”
lenders who are good deposit gathers. So, like you identify a good deposit gather and then you
check to see if they are making loans in a state they haven’t before, in a loan category they
haven’t before, in something you suspect to be a bubble, etc. The tough part for investors is that
they usually focus on the size of the loan category instead of the size of the potential losses. So,
like they’ll see that residential is 50% of the bank and RV loans are only 15% of the balance
sheet. Focus on the RV loans instead of the home loans. It is easier to blindly do something
dumb that will risk the bank as an overall entity by putting 15% into RV loans than it is by
putting 50% into home loans. I mean, as long as you are in a part of the country where land
values are not overinflating – you’d have to be dumb in pretty creative ways to sink a bank with
50% in home loans. They are just such a “general” type of loan that it shouldn’t be possible to do
something that destructive unless there’s a bubble that you deny.
Bubble denial could cause a wipe-out of almost any bank. So, you want to watch out for that. If I
was invested in a bank making energy loans and they said $110 a barrel was the new normal in
oil and they just look at the market price and so on – I’d get out of that stock. If instead they
mentioned that although oil is at $110 a barrel, we keep making our loans on an assumption of
$60 a barrel – then, they might be right or wrong but they aren’t just blindly denying a bubble.
I’d say the biggest risk to a bank that is actually skilled in lending is that a bubble develops in a
category that is large for them. This could sink any bank. I’ve mentioned this with Farmer Mac
(AGM). They are an agricultural bank (not really a bank – they’re a GSE, but we’ll pretend they
are “banklike” for this discussion). I honestly believe a true farm bubble like we saw twice in the
last 100 years would basically bankrupt AGM. I don’t think any management team could stay
prudent long enough at a GSE like that not to be wiped out by a bubble. Farm bubbles just get
too big for it to be safe to have 100% of your assets tied to them and use the leverage Farmer
Mac uses.
I feel that way about other banks too.
So, in terms of lending…
1) Are they prudent?

2) Are they specialized?
3) Are they diversified?
4) Are they trapped in a bubble?
If a good lender is trapped in a bubble – honestly, I’d probably just bail on the stock. This sounds
unfair to management. And perhaps it is. But, the risks of large lending losses outside of bubbles
are just so small compared to the risks inside a bubble – that I’d just avoid bubbles altogether.
I’ve mentioned this before with other lenders. Like, I did a write-up of Car-Mart (CRMT) where
I said how much I liked CRMT but how little I liked its competitors. If you feel the competitors
are making such bad loans that it’s hard for anyone in the industry to stay prudent without their
market share vanishing to nothing – it may be right to just avoid anyone in that loan category
altogether.
 Time: 2020
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How I Analyze Bank Stocks
We did a Focused Compounding Podcast episode that was 100% dedicated to bank investing.
In that podcast notice that I analyze banks completely differently than most value investors. I
don’t believe price-to-book is an especially important metric. I value banks based on the amount
of their share price, their deposits per share (so P/Deposits so to speak), their growth in deposits,
and finally the profitability of those deposits (how low cost are they, how “sticky” are they).
I spend very little time on the asset side of the bank except to see if I think it is safe enough for
me. I just assume – and this assumption isn’t 100% correct or anything – that money is a
commodity, so banks will make roughly similar amounts over time on whatever they lend out,
buy bonds with, etc.
However – at least among U.S. banks – you have banks that pay very different amounts on their
deposits (in interest), and even MORE important very, VERY different amounts in terms of non-
interest expenses per dollar of deposits. There are banks in the U.S. that have $50 million per
branch and pay HIGHER interest on most deposits compared to banks that have $200 million per
branch. The bank with 4 times the deposits per branch brought in with MORE non-interest
bearing accounts is going to have such a “all-in” cost advantage over the other bank that it can
make fewer loans and buy more bonds, it can make safer loans that yield less, it can buy shorter-
term bonds that yield less, etc. and it’ll still make more money than the bank that has to hustle to
make the highest yielding loans, buy the highest yielding bonds, etc.
My belief is that a strong, durable advantage on the deposits side in terms of economies of scale
at the customer level and the branch level especially is what creates value in banking.
It’s not impossible to create value in other ways. Prosperity Bank has done this. But, taking in a
lot of small deposits from a lot of less wealthy people at a lot of different branches means the
only way you can succeed would be extreme penny pinching on the deposit side and then really
good lending on the asset side. You’d have to be cheaper than the other guys when it comes to
running a customer oriented business and/or you’d have to be smarter, more driven, etc. lenders.
I think that’s tough.
Recently, I also wrote-up Truxton (TRUX). You can see the same focus on economies of scale
here, because:
1) Truxton operates BOTH a wealth management business and a private bank out of the location
that is ALSO ITS HEADQUARTERS
2) Truxton has about 8x more deposits per branch (it only has one branch) than U.S. banks
generally
3) Truxton focuses on RICH clients (this means Truxton might get 10x the dollar amount of
deposits from each depositor relationship as U.S. banks generally – allowing higher ratio of
employees to customer but lower ratio of employees to dollar deposited – so, better customer
service and/or lower costs)
4) Truxton “cross-sells” the same families on both depositing with the bank and entrusting assets
to the wealth management business
Truxton’s actual yield on loans isn’t all that high. Its actual interest cost on deposits isn’t
amazingly low. So, it isn’t a really big “net margin” here that drives results.
Most value investors seem to really like a bank to have 3 things:
1) A low P/B ratio
2) A high dividend yield
3) A wide net interest margin
I really want the bank to have:
1) Low non-interest costs per dollar of deposits
2) Low interest costs per dollar of deposits
3) High deposit PER SHARE growth
4) A low P/Deposits ratio
Finally, as far as bank safety I also feel differently than most investors. I think the 2 most
important things for a bank’s safety are:
1) Being funded as close to 100% by customer (retail relationships NOT wholesale transaction)
accounts
2) Earning an acceptable rate of return on its equity even in bad years
Number one is the key to surviving a financial crisis. In the U.S. individual customers – both
households and businesses – don’t pull money from banks. They keep deposits very stable. There
have been very few years where the actual level of deposits of this kind of decline even slightly
in the U.S. It’s easy to retain these customers if you just roughly match prevailing interest rates.
Even a slight interest rate difference between you and competitors would not cause a flood of
money in or out the door for typical checking / savings accounts. However, for things like CDs,
borrowing from other financial institutions, etc. – that money can move quickly.
Number two is the key to rebuilding an inadequately capitalized balance sheet. I think value
investors underestimate this. But, if you have a well-capitalized bank with a 4% ROE in good
years – this bank is not in a position to grow itself back out of any capitalization problem. You
may look at it and think that the bank can lose 50% of its tangible common equity and still be
well capitalized for regulatory purposes. This might be true. But, if a bank with a 4% ROE in a
good year gets in a situation where it is just barely well capitalized it will stay just barely well
capitalized for quite a few years as growth coming out of some big problem might inch along
with an ROE closer to 0% than 4%. On the other hand, if you have a bank with ROE’s like Bank
of Hawaii, Wells Fargo, Bank of America, etc. in good years – then, as long as a regulator lets
the bank continue to operate, it WILL earn back a capital buffer during a couple years of
economic recovery simply by not paying a big dividend. That’s all it has to do.
So, I think that very stable, low cost funding from the bank’s own customers (not from
wholesalers) is the key to avoiding trouble during moments of panic and then the way to build
back up any underfunded balance sheet and be back in a position where you can operate
normally is to have a high degree of profitability in your business model.
But, like I said, my ideas on banks are certainly heterodox and some deep value investors might
even say they’re outright heretical. I think these ideas are, however, closer to how Buffett thinks
about banks: https://www.aol.com/2013/04/08/buffetts-key-to-valuing-banks/
 URL: https://focusedcompounding.com/how-i-analyze-bank-stocks/
 Time: 2020
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Frost (CFR) in Barron’s: Read My Interview about Frost and My Report on

Frost
Some blog readers emailed me to say this week’s Barron’s did a piece on Frost (CFR). If you
read that piece and are looking for more about the bank you can:
Read my interview with Punch Card Research about Frost
Read the report I did on Frost
Frost is my biggest position. It is around 40% of my portfolio.
The stock’s price is now a little under $90 a share. In a “normal” interest rate environment, I
think it’d be worth $150 a share.
Of course, it could be a while before interest rates are normal.
 URL: https://focusedcompounding.com/frost-cfr-in-barrons-read-my-interview-about-
frost-and-my-report-on-frost/
 Time: 2017
-----------------------------------------------------
Valuing Financial Companies: ROIC, ROE, or ROA?

Someone who reads my blog sent me this email:
All else being equal, which measure is preferred for financial firms such as banks: ROIC or
ROE? I am using ROIC for non-financial firms but I didn’t know if it gave a useful reading for
financial firms or not.
Thanks,
Chad

ROIC is not useful.
For non-financial companies:
I know you like ROIC. But I think it’s too clever by half.
I use the pre-tax return on tangible invested assets.
In other words, I look at what a company earns and divide those earnings by the assets on its
balance sheet excluding cash and intangibles.
For financial companies:
Normally you use return on assets. Then you multiply ROA by an appropriate leverage ratio.
Say Wells Fargo (WFC) has a long-term average ROA of 1.3%. If in the future you expect
banks to be levered 10 to 1, you would multiply 1.3% times 10 to get a 13% ROE. If you expect
normal leverage to be 12 to 1 – you’d multiply 1.3% times 12 to get a normal ROE of 15.6%.
And so on.
For a good discussion of financial companies, read Variant Perceptions.
 URL: https://focusedcompounding.com/valuing-financial-companies-roic-roe-or-roa/
 Time: 2011
-----------------------------------------------------
Warren Buffett and Western Insurance

A reader asked me this question:
…your last article on Gurufocus regarding 50% returns and microcaps…seems (to) have
sparked a lot of responses on it. Some are off the mark or just misinterpreting the point of the
article. Other comments provide good points. Not sure if you were planning on responding to all
the various comments. There is a difference between cigar butt approach and hold forever
approach. Personally I think your approach considers the downside based on your checklist…
Maybe discussion on margin of safety in the approach should be mentioned…your thoughts?

Regarding the difference between the cigar butt approach and the hold forever approach, Warren
Buffett was not using a cigar butt approach to invest in micro caps in the 1950s. He was just
focused on decent, dependable, dirt cheap, neglected stocks. The companies Buffett invested in
for his own account in the 1950s were not cigar butts. He just didn’t plan to hold them forever.
He sold out of one cheap stock whenever he found a cheaper one.
But these weren’t low quality businesses.
Let’s take a look at one…
Western Insurance
I found some strange things when I was 20 years old. I went through Moody’s Bank and Finance
Manual, about 1,000 pages. I went through it twice. The first time I went through, I saw a
company called Western Insurance Security Company in Fort Scott, Kansas…Perfectly sound
company. I knew people that represented them in Omaha. Earnings per share $20, stock price
$16…I ran ads in the Fort Scott, Kansas paper to try and buy that stock – it had only 300 or 400
shareholders. It was selling at one times earnings, it had a first class (management team)…I’d
never heard of Western Insurance Services until I turned that page that said Western Insurance
Services. It showed earnings per share of $20 and the high was $16. Now that may not turn out
to be something you can make a lot of money on, but the odds are good. It’s like a basketball
coach seeing a guy 7’3” walk through the door. He may not be able to stay in school, and may
be very uncoordinated, but he’s very large. So I went down to the Nebraska Insurance
Department, and I got the convention reports on their insurance companies, and I read Best’s. I
didn’t have any background in insurance. But I knew I could understand it if I worked at it for a
while. And all I was really trying to do was disprove this thing. I was really trying to figure out
something that was wrong with this. Only there wasn’t anything wrong. It was a perfectly good
insurance company, a better than average underwriter, and you could buy it at one times
earnings. I ran ads in the Fort Scott, Kansas paper to buy this stock when it was $20. But it
came through turning the pages. No one tells you about it. You get ‘em by looking.
I would put something like Bancinsurance in that class. It was a micro cap. But it was not a cigar
butt. It had an average combined ratio of 90 over the last 20 years and was selling at less than 5
times pre-tax earnings after the CEO made his buyout offer. Bancinsurance was no cigar butt. It
earned a higher return on capital than most insurers. It was a better underwriter. It was focused.
And it was certainly easier to understand than 9 out of 10 insurance companies.
I think the margin of safety and high returns in these stocks are both caused by the same thing:
neglect.
These stocks aren’t priced right.
It’s not about some trade-off between risk and return. It’s about the trade-off of paying attention,
finding the stock, and then buying into something you’ve never heard anyone else talk about –
ever.
A lot of folks don’t like the feel of that.
That’s the trade-off.
 URL: https://focusedcompounding.com/warren-buffett-and-western-insurance/
 Time: 2011
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On Ben Graham, Bank Stocks, and Tom Brown
I wrote a response to Jason Zweig’s column on Ben Graham and bank stocks. Now, Tom Brown
of Bankstocks.com has done the same. I have to admit, Tom’s article is better than mine. Both
take Zweig to task for his explanation of why Ben Graham wouldn’t be a buyer of bank stocks
today. However, Tom’s post does a better job of presenting the opportunities and challenges in
analyzing bank stocks today:
Zweig’s premise seems to be that no one inside or outside a financial services company can ever
reasonably value the institution’s assets–particularly if the assets are secured by real estate at a
time when real estate values are declining on average. The stock’s valuation? Irrelevant.
Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black
boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these
companies. But we know as a matter of fact that that is not true.

Graham saw every investment as a black box – and that didn’t trouble him. A lot of investors
spend a lot of their time worrying about the inner workings of the companies they own – Graham
never did. He didn’t look inside the “system”, i.e. the company itself; instead he looked only at
the outputs – the financial statements. He spent almost no time worrying about a business’s
management, corporate culture, or future prospects. He didn’t worry about competitive
advantages. He looked to the balance sheet first. When he moved on from there to consider
earnings, his usual approach was to rely heavily on the past record in an attempt to discover what
“normal” earnings might look like.
Graham was a rear view mirror guy. His margin of safety was based on making purchases at
prices that would’ve worked well in the past. He liked sure things. For instance, he knew that
NCAV stocks were sure things – and subsequent research continues to support that claim. I
mentioned NCAV stocks in my previous post, because they are perhaps Graham’s most
characteristic investment category. They combine elementary arithmetic and logic in a
potentially lucrative but almost certainly safe investment operation. Also, unlike much of what
he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV
investments during his Wall Street career.
Before we can answer what Graham would do today, we need to know what he did do in his own
lifetime. When writing about Graham, one needs to consider three separate categories: what
Graham practiced, what Graham preached, and what Graham’s principles were.
What Graham Practiced
In the Intelligent Investor, Graham lists the five successful techniques his partnership employed
from 1926 – 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control
investments.
Control Investments
Graham does not discuss control investments in any of his books; however, GEICO is a well-
known example of a Grahamian control investment.
Arbitrage
Buffett has discussed this techniques in some detail. See especially Buffett’s discussion of
Berkshire’s purchase of Arcata shares. Both Buffett and Graham had stellar results in the
arbitrage field, as Buffett explains in his 1988 letter to shareholders:
In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett
Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence,
also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire
1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in
1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then
Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the
1956-1988 returns averaged well over 20%.

That’s a long history of success. From 1926-1988, unleveraged arbitrage returns from Graham’s
partnerships, Buffett’s partnerships, and Berkshire averaged better than 20% a year. Since some
leverage was employed, actual returns over this sixty-three year period were even better than
20% per annum. Arbitrage works.
Liquidations
Liquidations are the simplest type of investment there is. You simply buy the stock below the
expected final payout and wait for things to wind down. Buffett has invested in liquidations
several times – most are not well-known. For a recent example, see Comdisco Holdings
(CDCO). For a less recent example, see the Kaiser liquidation (from the 1970s).
Net/Nets
Net current asset issues are not well-known, even today. However, the technique itself is well-
known. Jonathan Heller of Cheap Stocks created an index to track (some) NCAV stocks. Since
inception the Net/Net index has outperformed the relevant benchmark. However, it is a very
young index.
Related Hedges
Related hedges are not appropriate for individual investors. They belong to a category of
techniques that Graham employed with some success, but which have subsequently become far
less fertile ground for investors, because modern theory and practice is better able to efficiently
price a variety of more complex securities. Basically, Graham would go long a certain
company’s convertible senior security and go short that same company’s common stock. If the
stock rose, he would take a small loss. If it dropped sharply, he would make a nice gain.
Obviously, these related hedges would provide a performance boost when the rest of Graham’s
portfolio was struggling (since stock prices in general would be falling) and vice versa.
The first real coup of Graham’s career belongs to this category of mispriced special securities.
Graham was a low-level employee of Newburger, Henderson, and Loeb when he brought up the
idea of investing in the bankrupt Missouri, Kansas, and Texas Railway. The company’s
bankruptcy plan gave owners of the old common stock the right (but not the obligation) to buy
shares in the new company. This went mostly unnoticed at the time – or, if it was noticed,
speculators were not using the old common stock as a way to play the new MKT. As a result, the
old stock traded at just fifty cents. Graham figured that during a strong period for railroads the
old common stock could easily rise three or four dollars – while the maximum loss on each share
would still be just fifty cents. The firm bought into Graham’s idea and ended up making $15,000
on its $2,500 investment in less than a year (this was back in 1915 when $15,000 was real money
– perhaps something like $300,000 today).
Graham’s partnership was a prototypical hedge fund. For starters, Graham actually hedged. He
was short some securities and long others. For a while, he tried a basic long/short value
approach, where he went long clearly cheap stocks and when short clearly expensive stocks.
However, he found riding out the speculative surges in the stocks he was short to be an
extremely unpleasant experience. He also found, over time, that he wasn’t especially good at
finding stocks to short – certainly not good enough to get a better overall result (an investor has
to be a lot more skilled at going short than going long to make it worth his while to short– if
volatility and consistency aren’t as important to him as long-term results). Also, since Graham
was always invested in an unusual mix of cheap stocks, liquidations, and related hedges, he was
able to deliver rather consistent results without resorting to a more conventional long/short
strategy. Eventually, Graham took the technique of shorting overpriced stocks out of his
repertoire.
What Graham Preached
This is where Zweig comes in. Very little of what he writes has anything to do with what
Graham practiced; generally, he writes about what Graham preached. These two things are quite
different.
Why?
Graham liked rules, methods, and standards. Whether he was writing for professional security
analysts or amateur investors, his goal was the same: to provide a practical, workable approach
to the field of investments. He may have underestimated the common man; but, I doubt it. Even
in The Intelligent Investor, he included a small section describing the actual techniques employed
by his partnership. He also gave a separate set of rules for the enterprising investor to follow.
Graham didn’t divide investors by their risk appetite; rather, he divided them by their work
appetite. Those who would work harder and be more businesslike – more like true professionals
– would naturally come closer to the methods Graham himself employed.
So, if we were to use Graham’s own actions as our sole source for determining what he would do
today, we’d have to say he’d invest in almost nothing that makes it into Barron’s, The Wall
Street Journal, CNBC, or Bloomberg.
Graham would mostly do what he always did. There are still some NCAV stocks today; arbitrage
still exists; liquidations still occur (e.g., I participated in what was essentially the liquidation of
an Icahn controlled company last year – Atlantic Coast Entertainment Holdings, see Joe Cit’s
post for details).
But, wouldn’t all of this be too small for Graham?
Yes and no.
No, Graham never needed big cap ideas, because Graham always kept his partnership small –
much, much smaller than it could have been. He could have managed a lot more money; he was
always much more famous than his assets under management would lead you to believe. He
returned capital gains instead of allowing them to accrue in his favor. Overall, he tended to keep
his operation very small by any standards – and infinitesimally so by the standards of today.
However, yes, Graham would need some other ideas. The most likely answer is that he’d rather
change venues than change standards. Therefore, I doubt he’d be investing in even moderately
pricey names in the United States whenever there were opportunities to buy ridiculously cheap
stuff abroad. He’d probably have been in Korea after the Asian contagion; he’d certainly have
been in Japan at some point, where there were some overcapitalized and underpriced public
companies.
I know these aren’t exactly the most exciting answers. It’s a lot more interesting to argue over
whether or not Graham would be buying bank stocks today than it is to consider what he’d
actually be doing in modern times. My best guess is that if Graham were around today we’d
consider him a very strange, very boring investor with a taste for odd and obscure securities in
unappealing industries and out of favor countries.
Grahamian Theory
So where does that leave us regarding Graham and bank stocks?
All we have to go on are Graham’s principles. And this is where I think Zweig failed in his most
recent column. His reasoning is all wrong. It paints an entirely inappropriate, almost
stereotypically stodgy picture of Graham. Zweig confuses the conservatism of modern financial
advisors with the conservatism of Graham. They are two very different things.
Graham would not have avoided bank stocks, because of falling real estate prices. He would
avoid bank stocks, because there is an insufficient margin of safety (many are still trading above
book value). He might demand a greater discount to book, because many banks have businesses
and recent records built upon boom times. Graham always wanted to see how a business had
performed under a variety of different circumstances, and this need for a solid past record would
be even more important for banks, because of the nature of credit “cycles”. However, the mere
fact that something unusual or even unprecedented is occurring in real estate and thus in
financials would not have deterred Graham. His conservatism was not of that sort.
He could buy in the midst of the storm. He could catch a falling knife. Quite frankly, these
weren’t his concerns. If a stock was sufficiently cheap and a business cleared a series of hurdles
regarding its past performance and current financial position, Graham would buy it.
Zweig seems to be arguing that you can’t really know anything about a bank’s current financial
position. When applied to Graham this makes little sense. Graham worked at a time when there
was less disclosure and more fraud than there is today.
Consider the case of Northern Pipeline. The company provided investors with almost no
financial data. Graham found the stock was trading for far less than the value of its investments
per share by digging up the company’s filing with the ICC (Interstate Commerce Commission).
Had he not done so, he never would have known. Most investors didn’t know.
While the balance sheets of banks may prove inaccurate (both on the way down and the way up),
this wouldn’t have stopped Graham, because Graham always demanded a margin of safety. The
precise financial condition of a bank becomes more important as it becomes more precarious.
Likewise, the precise earnings power of a bank becomes more important the higher the multiple
you’re willing to pay. But, if (as Graham would), you insist on both extraordinary financial
strength and extraordinary cheapness, the importance of both concerns lessens. It never vanishes
entirely. However, you can put yourself in a position, where your analysis can be more wrong
than many analysts and yet your investment results can be better. The key of course, is to add a
margin of safety everywhere. You have to start with a strong past record and then you have to
buy it on the cheap.
That’s why I brought up Valley National (VLY). Not because I think it’s the best bank out
there, but because I think it’s the sort of place Graham would start if he were going to apply his
principles to bank stocks. He wouldn’t look for the fastest growing, highest quality company. He
would look for the stodgiest bank he could find as shown by the bank’s past earnings history, as
well as its credit quality, historical losses, etc. He wouldn’t be looking at the management –
maybe he should – but he wouldn’t. Graham would be looking at the numbers. If ever a bank like
Valley National were selling at two-thirds of book, then Graham’s principles would clearly allow
the buying of a bank stock.
Now, you might rightly argue that Valley National is trading nowhere near two-thirds of book
and might never do so, while other banks – lesser banks (in Graham’s eyes) – are trading at
lower price-to-book ratios.
That’s true. And that’s where Buffett and Brown come in.
Buffett and Brown
When it comes to bank stocks, Tom Brown may be closer to Warren Buffett than Warren Buffett
is to Ben Graham.
Why?
Graham did not specialize in financial service stocks. Tom Brown does. Warren – strictly
speaking – doesn’t. However, he knows a great deal about them and has a long history with
them. True, Buffett probably knows more about insurance than he does about banks, but his
knowledge of banks is probably more useful to him as an investor. Let’s not forget, Berkshire
once owned a bank.
Buffett’s partnership also owned banks at times. For instance, he had a large position (10-20% of
his portfolio) in a New Jersey bank (Commonwealth Trust) back in 1958. He bought twelve
percent of the bank at an average of five times earnings. Buffett conservatively estimated the
bank was worth $125 per share. He ended up selling it for $80 per share (a 60% profit) to free up
capital for the partnership’s large investment in Sanborn Map (a Northern Pipeline style
investment).
Why bring up something Buffett did fifty years ago – when his more recent investments, like
Berkshire’s purchase of Wells Fargo are more applicable to today?
Because, in 1958, Buffett’s approach was closer to Graham’s than it is today. Also, his
description of the Commonwealth Trust investment better resembles the way Graham might
think about bank stocks, if he were forced into that field.
Buffett’s Wells Fargo investment is further from the way Graham would have operated, if only
because Buffett’s thinking had moved further from Graham’s over the years.
Buffett and Brown approach bank stocks very differently from the way Graham would have.
They are more focused. They do more of a 360 degree analysis. They place greater emphasize on
intangibles. There are a lot of differences.
They may have the better approach. It may be better to find the right stocks – even at today’s
prices – than to look for the most statistically conservative stocks at the most statistically cheap
prices.
Graham was ill-suited to investing in banks. However, Zweig’s reasoning isn’t right. In fact, it’s
downright confusing for investors who know little of what Graham preached and what he
practiced. Very few investors wouldn’t be deterred by the “perfect storm” in financials.
Ben Graham was one of the few who wouldn’t be.
Whether Graham would have invested in bank stocks or not, he would have made his decision
based on past results and current prices – not real estate prices, or the credit climate, or any other
macro-concern. At the right price, Graham would buy past earnings today assuming they would
eventually materialize again tomorrow – and (as Brown says) the stocks might well bounce back
first.
So, again, Zweig may be right about Graham not buying bank stocks. But, his reasons are all
wrong.
Simply put, a smart guy wrote a stupid article.
 URL: https://focusedcompounding.com/on-ben-graham-bank-stocks-and-tom-brown/
 Time: 2008
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Pompous Prognostication: Irish Banks
any readers of this blog would like me to make more specific, actionable stock “calls”. This isn’t
really that sort of blog; but, I’ll try to appease those readers with an occasional pompous
prognostication. Here is today’s:
Irish stocks look cheap. Irish banks look very cheap.
The Irish banking industry is highly concentrated; a few players account for the majority of the
industry. It’s been an excellent business for a long-time; and in the long-term I expect it to
continue to be an excellent business.
In the short-term, the Irish economy is going to slow-down, house prices are going to drop
sharply (more sharply than in the U.S.), and construction activity is going to drop dramatically
(much more dramatically than in the U.S. – where a lot of uneconomic building has continued
despite the dire headlines).
Two banks (with ADRs) worthy of your consideration are Bank of Ireland (IRE) and Allied
Irish Banks (AIB).
Your time will be much better spent studying these two companies than trying to sift through the
rubble and find a gem among the major U.S. financial services firms who face:
1. A tougher short-term credit environment

2. A less promising long-term economic outlook
3. An inferior competitive position
Furthermore, these major U.S. financial services firms – diversified though they may be – have
shown no evidence of possessing corporate cultures more inclined to conservativism than the
Irish banks mentioned above. So, basically, these great big behemoths are set to sail stormier
seas with inferior crews.
I know you think you know Citigroup, JP Morgan, Bank of America, and Washington Mutual –
and maybe you do. But, now’s the time to get to know these two Irish banks, which I think you’ll
find are better buys than the domestic giants that constantly clog the financial media with
headlines.
So that’s today’s pompous prognostication: Shares of Irish banks, Bank of Ireland and Allied
Irish Banks, to outperform the biggest U.S. banks.
More importantly, shares of these two Irish banks look cheap for long-term investors, not just
relative to the biggest U.S. banks, but relative to just about everything out there – in the U.S. and
abroad.
 URL: https://focusedcompounding.com/pompous-prognostication-irish-banks/
 Time: 2007
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How to Think About Business
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-of-
companies-not-keeping-enough-cash-on-hand/
 Time: 2020
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On Banks
About two weeks ago, Morningstar analyst Jim Callahan wrote an article entitled “Do All
Banks Have Moats?”. It’s a good question.
Superficially, banking appears to be a commodity business. In fact, it appears to be a

particularly poor commodity business, because capacity is not constrained by the need to invest
in a substantial physical infrastructure. True, whatever investments are made in tangible assets
are usually intended as a means to acquire more intangible assets; however, a branch is hardly
comparable to an oil well.
A bank’s ability to lend money (and thus produce income) is not completely and inextricably
linked to the size of its deposits. In other words, loans are the result of both a bank’s capacity to
lend money and its willingness to lend money.
It’s hard to find a parallel in tangible commodity businesses. Theoretically, this should make
little difference in the long run. However, the lack of physical supply constraints in the market
for loans creates the possibility for large, industry-wide mistakes. Pricing in such an industry can
get very weak at times.
There’s one catch here. The underlying assumption whenever the commodity business label is
used is that both the demand for a product and the supply of that product are general in nature.
They can’t be specific, because that would destroy the involuntary nature of pricing within the
industry.
For example, if all pineapples were unbranded, identically tasting fruits the demand side of the
business would meet the requirement for a commodity business. However, if most pineapples
take eighteen months to grow, but there is one magical plantation where the fruit develops fully
in just three months, the supply side of the business does not meet the requirement for a true
commodity business. The magical pineapple plantation would produce six times as much fruit
per acre and thus the plantation owner would be able to undercut his competitor’s prices. He
would earn extraordinary profits, because the return on capital in his business would be much
higher than that of the industry as a whole.
What does this fairy tale have to do with banking? It suggests extraordinary profits can come
from having “sticky” customers or lower costs. The lower costs needn’t be the result of lower
marginal inputs. The magical pineapple plantation turned the crop over faster; it didn’t need
access to below market prices for any of its inputs.
The same is true of a grocery store. Two stores that buy and sell cans of soup at the same exact
prices may have very different returns on capital, if one of the stores turns over its inventory
more quickly, because the fixed costs will be spread over a larger number of sales.
How does this relate to banking? While a quick turnover (or some other form of operational
efficiency) is the most common reason for one firm’s unusual profitability in a commodity type
business, there are other ways to earn extraordinary profits. Some of them are conceptually quite
similar to the idea of owning a magical, one of a kind pineapple plantation. In such situations, the
product appears the same to the consumer; but, the producer is actually unique (or at the very
least special).
All of this helps to explain why some banks are more profitable than others. However, it doesn’t
address the question posed by Morningstar. So, do all banks have moats?
Before answering that question, it might be best to ask under what circumstances all banks could
have moats. What could insulate an entire industry from the ravages of competition? This is the
question I discussed in the podcast episode: “Nature of Competition”. Why can some industries
support plenty of profitable players, while others merely support a handful, one, or none?
Switching costs are one of the most commonly cited reasons for a wide moat. I think the
matter is actually a lot more complicated than that. Financially prohibitive switching costs do
create moats. However, most wide-moat companies don’t have truly prohibitive switching costs.
What they do have is a situation in which it makes little sense to switch to a competitor and/or a
tendency for their customers to not actively seek to learn more about competing products.
Where the cost of a product is particularly small per cash outlay, consumers are usually
apathetic about seeking out alternatives. The key here is that the amount has to seem very
small to the buyer at the time the purchase is made.
If you buy a cup (or two) of coffee every morning, it does not occur to you that you are spending
hundreds or thousands of dollars a year on that coffee and that you could save a lot of money by
buying the cheaper alternative. However, if you’re buying an appliance or piece of furniture the
difference is immediately obvious and thus price is a major concern.
Generally, if a product can be sold over and over again at a very low price per transaction,
profits will be higher, because the buyer will not make much of an effort to compare prices.
Likewise, if a customer is billed for a variety of different products or services each amounting to
only a small charge, the customer’s price awareness will be lower than if the charges were
combined and listed as a single item.
Where price visibility, comparability, or immediacy is reduced, extraordinary profitability
becomes more likely. People are very sensitive to price differences between large, juxtaposed
numbers. If tomorrow the federal government prohibited gas stations from posting their prices
per gallon, drivers would begin to become less concerned about gas prices.
There would be an uproar at first. But, over the years, gas prices would receive less and less
news coverage and would fall off the list of consumer concerns. Obviously, a crude oil price
quoted in dollars also contributes to price awareness. But, the point remains the same. Where
prices are less visible, price competition is less fierce.
Compounding is a great way to exploit a lack of price awareness. The differences between
various interest rates always seem small when placed side by side. Over time, these differences
become quite large. However, the fact that no large differences are clearly visible at the time a
decision is made about where to bank helps to minimize price competition between banks.
It also increases the relative importance of other aspects of banking like convenience and service.
Usually, the cost to make a good impression is very low compared to the size of the assets that
could result from attracting more deposits.
On the other hand, the importance of making a good second and third impression is minimal.
Once a depositor uses a particular bank, he is unlikely to visit competitors. When he needs to do
his banking, he will go directly to his own bank (or its website).
This is very different from the environment found in most consumer businesses. Packaged
goods companies have their products placed next to their competitor’s products on store shelves.
Retail stores are usually clustered. Whether they are located in malls or in free standing
buildings, it’s a safe bet the customer has to pass at least one competing retail outlet to shop at
their favorite location. In most cases, the other location won’t compete in every category as the
customer’s favorite store; but, it will offer at least some competing products. As a result, the
shopper is offered the option of switching every time she makes the trip.
When someone walks into a bank, it’s usually their own bank. They don’t have any use for other
banks (after all, their money isn’t there). The cost of switching banks isn’t very high. However,
the amount of active effort required to make the switch is substantial.
Switching banks isn’t as easy as switching toothpaste. But, more importantly, the alternative isn’t
as obvious in banking. We all know other banks exist. But, unless we have a reason to consider
switching from our current bank, we don’t even bother to check out the competition.
The result is a very narrow, very real moat.
 URL: https://focusedcompounding.com/on-banks/
 Time: 2006
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How Fast Can a Big Bank Grow Its Deposits?
“I own Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC, Financial). Each of them
is growing deposits at different rates (off the top of my head, around 5%, 1% and 6% per
annum). U.S. deposits have been very consistent at 6% for many, many years. This is probably
an incredibly stupid question, but how can deposits continuously grow at such a clip? My initial
reaction was that the Fed is printing money at a rate above real GDP growth of around 3.5-4.0%?
Are deposits continuously pouring in from overseas? Is that growth rate sustainable / does it
make sense (if it does, banks are obviously very attractive investments)?”
Growth in bank deposits is something of a special case because we are just talking about money
here. It’s a very, very generic thing. So, we don’t have to worry about the popularity of money,
possible substitutes, societal change, etc. This makes growth in banking far easier to predict than
growth in any real good.
If a bank maintains the same market share it should be able to grow deposits at the rate of
nominal growth in the local economy. This statement assumes that deposits as a percent of
nominal GDP will neither rise nor fall. That’s not true cyclically. And it may not always be true
even historically over the development of a state, country, etc. For example, American
households don’t keep much of their savings in deposits because they have access to other types
of investments. In many countries in Asia, that’s not true. People actually use deposits as a
significant part of household savings. That changes the economics of banking. For example, it
makes interest rates more important in attracting deposits from households. A lot of money kept
in banks in the U.S. is not really surplus. It is money that is used for general operating purposes
by either a household or a business that does not consider the account to be where they would
actually put money they intend to save for many years to come. Having said that, there is still a
cyclical aspect to deposits. You can see this historically. But, it may not be important to your
analysis. If you are just looking for what the long-term rate of growth in deposits is likely to be –
that’s easier to answer.
Let’s start with a theoretical explanation of what the growth in deposits – ignoring any
cyclicality – should be in the U.S. banking industry overall. Banks are often local or regional. So,
for most banks, the nationwide growth in deposits is irrelevant. As an example, I wrote reports
on both Bank of Hawaii (BOH, Financial) and Frost (CFR, Financial). In those reports, I
suggested that deposit growth could be as low as 3% in Hawaii and as high as 6% in Texas.
That’s mainly because Texas should grow its population faster than the overall U.S. while
Hawaii should grow its population slower than the U.S. This is largely just a matter of population
density. Land is expensive in Hawaii. Land is cheap in Texas. People move inside the U.S. Not
many people will choose to move from other U.S. states to Hawaii. However, many people will
choose to move from another U.S. state to Texas. This explains almost all of the difference in
expected deposit growth rates for Hawaiian and Texan banks.
So, what’s the theoretical description of what deposit growth should look like in a bank’s market
area? Basically, it should be population growth plus real output per person growth (which is the
real GDP number you mentioned) plus inflation. You said “My initial reaction was that the Fed
is printing money at a rate above real GDP growth of around 3.5-4.0%”. Yes, nominal GDP
growth tends to be higher than real GDP growth. The Fed talks about something like a 2%
inflation target. So, if you expect 3% to 4% real growth, then you’d expect 5% to 6% nominal
growth – if you believe that 2% target. Historically, the Fed – and almost every other central
bank – has not tended to get inflation as low as its target. The long-term reality is more like 3%
inflation despite talk of a 2% target. Recently, inflation has been quite low. Should you look at
the more recent figure instead of the long-term figure? I have no way to choose between 2%, 3%,
or 4% inflation as being more likely in the very long-term. You can use any of those numbers as
reasonable. Let’s say the historical rate had been 3% and the target is 2%. Then why not use
2.5%? That’s as good a guess as any. No one knows what the long-term inflation rate will be. It
is much easier to predict population growth. It’s also easier to predict real output per person
growth. So, it’s easier to predict the long-term growth in real GDP than in nominal GDP. Let’s
say U.S. population growth will be roughly 1%, real output per person growth will be roughly
1%, and then inflation will be roughly 2.5%. That gives you an estimate for nominal GDP
growth of 4.5%. But, that number will be different in different states. Even if the numbers I just
laid out hold true for the U.S. as a whole for many, many years to come – I’d still expect deposit
growth in Hawaii to be less than 4% and deposit growth in Texas to be more than 5%. The
difference in their rates of population growth should be at least 1%. As a rule, you’d expect
places with low population density and a low cost of living to grow faster than places with high
population density and a high cost of living if people were willing and able to move between the
two places.
For bank deposits, it’s important to consider a few factors. One, different countries have different
sized financial systems relative to their GDP. This is also true for states. The U.S. does not – for
a rich country – have a particularly large amount of bank deposits and bank loans. So, it’s not
something to spend a lot of time thinking about. You may want to spend more time thinking
about cyclicality. The year-to-year rate of growth in bank deposits is pretty lumpy. It’s lumpy
because you are looking at such short periods of economic growth and sometimes contraction
that we are really dealing with something closer to acceleration and deceleration in the short-
term rather than the long-term average “speed” of the economy. To smooth out this problem,
don’t look at this year’s growth in deposits. Take something like a 7-year period. If you have
data on a bank going back 17 years, then you have 10 years where you can calculate a 7 year
period that ends in that year. There’s nothing magical about a 7-year period. You can use 5, 10,
or 15 year periods. The difference between these periods will rarely be noticeable. But,
sometimes, you have unusual economic events that will make some 5 year periods look strange.
If deposits are coming in at a cyclically unusual rate, you will probably notice a pattern inside the
bank. You’ll see loans divided by deposits falling. So, you may see that a bank had $10 billion of
deposits in 2006 and $9 billion of loans in that same year – but then in 2009, it had $12 billion of
deposits and still only had $9 billion of loans. That means loans fell from 0.9 times deposits to
0.75 times deposits. This is typical of unusually fast deposit growth. You can also check this
over the long-term by seeing if the company tends – over a couple decades – to have a consistent
relationship between loans and deposits. Sometimes you’ll find a company had 60% to 80% of
its deposits loaned out through the 1990s and early 2000s, but now has only 40% to 60% of its
deposits loaned out in the 2010s. This is a sign that deposits are cyclically high and loans are
cyclically low. Deposit growth has been higher than loan growth. At some point, loan growth
will be higher than deposit growth. So, at some point, deposits are likely to grow slower than the
nominal GDP of the region the bank operates in.
The growth of the industry’s deposits isn’t very useful to you. Three things matter more. One,
the growth in deposits at the bank you’re looking at. Two, the growth in deposits per branch at
the bank you’re looking at. And, most importantly, the growth in deposits per share of stock at
the bank you are interested in. Companywide growth in deposits is close to irrelevant. At small
sizes, there are economies of scale in banking. However, the greater efficiency of giant banks
over big banks is almost entirely due to increased cross-selling and more fee generating
businesses. There’s not much evidence that a bank with $200 billion in assets is more efficient in
either gathering deposits or making loans than a bank with $20 billion in assets. This is not true
at the branch level. A bank that has $150 million in deposits per branch will be much more
efficient than a bank that has $15 million in deposits per branch. So, it’s always good to have
deposits grow quickly and branches grow slowly. In fact, that is one really hopeful sign for banks
– especially the big banks you mentioned in your question – for the future. They may be able to
grow deposits at nominal GDP type rates while not growing branches at all anymore. Branches
are being used less and less every year. This reduces the need for a bank to pay rent and salary
relative to the amount of deposits (and therefore loans) it has.
I mentioned how I expect Hawaii to have very, very slow deposit growth over the long-term.
That’s not as bad for Hawaiian banks as it sounds. I don’t expect any new entrants into the
Hawaiian market. Mainland banks don’t really operate in Hawaii. I also don’t expect the four
biggest Hawaiian banks (who together control virtually all deposits in the state) to open more
branches than they close over the next decade or two. So, I expect the four big banks in Hawaii
to have stable market share. That means even if I expect Hawaiian deposits to grow as slowly as
3% a year, I expect the nominal growth rate in deposits per branch to be at least 3% a year – and
maybe higher. Furthermore, companies like Bank of Hawaii should earn a high return on equity
while having little opportunity to re-invest in Hawaii. If they want to stay focused on that state,
their only choice is to pay dividends and buy back stock. I expect BOH to buy back a fair amount
of stock. Let’s say BOH buys back at least 2% of its shares each year. That means the growth in
deposits per share will be higher than 5%. It also means the branch level economics should be
stable to improving due to growth in deposits equal to or greater than growth in rent and salaries.
Basically, it means the stock can return 5% a year or better plus whatever its dividend yield is.
The dividend yield now is 2.4%. So, that’s a 7.4% total return potential on something as bad as
3% deposit growth. In the long run, a lot of “growth” stocks won’t manage to return 7% to 8% a
year even while they grow their sales faster than the economy.
I should mention that fast growing banks are even better investments. Most of what I just laid out
for Bank of Hawaii is equally true of a bank of equal quality that grows a couple percentage
points faster in terms of its deposits. So, if you could grow deposits by 5% to 7% a year instead
of more like 3% to 5% a year, the stock could return about 2% more a year. Again, banking is
unusual in this case because money is a commodity type product but banks have no trouble
retaining customers who deposit money with them. The only thing I can think of that’s similar is
auto insurance. And auto insurance is much, much more price competitive than banking. In the
U.S., banks don’t adjust the interest rates they offer with the same competitive aggressiveness
that auto insurers adjust their premiums. It’s possible for a bank to retain about 90% of
customers from year to year. In a normal year, any U.S. bank of real size that is run at all
efficiently will have more cash profits than it needs to grow. That’s what makes U.S. banks –
provided they are careful lenders – above average investment candidates. A lot of companies can
grow 4% to 6% a year. However, there are banks that can grow 4% to 6% a year while paying
out dividends and share buybacks of close to 4% to 6% of their share price at the same time. A
business that grows 6% a year and pays no dividend isn’t attractive. A business that grows 6% a
year and pays a 4% dividend yield at the same time is a market beating investment. For cyclical
reasons, the banks you mentioned will grow their deposits somewhat slower in normal years than
they have recently. However, they will be capable of having pretty high dividend yields in the
future. The combination of growth in deposits per share and the dividend yield is what matters.
For the U.S. as a whole, nominal GDP growth of 4% to 5% is possible. So, for big banks, deposit
growth of 4% to 5% is possible. The question then is how much money they have – after
retaining what they need to maintain leverage levels from year-to-year – to pay out to you. I
don’t expect the S&P 500 to return 8% a year over the next 15 years. It’ll do worse than that. So,
if you can find a bank that can – at a normal Fed Funds Rate – grow deposits per share by 4% a
year while paying you a 4% dividend yield, you’ll beat the market.
I don’t own Bank of America (BAC), Citigroup (C), or Wells Fargo (WFC, Financial).
However, Warren Buffett (Trades, Portfolio) does own Bank of America and Wells Fargo. And I
certainly believe that Wells Fargo is capable of doing what I just described. I don’t own Wells
because it’s more complicated than other banks I could find. But, I have nothing against the three
banks you mentioned. I wouldn’t be surprised if they outperformed the market going forward. I
especially think Wells Fargo is an excellent bank. In fact, I think Wells is the best bank I never
wrote a newsletter issue about. Like I said, I didn’t reject it because it was a bad bank. I rejected
it because it was more complicated than other banks. The only bank stock I own is Frost
(CFR, Financial). It’s a Texas bank. I think it’s simpler than Wells. And I think I’d rather invest
in Texas alone than the U.S. generally. But, I did newsletter issues on: Frost, Prosperity (PB),
Commerce (CBSH), Bank of Hawaii (BOH, Financial), and BOK Financial (BOKF). A lot of
them have much higher prices than when I picked them. But, I think they’re fine as a basket. I
also see nothing wrong with the biggest banks like BofA, Wells, and J.P. Morgan (JPM) except
that they’re complicated and they are subject to some special rules that regional banks (due to
their smaller size) aren’t. But, honestly, I think just about any of the banks mentioned in this
article are good. I think a basket of all of them is a perfectly good alternative to owning the S&P
500. The economics of a U.S. bank are better than the economics of the average publicly traded
company. Banking in the U.S. is a good business. One caveat: nothing I’ve said here should be
expanded into other countries. The U.S. banking industry is unlike banking in other countries.
I’ve never found foreign banks I liked as much as U.S. banks – and I’ve definitely tried looking.
In fact, I’ve wasted a lot of time trying to find foreign banks that were as good as U.S. banks. So,
my advice is to stick to U.S. banks. And then try to figure out the long-term deposit growth per
share potential plus the dividend yield. I think nominal GDP growth of the state (for a regional
bank) or the country (for a nationwide bank) is a good proxy for long-term deposit growth. In the
U.S., that means you’re probably looking at long-term deposit growth potential of maybe a little
less than 3% to maybe a little more than 6% a year depending on which city or state the bank is
in.
 URL: https://www.gurufocus.com/news/485199/how-fast-can-a-big-bank-grow-its-
deposits
 Time: 2017
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How to Value an Insurer Using the S&P 500 as a Yardstick
“How do you value insurance companies? Berkshire, Markel, Progressive...
There are many different ways to do it. E.g. with Berkshire, people like to do e.g. 1) investments
plus multiple on earnings 2) pre-tax earnings less insurance plus investment portfolio (haircut
or not) 3) book value based on buyback level. There are also float-based methods and so on.”
Honestly, I have always thought the same way about insurance companies, closed-end mutual
funds, holding companies, etc. What matters is the annual return you get. That annual return can
either be in the form of some payout to you (like a dividend) or it can be “growth” in the sense of
an increase in the economic earning power of the business from year to year. I know others will
use a price-to-book approach – or something similar. I do not think that make sense.
GuruFocus has detected 5 Warning Signs with Berkshire Hathaway Inc BRK.B.
 BRK.B 30-Year Financial Data

 The intrinsic value of BRK.B
 Peter Lynch Chart of BRK.B
I will use Bancinsurance (no longer a public company) as an example. I wrote a couple letters to
the board of that company. That was an unusual thing for me to do, so you can be sure that what
I put in those letters was something I thought was important. My argument was that book value
might be a relevant metric for some insurers – even most insurers – but it was not a relevant
metric for Bancinsurance. The company usually had a combined ratio below 100. Basically, it
did not have a positive cost of float in almost any year. So it had “free money”. As long as the
company’s premiums did not decrease by a lot from year to year, it had a stable source of
essentially 0% (or less) money. I do not see any reason why a permanent accounting liability
(like float) should be treated as an economic liability at all. If you were going to liquidate the
business, it would make sense to net out that liability. But you are not going to liquidate the
business, so it does not matter what you see on the balance sheet. What matters is the normal
earnings power of that float.
You can do a check to prove what I’m saying. In the very long run, the S&P 500 has maybe
returned close to 9% a year. Any insurer that had a 9% return on equity in each and every year
should not be valued below book value. If the company had a 6% return on equity each and
every year, then it should trade at a discount to book value. If the company had a 12% return on
equity each and every year, then it should trade above book value. My point here is that book
value does not matter. What matters is the annual return in the business and the annual return in
the S&P 500. The “fair value” of a stock should be the price that equalizes the forward return on
that stock with the forward return on the S&P 500. So, if Bancinsurance was earning a 10%
return on equity, and the S&P 500 was priced to return 8% a year – I would argue that
Bancinsurance needed to trade above book value (not below it) to equalize the forward return on
its shares with the forward return on the S&P 500.
For an insurer, you can break the earnings situation down into the underwriting profit and the
investment profit. For any one year, this is not really that helpful. Both underwriting results and
investment results are cyclical. For example, Progressive has made good enough underwriting
profits since 2008, but it hasn’t made much of an investment profit at all. That is
because Progressive (PGR, Financial) invests in high-quality short-term bonds. These are tied
closely to the Fed Funds Rate. So if the Fed raises rates, Progressive’s investment profits will
rise. If the Fed cuts rates, Progressive will earn less on its investments. I do not think the intrinsic
value of Progressive changes from year to year based on the Fed Funds Rate. It changes based on
the amount of float the company has and the cost of that float. This is the same approach I use
when valuing Frost (CFR, Financial). I have used the example before that from 2008 to 2016,
Frost’s deposits roughly doubled. However, EPS did not grow. To me, the company doubled its
intrinsic value from 2008 to 2016. Other investors may disagree with this. They think a
company’s intrinsic value must follow its actual earnings. That makes no sense to me. The
retention rate on deposits is high. At Frost, it is probably just over 90%. That is very similar to
the renewal rate on auto insurance policies at some place like GEICO. It is even higher than
Progressive’s renewal rate. Progressive tends to have younger customers who have “unbundled”
policies. It probably has more single people than some insurers. Those kinds of policyholders
renew at lower rates than older married people. Old married people almost never switch insurers.
I do not see any difference between Progressive’s “float” and Frost’s deposits. They are both
stable sources of funding. Their cost can be estimated fairly easily. Progressive’s combined ratio
– like GEICO’s – is cyclical, but it’s not impossible to estimate. Both Progressive and GEICO
have so much lower costs than other auto insurers that they are not likely to have large losses for
long due to competitive pressure. It’s possible. There was a year where even GEICO and
Progressive had combined ratio problems because of intense rivalry with another big insurer, but
it’s rare. There is no pressure like that in banking. Frost cannot be forced to pay a lot more on
deposits to stop them from flowing out of the bank and going elsewhere. Most bank customers
do not really chase higher interest rates on their money. The customers who do are not the kind
of customers you want. So I look at Frost and Progressive as being very similar.
My newsletter co-writer (Quan) and I picked both Progressive and Frost. We wrote issues on
each stock. I like Frost a lot more than Progressive. That is not because of differences in
insurance versus banking. It’s for unrelated reasons. One, I think driverless cars will eventually –
decades from now – obsolete the business of both Progressive and GEICO. So, there is a limited
lifespan left on those companies. Banking will be around a hundred years from now. I expect
bank branches to mostly disappear over time. But other than disappearing branches – which are
potentially positive for bank stocks – I do not expect much change in the bank industry.
The math is really the same for Berkshire, Progressive Â or Frost. Pretend we wanted to find the
right price-to-book ratio for each of these stocks. How much do they pay out in dividends as a
percent of book value? How much stock does each company buy back each year? And then how
much does the company’s shareholder’s equity grow each year? If a company has 5% growth in
shareholder’s equity, a 2% share buyback rate and a 2% dividend yield – it’s priced to return
about 9% a year. It’s fairly valued. Maybe a little cheap compared to where most stocks trade at
today, but it’s not clearly undervalued by a lot or overvalued by a lot. This assumes that today’s
earnings are normal. Often, they are not. In the case of both Frost and Progressive, we picked
those stocks specifically because we thought earnings were at a cyclical low. Investment profits
were lower than they would be in a higher interest rate economy. So, you always must adjust
earnings to a “normal” level. That is true for all stocks.
Let’s look at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Berkshire is easy. It

does not pay dividends and rarely buys back stock. It also does not issue much stock. So, for the
most part, we can just focus on the change in book value for the entire company. Say you believe
– as I do – that the S&P 500 is not going to return much more than 7% a year from now on.
Since the financial crisis, Berkshire has grown per-share book value by something like 12% a
year. I just eyeballed the non-compounded (simple) numbers from the annual letter. That is not a
very accurate average I just gave you, but it lets us know what kind of number we are talking
about. The stock market has performed very well since the financial crisis. Berkshire is a lot
bigger now than it was in 2009. So I think we cannot possibly assume a growth rate in per-share
book value as high as Berkshire had since the crisis. I will use 10%. I think 10% is a fair estimate
for what Berkshire will compound book value at in the future. This is especially true if Berkshire
starts buying back stock. Stock buybacks could help sop up funds when the shares are
undervalued. It may hurt the chances of very rapid book value growth, but it will also lower the
range of possible outcomes for the stock. I think share buybacks will make it more likely the
stock will compound growth at something like 10% a year. So let’s see what that means for book
value.
Again, my estimate is that the S&P 500 will not do better than 7% a year. I’m also estimating
that Berkshire will not do worse than 10% a year. These are the two critical assumptions.
Everything about what I’m going to say rests on these two assumptions. Other investors will pick
different numbers for both of these. If we go with my numbers – the “fair value” formula at
Berkshire is 10% / 7% = 1.43. If you believe Berkshire definitely will grow per-share book value
by at least 10% a year and you believe the S&P 500 definitely will not return more than 7% a
year – you should sell your S&P 500 index fund and buy Berkshire Hathaway stock whenever
Berkshire is priced below 1.43 times book value. I think it makes sense to buy Berkshire
whenever it goes for 1.5 times book value or less. When Berkshire trades at a much higher price
– like two times book value – I would be hesitant to recommend the stock over holding cash. I
have no problem with anyone putting whatever cash they have lying around into Berkshire
whenever the stock is at 1.5 times book value or less. Notice, however, that this would change
depending on the level of the S&P 500. The higher the price on the S&P 500, the more
comfortable I am with the idea of owning Berkshire. That is because my idea of “fair value” is a
relative value approach. A stock is fairly valued when it’s priced such that the forward return on
an alternative is similar to the forward return on the stock.
Let’s use Bank of Hawaii (BOH, Financial) as an example of a bank instead of an insurer. The

dividend yield on that stock is 2.3%. The share buyback rate is usually no lower than the
dividend. We can assume a combined dividend and share buyback rate of about 2.3%. That gets
us to 4.6%. You can use this figure in one of two ways. One, you can estimate the growth rate
needed for BOH to match the S&P 500. Assuming the S&P 500 will return no more than 7% in
the future – as I do – you get a required growth rate of 7% minus 4.6% equals 2.4%. Bank of
Hawaii needs to grow deposits at about 2.4% a year. In reality, I do not even think it needs to do
that to match the S&P 500. I think normal earnings at BOH are higher than what it is earning
now. That is why I picked the stock for the newsletter. Let’s look now at the actual growth rate I
expect for Bank of Hawaii. I feel certain the bank will grow deposits more than 3% a year but
less than 6% a year. Let’s use the midpoint (4.5%) as the most likely figure. A 2.3% dividend
plus a 2.3% buyback rate plus a 4.5% deposit growth rate gets you to a 9.1% annual return at
today’s price. You can divide 9.1% by 7% and get a 1.3 multiplier. This means BOH stock
should be trading 30% higher to equalize its forward return with the S&P 500. BOH stock is now
trading at $85 a share. If you do $85 times 1.3, you get about $111 a share. So the stock should
be priced at something like $110 a share to have the same forward return expectation as the S&P
500. Again, this does not consider the lack of normal earnings today. So BOH should be priced
at about $110 a share if you expect interest rates to stay where they are forever. I expect them to
rise. So I expect the stock should be worth more than $110 a share. Again, this is a relative
approach. For the newsletter, Quan and I took an “absolute” approach. We got a value of $97 a
share for BOH. That is the correct value if what you mean is that you need an 8% to 10% annual
return in the stock. This figure is lower than the fair value of over $110 a share I gave – and a lot
over $110 a share in a higher interest rate environment. Again, this is because I expect the S&P
500 to return 7% a year or less not 8% to 10% a year (like it did in the past).
I think it’s most useful for an individual stock picker to define “fair value” as the price at which a
stock has the same expected future return as the S&P 500. For Bank of Hawaii, I am confident
that fair value – defined that way – is no less than $110 a share. And it might be more.
 URL: https://www.gurufocus.com/news/462608/how-to-value-an-insurer-using-the-sp-
500-as-a-yardstick
 Time: 2016
-----------------------------------------------------
Illiquid Stocks
An Illiquid Lunch
There are a couple sayings every modern investor and econ student has had drummed into him
over and over again. One is: “there’s no such thing as a free lunch.” It sounds like the kind of
thing an economist would come up with. Though it’s not. In the 1970s, an economics writer
(Milton Friedman) took the saying from a science fiction writer (Robert Heinlein) who had – in
the 1960s – simply transplanted an old 1940s saying to the moon. The actual marketing ploy of
giving a free lunch dates back to 1800s America. Some bars in the U.S. offered a free lunch to
new customers as a loss leader to drive sales of booze. The marketing ploy has long been
forgotten. But, modern economists have embraced the saying, with Gregory Mankiw – in a
textbook that has, no doubt, earned him tens of millions of dollars in royalties – describing the
principle as: “To get one thing that we like, we usually have to give up another thing that we
like. Making decisions requires trading off one goal against another.” That’s not as catchy as
saying “there’s no such thing as a free lunch.” But, it’s a lot more honest. Because, there is – of
course – such a thing as a free lunch. It’s called trade. Two centuries back, David Ricardo
explained comparative advantage, a concept which basically boils down to the maxim that: “if
two parties can trade with each other, it’s best for each party to focus on the thing they
themselves do best.” The thing you should train yourself to get best at is learning to hold illiquid
stocks. I know of no simpler way to improve your lifetime rate of compounding than to accept
lower liquidity in exchange for higher returns. Lucky for you, there’s always someone willing to
take the other side of that trade. In a 1990s episode of a series in the Star Trek franchise, a
character from a very capitalistic species of alien traders explains his people’s belief that:
“…there are millions upon millions of worlds in the universe, each one filled with too much of
one thing and not enough of another. And the Great Continuum flows through them all, like a
mighty river, from ‘have’ to ‘want’ and back again. And if we navigate the Continuum with skill
and grace, our ship will be filled with everything our hearts desire.”
Well, there are millions upon millions of traders out there looking to buy and sell many of the
same stocks you are looking to buy and sell. And the one thing they all want – and you’ve got –
is liquidity. Like the case for trade, the case for investing in illiquid stocks is backed up by the
historical record. Those of you who follow me on Twitter (@GeoffGannon) saw me retweet a
table of historical returns from the 1970s through today which showed that even within each
market cap size – microcaps, small caps, midcaps, big caps, etc. – the stocks that performed
worst were the stocks with the most liquidity and the stocks that performed best were the stocks
with the least liquidity. Everyone wants to rent stocks, no one wants to own them. Despite the
facts, most investors find comfort in liquidity just as most societies find comfort in self-
sufficiency. We know returns from trade and illiquidity are higher – but the actual
implementation of these ideas still makes us a little queasy. There’s a trade-off between liquidity
and returns. The more liquid your portfolio tends to be, the lower its returns tend to be. So, ask
yourself: do you want to maximize liquidity or maximize returns? And, if you do want to
maximize returns, just what exactly is the absolute minimum amount of liquidity you need? If
you’re a net saver month-to-month, that number can and should be very close to zero. And you
can and should learn to love illiquidity.
 URL: https://focusedcompounding.com/an-illiquid-lunch/
 Time: 2018
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Can You Build A Liquid Portfolio With Illiquid Stocks?
Hi Geoff,
Thinking about one of your posts, "Illiquidity and You"… I have a question that is somewhat
imprecise.
I have doubts about the size of the position you should have in illiquid stocks (like SODI and
others) regarding the overall size of your portfolio. You can assume here that we are not talking
about control investing in any form and you do not need the money… considering that usually
you do not take too concentrated position in this kind of stock (as opposed to a Buffett-Munger
kind) what size should be wise?
Up to what amount can you consider that your portfolio is too big for these kinds of
opportunities?
It would be very helpful for me if you can give me a numerical example and some advice to
analyze this type of situation.
Regards,
Fernando
For things like Japanese net-nets, I don’t put more than 10% of my portfolio in any one stock.
And I don’t put more than 50% of my portfolio in the whole group. But this is my personal
preference. Let’s talk a little about how illiquidity applies to everyone — not just me.
First of all, I’m going to take your question about at what size your portfolio is too big for a Ben
Graham-type net-net like Solitron Devices (SODI). It depends on the amount of stock you can
buy and the position size you like. For me, I try not to start buying a stock that I think will never
make up 10% of my portfolio. If you don’t mind having 5% positions in your portfolio, your
portfolio can obviously be twice as big as mine and you can still consider buying the same small
stocks I do. In terms of specific stocks, it depends on the amount of float and the volume the
stock trades in an average month. We are really getting into specifics here. And I may be boring
people. But if you’d like to hear more about the minutiae of how you actually buy and sell tiny
stocks like these, let me know, and I’ll do an article on the subject.
By the way, there is a hard and fast rule of thumb that it usually makes no sense to invest in a
company with a market cap that is smaller than your portfolio. This is true for both fund and
individual investors. Funds break it all the time. But, frankly, it is probably a waste of an
analyst/fund manager’s time to even analyze such tiny positions relative to the size of the whole
portfolio. Since even when we are discussing very small stocks we are still talking about millions
and millions of dollars in market cap, this is hardly a concern for most individuals.
So, for individual investors, actual inability to acquire enough shares of a company to
meaningful influence their portfolio is rarely the problem. If you bid for a stock month after
month — you’ll get your shares.
The concern for individual investors is not whether buying enough shares is possible. The
concern is how quickly and easily you can buy and sell. This is what we call “liquidity.”
Instead of thinking about stocks as liquid or illiquid, you should think in terms of your portfolio
and your liquidity needs. It doesn't make much sense to use what I'll call an "objective" (as in
stock-oriented) approach to liquidity rather than a "subjective" (as in investor-oriented) approach
to liquidity.
For example, let's say you have a $1 million portfolio. And let's say that given your current
situation in life, your job, how much you are saving, etc., it makes little sense for you to ever
need more than $100,000 to spend in a year. This would even be true if say you have needs in
terms of making a down payment on a house, paying for a child's education, etc. In this example,
you would have a large portfolio for an individual investor. However, whether you have a $1
million portfolio or a $100,000 portfolio is not the determining factor in your attitude toward
liquidity.
So what is?
The fact that you are an individual investor means your liquidity needs are lower than any
institution. This is critical. And many people overlook it. What works for a mutual fund manager
— or what doesn’t work for a mutual fund manager — may have little to do with what works for
you as an individual investor. I point this out because I would never manage an institutional fund
— especially something like an open ended mutual fund — the same way I would manage my
own money or a small, investment partnership where investors are “locked up.”
Bruce Berkowitz (at Fairholme) and Marty Whitman (at Third Avenue) need to be careful about
liquidity. You don’t. At least not in the same way they do. And not for the same reasons. They
need to make sure individual position sizes are not huge. Why? Because they could own too
much Bank of America (BAC) shares at the same moment that too many of their investors want
to bail out. If you look at the history of many value mutual funds, you’ll see that their investors
abandoned them in the midst of the dot-com craze. That was probably the worst time to sell old
economy value stocks. But if you managed an open-ended mutual fund, that’s exactly what you
had to do. You had to sell whether you wanted to or not.
You don’t have that problem. Only you can force yourself to redeem stocks for cash. The one
exception to this — and it’s a big exception — is a personal emergency. A funding need. Like,
for instance, losing your job. That is something you can’t control. And you need to be prepared
for things you can’t control. So does a mutual fund manager. But for the mutual fund manager
the risks of illiquidity are higher. Because his own fund’s investors can force him to sell stock at
exactly the wrong moment. They’ll probably panic when everyone else panics. When the market
panics.
Will you?
In some ways, you can be less concerned about selling during a panic. I don’t know. This
depends on your own disposition. Maybe you are just as likely to panic as any other investor. If
that’s true — you have a big problem. And you need to address it. Either by curing yourself of
panicking when everyone else is panicking too or by staying out of stocks. But if you are going
to be a successful individual stock investor you’ll need to hold stocks when everyone else is
selling them. Mutual fund managers don’t have this luxury. They have to sell when their
investors sell. You don’t.
So that’s a personal issue. One only you can answer. Let’s talk about something that applies to
everyone.
The way to think about liquidity is to imagine a bath tub. This analogy works as well for your
liquidity position as it does for a company’s liquidity position. Ask the same questions about
your liquidity that you would ask about a company’s liquidity.
Is cash flowing into or out of your portfolio on a, let’s say, monthly basis? If you have a few
thousand dollars on hand in a bank account, and you're 35 or 45 and/or you're putting some
money into savings every month, liquidity is a very minor concern for you. It may not feel that
way. But if you are adding to your investable funds every month or every year or whatever, you
are actually in a pretty strong position in terms of liquidity. If you need to, you can stop adding
to investments and increase the amount of cash you have on hand that way.
Liquidity is not just about being rich or poor. It’s not just about having few liquid assets or
having a lot. The flow is often more important than the stock. Even a rich retiree is often in a
weak liquidity position. If you're retired with $1 million, that may mean you can't invest much in
illiquid funds.
If you're usually drawing on your investment funds over a full year instead of adding to them,
illiquid stocks aren’t for you. This is an ironclad rule. Illiquid stocks are for savers. Not for
spenders.
Okay. What if your liquidity position is okay — you’re working age, have a salary and save a
little bit at least every month — what should you do?
My advice is to divide your portfolio into three parts:
 Money that is always touchable

 Money that is only touchable in a true emergency
 Money that is never touchable — not even in an emergency
Illiquid stocks fall into category number three. Solitron Devices (SODI) is to be considered an
always-untouchable stock. Yes, you will sell it one day. Of course. Every stock you buy is
something you intend to sell one day. But you can never count on selling a stock like Solitron.
That’s what an illiquid stock is. It’s a stock you can’t count on selling. Sure, you can sell it
— some day at some price. But not necessarily today at the current price. That’s what makes an
illiquid stock “untouchable money.”
You should always treat your investment in a stock like Solitron Devices as if it would take a full
year to extract that money and put it in your pocket.
Always touchable money is cash. For individuals, there's little reason for it not to be a simple
bank account, money market fund, etc. For most investors, you can just let this stock sit in your
brokerage account. Many brokers will sweep unused cash into a money market account — or
other form of savings — where it can earn a tiny amount of interest for you while staying totally
liquid. One advantage of keeping cash in this form is that you can look at your cash and stock
positions on the same (web)page any time you want. So, for example, if you know you want to
keep 10% of your portfolio in cash — you can see that you have $12,000 in cash as part of your
$120,000 brokerage account and that means you are right on target with your liquidity goal.
In my personal opinion — and I must warn you this is not a popular or consensus opinion at all
— a good individual stock picker who likes to do research himself, is better off increasing the
cash portion of his portfolio and reducing the highly liquid stock portion than sticking picking
only liquid stocks. So, instead of being 100% in IBM, Microsoft, Apple, Wal-Mart, 3M, etc. to
get his needed liquidity, he should put 20% of his portfolio in cash, 30% in liquid stocks (like
IBM), and 50% in illiquid stocks (like Solitron). In this way, he can instantly and always touch
20% of his portfolio. And he can get 50% of the money in a real time of personal need. The other
50% is totally untouchable at all times. That 50% should be thought of as retirement money or
something similar. It should never be thought of as anything approaching cash.
So, in our example of a stock picker with a $120,000 portfolio, he could divide up his funds as
follows:
1. $24,000 in cash
2. $36,000 in blue chip stocks
3. $60,000 in illiquid stocks
Look at that portfolio and ask yourself whether you could live with that arrangement. I know it
seems inefficient to keep some money permanently in cash. But if that small cash pile allows you
to — comfortably — keep more money in illiquid stocks, that could very well be the best way to
go.
All of this depends on your stock picking abilities. It depends on what areas of investing you
excel at. If you’re great at picking Ben Graham bargains, don’t put all your money in the IBMs
of the world. Put some in cash. And some in stocks like Solitron.
Of course, you need to weigh how much cash to hold against how heavy that cash anchor is —
and how far it drags down your performance. If we compare net-nets to blue chip stocks, you'd
actually find that a portfolio that is 50% net-nets and 50% cash will tend to perform about as well
as a portfolio that is 100% blue chip stocks.
By the way, that’s only true if you keep your net-net trading costs to a minimum. This is
something I’ll talk about in other articles. But basically it means you can’t trade net-nets
frequently. You have to bid for them conservatively, be patient enough to wait for someone to
come down to your price, and then hold net-nets for years instead of months.
If you can do all that, you can afford to hold a lot of cash and a lot of net-nets rather than a lot of
blue chip stocks and zero cash.
Which portfolio is more liquid?
It depends on your point of view. To me, the 50% net-net and 50% cash portfolio provides more
safety because it is still very liquid even in a market panic. The 100% blue chip stock portfolio
can still drop 30% or more in a 2008 style panic. If that happens to coincide with you losing your
job or something — boy, that 100% liquid stock portfolio is suddenly forcing you to sell at a bad
time. Liquidity doesn’t feel like much of a blessing in the midst of a market panic.
Individual position size is far less important than the overall liquidity of your portfolio. For
individual investors position size shouldn’t be a significant concern.
It's really the three categories: cash, liquid stocks and illiquid stocks that matter.
You can have 10 illiquid stocks of 5% each or five illiquid stocks of 10% each or two illiquid
stocks of 25% each. Day-to-day the fluctuations will feel very different. But in terms of liquidity
they are all similar. It can easily take one month to sell half your portfolio — if it is in stocks like
SODI — in an orderly way. I wouldn't think the amount in each stock matters as much. What
matters is how much of your portfolio you have in: (1) cash, (2) liquid stocks and (3) illiquid
stocks.
Always look at your own personal situation. Especially pay attention to whether you are adding
or subtracting from investable funds each month and each year.
Personally, I'd suggest holding more cash and more illiquid stocks at all times rather than
holding only liquid stocks.
You can always hold more illiquid stocks if you increase the amount of your portfolio you keep
in cash. That’s one way to get comfortable holding less liquid stocks.
But each investor has to do what makes him comfortable.

So, if illiquid stocks make you uncomfortable I'd amend that advice. The best decision for any
investor is usually the program — system, approach, whatever you want to call it — that allows
you to make investing decisions without feeling uncomfortable and prone to panic.
Never pick a portfolio allocation that looks good on paper — and is empirically proven — if it
makes you uncomfortable. The element of human error you introduce will destroy any advantage
the portfolio had.
Instead, pick a portfolio you can live with. Something that has empirical support. And that is
psychologically suitable for you personally. Both of these elements must be present. Having only
one or the other is not enough.
You need to use a proven strategy, like net-net investing. And you need to invest in a way that
keeps you comfortable.
161316/can-you-build-a-liquid-portfolio-with-illiquid-stocks
 Time: 2012
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Illiquidity and You
Aswath Damodaran has a post on Asset Selection and Valuation in Illiquid Markets. It’s a fine
theoretical discussion of the subject.
But I’d like to talk about practical illiquidity. What does illiquidity have to do with stock
picking?
Let’s start with the big question.
Should you apply an illiquidity discount to specific stocks?
No.
My view of illiquidity discounts is basically Warren Buffett’s view of using risk based discount
rates. Risk isn’t something you account for in the last step of the process. Risk is something you
think about every step along the way. Same with illiquidity.
You start by asking: Is it safe to hold this stock forever? Can I afford to get locked into this
stock?
That means you check the stock’s vital signs. What’s the Z-Score and the F-Score? How is the
balance sheet? Does it have 10 straight years of positive free cash flow? Does it have minimal
cap-ex requirements? Has it earned an above average return on tangible capital over the last 10
or 15 years?
Yes.
Then you can afford to hold the stock forever. The downside risk of getting locked in the stock is
not catastrophic. The stock is safe in the sense that the business itself isn’t going to implode and
the intrinsic value isn’t likely to decline over time. At worst, it’s a big time suck. But, if you buy
at the right price, you’re risking your opportunity cost instead of your principal.
Next, you calculate if it’s possible to get in and out of the stock. If you’re a patient, individual
investor the answer is almost always yes. Even if we take a very illiquid stock like one that on
average trades shares worth $5,000 each day, that’s usually enough for an individual investor to
make a long-term investment in the stock.
Here’s why.
A stock that trades $5,000 a day trades $100,000 a month (if a month is 20 trading days).
Charlie Munger mentioned that Berkshire Hathaway (BRK.B) bought 30-40% of the daily

trading volume in Coca-Cola (KO) when it amassed its stake. Buying micro-caps, I’ve often
bought even more than 40% of a stock’s volume. In several cases, I never paid a cent more for
any of my shares than the last price the stock traded at before I started buying. Weird, huh?
But totally true. It doesn’t always work that way. Obviously if I’d tried to force it and buy the
amount I wanted without regard to price, that’s not what would’ve happened. Instead, I just sat at
the same bid for weeks and took whatever shares came down to that price.
I should point out that sometimes it works differently. Sometimes you get your shares the way
Berkshire Hathaway got its investment in the Washington Post (WPO). Berkshire got virtually
all its stock in the Washington Post from just 4 or 5 large investors. It happened very fast.
I’ve had that happen too. I go in expecting to be buying for a month. And then in just a couple
trades over 1 or 2 days my entire order is suddenly filled with 20 or 30 times the stock’s normal
volume.
The truth is that with micro-caps there is no such thing as normal volume. There’s just an
arithmetic average. But no one said the mean is the mode. If you look at the day-to-day numbers,
you see the volume comes in droughts and floods. Just make sure you have your bucket out when
it rains.
So, you have to head into an illiquid stock with the idea that you aren’t going to trade it. You’re
just going to collect it. It isn’t a commodity. It’s a piece of art. That’s the attitude going in.
If we take a very conservative estimate on that hypothetical stock that trades $5,000 a day and
say you can only buy 20% of the volume, that would mean sinking $20,000 a month or $60,000
a quarter into the stock. For most individual investors, $20,000 is more money than they’re
adding to their investable savings each month.
So, for individual investors who are willing to spend weeks and months buying a stock, there’s
really no limit to how illiquid you can go.
But how illiquid should you go?
My advice here is that for a true Buffett and Graham type stock picker, there’s absolutely no
limit to how illiquid you can go in terms of individual stocks. There is, however, always a limit
to how illiquid you should make your entire balance sheet.
These are really two completely different questions. An illiquid balance sheet is dangerous. An
illiquid security on a liquid balance sheet is often just a good investment.
And that’s my biggest problem with using illiquidity discounts. From an investor’s perspective,
illiquidity is not a security specific threat, it’s a system wide threat.
Your entire financial life should be organized in a way that lets you buy illiquid stocks. That
means you never, never, never put money into a brokerage account you may need anytime
soon. And anytime soon means the next 3-5 years.
I’m not kidding about this.
A “safe” security you can’t hold beyond 5 years isn’t an investment anymore, because you’ve
gutted the margin of safety. In stocks, the margin of safety is the combination of intrinsic value
and time. How long you actually hold a stock isn’t important. What’s important is how long
you can hold a stock if you keep getting ridiculously low offers for it.
Remember, Berkshire Hathaway was ready to take on Long-Term Capital Management’s

portfolio. Buffett felt the investments were sound if they were on someone else’s balance sheet.
But they needed to be held by someone who had the ability to hold them until somebody offered
a fair price for them. Long-Term didn’t have that luxury.
Volatility doesn’t matter. Having the ability to hold an investment is what matters.
This is part of the reason I don’t think stock pickers should own bonds. I think defensive (non-
enterprising) investors are fine mixing stocks and bonds the way Ben Graham suggested (25-
75% in each) as valuations fluctuate. But I don’t think stock pickers should hold other assets just
to reduce volatility. If you want less volatility, hold some cash.
You should buy bonds because you actually want to own some bonds. Not because you want the
market value of your portfolio to bounce around a bit more or a bit less.
By the way, mixing some illiquid stocks into an otherwise liquid stock portfolio will often make
your portfolio less bouncy rather than more bouncy.
I don’t worry about beta here. And I don’t think you should either. You should buy an illiquid
stock because you want to own the business and you can’t find any businesses of comparable
quality at anywhere near comparable prices among liquid stocks.
That’s the only good reason to own an illiquid stock.
What about the risks of illiquidy?
You always look at liquidity from an entity wide perspective. In this case, you are the entity. And
your obligations (like a mortgage) are part of the calculus, as is your employment situation, and
your bank account, and your brokerage account.
Applying illiquidity discounts to individual stocks doesn’t make much sense. It’s extremely
arbitrary. Especially since I’ve found you often get cashed out of these situations through
buyouts. Each year, I find about 20% of my portfolio gets bought out. As a result, I’ve often
ended up selling an illiquid position not to another outside investor in the stock – like me – but to
someone who was paying for control of the whole company.
And dividends come in the form of cash regardless of whether you get them from a liquid or
illiquid stock.
I’ve talked about illiquid stocks on this blog that yield 3% to 5%. That’s at least half the
expected return in the super liquid S&P 500. And that 3% to 5% comes in cash, which is the
most liquid asset of all.
If you add returns from buyout premiums and dividends together it’s a pretty big number. And
none of it has anything to do with illiquidity. Dividends are paid in cash. And buyout premiums
are paid by control investors, not people who buy and sell on a stock exchange.
So, you always want to look at what liquidity means to you.
Do you need liquidity?
If so, you can’t buy that lovely micro-cap regardless of the price.
But if you’ve structured your personal financial situation so you don’t need any liquidity from
your stock portfolio – which is how every individual investor should structure things – you can
buy as many illiquid stocks as you want.
For each illiquid stock, all you need to do is a series of calculations on how fast the intrinsic
value of the business is growing or decaying and how long you can afford to hold the stock.
In one extreme example, I calculated what would happen if I was stuck in a particular stock for
10 years and the business did worse than usual. The answer? I’d probably match the market.
That was the downside risk of illiquidity. The upside, of course, is that something would happen
within 10 years to unlock the value.
In my experience, it almost always does. It’s hard to know what that something will be and when
that something will come. But if you can afford to be stuck in a stock for 5 or 10 years, you’ll
almost always find the price and intrinsic value meet somewhere along the way. And it’s usually
a lot faster than 5 or 10 years.
If you want to emulate early Warren Buffett and Benjamin Graham, illiquid stocks are the place
to be.
By the way, I think illiquid stocks are the best training ground for new value investors, because
you see Ben Graham’s Mr. Market metaphor so clearly in these stocks. You realize that a price
move up or down 6% isn’t a market signal, it’s just two guys trading some shares.
Finally, something I can’t stress enough is that you have to take illiquid stocks seriously. You
have to evaluate them as pieces of a business. You have to do all the Warren Buffett and Ben
Graham basics.
You can’t think of them as play money. For some bizarre reason, I know a lot of folks who think
they’ll put their “real” money into Microsoft (MSFT) and Kimberly Clark (KMB) and then
their “play” money into Birner Dental (BDMS).
It doesn’t work that way. Liquid and illiquid stocks aren’t two different arenas for you to play in.
You evaluate each of them the same way. You judge each stock against all your alternatives.
You can’t speculate. Not even a little bit. Not even in illiquid stocks.
And that’s what’s so weird about this perverse desire to speculate in illiquid stocks. I can show
you long lists of illiquid stocks that have wonderful 10 and 15 year records. The notion that
Microsoft is something you keep and Birner is something you flip gets no support from the past
record.
Ben Graham and Warren Buffett didn’t discriminate against illiquid stocks. And Charlie Munger
will tell you the best markets to operate in are the most inefficient markets.
You can find some tremendous inefficiencies in illiquid stocks.
Some people can’t stand being in stocks where you’re not sure you’ll get a tick every day. And
that’s fine. Illiquid stocks aren’t for people like that.
But for folks who consider themselves more business analysts than stock traders, illiquid stocks
are the best place to be.
 URL: https://focusedcompounding.com/illiquidity-and-you/
 Time: 2010
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Industries
Understanding An Industry - Is Simple Better Than Familiar?
Geoff,
I am a senior in college and I am in the process of interviewing for full-time positions in asset
management/equity research. I have a "super week" on campus… where I will have a number of
important interviews, and I would like to be able to tell the interviewer, 'I know a lot about x
industry.' I am familiar with many industries, but I wouldn't say that I have a deep
understanding of any one in particular. Can you recommend an industry that I could sit down
and study for the next month and develop a deep enough understanding to tell an interviewer 'I
know a lot about this industry'?
I know a lot about oil and gas compared to what I know about other industries, but O&G; is
such a deep industry that I would feel much more confident trying to master a simpler industry
for interviewing purposes.
Thank you for your advice.
- Ted
Honestly, I would go with your instincts. With what you are already interested in. If you know a
lot about oil and gas, I would study oil and gas. The most important requirement for
understanding anything is your interest in it. Often, it's not enough to "need" to know something.
You have to "want" to know it.
My focus is almost exclusively on industries where customer behavior is easy to understand.

Where once you have a good idea of how the customer sees the product, how they search for
alternatives, etc. you have a good understanding of the business. To me, the simplest industries
are industries in which costs are less important to the company because they are less important to
the customer. Usually, I am focused on industries where the purchase decision does not involve a
very large amount of money relative to the customer's total purchases.
So, I think of simple industries as food, entertainment, etc. And anything where logistics provide
a competitive advantage. I mentioned a company I own shares of – George Risk Industries
(RSKIA) – before. Its advantage is the ability to deliver a cheap product on time. They can't
produce the product for less than the competition. If the purchase price was huge relative to what
the end customer was purchasing as part of the same activity (the end customer is construction in
this case) price competition would be important. Instead, delivery is important.
This is similar to Mid-Continent Tab Card Company. Warren Buffett invested in Mid-Continent

Tab Card Company back in his partnership days. Another example of a company that competes
on delivery is ADDvantage Technologies (AEY). It's going through some changes now – due to
a new (adverse) agreement with Cisco (CSCO). But, historically, it competed on delivery alone.
By having products in stock and ready to ship – their motto is “on hand on demand” –
ADDvantage could compete with original equipment manufacturers even though those
manufacturers could sell the same product (in large numbers and slow delivery times) for much
less.
That's my biggest concern with whether an industry is easy to understand or not. If a competitor
offers to sell its product for 5% less than you charge, how do you respond? Do you have to
respond? Can you ignore price competition like that?
Now, there are obviously industries where price competition is critical and yet the business is
easy to understand. Groceries, auto insurance, etc. Even the deposit gathering aspect of some
banks is very simple and easy to understand.
The lending part… not so much.
My concern is a durable competitive advantage. Something that I can recognize. I have to be able
to understand it. In some sense, to actually imagine it. There are many companies with
competitive advantages that are just too esoteric for me to understand. I’d probably recognize
them if I worked in that industry day after day. You notice things when you’re close enough to
see them illustrated every day in a million different anecdotes. Reading about an industry from
afar is much harder to do. So the competitive advantage has to be pretty plain and simple. Or I
won’t see it when I read it. But that’s competitive advantages. And I'm not sure competitive
advantages are the topic of greatest interest to the folks you'll be interviewing with.
I know that when it comes to what stocks people are most likely to make money on – it often
comes down to familiarity. Are you willing to study the company? And then are you willing to
trust your judgment when the stock price moves against you – as it almost certainly will – at
some critical moment in your holding period. That’s how it seems to work with stocks. Picking
the right stock is not enough. You have to be able to hold it too.
I know you didn’t ask about buying stocks. You asked about a job interview.
But the topic you’ll sound best talking about is the topic you’re most interested in.
Really, you should go with what you are passionate about. What you are curious about. If you
are interested in an industry and apply yourself to understanding it, you'll do fine. I would
recommend coming up with a list of public companies in the industry you want to study. Print
out the 10-K, 10-Q, and 14A for each. You can get them at EDGAR. Have a pen in hand. Take
notes. Compare the companies.
Many of the most important aspects of every company – and the industry itself – will be obvious
just from these reports. They are most useful because they are essentially primary sources. A lot
of the information you will read about a company or industry has already been shaped by some
other analyst (or reporter's) opinion. SEC reports are less likely to cause you to embrace the
conventional wisdom where it is wrong.
One thing I would strongly suggest is to avoid reading resources prepared with investors in mind.
When doing stock research, you should either use rather dry and formulaic information dumps
like the 10-K, 10-Q, and 14A or you should read documents that were specifically created for
non-investors. Depending on the industry, there is sometimes a lot of information that was
created by or for academics, regulators, customers, industry participants, and general interest
audiences. Some of this stuff can be very useful if you make connections with what you find in
other reports. Some folks will listen to industry gossip. Others will read the SEC reports. Far
fewer will bother to connect the two.
If you can talk to anyone in the industry – whatever their role – I would encourage that. This is
easy to do if you gather information on their company, industry, or function ahead of time. If you
demonstrate you already know something about the topic and are interested in it all you have to
do is let them talk. People love to talk about themselves. And actually talking to folks in the
industry can help in a few ways. The most useful is in terms of human behavior. People can often
reveal why prejudices and biases exist in certain decisions made in their industry. They can help
you understand the human element.
Warren Buffett mentioned doing this before his recent investment in IBM (IBM). Basically, he
wanted to know why people would be likely to prefer IBM to competitors and why they stay
with IBM. In his CNBC interview, Buffet seems to say there is a certain tendency to bet on the
known quantity when it comes to IT providers. He especially mentions this in regard to foreign
companies. It was interesting to see Buffett mention doing this kind of scuttlebutt with IBM –
because in past interviews he's said that while he used to do all the Phil Fisher scuttlebutt – he'd
gotten to the point (by the 1990s and 2000s) where he kept Phil Fisher’s principles in mind but
he could basically make a decision just from reading public reports.
161490/understanding-an-industry--is-simple-better-than-familiar
 Time: 2012
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How to Find Safe FCF Yields: Go Where the Competition Isn't
Why do you focus so much on FCF yield?
What would stop them from returning 10 %+ every year, as opposed to NACCO, OMC etc.,
stocks that have very high FCF yields, and that you openly like a lot?
In other words, how do you look at different FCF Yields and decide: This is a real yield, and this
is not?”
The number that really matters isn’t free cash flow. It’s the amount of cash flow available to buy
back stock, pay dividends, acquire other businesses, etc. divided by the stock price (so that’s
your “free cash flow yield”) plus the annual rate of growth in that cash flow while still making
such payments.
To simplify, if a stock could have a 5% dividend yield and a 5% growth rate (while still having a
5% dividend yield), it would interest me as much as a stock that just had a 10% dividend yield or
just had a 10% growth rate. It’s today’s payout plus the growth in that payout that matters to me.
Doing that kind of math on any of the stocks I buy (at the time I buy them) will get you closer to
seeing what I saw in them. So, if I buy a bank with a 4% dividend yield, I think that it could
grow 6% a year while paying that 4% yield out. It’s usually something like that. I see a clear path
to 10%+ type returns even if you end up having to hold the stock for a while.
So, how does that relate to your list of stocks with 10% plus free cash flow yields?
Well, one issue is that some of the stocks on that list are leveraged. So, you have a supermarket
stock like SuperValu (SVU, Financial) which has a lot of debt. I wouldn’t view that the same
way as Village Supermarket (VLGEA) which has an overcapitalized balance sheet (for a
supermarket) or Kroger (KR) which actually owns about half of its properties and then has a very
nice debt structure of long-term, fixed rate bonds that should lock in a very low real interest rate
for a very long time.
SuperValu equity might be cheap. But it’s risky. The common stock is junior to debt. The
company has a lot of debt. That means a lot of financial leverage is being piled on top of a
business (supermarkets) with a ton of operational leverage. If same-store sales decline just 2% a
year for a few years in a row – you will suddenly become very concerned about whether debt
payments will be made and your stock will be safe. Supermarkets do end up in bankruptcy. Like
railroads, the reason for this is usually that someone put too much debt on them. Owning a
supermarket outright that you bought with 100% cash and where you own the land and the
building and so on – that’s a really quite safe business. But, then if you are leasing the building
and you are making acquisitions using debt – or if you went public having been an LBO in the
past….
Situations like that are risky. SuperValu is a situation like that. I’d skip it.
You mentioned Omnicom and NACCO as being two stocks I spoke about having good enough
free cash flow yields. Omnicom is financed largely through “float” produced by getting paid by
customers before having to make payments on behalf of those customers. Like almost all ad
agencies, the traditional Z-Score (which is meant for manufacturing firms) would tell you
Omnicom is in financial distress. However, Moody’s and companies like that would rate
Omnicom bonds as an investment grade type risk. So would I. What you are talking about with
Omnicom is that I said previously (in 2017) that if you could buy the stock at about $65 a share –
I thought it was cheap and would suggest buying it. I meant that the free cash flow yield – when
coupled with the growth rate I’d expect – was adequate. And then, on top of that, I didn’t think
Omnicom was overleveraged at this point. I wouldn’t be so sure about SuperValu. So, I’d cross
SuperValu off my list of stocks to analyze based on high free cash flow. But, I’d keep Omnicom
on the list.
In the case of NACCO (which I own), I knew the stock would have about $5 of net cash per
share after the spin-off was completed. The company was basically laying off debt on its spin-off
(Hamilton Beach Brands) by having Hamilton Beach pay NACCO a cash dividend right before
the spin-off. NACCO is also structured in a way that liabilities are mostly at the unconsolidated
subsidiary level and non-recourse to NACoal (the parent of those subsidiaries) and then the
liabilities at that level (NACoal) are in turn non-recourse to NACCO. Now, NACCO does have
liabilities related to its history as an underground coal mine operator that it will never get rid of.
It has environmental and pension type liabilities. That’s at the parent company level. And it’s a
risk. But, overall, I looked at the company and decided it had much better financial strength than
something like SuperValu. So, I would consider buying NACCO but wouldn’t consider buying
SuperValu. This is a judgment call. Other people would say coal is a dying business but
supermarkets will be around forever. Investors who think that way would cross NACCO off their
list and keep SuperValu on it. That’s what makes it a judgment call. From my perspective,
NACCO’s a lot safer stock than SuperValu. This is because I want to see an unleveraged free
cash flow yield plus growth that gets you to 10%+ a year. SuperValu might get you a 10%+ yield
and outperform any and all the stocks I’d consider. But, it’s going to do that by using leverage.
And that’s not what I’m looking for.
Other stocks on your list of high free cash flow stocks include some industries that are tricky for
me to calculate a “normal” free cash flow yield. For example, I didn’t look at NACCO’s last
twelve months of free cash flow when considering whether to buy it. What I actually did was
take the average of all years from 1991 to the present (so about 25+ years) in terms of real profit
per ton of coal mined and then I used the current level of coal production in tons. I then made
some other assumptions I considered conservative. For example, I used an estimate for losses
from corporate overhead that are probably excessive now that the company has shrunk in size.
My point is that I’m looking for “normal” free cash flow – not last year’s free cash flow. There is
an oil refiner on the list of 40 stocks with a free cash flow yield over 10%. The economics of oil
refining are such that I can’t estimate free cash flow for them. NACCO was easy because they
operate under long-term cost plus contracts on behalf of customers where a mine is sited next to
a power plant. The economics of what kind of “spread” in terms of profit per ton you are going
to get is really clear. I’ve looked at oil refiners and I just can’t get comfortable with estimating a
normal spread the way I can with a long-term cost plus contract. This is similar to why I might
own something like BWX Technologies (BWXT) and not another kind of defense contractor.
BWXT is a cost plus monopoly provider of a key system (shipboard nuclear reactors and the
associated equipment) for the U.S. Navy. The Navy buys submarines from more than one
provider. However, those subs use reactors from only one supplier (BWX Technologies). So, I’d
be more comfortable with the lack of competition in the case of BWX Technologies than I would
with other defense related businesses.
This is a big one. I tend to focus on companies where I believe competition is limited. For
example, on my member website, I recently wrote about both Cars.com (CARS, Financial) and
NIC (EGOV). Honestly, I’d be more likely to spend time researching NIC than Cars.com,
because NIC faces limited competition for operating dot gov portals on behalf of U.S. states (it
already operates 27 portals and there are only 50 U.S. states). Meanwhile, Cars.com faces
publicly traded competitors who are spending 50% to 75% of their annual revenue (you read that
right) on advertising. I don’t feel comfortable investing in an industry where everyone is
desperately trying to achieve scale. Those companies obviously feel the car buying information
website market is a winner take all kind of business. Otherwise, they wouldn’t spend more on
advertising than they actually make in profit. They are spending their way to a loss right now,
because they believe they can achieve phenomenal annual growth rates in numbers of visitors to
their sites. That’s too unsettled an industry for me to invest in.
So, I’ve mentioned SuperValu as an example of one disqualifying trait (high leverage). I’ve
mentioned Western Refining (WNR, Financial) as having a business model (operating oil
refineries) I find too difficult to predict cyclically normal free cash flow for. And then I just
mentioned Cars.com as an example of an industry that is growing too fast, is too competitive,
etc. for me to feel comfortable investing in.
The easiest way to test whether I’d buy into a high free cash flow yield stock or not is to imagine
I’m not buying a stock. Instead, I’m buying a business. Imagine I’m in Warren
Buffett (Trades, Portfolio)’s shoes. Or, rather Warren Buffett (Trades, Portfolio)’s shoes when
Berkshire was much smaller. If I controlled a holding company and had the chance to put 20% of
the net worth of the conglomerate into buying all of Omnicom (at $65 a share, like I said) –
would I do it?
Yes.
I would definitely buy all of Omnicom and keep it forever.

Would I buy all of NIC?
Probably. At the right price, I think I would.
What about Cars.com?
I just don’t understand the competitive landscape well enough.
Western Refining?
I wouldn’t want to be in the business of owning oil refineries. It’s just not a business model I can
reliably quantify over a full cycle. So, no. I would want to be in the advertising business but not
in the refining business.
Some of the other stocks mentioned on that high free cash flow yield list are stocks I’ve looked
at. I researched NeuStar extensively. This is now a private company. They had one very good
business. They administered the “North American Numbering Plan” which is mostly the
assigning of telephone numbers in the U.S. (but also Canada and some other smaller countries).
They had the contract for about 20 years but lost a re-bid process in 2015. I don’t remember
exactly when they finally lost the contract (rather than the stock market just knowing they were
going to lose it), but that’s probably why you saw the free cash flow yield being so high. The
market knew they had lost the contract and hammered the stock price accordingly, but the free
cash flow associated with the contract was still appearing in the last 12 months of results. They
had a very high free cash flow, monopoly type business that was going to disappear. They had
taken the proceeds from that and bought or expanded into other things. So, there was still a lot of
value left in the company and it went private. But, I analyzed it as a possible investment only on
the basis of the North American Numbering Plan. I came to the conclusion there was a real
chance they’d lose the contract. They did. So, that’s why I never invested in it. The stock was
trading at a cheap price if you were sure they’d win the contract again.
I wasn’t sure. So, I didn’t buy the stock.
Note the difference here between NeuStar and either NACCO or BWX Technologies. A lot of
people think I bought into NACCO or BWX because of the contracts. But, that’s not true. Yes,
they have contracts. But, I bought in because of the competitive economics that underpin the
contracts. The reason a customer of BWX Technologies signs a contract is because BWX
Technologies is either the only producer at scale of something like nuclear reactors (in the U.S.)
or it is a member of a more oligopolistic type market (like in the case of administering nuclear
related sites). The companies doing nuclear-related work for the U.S. government generally have
to be both American and historically rooted in Cold War programs (the Manhattan Project in the
1940s, nuclear weapons in the 1950s, nuclear submarines in the 1960s, etc.). This is because
interest in nuclear technology among companies peaked from about 1950 to about 1980. Since
1980, this has not been a growth field that others are interested in. And then for national security
reasons, countries with nuclear weapons, nuclear powered ships, etc. rely on a provider in their
own country. It’s true that both the U.S. and Russia have nuclear powered navies and it’s also
true someplace like China might want to build a lot of ships much like those in the U.S. Navy –
but, U.S. companies aren’t going to build the reactors for the Chinese government and Chinese
companies aren’t going to build the reactors for the U.S. Navy. There’s a local, historical reason
for why the contract would be granted to BWX Technologies. Generally, whoever had the U.S.
Navy as a customer in the past is going to be the only company ready to meet its needs in the
future.
The same sort of thing is true with NACCO. The power plants were built where they were built
for a reason. They were designed to be fueled with coal and they were built on top of coal
deposits. This is very different from siting a power plant near a railroad and shipping in coal at
commodity prices. The mine and the power plant are interdependent. It’s true there’s a contract.
But, the economics would be good even if there wasn’t a contract. Ultimately, you are always
going to fuel your power plant using the coal from the mine you are sitting next to. The two
options are: 1) Close the power plant or 2) Use the locally available coal.
The risk with NACCO is that coal power plants close. The risk is not that the coal power plants
they are now fueling consider a lower bid from someone else. The economics of the business
preclude that. That’s why it’s not a competitive business they’re in. Competition wouldn’t make
any sense there.
Most of the companies on that list of 40 high free cash flow yield stocks don’t have that kind of
easily understandable moat. There are some dominant companies on the list. For example,
GameStop (GME, Financial). GameStop dominates the market for video game retailing,
especially used video games. There are network effects in that business. And this is not a market
others want to enter anymore because they think it’s all going digital. That, of course, is the
danger. GameStop might become obsolete after everyone has an Xbox or PlayStation hooked up
to very fast broadband and is buying a digital copy for direct delivery over that broadband.
I’ve thought about GameStop as a stock. I buy video games myself. And for many years now, I
haven’t gone to any place like a GameStop to get a game. All my purchases have been either
digital or done on Amazon. Now, I tend to be a little faster to adopt some of these technology
changes. So, that doesn’t mean GameStop will be out of business by this time next year. I had a
Kindle as soon as it was released. It took years and years from the time I switched to only
reading digitally for half of all author royalties to start coming from e-sales instead of print sales.
For example, “cord cutting” is something being talked a lot about now. I got rid of cable 6 years
ago. So, for the last 6 years I’ve certainly been cautious about investing in any TV content
related business.
But, I still research these stocks. I have visited several GameStops and tried to do a little
scuttlebutt in regards to that company. I doubt I’ll ever own the stock. But, it’s something I’ve
spent time researching.
And I did some research on MSG Networks (MSGN, Financial) as well. The issue with MSG
Networks is a combination of whether subscribers are durable in the truly long-term and whether
the company has too much in liabilities. They have a long-term contract that depends on
subscriber numbers for them to service safely. The issue is that liabilities are fixed while
subscribers are variable. If they keep their subscribers, this will be a great stock for the next 15
years. But, if they lose subscribers, this stock could face real financial risks. If they had signed
the kind of contract they have now in 1990, I wouldn’t be worried. But, cable channels are just
changing too much for me to get comfortable with MSG Networks. I don’t know what subscriber
figures will look like from 2018-2032. And if you don’t know that, you don’t know the company
will always be solvent. The stock might do great. But, I’m not sure the future will be anything
like the past. It’s too unpredictable.
Generally, I’m looking for a company that has what Warren Buffett (Trades, Portfolio) would
call a “moat” or what GuruFocus would call “predictability” or what I would call a lack of
competitive pressure – especially in regards to price competition. Yes, I want a high free cash
flow yield. But, I want that free cash flow yield to not be at risk from price competition from
rivals and I want the company to be able to pass along inflation.
On any list of 40 stocks, I’d probably throw out 36 of the 40 names pretty quickly. They just
aren’t “predictable” enough or “moaty” enough. What I mean is: they are in industries that are
simply too competitive.
I always want to invest where I see a lack of competition. That’s probably my No.! rule. Go
where the competition isn’t.
 URL: https://www.gurufocus.com/news/633121/how-to-find-safe-fcf-yields-go-where-
the-competition-isnt
 Time: 2018
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Buying a Good Business in a Bad Industry
“How do you feel about good businesses in poor industries? Are there any industries that you
just won’t even consider?”
No. In theory, I do not think there is any industry where I would not consider a good business
worthy of investment just because it was part of that industry. But, this question is not that
simple to answer. Let me start by giving some examples of businesses I like in industries I do
not.
I wrote a newsletter about Progressive Corp. (PGR, Financial). I do not mind direct insurers, so
I am fine with companies like Progressive and GEICO in the U.S. and Admiral in the U.K. There
are differences between these three companies, but they are different from auto insurers that get
all their policies through agents.
Most insurance that covers general risks is not very interesting to me. I have invested in insurers
before, but it would be pretty hard for me to ever imagine investing in a life insurer or something
like that. If the insurer markets directly (online, through direct mail, etc.) and covers non-
standard risks or operates in some specific niche, I would be more likely to consider those kinds
of insurers. Progressive does both. It got started in non-standard auto and also has a direct
business. At the opposite extreme would be something like life insurance sold through an agent.
Like I said, I cannot imagine ever investing in a company like that. It is the commodity nature of
that kind of business that turns me off.
I picked America’s Car-Mart Inc. (CRMT, Financial) for the newsletter. The company sells

used cars. However, it really sells those used cars in order to lend money at high rates to finance
the purchase of said cars. So, it is really a deep, deep subprime lender. I do not like the car loan
industry. I made that clear in the report I wrote about Car-Mart. I felt then – and feel even more
so now – that lending for the purchase of cars in the U.S. is way too loose. This is a cyclical
problem for Car-Mart. I also felt the kind of loans it makes are difficult to securitize. You do not
need to know anything to make car loans to prime borrowers. It is like letting prime borrowers
carry a balance on their credit card. There just is not much risk because of who the borrower is
and how they are likely to treat their debt. They tend to do what they can to pay it off. They are
not going to walk away from the loan and are unlikely to declare personal bankruptcy.
The kinds of loans Car-Mart makes are very different. For one, I think borrowers often buy the
car to get to a job. So, if the car breaks down (Car-Mart’s cars are usually quite old) and needs
repairs, or if the borrower loses their job, ends up in the hospital or gets divorced – I think any of
those events could trigger a default. The borrower certainly did not have good credit to start with
– and often really had no credit. If they no longer want the car, they really are not worried about
failing to make payments on the loan. This makes quickly contacting borrowers who have
missed payments, aggressively collecting loans and also modifying loans (no one at Car-Mart
wanted to talk to us about modifications, but I am sure they do them) really important.
Therefore, I thought Car-Mart could be a good business in a bad industry, but it is really niche
and it needs to stay really niche for this to work. First of all, Car-Mart is really for borrowers
with no credit at all. Credit checks would not provide meaningful information for their customer
base. So you are lending blind compared to what some other lenders do. Second, Car-Mart is
basically just in the Southern U.S. And third, even within the South, Car-Mart has been far more
successful outside of major cities. For example, the company is in Texas, but there is too much
competition for car loans in the major cities. Parts of Texas are very rural, but the biggest cities
in Texas are some of the biggest in the U.S. You have to avoid those if you want to stick to your
niche.
I am not sure how good of a stock pick Car-Mart has been. In some ways, we were completely
right. In other ways, it did not matter that we were right about the things we were right about. We
were right about both the company and the industry. However, the damage that excessive
competition in this loose credit part of the cycle has done is really serious. The behavior of Car-
Mart's competitors and the likelihood of the Federal Reserve keeping rates low for a long time
were both things we considered when we picked Car-Mart.
Even if Car-Mart works out well as an investment, it will still have been riskier than I intended
the investment to be. The only way Car-Mart can perform well is if management demonstrates
willpower and restraint beyond what a normal management team would. There has always been
a risk that Car-Mart will eventually give in to making loans in ways I think are unacceptable for
the long-term health of the company and the industry.
Car-Mart has relaxed its standards in certain ways – for example, it has made longer loans. I do
not blame them for doing that. Competitive pressure really forces its hand. Some of Car-Mart’s
safer borrowers can actually be poached by more mainstream lenders. I personally think it is a
little crazy that there are lenders, who have never experienced the kind of loss rates Car-Mart
deals with routinely, making loans to its ex-customers. When I picked the stock, I knew that kind
of competition was possible if the Fed kept rates low for a long time. Car loans are pretty short
term.
Lower quality car loans have nice yields compared to other assets with shorter maturities. If
investors want yield but do not want to go out very far in terms of how long dated the bonds they
buy are – because they know interest rates will be higher in the future than they are now – then
assets like subprime car loans are going to get overvalued. If those assets get overvalued, some
people are going to create subprime car loans when they really should not. So, here we can see
the industry problems we know are damaging Car-Mart, even though I said it is the most niche
auto lender you can find in the U.S. That is the danger you run into.
I do not like the car loan industry, but I do like Car-Mart. So far, I would say the results have
been mixed. I was not wrong about anything, but I might have been better off taking my
concerns about the industry more seriously and just ignoring any business related to car loans.
Village Super Market Inc. (VLGEA, Financial) is another example of a business I considered

to be good in an industry I considered to be bad. I do not like generalist supermarkets because I
think the store level economics of these stores are poor. They are not necessarily dismal, but they
are still not good.
The way competition in generalist supermarkets works is that households generally shop at one
supermarket. If there is a family with two kids, a mom and a dad, and the mom makes 70% of
the grocery shopping trips – then she probably makes those trips to the same local place week
after week. Sure, some groceries are purchased in smaller batches during the week by other
people in the household or as part of trips to discount chains like Target (TGT, Financial)
or Wal-Mart (WMT, Financial), but those trips are not competitively meaningful. There is a
circle of convenience around a household that probably extends for more than about five minutes
of driving time and almost certainly does not extend beyond 15 minutes of driving time. Grocers
within that circle of convenience can compete to be the primary grocery shopping destination for
that household.
Village – which operates Shop-Rite stores in the state of New Jersey – is generally competing
with stores like Kings and Stop and Shop. They could also compete with big format stores like
Wegman’s that are regional to that part of the country (but extend far beyond the state). They
also compete with some supermarkets that have different business models. Those “supermarkets”
include Whole Foods (WFM, Financial) and The Fresh Market. The Fresh Market – which had
been public – was officially classified as a supermarket for industry purposes. However, even in
its own 10-K, The Fresh Market said it was not a supermarket, which I agree with completely.
They do, however, present a problem for stores like Village because they can put a smaller
format store that generates enough free cash flow to provide a shorter payback period on the
investment. This is critical because it means The Fresh Market could enter markets where no one
would put an additional Shop-Rite, Kings, Stop and Shop or Wegman’s location.
So, why did I like Village? As I just laid out, the economics of the supermarket industry are very,
very local. What matters most is the population within your circle of convenience. If you have a
supermarket with very few and very poor households within the store’s radius of convenience –
that store will have a low return on equity. If you have a supermarket with very many and very
rich households within the store’s radius of convenience however – that store will have a high
return on equity. This factor is huge. I would estimate that equally well-run supermarkets in a
poor, rural area and a rich, dense suburban area (think Northern New Jersey or Southern
California) could have pre-tax returns on equity of as low as 10% and as high as 30%
respectively.
In other words, a supermarket in a poor, rural area is a below-average business. A supermarket in

a rich, suburban area, however, is an above-average business. The advantage here is location. I
even pointed out in the newsletter that although Village Super Market has much higher unlevered
returns on tangible equity than Kroger (KR, Financial) does – I do not think it is better run. In
fact, I suspect Kroger is – in some respects – better run than Village. Frankly, I think Kroger is
really well run, and I know Village’s top executives are a bit overcompensated. So, there is even
a little bloat to the SG&A line that is the result of being a family controlled company.
Kroger has a good store format and is well run, but its store base is spread over a lot of the U.S.
that is not particularly rich or particularly suburban. Village’s stores are almost entirely located
in the state of New Jersey.
New Jersey is the best state in the U.S. for running a supermarket. On top of that, a lot of those
stores are in Northern New Jersey. Northern New Jersey is the best part of the best state for
running a supermarket. The volume of business that an incumbent supermarket does in a
Northern New Jersey town is just much higher than what supermarkets in the rest of the country
can do. So, it is not fair. It is just a historical accident. Some companies happen to have been
founded in the New Jersey area and some companies happen to have been founded in the
Midwest. The supermarkets in New Jersey got to sign their leases, build their parking lots and so
on at a time when it was possible to put in a new supermarket. They then expanded those stores
in size. To now put in a new supermarket of 60,000 to 80,000 square feet in a densely populated
suburban region like Northern New Jersey is just unrealistic.
Once in a while, you can get lucky and get the site you want. But even then, you would have no
local scale. Your brand would be new in the region. You just cannot put in enough new
supermarkets from outside the state to compete away the superior returns the existing
supermarkets have. Now, the downside to this is that Village cannot really grow, but that was not
the problem I had to consider when I picked the stock.
When I picked Village for the newsletter, it was actually trading at a lower price-sales ratio than
most of its peers. Village has better locations than those peers. If auctioned off separately, each
of its stores would fetch a higher price relative to sales than a competitor’s store. A company like
Kroger would pay a lot to control the locations Village already does. That is what attracted me to
Village.
So, what gave me confidence investing in a supermarket? It was the knowledge that land that
could be developed for use as a big format supermarket was very rare in all of Village’s local
markets. Supermarkets do not compete across state lines. To compete in New Jersey, you need to
build a store in New Jersey. To compete well with a 60,000-square foot store, you need a 60,000-
square foot store of your own. I knew that no matter how eager competitors were to put such
stores in New Jersey – it just was not going to happen. Very few development projects along
those lines would ever be approved. Even if they were eventually approved, they would take
forever to actually get done. It did not make sense for a nationwide supermarket chain to spend a
lot of time and attention on trying to crack into the New Jersey market. It would be a lot of work
that would not move the needle for the corporation as a whole.
All three of these examples kind of focus on niches. I am willing to buy into almost any industry
as long as there is some “moat,” as Warren Buffett (Trades, Portfolio) calls it, that would insulate
the company from irrational competitive actions taken by competitors. I would buy Progressive
even though I do not like the insurance industry in general. I might buy Car-Mart even though I
do not like the car loan industry – although that idea has really been tested by the actions I have
seen competitors taking. And I would – in fact, I did in the past – buy Village even though I do
not like the supermarket industry. At the right price, I would even consider a supermarket
operator like Kroger, but it would have to be the right price.
I am really not going to invest in a company that I think is going to make less than 10% a year
after tax on its tangible equity. If a stock is really, really cheap – I would buy it even if the ROE
was as low as 10%. There is a catch though. The lower a company’s ROE, the more certain I
have to be it will achieve that return on equity. So yes, I would buy a very, very cheap
supermarket stock or a very, very cheap insurer or something like that if the return on equity was
in the 10% to 15% range. I would, however, still need to see some sort of insulation from
competition that proved to me the company would never end up with an ROE in the 5% range.
Obviously, a big structural advantage over competitors could do that. For example, I have looked
at Southwest Airlines (LUV, Financial) in the airline industry, Carnival (CCL, Financial) in the
cruise industry, Western Union (WU, Financial) in the cross-border money transfer industry and
Progressive in the auto insurance industry. Among major competitors, all of these companies
have the ability to survive a price war longer than the other players in the industry. It would be
difficult for Southwest to earn a 9% return on equity year after year for very long without other
airlines earning closer to nothing. So, having a structurally supported profit advantage – it is
usually due to scale and lower costs– over the competition would make me a lot more likely to
invest in a business in a bad industry.
Generally speaking, a good business in a bad industry needs to either be the clear market leader
or inhabit a niche others cannot invade. I would say the best niche is usually a local one. It does
not matter to the big four U.S. airlines how rational or irrational competition among European,
Middle Eastern or Asian airlines are. Southwest does not fly to those places, so it is possible to
invest in the market “niche” of major U.S. airlines even though I would be worried about
investing in airlines in parts of the world where passenger traffic is growing rapidly.
You will notice that in all these examples, I have focused on more “settled” industries. My
biggest rule as far as industry selection goes is to always avoid bad, immature industries. If you
have to invest in a bad industry, at least make sure it is a mature industry. The easiest way to go
broke is to invest in a business that is growing quickly and unprofitably. Airlines today might be
viable investments, but they were not in their fast growth phase. Likewise, I would never buy a
supermarket anywhere there is plenty of land to build a new one. I would only buy a supermarket
in a town where land is scarce.
So yes, you can invest in good businesses in bad industries. Always avoid young, bad industries
however. If you do invest in a good business in a bad industry, make sure the business is either
the clear market leader or occupies a niche that protects it from the bad behavior of its
competitors.
 URL: https://www.gurufocus.com/news/485589/buying-a-good-business-in-a-bad-
industry
 Time: 2017
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How to Tell Which Company Will Survive an Industry Downturn
“If there are two companies in good industries that previously have good records of
profitability, but currently their revenue is declining due to slowing down/temporary oversupply
condition in their business sector/industry, how do you determine which company will survive
once the sector recover vs. the company that will not survive. What parameters do you usually
look at?”
This kind of analysis is going to be more useful in situations where competition is very
direct. Warren Buffett (Trades, Portfolio) has talked about the test of asking how much damage
could you do to another company if you were given billions of dollars to do so? In other words,
if you gave me $10 billion, could I put a big dent in the number of units of Coca-
Cola (KO, Financial) sold this year? Or, could anything I do make Coca-Cola lower the price it
charges for its products? In that case, the answer is I could do very, very little damage to Coke,
and it would be hard for me to influence the amount Coca-Cola charges for its products.
Competition is indirect in situations where the customer retention rate is very high or the price
charged for the product is not frequently changed for competitive reasons. Competition is direct
in situations where we are essentially talking about a commodity. Two gas stations on opposite
corners of the same intersection are in direct competition. Meanwhile, two ad agencies are not in
direct competition. Competition between ad agencies isn’t very direct because clients usually
make two separate decisions. One, they decide to put an account “in review” and then two, they
choose – if they fire their existing agency – with whom to replace that agency. Price is often not
a major factor. Here we are going to be talking about those industries where an overzealous
competitor can do a lot of harm to a more rational competitor. We are going to be talking more
about things like auto insurance and less about things like advertising.
In insurance, GEICO and Progressive (PGR, Financial) have big advantages over many of their

competitors. Nonetheless, a competitor like State Farm or Allstate (ALL, Financial) can take
actions that would result in a much worse combined ratio for GEICO and Progressive for as long
as the company is underpricing its policies. In the long run, neither State Farm nor Allstate can
price policies profitably at a level that can do harm to GEICO or Progressive. Provided Allstate
or State Farm are willing to have underwriting losses year after year – they can certainly reduce
the profits of both GEICO and Progressive a lot. You can see this in the past record of these
companies.
Let’s talk about general signs you can look at that will tell you the difference between a marginal
player in an industry and the leader in terms of competitive factors like unit cost, name
recognition, etc. Probably the most general – though somewhat technical – measure you can use
in all industries is the variation in operating margin. A company’s operating margin is earnings
before interest and taxes (EBIT) divided by sales.
The variation I am talking about here is called either the coefficient of variation or the relative
standard deviation. It’s a dimensionless number. It has no unit. Basically, you can compute – or
rather, you can have Excel compute for you – the standard deviation in a series of past operating
margin results. The standard deviation itself is uninteresting. If a company had an average
(arithmetic mean) operating margin of 30% over the last 10 years and if the standard deviation in
that series was 10%, this is interesting for our purposes only in the sense that 10% divided by
30% is 0.33. In other words, the variation in this company’s operating margin is one-third. That’s
low.
But we aren’t looking at the absolute level here. What we care about is the order – when ranked
from lowest variation to highest variation – that the firms in the industry are arranged in. If we
are looking at producers of copper wiring in the U.S., and one firm has a coefficient of variation
(standard deviation divided by arithmetic mean) of 0.4 while another firm has a coefficient of
variation of 0.9 in its operating margin – we can be relatively sure the first firm is in a more
stable competitive position. It’s more likely to have the inside track.
Why? Well, that’s a little complicated to answer. Basically, firms tend to keep prices more stable
than a constant re-evaluation of their pricing power would suggest. In other words, a monopolist
may not be raising prices as quickly as theory says it could. However, you would be able to see
that when a monopolist does raise its prices, it sees little resistance to the price increase.
The rule of thumb is that firms don’t like to experience contractions in their operating margins.
They like to increase unit sales over time, and they like to do that at the same or possibly higher
profit in the future. This is a rule of thumb. It’s not perfect. But if you have five different firms in
the same commodity industry and you order them from the firm with the lowest variation in its
operating margin to the firm with the highest variation in its operating margin, I’d be shocked if
the firm with the lowest variation in its operating margin is in a weak competitive position.
Variation in the operating margin is really a measure of profit wobble. In a capitalist economy,
some firms tend to act as shock absorbers – they take a hit – and other firms tend to pass the
shock on to customers, suppliers and employees without themselves showing much sign of the
shock rippling through their industry, the economy, etc.
High variation in operating margins is like a seismic reading showing a shock at various points in
the firm’s history, the industry’s cycle and the overall macro-economy. The rule of thumb is that
the firm with the lower variation in its operating profit is the firm with the less marginal
competitive position.
There are plenty of other signs. Let’s stick to ones you can see at the corporate level. Try to find
as long a history as possible for all the companies in the same industry. If possible, even in 2016,
you want data from different firms in the same industry as far back as 1994. Why? Because this
will give you the best chance of having boom and bust figures for each company.
If most of the companies in a given industry were losing money in 2003, but the company you
are looking at was turning a profit – the company you’re looking at is more likely to be the
industry leader. A counter-intuitive sign you can often rely on is which company gets talked
about the most in the press, by analysts, etc. during a recovery. That company is probably in a
weak competitive position. A company in a strong competitive position will show less earnings
growth from the bottom of a cycle to the top of a cycle. In fact, in the midst of a boom period,
analysts and journalists and investors will often focus on the company with the weaker
competitive position and talk about how quickly that company is growing earnings relative to the
industry leader. They may not talk a lot about the speculative and cyclical nature of this growth.
Obviously, a supermarket that had a 1% margin in bad economic times and a 2% margin in good
economic times will show higher earnings growth than a supermarket that had a 2% margin in
bad times and a 3% margin in good times.
Note that the relative profitability of the firms here didn’t change. In fact, the leader always kept
a 1% profit advantage – which may be the result of a constant advantage in expenses –
throughout the recovery. If two companies have similar business models, you can also gauge
competitive position by comparisons of returns on capital, margins, turns and credit ratings.
Especially in an industry with economies of scale that can continue to be captured even at really
big size, the leading firm will be able to match the growth rates of weaker firms even while
having a higher credit rating. There could be noncompetitive reasons – purely financial decisions
made by a private equity owner, etc. – that explain financial strength differences. And this is
definitely a backwards-looking measure. But if you take something like the airline industry in the
U.S., it’s clear that Southwest (LUV, Financial) must have had a much stronger competitive
position than the other major carriers at some point. Southwest has much greater financial
strength than its peers. It owns a lot of its planes, it has a better credit rating, etc.
Now, let’s talking about industry-specific data. Some industries provide competitive information
below the corporate level. Airlines may tell you their cost per seat mile. A producer of copper
wiring may tell you its price per pound. GEICO and Progressive give you their combined ratios.
They also break the combined ratio down into the loss ratio and the expense ratio.
In some cases, it is easy to do direct comparisons. For example, in the airline industry costs are
well known. The same is true in the cruise industry. Carnival (CCL, Financial) and Royal
Caribbean (RCL, Financial) are comparable. You can always check which company has the
lower costs per passenger. In the cruise industry, ships always sail full. That’s an
oversimplification, but it’s not much of one. Price is relatively unimportant. A computer will
determine what price will result in maximum revenue without sacrificing any occupancy for a
specific cruise. What you need to know is the cost per passenger for the cruise line. The only
tricky part here – as with airlines – is that these firms don’t control their fuel costs. Oil is a
commodity. Jet fuel and bunker fuel is going to cost the same for everyone. I would suggest that
you segregate fuel costs from nonfuel costs. The lasting competitive advantage of one firm over
another has to be something internal. It can’t be driven by fuel costs.
Sometimes firms in direct competition have advantages other than price. Two examples are
batteries and money transfers. Duracell and Energizer and companies like Rayovac do compete
on price. But, no one buys Rayovac batteries when they are priced at the same level as Duracell
and Energizer. Basically, Duracell and Energizer (ENR) are full-price batteries and other
competitors are value competitors. They are unable to compete unless they charge less.
The same is true in money transfer. MoneyGram (MGI, Financial) competes with Western

Union (WU, Financial). We know that MoneyGram is – in many corridors – at a competitive
disadvantage to Western Union because of three figures it discloses or which it’s possible (with a
little digging) to turn up. Western Union is sometimes able to offer the same services as
MoneyGram at a higher price. MoneyGram may charge $9 for a certain money transfer whereas
Western Union will charge $10 for that exact same service. This wouldn’t happen unless
customers were not indifferent to the two brands at the same price. It turns out customers aren’t
indifferent. If you offer customers the choice of using MoneyGram or Western Union at the same
fee level, most customers choose Western Union.
The same is true of agents. If you look at what we know about signing bonuses paid to agents
and at the commission split between the payment processors and the agent, we can see that
MoneyGram has offered more lucrative terms to its agents than Western Union has. I’m talking
in the aggregate here. I’m sure there are some corridors where MoneyGram has offered the same
or even less attractive terms than Western Union. Overall we know that MoneyGram tends to
charge less for the same service as Western Union, it tends to offer a bigger signing bonus to its
new agents, and it tends to offer a slightly more favorable commission split to its agents. You
don’t charge customers less or pay suppliers (which are essentially what agents are here) more
unless you have a reason to do so. Western Union has greater market power than MoneyGram.
You can test this by digging up the kind of more basic competitive data like price, signing
bonuses and commission splits – or you can look at things like operating margin data. You can
also look at scale.
As a rule, you’d expect a company in a stronger competitive position to have higher transaction
volume per agent and a bigger agent network. In some industries, it’s complicated. Credit cards
are a good example of an industry with direct competition but where it’s complicated by the
different business models of the competitors. American
Express (AXP, Financial), Visa (V, Financial) and MasterCard (MA, Financial) all compete
with each other and with Discover (DFS, Financial). Who is in the best competitive position? By
some measures, it’s clearly Visa and MasterCard. By other measures, it’s American Express. By
no measure is it Discover. Discover is clearly in the worst competitive position. MasterCard and
Visa have some huge scale advantages. But American Express has scale advantages in terms of
transaction value per customer (that is, per card) and brand preference.
There are signs that American Express had been – at least in the past – able to offer less to both
its cardholders and merchants than MasterCard and Visa did. On the other hand, Visa and
MasterCard grew faster. The problem all these companies have – which you can find in industry
data – is that they have all tended to raise their rewards rates in recent years. That is a sign of
shifting power away from payment processors and toward credit card holders. It’s a bad sign for
the industry. Basically, it’s as if Duracell and Energizer were both flooding the market with more
coupons to sell the same number of batteries.
I don’t think it’s usually difficult to figure out which firm in a shrinking industry is in the
strongest positon. I mentioned before how both Barnes & Noble (BKS, Financial)
and Staples (SPLS) were clearly the strongest off-line players in their respective industries.
Likewise, if driverless cars eventually spell the doom of the auto insurance industry, it’s clear
that GEICO and Progressive will turn a profit for longer than other insurers. GEICO and
Progressive have a better business model than their competitors.
By almost all the signs I discussed here, GEICO and Progressive have the inside track in auto
insurance. If they pursued a suicidal strategy, they could inflict underwriting losses on other auto
insurers year after year. The reverse isn’t really true. Other auto insurers don’t have the financial
strength and the low costs needed to force GEICO and Progressive to continually lose money.
They can force GEICO and Progressive to have a bad year – but not a bad decade. They’d be out
of business long before GEICO or Progressive was out of business. The industry cost data is
really clear on that point. But even the corporate level financial statements are clear indicators
that GEICO and Progressive are the strongest competitors and will outlast the other players in
their industry if there is a multiyear price war.
 URL: https://www.gurufocus.com/news/483949/how-to-tell-which-company-will-
survive-an-industry-downturn
 Time: 2017
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How to Research Obscure Industries
“I enjoyed your podcast on how to research an industry. I wanted to ask whether you take
different approaches when it comes to researching a mature industry versus a growing industry.
I can find a good amount of information (through investor presentations and industry reports)
on growing markets such as e-commerce, but I struggle to find the same depth and breadth of
information for relatively mature industries such as apparel, shoes, etc."
The best source of information on an industry is usually the investor presentations of the various
companies that make up that industry. The 10-Ks are also useful. However, a 10-K involves a lot
of boilerplate. You need to know which parts of the 10-K – and even which specific lines – are
really, really important. I will give you an example. There is a line – or sometimes a whole
section – in every 10-K that will discuss the factors on which a company competes. In the
competition section of the 10-K, you will find a company say something like:
"The supermarket industry is subject to intense competition and is relatively fragmented. Like
most supermarkets, we primarily compete on selection, price and location. Some of the largest
competitors in our market area are regional supermarket chains such as Stop & Shop, Kings
and Wegman’s. In recent years, we have also experienced competitive pressure from national
and specialty supermarkets such as Whole Foods (WFM, Financial) and The Fresh
Market (TFM, Financial). Some of these competitors may have different business models from
our own, which may present unique competitive problems for us. In certain market
areas, Walmart (WMT, Financial), Target (TGT, Financial) and Costco (COST, Financial)
locations sell some of the same product ranges we do. However, management believes
competition with such retailers is limited."
That is not an exact quote from any 10-K, but it is very close to what you will normally read in
the competition section.
At some point, there will be a boilerplate line that says some of the competitors may have greater
financial resources or better name recognition. You can safely ignore this line. It is included even
in 10-Ks where it is completely meaningless. There are certain other nuances of which you
should be aware. In most cases, a U.S. company will overstate the intensity of competition in its
industry and understate its own competitive position. This is not necessarily true in other
countries.
It is important to start with an idea of what a typical, meaningless sort of “competition” section
in a 10-K looks like. Once you know what the standard is, you can quickly pick out any terms
that stray from that norm. For example, Nordstrom Inc. (JWN, Financial) includes “customer
service” as a key competitive factor. That is unusual for a department store. Almost everyone
includes “price” as a competitive factor. If you ever read a 10-K where the company does not
mention the word “price," that is critically important.
It is also important if the company includes competitive factors that are in some way unusual.
Most 10-Ks will not stress “credit terms” or “prompt delivery” or “order fill rates” or anything as
mundane and logistical as that. There are industries where that is important.
It is also important to notice limiting factors on competition. If a supermarket says customers are
generally unwilling to drive more than five to 15 minutes to shop for groceries, that is very
important. The company may phrase this in a way that makes it sound like a bad thing. For
example, they may say that because customers are unwilling to drive more than five to 15
minutes and it is difficult to find locations with sufficient parking, their growth may be
constrained by the lack of available places to put a new supermarket. You can look at that
limitation to the company’s growth and see that it is really a barrier to entry.
In some cases, the company will not make a big deal about barriers to entry in its industry. You
have to judge whether the tone of the information is promotional or conservative. For instance,
10-Ks are especially vulnerable to being full of nothing but legal disclaimers that do not really
mean anything. The company will often include nonmaterial risks. I have seen companies like
movie theater chains include global warming, SARS and even terrorism. This is wrong. In fact, it
really does not match the guidance they have been given on what is and is not a material risk. I
have also seen companies that do not need access to credit include risks to the financial system.
This is what makes reading 10-Ks difficult. They have a lot of nonsense in them that neither the
preparer of the report nor the user of the report actually believes is in any way material. It’s just
fine print that covers every possible negative occurrence the company could experience.
Obviously, the “competition” section is the most important part of a 10-K. And certain key
phrases like “a limited number of competitors,” “relatively high barriers to entry” and “compete
primarily on factors other than price” are the ones you want to look for. They’re rare. I’ve seen
10-Ks where even long established duopolies or oligopolies won’t really come out and say
competition in the industry is limited and market entry has been unheard of for decades. One of
the giveaways that an industry is very consolidated will be the company’s willingness to list
essentially all of its competitors in the 10-K. Hanesbrands (HBI, Financial) may actually come
out and say we compete with Fruit of the Loom and other lesser-known brands. Or Energizer
may say we compete with Duracell, Rayovac and other lesser-known brands. The most useful
information is when a company gives information about market share, actual brand names and
competitive strategy of either itself or its competitors. For example, a company may describe
pricing positions in the 10-K saying that Energizer and Duracell compete on factors besides
merely price while Rayovac openly positions itself as a “value” brand with performance similar
to the leading brand and a lower price.
There will also be some talk of distribution. This is critically important. You want to know who
sells a company’s products. The seller of the product is going to be a key source of industry
information. It’s very important to know if Sherwin-Williams (SHW, Financial) is sold mostly
through Sherwin-Williams stores or through places like Home Depot (HD, Financial).
The most useful report you will ever find is the presentation that accompanied a company’s
going public – or being spun off – in the first place. Always go to EDGAR and search for an “S-
1” or something similar. I always go back in time to find the very first filings a company ever
had. It doesn’t matter if this information is from the company you’re interested in or a
competitor. In both cases, it will be useful. The reason this document is so helpful is that it often
explains the business model and the industry structure to analysts who might not otherwise
understand what to expect from the company.
To give you an idea of how boring and mature an industry can be and still provide useful
information, I read a pretty good investor presentation on the school bus manufacturing industry
in North America and another pretty good investor presentation on the potato processing (like
french fries, tater tots, etc.) industry. In both cases, a newly public company decided to devote a
lot of its presentation to explaining an industry that might otherwise be obscure. Actually,
industries no one knows anything about often have good information.
The problem is usually when you are analyzing a company that does something very specific in a
big industry group. Aerospace is a good example. IT is another good example. There are tons of
analysts that cover these industry groups. If you find a company that makes some specific part, it
may be hard to find much out about that part.
When Quan, my newsletter co-writer, and I were writing the newsletter, we picked a company
called Breeze-Eastern (now private). It made rescue hoists for helicopters. The helicopter
industry is huge, but most helicopters aren’t involved in search and rescue operations. You can
find a ton of information about companies that supply helicopters to NATO militaries and even
some information about helicopters used to fly people back and forth from onshore and offshore
locations. But, there isn’t any discussion of search and rescue hoists. We had to find decision
makers who had something to do with the actual training of search and rescue crews to
understand the industry.
We didn’t have a great understanding of Breeze-Eastern until we were able to find contact
information for something like state police, firefighters, etc. We didn’t pick Q-Logic (no longer
public). We would have had a similar problem with Q-Logic. That company makes what is
essentially a small part of big projects. It was easy to find information on the end customer and
on the companies that provided the overall setup. It was more difficult to find information on the
reasons why a company would choose to use Q-Logic’s product or a competitor’s product. The
most difficult part in that case was understanding technological change. We were able to gather
enough information to understand Q-Logic’s competitive position provided everyone always
chose to do something a certain way. If some larger scale decisions were made differently, we
had a hard time knowing what that meant for Q-Logic. It was a small part of a big ecosystem.
I would suggest reading all the 10-Ks and investor presentations and especially the initial filing
documents for every company in a mature industry you are interested in. My next suggestions
would be to try to find the customers of this industry. If you are interested in apparel or shoes,
can you find the wholesalers or the retailers who buy these products? What do they say about
their suppliers? Do they list their largest supplier? Do they talk about their dependency on these
suppliers? Can you find people inside these companies – buyers – to talk to? People are always
happy to tell you about what they do and why they do it. I get emails from individual investors
all the time who ask: “how can you get people to talk to you?” If you find people who make the
decisions to buy Stressless recliners or Hunter Douglas (XAMS:HDG, Financial) blinds for
their store or carry Progressive insurance at their agency or outfit the department’s six
helicopters with Breeze-Eastern rescue hoists, they will be very, very happy to tell you exactly
why they made the decisions they made. They’ll volunteer information about their contacts at the
supplier company and whether who tends to call the other and how often they talk and whether
the suppliers are better or worse than the last guys were and all that stuff.
The same is true, by the way, of branch managers for any kind of store. Store managers are
always eager to tell you what corporate is doing right and what it’s doing wrong and who the
easiest customers are to sell to and who the hardest are. If they’ve worked at more than one
location, they’ll be happy to tell you why it was easy to run location and hard to run the other
one. Remember, no one outside of the company ever asks this person about what they do all day.
A store manager’s husband may ask her what her day was like. But, even he’s not really going to
ask which kind of customer is best and how easy or hard it is to retain good entry-level people
and all that sort of stuff. I mean, we did a newsletter on Grainger (GWW, Financial) and
on MSC Industrial (MSM). I’m sure the plant manager of a machine shop that uses MSC has
never talked to anyone outside the company about why he made that decision. He’ll be happy to
get a chance to talk to you about it.
A lot of investors who haven’t tried what Phil Fisher called the “scuttlebutt” approach have
trouble believing this. Why will someone tell you about their job? Why will they tell you what
their company is doing right, what it’s doing wrong, who the best competitor is, what
competitors are better at, what their company is better at, etc.? It’s what they do all day and no
one talks to them about it. People like talking about themselves and their jobs. If you seem
informed, interested and nonjudgmental, they’ll tell you lots of stuff. Some people won’t.
Generally, people at bigger companies and more visible companies won’t talk as much to you.
Some people will refer any contact you attempt with them to investor relations.
I only have a few specific hints to offer. One is to read Fisher’s writings. Another bit of advice is
to always tell any contact you make that under no circumstances will you short the stock (this is
always true for me so I don’t mind promising it) and that you will never reveal the source of your
information. Also, it’s a very good idea to demonstrate your knowledge of the industry, the
company and even the job of the person you are talking to right off the bat. You can use sites like
Glassdoor, ads for open positions at the company, and self-descriptions (on social media, etc.) by
employees and especially ex-employees of what their position entailed. The more someone
thinks you know ahead of time, the more they’ll tell you things you want to know.
You’ll also find this tip from Fisher. He mentions not talking to top management until you’re
nearly done with all your other research. I agree with that. There’s little use in talking to people
high up in an organization until you know a lot about the company already. The more you know
before going into an interview, the more you’ll get out of that interview.
Personally, I don’t find it helpful to talk to top management. And I’ve learned how to do the kind
of research you get out of the “scuttlebutt” approach without actually doing it. I’ve heard Warren
Buffett (Trades, Portfolio) say something similar. He did a lot of scuttlebutt in the past but now
gets enough of the same info just from the way he’s learned to interpret the publicly available
documents, etc. That’s very true. The more scuttlebutt you do, the more you find you don’t really
need to do scuttlebutt if you just learn to read between the lines more than most investors,
analysts, etc., do. Almost all the facts that matter are right there in earnings calls, 10-Ks, investor
presentations, interviews with the CEO, etc. You just have to do a lot more inferring than most
investors do.
 URL: https://www.gurufocus.com/news/478229/how-to-research-obscure-industries
 Time: 2017
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Should You Ever Invest in a Shrinking Industry?
“What are some of the most interesting investments in particular classes such as deep value,
quality/moat, cheap cyclicals or special situations that would be interesting to recount? How do
you position your own portfolio? Do you solely invest in moat businesses?”
I don’t have a rule where I only invest in moaty businesses. I’d be willing to invest in other kinds
of businesses if I have confidence that the investment would work out. My style doesn’t have to
do with moat specifically. I don’t consider myself either a high quality or a deep value investor. I
don’t consider myself mostly a Warren Buffett (Trades, Portfolio) or Ben Graham type investor.
I just think in terms of 1) What will the business look like in five years? And 2) What would an
acquirer pay for the business at that time? A value stock could qualify under this approach. I
definitely look at companies that most people don’t consider “high quality.” Although, to be
honest, the lack of quality usually has to do more with the lack of growth or with being in a
“buggy whip” type industry. It rarely has to do with having a poor competitive position, being a
marginal player in the industry, etc.
Let me give a few examples. I owned shares of Barnes & Noble (BKS, Financial). The company
with the best position overall in book retailing (both printed and e-book) was
probably Amazon (AMZN, Financial). This was back in 2010 that I made the investment,
therefore the situation was somewhat different than today. But, still, I’d say that Amazon had the
best future in book retailing and Barnes & Noble had the second-best future. There were
companies in a much worse competitive position. For example, I expected Borders to end up in
bankruptcy and close most of its stores. That’s what happened. Overall, I expected the total
amount of shelf space dedicated to selling books would decline over time. I didn’t expect people
to buy more books in the future than they had in the past. But, I did expect Barnes & Noble to be
one of the biggest - along with Amazon - sellers of books five years down the road.
This investment didn’t work out for me. The biggest reason for that was my miscalculation
regarding capital allocation. I had valued Barnes & Noble by putting a positive value on the free
cash flow that the stores would produce over the next five years or so - while I expected to hold
the stock. I added up the amount of free cash flow I expected the company’s stores to produce -
in aggregate - over the next five years. I tried to guess how much the company’s stores would
still be producing in five years. Or would they be bleeding cash? That’s the calculation I did. The
answer I came up with was that the retail stores were capable, even with declining sales of print
books, of producing free cash flow that would add up to more than the market cap of the
company. In other words, if Barnes & Noble wanted to, I thought it could simply pay out more in
dividends to shareholders from 2010 through 2015 than new shareholders (buying into the stock
in summer 2010) would have to pay for the entire company. So, over five years, you could get
paid back everything you put into the stock and you’d have this leftover bookseller who I
thought would still have market share behind only Amazon in the U.S. book business.
What went wrong? Barnes & Noble took the free cash flow from the cash cow stores it was
milking, and then invested that milk in the Nook. The Nook was a failure that lost a lot of
money. The free cash flow from the declining print book business was never used to the benefit
of shareholders. Instead, the company could have just had a bonfire and set all that cash from the
stores aflame. The result would have been about the same for shareholders. Did Barnes & Noble
have a moat? I wouldn’t say so. But, I’m not sure thinking about moat mattered much here. I
didn’t expect anyone to seriously want to enter the print book business, and I didn’t expect
anyone who wanted to enter the e-book business without being in the print book business to have
success. I figured that Amazon and Barnes & Noble had a lot of the total market - print and
digital - for books in 2015 and that Amazon and Barnes & Noble would have a lot (maybe more
in fact) of a market that could be smaller in 2015.
Here, it might help to make a distinction between “moat” and “competitive position.” I don’t
necessarily care about moat. I certainly don’t care about the concept of “barriers to entry” as
being the only way a company can be successful. In the case of books, I felt the market was
settled and it wasn’t attractive to new entrants. Was there a moat? I didn’t think that mattered.
It’s not like Barnes & Noble or Amazon could open a new store and get a decent return on their
investment. Capital wasn’t going to be added to this business. I thought the print book retailing
business wasn’t going to become more competitive in the future and that it might become less
competitive.
A current example of this is Staples (SPLS, Financial), a stock I don’t own. But, it’s a stock I’ve
followed. I’ve been very interested in the company. Why? Because I think the amount of selling
space dedicated to the sale of office products will decrease. Staples wanted to merge with its next
biggest competitor. This was banned by the government. But, it shows this is an industry that the
main players want to see consolidate. They aren’t focused on growth. They’re focused on
reducing costs and reducing competition. Staples has this idea that it can reduce the size of each
of its stores by a lot, almost 50% in terms of square footage. Yet this should still allow them to
capture 90% of the sales they were making before. If that’s true - and I think it might be - that’s
great for the per store economics. A lot of the sale of office products has already gone online. A
lot of Staples' profit already comes from a combination of two activities that are different from
what other retailers do.
The first profit source is its business customers who get deliveries from Staples directly (instead
of shopping at the company’s stores) under a contract. This isn’t quite an MRO type business
like Grainger (GWW, Financial), MSC Industrial (MSM, Financial)
or Fastenal (FAST, Financial), but it isn’t exactly just a pure in-store retail business either. The
second profit source is people who go to Staples stores but just place their order at a Staples
kiosk - basically an online order - instead of buying the product and checking out physically in
the store. Now, if you are doing deliveries and kiosks, you don’t need a lot of square footage. If
you are one of the strongest competitors in a shrinking market, you are going to have competitors
closing their stores in your area. You'll have these forces at play that should help you increase
sales per square foot.
There are few trends that benefit a business more than the ability to increase sales per square
foot. So, if I really believed that Staples was going to have higher (real) sales per square foot in
2021 than it does today, I’d be very interested in buying the stock. If you look at recent free cash
flow results at Staples and the company’s enterprise value, you could be talking an adjusted P/E
of 9 to 11. The company might be trading pretty close to a 10% free cash flow yield already. If
that’s true, you don’t need any growth to do well in the stock. Now, you do need to avoid any
sales shrinkage that would cause deleveraging in the operations of the business such that
earnings declined faster than sales. If you could have sales at around 0% growth and costs
actually declining by a percent or two a year - well, then, you could justify an investment in the
company over the next five years. If earnings had been growing over the last five years, even
while sales were not, and the company had a solid financial position, I could imagine a private
equity or other acquirer being interested in the company in 2021 at a fair multiple. In that case,
Staples would meet my criteria.
The Staples situation is a little trickier than I just laid out. The biggest issue here is, of course,
capital allocation. Staples has done some things recently that make me think they are doing the
things I’d do if I controlled the business. When I was writing the newsletter, my co-writer Quan
and I talked about what we wanted to see from Staples. It was pretty simple. We wanted them to
merge if they could. We wanted them to stop opening stores. We wanted them to shrink the size
of existing stores and/or move them to lower rent locations wherever possible, and we wanted
them to exit all the non-U.S. businesses.
Staples has some big advantages in the U.S. Three of the biggest advantages are: 1) a great
national distribution footprint (very few companies have distribution centers around the country),
2) a large number of contracted business customers and 3) a website that is already doing a huge
amount of sales relative to competitors. If Staples.com was its own business, it would actually be
one of the bigger e-commerce sites around. The company doesn’t have these advantages in other
countries. We really wanted to see them exit the U.K., continental Europe, etc. Recently, Staples
has moved in that direction. It looks like it has been planning to exit those businesses.
The other thing we wanted to see Staples do is pile up some cash and not have any debt so that it
was financially sound despite declining sales. Then the company could focus on paying out
everything it could in dividends. We really didn’t want to see Staples acquire any other
businesses outside of office products in some sort of attempt to stay relevant with retail stores
that weren’t going to be obsolete. We didn’t want to see that because we think all retailers - or
almost all retailers - are subject to much the same risks Staples has already survived. Almost all
other retailers are in more competitive markets than office products. In the long-run, I expect all
retail products to see the same erosion of their business that office products saw first. Yet there
are many more players in other retail fields. Staples is more similar to Barnes & Noble. It
dominates what is left of the office products industry. So, I’d much rather Staples return free
cash flow to shareholders or - and this is by far my second choice - simply buy back its own
stock. I’m very scared that Staples will actually use free cash flow from its office products retail
business to buy other types of retailers. That’s something I don’t want to see.
It’s the main reason I’ve never invested in GameStop (GME, Financial). GameStop is

comparable in some ways to both Barnes & Noble and Staples. It’s a business that would catch
my attention. But, my fear with GameStop is that it will take the free cash flow from its video
game retail business (where it has a strong competitive position) and invest either through
acquisitions or through opening new stores, remodeling old stores, into other businesses like
AT&T stores and those sorts of things. Here, the company’s capital allocation history has me
worried. That doesn’t mean GameStop is making a mistake. It just means GameStop is moving
out of something that seems more settled, even if it’s doomed to shrink, and where it’s clearly
the leader into other stuff where I’m less sure what the competitive situation will be.
This is what Coinstar, now Outerwall (OUTR, Financial), did. I owned stock in Coinstar when it

was really just a coin counting kiosk company. I liked the business. I thought the product
economics and competitive position were excellent. I had no idea where it could possibly spend
all its free cash flow. And that turned out to be a problem. The company got involved in things
with better growth prospects, notably RedBox. DVD rental became a huge growth business and
then that business collapsed. DVD rental was supposed to be the new, durable route compared to
coin counting. If you look at the Coinstar part of the business, it was always more predictable.
It’s the same pattern, but leading to a less destructive outcome that we saw with Barnes & Noble.
I thought I understood how much free cash flow Barnes & Noble’s retail stores would produce
over the five years I planned to own the stock. Then I thought I knew it would still be in the top
two (along with Amazon) of booksellers at the end of those five years. I didn’t think there were
going to be new entrants. I thought I knew who the leaders would be and that the leaders would
still have a lot of market share. But, I didn’t predict that the free cash flow from the retail stores
would go into Nook. Once I realized that was what was happening in a big way, I sold Barnes &
Noble.
The same thing many years earlier happened with Coinstar. Once I realized it really was
becoming a DVD rental company, I sold that stock. For shareholders, the outcomes were
different. But, to me, both companies became “un-understandable” once they moved away from
the original cash cow business I understood. I understood the competitive position of Barnes &
Noble’s retail stores and Constar’s coin counting kiosks. I didn’t understand the competitive
position of either the Nook or Redbox. So, I sold those stocks. I didn’t have a clue what those
businesses would look like in five years.
So, would I buy GameStop or Staples? If I really thought I knew what they would look like in
five years and what an acquirer would be willing to pay for that, yes, I would. I don’t need
growth. For example, if Staples could pay out close to 10% of its share price in a combination of
dividends and share buybacks over each of the next five years and then the multiple an acquirer
(or the market) would pay for the company in 2021 was higher (something like 15 times earnings
instead of 10 times), then you have a good, solid profit potential there. I don’t think other
companies want to enter the office products retail business. Honestly, I don’t even think Staples
or its next biggest competitor really want to grow their square footage. So, I think competition
will be muted. The economics of the business could improve even if the size of the market is
smaller in five years than it is today. So, here we have an example of a “decay” instead of a
“growth” company. And yet, yes I’d be willing to buy it.
Do I think I will buy Staples? Probably not. The reason for this is that if I compare Staples to
something like Howden Joinery - a U.K. building products retailer (for trade accounts only) - I’d
say I like Howden better. Howden is more expensive, at least 50% more expensive by my math.
However, I feel a lot more certain that Howden will be making more money in 2021 than it is
today, than I am that Staples will be making more money. However, the reason for this isn’t
industry growth. It’s just that Howden has 600 stores now and I believe them when they say they
can reach 800. And then I know it takes a really long time for Howden locations to reach their
full sales potential.
When I run those two assumptions through my model of what the company would look like in
2021, I get a much higher rate of growth in earnings per share than in total sales. As odd as it
sounds, I actually analyze Staples and Howden the same way. Howden is a “growth” stock and
Staples is a “value” stock in a buggy whip industry. Howden is 50% more expensive right now.
But, my focus in both cases is really on what I think the companies will be earning in five years
and what an acquirer would pay for a business earning that much in 2021. Howden is easier for
me to see a path to 10% to 15% annual returns over five years. Staples might be capable of that.
But, it really depends on capital allocation. With truly ideal focus and capital allocation on the
part of management, Staples could be a good investment even though it’s in a dying industry.
But, remember, I felt that way about Barnes & Noble. I still feel that way about Barnes & Noble.
If it had been more focused, more disciplined in capital allocation, and ignored e-books, I think it
could have paid off for shareholders from 2010 to 2015. The price in 2010 was cheap and the
retail stores produced good free cash flow. Barnes & Noble didn’t work out for me. But, that
doesn’t mean I would never consider a situation like Staples. I am considering Staples. Right
now, it’s just that I consider Howden Joinery to have an easier to foresee five-year future than
Staples. Therefore, I’m more likely to buy Howden next rather than Staples. But, I’m definitely
open to the idea of buying a retailer in a shrinking industry. I don’t require a growing industry.
The good thing about a shrinking industry is that it’s often very settled competitively.
Competition often decreases in a shrinking industry instead of increasing. I love investing in a
business where I think competition will decrease over the time I own the stock.
 URL: https://www.gurufocus.com/news/477233/should-you-ever-invest-in-a-shrinking-
industry
 Time: 2017
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How to Research an Industry
“One thing I was wondering about was how you conduct industry research? Do you study
industries in a general sense (if so, where do you find the info) or do you just accumulate
industry knowledge by reading a ton of 10-K’s and Annual Reports across a given industry
group?”
When I research companies, I do it in groups. For example, say I’m only interested in American
Express (AXP, Financial) and Discover (DFS, Financial) right now, because they are the only
credit card stocks that look cheap. MasterCard (MA, Financial) and Visa (V, Financial) look
too expensive. I’m not saying that’s true. This is a hypothetical. But, it illustrates my point well.
Some investors would just read about American Express if they knew American Express was the
only stock in the group they might buy. I don’t do that. I’d research American Express, Discover,
MasterCard, Visa, and maybe one other peer at the same time. In big industries, I can’t research
everything out there at once. But when Quan and I were writing the newsletter, our standard
routine was to pick five peers for every company we analyzed. Doing that required us to always
come up with the five public companies that were most similar to the one we were interested in.
This provides a list of future candidates for investment. It also gives you a way of learning about
the industry.
We picked two different MRO distributors – Grainger (GWW, Financial) and MSC
Industrial (MSM, Financial). We also looked at Fastenal (FAST, Financial) about as seriously
as those two. So, what I know about the MRO industry really just comes from reading the 10-Ks,
investor presentations, etc. of those three companies. We researched each of the three as serious
stock ideas. We only picked two of the three. We never picked Fastenal. But, looking at Fastenal
helped us understand Grainger and MSC.
This approach was very useful in looking at banks. It was difficult for Quan and I to start picking
banks, because these stocks were different from other stocks we’d looked at in the past. We
needed a whole different way of estimating the earning power of these companies. It became
easier to analyze banks as we went, because a lot of these banks are a lot like each other. One of
the first banks we wrote about was Frost (CFR, Financial). One of the last banks we wrote about
was Bank of Hawaii (BOH, Financial). Frost and Bank of Hawaii are pretty similar. I like Frost
a lot more than Bank of Hawaii. But they both make money in much the same way. Most of the
Excel sheets, ways of appraising the company and possible risks were really the same at the two
banks. It was easier to write about Bank of Hawaii because we’d already written about Frost.
Now, Bank of Hawaii is in Hawaii and Frost is in Texas. So, Bank of Hawaii and Frost aren’t
competitors; they’re peers.
The easiest way to motivate yourself to do serious industry research is to actually believe you
might buy these other stocks one day. So, if there’s a decent chance you might one day buy
MasterCard or Visa at the right price, it’s going to be easy to do great research on American
Express’s peers. But, if you don’t see any way you’d ever buy any credit card stock except
American Express, then it’s harder to motivate yourself to put in the work. So, it was easy for us
to do industry research in banks. I knew I might actually one day buy Frost, Prosperity, BOK
Financial, Commerce, UMB Financial and Bank of Hawaii. It was easy to put in the time to learn
about those companies. Likewise, it was easy to put in time researching MSC Industrial and
Fastenal when we were writing an issue about Grainger. Knowing I might, at the right price, be
willing to invest in either MSC or Fastenal made that research easy to do.
It’s harder when you are researching peers you know you will never get the chance to buy. For
example, we wrote an issue about Progressive (PGR, Financial). In the direct channel,
Progressive’s closest peer is GEICO. The company’s second closest peer in the direct channel is
USAA. These aren’t standalone publicly traded companies. So, I was never going to get the
chance to buy either GEICO (a Berkshire Hathaway company) or USAA. I also knew that I
wasn’t going to buy stock in other insurers that had a very different business model like Allstate
or State Farm. Researching Progressive’s peers was more of a slog compared to researching
Grainger’s peers. When researching Grainger, I knew I might turn up another good stock idea or
two in MSC and Fastenal. When researching Progressive, I knew this was impossible. My
research would either convince me to buy Progressive or not. It wouldn’t lead me to any other
great stock ideas. So, I’ll admit it’s tougher to motivate yourself to do the same level of industry
research when the other companies in the industry aren’t viable potential investment
opportunities.
I still try to do it, though. Quan and I wrote about Village Supermarket (VLGEA, Financial),
which operates Shop-Rite supermarkets in New Jersey. The stores are pretty big, averaging more
than 60,000 square feet. And almost all of them are located in New Jersey, the most densely
populated state in the U.S. The closest peers for Village were other Shop-Rite operators (which
aren’t public), Wegman’s (which isn’t public) and maybe Kroger (KR, Financial), which is
public. Quan and I also tried to learn as much as possible about Publix. That company isn’t
publicly traded either. There were a few previously publicly traded supermarkets that might have
been decent peers. We usually didn’t include a lot of information about companies that were no
longer publicly traded in the actual issues of the newsletter we did. But, it’s something we looked
at.
A lot of supermarkets get acquired by bigger chains. Therefore, it can be helpful to see what
multiples different buyers paid for the chains they acquired. This wasn’t directly applicable to
Village, because Village is part of a co-op (Wakefern) that controls the Shop-Rite name. An
acquirer couldn’t really buy one Shop-Rite operator and integrate it into their operations in the
same way they could acquire other chains. So, the value Village would have to an acquirer like
Kroger could be less than you’d think. Of course, the value to a financial buyer who didn’t want
to change the way the business was run wouldn’t be different than you’d expect. It might still
matter what different buyers had paid for supermarkets with strong positions in other parts of the
country. We certainly looked at all the deals that had been done in the supermarket industry in
the last 10 years or so.
Let’s assume you want to take this same approach to industry research. First, you find a stock
you might be interested in, and then you do your best to seriously research all the publicly traded
peers you can find. If you’re interested in Omnicom (OMC, Financial), you’d also
research Interpublic (IPG), Publicis (a French company), WPP (a U.K. company) and Dentsu (a
Japanese company) at the same time. There are other companies you might want to look at, too.
It would depend on how interested you were in different parts of the business. But there are
companies out there like Havas, Saatchi and Brainjuicer, too. Some of these are a lot less
comparable to Omnicom. But the best way to learn about some specific part of a big,
complicated business is often to read everything you can about a smaller, simpler business doing
the same thing.
Let’s go back to that American Express example. In some ways, American Express is actually
pretty complicated. The company has more of a fully integrated approach than some of its
competitors. Although MasterCard and Visa are huge, they aren’t doing as much in each
transaction as American Express is. MasterCard and Visa have a different focus than American
Express. Discover also has a different focus. This will come out clearly in the investor
presentations and the earnings calls. Analysts will zero in on those parts of the business they
think will most influence the earnings estimates they will come up with for the company. The
downside to this is that earnings call transcripts often aren’t that useful. Using the American
Express example, analysts may be really interested in co-branded deals like the Costco deal that
American Express lost. This won’t be of much interest to a long-term investor.
I remember this issue when I was looking at Omnicom (OMC, Financial). Analysts were very
interested in whether (and when) Omnicom would lose the Chrysler account. At the time, this
might have been Omnicom’s single biggest account. I don’t remember exactly. But, it’s not
important. Because I can definitely tell you that Omnicom’s single biggest account wasn’t
actually that big when compared to the entire company. Omnicom was never going to lose 30%
to 50% of its business by losing a single client. It might lose 3% or 5%. But then it might be in a
better position to win business in that same industry. And, of course, the overall increase or
decrease across all clients is often 3% to 5% in a year anyway. Just the cyclical nature of the
business could disguise the loss of a big client.
This is why I don’t find earnings calls as useful as investor presentations. 10-Ks are great.
Earnings call transcripts are sometimes useful. But, if you’re only going to read one document
from each company, read an investor presentation from each of them. If the companies in the
industry are all large and publicly traded, they may all have done an investor presentation at
some time. I strongly recommend you download an investor presentation – the most recent one is
fine – from each of the publicly traded companies in the industry. They are short. They are easy
to read (they’ll be in slide form). And they’ll often have some data about the company’s own
market share and the market share of competitors. They’ll also have data on sales by geography
and sales by product categories. This can help you get an overview of what each company in the
industry does. How are their business models different? What are their relative strengths and
weaknesses? What do they each focus on?
Of course, the most important information is what the management of all the companies agree
on. If they all agree price is important or delivery speed is important or something like that – you
can bet that’s true. They will all try to paint a rosy picture of the industry. And they will usually
try to paint an especially rosy picture of their company relative to competitors. That kind of
information isn’t going to help you much. But, the more you read about all the companies in the
industry – the less you’ll fall into the trap of only focusing on what management is telling you.
You’ll be able to see the other side of what they’re doing and why they might be doing it.
This is especially true when you are looking at companies who have different business models. If
you just look at Visa or MasterCard, you won’t have a very full picture of the industry. But, if
you pick either Visa or MasterCard and then American Express and Discover to look at - now
you’re going to be reading a lot of talk about which business model is better and why. This will
help you get a complete picture of what each business model is really all about. The important
thing is understanding the different business models. It’s not about deciding which is best and
which is worst.
For example, Quan and I researched Fastenal, MSC Industrial Direct and Grainger. We never
came to a conclusion about which of those three business models is best and which is worst. But
we came away with a much better understanding of each of the three companies because we
studied the other two peers at the same time.
My advice on industry research is not to do it. Always think of an industry as a group of

individual companies that you can study. Don’t think of the industry as this big, amorphous blob.
Instead of trying to research the credit card industry – research Discover, Visa, MasterCard and
American Express all at the same time. You can learn about an industry without ever having to
do research apart from a specific stock. That will keep you motivated. It will keep you engaged.
And it will keep you focused – not just on a specific industry, but always on a specific stock you
might one day buy if it gets down to the right price.
 URL: https://www.gurufocus.com/news/463616/how-to-research-an-industry
 Time: 2016
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Talking to Competitors Is More Useful Than Talking to Management
“As a private investor, I try to analyze those companies where I might find an informative
advantage of any kind, and it is usually in micro, underfollowed companies where it is easier to
find (while access to management is better). The problem with these companies is that
information about their business model, their industry, their products, etc. is usually scarce,
which makes talking to management quite necessary.
Even when within my circle of competence, my main concern is that, as more commonly
management is heavily biased towards the company, I am afraid I will buy their “wonderful
equity story.” Especially since I cannot contrast that information, as it is scarce in the first
place.
How do you avoid getting lured by management? Maybe using checklists? What kind of
questions do you want answered and how do you ask them? How much should you rely on their
answers? How do you contrast the answers?”
Thanks for your question. I do not rely much on talking to management. In fact, I prefer not to
talk to management. I know a lot of value investors feel differently. I can think of some
situations where reading what management said in earnings call transcripts, etc. over a long
period of time did help me understand the business. However, I cannot think of any cases where
talking to a member of management myself was useful. So, I’m not as much at risk of falling for
a “wonderful equity story” as many investors might be. I do, however, read investor
presentations. I do get management’s take in shareholder letters, press releases, earnings call
transcripts and investor day presentations.
There are a few ways to avoid being taken in by management’s enthusiasm. One very good way
of doing this is to research stocks in peer groups. Say I’m interested in Southwest
Airlines (LUV, Financial). I do not have any interest in buying another U.S. airline. How can I
be more objective? I can research
Southwest, American (AAL), United (UAL), Delta (DAL), Alaska (ALK) and JetBlue (JBLU)
all at the same time. When Quan and I were writing "Singular Diligence," we always picked five
peers to compare to the stock we were interested in. There are a few reasons for doing this. One,
it lets you see if it’s just this stock that is cheap or if the whole group is cheap. Two, it gives you
a better understanding of the industry. Three, it lets you see if there is a better business in the
group than the one you are looking at.
Picking the right industry is very important to me. Sometimes, it can be more important to pick
the right industry than the right business in that industry. You need to pick an industry where
competition is not going to destroy even a good business with a rational, long-term oriented
management team. We picked Car-Mart (CRMT, Financial) for the newsletter. That’s an
example of a good business in a potentially not so good industry. When we researched that stock,
we found no evidence that other competitors in the industry – especially those who extend more
and more into subprime auto loans when credit is loose – are good, rational competitors. Our
biggest worry with that stock is the damage that irrational competition can do when credit is too
loose. Car-Mart is not insulated from competition. It will lose business if competitors make loans
they should not. This is not true of something like the advertising industry. In the ad industry, as
long as the management team of the company you are looking at is doing its best to grow
intrinsic value – the stock will do okay. Competitors cannot do much harm to each other in the
advertising business. They can do a lot of damage to each other in the subprime auto loan
business.
Sometimes you cannot find a lot of peers. Sometimes you can. It was easier for Quan and I to
find peers for banks, MRO distributors, watchmakers and ad agencies. We really could not find
any peers for “hidden champion” type companies like Tandy (TLF) and Breeze-Eastern (no
longer a public company). The more niche a company is – the harder it is to find peers. This is a
problem because very niche businesses are often very good businesses. Even with a company
like Car-Mart, it was not easy to find real peers. None of the other subprime auto loan companies
we could find had as high charge-offs as Car-Mart. We could not find any businesses that lend to
as uncreditworthy customers as Car-Mart. In fact, that was one of our reasons for liking the
stock. Although you could easily securitize subprime auto loans – we did not think it would be a
good idea to securitize the kinds of loans Car-Mart makes. Car-Mart’s loans have such different
loss rates and require such hands-on collections that it is hard to imagine other holders of that
debt having as good an outcome as Car-Mart gets. We did not think it was safe to securitize the
kinds of loans Car-Mart makes, but we could not prove that was true. We could not find detailed
information on any company that was enough of a true peer to Car-Mart to know a lot about this
business other than what Car-Mart’s management told us.
In cases where competition is not very direct or very intense, peers can sometimes provide
information about each other. For example, we learned a little reading about Prosperity (PB)
and Frost (CFR, Financial). They are both big Texas banks. And, in fact, Prosperity’s
management said that when there is a bank up for sale in Texas, the first bank to get a call is
probably Frost. Then Prosperity. Frost gave some vague information that suggested it sees a lot
of deals and makes very few. But Prosperity has done a lot of deals. Prosperity says that they
think they are the second bank you call in Texas when you are looking to sell – and that maybe
Frost is the first bank people call. Based on that, we know that Frost passes on a lot of deals. I am
sure I could find a quote somewhere that has a Frost CEO saying something like “We pass on a
lot of deals”. But it’s not as convincing as when Prosperity says that Frost probably sees as many
deals as they do and does not acquire as much. Other industries like ad agencies, MRO
distributors and direct auto insurers (Progressive and GEICO) fall into this category of peers that
are willing to talk about each other honestly. We talked to some people at the different MROs.
They all said they had the best business model. Grainger (GWW, Financial), MSC
Industrial (MSM) and Fastenal (FAST) all have different business models. They have different
levels of online and offline businesses. Some – like MSC – ship very directly without using
stores at all. Others, like Fastenal, make small-format stores near the customer a big focus. They
even want to grow them. These peers will talk in detail about why – at least for them – their
system is more economical than if they adopted the competitor’s system.
Now, I will be honest with you. Quan and I ran all the cost numbers we could on Grainger, MSC
and Fastenal. The truth is we never could come to a conclusion about which model has lower
costs. They have different types of customers. In each case, shifting somewhat away from their
specific system and adopting aspects of their competitor’s system would probably increase costs.
They developed along with their customers. And they tend to be especially good at efficiently
serving their specific customer types. If they had a different mix of accounts, their efficiency
levels would be different. So, I cannot offer a clear conclusion on whether Grainger, MSC or
Fastenal has the most economical model. But I can tell you that people at all three companies are
willing to talk about the way the other two are run and the way their company is run and why
they think their company’s approach makes more sense. I should also point out that these
companies are “peers” more than competitors. Direct competition between Grainger, MSC and
Fastenal for the same accounts is much, much lower than investors believe. If you read what a lot
of investors, analysts, etc. write about these three companies – you would think they were the
only three competitors in the industry. The truth is that something like two-thirds of the industry
is controlled by other companies. And while there may be quality differences between Grainger,
MSC and Fastenal – the differences are compared to the quality gap between the kinds of returns
on capital these companies generate versus the kinds of returns on capital the local or regional
competitors produce. Normally, these companies are going up against smaller, more local
competitors. Those companies are not public so we cannot see detailed financial information on
them. However, we can find some information on them as a group. It’s obvious that although
Grainger, Fastenal and MSC account for less than half the industry – they account for a big
amount of the total reinvestment made in the industry each year. Smaller competitors just do not
earn enough money to reinvest large amounts of earnings in websites, large-scale distribution
centers, etc. They cannot invest in the same level of automation, new systems, etc. If you look at
the figures of even how much gross profit they are producing – they just cannot be spending as
much per client on investment in future growth. That is something we might not know if we did
not look at all three of these public companies plus whatever other companies we could find
information on.
So, my advice on how to avoid getting caught up in one management team’s view of a business,
industry, etc. is to get the views of all the managements of all the public companies in that
industry. If you’re interested in NVR (NVR), do not just read about NVR’s business model.
Read about the business model of some other – more traditional – homebuilders. Or read
about LGI Homes (LGIH). LGI is sort of a nontraditional homebuilder too. But it’s
nontraditional in a way that is different from NVR.
There are some cases where this will not be possible. And I do not have a very good answer of
how to look at these companies. But Quan and I did try to find peers for all companies – no
matter how small and niche. One good example – which we never did an issue on –
is Transcat (TRNS, Financial). Transact has a $70 million market cap, so it’s a small company.
It’s a micro-cap in fact. It’s also in a niche business. Transcat distributes instruments used for
measurement, testing, etc. It’s not a small industry, but it’s a fragmented industry. Many
competitors are regional. There are some companies – like Electro-Rent (ELRC) – that will
show up as “peers” when you search for Transcat online. However, the business model of
Electro-Rent is not similar to the business model of Transcat. Furthermore, our research was
complicated by the even “niche-er” nature of what we were interested in. Quan and I really did
not care about Transcat’s instrument distribution business. What we were excited about was the
calibration business. Calibration is a service. And we thought that the economies of scale in
calibration for Transcat could be big. When the company first entered this business it would not
be making any profit. Later, it would show a tiny operating margin. After that, profit growth in
this segment would always be higher than sales growth as operating margins climbed higher and
higher. That is the kind of thing that is very hard to learn about without relying on management.
How much was Transcat really going to focus on the calibration business? How big are the
economies of scale in calibration? How quickly could this business grow? What would Transcat
look like in five years?
The “what will this business look like in five years” question is the big one for me. Sometimes,
it’s worth listening to what management has to say. Usually, you can find some peers to compare
a company to. But, yes, in the case of something like Transcat – you may have to rely a lot on
what management says the company will look like in 2021. You have objective data on what
Transcat looks like in 2016, but that does not matter. If I buy Transcat stock this year – I’m not
going to be selling it till something like 2021. So, what matters is what Transcat will look like in
2021. How big will calibration be? What will the operating profits from calibration be in 2021?
Transcat is such a small, niche business in such an underanalyzed industry – that you might have
to either trust management or just ignore the stock. I’m not sure you can get a lot of information
from peers. So, Transcat is the kind of stock where you might end up believing in a tale
management is telling that turns out to be a pipe dream. That is one of the risks of being a
longer-term micro-cap investor. I do not know how to avoid it entirely.
 URL: https://www.gurufocus.com/news/462606/talking-to-competitors-is-more-useful-
than-talking-to-management
 Time: 2016
-----------------------------------------------------
Investing Approach
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
Someone asked me a question about trusts:
“I was watching one of your past podcasts and you mentioned you would not buy dividend
stocks for an income portfolio you would buy trusts. How would I go about or is it possible to
research and possibly purchase these? I found that idea fascinating.”
The best trusts are usually illiquid and a bit difficult to find. You have to do a little research on
them and what backs them. Some examples of the kinds of trusts I was talking about are:
Beaver Coal (BVERS) – Mainly royalties on met coal, timberland, and rental income (variety of
business, etc.) in and around Beckley, WV
Mills Music Trust (MMTRS) – Royalties on old songs like “Little Drummer Boy”
Pinelawn Cemetery (PLWN) – Interest in proceeds from sales of burial plots in one cemetery on
Long Island, NY
Things like that.
Many investors avoid these because they complicate your taxes. You’ll need an additional form
from each trust you own (they should send it to you, if they don’t – you’ll contact them and
request the form). And it may sometimes cause you to request late filing of your taxes.
For this reason, partnerships (like the one Andrew and I run) and professional investors running
managed accounts (like the ones Andrew and I manage) will avoid buying these trusts simply
because they don’t want to lose clients through annoying the client with additional tax work for
the client. As a result, many professional investors who may know of and like these trusts (and
even own them personally) won’t buy them for clients. This can keep the price of the trusts
reasonable. These stock prices (technically they are trust certificates, not stocks) tend to bounce
around in price.
It is best to only buy them when the yield on the trust (making sure you check to see if the
distribution recently is similar to what it is normally) less the rate you’d pay on taxes still makes
it make sense. For example, say you want an 8% annual return in the trust certificate and you pay
30% in taxes on income from a trust, then you don’t want to buy when Distribution/Price is
anything worse than 11.5%.
Often, your total return in the trust is not going to be great compared to buying and holding a
stock that is actually retaining its earnings.
However, it is true that for income purposes only – these trusts will often yield more than the
dividend yield you can get on other kinds of stocks, the yield you can get on preferred stocks, the
interest rates you can collect on bonds, etc.
But, keep in mind five things:
1) Owning these will complicate your taxes
2) Income from trusts is usually less tax efficient – you’ll pay more in taxes – than creating
income by buying and holding stocks and selling them when you need income
3) The best trusts are usually totally illiquid – so, you need to look at these like you would
outright purchases of entire bonds, etc. (not like ownership of a liquid trust, a bond fund, etc.)
4) Income from trusts will often be extremely low growth, could decline over time etc. — look
carefully at the assets producing the cash flows these trusts pay out
5) Some trusts will eventually pay out all income and have nothing valuable left over (for
example, one day Mills Music Trust’s songs will be off copyright and income will drop to
nothing and leave no residual value)
The remaining life of the trust is very important.
I’ve seen cases – though, admittedly it is in somewhat more actively traded trusts – where I
believe the people buying into the trust are vastly overestimating the remaining life of the trust.
Or, maybe they are just buying based on today’s yield and not reading any of the disclosures the
trust makes. A trust with a short life could have a 20% or 30% yield and still be unattractive,
because – unlike a bond – it is not going to pay you a lump sum at maturity.
On the other hand, some trusts may have longer lives than people assume.
For example, met coal royalties from Beaver Coal will eventually disappear – but that trust
actually outright OWNS the land (not just the mineral rights), so the trust will still have surface
ownership of 50,000 acres of land in and around Beckley, WV even after met coal royalties drop
off. The distributions Beaver Coal has paid out have come very, very little from any sales of
land. Mostly, they’ve been distributing royalties. They’ve sold off very little land over time. So,
in a sense there is a “residual value” at Beaver Coal in the sense that land is carried on the books
that is not being liquidated at present to pay distributions. That’s not the situation at Mills Music
Trust. Those are basically “self-liquidating” assets because eventually songs do come off
copyright and enter the public domain. Mills has a list of its top songs and years when the
copyright expires. So, make sure you read that and understand it. Don’t count on royalties on a
song that is going to be off copyright unless that copyright has a lot of years left on it.
Some people I know have done work on Pinelawn Cemetery and believe that the cemetery has a
large amount of land people haven’t been buried in that will last many, many, many decades.
But, I have not visited the site or spoken with anyone at the cemetery myself – so, I can’t
confirm this.
I have visited Beckley (home of Beaver Coal). I’ve seen the assets the company owns. And
Andrew spoke very briefly to the general manager of Beaver Coal. So, I have a little bit more
insight into the longevity of that trust.
Obviously, you would want to create a diversified and uncorrelated revenue stream.
So, combining:
1) Old music
2) Met coal
3) Burial plots
Would be a good kind of mix, because I can’t really see how nostalgic music and met coal and
value of burial plots have anything in common. What you wouldn’t want to do is only buy
income that is all tied to the same commodity, the same type of real estate, etc.
This is a specialized area.
You can do well if you choose to focus on overlooked trusts.
But, it’s something you’d need to spend time working on yourself.
You aren’t going to find helpful information online about these kinds of situations the way you
might in more general stock ideas in good businesses that compound over time or value stocks or
something like that. A few have been written up a little. Mills is SEC filing, so there are Seeking
Alpha write-ups and stuff like that I think. There was a write-up by David Flood (Elementary
Value Blog) for Beaver Coal. Trey Henninger (DIY Investing) has done stuff on Pinelawn. But,
generally, there’s not a lot of info on these things and you’ll be doing your own homework.
Having said that, yes, I personally would look at these kinds of trusts instead of bonds or
preferred stock if I needed to have income (not capital gains) for my own personal portfolio.
I DO NOT own these trusts myself, because I don’t invest for myself outside of the fund that I
run with Andrew. And because, like I said, funds like mine basically don’t buy these trusts
because the cost of annoying clients with tax complications would harm our business’s assets
under management by far more than any returns we could get from owning the trusts. So, these
are not appropriate investments for professional investors running money for other people. These
are really only good choices for individual investors who choose to specialize in these kinds of
trusts.
Yes. It’s possible to research them. Several file with the SEC. Others report disclosures (non-
SEC) with OTCMarkets. The best place on any obscure / over the counter / non-SEC filing / dark
etc. security would be to go to OTCMarkets.com and then type in the ticker for the trust you’re
interested in. Then, go to the disclosures tab on that stock’s page. You can also contact many
trusts directly by calling their office. Trusts also use someone (it’s going to tend to be a bank) to
handle the trust as well. So, there will be disclosures at OTCMarkets.com, sometimes at their
own website (Beaver Coal has a website, many of these trusts don’t), and then by directly calling
the office that is running the trust’s affairs day-to-day. Some day-today operations are
meaningful (like Beaver) and others consists of little more than collecting money coming in and
paying money out (Mills Music Trust, for example). You may also be able to find lists of the
trusts other holders and contact them. It’s up to them if they will or won’t talk to you about their
experience holding the trust. But, for SEC filing trusts – the major holders are not a secret. The
disclosures are usually minimal. But, there are some of these — like Mills — that do, in fact, file
with the SEC.
Finally, any trust that owns real estate assets can be analyzed directly by visiting the site. So, you
can just go in person to view any land for yourself. There are also land records. And for mineral
resources – there are state, government, and trade association records you may be able to find.
Even if management will not speak to you, it is probably possible to find regulatory info that can
be correlated with some degree (though not 100%) confidence with the company’s filings such
that you have an idea of coal production in that country, the financial condition of a certain
cemetery, etc.
There’s nothing magical about the 3 trusts I mentioned.
They’re just a sample of the kinds of trusts I was talking about. These are things that were
created a long time ago and then aren’t really promoted to investors. Unless you have very good
reason to, I’d avoid the bigger trusts that are marketed to investors and increase their certificate
count over time. The best opportunities – or at least the simplest to figure out you’re getting an
adequate return – are things that were created a long time ago and then do nothing to reach out to
investors. Again, I would caution that I don’t believe these are usually superior on an after-tax
basis to buying and holding stocks and then selling what you’ve bought and held to create
income. But, if you have your heart set on collecting income — it may be easier to get a better
margin of safety in these kinds of trusts than in better known and more liquid income paying
securities like bonds, preferred stocks, and wellknown trusts. That’s because better known
securities tend to get picked over for yield pretty severely. So, they are bid up to yields that just
aren’t attractive. Sometimes the more obscure trusts offer better yields. But, again, check to
make sure you’ve calculated your AFTER-TAX yields on these things. Your own tax situation
will vary from others. And I can offer no suggestions on tax matters personal to you.
 URL: https://focusedcompounding.com/investing-in-trusts-why-andrew-and-i-dont-own-
them-why-you-probably-wont-want-to-too-and-how-to-get-started-if-youre-sure-this-is-
really-an-area-you-want-to-expl/
 Time: 2020
-----------------------------------------------------
Hunting for Hundred Baggers: What Stocks Should – and Shouldn’t – Go in a

Coffee Can Portfolio
From a “100-bagger” type perspective, the criteria are pretty simple: 1) Is it a small stock
(probably a micro-cap, definitely a small-cap)? – We’re talking <$300 million market cap
probably, but certainly like $1 billion or so – not multi-billions 2) Does it have a market multiple
or lower (so, say most P/Es today are 18 or whatever – is it 18 or less, not above) 3) Does it grow
faster than most businesses, the economy, etc. 4) Is it self-funding? There are other things you
could look for in a stock that would be good pluses to have. But, those 4 criteria are the really
important ones for whether something is immediately disqualified as potential buy and hold
forever type stock. Basically, it HAS to be small (if it’s in major indexes like S&P 500 – it’s not
a buy and hold forever stock), it can’t have a multiple that will contract while you own it (so, it
doesn’t have to be a “value” stock, but it can’t be especially high priced), it has to have strong
growth, and then it has to be able to fund a lot of or all of that growth (it shouldn’t be issuing a
lot of shares, for example). You could make this into a 4-point checklist to make decisions on the
stocks you own.
Once you’ve decided a stock might be a possible coffee can portfolio candidate – it passes the
screen of: small market cap, not high P/E, good growth, self-funding – then you can start on the
more qualitative checklist.
You have to ask questions like:
1) Is this stock in one of my areas of expertise?

2) Is this an above average industry to be in for the long haul?
3) Is this an above average company within that industry?
4) Is this run by an above average management team?
5) Am I paying a below average price for this business?
Those are the 5 questions I’d ask when deciding whether to add a potentially promising stock to
your coffee can portfolio. Honestly, the most important is #1. You want to avoid businesses that
are outside the areas where you exercise your best judgment. For example, if someone brought
me 4 stocks that had the exact same financial histories and prices but one was in finance, one
was in entertainment, one was in medicine, and one was in semiconductors – I would
immediately decide not to buy the medical or semiconductor companies because my judgment in
those areas is poor.
I would consider the finance and entertainment businesses though. This is because my judgment
in the areas of finance and entertainment is “expert” enough that I know it’s better than most
buyers and sellers of those stocks. I will, of course, still make mistakes. You’ll make mistakes
from time to time in all areas. But, you’ll make fewer mistakes in your areas of expertise. For
me: finance and entertainment are areas of expertise – medicine and semiconductors aren’t. For
Buffett: his judgment of newspapers, for example, was always excellent. He had good judgment
in insurers too. Insurance, banking, media, advertising, and consumer brands together probably
account for more than 100% of Berkshire’s value creation (I wouldn’t be surprised if everything
else Buffett has done – at least in his Berkshire years – has been neutral to value destroying when
we take opportunity costs into account). So, if you know certain industries better than others –
stick to those industries. And the, within those industries, you have this 9-point checklist to
apply:
1) Is it a small enough stock?

2) Is the multiple low enough?
3) Does is grow fast enough?
4) Is it self-funding?
5) Is the industry within one of your areas of expertise?
6) Is it an above average industry to be in long-term?
7) Is this an above average company in that industry?
8) Is the management team better than most?
9) Are you paying a below average price for the business?
I actually find it easier to slightly invert questions like this. So, instead of screening “for”
something – screen against it. Like ask: Is this stock too big to make sense in a coffee can
portfolio? Is this P/E multiple too high to avoid multiple contraction while I own it? Is the
growth rate here too slow to ever produce a 100-bagger? Is the company issuing too much stock,
borrowing too much, etc. to compound shareholder money like I need it too? Is this an industry I
don’t understand well enough? What’s the evidence this is a below average industry over the
long-run? What’s the evidence this is a below average company within its industry? What’s the
evidence this is a below average management team? And, finally, am I paying a higher than
average price for this stock?
Basically, if you can get past all 9 questions without any clear “black marks” against the stock –
that’s probably a pretty great stock to consider investing in. In fact, a stock that gets through all 9
of those points, doesn’t need to score amazingly on any one point. It doesn’t have to have a P/E
of 5 or growth rate of 25% or ROIC of 100% or the most amazing management team in the
industry. As long as it really doesn’t seem to fail any of those 9 tests – you probably won’t regret
buying the stock, and you might get lucky and have a big upside. But, if a stock passes all 9 of
those tests – the downside should be pretty limited.
I didn’t mention things like Z-Scores, debt-to-EBITDA ratios, etc. Generally, a consistently
growing company in a good industry with a good management team that has always mostly
funded itself from its own retained earnings is not going to present any sort of financial risk. But,
that is the one other thing to keep in mind: “catastrophic risk”. I can’t really put that point into a
clear checklist item. But, it may be appropriate to pass on a stock that has a serious risk of
extinction even if it passes all 9 other checklist items. The cases where this would occur though
are really, really rare. And, honestly, most instances where the market perceives an existential
risk to a stock that passes all 9 of those checklist items are imagined. They are usually just a
brutal temporary problem that will pass. Truly unsolvable problem stocks are more likely to
show evidence in lack of growth, lack of self-funding, bad industry to be in long-term, weak
management team, etc.
 URL: https://focusedcompounding.com/hunting-for-hundred-baggers-what-stocks-
should-and-shouldnt-go-in-a-coffee-can-portfolio/
 Time: 2020
-----------------------------------------------------
Was Peter Lynch Right? – Does Earnings Performance Drive Stock

Performance?
I’m writing today’s Focused Compounding daily from a Best Western in Kansas. By the time
you read this, I may already be back in Plano. Today will complete this short – only like four
days total – research road trip by me and Andrew. We spent some time in New Mexico, Arizona,
and Kansas basically.
While on this trip, I’ve been re-reading some books by a guy who did a lot of these sorts of trips:
Peter Lynch. Lynch isn’t exactly a value investor. So, some of the things he says can be
particularly interesting for a value investor to hear. One of the most interesting things he says
repeatedly is that – in the long run – stock performance tracks earnings performance. So, you just
find the stocks that are going to grow earnings a lot over the next 5, 10, 15 years. And then you
make sure those stocks don’t have crazy high P/E ratios today. And then you buy them.
This part about how earnings performance drives stock performance tends to be true in the very
long run. If you look at list of 100-bagger stocks, they are basically lists of 100-bagger
businesses in terms of profits and even earnings per share. You don’t have many 100-baggers
where earnings went up only 10 times but the stock went up 100 times. Usually, you need the
two working together. So, yes, the multiple goes up 5 times, but the earnings go up 20 times. Or,
the multiple triples and earnings increase 30-40 times. There aren’t a lot of pure value stocks on
a list of 100-baggers. Nor, actually, are there as many pure growth stocks as you’d think. If a
growth stock is something with a P/E of 50, or 75, or 100 – that’s not where hundred baggers
usually come from. If it’s a very fast growing business with a P/E of 30 – then, yes, plenty of
100-baggers do come from stocks as expensive as that.
The problem for investors – even pretty long-term investors – is that, in some stocks, the tracking
of earnings and price is very weak. In an earlier article, I mentioned FICO (FICO). Over the last
10 years, measures of things like sales per share, earnings per share, free cash flow per share, etc.
have basically tripled. Meanwhile, the market cap of the stock has increased about 10 times. The
P/E went from about 15 to about 50. Price-to-sales from like 1.5 to 7.5.
The risk for the investor is, of course, that he thinks of the multiple expansion the same way as
the earnings growth. Investors rarely tell themselves I bought a stock that increased EPS at 15%
a year for 10 years and I bought it at a pretty low starting price (let’s say 15 times P/E). So, I’ve
done well in this stock because I bought in at a P/E of 15 and it grew EPS at 15% a year for a
long time. Instead, they have one other bit of information that can be dangerous: they know the
combined result of multiple expansion and contraction with earnings growth or shrinkage. So,
they know when a stock has compounded at 30% a year even when earnings have only
compounded at 15% a year, and they give themselves credit for that.
Is this a bad way of thinking about stocks though?
I’ve talked about the “Davis Double Play”. You buy a stock with a P/E that you expect to expand
over time and with earnings that you expect to expand over time. This, in fact, is where 100-
baggers tend to come from. I think it’s a little aggressive to swing for a stock that returns 100
times your money in it. They are – outside of decades with a lot of inflation – pretty rare even
over long holding periods. They’re good subjects to study. Because, even if that 100-bagger had
worked out pretty differently – it still would’ve worked out as an amazing stock. So, reverse
engineering 100-baggers makes a lot of sense in terms of studying the past. In terms of aiming
for future returns – I think aiming for 10-baggers over 15 years is actually a realistic target.
You’ll miss it a lot. But, it gives you something realistic and long-term to aim for. Ten baggers
are also a lot less rare than 100-baggers. It isn’t difficult to identify some stocks that might turn
every $1 you put into them today into $10 by about 15 years from now. Aiming for a 10-bagger
in fifteen years would be like aiming for returns of 16-17% a year. There are differences in actual
returns based on whether it become a 10-bagger in year 14, 15, 16, etc. of course. Plus, there are
pretty meaningful differences between trying to make 16-17% a year by turning over all your
stocks (trading your entire portfolio) every year versus holding one stock for 15 years that
compounds at 16-17%. But, this is a realistic target for someone applying a Peter Lynch or
Warren Buffett or Phil Fisher or Shelby Davis type approach. Think 15 years out and think 15%
+ annual returns.
The relationship between stock price and earnings over a 15-year period will not be perfect. In
some stocks, it’s not even all that strong.
I’ve seen stocks where EPS grew about 11% a year and the multiple expanded about 6% a year
for the result of a 10-bagger in about 15 years. Sometimes, the P/E starts out normal – like in the
FICO case – and gets absurd by the end. Other times, the P/E starts out too low and gets more
normal over time. There are stocks that used to trade around 5-7 times earnings year after year
that suddenly start trading at 15-20 times a year and never look back. I’ve seen this a bunch of
times in very small, very boring stocks. But, it seems to happen most often when the business is
pretty predictable. When a very small stock graduates to being more of a medium sized stock, the
predictability of its past earnings performance – like the fact it has grown sales, earnings per
share, etc. every single year in a row – becomes very important in setting the P/E multiple. For
whatever reason, this seems much less true of tiny stocks. Business quality seems to be rewarded
with very high multiples among big stocks. But, business quality among tiny stocks doesn’t seem
to set the multiple at a higher level than among other tiny stocks. I don’t know why this is.
Maybe investors see all smaller stocks as more speculative and all bigger stocks as less
speculative and they only look for quality among “investments” not among “speculations”.
Sometimes, the relationship between a stock’s earnings and price is much stronger. Let’s take
another business – I’ve mentioned this one before – that has some similarities on the surface to
FICO. That stock is called Hingham (HIFS). It’s a bank in New England. I bring this stock up,
because – over the last 10 years – many of its metrics have grown along the same sort of trend as
FICO. The most basic number for a bank is stuff like deposits – not sales (revenue is skewed by
interest rate moves, so it’s a less “pure” measure of business growth in banking than deposits).
So, how fast has Hingham’s balance sheet been growing? Stuff like deposits, loans (or “earning
assets” in total), etc. have grown like 11-12% a year for the last decade. That means the
underlying business has been growing faster than FICO. FICO’s revenue – NOT revenue per
share – has only grown in the single digits. However, FICO has bought back stock. And its
margins have widened. And its multiple has expanded. The P/E multiple part is important there.
FICO went from a P/E of like 15 to a P/E of like 50. Meanwhile, Hingham went from a P/E of
like 9 to a P/E of like 12. This is a huge difference. And it brings up the potential problem with
the Peter Lynch approach – which I don’t think is much of a problem of all.
Wouldn’t a BUSINESS analysis of both Hingham and FICO done in 2010 suggested – even if it
was a very, very accurate business analysis – that the 10-year future for these two businesses
would look very similar. I picked Hingham and FICO for a reason. Both have grown at
meaningful but not unbelievable rates these past 10 years. Both are tied to credit expansions.
Some of the growth was obviously very cyclical. But, they were both cheap in 2010. The
question is: are the two stocks equally attractive now even if their futures are equally attractive.
I’d say no. Hingham’s future as a stock looks more interesting to me. That’s because the P/E
there is 12 and the P/E on FICO is more like 54. If FICO’s stock price fell 50% at the same time
Hingham’s stock price doubled – Hingham would still be a bit cheaper than FICO. So, I’d
suggest investors focus on a stock like Hingham instead of a stock like FICO. In other words, I’d
say the next 10 years could have a big divergence in the stock performance of FICO and
Hingham even if there is not a big divergence in the business performance.
That isn’t too troubling a thought if it happens one time, right? It’s an anomaly. But, let’s think
for a second about why I believe Hingham and FICO could have very different stock
performances over the next 10 years even if they end up having pretty similar business
performances.
The reason is that they ALREADY have had really different stock price performances as
compared to business performances. Let’s pretend I am somehow clairvoyant over a period of
ten years looking forward. FICO and Hingham both grow their business nicely and consistently
and quickly (but by growth stock standards, kind of moderately) over the next 10 years. FICO
stock vastly underperforms Hingham stock because FICO’s P/E starts the decade of the 2020s so
high and Hingham’s stock starts the decade of the 2020s so low.
Okay. But, why is the P/E of Hingham low and the P/E of FICO high? It’s because anyone
making the same prediction in 2010 would’ve been wrong. Hingham and FICO would’ve had
much closer business performances than stock performances. Now, if I’m right during the decade
of the 2020s, that does mean that over the VERY long-run, someone making this projection that
earnings growth drives stock price growth and applying it to FICO and Hingham would be
proved right. But, they’d be proved right over the entire two decades of the 2010s and 2020s.
They would actually be wrong for the decade of the 2010s alone. And wrong again for the
decade of the 2020s. Any 10-year prediction they’d make based on stock price performance
tracking a business’s earnings performance wouldn’t work. And it wouldn’t work, because – in
the case of FICO and Hingham – 10 years was too short a holding period to judge this strategy.
Now, that’s pretty alarming. Most investors I know – no matter how long-term they consider
themselves – don’t have the patience to be right for 10 years on the facts and yet wrong on the
outcome.
How can we deal with this problem?
There are a couple ways. One is diversification. The reason the example of Hingham and FICO
doesn’t work has more to do with FICO than Hingham (FICO’s P/E went from “normal” to 50+
in under a decade). It actually has a LITTLE to do with Hingham as a bank. So, it’s a somewhat
unfair comparison. I knew that FICO fits the kind of stocks that are popular right now. And I
knew that the industry that has the widest divergence between its business performance and its
stock performance has been banks. So, I unfairly picked something I knew to be very in favor
(high quality, asset light, leader in the field, etc.) FICO vs. a true bank stock. It would be harder
to find examples of “growth companies” with P/Es of 10, 11, or 12 outside of banks. Banks are,
right now, the only place I know of where you can consistently find cheap growth stock. There
are industries with cheap stocks out there. But, they’re not growing. And there are industries with
growth stocks. But, they’re not cheap. Banking is about the only area where you are just finding
buckets of growing businesses trading at low P/Es. It’s an anomaly compared to all the other
industries in the public markets today. That means picking a stock in an industry that ends up
way out of favor – banks are very out of favor right now as stocks – will skew multiples so much
that you could have strong business performance lead to underperformance as a stock even over
a 10-year holding period.
So, Lynch’s approach won’t work if the end of your holding period happens to be when the
stocks in the industry you’ve picked to invest in are particularly out of favor.
Of course, one solution to this problem is that if business performance has continued to be strong
while stock price performance has weakened – you just don’t sell during those times. That would
suggest not selling banks right now. And I’d agree with that. It’s commonsense. If you own a
bank that is safe and solid – don’t sell it now. Now is not the right time to sell a bank. They are
too unpopular as stocks. So, don’t sell a good business into a bad market for the stock. That’s
common sense. And you can apply it just fine. But, it doesn’t solve all the problems here.
There’s still a problem with the difference between individual investment results and a theory
that works diversified over a lot of stocks and a lot of years.
There really could be people who bought BOTH Hingham and FICO in 2010 and held them till
today and have now been taught that buying FICO was right in a way that buying Hingham was
wrong.
This particular problem has shown up in the emails I’m getting from people these days. They
talk a lot about the price performance of what stocks have worked and haven’t worked without
thinking about how much of this return comes from multiple expansion and how much from
earnings growth. I’d be very, very carefuly with this kind of thinking. Honestly, based on what
you could’ve known at the time and what was reasonable to assume might happen and so on – I
do think that you could’ve decided in 2010 that it was a smart idea to buy Hingham and it was a
smart idea to buy FICO. I think you could’ve imagined a day when Hingham’s P/E expanded
from 9 to 18 and FICO’s from 15 to 30. I don’t think you should kick yourself now for not
imaging FICO’s P/E wouldn’t stop at 25 – but zoom right past 50. That’s the kind of “resulting”
you need to be careful about. Even if you made a ton of money in FICO these past 10 years, I
don’t think you should count all that mney as being a valid profit on your part. Skill might
explain half your return from holding FICO these past 10 years. But, I really think luck explains
the other half. There’s nothing wrong with profiting from some luck. But, there would be
something wrong with learning from this experience that you should be biased more toward
stocks like FICO and less toward stocks like Hingham because stock’s with P/Es of 9 only go to
P/Es of 12 while stocks with P/Es of 15 sometimes go on to become stocks with P/Es of 55. I
think that’s the wrong lesson to learn. It worked for this cycle. But, it won’t work over all cycles
at all times. And yet this is the lesson I hear about from most people who email me. They’ve
learned to pay up for stocks in a way that could be potentially dangerous. It’s fine to pay up for a
business that will grow its earnings faster for loner. It’s not fine to pay up for a stock because it
has a higher chance of abnormal recognition from the market resulting in a rapidly accelerating
multiple without rapidly accelerating earnings growth.
So, what does this mean for investors on the other side of things? Instead of getting lucky
through wild multiple expansion on a stock you were right to buy in the first place – but has now
zoomed higher in price than you ever imagined – you are staring at a portfolio that has lagged the
market.
Okay.
Has your stock portfolio lagged the market in terms of stock price performance? Or: has your
stock portfolio lagged the market in terms of underlying business performance? Or is it both?
If you own a basket of stocks that have been increasing their earnings each year as fast or faster
than the S&P 500, but have been underperforming the S&P 500 for a couple years now – that’s
not something to be deeply worried about. If the stocks you own have seen their earnings
contract, or have failed to match the EPS growth of the market, that is something to worry about.
So, should you be concerned if your stocks are really underperforming the market right now?
Maybe.
Are the businesses really underperforming too? Or, are the business performing as well as the
market – while the prices of the stocks you own are not.
Poor stock performance combined with poor earnings performance is the thing to watch for. Poor
price performance alone is what cycles in sentiment look like. You just have to learn to live with
those.
 URL: https://focusedcompounding.com/was-peter-lynch-right-does-earnings-
performance-drive-stock-performance/
 Time: 2020
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How Can Long-Term Value Investors Make the Most of This Week’s Short-
Term Volatility?
Andrew and I just did a podcast about volatility. And, of course, when we say “volatility” I want
to remind everyone that’s a codeword for “downside volatility”. Nobody minds upside volatility.
There are basically two topics worth discussing when it comes to volatility and how you as an
investor should behave. One is how to “handle” volatility – psychologically and such. The other
is how to take advantage of volatility. If we go back and think about Ben Graham’s Mr. Market
metaphor – it’s really all about volatility. Mr. Market’s existence really only benefits you if he is
giving you wildly different quotes over some period of time. Sure, it doesn’t have to be day-to-
day. But, if all stocks are rising by similar, gradual amounts over time – a public quote for your
shares doesn’t give you much benefit in selling one thing and buying another. You need either
relative moves among stocks – where you own an airline stock down a lot and a healthcare stock
that’s rising in price – or you need very different quotes on the same stock depending on the day.
There’s an old article (but a good one) up on the Focused Compounding site that talks about the
concept of “value trading”. This is where a value investor owns maybe 5 stocks he really likes
for the long-run. But, in any given year – one of these stocks will rise a lot closer to his estimate
of intrinsic value while others will fall. For example, Warren Buffett’s stock portfolio at
Berkshire Hathaway rose something like 40% last year. Obviously, the underlying business’s
earnings power barely budged. Maybe it rose 5%. Maybe not even that. You’ll notice that
Berkshire’s wholly owned businesses didn’t have any increase in their operating earnings. I think
Berkshire’s partially owned businesses did a lot better. But, they didn’t do 40% better. So, in a
year like that, you have some of your stocks rising a lot closer to your estimate of intrinsic value
while others don’t. The obvious example at Berkshire of a stock that rose far faster than its
intrinsic value last year would be Apple (AAPL).
Now, Buffett can’t “value trade”. Or, at least, he shouldn’t try to. Buffett has to put more and
more cash to work each month, quarter, and year. If he sells any of his Apple stock – he has to
find somewhere else to put it. And, because he owns such big chunks of the public companies
he’s in – that’s a problem. This is a problem even for much smaller investors. Andrew and I run
a fund where we have allocations to specific stocks that are in part based on how much of the
fund we’d like in those stocks – but, also partially based on simply how much of those stocks we
can own. This issue mostly crops up when a fund has more assets under management than the
market cap – or, at least, the “float” – of the company it is trying to buy shares in. Well, as an
individual investor, you’ll almost never have that problem. You can nimbly move out of Apple
and into something else. In fact, you can sell your whole Apple position in a single day. And –
you can do so without moving that stock’s price.
This is the advantage Mr. Market gives you. Some stocks are liquid enough – and some investors
have portfolios small enough – that you can reduce your position in one business you like a lot
and increase your position in another business you like just as much but that is trading at a much
lower price.
The “like just as much” is the hard part. I can’t tell you how many times I’ve owned two stocks
where one is up 20-50% over a fairly short period of time and another is down 20-50% over a
fairly short period of time – but, I like the BUSINESS of the stock that’s up 20-50% A LOT
more than the BUSINESS of the stock that’s down 20-50%. That’s usually the problem with
specific stock rallies and routs. Very often, a specific stock surges ahead when it has a lot of
good things going on in the underlying business. And, very often, a specific stock collapses in
price when it has a lot of bad things going on in the underlying business. There are sometimes
opportunities to “value trade” among the stocks in your portfolio. But, I’ve been a lot more
skeptical about this approach in practice than I am in theory. I know a lot of investors who trade
around their positions. And, for lower quality businesses, it may work well. But, I also know
some investors who were smart enough to find a good, unloved business early on and patient
enough to hold it for the long-term – but, they made the mistake of trimming the position from
time-to-time whenever it seemed to be “getting ahead of itself”. They recycled the “profits” from
that great business where the stock was getting ahead of itself into a lesser business where the
stock was getting cheaper and cheaper. At least among the very small number of value investors
I know well enough to actually talk about when they did this and how it worked out – none has
been able to go back into their brokerage statements and prove to their satisfaction that all this
extra activity really added value. I should point out – these aren’t investors who underperformed
the market. They just underperformed what they might have done had they never tried to trade
out of higher priced shares of businesses they liked better and into lower priced shares of
businesses they liked a little less. I did an article over at Focused Compounding – even older than
that “value trading” article I mentioned – about the sell decisions I made over the years. In my
experience, when I’ve been right about a business – I’ve been wrong to sell that stock when it
seemed to be getting pricey and rotate into something else.
Having said that, there have been times where a stock I bought had a good 5-10 year run as a
business, but then obviously deteriorated after that. You could say I was right about the business
in the – what do you call 5-10 years, the medium term? – and wrong about the business in the
long-term. Or, you could say I just didn’t look out far enough when I analyzed the business in the
first place. But, I think that’s different. I think there are many good reasons to sell a stock you
originally liked. This could include the stock getting ridiculously overpriced. But, the best reason
is that the business has deteriorated from what you originally expected. Basically, looking
forward to the NEXT 10 years, the business doesn’t look so good anymore.
Maybe Buffett should have sold his shares of stocks like Coke and Gillette in the 1990s. Coke
got truly and ridiculously overpriced. The business eventually became less attractive too. But,
what if Coke had only gotten half as overpriced? Should he have sold it then?
That is usually what we are talking about with “value trading”. Unfortunately, it’s rarely as easy
as having two businesses you like just as much where one drops from a P/E of 15 to 10 while
you own it and the other rises from a P/E of 15 to 25 while you own it. In that case, I’m all for
selling the stock with the P/E of 25 to buy the one with the P/E of 10.
What tends to actually happen is what happened with me when I started managing money for
others. Of all the stocks we bought in that year, the one I felt most “comfortable” with as a
business – that is, the one I liked the most if we put aside the very important issue of price – was
Computer Services (CSVI). Whereas the two stocks I felt least comfortable with as businesses –
mostly because the rationale for their purchase depended mostly on their market values versus
their asset values, these were “asset plays” – were Keweenaw Land Association (KEWL) and
Maui Land & Pineapple (MLP). Well, guess what happened over the next year to year and a half
with KEWL, MLP, and CSVI. Computer Services rose in price while KEWL and MLP either
stayed flat at times or actually fell quite a lot. This could’ve been a situation you could value
trade. And perhaps it’ll prove to be that in the very long-run I’d have been better off selling some
of CSVI and buying some of KEWL and MLP. But, that’s not what I did. Because,
unfortunately, the quality of those assets – MLP, KEWL, and CSVI as actual businesses – wasn’t
very comparable.
Volatility among all stocks in the market – the kind of volatility you’ll get on days investors are
worried about the new virus – works differently. It’s possible that some countries, some
industries, and some stocks might fall more in price than others.
So, accounts I manage own a stock tied to airlines and own NACCO (NC). NACCO mines coal
for utilities and earns a steady, contractual kind of profit per ton supplied. I’m simplifying a bit.
But, that’s pretty close to the reality. Meanwhile, a stock tied to airlines depends a lot on how
full those airplanes are flying. Well, obviously airplanes are going to be flying a lot less full in
the days, weeks, months, and maybe years ahead than investors imagined throughout 2019. So,
it’s likely that any stock tied to airlines will fall more than any stock tied to demand for a fuel
used in the production of power by utilities. No matter what happens with this new virus –
demand for electricity in much of the middle part of the U.S. (which is what NACCO’s
production is tied to) isn’t going to vary much. However, the value of one airline seat is going to
vary a lot. The supply of airlines seats can’t be contracted very quickly in a very big way even if
all the major airlines around the world know that’s the right thing to do. So, you can quickly end
up with a severe imbalance between supply and demand. This can be devastating to operators of
cruise ships, airplanes, theme parks, casinos, and hotels. They all have high fixed costs. And the
marginal cash contribution from one more room, one more airline ticket, etc. bought or not
bought is huge. In some cases, these companies will be losing business that would’ve had close
to a 100% cash contribution margin. Flights (and nights) that would’ve been profitable will now
be burning cash. Those industries could be hit hardest. And the market would anticipate this by
causing their stocks to plummet.
Of course, certain stocks in those industries should fall by even more than others. Which stock?
The weakest financially. If you assume that whatever impact there is from this new virus is
severe but temporary, the stocks you’d expect to be most imperiled would be anything that
combines financial leverage with operational leverage and depends on trade or travel. Heavily
indebted airlines, heavily indebted cargo ship owners, heavily indebted miners of globally traded
commodities, etc. might all drop a lot in price for what turns out to be a short amount of time.
If you own some of these stocks already – or, you’ve researched them but passed till now, these
are the stocks you might get the chance to “value trade” into.
For example, Quan and I wrote a report on Carnival (CCL) that is up on the Focused
Compounding website (premium members can find it in the stocks A-Z section under “C” for
Carnival). That stock has done poorly since we wrote it up. But, it’s done especially poorly since
concerns about the virus have been at the front of investor’s minds. There will obviously be
much, much worse headlines for cruise ship operators yet to come. It’s hard to imagine an
industry more at risk than cruise ships. The last cruise I was on put me in close proximity to
6,000+ people from all over the world for a full 7 days. That’s not something anyone is going to
want to do if they’re concerned about a highly contagious disease.
But, 10 years from now – there will be companies earning a lot of money from cruises. If some
companies in the industry are financially weak – it’s possible there will be fewer players in the
industry. So, it would make sense to start researching which companies in the industry have the
best financial strength, which ones might be able to survive the longest with the lowest numbers
of passengers, and at what prices you’d want to own the cruise ship operators most likely to last
the longest.
There are probably half a dozen industries out there full of stocks that could be hit almost as hard
as the cruise ship companies. Now might be a good time to study up on them and focus in on the
companies who are likeliest to survive the longest. You might eventually get the opportunity to
scoop their shares up at a price you couldn’t imagine back in 2019.
 URL: https://focusedcompounding.com/how-can-long-term-value-investors-make-the-
most-of-this-weeks-short-term-volatility/
 Time: 2020
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Is There a Difference Between Being a Good Investor and a Good Stock

Picker?
On a recent episode of the rundown – a weekly YouTube show with Andrew Kuhn and Vetle
Forsland – Andrew asked the question of whether you could be a good investor without being a
good stock picker and vice versa.
To answer this question, I’m going to use an analogy I made on a recent podcast between picking
stocks and playing poker. If, in a game of Texas Hold ‘em – you are dealt the hole cards Ace /
Ace, you have a better chance of winning the hand than if you are dealt 7 / 2.
However, the truth is that a great many hands of Texas Hold ‘em will never get to the point
where two players turn over their cards and we see who wins. For that reason, it’s perfectly
possible to do well playing the other players with 7 / 2 (since they can’t see your cards, it can’t
make a ton of difference what those cards actually are). Does that make not folding 7 / 2 a good
move as long as you can outplay the other players irrespective of the cards? Likewise, you can be
beat with your Ace / Ace if the hand does result in two or more players comparing their hands.
We could call this bad luck. We could say it’s a pretty obvious observation. But, I think there’s
something more to this analogy. In a sense, your return on 7 / 2 would have to be of a speculative
nature – guessing how other players will react to what you do – rather than an investment nature
(what your cards are versus what is on the board). There is an element of the cards and the play
that matters with either set of two hole cards (great or terrible). But, the element of the cards
could potentially be much more important with Ace / Ace and the element of the players more
important with 7 / 2.
Does investing – or stock picking – work the same way?
In a sense, I think it does.
We can break your CAGR as a stock picker into two parts: the return you can get from judging
the business right (which I’ll compare to judging the cards you are dealt and the cards on the
board as they appear) and judging the other market participants right (which I’ll compare to
judging the players at the poker table).
Multiple expansion is ultimately about judging the other players right. If you know you are very,
very right about how other current and potential future holders of a stock will behave – you don’t
actually need to own the right business. You can win with 7 / 2. You could buy a junk company
as long as you correctly predict that the market will award a higher multiple to the stock. Now,
some will say you need a positive development in the business that exceeds the current
expectations of the market. My experience investing has taught me – that’s often not true in any
way that can be well-proven. The theory of betting versus future expectations makes sense. But,
it’s a hard theory to prove empirically in the investment world I’ve observed. Very big and
prolonged multiple expansions and contractions seem to happen for reasons that have everything
to do with the players and nothing to do with the cards. Sometimes they have to do with the
cards. But, many times they don’t. Many times the multiple on a bad business will keep
expanding even if the business is not showing actual results that would support such an
expansion. And many times the multiple on a good business will stay stagnant or decline even as
perfectly decent results are reported.
We could call this sentiment. We could call it momentum. We could say it is all about reading
developing bubbles and busts and playing into them – but, then getting out before the other
players in the investing game get out.
Now, investors following the Buffett school will often say that as long as you buy right and hold
for the long-term, you needn’t worry about the “voting machine” aspect of the market and can
just worry about the “weighing machine”. In other words, it’s almost like you could play the
hand without regard to the actions of the other players. You know you have the best cards. As the
hand develops, you keep seeing you have the best cards. So, you don’t need to worry about the
players to the extent you would if you owned a bad business that was getting worse.
This is true – to some extent. But, it may be true to less of an extent than investors would like to
think.
Here’s the discomforting fact. A very long holding period for most investors I know would be 10
years. Most investors who say they’re willing to hold for 10 years will never own a stock nearly
that long.
So, how much does the play of the other players matter over 10 years? And how much do the
actual cards (the business results) matter?
A pretty common multiple expansion or contraction for a stock long-term is 100% or 50%. That
is, the stock goes from a P/E of 16 to 8 or a P/E of 16 to 32. As you get to more extremes – away
from “normal” P/Es like 16 – the multiple contraction or expansion tends to be more extreme.
I’ve been invested in things that went from a P/E of 5 to 15-20. So, that’s a 3-4 times expansion.
That’s not unusual for stocks with a P/E of 5 if they turn out to be decent businesses, because
there’s often a point where a decent business will trade at a decent P/E. Likewise, the contraction
possibilities become more severe as you pay up for bubble type stocks. Andrew and I talked
about Microsoft (MSFT) on the podcast. It experienced a multiple contraction of around 70%
over a decade where it actually had very good business results. This is because its P/E had gotten
to be more than 2 times a “normal” level at the top of the millennium bubble. And then it
eventually got priced at maybe 2/3rds of a normal stock’s level about 10 years after that bubble
(around the time of the financial crisis). If we think of “normal” as “x” then we are basically
saying the P/E went from 2x to 0.65x. If that were to reverse – and, over the next 10 years at
MSFT, that’s exactly what did happen – you go from 0.65x to 2x. This multiple expansion
contributed about 12% a year to MSFT’s returns.
Now, you could say – that’s hindsight bias. But, let’s put it in even more troubling terms. Say
you only could foresee that the odds of a multiple expansion from 0.65x normal to 2x normal
over ten years was about an even money proposition. But, you knew that there was no chance the
stock’s multiple would be less than 0.65x normal (about a P/E of 10) ten years hence. On a
probability weighted basis, a 50/50 chance of an expansion from here still adds more than 6% a
year to your returns. There are different ways of calculating exactly what a probability weighted
return on a 50/50 chance of having a P/E of 2x normal in 10 years would add to returns. I think
the best way of thinking about this would mean your probability weighted CAGR would add
about 7.5% to your returns. The reason it adds more than 6% a year is because of the floor I
mentioned. If the probability of something going up is 50%, but the probability of it going down
is 0% (we assume the other 50% is it staying flat) this floor of absolute certainty means you
should calculate the probability adjusted CAGR such that it is even higher than half of the
potential upside from the event actually happening. This may sound like a weird way of doing it.
But, think logically for a second. Was MSFT’s P/E ever going to zero? I mean – I guess earnings
could go to zero. But, let’s face it – if the stock has an EPS of $4 a share ten years from now –
it’s not going to have a price of $0. There are not the same odds of a contraction from a 10 P/E to
a zero P/E as from a 10 P/E to a 20 P/E (or even a 30 or 40 P/E – in fact, a 40 P/E must be more
likely than a zero P/E). This makes the probability weighted potential in low P/E stocks of good
businesses higher than you’d initially guess even over periods as long as 10 years (when you’ve
got a P/E of 9 to start with – the odds of the P/E tripling are just really strong versus the odds of
the P/E falling by another two-thirds).
The Microsoft example may be extreme. But, a typical example of multiple expansion isn’t much
better. If you buy a stock at a P/E of 8 and it goes to 16 – you’ve added 7% a year to your
returns. A stock going from a P/E of 32 to 16 works the same way in reverse. This explains why
value investing – in the sense of buying stocks with P/Es of 8 and not buying stocks with P/Es of
32 – works.
The problem is that if we assume 10 years is a truly long investment holding period and we
assume multiples will tend to snap back toward a P/E of 16 over any given decade – we get the
answer that about half of your return is going to come from other people’s changing assessment
of the business. Basically, portfolios full of 8 P/E stocks that turn out to be average or 32 P/E
stocks that turn out to be average will have returns that differ to the amount of about 7% a year
from a basket of equally good 16 P/E stocks. If the business quality, future performance, etc. is
equal in the 8, 16, and 32 P/E baskets – your investment results in the cheap basket will be
determined 50/50 by business results and multiple expansion, in the 16 P/E basket entirely by
business results, and in the 32 P/E basket half by business results and half by multiple
contraction (which will offset). You’ll have a negative edge in the expensive stocks, a positive
edge in the cheap stocks, and no edge in the normally priced stocks.
I’m simplifying by saying these are all equally good businesses with different P/Es. This would
also work if you bought stocks with 20 P/Es that turned out to be such amazing businesses you
could sell them at 40 P/Es in a decade. I think you understand my point though. It’s going to tend
to be the case – even over as long as a 10-year holding period – that half your return in going to
be dependent on other people coming around to your way of thinking about the business after
you do.
The reason for this is that the underlying public companies – if we’re looking at an index, for
example – will only be delivering about a 7% business result. Their growth rate might be 5% and
dividend yield 2%. Some could argue – based on long-term returns – that it’s more like 8%.
Maybe it is. It’s probably not 9% a year. And there’s no way it’s 10% a year. The only way you
make 10% a year in a stock index over the truly long-term is if the index’s multiple expands over
time.
Now, you could pick such good businesses that free cash flow yield plus growth is greater than
the influence of multiple expansion and contraction. But, even then – it’s unlikely to be much
greater.
Consider a stock with a free cash flow yield of 10% a year and growth of 5% a year. That’s
likely to be an amazing stock. But – over a 10-year period – it’s still likely you’ll only be getting
about 65% of your return from that free cash flow and that growth. The other 35% of your return
is still going to come from multiple expansion. Say the FCF yield will decline from 10% a year
to 5% a year while you own it. This will drive 7% a year returns from multiple expansion. You
might make 22% a year in the stock (again, an amazing result). But, it’s still the case that as
much as one-third of your investment is coming from how well you are reading the future actions
of the other “players” in the market and not how well you are reading the business.
We could take this to the extreme. Over short periods of time, there is no doubt that you should
just play the other players. If you’re going to be owning stocks for 10 months at a time instead of
10 years – all you need to do is pick stocks that others will discover after you already have.
There’s no point in spending much time thinking about the actual businesses you own.
Conversely, over very long holding periods – imagine owning a stock for your entire lifetime –
the play of other players is irrelevant. You just need to find the right business. This is because
multiple expansion from 1x to 2x over 30 years (as long as Buffett has held a few stocks now)
would only add 2% a year to your return. A business that doubles its multiple over 30 years is
probably giving you an actual return of at least 7% a year (again, it could be closer to 9% a year).
Still, this would mean that even over a 30-year holding period – your return from correctly
judging the market for the stock instead of correctly judging the underlying business is driving
about 20% of your stock return. In fact, I’d say this is a limit that is hard to get much below. It’s
always going to be the case – even over incredibly long holding periods – that only 80% or less
of your return is coming from the actual business while 20% or more is coming from how others
view the stock. Over short periods of time – it’s more extreme.
For most investors – holding periods are far less than 10 years. This means that the business is
driving far less than 50% of the return in a stock. So, your result in a stock will tend to be more
than 50% driven by how others view the stock while you own it. In other words, if you could be
as correct in your judgments of future market sentiment toward the stock as you are in your
judgements of the future of the business – you should actually bet based on your judgment of
market participants not of the business.
Does this mean it’s hopeless to get better than average investments results by focusing on
business judgment alone?
Actually, no.
There are two reasons for this. I’ll start with the simpler one.
The simpler reason here is that no matter how big or small the proportion of the return mix that
comes from business judgment versus market judgment – it basically never approaches the actual
number zero (it does, if you’re a day trader – but, not if you hold stocks for years at a time). As a
result, all this math we’ve been talking just means you’ll be watering down your edge on
whichever side (the business or the market) you have one. You’ll never be eliminating your
edge.
So, let’s say you tend to hold stocks for 10 years at a time and you are so good at business
judgment that you can buy things such that they return 10% a year more than other businesses
would. For example, you are able to find things you know will grow 10% faster than other stocks
with the same free cash flow yield. Multiple expansion or contraction will water down this 10%
edge. But, it can never make it go away.
It works the same way in terms of the 50% of your returns that would come from market
sentiment. As long as you get an average market sentiment result – your edge on the business
judgment side will provide an overall advantage in your annual returns. The only way you could
end up with a good business judgment record and yet a bad stock investing record would be if
you tended to pick stocks that somehow perform well as businesses but poorly in terms of market
sentiment. In other words, their earnings always go up but their P/E always goes down. This is –
over a 10-year holding period – not an easy thing to stumble into. It just doesn’t happen that
often that a stock which wasn’t super expensive to begin with keeps seeing its P/E multiple
contract while its earnings keep growing. I’ve owned stocks where EPS rose for 5 years while
P/E contracted for 5 years (not a lot, but it has happened). I haven’t yet owned one where this
divergence between business results and P/E multiple continued for a full 10 years.
Finally, there is one bit of comfort here. I promised a more complicated reason why business
judgment alone might work better in terms of driving returns than just being 50% skill and 50%
luck. That reason is correlation. Anecdotally: I think multiples and the things they are multiples
of tend to move together with correlations greater than nothing. If a company is growing
EBITDA by 10% a year while most stocks are growing it by 5% a year, the EV/EBITDA
multiple of that stock will – other things (especially starting price) equal – tend to expand. The
company with 0% EBITDA growth will tend to see its multiple contract.
So, if you are betting on only one side of a 50/50 return mix, but you know the other side is at
least somewhat correlated with the side you are betting on – the truth is that you’ll be making a
bet that works much like if it accounted for far more than 50% of the stock’s return over time.
How much more will obviously depend on the degree of correlation between the business as an
economic value creating machine and the stock as a speculative vehicle. Over long periods of
time, the correlations on these things tend to be high enough that a business judgment focused
approached to stock picking (an “investor” approach) works well despite the huge implications
of multiple expansion or contraction. In other words, I don’t believe business judgment bets only
drive 50% of returns. I believe they – over a 10-year period – often drive like 50% directly and
then some number between 0% and 50% indirectly via correlation between business results and
sentiment. This means – over long periods of time – correct bets on business judgment will drive
more than 50% but less than 100% of returns even though they may seem to be only driving
50%. Sentiment toward a stock – over long-enough periods of time – just isn’t random and
totally unconnected from underlying business results.
So, what’s an investor – or non-investor stock picker – to do?
My advice on this has always been the same. If you are going to hold a stock for more than 15
years – almost all of your return is likely to come from business results. If you are going to hold
a stock for less than 3 years – almost all of your return is likely to come from market sentiment
changes. If you (like most investors I know) target holding periods in the 3-15 year range –
you’re going to see a very mixed return driven both by a lot of business results and also just by a
lot of market sentiment shifts. Without knowing how volatile the business results or sentiment
shifts will be – there’s no perfect rule for what the business results vs. stock sentiment mix will
be. But, 3-15 years is a good guide. Stock picking with a less than 3-year horizon is primarily a
sentiment guessing game. Stock picking with a more than 15-year horizon is primarily a business
predicting game. And stock picking with a 3-15 year time horizon is a blend of the two.
 URL: https://focusedcompounding.com/is-there-a-difference-between-being-a-good-
investor-and-a-good-stock-picker/
 Time: 2020
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How Buffett Holds: The Incredible Importance of the “Contrasting

Trajectories” of Long-Term Winners and Losers
In my first article about Warren Buffett’s annual letter to Berkshire Hathaway shareholders, I
talked about how difficult it would’ve been to hold Berkshire stock during all the years when it
rose so much so fast. That’s one underappreciated part of how successful Berkshire has been as
an investment. Buy and hold often sounds like a simple strategy to follow. Berkshire has
returned 20% a year compounded over more than 50 years. It would’ve been easy to hold the
stock if it rose 20% a year every year. But, sometimes it got far ahead of itself – jumping 100%
or more in price in a single year. And then, other times, the stock price lagged the intrinsic value
gain for several years in a row. But, the long-term trend in Berkshire Hathaway’s results was one
of compounding at about a ten percentage point a year advantage over the S&P 500. Today, I
want to talk about a different underappreciated aspect of Berkshire’s compounding. Yesterday,
we talked about how uneven the compounding was over time. Today, we’re going to talk about
how uneven the compounding is in terms of sources.
Berkshire’s results are fueled a lot by its insurance operations. As an insurer, Berkshire tends to
turn an underwriting profit. This gives Buffett a cost free form of money called float. Berkshire
uses some of this float to invest in stocks and to buy entire businesses. The company uses its
retained earnings to finance the rest of these two portfolios – one made up of private businesses
100% owned and the other made up of minority stakes in publicly traded companies. The
underappreciated part of what Buffett does that we’ll be talking about today is exactly how he
buys these businesses and these stocks. How he buys businesses is pretty normal. Most
acquisitions done by big U.S. companies are done the same way. You buy basically 100% of a
company using a combination of debt you raise, cash you have on hand, and maybe (Berkshire
does this only occasionally) shares of your own stock. You make the purchase at one single point
in time. Sometimes you might draft some kind of earn-out agreement where the former owners
(who often stay on to manage the business you now own) make more money if the business they
sold to you hits certain targets over the first few years you own it. But, that’s a very small part of
the overall purchase price. We can simplify this by assuming you pay “x dollars” for the stock
upfront in cash and then hold the business forever. That’s how most acquisitions work.
What a lot of investors don’t appreciate is that Buffett runs his stock portfolio a lot like he runs
his stable of 100% owned businesses. Buffett buys and holds his shares in a company in a totally
different way from almost any other investors out there. And this has some pretty big
implications when it comes to just how the compounding of his stock portfolio works. Basically,
Buffett isn’t joking when he talks about how he buys his stocks the way he’d buy entire
businesses. That’s not just a metaphor for him. It’s literally how he makes many of his
purchases. For example, we can see in Berkshire’s 1977 letter (this is the oldest letter on
Berkshire’s site, if we went back further we’d see the same info) that the company’s Washington
Post investment had a cost of $11 million. Thirty years later – in 2007 – Berkshire’s cost basis in
the Washington Post was still $11 million. During this time, the market value of the Washington
Post shares Berkshire owned rose from $33 million to $1.4 billion. However, the cost basis
stayed the same. What does this tell us? Berkshire didn’t buy more Washington Post stock during
this time. It also didn’t sell out of the position, trade around the position, etc. Buffett just
acquired a minority position in the Washington Post in the 1970s and then kept that same
position – without adding or subtracting from it – for more than 30 years. That’s not how traders
think. It’s not how most investors think. It’s not even how most long-term investors or even
investors who say they are “buy and hold investors” think. Most people I know who refer to
themselves as buy and hold investors mean they stay in a stock for a long time in some form.
But, they might add to that stock each month as they save more money in their retirement
account. They might trim back the position to get it more in line with the original percentage of
their portfolio they devoted to the stock. In other words, they might “rebalance”.
Buffett doesn’t rebalance. He doesn’t rebalance the 100% businesses he owns. And he doesn’t
rebalance stocks in his portfolio. He buys a lot of Coke stock basically once. Buffett has
sometimes added a bit more to stocks like Coca-Cola, Wells Fargo, etc. over the years. But, if
you look at Berkshire’s history of buying stocks – Buffett is remarkably one-off in both his entry
into a stock and his eventual exit (if he ever exits). The other investment managers at Berkshire
might work differently. But, the biggest difference between Warren Buffett and most people
reading this article is the way he both buys and sells. Buffett doesn’t – at least not at Berkshire,
we don’t have as detailed info on his partnership years – tend to buy a stock slowly over a very,
very long period of time. He definitely doesn’t rebalance his stock portfolio by trimming back
winners and buying more of losers. If a stock starts out as 10% of his portfolio and outperforms
his other holdings – it becomes 30% of his portfolio. And he lets that happen. But, just as
importantly – if Buffett puts 10% of his portfolio into a stock and it turns out to be a real loser,
that loser just vanishes from his top holdings table without him ever needing to sell it.
Now, Buffett does sometimes sell losers. We’ve seen him do that. He will never sell a loser of a
100% controlled business. But, he will sell a loser as a stock. However, if you are adding more
and more money over time to your investable savings – as Buffett is at Berkshire Hathaway –
and you aren’t just automatically buying more of the stocks you already own to keep to some set
portfolio weighting, your losers will become a smaller and smaller percentage of your portfolio.
Imagine you have $100,000 in savings and add $10,000 in savings during the year. At the start of
the year, you bought two 20% positions – we’ll ignore the other positions you bought for this
illustration – where the stock with ticker “DBL” went on to go from a $20,000 market value to a
$40,000 market value. The stock with ticker “HLV” fell 50% from a starting market value of
$20,000 to $10,000. What relative importance will the returns in these two stocks have in year 2?
Well, at the end of year 1 you’ve added $10,000 to your account and one stock had a gain of
$20,000 and another stock had a loss of $10,000. We’ll assume your other 3 positions were a
total wash. So, that leaves you with a portfolio at $120,000 at the start of year 2 ($100,000 +
$20,000 + $10,000 = $130,000; $130,000 – $10,000 = $120,000). Now, the poorest performer
you had was HLV which dropped from a market value of $20,000 to $10,000. And
$10,000/$120,000 = 8%. Without selling a single share, you’ve cut your allocation to stock HLV
from 20% to 8%. At the same time, your best performer was “DBL”. It increased in market value
from $20,000 to $40,000. A lot of people would sell this stock now. But, you’re a buy and hold
investor. So, you’ll keep it in year 2 when its new portfolio weighting is 33%
($40,000/$120,000). Last year’s biggest winner is now 4 times more important to your portfolio
going forward than last year’s loser.
A lot of value investors might rebalance these. Buffett doesn’t. Clearly, he doesn’t in the case of
100% owned businesses. No one does that. That’s why any serial acquirer ends up heavily
weighted to two kinds of acquisitions – past acquisitions that were very successful growers and
recent acquisitions that were of a very big size – and very insignificantly weighted to one other
kind of acquisitions (unsuccessful acquisitions from long ago). You’ll notice this in the long-
term record of companies that acquire lots of other companies. If they did a deal a long time ago
and that business unit never really grew much – it just gets dropped from discussion in
presentations, annual letters, the 10-K, etc. It doesn’t get its own segment reporting. It doesn’t
have to be sold. It just slowly gets put so far in the distance to be made a speck by the simple
process of compounding happening at the other growing business units.
I was very impressed by Buffett’s discussion of this phenomenon in his 2019 letter. Now, he was
talking about 100% owned businesses. But, the same force is at work – somewhat lessened by
Buffett’s willingness to completely eliminate his positions in true losers when they are stocks,
not 100% owned businesses – in Berkshire’s stock portfolio.
Here’s what Buffett said:
“…the fallout from many of my errors has been reduced by a characteristic shared by most
businesses that disappoint: As the years pass, the ‘poor’ business tends to stagnate, thereupon
entering a state in which its operations require an ever smaller percentage of Berkshire’s
capital. Meanwhile, our ‘good’ businesses often grow and find opportunities for investing
additional capital at attractive rates. Because of these contrasting trajectories, the assets
employed at Berkshire’s winners gradually become an expanding portion of our total capital.”
This is only something that happens to buy and hold investor’s portfolios. It doesn’t happen if
you actively trade around positions. It doesn’t happen if you rebalance. It happens because a buy
and hold investor allows the “contrasting trajectories” of the underlying businesses in the
portfolio to naturally shift the percentage of capital employed in one business into another.
Let me use a longer term example of what could happen with those two stocks – “DBL” and
“HLV” – over a period as long as one decade. Let’s say you tend to be about a 10% a year type
investor in the sense that the average business you pick out to own in your portfolio will tend to
compound at 10% a year while you hold it. Okay. But, you’ll have some winners and some
losers. There will be quite a lot of dispersion in your results around that central tendency of
buying 10% a year compounders. However, unlike most investors – you won’t sell your stocks
before 10 years is up. You also won’t sell your winners to buy more of your losers. Nor will you
employ any kind of rebalancing. You’ll just buy however much you want of stocks “DBL” and
“HLV” this year (2020) and keep holding them ten years from now (in 2030). In this case, I’ll
imagine you aren’t saving more and adding that cash to your portfolio each year. If you did, that
would water down the concentration in “DBL” but also water down “HLV” further than what
I’m calculating here.
Let’s imagine “DBL” is an especially good compounder doing 20% a year for 10 years. A great
pick by you. But, “HLV” is a laggard. It’s not a disaster. But, you misjudged it. The stock
compounds at just 5% a year for the next 10 years. You have a 5-stock portfolio. You start with
20% of your portfolio in DBL, 20% in HLV, and 60% in 3 other stocks that are all truly
“average” picks by your standards.
How much of your portfolio will be in DBL at the end of 10 years?
How much of your portfolio will be in HLV at the end of 10 years?
Well, $10,000 invested in DBL will become $62,000 in 10 years.
Meanwhile: $10,000 invested in HLV will become $16,000 in 10 years.
The rest of your portfolio will go from $60,000 to $156,000.
Your overall portfolio has grown from $100,000 in 2020 to $234,000 in 2030 (a 9% a year
CAGR).
But, what I’m interested in is how much of your compounding in the 2030s will be driven by
each of the stocks you bought in 2020. You started out with 5 equally weighted 20% positions.
But, going into your second decade – your portfolio is now 26% in DBL and only 7% in HLV.
DBL will have nearly 4 times the influence on your compounding in the 2030s as HLV will. And
yet you didn’t make any active choice about either stock. You just let DBL outrun HLV by so
much over those 10 years that it became a progressively bigger part of your portfolio.
If this same difference in compounding – 20% a year versus 5% a year – was sustained for a full
20 years, your winning position would be 14 times larger than your losing position. If you were
running a fairly concentrated portfolio, adding more to your savings each year, and had even just
a couple more big winners – that “losing” position would seem to simply vanish into
unimportance in your brokerage statements. You wouldn’t have to sell a share. Your mistake
would just gradually erode over time.
Is this a good strategy though?
Should you bet more and more on stocks with the highest CAGRs in your portfolio and less and
less on the stocks with the lowest CAGRs in your portfolio?
I can’t answer that question.
Obviously, that is how fortunes are made. It may not be how jobs are kept though. I wouldn’t
recommend it to the average mutual fund manager. But, no business or investor has grown their
net worth to a tremendous size by rebalancing their winning businesses and losing businesses
over time. It’s also kind of inefficient in other ways. But, even before worrying about taxes and
fees and such – equal weighting your bets to start and then not adding to them or cutting them
back would be the approach that seems closest to how super successful investors built their
records over time.
It’s certainly the way Buffett did it. He tends to buy a lot of a stock till he stops. And then he
holds that stock till he decides to eliminate it. He clearly does not target some sort of percentage
allocation to various stocks. If Apple looks cheap to him, he’d buy it whether it was 10% of his
total stock portfolio, 30%, or 50%. And, if it didn’t look cheap, he’d just keep holding it without
rebalancing it with the other stuff he owns.
The section where Buffett discusses how the errors he made in buying 100% controlled
businesses have been overwhelmed into percentage insignificance by the compounding of the
successes he had is my favorite part of this year’s annual letter.
It’s definitely worth a reread. And it’s something I’ve been struggling with now that I run both a
hedge fund and separately managed accounts. The fund structure allows you to buy like Buffett
buys. And that certainly feels more natural to me. The separately managed accounts don’t really
allow you to do that. And so you are really targeting percentages of the portfolio to allocate. That
makes a lot of sense to a lot of investors. It seems to be the way most professionals think. But,
it’s not the approach that seems most intuitive to me.
You can certainly buy the same kinds of stocks as Buffett does in any structure. You can buy
what he’d buy and rebalance it. You can buy what he’d buy and trade around it. But, will you get
similar results? Is Buffett’s success as an investor due to which stocks he picked? Is it due to
how much he put into each of those stocks? Or, is it due to the fact he leaves both his winners
and losers alone far more than the average investor does?
Probably some combination of all three. But, it’s usually only the first point – what to buy – that
gets discussed. How he holds his stocks is rarely discussed.
Reading this year’s Berkshire shareholder letter gives us a chance to look at the way we hold the
stocks we’ve bought and look for ways we can improve our “hold process”. Do we really want to
be more like Buffett? Do we have the stomach for it? Or, do we need to constantly be tweaking
our position sizes to feel like we’re earning our fees?
 URL: https://focusedcompounding.com/how-buffett-holds-the-incredible-importance-of-
the-contrasting-trajectories-of-long-term-winners-and-losers/
 Time: 2020
-----------------------------------------------------
Ask Yourself: In What Year Would You Have Hopped Off the Warren
Buffett Compounding Train?
Warren Buffett’s annual letter to Berkshire Hathaway shareholders was released today. It starts –
as always – with the table comparing the annual percentage change in Berkshire Hathaway with
the annual percentage change in the S&P 500 with dividends included. Long time readers of the
Buffett letter will remember when the change in book value of Berkshire Hathaway was
included. That’s been removed. We are left with the change in per-share market value of
Berkshire Hathaway.
Today, I’m just going to focus on this table. Over the next few days, I’ll talk about a few
different parts of Buffett’s letter I found interesting. But, one of the most interesting pages in the
letter is the very first one. The one with the table showing Berkshire’s performance vs. the S&P
500.
What’s notable about this table? One, Berkshire has outperformed the S&P 500 by about 10% a
year over more than 50 years (1965-2019). Berkshire has compounded its market value at about
20% a year while the S&P 500 has done 10% a year. What’s also notable is the many very big
years for Berkshire as a stock. On my print out of the letter, I circled some years that stood out to
me. Basically, I just assumed that it’s incredibly rare for the S&P 500 to ever have a return of
around 50% a year. Generally, an amazing year for the S&P 50 would be one like what we saw
last year (up something over 30%). If you are completely in the S&P 500 index, your portfolio is
not going to have up years of 40%, 60%, or 120%. Berkshire’s stock price sometimes does go up
that much. Or, rather – it sometimes did. It hasn’t lately.
Berkshire had amazing up years – as a stock, these don’t necessarily match up with business
results – two times in the 1960s, three times in the 1970s, three times in the 1980s, twice in the
1990s and then never again since the late 1990s. Berkshire’s stock has gone over 20 years with
no what I’d call amazing up years. Any good year Berkshire has had as a stock in the last 20
years has been the kind of up year an index like the S&P 500 is also capable of. This obviously
tamps down on Berkshire’s long-term performance potential. Most stocks that have amazing
long-term compounding records will achieve those records with a bunch of short-term upward
spurts in their stock price like Berkshire had in the 1970s, 1980s, and 1990s. In the last 20 years,
Berkshire has had several years where returns were in the 22-33% range. Those are great years.
But, they are years the S&P 500 is also capable of having (it was up 32% last year). The
disappearance of these very big up years – the “lumpy” outperformance – in Berkshire as a stock
explains a lot of why the stock performed so well versus the S&P 500 for its first 30 years under
Buffett and so much less well over the last 20 years.
I also wanted to focus your attention on this table to consider whether you would have really
held Berkshire Hathaway stock through the 1970s, 1980s, and 1990s. It hasn’t been hard to hold
Berkshire stock these last 20 years. The stock hasn’t had many huge up years or huge down
years. It would be easy to convince yourself the stock was always within spitting distance of fair
value and you might as well hold on. But, we need to remember that Berkshire’s outperformance
over 50+ years is much more weighted to the 1960s, 1970s, 1980s, and 1990s.
Berkshire’s stock rose 50% in 1965 (around the time Buffett was taking over the company). It
was basically a poorly performing (but not terribly small) net-net focused on textiles. It now had
a successful hedge fund manager in control of the board. So, a 50% increase in the stock price
would’ve meant the stock was still crazy cheap and now you had a great catalyst. Okay. You
may have held on from there. It rose another 78% in 1968. At this point, would you have held the
stock or “taken profits” in this underperforming textile company. Remember, Berkshire was still
overwhelmingly in textiles in 1968. Now, it’s possible you might have held. I know plenty of
investors who hang on to a stock they like even after a 78% gain in one year. Though I probably
know more that like to trim back such a position – especially if it started as an oversized holding
for them – and “take money off the table”. If something doubles, they like to sell about half of it
and “play with house money”. Still, stocks weren’t that cheap in 1968. Berkshire was already
performing well as a stock compared to a lot of the other stuff that might’ve been in your
portfolio from 1965-1968. It was not expensive. Buffett was clearly doing stuff with it. He had
an amazing record as a hedge fund manager in the 1950s and 1960s. And, in 1967, he bought an
insurance company in the city where he lived (Omaha). So, there was a really clear catalyst here
where a star hedge fund manager was shifting a New England based net-net away from its bad
textile business and into an Omaha based insurance business. Insurers control money. They make
investments. Even if you didn’t know Buffett had a history investing in GEICO personally – and
I’m pretty sure you wouldn’t have known that in 1968 – you still would’ve known insurers have
an investment side and an underwriting side. Buffett already had a record as one of the best
investors in the U.S. He was young. He was already improving capital allocation at Berkshire.
Would a deep value investor have held at this point? No. He’d have sold out. But, someone who
believed in Buffett? Yes. He might have stuck with this stock into the 1970s – which is where I
see the first years that would’ve gotten a lot of value investors out of this stock.
Berkshire had one terrible year in the 1970s. In 1974, the stock plunged 49%. The S&P 500 was
down over 40% during 1973 and 1974. If you look at calendar year results – Berkshire badly
underperformed the market in 1974. But, my guess is that Berkshire’s decline in the 1973-1974
period (a terrible one for many stocks) was about equal to what you would’ve seen in other
stocks in your portfolio. There’s no reason to think you would’ve seen this as a big buying
opportunity in Berkshire – or, as a sign you needed to dump the stock. A lot of investors were
dumping a lot of stocks. But, the decline in Berkshire in 1973 and 1974 would’ve been pretty
typical of what you might’ve seen across the board in your brokerage statements. Remember,
Berkshire was not a big stock at this point. It wasn’t all that widely traded. Also, stocks in
general were much less frequently traded in the early 1970s than they are today. NYSE listed
stocks in the 1970s and 1980s probably turned over at a rate you now see only in fairly illiquid
OTC type stocks. So, you should keep in mind that when we’re talking about the first 20 years of
Buffett’s record at Berkshire (from 1965-1985) we’re talking about a period of generally falling
interest in stocks among the public, low share turnover, etc. A lot of these were pretty pessimistic
years in terms of people’s expectations for stocks. That was not true right around the start of the
period (1965 and earlier) and wouldn’t be true again once we get out of those first 20 years
(1985-2000). A lot – but certainly not all – of Buffett’s great compound record is due to these 20
years from 1965 to 1985 where people were generally getting less interested in and more
pessimistic about stocks.
It’s not the down years in the 1970s that worry me. It’s the up years. This is what would’ve
shaken out a lot of the best investors I know today. Value investors have a tendency to sell their
winners. And Berkshire was a bigger winner several times in the 1970s. Would you have sold
out – or, more likely, trimmed back your position to a “prudent level for diversification
purposes” – in years like 1971 (up 81%), 1976 (up 130%), or 1979 (up 103%).
Those years are the kind of years that tend to weed out the value investors among a shareholder
base. Berkshire’s compounding record – in stock market value, not book value – wasn’t all that
smooth. There are strings of strong but steady results. I think investors would’ve enjoyed the
years 1980, 1981, and 1982 for example. The stock was up 33%, 31%, and then 38% in those 3
years. In my experience, investors love annual returns in the 30% range. If you buy a stock and it
goes up 120-175% in one year – you usually sell. But: if that same stock goes up 30-40% in year
1, 30-40% in year 2, and 30-40% in year 3 – you’re a lot more likely to stick with the stock if it’s
your favorite business run by your favorite CEO. By the early 1980s, Berkshire was also looking
a lot more like a business that would be comfortable to hold. Buffett had successfully diversified
the company away from textiles – to the point where the New England mills barely mattered. In
1980, you would’ve already read Berkshire’s 1979 annual report. You would’ve known
Berkshire was getting most of its earnings from insurance – not from textiles. It was like 50/50
an insurer slash investment portfolio and the other 50% a group of owned businesses. The
biggest of these owned businesses was an excellent bank in Illinois. The second biggest was a
very successful candy company in California. Then there was a mix of mostly other financial
type companies. In fact, by 1980 – you could’ve expected Berkshire would become mostly some
sort of financial company. It did have a big (loss making) investment in a Buffalo newspaper and
a minority position in the Washington Post and some other media properties. So, you would’ve
realized Buffett liked media companies. But, he seemed to like insurers and banks at least as
much. I don’t think the steady returns throughout the early 1980s would’ve been a problem.
But, even in the later 1980s we see some pretty big one year gains. In 1983, Berkshire rose 69%
vs. 22% for the market. Then 94% versus 32% for the market in 1985. The really tough time to
keep holding Berkshire would’ve been the end of the 1980s. Berkshire was up 59% in 1988 and
85% in 1989. It then plunged 23% in 1990.
After that, it got relatively easy to hold Berkshire Hathaway. Buffett was a pretty well known
person – at least among investors in the know – by 1991. He was kind of famous from this point
on. Not as famous as he’d become as an old man. But, famous enough that he was as well known
as anyone in the investment world. Berkshire rarely had huge up or down years after 1990. It did
rise 50% or more twice in the 1990s. But, so did a lot of stocks. These were amazing years for
the overall market. Berkshire was more of a value stock than the other things you could’ve
bought. I don’t see a lot of value investors who stayed plain vanilla value investors – instead of
getting into the dot com stuff – being likely to hop off Buffett’s compounding train anytime in
the last 30 years.
What were the tough years?

For value investors, I think there were several years in the 1970s and 1980s that would’ve really
tested their willingness to hang on to an amazing winner. Berkshire wasn’t a hot stock ever. But,
it did have some good years in the 1970s when some other stocks were insanely cheap. To be
fair, getting off the Berkshire compounding train at this point and into one of these other super
cheap stocks wouldn’t have been as dumb a move as it seems to us now. Berkshire even owned
some of the stocks I think value investors would’ve been tempted to get out of Berkshire for. A
good example would be ad agencies. Other examples would be leading big city newspapers.
Berkshire bought into both type of stocks in the 1970s and had great results. And remember:
Berkshire paid no dividend – while a lot of these great ad agencies, newspapers, etc. had
dividend yields of 6-10% a year at the market’s bottom. So, a lot of investors would’ve
abandoned a company with a dividend yield of nothing for one with a nearly double-digit yield.
And these Investors abandoning Berkshire for some of those same shares Buffett was buying in
the 1970s would’ve gotten some good compound results too.
But…
Would they have ever gotten back into Berkshire?
That’s the problem.
In any decade, we can find a few stand out stocks in a few stand out industries that would’ve
compounded like Berkshire. But, how many of the winners of the late 1960s were the winners of
the 1970s? How many of the winners of the 1970s were the winners of the 1980s? And so on.
Part of Berkshire’s success came from the fact it had a really good 1965-1972 period (especially
versus other stocks) AND a really good 1985-1992 period. I can’t think of many businesses that
were still that good at compounding 20 years later. The best returning stocks from 2010-2019 are
very unlikely to be the best returning stocks again from 2030-2039. We’ll have forgotten the
names of many of the market’s winners over these last 10 years by the time the 2030s end.
So, when would you have gotten off the Berkshire Hathaway compounding train?
When would you have taken profits, trimmed back your position to a manageable size, gotten out
entirely?
And would you have ever gotten back in?
Learning from Buffett’s success as an investor has two parts. One, you need to know how he
compounded like he did and try to copy what you can. Two, you need to know how to let a
successful investment – once found – compound for you for as long as he has.
I’m sure I never would’ve stayed in Berkshire stock till 2020 if I’d bought it in 1965. I’m less
sure of where I would’ve sold out, why, and if I’d ever get back in.
Try the thought experiment on yourself at home. Imagine you bought Berkshire in 1965. Which
specific years would’ve most tested your resolve to keep betting on Buffett. Would it have been
a mistake to sell? And, what can you from this little bit of self-discovery about your approach to
buy and hold?
 URL: https://focusedcompounding.com/ask-yourself-in-what-year-would-you-have-
hopped-off-the-warren-buffett-compounding-train/
 Time: 2020
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Outperformance Anxiety
I spend a surprising amount of time talking with members about other investors – investors who
are doing better than them. The truth is: returns much beyond 20% a year aren’t even worth
thinking about. Sure, you can find investors who have done better than 30% a year for a ten year
stretch. I have a copy of Joel Greenblatt’s “You Can Be a Stock Market Genius” sitting here on
my desk. And if I flip to the back of that book, I’ll find a performance table that goes like this:
70% (1985), 54% (’86), 30% (’87), 64% (’88), 32% (’89), 32% (’90), 29% (’91), 31% (’92),
115% (’93), and 49% (’94). The works out to a 10-year compound annual return of 50%. Then
there’s Warren Buffett’s partnership record which reads: 10% (1957), 41% (’58), 26% (’59),
23% (’60), 46% (’61), 14% (’62), 39% (’63), 28% (’64), 47% (’65), 20% (’66), 36% (’67), 59%
(’68), and 7% (’69). That works out to a 13-year compound annual return of 30%. One member
wanted to talk to me about the performance of a fund manager – better than 30% a year for
longer than 5 years – who followed a concentrated portfolio. For the managed accounts, Andrew
and I target six equally weighted positions. So, I’m always interested in seeing what a
concentrated portfolio looks like. This fund manager had most of his portfolio in 4 stocks:
Herbalife, Cimpress, Credit Acceptance, and World Acceptance. A portfolio like that is taking
risks very different from the ones you’re taking. They may be right about all those risks. But,
they have to have opinions about subprime credit risks, pyramid schemes, tax avoidance
strategies, etc. It isn’t just that those stocks are often shorted, controversial, etc. as stocks. The
actual businesses are doing riskier things than the businesses you likely own. You don’t have to
take big risks to get rich. But, you often do have to take big risks to get rich quick. I mentioned
Joel Greenblatt’s record at Gotham Capital. It was 50% a year over 10 years. Charlie Munger’s
record was just 20% a year over 14 years. Warren Buffett’s record at Berkshire – not his
partnership – has been 22% a year over 53 years (and Walter Schloss did 15% a year over
something like 45 years managing smaller sums). During the time Berkshire did 22% a year, the
S&P 500 did 10% a year. Those are the two yardsticks you should look at: 10% a year and 20%
a year. In every year where you manage to do 10% a year, you are on pace to match or beat the
long-term rate for the S&P 500. In ever year where you manage to do 20% a year, you are on
pace to match or beat the long-term rate for some of the very best investors in the world. People
mention the performance of investors like Joel Greenblatt and Peter Lynch a lot. But those
performances are for less than 15 year stretches. You have more than 15 years of investing left in
you. So, you should be thinking in terms of what kind of performance you can sustain for 20
years or more.
– Geoff Gannon
 URL: https://focusedcompounding.com/outperformance-anxiety/
 Time: 2018
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Pre-Judging a Stock
This week, a Focused Compounding member sent me a link to a blog post about Brighthouse
Financial (BHF). Brighthouse Financial is the spun-off retail business of MetLife. Although
websites often list Brighthouse Financial under the industry group “Life Insurers”, the stock is
really a seller of annuities. Many of these annuities are tied to the performance of the S&P 500 or
other stock indexes. So, the company’s investor presentation includes a slide where it shows how
badly affected the company would be by various percentage declines in the S&P 500. Based on
that slide, the writer of that blog post eliminated the stock from consideration. He had spent –
perhaps – an hour or less looking at this company. That was enough to tell him no to invest.
Should it be? What we are talking about here is literally prejudice. It is judging a business before
you fully understand it. It is making a snap judgment based purely on your initial impressions.
And especially on this stock’s resemblance to other such stocks you’ve seen before. You think
back to all the stocks you know that have some similarities to this one and you make a snap
judgment – assigning this stock to the same group as those stocks. It’s definitely a time saver.
And for those who believe in Peter Lynch’s motto that he who turns over the most rocks wins –
it’s an efficient approach. If you can quickly glance at a thousand stocks and find ten that really
excite you on your first impression and buy those – maybe that’s enough. A lot of investors
follow the pre-judging approach. I tweeted about the KLX Energy Services business. This is
technically going to be a spin-off. However, what is really happening is that Boeing is buying
KLXI’s aerospace business for cash and leaving KLX Energy Services for KLXI’s current
shareholders. This is the spin-off I’ve most been looking forward to this year. Someone on
Twitter mentioned that “…if I recall ESG is a collection of absolutely garbage businesses.” KLX
Energy Services was formed as a super fast roll-up of a bunch of
U.S. energy service providers that served “tight oil / tight gas” (shale oil) producers in the U.S.
The price of oil dropped quickly around the time of KLX’s acquisition spree (late 2013 through
2014). Some of these acquisitions were made when oil was around $100 a barrel. So, KLX paid
high multiples of EBITDA for businesses where the EBITDA completely vanished in the oil
price crash. This collection of businesses may be garbage. But, it’s impossible to know they
really are if you only have data going back about 5 years and those 5 years don’t include
anywhere near a full cycle in oil.
Brighthouse Financial and KLX Energy Services are both tempting stocks to pre-judge, because
if you don’t pre-judge them you have to do some heavy lifting. Brighthouse Financial is
complicated. KLX Energy Services doesn’t have the past financial performance data I’d want to
see. In both cases, the analyst has to do the very hard and very speculative work of coming up
with future estimates based on what they know of the business model. Snap judgments are a lot
faster. And they allow you to focus on simpler, better understood businesses. Of course, if other
investors happen to be making the same snap judgments you are about the same stocks you are –
then the stocks you’re quickly dismissing may be the least efficiently priced stocks out there.
– Geoff Gannon
 URL: https://focusedcompounding.com/pre-judging-a-stock/
 Time: 2018
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Doubt as a Discount
Let’s play a game. I ask you a series of questions. You give me a series of answers. I then test the
answers you give to prove them false using as unfavorable a definition of false as I feel like. You
have $1,000 in your pocket. You can’t leave the room. You can’t use your phone. And you can’t
take off your shoes. I offer you even money odds on each of the following questions asked in
succession: 1) What is your gender? 2) How old are you? 3) Who is your biological father? 4)
What is your shoe size? 5) How tall are you? 6) How much do you weigh? 7) How many times
will you go to the gym this week?
To complete this game, you need to give me seven pairs of answers. One, what percent of the
money in your pocket are you betting? And two, what’s your answer. This game can end with
you having anywhere from $0 to $128,000. Now: get out an index card. And write down your 7
answer pairs. Don’t read on till you’ve done that. Okay. Let’s assume you did bet all $1,000 that
your gender is male. Should you have bet 100%? To answer this question, we need to know what
the chances are that you would think you’re male and yet I could prove that answer false under
the strictest test. If we assume the only way you could win this bet is if you said male and your
chromosomes are “XY” and only “XY” then we can create a range of chances that someone
might say they are male and yet fail this test. By my estimates, more than 98% of males would
have no doubts they were male and be right even if subjected to the “XY” only test, perhaps up
to 2% (an over estimate) of males would have doubts and could lose this bet under the strict
“XY” only test, and about 0.2% might not have any doubts and yet could lose this bet. How
should you have bet?
One way for figuring out how much to wager on each of a series of bets is the Kelly Criterion. I
haven’t met any investors who say they use the “full Kelly”. However, I have met investors who
say they use “a third Kelly”. Say the Kelly Criterion tells you to bet 96% on the answer “Male”.
Someone using a third Kelly would bet 32%. The third Kelly leads to a bad bet here. Why? The
Kelly Criterion sets the limit of how much you should bet given the chances and odds you’ve
plugged into the formula. In the case of the gender question: a full Kelly doesn’t ask if you
understood what I meant by male. Meanwhile, a third Kelly applies a 67% doubt to your own
thinking about every problem you encounter. Betting 32% on the answer “Male” is like saying
you’re 98% sure you’re male as you understood the question but there’s a 67% chance you didn’t
understand the question. This is the same as betting like you’re 66% sure you’re male and 100%
sure you understood the question. Here, a third Kelly absurdly overestimates the furthest fringe
estimate of a reasonable level of self-doubt. Factoring in a doubt discount (assuming there’s a
chance the world works differently than you think) is a sound step to take in every investment
decision. For example, you may not have considered any chromosome combos but “XX” and
“XY”. Among the other questions…You may not have considered that your height changes
throughout the day. You may not have considered that although you look like the man you think
is your father – your dad has brothers. Once reminded of these facts, you should adjust your bet
size down – but only within reason. Notice that all 7 questions are things you should know.
Several are objectively verifiable facts. And yet none of your answers will be 100% free from
doubt. Therefore, none of your bets can be either.
– Geoff Gannon
 URL: https://focusedcompounding.com/doubt-as-a-discount/
 Time: 2018
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Stylistic Skew
This week, Vetle Forsland was our guest for two podcast episodes. One was about GameStop
(GME). The other was about Entercom (ETM). You should listen to them both. What stood out
to me in those two episodes was Vetle’s style as a stock picker. GameStop sells – among other
things – physical copies of video games. Entercom owns terrestrial radio stations. A lot of
investors think these two stocks are in buggy whip businesses. And so, these investors don’t even
bother trying to come up with an appraisal value for the businesses and compare that to the
market price of the stocks. For most investors, these two stocks are unsafe at any price. But Vetle
is willing to search through other investors’ trash to see if there is any treasure hidden there.
That’s his stock picking style.
Vetle’s two podcast episodes went up the same week I started thinking about exactly what I’m
going to put in the first letter I will have to write to clients of Focused Compounding Capital
Management. The first letter to clients went out today. Andrew wrote that one. It discussed the
general strategy those managed accounts will employ. But next month’s letter will be written by
me, not Andrew. And it won’t be discussing general strategy – it’ll be talking specific stocks.
That letter would be easier to write if each stock stood out as an utterly unique case. I could just
rattle off five paragraphs about five different stocks. The problem is that there’s clearly a
common – yet unconsciously woven – thread running through those five stocks. I noticed it the
other day. I was looking over the five stocks sitting in the planned “Buy” pile for those managed
accounts and glanced at a number we don’t normally talk about in these memos: “beta”. As you
probably know, beta is an indicator of a stock’s volatility scaled to some index’s volatility. A
beta of 1 would suggest similar volatility to the S&P 500. The five stocks in that “Buy” pile for
the managed accounts have betas of: 0.64, 0.33, 0.19, 0.17, and negative 0.10. Now, I don’t put
much stock in those betas because the actual correlation with the market for these stocks is
probably pretty low. I doubt these stocks tend to be green on days when the market is green just
to one-third or so of the extent the market is up and red on days when market is red just to one-
third or so of the extent the market is down. So, that series of five betas doesn’t mean much. But,
it does mean one thing. That wasn’t luck. You don’t draw betas of 0.64, 0.33, 0.19. 0.17, and
negative 0.10 randomly out of a hat with every stock in it. Likewise, Vetle probably (a sample
size of two is awfully small) doesn’t draw two investment write-up subjects out of a hat
randomly and find that both of them just happen to be in industries most investors consider to be
on the brink of extinction. The way you end up writing about two such stocks is if there is some
inherent bias in your stock selection – a signature stylistic skew to the way your mind sorts the
entire investment universe.
Is Vetle a contrarian investor? Are Andrew and I risk-averse investors? We can’t know that. But,
we can know we each have our own unique style – and it shows even in ways we don’t intend it
to. Till this past week, I’d never checked the betas on the stocks Andrew and I picked for the
managed accounts. So, “low beta” certainly wasn’t a conscious choice. Rather, it was an
unconscious outcome of our stock picking style. My question for you this week is: what’s your
stylistic skew? And then the harder follow-up: what is it about your stock picking style that
skews your portfolio away from the norm?
 URL: https://focusedcompounding.com/stylistic-skew/
 Time: 2018
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Relative Regret
One of the most difficult things for investors to deal with is to watch other get richer faster than
you. In the stock market, the same choices are available to everyone. So, if someone is up 20%
this year, they are up 20% purely on a collection of opportunities you passed on. Two things
make this even tougher for the people reading this memo. One, you judge yourself on your
relative results versus a benchmark like the S&P 500. Two, you judge yourself on a yearly basis.
Even if your process is superior to that of most other investors – there’s a decent chance you’re
lagging this year. Does that mean you’re a failure as an investor? Is it even realistic to set the bar
as high as beating a benchmark each and every year?
Let’s think about this another way. Let’s remove the idea of you from this analysis. Instead let’s
imagine we are evaluating not an investor but an investment strategy. And, to make this easier,
let’s set the pace horse a lot slower. Investing in the S&P 500 is not a bad strategy long-term.
What is a bad strategy? Putting 100% of your savings into a commodities basket month after
month. History shows that holding a basket of commodities indefinitely barely keeps up with
inflation. So, if you continue to make a 100% commodities wager month after month for the rest
of your working life you are almost certain to underperform the person who makes a 100% S&P
500 index wager month after month for the rest of his working life. In fact, based on the very
long-term past record the annual real edge your neighbor would have over you if he invested
100% in a stock index fund and you invested 100% in a commodities basket would be greater
than the house’s edge on a single game of baccarat, blackjack, roulette, or craps.
To simplify this hypothetical, let’s say you get only one investment choice your whole life.
Instead of picking specific investments as the years go by – you only get one choice at the start
of this 30-year period. And that choice is a strategic choice. You can either pick the 100% stocks
strategy or the 100% commodities strategy. You can’t switch. Will there be years in which you
regret taking the 100% stocks strategy? In a sense, yes. A basket of commodities will – in some
of the next 30 years – outperform a basket of stocks. Yet, to say you would – in those years –
actually regret your initial choice of the 100% stock strategy is like saying a casino would rather
be the player than the house. If the casino knew the future of each hand, each night of play, etc. –
I guess you could say that. However, what exactly is it that an investor is actually regretting in
his poor relative performance years? He’s regretting not switching strategies from a long-term
superior strategy to a long-term inferior strategy, because not switching has caused him to
underperform for stretches of time during which the better strategy underperforms the worse
strategy. In other words, an investor might regret sticking with one strategy for 30 years, because
he may believe that cycling through different strategies at different times would give him a better
result. That kind of regret sounds like the regret of not knowing the future. Any strategy that
works long-term (like taking the house’s side on a casino game) will have stretches where it
doesn’t work. Trying to minimize those periods of regret, will cause an investor to use his best
strategy in fewer years and thereby reduce the rate at which he compounds his money over 30
years. It will be as if he chose to take the house’s side in 20 hands and the player’s side in 10
hands instead of sticking with the house on all 30 hands.
 URL: https://focusedcompounding.com/relative-regret/
 Time: 2018
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Anything Times Zero
Since I read “Fortune’s Formula” and “A Man for All Markets” this past week, let’s talk
blackjack. In blackjack, the player has an advantage over the casino if he’s counting cards. A
card counter can bet nearly the minimum when he suspects the rest of the deck has cards
unfavorable to him in higher proportion than a fresh deck and he can bet nearly the maximum
when he suspects the rest of the deck has favorable cards in a higher proportion than a fresh
deck. Applying this to stocks, let’s say you’re convinced Wells Fargo is a safe bank and Bank of
the Ozarks is a risky bank. You have $10,000 to invest in bank stocks. These are the only two
bank stocks you know anything about. You have one question: what happens if instead of taking
your $10,000 and putting $5,000 into Bank of the Ozarks and $5,000 into Wells Fargo you
instead put $1,000 in Bank of the Ozarks and $9,000 in Wells Fargo. You still start off with
$10,000 worth of bank shares, but now you are acting like a card counter – betting nearly the
maximum when you think the rest of a deck (Wells Fargo’s future) is favorable and betting
nearly the minimum when you think the rest of deck (Bank of the Ozarks’ future) is unfavorable.
How important is your decision to split your money 10/90 in favor of Wells Fargo?
Let’s say the chance of Wells Fargo stock going to zero in any one year is 0.5% and the chance
of Bank of the Ozarks going to zero in any one year is 5%. Over a single year, a bigger annual
upside – especially in the form of a quicker catalyst – can make up for a stock being 10 times
riskier. Stocks are volatile. And any extra chance of a 50% pop in the stock’s price this year
could overcome a 4.5% difference in the rate of catastrophe. So, if you frame your own
investment lifetime as lasting only a single year – the math says it’s perfectly fine to bet as much
on Bank of the Ozarks as on Wells Fargo. Catastrophic failure is not a big deal over one year.
And you’ve promised yourself you’ll only play one hand. You’ll buy both Wells and Bank of the
Ozarks today and sell twelve months from today no matter what. Whatever result you get won’t
compound. That makes failure cheap. And if there’s some upside catalyst you see for Bank of the
Ozarks this year – that catalyst could overcome the 4.5% greater chance of catastrophe this year.
But, that’s framing the choice as a one-year bet. Buffett has owned Wells for 27 years. So, let’s
ask: what is the difference between a 99.5% annual survival rate and a 95% annual survival rate
if you’re committed to letting each bet ride for the full 30 years? Now failure isn’t cheap. It’s
expensive, because it kills compounding. If you keep letting the risky bet ride, you will –
sometime after five years – have survived a 1-in-4 chance of catastrophe, after 10 years you’ve
dodged a 4-in-10 chance, after 15 years you’ve survived a 50/50 chance of disaster, after 20
years a 2-in-3 chance of disaster, and after 30 years a 4-in-5 chance of total failure. Meanwhile,
in Wells Fargo you’ve dodged a 1-in-6 chance of failure after the full 30 years. If the surviving
stock had been compounding at even just 6.2% a year it is now worth 6 times what you
originally paid. Let’s look at the 50/50 split approach. If you held for 30 years, your two $5,000
bets would result in an 80% chance of having zero dollars in the first bucket (Bank of the
Ozarks) and an 85% chance of having $30,000 in the second bucket (Wells Fargo). A 10/90 split
would – after 30 years – result in you having an 80% chance of having zero dollars in the first
bucket (Bank of the Ozarks) and an 85% chance of you having $54,000 in the second bucket.
The tiny bet / giant bet approach works when holding for 30 years. Why? It’s not because the
safe stock ever offers better one-year odds than the risky stock. It’s just that the safe stock offers
the best chance of never killing compounding.
 URL: https://focusedcompounding.com/anything-times-zero/
 Time: 2018
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The Second Side of Focus
Back in 1991, Warren Buffett and Bill Gates were asked the same question. What one word
described how they became successful. Both men said “focus”. Most investors I talk to
understand the importance of focus. But, they understand it wrong. They think that Buffett and
Gates mean they applied themselves longer, harder, and in a more disciplined way to a particular
task. This is the focus means more school of thought. It’s half the story. There is a second side to
focus.
Warren Buffett’s biographer, Alice Schroeder said this of Buffett: “…he expends a lot of energy
checking out details and ferreting out nuggets of information, way beyond the balance sheet. He
would go back and look at the company’s history in depth for decades. He used to pay people to
attend shareholder meetings and ask questions for him. He checked out the personal lives of
people who ran companies he invested in. He wanted to know about their financial status, their
personal habits, what motivated them.
He behaves like an investigative journalist. All this stuff about flipping through Moody’s
Manuals picking stocks, it was a screen for him – but he didn’t stop there.” That’s the kind of
focus investors imagine. Hard work. But, there is another way to look at what Alice Schroeder
said there. Focus means doing more about less. But, focus also means doing less about more.
Alice Schroeder did a Reddit interview where she talked about Buffett’s approach to time
management: “Warren is a master of time management. He knows how to ease people off the
phone without making them feel dismissed. He is great at saying no…he manages his energy,
reading when it’s optimal, talking on the phone when he’s got the right energy for that and so
forth… he does not multitask through his day.”
The question then is why others don’t do what Buffett has done. Why don’t they focus as much?
Is it the first side of focus: the hard work, the deep dive into one specific subject? Or is it the
second side of focus: denying yourself the possibility of knowing a lot of subjects superficially.
This comes up whenever I talk about specializing in some specific type of stocks. Recently, I
gave this advice to two different people. I said here is a list of categories of stocks that “work”.
They tend to get overlooked. So, instead of sifting through all the public companies out there –
start by limiting yourself to stocks that are spinoffs or have spun something off, that are OTC
stocks, that are illiquid, that have just come out of bankruptcy, etc. The reaction from both
people was: “Eh. Why restrict myself? Maybe I’ll have a great idea that doesn’t fit into any of
these arbitrary boxes.” And they probably will. Odds are that the very best investment
opportunity out there right now isn’t in any of those arbitrary little boxes. But, you
don’t need the very best investment idea out there. All you need is a hunting ground that reliably
turns up enough ideas for you to focus on.Buffett’s best returns were in the 1950s. Think of all
the great, big businesses he never considered during that decade. That’s the painful part of focus.
You are giving up a superficial knowledge of almost every stock out there in exchange for an in-
depth knowledge of the small group of stocks you choose to specialize in. It’s a trade-off. And
no one likes trade-offs. Everyone likes to keep their options open. All their options. But, it’s only
when you start closing off options that you open yourself up to focus. You have to find a way to
eliminate 95% of the ideas out there to focus on the 5% that matter most.
 URL: https://focusedcompounding.com/the-second-side-of-focus/
 Time: 2018
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All About Edge
Richard Beddard recently wrote a blog post about company strategy. And Nate Tobik recently
wrote one about how you – as a stock picker – have no edge. I’d like you to read both those posts
first. Then, come back here. Because I have something to say that combines these two ideas. It’ll
be 3,000 words before our two storylines intersect, but I promise it’ll be worth it.

Stock Picking is Like Playing the Ponies – Only Better
Horse races use a pari-mutuel betting system. That is, a mutual betting system where the bets of
all the gamblers are pooled, the odds adjust according to the bets these gamblers place, and the
track takes a cut regardless of the outcome.
At the race track, a person placing a bet has a negative edge. He places a bet of $100. However,
after the track takes its cut, it may be as if he now “owns” a bet of just $83.
At the stock exchange, a person placing a buy order has a positive edge. He places a bet of $100.
However, after a year has passed, it may be as if he now “owns” a bet of $108.
All bets placed at a race track are generically negative edge bets. All buy orders placed at a stock
exchange are generically positive edge bets.
In horse racing, the track generally has an edge over bettors. In stock picking, the buyer
generally has an edge over the seller.
In the Long Run: The Buyers Win
The Kelly Criterion is a formula for maximizing the growth of your wealth over time. Any such
formula works on three principles: 1) Never bet unless you have an edge, 2) The bigger your
edge, the more you bet and 3) Don’t go broke.
In theory, the best way to grow your bankroll over time is to make the series of bets with the
highest geometric mean. Math can prove the theory. But, only in theory. In practice, the best
way to prove whether a system for growing your bankroll works over time is to back test the
strategy. Pretend you made bets in the past you really didn’t. And see how your bankroll grows
or shrinks as you move further and further into the back test’s future (which is, of course, still
your past).
Try this with the two “genres” of stock bets:
1) The 100% buy order genre
2) And the 100% sell order genre
Okay. You’ve run multiple back tests. Now ask yourself…

Just how big was your best back test able to grow your bankroll over time by only placing buy
orders – that is, never selling a stock. And just how long did it to take for your worst back test to
go broke only placing buy orders.
Now compare this to back tests in the sell order genre.
Just how big was your best back test able to grow your bankroll over time by only placing sell
orders – that is, never closing a short position. And just how long did it take for your worst back
test to go broke only placing sell orders.
What you’ll find is that generally a 100% buy order approach compounds wealth faster and
bankrupts you less often than a 100% sell order approach.
Why?
Over a long series of bets, one generic strategy can outperform another generic strategy by: 1)
Placing more bets with an edge, 2) Making bigger bets when your edge is bigger, and/or 3)
Making smaller bets when your edge is smaller.
Here, the reason a stock buying strategy outperforms a stock selling strategy is because the buy
strategy bets with an edge more often than the sell strategy.
Why All Stock Buyers Have an Edge
In stock markets: sellers generally have a negative edge and buyers generally have a positive
edge, because the asset being given up by sellers (a part interest in a business) is of higher
quality than the asset being given up by buyers (cash).
This is not a unique feature of stock markets.
We can see the same concept illustrated by a hypothetical barter trade involving two
commodities. Party A wants to be rid of his holdings of aluminum; Party T wants to be rid of his
holdings of timberland. Like cash and stocks, aluminum and timberland are both assets. And like
cash and stocks, aluminum and timberland are assets of differing quality.
Generally, swaps of cash for shares favor the side getting shares and giving cash. And, generally,
swaps of aluminum for timberland would favor the side getting timberland and giving aluminum.
Some specific sales and specific systems for the sale of stock for cash favor the seller and
some specific trades and specific systems for the trading of timberland for aluminum would
certainly favor the party trading away his high quality timberland for low quality aluminum.
However, the special edge the trader of timberland for aluminum would need to juice his returns
on any one deal to the point it was a net profitable trade for him would be big. Likewise, the
special edge a seller of shares would need to juice his returns over a buyer of shares to make any
one sale a net profitable trade for him would also have to be quite big.
Excellent selection and timing of which stocks to sell when and which timberland to sell when
could allow you to make a trading profit. However, in the real-world excellent selection of which
races to bet on, which horses to bet on, and how much to bet on those horses in those races really
does allow some bettors to profit at a race track even though the generic strategy of betting on
horses is still a bad one.
You can make money betting on a horse race. And you can make money selling a stock. But, a
generic strategy of not betting on horse races outperforms a generic strategy of betting on horse
races. And a generic strategy of buying stocks outperforms a generic strategy of either selling
stocks or neither buying nor selling stocks.
Generally, buying stocks works. As a result: stock buyers have a “dumb money” edge.
The 3 Levels of “Edge”
At a stock exchange, there are 3 levels of edge:
1. Generic edge: The “dumb money’s” edge. Since buying stocks generally works better than
selling stocks or not owning stocks, a constant buyer of stocks – such as an investor in an index
fund – has an edge over other kinds of operators (non-investors, investors who hold mixed
portfolios with bonds, market timers who sometimes hold cash, and long/short investors).
2. Special edge: the “factor investor’s” edge. Since buying certain kinds of stocks (high
quality businesses, cheap stocks, and stocks rising in price) works better than buying other kinds
of stocks (low quality businesses, expensive stocks, and stocks falling in price) an investor who
systematically bets in order to maximize certain factors (like high quality, good value, and
positive momentum) has an edge over both operators who systematically bet in order to
maximize other factors (low quality, poor value, and negative momentum) and operators who
don’t bet systematically.
3. Unique edge: the “stock picker’s” edge. This is the kind of edge Nate is talking about
when he says “You have no edge. Get over it.”
Does the Stock Picker’s Edge Exist?
There is no debate over whether the generic edge an index fund has and the special edge a factor
based fund has exists.
Both exist.
A generic strategy that bets in favor of stocks is a better generic strategy than one that bets
against stocks. And a special strategy that systematically bets in favor of quality, value, and
momentum is better than a special strategy that systematically bets against quality, value, and
momentum.
For example: a “dumb money” stock index fund outperforms a “dumb money” bond index fund.
This is due to the generic edge that buying stocks has over not buying stocks.
And: A semi-smart system like Toby Carlisle’s (low EV/EBITDA) “The Acquirer’s

Multiple” outperforms a “dumb money” strategy like putting everything in an S&P 500 index
fund.
How to Win a Coin Flipping Contest – Play Against Humans
Of course, the dumb money approach will outperform the semi-smart money approach over
some series of years. That’s irrelevant. Picking heads 0% of the time at better than even money
odds will outperform picking heads 100% of the time at worse than even money odds over some
series of coin flips. As a rule: bad bets sometimes outperform good bets. This has nothing to do
with the stock market. It has everything to do with betting.
So, is the dumb money approach to winning a coin flipping contest – that is, not betting because
I have no edge – neither better nor worse than the semi-smart strategy? The semi-smart strategy
would be accepting even money odds on coin flips and then just trying to make the best bets you
can.
I know what you’re thinking: not betting and betting the best you can on coin flips will tend
toward the same outcome.
That’s true if you’re playing against the house and the house is offering even money odds.
But, what if you were participating in a pari-mutuel coin flipping contest. Remember, there is no
“house” in stock picking. There is no “vig”. It’s like playing the ponies – only better. The stock
market isn’t like a coin flipping contest. A coin flipping contest is usually modeled as having
fixed even money odds.
There’s actually a really big assumption in coin flipping models. The assumption is that whoever
is giving you odds on coin flipping consistently applies his best available strategy on every flip.
It’s true you can’t win a fixed even money odds coin flipping game even if you use your best
available strategy for betting. But, that’s only because the other player is also using his best
strategy available. He’s “selling” you coin flips at even money odds on both heads and tails.
That’s literally the only move he can make that guarantees you can’t take advantage of him. If he
ever makes any other move, you can beat him.
Real Games Don’t Really Work This Way – Real Players Don’t Really Play This Way
This is an ideal opponent fallacy. It’s a fallacy in the “begging the question” sense. The question
is: “Can you profit from a coin flipping contest?” And the unstated argument is: “You can’t
profit from a coin flipping contest, because your opponent in a coin flipping contest must
always make the best available move.”
A coin flipping game is so simple that we tend not to realize we’re assuming the
argument “because your opponent in a coin flipping contest must always make the best available
move.”
Is that really how a large group of humans would play a coin flipping game?
Let’s simplify it down to one guy. You and an opponent. Would your opponent always offer you
even money odds on both heads and tails?
What if he doesn’t? What if he makes a mistake?
You’re Always Playing the Player
Why do I have a negative edge when I sit down to play blackjack at a casino?
It’s not just because I’m playing blackjack. It’s because I’m playing against the casino’s dealer at
fixed odds set by the casino. The casino’s dealer has to employ a strategy that is, in practical
terms, close enough to ideal. No, it’s not quite the best strategy. But, it’s very easy to
apply consistently and very hard to beat with out a lot of extra effort.
Now, replace the casino’s dealer with a third grader and replace the casino’s fixed odds with
variable odds – shouted out before each hand – by a sixth grader.
I now have an edge. And it has nothing to do with counting cards. The third grader will not
employ a strategy as good as the casino’s dealer was forced to and he will not apply any
strategy as consistently. Meanwhile, the sixth grader will get bored and sometimes shout out
odds that are more favorable for one hand and then less favorable for the next.
That’s all I need. I don’t need an ideal strategy. I just need a sound strategy that takes advantage
of my opponent’s occasional mistakes. If the odds are set inconsistently, I can now profit at the
blackjack table without applying any effort. I only need two skills. One: the mental ability to
recognize mistakes in my opponent’s play. And two: the patience coupled with courage to bet
big when my opponent errs and only when my opponent errs.
In the stock market: you are not playing against the house. You are not facing the ideal opponent.
And the odds are not fixed.
So, if other bettors use a negative edge strategy and you use what should (against an ideal
opponent) be a zero edge strategy – you’ll win. In a mutual betting system, the presence of losers
creates winners. If some bettors bet badly, then bets that should yield you no advantage will
instead yield you an advantage.
So: Should You Bet on Coin Flips?
A while back, I asked which of two strategies works better. Strategy A: Never bet on coin flips.
Or…
Strategy B: Bet on coin flips in such a way that you’d expect to have very close to zero gain and
zero loss after a long series of flips of a perfectly fair coin.
If the odds are fixed, it’s safer and easier to just not play.
But: If the odds aren’t fixed, it’s potentially profitable to play.
If you apply a consistently sound strategy and your opponent’s strategy is either unsound
or inconsistently applied – you can profit from a coin flipping contest.
Why?
Short Stupidity
The semi-smart approach of assuming you know there is an equal likelihood of a coin flip
coming up heads or tails but you don’t know which particular flips will come up which
outperforms the truly idiotic approach of assuming you don’t know what the likelihood of a coin
coming up heads vs. tails is and so you just guess (it could be 50/50, it could be 90/10, who
knows?).
I know what you’re thinking. No one would bet that way.
But, consider this…

In the Real World: There is No House – And There are Idiots
If you were given a $25 bankroll (free) and the chance to bet heads or tails on a series of flips of
a coin that comes up heads 60% of the time and tails 40% of the time, how much money would
you bet on each flip? And, would you bet heads every time, tails every time, or some mix of the
two?
My last question sounds absurd.
In theory, it is.
But, the real-world experiment – using mostly people who were either currently studying finance
or economics at college or who were currently working at a finance firm – resulted in 65% of the
participants betting tails on at least one toss. These people had been told the coin was biased to
come up heads 60% of the time and tails 40% of the time. And they were eligible to walk away
from this experiment with up to $250.
The results?
Most people (65%) made at least one negative edge bet (picking tails) during the experiment.
And nearly 30% of the participants ended up with zero dollars. That’s most likely because 30%
of the participants bet everything on a single coin toss.
The study wasn’t perfect. The participants knew it was an experiment and knew they had
been told the coin would come up heads 60% of the time and tails 40% of the time. This is a
pretty close to fatal flaw in the design of the experiment. The way the experiment was designed
would certainly prime many participants to suspect they were being lied to.
But, even if that is what happened here (and I suspect it is), that still raises an interesting
question. Were some people so afraid of looking foolish that they lost $25 in actual cash and lost
$225 in potential cash just to avoid a loss of face.
The result of this study does seem to suggest it’s either one or the other. Either, people believed
the experimenters when they were told the likelihood was 60% heads and yet they still made
idiotic bets like picking tails or betting their entire bankroll on a single coin toss – or, they
thought there was a chance the experimenters were trying to fool them, so they avoided believing
a lie at the cost of free cash.
In Practice: The World is Not Like it is in Theory

We often model approaches to asset allocation, position sizing, stock picking, etc. using
unrealistic assumptions. For example, we benchmark different investment approaches against an
index. However, this assumes an average investor not employing this strategy will get the same
result as the index (most likely: he won’t, he’ll get a worse result).
Likewise, we frame the concept of edge in terms of special edges (factors) and unique edges
(stock picking) without thinking about just how odd it is that stocks have enjoyed a generic edge
over other assets even in periods when the investing public knew stocks had historically had this
generic edge.
So, what if we discard theory?
What if we put aside a logic based approach (like the one Nate uses in his post about the non-
existence of edges) and instead use an entirely empirical (that is, observation based) approach.
To do this, I want to consider one and only one kind of edge.
In his post “Getting Serious About Strategy”, Richard Beddard says:
“…how many investors, people who depend on a company making the right choices actually
take the trouble to work out what a company actually does?”
The most valuable edge you can have as a stock picker is to better understand what a
company actually does than the person on the other side of the trade from you.
We know stock buying is a better generic strategy than stock selling. So, I’d suggest the best
decision you can make as an investor is one in which you – as a stock buyer – know more about
what a company actually does than the fellow selling his shares to you.
What Does NACCO Actually Do?
I’m not cherry picking here. NACCO (NC) is my biggest (50%) and most recently added
(October 2017) position. Here is an excerpt – courtesy of Seeking Alpha – from the company’s
latest earnings call (its first after it spun-off a big division):
Investor: I want to thank you…for completing the spin-off. This has probably been one of the
best investments I have made in years. But I have a question about it, even though I have sold
almost all of my position, I have a small position left. The value of this stub, which was the
parent company less the value of the when issued, spin-off of Hamilton was trading around $20
per share before the confirmation of the spin-off. And then in the brief period since the spin-off,
the value of the stub which now is no longer technically a stub, it’s a…stand-alone and its
symbol NC (has) gone close to $40 and even $44 which, again, (I’m) very thankful of, because I
made lots of sales during that period. Do you have an explanation why the value has gone up
over…100% despite the fact that the outlook for 2018 does not appear to be salubrious and that
coal prices have been stable to down slightly and (royalties) and production from the mines at
North American Coal does not appear to have skyrocketed or has done anything exceptional?
CEO: …why the stock trades up, why it trades down is often a mystery. Your comment about the
coal prices, our business model really doesn’t have us with any exposure whatsoever to coal
prices. Our unconsolidated mines really operate as a service business and our one consolidated
mine has a formula price for the coal it sold. So it’s not like any of this is driven by coal prices.
Investor: …But don’t you agree that the higher coal prices might lead to higher production at
the associated mines?
CEO: I don’t know that it’s really connected. Our mines are individually dedicated to a single
customer. And it’s really just that customer’s demand for electricity that determines how much
coal we sell to them.
I don’t know for sure if I bought shares of NACCO that this caller was selling (though his
comments make it sound like we might have been on opposite sides of a trade). And I don’t
know for sure if I have an edge in understanding NACCO’s strategy better than this caller.
However, I do know 3 things:
1) NACCO’s strategy is to sell coal at a fixed (rather than a market) price so that its earnings
do not fluctuate with the price of coal.
2) If NACCO’s earnings did fluctuate based on the market price of coal, I would not have

bought the stock.
3) This caller clearly would have bought the stock even if NACCO’s earning fluctuated with
the price of coal.
So, we know that I had one understanding of NACCO’s business strategy and this caller had a
different understanding of NACCO’s business strategy. I was a buyer of the stock while he was a
seller of the stock. And we know that my buying was based on my understanding of NACCO’s
business strategy while his selling wasn’t (it might have been based on his understanding of
NACCO’s business strategy, but it certainly wasn’t based on our shared understanding of
NACCO’s strategy – because this call makes it clear we don’t share any understanding of what
the company’s strategy is.)
Does this constitute an edge?
Who knows.
But, this is the kind of situation I want you guys to focus on.

I Was Cherry Picking – You Should Too
I said I wasn’t cherry picking. But, I was. In most stocks: most big buyers and big sellers of the
stock know how the company makes money. In NACCO: some big buyers and some big sellers
of the stock don’t know how the company makes money.
There are two things I want you to take away from this post:
1. Generally, stock buyers have an edge over stock sellers. And…
2. Stock buyers have a unique edge in cases where they understand “what a company
actually does” better than the person they are buying their shares from.
Therefore, focus most of your attention – and most of your bankroll – on buying stocks where
you think you know what the company actually does better than sellers of that stock.
 URL: https://focusedcompounding.com/all-about-edge-2/
 Time: 2017
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Insider Buying vs. Insider Incentives
A blog reader sent me this email:
“Do you ever pay attention to insider transactions when analyzing a company?”
I do read through lists of insider buys from time-to-time. I follow a blog that covers these kind of
transactions. But, I can’t think of any situation where I incorporated insider buying or selling into
my analysis.
Learn How Executives are Compensated
I can, however, think of situations where a change in how insiders were compensated was

included in my analysis. For example, years ago, I was looking at a stock called Copart
(CPRT). It had a high enough return on capital and generated good enough cash flow that it was
going to have more cash on hand than it could re-invest in the business pretty soon. Up to that
point, it had been able to plow a lot of the operating cash flow back into expanding the business.
However, it seemed like they had gotten too big to keep that up. So, they were going to have to
buy back stock, pay a dividend, do an acquisition, or let cash pile up on the balance sheet.
I saw that the Chairman and the CEO (two different people, the CEO is the Chairman’s son-in-
law) were now going to be compensated in a form that meant the share price a few years down
the road is what mattered (if I remember right: compensation would now be a big block of five-
year stock options combined with an elimination of essentially all other forms of compensation
for those next 5 years). I had also read an interview with the Chairman (it was an old interview I
think) where he didn’t strike me as the kind of person who was going to venture out beyond his
circle of competence if and when he had too much cash.
So, I felt the likelihood of big stock buybacks happening soon was high.
To answer your question: no, I don’t really pay attention to insider buying and selling. But, yes, I
do pay attention to whether insiders own a lot of stock, how they are compensated (what targets
the company has for calculating bonuses), etc.
I can think of one situation where both the company and the CEO were buying a lot of stock at
the same time. And, I should have bought that stock. If I had, I would’ve made a ton of money.
However, to be honest, even if the CEO wasn’t buying shares and the company wasn’t buying
back stock I should’ve seen this was a stock to bet big on.
It was trading for less than the parts would’ve fetched in sales to private owners. It was an
obvious value investment. And that’s probably why insiders were buying.
Insiders Are Like You – Only Confident
Insiders tend to be value investors in their own companies. So, I think outside investors assume
that insiders are acting more on inside information and less on just pure confidence than is really
the case. To me, insider buying often just looks like how an especially confident value investor
would behave. It’s not that the insider has all this information you don’t – it’s more that (unlike
you) the insider doesn’t assume the market knows something he doesn’t.
Part of what I’m basing this on is discussions with insiders about transactions in their own
companies. I know some people who have worked at public companies and bought and sold
shares of those companies while they were there. Generally, they’ve explained why they bought
stock in their company’s shares by saying that the market price moved a lot while nothing inside
the company seemed to be changing. Almost always: they’ve described the purchase of shares in
the company they worked at as the most “obvious” investment decision they ever made. That’s
the word they tend to use: “obvious”.
Read the 14A
I always read the 14A. The 14A is a proxy document that includes a list of major shareholders,
shows how much top executive are paid, discusses the bonus plan (if there is one), etc.
So, I am aware of whether management is paid in cash or stock and what the targets are in the
bonus plan. I’m also aware of who the major shareholders are. If I don’t recognize names on that
major shareholder list, I’ll try to track down who they are. Sometimes, I also do a little research
into when major shareholders bought their stake and whether they’ve ever talked about the
business.
I wrote a report on Breeze-Eastern (now part of Transdigm). And, in that case, the major
shareholder list made me think the company was more likely than most to sell itself within the
next couple years.
That’s not inside information. Who the shareholders were, what they had said publicly, etc. was
all out there for anyone to look at.
On the other hand: I have gotten information about a possible sale other folks did not have in two
cases. In both cases, someone who interacted with the CEO from time-to-time was sure the
company would soon be sold. In both cases, I received that “information” – I’d call it pure rumor
– years ago. And, in both cases, the company has still not been sold and the stock does not trade
at a higher price now than it did then.
So, the information “everyone knew” was worth more than the information only I knew. The fact
of the shareholder list was more useful than the gossip out of headquarters.
All of this research is much easier to do than it sounds. Like I said, facts everyone knows are at
least as valuable – I find them more valuable – than gossip only a few people have heard. And
the 14A includes sufficient detail to do internet searches on every executive and every major
shareholder.
Like 10-Ks, you get better at reading 14As the more you’ve seen. I’ve certainly read hundreds by
now.
When I look at any stock: I always read the 10-K and I always read the 14A. Other things like
the latest 10-Q, the company’s investor presentation, a recent earnings call transcript, etc. are
more optional.
The two documents I consider mandatory reading in all cases are the 10-K and the 14A.
Also, if there’s a “going public” document of some kind (either an IPO or spin-off) that is
mandatory reading as well.
Read the Merger Document
I’ll take this opportunity to mention that the two documents every investor should be reading
(but probably isn’t) are both 14As. By “both” I mean the 14A that is filed in regard to the
upcoming annual meeting and the 14A that is filed after the announcement of a merger, going
private transaction, etc. looks ready to end the company’s time as a public company.
Generally, the press and analysts and investors basically stop following a public company once it
agrees to a merger everyone knows is going to go through.
I want you to be the exception to that rule. Keep following a company till after it is no longer
publicly traded.
There will be a wonderful document you want to read that provides:
1. A “fairness opinion” which will likely include a list of past transactions in the industry and
what multiples they were done at.
2. A “background of the merger” section that will provide a sort of narrative timeline of
board decisions, negotiations, etc. from the time someone first considered selling the company to
the time the deal went through.
The best source of information about what a public company in an industry is worth is usually
this document explaining how a once public peer of the company sold itself.
Here is an example of the merger document Harris Teeter filed in connection with its sale to
Kroger (KR). Note here that Harris Teeter actually filed some of the most important parts of this
document as a later amendment. For example, the table of EV/EBITDA ratios of past
transactions in the supermarket industry was filed in a later amendment.
So, when I say “read the document”, I mean dig through all the amendments too.
This is one of those times where I’m telling you there’s an important piece of information that is
very easy to obtain and read – and yet most people aren’t doing it.
It’s public information. But, most investors who could benefit from reading these documents
have never read them. So, it might as well be private information.
 URL: https://focusedcompounding.com/insider-buying-vs-insider-incentives-2/
 Time: 2017
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So: Am I Keeping Stocks Forever Now – Or Not?
There is a discrepancy between two posts I wrote. One is this post at Focused Compounding.
Another is yesterday’s post here on this blog. A reader pointed this out:

In your post on NACCO from 15 December 2017, you state: “I don’t trade around a position. I
buy all my shares at one point and sell all my shares at another.”
However in your post from 29 May 2017, your verdict is: “Geoff will never voluntarily exit a
position entirely. Once he owns a stock, he’ll keep owning at least some of that stock forever
unless that company is taken over or goes bankrupt. He will simplify things down to a true “buy
and hold” approach. No thought will be given to selling a stock ever again.”
Don’t you think that these two statements are contradictory? Do you have a true “buy and
hold” approach?
I don’t have a true buy and hold approach. I’m not a buy and hold investor. I’m always 100%
open to selling a stock because I no longer like something about the business, the balance sheet,
the management, the capital allocation, etc.
However, I’m not really open to selling a stock because it’s gotten too expensive.
Keep in mind: I find new stocks to buy over time. There are dry spells. Recently, I went almost
two years without buying anything. But, my tendency to feed new ideas into the portfolio – in
big initial position sizes – means that old ideas tend to become a smaller part of my portfolio
over time.
So, even if a stock does become more expensive, I’d still be selling some shares of that stock
over time just to fund new purchases. The stock could rise as a percent of my portfolio, but I’d
still have sold shares in it. Two good examples are Frost and BWXT. Frost is a more than 25%
position now (so, it’s slightly bigger in percentage terms than when I first bought it even though
I’ve sold shares) and BWXT is close to a 15% position now while it was only originally part of a
20% position that got broke up (I bought Babcock & Wilcox stock pre-spinoff). I’ve sold about a
third of BWXT and Frost, and yet they’re both just about the same percentage of my portfolio as
when I first bought them.

Having said that, it should tend to be the case the the “stale” ideas in my portfolio will tend to get
sold down and the “fresh” ideas in my portfolio will tend to be the biggest positions. The one
exception to this would be if something in my portfolio was rising in price at a really unusual –
probably very momentum driven – way.
It’ll be an interesting test of my resolve not to sell based on price if and when that ever happens.
So, I’m always open to selling a stock because I no longer like that stock (however, this has
historically been a very rare reason for me selling). What has changed in my approach is that I no
longer like to choose which stock to sell when buying a new stock.
As far as how I’ll eventually exit NACCO: I don’t know if it’ll be a sale of all of the position at
once or a gradual reduction of something like one-third of the position each year (as I buy new
stuff) along the lines of: 2017: 50% position, 2018: 34%, 2019: 22%, 2020: 15%, 2021: 10%,
2022: 7%, 2023: 5%, 2024: 3%, etc…
I’d prefer that my exit from the stock looks like that percentage position size series above.
However, that will only happen if I never decide that NACCO – as a business – is too risky to
hold on to. If I keep liking the stock, that gradual sell-down is what you’ll see. If I decide I made
a mistake buying the stock, or something unexpected happens with capital allocation,
management, etc. that really bothers me – you’ll see the position go to zero overnight.
I don’t know which I’ll do. My preference would certainly be to sell a stock only to replace it
with another stock.
So, say my portfolio is now:
NACCO: 50%
Frost: 28%
BWXT: 14%
Natoco: 7%
And I decide – hypothetically, that I would like to have a new position in Howden Joinery. At a
minimum, I would probably want that position to be 20% (as if it was part of a five stock
portfolio) and at maximum I would probably want that stock to be a 33% position (as if it was
part of a 3 stock portfolio).
In the minimum position size (20%) case, the resulting portfolio might look like:
NACCO: 40%
Frost: 22%
Howden: 20%
BWXT: 11%
Natoco: 6%
And, in the maximum position size (33%) case, the resulting portfolio might look like:
NACCO: 34%
Howden: 33%
Frost: 19%
BWXT: 9%
Natoco: 5%

However, there are 2 reasons why this literal application of the rule I laid out in the Focused
Compounding post – that is, that I’d sell my existing positions down in in exact fractional
proportion to my new position to fund that new position – would not be implemented.
One, this would be difficult to apply with illiquid and very small positions. So, at some point, I’d
just eliminate a small position. To fund my NACCO purchase (in October) I sold about a third of
Frost and a third of BWXT to have a position that was half my portfolio (the rest came from
cash). However, I didn’t touch Natoco, because that stock was too difficult to trade quickly
enough to fund a new purchase.
So, Natoco is likely to just be sold off from 7% of my portfolio to 0% at some point.
The other reason I wouldn’t implement this rule is if I decided I wanted to sell a specific stock
for some reason having to do with that old position other than buying a new position. In other
words, I still might make a sell decision instead of a buy decision.
Let’s say I decide that – after about a year of owning it – I re-consider NACCO and decide I
don’t like the capital allocation, I don’t like what the management is doing, I’m more concerned
about the future of the company’s customers than I was at first, etc. Then, I’d just sell it down
from 50% to 0% in one decision.
What I was talking about in that post about being a “collector” of stocks is something different.
In the past, if my portfolio looked like this:
NACCO: 50%
Frost: 28%
BWXT: 14%
Natoco: 7%
And I wanted a new 20% position, I’d decide between selling either BWXT and Natoco or just
all of Frost or something like that. I’d make a decision about which stock to sell to fund a new
purchase.
I’m not going to do that anymore. So, if you see my sell NACCO and just NACCO – it’ll mean I
wanted to get out of NACCO for some reason.
If I decide to buy a new stock, I will fund it – as best as I think is practical – through selling
down all the stocks I already own in equal proportion.
Now, what about the language I just used “as best as I think is practical”. There are 2 reasons
why selling a position as part of a proportional sale of my existing portfolio would be
impractical:
1) I’ve owned the stock for less than one year (in other words, it is impractical to sell from a tax
perspective)
2) The stock is illiquid (in other words, it is impractical to sell from a trading perspective)
Finally, there is one reason why it would be impractical to keep a position:
1) Below a certain portion of my portfolio – it might start to become expensive to sell pieces of a

position.
I don’t use a discount broker. Now, if you look at my actual trading behavior, although I use a
very high fee, high commission, etc. broker – I don’t have high fees/commissions etc. as a
percentage of my portfolio compared to people who use discount brokers. This is because I trade
much, much less than they do.
One, I sometimes have lower portfolio turnover than people who use discount brokers. And two:
I place much bigger orders – as a percent of my portfolio – than people who use discount
brokers. I will place single buy or sell orders that are 20% to 50% of my portfolio. So, the actual
number of trades that are executed each year on my behalf is very, very small.
But, this kind of approach would break down if I slowly sold off a very small position into
oblivion. So, if I had a 5% position this year that became a 4% position next year a 3% position
in 2019, a 2% position in 2020, a 1.5% position in 2021, a 1% position in 2022, a 0.67% position
in 2023, etc. That would eventually become wasteful. If I had a $1 billion portfolio, trading a
stock exponentially downward by like 0.80 or 0.75 or 0.67 a year forever wouldn’t create trading
costs that mattered. But, I don’t have a $1 billion portfolio. So, eventually that would create
meaningful trading costs relative to the position for me.
It certainly won’t at 5% of the portfolio or above (and honestly, I could go a lot lower without
worrying about this).
But, as a rule, I’d say that you’re right in thinking that positions which are about 5% or higher
will be sold down proportionately to fund new positions – as I discussed in the post on
“collecting” stocks.
Once a stock gets to about 5% or below – I might eliminate it at some point. I haven’t had to face
this situation yet. Other than Natoco, it could be years before this becomes an issue for me.
As far as never selling a stock…
I never intended that to mean I wouldn’t sell a stock because I no longer liked that stock. I am
still retaining the power to sell a stock as a sell decision. What I am doing away with is my
power to pick between which stocks to sell to fund a new position.

So, in the past, if I owned both FICO (FICO) and Omnicom (OMC) and wanted a new position –
I’d choose to either sell all of FICO or all of Omnicom.
In the future, I’d just sell a fifth of my FICO position and a fifth of my Omnicom position to
create a new position that was a fifth of my portfolio.
Like I said in my post on whether I’d sell NACCO – I’ll re-consider that stock in about a year. If
I don’t like that stock for some reason, I’ll sell all of it.
But, if I just want to buy a new position, I’m not going to sell all of NACCO to do that.
I was unclear in my post on NACCO. I said I’d sell all of the position. I didn’t mean I’d sell all
of it to fund a new purchase. I meant only that if I disliked the stock for some reason – I’d sell it
all at once.
Whenever I make a new purchase, I’ll fund it through selling all of the stocks in my portfolio in
the same fractional terms as the new position I want is stated relative to the total portfolio. So,
for a 20% position, I’d sell one-fifth of everything I currently own.
Finally, I don’t know if I mentioned this before or not – but, I’ve always though of Natoco (the
Japanese net-net) as being separate from this new approach. Natoco is an old, leftover position
that is more difficult to trade and which I’ve long said (it’s been years now) is slated for the
chopping block. When I see a moment where I’d like to exit Natoco, I’ll probably exit Natoco in
full.
 URL: https://focusedcompounding.com/so-am-i-keeping-stocks-forever-now-or-not/
 Time: 2017
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Why I Spend 95% of My Time Thinking About New Stocks
I’ve done a couple posts recently that have too many “rules” type statements in them. As
investors: it’s less important what we tell ourselves we’re doing and more important what we’re
actually – habitually – doing.
So, how do I spend my day?
If I told you I spend 95% of my time thinking about new stock ideas and 5% of my time thinking
about the stocks I already own – I’d be exaggerating how much time I spend thinking about the
stocks I already own.
I’m on a constant quest to find new stocks. That might not be obvious judging by how rarely I
buy something new. But, that’s how I spend my days. I’m always looking to buy something new.
I don’t really think about what I own. And I don’t really think about “selling right”.
I just think about “buying right”.
Which really consists of:
1) Picking the right business to be in
2) Paying the right price
Using NACCO as an example, I decided early on in my research on that spin-off that the coal
business was the business I wanted to be in and the small appliance business was the business I
didn’t want to be in. It then became a question of the price I was willing to pay.
In very rough terms, I’d decided that I wanted to pay less than $40 a share for the coal business.
When I first looked at the price after the spin-off, the coal business was selling for about $32.50.
So, I bought it.
The truth is: I’m not really going to re-visit NACCO at all – except sometimes to write a little
about it – till the end of 2018.
Someone asked me recently if writing about stocks made me a better investor or a worse
investor. I’ll answer that question on the first Q&A episode of my new podcast (reminder: read
this post, and send us a question if you get a chance).
It certainly makes me a different investor. The investor part of me spent all my time thinking
about NACCO before buying it. The writer has spent all his time thinking about NACCO after
buying it.
If I wasn’t writing about the stock, I would’ve bought it in October 2017 and then only checked
in again with it around December 2018.
I’ve always thought my attention is best spent focused 100% on finding new ideas. And I know
from past experience that thinking a lot about what you own is as likely to hurt your returns as to
help those returns.
I know that a lot of attention and effort spent on a stock in the research phase generates better
returns. I’m not sure that extra attention and effort spent on a stock you already own generates
better returns.
For some people, I think it leads to worse returns.
 URL: https://focusedcompounding.com/why-i-spend-95-of-my-time-thinking-about-new-
stocks/
 Time: 2017
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Why I Don’t Use WACC
A blog reader emailed me this question about why I appraise stocks using a pure enterprise value
approach – as if debt and equity had the same “cost of capital” – instead of using a Weighted
Average Cost of Capital (WACC) approach:
“…debt and equity have different costs. In businesses with a (large) amount of the capital
provided by debt at low rates, this would distort the business value. In essence I am asking why
do you not determine the value of the business using a WACC, similar to how Professor
Greenwald proposes in Value Investing: From Graham to Buffett and Beyond. The Earnings
Power Value model seems theoretically correct, but of course determining WACC is complicated
and subject to changes in the future. Nevertheless, your approach of capitalizing MSC at 5% is
basically capitalizing the entire business value, including the amount financed by debt, at what
is presumably your cost of equity for a business with MSC’s ROIC and growth characteristics.
Perhaps I am coming at this from a different angle than you, but it seems a little inconsistent
from the way I am thinking about it, and for businesses with more debt this would lead to bigger
distortions. AutoNation would be a good example of a business with meaningful…debt that this
approach would distort the valuation on.”
When I’m doing my appraisal of the stock – this is my judgment on what the stock is
worth not whether or not I’d buy the stock knowing it’s worth this amount – I’m judging the
business as a business rather than the business as a corporation with a certain capital allocator at
the helm. Capital allocation makes a huge difference in the long-term returns of stocks. You can
find proof of that by reading “The Outsiders”. Financial engineering makes a difference in the
long-term returns of a stock. You can read any book about John Malone or Warren Buffett to see
that point illustrated.
But, for me…
My appraisal of Berkshire Hathaway is my appraisal of the business independent of Warren

Buffett. Now, knowing Warren Buffett controls Berkshire Hathaway would make me more likely
to buy the stock and to hold the stock. So, it’s an investment consideration. But, it’s not an
appraisal consideration for me. When I appraise Berkshire Hathaway, I appraise the businesses
without considering who is allocating capital. Otherwise, I’d value Berkshire at one price today
and a different price if Warren died tomorrow. I don’t think that’s a logical way to appraise an
asset. Although I do think that buying an asset that’s managed by the right person is a good way
to invest.
A good example of this is DreamWorks Animation (now part of Comcast). Quan and I valued
DreamWorks Animation at a level that was sometimes more than double the stock’s price.
There was a point where we could have bought the stock at probably 45% of what we thought
the business was worth.
However, we asked each other: “If you bought this stock today and then Jeffrey Katzenberg died
tomorrow, would you hold the stock?” Both of us said no.
That didn’t change our appraisal of the stock.
It did change whether we’d buy the stock or not.

We thought that – with or without Katzenberg running the company – the business of
DreamWorks Animation (its distribution deals, the library it had, the characters it had the rights
to, the systems it had in place, etc.) meant it was worth more than the stock market was then
valuing it at. We just weren’t comfortable investing in a movie studio – even at a discount to our
appraisal of that movie studio as a movie studio – without being sure we liked the guy running
the place. What I mean is that if I was a private buyer and I was offered DreamWorks stock at
$18 or whatever the low on that stock was at one point – I would’ve said “does it come with
Katzenberg or not?” And if the answer was “No, he’s retiring”, my answer would be “Thanks.
But we’ll pass on this deal”. I don’t want to own a movie studio without knowing who is going
to run it.
I can value a movie studio without knowing anything about the head of that studio. But, I can’t
invest in it.
When I appraise the business – I just appraise the business like I’m being asked by a private
buyer and a private seller to arbitrate the case of how much cash should pass between the buyer
and seller for this asset.
So, questions of how a business is organized as a corporation – where it is incorporated, how

much debt it uses, how aggressively it avoids taxes, etc. – can be part of my thought process
when it comes to a “go or no go” call on investing in the stock. But, these considerations don’t
change how much I appraise the stock for. I would never arbitrate a dispute between a buyer and
seller differently because of those considerations.
Honestly, I always value a stock – that is, a single piece of equity in the company – by first
valuing the entire enterprise as if it was being sold to a 100% private buyer. Although I’m
looking at a public company – I always think of it as if it’s about to become a private company.
I always use capitalization independent measures of value (an enterprise value based approach)
when valuing a business. I understand the logic of valuing a business controlled by a certain
capital allocator – Warren Buffett, John Malone, Robert Keane (head of Cimpress / “Vistaprint”)
etc. – using a mix where debt and equity are valued differently. However, when valuing a
business, I am trying to appraise the day-to-day operations of the business in the sense of what is
inherent to the operation – not the current corporate structure, current capital allocation policies,
etc. which can all change if the company’s management changes.

Sometimes, there are long-term financing advantages in place at a company. For example,
among U.S. supermarket: Village Supermarkets (VLGEA) has long-term leases (often running
20-40 years) that allow it to occupy good locations in New Jersey at reasonable rental rates
and Kroger (KR) has effectively financed the supermarkets it owns outright (about half of
everything it occupies) using long-term fixed rate bonds that mostly pay low after-tax interest
rates. When considering whether or not to invest in these businesses, I certainly consider the fact
these leases don’t run just 5 years and these bonds aren’t due in just 5 years.
But, normally, I try to value businesses using multiples of EBIT, EBITDA, etc. that are
independent of how the business is capitalized (whether it is using debt or equity) and even often
how the business is taxed (if it is incorporated in the U.S. or Swizterland for example).
When writing Singular Diligence, Quan and I disagreed a bit about this. And so, sometimes we
applied a higher EBIT multiple for European companies than we did for U.S. companies. I am
not sure I agree with that kind of thinking. Over time, corporate tax rates in a European country
could rise and corporate tax rates in the U.S., Japan, etc. could fall. It is probably unwise to
assume a 100% probability of the same corporate tax rate everywhere in the world. However, I
have always also felt that it’s actually wrong to assume a 100% probability that the current
corporate tax rate in a country will remain the current corporate tax rate.
Within a year, the U.S. corporate tax rate could be about 40% of what it was 50 years ago. I’m
not sure that – 25 years ago – your ability to guess whether the U.S. corporate tax rate would stay
the same, double, or halve over the next 25 years would have been very good.
Taxes from country to country – and state to state within the U.S. – vary quite a lot. Countries
and states can change their tax rates. And corporations can change where they do business to
avoid taxes.
Often, the difference a change in tax rates would make is not taken into account by investors.

For example, Village Supermarket (VLGEA) hasn’t really paid less than 41% in taxes at any
point in the last 15 years (there’s one exception that’s too complicated to get into here), and
would – under some proposed tax plans in Congress – have made about $1.90 to $2 in EPS last
year instead of $1.60 if rates had been different.
If you just take the most recent tax rate as being the tax a company will always pay – you’d be
changing your appraisal of Village by something like $6 a share depending on whether the
federal tax rate was what it is now or what it might be soon. It’s only a $23 stock. So, a $6
adjustment in your appraisal price is about 25% of the market price.
The stock’s EV/EBIT of less than 7 looks low. The stock’s P/E over 14 doesn’t looks so low. If I
could only use one measure: I’d always favor EV/EBIT over P/E. So, I’d say that stock looked
cheap to me. Other folks – looking at the P/E of 14 – don’t see anything noteworthy there.
It sounds like a small point when I warn someone that Village might be worth $5 to $6 more per
share if corporate tax rates were cut or Apple might be worth $15 less a share if top management
decided to be less aggressive about avoiding taxes.
But, this becomes an issue in some cases that the market doesn’t pay enough attention to. I can
see some industries right now (like ad agencies) where global peers inside and outside the U.S.
have tracked each other nearly perfectly in terms of stock price movements this year but which –
if the U.S. cuts its corporate tax rates – will see very different movements in their P/E ratios in
the years ahead. The U.S. headquartered companies are going to grow their after-tax earnings a
lot faster than the non-U.S. headquartered companies. And this isn’t because they are doing
business in different countries – it’s just because of where they’re headquarters is.
Now, you can certainly use an approach where you value debt and equity differently and still be
aware of these things. But, that’s a lot to think about. And you’re likely to default to just
assuming that whatever the market now values stocks at is what tells you the correct cost of
equity, whatever tax rates now are goes into your model, etc.

I’d rather move up the income statement and think in terms of how much pre-tax income (in cash
form) the company is producing versus the amount of total capital it’s using (not what is equity
and what is debt in that mix).
I find the approach that works best for me is to try to value whatever company I am looking at –
Village Supermarket, Apple, etc. – as if I’m appraising the business independent of the corporate
tax policy, corporate debt policy, etc.
Then I just take the amount of debt the company has and give the bondholders the first portion of
EV (up to the face value of the debt) and the appraised business value that’s left over is what I
assign to the equity holders.
Why?
This gets into the issue of what I’m trying to accomplish by using an appraisal method of
Enterprise Value (not just market cap) that uses EBIT (earnings before interest and taxes).
A business model does not have an inherent and immutable interest rate it pays, it does not have
an inherent and immutable tax rate that it pays, and it does not have an inherent and immutable
mix of debt and equity. These things will change over time. They are really “corporate” issues –
that is, issues of financial engineering – rather than business issues.
When I appraise a company I generally want to use a “highest and best use” type approach like
one would use with real estate. So, if a company is – like Village Supermarket (VLGEA) is –
paying a 41% tax rate (between U.S. Federal and New Jersey state taxes) I don’t want to make
the mistake of assuming that’s entirely a result of business decisions rather than financial
engineering (corporate) decisions. The same is true – in the opposite direction – of something
like Cimpress. Cimpress would be difficult to engineer in a way where it would pay less in taxes.
The same is true for many of the big tech and drug stocks in the U.S. It would be hard to
engineer these companies in a way where they would pay less in taxes than they already are. We
need to dock them for that relative to company’s that can be financially engineered to pay less in
taxes, carry more debt, etc. than they are now.

I want to be careful not to overvalue Apple and undervalue Village. The EV/EBIT ratio is
helpful in avoiding this. The P/E ratio is not.
We could assume that we should treat things like debt-to-equity ratios, tax rates, interest rates,
etc. as givens that won’t change.
Or: we could assume that these things should tend to be leveled off much the way they would be
in a 100% buyer’s mind.
I think that’s the best approach. Instead of always thinking about what tax rates might change,
how the cost of debt and equity might change, etc. we try to think in terms of what a private
buyer would pay for 100% of the business if he could organize the business under any corporate
umbrella he wanted to.
Let’s use Village Supermarket as an example. Imagine it was for sale. Now, Village is – I think –
the second biggest member of Wakefern. There are limitations on a non-Wakefern member being
an owner. So, you can’t really own supermarkets inside and outside the Wakefern (Shop-Rite)
system. This means Kroger can never acquire Village. However, there is nothing stopping
someone like a private equity owner from buying both the #1 and #2 biggest Wakefern members,
firing the family members who work at those companies, leveraging up the combined (and now
more synergistic) Shop-Rite operator and thereby paying less in corporate expenses, paying less
in taxes, and tying up less capital relative to sales than is currently done at Village. In fact, if I
had hundreds of millions or $1 billion on hand that is exactly how I would consider buying 100%
of Village in a negotiated transaction. And ultimately it is this figure – what a company would be
worth to a private control buyer – that I want to nail down. It’s important that – if I’m going to
come to a conclusion that’s independent of the stock market – I think in terms of a transaction
for the whole company instead of asking myself what a passive, minority shareholder would pay
for a share of the stock.
I don’t want to ask: what would the stock market pay for Village?

I want to ask: what would a knowledgeable, private owner/operator of supermarkets pay for
Village.
I find treating debt and equity the same useful when making that calculation.
Using Cimpress as an example takes us the other way. Cimpress may be valued more highly in
the stock market than it would be valued by a private owner, because the person who controls
Cimpress is running it in a way to maximize how much he can report in “adjusted” earnings and
how little the company pays in taxes and so on. This isn’t necessarily the wrong way to run the
business to maximize intrinsic value over time. It might be the right way. But, what I’m saying is
that – if I was analyzing the acquisition of Cimpress as a 100% control buyer intending to take
the company private, I’d have a hard time figuring out what I could do to end up with more after-
tax cash in my pocket than the company is producing now. Likewise, I’d have a hard time
figuring out how I could keep less of my own capital in the business (Cimpress has debt, capital
leases, etc.) when I owned it than shareholders are now keeping in Cimpress.
If you have the time, go look at what Cimpress has paid over the last 15 years or so in taxes and
what Omnicom has paid over the last 15 years or so in taxes. Then try to figure out how much of
each company’s earnings have come from high tax countries like the U.S., lower tax countries,
etc. I can’t come up with a business explanation for the tax differences. I can, however come up
with theories on how you could do that through corporate level decisions.
That’s what financial engineering looks like. Based on that, I don’t think it would be a good idea
to award as high a P/E ratio to Cimpress as you would to Omnicom. You can level this by
looking at measures like EV/EBITDA and EV/EBIT.
Overall: I really want to discourage investors from ever using the P/E multiple in place of the
EV/EBIT multiple.
In some cases, like Berkshire Hathaway (BRK.B) and Village Supermarket (VLGEA) there

are steps the companies could take immediately to report higher earnings after-taxes than they
now report. The stock market often does not see this or does not care about this. However, a
potential buyer of the entire business always thinks in these terms. He thinks about how he could
use debt instead of equity, how he could pay less in taxes, how he could combine one company
with another, what he could do with excess cash on the balance sheet, etc.
The concept of weighted average cost of capital (WACC) is popular with academics. Bruce
Greenwald is an academic. And so he used WACC in the book he wrote on value investing. If I
ever wrote a book on value investing, I’d never once mention WACC.
And I don’t think Buffett or Munger would either.
Now, that isn’t to say that “cost of capital” doesn’t matter. But, the way WACC is used by
academics is problematic. Here’s why. One, it’s unnecessarily complicated. There is no need for
the board of directors, the CEO, etc. to know what the cost of equity capital is. Their job is to
maximize the return on equity. This means they may want to take on debt to the extent they can
safely increase the after-tax earning power of the equity. It also means they may want to buy
back stock if it increases the after-tax earning power of the equity. And, they may even want to
issue stock if it increases the after-tax earning power of the equity. So, they need to think in
terms of earning power. But, it’s not actually necessary for any capital allocator to know what
the market is going to value their equity at. John Malone is a good example. John Malone does
not need to think in terms of Discovery Communications having a higher cost of capital when it
uses equity, because investors are likely – since Discovery owns cable channels – to assign a
lower earnings multiple to Discovery’s equity than to the equity in other Malone holdings.
First of all, they could be wrong. In fact, I suspect John Malone and passive, minority investors
differ in their appraisal of Discovery Communications equity.
And honestly, it is John Malone’s appraisal of Discovery Communications stock that probably

matters more than passive, minority investors’ appraisal of the stock. That’s because the value in
Discovery Communications can always come from a transaction done outside of the stock
market (taking it private, combining it with another company for cash, combining it with another
company for stock, etc.).
Or, we could take the Disney and Fox negotiations. Murdoch has to consider whether he wants to
be paid in stock or cash. He might also prefer one buyer over another, because he prefers one
stock over another. Murdoch doesn’t need to think in terms of WACC to make this decision. He
just needs to think of the price he is being offered in terms of the intrinsic value of Disney shares
rather than the market price of Disney shares. If you’re locking yourself into a stock for any
reason, the market price of that stock isn’t what matters to you. What matters to you is your
appraisal of the intrinsic value of that stock.
I just don’t see how thinking in terms of WACC makes sense when you are talking about equity.
Now, what the cost of a company’s liabilities are does matter. And we can get into that
discussion in a second. But, the cost of equity is not something you need to figure out. It’s an
unnecessary complication in determining value. It’s overly academic.
Very often, when you believe one company’s equity is worth a low multiple of book value and
another company’s equity is worth a high multiple of book value – what you’re really saying is
that one company (the high book value company) has ample access to stable, long-term, and
low-cost funding as part of its day-to-day business. Examples would be: Berkshire Hathaway
(BRK.B), Frost (CFR), Progressive (PGR), Omnicom (OMC), and Dun & Bradstreet
(DNB).
In all those cases though, the low-cost funding comes from the basic business model. It is not the
result of commodity type liabilities like issuing bonds. For example, Omnicom – and actually
Berkshire long ago in its history (about 1989 I think) – did engage in some financial engineering
to get low cost funding where they issued zero-coupon bonds. In a sense, issuing zero coupon
bonds – the Omnicom zeroes were convertible into the stock – was a long-term speculation on
interest rates (and because the bonds were convertible, the stock’s P/E ratio). Basically,
Omnicom tried to lower its cost of capital (its WACC) through a pure financing play of trying to
take the other side of a speculation from the market.
Omnicom was – this was in 2003 just after the millennium bubble years – betting that long-term
interest rates were low and the stock’s own P/E was high. The imputed interest – interest you
owe each year but don’t actually pay yet – also has tax implications that a financial engineer
might be interested in.
Basically, these are bets. To the extent Berkshire and Omnicom were able to lower their cost of
capital via these deals it’s really just because they were smarter than the people on the other side
of the table from them. You too can find ways to bet P/E multiples won’t expand from a certain
point, interest rates won’t rise from a certain point, etc. If WACC got lowered by these deals,
that’s because management was smart and opportunistic not because it was an inherent
characteristic of the business model.

I’m only interested in things that lower WACC that are a constant feature of the business itself.
I have written a ton about a company’s cost of liabilities. But, I’ve done it specifically about
what I consider day-to-day cost of liabilities concerns rather than financial engineering concerns.
If I was a control investor – or at least an “influence” investor – like John Malone often is, then I
might worry about financial engineering. But, I can’t buy Village Supermarket with the idea of
getting them to make changes to their cash, debt, owned buildings, leased buildings, etc. in order
to reduce the amount of equity capital in the business while also reducing the amount of taxes
paid. John Malone can do that in some cases.
So, what companies have a low cost of liabilities?
One, insurers have a low cost of liabilities if they are able to operate at a combined ratio below
100. This is what Berkshire Hathaway’s insurers do. Berkshire owns a ton of niche insurers that
have very low combined ratios (but aren’t big enough to get individually discussed in Buffett’s
annual letters). Berkshire also owns GEICO. Progressive is a good comparable for GEICO.
Progressive has been able to achieve high returns on equity (and grow intrinsic value per share)
because it has a lower cost of liabilities than a life insurer like MetLife. In the long-run, MetLife
is going to have trouble compounding shareholder value the way Progressive does because
MetLife is paying more for its liabilities than Progressive is.
Other companies I have written about also have ample day-to-day business access to liabilities
that have a cost of 0%. These include database / subscription type businesses like John Wiley,
Dun & Bradstreet, IMS Health, etc. These companies can operate with negative book value if
they want to. Basically, they can use all their profits to buy back their stock at above book value.
And – over time – they’ve tended to outperform companies with business models that require
them to pay more for liabilities.
Who pays more for their liabilities?

Any company that needs to borrow long-term to finance some kind of specialized capital like a
steel plant, a race track, a copper mine, a stretch of railroad, a stretch of cable, a cruise ship, an
airplane, etc. runs into this problem.
Some of these businesses can be good enough – because they may have monopoly like
characteristics – to offset a high cost of liabilities. Examples would be: Hilton Food, Ball
(BLL), U.S. Lime (USLM), etc. The business model requires capital. But, once you’ve built
what you needed the financing for – you usually have zero local competition.
A low cost of liabilities is a feature in many – probably most – of the stocks I’ve bought recently.
Frost has a low cost of liabilities. In general, Frost can fund about 90% of itself at a cost that is
no more than the Fed Funds Rate. Here, I am including both the actual interest cost Frost pays
and the net non-interest cost it pays. What I mean is that – in a normal year – the Federal
Reserve and Frost are paying similar amounts for their funding. That’s really the key element of
my analysis of Frost.
I get emails all the time about banks that trade at lower price-to-book ratios than Frost. However,
the price-to-book ratio only works well when you are comparing two firms with the same cost of
liabilities.
So, say MetLife trades at 1.2 times tangible book and Progressive trades at 3.8 times tangible
book. Is MetLife stock really cheaper than Progressive stock?
Well, Progressive should trade at a very high price-to-book ratio because it normally has a
negative cost of liabilities. The company is “paid” to make use of other people’s money.
Many bank investors think Frost is expensive at 2.5 times tangible book. However, I disagree.
The book value you are judging the expensiveness or cheapness of is only the equity portion of
the company. A bank’s value resides not in its equity but in its deposits. So, you can only decide
whether Frost is expensive or not once you’ve done your best to determine how much or how
little it pays for its liabilities.
Ad agencies pay nothing for their liabilities. This has been critical to their outperformance of
other public companies over time.
So, if you want to talk about WACC in the sense of comparing the fundamental elements of a
business model between industries, firms in an industry, etc. – I’m right there with you.
In the long-run, I want to own ad agencies rather than railroads. People forget this, but Omnicom
stock has (even now when it’s cheap) outperformed Union Pacific stock (even now when it’s
expensive) over these past 30 years – and not by a small margin. Over the last 30 years, the
economics of railroads have improved a lot more than the economics of ad agencies have
improved. But, advertising is still such a better business because it pays 0% on its liabilities
(client money) while Union Pacific pays anywhere between 2% and 8% (pre-tax) on the bonds it
uses to finance itself. In addition, Union Pacific’s financing needs constantly increase in nominal
dollars (because assets must always be replaced in real dollars) while Omnicom’s financing
needs constantly decrease in nominal dollars (it gets more float as client billings rise each year).
So, I do think of a company’s cost of liabilities – whether it needs capital on top of the equity it
has outstanding and how much that will cost. This is a key part of assessing the quality of the
basic business model.
A great example of this is NACCO (NC).
NACCO has one consolidated mine. Other than that…
NACCO’s customers finance the mines NACCO operates to supply those customers with coal.
These economic liabilities – they don’t show up as accounting liabilities, because under GAAP
you don’t consolidate an enterprise you are incapable of financing yourself – are non-recourse to
NACCO but the economic benefits (the free cash flow) is paid out 100% to NACCO each and
every year (it’s not held at the unconsolidated subsidiary level where the liabilities are).
If NACCO was the company funding the mining operations – as it does with the one
consolidated mine it has – there’s no way I would buy the stock at any price. So, the way the
company’s business model works – in the sense of what liabilities cost the company –
determined whether or not I’d invest. The company’s business model – not corporate level
financial engineering – also gives it a lower tax rate (since it operates the mines that take the coal
out of the ground – it gets the depletion benefit for tax purposes even though it isn’t financing
those mines).
But, these liabilities come from the day-to-day operations of the business.
So, when Bruce Greenwald talks about something like the negative working capital cycle at Dell,
I’m in agreement with his thinking. But, when he talks about using WACC to value a business –
I’m not on board with his thinking.
The simple answer is that I never use WACC.
The more complicated answer is that I appraise a business in terms of what it would be worth to
a 100% buyer who put those assets to their highest and best use.
And then the honest answer is: I focus heavily on stocks with access to low cost, no cost, or
negative cost liabilities. These are the best businesses in the world. But, all my thinking goes into
how the business model provides these valuable liabilities. None of my thinking goes into
financial engineering.
One reason for this is that a business model seldom changes while financial engineering changes
dramatically all the time at many public companies.
 URL: https://focusedcompounding.com/why-i-dont-use-wacc-2/
 Time: 2017
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Stocks You Can’t Buy
The always interesting Japanese stock blog (it’s written in English), Kenkyo Investing, has a post
on a negative enterprise value stock called Hokuyaku Takeyama. The reason this stock is cheap
is because it trades on the Sapporo Stock Exchange – not one of the more popular exchanges like
Tokyo or Osaka. Very few stocks only trade on the Sapporo Stock Exchange. So, very few
investors make the special effort to do business with a broker who will give them access to this
exchange.
Watlington Waterworks (Bermuda Stock Exchange)
I wrote about a similar situation in March of 2011. That stock was called Watlington
Waterworks. It’s a water company on the island of Bermuda. Because it’s on the island of
Bermuda – a rich, densely populated remote island with no fresh water – the economics of
Watlington Waterworks are generally superior to all other water companies around the world.
And yet – in March of 2011 – the stock traded for lower multiples of earnings, book value, etc.
than other water companies. In the 7 years since I wrote about Watlington Waterworks, the stock
has risen in price by about 9% a year. It also paid a dividend. So, holders of the stock got 10%+
owning something that was a true diversifier in their portfolio (Watlington’s price doesn’t move
based on how the Dow Jones, Nasdaq, or S&P 500 are doing). In fact, on many days, it doesn’t
move. What’s more impressive is that Watlington returned more than 10% a year over 7 years
while finishing that period with a P/E ratio less than 12, a price-to-book ratio less than 1, and a
rock solid balance sheet.
Many stocks have returned more than 10% a year over the last 7 years. However, very few
stocks that returned more than 10% a year now have a P/E under 12, a P/B under 1, and a solid
balance sheet. Meanwhile, many companies that now have a P/E under 12 and a P/B under 1
have returned far worse than 10% a year over the last 7 years. In other words: Watlington is rare
in the sense it combines a 7-year total return performance that has been adequate with a stock
price that has always remained at an investment level rather than straying into speculative levels
like most stocks. Basically, it’s been a decent “set it and forget it” investment. The business has
never really performed badly. And the stock’s price has never really been anything but cheap.
Also worth mentioning is the way I presented Watlington Waterworks. I showed the company’s
recent financial results on this blog – but didn’t give out the company’s name or business
description. Readers then guessed where the stock traded. Back in 2011, almost everyone came
up with a guess in the $20 to $30 price range. At the time, the stock traded at $14.

What Ben Graham Would Really Be Buying Today
These are the kinds of stocks you want to find – stocks like Hokuyaku Takeyama and Watlington
Waterworks. They are stocks that just about everyone – if shown the company’s financials
but not told the obscure exchange the stock trades on – would value at a price higher than where
the stock actually trades.
In the U.S., these are usually OTC stocks. You can read blogs like Oddball Stocks to learn about
some of these kinds of companies.
When people ask what would Ben Graham buy – this is it. He wouldn’t be buying the net-nets
that turn up on screens (like Chinese reverse mergers). He would be opening an account in Japan,
an account in Bermuda, etc. and putting 1%, 2%, or 3% into becoming a collector of little,
illiquid, but clearly incorrectly priced stocks like these.
Bancinsurance
I’ve written about my experience in Bancinsurance many times before. Back in 2010, I bought
into this stock. It was traded over-the-counter at the time. However, I was familiar with the
company from years before when it was a listed stock. If you look at the second letter I wrote to
the board of directors of Bancinsurance, you can see a graph showing that after the company de-
listed, the stock started to consistently trade below book value even though (when it had been
listed) the stock often traded above book value.
This is what we – as value investors – want to look for. The stock is priced differently because of
factors like who owns it, what exchange it trades on, how it is categorized by investors, etc.
rather than whether the balance sheet, the industry, the company, and the management team are
solid or not.
In the case of Bancinsurance, it was priced differently than a “normal” stock in two ways:
1. It was an insurance stock with a history of underwriting profits (the combined ratio was
less than 100 in 28 of the last 30 years) and yet it traded at a discount to book value
2. There was a $6 a share offer to take the company private from the CEO (and majority
shareholder) and yet the stock consistently traded below the going-private offer
In other words: because of its obscurity, this stock wasn’t getting the attention of investors who
specialized in insurance stocks or arbitrageurs who specialized in speculating on higher takeover
offers. In this case, the deal was eventually done at $8.50 instead of $6. Normally, a deal that
ends up being done at a 40% higher price within about six months to a year would attract special
situations speculators. That didn’t happen here. Between the time the original $6 offer was made
and the time the board accepted the $8.50 offer, I had very little competition buying as much of
this stock as I could get my hands on. Honestly, I was my own competition for this stock. And it
was only my reluctance to bid up the stock on myself that kept the price in check (and the
number of shares I ended up getting lower than what I would have wished).
Here again we see what we – as value investors – should be looking for in a stock: a good asset
traded in an inefficient market.
After all: how efficient is a market likely to be when there are days with no serious second
bidder?
Warren Buffett (The Snowball): National American Fire Insurance and Blue Chip Stamps
In Warren Buffett’s pre-Berkshire investing days, he came across several stocks where the
market for those stocks was inefficient for historical reasons.
Let’s talk about two.
The first is National American Fire Insurance. This was the holding company in which the
Ahmanson family stashed some of their best assets. However, it was built out of an unrelated
company that had done badly as a stock for many people in the local Omaha area.
You can read the full story in Alice Schroeder’s “The Snowball”. This is what I wrote in an
article called “How Warren Buffett Made His First $100,000”:
“…it was a super illiquid stock that had once been worth a lot more. The shares ended up
spread thinly across a lot of different individual investors. They remembered when the stock was
worth $100 a share. That’s where a lot of them bought. And many of them didn’t want to sell
until the stock got back to $100 and made them whole. But, because the stock had burned them
so bad, they also had no interest in buying more shares. They just clung to what they had.
Now, what’s really fascinating about this story is what Warren Buffett did. So, the stock was last
selling for about $27 a share. At first, he tried buying around $30 a share. Then he went to $35.
He went to towns where he knew people owned the stock. He talked in person to people to try to
get them to sell to him.
Eventually, he offered some people $100 a share. Now, think about this for a minute. That’s still
a very, very low price for this stock. At $100 a share, Buffett was paying 3.5 times earnings. And
he was still only paying about 75% of book value for what he thought were some of the best
insurance companies in America.”
Warren Buffett – and Charlie Munger – also bought into a company called Blue Chip Stamps.
What attracted them to this business was its “float”. But, what attracted me to discussing it here
in this post is the odd way that shares of Blue Chip stock had been distributed.
Blue Chip Stamps was a trading stamps company. It ran a multi-retailer loyalty program. A
shopper would make purchases at participating grocery stores, gas stations, drug stores, etc. and
would receive a certain number of Blue Chip Stamps in return. These stamps could then be
exchanged for merchandise. This kind of loyalty alliance between a participating group of
retailers encouraged households that already shopped at say a grocery store giving out Blue Chip
Stamps to also seek out a gas station, a drug store, etc. that gave out Blue Chip Stamps instead of
a competing location that gave out nothing, or gave out competing Sperry & Hutchison Green
Stamps. Basically, it encouraged locking shoppers into a loop of retailers and encouraged
locking retailers into that loop as well. The bigger the loop got in terms of attracting shoppers –
the more it could attract retailers. And the bigger the loop got in terms of attracting retailers – the
more it could attract shoppers. The company’s business would decline in the years after Buffett
bought in (eventually disappearing altogether). But, it obviously had similarities to payment
processing companies like American Express (AXP) charge cards.
What’s important for our purposes here is not how attractive Blue Chip Stamps was as a
business. What we’re discussing here is the odd way that shares of the stock were allocated.
In 1963, the United States government opened an anti-trust case against Blue Chip Stamps. Four
years later, Blue Chip Stamps settled with the U.S. government via a “consent decree”. (I’m
simplifying here. In reality: first, it seemed like there was an agreement, then there wasn’t, then
there was again, then there was one last court case, etc. – but the end result was that Blue Chip
Stamps and the government came to an agreement over anti-trust issues).
You may have heard of “consent decrees” before. One of the most famous is the 1948 Paramount
consent decree that spelled the beginning of the end for the “Hollywood System”. Consent
decrees are of interest to investors because they often involve a company settling an anti-trust
issue with the U.S. government.
Usually, this means two things.
One: the company has a lot of “market power”. It has some sort of monopoly, market
dominance, etc. Otherwise, it wouldn’t sign a consent decree.
And two: the company is often agreeing to take some sort of extraordinary action – like
separating a movie theater chain from a studio that makes movies (the Paramount case) or
breaking up the various stages (or geographic regions) of oil distribution in the United States (the
Standard Oil case) that may unlock the potential for investors to suddenly invest in pieces of a
once dominant business. These pieces may be mispriced, they may end up in the hands of owners
who didn’t originally intend to invest in just that one part of the parent alone, etc.
A Brief Aside: Northern Pipeline

Ben Graham invested in Northern Pipeline. Northern Pipeline was a stock that had a more
valuable investment portfolio than it did a stock price. Northern Pipeline was part of the Standard
Oil system broken up by that anti-trust case.
For more details on Ben Graham’s investment in Northern Pipeline, read my 2007 GuruFocus
article on the subject.
Back to Blue Chip
In the case of Blue Chip Stamps, the participating retailers (actually, past participating retailers)

ended up with a little over half the shares of Blue Chip Stamps stock.
To give you some idea of the inefficiency likely to result from this kind of distribution, I will
quote from a later (mid-1970s) case involving Blue Chip Stamps where a U.S. court (actually the
Supreme Court) included a description of the consent decree as background in that court’s
opinion:
“…Old Blue Chip was to be merged into a newly formed corporation, Blue Chip Stamps (New
Blue Chip). The holdings of the majority shareholders of Old Blue Chip were to be reduced, and
New Blue Chip…was required under the plan to offer a substantial number of its shares of
common stock to retailers who had used the stamp service in the past but who were not
shareholders in the old company. Under the terms of the plan, the offering to non-shareholder
users was to be proportional to past stamp usage, and the shares were to be offered in units
consisting of common stock and debentures. The reorganization plan was carried out…
Somewhat more than 50% of the offered units were actually purchased. In 1970, two years after
the offering…a former user of the stamp service and therefore an offeree of the 1968 offering,
filed this suit in the United States District Court for the Central District of California…(alleging,
among other things) that the prospectus prepared and distributed by Blue Chip in connection
with the offering was materially misleading in its overly pessimistic appraisal of Blue Chip’s
status and future prospects. It alleged that Blue Chip intentionally made the prospectus overly
pessimistic in order to discourage (the) respondent and other members of the allegedly large
class whom it represents from accepting what was intended to be a bargain offer, so that the
rejected shares might later be offered to the public at a higher price. The complaint alleged that
class members, because of and in reliance on the false and misleading prospectus, failed to
purchase the offered units.”
Think of all the ways that distributing Blue Chip Stamps shares in this manner was likely to lead
to an inefficient market in the stock (a mispriced stock). One, Blue Chip – which knew the most
about its own business – had incentives to discourage people from buying the stock. Two, the
stock was offered in proportion to past stamp usage and specifically to past stamp users who
were retailers but not investors in Blue Chip. In other words, the stock was being offered
specifically to entities that were likely to be businesses but not investors. So, the well-informed
entity here (Blue Chip) had incentives to make itself look bad when offering to sell itself to what
were essentially potential investors who had no experience investing in anything (these were
businesses not investors). Furthermore, Blue Chip was offering combined units of both stocks
and bonds to retailers who had no experience dealing in either stocks or bonds. So, you’re asking
someone who has never been a buyer of stocks or bonds – only sometimes an issuer of their own
stocks and bonds – to suddenly make a decision about the attractiveness of units that combine
both stocks and bonds.
Think about this for a second. For value investors: the Blue Chip Stamps consent decree resulted
in something even better than a spin-off.
Why Spin-Offs Can Sometimes Be Unusually Attractive to Value Investors
In a spin-off, a group of investors – both institutions and individuals – is given stock in a

company that might not be related to their original reason for buying into the parent. For
example, I bought into a company called NACCO (NC) the day after it spun-off Hamilton
Beach Brands (HBB). Hamilton Beach is a maker of small appliances like crockpots, slow
cookers, microwaves, toasters, etc. The remaining business at NACCO – NACoal – is a cost-plus
miner of lignite (brown) coal for power plants sited very near the mine. The two businesses have
nothing in common. So, some investors may have originally bought NACCO stock because they
liked Hamilton Beach Brands. Other investors may have originally bought the stock precisely
because it was a “special situation”. Once Hamilton Beach was spun-off from NACCO, these
investors were no longer invested in a conglomerate/special situation type investment. So, the
folks who just wanted Hamilton Beach might want to unload NACCO. And the folks who were
just invested in the combined company as a special situation might want to unload NACCO too,
because now it was just a pure play coal company (there was no longer anything special about
the situation). That’s usually how a spin-off works. Investors might not be interested in one of
the two parts post break-up.
But – even in a spin-off – all these supposedly lazy investors are still investors who are used to
analyzing public companies, deciding whether or not to hold a stock, etc. So, while they may not
want a coal company – they certainly don’t mind holding a share of stock in something. Even if
the people selling to me didn’t want to own a standalone coal company at (almost) any price –
they were still investors who knew full well how to analyze NC stock as a stock. Even in the
strangest of spin-offs, you usually still have to buy the stock you want from investors who have
spent years analyzing stocks.
The Blue Chip Stamps case involved the creation of shareholders – the participating retailers –
who didn’t want to own stocks at all. They weren’t investors. They were retailers. So, naturally,
they were going to be too eager to unload as much stock as possible as quickly as possible
without much regard to what that stock was worth.
You can compare this to situations where a government owns some stock in a public company
and is now showing a profit on that position. If the government has political reasons why it might
rather not own the stock – as soon as it shows the slightest profit, it’s going to be very tempted to
sell that stock and just wash its hands of the matter.
In the case of Blue Chip Stamps: Warren Buffett obviously saw the potential to get a lot of
shares from unusually motivated sellers. In fact, he even started buying the shares of publicly
traded retailers that received Blue Chip Stamps shares – not because he was interested in these
retailers as businesses, but purely because he believed he could get the retailers to agree to swap
their shares in Blue Chip Stamps for his shares in them. Basically, he was betting he could get a
company to give him Blue Chip Stamps to make him go away (as a shareholder).
Dealing in Illiquid Stocks: You Can’t Know Till You Try – George Risk and NACCO
Finally, I need to discuss the two ways in which something may be thought of as “a stock you
can’t buy”.
Really, there are 3 ways. However, one is so odd most of you will never come across it.
So, reason #1 is legitimate but extremely rare. There are a few stocks around the world that have
special rules which may literally prohibit you from buying the stock purely for investment
purposes. These are often some kind of club that needed capital (a town, a housing development,
etc.) and so issued stock to raise capital but never really intended to be operated purely for profit-
seeking purposes. This is so rare you’re likely to never come across such a case. They do exist
though. And in such cases, it may literally be true that you “can’t buy the stock”.
What are the other two cases?
The two cases you’ll actually run into are: 1) Your current broker won’t buy the stock for you or
2) You think the stock is too illiquid.
In reality, #2 is almost never a real problem for a small investor. But, I stress both those words:
small and investor. Illiquid stocks are obviously un-buyable for a big trader. But, for a small
investor – these stocks aren’t really “stocks you can’t buy”.
One, your portfolio must be small: thousands, tens of thousands, hundreds of thousands, or
millions. But, not tens of millions or hundreds of millions. However, provided you are investing
less than $10 million total – it will almost never be the case that you literally can’t get enough
shares of a publicly traded company to matter to you. For example, say you are managing $10
million. A 5% position would be $500,000. Assume you buy one-third of the volume of a stock
(I’ve bought more) for a period of six months. If the stock trades about $15,000 worth of stock
per day – you’ll have no problem buying into it. And a lot of people reading this are managing
less than $1 million. Buying illiquid stocks will be more than 10 times easier for you. That
means many people reading this blog can invest in stocks trading as little as $1,000 to $2,000 a
day. And some of you can invest in stocks trading much less than that.
So, illiquidity is almost never an excuse in terms of getting in.

Illiquidity may be an excuse in terms of getting in quickly or getting out quickly – or feeling you
can get out at a price reasonably close to the last trade price. However, those are all trading
concerns. Not investing concerns.
I know that sounds glib of me. But, the ability to get out of a stock at a price close to the last
trade price is 100% a trading concern and 0% an investing concern. It has become so
conventional to think in terms of liquidity that many people who consider themselves investors
assume that the ability to get out of a stock at near the last trade price is some kind of necessity.
That’s not even a legitimate concern for an investor to have.
When you invest in a house, a small business, a farm, etc. you don’t have any expectation you
can get out either 1) quickly or 2) at a price similar to some “last trade”. All you are betting on –
as an investor – is that you’ll be able to eventually unload the asset in a way that gets you an
adequate annual return over the period you owned it. There are many stocks out there that
promise adequate annual returns without promising the ability to get out reasonably quickly or
reasonably close to the last price someone else paid for the stock.
Now, let’s move from the theoretical argument of why illiquid stocks are worth your attention to
a couple practical examples of the difficulties involved in buying enough of these stocks to move
the needle in your portfolio.
As an example: I bought stock in George Risk (RSKIA). The stock supposedly averages a little
over $5,000 in daily volume. I owned the stock for about 6.5 years. When entering the stock, I
put in a lot more than $5,000 and I did most of it in a single trade. When exiting the stock, I sold
a lot more than $5,000 and I again did most of it in a single trade. In neither case did I bid for
stock or offer stock at a price that was less advantageous to me than simply using the last trade
price (what most people used to dealing in liquid stocks simply call the “market” price). As it
turned out, the illiquidity of this stock never mattered to me. Both going into this stock and going
out of it – I was prepared to wait a month or more and get a price that was a lot different than the
last trade. It didn’t turn out that way. It turned out to be way easier to get in and out of George
Risk than I ever would have dreamt.
NACCO was a different story. So far, I’ve only gone into this stock. I still have 50% of my
portfolio in the stock. I planned to buy once it was trading separately from Hamilton Beach
Brands. Because the stock’s market cap – as a combined company – had been several hundred
million dollars and because my buying was to be done on the day the two stocks started trading
separately (thus attracting a lot of attention including from special situations folks, etc.) I
expected it to be very easy to get all the shares I wanted in this stock right away at very close to
the last trade price.
It didn’t work out that way. I only checked the stock price several hours after the open – I don’t
place orders when the market first opens – and by that point in the late morning there was a lot of
volume. But, there was no one interested in doing one big trade near the last trade price. So, I
had to make the decision to accept dozens of smaller trades – each of which might move the
price a little – to fill my order rather than insisting on one all-or-nothing deal. Like I said, there
was a lot of volume. So, I don’t think it made much difference to the average price I got over the
entire day. You could have bought any time in the late morning through to the close of that day
and probably gotten a very similar average cost for your shares whether you did it in one trade,
ten trades, or a hundred trades.
But, it definitely wasn’t easier for me to get into NACCO than it had been to get into George
Risk. And you wouldn’t have predicted that from looking at the average daily volume in those
two stocks.
So, never assume you can’t get a stock just because it hasn’t traded a lot of shares in the past.
Always make an effort. Put a bid out there and see what you can get.
Inconvenience Yourself
The other reason you might not buy a stock is because your broker doesn’t offer you access to
the exchange on which that stock trades. This is a very common reason for why individual
investors don’t buy some stocks. In fact, I’ve written several newsletters, did a report on
Japanese net-nets, etc. and this is the most common complaint given whenever you mention
foreign stocks to someone. They’d need to open another brokerage account with someone else.
I’ve gotten a lot of emails from investors saying they’d love to buy some specific stock but they
can’t.
Eh…
Can’t or won’t?
They could open another brokerage account. They just won’t.
Do it.
This is a good illustration of how the concept of “switching costs” doesn’t mean what it appears
to mean. It’s not expensive to find a broker to buy the stock you want to buy. What is it?
It’s inconvenient.
When we say “switching costs” we often just mean “inconvenience”.
All I can say about the cost of this kind of inconvenience is to consider how much you’d put into
the stock and how much more you’d likely make on this stock rather than something your broker
will buy for you.
If you’re the kind of person who would choose to fly coach rather than first class when crossing
the Atlantic but won’t open a brokerage account to buy that stock you want so badly in Japan –
you’re probably doing something wrong.
It may feel like it’s reasonable to prefer coach over first class for financial reasons but
unreasonable to open another brokerage account just to buy some obscure stock.
From your net worth’s perspective though: those are equally reasonable actions.
It’s very likely that giving up on buying some obscure stock because your broker says he can’t
buy it for you is costing you more than a first class plane ticket would.
So, you’re actually spending thousands on avoiding an inconvenience.
I Don’t Use an Online Broker
To be fair, most people reading this use an online discount broker of some kind.
I don’t.
My reason for not using something like Interactive Brokers isn’t that I want access to more
exchanges around the world than that broker would give me.
My reason for not using an online broker is that I specifically don’t want the ability to place
trades myself.
If you want to focus on investing – the first thing to do is prevent yourself from having the
ability to trade. So, I leave trading to someone else entirely. This works very well for me.
But, I understand it is potentially more expensive and certainly less convenient than the approach
others take.
Personally, I think it’s much easier on the mind and potentially more profitable in the long-run to
go the old fashioned route and call your broker on the phone instead of placing a trade with your
mouse.
I promise you you’ll make less trades this way.
But, I know I’m not going to win any converts to my side here.
In fact, nothing I say is going to get you to switch brokers. This is what we really mean when we
say “switching costs”. I can change people’s minds about a lot of things. But, it’s very hard to
convince someone to do anything that’s both: 1) inconvenient and 2) a break from their
established habits.
In some sense that’s probably why there will always be some oddly mispriced stocks out there.
We’d have to break our habits and put in some extra effort to track them down and buy them.
 URL: https://focusedcompounding.com/stocks-you-cant-buy/
 Time: 2017
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Why You Might Want to Stop Measuring Your Portfolio’s Performance

Against the S&P; 500
Someone emailed me this question about tracking portfolio performance:
“All investors are comparing their portfolio performance with the S&P 500 or DAX (depends
were they live). I have asked a value investor why he compared the S&P 500 performance with
his portfolio performance…for me as a value investor it makes no sense. A value investor holds
individual assets with each of them having a different risk…it’s like comparing apples and
oranges.
The value investor told me that…Warren Buffett compares his performance with the S&P 500.
But I believe he did it, because other investors…expect it or ask for such a comparison.
How do you measure your portfolio success? Do you calculate your average entry P/E and
compare it with S&P500 or Dow P/E to show how much you (over)paid for your assets? Or do
you avoid such a comparison and calculate only the NAV of your portfolio?”
I don’t discuss my portfolio performance on this blog.
And I think it’s generally a good idea not to track your portfolio performance versus a
benchmark.
It’s certainly a bad idea to monitor your performance versus the S&P 500 on something as short
as a year-by-year basis.
Why?
Well, simply monitoring something affects behavior. So, while you might think “what’s the
harm in weighing myself twice a day – that’s not the same thing as going on a diet” – in reality,
weighing yourself twice a day is a lot like going on a diet. If you really wanted to make decisions
about how much to eat, how much to exercise, etc. completely independent of your weight –
there’s only one way to do that: never weigh yourself. Once you weigh yourself, your decisions
about eating and exercising and such will no longer be independent of your weight.
Knowing how much the S&P 500 has returned this quarter, this year, this decade, etc. is a curse.
You aren’t investing in the S&P 500. So, tethering your expectations to the S&P 500 – both on
the upside and on the downside – isn’t helpful. The incorrect assumption here is that the S&P
500 is a useful gauge of opportunity cost. It’s not.
Let me give you an example using my own performance. Because of when the 2008 financial
crisis hit, we can conveniently break my investing career into two parts: 1999-2007 and 2009-
2017.
Does knowing what the S&P 500 did from 1999-2007 and 2009-2017 help me or hurt me?
It hurts me. A lot.
Because – as a value investor – the opportunities for me to make money were actually very
similar in 1999-2007 and 2009-2017. In both periods, I outperformed the S&P. However, my
outperformance in 2009-2017 was small while my outperformance in 1999-2007 was big. In
absolute terms, my annual returns were fairly similar for the period from 1999-2007 and 2009-
2017. It is the performance of the S&P 500 that changed.
Many value investors have a goal to outperform the S&P 500. But, is this a useful goal?
I don’t think so. Let’s look at the 1999-2007 period to see why it’s not a good goal. The S&P 500
returned very little from 1999-2007. However, a value investor – like me – who was looking to
own only 3-5 specific stocks at a time could have made 15% a year. It’s this number – something
like 15% a year – that’s the rabbit you should have been chasing in 1999-2007, not the 5% or so
the S&P 500 did.
Let’s assume the S&P 500 returned about 5% a year from 1999 through 2007. And then let’s
assume that some value investor returned 8% a year during the same time period. This value
investor is very proud of himself.
Should he be?
No. He blew it.
If you were an individual investor who made 8% a year from 1999-2007, you missed a lot of
opportunities you should have taken advantage of. It was possible to make 15% a year without
taking a ton of risk. And, so, you left something like 7% a year on the table over a period of 8
full years.
That kind of underperformance versus your potential rate of compounding has – when it occurs
over a period as long as 8 full years – a significant (really permanent) influence on your
lifetime investment outcome. If you had been making 15% a year from 1999-2007 you’d have
$1.72 for every $1 you’d have if you were making 8% a year from 1999-2007. And yet, because
you outperformed the S&P 500 – you chalked this period up as a win for you.
When we look at the period 2009 through 2017, we see the opposite problem. We especially see
it in the last couple years. But, let’s look at the full period. Let’s say that from 2009 through 2017
you again made 15% a year.
This time you’d say you just about tied the S&P 500. You certainly didn’t beat it. And so, if you
did 15% a year from 2009 through today, you’d say you don’t deserve any accolades at all.
Is that right?
Well, it depends on how you achieved it. The argument that people make about why you should
track your results against the S&P 500 is that the S&P 500 is always a viable alternative. So, if
you didn’t do much better than 15% a year from 2009 through 2017 – you didn’t add value.
Your effort was wasted.
There’s a logical problem here. As an investor, you don’t control outcomes. You only control
process. Any benchmarking against historical performance is limited in the sense that it starts at
one exact beginning point and finishes at one exact end point.
Basically, we are assuming clairvoyance on your part. I don’t just mean that we’re assuming you
knew everything that could be known in 2009 and reasoned everything out correctly from there.
I’m not just saying you were omniscient and infallible. I’m saying you could actually foresee the
future free from uncertainty.
That’s no way to measure results.
I’m now going to take you on a very involved philosophical detour. But, it’s an important side
trip to take if we’re going to understand that what we want to judge is always our process not our
outcome even though the most readily available tool for measuring our process (indirectly) is
reasoning backwards from our outcome.
Just remember this: we have no control over outcomes. We control only process. So, going
forward, our goal is to fix our process – not our outcome.
In the long run: outcomes will follow process.
The Past is Only Fixed in Retrospect

People intuitively understand that the future is not fixed. However, they don’t always make the
(correct) logical leap that the present we are now living was never a 100% certainty at any point
in the past. In other words, even when you are able to correctly predict the future – you should
never make a 100% bet on that future. Retrospectively, this means that while the particular past
that got us to today’s present is mostly informative of what we should have done in the past – it
is never fully informative. The moment we are in now is somewhere near the average of
moments that might have been. It is not – all by itself – ever a perfectly precise measure of what
the likely future was at any point in the past.
This is very important when considering something like the performance of the S&P 500 over
the past year. Let’s say the S&P 500 returned 20% in 2017. How correct was a bet made in
January 1st of this year that the S&P 500 would be 20% higher on December 31st? I’d say such a
bet was a bad bet even though the outcome was positive. What I mean is this: rolling one die and
betting 1-to-1 odds that it will come up 3 is a bad bet even if it does come up 3. A bet that the
S&P 500 might return 10% this year could be an okay bet. But, a bet that the S&P 500 would
return 20% a year – which turned out to be the truth – is still a bad bet. This isn’t obvious
because you lived only one 2017. But, if you could live 1,000 2017s in a row one-after-another
in some sort of set of parallel experiences – it’s not likely that the central tendency of those 1,000
different last years would work out anything like the last year we all just lived.
Why It’s Better Not to Know EXACTLY What the Dow Really Earned Last Year
About 11 years ago now, I took a look at returns in the Dow based on a smudged history
approach. Instead of assuming that the EPS reported for the Dow in any one year was the
inevitably “correct” EPS for that year (as if you could have foreseen that it always had to work
out that way), I assumed that the best way to think of the Dow’s earnings in any one year was to
look at the 15 years preceding it and then draw 15 lines – moving at 6% a year – forward in time
till they reached the current year. You then – metaphorically – took your finger and smudged
those 15 endpoints.
That’s the normal earnings for the Dow.
It’s the central tendency suggested by 15 points from the past rather than the actual observed
point we’re at now (the present). As it turns out, using the central tendency suggested by 15 past
points works much better than relying on one present-day point.
Never Measure One Point In Time
This sounds strange, counterintuitive, and overly complex. But, it’s actually a much more logical
way to look at the historical level of anything. If I was shooting a pistol at a target and sometimes
hit the left shoulder and sometimes the right and then maybe the head and once or twice the
abdomen and then finally – with my very last bullet – I hit the target right in the heart…
Should we award you any points for guessing that I’d hit the heart with that last shot? In what
way does it even make sense to say I hit the heart? I mean, I also hit both shoulders and the head
and the gut.
So, what would constitute a good guess on your part?
If you correctly guessed the central tendency of my shots to cluster in some particular part of the
target over 5 attempts, 50 attempts, 500 attempts, or 5,000 attempts – that would be something
worth giving you credit for.
So, history is certain and precise. But, the certainty and precision with which we can measure the
past is not necessarily useful. Over very long periods of time – for example, from 1999 all the
way through 2017 – a comparison of your results versus the S&P 500 might tell you something.
What’s Easiest to Measure vs. What Matters Most
But, even then: does it tell you what you care most about?
Should the average person really be aiming to get a better performance than the S&P 500?
In terms of building wealth, it’s the long-term rate of compounding that matters.
I once broke this down as follows…
If you string together back-to-back-to-back 15-year periods of 5% annual returns: you aren’t
going to achieve any of your long-term financial goals.
If you string together back-to-back-to-back 15-year periods of 10% annual returns:

you may achieve most of your long-term financial goals if you make enough, are frugal enough,
etc.
And finally…
If you string together back-to-back-to-back 15-year periods of 15% annual returns:

you will achieve all your long-term financial goals.
Now, I’ve brushed over the issue of inflation there. But – aside from differences in the rate of
inflation over your investment lifetime – what I’ve said is true.
What matters is getting a good absolute rate of compounding over 40-50 years. Getting a good
relative rate of compounding over 4-5 years isn’t important.
Because some financial cycles – like interest rates, P/E ratios, bull markets, etc. – are so long: I
suggest measuring your annual returns over 15-year intervals.
And – because you can’t eat relative returns – I suggest you think in terms of absolute returns.
If, over the last 15 years, you’ve done 5% a year: that’s not good enough.
If, over the last 15 years, you’ve done 10% a year: that’s fine.
And if, over the last 15 years, you’ve done 15% a year: that is good enough.
As an individual investor, your goal should be to try to do 2 things:
1) Avoid doing anything that might get you returns as low as 5% a year for as long as 15
years
2) Seize any opportunities that come along that seem likely to get you returns as high as 15%
a year for as long as 15 years
When I say that: I’m talking about individual stock picks, strategies you can adopt, process
improvements – everything. If you think it can get you to 15% a year over 15 years – go chase it
down.
Okay. So far I’ve said:
1. Measure your absolute returns
2. Think in terms of 15-year intervals
Is that all you can measure?
No. You can measure the performance of individual stock picks.
Measure Your Individual Forced Outcomes
In fact, you will find that several of the picks you make will resolve themselves permanently in
less than 15 years. Some stocks you pick will suffer a permanent impairment of intrinsic value –
they may even end up in bankruptcy. Others will be acquired at a price higher than you paid for
them.
For example, I bought a stock called IMS Health in 2009. That company went private. It’s public
again. But, my investment was permanently resolved – by that private equity buyout – in the
sense that I had no choice of whether or not to take a profit. I was forced to take a profit.
Likewise, in 2010, I bought a stock called Bancinsurance. About 9 months later, that stock was
taken private. Again, I had no choice of whether or not to take a profit. I was forced to take a
profit.
Before the financial crisis, Warren Buffett invested in some Irish bank stocks. They ended up
being basically worthless. So, Buffett didn’t choose to take a loss in that stock. He was forced to
take a loss.
You can always measure your performance in stock picks that permanently resolve themselves
irrespective of your actions. You can look at the annual returns in those stocks.
For example, my return in Bancinsurance was about 40% in about a year. Do I spend time
thinking: what was the return in the S&P 500 during the period when I held Bancinsurance
stock?
No.
I just think that any time you can find something that makes you about 40% a year – that’s a win.
Now, there was obviously a chance that Bancinsurance could have ended up much, much worse.
I couldn’t have foreseen a 100% probability of a 40% profit ahead of time. But, when you look
back at what I knew when I made my decision to invest – you could imagine that, based on the
probabilities of the situation, a return of 20% a year was a good guess. At the time I made the
investment, the most likely outcome seemed to be a return of no less than 3% but no more than
60% in perhaps less than a year. The important thing was this: it seemed a good enough bet in
the sense it was likely to return 15% or better annualized.
And, as an individual investor, that’s what you’re looking for. You’re looking for absolute
returns. You’re looking to avoid anything – like an S&P 500 index fund today – that seems more
likely to return 5% a year over the next 15 years rather than 10% a year over the next 15 years.
And you’re looking to jump on any opportunities that seem more likely to return 15% a year
rather than 10% a year.
So, for individual investors, I think benchmarking your results against an index is bad for two
reasons: 1) The time period you care about is long-term (1-year results, 3-year results, even 5-
year results aren’t going to be informative much of the time) and 2) The returns you care about
are absolute returns not relative returns.
If you’re picking stocks for yourself and only yourself – your long-term, absolute rate of
compounding is all that matters.
Why Individual Investors Have It Easy
Who should use benchmarking then?

Professionals.
Professionals are looking to attract and retain clients. Clients care about relative returns. Should
clients care about relative returns? That’s a question for another day. But, they do. And they
often care about short-term results. For example, I just read a blog post that said Bill Ackman’s
results were “mixed” because:
“At Pershing Square he significantly underperformed from 2015 to 2017 and outperformed from
2004 to 2014.”
Now, the period 2004-2014 is a lot longer than 2015-2017. And, more importantly, this blog post
showed results from 2004-2016. Ackman’s cumulative results from 2004-2016 were a lot better
than the S&P 500 (his benchmark). And yet, the general feeling is that Ackman’s track record is
mixed. When people say “mixed” they mean his long-term results are good but his short-term
results are bad. For an individual investor, that’s not a mixed track record. That’s simply a good
track record. But, for a professional – that kind of track record means clients are going to pull
their money.
So, professionals track performance versus a benchmark, because: 1) Clients care about short-
term performance and 2) Clients care about relative performance.
There is one other reason why benchmarking makes sense for most professionals and yet doesn’t
make sense for many individual investors.
This reason doesn’t apply to Bill Ackman (a concentrated investor). But it does apply to most
money managers (diversified investors).
I try to own 3-5 stocks at a time. There are 500 stocks in the S&P 500. And there are more like
5,000 stocks that are investable for me. So, at any moment in time – I only need to say “yes” to
something like 1% to 0.1% of all potential investments. Professionals who are diversified may –
depending on how big the pile of assets they manage is – need to say “yes” to more like 1% to
10% of all stocks they learn about.
Let’s take an extreme case. Imagine someone is managing $10 billion in a diversified way. This
manager will often need to stick to S&P 500 type stocks. And he will often need to hold 30-50
stocks. In reality, holding 50 stocks instead of 20 stocks isn’t going to add much diversification
in terms of the resulting volatility versus the benchmark. But, the convention among professional
money managers is often to hold up to 50 stocks for the purpose of diversification whether or not
this can be shown to make a meaningful difference in the ups and downs of the portfolio or not.
A money manager who holds 30-50 stocks of S&P 500 sized companies needs to say “yes” about
6% to 10% of the time. This is 6 to 100 times more frequently than I have to say “yes”. As a
result, the performance of such a money manager’s portfolio – whether he wants this to be the
outcome or not – is going to be a lot closer to his benchmark from year-to-year.
Now, this is a position number / position size issue (that is, lack of selectivity issue) not a
professional versus individual investor issue. A professional money manager who runs $10
million by allocating that portfolio to just 3-5 stocks would be in the same boat at the individual
investor rather than the worst case professional (a big, diversified fund) I showed here.
In reality, a professional money manager who has to invest $10 million or maybe even $100
million and is willing to keep that in as few as 3-5 stocks is in the same position as an individual
investor except for the fact that he has an unstable source of funding (his clients) who may pull
money the second his short-term relative performance weakens.
So, benchmarking makes more sense for people who:
1. Rely on other people’s money
2. Own a lot of different stocks and
3. Manage a lot of money
Benchmarking makes less sense for people who:
1. Invest only their own money
2. Own very few stocks and
3. Manage a small amount of money
Most readers of this blog fall more into the second group (as I certainly do) than the first group.
Therefore, benchmarking is something you are probably better off eliminating from your
investing process.
Personally, I don’t care what the S&P 500 does. I only care what I do. So, I do my best to ignore
all benchmarks.
 URL: https://focusedcompounding.com/why-you-might-want-to-stop-measuring-your-
portfolios-performance-against-the-s-500-2/
 Time: 2017
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The Risk of Regret: NACCO (NC)
Someone emailed me this question about NACCO (NC):

“If you don’t mind me asking, why do you so strongly recommend other people not buy the stock
given your obvious high conviction? It seems like a classic value situation where a company in a
hated industry (coal) with a long-term bleak outlook has an individual player (NC) where the
cash flow characteristics are more than enough to justify the current stock price. If you prefer
not to answer because your answer is embedded in your member-only site, I totally understand,
but I am quite intrigued. For what it’s worth, I am not at a point where I am seriously
considering NC for potential investment – I am more interested in Frost (CFR), although I
would prefer it to come down more. I am just trying to understand the business and what a fair
price for it is. It seems to me that if we had 100% certainty that all the contracts would remain
viable for a couple of decades, then NC is easily worth say double where it trades now, but the
name of the game is in handicapping the risks of the mines closing, and I would be interested in
your thoughts about doing that. It’s obvious that you view this risk as worth the price paid, but I
am curious why you do not think others should take the same risk.”
I’ll quote from the write-up I did on the Focused Compounding member site. I had sub-titled
sections in this write-up. So, let’s just bullet point the headlines that appeared in the article.
They were:
* All value comes from the unconsolidated mines
* There are risks
* NACCO’s business model
* Each share of NACCO is backed by 5 tons of annual coal production
* NACCO makes anywhere from 57 cents to $1.75 per ton of coal it supplies
* Side not: amortization of coal supply contracts
* NACCO vs. NACoal
* Quality of earnings
* Risk of catastrophic loss
* How I “frame” NACCO
* Why I don’t recommend NACCO shares

You asked about “why I don’t recommend NACCO shares” and that’s one of the section
headers. So, let’s look at that part:
“I put 50% of my portfolio into NACCO. But, I think people reading this should put 0% of their
portfolio into NACCO. As long as electricity demand in the U.S. is declining and natural gas
production is rising, coal power plants will shut down. As a shareholder of NACCO, you could
wake up any morning to the news that the company has lost 35% of its earnings overnight. I
don’t think this is a risk most investors can handle.
Therefore, I don’t recommend anyone invests in NACCO even though it’s now my biggest
position.
Let me be clear: I’m not just saying this is a ‘perceived’ risk you may want to avoid.
It’s a real risk.
NACCO is a risky stock.
I absolutely can’t prove that all of the power plants NACCO supplies won’t shut down real soon.
This means I can’t prove NACCO won’t lose literally all of its business in the very near future.”
I wasn’t joking when I wrote any of that. I talk a lot to investors. And I feel certain they
shouldn’t put any money into NACCO. That kind of business specific risk – that a stock you
picked could lose 35% of its earnings overnight – has the potential to make them feel so stupid,
that they shouldn’t invest.
It’s not just that I think differently about stock picking than other people. It’s that
I feel differently about stock picking. If I lose a lot of money in NACCO, I’ll lose a lot of money
– same as anyone else. But, losing a lot of money in NACCO won’t crush my psyche. That kind
of loss will do a number on most other investors’ heads.
To have success in investing, you have to stay in it long-term. That – more than anything else –
is the key. You can have the optimal system picked out, but if you quit after just 8 years of
investing instead of sticking it out for 50 – you lose. The real risk to investors is not the risk
shown in something like the Kelly Criterion where you will end up with a zero dollar bankroll at
some point. The real risk is that you’ll stop picking stocks. And the reason you’ll do that is
because your mind gets broken – not your bankroll.

Losing a lot of money in an obscure stock like NC that I picked out for myself vs. losing a lot of
money in the S&P 500 doesn’t feel any different to me. It feels different to the average person
out there. So, when I say: you might lose 35% overnight in NC because of a single event that
hasn’t happened – that’s disturbing to most investors. But, the way I look at it – you might lose
35% in NC because of an event that hasn’t happened yet. But, you will lose 35% in the S&P 500
because of an event that has already happened (it’s more than 50% overpriced right now).
That sounds wrong to most people.
But, it’s right.
The fact that all investors are aware of the S&P 500 and almost all of them don’t believe it’s
overvalued by at least 50% doesn’t change the fact that it is overvalued by at least 50%.
Likewise, the fact that almost no investors are aware of NACCO doesn’t change the fact that
there is some price level below which it should not sell.
I looked at the stock before the spin-off. And I came to the conclusion that the stock shouldn’t
sell for less than about $45 a share. I didn’t value it at $45 a share. I just said: “it’d be really
weird for this stock to ever trade below $45 a share” and then the stock was trading at around
$32.50 a share when I first checked the price on October 2nd (the day of the spin-off). So, I
bought it.
I wrote the article at Focused Compounding in which I discussed NC after the spin-off had
happened. So, I used $32.50 as the price I discussed in that article.
Basically, what I said was something like this:
Over the last 5 years prior to NC’s expansion into (and now exit from) the very different
business of owning and operating an underground bituminous coal mine (Centennial), NACoal
reported an after-tax profit of over 90 cents per ton of coal mined if we assume all “corporate”
losses stay with NC and none go to HBB. NACCO is now producing more than 5 tons of coal
per share of NC stock. So, 90 cents times 5 tons = $4.50 per share in earnings. Furthermore,
NACCO is taking a non-cash charge in the form of amortization of its coal supply contracts with
every ton of coal it mines. This causes NACCO’s reported profit per ton of coal mined to come
in well below its cash received per ton of coal mined.
Then, I knew that HBB was supposed to pay NACCO a $35 million cash dividend just prior to
the spin-off. And, knowing that, I could see that this would leave NACCO with a balance sheet
that was basically free of meaningful net debt or net cash. NACCO has long-term liabilities. But,
these don’t require much in the way of immediate funding (they aren’t things like bank loans).
And the company has cash on hand right now. So, I assumed the net result – in my quest to
simplify the situation – was that the asset and liability situation came close enough to being a
wash that I could just value the stock as if it was nothing but an annual stream of free cash flow.
So, for the sake of simplicity, you have a stream of free cash flow that’s about $4.50 a year and
costs you about $32.50 (with no meaningful cash or debt attached).
Normally, free cash flow is capitalized in the stock market at a rate no higher than 6% (that is,
16-17 times free cash flow). So, a stock priced at $32.50 a share with neither meaningful debt
nor cash attached to it is priced like it is expected to deliver an annual stream of free cash flow of
$1.95. In other words, NACCO looked like it would normally have about $4.50 a share in free
cash flow and yet it was priced like it would normally have about $2 a share in free cash flow.
This meant that NC’s free cash flow could end up being (more than) 50% lower than what I
calculated without the stock price needing to decline to reach fair value.
The way NACCO’s unconsolidated mines are set up – where the customer takes all the capital
risk – made me feel that NACCO was better situated to lose a big chunk of revenue without
necessarily losing a much bigger chunk of free cash flow. At many businesses, a decline of say
35% of revenue could cause a 100% decline in earnings. Here, I didn’t think that – after the
initial year or so following the contract loss – a loss of 35% of revenue would cause much more
than a loss of 50% of free cash flow.
So, I looked at the stock and said that NACCO at $32.50 a share is already priced like it has lost
its biggest customer. That’s your margin of safety. It’s priced like it’s lost its biggest customer.
And yet it hasn’t yet lost its biggest customer yet. And – while you own the stock and wait for it
to lose that biggest customer – cash will pile up on the balance sheet at a rate of about 10% to
15% of your original purchase price, or you’ll get a dividend (right now, it’s about 2% of my
cost in the stock), or the company will buy back stock, or the company will – as it did in the past
– acquire businesses unrelated to coal mining.

This looked like a good deal to me. So, I bought the stock. However, I don’t recommend anyone
else buys the stock, because they will have such tremendous regret if they buy NACCO and then
coal power plant after coal power plant after coal power plant closes and the company’s stock
drops nearly to zero.
The regret they feel losing money in NACCO will be much greater than the regret they’d feel
losing the same amount of money in something like an S&P 500 index fund, because in the case
of NACCO their loss will be their fault. In the case of the S&P 500, they can take solace in the
knowledge that everyone they know also lost money the same way.
Unlike most people, I don’t really feel regret. And so: one loss feels just like another loss to me.
For example, I lost a lot of money in Weight Watchers (WTW).
That doesn’t really bother me. I know some other people who followed me into that stock, lost
less money than me (or pretty much broke even) and yet are still bothered by the experience.
This is why I warn everyone away from NACCO even while owning the stock myself. You may
really regret owning NACCO in a way I won’t.
For me, if I look back on a stock purchase I made and can say “knowing what I knew then it
seemed like a good bet at the time” – I won’t regret that purchase no matter how much I lose.
Also, if I do something like keep money in cash that could go into the S&P 500 and then the
S&P 500 goes up 20% or so (like it did this year) despite already being expensive – I won’t
regret not being in the market. Because, yes, it went up 20%. But, looking back a year ago – it
certainly didn’t look like a good bet at the time. So, I don’t think anyone who has made 20% in
stocks this year should give themselves credit for being lucky a little longer than it probably was
safe to be.

This may or may not be how most investors think. But, I know it’s not how most investors feel.
So, there are just certain stocks the average investor should avoid for purely psychological
reasons. And I think NACCO is one of those stocks.
 URL: https://focusedcompounding.com/the-risk-of-regret-nacco-nc/
 Time: 2017
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What Most Investors Are Trying to Do
John Huber, who writes the Base Hit Investing blog and also runs the excellent BHI Member
site, did an interview over at Forbes.com. In that interview, Huber says:
“(My) strategy is very simply to make meaningful investments in good companies when their
stocks are undervalued.
This is obviously what most investors are trying to do…”
Like John, I used to think that this is what most investors were trying to do. However, the
thousands of email exchanges I’ve had over the 12 years I’ve been writing this blog have taught
me that most investors are not trying to “make meaningful investments in good companies when
their stocks are undervalued.”
Let’s break this statement down to see what I mean:
1. Make meaningful investments
2. In good companies
3. When their stocks are undervalued
We have 3 key words there:
1. Meaningful
2. Good
3. Undervalued

Make Meaningful Investments
What is a meaningful investment?
“Meaningful Investments” According to Me
My minimum position size is around 20%. My maximum position size is around 50%. I usually
own 3-5 stocks. I often have some cash.
At the start of this quarter, my portfolio was more concentrated than usual. I had 50% of my
portfolio in my top stock alone, 78% in my top 2 stocks combined, and 92% in my top 3 stocks
combined.
“Meaningful Investments” According to Joel Greenblatt
Quote: “After purchasing six or eight stocks in different industries, the benefit of adding even
more stocks to your portfolio in an effort to reduce risk is small.”
Answer: A meaningful investment is 13% to 17% of your portfolio (1/8 = 12.5%; 1/6 =
16.67%).
“Meaningful Investments” According to Warren Buffett
Quote: “Charlie and I operated mostly with five positions. If I were running $50, $100, $200
million, I would have 80 percent in five positions, with 25 percent for the largest.”
Answer: A meaningful investment is 16% to 25% (80%/5 = 16%).
“Meaningful Investments” According to Charlie Munger
Quote: “If you are going to operate for 30 years and only own 3 securities but you had an
expectancy of outperforming averages of say 4 points a year or something like that on each of
those 3 securities, how much of a chance are you taking when you get a wildly worse result on
the average? I’d work that out mathematically, and assuming you’d stay for 30 years, you’d
have a more volatile record but the long-term expectancy was, in terms of disaster prevention,
plenty good enough for 3 securities.”
Answer: A meaningful investment is 33% (1/3 = 33.33%).
So, the above value investors (jointly) define a “meaningful investment” to be in the range of
13% to 33% of your total portfolio.
Over the last 12 years, I’ve discussed position size with dozens of individual investors. Maybe
five of them take “normal” positions of 13% to 33% of their portfolio. I would estimate that at
least 85% of investors do not try to make meaningful investments.
In Good Companies
What is a good company?
Good Companies According to Me
Quote: “A business with market power is a good business. A business without market power is a
bad business…Market power is 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.”
Answer: A good company is a player in markets (both those it buys from and those it sells into)
where competition is extraordinarily imperfect.
Good Companies According to Warren Buffett
Quote: “The single most important decision in evaluating a business is pricing power. If you’ve
got the power to raise prices without losing business to a competitor, you’ve got a very good
business. And if you have to have a prayer session before raising the price by 10 percent, then
you’ve got a terrible business.”
Answer: A good company faces extraordinarily mild price competition.
Do Most Investors Look for Good Companies?

Most public companies don’t have highly persistent profitability. They experience mean
reversion. This is because either: 1) They operate in markets (both those they buy from and those
they sell into) where competition is not extraordinarily imperfect and therefore tends toward the
“mean reversion” of profitability common in more perfectly competitive markets or 2) They
expand the corporation by taking the profits earned in an extraordinarily imperfectly competitive
market (one in which they have a “moat”) and re-invest them in a more perfectly competitive
market (where they don’t have a moat).
Is it possible to identify imperfectly competitive industries ahead of time?
Yes.
They’re less cyclical.
Let me explain.
A perfectly competitive market is made up of a large number of price takers. An imperfectly

competitive market is made up of a small number of price setters. A large number of price takers
– each believing they have no influence on the market they operate in – act irresponsibly in the
literal sense of believing their individual actions are not responsible for the outcome the group
experiences. A small number of price setters – each believing they have some influence on the
market they operate in – act responsibly in the literal sense of believing their individual actions
are responsible for the outcome the group experiences.
In other words…
Players in a perfectly competitive market act like humans do when wearing masks, among
strangers, etc.
Players in an imperfectly competitive market act like humans do when showing their face,
among peers, etc.
As a result, perfectly competitive markets are driven by more self-destructive decision making.
Self-destructive decision-making leads to cyclicality.
This is because a cycle is only possible if a decision is made now that is regretted later. An
industry free of regrets would be an industry free of cyclicality.
A decision may be regretted later because it was based on information that proved to be false
or…
A decision may be regretted later, because – despite having the correct information – a player in
the market made a decision they knew was against the group’s long-term interest because they
believed it might be in their own short-term interest.
Economists, investors, etc. tend to focus on bad information as an explanation for behavior that
is later regretted. However, anecdotally, I think many of us would have to say that the regrets we
observe in our day-to-day lives are at least as frequently due to the decision maker having all the
necessary information to make a correct decision but still giving into a short-term impulse simply
because the ill effects of the decision were known to be felt only in the long-term.
The classic quote here is, of course, from Citigroup CEO Chuck Prince in July 2007:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music
is playing, you’ve got to get up and dance. We’re still dancing.”
Note the focus on time as opposed to risk. This is something you hear in cyclical industries but
never in non-cyclical industries. He said: “in terms of liquidity, things will be complicated.”
That’s all you need to know to know you shouldn’t be dancing. That’s the risk. But, he prefaced
the bit about risk with “When the music stops” and added the afterword: “But as long as the
music is playing…” This kind of quote is common – though rarely as direct – in cyclical
industries. The justification for self-destructive behavior is that “yes, we’re doing something
risky” but “no, now’s not the time we’ll have to pay for the risks we’re taking”.
Credit Suisse did a study of how persistent profitability was by industry. (You can Google the
title “Do Wonderful Companies Stay Wonderful” to find a discussion of this report).
The extreme results – the industries listed as those where firms had the most persistent
profitability and the industries listed as those where the firms had the least persistent profitability
– were not surprising.
The 3 industries where firms had the most persistent profitability were: 1) Household and
Personal Products, 2) Food and Beverage, and 3) Hotels and Restaurants. All non-cyclical
industries.
The 3 industries where firms had the least persistent profitability were: 1) Insurance, 2)
Semiconductors, and 3) Real Estate. All cyclical industries.
Let’s take a look at Berkshire Hathaway’s 5 largest stock positions shown in the 2009
shareholder letter:
(This is the last year where Warren Buffett was the only person at Berkshire making investment
decisions.)
#1) Coca-Cola (KO): Soft drinks
#2) Wells Fargo (WFC): Banking
#3) American Express (AXP): Credit cards

#4) Procter & Gamble (PG): Toiletries
#5) Kraft (KFT): Food
Coke and Kraft are in the food and beverage industry. That’s the #2 industry in terms of most
persistent profitability among firms. Procter & Gamble is in the household and personal products
industry. That’s the #1 industry in terms of most persistent profitability among firms. There were
24 industries listed in that Credit Suisse report. So, 60% of Buffett’s top 5 stocks in 2009 were in
the top 8% of industries by persistence of profitability at the firm level. Almost without
exception, Buffett’s 2009 stock investments were in companies that were either in non-cyclical
industries or in financial services.
(The exceptions are Posco and ConocoPhillips. Berkshire also owned BYD; however, this
investment was probably made by Charlie Munger – not Warren Buffett).
Berkshire’s investment portfolio skews heavily towards the very least cyclical industries around.
Do most investors look for good companies?
When I put out a call for readers to request I research specific stocks for them (I’ve since
cancelled this project), I got as many requests for companies in cyclical industries as in non-
cyclical industries.
In fact, after getting a flood of requests from readers – I wrote this on the blog:
“Finally, a suggestion. I will certainly try to do my best to research any stock you ask about.
However, I have gotten a lot of requests to research companies that are speculative in the sense
that:
· They are in bankruptcy right now
· They are losing money right now
· They have never made money in the past
· Statistical measures like Z-Score and F-Score suggest they are very poor credit risks
I can research these stocks. But, common stock is junior to the company’s obligations. So, in
cases like this, my write-up is likely to focus on the company’s weak financial position and the
possibility that the stock will be worthless.”
These requests were not for good companies.
Conclusion: I would estimate that investors spend about 50% of their time looking at good, non-
cyclical companies and about 50% of their time looking at bad, cyclical companies. Except
among a very small subset of readers I exchange emails with – I have not detected any tendency
for investors to focus on good, non-cyclical companies to the exclusion of bad, cyclical
companies.
When the Stocks are Undervalued
I write a value investing blog. And I have to say that my readers do tend to ask about cheap
stocks. They tend to own the stock that has the lowest P/E, EV/EBITDA, etc. in an industry.
They are much more interested in stocks hitting 52-week lows than 52-week highs.
Conclusion: In my experience, value investors really do like to buy stocks that have fallen in
price, stocks that are cheaper than peers, and stocks with low price-to-book ratios, price-to-
earnings ratios, and especially low EV/EBITDA ratios.
One Out of Three
My experience is limited to talking with readers of the blog over the last 12 years. These readers
(or at least the ones who email me) are maybe 40% American and 60% from other countries.
They almost all identify as value investors. A very slight majority are individual investors who
don’t work in the investment industry. Most of the remaining minority are professionals in the
sense they work in the investment industry – often as analysts – but do not have ultimate
responsibility for a portfolio. A much smaller minority – probably no more than 5% – are fund
managers. The funds they are running are usually small: anywhere from tens of millions to
hundreds of millions of dollars – not billions.
So, the population I’ve interacted with skews entirely to the “value” side. It is more individual
investors than institutional. A lot of money is run by big institutions which may not be value
oriented. I can’t talk about them.
For those investors I can talk about: how do they score on John Huber’s 3-point strategy?
#1: Make Meaningful Investments
False. Overwhelmingly, the investors I know prefer to make non-meaningful investments. They
prefer taking a 5% position over a 15% position and a 3% position over a 33% position.
#2: In Good Companies

Neither true nor false. At the same price, I get the impression they’d prefer investing in a good,
non-cyclical company over a bad, cyclical company. But – give the prices at which stocks
typically trade – they seem as interested in bad, cyclical companies as good, non-cyclical
companies. When a reader asks me about a stock unprompted – that stock is as likely to be a bad,
cyclical company as a good, non-cyclical company.
#3: When Their Stocks are Undervalued
True. The value investors who read my blog like stocks that have dropped in price. They like
stocks with low EV/EBITDA multiples, low P/E ratios, and sometimes even low price-to-book
ratios. They like stocks that are cheaper than their peers.
Conclusion: The value investors who read my blog don’t really follow John Huber’s approach of
seeking to “make meaningful investments in good companies when their shares are
undervalued”. Instead, they seek to make less than meaningful investments in companies
regardless of their quality when those stocks are cheap.
 URL: https://focusedcompounding.com/what-most-investors-are-trying-to-do/
 Time: 2017
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Risk Habituation and Creeping Speculation
In response to an email a reader sent about some of my recent posts on the difference between
investment and speculation, I entered lecture mode…
I am especially worried about the tendency among readers to speculate using the logic that value
investors (like me) are sometimes wrong (like in WTW) and these “investments” turn out to be
speculations. Therefore, how is buying at 8 times EBITDA in what has historically been a fairly
predictable company different from buying at 16 times EBITDA in a company that hasn’t
historically been predictable? Aren’t they both speculations since you are always ultimately
going to make money or lose money based on how right you are about the future?
Are You Better Off Than You Were 8 Years Ago? – Are You a Better Investor?
I feel this is an issue with the length of the latest bull market. Whether or not stocks are very
expensive (and I do find them expensive generally, but this point still stands if I’m wrong about
that), most readers of the blog have seen mostly good results from the stocks they’ve chosen to
hold over the last 8 years now. Eight years is a long time. Many people have not even been
following the same investment strategy for more than 8 years.
Their current approach has never been battle tested.
So, now I hear a lot from people who are more into paying up for higher quality, holding longer,
etc. There are ways of implementing a strategy like that which work. But, I think the experience
of the “recent” past is what gets them thinking in these directions.
Although I’m “only” 32, I was investing seriously (in terms of how much time I spent thinking
about the subject) in 1999-2002 and in 2007-2009. Now, most years are not like 1999-2002 or
2007-2009. But neither are they like the run from the second half of 2009 through to today (the
end of 2017). That kind of run is rarely this smooth. And so, when you have not seen a period
with P/E multiples of even good stocks contracting 30% or 50% or more – you are less worried
about the distinction between investment and speculation.
When you look at something I own like BWX Technologies (BWXT), which has performed
well both as a business and as a stock, you see that it is now trading at 31 times earnings. It’s a
great business. But, even if it is always recognized as a great business by the market – it may
yet be assigned a P/E of 20 instead of 31. Great businesses sometimes trade at a P/E of 20. So,
right there, you have the potential for a 35% decline in the price of this stock.
I still own the stock. And I’ll keep owning it till I know for sure that whatever new stock I want
to buy is better than holding on to this stock. But, what is always foremost in my mind when I
look at BWXT is the potential of this 35% decline in the price – absent any decline in the
underlying business – simply because there will come a time when the P/E does contract from 31
to 20.
This is my bigger concern. Not that the Shiller P/E is high (though it is). But, that things have
gone so well for so many investors even when their stock picking has been rather sloppy in terms
of risk avoidance that they no longer think first about risk avoidance.
Risk Habituation
I’ve always believed that errors in investing which lead to excessive risk taking are the result of
habituation. Wikipedia has a fairly good description of habituation which I quote here:
“It is obvious that an animal needs to respond quickly to the sudden appearance of a predator.
What may be less obvious is the importance of defensive responses to the sudden appearance of
any new, unfamiliar stimulus, whether it is dangerous or not. An initial defensive response to a
new stimulus is important because if an animal fails to respond to a potentially dangerous
unknown stimulus, the results could be deadly. Despite this initial, innate defensive response to
an unfamiliar stimulus, the response becomes habituated if the stimulus repeatedly occurs but
causes no harm. An example of this is the prairie dog habituating to humans. Prairie dogs give
alarm calls when they detect a potentially dangerous stimulus. This defensive call occurs when
any mammal, snake, or large bird approaches them. However, they habituate to noises, such as
human footsteps, that occur repeatedly but result in no harm to them.”
In other words: investors should always be scanning their own thinking for risks they’ve taken
but haven’t yet harmed them. It’s the risks you’ve gotten used to taking that kill you.
Prairie dogs can’t employ reason. Humans can. Even if the P/E ratios of stocks I’ve owned have
done nothing but go up, up, up for the last eight years – I can reason out that multiple expansion
is ultimately a self-defeating rather than a self-reinforcing trend.
I think the distinction between investment and speculation is the most important concept in value
investing.
When people say they are a value investor, they often stress that first word “value” and forget the
second word “investor” is just as important.
An investor looks to the downside first, insists on a margin of safety, and only then thinks about
how he might profit from a brighter future than the market now imagines.
 URL: https://focusedcompounding.com/risk-habituation-and-creeping-speculation/
 Time: 2017
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Why Smart Speculations Still Aren’t Investments
I got an email in response to my earlier post about the line between investment and speculation.
It’s a good email, so I want to quote it in full:
“Really interesting post today, but I was wondering how you would evaluate the Weight
Watchers (WTW) situation.
It seems like an investment that turned into a speculative situation.
I think there are a couple of cases like this where a seemingly safe investment turns into a very
speculative situation. Fossil (FOSL) is another one that comes to mind. Even though it had
some debt, nobody would think that it would have an existential crisis at some point due to
changes in business and the weight of its debt. I don’t think anybody would have called it a
speculation 3 years ago at over $100 a share. But on the other hand, it’s speculative now at
under $7 a share.
On the other hand you have situations like Facebook (FB) which IPO’d at an extremely
speculative price but the business turned out to be so strong that even at that price, it morphed
into an excellent investment had the margins not expanded so much.
I’m not saying that’s the case for Amazon or Netflix today, but maybe it’s not so easy to
distinguish between investment and speculation in some cases because there are factors that we
cannot foresee or do not yet understand. If you have the knowledge that it’s almost certain the
company will grow into and beyond the current valuation, then perhaps it would be a good
investment at what others may consider to be a speculative price.
If you know that a business could potentially come under hard times and the modest amount of
debt it has could compound the problem, then a company with a very modest valuation may
morph into a speculative stock at even 1/10th the original price a few years down the road.
In the end, a lot of it depends on what you really know I think.”
George Orwell wrote an essay called “Politics and the English Language”. One passage from
that essay is helpful to quote here:
“The word Fascism has now no meaning except in so far as it signifies ‘something not
desirable’. The words democracy, socialism, freedom, patriotic, realistic, justice have each of
them several different meanings which cannot be reconciled with one another. In the case of a
word like democracy, not only is there no agreed definition, but the attempt to make one is
resisted from all sides. It is almost universally felt that when we call a country democratic we
are praising it: consequently the defenders of every kind of regime claim that it is a democracy,
and fear that they might have to stop using that word if it were tied down to any one meaning.”
The word “democracy” has an actual definition, etymology, and history we can trace. The
etymology is Greek. It means literally something like “people-power” or “people-rule” in the
sense of “the people” as a group and not “people” as individuals (persons). The history is
Athenian. The term “democracy” is first used to describe the government of Classical Athens
specifically in opposition to monarchies, tyrannies, and “mixed” governments (what we’d now
call “republics”) like Sparta, Carthage, and Rome
In the modern, Western world the term “democracy” is almost universally considered positive.
And two of the most commonly copied systems of government, those of the U.K. and the U.S.,
like to refer to themselves as democracies. But neither has much in common with the
government of Classical Athens. And when being precise, we modify the “democracy” of the
U.K. by saying it is a parliamentary democracy and we modify the “democracy” of the U.S. by
saying it is a federal, democratic-republic.
The knee-jerk definition of democracy is “good”. The sloppy definition is “like the U.S., U.K.,
etc.”. The precise definition is “like the government of Classical Athens, only those elements of
the U.K. government which are not specifically parliamentary, only those elements of the U.S.
government which are neither specifically federal nor republican.”
In other words: we are capable of thinking about democracy very quickly and fuzzily (all heart
no head), somewhat quickly and fuzzily, or very slowly and sharply.
We can think about investment and speculation the same three ways.
As value investors, our knee jerk definition of investment is “good, right, sound, what I do, etc.”
and our knee jerk definition of speculation is “bad, wrong, risky, what everybody else does, etc.”
We equate speculation with gambling. But, true gambling is different from speculation just as
true speculation is different from investing.
Let’s think slowly and sharply about “investing” and “speculation”. What is the definition,
etymology, and history of these two terms?
In my last post on the line between investment and speculation I cited a post by Richard Beddard
which in turn cited “The New Speculation in Common Stocks” by Ben Graham. You can google
“The New Speculation in Common Stocks” and find a PDF of Graham’s speech.
Graham’s point was that investors had bid up the price of some common stocks enough that
though the firms themselves had been investments, they became speculations at this higher price.
In that talk, Graham introduces the term speculation by saying:
“The dictionary says that ‘speculate’ comes from the Latin ‘specula’, a look-out or watch-tower.
Thus it was the speculator who looked out from his elevated watch-tower and saw future
developments coming before other people did.”
Graham had earlier defined investment and speculation in his 1934 book, Security Analysis:
“An investment operation is one which, upon thorough analysis, promises safety of principal
and an adequate return. Operations not meeting these requirements are speculative.”
The other definition that I would offer is that if investment is in some sense an antonym of
speculation – if speculation is rooted in the future, then investment must be rooted in the present
and the past.
In other words, an investment is a stock purchase that can be fully justified on the evidence
provided by the current financial position (balance sheet) and past earnings record (income
statements and statements of cash flows) of the business.
A speculation is an operation that can’t be fully justified on the evidence provided by the current
financial position and past earnings record of the business.
I am not making a distinction between quantitative and qualitative factors here. I am making a
distinction between a business’s recorded history and its projected future.
Let me quote from another email I received about the line between investment and speculation:
“…this was the worst (post) I ever read from Geoff…I don’t think he understands Amazon at
all…and it is obvious that he has not tried to objectively analyze Amazon. I think there is a real
chance that OMC is more speculative than Amazon…I actually think Amazon looks cheap and I
consider myself a hardcore value investor. You probably think I’m crazy so I’ll stop right here.”
I don’t think the person who wrote that email is crazy. And if he had said “I think there is a real
chance that Amazon stock outperforms Omnicom stocks” instead of “I think there is a real
chance that OMC is more speculative than Amazon” I’d agree with him. There is a real chance
Amazon will outperform Omnicom. But, that doesn’t make Amazon an investment. And it’s
possible for Amazon to “look cheap” and still be a speculation.
Let’s look at why I called Amazon a speculation. First, here’s what I wrote about Amazon in that
earlier post:
“And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The

enterprises themselves aren’t speculative. They are proven money makers. But, the prices
investors now put on these stocks make them speculative. There is no measure – P/E, P/B,
EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average
price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are
above average. He is betting that they are better enough to offset paying a higher than average
price for the stock.”
The last two sentences are what defines Amazon as a speculation for me: “a buyer of Amazon
stock is not just betting that the business is above average. He is betting that the business is
better enough to offset paying a higher than average price for the stock.”
Buying Amazon stock is an exercise in handicapping. Let’s look at how much extra weight this
horse is carrying.
I will take data from GuruFocus. Amazon shares now trade at $1,130. Revenue per share is $328.
EBITDA per share is $29 a share. However, “cash flow from operations” is 16% higher. That’s
not “free cash flow”. Just “cash flow from operations” before any cap-ex. As the email writer
said, I haven’t tried to objectively analyze Amazon. So, it is possible “cash flow from
operations” is a more accurate gauge of Amazon’s cash generating ability than EBITDA. Note
that it is very difficult for a company’s “owner earnings” to be higher than both EBITDA and
cash flow from operations. And also note I am starting by using a figure that is 8 times
Amazon’s reported earnings for this last year. I know it is not appropriate to use Amazon’s
reported earnings. I’m not using that number at all here.
So, we will start with Amazon’s “cash flow from operations” per share of $33 as the maximum
possible proxy for current earning power. Let’s assume Amazon grows this $33 per share in
“cash flow from operations” at a rate of 20% a year for the next 20 years. That gives you cash
flow from operations per share of $1,265 at the end of 2037. Assume this is equivalent to
EBITDA per share (it’s not, it’s lower). And apply a normal EBITDA multiple of about 8 times
(an EBITDA of 8 times tends to roughly equal a P/E of 15 for an unleveraged company paying a
35% U.S. tax rate). This gives you a future share price of $10,121 at the end of 2037. The
compound annual growth rate needed to get you from a share price of $1,130 today to $10,121 is
11.6% a year. So, Amazon stock would return something like 12% a year over 20 years if it grew
its earning power per share by about 20% a year for the next 20 years.
How difficult is that to do?
Amazon would have to grow its size relative to the economy by about 12 times if the economy
grew at about 6% a year for the next 20 years while Amazon grew 20% a year. So, however
much clout Amazon has today – imagine it has 12 times more clout.
The path I’ve laid out here is difficult for Amazon to accomplish. The company is too big
already to easily achieve that. Once a company has meaningful market share in an industry, it
becomes more and more difficult to grow faster than that industry. Within 20 years, things like
online retail and probably cloud computing as well will be mature industries. They won’t be
growing much faster than the economy.
Are there other ways Amazon stock can return something like 12% a year over the next 20
years?
Yes. It can buy back stock to allow it to grow slower companywide – but the stock is too
expensive for that to work right now. In fact, Amazon has historically diluted its share count. So,
I’ve actually underestimated the necessary increase in the size of the overall enterprise in my
example above. To achieve a 20% annual growth in earning power per share – companywide
earnings would have to grow even faster. Maybe all of the company’s spending on research and
development is really profit. It’s necessary to spend $42 a share on research and development
right now – but maybe in 20 years, Amazon will no longer have to spend a penny on R&D if it’s
done growing.
The stock could also pay less in taxes, trade at a higher EBITDA multiple in 2037, etc. These are
all possible.
But they’re speculative. The only potentially non-speculative argument here is that Amazon is
expensing items which are actually profits that are being re-invested in future growth. So, for
example, what if all of the company’s R&D was treated more like growth cap-ex on the cash
flow statement.
If you count all of the company’s cap-ex and all of the company’s research and development as
being purely for the purpose of further growth – none of it is needed to maintain the current sales
level – you can get to a price on the company today that is about 15 times this adjusted free cash
flow figure. That’s a leveraged number. But, the number including debt wouldn’t be much
higher.
So, the stock could actually be trading at about 15 times (heavily adjusted) owner earnings right
now?

There’s a problem with that assumption. The company is spending on research and development.
So, it has to grow at the sorts of rates I laid out to justify the investment in R&D for as long as it
keeps making those investments. As long as you are spending $15 billion a year on cap-ex and
$21 billion a year on R&D, you have to grow sales by $36 billion a year.
Let me explain why this is.
For an “investment” in R&D or cap-ex to be worth as much as profit you have in cash today, you
would need to get something like a 10% after-tax return on that money. Otherwise, shareholders
would be better off receiving a dividend and finding another stock that can return 10% a year.
Even if you add back Amazon’s R&D expense, you still only get an adjusted operating margin of
about 15% which works out to about 10% after-tax. For Amazon to grow its earnings
– before R&D expense – by about $3.6 billion a year, it needs to grow sales by about $36 billion
a year. That’s because $36 billion of added sales creates $3.6 billion of added profit (before any
R&D expense but after taxes), which is about 10% of the $36 billion Amazon is investing in cap-
ex and R&D right now. The company has $161 billion in revenue right now. So, adding $36
billion to that would be an increase of about 22%.
Once again, we come to about the same conclusion. To guarantee a 10%+ return in the stock,
Amazon has to grow at about 20% a year.
Of course, that’s only if the company keeps investing in R&D and capital spending. It could stop
investing in those things and slow its growth considerably and generate similar returns for
shareholders. But, it either has to reduce investment in R&D and cap-ex and grow slower or
grow at 20% a year or so and keep investing. It can’t keep investing and grow slower while
delivering adequate returns for shareholders. That’s the one combination it’s not allowed
Let’s compare this to the example I gave of an investment: Omnicom (OMC) at $68 a share.
Right now, the stock has a P/E of 13, a 3.25% dividend yield, and a 2.25% annual rate of
reduction in shares outstanding. A P/E of 13 is a smidge below the long-term historical average
of around 15 for U.S. stocks. A 3.25% dividend yield and a 2.25% share buyback rate combined
give you a 5.5% annual return if the company itself neither grows nor shrinks and the P/E
multiple neither expands nor contracts. If you consider a 10% annual return adequate, the math
works out as follows: 10% – 5.5% = 4.5%. The stock can deliver a 10% annual return if the
company itself grows at 4.5% a year. The economy is likely to grow – in nominal terms – at
something like 4% to 5% a year. So, if Omnicom as a company grows at the same rate as the
economy and the stock becomes neither more or less expensive over time – investors who buy
the stock today should expect a 10% annual return for as long as they hold it.
This is why I call Omnicom an investment. The most common-sense way of looking at the
company based on the present situation and the past record suggests the stock will return about
10% a year.
The Amazon case is trickier. It assumes that large amounts of money spent on research and
development and cap-ex will continually generate after-tax returns in excess of 10% a year.
That’s a speculation. Is it a good speculation?
Up to a point, I think it is. I don’t think it’s an unreasonable speculation to say that Amazon can
commit $20 to $40 billion a year on projects that will generate 10%+ after-tax rates of return in
2018 or 2019.
The problem is the 18 years after that. I don’t know of any historical examples of R&D on that
scale that have generated adequate returns for the company doing them. At the rate Amazon is
going, it would be spending $50 billion a year on R&D in 5 years and $120 billion a year on
R&D in 10 years. Or…
Or, it would stop.
And here is the other part of the speculation: Jeff Bezos.
You could speculate that management is focused on return on capital rather than just growth.
Amazon spends on growth now because it gets good returns on capital by doing so. But, it’ll stop
spending in the future when it stops getting good returns on that spending.
I wouldn’t bet against that kind of management-based speculation. I wouldn’t bet against
Amazon either as a company or even as a stock (and even at this price level).
But, I would call Amazon a speculation. Amazon can be a good enough speculation and
Omnicom can be a bad enough investment that Amazon outperforms Omnicom. But, that doesn’t
mean in hindsight that Amazon was an investment.
Let me return to the email I started this all with:
“…but maybe it’s not so easy to distinguish between investment and speculation in some cases
because there are factors that we cannot foresee or do not yet understand….”
If we cannot foresee or do not yet understand factors, those are speculative factors. They’re
important factors to consider if you’re speculating. And I’m not saying people shouldn’t
speculate. If you think you have really sound reasons for believing the world will be different in
the future than it is now – you can make such a speculation.
For example, several years ago – when Brent was at about $110 a barrel – I was interested in
researching companies that used fuel as a commodity input but were otherwise pretty stable,
understandable businesses. I looked at oil prices and couldn’t come up with good reasons for
why oil should be at $110 a barrel instead of $70 or less per barrel. So, there was a speculation
here on my part that might uncover a potential investment.
Likewise, there is a speculative element any time you are considering an investment with a
“catalyst”. So, when I was researching Barnes & Noble (BKS) in 2010, the investment case was
the high free cash flow from the stores versus the low market cap of the company. The
speculative element was the proxy battle between Ron Burkle and Len Riggio that might serve as
a catalyst which would re-direct the free cash flow to uses that I favored. I was wrong on that
speculation. Riggio stayed in control of the company. And Barnes & Noble directed the free cash
flow from the stores into the Nook. I sold out once I saw the profit from the stores would not
come in the form of cash but rather would come in the form of R&D and start-up losses on the
Nook. I could evaluate what cash was worth. I couldn’t evaluate what the Nook was worth.
And then there is the point about investments turning into speculations:
“If you know that a business could potentially come under hard times and the modest amount of
debt it has could compound the problem, then a company with a very modest valuation may
morph into a speculative stock at even 1/10th the original price a few years down the road.”
This is the “fallen angel” concept. And it relates to Graham’s talk on “The New Speculation in
Common Stocks”. There have always been high yield bonds. But, during Ben Graham’s career
high yield bonds were “fallen angels”. The bonds had good credit ratings at one time, adequate
interest coverage, and could be considered “investments”. But then the enterprises who issued
these bonds fell on hard times and the bonds fell in price. In hindsight, the bonds were bad
investments when initially issued but could often be good speculations when bought when the
company was distressed and the bonds sold at pennies, dimes, or quarters on the dollar. Later,
after Ben Graham retired from investing, bonds began to be issued as high yields from the start.
This was speculative grade stuff. Not because the company issuing the bonds was distressed, but
because the amount of debt issued made the situation speculative. Bond investors were willing to
speculate as long as the potential returns were greater (the yield was higher).
The potential upside in Amazon stock is much, much greater than the potential upside in
Omnicom stock. But, the likelihood of an adequate return in Omnicom stock is higher than the
likelihood of an adequate return in Amazon stock. This is not because Omnicom is a safer
business than Amazon. It’s because Omnicom is trading at a much lower price relative to actual
free cash flow – cash that will (this year) be used to buy back stock and pay dividends – than the
price Amazon trades at.
Amazon may be reasonably priced versus some form of adjusted earnings. But consider the form
these adjusted earnings come in. They are R&D and capital spending. The certainty that $1 of
money spent on additional R&D and capital spending is worth at least $1 in market value is
much less than the certainty
that $1 of cash spent on buybacks and dividends is worth at least $1 in market value.
Graham speculated.
He bought – as a group operation – into a variety of arbitrage situations and other “workouts”.
Some of the workouts were investments in inherently cheap businesses. But, some weren’t.
Sometimes he was buying into a stock purely on the odds that an acquirer would successfully
close the deal at the announced price. That’s speculation. It’s smart speculation with a calculable
“edge”. But it’s still speculation.
Warren Buffett has speculated too. In his 1988 Letter to Berkshire Hathaway Shareholders he
described his arbitrage operation in Arcata:
Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and
turns of the business. On September 28, 1981 the directors of Arcata agreed in principle to sell
the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy
out firm. Arcata was in the
printing and forest products businesses and had one other thing going for it: In 1978 the U.S.
Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to
expand Redwood National Park. The government had paid $97.9 million, in several
installments, for this acreage, a sum Arcata was contesting as grossly inadequate. The parties
also disputed the interest rate that should apply to the period between the taking of the property
and final payment for it. The enabling legislation stipulated 6% simple interest; Arcata argued
for a much higher and compounded rate.
Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating

problem, whether the claim is on behalf of or against the company. To solve this problem, KKR
offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the
government for the redwood lands.
Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate
the transaction since, among other things, its offer was contingent upon its obtaining
“satisfactory financing.” A clause of this kind is always dangerous for the seller: It offers an
easy exit for a suitor whose ardor fades between proposal and marriage. However, we were not
particularly worried about this possibility because KKR’s past record for closing had been
good.
We also had to ask ourselves what would happen if the KKR deal did fall through, and here we
also felt reasonably comfortable: Arcata’s management and directors had been shopping the
company for some time and were clearly determined to sell. If KKR went away, Arcata would
likely find another buyer, though of course, the price might be lower.
Finally, we had to ask ourselves what the redwood claim might be worth. Your Chairman, who
can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at
somewhere between zero and a whole lot.
We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks
purchased about 400,000 shares, or 5% of the company. The initial announcement said that the
$37.00 would be paid in January, 1982. Therefore, if everything had gone perfectly, we would
have achieved an annual rate of return of about 40% – not counting the redwood claim, which
would have been frosting…”
I have also made speculations. Years ago, there was a case in which a state government took land
belonging to a publicly traded company. The issue went to trial. And I started following the
story. At that point: it was possible to figure out what other pieces of land in the same area sold
for per acre, it was possible to see what compensation the company was seeking for the land, etc.
But, I didn’t have faith in my ability to predict an outcome at trial. It was just too hard to tell if
the company had a 45% chance of winning or a 95% chance of winning. Once the company won
the trial, the stock jumped a great deal. But, it didn’t jump to anywhere near the actual level of
cash the company would eventually be awarded once the state had exhausted its appeals. At that
point – although the potential upside was now much lower – it was possible to see the company’s
chance of winning the appeal was much closer to 95% than 45%. So, I was now ready to buy the
stock.
That purchase was a speculation – not an investment. It was purely based on my belief that I
could more correctly judge the odds of a decision being upheld on appeal than other investors
could. I think it was a sound speculation. I read the decision, I talked to lawyers, I looked for
examples of similar decisions being overturned on appeal, etc.
This was not gambling. But, it was speculating.
To understand the difference, we have to think about: subjectivity and edge.
If I play a hand of blackjack at a casino, I am gambling because I’m certain the house has an
edge. It’s a small edge – but it’s against me. As long as I knowingly put money down in which I
know the edge is against me – not with me – I’m gambling, not speculating.
Speculating is when I believe I have an edge. However, I believe that edge has to do with a
future event. When Buffett thought the redwood claim could be worth somewhere between “zero
and a whole lot” he thought he had an edge about a future event: a court decision. Likewise,
when I bought stock – after the trial but before the appeal – in the company that had land seized,
I thought I had an edge about a future event: the appellate court decision. If I had believed that
Ron Burkle would win the proxy fight with Len Riggio at Barnes & Noble, I would have been
betting on an edge I thought I had in predicting a proxy election. If I had invested in a company
that was now trading at 20 times earnings when oil was at $110 a barrel but would be trading at
10 times earnings when oil was at $65 a barrel, I’d be betting on an edge I thought I had in
predicting a future event: at some point oil prices would fall.
Subjectivity means that – in judging whether an action would be a gamble, a speculation, or an

investment – I am not omniscient. I am limited by my lack of knowledge of future events. I am
limited by only being able to consider information that is accessible to me at the time.
It may be that Amazon is – today – an investment from God’s perspective. However, it’s still a
speculation from my perspective. An investment is an action that I (the subject) take. We can’t
consider whether something is gambling, speculating, or investing apart from when I’m making
the decision and what I’m capable of knowing. In hindsight, it may be that I will know things
about Amazon that weren’t possible for me to know now but which – had I known them now –
would have made me realize Amazon was an investment rather than a speculation. Those things
don’t count. If they did, we’d simply call all decisions that were right in hindsight “investments”
and all decisions that were wrong in hindsight “speculations”. By this logic, hitting on 17 could
be an “investment” if we later learned the next card was a 4.
You can judge whether something is an investment or a speculation by keeping those two
concepts in mind: edge and subjectivity.
What do I (the subject) believe my edge comes from? Do I have a positive edge? If I have a
positive edge: I’m not gambling. If my edge comes from predicting a future event: I’m not
investing. I’m speculating.
Now, some people reading this will be saying “wait: isn’t every stock purchase a speculation?
Aren’t you always betting on future events?”
The outcome always depends on future events. However, saying that the outcome depends on the
future is very different from saying your edge in an investment comes from a future event.
There’s a simple way to think of this: “invert”. Flip your analysis. Don’t ask: what has to happen
for this investment to work out for me? Ask: what has to happen for this investment not to work
out for me?
Are the risks “investment” risks or “speculative” risks?
The risks in Omnicom at today’s price are all speculative. For you to be wrong, we have to
speculate that Omnicom will grow slower than the overall economy.
The risks in Amazon at today’s price are all investment risks. For you to be wrong buying
Amazon, you simply have to be wrong about the long-term return on the company’s spending on
R&D and cap-ex. If Amazon was to grow at the same rate as the overall economy, you’d lose a
lot of money. If Amazon was to get the same returns on its R&D and cap-ex as other companies
do, you’d also lose money.
Now, you could say this is the wrong way of looking at it. All Amazon needs to do is to continue
its present trend.
This is usually the argument made for why speculative stocks are really investments. If they
continue at the current rate of growth, they will justify today’s prices. If they continue generating
the same returns on capital, they will justify today’s prices. It’s possible for returns on capital to
be persistently high. It’s also possible for growth rates to be persistently high (though only for a
time). But, it’s very hard to maintain high returns on capital at high rates of growth for long
periods of time.
No high growth trend can continue indefinitely.
Assumptions about stocks maintaining a certain dividend level, stock buyback rate, and growth
in line with the economy can, in fact, continue indefinitely. There’s nothing about those
assumptions that isn’t infinitely repeatable.
 URL: https://focusedcompounding.com/why-smart-speculations-still-arent-investments/
 Time: 2017
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What is the Line Between Investment and Speculation?
In a recent post, Richard Beddard mentions Ben Graham’s speech “The New Speculation in
Common Stocks” and particularly how it ends with a quote from the Roman poet Ovid:
“You will go safest in the middle course.”
At the end of that talk, Graham adds: “I think this principle holds good for investors and their
security-analyst advisors.”
What Graham is saying is that investors should avoid both stocks that are speculative because the
underlying enterprise is speculative and stocks that are speculative because the price is
speculative.
I agree with Graham on this one. And I think it helps clear up some confusion that readers have
with my own approach to investing. I get a lot of questions from investors – each coming from
one of the two opposing philosophical camps – that go something like this: “When I look at the
stocks you own, I wonder are you really 100% a value investor?” That’s the question from the
Ben Graham value camp. And then the other question goes something like: “When I look at the
stocks you own, I wonder are you really 100% a wide moat investor?”
My answer to these questions tends to go something like this:
If you look back at all the stocks I’ve bought, how many times in my life have I ever really paid
more than about a P/E of 15?
And, if you look back at all the stocks I’ve bought, how many times in my life have I ever really
bought into a company with a weak competitive position?
Those – to me – are the two speculations the average investor slides right into without much
thought.
1. He speculates that this business he likes is not just better than other businesses but
better enough to more than offset paying a higher than average price for the stock (that is, a P/E
over 15).
2. And he speculates that this business he likes will withstand the ravages of competition that
are an ever-present part of capitalism.
Now, there are other kinds of speculations you can make. Readers are quick to point out that I
own NACCO (NC) which is basically a speculation that no more than one of the coal power
plants the company supplies will be shut down in the truly near-term future. I also own BWX
Technologies (BWXT) which is a speculation that the U.S. Navy will continue to use aircraft
carriers, ballistic missile submarines, and attack submarines – and that those 3 classes will be
nuclear powered. I own Frost (CFR) which is a speculation on higher interest rates in the sense
that if the Fed Funds Rate was never to rise from the level it is at today, my returns in Frost
would be middling.
But when you stretch the word “speculation” that far, you demolish any distinction between
investment and speculation in the way Graham used those words. The future is always uncertain.
But, we have to be able to define the words “investment” and “speculation” in such a way that
we can all agree lottery tickets are speculations and savings bonds are investments; that stock
options are speculations and investment grade corporate bonds are investments.
How would we apply this distinction between investment and speculation to stocks today?
Well, we would say that Tesla (TSLA) and Twitter (TWTR) are speculations, because the

enterprises themselves are speculative (they have yet to make money). These stocks would be
speculative at any price. It is – as yet – impossible to make an “investment” in them.
And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The

enterprises themselves aren’t speculative. They are proven money makers. But, the prices
investors now put on these stocks make them speculative. There is no measure – P/E, P/B,
EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average
price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are
above average. He is betting that they are better enough to offset paying a higher than average
price for the stock.
What then is an investment?
I would say Omnicom (OMC) at $67 a share is an investment. The competitive position is not
speculative. And the stock’s price – at 13 times earnings – is not speculative. So, it is an
investment. I would also say The Cheesecake Factory (CAKE) at $44 a share is an investment.
The competitive position is not speculative. And the stock’s price – at 16 times earnings – is not
speculative.
What wouldn’t I say?
I wouldn’t say that Omnicom and the Cheesecake Factory at $67 and $44 a share respectively are
better stocks than Amazon and Twitter at $1,120 and $19 respectively. Amazon and Twitter may
be good speculations. And Omnicom and Cheesecake Factory may be bad investments.
Reasonable people can disagree about that. The future is always uncertain. But that does not
mean the line between investment and speculation is invisible.
Amazon and Twitter are speculations. Omnicom and Cheesecake Factory are investments.
There is a real danger some of us will forget that. Amazon’s future may be brighter than
Omnicom’s. But, when we make a statement like that – we are comparing two entirely different
classes of financial assets. Amazon’s future needs to be many, many times brighter than
Omnicom’s to preserve even a fraction of the capital you put into it today. Just because society
has several hundred billion dollars riding on a certain stock doesn’t make that stock any less of a
speculation.
Is it wrong to speculate?
Should you ever speculate?
My own investment process is based on finding investments not speculations. So, my answer
would be that you should train yourself to distinguish between good and bad investments and
ignore speculations all together.
Having said that, I wrote about Hostess Brands warrants (TWNKW). At today’s price of $2.66
for a pair of warrants (owning a pair of warrants gives you the right to buy one share of TWNK
common stock at $11.50 in late 2021), I think they might be a good speculation.
They aren’t an investment.
And I think it’s important to remember that. No matter how good a speculation those warrants
are – a Hostess Brands warrant at $1.33 is a speculation and Omnicom stock at $67 is an
investment. The Hostess warrants can outperform the Omnicom stock. But that should never fool
us into thinking a speculation has become an investment.
Words have meaning.
 URL: https://focusedcompounding.com/in-2017-what-is-the-line-between-investment-
and-speculation/
 Time: 2017
-----------------------------------------------------
My New 50% Stock Position is NACCO (NC)
Someone on Twitter mentioned it’s been 32 days since I put 50% of my portfolio into a new
stock and said: “I’ll reveal the name of this new position on the blog sometime within the next 30
days”. Since, I promised 30 days this time, I’ll reveal the name now. In the future, I think I’m
going to wait a full quarter (3 months) between the time I mention a stock on my member site
(Focused Compounding) and on the blog. I want to be open with blog readers. But, I also want
the people who provide me financial support through their monthly subscriptions to get real
value for their money. The only reason I can afford to spend time writing content on this blog for
free is because there are subscribers on the member site. So, the member site will always hear
about my new stock ideas first.
Anyway….
On the morning of October 2nd, I put 50% of my portfolio into NACCO (NC) at an average cost
of $32.50. That was the first day the North American Coal Company was trading separately
from Hamilton Beach Brands (HBB).
NACCO operates unconsolidated (their debt is non-recourse to NACCO) surface coal mines that
supply “mine-mouth” coal power plants under long-term cost-plus contracts that are indexed to
inflation.
You can learn more about NACCO by reading:
The company’s investor presentation
Clark Street Value’s post on NACCO
NACCO’s first earnings report as a standalone company
You can also listen to the company’s earnings call here
Finally, you can buy a book that provides a complete corporate history of NACCO from 1913
through 2013. The title is “Getting the Coal Out”. The author is Diana Tittle. It’s available used
at places like Amazon. You may also be able to order it from the company. I’m not sure about
that.
Yes, I do own a copy.

My NACCO position was posted immediately on the member site. I’ve written several articles
about it there over the last month, mostly in response to questions from Focused Compounding
members.
So, as of October 2nd, my portfolio was:
NACCO (NC): 50%
Frost (CFR): 28%
BWX Technologies (BWXT): 14%
Natoco: 7%
 URL: https://focusedcompounding.com/my-new-50-stock-position-is-nacco-nc/
 Time: 2017
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Buy Unrecognized Wonder; Sell Recognized Wonder
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful
price.”
– Warren Buffett
Richard Beddard has an excellent post worrying about whether the stocks in his Share Sleuth
portfolio are becoming too popular.
I want to use his post as an opportunity to talk about how an investor – or, at least an investor
like me – needs to cycle out of stocks that are getting recognized for what I believe them to be
and into stocks that aren’t getting recognized for what I believe them to be.
I like “wide moat”, predictable businesses. But, I can’t afford to pay the kind of prices that stocks
with recognized moats and recognized predictability trade for. So, I need to find unrecognized
moats and unrecognized predictability.
The top three stocks I own are: NACCO (NC), Frost (CFR), and BWX Technologies
(BWXT). The best performer among that group is BWX Technologies. That good performance
is the result of increased recognition of what BWX Technologies is. When I bought Babcock &
Wilcox pre-spinoff (and then later sold my BW shares but kept my BWXT shares) I was seeing
the company differently than the market was. Today, the market sees BWXT the same way I do.
Let’s look at this in chart form.

Today, the market values BWX Technologies about 120% higher than it valued the combined
Babcock & Wilcox. The stock you are seeing here spun something off (so it disposed of value)
and yet it still more than doubled its market price.
The stock now has a P/E of 32. The return here is due to multiple expansion. BWX Technologies
– as part of Babcock & Wilcox – went from being valued as an average company (a P/E around
15) to being valued as a wide-moat, predictable company (a P/E around 30). BWXT’s biggest
business is being a monopoly provider to the U.S. government under cost plus contracts indexed
to inflation. That’s not new information. The market just sees the same old information
differently now that BWXT is reporting its own clean, independent EPS and giving long-term
guidance for EPS growth as far as 3-5 years out.
The price on this stock (a P/E of 30+) indicates the market sees this business much the way I see
this business. If we have the same understanding of the business – it’s time for me to consider
selling.
Now, I don’t sell a stock just to have cash. But, if I want to buy anything new – I should buy
something that’s a wide-moat, predictable business that has yet be recognized for being that and
fund the purchase by selling BWXT which is also a wide-moat, predictable business but is now
recognized as such.
The next chart is Frost. You can read an explanation of how I see the stock here.
The stock has about doubled. Here, though, it is not appropriate to use the P/E ratio for Frost
(because earnings rise faster than deposits as interest rates rise). The better way to value Frost is
price-to-deposits. So, that’s share price divided by deposits per share. For Frost we use “earning
assets” – which are loans, bonds, and money left at the Federal Reserve – as a proxy for deposit
funded assets. At Frost, these assets are about 93% funded by deposits (the rest is funded by
shareholder equity). When I bought Frost, it had about $25.91 billion in earning assets and 63.18
million shares outstanding. So, it had $410 a share in earning assets. I bought at a price just
under $50 a share. So, I paid 0.12 times earning assets ($50 / $410 = 0.12). Today, the bank has
$28.34 billion in earning assets and 63.16 million shares outstanding. So, it has $449 in earning
assets per share. The stock price is just under $98 a share. So, the market now values Frost at
0.22 times its earning assets ($98 / $449 = 0.22).
Again, the rise in the stock price is due to multiple expansion. Frost’s stock price is now 96%
higher than when I bought it. However, the amount of earning assets per share is just 10%
higher. Where did the other 86% increase in market value come from? The market now values
Frost at 0.22 times its earning assets instead of 0.12 times its earning assets.
So, has the market fully recognized what I saw in Frost about two years ago?
Not fully, no. In the report I wrote on Frost, I said that a valuation of 0.35 times earning assets
(not 0.22 times like today) would be appropriate for Frost in “a normal interest rate
environment”.
That phrase is key. Frost trades at a P/E of 19. So, it is fully recognized as a good bank given
today’s interest rates. However, I believe a “normal” Fed Funds rate is about 3 times today’s Fed
Funds Rate. I see a 3% to 4% Fed Funds Rate as normal. The market does not. So, the market
doesn’t yet see Frost quite the same way I see Frost.
Since the market doesn’t fully recognize everything I see in Frost – the way it does with BWXT
– I should cling harder to my Frost shares than I would to my BWXT shares.
What would cause me to sell Frost?
Well, we have a good example of that. About a month ago, I got the chance to buy NACCO at
$32.50 a share. I sold one-third of my Frost shares to help fund that new position.
It means I think I see something in NACCO that is not as recognized by the market as what I see
in Frost.
Do I like NACCO better than Frost?

That’s not the right way to ask the question. The market operates on a handicapping system.
Everyone thinks Netflix has a brighter future than Viacom – they “like” Netflix better as a
business. But, Netflix stock is saddled with an incredibly high price (its enterprise value is more
than 8.2 times sales) while Viacom isn’t carrying much weight at all (its enterprise value is 1.5
times sales). The question is whether Netflix can outrun Viacom when Netflix is carrying more
than 5 times as much weight.
So, what’s the right question to ask?
You can ask – at the same price – would I prefer BWXT over Frost and Frost over NACCO?
Probably.
But they’re not at the same price.
NACCO is my biggest position, Frost is my second biggest position, and BWX Technologies is
my third biggest position – because I think the market recognizes all of what I like about BWXT
but only recognizes some of what I like about Frost and doesn’t recognize any of what I like
about NACCO.
It’s a great goal to own the best businesses you can. But, you can’t afford to pay the price
everyone else pays for wonderful businesses and still hope to do better than everyone else.
Don’t just look for wonderful businesses. Instead, look for businesses where you see something
wonderful about them that the market doesn’t yet recognize.
 URL: https://focusedcompounding.com/buy-unrecognized-wonder-sell-recognized-
wonder/
 Time: 2017
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Seeking Out Strange Stocks: How to Create a Value Investing Basket that
MIGHT Get Decent Returns Even When the Market Falls
“I know you are a stock only person.
But just for a minute I need your knowledge…I don’t look for 15% per year. I look for 6% a year
for the next 5-7 years…on my money.
What would be the best/safest way to get it? Will a certain ETF, a dividend stock? SPY? Japan
ETF? India or Russia?”
I don’t know of anything that can safely guarantee you anything like 6% a year. To give you
some idea, even junk bonds now yield about 5.5%.
And I wouldn’t call junk bonds safe. Their prices would fall as interest rates rose and the
economy entered a recession. Both of these things will happen at some point. Will it be in the
next 5-7 years? I don’t know. But, you can’t buy assets like that at today’s prices if you’re
hoping to make 5-7% a year over the next 5-7 years even if the stock market does badly.
However, you can certainly find things that should return at least 5% to 7% a year over the next
5-7. It’s just that:
1) Some of them will be specific stocks – not ETFs
2) Some of them may return a lot more than 5% to 7%
3) Some of them will lose money
4) It will take a lot of work on your part to find them
5) You will need to use a basket approach
6) Actually: I’m going to recommend a “basket of baskets” approach
I don’t diversify widely. But, if you’re looking to find something that will return 5% to 7% a
year over the next 5-7 years, your best bet is to own a basket of very cheap (probably obscure)
stocks. If these stocks are cheap, small, obscure, illiquid, etc. – it’s less likely they will move
with the overall market. Special situations (like spinoffs and other things mentioned in Joel
Greenblatt’s “You Can Be a Stock Market Genius”) should also help get you closer to your goal
of 5% to 7% annual returns over 5-7 years no matter what the market does.
The reason I’m starting off a discussion with “cheap, small, obscure, and illiquid stocks” is that
I’m not at all confident I can find an entire stock market for you that will return 5% to 7% a year
over 5-7 years given today’s starting price. Although, in a moment we will discuss the possibility
of putting 20% to 40% of your portfolio in things that are either directly or indirectly “funds”
rather than specific stocks. More on that later.
But, first, let’s start with the specific stocks.
If you aren’t doing a lot of intense stock picking that results in you only owning maybe 3-5
stocks at once (like me), you need a process for finding investments that is a more formulaic,
“wide-net” approach.
A fund manager has to worry about putting large amounts of money to work. So, they lean in the
direction of owning even more stocks than are really beneficial for “business risk” diversification
purposes. You’re an individual investor. So, you can just go with sort of the “optimal” amount of
diversification in the sense of finding the point where adding additional stocks to your portfolio
would have very little benefit in reducing volatility. That point is probably something like 20 to
30 stocks. The difference in volatility between a portfolio with 30 stocks and 100 stocks may be
noticeable. The difference in volatility between a portfolio with 30 stocks and 50 stocks isn’t.
So, no more than 30 positions for you.
And, we could do it with as few as 20.
For the sake of simplicity: I’m going to talk in terms of 5 baskets of 5 positions each. So, that’s a
25 stock portfolio.
I think your best bet would be to pursue a few sort of formulaic value strategies – “rule based”
strategies – let’s call them instead of using your judgment. So, what you’d do is go out and
screen by hand to find the specific situations but those situations would each fit in one of maybe
5 strict bucket approaches.
So, I might suggest you set out to create a 25 stock portfolio with five buckets:
* 5 net-nets
* 5 spinoffs
* 5 closed-end funds/holding companies/etc. trading at a discount to NAV of their publicly

traded holdings
* 5 stocks trading for less than the fair market value of their real estate (so stocks that own real
estate but probably aren’t REITS)
* 5 cheapest ETFs/Country closed-end funds you can find in terms of Shiller P/E ratio
You mentioned yield.
Can you buy stocks where most of the returns come from dividends?
You could. So, you could have one bucket that is stocks with a dividend yield about the same as
long-term corporate bonds but with a strong balance sheet, low volatility in the stock, etc.
Examples would be…
Village Supermarket (VLGEA): 4.1%
George Risk (RSKIA): 4.4%
I don’t think there’s anything particularly wrong with buying stocks like that if you’re looking
for 5% to 7% returns over 5-7 years. Those stocks have somewhat higher dividend yields than
big cap stocks that pay dividends and yet their balance sheets show they are more overcapitalized
and their stock trading histories show they are less volatile than big cap dividend payers like:
Kimberly-Clark (KMB) with a 3.5% yield. Their business is not as diversified or predictable as
Kimberly-Clark though. We could compare them to utilities. Those two stocks pay dividend a
little bit higher than utilities. And utilities have a lot of net debt and no cash. These companies
have low debt and high cash for the industries they are in.
So, would I include a dividend yield bucket?
Only if you found enough situations like the two I listed above. And I think asking you to assess
individual dividend payers among more obscure stocks would be giving you a demanding task.
It’s harder to apply a formulaic approach here. You need to understand the underlying
businesses. So, I think it might be more trouble than it’s worth to look for dividend payers.
What about the other buckets?
Spin-offs
There were several spin-offs this year including Hamilton Beach (HBB) from NACCO (NC) at
the start of this month, Cars.com (CARS) from TEGNA (the TV side of the old Gannett). I own
BWX Technologies (BWXT), because I bought into Babcock & Wilcox pre-spinoff and then I
kept the BWXT shares and sold the BW shares.
You can see a list of upcoming spinoffs here.
If you are going with 5 buckets that each have 5 stocks in them, I’d suggest making one of those
buckets a spin-off bucket and keeping 5 spun-off stocks in there at all times.
Read and re-read Joel Greenblatt’s “You Can Be a Stock Market Genius”. The case studies from
that book are all you need to know about how to invest in spin offs.
Holding Companies Trading at a Discount to NAV

The obvious example here is Pargesa. You can find a detailed description of the company’s net
asset value here.
And you can find the stock’s price and net asset value updated here.
Pargesa shares currently trade at about 65% of their net asset value. That kind of discount – 35%
– isn’t unusual compared to the trading history of the stock versus its NAV over the last 20
years.
The discount isn’t necessarily fully justified though. Pargesa’s NAV has underperformed its
benchmark over the last 2-10 years. But, it’s outperformed over the last 20 years and is beating it
this past year too. The stock also pays a dividend.
I wouldn’t put my own money into Pargesa at a discount of 35% to its net asset value. But, I
would recommend it as part of a bucket where you have 5 closed end funds / holding
companies / etc. trading at discounts to their net asset values. That’s only if you’re also using
other, different buckets like spin offs.
Other publicly traded companies that trade sometimes at a discount to the shares they own
include Urbana (in Canada), and now Altaba (AABA). Each situation is different. Urbana is
partially publicly traded stocks like Pargesa but partially not. And Altaba is non-diversified in
the extreme (it’s mostly Alibaba and somewhat Yahoo Japan). Management there has stronger
incentives to close the gap between share price and NAV though.
There are tons of closed end funds out there. Many may deserve to trade at a large discount to
NAV. I’d consider closed-end country funds more in another basket I’m going to talk about later.
If you can find a country with a beat down stock market that has a low Shiller P/E and there’s a
closed-end fund there that’s trading at an especially big discount to NAV because the country is
so unpopular – that’s just a plus. So, I’d think more of holding companies trading at a discount to
NAV for this bucket and then look for closed-end funds more in the low Shiller P/E country
bucket I’ll discuss later. But, sometimes there are closed-end funds with discounts that seem
large given what they own. You could put one of those in this bucket.
I used the example of Pargesa, because it has a diversified enough portfolio (20% type position
sizes) in big, public European companies and it publishes very clear information on what it now
owns, where the stock trades, etc. So, it’s the “cleanest” holding company I could come up with
as an example.
Trading for Less than the Fair Market Value of their Real Estate
Warren Buffett owns shares of Seritage (SRG) in his personal portfolio. This is the company
spun-off from Sears (SHLD) that still has Sears as a tenant (often paying below market rents). If
and when Sears enters bankruptcy, there’s concern Seritage will be insolvent (I imagine it will
also get sued by Sears’s creditors at that point). Will someone step in offering to recapitalize it
and take control? Will someone want to acquire the whole thing? I don’t know. I wouldn’t put
my own money in Seritage. But, as part of a bucket of 5 stocks that appear to be trading for less
than the property they own/control (have long-term leases on). I think this makes sense.
In the past, I’ve mentioned a couple other companies that will – at certain prices – come close to
qualifying for this group. You should watch them. They are: J.W. Mays (MAYS), Ingles Markets
(IMKTA), and Green Brick Partners (GRBK). These aren’t my top suggestions for this bucket
(though J.W. Mays is something to look at very hard). They’re just examples of stocks I’ve
mentioned at some point on the blog that have a substantial amount of real estate relative to the
market cap the companies sometimes trade at.
Again, I wouldn’t spend a lot of time speculating about the future of these companies like you
would if you were making individual stock picks for an overall portfolio. Instead, I’d look at
something like J.W. Mays which is illiquid, has no correlation to the overall market, etc. and just
try to figure out if the properties it owns/controls are worth more than the market cap. If they are,
add it to your “stocks trading for less than the fair market value of their real estate” bucket. And
then try to keep 5 stocks in that bucket at all times. Don’t sell one till you have something new to
take its place in the bucket. That’s true for all these buckets. Hold each position till you can find
a “sixth” position that could replace it. Only then sell out of anything in the bucket.
Net-Nets
These are incredibly hard to find in the U.S. They are often so illiquid even individual investors
may have trouble getting enough shares. Around the world, like in Japan, it can be easier to find
net-nets. Don’t buy into frauds or companies clearly on the brink of insolvency. Don’t buy into
any company that is actually Chinese but lists in the U.S.
Honestly, I’d suggest just finding 5 Japanese net-nets right now, because that will be easiest.
This would, however, put your portfolio 20% in Japan. You might not want to do this. Though, I
actually think it’s fine. As long as you are creating the kind of value buckets I’m talking about
here, I think you can put 20% in one country and not hedge the currency. I’m going to talk about
5 countries to invest in later and I’m not going to mention hedging the currency there either.
But, what if you really wanted to hold U.S. net-nets instead.
What are some current examples of the kind of stocks you can put in your net-net “bucket”?
– Paradise (PARF)
– Richardson Electronics (RELL)
There are others out there. The traditional – Ben Graham – rule is to buy these stocks at two-
thirds of NCAV and then sell them when they reach NCAV (for a 50% gain). Ignore this. Any
stock trading near NCAV is incredibly cheap, has to be unloved, obscure, etc. Once a stock gets
down to the price level of being a net-net just focus on whether it’s a fraud, whether the financial
strength (F-Score and Z-Score) is adequate, and whether the company has been around a long
time and made money in the past.
Just keep this bucket – like your other buckets – full of 5 stocks at all time. So, when you
identify other net-nets that can take the place of the existing ones, you’re allowed to sell the old
ones. But, don’t leave an empty slot in this bucket.
Once you buy any position – in any of these buckets – I’d also encourage you to make that
position “off-limits” as a sell for a full year. So, just review old positions to be replaced with new
positons once a year. People spend too much time deciding how quickly to sell their spin-offs,
net-nets, etc. when they start moving. Let them run a year. Then decide.
Cheapest Countries Bucket
You can find mentions of the Shiller P/E (“CAPE”) for various countries on some websites and
in some articles. Here are two examples:
GuruFocus
Article in The Telegraph
Right now, these kinds of articles / sites are going to suggest you buy ETFs/closed end funds in
markets like:
*Russia
*Brazil
*Turkey
*South Korea
*Spain
Etc.
I wouldn’t put my own money in any country funds. But, if you are only allocating 20% of your
portfolio into country funds in total and you always keep 5 countries in this bucket, you’ll be
putting 4% into each country. That’s an acceptable risk. Don’t bother hedging anything.
So, if you want to try to find an approach that is more likely to get you 5% to 7% returns over the
next 5-7 years regardless of what the market does, I’d suggest using 5 buckets with 5 stocks in
each of them.
So that’s: 5 low Shiller P/E country funds, 5 holding companies trading at a discount to NAV, 5
stocks trading at less than the fair market value of their real estate, 5 net-nets, and 5 spinoffs.
That will give you 25 stocks that should have a chance of returning 5% to 7% a year over the
next 5-7 years even if the market doesn’t.
 URL: https://focusedcompounding.com/seeking-out-strange-stocks-how-to-create-a-
value-investing-basket-that-might-get-decent-returns-even-when-the-market-falls/
 Time: 2017
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How I “Screen” For Stocks – I Don’t
I get asked a lot how I screen for stocks. And the basic answer is that I don’t. I sometimes run
screens, but I rarely find ideas off them.
I can rephrase the question though. When most people ask me how I screen for stocks, what
they’re really asking is something more like: “How do you decide which 10-K to read next?”
In other words: “How do you come up with new names to research?”
Other Investors Tell Me What They’re Interested In
I meet about once a week with my Focused Compounding co-founder, Andrew Kuhn, to just talk
stocks. We both read a specific 10-K and analyze that stock. We bring our notes, Excel sheets,
etc. to a local restaurant. And then we have a cup of coffee together and take 2-3 hours to go over
the idea. Recent ideas Andrew has wanted to talk about include: Hostess Brands
(TWNK), Cars.com (CARS), Green Brick Partners (GRBK), and Howard Hughes (HHC). I
wouldn’t have researched these stocks if Andrew hadn’t pick them as our next meeting topic.
I also talk via Skype’s text messaging system with investors around the world who I’ve never
met in person.
I spend several hours a week doing all this.
But I guard my time pretty closely. If you’ve ever asked to chat with me this way – you’ve
probably noticed two things: 1) I don’t talk on the phone (or do audio on Skype) with anyone no
matter how nicely you ask and 2) I insist we agree on a specific stock to talk about. I’ll talk about
whatever you want to talk about, but I’m not interested in any sort of general discussion.
These are anti-time wasting rules I’ve learned to adopt through experience.
I Mine My Favorite Blogs for All They’re Worth
I’ve mentioned before that my favorite blogs are:
Richard Beddard’s Blog
Value and Opportunity
Clark Street Value
Kenkyo Investing
I go through all their archives and make up lists of stocks they’ve written about. Some of them
also have “portfolio” type pages (Value and Opportunity, Richard Beddard) that help generate a
list of stocks they’ve covered.
Now, I’ll tell you a secret. Although I love these bloggers and the way they look at things –
there’s one situation where I specifically don’t read what they’ve written. It’s when I’m
interested in a stock they’re writing about.
So, let’s say I’m reading Clark Street Value’s write-up on the Hamilton Beach (HBB) spin-off
from NACCO (NC) or one of Richard Beddard’s articles on Howden Joinery and something in
that post makes my investing antennae twitch. I stop reading the post the second I hit that line. I
just go off and research the stock myself. Then – and only then – I come back and read what one
of my favorite bloggers has written.
This brings up a bigger point. Once you know an investor you think is a clear thinker owns a
stock or considered owning that stock – that’s often more useful than knowing exactly why he
bought the stock. The blogger, famous investor, etc. is giving you the “name” as an initial lead.
After that, the work is all yours.
Spin-Offs
I will look at any stock that is being spun-off. I will look at the parent too. If I hear a spin-off is
planned, I will add that stock to my research schedule right away. I’ve even researched stocks
like Hawaiian Electric (HE) – it’s a utility that owns a bank – in anticipation of the possibility
of a spin-off that never happened.
IPOs
I’ve never bought an IPO. About the closest I ever came was a stock called OpenTable (it was
later acquired by Priceline and then written off). And even then I never really came very close to
buying it.
However, I do read what companies file when they go public. Companies put out a lot of
information that may be useful to have a few years down the road. So, I read a surprising amount
of IPO documents.
Anti-Competitive Practices (Blocked mergers, etc.)
I am interested in companies with “market power” which I define as:
Market power is 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.
As a result, any article that mentions anti-competitive concerns gets me interested in an industry /
company / etc.
On Twitter, I recently linked to a Bloomberg article about the Luxottica / Essilor deal. This is the
kind of article that – if I’d never head of Luxottica or Essilor – would immediately cause me to
research the company, because it mentions concerns that regulators in the U.S. and E.U. have
with the deal.
A while ago, I also linked to a Bloomberg article “Is the Chicken Industry Rigged?” about
chicken producers sharing production data. That can reduce competition in such a short-cycle
industry. Any time I see a hint that competition is low in an industry or is going to decline – I put
companies in that industry near the top of my research list.
I did some research on Staples back when that company was public. What got me interested in
Staples was the company’s strong position with U.S. business customers (its delivery business). I
wasn’t interested in the Staples stores. When Staples tried to merge with Office Depot, the
merger was blocked. That kind of news – a blocked merger – is typical of the kind of thing that
would get me interested in a stock.
Peers
This is the biggest source of my “new names”. Whenever I research a stock, I try to come up
with at least 5 peers. Whatever price ratios I calculate to determine the cheapness of the stock
I’m actually interested in – I also calculate for the peers.
So, by researching Fossil (FOSL) I get interested in Movado (MOV). By researching Village

(VLGEA) I get interested in Kroger (KR). By researching Nike (NKE) I get interested
in Under Armour (UA).
This is my best “screen”. Why?
It’s extremely time consuming and risky to research the first stock in an industry you’re
unfamiliar with. The research process becomes progressively faster and less risky as you work
your way through a series of companies in the same industry.
It is much easier to research your seventh straight regional bank stock in the U.S. than it is to
research your first. The same is true of supermarkets. Local businesses are an especially good
source of “new names”, because every state needs to have a local bank, supermarket, etc. In most
cases, you won’t have researched this company or any direct competitor before. And yet you will
have researched companies with similar business models in other states.
A Steady Diet of Specific Stocks
This is kind of just my catch-all term for trying to fill your eyes, ears, etc. each day with specific
stock names instead of general investing news. For example, while working at my computer, I
try to only listen to old episodes of “The Value Guys” podcast. Some of the episodes are more
than 10 years old. Odd as it sounds: I find 10 year-old mentions of specific stocks much more
useful than today’s economic news.
I don’t have CNBC on mute. I don’t read newspapers like The Wall Street Journal, The Financial
Times, etc. Whenever possible, I try to identify any time I spend exposed to general financial
news and replace it instead with exposure to discussions of specific stocks.
Real Life: Finding Stocks “Out in the Wild”
People who know me in real life and don’t care about business / investing find this habit
frustrating. I’m often saying things like “How many square feet do you think this store is?”,
“How many employees have you seen in here so far?”, etc. I research public companies I come
in contact with through my day-to-day life.
For example, I live in an apartment complex. When I first moved here, I searched to see if my
landlord was publicly traded. It is. So, I read the 10-K. If I eat at a Zoe’s Kitchen (ZOES), I
research Zoe’s Kitchen as a stock. If I got to an AMC movie theater, I research AMC as a stock.
If I go to Dave & Buster’s (PLAY), I research Dave & Buster’s as a stock.
Historically, finding stocks “in the wild” has been an excellent source of ideas. But, the ratio of
stocks researched from this group to stocks I actually buy is quite high. You’re going to read
about 100 stocks and buy maybe 1 using a finding stocks in real-life approach.
Long ago, I found:
· Village Supermarket (VLGEA) because I worked in one of their stores as a cashier
· Coinstar (it later became Outerwall) because I saw people using Coinstar in the store I
worked at
· Blue Rhino (it was later acquired by Ferrellgas) because I preferred using the company’s
propane tank exchange over having to re-fill a propane tank
The bad thing with ideas you find “in the wild” is that it’s a needle in a haystack approach.
You’re finding them for reasons that don’t have to do with the stock’s price, the business’s
quality, etc. Basically, you’re going just off product quality.
The good thing with ideas you find “in the wild” is that you’ll have a firmer understanding of the
business model, more confidence in the company, etc. if and when you do choose to invest. It
can be difficult to imagine what a company really does just from the 10-K.
First-hand experience of the product combined with a close reading of the 10-K is usually the
easiest way to truly understand a business.
Things That Might Work For You: Value Investors Club, Corner of Berkshire and
Fairfax, “Superinvestor” Portfolios
I’ve spent days digging through Value Investors Club, Corner of Berkshire and Fairfax, and
portfolio holdings of famous investors. I’ve never found these sources of ideas any better than
just “going A to Z”.
And I have some experience just going A to Z through a stock list. That’s how I found the
Japanese net-nets I invested in about 5 years ago. There was no screen. I just went through a list
of Japanese stocks. It worker pretty well. But, I knew I was just looking for net-nets. So, I was
able to manually “screen” out each stock in a manner of seconds.
 URL: https://focusedcompounding.com/how-i-screen-for-stocks-i-dont/
 Time: 2017
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The Chains of Habit
In my last post, I mentioned Twitter is a distraction most investors are better off keeping
themselves clear of. I got some responses like:
“Agree (Twitter) can be (a) distraction. I’m careful who I follow, restrict my usage, save leads
for later like you!”
But also:
“…if it’s a distraction for him I get it. But you can literally pick who you follow, don’t have to
tweet, connect (with) other investors…”
And:
“…get Geoff’s (point) here, but Twitter has led me to some great ideas, resources, convos. Great
tool if used correctly.”
All of these responses are right, of course.
Some people I’ve gone on to meet in real life have mentioned the first place they saw my name
was on Twitter. It helps that my Twitter profile says I live in Plano, Texas. This has encouraged
investors who live in Texas or are passing through one of Dallas’s airports to reach out to me for
a face-to-face meeting. In a couple cases, good things have come from that. And I have Twitter
to thank for it.
So, why don’t I think Twitter’s so great?
Part the First: Wherein Geoff Complains All the Good Playwrights have Gone to Hollywoo
I started blogging on Christmas Eve 2005. Back then, I used to read a lot of value blogs. Most of
them don’t exist anymore. And not enough good ones have been stared up since. Why? Twitter.
Some of the best “would-be” value bloggers spend their time on Twitter instead of blogging.
I talk stock ideas with a lot of people via email, Skype, etc. You wouldn’t know the names of
anyone I talk with. But some of them are good. Very good. And they know small, obscure stocks
in their home regions – Benelux, Nordic countries, India, Southeast Asia, Hong Kong, Latin
America, wherever – so much better than I do or likely ever could. In the past, I’d tell them “you
should start a blog.” And sometimes, they would. Now, I tell them “you should start a blog”.
And they say: “If I have something to say, I can put it on Twitter.”
And they can. And in terms of visibility, I think they’ll get more out of Twitter. They’ll reach a
bigger audience. But, if I can be selfish here for a second…
They are robbing me of depth
Part the Second: Wherein Geoff Complains that All Music Ought Not to be Pop Music
They are robbing me of a considered, potentially contrarian take. Because Twitter is many
things. But the one thing it is above all else is: “catchphrase”. To appear on Twitter, an
investment idea has to be distilled into a single phrase. And that phrase – if it’s to be re-tweeted
widely – has to be catchy.
I’m writing this post in a noisy environment. There are other people here doing other things. And
they’re a distraction. So, I have on some good headphones and I have a piano version of
“Pachelbel’s Canon in D Major” playing loud on loop. It’s a catchy tune. If you’re not sure if
you’ve heard it, you have. If you’ve been on planet Earth any time in the last 30 years, I promise
you you’ve heard this song. Parts of it – especially one particular part – crop up in all sorts of
music that worms its way into your ears as you go about life (listening to your car radio,
shopping in stores, watching TV, going to weddings, etc.)
Here’s the thing. If you search online for Pachelbel’s Canon right now and play it – I’m pretty
sure it won’t sound novel to you. I can promise that. You won’t be 100% certain this is the first
time you’ve heard this song. None of you will. For some of you, you’ll know exactly where
you’ve heard it before. Congrats. But, for others, you’ll know only that you have heard it before
– but you won’t remember where.
And then there will be some of you for which this will happen…
You will hit that chord progression (or whatever the famous part is, I don’t know music) and
you’ll know only that you are sort of nodding your head on the inside: “Yes, yes this is familiar
and catchy and that’s really all I know and really all that matters in this second.”
That’s Twitter. Twitter is Pachelbel’s Canon.
Now, there’s nothing wrong with that if you use it the right way. I’m looping a bit of piano to
create a musical cocoon I can write in. If I had a workspace all my own at this moment – I
wouldn’t need a piano playing on loop. Likewise, If you’re using Twitter the way investors of
old used to start their day with The Wall Street Journal, The Financial Times, etc. and a cup of
coffee to ease into the day – that’s fine.
But, Twitter is – like skimming a newspaper – shallow work with a low return on your
attentional investment.
I’ve said before that Cal Newport’s “Deep Work” isn’t a great book. But, it is a great idea. Let
me plug it again here.
Part the Third: Wherein Geoff Complains that Writers Can’t Ever Be Just Readers Again
You don’t know this about me, but I sometimes write fiction to relax. And I sometimes hang out
with real fiction writers – novelists who make a living making stuff up. And when you ask these
novelists a question you think is really clever – “what’s the one thing about being a professional
writer no one ever told you to expect?” – they all pretty much give you the same 3 answers:
1. It’s physically demanding. At some point, you’re 100% certain to majorly mess up your
back.
2. You read less.
3. It changes the way you read.

As someone who managed to mess up his back writing before he reached the age of 30, I’d
prefer not to dwell on #1. So: why do writers read less once they become professionals?
Writers, not surprisingly, spend a lot of time writing. And writing and reading exercise the same
mental muscles. Writing often feels enough like reading that it ends up taking its place.
Amateurs can write or not write. Professionals don’t have that luxury. They have to write. So,
they end up cutting reading from their life. No editor or agent has ever called them up saying “so,
how’s the reading coming along?” Any prodding they get from others pushes them toward
writing – not reading.
What does this have to do with Twitter? I fear that an hour spent skimming stock related Tweets
feels a lot like an hour spent reading a 10-K. We all know our time is better spent actively
reading 10-Ks, taking notes, doing our own calculations, etc. And yet, what are we being
prodded to do?
Twitter prods us to:
· Quickly agree/disagree (make a knee-jerk logical judgment)
· Get outraged about something (make a knee-jerk moral judgment)
· Click that link (I started this post with a link).
· Read that book (I told you to go out and get “Deep Work”).
· Watch that interview.
· Etc.
No one is prodding you to read a 10-K. A terrific investment for a stock picker to make would be
to buy a parrot and teach him only those two words: “10” and “K”. I doubt I could ever give you
a morsel of advice that would do as much to improve your actual stock picking as that kind of
constant nagging.
Finally, professional writers report that they can’t read the way they used to. They can’t read
“just for fun” anymore. They watch a magic trick, and they see the magician at work. Reading
for them becomes more about analyzing the artifice of good storytelling than simply
surrendering themselves to the tale.
This, honestly, is where you (the reader of this post) and me (the writer of the post) diverge in
terms of our attitudes toward Twitter. A writer is more likely to be changed by Twitter than a
reader.
A huge problem with Twitter is that I can clearly see which posts of mine “work” and which
“don’t work” in terms of the immediate response of new followers, re-tweets, reactions from
people, etc.
My goal isn’t really to get a lot of followers, re-tweets, etc. It’s to write stuff that resonates. More
than anything, I want to write stuff that translates into some practical improvement for my
readers. I don’t want them to agree with what I write. I want them to incorporate something I
wrote into their investment process. I want them to get better because of me.
It’s fine to say that. But, our actions aren’t driven by what we claim to believe. Beliefs simmer
on the back burner. Actions are determined by more immediate front burner stuff. They’re driven
by things like a nagging parrot that squawks “10-K, 10-K, 10-K”. Our actions are driven by
reminders. Our actions are driven by habits. Our actions are driven by the stuff we choose to
measure.
If I want to lose weight – I don’t actually have to change my beliefs about what food I should be
eating. All I have to do is start recording everything I eat throughout the day. That simple act of
monitoring my diet will change my diet. Buy a journal, buy a scale, get someone to nag you to
exercise – and that’s all it takes. You’re going to lose some weight. Will this “new me” prove
durable without the right principles, motivation, etc. to back it up? Maybe not. But it’ll get you
started faster than thinking the right thoughts. It’ll get you actually doing the right things. The act
of monitoring followers, re-tweets, likes, etc. can change behavior. If you want your behavior to
be changed in the same direction as the stuff Twitter measures and notifies you about – that’s
great. Your interests and Twitter’s metrics are aligned.
But, if your preferred metrics for success are different from Twitter’s – that’s a problem.
Because you’re going to do what you’re reminded to do – not what you believe in but don’t
measure.
Part the Fourth: Wherein Geoff Tells Investors to Eat Their Vegetables
I told you I know some professional novelists. I’ve read one of the earliest works (unpublished of
course) by one of these writers. It’s terrible. I don’t just mean it’s unpublishable. I mean, it
would quite likely not make it into the top few slots of your average high school writing class.
There isn’t anything there that would give you the slightest whiff of innate ability. No teacher
would encourage this writer to write more because they saw something good in what the kid was
already doing. The only reason they’d encourage him is because they saw passion and they saw
some serious work ethic. In fact, this writer went on to write more completed books – before
ever getting published – than some successful novelists write in an entire career. He willed
himself to become good. And he did.
I’ve talked to a ton of investors over the 12 years I’ve been blogging. Intelligence is not what
separates the successful ones from the unsuccessful ones. Having the “best” investment
philosophy isn’t what does it either. The ones with initiative succeed. The lazy ones don’t. The
difference between those who made it and those who didn’t comes down to what I’d call
“intellectual assertiveness”. I’ve been doing this 12 years – so, I’ve now met people who were in
high school or college at first and now have several years of really solid investing behind them.
All the good ones today are people who from the moment I first met them were willing and eager
to go off and do their own work and come to their own conclusions. They were all people who’d
rather spend time with a 10-K than with Twitter.
Does that mean a little Twitter is so bad?
No.
But, I want you to be very honest with yourself here when I ask you this. If you are presented
with two next actions to take and one is “quick” and “easy” and one is “slow” and “hard” –
what’s your next action going to be?
Conclusion: Wherein Geoff Presents Two Expensive, Irrational Habits He Has
I read 10-Ks in a little office I rent about a ten-minute walk from my apartment. It costs me
money to rent an office. So, why do I do it?
I use a full service broker I have to call up on the phone to place a trade with. It costs me money
to use a full service broker instead of an online broker where I’d enter the trades myself. So, why
do I do it?
Twitter is a great tool if you use it right. Online brokers save you a lot of money if you use them
right.
I have a lot less confidence in my ability to consistently tackle the slow, hard things when I could
instead tackle the quick, easy things than most people do.
Most people judge a tool by how useful it is when put to its best use.
There is a tendency to think all future decisions will be made in the clear light of day.
I try to imagine all future decisions will be made when it’s 2 a.m. – I’m a little sleepy, a little
hungry, I’ve had a drink or two. What could go wrong?
 URL: https://focusedcompounding.com/the-chains-of-habit/
 Time: 2017
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Hostess Brands (TWNK) Warrants
Note: Hostess stock is down about 8% as I write this; the warrants are down 10%. Make sure
you check for an updated quote on both.
My Focused Compounding co-founder, Andrew Kuhn, recently wrote up Hostess Brands

(TWNK) common stock on the member site. Today, I put up a link on my Twitter noting that the
company’s CEO is leaving and the Executive Chairman (billionaire Dean Metropoulos) will
assume additional duties in the interim. From these two facts, you can probably guess Andrew
and I have been looking at Hostess.
That’s true. But, this post isn’t going to be a write-up of Hostess stock. It’s a good business with
very strong brands (most famously Twinkies). But, it’s also highly leveraged. Hostess Brands is
essentially a publicly traded LBO. And, in the past, Metropoulos has flipped the food companies
he’s turned around (example: Pabst Blue Ribbon 2010-2014) fairly quickly.
The above suggests there may be two important limitations on Hostess Brands common stock:
1. The company is so leveraged the stock may be unsafe even if the brands are safe
2. The company may be sold within 5 years, limiting the stock’s long-term potential
Downside protection and unlimited time for your idea to work out are usually two of the biggest
advantages a common stock holder has over an option holder. If, in this case, the common stock
itself is a very leveraged bet and is less likely to be public in 5 years than is normal – you might
want to consider buying options instead.
Or better yet: long-term warrants.
Hostess has publicly traded warrants (they trade under the ticker TWNKW – that’s TWNK with
an extra “W”) that expire on November 4, 2021 (so, just over 4 years from now).
You need two warrants to get one share of common stock. So, I’ll simplify things by talking in
terms of a “pair” of warrants. A pair of warrants are exercisable at $11.50 a share. However, they
really must be exercised once the stock exceeds $24 a share, as you can see from this quote taken
from the prospectus:
“Once the Public Warrants become exercisable, we may call the Public Warrants for
redemption:
• in whole and not in part;
• at a price of $0.01 per warrant;

• upon not less than 30 days’ prior written notice of redemption to each warrant holder; and
• if, and only if, the last reported sale price of the Class A Common Stock equals or exceeds
$24.00 per share for any 20 trading days within a 30 trading day period ending on the third
trading day prior to the date we send the notice of redemption to the warrant holder.”
So, if you buy 2 warrants today, what you get is: 1) 4 years during which you only need to put
down the price of 2 warrants instead of the price of the common stock (as of yesterday, the
common stock was over $13 a share and two warrants were priced under $4 a share) and 2) the
4-year possibility of upside limited to movements in the stock price between $11.50 and $24.
So, am I recommending you buy Hostess warrants?
No. But that’s because I’m not ready to recommend you buy Hostess stock.
What I am recommending is that you look at Hostess Brands in general and the warrants in
particular.
Why?
I was talking to someone who had analyzed Hostess Brands stock recently and asked him: 1)
Okay. That’s your appraisal of the stock. Now, what’s your appraisal price for the warrants? 2) If
you were going to invest in Hostess, would you do it through the common stock or the warrants?
He didn’t have an answer to those questions. Why? Because, he hadn’t really looked at the
warrants at all. Looking at the stock just seemed simpler.
In my last post, I said “As a stock picker: Your job is to find a great business no one thinks is a
great business yet.”
Well, looking at a security that some people aren’t thinking about at all is always a good idea.
Other things equal, if you know more people are analyzing the common stock than the warrants
– you should start by analyzing the warrants.
Ready to get started? Here is the prospectus for those warrants. And here is Hostess’s 10-K.
 URL: https://focusedcompounding.com/hostess-brands-twnk-warrants/
 Time: 2017
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Roam Free From the Value Investing Herd
Although allegedly a value investor, my own portfolio is usually idiosyncratic in two respects:
1. The position sizes I take (right now they’re 50% / 28% / 15% / 7%) are not the position
sizes well-known value investors use.
2. The stocks I own are not owned by well-known value investors.
A lot of readers comment on point #1 (my level of portfolio concentration is by far the topic I get
the most emails about). No one ever comments on point #2.
To prove to you that almost none of the stocks I own are owned by well-known value investors,
I’ll use Dataroma.
Dataroma tracks the portfolios of about 60 investors. I would call most of them “value investors”
and some of them “famous” in the sense that the sort of folks who read this blog would have
heard of them.
Here’s my portfolio’s popularity according to Dataroma:
· Undisclosed Position (50%): One of the investors tracked at Dataroma owns this stock. He
has less than 1% of his portfolio in it.
· Frost (28%): No investor tracked at Dataroma owns this stock.
· BWX Technologies (15%): No investor tracked at Dataroma owns this stock.
· Natoco (7%): This is a Japanese stock that Dataroma doesn’t track.
Basically, no famous value investor has a meaningful amount of his portfolio in any stock I own.
This is very different from almost all the stocks I get emails about. People want to talk to me
about stocks that a lot of value investors own. They want to talk about stocks that you can find in
portfolios over at Dataroma or GuruFocus and that you can read threads about on Corner of
Berkshire and Fairfax or read write-ups about at Value Investors Club.
My favorite investing book is Joel Greenblatt’s “You Can Be a Stock Market Genius”. If I can
cheat a bit, I’d say my second favorite investing book is the section of “The Snowball” that
details Warren Buffett’s career from about 1950-1970.
Both books teach you the importance of doing your own work. In fact, my favorite Ben Graham
quote is:
“You are neither right nor wrong because the crowd disagrees with you. You are right because
your data and reasoning are right.”
The key word here is “your” data and “your” reasoning. At some point, you have to go into a
room alone with just the 10-K. And when you come out of that room you need an appraisal value
for that stock that’s yours and yours alone.
I would say that 90% of the investors I talk to never get this far. They pick their own stocks. But,
they don’t do their own work.
Nothing is going to make you a better investor faster than just picking the 10-K of a stock that’s
not well-covered and coming up with an appraisal value for that stock on your own. Repeat this
every week. And you’ll be a better investor in no time.
To get you started, here are some stocks that aren’t well-covered but are worth learning about:
· George Risk (RSKIA)
· ATN International (ATNI)
· Ark Restaurants (ARKR)
· Transcat (TRNS)
· Tandy Leather (TLF)
· U.S. Lime (USLM)
· Green Brick Partners (GRBK)
· Seaboard (SEB)
· Hostess Brands Warrants (TWNKW) – Not a stock but worth doing your own homework
on
I intentionally limited this list to U.S. listed stocks and tried to find some names that have market
caps over $100 million (in fact, a couple there have market caps over $1 billion). The easiest way
to find things other value investors don’t own is by focusing on stocks under $100 million and
including stocks listed outside the U.S.
Let’s talk small caps.
There’s no perfect relationship between market cap and popularity of a stock. But, going in sort
of “order of magnitude” intervals, we could say:
· Under $300 million market cap: Unknown to investors who don’t do their own work
· $300 million to $3 billion: Known to professionals and serious stock pickers
· $3 billion to $30 billion: Known to investors generally
· $30 billion to $300 billion: Known even to people who don’t invest any of their own
money
If you look at the portfolio I have now, at the time I bought shares in these companies:
· Two of the four stocks had market caps of about $300 million or under
· Two of the four stocks had market caps of about $3 billion or under
So, about 50% of my ideas were in the $0 to $300 million market cap category and 50% of my
ideas were in the $300 million to $3 billion market cap category. None were really in the $3
billion to $30 billion or $30 billion to $300 billion categories.
This isn’t a bad rule for you to follow. Certainly, in the U.S.: at least half of all the good ideas
out there have a market cap under $300 million. So, at least half of your portfolio should
probably be in stocks with a market cap under $300 million.
 URL: https://focusedcompounding.com/roam-free-from-the-value-investing-herd/
 Time: 2017
-----------------------------------------------------
My 4 Favorite Blogs
I get asked a lot what my favorite blogs are. I started blogging in 2005. Most of my favorite
blogs are no longer active.
However, the four blogs I’d recommend right now are:
1. Anything by Richard Beddard
2. Value and Opportunity
3. Clark Street Value
4. Kenkyo Investing
You can also follow some of these authors on Twitter (but, you shouldn’t). I’m on Twitter. But,
again, you shouldn’t be on Twitter.
Why?
I just wrote a post about how you need to go into a room alone with just a 10-K and sit still there
for several hours.
You’re not going to do that if you can check your Twitter feed instead.
So, I have three pieces of advice about learning from bloggers:
1. Read: Richard Beddard, Value and Opportunity, Clark Street Value, and Kenkyo
Investing.
2. Don’t follow any bloggers on Twitter (because you should delete your Twitter account if
you’re serious about investing).
3. Whenever you come across a potentially interesting blog post, print that post out and put it
in a folder somewhere that you read all the way through like once a week. Don’t “browse” from
one post to another and one blog to another. The way to get a lot out of any reading material is to
focus on it and read it closely (like with a pen and calculator). Don’t skim.
 URL: https://focusedcompounding.com/my-4-favorite-blogs/
 Time: 2017
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The Dangers of Holding on to Great Stocks
Someone emailed me a question about Activision (ATVI), a stock I put 100% of my portfolio

into a little over 16 years ago (the stock went on to return 22% a year – but, of course, I didn’t
hold on to it these last 16 years):
“Would it be fair to say that your returns would have been much better had you just put all your
money into Activision at the time you initially bought it… and just sat on your butt until now?
Let’s assume that this is a fair assessment for now.
So if we brought ourselves back to the year you bought it, early 2000s was it? If we looked at it
with the models you currently possess but likely did not possess back then, could you have made
a better allocation based on those models alone?”
The only “model” I can think of that would have improved my performance is not letting myself
make any conscious sell decisions. In other words, just selling pieces of all the stocks I own in
proportionately equal amounts to fund new purchases, never selling just to hold cash, etc.
I wrote an article discussing some of this. Overall, my sell decisions haven’t added much (if any)
value to my investing record. My investment results are primarily a result of taking larger than
normal positions in some stocks and then secondarily in picking the right stocks more often than
I pick the wrong stocks.
With hindsight, I would have done as good or better while doing far less work if I’d just stuck
with a stock like Activision that I once (16 years ago) had the conviction to put 100% of my net
worth into it.
However, I think there is both: 1) A valuable truth and 2) A dangerous falsehood in this kind of
thinking. Basically, what you’ve uncovered here is a good idea. But, a good idea can be taken to
a bad extreme. And, I think the combination of 1) abusing hindsight and 2) going off the stock
performance rather than the business performance can skew just how good and certain an idea
Activision really was in September of 2001 (when I allocated 100% of my portfolio to it).
I couldn’t have foreseen that Activision would return something like 20% to 25% a year for the
next 15-20 years. At the time, I thought I was able to foresee Activision could return 10% to 15%
a year for the next 10-15 years though. Now, it’s true I thought this thought with enough
“certainty” that I was willing to put 100% of my portfolio into the stock. But, I didn’t go “all in”
on Activision believing I could make 20% to 25% a year. I did it believing I could make 10% to
15% a year (with greater confidence than I had in any other stocks).
Since 2001, Activision’s capital allocation has turned out to very good, or very lucky – or some
combination of the two. Should I have known that would happen? To some extent, yeah. A key
reason – really, the key reason – for me buying Activision instead of something like EA is that I
liked Activision’s management and capital allocation a lot better. In fact, I disliked EA’s
management so much I’d never consider buying the stock as long as that management team was
there. And I really liked Activision’s management a lot. It’s not like I was neutral on the top
people there. I thought they were saying the right things about capital allocation at a time
(around the turn of the millennium) when no one was saying the right things about capital
allocation. I knew that in a business like video game publishing, book publishing, movies, etc.
you bet the “jockey” if by “jockey” we mean best capital allocator. That’s because these
businesses produce tons of free cash flow, so your return is largely going to be the return on re-
invested cash. There’s no requirement to put the cash back into the franchise that earned in. In
fact, you often can’t do that. A hit media franchise can never come close to re-soaking up all the
free cash flow it gushes.
Okay. So, I should have held Activision longer. Is this part of a bigger pattern for me?
In general, I haven’t been much better off selling a stock I bought to buy another. Certainly, of
the stocks I sold within about 10-15 months – where things were going well and the price was
rising – I would have been better holding for 10-15 years.
You can see this even more recently. For example, I bought FICO about 7 years ago. The stock
has returned over 25% a year since then. I didn’t hold it from then till now.
What you have to be careful about here though is multiple expansion. When you buy something
like Activision, J&J Snack Foods, FICO, or Village Supermarket (these are all stocks I bought a
lot of when they were really cheap) at a low multiple of sales, book value, earnings, etc. you can
consider the substantial annual return bonus you get in the stock from multiple expansion to be
one-time but fully justified (and therefore not going to be reversed in future years) up to a point.
I’m going to spend the rest of this post explaining what “up to a point” means. It’s one of the
most important concepts to long-term, buy and hold investors. This idea that you are – if you buy
only cheap stocks – entitled to getting one and only one multiple expansion “bump” to your
returns is something buy and hold investors need drilled into their heads during the last stages of
a bull market. Since we may now be in the last stages of a bull market, let’s talk about how a
justified initial multiple expansion in a stock can quickly morph into a totally unjustified
subsequent multiple expansion.
Let me give you some examples.
Activision: I bought this stock at something like an EV/Revenue of 1. It now trades at an

EV/Revenue of more than 6. This multiple expansion counts for over 10% of the annual return in
the stock. How much of it is justified? Activision shouldn’t trade at an EV/Revenue of 1, but I’m
not sure it should trade at an EV/Revenue of 6 either. Today, the stock would have to fall more
than 50% before I’d say it was clearly “cheap”.
FICO: I bought this stock at something like an EV/Revenue of 2. It now trades at an EV/Revenue
of more like 5. This multiple expansion counts for over 22% of the annual return in the stock.
FICO might have to fall close to 70% before I’d say it was clearly “cheap”.
You want to be careful about this, especially as we are now in one of the longest lasting bull
markets ever. It’s often better to look at your returns in terms of the business results than the
stock results. So, judge your returns by the increase in per share sales, free cash flow, etc.
Having said that, you must also take justified multiple expansion into account to some extent if
you’re a value investor. I bought Village Supermarket (VLGEA) at a P/E of let’s say less than
7 and an EV/Revenue of around 0.1. It was reasonable I think to believe that because the
business was a perfectly decent one it would eventually deserve a P/E of about 15 and an
EV/Sales of about 0.2 or 0.25. Beyond that, you are starting to get speculative. I often think in
terms of what I think I can get as a return over the next 5 years if the company’s stock takes that
long to get valued at what I think is the “right” multiple. For me (a value investor) this means I
am usually buying below the market’s “normal” P/E and expecting the stock to at least rise to
that level. So, I’m buying Village at a P/E of 7 and expecting it to one day trade at a P/E of 15.
For some exceptional businesses – like Omnicom, FICO, and BWX Technologies – I may be
buying at a P/E of 15 and expecting the stock to one day trade at a P/E of 25. What I’m not doing
though is buying at a P/E of 20 and expecting the stock to one day trade at a P/E of 40 – even
though, I know, there may come a time where Mr. Market gets overexcited with this kind of
wonderful business and really does give it a P/E of 40.
So, does that mean I should sell when it reaches that level? If I expect a multiple expansion from
a P/E of 7 to a P/E of 15 for an average business or from a P/E of 15 to 25 for an above average
business, should I sell the second a stock I own hits my P/E “target”?
No.
But, even if you look at someone like Buffett’s returns – you can see two features. One, he often
did fine if he never sold. This is true even of stocks he did sell. For example, Buffett
bought General Dynamics (GD) shares in the early 1990s. He sold the stock. But, he would’ve
done very well if he’d hung on to General Dynamics for the last 25 years. Why? Probably
because Buffett analyzed the business and saw it was a good one and he saw that capital
allocation was going to be good and then the CEO then in place followed through with that kind
of capital allocation and the CEOs that followed him copied those practices. So, the two things
Buffett saw that he liked: good economics and good capital allocation proved to be durable.
As an example of what’s durable here – the industry structure of defense contractors and the
market power they have with respect to their customer (the U.S. government) and their suppliers
(often companies who do not deal directly with the U.S. government the same way they do on
big projects) is going to tend to stay the same. If market power and capital allocation don’t
change – the right business to own in the 1990s will often stay the right business to own in the
2000s, the 2010s, etc.
This is why it’s often a bad idea to ever sell a stock you’ve bought. In a sense, you are making a
very tough bet to get right. You’re saying that you correctly judged the quality of the company to
be high, its future to be bright, etc. but now you are correctly judging that the company’s quality,
future prospects, moat etc. are not high enough to overcome the current elevated price. That’s a
tough bet to ever win. The more certain you were of this business in the first place, the more you
should doubt ever selling it. This is if you did the sort of in-depth look at moat, etc. that someone
like Buffett does or that I often do. If I think WTW has a moat (like its relative size versus
competitors), it’s hard to later be right in saying the moat has been breached. If I think BWXT’s
industry structure (it’s a monopolist in some areas and an oligopolist in others) and product
economics (it rarely has to tie up much capital ahead of time in anything it does) are so favorable
it’s the right stock to buy at a P/E of 15 – then, it’s much harder than you might think for me to
reverse myself correctly at a P/E of 30 from a handicapping perspective. This requires an ability
in precise quantification that I probably lack. How much is the right product economics and the
right industry structure worth? It’s hard to say. What I know is I researched these questions in-
depth and liked the answers when I first bought the stock. To do what is probably a more
superficial (and biased towards “recency”) analysis later that overturns my initial decision –
that’s hard to do. Common law legal systems operate on a principle of precedent. If you believe
you made a correct precedent setting decision years ago, leave that decision undisturbed now. A
lot of investors are making decisions based on beliefs they might have 50% to 75% confidence
in. Don’t do that. You want every decision you make – including overturning a prior decision
you made – to be decisions you make with 90% to 100% confidence. The likelihood that you’ll
ever have 90%+ confidence in a decision that overturns a previous decision you made is
extremely low. Who can reverse themselves with 90% confidence?
Okay. So, whenever possible, leave your stocks undisturbed and your prior decisions in place.
But, I did say there were two features you see with the buy and hold practices of someone like
Buffett.
The other feature is that while it’s true that if you measure from the time he bought a stock till
the time he is still holding it decades later, the return is still often good despite him not selling
out at an earlier date – the annual returns is often not as good as it once was. This isn’t always
true. For example, General Dynamics did worse over the first 10 years from the time Buffett
bought it versus the subsequent 15 years. However, if we break down the returns in some of
Buffett’s favorite stocks into two time periods: the first 10 years and then all the other years – we
can see the first 10 years sometimes had really amazing results.
Based on information in Berkshire’s annual letters, I estimate Buffett’s Washington Post stock
returned about 32% a year for the first 10 years he owned it. The stock still did fine as an
investment for Buffett once you include the next 20-25 (taking it through the 2000s). But, the
returns were very strong in those first 10 years.
Coke shows a similar pattern. The return in that stock was something like 25% a year for the first
10 years. That stock hasn’t done well over the last 18 years. A lot of people will blame changes
in consumer tastes for that. But, really it was Coke’s P/E. The company experienced multiple
expansion for the first 10 years Buffett owned it that was very extreme.
This is why people should be careful about the FANG stocks. Not because they aren’t great
businesses, but because their stock prices have been growing faster than the underlying business
value.
Facebook: Over the last 5 years, there’s been a 5% boost to the annual return in FB stock due to
multiple expansion (EV/S).
Apple: Over the last 5 years, none of AAPL’s annual return has been due to multiple expansion.
Amazon: Over the last 5 years, there’s been a 12% annual return boost in AMZN stock due to
multiple expansion.
Netflix: Over the last 5 years, there’s been a 43% annual return boost in NFLX stock due to
multiple expansion.
Google: Over the last 5 years, there’s been a 7% annual return boost in GOOGL stock due to
multiple expansion.
I based all those multiples on sales, which is usually the safest way to do it. Investors often use
the P/E multiple. That can be risky though. Because you are then assuming that both higher sales
and higher margins (today vs. the past) are normal. Unless you have very strong evidence about
the long-term structure of this business as it scales, I would strongly suggest using growth in
sales per share or maybe growth in gross profit per share rather than growth in EPS as your guide
to intrinsic value growth.
I actually looked pretty hard at Netflix about 5 years ago and couldn’t bring myself to buy it
because I’m too much of a value investor who focuses on certain multiples you get accustomed
to paying in terms of earnings and things like that. But, Quan and I both knew Netflix was cheap
and it was going to have a wider moat in 5 years than it did in 2012.
Should I blame myself for not having the flexibility to break free from some of that value
investing dogma that fills my mind and buying Netflix?
Sure. Probably.
But, should I blame myself for missing out on an 80% annual return in the stock?
No. Netflix has only grown its revenue per share by something like 20% a year.
Two things have happened to expand Netflix’s share price result far beyond this. One, it grew
debt. Two, investors valued each dollar of sales higher (even when it came attached with more
debt).
A re-rating of Netflix from having an EV/Sales of 1 to having an EV/Sales of 2 or even 2.5

might make sense based on the company’s own past history. Knowledge of the historical
economics of similar media companies (cable networks, TV stations, etc.) might even get you to
a belief that if Netflix would become both dominant and mature it might even deserve a
EV/Sales of 4 at that time. However, no analysis I’d be able to come up with would ever tell me
that Netflix deserved an EV/Sales anywhere near 8 unless it was still growing phenomenally fast.
The danger here is always that because of the combination of a strong business performance and
then a strong stock performance on top of that (due to multiple expansion) we may become more
sure of Facebook, Amazon, Netflix, and Google or of Activision or FICO or whatever long-term
winner we own in our portfolio. And the truth is that while some of those businesses are certainly
on more stable ground today than when I first analyzed them – other aren’t. FICO isn’t a wider
moat, better company today than when I looked at it. FICO should have been priced at the exact
same multiple of sales in 2010 and 2017. Instead, Mr. Market is willing to pay 2.5 times more
per dollar of FICO’s sales in 2017 than he was in 2010. FICO was too cheap in 2010. And it’s
too expensive now. I could’ve gotten a tremendous return – something like 25% a year – in
FICO by holding all the way from when I bought it (knowing it was way too cheap) in 2010 and
holding it till today (when I know it’s way too expensive).
But: Is that smart? Is it safe?

Nothing happened with FICO that I didn’t pretty much expect to happen over the next 7 years –
except for one thing: I never expected the stock to end up with a P/E of 40.
Let’s look at Netflix over the last 5 years. I’m not sure I’d say Netflix’s competitive position
today is different from where I expected it to be at this point in time. However, the stock is
probably 4 times higher than where I would’ve told you it should be. In other words, I could
have correctly – in very rough terms – guessed where Netflix might be in terms of its number of
subscribers, how much it was charging, and how much competition it was facing for the
acquisition of content (this was always my biggest concern). Now, I was nowhere near 100%
certain of my guess as to where Netflix would be in 5 years. Otherwise, I would have bought the
stock. But whether I was 51% certain or was I 75% certain of where the business would be – I
still never would have guessed where the stock would be today. I’d have guessed that if Netflix
hit all the expectations I had for it (as a business) the stock might return 20% to 30% a year over
the next 5 years – not 80% a year.
If you look at Buffett’s investment in Coke, the P/E on that stock expanded by about 13% a year
in the first 10 years he owned the stock. And I’m sure Buffett would say the quality of those
earnings deteriorated as well. Now, I don’t mean to say that Buffett was wrong buying Coke at a
P/E of 15-17 or whatever he bought it at and believing it deserved a P/E of 25 sometime down
the road. We can see from the stock’s subsequent history that outside of moments of real
financial stress in the market – Coke hasn’t really had a P/E of 15-17 since Buffett bought it
almost 30 years ago. So, he was justified in the belief (if he had any such belief) that Coke
deserved an expansion of its P/E ratio. But, Buffett wouldn’t be justified in believing Coke
deserved a re-rating in the P/E from 15-17 to say 45-51 (3 times expansion). And yet, at times,
Coke actually traded at such a P/E and the stock’s long-term performance would have looked
amazingly good during those periods.
That brings us to the classic question: Should Warren Buffett have sold Coke in the late 1990s?
He has a different calculus than the rest of us. Berkshire brings in a lot more new cash to invest
all the time. So, I think by not buying more of stocks he already owns he is watering them down
in much the same way an individual investor would be when he sells all the stocks he owns in
equal proportions.
This is the approach I’ve chosen to take.
You can see that with my latest purchase. At the start of October, I put 50% of my portfolio into
one stock. However, I only had about 30% of my portfolio in cash at the time. So, I had to sell
something. Instead of selling all of BWXT (the most expensive stock I owned) I sold about one-
third of BWXT and one-third of Frost which means I express no preference when it comes to
selling. Now, actually I prefer Frost over BWXT at today’s prices. But, I forced myself to ignore
that. I’m trying to only express my preferences in buy decisions – not sell decisions, from now
on. Basically, I’m trying to “buy right” and then just forget about what I own.
If I continue to apply this rule, it means I will slowly sell down stocks I own over several years
making them a smaller and smaller part of my portfolio as they age.
For example, I took a 50% just now. If I buy a new 20% in 2018 and another new 20% in 2019
and then another new 20% position in 2020, and so on…
That would hypothetically (if the 50% position had the same performance as my other stocks)
result in the stock I just bought being 50% of my portfolio in 2017, 40% of my portfolio in 2018,
32% of my portfolio in 2019, 26% of my portfolio in 2020, 20% of my portfolio in 2021, and so
on.
That’s not a true “buy and hold” approach. But, it both relieves me of having to make sell
decisions and yet also gradually clears out my old ideas (which have presumably risen closer to
their intrinsic value) and replaces them with my new (and hopefully cheaper) ideas.
This is the approach I think makes the most sense. I think buy and hold makes a tremendous
amount of sense and I recommend it to people who have a constant influx of cash into their
savings and don’t have a ton of time to ferret out new stock ideas.
In fact, for the average stock picker my advice is:
· Take everything you saved this year
· Buy just one stock with all those savings
· Never sell that stock
· Repeat every year
That might lead you into situations like Activision and lead you to hold them forever. It would
certainly cause you to be focused on what I think matters most: your highest conviction buys.
Superficially, it would also seem that this approach should lead to wide diversification. However,
in practice, this is unlikely to happen. Your winners will become much bigger than your losers if
you truly never sell the winners.
I think it’s important – especially as I write this in October of 2017 – to consider how with
hindsight the results of buying and holding the right stocks through a bull market look better than
we should perhaps expect we can do in the future. There are stocks that may have looked like
Activision and didn’t work out. And then there are periods (like 1965-1982) where multiples
simply do not expand on stocks.
However, have I often sold too soon?
Yes. There are definitely chances I missed to buy and or simply hold a business I knew well and
liked. But, I’d also say that much of the subsequent return in these stocks is something I couldn’t
have counted on (an expanding multiple beyond the historical norm).
I think it’s reasonable to buy an undiscovered or misunderstood stock at a low multiple and
expect a one-time re-rating of the correct price multiple as that stock is discovered and better
understood by the public. However, this is a one time and one time only bump in the stock that
may take 3, 5, or even 10 years. A multiple expansion from an EV/EBITDA of 6 to 12 may be
justified in cases where you know just how great a business is and the market doesn’t yet. An
expansion from an EV/EBITDA of 12 to 24 won’t be justified ever. But, it will still happen to
some stocks you own and while you own it this second expansion may not feel that different
from the first (fully justified one).
The thing about bull markets both in the overall market and in specific stocks you own too is that
a good idea is first latched on to by a few very smart people and then over time some less and
less intelligent people doing less and less in-depth work of their own on that stock take this good
idea and they take it way too far.
When I tell the story of BWX Technologies (BWXT) it makes a great deal of sense at half of
today’s price (about where I bought it). But, that same story makes a lot less sense as a reason to
buy the stock today. The story is the same: BWX Technologies is still a high return, monopoly
business that can pass inflation along to its customer (the U.S. Navy). It’s clear that you should
buy such a business at a P/E of 15. At a P/E of 30, it’s less clear. And yet it seems more certain
(because of the stock’s multiple expansion) to people looking at the stock today than when I first
wrote about it.
That’s the fear I have when talking about some of these businesses. What you want is to buy an
above average business at a multiple below what will be justified in the future when the stock is
still undiscovered or misunderstood.
When I ask for examples of great businesses from people, they bring me examples of businesses
that are already recognized by the market as being great.
If you read what I write about the stocks I own – Frost, BWXT, etc. – or stocks I would seriously
consider buying (Omnicom, Howden Joinery, etc.) you’ll notice that I’m saying both:
1) I think this is a great business AND
2) I don’t think the market fully appreciates this is a great business
So, with BWXT I’ll say that unlike with other stocks you have greater visibility into the long-
range buying plans of BWXT’s customer in real terms. With the stock at a P/E of 30, this may
now be recognized. At a P/E of 15, it wasn’t. With Frost, I always say that this is a far above
average bank at a normal Fed Funds Rate. With a Fed Funds Rate at 0% to 1%, I don’t think
the market recognizes this. With a Fed Funds Rate at 3% to 4%, it will recognize it.
It’s nice to talk about stocks I bought 15-20 years ago that have worked out well. But, the market
recognizes the quality of those businesses today. When I bought J&J Snack Foods (JJSF) like
17 years ago, it wasn’t recognized as being anything other than a mediocre small-cap stock (the
P/E was 12). Over the following 17 years, the business changed far less than the stock did. The
stock became recognized.
It’s not worth spending even a second thinking about businesses the market already recognizes as
great. The problem with FANG stocks isn’t that they aren’t great businesses. It’s that everyone
knows they are great businesses.
As a stock picker: Your job is to find a great business no one thinks is a great business yet.
 URL: https://focusedcompounding.com/the-dangers-of-holding-on-to-great-stocks/
 Time: 2017
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Bought a New Stock: 50% Position
I bought a new stock today. This is the first buy order I’ve placed in about 2 years.
As of this moment, the new stock is just under 50% of my portfolio.
To fund this purchase, I had to:
· Use my 30% cash balance
· Sell one-third of my position in Frost (CFR)
· Sell one-third of my position in BWX Technologies (BWXT).
I’ll reveal the name of this new position on the blog sometime within the next 30 days.
 URL: https://focusedcompounding.com/bought-a-new-stock-50-position/
 Time: 2017
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NACCO (NC) Spin Off Article
You can read a new article over at GuruFocus that I wrote discussing the lignite coal mining
business (NACoal) that will be left over once NACCO spins off its Hamilton Beach brand of
small appliances.
NACCO: Why NACoal Is Inside My Circle of Competence and Hamilton Beach Is Outside It
“The company is involved in operating lignite (again that’s “brown”) coal mines for a few
major customers. These customers are usually power plants of some kind. They sit very, very
near (in some cases, basically on top of) the coal deposit that NACoal is working. I was able to
confirm this to my satisfaction by going online and getting satellite images of NACoal’s five
biggest mines. Using those images, I can see where the customer’s plant is in relation to the
surface mining activity.
I’ve never researched a coal miner before. However, I have researched two companies related
to coal mining…”
NACCO: Why NACoal Is Inside My Circle of Competence and Hamilton Beach Is Outside It
 URL: https://focusedcompounding.com/nacco-nc-spin-off-article/
 Time: 2017
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Are You Buying Anything Now?
A blog reader emailed me this question
“Are you buying anything now?”
No. I still haven’t bought a stock this year.
I like Cheesecake Factory (CAKE) a lot. There’s a write-up in the Focused Compounding
member idea exchange about it. If I was to buy something right now, it would probably be
CAKE. It’s a good business facing a temporary problem. Over the last two years, “food away
from home” (at restaurants) is up 5% in price while “food at home” (supermarkets) is down 1.6%
in price. So, the relative cost of eating out versus eating in has changed 6.6% in the last 2 years
in the U.S. As economic theory would say has to happen, value seeking households have done
some substituting from eating out to eating in. This has caused a decline in same store sales. The
Cheesecake Factory’s same store sales are down 1% this year. The stock is down 32%. I had
researched the business previously. CAKE shares were probably about fairly valued at the start
of this year ($60 then vs. $40 today).
I would consider buying Omnicom (OMC) at about $65 a share. It’s at $73 a share now.
And you know I like Howden Joinery and continue to follow that stock as a possible purchase as
well.
Not that long ago, I dropped everything and looked intensely at AutoZone (AZO) when it
plunged just under $500. It’s at $570 now. I liked what I saw. At $500 a share, I think AutoZone
would make sense as a “value” stock (really more of a cannibal that grows EPS through
buybacks). But – for me at least – it’s the kind of stock you’d want to buy now and sell in 3 years
or whenever its multiple expands again instead of holding forever.
I’ve looked at other companies recently, but have not bought any.
I looked at Howard Hughes (HHC) this past week. The company still owns a lot of valuable land
in high-end master planned communities like Summerlin, Nevada (about 10 miles from the
Vegas Strip) and is developing commercial real estate at the South Street Seaport in Manhattan
and Ward Village (about 3 miles from Waikiki Beach in Honolulu). It has nice assets. It doesn’t
seem obviously overpriced (before I looked, I expected it would be). But, I can’t prove it’s
cheap. I’m only able to come up with estimates for some of HHC’s assets. Not all. I can’t
imagine ever being able to come up with a solid appraisal value for the whole company.
I plan to look at Green Brick Partners (GRBK) and LGI Homes (LGIH) this week. They build
homes here in Texas and elsewhere.
The only U.S. stocks that show up on Ben Graham type screens right now are a lot of retailers
and some homebuilders. There’s literally nothing else here in the U.S. that’s quantitatively cheap
anymore.
 URL: https://focusedcompounding.com/are-you-buying-anything-now/
 Time: 2017
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5 Stocks Ben Graham Would Buy
In an earlier post, I said that the only stocks in the U.S. showing up on Ben Graham type screens
right now are retailers.
Here are 5 of those retailers:
(All numbers are taken from GuruFocus)
What do I mean when I say a Ben Graham screen?
There are three ways to go with this. A “Ben Graham screen” could mean: A) a screen that uses a
single, specific formula Graham developed (like a net-net screen), B) a screen that uses a
checklist that Ben Graham laid out for investors in one of his books (like the criteria he lists for
“Defensive Investors” in “The Intelligent Investor”), or C) a screen that tries to duplicate the
approach Ben Graham used in his own Graham-Newman investment fund.
Here, I chose “D” which I would define as adhering to the “spirit” of Graham rather than the
letter of any Grahamite law.
What do I consider the spirit of Ben Graham?
1. Don’t pay too high a price relative to a stock’s earnings (eliminate high P/E stocks)
2. Don’t pay too high a price relative to a stock’s assets (eliminate high P/B stocks)
3. Don’t buy stocks with a weak financial position (eliminate low F-Score stocks)
4. Don’t buy unproven businesses (eliminate stocks that either lost money or didn’t exist
sometime within the last 15 years)
5. And needless to say: don’t buy into frauds (eliminate U.S. listed stocks that operate in
China)
If you apply those 5 filters to all U.S. listed stocks, you’re left with just 5 stocks:
These are all retailers. And, obviously investors are concerned that Amazon and others will put
offline retailers out of business. Do I think Ben Graham – knowing internet retailers were
coming for these stocks – would buy a basket of these 5 retailers today?
I do.
The Warren Buffett of the 2010s wouldn’t. But, the Ben Graham of the 1950s would.
The reason I’m so sure Graham would buy these 5 stocks if he were alive today is that they all
share the same exact value proposition. The bear case is speculative (future oriented). The bull
case is historical (past oriented).
Graham’s approach was always to bet on the basis of the past record you do know and against
the future projections you don’t know.
The quote he opened Security Analysis with is from the Roman poet Horace:
“Many shall be restored that now are fallen; and many shall fall that are now in honor.”
These 5 stocks are all fallen angels. In almost all past years, they were valued more highly than
they are today. They are the common stock equivalent of junk bonds.
Hibbett Sports (HIBB) – P/E 7, P/B 0.9, F-Score 6
Hibbett Sports runs small format sporting goods stores in mostly rural America. The best way I
can sum this up is that if you drive through an American town where Wal-Mart is the main retail
destination for just about anything, there will be a Hibbett Sports. However, if you drive through
an American town where there’s a big format supermarket, or a Best Buy, or a Nebraska
Furniture Mart or an Ikea anywhere in sight – you’re not going to find a Hibbett there. Instead,
you’ll find something like a Dick’s Sporting Goods (DKS). The average Dick’s location is
about 50,000 square feet. The average Hibbett location is about 5,000 square feet. Quan and I
considered researching Hibbett Sports for the newsletter. Just based on his reading of various
company filings, Quan had concerns about the Hibbett business model’s survival as sporting
good retail shifted more online. After travelling more in towns where Hibbett is located, I pretty
much eliminated this stock as something I’d ever consider buying. I could be completely wrong
to do that. But, Hibbett serves a very weird purpose where it’s basically in towns that can’t
support a sporting goods store with a wide selection. Online retail isn’t great at a lot of things
(it’s often not cheaper than offline). But, the one thing online can always do better than offline is
bring a wider selection of products to places that used to be offered only a narrow product line-
up.
Bed Bath & Beyond (BBBY) – P/E 7, P/B 2.1, F-Score 6
Bed Bath & Beyond is a category killer in soft stuff for the home. Of the stocks that come up on
this screen, Bed Bath & Beyond is clearly the best positioned competitively – at least offline.
The company’s position is similar to something like Barnes & Noble (BKS), GameStop
(GME), or Best Buy (BBY). If anything in this company’s category survives in an offline form
– it’ll have to be Bed Bath & Beyond. The most recent earnings release showed online sales
growing 20% a year. Meanwhile, offline same store sales declined at a “mid-single digits” rate. I
was surprised to see this stock show up on a Graham screen I created. That’s because I was
surprised to see it has a P/E of 7. Even more amazing is the current market cap divided by the
15-year average net income is only 6. It’s very rare to find a stock trading for a single digit P/E
relative to its average net income over the last 15 years. For perspective, Bed Bath & Beyond is 3
times larger today than it was 15 years ago. And yet the stock is only trading at 13 times what it
earned back in 2002. This is definitely a Ben Graham stock.
Kohl’s (KSS) – P/E 12, P/B 1.5, F-Score 8
This company has a solid past record. However, as a department store, it faces the most
competition from both the online front and the offline front of any of the stocks on this list.
Genesco (GCO) – P/E 8, P/B 0.9, F-Score 7
This company operates the Journeys, Lids, and Schuh stores. They mostly sell shoes, caps, and
apparel to mallgoers in their teens and twenties. They also own the Johnston & Murphy shoe
brand. Last year, almost three-quarters of earnings came from the Journeys part of the business.
Journeys sells shoes to teenagers. It’s not a business I feel I could ever learn enough about to
judge. So, I could never buy the stock. But, I imagine Ben Graham could as part of a basket.
Ingles Market (IMKTA) – P/E 10, P/B 1.0, F-Score 7
Ingles Market runs about 200 supermarkets (and owns over 150 of them) in North Carolina,
South Carolina, Georgia, and Tennessee. Ingles is undoubtedly the most “Grahamian” stock on
this list. The P/E is reasonable at 10. And the price-to-tangible book is very reasonable at 1 times
book. It’s also clear from reading the company’s 10-K that book value understates market value,
replacement cost, etc. So, this company is selling for less than its net assets.
Those assets include:
· 155 existing supermarkets
· 18 undeveloped sites suitable for a new supermarket
· “numerous outparcels and other acreage adjacent to” its supermarkets and shopping
centers
· 3 million square feet of leasable shopping center space not used by its own supermarkets
· A 1.65 million square foot distribution center / headquarters
· The 119 acres on which the distribution center / HQ is located
· A 139,000 square foot warehouse
· The 21 acres on which that warehouse is located
· A 140,000 square foot milk production/distribution center along with truck
fueling/cleaning site
· The 20 acres on which those buildings are located
All that plus equipment and trucks is held at a depreciated cost of just under $1.25 billion on the
company’s books.
The company also has 38 supermarkets under very long-term leases (like 30+ years if the
company chooses to renew). I believe these are the result of a sale and leaseback transaction
done sometime in the late 1980s or early 1990s. Long-term leases (although a balance sheet
liability) are often the most valuable economic asset a good supermarket company has.
On the downside: Ingles also has a lot of debt. It’s about $850 million of debt versus just $200
million to $250 million of EBITDA (so, net debt is almost 4 times EBITDA). That’s a lot of debt
for a supermarket operator to carry. But, $850 million of debt doesn’t sound excessive relative to
the list of real estate assets I just gave you. Most of the debt ($700 million) is due in 2023 (so just
over 5 years from now).
The most important fact here is that it appears that at least two-thirds of all the assets I mentioned
were already owned by Ingles in 1992. That was 25 years ago. To adjust for inflation, anything
put on the books in 1992 – and obviously, almost all of these assets listed here were put on the
books before 1992 (that year is just the furthest I could go back using EDGAR) – would need to
be adjusted up in value by about 70% to take 25+ years of inflation into account.
If you make this inflation adjustment to Ingles Market’s property, plant, and equipment line
you’d be adding $28 a share in book value adjusted for inflation. That would make book value
adjusted for inflation $52 a share versus a stock price of $24.50 a share right now. It seems very
likely that Ingles has at least $2 in shareholder assets for every $1 of market price on the stock.
In fact, the stock is probably trading for well under 50% of the fair market value of its net assets.
The company is family controlled through super-voting “B” shares. The 10-K says Ingles
considers real estate operations to be an important part of their business. And, of course, if you
adjust past return on equity to reflect what the property Ingles controls is probably really worth –
earnings have always been very small relative to assets.
Ingles has never been a compounder. Over the last 30 years, the stock badly underperformed the
overall market – and that was true even before it dropped 49% in price this year.
Ingles looks like your typical dead money stock. It’s definitely your typical Ben Graham bargain.
Ingles is the one stock on this list that stands out as being an asset play more than anything else.
 URL: https://focusedcompounding.com/5-stocks-ben-graham-would-buy/
 Time: 2017
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Why Ad Agencies Should Always Buy Back Their Own Stock
Someone who’s been reading my blog for the past few years emailed me this question:
“With (Omnicom), I particularly like the durability of the advertising agency industry, the
nature of the customer relationship (long term in nature and high retention rate), it operates in a
rational duopoly environment and good capital allocation policy of John Wren. I also like WPP
which also looks attractively valued at around £14 but I prefer OMC as it uses the excess cash to
buy back its shares compared to WPP’s acquisitive approach. Would be great to get your
thoughts and insights on the following:

– Any significant misjudgment I should consider that could potentially impair OMC’s ability to
compound by around 10% in the long term;
– Your thoughts on WPP as a potential alternative consideration to OMC, especially at the

current price of around £14 and its market leadership. I like OMC even more now that it is in
the low $70s but it would be interesting to get your take on your appraised value of WPP and if
there are factors I should favour WPP over OMC apart from the valuation margin of safety and
different use of excess cash (share buybacks versus acquisition).”
No. There’s no significant misjudgment on your part that’s going to cause Omnicom to fail to
compound at 10% a year while you own it. I’ve looked at ad companies recently and don’t see
any changes in the industry that worry me. I’ve gotten a lot of emails – and responded to some of
them – about whether ad companies will have a narrower “moat” in the future than they have in
the past. I think the concerns are very speculative. And I don’t see any long-term reason for the
decline in the share prices of ad companies like WPP and Omnicom.
Obviously, there are cyclical reasons that explain these price declines well.
The big change in advertising is that Google (both the search engine and YouTube) and
Facebook are the venues where all incremental ad spending in the world is now going. So,
Google and Facebook will have a big share of ad spending in the future. But, that’s not new.
Brands have often spent a large portion of their ad budgets at a small number of media outlets.
The new part is that global conglomerates (like Omnicom) made up of different agencies will be
doing a lot of their overall buying for clients at just two corporations: Facebook and Google.
I understand it worries other people. It doesn’t worry me. I don’t see anything in the way that the
ad industry is developing now that seems like a bigger shift than the rise of TV, the death of
newspapers and magazines, or the rise of the internet. Those things already happened by the way.
It would be impossible to know that from looking at the financial results of global ad companies.
None of those events left the slightest mark on their earnings per share. And they didn’t change
the economics of the ad business much at all even though they completely changed where clients
spent their money.

So, personally, I’m not worried about the moat around ad companies getting any narrower.
Now, let’s discuss why I’d pick Omnicom over other ad companies if I was to pick just one ad
stock to buy and hold.
I tend to make my investing decisions based on four sort of “laws” I guess you could call them.
The first law is: Buy a business with strong and strengthening market power.
The second law is: Buy into a corporation with good and improving capital allocation.
And the third law is: Buy the stock at a discount price to your own appraisal of intrinsic value
per share.
So, my 3 objective criteria are: 1) Market power, 2) Capital Allocation, and 3) Discount Price.
And, yes, their importance is in that same order.
The most important law of all though is the “zeroth” law. It’s subjective.
The zeroth law is: Bet on the assumption you’re most comfortable with.
Here, the discount price and the market power aren’t very different between WPP and Omnicom.
What is different is capital allocation. I’m not sure WPP’s capital allocation will be worse than
Omnicom’s. However, I am more comfortable making the assumption that Omnicom’s capital
allocation will be close to what I expect. So, it’s Omnicom’s victory on account of the zeroth
law: “Bet on the assumption you’re most comfortable with.” I’m most comfortable with the
assumption Omnicom will keep buying back its own shares over time. So, if I had to make a bet
in the ad industry – that’s the bet I’d make.
Still, there’s no doubt the top two contenders for my consideration would be WPP and
Omnicom.
And I do like them both.
In fact, I would recommend the average investor buys them both. But, I prefer to concentrate my
investments in just one stock in an industry. For example, among U.S. banks I really like: Frost
(CFR), Prosperity (PB), and Bank of Hawaii (BOH).
But, I only bought Frost for myself.
For other investors (who tend to prefer diversification over concentration) I’d recommend
splitting your money among those 3 banks or even among 6 or 7 banks (adding BOKF, CBSH,
UMBF, and even WFC to that mix).
The reason for that is the zeroth law: Bet on the assumption you’re most comfortable with.
If you’re more comfortable assuming that – on average – a basket of those 6 or 7 banks will still
be around in 5 years and will have meaningfully higher EPS in 5 years, that’s the bet you should
make.
I’m more comfortable with the assumption that Frost will still be around and will be making
much more in earnings per share in 5 years than I am with the assumption that – on average –
that basket of banks will be around and earning more.

If I was more comfortable with the assumption based on a basket – I’d do it as a basket.
That’s what I did with Japanese net-nets.
I looked at a ton of them. And I picked 6 of them. I didn’t bet on just one.
Because I was more comfortable with the assumption that a basket of 6 Japanese net-nets would
– within 5 years – be valued more highly in the future than they were when I bought them than I
was about the same assumption regarding any individual Japanese net-net I could find.
Always “bet on the assumption you’re most comfortable with”. Always.
So, let’s apply that to ad company stocks.
For the average investor, there is nothing wrong with buying a basket of all the big ad agency
groups like: Omnicom (OMC), WPP, Publicis, Interpublic (IPG), Havas, and Dentsu. Of course,
I’d eliminate Havas from that group because of Bollore’s (that is, Vivendi’s) offer to buy Havas
at a much higher multiple than the rest of the group now trades at.
But, you could put together a 5-part basket of Omnicom, WPP, Publicis, Interpublic, and Dentsu.
I take very concentrated positions. If I was to buy Omnicom, I’d put somewhere between 20%
and 25% of my account into it. Most people would be uncomfortable putting 25% of their
account in one stock. But, they might be comfortable putting 5% in Omnicom, 5% in WPP, 5%
in Publicis, 5% in Interpublic, and 5% in Dentsu – for a total of 25% in ad agencies. If that’s the
way to get the average investor comfortable putting 25% of their money in ad agencies – then
I’m all for it. That basket will serve them better long-term than any index fund. At today’s prices
for those ad companies, you’ll get both higher returns and lower risk than you would in an index
fund.

Personally, I like OMC and WPP best. And I know OMC better than WPP. So, I would just put
20% to 25% of my account into Omnicom. My appraisal value for Omnicom was about $95 a
share when I wrote my report on that company a while back. The stock has increased its sales per
share by about 5% since I wrote that report (mostly through a decreasing share count due to
buybacks). So, I’d now value Omnicom at $100 a share. I tend to buy businesses I like when
they trade at a 35% discount to my appraisal of their intrinsic value. So, the “trigger” for me on
OMC would be about $65 a share. If and when the stock crosses that level (it’s at $73 now),
don’t be surprised to see I’ve put 20% of my account into OMC.
Why do I prefer Omnicom over WPP?
I think they’re comparable in quality. And I know OMC better.
I understand Omnicom better because it has a longer history of allocating capital the way it is
allocating it now, it has acquired fewer companies in the past, and some other small factors like
that. I think WPP is the second best ad group behind Omnicom. And, by the way, WPP’s capital
allocation is good. It’s just more flexible and opportunistic. And therefore: less certain.
Now, we have to address a controversial topic.
I’m going to make a strange claim here.
I’m going to say that a hypothetical publicly traded ad company that “dumbly” just dollar cost
averages into its own stock by always using 100% of its earnings to buy back shares will likely
outperform “smart” capital allocation by someone like Martin Sorrell at WPP.
In the long-run, I truly do doubt that WPP’s actions other than share buybacks can compound
value faster than share buybacks alone would. This is just a general long-term rule for all the
publicly traded ad companies.

I now have to go on a very long tangent to explain something I believe to be true that will seem
odd to hear. I believe the stock market has inefficiently priced the shares of publicly traded ad
agencies for about as long (over 40 years in some cases) as those agencies have been publicly
traded. It’s as if the market has had 4 decades to learn the right price for a certain business model
and yet it’s never figured it out.
My belief is that the market undervalues the ad agency business model. It doesn’t understand the
P/E premium over the market that an ad agency would need to trade at to equalize the likely
future return of the ad agency with that of a “normal” business. Every year, an ad agency both
grows organically (in line with growth in the ad budgets of its existing clients) and is able to
payout 100% of its earnings. Normal businesses can’t do both of these things at the same time.
So, they can grow 5% a year, but they can only pay out say 50% of earnings. That means a
normal business trading at a P/E of 15 would be priced to return 8.33%. Actual returns in the
stock market have not been exactly 8.33%. But, they’ve been close and they’ve been close for
the reason I just explained.
The typical stock grows 5% a year organically, it pays out half its earnings in dividends (or share
buybacks), and it trades at a P/E of 15. Those conditions will – in the very, very long-run – give
you a return of 8.3% a year.
A P/E of 15 is an earnings yield of 1/15 = 6.67%. Half of 6.67% is 3.33%. So, I am saying that to
the extent stocks tend to trade at a P/E of 15 and retain 50% of earnings they will tend to have an
annual payout (in either the form of dividends or reductions in shares outstanding) of 3.33% of
their market price. When you add this “yield” to the growth rate, you get a return for the investor
of 8.3%. In some periods, the Shiller P/E – or whatever normalized valuation measure you want
to use – will expand and returns may reach 10% or 12% over a certain 15 years. But, in other
times valuations may contract and there will be 15 year periods where returns are just 6% or
even 4%. For a typical business: what’s really underlying all this is about an 8% to 8.5% increase
in intrinsic value (which is normally turned into about 5% sales growth and like 3% to 3.5%
dividends and share buybacks).
Now, do the same math with an ad agency and you get a different number. Ad agencies retain no
earnings as they grow 5% a year. So, if an ad agency stock trades at the same P/E ratio of 15 as a
“normal” stock, it will have a 6.67% yield in terms of what it is going to use on dividends and
buybacks. Add that to the growth rate and you get an 11.7% long-term expected return instead of
an 8.3% long-term expected return. That’s an inefficient pricing.

How would the market efficiently price ad agency stocks?
The market would need to put a P/E of 30 on ad agencies instead of a P/E of 15. Value investors
don’t like hearing this. But, it’s true. If Company A can grow 5% a year and pay out 3.3% and
Company B can grow 5% a year and pay out 3.3% – they’re equalized in terms of future return
expectations. Because ad agencies have a 100% earnings payout, they will only reach intrinsic
value parity with the market when they trade at a P/E of 30 and the market trades at a P/E of 15.
The earnings yield on an ad agency stock should be half the earnings yield on the overall market
for it to be correctly valued.
Let’s look at what’s really happened in the past.
I told you there’s a quirk in the stock market where publicly traded ad agencies tend to be
inefficiently priced such that they are usually underpriced as long-term buy and hold
investments.
Let’s look at some results to see what I mean.
As a very rough sketch type exercise, I’ll just give you Omnicom’s total return from 1979 to
now, 1984 to now, 1989 to now, 1994 to now, 1999 to now, 2004 to now, and 2009 to now.
1979: 11.7%
1984: 10.9%
1989: 12.9%
1994: 11.7%
1999: 5.3%
2004: 4.1%
2009: 14.0%
You can see timing isn’t important.
I just started in 1979 and went forward 5 years at a time. I always picked the first week in
January as my start date. And we know the end date is conservative. Omnicom trades at a P/E of
15 right now. The market’s P/E is higher. Because I used today’s price (which I think is low) as
the end point for all those measurements – I may have understated Omnicom’s true
compounding power as an investment for all the periods measured there.
If you just avoided the 1999-2004 bubble type period (where Omnicom’s P/E was astronomical)
you would have gotten buy and hold returns of between 11% and 14% a year just by picking
Omnicom as a business and then throwing darts at a calendar to decide when to buy into that
business. Mostly, the stock’s annual rate of return has been in the 11% to 13% a year range. So,
about 12% a year for long-term holding periods.
While the S&P 500 has certainly matched Omnicom’s rate of compounding over some periods
(we can cherry pick start dates and get times where the stock doesn’t outperform) it’s also done it
with low risk. Omnicom has never lost money. It’s never had negative free cash flow. It’s never
really had a bad credit rating. And it has had far less volatility in actual business results (things
like margins, sales growth, etc.) than the market as a whole.
There’s no easy explanation for why the shares should outperform the market.
All the usual explanations: higher risk, illiquidity, greater volatility, etc. don’t work. In fact,
GuruFocus rates Omnicom a 4.5 out of 5 in terms of predictability. My own method of
determining volatility in business results (EBIT margin volatility) shows Omnicom is very close
to the most predictable company in the world. Costco (COST) is more predictable. Off the top
of my head, I can’t come up with any company other than Costco that has lower volatility in its
margins.

This raises a very real problem:
Either the market hasn’t – even after 40+ years of experience – correctly learned how the ad
agency business model works and incorporated that into the P/E ratio for ad agency stocks…
…or…
…the market is never looking far enough into the future.
I think the second possibility is the answer.
I don’t write a lot about market efficiency. But, what I’ve come to believe through my own
experience investing in stocks is that the market is fairly efficient over short periods of time (like
the next 3 years) but very inefficient over long periods of time. In some stocks, like Frost
(CFR) when I bought it at less than $50 a share and Omnicom (OMC) when it trades at under
$75 a share now – I think “the market” is making no attempt to price the stock as a long-term
investment.
The market is – perhaps very efficiently – asking what should this stock be priced at to give you
the same return as other stocks over the next 3-5 years. However, the market is making no
attempt to ask what the stock should be priced at to give you the same returns as other
opportunities over the next 15-25 years. I don’t think it’s an issue of efficiency or inefficiency or
me being contrarian to the market in my beliefs or anything like that. I just believe the market
has no beliefs over 15-25 years. It only has beliefs over 3-5 years.
If that’s true, quality companies will tend to be underpriced.
Let’s say three things work in investing: momentum, value, and quality.

Well, momentum is a strong force in the short-term. Value is a strong force in the medium-term.
And quality is a strong force in the long-term. If the market is not making any attempt to
correctly price stocks over 15-25 year holding periods instead of just 3-5 year holding periods –
then, it’s quality that’s going to be underpriced.
That’s a good argument for buying and more importantly holding ad agency stocks forever.
But, I said this was a tangent about why ad companies that buy back their own stocks will likely
do better than ad companies that follow a more diversified approach to capital allocation.
Big ad companies are buying from institutional investors when they buy back their own stock. I
believe these investors are not correctly pricing ad agencies. However, the big ad companies are
normally not buying publicly traded stocks when making acquisitions. They aren’t buying from
institutional investors. They’re often buying out owners who know a lot about ad agencies.
There is sometimes an “arbitrage” in roll-ups of local, boring businesses (like small print shops)
where a publicly traded stock that owns 100 of these things is valued at a higher multiple than 1
of these sites would be selling for on its own. So, the market will pay more for a public company
that owns one gas station in each of America’s 50 states than for a company that owns just one
gas station in one state even though the economics of the business with 50 scattered gas stations
may not really be much better than that one owner/operator gas station. In such situations, the
public company can issue stock to a private seller and thereby immediately increase its stock’s
own value per share. It can give stock worth 5 times EBITDA to a seller and then it has increased
its own EBITDA through the acquisition and the market puts an 8 times EBITDA value on this
incremental gain to earnings.
Ad companies don’t work that way. They work the reverse way. It’s easier to get a bargain price
for an ad agency through buying shares in the open market than it is trying to negotiate a 100%
control purchase of an agency. When you consider earn out agreements and things like that, you
just don’t get prices on acquisitions that routinely offer as much as buying back your own stock
does.

So, I think that if you own an ad company long enough – you’re best off owning the ad company
that uses more of its cash flow to buy back stock than any of its peers.
I’m more comfortable with the assumption that will be Omnicom than I am that it’ll be WPP. It
might be WPP. Omnicom pays a dividend (I wish it didn’t). And WPP buys back stock now. So,
I can’t guarantee Omnicom will buy back more of its shares outstanding than anyone else. But,
over longer periods of time, I’m more comfortable with that. And I’m more comfortable
assuming that the range of possible returns on those buybacks is narrow for Omnicom. If you
hold an ad company long enough and it devotes almost all of its earnings to buying back its
stock, you should get close to an 11% annual return over the time you hold the stock.
If you look at Omnicom’s history of buying back its stock, you’ll see why I have more
confidence it will devote more of its cash flow to buybacks than its peers will.
Other than that, I think the big ad companies are pretty similar in quality. If you want to put your
money into just one ad company, I’d make that decision based on two criteria:
1. Which ad company’s stock has the lowest price-to-sales ratio?

2. Which ad company seems most likely to buy back the greatest percentage of its own
shares over the next 15 years?
The company with the lowest P/S ratio when you buy it and the highest buyback rate while you
own it is going to be the best investment.
 URL: https://focusedcompounding.com/why-ad-agencies-should-always-buy-back-their-
own-stock/
 Time: 2017
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Unleveraged Return on Net Tangible Assets: It Only Matters When Coupled
with Growth
The best way for you to understand unleveraged return on net tangible assets is to look at the
reports in the Library section of Focused Compounding. I’m going to give you the basic formula
for return on unleveraged net tangible assets here, but it won’t make as much sense as seeing the
calculation for yourself by looking down each yearly column of the “datasheet” on one of the
20+ reports in the Focused Compounding library.
The definition of return on unleveraged net tangible assets is usually approximated as:
Earnings Before Interest and Taxes / ((Non-Cash Working Assets: Receivables + Inventory +
Property, Plant, & Equipment – (Working Liabilities: Accrued Expenses + Accounts Payable))
You can then adjust that result by a tax rate of 35% (so, multiply it by 0.65) to get an after-tax
figure for U.S. companies.
Again, It’s best for you to look at some sample reports that include this figure long-term. So,
here is an example using Grainger.
It’s very important to stress two points:
1) Unleveraged return on net tangible assets is a useful indicator of the actual business’s day-to-
day profitability. It ignores things like cash and goodwill because these things are not needed to
run the day-to-day business; instead, they reflect past decisions by the board (to make high
priced acquisitions or to hoard cash or whatever)
2) You only need to know what unleveraged returns on net tangible assets are within a certain
range. Basically, pre-tax returns of worse than 15% are a problem (since, after-tax they can be
less than 10% which is roughly the long-term return in the stock market) and pre-tax returns
greater than 30% are always sufficient (because, after-tax returns would be 20% or better in that
case which is – over the truly long-term – a better record of compounding wealth than all but a
very small number of public companies).
What matters is the incremental return on the money retained by the corporation that could
otherwise be paid out in dividends or used to buy back stock.
I think return on NTA is a very important number. However, I don’t think you should necessarily
prefer a business with a 400% return on NTA over a business with a 40% return on NTA.
Let me explain why. But, first let Warren Buffett explain why:
“…growth can destroy value if it requires cash inputs in the early years of a project or
enterprise that exceed the discounted value of the cash that those assets will generate in later
years. Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’
styles as contrasting approaches to investment are displaying their ignorance, not their
sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value
equation.”
– Berkshire Hathaway Shareholder Letter (2000)
Remember that last phrase “usually a plus, sometimes a minus”. Growth is usually good. But
what’s always true is that whenever a company has a high return on net tangible assets – you as a
shareholder want growth. And, whenever a company has growth – you, as a shareholder, want a
high return on net tangible assets.
The combination is key.
Let’s put it into numbers. These are rough numbers. But, when scanning a company’s past
history, I do find them useful.

When looking at pre-tax return on NTA (and a 35% U.S. corporate tax rate), you can basically
assume that at a return on NTA of less than 15% a company’s growth is not a meaningful plus
for you as an investor – and might actually be a minus. This is because you can – if you are a
patient, selective investor – usually find things to do with the money the corporation you own
pays out to you in dividends that will compound that money at 10% a year or better. Therefore, if
return on NTA is 15% or less pre-tax (so 10% or less after-tax), it is better off being invested by
you in a new stock rather than by the company in growing the business.
In fact, I would always have more faith in my own ability to earn 10% a year or better by finding
a new stock than I would have in a business with a history of earning just a 15% annual pre-tax
return on NTA retaining that money for me and clearing that same 10% compounding of wealth
hurdle on my behalf.
That’s a bad news situation. We don’t want to see a pre-tax return on unleveraged net tangible
assets below 15%. What do we want to see?
A pre-tax return on net tangible assets of 30% or higher would make all growth very valuable.
This is because the after-tax return would be 20% or higher in this case. It is very difficult for
you as an investor to find stocks that will return 20% a year for very long. You can find cheap
stocks that return 20% for maybe 5 years at a time. But, it becomes difficult to find stocks that
you can buy today and can return 20% a year for 20 years. In fact, it’s nearly impossible.
If this company had a repeatable formula for growth – for example, it was a restaurant or retail
chain opening new stores as it expanded nationwide – I would actually prefer that such a
predictable growth business making at least a 30% pre-tax return on its unleveraged net tangible
assets keep every penny of earnings it could instead of paying out dividends to me or buying
back its own stock. That’s because such a business can repeatedly make a 20% after-tax return
on incremental investments. I can’t. I can sometimes find stocks that will return 20% a year. But,
the stocks I can find that return 20% a year don’t do it for 10, 15, or 20 years. So, I need to
constantly replace these ideas more like every 3 or 5 years to make returns as high as 20% a year.
A repeatable business model doesn’t have to do that. It’s less risky to keep your money in a
growing, high return on NTA business than trying to keep finding value stocks over and over
again.

In broad strokes, here’s what we’re looking for.
It makes sense to avoid companies with:
* High growth and low returns on net tangible assets
And focus on companies with:
* High growth and high returns on net tangible assets
The best way, in fact, to think about return on net tangible assets is to invert it. Instead of
thinking about returns on assets, equity, or net tangible assets – think about the “cost” of growth.
Assume two companies can both grow sales at 5% a year. How does return on net tangible assets
matter here?
Most companies can only grow about 5% a year while paying dividends out that are half of
earnings. In other words, they have to retain half their earnings just to grow about 5% a year.
A company with an infinite return on net tangible assets (because it has negative net tangible
assets due to “float”) like Omnicom can pay out all of its earnings in dividends while growing
5% year.
So, let’s say both Omnicom and this other “normal” stock trade at a P/E of 15. A P/E of 15 is an
earnings yield of 6.67% (1/15 = 6.67%).

So, Omnicom’s stock can return 11.67% a year when it trades at a P/E of 15 and grows sales by
5% a year, because it would be able to grow sales by 5% a year (and therefore intrinsic value)
plus it would also be paying out 6.67% of your purchase price in some combinations of
dividends and share buybacks. In fact, if Omnicom always traded at a P/E of 15 and always used
all of its earnings to buy back its own shares, the company’s EPS growth rate could be as high as
12% a year while the company’s income was growing just 5% a year.
Compare this to a more typical business. It grows 5% a year. It trades at a P/E of 15. It has the
same earnings yield of 6.67%. But, it has to retain half of this. So, it can only pay out a dividend
yield plus share buyback rate of 3.33% to you. This means the stock will tend to return about
8.33% (5% growth rate plus 3.33% buyback/dividend yield).
So, two companies with the same P/E ratio (15) and the same net income growth (5%) could
actually have returns for shareholders that differ by 3.33% a year. That sounds small. But, for a
true buy and hold strategy – it would make a big difference. Over 30 years, a $1,000 investment
in the “normal” type stock would grow to $11,000 (8.33% a year) while the same $1,000
investment in the Omnicom type stock would grow to $27,000 (11.67% a year).
So, really it is the inverse of return on net tangible assets (how much you have to add to NTA
each year to grow earnings by a certain amount) that – when coupled with a company’s growth
rate – is what matters.
A very high return on net tangible assets but no growth doesn’t do anything for you. For
example, assume Omnicom grew its earnings at 0% a year and traded at a P/E of 15. In that case,
it could only ever return 6% to 7% a year as a stock. It could pay out all of its earnings. But, it
couldn’t grow that payout over time.
Now, take the other extreme. Assume a company can grow fast (let’s say 10% a year for a long
time), but it only has a return on net tangible assets of 10% pre-tax.
Such a company would have to issue more shares of stock or take on debt just to grow. After
taxes, a 10% pre-tax return on NTA would work out to be about 6.5%. This means the company
would need to increase its assets by about $15 a share for every $1 a share it added to earnings.

For an example of a business that looks somewhat like this – though perhaps not quite as bad –
look at Micron Technology (MU). The semiconductor industry has never had a shortage of
growth during the 40 years or so Micron has been in business. However, Micron’s profitability
has often been insufficient to fully support that growth internally. So, yes, the company has
grown. But, shareholders have not gotten dividends or buy backs. In fact, Micron has sometimes
taken on debt. The long-term (like 30-40 year) comparison between Micron and Omnicom
illustrates that Micron has always had better growth prospects as a company and yet Micron
shareholders have usually gotten worse returns and probably taken higher risk for those worse
returns than Omnicom shareholders.
A company can grow and be a mediocre investment. It depends on how much money it needs to
support its growth and where it gets that money from.
Where can that money come from?
It can only come from issuing more shares (the opposite of a stock buyback) which would cause
the company’s 10% rate of growth in net income to now be higher than the EPS growth rate that
shareholders get. For shareholders, issuing shares is like slowing down growth. Or, the company
could borrow money from a bank, issue debt, etc. That can work for a time. And debt might be
available at well less than 10% pre-tax. So, the company might be able to keep adding debt and
keep paying the interest on that debt. The added leverage could benefit shareholders in the form
of higher returns. But, it would also bring higher risks.
To reliably compound the size of your business – without adding debt or new shares – you really
need to generate pre-tax returns on net tangible assets of about 15% or better. Cyclicality is also
important here. A return on net tangible assets of 16% a year in every single year can actually be
much better than a return that averages – in the sense of an arithmetic mean – some figure above
16%, but which has years below 16%. At the risk of getting overly mathematical here, what you
always like to see is a harmonic mean that looks good not just an arithmetic mean. Or, more
simply put, you want the lowest return on net tangible asset years to still be pretty good years.
My advice is to look for companies that generate a pre-tax return on net tangible assets higher
than 15% in virtually all years.

In some industries, this is impossible. Hunter Douglas is a good business and the world leader in
blinds and shades. However, it’s in the housing industry and about 50% of its sales come from
the U.S. From 2008-2012, Hunter earned just a 9% to 14% return on net tangible assets before
taxes. This works out to be about 6% to 9% after-taxes. That’s an unacceptable rate of return.
However, net tangible assets actually decreased during this period. So, the incremental return on
net tangible assets – what Hunter earned on the earnings it retained from shareholders during
those years – was actually better than it appears.
The worst thing you can see is when a business keeps growing net tangible assets while having
insufficient and worsening returns on net tangible assets.
The best business in the world would be something like Omnicom (or any ad agency). It can
grow and pay out 100% of earnings at the same time.
The second best business in the world would be something like a successful restaurant chain or
retailer. It can grow while earning more on its money (a pre-tax return on NTA greater than 30%
a year) than you could ever make investing in other stocks. It can’t pay out earnings to you
while it’s still in its growth phase. But, what it keeps it does a better job growing than you could
do on your own.
The second worst business in the world would be something that has high or even infinite returns
on net tangible assets but can’t grow at all. This business can only pay out its earnings yield to
you (so, you can only make 6% to 7% buying at a P/E of 15, 10% buying at a P/E of 10 and so
on). The good news is that while this business can’t grow what it pays out to you, it will never
need more money from you. What it earns, gets paid out to you – it doesn’t get retained.
The worst business in the world is something that grows while earning a low return on net
tangible assets. This business is incapable of paying anything out to you. And the only way it can
even return 7% a year or better if you buy it at a P/E of 15, is if it manages to grow fast
enough ON A PER SHARE BASIS – after issuing the stock it needs and taking on the debt it
needs to grow.

I would recommend avoiding all businesses that sometimes earn 15% a year or worse on their
net tangible assets.
I would recommend focusing your search for businesses on those that almost always earn 30% a
year or more on their net tangible assets.
If you do that, any growth you do get will be very valuable growth. At rates between 15% and
30% pre-tax it gets a little tricky. Businesses that grow faster even at slightly lower returns might
be better. However, businesses with high consistency (very, very few years of sub 15% pre-tax
returns on net tangible assets) may work out better than companies that are growing faster right
now but generate unacceptable returns at the bottom of each cycle.
What you’re looking for is a business where you are confident that:
* There will be growth
* And that growth will be very profitable
And what you really want is for those two facts to hold true in almost every year you hold the
stock.
I’ll let Warren Buffett sum up:
“Leaving the question of price aside, the best business to own is one that over an extended
period can employ large amounts of incremental capital at very high rates of return.”
That isn’t necessarily going to be the business with the highest returns on net tangible assets.
But, it’ll never be a business with average or below average returns on net tangible assets. So,
you always want to start by demanding above average returns on unleveraged assets. Once you
know you have that, you can start worrying about growth.
 URL: https://focusedcompounding.com/unleveraged-return-on-net-tangible-assets-it-
only-matters-when-coupled-with-growth/
 Time: 2017
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My Investing Goal
“For the past months I’ve dug into your posts on Gurufocus…in this article you write about
Warren Buffett’s early years:
‘Warren Buffett was thinking about compounding wealth. He was interested in getting rich.’
This sentence piqued my curiosity a little. What (are) your goals and objectives in the stock
market? Is it getting rich, saving for retirement, or something not money related?”
I have zero interest in getting rich. Investing is a purely intellectual exercise for me. I love
writing and I love investing. My only financial goal is to make enough money so I never have to
do any work that isn’t either writing or investing.
A lot of people email me asking if I’d ever be interested in managing money.
The answer is no.
If I was interested in getting rich, the answer would be yes. The way to get rich in the stock
market is to manage other people’s money and manage it well. That’s what Buffett did.
For myself, I’d be really happy if I could:
 Save some money every year

 Put all the money I saved that year into just one new stock
 Keep that stock for the rest of my life
 Repeat annually till dead
I can do the likely compound math and see that would ensure an adequate result in my case. I’d
like the intellectual challenge of picking one and only one stock a year and never being able to
reverse that decision. But what I’d really love would be never being troubled by the constant
irritation of active portfolio management.
The only thing I like about investing is picking stocks. Nothing else about it appeals to me.
So, those bullet points are the routine I’d follow if I was just investing for myself and not having
to write about it for anyone else.
 URL: https://focusedcompounding.com/my-investing-goal/
 Time: 2017
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The Two Things Every Stock Picker Needs to Learn: Independence and
Arrogance
I get a lot of emails from people asking how to become a better investor. They usually have very
specific ideas about what would help them improve. For example, they think they need to get
better at reading 10-Ks and that would fix their problem. Or they think they need to get better at
deciding which stock to research in the first place. The truth is that most of the people I’ve talked
with and tried to help improve as investors suffer from the same mental block.
They think there is a right way and a wrong way to analyze a stock. They have – whether they
realize it or not, and I think usually they do not – a kind of moralistic view of how investing
ought to be done. They believe that if you do what you’re supposed to do, work hard, etc. you
will get a good outcome. Investing doesn’t work like that. Stock analysis doesn’t work like that.
It really doesn’t matter whether you are a very hard working, diligent researcher of stocks or a
lazy but brilliant one. There are no points for effort. Nor is there any degree of difficulty
modifiers. Often, the best ideas are easy to come up with. They don’t take much time to research.
They are 99% inspiration and 1% perspiration type ideas.
So, what do you need to be a good stock analyst? What is the key to hunting for and finding the
right ideas to bet big on?
You need a different, better way of seeing the stock than most investors do. I’ve talked about the
importance of “framing” an investment problem before. In my discussions with readers, I’ve
realized they really underestimate the importance of this. Yes, I read the footnotes to financial
statements, and I take notes on the 10-K, and I put together Excel spreadsheets. But there’s really
nothing in any investment thesis that’s going to flip the correct answer of whether to buy a
certain stock from a “no” to a “yes” or vice versa depending on whether the P/E is 14 or 18, the
projected future growth rate is 4% or 6%, the Net Debt / EBITDA ratio is 1.5 or 2.5. If
something as small as that can change your decision to invest – this stock probably isn’t worth
your time.
The investment ideas really worth having are all “framing” problems. You have to find a stock
where the way you frame the entire problem of analysis and appraisal is different from the way
other people frame that same problem.
Let’s start with two examples from my own portfolio. Right now, I have 40% of my portfolio
in Frost (CFR) and 25% of my portfolio BWX Technologies (BWXT). No other stock accounts
for more than 6% of my portfolio. So, these are really the only two stocks that matter in my
portfolio. In both cases, I framed the problem of appraising those stocks differently than most
investors probably did.
Let’s start with the smaller position: BWX Technologies. I bought BWX Technologies when it
was Babcock & Wilcox. That company had been separated from a larger public company –
McDermott International – about 5 years before and Babcock itself was expected to break-up a
second time into two units: BWX Technologies and B&W Enterprises. B&W Enterprises was a
highly cyclical engineering company tied especially to maintenance on coal power plants in the
U.S. and new build revenue on other types of power plants around the world that also used big
steam boilers. That is what united the two parts of Babcock. Both BWX Technologies and B&W
Enterprises had long experience engineering steam boilers for use in industrial power plants,
power plants owned by electric utilities, and the onboard nuclear power plants that power U.S.
Navy submarines and aircraft carriers. I was not interested in owning B&W Enterprises. I was
interested in BWX Technologies. That company’s profits came from its work providing nuclear
reactors and other critical components to 3 U.S. Navy projects: 1) aircraft carriers, 2) nuclear
ballistic missile subs, and 3) attack subs. It also made some profits from other nuclear work for
other parts of the U.S. government. For example, it down blended weapons grade uranium from
the level of enrichment that the U.S. military used in its nuclear weapons program to a level that
would allow civilian uses. And it also provided material to the U.S. nuclear weapons program.
There were some other businesses like maintaining nuclear power plants in Canada (where
nuclear reactors were built to a different design than the rest of the world). I thought nuclear was
a mature technology with a limited number of companies that had experience in it, with certain
national rivalries and security concerns that often kept foreign competition low, and – most
importantly – I thought it was an area most companies weren’t interested in entering. In Warren
Buffett’s terms: I thought BWX Technologies had a wide moat. In GuruFocus terms, I thought it
was inherently a “5-star” type predictable company. None of this showed up in the headline
financial data though. BWX Technologies had been part of a much larger company and then part
of a combined company with a unit that did work on coal power plants. Also, there was a unit
called mPower that was basically a skunkworks type project for an experimental modular nuclear
reactor (a nuclear reactor so small you could deliver it by train anywhere there was a rail line and
run it for years without needing to refuel).
Basically, the way I framed the problem was that I was looking at a crown jewel type business
that should trade at 20 to 30 times earnings in normal times. And yet, when you tried to take the
entire combined company – B&W Enterprises, mPower, and BWX Technologies – together and
value it, you saw the market was putting a P/E of 10 to 20 times normal earnings on the stock.
There really were not big differences in any sort of math here between what I saw and what
anyone else saw. I had perhaps slightly more aggressive targets for the unit that became BWX
Technologies over the next 5 years than others might have (but I was basing that on BWXT’s
announced backlog, the U.S. Navy’s announced long-term plan for its capital ship needs, etc.).
There was nothing very math-y about any of my calculations. There were a couple key
differences to how I saw the stock. One, was deciding that mPower had a value of zero – not a
negative value as some investors might have put on it if they lumped in its EBIT loss each year
with the EBIT profit of the established businesses and then slapped a multiple on the corporate
EBIT as a whole. Two, was deciding that BWX Technologies was really as blue as a blue chip
stock could get and should trade at a P/E of 25 or whatever companies like Coca-Cola, Colgate,
etc. deserve – because its future seemed as certain and as profitable to me as those kinds of
companies. And then the last part was that I decided to buy the stock right then – when it still
consisted of mPower, B&W Enterprises, and BWX Technologies all together and hadn’t
technically announced for sure that it was definitely going to split up on such and such a date.
So, my way of framing the problem was to say that BWX Technologies was a wide moat,
predictable company worth 25 times earnings and you could buy it now if you’d just put up with
some waiting time and uncertainty about when mPower would be shut down and when the spin-
off would take place. In retrospect, you could have done fine in BWX Technologies by making a
different decision than me on that last one. You could have waited till BWX Technologies was
trading cleanly on its own. You couldn’t – however – have made as much money if you waited a
full year or so for BWX Technologies to report a full year on its own, give long-term EPS
growth guidance, etc. So, to me, BWX Technologies is an investment that is all about how you
“frame” the problem. I didn’t see anything other investors didn’t. I just saw the stock differently.
I saw it as this blue chip unit hidden in a hodgepodge of 3 different business units that were
muddying the reported results.
My bigger position is in Frost. This is an extreme example of kind of crunching the numbers
exactly the same as other investors do – but just choosing to focus on different numbers. I think
Frost is – in normal times – one of the most value creating banks in the country. Let me explain.
Frost has some of the lowest “all-in” funding costs per dollar of deposits. Banks pay two types of
costs for their deposits. They pay interest. And then they pay everything else – branch costs, the
cost of providing you with a nice website, moving your money around at no extra cost, etc.
However, banks also charge fees. Frost doesn’t charge much in fees. It charges very little relative
to what it provides. But, for some – especially big – banks fees are a huge offset to services. So,
the way I look at banks is simply to add up what I think normal interest expense is and normal
NET non-interest expense (cost of services less revenue from fees) and then divide that number
by the bank’s deposits. If you do this, you get an “all-in” cost of funding which might be 2%,
4%, 6%, etc. Right now, if it’s 6% – that bank’s not worth anything. Banks make loans which
aren’t better investments than government bonds, mortgage backed bonds, corporate bonds, etc.
So, the way I “frame” the problem of valuing a bank – money is a commodity. Loanable funds
are the same as investable funds. I don’t care if you are a life insurer that is buying long-term
corporate bonds, a bank that is making loans to small businesses, or a sovereign wealth fund that
is buying U.S. Treasuries. The asset side of your balance sheet is basically the same. I’m not
going to be interested in an investment because of what the financial firm owns. I’m only
interested in what it “owes”. I am interested in an insurer for its float. I am interested in a bank
for its deposits.
Many banks use some liabilities other than customer deposits. These tend to be expensive.
Frost’s balance sheet is pretty close to fully funded by shareholder’s equity (a little bit) and
customer checking and savings accounts (a big bit). I don’t want them to use a lot of
shareholder’s equity – that’s “my” money that they’ve had to retain. What I want them to use is a
lot of low-cost, stable deposits. That is their “float”. If Frost can invest in 4.5% bonds the same
as everyone else but it can fund deposits at an “all-in” cost of 2.5%, then it can make a 2% pre-
tax profit on this “float”. And then I think Frost is a bank with a higher than average retention
rate. Although I can’t definitively prove it, there’s evidence that Frost’s retention rate is the equal
of any other bank in the U.S. A bank with a higher retention rate will grow deposits faster than a
bank with an industry average retention rate. And then Frost is in Texas. Texas will grow its
economy – and its banking deposits – faster than the rest of the country. So, the way I “frame”
Frost is that I see a bank with low cost float that is going to grow that float faster than other
banks (including banks with much higher cost float). I may or may not be right about that.
However, I’m definitely different in doing that. I value Frost purely on deposits per share and the
growth rate in deposits per share. So, if Frost had $200 a share in deposits and was growing
deposits at 6% a year, I’d use a multiplier (it’s always actually a fraction less than 1) to multiply
the deposits per share by to get a valuation figure. So, I might say that Frost is – if growing
deposits by 6% a year – worth somewhere between 0.25 and 0.35 times deposits.
I don’t care what the P/E is today. I don’t care what the price to tangible book value is. I also
don’t care what the “efficiency ratio” is (this is costs as a percent of revenue) because I always
think in terms of costs relative to deposits never costs relative to revenue. And I don’t think
about net interest margin. Float will appear to be less valuable in low interest rate environments
and will appear to be more valuable in high interest rate environments. However, bank customers
rarely switch banks or pull their deposits – so a dollar you add to your “float” in a low interest
rate environment will eventually be an extra dollar you have in the next high interest rate
environment.
I bought Frost a couple years ago. Before buying it, I analyzed and appraised it. When I valued
Frost this way, I got an appraisal that was something like 2-3 times the then current stock price.
Frost was then trading at 0.16 times its deposits while I valued the stock at 0.37 times deposits.
This is what I mean by an investment not being about seeing something others don’t and instead
being about seeing the entire stock analysis problem differently. If I had framed Frost as
something to be valued on the basis of the current P/E, P/B, etc. I would have seen the P/B was
high and the P/E was a fairly normal 14 or so. Frost was – at the time I bought it – about the most
normal looking stock you could find in terms of P/E, dividend yield, and EPS growth rate. It
looked like a boring and correctly valued stock.
I looked at it differently. I valued the stock for the low cost “float” provided by its deposits. I
didn’t look at the reported EPS growth rate from 2008-2014. Instead, I looked at the deposit
growth rate from 2008-2014. And I didn’t look at what that float would provide in interest
income when the Fed Funds Rate was 0% (as it was when I started looking at Frost). Instead, I
looked at the interest income Frost would take in when the Fed Funds Rate was 3%.
What I am outlining here may seem like a boring rehash of the investment cases for two stocks I
already own and which you can no longer buy at anywhere near the prices I paid for my shares.
But, the process I am laying out here is one of the most important parts of successful investing.
There is an intellectual pillar to good investing and there is an emotional pillar to good investing.
The intellectual pillar is seeing things differently than others see the stock. The emotional pillar
is holding on to your shares while others continue to see the stock the way you think is wrong.
There isn’t much I can do to help anyone with the emotional pillar of good investing. But, the
answer to mastering the intellectual pillar is easy. You need to be more arrogant and
independent. You need to be independent minded enough to be willing to frame the problem of
appraising a stock in a way that is completely different from the approach everyone else is
taking. And then you need to be arrogant enough to recognize that sometimes – far less than half
the time, but yes, sometimes – your view is so clearly correct and yet so clearly at odds with the
standard valuation approach, that you need to act on it.
I know it’s scary to think that way. Suggesting that most value investors I’ve come across lack
both the independence and the arrogance to carry out a good, contrarian analysis and pounce
seems like dangerous advice. But that’s what stock picking is. If you want to use “standard”
approaches with the Ben Graham stamp of approval or something like that – you can. I think
that’s a great approach. But, it’s a basket approach. You don’t need to spend a lot of time
“picking” specific stocks along the traditional value metrics of price-to-book, EV/EBITDA, etc.
If all banks are cheap enough – buy a basket of 5 of them, don’t try to select one over another.
But, if you want to invest a lot of time in picking one stock over another – the only sensible
approach is to up your level of intellectual independence and arrogance to the levels you see in
someone like Warren Buffett.
If you’re going to pick specific stocks, you have to trust your analytical abilities enough to allow
you to create a model of a stock that differs from the standard model. Every stock pick is an act
of arrogance. If you don’t think you’re capable of seeing a stock more clearly than the market –
get out of the game.
In 99 cases out of 100, I’m not capable of seeing a stock more clearly than the market. But, when
I do act – it’s usually because I have the intellectual independence and, yes, arrogance to believe
I’m framing the investment problem more clearly than the market is.
 URL: https://focusedcompounding.com/the-two-things-every-stock-picker-needs-to-
learn-independence-and-arrogance/
 Time: 2017
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How to Read Between the Lines of a 10-K
Question
“I have read some of your Singular Diligence content and one of the most interesting parts of
the reading are the notes that you and Quan used and published in those reports.
So one of the most remarkable things that I have noticed in the notes is that you did not use a lot
of information in the annual reports. And this sounds intriguing to me since I am a regular
reader of your blog and you have always emphasized how important it is to read (the) 10-K,
annual reports, (and) quarterly reports. Having said that, it would be good to understand why
did you not use more info from those sources. Moreover, I was actually curious how do you
allocate your time when doing research? I am currently also doing research so I was looking to
see which sources you prioritize?”
Answer
It depends on what you mean by prioritize? If a top priority is the thing you read first, then I
make 10-Ks a top priority. If a top priority is the thing you spend the most time on, then SEC
filings are a low priority. And then, if a top priority is something you quote a lot – as you
mentioned – SEC filing are a very low priority for me.
I’ve said before that I always read the newest 10-K and the oldest 10-K of a stock I’m
researching. So, imagine I am researching a U.S. stock that has been public for a long time. The
SEC’s database of company filings – which includes 10-Ks (annual reports), 10-Qs (quarterly
reports), and “going public” or spin-off documents if the company has any of those. If the
company has been public in its current form for a long time, the oldest annual report (10-K) will
be something from maybe 1994-1996. That’s around the time companies started being required
to file electronic copies of their 10-Ks with the SEC. As a rule, a U.S. company that has long
been public will now have about 20 years of annual reports for you to read in full.
Don’t do that. I just read the 2016 (last year’s) annual report and then the 1994 or 1995 or 1996 –
or whatever the oldest report you can find is – annual report. I want to get a sense of how the
business has changed.
The 10-K – when read on its own – is of limited value when making an investment. All of the
financial data that Quan and I used to create the “datasheet” of a Singular Diligence comes from
the 10-K. So, the financial statements – especially the income statement, the balance sheet, and
the cash flow statement – are useful. The datasheet we presented was usually a 15-25 year
history of a company’s finances. It’s by far the most important thing in those reports. It may be
possible to make an investment based purely on the financial statements if you have both income
statement and balance sheet data for at least 15 years and preferably closer to 30 years. I’m not
going to say that qualitative judgments are entirely unimportant – but long-term historical
financial data is by far the most important source of information an investor will ever see. A
great investor – like Warren Buffett – will often be able to make the decision to invest in a
business or not invest in a business based on just 15-30 minutes spent with 15-30 years of past
data. Most people don’t believe this. But, it’s true. If you know a lot about how businesses
normally look, what ratios are normal, what years were good or bad years in the economy, etc.
and you have 15-30 years of really detailed history in front of you – you have 90% or more of
the information you need to make an investment. The difference between ordinary and
extraordinary businesses jumps out at you in the long-term financial results. Honestly, it doesn’t
take even 60 seconds to discard at least 50% of all investment opportunities based purely on their
15-30 year past financials.
But, I will assume you are asking about the written part of the 10-K – the text the company
includes. This text is of limited value for a number of reasons.
One, like accounting data, the business summary and executive summary of the past year’s
operations and so on in the 10-K are created in a way to increase comparability. Comparability is
a double edged sword. For example, under U.S. GAAP (Generally Accepted Accounting Rules)
there is a high degree of comparability in the way earnings per share are presented for all
companies. We are given an EPS figure for every public company. And those EPS figures are
calculated in a similar way for all of them. Certain rules are followed.
How helpful are those EPS figures in making decisions about what a business is worth?
Sometimes, not very. For example, railroads and ad agencies both report EPS. As I’ve said
before, a railroad trading at 20 times earnings is much, much more expensive than an ad agency
trading at 20 times earnings. The management of both the railroad and the ad agency knows this.
Analysts and investors who specialize in those two industries know it too. But, there isn’t a lot of
care given in the 10-Ks of either railroads or ad agencies to explain the actual underlying cash
economics of their respective businesses and to explain why EPS is not a good guide in either
case. I cherry-picked two unfair examples. But, there are many more industries where reported
earnings in any one year can be very misleading. Insurance and bank results for any one year
aren’t really helpful. Management has wide discretion in reserving for losses in both cases. Both
insurers and banks are sensitive to the level of interest rates. They are also sensitive to the
“animal spirits” – basically the carefulness or recklessness – of competitors. In interviews that
management does with the media (or with you if you try to approach them and they answer your
email, take your phone call, etc.) they will be more open about the actual numbers that matter.
So, we tend to get more of our notes from articles (that quote management, analysts, etc.),
interviews with branch managers, customers, etc., earnings call transcripts, investor
presentations, etc. We also get a lot of notes from competitors rather than from the company
itself. In fact, it’s possible we tend to cite non-10-K sources from competitors more than we cite
the company’s own 10-K.
This has to due with the usefulness of the info we can get – especially the candor. Candid
information is the most valuable information. 10-Ks aren’t very candid. You need to have read a
lot of 10-Ks to be able to read between the lines.
In the U.S., the text portions of 10-Ks tend to be very, very conservative compared to what you
will find in the presentation of official annual results in other countries. There a couple reasons
for this. One, American business culture is less promotional than what you will find in some
emerging markets. It’s not less promotional than what you will find in Japan, the E.U., or the
U.K. though – and yet, the annual reports of American companies are often far more
conservative in their dire phrasing of business risks, etc. than the annual reports of those
companies.
The reason is probably the influence of legal advisors on how a 10-K is written. Lawsuits are
common in the U.S. Bad press is common in the U.S. And very few American investors actually
read the 10-K. So, putting bad stuff in the 10-K is a good way to avoid lawsuits and muckraking
reportage later if things do go bad for your company. You can always point to the 10-K and say
those risks were disclosed – often in the most dire yet broad and ambiguous ways – when you are
accused of tricking investors into believing your stock was a better investment than it turned out
to be.
For this reason, you have to get very good at reading between the lines of a 10-K. For example,
there is a section of a 10-K that tells you about competition. The normal, boilerplate statement
here basically consists of three parts:
1. The industry is “highly competitive” or “competition is intense”

2. The company has competitors who “are larger”, have “greater financial resources”, than
the company
3. The company competes on the basis of “price”
Finding any of those phrases in a U.S. 10-K means absolutely nothing. All U.S. companies tend
to say in their 10-K that their industry is highly competitive, some competitors are larger, have
established brand names (if that matters in the industry), and have greater financial resources
than the company. And they all include a series of factors on which they compete of which
“price” is the most common.
So, a lot of beginning investors reading a 10-K with those warnings will take them seriously.
They might even highlight those terms, write about them when they blog about the stock (if
they’re a blogger), etc. They believe this is part of good due diligence.
It’s really not. That’s just boilerplate. It is only the omission of those phrases that is worth paying
attention to.
Anything in a 10-K that is ordinary needs to be ignored. You only need to highlight, take notes,
remember, etc. those parts of the 10-K that are extraordinary. All the normal stuff you can forget
the second you read it. All the abnormal stuff you need to remember forever.
For example, if a company does not say it competes on the basis of price – that’s a statement of
extraordinary importance. It may be the most important thing you “read” in that 10-K. And yet,
almost no U.S. company will ever say “we believe price is not a primary basis on which we
compete”. Yet, some U.S. companies will omit “price” from the list of factors on which they
compete.
I’m going to test your 10-K reading ability with this excerpt from the most recent Landauer
(LDR) 10-K:
“In the U.S., the Company competes against a number of dosimetry service providers. One of
these providers is a division of Mirion Technologies, Inc., a significant competitor with
substantial resources. Other competitors in the U.S. that provide dosimetry services tend to be
smaller companies, some of which operate on a regional basis. Most government agencies in the
U.S., such as the Department of Energy and Department of Defense, have their own in-house
radiation measurement services, as do many large private nuclear power plants. Outside of the
U.S., radiation measurement activities are conducted by a combination of private entities and
government agencies.
The Company competes on the basis of advanced technologies, competent execution of these
technologies, the quality, reliability and price of its services, and its prompt and responsive
performance.”
Okay. Go back and read it again if you have to. I’m about to highlight the parts of that paragraph
and a half that matter – and matter in such a big way that you’d immediately latch on to
Landauer as a possible wide-moat company. Here are my highlights:
“In the U.S., the Company competes against a number of dosimetry service providers. One of
these providers is a division of Mirion Technologies, Inc., a significant competitor with
substantial resources. Other competitors in the U.S. that provide dosimetry services tend to be
smaller companies, some of which operate on a regional basis. Most government agencies in
the U.S., such as the Department of Energy and Department of Defense, have their own in-
house radiation measurement services, as do many large private nuclear power plants. Outside
of the U.S., radiation measurement activities are conducted by a combination of private entities
and government agencies.
The Company competes on the basis of advanced technologies, competent execution of these
technologies, the quality, reliability and price of its services, and its prompt and responsive
performance.”
So, what was hidden between the lines in Landauer’s discussion of competition?
1. “against a number” – This is an unusual way of phrasing the number of competitors. It is

normal for the 10-K to say something like “a large number”, “many”, “highly
fragmented”, etc. when describing the number of competitors. Saying “a number”
suggests the company may not have felt it was reasonable to use such terms because they
would be an excessive exaggeration. This phrase suggests there may be only a small
number of national competitors to Landauer.
2. “One of these providers” – This confirms the hint in phrase #1. It is rare for a U.S.
company to cite a competitor by name. When a company you are reading about names a
single competitor outright, you can be confident the industry has only a small number of
major players. When the company you are reading about provides the names of maybe 3-
5 competitors, we may be talking about more of an oligopoly type situation. Companies
in truly competitive – and especially nearly perfectly competitive industries – will not
give you the name of specific competitors.
3. “tend to be smaller companies, some of which operate on a regional basis” – This is their
way of telling you – without being promotional – that Landauer is larger and more
national in scope than almost all companies in the industry.
4. “own in-house” – You might have missed this one. It’s actually one of the most important
lines in this paragraph and a half. Companies that face little actual competition tend to
talk about in-house competition. For example, an ad agency, IT services provider, etc.
that doesn’t really have a lot of competition may say that they “compete” with their own
customers in the sense that their customers could choose to provide these services for
themselves without hiring out the work to an external firm. Think about this. Most
companies face this problem. Yet, they don’t mention it. All restaurants compete with
cooking at home. All car companies compete with people taking buses and trains. They
don’t make a big deal of it. Why not? Because they have plenty of competition among
themselves (in the industry). When a company starts insisting they compete with “in-
housing”, you know you’re dealing with an industry with limited competition among the
players.
5. “and price” – It’s unlikely Landauer competes primarily or maybe even secondarily on
the basis of price. The way they say “and price” here is really buried. The actual phrase is
“reliability and price of its service” which is presented between two commas and yet it’s
not the final item in the list – “prompt and responsive performance” is the last item in the
list. In English, it’s hard to de-emphasize something any more than connecting it with an
“and” within a list where some items are stated on their own (see “quality”), and where
the item is presented neither as the first nor the last item in the list. No one is going to
remember the word “price” was even in that sentence. Important items are listed first or
last in a series, are not paired with other items between two commas (“milk and cookies”
de-emphasizes both milk and cookies as standalone snacks if you list them together like
that).
So, there’s a ton of information I’d get out of that paragraph and a half of the 10-K. But, then I’d
just use them as “leads” and go investigating what the company meant by what it said and try to
confirm that with customers, sales people, etc. I could talk to. I’d look for what confirms this or
challenges it in any earnings call transcripts, etc.
The most important textual parts of the 10-K are the business description and the competition
sections of the 10-K. However, the company is unlikely to include much of the most important
competitive information in the 10-K. In the 10-K, companies rarely provide detailed estimates of
key facts like:
1. Market share
2. Relative market share
3. Customer retention rate
They also often include competitive strengths that rarely matter in most industries – like patents
and “people” – while excluding discussion of factors like location that are much more likely to
be important.
For example, I’ve researched companies in industries where imports into the U.S. are not a
realistic way of competing because of the low value/weight ratio of the product and the desire of
customers to have low inventories of the product on site while having jobs done when scheduled.
Under those conditions – where prompt delivery of a product with low value to weight is what
all customers want – there is no risk of foreign competition. And yet, in the 10-K, the only
disclosure of this fact was something like “because imports are usually less than 1% of U.S.
consumption and exports are small, industry data is traditionally compiled using domestic
production data alone”. I made up that exact quote. But, it’s very close to statements I have seen.
Those kinds of things are very, very important to notice.
But, even in those cases, the most useful data wasn’t in the 10-K. Instead, a mention like that of
imports being immaterial lead me to the industry report compiled by someone like the U.S.
government or a trade association which gave long-term data showing that throughout all of
history, neither imports nor exports were the least bit meaningful. Knowing that history, you
know that competition has to be very localized.

This is usually how the research works. The 10-K is important in providing an original lead –
usually from reading between the lines, nothing explicitly stated – that gives me questions I then
write down to use in investigating the earnings call transcripts, discussions with customers or ex-
employees or whoever, industry reports, media reports, etc.
If you look at the Singular Diligence reports, I think you’ll notice I am biased toward 3 things
being really important in making an investment:
1. What is the company’s market power – is it going to get stronger or weaker?

2. How does management allocate capital – is it going to get better or worse?
3. What is the stock’s price – will investors value it more highly or less highly in the future?
If you can answer those three questions by saying:
1. Market power is strong and getting stronger

2. Capital allocation is smart and getting smarter
3. Stock price is cheap but won’t stay cheap once the stock’s back in favor
You have the perfect stock. It’s hard to do much research into “market power” which is my
number one criterion using the 10-K. Even things like capital allocation sometimes require a
little context outside of the 10-K.
The 10-K is most important for the financial data it provides. It is also important for its
discussion of how the business works and how competition works. All other parts of the 10-K
are of limited use. I read the 10-K as a first step. Sometimes, I have found things in a 10-K that
made me decide to eliminate the stock from consideration. I’ve never found a 10-K that got me
100% of the way to deciding to invest.
Long-term (15-30 year) historical financials are much more important than the 10-K. But what
you can get out of reading those financials or reading the 10-K depends a lot on how much prior
investing experience you have. If you have been looking at long-term financial histories (Value
Line / GuruFocus type presentations) and 10-Ks for a long time, you can often get more out of
them in 60 seconds than the average investor can get out of reading them for 60 minutes.
If you and Warren Buffett both read a 10-K, it can’t really be considered the same 10-K. There is
a lot more he can get out of it than you can get out of it, because he brings the context of mastery
of finance, business, and economics that comes from decades of experience.
 URL: https://focusedcompounding.com/how-to-read-between-the-lines-of-a-10-k/
 Time: 2017
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How to Judge a Company’s Bargaining Power With its Customers and

Suppliers
A Focused Compounding member asked me this question:
“…what are the factors we should be thinking about when assessing the bargaining power of a
given business relative to its customers and suppliers?”
In an earlier memo, I talked about “market power”. My definition of market power is the ability
of a company to make demands of its customers or suppliers without fearing that such demands
will end their relationship. Why would a supplier or customer agree to demands without
considering ending the relationship?
Dependency.
Recently, it was reported that Wal-Mart will start fining suppliers for delivering early as well as
delivering late. Wal-Mart wants to manage inventory in their stores. So, they want to make sure
that orders arrive on-time and in-full. Many suppliers to a retailer like Wal-Mart don’t have a
good track record when it comes to making sure 100% of the order is there on the scheduled
day. This causes problems for retailers. For example, I was at Costco last week and picked up
the very last box of Eggo waffles available in that store. A few days later, there were several
dozen boxes of Eggos – all containing 72 waffles each – stacked sky high. Everyone who came
to Costco after I did was either looking for their usual supplier of frozen waffles and didn’t get
them – or they have no idea Costco even sells Eggo products. Getting a supplier to deliver on
time and in full sounds like a small thing, but a business model like Wal-Mart depends on
keeping inventory at the right level. Wide selection in store is Wal-Mart’s main advantage. In
most of the towns Wal-Mart is in it’s the offline “everything store” that Amazon aspires to be
online. It is the only place to make a true one-stop shopping trip. If shelves are bare of any items
at all – shoppers go away disappointed. Too much inventory obviously causes problems for
shareholders – it ties up more capital and lowers free cash flow for the year – but it’s also a
problem for employees. Because of the way Wal-Marts are run, employees spend a lot of time
in areas shoppers don’t see. Sometimes, those areas aren’t the most pleasant places to work.
When they are overcrowded with inventory, they became very unpleasant places to work.
Wal-Mart has a lot of bargaining power with some suppliers. Mostly, these seem to be suppliers
that have gradually become dependent on Wal-Mart over time. This could happen for a few
reasons. One of the most common reasons you see is chasing high growth in slow growth
industries. So, if a company was in the soda business or the cereal business and Wal-Mart was
quickly expanding around the nation during the 1970s, 1980s, 1990s, and early 2000s – such a
company might have tried to grow faster than its category by selling a greater share of its
product to faster growing retailers like Wal-Mart. This sounds like a good idea at the time. It
allows the company to grow faster than its competitors and faster than its product category. But,
there’s a problem here. A faster growing retailer will become a retailer with greater scale than
the slower growing retailers. Is it really a good idea to sell through Amazon, Wal-Mart, Costco,
and Home Depot? Or, is it a better idea to sell to smaller chains, regional chains, and slower
growing chains?
The other reason a supplier might become dependent on a certain customer is that the customer
controls access to a desirable demographic group. Wal-Mart has a fine position across the
country. In certain categories and certain states – the company’s position isn’t really that
impressive. For example, I wrote a report about a supermarket in New Jersey called Village
(VLGEA) that operates Shop-Rites. If you are selling perishables like fruit, vegetables, meat,
seafood, and fresh bread – you can ignore Wal-Mart if your focus is New Jersey. Wal-Mart isn’t
a leader in those categories in that state. Likewise, if you are interested in selling food in Florida
– you shouldn’t focus on Wal-Mart, you should focus on Publix. In Texas, you shouldn’t focus
on Wal-Mart – you should focus on H-E-B. But, if you are interested in selling to certain groups
of people (lower income) and certain parts of the country (rural) – you would need to sell to
Wal-Mart to reach those groups. For example, I was recently in a very rural part of Oklahoma.
In a place like Northern New Jersey (where most of Village’s Shop-Rite stores are located) there
will often be 2-4 good food store choices within 5-15 minutes. Out in the part of Oklahoma I
was in, there’s 1-2 food store choices within a 20-30 minute drive. None of Wal-Mart’s
competitors in the area (they’re all local) really offer anything in food that Wal-Mart doesn’t.
And then Wal-Mart offers you the option of buying everything else at the same time. When
driving to any store of any kind takes 20-30 minutes instead of more like 5-15 as in highly
populated areas – that’s a real advantage. Also, the difference in income levels between where
Village is in Northern New Jersey and where I was in rural Oklahoma is big. I’d guess people
average an income level about 65% lower in the part of Oklahoma where I was relative to the
part of Northern New Jersey where I grew up (and where Village’s stores are). So, serving a
customer like Wal-Mart can be the only good way to sell to very poor and very rural areas. The
companywide figures often don’t illustrate this well. Wal-Mart is everywhere in the United
States now and it sells to some wealthier and more suburban customers. But, there is a part of
the company’s store base – think the 20% of the chain that is in the most rural locations – that
serves a customer base you really can’t reach without becoming dependent on Wal-Mart.
If you imagine the difficulty of reaching different demographic groups, you can see why a
supplier would become dependent on retailers like Amazon or Costco. Also, all of these
companies – like all popular retail concepts – had a very fast growth period where selling to
them would drive faster than industry growth for your company.
So, asking whether a supplier gets a large portion of its sales from a single customer (the
percentage of sales – if more than 10% – is included in the 10-K) is a good first check. A second
question to ask is whether this percentage is bigger than the supplier’s competitor’s sales to the
same company. For example, if Hanes gets 20% of its total sales from Wal-Mart – does Fruit of
the Loom get 10%, 20%, or 30% of its sales from Wal-Mart. If the answer is that they get the
same amount of sales, this lowers the concern of insufficient bargaining power. If the answer is
that the supplier you are looking at gets more of its sales from a single customer than
competitors usually do, that’s a possible red flag.
The next step is to look at the flipside, how much of its purchases within a category does a
buyer allocate to this supplier. This is – in rough terms – very easy to check in retail. One Wal-
Mart is pretty much like any other Wal-Mart. So, if you want to know how much of its
underwear needs Wal-Mart buys from Hanes, Fruit of the Loom, etc. you just go to a Wal-Mart
and check it out. If a battery maker says they get 20% of sales from Wal-Mart, but you see 50%
of shelf-space for batteries dedicated to this company’s brand – then is Wal-Mart more
dependent on the supplier or is the supplier more dependent on Wal-Mart? There’s a tendency
for investors to worry a lot about investing in a supplier who gets a lot of sales from a certain
customer. I see this all the time in write-ups on blogs and by analysts, etc. What I don’t see
enough is a discussion of depending too much on a single supplier.
This can happen to any company. Even a very big company can – if it’s not careful about how it
fulfills its needs – become dependent on a single supplier. For example, Wal-Mart allowed itself
to become dependent on Cott for its private label beverage needs. Wal-Mart wanted to sell more
private label beverages. That’s fine. But, Wal-Mart is big and its national. And, honestly, there
just aren’t that many companies in the U.S. and Canada who could supply you with things like
soda who aren’t themselves owners of big brands like Coke, Pepsi, or Dr. Pepper. So, if you
want to get away from just selling Coke, Pepsi, and Dr. Pepper products – you’re very likely
going to end up dependent on a single supplier like Cott. If it was easy to get private label soda
on store shelves – everyone would do it. The big manufacturers don’t just have the brands
customers want most – they also have the best distribution and lowest unit costs due to their big
scale and very long histories in each region. To match that kind of scale and get good prices on
private label stuff – you’re often going to have to commit a lot to private label, focus on giving
all your private label business in a category to just one supplier, and sometimes even guarantee
buying a certain amount or buying exclusively from a certain supplier for a number of years.
When Wal-Mart buys a ton of underwear from Fruit of the Loom or Hanes – it doesn’t have to
do any of that. It buys whatever it needs whenever it needs it.
So, that’s one example. Wal-Mart became dependent on Cott. Years ago, I read a lot of posts
about how dangerous this situation was for Cott. I didn’t read much of anything saying that
Wal-Mart had become dependent on Cott, because its private label needs had far outgrown what
other suppliers in North America could hope to meet. The scale of what they needed to buy and
where they needed it (everywhere) had grown too big to smoothly find another supplier.
This actually happens a lot. Really big customers can find themselves in situations where they
need a really, really big supplier – and there usually aren’t many. I own shares of BWX
Technologies. BWXT supplies very nearly all of the critical components needed for a shipboard
nuclear reactor. The U.S. Navy uses BWXT exclusively for all its reactor needs for aircraft
carriers and submarines. The U.S. Navy has long been 100% nuclear powered for its carriers
and subs. So, as long as the U.S. Navy feels it needs to buy carriers and subs and that they have
to be nuclear powered – the U.S. Navy is dependent on BWX Technologies. Of course, BWXT
is completely dependent on the U.S. Navy. I feel there would be no BWXT without a U.S.
nuclear powered navy and there’d be no U.S. nuclear powered navy without BWXT. There is a
tendency to pay a lot of attention to the risk that the U.S. Navy could put BWX Technologies
out of business without paying enough attention to the risk that the U.S. Navy couldn’t have
nuclear powered ships without getting the reactors from BWXT.
In these kind of bargaining situations, you’ll often find that the best position is to bet on the side
of the table which cares most about the price/cost and which has more at stake. Usually, you
want to look for situations like BWXT where reactors are an important part of the Navy budget,
but they’re only part of a few very key projects for the Navy. And, most importantly, the Navy’s
priorities aren’t really to spend less on ships in total. The U.S. Navy isn’t a for-profit business. It
likes having more ships and better ships and higher budgets every 5-10 years. Yes, it wants to
economize. But, it often wants to economize by spending less on this ship so it buy some other
ship. As I’ve written before, I think the Navy would be about as excited by the prospect of
buying a run of 11 subs for the price of 10 subs rather than 10 subs at 10% less per sub than it
originally expected to pay. In other words, the Navy is open to getting 10% more ship for the
same price rather than the same ship for 10% less money. That’s not how a for-profit business
works. Many for profit companies have a specific need and want to buy that quantity at the
lowest cost to save money they will then convert into profit or use somewhere else in the
industry.
The strongest bargaining power is when the firm on the other side of the table won’t seriously
consider terminating the relationship. This is always the most powerful bargaining chip. So, any
business where customers are afraid of serious disruption if they dump the current provider is in
a good position. For example, households are reluctant to switch banks, brokers, etc. And banks,
brokers, etc. are reluctant to switch any sort of custodial relationship.
Some industries have nearly perfect client retention. The best example of this is advertising
agencies. Very big brands almost never switch ad agencies. Over time, the various marketing
functions of the client and a lot of different specialties inside the agency become entwined in all
aspects of positioning a brand, creating campaigns, researching customers, etc. Consumer brand
companies do replace their agencies. But, they don’t really replace their agencies more
frequently then they make desperate shifts in corporate strategy like firing the CEO or selling
the entire corporation to a competitor, private equity owner, etc. Each of those events is as likely
as firing the ad agency.
Bargaining power for a supplier is often good when:
Customer buys all or most of its needs in a category from a single supplier
Customer can’t vet possible alternative suppliers ahead of time without causing problems
There is a large gap between the “price” the supplier charges and the “cost” as the customer
calculates it
The buyer can serve as a middleman that puts the supplier and customer on the same side versus
the end consumer
A good example of #4 would be Apple. In a sense, Apple – and other device makers – depend a
lot on wireless carriers getting end customers to buy the product in a certain way. If the average
phone user bought Apple products using cash from their own pocket, paid instantly, in a Wal-
Mart type setting next to other competing models – Apple wouldn’t be such a good business.
But, a lot of people who have iPhones aren’t even sure exactly how much they are really paying
for the phone as opposed to the plan. This works well for both a company like Verizon and a
company like Apple though. They are both in a position of trying to maximize the lifetime value
of customers by getting phone users to pay a lot more for a lot longer than they otherwise
would. They both benefit from making pricing very opaque.
I would say that #3 is usually the most important. Whenever you are looking for a business you
think has bargaining power, you want to find a company where the price it receives is not what
the customer considers the cost to be. For example, a customer that already owns original
equipment and now is going to buy replacement parts and maintenance services (a “razor and
blade” business) is a good customer not just because they are locked into buying parts and
services. They are a good customer, because their “cost” is – in their eyes – usually calculated as
downtime rather than the price of the parts and services. The cost of grounding a helicopter in
your search and rescue fleet, shutting down an escalator in your department store, delaying a
construction project, etc. because of missing parts and services is not usually calculated in terms
of the purchase price at all.
Finally, I should talk a little about “switching costs”. All economists and some value investors
talk about “switching costs” as being the explanation to many “moats”. I think the term
“switching costs” is misleading. The cost in switching banks is really not that high. I researched
a dominant company – Breeze-Eastern – in the helicopter rescue hoist industry. It was explained
to me time and time again that engineering the necessary changes to make a helicopter work
with a competitor’s hoist is neither expensive nor difficult to do. Yet, it’s something that’s very
rarely done. That’s the only part that matters to investors. If switching is “very rarely done” –
that’s all we need to know. We don’t need to seek a rational explanation for this behavior. If
someone thinks Coke and Pepsi taste basically the same, cost basically the same, and are
available at basically all the same places – there is still a “moat” around Pepsi if that customer
always buys Pepsi without checking the price of Coke. What matters is that someone is loyal
enough to buy one brand without checking the other. And, in fact, what I just described is fairly
typical behavior. A lot of soda drinkers will substitute Coke for Pepsi or vice versa when that is
what a waiter tells them they must do. However, that same customer will always buy their
preferred brand in the store without checking the price on the competing product. That’s all that
matters. Does the customer do any “comparison shopping”? You always want to look for
situations where the customer won’t comparison shop. They just never start the process. That’s
almost always how banks keep their depositors. Depositors – once they’ve been with a bank or a
few years – simply never again compare different banks. That’s always what you want to look
for – customers who never enter “search mode”. If they aren’t looking at the alternatives –
you’ve got them for life.
I give the example of phone makers and wireless carriers being an industry where two
businesses often have interests that align to their benefit at the expense of the end user. Often,
especially in retail, the interests of the supplier are different from those of both the buyer and
end user. For example, I do very close to 100% of all my shopping at just two places: Amazon
and Costco. Those are good places for households who buy there. I’m not sure they are good
places for suppliers who sell to them. If I was running a business, I wouldn’t be looking to sell a
lot at Amazon or Costco. I’d avoid customers like Home Depot too. Some of the best positioned
companies do just that.
Focused Compounding members can read my report on Hunter Douglas. That company had not
– until it made an acquisition recently – really sold anything through stores like Home Depot
and Lowe’s. And yet it’s by far the leader in blinds and curtains in the U.S. Sherwin-Williams is
the leading paint brand in the U.S. It’s also been one of the best performing true “buy and hold”
investments you’ll ever find (SHW stock has returned 16% a year for 40 years). And yet,
Sherwin-Williams mostly sells through about 4,000 company owned paint stores. In the long-
run, having the kind of market power that Sherwin-Williams and Hunter Douglas have will
often get better results for the stock than selling more and more to a fast growing customer who
you come to depend on.
The best example of a company deliberately growing its market power over time is Luxottica.
As a member, you can read that report in the Focused Compounding “library” as well. The
merged Luxottica-Essilor will have even more market power because it combines the world
leader in eyeglass and sunglass frames with the world leader in eyeglass lenses. If you want to
learn about market power, I’d suggest you study the history of Luxottica under Leonardo Del
Vecchio from the time it was founded till the merger with Essilor.
Really digging into Luxottica’s corporate evolution will teach you so much more about
bargaining power than I ever could in this one memo.
 URL: https://focusedcompounding.com/how-to-judge-a-companys-bargaining-power-
with-its-customers-and-suppliers/
 Time: 2017
-----------------------------------------------------
What My Portfolio Looks Like Right Now – July 3rd, 2017
Frost (CFR): 42%
BWX Technologies (BWXT): 23%
Natoco: 6%

Cash: 29%
 URL: https://focusedcompounding.com/what-my-portfolio-looks-like-right-now-july-3rd-
2017/
 Time: 2017
-----------------------------------------------------
All Supermarket Moats are Local
Following Amazon’s acquisition of Whole Foods and the big drop in supermarket stocks –
especially Kroger (KR) – I’ve decided to do a series of re-posts of my analysis of the U.S.
supermarket industry.
Today’s re-post is a roughly 1,300 word excerpt from the Village Supermarket (VLGEA) stock
report Quan and I wrote back in 2014. This section focuses on how the moat around a
supermarket is always local.
Read the Full Report on Village Supermarket (VLGEA)
In the Grocery Industry: All Moats are Local
The market for groceries is local. Kroger’s superstores – about 61,000 square feet vs. 58,000
square feet at a Village run Shop-Rite – target customers in a 2 to 2.5 mile radius. An academic
study of Wal-Mart’s impact on grocery stores, found the opening of a new Wal-Mart is only
noticeable in the financial results of supermarkets located within 2 miles of the new Wal-Mart.
This suggests that the opening of a supermarket even as close as 3 miles from an incumbent’s
circle of convenience does not count as local market entry.
In the United States, there is one supermarket for every 8,772 people. This number has been
fairly stable for the last 20 years. However, store churn is significant. Each year, around 1,656
new supermarkets are opened in the United States. Another 1,323 supermarkets are closed. This
is 4.4% of the total store count. That suggests a lifespan per store of just under 23 years. In
reality, the risk of store closure is highest at new stores or newly acquired stores. Mature
locations with stable ownership rarely close. So, the churn is partially caused by companies
seeking growth. Where barriers to new store growth are highest – like in Northern New Jersey –
store closings tend to be lowest. Village’s CFO, Kevin Begley, described the obstacles to
Village’s growth back in 2002: “…real estate in New Jersey is so costly and difficult to develop.
New Jersey is not an easy area to enter. This situation also makes it challenging for us to find
new sites. It’s been very difficult for us, and for our competitors, to find viable locations where
there is enough land especially in northern Jersey and where towns will approve a new retail
center. With the Garwood store…we signed a contract to develop that piece of property in 1992;
it just opened last September (2001). So it can be a long time frame from when you identify a
potentially excellent site and when you’re able to develop it. Finding viable sites is certainly a
challenge that we face, as do our competitors.”
New Jersey is 13.68 times more densely populated than the United States generally (1,205
people per square mile vs. 88). It is about 12 times more densely populated than the median state.
This means New Jersey should have about 12 times more supermarkets per square mile to have
the same foot traffic per store. The lack of available space makes this impossible. As a result, the
number of people visiting a New Jersey supermarket is greater than the number of people
visiting supermarkets in other states. The greater population density in New Jersey has several
important influences on store economics.
One, it encourages the building of bigger stores. This sounds counter intuitive. If there are a lot
of people in a small space and land is difficult to develop, it would be logical to enter the market
with a small format store. That is true. However, incumbent stores have big advantages over new
entrants. Incumbents have leases in key locations. Their stores are highly profitable. As a result,
store owners in New Jersey will favor expanding each existing store to the maximum possible
square footage whenever renovation is a possibility. This is what most Shop-Rite members have
done. Village does not operate especially large Shop-Rites. However, 58,000 square feet is huge
by national supermarket standards. Whenever Village has renovated a store, it has tried to
increase square footage. Village has sometimes relocated stores to larger footprints. And
Village’s most recent new stores have been huge. For example, Village recently built a 77,000
square foot replacement store in Morris Plains. This store is almost as large as the Wegman’s
superstores (80,000 to 140,000 square feet) that tend to be the biggest supermarkets in New
Jersey.
Two, New Jersey supermarkets turn the product on their shelves faster. This changes product
economics for the store and the experience for the customer. A Shop-Rite turns its inventory
phenomenally fast relative to the grocery section of a Wal-Mart. As a result, stale inventory and
lack of help – the two largest complaints from grocery shoppers at Wal-Mart – are unusual in
New Jersey supermarkets. More customers per square foot means higher sales velocity. It is not
possible to stack more inventory per square foot. It is only possible to restock inventory faster.
High inventory turnover can increase customer satisfaction by increasing the freshness of the
product without requiring the store to buy different merchandise than a competitor with stale
product on its shelves. More importantly for the stores, gross margins can be lower at a high
traffic location and yet gross returns can be higher. In fact, this is exactly what happens at
Village. Village’s gross margins are 10% lower than Kroger’s (27% vs. 30%) while gross profit
divided by net tangible assets is 2.32 times higher (290% vs. 125%). A New Jersey Shop-Rite
generates much higher returns on capital than any other traditional supermarket around the
country. Again, this encourages reinvestment in existing stores. This further raises the barrier to
local entry. A new store would need to find an open location where it could put a 60,000 square
foot location to rival the breadth of selection and the low prices of the incumbent supermarkets.
In most of the country, land is more widely available and the incumbent supermarkets are only
around 35,000 square feet. Nationally, the average supermarket does $318,170 a week in sales.
In New Jersey, the average Shop-Rite does $1 million a week. The initial investment required to
enter a local grocery market in New Jersey is higher because the industry standard is higher and
the costs of developing anything are higher. It is important to remember that the barrier is not
simply the roughly 100% more expensive real estate in New Jersey versus the country generally.
Nor is the barrier simply the lack of available space in New Jersey. The final hurdle to clear is
the simple fact that supermarkets in New Jersey have evolved into much larger, lower margin
beasts than the competition elsewhere.
Large stores support wide selection, low prices, fresh inventory, and high customer service. A
comparison of inventory turns (Cost of Goods Sold / Average Inventory) helps illustrate this
point. Village’s inventory turns are 26, The Fresh Market 21, Whole Foods 21, Fairway 20,
Kroger 12, Safeway 11, and Weis Markets 9. It is easy to imagine a division between two
groups: the supermarkets focused on freshness and the supermarkets focused on low cost.
However, Village – a low cost generalist – has higher inventory turns than the group of “fresh”
supermarkets (The Fresh Market, Whole Foods, and Fairway). Village turns its inventory twice
as fast as traditional supermarkets like Kroger and Safeway. Kroger is an especially good
comparison because its store size is the same as Village’s and its business strategy (big stores,
wide selection, low prices, and generalist) is virtually identical. The difference between
inventory turns at Village and Kroger is that almost all of Villages’ stores are in New Jersey
while none of Kroger’s stores are in New Jersey. As a result of this higher inventory turnover,
Village can charge customers 3 cents less per dollar of sales than Kroger and have double the
return on capital (33% vs. 17%). The moat around Village is its portfolio of big, established
stores in New Jersey that would take a lot of time, money, and risk to duplicate. If Kroger
controlled these locations it would have at least as good returns on capital as Village. But the
only way Kroger will ever control key New Jersey locations is through the acquisition of a New
Jersey supermarket chain. The time, cost, and risk of introducing a new banner – the Kroger
name is unknown in New Jersey – makes entry by any means other than acquisition extremely
unlikely. The moat around Village is entirely local and historical. It runs big, mature stores under
the well-known Shop-Rite name. Most importantly, it runs them in the best locations in America
for supermarkets.
 URL: https://focusedcompounding.com/all-supermarket-moats-are-local/
 Time: 2017
-----------------------------------------------------
Can Howdens Joinery Expand to the European Mainland?
Richard Beddard has added Howdens Joinery to his Share Sleuth portfolio. I mention this
because I’ve written a little about Howdens Joinery in the past. And some of you know Howdens
is the stock I like best that I don’t yet own.
This raises the question:
Why haven’t I bought Howdens yet?
There are two reasons:
1. I try to buy stocks I’m confident I’d be willing to hold for more than 5 years if necessary
2. I try to simply hold cash till I’m confident a stock will return at least 10% a year while I
hold it
I believe Howdens may – in about five years from now – have fully covered the U.K. with about
as many depots as it ever will have in that country. I’m not 100% sure this is true. I’ve seen
companies raise their estimates of the size of their chain’s footprint that their home country can
support. So, Howdens may have more years of depot growth ahead of it beyond 2022.
But, there will eventually be a limit to how many depots Howdens can build in the U.K. So, the
next question is:
Can Howdens expand to other countries?
Richard Beddard writes:
“The other risk is Howdens might fill the UK with depots within my 10-year scenario, in which
case it would need to find some other way to grow. Due to its entrepreneurial culture and
decade long experimentation with European stores, I think it probably will be able to adapt its
business model and establish profitable stores abroad.”
I don’t doubt Howdens’s entrepreneurial culture. But, at the risk of ethnocentrism here (I am an
American writing about a British company), I am not 100% certain that Howdens’s
entrepreneurial culture will – at the depot level – be easily exportable to non-English speaking
countries. I’ve researched a few organizations in the past – notably Tandy Leather
(TLF) and Car-Mart (CRMT) – where scuttlebutt taught me the importance of delegation and
incentivization of the branch managers.
I believe Howdens’s model depends heavily on good management at the depot level.
As a rule, English speaking countries tend to be among the most “flexible” when it comes to
labor in the sense employers can easily fire workers with little cost. And, as a rule, continental
European countries tend to be among the least flexible when it comes to labor.
In its 2015 annual report, the company said:
“Managers hire their own staff locally and develop relationships with local builders. They do
their own marketing to existing and potential customers. They adjust their pricing to suit local
conditions. Managers manage their own stock. They work out where to put everything they can
sell – old favourites and new introductions. Every day, they balance the needs of builders, end-
users, staff and everyone in their local area who has an interest in the success of their depot…
Managers are in charge of their own margin, and effectively of their own business. Both
managers and staff are strongly incentivised on a share of their local profit less any stock loss,
which results in a common aim to improve service, and consequently profit, with virtually no
stock loss.”
Howdens’s most recent annual report included this statement:
“We continue to investigate the opportunities for Howdens in Europe. At the end of 2016, we
had twenty four depots outside the UK: twenty in France, two in Belgium, one in the Netherlands
and one in Germany. We have been in mainland Europe for eleven years and continue to
learn. We intend to thoroughly understand these markets before any decision is made to
expand in them.”
The emphasis is mine. But, I think it’s reasonable to assume – from this statement and other little
bits you can find in past annual reports – that the depot level economics are not as good in
France as in the U.K.
Finally, the most recent annual report includes this passage:
“We give staff the opportunity to get substantial bonuses for exceptional performance. This has
always been part of the Howdens business model and culture. Our people share in the
profitability of their local site, as well as in the profitability of Howdens as a whole. In the words
of some of our staff, the bonuses that they can achieve for exceptional performance in our peak
trading period can be ‘life-changing’.”
As an American, I don’t know much about the differences between the U.K. and countries like
France and Germany in regard to how low guaranteed pay can be and how big bonuses can be –
nor how easy it is to fire people who don’t fit with your company’s “entrepreneurial” culture.
I’m not sure Howdens’s depot level culture can spread to other countries that easily. If I believed
the model was easily repeatable in other countries – this might be my favorite stock of all (ahead
of even the two I already own: BWX Technologies and Frost).
Instead, Howdens is on the bubble for me. I like the at least five year future I see in the U.K. And
I can imagine the stock returning 10% a year for the next 5 years. I am less certain of the
repeatability of growth beyond five years.
Does this mean I like Howdens less than Richard Beddard?
Actually, no.
His Share Sleuth portfolio has a “meaningful position” definition of about 3% to 4% of the
portfolio. For my personal portfolio, a normal position would start at around 20% of the
portfolio. If I was considering whether or not to put something like 3% or 4% or 5% of my
portfolio into Howdens – I’d have already made the decision to buy. Because I’m considering
putting 20% of my portfolio into Howdens, I still haven’t made a decision.
 URL: https://focusedcompounding.com/can-howdens-joinery-expand-to-the-european-
mainland/
 Time: 2017
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Do Supermarket Stocks Have Long-Term Staying Power?
Read the Free Report on Village Supermarket
Check Out Focused Compounding
Following Amazon’s acquisition of Whole Foods and the big drop in supermarket stocks –
especially Kroger (KR) – I’ve decided to do a series of re-posts of my analysis of the U.S.
supermarket industry.
Today’s re-post is a roughly 1,300 word excerpt from the Village Supermarket (VLGEA) stock
report Quan and I wrote back in 2014. This section focuses on whether or not a supermarket can
be a durable investment. The full 10,000+ word report on Village – along with 26 other reports
of similar depth – are now available at my new site, Focused Compounding.
Some facts have changed since this report was written. For example, Amazon’s companywide
sales figure is much, much higher than it was in 2013 (the last year for which we had data when
we wrote this report).
And – more relevant to the grocery industry – Amazon Fresh has gone from a $300 a year add-
on to Amazon Prime to a $15 a month add-on to Amazon Prime (so 40% cheaper).
Durability (From the 2014 Report on Village Supermarket)
High Volume Supermarkets are Durable Local Market Leaders
Demand for food is stable. Most grocers do not experience meaningful changes in real sales per
square foot over time. Changes in real sales numbers almost always reflect changes in local
market share. There will be online competition in the grocery business. However, in Village’s
home market of New Jersey, direct to your door delivery of groceries has been available for 18
years. Peapod started offering online grocery shopping in 1996. The company was later bought
by Royal Ahold. Royal Ahold owns Stop & Shop. Peapod has 4 locations in Somerset, Toms
River, Wanaque, and Watchung. These locations offer grocery delivery in Village’s markets.
They are direct competition and have been for years. Peapod does not require a $300 annual fee
like Amazon Fresh. Instead, Peapod simply adds a delivery charge. Customers also tip the driver.
Since the driver normally carries the bags into the customer’s home and puts them on the kitchen
counter for the customer – the tip is usually a generous one. Peapod charges $6.95 for orders
over $100. The charge for orders under $100 is $9.95. The minimum order size is $60.
Customers can also order online and then drive to one of the 4 Stop & Shops mentioned above
(Peapod often uses the second floor of a building where the ground level is Stop & Shop’s retail
store) and pick up their own order. Pick-up is free. However, a Peapod employee still collects the
groceries and brings them to the customer’s car. So, a tip is still expected. Common tips are
probably $5 to $10. So, the total cost of a Peapod home delivery order is probably anywhere
from $12 to $20 higher than a trip to a Stop & Shop grocery store. Even a pick-up is probably $5
higher than a normal Stop & Shop visit – and the customer still has to drive to a store to make
the pick-up.
Wakefern is a large co-op with similar scale to Stop & Shop nationally and more scale than Stop
& Shop in New Jersey. Creating a retail website is easier now than it was in 1996. Therefore, it is
no surprise that 87 of Shop-Rite’s 480 locations offer online shopping. In fact, online shopping is
available from both Shop-Rite and Peapod in certain towns like Somerset.
This is important, because the average supermarket customer in the U.S. does not drive far to
visit a location. Kroger uses a 2 to 2.5 mile radius to define its local market. Research on the
opening of a new Wal-Mart found that supermarkets further than 3 miles from a new Wal-Mart
saw no meaningful impact to their sales. This suggests that Wal-Mart Supercenter’s do not draw
grocery customers from more than 3 miles away. So, a 2-3 mile radius is a reasonable definition
of a supermarket’s local market. Convenience is the biggest hurdle for online grocery providers
to clear. Amazon Fresh requires a $300 annual fee from its customers. Peapod requires a $60
minimum order.
The average grocery store visit results in a checkout of less than $60. At Shop-Rite, the average
customer pays $52 at checkout. So, online grocery shopping tends to be more expensive and
require larger orders than traditional brick and mortar supermarkets. Furthermore, online
selection is usually inferior to the largest traditional supermarkets. For example, Peapod has a
narrower selection of items on its website than it does at its retail stores – even though its online
business is literally housed in actual supermarkets. This is a logistical problem caused by the
difference between running a delivery business, an employee collected pick-up order, and a
customer’s self-selected in store order.
Costs tend to be lowest and selection widest when a customer is forced to put their own items in
their own cart by going through the store aisles themselves. Another problem with online
ordering is the need for scheduling. Online grocery orders require the customer to be home at a
specific time. The customer is usually given a window that can be as long as 2-3 hours during
which they must be home to answer the door. Meanwhile, in store visits are always at the
customer’s options. Traditional supermarkets are often open from roughly 10 a.m. to 8 p.m.
seven days a week. Customers can drop into their local store at their convenience – including on
the way home from work – and pick-up an order of any size. There is no scheduled time, no
delivery fee, no tip, and no minimum order size. The selection is usually as wide as the company
can provide.
For example, Village’s largest new store is 77,000 square feet. It includes plenty of fresh foods
and prepared foods that are not sold online. So, online competition is not new to the New Jersey
grocery market. And groceries are an especially tough business for online retailers to compete in.
One problem for online retailers is that all of their offline competitors have local scale. There is
no such thing as a “Mom and Pop” grocery store in the U.S. Unlike hardware stores, pet stores,
and book stores – the supermarket business is very locally consolidated. It would take an online
retailer a long time to have scale locally. However, it would be possible for online retailers to
develop bargaining power with suppliers. This is why Shop-Rite is run as a co-op.
Online retailers will continue to enter the grocery business. It is a huge market. The opportunity
for growth is enormous. For example, the U.S. grocery business is probably about $600 billion a
year while Amazon’s entire companywide sales are just $75 billion. Amazon could more than
double its sales with just a 13% share of the nation’s grocery business. The size of the
opportunity in groceries will continue to attract online and non-traditional competitors.
Non-traditional competitors are the biggest threat to Village. In the industry, “non-traditional”
refers to both deep discount and high end (especially fresh and/or organic) grocery stores. In
New Jersey, the high end is the area of greatest concern. The non-traditional supermarket with
the store model best suited for entering New Jersey is The Fresh Market.
Local competitors that segment the market are a risk for existing supermarkets. The one-year
customer retention rate in American supermarkets is probably around 70%. About 30% of
customers may switch to a local competitor each year. In a Consumer Reports survey, the top
reasons giving for switching were: “lower prices” and “better selection”. Shop-Rite generally has
the lowest prices and widest selection in its local market. The only exception is in towns with a
Wegman’s. Wegman’s has larger stores and wider selection than even the biggest Shop-Rites. As
a result, Wegman’s is usually ranked #1 in customer satisfaction.
Supermarkets tend to be durable. However, there is a constant churn of locations at most

companies – closing failed stores and relocating stores to better locations – that can be costly.
Since a restructuring in the early 1990s, Village has not experienced any store failures. Nor has it
relocated a store for any reason other than wanting to increase its size. Over the last 17 years,
Village has spent just 1.7% of sales on cap-ex. Meanwhile, Kroger spent 2.7%, Safeway spent
3.0%, and Weis Markets spent 3.2%. Village’s low cap-ex advantage is entirely due to not
closing stores. Because Village – as a Shop-Rite operator – has the highest sales per store of any
supermarket, it also tends to be able to renew leases. Supermarkets are the “anchor” tenant at
strip malls. In the last 17 years, there was only one example – in 2003 – of Village failing to sign
a new lease. Village has the most durable portfolio of supermarkets of any publicly traded
company. For example, in just the last 12 years, Kroger closed 21% of its starting store base.
Village owns 4 stores (with 335,000 square feet of selling space) and leases 24 stores (with 1.3
million square feet of selling space). The initial term of a lease is usually 20-30 years. Many
have multiple renewal options after those first 20-30 years.
 URL: https://focusedcompounding.com/do-supermarket-stocks-have-long-term-staying-
power/
 Time: 2017
-----------------------------------------------------
The 3 Ways an Investor Can Compromise
“There are 3 ways an investor can compromise:
1. He can compromise by paying a higher price than he’d like to
2. He can compromise by buying a lesser quality business than he’d like to
3. He can compromise by not buying anything when he’d rather own something
You could use these 3 compromises as a test of what kind of investor you are.
A growth investor – like Phil Fisher – compromises by paying a higher price than he’d like. He
won’t compromise on quality. So, he has to compromise on price. A value investor – like Ben
Graham – compromises by purchasing a lower quality business than he’d like. He won’t
compromise on price. So, he has to comprise on quality. Finally, a focus investor – like me –
compromises by not owning any stock when he’d much rather be 100% invested.”
 URL: https://focusedcompounding.com/the-3-ways-an-investor-can-compromise/
 Time: 2017
-----------------------------------------------------
Over the Last 17 Years: Have My Sell Decisions Really Added Anything?
I get a lot of emails from people saying that my strategy has changed – I’ve become more of a
growth investor and less of a value investor – over time.
It’s true that the investments I’ve made in recent years have definitely changed.
But, my philosophy has changed less than it would appear from my stock picks. I concentrate
heavily and go where I see opportunities I consider “nearly certain” rather than being the highest
return opportunities based on pure probabilities.
There is, however, one area where my philosophy really has changed:
I’m convinced that I should simply hold stocks indefinitely.
Why?
Let’s start with two spin-offs I bought. One spin-off happened 2 years ago. The other spin-off
happened a little over 10 years ago.
First, the 2-year-old spin-off. I have 25% of my portfolio in BWX Technologies (BWXT). I
bought that as part of a spin-off from Babcock & Wilcox. The stock has returned more than 30%
a year in the two years since the spin-off. It now trades at a P/E of 26. Normally, this is when a
value investor would sell the stock. However, I think the company can grow earnings per share
by 10% a year for the next several years. I also think a company of this quality should always
trade at a P/E no less than 25. So, with no new ideas that seem more likely to deliver returns of
10% a year or better – I have no intention of selling BWXT. With the catalyst from the spin-off
gone and the P/E above 25 – no value investor would keep holding this stock. But I intend to.
Does that mean I’m not a value investor?
It might mean that. But, it also may just mean I learned from the last spin-off I liked a lot.
About ten years ago, I picked a spin-off called Hanesbrands (HBI). Here’s a quote from a
roundtable discussion I did back in 2006 (share prices are not adjusted for subsequent splits):
“However, there are many situations (and here is usually where you find some bargains) where
the EV/EBIT measure is not the most useful. When I can predict a high free cash flow margin
with confidence, I use a very long-term discounted cash flows calculation. For instance, this is
what I would do with Hanes Brands which was recently spun-off from Sara Lee. On an EV/EBIT
basis, it may not look cheap. But, looking truly long-term, I’m convinced the intrinsic value of
each share is much closer to the $45 – $65 range than the roughly $23 a share at which it now
trades. But, that’s a special case – Hanes is a special business.”
I gave that quote back in October of 2006. Hanesbrands stock has compounded at 12% a year in
the 10 years since I made that comment (it’s compounded at 15% a year since the actual spin-off
date).
I probably should have just held on to that stock. When we include the crisis years of 2007-2008
in my results, it’s hard to see how selling out of Hanesbrands and buying other things – while
paying taxes, etc. – has materially benefited the long-term compounding power of my investment
account. That’s typical of my good stock picks, by the way – selling them to buy something else
has never really been necessary to get an adequate long-term return in my overall account.
Investing is all about taking decisive action. Making a decision and then acting on that decision.
So, the question is: Do my sell decisions add value?

Any decision I make that doesn’t add value is an area I either need to improve or stop worrying
about altogether. In other words, if selling hasn’t helped my returns – I either need to learn to
become a better stock seller or I need to ignore selling all together.
Have my sell decisions added to my returns?
Let’s start our investigation with three stocks I liked best around the time I started investing as a
teenager. They were:

2. J&J Snack Foods (JJSF)
3. Activision (ATVI)
I started investing at age 14. I read the Intelligent Investor at age 16. I originally bought these
stocks after I started investing but before I started trying to implement more of a Ben Graham
type approach. These were stocks from my self-directed, philosophy-less days – before I called
myself a value investor.
How have those stocks done?
Let’s use January 1st, 2000 till today as a convenient measurement day. I don’t own any of these
stocks anymore. So, the idea here is – since we know I did buy them – let’s ask: what if
I never sold them?
Measuring from January 1st, 2000, the holding period would be 16.5 years. Over the last 16.5
years, those 3 favorite stocks of teenage me have compounded annually at:
1. Village Supermarket: 13%

2. J&J Snack Foods: 17%
3. Activision: 26%
Those long-term results are good. Because of the way compounding works, a three stock
portfolio consisting only of those stocks would have actually outperformed what I did myself by
buying and selling dozens of different stocks over the last 16.5 years. I could have saved myself
a lot of trouble and gotten a better result just by holding on to everything I owned when I was 15
years old.
Activision skews those results. That could be pure luck. So, we can either take the median result
(J&J Snack Foods’s 17% result) or even an average of the other two stocks (15% is the average
of Village and J&J over the last 16.5 years) or we could even just take the bottom result (13%).
Whichever way we slice it, I’ve added anywhere from negative value, to fairly neutral value, to
an almost immaterial amount of value to my compound result by buying and selling dozens of
stocks over the years instead of holding what I bought around 15 years ago.
It certainly seems that I was capable – as a teenager – of picking a stock that would return 13% a
year over the next 15 years. When you consider that a 13% annual result that comes mostly in
the form of unrealized gains isn’t taxed till you sell it – it becomes very unclear if all my buying
and selling over the years has added any value beyond the result I could have gotten by simply
holding the worst of those 3 stocks for the last 15 years.
Some of you may know this number better, but I’d guess the overall stock market has returned
more than 3% but less than 5% a year over the last 16.5 years. Let’s be generous and call it 5%
(which from January 1st, 2000 as your start date – I’m sure it isn’t any higher than). In all 3 of
these stocks, we are talking about compounding at comfortably more than 10% a year when the
market was doing worse than it normally does. The market was doing 5% a year or worse. These
stocks were all doing 10% a year or better. If you can compound at better than 10% a year
forever, you can achieve all your long-term financial goals.
Here’s an illustration.
An initial investment of $10,000 that compounds at 5% a year for 15 years becomes $20,789.

An initial investment of $10,000 that compounds at 10% a year for 15 years becomes $41,772.
And an initial investment of $10,000 that compounds at 15% a year for 15 years becomes
$81,370.
The key is obviously avoiding the first result. You never want a 15-year period where you
compound at only 5% a year. Roughly speaking, in 15-year chunks: a 5% annual result gives you
a double, a 10% annual result gives you a quadruple, and a 15% annual result gives you an
octuple.
So, a good goal is to find quadruples and octuples. Stocks that can be held for 15 years while
returning 10% to 15% a year.
That, at least, is what my own experience has taught me.
Obviously, I’ve owned stocks that have had much higher annualized returns than that. I bought
Bancinsurance when there was an offer to take the company private at $6 a share. Here’s what I
wrote when I sold that position:
“My cost was $5.82 a share. Bancinsurance’s board agreed to an $8.50 a share buyout. I sold
my shares between $8.00 and $8.20…That’s a better than 38% return in less than 7 months. If
I’d held Bancinsurance through the buyout I would’ve done better with a 46% return in less than
10 months.”
Here, it’s worth noting that I sold my Bancinsurance shares which would have go on to return
another 5% raw which is more than 20% annualized by the time the deal closed. I used some of
the proceeds to buy Barnes & Noble (BKS), which was completely flat for me as a stock. No
gain. So, even here, I sold too soon. I should’ve just held Bancinsurance till the deal closed.

So, can I sometimes find opportunities that return 40% or more in a single year? Sure. It’s
happened. In 2009, my entire account did better than 40% a year. But, that was 2009. Stocks
started that year in a crisis. In the eight years since, there’s never been a market wide opportunity
like that.
There are better investors than me – people like Warren Buffett and Charlie Munger when they
were running their partnerships – who were able to routinely find opportunities to fill an entire
portfolio with things that could compound at 20% to 30% a year if you bought them, sold them,
and then rotated the proceeds into something else over and over again. They worked hard and
found a steady flow of Bancinsurance type opportunities.
I have not found enough such opportunities. What I have been able to find – a lot of actually – is
stocks that can do between 10% and 15% a year over the next 10 to 15 years. That doesn’t sound
very impressive. But, when you chart those stocks against the S&P 500, they come out way
ahead.
Let’s go back to the Hanesbrands example. From the moment Hanesbrands was spun off till
today – so 10.5 years – it has returned 15% a year. That meets our goal of a stock that can return
10% to 15% a year over 10 to 15 years. Meanwhile, the market has compounded at closer to 6%
a year.
Now, you can make mistakes and get a worse cumulative result than this even over a very long
period of time. For example, in the same year I picked Hanesbrands, I also picked Posco (PKX).
Posco was actually much more of the value stock. It was even – in some ways – perhaps more of
a “moat” stock in an academic analysis. But, clearly not the better, safer company. If I had to put
all my life savings into just Posco or just Hanesbrands in 2006 – it’d take half a second to decide
on Hanes. Steel is a bad business. Korea is right next to China (which overbuilds things like steel
plants). And I don’t usually want a Korean management team making capital allocation decisions
for me. So, Posco was never the kind of company you’d want to own forever. Hanes could be.
Over the last 10.5 years, Posco has returned exactly nothing. The market has done 6% or so.
So, if you put equal amounts of money into both Hanes and Posco on the same day and held
them till today – your result would be closer to the S&P 500 than if you just bought Hanes alone.
Because the result in each stock is compounded (and therefore Hanes has an outsized effect on
the portfolio in later years), I think you’d have gotten a 9% to 10% annual result over the 10.5
years. Let’s call it 9%. So, picking one good compounder like Hanes and one completely flat
stock – like Posco – and holding them both for a full decade could get you down to 9% versus
6% a year for the S&P 500.
Again, we see a basic problem that I have noticed with my investment results. Simply holding a
stock I picked a long, long time ago has been surprisingly competitive with all my hard work
spent buying and selling dozens of stocks in the ensuing years. I’ve done better than 9% a year
over the last 10.5 years. But, I haven’t done better than 15% a year over the last 10.5 years. So, I
would have had to combine a good pick with a bad pick in equal proportions for a buy and hold
strategy to underperform all the buying and selling I’ve done over the last decade. Also, even
combining one of my bad ideas with one of my good ideas from 2006 and holding them through
today would have still outperformed the market.
So, why am I working so hard? Why am I worrying about selling at all?
Maybe the real duds are the problem. Maybe knowing when to sell a loser is key. What about the
duds? I concentrate. So, I can lose a lot in one stock. I put 25% of my account into Weight
Watchers (WTW) at one point. That stock was a disaster. Here’s what I said when I reported my
sale:
“My Weight Watchers position was eliminated at an average sale price of $19.40 a share…My
Weight Watchers position had an average cost of $37.68 a share. So, I realized a loss of 49% on
Weight Watchers.”
So, I sold Weight Watchers at a price of $19.40 a share. What has happened with Weight
Watchers stock since then?
WTW now trades at $26.90. So, I missed out on 39% upside by selling.
I realized a loss of 49% on my Weight Watchers investment. If I had held on to that stock
through today, my unrealized loss would now be only 29%. No one likes a 30% paper loss. But,
a 50% paper loss is worse. As usual, I did worse by selling.
More importantly, I know the experience of some blog readers and newsletter readers who
followed me into WTW was even worse than my own. Weight Watchers fell from over $38 a
share when I bought it to a low of around $4 a share. Someone emailed me recently asking me at
what price I thought various people who talked to me about WTW finally threw in the towel and
sold their shares. I looked back through my emails, and best guess – this is a pure guess based on
those who said they were selling in their emails – is that they exited the position around $8 to
maybe $12 (at the very most). The anecdotal evidence (it’s a small sample size) says $8. But,
let’s say it was $12 a share. Today, the stock is more than twice that level.
If look back at the stock’s chart, and I pick a time when WTW was selling at around $12 a share
as the hypothetical sale date for many readers who followed me into the stock – I get a
comparison between WTW and the market which tells me WTW is up 130% since then versus
the market being up 15% since then. Odds are, if you followed me into WTW and then you sold
that stock – you ended up selling an asset that would go on to return 130% while you put the
proceeds into something that did just 15%. You see the problem with selling out of even a
“broken” investment idea. It was a mistake to buy Weight Watchers. But, it was also a mistake
for me to sell at $19 a share and an even bigger mistake for most people to sell at $12, $10, $8,
or even $4 a share – as some people really did.
Of course, Weight Watchers survived its crisis. Not all stocks do. Some go to zero. And Weight
Watchers very well could have. For example, if Weight Watchers’s decline in membership had
coincided with the financial crisis – I’m convinced the company would have entered bankruptcy.
The company needed access to credit. Because of high debt levels, the corporation would have
failed – wiping out all shareholders – even if the brand survived. The reason the corporation
survived was that credit was loose when the company experienced its crisis.
But, this is a post about my own investment philosophy. What has it been? What should it be?
I’m looking for process improvements I can implement. I’m not looking for process
improvements to suggest to everyone else out there.
One thing that has hurt the compounding power of my account has been holding on to a “dead
money” stock. This is a stock with little growth and no catalyst. I owned a stock like that for the
past 7 years. I bought George Risk in 2010. I sold it earlier this year. Let’s pretend I never sold it.
Looking at the stock from the time I bought it – 7 years ago – to today, we can see the annual
return has been 10.3% a year. That’s the return you would have gotten if you bought George
Risk shares when I did and continued to hold them through today. The S&P 500 has done well
since the summer of 2010. I think it’s done about 12.3% a year since the day I bought George
Risk. So, buying and holding George Risk for too long would have cost you about 2 percentage
points a year over the last 7 years versus owning an index fund.
What could I have done differently? George Risk once traded at a higher price than it does now.
It hit an all-time high of roughly $9 a share several times while I owned the stock. Let’s pick the
earliest of those times. It was August of 2013. I bought the stock almost exactly 3 years before
that day. So, it would’ve been possible – if I timed my sale perfectly – to make 25% a year in
George Risk over 3 years. Instead, I made 10% a year over 7 years. My rate of compounding was
15% lower because I didn’t sell then.
In my defense, you might ask: how could you time the sale perfectly?
Well, Oddball Stocks timed this post “Is It Time to Dump George Risk?” pretty much perfectly.
That post was written in August of 2013:
“I’m also going to continue thinking about selling the position. I love this at $6, but at $9 not as
much.”
That turned out to be right. Oddball Stocks also wrote this:
“I feel that selling stocks is a weakness for most investors, if not all investors. It’s easy to spot a
bargain and buy it, but it’s hard to tell when the music is over and it’s time to sell. In general I
try to keep a few things in mind when I look to sell a stock. The first is whether the company has
a margin of safety at the current level. For most investments this means an asset backed margin
of safety. I do own one moat stock, Mastercard, and the margin of safety for that stock is the
brand. If there is still a margin of safety at the current price, and nothing else has changed with
the business I will continue to hold.”
So, maybe knowing when to sell was a weakness of mine with George Risk.
If so, how do I correct that weakness in the future? Do I sell stocks after a certain period of time?
Do I sell them when they reach my estimate of fair value? Do I continue to hold them
indefinitely?
What is a practical rule I can adopt?
The simplest pattern I can see is that it’s been very hard for me to do better than just buying and
holding the stocks I liked most. I was most “certain” of George Risk when I picked it in 2010. I
was most certain of Hanesbrands when I picked it in 2006. If I held George Risk for a full 7
years, I’d be sitting on a 10% compound annual return without paying much of anything in taxes
and without creating more work for myself (by having to find another stock to replace it with). If
I held Hanesbrands for a full 10 years, I’d be sitting on a compound 12% annual return without
paying much in taxes or having to do any additional work. So, again, it seems I’m capable of
finding stocks that can – if held indefinitely – return 10% to 15% a year. George Risk and Hanes
would both – if held through today – have given me what I consider an “adequate” return of 10%
a year. I’d prefer 15% a year. And it was possible to make 25% a year in George Risk if you
adopted a Ben Graham type mindset and bought around $4.50 when I did in 2010 and sold
around $9 in 2013 (when Oddball Stocks raised the possibility it was time to sell George Risk).
But, you are going to do better than most investors if you keep finding stocks that return 10% a
year regardless of the market environment and just hold on to them.
It may seem like I’ve cherry picked specific investment ideas of mine that have continued to
have especially high compound returns after I sold them. I assure you I haven’t. In fact, I’ve
actually excluded some outliers. I bought Fair Isaac (FICO) in 2010. Here’s what that stock has
done since then. To downplay the timing of my purchase – the market was still cheap in 2010 –
I’m going to assume I bought at the highest price FICO ever traded at in 2010. The high for that
year was a little under $26 a share. Today, the stock trades for $133 a share. That’s a compound
annual return of 26% over 7 years. Obviously, I should have just kept holding FICO. The stock
now trades at a very un-value-investor like 33 times P/E. But, almost all the good stock picks
I’ve made over the year have followed a pattern of being priced at below average to average P/Es
versus the market when I buy them and then being re-evaluated by the investment community
such that they are then consistently priced at a premium to the market in later years.
I think the best case for why I shouldn’t make sell decisions at all is Omnicom (OMC). I bought
that stock in 2009 at around $28 a share. The stock has returned 12% a year since then. The S&P
500 has also returned 12% a year since then. This would seem to suggest there was no harm in
me selling Omnicom when I did – at a time when it had outperformed the market while I held it.
And that might be true, but I actually like Omnicom at today’s price. So, I bought a stock at $28
a share in 2009 that I am now considering – in 2017 – buying again at $83 a share. I wrote a
whole newsletter issue about it. It’s on my personal watchlist with just 3 other stocks right now.
So, I obviously still really, really like the stock. And yet, it’s 8 years later and the price is 3 times
higher. If you pick a stock today that you’re still going to like at triple the price 8 years from now
– then why ever sell that kind of stock?
I think there are strategies that can benefit from including good sell decisions. And I think there
are investors who pick the kinds of stocks that should be held for a few years and sold. Those are
just the stocks they’re most comfortable owning. Over the years, I’ve learned that I’m not that
kind of investor. The stocks I pick don’t benefit much from well-timed sales. There’s usually
little harm in holding on to them much, much longer than I do.
So, I’ve decided to hold the stocks I own indefinitely. When I find a really, really good stock
idea – which might happen once a year – I will need to sell pieces of the stocks I already own to
raise cash for that purpose. I’ll do that. So, if I’m fully invested and want to put 20% of my
money into a new stock – I’ll have to sell 20% of each stock I now own. But, I’m not going to
eliminate my entire position in a stock anymore. Those decisions to completely exit a specific
stock haven’t added value for me. So, I’m not going to try to make them anymore.
From now on, I’m going to be a collector of stocks.
The hard part will be implementing this – no full sale, ever – policy once I’m fully invested.
Right now, I have about 35% of my portfolio in cash. So, I have no need to sell anything when I
next find a stock to buy.
Geoff’s Verdict
From now on: Geoff will never voluntarily exit a position entirely. Once he owns a stock, he’ll
keep owning at least some of that stock forever unless that company is taken over or goes
bankrupt. He will simplify things down to a true “buy and hold” approach. No thought will be
given to selling a stock ever again.

Your Verdict
Is Geoff’s resolution to never sell a position entirely too extreme? Have your own selling
decisions boosted your account’s long-term compounding power? What can you do to become a
better seller of stocks?
Comment below.
 URL: https://focusedcompounding.com/over-the-last-17-years-have-my-sell-decisions-
really-added-anything/
 Time: 2017
-----------------------------------------------------
I’ve Decided to Stop Deciding Which Stocks to Sell
“The stocks I pick don’t benefit much from well-timed sales. There’s usually little harm in
holding on to them much, much longer than I do.
So, I’ve decided to hold the stocks I own indefinitely. When I find a really, really good stock idea
– which might happen once a year – I will need to sell pieces of the stocks I already own to raise
cash for that purpose. I’ll do that. So, if I’m fully invested and want to put 20% of my money into
a new stock – I’ll have to sell 20% of each stock I now own. But, I’m not going to eliminate my
entire position in a stock anymore. Those decisions to completely exit a specific stock haven’t
added value for me. So, I’m not going to try to make them anymore.
From now on, I’m going to be a collector of stocks.”
 URL: https://focusedcompounding.com/ive-decided-to-stop-deciding-which-stocks-to-
sell/
 Time: 2017
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The Fastest Way to Improve as an Investor
1. Study a series of related stocks.

2. Give each stock your absolute undivided attention – focus like you’ve never focused
before (it’s fine if you can only do this for like 45 minutes at a time).
3. Put your thoughts into writing.
4. Bounce those ideas off another person.
5. URL: https://focusedcompounding.com/the-fastest-way-to-improve-as-an-investor/
6. Time: 2017
7. Back to Sections
-----------------------------------------------------
The First 8 Things to Look at When Researching a Stock
The other day, someone I talk stocks with on Skype asked how I normally go about starting my
initial research into a stock. What documents do I gather?
Here’s what I said:
“Basically, I start by finding the longest series of financial data I can (GuruFocus, Morningstar,
whatever) and then look at that along with reading the newest 10-K and the oldest 10-K in
detail. So, 10-year+ financial data summary, 20 year old 10-K (or whatever), this year’s 10-K,
and then the investor presentation if they have one, and the going public/spin-off documents if
that’s online. Also, I read the latest proxy statement and the latest 10-Q as needed for info on
management, share ownership, the balance sheet etc.”
I also check the very long-term performance of the stock. So, I will chart the stock – at
someplace like Google Finance – against the market over a period of 20, 30, or 40 years.
So, here’s a full list of my usual sources:
1. Check long-term stock performance (what is the compound annual return in the stock over
20, 30, or 40 years?)
2. Find the longest series of historical financial data possible (search for a Value Line sheet, a
GuruFocus page, or go to Morningstar or QuickFS.net to see the long-term financial results)
3. Read, highlight, and take notes on the latest 10-K (so 2016)
4. Read, highlight, and take notes on the oldest 10-K (On EDGAR, this is usually around the
year 1995)
5. Read, highlight, and take notes on the company’s own investor presentation
6. Read, highlight, and take notes on the IPO or spin-off documents (On EDGAR, this will be
something like an S-1 or 424B1)
7. Read, highlight, and take notes on the latest proxy statement (On EDGAR, this will be
something like a DEF14A)
8. Read, highlight, and take notes on the latest 10-Q.

Why Check the Long-Term Stock Performance?
This is something a lot of value investors wouldn’t think of. But, I find it very useful. Any time
you are looking at a stock’s performance your choice of start date and end date are important.
The good news is that your start date will be fairly arbitrary if you just look as far back as
possible. So, if the stock has 27 years of history as a public company – and you look back 27
years – you probably aren’t picking a price near an unusual low point in the stock’s history. In
fact, you’re probably picking the IPO price, which will rarely have seemed a “value” price at the
time. The other good news is that – as a value investor – you’re probably attracted to stocks that
seem cheap now. They trade at low or at least reasonable multiples of earnings, EBITDA, sales,
tangible book value, etc. This means that any stock you are looking at as a possible purchase is
unlikely to be benefiting right now from a particularly good choice of an end point.
Here’s an example.
If we go to Google Finance, we can see that Fossil (FOSL) has a stock price performance from
1994 through 2017 (so about 23 years) that’s a bit better than the S&P 500. You can use the data
in Google Finance and combine that with a compound annual growth calculator to find the
stock’s annual return was about 9% a year over the last 23 years. Does that mean Fossil created
value over 23 years? Did it compound its intrinsic value faster than the average stock? That
would be hard to tell if Fossil had started the period trading at a low price and now traded at a
high price. However, the stock now trades at an EV/Sales ratio of 0.3. Historically, it traded
around 1.5 times sales. It’s rare for a company in this kind of business to trade much below sales.
So, if Fossil survives its current crisis and investors eventually warm to the stock’s future
prospects – you’d expect the share price to jump at least 3 to 5 times. The stock’s $12 now. But,
you’d expect it to be in the $35 to $60 range the moment investors felt sales had stopped
plunging. That sounds like a big prediction to the upside – but this stock once traded at $120 a
share. So, that’s still only a slight recovery of what Fossil’s market value had been.
Now, if Fossil stock was at a price 3-5 times higher than it is now, the 23 year return wouldn’t be
9% a year it’d be in the 14% a year to 17% a year range over more than 20 years. That’s a lot of
value creation. In fact, if the end point had been the start of 2015 (when Fossil’s current
problems hadn’t yet devastated its sales and earnings) instead of the middle of 2017, Fossil
would have returned about 22% a year over more than 20 years.
So, the exact start point and end point you pick matters a lot when judging a stock’s past long-
term compounding power. But, if you are looking at something that appears to be a value stock
now and yet it still had returns of about 10% a year in its share price over 20, 30, 40 years or
more – you’re fine. This is a business that didn’t destroy value over time. It compounded its
intrinsic value as well or better than the stock market. If the stock’s future is as good as its past –
and you’re buying it at a below average price – you’ll do well.
Those are two big ifs.

But, this check of the stock price performance compared with the more usual approach of
looking at return on equity, return on capital, etc. over the past few decades will give you a good
idea of what kind of quality business you’re dealing with. The stock performance check is
especially important with conglomerates, cyclical companies, companies that issue and/or
buyback a lot of stock, serial acquirers, and other corporations that are involved in a lot of
financial engineering at the corporate level.
I strongly suggest checking the long-term stock performance when you’re looking at companies
like: Baker Hughes (BHI) which is cyclical, Omnicom (OMC) which buys back its own
stock, Textron (TXT) which is a conglomerate, and UniFirst (UNF) which acquires companies
in the uniform industry.
Although it is easy to find the return on equity for these companies in any one year – it can be
difficult to know what the return on investment of their various acquisitions, stock buybacks, etc.
has been over a full cycle without using the long-term stock price performance as a guide.
It’s still not a perfect guide.
Remember, depending on exactly when in the last 2-3 years you checked Fossil’s stock price,
you’d see long-term compound annual returns of anywhere from 9% to 22% in the stock. The
important point is that you wouldn’t get a long-term compound annual return figure much below
the S&P 500. So, you’d be able to assume Fossil had – historically – been an average or even an
above average business. What you’re looking for here is any discrepancies where a company that
seems to have an above average return on capital manages to always barely keep pace with – or
even lag – the S&P 500 over the decades.
Why Use the Longest Series of Financial Data Possible?
The simplest reason here is that most investors don’t do this – so you should. There are figures
that might be useful – like knowing what a company is expected to report in EPS next year, that
have their usefulness diminished by the fact everyone else buying and selling the stock knows
this figure. There are other numbers that might also be useful – which other investors aren’t
looking at. You want to focus on figures that matter but are ignored by most people.
Let’s stick with the Fossil example. Knowing that Fossil’s pre-tax earnings dropped 22% in
1995, 18% in 2001, and 23% in 2005 might be useful when looking at the stock in 2015 because
earnings had never declined from 2006-2014. So, at the end of 2014, a lot of investors might
have only been looking at Fossil’s results from 2006-2014 (since that gives you the 5-10 years of
history that many investors feel they needn’t look past). Investors may have also been looking at
analyst estimates and the company’s guidance for the year ahead. I have nothing against you
looking at near-term future projections. But, you should know, that probably 99% of investors
are looking at projections for next year’s earnings while maybe 1% of investors are looking at
historical data from further than 10 years in the past. That means the old historical data is more
likely to give you an unorthodox insight into a company. And that’s what you need to be right
when others are wrong.
Why Read the Most Recent 10-K?
As a serious value investor you know you’re supposed to do this. Everyone tells you you’re
supposed to do this. You read the most recent 10-K to learn about the company as it exists today.
I’m not going to waste words pushing this particular practice. If you aren’t reading 10-Ks, you
should try it. They’re the most useful documents out there.
Why Read the Oldest 10-K?
Again, part of the reason for doing this is the same reason a lefty can have an advantage playing
baseball. In absolute terms, it makes no difference if you’re left handed or right handed. Left
handedness doesn’t make you a better baseball player. But, if 90% of the world is naturally right
handed – being left handed makes you different. It makes you the opposite of what your
opponent (the pitcher or the batter) normally faces. If trying to bat left handed makes you a
worse hitter – there’s a point where you shouldn’t invest the effort in learning to do it. Likewise,
if it’s a complete waste of your time to read the oldest 10-K, you shouldn’t read it. But, I don’t
think it’s a waste of your time. And I know almost no one else does it. So, here’s something you
can do that’s both useful and different.
Reading the oldest and newest 10-Ks one right after the other is a shortcut to understanding how
the business developed and how the industry developed. You could work on studying the
company’s entire history. But, that’s a huge investment of time for a stock you’re not sure you’re
interested in yet. By reading the oldest annual report and the newest annual report, you get the
quickest overview possible of the truly long-term history of the company. I think it’s sometimes
useful. And I know it’s very rare for other investors to do this. So, if you’ve never read the oldest
10-K you can find on a company, try adding this to your regular routine.
Why Read the Company’s Own Investor Presentation?
This one is a bit more of a mixed bag.
There are aspects to reading this report that probably aren’t good for your understanding of the
stock. One, everything in the presentation is well known by people buying and selling the stock.
Two, this pitch is being made directly by the company’s management and aimed directly at
people like you (potential investors).
So, it can be dangerously biased.
Those are the negatives. And they’re big negatives.
The positives are that, frankly, the investor presentation can give you the most background on a
company and an industry in the shortest amount of time. If, for example, you have no idea how
the frozen potato industry in the U.S. works, reading the Lamb Weston (LW) investor
presentation is the quickest way to get an overview of the industry, the company’s rivals, and the
company’s customers.
This is especially true for obscure industries – like frozen potatoes – where nobody writes books
about the industry, none of the companies in the industry have ever had much cultural impact,
and the companies just aren’t that well known by the public.
For example, you really need to read an investor presentation by Grainger (GWW), Fastenal
(FAST), or MSC Industrial (MSM) to start your research into the MRO industry – because
most people don’t know what the MRO industry is or how it works. It’s an invisible part of the
economy.
If you don’t have much time to spend researching a stock before deciding whether or not to cross
it off your list – I’d say skim at least 10 years of financial data (at someplace like GuruFocus)
and read the investor presentation (on the company’s own website). That’ll take you a matter of
minutes, not hours. And it’ll give you the background you need to look for the names of
competitors, suppliers, and customers and to know what to look for in the 10-K. So, the investor
presentation is often the best place to start your research into a company.
Why Read the IPO or Spin-Off Document?
This is often a very detailed report. It will have a lot of information on the industry. It is probably
the single longest document on this list. Take your time. If you can work your way through a 10-
K, you can work your way through an S-1, etc. Finding this document on EDGAR can
sometimes be inconvenient because the company will often file a bare bones version initially and
then keep amending it. Sometimes companies keep their original going public roadshow
presentation on their website many years after actually going public. The same is true for spin-
offs. For example, I own BWX Technologies (BWXT). Even though it is now 2017, that
company keeps a 60 or so page presentation on its website that dates back to the 2015 analyst
day which discussed the spin-off. Like a lot of IPO / spin-off presentations, that one takes a
longer term view of the company. So, it has some discussion of how Babcock’s nuclear business
evolved from the early 1990s through 2015. That’s the kind of historical information that is
rarely discussed in quarterly earnings results. You’ll only find it in company presentations.
Historical discussions that take a longer term view are especially common when a company goes
public or is spun-off. So, an IPO or spin-off document is kind of the opposite of a quarterly
earnings call transcript.

Why Read the Proxy Statement?
This will be the DEF14A on EDGAR. I read this just for background information on
management, to understand how much control big shareholders have over the company, and to
see how management is compensated.
So, I’m looking for: 1) Who the managers are 2) Who the owners are and 3) How the owners
choose to compensate the managers. Incentives are part of what I’m looking for here.
For example, Grainger (GWW) has a passage in the latest DEF14A that reads:
“The 2016 Company Management Incentive Program (MIP) payout was calculated at 75% of
target for all eligible employees as the Company fell short of the 2016 sales growth goal of 5.5%
and the ROIC goal of 26.6%.”
So, we see that Grainger incentivizes management to hit two targets: 1) A sales growth goal and
2) A return on capital goal. The sales growth goal is modest. In a normal year, nominal GDP
growth in the U.S. might be in the 4% to 6% range. So, a 5.5% sales growth target is close to a
GDP type growth rate. And then the return on capital goal is aggressive. A 26.6% return on
capital before taxes translates into about a 17% unleveraged return on equity. A business like
Grainger can use some leverage. So, this return on capital target – if achieved – would tend to
deliver a 20% or better after-tax return on equity for Grainger shareholders. There are more
details about how incentive compensation is paid (in what form and when) as well as if it’s
capped at some level. But, what I’ve discussed above is one of the most important parts of the
proxy statement. Look for the metrics management is judged on for compensation purposes. And
also look at what the specific target levels are for those metrics.
Finally, you also want to look at the ownership structure of the company. For example,
the Under Armour (UA) proxy statement – this is the DEF14A – tells you that the CEO, Kevin
Plank, is also the company’s founder. It tells you he has a 15% economic interest in the company
and a 65% voting interest. It also tells you he’s 44 years old. Founders often make it to a
retirement age of 65 or beyond. So, you this tells you that – since he has voting control of the
company – Under Armour’s founder might lead the company for another 20 years or more.
Minority shareholders have no say in the company, because the CEO has more than 50% of all
votes. Also, we know the CEO owns about 15% of the company and UA has a market cap of
around $8 billion. So, he has maybe $1.2 billion or so of his net worth in the company’s stock.
His total compensation was usually in the $2 million to $4 million range over each of the last 3
years (that kind of information can be found in this same proxy). So, the performance of Under
Armour stock is something like 300 times more important to Plank than his own pay. So, the
proxy statement has told us: 1) This is a controlled company – your votes don’t matter 2) The
company may have another 20 years to go in its founder led era and 3) The CEO’s overriding
incentive is getting the best possible growth in the stock price over time.
A lot of people skip the proxy statement. But, the points I just made about Under Armour are
huge. You could have another 20 years of the company being run by a founder who is something
like 99% compensated as a permanent owner.
And that founder has voting control – so your votes don’t matter. Under Armour has 3 classes of
stock. You can buy two of those classes. The two classes you can buy have identical economic
rights but one comes with voting power and one comes with no votes. The shares with the
“UAA” ticker cost $19.10 and have one vote each. The shares with the “UA” ticker cost $17.86
and have zero votes each. The proxy tells us your vote can’t matter in either case. So, you should
buy “UA” shares not “UAA” shares and save yourself more than 6% of the purchase price. See,
reading that proxy just made you 6% smarter. That’s why you should always read the proxy
statement. You want to know: who the owners are, who the managers are, how everyone is
compensated, and which class of stock is the better buy.
Why Read the 10-Q?
The more you know about accounting, the more you’ll get out of the 10-Q. The 10-Q is useful
because it has the exact number of shares outstanding on the front of it (and, of course, this
figure will be more recent than the 10-K in 3 out of 4 quarters of the year). You will want to
study the balance sheet. And you’ll want to read the footnotes to the financial statements. A lot
of the value in the 10-K and 10-Q comes from reading about how the company accounts for
everything in the financial statements. What is amortization made up of? How quickly are they
depreciating various assets? How long have they had certain assets – like land – on the books?
Do they lease or own all their property? If you’re more of a Ben Graham type investor than Phil
Fisher type investor – you’ll get more out of the 10-Q. Honestly, a long-term growth investor
isn’t going to find anything in the last quarter to change his mind about a company. As far as
sales and earnings go, it’s not necessary to check in more than once a year with the stocks you
own. I’ll look at a 10-Q or even read an earnings call transcript or two if there’s been a big drop
in the stock and I want to understand if the reaction from investors is appropriate given some
change in the company. For example, Under Armour’s stock dropped a lot after an earnings
report. The company’s sales growth has decelerated from more than 20% a year to closer to 10%
a year (which is about what management is now guiding for in fiscal 2017). Recently, sales
actually dropped about 1% in the U.S. So, you can read the 10-Q for Under Armour along with
checking the 10-Qs of competitors like Nike (NKE) and key customers like Dick’s Sporting
Goods (DKS) to try to understand exactly why sales and earnings disappointed investors, what
the problem is, and whether or not it’s temporary. Other than that kind of analysis of a very
recent event – the 10-Q is most useful for giving you an up to date balance sheet.
So, those are the first 8 things I look at when researching a stock. They aren’t necessarily the
most important 8 things to look at. But, they are easy enough to find and important enough to
give you a good foundation for understanding the business even if you never read anything else.
 URL: https://focusedcompounding.com/the-first-8-things-to-look-at-when-researching-a-
stock/
 Time: 2017
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Analyzing Stocks With a Partner
Someone who reads the blog emailed me this question:
“Buffett has Munger, and you have Quan. It seems like in this industry, a collaboration of minds
can be a potent formula for long-term success if approached correctly. That said, how would you
recommend investors/ aspiring portfolio managers to find a suitable partner who not only is able
to shine light on your blind spots, but who can also be of one mind and culture?”
It’s a huge help to have someone to talk stocks with. But, I’m not sure it’s a help in quite the way
people think it is. I think people believe that Buffett is less likely to make a big mistake if he has
Munger to talk to, that I’m less likely to make a big mistake if I have Quan to talk to, and so on.
I’m not sure that’s true. I know from my experience working with Quan that our thinking was
more similar than subscribers thought. For example, one question I got a lot was who picked
which stock. And that’s a hard question for me to answer. Some of that might be the exact
process we used. I can describe that process a bit here.
When I was writing the newsletter with Quan, we had a stock discussion via instant messaging
on Skype. We did this every week. The session lasted anywhere from maybe 2 hours at the very
shortest to maybe 8 hours at the very longest. A normal session was 4-5 hours. So, we were
talking for let’s say 4 hours a week about stocks. We weren’t talking about stocks we had already
decided on. Instead we were just throwing out ideas for stocks we could put on a “watch list” of
sorts. We called it our candidates pipeline. It was really a top ten list. So, instead of saying “yes”
or “no” to a stock – what we did is rank that stock. We always had the stock Quan was currently
writing notes on, the stock I was currently writing an issue on, and then 10 other stocks. In
almost every case, once I started writing an issue – that issue did end up going to print. In most
(but not all) cases, whenever Quan started writing notes on a stock – that stock eventually
became an issue. But, there were probably 3 to 5 times that he started writing notes on a stock
and yet we didn’t publish an issue on that stock. This was rare. Most stocks we thought about but
eliminated were eliminated in the “top ten” stage.
So, we’d have a list of ten stocks that we weren’t yet doing but that we planned – if nothing
better came along – to work on next. Let’s make up a list here. Let’s pretend #1 is Howden
Joinery, #2 is UMB Financial, #3 is Cheesecake Factory (CAKE), #4 is Kroger (KR), #5 is
Transcat (TRNS), and #6 is ATN International (ATNI). It would go on like this for 10 stocks. A
lot of times there were stocks on there that we didn’t really love – but we had this rule that we
had to always keep 10 stocks on the board. This kept us from ever saying an idea just wasn’t
good enough. We were trying to do an issue a month – so the answer was that if it’s better than
every other idea we have right now, it should be the next issue. This way of working – by
making our next best idea the hurdle – was very helpful. Each week, as we’d talk, we’d move
stocks up or down. So, maybe I would say that I had been reading about Cheesecake (since it’s
number 3 on our hypothetical list) and I decided that its future growth prospects in terms of the
number of sites it could open is just not high enough to justify its P/E. It might be fairly valued.
But, it’s unlikely to be undervalued. So, I wanted to move it down the list. Well, instead of just
moving it down the list – I had to say where I wanted to move it and what I wanted to move up
in its place. In other words, I’d have to explain to Quan why I thought Cheesecake was a less
attractive stock than Kroger, Transcat, and ATN International. Otherwise, the stock would stay
where it was.
I’m sure that if each of us had done separate newsletters, we would have ended up with a
different set of stocks than Singular Diligence covered. But, it’s not like Quan and I disagreed
much on which stocks to do. I think we tended to be furthest apart in the earliest stages of
considering stocks. Early on, we weren’t going to do any financial stocks. But, independently,
Quan and I had kept looking at Progressive (PGR). This was an obvious choice for the
newsletter. GEICO and Progressive are similar. Over the years, they’ve become even more
similar. Progressive has a very long history of excellent stock returns (something we always
looked at). Some value investors own it. I think it had been consistently buying back stock and it
may even have been within spitting distance of a 5-year low when Quan and I first talked about
the stock. Things like a continuously declining share count (“cannibals” as Munger calls them)
and a 5-year low (we don’t look at 52-week lows – but we are interested in when a company
seems to have gotten better while its share price has gone nowhere) would have attracted us to
the stock. So, either I brought Progressive up to Quan or Quan brought Progressive up to me.
And the other one said he’d already looked at the stock. And neither of us was sure at first
whether we’d do it. It’s not that we didn’t like Progressive. We just weren’t sure we ever wanted
to do an insurer. We had done HomeServe (a U.K. stock). But, the actual insurance aspect of
HomeServe – the risks it takes – is extremely minor when compared to something like
Progressive. Progressive is a true financial stock. It is taking tremendous underwriting risk. In
fact, you won’t find many insurers that write more in premiums (and expect to cover more in
losses) relative to their shareholder’s equity than Progressive. If Progressive suddenly had a
combined ratio of 110 for 2-3 years in a row – the company would be insolvent. On the other
hand, if Progressive had low equity levels and then had 2-3 years of its usual – very good –
underwriting profit, it could quickly re-build an insufficient capital level to an overcapitalized
position. Progressive takes very little investment risk. But, it takes huge underwriting risk.
Premiums are very high relative to equity. It can – if it misprices its policies – wipe out a good
chunk of its shareholder’s equity in a single year.
So, Quan and I thought about Progressive a lot. Did we really want to break the seal on financial
stocks? Once we did Progressive, other financial ideas might start appearing on our top 10 list. I
mean, if we can do Progressive – why not Wells Fargo?
And that’s exactly what happened. We saw how much Progressive was hurting because of low
interest rates. I described it as “flying on one engine” because Progressive usually made profits
on both investments and underwriting. But, the stock’s current P/E only reflected the
underwriting profit. It had way more float than it had ten years ago – yet it wasn’t earning more
investment profit than it had 10 years ago. If that was true of Progressive – it was probably true
of some banks too. There had to be banks that had twice as much in deposits today as they did
before the financial crisis – and yet they weren’t earning a penny more in income than they had
before the crisis. The stock I’m describing here is Frost (CFR). I had mentioned it to Quan
several times. But, we weren’t doing financial stocks. It’s just not something we ever planned to
do. And so, whenever I mentioned Frost – Quan wouldn’t say there was anything wrong with
Frost. He just said we weren’t doing financials. But then we had done Progressive. So, now we
were doing financials. So, it was time to look at banks.
Warren Buffett has said something like – I’m paraphrasing here: the best investments are the
ones where the numbers almost tell you not to invest, because then you are so sure of the
underlying business.
I don’t think he is talking about numbers specifically when he says that. I don’t think that
statement is an argument against value investing. It’s an argument against prejudice. So, Warren
Buffett is – at heart – a value investor. He is going to make the mistake of passing on a great
business because it trades at too high a P/E ratio more often than he’s going to make the mistake
of buying a great business at too high a price. Well, we each have our own biases. I certainly
have that same value bias that Buffett has. I have missed out on some stocks I should have
bought because they were trading at an above average P/E ratio, EV/EBITDA ratio, etc. They
looked expensive by all the usual metrics. I also have a bias against financials stocks. So does
Quan. So, it took a lot for us to move in that direction. We didn’t do it for just any insurance
company – we did it for Progressive. And then when we moved into banks, we didn’t just pick
any bank – we picked Frost (CFR). Progressive is a much better business than almost any other
insurer. Frost is a much better business than almost any other bank
It’s interesting to talk about how we moved into doing banks at all. It took a lot of time. What
happened was Quan had to do some research into the industry. He needed to gather information
on a lot of banks and create some Excel sheets we couldn’t find ready made elsewhere. There
were two reasons for this. One, we needed long-term data on the industry to prove that
something like the 2008 financial crisis wasn’t more common than we thought. And, two, we
needed many banks to draw from for potential picks. It was especially hard to come up with
good banks. We thought we’d find a ton of them. If we’d been looking for banks that were cheap
enough – value stocks – we might have found plenty. There are thousands of banks in the U.S.
But, they aren’t equally attractive. Small banks don’t have the economies of scale of big banks.
They tend to have higher expenses as a percent of their total earning assets. They also don’t have
equally attractive deposit bases. I know the three banks I was most interested in from the start
were: Frost (CFR), Bank of Hawaii (BOH), and Wells Fargo (WFC) because I was most
comfortable with their deposit bases. We never did an issue on Wells. Quan looked at it for a
very long time. I can’t think of another time where we talked so much about a stock we didn’t
do. But, we did do issues on Frost and Bank of Hawaii.
We also did issues on Prosperity, BOK Financial, and Commerce (CBSH). We found those
stocks as peers. Frost’s most natural peer in Texas is Prosperity. It’s the second largest bank in
Texas. And then Frost’s closest peer in energy lending is BOK Financial. Commerce would have
shown up as a peer of BOK Financial. And we were going to do an issue on UMB Financial.
UMB is controlled by different descendants (I guess they’re cousins) of the founder of
Commerce. So, members of the “Kemper” family control both Commerce and UMB. However,
the lines of succession split off almost a century ago, so these people are not closely related even
though the banks share the same founder and are both controlled by Kempers.
So, what can this tell you about working with an investing partner? Quan and I both had a bias
against financial stocks. It may have taken us even longer than it would have if we were
investing on our own to branch out into these stocks. Would I have written about Frost sooner if
Quan hadn’t been so reluctant to do banks? Maybe. But, I certainly wouldn’t have done issues on
Prosperity, BOK Financial, and Commerce without Quan. Those were much more his picks than
mine. Without Quan, I might have eventually done issues on both Frost and Bank of Hawaii. I
don’t know about Wells Fargo. Wells is a tricky idea to discuss. Quan and I both like the stock a
lot. We thought – even at the time we were looking at the stock – that it was one of the cheapest
banks we’d looked at on a normalized basis. And yet we didn’t do it. Quan was more insistent
than me that we not do it. But, I’m not sure I’d do Wells if I’d been writing the newsletter on my
own. I know I would have written about Frost first, Bank of Hawaii second, and Wells – if I ever
decided to write about Wells – third. I was more comfortable with both Frost and BOH than
Wells. Quan was more comfortable with all the banks we did than with Wells.
There are sometimes slight differences between Quan’s preferences and mine. For example, I
told some subscribers who asked about it that Quan probably likes Prosperity (PB) a bit more
than I do and I probably like Bank of Hawaii (BOH) a bit more than Quan does. But I like
Prosperity fine. And Quan likes BOH fine. Maybe this reflects a difference that Quan is a little
more comfortable with a long-term strategy of serial acquisitions and I’m a little more
comfortable with a long-term strategy of continual stock buybacks. Prosperity is unusual in how
many acquisitions it does. BOH is unusual in how much stock it buys back.
There’s a chance I would’ve done Wells if Quan wasn’t co-writing the newsletter. There’s a
chance I would’ve done ATN International (ATNI) if Quan wasn’t co-writing the newsletter. I
think ATNI is more likely than Wells. But, in most cases where we eliminated a stock – it was
unanimous.
I’ll give just two examples. Two stocks we liked a lot – and thought were “good” bets in some
sense – but eliminated from consideration were Western Union (WU) and Wells Fargo (WFC).
However, we were pretty much in agreement that Wells was too difficult to understand and that
we didn’t like the management at Western Union. If one person had each of these “hunches”
alone – would they have ignored it? Maybe. So, maybe analyzing stocks in pairs helps build your
confidence more than it helps you avoid your blind spots.
 URL: https://focusedcompounding.com/analyzing-stocks-with-a-partner/
 Time: 2016
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How to Find the Most Persistently Profitable Companies
“GuruFocus provides data on predictability of a business. Do you like this metric? Do you use
this metric in your analysis? It seems to me that the more predictable a company’s historic
earnings, the easier it should be to calculate the intrinsic value of the company. Do you agree
with this assessment?
The problem with this for value investors is predictable businesses tend to not get nearly as
mispriced (at least highly followed large cap stocks).”
I do use predictability in a general sense. I don’t want to talk about GuruFocus’s measure of
predictability specifically – because GuruFocus publishes some of the stuff I write. So, I’m
biased. If I say something good about a GuruFocus feature – you won’t believe me. And I
wouldn’t want to say something bad because they’re kind enough to publish my writing. I’ll just
say that “predictability” is a good measure to look at. And that is what the GuruFocus
predictability rank is trying to do. So, it’s trying to do a good thing. And you’re not going to
come to any harm by looking at it. And you might get something positive out of looking at
GuruFocus’s predictability score for a company. So, yes, I like the metric of predictability.
Now, what do I use personally? I enter a company’s financial data into Excel myself. I’ll look at
the data at places like GuruFocus. But, I want to go to the historical 10-Ks and pull the numbers
out myself and adjust them as I see fit. This is to get comfortable with the numbers. There’s a
difference between when you are relying on something a computer has done and when you are
doing the data entry yourself. So, I set up an Excel sheet with 15 years or 20 years or 30 years of
financial data. I prefer 30 years where 30 years of data exists. I also like to read the very oldest
and very newest annual report from the company. Sometimes I read other specific past annual
reports (like the 2008 financial crisis year) that were unusual for the company, the industry, or
the country it operates in.
One thing I have Excel calculate is the variation in EBIT margin. So, if you have say 30 years of
financial data for EBIT, and the EBIT margin is positive in every single year – you’ll be able to
calculate both the standard deviation and the (arithmetic) mean in the series. Excel can give you
other types of averages too. It does geometric and harmonic means which investors use rarely.
But something like the harmonic mean is actually a useful measure for the very long-term return
on capital, because as a rule – a company’s compounding in its intrinsic value will not be less
than the long-term harmonic mean of its return on capital. It could – especially if it’s in a very
cyclical industry – be much lower than the arithmetic mean. I bring this up because it’s sort of
related to “predictability”. Investors don’t pay much attention – except to “recency” – to the
order a company’s results come in. But, the order of results is important for things like
compounding. It’s not important if the variation in ROC is close to the mean. Let’s say I’m
looking at ROC and I have a 30-year series of ROC figures with – Minimum: 10%, Maximum:
20%, Median: 15%, Mean: 15%, Standard Deviation: 5%. That’s a very predictable company.
The median and mean are the same. We can scale the standard deviation to the mean (5% / 15%
= 0.33). Variation of 0.33 in ROC is low. Not many companies have such low variation in ROC.
I use the same calculations I just showed you for the company’s ROC history and apply it to the
company’s EBIT margin history. I like to look at both return on sales (EBIT/Sales) and return on
capital (EBIT/Net Tangible Assets). When you are buying into a company – you must remember
that earnings aren’t actually that stable. As a rule, things like assets and sales are going to vary
less than earnings. That’s as a rule. It’s not totally true. There are cases where a company has
several good business units and one money-losing or breakeven business it’s just running as a
legacy. In that case, it could dispose of a lot of assets and eliminate a lot of sales and yet not
make much of a dent in earnings. But, if we’re talking about the core business – the good
business – a change in assets or sales from year to year is going to be smaller than a change in
earnings.
Let’s talk about the danger of using the two ratios value investors mention most: P/E and P/B.
Earnings are volatile. So, P/E isn’t a good measure. And then P/B is a net number. Book value –
or tangible book value (you should always be using tangible numbers for equity and assets) – is
net of the liability situation. So, it’s a heavily leveraged number. When a company has low
liabilities, P/B could be a pretty stable and solid indicator because it’s basically like
Price/Tangible Assets. But, in cases where the company has an “iceberg” type balance sheet
where it has $100 a share in assets and $90 a share in liabilities and a stock price of $8 a share –
yes, it’s selling for a price-to-book ratio of 0.8. But, an 11% decrease in assets would wipe out all
of the company’s equity. You see the problem. If we look at things like sales and assets – those
are much more stable.
I also do something else people think is really weird. I look at gross profit. Gross profitability is
an important number for me. When I say gross profitability, I mean Gross Profits / Tangible
Assets. So, it’s possible a supermarket – which tends to have a ton of operating leverage, it’s a
high unit volume business – could have a 120% gross return on assets (Gross Profit/Total Assets
= 1.2) and yet it only has a 20% pre-tax net return on assets (EBIT/Total Assets = 0.2). That can
actually happen with a supermarket. So, why does gross profit matter? It has to do with things
like scale, business organization, who is running the company at the top, how much are they
getting paid. Things like that. For example, Village Supermarket (VLGEA) is a relatively small
(by number of stores) Shop-Rite operator in New Jersey. It is run by members of the family that
control the company’s stock. They are well compensated. It’s possible that there are years where
the company makes say $30 million in EBIT and yet pays $5 million to top executives of a
company with only about 30 stores. Now, if another New Jersey Shop-Rite operator (Wakefern
co-op member) acquires Village, it’s not going to pay management $5 million a year to run 30
supermarkets. I’m not sure it’s even going to pay a combined $1 million to however many
people you have running a 30-store operation. An acquirer already has general counsel, a CFO, a
CEO, a COO, a board, etc. So, there’s $5 million right there that can be severely trimmed. And I
don’t know how lean Village runs its head office, its IT, etc. I can better judge the stores. So,
collecting data on the store level – and the gross profit level – is more useful. I’m not sure that
high gross profitability is ever a “green flag”. But low gross profitability absolutely is a “red
flag”. Companies talk about synergies all the time. They talk about plans to turn a business
around and improve margins and so on. Sometimes these plans are realistic – sometimes they
aren’t. But, I’ll tell you right now – they’re a lot more realistic if they plan to increase operating
profit relative to gross profit. They are a lot less realistic if they think they are going to raise
gross profit as a percent of total assets or total sales. If you have 10 firms in an industry with a
combined $10 billion of assets and $2 billion of gross profit – that’s a bad industry. And it’s
likely to be a bad industry even if you consolidate down to just 8 firms, 6 firms, or even 4 firms.
The economics of that business have something severely wrong with them. The ratio of just 20
cents of gross profit for every 1 dollar of assets in service is simply unacceptable.
What does this have to do with predictability? It’s easy to predict an industry like that will have
long-term problems it can’t fix. On the flip side, if you have a company with good gross
profitability year after year for decades and yet net profitability is only now looking good – that’s
something you might want to buy. The reason for this is that when we’re talking about
predictability – we’re talking about persistency. How durable are sales, assets, gross profits, net
income, book value, etc. Things like sales per share, assets per share, and gross profits per share
are more persistent and more predictable from year to year. Now, some investors are going to
say: so what? As an investor, you make money from free cash flow. Free cash flow is usually
somewhat approximated by net income (it can be a very approximate relationship) and so the P/E
ratio is telling you what kind of dividends and share buybacks a company can give you. That’s
why a P/E ratio can tell you what kind of returns to expect in the future. I’d agree with that line
of logic if you applied it to an entire nationwide market. If we’re talking the S&P 500. Then yes.
First of all, the P/E ratio still doesn’t matter. But a normalized P/E – like the Shiller P/E does
matter. But that’s because we know the quality of the S&P 500. It doesn’t get better or worse.
It’s too generic a mix of businesses to be worth buying on anything but price.
A company can be worth buying for its predictability though. Some industries have more
persistent profits than others. When I was writing my newsletter, Quan (my co-writer) and I gave
every single stock we looked at an industry category code. So, we’d code an ad agency like
Omnicom as “business services” and a fast food joint like Greggs as “restaurant” and a
helicopter hoist maker like Breeze-Eastern as “capital goods”. You can find research on the
relative persistency of profits in industries like business services, restaurants, and capital goods.
Generally speaking, the lower your customer retention, the lower the purchase frequency, and the
further you are from the end consumer – the worse the persistency of your profitability is. Now,
this isn’t always true. Market structure matters too. Breeze-Eastern was a duopolist with a 50%
or higher share of search and rescue helicopter hoists. It was serving an oligopoly (about 5-6
helicopter makers). As a rule, a duopoly that serves an oligopoly is going to have highly
persistent profits compared to some other market structures. For example, the beverage can
manufacturing business has persistent profits. In a given market, you generally have like 3
companies: Crown (CCK), Ball (BLL), and someone else serving a small number of customers
(Coke, Pepsi, Coors, etc.). There’s probably a huge market for smaller plants serving smaller
customers. But the biggest customers need someone who can do huge volumes at one plant. So,
you have only a small number of customers who need huge volumes at a single plant and only a
small number of competitors who are willing to produce huge volumes at a single plant for a
single customer. So, you have persistency in that kind of business. I think BWX Technologies
(BWXT) should have persistent profits. It’s the monopoly provider of all but one (Curtis-Wright
makes the one) nuclear components for reactors in U.S. Navy submarines and aircraft carriers. It
also has a monopoly position in uranium down blending and some other stuff related to the U.S.
nuclear weapon program. I think it’s persistent because I don’t think the U.S. Navy will – within
the next few decades at least – want to stop producing nuclear powered submarines or aircraft
carriers and I don’t think they can possibly choose any other provider besides Babcock for what
they need. So, Babcock has a monopoly position.
The best kind of persistence comes from high customer retention. I like the ad agency business,
the auto insurance business (although I’m convinced driverless cars will obsolete this business
over the next few decades), and banks because the customer retention rates for an ad agency can
be 95%, for a bank they can be 90%, and for an insurer they can be 80%. If ad agencies, banks,
and insurers didn’t retain the same clients – if they had to market aggressively to win new
business, I’d have no interest in them. The lack of price competition to retain customers is what
attracts me to this business. Now, there is very intense price competition in insurance –
especially to win a new customer. In fact, auto insurers lose money on new customers at first
because they spend so much on marketing. Once they have a customer though, retention rates are
high. There are people who have been renewing with the same insurer for 25-50 years. Ad
agencies are even better. There are tons of big brands that have been with the same creative
agency for more than 25-50 years. A couple have been with the same agency for 100 years.
So, yes. I do look for predictable companies. I look at long-term variation (standard deviation /
mean) in return on capital and EBIT margin. GuruFocus also has predictability rankings. You
can use those too. Think a lot about how persistent profits tend to be in each kind of industry.
Know that EBIT margins at a restaurant are a lot more predictable than EBIT margins at a capital
goods company. And remember that things like assets and sales are more persistent than
earnings. Gross profit is also more persistent than net profit. So, start by looking at long-term
trends in sales, assets, and gross profit. For example, has asset growth been consistent? Or has it
been accelerating in recent years? Try not to buy into a company that is growing its assets more
rapidly than everything else. High asset growth right now is usually a bad sign for ROA in future
years. Growing profits faster than assets in recent years is usually a better sign.
I’d focus on persistence on measures like ROC and margins rather than growth itself. Consistent
growth is good. But, a 7% annual growth rate that is consistent and accompanied by a high ROE
is all you need. You don’t need 12% annual growth. What you need is consistent growth
accompanied by a high ROE.
 URL: https://focusedcompounding.com/how-to-find-the-most-persistently-profitable-
companies/
 Time: 2016
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How to Invest When You Only Have an Hour a Day to Do It
“If one was a widely-read value investor but only had 5-10hrs per week to spend on investing
(due to employment / family constraints) and one had less than $1m, would you recommend a
classic Graham net-net portfolio as the surest and best way to make market beating returns? If
no, what other strategy (apart from indexing) would you recommend under these time
constraints?”

I’m going to rephrase this question as “If one only had an hour a day to spend on investing”. You
said 5 to 10 hours. I’m going to ask you to spend 5-7 hours a week on investing. But it must be
an hour a day – every day – instead of five hours all at once. There’s a reason for this. I want you
100% focused when you are working on investing. You don’t have to spend a lot of time on
investing. But you do need to be focused when you are doing it. Most people who invest are
never fully focused for even an hour on a narrowly defined task. So, that is what I need from
you. An hour a day of total focus. If you can’t do it every day – then don’t do it at all on
weekends. Just spend an hour a day on Monday through Friday. But never skip a day. Okay.
Let’s say you’re willing to make that commitment. Then what?

The approach for you to use is not a net-net approach. It’s a focused approach. A concentrated
approach. You don’t have a lot of time. So, you need to spend that time focused on what matters
most. Stock selection is what matters most. So, first I want you to give up the idea of selling
stocks. Don’t worry about it. You’re only going to sell one stock to buy another stock. You’re
not going to sell a stock because it is now too expensive, the situation has played out, etc. Okay.
So, we’ve cut out about half the time investors spend thinking about stocks. You can now devote
all the time you would have spent thinking about selling the stock you already own and instead
double the time you will spend thinking of the next stock to buy. I also want to eliminate the idea
of portfolio management – asset allocation, diversification, etc. – from your schedule. So, I’m
going to ask you to commit to identically sized positions. By this I mean the positions will be the
same size when you buy them. So, if you are comfortable being as concentrated as I am – then
you’ll want to set 20% as your position size. You’ll own just 5 stocks. If you want to be more
diversified – you can settle on owning 10 stocks at a time. That’s fine. But I don’t want you to
have some 5% positions and some 20% positions. If you are going to own 10 stocks at a time –
make every position a 10% position. If you want to be really, really diversified – you can own 20
stocks at one time. In that case, every time you buy a stock – you put 5% of your portfolio into
the stock. There’s no point owning more than 20 stocks. It doesn’t do much to diversify any
risks. And it does distract you from what matters most – deciding which stock to buy next. So,
start out by making that decision now. Do you want to own 5 stocks, 10 stocks, or 20 stocks? Do
you want to put 20% into each stock, 10% into each stock, or 5% into each stock? Make that
decision now. And then that rule is set in stone for you. Never vary how much you put into a
specific stock. This will keep you from being distracted by concerns about how much you like a
stock – how much you “should” allocate to it. The answer is that you should allocate the same
amount as you always do to every stock you like. Now, you can focus 100% on finding stocks to
buy.
The next thing you need to do – if you only have an hour a day to spend on investing – is to
commit to holding stocks for as long as possible. This is critical. I was talking to someone
recently who considers himself a buy and hold investor. And yet he found that over the last year
– when he was pretty happy with his portfolio – he still had portfolio turnover of about 30%.
That means, on average, he was holding stocks for only about 3 years. And he probably had
years – years where in January he liked the stocks in his portfolio less – where his turnover was
more than 30%. Let’s think about the difference between owning stocks for an average of 2 years
– as even many value investors do – and owning stocks for an average of 5 years. I want you to
try to get closer to the 5-year holding period. Why?
The three choices I gave for diversification were a portfolio of 5 evenly weighted positions, 10
evenly weighted positions, or 20 evenly weighted positions. The ideal situation in terms of
focused attention is a 5-stock portfolio and a 5-year holding period. That’s because this is a low
maintenance portfolio. The “maintenance” level of idea replenishment is just one great idea per
year. You have an hour a day to spend on investing. If you spend that every day – including
weekends – that means you have 365 hours to spend picking just one stock. Coming up with one
good idea for every 365 hours you spend looking for one sounds easy, right? Even if you don’t
work on investing on the weekends – it’ll still be 260 hours of thought to come up with just one
idea. Now, what if you own 10 stocks and hold them each for 5 years? Then your idea
replenishment rate has to be 10 stocks / 5 years = 2 stocks a year. If you’re only spending 260
hours a year on investing – we’re down to 130 hours spent coming up with one idea. At 20
stocks / 5 year holding period it’s 4 stocks a year. And that’s only 65 hours of thinking per idea.
Think of the worst-case scenario here: a portfolio of 20 stocks that you only hold on average for
2 years. Some investors do invest that way. How can they? You’re still committing to just 260
hours of focused thought on investing. But now your replenishment rate is 20 stocks divided by a
2-hour holding period equals 10 stocks. You’d need 10 new stock ideas this year. You only have
260 hours to spend thinking about investing this year. So, you’d have to come up with one great
idea every 26 hours. That’s less than a work week (40 hours) of thought to come up with a great
stock idea. Who can do that? You’re going to end up relying on other people’s judgment.
Because you aren’t going to have enough time to form an opinion of your own.
Let’s go back to the ideal. You spend an hour a day – including weekend. You only hold 5
stocks. And you hold each of them for 5 years on average. That’s 365 hours of thinking for just
one great idea. This is what I want every value investor to reach for. Come as close to spending
one focused hour a day on investing as you can. Come as close to keeping stocks for 5 years as
you can. And come as close to owning just 5 stocks as you can. Most investors will fall short of
each of these 3 goals. But these should be the goals you’re reaching for.
So, what kind of stocks should you spend this 365 hours a year looking for? And where can you
find these ideas? You want great businesses that are having temporary problems. You want a list
of companies you might one day own. Where can you come up with such a list? GuruFocus has a
Buffett-Munger newsletter, it has a Buffett-Munger screen, and it shows 15 years of financial
data for stocks. Look for the predictable ones. You can use ratings on this. But, look yourself at
predictability as you would judge it – not just as a computer program would. Do you see a
dependable history of EPS stability, EPS growth, margins, returns on capital, etc. I look at
operating margin (EBIT) margin volatility. That’s always my favorite measure. In my
experience, most companies – by which, I mean most managers who run the day-to-day business
of each unit, location, etc. – don’t want to do less physical volume this year than last year and
they don’t want to have a thinner profit margin. They like doing a little more physical volume –
unit volume – than last year and they like making a little more profit per dollar of sales than they
did last year. They are frightened by the idea of falling volume and falling margins. So, the
competitive pressure in a lot of industries is toward protecting volume and protecting margin.
When volume declines – a company may try to lower prices, increase marketing, etc. When
margins decline – a company may try to cut overhead, look for synergies, cheapen the product,
etc. We often don’t have good unit volume data. In fact, most public companies are too
diversified across too many different product lines to have consistent reporting on unit sales and
pricing per unit. Some commodity type businesses do have data on this. A miner, a steelmaker,
an airline, a hotel, etc. has good data on this. But all companies have data on EBIT margin
variation. So, that’s what I look at. EBIT margin is just pre-tax operating profit divided by sales.
The level of the EBIT isn’t what’s important to me. In a business like software you could have
an EBIT margin of 30%. In a business like groceries you could have an EBIT margin of 3%.
What matters to me is how likely it is that the 30% margin for the software company is going to
stay in the 20% to 40% (plus or minus one third of the average), and how likely the margin of the
supermarket is to stay in the 2% to 4% range (plus or minus one third of the average). That’s
really the same thing. So, stability in the EBIT margin has to be defined as variation scaled to the
mean. For a company that has been profitable in each of the last 15 years – you could use 15-
year average Standard Deviation / Mean. That’s a number I track in Excel. I prefer industries
where EBIT margin variation (defined as the Standard Deviation in the 15-year EBIT margin
divided by the 15-year mean EBIT margin) is low. And I like those companies in an industry
who have the lowest EBIT margin variation. These are usually the least marginal players. They
are leaders in their market niche. The weakest companies in an industry – especially those that
compete primarily on price – often have wobbly EBIT margins compared to the leaders. It’s not
a perfect measure. Scale can be a problem. Some companies have wobbly EBIT margins simply
because they aren’t big enough to enjoy economies of scale. These companies may not be good
investments yet – but they are good takeover targets for the bigger companies in the same
industry. So, this isn’t a perfect measure. But some measure of predictability – whether it’s EBIT
margin variation, or GuruFocus’s predictability measure, or your own eyeballing of the 15-year
history, is a good place to start your search for ideas.
You can read blogs and articles. I recommend the GuruFocus articles written by “The Science of
Hitting”:
http://www.gurufocus.com/news.php?author=The+Science+of+Hitting&u=110170
And the blog “Base Hit Investing”:
http://basehitinvesting.com/
There are also idea boards like “Value Investor’s Club”:
https://www.valueinvestorsclub.com/ideas/atoz

I don’t recommend Value Investors Club the same way I do the blogs and articles I mentioned
above. A lot of that board is short-term oriented, interested in shorting, etc. And the quality of
the ideas is very hit or miss. So, I’m not suggesting VIC on the basis of idea quality. Just
quantity. It has a ton of different stocks that have been posted there over the years and those
stock ideas come with plain English descriptions of the business and its possible competitive
advantages. So, it’s a good place to peruse.
One caveat: if you’re going to read articles and blogs – don’t read them willy nilly. Block out
your article and blog reading times. So, don’t read one article of mine at a time or one “The
Science of Hitting” article or “Base Hit Investing” blog post. Instead, identify the articles you are
interested in as you find them. But then print them out and put them aside till the end of the
week. I want you to spend a full hour of total focus reading the blog posts, articles, etc. you
thought you’d be interested in. Don’t just dip in for 15 minutes at a time reading blog posts,
articles, newspapers, etc. as you come across them during the week. Put them away in a folder
till you are ready to focus on them.
This is what I do. I have baskets that I fill with reading material during the week. Then I tell my
Amazon Echo to set a timer for one hour and I read as much of the material as I can get through.
I put the rest aside till later and do this again. I read with a pen in my hand and mark up the
articles, posts, etc. I read with questions of my own. This ensures I’m 100% focused and 100%
engaged with the material. Most people who read an article or blog post are neither fully focused
on it nor fully engaged with it. They just read it passively for 10 or 15 minutes and then move on
to the next unrelated task. They may have just been checking their email a minute before and will
be checking their phone a minute after. Don’t do this. Create a “batch” of reading material you’re
interested in. Set a timer for one hour. And then do nothing but read that material for that hour.
An hour a day is plenty to spend on investing. But you have to spend it 100% focused.
For more information on how to do this kind of focused work you can read the book “Deep
Work: Rules for Focused Success in a Distracted World” by Cal Newport. I’m recommending
the subject. I’m not really recommending the book as a book. It’s not a great book. But it’s a
great subject. And I’m sure you’ll get something out of reading the book if you haven’t already.
So, my five suggestions for someone who only has an hour a day to spend on investing are: 1)
Read “Deep Work: Rules for Focused Success in a Distracted World” 2) Spend all your
investing time focused entirely on selecting which stocks to buy 3) Read articles from authors
like “The Science of Hitting” and blogs like “Base Hit Investing” – but only in hour long focused
batches of reading material 4) Use tools like GuruFocus’s predictability ratings and 15-years of
financial data to find the most predictable businesses and 5) Buy great businesses that are going
through temporary problems.
 URL: https://focusedcompounding.com/how-to-invest-when-you-only-have-an-hour-a-
day-to-do-it/
 Time: 2016
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Is Value Investing Broken?
“Is value investing broken?
To clarify: with worldwide debt at 200+ trillion and incomes stagnating or falling who exactly is
going to go out and buy new products (whether from Luxottica, Movado, Swatch etc.) when they
have record debt levels and are getting by at $10/hr? I realize that is a limited example but in
many industries there is massive change going on that will, temporarily at least, push down
income levels (driverless cars and trucks, robotic everything etc.) and people will therefore be
spending less. Does value investing still work in this environment? Do you bother investing at
all?
Apologies for the gloomy tone of this email but I don’t see a good place currently to invest and
am frustrated by my inability to figure it out. Please help!“

No. Value investing is not dead. There’s a tendency for people – people of any time – to see the
time they live in as unique, dangerous, different, unlike any other age. In some ways, they are
always right. Some things really are different this time from all other times. But, mostly, they’re
wrong. And what they are wrong about is reading a golden age of stability into the past. I was
talking with a value investor once and this value investor said that sure Ben Graham’s ideas
worked in Ben Graham’s times. But Ben Graham invested in simpler times.

Here are the times Ben Graham invested in: the 1910s through the 1950s. He invested during
Two World Wars, the start of the Cold War, the atomic bombings of Nagasaki and Hiroshima by
the U.S. and then the testing of nuclear weapons by other countries, The Great Depression, a big
explosion (reportedly a terrorist bombing) on Wall Street, and the longest shut down of trading in
Wall Street history that I can remember at least (right as World War One started). People talk
about political risk today. Political risk in Ben Graham’s time meant Marxists and Fascists.
Investors saw hyperinflation in Germany after the war and then they saw deflation after the 1929
crash. These were not simple times. If you go back and read the newspapers from the time – you
can see how not simple they were.
Now, yes, they were different from today in some ways. Much of the period investors and
economists in the U.S. study were more regulated than today. So, you either had the Gold
Standard or Bretton Woods. You had much greater belief in planned and insular economies in a
lot of countries. With the benefit of hindsight – and seeing the entire sweep of history – many of
these decades seem simple to us. They rarely were. Try to find a decade without too much
inflation, too much deflation, too much war, the mania of some bubble, or the bursting of that
bubble. At any point in that past, people could have believed value investing was dead. And yet,
buy and hold investors – business owners and the like – have been compounding fortunes in the
U.S. from the 1800s through today. If there are companies that can make founders and their
families billionaires – there are companies that can make shareholders very rich if they buy and
hold.
It’s hard for me to address the specific issues you mention in your email, because I don’t think
that’s the problem here. The problem is that you are looking at the entire investment landscape as
a depressive would look at their own life. You are fixating on some negative things – some real
headwinds – that are likely to be a drag on the performance of some investments for many years
to come. Sure, those things exist. But, both good and bad things exist in all sorts of years. In
1946, an investor could have lamented the low yield on bonds, the inevitable depression that
would come from demobilization (many people at the time believed there would be such a return
to Depression as soon as the war was over) and then either another World War or a nuclear
exchange. With hindsight, we can see that 70 years later, there never was another World War nor
did anyone else use nuclear weapons. But, that would have been a hard sell in 1946. Try
convincing people who had been through two World Wars in 30 years and now saw the
invention of a weapon of mass destruction that there would be no war on that scale again in their
countries and there would be no nuclear exchange.
Your question was not about geopolitics. And some value investors get tired of Warren Buffett
often repeating that he first invested in 1942 when the U.S. was losing the war against Japan.
But, it is worth remembering these things. Because to the people who were caught up in them at
the time – the outcome was not clear. We may believe The Great Depression was some sort of
one-off event and that while World War Two may have provided a great deal of stimulation to
the economy that did not mean that the second it ended, the peacetime economy would again
return to that Depression. But, people at the time did believe that. They were unsure. Just as we
are unsure.
As far as things like mechanization – I understand your concern. And I don’t deny that over time
you will see the substitution of capital for labor. But, that has already happened in the past. My
grandparents all worked in jobs that are now done by machines. They either did factory work
that is completely automated now or they did office work that is now performed by managers
using computers instead of secretaries. There are still workers in those factories. But the tasks
they themselves performed are not done by humans any more. There are still workers in those
offices. But there are not secretarial pools typing up all the inter-office communications that is
now done entirely by email. So, those jobs don’t exist. That’s not at all unusual.
And deflationary pressure from investment in capital like driverless cars is not unusual either.
Driverless trucks aren’t really that different from railroads. Very little labor is involved in
running railroads now. If you look at things like railroads and farms in the U.S. and how many
people used to be involved in doing work at those sites and how much greater output there is
now with far fewer people – you’ll see that these are not new trends.
Deflation is probably the natural state of an economy. Even if you look at economies like the
U.S., you don’t have much in the way of inflation between about the end of the Revolutionary
War and the start of the Second World War. The inflation you have is largely over the last 75
years. Now, obviously, the economy grew tremendously quickly before all of that inflation.
Debt problems are not new either. In the ancient world – the Roman Republic and Athenian
Democracy – the most common call for reform was debt relief. There were occasional monetary
crises and these were often discussed in terms of heavy debt loads that couldn’t be serviced.
There was a push even in Ancient Athens to get farmers to stop investing in growing food crops
and instead focus on a cash crop (olive oil) that the city could export. Olive trees take time to
mature. So, they require an upfront commitment of capital with no immediate payback. Farmers
didn’t want to do this. And it was only those who had ample capital – probably from trade – who
were eager to make the investment. It is not an unusual problem to see those with heavy debt
loads unable to make the necessary investments in capital and falling behind in society. Back in
ancient Rome and Athens this was investment in large scale farms. It was investment in slaves,
and implements, and land improvement, and focus on cash crops instead of food crops. Doing
those things took savings. Today, it can be the cost of tuition. Education is critical to future
earnings. So, a parent in the U.S. may feel they have to buy a home – taking out a huge mortgage
to do so – to raise their kids in the right town with the right schools. And those kids may – when
they reach college age – feel they need to take out student loans and pursue graduate degrees and
so on. Most people don’t have the savings to do this. So, they borrow. They have to borrow to
invest in their own human capital. People who have only their labor – and no saved up “human
capital” in the form of education and specialized skills – fall behind relative to others. That’s the
kind of story you are telling me now. It’s a sad story. But, it’s not a new story. Likewise, cyclical
debt problems aren’t new. They aren’t new for households, for businesses, or for governments.
Historically, governments defaulted all the time. The conclusions in the book “This Time Is
Different” might not be right. But the list of defaults they have for governments going back
centuries isn’t wrong. Those governments really did default. And some of these government
defaults happened during periods we now consider “normal” and “stable” and “simple”
compared to today.
There are a lot of changes happening in the economy right now. There are a lot of risks. I just
wrote a post about the possibility of negative interest rates. Now, in the 1970s and 1980s, what
would an investor say about such a post? They’d think I was crazy to even write such a post. And
they wouldn’t necessarily think that sounded like such a bad place. A place without inflation?
The concern back then was that inflation would destroy an investor’s returns even if he picked
the right stock. And you know what – they were right.
As a buy and hold investor, the risks posed by depression, deflation, and negative interest rates
aren’t as bad as the risk posed by persistently high inflation. It’s easy to forget that now. You
look back at Berkshire Hathaway’s results through the 1970s and you think they look pretty
good. But, as Warren Buffett wrote in one of his letter to shareholders – the truth is that an
investor could have done about as well simply by investing in a barrel of crude oil or an ounce of
gold instead of Berkshire Hathaway stock. That’s not because Buffett wasn’t making great
decisions. Buffett’s own record has gotten progressively worse each decade in terms of the value
his decisions have added. His best decade as an investor was the 1950s, his best decade at
Berkshire was the 1960s, then the 1970s and so on. But, during the 1970s and into the 1980s – it
was very hard for an investor buying and holding high quality businesses to outperform assets
like land, gold, and oil. Low amounts of inflation might be good for some businesses. For
example, Grainger (GWW) has said that it benefits from inflation because its own business is
deflationary. So, it can take costs out of its own distribution centers before it passes those savings
on to customers. There is a time lag. And that lag can benefit the company by as much as 2% a
year. Customers will eventually see the benefit of the company’s cost savings. But, the company
will see them first and then only update catalog prices later. But, most businesses can really only
insulate you from inflation. They can’t benefit from it. So, I’m not even sure that too much debt
is a worse problem for investors to have than too much inflation. If you look at the real return on
equity (nominal ROE less inflation) at companies, it has obviously been good recently. It was
terrible at times in the 1970s and 1980s. There were large U.S. companies that weren’t creating
any real – inflation adjusted – value for shareholders. You could buy the Dow near book value
and it would just manage to preserve your real purchasing power – not help grow your actual
wealth.
The problem here is not with the world economy. It’s with your framing of your situation. Even
if there was a problem with the world economy – and there is always some problem – you need
to frame your behavior in terms of your own problems and your own opportunities. What can
you do today to make your situation better? It’s not enough to have an opinion about what is or
what isn’t true about the world. You need to have an opinion that’s useful to you as an investor.
You need an idea about how you can get to work doing something to improve your own
situation.
 URL: https://focusedcompounding.com/is-value-investing-broken/
 Time: 2016
-----------------------------------------------------
The Moat Around Every Ad Agency is Client Retention
Moat is sometimes considered synonymous with “barrier to entry”. Economists like to talk about
barriers to entry. Warren Buffett likes to talk about moat. When it comes to investing, “moat” is
what matters. Barriers to entry may not matter. Thinking in terms of barriers to entry can frame
the question the wrong way.
If you’re thinking about buying shares of Omnicom and holding those shares of stock forever –
what matters? Do barriers to entry matter? Does it matter if it’s easy to create one new ad agency
or a hundred new ad agencies? No. What matters is the damage any advertising company –
whether it’s WPP, Publicis, or a firm that hasn’t been founded yet – can do to Omnicom’s
business. How much damage can a new entrant do to Omnicom’s intrinsic value? How much
damage can Publicis or WPP do to Omnicom? The answer is almost none. In that sense, the
barriers to entry in the advertising industry are low but the moat around each agency is wide.
How can that be?
First of all, the historical record is clear that among the global advertising giants we are talking
about a stable oligopoly. The best measure of competitive position in the industry is to use
relative market share. We simply take media billings – this is not the same as reported revenue –
from each of the biggest ad companies and compare them to each other. If one company grows
billings faster or slower than the other two – its competitive position has changed in relative
terms. Between 2004 and 2014, Omnicom’s position relative to WPP and Publicis didn’t change.
Nor did WPP’s relative to Publicis and Omnicom. Nor did Publicis’s position relative to WPP
and Omnicom. Not only did they keep the same market share order 1) WPP, 2) Publicis, 3)
Omnicom – which is rarer than you’d think over a 10-year span in many industries – they also
had remarkably stable size relationships. In 2005, WPP had 45% of the trio’s total billings. In
2010, WPP had 45% of the trio’s combined billings. And in 2014, WPP had 44% of the trio’s
combined billings. Likewise, Omnicom had 23% of the trio’s billings in 2005, 22% in 2010, and
23% in 2014. No other industries show as stable relative market shares among the 3 industry
leaders as does advertising. Why is this?
Clients almost never leave their ad agency. Customer retention is remarkably close to 100%.
New business wins are unimportant to success in any one year at a giant advertising company.
The primary relationship for an advertising company is the relationship between a client and its
creative agency. The world’s largest advertisers stay with the same advertising holding
companies for decades. As part of our research into Omnicom, Quan looked at 97 relationships
between marketers and their creative agencies.
I promise you the length of time each marketer has stayed with the same creative agency will
surprise you. Let’s look at some of the examples. Wrigley – now a part of Wrigley Mars – used
Saatchi & Saatchi as its creative agency from 1954 till 1995. Wrigley left Saatchi because of
squabbling within the Saatchi family itself. After leaving Saatchi, Wrigley has been with
Omnicom from 1995 through 2015. So, 40 years with Saatchi and then 20 with Omnicom.
Procter & Gamble has historically used Saatchi and Grey. P&G’s relationship with Saatchi dates
back to 1921. Its relationship with Grey started in 1956. P&G’s relationship with Grey was
costly to Omnicom, because P&G acquired Gillette in 2005. Gillette had been a client of one of
Omnicom’s agencies for about 70 years. But, since P&G prefers working with Saatchi and Grey
– it moved the Gillette account to Grey in 2013. This is how many big clients are lost. The client
merges with a company that is served by a competing agency. Unilever has been an even more
loyal client than P&G. Unilever prefers working with J. Walter Thompson and Lowe. It has been
with J. Walter Thompson since 1902. So, that relationship is now 114 years old. It’s not the
oldest relationship for Unilever. The company started working with Lowe in 1899. So, that
relationship is 117 years old. Another example in household products brands is Clorox. Clorox
has been with Omnicom’s DDB since 1996. Its prior relationship lasted 75 years. So, Clorox
chose an agency in 1921. Then, it switched creative agencies in 1996. So, two moves in close to
a hundred years.
Some industries have very high client retention. It seems financial services firms mostly leave
agencies due to consolidation. So, one bank buys another and they switch to the bigger bank’s
creative agency. Otherwise, the relationships are almost all long ones. State Farm has been with
Omnicom’s DDB from 1930 till today. Between 2010 and 2011, State Farm shifted some of its
business – especially the car insurance brand – to a different creative agency, but it moved all of
that work back to DDB the following year. Allstate has been with Leo Burnett since 1957. Geico
has been with the Martin Agency since 1994. All of GEICO’s campaigns you remember were
created by The Martin Agency. American Express has been with Ogilvy since 1962. Visa is an
interesting example of “moat”. Visa has been an Omnicom client from 1985 through today.
However, Visa dropped BBDO in 2005. Omnicom asked Visa to limit its search for a new
agency to among Omnicom owned agencies only. Visa agreed. And so the firm selected from
pitches made by DDB, TBWA, etc. It didn’t consider moving to an agency owned by WPP or
Interpublic or anyone else. In 2005, Visa switched from Omnicom owned BBDO to Omnicom
owned TBWA. However, it moved back to BBDO in 2012. So, Omnicom retained Visa as a
client despite one of Omnicom’s agencies being fired two different times in that period. Wells
Fargo has been an Omnicom client since 1996. Discover Card was an Omnicom client from 1987
to 2006. Then, Discover moved from Omnicom to The Martin Agency. By 2006, The Martin
Agency would’ve already been well known for the amazing work it had been doing for GEICO
throughout the 1990s and early 2000s.
I don’t want to bore you with almost a hundred different examples of how long one client stays
with one creative agency. But, I do think this is the most important fact in this entire issue. So, I
encourage you to flip to the “Notes” section of the issue and read the list of relationships and
their start dates that Quan prepared for industries ranging from carmakers to transportation
companies to electronics brands.
Consolidation is the leading cause of losing a once loyal client. The other reason clients leave is
because they are fickle. The same brand keeps switching creative agencies. This is common
among troubled brands. A good example is Heineken in the U.S. Heineken is an imported beer
that basically has the same positioning as “better beer” brands like Samuel Adams. Heineken
originally competed with the big, boring domestic brands like Bud. Over the last 20 years, it’s
had to compete with U.S. based craft beers and other imports. In the last 10 years, the brand has
been in constant turmoil. From 2005 through 2011, Heineken had 4 different CEOs and 4
different chief marketing officers. Its creative agency from 2003 to 2007 was Publicis, then
Wieden & Kennedy for 2008-2009, then Euro RSCG from 2009-2010, then back to Wieden &
Kennedy for 2010-2015, and then in 2015 Heineken left Wieden and returned to Publicis. You
can see this is not a problem with a particular creative agency. It’s a problem with the Heineken
brand.
The other reason clients switch is because they belong to an industry with a lot of cyclicality to
brand perception. Restaurants and retailers are the most fickle client group. Still, “fickle” is a
relative term. Client retention is still very high compared to other industries. Wal-Mart has used
3 agencies over the last 30 years. Darden (Olive Garden) has been with Grey since 1984.
McDonalds has used Leo Burnett and DDB since the 1970s.
There is no customer retention figure generally available for Omnicom or for the industry. But,
you can easily estimate the retention rate is above 90% based on the nearly 100 relationships we
looked at. You can peruse many of these relationships in the notes. From time to time, articles
give client retention figures for a single agency. For example, in 2001 and 2002 and 2003 it was
reported that DDB retained 98% or 99% of clients. In 2014, it was reported Grey had a 95%
retention rate. An industry wide customer retention rate of 90% would be conservative for key
accounts. A figure like 95% may be more realistic.
The most important fact to consider is that agencies don’t try to take business from each other.
They try to take business once it is “in review”. In 2006, Omnicom’s CEO said: “We’re invited
to new business pitches…we can’t create them…Fortune 100 companies, typically take their
time and go through a lot of deliberations before they actually…put an account or an assignment
into review.”
In 2007, Omnicom’s CEO (John Wren) again said: “…what goes into review is driven by
clients…we can’t cause somebody to put their account in review.”
In other words, the only time one agency takes a Fortune 100 type client from another agency is
when the client decides first to put the account in review. First, the client says they may fire the
agency and then other agencies pitch for the business. When agencies do pitch for an account in
review, they don’t usually compete on price. Traditionally, creative agencies took a 12%
commission on billings. Media agencies took a 3% commission on billings. Now, the work tends
to be fee based. But, it doesn’t matter. It’s clearly been structured the same way to keep price
competition from happening. Omnicom has a very consistent EBIT margin from the 1990s
through today. It has a quarter century record of extreme consistency in pricing versus its
expenses. It’s basically a cost plus business. We can see with WPP – who reports billings while
Omnicom doesn’t – that sales were between 20% and 22% of billings over the last 20 years.
Again, it’s a consistent number and it’s not lower than the traditional commission structure the
industry used. So, there is no evidence of agencies competing for business by trying to offer
lower fees and commissions. The moat around each ad agency is wide because: 1) Customer
retention is nearly perfect 2) Pricing is very consistent and 3) The relative market share of the
oligopolists in this industry is also very consistent. Without changes in prices or relative market
share – a business is basically the same from year-to-year. So, ad agencies mostly report earnings
growth and declines based purely on the increases and decreases in ad spending by their existing
clients. In fact, what you see in the year-to-year results of an advertising company is basically
just that. It’s mostly just a record of what the existing client roster did in terms of their ad
spending compared to last year. So, the industry is incredibly stable over full cycles. It is cyclical
to the extent that ad spending is cyclical and follows the macro economy.
 URL: https://focusedcompounding.com/the-moat-around-every-ad-agency-is-client-
retention-2/
 Time: 2016
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26 Small Stocks
Over the last two years, Quan and I failed to find as many good, small stocks for the newsletter
as we should have. We did Breeze-Eastern which was small. We also picked Ark
(ARKR), Tandy Leather (TLF), and Village Supermarket (VLGEA). All of those are under
$500 million in market cap. America’s Car-Mart (CRMT) is also on the small side. But, it’s a
financial stock.
If your biggest problem with sifting through small stocks is getting rid of the low quality and
high risk stocks in the group – there’s an easy screen for this.
Just look for stocks that:

1. Have been public a long time
2. Have a long history of profitability
3. Have an adequate Z-Score
4. Have an adequate F-Score
This won’t leave you with a list of good stocks. But, it will remove the junk. This is a value
investing blog. So, we’ll insist on an enterprise value no higher than 10 times EBIT (ideally, it
would be 10 times peak EBIT – but that’s harder to screen for).
If we apply these 5 criteria – 1) didn’t go public recently, 2) decent history of past profits, 3)
decent Z-Score, 4) decent F-Score, 5) decent EV/EBIT – we are left with 26 U.S. stocks with a
market cap under $500 million:
 Armanino Foods of Distinction (AMNF)

 Jewett—Cameron (JCTCF)
 Medifast (MED)
 Span-America (SPAN)
 Espey Manufacturing (ESP)
 IEH (IEHC)
 Educational Development (EDUC)
 Chase (CCF)
 Shoe Carnival (SCVL)
 Air T (AIRT)
 Flanigan’s (BDL)
 Comtech Telecommunications (CMTL)
 Eastern (EML)
 Miller Industries (MLR)
 ADDvantage Technologies (AEY)
 Collectors Universe (CLCT)
 Houston Wire (HWCC)
 Wayside Technology (WSTG)
 Lakeland Industries (LAKE)
 Taylor Devices (TAYD)
 Zumiez (ZUMZ)
 Core Molding (CMT)
 Natural Gas Services (NGS)
 Universal Truckload (UACL)
 Acme United (ACU)
 Preformed Line (PLPC)
This list excludes stocks I’ve already picked. Tandy, Village, and Ark would be on the list if that
wasn’t the case.
Sorting through that list then becomes a matter of personal preferences and biases. For example,
I’d be less likely to research Zumiez – which is a specialty retailer (it’s basically a mall based
chain of stores selling skateboarding related clothes, etc. aimed at teens) because Quan and I
rarely consider investing in retailers. I might be more likely to look at Collectors Universe and
Miller Industries because they have big market share in their niches (collectibles grading and tow
trucks respectively).
 URL: https://focusedcompounding.com/26-small-stocks/
 Time: 2016
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14 Stocks For You To Look At
Quan and I have picked 19 stocks over the last couple years. One of those stocks, Babcock &
Wilcox, split into two different stocks. So, there are 20 stocks that had our blessing. Six of these
are not good choices for you to look at. Two have been acquired so you can’t buy them
(LifeTime Fitness and Breeze-Eastern). Two were stocks we shouldn’t have picked in the first
place (Town Sports and Weight Watchers). And two are now too expensive to be worth your
time (BWX Technologies and HomeServe).
Here is the full list including the six stocks that I’d disqualify.
Once you disqualify those 6 stocks, you’re left with 14 stocks that are still worth looking at
today:
 America’s Car-Mart
 Ark Restaurants
 Babcock & Wilcox Enterprises
 BOK Financial
 Ekornes
 Fossil
 Frost
 Hunter Douglas
 John Wiley
 Movado
 Progressive
 Swatch
 Tandy Leather
 Village Supermarket
America’s Car-Mart
Sells old cars on credit to deep subprime customers mostly in the U.S. deep South.
Ark Restaurants
Runs big single location restaurants (not chains) in high visibility venues (casinos, museums,
train stations, parks, etc.).
Babcock & Wilcox Enterprises
Builds and maintains big steam boilers for thermal power (coal, incinerator, etc.) plants.
BOK Financial
A Tulsa, Oklahoma based commercial bank that does a lot of energy lending.
Ekornes
Makes Stressless brand recliners.
Fossil
Sells watches under the Fossil and Skagen brands it owns and the many fashion brands (Michael
Kors, Armani, etc.) it licenses the rights to.

Frost
A San Antonio, Texas based commercial bank that also does a lot of energy lending.
Hunter Douglas
Makes the Hunter Douglas and Luxaflex brands of shades and blinds.
John Wiley
Sells academic journal subscriptions to university libraries.
Movado
Sells watches under the Movado brand it owns and the many fashion brands (Coach, Tommy
Hilfiger, etc.) it licenses the rights to.
Progressive
Writes car insurance coverage for American drivers who go to the company’s website or get
their policy through an agent.
Swatch
Sells watches under the many brands (Omega, Longines, Tissot, Swatch, etc.) the company
owns.
Tandy Leather
Runs a chain of leather goods stores that serves both retail and wholesale customers.

Village Supermarket
Runs a couple dozen big Shop-Rite supermarkets (they average 60,00 square feet of selling
space) in New Jersey.
 URL: https://focusedcompounding.com/14-stocks-for-you-to-look-at/
 Time: 2016
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Boredom Is a Good Friend of Long-term Investors
Geoff said in the last post that: “simply learning to love illiquidity, boredom, and a lack of
headlines in your portfolio might be enough to improve your returns.” The key word is boredom.
I think 3 main reasons for a stock to be boring are low growth, lack of catalyst, and a so-so price.
A stock with these characteristics is not attractive to growth investors, value investors, and
momentum investors. But sometimes these characteristics hide qualities that can generate great
long-term returns.
Quality of Growth
I once made a bold statement that Frost promises the best growth investors can find. I think that
Frost can have 7-8% growth for the next 20-30 years and I don’t normally find a stock with such
high growth potential. My friend was surprised at my claim and he said “you can’t say that
because 20% growth is a certainty for companies like Valeant!” What he said represents the
attitude towards growth of most people. To them, a single-digit growth isn’t stellar. To me, 7-8%
growth is a treasure. That doesn’t mean I’m less demanding. I’m just focused more on quality of
growth.
Low growth can be valuable if ROIC is high. Let’s compare Bristow, Frost, and Omnicom.
Over the last 10 years, Bristow’s revenue almost tripled from $674 million in 2004 to $1,859
million in 2014, which translates into an 11% annual growth rate. Annual sales growth was
always higher than 10% except for the “bad” years between 2009 and 2011. The problem is that
pre-tax ROIC is just about 9%. So, Bristow had to use debt and equity to finance growth. Over
the period, net debt increased by $650 million. Share count increased by more than 50% from 23
million to 36 million mostly as a result of the issuance of $223 million in convertible preferred
stock in 2007.
Frost is a better business. Frost grew deposits from $7,767 million in 2004 to $22,053 million in
2014. That means intrinsic value has compounded annually by 11% over the last 10 years.
Unlike Bristow, Frost can make 18-20% ROE. So, Frost was able to return 40% of total earnings
over the last 10 years.
Omnicom is even better. Omnicom grew sales by 5% over the last 10 year while returning 110%
of earnings to shareholders. Omnicom doesn’t need to retain earnings to grow. It actually
received about $1 billion from the decrease in its negative working capital over the period.
Omnicom’s 5% growth can be as valuable as Frost’s 8% growth. If we pay 20 times after-tax
earnings for both stocks, we can get similar returns. Omnicom can give us 5% growth and 5%
yield, adding up to 10% total return. Frost can grow 8% while paying out 50% of earnings. So, it
can give us 8% growth and 2.5% yield, adding up to 10.5% total return. A similar calculation
shows that we can get 11.67% total return from Omnicom and 11.34% return from Frost if we
pay 15 times after-tax earnings for both stocks.
So, growth can be more valuable than numbers suggest. Adjusted for quality, Omnicom’s 5%
growth is equivalent to Frost’s 8% growth, and is much superior to Bristow’s 11% growth.
Consistency also contributes to quality of growth. Geometric means are always smaller or equal
to arithmetic means. Therefore, low-growth years tend to pull compounding growth more than
high-growth years. In other words, of two firms with the same average (arithmetic mean) growth,
the one with more consistent growth has the higher compound annual growth rate.
To illustrate this point, let’s look at Frost’s deposit growth over the last 10 year and Select
Comfort’s sales growth from 2002 to 2012:
Frost’s annual growth: 13% 11% 3% 18% 13% 8% 14% 11% 14%
Select Comfort’s annual growth: 37% 22% 24% 17% -1% -24% -11% 11% 23% 26%
Over the 10-year periods, Frost’s average growth was 11.8%, and compounding growth was
11.0%. Select Comfort’s average growth was 12.3% and compounding growth was 10.8%.
Select Comfort’s growth looks fancy. It was higher than 20% except for recession years. But
Select Comfort’s average compounding growth was actually lower than Frost.
A serial acquirer like Valeant may have a great platform to create value from acquisitions. But
we never know when the party will end. At some point, smaller acquisitions can no longer move
the needle. Bigger acquisitions can be more expensive. The company may become too big for
adequate management. So, Valeant’s growth is repeatable but not predictable.
I prefer companies with consistent growth drivers. Some drivers are company-specific and some
are external.
Store expansion is a reliable internal growth driver. If a company is disciplined in picking new
locations that fit its model, and if it successfully replicates its competitive advantage,
performance will be consistent. Growth is predictable. We can pick a conservative number of
stores the company can open, and pick a conservative number of years for it to fill in the
opportunities. For example, America’s Car-Mart (CRMT) will keep opening stores in small town
with populations from 20,000 to 50,000 in South-Central states. It has huge competitive
advantages over mom-and-pop operators in these areas. Car-Mart now has 141 locations. It may
double store count in 10 years. So store openings can lead to 7.2% growth. With 3-5% same-
store sales growth, it can have double-digit growth for the next 10 years.
The driver I’m most comfortable with is market share gain. Some companies have durable
weapons to consistently gain market share. For example, Progressive (PGR) and Geico have
low-cost advantage to gain market share almost every year. Industry growth is usually
predictable so betting on market share gainers allows me to sleep well at night.
Industry tailwinds can make market share gainers more attractive. For example, banking is a
better business than car insurance. Total deposits tend to follow GDP growth while car insurance
policies face deflationary pressure as technology reduces accident frequency. Texas GDP grows
about 1% faster than the U.S. GDP so banks in Texas have 1% higher growth than the average
U.S. bank. Frost is a great franchise in Texas. It’ll keep growing its relationships with small
businesses. It’ll keep attracting consumers for being a Texas bank and for great customer service.
So, it’s safe to expect 7-8% annual growth far into the future.
Omnicom also benefits from changes in the industry. Marketing budget is stable as a percentage
of sales at most companies. So, total marketing spending tends to follow GDP growth. However,
marketing is becoming more and more fragmented due to the rise of new channels like online,
mobile, social media, etc. Marketing spending will shift from traditional media to new mediums.
That means more and more work for agencies. Omnicom has done a great job at building new
capabilities or making small acquisitions to serve client needs. Another trend is that marketers
want to deal with fewer vendors, leading to account consolidation. These two trends allow
Omnicom to capture more % of clients’ spending over time. So, Omnicom’s organic growth is
about 1% or 2% higher than GDP.
Margin expansion can make growth better than it looks. Margin expansion usually happen when
gross margin is high, price competition is low, and fixed cost is significant. Watches are a good
example. A watch isn’t a timepiece. It’s a fashion piece or a jewelry piece. Watch brands don’t
really compete on price. People have a price range for their watches and they choose the brand
and style they like most within that range. So, even cheap Chinese made watches that Fossil
(FOSL) sells have 50-60% gross margin. Fixed costs of designing, distributing and advertising
watches for a brand are quite significant. So, bigger brands have higher margin. Fossil’s 16%
EBIT margin is higher than Movado’s 12% because Fossil has higher revenue per brand.
Within Fossil, Michael Kors possibly makes 30% EBIT margin. Revenue from Michael Kors
watches was over $900 million last year. But Michael Kors can be a fad. It can rise and fall, and
has a big impact on Fossil’s EBIT margin.
Margin expansion is better when combined with consistent growth. It causes EBIT to grow faster
than sales. So, mid-single digit sales growth may mean high single-digit earnings growth. Of the
candidates I’m looking at, Grainger (GWW) is potentially a company with both margin
expansion and consistent growth. If that’s true, it can have low double-digit earnings growth for
many years and deserves a high multiple.
So, investors should be skeptical of high growth, and be positive about low growth. High growth
can be a problem if it’s unpredictable and leads to high expectations and thus a high multiple.
Low, boring growth can be a treasure if it’s consistent and supported by high ROIC and margin
expansion.
Lack of Catalyst
A lack of catalyst can cause even value investors to neglect a stock. Two of the least
controversial stocks we’ve analyzed are Progressive and Frost. Most people agree on their moat
and quality, and most don’t think the stocks are cheap. Geoff and I didn’t realize how cheap they
were until looking deeply at them. Higher interest rates can be a catalyst but most responses I get
from people are “interest rates may stay low for a while” or “how quickly earnings will
increase?” What’s interesting is that no guru owns these stocks while many own Wells Fargo.
According to Morningstar, most concentrated shareholders are ETFs or institutions that put a
small % of total portfolio into Frost. So, it’s possible that most professional investors just look
casually at the stock.
I’m not sure how important catalysts are. It’s easy to imagine catalysts and get excited. People
tend to overestimate the chance of catalysts happening and underestimate the chance of
unexpected events. In my short experience, I’ve seen stocks we’ve picked like Ark Restaurants
(ARKR), PetSmart, and Lifetime Fitness get acquired or buyout offers. Such events happened
more often than I expected.
I don’t think there’s any problem with the lack of a catalyst. Time is such a good friend that good
businesses don’t need a catalyst. We’ll do fine as long as we buy businesses that can compound
intrinsic value.
That said, I do see catalysts work in some special situations. Sometimes catalysts are playing out
but the market is so inefficient that the stock price doesn’t reflect the ongoing developments.
That’s true for the two best performing stocks we picked this year: Babcock & Wilcox and
Breeze-Eastern (BZC). Babcock returned about 30%. Breeze-Eastern returned about 22% since
our issue on the stock was published, and about 40% since when I began analyzing the stock in
May.
Babcock is a spin-off. I’m really surprised because value investors follow spin-offs closely. I
started analyzing the stock in October 2014. There were several presentations about the spin-off
and I was worried that the price would move a lot before we published the issue. Yet, it stayed
flat for months. And then it worked out exactly as Joel Greenblatt taught us about spin-offs: the
good Babcock (BWXT) is expensive at 13.4x EV/EBIT, and the bad Babcock (BW) is cheap at
5.4x EV/EBIT.
Breeze-Eastern was lucky timing. I analyzed the stock when it was finishing some long-term
projects. So, R&D expense was going down and revenue was ramping up. Years of under-
earnings were coming to an end. Anyone could expect Breeze to make more profit. But few
people acted until it released quarterly earnings.
It’s worth noting that some investors (who are now among the company’s biggest shareholders)
bought Breeze-Eastern on the same thesis in 2011. But they had to wait until 2015. So, I was
lucky to analyze Breeze-Eastern in 2015 when I saw that R&D had been declining.
Right now I think Ekornes is another special situation. Ekornes keeps most production in
Norway. A lot of cost is in Norwegian Krone (NOK). But Ekornes gets 95% of revenue outside
of Norway. So, most of revenue is in U.S. dollars, Euros, or other currencies. For years, Ekornes
was badly impacted by the overvalued NOK. But the recent crash in oil price caused NOK to
decline against U.S. dollars and Euros. On the surface, currency is a risk. American investors
buying Ekornes today may sell Ekornes and convert into fewer $ if NOK weakens. But weaker
NOK is actually a boon for Ekornes because revenue in $ or € will be converted into much more
NOK while costs in NOK won’t change. As a result, margin can expand by a huge amount, and
the NOK-based stock price appreciation will far outweigh NOK valuation.
So-so Price
Value investors can have different styles but they all buy stocks on the same principle: they
minimize downside.
Buy-and-hold investors seek safety in business quality. They ask themselves if they buy a stock
at current market price and hold forever, what is the very conservative expected return they can
get? If the expected return is adequate – say 10% – the stock is very safe.
How can they make more than 10%?
They can get more than 10% return as long as they buy a good business at a lower than average
price. Sometimes they’re luckily to buy a good stock very cheaply. For example, paying 10 times
unlevered P/E for a business that can grow 5% while paying out all earnings can result in 15%
total return. More realistically, they can only buy at 12-15x unlevered P/E. That’s still good
because the stock – if it’s truly a good business – will soon trade at the normal 18-20x P/E. Even
if it takes 3 years for the multiple to expand from 15x to 18x, the expansion still generates 6.3%
annual return. Adding 5% annual growth and 6% cash return results in over 17% annual return.
So, just like growth, price can be better than it looks if we consider quality.

Low Expectation
One great lesson I learnt from Geoff is to keep expectation low. He says if he does everything
right, he might be able to get 10% a year long-term.
I do think that keeping expectation low is the key to learning to love boredom. 10% sounds low
to most investors. Investors like things that can double in 2 or 3 years. In pursuit of high return,
they embrace dirt-cheap price or fancy growth. My view is that there’s no certain 20% return.
Big upside comes with high risk. There are a few certain 15% returns. And there are some
certain 10% returns. So, I stay with such certain boredom. If I’m lucky I can get 15-20% return
in my career. But without luck, I can still make 10%. I’m really comfortable with luck-
independent 10% return.
 URL: https://focusedcompounding.com/boredom-is-a-good-friend-of-long-term-
investors/
 Time: 2015
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You Can Afford to Hold Cash
In my last post, I said stocks were too expensive. Instead of putting more of your money into
diversified groups of stocks, you should just let cash build up in your brokerage account.
A lot of people have a fear that those lost years of making zero percent on their idle cash can
never be made up for.
I’ve created a graph to show how much ground you’d have to make up.

Let’s say you have two choices: one is to invest in an overpriced basket of stocks today and hold
that basket from 2015 through 2030. This choice will compound your 2015 money at a rate of
6% a year.
The second choice is to do nothing for all of 2015, 2016, 2017, 2018, and 2019. You just hold
cash. That cash earns 0% for those 5 years. In 2020, you finally get an opportunity to make an
investment that will return 10% a year from 2020 through 2030.
If your investment horizon extends all the way out from today through 2030, the second
approach overtakes the first approach about 15 years from now.
Doing nothing for 5 years and then something smart for 10 years is a better 15 plus year strategy
than “just doing anything” today.
Here we define something smart as 10% a year and “just doing anything” as 6% a year. You can
decide for yourself whether your something smart is 10% a year or not. That’s subjective. What
the “doing anything” returns is a lot more objective. So, let’s talk about that.
Over the last 15 years, the S&P 500 returned about 5% a year. During that time period, the
Shiller P/E ratio contracted from 43 to 27. The same percentage contraction – 37% – would be
required to get the Shiller P/E down from today’s 27 to a historically “normal” 17.
I see no reason why the S&P 500 should do better from 2015 to 2030 than it did from 2000 to
2015. That means I see no reason why buying the S&P 500 today and holding it through 2030
should be expected to return more than about 5% a year.
(Almost all readers I talk to have a total return expectation for the S&P 500 that is greater than
5% even for periods shorter than 15 years.)
It’s also worth mentioning that while I have no predictions as to when idle cash would earn more
than zero percent – the Fed does. And those predictions show cash earning a few percent in 2018
and 2019 instead of zero percent.
For those reasons, the graph in this post is probably an underestimate of how quickly sitting and
doing nothing till you can do something smart outperforms continuing to shovel cash into the
S&P 500 at today’s prices.
I think the reason people don’t feel secure in waiting for an opportunity to do something smart is
that they’re not sure when that opportunity will appear.
Maybe there will be no chance in all of 2015, 2016, 2017, 2018, 2019, 2020, or even 2021 to do
something smart. If that’s true – isn’t it possible doing anything now could outperform waiting to
do something smart later? If that later is sometime after 2021 – couldn’t it be better to just buy
the index today?
Yes.
I can only point to history.
Pick any year in the past. Then move forward 6 years from that time. In the intervening years,
was there an opportunity to do something smart?
The hardest waiting period in history was during much of 1995 through 2007. Although stocks
were often cheaper than they are today – the largest and best known American stocks were
almost always more expensive than they had been at any time before 1995.
I think this is the real reason why investors I talk to are hesitant to hold cash. Much of their
investing lifetime was spent during a time of high stock prices.
There is no advantage in buying something that is unlikely to provide a good long-term return
instead of holding cash till something good comes along. If we take 15 years as long-term, we
can say that the S&P 500 will not provide good long-term returns if bought today.
You can afford to avoid 5% a year type long-term commitments if you have a real chance at
finding 10% a year type long-term commitments sometime in the next 5 years.
You don’t need to know exactly when or where this opportunity will come.
A lot of investors who live outside the U.S. read this blog. They have an advantage. Their home
country’s stock market might provide a 10% a year opportunity sometime in the next 5 years.
American investors probably won’t notice such an opportunity when it appears.
By buying into an index today, you are really saying you will just take whatever price Mr.
Market gives you. You do this because you’re not sure he will ever give you a good price again.
Or, if he does, it may come far more than 5 years in the future.
Caving into Mr. Market’s mood is not something value investors think is appropriate when it
comes to individual stock purchases. Yet, a lot of the people who read this blog – who are
otherwise value investors – feel they have no choice but to continuously add to the actively and
passively managed mutual funds in their brokerage account.
The other choice is to hold cash. And the longer “long-term” is for you, the more sense holding
cash makes.
It makes a lot of sense right now.
 URL: https://focusedcompounding.com/you-can-afford-to-hold-cash/
 Time: 2015
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You Can Always Come Up With a Reason For Why the Stock You Are
Researching is Actually About to Go Out of Business
Someone who reads the blog sent me an email asking how Quan and I judge qualitative factors
like a company’s durability.
For most stocks, you can easily imagine a future condition that would obsolete the entire
business model.
I’ve decided to make this post nothing but a series of examples.
John Wiley
Open access journal articles.
There is a whole Wikipedia page about this one. The idea here is that someone else will pay the
cost of publishing journals in place of the subscriber.

Weight Watchers
Apps.
Dieters will use free apps like MyFitnessPal to count calories instead of going to meetings or
using websites like Weight Watchers.
HomeServe
Illegal marketing.
Without aggressive marketing aimed at old people – would this product even exist? You can read
about the FCA (a U.K. regulator) fine imposed on HomeServe and the reasons for it here.
Ark Restaurants
Leases expire.
Ark may not renew its leases because the casino or other landlord would want to charge a lot
more rent now that the location and the restaurant is a proven success. So, Ark as a corporation
has a finite lifespan except insofar as management reallocates capital to new sites.
Village Supermarket
Online groceries.
Traditional supermarkets have 3 durability risks people raise: 1) Online groceries 2) Wal-Mart 3)
Organic and fresh competitors: The Fresh Market, Whole Foods, etc.
America’s Car-Mart
Securitization.
America’s Car-Mart sells used cars so it can collect interest on high risk auto loans. The difficult
parts of the business are underwriting and collecting loans. If this could be centralized – as it is
in lower risk subprime auto loans – then the loans would become commodities.

PetSmart
Online dog food.
The two concerns here are that places like Wal-Mart can sell more dog food and websites
like Petflow can sell more dog food.
Atlantic Tele-Network
Guyana can take away their monopoly.
Greggs
British shoppers will stop frequenting high streets. Or, they will eat healthier food instead.
Progressive
Self-driving cars will eliminate accidents and therefore the need for auto-insurance.
Babcock & Wilcox
U.S. utilities will shift away from coal power plants – which use boilers – toward natural gas,
wind, and solar power plants which don’t use boilers.
The U.S. Navy could stop using: nuclear powered aircraft carriers, nuclear powered ballistic
missile submarines, and nuclear powered attack submarines.
Swatch
People will wear products like the Apple Watch instead.

Movado
Same.
Fossil
Same. Plus, Michael Kors may be a fad.
Western Union
Online competitors like Xoom can replace agent location based money transfers.
Hunter Douglas
Big box retailers like Home Depot and Lowe’s can sell blinds in their stores. Blinds can be sold
online. As a result, people will stop going to the independent dealers that Hunter Douglas gets all
its sales through.
Strattec
Smart keys and push to start ignitions can eliminate the need for locks and keys used in car doors
and the steering column.
Q-Logic
The cloud will eliminate the need for storage area networks.
 URL: https://focusedcompounding.com/you-can-always-come-up-with-a-reason-for-why-
the-stock-you-are-researching-is-actually-about-to-go-out-of-business/
 Time: 2015
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Babcock & Wilcox Sets Spin-Off Dates
Babcock & Wilcox (BWC) has set the dates for its spin-off. Those who own the stock on June
18th will get their spin-off shares on June 30th:
“As a result of the spin-off, Company stockholders can expect to receive as a dividend one share
of New B&W common stock for every two shares of the Company’s common stock held as of
5:00 p.m. EST on June 18, 2015, the record date. The distribution of New B&W shares is
expected to occur on June 30, 2015 and is expected to be tax-free. “
Shareholders will then own two separately traded stocks. The stock with the “BWXT” ticker will
be the government business. The stock with the “BW” ticker will be the power plant business.
The press release gives an accurate description of what “BWXT” will be:
“BWXT is the sole manufacturer of naval nuclear reactors for submarines and aircraft carriers;
provides nuclear fuel to the U.S. government; provides technical, management and site services
to aid governments in the operation of complex facilities and environmental remediation
activities; and supplies precision manufactured components and services for the commercial
nuclear power industry.”
It gives a poor description of what “BW” will be:
“New B&W will continue to be a leader in clean energy and environmental technologies for the
power and industrial sectors. New B&W also will provide one of the most comprehensive
platforms of aftermarket services to a large global installed base of power generation facilities.”
BW is really the boiler business. They build boilers and related equipment for power plants.
Some of those plants are clean energy plants – but a great many are actually coal power plants.
Babcock & Wilcox was a Singular Diligence stock pick. I own the stock personally. Quan does
not. I plan to keep both my “BWXT” shares and “BW” shares indefinitely.
I’ll let you know if that changes.
 URL: https://focusedcompounding.com/babcock-wilcox-sets-spin-off-dates/
 Time: 2015
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When Should You Diversify?
Someone who reads the blog sent me this email:
“I have been thinking about portfolio construction lately.
…due to the strict standards you have, I thought it was very natural to just hold mainly four
stocks…unfortunately, this method has shown its short comings lately. Both because of (your)
mistake in picking CLUB/WTW instead of the other winners discussed in Avid Hog/Singular
Diligence, and also because I am currently getting in touch with a lot more very cheap
opportunities in the Asia region…I have also been rereading Buffett’s partnership letters and
was reminded he once held like 40 stocks. Even though he concentrated at his top several
positions sometimes and also he sometimes put 30% to 40% of his portfolio into the workout
category, he did say they usually have fairly large positions (5% to 10% of their total assets) in
each of five or six generals, with smaller positions in another ten or fifteen. (This) of course is a
far cry from the 20%/25% position sizing we usually talk about…
What are your thoughts? Is it actually better to spread our portfolio a bit more?…I am getting
more and more the feeling that finding the right stock is not the most important part, but picking
the right ones to actually put money in is the key. Would (being) willing to spread a bit more
make this key job easier? The very cheap stocks I am finding these days may not fit something
you will invest in as they are likely not good buy and hold investments. Yet they are also not
exactly like cigar butts, i.e. not of very, very low quality stuff. Is it wise for me to ignore them in
my personal portfolio and just pick those that are more like the buy and hold category?”
I hold 4-5 stocks because I find that is most comfortable for me. You want to combine an
approach that makes enough objective sense to work for anyone in theory with an approach that
makes enough subjective approach for you to carry it out in practice. I found owning 20 stocks
was not practical for me. I spent more time watching what I owned than coming up with a good
list of new stocks to research. I didn’t spend enough time focused on what I was buying. When I
owned 20 stocks, I spent too much time on the HOLDING and the SELLING and not enough
time on the BUYING. It’s no accident that the only thing we do for Singular Diligence is tell you
which stock to buy. We never revisit it. We never tell you to sell. It’s all focused on a one-time
buy decision. I think that’s the decision that really matters. If you get that moment right the next
5 years or more will take care of themselves. There’s just a heck of a lot of time spent on stuff
other than worrying what to buy next when you have 20 stocks. When you have 5 stocks, you
can spend all your time thinking about what you want to buy next. I don’t want a situation where
someone asks me “So what stocks do you own” and I go: “Oh, let me just check this list here.”
That’s a problem unless you choose to embrace almost total neglect of what you own. I think
Ben Graham mostly did that. It’s okay to own a lot of stocks if once you buy them you just
forget about them. It’s not okay if you spend a lot of time wondering whether you should sell.
And if you own 20 stocks, there will always be one or two you’ll be thinking you should
probably sell because their price has risen so much or something has changed. Pretty soon you
are thinking as much about selling as stock picking. I don’t like that.
At many times, I held many more stocks than I do now. These were usually special situations,
micro-cap value stocks, etc. I find the experience less comfortable for me. For many other
people, the reverse is true. They prefer holding more stocks. I think that is fine.
I don’t think the big issue is whether you HOLD a lot of stocks or HOLD very few stocks. I
think the issue is whether you BUY a lot of stocks in any one period.
Most people I talk to could benefit from higher selectivity and lower activity.
Some of these people buy 12 stocks a year and sell 12 stocks a year. That means they are making
a buy or sell decisions once every 15 days or so. That’s a lot of work. It is too little thinking and
too much acting.
On the other hand, you can own 30 stocks and be relatively inactive. Let’s say you own 30 to 50
stocks and you hold a stock for an average of 5 years. If you hold 30 stocks for an average of 5
years, that means you only need to buy one new stock every 2 months. That is more manageable.
And you can eliminate the sell decision by just waiting 5 years and then selling.
So, let’s say you own 30 stocks and hold each for 5 years and then sell. Now, every 5 years all
you have to do is make 30 buy decisions and no sell decisions. That is just one decision every 2
months.
The benefits of diversification beyond 30 stocks is minimal. The dangers for holding a stock for
too long when you sell automatically in 5 years is low. So, I think you can be a selective stock
picker who holds 30 stocks. The way to do that is to forget about selling. And to hold stocks for
5 years.
Let’s take an example of a stock I’ve been “stuck” with. George Risk. The business has done
fine. The stock was cheap – on an EV/EBIT basis – when I bought it. It is still cheap today. This
is the classic example of a no catalyst stock. It is dead money. But, otherwise it was not a bad
stock pick. I was not wrong about the business’s future. I did not overpay. It was safe when I
bought it. It’s safe today. So, it is a financially strong company selling at a cheap price. This was
true then and now. But, as many were right to point out when I bought it – there’s no catalyst.
I’ve held George Risk shares for about 5 years. It paid some dividends during that time. Let’s go
back exactly 5 years – not the precise date I bought, but it works well for this example. George
Risk stock is up 80% over those 5 years. The S&P 500 is up 92%.
So, George Risk underperformed. This can be a selection problem. Maybe the lesson is never to
buy a stock without a catalyst. Don’t buy a stock where management is piling up cash year after
year after year. Or it could be a matter of luck. Maybe George Risk is the kind of stock that will
have a catalyst if I bought today and held for the next 5 years – but it didn’t for these 5 years.
Obviously, if the family chose to pay a special dividend or sell the company or something – the
return would be big and instant. This is an $8 stock with $6 in cash.
Diversification can fix this problem. You find maybe 5 stocks like George Risk – I’m not sure
there are 5 stocks like George Risk, but let’s pretend that’s not the problem – and you split your
money between them. If you want to hold say 25 stocks, then you simply diversify by putting
20% of your portfolio into “George Risk type stocks” rather than putting 20% of your portfolio
literally into George Risk.
I think that’s fine. I even think it’s a good idea. I think any time you can find 5 stocks of a
certain “type” it is a good idea to split your money between them.
Right now, I own:

 Babcock & Wilcox
 Ark Restaurants
 Weight Watchers
 George Risk
I could easily own something like Tandy or Ekornes instead of one of those stocks. See Quan’s
post on “Stocks Picked and Lessons Learned” for details of the stocks that we picked for
Singular Diligence and therefore could be in the portfolio.
Quan broke some of those stocks down by category. I think it’s a wonderful idea to diversify by
category. So, if you really like net-nets and you really like franchise (wide moat) stocks and so
on you divide your portfolio not in stocks – but into categories.
You can do the same thing with countries. A lot of countries move together though. So, I don’t
think this provides as much diversification as the financial press and mutual fund marketers
would lead you to believe. If you own Dow Jones type companies in the U.S., U.K.., France,
Japan, etc. I am not sure you get that much diversification aside from currencies. And it’s a lot of
work for you. And you don’t know the cultures. And you don’t speak the language. And there
are different laws. And your selectivity could suffer.
But, I think it’s a wonderful idea for an investor to split his portfolio into half domestic and half
foreign. So, if you live in France keep half your portfolio in Euros and half in Pounds and
Dollars and Yen and so on. This gives you some diversification away from your currency. It
gives some diversification against the risk that your specific country at this specific time is in a
bubble or something and you don’t see it.
So, let’s review. I think a half and half diversification among foreign and domestic is good if you
can do it. And I think a 5 instead of 1 diversification by category – net-net, growth, franchise,
value, turnaround, etc. – is good. When Quan and I were looking at Carnival, I wanted to invest
in Carnival because I believed that oil prices – which were then close to $100 a barrel for the
Brent type stuff Carnival was buying – should tend to be priced around $60 or so in the future. I
looked at oil and said I can see the sense in $30 prices and the sense in $70 prices. There’s no
sense in $100 prices. And so I was eager to buy Carnival because it was in a business with
durable demand in terms of volume and it had a good cost structure when you took out fuel. But,
notice, you could have said the same thing about Southwest. A lot of the arguments against
Carnival and Southwest were that their costs weren’t good when you included fuel and that they
weren’t cheap on recent earnings. Also, their ROEs were low. But, if the price of oil falls from
$100 to $50, then suddenly their costs are better, their ROEs are good, and their P/Es are nice
and low enough. So, Carnival and Southwest were in the same category. And I see no problem
with saying instead of putting 20% in Carnival you put 10% of your portfolio in Carnival and
10% in Southwest and say it’s one 20% bet that will go wrong if oil never plummets.
We can do the same thing today with Progressive (PGR), and Valley (VLY). We did a Singular
Diligence report on Progressive. We mentioned how we thought future earning power would be
higher because their investment assets which are a lot of short-term government backed debt pay
next to nothing now but will pay more in the future. Let’s say they are mostly in two year notes
that yield 0.5% right now. Well, in normal times, the yield on that same debt would be 5.5%. The
long-term history of Progressive’s investment portfolio is about 5.5% returns or something like
that. You’d expect 5% to 6% returns. And yet you have some people looking at the stock and
saying the portfolio may only make 2% a year till rates move. So, why invest now?
Valley National has the same problem. If you read the Morningstar analysis – for instance – they
complain that Valley’s efficiency ratio is not good anymore.
The problem with the efficiency ratio as used in banking is that it is a ratio of expenses to
revenue. It is not a ratio of expenses to assets. Nor is it a ratio of expenses to deposits.
Really, the cost side of banking should be the ratio of expenses to deposits. Deposits may be
liabilities but they are the ultimate source of all earning power. This is the same way that float is
the ultimate source of all of Progressive’s investment earning power.
The efficiency of Progressive’s investment business should be judged by the cost of its float –
not the investment income generated by the assets it finances with float. Likewise, Valley’s
efficiency or lack of efficiency should be judged by its cost of deposits not its expenses divided
by revenue. Valley does not control its revenue – which is set mostly by interest rates – any more
than Progressive controls its investment income.

So, here we have two stocks – Valley and Progressive – that aren’t cheap on today’s numbers.
But, if we imagine interest rates of 6.5% on the 10-year bond instead of 2.25% today – you have
a different earnings picture on the same dollar amount of loans.
Therefore, Progressive and Valley are both part of the same category of stocks that would be
cheap if interest rates were “normal” but are not cheap today. So, just like you could split your
money into Carnival and Southwest and admit the risk – that oil prices would never plunge – was
the same in both stocks, you can buy both Progressive and Valley today and admit the risk – that
interest rates will never “normalize” – is the same in both stocks.
So, I would endorse that kind of diversification. I would endorse putting 10% of your portfolio
into Carnival and 10% of your portfolio into Southwest instead of 20% into only one if you felt
oil prices should drop by half and the stock market price for oil consuming companies didn’t
reflect this.
I would also endorse putting 10% of your portfolio into Progressive and 10% of your portfolio
into Valley instead of 20% into only one if you felt that interest rates will skyrocket from here
and the stock market price for interest collecting companies doesn’t reflect this.
Just recently, we published a Singular Diligence issue on Swatch. Swatch is the cheapest really
good watch company. It has a huge business in China. It is big in the actual production of
components for watches. It is a manufacturer – not an assembler. Movado is the opposite. It is
not as high quality a business as Swatch. But it’s an even cheaper stock. It is big in America and
small elsewhere. It has a big licensed brand business. It is an assembler – not a manufacturer. It
is not big in components like Swatch is.
I think both Swatch and Movado are good long-term values. They both look like excellent
relative values.
So, if by diversification you mean instead of something like a portfolio that includes this:

1. Carnival: 20%
2. Progressive: 20%
3. Swatch: 20%
You want a portfolio that looks more like this:
1. Carnival: 10%
2. Southwest: 10%
3. Progressive: 10%
4. Valley: 10%
5. Swatch: 10%
6. Movado: 10%
I think that’s great. I think you are still making the same bets – oil prices will fall, interest rates
will rise, some watch companies are too cheap – without putting as much money in any one
stock.
But, there’s also a selectivity element here. I only approve of this kind of diversification because
Southwest has a similarly excellent 30 year past record as Carnival. Because Valley has a
similarly excellent underwriting record as Progressive. Because Movado – although a one brand
company plus licenses and big only in the U.S. – has great mindshare where it does compete. In
its price category and country (the U.S.) the Movado brand is actually much stronger than
anything Swatch sells here.
So, I don’t think the deterioration in quality – the compromise brought on by less selectivity – is
high in picking both Carnival and Southwest instead of just Carnival, or both Progressive and
Valley instead of just Progressive, or both Swatch and Movado instead of just Swatch.
But, let’s stop now and talk about an instant where the compromise in quality was great and the
results of diversification dangerous.

We made a mistake buying Town Sports (CLUB). Quan and I both bought this stock. And both
of us have since sold it. We also wrote a Town Sports issue for Singular Diligence. So, our
subscribers suffered as well.
We actually picked two gym stocks for Singular Diligence. One was Town Sports. The other was
Life Time Fitness. You can read about those two gym stocks in Quan’s blog post.
For Singular Diligence, we made a diversified mistake. Town Sports stock did very badly. Life
Time Fitness did well. At the time Quan wrote that blog post, Town Sports was down 41%. Life
Time Fitness stock was up 46%. The net result of those two picks is bad. If you put $5,000 in
Town Sports and $5,000 in Life Time Fitness – you did badly.
But some of our subscribers did worse. They bought Town Sports but did not buy Life Time
Fitness. Quan and I did the same. We bought Town Sports. We did not buy Life Time Fitness.
Actually, Quan owned Life Time Fitness at one time. But, that’s not relevant to this discussion
here other than to show he was smarter than me in recognizing the virtues of Life Time Fitness
but not smarter in recognizing the vices of Town Sports.
Now, we could say this is a diversification problem. Subscribers who put even amounts of
money into all our newsletter’s picks would do better than those who bet only on Town Sports
but not Life Time Fitness. Buying an even amount in every stock we pick gives you safer results.
Maybe.
But there’s a problem. Quan and I bought Town Sports but not Life Time Fitness. We did that
with our own money. We also wrote about both Town Sports and Life Time Fitness in Singular
Diligence. So, we – by diversifying – gave our subscribers the opportunity for better net results
than we ourselves got. They could put one egg in each basket. We picked the bad basket for
ourselves.

Here’s the catch. If you had told either Quan or me that we could pick only one gym stock for
Singular Diligence – we both would’ve answered: “Life Time Fitness”. If we could only ever
buy and hold one gym stock – there’s no question we would’ve said “Life Time Fitness”.
So, you have three different ways of selecting. When given the “Punch card” rule of having a
card with only 20 punches for a lifetime of investing – we are forced into the stock that did
better. If we had only one “punch” to use on a gym stock – we’d use it for Life Time Fitness.
Life Time was the better buy and hold than Town Sports. We knew that even when we picked
them both.
So, too many punches can results in picking one good and bad stock versus just one good stock.
If we were “stuck in one gym stock forever” we would make sure that gym stock was Life Time
Fitness. No doubt about that.
But then why did Quan and I buy Town Sports?
We focused on the upside. In our own portfolios, we looked at the highly leveraged and very
cheap Town Sports and the anti-leveraged (they actually owned a bunch of land that wasn’t fully
mortgaged up at the time) Life Time Fitness and we chose based on upside potential. We were
greedy. We weren’t fearful. Fear would have forced us into Life Time Fitness. Greed lured us
into Town Sports.
So, what’s the lesson?
If you think in terms of which stock in an industry would you pick if you had to buy and hold it
forever – you would be more likely to pick a stock like Life Time Fitness.
If you think in terms of diversification – you’d pick both Life Time Fitness and Town Sports.

If you think in terms of immediate upside potential – you’d pick Town Sports.
In our own portfolios, Quan and I applied Warren Buffett like levels of concentration. Yet, we
included a stock Buffett would never pick. Might he own Life Time Fitness? Maybe, I guess.
Might he own Town Sports? No. Definitely not. Let’s put it this way: if Warren Buffett was ever
going to buy a gym stock – and I’m not at all sure he ever would – there’s no doubt that gym
stock would be Life Time Fitness.
So, maybe greater diversification is the safest bet. Or, maybe greater selectivity is. Certainly,
thinking in terms of moat and financial strength and which stock would you rather own forever
leads to safer stock picking. Focusing on the upside adds risk. Focusing on the downside lowers
risk. Focusing on the short-term adds risk. Focusing on the long-term lowers risk. Diversifying
waters down risk and return. So, it reduces risks that you take that the rest of the market doesn’t.
Let’s look at our other disaster: Weight Watchers. This is a debt story. If you asked Quan and I
what weight loss company would we buy if we had to hold it forever – we’d say Weight
Watchers. If Warren Buffett had to buy one weight loss stock, which would it be? No doubt. It
would be Weight Watchers. Now, he might never buy any weight loss stock. That would make
perfect sense. But, if you are going to buy a weight loss stock the only claim any of them has to
any sort of moat or franchise is Weight Watchers.
Buffett would certainly never have bought Weight Watchers when we did. It was up to its nose
in debt. That was our mistake.
Quan and I both still own Weight Watchers. We like the business better than Town Sports. We
did when we picked those stocks. And we still do now.
Weight Watchers has done horribly as a stock though. The business has done badly. The stock
has done worse. You can read Punch Card Investing’s post in August of 2013 to see how right
Punch Card was and how wrong Gannon and Hoang were on Weight Watchers.

That’s a mistake. We’ll make them. We’d make them whether or not we diversified. As we’ve
said on the blog before – Quan and I certainly regret picking Weight Watchers for Singular
Diligence. You can’t have a stock down 75% or more and expect subscribers to stick with it. We
both still own the stock ourselves though. If we thought Weight Watchers was a mistake to buy
in our own portfolio – you might guess we’d sell it by now. We haven’t. I won’t say that means
we don’t think it’s a mistake. But, I would say we consider our error in buying Town Sports to
be clear in a way our error buying Weight Watchers was not and still is not. Town Sports was a
much worse mistake than Weight Watchers. This is from our perspective. For the market result,
Weight Watchers was a truly terrible error.
Diversifying can reduce the loss in something like Weight Watchers. If you owned 20 stocks
instead of 5 – you’d cut a 20% stake in Weight Watchers to 5%. If you had a 75% loss in Weight
Watchers you’d lose 15% of your portfolio in a 5 stock portfolio and just 3.75% of your portfolio
in a 20 stock portfolio.
The truth here is pretty simple. Avoid making 75% losses. The way to do this is easy. Don’t buy
stocks that are leveraged at like 5 times EBITDA. If you buy stocks with no debt – you aren’t
going to lose 75% on the stock if you are at all good at picking the company. The reduction in
Weight Watcher’s enterprise value is a lot less than the drop in its market cap. This was a highly
leveraged stock. Buffett would never, ever buy something with so much debt. We shouldn’t have
picked a stock with so much debt for Singular Diligence. In the future, we will never do that.
You’ll never see as highly leveraged a stock as Weight Watchers be a Singular Diligence pick in
the future.
Town Sports also had a lot of operating leases. Rent expense is what has sunk that company. So,
the lesson from both Town Sports and Weight Watchers is probably avoid companies with debts
and leases. Don’t buy leveraged companies.
Is there a lesson about diversification in there somewhere?
I don’t see it. If Weight Watchers had been debt free when we bought it, we’d be holding it quiet
calmly right now as I hope most of our subscribers would. It’s the debt that worries us with
Weight Watchers. With Town Sports, we have a direct comparison. Town Sports had a lot of
rent expense. It didn’t own any of its properties. There is one exception. Meanwhile, Life Time
Fitness owned its properties. Its real estate portfolio was very, very safe. So, we had one
unusually high leverage gym stock in Town Sports. And we had one unusually low leverage gym
stock in Life Time Fitness. If there’s a lesson there – it’s a lesson in leverage, not diversification.
Quan and I should have eliminated Town Sports because of its leverage. And we should have –
in our own portfolios – preferred the no leverage stock to the high leverage stock. We should’ve
thought about downside instead of upside. We should have thought about the long-term rather
than the short-term. Long-term we knew the downside in Life Time Fitness was lower. If the
long-term downside in a stock is lower – that’s probably the stock you should prefer. We didn’t.
We picked the highly leveraged, cheaper stock. A lot of value investors do that. A lot of big
value investing losses come from very highly leveraged stocks with low multiples.
If you want to avoid something like Weight Watchers, there are three ways. One, you can
diversify. This can turn a 15% of your account loss into a less than 4% of your account loss if
you just expand your portfolio from 5 stocks to 20 stocks. This may work fine for many people. I
won’t condemn it. Two, you can avoid an industry like gyms all together. Many of our
subscribers did this. We published issues on Life Time Fitness and Weight Watchers and Town
Sports. And they responded by saying: “I’m not going to buy any weight loss business or any
fitness business. They’re too faddish.” So, maybe you can avoid fads by ignoring an entire
industry. There is a good logic to this. Weight Watchers and Life Time Fitness and Town Sports
all have very high customer attrition rates. They lose 30% to 50% or more of their customers
every year no matter how good a job they do. People just quit on self-improvement a lot. That
will always be the case. It’s better to sell junk food and cigarettes and alcohol than to sell weight
loss and fitness. It’s easier. Products in the first group are a lot more compelling. You don’t
exercise on impulse. So, you can stick with the sin stocks and avoid the self-improvement stocks.
I actually think there’s a lot of logic to that. I would tend to favor that approach over
diversification. Stick to stocks that retain their customers. Avoid stocks that depend on people’s
willpower being strong for them to stay a customer. That’s great advice. It applies to Weight
Watchers, Town Sports, and Life Time Fitness. The third way to avoid a Weight Watchers type
disaster is to look at the balance sheet. Just don’t buy companies with that much debt.
A separate question here is whether it’s okay to own a lot of stocks simply because you have a
lot of ideas. My answer to that is yes. If you have a lot of equally good ideas – spread your
money around evenly.
But are the ideas actually equally good?
My test is whether I can or can’t discern between the quality of the stocks involved. It’s a
subjective and personal test. I know I can’t exactly predict which of 5 possible good ideas will
work best and which will work worst. That’s predicting the future.

And that’s not what I mean. But, in our Swatch issue we mentioned 6 companies. We mentioned
Swatch (obviously) which trades at about 11 times EBIT. We mentioned LVMH which trades at
15 times EBIT. Richemont trades at 17 times EBIT. Fossil at 8 times EBIT. Movado at 7 times
EBIT. There are 3 Japanese watch makers. We mentioned only two. They trade between 10 and
14 times EBIT.
Now, if you said you’d like to diversify by buying all the Japanese watch makers – I’d say fine. I
don’t particularly like any of them at today’s prices. But if I did like one – I’m not sure how
different I’d feel about Citizen, Seiko, and Casio. So, if you wanted to diversify among those 3 –
that’s fine. I’d pass on all 3. I’m not sure I can choose between them.
Likewise, if you said you wanted to buy Richemont and LVMH – I can see how you might think
they are similar. I’m not sure I’d agree. And I would spend more time looking at those
companies. They really aren’t that similar. And they are expensive.
The 3 watch companies I think it would be okay to diversify among are Swatch, Movado, and
Fossil. I’m not sure I like Fossil as much as Swatch or Movado. Fossil relies a lot on Michael
Kors. It’s an unusually hot watch brand. It also skews incredibly female. So, a really big portion
of Fossil’s profit comes from sales of women’s watches under the licensed name: “Michael
Kors”. That’s unusual for a watch company. A watch brand is usually not as young as Michael
Kors in terms of its history. Most watch brands are really old. Some licensed brands aren’t. But –
putting aside Michael Kors – each licensed brand for Fossil and Movado is normally quite small.
No one brand matters that much other than the owned brand that the company has. In the case of
these two companies that’s the Fossil and Movado brands.
I think a basket of Swatch, Movado, and Fossil would be fine. I don’t think I’d want to buy
Fossil alone. But, maybe Fossil will be the best performer long-term. Fossil is strong in licensed
brands. They can be the best home for a lot of licensed brands in the future. So, they can win
licenses that eventually become hits. And we can’t predict what brands those will be. But Fossil
is in a good position to get them. So, while I consider Fossil more speculative than Swatch and
Movado – I wouldn’t blame anyone for creating a basket of all three watch companies.
So, let’s say instead of putting 20% of your portfolio in Swatch you put 6% or 7% in Swatch and
6% or 7% in Movado and 6% or 7% in Fossil.
That kind of diversification is fine. I’m all for that. On an after-tax basis (Swatch pays low
corporate taxes) they are all nice and cheap. If you imagine a one-third and one-third and one-
third blend of those 3 companies – you’re getting a high quality, low priced watch stock with
little debt. And by dividing 20% of your portfolio into equal parts and putting it in these 3
companies you are relying less on Michael Kors than a 20% bet on Swatch would. And you are
relying less on China than a 20% bet on Swatch would. Swatch gets a huge amount of its profit
from China. Most of the company’s growth has come from Asia for a long time now. Swatch
doesn’t get a lot of sales from the U.S. and licensed brands while Fossil and Movado do. So,
that’s a very nice form of diversification. And you are still paying a mix of a high single digit
EV/EBIT by our calculations for all 3 companies. That’s a good kind of diversification. But,
notice that I excluded Richemont for being way too expensive. I also excluded all the Japanese
watch makers because I think their business quality is not high and their stock prices are not low.
So, I still took about 7 watch companies (Swatch, Movado, Fossil, Richemont, Casio, Seiko, and
Citizen) and narrowed them down to just 3 acceptable buys (Swatch, Movado, and Fossil).
Personally, I like Swatch and Movado and think Fossil is a bit speculative due to Michael Kors.
But, if someone asked me “Should I buy a stock basket of equal parts Swatch, Movado, and
Fossil?” – I’d say yes.
So, in that sense, I’m in favor of diversification. Watches have good product economics. These 3
companies are good relative bargains when you consider their high quality and low price. If you
buy a basket of these 3 and promise to keep them for 5 years – I think that’s wonderful. I think
the average investor might do better in a combination of all 3 than in just one. They – like I did
with Town Sports – might otherwise pick the wrong stock in a group with one or more good
stocks in it. Most importantly, lots of people feel safer having 7% of their portfolio in Swatch,
7% in Movado, and 7% in Fossil instead of 21% in one of them. If that feeling of safety makes
them a longer-term investor, then I’m for diversification.
The other obvious time to diversify is when you are a quantitative investor like Ben Graham.
Warren Buffett isn’t normally. I’m not normally. But, when Warren Buffett bought stocks in
Korea he diversified widely. He told a group of Kansas University students:
“My broker at Citigroup told me to look through this Korean version of the Moody’s guide. He
said it would look just like 1951. He was right. I began flipping through the pages and found a
lot of good companies trading at very low multiples. In 5-6 hours I put together a small portfolio
of 20-25 stocks – about $100 million total. One example was DaeHan Flour Mills. It has a 25%
market share in wheat flour in South Korea. Book value was 206,000 Won and the company had
201,000 Won in marketable securities and was trading at 2x earnings. The market is clearly not
efficient all the time. There are certain opportunities that can make you fabulously rich.”
So, he put about $5 million into about 20 companies. When I looked at Japan a few years ago, I
was originally going to find something like 20 stocks. That was my plan. But, then I winnowed a
list down and came up with two groups. One, was net-nets that had been consistently profitable
for a while. There were about 15 of these. I sold a report on the blog with those 15 net-nets in it.
The other group was stocks with negative enterprise values that had been consistently profitable
for 10 straight years or so. That was a sub group. Maybe 5 of the 15 stocks were in that group.
So, I had to decide do I buy a big basket of say 30 or whatever stocks in Japan that are really low
priced “value” stocks. Or, do I stick to just 15 net-nets with no losses in recent memory. Or, do I
pick from this even smaller group of maybe 1 out of every 3 of those net-nets that actually have a
negative enterprise value.
I decided I would put only 50% of my portfolio in Japan, because I didn’t want more than 50%
of my portfolio in the Yen. It was an overvalued currency at the time. And I wasn’t going to
hedge. That was fine. These stocks were cheap enough that if the Yen fell – and, in fact, it did
fall – the U.S. dollar returns were still going to be fine. And the returns were fine.
I think they would’ve been fine any way I did it. I think picking those 15 net-nets I put in the
little statistical report would’ve given you a fine portfolio. I think that the stocks Nate at Oddball
Stocks wrote about and bought did absolutely fine. And I think that if you hedged the Yen you
did well obviously. But, if you didn’t hedge the Yen your returns in dollars were also just fine.
And these little Japanese net-nets didn’t behave like the stocks most people have in their
portfolios. And obviously the Yen moving against the dollar doesn’t have all that much to do
with the average American investor’s portfolio. So, you had a nice basket that was a diversified
value investment. And I think you would’ve had that basket if you hedged or didn’t hedge the
currency and if you picked 10 or 30 net-nets or just the 5 negative enterprise value stocks with 10
straight years of profits that I settled on. Basically, Japanese micro-cap value did fine for a few
years. And it did fine in Yen. But it also did fine in U.S. dollars.
So, should you have diversified or not?
I knew nothing about Japanese companies. I was never going to pick just one stock. Many didn’t
have information in English. And that doesn’t even matter that much. I read reports in English
from Japanese companies – and I still don’t feel I understand them well enough to buy them
alone. If I was going to buy Nintendo then I would’ve bought just Nintendo. But, I wasn’t. I was
doing a Ben Graham type operation. It was similar to what Graham did all his life. It was similar
to what Buffett did in the 1950s in the U.S. and again in Korea in the 2000s. And it’s what I did
in Japan. Like I said – it’s also what Nate at Oddball Stocks did. I’m sure my results weren’t
better than his. And he may have diversified way beyond 5 stocks. So, there was no real harm in
diversifying in Japanese net-nets.
Oddly, Mohnish Pabrai didn’t really make money in Japan. I still have no idea what that was
about. I think that might have been more of an attention deficit disorder issue on his part than
anything to do with selection. He wanted to put bigger sums to work. And he seems to have
bought and sold faster than I did.
In fact, I have a very small position in one Japanese net-net left over. I wrote the “Buy Japan”
blog post on March 16th, 2011. So, it’s been over 4 years now. And these Japanese net-nets are
up a big amount. And yet I still have a really small piece of one of them I never sold. I was going
to sell it to buy something else and then I never got a good price for it in Japan. So I just held on
to it. One day, the stock will pop again and will sell it. It’s such a tiny position because I was
able to sell most of it at the price I wanted. It’s just illiquid. And so I didn’t get the price I wanted
after that. My point is that I’m not in a real hurry to sell a stock. I’ll just leave it there doing
nothing for a long time. I don’t know exactly how Nate at Oddball Stocks runs his own account.
But, I think it’s also a bit less actively than Pabrai might have been in Japan.
So, I think it’s fine to own 100 stocks, 50 stocks, 30 stocks, 20 stocks, 10 stocks, or 5 stocks. If
the stocks you own seem equally good to you on the criteria you use to buy them – then your
portfolio works for you. If you look at your portfolio and realize that 5 of these 25 stocks you
have are much, much better companies than the other 20 – then I think you have a problem. I
think you are watering down your stock picking.
But, if there had been 15 stocks in Japan with negative enterprise value and no losses in the last
10 years – I would’ve bought 15 stocks instead of 10. I mentioned George Risk earlier. I bought
George Risk at around net cash. You paid for the $4.50 or $4.75 or whatever the cash per share
was and then you got the business for free. The business is a good one. It makes money every
year. It would have an unleveraged ROE of over 20% year after year if the company didn’t hold
all that cash. So, you had a box of cash and investments – it’s actually a mix of equity mutual
funds, cash, and municipal bonds – and then you had the business. If I could find stocks in the
U.S. that were consistently profitable – like, they made money every year for 15 years and their
pre-tax ROC was like 15% a year or something – trading for their net cash per share, I’d buy
every single one of them. If there were 30 companies that were like George Risk in the sense
they were consistently profitable businesses trading for their net cash position, I’d buy every
single business that met those criteria.
If you can find profitable, negative enterprise value stocks in Asia right now that you don’t think
are frauds – then just buy them. Buy them all. If there are 50 of them, put 2% in every stock. If
there are 10 of them, put 10% in every stock. Don’t buy anything else. Don’t be picky. A
profitable company selling for net cash is a bargain of a lifetime. Buy it. And don’t judge
between them.
But, in normal times in the U.S. I don’t find any stocks like that. You don’t normally find even
one. It’s often zero. That wasn’t true when Buffett was investing in the U.S. in the 1950s. It
wasn’t true during Ben Graham’s career. But, I was born in 1985. It’s been true for most of my
life. There are brief crisis moments where it’s not true. And sometimes some micro caps get
neglected. And specific countries – not the U.S. – sometimes end up with a lot of very, very
cheap stocks. But, remember, Japan’s economy and stock market had done pretty badly for about
20 years when I found those net-nets. That’s why they were there. Business was going sideways
for 20 years. And then they were just paying down debt and piling up cash over a couple
decades. And nobody in Japan really noticed or cared or saw a catalyst in the stocks. And they
were tiny stocks. So, they get neglected. If you can find 50 stocks like that instead of 5 – you
have my blessing. Buy all 50 of them. It’s fine.
 URL: https://focusedcompounding.com/when-should-you-diversify-2/
 Time: 2015
-----------------------------------------------------
Babcock & Wilcox (BWC): Considering Separation into Two Companies
Babcock & Wilcox (BWC) just announced it is considering separating into two companies:
“…Board of Directors is evaluating the separation of the Company’s Power Generation

Business and Government & Nuclear Operations Business into two publicly traded companies.
The Board’s goal is to determine whether a separation creates the opportunity for enhanced
shareholder value and business focus. B&W has retained JPMorgan as its financial advisor and
Wachtell, Lipton, Rosen & Katz and Jones Day as legal advisors to assist in this process.”
The company reports its results in 4 segments (one of which is the experimental money
losing mPower – tiny nuclear generator – business). So it is easy to analyze what the company
will look like post any possible break-up. The stock is up 7% as I write this.
It still looks cheap.
 URL: https://focusedcompounding.com/babcock-wilcox-bwc-considering-separation-
into-two-companies/
 Time: 2014
-----------------------------------------------------
Adidas Announces Share Buyback
Adidas announced plans to spend up to 1.5 billion Euros over 3 years buying back its own stock.
The company will take on debt (it has no net debt) and continue to pay a dividend. Dealbook
quotes the company’s CFO as saying:
“We believe that our shares are currently significantly undervalued and this provides an
excellent opportunity to optimize the company’s cost of capital, deploy cash and create further
value for our shareholders”
(Dealbook)
At the current share price, the company could buy up to 10% of its own shares over 3
years. Bloomberg also has an article on the buyback and it focuses more on the possibility of
activist investors targeting the company. The article speculates activists would want the company
to replace its CEO and spin-off Reebok and TaylorMade.
Adidas is very cheap compared to its two best known – and expensive – peers: Nike (NKE) and
UnderArmour (UA).
Adidas is valued more in line with the company with which it shares a founding family: Puma.
When looking at the history of those 4 companies and their cultures – it is difficult to argue that
Adidas is truly comparable to either Nike or Under Armour.
Regardless, Adidas is cheap given the level of stock prices generally and the multiples at which
athletic apparel companies normally trade.
 URL: https://focusedcompounding.com/adidas-announces-share-buyback/
 Time: 2014
-----------------------------------------------------
Barnes & Noble (BKS) Will Separate Retail from Nook
Barnes & Noble (BKS) announced it plans to break up the company:
With the objective of optimizing shareholder value, the Company’s Board of Directors has
authorized management of the Company to take steps to separate the Barnes & Noble Retail and
NOOK Media businesses into two separate public companies. The Company’s objective is to
take the steps necessary to complete the separation by the end of the first quarter of next calendar
year.
The company provided a PDF giving segment performance.
Over the last year, Retail had positive EBITDA of $354 million. College had positive EBITDA
of $115 million. Nook had negative EBITDA of $217 million.
The company ex-Nook would have $6.04 billion in sales, $1.78 billion in gross profit (29% gross
margin), and $469 million in EBITDA (8% EBITDA margin).
(I do not own any shares of Barnes & Noble. I bought shares in August 2010 and sold them in
December 2010).
 URL: https://focusedcompounding.com/barnes-noble-bks-will-separate-retail-from-nook/
 Time: 2014
-----------------------------------------------------
The Inevitables
In his 1996 letter to shareholders, Warren Buffett explained his strategy of investing in
“inevitables”:
Companies such as Coca-Cola and Gillette might well be labeled “The
Inevitables.” Forecasters may differ a bit in their predictions of exactly how much soft drink or
shaving-equipment business these companies will be doing in ten or twenty years…however, no
sensible observer – not even these companies’ most vigorous competitors, assuming they are
assessing the matter honestly – questions that Coke and Gillette will dominate their fields
worldwide for an investment lifetime.

I happen to have a Standard & Poor’s Stock Market Encyclopedia published in 1967. So, I
figured I could check just how persistent the profitability of these “inevitables” is.
Here are the operating margins of 5 such inevitables.
 URL: https://focusedcompounding.com/the-inevitables/
 Time: 2013
-----------------------------------------------------
(All) My Thoughts on The Avid Hog
This post is going to be all about the new newsletter Quan and I just started. So, if a paid
newsletter isn’t something you’re looking for right now – this post is going to be pretty boring
for you.
It’s also going to be pretty long. I have a lot to say about The Avid Hog. I know most readers of
the blog aren’t interested in ever paying $100 a month for any product. So, I don’t want to clog
up the blog with a lot of little posts about the newsletter. Here’s one big one. If you’re not
interested, skip it. Regularly scheduled (non-promotional) content will resume next week.
Quan and I have been working on The Avid Hog for over a year. I’m here in the United States
(in Texas). Quan is back in Vietnam. He went to school in the U.S. And we started work on The
Avid Hog in person while he was still living over here just after his graduation.
Quan moved back to Vietnam. But that did not end preparations for The Avid Hog. Today, we
do everything by email, Skype, etc. The only difficulty is the time difference. It’s exactly 12
hours. It’s midnight in Hanoi when it’s noon in Dallas and vice versa. This make picking Skype
times interesting.
The Avid Hog is an unusual newsletter for a few reasons. The biggest reason is that it’s a product
of two people. All the decisions about what stocks we start research on, what stocks make the cut
and get a full investigation, and what stock makes it into the next issue – these are all decisions
we make together.
It’s easier than you might think. Quan and I don’t disagree on a lot about stocks. This is both a
plus and a minus. The plus is that it makes it easier to produce The Avid Hog. The minus is that
anything I badly misjudge is something Quan’s likely to misjudge too. We are not very good at
catching each other’s mistakes. We are too similar in our thinking about stocks for that.
What is our thinking about stocks?
Officially, the label would be “value investor”. But that’s a rather wide tent. And we tend to be
pretty far over on the quality side of things. If we’re going to compromise on quality or price, it’s
always going to be price. I think we both tend to agree with Ben Graham. The biggest danger for
investors isn’t usually paying too high a price for a high quality business. It’s paying too high a
price for a second rate business.
The model business we like would be something like See’s Candies. Read Warren Buffett’s 2007
letter. There’s a section in it called “Businesses – The Great, The Good, and The Gruesome”.
See’s is given as the example of a great business.
If you read that section carefully, you’ll understand what I mean when I say See’s is the kind of
business Quan and I like. Buffett mentions that See’s uses very little net tangible assets – this is a
big focus for Quan and me – and that it has a huge share of industry profits. He also mentions
that unit volume – pounds of chocolate sold – rarely increases. And that there has been at least as
much exiting from this industry as entering it. Basically, it’s a settled industry.
You might think that a fast growing business would attract us. Historically, that has not been the
case. I doubt it will be the case very often in the future. There are several reasons for this.
One, fast growing industries are by definition less settled. For an industry to grow unit volume, it
generally has to be growing the number of customers. Customer growth is always disruptive
because the easiest way for a new entrant to gain ground is with new customers.
There are businesses that experience some constant unit growth without much customer growth.
Obvious examples are businesses where you are charging your customers based on the amount of
work you are doing for them. An ad agency can grow its top line without adding net new clients
if those clients increase spending every year on average. FICO (FICO) can grow sales without
adding customers – which is good, because just about everyone who could be a client of FICO’s
already is – if their frequency of using a FICO score increases. The company in our September
issue also fits this model. They aren’t going to grow their customer list. They will do a little more
for the same customers each year. And they will charge a little more for everything they do. But
that’s about it.
Those tend to be the businesses we like, because we are often focused on the idea of a “profit
pool”. I’ve mentioned Chris Zook’s books on the blog before. I recommend all of them. They
touch on a subject that is the key to long-term investing. How does a business gain a large share
of an industry’s total profits? How does it keep that share year after year?
You aren’t going to find Apple (AAPL) in The Avid Hog. I suppose I can’t swear to that. But I
pretty much can. Even if Quan liked the stock – even if it was a lot cheaper – I’d still veto the
idea. The reason has to do with these ideas of market leadership and “profit pool”.
If you pick a moment in time and a product category – any product category – in consumer
electronics, you can come up with a leaderboard of companies. You can choose the top 3
companies, top 5, top 10. Whatever you want. Often, if the industry involves worldwide
competition – not a whole lot of companies beyond the top 3 will be making money.
But let’s put aside profits. Let’s just look at market share. Take any consumer electronic device
(radio, microwave, TV, watch, game console, cell phone, etc.). Look at the leaderboard. Then
fast forward 5 years, 10 years, 15 years. Check it again. How many names stayed the same? How
many changed? How many are in totally different countries?
That’s not the kind of business we want to invest in. I recently did a podcast about
Addressograph as of 1966. Everything looked pretty good. The stock traded at about 20 times
earnings. Over the previous 10 years, it had traded at 20 to 40 times earnings on average. In
about 15 years, it was bankrupt. That’s a tough business to buy and hold.
Most of Addressograph’s big competitors – including Xerox (XRX), IBM (IBM), and Kodak –

had their own problems later on. Many exited those businesses. New companies – often foreign –
gained a lot of share. And prices came down a lot.
This last part is hard to emphasize enough. I’ll be doing an information post soon to prepare you
guys for the next Blind Stock Valuation Podcast. As part of that post, I’ll be including the retail
price of watches a mystery company sold in 1966. I’ll also be giving you the inflation adjusted
prices for those watches. In other words, what those 1966 watch prices would be in 2013 dollars.
Whatever you think watch prices were in 1966 – they were higher. Of the four brands this
company made their middle of the road brand – the big seller – retailed for an inflation adjusted
price of about $380. The fully electronic watches – remember, this was the 1960s – sold for $800
to $17,000 in today’s money.
Unless you are assured of future domination of a growing industry, you generally don’t want the
real price of your product to fall by 80% or so. Quan and I have looked at a couple deflationary
businesses we liked. In both cases, the company we looked at had the highest market share, the
lowest costs, and was around since basically the time the industry started. So far, neither
company – they’re Western Union (WU) and Carnival (CCL) – is slated to appear in The Avid
Hog. In the case of Western Union, the durability of the business – not their moat relative to
competitors – is an open question. Basically, the internet is opening up a lot of different
possibilities for how Western Union’s niche could be ruined by more general payment solutions.
Some of the things that are really necessary and really hard to do right now (mostly on the
receive side in countries emigrants leave) may be easier hurdles to clear in the future. Maybe not.
We’ll see. But the situation is less clear than it was a few years ago.
Carnival can’t control the price of oil. It’s a big input cost for them. If oil prices drop and stay
down, Carnival will turn out well as an investment. If they don’t, it’s very possible the stock
won’t do well at all. And, of course, oil prices could rise. It’s a lot less certain than the
investment we want to make. So, for now, it’s not near the top of the list of Avid Hog candidates.
These two companies – and their uncertain futures – illustrate what The Avid Hog is all about.
And it’s important potential subscribers know this. The Avid Hog isn’t exactly a newsletter with
stock analysis. It’s really a business analysis newsletter. Those businesses happen to be publicly
traded. And we happen to appraise the equity value – not just the enterprise value – at which the
business would be attractive. But it’s a really unusual newsletter. We aren’t looking for reasons
for the stock to go up over the next few months or few years. We’re looking for a business we
think is one you’d want to hold. And we’re looking for an acceptable price to buy it at.
This is where the oddity of the partnership between Quan and me is most evident. I said we were
value investors. That’s true. But I doubt many of the stocks you hear value investors talk about
this year are going to make it into The Avid Hog.
For one thing, we really do adhere to Ben Graham’s Mr. Market metaphor. The stock we picked
for the September issue wasn’t far from its all-time highs. I said before I think it was within
about 10% to 15% or so of its all-time highest price. We’re fine with that. We thought it was a
bargain regardless of where it had been priced in the past.
The question we ask is whether we’d buy the whole business for the enterprise value at which
it’s being offered. That’s another point subscribers need to be warned about. I’m a little more
dogmatic on this one than Quan is. But we both take it pretty seriously.
We appraise the business. We compare the value of the business – as we appraised it – to the
value of the company’s entire capital structure. We know these are intended to be buy and hold
investments. So we don’t assume we know what the capital structure will be when you sell the
stock.
As a rule, we want subscribers to enter any stock we pick knowing – absolutely for sure – that
they aren’t going to sell for 3 years. We are very serious about this point. The kind of (business)
analysis we do isn’t something that can be expected to pay off in a matter of months or even a
matter of a couple years.
If you think about what we are doing – analyzing the durability of a company’s cash flows,
counting up those pre-tax cash flows, and then comparing them to the cost of buying all of a
company’s debt and equity – it’s not that different from how a private equity buyer would look at
a stock. They wouldn’t expect a return in less than 3 years. They might expect it to take quite a
bit longer than that. So do we.
That’s a little unusual for a newsletter. But I don’t think it should be that unusual to the folks
reading this blog. The idea that you can pick the right business to buy, pick the right price to pay,
and pick the right time to make your profit – we’re not sure you can do more than 2 out of 3
there.
A lot of our time preparing The Avid Hog for launch over this last year (actually a little more
than a year now) was spent on “the checklist”.
Checklists are very popular with value investors these days. So, I’m a little wary of the term. I’ll
use it here as a name for a list of key ideas we always want to discuss. By key I definitely mean
no more than 10. Right now, there are 7 sections we consider important enough to include in
every issue:
1. Durability
2. Moat
3. Quality
4. Capital Allocation
5. Value
6. Growth
7. Misjudgment
This is hardly a novel list. Everybody has read Warren Buffett. Everybody knows you look for a
good business with a durable product and a wide moat. Those are our top 3 concerns. They are
probably the top 3 concerns of many value investors.
We diverge a little with many value investors – though probably not Buffett – in putting “Capital
Allocation” at number 4. This list is in order of importance. Basically, failing a section near the
top will kill an idea faster than failing a section near the bottom. There is one exception:
“Misjudgment”. It’s at the bottom not because it’s unimportant – it’s the most important topic.
It’s at the bottom because we can’t know what we don’t know until we know what we know. So,
it’s always the last question we answer.
Capital allocation is ranked ahead of value and growth. I would guess almost every other value
investor would put value ahead of capital allocation. And quite a few would put growth ahead of
capital allocation.
We obviously think capital allocation is more important than most investors do. It can be a
difficult area to judge, because we have to use past behavior and present day comments to
predict future actions. The human element is particularly large in capital allocation. So, it tends
to be viewed as a squishier subject.
Over time, I’ve learned that capital allocation is a lot more important than I thought it was. And I
started investing believing capital allocation was a lot more important than most investors think
it is. I’ve become more extreme in my views on capital allocation. This colors our candidates for
The Avid Hog a bit. It tends to eliminate tech companies. Even when we can judge their future
business prospects – we can rarely predict which businesses they will choose to be in. It is one
thing to analyze Google (GOOG) as a search engine. It’s another thing entirely to analyze
Google as a company. The reason for that is capital allocation. It’s not enough to know how
much cash a company will produce. We also need to know what value that cash will have when
it is put to another use. At some companies, those uses are fairly limited and we can guess that a
dollar of retained owner earnings will add at least a dollar of market value to the stock over time.
At other companies, we can’t do that.
Capital allocation is especially important in buy and hold investing. If you are right about a
company’s quality, the durability of its cash flows, and how it will allocate its capital – you don’t
really need to be right about anything else. That’s usually enough to tell a good buy and hold
investment from a bad one. It may not be enough to find the very best investment – value often
plays a bigger role in determining your annual returns (especially how quickly you’ll make your
money). But getting quality, durability, and capital allocation right will often be enough to know
you’ll earn an adequate return.
What is an adequate return?
This is a critical question for any subscriber to The Avid Hog. Our newsletter costs $100 a
month. That’s $1,200 a year. So, there’s no point in subscribing unless you can make more than
$1,200 a year based on the content of that newsletter.
We’re not promising anything. Nobody does that. But we’re not even aiming that high. I don’t
think it’s realistic to assume any newsletter that serves up 12 ideas a year – that’s a lot more than
either Quan or I invest in each year – can do much more than about 10% a year.
We try to limit our picks to stocks that should return at least 10% a year if bought and held. The
second part is key. Maybe you can make more money flipping them in a year. But, some will
obviously decline in price over just one year. So, that’s not a good way to judge the value The
Avid Hog can provide to subscribers.
The only way to judge that is to look at a holding period of at least 3 years. Do we think we can
pick ideas that will return 11% a year over 3 years?
That sounds like a good goal to me. Don’t subscribe to The Avid Hog if you’re looking for more
than that. I’m sure you can do better than 11% a year by focusing on the very best of the 12
ideas. That’s what I always do when investing my own money. And that’s what I’d recommend
to the folks who can stomach a more concentrated portfolio.
But a list of 12 stocks is pretty diversified. And it’s not easy to do much better than 11% a year if
you’re not concentrating. I don’t think anyone should expect better than 11% a year from any
newsletter – and certainly not from The Avid Hog.
So, who is the newsletter for then? Is it for institutional investors or individual investors?
There’s no price difference. It’s $100 a month regardless of what you use it for. We know the
majority of our subscribers – right now – are either current or former employees of investment
firms. Of course, that doesn’t mean they plan to use The Avid Hog professionally. They have
personal portfolios. Again, we don’t ask what subscribers do with the information we provide.
The price tag is a bit of a hurdle for individual investors. But I think the content is a bigger
hurdle. The Avid Hog runs about 12,000 words. The first issue had 21 years of financial data in
it. Not a lot of folks without some sort of analyst background are going to be interested in
spending that much time with that much information about one company.
It’s not a breezy read. And it is extremely focused on just one company. So, it’s meant for a
limited audience of equally focused investors. You have to like spending half an hour to an hour
focused entirely on one company. If you read every line of The Avid Hog – and I certainly hope
you do – you’ll probably need to spend 25 to 50 minutes with the issue. That’s at a normal
reading speed. Some people read a little faster or slower than that. Most don’t. So the issue isn’t
even something you can consume in less than the time it takes to watch a TV show. If you’re a
fast reader, it’ll go by in about the time it takes to watch a sitcom. If you’re a slow reader, it’ll
run about as long as an hour long drama. There are also charts and graphs, a bit of arithmetic
here and there, etc. We hope you’ll linger with the issue longer than the absolute minimum time
it takes to read the issue. But even that is on the long side for a lot of people. A lot of newsletters
probably read faster than The Avid Hog. And, of course, most of them cover more stocks. So,
you’re committing to a lot of time focused on one stock when you sit down with The Avid Hog.
This is really the whole point of the newsletter. Quan and I – when investing our own money –
naturally do this. We focus for weeks at a time on one stock. It’s how we work. And it’s always
been how we worked. I don’t know another method of analysis that works as well as really
investigating a stock over a couple weeks.
The Avid Hog is really the product of a month of two people looking at one stock. This is
something we always did. But it’s not something we saw a lot of people selling. There may be a
good reason for that. Maybe the market for newsletters is a market for shorter, more varied
reports. Since we’re focus investors – we wouldn’t be able to write those.
The basic idea of The Avid Hog is to provide you with the info we use when making an
investment decision. We don’t do a perfect job of that. There was a ton of information we had on
the company in our September issue that didn’t make it into the final issue. But, we didn’t get a
lot of people asking for more information than we provided. A few suggested a little less would
have sufficed.
Over time, I hope this is something we get better at. As an investor, you have a relationship with
a business – a familiarity – that goes far beyond anything you can easily convey to a reader. This
is a constant problem. It’s the one we are trying to overcome. But it’s still a very tough problem
to solve. You can bet that we have a higher degree of confidence in any stock we pick than our
readers will after reading an issue.
It shouldn’t be that way. We should be able to communicate our thoughts and analysis in such a
clear way that everything we learned about a company can be as convincing – as great an aid to
understanding – as when we finally digested it in our own heads. It never works out that way.
Something is always lost in translation. And I’m afraid that conviction is a hard thing to express
when your reasons for it are simple but also based on an accumulation of evidence from a lot of
different sources that you’ve gather up over a month or so.
So, we’re still not perfect at getting across to readers everything we know. But that’s the point of
The Avid Hog. We take a month to gather up everything we think is relevant. And then we
present it to you. If you don’t have enough information to make an investment decision after
reading the issue – then we’ve clearly failed.
One of my biggest concerns is how people will use The Avid Hog. Let’s look at a quick example
of the math needed to make a subscription work.
If The Avid Hog can improve your results by 3% a year and you have a $50,000 portfolio – it
works. Once the numbers are less favorable than that (we can’t improve your results by at least
3% a year, or your portfolio is less than $50,000) the math just doesn’t add up. It’s not worth the
subscription price unless you can get a 3% annual increase and/or you have a portfolio of
$50,000 or more.
That’s because a subscription is $1,200 a year. And 3% of $50,000 is $1,500. You can do the
math on what kind of advantage The Avid Hog would need to provide your portfolio to make it
worth subscribing. At $25,000, you’d need a 6% annual lift from our picks. That’s tough. Too
tough in my opinion. So, I’d say folks with a portfolio of $25,000 simply can’t pay the $100 a
month needed to become a subscriber. It’s not worth it for them.
On a $100,000 portfolio, just a 1.5% advantage would make the subscription pay for itself. I
don’t think there are many people with a portfolio of $100,000 or more who wouldn’t come out
ahead subscribing to The Avid Hog. But I’m biased. I think – if you act on our picks – you can
make 1.5% more a year.
There is one other area that should be a big benefit. In fact, for some folks, this secondary benefit
should more than pay for a year’s subscription to The Avid Hog.
It’s taxes. I’ll just talk about the U.S. here because I know the tax rules. Some people reading this
have short-term capital gains in many years. This is very tax inefficient. At times, it can’t be
avoided. I had a company bought out a few years ago. Most of my purchases were made within
one year of the consummation of that buyout. So, I couldn’t avoid a short-term capital gain.
That’s not an awful position to be in. Only having short-term capital gains in the event of a
buyout usually means you at least still end up with a high annual return after-taxes.
As a general rule, American investors need to avoid any short-term capital gains. I can’t think of
many situations where you could actually demonstrate the benefit of selling before one year of
purchase convincingly enough to make me recommend a sale within one year.
And yet, some people do it. Some people – even some value investors – end up with short-term
capital gains.
The minimum intended time frame for any Avid Hog pick is always 3 years. We never want to
see a subscriber sell before 3 years are up. They will. We know they will. And we know there’s
nothing we can do about it. But, we also know there is at least a strong tax incentive for them to
keep a winner for more than one year.
There’s, unfortunately, an incentive to sell a loser within one year as well. We don’t think the
incentive there is strong enough to offset the likelihood that selling a pick – at a loss – within just
one year is a really, really bad idea.
We can’t tell subscribers how long to hold their stocks. I mean, we can – and we do. We say 3
years at an absolute minimum. And we’ll keep saying that.
But the truth is that the value of our picks is in how you use them. If you have a portfolio of
$50,000 or more and you really do devote it to just picks from The Avid Hog and you really do
hold each stock for at least 3 years – I’m confident you’ll get more than $1,200 a year out of our
newsletter. Honestly, I’m not very confident subscribers will do all those things I just said. I’m
not sure the implementation will always be ideal in practice. But you know yourself. And you
know if it would be in your case.
So, in theory, the tax savings from moving to a 100% buy and hold approach should be enough
to justify a subscription to The Avid Hog for those who have fairly large portfolios and some
short-term capital gains. Again, you can do the math on your own portfolio. But moving $7,000 a
year from short-term capital gains to long-term capital gains would more than pay for a
subscription for investors in the top three U.S. tax brackets.
Of course, you don’t need to subscribe to The Avid Hog to turn short-term capital gains into
long-term capital gains. You just need to commit to a buy and hold approach. You can do that on
your own. Or you can do it with The Avid Hog.
We hope that subscribers will get some additional lift – some extra value each year – from
moving more of their capital gains into the long-term variety. Even if there was no tax advantage
in doing so, we’d always want to have subscribers holding for the long-term.
The other benefits of The Avid Hog are less tangible.
The first is simplification. We want to simplify and focus the investing lives of our subscribers.
We want to encourage them to turn off CNBC and Bloomberg, put down the Wall Street Journal
and The Financial Times – and focus on one business at a time. We’re only asking for about an
hour of their time once a month. But we hope that will be focused time.
That’s the word we like best when talking about The Avid Hog: focus. We certainly focus on a
specific checklist, on a single stock, etc. We go into greater depth instead of giving you a lot of
breadth. That is all fairly obvious in the issues. If you haven’t sampled an issue yet, you can
email Subscriber Services and ask for one. There will be an email address at the bottom of this
post.
Quan and I don’t want that to be the only focus though. We don’t want The Avid Hog to be only
about the two of us focusing on a stock. What we really want is for The Avid Hog to be an oasis
of focus in your investment life. We know that anyone who subscribes to The Avid Hog has a
less simplified investment life than they’d like. They certainly have a less focused investment
life than is ideal for achieving the best long-term returns.
We would like to create a product that – once a month – gives readers the opportunity to forget
there are other stocks out there. To forget there is a market. And just to focus on a single
business and a single price. It’s a handpicked business and price. So we think it’s an attractive
one. But, even if you don’t agree, we hope that hour or so you spend with us each month will be
– minute for minute – the best time of your investing month. We hope more than anything that it
will be the most focused. It will come closest to the Mr. Market ideal of seeing a quote and using
it to serve you rather than guide you.
We know a lot of the folks who will subscribe to The Avid Hog will not be living exactly the
investment life they aspire too. They are value investors. And their life situation – often their job
at an investment firm – will put certain demands on them that lead them further from the ideals
described by Buffett and Graham than they would like.
More than anything, we know they feel overwhelmed. We know they feel like they consume a
lot of noise. And don’t get to spend enough time on the stuff that really matters.
We hope paying $100 for an issue will be incentive enough for them to block out a time that they
can spend with just one stock.
This is how Quan and I spend virtually all our time. It’s how many great investors spend their
time. And it’s really how individual investors should be spending their time too.
But the world isn’t designed to accommodate that kind of focus. Almost every form of financial
media is going to bombard you with a lot more breadth than depth.
We’re trying to flip that around for about an hour a month for our subscribers. That’s the thing
Quan and I are most interested in doing for subscribers. We’d like to create an environment
where they can focus. We’d like to make them feel we’ve simplified their investment life.
Of course, that’s not something we can do alone. Like the matters of returns and taxes – focus
isn’t something we can guarantee for subscribers. It’s something they have to work as hard
receiving as we do on giving. So it’s an uncertain benefit of The Avid Hog. But it’s the one I’m
most hopeful we can provide. It’s the one I think is actually most valuable. If we can provide our
subscribers with an hour of intense focus each month, I think we’ll have provided good value for
the $100 a month price we charge.
I don’t know how many subscribers will focus on the issue the way we hope. It’s one thing to
invest $100 of your money. It’s another to invest an hour of your total focus. For many people,
the latter is actually the harder one to give.
Speaking of focus, the focus of The Avid Hog on above average businesses should provide an
added benefit for subscribers. It should give them a list of companies they can revisit in later
years – even if they don’t buy the stock today.
We don’t sell individual issues of The Avid Hog. All subscriptions are billed monthly at $100.
So, from that perspective, it’s like every issue is sold separately. But we don’t like to think of it
that way. We like to think of The Avid Hog as being as much about the process as the product.
In a year, we’ll publish 12 issues. As I mentioned, each issue is about 12,000 words. So, you can
do the math and see you’re basically reading a book or two a year with The Avid Hog.
We like to think of The Avid Hog more like that. We like to imagine that you are getting 12
chapters you can use later even if you don’t put them to use now. Quan and I certainly won’t put
our money into 12 stocks a year. We tend to be more of the “one idea a year is plenty” type
investors. A lot of subscribers will want to diversify more. But plenty will still decide to pass on
some of our picks.
We hope that doesn’t mean they pass on the businesses. Knowledge of a good business has a
certain permanence to it. Or at least it has a longer shelf life than a lot of what you know about
investing.
The Avid Hog doesn’t revisit past picks. But we hope subscribers will. We hope that when an
above average business we profiled earlier plunges in price, some of our subscribers will be
ready to jump in. We hope you’ll be able to build up a personal database of above average
businesses. We’ll discuss them at the rate of 12 a year. That should provide a pretty good
shopping list in the next market downturn.
That brings me to the market. And to a point I haven’t stressed enough yet. The Avid Hog is not
meant to outperform the market. We hope we’ll do that. We expect to do that. But we don’t aim
to do that. Quan and I don’t try to beat the market. We just try to find the best above average
business trading at a below average price this month. And repeat that every month.
We believe that process will – over time – beat the market. But, we also believe it will
underperform in great years for the market. It’ll outperform in some very bad years. But neither
will be the result of our actually trying to beat the market in the bad years or holding back in
some way in the good years.
The process will always be the same. The relative results will vary because the S&P 500’s
returns will vary. And because the opportunities the market serves up will vary.
We don’t target relative results. We think we can – long-term – get good relative results without
worrying about them. That has always been my personal experience. But a lot of newsletters –
and some investors – do focus on relative results. So it’s important that anyone thinking about
subscribing to The Avid Hog knows that we do not – and we never will – target relative results.
What do we target?
My number one focus is always the margin of safety. If there’s no margin of safety, you can’t
buy the stock. How big is the right margin of safety?
That’s up to you. Valuing a stock is as much art as science. Exact appraisals vary a bit. On the
last page of each issue of The Avid Hog, we print an exact (dollar and cents) appraisal of the
company’s shares. We actually write “Company Name (Ticker Symbol): $46.36 a share” or
whatever. We’re that precise.
That can be misleading if you don’t see the appraisal in the context of the other stuff on that
page.
So, the last page of each issue is called the “appraisal” page. It has a calculation of “owner
earnings”. It has an appraisal of the value of each share (using a multiple of owner earnings).
And it has a margin of safety measurement. It also presents some data and how the current stock
price – and our appraised price – compare to the market prices of some public peers.
I want to focus on the owner earnings calculation, the appraisal, and the margin of safety.
You probably know the term “owner earnings”. If you don’t, you can read the appendix
to Warren Buffett’s 1986 letter to shareholders. We use the basic approach he does. We basically
want to count pre-tax cash flow. We use pre-tax numbers because we always value a business
independent of its capital structure. Only after we’ve settled on a “business value” do we
compare that value to the debt and equity of the company. This is pretty typical stuff for a lot of
value investors. Like I said, we’re a bit more dogmatic – at least I am, I won’t speak for Quan
here – about using capitalization independent (unleveraged) numbers and about using cash flow
rather than reported earnings.
It’s very important to mention how unconventional we are here. You should never pick up The
Avid Hog expecting to be told about a company’s EPS. We don’t do earnings per share. We
don’t talk about earnings per share. I don’t mean we discuss it as one of many things. I mean we
literally don’t spend a second on EPS. Whether a company will or won’t be able to report
earnings doesn’t mean anything to us as long as the company will be able to harvest that cash
flow.
This attitude pervades everything in The Avid Hog. So it’s important that you know ahead of
time that reported earnings will never, ever be discussed. I know EPS is a relevant number in a
lot of the financial media. It is irrelevant for us. And we never discuss it. Likewise, we tend to
discuss prices in relation to enterprise value rather than market cap. We do move on to valuing
the equity after comparing the company’s debt to its business value. But we really don’t do P/E
ratios at all.
For some subscribers, it’s a bit of an adjustment to only think in terms of enterprise value and
owner earnings rather than EPS and P/E ratios. But it’s the only approach that makes sense to us.
And Quan and I don’t do anything halfway. We don’t compromise on this point. In a lot of
issues, you’re literally going to get 12,000 words without a single mention of EPS. I know that’s
unconventional. A lot of The Avid Hog is unconventional in this sort of ways. We present the
stuff we think matters. We don’t present information that is customary but ultimately irrelevant.
So we do our little owner earnings calculation. We present it item by item. So, you’ll see items
adjusting for non-cash charges, for pension expense, for restructuring, for cash received but not
reported (yet) as revenue, and so on. We do it as a reconciliation of reported operating income to
owner earnings. Think of it like a statement of cash flows. It’s the same basic idea.
Sometimes there’s very little to reconcile. Right now, it looks like the stock in the October issue
has similar owner earnings to reported operating income. Not a lot of big changes.
If you read the September issue, you know the company in that issue has owner earnings that are
a lot higher than reported operating income. Again, we don’t care even a little bit about reported
operating income. You can see the reconciliation yourself. And you may be inclined to trust
reported operating income more than our estimate of owner earnings.
Personally, I think you’d be very, very wrong to do that. But the information is there for you.
You can quibble with us line by line. We put every item right there on the page. So, if we count
something as earnings that you wouldn’t – go ahead and make your own adjustment.
Everyone’s appraisal of a company’s intrinsic value differs a little. Even Quan and I – who’ve
been looking at the same facts and talking about the stock for a month or so – come up with
slightly different intrinsic values for the same stock. For the September issue, I think my intrinsic
value estimate would be a bit higher than Quan’s. That won’t be true for the October issue.
Where we have significantly different methods, we show you both. Generally, we go with the
most conservative method that we still consider reasonable. We don’t use unreasonably
conservative appraisals. The conservatism should come through insisting on a margin of safety –
not through making an unreasonably low appraisal of the stock. But, when in doubt, we err on
the side of conservatism. The price printed in the September issue is lower than the appraisal I
would put on a share of that stock. If you offered to buy the stock from me at that price, I would
turn you down. Logically, if I would reject your offer at that price, that means I’d appraise the
stock higher. So, the appraisal in the September issue is lower than what I would have come up
with privately. But it’s a number I’m comfortable having out their publicly. That’s what I mean
when I say we err on the side of conservatism. We aren’t going to print an appraisal I think
makes no sense. But we will print an appraisal that’s on the low side of what I think makes
sense. The same goes for Quan. In the case of the September issue, I would’ve been the one
arguing for a higher appraisal. In future months, I’m sure our positions will be reversed.
We’re not the Supreme Court. We don’t print dissenting opinions. The figure you see is always a
consensus agreed upon by the both of us.
As I said earlier, The Avid Hog is as much about the process as the product. That’s why Quan
and I spent a year perfecting the process.
Our process for the appraisal page has been standardized by now. It will be the same in each
issue. We calculate owner earnings. Then we come up with a fair multiple of owner earnings.
We apply the multiply. We then compare Owner Earnings x Fair Multiple = Business Value to
the enterprise value of the company. The excess of business value over the company’s debt is
used to calculate the equity value. And, of course, the equity value divided by fully diluted
shares is how we get our appraisal price per share. We then measure the margin of safety.
The margin of safety confuses some people. It’s easy to understand if you look at the calculation
we show. Basically, the margin of safety is always the percentage amount by which the business
could be less valuable than we think. It is not a measure of the difference in stock price between
our appraisal price and the market price. That would only occur in instances where the company
had neither debt nor cash. In that case, an appraisal value of $70 a share and a market price of
$50 a share would result in a 29% margin of safety ($70 – $50 = $20; $20 / $70 = 29%). That’s
not normally how margin of safety works, because the company is less safe to the extent it has
debt.
Let’s take our October issue – not yet released – as an example. It’s not finalized yet, but I can
give you a pretty good idea of what the margin of safety on the stock is by our estimates. The
stock trades for about 60% of our appraisal value. So, if it’s a $30 stock, we think it’s worth $50.
That’s pretty simple. But the company has debt. So, in theory, the upside on the stock would be
about 67% ($50 – $30 = $20; $20 / $30 = 67%). Quan and I don’t calculate the upside. So, that’s
not a number you would ever see. It’s a number that reflects leverage. And leverage is only on
your side if we are right in our estimate of that $50 (or whatever) appraisal.
The number we actually show you is very different. It’s how much the business value of the
stock could decline and still be greater than all of the company’s debt and the price you paid for
the stock. Imagine an example where a company has a $30 stock price, $10 of net debt per share,
and a $50 business value per share appraisal from us. In that case, the margin of safety is only
20% ($50 – $40 = $10; $10 / $50 = 20%). And that’s the only number you would see. We would
never mention the stock has a 20% margin of safety and a 67% upside. We would just talk about
the 20% margin of safety.
Our reasoning on this goes back to Ben Graham. But it’s also consistent with what we want The
Avid Hog to be. What we’re trying to do is come up with above average businesses at below
average prices. We’re trying to do that regardless of how the market performs. So, our focus is
not on the upside over the next couple years. Our focus is on getting subscribers in the best
possible business to buy and hold and ensuring that there is a margin of safety that protects them
from a permanent loss of principal. As long as the purchase price is justified, they will end up in
a better than average business. That’s the part that should lead to good long-term returns. Our
value calculation is really all about ensuring the presence of a margin of safety. This is the
protection you get when you buy the stock. The quality of the company – and the durability of its
cash flows and the moat around its business – is what ensures adequate returns over time.
This means we discuss value a bit less than most value investors do. We certainly discuss the
upside implied by our valuation a lot less. We don’t make a big deal of paying $45 for a $70
stock. We make a big deal about getting in the right business at a suitable discount to what we
think the entire business is worth.
For ease of illustration, I used per share values here. We tend to focus on the value of the entire
business right up till the last step – where we divide by the diluted share count. So, we talk about
a business being worth $5 billion and having an enterprise value of $3 billion rather than being
worth $50 a share and trading for $30 a share. The per share intrinsic value is really only
discussed once.
Like I said, different people will come up with different intrinsic values for the same stock. Quan
and I discuss ours on the appraisal page. But we also provide the data subscribers need to make
their own judgments. This starts on the datasheet. When you first open The Avid Hog – after
seeing a cover page, it’s just a teaser drawing that hints at the business we’ll be discussing – you
find a datasheet. The datasheet presents the numbers Quan and I care most about.
These are historical financials. The September issue went back pretty far. It had a total of 21
years of financial data. The company we chose has already reported its fiscal year 2013 results.
And we had data for the company going back to 1993. Quan and I don’t have a target for how
many years of financial data we give you. We simply print everything we use. Generally, we use
everything we can get our hands on. In the current issue of The Avid Hog, that happens to be 21
years of data. Next month’s issue will have a lot less. Probably fewer than 15 years of data. The
company hasn’t been public for that long. In any case, we’re confident we’ll be providing you
with more historical financial data on the company than you’ve ever seen. It’s also probably
more data than you can find on that company anywhere other than EDGAR. And EDGAR
doesn’t put it into nice rows and columns for you. You have to go back and read the 1993 report
for yourself.
What kinds of information do Quan and I care about? What’s in the datasheet?
Again, we’re unconventional in our approach. There is no mention of per share numbers. You
won’t see anything about earnings per share, book value per share, etc. It looks a lot like a Value
Line page. But that’s just the first impression. The actual numbers presented are quite different.
We focus on sales, gross profits, EBITDA, and EBIT. Balance sheet data is all about the
numbers needed to calculate net tangible assets – which we do for you – so that’s receivables,
inventory, PP&E, accounts payable, and accrued expenses. There’s also the issue of deferred
revenue at some companies. We present the liability side together. It’s usually more important to
look at receivables and inventories separately than to look at accounts payable and accrued
expenses separately. So we break out the current assets by line. We don’t break out the current
liabilities.
Quan and I care a lot about returns on capital. We especially care about returns on net tangible
assets. So we provide all the info you need to make that calculation. That means we do margins
(Gross Profit/Sales, EBIT/Sales, and EBITDA/Sales) as well as “turns”. We show you the
turnover in the business’s receivables, inventory, PP&E, and – most importantly – its NTA.
When you put the two numbers together – margins and turns – you get returns. We don’t just
calculate EBIT returns. We also do gross returns and EBITDA returns. At some companies,
EBITDA returns are quite important. Gross returns are rarely important in the short-term. But as
mentioned in some journal articles, they are actually a good proxy for how profitable a business
is. Basically, if a company’s gross returns are too low today, they’re likely to always have a
problem earning a good return on capital. This is less true of things like EBIT/NTA. That’s a
number that some companies can improve a lot by scaling up. But scaling up usually isn’t going
to help enough if your Gross Profit/NTA is really low.
The first couple companies we’ll be profiling for you in The Avid Hog have essentially infinite
returns on tangible assets. They don’t really use tangible assets. This makes the return figures
less important. The turnover numbers are also less important. The margin data may be useful.
Regardless of how useful the number is for the particular company, we always include it.
These calculations are done for every year where we can do them. In our September issue, I
think we had full calculations of all lines for at least 19 years. Returns on capital can’t be
calculated for the first year in a series because you don’t know what the average amount of
capital was in a business until you have two balance sheets – a starting and ending one – to work
from. We can – and do – obviously calculate margins for all years. So, the September issue had
21 years of gross margins, 21 years of EBITDA margins, and 21 years of operating margins.
Free cash flow data is not shown explicitly in the datasheet. But you can think of the datasheet as
really being all about free cash flow. We calculate year-over-year growth numbers for all items.
So, you can see – for example – that the company we chose in the September issue increased
EBITDA by about 9% a year on average while NTA increased only 6% a year on average. I’m
using median as the average here. We present minimum, maximum, median, mean and some
variation numbers. If you use only one number – I’d use median. But it’s up to you. Anyway,
you can see from the 3% a year difference in a cash flow number compared to NTA that the
company will tend to always have higher free cash flow than reported income. This is because
the amount of additional cash coming in is always exceeding the amount of growth in net assets.
You can see this at a website like GuruFocus or Morningstar for the last 10 years (or whatever)
by looking at free cash flow. But you can also see it in our 21 years (or whatever) of data that
includes growth rates in NTA versus growth rates in sales, gross profits, EBITDA, and EBIT.
The biggest departures for our datasheet relative to what others like to show you is our focus on
gross figures and our focus on net tangible assets. These aren’t the two most important numbers
in the datasheet. But they are the two most important numbers you’ll see highlighted in The Avid
Hog that you won’t have heard much about when studying the same stock using someone else’s
data. This is just a matter of presentation. Everyone provides enough info for you to do these
calculations yourself.
I suppose the biggest difference between our datasheet and the data you’ll get elsewhere is how
far it goes back. I’m sure a lot of subscribers will doubt the importance of seeing 1990s era data
in 2013. What importance could a company’s results in the 1990s have on its future in the
2010s?
It’s a logical sounding complaint. But it’s not supported by the facts. The length of time a
company has been consistently profitable is a surprisingly good indicator of what future results
will be. In fact, if you asked me for just one criterion to screen on it would be the number of
consecutive years of profits. Most investors err badly by assuming that a company that has a
couple losses in the last 10 to 15 years is fine because it’s made money now for 6 straight years
or whatever. Making money for 20 straight years tells you a lot more than making money for 6
straight years.
There are economic cycles and industry cycles. Some can be short. But some can be long. The
longest – something construction related like housing, shipbuilding, etc. – probably run in the 15
to 20 year length rather than the 5 to 10 year length. I’ve never felt that 5 to 10 years of data was
sufficient to make a decision about a stock. I would hate to have to decide much of anything on
less than 15 years of data. I do think it’s relevant that Apple today has nothing to do with Apple
15 years ago. And I think a company’s long-term financial results show you that.
Again, Quan and I are on the wrong side of convention here. But I think we’re on the same side
as Warren Buffett. When he buys a company, he likes to see as many past years of data as they
have. But he doesn’t want to see any projections for the future. We like a clear past and a clear
future. But only one of those things is verifiably clear. The past actually happened. The future is
merely a projection. We think investors could all benefit from seeing a lot more past data than
they do now. And we hope that including so much past data in The Avid Hog – and we’ll always
include every bit we’ve got – will convince others of the usefulness of that approach.
Now the past data is more useful the more you know about the past. So, it helps to know what
were good and bad years for the industry – not just the company. It helps to know what was
going on in the economy. We can’t provide you with all of that. But we hope you’ll linger over
the datasheet. In fact, we hope you’ll print out the datasheet, carry it around with you, do some
exploring of the past yourself. We also think the datasheet makes our explanation of the
company’s history clearer. We can’t – in prose – get into the kind of detail we’d like to see on a
company’s past. But we can discuss a few qualitative aspects in words. And then we can present
the rest to you in numbers on that one datasheet.
The datasheet is another area where I think The Avid Hog offers a lot. But you’re only going to
get a lot out of it if you put a lot into it. You can flip through the datasheet in a couple seconds.
Or you can spend a lot of time with it. There is a lot to think about in that datasheet. And I hope
that it’s an area subscribers won’t just linger on – I hope it’s actually one they’ll ponder. And
maybe even go back to the next day. Having that much data would always be the foundation of
any investigation of a company for me personally. That is where you start. You start with the
numbers. You start with the patterns in them. And then you move to trying to explain those
patterns and see which are likely to prove durable.
The datasheet is something that I really wanted to include, because it’s something I always want
to see in reports – and never do. Whether I am reading a blog post about a stock, a newsletter, or
an analyst report – I’m always eager to see more data than I’m given. That’s why Quan and I are
including all the data we can on that datasheet. That’s why we’re going much further into the
past than most reports do.
This brings me to the question of why we’re doing this. Why did Quan and I create a newsletter?
And why did we create this particular newsletter?
At a $100 a month price tag, the obvious motivation would seem to be money. But when you
consider the amount of work that goes into the newsletter – and the small potential audience for a
newsletter that focuses in this kind of depth on just one stock – money is less of a motivating
factor than you might think. We’d like to get to the point where we have enough subscribers to
justify the labor cost. We’re nowhere near that level now. And I’m not sure we’ll ever get to that
level. There aren’t a lot of products like The Avid Hog. There are other monthly newsletters that
charge $100 a month (a little more, a little less). Some bill annually. We bill monthly. But there’s
really not a big difference on those points. There are plenty of other newsletters that come out
with a similar frequency (monthly) and charge a similar price ($100 an issue).
The difference is in the product itself. If you’ve sampled The Avid Hog, you know this. It
doesn’t look like other newsletters. It looks like a collection of articles on one company. It lacks
the variety of other newsletters. We think it makes up for it in focus.
But we’re biased on that point. And this is the real reason Quan and I created The Avid Hog. It’s
what we love to do. We would be doing all the research that makes The Avid Hog possible
whether or not we were publishing it. We like to spend our time focused on a single stock for a
full month. Business analysis is the kind of analysis we like best. Coming up with a list of 10 or
20 ideas doesn’t appeal to us in the same way that focusing on one or two ideas does. It never
has. And it never will.
So The Avid Hog is really about trying to do what we like best while making enough money to
support the process. As you can imagine, the external costs associated with producing one issue
of The Avid Hog are minimal. The cost of a month of creating The Avid Hog is basically $300 in
some fixed costs plus the time Quan and I put into it.
There are good and bad sides to this. The good side is that we have almost no costs other than
our time investment. This means we can stick with The Avid Hog when it would be – like now –
not remotely financially viable because the subscriber count is too low. Through our dedication
to the product, we can keep it going for many months when any rational publisher would shut it
down.
That gives us the chance to grow an audience and ensure the long-term survival of The Avid
Hog.
The downside to not having a lot of costs other than our labor is obviously the price. We’d love
to be able to charge a lot less. But you can only do that with a lot of subscribers. Other sites have
a much bigger platform – more of a megaphone – from which to announce their product. They
have bigger distribution capabilities than we do. And so they will always have a much larger
group of subscribers for any product they put out. It will be better for the good products than the
not so good products. But even a lousy product put out on a big online platform will sell more
copies than the best product we could ever produce.
I can tell you now, the price of The Avid Hog will not drop. I just don’t see anything in what we
know about the potential audience size that would allow that to happen. You can run the
numbers yourself – after having read a sample – and guess what you think the commitment of
labor is to something like that. It’s not a one person product. So, it requires a good deal of
revenue to put out a product like that. It doesn’t for the first few months. But that’s only because
Quan and I are committed to not getting paid for a long time.
So that’s the good side and the bad side of the cost situation. The good side is that we are
committed to working for free on The Avid Hog. And the product doesn’t require much ongoing
investment other than our time. So we can keep the thing running. The bad side is that because
we are appealing to a very small audience – it’s a very niche product – we are never going to be
able to lower our price per issue to a level we’d like to. We’ll never be price competitive with
more general, more popular newsletters.
We didn’t design the product with financial considerations in mind. In fact, we didn’t design The
Avid Hog with many marketing considerations in mind.
What we did is design the product we would want to read ourselves. And we created the product
we love working on. It’s unclear whether there are enough likeminded people to support such a
product. And, if there are, whether they read this blog. But it’s a passion project for me and
Quan. And I know we will continue it at a loss for longer than most people would keep it going.
I should probably talk a little bit about that passion. Quan and I wanted to work together. And we
wanted to work together on a product we could be proud of. I have had the experiences – no, I
won’t be naming names – of working on some products I was not proud of. Generally, I think I
did the best I could to make those products a lot better than they would have been. And I had to
operate under that assumption. I had to believe that making a product better than it otherwise
would’ve been was justification enough for the work.
It was not a fun experience for me. That isn’t because the products weren’t good. Nor is it
because there wasn’t demand for the products. I think there was a lot more demand for the things
I worked on that I wasn’t proud of than there will be on The Avid Hog (which I am proud of).
But there was a serious mismatch of the content and the creator. Sometimes – if the content and
the customer are matched up well – that can be financially rewarding. But it’s emotionally pretty
tough for the creator of the content. I don’t think it leads to a good product. And it’s rarely
sustainable. Because the creator will eventually quit regardless of financial rewards.
The Avid Hog is a good product. And it’s sustainable. At least it’s sustainable from a production
side. We’ve worked hard to perfect production over the last year. As you can imagine – if you’ve
read a sample – our first attempts at production (our pilot programs) failed to get an issue out in a
month. Repeated iterations of the entire process were necessary to reduce the time it takes at
every stage of production. Today, we’re very confident we can get an issue out each month. As
we’ve already hit that target privately (we just haven’t published until now).
How sustainable is The Avid Hog from a demand perspective? This is the tougher question to
answer. We are obviously far from the level of subscribers that would be needed to support the
labor involved. You have two people – Quan and I – working on this full time. That’s a very
high hurdle to clear in terms of revenue. And we’ll see if we’re ever able to clear it.
Subscribers won’t notice one way or the other. We will be burning through our savings to
produce the newsletter for the next few months. And it may be for a lot longer than that.
Obviously, this is one of the reasons we only offer subscriptions that are monthly. We don’t want
to – as many newsletters do – receive payments up to a year in advance when we expect The
Avid Hog to be running at a loss throughout much of that subscription period. We prefer to
collect payment when – or actually a little after – we put out the issue we need to deliver for
people.
Our commitment to The Avid Hog is certain. Our passion for the product is certain. And –
having now put out a finished issue – I can also say that our pride in the product is certain too.
It’s a good product. It may not be to everybody’s tastes. We can’t guarantee you will like it. But
we can guarantee that if you like this sort of thing – if a 12,000 word report on a single stock
sounds appealing – this one will satisfy you. It would satisfy me as a subscriber. And that’s
always what we’ve been aiming at. We’ve tried to create the product we would want to read.
I listed some of the hoped for benefits of The Avid Hog. We’d like it to improve your returns. If
we can help you make 3% more a year on a $50,000 portfolio we can justify our subscription
price. If not, we can’t. We hope it will save you on taxes. Our American readers should only end
up with long-term capital gains. There’s an advantage in that. But it will only materialize if their
behavior causes it to materialize. We can promise the possibility of that benefit. We can’t
promise you’ll capture the full value of the tax benefit – because we can’t ensure you won’t sell
out of stocks we pick far quicker than you should or we would. We know it will provide you
with a database – a sort of mental filing cabinet – of above average businesses that you now
understand well and can return to in future years. That’s one benefit we can guarantee. We hope
it will simplify your investing life. We think it will allow you to focus in a way you may never
have before on a single, promising investment idea. We can’t guarantee that. But the $100 sunk
cost makes us pretty optimistic you’ll spend time focused on something you paid that much for.
So, focus is a benefit we feel pretty confident we can deliver. Finally, we think you’ll become a
better business analyst over the months and months you spend reading The Avid Hog. There are
other ways to improve those skills. But seeing us analyze real world examples and then
questioning and critiquing our approach – making it your own through an analysis of our
analysis – is as good a way of becoming a better business analyst as I can imagine. So, again,
that’s a benefit we feel pretty sure of.
Our return expectations for The Avid Hog are modest compared to what other newsletters aim
for. However, they are immodest compared to what I think most individual investors achieve.
We ignore the market. We don’t target any relative outperformance. We hope to provide you
with stocks you can buy and then make 10% a year holding. We have no clue what the stocks we
pick will do over the next 2 months or even 2 years. But, if you come back to us with a stock we
picked 3 years ago and see that it has not done 11% a year – we won’t be able to consider that a
success regardless of what the market did. I should warn you: we will have failures. I am sure we
will have failures. Nobody is in the business of promising certain returns – for obvious legal
reasons – but even if we were, we wouldn’t feel certain about the results of any one stock we
picked. It is too much to pick 12 stocks you are individually certain of each year. Quan and I can,
however, pick the 12 stocks we are most convinced of. And we can provide a group of 12 stocks
each year that we would be confident putting our own money in. Here, at least, we can speak
relatively.
Quan and I would certainly feel more confident putting all our money in the 12 stocks we pick
each year rather than the S&P 500. We are also confident that you will be better served by going
with our 12 stocks than with those 500. That does not mean we think our 12 will always
outperform those 500. It does mean we think you will be getting relatively better returns while
taking relatively less risk for those returns in the group we pick. I am sure we will underperform
in many years. I have always opted for a much more concentrated portfolio than 12 stocks. And I
have underperformed in some years in my personal portfolio. Last year (2012), is a good
example of that. I would expect The Avid Hog will fare no better in its picks than I have done
investing my own money over the years. That means there will be underperformance. And that
underperformance may get pretty bad in great years for the S&P 500.
Quan and I have a good process. So, I am not worried about our conviction in the ideas that
make it into The Avid Hog. We have a brutal winnowing process. A very large number of initial
ideas turns into a very small number of stocks we actually write about.
I am, however, always concerned with the conviction – the trust – our subscribers put in us. I
think this is the hardest part in writing a newsletter. There is always a great fear that even if you
provide all the information to get great results – your subscribers may not act on that information
in a way that justifies your newsletter’s price tag. That is my fear. We may do a good enough job
picking the stocks. But we may not do a good enough job “selling” our subscribers on the stocks.
We don’t present a balanced view in the issue. We like these stocks. We wouldn’t write about
stocks we don’t think are above average businesses at below average prices. So, we’re not going
to try to present the “bear” case in situations where we don’t agree with it. That would never
accomplish anything more than setting up a straw man.
So we don’t go for fake balance. But we do try to present the information we think matters.
There’s a section near the end of each issue – it’s right before the “Conclusion” – that we call
“Misjudgment”. This is obviously a Charlie Munger inspired section. And in that section we tell
you all the reasons we might be wrong.
I don’t mean we tell you the risks – the unknowables – that often appear in the front of a 10-K.
We don’t tell you about terrorism, global warming, a repeat of the 2008 financial crisis, SARS,
or any sort of extraordinary event that could render all analysis of the future meaningless. We
just talk about our biases. We talk about how our interpretation of the business may be flawed
because we may want to see something that isn’t there.
That is as far as we go with balance. To some extent, that section alone may undermine our
ability to “sell” subscribers on a stock. To really communicate our conviction directly to them. I
hope that turns out not to be the case. I hope that an honest discussion of the errors we may be
making will increase rather than decrease people’s faith in our pick. Past experience tells me it
doesn’t work that way. And it’s usually easiest to hide errors in judgment by eliding them rather
than analyzing them.
But one of our mantras for The Avid Hog – you may notice we have accumulated quite a few in
the year of preparation for the launch – is that we’re producing the report we’d want to read
ourselves. For me, that report would include the biases of the people who created the report. I
tend to prefer candor to precision. And while I can’t claim we’ve produced a balanced report –
these are all “buy” recommendations – I can claim we’ve produced a candid one.
What you get when you open an issue of The Avid Hog is my thoughts and Quan’s thoughts
about a specific stock. To the extent we have blind spots, The Avid Hog has blind spots. To the
extent we err, The Avid Hog errs.
What I’m proud of is not our ability to eliminate the errors in our judgment – which we can
never do – and keep them out of the report. What I’m proud of is our ability to communicate our
judgment.
It is the judgment of two people who focused on one stock for a full month. I think it is worth
$100 a month. I hope readers of this blog will too.
I promised an email link where you can sample the current issue. Just email Subscriber
Services and ask to sample the current issue of The Avid Hog. When you click that email link,
you’ll be talking to my Dad. He handles customer service for Quan and I (who know nothing
about that topic). My Dad is retired now. But he spent his career in customer support at financial
services companies. I won’t tell you how long he worked in the industry. But, I will tell you that
in the early years he ran call centers. Those call centers were in New York City and New Jersey.
So, it was a different time. Anyway, he’s quite comfortable talking with customers. You can
email him any questions – not just a sample request – and he’ll get back to you. You can also call
him if you prefer to talk on the phone. You can find his contact info at TheAvidHog.com.
That’s the website we set up for the newsletter. I created it, so it’s not very pretty. But it has
some of the info you might need. And I will be adding to it piece by piece over time. If you’re
interested in The Avid Hog, that’s the site to bookmark. We won’t discuss the nitty gritty of
subscriptions, billing, etc. on this blog anymore. The product is launched. We’ll discuss it to the
extent it has to do with companies the folks who read this blog might be interested in. But, most
people reading this blog are never going to subscribe to The Avid Hog. So we’ll keep the
technical information over at TheAvidHog.com.
Well, those are (all) my thoughts on The Avid Hog. Some of you reading this and noticing just
how long it was running might have had a sneaking suspicion there was more to the length than
met the eye.
There is. If you’ve read every word of this blog post – you’ve read about 12,000 words. You’ve
read the equivalent of one issue of The Avid Hog. So, you should now be able to gauge your
appetite for that much text. If you enjoy gorging yourself like this each month, The Avid Hog
might be the newsletter for you. Like I said, it’s a niche newsletter. If you’re not a voracious
reader – this isn’t the report for you.
Questions about subscriptions, samples, etc. are best directed to Subscriber Services (again,
that’s my Dad – his name is Harvey, I’m Geoff). But questions about the newsletter more
generally can be sent my way. I’m always happy to answer any emails you send. Just click the
link below.
Finally, I want to thank our subscribers. I know signing up on the first issue of a new newsletter
is taking a big risk. Quan and I appreciate your faith in us. And we look forward to sending a lot
of great issues your way in the months ahead.
 URL: https://focusedcompounding.com/all-my-thoughts-on-the-avid-hog/
 Time: 2013
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Finding Enough Investment Ideas
Upon seeing that The Avid Hog is a monthly newsletter, someone asked this question:
…how do you expect to find suitable candidates every month? Is the supply of good companies
that large?
The supply of good companies is enormous. If you don’t have any restrictions on market cap or
country, there are always good companies out there. Supply is never the problem. Knowing that
supply well enough is.
Although I consider myself a value investor, I don’t get ideas the way most value investors do.
You can see a good example of how a value investor looks for ideas in this video of Michael
Price’s presentation at the London Value Investing Conference. Another good example is this
quote from Nate’s latest post at Oddball Stocks:
I value banks like I value companies. I find a bank that’s clearly undervalued, then I work to
either confirm or deny the valuation. This is the opposite of someone who might research and
value a company and once the valuation is done look at the market value. I start with the market
value, I’m not looking for franchise companies, I’m looking for companies that appear cheap,
and I want to confirm they actually are cheap, if so I invest. This means I don’t have a Watchlist
of banks or companies I’d like to buy if the price were right. Rather I continually trawl low P/B
stocks and pick up what’s on sale that week or month
Let’s contrast that with the ideal I strive for. In a perfect world, my approach looks more like
how Warren Buffett described his analysis of PetroChina to Fox Business. He told Fox Business
the important parts of his approach are that:
1. He tries to look at the business first, without knowing the price

2. He decides what he would pay for the entire company
3. He compares the price he would pay to what the entire company is trading for in the
market
4. If the price he would pay is a lot higher than what the whole company trades for in the
market, he buys it.
That’s the ideal approach for me. I’ve found personally that it’s the one that works best. If I
appraise the entire business with fairly little preconception of where the stock should trade, has
traded, etc. and then I compare my appraisal to the market price I’m on the firmest footing in
terms of knowing I have a bargain.
The hypothetical I often pose when talking to Quan about a stock is:
Imagine you are running a family holding company. The assets of all your family members are
tied up in this company’s stock. You can put 25% of the value of your holding company into
buying this business in its entirety. Would you do it?
In other words, is this a business you want to be in forever? Is the price good? And would you be
willing to put 25% of the money of the people you care most about into it?
This approach raises the threshold in a few areas:

1. Durability
2. Moat
3. Quality
You aren’t going to buy something for keeps unless it’s durable. You are not very likely to buy
something without a moat. And you are going to insist on a certain level of quality. It probably
doesn’t have to be a great business (high pricing power and no tangible capital requirement) but
it does at least have to be an above average business.
If I started with a list of statistically cheap stocks, it would be very hard to keep a good flow of
the ideas I’m interested in. Aside from EV/EBITDA, there are relatively few value measures that
wouldn’t eliminate companies I’m interested in.
For example, I’m fine with a company with negative net worth. I’m also fine with a company
that has high free cash flow but doesn’t report it as earnings. Book value and reported earnings
are not deal breakers for me.
So how do we actually end up finding ideas?
Well, you already have some evidence of how we do that. Quan has written about Tandy
Leather (TLF) and EPIQ Systems (EPIQ). At the start of each post, he told you where he
found the idea. He said Tandy Leather came from a list of ticker symbols I send him each week.
And he said EPIQ Systems came from a list of stocks that compounded their share price at 10%
or more a year since 1999.
The second list is something I created for Quan at Portfolio123. He requested it. I created the
screen. It’s a huge list. There are hundreds and hundreds of companies that achieved a 10%
annual return over the last 14 years. And that is just in the U.S.
Tandy Leather is not a new name to value investors. I sent it to Quan because we talk about
retailers sometimes. This seemed like one with a strong niche. I tend to like distribution
advantages, specialty products, and loyal customers. Tandy looked like it compared favorably to
other retailers on those fronts.
Quan had already researched Games Workshop. That’s a U.K. company that owns the
Warhammer intellectual property. It makes war gaming miniatures. Gross margins are very high.
It sells its products through a chain of small, dedicated hobby shops. Because Quan was familiar
with Games Workshop, he may have been more interested in Tandy’s stores than investors who
hadn’t researched a company like that.
This brings me to an obvious but key point. We tend to find new companies because we know
old companies. People who have sampled the first issue of The Avid Hog know there is a list of
5 comparison stocks in there. That’s not something we created specially because it would make a
pretty table. It’s there because we like to look at about 5 comparison companies when analyzing
a stock for ourselves.
Now, when I say comparison, I don’t always mean it’s a competitor. For example, if Tandy
Leather ever makes it into an issue of The Avid Hog, you can bet Games Workshop will be listed
as a comparison company. Not many companies have that kind of presence in a specific niche
hobby and sell through dedicated hobby shops like that.
Many investors wouldn’t put Tandy and Games Workshop together in their minds. That’s a
mistake. They have a lot more in common than Tandy and Coach (COH), which is the company
many websites will toss out as a comparison for a leather business like Tandy.
A lot of ideas come from companies that are in some way connected to companies we already
looked at. In oligopolies, we look at everything. If we like Hasbro (HAS) we do just as much
work on Mattel (MAT). If we like Carnival (CCL) we do just as much work on Royal
Caribbean (RCL).
Sometimes, we discard a company because of capital allocation or price. Well, competitors will
tend to have similar business quality, durability, and – sometimes – moat. They will, however,
tend to have different management and may not always be equally well liked by Wall Street.
That encourages us to look for other comparable companies, when we like a business but don’t
like its management or its current stock price.
We read a lot of 10-Ks. We each – separately – read a lot about specific companies. I don’t know
how much people assume we do on this front. But, I know we do a lot more than you’re thinking.
The reason for this is mostly that we’re doing less of other things than you imagine. My
consumption of general business news is really, really low. You wouldn’t get very far talking to
Quan or me about the economy. We’re not that up on what is happening in economics, politics,
etc. except when we can cite specific examples from companies we’ve researched. For example,
I can tell you a lot more about Mediaset than about Berlusconi.
We read more blogs than newspapers. Blogs that analyze companies are our favorites. I
read everything that Richard Beddard writes, everything at Value and Opportunity, everything
at Oddball Stocks, etc.
It’s difficult to explain exactly how this works. For example, why – if I’m looking for above
average businesses – do I read Oddball Stocks? The answer is that any time spent reading an
analysis of a company, thinking about that business, and valuing that business is potentially
moving you toward good, new ideas.
Some of it comes down to interpretation. I recently wrote an article at GuruFocus about whether
you needed to know something the market doesn’t or just need to interpret something differently.
I say a different interpretation is more important than different data.
I own a stock called George Risk (RSKIA). I bought it 3 years ago. It was profiled on Rational
Walk as a net-net. I bought it because I liked the net-net price. But I only bought it because I like
the business quality. I thought it was a really good business. It happened to be at a very low
price. But I didn’t analyze it the way I would a net-net. I just used its low price as an obvious
indicator that I didn’t have to be really worried about the value part of the analysis here. It was
cheap enough. As long as I determined it was durable enough, I could buy it.
This idea of using the same data for different purposes is a big part of what we do. For instance,
you may be surprised to know I read up on IPOs. I read the filings. They’re some of my
favorites.
I’ve never bought an IPO in my life. I’ve never bought a company within months of it going
public. I doubt I’ll ever buy stock in a company that’s been public for less than a year. It doesn’t
matter. There’s a lot of interesting info about the business and the industry in those documents.
I mentioned that Quan and I have looked at Carnival. Norwegian (the third largest cruise
company) filed some documents with the SEC despite its equity not being publicly traded.
We’ve read those.
Now, that sounds like a real bad use of time. I mean, here I am telling you to stay away from
CNBC and Bloomberg and all the chatter about the Fed and instead focusing on specific stocks –
and I’ll spend time reading about a company that’s not public.
Our feeling was that knowing the cruise industry would be helpful not just in analyzing Carnival
at that moment in time, but also it would just be good knowledge to have. It’s not a very fast
changing industry. It’s the sort of industry where knowledge of what was happening a few years
back is enough to get you pretty far into making an investment decision today.
The list of companies we’ve looked at and are interested in is always long. It’s usually a lot
longer than we can handle. Price focuses us a lot. The problem with most companies is that they
aren’t obviously cheap. They often seem priced about right.
Now, on this last point, our interpretation of cheap is a little different from what you’ll read
about at someplace like Oddball Stocks. We don’t need historically cheap. That’s not a really big
selling point for us. The company can be at an all-time high.
For example, I don’t think the stock price of the company we wrote about in our September issue
has ever been more than about 10% higher than it is today. That doesn’t matter to us for a few
reasons:
1. The business is more valuable today than it’s ever been

2. The enterprise value is lower today than it has been in the past
3. The stock has returned 13% a year over the last 35 years.
This last point is critical. Historical valuations can be important. But they always have to be
viewed both with the understanding that tomorrow may be a lot different than yesterday and also
with the understanding that some assets have returned a lot more each year. Those assets deserve
to trade at higher prices than they did historically.
This even happens in net-nets. I’ve had people mention that a certain net-net has shown up on a
screen of net-nets for many years. That’s often true. But there are also a couple net-nets that have
increased their share price at 10% or more a year for 10 to 15 years. The market hasn’t done that.
So, why should we assume the past price was correct – the historical average is the mean the
price should revert to – if holding the stock actually returned a lot more than holding an index
fund?
Quan and I look at stocks that way. We don’t feel historical valuations are important unless they
are understood in light of historical returns. If some commodity has returned 4% a year over 100
years, I don’t want to own it even at its long-term average price. If a stock has returned 13% a
year over its time as a public company, I may want to own it even at a historically “normal”
price.
This attitude widens our net in some areas value investors may not imagine. You’re probably not
thinking that a stock within 10% of its all-time highs might be a bargain. Sometimes, that’s
exactly what we’re thinking.
Quan and I do consider ourselves value investors. However, we certainly don’t consider
ourselves contrarian investors. A stock doesn’t have to fall a lot to get us interested in it. We’re
willing to look at stocks near highs and near lows.
The scheduled next issues of The Avid Hog will demonstrate this. Based on what we have
planned, you’ll get a stock near all-time highs in one of the first issues and you’ll get a stock that
dropped a lot in the last year or so.
We actually don’t consider them to be priced very differently. We view the two stocks as being
about equally cheap.
So the simple answer is that we don’t do a lot of value screens. We will sometimes turn up ideas
that are not very contrarian.
I don’t know all the stocks that will appear in The Avid Hog. But I would guess that if at the end
of September 2014, you lined up all the names, you’d probably call it more of a quality list than
a value list. I’m sure there would be very little overlap with anything Michael Price owns. So it’s
no surprise our approach to generating ideas is different from his.
 URL: https://focusedcompounding.com/finding-enough-investment-ideas-2/
 Time: 2013
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How Did Mohnish Pabrai Not Make Money in Japanese Net-Nets?
This is a serious question. I’m probably not qualified to answer it, because I have a poor
understanding of Pabrai’s investment approach.
Here is the blog post that stumped me:
The Pabrai funds invested in a basket of Japanese (net-nets) starting October 2010. Mohnish has
exited all the positions with a realized gain of 2.2% including dividends, or 1.4% annualized.
The notes go on to give examples of some stocks Pabrai owned:
Examples include Hibiya Engineering and Ryoyo Electro. Both were trading below NCAV at the
time of his investment, generating profits as well as positive and consistent cash flows.
Managements of both companies were also repurchasing shares. Hibiya ended up just a little bit
profitable and Ryoyo turned out be a -15% loss.
I can’t explain Pabrai’s experience with Japanese net-nets. But I can tell you a little about my
own. We have two records of it. One is personal (my own account where I actually bought net-
nets and made money). The other is public (a paid report I put out on March 21st, 2011). There is
a third record you should check out. Go to Nate Tobik’s Oddball Stocks and read all his Japanese
net-net posts. These three experiences are more indicative of what individual American investors
would have gotten out of their Japanese net-nets.
I won’t talk a lot about my private record, because it’s private. You can’t verify it. But it’s better
than the public record I’m about to show you. Instead of picking 15 Japanese net-nets, I went
with no more than 5 at a time. I ended up buying a total of 6. I started with 5 and then added one
later to replace a stock (Sanjo Machine Works, which is on the list) that was bought out. Like
always, I concentrated a little more than other investors might. In this case, that got me a better
personal result than the more diversified group I’m about to show you.
So let’s talk about that group of 15 net-nets. Let’s talk about the public record.
I published a (paid) report on Japanese net-nets on March 21st, 2011. So we have a list of 15
Japanese net-nets we can look back on without the usual biases of a hypothetical backtest. This is
an actual observation. We’re working off a dated PDF that went out to buyers.
Here are the returns (in Yen) of those 15 Japanese net-nets since March 21st, 2011.
Zaoh (9986): 84%
Fuji Electric Industry (6654): 23%
Mitsui Knowledge Industry (2665): 28%

ASICS Trading (9814): 82%
Sonton Foods (2898): 47% TAKEOVER
Nisshin Electronics Service (4713): 33%
Daito Gyorui (8044): 9%
Sanjo Machine Works (6437): 186% TAKEOVER
NJK (9748): 67%
Noda Screen (6790): 62% TAKEOVER
M.O. TEC (9961): 41% TAKEOVER
Yasuhara Chemical (4957): 1%
Techno Associe (8249): 71%
Kawasumi Laboratories (7703): 12%
Seiko PMC (4963): 83%
Now, the Yen has fallen 18% against the dollar since March 21st, 2011. So, we will factor that
into our results. Taking the currency loss into consideration, here are the cumulative (since
March 2011) dollar returns an American investor who acted on my net-net report might have
gotten.
Minimum: (17%)
Maximum: 168%
Median: 26%
Mean: 35%
All 15 stocks had positive returns in Yen. Only 12 of 15 had positive results in dollars. Four of
the 15 stocks were taken over.
Pabrai had a realized gain of 2.2%. To put this in perspective, 6 of the 15 net-nets in my report
returned at least 40% since March 21st, 2011. Again, that’s in dollars. Returns over 40% (in
dollars) were actually more common than returns under 10%. The group median – which should
be the most telling number – was a 26% cumulative return. That’s in dollars and ignoring
dividends.
Pabrai’s result is nowhere near that. I would love to take credit for being some sort of especially
good Japanese net-net picker. But I know that’s not true. I think if you look at other value
bloggers that also bought Japanese net-nets – you’ll see similar results.
I think individual American investors who bought Japanese net-nets in March 2011 and held
them till today generally got a median result of 20% to 30% cumulative returns. They usually
had very few losers. And they almost always had a couple takeovers.
Pabrai’s result in Japanese net-nets was awful. And it was clearly his fault. Now, he may –
because he is managing a lot of money – have focused on big net-nets.
I always say that’s a bad idea. The bigger the net-net, the worse the business. I think you should
focus on the smallest net-nets you can find. But if you’re managing a hedge fund, you can’t do
that. Small and boring is best. Hedge funds can do boring. They can’t do small.
This is not meant to be a criticism of Pabrai. He has – over his career – gotten better annual
results than I have. He’s obviously a better investor than I am. And yet he obviously did a bad
job implementing his Japanese net-net strategy.
The real purpose of this post is to point out to the folks reading the notes to Pabrai’s annual
meeting that individual value investors – including Americans who obviously lost a lot on the
Yen decline – made a lot more money in Japanese net-nets than Pabrai did.
It would be a shame if people read Pabrai’s annual meeting notes and figured Japanese net-nets
didn’t pan out. They did pan out for people reading and writing blogs like this one and Oddball
Stocks. They didn’t pan out for Pabrai.
Look at the names listed above. Those are the 15 names – and the only 15 names – that were in
my net-net report. I can also tell you that I put my money where my mouth was. So, whatever
liquidity costs were – I’ve come out way ahead after all those real life issues of liquidity,
currency, and broker fees.
I would also encourage everybody to check out Oddball Stocks. I think Nate’s experience in
Japanese net-nets has been similar to mine. And very different from Pabrai’s.
 URL: https://focusedcompounding.com/how-did-mohnish-pabrai-not-make-money-in-
japanese-net-nets/
 Time: 2013
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Ben Graham Defines an Investment
An investment operation is one which can be justified on both qualitative and quantitative
grounds.An investment operation is one which, upon thorough analysis, promises safety of
principal and a satisfactory return.Thorough Analysis: The study of the facts in the light of
established standards of safety and value.Safety: Protection against loss under all normal or
reasonably likely conditions or variations.Satisfactory Return: Any rate or amount of return,
however low, which the investor is willing to accept, provided he acts with reasonable
intelligence.
(Security Analysis, 1940)
To have a true investment there must be present a true margin of safety. And a true margin of
safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a
body of actual experience.
(The Intelligent Investor, 1949)
Key Terms
 Operation
 Qualitative
 Quantitative
 Thorough Analysis
 Safety of Principal
 Satisfactory Return
 Margin of Safety
 Figures
 Persuasive Reasoning
 Body of Actual Experience
 URL: https://focusedcompounding.com/ben-graham-defines-an-investment/
 Time: 2013
-----------------------------------------------------
How to Read a 10-K
A blog I read, valueprax, reviewed How to Read a Book. I had never read the book before. So I
thought I would give it a try. It is – of course – mostly about reading books. And while investors
read a lot (in fact, that’s most of what they do) it rarely comes in book form.
Still, a lot of what you’ll find in How to Read a Book can help with reading 10-Ks, S-1s,
investor presentations, earnings call transcripts, annual letters, newspaper articles, trade journals,
etc.
I think this quote sums up the problem new investors have:
Most of us are addicted to non-active reading. The outstanding fault of the non-active or
undemanding reader is his inattention to words, and his consequent failure to come to terms with
the author.
SEC reports are not known for being communicative. But in most cases where someone emails
me asking about a part of a 10-K they do not understand – the answer can be found in the same
10-K. You just have to read the footnotes, understand how the income statement and cash flow
statement and balance sheet relate, and know whether the company is using GAAP or IFRS.
With the internet, you don’t even need to know all the actual norms of GAAP and IFRS – since
you can always just google “IFRS biological assets” if you’re confused.
This sounds like a lot to keep straight. But if you come to every 10-K armed with a pen, a pad of
paper, a highlighter, and a calculator – it’s so much easier. When I see something out of the
ordinary I just scrawl “Depreciating too fast?”, “Why did marketing expense double?”, “When
was building bought?”, etc. right in the margin.
It is easy to miss the relevance of depreciation method, useful life, residual value, etc. in a
depreciation footnote if you read it the way you would read a newspaper article, novel, etc. Most
people read most things passively.
Read the 10-K actively.
A depreciation footnote takes on a whole new meaning when you are looking through the 10-K
specifically making calculations based on questions you came up with yourself about
depreciation. You now read it in the context that matters to you.
Here’s one other great piece of advice from How to Read a Book. Just read the whole thing
straight through first. It’s amazing how few people read a 10-K twice. If you’ve ever seen a
movie straight through twice – within the same week or so – you’ll realize you missed a lot the
first time through. Popular movies are not made to be dense or difficult to understand. But I
don’t think there’s anyone who can see even a very superficial seeming movie twice in the same
week and not find something in the rewatch they missed the first time through.
Why?
Context. The best context in which to analyze something is to already be familiar with it. The
first time you see something you’re seeing it. The second time you see something you’re
analyzing it.
If you feel like you’re not getting enough out of 10-Ks, try to read a 10-K a day. And try to read
it twice. Read it once without worrying about whether you understand it. Then read it the second
time with you pen and paper and highlighter and calculator.
You will always find something you missed the first time.
And yes, it’s much easier to read your 100th 10-K than your first 10-K. They are a genre. It’s a
pretty dry genre. But it’s still a genre. And you’ll be pretty genre savvy by the time you reach
your hundred and first 10-K.
 URL: https://focusedcompounding.com/how-to-read-a-10-k/
 Time: 2013
-----------------------------------------------------
Hint: Read the Oldest 10-K
I recently mentioned something in an email that I’m not sure I’ve said before on this blog. I
always read the newest and oldest 10-K for a company when I start analyzing it. Reading the
oldest 10-K gives you perspective.
This little habit will make you a better investor.
EDGAR has 10-Ks going back to the mid 1990s. So, you’ll have the experience of reading a
2012 annual report and something like a 1996 annual report.
This always gives me added perspective on the business. And it gets my thinking about how the
business has changed over time and how it will change in the future.
 URL: https://focusedcompounding.com/hint-read-the-oldest-10-k/
 Time: 2013
-----------------------------------------------------
Charlie Munger’s 3 Places to Find Stocks
Market Folly links to an interview Mohnish Pabrai gave to The Motely Fool. In that interview,
Pabrai mentions 3 places Charlie Munger said you should look for stocks. Munger said to look
for stocks that:
1. Great investors are buying

2. Are reducing their share count
3. Are being spun-off
For #1 you can read the Market Folly blog, go to GuruFocus, or subscribe to the Hedge Fund
Wisdom Newsletter.
For #2 you can read Value Line, go to GuruFocus, or go to Morningstar.
And for #3 you can go someplace like StockSpinoffs.com.
 URL: https://focusedcompounding.com/charlie-mungers-3-places-to-find-stocks/
 Time: 2013
-----------------------------------------------------
30 Obscure, Profitable Stocks
Here are 30 of the most obscure stocks with a history of profits:
1. Superior Uniform (SGC)

2. Bowl America (BWL.A)
3. Seaboard (SEB)
4. Atrion (ATRI)
5. Arden (ARDNA)
6. Micropac (MPAD)
7. Ark Restaurants (ARKR)
8. United-Guardian (UG)
9. Span-America Medical (SPAN)
10. Nortech Systems (NSYS)
11. Air T (AIRT)
12. Mesa Labs (MLAB)
13. Monarch Cement (MCEM)
14. Educational Development (EDUC)
15. Flanigan’s (BDL)
16. George Risk (RSKIA)
17. Tofutti Brands (TOF)
18. TNR Technical (TNRK)
19. Daily Journal (DJCO)
20. Jewett-Cameron (JCTCF)
21. Opt-Sciences (OPST)
22. Paradise (PARF)
23. National Research (NRCI)
24. Earthstone Energy (ESTE)
25. Mexco Energy (MXC)
26. Espey Manufacturing (ESP)
27. LICT (LICT)
28. Scientific Industries (SCND)
29. United States Lime (USLM)
30. Boss Holdings (BSHI
 URL: https://focusedcompounding.com/30-obscure-profitable-stocks/
 Time: 2012
-----------------------------------------------------
Catalysts Not Included
A blog I read, Value and Opportunity, has a post about Porsche and Volkswagen. There is also a
link to a Market Folly post. They are both worth reading. I have no comment on the stock. I
know nothing about cars or car makers.
I do know something about holding companies that trade at a discount to their parts. And I don’t
agree with that part of the post. If the underlying assets are compounding nicely – you shouldn’t
assume a holding company discount is correct just because the market applies one to the stock.
You can’t both beat the market and defer to it.
When analyzing a stock that trades at a discount to net asset value – whether it is an insurer, a
closed end fund, or a holding company – you need to look for reasons apart from market
perceptions why the stock should be valued that way. If an insurer earns 5% on book value – it
should trade at a discount to book. If it earns 10% on book value – it should not.
If the return on assets is satisfactory – the market price of those assets will one day be
satisfactory.
Stock pickers should take advantage of market perceptions. Not incorporate them into their
analysis. Much of the money you make in a value investment comes from a change in the
market’s perception. You buy an ugly stock. And sell a pretty one.
Focus on value and ignore catalysts. Catalysts are made in the imagination. And our
imaginations are too small. The future we sketch is always narrower than the future we get.
Who would have imagined Porsche’s past few years?
I made 150% on a Japanese net-net. It was taken private by management. Never once in my
search for Japanese net-nets did I consider that a possible catalyst. Everybody knew Japanese
companies did not go private. I knew it too.
The great thing about value investing is that you still get paid for upside scenarios you never
imagined.
 URL: https://focusedcompounding.com/catalysts-not-included/
 Time: 2012
-----------------------------------------------------
Rise of the Guardians Has DreamWorks’s Worst Opening Weekend
We’ve talked about DreamWorks Animation (DWA) on this blog before. Last weekend,
DreamWorks released a movie called Rise of the Guardians.
Here is a list of original computer animated solo productions by DreamWorks and how each
movie opened in the U.S. All amounts are adjusted for inflation.
1. Kung Fu Panda: $67 million

2. Monsters vs. Aliens: $63 million
3. Shark Tale: $61 million
4. Madagascar: $58 million
5. Over the Hedge: $47 million
6. Megamind: $46 million
7. Bee Movie: $44 million
8. How to Train Your Dragon: $44 million
9. Puss in Boots: $35 million
10. Antz: $29 million
11. Rise of the Guardians: $24 million
Rise of the Guardians cost $145 million. DreamWorks has had worse opening weekends. But
none were computer animated solo productions. They were either hand drawn movies – which
DreamWorks no longer makes – or movies made with Aardman.
DreamWorks’s stock dropped on Monday. Shares now trade at $17.30.
 URL: https://focusedcompounding.com/rise-of-the-guardians-has-dreamworkss-worst-
opening-weekend/
 Time: 2012
-----------------------------------------------------
How to Lose Money in Stocks: Look Where Everyone Else Looks – Ignore
Stocks Like These 15
This isn’t an article for traders. It’s meant as advice for long-term value investors.
I’ve been reading Howard Marks’s The Most Important Thing. This got me thinking about risk.
And how I don’t talk about risk enough on the blog.
I don’t want to talk about risk in theory. I want to focus on the practical risks value investors –
especially long-term value investors who focus on picking specific stocks – face each and every
day.
How do value investors screw up?
How can they have the right philosophy and yet implement it so badly, they actually lose money
in some of their investments?
One way is to buy and sell stocks at the wrong times. I’ll talk about that tomorrow. Today, I want
to talk about the umbrella category that falls under: acting like everyone else.
It’s risky to act like everyone else.
And one way investors can act like everyone else is by looking at the same stocks everybody else
looks at.
Another way is by entering and exiting stocks along with the crowd.
Both are risky mistakes.
How Mutual Fund Investors Manage to Do Worse Than the Funds They Buy
Mutual fund investors are masters of bad timing. Usually, they are pretty good at knowing what
fund is best. It’s no secret that Bruce Berkowitz is a good investor. But even investors who know
that – and who therefore trust Berkowitz with their money – manage to destroy the profit
potential in partnering up with a superior investor.
Morningstar keeps data on just how bad mutual fund investors are when it comes to timing their
entrances and exits. For example, over the last 10 years, Bruce Berkowitz’s Fairholme Fund
(FAIRX) has returned 9% a year. The average Fairholme investor has earned just 1.7% a year.
New money enters the fund just before performance goes bad. And money exits the fund just
before performance turns right back around.
I’ll talk about the issue of terrible timing in another post. Today, I just want to use this terrible
timing as evidence. It’s evidence that following the crowd is not safe.
Following the crowd is so risky that even if you are right about which fund manager to invest
with, you can be wrong enough in your entrances and exits that you fritter away 7% a year on
nothing but needless activity.
Does the Average Investor Really Match the Market?
I’ve never believed this for a second. The truth is that if you can find an entirely arbitrary
allocation (50% bonds/50% stocks) or a hedge fund or a program or system or whatever that
keeps you invested enough at all times in good enough assets – you’ll do better than most
investors.
Most investors think their problem is figuring out what assets have the best long-term returns,
which managers are the best investors, and what approaches to investing work.
Investing is More about Practical Psychology than Theoretical Efficiency
My constant contention has been that investing is more like dieting than investors admit. The
problem has never been that science can’t figure out which diets works. I don’t even think –
practically – it’s worth the time of most fat folks to give a moment’s consideration to whether
one diet is more or less efficient, effective, safe, etc. than another. A lot of diets are good enough.
That’s all that matters.
Because chances are you won;t stick to any of them. That’s where your research time should be
spent. Don’t worry which diet is best. Worry which diet you can stick to.
The goal is to find an adequate approach you can see through forever.
I’ve proposed many such stock picking systems before. You can use Joel Greenblatt’s magic
formula if you want.
But you can use entirely different systems – often untested – which I promise you will tend to
work well enough for you if you stick to them.
I’ll offer a simple, easy example. I ran a screen of StockScreen123 to do this for you. There’s
nothing magic about it. But it’ll work the same way most diets do. If you stick the names on this
list and you never backslide – you’ll get decent results.
But before I get to the list of the kind of stocks you’re allowed to eat on this diet – let’s talk
about the kind of weight you can expect to lose.
Aim Lower, Be Happier
Yes, it’s possible to earn 30% a year over a decade. You know Warren Buffett’s record from his
partnership days. You’ve probably seen the table of annual returns in Joel Greenblatt’s “You Can
Be a Stock Market Genius”.
Should you aim for that?
If your plan to devote yourself to extreme concentration, constant – like every waking hour of
your life – intense focus on investing, a life of continuous learning, deliberate practice, etc. –
sure, go for it.
It’s possible. Don’t let anyone tell you it’s not. Because somebody is going to do it. Somebody
will earn terrific returns purely through value based stock picking that will set them apart from
the pack over the next 5, 10, and 30 years. You could be that someone.
A lot of people reading this blog have that potential. Some of you are probably too old. No
offense. It’s just that the later you get addicted to some pursuit – the harder you have to work at
learning it. Some lack the right temperament. Most could never devote themselves to investing
the way someone like Warren Buffett does.
But those are self-imposed shackles. It’s probably not that you lack the brainpower. It’s
definitely not that the pursuit of investment knowledge is closed off and made available only to a
chosen few. It’s available for anybody. It’s not hard to get better at investing.
But most investors are never going to get that good. I’m not sure most investors realty want to
attempt to make 30% a year for the next 10 to 15 years.
If you knew what that entailed – what young Warren Buffett’s life was like – I’m not sure a lot
of people are eager to make that trade. They may say they are. But it doesn’t require just a long-
term commitment. It requires every day commitment. It requires thinking about stocks first thing
in the morning and last thing at night.
From talking to a lot of investors – I’d say most people’s goals are more humble. They want to
work hard at investing. They want to learn a value investing based system. They want to apply it.
They want to stick to it forever.
What can people like that expect?
What should you really aim for?
I’d say you should aim to earn 7% to 15% a year for the rest of your investing life. Not 7% to
15% next year. Not beating the market. If you do 7% to 15% over the long-term, you’ll have a
decent chance of beating the market. And – if you do even just a decent job of saving up money
– you’ll live quite well on 7% to 15% a year.
Is it really possible to achieve 7% to 15% a year?
For value investors, I think it is. And I’ll try to show you a way – not the way, but one of many
ways – that can get you to your goal.
A Simple, Successful Strategy You Can Stick To
That’s all most value investors should hope for. It’s all most investors should hope for.
One thing to think about is how you want to spend your time investing. Do you like analyzing
companies? Learning about competitive advantages? Assessing management?
Great. Then let a computer take care of price and hype for you. Tell the computer to go out and
find you some decently reliable, decently cheap, decently unhyped stocks – and then you do the
rest.
That’s the strategy I’ll be talking about today.
The exact details of this screen – which I ran on StockScreen123 – aren’t important. The basic
idea is.
Here’s the basic idea.
A good investment is likely to be the purchase of the equity of a good company that is believed
to be:
 Reasonably reliable in terms of past profitability

 Reasonably cheap in terms of EV/EBITDA
 And reasonably unhyped in terms of analyst attention
That’s it. I’m agnostic as to whether you use a Ben Graham approach, a Phil Fisher approach, or
a Peter Lynch approach.
Maybe you’re looking for cheap stocks based on assets, the past earnings record, etc. Maybe
you’re looking for the best organization. For a company with some real business momentum – a
turnaround or a fast grower. Or maybe you’re looking for a moat.
The stock market isn’t perfectly efficient. But it’s not like Wall Street is an undiscovered little
bistro either. The major stocks are in the guidebook. If you know railroads, cruise lines, grocery
stores, cell phone makers, superstores, etc. – so do a lot of other folks. And probably a lot better
than you do.
I’m not saying you can’t make money off those folks. To the extent I’ve made money buying
something in the stock market, it’s certainly not because I had a higher IQ than the seller. And
it’s probably not that I had superior knowledge.
I’ll talk another time about how you really make money in stocks. What people will pay you to
take from them – illiquidity, uncertainity, unpleasantness, inconvenience– etc. But these posts
are about risk rather than reward.
So, I’m laying out a list of stocks here which – if you constantly create a similar menu to choose
from every 6 months or a year – will give you a selection that allows you to practice an approach
to investing that utilizes your talents and interests without introducing tons of risks.
The idea with today’s list is to reduce the risk that you’ll look at the same stocks everybody else
does.
Once again, the criteria are:
 Reasonable past profits

 Reasonable price
 Reasonably unhyped
And the stocks are:
1. The Eastern Company (EML)

2. Arden (ARDNA)
3. Weis Markets (WMK)
4. Oil-Dri (ODC)
5. Sauer-Danfoss (SHS)
7. U.S. Lime (USLM)
9. Seaboard (SEB)
10. American Greetings (AM)
11. Ampco-Pittsburgh (AP)
12. International Wire (ITWG)
13. Terra Nitrogen (TNH)
14. Performed Line Products (PLPC)
15. GT Advanced Technologies (GTAT)
I don’t think that’s an especially good list of 15 stocks. But I think it’s a good list of the kind of
stocks that everyone else ignores.
You should start your search for decent returns among the stocks other people don’t pay enough
attention to.
You should start with stocks like those 15.
 URL: https://focusedcompounding.com/how-to-lose-money-in-stocks-look-where-
everyone-else-looks-ignore-stocks-like-these-15/
 Time: 2012
-----------------------------------------------------
Why Capital Turns Matter – And What Warren Buffett Means When He
Talks About Them
Someone asked me what Warren Buffett meant when he talked about a company turning over its
capital “x” number of times a year.
When Buffett says capital turns he means Sales/Net Tangible Assets.
Most websites, etc. tend to just use assets. And they may even be including cash assets as part of
that ratio. Based on the way Buffett has talked about return on investment at Berkshire
subsidiaries in the past – it’s clear he uses the net amount of tangible capital invested in the
business. In other words, he nets tangible assets against accounts payable and accrued expenses.
He gives a company credit for these zero interest liabilities – rather than assuming shareholders
are really paying for all of a company’s assets themselves.
A lot of the businesses Buffett has bought for Berkshire actually don’t have very high margins.
What they have is higher sales per dollar of assets. Distributors for instance. Once a company in
a business like that can achieve higher sales per dollar of assets it is hard for others to compete –
because even if they have the same margins, they have lower returns on capital.
The Advantages in Always Moving Product
Buffett has talked about survival of the fattest before. A high volume, low margin business can
sometimes turn into a survival of the fattest situation. That’s because everybody has to start with
just a trickle of product moving through their pipes. This is not a recipe for catching up to the
leaders who are already moving flood like quantities through their infrastructure.
We’ve talked about movie studios – mostly DreamWorks (DWA) – on this blog before. That’s
a bit of a survival of the fattest situation. The best way to distribute a movie is to distribute 12 of
them a year – not 2 of them. But the best way to make movies is to make 2 of them a year – not
12 of them. A producer’s dream situation is to make 2 blockbusters a year. A distributor’s dream
situation is to always be distributing something. Over the last three quarters of a century there
hasn’t been much change in who distributes movies. In fact, from a competitive economics sense
– when we say “studio” we mean “distributor”. That’s where the oligopoly exists. You’ll notice
that where someone new did became a major studio – Disney – they did it by succeeding on
different terms as a producer first and then succeeding as a distributor. Basically, they cheated.
It’s an interesting question whether the integration of production and distribution influences the
movies that are made. My belief is yes – it does. And that the historical evolution of the movie
industry lead to a situation where more smaller, lower quality movies were made than would
otherwise be the case. I actually think there were always huge incentivizes to make blockbusters.
They’re just weren’t huge incentives for distributors to focus exclusively on blockbusters –
because maximum efficiency in distribution can’t be achieved if you put out 2 movies a year.
The Advantages in Doing a Lot of Volume in One Place
Grocery stores often compete on turns instead of margins. With the exception of a few grocers,
like Whole Foods (WFM) and Arden (ARDNA), most grocers will not depend on a strategy
that actually requires them to have better margins than the competition to win in their market.
Instead, they try to drive more traffic per store rather than specifically drive margin
improvement.
In fact, when gross margins improve because costs fall, they will often pass these cost reductions
right on to the shopper if they have good reason to hope they can take more trips from each
shopper and more shoppers from the other grocers in town.
This is not immediately obvious to folks who look at grocery store stocks for two reasons:

1. Inflation causes grocery stores to report increasing costs of goods sold even when they
may be holding costs of goods sold completely steady or actually allowing it to expand at
lower than the rate of inflation.
2. Margins vary tremendously on different items in a grocery store. Increasing traffic per
store is often coupled with increasing sales of prepared foods, bakery, etc. If you are
getting the big weekly shopping trips from families, etc. you’re also probably getting
more and more of this high margin business which makes your reported margins look like
they are widening even when you aren’t making any more money per purchase on cereal,
soup, etc.
In this way, they can get to a position where it is very hard for any grocer – even a grocer with an
equally low cost structure – to compete with them in the same local market.
You Can Only Target a Capital Turns Advantage in Some Industries
The reason is capital turns. The amount of sales a single grocery store can do is tremendously
variable. As a teenager, I worked in a store that did around $50 million a year. The reason for
this is complicated but includes:
 Location
 Size
 Price
 Selection
 Parking
Some of these factors are so important – like location – that in the town I grew up in we had 3
grocery stores of which none (despite many changes in corporate ownership) ever moved its
location nor did a new location open for almost a quarter century despite the town’s population
more than doubling. When a new store opened it was only because land that had been previously
off-limits to development was turned into a new strip mall. Even more telling, 2 of the 3 grocery
stores were located directly across the street from each other. They still are. They’ve been close
to 30 years in those locations. Again, the parent companies of 2 of these 3 stores have been
through several mergers, spin-offs, bankruptcies, and reorganizations of all sorts.
What’s the point of this story?
Sure, there are some differences in how much capital it takes to open a grocery store. But you
can’t do it with no capital. And the store doing $50 million in sales is probably not using 2.5
times more capital than the store doing $20 million in sales.

Gross Profitability Matters
This is not true in some other industries. In some businesses, if you are doing $50 million in sales
and a competitor is doing $20 million in sales it is almost certainly the case that you are tying up
about 2.5 times more capital to achieve this. I’ll talk up one such industry in a minute.
But let’s look at the issue of gross profitability on the micro level and how important capital
turns are to paying for all the stuff a corporation needs to – and wants to – pay for.
Imagine the two of us run competing grocery stores. We each have gross margins of 24%. Your
annual sales are equal to your assets. But my annual sales are 4 times my assets. If I have $100 of
assets – I will be generating $96 of gross profits to pay all my operating costs, to advertise, to
build new stores, etc. You will have only $24 in gross profits to pay all your operating costs,
advertise, build new stores, etc. In the grocery business – even if you are pretty efficient putting
aside COGS – you’ll actually have a really hard time doing any better than break-even with a
24% gross margin if you don’t turn your capital faster. If you can double the turns, it’s not
inconceivable that you can achieve a 10% return on your capital while a competitor who has a
pretty similar price and cost structure to you in the store is actually earning very close to 0%.
This is a big deal. For example, a grocery store with half the gross margins of a jewelry stores
can actually make twice the return on capital. That’s because a jeweler can have capital turns as
bad as 1 times sales. Whereas a good grocery store can do $400 million of sales on just $100
million of invested capital.
I actually think capital turns were a very important part of the tab card industry. The kind of
gross margins they had were good. But there are manufacturers in some industries who
comfortably have 50% gross margins over time.
There are even companies with 50% gross margins that actually aren’t very good businesses at
all. They never have been. And unless they can change their inventory situation – they probably
never will be.
Personally, I think there’s much more protection investing in a business that’s part of an industry
which has shown it tends to have both:
 Adequate gross margins

 Adequate capital turns
A Strong Flank Lets You Kill Competitors Who Are Focusing on the Center
In industries that haven’t demonstrated this double adequacy, you should be even more careful
about betting on a follower rather than a leader.
Part of the reason is competitive. If an industry depends heavily on either margins or turns it
opens itself up to a devastating attack from the player who can maximize the key variable you
can control – which could be:
 Price
 Cost
 Working capital management
 Etc.
I can think of a lot of industries where this happened. For example, Dell (DELL) was able to go
very far in working capital management precisely because PC manufacturers can’t live on
margins alone. They need turns. In other businesses where turns are relatively fixed – capital
turns in transportation businesses tend to be very hard to use to get an edge on anyone – you
have to find some other advantage.
This is why I think Carnival (CCL) has a really big advantage in the cruise business. I think the
cruise business is a cost leadership business. An efficiency business.
Companies Can’t Compete on Metrics They Don’t Control
That’s because I believe the nature of the assets means you are going to tend to all have pretty
similar ratios of passenger nights to offer relative to PP&E you own. And then I think you are all
going to price to fill your ships.
So capital turns are mostly fixed by the asset you are using. And price is mostly fixed by the
capacity of the industry in any given year relative to demand.
So I think every cruise company will tend to be an asset owner and a price taker. But I think
some companies can be a cost leader.
So the key competitive metric for me in the cruise business is cruise costs excluding fuel per
potential passenger night. All 3 major cruise companies give out this info.
If the capital turn circumstances of the business were different – if I thought you could get more
passengers each night, more nights a year, etc. from the same ships – I’d feel differently. I do
feel differently in the grocery store business. The grocery store business is not just about costs.
In fact, if you can charge high prices and have normal costs while achieving high capital turns in
the grocery business you can compete with someone who has normal prices and low costs and
good turns.
What you both need is margins and traffic. Not just margins. You don’t have to be low price. But
you do want to achieve the double whammy of margins and turns. If you can be high price and
attract high traffic – more power to you. If you can be low price, low cost and attract high traffic
– go for it. But you need to find a position where you can get the complete combo of margins
and turns working for you.
It would actually be a mistake to try to figure out the absolute cheapest way to get food on store
shelves, because unless you can keep people coming back week after week low costs aren’t
enough. For instance, you can’t alienate customers with a non-sensical (from the shopper’s point
of view) stocking scheme just because it keeps costs down.
Low costs only work in groceries if you can keep the store full of shoppers.
Locally, this presents some problems in groceries – unlike cruises – because it can encourage a
competitor to keep driving prices lower and lower as they gain more and more traffic to the point
where you can’t compete.
In cruises, someone will only do this if they have the available capacity. So, if someone can kill
you in cruises they have to kill you slowly. They have to kill you year by year rather than month
by month. In the short-term it’s hard to increase the number of passengers on your cruise line.
It’s not so hard to increase the number of shoppers in your grocery store. In fact, some
companies can keep doing this year after year after year in some towns if they keep margins
pretty steady even while their costs are falling. And they’ll do exactly that because more traffic
per store is something they want. It allows them to both make money and widen their moat in the
local market at the same time.
To Adapt You Need a Relevant, Controllable Metric You Can Win On
My point is just that companies often compete on a specific trait. It has to be a trait that is
relevant for business success. It has to be a trait that is variable – you can target it for change.
Obviously, you can make mistakes by trying to adapt to your circumstances in a way that ends
up backfiring. This is what happened to George Risk’s competitors. They thought targeting costs
made sense. They tried out a “low cost” variation. It turns out the low cost trait is inversely
correlated to the dependable, customized delivery trait. And it turns out dependable, custom
service was actually preferred to low costs.
Sometimes a Move That Reduces ROI Increases Competitiveness
Capital turns are important. But they aren’t always the answer. Dell had success competing
through better working capital management. It was an inherent part of their system. It was great
for ROI and great for competitiveness.
Meanwhile, ADDvantage (AEY) actually has a high working capital burden as an inherent part
of their system. They think carrying more slow moving inventory can be a competitive
advantage because of the needs it lets them satisfy for customers (and the prices they get to
charge for such satisfaction). Historically, they were right about this. And their record compared
to competitors who though keeping working capital low has been quite good over the last
decade.
To me, it’s very interesting that tab cards had both high margins and fast capital turns. It was a
dream business. And it looked like a business where Buffett could make money on an investment
in a company where he didn’t know if they would end up being a leader in the national industry
or not.
He felt he knew they’d make enough money faster enough for his investment to pay off.
 URL: https://focusedcompounding.com/why-capital-turns-matter-and-what-warren-
buffett-means-when-he-talks-about-them/
 Time: 2012
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How Today’s Profits Fuel Tomorrow’s Growth
Over at Adjacent Progression, there’s a post called “The Profitability Bias”.
Adjacent Progression asks:
When thinking about business, we immediately let our minds wander to profits. Great businesses
generate tons of profit. Of course, but we have a profitability bias in that we use it as an early
measure of judging how good a business is. Does it bring in substantially more money than it
must spend to buy its raw materials, build its products and convince you to buy them? If there’s
money left over, it’s a profitable company. And the bigger the profits, the better the company.
And why would anyone argue with that? We like profits, and the profitability bias is not
necessarily a bad one to have. When you’re using a framework to understand and assess
businesses, it’s fair that you would want your checklist to include profitability. But like so many
frames we use to understand complex and fluid systems, we do ourselves a disservice using just
one, in isolation, without considering other important concepts as we scratch through the
qualities the best companies must possess.

Our focus on net profits is probably excessive. Perhaps we need to move up the income
statement.
For me, there are two elements to consider with any business’s returns – sales margins and
capital turns.
1. How much can you make per dollar of sales?

2. How much can you sell per dollar of capital you tie up?
Most investors and analysts pay too much attention to margins and too little attention to capital
turns. In Alice Schroeder’s discussion of Warren Buffett’s investment in Mid Continent Tab
Card Company, she mentions that Buffett looked at margins and capital turns.
Gross Profitability Matters More Than Most Investors Think
It is not necessary for a company to have high margins – and certainly not pricing power – to
achieve truly remarkable returns on capital. And it’s definitely not necessary to have a high net
profit margin from the business’s earliest days.
But you do need some basic evidence of a strong business model. What is a strong business
model?
There are countless qualitative ways of looking at a business model. I’ll propose one basic
quantitative check:
Gross Profits / ((Receivables + Inventory + PP&E) – (Payables + Accrued Expenses))
This number should start looking good – and keep looking better pretty early in a company’s
history.
Look, Amazon (AMZN) is an expensive stock. I’m not going to argue otherwise. And it’s got
low margins. But it also doesn’t tie up capital in the business. And it’s got the same gross
margins Wal-Mart (WMT) does.
So, to me, Amazon is a proven business model quantitatively. And qualitatively I feel its
competitive position will be better in five years than it is today. I think Wal-Mart’s will be
worse.
Now, Amazon’s operating margin is worse than Wal-Mart’s. But I’m not sure Amazon’s
business is worse. And I actually suspect it’s better.
This is what I mean when I say we sometimes focus too much on margins.
The Need to Self-Fund
Can a company develop a sustainable competitive advantage without earning strong returns on
capital relative to its peers?
It’s possible. But, remember, Amazon is a rather weird example of a company that developed
strong advantages early on without making good profits. By the time Amazon was strongly
profitable, it already had a solid competitive position.
How common is this?
Amazon went public in a bubble. In fact, one of the reasons why Amazon’s management felt
they had to expand so quickly in the early years is that it was still possible for new entrants to
raise a lot of equity financing. The bursting of the bubble was one of the best things that ever
happened to Amazon.
Once an industry matures even a little bit, self-funding – the use of retained earnings in the
business – becomes a critical part of future growth. It is often the fuel that drives growth.
Retained earnings are the most reliable form of fuel. For this reason, a company that earns a
higher return on its invested capital isn’t just more profitable – it’s better able to grow the
business reliably.
Consider the example of an industry growing 7% a year. One company has an 8% after-tax
return on unleveraged net tangible assets. The other has a 4% return on after-tax return on
unleveraged net tangible assets.
Putting aside the issue of how safe it would be for a company with a 4% after-tax return on
capital (basically, 6% before taxes) to borrow anything, there’s still the very real problem that
Company A can grow the business 8% a year without leverage – which is fast enough to
maintain or even grow market share. Meanwhile, Company B can’t. No matter how much
customers may prefer Company B’s product to Company A’s product – if Company B is starting
from a position with a 4% after-tax return on capital – it really can’t self-fund growth of more
than 4% a year.
It’s Hard to Keep Growing Sales Faster Than Assets

To maintain market share in most industries, it is necessary to increase capital pretty close to the
rate at which the overall market is growing. So, if Company B wants to maintain its market share
– it really needs to get half its growth capital from debt.
Maybe the business is very stable, and maybe the cost of debt is consistently below the 6% pre-
tax return on capital Company B can achieve. But if Company B can safely borrow with a 6%
pre-tax return on capital, Company A should be able to safely borrow with a 12% pre-tax return
on capital.
Can Company B keep pace?
Sure. If Company A doesn’t borrow – and Company B does – the two companies can start from
the same size and grow capital at the same rate over time.
But, if Company B thinks scale is so important it’s worth borrowing to grow 8% a year despite
only being able to self-fund 4% a year – maybe Company A will think scale is important enough
to try to grow 16% a year.
Well, Company B really can’t do that. If you have to increase invested capital to increase sales
and both Company A and Company B refuse to use any debt to grow – then obviously Company
A can outgrow Company B to the extent Company B’s return on capital is both lower than the
growth in the overall market and lower than Company A’s return on capital.
Likewise, if Company A and Company B are both willing to borrow to the hilt – then Company
A can still outgrow Company B. Although, in this case, if Company B’s product is preferred to
Company A’s product it may be possible for B to grow a little bit faster than A. Of course, if
Company A really can’t grow that fast, it really won’t borrow that much.
Any way you slice it, there is an advantage in having a high return on capital. It allows for the
charting of a more reliable growth path.
What if You’re Not The Market Leader – And You’re Not Earning a High Return on
Capital?
In industries where returns on capital increase with market share, the danger of being either a
company with lower market share or a lower return on capital is real.
The danger of being a company with both a lower market share and a lower return on capital –
probably means your chances of overtaking the leader are miserable.
How can you solve this problem?

You can borrow more than your opponent in an industry where returns on capital increase with
market share. If returns on capital are poor when everyone has low market share but good when
everyone has high market share – it might make sense to try to sprint for cover so to speak.
But this is a pretty reckless strategy that is only necessary in industries where key variables – like
pricing and asset turns – are outside of the control of individual companies. In an industry like
that, your only possible advantage is a cost advantage. So rushing to gain sufficient scale makes
sense.
But there’s a better way in many industries. And that’s to find some way to achieve a return on
capital advantage that can allow you to self-fund growth.
For examples of two industries with totally different defensible positions consider the case
of Boston Beer (SAM) and Royal Caribbean (RCL).
Royal Caribbean has far more market share than Boston Beer. Depending on whether you are
using price or volume, Royal Caribbean has anywhere from 12 to 25 times more market share in
the cruise industry than Boston Beer has in the beer industry.
Everybody knows beer is a better business than cruises. And Boston Beer earns great returns on
equity without using debt. While Royal Caribbean ekes out a modest return on its capital.
Scale is important in both industries.
But there’s a critical difference. Boston Beer is already in a position within its industry where it
earns enough on its capital to completely self-fund its growth. As a result, the major constraint
on Boston Beer’s market share growth is the relative attractiveness of its product in the beer
industry.
Is the main constraint on Royal Caribbean’s market share growth the relative attractiveness of its
product in the cruise industry?
I’m not so sure. I think there’s a very real risk that the cruise industry can grow faster than RCL
can self-fund. Which means RCL has to use debt just to hold its market share steady.
Boston Beer doesn’t have to do that.
Now, don’t get me wrong. Boston Beer will never overtake Budweiser and have a leading
position in the U.S. beer market. I can promise you that’s not going to happen.
But the reason it won’t happen is because Boston Beer’s product has limited appeal. The product
is not positioned to be a blockbuster brand.
That’s a marketing constraint. Not a funding constraint.

RCL has a funding constraint. It’s actually possible for people to prefer an RCL cruise to
a Carnival (CCL) cruise and yet for RCL to run into a lot of trouble expanding its market share
versus CCL.
It’s possible. But it’s not that easy without taking more risk than CCL is taking at the same
moment. And consistently taking a little more risk – being always a bit more aggressive than
your opponent – is hardly a recipe for reliable long-term success in any business.
This is not true for Boston Beer. If Boston Beer’s product positioning allows for a doubling or
tripling of its market share – Boston Beer’s business can self-fund this growth.
Why?
Because Boston Beer is already earning a high return on capital. Much, much higher than the rate
of growth in its industry.
Royal Caribbean is not.
So, yes, investors do sometimes over emphasis today’s profits over the future conquests a great
competitive advantage can provide.
But you need more than time, opportunity, and determination to grow. You need capital too.
The easiest place to get that capital is from your own successful operations.
So for most companies, a lot of tomorrow’s capital will come from today’s profits.
 URL: https://focusedcompounding.com/how-todays-profits-fuel-tomorrows-growth/
 Time: 2012
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How to Become a Better Analyst – One Hour at a Time
Over at Portfolio14, there is a good question about spending time researching new stocks as
opposed to just adding to the same old positions:
Charlie Munger always says diversification is diworsification. My dilemma here is whether I
should diversify in order to reduce my exposure to one single company. No matter how high my
conviction is, there are always “unknown unknowns”. There is also this unhelpful thought
urging me to divest: “Earning outstanding returns requires hardwork. If I keep on adding to just
the same old position and not spending time to dig deep into other companies, I’m not working
hard enough.”
(Portfolio14)
This is a great question to ponder. On the one hand, I agree that diversification often leads to
diworsification. On the other hand, it is important to practice, practice, practice:
A little over a year ago, Geoff Gannon wrote a post where he gave readers the salient financial
information of company, but didn’t give the ticker/name of the company. He then had readers
guess the stock price. It was an amazing little experiment derived from a quote of Warren Buffett
where WEB goes on to say he likes to guess the stock price before looking at the actual price
when he analyzes investments.
As always, WEB was well ahead of his time. Much work and study from behavioral
finance/economics, like that of Daniel Kahneman, discusses the effects anchoring has on each of
us. If we see a stock price before valuing the company, we will unconsciously fix our valuation
near the actual price.
Ever since Geoff’s original post I have been fascinated by the experiment. I even went as far as
making an Excel program that would randomly generate ticker from the Russell 3000, display
the financial information with ticker and price hidden. I could then go about valuing the
company and check my work to see how I was doing.

(Distressed Debt Investing)
What’s the solution here?
Be Focused in Your Buying – But Omnivorous in Your Research
Should you buy a lot of different stocks? Analyze a lot of different stocks but don’t buy them?
Or take the Peter Lynch approach and buy tiny amounts of many stocks just to keep them on
your radar – then only load up on the ones you really love?
It’s a tricky question. To gain experience you need to do something similar over and over again.
But it can’t be exactly the same. Otherwise, you will become experienced just at that one task. If
you become an expert at analyzing Microsoft (MSFT) – you will know how to analyze
Microsoft, not how to analyze stocks generally.
Use Real World Examples to Master Abstract Concepts
There’s another complicated issue that has to do with patterns.
I think two of the surest signs of real mastery of a subject are:
 Ability to talk fluently about the subject in everyday language without use of
jargon; ability to use short sentences; having a low frequency of big clichéd word chunks
common to the field in your writing, speech, etc.
 Ability to group examples and problems in unusual categories; to see connections
between aspects of examples that are not usually the primary basis of categorization
within the field
Let’s take movies as an example. We can all group movies according to whether they are:
 Drama
 Comedy
 Horror
 Romantic comedy
 Adventure
 Thriller
 Etc.
I want to point out something obvious but important here. No definition or rule is really being
used here. We are naturally grouping things by a strong “genre” element we see that reminds us
of some exemplar – either concrete or abstract.
And there is some abstraction going on here. My clichéd idea of a James Bond movie – the Bond
formula in my head – is actually more formulaic than any single Bond movie I can point to. All
of the actual movies are missing one or two elements I’d include on a list of what constitutes a
James Bond movie. So I’ve abstracted this idea of a James Bond movie that shares maybe 80%
of its DNA with every actual James Bond movie but doesn’t share 100% of its DNA with any
single James Bond movie. The abstract concept overlaps with every concrete example – but it
never overlaps 100% with any one example.
This is important. Because it means we can’t learn a single definition of a category separately
from learning examples in the category. We actually have to get some first or second hand
experience with the aspects of various objects belonging to that class to really understand the
class at all.
How to See Connections Most People Can’t
And as we get better and better at analysis, it’s actually possible to see congruent elements
present in objects that belong to different classes. We are no longer limited to thinking in terms
of an object belonging only to a single class.
For example, if you’ve seen a lot of romantic comedies and you’ve seen a lot of comedies –
you’ve noticed that maybe four-fifths of the way into the movie, there’s going to come a moment
(it’s a pretty low point) that’s going to feel very familiar. And maybe you’ll even be able to
predict that from this point – where the two leads are not together – someone’s going to have to
make a decision that’s going to put the two of them together and resolving something from
earlier in the story in the next few minutes.
There’s a French movie playing in (parts) of the United States right now: “The Intouchables”.
It’s not a romantic comedy. It is a relationship movie. And it follows that formula I just
described.
A critic can criticize it for doing that. An audience can be satisfied by the formula. But an analyst
has to see the similarity with other movies – and other stories – that aren’t about the same
subject, aren’t from France, aren’t rated R, etc. And hopefully the analyst can understand how
the pieces fit together, what their purpose is, why they are where they are, etc. This is necessary
for the analyst to do more than just say the movie is French, rated R, a comedy, and about a guy
in a wheelchair.
In investing, we face the same analytical problem. There are classes of stocks – value and
growth, specific industries, brand companies versus commodity companies, big caps vs. small
caps, recognized names versus obscure stocks, etc.
We can certainly spend some time analyzing stocks on the basis of such categories. If you’re
analyzing a railroad, you want to spend a little time talking about railroads.
But you don’t want to spend all your time talking about the industry.
There are some key concerns that span stocks from many different industries like:
 Competitive position
 Product economics
 Return on capital
Let’s start with the kind of simple, innocent sounding question that – when asked about a real
stock out in the wild – can lead you on an investigation that shapes both the way you see one
stock and the way you’ll analyze other similar stocks in the future.
The company is Paradise (PARF).
And the question is: Does this company have industry leading market share?
A Real World Example That Illustrates Abstract Concepts
That question alone won’t tell you if return on capital is good. Paradise (PARF) has an 80%
share of the U.S. candied fruit business.
It earns low returns on capital. That’s because the product economics of candied fruit suck.
The company has to build up raw material inventory whenever the fruit is ready throughout the
year, produce throughout the year, and then rush the product to market so the grocery stores have
it on shelves in time for the roughly 6 weeks or so which constitute the only time the end user
actually seeks out the product.
To understand Paradise, it helps if you know:
 Other companies with 80%+ market share

 Other products where virtually all retail sales are made in under 2 months
 Other products where it is necessary to acquire raw material at set times
 Other products where it is necessary to produce a product without selling it for most of
the year
It may also help to know a little about societal trends and how they usually play out in business.
Candied fruit goes into fruit cake. Most people analyzing this company start with no knowledge
of fruitcake other than thinking it a rather antiquated product. So – before analyzing Paradise, it
helps to have some prior experience learning about a product you’re not that interested in, might
be biased against, etc. Having that experience gives you an advantage over analysts who let their
pre-conceived notions of a product dominate their analysis of a stock.
Analyzing other stocks can help with all of this. For example, when I first looked at Paradise –
which was a net-net – I had plenty of experience with other net-nets. I had analyzed dozens of
net-nets in depth. And I’d glanced at hundreds of net-nets over the years.
I also was familiar with a handful of companies that had 50% to 100% market share. Especially
in tiny industries. This is a particular interest of mine. You’ll remember that Hidden
Champions is one of my favorite books.

Collect an Archive of Informative Examples – Then Abstract From Them
How do you start to build up little mental file cabinets full of ideas about stuff like companies
with 80% market share?
For the most part, you can only do it by analyzing stocks. Analyzing different kinds of stocks.
But most importantly – analyzing specific stocks. Not abstract ideas about stocks.
Should you analyze stocks you aren’t going to buy?
Yes.
It’s great practice. And sometimes it’s hard to know what you will and won’t buy before you
start analyzing the company.
Now, some folks will argue that it makes no sense to analyze companies you know are not
especially cheap – because there are conspicuously cheap stocks out there. If one stock has an
EV/EBITDA of 4 and another has an EV/EBITDA of 10 – why waste time on the stock with an
EV/EBITDA of 10? If you look hard enough, can’t you find something with an EV/EBITDA of
4 that you really like? And isn’t there a lot of academic research, backtests run by bloggers like
me, etc. that shows it’s better to hunt for a decent company trading at an EV/EBITDA of 4 than
trying to outguess the competition when it comes to well known companies with an EV/EBITDA
of 10?
In other words, shouldn’t you just focus all your time on obviously cheap and obscure stocks?
That’s where the best bargains are. And you’ll learn a lot analyzing those stocks.
But, if you put in enough time – you’ll learn from analyzing almost any stocks.
Some people are worried about having too little time. I’m going to sound harsh here – and maybe
this really doesn’t apply in your case. Maybe your life really is too busy to add another minute of
stock analysis to your day.
But I doubt it.
How to Sneak in an Extra 250 Hours of Investing Practice a Year
Most people spend about an hour – or more – of their time each weekday night on something
non-critical. It may be watching some mediocre TV show. I’m not judging. I’m just saying you
can probably find a way to go to sleep about one hour earlier than you do right now.
That means you can – with the same amount of sleep – get up an hour earlier. If you go to sleep
one hour earlier tonight than normal, and you normally wake up at 6 a.m. – tomorrow you can be
just as rested waking up at 5 a.m.
When you first wake up is a very productive time. An hour of analyzing some stock from 5 a.m.
to 6 a.m. each morning is likely to be as effective as an hour and a half (or more) spent analyzing
some stock in the evening.
Try it. You’ll be amazed how productive you are when you focus your mind on a single task
very early in the morning.
Anyway, you can add 5 hours of stock research to your week this way. And that’s just on
weekdays. I think this is something almost anyone could manage to add to their life.
Five hours is enough time for most people to research most stocks. That means you can research
52 stocks a year. We’ll give you a vacation each year and call it 50 stocks a year.
That’s a lot of practice. You build up a big library of examples by analyzing an extra 50 stocks a
year.
I recommend keeping two lists:
1. A list of stocks you find interesting but know almost nothing about – this is your research
list
2. A list of the stocks you researched and now know best – this is your watch list
The great things about knowing a company really well is that the knowledge stays fresh longer
than you’d think. Good businesses change pretty slowly. Much slower than stock prices.
You’ll often find a company you researched – but thought too expensive – has seen its stock
price drop 50% or more since you spent a week analyzing it.
In this way, research you thought was purely for practice suddenly becomes very practical.
Very actionable.
 URL: https://focusedcompounding.com/how-to-become-a-better-analyst-one-hour-at-a-
time/
 Time: 2012
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Why I Concentrate on Clear Favorites and Soggy Cigar Butts
The choice between concentration and diversification is a personal decision. But it is also a
process decision.
There is nothing wrong with having 50 positions – if you can do that well – or 20, or 10.
I think people fool themselves into thinking they need to have 25 or 50 ideas. But there is
nothing wrong with choosing to have that many.
Our Investing Heroes Thought Longer and Traded Slower – Check Their Turnover
Ben Graham and Walter Schloss both owned more than 50 stocks for most of their careers.
However, they turned their portfolios over much less frequently than people do today. So, even
when operating at what was for them a frentic pace, they were still probably only adding one
new position a month. Certainly not much faster than that. And sometimes much, much slower.
I think there is a limit to how many amazing decisions you can make in a month, a year, etc.
Running a portfolio in a way that requires a good idea every couple weeks is far beyond my
abilities.
Limit the Number of Good Ideas Required – Not Necessarily the Number of Stocks Owned
But there are many ways to solve that problem. You can increase concentration. You can
increase how long you hold a stock. Or you can buy entire groups of stocks at once. Buying a
group of stocks sometimes qualifies as a single decision. I bought 5 Japanese net-nets at once,
because I did not know enough about Japanese business to discriminate between Japanese
companies that were both:
1. Profitable
2. Selling for less than their net cash
So I just bought up 5 such stocks at once. That was my way of making really just one big
decision – going more than 40% into Japanese net-nets – without actually having to put 40% or
20% or something into a single Japanese stock.
There was no Japanese stock I felt comfortable putting 20% of my portfolio into. And I did not
know how to get comfortable doing that – having never visited Japan and not being able to speak
Japanese.
Language was actually the least of my problems investing in Japan. The divide in business
culture between Japan and the United States was my biggest problem.
Sometimes, this can be a big issue in Europe as well. Especially when analyzing some
companies in southern European countries.
There are Little Exceptions Hiding Everywhere – Europe, Asia, the Midwest
But it is best not to paint countries with too broad a brush.
I think a foreign investor’s image of American business includes stock analysts, earnings calls,
and press releases. But there are thousands of public American companies – often far from either
New York of Los Angeles – that are as tight lipped as any company you’ll find in less bombastic
parts of the world.
I have found Japanese companies with the kind of business culture an American can understand
and I have found Portuguese companies with the kind of business culture an American can
understand.
It is true, however, that it is easier for an American to understand what management is saying in
the U.K., Switzerland, etc.
For me, portfolio concentration is always tied up with ideas like these. Questions of comfort:
 Which countries do I invest in?

 How many cheap companies can I find in industries I understand?
 How many family controlled companies can I find?
If there were 2,000 public family controlled grocery store chains in the United States, I’m sure I
would own dozen of stocks. Because that is an industry where I know good management from
bad. And where I know what cheap looks like.
Interesting Businesses are Often Unique – And Alleged Comparisons are Often Superficial
But it usually doesn’t work that way. For example, Quan has written about DreamWorks
(DWA) recently. The truth is that there is only one DreamWorks. While some might compare a
company like Disney (DIS) to DreamWorks – there is really no comparison. All of
DreamWorks’s value is in animated movies. Probably two-thirds of Disney’s value is in TV
networks today.
Disney and DreamWorks share a past. But not a present.
There are a lot of companies like that. In most markets, there are probably only about 3
companies I would really be interested in owning. When I say market, I do not mean industry
exactly.
Market Leaders Don’t Have to be Industry Leaders – Some are Actually Pretty Small
For example, Bank of Hawaii (BOH) and Valley National (VLY) are both banks. But they
don’t compete with each other.
Likewise, Village Supermarket (VLGEA) and Arden (ARDNA) are both grocers. But there’s

no overlap in their markets.
Well, in a lot of industries the business is not as local as banks and grocery stores. So if I’m only
interested in the top 3 or so companies in a market, and if that market is national or international
– there’s only a handful of companies per industry I’m really interested in owning.
That is a very different approach from Ben Graham. But experience has taught me that if a
company is not among the top 3 players in its market, that company’s future growth is probably
pretty worthless to investors.
It is a rare company that can grow profits as fast as GDP while comfortably earning more than its
cost of capital. And it’s almost always a company that can break free from the pack and keep
pace with the leaders in its market.
That is one approach. Then there are – often at the back of the pack – the true Ben Graham
bargains. These are companies selling for less than they could be liquidated for.
That is the Ben Graham approach. The approach I took in Japan.
It works too.
Don’t Waste Time on Borderline Calls – Look for Obviously Unusual Stocks
Most investors spend a lot of time analyzing the companies bunched up in the middle – the ones
that are neither definitively cheap nor definitively the pace setters in their markets.
I think that is a mistake.
And it is the main reason I do not diversify.
My ability to tell what the future will hold for the number 4 or number 5 horse is poor. I need an
absurdly good payoff on a mediocre prospect or a clear favorite.
I have not had much success betting on anything else.
 URL: https://focusedcompounding.com/why-i-concentrate-on-clear-favorites-and-soggy-
cigar-butts/
 Time: 2012
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One Good Idea a Year is All You Need to Beat the Market
Someone who reads the blog asked me a question about why I don’t just use Joel Greenblatt’s
Magic Formula to invest instead of picking my own stocks.
This lead to a discussion of what kind of results you can achieve picking your own stocks.
It’s a question closely related to portfolio concentration. I’ve never figured out how to perform
well while holding a lot of stocks. When I’ve outperformed the market, that outperformance has
really boiled down to just a few decisions.
Over the last 3 years, I’ve averaged less than one such performance powering investment.
The Power of One Good Idea a Year
I started managing a new account in January of 2009. That’s close to the perfect timing
imaginable for having good returns. So these numbers are wildly inflated over what anyone can
expect in the future.
Because it’s a single account, I have exact results for each year. Here are my returns:
2009: 41%
2010: 33%
2011: 21%
YTD: 0%
You can see I’m underperforming the S&P 500 this year.
The average number of stocks I’ve held has been about 5. The highest I ever owned at once was
11 – and that included some positions that never reached the size I wanted. My lowest number of
positions at one time was 1, but that was when the majority of the account was in cash.
My outperformance was driven entirely by a few major successes:
1. IMS Health
2. Bancinsurance
3. Sanjo Machine Works (and Japanese net-nets generally)
IMS Health
IMS Health was a fairly large – over $1 billion market cap – stock with a wide moat. It was
selling for less than 10 times free cash flow when I first bought it. Eventually, it was bought out
by a private equity firm.
Bancinsurance
Bancinsurance was a niche property and casualty insurance company. It usually had a combined
ratio under 100. Meaning it made a profit on underwriting. Not just on its investments. It was
selling at about 60% of book value when I first bought it. Eventually, the CEO bought it out.
Sanjo Machine Works
Sanjo Machine Works was a Japanese company. I first bought it around 50% of its cash.
Eventually, the CEO bought it out.
Japanese Net-Nets (Generally)
My Japanese net-net investments were a departure for me in that I diversified across 5 stocks at
once. They did better in Japanese Yen than I ended up doing because the Yen fell against the
dollar. They still did fine. Sanjo was the star performer. The rest had modest positive results in
dollar terms.

3 Years of Outperformance Really Just Due to 3 Decisions
I made other investments over the last 3 and a half years. But very few of them mattered. There
were no big losses. Many of the other investments slightly outperformed or slightly
underperformed the market while I owned them. But, together, they were pretty much a wash
relative to the stock market.
So, my entire outperformance is really due to 3 decisions made over 3 and a half years.
This is why I talk about concentration rather than diversification. I haven’t figure out how to earn
market beating returns while diversifying. I’ve done it while concentrating.
That doesn’t mean it’s the right approach for everyone.
But it’s worked for me.
 URL: https://focusedcompounding.com/one-good-idea-a-year-is-all-you-need-to-beat-
the-market/
 Time: 2012
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Some Links You’ll Like
I started this blog on Christmas Eve 2005. Back then, I used to link to things. I’d tell readers
what interesting blogs were out there, etc.
I haven’t done that much lately. Mostly because of Twitter. If you aren’t following me
on Twitter – you aren’t seeing links to the stuff I’m reading.
But sometimes a few interesting links pile up at once and I decide it’s worth mentioning them on
the blog – not just on Twitter.
Today is one of those times.
Practice Truth, Fear Nothing – A Wall of Great Value Investing Posters
The creator of this site – Practice Truth, Fear Nothing – sent me a link to his “wall” of value
investing and creative thinking/advertising. He’s in the advertising business. You may or may
not like the stuff that applies to advertising. You’ll love that stuff that applies to value
investing. Check it out.
Market Folly: Top Finance People to Follow on Twitter
Market Folly is a blog I always read. And I don’t talk about it enough on this site. If you follow
me on Twitter, you know I read it. But if you just read this blog – you’d probably never know I
read Market Folly.
Hopefully, this will change that. Twitter is a great resource for seeing what other value investors,
bloggers, etc. are reading. Whenever I Tweet, there’s a link. I use it mostly to share reading
material.
You can get a lot out of using Twitter for your investing. And you can start by following the
folks on Market Folly’s list.
Interactive Investor Blog: A Must Read Blog Getting Even Better
I read Market Folly all the time. But I rarely talk about it on this blog. No idea why. I
read Richard Beddard’s blog all the time. And I do talk about it on this blog. Again, no idea why
one gets mentioned here all the time and the other doesn’t.
I hadn’t given it much thought until writing this post – when I thought about all the people who
read this blog but don’t follow me on Twitter.
Anyway, Richard’s blog has been great for years. And I’ve been reading it for years. So I feel
kind of silly recommending it over and over again.
That’s changed in the last year or so. Richard’s blog has been getting even better. One of my
favorite features is Richard’s two minute drills. These are based on advice Peter Lynch gave.
Peter Lynch is underappreciated by value investors. Maybe his name is too well known or
something. Maybe his advice is too simple. I don’t know. The guy always made sense to me.
Like Warren Buffett, Peter Lynch was especially good at thinking about how to think about
stocks. He was good at knowing that it wasn’t enough to have the most info – you had to act
right on the info you had.
Lynch was always really quick to admit when he did something dumb. There are plenty of
confessions in his books. Especially about errors of omission. Stocks that were right under his
nose that he never bought – or sold too soon.
Well, Richard’s been using one of Peter Lynch’s best techniques – the two minute drill. And it
works wonderfully in blog form. Maybe I should try it.
I’d definitely like to see some other bloggers give it a whirl.
Even more recently, Richard has announced The Human Screen. He’s abandoning mechanical
screening altogether for his Thrifty 30 portfolio.
This makes a lot of sense to me. Screens have their limits. And I love reading what Richard has
to say about any stock. Casting a wider net is definitely something that will lead to some
interesting posts.
Oddball Stocks: Some Wonderful Non Stock Specific Posts
Oddball Stocks is one of my favorite blogs. Nate excels in the analysis of specific stocks. He
focuses on net-nets. But I don’t think that’s the limit of his analytical abilities at all.
I don’t usually think of Oddball Stocks as being a place where you get more…philosophical
posts.
But Nate’s done a couple great ones lately:
Is it Worth Investing in Net-Nets?
The Investor as a Merchant or a Collector
European Stock Blog: Value and Opportunity
I mention U.K. blogs more than European blogs focused on countries on the continent. That’s
not a good habit. Because I do read some European stock blogs.
This is a really good one. You’ll enjoy it.
And now’s a good time for Americans – and other non-Europeans – to catch up on their
knowledge of companies on the continent producing most of today’s scariest finance headlines.
One of the best European stock blogs is called Value and Opportunity. Check it out.
Distressed Debt Investing: A Bond Blog Every Stock Investor Should Read
I love this blog. It really is about distressed debt investing. If that sounds outside your circle of
competence, nobody said you have to buy anything you read about here. But there’s a lot to learn
from.
If you aren’t reading this blog, give it a try.
You’ll learn a lot. About distressed debt. And about investing.
Check out Distressed Debt Investing.
 URL: https://focusedcompounding.com/some-links-youll-like/
 Time: 2012
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Best Place to Run Screens: StockScreen123 – Bloomberg.com Underrated
Geoff –
Nice article on EV/EBITDA – no qualms here. I’m curious, however, where you run your
screens? Being the cheap bastard that I am, I don’t subscribe to any specific data sites, so I’ve
typically begun with google finance, which isn’t very helpful when it comes to non-GAAP
criteria.
Thanks,
Jay
StockScreen123 is the Best Place to Run Screens – But It Takes Time to Learn
The best place to run screens – for the price – is StockScreen123. It is not user friendly. You
need to read about how the functions work, etc. and experiment a bit. But it’s the best site by far.
I highly recommend it.
For U.K. stocks I use Sharelockholmes.
For worldwide, I don’t have a good (cheap) solution. A lot of people use the FT screener.

Bloomberg.com is Actually a Super Handy Site – If You Know What It’s Best At
Blommberg’s (free) website has great coverage of just about every stock on planet Earth. They
don’t have much data. But if you type in a public company name – that trades anywhere in the
world – you’ll get basic info like EV/EBITDA.
Here are some obscure examples to prove my point:
 Precia (PREC:FP)
 Otec (1736)
 Paradise (PARF)
 Watlington Waterworks (WWW:BH)
If they’ve got those companies – they’ve got everything.
So Bloomberg is a great resource when you know a company’s name but you aren’t sure whether
it’s public or private, where it trades, etc.
I often start my stock research at Bloomberg.
 URL: https://focusedcompounding.com/best-place-to-run-screens-stockscreen123-
bloomberg-com-underrated/
 Time: 2012
-----------------------------------------------------
How My Investing Philosophy Has Changed Over Time
Someone over at GuruFocus asked me about my background:
Hey Geoff, I recently started listening to some of the audio recordings you posted. You are
really knowledgeable, what is your background?
My educational background is that I am a high school dropout. My investing background is that I

got interested investing when I bought my first stock at 14. That’s when I read Ben
Graham’s Security Analysis and The Intelligent Investor.
My Investing Approach Has Drifted From Graham Toward Buffett
Over time, based on my own investing results, I probably became less of a Graham type investor
and more of a Buffett type investor.
I made the most money by far buying and holding companies with strong competitive positions
when they were temporarily priced at 6 or 10 or 12 times earnings. I also buy net-nets, net cash
bargains, etc. But generally I like a reliable business with almost no history of losses and a
market leading position in its niche. That’s probably more Buffett than Graham.
Hidden Champions of the 21st Century is My Favorite Book
My favorite book is: “Hidden Champions of the 21st Century.”
Technically, it’s a business book – not an investing book. But business books are almost always
more informative for investors than finance type books.
If I had to hand 3 books to someone who didn’t know anything about what it takes to be an
investor – I’d hand him:
1. You Can Be a Stock Market Genius

2. The Intelligent Investor (1949)
3. Hidden Champions of the 21st Century
If you aren’t in love with the idea of the treasure hunt after reading those 3 books – I don’t think
you’ll ever become a value investor.
All I Really Know – Compounding, Mr. Market, Margin of Safety, Moats
If you know:
 The Berkshire/Teledyne stories

 Ben Graham’s Mr. Market Metaphor
 His margin of safety principle
 And you’ve read “Hidden Champions of the 21st Century”
You have everything you need to make money snowball in the stock market.
All It Really Takes – Patience, Common Sense, and a Few Sound Principles
My feeling is – and it’s controversial, but it’s right – that if you’ve got those 4 ideas in your head
and once a year you buy the very best stock you can and then you forget you own it for at least
the next 3 years, you’re gonna do okay in the stock market.
You don’t need to know if you should be 100% in stocks or 100% in bonds – I was 100% in
stocks when the dot-com bubble burst – and I’ve made more than 15% a year returns since then.
Most of the Advanced Concepts Are a Distraction – Forget Them
Now, true, I didn’t own any tech in 2000. I owned companies in groceries, snack foods, and
video games. But that’s not because I was clairvoyant. It’s because I was a kid. I didn’t know
any better. Over time, you learn all these ideas about diversification, and macroeconomics, and
market timing – and those tend to make you more likely to be able to justify owning Cisco or
something in 2000.
If all you know is that a stock is a piece of a business – which is all a kid knows – there’s no way
to justify that level of stupidity. You can’t participate in bubbles like that. Because bubble
thinking requires higher math, or emotional intelligence or something – not just doing arithmetic
alone with the annual report.
I Know Less About the Euro Than You – But I Won’t Be Paralyzed By It
People make excuses for why you need to know if the market is overvalued, if the Euro is going
to disintegrate, etc.
Of course I think the Euro is going to break up. But that’s not going to stop me from buying
good European companies.
I can’t outguess people on something like the Euro. It would be a waste of time. There are so
many things everybody is trying to figure out. And there are so few things that matter to any one
specific stock.
Graham and Buffett Both Work – But Buffett Requires Fewer Decisions
So, over time, I’ve tended to think the Graham approach is less practical. And it’s not something
a human should carry out. It’d be easier carried out by a computer.
The Buffett approach is also hard to carry out. Most humans can’t carry it out. But a few can. I
feel like I can. So I’ve tended more in that direction over time.
It’s not that those kinds of stocks do better in back tests or anything – they don’t. It’s just that the
Buffett approach is a very reliable way of repeatedly making money in stocks. You don’t get a
lot of opportunities to screw it up. You don’t have that many points where you have to make new
buy and sell decisions – which is what derails everyone who tries the Graham approach. Of
course, they all trade faster than Graham ever did.
I’ve Yet to Meet Someone Who Screwed Up By Holding Stocks Too Long
We could all benefit from tripling how long we hold our average stock. This is not something I
would’ve believed when I first read Graham. It took a lot of direct experience and hearing from
other folks about their actual investment decisions to teach me just how nutty investors really
are. How easy it is to screw up a good thing purely through unneeded and emotionally charged
activity.
Buffett Stocks Don’t Have to Be Blue Chips – Look For Oddball Stocks
Start with the appropriately named blog: “Oddball Stocks“.
Generally, people think I’m more of a Graham investor because I buy smaller stocks. The big
cap/small cap distinction is something a lot of people pay attention to. I blame mutual funds. It
makes no difference. I’ve seen tiny companies with dominant market positions – like sub $30
million stocks. And I’ve seen $30 billion stocks with dominant positions. I’ve also seen
companies of both sizes at real risk of being bankrupt in the next couple years. It’s so silly to
define an investor by the size of the companies they invest it.
There’s a tiny Nebraska company called George Risk (RSKIA). I own shares in the company.
And its returns on capital over the last 10-15 years have been right in line with what a Warren
Buffett type business achieves. It has a $30 million market cap.
The market leader in candied fruits is Paradise (PARF). It’s an awful industry. And Paradise
dominates that awful industry with an 80% market share. Paradise has a $9 million market cap.
Now that’s a Hidden Champion.
I’m Not Above Buying Something Selling for Less Than Liquidation Value
Now, it’s true that I sometimes buy stocks selling for less than net cash. And that they are almost
always illiquid.
It’s hard to pass on a profitable business selling for less than its cash. If you have the Mr. Market
metaphor in your head – it’s hard to convince yourself that paying for a cash pile and getting a
historically profitable business for free is something you should walk away from.

Buffett Has Always Said There’s More Than One Way to Get to Heaven
Maybe that’s more Graham than Buffett. I don’t know. I think Buffett might still buy net cash
stocks if he had millions rather than billions to invest.
I’m not really sure there was ever a difference in those respects between Graham and Buffett –
it’s just that Buffett grew very big at some point while Graham kept his fund very small.
So, I tend to buy tiny stocks. Because I can. And because those are almost always where the best
bargains are.
My Most Controversial Investing Belief: Extreme Concentration Works
I buy very few stocks. Again, this comes from personal experience. By far, the worst losses to
my portfolio came in years where I held the most stocks. The best performance came from 25%
or bigger positions in my portfolio that I chose to hold longer term.
I’ve made a lot of money by:
 Sticking around for the buyout

 And having more than 25% of my portfolio in the stock when that buyout came
Today, I would never buy a stock that makes up less than 10% of my portfolio. I prefer not to
start a new position unless it is expected to eventually be 25% of my portfolio. I am not
interested in owning more than 5 stocks at a time. I’ve done it – like with Japanese net-nets. I
may do it again in similar basket type situations. But I’m a lot less likely to. So, basically I own
4-5 Warren Buffett type stocks (in terms of competitive position) bought at Ben Graham type
P/E ratios.
Right now, I’m looking for a European stock to put 25% of my portfolio into. It won’t be 5
European stocks at 5% each. It’ll be one at 25%.
Competition Kills – The Greatest Speculation is Always on the Business
The longer I’ve been an investor the greater my fear of competition has become. I’m not afraid
of investing in a frothy market. I’m not afraid of investing in a depressed economy.
I’m afraid of capitalism.

I am afraid of competition. I think at 9 out of 10 companies investors are fooling themselves
about just how great a risk they are taking in the business itself.
There is a higher extinction rate in public companies than we are willing to admit.
Investment Grade Isn’t About Market Cap – It’s About Competitive Position
Today, something like Dun & Bradstreet (DNB) or Corticeira Amorim (in Portugal) would be
good examples of the kind of things I own. Right now, I own some DNB. No Amorim. But I’d
consider buying both at today’s prices. And they are very good examples of the kind of stocks I
like.
I own a bunch of George Risk. Have for like two years now. It’s typical of the kind of thing I
like.
No Teacher is as Effective as Direct Experience
So, that’s how I invest today. And that experience mostly came from learning through actual
investing.
It also came a little bit from doing the blogs, podcasts, etc. starting in 2005 and going through
today. So, for the last 6 or 7 years, everything about me in terms of investing is stuff you can see
online. It’s the articles at GuruFocus, the podcast, and the blog.
But mostly it came through direct experience. I wish I had been a little better at learning from
other people’s mistakes. It’s been an expensive education.
 URL: https://focusedcompounding.com/how-my-investing-philosophy-has-changed-over-
time/
 Time: 2012
-----------------------------------------------------
Can You Screen For Shareholder Composition? – 30 Strange Stocks
Nate Tobik has a terrific blog post about shareholder composition over at Oddball Stocks called
“Could Value Investors Be the Reason a Stock’s Cheap?”
I’ve often found companies with unusual shareholder composition to be interesting opportunities.
That’s not exactly the point of Nate’s post. He wonders – correctly, I think – whether the sort of
catalyst a value stock like George Risk (RSKIA) requires is something that gets folks other than
value investors interested in the stock.
A change in the perception of what kind of stock a company is can have a huge influence on
where it trades. If you look at Village Supermarket (VLGEA), it went from being a regional
grocer valued at a discount to the big guys to being seen as a predictable stalwart of sorts. The
increase in the ratio of price-to-earnings, price-to-book, and price-to-sales has been magical. The
business has improved. But then Mr. Market has also valued improvement in the business at
about 3 times more than he did just 10 to 15 years ago.
Who Owns a Stock Matters
I think shareholder composition often helps explain why a stock is cheap. However, it’s not
always just a matter of whether the folks who own the stock are value investors, growth
investors, etc.
Shares Are Sometimes Spread Around in Weird Ways
Sometimes – like at Solitron Devices (SODI) – shareholders are former creditors.
I read a recent blog post where someone had commented wondering why Solitron is a public
company. That’s easy. Solitron was once a big public company. It went bankrupt. It just never
went private.
The company you see today bears little resemblance to the company that went public. Instead,
it’s the company that emerged from bankruptcy in the 1990s.
Other times, shareholders have become “lost” over the years. They’ve forgotten they own the
stock. And they don’t trade it. This was the situation at George Risk.
And George Risk has made a point in its SEC filings of saying that paying a dividend on the
stock helped remind “lost” shareholders about the stock – and helped them get these shareholders
to offer shares on the open market. Where the company is a buyer of its own shares.
I once read an interview with the CEO of a family controlled, thinly traded bank. When asked
why the company went public he said they wanted local businessmen to have a stake in the bank.
They went public as something of a local PR ploy.
Warren Buffett Made Money on Stocks With Oddly Distributed Shares
Two of Warren Buffett’s big successes – National American Fire Insurance and Blue Chip
Stamps – were stocks with very oddly distributed shares.

Warren Buffett and National American Fire Insurance
I told the story of National American Fire Insurance in “How Warren Buffett Made His First
$100,000”:
This company was controlled by Howard Ahmanson. It’s a strange story. The original stock was
pretty much worthless. It ended up being taken over as part of Ahmanson’s empire. Ahmanson
was from Omaha. Although he’s most associated with California.
Basically, Ahmanson’s father had owned an insurer in Omaha. Ahmanson got

started very young (he was a financial services prodigy) and got extremely rich underwriting
insurance in California during the Great Depression. He then bought National American
Insurance Company (in Omaha) because it was his Dad’s old company. He was retaking control
of the family company.
Through this weird coincidence, National American Fire Insurance ended up with some terrific
assets. The Ahmansons were very private. And these assets were controlled through different
holding companies, trusts, etc.
Anyway, here’s Warren Buffett explaining what he found when he looked into what NAFI really
was:
“I found National American Fire Insurance…NAFI was controlled by an Omaha guy, one of the
richest men in the country, who owned many of the best run insurance companies in the country.
He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The
share price was $27. Book value was $135. This company was located right here in Omaha,
right around the corner from (where) I was working as a broker. None of the brokers knew
about it.”
What’s weird about this story is that on the surface the stock looked insanely cheap. It was
selling for less than 1 times earnings. And about 20% of book value. But that really understates
how cheap the company was. The deeper you delved into the story, the cheaper the stock looked.
This was a personal holding company for one of the smartest investors in the insurance business.
If you look at the book value and the earnings per share in 1950, you can see the company must
have had something like a 20%+ ROE. Why would a company with a 20% return on equity ever
trade for one-fifth of book value?
Read The Snowball to find out. Basically, it was a super illiquid stock that had once been worth
a lot more. The shares ended up spread thinly across a lot of different individual investors. They
remembered when the stock was worth $100 a share. That’s where a lot of them bought. And
many of them didn’t want to sell until the stock got back to $100 and made them whole. But,
because the stock had burned them so bad, they also had no interest in buying more shares. They
just clung to what they had.
What’s really neat about this story is that Buffett kept buying the stock – going door to door
when he had to – even when he was paying 3 to 4 times more than what the stock had originally
traded at. It’s a great illustration of Ben Graham’s Mr. Market Metaphor. It was a bargain even at
300% of the last trade price. And Buffett knew it.
What about Blue Chip Stamps?
Warren Buffett and Blue Chip Stamps
Blue Chip Stamps was a monopoly in California. It faced antitrust action. And agreed to a
consent decree. Blue Chip had to sell 45% of the company to the retailers who gave away the
stamps.
This is where Buffett got a lot of his shares from. He bought shares “from Lucky Stores, Market
Basket, and Alexander’s Markets…he also bought five percent of the stock of Thriftimart Stores,
one of Blue Chip’s largest shareholders. Buffett figured he could eventually get Thriftimart to
swap the Blue Chip it owned for its stock.”
This all reminds me of Joel Greenblatt’s advice that buying a spin-off makes sense because some
of the sellers are folks who got a stock they never wanted. That was literally true at Blue Chip
Stamps. And Buffett knew it.
Can You Screen For Stocks With Strange Shareholder Composition?
That’s what I tried to do. It’s far from a perfect screen. But I think it’ll turn up some names you
might not know. And I know some of them do have strange shareholder composition.
I used StockScreen123 for this screen.
I just searched for the combination of oldest public companies with the lowest floats – in terms
of shares outstanding rather than market cap. This is critical. I’ve found a lack of stock splits
combined with high insider ownership to be a good gauge of how uninterested a company is in
pleasing Wall Street.
Here are the top 30 stocks in terms of the likelihood of their shares being strangely distributed:
1. H&E Equipment (HEES)

2. DVL (DVLN)
3. American Biltrite (ABLTD)
4. LICT (LICT)
5. J.W. Mays (MAYS)
6. Helios & Matheson (HMNY)
7. Seaboard (SEB)
8. Scope Industries (SCPJ)
9. TNR Technical (TNRK)
10. The Hallwood Group (HWG)
11. AMCON Distributing (DIT)
12. The Flamemaster Corporation (FAME)
13. LiveDeal (LIVE)
14. The InterGroup Corporation (INTG)
15. Chicago Rivet & Machine (CVR)
16. PrimeEnergy (PNRG)
18. Income Opportunity Realty Investors (IOT)
19. Daxor (DXR)
20. Good Times Restaurants (GTIM)
21. Micropac Industries (MPAD)
22. Isramco (ISRL)
23. Birner Dental Management Services (BDMS)
24. Paragon Technologies (PGNT)
25. Arden Group (ARDNA)
26. New Concept Energy (GBR)
27. Jewett-Cameron Trading (JCTCF)
28. Gyrodyne (GYRO)
29. Solitron Devices (SODI)
30. Value Line (VALU)
Some of those companies are going through stuff right now. So watch out. There are some messy
situations in there.
That’s kind of the point.
Weird Stocks Like These are More Likely to Be Misunderstood
Some of those 30 stocks are probably misunderstood.
Of course, there’s probably no catalyst. And you’ll probably just be joining a bunch of other
value investors in the stock.
There are worse fates.
 URL: https://focusedcompounding.com/can-you-screen-for-shareholder-composition-30-
strange-stocks/
 Time: 2012
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Notes On Warren Buffett’s 2011 Letter To Shareholders
Berkshire Hathaway (BRK.B) is out with Warren Buffett’s latest letter to shareholders. It’s
only been a couple hours since I read it. So I haven’t had much time to digest the contents – a
full article on Berkshire’s intrinsic value will follow – but I did manage to write down some
notes.
Here they are:
· From 1965 through 2011: Berkshire Hathaway’s book value per share grew 19.8% a
year. This is basically Warren Buffett’s long-term record. Of course, he ran an investment
partnership before this where he averaged 30% a year over about 10 years. If you factor this part
of Warren Buffett’s career in, his returns are about 22% a year. Regardless, we are talking 20%
to 22% a year compounded over a 56-year investment career. It is the length of the career that
makes this so impressive. See my article on Walter Schloss’s 47-year investment career for a
comparison. Between Warren Buffett, Walter Schloss, and Ben Graham you have something like
130 years of investing in common stocks – and yet you have very little overlap between them
owning the same stocks at the same times. The careers of these 3 men are a treasure trove of
truly long-term investing results. The concept of luck is pretty unimportant when we’re talking
about 3 obviously intellectually connected men each picking hundreds of stocks over 3 to 5
decades. Learn everything you can about these men. What they really owned. And when they
owned it. Their system works.
· Todd Combs and Ted Weschler “have the brains, judgment, and character to manage our
whole portfolio when Charlie and I are no longer running Berkshire.” We’ll see more talk
from Warren Buffett about Berkshire’s future portfolio managers. For now, they are each going
to be running a smidge under $2 billion. It will be interesting to follow their picks. You’ll notice
that most of the smaller positions GuruFocus tracks for Warren Buffett are actually positions
bought for Berkshire Hathaway by Todd Combs or Ted Weschler. Buffett also mentions that
both men will help in finding acquisitions. And that they are each getting 20% of their
compensation based on the other guy’s performances – to increase idea sharing. Not a bad
system.
· Lubrizol has grown pre-tax profits under James Hambrick from $147 million in 2004 to
$1,085 million in 2011. That’s a 28% earnings growth rate over 8 years. Which is very
impressive growth. I know a lot of that came from margin expansion. Margins were the key
concern that Buffett discussed with Sokol about Lubrizol.
· Berkshire has already spent $493 million on 3 “bolt on” acquisitions of specialty chemical
companies. That’s a lot to spend in a short time. Berkshire has made a lot of bolt on acquisitions
that go under reported in the media. This may be part of the attraction of some very big
companies in industries with favorable long-term prospects. With companies like Marmon, Iscar,
Burlington Northern, MidAmerican, and Lubrizol – Buffett can probably buy a lot of smaller
companies to add to what he already owns. It’s a good way to invest even more money into
industries he believes in. MidAmerican can also invest in lots and lots of power projects as well.
Buffett mentions investments in wind and solar – and the fact that MidAmerican retains all its
earnings – later in his letter.
· Burlington Northern, Iscar, Lubrizol, Marmon, and MidAmerican all had record
earnings in 2011. This reinforces for me how much of a growth at a reasonable price
investor Warren Buffett is. He doesn’t buy companies that need to be turned around. Sure, these
are recent acquisitions. But it’s not like every company in the world is reporting record earnings
in 2011. Most of Buffett’s big recent acquisitions are. As an investor, I think Buffett’s 4 key
criteria are: return on equity, growth, price, and staying power. Warren Buffett’s approach isn’t
identical to any other great investors I can think of. He’s not quite like Ben Graham anymore.
But he’s definitely not like Phil Fisher – who wasn’t concerned with price. And he’s not like
Peter Lynch – who was eager to have growth even if it wasn’t at the absolute highest returns on
equity. And Lynch was a lot less concerned with staying power. Some of Lynch’s consumer
picks look kind of faddish compared to Buffett’s. Buffett does have some similarities with Phil
Fisher though. Both men were always looking for a company that could be a perpetual growth
machine. Warren Buffett isn’t looking for something that will grow at 20% for the next 5 years
or 10 years and then never again after that. I think Wells Fargo (WFC) is probably the Warren
Buffett investment archetype at this point. Although Berkshire hasn’t yet seen phenomenal
returns in Wells Fargo stock – the cost and market value comparison is pretty tepid at this point –
it’s clearly a company Buffett loves and a stock he believes is cheap right now. He even points
out that Berkshire added another $1 billion to its Wells Fargo stake this year – something that
has been under reported because Wells Fargo is a very old position for Buffett.
· Buffett expects these “fabulous five” will deliver aggregate earnings comfortably topping

$10 billion in 2012. The “fabulous five” are: Burlington Northern, Iscar, Lubrizol, Marmon, and
MidAmerican. He expects them to grow. And he’s obviously focused on Berkshire’s earnings
per share growth rather than its investments per share growth at this point. Buffett makes this
point in the annual report – page 99 – where he discusses intrinsic value. He says that for the first
25 years after he took over Berkshire Hathaway it focused on growing investment per share.
Over the last 20 years, it has focused more on growing earnings per share. This is probably a
result of: a) Berkshire’s size and b) Stock prices. Stock prices were a lot higher in the 1990s and
2000s than they were in the 1970s and 1980s. The combined influence of a bigger Berkshire and
higher stock prices has made Warren Buffett’s job of growing Berkshire Hathaway’s intrinsic
value per share much harder over the last 20 years.
· Berkshire Hathaway’s capital spending was $8.2 billion in 2011. 95% of the spending was
done in the U.S. Capital spending in 2012 will be even higher. This just reinforces for me how
much Berkshire has changed since the 1970s and 1980s. If you look at the companies Berkshire
owned they were either insurance or asset light businesses with terrific – but small – niches. And
his stock investments were in: insurance, media, advertising, and brands. Today – it’s totally
different. Berkshire owns a lot of very tangible businesses. The idea that Warren Buffett would
own a power company and a railroad – that would’ve seemed really odd in the 1970s and 1980s.
Today, they are a huge part of Berkshire. This transformation seems to be a result of Berkshire’s
size rather than any change in Buffett’s philosophy. I still think he like companies with valuable
intangibles and little need for capital spending. He just has a hard time finding the right
companies at the right price at the right scale for Berkshire. Maybe this is part of the modern
day Berkshire that individual investors shouldn’t emulate. I don’t think Buffett is saying little
investors should own railroads and utilities. But that’s the best path for soaking up Berkshire’s
immense mounds of cash. The cash keeps coming into Omaha month after month. Buffett has to
find a place to deploy billions of dollars at decent returns on capital. Regulated, capital-intensive
businesses at least are predictable and protected from competition. The downside is their lack of
tremendous upside potential.
· Berkshire had 9 straight years of underwriting profits. Underwriting profits have added
almost $2 billion a year to Berkshire’s pre-tax profits ($17 billion over 9 years). Berkshire’s
insurance operations have gotten much, much better over the years. One thing that the Berkshire
Hathaway of 2012 has on the Berkshire Hathaway of the 1970s and 1980s is a much better
insurance business. This has helped to offset some lower returns on equity at the owned
businesses and some vastly inferior stock holdings. By vastly inferior – I mean Berkshire had to
spend way more money to buy equal amounts of earning power in the stock market during the
1990s and 2000s than it did in the 1970s and 1980s. But back then, Berkshire’s insurance
operations were much worse. Today, Buffett thinks Berkshire has the best large insurance
business in the world. He never would’ve said that in the 1970s and 1980s. In fact, I remember
him plainly saying that SAFECO was a better insurance business than anything Berkshire
owned. That’s why he bought the stock. See Warren Buffett’s 1978 letter to shareholders for
details.
· Buffett “expects the combined earnings of...(American Express, Coca-Cola, IBM, and Wells
Fargo) – and their dividends as well – to increase in 2012 and, for that matter, almost every
year for a long time to come. A decade from now, our current holdings of the four companies
might well account for earnings of $7 billion, of which $2 billion in dividends would come to
us.” Buffett thinks these companies can grow their earnings per share at 8% a year over the next
10 years. That sounds about right. Especially if they are buying back shares the way IBM is. As
far as dividends, Buffett probably thinks Wells Fargo can increase its dividend faster than it
increases earnings over the next 10 years. That’ll make it easy for the four stocks to provide $2
billion a year in dividends to Berkshire by 2022.
· Berkshire wrote down $1.4 billion of its investment in the bonds of a Texas electric utility
that is dependent on natural gas prices. Warren Buffett is a terrible investor when it comes to
commodities. I’ve had a hard time finding any situation where his investment in a commodity
company worked out better than similar investments he was making – and could’ve presumably
added more to – at the same time. At best, Berkshire’s commodity related investments have done
about as well as its non-commodity related investments made at the same time. At worse,
they’ve failed miserably. This one looks like it falls into the latter category. Of course, there was
one very big exception to Berkshire’s sorry history of investing in commodity stocks –
PetroChina. That was a smashing success. Buffett’s other oil investments – like ConocoPhillips
(COP) – not so much. Even if you go back to the 1970s and 1980s when Buffett was probably
looking at commodity companies as helpful in his fight against inflation – he still wasn’t getting
more for his commodity company investments than from his media company investments. It just
seems like this is an area Warren Buffett should stay away from. If the thesis depends on the
price of oil, coal, silver, aluminum, etc. – it isn’t a Warren Buffett investment. At least it’s not
a Warren Buffett investment that’ll live up to the name. But he keeps making these mistakes. It’s
something to think about. If your record is pretty spotty in one sector – maybe that’s a sector you
should stay away from. There’s a reason I’m very reluctant to buy retail stocks – I tend to lose
money on them. It wouldn’t be a bad idea for Buffett to apply the same logic to his commodity
related investments.
· Berkshire’s housing related companies earned $1.8 billion in 2006 and only $513 million
in 2011. Warren Buffett is not an economist. And economists are not investors. Just as he should
stay away from commodity investments – he should stay away from investments that depend on
his knowledge of some economically sensitive sector. If he can’t predict oil prices – why does he
think he can predict house prices? This is one Buffett got very, very wrong. A value investor like
Buffett – and someone who is so attuned to the public’s waves of fear and greed – should’ve
been better aware of the housing bubble. He seemed to subscribe to the ridiculous notion that
house prices – nationally – could never decline a whole heck of a lot at once. They did. Buffett
got this one wrong. And it cost Berkshire a lot of money. Some of Berkshire’s biggest losses –
like its investment in two Irish banks – were directly tied to Buffett’s not realizing there was a
huge housing bubble. Buffett’s housing related mistakes and commodity related mistakes
reinforce the idea that predictability is key. You need to understand where a company gets its
money from. Buffett understands Coca-Cola. He never understood Bank of Ireland or Energy
Future Holdings. The dumbest mistakes Buffett has made have been mistakes that looked good
by the numbers. Should Buffett have seen the housing bubble? Actually, I think he did see the
bubble. He knew it was a bubble. He just didn’t think hard enough – and internalize – the need to
distrust the kinds of number (like earnings) he was used to trusting for any company tied to
housing. The same is true for commodities. These are places Warren Buffett is better off not
investing. They are simply outside of his circle of competence. They need to go into the “too
hard” pile. This is a good lesson for all of us. We all think we know more about more industries
than we really do. Of course, when we commit the sin of investing in something we know
nothing about – it’s a much greater crime. Buffett at least has the excuse of having to act on an
immense scale. He needs to buy billions of dollars of stocks or bonds in some company. We
don’t. We can certainly afford to ignore housing or energy or retailers or airlines or whatever we
know nothing about. There are thousands of stocks for us to choose from. For Buffet there’s – at
best – a couple hundred.
· “Housing remains in a depression of its own”. Here, Warren Buffett is just reminding us how

wrong he was on housing. He was wrong when he bought housing related companies. He was
wrong when he bought insolvent Irish banks. And he was wrong when he predicted the economy
would bounce back – and unemployment plummet – faster than the pundits thought. Why?
Because he thought housing would bounce back. Because he thought we couldn’t go on growing
our population so much faster than our housing stock. That was a failure of imagination – on the
upside and the downside. Families got really small in the boom and they’ll grow really big in the
bust. Of course, Buffett is right. Eventually, housing will return. New construction will return.
But this is a good reminder of how successful Warren Buffett has been as an investor while
simultaneously being totally unsuccessful in predicting anything about houses, commodities, etc.
It’s a message of hope. You too can be incredibly dumb about a lot of things. As long as you are
smart about a few things. And you bet on those things.
In this year’s letter – Warren Buffett also talked about Berkshire’s intrinsic value more than he
normally does. It’s clear he thinks the stock is undervalued. I’ll talk more about this in an article
laying out my thoughts on Berkshire Hathaway’s intrinsic value.
164027/notes-on-warren-buffetts-2011-letter-to-shareholders
 Time: 2012
-----------------------------------------------------
What to Look for in Japanese Net-Nets
Someone who reads the blog sent me an email asking about a specific Japanese net-net. Rather
than trying to choose the best net-nets from among the entire hoard in Japan, I would suggest
doing one of two things:
1. Bigger investors can simply collect all the Japanese net-nets they find.
2. Smaller investors can simply apply a tougher standard than mere net-netness.
In my own portfolio, I went with option #2. I bought 5 Japanese net cash stocks last year. I’ve
since sold one of them. I have some cash. And am looking to add a couple more Japanese net
cash stocks. Right now, they make up 30% of my portfolio. Again, I’m willing to go as high as
50% in Japan. We’ll see what happens.
But that’s me.
What would I suggest for others interested in Japanese stocks?
Here’s how I would look at Japan. If you can find stocks selling for less than net cash with
few/no operating losses in their long-term history, buy them. Don’t so much look for net-nets in
general. Start with an even higher standard. Start with profitable, net cash companies. They are
close to non-existent in the U.S. But not Japan. After that, I’m not sure I would necessarily just
look at net-nets. For example, there are some cheap Japanese gas companies that are not net-nets
(most of their assets are PP&E) but are super reasonably priced on an EV/EBIT basis. To me, it
is more important to find totally obvious bargains than to get caught up in the definition of what
a net-net is or isn’t.
Totally obvious bargains fall into a few categories. Here are 2:
1. Stock market says the business is worth more dead than alive (profitable net cash
stocks)
2. Stock is much cheaper than its peers around the world (gas companies)
In fact, if you really look, you may find some gas companies, grocery stores, etc. that are very
cheap on an EV/EBIT or EV/EBITDA basis that you like better than some of the net-nets. That’s
fine. Buy the most obvious bargains. The things that are clearly selling for less than they are
worth.
If you’re only going to buy half a dozen Japanese net-nets, you should look for net cash
bargains. Once we are talking about receivables, inventory, etc. you need to know more about
the business. So it needs to be a simple business or a business you can learn about. That’s harder.
For me personally that means it makes sense to buy net cash bargains in Japan and look for net-
nets on the basis of receivables, inventory, etc. in the U.S. Because in the U.S., I have a better
chance of knowing the difference between a predictable business and an unpredictable business.
If I could find 10 consistently profitable companies selling below net cash in the U.S., I wouldn’t
buy any Japanese stock. Because I understand American businesses better. But I also understand
that a consistently profitable company selling for less than net cash will work out as an
investment regardless of how well I understand the business. And, of course, the idea is to buy a
handful of these companies.
Not just one.
 URL: https://focusedcompounding.com/what-to-look-for-in-japanese-net-nets/
 Time: 2012
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What Are The Minimum Requirements For A Good Net-Net?
Geoff,
What are your minimum mechanical checks to invest in a net-net? For example a certain F-
Score, percent of shares held by management, particular industry, etc.
Are there criteria that cause an immediate pass when looking at a net-net?
Regards,
Steve
Great question. Technically, there is nothing that would eliminate a stock automatically. What I
mean by that is that the Ben Graham Net-Net Newsletter has bought:
 A net-net with a bad business but an investment portfolio worth more than its stock
price
 A net-net with no business but cash worth more than its stock price and the intent to
merge, liquidate, etc. at some point
 And net-nets with good businesses but little or no excess cash
Really, it depends on the cash situation. If a stock is a net cash bargain (cash minus total
liabilities is greater than its stock price) than it could be picked even if it would fail other tests.
Also, about 90% of the stocks we've picked have been what I'd call actual operating businesses.
One wasn't. And another one was – but we weren’t buying the for its business – just the cash. So
those are special cases.
Technically, those stocks could have really bad F-Scores, past losses, etc. because they really
aren't ongoing businesses as much as cash piles. But these are the exceptions. And I'd always
rather pick an operating business with a cash pile over just a cash pile anyway. A profitable,
operating business is always best. Warren Buffett's recent article in Fortune reinforces this idea.
A decent, productive business – yes, even if it is a net-net – is something I'd prefer to pick over
just a pile of cash.
But that does bring up another exception. If I had really good reasons to believe the company had
very valuable assets not stated on the books in addition to its current assets (for example: real
estate, interest in another company, etc.) it could be made a Ben Graham Net-Net
Newsletter pick even if it failed on most of the criteria I usually care about.
Having said that, a company should always have a Z-Score of at least 3. It should preferably
have an F-Score of let's say 5. But I've picked things that were very borderline. Maybe I
shouldn't have. But it's happened. So while the Z-Score is a hard and fast rule the F-Score hasn't
been used that way in the past. Insider ownership is another area where I have not practiced what
I preached with the newsletter in all situations. And, in fact, there was one pick that had both a
low insider ownership and weak F-Score. Not surprisingly, it's one of the newsletter's worst
performing picks so far. That one was probably a mistake. I should be tougher on those counts.
And will try to be in the future. Unfortunately, that pick was made when there were only about
one-fourth as many net-nets as today. The number of net-nets rose throughout 2011 – making the
newsletter's performance poorer but my job easier. The worse net-net stocks perform, the more
choices you get. The toughest time to pick net-nets is when they are doing well.
So a Z-Score of 3 is mandatory. And I will never pick a Chinese reverse merger net-net. Those
two points are non-negotiable. And they both have to do with the risk of catastrophic loss. I try
very hard not to pick net-nets that could go to zero.
There are some huge black marks like having negative retained earnings, public company history
of less than 10 years, and being a retailer.
I am very reluctant to buy retail net-nets. Other than having a Z-Score under 3 or being a Chinese
reverse merger – being a retail net-net is close to the worst thing a company can be. I’m joking of
course. I just have a hard time evaluating retailers. This absolutely does not mean that retailers
make bad net-nets. Nor am I saying you should avoid buying them. I’m just saying I avoid
buying retail net-nets, because I’m really bad at judging retailers. See my articles on Barnes &
Noble (BKS) if you need the gory proof.
For the Ben Graham Net-Net Newsletter, I don't pick stocks that aren't filing with the SEC.
That's for the newsletter. For myself, I'd be open to buying a stock that stopped filing with the
SEC. Some companies keep reporting balance sheets every quarter even after they "go dark". I'd
be okay owning a company like that. But I don't pick them for the newsletter.
And then, again, for the newsletter we do just American companies. For myself, I'm willing to
buy in other countries. I prefer U.S. companies because I understand them better. But half of my
portfolio is in Japanese net-nets. So I clearly have no problem investing overseas.
So, for the Ben Graham Net-Net Newsletter the rules are basically:
1. It has to be a net-net
2. It has to be a U.S. stock
3. It has to be current in its SEC reports
Down one level from that in terms of how mandatory it is would be the Z-Score and no Chinese
reverse merger stocks. To be clear, Chinese companies sometimes show up as U.S. companies
due to being a reverse merger. Many people/websites treat them as U.S. stocks because they
trade on U.S. exchanges. I won't touch them. And would never pick them for the net-net
newsletter. Some of them are frauds. And none of them are truly U.S. companies. They shouldn’t
be part of a U.S. focused newsletter.
I can't imagine a situation where I'd pick a net-net that had a Z-Score of less than 3. So that's
pretty much mandatory as well.
After that, with the exception of companies that trade for less than their net cash, the Ben
Graham Net-Net Newsletter normally picks:
· A non-retailer
· With positive retained earnings

· A Z-Score of 3 or higher
· An F-Score of 5 or higher
· And few or no operating losses in the last 10 years
Many of the Ben Graham Net-Net Newsletter's picks have been profitable for at least 10 straight
years. The F-Scores vary more. Many fall in the 5 to 7 range. Off the top of my head, I can't
remember if we've picked more than one 4 or lower F-Score stock that wasn't a net cash stock.
There was at least one though.
Anyway, I'll write a full description of each stock as it exits the portfolio. So, starting around
April (I think), we'll beginning selling net-nets we've held for a full year. After we sell them from
the model portfolio, I'll write an article describing what the stock looked like when we picked it
including things like the F-Score, past earnings history, etc. and then how the stock performed
while we held it and of course what it looks like today.
Some particularly patient bargain hunters might even want to buy stocks the Ben Graham Net-
Net Newsletter sells at a loss. After all, they'll be even cheaper than when we first bought them.
We'll see. In some cases, it may be clear I made a mistake picking the stock in the first place.
You won’t want to buy those.
And I'll try to own up to my mistakes.
It’ll be a learning experience for everyone. So, expect to see those articles on the net-nets
the Ben Graham Net-Net Newsletter sells each month starting later this Spring.
Until then, premium members of GuruFocus can always read the newsletter issues as they come
out. I make the pick on Friday. And we buy the stock on Monday. So you always have the
weekend to think things over. And you’re never being told what stock we’ve picked after the
fact. You’re always told before we buy the stock. Not after.
161369/what-are-the-minimum-requirements-for-a-good-netnet
 Time: 2012
-----------------------------------------------------
Pain And Patience: Net-Nets, Magic Formulas, And Micro Caps

Hello Geoff,
I followed your advice on patience, and was finally filled on (the Ben Graham Net-Net
Newsletter’s September 2011 pick). Hopefully I can secure some (of this month’s pick) at some
point. The strategy is not working as well as I had hoped, but I will follow your advice (2-3 year
hold). Hopefully those long term results that you discussed in the last issue will materialize. Do
you think that same time horizon should be followed with the Magic Formula micro cap
strategy?
Best Regards,
Henry
I'm glad the patience finally paid off with you getting shares of the September pick at a lower
price than the newsletter’s own model portfolio got them. One of the difficulties for the Ben
Graham Net-Net Newsletter is that we make a pick on Friday night but then Monday morning
comes and it might take a while for our own model portfolio to get shares. That is certainly a
possible problem with this month’s pick. But it could've been a problem with two of the picks
from last year (in particular). And in those cases the model portfolio got shares fairly easily. It’s
always hard to tell ahead of time. There have been times in my own portfolio where a stock had
averaged a few hundred shares a day in volume and then – wham – I put in an order for 10,000
shares and was filled right away.
Regarding this month’s pick, I have had to wait anywhere from 3 weeks to over a month or so
for my own orders to be filled in stocks of similar size and illiquidity. But it has been worth it.
For myself, I don't really compromise on price. I usually put in an order about a penny above the
last trade and then just wait. For the model portfolio, we do it a little differently. And this could
hurt our performance by about 5% a year or so (because we are bidding about that much higher
than the last trade price in many situations).
2011 was a bad year for net-nets. Actually, that’s not a fair description. I should say the first
half of 2011 was utterly awful for net-nets. The second half was pretty decent. So 2011 worked
out to be a worse than usual calendar year for net-nets.
And 2011 wasn’t a good year for the Ben Graham Net-Net Newsletter generally. The price of
net-nets came down rather than up throughout 2011. So far, we have done worse than the overall
market. I don't think we've done worse than net-nets generally. But there is no standard
benchmark to compare to. The total number of net-nets has almost tripled since we started the
newsletter. This is due to price declines in near net-nets. I know of one person (Jon Heller at
Cheap Stocks) who keeps track of a kind of net-net index. You may want to check out his blog.
He updates the index from time to time. It'll give you an idea of what net-nets outside the
newsletter are doing.
Relative to the overall market, 2011 was probably the worst year for net-nets in a decade. A lot
of these stocks have just drifted lower. It is pretty much across the board. I wouldn't worry about
it. I'd worry more about specific stocks blowing up because they were a bad pick. We had one of
those. It didn’t exactly blow up. But we did pick a stock that is down 15% for the year. It was a
very conventional pick – one of the biggest market cap stocks we picked – and probably not a
good one in terms of my self-professed standards of F-Score, insider ownership, etc. I consider
that one a mistake. But net-nets were hard to find through the summer months. What you should
really be worried about are actual events (like bankruptcies) happening to stocks picked for
the Ben Graham Net-Net Newsletter. Or steep declines in specific stocks like 30%, 50%, etc.
Lower declines spread across the entire portfolio may be more of a short-term phenomenon. I
would certainly treat them that way.
Like I said, Ben Graham and Walter Schloss tended to have an average holding time of 2 to 5
years for net-nets (turnover of 20% to 50% a year). And Phil Fisher – who invested in stocks
very different from net-nets – thought you should hold a stock for 3 years before throwing in the
towel merely because the stock price moved against you. In other words, the only reason to sell a
stock in less than 3 years is because something has changed with the business not just with the
stock price. I agree with that sentiment.
My biggest concern both for the Ben Graham Net-Net Newsletter's model portfolio and for the
buy/sells subscribers choose to make is the trading part. Many people are not used to buying
illiquid stocks. And I am concerned people will through a combination of the bid/ask spread,
commissions, etc. manage to trade away 5% or even 10% a year (each and every year). It's very
important not to do this. But that's why we have the model portfolio, to simulate the reality of
trading these stocks yourself as realistically as possible. I hope subscribers are disciplined in this
area. But that part is really up to them.
Unfortunately, I saw the Ben Graham Net-Net Newsletter’s February pick traded recently at

what had been the ask price before we published our issue. Hopefully, it was not a subscriber
who put in that order. But, basically, somebody agreed to trade at the ask price rather than
getting any movement from the other side. That's sad to see. And I really do hope it was not
someone who read the issue I wrote. Because I didn't write to pay the ask price. I did everything
I could to stress the importance of being patient and demanding when it came to price. I even put
that part in front of the actual discussion of the stock. But I know that part is very, very hard for
people. Especially if you are new to net-net investing. If you are used to buying blue chip stocks
the idea of bidding for a stock instead of just getting your shares – it’s a foreign concept. And it’s
something the Ben Graham Net-Net Newsletter has to teach. Otherwise, subscribers will not
have the success Ben Graham did.
As you know, I don't write the micro cap magic formula newsletter. I think 2-3 years of holding
a stock is a good idea. For many strategies any holding period of 2 years all the way up to 5 years
will still get good results if the underlying strategy is as solid as net-nets. Magic formula stocks
are a little trickier. Personally, they are not my favorites. But there is no doubt the strategy
works. The problem – and I think this is also the secret to why the magic formula keeps working
– is that It is very easy to pick bad ones. Joel Greenblatt has written about this a bit. People who
chose their own magic formula stocks often did much worse than an automated list chosen for
them. That scares people away from using the approach.
By the way, this is a big risk with all stocks. Net-nets chosen by a computer do very well. It’s
hard for a human to improve on those results. And easy for a human to mess them up.
This risk of human error is at least as big a problem for Magic Formula stocks. Maybe even
bigger.
There's a reason for this. Magic formula stocks are the opposite of something like high F-Score
stocks. Rather than having a range of positive outcomes they have big positive and big negative
outcomes with the scale of positive outcomes more than making up for the frequency of negative
outcomes. They're like low price-to-book stocks that way. If you’ve read Piotroski’s F-Score
article you know what I’m talking about. And if you haven’t read it – what are you waiting for?
(You can just Google “piotroski f score” and the professor’s Chicago Booth School paper should
be one of the top results. Read it.)
So the problem with magic formula stocks is making sure they are safe. It's also the problem
with net-nets. But I work very hard on that part.
Here's what I can say. If you picked the right magic formula stock from the start, and especially
if you picked a safe stock – 3 years is a very good choice in terms of holding period. I think it's
the holding period I'd recommend myself. But if you ever realize there's something seriously
wrong not just with the stock but with the actual business you picked – you need to sell it fast.
That's true of all holding periods. Once you realize you have an unsafe stock in your portfolio
you need to cut it right away – regardless of how big a loss you'd take.
While as long as you have a safe stock you can afford to hold it. If it's part of a solid strategy like
net-nets, magic formula, etc. you should hold a safe stock for about 3 years as long as the
business isn't impaired. By that I mean you see a real risk of catastrophic loss. When you see that
in any portfolio – when you perceive a real risk of catastrophic loss – that’s when you sell no
matter how long you've held the stock or how big your loss will be. It's best to sell anything
where you fear losses could be huge (50%+) under some scenarios. That's one reason why
picking things like bank stocks is hard. There's often a big upside/big downside situation that
may have good probabilities but still have a real risk of catastrophic loss.
I try to avoid things like that in my own portfolio. And always try to do it with net-nets. That is
my biggest concern in writing the Ben Graham Net-Net Newsletter. The question is always how
can I keep the level of catastrophic risk as low as possible while building a portfolio built solely
from net-nets. That's the biggest concern both with magic formula stocks and net-nets. If you feel
uneasy about the risk of catastrophic loss due to permanent impairment of the business – you
should sell. Don't worry about the holding period. Just get out.
This can be due to bankruptcy risk, technology change, fraud, etc. But if the risk is real – sell
now. Otherwise, if you picked the right stock in the first place I'd be willing to hold it for 3 years
before I threw in the towel.
Warren Buffett saw the price of stocks like The Washington Post (WPO) go against him for
about that long. And eventually he made 30% a year over his first decade in that stock. So,
waiting 1 year or even 3 years because you believe in the business but the stock price doesn't
show it yet is fine.
But it’s never fine to keep holding a stock if you realize there's a risk you didn't see at first. Or if
the risk to the business has really changed since you bought it. It's rare for that to happen so fast
outside of a few super fast changing industries. But it can happen. If you see catastrophic risk –
sell. Otherwise, hold for 3 years. That advice is sound both for net-nets and magic formula
stocks.
And it’s especially sound for micro caps.
Micro cap stocks are the worst stocks to sell in a hurry.
161404/pain-and-patience-netnets-magic-formulas-and-micro-caps
 Time: 2012
-----------------------------------------------------
How To Read A 10-K: What Is The Most Important Part?
Hi Geoff,
First of all, thanks for blogging your thoughts on investing. I really enjoy the blog and while
driving over the holidays, I listened to most of the podcasts. They were great.
In this post, you described your research process. I was just looking for a little clarification. Is
the only 10-K that you read, cover to cover, the most recent? Aside from that are you focusing
on the MD&A; (Management Discussion and Analysis)?
Thanks,
Reid
Yes. I'd say the only 10-K I read from cover to cover is the most recent 10-K. I always print out
and mark up a hard copy of the latest 10-K, 10-Q, and 14A. How much I read of the other SEC
reports depends on the specific company and its situation. Normally, I will check all of the 8-Ks
and 13Gs from the last year or so. If I know anything specific about the company's past – like
there was a scandal, a proxy battle, legal case, unconsummated merger, etc. – I will read the 8-Ks
and other documents surrounding that time period even if it was many years ago.
Also, I usually read the oldest 10-K as well as the newest. For example, if a company last filed
its 10-K for the 2011 year, but it has been filing with EDGAR since 1996, I will read the 2011
10-K and the 1996 10-K. But unless I have a reason to I will not read all the 10-Ks in between. I
will however read any shareholder letters ever written that are still available. So, if the 10-Ks
included part of an annual report sent to shareholders like some do, I would read that part of the
10-K for all 15 or 16 years or however long the company has been sending them to EDGAR.
A few companies keep old annual reports, shareholder letters, etc. on their company website. I
always check both EGDAR and the company website. In probably 19 out of 20 cases, there is
nothing more in terms of corporate communication on the website than you can find on EDGAR.
So I end up only using EDGAR.
Of course, companies that sell things have very useful information on their websites about their
products, prices, sales methods, etc. which are often not reported to the SEC. Most companies
are vague about these things. Although I've seen 10-Ks (especially for smaller companies) where
they honestly list the exact names of competitors, the exact names of products, and the actual
sales prices. This is rare for larger companies. But in all cases internet searches will provide that
kind of information. So you end up doing some Googling along with reading EDGAR.
Otherwise, I do not have a one size fits all approach to how much of the past filings I read. I read
the financial statements themselves for all years. And I enter balance sheet, cash flow, and
income statement data into Excel sheets I have for every year the company reported to EDGAR.
If the company has long been public this will be something like 14-17 years of data (it took a few
years for EDGAR to be phased in. Different companies started at slightly different dates). I
always have at least 10-year data. And this is the data I use for direct comparisons between
companies. But in addition to this I fill out summary balance sheets, cash flow statements, and
income statements for every year the company has reported using EDGAR.
Usually, you will end up with more than 10 years but less than 20 years of historical data. Like I
said, some companies go further back. Obviously, they will mention data from before this period
– especially if you read the oldest 10-K – but complete financial information is rarely available
before the 1995-1997 period.
No. I wouldn't say I'm focused on the Management Discussion and Analysis (MD&A;).

Sometimes it is useful. But it depends very heavily on how honest and complete the company
chooses to be. Many times, the MD&A; is formulaic. It is very cut and paste. There is no logic to
this. Probably the best disclosures I have seen in that area come from very tiny companies. At
times it seems small companies don't bother to truly separate SEC reporting from the rest of their
business. And so you get some descriptions thrown in there that were probably created for other
purposes. For example, I've seen descriptions of new products and things like that which were
almost certainly prepared originally for internal use. This is most common when the largest
shareholder of the company is also the chief executive. Of course, there are also situations with
small companies where almost no disclosures are made. Large companies tend to be the most
formulaic in their reporting. Often none of the prose feels like it was written by a human being.
The things I look at most are actually the notes to the financial statements. Together, the general
business description, the historical financial data (I take from the financial statements and enter
in Excel) and the notes to the financial statements provide the vast majority of my understanding
of a public company.
This information will sometimes be supplemented by data sources like competitors reports, trade
publications, information presented to customers, interviews, news reports, and things like that.
The two most important bits of information that are usually not provided in the 10-K (or any
SEC report) are the management perspective and the customer perspective. What is customer
behavior in the industry? Why do customers choose what they choose? And then what does
management really think? What are they really like?
Interviews, old news reports, etc. can help with the management perspective. So can (the more
candid) shareholder letters. Customer behavior is usually best found in data rather than
descriptions. Both customers and companies are badly biased in describing why they think
customers behave as they do. Usually, data gathered by the industry, government, etc. is useful.
Especially useful is the frequency and size of orders, who makes the purchasing decision, etc.
Sometimes studying the history of the industry and other companies in similar situations helps.
For smaller companies, it is often possible to learn about the same industry through many
different regional examples.
But, overall, I'd say learning about the customer is very, very important. And it is very hard to do
just from the SEC reports. Most are badly lacking in this respect. And my lack of comfort with
my understanding of a company's customers is often a reason I pass on buying a stock. I tend to
prefer investing in companies where I feel I understand customer behavior best.
How you get this information varies. And different investors will choose to get it differently. We
are verging on the Phil Fisher scuttlebutt realm of stock research here. It’s important. But it’s
often harder to lay out the process as rigidly as when you are doing Ben Graham type research.
One thing I recommend to all investors is reading the notes to the financial statements. These are
very important. They tell you a lot about the company.
And some investors don’t read the notes at all.
161372/how-to-read-a-10k-what-is-the-most-important-part
 Time: 2012
-----------------------------------------------------
How Long Should You Hold A Net-Net?
Hi Geoff,
In case a net-net stock price rises significantly when would you sell?
when the stock price reaches:
- net cash value

- ncav
- tbv
- bv
- something else?
My advice on net-nets is to wait one to three years.
I say this a lot. And I probably don’t do a good job explaining what I mean. I’m saying you
should hold a net-net for a full year regardless of stock price appreciation.
Why?
Because net current asset value is cheap. And there’s this tendency for people to think a stock is
expensive – or at least a good candidate for sale – once it rises 30% or 50% or 100%. Those just
seem like big numbers. If you’re showing a gain like that in some stock it’s natural for you to
want to sell.
But does that really make sense?
Let’s say a stock was trading at two-thirds of its net current asset value when you bought it. It
has risen 50%. Sounds great, right? But that means it’s only just now reaching its net current
asset value.
Think of how many stocks – how many lousy businesses – trade much higher than their net
current asset value. Is now really the time to sell?
A stock that trades at its net current asset value is far from a beloved stock. In fact, most stocks
that trade around 1 times net current assets are hated stocks. People don’t like the companies.
They’re concerned about the management, or the industry, or whatever. But this is far from a
pricey stock. It’s usually still cheap.
So even though you may be showing a gain of 50% in a stock, that doesn’t mean it’s expensive.
This is common sense. But it’s harder to apply to net-nets than you might think.
Here’s why.
Phil Fisher-type companies are a hoot to own. You get to talk about the wonderful management,
the great new products they have coming, the growth prospects for some emerging industry. It’s
easy to watch a growth stock rise 50% and still convince yourself to hold on. It’s hard to watch a
Ben Graham-type stock rise 50% and still hold on.
Now, some people will say that’s because you should hold the Phil Fisher stock even after a 50%
rise – but not the Ben Graham stock. I agree. To a point.
There’s a reason Warren Buffett talks about Ben Graham stocks being “used cigar butts.” Net-
nets are stocks with “just one puff” left in them. You shouldn’t hold a Ben Graham net-net for
the long-term because the business probably sucks.
Net-nets usually aren’t companies earning high returns on equity. Sales, earnings and book value
simply aren’t growing at many net-nets. Every day you spend owning a net-net is a day you are
spending invested in a mediocre or sub-par business. It’s a day you’re stuck earning mediocre or
sub-par returns on your investment capital.
That’s true. But I think the thing being wasted here is time. Not money. The issue isn’t whether a
Ben Graham net-net should be held after a 30% or 50% run-up in its price. The issue is whether a
Ben Graham net-net should be held after three or five years.
Those are two different questions.
I totally agree with the fear of getting stuck in a net-net. I don’t agree with the idea that you need
to take your profits in a net-net because there’s been a price rise.
Value investing is an art. Not a science. Appraisal is an art. Not a science. What I’m trying to do
– and this is all Ben Graham was ever trying to do – is to prove to myself that a stock is clearly
worth more than the price it’s trading at.
It’s very hard to know whether a stock is worth 25% or 50% or 100% or 200% more than the
price it’s trading at. Value investors don’t need to do that. All we need to do is make sure that the
stocks we buy are clearly worth more than we pay for them. And then we need to make sure our
portfolio stays that way. That it stays full of stocks that are worth more than they are trading for.
A one year ban on selling net-nets doesn’t seem outrageous to me. And it has several benefits.
One, it keeps you focused on being really, really careful about the stocks you pick. Instead of
worrying about selling stocks, you’re always 100% focused on making sure you pick the
cheapest, safest net-net today.
This is the most dangerous part of net-net investing. Picking a new net-net is risky. You need to
stick to safe stocks. Some net-nets will fall to zero. They will go bankrupt. You’ve got to
sidestep those landmines. The way to do that is to focus very carefully on what you are buying
when you are buying it.
A good way to stay focused on the safety of the stocks you’re buying is to spend as little time
worrying about selling as possible. A one-year waiting period before you sell a net-net is a good
way of making sure you stay focused on what matters most: your original purchase decision. The
moment when you pull the trigger and buy a stock. That’s when you introduce risk into your
portfolio. That’s when you need to be vigilant.
The other thing that a one year waiting period between purchase and sale does is reduce trading
costs. This is very important. Net-nets are illiquid. It can be very expensive to trade them. Look
at the bid/ask spread on some net-nets for proof of this. If you really just went out there and took
the other guy’s price every time – you’d never make money investing in net-nets.
There’s no reason to make net-net investing more costly than it has to be. You want to minimize
commissions, taxes and bid/ask spreads. Making sure you always hold your net-nets for a full
year helps enforce this trading discipline.
The biggest mistake new net-net investors make is trading too frequently. They manage to fritter
away several percentage points in annual returns by being impatient when it comes to how they
place their trades.
If you read about the way Warren Buffett traded in his net-net buying days – boy, was he a
stickler when it came to price. This was when over the counter stocks really did trade by
appointment. Buffett would call his brokers at Tweedy, Browne. And he was merciless in not
compromising by never just taking the price the seller was asking when he bought a stock.
Today, with super liquid stock markets – and online brokers – many investors are accustomed to
getting all the shares they want today at the last trade price. As you know, that’s not how net-nets
work. If you force yourself to forget about trading a net-net for a full year after buying it – you
stay focused on the two things that matter most:
1. Picking the right stock
2. Holding that stock regardless of what the market does
Unless you were wrong (from a safety perspective) to buy a net-net in the first place you should
always wait one full year before selling no matter how high it rises.
You're an investor. Not a trader.
Selling below NCAV is an extremely low price. Stocks tend to overshoot. Why not hold for a
full year? Especially if there's a tax advantage in doing so. But even when there isn't my advice is
never to sell a net-net in less than one year.
There are two exceptions:
1. If you made a mistake

2. If you need to buy something else
The “need to buy something else” hurdle should be very high. But if you find a net-net you really
love in terms of management, industry, history of profitability, competitive position, etc. and are
convinced it's much safer than anything else you own you can sell anything you already own to
buy it.
Only you can make this decision. It's really about your comfort. You can always sell a stock to
raise cash and buy something that's clearly better, safer, etc. Just make sure it's not added
excitement you're after but added comfort. When you find something truly special you're always
allowed to sell the things you own to buy it. Otherwise, don't sell due to a price increase until
you've held the stock for a full year.
The three-year advice is just that you shouldn't sell something for lack of action. Maybe you
thought some corporate event would happen or something would turn around or whatever. Wait
three years. If it's the stock price you are waiting for – I wouldn’t sell before three years just
because I get tired of owning the stock.
As for five years, I think it's unwise to hold any lower quality companies – however cheap –
more than five years. The math is against you. If you own a business compounding book value,
EPS, etc. by 0% or 2% for a full five years it's hard to argue any level of cheapness is going to
provide you with enough of a pop in the stock price to make up for passing on a better business
for half a decade or more.
That’s how I get to the idea that a one-to-five-year holding period is the right length for net-nets.
If you want to sell a net-net because it’s gone up in price but it hasn’t been a full year yet – wait.
If you believe in a company and you know it’s safe, but you haven’t seen any price movement
yet – wait for three full years. And then, don’t fool yourself. It doesn’t make sense to hold a net-
net for more than five years. If you want to hold the same stock for more than five years, you
need to make sure it’s a super high-quality business.
Never plan to hold net-nets for more than five years. Look, if you happen to find a true gem
trading as a net-net – which is really, really rare – you can hold it for as long as you want. The
five-year thing is just me saying there's a difference between a Phil Fisher/Charlie Munger
growth/moat type business and a Ben Graham net-net. You can't afford to hold cigar butts
forever. So never expect to hold a net-net for more than five years.
Three years is a good amount of time to give any stock when you believe in the cheapness and
safety of the business. If a net-net is sound (as a business rather than a stock) you can afford to
wait three years. If you own something like 10 net-nets at once, holding them for three years at a
time will mean you're always selling some stocks and you’re always buying new stocks. You’ll
be plenty busy.
When would I sell?
I'd hold a net-net for one year no matter what. This is actually a rule in the net-net newsletter.
And it's my rule. I think it's a good one. I think most people sell net-nets too fast.
As far as selling at net cash value, tangible book value, etc. it depends on the business. I would
never sell a net-net just because it reached NCAV. NCAV is still really, really cheap. A stock
trading at NCAV tends to be cheaper than most stocks. The price can look high on one year's
(bad) earnings or something. But you would need some real proof in terms of price-to-sales and
price-to-normal-earnings to believe NCAV was the right value for a business. This is especially
true – if historically – the company has not lost money.
For a company with no operating business, you could definitely sell at net cash. So you could
sell Cadus (KDUS) at net cash. And if you think the operating business at Gencor (GENC) is a
net negative for the stock, you could sell that when the investment portfolio's value is equal to
the stock price. So net cash is an appropriate sale price for stocks that have no real value besides
their surplus cash.
I'd be willing to sell something at tangible book value if I had a really good reason for believing
it will never have sustained earnings to justify a higher than tangible book value price. That's
pretty rare. I can think of examples where it could happen. Insurance is a good example. If you
have a non-niche insurance business trading at tangible book – I might sell that especially if I
wanted to buy something with less risk. But it pretty much has to be an industry-wide issue.
Something about the industry tends to make businesses worth no more than their tangible assets.
I wouldn't sell most net-nets just because they reached tangible book value.
What I would do is re-evaluate every net-net one year after buying it. If it's no longer a net-net
and I can find good net-nets today, I'd sell it.
Likewise, I'd consider re-evaluating anything I'd owned for three years and never gotten results
from. I'd look to see if I'd made a miscalculation of some sort. Or if I was only hanging on to the
stock because it hadn't gone up yet and I was being stubborn.
It really depends on the person. For example, the last one – being stubborn, waiting for a stock to
go up, show green before selling, etc. – that’s a problem I don’t have. I'm quite willing to sell
something – even at a small, quick loss – if I find something better. I'm pretty merciless when I
think I've found an upgrade for my portfolio. I've taken a lot of small losses on stocks. Some
people don't like doing that. But it's never been something that bothered me. I'm more bothered
by the possibility of big losses.
Barnes & Noble (BKS) is a good example. Basically, once the Burkle lost the proxy fight and it
was clear B&N; was spending huge on the Nook – I got out. Overall, it was not a big loss.
But I'd written about Barnes & Noble a lot on GuruFocus and it was definitely
a "contrarian" position that had gotten me a lot of grief. So, it would've been natural to want to
hold B&N; until I could show a small gain. I was never tempted by that. That's just a personality
thing.
We all have our flaws. I trade too much. But it's rarely because I sell too fast. Rather, it's because
I buy too fast when I've got cash. Cash is very dangerous for me. Having 30% or 50% of my
portfolio sitting in cash tends to make me lower my standards a lot – without admitting it – and
this is a big character flaw. For other investors, that risk might not be there. For most people, I'd
say picking an unsafe net-net with a lot of upside potential and simply selling net-nets too soon
are the two most common net-net investing mistakes I see.
So my advice is to take your time when buying net-nets and when selling them.
The ideal holding period for a net-net is usually longer than you think.
161348/how-long-should-you-hold-a-netnet
 Time: 2012
-----------------------------------------------------
Are Most Net-Nets “Uninvestable”?
Someone who reads my articles sent me this ]email:
Geoff,
I read an article the other day that stated… that only 1/6th of all net-net stocks are investable
and the rest are frauds, value traps, etc.
Regards,
Rijk
As far as the 1/6 net-nets are investable comment – I don't know. I'd say I'm reasonably tough in
terms of not liking just cash shells, Chinese reverse mergers, etc. And I'd have to put the number
closer to one-fourth to one-third of net-nets standing out as attractive.
As I write this, there are – by my count (everyone's net-net count varies a bit) – 100 net-nets in
the U.S.
I could – if I absolutely had to – come up with a portfolio of 30 net-nets that I would be

confident would outperform the market – as a group – if equally weighted and held for 3 to 5
years. There are at least that many net-nets with acceptable F-Scores and Z-Scores. And if you
are buying a big group of net-nets with good F-Scores I think you are investing intelligently. Of
course, profitability is a mixed picture. You’d probably end up buying some companies with
decent balance sheets that are reporting losses. The Ben Graham Net-Net Newsletter rarely picks
stocks with losses. But then I only plan to take the Ben Graham Net-Net Newsletter’s portfolio
up to about 13 – not 30 – stocks.
Right now, there are a bit under 100 net-nets. In fact, the number is almost exactly 100 as I write
this. If only 1 out of 6 net-nets were “investable” that would mean there are 17 “investable” net-
nets. Does that sound right? I mean, we started this month with 11 net-nets in the
newsletter’s model portfolio. And I picked another one this month. So that’s 12 net-nets that I
obviously considered investable. Are there more than 5 out there?
If retailers are “investable” – then the answer is yes. As you know, I have this really strong –
let’s call it what it is, a phobia – about retail net-nets. I’ve never said they don’t work out as a
group. In fact, I think you’ll hit some home runs investing in retail net-nets. But I don’t think
they are – individually – safe stocks.
I think non-retail net-nets are less likely to go to zero. Or at least it’s easier to tell which net-nets
are safer than others when you don’t throw retail net-nets into the mix.
And I try to keep the Ben Graham Net-Net Newsletter’s portfolio stocked with the net-nets I
think are least likely to go to zero. So I pretty much toss out retail net-nets.
Off the top of my head, I can name a handful of retail net-nets most people would
consider “investable”. Examples include:
1. Trans World Entertainment (TWMC)
2. Hastings Entertainment (HAST)
3. Books-A-Million (BAMM)
4. Tuesday Morning (TUES)
5. Duckwall-ALCO (DUCK)
If I was picking stocks for the Ben Graham Net-Net Newsletter’s model portfolio based purely
on the numbers – I’m sure some of those guys would’ve slipped in. But whenever I’m given the
choice between a net-net that’s a retailer and a net-net that’s not a retailer – I chicken out and
pick the non-retail net-net.
If you want good analysis of retail net-nets, there are plenty of good bloggers out there who don’t
share my (irrational?) fear of retail net-nets. Examples include:
1. Cheap Stocks
2. Whopper Investments
3. Oddball Stocks
They’re all good.

So, right there, if you’re willing to admit retail net-nets on equal footing with non-retail net-nets
– and Ben Graham was – you’ve already got 17 investable net-nets. Which is about one-sixth of
the total net-nets out there.
I don’t want to get into too much detail arguing about specific net-nets. Especially about whether
they are investable or not. But I will say this. I’m looking at a list of exactly 100 net-nets right
now. I picked 12 net-nets for the newsletter, there are certainly 5 retail net-nets I haven’t picked
that most folks would call investable. In addition to that there are many net-nets owned by
investors you’ve heard of. You can find some of these net-nets on GuruFocus by looking at the
portfolios of those Gurus.
Just as a quick example, I can see net-nets on this list that aren’t owned by the Ben Graham Net-
Net Newsletter but are owned by Mario Gabelli, Third Avenue, Whitney Tilson, etc. Maybe you
and I don’t think those net-nets “investable” but some big time investors clearly did. So,
objectively, I think we have to call those net-nets investable.
So, clearly more than one-sixth of all net-nets are investable. But could the number of investable
net-nets be as low as one-fourth?
Maybe.
I don’t think it’s as high as half. I think close to half of all net-nets are stocks I wouldn’t consider
buying. Certainly one-fifth of all net-nets (right now) are stocks I’d feel comfortable buying. So,
somewhere between those two numbers is where I’d put the actual percentage of what we’re
calling “investable” net-nets. It’s at least 20% of the total number of available net-nets. But it’s
less than 50%.
At least that’s my entirely subjective guesstimate.
I should point out that there’s a big difference between buying an individual net-net and buying a
group. I said about half of all net-nets are stocks I wouldn’t buy. That’s true – individually. But
as a group even the bottom half of net-nets – as we see them– may work out fine. After all, we’re
fallible. Some of what we call the best net-nets may turn out to be the worst and vice versa.
Some of those low quality net-nets will turn into home runs. But I wouldn’t call them safe. And
generally that’s what we’re looking for in the Ben Graham Net-Net Newsletter.
We’re trying to pick the safest net-nets out there.
Just to be clear, I didn’t choose 13 stocks as the portfolio size for the Ben Graham Net-Net
Newsletter because there are only 13 “investable” net-nets. I chose 13 stocks as the size for the
newsletter’s portfolio because I don't see the benefits of selectivity beyond that point. At least
not selectivity on qualitative grounds. If I was buying 30 net-nets or more, I wouldn't bother
analyzing them myself. I would use a set of standard metrics like the F-Score. I would not try to
apply much human judgment beyond ranking the whole universe of net-nets according to
numbers I thought indicated quality when bought as a group. I'd then buy say the top fourth
(25%) of the entire group.
As for why we settled on a total portfolio size of 13 stocks for the Ben Graham Net-Net
Newsletter – that’s because picking more than one stock a month is against my nature. And
finding things to say about net-nets beyond the stats is pretty difficult even for just one stock.
The cheapness and risks in most net-nets are pretty obvious compared to something like big cap
stocks. It's right there in the balance sheet, earnings record, and insider ownership.
If you buy net-nets, you're going to spend a lot of time owning family controlled businesses. In
fact, one of the best ways to sort net-nets in back tests – and in my own experience of seeing
which net-nets I owned worked and didn't work – is simply dividing a stock's insider ownership
by its institutional ownership.
As a rule, the more stock owned by insiders versus institutions the better a stock will do. The less
stock owned by insiders relative to institutions, the worse a stock will do.
One of the worst features for any net-net is high institutional ownership. It is close to the
strongest predictor of bad returns you can find in net-net land.
This will shock you. But it's true. I mentioned a back test of 13 randomly selected net-nets a year
that are turned over for new net-nets each year returned about 21% a year since 2001. If instead
of randomly selecting those net-nets you picked the 13 net-nets with the highest insider
ownership to institutional ownership ratio, the annual return would be 40% a year. If you picked
the 13 net-nets each year with the lowest insider ownership to institutional ownership ratio, the
annual return would be just 10% a year.
It's very hard to find any single metric to sort net-nets by that brings their returns down as low as
10% a year. And keep in mind that's before trading costs. That doesn't take illiquidity into
account. When you consider the high costs associated with that sort of trading – and
the work involved – it’s clear that buying the most institutionally owned net-nets isn't worth it at
all.
On the other hand, a portfolio of the highest insider ownership to institutional ownership net-nets
actually has much lower turnover than other net-net portfolios. Obviously, ownership changes
slowly. Especially insider ownership in companies where it is high. So trading costs would be
lower than in a normal net-net portfolio because turnover would be lower.
In my experience, people gravitate toward the net-nets that will actually perform worst as a
group. They dislike family ownership. And they like institutional ownership.
By the way, this isn't something that works only in short-term oriented net-net portfolios. If you
look historically at stocks that were net-nets but went on to have good 10 and 15 year returns,
you find a lot of insider dominated companies. I don't have good data on this – I don't have a way
of screening for net-nets more than 10 years in the past – but I see it all the time. And you'll
notice that some stocks picked in the Ben Graham Net-Net Newsletter actually had decent
records – sometimes better than the stock market – over the last 10 to 15 years.
Again, these tend to be controlled companies.
Finally, as Walter Schloss said about the net-nets he bought:
“They were mostly secondary companies; they were never the top grade companies. And they
tended to be ignored by the public because they didn’t have any sex appeal, there wasn’t any
growth – there was always trouble with them. You were buying trouble when you bought these
companies, but you were buying them cheap. Of course, when you got them too cheap, they
maybe ended up going down the tubes. So you try to be a little careful. But people don’t like to
buy things that are going down.”
And perhaps more importantly for our topic:
“When Ben was operating in the 1930s and 1940s, there were a lot of companies selling below
their net working capital. Ben liked these stocks because they were obviously selling for less
than they were worth but in most cases, one couldn’t get control of them and so, since they
weren’t very profitable, no one wanted them. Most of the companies were controlled by the
founders or their relatives and since the 30s was a poor period for business, the stocks
remained depressed."
I have very few definitive answers about any individual net-net. These are not perfect stocks.
They’ve got problems I can only talk about it as part of a group operation. I think the group of 13
net-nets picked for the Ben Graham Net-Net Newsletter will perform well over time. I don’t
know about individual picks.
But I will say a few things about net-net investing. I know some people who dabble in it. And
usually their returns are not anywhere near as good as just randomly buying net-nets.
I'm not exactly sure why. But I have my suspicions.
Two things stand out as almost always true of bad net-net investors:
1. They have an aversion to controlled companies.
2. They sell too soon.
Studies of net-nets that bother looking out 3 to 5 years, generally show market beating returns
even that far out. But some people are reluctant to commit to a full year of ownership before
reconsidering. I think that's silly. If you do everything you can to choose a stock wisely –
especially a statistically cheap but ugly, ugly stock like a net-net – revisiting your decision more
than once a year is not an optimal strategy. It's counterproductive. It's better to focus on a stock
intensely for a while when making a decision and then putting it out of your mind entirely for the
next year. Then repeat. But it shouldn't be done more than once a year. I've never met anyone
who is expert in making money on the good decisions they make between the day they buy a net-
net and 365 days later. It's just a question of buying the right ones and having the stomach to
hold them.
Then there’s the whole family control thing. Insiders scare people. Families scare people.
Control scares people. It’s a risk. But companies with well-meaning insiders go bankrupt all the
time. If a net-net isn’t financially sound – the most honest CEO in the world won’t make it worth
buying.
161511/are-most-netnets-uninvestable
 Time: 2012
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Berkshire Hathaway’s New Buys – And One Really, Really Old One
Based on Berkshire Hathaway’s new portfolio we can safely assume that Warren

Buffett himself bought shares of:
· IBM (IBM)
· Wells Fargo (WFC)
While new portfolio managers – at GEICO – bought:
· DIRECTV (DTV)
· Liberty Media (LMCA)
· CVS Caremark (CVS)
· Visa (V)
· General Dynamics (GD)
· Verisk Analytics (VRSK)
· DaVita (DVA)
You’ll remember that Ted Weschler’s portfolio – before he joined Berkshire Hathaway –

included DirecTV (26% of his old portfolio), DaVita (19% of his old portfolio), and Liberty
Media (12% of his old portfolio). So those are clearly Ted Weschler’s stocks.
Even after changing jobs, Weschler is keeping some of the same stocks.
The two stocks Buffett himself bought are “old” news. IBM was big news when Buffett broke it
on CNBC’s Squawk Box. (Remember the HAL fiasco).
And Wells Fargo has been a bit of a stealth story. Basically, Warren Buffett just keeps buying
Wells Fargo whenever he gets the chance. He hasn’t been shy about telling people. He’s even
mentioned it on TV. Buffett hasn’t reduced his stake in Wells Fargo since the 2008 crash – when
he had to raise cash to bail out Goldman Sachs (GS), General Electric (GE), etc.
Well, he didn’t have to but they were offering convertible preferred stock – something Buffett
has never been able to resist. (Just ask Bank of America).
One interesting twist in Berkshire’s 13-F is the General Dynamics purchase. Berkshire continued
to add to this position.
Since the General Dynamics shares were bought for GEICO we can be pretty sure Buffett
did not make the purchase himself. But Buffett did buy General Dynamics – once.
Back in 1992, Warren Buffett bought 14% of General Dynamics’s shares.
This is what Warren Buffett said about General Dynamics when he bought the stock – himself –
19 years ago:
“We were lucky in our General Dynamics purchase. I had paid little attention to the company
until last summer, when it announced it would repurchase about 30% of its shares by way of a
Dutch tender. Seeing an arbitrage opportunity, I began buying the stock for Berkshire, expecting
to tender our holdings for a small
profit. We've made the same sort of commitment perhaps a half-dozen times in the last few years,
reaping decent rates of return for the short periods our money has been tied up.
But then I began studying the company and the accomplishments of Bill Anders in the brief time
he'd been CEO. And what I saw made my eyes pop: Bill had a clearly articulated and rational
strategy; he had been focused and imbued with a sense of urgency in carrying it out; and the
results were truly remarkable.
In short order, I dumped my arbitrage thoughts and decided that Berkshire should become a
long-term investor with Bill. We were helped in gaining a large position by the fact that a tender
greatly swells the volume of trading in a stock. In a one-month period, we were able to purchase
14% of the General Dynamics shares that remained outstanding after the tender was
completed.”
Now, Berkshire Hathaway is a General Dynamics shareholder once again. But this time the
buyer was not Buffett. And the purchase was much smaller.
In 1992, Berkshire Hathaway spent $312 million buying shares of General Dynamics. Today,
Berkshire owns just $272 million worth of General Dynamics stock.
That $272 million of GD shares Berkshire owns is 1% of the company. Compared to the 14% of
the General Dynamics Berkshire bought 19 years ago.
It’s interesting to wonder what would’ve happened if Berkshire had held its shares of General
Dynamics all these years.
The other interesting similarity is the times. Buffett bought General Dynamics just after the end
of the Cold War. And now Berkshire is buying General Dynamics just after the United States
announced plans to end the second of its two long wars.
It looks like Berkshire’s new portfolio managers are following in Buffett’s footsteps.
161580/berkshire-hathaways-new-buys--and-one-really-really-old-one
 Time: 2012
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David Einhorn’s Buys: More Tech And A Return To Yahoo (YHOO)
David Einhorn’s new buys include even more tech stocks. Einhorn already owns boatloads
of Apple (AAPL) and Microsoft (MSFT). Now he’s adding:
· Dell (DELL)
· Yahoo (YHOO)
· Research In Motion (RIMM)
The least loved of these is – of course – RIMM. Einhorn already has a paper loss in that stock.
His average cost was $18.88 a share. Today’s price is $15.05. That’s a 20% loss. And Einhorn
only started buying Research In Motion in the last three months of 2011.
But Research In Motion is a pretty small position – 0.81% of Einhorn’s total portfolio –
compared to one of his other new buys: Dell.
Einhorn already owns $255 million of Dell shares. He paid $15.36 a share. The stock is now at
$18.08 a share. That’s an 18% gain. And Dell will mean a lot more to Einhorn’s performance
than Research In Motion. Dell is a 3.9% position for Einhorn. That’s almost five times the size of
his investment in Research In Motion. So – for now at least – Einhorn’s paper gain on Dell will
more than make up for his paper loss on RIMM.
Finally, there’s Yahoo.
This is a quasi-new buy for Einhorn. He actually bought a 8.5 million shares of Yahoo in the
first quarter of 2011 only to sell them for a 2% loss the next quarter. Einhorn was out of Yahoo
completely for the third quarter of 2011. And now he’s back in with about 3 million shares
bought in the fourth quarter of 2011. Einhorn’s average price is a wee bit lower this time. His
original purchase price – back in first quarter 2011 – was $16.64 a share. He got his Yahoo
shares about 6% cheaper this time around. Einhorn paid $15.66 a share for his 3 million shares of
Yahoo. The stock is down a smidge from there. Around $15.25 a share.
There have been reports of a breakdown in Yahoo’s buyout talks. But that’s par for the course in
a situation like this where a company is shopping itself around. There will be lots of people
leaking stories for lots of different reasons. Don’t believe everything you read about Yahoo. And
certainly don’t try to trade on everything you read about Yahoo.
Why is Einhorn buying Yahoo?
Probably on a sum of the parts basis. As everybody knows, Yahoo has some very valuable Asian
assets. Unfortunately, they also have a history of mismanaging their U.S. business and losing the
trust of their shareholders.
Einhorn owns just 0.24% of Yahoo. Much less than the more than 5.6% owned by Daniel Loeb.
Not surprisingly, Loeb is not a fan of Yahoo’s board. Loeb had this to say to Yahoo:
“…Recent press reports (indicate) that the Board’s current strategic direction is to emphasize
the technology aspects of (Yahoo’s) business at the expense of advertising and media, which
accounts for the vast majority of (Yahoo’s) revenues. (We) believe that this approach places
(Yahoo’s) core revenue generating capability at substantial risk, fails to recognize the
tremendous growth opportunity in video, and directly results from a dearth of essential expertise
in media and entertainment at the Board level.
…The reluctance of the Board to prioritize shareholder value to date – evidenced by years of
deferring and delaying comprehensive strategic initiatives and missing out on myriad accretive
transactions and strategic opportunities – will no longer be tolerated or endorsed by investors.
Shareholders deserve earnest representation and oversight as (Yahoo) confronts the critical
investment and capital allocation decisions it expects to face in the next few months.”
Is Einhorn content to ride Daniel Loeb’s coattails at Yahoo? Who knows? But we do know
that David Einhorn is back in Yahoo stock as of last quarter.
161718/david-einhorns-buys-more-tech-and-a-return-to-yahoo-yhoo
 Time: 2012
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Glenn Greenberg’s New Buys: Growth Stocks For Value Investors
Glenn Greenberg – formerly of Chieftain Capital now of Brave Warrior Capital – bought some
new stocks last quarter. They were:
· Vistaprint (VPRT)
· Adobe Systems (ADBE)
· Oracle (ORCL)
· Globe Specialty Metals (GSM)
Greenberg is an especially interesting investor to watch. In fact, he’s one of my favorite Gurus to
watch. Why?
Because he holds such concentrated positions.
For example – although these are new positions – Greenberg already has 5.2% of his portfolio in
Vistaprint, 3.3% in Adobe and 2.1% in Oracle. Globe Specialty Metals is a measly 0.3%
position. But other than that we’re talking about position sizes that – right off the bat – are as big
as some Gurus’ top positions ever get.
You know I’m a big believer in focused investing. Not diversification. But concentration. So I
like to steal ideas from investors who love their stocks enough to risk a good portion of their
portfolio on every new idea.
I’ve never been sure why people are fascinated by some Guru’s one-percent position. If one
Guru is buying 100 stocks and another Guru is buying 20 stocks – I’m going to look at the list of
20 stocks first.
Have you ever met anyone with 100 good ideas? I haven’t.
Greenberg is also interesting to follow because he is a true qualitative investor.
(Weirdly: Glenn’s son, Spencer Greenberg, is a quant.)
Glenn Greenberg thinks a lot about the stocks he buys as businesses. In fact – aside from Charlie
Munger and Warren Buffett – I don’t think I’ve ever heard any investor talk as much about
the businesses he owns as Greenberg does.
So Greenberg’s new buys are one of my favorite places to look for stock ideas. Certainly, if
there’s a company Greenberg is buying that you haven’t heard of – you should start researching
it immediately. Because this is not a guy who buys cigar butts. He buys world-class businesses.
Adobe (ADBE) is a good example of this. Adobe has a GuruFocus business predictability
ranking of 5 stars. The company’s revenue per share line almost perfectly matches its 10-year
trend line. Operating margins at Adobe are over 20%. If Warren Buffett bought tech businesses –
other than IBM (IBM) – he’d buy businesses like Adobe.
One question to consider when looking at the stocks Glenn Greenberg buys is valuation. Since
Greenberg is very big on buying great businesses, he sometimes has to compromise a bit on
price.
But Greenberg is obviously a value investor. Or at least a "growth at a reasonable price" investor.
Many of the stocks he buys are trading at low valuations relative to their past. Although they
aren’t always trading at low prices relative to their peers.
For instance, Adobe doesn’t look cheaper than Microsoft (MSFT). Of course, maybe Greenberg
prefers Adobe – as a business – to Microsoft. His second biggest position is Google (GOOG) so
it’s possible Greenberg is not a big believer in Microsoft’s moat.
It’s interesting to see how much of Greenberg’s portfolio is now in some sort of software
company. Google is 16% of Greenberg’s portfolio. Adobe is 3%. And Oracle is 2%. That may
not sound like much – but it’s extremely unlikely that Greenberg would start buying Adobe or
Oracle if he really intended them to stay such small positions. It’s much more likely that if
Greenberg gets the chance to buy more of those two stocks at the right price – you’ll soon see
Adobe and Oracle rise towards the top of Greenberg’s biggest positions.
Vistaprint (VPRT) is the most interesting new buy from Greenberg. Personally, it’s the first
company I’d be looking at.
Vistaprint hasn’t been public company for very long. In fact it’s only been in existence for 11
years. But it has delivered an impressive growth performance since going public in 2005.
Vistaprint serves a very fragmented market. It had over 5 million customers in over 120
countries when it went public. That sounds like an impossibly high number. But Vistaprint is
focused on handling printing and graphic design for companies with fewer than 10 employees.
Which is a huge market. In the U.S. alone, there are more than 20 million businesses with fewer
than 10 employees.
Vistaprint’s investment appeal is explained quite succinctly in its 10-K:
“Our total revenues have grown from $6.1 million for the fiscal year ended June 30, 2001 to
$670.0 million for the fiscal year ended June 30, 2010. All of our revenue growth has been
organic.”
So what’s the downside to Vistaprint?
We’re talking about a stock with a P/E around 20, a P/B of more than 5, a P/S ratio near 2, no
dividend, etc.
In other words: a growth stock.

161732/glenn-greenbergs-new-buys-growth-stocks-for-value-investors
 Time: 2012
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Walter Schloss: 1916 – 2012
Walter Schloss died over the weekend. He was 95 years old.
Schloss was one of the greatest investors of the 20th century. He beat the S&P; 500 by 6
percentage points a year over 47 years. And was included as one of Warren Buffett’s
“Superinvestors of Graham and Doddsville” in Buffett’s 1984 speech at Columbia.
Walter Schloss – like Warren Buffett – was a student of Ben Graham. However, Schloss took a
more arithmetical approach to investing. Schloss remained more quantitative than Warren
Buffett. He was never quite comfortable with the Phil Fisher’s scuttlebutt approach. In this way,
Schloss stuck closer to Ben Graham’s teachings than Warren Buffett did.
Schloss’s almost 50 year record was similar to Ben Graham’s record in common stocks. Like
Graham-Newman – where Schloss worked in the 1950s – Schloss Associates often held nearly
100 stocks at a time. Schloss’s technique and results were similar to what Graham-Newman
achieved in their “private owner bargains” category.
This seems to have been Schloss Associates’ focus.
For most of Ben Graham’s career, “private owner bargains” meant one thing: net-nets.
Net-Nets
A net current asset value bargain – or net-net – is a stock selling for less than the value of its
current assets (cash, receivables, and inventory) minus all liabilities.
Basically, it’s a stock selling for less than its liquidation value.
Net-nets were common during the 1930s and early 1940s.They started to become less common
in the late 1940s and early 1950s when Walter Schloss worked for Ben Graham’s hedge fund:
Graham-Newman. This scarcity of net-nets was one of the reasons Ben Graham closed down his
fund in the mid-1950s.
Buffett and Schloss
Warren Buffett and Walter Schloss were both out of a job when Graham-Newman decided to
shut its doors. It took the fund a while to wind down (Graham tended to own illiquid stocks).
And, in that time, both Schloss and Buffett started funds of their own. Schloss’s career as a
money manager began in 1955. Making Schloss’s investment career almost perfectly
contemporary with Warren Buffett’s career.
For roughly the first ten years of both men’s careers net-nets remained the best way to make
money in the stock market. That changed in the “Go-Go” years of the 1960s. But net-nets – and
cheap stocks of every stripe – flooded the U.S. market again in the early 1970s. That’s when
Walter’s son, Edwin, joined the firm.
Stocks Schloss Owned
A list of stocks Schloss sent to Warren Buffett in 2007 shows that Schloss didn’t always stick to
net-nets and book value bargains. Some stocks with very low P/E ratios but few tangible assets
show up on a list of stocks Schloss owned. There are also some more “Buffett” like buys on the
list of stocks Schloss bought such as:
· American Express
· GEICO
· Berkshire Hathaway
But most of the stocks Schloss owned had nothing in common with Warren Buffett’s portfolio
except for cheapness.
Low Turnover
Schloss once estimated that his portfolio turnover was about 20% to 25%. This is perhaps a bit
lower than Ben Graham’s turnover. Graham’s turnover was often around 30%.
An analysis of Graham-Newman’s turnover and Schloss Associates turnover would probably

show the difference in turnover was due to Schloss engaging in less arbitrage and related hedges
than Graham did. These complex and volatility reducing techniques were a favorite of Ben
Graham’s. But they did nothing to improve Graham-Newman’s long-term record. In the long-
run, Graham’s returns came from being long extraordinarily cheap stocks – especially net-nets.
The same was true of Schloss’s performance.
Schloss said that it usually owned a stock for 4 years. He tended to be too early. Almost always
losing some money – on paper – before he started making money.
It’s interesting to note that if Schloss owned as many positions as Graham – roughly 100 stocks
at a time – and held them for four years, Schloss only needed to find two new buys a month.
Considering that Schloss spent all his time holed up in his office reading financial reports –
finding one new stock every 2 weeks seems like a perfectly leisurely pace compared to today’s
fund managers.
Obscure Stocks
If you take a look at that list of stocks Schloss sent to Warren Buffett in 2007 – you’ll find more
than a few names you don’t recognize. Warren Buffett noted this in his 2006 letter to
shareholders:
“Following a strategy that involved no real risk – defined as permanent loss of capital – Walter
produced results over his 47 partnership years that dramatically surpassed those of the S&P;
500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities,
mostly of a lackluster type. A few big winners did not account for his success…There is simply
no possibility that what Walter achieved over 47 years was due to chance.”
Underrated Investor
In that same letter, Buffett also mentions that Schloss didn’t go to business school – or college.
In Alice Schroeder’s biography of Warren Buffett she talks about Schloss not being taken as
seriously as a future Graham-Newman partner as Warren Buffett was. It should be noted that –
although in his recollections, Buffett usually downplays this as a real possibility – Ben Graham
was obviously interested in having Warren Buffett succeed him at Graham-Newman. In fact,
when limited partners asked who they should put their money with, Graham mentioned there was
someone in Omaha. Apparently, Schloss was not viewed the same way.
Remarkable Record
Regardless of how he was seen, Schloss’s results over the next 47 years were remarkable. As
good as Ben Graham’s. And certainly as good as the best modern hedge fund manager. Though,
of course, there aren’t directly comparable investors to Schloss. Almost no fund managers have
stayed in the game for more than 4 decades.
Even among those who had much shorter careers – beating the S&P; 500 by 6 percentage points
a year is an impressive record. By combining this 6 percent annual outperformance with 47 years
of longevity, Walter Schloss earned himself a place in the investment hall of fame.
A $1,000 investment made with Schloss in 1955 would be worth over $1 million in 2002. We are
talking about turning every one dollar in 1955 into one thousand dollars by 2002.
And, yes, all of these figures are after fees.
Lasting Lesson
What can we learn from Walter Schloss?
The Ben Graham way works. Buying a hundred stocks at less than their value to a private owner
is a recipe for success.
You don’t need to talk to management, listen to analysts, forecast the macro-economy, or even
be especially selective in the stocks you choose.
All you need to do is buy stocks that are clearly selling for less than their conservatively
estimated value to a private owner – and then hang on.
Portrait of a Superinvestor
Schloss appears – under a pseudonym – in Adam Smith’s Supermoney:
“He has no connections or access to useful information. Practically no one in Wall Street knows
him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the
annual reports, and that's about it.
In introducing me to (Schloss) Warren had also, to my mind, described himself. ‘He never
forgets that he is handling other people's money, and this reinforces his normal strong aversion
to loss.’ He has total integrity and a realistic picture of himself. Money is real to him and stocks
are real – and from this flows an attraction to the ‘margin of safety’ principle.”
Warren Buffett on Walter Schloss
This is what Warren Buffett said of Walter Schloss in his 2006 letter to shareholders:
“Walter did not go to business school, or for that matter, college. His office contained one file
cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary,
clerk or bookkeeper, his only associate being his son, Edwin…Walter and Edwin never came
within a mile of inside information. Indeed, they used ‘outside’ information only sparingly,
generally selecting securities by certain simple statistical methods Walter learned while working
for Ben Graham.”
And, finally, this is what Warren Buffett said of Walter Schloss in 1984:
“…He knows how to identify securities that sell at considerably less than their value to a private
owner… He simply says, if a business is worth a dollar and I can buy it for 40 cents, something
good may happen to me. And he does it over and over and over again. He owns many more
stocks than I do – and is far less interested in the underlying nature of the business; I don't seem
to have very much influence on Walter. That's one of his strengths; no one has much influence
on him.”
That’s probably the most important lesson we can learn from Walter Schloss.
162766/walter-schloss-1916--2012-
 Time: 2012
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What Stocks Would Phil Fisher Buy Today?
Someone who reads my articles sent me this question:
Hi Geoff,
…Among the companies that you know well, which ones do you think would interest Phil Fisher
today?
Sylvain
Wow. That’s a hard question. It’s a good question. But a hard one to answer. I know what
companies I know well. And I think I know what companies would interest Phil Fisher. The
problem is finding where those two lists overlap.
So – first of all – Phil Fisher was not concerned with price. I’m not saying he would’ve bought a
dot-com company at the height of the bubble. But I am saying he didn’t worry about price. If a
stock had a P/E of 14 or 40, he might still be interested. I’m not interested in a stock with a P/E
of 40.
Someone asked me the other day if I’d ever bought a stock with a P/E over 20. I’m not sure I
have. I mean – I’m sure I have technically bought a stock with a P/E over 20. Because I’ve
bought stocks in years where they had almost no earnings. The way math works, it’s easy to get
very big price ratios if you have a denominator close to zero. So when a company is basically
just breaking even in a bad year – the P/E ratio could be astronomical. But I’m sure that’s not
what he meant. The question I think he was asking was whether I’d ever paid 20 times a
company’s record earnings.
I don’t think so.
No. I’m pretty sure I’ve never paid 20 times a company’s all-time high earnings. I think I’d
remember doing that.
Well Phil Fisher was different. He would gladly pay 20 times earnings for the right company.
For Phil Fisher, the right company was a fast grower.
Fisher was also very focused on a company’s organization. Not just competitive advantages
like Warren Buffett. But the actual people who worked at the company.
And while Buffett is interested in per share profit growth – wherever it comes from – Fisher was
a much bigger believer in looking for organic sales growth. Not just growth through buybacks.
I tend to be much more of a Buffett investor than a Fisher investor. I am probably happiest
buying a somewhat slower growing company with a lower price than a faster growing company
with a higher price.
In theory, this isn’t very logical. Let’s look at how many earnings $100 of my capital would buy
at two different companies.
First is Coach (COH). Coach costs $74.06 a share. So $100 will buy you 1.35 shares of Coach.
Coach has $3.25 in earnings per share. So, 1.35 shares would deliver $4.39 in earnings. We can
think of $4.39 as the amount of present earnings your $100 can buy in Coach stock.
Now let’s look at Dun & Bradstreet (DNB). Dun & Bradstreet costs $80.27 a share. So $100
will buy you 1.25 shares of Dun & Bradstreet. Dun & Bradstreet has $5.29 in earnings per share.
So, 1.25 shares would deliver $6.61 a share in earnings. We can think of $6.61 a share in
earnings as the amount of present earnings your $100 can buy you in Dun & Bradstreet stock.
Coach grew revenue per share 20% over the last five years. While Dun & Bradstreet grew
revenue per share 9% a year over the last five years.
Let’s imagine – just for the sake of argument – what would happen if Dun & Bradstreet and
Coach both grew their earnings for the next five years at the same pace they grew them over the
last five years.
This is how much earnings my same $100 would buy in each stock:
Coach (COH) Dun & Bradstreet (DNB)

Toda
y $4.39 $6.61
2012 $5.27 $7.20
2013 $6.32 $7.85
2014 $7.59 $8.56
2015 $9.11 $9.33
2016 $10.93 $10.17
In four years, my $100 investment in Coach would be earning nearly the same amount per year
as my $100 investment in Dun & Bradstreet. And in five years, Coach’s earnings would pass
Dun & Bradstreet’s earnings.
If Coach’s growth prospects still looked good in five years, the stock might have a P/E of 20.
Meanwhile, Dun & Bradstreet’s growth might still be barely inching along. Actual sales growth
at DNB is only around 3% a year. The per share growth is due to constant share buybacks. Check
out Dun & Bradstreet’s 10-year financial summary for evidence of the mammoth stock buyback
they’ve done over the last decade. Shares outstanding have declined almost 40%.
Anyway, if DNB’s organic sales growth was around 3% or so five years from now – the stock
could easily have a P/E of 12. So, you could certainly imagine a scenario five years from now
where Coach’s price per share is $219 ($10.93 * 20) while Dun & Bradstreet’s stock price is
only $122 ($10.17 * 12).
I can’t argue with that. It’s certainly possible. Personally, I’m not at all sure a P/E of 12 makes
sense for Dun & Bradstreet under any circumstances. If they simply diverted all the cash they
use to buy back shares to paying out dividends instead – it’s unlikely even a no-growth stock
would have a dividend yield of 8%. This illustrates the lunacy of focusing on growth apart from
earnings retention. You can’t have it both ways. Either DNB is a 9% grower – which means you
count the buybacks – or DNB is a 3% grower, but it pays out all its earnings in dividends.
I’m saying that the high quality of DNB’s earnings – they entirely in the form of free cash flow –
and the stable nature of their wide moat business means the stock should sell for 15 times
earnings even when it’s barely growing. I believe that.
What do I believe about Coach? It’s hard to say. I don’t believe – or at least I’m not willing to
act on my belief – that Coach will grow its earnings by 20% a year over the next five years. It
could. But even if it does accomplish that the market’s view of growth from that point on will be
key.
A simple way of looking at this is to see that Coach is trading at a multiple that’s around two
times Dun & Bradstreet’s multiple. What are the chances Coach’s multiple will contract from the
roughly 24 times earnings range to the roughly 16 times earnings range? And what is the chance
that DNB’s multiple will expand from around 12 times earnings to around 16 times earnings?
Both of those events are real possibilities. And I tend to see the investment world in that way. I
think it’s very possible $100 invested in Coach and $100 invested in DNB will produce similar
amount of earnings five years from now – and those earnings may be valued in similar ways.
Coach’s growth could falter before the five years is up. Or Coach could so wow investors in
terms of its truly long-term growth prospects that the stock still fetches a P/E of 20 to 25 half a
decade from now.
It would be hard for me to choose between those two stocks. Quantitatively it would be
impossible. If forced to choose, I’m sure I’d pick Dun & Bradstreet. But that’s a qualitative
decision. I think I understand DNB’s business – its competitive advantage – better than I
understand Coach. That would be the only reason for picking DNB over Coach. I can’t argue
mathematically that Coach is an inferior stock at this price. In fact – by the numbers – Coach
looks absolutely wonderful.
That’s how I look at stocks. But that’s not how Phil Fisher looked at stocks.
I don’t think Phil Fisher would actually be attracted to either Dun & Bradstreet or Coach. I think
he would consider both stocks outside of his circle of competence. In one of his books, he
explains how he personally focused on manufacturing businesses with a significant technical
aspect. Something scientific. That was his niche. Fisher didn’t argue that his general approach
couldn’t be applied to food companies, retailers, media businesses, etc. He just didn’t invest in
those companies himself.
I’m sure Fisher would consider commercial databases and luxury goods way outside his circle of
competence. So, Fisher’s approach might work for those stocks. But they wouldn’t be stocks
he’d buy personally.
Here are some stocks Phil Fisher might be interested in:
· Waters (WAT)
· Balchem (BCPC)
· Idexx (IDXX)
· II-VI (IIVI)
· Mesa Laboratories (MLAB)
· Masimo (MASI)
I don’t know most of those companies very well. I probably know Waters the best out of that
group.
Obviously, there are companies outside of Phil Fisher’s area of focus – manufacturing with
technical elements – that fit many of his principles.
Among really high profile companies, the three that stand out are:
1. Amazon (AMZN)
2. Netflix (NFLX)
3. Wells Fargo (WFC)
Of those 3, Amazon stands out the most. Jeff Bezos often seems to be channeling Phil Fisher.
And I imagine that if Fisher were ever interested in a retailer it would be a retailer with
Amazon’s attitude about technology, customers, growth, and the long-term. More than anything
though it’s Amazon’s constant internal push to develop new sales and especially new ways to
serve existing customers without being prompted by outside forces that makes me think it’s a
company Phil Fisher would be very interested in.
Fisher liked companies that had a philosophy of growth. Something internal to the organization
that caused it to seek ways to grow sales, win new customers, develop new products. Fisher
obviously wanted a great organization in an industry with great long-term prospects. But I think
a lot of growth investors focus more on the latter issue than Fisher would. I know they don’t
focus enough on the first issue. Fisher wanted a great organization first and foremost.
I’m not sure any of the stocks I’ve mentioned in this article are necessarily good buys. The one
exception is Wells Fargo. I’m never comfortable calling a bank entirely safe. So I’m less sure
about suggesting any financial stock as a good buy than I am about stocks in most industries. But
if you look at what Wells Fargo has achieved and what they are likely to achieve over the next
ten years or so and then consider the price you are paying for the stock today – I think it’s pretty
hard to come up with reasonable assumptions that tell you Wells Fargo is too expensive right
now. Maybe you don’t feel the same way I do about the organization and the opportunities in
cross-selling products to existing customers. That’s fine. But if I had to pick one stock I
mentioned here as a stock worth investigating as a long-term buy – and long-term is the only
kind of buy Phil Fisher believed in – it’s Wells Fargo.
Waters is not especially cheap. But that’s also an interesting company. It might be a bit slow
growth – a lot of the EPS growth you see there is from buybacks – for Phil Fisher’s taste. But it
seems like a perfectly good company to me.
There is one stock in one industry that is pretty far afield from the kind of companies Phil Fisher
actually invested in during his lifetime that I’m definitely interested in and I actually think lines
up pretty well with a bunch of Fisher’s principles.
That stock is DreamWorks Animation (DWA).
I won’t try to defend DreamWorks as a Phil Fisher stock. I’m sure a lot of you are scratching
your heads right now about that name and what it has to do with Phil Fisher. If you are – I’d
suggest learning more about DreamWorks.
It’s no use reading the financials. This is a movie studio. It makes a couple movies a year. You
won’t find a pattern in the summary financial data.
But I think if you learn about the management, organization, employees, their attitude toward
technology and growth and so on – I think you’ll find DreamWorks to be surprisingly in sync
with Fisher’s philosophy.
Which brings me to my most important point. Just about all the stocks I talked about are pretty
big stocks. Because people think of Fisher as being synonymous with world class quality they
tend to look at bigger stocks than Fisher himself usually did.
The important thing is taking Phil Fisher’s philosophy and applying it to the industries you know
best. It’s Fisher’s general approach that matters. Not necessarily his focus on any one specific
industry.
And try to apply Fisher’s ideas to the smallest stocks you can find. Everyone is looking for high-
quality companies with good long-term growth prospects among the biggest companies out
there.
The best place to apply Fisher’s ideas is somewhere that’s considered highly speculative. If other
investors are buying and selling some stocks without regard to the quality of the businesses –
that’s the place you’ll get the most use out of Fisher’s ideas.
But the most important part of Fisher’s philosophy is the holding. You need to buy a stock with
the intent of holding it forever. You need to wait 3 years before you’ll know if the stock is
panning out.
I’m serious about the 3 year part. Fisher mentions 3 years as the amount of time you should wait
if you like a company, buy its stock, and then watch its stock go nowhere. He says you should
wait 3 years before you call it quits.
That’s simple advice. But it’s probably the part people have the hardest following.
162963/what-stocks-would-phil-fisher-buy-today
 Time: 2012
-----------------------------------------------------
Faith in Net-Nets
My latest net-net article over at GuruFocus includes my clearest explanation of what to look for

in net-nets – and more importantly – what it takes to make money investing in net-nets:
If the balance sheet is very liquid and insider ownership is very high – there’s a good chance
something will happen. I have no idea what. And I have no idea when. But someday, something
will happen to increase the return on those assets…Sometimes it’s as simple as returning the
assets to shareholders, using net cash to make a management buyout super cheap, or using net
cash to buy a totally different business…When you buy a net-net you are not buying future
earnings. You are buying future assets. What I’m talking about here is asset conversion. At some
point, you are expecting today’s assets will be converted into something you can profit from.
Something a control investor will pay for. Or something the market will reward.
It’s very hard to imagine these events ahead of time. But you can still bet on them:
That’s the uncertainty in net-nets. Most of the best net-nets have this certain/uncertain duality. It
is certain the stock is selling for less than it’s worth. It is uncertain how the stock will ever sell
for what it’s worth.

Remember what Ben Graham told the U.S. Senate:
The Chairman: When you find a special situation and you decide, just for illustration, that you
can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a
lot of other people decide it is worth 30, how is that process brought about – by advertising or
what happens?
Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to
everybody else. We know from experience that eventually the market catches up with value. It
realizes it one way or another.
 URL: https://focusedcompounding.com/faith-in-net-nets/
 Time: 2011
-----------------------------------------------------
Investor Questions Podcast: All Interviews and Episodes
Hey Geoff,
Thanks for posting up your old podcast episodes! Any chance you can put up the interview
series episodes as well? Thanks!
-Drew
Sure. Here are links to all the interviews and episodes. Remember, they are old. So any
references to stock prices, market conditions, etc. are out of date.
Interviews
Tariq Ali of Streetcapitalist (Interview/Site)
George of Fat Pitch Financials (Interview/Site)
Asif Suria of SINLetter (Interview/Site)
Jon Heller of Cheap Stocks (Interview/Site)
Toby Carlisle of Greenbackd (Interview/Site)
Episodes
Episode 1
Episode 2
Episode 3
Episode 4
Episode 5
Episode 6
Episode 7
Episode 8
Episode 9
Episode 10
Episode 11
Episode 12
Episode 13
Episode 14
Episode 15
Episode 16
Episode 17
Episode 18
Episode 19
Episode 20
 URL: https://focusedcompounding.com/investor-questions-podcast-all-interviews-and-
episodes/
 Time: 2011
-----------------------------------------------------
Japanese Net-Nets: 6 Months Later
It’s been about 6 months since I bought a basket of 5 Japanese net-nets.
A couple people have asked about how my Japanese net-nets have done. I started making these
investments around April of this year. I wrote the “Buy Japan” post before buying my 5 Japanese
net-nets. And it took me about a month of bidding for these micro caps to get my orders filled.
Since then, in dollar terms, the 5 stocks are up: 6.41%, 7.53%, 12.80%, 18.35%, and 20.88%.
You can use the March 16th date of my “Buy Japan” post as a convenient way of measuring the
influence the Japanese Yen / U.S. Dollar exchange rate has had on the performance of those
stocks. For Japanese investors, your results would obviously not include these Dollar exchange
rate changes.
Let’s just say these Japanese net-nets have done better than my U.S. net-nets this year. It doesn’t
matter if you are calculating returns in local currency or dollars. My Japanese net-nets have been
my best performers this year.
I will re-evaluate the positions around June of next year.
I generally hold net-nets for at least a year before considering whether they should be sold. This
gives them time to run.
Most people sell net-nets too fast because they dislike the underlying businesses and are not used
to having such large gains in a single year.
Of course, the truth is that a net-net that rises 50% or even 100% is usually still a very cheap
stock. So it’s silly to sell a net-net just because it’s gone up.
 URL: https://focusedcompounding.com/japanese-net-nets-6-months-later/
 Time: 2011
-----------------------------------------------------
Investor Questions Podcast Episodes
Some people have asked where they can find episodes of my defunct podcast.
Here they are:
Episode 1
Episode 2
Episode 3
Episode 4
Episode 5
Episode 6
Episode 7
Episode 8
Episode 9
Episode 10
Episode 11
Episode 12
Episode 13
Episode 14
Episode 15
Episode 16
Episode 17
Episode 18
Episode 19
Episode 20
 URL: https://focusedcompounding.com/investor-questions-podcast-episodes/
 Time: 2011
-----------------------------------------------------
12 Stocks I’d Consider Buying
Hi Geoff,
My question for you is about the recent market correction. I know you might not be comfortable
talking about any stocks you bought, but I’d love to hear anything you can say about how you
approached Mr. Market’s most recent mood swing; what kind of actions did you take? Did you
stick to pre-researched stocks on a watch list or did you go into overdrive with researching new
businesses? I guess my question is mostly about mindset and preparedness. How do you prepare
for this, and what does your thought process look like while it’s happening?
Thanks,
Mike
I answered Mike’s question over at GuruFocus.
In my article, I talk about 12 stocks I’d consider buying:
1. Omnicom (OMC)
2. Regis (RGS)
3. Fair Isaac (FICO)

4. Moody’s (MCO)
5. Dun & Bradstreet (DNB)
6. Birner Dental (BDMS)
7. VCA Antech (WOOF)
8. Prestige Brands (PBH)
9. Carnival (CCL)
10. Dreamworks (DWA)
11. Nintendo (NTDOY)
12. CEC Entertainment (CEC)
 URL: https://focusedcompounding.com/12-stocks-id-consider-buying/
 Time: 2011
-----------------------------------------------------
The 4 Questions to Ask Before Buying a Stock
Someone who reads the blog wrote me this email:
In your recent article you wrote:
“Intrinsic value is a guess. Buying is the belief. You don’t need to
use a lot of math to prove exactly what something is worth. You just
need to present a convincing case for buying it.”
Interesting observation. I’ve seen a few YouTube vids with Bill Ackman
in them. The interviewers have sometimes pressed him for what he
thinks a stock is worth. He never gives a numerical answer. I get the
distinct impression that he never has a definite intrinsic value X

when he buys a stock; only that a stock is “clearly undervalued” at a
current price. As Ben Graham would say: you don’t have to know a man’s
weight to know that he is fat.
All the best,
Mark
I think there are really 4 questions you answer before buying any stock:
1. Is it safe?
2. Is it a great business?
3. Am I getting a great price?
4. Can I hold this stock for as long as it takes?
The ideal stock would get 4 “yes” answers.
The 5 Japanese net-nets I own do not get 4 “yes” answers. But I made sure they passed questions
#1, #3, and #4.
A lot of differences in style come down to how you answer these 4 questions. Someone emailed
me saying he thought Mohnish Pabrai was more of a Ben Graham investor than a Warren Buffett
investor.
Not really. Graham was obsessed with question #1. He wanted to know a stock was safe. Pabrai
cares less about #1 and more about #3. Pabrai’s overwhelming focus is on getting a great price.
Graham wanted a great price. But safety always came first.
There are stocks Pabrai has owned that Graham wouldn’t. Nothing wrong with that. Different
people invest differently.
We all rank these 4 questions a little differently. We obsess about one. And our standards are a
little too loose on one of the others.
But I think most stock decisions come down to these four questions.
If you can answer those questions – you don’t need an exact estimate of intrinsic value.
 URL: https://focusedcompounding.com/the-4-questions-to-ask-before-buying-a-stock/
 Time: 2011
-----------------------------------------------------
Ted Weschler’s Portfolio
Yesterday, Warren Buffett’s Berkshire Hathaway (BRK.B) announced it hired Ted Weschler

as an investment manager. Weschler will manage between $1 billion and $3 billion of
Berkshire’s money. He starts next year.
Weschler currently runs a hedge fund.
Here is his latest portfolio:
DirecTV (DTV): 25.98%
W.R. Grace (GRA): 25.11%
DaVita (DVA): 19.04%
Liberty Media (LCAPA): 11.83%
Valassis Communications (VCI): 7.74%
Cogent Communications (CCOI): 3.48%
Cincinnati Bell (CBB): 3.36%
WSFS Financial (WSFS): 3.04%
Fibertower (FTWR): 0.42%
These are long positions only. Weschler shorts stocks and uses leverage. For details, see Carol
Loomis’s story.
Weschler is an investor after my own heart. His top 5 positions make up 90% of his portfolio.
And he spent time at two of the companies he owns: W.R. Grace and WSFS Financial.
The W.R. Grace connection is well documented.
Weschler became a director of WSFS in 1992. He’s 50 now, so he must have become a director
of WSFS at 31 or 32. By age 34, Weschler is shown as a director of 6 different companies. And
described as “the general partner for several investment partnerships.”
Weschler worked for Quad-C which controlled Thrift Investors LP which in turn owned 24.81%
of WSFS Financial back in 1996 (the earliest date when WSFS filed with EDGAR). So, in
reality, Weschler was WSFS’s biggest shareholder as far back as the 1990s.
This supports the general impression that Weschler – like Buffett – buys what he knows. He
holds few stocks. And he has relationships with some of these companies going back many,
many years.
 URL: https://focusedcompounding.com/ted-weschlers-portfolio/
 Time: 2011
-----------------------------------------------------
LEAPS – And a Lack of Good Ideas
Dear Geoff,
in your article “Should you Buy Microsoft?” on GuruFocus, you said, that it makes sense for
some investors to use LEAPS instead of the stock.
After thinking long about that, I came to the conclusion, that LEAPS can be viewed as a form of
leveraged investment with an insurance against a falling stock price included…So LEAPS would
make sense, if you want to leverage your portfolio with relatively low risk.
I’m not endorsing LEAPS.
I think they make sense only in situations where there is a level of catastrophic risk in the
underlying stock that is not priced into the option. In general, this means low volatility stocks
that nonetheless can fail catastrophically if infrequently.
Like banks.
I would use LEAPS to buy a bank because there is always the risk that a bank will go to zero. In
that sense, LEAPS leverage your investment and provide protection – basically an involuntary
surrender – where you cut down a huge loss while still betting on a favorable outcome.
The problem with LEAPS is that they aren’t long enough dated. 5-year LEAPS would be good.
10-Year LEAPS would be virtually indistinguishable from a stock in terms of a correct analysis
resulting in profit. But 2 years is not long enough for a value investor. If Warren Buffett had
bought Washington Post 2-year LEAPS instead of Washington Post stock in the 1970s he would
have lost his entire investment. By buying the underlying stock, he had a return of 30% a year
compounded over the first 10 years.
I’ve had stocks that didn’t work out for 2 years. But, boy, did they work out over 5 years. I
would’ve lost money on the LEAPS.
Any bet that depends on the market recognizing something within 3 years is a bet where a value
investor can be completely right in terms of analysis and yet lose everything simply because the
clock runs out.
Value investing is largely based on being able to hold a position until the market changes its
mind. I’d say it’s very unreliable to assume mean reversion in the market mood on a stock within
3 years.
The exception to this is when you’re diversifying both across a group of separate bets and across
a period of time. For example, if you buy one stock a month every month and turn over the
portfolio every year (by swapping out one stock each month), you may average an acceptable
result because you’re actually making a dozen different bets on a dozen different stocks that
depend on prices at a dozen different future moments in time.
That’s not what you’re talking about. You’re talking about making one bet on one stock that will
succeed or fail based on whether or not the stock reaches a certain price fast enough.
Personally, I’m not interested in LEAPS.
And I really don’t think it makes sense to buy LEAPS on a stock like Microsoft. It makes much
more sense to simply put a huge part of your portfolio into the stock if you believe in it so much.
This is something people overlook. The best way for most investors to leverage a good idea is
simply to bet big on it. If you look at Microsoft and then you look at the S&P 500 – it’s very
clear that right now you’re not giving up much by putting a lot of your portfolio into Microsoft
because the opportunity cost is very, very low.
The risk/reward on the S&P 500 specifically – and stocks generally – is lousy right now.
I don’t really get why someone would want to put 5% of their portfolio into Microsoft LEAPS
instead of putting 25% of their portfolio into Microsoft shares.
I’m not exactly drowning in good ideas over here.
But different people see these things differently.
Personally, I’d opt for 25% in Microsoft shares rather than 5% in LEAPS.
I don’t own any of either. And have no plans to buy Microsoft in any form.
As far as LEAPS themselves, it’s probably best to look at LEAPS as offering you the ability to
do two things:
 Surrender
 Buy something else
Putting less money down only offers two real benefits.
You get to have your cake and eat it too. Or, rather, you get a return on your capital without
putting all of that capital out there. And you get the chance to lose only a portion of the capital
that would be necessary to buy the underlying stock.
But that’s really all leverage offers. The idea that leverage is attractive when you don’t have
more ideas than money is kind of silly. Leverage only works in situations where you wish you
had more cash to buy stocks than you have now.
Looking at the opportunity cost of using capital, I’d say LEAPS don’t make much sense for most
investors given today’s stock prices. They’re high. Future returns will be low. By holding cash
you may have the chance to invest more in the future when stock prices are lower and returns on
your investment will be higher.
So there’s strong logic behind the idea of holding cash right now (simply because there aren’t
better places to put it). And there might be strong logic to holding Microsoft shares right now.
But where’s the logic behind buying Microsoft without using a full serving of your own cash?
I don’t see it. There’s a big gap between the opportunity Microsoft offers and the opportunity
most stocks offer right now. Since the opportunity offered by most stocks is so low, why not just
use cash (and forfeit those bad options) to buy Microsoft stock outright?
If you’re buying LEAPS instead of buying the stock itself, you need to ask yourself what exactly
you intend to do with the capital you’ve saved. Do you really have good uses for it? Uses that are
worth the risk you are taking by greatly increasing the chance of permanently losing all the
capital you put into the LEAPS?
I don’t think it makes sense to use leverage of any kind when the price of the assets you like to
buy is high. It makes the most sense to borrow when the general price level of the assets you tend
to own – presumably stocks – is especially low.
That’s when you’re likely to get the most bang for the bucks you invest. It’s also when the
opportunity costs are highest because capital is scarce relative to opportunities.
I don’t see that right now. Capital is plentiful. Ideas are scarce.
So, if you find a good idea – like Microsoft – why not just load up on it with a big chunk of your
own capital instead of making a leveraged bet?
I think most investors either have plenty of cash or plenty of fairly and – let’s be honest –
overvalued shares lying around. Sell those to buy Microsoft.
Don’t buy LEAPS unless you’re sure you’ve got more good ideas that money.
You might.
I don’t.
So if I was buying Microsoft – I’d just buy a ton of the stock. I wouldn’t buy the LEAPS.
 URL: https://focusedcompounding.com/leaps-and-a-lack-of-good-ideas/
 Time: 2011
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Asset-Earnings Equivalence
When it comes to valuing a business, do you believe more in asset valuations or earning?
Earnings aren’t guaranteed to be there in the future (depending on the industry, of course), but
assets are only worth what you can sell them to somebody else for. Do you think a pizza shop
should be analyzed based on how much pizza they sell or the value of its real estate & bank
account? Should they all be assessed when determining a value for the business? This is the
question i’ve been thinking about in trying to understand valuation…
I think earnings and asset valuation are kind of the same, because operating (earning) assets
generate earnings. So the value of those earning assets are the present value of future expected
earnings (owners’ earnings) generated by those assets…Then I think we need to add things like
real estate, cash, marketable securities which i think are non-earning or non-operating (core)
assets, then subtract liabilities to arrive at value of the firm as a whole.

Assets and earnings are equivalent.
You can always restate an asset in terms of earnings. And you can always restate earnings in
terms of an asset.
You can always ask: what would this asset have to earn to be worth what the balance sheet says
it’s worth? And you can always ask what someone would pay for a certain amount of earnings. If
they’d pay that amount that means they’d trade you cash today for those earnings. And that
means earnings can be thought of as being worth their (cash) sale value. So earnings can always
be thought of as if they were an asset.
In physics, mass is a measure of the energy content of a body.
In investing, value is a measure of the earning content of a specific instance of capital.
When I say a business will provide earnings of 40 cents a share pre-tax and a business is worth
$4.00 a share – I’m really saying the same thing under special conditions (certain interest rates).
Intrinsic value is always relative.
You can’t value anything without a reference point.
There are two ways you can value an asset. You can value it in static terms by comparing it to
other assets and valuing the asset against them. This uses other assets as your reference point. Or
you can value an asset by restating it as a flow of earnings and comparing that flow to the price-
to-free cash flow multiples of other businesses. This uses other cash flows as your reference
point.
Really, you’re just valuing the same thing – capital – in two different states.
This is very obvious if you look at businesses over time. Or if you look at special situations. Or
deals of any kind.
Basically, capital starts its life in a business with no earnings and a lot of potential. Then it gets
put into all sorts of specific forms (real estate, inventory, receivables, intangibles). These forms
produce cash flows which throw off earnings that again build up as assets of some kind.
The process is constantly cycling.
Understanding this idea of asset-earnings equivalence will help you avoid errors caused by a one
track mind.
Take the example of a business that has $4.75 in cash per share and 40 cents in pre-tax earnings
per share. Let’s say the stock trades for $4 a share. Sounds fair, right?
After all, that’s a P/E of 15 after-tax. Hardly cheap.
Here’s the problem with that logic.
Let’s say businesses can be bought and sold for 10 times pre-tax earnings in our little investing
universe. At first – from an earnings perspective – it seems fair for a stock with 40 cents in pre-
tax earnings to trade for $4.
But then we remember that assets and earnings are equivalent. Obviously, if businesses really
can be bought and sold for 10 times pre-tax earnings, the company we’re looking at can just use
its $4.75 in cash and buy another 47.5 cents of pre-tax earnings by going out and acquiring
another business. But then the stock would have 87.5 cents of pre-tax earnings, which would
make the stock worth $8.75 a share. Not $4.
Again, we’re just saying the same thing two ways. An asset worth $4.75 plus 40 cents of pre-tax
earnings equals $8.75 a share (if 10 times pre-tax earnings is a common multiple at the moment).
Capital on the balance sheet is just potential earnings on some future income statement.
But – and this is where we get into the softer side of the science of investing – capital doesn’t
move as freely from each of its special forms.
Cash can turn into earnings very easily because it can be converted into any other form of capital
instantly.
What about land? What about inventory? What about machinery?
It depends.
Some of these assets are stuck capital. Machinery is often such a special and rigid form of capital
that it’s economically equivalent to a prepaid expense.
I pay my website hosting fees ahead of time and my website stays up for another month. It’s a
prepaid expense. The only value I get out of this asset is the use I put the website to over the next
30 days.
Likewise, machinery may be carried on the balance sheet at its original cost less accumulated
depreciation – but it’s really just worth however much use you can get out of it.
That’s not true of cash.
And it’s not true of assets like inventory and receivables if – and only if – they can be turned into
cash and removed from the business under certain circumstances.
Often, when sales decline, inventory and receivables can be turned into cash and put to use in
new lines of business.
That’s part of the genius of Ben Graham.
He focused on current assets. Under many – but not all circumstances – current assets that are
underperforming in terms of earning production can be turned into other forms of capital that
will earn the returns generally available in the economy.
You can apply this test to any stock you buy for its assets. Just pick a rate of return – I suggest
using the 30-year AAA corporate bond yield – and apply it to the tangible invested assets of the
stock you’re looking at.
Remember to separate invested assets from assets that have accumulated on the balance sheet –
like cash – that aren’t being used in the business. Then apply the long-term rate on safe business
bonds (today it’s 5%) to the invested capital inside the business.
So, take a business with $12 of invested tangible book value and multiply that $12 per share
times 5% to get 60 cents in pre-tax earnings potential. That gives you some idea of what the
business’s capital could produce in earnings if put to use someplace else.
Why does the earning potential of capital matter if the capital isn’t earning up to that potential
now?
Two big parts of net-net investing are return of capital and transformation of capital. Return of
capital means turning more and more assets into cash and kicking them back to shareholders.
Transformation of capital means investing the same old capital in new and different ways.
So how should you value a business? Should you use earnings or assets?
I don’t look very hard at a stock’s earnings unless I think there’s something special about the
kind of capital in the business.
Take FICO.
Each of those four letters F-I-C-O are probably worth between $100 million and $150 million. In
other words, the FICO name is worth $400 million to $600 million easy.
Intangible assets are often carried on balance sheets at amounts that have nothing to do with their
economic value. So when I look at a business like FICO, I look at the earnings. They give you a
clearer idea of the value of the intangible assets the company controls.
The same would be true of a movie library. It’s often easier to look at the cash the library throws
off than the amount the library is carried on the books at.
 URL: https://focusedcompounding.com/asset-earnings-equivalence/
 Time: 2011
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My Investing Checklist
Risks
1. Catastrophic Loss
2. Failure to Snowball
Numbers
1. Altman Z-Score
2. Piotroski F-Score
3. Free Cash Flow Margin
4. Return on Capital
5. Free Cash Flow Margin Variation
6. Return on Capital Variation
7. Enterprise Value/10-Year Real Free Cash Flow
8. Enterprise Value/10-Year Real Earnings Before Interest and Taxes
9. Price/Net Current Asset Value
10. Price/Tangible Book Value
Questions
1. Is it crazy cheap?
2. Has it been profitable for a long, long time?
3. Does it do the same thing year after year?
4. Are folks who use the service happy to leave some cash crumbs on the table?
5. Is the value the company provides intangible?
6. Will existing customers stay even if a competitor lowers its price?
7. URL: https://focusedcompounding.com/my-investing-checklist/
8. Time: 2011
9. Back to Sections
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Stock Analysis Process – How Geoff Researches Stocks

I’m interested to know when you analyse a company, do you follow a particular order? Do you
always start from a screen? Do you look at its overall business and competition landscape
before diving into its financials? And when you look at its financials, do you follow a particular
order? Do you look at its income statement first and then balance sheet?
I don’t have a particular order for finding a stock/company. I do screens and stuff like that. I read
blogs. I look at company’s competitors. I just go through some foreign stock exchanges from A
to Z. Or some states from A to Z. Or some industries from A to Z.
Basically, I’m looking through lists of companies the way I figure Warren Buffett flipped
through Moody’s Manuals. I’m moving quickly to see if the company is really cheap compared
to past earnings and current tangible assets and current sales. But I’m not doing any math, I’m
just using websites like GuruFocus or Morningstar or MSN Money or the stock exchange sites,
or the company’s 5-year or 10-year financial summaries. You can find something like that online
for a lot of companies and then you quickly just run your eyes over those numbers. Are they
pretty ordinary looking? If so, just move on. If something pops, stop and look at the stock.
If any number catches my eye – like a ton of excess cash, or low p/b, or low p/s, or low EV to
past EBIT, FCF, etc. I look at the company description. Usually I’ll use Bloomberg for this or
the company’s own website. What does the company say it does? If it says it invests in real
estate, copper mining, is an investment bank, etc. I drop it there. If it says it does something I
think I can visualize if I work real hard at it, then I keep going. I look for words like “niche”,
“specialized”, etc. I look for business descriptions that sound non-capital intensive. Do you test
or monitor or score or report? That’s good. Do you make capital goods? That’s bad. Do you
make something cheap and repeat purchased, that’s good? Do you distribute? Good. Produce?
Bad. Do revenues sound recurring? Are you a one of a kind company? A possible “hidden
champion“?
This is all from the one paragraph description. Some are pretty inaccurate. But a lot aren’t. You
get interested in Bunzl real fast when you read about it, because of what the business does. This
is the Bloomberg description for Bunzl:
Bunzl plc is a distribution group supplying a range of non-food consumable products for
customers to operate their businesses but which they do not actually sell. The Company
partners with both suppliers and customers in providing outsourcing solutions and service
oriented distribution. Bunzl’s main customer markets include grocery, foodservice, cleaning
and safety.
Really, those are the only words I saw. They distribute. It’s not food. It is consumable (great!).
The customers need it, but they don’t sell it. What could be better? And then who are the
customers? They’re “grocery, foodservice, cleaning and safety”. I think I can understand those.
Then I probably go the LSE site if I haven’t done that already and just run my eyes over
operating income, return on capital, and whether revenue is up/down over last 3 years and
magnitude of move. I still haven’t calculated anything, just used my eyeballs.
Finally, I go to the company website. I want to make sure it’s geared to customers instead of
investors – unless it’s a holding company or decentralized to the point where customers see name
different from the one on the HQ. Except for that possibility, I want to make sure this isn’t a
promotional company. They can report their financials and have reports and stuff, but I’d rather
not see a lot of investor oriented stuff on the front page. I want them to use the site to
communicate with customers. I don’t want it to feel like an IPO. The company should be
unknown, unloved, unadvertised. That would be ideal.
Now, I go to the annual report (if the company has one – otherwise I settle for the 10-K). I open
it up and peruse it. I read the entire letter from the CEO/Chairman. I glance at graphs/charts/table
they include. What factors do they focus on? Do they talk about free cash flow? Good.
Combined ratio? Good. Record Sales? Eh. Consecutive reading breaking years? Great.
At this point, I go to the financial statements and check operating cash flow and cap-ex. I’d like
free cash flow to be positive. I check for operating income – though I probably saw this on the
internet already – and want it to be positive too. I shouldn’t see negative numbers anywhere. It
should look like a business. Again, this is all eyeballs. I can tell a 15% profit margin from a 1.5%
profit margin just by glancing at profit and sales I don’t need a calculator. I can tell a 0.4 asset
turn from a 4.0 asset turn. That’s the kind of eyeballing we’re talking about here. Nothing normal
is interesting. I want especially high or low numbers in certain areas. I want a way to understand
the business. If it has huge margins or really fast turns or something, I can start to understand it.
If it has close to zero cap-ex I can start to understand it. If free cash flow is greater than reported
earnings, I can start to understand it. I’m thinking how this could be even better than I first
imagined. I want to know you can take capital out of the business every year and still grow the
business. I want it to be like owning some timberland where maybe your land grows 7 new trees
for the 100 you started with, you cut down six and next year you still have 101 trees instead of
100 trees. I’m looking for something like that. I’m not looking for something that grows but
can’t be harvested.
At this point, I’ve decided whether the company is really something I’m going to study as a
possible investment or not. I’ve probably thrown out at least 95% of companies by this point. I’d
say it’s more like 99%. It’s a big, big number. Very few stocks make it past this first impression
of 10 – 20 minutes tops.
Once I get to this point, I create a folder on my computer to store all the company’s annual
reports. I download all the annual reports. Then I read them all, taking the data and putting it in a
Microsoft Excel workbook I created. I use the last 11 years of data (really 10, but I need some
year-end data from the 11th year for some calculations).
It can take me a while to enter all the data. For U.S. stocks, it’s all in EDGAR. I just need their
most recent 10-Q and their past 10 10-Ks. I have to do this all by hand, because I make
adjustments to lines like “cash” to adjust for other marketable securities they have on the balance
sheet that might be non-current. And I’m adjusting capital expenditures to add in certain
spending on intangibles, pre-publication expense, etc. that a website might not include. Anyway,
depending on how it goes this can take 20 minutes or 60 minutes. I do a split-screen in Windows
7, where I’ve got Excel on the left and the financial report on the right. I’ve gotten pretty fast
with this. It would take a new person a lot longer, because they can’t navigate the reports quite as
fast as I can because I know where things normally are.
Within 20 minutes to 1 hour, I have all the 10-year data in. So now I have all the data I like to
look at. I have the 10-year average free cash flow margin, return on capital, the F-Score, the Z-
Score, the coefficient of variation on different stuff, price/multiples etc., I also have a sheet that
shows me the DuPont analysis for all 10 years. And I can look at 10-year data for each of the
variables I care about. I can basically do a Value Line type sheet with everything from free cash
flow margin and return on invested capital to tangible asset turns to cash conversion…
everything. I have these workbooks for every stock I’ve looked at. So, I can compare them on
these numbers.
Finally, if I like what I see in terms of the numbers, I will then do 2 more things. I’ll do a full
historical workup on the company’s past financial data. In the U.S., this usually means going
back 15-17 years instead of just 10. So, I’ll have a Value Line type page that goes back 15-17
years with earnings, sales, margins, turns, ROC, etc. I’ll also do any bonus nuggets they throw in
like store counts, square footage of retail space, unit volumes, etc. I’ll look for any less common
ratios that are important here, like railroads and cruise ships and airlines and hotels and movie
theaters and store owners and stuff like that have industry specific ratios you want to look at
going back 15-17 years and comparing to industry averages, competition, etc. So I spend another
hour or whatever on that.
If I’m still interested, I read all the past annual reports from oldest to newest in order. Preferably,
in one sitting. I’m not looking at notes to the financials and stuff like that. I’m reading everything
other than the financial statements, notes, etc. I’m just looking for commentary on customers,
segments, products, etc. I’m looking at capital allocation. I’m looking at management’s way of
talking about things.
Finally, I print out the latest 10-K, the latest 10-Q, and the latest 14A. I get a highlighter and a
pen. I read the 10-K first, then the 14A, and finally the 10-Q. I go through highlighting and
marking the margins with notes.
Once I do all that, I’ll sometimes do other things like look for interviews with management,
investor presentations, any references on the internet from trade publications, local newspapers,
etc. Just looking for some additional coverage. When I’m doing this, I have specific questions. I
probably want to know more about how/why customers choose between competitors.
Throughout this whole process I always keep a notepad on a clipboard with me wherever I go. I
have this notepad, calculator and pen at my side at all times. And I just doodle calculation like
say in 5-years the net margin is 4% on today’s same dollar volume of sales, slap a 10 P/E on that,
what’s the compound annual return on the stock. Assume they don’t pay any dividends, do
buybacks, etc. for 10 years. Then a special dividend pays out all accumulated cash, what would
that annual return be over 10 years. Is it better than the stock market overall is likely to do?
Then, I can afford to get “stuck” in that stock. I sketch out scenarios real fast like that.
If I ever get to this point with a stock, I’m basically going to buy it. I would have dropped the
idea earlier if I was ever going to drop it at all. I sometimes do other things like go through 8-Ks
and 13Ds for the last few years. I’ll check who owns a stock and what events have happened and
stuff like that. But that’s really only going to provide color on my investment at this point.
Because if I made it this far, there’s a much better than 50/50 chance I’ll buy the stock.
So, I can’t say there’s one point where I have a real debate over buy/don’t buy. Instead I just
have a process that makes me eliminate 99.99% of stocks or whatever before letting me get to
the end. I get uncomfortable about the stock at some point before the end of the process and then
I just start over with the next one.
 URL: https://focusedcompounding.com/stock-analysis-process-how-geoff-researches-
stocks/
 Time: 2011
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Why Don’t You Write About Spin-offs? – Why “You Can Be a Stock Market
Genius” is So Great
I know you called “You Can Be a Stock Market Genius” the best investment book ever written
awhile back on your blog, and now you’re saying it again, so this has me wondering why you
don’t discuss similar ideas (or his/your framework) on your blog? I understand you like the
book because it’s about a mental framework for investing / hunting for ideas, but still, a little
surprising.
Also, I understand your view on why Greenblatt’s latest book isn’t practical (I somewhat
disagree as I know several passive investors who simply stopped looking at their accounts
during the downturn, yet they never once thought about selling), but is Stock Market Genius
really practical anymore to the enterprising investor? Yes you like his book for the framework,
but investors will read the book and then overpay for spinoffs, etc because that is what
Greenblatt says to own. Every idea in that book is now a much more efficient market (in general)
than it once was, with exception to the very small spinoff. Not saying money cannot be made in
his ideas, but it is much, much tougher.
I know you’re into your high quality small caps and net-nets (at present) but it would be
interesting to see you discuss special situations if you ever look for/find them.
Yes.
“You Can Be a Stock Market Genius” is probably the most practical investment book out there.
I’d say the 1949 edition of The Intelligent Investor – which includes a section on valuation –
and Peter Lynch’s books are probably the other practical books. Phil Fisher’s book is also
practical. But I don’t think many people are going to actually adopt his approach. Almost no one
I talk to is willing to limit themselves to just a handful of stocks that they research for hours and
hours and hours before they buy and then hold for a long time. Even though I think – both for
value guys and growth guys – that is by far the best way to go.
Back to “You Can Be a Stock Market Genius”. I’m not sure why you think the spin-off market is
much more efficient than it once was. It may be by some measurement. But all the estimates I’ve
seen – there were some really good ones over at a now defunct blog called the special situations
monitor – show that spin-offs still do better than the rest of the market. In addition, spin-offs
(like net-nets) aren’t that hard to separate the possible very, very bad performers from the rest of
the pack ahead of time.
That’s similar to net-nets where a stock with zero retained earnings, losses in most of the last 10
years, and some leverage is a lot more dangerous than a stock with a history of profitability and
almost no use of liabilities at all. It may work out. It may even turn out to be one of the best net-
nets. But, it doesn’t belong in the “safe” net-net category. Spinoffs – like net-nets – are a place
where a little selectivity can remove a lot of risk. Obviously, that’s because they aren’t being
very carefully scrutinized by the people selling the stock.
Spin-offs are a great place to invest. And when folks ask me how they can learn about analyzing
businesses and what is the best place to do it my answer is spin-offs. The big reason is that you
don’t see the price ahead of time. You can evaluate the business before it trades separately.
There’s no better learning experience than that.
I haven’t written about spin-offs in a while, because there haven’t been many that interested me.
Right now, you have Huntington Ingalls – a spin-off from Northrop Grumman (NOC) – which
is interesting in the sense that it might work out well. But it’s not something I’m likely to write
about. There are a few reasons for this. One, it’s carrying a lot of debt relative to EBIT and it’s
got slim margins. So, it really depends on EBIT expansion to survive and thrive. The stock is
leveraged and that’s where your returns will come from. You’re depending on an uptick in EBIT
margins being multiplied by a lot of leverage – they’re borrowing at 7% in a low ROC business –
to make you money. That might happen. And if you know a lot of about shipbuilding for the
federal government, you might want to buy that stock. That one comes down to a qualitative
analysis of how much of a risk there is that a business like that could ever get so bad it can’t
cover its interest. Basically, you’d have to feel much better about the risk that nothing especially
bad can ever happen in that business than I’m ever going to feel. It’s just not something I know
or feel I can know well enough when you’ve got that much debt.
I talked about Hanesbrands (HBI) when it was spun-off from Sara Lee (SLE) in 2006. That
was definitely my favorite stock idea around the fall of 2006. I mentioned it in a roundtable
discussion as being my favorite idea. It was (and is) leveraged. But it’s got a good position in a
good business. The competition in the U.S. is just Hanesbrands and Berkshire Hathaway owned
Fruit of the Loom.
I understand underwear better than shipbuilding. That’s the difference there.
Part of the problem with writing about spin-offs is just the audience that I’m writing for. Spin-
offs and special situations are – well – special. People would like to learn some tools in addition
to some stock picks. Or at least I’d like to think I’m giving people the ability to find stocks on
their own. Spin-offs are pretty simple. They just involve reading. You read about them yourself
and then you value them. If they trade at a very much lower price from what you think is right,
you buy them. That’s it.
It’s not even that important exactly how you value them. You don’t need the perfect model. You
just need to be able to read about a business, appraise a company, and tell an elephant from a
mouse.
I mean, if you look at Hanesbrands, I think it was spun-off in the $18 to $19 a share range. It’s at
$28 right now. It’s leveraged. That’s the part you can argue about. But it’s not like $28 is
expensive. In fact, if it can handle the leverage it’s got, the stock is worth more than $28 a share.
And yet $28 is about 50% higher than where that stock was spun-off. I wouldn’t say anything
especially good has transpired at Hanebrands. You just had a brief period where people were
willing to sell something for $18-$19 that was in all probability worth $30+.
So, the impediment to people understanding what I’m writing about enough to buy the stock
really isn’t some concept they don’t get. It’s just that a lot of people who read my blog or my
articles at GuruFocus aren’t going to read the SEC reports, the investor presentations, etc.
Spin-offs are very basic that way. You look at them and try to value them a bunch of different
ways and then you just judge if the market is way off. If it is, you can buy stock.
I’d be happy to discuss spin-offs in the future. And this is an area where I think there should be a
lot more coverage. Even bloggers don’t write enough about spin-offs.
So, yes, spin-offs are an area I’m very interested in.
And yes, it’s the general approach Greenblatt uses – and the way the book is written – that makes
me say “You Can Be a Stock Market Genius” is the best investment book ever written. It’s
extremely practical.
It’s really not about how great spin-offs are.
It’s about how you just need to analyze a few situations independently of the market and have
confidence in your independent analysis.
It’s like Buffett says…
Don’t look at the stock price before doing your analysis. Value the company. Then check the
price:
Buffett Video on PetroChina
You can do that in micro caps as well as spin-offs; foreign stocks as well as domestic stocks.
The key is doing that totally independent analysis – just an honest appraisal of the business.
If you have the skill to make that honest appraisal of a business all you have to do is go looking
for neglected stocks. They can be neglected because they are illiquid, family-controlled
businesses with market caps under $100 million or $50 million or whatever. They can be
neglected because they are spin-offs. They can be neglected because they are in Japan.
But the basic idea is that if you can understand the appraisal idea that Joel Greenblatt talks about
in “You Can Be a Stock Market Genius” or Ben Graham talks about in “The Intelligent Investor”
all you have to do is find neglected stocks and appraise them. That’s it.
So, I don’t really think of “You Can Be a Stock Market Genius” as being about spin-offs. I think
of spin-offs as being places where people can easily – in a psychological sense – appraise
businesses honestly, because they don’t have the stock price and stock price history skewing
their brains.
It’s just very natural to appraise assets where you don’t have a price quote.
And if you want to invest in stocks, you need to be able to appraise them apart from that quote.
You can’t rely on the market. You have to do the work yourself.
And spin-offs are all about working out what a company is worth on your own.
 URL: https://focusedcompounding.com/why-dont-you-write-about-spin-offs-why-you-
can-be-a-stock-market-genius-is-so-great/
 Time: 2011
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Japanese Stocks: Now 34% of My Portfolio – Plan to Hold Them For At Least
1 Year
Just a quick update on Japanese stocks.
A while back I wrote a post entitled “Buy Japan”. A little later, I put out a report on 15 Japanese
net-nets.
Some readers are curious about whether I’ve been putting my money where my mouth is.
Yes. Over the last couple weeks, I’ve been buying some of the smallest, most obscure – and least
liquid (that’s why it’s taken weeks) – Japanese stocks.
So far, I’ve put 34% of my portfolio into a total of 4 Japanese micro cap stocks. There’s a fifth
Japanese stock I’d like to buy. I’m willing to put 10% into it. If I get that order filled, I’ll have
about 45% of my portfolio in Japan.
No. I’m not revealing which Japanese stocks I bought. Over the last couple weeks, I’ve been
buying most of the volume of these stocks. They don’t trade much. So I have to be very
patient. And very quiet.
All 4 stocks had negative enterprise values. In fact, I got my shares in each of the 4 stocks for
less than 60% of net cash. Over the last 10 years, 3 of the 4 stocks had no losing years. One of
the 4 stocks had an operating loss exactly 10 years ago. None had any losses in the last 9 years.
And 3 of the 4 stocks were bought at less than 10 times normal after-tax earnings. All pay
dividends.
Despite my feeling that the Yen could be overvalued against the dollar by as much as 25%, I
decided not to hedge the currency.
All my other assets are in U.S. dollars. And I have no view about inflation in the United States.
So having anywhere from a third to half of my assets in another currency isn’t the worst form of
diversification.
I’ll hold my 4 Japanese micro caps for a little over a year. I plan to re-evaluate them in July
2012. I don’t know enough about Japan to evaluate their business performance in between.
I think it’s probably better to impose a trading ban on myself for a full year so I’m not tempted to
sell based on headlines. I didn’t buy these stocks because of headlines. I bought them because
they are the cheapest stocks I’ve ever seen. It would be a mistake to sell on news what I bought
purely on price.
If any fat pitches come along they’ll have to be funded through sales of the 50% of my portfolio
in U.S. stocks (which is actually only 2 stocks).
Right now, having more ideas than money is definitely not my problem. There are almost no
good net-nets in the U.S. I mean literally almost zero decent net-nets. Don’t believe me? Ask Jon
Heller.
But nothing lasts forever. One day, American net-nets will return.
Until then, at least we have Tokyo.
 URL: https://focusedcompounding.com/japanese-stocks-now-34-of-my-portfolio-plan-to-
hold-them-for-at-least-1-year/
 Time: 2011
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Buy Japan
I haven’t posted to the blog in a while. But the situation in Japan – and Japanese stocks – is
definitely worth coming out of hiding for.
No matter how bad the nuclear situation gets, the earthquake and the events that followed will
probably be classified by history as:
 A major human disaster

 A moderate economic disaster
 A minor investment disaster
Public companies in Japan have already lost more value in terms of their market caps than could
ever be justified by the disaster – no matter how bad the nuclear situation gets – because there’s
no way these companies’s future cash flows could be permanently impaired to the degree
necessary to cause a loss in intrinsic value equal to their recent loss in market value.
And Japanese public companies were already some of the world’s cheapest businesses. So some
of the world’s cheapest stocks just got cheaper.
Some folks are going to argue that the disaster in Japan – and subsequent stock sell-off –
provides an opportunity to buy stocks elsewhere. Ignore them. U.S. stocks aren’t cheap. Japanese
stocks are. Don’t get fooled into buying stuff on the other side of the world. Go straight for the
center of the crisis. Buy there. That’s where the bargains are.
There are lots of problems in Japan.
And I’m going to be brutally honest about them here. Seeing the human tragedy in Japan is
something we can mourn as fellow human beings. But it shouldn’t color our view of Japan as
investors.
I don’t like most Japanese businesses. The country’s business culture is toxic. It is very
shareholder unfriendly. Returns on capital are – and frankly, have always been, even in the boom
years – completely unacceptable. Most Japanese companies pander to their customers and do not
price their products at the best levels for their shareholders. Japan is an investment basket case.
And Japanese stocks deserve to trade at lower price-to-book ratios than the rest of the world’s
stocks now and forever.
Having said that, I’m going through the Tokyo Stock Exchange and finding dozens of bargains.
Examples include grocery stores, logistics companies, and gas utilities. Some of these companies
– unlike the vast majority of Japanese businesses – earn unleveraged returns on invested capital
equal to their counterparts in the United States and Europe. Of course, they are all irrationally
underleveraged. Many Japanese companies are.
There are tons of net-nets in Japan.
Some of these companies deserve to remain net-nets forever. Such justifiably permanent net-nets
are very rare in the rest of the world. In the U.S., I can name – at most – about half a dozen net-
nets that are consistently profitable but have such consistently pathetic returns on capital to
deserve a fate of staying a net-net forever. One American example is Duckwall-ALCO
(DUCK).
Economists may argue this has to do with Japan’s economic circumstances. I’m more inclined to
believe Japan’s economic circumstances have been exacerbated by its business culture.
The profit motive is very weak in Japan.
Traditionalism – in the sense of non-profit driven economic relationships – is very strong in

Japan.
Thinking of Japan as just another developed economy would be like thinking of the pre-war
Southern states as being just another place in the U.S. They weren’t. They wove their economic
bonds together in different – non-capitalist – ways. Tradition trumped profit. And they were a
people apart from the rest of the developed United States.
Same thing in Japan.
Japan doesn’t have plantations. But it does have business relationships based more on tradition
than profit. The financial reports of most Japanese companies make this very clear. The numbers
scream it out at you. They tell you this ain’t a for-profit enterprise you’re looking at.
To call Japan a capitalist country strecthes that term to the breaking point. Japan’s economy is
organized around relationships that are only partially concerned with profits. Companies are
often content with meager profits. They may not accept losses. But they do not insist on adequate
returns on capital. They regularly venture into operations that will never pay back the capital
investment required. All of this is obvious from perusing the financial reports of public Japanese
companies. There’s no history, sociology, or macro-economics involved in this assesement. It’s
presented – quite obviously – in the company reports.
Japanese companies are not super inefficient. They’re just super concerned with all sorts of
things that don’t lead to squeezing the last drop of profit out of their operations.
Japan is barely a capitalist country.
So dosing the patient with the same Keynesian medicine that works in countries with a strong
profit motive doesn’t spur animal spirits in the same way. Japan’s problems are much worse than
they appear. It’s the country I’m normally least eager to invest in. It’s definitely the most
investor unfriendly place on the planet – excluding a few countries that seize private property.
Other than those, Japan ranks dead last in attractiveness to investors. And it’s harder to
overthrow a culture than a government. So, Japan is one of the most economically hopeless
places on Earth.
But now is the time to buy Japanese stocks.
You can buy them indiscriminately if you want. I won’t. But you’ll probably hear I bought one
or more Japanese stocks very soon.
You can diversify across 5 or 10 Japanese net-nets if you like.
Or you can buy an ETF. Or you can pick just one stock.
Whichever way you do it, do it soon.
If you’re an investor who spends hours and hours every week bargain hunting in the U.S. and
around the world – my advice is to drop everything and focus 100% of your time on Japan’s
cheapest stocks.
The truth is that fortunes – big and small – are made on only a few investment decisions. And the
big opportunities come around very, very rarely.
Looking back at the last 27 months of my own performance – since the start of 2009 – I see that
only 3 of my investment decisions really mattered. In other words, all the work I did boils down
to making one good decision every 9 months.
Two of those decisions were about loading up big on specific stocks. The other decision was
being 100% invested in the best American companies I could find at the market bottom in early
2009. Beyond that – all the research, all the stockpicking, hundreds of hours of work – yeah,
none of that really meant anything. If I’d picked my 8th best idea instead of my 4th best idea or the
company’s closest competitor or whatever – the results would’ve been pretty similar. Only 3
decisions really turbocharged my investment results in a way that had nothing to do with what
would’ve happened anyway if I’d picked the next best option.
That’s often how it works. You make most of your returns by seeing a few big opportunities and
seizing them.
Japanese stocks are a once in a lifetime bargain.
Buy them.
 URL: https://focusedcompounding.com/buy-japan/
 Time: 2011
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Barnes & Noble – The Human Element
The way Barnes & Noble (BKS) is trading is starting to bother me. I don’t see anything in the
recent 10-Q that wasn’t already announced. Borders CEO is saying they hope to come out of
(bankruptcy) by end of summer, ok but that is not the end of B&N. Other than that there is
nothing but the market trading as if B&N is going to end in (bankruptcy) itself. I don’t get it.
Can you offer your take? I realize you no longer like B&N or maybe you are not interested to
offer comments but this sort of movement seems irrational and I am getting uncertain.
One of the really big issues with Barnes & Noble – and probably the reason I sold out – is that
the non-profit motivations of Riggio and others didn’t align with my (as an outside investor) very
much for profit motives of buying the stock. My fear was that once Riggio defeated Burkle in the
proxy contest, the company would be more geared to relentless pursuit of being a big, relevant
force in bookselling regardless of what that meant for profits that could actually repay
shareholders.
In other words, I was very scared that Nook spending wasn’t a one-time thing. That the
existential threat to Barnes & Noble as a company was what management would respond to
instead of minimizing direct investment in the Nook and maximizing the milking of today’s cash
flows from the actual stores. Basically, I thought Burkle’s motives were safely capitalistic while
Riggio’s motives were dangerously paternalistic.
I still do.
Maybe things will work out for Barnes & Noble the company, for Barnes & Noble the institution
– but I didn’t think they’d work out well for shareholders. The actions they are taking are crazy
from a return on capital perspective. But they obviously make sense from a long-term survival
perspective. Still, they are unnecessarily dangerous from a short-term survival perspective.
Barnes & Noble’s financial health would be fine without the Nook. It isn’t fine right now and
that’s entirely because of the combination of cashing Riggio out of B&N College and spending
on the Nook combined with maintaining the dividend through the proxy fight.
Ironically, this pursuit of long-term relevance has endangered the financial health of the
company. Unless they stop spending on the Nook, they’re going to be flying a lot closer to the
sun than they ought to be. A company with these cash flows shouldn’t be doing this kind of new
product investment. They’d say the level of spending is temporary. I’d say you either commit to
an arms race or you don’t. But once you commit, it’s out of your control how many missiles
you’re going to need next year. Both sides get a say in how much you have to add to the arsenal
each year. If Amazon raises the bet, you have to match them or fold. But you no longer get to
choose your level of investment. That’s how the game works. It’s brutal. And it’s stupid to play
it. But they’re playing it.
Anyway, Japan and Barnes & Noble both illustrate one of the most important concepts in
investing. When I got started at age 14, I thought companies would be all profit driven and
heartless and perfectly rational. What I found out is that investing often involves figuring out
how and why companies behave irrationally and emotionally. Why they keep factories open they
should’ve closed a decade ago. Why they try so hard to stay in the industry they started in – even
when it’s obvious they can’t earn an adequate return on capital. Things like that.
That human aspect of investing is actually a really big part of what I do. Sometimes the biggest
part. And that’s the real reason I sold Barnes & Noble. Once I saw the proxy contest was over,
the human element became such a huge impediment to the investment that I had to sell out. With
Riggio firmly in control and irrationally determined to battle it out in e-books despite the
destruction of shareholder wealth – well, my entire investment argument for Barnes & Noble
was undermined by the human element. That happens. Human factors can destroy an investment
that would otherwise make sense based on the numbers. Barnes & Noble stock would be a
terrific bargain today if Burkle was in complete control. Instead, it’s a dangerous investment
because Riggio is in control.
So, like I said, the human element can destroy an investment that would otherwise make sense
based on the numbers.
That’s true at Barnes & Noble and normally that’s been true in Japan. I can’t stress enough how
strangely public Japanese companies are run. They don’t have any interest in getting good
returns for their shareholders. They think of employees, customers, and suppliers first and
investors last. They pursue sales just to increase their size. They improve technology merely for
the prestige. Profit is the very last thing on their minds.
But Japanese stocks have gotten so cheap, I’m interested.
Could the same ever be true of Barnes & Noble?
No.
Not for me.
I wouldn’t buy Barnes & Noble stock at any price.
As long as Riggio is in charge and the company is focused on spending big bucks on the Nook –
I’m unwilling to buy the stock at any price. It’s too dangerous. It has such a huge liability in
terms of management – in terms of who the steward of your capital is – I just can’t buy the stock
at any price.
For an investor, the story you read in the press is totally wrong. The press will tell you Barnes &
Noble is having all these problems but at least there’s the Nook. Well, that might be true for
employees – not in the stores, but at Barnes & Noble’s offices – but it’s not true for investors.
The Nook isn’t offsetting some problem.
The Nook is the problem.
Barnes & Noble is taking the free cash flow from its stores and then spending it – and then some
– on direct investment in cutting edge consumer technology that it has no business developing.
Look, Barnes & Noble and Amazon are not analogous to Nokia. The business that matters isn’t
making the device. It’s the stuff delivered on the device. Barnes & Noble and Amazon are
carriers of e-books. Fundamentally, that’s all their customers want them to be. They just have to
subsidize Kindle and Nook. They don’t have to get directly involved in producing the device.
The e-book business has always been headed in one direction: selling e-readers as part of a
subscription to an e-book carrier.
Eventually, Amazon is going to give away the Kindle with a subscription to Amazon Prime.
Economically, that’s the end point here. It’s always been the end point. The whole device thing
is just a spur to get the e-book market going. But it’s never been about selling devices. It’s
always been about selling e-books.
Two companies – Amazon and Barnes & Noble – have the established “network” of e-books that
every e-reader needs to tap. They are the only special properties. The carriers. Amazon and
Barnes & Noble. The existing customers of those companies combined with their relationship
with publishers – that’s it. Nothing in e-books is special except Amazon and Barnes & Noble
being the two places where book publishers and book readers meet. You can’t replicate that. You
can replicate anything else.
You can replicate the devices.
The devices themselves are not special.
Anyone willing to sink ungodly amounts of capital into developing the devices can do it.
Barnes & Noble has decided to develop the device themselves. That was stupid. And it still is
stupid. And eventually it may prove suicidal.
But that’s the decision management made. So, if the decision stands and the management stays –
I’m not going to buy Barnes & Noble at any price.
As long as the company is aggressively investing directly in the Nook, I have no interest in the
stock.
Given Riggio’s hold over the company – and his love for the book business – I see no reason
why anyone in Barnes & Noble management is going to pursue the rational choice from an
investor perspective. Instead, they’ll pursue the rational choice from an employee perspective.
And that choice is to destroy shareholder wealth in an attempt to maintain Barnes & Noble’s
place in the world of bookselling – both in print and digital form.
Which means shareholders are screwed.
So – for me personally – I don’t care what the price of the stock is. That’s not the signal to buy.
The only signal to buy would be a complete change in strategy or management. And by
management, I mean Riggio, so there’s no way that’s happening.
Whether other folks should buy or sell Barnes & Noble stock – I can’t say. I can only tell you
that I would never be comfortable holding the stock with the current management and current
strategy they are pursuing.
It’s suicidal.
Right now, they’re intent on death by Nook.
And I’d rather not join them.
 URL: https://focusedcompounding.com/barnes-noble-the-human-element/
 Time: 2011
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Investing in Japan – Questions and Answers
In your research have you come across any good closed end funds? So far I’ve only found JEQ
and JOF.
I don’t plan to buy a closed end fund. I plan to buy stocks I select myself.
If your broker can buy in Japan, I’d suggest doing that. Last I saw, the discount/premiums on
Japanese closed end funds and ETFs are tighter than normal not wider. In other words, like in
Egypt, foreigners are buying into the country wide funds in the middle of the crisis. People are
fleeing the specific stocks. But that doesn’t seem to be matched – and certainly not exaggerated –
in the funds. Usually, slow motion market declines show the reverse trend. But people may
actually be attracted by bad headlines when they happen fast in a country they normally don’t
invest in.
I’m working on a list of 100+ Japanese stocks. These are individual stocks I picked myself based
purely on their 10 year earnings records. I’ll probably just make my own basket out of those
instead of buying into a fund.
But, depending on your broker, that could be too expensive in your case.
A reader also sent me this email:
How are you sizing your Japanese positions? Are you setting a maximum limit of how much your
portfolio will be invested in Japan?

I expect to put 25% of my net worth into Japanese stocks.
If prices fell a lot from here and I found stocks I liked, I’d definitely put 50% into Japan.
I’m unlikely to put more than 50% into Japan under any circumstances. It would be possible. But
the Japanese stock market would have to drop further by some crazy amount like 50% or
something for me to put more than half my net worth into Japanese stocks.
I’m saying that now, but I could change my mind. If I really liked the prices, there’s ultimately
no limit to what I’ll put into one country. They’ve got enough public companies in Japan that
interest me. If they offer them at low enough prices, I’d be willing to go to 100%. But I already
own some American stocks I like, so putting more than 50% in Japanese stocks would be hard
right now.
I’m expecting my portfolio will be 25% to 50% in Japanese stocks very soon.
Beyond that – your guess is as good as mine.
But I won’t buy indiscriminately. I’m not going to buy a fund. I’m going to buy from my own
list of the cheapest Japanese stocks.
A reader also sent me this email:
“How are you thinking about currency risk?”
I always think about currency risk in terms of purchasing power parity. I just assume I will
exchange my foreign currency back into U.S. dollars at the lower of today’s exchange rate or
purchasing power parity.
So, I punish overvalued currencies, but don’t treat undervalued currencies as being more
attractive. That keeps me out of some countries, because unless their stocks are super cheap I can
never buy companies in Denmark, Sweden, Norway, etc. Sad but true.
Japanese and American purchasing power parity would be at 109 Yen to the dollar. So, at 80
Yen to the dollar, the Japanese Yen is about 36% overvalued versus the U.S. dollar. In other
words, assume a 27% loss when you exchange your Yen back into U.S. dollars.
Basically, knock 27% off the return you expect from the underlying stock.
For my own recordkeeping, I actually carry foreign positions at the lower of purchasing power
parity or the market exchange rate, the way companies carry inventories at the lower of cost or
market. I view the excess of market value exchange rates over purchasing power parity as
completely speculative. You shouldn’t count on them. So, assume a 27% loss on your Japanese
currency offset by however big a gain you expect on the Japanese stocks you invest in.
I’m not saying the Yen will fall 27% from here. I’m saying that’s what I assume when I buy
Japanese stocks, because prices in Japan are higher than prices in the United States, and I don’t
think a conservative investment should ever be based on the assumption that prices will stay
higher in one country than in another country. Every foreign investment you make needs to be
justified on a purchasing power parity basis.
So, Japanese stocks have to be 27% cheaper than U.S. stocks just to make up for their overvalued
currency and the risk that comes from that.
The Yen looks so clearly overvalued here, that I’m going to look into hedging the currency.
I haven’t decided how I’m going to do that. But I’m definitely leaning toward some sort of
hedge.
I would guess a dollar should buy 90 to 110 Yen under “normal” circumstances. And that means
there’s a real risk of losing 10% to 30% on the currency part of buying Japanese stocks.
That’s why I’m leaning toward hedging.
 URL: https://focusedcompounding.com/investing-in-japan-questions-and-answers/
 Time: 2011
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15 Japanese Net-Nets
Since my “Buy Japan” post I’ve been getting lots of emails asking exactly which Japanese stocks
are worth buying.
The simple answer is net-nets.

Net-nets are stocks selling for less than the value of their current assets – cash, receivables, and
inventory – minus all liabilities. Basically, they’re stocks selling for less than their liquidation
value.
I’ve put together a list of 15 of Japan’s best net-nets. These are small, unknown, super cheap
stocks.
I ranked these 15 stocks on 5 key criteria:
1. Size
2. Sales Growth
3. Profit Margin Variation
4. EV/EBIT
5. Price/NCAV
By combining those 5 criteria, I was able to sort these 15 Japanese net-nets from most attractive
to least attractive. In other words, I was able to make a list of 15 Japanese net-nets with the best
ideas up top and the worst ideas at the bottom.
This report is perfect for someone looking to buy a basket of 5, 10, or even 15 Japanese net-nets.
Or for anyone who would like to start researching Japanese net-nets but has no idea where to
start.
The price of the report is $100.
That’s about $7 per stock.
If you click the “Buy Now” button below you can pay using PayPal. Once you’ve paid, you’ll be
taken to the page where you can download the report as a PDF.
 URL: https://focusedcompounding.com/15-japanese-net-nets/
 Time: 2011
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Screening for Decent Businesses at Decent Prices – 7 U.K. Stocks
I’ve mentioned before how Richard Beddard’s Interactive Investor blog is probably my favorite
blog.
Well, reading Richard’s posts finally inspired me to start using Sharelockholmes. It’s a site that
screens stocks in the United Kingdom. And it’s very, very good.
It’s also reasonably priced. About $8 a month at the current exchange rate.
Anyway, I was thinking about how I’d just written an article where I said Warren Buffett looks
for a good business priced to return 10% a year initially and grow from there. It used to be 15%.
But he’s lowered his standards. Berkshire simply has too much cash to invest. It doesn’t help that
stock prices aren’t real low right now. But you play the cards you’re dealt.
It shouldn’t be too hard to find the kind of decent businesses at decent prices that Warren Buffett
might invest in, right?
This is the quote I had in mind when designing my screen:

If we were working with $25 million – so we could sort of look at the whole universe of stocks – I
would guess that you could find 15 or 20 out of three or four thousand that you would find that
were A) selling for substantially less than they’re worth, and B) that the intrinsic value of the
business was going to grow at a compound rate which was very satisfactory. You don’t want to
buy a dollar bill that’s sitting for 50 cents, and it demands positive capital, and it’s going to be a
dollar bill ten years from now. You want a dollar bill that’s going to compound at 12%…And,
you want to be around some competent people. Just the same thing as if you went in and bought
a Ford dealership in South Bend. The same exact thought process goes through your…mind
about all the other businesses that are in Standard and Poor’s.
I figured I could do a quick screen and come up with a preliminary list of stocks that looked like
they could both start you off with a 10% initial return – basically, a P/E ratio under 10 – and then
reinvest future earnings at an acceptable rate.
Well, the preliminary list actually turned out to be quite short.
My requirements may have been a smidge too strict.
I asked Sharelockholmes to find companies with a 10-year ROE of at least 10% and a price to
10-year EPS of no more than 10. I also demanded the Z-Score be at least 3 since that’s the
clearly “safe” cut-off.
I then threw out any homebuilders myself, because I couldn’t trust their Z-Scores. I didn’t feel
right including them in a list intended for Americans and other investors who might be looking at
the U.K. stock market for the first time. Development works a little differently over there. It’s
tough to judge homebuilders by their 10-year records since there was a housing boom. So I just
felt better leaving homebuilders out of this for now.
Once that was done, I went through each stock by hand adding up the 10-year or 11-year or 12-
year average operating income – the length of the financial history differs from one company to
the next – and comparing that number to the enterprise value. Basically, I checked to make sure
the following inequality held true:
(Market Cap + Net Debt) / (Average Operating Income * 0.65) < 10
So, basically if you issued stock to replace all the debt and you took the operating income and
taxed it at 35%, you’d still end up with after-tax income equal to at least 10% of your purchase
price.
Again, I may have been too picky.
But then that is what we’re trying to do here – pick stocks. The best businesses at the best prices.
Oh, I also threw out companies that reported any operating losses in the last 10 years.
Again, picky.
This list is based on the data Sharelockholmes gave me. So it’s subject both to their errors and
my own.
Here’s my stab at a list of 7 decent U.K. businesses selling at decent prices:
1. T. Clarke (CTO:LN) – Reports
2. Flying Brands (FBDU:LN) – Reports
3. Clinton Cards (CC:LN) – Reports
4. Game Group (GMG:LN) – Reports
5. Bloomsbury Publishing (BMY:LN) – Reports
6. Fletcher King (FLK:LN) – Reports
7. Andrews Sykes (ASY:LN) – Reports
Now, obviously, there’s no way Warren Buffett is actually going to buy any of these stock.
They’re far too small for Berkshire Hathaway.
And looking over the list, I’m not even sure these are the kinds of stocks Buffett would have
bought back in his partnership days or his first few years at Berkshire Hathaway.
Still, a couple of the companies look interesting. Maybe not interesting enough for Warren
Buffett to invest in. Maybe not even interesting enough for me to invest in. But certainly
interesting enough for me to write about.
I plan to write articles about some of these 7 U.K. companies. I’ll try to look at them the way
Warren Buffett might.
Watch for those articles over at GuruFocus.
In the meantime, start reading Richard Beddard’s blog if you haven’t already.
He’s written about several of these companies already, like…
Flying Brands
Game Group
Andrews Sykes
 URL: https://focusedcompounding.com/screening-for-decent-businesses-at-decent-prices-
7-u-k-stocks/
 Time: 2011
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Return on Invested Assets
There are a lot of ways to calculate return on capital. Whenever, you see me use the term, it
means:
Operating Income / (Total Assets – (Intangibles + Cash))
That’s it.
To be completely honest, I don’t look at net income. I look at operating income and I look at free
cash flow. As far as I’m concerned – operating income, free cash flow, and comprehensive
income make more sense than net income. But net income is the number they print in the papers.
So it gets talked about.
Shouldn’t you include intangibles?
No.
I want to know what the business naturally earns on its own assets. The book value of all assets
is somewhat arbitrary. The book value of intangibles is completely arbitrary. It’s based on
corporate events like acquisitions. It’s not the general manager’s responsibility. Often, the most
valuable intangibles don’t appear on the balance sheet. And the least valuable intangibles appear
on the balance sheet only to be written off later.
Shouldn’t you count some cash as non-surplus?
No.
I hear people say that all the time. But it doesn’t make much sense to me. Sure, businesses
usually have some cash on the balance sheet. But it’s much easier to assume that cash is always
an asset apart from day-to-day operations than to try separating required cash balances from
surplus cash. That’s being too clever.
If you really want to talk about surplus and non-surplus cash, that depends on cash relative to
liabilities. In other words, a totally unleveraged company can always borrow money and get the
“required” cash into the coffers that way. While a leveraged company can have plenty of cash on
hand and yet not really be holding enough cash to pay its bills as they come due, because it’s got
debt repayment to deal with too.
For me, cash should always be separated from the return on capital calculation. Cash is part of
the solvency analysis. It’s not part of the business quality analysis.
And it’s easier to use just one formula. Otherwise, you get too clever and start letting your
personal biases determine the right formula for every industry.
Basically, I want to start by looking at the business alone. The stuff the company actually does
and the assets it actually uses. I don’t want to start by worrying about whether it uses common
stock, preferred stock, short-term debt, long-term debt, insurance float, whatever. I want to start
with the business. Then I move on to the finances.
There is one very legitimate argument against using the return on capital formula above…
Isn’t the return on equity what really matters?
Absolutely.
But, when I don’t know anything about a company, I always start by looking at the return on
invested tangible assets. Then, if it’s a railroad, or a power company, or a water company, or a
bank, or whatever – we can talk about what the appropriate leverage ratio should be.
But I like to start by looking at the actual amount earned on the tangible assets inside the
business.
 URL: https://focusedcompounding.com/return-on-invested-assets/
 Time: 2011
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Coming Up With a List of U.S. Stocks
“I was curious about how you go about looking at companies A through Z. Obviously there are
many ways to do that and many sites that can be used, but what is your method? Which site do
you use for domestic securities? And do you have a list of all publicly traded companies that you
go off of?”
For complete lists of the stocks in any country, you always start by going to their stock
exchange.
Here’s a list of the world’s stock exchanges.
Now back to your question. How to find stocks in the U.S…
The U.S. has quite a few really big stock exchange websites. There’s
the NYSE, NASDAQ, AMEX, and OTC Market.
Technically, the OTC Market isn’t a stock exchange. But for the purposes of generating this list,
it’s just as good. And the OTC Market website is at least as good as NYSE and NASDAQ.
Probably better. It’s definitely easier to navigate and much more geared to actually researching
stocks.
There are so many stocks in the U.S. it can be difficult to go through them using the various U.S.
stock exchange websites.
However, coverage of U.S. stocks is so good by screeners that you’ll almost never miss an
interesting U.S. stock using one of the better screeners out there.
A good site for U.S. stocks is Morningstar.
They have a screener for paid subscribers that covers just about every U.S. stock. So, if you tell
the screener you want just U.S. public companies with a market cap of at least $2 million – to
throw out stocks that are inactive but still listed on the screener – Morningstar will spit out a list
of 6,267 stocks. That’s more than enough stocks for most people!
And these are just American companies. There are tons of foreign companies traded in the
United States. We’re not talking about them. Even if we just look at U.S. companies with
publicly traded stock we’re talking about over 6,000 choices.
My advice is to pick small sections of this 6,000+ stock universe and then work your way
through them.
Let’s say you’re from the state of Illinois. If we do the same search for domestic stocks with at
least a $2 million market cap headquartered in Illinois we get 209 stocks. Morningstar says the
biggest Illinois based stock has a market cap of $78 billion. And the smallest has a market cap of
$2 million. There are more than a dozen Illinois stocks with a market cap under $10 million.
That’s tiny. Let’s go a little bigger.
There are 58 Illinois stocks with a market cap under $100 million. If Illinois was my home state,
I’d pretend those 58 stocks were my whole universe for a couple days and just go through that
list from A to Z.
This works well for a lot of states. New Jersey has even more public companies than Illinois:
247. The biggest New Jersey stock has a market cap of $170 billion. The smallest has a market
cap of $2 million.
There are 130 New Jersey stocks with a market cap under $100 million. That’s the size of some
foreign stock exchanges!
You might think all these New Jersey micro caps are trash, but they’re not.
A couple of these small stocks have high returns on capital. Usually they fill a very, very small
niche. Like one product.
Obviously, it’s easier to find high quality businesses among big caps. That’s how they got to be
big caps. They retained a lot of earnings over the years.
So, I’d use a screener like the Morningstar Premium screener and then screen not for valuations
but locations, size, etc.
You can screen for a specific industry if you want.
For example, Morningstar says there are 56 publicly traded property & casualty insurers with
headquarters in the United States. There are 93 with headquarters anywhere. Some of these
insurers are really American but headquartered offshore. Forget those for now. And just start
with the 56 P&C insurers headquartered in one of the 50 states. The biggest has a market cap of
$25 billion. The smallest has a market cap of $14 million.
Again, 56 stocks is a manageable number. If you thought you had some real insight or ability to
learn the P&C business, that’s a good group to start with.
An even better group to start with would be all publicly traded P&C insurers headquartered in
the U.S. with a market cap under $100 million. There are just 10 of those. Start by mastering that
group, then expand to the full 50+ P&C insurers headquartered in the U.S.
If someone asked me what’s the best way to get started picking stocks, I’d say go to Morningstar
and build a list of all the stocks under $100 million in your home state. Learn them. Then go
from there.
I don’t talk to management. But many of the executives at these companies are happy to talk to
any investor who calls (since no one ever does). If you’re local it’s even easier. And local small
companies are different from local big companies in that they tend to have all of their operations
in the same state (often the same building). So, they’re very easy to research in a Phil Fisher
scuttlebutt sort of way.
Most people could improve their stock picking tremendously if they looked at local micro caps.
Warren Buffett did:
I found some strange things when I was 20 years old. I went through Moody’s Bank and Finance
Manual, about 1,000 pages. I went through it twice. The first time I went through, I saw a
company called Western Insurance Security Company in Fort Scott, Kansas…Perfectly sound
company. I knew people that represented them in Omaha. Earnings per share $20, stock price
$16…I ran ads in the Fort Scott, Kansas paper to try and buy that stock – it had only 300 or 400
shareholders. It was selling at one times earnings, it had a first class (management team)…I’d
never heard of Western Insurance Services until I turned that page that said Western Insurance
Services. It showed earnings per share of $20 and the high was $16. Now that may not turn out
to be something you can make a lot of money on, but the odds are good. It’s like a basketball
coach seeing a guy 7’3” walk through the door. He may not be able to stay in school, and may
be very uncoordinated, but he’s very large. So I went down to the Nebraska Insurance
Department, and I got the convention reports on their insurance companies, and I read Best’s. I
didn’t have any background in insurance. But I knew I could understand it if I worked at it for a
while. And all I was really trying to do was disprove this thing. I was really trying to figure out
something that was wrong with this. Only there wasn’t anything wrong. It was a perfectly good
insurance company, a better than average underwriter, and you could buy it at one times
earnings. I ran ads in the Fort Scott, Kansas paper to buy this stock when it was $20. But it
came through turning the pages. No one tells you about it. You get ‘em by looking.
And, of course, Warren Buffett also bought Nebraska Furniture Mart and Borsheim’s. Both
businesses are in his home town of Omaha.
One of the first stocks I ever bought was Village Supermarket (VLGEA). Village runs the
biggest supermarkets where I live. When I was 15, I worked as a cashier in one of their stores.
I hated the job. I’m not cut out for customer service. But I loved the store. It was very well run.
No one told me Village was a public company selling for less than its book value.
That’s why you need to start with a list you can work through from A to Z.
No one tells you about these stocks.
You have to find them yourself.
 URL: https://focusedcompounding.com/coming-up-with-a-list-of-u-s-stocks/
 Time: 2011
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Investing in Turnarounds
Do you invest in turnarounds / cyclicals?
I came across Furniture Brands (FBN). Avg. FCF over 10 years is $75 million. Current EV is
$280 million. Of course, last two years were horrible from an earnings perspective…However,
FCF was not bad in those years…Trades at 1.2x tangible book value and 0.2x sales…The low
ROE even in good years tells me this is not a great business…thoughts appreciated.
I wouldn’t pay a dime more than tangible book for any company involved in making furniture. In
fact, I’d want about a 33% discount to tangible book to even get interested in that sort of thing. I
think invested assets in the furniture industry are worth far less than book. The more likely
capital is to stay invested in the furniture industry, the less likely I am to value that capital at
anywhere near book value.
I don’t think of myself as investing in turnarounds or cyclicals. But others might disagree.
Was Barnes & Noble (BKS) a turnaround? I don’t think so. It was more the expectation of
horrible things happening in the future than the present that was weighing on that stock.
However, I will invest in stocks that are temporarily unloved because of the state their industry is
in. So I would buy something like Masco (MAS) or Mohawk (MHK) at the right price. I
bought Omnicom (OMC) when the advertising industry looked bad (early 2009). And it’s only
because I have a pretty high hurdle rate – and a micro cap bias – that I don’t own Fair Isaac
(FICO) right now. I’d say each of those companies at one point had a low stock price mainly –
though not exclusively – because it was the wrong time in the cycle for their industry. But I want
a good long-term record and good operations relative to peers. I don’t want to invest in
something that’s gone downhill compared to competitors. But, if I think their competitive
position is strong – it’s just the industry that’s weak – I would definitely consider buying
something like that.
The thing with Furniture Brands is that all the stocks in the furniture industry are really, really
cheap. I mean, I posted Mason’s report on Stanley (STLY) on the blog and Chromcraft
Revington (CRC) shows up in Ben Graham net/net screens. My problem is that furniture looks a
bit like textiles when Buffett bought Berkshire Hathaway (BRK.B). Textile production was
moving from New England to the South back then. And there were very good, very permanent
reasons for that happening. Not permanent for the South keeping the mills but permanent for the
North losing them.
Furniture – unlike textiles – is a consumer product. But furniture is tricky because like
appliances, computers, flat screen TVs, etc. it’s a product where the customer often does an
exhaustive search. I don’t like businesses where the customer rationally considers alternatives.
Furniture isn’t a repeat purchase business. Brand loyalty is low. Credit can be involved. It’s like
someone combined every negative economic aspect a consumer product can have and built a
capitalist’s nightmare.
If it’s between owning a company that makes furniture and a company that makes underwear,
I’m buying the underwear company. If they’re one of the two leaders today they’ll probably be
one of the two leaders in 20 years. And if they have 10% operating margins today, as long as
they run things right, they’ve got a shot at 10% margins in 10 or 20 years whether they make the
stuff in North Carolina, the Dominican Republic, or Vietnam. It’ll fluctuate. But over decades I
kind of know what the return on capital and sales in the underwear business will be for Fruit of
the Loom and Hanes (HBI). The furniture business is the polar opposite of the underwear
business from the customer’s perspective – always the most important perspective – and so I
have no clue what the return on capital or sales in furniture will be in 2020.
It sounds silly to talk about 2020. But my problem is that I don’t believe I have a much better
insight into 2012 than 2020. The future of some businesses is very unclear. The future of other
businesses is roughly clear. Not in the sense that I know what they will make in any one year, but
in the sense I know they will produce free cash flow and earn a decent return on capital. As long
as you buy into a business like that at a low price, the risk of a catastrophic loss on your
investment is very low. Eventually, your purchase will work out.
I don’t think an investment in a furniture company is like that. I think there are real risks even at
low prices, because I think it’s hard to tell if they’ll be clear skies at any point in the future.
If I was looking at the furniture industry I think I would look hardest at retailers (and you know
how little I know about them) and especially distributors. The advantages one distributor has
over another should stay intact better than the advantages of companies on the production side. I
usually prefer the distribution side to production side of most industries anyway. Enduring,
intangible competitive advantages tend to accrue more to distribution than production in non-
integrated industries. So, if I was looking at a stock that would rebound with the furniture
industry, I would look hardest at the distribution side. I would look for a distributor that had been
consistently profitable up until the economy crashed.
The first stock that comes to mind is Craftmade (CRFT).

There are two strikes against this one. One, it doesn’t file with the SEC anymore (you just get
the press releases via the pink sheets website). And two, it doesn’t have a sparkling balance sheet
(an understatement). But the business itself is almost certainly worth more than it sells for if it
had the right balance sheet. A competitor has been sniffing around the company for years now. I
think they bought 15% of the company in a kind of creeping, kind of hostile way.
Since Craftmade is an off the radar micro cap stock that doesn’t file with the SEC, don’t expect
to get timely updates on that situation.
And if you want to read a blogger who actually knows something about turnarounds, take a look
at Variant Perceptions.
 URL: https://focusedcompounding.com/investing-in-turnarounds/
 Time: 2011
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What Broker to Use When Buying International Stocks
The author of a great value investing blog, Value Uncovered, asked me this question on Twitter:
“What broker do you use that supports buying international stocks?”
I use a full service broker.
But I would recommend most people interested in buying foreign stocks start by looking
at Noble Trading and Interactive Brokers.
As far as I know, any full service broker should be able to buy you any stock you want. The
question for full service brokers is whether they want to buy you any stock you want and then
how much they’ll charge. The easiest answer to both these questions is to personally know a
broker at one of the full service firms beforehand and then give him your account with a clear
understanding of exactly what it is you want to do. You don’t need advice. Just execution.
Now, you need to think of things from the other guy’s perspective.
If you’re a super concentrated, go anywhere value investor like me you have two problems. One
is a problem for the investor. The other is a problem for the broker. The investor’s problem – my
problem – is that I want to buy any stock anywhere and the long list of fees normally tacked on
to this sort of thing can pile up to a horrendous dollar amount per trade. However, since I don’t
hold more than 5 stocks at once – from the broker’s perspective – I make a horrendously low
number of trades each year.
You – the investor – need to be assured you won’t have all your gains eaten up by commissions.
But the broker needs to be assured the account will be worth his time.
It would be heartless of you to ask a full service broker to take on this kind of account without
giving him 1% of each round trip in return (0.5% of each order). It would be greedy for him to
ask for more than 2%.
You can work something out in that range. For example, if you have a $200,000 portfolio that
you want to put into no more than 10 stocks at once, each order will be $20,000. If you turn your
portfolio over once a year, you’ll be placing 20 orders – each for $20,000 – each year (after the
first). That means you can pay $100 to $200 on each order (0.5% to 1% of each order) in
commissions to your broker.
Obviously, if you have more money to invest and hold fewer stocks (as I do), you can pay a
higher commission on each order. At my level of concentration – just 5 stocks – you can pay
$200 to $400 on each order and still be paying your broker only 1% to 2% of your $200,000
portfolio each year.
Although numbers like $400 an order and 2% of assets a year sound obscene, they really aren’t if
the service you are getting is worth it.
If a brokerage firm appeared tomorrow that promised it could buy literally any stock anywhere in
the world for me and wanted 2% of assets a year in return, I’d happily make that deal. It would
make my life easier. And it would make my investing – net of commissions – more profitable.
I only look at my returns after commissions. In fact, I only look at my cost in a stock after
commissions. When I tell you my average cost per share in Barnes & Noble (BKS) was this and
my cost in Bancinsurance was that – the “this” and “that” include the total commission divided
by the number of shares. When I’m looking to buy a stock, I double the commission (to account
for selling) and add that amount to the per share stock price. Because that’s the cost of the stock
to me.
If you’re not interested in neglected international stocks, don’t use a full service broker. If you
are – and you run a concentrated portfolio like me – a full service broker might be for you. But
only if you both understand exactly what you want (and don’t want) from your broker and how
much you’re willing to pay going in.
For many people reading this – especially those with less than $200,000 to invest or more than
10 stocks in their portfolio – a full service broker is not the best choice. You should go
with Noble Trading or Interactive Brokers.
But, whoever you go with, don’t just pick the lowest price. For me, a broker who did all my
trades for free but refused to buy any international stocks would actually be more expensive than
a full service broker, because my lost returns would be higher than all the fees I pay.
Remember Warren Buffett’s stories about advertising for Western Insurance in a local
newspaper and manually swapping stock for cocoa beans in his Graham-Newman arbitrage days.
Because of the internet, you don’t have to do those kinds of things today to get the best bargain
stocks. But, if you find a bargain micro cap in France, and your online broker won’t buy that
stock for you – open another account to buy that stock.
That’s what Warren Buffett would do.
“My broker won’t let me buy that stock” is never a valid excuse. If a broker won’t buy the stock
you want, get a new broker.
Brokers are easier to replace than bargain stocks.
And always, always, always actually do the math. If you have to go with a less good idea that’s
5% more expensive than your best idea, actually multiply that 5% times the dollar amount you’re
putting in. That’s the cost of a broker who limits your choice. And it’s often much, much bigger
than what you’d save by sticking with your current broker.
Finally, ask yourself if it’s cost or convenience that’s keeping you with your current broker. I
think most people just don’t want the hassle. They’d rather give up on some French micro cap
than have to open a new brokerage account.
Ben Graham said investing is most intelligent when it’s most businesslike. Business often means
work.
Work like switching brokers.
Do it.
Never let anything get in the way of buying the best bargains.
 URL: https://focusedcompounding.com/what-broker-to-use-when-buying-international-
stocks/
 Time: 2011
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Warren Buffett and The Washington Post
From Warren Buffett’s 1991 Lecture at Notre Dame:

In ‘74 you could have bought the Washington Post when the whole company was valued at $80
million. Now at that time the company was debt free, it owned the Washington Post newspaper,
it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida,
the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000
acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the
International Herald Tribune, and probably some other things I forgot. If you asked any one of
thousands of investment analysts or media specialists about how much those properties were
worth, they would have said, if they added them up, they would have come up with $400, $500,
$600 million…That is not a complicated story. We bought in 1974, from not more than 10
sellers, what was then 9% of the Washington Post Company, based on that valuation. And they
were people like Scudder Stevens, and bank trust departments. And if you asked any of the
people selling us the stock what the business was worth, they would have come up with an
answer of $400 million…It isn’t that hard to evaluate the Washington Post. You can look and
see what newspapers and television stations sell for. If your fix is $400 and it’s selling for $390,
so what?…If your range is $300 to $500 and it’s selling for $80 you don’t need to be more
accurate than that.
 URL: https://focusedcompounding.com/warren-buffett-and-the-washington-post/
 Time: 2011
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How Warren Buffett Thinks About Micro Cap Stocks
The key to understanding why a stock picker like Warren Buffett made his best returns when he
was investing in micro caps is understanding that a neglected stock is more likely to offer a
mispriced bet.
The idea that there’s a trade-off between risk and return only makes sense if people are paying
attention to a stock and correctly pricing it. In other words, the more people are correctly
handicapping the situation, the more there is a trade-off between risk and return. The less people
are correctly handicapping the situation, the less there is a trade-off between risk and return. This
trade-off is not inherent to the situation itself. A fast horse and a slow horse – a good company
and a bad company – only become equal in risk adjusted terms when the necessary and correct
bets are placed to move the odds to the point that equalizes the expected payoff.
The trade-off between risk and return comes from price. And the price comes from the betting
public placing their bets correctly so that favorites pay less and long shots pay more. If the public
bets wrong, there is no trade-off between risk and return.
As Ben Graham said:
“…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, objectively observed prices are the outputs of subjective analysis. Obviously,
both the inputs and the black box – the human minds – into which the data is being input will
together determine the market price.
People set prices using their minds.
And here’s the thing about minds. They work from experience. And they only experience what
they pay attention to.
Here’s William James:
“…one sees how false a notion of experience that is which would make it tantamount to the mere
presence to the senses of an outward order. Millions of items of the outward order are present to
my senses which never properly enter into my experience. Why? Because they have nointerestfor
me.My experience is what I agree to attend to. Only those items which Inoticeshape my mind –
without selective interest, experience is an utter chaos.”
So prices depend on attention.
The mere presence of data means nothing. People have to read 10-Ks. And they have to care
about them. If nobody pays attention to a 10-K, that 10-K doesn’t enter into a stock price.
Because the data in a 10-K only moves stock prices through people’s minds.
If you want to think about it like advertising you can. Some stocks are advertised by analysts and
newspaper reporters and their own well-known consumer brands and products. Other stocks are
unknown because they’re headquartered in the wrong state or wrong country, because they make
stuff you’ve never heard of, and because you just aren’t paying attention to them.
Of course, even advertising is useless unless you pay attention to it. A lot of ads are forgotten
immediately. And very few ads accomplish anything when shown just once. You might only pay
attention to an ad the fifth time it crosses your path. Same thing with stocks. Unless you’re
looking for them. Which works for ads too. If you can put an ad in front of someone who’s
actively looking for that product, that ad has a good chance of being really effective. Most
investors aren’t looking for micro cap stocks. So, it’s really hard to “advertise” micro caps and
actually get someone’s attention.
Information about micro cap stocks just doesn’t percolate through the public quite the same way
it does in big caps.
The best returns for Warren Buffett, Ben Graham – and yes – even me, come from investments
where the public is not paying attention to the stock. It’s neglected. It’s under advertised.
Information is being ignored. Maybe the stock is weirdly distributed by happenstance – as in a
spin-off or a regionally owned stock.
Who knows?
What I do know is that the amount of attention a stock gets is going to skew who’s handicapping
it.
With neglected stocks, most of the people setting the odds – through their bids and asks – are
amateurs instead of professionals.
It’s easier to compete against grannies than hedgies.
So, instead of a correct trade-off between risk and return and fairly equal results for buyers and
sellers – you end up with professionals, insiders, and people who spend hours hunting for these
things winning a lot of money at the expense of amateurs who often know little and care little
about the shares they’re selling.
I owned shares in a profitable company that continually bought back stock from its own
shareholders at a price less than its net cash per share. There is no equality of risk and return in
that situation. There is just the inequality of uninformed and unmotivated amateur investors
losing more and more money in round after round of bad bets made against the company,
insiders, professionals, and bargain hunters who read SEC reports.
In many cases, the sellers do not actually believe they are selling out at a fair price. They are not
rational. They are demoralized.
Since I blog about micro caps, I’ve actually had the pleasure of talking to folks who I realized –
after the fact – were on the other side of trades I made. We realized one of us was buying and the
other selling during the same week. Essentially, we were sitting around the same poker table, or
betting the same race, or whatever gambling analogy you want to use.
Where I was a buyer and they were a seller of a micro cap, I’ve never had the other guy tell me
he thought he was getting fair value. I’ve never had someone tell me they thought the rest of the
stock market was cheaper than what they sold.
Here’s Warren Buffett :
“In ‘74 you could have bought the Washington Post when the whole company was valued at $80
million. Now at that time the company was debt free, it owned the Washington Post newspaper,
it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida,
the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000
acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the
International Herald Tribune, and probably some other things I forgot. If you asked any one of
thousands of investment analysts or media specialists about how much those properties were
worth, they would have said, if they added them up, they would have come up with $400, $500,
$600 million….That is not a complicated story. We bought in 1974, from not more than 10
sellers, what was then 9% of the Washington Post Company, based on that valuation. And they
were people like Scudder Stevens, and bank trust departments. And if you asked any of the
people selling us the stock what the business was worth, they would have come up with an
answer of $400 million.”
Buffett’s point is that people could appraise the company correctly. They just couldn’t think
clearly about the stock. The stock price was set by all these crazy fears swirling around their
heads. Intellectually, they knew the collection of properties the Washington Post owned could be
sold for close to $400 million. But emotionally they didn’t want to hold the stock when it priced
the company at just $80 million.
I see the same thing when people sell micro caps they know are good values. The seller never
quite says the stock is overvalued. Or even fairly valued.
What they almost always say is how disgusted they are with the stock. How beaten down and
mistreated and just kind of vaguely hopeless they’ve become.
They know the stock is cheap, but they don’t see a way out. They can’t visualize success.
I think this success visualization thing is actually a big part of why some neglected stocks offer
such good returns. I don’t want to delve into people’s brains and dredge up some wild theories,
but I can’t help but notice that most investors are obsessed with visualizing the exact scenario
under which they win.
That’s whacky.
I’ve said before that about 1 in 5 of the stocks I buy ends up getting taken private or bought up
by another company. Usually, I don’t plan this outcome ahead of time. I have done it a few
times, and my record of buying into situations where a buyout seems likely is pretty mixed. Just
buying stocks that are so cheap the buyout would happen at a 50% or 100% premium – that tends
to work best whether or not the buyout ever comes.
People really do try to visualize success. They want to know the exact winning scenario.
It doesn’t work that way.
Whenever I’m tempted to visualize my success, I try to snap out of the daydream. I can’t control
outcomes. I can only control process.
Visualizing success is a mental crutch. It biases you to seek out situations where the exit is clear
instead of situations where the difference between value and price is greatest.
Visualizing owning the stock makes more sense. How will I feel when it’s down 20% next
month. Will I buy more? What if they stop buying back stock? What if they suddenly dip into the
red for a quarter, a year, or 3 years? What if they go cash flow negative? What if they actually
issue more shares?
I visualize the things that I know will scare me the most. I try to avoid stocks where this bad stuff
will happen. Not just because I think these are bad, bad things –but because I know I’m a wimp
when it comes to these particular reversals.
I want to make sure I’m willing to hold a stock forever if need be.
I’ve tried to condition myself to work in a very specific way. I’ve tried to not focus on
visualizing possible outcomes or thinking about catalysts and stuff like that. I have done that at
times in stocks like Barnes & Noble (BKS, Financial) and look how well that worked out.
Instead I try to only think about owning the stock. I never think about my next move after that. I
don’t have a game plan. I don’t have a strategy.
I have a principle. The principle is to always be in the best position. Always own the cheapest,
highest quality businesses you can. If you can improve your position by selling one and buying
another, do it.
But don’t think you’ve got the future figured out. Because I know I never do.
I’ve taken this approach to an absurd extreme lately.
I now appraise all my stocks apart from their current market value and prepare an actual account
summary in non-market terms. Instead of just looking at the daily updated portfolio in terms of
the market quote, I also list the net current assets and the 10-year average free cash flow for each
stock and then multiply that by the number of shares I own of each stock and total it all up.
Sometimes it helps to see just how much cash, receivables, and inventory I own.
And how big a stream of look through free cash flow my portfolio should produce in a “normal”
year.
It sounds silly. And it is. But we have to play these silly head games – or at least I do – or I might
end up misthinking a stock in such a way that I do something stupid.
I take thinking about my own thinking very seriously. And I take micro caps very seriously.
Most investors don’t.
It’s understandable that professionals ignore micro caps. They can’t put enough money to work
there. But why do individual investors seem to buy and sell micro caps so glibly?
I don’t know.
I know from talking to some folks that the lack of press and analyst coverage is part of it. Often
the same negatives like related party transactions, takeover defenses, and cash hoarding that
occurs in lots of companies both big and small suddenly makes them very worried when it’s a
micro cap. When analysts or the press write about these issues, they become less scary. I guess
it’s fear of the unknown.
Actually, I don’t think so.
I’ve come to believe it’s just the lack of confirmation. When I write about a micro cap stock
someone owns, they feel differently – better somehow – than when they find the micro cap
themselves and never hear its name mentioned by another soul.
None of us like to feel alone. We start to question our sanity.
Personally, I’ve started to lean a bit the other way. When I read another value blogger – even one
I respect tremendously – write about a micro cap I own, I start to question whether maybe we’re
both fooling ourselves. I know how strong the urge is to welcome a familiar face to our little
neglected stock owners support group. You have to find a way to offset that. A stock can’t
rationally be any more attractive just because a blogger I like is buying it.
But emotionally it feels that way.
I think that’s the trade-off in neglected stocks. It’s not a trade-off between risk and return. It’s a
trade-off between mental comfort and discomfort. Most people don’t feel good owning neglected
stocks. They don’t feel comfortable.
When you’re alone in a room trying to think something through there’s often this mental tension,
like your brain is going to snap, and the tendency is to quickly choose something – anything –
just to make the tension go away.
Experts, analysts, friends, reporters – maybe even a simple product review – give us a convenient
excuse to break that tension. We go: “Oh, good, they love the Nook. Now I can buy Barnes &
Noble.”
With a neglected stock, there’s nothing outside your own mind that you can use to break the
mental tension. You’re the only person reading about it. It’s just you and EDGAR. Your doubts
can only be cleared up by your own thinking.
Prices are observed objectively but made subjectively.
Stock prices are determined not by the objective landscape but by the overlapping subjective
mindscapes of the buyers and sellers.
People don’t just face a trade-off between risk and reward when they buy a stock. People also
face a trade-off between brain pain and brain pleasure when they think about a stock.
There’s even a trade-off between using your scarce mental resources to pay attention to a stock
or doing something else.
The best investments Warren Buffett and Ben Graham made were where they turned their
attention – and allocated their scarce mental resources – to a stock nobody else was attending to.
Ben Graham’s investment in Northern Pipeline is a great example:
“One day I was looking through an annual report of the Interstate Commerce Commission to
obtain certain detailed data regarding railroad companies. At the end of the volume I came
across some statistics of the pipeline companies, which the tables said were ‘taken from their
annual report to the Commission.’ It occurred to me that such reports might contain information
not sent to stockholders…The next day I took the train to Washington…and asked to see the
annual report of all eight pipeline companies…To my amazement I discovered that all of the
companies owned huge amounts of the finest railroad bonds…Here was Northern Pipeline,
selling at only $65 a share, paying a $6 dividend while holding some $95 in cash assets for each
share…Talk about a bargain security!”
Nobody is saying neglected stocks are a free lunch.
I’m just saying folks are worried about the wrong trade-off. They’re imaging there’s this
especially potent trade-off between risk and return in micro caps. Quite the opposite, the trade-
off between risk and return is found most in big caps. The less risky they are, the less reward
they offer. It’s amazing how well people handicap some of the blue chips.
The trade-off you need to worry about in neglected stocks like micro caps is different. It’s the
trade-off Warren Buffett and Ben Graham made. They applied oodles of brain power to stocks
nobody else was looking at. They bought things that didn’t offer any psychological solace in the
form of acceptance by their peers or the ability to visualize future success. They turned their
attention to things other people ignored.
Simply put, they behaved bizarrely.

They stood out from the crowd and risked looking foolish.
The trade-off these men accepted was that they could get market beating returns by taking on
mental burdens. They either had to endure the brain pain or condition themselves not to feel it.
My advice to those who want to follow in the footsteps of Ben Graham and Warren Buffett is to
condition yourself to buy the stocks everybody else is neglecting.
Don’t accept the trade-off between risk and return. Instead, choose to make the trade-off between
feeling good and investing well.
Ben Graham took a train to Washington. Warren Buffett took out a newspaper ad to buy an

illiquid stock.
These guys didn’t just pick different stocks. They thought differently about stocks.
They turned their attention to things nobody else was looking at.
You can to.
Just focus on neglected stocks.
 URL: https://focusedcompounding.com/how-warren-buffett-thinks-about-micro-cap-
stocks/
 Time: 2011
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Where to Find Micro Cap Stocks
In yesterday’s GuruFocus article “Warren Buffett: How to Make 50% a Year in Micro Cap

Stocks”, I mentioned this Ben Graham quote:
The chief practical difference between the defensive and the enterprising investor is that the
former limits himself to large and leading companies whereas the latter will buy any stock if his
judgment and his technique tell him it is sufficiently attractive…The field of secondary stocks
cannot be delimited precisely. It includes perhaps two thousand listed issues and many
thousands more of unlisted ones which are not generally recognized as belonging in the
category of “large and prosperous market leaders”…The intelligent investor can operate
successfully in secondary common stocks provided he buys them only on a bargain basis.
So how do you find these secondary common stocks?
Here are 6 places to start:
1. Greenbackd – Toby Carlisle writes this great blog about Ben Graham bargains or
“undervalued asset situations with a catalyst” as he calls them. I interviewed Toby last year.
2. Cheap Stocks – Jon Heller writes this equally great blog about Ben Graham net current asset
bargains. Actually, as Toby mentions, Jon was part of what inspired him to write his own value
investing blog. I also interviewed Jon last year.
3. Interactive Investor Blog – Richard Beddard writes this U.K. centric Ben Graham style value
investing blog. He runs a model portfolio called The Thrifty 30. “It’s thrifty because the shares
are all cheap, usually in comparison to their average profits over the last ten or-so years.” The
Thrifty 30 is a double whammy of off the beaten path stocks for American investors since
Richard focuses on secondary stocks and he focuses on the United Kingdom. Most American
investors aren’t even familiar with leading U.K. companies. They’re totally clueless about the
ones Richard covers.
4. Value Uncovered – This value investing blog covers “mostly small-cap, obscure stocks
trading at a large discount to intrinsic value” as well as “merger arbitrage, going private
transactions, self-tender offers, (and) bankruptcy plays”. Things you won’t see covered by
financial journalists or stock analysts.
5. Shadow Stock – This is a micro cap value investing blog. It gives you a steady steam of quick
posts about almost totally unknown value stocks. No matter how much you think you know
about micro caps, you’re bound to find a couple stocks here you’ve never heard of.
6. Whopper Investments – This is another value investing blog that often features micro caps.
Last year I was searching for any mentions of some micro caps I owned and twice found this
blog was one of the only places that mentioned the stock. Whopper Investments often covers
stocks you won’t hear about elsewhere.
The other reason a stock can be neglected is because of a special situation. A good example
is Ascent Media (ASCMA) – a John Malone investment – selling one business and buying
another, all while remaining the same publicly traded stock. That can cause investors to misprice
the stock. Other examples of special situations include spin-offs and companies coming out of
bankruptcy.
Here are 3 places to find special situations:
1. Special Situations Monitor
2. Stock Spinoffs
3. Distressed Debt Investing
The place to go for any micro cap stock is OTCMarkets.com. This is the pink sheets website.
Type in a ticker symbol and see the bids and asks for that stock. There’s also a detailed day-by-
day price and volume history, so you can plan how many shares you can buy and how long it’s
likely to take you to build the position you want.
Finally, since these are unknown and uncovered stocks, you’ll be doing all the company research
yourself using EDGAR.
 URL: https://focusedcompounding.com/where-to-find-micro-cap-stocks/
 Time: 2011
-----------------------------------------------------
How I Got Started In Value Investing
I started investing in stocks when I was 14. I didn’t have any real strategy or philosophy. I just
tried to buy simple businesses for below average prices. I bought shares of grocery stores, snack
food companies, etc. Examples of stocks I bought back then include Village Supermarket
(VLGEA), J&J Snack Foods (JJSF), and Activision (ATVI). This was around the time the dot
com bubble reached it’s height (like 1998-2000). Many of the stocks I bought were in my home
state of New Jersey. I tried to stick to things I was familiar with. I was completely buy and hold
back then.
My Dad read an article about Ben Graham. At this point, I was picking all the stocks for my
Dad’s portfolio and he thought Ben Graham’s approach sounded like mine. I always started with
the balance sheet. Mostly because as a teenager, I had no accounting experience, so the income
statement was harder for me to understand. I was pretty much a balance sheet and cash flow
statement guy. Mostly, I still am.
Anyway, when my Dad told me about Ben Graham I went out and bought Security
Analysis and The Intelligent Investor. I read them and was hooked. After that, I tried to learn
everything I could about Warren Buffett’s partnership days and Graham-Newman’s actual
operations. I collect Moody’s Manuals from the 1910s to 1940s so I can look at the stocks Ben
Graham mentions in his memoirs and Graham-Newman lists in their annual reports. Things like
that.
I realized that Buffett and Graham both did best when buying really tiny, illiquid, unknown
stocks. Graham did better than 20% a year just in net current asset stocks. And Buffett really
does seem to have done 50% in his personal portfolio in the early 1950s. Their better known
investments were good – but with the exception of GEICO – never really on the level of those
kind of returns they were getting in tiny, unknown stocks.
So that’s become my focus over the years. I turn over my portfolio much more now. I’m willing
to sell anything when I find something clearly cheaper. I’m not buy and hold. But I try to own
very, very few stocks. Basically, I try to copy Warren Buffett’s approach to his own personal
portfolio.
Unfortunately, what I invest in and what I write about doesn’t always match. Most readers are
interested in bigger stocks. So I write about them most of the time.
My true love is really tiny, off the map stuff. Bancinsurance is probably the best example of what
I invest in. I only managed to buy about 0.5% of the company. So, it wasn’t a huge financial
success. But it’s the clearest example of what I look for these days.
 URL: https://focusedcompounding.com/how-i-got-started-in-value-investing/
 Time: 2011
-----------------------------------------------------
How to Get Started in International Value Investing
Hi Geoff,
I am a student and am very interested in international value investing. I was wondering if you
had any advice for me or if you knew of any people out there who are dedicated to this area
(both gurus as well as bloggers). If you could recommend any resources I would highly
appreciate it.
Best,
Ben
Start by limiting yourself. Pick which countries you will invest in and which countries you
won’t. I recommend drawing your circle of competence around these 22 countries:
1. Denmark
2. New Zealand
3. Singapore
4. Finland
5. Sweden
6. Canada
7. Netherlands
8. Australia
9. Switzerland
10. Norway
11. Iceland
12. Luxembourg
13. Hong Kong
14. Ireland
15. Austria
16. Germany
17. Barbados
18. Japan
19. Qatar
20. United Kingdom
21. Chile
22. Belgium
Those are the 22 countries perceived to be less corrupt than the United States according
to Transparency International’s yearly index. It’s not a perfect list. But it’s a good list. It’s pretty
close to what I’d tell you myself. And it has the benefit of not being one guy’s biased opinion.
Download Google Chrome. And bookmark the CIA World Factbook.
Chrome will translate websites from foreign languages into English for you. And the Factbook is
the best guide to the world’s economies.
Make Bloomberg your financial portal. It has the best international ticker search.
Read Hidden Champions of the Twenty-First Century. It’s a good introduction to foreign

companies. Mostly from German speaking countries.
American value investing shops that are heavily into foreign stocks include First Eagle, Third
Avenue, and Wintergreen. Thomas Russo also likes foreign stocks. You can watch 3 lectures
Russo gave to Professor Greenwald’s class here.
Some of my favorite value investing bloggers aren’t U.S. based. The author of the Interactive
Investor Blog is in the U.K. The author of Greenbackd is in Australia. And the author of Variant
Perceptions is in Mexico.
You can listen to me interview the author of Greenbackd here.
Richard Beddard of the Interactive Investor Blog isn’t just based in the U.K. He actually focuses
on U.K. stocks. His blog is a must read.
Other U.K. blogs include UK Value Investor’s Diary, 10 Value 10, and The Sunny Day Investor.
A lot of blogs include lists of other blogs the author reads. Go through the list. Click on each
blog’s name. Use a feed catcher like Netvibes to subscribe to any of them that interest you. I
subscribe to about 50 blogs. You could easily manage several times more.
You can do the same with Twitter. Pick an investing blogger you like who invests outside the
U.S. Then use him to find other value bloggers in the same country. Repeat.
Stock exchange sites are insanely difficult to navigate. Usually, you can use the sitemap to find a
buried page that lists all the securities alphabetically. For small countries, this is ideal. If you’re
looking at New Zealand or Ireland, you want to just go through the whole list the way Warren
Buffett flipped through Moody’s Manuals in the 1950s. Frankly, there are fewer stocks in these
countries than there were in those manuals.
Often, it’s easier to find companies if you think like a non-investor. Let’s say you’re interested in
Japanese stocks. Do you like publishers? If the answer is yes, just Google “List of Manga
Magazines”, the result will be a list of manga magazines which includes the publisher of each
magazine. You can copy and paste their names into Bloomberg and see that some are public
companies.
Obviously, we’re always looking for good businesses.
To make the search more efficient you want to focus on certain industries. You’re not likely to
go looking for a Bancinsurance type company in Japan. Most property and casualty insurers earn
low returns on capital. It’s too much work to hunt down the one that doesn’t in some country
you’ve never been to.
Instead, you want to look at industries that have the potential for high returns on capital. The
obvious way to do this is to find types of companies in the U.S. that earn high returns on capital
but are still mostly domestic.
Why?
Because that means there have to be a lot of foreign versions of that company.
Obvious examples include sports, publishing, food, and drinks.
You’ll find the best investment opportunities are in smaller stocks that are completely unknown
outside of their home country.
My list of 26 things I look for in a stock works just as well in other countries as in the U.S.:
1. Market capitalization under $100 million

2. Low float
3. Foreign – especially from a small country
4. Not listed in home country
5. Controlling shareholder (maybe owns 30% – 70%) runs company
6. Long history of free cash flow
7. Share buybacks that reduce the share count – especially if done every year
8. A Dutch auction to buy back a lot of stock at once
9. Delisted
10. Just spun-off
11. Huge, one-time problem (think American Express Salad Oil scandal)
12. Bankruptcy in past caused by legal trouble
13. Hostile takeover attempt by someone who owns good chunk of company’s shares
14. Mismatch between reported earnings and free cash flow – FCF is much higher
15. Accounting quirk – amortization, carrying at cost, owns part of another public
company
16. Selling for less than cash and investments
17. Selling for less than net current asset value
18. No analyst coverage
19. Niche business
20. Lack of price competition – or the price leader
21. One of a kind business
22. Wrong time in cycle to buy this kind of stock: advertising, credit, homes, autos
23. Goodwill write-downs and restructurings cause reported losses when making money
24. “Too much uncertainty”
25. Nowhere near a 52-week high
26. Stock once traded at several times today’s price
 URL: https://focusedcompounding.com/how-to-get-started-in-international-value-
investing/
 Time: 2010
-----------------------------------------------------
How to Come Up With Investing Ideas
Hi Geoff,
…I was wondering if there was any other advice you had on how to pick what companies I
should look into. You mention a few blogs that I should look to for ideas but what about stock
screens? Should I employ those in order to get a rough list of stocks and then choose a few and
analyze them by reading their 10-K, etc.? I am just worried I am not sure how to get all the
stocks to read their 10-K…
Best,
Phil
You won’t run out of ideas.
Start with one idea and follow that thread wherever it leads. Don’t obsess about any one stock.
Just sketch the investment idea quickly in your mind. Does it grab you? No. Then move on.
You can use screens. I recommend Magic Formula Investing, GuruFocus, Morningstar,

and RobotDough.
GuruFocus also has 2 newsletters for subscribers to the site. One is about Ben Graham NCAV
bargains. The other is about Warren Buffett / Charlie Munger bargains.
Use Bloomberg to “watchlist” stocks. Whenever you find an interesting company, go to

Bloomberg.com. Type the company name in the blank box in the upper right of the screen. It will
give you the symbol (and exchange) of the stock you want. Click on that stock. To the right of
the stock price, you’ll see an option that says “+ Add Security to your Watchlist”. Do that. You’ll
need to create a Bloomberg.com account for this. It’s free.
The beauty of the watchlist is that Bloomberg tracks the stock’s percentage price move since you
watchlisted it. Once a week, log into Bloomberg and just look at the stocks that are red. If the
company was interesting when you first saw it, it’s even more interesting now that it’s cheaper.
Bloomberg is the best place to follow foreign stocks. So enter any names you get from
reading Richard Beddard’s blog over there. Don’t try to track foreign stocks at sites like Yahoo
and Google. Or at your American broker.
That brings me to another point. Pick the right broker. If you’re looking to invest like Benjamin
Graham and Warren Buffett, don’t use Charles Schwab. Go with an online discount broker that
does international and over the counter stocks well like Noble Trading or Interactive Brokers.
Here’s the big mistake most investors make. They refuse to follow their best ideas!
Right now, some people reading this thought: “Really? I have to switch brokers?”
Nutty, I know. But totally true.
Someone will hear about some little company that trades in New Zealand or Denmark and
realize Morningstar, GuruFocus, EDGAR, etc. doesn’t have financial data on that stock. Or their
broker won’t do a trade there. So they don’t follow up on the idea.
Never limit yourself because you can’t get data on the company. Screens limit you. Pretty soon
you’re focusing only on screens that are running in just the universe of stocks known to the
website you happen to use. Don’t do that. Lots of companies have their own websites with
archives of their annual reports.
Here’s all the financial data you need on Egetaepper, a Danish carpet company. And here’s the
financial data you need on Delegat’s, a New Zealand wine company.
Where did I find these companies?
Here’s a list of small-cap companies trading in Copenhagen. Start with the A’s.
And here’s the entire New Zealand Stock Exchange.
I’ve got as many stocks to choose from in New Jersey.
Investigating a list of stocks from your own home state would be pretty cool, right?
It’s also easy to do. If you’re a Morningstar subscriber just go to Tools > Premium Screener >
Stocks > State – Location of Company and select the abbreviation for your home state. Now,
you’ve got a list of stocks for your home state. For Michigan, I’m guessing it’ll take you a little
over 3 months if you go through the list at a speed of one stock a day without taking any days
off.
Do you subscribe to any trade publications?
Warren Buffett does. He reads American Banker, Beverage Digest, and Furniture Today, among

many others. If you liked my Barnes & Noble (BKS) posts, you can subscribe to Publisher’s
Lunch for $20 a month.
Really, you don’t even have to spend money to do this kind of research. When I type “2010
combined ratios” in Google, the 6th result down is a list of the top 100 insurance groups and their
combined ratios for 2009 and 2008 from National Underwriters.
Read company presentations. They often mention customers, competitors, and suppliers.
Walk a grocery store. Store aisles are visual representations of industry structure. Look for the
manufacturer names on breakfast cereals and soft drinks. Notice how many “competing” brands
are made by the same company. Look at the store brands. Some carry specific warnings like:
“This product is not manufactured or distributed by Prestige Brands, Inc.”
Don’t you want to own a trademark that drugstores are so desperate to infringe on?
You can. Prestige Brands (PBH) is a public company.
Think of the name of a big business you think also happens to be a great business.
Maybe McCormick (MKC).
Google Finance kindly provides the names of “related companies”. In this case, you get:
Campbell Soup (CPB), Tree House Foods (THS), Heinz (HNZ), Conagra (CAG), General

Mills (GIS), Ralcorp (RAH), and J.M. Smucker (SJM) among others.
Always have a pad of paper with you. Write down company names you come across when
researching a stock.
And that’s the problem with screens. I don’t mind you using them sometimes. But your best
ideas are going to come from reading blogs, annual reports, investor presentations, trade
magazines, and all sorts of other things that get you thinking about the business.
That’s why I say you should move quickly and just sketch your investing ideas. You can tell if
it’s interesting or not from a sketch. I knew I was interested in Bancinsurance at the right price.
Because it was a niche insurer with a good combined ratio. That was the sketch. If
Bancinsurance had been a reinsurer, I wouldn’t have followed up on my sketch. It wouldn’t have
excited me.
Researching stocks is a lot like writing. You start with a quick mental sketch. Then you ask: “Is
this a good idea? And does it excite me?”
If the answer to both questions is yes, then you can worry about really analyzing the company in
detail. But you want to start with a good idea and the feeling that you can squeeze something
good out of that idea.
That’s why you need to pick your spots. It could be specific screens like net current asset
bargains. Or it could be specific industries.
Usually, the connections are more abstract than that. It’s more like working in the same genre.
It’s hard to define a genre. But you recognize the members of that group when I name them.
Think about some of the stocks I’ve owned and mentioned on this blog: IMS Health, Omnicom
(OMC), Fair Isaac (FICO).
Think about how similar those businesses are.
Technically, they may not be in the same industry. But, they’re very much in the same genre of
investing ideas. Each company immediately excited me when I sketched the idea.
That’s what you’re looking for. You want to learn a theme. And then just keep looking for
variations on that theme.
 URL: https://focusedcompounding.com/how-to-come-up-with-investing-ideas-2/
 Time: 2010
-----------------------------------------------------
Should You Learn Investing By Reading or Doing? – Geoff’s Advice to a

College Junior
Hi Geoff,
I am a junior in college who only recently has stumbled upon the realm of value investing. At
this point, I have read Margin of Safety, You Can Be A Stock Market Genius, parts of The
Intelligent Investor, and have recently begun Warren Buffett’s essays. As a part of my
schoolwork, I have taken basic courses in corporate finance, financial accounting, and capital
markets.
What I am wondering is how I can best allocate the free time I devote to learning about investing
in order to maximize its learning potential, as I am a busy college student now, and will
hopefully be a busy employee in the future. But far from not knowing where to turn, I am rather
overwhelmed by the wealth of good resources there are out there concerning value investing,
between books, articles, and blogs such as yours.
So my question is: what activity would best serve my education in investing right now, given my
elementary exposure to the field? I am under the impression from my research that the best way
to learn about value investing is to do it. However, value investing is a long and tedious
process, involving a lot of searching and reading, often times about company-specific knowledge
that in themselves don’t really teach much in terms of the art of investing. Would it be more
educational for me to simply pick good ideas from books and blogs and try to “reverse
engineer” the thought process at this point? Or have I gotten ahead of myself, and should read
more classics / take more advanced courses in corporate finance before going further?
Best regards,
Vincent
Learn by doing.
Don’t worry about abstract theories. Start work on specific stocks. Steal someone else’s ideas
and study those stocks. I wrote a post about four microcaps: Birner Dental Management
Services (BDMS), George Risk Industries (RSKIA), Solitron Devices (SODI),
and Bancinsurance (BCIS). Three of those four companies are still around.
Pick one of those three companies. Go to EDGAR and find their latest 10-K. Print it out.
Take the 10-K, a pen, a calculator, and a highlighter to the library. Highlight any phrases that
sound worth remembering. Don’t overdo it. Be honest. Just highlight the stuff that sounds like it
could swing you one way or another on buying the stock. A good way to do this is to imagine
you’re running a conglomerate that is considering buying this business in its entirety. You’ve
asked someone working for you to study the company and present the acquisition opportunity to
you – in conversation, not a written report – tomorrow morning. What would you want him to
highlight?
That’s what you highlight.
Use the pen to write notes in the margin. For me, these are usually questions or calculations.
Don’t take random notes. Follow a thread. Like an interviewer. Imagine the 10-K isn’t just
written text but a real person sitting in front of you. What would your follow-up questions be?
Write them in the margins.
When you finish the last page of the 10-K, head back to your dorm. Don’t look at the 10-K.
Don’t think about the stock.
Ask yourself if there’s anyone from those accounting and finance classes you could bribe into
listening to you talk for 5 minutes.
There is? Good.
Tomorrow morning you’re going to buy him a coffee. Or more plausibly, tomorrow evening
you’re going to buy him a beer.
Once he’s got a free drink in front of him, you tell him about the stock. You don’t need a
stopwatch. But you do need to finish your story before he finishes his drink. And you need to
respond to anything he says. Those are the rules.
If you can do that, you’ve learned a lot.
Imagine you show someone your portfolio and they ask: “What’s the story with that stock?”
Here’s how I answered that question for 2 stocks I owned:
George Risk Industries
The stock was stupid cheap. So I expected to find George Risk’s actual business was worthless. I
looked at the 10-Q and the past 10-Ks. I saw the business was worth a lot. The stock price was
95% covered by George Risk’s stocks, bonds, and cash. If you bought the stock: you got the
business for free. So I bought the stock.

Bancinsurance
The CEO was offering to buy the company for $6 a share. That was 0.7 times tangible book
value, 4.9 times pre-tax earnings, and 6.2 times after-tax earnings. Bancinsurance had operated
at a combined ratio below 100 in 25 of the last 28 years. I didn’t know of any acquisitions of
adequately capitalized property/casualty companies with underwriting histories like

Bancinsurance’s done at multiples that low. You could buy the stock at the same price the CEO
was offering. So I bought the stock.

You need to learn how to do this.
I don’t just mean you need to learn how to tell the premise underlying your stock purchases. You
need to recognize a great premise when you see it.
That won’t come from general reading.
Joel Greenblatt’s “You Can Be a Stock Market Genius” is great because it gives you specific
stocks Joel Greenblatt bought and explains the premise behind each purchase.
But you’re really only going to learn by doing.
The best thing for you to do right now is take a stock idea from this blog –
or Greenbackd or Street Capitalist or Variant Perceptions or Cheap Stocks or Interactive
Investor – learn its story and then tell that story to someone else.
Do one stock a week. It won’t take much time. Just read one 10-K every Thursday and tell one
stock story every Friday.
You’ll learn.
 URL: https://focusedcompounding.com/should-you-learn-investing-by-reading-or-doing-
geoffs-advice-to-a-college-junior/
 Time: 2010
-----------------------------------------------------
What Jobs Prepare You for Running a Value Fund? – Geoff’s Advice to a
College Senior
I am currently a senior in college and well underway with my job search. I have, since grade
school, been devoted to the works of those prominent within value investing…Since about the
same time I have managed a personal portfolio geared toward their ideas. Ideally, I see myself
within the next ten years starting a value-oriented hedge fund. The issue that I have been pressed
with lately is what type of job to get now, knowing… managing people’s money through a fund is
eventually what I want to be doing…do you have any perspective or advice in terms of the types
of jobs that would better prepare me for eventually running my own fund?
It’s hard to know what experience will be worthwhile.
Graham started as a bond salesman. He was a terrible salesman. But he learned Lawrence
Chamberlain’s bond book. You can read Graham’s early writings and see that all Graham really
did was apply the ideas of bond investing to common stock investing. That was revolutionary. If
Graham had learned stock investing the way it was practiced in his day, would he have taken the
same revolutionary approach?
Probably not.
Peter Lynch was an analyst. That probably taught him how to run a fund his way. Lynch was big
on meeting with management and finding the exact moment when a company’s fortunes were
turning. That’s analyst stuff.
Charlie Munger was a lawyer. Michael Burry was a doctor. What does this tell us? Nothing
really. The important thing is that at some point you get completely and totally focused on
investing. What you did professionally – even if it was in finance – is often very secondary. It
might be meaningless. A lot of investors learned more in their off hours than at their job.
But can you combine learning investing and a career?
You can certainly try.
Here’s how…
Find people you respect. Phil Fisher was not a value guy. Warren Buffett had a lot of respect for
him. Try to work for someplace you think does what they do well.
My other advice is to choose someplace smaller and younger.
You can always go to a bigger place later. If you have a choice, pick someplace where they
might actually let you do something. Go someplace where there’s more work than workers.
And then just stay in touch with all the value people you meet. Don’t just send me one email.
Keep emailing me whenever you have an idea.
Write down the names of any bloggers, analysts, reporters, fund managers, anyone you come
across that you respect. You like an insight of theirs or whatever. Write the name down and keep
the name. Contact them. If you can make it about a specific stock and tell them something they
don’t know, they’ll listen. Keep talking. Do the maximum amount of socially acceptable
conversing about stocks.
Make it a rule to never say “no”. If someone asks you to do anything investing related – whether
it’s for pay or not – always say yes. You’ll learn something. They’ll remember your name.
Your best bet in any industry is to find people you respect and then figure out a way to do them a
favor. Repeat that over and over while working at whatever job pays the bills. Write an investing
blog. Manage your own account. You’ll do fine.
By the way, the most important thing you did was get into stocks at a young age. If you’ve been
reading about Buffett and Graham and buying stocks for yourself since before you were in high
school, you will be successful as a professional value investor.
How skilled you are at investing is mostly a result of how long and intensely you’ve practiced. A
lot of great value investors were very good when they were very young. They just weren’t
recognized at the time.
 URL: https://focusedcompounding.com/what-jobs-prepare-you-for-running-a-value-fund-
geoffs-advice-to-a-college-senior/
 Time: 2010
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Getting Started: What Should a New College Graduate Do to Get a Career in

Investing? – 2 Tips
I graduated college this past May and I am working in finance in Manhattan…What type of work
experience would you recommend for a recent graduate other than reading SEC filings and
managing their own portfolio?

#1 Write a blog.
Each of the 5 investing bloggers I interviewed said blogging makes them a better investor. Write
about the stocks you’re studying. Tell people what you find in the SEC reports. And tell them
what you think it means.
If you give out your email address – like I do – you’ll get emails. Trust me. You’ll hear from
professionals, amateurs, students and everyone in between. And if you blog about a stock they
own: they’ll tell you what you got right and what you got wrong.
I don’t allow comments on this blog. That’s not because I’m trying to limit speech. It‘s because
I‘m trying to increase the number of emails people send me.
When the subject is stocks: most people are more comfortable emailing you. Most the bloggers I
interviewed had the same experience I did. You’d get comments. But the best comments came
from emails. Some of this is legal. Most of it is cultural. People like to talk stocks in private.
#2 Write Research Reports
When Benjamin Graham came to Wall Street he was a 20 year old college grad. He’d been
offered 3 teaching positions at Columbia: Math, English, and Philosophy. He was clearly suited
for an analyst job. Guess what? The firm that hired Graham made him a bond salesman.
So how did Graham get an analyst job?
He wrote a research report about the Missouri Pacific Railroad. No one paid him to do it. He just
did it. A friend of his shared it with another firm – not the one Graham worked for – and they
liked it. But they weren’t interested in shorting the Missouri Pacific. It wasn’t the idea they liked.
It was the author. They offered Graham a job as an analyst.
Graham’s bosses realized they had to make Graham an analyst if they wanted to keep him.
And I didn’t tell you the most important part of the story. The firm Graham worked for didn’t
have a statistical department before Graham. They didn’t have analysts. They created a new job
for him. Because they saw he was good and wanted to keep him.
The job you have now probably doesn’t let you do the work you want to do. It probably doesn’t
let you show people what you’r best at. So use your free time to do the work you want to do. If
you’re good at it: someone will pay you for it one day.
It’s hard for people to see you’re good at something if the job you’re in doesn’t let you show
those skills.
Make report writing a hobby. It will make you a better analyst. It will make you a better writer.
And it will give you something to show people who can get you your dream job.
It’s also the easiest way to connect with other value investors. If you analyze a stock on a blog –
or in a report – other value investors will be interested in reading what you write. They’ll share
their ideas with you.
All this depends on what your job is and what you want to do. Use the job you have to support
you. But make sure you set aside some time outside of your job to do the work you really want to
do.
Some people fool themselves into thinking that because they’re working in the right industry – or
for the right firm – they’re already on track for the career they really want to do.
But remember Benjamin Graham’s example. Or Warren Buffett’s. After Buffet got out of
Columbia and before he went to work for Graham-Newman – he was a stock broker.
I’m not sure that was a useful experience. Buffett didn’t have a lot of choices then. Graham
wouldn‘t hire Buffett at first. So Buffett kept sending ideas to Graham. And he wrote some
pieces analyzing stocks.
Doing everything I’ve said here really doesn’t take more than 30 minutes to an hour a day. Take
that time each day and write about stocks outside of work.
The internet makes that easy. Feel free to send me anything you write. I’ll give you my thoughts.
If it’s good – I’d be happy to share it on the blog.
That goes for anyone. Send me your investment writing and I’ll send you my honest thoughts.
 URL: https://focusedcompounding.com/getting-started-what-should-a-new-college-
graduate-do-to-get-a-career-in-investing-2-tips/
 Time: 2010
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Investing Ideas: Where Does Geoff Get His Investing Ideas? – Screens, Blogs,
and 4 Examples
“So, where do you get your investing ideas?”
I can’t answer that.

Some fiction writer – I’m going to say it was Stephen King in On Writing but I’m probably
wrong – said writers can’t tell you where they gets their ideas. All they can really do is tell you
where they got this one idea.
It’s the same with investing ideas. I can tell you where I got a specific idea. I can’t tell you where
I get my ideas generally. Because I don’t know.
Idea #1
I got the idea for Bancinsurance (BCIS) from a screen.
Back in 2006: I screened for insurers trading below book value. I threw out most insurers that
passed the screen. I wanted an insurer with a long history of low combined ratios.
Bancinsurance had a low combined ratio – that means a high profit margin – in most years. And
it had a niche.
This was during Bancinsurance’s bail bond reinsurance problem. So I just followed the stock. I
didn’t buy. I kept Bancinsurance in mind. It got real cheap during the 2008 crash. But I was busy
looking at other stocks. Then: the bargain stock herd was thinned by the 2009 rally. So my
options were limited. My opportunity cost was low.
The SEC dropped their investigation. And I bought Bancinsurance stock.
The original screen was simple:
Industry = Property/Casualty Insurance
Price-to-Book < 1
Idea #2
Where did I find Solitron Devices (SODI)? Easy. I got it from Greenbackd. There was a guest
post on Greenbackd. It was good. So I looked into the stock.
Idea #3
I got the idea for George Risk Industries (RSKIA) from another blog post. This one was by
Ravi at Rational Walk. It sounded interesting. The stock was stupid cheap. So I expected to find
George Risk’s actual business was worthless. I looked at the 10-Q and the past 10-Ks. I saw the
business was worth a lot. The stock price was 95% covered by George Risk’s stocks, bonds, and
cash. If you bought the stock: you got the business for free. So I bought the stock.
Idea #4
I got the idea for Birner Dental Management Services (BDMS) from a screen. Actually: 2
screens.
I always screen for stocks that buy back enough stock to lower their share count year after year.
And I screen for stocks that have free cash flow year after year. One day: I combined the two
criteria. Birner passed the screen.
So where do I get my investing ideas?
I got 2 of the 4 ideas I talked about in an earlier post from blogs. I got the other 2 from screens.
I don’t know if that’s a good sample.
I’ve checked the last 10-Q and 10-K for thousands of stocks. I’ve glanced at their 10-year
histories. If that’s an investing idea: I’ve had thousands of them.
But that’s not an idea. An idea is when something in that SEC report says this is a special stock.
This is something worth studying for more than 15 minutes.
Those ideas come from sitting and thinking about a specific stock. Do that a few hundred times
with different stocks. You’ll start getting ideas.
 URL: https://focusedcompounding.com/investing-ideas-where-does-geoff-get-his-
investing-ideas-screens-blogs-and-4-examples/
 Time: 2010
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Small Stocks: Should Value Investors Only Buy Microcap Stocks? – 4 Stocks
People Ignore
Greg Speicher has posted twice now on a great discussion over at the Corner of Berkshire and
Fairfax message board.
Question: Should value investors stick to small cap stocks when investing their own money?
My Answer: Every value investor should try small cap stocks. Most don’t.
I get a lot of emails saying something like this:
I’m getting out of college this year and I just recently got interested in value investing by reading
Warren Buffett and Benjamin Graham – what should I do?

I give a lot of responses like this:
You should focus on the smallest stocks out there. Nobody else is. You’ll have to do real work
every day. You’ll only be able to work with primary sources: the 10-Ks and 10-Qs. You’ll learn
more working with small cap stocks. And you’ll have to decide for yourself. Benjamin Graham’s
Mr. Market metaphor is obvious in tiny stocks. In big stocks: even value investors get lazy and
listen to the market instead of taking advantage of it.

Microcaps are the best place to learn investing. But are they the only place to make money?
No.
You can make money buying stocks people hate or you can make money buying stocks people
ignore.
Here are 4 microcap stocks people ignore – and the reason why:
1. Bancinsurance (BCIS): Unusual Combined Ratio

2. Solitron Devices (SODI): Past Bankruptcy; Can’t Pay Dividend
3. Birner Dental (BDMS): Cash Earnings Not Reported as Income
4. George Risk (RSKIA): Combines Investments With a Business
Here’s where I agree with some folks who say microcap investing is harder today than it was
when Buffett started. It is harder. There are mechanical screens. Most of the good bargains you
find depend on something you can’t screen for.
A microcap bargain is often the result of an accounting quirk or a one of a kind business.
If Bancinsurance had a combined ratio of 100, it might’ve been worth 2/3 of book value. Lots of
insurers write at a combined ratio of 100. And lots of insurers trade below book. But
Bancinsurance had a very long history – 29 years – of writing at very low combined ratios. If
Bancinsurance was a big cap stock, everyone would know that. Nobody thinks Progressive
(PGR) is worth book value. Everybody knows a dollar of Torchmark (TMK) book value is
worth at least as much as a dollar of MetLife (MET) book value, because everybody knows
MetLife – blimps and all – can’t write at a lower combined ratio than Torchmark.
Since Bancinsurance was a microcap – delisted in fact – it’s incredible underwriting history was
ignored. Even after the CEO offered $6 a share, I could get some shares at $6 and under. Try
doing that in Torchmark or Progressive. In years that don’t end in ’29 and ’08 – it just doesn’t
happen.
Let’s look at the 4 examples of microcap bargains I threw out off the top of my head. There’s a
madness to the market’s method in each case. Basically: the market is getting each of these
stocks half right.
Solitron has a weird bankruptcy in its past. It can’t pay a dividend – yet. Buying stocks like
Solitron was a favorite tactic of both Warren Buffett and Benjamin Graham. Buffett says –
in one of his partnership letters – that a bank he was buying in a big way couldn’t pay a dividend
despite strong earnings. And Graham was sure Northern Pipeline was being valued by its
dividend alone. People ignore cash that can’t be paid out when the cash is in a microcap stock. If
Solitron was a big cap stock, everybody would know the exact date Solitron could start paying
that cash out.
I’ve mentioned Birner Dental before. Because corporations can’t own dentist offices, Birner
acquires dentist office management contracts instead of the offices themselves. Birner amortizes
the acquisition over 25 years. This hides a ton of cash earnings for a long time. Investors in big
cap stocks read analyst reports that tell them about big differences between the cash flow
statement and the income statement. Investors in microcaps have to look at the statements
themselves. They don’t.
George Risk is the simplest explanation of all. The market sometimes values the stock right as an
investment portfolio and sometimes values the stock right as an operating business. But it almost
never values it right as both.
Why not?
There are no analysts – though there are a few bloggers – writing sum of the parts analysis on
George Risk. If George Risk was a big cap stock everyone would know exactly how much cash
it had. Think about Microsoft (MSFT) and Apple (AAPL). Proportionally, they don’t have
more surplus cash than George Risk. But no analyst is going to tell you that. You have to read
the SEC reports yourself.
George Risk has a huge number of small shareholders. On average: they own a little over 1,000
shares. Most big companies have fewer shareholders of record than George Risk. The shares are
ridiculously spread out. You’ve got a strange group of people trading that stock. And they don’t
trade it often. In that case: it’s easy to see what Benjamin Graham meant by Mr. Market.
Are all 4 of these stocks winners?

No.
Bancinsurance was a clear winner at $6 a share. It isn’t at $8.50. The board wants to sell it to the
CEO at that price. He’s lucky. A big cap stock’s shareholders would reject $8.50.
So – yes – sometimes even buyout prices are too low for small cap stocks. Sometimes the
ignorance discount never goes completely away – but getting 90% of fair value is enough to
make big bucks when the stock is sometimes priced at 50% off.
Warren Buffett and Benjamin Graham were security analysts first. The place to do security
analysis is in microcaps.That’s why microcaps are the best place to learn value investing.
One huge warning: I’ve noticed – over the years – that most value investors think differently
about big caps and microcaps. They choose their big cap stocks as investments and their small
cap stocks as speculations. Don’t do that. It’s a self-fulfilling prophecy.
There are so many times more small stocks than big stocks that it’s plenty easy to find quality
small cap stocks as long as you’re willing to sift through 10 or 100 times as many candidates.
That’s all it takes. Work.
Searching for microcaps is like doing research. Everybody assumes the best work in the field is
the paper people already cite the most. Maybe. But you can’t know that until you dig through the
archives and read stuff that’s 90% garbage.
Usually you find something just as good that nobody’s heard of.
 URL: https://focusedcompounding.com/small-stocks-should-value-investors-only-buy-
microcap-stocks-4-stocks-people-ignore/
 Time: 2010
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Investment Returns: Home Runs and Strike Outs – What Kind of Hitter is
Geoff?
I’d assume you must either hit home runs or strike out, what’s your long term ROI?
– Fred
Going back 10 years: my compound annual growth rate is about 15%. That’s misleading. I was
down 38% in 2008, up 41% in 2009, and up 39% this year.
I don’t just hit home runs and strike out. I could say why in words, but you’d have to trust my
interpretation of what a “home run” and a “single” is.
Instead: I went back and took the non-annualized returns on positions I closed in 2009 and 2010.
Here’s the breakdown:
Minimum: 7.57%
Maximum: 61.10%
Median: 22.61%
Arithmetic Mean: 27.45%
Geometric Mean: 22.82%
Harmonic Mean: 18.72%
Standard Deviation: 16.31%
Coefficient of Variation: 0.59
I haven’t closed a “strike out” position in two years unless you count +7.57% as a strike out.
Considering how far the market’s bounced from early 2009, maybe we should count 7.57% as a
strike out. I don’t see any home runs either. I mean up 61.10% is nice, but individual stocks have
moved way more than that since 2009.
I didn’t count open positions. But it wouldn’t change things much. None of my open positions
have unrealized losses. Some are close. For example: Barnes & Noble (BKS) is at $16. My cost
is $15.36.
I get a lot of doubles and walks. I’m not a home run hitter. 100% returns in a single stock are rare
for me. I sell too soon.
 URL: https://focusedcompounding.com/investment-returns-home-runs-and-strike-outs-
what-kind-of-hitter-is-geoff/
 Time: 2010
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What are the 4 Most Important Numbers to Know About a Stock?
A lot of investors think they have to be scientists. They have to be rational. They have to be
objective. And they have to weigh all the facts equally.
Some of those are good ideas. Others aren’t. Yes – You need to be rational when judging a stock.
But I’m not sure you need to be objective. Let’s talk a bit about that.
I’ve said before that if you want to become a better investor, you should think less about stocks
and think more about thinking.
Thinking about how you think is not objective. But it is rational.
Being objective means focusing on the stock instead of the investor. Scientists write papers from
an objective view. They describe their experiments in a way others can copy. They don’t make
science personal.
So why should you make investing personal?
Because it’s safer that way.
There’s a great book called
The Checklist Manifesto: How to Get Things Right
. It talks about how checklists can be used to break complex tasks into simple steps that prevent
mistakes. Not just for amateurs. But for professionals. For experts.
People like doctors, pilots, – and yes – even investors make fewer mistakes when they use
checklists.
I’ve talked about checklists in the past. In “Investor Questions Podcast #11: Why Does
Evergreen Energy’s Stock Always Go Down?”, I said you should focus on stocks with Z-Scores
of 3 or more, F-Scores of 3 or more, and 10 straight years of positive free cash flow.
I still think that’s a good idea. Investors who stick to those rules will make fewer mistakes than
investors who don’t.
But that checklist isn’t good enough. There are other mistakes you can make. The checklist I
gave you in podcast #11 won’t protect you against all of them. The most important rule I left off
was price. Investors who don’t add a price rule to their checklist can still lose a lot of money.
I’ll give you a fuller checklist later. For now let’s talk about why you need a checklist in the first
place.
I want you to take off your lab coat and put on a fedora. Stop thinking of yourself as a scientist
and start thinking of yourself as a detective.
You walk into a hotel room. There’s a dead man in a business suit lying face down on the carpet.
The hotel room is full of clues. Dozens of them. But how do you know what’s a clue? How do
you make sense of the data?
There are two ways to tackle this problem. One way is to start in gatherer mode. You walk
around the room looking at stuff, taking pictures, and writing things down.
The other way is to start in hunter mode. Instead of starting with the data you start with a theory.
Or a question. Or a hunch. You follow that thread as far as it takes you.
Which way is best?
I don’t like either of them. The gatherer mode is hopeless. You could walk around the room and
look at everything. But that won’t get you anywhere. You’ll end up with hundreds of pieces and
no idea how the puzzle fits together.
Now that doesn’t mean taking an inventory of everything is wrong. I actually like that idea. But
that’s not analysis. That’s something anyone can do. It’s important work. But it isn’t the
analyst’s main job. It’s basically a reporter’s job. It’s just taking everything in the room and
putting it into a standard form that will make sense a week or a month or a year from now when
someone wants to look at all the evidence.
So I’m fine with the gatherer approach up to a point. Finding a stock’s price-to-earnings ratio
and price-to-tangible-book ratio is fine. It may even be important. But it’s not analysis. And
unless you have a theory to hang those numbers on – they won’t do you much good.
Let’s say you know a stock’s price-to-earnings ratio is 9. Fine. What does that tell you? It tells
you the stock might be interesting. It might be cheap. But now you need to ask if those earnings
come in the form of cash. Like I said in “Investor Questions Podcast #4: What is the
Difference Between Earnings, Free Cash Flow, and EBITDA?” – a railroad with a price-to-
earnings ratio of 9 is a lot more expensive than an advertising agency with a price-to-earnings
ratio of 9 – because railroads need to plow most of their earnings back into the business.
Advertising agencies don’t.
Where in the business cycle are we? Is this a bank or an insurance company you’re looking at? If
it’s a bank, an insurance company, or a homebuilder – where we are in that industry’s cycle
matters a lot. Banks can earn a lot of money right now because the Federal Reserve is pushing
short-term interest rates down to zero. Will that be true in the future? No. Not forever.
The same thing is true when times are good in the insurance business. A low P/E ratio might not
mean much in good years. It means a lot in bad years. You have to look at the long-term
combined ratio for the insurance company you’re interested in and compare it to the long-term
combined ratio for the industry. If they’re both lower this year than they have been in 5 or 6
years, that low P/E ratio isn’t as great as it sounds.
But you know all this. That’s why you asked the question. You said you’re confused. I don’t
need to remind you how complicated things are.
And they are complicated. There are a lot of numbers to look at. But I hope you see how I’m
looking at them. I’m starting with the number that catches my eye – like a low P/E ratio – and
then I’m following that thread where it takes me. I’m asking follow up questions.
Whether you want to think of yourself as a reporter or a detective doesn’t matter. But you need
to remember your job is to ask questions. Don’t just gather clues. Follow leads.
Now that I’ve told you to follow leads instead of gathering clues, I need to give you a warning.
I don’t want you to start by following leads right away. You’ll jump to conclusions if you do
that. And you could make dumb mistakes that are hard to fix later.
So the first thing I want you to do when you walk into that hotel room is look at your checklist.
Think of yourself as that detective. What checklist should you use?
Once again, here’s the scene: you walk into a hotel room; a dead man in a business suit is lying
face down on the carpet.
Before you start gathering clues and following leads, what simple steps do you need to take?
A good way to figure out which steps to put on the checklist is to start by thinking about the
mistakes you can make. What can go wrong here? What can you do in the first few seconds to
screw up your investigation for good?
Think of your unspoken assumptions. Now try to say them out loud.
I’ll list a few assumptions a lot of people make in this position. See if you made any of them.
Unspoken assumption #1: The man died violently.
Unspoken assumption #2: This is the dead man’s room.
Unspoken assumption #3: This is where the man died.
Unspoken assumption #4: These are the clothes the man died in.
The first assumption, that the man died violently, is the one you’re least likely to make because
you’re focused on it. How the man died, whether it was murder, and who the killer was are the
questions your mind automatically jumps to. So you probably didn’t make that assumption.
The other assumptions are more common. Assuming the dead man is the guy who rented the
hotel room is an easy mistake. It’s also a big mistake. Making that assumption, and being wrong
about it, can cause your investigation to fail in a way you can’t fix later. The man or woman who
did rent the hotel room will be long gone if you don’t get this question right from the start.
The good thing about these mistakes is that they’re easy to avoid. As soon as you walk into the
hotel room – you can look for signs of violence, check the body for identification, look for signs
the body was moved, and check to see if the dead man’s clothes are on right. After you’ve
checked those 4 things you can start gathering clues.
Jumping over those 4 steps would be bad. Especially if this isn’t the dead man’s hotel room.
Making that mistake would cause you to misinterpret everything in the room. You’d head down
the wrong path and none of your work would matter.
What does this have to do with investing?
I started by talking about a crime scene because I figured books and TV have taught you to think
of crime scenes as mysteries instead of data dumps. Most people try to figure out a murder.
Not everybody knows they need to figure out a stock.
The question that matters in a murder is who the killer was. The question that matters in
investing is whether or not you should buy the stock you’re looking at.
That’s it. All the work you do has to help you answer that question: should you buy the stock?
Now let’s talk about how I want you to start your search for an answer.
When you find a stock you’re interested in, start by thinking of yourself as a detective standing
over that dead body. Start by thinking about the dumb things you could do right now to screw up
your investigation forever.
Start by thinking about a checklist. The book I mentioned before, “
The Checklist Manifesto: How to Get Things Right
”, spends a lot of time talking about doctors and hospitals. That’s because the author is a surgeon.
Regardless, medicine will work as a good metaphor here because we’ve all seen plenty of
doctors in fact and fiction.
Hospitals take patients’ vital signs. A patient’s vital signs are: body temperature, heart rate,
blood pressure, and breathing rate. All 4 signs are easy to take and can be put into numbers.
There isn’t a lot of room for interpretation when measuring the 4 signs. What they say about the
patient is open to interpretation. But the 4 numbers are easy to record and easy to read. They are
put in numbers every doctor can understand.
Hospitals take vital signs to prevent a failure that can’t be fixed. The 4 numbers are warning
signs that make sure doctors and nurses don’t ignore a problem that could kill a patient.
Investors should look at stocks the way hospitals look at patients. Start with the vital signs. You
want numbers that aren’t open to interpretation. They need to work as warning signs. And a few
numbers should tell you most of what you need to know.
I suggest using 4 vital signs: 1) Z-Score 2) F-Score 3)10-Year Free Cash Flow Margin
coefficient of variation and 4)10-Year Real Free Cash Flow Yield.
Recording these 4 vital signs will keep you from making most mistakes. I know that’s hard to
believe. But it’s true.
If you take the time to calculate these 4 vital signs before researching a stock any further you’ll
keep yourself from making most mistakes.
I like to write the ticker symbol of the stock on the front of an index card and record the stock’s 4
vital signs on the back. That way whenever I think about the stock, I can see the 4 numbers right
there in black and white.
It’s hard to lie to yourself about how safe a stock is when you see a Z-Score of 1.5 staring back at
you. It’s hard to tell yourself a stock is cheap when you see a real free cash flow yield of 3% on
that card.
I love this approach. It works for me. It’s made my investing much safer. Most of the mistakes I
made in the past would have been avoided if I had been using this approach back then.
This method may not work as well for you. I think it will work. But it probably won’t work as
well as it has for me. That’s because I designed this method based on my past mistakes. Not your
past mistakes. Every investor is different. You make different mistakes than I do. So my method
will miss some stuff you do wrong because it’s tailored to my weaknesses instead of yours.
I still think using these 4 numbers will cut your mistakes down.
But a lot of investors don’t like this idea. I can see why. It’s limiting. And it makes you feel like
a baby. It’s as if I’m saying you can’t trust yourself to make investment decisions.
I’m not saying that. But I am saying we all make dumb mistakes. Even experts. And a few
simple numbers can keep you from making most of those mistakes.
I talked about the Z-Score in “Investor Questions Podcast #13: How Do Find a Stock’s Z-
Score?”. And I talked about the F-Score in “Investor Questions Podcast #12: How Do You
Find a Stock’s F-Score?”.
I haven’t talked about real free cash flow yields. And I haven’t talked about coefficients of
variation. Those terms sound scary. But they’re not. You can figure both out in seconds using
Microsoft Excel.
I’ll show you how over the next two days. Episode #15 will be all about the 10-year free cash
flow margin’s coefficient of variation. I know it sounds strange and boring and maybe even a
little mathy, but it’s one of my all-time favorite numbers. Hopefully my enthusiasm will rub off.
Then on Thursday, I’ll talk about real free cash flow yields. They’re even easier.
 URL: https://focusedcompounding.com/what-are-the-4-most-important-numbers-to-
know-about-a-stock/
 Time: 2010
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On Buffett’s Big Blunder
Warren Buffett is getting a lot of criticism for a big blunder. He sold put options on four stock
indexes – including the S&P; 500.
Buffett described these derivatives in his 2007 letter to shareholders:
“Last year I told you that Berkshire had 62 derivative contracts that I manage (We also have a
few left in the General Re runoff book). Today, we have 94 of these…”

Financial Weapons of Mass Destruction
Before criticizing Buffett, we need to take a moment to praise him. After all, the guy had the
foresight to clean out the General Re derivatives before the credit crisis hit.
Yes, Berkshire took a loss. And, yes, Buffett clearly overestimated both the rationality and
morality of the human capital over at General Re – much as he had at Salomon.
Buffett was never well-liked at Salomon. And I’m sure there are some folks (or ex-folks) at
General Re who don’t find him quite as avuncular as he is reputed to be.
I would say they simply don’t understand each other, if I didn’t think the truth was exactly the
opposite. Buffett got to know Salomon and General Re better with time – and the better he knew
them, the less he liked them.
The General Re derivatives were a disaster averted. Had Berkshire kept the book intact or never
acquired General Re, we’d be hearing a lot more about what was in that book.
Is it a mere coincidence that Buffett, the CEO who made the decision to unwind the General Re
book, called derivatives “financial weapons of mass destruction”?
No. Buffet saw something in that book. And he did something about it. Most CEOs did not.
Style Drift
Enough praise. Back to the blunder:
“Over the past five years, Buffett frequently called derivatives ‘financial weapons of mass
destruction’, comparing derivates to ‘hell…easy to enter and almost impossible to exit.’ Yet, he
has, very much out of character, immersed himself in a large and, thus far, unprofitable
derivative transaction. His investment successes have not been in speculating in the market
(something he has been critical of) but rather by purchasing easily understandable companies
with dependable cash flows…”

That’s Doug Kass writing lasting year about Buffett’s style drift. He goes on to write:
“It immediately occurred to me after gazing at Buffett’s style drift (manifested in Berkshire
Hathaway’s large first quarter derivate losses) that he might be increasingly viewed as the New
Millennium’s Ben Franklin, a man who wrote ‘early to bed and early to rise’ but spent many of
his evenings in France, whoring all night…”

Not surprisingly, Kass is negative on Berkshire stock. I won’t argue that point. Berkshire has
fallen. And short sellers have made money.
Kass presents Buffett’s derivative transaction as “speculating in the market”.
Insurance
Let me offer an alternate explanation.
Berkshire Hathaway has substantial insurance operations. It is, in fact, a huge insurer of large,
often unusual risks. In some cases, Berkshire prefers to keeps such risks to itself instead of
sharing them with other insurers.
Buffett does not believe in the Noah’s Ark school of investing and Berkshire does not practice
the Noah’s Ark method of insuring. The company bets big in stocks and takes big risks in
insurance provided the odds look good and the cost of a losing bet would not imperil the holding
company’s health.
That’s the business model. And I love it. If you don’t love it, don’t buy Berkshire. Buffett has
been explicit about both parts of the process – the generation of float and the allocation of capital
– and he has been explicit about the fact that Berkshire is not a conventional insurance company.
This brings me to a critical point. I disagree with Kass. The put options Berkshire sold aren’t an
instance of style drift, because they aren’t investments – they are insurance.
Here’s how Buffett described them:
“These puts had original terms of either 15 or 20 years and were struck at the market. We have
received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The
puts in these contracts are exercisable only at the expiration dates, which occur between 2019
and 2027, and Berkshire will then need to make payment only if the index in question is quoted
at a level below that existing on the day the put was written…I believe these contracts, in
aggregate, will be profitable and that we will, in addition, receive substantial income from our
investment of the premiums we hold during the 15-or-20 year period…in all cases we hold the
money, which means we have no counterparty risk.”

As Whitney Tilson noted, it appears Berkshire is not required to post (much) collateral:
“Under certain circumstances, including a downgrade of its credit rating below specified levels,
Berkshire may be required to post collateral against derivative contract liabilities. However,
Berkshire is not required to post collateral with respect to most of its credit default and equity
index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had
posted no collateral with counterparties as security on these contracts.”

Trust
Considering these facts, two possibilities exist:
a) Buffett is lying or otherwise intentionally and materially misrepresenting Berkshire’s

derivatives situation.
b) These derivatives pose little to no risk to Berkshire’s solvency or long-term financial health
If Buffett is lying, Berkshire’s shareholders are screwed. But that’s not news.
When you buy Berkshire you are banking on Buffett’s integrity. The guy doesn’t have to be a
saint, but he does have to be a halfway decent human being. He controls the company and
conducts complex transactions on both the investment and insurance side.
Trust has always been required of those who invested alongside Buffett. In his early partnership
days, his disclosures were next to nil, investors’ money was locked up until year-end, and they
were putting their trust in a slightly odd young man who worked from home. Those were the
ground rules. And they turned some people off. The rest got rich.
If you don’t trust Buffett, don’t buy Berkshire, and don’t believe anything about these derivatives
contracts.
Me?
I trust the guy. I’m probably biased. But I’m also probably right.
A Good Bet
Also, I have to admit, if I were running Berkshire and was offered a deal to sell those puts on the
terms Buffett did, I would take it.
There is a difference between a good bet and a winning bet. A bet is good when the odds are in
your favor and your bankroll can bear the full brunt of an utter and unpredictable loss. A bet is
winning when you win. Most people judge themselves on outcomes. That’s insane. You can’t
control outcomes. Only process.
Buffett once wrote:
“You will be right, over the course of many transactions, if your hypotheses are correct, your
facts are correct, and your reasoning is correct. True conservatism is only possible through
knowledge and reason.”

Those words were written 47 years ago – before Berkshire, before the insurance business –
before everything but Graham’s training and Buffett’s rationality.
I don’t know if Buffett will lose this bet. But I do know his style hasn’t drifted an inch.
 URL: https://focusedcompounding.com/on-buffetts-big-blunder/
 Time: 2009
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On Buffett Back Riding

Warren Buffett is best known for his work at Berkshire Hathaway (BRK.A) where he grew
book value per share 21.1% a year over the last 42 years.
But Buffett was a money manager long before he was a CEO. He earned his super-investor
stripes by running an investment partnership. Buffett Partnership Ltd. beat the Dow every year
from 1957 to 1969, never had a down year, and posted annual returns of 29.5% a year. The Dow
managed just 7.4%.
Those numbers are phenomenal. And Buffett’s record is all the more phenomenal for its length.
How many investors have a track record stretching back half a century?
But past results are no guarantee of future returns. And Berkshire’s size is a guaranteed
headwind.
So can you really Buffett-back ride your way to investment success?
Maybe.
But there is a right way to do it and a wrong way to do it.
Common Mistakes in Preferred Stock
The wrongest of the wrong is to buy common stock in companies where Buffett holds preferred
shares.
Don’t buy General Electric (GE) and Goldman Sachs (GS) because Buffett told you to. He
didn’t. He took a senior position with a double-digit yield. If he wanted to buy the common, he
would have bought the common.
Buffett has bought preferred stock before. And, to be honest, it is not his strong suit. One of his
worst investment decisions was buying preferred stock in US Air. Berkshire nearly lost
everything. The investment worked out, but it was a big mistake – and Buffett knows it.
Another, lesser mistake was buying preferred stock in Gillette.
That investment worked out great. But it would have worked out even better if Buffett bought
the common stock instead of the preferred.
For details read Buffett’s 1995 letter to shareholders.
Buffett says he “was far too clever” to take the easier, more profitable route – instead insisting on
the more complex, and ultimately less profitable preferred stock.
When Buffett makes a preferred stock purchase, he is actually signaling that he does not like the
common stock. He may like the company. He may not. But he certainly does not like the stock.
If he did, he would buy the common stock.
So why did Buffett take preferred shares in GE and Goldman?
Some will argue these are sweet-heart deals pure and simple – and that’s why Warren took them.
Buffett certainly got in on special terms.
But, it’s not clear those terms were better than what he could get by buying common stock in a
business he loves when market prices are low.
In fact, almost all of Buffett’s biggest successes were either common stock purchases or
preferred stock purchases that would have worked out as well or better if Berkshire had bought
the common stock instead.
I can think of only two exceptions. Berkshire got some GEICO (now fully owned) and some
Freddie Mac (long ago sold) in ways that individual investors could not. Other institutions were
offered the same terms as Berkshire. Individual investors were not.
Putting those two purchases aside, Buffett’s best moves at Berkshire have been simple and easy
to copy.
Has Berkshire gotten special offers? Sure. But Buffett’s record on such special deals is much
spottier than his record of investing on the same terms the little guy could get.
Frankenstein Securities
Why are Buffett’s preferred stock investments often inferior to his common stock investments?
Part of it is the hybrid nature of preferred stock. All of Buffett’s preferred stock purchases
combined high yields with the chance to participate in the underlying equity (at some price).
Buffett does simple better than anyone.
Preferred stock is complex. There is a psychological trap of combining a mediocre bond element
with a mediocre stock element and thinking you’ve got yourself a great deal. Generally, it is a
bad idea to buy such a hybrid unless at least one of the two elements is attractive enough to fully
justify the purchase on its own.
Buffett’s preferred investments in GE and Goldman fail this test – at least for an investor as
demanding as Buffett. The yields on the GE and Goldman preferred are good, but they are just
barely good enough to clear Berkshire’s lowest hurdle of a 10% pre-tax return.
Buffett has said he never considers buying stocks that do not offer at least a 10% pre-tax return.
Neither the GE nor the Goldman investments offer much of a margin of safety. Instead they offer
a guaranteed, mediocre return (for a long-term Buffett investment) with an equity option.
It’s hard to see how these preferred stock investments meet the same level of quality as Buffett’s
big ideas in common stocks.
Most likely, Buffett saw the preferred stocks as good alternatives to fixed-income securities.
That was the logic behind the five preferred investments he made 15-20 years ago. Berkshire
swapped lower-yielding securities with no convertibility for higher-yielding securities with
convertibility.
That’s a good trade up as long as you don’t come to regret having less cash on hand. Since
Buffett made the deals, his opportunity costs have gone up. The value of cash is higher, because
stock prices are lower.
Does Buffett regret the deals? I doubt it. But the press has overhyped them. Preferred stock deals
are a sign of having a lot of cash to deploy and not a lot of places to put it.
There are two very good reasons not to follow Buffett into GE and Goldman. One: you can’t get
the deals he got. And two: the deals he got are not his best investment ideas.
Buffett’s Best Idea
I’m not going to argue for or against any one stock. I’m just going to give you the name of the
investment Buffett seems to like most: Burlington Northern (BNI).
Berkshire owns almost 22% of the company. Even for Berkshire, that’s a big stake. And Buffett
has kept buying BNI long after the position became public knowledge.
The last purchases I know of were done at $62.15 a share. But Berkshire had been a buyer at
prices well above that. Buffett has been buying as recently as this month.
Originally, Berkshire started building positions in several railroads. Then Buffett focused on
BNI. Why?
That’s his style. He doesn’t diversify. He concentrates. He doesn’t like small positions. He likes
big positions.
And he obviously likes Burlington Northern.
Conclusion
You can ride along with Buffett on BNI or not. But don’t let press reports and hearsay lead you
to GE and Goldman – or even worse, to American Express and Wells Fargo and other stocks that
Buffett bought into a long, long time ago.
The time to ask whether you should Buffett-back ride is when Buffett is first building his
position. This is not a guy who trades a lot.
In fact, he almost never sells. The only way you don’t have to worry about selling is if you do a
spectacular job of buying.
So, if you’re looking to ride with Buffett, either buy Berkshire when it trades at a reasonable
price – or go in with him on his best investment idea as he’s buying it.
Right now, the only name that fits the bill is Burlington Northern.
 URL: https://focusedcompounding.com/on-buffett-back-riding/
 Time: 2009
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Random Thoughts
I haven’t posted in a while and thought I might begin with some random thoughts.
Rick Konrad of Value Discipline has posted after a (similarly) long absence. Value Discipline is
one of the best investing blogs. If you’ve never read it – start now.
24/7 Wall St. recently posted on More Recession Carnage for Video Games. I would love to
have posted on the video games industry (especially publishing) more often on this blog. I rarely
have. The reason’s simple: video game stocks have been pricey for much of the life of this blog
(2006-present). That’s not true anymore. Unfortunately, so many stocks are now so cheap on a
normalized free cash flow (“earnings power”) basis that it’s hard to argue video game stocks
deserve special mention.
Take toys. A basket of three of the largest U.S. toymakers: Mattel (MAT), Hasbro (HAS),
and Jakks Pacific (JAKK) looks real reasonable. Do the math on what kind of free cash flow
these businesses have produced over the years and what kind of prices you can buy them at
today. Answer: You’re getting the American toy industry dirt cheap.
Are their risks? In the long-run, their may be greater risks in toys than video games, because toy
companies run a greater risk of becoming inflexible enterprises. Regardless, mankind’s appetite
for toys, video games, and just plain fun isn’t going to be permanently impaired by a recession or
depression (no matter how “great”).
Are these businesses recession proof? Nothing’s recession proof. But businesses that make
products people are passionate about aren’t a bad place to be in any economic environment. The
fact that both industries can and have supported multiple, profitable players isn’t a bad sign
either. Toys and video game stocks are both worth buying (even if you can’t separate the wheat
from the chaff) when you can get an acceptable no-growth normalized FCF yield on your
purchase price.
Focus on free cash flow. Not earnings. I don’t envy anyone who has to tell us what a video game
company (or toy company) made this year much less what they’ll make next year. Current sales
and expected (normalized) FCF margins are a better way to value these businesses than EPS. Be
conservative but realistic. And either buy the best or buy them all whenever you get the right
price. In other words, don’t rush out and buy a troubled, hurting quagmire (THQ) at the first
twinkling of a turnaround. That’s not necessary when real quality is on sale the way it is today.
Note: Yes. THQ (THQI) is cheap. But ask yourself: do I really need that kind of cheap in my
life, when real quality’s on sale.
Video game and toy stocks aren’t the only ones being offered at low prices to demonstrated free
cash flow. See Microsoft (MSFT) or Energizer Holdings (ENR) for evidence of this market
wide phenomenon.
But those are posts for another day.
 URL: https://focusedcompounding.com/random-thoughts/
 Time: 2008
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On Ignorance Admitted
In finance, liquidity is not a physical state it is a psychological state. Liquidity is a state of mind.
Worse yet, liquidity is in the eye of the beholder. That is not merely to say that liquidity is
subjective. Liquidity is subjective, but it’s also more than subjective – it exists in the minds of
others – others who can and do transact business with you. So liquidity is – to a great extent –
uncontrollable.
Good assets may not necessarily be liquid assets. As a result, good decisions do not necessarily
lead to good outcomes when an actor is dependent upon liquidity. An actor is dependent upon
liquidity whenever liabilities are great relative to assets. However, an actor can avoid insolvency
and make good decisions that will almost certainly lead to good outcomes if the actor can
studiously avoid disbursing cash or other assets to meet obligations in the near-term. An actor
who can finance an asset by selling a thirty-year zero-coupon bond does not have to worry much
about liquidity. Any actor so financed weds its destiny almost entirely to the intrinsic value of
the asset – and only the intrinsic value of the asset. All other worldly concerns seem to melt
away. This sort of financial nirvana is rarely achieved by any actor who has tasted of the sweet,
sweet nectar known as debt.
Actors – like addicts – can develop a dependence through regular use. There is no such thing as
non-habit forming debt. Debt is so addictive precisely because it is so useful.
Wonderful businesses have been brought down by a lack of common sense and an abundance of
debt. Great businesses – even some simple, great businesses – have been brought down by debt.
What their competitors could never do to them, these great businesses did to themselves.
Berkshire Hathaway (BRK.B) bought Fruit of the Loom out of bankruptcy. It’s hard to
bankrupt an entrenched underwear business. Only debt could kill a business like Fruit of the
Loom or Hanes (HBI).
So how can investors evaluate a debt-laden liquidity whore? For the most part they can’t.
Investors never like to hear that. But it’s true.
Hanes may have debt; but at least its business isn’t directly dependent on liquidity. Like Fruit of
the Loom, Hanes can go bankrupt, but Hanes can also be evaluated without reference to all sorts
of variables beyond the company’s control. An investor can decide if the company has too much
debt without giving much thought to capital markets, interest rates, commodity prices, and all the
other much discussed macro variables. The further an investor ventures from the specifics of the
business he is evaluating the more unstable all of his assumptions become. As he stacks unstable
assumption upon unstable assumption, he builds a teetering tower crowned with an intrinsic
value estimate that could prove perilous.
If you can make successful macro bets, make them. If that’s your strong suit, stick with it. But
don’t confuse the business of evaluating businesses and picking stocks with the business of
guessing which way the macro winds will blow.
You don’t need to have an opinion on every stock out there. It’s no mark of shame to admit you
can’t come to actionable conclusions within whole industries. If you knew Bear Stearns
(BSC) was a short – good for you. If you could admit Bear Stearns was beyond your
comprehension – even better.
Investors have a hard time roping off the areas they can work within from those they can’t. Too
many of us venture too far afield. A few good decisions can make a fortune. A few bad decisions
can lose one.
You’re going to make mistakes. But there’s no need to make them in unfamiliar territory.
The temptation to take a stand, either with the market or against it – with the bulls or with the
bears – is always great. Too great for most investors.
In the days and weeks ahead, most people will be focusing on Bear Stearns. However, most
investors would do better to focus on themselves.
Now is a good time to examine how honest you are with yourself. Admitting when you’re wrong
is good. Admitting when you don’t know is better.
What lesson will you learn from all this? How will you become a better investor?
 URL: https://focusedcompounding.com/on-ignorance-admitted/
 Time: 2008
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Is Warren Buffett’s Berkshire Hathaway Worth More Dead or Alive?
Alive – definitely alive.
This question – more than any other – dogs every discussion of Berkshire Hathaway (BRK.B).
It isn’t immediately visible to those arguing on either side (“Berkshire is overvalued”, “No!
Berkshire is undervalued”) but it underlies their arguments all the same.
What do I mean when I say Berkshire Hathaway is worth more alive than dead? I mean that
Berkshire as a continuing whole is more valuable than a Berkshire that is dismembered into its
constituent parts this very day – a Berkshire that is cut up and dished out like a Christmas ham.
Why?
A lot of people value Berkshire as a closed-end investment fund. Peter Lynch wouldn’t make
that mistake. He’d see that Berkshire fits the bill as one of his stalwarts:
“Stalwarts are companies such as Coca-Cola, Bristol-Myers, Procter and Gamble…and
Colgate-Palmolive. These multibillion-dollar hulks are not exactly agile climbers, but they’re
faster than slow growers…When you traffic in stalwarts, you’re more or less in the foothills: 10
to 12 percent annual growth in earnings”.

(From Lynch’s One Up On Wall Street)
That’s what Berkshire is – not a lifeless closed-end investment fund, but a living, breathing
stalwart – a mega-cap company that needs to be compared to (and valued like) other mega-caps.
I tried to make this point in the comments section of an earlier post, when I wrote:
“So, now the question isn’t whether Berkshire can compete with its past (it can’t). But, whether
Berkshire can compete with similarly sized public companies such as Nestle, Unilever, Google,
Microsoft, General Electric, Johnson & Johnson, HSBC, AT&T;, Wal-Mart, Bank of America,
and the big oil companies. Can it? I think it can. So, relative to its peers (in terms of size)
Berkshire isn’t overpriced. Is it overpriced compared to the Berkshire of twenty or thirty years
ago? Yes. But, so is just about every asset on planet earth. So, that’s not the right yardstick to
use. You have to compare Berkshire (the stock) to other stocks you can buy today – and
Berkshire the company to other companies with similar size constraints. On both counts, I think
a valuation of about $140,000 a share is appropriate and fair.”

Berkshire’s value is every bit as dependent on growth as the value of those other corporate
behemoths – more so, in fact, because Berkshire doesn’t pay out dividends. You need to value
Berkshire based on its likely intrinsic value growth rate, because that rate will determine what
the stock is worth in 3, 5, and 10 years’ time – just as it will at Microsoft and Bank of America
and Wal-Mart and Google.
Berkshire is a growth stock. And how fast is it growing? Since 1995, I estimate intrinsic value
has grown a little more than 15% a year. Of course, when I assign a value to Berkshire shares, I
don’t assume it can keep up that kind of intrinsic value growth. Rather, I assume it could grow at
a still stalwart like 10-12% annual rate with Buffett at the helm, and 8% a year without Buffett.
I may be (very) wrong about Berkshire’s growth prospects. But, I’m not wrong to see it as a
living, growing integrated whole rather than a lifeless closed-end investment fund that needs to
be parceled out soon and thus valued today as if it were already in liquidation.
That’s a pig-headed approach that runs contrary to everything we know about what Berkshire
was in the past, is now, and likely will be in the future. It’s a compounding machine that will
keep chugging along (at some pace) for many years to come.
How can I explain this simple truth in a way any investor can understand? How can I make
people realize that Berkshire isn’t just the sum of its parts – but, rather an integrated whole that
adds value that is not derived from the value of any particular part on its own, but rather comes
from making those parts work in harmony towards a single goal?
I don’t know. So, I’ll try a simile.
The Berkshire model works. To some extent, it works with or without Buffett. It works a whole
lot better with Buffett than without Buffett. But, a capital allocation conglomerate makes some
sense even where Buffett isn’t at the helm.
Why?
Because businesses face capital allocation constraints very early – a lot earlier than we like to
think.
An example of a good business in a smaller, narrower industry may help illustrate my point.
The following is total fiction – a complete hypothetical – however, I think it is oddly illustrative
of the way the capital allocation conglomerate model can work (and does work at Berkshire).
There’s no doubt Berkshire benefits from Buffett’s “magic”; but there’s also some value adding
alchemy in the capital allocation conglomerate model.
Berkshire is a combination of man and model.
The Strattec Simile
Strattec (STRT) is a small company with a market cap of just over $150 million and an
enterprise value of much less.
Strattec is flush with cash and always has been. For background on Strattec’s spin-off, see Joel
Greenblatt’s You Can Be a Stock Market Genius which includes a chapter outlining the case for
buying Strattec when it was spun-off from Briggs & Stratton.
Strattec has been a good business; but, it’s also been a small business. Today, it carries about $60
million of cash on its balance sheet – which is just over 40% of total assets and just under 60% of
total equity. That’s way too much cash for a public company to carry.
Strattec has been both blessed and cursed. It’s been blessed with a good, narrow business that
produces plenty of free cash flow and it’s been cursed with a good, narrow business that
produces plenty of free cash flow.
The cash kept coming; the growth never did. Over the last ten years, Strattec has tried to sop up
some of that cash – and has succeeded to the tune of about $95 million in 10 years, or nearly $10
million a year in share buybacks.
Strattec is part operating business and part investment company. The market treats the operating
business as the more valuable component, but there’s no denying capital allocation (or
misallocation) has been a key determinant of the company’s stock price performance.
Strattec has $60 million in cash today, and has (indirectly) plowed $95 million back into the lock
business through stock buybacks made over the last ten years.
Strattec could have really used a Buffett like capital allocator over the past decade.
Or, it could have just paid a nice, fat dividend. Either way would have worked.
You can see the conundrum. It’s natural for businesses (even publicly traded businesses) to find
themselves producing more cash than they ought to reinvest in their established field of
expertise.
Now, I’m not really saying that Strattec has too much cash today (though it very well might) and
needs to do something about this problem. That’s a much narrower argument that only matters if
you’re looking at Strattec as an investment.
I’m not doing that here. Rather, I’m saying that Strattec has had too much cash for a decade –
and a decade is a very long time in investing – so, Strattec doesn’t just have a sub-optimal
operating model today; it’s had one for ten years and its owners have suffered for that (“suffer”
is a relative term; the stock has done fine versus the S&P; – but, it hasn’t done fine versus the
actual business).
The math is simple. Over the past ten years, Strattec had $155 million in cash ($95 million in
buybacks + $60 million in cash now held) fall to the ultimate bottom line, the balance sheet.
Last I checked, the company had a market cap of – drum roll please….$155 million!
Investors who held the stock for ten years saw the business they owned generate $155 million in
completely free cash flow – and yet the business they own is now worth merely the sum of that
$155 million. Had all $155 million been paid out in annual dividends, the future value of the
business as of today would not now be valued by the market at $0/share; so, it seems we’ve had
some sub-optimal capital allocation over the past 10 years at Strattec.
The stock may be cheap too. I’m not ruling that out. But, even if it is very, very cheap today, if
some investor had taken over Strattec ten years ago and set out to emulate Buffett’s capital
allocation adventures at Berkshire Hathaway, shareholders of Strattec would be better off today.
Why?
For the past ten years, Strattec was a cash flow machine. To create value at a cash flow machine
you can do one of three things 1) turn it into a compounding machine (like Buffett did at
Berkshire) 2) turn it into a dividend paying machine, or 3) turn it into a EPS growth machine,
either by growing the business, or buying back shares at low prices (relative to earnings).
Growing the business was out of the question at Strattec. It’s a big player in a small industry, and
it was dependent on its key customers (GM, Ford, and Chrysler) growing their business. They
didn’t. As a result, Strattec was starved for growth. It was (through no fault of its own) a cash
rich, growth poor – highly profitable but hopelessly stagnant company.
Creating an EPS growth machine through stock buybacks was also a difficult proposition as
Strattec had an average P/E of over 13 during the last ten years. While a P/E of 13 isn’t
especially rich; it isn’t an especially low multiple for a no-growth business either.
Therefore, buyback fueled EPS growth would have been costly.
If an investor took control of Strattec ten years ago with Buffett’s mindset (but not necessarily
his skills), he would have richly rewarded shareholders over that ten year period.
How would this work? And why would it work?
Intelligent capital allocation provides some value in this kind of situation even if capital isn’t
allocated to investments that produce above-market returns, because something is being done
with the cash.
If Strattec hadn’t bought back its own stock, and had instead created a stock portfolio into which
it put all its free cash flow, that portfolio would now be worth over $150 million even if it
achieved nothing in the way of returns. This would have resulted in Strattec being worth much
more today, because Strattec would be valued as a $150 million closed-end investment fund with
an automotive lock business thrown in.
Instead, the company has a higher EPS than it otherwise would as a result of spending $95
million buying back shares; it also has about $60 million in cash sitting on the balance sheet –
unfortunately, the market tends to value that $60 million less optimistically than it would if it
believed the cash would be invested (at the holding company level) in a basket of stocks that
would be held for many, many years.
Capital reallocation would not have weakened Strattec’s financial condition in the least. In fact,
it would have strengthened the company’s financial condition, because by now the holding
company would have close to $100 million more that the lock business could tap in times of
trouble. Strattec would be even more ridiculously overcapitalized than it is today – since, the $95
million in cash spent on share buybacks would still be on the balance sheet (rather than in the
pockets of former shareholders).
This is a very conservative picture of what would have happened if an investor took over the
capital allocation job at Strattec ten years ago and left the management of the lock business in
place.
Why?
One, because Strattec really did produce $155 million in completely free cash flow – so, even if
a stock portfolio at the holding company level did absolutely nothing over that time period, it
would still have approximately that much in cash (invested outside the lock business). Returns in
excess of zero over that time period would have grown the value of the company’s investments.
Two – and this point is of tremendous importance – the capital allocator at Strattec would have
been ideally situated to make extremely intelligent investments (just as Buffett was at Berkshire).
Why?
Because the capital allocator at Strattec would have been in the same position as a mutual fund
manager – except he’d have no fear of redemptions, no need to produce market beating returns
within any single year or quarter, and fresh cash coming in each and every year.
What did Buffett do under similar circumstances? A lot of things. But, one of the most important
things he did was buy big chunks of businesses he believed in at deep discounts to intrinsic
value. Could a capital allocator at Strattec have done this?
The lock business would have been producing both earnings and free cash flow each and every
year. Let’s assume the amount of free cash flow produced by the lock business was $15 million
per year.
If the capital allocator had $15 million a year in cash to invest, he would have needed to find one
good opportunity a year in public companies with market caps in the $100 – $150 million range.
This would have given Strattec Berkshire like 10-15% stakes in public companies.
The capital allocator at Strattec could have lessened his work load even further if he limited
himself to bigger companies – say those trading in the $200 – $300 million range.
Then, he’d need only one good idea every two years. As you move up the market cap ladder,
great ideas tend to become scarcer. On the other hand, you can certainly wait for a perfect pitch
if you only need to swing once every two years.
Why does this capital allocation conglomerate model work?
It provides several benefits. Among the most important are:
1) A way to put cash to work

2) A rock-solid financial position
3) Extreme focus at every level – especially the top
The first point is obvious. The second point is easier to overlook. Berkshire can achieve good
returns while overcapitalized, because it’s a capital allocation conglomerate.
Financial strength isn’t a trait peculiar to Berkshire. Any holding company modeled on Berkshire
would naturally tend towards a rock-solid financial position, because that’s the nature of the
beast.
Management could intentionally undermine this rock-solid financial position by using leverage,
but unless they did, such a holding company would tend towards financial strength as a result of
the holding company’s capital reallocation activities.
Think about it.
How do slow growth, cash flow machines create value for shareholders?
Two ways: dividends or share buybacks. Both ways weaken a company’s financial position by
returning cash to shareholders. Share buybacks can increase earnings per share, but they still take
cash from the company.
Now, how does a compounding machine create value for shareholders?
It buys stocks or businesses. Both of these actions strengthen a company’s financial condition.
The company’s assets are not distributed, they are invested. Diversification increases in either
case. Stocks are highly liquid, but they are also solid long-term investments that offer capital
appreciation and some inflation protection. Operating businesses can also offer capital
appreciation and inflation protection – but more importantly they offer additional free cash flow
from a different source.
The process of building a compounding machine naturally leads toward extreme financial
strength– not because the capital allocator seeks to maximize the conglomerate’s financial
condition, but rather because he seeks to maximize shareholder wealth without buying back
shares or paying out dividends (which are normally the only options available to a high free cash
flow, low growth business).
This is exactly what would have happened at Strattec if a capital allocator with a Buffett like
mindset had taken control of the company ten years ago.
Look at the company’s results for those ten years and try to imagine what the company would
look like today. Even if the capital allocator wasn’t especially skilled, shares of Strattec would
almost certainly have a higher market value today than they do now – and the company would
have an even stronger financial position.
That’s the natural progression for a capital allocation conglomerate built on a high free cash
flow, low growth business. Businesses like Strattec become more valuable when they are part of
a capital allocation conglomerate than they are on their own.
Likewise, the private businesses Berkshire buys become more valuable when they are part of
Berkshire than they were on their own.
As separate businesses, they can harvest their profits – but they can’t plant new acreage.
As a result, next year’s yield will look a lot like this year’s yield. But, at Berkshire, Buffett can
plant new fields using harvests from prior years.
This allows Berkshire to grow faster than the sum of its parts. Buffett harvests the old fields and
plants new fields.
Of course, at Berkshire, there’s also the small matter of insurance (and the float it provides). But,
that’s not worth talking about, because no one will argue that an insurance company isn’t worth
more when it can invest its float than when it can’t. That’s already a generally recognized truth.
When you combine both elements – cash flow from operating businesses and float from
insurance businesses – you have the fuel that propels Berkshire’s growth.
 URL: https://focusedcompounding.com/is-warren-buffetts-berkshire-hathaway-worth-
more-dead-or-alive/
 Time: 2008
-----------------------------------------------------
Gannon to Barron’s: Berkshire Fairly Valued…As a Buffettless Empire!
Warren Buffett’s face graces (or disgraces) the cover of this week’s Barron’s. In big, bold print
the weekly stock market mag says “Sell Buffett”. Inside, the message is equally gloomy: “Sorry,
Warren, Your Stock’s Too Pricey”.
Is it?
Barron’s says:
The Street’s enthusiasm for Omaha-based Berkshire…might be excessive. Its stock now appears
overpriced, reflecting a sizeable premium for the skills of the 77-year-old Buffett. What’s
Berkshire worth? Our estimate, based on several valuation measures, is around $130,000 a
share – about 10% below the current quote.

Valuation – In Five Minutes or Less
My estimate – admittedly based on only a single valuation measure (the one I would use to value
any holding company / conglomerate / corporate hodgepodge) is around $141,000 a share. By
the way, that’s an “ex-Buffett” measure – in other words, that number is my first stab at the value
of any corporate hodgepodge – not a corporate hodgepodge with an investment legend at the
helm.
I didn’t come up with a specialized measure just for Berkshire (BRK.B) – all I really did was
“privatize” Berkshire at $141,000 a share. Of course, Berkshire’s too big to go private; Buffett’s
continued leadership adds value; and Berkshire’s collection of businesses (both majority and
minority owned) is far from average.
All those factors deserve special consideration.
But, before we consider those factors, it’s worth noting Barron’s is being a bit too cautious in
valuing Berkshire. Even if Berkshire had a miserable 2007, the sum of the parts would still be
greater than $125,000 a share which Barron’s sets as the low-end of the range ($130,000 a share
is the high-end).
What’s Berkshire really worth? That’s hard to say. If you gave me five minutes, a pen, paper,
and the 2006 annual report, I’d say $141,000 a share.
That figure is the result of taking Berkshire’s year-end 2006 businesses and securities, valuing
Berkshire’s pre-tax earnings to yield 8% (an appropriate rate for excellent, but not necessarily
fast growing businesses), valuing Berkshire’s securities at their market prices at the time of the
2006 annual report, and then correcting the combined value for the time elapsed since the 2006
annual report was published.
I did it this way so anyone could follow my logic without needing anything more than the 2006
annual report – you could look at Berkshire’s latest filings for more up to date earnings and
portfolio data. But, there’s no real need to add so many complications merely to get an intrinsic
value estimate that is nine months more timely.
Golden Years
Not surprisingly, Barron’s mentions Buffett’s age:
Buffett turns 78 next August, and his actuarial life expectancy is nine years. He’s likely to stay
on the job for as long as possible, but in reality, few CEOs can handle the demands of the job
much past 80. When Buffett departs, the stock is apt to drop as longtime Berkshire holders cash
out and the investment community waits to see whether his successors can live up to his legend.
Buffett’s successors will not live up to his legend. At this point, not even Buffett can live up to
his own legend – and he knows that. The amount of capital he needs to invest is just too big for
anyone to provide the kind of returns Buffett once did.
However, the age angle is overdone in most media reports. People look at Buffett (like Bill
O’Reilly recently did) and say “this guy’s old; he’s going to be dead soon”.
There are a few problems with this logic when applied to Buffett’s future services to Berkshire.
One, CEOs don’t usually die in office. Even great CEOs retire long before they reach 77 – and
86 is never even contemplated.
Buffett will work for as long as he’s able. Taking Barron’s actuarial life expectancy of nine
years, it’s obvious that Buffett is still expected to last longer at Berkshire than the average public
company CEO appointed today. CEOs don’t make it much more than five years on average; so,
Buffett’s expected future service time is actually above-average not below average.
He is old for a CEO; but, he’s not planning to retire. Most CEOs do retire – and quite early at
that. In fact, I would put Buffett’s effective age (considering his commitment to stay at the helm
of Berkshire) at more like 60-65 years rather than his actual age of 77.
You’ve heard of dog years. Well, now I’m introducing CEO years – and in CEO years, Buffett is
at least twelve years younger than he appears to be. I know this sounds strange, but it’s not a
contrivance by any means. Ask yourself this question: Do you really believe that a 60-65 year
old public company CEO chosen at random is likely to significantly outlast Buffett in terms of
years of service from this moment on? I don’t see that happening. I’ll take Buffett at 77 over the
average CEO at 62.
Why? Not because Buffett is immortal, but because he’s not going to retire. Most great CEOs
aren’t more likely to give you many years of service from age 60 on then Buffett is from this
moment on. To a shareholder, should it matter if the CEO has 25 years of retirement or 25
seconds?
What matters is how much work they have left in them – and on that count Buffett is not in a
lesser position than a 60-65 year old CEO. So, it’s appropriate to talk about succession plans;
but, certainly no more so than in the case of a CEO in his early to mid sixties. The situation at
Berkshire is roughly equivalent to the situation at any public company with a star CEO in his
sixties.
The $73 Billion Man?
So is Buffett really worth that much? Considering his age and Berkshire’s massive capital
constraints, how much more value can Buffett add to Berkshire? What do Berkshire’s
shareholders stand to lose if Buffett is hit by a truck tomorrow?
My best guess is $73 billion. That’s the present value of Buffett’s “value over replacement
player” (to use a baseball term) for nine years (his actuarial life-expectancy according
to Barron’s). In other words, Buffett’s future services to Berkshire are quite possibly still greater
than his own net worth.
Calculating the present value of Buffett’s future services is difficult, because you need to
consider what kind of compound annual growth rate Buffett is capable of achieving on
Berkshire’s net worth, what kind of CAGR a replacement investor would achieve, and what kind
of discount rate to use on Buffett’s expected value over a run-of-the-mill replacement over the
next nine years.
Again, my best guess is $73 billion or roughly $47,000 per share. Obviously, this is just a guess,
based on the likelihood of Buffett going much shorter or much longer than nine more years at
Berkshire, the likelihood of excellent investment opportunities appearing within Buffett’s circle
of competence, etc., etc., etc.
The $73 billion number assumes Buffett can compound Berkshire’s investments and pre-tax
earnings at a rate of 11.50% over the next 9 years while a run-of-the-mill replacement would do
no better than 8.00% – the discount rate is also 8% (that’s a typical discount rate for me and has
nothing to do with this specific scenario). Why 11.50%?
Because there’s a chance Berkshire will lose Buffett’s services long before nine years are up
(like tomorrow for instance), due to the nature of compounding, this possibility greatly reduces
the expected value of Buffett’s services. However, there’s also a chance Berkshire will keep
Buffett’s services for much longer than nine years, but due to the nature of discounting, this
possibility is somewhat less important than it first appears. Finally, there’s a chance that stock
market valuations for mega-cap stocks will be elevated for much of Buffett’s remaining years of
service. This possibility reduces the expected value of Buffett’s future services by making it
more difficult for him to deploy capital.
On the other side of the scales, there’s the possibility that Buffett could finally bag his elephant
(i.e., make a huge investment). There are (literally) a couple private elephants that Berkshire has
some chance of bagging with Buffett at the helm and would have almost no chance of bagging
without him. A huge investment in a publicly traded company is also a possibility – for that
reason, Berkshire (especially with Buffett at the helm) offers some downside protection against
an earnings multiple contraction in mega-caps (and the market as a whole). As price-to-earnings
ratios decrease, Berkshire’s opportunities increase.
Putting all these factors together, my best guess is that the expected value of Buffett’s future
services at Berkshire are derived from an expected 3.50% a year edge over a period of 9 years
(though this takes into account the possibility of a larger edge over a shorter period of time). Is
an 11.50% a year growth in net worth realistic considering Berkshire’s enormous size?
Buffett did this over the past decade – and that was during a very unfavorable market climate. In
fact, the unfavorability of that market helps explain why Buffett has put more and more money
into purchasing private companies outright; negotiated purchases of 100% of the earnings of
private companies have generally been possible at more attractive terms than market purchases
of a portion of the earnings of public companies.
But Berkshire is Slowing, Right?
Big time.
Berkshire was once a remarkably fast-growing investment company. For instance, Berkshire
once had an eighteen year streak of beating the S&P; 500 in terms of increase in book value per
share versus that year’s return on the S&P; 500 including dividends. From 1981 through 1998,
Berkshire outpaced the S&P; with the following relative results:
1981: 36.4%
1982: 18.6%
1983: 9.9%
1984: 7.5%
1985: 16.6%
1986: 7.5%
1987: 14.4%
1988: 3.5%
1989: 12.7%
1990: 10.5%
1991: 9.1%
1992: 12.7%
1993: 4.2%
1994: 12.6%
1995: 5.5%
1996: 8.8%
1997: 0.7%
1998: 19.7%
Since 1998, the record has been a lot spottier. First, Berkshire’s net worth was roughly flat in
1999, while the S&P; 500 charged ahead, leaving Berkshire with a return 20.5% behind the S&P;
500. Berkshire’s relative results have improved, but they haven’t returned to their best levels of
the the ’81-’98 run: (20.5%), 15.6%, 5.7%, 32.1%, (7.7%), (0.4%), 1.5%, 2.6%.
What’s wrong?
Valuations for one. You may recall from my series of posts on 15-year normalized earnings for
the Dow that 1996 was the year everything changed. It’s no exaggeration to say that starting in
1996 the market entered uncharted territory as far as normalized P/E ratios – uncharted territory
from which it has yet to return. In all his years of investing, Warren had never seen (normalized)
valuations this high – at least among the biggest stocks in the U.S. He admitted nearly as much in
his 2002 annual letter to shareholders:
We continue to do little in equities. Charlie and I are increasingly comfortable with our holdings
in Berkshire’s major investees because most of them have increased their earnings while their
valuations have decreased. But we are not inclined to add to them. Though these enterprises
have good prospects, we don’t yet believe their shares are undervalued.
In our view, the same conclusion fits stocks generally. Despite three years of falling prices,
which have significantly improved the attractiveness of common stocks, we still find very few
that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached
during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the
binge.
The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning
common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50
or so years have offered that kind of opportunity. There will be years like that again. Unless,
however, we see a very high probability of at least 10% pre-tax returns (which translate to 6½-
7% after corporate tax), we will sit on the sidelines. With short-term money returning less than
1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.
The idea that Warren is an over-demanding investor by historical standards is easily refuted by
the bolded statement above (“In my 61 years of investing, 50 or so years have offered that kind
of opportunity”). That’s more than four out of every five years.
Warren’s statement is consistent with my series of posts on normalized P/E ratios – stocks may
have been too cheap in the past, but they have been more expensive since 1996 than they ever
had been in the preceding 66 years (1930-1995). In every year since 1996, the Dow has had a
higher normalized P/E ratio than it had in any year from 1930-1995.
In terms of (normalized) valuations, not even the tops of those markets could rival the bottom of
this market since 1996. This time, valuations may have reached a permanently high plateau.
Regardless, we must recognize that the last decade was clearly a poorer hunting ground for
Buffett than the previous five had been.
It’s been ten years of pricey stocks. That’s not fun for a company (and an investor) that depends
on devouring them. It’s a cost of living increase that’s hard to overcome.
Still, Berkshire has managed. Over the last ten years, net worth has grown more or less in line
with the stock price, with compound growth in net worth of just under 12% a year and a stock
price performance of just over 12% a year. Needless to say, the S&P; 500 hasn’t fared so well.
It’s hard to say what Berkshire’s worth. But, here’s a good guess of where things stand today:
Stock Price: $143,000
Intrinsic Value without Buffett: $141,000
Intrinsic Value with Buffett: $188,000
So, should you buy Berkshire? That’s a bit more complicated. Let’s look at what Berkshire will
be worth in nine years (again using Barron’s actuarial life expectancy for Buffett) under different
scenarios:
If Berkshire grows both investments and pre-tax earnings by 6% a year over the next nine years,
investors buying today should expect something like a 5.84% annual return. If Berkshire grows
both by 8% a year, the return will be 7.84%; if Berkshire grows by 10%, expect 9.83%; if
Berkshire grows by 11.50% a year, expect 11.33%; if Berkshire grows by 12.50% a year, expect
a 12.33% return; and if Berkshire grows by 15% a year, expect a 14.83% return.
You may have noticed a pattern among all these numbers. The important thing isn’t my own
arbitrary guess of what Berkshire could do with nine more years of Buffett (grow by 11.50% a
year, and provide an 11.33% annual return for shareholders); rather, it’s the simple fact that
Berkshire is very close to fairly valued today.
You can ride with Buffett for free. Berkshire is worth close to $141,000 a share without Buffett
and it’s trading for $143,000 a share today. Trust me; $2,000 on a $143,000 stock is well within
the margin of error on any intrinsic value estimate. So, tomorrow, you can choose to have Buffett
manage your money for no extra charge.
There are some serious constraints here. Buffett has far too much capital to deploy to be as
effective as he should be. He won’t run circles around today’s best money managers.
If you think my very rough guess of 11.50% a year growth with Buffett at the helm is a
reasonable one, you can buy Berkshire today for roughly seventy-five cents on the dollar
($143,000 vs. $188,000 with nine more years of Buffett).
Is Berkshire a screaming buy?
No.
Is it the best place to put your money?
No.
Is there a margin of safety?
Yes.
Without Buffett, Berkshire is worth almost exactly what you’re paying for it today. With Buffett,
it’s probably worth quite a bit more.
There is no Buffett premium in Berkshire’s share price. That doesn’t mean the stock won’t
drop if Buffett kicks the bucket tomorrow – but long-term investors can still ride with Warren
Buffett for free.
You won’t do as well as his partners did back in 1956, but you may do better than the S&P; –
and you won’t have to pay for the privilege of having Warren Buffett manage your money.
On the downside, you’re buying into what amounts to the world’s biggest mutual fund. For a
fund this big, success forges its own anchor.
You can’t expect miracles, but you can expect something like 6% – 12% a year plus a “call” on
any market mayhem that causes mega-cap valuations to decline and fat pitches to once again fall
within Warren’s sweet spot.
Simply put, Berkshire is fairly valued. Buy it, hold it, or sell it – but don’t think you’re getting in
at a discount or paying some big Buffett premium – you’re not.
At $143,000 a share, you’re paying par; the rest is up to Buffett.
 URL: https://focusedcompounding.com/gannon-to-barrons-berkshire-fairly-valuedas-a-
buffettless-empire/
 Time: 2007
-----------------------------------------------------
On Hanes
Inelegant Investor has a post on Hanes. The post also links to The Stalwart.
Here are a few things to keep in mind with Hanes.
Two major players, Hanes Brands (HBI) and Fruit of the Loom (a Berkshire Hathaway
subsidiary), control most of the U.S. underwear market.
Hanes considers itself to be in the “apparel essentials” business which is to say the “t-shirts, bras,
panties, men’s underwear, kids’ underwear, socks, and hosiery” business. In 2005, the U.S.
apparel essentials market was about $44 billion. Apparel essentials have been growing faster
than the overall apparel industry – still this isn’t a fast growing market. You’re unlikely to see
sales growth exceed 5%.
Hanes divides its business into four segments: Innerwear, Outerwear, Hosiery, and International.
The company doesn’t do much international business. Hosiery is a dying business with good
margins. It generates cash; but, it’s going the way of the Dodo – fast.
That leaves innerwear and outerwear. Together these two segments account for something like
85% of Hanes sales.
Innerwear is underwear – and yes, it’s just as profitable by any other name. This segment is the
heart of the company. It generates more than $2.5 billion in sales and plenty of free cash flow.
Apparently, you can achieve low double-digit profit margins in this segment, which is
impressive given the volume involved.
The innerwear business is a ridiculously high volume business. Looking at it solely in dollar
terms doesn’t make that clear enough. So, let me give you some unit numbers.
Hanes manufactures and sells a billion socks a year – literally. That’s 500 million pairs of socks
a year. Even the T-shirt business is high volume; Hanes produces about 400 million T-shirts a
year.
The company’s biggest customers have high volume needs. Wal-Mart accounts for nearly 30%
of the company’s sales. Does Wal-Mart have leverage over Hanes? Maybe. Does Wal-Mart have
many other options? No. Hanes supplies them with well over $1 billion in product each year. It’s
a cheap product that can only be produced in such volumes at competitive prices by a few
companies on the planet. In the U.S., your choices are basically Hanes or Fruit of the Loom.
Furthermore, customers don’t contract this stuff. They simply buy what they need. The excess
inventory costs on these high volume products could easily eliminate all the profit for any
company that isn’t accustomed to producing on this scale. Hanes averaged total inventory
reserves of just under $100 million a year over the last three years. That’s the cost of
guaranteeing you have enough product to meet your customers’ needs.
Hanes employs a lot of people – and the workforce isn’t particularly cheap considering how
cheap the product is to produce. Before the spin-off, Hanes employed close to 50,000 people
worldwide. The vast majority of the company’s employees were located outside the U.S.;
however, the vast majority of the company’s labor costs came from inside the U.S.
Using American labor to produce underwear isn’t particularly economical. Since the spin-off the
company has clearly been moving to reduce costs. This means closing plants and firing people. I
expect the company will have to engage in a fair amount of globe hopping just to keep moving
jobs further down the global wage scale as wages in some of these countries may grow fast
enough to threaten price competitiveness. Of course, competitors are in the same boat. Absent
prohibitive tariffs, each of the players in the industry should end up about where they started –
though much of their current workforce will end up jobless.
Hanes has reduced its total sales in an attempt to eliminate some low margin product. Currently,
sales are around $4.5 billion. The company hopes to use that number as the base to maintain and
eventually grow. However, growth will be slow. Around the time of the spin-off, the company’s
“growth goals” set the bar at sales growth of 1-3%.
Hanes is highly leveraged (both financially and operationally), so single-digit sales growth can
produce double-digit EPS growth – for a time. Again, this isn’t a high growth business. In the
long-run, it’s a slow growth business.
The best margins are in the innerwear business. That’s also the area where Hanes has its most
important competitive advantages. However, the outerwear business isn’t a bad business and
there’s probably more growth potential there.
I’d like to see Hanes focus more on innerwear than I expect them to. However, management may
surprise me. They didn’t set particularly aggressive sales growth goals, which is a good sign,
because chasing growth would lead the company away from its competitive strengths – which
happen to be in a highly-profitable business.
Hanes wasn’t a good fit at Sara Lee (SLE). This isn’t a small business. It’s a big business with a
couple good brands and one terrific brand (Hanes). Hopefully, the brand will get more attention
now than it did under Sara Lee. We’ve already seen some evidence of that.
Long-term I hope to see Hanes grow international innerwear sales. However, underwear is a very
personal thing; you need to build up familiarity over time – it isn’t an area where buying habits
change rapidly or where there’s a lot of comparison shopping – so, it’s a hard market to break
into. But, with a lot of time and a little skill, there is the potential for growth in the international
segment. But, I wouldn’t count on any such growth when valuing the business.
Overall, I like Hanes today much the same way I liked Energizer Holdings in early 2006.
This is a good business with a lot of debt and a lot of temporary, transitional stuff obscuring the
company’s true earnings power. Look at the company’s record under Sara Lee, the information
filed since the spin-off, etc. and try to come up with some reasonable EBIT estimates. Then,
work back from there to get to a share price 3-5 years out.
With some good capital allocation decisions (or rather without some bad capital allocation

decisions) the stock should perform nicely over that timeframe (3-5 years) without requiring any
miracles from the business.
 URL: https://focusedcompounding.com/on-hanes/
 Time: 2007
-----------------------------------------------------
On the Northern Pipeline Contest
When Standard Oil was broken up, eight of the resulting companies were small pipeline
operators. Wall Street didn’t pay much attention to them. Little was known about their finances –
and they liked it that way. Their “income accounts” literally consisted of a single line. They
didn’t provide detailed balance sheets.
Ben Graham spent a lot of time looking through information provided by the Interstate
Commerce Commission (ICC), a regulatory body that oversaw the railroads (among other
businesses). One day, as Graham was looking through an ICC report, he found some statistics
clearly furnished by the pipeline companies. The statistics were accompanied by a note that read
“taken from their annual report to the Commission“.
Graham realized that the pipelines were filing reports with the ICC that contained information
not known on Wall Street. So, he requested a blank copy of the report from the ICC. The blank
form included “a table which required the companies to set forth a list of their investments at
cost and market value.”
Ben left for Washington the next day. He reviewed the reports for all eight pipeline companies.
What he found amazed him:
“I discovered all of the companies owned huge amounts of the finest railroad bonds; in some
cases the value of the bonds alone exceeded the entire price at which the pipeline shares were
selling in the market! I found, besides, that the pipeline companies were doing a comparatively
small gross business, with a large profit margin, that they carried no inventory and therefore
had no need whatever for these bond investments. Here was Northern Pipeline, selling at only
$65 a share, paying a $6 dividend – while holding some $95 in cash assets for each share,
nearly all of which it could distribute to its stockholders without the slightest inconvenience to
its operations. Talk about a bargain security!”

Northern Pipeline had the greatest amount of securities per share relative to its market price; so,
Graham focused on buying shares of that company. He bought slowly but surely. Eventually, he
was able to acquire a 5% stake in Northern Pipeline. Not surprisingly, the Rockefeller
Foundation was still the largest shareholder. The foundation held 23% of the shares outstanding.
Graham didn’t count on a contest. There were no such things as “activist investors” in those
days. Besides, Graham didn’t see any need for activism. The correct course of action was clear.
He would simply explain the situation to management and they would distribute the excess cash.
Graham met with the company’s President and General Counsel (they were brothers). He
explained the situation and what needed to be done.
The Bushnell brothers explained they couldn’t distribute the cash, because the par value of the
stock was too high. Graham explained how they could reduce the par value and treat the
distribution as a return of capital. The brothers explained they needed the capital. Graham asked
for what. The brothers said the investments were a depreciation reserve. Graham said fine – then
tell me when you’ll need to replace the pipeline. They couldn’t say. Approximately? Couldn’t
say.
Finally, Graham reached the point all activist investors eventually reach, the point where
management stops humoring you and starts lecturing you:
“Look, Mr. Graham, we have been very patient with you and given you more of our time than we
could spare. Running a pipeline is a complex and specialized business, about which you know
very little, but which we have done for a lifetime. You must give us credit for knowing better than
you what is best for the company and its stockholders. If you don’t approve of our policies, may
we suggest that you do what sound investors do under such circumstances, and sell your
shares?”
Graham didn’t do what sound investors do. Instead he told the Bushnell brothers he would come
to their next annual meeting.
He did. Unfortunately, he came alone. When Graham rose to read his report on the company’s
financial position he was asked to put his request in the form of a motion. He did. No one
seconded the motion. The meeting adjourned.
It was an extremely embarrassing – and extremely lucky – episode in his career.
He felt the embarrassment right away. The luck came in the full year he had to round up every
last proxy he could.
Graham hired a high paid law firm and got to work soliciting proxies. Naturally, one of his first
visits was to the Rockefeller Foundation. The foundation’s financial adviser told him the
foundation never interfered in the operations of the companies it invested in.
Graham told him he had no interest in Northern Pipeline’s operations just its assets –
its surplus assets. The proper use of those assets was the concern of the shareholders not the
management. It was no use. Graham left the meeting empty-handed. He thought he had failed.
Actually, he had just taken the first step in changing Rockefeller Foundation policy and the
financial future of all eight pipeline companies – though he didn’t know any of that at the time.
In January 1928, on the eve of Northern Pipeline’s annual meeting, Graham, his lawyers, and the
Bushnells all headed out to Oil City, Pennsylvania where the meeting would be held. It wasn’t a
big town. The two opposing groups met and agreed to count the proxies that night rather than
leave it until the next day. Both groups put their cards on the table; Bushnell’s reaction was
priceless:
“The management group was surprised and discomfited to see how many of their own proxies
had been superseded by later-dated ones given to us. After all this time I still remember old
Bushnell’s involuntary exclamation of pain when we established our right to one proxy for three
hundred shares. ‘He’s an old friend,’ he gasped, ‘and I bought him lunch when he gave me his
proxy.”
The Graham group had obtained proxies for roughly 37.50% of the company’s shares. More
importantly, the Rockefeller Foundation gave their proxies to the Bushnells – along with a
simple message: distribute as much cash as the business can spare.
In the end, Northern Pipeline immediately distributed $50 in cash and essentially promised $20
more would soon follow. Eventually, investors in Northern Pipeline would receive more than
$110 in distributions for each share held as of that January.
Not bad for a $65 stock.
 URL: https://focusedcompounding.com/on-the-northern-pipeline-contest/
 Time: 2007
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On Disney, Pixar, and Ratatouille
One of the Eight Best Investing Blogs, Cheap Stocks, has posted the second part of its look
at Disney (DIS).
Another one of the eight best investing blogs, 24/7 Wall St., has a new post entitled “Disney’s
Pixar Purchase: Never Give a Sucker an Even Break“. The post mentions that this weekend’s
estimated $47.2 million opening for Disney/Pixar’s “Ratatouille” was the worst Pixar opening in
nine years.
Regardless, Ratatouille was number one at the box office despite tough competition from films
such as Live Free or Die Hard and Evan Almighty – well, not exactly tough competition in the
latter case as Evan Almighty has been a big financial disappointment.
You could see it coming. If you look at any list of top grossing movies (adjusted for inflation)
comedies don’t do particularly well, especially considering how many get produced. The recipe
for a huge money maker is simple – and goes back to long before the beginning of movies –
make it epic, make it exciting, make it fantastical or historical (just don’t make it commonplace),
and make it for all ages. Most comedies don’t score well on those counts. I suppose Evan
Almighty does better than most comedies in aping the epic dramas that work. In fact, it matched
them a bit too well with a price tag around $175 million.
Why have I spent a full paragraph on Evan Almighty when I’m supposed to be writing about
Disney, Pixar, and Ratatouille? Because price matters. Here’s some of what 24/7 Wall St. had to
say about Disney’s acquisition of Pixar:
It would appear that Jobs sold at the top. It would also appear that Disney got a lousy deal. It’s
their own fault. Jobs was able to get more for the company than it was worth. The markets have
learned not to underestimate him…But, Disney got burned.

I’m sticking with that I wrote about a year and a half ago:
Is Pixar worth $7 billion (or whatever the offer ends up being)? That’s a complicated question.
First of all, you have to ask if $7 billion of Disney’s stock at today’s market price is actually
worth more or less than $7 billion. What’s the chance that Disney’s stock is currently
undervalued and Pixar’s is currently overvalued? It’s a real possibility.
On the plus side, this could mean Disney CEO Robert Iger wants to take Disney in a different
direction from what we’ve seen lately. I’ve always thought the real value at Disney would come
from providing content not distributing it. If the company really wants to be some sort of
“diversified entertainment company” wouldn’t a company built around kids make more sense?
A company focused on animation, theme parks, the Disney Channel, etc. would make more sense
to me. In fact, a few years ago, I would have been very happy if Disney announced an
acquisition of a toy maker, video game publisher, or licensing company that had something to do
with entertaining kids. Today, a lot of Disney’s business isn’t in places where Disney’s powerful
kid oriented properties can be leveraged.
Pixar fits into the kind of company I’d like to see Disney become, but that doesn’t necessarily
mean acquiring Pixar is a good move for Disney. After all, Fox Family fit into the kind of
company I’d like to see Disney become, but when Eisner decided to buy Fox Family and rebrand
it as ABC Family, I thought it made no sense (especially at the price he paid). We’ll have to wait
for details on the acquisition, but it’s hard to believe Disney is getting much of a bargain here.
Still, it’s a step in the right direction.

I probably focused on age a bit too much in that post. The age of your audience isn’t what
matters. It’s the quality of your content. For instance, I included “video game publisher” among
the list of properties that would make more sense for Disney to acquire than more generic
distribution properties in the entertainment business. Video game publishers don’t make the list
because they cater to kids – in fact, they don’t really cater to kids. But, they do live and die on
content. That content tends to have a much longer shelf-life than the much less financially
fattening stuff you see on network television.
Pixar provides Disney with the opportunity to get back to creating and caring for evergreen
intellectual property. That’s a good business. It’s always been a good business and it always will
be a good business. It’s also a business that isn’t going to change as much as the distribution side
of entertainment, which may or may not be a good business – but, certainly will be a different
business a few years down the road.
Pixar was expensive. But, as much as it pains me to say this (being as focused on price as I
usually am), if it helps convert them to content zealots over at Disney it will be worth it for long-
term shareholders. Disney can be an international superstar in the content business. It can never
be more than an also ran in the distribution business, because in that business you can’t think up
a $100 million idea, care and nurture it into a $1 billion idea over many years, and still have
something left over. In the distribution business, you generally pay full price for what you get.
There’s a lot of talk about advantages of scale in business. Some of it is true. Most of it is utter
nonsense. Content gives you the best advantages of scale, because you can show the world a
good idea. Anyone can think up a good idea – that doesn’t really increase with size, but the
ability to take that good idea and bring it to the fertile soils of an audience’s minds – that’s
something that does grow with the size of your enterprise.
I don’t know how Ratatouille will do. But, I do know that it’s unlikely it would do any better
anywhere else. There’s not a lot of products or properties about which you could say the same.
Having said all that, there’s no denying Pixar was a pricey acquisition for Disney.
 URL: https://focusedcompounding.com/on-disney-pixar-and-ratatouille/
 Time: 2007
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On the Dangers of Homogeneity
One of the Eight Best Investing Blogs, Value Discipline, has an excellent new post entitled “The
Dangers of Homogeneous Thinking.” Diversity of thought and interpretation is an important
concept.
A lack of variation within any population is a dangerous thing. An evolutionary system in

which an overall sense of conservatism (carrying what has worked in the past into the future)
combined with a lot of variation at the margins (sometimes in extreme and eccentric ways) has
often succeeded in consistently creating truly remarkable and effective outcomes that could
never have been devised by a single omniscient actor.
This is something I spend a lot of time thinking about. Unfortunately, there is a tendency for
success to sow the seeds of future failure, because the greatest enemy of great new ideas is
acceptable old ideas.
Major League Baseball is an extreme example of a system in which variation is surprisingly

stifled. I’ll use it, because although large corporate bureaucracies display some of the same
attributes (and thus outcomes), any discussion of specific corporations would be both less
concrete and somewhat more controversial – because it’s closer to the topic I normally write
about here.
Pitching techniques are surprisingly uniform in Major League Baseball. There’s basically
no evidence to suggest that any physical constraints should cause such bizarre uniformity.
Historical evidence shows that other techniques are pretty effective. Furthermore, employing an
unusual technique should be especially effective during a period in which a batter is highly
accustomed to pitches thrown at different angles and speeds from a different release point
following from a different motion. In other words, there’s a lot of evidence to suggest that
pitching counter to a batter’s overall experience and his expectations of a certain situation should
(all other things being equal) work better than pitching like everyone else does and like the batter
expects (both generally and in a specific situation).
Anyway, pitching techniques don’t vary a lot in the major leagues today. Try to pick a range of
speeds and a range of release points that will encompass a large percentage of all the pitches
thrown in the major leagues. It’s not very hard to do. The range won’t be that wide. Why is this?
I’ve come to only one good conclusion. I’m not sure if it’s the right conclusion; but, it’s the best
I can come up with for this very important question – and the question really is important,
because a system like professional baseball should display a lot of variation in this regard if it
works the way most such systems do.
My best guess is that it doesn’t. I think the relationship between the major leagues and the minor
leagues is the answer. Not all professional baseball players are doing everything they can to win.
Some are doing everything they can to advance.
There’s a huge difference between those two motivations. If winning is the key to success at
all levels, then techniques (however bizarre) that lead to winning will be selected by participants
and you’ll see a lot of variation. However, if advancement isn’t entirely dependent on winning –
and it certainly isn’t in the minor leagues – then variation will occur only to the extent that is
rewarded. If it’s punished – and I think that’s exactly what may be happening – then the degree
of variation will be unnaturally low.
That leads me to this question: if two minor league pitchers are equal in all other respects except
one throws more like the majority of current major league pitchers and the other doesn’t, who is
more likely to advance? My guess would be – and I have no evidence to back this up – it’s the
guy who throws like current major leaguers.
By the way, this same principle works at lower levels too. I’m not arguing that the minor leagues
are especially prone to imposing conformity – I’m just arguing that they are especially prone to
imposing conformity compared to what they were like in periods in which there was a greater
variety of pitching techniques in professional baseball.
Old pitchers, scientists, politicians, professors, economists, and money managers don’t learn new
tricks. They die. The next generation learns the new tricks, because experience hasn’t yet
conditioned them to reject simple truths and new ideas.
This is what Benjamin Graham had to say about the subject in his memoirs:
As a newcomer – uninfluenced by the distorting traditions of the old regime – I could readily
respond to the new forces that were beginning to enter the financial scene. I learned to
distinguish between what was important and unimportant, dependable and undependable, even
what was honest and dishonest, with a clearer eye and better judgment than many of my seniors,
whose intelligence had been corrupted by their experience. To a large degree, therefore, I found
Wall Street virgin territory for examination by a genuine, penetrating analysis of security values.
The participants in an adaptive system should have full access to the received wisdom, the old
ways, the knowledge, the traditions – whatever you want to call past experience – but, they
should never be rewarded for playing the hand they are dealt “by the book”, because they need to
write tomorrow’s book.
They should always be rewarded for winning. They should never be rewarded for the way they
won.
No one has yet seen what they will have to face tomorrow (that’s true everyday for every one of
us). That doesn’t mean they shouldn’t be prepared to see what has never been seen by knowing
what came before their time – but, it does mean that if they want to be a smarter actor in a
smarter system, they need to add to the accumulation of knowledge, they need to add to the
experience of the next generation by experimenting today.
The really smart ones – the true geniuses – learn how to turn their own mind into such a system.
They learn to be among the very few who can grow both older and smarter.
They learn to learn – it isn’t as easy as it sounds.
 URL: https://focusedcompounding.com/on-the-dangers-of-homogeneity/
 Time: 2007
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Berkshire Owns More Than 10% of Burlington Northern
Warren Buffett’s Berkshire Hathaway (BRK.B) has disclosed a greater than 10% stake

in Burlington Northern Santa Fe (BNI). Through three insurance subsidiaries (Columbia,
National Indemnity, and National Fire & Marine) Berkshire beneficially owns 39,027,430 shares
of Burlington Northern common stock according to an SEC filing made on Friday, April 6, 2007.
Berkshire’s most recent reported purchase was made on Thursday, April 5th, and consisted of
1,219,000 shares purchased at $81.18 each.
Upon presenting the familiar table of Berkshire’s major investments in his most recent letter to
shareholders, Buffett wrote:
“We show below our common stock investments. With two exceptions, those that had a market
value of more than $700 million at the end of 2006 are itemized. We don’t itemize the securities
referred to, which have a market value of $1.9 billion, because we continue to buy them. I could,
of course, tell you their names. But then I would have to kill you.”
It appears that Burlington Northern was one of the two large positions Berkshire was
accumulating. Clearly, Berkshire has been a big buyer of Burlington Northern shares since
Buffett wrote his letter to shareholders, because Berkshire’s position now has a market value of
approximately $3.2 billion.
The size of the Burlington Northern investment will make it one of about a half dozen very large
positions held by Berkshire. This investment dwarfs each of Berkshire’s investments made
during the past few years – it is already considerably larger than any other single investment
recently disclosed by Berkshire including the investment in Posco (PKX), US Bancorp
(USB), ConocoPhillips (COP), Anheuser Busch (BUD), Johnson & Johnson (JNJ), USG
(USG), Wal-Mart (WMT), and Tesco (TSCDY).
This is the biggest single common stock investment made by Berkshire in a long time.
It’s big news – and it seems to have caught most Buffett watchers off guard. GuruFocus, a site
that tracks Buffett’s moves religiously, announced that its contest to name the two mystery
investments alluded to in Buffett’s annual letter had failed to turn up any guesses that Burlington
Northern would be among the pair.
Burlington Northern Santa Fe operates one of the largest rail systems in North America. The
system includes 32,000 route miles of track of which 23,000 are owned route miles.
In recent years, Burlington Northern Santa Fe has been buying back stock. The company
expects share repurchases will remain the primary use of its free cash flow. In fact, Burlington
Northern may allow “a moderately higher level of debt” so the company can “devote additional
financial capacity to share repurchases”.
In that respect, at least, it is a typical Berkshire investment.
 URL: https://focusedcompounding.com/berkshire-owns-more-than-10-of-burlington-
northern/
 Time: 2007
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On the Mueller Mispricing: “A” Shares vs. “B” Shares
Some smart investors see value in Mueller Water Products (MWA). They’re probably right;
but, Mueller isn’t the kind of situation that jumps out at me as a clear bargain I can understand.
However, there is something peculiar about this situation that makes it worth writing about.
A or B?
There are two shares of Mueller Water Products common stock – Series A common stock and
Series B common stock. There are roughly three times as many B shares as A shares. The A
shares and B shares have identical economic rights. So, ownership of all of the B shares would
provide a roughly 75% economic interest while ownership of all of the A shares would provide a
roughly 25% economic interest.
Here’s where things get interesting. “Shares of Series A common stock and Series B common
stock generally have identical rights in all material respects except Series B shares have eight
votes and each Series A share has one vote per share.”
So, what’s the premium on the B shares? There is none. The last trade on Mueller A shares
(MWA) was at $13.98; the last trade on Mueller B shares (MWA.B) was at $13.64. Buyers of
the A shares are currently paying $0.34 a share more to reduce their voting power by 87.5%.
You can’t convert A shares into B shares or B shares into A shares. If you could, there would
be a profit in simply buying, converting, and selling. Unfortunately, you can’t do that. So, there’s
no “manual” arbitrage opportunity here. Obviously, you can bet that the discount on the B shares
will be eliminated – but, the market has to close the gap for you.
Regardless, there is a nonsensical discrepancy in price between the A shares and the B shares.
Anyone looking to make a new investment in Mueller should buy the B shares. There’s no
reason to even think about touching the A shares until they are trading at a discount to the B
shares.
Owners of Mueller A shares who currently hold those shares in a manner that would cost them
less than $0.34 a share to sell should immediately begin selling their A shares and putting the
proceeds into the B shares. Doing so would slightly increase their economic interest in Mueller’s
business (because they would end up with more shares), greatly increase their voting power –
and, over the long-term, possibly provide additional appreciation in the share price, if and when
the B shares consistently trade at a premium to the A shares.
Do the B shares have to trade at a premium to the A shares? Technically – no. But, in the future,
it’s possible that circumstances may make the B shares far more attractive to certain investors.
The A shares are extremely unattractive to any large shareholder who isn’t committed to
complete passivity as nearly 96% of the votes are tied to the B shares – the A shares are
essentially non-voting shares.
Furthermore, there are fewer A shares, so it would be more difficult for a large investor to
acquire a meaningful economic interest via the A shares without moving the price of those
shares.
While some investors might have very good reasons for buying the B shares when they trade at a
higher price than the A shares – no one has a good reason for buying the A shares when they
trade at a higher price than the B shares.
Right now, the choice seems simple – dump the A shares; buy the B shares.
 URL: https://focusedcompounding.com/on-the-mueller-mispricing-a-shares-vs-b-shares/
 Time: 2007
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On Buffett, Berkshire, and You
At the end of my post “On Billionaires, Their Buys, and Buffett“, I said “I will follow up with
another post on this topic tomorrow. Hopefully, I can give you some idea of what you should and
shouldn’t do based on news of Berkshire’s activities in specific stocks.”
This is that post. Unfortunately, before sitting down to write this post, a piece by James Altucher
(author of “Trade Like Warren Buffett“) was brought to my attention. I’ll link through Value
Investing News, because you should be visiting that site regularly – here’s Altucher’s article.
It’s good. However, there are still some things left for me to cover.
Altucher is right in stressing that Berkshire holds many positions that aren’t presently of interest,
because the business has changed (or more usually) the stock price has changed. A rare example
of the former is the Washington Post Company (WPO). If you want some idea of what the
Washington Post (the stock and the business) looked like back when Buffett bought it, see Max
Olson’s excellent article “Warren Buffett and the Washington Post“.
Buffett Holds
The Washington Post is a rare example of a Berkshire position that is no longer attractive
because of changes in the business. In most cases, it’s a change in the stock price that
disqualifies a Berkshire position from inclusion in your own portfolio. Several years ago, it was
painfully obvious that Coca-Cola (KO) was one such stock.
During the Millennium Bubble, shares of Coke were priced for pluperfection. Buffett didn’t sell
because he intends Coke to be a permanent holding for Berkshire. If he had been running his
partnership, he would have sold. He has a different attitude at Berkshire – one he has made clear
to shareholders countless times. As a result, he sometimes sacrifices better returns for Berkshire
by sticking with a permanent position he knows is overpriced. Coke is probably the biggest and
best known example of Buffett holding a stock he knew Berkshire would be better off selling.
But He Sells Too
However, Berkshire has many lesser known positions that it’s held for a long time. That
sometimes leads people to believe that Berkshire never sells. Not true. Berkshire does sell; in
fact, it has even gone as far as completely eliminating some large positions.
One recent example of such selling is H&R; Block (HRB). The company, which Berkshire once
owned more than 8% of, became badly distracted with operations outside of its core tax
preparation franchise. It seems clear Berkshire has eliminated its stake in H&R; Block. The
company’s single minded pursuit of diversification and cross-selling is probably what turned
Buffett off the stock – since Buffett bought in 2001, management has done a remarkable job of
shrinking the company’s moat and scattering its eggs across many different, less secure baskets.
So, how can you avoid having a bad experience in a Berkshire stock? Don’t overpay. Even in
some situations where Berkshire has only recently disclosed its stake in a company, the stock has
already run up quite a bit. The first time H&R; Block appeared in Buffett’s annual letter to
shareholders, the position was $255 million at cost and $715 million at market. That means the
stock was up 180% from where Berkshire bought its shares.
Posco
In Buffett’s most recent annual letter, we learned that Berkshire owned 4% of the South Korean
steelmaker, Posco (PKX). I wrote about this position at length in an earlier post entitled “On
Posco, Berkshire, and Buffett“. In that post, I reprinted some of my comments on Posco from my
quarterly newsletter where I had featured the stock in the April issue.
(NOTE: I appreciate the emails from readers who want to subscribe to the newsletter – but,
I have discontinued it on account of the scarcity of compelling bargains in today’s market and
I do not have plans to start it up again).
In the last issue of the newsletter (July 2006), I set my “best guess” for the intrinsic value of
Posco ADRs at $124. I also suggested that beyond $190, buying Posco would be a pure
speculation – i.e., the stock would have no investment merit.
My $124 a share estimate was always meant to be conservative – and, as it turns out, steel prices
have held up much better than I anticipated. So, even at $124 a share, the Posco ADRs should
have more investment merit than the major U.S. indices.
There’s no doubt Posco’s value to a private buyer would be substantially higher than the
equivalent of $124 on the ADRs. However, I don’t see how there could possibly be a negotiated
transaction for Posco – and I imagine both the company’s management and the Korean
government would do everything in their power (even if it means hurting Posco’s shareholders)
to prevent a foreign steel company from buying Posco.
The stock is up quite a bit. I first recommended the stock in my newsletter at $63.80. Buffett
bought his shares of Posco even earlier, so he managed to get them for considerably less.
Berkshire doesn’t own the ADRs; however, the equivalent cost on the ADRs for Berkshire
would be closer to $45 a share – the ADRs now trade for about $100 a share.
Buffett’s annual letter showed the value of the Posco stake had already doubled by the end of last
year. Shares of Posco have risen quite a bit since then; so, we are a long way from where Buffett
bought into Posco. At this point, Berkshire has a nearly 125% gain on its investment in Posco.
I think you could do a lot worse than Posco, even at these prices. However, more selective
investors should look elsewhere. Unless you’re someone who likes to hold upwards of twenty to
thirty individual stocks in your portfolio, there are better bargains to be had – especially among
stocks that are far too small for Berkshire.
Big Game Hunting
That brings me to the logic behind Berkshire’s investment in Posco. I think the case for Posco
was pretty simple: it was big and it was cheap. Almost no (remotely healthy) company the size of
Posco trades at such a ridiculously cheap price. This wasn’t a Fisher purchase. It was a Graham
purchase. Usually, Buffett can’t make those kinds of investments, because Berkshire has simply
gotten too big.
In fact, Buffett might have preferred to put ten times as much money to work in Posco. Berkshire
doesn’t need $500 million ideas; it needs $5 billion ideas. Posco was only a $500 million idea,
because although it’s a huge company, it isn’t General Electric (GE).
Posco is about a tenth the size of GE. That’s a problem, because even without ownership
restrictions, it’s very difficult to acquire a third of a company in the open market. That’s roughly
what Berkshire would have to do with a company the size of Posco to make it into a $5 billion
idea. As Buffett says, Berkshire needs “elephants” and a public company the size of Posco isn’t
big enough game.
Berkshire and You
Berkshire’s investment needs are different from yours. Berkshire needs someplace it can put
billions of dollars to work. You don’t. Aside from that, Berkshire’s list of new purchases is a
logical place to look for good investment ideas.
When looking at Berkshire’s new buys, you want to compare your own stock selection with
Buffett’s only insofar as your stock selection includes large companies. If you’re invested in
some companies with a market cap under $100 million or even $1 billion (and if you’re not
you should be), it makes no sense to compare those purchases to Buffett’s most recent buys.
Stocks of that size aren’t part of his investment universe. They are part of yours, because you
have a lot less capital to deploy.
When looking at stocks Berkshire has recently purchased, begin by evaluating them on these
three criteria:
1. Size of position relative to Berkshire’s other holdings

2. Size of Berkshire’s ownership stake
3. Degree of obviousness
The first two criteria are self-explanatory. The bigger the holding relative to Berkshire’s other
positions, the more consideration you should give the stock. Likewise, the bigger the size of
Berkshire’s ownership stake (i.e., the percent of the company Berkshire owns), the more
consideration you should give the stock.
When the two measures are both large, it’s likely you have a winner. When Berkshire’s
ownership stake is large, but the dollar value of that stake is small relative to Berkshire’s other
positions, there’s still a good chance you have a winner. However, when Berkshire’s ownership
stake is small, but the position is fairly large relative to Buffett’s other holdings you need to look
to the third criterion.
The third criterion is “degree of obviousness”. Unlike the first two criteria, the third criterion is
somewhat subjective. I thought Posco was such an obvious Buffett buy that I was surprised it
hadn’t appeared in the letter a year earlier. For others, Posco might have seemed less than
obvious. What’s important, however, isn’t really how obvious the stock is – it’s how obvious
the business is.
The more surprised you are when you see the company’s name and Buffett’s name in the
same sentence, the more likely the stock is something you want to analyze in depth. In fact,
if you have a stock that is large enough to appear in Buffett’s annual letter (thus satisfying
criterion #1) in which Berkshire has an ownership stake of – let’s say 3% or more (thus
satisfying criterion #2) and which seems a less than obvious choice coming from Mr. Buffett – if
you have all that – then, that’s the stock to start studying up on right now.
So, what recent Berkshire buys meet these criteria? The best matches are probably USG (USG),
Posco, and Tesco (TSCDY). Of course, there’s also the issue of price. Can you get these stocks
at prices close to what Berkshire paid?
Whether or not you can today, these are good stocks to watch in the future. At the very least,
they’re companies you’ll want to be familiar with. Another name worth considering, if only for
its “non-obviousness” is ConocoPhillips (COP).
Some of Buffett’s best purchases in the last few years have been in stocks that score well on
these three criteria despite not being discussed as much in the press.
Don’t Dive In
If a recent Berkshire purchase is in a big, blue chip and the position doesn’t score well on these
three criteria, take a moment to put things in perspective.
Buffett needs to put a lot of money to work. You shouldn’t go diving in to some big, blue chip
every time Buffett dips his toe in the water. Look for the less obvious choices – and you’ll find
Buffett watching can be a profitable hobby.
And One More Thing…
Wait for the fat pitch – the one stock you like, not because Buffett bought it, but for
the reasons Buffett bought it. For an example, see George’s discussion of USG.
Related Reading
On Billionaires, Their Buys, and Buffett
On Posco, Berkshire, and Buffett
Column: Warren Buffett and the Washington Post
Book Review: Trade Like Warren Buffett
 URL: https://focusedcompounding.com/on-buffett-berkshire-and-you/
 Time: 2007
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On Billionaires, Their Buys, and Buffett

I recently read a post by Barry Ritholtz over at “The Big Picture“. It’s called “Investing Advice:
If you are NOT a billionaire“. Ritholtz starts with a good premise: don’t try to “tag along” on
stock market investments made by billionaires simply because they’re billionaires.
Unfortunately, his argument goes off the tracks pretty quickly. He singles out three billionaires:
Kirk Kerkorian, Michael Dell, and Warren Buffett. Ritholtz has a point with Michael Dell, but
the same point is applicable to an awful lot of insider buying at large, public companies.
As for Kerkorian and Buffett, I’m afraid I can’t find anything to agree with in those arguments.
Regarding Kerkorian he writes:
He has a long and storied history as a corporate raider, greenmailer, etc. When one gets closer
to the long dirt nap, one thinks of their legacy. For all we know, this GM bid was an attempt to
improve his reputation.

I have to admit smiling when I read this, because about a year ago I wrote a post on some notable
billionaires (from the Forbes list) that included a fairly long digression on comments made by
bloggers about Kerkorian’s advanced age:
There’s been more than enough written about General Motors (GM) over the past year; so, I
won’t add anything here. I will, however, mention that one point made by some blogs (and even
some “mainstream” media sources) is nonsensical. It’s been written (presumably with a straight
face) that Kerkorian can’t possibly be making a long-term investment in GM, because (at 89) he
simply doesn’t have enough time left to see such an investment through.
The strongest argument against this line of reasoning is that making investment decisions based
on your anticipation of imminent death is akin to making life choices based on the belief that you
don’t have free will and all future events are predestined. In both cases, if your assumption is
correct, you gain little or nothing. If your assumption is incorrect, you lose a lot.
Besides, all of this assumes you have no interest in leaving greater wealth behind (whether to
charity or your family), which seems rather absurd. Kerkorian isn’t exactly forgoing his own
enjoyment; he already has far more money than he could ever spend on himself (that would be
true even if he were 29 instead of 89).
Also, it’s worth noting that Phil Carret lived to be 101. I don’t mean to suggest Kerkorian may
live just as long; rather, I mean to suggest even at 89, you could be hanging up your cleats
twelve years too early. To put that in perspective, if the average American male expected to die
twelve years before he actually did, he would be planning to die around the time he would start
collecting Social Security.
As a rule, investors who are as passionate as Kerkorian usually die long before they retire.
I don’t have anything more to say about Kerkorian. I do, however, have quite a lot to say about
Warren Buffett, the billionaire with whom Ritholtz concludes his post:
Warren Buffett has made numerous advantageous deals, getting all sorts of preferences in the
negotiated takeover terms that you don’t get.
If you like Buffett, (buy) Berkshire Hathaway — but don’t attempt to piggy back his trades, cause
you get very different terms than he does.

These comments reminded me of the ones made by Ken Fisher in his latest book. So, I’ll deal
with them both together.
Ken Fisher in the preface to his book, “The Only Three Questions That Count” goes on a rant
about Warren Buffett not being a money manager. I was surprised by how misleading Fisher’s
discussion of Warren Buffett was.
It’s misleading in that most modern of styles; it does not fabricate facts – it omits them. It is an
argument formed from carefully selected points strung together without any reference to the facts
weighing on the other side of the scales.
For instance, Fisher writes, “While he is a great man and a great success, he isn’t a portfolio
manager and has no correctly calculated performance record over the past 35 years as a
portfolio or money manager.” True. However, Buffett was a money manager – and he did have a
“correctly calculated performance record” from 1957 – 1969.
During the life of Buffett’s investment partnership, the Dow provided an annual return of 7.4%,
Buffett’s limited partners received 23.8% (after fees), and the partnership return (before Buffett’s
take) was 29.5% a year.
If we take the partnership return (before Buffett’s take) as being the most representative measure
of his skill, we find that in the thirteen years from 1957-1969, the partnership never had a down
year and never underperformed the Dow. On both counts, Buffett went 13 for 13.
By 1969, Buffett had one of the best “correctly calculated performance records” of any money
manager on the planet. That’s why he featured prominently in the 1972 book “Supermoney“.
Buffett and Graham are essentially given a chapter of their own in that book. Buffett’s inclusion
had nothing to do with Berkshire Hathaway.
At the time “Supermoney” was published, Buffett had yet to make his first stock market coup as
Berkshire’s chairman – that would come a year later when Berkshire acquired its stake in
the Washington Post Company (WPO). In Berkshire’s most recent annual report, it lists the
Washington Post stake as $11 million at cost and $1.29 billion at market.
One of this site’s contributing writers, Max Olson, wrote an excellent (“reverse engineering”)
piece on “Warren Buffett and the Washington Post“. Max cites Buffett biographer Roger
Lowenstein when he writes that the market value of Berkshire’s investment in the Washington
Post compounded at a 32% annual rate from 1974-1985. Berkshire’s own annual reports confirm
this fact.
One good investment does not make a career. However, the Washington Post was a good
investment (over the first ten years it was a great investment) and it was not made on especially
advantageous terms.
In fact, by all accounts, the management of the Washington Post did not know who Buffett was
until after Berkshire made the investment. Nothing was negotiated. Buffett did join the board,
and in that capacity (and especially in his relationship with Katharine Graham) he had some
influence on the Post’s corporate policies. But, there can be little doubt that the vast majority of
the return Berkshire achieved from 1974-1985 was derived from buying a good business at a
cheap price – something any individual investor could have done.
Finally, it’s worth noting that the returns mentioned regarding Berkshire’s investment in the
Washington Post do not reflect any sort of leverage provided by insurance operations.
It’s an apples to apples comparison of the capital used to purchase the stock compared to the
market value of those same shares years later. So, while it’s true that Berkshire has benefited
enormously from the use of the float provided by its insurance operations, downplaying Buffett’s
investing acumen because of his access to float is not defensible in situations where Buffett’s
investment actually outperformed Berkshire’s own book value growth over a number of years.
That’s one reason (among many) that I object to Ken Fisher’s statement that “All you can see is
how Berkshire Hathaway stock does which is largely driven by its insurance operations. For
decades, Berkshire was a terrific stock and made money for lots of folks in the same way
Microsoft or AIG did (or a lot of other great single stocks did). Many investors came to confuse
Berkshire the stock with a portfolio, which it isn’t.”
First of all, Fisher knows that you can see a hell of a lot more than what Berkshire Hathaway the
stock has done. Berkshire presents its major stock positions both at cost and market. Since, in
many cases, it reported the stake within a year of its acquisition (either in Buffett’s letter or in
some other filing) anyone with internet access can estimate Berkshire’s return on each of its
largest individual equity positions with a high degree of accuracy.
The one thing that these commentators (both Fisher and Ritholtz) are right to stress is that
Berkshire isn’t simply a closed end mutual fund. The company’s book value reflects more than
its activities in the stock market – including (to a greater extent every day) the importance of
negotiated purchases of private businesses.
However, none of this makes Buffett any less of an investor or a stock picker. He is worth
watching – not because he has compounded Berkshire’s book value at a phenomenal rate; but,
because he is undoubtedly one of the world’s greatest living investors. His
record before Berkshire supports that, his record at Berkshire supports that, and (from what little
we know of it) his record outside of Berkshire supports that.
Simply put, if you were looking for the best man to manage any amount of money (whether $1
million or $100 billion) it would be hard to think of someone better than Warren Buffett. That’s
why he’s worth watching. Not because he is a billionaire, but because he is a great investor – a
great stock picker.
That’s enough complaining for one day. My apologies to Mr. Fisher and Mr. Ritholtz who both
do what they do better than most. Of course, they are still wrong on this one.
I will follow up with another post on this topic tomorrow. Hopefully, I can give you some idea of
what you should and shouldn’t do based on news of Berkshire’s activities in specific stocks.
Related Reading
On Forbes List of The 400 Richest Americans
Column: Warren Buffett and the Washington Post
On Misreporting Warren Buffett
Against Mr. Lynn’s Buffett Bashing Phillipic
On Some Lessons from Buffett’s Annual Letter
What Would Buffett Do?
 URL: https://focusedcompounding.com/on-billionaires-their-buys-and-buffett/
 Time: 2007
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On the Risk of Settling
Rick of Value Discipline wrote an excellent post yesterday entitled “Value Delusions and
Strategic Thinking.” In my view, this post is an especially important read in today’s market
environment. Whether current market wide valuations are reasonable or not, it seems clear that
the supply of obvious bargains is relatively low.
It’s no secret that “value stocks” have outperformed in recent years. These are the conspicuously
cheap stocks – the ones that knock you on the head and say “Look at my price-to-book ratio,
look at my price-to-earnings ratio! Does it really matter what kind of business I am? I’m so
cheap the only thing you need to know is that I can pay my bills on time.”
And sometimes that’s true. Sometimes, there’s a veritable feast of such conspicuously cheap
stocks scattered across a variety of industries. By selecting a diverse group of stocks that share
only their conspicuous cheapness and nothing else, an unimaginative investor can rack up solid
returns during such times.
Today isn’t one of those times.
There are two kinds of unloved stocks: those that suffer from contempt and those that
suffer from neglect. The greatest long-term advantage in hunting for bargains among small cap
stocks doesn’t come from the companies themselves – rather, it comes from investors’ attitudes
towards these smaller stocks. Since there are so many small stocks, most investors can’t help but
neglect a great many of them. And so, there tend to be more bargains born of neglect among
small cap stocks than among their larger brethren.
Try this little exercise when you get a chance. Start with a blank piece of paper. Then, write
down the ticker symbols of the stocks you currently consider to be cheap. If you’re an
unmovable bear, write down the ticker symbols of the stocks you consider to be cheap relative to
the market. Treat this as a free write. Don’t linger on a particular stock or second guess yourself
– the moment your hand stops moving, you’re done.
Now, go over the list and ask three questions of each stock. One, is this a bargain born of
contempt or neglect? Two, is this stock cheap because of company specific concerns or because
of industry wide concerns? Three, if this were a private business, would it be considered a great
business, a good business, an average business, or a poor business? In other words, is this a
strong player in a healthy, growing industry or an also ran in the buggy whip business?
Hopefully, your list will feature a good mix of businesses from a variety of different industries.
Ideally, it will have some neglected names on it – truly special businesses that are being valued
like they’re nothing special.
I recently performed this exercise myself. After the list was complete and I had gone back over it
with the precise ratios in hand, I found the truly cheap businesses were not high quality names
and were concentrated in a very few industries. Just as troubling, the businesses I really did like
were trading at a considerable premium to the businesses I didn’t like.
A great investment opportunity shouldn’t have to pass a checklist without a single black mark,
because it isn’t the number of the deficiencies that matters – it’s the weight of the deficiencies
that matters. Still, a great investment opportunity should provide absolute comfort, not
merely relative comfort.
The greatest risk in today’s market is the risk of settling. While poor businesses may be
attractive at some price and quality businesses may be attractive at some considerably higher
price, an investor needs to have a clear intellectual and emotional awareness of what the price is
and what the merchandise is.
There’s a danger that otherwise intelligent investors will relax their standards or allow
themselves to be blissfully ignorant of “price creep” – where a business that once would have
been a bargain at six times earnings now begins to look attractive at 10 or 11 times earnings,
even if it isn’t the kind of business you really want to be in. The desire to cast a wider net when
confronted with a scarcity of the fish you know is natural; it’s also dangerous.
That kind of complacency – an unthinking willingness to embrace a new normal is the greatest
threat facing investors today. As is so often the case, it is necessary to battle the enemy within. It
is necessary to step back, take a deep breath, and ask yourself what you’re doing. What exactly
are you buying and why are you buying it?
Spend some time alone with that stock – with that business – and then ask yourself if it still
looks quite as pretty as it did when it was out there with all its friends.
Read ” Value Delusions and Strategic Thinking”
 URL: https://focusedcompounding.com/on-the-risk-of-settling/
 Time: 2007
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On Corus, Fremont, and the Impairment Charge
I haven’t written about the sub-prime lending story on this blog, because it didn’t involve the
kinds of stocks I would normally write about. Despite the recent market tumult, very few
financial services companies have seen their stock prices decline to levels where they would be
worth writing about. However, there are a few exceptions. Last Thursday, one of these
exceptions, Corus Bankshares (CORS), made an announcement that connected it to the wider
sub-prime lending story.
Impairment Charge
Corus announced that it had determined the decline in the market value of its stake in Fremont
General (FMT) constituted an “other than temporary” impairment (as defined by GAAP). As a
result, Corus plans to record a charge in the first quarter of 2007.
At the time of the press release (March 15, 2007) Corus held 2.5 million shares of Fremont
General purchased at an average cost of $12.73 a share. The most recent trade I saw on Fremont
was at $8.81 a share. So, at present, Corus’ common stock position in Fremont would be $31.83
million at cost and only $22.03 million at market. If the quarter ended today, Corus would record
a $9.8 million pre-tax charge. The impairment charge would increase to the extent that Fremont
General’s share price falls between now and March 31st; conversely, the impairment charge
would decrease to the extent that Fremont General’s share price rises between now and March
31st.
Adding to the Position
At year end 2006, Corus held only 1.6 million shares of Fremont General. The recent increase is
explained in the March 15th press release:
“During 2007, and since the recent disclosures and decline in Fremont’s stock price, Corus
has opportunistically purchased an additional 967,000 shares, bringing its total position to 2.5
million shares with an average cost basis of $12.73 a share.”

Common Stock Portfolio
The 2.5 million shares of Fremont General are held at the holding company level. The holding
company has a portfolio consisting entirely of the common stock of companies within the
financial services industry.
To give you an idea of what the portfolio looks like, here is a summary of Corus’ common stock
investments as of December 31st, 2006. Remember, this information is out of date – especially in
regard to the Fremont General position:
Bank of America (BAC): 16.5%
Fremont General (FMT): 11.8%
JP Morgan (JPM): 11.1%
Wachovia (WB): 10.4%
Regions Financial (RF): 8.9%
Comerica (CMA): 7.1%
Citigroup (C): 5.8%
Merrill Lynch (MER): 5.7%
US Bancorp (USB): 4.5%
MAF Bancorp (MAFB): 4.2%
Morgan Stanley (MS): 3.1%
Compass Bancshares (CBSS): 3.0%
Associated Bancorp (ASBC): 1.9%
SunTrust Banks (STI): 1.8%
Bank of New York (BK): 1.8%
National City (NCC): 1.3%
Amcore Financial (AMFI): 1.0%
Both on December 31st, 2006 and March 15th, 2007 the holding company’s common stock
portfolio had a total market value in excess of $200 million. Therefore, it is unlikely the Fremont
stake accounts for much more than 15% of Corus’ common stock portfolio.
Future of the Fremont Position
In announcing the “other than temporary” impairment, Corus went out of its way to state it “has
the intent and ability to retain its Fremont investment”. This is a direct reference to one of the
criteria for judging whether there has been an other than temporary impairment under GAAP.
Essentially, Corus is saying that its determination of an other than temporary impairment in its
Fremont investment is the result of: “The financial condition and near term prospects of the
issuer, including any specific events which may influence operations of the issuer or may impair
the earnings potential of the investment” and/or “The discontinuance of a segment of the
business that may affect the future earnings potential”.
I’m going with “and” here, since Fremont announced it will exit its sub-prime lending operation
as a result of the FDIC’s cease and desist order. This is a textbook case of “other than
temporary” impairment. Regardless of what Corus intends to do with its Fremont stake, it is
appropriate to record an impairment charge here.
As Corus notes in the press release, one odd consequence of taking such a charge is that the
company’s earnings will certainly be reduced when the charge occurs (at the end of the first
quarter of 2007); but, if Corus retains its investment in Fremont and the share price improves
considerably, it is quite possible that any countervailing improvement will not be reflected in
Corus’ earnings for a very long time.
Corus filed its 2006 annual report on February 27, 2007. You can read it here.
The company’s fiscal first quarter ends March 31st.
 URL: https://focusedcompounding.com/on-corus-fremont-and-the-impairment-charge/
 Time: 2007
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On Rex Stores, Real Estate, and Ethanol
In my post “On Posco, Berkshire, and Buffett“, I mentioned that I had published a quarterly
newsletter when I began this blog, but discontinued it during the second half of 2006, when I
found bargains had become too scarce to reliably provide enough material to fill a newsletter
each quarter.
In the first issue of the newsletter, back in April of 2006, I wrote about a company called Rex
Stores (RSC). Theoretically, Rex Stores is a chain of electronics retail stores. In reality, a
considerable amount of the corporate assets an investor acquires an interest in when he buys the
company’s common stock has little or nothing to do with selling electronics.
Some of you may remember how Bill Rempel answered the last of his twenty questions on
January 24th, 2006:
20. What’s the most interesting company we haven’t heard of?

Rex Stores (RSC). I looked at them in mid-2005 as a possible value play. This little electronics
store in the heartland, sitting on a bunch of real estate, with an extremely low effective income
tax rate. Huh? Turns out the company had a big hand in these synthetic fuel plants that were
getting oodles of tax credits, and the IRS was investigating several of these things because they
were throwing off tax credits but the fuel they were producing synthetically was costing more
than normal fuel, something along those lines. I can’t remember if the synfuel plant they owned
a part of was in the investigation or not, but I decided I didn’t like the notion of buying a small
cap retailer that was into quite that diverse an investment. It pays to read the fine print.
Bill’s intriguing description of Rex Stores is essentially correct (note: the IRS audit was
concluded favorably). This is how the company is described in its most recent 10-Q:
We are a specialty retailer in the consumer electronics/appliance industry. As of October 31,
2006 we operated 207 stores in 36 states, predominantly in small to medium-sized markets
under the trade name “REX”. Over the past eight years, we have also been active in several
synthetic fuel investments and as of October 31, 2006, we had funded two ethanol producing
entities and had contingent agreements to fund three additional ethanol producing entities.
The synthetic fuel partnerships are separate from (and older than) the recent funding of
ethanol producing entities. The production of synfuel generates tax credits; synfuel production
is only economical because of these tax credits. The credits are phased out once the price of oil
exceeds a certain level.
As you can imagine, the historically high oil prices of the recent past threatened to impair the
value of Rex’s synfuel investments, because such high prices would effectively cause synfuel
production to cease.
On October 31st, 2006 Rex made the following announcement:
REX recently received confirmation that all synthetic fuel plants for which it receives income are
in operation. As such, the Company expects to record higher levels of income from the sales of
its synthetic fuel interests than previously indicated through December 31, 2007 at which time
the Section 29/45K tax credit program is currently legislated to end.

Stuart Rose, REX’s Chairman and Chief Executive Officer, commented, “We are pleased that all
the synthetic fuel plants are open and operating. We believe our ethanol interests represent ideal
opportunities for REX to extend our presence in the energy sector and further diversify our
earnings mix.”
You may have noticed that Mr. Rose said “..higher levels of income from the sales of its
synthetic fuel interests…“. This is the sort of thing you really won’t be able to fully understand
until you dig into the filings yourself. I’m simplifying matters a bit here; for now, it isn’t terribly
important that you know the specifics of the agreements Rex made when it sold its synthetic fuel
interests. All you need to know is that Rex has sold its interests in the synfuel partnerships
and will receive quarterly cash payments through 2007 subject to production levels.
Real Estate
On October 31st, 2006 Rex’s balance sheet showed net property, plant, and equipment of
$121.85 million and mortgage debt of $23.81 million. On February 13, 2007 Rex announced a
major real estate transaction:
On February 8, 2007, REX Stores…entered into a Purchase and Sale Agreement…with Coventry
Real Estate Investments…Pursuant to the Agreement, the Company has agreed to sell to the
Purchaser 94 of its current and former store locations for approximately $84.0 million, before
selling expenses, and to leaseback a minimum of 40 of the properties for an initial lease term
expiring January 31, 2010. The leases will contain renewal options for up to 15 additional
years. Either party may terminate a lease after the initial six months of the initial lease term on
23 to 30 of the sites as selected by the Company.
The Company is in the process of analyzing the allocation of the purchase price to individual
properties which have a carrying value of approximately $66.5 million. Since the Company has
not identified all of the properties it intends to lease back from the Purchaser, the resulting gain
to be recognized cannot currently be determined. The Company intends to use the proceeds from
the sale to pay off approximately $17 to $19 million in mortgage debt related to these properties,
to fund its alternative energy projects and for other general corporate purposes.
As a result of this deal, Rex will eliminate nearly all of its mortgage debt (which was already low
relative to the value of the company’s real estate holdings). The deal will also provide more cash
for Rex to deploy in alternative energy investments. I expect those investments will be in ethanol
producing entities. Rex has been very active in that area over the last year or so.
The total sale price of $84 million against the carrying value of $66.5 million seems to support
the basic premise that made Rex an intriguing story in the first place – the company’s assets are
not carried at highly inflated values and the stock trades below book value.
When Rex sells at a considerable discount to book value, it may also be selling at a
considerable discount to the economic value of its assets. Of course, as an electronics retailer,
a large portion of Rex’s book value consists of inventory. On October 31st, 2006 the company’s
inventory had a book value of $116.07 million. This inventory is essentially worthless from an
investor’s perspective – at least insofar as it is considered separately from ongoing operations.
In other words, whatever value is present in the inventory, shouldn’t be assigned on the basis of
the book value of the inventory itself, but rather on the basis of an appraisal of the retail
operations as a whole. So, investors should ignore the book value of the inventory and simply
assign a (conservative) estimate to the retail operations based on some percentage of total sales.
What is needed here is a sum of the parts analysis. I’ll leave that to each of you to perform
individually. This isn’t the sort of investment opportunity you can get comfortable with unless
you have spent a reasonable amount of time going through the filings yourself.
My interest in this stock has nothing whatsoever to do with ethanol (Rex Stores is a simple asset
play. The specific nature of the asset is a secondary concern; its value relative to the market price
is the primary concern). However, if you do have an interest in ethanol, you should obviously
look at Rex Stores before you look at other ethanol stocks.
Rex Stores will release its 2006 annual report on Wednesday, March 28th.
Bill Rempel deserves a special thanks here. If you haven’t visited his site yet, now is a good time
to repay him for his remarks from a year ago.
Visit Bill Rempel
Please feel free to provide your thoughts and/or analysis regarding Rex Stores by leaving your
comments below. If you would prefer, you may discuss Rex Stores with me privately by sending
an email to: geoff@gannononinvesting.com.
 URL: https://focusedcompounding.com/on-rex-stores-real-estate-and-ethanol/
 Time: 2007
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On Misreporting Warren Buffett
I’d like to direct you to an excellent Warren Buffett related post written by Jeff Miller of A Dash
of Insight. Buffett’s annual letter to shareholders is immediately read, analyzed, and reported on
– though not necessarily in that order. Obviously, instant on air reports meant to give you the
highlights of the letter within moments of its release should be completely ignored by anyone
who has an interest in understanding what Warren wrote.
I excuse such reports, because they don’t even pretend to be serious reporting – they’re instant
regurgitation and they look the part. In prior years, Buffett’s annual letter was exempted from
such “breaking news” treatment; however, due to SEC regulations this year’s letter was released
on Thursday instead of Saturday.
Not surprisingly, coverage of the letter suffered from the early release. But, that’s not what I’m
writing about in this post – and that’s not what Jeff Miller wrote about over at A Dash of Insight.
While reading the letter on Thursday, I came across two words I knew would be
misinterpreted: “soft landing”. This misinterpretation is somewhat understandable coming from
someone with a background in financial reporting and no knowledge of Buffett, since the term
“soft landing” is usually used to describe a possible outcome of Federal Reserve tightening.
Unfortunately, if a reporter is somewhat confused about all this, the reader is doubly damned. A
quote alone would be confusing enough for someone who doesn’t know Buffett isn’t in the habit
of making short-term macro economic calls in his annual letter. When a quote from Buffett’s
letter is set within the body of an article authored by someone who isn’t entirely clear on what
Buffett meant, the reader has little hope of leaving the article without a misconception.
To be fair, there is nothing factually incorrect about the Reuters story Miller links to.
Unfortunately, readers get more than facts from a news story. The overall impression from this
Reuters story doesn’t fit well with the impression created by reading the actual letter. That’s
mostly due to the decision to lead with these words:
“Warren Buffett said on Thursday the U.S. economy may not enjoy a ‘soft landing’ because
Americans are taking on too much debt as the U.S. trade deficit worsens.”
Although this lead is factually correct, it misinforms the reader. Worse yet, in this electronic era,
the Reuters story (rather than a careful reading of Buffett’s actual letter) may serve as the germ
for another writer’s story. In this case, the reader who gets his information third hand will be an
unwitting participant in a game of telephone – hopefully he has the good sense not to pass the
message on.
There is one good thing to come out of such reporting – it may kindle a desire among some
investors to consult the primary source. It’s quite a source.
If you haven’t read it yet, now’s your chance.
Visit A Dash of Insight
Read Warren Buffett’s Annual Letter to Berkshire Shareholders
 URL: https://focusedcompounding.com/on-misreporting-warren-buffett/
 Time: 2007
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Berkshire Hathaway (BRK.B) released its annual report today – by now I expect most of you

have read Warren Buffett’s annual letter to shareholders. I’ll discuss the letter as a whole in
another post. For now, I’d like to focus on just one line.
First, I’ll need to include the paragraph that precedes that line. Here’s what Buffett wrote before
presenting his familiar table of Berkshire’s top common stock holdings:
“We show below our common stock investments. With two exceptions, those that had a market
value of more than $700 million at the end of 2006 are itemized. We don’t itemize the two
securities referred to, which had a market value of $1.9 billion, because we continue to buy
them. I could, of course, tell you their names. But then I would have to kill you.”
I direct your attention to line nine of the table (listed alphabetically) which reads:
3,486,006 POSCO 4.0 572 1,158
Okay. Now, what does this mean? The best way to follow along with this post is to go
to Berkshire’s website and open the letter for yourself. The table appears on page 15 of the letter
– which is available only as a PDF.
Obviously, this line means that Berkshire owns stock in the South Korean steelmaker, POSCO
(PKX). Using an appositive in the previous sentence may be grammatically incorrect, but it is
rhetorically honest as POSCO is the South Korean steelmaker. No one refers to it as “a South
Korean steelmaker”.
Anyway, this stake in Posco (I don’t capitalize the name, because English speaker don’t
capitalize such mixed acronyms – it would actually be “PoSCo” if you used our usual practice
and “PoSCo” just looks too weird to print) isn’t all that surprising. From past statements, we
knew that Berkshire (had once) owned some Posco, that Buffett was comfortable enough with
the name to cite it specifically when referring to South Korean stocks, and that in such
statements he more or less said it wasn’t going to go out of business tomorrow.
We also knew that Posco was dirt cheap. Everyone knew that. Every analysis I read that ended
with “don’t buy Posco” didn’t argue it was fairly priced, just that it was Korean, a steel company,
etc. The argument most often used was that it wasn’t the right time in the cycle to buy Posco.
The one argument I never read was that Posco was fairly priced when the ADRs were trading
below $65 a share.
Even now, most articles I read trying to explain the improvement in Posco’s share price don’t
make much mention of just how cheap this stock was – and it ain’t exactly expensive today, even
after quite a run up.
However, I did read one interesting comment today. Apparently, “an official at Posco” told
Reuters that Posco didn’t know when Berkshire bought shares in the company. That remark is
interesting solely because it suggests (though obviously does not guarantee) that Posco’s
management did not approach Berkshire as part of a takeover defense strategy.
Long before I read Buffett’s letter, the thought had crossed my mind that Posco might want
Berkshire to take a sizeable position in the company as part of a takeover defense. Buffett is a
well known and well respected foreign investor who takes passive stakes and has immediate
access to a cash hoard at Berkshire that is close to unrivaled. Years ago, he was involved in
several situations where he acted as something of a “white knight”. The U.S. market has never
since seen valuations that would make such chivalry an area of extraordinary profitability – but
Korea certainly has.
For those who don’t follow Posco or Korea, the company could really use a well known friendly
foreign (read “Western”) investor. Obviously, no one compares to Buffett in this regard. Posco’s
management would like to discourage a takeover without being accused of being either
xenophobic or value destroying. Basically (and I hate to say this) they don’t want to be accused
of acting like Korean executives.
So, it’s interesting that the comment from “a Posco official” to Reuters seems to indicate Posco
didn’t approach Berkshire. That’s not all that surprising, because Posco’s management wouldn’t
naturally think of Berkshire. They’d probably think of Korea, Japan, and the worldwide steel
industry as possible sources of assistance. Anyway, I thought it was worth noting that the
appearance of the name “Posco” in Buffett’s letter is likely to receive attention on the other side
of the world as well as here at home.
Look to the line in which Posco is mentioned (and it’s important to note Buffett does not
mention Posco anywhere in the body of the letter – it only appears in this one line):
3,486,006 POSCO 4.0 572 1,158

You’ll want to disregard the first number you see, because it will only confuse you. If you type
“Posco” or “PKX” anywhere on the web, you’ll likely be directed to information on the ADR.
Berkshire wouldn’t buy the ADR – so, that’s not the security this line is referencing.
Berkshire owns 4% of Posco. That’s what the “4.0” means. This isn’t a particularly large stake
for Berkshire (Buffett seems to really like 5-15% ownership stakes). There are rules about
foreign investment in Korea that differ considerably from what we are accustomed to in the U.S.
I’m not going to discuss them here.
I will, however, take a moment to say that the reason Berkshire’s Posco stake hasn’t been widely
discussed (in fact, smaller Berkshire stakes get much more attention) is because of rules on
disclosure. Buffett, if fully unfettered, would disclose as little as possible about Berkshire’s
operations in marketable securities. Domestically, he’s often unable to maintain the high level of
secrecy he prefers. Overseas, the situation is a bit different and Berkshire’s Posco stake is
evidence of this fact.
The last two numbers in the above line give the cost of Berkshire’s position in Posco and the
market value of that position. From these numbers, we can see that Berkshire’s 4% stake in
Posco was acquired at a total cost of $572 million and has a market value of just under $1.16
billion.
Berkshire has a gain of 102.45% on its investment in Posco. So far, Posco has been a winner
for Buffett – and yes, it would definitely be Buffett who picked Posco. Here, I should mention
something that many (but not all) of my readers already know. Some of Berkshire’s positions are
not the result of decisions made by Buffett himself. There’s an excellent stock picker at Geico
named Lou Simpson (Buffett references him in this year’s letter – in fact, Buffett references him
in just about every letter) who also buys stocks for Berkshire. Occasionally, some of these stocks
are erroneously reported as having been bought by Buffett.
Lou Simpson is a great investor; so, I wouldn’t worry too much about whether Buffett or
Simpson is the one buying any particular stock – you should take both of them seriously.
However, in this case, it seems obvious Posco was Buffett’s decision. Even at cost, we’re talking
about a $572 million stake. Also, Posco (at least at the time of purchase – and I’m guessing the
bulk of it was in 2005) would have had the kind of profile that Buffett can get comfortable with.
While Posco is certainly no cigar butt, it’s much more of a value purchase than the blue chip
stocks most closely associated with Buffett’s name in the mainstream media.
Buffett is a much more versatile investor than many people give him credit for. His hands
are tied by having a lot of capital to deploy at Berkshire. But, he still manages to surprise by
mixing in a USG (USG), Moody’s (MCO), PetroChina, or Posco with the likes of American
Express (AXP), Coke (KO), Procter & Gamble (PG), and Wells Fargo (WFC). A lot of
people who think they know Buffett couldn’t come up with the first group – almost anyone could
come up with the second group.
Finally, let me say that despite the amount of space in this post devoted to a discussion of Posco
and its desire to avoid a takeover, I don’t think there’s necessarily any reason to believe that
played a part in Berkshire’s investment. Buffett can handle himself in such situations. That’s not
why I’m downplaying the white knight idea.
I’m downplaying it, because Posco was just so unbelievably cheap. It wasn’t just
cheap relative to other steelmakers, or cheap relative to other huge corporations, it was
just absolutely cheap beyond belief. I have no doubt that Posco’s utter cheapness was Buffett’s
main motive for buying – he saw a ridiculously cheap stock and he knew he could get a
meaningful amount of it for Berkshire. That doesn’t happen everyday – it takes a cheap stock the
size of Posco to really interest Buffett these days.
I mentioned in my last post that I started a quarterly newsletter along with this site, but closed up
shop after just two issues, because during the third quarter of 2006 the supply of bargains in the
market went from a trickle to a slow drip at best. Anyway, the first issue of the newsletter (April
2006) ended with a discussion of Posco. At the time, the ADRs were trading at $63.80. Today,
the ADRs are trading over $90.
Now that my newsletter is defunct, I can share the name of Posco with you (I know, $27 a share
later, thanks a lot!) and reprint something I wrote about the stock in July of 2006.
I won’t share the original write-up with you, because it’s far too long for a blog and is filled with
lots of boring graphs on steel consumption and production by nation and other such tidbits that
are likely only of interest to one reader at most (myself included).
But, I will share the short follow-up I included in the July ’06 issue, which includes some of my
thoughts on the share price (here, I’m writing about the ADRs – again, that’s not what Berkshire
holds):
(NOTE: Remember, this piece was originally published in July of 2006)
There is little point in reviewing the most recent quarterly performance from Posco (PKX). The
Korean steelmaker makes news when it reports earnings; but, not because of what those earnings
say about the condition of the company itself. The financial media has a strong tendency to take
micro stories and turn them into macro stories. In Posco’s case, this actually makes a lot of sense.
In fact, it’s quite difficult for me to find much to write about in any Posco earnings release. Steel
is a commodity. Wild price fluctuations are part of the game. There will be good times and bad
times. It makes little sense to focus on whether times are good or bad today, because neither
elevated prices nor impressive trends will last.
High prices lead to increased production. Strong demand and high prices for the output lead to
strong demand and high prices for the input. An investor is bound to take too much from any
single earnings release. He will look for trends where none are sustainable. Each time, he will
convince himself this time is different.
In the short-run, the macro environment trumps the micro environment. In the steel industry, a
rising tide will lift all boats. Both the best companies and the worst companies will enjoy
tremendous results when times are good.
The truly important questions, those dealing with a company’s competitive advantages, are
difficult to answer in the short-term. These company specific competitive forces only assert
themselves over longer periods of time. Each steelmaker is judged by its bottom line. Of course,
it would probably make more sense to judge each company by the one thing it has at least some
control over – the cost of production. A successful steelmaker is a low-cost steelmaker. This
doesn’t mean the company sells cheap steel. It means the company produces the same product at
a lower price than its competitors. That’s how a steelmaker has to be measured.
In a few cases, a company possesses some competitive advantages other than low-cost
production. Posco is one of those cases. The company operates as a virtual monopoly within the
lucrative South Korean steel market. Posco accounts for approximately 75% of Korea’s domestic
steel production. Sales within Korea generate the majority of Posco’s revenues. Only about 26%
of the company’s annual revenues come from exports. Posco’s two largest export markets, China
and Japan, combine for about 15% of the company’s sales. Here too Posco has an advantage.
The company can ship to those countries much more quickly (and hence more cheaply) than
many of its competitors.
From an investor’s perspective, Posco is the world’s finest steel company. It operates as a near
monopoly in an enviable market. The company has a rock solid balance sheet maintained by
extraordinarily consistent and robust cash flows. For these reasons, Posco is among the most
interesting foreign investments around.
An investment in Posco isn’t a bet on steel. In fact, it isn’t even a bet on Korea. If you had to
make a macro bet, you could certainly do worse than steel and Korea. However, you don’t have
to make a macro bet. You can instead choose the much simpler task of buying a specific
company at a specific price. That’s what led to the inclusion of Posco in the portfolio. It’s a bet
on Posco – nothing else.
(NOTE: Remember, this piece was originally published in July of 2006)
Having said that, it’s worth checking in with the steel industry to see if there have been any earth
shattering surprises. So far this year, everything has gone about as expected. Posco looks set to
post a decline of slightly less than 50% in net income. At least that is what the first half of the
year had suggested. Right now, it looks as if the second half of the year may be a bit stronger
than I had earlier suspected. The environment in 2007 looks solid. Obviously, this could change.
China is the biggest threat to Posco. Is it an economy out of control? Has it been juiced up with
easy money and undisciplined capital allocation? The answer to both of these questions may well
be yes. That’s troubling, because a slowdown in China (and hence Chinese demand for steel)
would likely coincide with an Asian steel glut. It’s certainly something to watch for over the next
few quarters.
For Posco’s shareholders, changes in Chinese steel production may prove to be more important
reading than Posco’s own earnings releases. Although Posco primarily serves the Korean market,
a slowdown in China coupled with a steel glut would be very unfortunate, because it would
affect both Posco’s domestic sales and its export sales. This scenario was my greatest concern in
April; it remains my greatest concern in July.
Suggestions
Suggest Buying: $74.00
Consider Selling: $93.00
Best Guess: $124.00
Suggest Selling: $190.00
Okay. First, let me remind you yet again that the above was first published in July 2006 – so, it’s
woefully out of date.
Second, a few words are necessary regarding those prices at the end of the piece. In my
newsletter, I started using four “suggested prices” with each stock I recommended.
“Suggest Buying” meant: “when the stock is below this price, I suggest you buy it.”
“Consider Selling” meant: “Don’t even think about selling below this price!” This is usually
(but not always) the price at which qualitative judgments about future growth and profitability
start to play a meaningful role in the buying decision.
“Best Guess” meant: “This is my best guess as to the intrinsic value of the stock”.
“Suggest Selling” meant: “This is the absolute upper limit of a true investment. Once you go
beyond this price, you enter truly speculative territory”.
The wide discrepancy between my best guess price ($124/share) and my suggest selling price
($190/share) for Posco is due to my being extremely conservative on the best guess price. Posco
at $124 a share probably is fairly valued as a steel company – however, it’s probably not fairly
valued as Posco, because Posco is a great steel company even if it isn’t a truly great business.
The one thought I’d like to leave you with is the one that will remain the same regardless of
changes in stock prices and steel prices: “From an investor’s perspective, Posco is the world’s
finest steel company”. I’ll stick with that statement.
 URL: https://focusedcompounding.com/on-posco-berkshire-and-buffett/
 Time: 2007
-----------------------------------------------------
On Freston, Redstone, and Viacom
On Monday, Sumner Redstone fired Viacom’s CEO, Tom Freston. Yesterday, Viacom
announced that its Board of Directors had appointed Philippe Dauman President and CEO and
Thomas Dooley Senior Executive V.P. and Chief Administrative Officer (a newly created
position). Mr. Dooley’s role is expected to be similar to that of a Chief Operating Officer.
Both Dauman and Dooley are members of Viacom’s Board of Directors. They served in key
positions within the previous incarnation of Viacom, which was split into two separate public
corporations, Viacom (VIA) and CBS (CBS), approximately eight months ago. Sumner
Redstone is the Chairman of each company. Viacom’s new CEO, Philippe Dauman, will report
to Mr. Redstone. Thomas Dooley will report to Mr. Dauman.
Although The Financial Times went with the no nonsense headline “Freston Removed as Chief
of Viacom”, I fear The Wall Street Journal may have had the more accurate headline: “Ouster of
Viacom Chief Reflects Redstone’s Impatience for Results”. In fact, I couldn’t have said it better
myself. Of course, I was planning on writing more of a personal opinion piece than a front page
article (the story made the front page of both the FT and the WSJ). Still, I can’t fault The Wall
Street Journal for putting the painfully obvious in big print.
The Journal article (which is a good outline of the whole affair) won’t encourage faith in Sumner
Redstone among Viacom’s shareholders. It begins by quoting Mr. Redstone’s assurance (given
just six weeks before) that he could imagine “no circumstance” under which he would fire Mr.
Freston. Cut to Monday, at Sumner’s estate, where Tom Freston, a 26 year company veteran, is
told he has managed to lose his job, just eight months after being given the helm of the new
(CBS-less) Viacom.
The most obvious objection to Mr. Freston’s firing is simply that he wasn’t given enough
time. There are billions of people on this planet and it took more than eight months to produce
the majority of them; so, I imagine doing something truly remarkable, like steering a media
company through troubled, transitional waters, takes quite a bit longer.
The other objection is that Freston had already proved himself a capable executive. He may
not have been able to answer the question “What have you done for me lately?”. But, he had
built up quite a reputation at MTV. Recent results have taken some of the shine off that golden
boy (the channel, not Freston, who is no golden boy at age 60).
MTV is more than a golden boy; it’s Viacom’s crown jewel – accounting for about 70% of
the company’s revenue and nearly all of its profits. The aforementioned Journal article fears
“Mr. Freston’s departure could lead to a wider shake-up at the company, particularly within
MTV networks, much of whose management has been with the company for years and is
intensely loyal to Mr. Freston.”
Those fears are rational. Any time an executive this connected to a particular division is lost
there is a danger others may follow – especially when such an unceremonious exit is forced upon
a company vet by the powers that be. In this case, the (perceived) motives of those powers is also
a cause for concern.
There’s no doubt many at Viacom now see the long, decrepit arm of Sumner Redstone reaching
out from his Beverley Hills estate and reasserting his grip on the cable properties that were once
buried deep within his corporate behemoth.
At the time of the CBS / Viacom split, I knew Viacom would trade at a price that would keep it
well off my investment radar. If anything, I thought CBS would be the more likely opportunity.
Right now, I’m not tempted in the least by either stock. But, I have found myself much more
interested in Viacom as a business.
The one really exciting aspect of the CBS / Viacom split was the idea that an MTV native
would be running the new company. Viacom’s properties are very different from those owned
by CBS. There was (and still is) an opportunity here for Viacom to become a content focused
company.
CBS really isn’t content focused – and it shouldn’t be. That company’s biggest competitive
advantage is owning a U.S. TV network. There are only a handful of such networks and each is a
franchise (albeit a waning one).
Simply controlling a network, regardless of the quality of its current programming, has value.
The situation is analogous to owning a Major League Baseball team, which has some value
regardless of the quality of the players currently under contact.
Broadcast networks are in a very different position from cable properties, where excluding a
handful of properties (e.g., ESPN, Discovery, and the Food Network) competitors have no real
advantage in attracting good programming. Many large media companies are built around
delivery (though they have managed to delude themselves into thinking otherwise).
Content and delivery are two very different businesses that owe their marriage more to the egos
of media moguls and the capital of the investors who buy their securities (both equity and debt)
rather than to any natural economic synergy.
The origin of good content is always a choke point; the delivery of such content almost
never is. It takes only two competing buyers to make a market. I’ve never been convinced that
serving thousands of small customers is really a safer and more profitable business than serving a
few big ones (except in high volume, low margin businesses where a large customer playing
hardball can force you to eat your unused capacity). In cases where the product is unique and the
right to use that product is exclusive (as is often the case in the media business), the number of
different owners of the various delivery systems becomes an unimportant point.
The broadcast networks are an exception – a living relic of a bygone era. They have a
competitive advantage that isn’t derived solely from controlling content. They have an
established network, which acts much like a large installed base by providing a beachhead of
access and familiarity from which an offensive of solid programming can be launched into
millions of American homes.
Cable properties can’t emulate the networks. But, they can build finite competitive
advantages through bits of good content that can be milked for a time. Changes in technology
will never eliminate the choke point that accompanies good content. It will exist online and
offline just as it has existed in print and pictures.
Maybe Viacom’s new management will be focused on providing good content – but, I doubt it.
Somehow I suspect they will be more interested in doing deals and selling Wall Street on
Viacom’s future prospects. Such actions would be consistent with both their own backgrounds
and with Sumner Redstone’s expressed tendencies.
A Financial Times article entitled “Jumping Jack Crash: Digital Kills the Video Star” ends with
a quote from Mr. Redstone: “We will seek out every sensible deal – whether in the digital space
or otherwise…And…we are determined not to let it get out of our hands.”
Those are scary words for investors who have entrusted their capital to Viacom. When a public
company convinces itself it can’t afford not to do a deal, it usually gets the deal – and
shareholders pay the price.
There are real problems at MTV – and real challenges at Viacom. Both The Financial
Times and The Wall Street Journal noted that ratings for the MTV Video Music Awards were
down 30% this year. That’s on top of a decline in ratings the year before. The internet also
presents challenges (and opportunities) for Viacom. But, are Dauman and Dooley really any
better equipped to tackle these problems than Tom Freston was? For me, it’s difficult to imagine
anyone better suited to run the new Viacom than Tom Freston.
This is a big step backwards for Viacom. The benefits of autonomy that might have been
reaped under Mr. Freston are unlikely to flourish under Dauman and Dooley, who are, by all
accounts, legates of Chairman Redstone. The leash has been tightened.
 URL: https://focusedcompounding.com/on-freston-redstone-and-viacom/
 Time: 2006
-----------------------------------------------------
On Google’s Non-Search Products
Business Week has a good article about Google’s non-search products. Entitled “So Much
Fanfare, So Few Hits”, the article makes a few obvious points that are often omitted in a
discussion of Google’s innovation. The most obvious point is, of course, that these products have
not exactly been great successes.
The press (both online and offline) is obsessed with Google (GOOG). An interesting exercise
would be to clip the press coverage (or speculation) surrounding the launch of a new Google
product and compare it to that product’s performance some months later. I’m afraid this exercise
would prove the reality did not live up to the hype. Of course, most of this is not Google’s fault.
It isn’t that these products fail miserably. In many cases, they are simply competent products that
offer little advantage over the existing alternatives. So, Google moves on.
As one person interviewed for the article put it: “Google has product ADD”. I’m not sure if
that’s true or not. The fact that Google develops these non-search products does not in and of
itself suggest anything dangerous about Google’s future spending and the efficiency with which
its capital is deployed outside of the core search business.
After all, these products are really little more than ideas. Has the company really put much
behind any of them? That’s a more interesting question. It also happens to be one of the most
important questions for investors to answer.
This Google article reminded me of a blog post on Microsoft I had found via Seeking
Alpha. This blog post had one very memorable line: Name six innovations from Microsoft over
the past 12 months.
That line jumped out at me, because I’m not eager to invest in a company where you can name
six innovations over the past 12 months. No company develops six truly meaningful innovations
in a year. The issue is not the number of innovations. It’s finding one that really works.
Both Microsoft (MSFT) and Google had the bad luck to develop a unique cash cow in their
early years. As a result, both companies will inevitably have to face accusations of mediocrity in
their future endeavors.
Microsoft’s Windows (and by extension Office) and Google’s search are once in a lifetime finds
in an otherwise unforgiving competitive environment. These oases of extraordinary profitability
can not be duplicated. So, if your reason for buying into either stock is an expectation that future
products will rival past products in terms of profitability, you are on a fool’s errand. There will
be growth within each franchise and there will be other (lesser) franchises. But, neither company
will duplicate their initial success.
The reason they won’t has nothing to do with size or culture. It’s much simpler than that.
Both companies were marketed to investors as a great franchise. There aren’t many such
franchises and the odds that two such franchises would be developed by the same company are
extremely low. Most of the best businesses (not the biggest, but the best) learn to do one thing
very well – and then do that one thing over and over again, year after year.
Google should be able to move into other businesses beyond search – and should be able to
do so profitably. That isn’t the problem. Right now, the problem is the expectation that Google
will have many successes. It won’t. Usually, there’s no reason why Google will be any more
successful than the established players in a particular niche. Obviously, Google’s ventures have
the benefit of free publicity. Unfortunately, the benefits from such publicity multiply with the
differentiation of the product – and so far, that is an area in which some of Google’s innovations
have been lacking.
One Google product I really like is Google Finance. This is the kind of product that would seem
to have a lot of revenue potential if developed with that end in mind. I wrote a review of Google
Finance when it launched.
I hope Google Finance isn’t suffering from neglect. There are still many improvements needed
and I wouldn’t mind seeing Google spend a little more time improving existing non-search
products and a little less time developing new ones.
Finally, getting back to the question of what Microsoft has done lately, they did come out with
the Xbox 360. Although I don’t like the economics of the console market, I do like the
economics of the game market. Microsoft’s console may provide a beachhead in that market
(actually the original Xbox already provided such a beachhead).
We’ll have to wait to see how this round of consoles plays out. However, I already have to admit
Microsoft’s progress in the console business has been a lot faster than I expected prior to the
launch of the original Xbox.
It’s also worth noting that, despite the greater press coverage given to Microsoft’s Vista woes,
Sony’s problems with the PS3 are a lot more meaningful. People have to wait for Vista. They
don’t have to wait for the PS3 – and they certainly don’t have to pay up. After all, a game
console is no more than a platform. Prohibitive pricing will exclude some younger gamers from
buying the PS3, which obviously doesn’t bode well longer term.
My point is simply that I would value Microsoft’s single innovation over Google’s entire
assortment. To be fair, the one hit is what matters. Many misses are not really a bad omen. But,
they certainly don’t warrant all the hype.
Related Reading
On Google Finance
On Microsoft
 URL: https://focusedcompounding.com/on-googles-non-search-products/
 Time: 2006
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On Inflexible Enterprises
Yesterday’s Wall Street Journal had an interview with Anne Mulcahy, CEO of Xerox (XRX).
I’m not mentioning the article because of Xerox itself. I don’t see any margin of safety in the
stock.
Xerox isn’t particularly cheap on an enterprise value-to-EBIT basis. The company did earn
good returns on equity in the late 90s; but, those returns were largely the result of leverage. So,
investors who buy Xerox are betting on a turnaround with limited upside.
Considering the situation at Xerox and the current market valuation, it’s hard to say whether the
stock is overvalued, undervalued, or fairly valued. Regardless, it doesn’t look like an especially
attractive opportunity – it seems to be trading within that rather broad gray range that forces me
to withhold judgment.
However, the article was worth reading, because it reminded me of a particular problem I had not
yet discussed here.
Over time, a business puts down roots. It engages in activities that require it to take on
economic and moral obligations. Often, investors find extricating the business from these
obligations proves far more difficult than they ever imagined.
One answer in the interview contained an important lesson for investors. Said Mulcahy:
This is the pain of technology transitions. You can either sit and wait like Kodak or Fuji…and
fall off a cliff when it happens. Or you can migrate…It’s always more attractive to stay in the old
technology from a profit standpoint. Always. But you’ll be going out of business.
This problem isn’t limited to technology. Whenever a large investment has been made in a
particular area, whenever there is a lot of capital, people, and ego tied up with some operation,
the transition away from that operation is apt to be far slower than what an objective observer
would have expected.
As an investor, it’s easy to look at a corporation from afar and see the business the way a rational
capital allocator would see it. But, very few people within the organization are able to take such
a farsighted view. They are not able to asses the matter dispassionately. There are jobs at stake.
There is the admission of defeat. And there is the question of identity. Just as importantly, these
problems hang over the managers every day. Staying too long in a dying business is rarely the
result of one major misstep – rather, it is the result of a series of seemingly innocent steps that
merely serve to delay the inevitable.
Recognizing the terrible importance of the inflexibility of an enterprise that is tied to a particular
line of business, mode of production, or labor force is a difficult task. Many value investors have
been caught in this trap. Some business appears to offer excellent value today; but, if it should
cling too long to its old ways, that value will be destroyed. It’s tempting to think that managers
will see the obvious danger, act to remedy the problem, and forever change the
organization, before the inevitable occurs. But, that kind of thinking requires a leap of faith. It is
too easy for the investor to believe what he wants to believe – to assume that somehow tomorrow
will take care of itself.
Even Warren Buffett, a man who has been ever vigilant in his efforts to avoid prolonged
entanglements in businesses with poor economics, has suffered from delusions of an easy
transition. There are probably three good examples of such delusions from Buffett’s career.
Discussing only two will be sufficient (the third would be Baltimore department store
Hochschild-Kohn).
Buffett suffered from his most recent delusion in late 1993. That’s when Berkshire Hathaway
acquired Dexter Shoe. Buffett now realizes that deal was a mistake. In the 2001 annual letter to
shareholders he wrote:
I’ve made three decisions relating to Dexter that have hurt you in a major way: (1) buying it in
the first place; (2) paying for it with stock and (3) procrastinating when the need for changes in
its operations was obvious…Dexter, prior to our purchase – and indeed for a few years after –
prospered despite low-cost foreign competition that was brutal. I concluded that Dexter could
continue to cope with that problem, and I was wrong.

Buffett lists three separate decisions. I don’t think the way he presents the Dexter Shoe debacle is
simply a thoughtless arrangement. Buffett is admitting he shouldn’t have bought Dexter Shoe at
all. He shouldn’t have bought it with stock or cash.
His purchase was based on a false premise. It wasn’t simply a matter of overpaying (by using
stock). It’s also interesting to note the third decision he describes: “procrastinating when the need
for changes in its operations was obvious”. That’s a pretty harsh admission.
Buffett refers to procrastinating as a decision. No doubt it was a daily decision, not a one-time
choice between two separate paths; nevertheless, it was a costly decision. Excusing inaction as
being somehow a lesser offense than an incorrect action is a common occurrence in business;
but, it is not a productive way to learn from one’s own mistakes. Especially in investing, inaction
must be judged just as harshly as action.
The most interesting part of all this is the fact that Buffett separates the purchase itself from his
failure to push for change at Dexter Shoe. He does not suggest that buying the business and then
trying to change it would have worked well. Buffett seems to be saying the best course would
have been not to buy the business in the first place.
I think he’s right. The risks involved in purchasing an inflexible business are difficult to
quantify. However, they are real. These risks are frequently large enough to destroy any apparent
value that comes in the form of a bargain price relative to high current earnings (or cash flow).
A business that is purchased because it can throw off cash can quickly become a money pit.
Often, the buyer is well aware of this possibility. However, he manages to convince himself that
the necessary transition will be made with the speed demanded by a rational assessment of the
facts and a desire to put capital to its best possible use.
Operating managers rarely see things so clearly. Even when the road ahead is clear, the will is
often lacking. It is easy to rationalize decisions that seem to offer a middle course. A gradual
transition is always a tempting possibility. Who wouldn’t want to convince themself that a retreat
is really a fighting withdrawal?
In the 1985 annual letter to shareholders, Buffett gave Berkshire’s reasons for remaining in the
textile business as long as it did:
(1) Our textile businesses are very important employers in their communities, (2) management
has been straightforward in reporting on problems and energetic in attacking them, (3) labor
has been cooperative and understanding in facing our common problems, and (4) the business
should average modest cash returns relative to investment.
It turned out I was very wrong about (4)…I won’t close down a business of sub-normal
profitability merely to add a fraction of a point to our corporate rate of return. However, I also
feel it is inappropriate for even an exceptionally profitable company to fund an operation once it
appears to have unending losses in prospect.

The delusion Buffett suffered under was only in regard to his fourth reason for remaining in the
textile business. The belief that modest returns will be realized from a sub-par business is an
attractive one.
A rational assessment of the facts would have lead to the opposing conclusion. Past experience
demonstrated that apparent possibilities of future profitability based on greater efficiencies and
improved conditions within the industry rarely lead to any actual profits. There was always hope.
But, there was rarely any proof that such hope was justified.
Over the years, we had the option of making large capital expenditures in the textile operation
that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked
like an immediate winner. Measured by standard return-on-investment tests, in fact, these

proposals usually promised greater economic benefits than would have resulted from
comparable expenditures in our highly-profitable candy and newspaper businesses…But the
promised benefits from these textile investments were illusory.

An objective observer would have seen the flaw in the arguments offered in support of such
investments. The industry was plagued by an overabundance of capacity. In the past, there had
been a terrible misinvestment of capital that diverted a great flood of money into a seemingly
attractive industry.
Unfortunately, that capital did not go into easy to recoup investments. It went into massive
expenditures that saddled the owners with high fixed costs. A factory that produces nothing is
worse less than nothing. It’s a money pit. The owner has only two choices: exit the business or
attempt to obtain the most favorable variable costs by any means necessary. If enough players
opt for the latter the game is no fun for anyone.
Many of our competitors, both domestic and foreign, were stepping up to the same kind of
expenditures and, once enough companies did so, their reduced costs became the baseline for
reduced prices industrywide. Viewed individually, each company’s capital investment decision
appeared cost-effective and rational; viewed collectively, the decisions neutralized each other
and were irrational (just as happens when each person watching a parade decides he can see a
little better if he stands on tiptoes). After each round of investment, all the players had more
money in the game and returns remained anemic.

The image of a crowd of parade watchers on tiptoes is a good one for investors to keep in
mind. This is what a bad business looks like. This is the kind of investment you want to avoid. A
corporation rarely exits a business on economically beneficial terms. It does so in its own time –
long after the unending decline becomes obvious.
An inflexible enterprise is one that is tied to a particular line of business, mode of production, or
labor force. Most businesses are not as closely tied to these things as you might think.
A few are. Xerox and Kodak (EK) are two examples from the recent past. General Motors
(GM) is still tied to a labor force from a bygone era. GM is an example of a business that is so
inflexible it is tied not only to a particular industry but to a particular position within the
industry. The company was not structured in a way that allowed it to slim down in the event of a
loss of market share. For some businesses, a shift in the structure of their market can be as
disastrous as a shift in technology.
The consequences of such shifts can be dire. The good news is that it is not difficult to see
which companies are exposed to these future threats. General Motors was a huge, unionized
enterprise. It held a very large share of the U.S. market. It obviously had to maintain its market
share. That may not have on the mind of investors a few decades ago, because the idea that GM
would lose market share might have seemed absurd. But, if they had considered the matter, they
would have seen that GM’s survival was largely dependent upon maintaining a very large share
of the U.S. market.
Likewise, if Intel (INTC) or Microsoft (MSFT) lost much market share, they’d have to make
huge changes very quickly. The current structure of those companies can’t be supported by a
small share of the market. Of course, it would be much easier for these businesses to shed tens of
thousands of employees than it is for General Motors. At the same time, no sane investor is
buying shares of Intel or Microsoft unless he expects them to maintain roughly the same share of
the market for their products that they currently control.
Future market share is a key consideration at both these firms, because the weight of the
expenses they have taken on would crush any company that is not the biggest player in the
industry. The companies literally employ small armies. In fact, the combined workforce of these
two companies is no less than the number of U.S. troops in Iraq. So, clearly both companies have
made rather large commitments predicated upon their continued dominance. Without that
dominance, these commitments would become crushing burdens.
You need to give some thought to the flexibility of any business you invest in. The greatest
risk facing a large enterprise is a decrease in revenues that can not (or will not) be offset by a
similar decrease in expenses.
The “will not” part is important, because I’ve learned that it is easy to put too much faith in
management. No one likes to make tough decisions. The fact that a problem is obvious does not
mean those who understand the problem will necessarily seek to solve it. I have no doubt that
many in Congress recognize that the national debt is a problem. I also have no doubt that they
recognize it is not in their interest to address the problem. They would like to see someone else
address it at a later date. Everyone would.
It is too easy to rationalize a thousand small steps. Then, you never have to admit your one
big mistake. It may be that no one consciously chooses to tie a business to an inflexible and
potentially perilous position. Likewise, it may be that no one consciously chooses to continue
down that path. But, that is often precisely what happens. If the problem is not addressed until it
must be addressed, it is too late for the owners. The losses in both time and money are already
too great.
Therefore, it may be best to look for businesses where managers will not be required to make
tough decisions. An investment based upon the belief that managers will make tough decisions is
always a risky investment – regardless of the fundamentals.
 URL: https://focusedcompounding.com/on-inflexible-enterprises/
 Time: 2006
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On Special Situations
I don’t discuss special situations investing on this blog both because it is not my forte and
because I don’t think special situations investing is something most readers are interested in.
However, investing in special situations can be very profitable. In fact, if not for its demands on
time and temperament, special situations investing might be the best way for individual investors
to put their money to work.
Unfortunately, the demands on time and temperament are real, and they do preclude most
investors from successfully pursuing this strategy. Simply put, you have to be willing to put
some extra time and effort into such investments.
There is an almost constant flow of possible opportunities. Like any kind of investing, you are
going to have to say no a lot more often than you say yes. That isn’t a lot of fun for most people.
In fact, many investors will not succeed in this area, simply because they will be too eager to do
too much too quickly.
But, if you’re still interested in special situations investing, I’d recommend you do two things:
1. Read “You Can Be a Stock Market Genius” by Joel Greenblatt
2. Visit Fat Pitch Financials
Greenblatt’s book is a good introduction to special situations investing, because it discusses the
topic in a way that will make sense to investors who have never considered this area before.
There are some other books that treat select subjects in greater detail, but they aren’t the best
place to start – this book is.
George of Fat Pitch Financials discusses some excellent special situations on his blog. There’s
a membership access area that discusses current situations. But, if you just want to learn more
about special situations investing, the free content at Fat Pitch Financials is more than sufficient.
To give you some idea of what I’m talking about, here’s an excerpt from George’s most recent
post:
As you might recall, I purchased AutoNation on March 31, 2006 for the Special Situations Real
Money Portfolio. This was my first odd-lot tender offer opportunity that I’ve taken advantage of.

Odd-lot tender offers provide small individual investors a unique opportunity that the big boys
don’t have. By owning less than 99 shares of the stock that is being tendered, my shares received
preference in this tender offer since there was an odd-lot provision to the tender. The
AutoNation Inc tender was very oversubscribed and most shareholders that tendered their
AutoNation shares only had 26 percent of their shares cashed out. However, since I had an odd
lot, my tender was not subject to being prorated. This presented a very nice opportunity.
Let me show how nice. I purchased 95 shares on March 31, 2006 for a total cost of $2,056.10.
This morning I received $23 per share for a total of $2,160.00. My broker charged me a $25
dollar fee in addition since this tender was a voluntary action. My total profit was $103.90 or a
5.1 percent gain. That comes out to a 92 percent average annualized return for this 20 day
investment!
 URL: https://focusedcompounding.com/on-special-situations/
 Time: 2006
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On Confidence
I get a fair amount of emails both from readers of the blog and listeners to the podcast. Most of
the emails come from people who listen to the podcast. The two most common varieties
are: 1) “Before I listened to your podcast, I thought investing was impossibly complicated; now,
I think it may be simple enough for someone like me.” 2) “Before I listened to your podcast, I
though investing was simple; now, I think it may be too complicated for someone like me.”
Part of the reason for these two very different reactions is the nature of the podcast. I talk for
almost half an hour about things that aren’t regularly discussed at length by the financial media.
So, it’s natural for listeners to feel I’m discussing something familiar in an unfamiliar way.
That can cause listeners to question some of their beliefs, especially if those beliefs weren’t all
that firmly held to begin with. Most people’s beliefs about investing are very tenuous. There are,
of course, people who are very passionate about investing. They don’t view investing as some
esoteric subject, but rather as a field intimately connected to the human behavior they observe in
their everyday lives.
For everyone else, however, beliefs about investing come in the form of passive knowledge. The
tendency is simply to accumulate an inventory of conventional dictums. Investing beliefs are
formed much the way a student prepares for a test. If the subject of investing were as simple as a
third grade spelling bee, this wouldn’t be a problem.
But, investing is a far more complex subject. That isn’t to say it is necessarily a difficult subject.
For some, it is relatively easy. But, it is never simple. An investor can not analyze relationships
with the certitude and precision a physicist can. The investor is concerned with human
phenomena, which are necessarily complex phenomena.
The complexity of the subject is what makes it appear so difficult. While you can develop a
set of guiding principles, it is impossible to devise rules that will lead you to the best course of
action in each and every case.
If you try to build an intellectual edifice based on principles such as high returns on equity,
strong consumer franchises, low price-to-earnings ratios, low enterprise value-to-EBIT ratios,
high free cash flow margins, and rock solid balance sheets – you will fail.
The entire structure will collapse, leaving the architect disillusioned. Why? Because the items
listed above are desirable attributes – nothing more and nothing less. They are not true
principles. Even as rules of thumb, they are badly flawed. Ultimately, investment decisions are
not made about general classes; they are made about special cases.
Every investment decision requires good judgment and sound reasoning. You need to start
with the correct principles. But, principles alone are not enough. You aren’t being asked what the
law is, you’re being told to apply the law to the case before you.
This is where a lot of people start to feel overwhelmed. Having learned that investing is not
simply a matter of running down a checklist, they don’t know where to begin.
The answer is to start with what you know best. Begin with your most strongly held beliefs.
Subject them to honest scrutiny. Then, and only then, apply them to the case at hand.
Do you believe the concept of intrinsic value is a valid one? Do you believe it is a useful model?
If so, then begin there. What does the concept of intrinsic value really mean? What conclusions
follow from this belief?
In the case of intrinsic value, the most difficult conclusion you’ll have to grapple with is the idea
that you can pay too much for a great business. For some, this is a relatively simple conflict to
resolve. For whatever reason, they prefer cheap merchandise to quality merchandise.
For others, the conflict between intrinsic value and investing in great businesses is painfully
difficult to resolve. But, if you are ever going to have confidence in your judgments, you have to
be willing to submit your investment beliefs to honest scrutiny. You have to be your own
prosecutor. You have to present the evidence against your thesis.
If you aren’t willing to do that, you’ll end up questioning the investment beliefs you do hold
every time you underperform the market. Many proven investment techniques have lagged the
market over short periods of time. Occasionally, the performance gap has been very wide.
Regardless of whether you adopt a primarily qualitative or primarily quantitative approach to
investing, this short-term underperformance is unavoidable.
It’s avoidable in the sense that a good investor can get lucky and not suffer a down year for a
decade or so. Likewise, it’s possible to outperform an index year after year – if you’re lucky.
But, it isn’t possible to adopt a strategy that guarantees such outperformance.
The best you can do is adopt a strategy that offers the right odds. A series of investment
operations undertaken in accordance with such a strategy will not guarantee favorable outcomes
in every case, but it should provide satisfactory results over the long-term.
There’s more than one way to skin a cat. I don’t want to encourage dogmatism. But, I do want to
make sure you do not confuse that which is conventional with that which is reasonable. There is
a lot of conventional, moderate sounding advice given to investors that does not hold up to
careful scrutiny.
The most obvious example is diversification. Making a series of bets on separate high-
probability events is an excellent idea. Diversifying across several different asset classes and
hundreds of securities is something entirely different. Even if there are hundreds or thousands of
excellent investment opportunities, it does not follow that an investor ought to make every
reasonable bet. After all, some will appear to be more reasonable than others. There is no sense
in taking on several difficult tasks in the hopes of achieving a result that can be produced by
taking on a few very easy tasks.
You don’t have to agree with me on all these issues – most people don’t. But, it is vital that you
question the unstated assumptions upon which an investment operation is based. You might
come to the same conclusion as those who engage in wide diversification. But, you need to come
to that conclusion on your own.
Many investors have not even bothered to consider the underlying premise of
diversification. They aren’t really sure why diversification is a desirable strategy. They don’t
know how it minimizes risk or at what point the benefit from adding an additional position
becomes immaterial. Diversification may be a prudent strategy. But, you can only decide that for
yourself after you’ve considered the benefits in terms of risk reduction and the detriments in
terms of selectivity reduction.
If I were forced to spend my life betting on horse races, I’m quite certain I would bet on very few
races. Whenever I did bet on a race, I’d bet on several different horses.
Why? Because I know more about people than I do about horses. The likelihood that a few
horses in a few races get too much favorable attention seems much greater than the likelihood
that I could ever make reasonably specific judgments as to which horse is most likely to win a
given race. Of course, I would do best if I didn’t bet on any horse races at all.
So, the question is whether stocks are anything like horses. I don’t think they are. When it comes
to businesses, I’m a lot more comfortable with the idea of picking the few winners from the
many losers – especially when the odds get out of whack. The one tactic that would remain the
same is inaction. Acting less and thinking more is sound advice wherever money or commitment
is concerned.
A successful investor has to have confidence in his judgments. I don’t know how you can
gain that confidence without subjecting your beliefs to honest scrutiny. An unexamined
philosophy will never exorcise your deepest doubts – and for as long as these doubts remain, you
will be unable to find the confidence you seek.
 URL: https://focusedcompounding.com/on-confidence/
 Time: 2006
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On Buffett’s Big Bet
Over the past few days, there have been several stories written about Warren Buffett’s $14
billion bet on global stock markets. I believe these stories are all in reference to this disclosure in
Berkshire Hathaway’s annual report:
“Berkshire is also subject to equity price risk with respect to certain long duration equity index
put contracts. Berkshire’s maximum exposure with respect to such contracts is approximately
$14 billion at December 31, 2005. These contracts generally expire 15 to 20 years from
inception. Outstanding contracts at December 31, 2005, have been written on four major equity
indexes including three foreign. Berkshire’s potential exposure with respect to these contracts is
directly correlated to the movement of the underlying stock index between contract inception
date and expiration. Thus, if the overall value at December 31, 2005 of the underlying indices
decline 30%, Berkshire would incur a pre-tax loss of approximately $900 million.”

It’s impossible to evaluate exactly what this means for Berkshire (or what it tells us about
Buffett’s thinking) without knowing more details. But, there are a few things I’d suggest you
consider when reading the news reports.
First, the $14 billion headline number makes this bet look larger than it really is. According to
the above disclosure, a 30% decline in the underlying indices would only create a $900 million
pre-tax loss. One article stated that a decline in the indexes to zero was highly unlikely given
historical trends. It’s a lot more than highly unlikely. But, since we don’t know the details of
Berkshire’s exposure, we can’t evaluate the real risk of a very large loss.
A lot of these news stories have called Berkshire’s “long duration equity index put contracts” a
bet on global stock markets. A few individuals have been quoted as saying Buffett has become
bullish long-term. Buffett’s always been optimistic about the very long-term insofar as he
recognizes how better things are today than they have been at any other time in history, and how
that is likely to remain true for some time. Despite Buffett’s concerns about nuclear war, he
doesn’t see a return to the Dark Ages and those kinds of anemic returns on capital.
That’s important to keep in mind, because I’m not sure this bet is much more than that. If you
assume returns on equity will be similar to those achieved in the years since industrialization
began, and you assume central governments will continue to cause inflation, a long duration
equity index put contract isn’t much of a stretch.
Equity will earn returns, much of those returns will be retained by the businesses, and inflation
will increase (nominal) stock prices regardless of whether the underlying businesses’ assets are
increasing or remaining stable.
I’m not sure this is a bullish sign. In fact, it may be a bearish sign, because it suggests Buffett
can’t find individual equities to buy, three of the four indexes are foreign, and someone wants to
be protected against very large losses in a diversified group of holdings.
Remember, someone is paying for this protection. In my opinion, it’s not the kind of protection
investors need. It’s long-term protection on an index. I suppose I can see why a pension fund
might want this (to increase exposure to equities), but it seems like exactly the sort of thing an
insurance company can make money selling. There’s fear of a very large loss, and a lot of factors
that are hard to see that will tend to make that loss pretty unlikely.
We don’t know what premiums Berkshire is receiving, so we really can’t evaluate these
contracts. If someone writes hurricane insurance it doesn’t mean they think hurricanes are
unlikely, it just means they think someone is dumb enough to pay more than the protection is
worth. Knowing the odds of a decline in global stock markets isn’t enough to evaluate
Berkshire’s contracts, because we don’t know the price of those contracts.
I’m not enamored with current valuations in the U.S., but looking out a couple decades it’s not
all doom and gloom. Markets tend to overshoot in both directions, but there’s usually someone
sane enough to buy when stocks get cheap enough.
What’s remarkable about the way investors move stock prices isn’t the magnitude of the
truly major moves (up or down); it’s the frequency of meaningful moves when there’s no
meaningful changes in underlying values. Think about the price range of an average stock in
an average year – that’s the really irrational part of investor behavior. I wouldn’t want to have
anything to do with a one-year contract on a single stock. That’s a very different position from
the one Berkshire is now in.
 URL: https://focusedcompounding.com/on-buffetts-big-bet/
 Time: 2006
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On Asymmetric Opportunities
Most difficult investing decisions are not caused by fine distinctions. Two apparently similar
stocks are usually just that. There is little difficulty in evaluating such situations. More
importantly, the magnitude of whatever miscalculations are made is likely to be small. The true
difficulties arise when the investor is presented with two or more asymmetric opportunities.
The intrinsic value of a business isn’t printed anywhere. To the extent that a business’ intrinsic
value is similar to its earnings power, the evaluation process is simplified. In fact, this so greatly
simplifies the process that many investors are tempted to calculate earnings power alone and
simply assume the intrinsic value reflects the earnings power.
This is a mistake. While you will rarely lose a lot of money by focusing on earnings, you will
miss some great opportunities if you rely solely on earnings.
The intrinsic value of a business is the discounted value of the cash that can be withdrawn
from the business. It is not merely the discounted value of the future cash flows generated from
operating activities. This may sound like I’m splitting hairs. But, it’s an important concept to
understand.
Obviously, a cash flow neutral business with several hundred million dollars in cash (in excess of
total liabilities) is worth more than the intrinsic value of zero that would be calculated based on
the free cash flow generated from its operating activities. You could account for this by treating
the excess cash as a reduction to the purchase price. That is essentially what you’re doing when
you use a company’s enterprise value instead of its market cap.
Actually, you’re doing more than that, because you are adding debt in excess of cash to the
purchase price. Should you do that? It’s hard to say. For some businesses, this is an
unnecessarily harsh adjustment, because the debt needn’t be repaid anytime soon. The
advantages of the free cash flow generated will be amplified by the debt, which needn’t be repaid
until long after the cash flows are received.
But, by the same logic, one could argue that whatever excess cash a business holds needn’t be
returned to shareholders via a dividend, stock buyback, etc. within the next few years. If that
cash isn’t utilized relatively quickly, its intrinsic value will be diminished.
In my experience, you will seldom go wrong by valuing a company’s cash too highly. Judging
by the spreads in EV/EBIT ratios among various stocks, the market doesn’t seem to overvalue
cash too often.
So, my advice is to count the cash as if it were being paid out to you at the time you purchase the
shares. Since the cash has already been taxed, whatever advantages you would have in
generating returns on the cash greater than those the retained cash generates will be mitigated.
Counting excess cash as a reduction in the price per share isn’t a perfect solution, but it is a
simple, workable solution. As I mentioned in a previous post, there are advantages to having a
very strong financial position. Counting excess cash as a reduction in the purchase price per
share will have the effect of rewarding financially strong enterprises.
However, one thing to keep in mind is that cash generated from the issuance of new shares
should be viewed differently than cash generated from operations or from asset sales. While the
cash is worth just as much, you may want to make a mental note of the source so you can assign
a black mark to the management team.
What about non-cash assets? Is a business’ intrinsic value increased by real estate holdings,
intellectual property, etc. even if these assets are not currently generating earnings? To the extent
that these assets can be converted into cash they are valuable.
In the case of real estate, you will often need to make an adjustment to earnings even if the real
estate doesn’t generate rents, because the operating activities will appear more profitable where
they use owned assets instead of leased assets. Where the book value of the real estate is far
below its market value, both the adjustment and any attempt to value the real estate will become
more difficult. In some cases, it is possible to estimate the value of the real estate, because
similar properties are frequently sold. But, most of the time, it’s very difficult to value the real
estate.
Don’t try.
Look for a mediocre (or better) operating business with real estate holdings that happens to
be selling for less than its book value. If you can buy the operating business at a reasonable
price, you’ll get the real estate for free. As a result, you’ll have a little more upside and a lot less
downside.
Most other types of non-operating assets will be of little use to an investor who isn’t
knowledgeable in a particular area, because these will often be accompanied by large liabilities.
Marketable securities are easy to value, but they are often held by companies with liabilities that
are not easy to quantify. Occasionally, you will find interesting opportunities in small companies
that have important assets that could be separated from the operating business. These
opportunities become increasingly attractive as liabilities decrease.
The best opportunities are those where the assets are clearly much greater than the
liabilities plus the market value of the equity. But, even beyond this, you want to make sure
the liabilities are not too large compared to operating activities alone, because some
managements are stubborn enough to dig themselves into a very deep whole. If you can’t take a
large ownership stake in the business, you’ll have to accept the fact that assets can be terribly
mismanaged.
How do you compare asset heavy businesses that aren’t particularly profitable to asset light
businesses that are highly profitable? In one case, you’re likely buying a business at a price
below its book value; in the other case, you’re likely paying several times book.
The highly profitable business will better reward you the longer you hold it. The business
with all those great assets (but poor profitability) will become a less attractive investment the
longer you hold it. But, obviously, you don’t know how long you’ll have to hold it, because you
don’t know how long it will take the market to realize the true value of its assets.
This is a very difficult problem. Most short-run / long-run problems are. Where does the short-
run end and the long-run begin? No one can answer that. These bargains exist largely because
investors feel the short-run will last forever.
How often have you heard someone say this stock hasn’t gone up in years, what’s going to make
it go up now? People will ask this question even when they know the market is currently
undervaluing the business. They’re afraid the short-run may last a very long time.
The only effective method I know of that will tell you how long to hold a stock, when to sell it,
etc. is to look at the opportunity cost. What is the best alternative? When there are plenty of great
businesses selling at reasonable prices, the book value bargains become less attractive.
Today, I don’t see many great businesses selling at reasonable prices; so, now might be a good
time to buy businesses based on more than just earnings. Where the liabilities are very low, and
there is at least some free cash flow generation, you are likely to find good relative returns in a
market that won’t provide the kind of great returns most people still seem to expect. Now might
be a good time to look at some financially strong low price-to-book value businesses, land rich
businesses, and low EV/EBIT businesses.
It’s always difficult to value these asymmetric opportunities. Just don’t fall into the trap of only
buying cheap businesses or only buying good businesses. Buy bargains. When the market is
asking high prices for good businesses, buy the cheap ones – and vice versa.
I don’t talk about buying cheap stocks enough. You shouldn’t overlook that strategy. It has
worked in the past and will continue to work in the future. But, even when buying cheap stocks,
you need to be very selective.
 URL: https://focusedcompounding.com/on-asymmetric-opportunities/
 Time: 2006
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On Contrarianism and Negativity
In one of my earlier podcasts (“Why Small Caps?”), I said that undervalued stocks usually suffer
from either contempt or neglect. In some sense, I suppose it’s true that there are beloved bargains
out there; they just aren’t beloved enough. But, I don’t think you’re going to find too many of
those. Even though a stock may be a bargain when it trades at a higher than market multiple, I
haven’t seen many bargain stocks that were actually better liked than both their peers and stocks
in general.
I spend most of my time looking at stocks that suffer from neglect rather than contempt.
That’s one of the great virtues of small cap stocks. There are so many small cap stocks that a few
are always suffering from neglect. Most investors only have time for the hottest names in small
caps. Otherwise, they would have to look at thousands and thousands of individual businesses.
That’s why I talk about companies like Village Supermarket (VLGEA). Today, Village has to
perform to justify its P/E of 12. But, a few years ago, Village didn’t have to accomplish much of
anything to justify its P/E of 6. You could have bought the stock at a P/E of 6 and a 50%
discount to book value around the time of the millennium bubble.
Those were good times. It seemed every earnings report surprised investors, because no one was
paying attention. Oh? Earnings are up again? Well, I don’t really like the grocery business; but,
at a P/E of 5, I guess I have to buy.
While some institutions can’t put meaningful amounts of money to work in a select group of
small cap stocks, there are enough reasonably sized small caps that individuals don’t have to
worry about having more money than ideas. Of course, this may not be true at any given
moment. But, generally, there are plenty of opportunities among stocks that suffer from neglect.
So, why should investors even consider buying stocks that suffer from contempt? Isn’t buying
such stocks a lot riskier than sticking to those stocks few people care about?
I’m not sure it’s a riskier strategy to pursue. But, it is more psychologically demanding. You
have to be willing to wake up each morning and have The Wall Street Journal and CNBC
disagree with you – and that’s on the good days. On the bad days, it will be USA Today and the
evening news.
If you can remain rational when others can’t, you should do well with your contrarian
positions. But, you mustn’t take them for the sake of being contrary. You shouldn’t find pleasure
in disagreeing with the consensus; you should find pleasure in being right regardless of what
others think. Of course, because what others think is largely what sets the price of stocks, you’ll
likely find some of your best bargains on the other side of a trade from someone consumed by
negativity.
Where has the negativity been lately? Rick mentions media stocks in his post. Some well-known
value investors have been taking a good look at media stocks lately. Media isn’t one of my
favorite places to look for bargains, because there are plenty of people who know a lot more
about the business than I do. But, there have been some interesting looking opportunities lately.
Controlled Greed often discusses media stocks from a value perspective. If you’re interested in
media, you may enjoy reading that blog.
You’re unlikely to read a lot about media companies on this blog. But, I did discuss two stocks
that looked interesting: Journal Communications (JRN) and the Journal Register Company
(JRC).
I’m pessimistic on the long-term prospects for daily newspapers and terrestrial radio. I
mentioned JRN and JRC, because things didn’t look as bad at these businesses as they do at
some other, better known media companies. Journal Communications isn’t just a newspaper
company; and Journal Register isn’t just a big city daily newspaper company (in fact, it isn’t
a big city newspaper company at all). That may not sound like a lot. But, it’s something – and I
didn’t think it was priced into the shares. In both cases, there’s a lot of cash flow. Journal
Communications also has the benefit of a strong balance sheet.
Now that I think about it, I realize most of the stocks I discussed during the first quarter of 2006
were suffering from some sort of negativity.
People are negative on Lexmark (LXK) both because they’re negative on the printer business
and because they like Dell and HP more.
Any time you find a stock that people buy or sell because of a bigger story, you’ll have pretty
good odds betting against the crowd. This isn’t because the bigger stories are wrong. It’s because
they’re too big. They don’t apply equally to all the stocks they touch.
For instance, Wal-Mart (WMT) did crush a lot of other retailers. But, it didn’t crush all of them.
An astute investor would have asked what the chance was that Wal-Mart would destroy a
particular business. In some cases, where there was a lot of bloat, you would have shied away
from the stock. But, in other cases, where there was already a business doing things quite
cheaply, you would have been willing to buy the stock when it dropped to very low price-to-
earnings and price-to-book ratios (as Village did in the late 90s).
Pacific Sunwear (PSUN) suffers from a special kind of contempt. It has committed the
unforgivable sin of growing old. PacSun is no longer the growth stock it once was.
Wall Street has a tendency to go to extremes. I’m sure you’ve noticed this. What you might
not have noticed is how that tendency can cloud one’s judgment in particular cases. Pacific
Sunwear won’t grow like it once did, but it will grow. Nothing’s certain, but that’s the best bet.
At current prices, the odds on that bet are out of whack. PSUN is priced as if its future growth
will be very close to worthless. That’s why it’s now a value stock, and that’s why you were able
to read about it here.
Sherwin-Williams (SHW) was slapped with an adverse ruling in Rhode Island. The lead paint
liability sent the shares down; they’re up quite a bit since then. This is an example of a good
company that got hit by a lot of negativity. The price drop wasn’t big enough to make the stock
an obvious bargain. But, for those who took the time to study Sherwin-Williams, it offered an
opportunity to buy an above-average company at the kind of price an average company would
normally sell for.
The Street’s contempt for Overstock.com (OSTK) has been hard to miss. Three out of every
two people I’ve talked to are short this stock. That alone isn’t a good enough reason to buy a
stock. The real reason to buy Overstock is pretty simple: it’s cheap. I’ve made that case before,
so I won’t bore you with it again.
But you already know about all these stocks. I’ve written about them before. If I really wanted to
make this post useful, I’d mention some of the places where you might be able to exploit
negativity during the second quarter.
There’s still a lot of negativity about large cap growth stocks. Some time ago, I wrote a post
about the value in large cap growth. It’s still relevant today.
Negativity is often most interesting when it is focused on an industry cycle, macroecnomic trend,
or health scare. Homebuilders, steelmakers, and chicken producers are all good stocks to keep an
eye on. At some point, you might find a few stocks that are so cheap you don’t need to worry
about where we are in the cycle.
Look for low debt levels, a history of free cash flow generation, and above average
profitability. To value these companies, come up with a conservatives estimate for normalized
earnings. More importantly, if you can get a better than average player in the industry at close to
book value, you might want to consider it. Start your search with companies that are either small
or foreign.
You could take a completely different approach to exploiting negativity. Instead of looking for
conspicuously cheap stocks, you could look for great businesses selling at bargain prices. H&R;
Block (HRB) is a great business with a lot of negativity around it. There are serious questions
here about the long-term prospects for the business and the kind of returns that will be earned
on incremental capital. But, it’s certainly an interesting stock.
Harley-Davidson (HDI) and Intel (INTC) are two other stocks worth watching. Again, there
are a lot of long-term concerns. Recently, Harley has grown the business, but there are a lot of
reasons to think that isn’t sustainable. Intel hasn’t grown much at all in years, but is still talked
about like there will be growth ahead.
Some of the negativity around Intel has to do with competition. All of the negativity around
Harley has to do with demographics. Those facts would tend to favor Harley, because both the
brand and the industry will last regardless of the demographics. Intel has no brand to speak of,
and I have no idea what its industry will look like in a few decades.
Finally, whether you have a contrarian streak or not, don’t underestimate cash flow or cash on
the balance sheet. One of the best indicators of a bargain is a low enterprise value-to-EBIT ratio.
Whenever you hear bad news about a big company, run the EV/EBIT ratios for smaller
players in the same industry as well as the big company’s customers and suppliers. If
there’s continued bad news about more than one company in the same industry, it’s a pretty good
bet one of their rivals, customers, or suppliers has been beaten down to bargain levels.
 URL: https://focusedcompounding.com/on-contrarianism-and-negativity/
 Time: 2006
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On Probability, Observation, and Investing
Investors need to think about exactly what they mean when they use terms from
probability. They need to appreciate the role of the observer (and his limited knowledge). For
instance, if I flip a coin and cover it before you can see how it has landed, is it really correct to
say there’s a 50% chance the coin has landed head-side up?
The problem is that we know that the class of (fair) coin flips will be populated by as many
instances of heads as tails; therefore, if we know that a coin flip belongs to the class of fair coin
flips (but know nothing else about the special case), we may say that there is a 50% chance the
coin will land head-side up.
But, there is one somewhat unsettling matter to consider. Once I have flipped the coin and it has
landed, we can all agree that it has either landed head-side up or tail-side up. The event has
already occurred. But, it hasn’t yet been observed. Of course, I could lift my hand a bit and sneak
a peak. Then, I’ve observed the outcome, but you haven’t.
Speaking probabilistically, you might still say there’s a 50% chance the coin has landed head-
side up. But, you would now know that there is a difference between the knowledge possessed
by different observers. The unsettling part comes when you realize that a probabilistic statement
can not be made independent of the observer (and her knowledge).
It may seem a trivial problem when we consider the observer to be a single individual. But, all
our knowledge is dependent upon observation, and all our probabilistic statements are dependent
upon our knowledge – so, all of our probabilistic statements are dependent upon our knowledge.
That’s obvious, because we only make such statements where our knowledge is limited (we
know something about the class but not the special case). The problem for investors is that two
analysts with the same data may interpret that data differently such that they arrive at two very
different conclusions. Essentially, they will make two different probabilistic statements (largely
based on what data they believe pertains to the special case in question).
For instance, you can make a statement about stocks trading at a P/E of 12, or stocks trading
below book value, or stocks that have achieved a ROE of greater than 15% in nine of the last ten
years. But, that may not be the best class to consider.
I just mentioned Harley-Davidson (HDI) in a previous post. Does Harley-Davidson belong to

the class “stocks with a P/E of 15”? Or, does Harley belong to the class “stocks of companies
with entrenched consumer brands”? After all, some stocks with a P/E of 15 may be in
commodity businesses.
The investor needs to reference several different past records at once. She needs to consider
the past record of entrenched consumer brands (how many had their earnings power diminished?
How many of the brands lost their luster? How many increased their earnings power?).
Harley-Davidson might more properly be classified as a growth stock. Look at the annual rate of
increases over the last ten years: Book value per share has increased at a 17.78% annual rate;
EPS has increased at a 21.92% rate. Or, we could classify HDI as a stock that has consistently
earned high returns on equity while employing very little debt. At this point, we haven’t even
considered classifying it by industry. Is that an appropriate classification?
The investor is in the unenviable position of performing an overwhelming calculation. She

has knowledge of the past records of countless other stocks and countless other businesses that
are in some way related to the case at hand. But, how closely related are they? And in what way
are they related? What is the proper weight to assign to each variable? And what is the proper
estimate for that variable?
Some very smart investors (e.g., Warren Buffett, Peter Lynch, and Benjamin Graham) have
pointed out the similarities between investing and gambling, but haven’t gone as far as
suggesting there are similarities between the (intelligent) investor and the gambler. Why?
Because investing really is a game of odds. But, no sane man would take the gambler’s position.
An intelligent investor bets only with the odds in his favor. He has no interest in luck. The
investor looks for high-probability events and a margin of safety. He wants to tilt the odds in his
favor; he doesn’t want to play a game of chance. But, his knowledge is always limited. Nothing
is certain. So, the best he can hope for is playing a game of odds the way the house does. He
begins with a clear advantage that will reduce the importance of the element of chance inherent
to the game.
Some time ago, I wrote a short post on intrinsic value. I think it’s worth revisiting:
The intrinsic value of a business can not be determined through clairvoyance or calculus,
prescience or projections – for even the best projections sit precariously atop a mountain of
complex assumptions. Determining the intrinsic value of a business requires simple arithmetic,
common sense, and a careful analysis of the past performance and current financial position of
the firm. Most importantly, it requires the separation of those things which are both constant
and consequential from those things which are either mutable or meaningless.
When your knowledge is limited (as the investor’s knowledge always is) you’ll do best to focus
on those things which are both constant and consequential. Actually, I omitted one key word
when I wrote that post on intrinsic value.
I’ve always believed an investor should focus on those things which are constant, consequential,
and calculable.
You need to focus on those things that can be both known and weighed. The relative weights
assigned to each variable are where most investors make their biggest mistakes. It tends to be the
things they know, but can’t weigh, that kill them.
Just remember to be conservative in all your estimates – and, when in doubt, withhold your
judgment. Investors have the luxury of inaction. That comes in handy whenever the question
posed is complicated. You only need to know the easy answers – as long as you know
when not to give an answer.
 URL: https://focusedcompounding.com/on-probability-observation-and-investing/
 Time: 2006
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On Value Investing
What is Value Investing?
Different sources define value investing differently. Some say value investing is the investment
philosophy that favors the purchase of stocks that are currently selling at low price-to-book ratios
and have high dividend yields. Others say value investing is all about buying stocks with low P/E
ratios. You will even sometimes hear that value investing has more to do with the balance sheet
than the income statement.
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:
We think the very term “value investing” is redundant. What is “investing” if it is not the act of
seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock
than its calculated value – in the hope that it can soon be sold for a still-higher price – should be
labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).
Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the
purchase of stocks having attributes such as a low ratio of price to book value, a low price-
earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear
in combination, are far from determinative as to whether an investor is indeed buying something
for what it is worth and is therefore truly operating on the principle of obtaining value in his
investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a
high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value”
purchase.
Buffett’s definition of “investing” is the best definition of value investing there is. Value
investing is purchasing a stock for less than its calculated value.
Tenets of Value Investing
1) Each share of stock is an ownership interest in the underlying business. A stock is not
simply a piece of paper that can be sold at a higher price on some future date. Stocks represent
more than just the right to receive future cash distributions from the business. Economically,
each share is an undivided interest in all corporate assets (both tangible and intangible) – and
ought to be valued as such.
2) A stock has an intrinsic value. A stock’s intrinsic value is derived from the economic value
of the underlying business.
3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market
Hypothesis. They believe shares frequently trade hands at prices above or below their intrinsic
values. Occasionally, the difference between the market price of a share and the intrinsic value of
that share is wide enough to permit profitable investments. Benjamin Graham, the father of value
investing, explained the stock market’s inefficiency by employing a metaphor. His Mr. Market
metaphor is still referenced by value investors today:
Imagine that in some private business you own a small share that cost you $1,000. One of your
partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your
interest is worth and furthermore offers either to buy you out or sell you an additional interest
on that basis. Sometimes his idea of value appears plausible and justified by business
developments and prospects as you know them. Often, on the other hand, Mr. Market lets his
enthusiasm or his fears run away with him, and the value he proposes seems to you a little short
of silly.
4) Investing is most intelligent when it is most businesslike. This is a quote from Benjamin
Graham’s “The Intelligent Investor”. Warren Buffett believes it is the single most important
investing lesson he was ever taught. Investors ought to treat investing with the seriousness and
studiousness they treat their chosen profession. An investor should treat the shares he buys and
sells as a shopkeeper would treat the merchandise he deals in. He must not make commitments
where his knowledge of the “merchandise” is inadequate. Furthermore, he must not engage in
any investment operation unless “a reliable calculation shows that it has a fair chance to yield a
reasonable profit”.
5) A true investment requires a margin of safety. A margin of safety may be provided by a

firm’s working capital position, past earnings performance, land assets, economic goodwill, or
(most commonly) a combination of some or all of the above. The margin of safety is manifested
in the difference between the quoted price and the intrinsic value of the business. It absorbs all
the damage caused by the investor’s inevitable miscalculations. For this reason, the margin of
safety must be as wide as we humans are stupid (which is to say it ought to be a veritable
chasm). Buying dollar bills for ninety-five cents only works if you know what you’re doing;
buying dollar bills for forty-five cents is likely to prove profitable even for mere mortals like us.
What Value Investing Is Not
Value investing is purchasing a stock for less than its calculated value. Surprisingly, this fact
alone separates value investing from most other investment philosophies.
True (long-term) growth investors such as Phil Fisher focus solely on the value of the
business. They do not concern themselves with the price paid, because they only wish to buy
shares in businesses that are truly extraordinary. They believe that the phenomenal growth such
businesses will experience over a great many years will allow them to benefit from the wonders
of compounding. If the business’ value compounds fast enough, and the stock is held long
enough, even a seemingly lofty price will eventually be justified.
Some so-called value investors do consider relative prices. They make decisions based on
how the market is valuing other public companies in the same industry and how the market is
valuing each dollar of earnings present in all businesses. In other words, they may choose to
purchase a stock simply because it appears cheap relative to its peers, or because it is trading at a
lower P/E ratio than the general market, even though the P/E ratio may not appear particularly
low in absolute or historical terms.
Should such an approach be called value investing? I don’t think so. It may be a perfectly valid
investment philosophy, but it is a different investment philosophy.
Value investing requires the calculation of an intrinsic value that is independent of the
market price. Techniques that are supported solely (or primarily) on an empirical basis are not
part of value investing. The tenets set out by Graham and expanded by others (such as Warren
Buffett) form the foundation of a logical edifice.
Although there may be empirical support for techniques within value investing, Graham founded
a school of thought that is highly logical. Correct reasoning is stressed over verifiable
hypotheses; and causal relationships are stressed over correlative relationships. Value investing
may be quantitative; but, it is arithmetically quantitative.
There is a clear (and pervasive) distinction between quantitative fields of study that employ
calculus and quantitative fields of study that remain purely arithmetical. Value investing
treats security analysis as a purely arithmetical field of study. Graham and Buffett were both
known for having stronger natural mathematical abilities than most security analysts, and yet
both men stated that the use of higher math in security analysis was a mistake. True value
investing requires no more than basic math skills.
Contrarian investing is sometimes thought of as a value investing sect. In practice, those who
call themselves value investors and those who call themselves contrarian investors tend to buy
very similar stocks.
Let’s consider the case of David Dreman, author of “The Contrarian Investor”. David Dreman is
known as a contrarian investor. In his case, it is an appropriate label, because of his keen interest
in behavioral finance. However, in most cases, the line separating the value investor from the
contrarian investor is fuzzy at best. Dreman’s contrarian investing strategies are derived from
three measures: price to earnings, price to cash flow, and price to book value. These same
measures are closely associated with value investing and especially so-called Graham and Dodd
investing (a form of value investing named for Benjamin Graham and David Dodd, the co-
authors of “Security Analysis”).
Conclusions
Ultimately, value investing can only be defined as paying less for a stock than its calculated
value, where the method used to calculate the value of the stock is truly independent of the
stock market. Where the intrinsic value is calculated using an analysis of discounted future cash
flows or of asset values, the resulting intrinsic value estimate is independent of the stock market.
But, a strategy that is based on simply buying stocks that trade at low price-to-earnings, price-to-
book, and price-to-cash flow multiples relative to other stocks is not value investing. Of course,
these very strategies have proven quite effective in the past, and will likely continue to work well
in the future.
The magic formula devised by Joel Greenblatt is an example of one such effective technique that
will often result in portfolios that resemble those constructed by true value investors. However,
Joel Greenblatt’s magic formula does not attempt to calculate the intrinsic value of the stocks
purchased. So, while the magic formula may be effective, it isn’t true value investing. Joel
Greenblatt is himself a value investor, because he does calculate the intrinsic value of the stocks
he buys. Greenblatt wrote “The Little Book That Beats The Market” for an audience of investors
that lacked either the ability or the inclination to value businesses.
Simply put, you can not be a value investor unless you are willing to calculate business values.
To be a value investor, you don’t have to value the business precisely – but, you do have to value
the business.
 URL: https://focusedcompounding.com/on-value-investing/
 Time: 2006
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On Some Lessons From Buffett’s Annual Letter
Warren Buffett’s annual letter to Berkshire Hathaway (BRK) shareholders was released

over the weekend. Readers will find plenty of investing lessons among the twenty-three pages.
Warren began this letter as he begins each letter, by stating Berkshire’s change in per-share book
value:
Our gain in net worth during 2005 was $5.6 billion, which increased the per-share book value of
both our Class A and Class B stock by 6.4%. Over the last 41 years, (that is, since present
management took over) book value has grown from $19 to $59,377, a rate of 21.5%
compounded annually.
Some may wonder why Buffett opens by announcing the change in per-share book value rather
than the earnings per share number. Over long periods of time, the change in per-share book
value should nicely approximate the returns to owners. You may remember that, in my analysis
of Energizer Holdings, I applauded the company for reporting comprehensive income within the
income statement. Although a company’s net income is often referred to as its bottom line, net
income is, in fact, a (sub)component of comprehensive income. Energizer Holdings
(ENR) literally reports comprehensive income as its bottom line.
FASB merely requires that “an enterprise shall display total comprehensive income and its
components in a financial statement that is displayed with the same prominence as other
financial statements that constitute a full set of financial statements”. Unfortunately, despite the
lack of attention paid to it by investors, the statement of changes in stockholders’ equity is
considered “a financial statement that constitutes a full set of financial statements”.
Therefore, comprehensive income can be reported in a statement many investors either do

not review or do not understand. Alternatively, a company may choose to report
comprehensive income in a separate Statement of Comprehensive Income. This, of course,
baffles many investors, who think they are reading a second copy of the income statement. After
all, what is comprehensive income? Isn’t the net income number reported in a (traditional)
income statement a comprehensive number?
No. The widely reported earnings per share number is not comprehensive. That isn’t to say the
EPS number isn’t important. It is very important. In fact, for certain businesses, it may be the
most useful figure for evaluating a going concern. This is especially true if the investor is only
looking at the financials for a single year. A single year’s comprehensive income may actually be
less representative of a business’ performance than a single year’s EPS number (both can be
pretty unrepresentative).Remember, the earnings per share number does not tell you how much
wealth was actually created (or destroyed). You need to look to the comprehensive income
number to find that information.
Essentially, Buffett is reporting Berkshire’s earnings in that opening line. He is simply using
a more comprehensive income figure. He’s saying here’s how much wealth we created, and
here’s how much capital it took to create that wealth. When he writes “Our gain in net worth
during 2006 was $5.6 billion, which increased the per-share book value of both our Class A and
Class B stock by 6.4%” he’s really saying Berkshire earned $5.6 billion and a 6.4% return on
equity. He prefers using comprehensive income rather than net income, because comprehensive
income includes non-operating earnings such as changes in the market value of available for sale
securities.
If you still have doubts about the idea that Buffett is essentially reporting Berkshire’s
comprehensive income in that formulaic opening line of his annual letters, compare the change
in net worth numbers Buffett has reported in past years to the comprehensive income numbers
found in Berkshire’s annual reports. For the past three years, Berkshire’s reported “gain in net
worth” and Berkshire’s reported “comprehensive income” were $5.6 billion vs. $5.5 billion, $8.3
billion vs. $8.2 billion, and $13.6 billion vs. $13.4 billion. I hope this helps explain why I like it
when public companies prominently report comprehensive income instead of presenting net
income as if it were the Holy Grail of investing.
Of course, there is no such Grail. Neither net income nor comprehensive income captures the
true economic changes to an owner’s share of the business. There is no truly comprehensive
income number – and there never will be. A review of the financial statements alone is not
sufficient to determine how a business’ competitive position has improved (or deteriorated) over
the course of the year.
Every day, in countless ways, the competitive position of each of our businesses grows either
weaker or stronger. If we are delighting customers, eliminating unnecessary costs and
improving our products and services, we gain strength. But if we treat customers with
indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our
actions are imperceptible; cumulatively, though, their consequences are enormous.

It is to these actions and their effects that an investor must look when he is forming his
qualitative assessment of a business. After all, a company may lose money and yet improve its
competitive position. In fact, that is exactly what a great many young businesses do. The
question, of course, is whether those present losses will be more than offset by future gains after
accounting for the opportunity costs incurred.
All costs are opportunity costs. It makes no sense to evaluate a year’s losses as if the alternative
was to stop time. The available returns on the lost capital must be considered as well. That is
why when one of Berkshire’s units has consumed capital, the loss has weighed heavily on
Buffett.
Over Berkshire’s history, the cost of any losses also included the over twenty percent
compound annual gain that was foregone. Buffett has always been painfully aware of the fact
that, for Berkshire, losing $1,000 today would be much the same as losing over $7,000 ten years
from today or over $125,000 twenty-five years from today. Berkshire will no longer grow its
per-share book value at over 20% a year. So, these particular figures are outdated. However, if
you refer to Buffett’s thoughts at the time when the Buffalo News was losing money (and when
Berkshire’s textile operations were losing money), you will see just how heavily these
opportunity costs weighed on him.
Still, it is possible that a business operating at a loss is actually improving its competitive
position and creating wealth for its owners. One very difficult question that must be answered
is exactly what the assets (often the intangible assets) that have been gained at great expense are
actually worth. In some very special businesses, huge expenses are fully justified.
Auto policies in force grew by 12.1% at GEICO, a gain increasing its market share of (the) U.S.
private passenger auto business from about 5.6% to about 6.1%. Auto insurance is a big
business: Each share-point equates to $1.6 billion in sales.
While our brand strength is not quantifiable, I believe it also grew significantly. When Berkshire
acquired control of GEICO in 1996, its annual advertising expenditures were $31 million. Last
year we were up to $502 million. And I can’t wait to spend more.

This excerpt helps explain why I think all the money PetMed Express (PETS) puts into
cable TV ads is money well spent. Pet medications, like auto insurance, is a highly fragmented
business. Sales volume is important. Obviously, name recognition is as well. PETS can spend a
lot on cable advertising and still spend less per sale than its competitors. It’s also important to
remember that pet medications are rarely the sort of thing a customer buys once (just like auto
insurance). While you won’t be able to retain all your customers, you will have a much easier
time getting a current customer to stick with you than you will getting a new customer to switch
from a competitor.
I’ll end this post with one of Buffett’s best lessons:

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But
Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble,
explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he
had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth
Law of Motion: For investors as a whole, returns decrease as motion increases.
 URL: https://focusedcompounding.com/on-some-lessons-from-buffetts-annual-letter/
 Time: 2006
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On the Physical Effects Fallacy
This post was prompted by something I read over at Absolutely No DooDahs. As I’ve said
before, most of the commentary on Bill’s blog is highly intelligent. So, I feel bad about singling
out this most unintelligent (and most unrepresentative) post. However, this myth has been
around for several centuries, and has enjoyed the support of some otherwise intelligent
individuals; so, it is in desperate need of dispelling.
Regarding Anheuser-Busch (BUD) and Coca-Cola (KO), Bill wrote:
Colored, flavored corn – syrup water doesn’t generate brand loyalty, and neither does fermented
hops and barley malt. The desired effects of either can be gotten with off-brand products and
substitutes.

This statement is false. The desired effects can not be gotten with substitutes. The demand for a
product is not determined by the physical effects of that product on the user.
Most misinterpretations of economic activity begin with a failure to properly define

economics as the study of human choice. If the field is further limited in scope, it can no longer
explain commerce. In other words, a unified theory of economics must explain all human
actions, because humans do not have one “program” for making economic choices and another
“program” for making non – economic choices.
The demand for a product is derived from that product’s (expected) ultimate impact. I’m
using the word “impact” simply because I want to conjure up the image of the mind as
something that is being stamped or imprinted. In ancient times, the idea of the physical world
“stamping” the mind was popular, and I think it’s an apt metaphor in this case.
Humans act to effect changes in their mental states; humans do not act to effect changes in
their physical state. Human actions that appear to be motivated by a desire to alter one’s
physical state are actually motivated by a desire to alter one’s mental state. That’s where the
“ultimate” half of “ultimate impact” comes from. Alterations to one’s physical state are merely
desirable insofar as they lead to alterations in one’s mental state.
Let me use a few examples. You don’t eat to prevent starvation; you eat to eradicate the
sensation of hunger. You don’t take your hand off a hot stove to prevent further burning of your
flesh; you take your hand off a hot stove to prevent further pain.
I’m not just splitting hairs here.
Humans are rational in the sense that they act to maximize pleasurable mental sensations
and minimize painful mental sensations. They are not rational in some greater sense. For
instance, humans have no inherent desire to live, they merely tend to believe living is the more
pleasurable state. Some humans weigh all the pleasure and all the pain and find they’d prefer a
quick exit. Many rational people have committed suicide under extreme circumstances. The fact
that under normal circumstances most rational people do not contemplate suicide doesn’t
necessarily mean we are hard – wired to live, it could simply mean we are hard – wired to seek
pleasure, and for most of us death is the greatest displeasure.
It’s important to dispel the myth of physical primacy to understand what products really
are. They are far more than their physical properties. They are agents of change.
For whatever reason, many people have trouble recognizing the fact that the physical properties
of a tangible good are only important insofar as they effect changes in the user’s mental state.
I’m not sure why this is.
We all know that if you were eating something particularly delicious and I began to describe a
festering, rotting, rancid, pus – filled something or other, you would no longer find your meal
quite so tasty. I did not alter your physical state (directly). Rather, I effected physical changes by
first altering your mental state. The gagging isn’t the important part. That came after your mental
state was altered.
Obviously, we all know about the placebo effect as well. If you give someone a sugar pill and
say “this is a sugar pill” and you give someone else a sugar pill and say “this is a drug” you get
two very different results. In reality, you have two different products.
The fact that both pills are physically identical is immaterial. An identified sugar pill is
different from an unidentified sugar pill as far as human minds are concerned. Human minds take
human actions and human actions are all there is to the economy. Therefore, an investor needs to
concern himself solely with how products are perceived by human minds. Products’ physical
properties are unimportant except insofar as they affect those perceptions.
There can be no doubt that Coke and Bud both generate brand loyalty. They are highly
differentiated products. As I’ve said before, most people view Coke and Pepsi as being very
different products (they may place them in the same class of products, but they do not view them
as true substitutes).
There are many other competing products that are less similar physically and yet also less
differentiated in consumers’ minds. Drugs are an excellent example. Some competing drugs have
very different physical properties, but they tend to be poorly differentiated. In fact, if the efficacy
of prescription drugs wasn’t tested in any way, and doctors were willing to hawk sugar pills,
people would buy them – and I’m sure a lot of people would swear by them. After all, a lot of
people already swear by various herbal supplements that do absolutely nothing.
So, if you want to make the argument that there’s something unethical about selling Coke or Bud
rather than a cheaper generic, you might have some standing. But, to argue that “the desired
effects of either can be gotten with off-brand products and substitutes” is absurd.
By that logic, a Red Sox fan could get the desired effects of rooting for the Red Sox by switching
over to rooting for the Yankees. Yet, somehow, I think the rights to broadcast Red Sox games in
New England are a lot more valuable than the rights to broadcast Yankees games – and I don’t
think that will be changing anytime soon.
By the way, I do agree with Bill’s assertion that Bud and Coke are not the best options for
individual investors, because Buffett’s options are greatly limited by the amount of capital he has
to deploy. Neither of these stocks is super cheap right now. But, they are great businesses and
great franchises.
 URL: https://focusedcompounding.com/on-the-physical-effects-fallacy/
 Time: 2006
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Against the Top Down Approach (Again)
Guru Focus recently reprinted my post “Against the Top Down Approach”. In the discussion
forum, there was a post by an author who disagreed with me. I wrote a response, and thought it
was worth sharing on the blog. By the way, If you haven’t visited Guru Focus yet, you should.
It’s a great resource.
Considerations as to the future growth or profitability of an industry are a part of a bottom

up approach insofar as they affect the individual security being evaluated.
Obviously, any evaluation of a property in Baghdad would have included an analysis of the risks
associated with the ownership of such a property. The fact that those risks also apply to many
other properties does not mean a top down approach is necessary. A top down approach begins
with those risks. A bottom up approach considers them only insofar as they affect each
investment.
An intrinsic value analysis is not the same thing as applying a multiple to current levels of
free cash flow. I know this is not what you suggested. However, it is implied in some of your
criticism (particularly the Baghdad example).
For instance, if you believe current steel prices are unsustainable, your intrinsic value estimates
for steel producers will be lower than they would be if you simply projected current free cash
flow levels into the distant future. A belief that steel prices are high is not inconsistent with a
bottom up approach. A bottom up approach simply requires you compare your intrinsic value
estimates for each investment against your estimates for all other investments regardless of
industry.
A retailer, a homebuilder, a steel producer, and a bank should all be judged on the basis of
a conservative intrinsic value analysis. There is no need to first determine that any one of these
groups is inherently more attractive than any other.
Buffett’s “play” on the dollar is exactly that. I wouldn’t criticize him for it. However, I believe
that, if you were to ask him, he would say it was merely the best opportunity to deploy large
amounts of capital for a short period of time. He would much rather make long term investments
in common stocks at attractive prices. Mr. Buffett would not be doing the same thing if he had
less capital to deploy, and therefore a much larger investment universe.
I suspect his attitudes toward the dollar play are similar to those he has expressed about his
past arbitrage operations. They are short term commitments with limited upside, and are far
less attractive than long term commitments in common stocks made at bargain prices.
Berkshire’s investment universe has shrunk considerably as its pool of capital has grown. This is
not the kind of investment Buffet made with his own money back in the 1950s, with the
partnership’s money, or with Berkshire’s money in earlier years. I doubt he would suggest it is
an attractive option for individual investors.
In my article, I wrote:
“All investments are ultimately cash to cash operations. As such, they should be judged by a
single measure: the discounted value of their future cash flows. For this reason, a top down
approach to investing is nonsensical.”

In his 1992 Annual Letter to Shareholders Mr. Buffet wrote:
“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one
current earnings and book value. Moreover, though the value equation has usually shown
equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be
the more attractive investment, they should be bought.”

I believe these two statements make exactly the same point. I did not argue that bonds are
always inferior investments; neither did Mr. Buffet. I stated, just as he has, that all investments
must be judged by a single measure. The investment shown to be most attractive by that measure
is the one to buy. Neither the form of the security, nor the industry of the issuer is of any
independent importance. It is of importance only insofar as it affects the intrinsic value analysis.
Let me now provide a few examples to illustrate the dangers of a top down approach and the
advantages of a bottom up approach. I will begin with a very unattractive business: grocery
stores.
Below is a 10 year chart of the S&P; 500, Wal – Mart Stores (WMT), and Village Supermarket
(VLGEA). Village Supermarket is one of the largest members of the Shop – Rite retailer co-op.
Shop – Rite is the largest retail cooperative in the U.S. grocery business. From 1996 – 2004
VLGEA has been available at a price/book ratio of 0.45 – 0.84.
Note that this is not what Village sold for at its lowest points for the year. This is the average
price/book value ratio. It is reasonable to expect an individual investor who sought to acquire
shares of VLGEA during this period would have purchased them within this range of a 55% to
16% discount to book value. During this same period the average P/E ratios were 5.0 – 13.4. The
average price to sales ratios were 0.04 – 0.11. The average debt/equity ratio for any one year
never exceeded 0.50. This was not a high risk investment. However, as you can see from the
chart, Village easily outperformed Wal – Mart during this 10 year period (which was a good one
for WMT). Any top down approach would have told you to steer clear of grocery stores. You
would have missed this great low – risk, high – return investment.
Here’s the chart

As another illustration, here is a list of the “17 Stocks That Go Up Year After Year” from an
article by Jon D. Markman:
• Chico’s FAS (CHS)

• SCP Pool (POOL)
• Expeditors International of Washington (EXPD)
• Center Financial (CLFC)
• Brown & Brown (BRO)
• Florida Rock Industries (FRK)
• Genlyte Group (GLYT)
• Cathay General Bancorp (CATY)
• Graco (GGG)
• Southwest Water (SWWC)
• Simpson Manufacturing (SSD)
• Harbor Florida Bancshares (HARB)
• Franklin Electric (FELE)
• Australia and New Zealand Banking (ANZ)
• Home Properties (HME)
• National Australia Bank (NAB)
• New Jersey Resources (NJR)
A few industries provide several companies on this list (e.g., construction / materials, banks).
However, what top down approach would have kept you in these stocks for the last ten years? I
can’t think of any. At times, a top down approach may have lead you to the right industries. But,
this is not quite the same thing. For instance, over the last ten years, you would have done better
investing in these banks than in banking as a whole.
What top down approach would have lead you to Genlyte (GLYT)? That stock has returned
about 1,400% since 1996. I can’t imagine a top down approach ever leading you to that stock (it
makes lighting fixtures for commercial, residential, and industrial customers).
I do, however, know of one approach that would have lead you to this stock and kept you in it. A
simple bottom up value investing approach would have done the trick. The stock has consistently
traded at low P/E and P/S ratios and earned good returns on capital while employing relatively
little debt. It’s always had a high ROA (a trait it has in common with many of the best bargains).
I could go on and on. But, I won’t. I’ll just mention two more stocks that were very obvious
bargains from a bottom up approach and yet never all that conspicuous from the top down
standpoint. They are both relatively small companies yet they both have relatively well know
names. They are CEC Entertainment (CEC) and Timberland (TBL). CEC stands for Chuck E.
Cheese. Here’s a 10 – year chart of CEC, TBL, and the S&P; 500.
While Timberland looks like a growth stock, it’s high return on capital, low debt, reasonable
multiples, and tons of free cash flow that are present today were also present throughout the vast
majority of the last ten years. A bottom up value investor looking for a good company would
have been happy to buy and hold this stock for 10 years.
Chuck E. Cheese has been, perhaps, a little more expensive. However, it was still quite clearly a
bargain relative to the market in each and every year. Both of these stocks were. If you asked
most diligent, concentrated bottom up value investors for their opinion on whether CEC and
TBL were bargains relative to the market, each and every year for the last ten, you would have
received an emphatic yes.
So, respectfully, I don’t think there’s anything limiting about a bottom up approach.
 URL: https://focusedcompounding.com/against-the-top-down-approach-again/
 Time: 2006
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On Financial Strength
Although I have previously discussed companies with heavy debt loads (e.g., Energizer), I
generally seek to buy shares in companies of unquestionable financial strength. I agree with
Marty Whitman, who wrote in his book The Aggressive Conservative Investor that a strong
financial position has more to do with the absence of liabilities than with the presence of assets.
Businesses with substantial future obligations, whether these obligations are stated on the
balance sheet or not, often prove to be disappointing investments.
An absence of liabilities is not merely a safeguard against insolvency. A strong financial

position is a first class asset. It allows a company to borrow when money is cheap, rather than
when money is needed. Even more importantly, it encourages long – term thinking. There are
times when big investments in the future are required. A financially sound firm is in the best
position to make such investments.
One of the greatest benefits of a strong financial position is the protection it affords the common
stock holder. Countless times, I have mentioned the damage done to shareholders by new equity
and debt financing. New equity dilutes; while new debt imperils.
Growth is an important part of the value equation. But, it only counts insofar as the shareholder
reaps the rewards. No owner benefits on the basis of total revenues; each benefits to the extent of
the profits attributable to his share of the business. Siphoning profits off to creditors or divvying
them up among new owners effectively destroys that growth.
Buying stocks when they trade at low earnings multiples does help minimize an investor’s
downside risk. But, that isn’t the only way to minimize risk. The future is always uncertain.
There are a few companies who possess such wide moats that an investor can largely confine his
analysis to the earnings record. He can feel secure in his belief that thirty years from now the
business will remain much as it is today. But, these companies are few and far between. Mr.
Market rarely offers them at bargain prices.
A strong financial position offers a kind of freedom. It also acts as a safeguard against
uncertainty. If an investor buys stock in a company with a strong financial position when it is
trading at low price – to – earnings, price – to – sales, and price – to – book ratios, he will greatly
limit his risk.
Companies that are both highly profitable and relatively unencumbered can prove to be
spectacular investment opportunities, even when the industry in which they operate faces
great uncertainty. It is not unreasonable to expect that a financially sound firm generating large
amounts of free cash flow will eventually find a way to productively use those cash flows.
A financially sound firm has the luxury of time. It can play the nimble competitor. A highly
encumbered business faces greater risks in a period of upheaval.
Insolvency is not the only threat. Often, a highly leveraged company will be able to pay its
bills, but will be unable to make an adequate investment in the future. Eventually, every business
will make mistakes. Isn’t it best to put your money where those mistakes are likely to be the least
costly?
The greatest liability is usually the one that does not appear on the balance sheet. Nothing
destroys shareholder wealth faster than the expenditures necessary to stay competitive. These
requirements may come in the form of capital expenditures, or advertising, or research, or a
hundred other things specific to the industry.
Some businesses only acquire new customers at great cost. When analyzing such businesses, it is
unreasonable to expect advertising expenses to ever abate. They are a necessary and permanent
part of the business. The brand must be maintained just like the equipment on the factory floor.
These businesses are as unattractive as the old manufacturing companies who must pour ever
greater amounts of capital into ever outdated plants.
The best business is usually the one that costs the least to maintain. Such a business offers the
greatest rewards and the least risk, provided it is purchased at a bargain price.
 URL: https://focusedcompounding.com/on-financial-strength/
 Time: 2006
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What Would Buffett Do?
A while back, there was an interesting post on Shai’s blog about Warren Buffett’s assertion that
he could achieve 50% returns on $1 million. This, among other things, got me thinking about
how Buffett would invest if he were in the position most of you are. What would he do as an
individual investor with a small enough amount of capital to invest that it was really no
hindrance?
There are several sources we could use to guess what Buffett would do in your shoes. He has
invested some of his own money since taking control of Berkshire, and some of these positions
are known publicly. Maybe I don’t watch Buffett closely enough, but I doubt these reports give
us a good idea of what Buffett would really do if he were in your shoes.
Buffet ran a partnership before taking control of Berkshire. We could glean something from
what’s known about his activities then. But, I don’t think that’s necessarily the best guide either.
From what I can tell, the partnership’s holdings were more diversified (in the early years at least)
than I suspect a modern Buffett portfolio would be.
I think the right answer is small caps. Buffett’s admitted as much at times. If he didn’t have all
that capital to deploy, he’d be looking for the most obviously inefficient pricings – that’s small
caps. It has to be. The sheer number of really small publicly traded companies guarantees that’s
where the best bargains will be. Small caps are the best place to take advantage of a detailed
knowledge of each company. A lot of funds are spread so thin; they can’t have even read all the
10-Ks that well. Several of Buffett’s early purchases seem to echo Graham’s Northern Pipe Line
purchase. They involve buying shares in a business for assets that are unrelated (or not
necessarily related) to the main line of business. Another similar tactic is buying a business for
cash flows (including future working capital reductions) that can be diverted into a more
lucrative area (like securities). That’s what led Buffett to Berkshire.
These kinds of opportunities are very rare outside of small cap stocks. If, for instance, a major
retailer was, year after year, taking all its free cash flow and using it to buy its leased properties,
make early repayments of its mortgages, and buy back stock, people would notice. It would be
obvious you weren’t really paying for a business that operates a chain of stores – you were
paying for real estate holdings. In small caps, this kind of thing can and does happen. Granted, it
doesn’t happen a lot. But, it happens more than enough to create a portfolio based on these kinds
of situations.
You really can find businesses that have the majority of their assets in something that isn’t
strictly necessary to continue the business. For instance, there are small cap retailers who own
almost none of their stores and there are small cap retailers who own almost all of their stores.
Some have assets on their books carried in accordance with a transaction that happened last year;
others, have assets on their books carried in accordance with a transaction that happened last
decade. Even many of the existing shareholders don’t really notice this kind of thing. Maybe
they’ve read about it. But, it hasn’t sunk in. They haven’t looked at the value of those assets in
relation to the market cap.
In large cap stocks, you basically have to make the opposite bet from the guy on the other side of
the trade. In some small cap stocks, you can make an entirely different bet. Even very simple,
and very obvious things, like the amount of excess working capital less total liabilities goes
unnoticed in some very small stocks. Sure, if net current assets were great enough to exceed the
market cap, people would notice. But, when such assets are only enough to give an even greater
discount on an already cheap stock, a lot of people don’t notice.
On several occasions, in the past, I’ve bought into a very good (small) company selling at a
reasonable multiple, because excess working capital, no debt, and tons of free cash flow made
the stock even cheaper than the standard multiples suggested.
One thing I do think Buffett would pay attention to, in small caps just as he does in large caps, is
the economics of the industry – specifically, the nature of competition in the industry. But, that
doesn’t mean he would only buy world class brands. In large caps, where Buffett has to look,
that’s often what he has to do. But, in small caps, it may just mean sticking to industries where
everyone can earn a good return on capital and where no one foolish competitor can mess
everything up. I’ve mentioned this kind of thing before.
For instance, Energizer Holdings (ENR) is inferior to (the old) Gillette, but that’s okay. In
razors and batteries, the number two player can still earn a very nice return on capital. Hasbro
(HAS) and Mattel (MAT) may be the dominant toy companies, but that won’t stop a smaller
player like Jakks (JAKK) from generating good returns. The same is true in video games.
Eventually, there may be four or five large publishers, all smaller than EA (ERTS), and all
earning good returns on capital. There’s a difference between video games and airlines. I think
you can recognize that without moving to the large cap Buffett extreme of owning Coke (KO).
In large caps, the “hidden” value is going to be mostly intangible. In small caps, it can be a lot
more concrete.
 URL: https://focusedcompounding.com/what-would-buffett-do/
 Time: 2006
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On The Two That Got Away
“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one
current earnings and book value.”

(Read Warren Buffet’s 1992 Annual Letter to Shareholders)
Lately, I’ve been thinking a lot about Fisher and Munger and their influence on Buffett. If I have
not said it before, let me say it now: I believe both men’s influence on Buffett’s investment
decisions have been overstated. I do not mean that as a slight to either man. They both have
impressive records of their own, and they both offer a lot for investors to study. Phil Fisher and
Charlie Munger are two of the greatest investment thinkers of all time. Besides, this post is not
about the influence these men had on Buffett. This post is about investment mistakes I have
made – mistakes I would not have made had I heeded the advice of Fisher, Munger, or Buffett.
This post is, at least in part, the result of the time I spent at Jason Bond’s blog over the weekend.
That may not be obvious; nevertheless, it is true. I’m currently working on a three part podcast
series on spotting great companies. I’m also in the process of reviewing two books: Phil Fisher’s
“Common Stocks and Uncommon Profits and Other Writings” and Charlie Munger’s “Poor
Charlie’s Almanack”. Obviously, these projects are closely related. That fact has been reinforced
by two activities I engaged in this week: rereading Warren Buffet’s annual letters and
visiting Jason Bond’s blog. Having done these things, I knew I had to write this particular post
today.
Two weeks ago, I posted “On Blogs as Public Records”. In that post, I wrote:
“We’ll go over my mistake. Think of it as an autopsy. We’ll determine the cause of my error, and
look to prevent it from creeping into our thinking in the future.”

Not surprisingly, both of the biggest mistakes of my investing career have been errors of
inaction. However, these errors were not passive. When analyzing decision making, inaction
must always be considered an action. A choice is made in either case; whether the outside world
sees the results of that choice or not is irrelevant to an analysis of one’s own judgment – or
misjudgment.
Three years ago, I failed to buy shares of Building Materials Holding Company (BLG). A year
ago, I failed to buy shares of PetMed Express (PETS).
In each case, the stock was clearly undervalued. In each case, I did an intrinsic value analysis and
compared the margin of safety to all possible alternatives. In neither case, did I find a possible
alternative that had a margin of safety even remotely comparable to that of the stock being
considered.
I will spare you the details of my analyses. It is sufficient to say that my best estimate of the
value of each business was several times the market cap of that business. So, why didn’t I buy?
I failed to heed the tenth of Fisher’s ten don’ts for investors: “Don’t Follow the Crowd.”
It may have been a different crowd in each case; but, my mistake was the same. I lacked the
courage to act on my convictions. I allowed myself to be swayed by inconsequential
considerations about which I knew nothing. Even worse, I let these considerations outweigh
those matters of real import – matters which I knew a great deal about.
In the case of BMHC, I let macroeconomic considerations keep me from buying a cheap stock.
This might have been the best course of action, if the margin of safety present at that price was
just barely sufficient to qualify as an investment. Then, I would have been justified in not buying
the stock, because there were real economic threats about which I knew nothing. However, no
economic threats could erase the margin of safety present in those shares. I knew that, and still I
didn’t buy.
My mistake in the case of PetMed Express was a very simple, very stupid one. I paid attention to
traditional metrics such as price – to – earnings and price – to – book value. I knew the intrinsic
value of the company was many times the current market cap, and still I didn’t buy.
Why? Because the P/E ratio was too high. That’s not what I told myself, of course. But, that was
the real reason. As a value investor, I was used to low price/earnings, low price/book, and low
price/cash flow stocks. PETS was unlike those stocks. Even so, I knew it was a bargain, and still
I didn’t buy.
PetMed Express is an example of a great business. It fails to meet several of Fisher’s fifteen
points. There are management concerns and legal concerns. But, those are of little consequence.
They are mere pebbles on the scales when you consider the economics of the business. PetMed
Express is about as good a business as there is. It is a fast growing business in a highly
fragmented, slow growth industry. The barriers to entry are high. The economies of scale are
enormous. PetMed Express buys lots of cable advertising; if the company’s management is
smart, it will buy even more. Consumers know about 1 – 800 – Pet – Meds, they don’t know
about competitors. The company controls a very small part of the market; yet, it will almost
certainly dominate the market in time.
PetMed Express has a competitive advantage like no other. I knew that. I did the math. It wasn’t
even close. Still, I didn’t buy. I didn’t listen to Buffett’s best piece of advice:
“The investment shown by the discounted-flows-of-cash
calculation to be the cheapest is the one that the investor should
purchase – irrespective of whether the business grows or doesn’t,
displays volatility or smoothness in its earnings, or carries a
high price or low in relation to its current earnings and book
value.”

Don’t make the same mistake.
 URL: https://focusedcompounding.com/on-the-two-that-got-away/
 Time: 2006
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On Small Cap Value and Large Cap Growth
Yesterday, there was an interesting post entitled “Finding Value in Growth” over at Value
Discipline. About midway through the post Rick writes:
“As someone who generally has espoused small cap value picks, I have to admit how difficult it
is to find value in this part of the universe. A few exceptions naturally do apply, but overall, the
pickings are slim.”
I couldn’t agree more. The wheel has turned.
Immediately following the bursting of the speculative internet stock bubble, growth stocks were
still overvalued. I found occasional exceptions, but these were short – lived. For instance, I
briefly owned Cisco Systems (gasp!). However, I purchased the shares at what happened to be
just about the lowest point they’ve traded at in eight years. I sold the stock within a matter of
months. This is unusual behavior for me, but I bought the stock when it was undervalued and
sold it when it approached fair value – the fact that this happened within a matter of months is
the market’s fault, not mine.
What’s really remarkable here is that this undervaluing of Cisco (CSCO) only lasted for a matter
of months. Ever since, Cisco hasn’t even approached levels I’d consider buying at. What (still
extant) stock is more closely linked in investors’ minds with the internet induced insanity of the
late 90s than Cisco? I can’t think of any.
So, one would have assumed Cisco would become one of the most reviled stocks of the earlier
00s. But, that didn’t really happen. Cisco was certainly less appreciated. But, it was only very
briefly underappreciated. As I watched the bubble burst, my mouth was watering for the
bargains that never came. I was sure great companies like Intel (INTC), Microsoft (MSFT),
Cisco (CSCO), and Dell (DELL) would finally be offered at bargain basement prices. But, it
didn’t happen.
This once again demonstrates my complete inability to predict stock price movements, future
market levels, investor psychology, etc. I’m only good at one thing – finding businesses that are
selling for less than they’re worth. Fortunately, this is the only skill an investor needs. Still, the
whole experience does serve as a good reminder to ignore anything I have to say about the
broader markets or short – term price movements. If I am ever foolish enough (and I’m sure I
will be) to write about those things on this blog, please ignore me. That’s the best advice I’ll ever
give.
Returning to the Value Discipline post, you’re probably wondering what this little story about
Cisco has to do with “Finding Value in Growth”. Well, the wheel has turned. After all these
years, “growth” is cheap and “value” is expensive. As I’ve said before, as far as you are
concerned there are no such things as growth stocks and value stocks; there are just stocks. Don’t
decide on growth or value and then pick a stock that fits into one of those boxes. Just go out and
find a business that’s selling for less than it’s worth. If you keep that advice in mind, there’s no
harm in noting that, generally speaking, those stocks that are usually most loved by self
proclaimed growth investors are looking cheap; while those stocks that are usually most loved by
self proclaimed value investors are looking pricey. All this is because the wheel has turned.
What do I mean when I say the wheel has turned? No, I’m not trying to be cryptic. I’m trying to
be illustrative. Keep that picture of the turning wheel in your mind’s eye, but make room for a
few more pictures. I don’t normally pay attention to stock charts. However, these particular
charts paint such a clear picture, I couldn’t resist.
About three years ago, a member of my family approached me looking for some free stock
advice. I don’t normally give advice – at least not the kind of advice most people want. Most
people are looking for advice along the lines of: “buy stock X, stock Y, and stock Z. I’ll call you
when it’s time to sell stocks X, Y, and Z.” There are very good reasons for not giving this type of
advice to anyone – especially anyone you know. The number one reason is that most people who
ask such questions are not equipped to handle the answers. Usually, they neither think for
themselves, nor trust others to think for them. They tend to make decisions first and ask
questions later. Those questions are always asked of the advice giver and never of themselves.
They are the kind of people who buy and sell the same stock about twenty times in twelve
months. These are not the kind of people you want to give advice to.
This person was not one of them. He can think for himself and, if he takes your advice, he will
stick to it. So, he is the kind of person you can give advice to.
He came to me with two questions. Actually, he came to me with one question and one
statement, but the statement was really just a question masquerading as a statement. It went like
this: “I bought some Wal – Mart”.
Now, when someone says, “I bought some Wal – Mart” to me, that’s not what they mean. When
they say “I bought some Wal – Mart” to their accountant or their spouse, that’s exactly what they
mean. They’re letting them in on a fact. But, when they say it to me, they’re asking a question.
The question goes something like this: “Am I an idiot?”. When this particular person said “I
bought some Wal – Mart”, I must have made the kind of face that responded, “Yes, in fact, you
are an idiot”, because he immediately became interested in exploring alternative purchases.
I suggested he buy Village Supermarket (VLGEA). If he was wedded to the idea of buying a

discount superstore, I proposed BJ’s Wholesale Club (BJ) as a better alternative. I told him I
didn’t believe Village and BJ’s were better companies than Wal – Mart, but I did believe they
were better investments given the difference in price.
He was clearly thinking large cap growth while I was thinking small cap value. Here are the
charts for those three companies:
Wal – Mart (WMT) vs. Village (VLGEA) and BJ’s (BJ).
There is no bias here. These were the only retailers we discussed, and the discussion happened
almost exactly three years ago. The charts basically show you exactly what those stocks have
done since the conversation. Can you see the wheel turning?
At the same time, this individual was also considering buying stock in a big pharmaceutical
company. The boomers were aging and he wanted to cash in on the trend. He mentioned two
stocks: Pfizer (PFE) and Merck (MRK).
I said I didn’t understand pharmaceutical companies very well. Their revenues were hard to
predict, and were dependent upon government rulings. Despite my misgivings, I said I would
look into health stocks for him, but I wasn’t going to limit my search to big pharma.
I came back to him with two names: Bio – Reference Labs (BRLI) and U.S. Physical Therapy
(USPH). Both were real small stocks. I told him I’d rather own USPH than Pfizer or Merck, but
that I couldn’t actually recommend the stock given its price (the margin of safety was
insufficient). I told him BRLI was selling for less than it was worth and he should definitely buy
it. He wanted to know if there were any other interesting health stocks. I told him there weren’t.
All he was getting out of me were two “interesting” labels and one buy recommendation –
nothing more.
Again, there is no bias here. Three years ago we discussed these four stocks and only these four
stocks. Check out the charts:
Pfizer (PFE) and Merck (MRK) vs. Bio – Reference Labs (BRLI) and U.S. Physical Therapy

(USPH)
Can you see the wheel turning?
As you probably already know, Warren Buffett’s Berkshire Hathaway has bought shares in
Anheuser Busch (BUD), Home Depot (HD), and Wal – Mart (WMT). Now, I am not as
enthusiastic about these stocks as Mr. Buffet is. Obviously, your best bet is to trust him, not me.
Even though these stocks aren’t at the top of my pile of good ideas right now, I’d rather own a
basket made up of BUD, HD, and WMT than the S&P.; Wouldn’t you?
The wheel has turned. A new inefficiency has appeared. In a market that’s mostly efficient, this
kind of thing isn’t supposed to happen. The question I asked about owning a basket of three
large, well – known companies or owning the best – known index should be a really tough
question to answer. It isn’t. The BUD, HD, WMT basket is a much better buy than the S&P.;
The wheel has turned. The market is still inefficient; but, now, there’s a new way to exploit its
inefficiency.
The growth/value imbalance isn’t limited to the biggest companies. Look at PacSun (PSUN) and
Timberland (TBL). Two small stocks, but pretty well known names that were once well liked by
the growth crowd. Today, they could use a little love. Maybe you should be the one to give it to
them. Are they selling at the kind of discount I suggested Overstock was selling at (67%)? No.
But, they both look like they’re selling for less than they’re worth. I’d rather own a 50/50 PacSun
– Timberland basket than the S&P.; Wouldn’t you?
I’m sure a lot of people will start looking at Intel, Microsoft, and Dell. I’m not looking there –
yet. But even I have to admit those stocks do look more attractive than they have in some time.
The wheel has turned. We may be principled when it comes to buying a business for less than
it’s worth. But, that doesn’t mean we have to be dogmatic or close – minded.
So, don’t forget to think growth and think big.
Read the refreshingly short post that prompted this verbose sermon
 URL: https://focusedcompounding.com/on-small-cap-value-and-large-cap-growth/
 Time: 2006
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On The Great Chicken Debate
Okay, so maybe it hasn’t quite risen to those proportions yet. But, if you’ve been reading this
blog, or Shai’s blog, or the Value Discipline blog, you know there has been an ongoing debate
about two chicken stocks: Sanderson Farms (SAFM) and Pilgrim’s Pride (PPC).
On January 5th, I suggested that investors should look at Sanderson Farms before looking at
Pilgrim’s pride. Shai had invited me to put some of my stuff up on his blog. So, as this was a
topic of both “Grahamian Value” and news value (on account of Pilgrim’s earnings
warning/price drop), I sent the link over to Shai. He kindly ran it.
Now that would have been the end of it, but there was a comment made to the post ran on Shai’s
site that prompted a post from Shai on blogging and investing. It’s a good post and an interesting
topic, so I do encourage you to read it (for both posts on Shai’s site, the comments are worth
reading as well). However, it really doesn’t have to do with The Great Chicken Debate.
It’s the comment itself that’s most relevant to this topic. In it, the author says a few words about
Pilgrim’s Pride. Upon reading the comment, I decided I had no other choice but to take another
look at PPC and SAFM (after all, maybe I was wrong). Well, I did take another good look at both
companies, and decided I wasn’t wrong. So, I wrote a response to that effect.
The best part of all this was that it lead me to read some posts on Value Discipline, a blog which
I am ashamed to say I was not familiar with. It’s a great blog; we need more like it. Of course, if
you’ve been reading my blog, you already know that, because on January 5th, I posted a quick
note mentioning this great blog and two posts about these chicken stocks.
Today, there’s a new post at Value Discipline entitled “Oh no…not chicken again!”. It’s the best
thing I’ve seen written on this topic. Even I have to admit, it’s a far, far finer post than my
original one.
I especially want you to note Rick’s use of the free cash flow margin (free cash flow as a percent
of sales); this is an important metric, and one I have not yet discussed. It is of less utility over
short periods of time and in commodity businesses. Well, that’s not exactly true. I should say it is
of less utility in commodity businesses during a period of abnormal business conditions.
However, it is an excellent number to use in comparing two or more competitors over a period of
five to ten years.
I agree with everything in the post except perhaps with one slight omission. While it is true that
interest coverage at both SAFM and PPC is ample at the moment, a review of both firms’ records
will show that their interest coverage has not always been sufficient to provide suitable
protection for the common stock. This isn’t surprising, because chicken is a commodity business.
Interest coverage will be very poor in a period of unfavorable business conditions and very good
in a period of favorable business conditions. However, I think you should be alerted to the fact
that only three or four years ago, interest coverage at PPC was at a level that would have caused
concern had it been sustained. A few years before that, much the same could have been said
about SAFM. I can’t really blame Rick for this omission, as I made the same omission in all my
posts. I just thought I should bring it up now, because if business conditions were to worsen
considerably within the poultry industry, interest coverage could once again become an issue.
Anyway, it’s a great post.
 URL: https://focusedcompounding.com/on-the-great-chicken-debate/
 Time: 2006
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On Formulaic Investing
One question almost every value investor asks at some point is whether it is possible to
achieve above market returns by selecting a diversified group of stocks according to some
formula, rather than having to evaluate each stock from every angle. There are obvious
advantages to such a formulaic approach. For the individual, the amount of time and effort spent
caring for his investments would be reduced, leaving more time for him to spend on more
enjoyable and fulfilling tasks. For the institution, large sums of money could be deployed
without having to rely upon the investing acumen of a single talented stock picker.
Many of the proposed systems also offer the advantage of matching the inflow of investable
funds with investment opportunities. An investor who follows no formula, and evaluates each
stock from every angle, may often find himself holding cash. Historically, this has been a
problem for some excellent stock pickers. So, there are real advantages to favoring a formulaic
approach to investing if such an approach would yield returns similar to the returns a complete
stock by stock analysis would yield.
Many investment writers have proposed at least one such formulaic approach during their
lifetime. The most promising formulaic approaches have been articulated by three men:
Benjamin Graham, David Dreman, and Joel Greenblatt. As each of these approaches appeals to
logic and common sense, they are not unique to these three men. But, these are the three names
with which these approaches are usually most closely associated; so, there is little need to draw
upon sources beyond theirs.
Benjamin Graham wrote three books of consequence: “Security Analysis”, “The Intelligent
Investor”, and “The Interpretation of Financial Statements”. Within each book, he hints at
various workable approaches both in stocks and bonds; however, he is most explicit in his best
known work, “The Intelligent Investor”. There, Graham discusses the purchase of shares for less
than two – thirds of their net current asset value. The belief that this method would yield above
market returns is supported on both empirical and logical grounds.
In fact, the NCAV strategy currently enjoys far too much support to be practicable. Public
companies rarely trade below their net current asset values. This is unlikely to change in the
future. Buyout firms, unconventional money managers, and vulture investors now check such
excessive bouts of public pessimism by taking large or controlling stakes in troubled companies.
As a result, the investing public is less likely to indulge its pessimism as feverishly as it once did;
for, many cheap stocks now have the silver lining of being takeover targets. As Graham’s net
current asset value method is neither workable at present, nor is likely to prove workable in the
future, we must set it aside.
David Dreman is known as a contrarian investor. In his case, it is an appropriate label,

because of his keen interest in behavioral finance. However, in most cases the line separating the
value investor from the contrarian investor is fuzzy at best. Dreman’s contrarian investing
strategies are derived from three measures: price to earnings, price to cash flow, and price to
book value.
Of these measures, the price – to – earnings ratio is by far the most conspicuous. It is quoted
nearly everywhere the share price is quoted. When inverted, the price to earnings ratio becomes
the earnings yield. To put this another way, a stock’s earnings yield is “e” over “p”. Dreman
describes the strategy of buying stocks trading at low prices relative to their earnings as the low
P/E approach; but, he could have just as easily called it the high earnings yield approach.
Whatever you call it, this approach has proved effective in the past. A diversified group of low
P/E stocks has usually outperformed both a diversified group of high P/E stocks and the market
as a whole.
This fact suggests that investors have a very hard time quantifying the future prospects of
most public companies. While they may be able to make correct qualitative comparisons
between businesses, they have trouble assigning a price to these qualitative differences. This
does not come as a surprise to anyone with much knowledge of human judgment (and
misjudgment). I am sure there is some technical term for this deficiency, but I know it only as
“checklist syndrome”. Within any mental model, one must both describe the variables and assign
weights to these variables. Humans tend to have little difficulty describing the variables – that is,
creating the checklist.
However, they rarely have any clue as to the weight that ought to be given to each variable.
This is why you will sometimes hear analysts say something like: the factor that tipped the
balance in favor of online sales this holiday season was high gas prices (yes, this is an actual
paraphrase; but, I won’t attribute it, because publicly attaching such an inane argument to
anyone’s name is just cruel). It is true that avoiding paying high prices at the pump is a possible
motivating factor in a shopper’s decision to make online Christmas purchases. However, it is an
immaterial factor. It is a mere pebble on the scales. This is the same kind of thinking that places
far too much value on a stock’s future earnings growth and far too little value on a stock’s
current earnings.
The other two contrarian methods: the low price to cash flow approach and the low price
to book value approach work for the same reasons. They exploit the natural human tendency
to see a false equality in the factors, and to run down a checklist. For instance, a stock that has a
triple digit price to cash flow ratio, but is in all other respects an extraordinary business, will be
judged favorably by a checklist approach. However, if great weight is assigned to present cash
flows relative to the stock price, the stock will be judged unfavorably. This also illustrates the
second strength of the three contrarian methods.
They heavily weight the known factors. Of course, they do not heavily weight all known
factors. They only consider three easily quantifiable known factors. An excellent brand, a
growing industry, a superb management team, etc. may also be known factors. However, they
are not precisely quantifiable. I would argue that while these factors may not be quantifiable they
are calculable; that is to say, while no exact value may be assigned to them, they are useful data
that ought to be considered when evaluating an investment.
There is the possibility of a middle ground here.
These three contrarian methods may be used as a screen. Then, the investor may apply his
own active judgment to winnow the qualifying stocks down to a final portfolio. Personally, I do
not believe this is an acceptable compromise. These three methods do not adequately model the
diversity of great investments. Therefore, they must either exclude some of the best stocks or
include too many of the worst stocks. It is wise to place great weight upon each of these
measures; however, it is foolish disqualify any stock because of a single criterion (which is
exactly what such a screen does).
Finally, there is Joel Greenblatt’s “magic formula”. This is the most interesting formulaic
approach to investing, both because it does not subject stocks to any true/false tests and because
it is a composite of the two most important readily quantifiable measures a stock has: earnings
yield and return on capital. As you will recall, earnings yield is simply the inverse of the P/E
ratio; so, a stock with a high earnings yield is simply a low P/E stock. Return on capital may be
thought of as the number of pennies earned for each dollar invested in the business. The exact
formula that Greenblatt uses is described in “The Little Book That Beats the Market”. However,
the formula used is rather unimportant. Over large groups of stocks (which is what Greenblatt
suggests the magic formula be used on) any differences between the various return on capital
formulae will not have much affect on the performance of the portfolios constructed.
Greenblatt claims his magic formula may be used in two different ways: as an automated
portfolio generation tool or as a screen. For an investor like you (that is, one with sufficient
curiosity and commitment to frequent a site such as this) the latter use is the more appropriate
one. The magic formula will serve you well as a screen. I would argue, however, that you
needn’t limit yourself to stocks screened by the magic formula, if you have full confidence in
your judgment regarding some other stock.
These four formulaic approaches (the three from Dreman and the one from Greenblatt)
will likely yield returns greater than or equal to the returns you would obtain from an
index fund. Therefore, you would do better to invest in your own basket of qualifying stocks
than in the prefabricated market basket. If you want to be a passive investor, or believe yourself
incapable of being an active investor, these formulaic approaches are your best bet. In fact, if I
were approached by an institution making long – term investments and using only a very small
percentage of the fund for operating expenses, I would recommend an automated process derived
from these four approaches. I would also recommend that 100% of the fund’s investable assets
be put into equities, but that is a discussion for another day (in fact, it’s a discussion for Tuesday;
my next podcast is devoted to the dangers of diversification).
If, however, you believe you have what it takes to be an active investor, and that is truly what
you wish to be, then, I would suggest you do not use these approaches for anything more than
helping you generate some useful ideas.
If you choose this path, you need to be clear about what being an active investor entails.
Read this next part very carefully (it is correct even though it may not appear to be): I have never
found a screen that generates more than one buy order per hundred stocks returned. Even after I
have narrowed the list of possible stocks down by a cursory review of the industry and the
business itself, I have never found a method that can consistently generate more than one buy
order per twenty – five annual reports read. Here, I am citing my best past experiences. In my
experience, most screens result in less than one buy order per three hundred stocks returned, and
I usually read more like fifty to a hundred annual reports per buy order at a minimum.
You may choose to invest in far more stocks than I do. Perhaps instead of limiting yourself to
your five to twelve best ideas as I do, you might want to put money into your best twenty – five
to thirty ideas. Do the math, and you’ll see that is still quite a bit of homework. That’s why
remaining a passive investor is the best bet for most people. The time and effort demanded of the
active investor is simply too taxing. They have more important, more enjoyable things to do. If
that’s true for you, the four formulaic approaches outlined above should guide you to above
market returns. If, however, you’d prefer the life of the active investor, you can join me here
every day and try to do even better.
 URL: https://focusedcompounding.com/on-formulaic-investing/
 Time: 2006
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On Conviction and the Value Gap
Recently, Tommy Hilfiger Corp (TOM) accepted an offer of $16.80/share from private

investment company Apax Partners. Not long after hearing this, I was talking to someone who I
had suggested the stock to almost a year ago. I asked him if he still had his shares. “No”, he said
– he’d already sold.
Now, it would be easy to let the blame for this rest solely upon the impatience of that investor.
However, I have to admit I deserve the lion’s share. You’ll rarely be successful buying a stock
on someone else’s advice unless you understand the logic behind the purchase. I did a god awful
job of explaining the logic behind buying shares of Tommy Hilfiger.
I never believed Tommy Hilfiger was a great company. Nor, did I have any illusion it would
perform well in the long – run. I simply recognized that the company was selling for less than it
was worth. All the profit from such a purchase would be derived not from the firm’s ongoing
success but from a one time increase in the stock to close the value gap (between the market
price of the stock and the intrinsic value of the business). As you can see on the right side of
this three year stock chart for Tommy Hilfiger, that’s exactly what happened.
My mistake was confessing my lack of confidence in Tommy’s future prospects, without

adequately explaining why this investor needed to hold onto those shares. I should have insisted
upon showing him a balance sheet and statement of cash flows; I should have explained to him
why the intrinsic value of the business still exceeded the market price despite the firm’s
mediocre prospects. I didn’t. I just told him it was cheap, but it wasn’t a company I had any
confidence in going forward. That was a terrible mistake.
Whenever you make a stock purchase for yourself or (in my case) when you recommend a stock
to someone else, you have to clearly and simply state the argument that the intrinsic value of the
business far exceeds the going price. In the case of Tommy, that argument was very clear to me,
but not to the investor I was talking to. That’s because while estimates of Tommy’s discounted
future cash flows were etched into my mind by the process of research and analysis, I never
explained to this poor investor why there are times when the purchase of a mediocre or even sub
par business can make sense.
I could have, and should have, taken the statement of cash flows and Tommy’s market cap,
written them down on a piece of paper, and circled the value gap that was so clear in my mind. I
didn’t. Remember, clarity and honesty are essential to good investing.
You can purchase a stock expecting your returns to come entirely from a one time run up that
erases the value gap. As long as you’re honest with yourself – that is, you admit you’re investing
in a mediocre company – and you have the courage and conviction to hold the stock until that
value gap is erased. A great company can continue to beat the market year after year as it
deploys the capital from its retained earnings and continues to earn extraordinary returns on that
capital. Obviously, a mediocre business can not do this. However, a mediocre business can be a
suitable investment, if, and only if, the valuation gap is wide enough and the investor is honest
enough.
Learn from this investor’s mistake. His purchase of Tommy Hilfiger wasn’t the wrong move. It
was just made for the wrong reasons. You’re not going to have the conviction to hold a stock
unless you were convinced by the argument to begin with.
 URL: https://focusedcompounding.com/on-conviction-and-the-value-gap/
 Time: 2006
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A Two-Step Approach to Assessing 'Earnings Quality'
One of the most important tasks a value investor has is judging “earnings quality.” A stock’s P/E
ratio tells you something. But, it doesn’t tell you enough. And the longer you are invested in a
stock – the less it tells you. Value investors often try to fix this problem by focusing on free cash
flow instead of earnings per share. They also think a lot about return on invested capital. For
example, Joel Greenblatt (Trades, Portfolio)’s “The Magic Formula” uses EV/EBIT (which is a
pre-tax P/E ratio that counts debt as part of the price) as a sort of earnings measure combined
with last year’s return on capital.
However, there are a few problems with a true stock picker – not a buyer of a formulaic basket –
using that approach. One, you aren’t going to sell the stock in one year. So, return on capital
might change quite a bit while you own the stock. Two, earnings are an accounting – rather than
an economic – number. This is why Tobias Carlisle’s “The Acquirer’s Multiple” which is based
on the simple EV/EBITDA approach (with no return on capital consideration) might work just as
well. An acquirer doesn’t actually think in terms of reported earnings or even EBIT. An acquirer
uses a measure of cash flow vs. the price of debt and equity in the business. So, an EV/EBITDA
approach is closer to a cash approach. Also, it’s possible that return on capital may “revert to the
mean.” There’s actually a lot of evidence that in well settled, non-cyclical industries reversion to
the mean in terms of returns on capital is pretty weak. For example, in restaurants – Starbucks
(SBUX), Dunkin Donuts (DNKN), and Domino’s (DPZ) – there is strong profit persistence
where the coffee chain, pizza chain, etc. with the highest return on capital keeps having the
highest return on capital and the ones with the lowest keep having the lowest. Think about what
the return on capital is for two leaders in coffee – Starbucks and Dunkin Brands – and then try to
imagine what it is for everyone else. You just don’t see the same reversion to the mean that you
see in cyclical industries like insurance, semiconductors, etc. This persistently high level of
profitability among companies who are leaders, have better business models, etc. is why Warren
Buffett (Trades, Portfolio) could make bets that pay off over long periods of time. He has owned
Wells Fargo (WFC) for about 28 years and has outperformed what he could do by picking a
random bank. Returns on capital can completely avoid reversion to the mean in situations where
you have excellent product economics and low growth in tangible assets. For example, Berkshire
Hathaway (BRK.B, Financial) has owned See’s Candies for a very long time and had a very high
return on capital – but, what hasn’t it done? It hasn’t opened many See’s Candies locations in
states where the brand wasn’t already well established. Likewise, Nebraska Furniture Mart can
have strong economics versus other furniture stores – but it’s actually had very low growth in
terms of the number of locations, square footage, etc.
This brings us to the issue of re-investment of capital. So, a company’s economic earnings are
what it earns in actual free – that is, distributable by the owner – cash flow. We know See’s
Candies has high free cash flow, because Warren Buffett (Trades, Portfolio) has taken the cash
from See’s and invested in other things. He has bought other businesses, stocks, etc. using the
cash flow from See’s. That proves that See’s “earnings quality” is high. It earned money in cash
flow that can be used elsewhere. But, for Berkshire – and really any company that’s only half the
“earnings quality” equation. To be of high quality, earnings must come in the form of cash. If a
company keeps growing its inventory and receivables year after year, but never seems to grow its
cash balance – that earnings quality is low. If a cruise line keeps growing the size of its fleet year
after year – but never has more cash on hand at year end, the earnings quality there is suspect as
well. A business that “earns” in the form of additional tangible investment in day-to-day
operations has low quality earnings.
But, even a business with high free cash flow can have low earnings quality. This is because
there are really two parts to earnings creating added stock market value. If a company earns $1,
there is first the question of whether 85 cents, 90 cents, 95 cents or 105 cents is generated in free
cash flow. The worst businesses – often those with large amounts of property, plant, and
equipment and receivables and inventory – may generate just 80 cents in cash for every one
dollar of earnings they report. Meanwhile, the best businesses – take something like the ad
agency holding company Omnicom (OMC, Financial) – may generate 5 or 6 cents more in free
cash flow for every dollar of earnings they report. In other words, such a stock reporting $5 in
EPS might actually have up to $5.30 in free cash flow in a “normal” year. Still, this is only half
the “earnings quality” equation from the shareholder’s perspective.
The next question is what use that free cash flow will be put to. This is where Berkshire
Hathaway excels. Warren Buffett (Trades, Portfolio) harvests $1 of free cash flow from a
subsidiary that isn’t growing and he turns it into more than $1 of added market value to
Berkshire stock by picking the right stocks, buying the right businesses, etc. with the free cash
flow. Many companies don’t do this. And poor capital allocation lowers earnings quality.
Let’s return to the example of Omnicom. In recent years, Omnicom’s earnings quality has
decreased a bit in the sense that it has generated less free cash flow per dollar of reported
earnings. But, the level of free cash flow relative to reported EPS is still very high. That’s a core
part of the business model. And it doesn’t change much from say 1998 to 2003 to 2008 to 2013
to today.
What does?
The value created or destroyed by capital allocation. The incremental return on the free cash flow
once it is re-deployed has changed a tremendous amount. For the permanent shareholder, one
dollar of free cash flow today at Omnicom should be worth much, much more than $1 of free
cash flow back in 1998. That’s because Omnicom re-deploys a lot of its cash through investment
in its own stock. It buys back its shares. The price of its shares in 1998 was very high in terms of
P/E ratio, EV/Sales, etc. Today, it’s much lower. This means the earnings quality of the stock is
now higher because of the “second step” in the process. A shareholder in Omnicom doesn’t
really get that much free cash flow paid out to him. He gets some. There’s a decent dividend
yield on the stock right now. But, historically, more of the company’s EPS has been paid out in
the form of stock buybacks than in the form of dividends. It’s important to consider the return on
investment of each use of free cash flow.
Omnicom has very little need for tangible capital growth inside its business. It does acquire some
companies (though, it acquires less than some of its peers). So, the P/E ratio alone isn’t sufficient
to judge Omnicom. Instead, an investor needs to look at that P/E ratio (which is EPS/Stock Price)
and then think about the “second round” earnings quality. The first round is the generation of
free cash flow. As I said this often exceeds EPS – so that part has high “earnings quality.” But,
the company blindly buys back stock. It isn’t very sensitive to price with its buybacks. This
makes the ultimate value of free cash flow – the “value add” to intrinsic value – differ quite a bit
depending on the stock’s price. Omnicom becomes much more attractive for a long-term holder
of the stock whenever the stock price gets cheap and is likely to stay cheap for a while. The stock
has sometimes been cheap enough to ensure about a 10% return on stock buybacks. That’s
impressive when you consider the EPS conversion to free cash flow has been greater than 100%
at times. When Omnicom stock is cheap – about where it is now or even cheaper – a long-term
shareholder is getting an extremely high earnings quality. The P/E might say 15, but the P/FCF
ratio is even lower. And then a good deal – sometimes even two-thirds – of the EPS is going into
buying back the shares. Let’s say the P/FCF ratio is 14. That’s a free cash flow yield of 7%.
Maybe 3% of that will go to dividends. But, the other 4% will go to share buybacks. If the 4%
that goes to share buybacks has a long-term buy and hold type return of 10% or more on its share
buybacks – that elevates the value add for the stock. This is because the market will capitalize a
stock like Omnicom at an earnings yield of maybe 6% (like a P/E of 16 or 17) when the stock
can re-invest (in itself) at 10% or more (the stock it buys both generates earnings right away and
then also grows over time). In a sense, the market is demanding a 6% return and the re-
investment is giving the company a 10% return.
This is an important point. But, I’m sure it sounds kind of trivial to you right now. After all,
many companies have much, much higher returns on equity than 10%. That’s true. But, therein
lies the problem with something like “The Magic Formula” or with the ROE number you see
here at GuruFocus.
Remember: three things matter while you hold a stock. One is pretty speculative. It’s what the
market will capitalize earnings at when you want to sell the stock (in other words, how high will
the P/E will be). That’s your “sell” return. But, the other two things that matter are “hold”
returns. They are: #1) How much free cash flow will the stock generate? And #2) What will this
free cash flow be used for? To make money in the stock, you want three things to happen. One:
You want a lot of free cash flow generation. Two: You want the free cash flow to be re-invested
in a way that creates more earnings power relative to the free cash flow being consumed. And
three: you want a high multiple put on the ending free cash flow generation when you sell the
stock.
If a company buys back its stock at a high P/E ratio, the ultimate “earnings quality” is actually
low. And the stock will perform worse than you expect or the stated return on investment would
suggest. For example, look at Intel (INTC) around the year 2000. That company bought back
stock to offset employee stock option issuance. The financial statements said Intel had pretty
good “earnings quality” because it was generating a lot of free cash flow. But, investors didn’t
get to see that free cash flow paid out to them. Instead, the free cash flow was used to reduce the
company’s share count. This was not an effective way to grow future free cash flow per share.
The company paid too much in terms of free cash flow now to grow free cash flow later. The “all
in” earnings quality was poor. Intel’s operations were good. Its capital allocation was poor. This
made the stock’s “earnings quality” mediocre.
This kind of “earnings quality” problem is one investors in high debt companies face a lot. It can
be a surprisingly bad decision to invest in a highly leveraged company that de-leverages while
you own it. This sounds like a nice scenario at first. After all, the stock gets safer. But, if the
company’s credit rating starts out decent – paying down debt is usually a really bad use of funds.
We can look at General Electric (GE, Financial) today.
Personally, I’m interested in GE as a value investment but very worried about GE in terms of
“earnings quality.” One, I’m worried that some segments of GE may only convert 80% or less of
their reported earnings into free cash flow. And then, two: I’m worried that – if I became a stock
owner today – some of that free cash flow would go to plugging the company’s pension
obligations. That’s a very low return use of cash.
For example, imagine that GE stock trades at a P/E of 13, so an earnings yield of 7% to 8%. But,
then only 80% of that earnings yield is turned into free cash flow. That gets you to a free cash
flow yield of 6%. But, imagine a worst case scenario where GE used all of the free cash flow –
this is an extreme assumption I’m using just to illustrate a point – to plug the pension hole. Well,
the return on doing something like that could be as low as 5%. That’s two-thirds of what the
return in buying back the company’s stock would be – even if the company didn’t grow. I should
make the point here that the company did buy back stock at an earlier date. But, buying the stock
back now would be a higher return decision than when the company chose to do a big buyback.
Still, GE is unlikely to do a big buyback now. It really might do something like shore up the
pension funding instead of buying back stock. So, you can quickly get to a scenario where a P/E
of 13 on a company with a EPS to free cash flow conversion rate of 80% and then a capital
allocation program with a 5% return on investment is no better than a stock with a P/E of 25 that
converts at least 100% of EPS into free cash flow and pays it all out in dividends. The
explanation for why a company with a P/E of 25 can sometimes be as attractive as a company
with a P/E of 13 is “earnings quality” differences. If a company generates more cash per dollar of
earnings than another company and it uses that cash better – it can be a better investment even at
a higher P/E ratio.
And, if my suggestion of a 5% return on investment seems totally outlandish to you – after all,
stocks usually have much, much higher ROEs than that – consider that quite a few big
companies have had returns on acquisitions that really are about that bad. And some of the worst
returning acquisitions have had some of the biggest price tags.
Usually, a company’s core day-to-day operations have much better return potential than any kind
of activity it can undertake in the corporate finance department.
So, a big part of getting into a high “earnings quality” stock is simply avoiding companies that
make a lot of acquisitions, buy back their stock when it’s overpriced, or pay off debt that’s fairly
low yielding.
When analyzing a stock, it can be a huge help to know it won’t make any acquisitions or that it
will spend all its free cash flow on dividends or share buybacks. This greatly simplifies the
earnings quality calculation. We now know that GE’s earnings quality was poor in recent years.
It might have been hard to detect that ahead of the bad recent results. However, it would have
been easy to see that there was no way to be sure GE had high “earnings quality.” It was too
difficult to assess the “earnings quality.” Stocks with low earnings quality or difficult to assess
earnings quality should have below market P/E ratios – not above market P/E ratios. They should
only ever be bought as low P/E value investments.
 URL: https://www.gurufocus.com/news/638457/a-twostep-approach-to-assessing-
earnings-quality
 Time: 2018
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Risks You Can Remove and Risks You Can't
The stock market has taught us an important lesson these last few days: There are risks you can
remove from owning stocks and risks you can’t. No matter how diversified you are – you can’t
remove the risk of experiencing a paper loss of 5% or 10% within a few days or weeks. That risk
will always be there. Does that mean you shouldn’t diversify?
I don’t diversify. My approach is to try to own about three to five stocks at once. I don’t
recommend that approach to everyone. In fact, I don’t think most people are made for the kind of
investing. So, I think diversification does make a lot of sense. But, diversification can’t do what a
lot of investors want it to do.
Owning 50 stocks instead of five stocks or even 30 stocks instead of three stocks is not going to
help you avoid seeing days where your portfolio is down 5% or 10%. Why? Because those kinds
of losses tend to happen when stocks are down just because they are stocks. If you wanted a
portfolio that wasn’t down as much as the Dow was this Monday – the way to do that (if you
were only going to own stocks) would be to own very few stocks rather than very many. You’d
actually have a better chance of being down a small amount if you owned 3 stocks instead of 50
stocks. This is just because owning very few stocks gives you better odds of moving in a way
that’s different from the market. You’d also have a much better chance of being down on days
the market wasn’t down. But, I’m not recommending you own three stocks instead of 50 stocks.
Rather, my advice is just to accept that – if you are going to be 100% in stocks (which I think
you should be) – then you aren’t going to be able to remove the risk of big, sudden paper losses.
There will be weeks where you lose a lot of money. And that’s going to be the case if you own
three stocks or 300 stocks. It’s true that you’ll have fewer weeks with big drops if you own 50
stocks than if you own five stocks. But, the really big drops in any stock tend to happen when
just about everything is falling at the same time. So, a lot of diversification may help you avoid a
few more down weeks. But, it’s not likely to cure the problem that most worries you – which is
really big down weeks.
Diversification can remove business risk easily. For example, my portfolio has a ton of specific
business risk in it. I own a stock called NACCO (NC). It has a customer that accounts for
probably one-third of its business. In one day, NACCO could lose that customer and I – because
there have been times where NACCO is 50% of my portfolio – could lose 15% of the intrinsic
value of my portfolio in a single day (50% of 30% is 15%). If you don’t diversify, the loss of a
single client at one of your businesses can hurt you. If you do diversify, it can’t. But, there are
other ways of eliminating this risk. For example, if you buy Omnicom (OMC, Financial), which
is just one stock – no client will account for more than about 3% of that company’s revenue. So,
the loss of Omnicom’s biggest client would – even if you had 50% of your portfolio in Omnicom
– cost you less than 2% of the intrinsic value of your stock portfolio (50% of 3% is 1.5%). So,
diversification does eliminate customer concentration risk. But, simply choosing stocks with a
large number of small customer fixes this problem just as well. What about business risk? This
can be solved through diversification. So, you can own Omnicom and Interpublic (IPG) and
WPP and Dentsu and Havas instead of just owning Omnicom. But, I don’t think that really does
anything in this case. For example, Omnicom actually consists of three of probably the 10
biggest ad agencies in the world. Those agencies are mostly run separately. They’re just under
the same corporate umbrella. So, I see no need to diversify across many ad agency stocks to
avoid business risk. You can own more than one ad agency by owning just one stock.
But, there could be “corporate” risk even where there isn’t business risk. For example, there’s
little business risk in owning Berkshire Hathaway (BRK.B, Financial). Berkshire owns a bunch
of stocks in different industries. Funds are generated through insurance operations. And these
funds either go into that stock portfolio or into businesses like utilities, railroads, industrial
companies, etc. Berkshire doesn’t have customer concentration risk. Nor does it have business
concentration risk. So, losing a client or failing in some specific business isn’t a risk in owning
just that one stock.
But, should you put 100% of your net worth in Berkshire Hathaway?
Is that as safe as putting 100% of your net worth in an index fund?
There’s still corporate risk. Berkshire has one board of directors, it has (mainly) one capital
allocator ( Warren Buffett (Trades, Portfolio)), much of the company’s debt (though not all) is
guaranteed by the parent company. So, the company’s financial strength and its top management
is non-diversified. Buffett (Trades, Portfolio) and Ajit Jain, head of insurance operations, are
only two people, yet they account for a lot of key decisions at the company. I think most of us
wouldn’t have any problem betting on them. But, we might want to diversify that bet a bit. So,
you could make Berkshire 20% or 33% of your portfolio (that is, have a five-stock or three-stock
portfolio) to diversify down this “corporate” risk. Obviously, the S&P 500 consists of 500
different corporations. And none of them account for more than like 4% of an S&P 500 index
fund. The “corporate” risk at Apple (AAPL) might only put 4% of an S&P 500 index fund at
risk. A portfolio that was 20% Berkshire Hathaway would mean that corporate risk at Berkshire
Hathaway would put 20% of your portfolio at risk. That’s five times more corporate risk than
you have with an index fund being 100% of your portfolio.
With Berkshire, you might risk it. But, still, even a conglomerate might be too risky to own just
one of. Now, if you could own five conglomerates that might be enough. But, are there really fie
conglomerates at any one time that are good enough and cheap enough to own?
You can never be completely certain of the management or the finances of a company. So, even
if you focused on Buffett (Trades, Portfolio)-level managers and triple-A type companies – you
might still want to diversify a little.
Then there is the “asset risk” or the “market risk” in owning stocks. This is at once one of the
toughest risks to remove and also one of the easiest. If we are measuring over very short-term
periods – like what a stock does today, this past week, or this past month – there’s nothing you
can do about this kind of risk. You can’t remove it. And you can’t diversify it away. You could
own other assets besides common stocks – but the cost of doing that (in terms of the compound
annual growth rate drag over your investing lifetime) is simply too great. Yes, people do own
mixed portfolios of stocks and bonds. Some people have mixed portfolios of long-term bonds,
common stocks, cash and gold. That would be a very diversified portfolio in terms of asset class
risks. But, it’s not a good portfolio. It will underperform a 100% stock portfolio in the long-run.
The reason for adopting such a portfolio would be if you can’t really trust yourself to stay 100%
in stocks. Otherwise, all you gain from that kind of diversification is a smoother, slower ride to
less wealth at the end.
But, what about over the longer-term? Do all stocks really move together over the longer term?
Or, are there other ways to diversify within stocks?
The reason stocks outperform other asset classes has to do with the inherent economics of a
business. A successful business grows each year and is profitable each year. It does both. So,
there is profit to be harvested (dividends, share buybacks) and there is growth that means
dividends and share buybacks can be greater next year than last year. The same thing is true of
timberland. So, we’d assume that assets like stocks and timberland outperform other assets like
bonds and gold. Stocks and bonds can both suffer from inflation. But bonds offer a harvest with
no growth while stocks offer a harvest and growth. Gold and timberland are real assets. But, gold
doesn’t grow. To profit from it, you have to use enough of it that you end the year with less gold
than you started the year. Timberland doesn’t work that way. You could harvest trees and still
end up with as many trees as you had previously.
Now, any of these advantages can be offset by the “handicapping” mechanism of the market.
There is some price – and it’s been reached before – where some bonds can be more attractive
than some stocks.
We’re not at that point now. As I write this, the 30-year U.S. Treasury Bond yields 3.07% and
Omnicom common stock yields 3.25%. So, that’s an 18 basis point advantage for Omnicom
common stock over U.S. Treasury bonds and then Omnicom usually spends more on share
buybacks than dividends. So, that’s – at a minimum – about a 3.25% cash yield plus a 3.25%
“payment in kind” (you own more of the stock). That’s a 6.5% return. If the company as a whole
grows profit by just 3% to 4% a year – then, you’re up to a 10% annual return in Omnicom stock
versus a 3% annual return in the 30-year bond. It doesn’t matter how much of a “diversifier” that
30-year Treasury bond is to your portfolio. It’s not worth it. An expected annual return gap that
big is going to prove way too costly over the long-run. Accepting such a huge annual drag is
irrational. Only someone who values a smooth ride much more than a ride that gets you to a
higher plateau 10, 20, 30 years from now would ever go in for a deal like that.
Yes, the bond diversifies you in a big way. But, it’s far too expensive a method of risk removal
in the long run. Don’t buy bonds to remove risks. There are usually other, cheaper ways to try to
remove a risk. For example, you may not be sure of Omnicom’s future – but you can be sure of
the future of the five biggest ad agency holding companies combined. So, put 20% of what you’d
put into Omnicom into each of them. There’s some cost to that diversification (I think
Omnicom’s a bit cheaper and a bit better than some of its peers). But, it’s a very cheap form of
risk reduction versus buying a Treasury bond.
What are other cheap ways to diversify within the asset class of stocks?
Most stocks are hurt by higher interest rates in the sense that higher interest rates usually
coincide with lower P/E ratios. So, the price multiple on the same earnings per share usually
contracts causing a stock’s price to grow less than its earnings when rates are rising. So, instead
of looking to have 65% of your portfolio in stocks and 35% of your portfolio in bonds or
something like that – why not think about having 35% of your portfolio in stocks that benefit
from higher interest rates? This is only a partial offset. Even stocks where earnings rise with
higher interest rates still experience the P/E multiple contraction problem. But, finding banks that
have cheap deposits is a good way to pack your portfolio full of stocks that should hold up better
when interest rates rise.
Inflation hurts all stocks. It hurts bonds too. Some people think stocks perform well during
inflation. That’s not true. They just lose less of their value than bonds. Even stock that can raise
prices in line with inflation often have some tangible capital requirements that become
problematic.
As a rule, you probably want to own as many stocks as possible that handle inflation well. Why?
Because simply by owning stocks you are exposing yourself to inflation risks. All stocks get hurt
by inflation. But, Omnicom gets hurt a lot less than Union Pacific (UNP). Railroads and
supermarkets and things like that do badly during periods of inflation because they have to
replace tangible assets in today’s dollars. Companies with almost no net tangible assets in the
business – like ad agencies, some software companies, etc. – handle inflation better. More
importantly, these stocks don’t do worse in terms of long-term annual returns versus other
stocks. So, this is a form of risk removal – you’re removing some inflation risk from your
portfolio – that literally costs you nothing (most of the time). Right now, for example, you can
easily sell a railroad stock you own and replace it with Omnicom without paying up. The ad
agency doesn’t have a higher P/E than the railroad right now. So, that’s the kind of risk removal
to consider.
There are two other obvious ways to remove risks. One is to own stocks outside your home
country – or outside whatever country you mostly invest in (I know some investors in small
countries who actually have more money in U.S. stocks than in their home country).
I don’t do enough of this. But, if you own stocks in the U.S., Canada, Japan, Australia, the U.K.
and continental Europe all at the same time, your portfolio will be diversified in a way that
doesn’t have to reduce your long-term return expectations. A great business in the U.K. has the
same long-term return potential as a great business in the U.S.
The diversifying-by-country approach can be combined with the last risk removal technique:
buying cheap stocks. So, the biggest risk to stocks as an asset class is that they get overpriced as
a group sometimes. They’re overpriced right now.
But, that doesn’t mean all stocks all over the world are overpriced. The U.K. market is cheaper
than the U.S. market right now. Let’s say you like car dealers as a business. You’re an American.
You see Berkshire Hathaway bought a chain of car dealerships. Buffett thinks it’s a good
industry with a moat. You want in.
What do you do?
Your best bet isn’t to buy publicly traded U.S. car dealerships. Why not?
One, as an American you probably already own a ton of U.S. stocks. What you own is
denominated in U.S. dollars. The companies in your portfolio earn money in U.S. dollars.
Instead, look at U.K. car dealerships.
Why?
They earn their money in pounds. And – here’s the important one – they’re cheaper. As a group,
U.K. car dealers are much, much cheaper than U.S. car dealers. So, if you are going to invest in a
car dealer – make it a British car dealer.
For an American investor, this kills two risky birds with one stone. The risk of having all your
money in businesses that earn their money in dollars is lessened. You now own some stocks that
produce earnings in pounds. And the price of U.K. car dealers is often 50% cheaper on various
earnings metrics than U.S. car dealers. So, your price risk is lower.
The one thing to check is to make sure the long-term return potential of the business itself – the
return on equity – is as good at the U.K. car dealers you find as it is at many U.S. car dealers.
I think you can find some U.K. car dealers that are a better buy. If you don’t know the group
well, you can diversify across five publicly traded U.K. car dealers instead of just one.
So, instead of putting 25% of your portfolio into say Vertu Motors, you put 5% into Vertu and
5% into four of Vertu’s peers. You are still betting a big part of your portfolio on: the U.K., car
dealerships and cheap stocks (remember, U.K. car dealers are cheaper than U.S. car dealers).
That’s the kind of diversification – and the kind of risk removal – that makes sense.
What you want to find is ways of removing risks without lowering the long-term rate of
compounding in your portfolio. Don’t do the conventional kind of diversifying. Don’t own some
Treasury bonds. That is such an awful anchor to attach to your portfolio and have to lug around
for decades. It’s just too expensive to try to reduce risk that way. It’s irrational to be so eager to
reduce risk that you ensure you enter retirement with less wealth than you would have had using
a less conventional, but still conservative approach.
There is nothing wrong with being 100% in stocks 100% of the time. But, you will have to be a
little more pro-active in finding ways to remove risks while still staying in businesses that
compound their value at good rates for a long time.
Use my example of buying a basket of U.K. car dealers as the model of risk reduction to strive
for.
Diversify by country and by company. But don’t sacrifice stock cheapness or business quality to
do it. Those two factors are paramount in every investment move you make. Always insist on
getting a high quality business at a low stock price. Any diversifying move that doesn’t fit those
two criteria is a bad decision.
 URL: https://www.gurufocus.com/news/636813/risks-you-can-remove-and-risks-you-
cant
 Time: 2018
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When Markets Drop, Turn Your Useless Emotions Into Useful Drudge Work
With the stock market dropping significantly over the last two trading days – and probably your
brokerage account balance with it – I would like to talk about how useless emotions are in
helping you handle drops like this.
First, let’s remember that if this depressive period of the last two days is abnormal, so is the
manic period of the last 12 months. Benjamin Graham wrote about Mr. Market as a sort of
business partner with mood swings who would offer you very different prices on the very same
business depending on what mood he was in. Last year, Mr. Market kept valuing most businesses
higher and higher. In the last two days, he keeps valuing them lower and lower.
Both periods are abnormal, but one is not more abnormal than the other. The way humans think
tends to cause us to view the last two trading days as the oddity and the last year or so as
something fairly normal. Both periods were extremely odd. And it is probably not random
chance that a couple very volatile days followed an incredible streak of very non-volatile
months. Why, then, do many smooth months feel more normal than a couple rocky days?
This is a pattern you will see again and again. People do not like to think of a Shiller price-
earnings ratio of 16 or an EV/EBITDA of 8 or whatever as “normal”. What they like to think of
as normal is whatever level they have seen for a few years in a row. I have talked about this
before, especially with the Federal Funds Rate and oil prices. I own a stock that would benefit
quite a bit from a higher rate.
When I bought the stock a couple years ago, one of the reasons for me buying it was that the Fed
Funds Rate was likely to be a lot higher in five years (when, hopefully, I’d be selling the stock)
than it was back (at 0% to 0.25%) when I bought it. You wouldn’t think that was a controversial
claim, but a lot of investors had gotten used to a really low rate. The report on my Focused
Compounding site that discusses a 3% Fed Funds Rate when making all these calculations of
intrinsic value got a lot of feedback from readers, where they said: “Do you really think the Fed
Funds Rate will get back to 3%?”.
Now, of course, the Fed Funds Rate is nowhere near 3%. And maybe it will not ever get there.
But I figured it would eventually get there and the people betting it would stay closer to 0% than
3% even five years from now were basing that bet intuitively on just one thing: it had been at 0%
for the last five years or more. In other words, people got used to that 0% level.
Given enough time, investors will feel the now is normal – regardless of how historically unusual
the “now” is. You can see this with the price drop of the past several days. It feels wrong that
prices should drop so much, so fast. But does it feel more wrong than the market trading at a
Shiller price-earnings of 30 or higher? The market is still at such a high level after the drop. A lot
of investors have gotten used to these incredibly high stock prices because they have come about
gradually. A big price drop feels wrong, at first. But people learn to accept much lower prices as
normal after months of declines. We should be careful. We need to remember the “normal”
scenario is for stocks to be about 40% lower in price than where they are right now. It doesn’t
feel that way. The idea of a 40% decline in stocks seems outlandish, but a Shiller price-earnings
of 30 or higher is outlandish. So we are already living in outlandish territory. It is just that getting
there through years and years of strong stock market gains that outstrip earnings feels normal
because it is so gradual and we are now so used to it. Sudden declines do not feel normal because
we have not had time to get used to them. That’s sort of the definition of “sudden”: something
happening so fast you’re not used to it yet.
In the long run, though, valuations are destiny when it comes to stocks. Stocks are unlikely to
perform well from here, not for any economic or technical reason, but simply because they are
clearly too expensive. It’s boring to keep harping on something like the Shiller price-earnings
ratio, but that’s what will determine your long-term returns much more so than what happens
over a few trading days – however dramatic they’ve been.
Should you sell now?
I imagine the urge to sell comes pretty easily to most investors reading this right now. Why?
Because your stocks are in the green – not for the last couple of trading days, but since you
bought them.
Right?
Go look at your unrealized gains and losses in your brokerage account. I bet you do not see a lot
of red. There are not a lot of unrealized losses in there. Rather, there are a lot of unrealized gains.
People are usually pretty quick to take gains in stocks that are up since they bought them and
pretty slow to take losses in stocks that are down since they bought them.
I think that’s dumb. But I know from experience - and from talking with a lot of otherwise really
intelligent investors – that this is one of the most common irrational activities even value
investors engage in. For some reason, if a stock they bought in early 2017 went up 25% last year
and has now fallen 8% in the last two days – they’re happy to sell and be done with it. But if a
different stock they also bought in early 2017 rose just 4% last year and is also down 8% in the
last two days – they are reluctant to sell. It is painful to “lock in” that loss.
Well, there are not many losses to lock in right now. If you are a longer-term holder – an
investor, not a trader – you have a brokerage account chock full of unrealized gains. It will feel
pretty easy to part with those stocks. The very few (do you have any?) stocks that have
unrealized losses are the ones that are tough to sell.
Obviously, that’s irrational.

What’s the rational way to approach trimming your portfolio?
The most rational way is to think in terms of three things: 1) What is the price of each of the
stocks you own, 2) What is your appraisal value of each of the stocks you own and 3) What
stocks would you own if the stock market stayed open but barred you from trading anything you
owned?
In other words, what stock would be the least frightening to see plunge if you couldn’t sell it?
That stock belongs near the bottom of your list of stocks to consider selling.
Then, what stock would be the most frightening to see plunge if you couldn’t sell it?
That stock belongs at the very tippy-top of the list of stocks to consider selling.
Your portfolio should be made up of the businesses you love the most, provided the shares of
those businesses are among the cheapest. I own three stocks. And I have to admit they are quite a
mix in this regard. I think my largest position is the cheapest. My second-largest position is a
business I love and is cheap enough (it’s trading at maybe two-thirds of what I think it’s worth).
My smallest position is a business I am quite happy to hold forever but quite unhappy with the
market price of (it trades at about 30 times earnings).
I have no intention of selling any of them unitl I find something better to buy.
But that’s me. What if I was willing to sell a stock without having another stock to buy?
Well, then, the last stock I mentioned is the only one worth considering selling. If a business is
good enough that you feel comfortable with it and the shares of that business are cheap enough
that you feel comfortable owning them – then, stick with them.
Don’t sell any business you like when it’s cheap. If you have to sell something – sell a business
you don’t like or a business that isn’t cheap. That sounds obvious, but I’ve known plenty of
smart people who talked themselves into selling a cheap business they liked.
Sometimes, something can be “cheap enough” even when you have a pretty big unrealized gain
in the stock. The stock I told you I think is only trading for about two-thirds of what it’s worth is
actually a $102 stock today that I bought at $48. So when I go into my brokerage account, I see a
100%-plus unrealized gain in that position. Does that large gain tempt me to sell?
It shouldn’t.
Now, if the business was one I didn’t like – I should be tempted to sell pretty quick. And, even if
the business is one I like, once it passes my appraisal of what I think it’s worth: I should start
entertaining thoughts of selling.
Personally, I plan to be in stocks for life. I got started investing when I was 14 in the late 1990s.
I’m 32 now, so I’ve been investing for over half my life now. I hope that when I’m 64, I can look
back over the years and say I was as close as possible to 100% invested in stocks as often as
possible. For a concentrated stock picker – and since I have over 90% of my portfolio in three
stocks, I think I qualify – there is always something to do in good markets and bad.
Yes, I personally believe we are in a bubble. I have said my “appraisal value” for the market as a
whole – the S&P 500 – is about 40% lower than today’s (post-selloff) price.
That frightens some people and upsets some others, but I don’t think it should do either. I am not
saying you should stay out of stocks. I’m staying in them as best I can. And I’m not making any
predictions about when the bubble will burst (two bad days like this can easily be reversed and
forgotten in time) or if “the bursting” really will be a decline of 40%.
That kind of thinking doesn’t interest me. Stock picking interests me. And this is where things
just got easier.
I don’t have a theory about how bubbles work or how they will pop. To me, the definition of a
theory is a “useful operating assumption.” What I mean by that is it doesn’t much matter what
the capital-T truth is or how nature works – it matters how you frame the day-to-day work you
set out for yourself. If subscribing to a certain theory helps you get work done (get the correct
answers), it’s a good theory. If it doesn’t help you get correct answers to your practical day-to-
day problems, it’s not a good theory. It might be true – but it’s not useful.
Moving away from the very emotional topic of what is or isn’t true and why and toward the
much less emotional topic of how to improve your own practical process of investing is going to
make you a much better investor and a much saner person.
On the topic of sanity, I have (just today) read arguments that “prove” computers, the Federal
Reserve, a Democratic president or a Republican president are responsible for the sudden drop in
stock prices we have seen these last couple days. These are opinions you don’t need in your life.
Holding them – correct or not – may make you feel better (and certainly more righteous). But
they aren’t going to make you richer. And they aren’t going to make you a saner, calmer, happier
human being. Leave those kinds of beliefs to professionals who are paid to have opinions. You
are paid to pick stocks.
Now is the time to take Twitter off your phone, swear off message boards, turn off CNBC – and
instead crack open a 10-K.
Do you have a watch list? No. Well, do you at least have a list of stocks you’ve analyzed in the
past? Probably not an exhaustive one, but I bet you could recreate quite a lot of that list if you
tried. Get a yellow pad of paper and a pen. Sit down and try to write the names of every stock
you have owned or researched in your life. Then – without looking at stock prices, news or
anything else – ask yourself to order those names from the one you know best to the one you
know least. This exercise will take you a while, but at the end of that process you will have a list
of stocks you know well.
Now, whatever you do – don’t look at their stock prices. Don’t check the EV/EBITDA ratio on
the summary page here at GuruFocus.
Instead, take those stocks one at a time from the other side of things. Forget the price. Think only
of your “appraisal value.” Try to get through appraising the top five stocks on your list. These
are the five businesses you feel you know best. If you really commit to this – which means
reading and taking notes on one 10-K a day – you can probably work through all five of your
best-known stocks in a week.
Where will the market be trading in a week? Higher? Lower? About the same?
The great thing is none of us have any idea.
SoÂ just focus on those five businesses you think you know best. Focus on the appraisal values
you are going to mark down – I want an exact number like $57.43 a share – for each of them.
Why an exact number? I want you to take your appraisal value as seriously as the market price.
Then, in one week, compare the appraisal value you have for those five stocks to the market
price.
If all five market prices are higher than all five appraisal values you wrote down, then – as far as
you’re concerned – yes, we are in a bubble. If some of the market prices are lower than the
appraisal values, then it doesn’t matter if the market is in a bubble. Your personal watch list is
not. There’s something for you to do. There’s something for you to consider buying.
And that’s all that matters.
If you’re reluctant to try this practice of just focusing on the five stocks you know best – ask
yourself how much time you suspect you’ll be spending watching TV about the stock market,
reading articles, on Twitter, constantly checking the price of your own portfolio, etc. Now
imagine if you spent that amount of time appraising the five stocks you know best but don’t yet
own.
Which use of your time do you think is more likely to make you richer?
Have the discipline to force yourself to use your time that way. That’s the rational thing to do –
especially during irrational times.
 Time: 2018
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Volatility Is the Value Investor's Friend
In recent days, the market has experienced some of its biggest point drops ever. The past couple
trading days have been abnormal. But, the many months that led up to these last couple days
were just as abnormal in a different way.
They weren’t volatile.
The market moved steadily upward. And when I say “market” I mean quite a lot of different
stocks and even quite a lot of different markets. Obviously, the U.S. stock market has been
getting progressively more expensive on valuation ratios like the Shiller P/E ratio since about
mid-2009. There is nothing wrong with a stock market – or a single stock – getting suddenly a
lot more expensive. Sometimes it is well-deserved. From the market bottom in early 2009, it
wasn’t unusual for an investor’s portfolio to have gained about 50% over the next 12 months.
And there was nothing wrong with that, because – after that 50% bounce off the bottom – stocks
were priced much in line with the kind of normalized P/E ratios they had traded at in the past.
I’ve written before about how I believe we are in a bubble. I think it was on Dec. 19, 2017, that I
did a blog post officially admitting that “yes, I think we’re in a bubble.” Since then stocks
haven’t really changed much in price. That is, they’ve changed quite a bit. But, they went up a
lot and then down a lot and have now ended up not far from where I wrote that post. So, we can
safely say I still think we’re in a bubble.
I am also 100% invested. And it’s investing – not bubbles – that I’d like to talk to you about. It’s
not worth spending time worrying about anything that isn’t going to change and potentially
improve your own investment process. If it doesn’t help you pick better companies to buy, pick
better times to buy them or pick better times to sell them – then it’s not worth worrying about.
I’m not sitting here worrying about whether I should be 100% invested or 60% invested or 20%
invested in stocks. Certainly, I would have been better off if I started February (but not any
month before then) with a lot more cash and lot fewer stocks. It seems to me that kind of timing
requires clairvoyance. After all, I said in December I thought we were in a bubble, but that didn’t
mean I knew the market would drop 40% in the next year or go nowhere for the next eight years.
Either path gets you to about the same outcome in terms of valuations.
So, let’s not fixate on the price level of the overall market. We’re value investors. We’re stock
pickers. So, we will always focus on the price level of the individual stock we’re choosing to buy
next. That’s enough. The market may be overvalued at a Shiller P/E of 32. But, if Starbucks
(SBUX, Financial) sounds good to you at an EV/EBITDA ratio of 11 or Wells Fargo
(WFC, Financial) sounds good to you at a P/E ratio of 14 – you should buy those stocks even if
you wouldn’t buy the overall market. I might pick different stocks and I might not get especially
excited about those exact price levels. But, I certainly can’t argue that it’s unreasonable to pay 11
times EBITDA for Starbucks or 14 times earnings for Wells Fargo. Those are reasonable prices
to pay for well-entrenched businesses. It is, however, unreasonable to pay a Shiller P/E of 32 for
the overall market.
So, what we are talking about here is being selective about price. Last year, someone asked if I
thought Omnicom (OMC, Financial) was a good stock to buy. And I said I thought it was an
obviously good choice at $65 a share. Well, it’s at $73 a share right now. So, if you believed
what I said made sense back then – you’d have to wait for another 10% decline in the stock
price. You wouldn’t be able to buy it today. You would need to exercise selectivity when it
comes to price.
Last year, investors had little chance to exercise selectivity when it came to prices. A lot of
stocks kept rising month after month. The market didn’t give you even a 5% drop from top to
bottom – much less a 10% drop like what I’m saying you should wait for in Omnicom. Of
course, that’s an arbitrary number. I am saying Omnicom looks really obviously good to me as a
buy-and-hold stock if you do the buying at $65 a share. It looks less obviously good at $75, $85
or $95. I think it’s worth more than $75, $85 or even $95. But, I wouldn’t buy it till it was selling
for as little as $65. That is the margin of safety value investors are always talking about.
And that margin of safety comes from volatility. Over the truly long term, most stocks trade
mostly in line with their intrinsic value if we average out the highs and the lows for the year.
Omnicom and the other ad agency holding companies have – over the last 30-40 years – been
perhaps a bit cheap on average. They’ve worked better as buy-and-hold investments than other
industries. But, there have been long periods – sometimes an entire decade in the case of
Omnicom – where you wouldn’t have gotten a market-beating type return if you bought the
stock at its average price for the year.
But, stocks don’t trade at just one price all year long. Normally – not in a year like 2017, but in a
“normal” year – there’s volatility. Mr. Market offers you different prices on different days.
And that’s what a value investor needs to do the day-to-day drudge work of picking stocks and
actually buying them. He needs volatility. That is why the last couple days of trading should be
exciting rather than frightening for value investors.
Stock are still – on average – far, far overpriced. If you asked me what the “right” price for the
Dow Jones or something like that is right now – I’d have to say down 40% from here. But, that
doesn’t mean I can’t find stocks to buy. As long as there is volatility, there will be stocks to buy.
Why?
Because there are so many stocks. And because volatility offers the same stocks at such different
prices during the year. So, if you follow my advice for how to best become a better value
investor – which is to read one 10-K a week and come up with your own “appraisal” of intrinsic
value for that stock – you will find some stock during the year (out of the 52 stocks you study)
that trips a level you find acceptable to buy at.
For me, it is 65% of my appraisal value. That’s the level that tells me it’s okay to buy. So, when
you hear me say that Omnicom is obviously cheap enough to buy at $65 a share – that’s my way
of saying Omnicom’s intrinsic value is at least $100 a share.
If I really believed Starbucks was a good buy at 11 times EBITDA, I’d need to believe Starbucks
was worth at least 17 times EBITDA. If I really believed Wells Fargo is a good buy at 14 times
earnings, I’d need to believe the intrinsic value of Wells Fargo would be reached when the stock
hits a P/E of no less than 22.
I’m not sure I quite believe those things. But, I am sure that I’m not confident that Starbucks
isn’t worth at least 17 times EBITDA and Wells Fargo isn’t worth at least 22 times earnings. I
am, however, totally confident that the S&P 500 isn’t worth a Shiller P/E of 32.
So, I’ve just mentioned three stocks – Omnicom, Starbucks and Wells Fargo – that are cheaper
than the market in the sense that I’m not sure they’re overpriced while I am sure the market is
overpriced. Now, imagine if these stocks – stocks like Omnicom, Starbucks, and Wells Fargo –
were to move down as much as 8% in just the next couple trading days. What if – pretty soon –
you got the chance to buy these stocks at 10% or less from where they now trade?
In many years, in many stocks that’s often true. It’s pretty much taken for granted that you’d
have a very good chance of seeing any stock you’re looking at trade for 10% less on no real
news. There’s also a good chance you’d see it trade for 10% more on no real news.
But, in the very recent past – this changed. The market taught stock pickers like us that it wasn’t
very likely at all that we’d get a chance to buy the stock we were looking at today at 10% less
some time in the near future.
We have to re-learn this belief. I don’t know if the big drops of the last couple trading days are
the beginning of a bubble popping or a blip that will be reversed within a day or a week or a
month. But, I do know that stock prices will be more volatile in the future than they have been in
the recent past.
And, more importantly, I know that’s great new for value investors. I recently did a podcast
about a stock called NIC (EGOV, Financial). The stock lost its biggest client, the Sate of Texas,
and dropped 20% on the news. Texas accounted for about 20% of NIC’s revenues. This is the
kind of stock drop that’s not helpful for value investors. There was some very big bad news. The
stock’s price dropped big too.
Not very helpful.
Sure, we can try to work out the math of exactly how bad the loss of Texas will be to NIC. We
can assume the profit drop will be a lot bigger than the 20% stock drop. But, what odds was the
market putting on the loss of that contract. It wasn’t a secret that companies would get to bid on
that Texas business and someone other than NIC might win it. So, what if the market was putting
a 65% chance on NIC keeping the business and a 35% chance on NIC losing the business? You
see how the math gets a little complicated. And it quickly becomes apparent that although the
stock dropped a lot and earnings will drop a lot too – it’s not such a clear cut big buying
opportunity or a clear cut big selling opportunity. That kind of event counts as volatility as far as
people looking at that stock. They see the earnings release came out and the next day the stock
was down 20%. They know that’s a volatile stock. But that was stock price volatility driven by
underlying earning power volatility.
That kind of volatility isn’t real helpful. What kind of volatility is?
Well, this same stock – NIC – had declined 30% in price in the 12 months leading up to the loss
of the Texas contract. During those 12 months, the U.S. passed a tax bill that would likely reduce
NIC’s tax rate – including both state and federal taxes – from between 35% to 40% of operating
profit (as it had been in most past years) to something close to 25%. So, you have an undeniably
positive tax law development that probably increases the value of the EBIT in shareholder (rather
than “government”) hands by at least 15% after-tax. And yet, during that same year, the market
values the business at 30% less. This is equivalent to a 40% decline in the price of a stock with a
static intrinsic value. And, of course, the business grew a little – maybe a bit better than the
nation’s nominal GDP rate. So, really it’s more like the stock got 45% cheaper in a year.
That’s exciting. And that’s the sort of mindless – random walk looking – volatility that batters
the average stock around in the average year. We haven’t had an “average” year of volatility for
quite some time.
As you can see in the “disclosures” at the bottom of my articles, I own three stocks. I own
NACCO (NC, Financial), Frost (CFR, Financial) and BWX Technologies (BWXT). You can
look up these companies’ business descriptions here at GuruFocus for yourself. But, I’ll tell you
right now – they don’t have much of anything in common. One depends on electricity demand at
coal power plants. One depends on short-term interest rates. And one depends on U.S.
government demand for nuclear powered ships. Nothing causes their “earnings power” to move
in the same direction at the same time. Well, in the last two trading days the coal company is
down 15%, the nuclear company is down 6% and the bank is down 4%.
Look at the stocks in your own portfolio. Why are they down? Right now: Most stocks are down
because they are stocks. People are selling stocks indiscriminately. And no one is interested in
buying stocks indiscriminately. That should make the discriminating value investor – the true
stock picker – very excited.
 URL: https://www.gurufocus.com/news/635833/volatility-is-the-value-investors-friend
 Time: 2006
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The Trouble With Taking Profits
Warren Buffett (Trades, Portfolio) said that there was one part of how businesses worked that he
didn’t believe and wasn’t prepared for till he saw it in action himself. He called it the
“institutional imperative.” And he said this institutional imperative was: “the tendency of
executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to
do so.”
I’ve spent over 12 years now mostly in the company of other value investors. The virtual
company, that is. It’s rare that a day goes by without me conversing by email or Skype with
some reader of my blog, listener to my podcast, or others, about investing. Very often – most
often, I’d say – we talk about some specific stock they don’t yet own but are considering buying
or a stock they own and might sell.
Today, I want to talk about that second category: a stock you own and might sell.
I’ve read a lot of books about investing. And I spend a few hours of every day thinking about
investing myself. So, I didn’t expect to see behaviors that surprised me. But, I do see a pattern of
behavior with value investors that does surprise me. And that’s what I’d like to talk about today.
It’s a well-known behavioral pattern.
Officially, it is known as the “disposition effect.” That’s an unmemorable name, however. So,
I’m going to call it the “tendency to take profits.” In my experience, it hits value investors like an
itch the second their stock is meaningfully in the black – that is, the second they are showing a
paper gain they could crow about. If a stock is up 30%, that’s often enough to get a value
investor itching to sell.
Why?
I’m not sure exactly. There are a few possible explanations. One is the simplest: People like
doing things. People don’t like not doing things. Investors have a very strong tendency toward
considering their options and they really don’t like to be left in limbo. Personally, I have to say I
really enjoy only buying about one stock a year. But, this is one of the parts of my approach to
investing that gets the oddest looks from others. The idea that you could write about investing,
think about investing, research stocks, etc., all year long and in 11 months out of 12 months
make no change to your portfolio seems really weird to people.
I don’t have anything against action I feel pretty sure will add value. But, looking back at my
own past actions – it’s rare for me to have an impulse to sell one stock and replace it with
another and for that impulse to be proven definitely and materially correct over the long-term.
Honestly, what I buy doesn’t much outperform what I sell. This wasn’t always obvious to me. I
used to do more tracking of my portfolio performance versus something like the S&P 500. And
so, if what I bought outperformed the market over the time I held it – I tended to think my
purchase was a good decision. However, when I went back and really analyzed the decision in
terms of my subjective opportunity cost rather than everyone’s objective benchmark – the results
were a lot less clear.
See this article for details: “Over the Last 17 Years Have My Sell Decisions Really Added
Anything?”
This might just be because I think a lot about buying businesses that have good competitive
positions. If I was more interested in “deep value” type stocks, this pattern might not hold. But,
the pattern tends to be that if I correctly identify a stock as having a strong competitive position –
a “moat,” an industry “tail wind,” improving economies of scale, etc. – that correct assessment
wouldn’t just get me good returns over the one to three years during which I actually owned the
stock. The same insight would be paying off in years five, six, seven, eight and nine. Those are
years in which I’ve often already sold the stock.
Now, it’s true that selling one stock to buy another works sometimes for me. But, mostly it’s
from the “value” component of the two stocks having a big difference.
I’ll give you a “live” example now and you can decide for yourself. I own a stock called BWX
Technologies (BWXT, Financial). It has a P/E of 32. I didn’t buy it at anywhere near today’s
price. It’s a $64 stock today. I bought it at more like $27 before a spin-off that also gave me
another business I sold for $10 a share. So, I guess you could say I bought this stock – the BWX
Technologies part – at something like $17 a share and now it’s at $64 a share. That part scares
value investors. The P/E of 32 is scary. But, a stock going from $17 to $34 to $51 to now $64
isn’t necessarily a reason to sell something. It’s not how much profit you are showing in the
stock – it’s how expensive the stock is now versus what you think it’s worth now. BWX
Technologies now has a P/E over 32. And it also has some net debt now. We can all agree: It’s
expensive.
Compare this to a stock I might replace BWX Technologies with. There’s a publicly traded
collection of car dealerships in the U.K. called Vertu Motors. I’m not saying this is definitely the
stock I’d replace BWX Technologies with. But, it’s a possibility. As of this moment: It’s the
kind of stock I might replace BWX Technologies with. It’s probably close to the top of the
possible replacement list.
Well, Vertu has no net debt. And it’s trading at something like a P/E of 6. So, the rough estimate
here would be that BWX Technologies is about five times more expensive than Vertu Motors.
Selling out of BWX Technologies and buying Vertu Motors may make sense, because I would
be selling out of something with a P/E of 30 and getting into something with a P/E of 6.
I don’t think Vertu’s future is as clear as BWX Technologies’ future though. So, I’m not sure the
two deserve anything like the same P/E ratios. But, it’s possible Vertu deserves to have a P/E
ratio two to three times higher than what it has now and BWX Technologies deserves to have a
P/E ratio that is just 2/3 of what it has now. So, maybe Vertu deserves a P/E of 12 to 18 and
BWX deserves a P/E of 20 to 25, but no higher. If that were true, then obviously Vertu would be
a lot cheaper than BWX Technologies right now.
That’s the kind of swap a value investor should make. And that’s the right way to think about
selling a stock. You sell something that is clearly expensive – its P/E ratio is 1.5 times or 2 times
the level of the overall market. And you replace that expensive stock with something that has a
P/E that is two-thirds or even one-third the level of the overall market. That kind of huge
“trading up” in terms of getting more value for your money makes sense.
But, when I talk to people about a stock like BWX Technologies that isn’t where the
conversation goes. The conversation goes something more like this: “Didn’t you buy both BWX
Technologies and the other part of Babcock together for like $27 a share and then sell the other
part for $10 a share. So, isn’t it like you bought BWX Technologies at $17 a share? And, if you
bought it at $17 a share, I can understand why you’d hold it till maybe $34 a share (a double).
But, now you’re holding it when it’s closing in on something like $68 a share (a quadruple).
Certainly, you didn’t originally think you were buying something at 25% of intrinsic value. So,
isn’t BWX Technologies overpriced, and shouldn’t you sell it?”
Now, my own feeling on this is a little extreme. But, I’ll tell it to you anyway. I don’t think you
should ever sell a stock just to sell a stock. I think you should only sell a stock to replace it with
another stock. I do sell stocks in anticipation of buying a new stock – and so, I sometimes have
cash lying around if I don’t pull the trigger on the new buy right away. But, I don’t sell a stock
just to get out of it or “take a profit."
Why not?
One, stocks as a group outperform cash. And not by a little bit. It’s by a lot. So, if the average
stock out there would normally return 8% a year and the average bank account out there would
normally return 3% a year – you’d have a 5% annual drag from holding generic cash instead of a
generic stock. It’s true that stock you own could be really, really overvalued. But, I just used an
example of a stock with a P/E of 30+ and I’m still not sure this argument works. Would I really
be better off holding cash for the long-term (let’s say five years) rather than holding BWX
Technologies? It’s true the P/E multiple might contract from 32 to 20. But, it’s also true the
stock’s earnings per share might grow about 10% a year during much of this time. So, when we
do the math, we’d have to be pretty confident the multiple contraction is coming soon (like in the
next three months to three years) to argue that we’ll be better off getting out of even a really
expensive stock like BWX Technologies.
The other problem – and this one is the much bigger problem for me – is that selling a stock to
“take a profit” essentially means reversing your early decision. The stock you’re selling isn’t a
generic stock. Would I sell the S&P 500 today (if I held it) to hold cash for the next one, three or
five years? Maybe. Yeah, I might be open to that. I don’t much like the S&P 500 at today’s
price. I wrote in a recent blog post that I think – as of 2018 – we are now in an actual bubble in
U.S. stocks.
But, I didn’t “pick” the S&P 500. I did “pick” BWX Technologies. And I had reasons for picking
it. I thought it had an amazing competitive position. The company is in a monopoly/monopsony
situation (bilateral monopoly) where I felt the U.S. Navy effectively needs BWX Technologies
to stay in business and be its sole supplier for nuclear related activities like building nuclear
reactors for all of the Navy’s submarines and aircraft carriers and BWX Technologies in turn
needs the Navy to keep ordering these reactors. The visibility for nuclear reactor demand from
the U.S. Navy is very high. We have planning that goes out like 25 years. These are all things I
liked a lot about BWX Technologies when I first bought it.
Stock picking is essentially handicapping. So, yes, the average stock with a P/E of 6 will
probably outperform BWX Technologies with a P/E of 30. But, it’s not likely to outperform it by
5 times. There’s probably a quality difference between Vertu and BWX Technologies offsetting
some of that price gap.
When I first bought BWX Technologies, I thought it would have pretty quick and very
predictable EPS gains for years to come. That hasn’t changed. My assessment of the business
hasn’t changed. So, I wouldn’t be selling a generic stock with a P/E of 30. I’d be selling a part
interest in a business I thought had a clear and good future for as far as the eye could see.
That’s what I mean about having to reverse yourself when you sell a stock. You are – in part –
betting against your own initial analysis of the business. If BWX Technologies is really still such
a good business, then it can compensate future holders of the stock for a lot of the downside of
buying such an expensive stock. It’s possible a really good business with a P/E of 30 could
outperform a generic business with a P/E of 20. And I knew that when I first picked this stock.
Selling is something I struggle with. But, it’s something I’ve gotten better with over time to the
extent I decided on three things…
One, never sell a stock within the first year of buying it. The general principle here is to hold a
stock at least long enough for your original thesis to play out. For example, I bought Frost
(CFR, Financial) believing its earnings per share would rise as the Fed Funds Rate rose. I
shouldn’t sell the stock while the Fed is still raising rates. Otherwise, I’m not letting my original
thesis play out. I’m cutting it short. The guiding principle is: don’t sell a stock before you let the
original thesis play out. The ironclad rule is: don’t sell a stock within a year of buying it. If you
do that, you’re a trader. For example, I have a big position in NACCO (NC, Financial) and
people always ask if I’m going to trim it. I’m open to trimming it eventually. But, I just bought it
last October. I won’t re-visit the stock till October of 2018. Worrying about selling at an
especially opportune time in the first 11 months of owning a stock is giving in to a trading
mindset instead of an investing mindset. Two, don’t sell a stock to “take a profit”; sell a stock to
buy a cheaper, better stock. In other words, don’t “take profits” just “swap stocks”. And finally,
there’s number three. This one for me has been the hardest. It’s simply: focus on what you’re
buying instead of what you’re selling. In other words, let your buy decisions dictate your sell
decisions – never the other way around.
If I research Vertu Motors a lot and discover I love this stock at this price – then, yes, I’ll sell out
of BWX Technologies. But, I won’t let myself think “Oh, I should really sell out of BWX
Technologies now that it’s so expensive – let me scour the globe looking for something cheaper
to replace it with”.
That’s letting the tail wag the dog. If you buy right, selling mostly takes care of itself. This is
largely because even if the price is now wrong – the stock you own is too expensive – the quality
will still be there. The greater danger is owning the wrong business rather than owning the right
business at the wrong price.
So, if you like the businesses you already own – then, stick with the status quo until proven
otherwise. You own the stocks you own for a reason. You liked them once better than any other
stocks out there. So, have the faith to stick with them till you find something that excites you as
much as those stocks once did (when they were cheap).
Most importantly, learn to love inaction. And strike the term “profit-taking” from your
vocabulary. Locking in a paper gain – turning it into a realized gain, that doesn’t matter. All that
matters is opportunity cost. Is the stock you’re adding to your portfolio going to outperform the
stock you’re dumping from your portfolio. That’s the only “gain” that matters.
 URL: https://www.gurufocus.com/news/634099/the-trouble-with-taking-profits
 Time: 2018
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Warren Buffett and the Art of Stock Picking
I recently listened to a podcast where the author of a Warren Buffett (Trades, Portfolio)

biography (Roger Lowenstein, "The Making of an American Capitalist") mentioned the “art”
part of stock picking in regard to what Warren Buffett (Trades, Portfolio) does. In other words,
business analysis as opposed to just looking at the numbers here at GuruFocus or in a Moody’s
Manual or something.
I thought this was an important topic to discuss. Because I get a lot of questions – including the
recent one about free cash flow yields I answered in an article yesterday – that basically come
down to: What’s the “rule” for how best to handle this subject? Should I buy low price-to-book
stocks? Magic formula stocks? Low P/E stocks?
Those are questions best left to journal articles and statisticians. They’re questions you can
analyze only as group operations. Picking specific stocks is different.
The answer is that when it comes to stock picking – not investing in baskets of stocks, but
putting a lot of your eggs in one business basket – it is an art (or at least a craft) and not so much
a science.
When buying entire companies for Berkshire, one of the most important decisions Warren
Buffett (Trades, Portfolio) has to make is whether a business will continue to earn a good enough
return on capital for a long time. So, it is Buffett’s judgment of a company’s “moat” that often
matters most. This is especially true in some of his truly long-term investments like the
Washington Post (an investment he held for 30+ years), Coca-Cola (KO, Financial), American
Express (AXP, Financial) and Wells Fargo (WFC, Financial). The most important question over
a holding period of 20 or more years is going to be whether or not you judge a company’s moat
correctly.
So, how do you do that? What is this art of stock picking?
One, it’s very selective. Buffett can only pick stocks for the very long-term in a small number of
industries and often can only pick businesses that are already in some sense leaders in their field.
They can be small. See’s Candies was small when Buffett bought it. But it was already the clear
mindshare leader in boxed candies in California. Nebraska Furniture Mart was small when
Buffett bought it. But, that single store location already dominated the market for furniture retail
in the Omaha, Nebraska market.
Here’s a story about just how “limited” your competitive crystal ball has to be.
I owned a stock many years ago called Village Supermarket (VLGEA, Financial). It operates
supermarkets under the Shop-Rite banner (which it doesn’t own, it’s just a member of the co-op
that owns that name) in New Jersey. The company has tried expanding into other markets. It
entered the Maryland market. I felt pretty comfortable with the company’s “moat” inside the
state of New Jersey. But I wasn’t at all comfortable predicting anything about Shop-Rites in
Maryland. Likewise, it plans to open a store in the Bronx (New York City). I can’t make
predictions about that. Markets really are that local when it comes to groceries. The first step in
the art of picking a single stock is usually finding something that is already a leader in its
industry, its local area, or its niche.
That’s not always true. Buffett bet on GEICO starting in the 1950s. It wasn’t a market share
leader by then. Today, GEICO and Progressive combined are huge leaders in the market for truly
new car insurance customers. Market share appears more fragmented than the market for new
policies, because people tend not to leave their original insurer. There are a lot of old people who
have policies with Allstate and State Farm but whose kids will have policies with GEICO or
Progressive. Trust me when I say the big direct sellers – GEICO, Progressive, and USAA (the
company GEICO’s business model is a copy of) – have a big tailwind when it comes to gaining
market share over insurers who sell through agents (either captive or independent). This has
become very obvious since the start of selling car insurance over the internet. But, the
advantages of direct selling (then done through the mail) were obvious to Buffett even in the
1950s. GEICO had a better business model. It would gain market share forever.
It’s very hard to bet on the No. 2 or No. 3 in a field. Being able to predict a company’s transition
from “good” to “great” is a lot harder than finding a company that was pretty much born great.
Buffett usually bets on the status quo. He doesn’t bet on the side of disruption. Instead, he tries to
just sidestep industries with a lot of change.
Of course, Buffett makes mistakes even when betting with the leaders. Over in Ireland, he
bought shares of Bank of Ireland. And in the U.K., he bought shares of Tesco. Both of those
decisions were big mistakes. But, they were still in keeping with betting on a company that
seemed to have a “moat.” The supermarket industry in the U.K. was – when Buffett bought into
it – especially non-competitive. A small number of companies had a lot of market share all over
the country. Margins looked good. The ability to sell store brands instead of name brands also
looked good. It would have seemed to Buffett that Tesco had a much better position in the U.K.
than a company like Kroger (KR) has in the U.S. It looked like a less competitive market. Of
course, that less competitive market was disrupted by discounters that invested heavily in growth
in the U.K. and fragmented the market from being one controlled by a few generalists to one
where those generalists now had less of the total market. It became a more specialized industry.
It ended up getting a lot more competitive – and a lot more like the U.S. market.
Bank of Ireland is another example of a mistake Buffett made that still fits how he usually picks
stocks. The Irish banking industry was very, very consolidated. By comparison, the U.S. banking
industry is incredibly fragmented by international standards. Ireland is one of the most
concentrated markets for banking. There was a housing bubble in Ireland. And there was a
financial crisis. Buffett made a mistake. But, he wasn’t betting on a highly competitive industry.
He was buying what looked like a cheap bank in an industry with low competition.
We see this again and again with Buffett’s stock picks whether they turn out really well, really
badly, or something in between. For example, he bought stock in USG (USG, Financial). It’s a
commodity business. The company’s trademark product is SHEETROCK (a brand of drywall) –
which is so well-known in the building trade that you may have thought SHEETROCK was itself
the generic term for the product. I don’t know if Buffett’s judgment of the cycle was great with
USG. But, he was betting on a leader in the field. He knew the company was unlikely to be
unseated by a competitor. It had comparative advantages over others. Whether those would
translate into a good absolute return on equity or not is another question. But, it would’ve been
reasonable for Buffett to expect the economics of USG were better than those of competitors and
would stay that way.
This focus on competitive position is the big difference between Buffett and most value
investors. It is the “art” part of what he does.
Again, we can see a competitive position reason for even his not so great investment decisions.
Buffett’s investment in IBM (IBM) didn’t go well. But, his reasons for buying the stock came
down to competitive position. The two things I really remember clearly about why Buffett said
he bought the stock were: 1) Corporate IT departments that were already using IBM were
unlikely to stop using IBM and 2) The company was likely to keep buying back its own stock.
One of those is a capital allocation reason. But, the first one is a competitive position – a “moat”
– reason. He felt that once IBM got entangled in a company’s day-to-day operations – the client
was unlikely to get rid of them and use a different company. Now, Buffett has said he thinks of
IBM differently. So, he may have misjudged the company’s competitive position. But, even
when he makes an error – it’s often an error in terms of assessing a business’s competitive
position.
One of Buffett’s really good investments that looked like it was going to be a really bad
investment for a while there was his purchase of the Buffalo Evening News. This – and his
GEICO purchase in the 1970s – is about as close as Buffett gets to a pure “speculation.” The
Buffalo Evening News was one newspaper in a two-newspaper city. History – over the last 40
years by that point in the 1980s – had shown that two paper towns eventually became one paper
towns. The Buffalo Evening News had the stronger position. In fact, the company’s main
competitor mostly survived by publishing a Sunday edition which the Buffalo Evening News did
not compete with.
The competing paper did not give in easily. There was a brutal period of competition where the
Buffalo Evening News lost money. But, Buffett stuck with it. And when the Buffalo Evening
News outlasted its competitor it became a monopoly. It then started earning monopoly profits.
Newspapers are one of the businesses that Buffett says are “Survival of the Fattest” industries
rather than “Survival of the Fittest” industries. The paper with the most subscribers gets the most
advertisers. The paper with the most advertisers is most attractive to subscribers. And subscribers
want to read what their neighbors are reading.
This was most obvious back when classified ads were a big part of a newspaper’s profits. It’s
hard to imagine such a time now. But, in the 1980s and early 1990s – before people used the
internet for these things – classified advertising was a very important profit source for
newspapers. These papers were like bulletin boards that connected the people placing ads with
the people reading ads. If you were going to read one bulletin board a day – it made sense to read
the bulletin board where people were putting the most ads up. And if you were going to post to a
bulletin board somewhere – it made sense to post to the bulletin board that everyone read.
A discussion of the competitive position of a leading newspaper in two-paper towns seems

quaint now. But a lot of the same competitive pressures are at work on the internet. There are
many businesses that tend toward a winner-takes-all outcome. Facebook (FB, Financial) is a lot
like a local newspaper. The economics of Facebook are a lot like those of a local newspaper.
And much of the world is now a one-newspaper town as far as how you get information on your
friends and family. You scroll through Facebook to do it the same way you browsed your local
newspaper to see the name of your niece and how many points she scored for the high school
basketball team.
Why is Buffett so focused on investing as an “art” of stock picking rather than a “science” of
portfolio construction?
Because he’s a very concentrated investor. Buffett doesn’t diversify. That’s the trait that set him
apart from other Ben Graham-type investors from the beginning. He was willing to put 50% or
more of his net worth into a stock like GEICO when he found it. Graham put much less of his
partnership’s funds in GEICO than Buffett put into the same stock. Buffett overweighted the
ideas he liked best. And so he quickly outperformed his mentor, Ben Graham, and some of his
fellow students of Graham. In his earliest years investing, Buffett seems to have done this not
through having better or different ideas than other followers of Graham – but simply through
betting very big amounts of his money on the few ideas he liked best. Graham’s partnership
often had close to 100 positions. The top 10 stocks would often account for less than 50% of the
fund. In other words, Graham’s ideas that didn’t make the top 10 would be half of his portfolio.
This waters down your 10 best ideas by 50% each. It’s like halving your bet on every really good
idea you have. Graham was a very defensive investor after his experience in the 1929 crash and
the few years after that.
It’s worth noting here that Graham’s actual stock picks don’t seem to have been the problem in
the early 1930s. It was more that Graham used leverage. That sounds risky to people reading this
today. But, Graham probably used a lot less leverage than the vast majority of individual
investors in 1929 were using – and yet he was still almost bankrupted by it.
So, Graham diversified widely. He relied on the “science” of picking groups of stocks.
Buffett improved on Graham’s results by focusing on the “art” of picking specific stocks out of
those groups and betting big on them.
Charlie Munger (Trades, Portfolio) is often credited with getting Buffett to move in the direction
of focusing more on business analysis. But, Buffett had already put most of his net worth into
GEICO (in the early 1950s) because he loved that company’s business model – not because it
had a low price-book ratio. He had also made his biggest investment ever in American Express
during the Salad Oil Scandal. American Express’s value was in its brand name and network
effects. It was never a Ben Graham stock. And he also bought a position in Disney that was
certainly attractively priced on an asset basis – but which was also bought largely for non-
Graham type reasons. Buffett went to the theaters to check out Disney’s latest release. That’s a
form of scuttlebutt Phil Fisher would do and Ben Graham wouldn’t do.
So, Buffett was already pretty far along in moving from the “science” of group stock selection
that Ben Graham favored to moving to the “art” of individual stock picking that became
Buffett’s signature style.
That art of stock picking is largely the art of analyzing a business’s long-term competitive
prospects. For the last 40-50 years of his career, that’s how Warren Buffett (Trades, Portfolio)
has made his money.
 URL: https://www.gurufocus.com/news/634094/warren-buffett-and-the-art-of-stock-
picking
 Time: 2018
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How to Find Great Businesses Without Resorting to Actual Math
In yesterday’s article, I said that the two best lists to come up with as far as stocks to research
next are a list of great businesses and a list of stocks likely to be mispriced. I should point out
that we can’t know whether a business is great or not before we research it. So what we’re
talking about here is the ability to quickly identify businesses you don’t yet know much about
but which you should spend time getting to know better.
An example I recently wrote about on my member site (Focused Compounding) was NIC Inc.
(EGOV, Financial). I wouldn’t say NIC is an especially cheap stock. But it did stick out right
away as a fairly normally priced – relative to other stocks you can buy today – stock that is a
much better than average business.
Why do I think it’s a much better than average business?
There are three things that hold a lot of businesses back from making tons of money over time:
1. The business requires capital to grow.

2. The business faces competition.
3. The people running the business make serious mistakes every so often.
So a potentially “great” business is one that is the opposite of these three things, meaning it:
1. Takes almost no capital to grow.

2. Faces almost no competition.
3. And has almost no discernible “cycle.”
I don’t want to get overly philosophical here. But note that I’ve equated a “cycle” with a business
that makes mistakes. This conflation of the two concepts is not obvious to many investors. But
it’s an important one. Cycles aren’t magical. They come about because of human error. If all
buyers, sellers and suppliers really knew their future actions and the future actions of their
customers and suppliers, they’d be able to avoid creating a cycle. They don’t though. And so
they make misjudgments. And these misjudgments cause cycles. As a stock investor, you are
familiar with human misjudgments causing cycles in prices. The value of public companies
changes very little over a given decade or two – but the price of these public companies
fluctuates tremendously. Often, a stock that was valued at eight times earnings in early 2009 will
now be valued at 24 times earnings (three times more per dollar of earnings) just nine years later.
And within nine years from today, we may see a collapse in prices again that goes too far. So
we’re used to cycles extending over periods as long as 18 years. The kinds of mistakes we make
as a group of investors are also made by groups of competitors in many industries.
An example of a cyclical industry would be something like oilfield services. A rising price of oil
encourages producers to look for and extract more oil while it also sows the seeds of an eventual
decline in prices (both by increasing the incentive to increasing production and the incentive to
reduce consumption). What I’m saying here is that there’s a difference between a market where
oil is sometimes $30 a barrel and sometimes $100 a barrel versus a market where oil is always
$65 a barrel. As a business owner – you will likely do worse in something that fluctuates from
$30 to $100 and back again than you would in something that always stays $65. But, this is due
to a lower “hold” return – not a lower “buy” and “sell” return. There are two parts to being a
value investor. The “value” part, which means buying something for less than it’s worth and
selling it for more than it’s worth. That part of what you do benefits from volatility and
cyclicality. It’s easier to get a bargain in a cyclical industry. But, it’s harder to make money as a
long-term holder of a cyclical business.
One way to think of this is that the safest business to hold long term would be one with the
highest harmonic mean in terms of return on equity. You don’t just want a high arithmetic mean.
You especially want the “bad” years to still be pretty good. I wrote an article called “How to
Find Mispriced Stocks.” In that one, I say you should look for cyclical stocks. But here, where
I’m talking about finding good businesses – you should avoid cyclical stocks. Non-cyclical
industries tend to have better long-term returns than cyclical industries. The exception to this
would be if you have a good capital allocator running the business. Smart capital allocators can’t
take advantage of cycles by being contrarians.
Let’s move away from the theoretical – look for non-cyclical businesses – and into the practical.
How?
One, you look for any stocks that GuruFocus gives a 4-, 4.5-, or 5-star predictability rank. Those
are the companies to focus on. And the industries those companies are in are the industries to
focus on. I mentioned NIC. It has a 4.5 predictability rank. But you’ll even find high
predictability companies in tough industries like retailing. Tandy Leather (TLF) has a 5-star
predictability rank. It’s a retailer. But it’s a giant among ants in the leathercrafting retail business.
It has a dominant market share in the U.S. and especially a dominant relative market share – with
no close competitor. Even AutoZone (AZO), which has a couple strong competitors – often
located quite close to its stores – has a predictability rank of 4. Just knowing a company has a
predictability rank of 4, 4.5, or 5 is enough to put it on your list of stocks to research next.
Don’t just focus on the well-known predictable stocks though. Look for the less-known and
unknown ones too. Tandy isn’t that well-known. Transcat (TRNS) – which GuruFocus gives a 5-
star predictability rank – is probably even less well-known.
To come up with a list of “non-cyclical” companies, I’d use GuruFocus’ star predictability ranks
(4 to 5 sounds good to me). What about a list of non-cyclical industries?
The least cyclical industries tend to be a low-cost consumer product that is purchased frequently.
Anything related to food is non-cyclical. Fast food restaurants, restaurants in general and
supermarkets are all less cyclical than most other industries. Habit-based businesses are very
non-cyclical. Two of the most predictable products you can think of are coffee and pizza. So
businesses like Dunkin Donuts (DNKN, Financial) and Starbucks (SBUX, Financial) and
Domino’s (DPZ, Financial) and Papa John’s (PZZA, Financial) are good stocks to research now
if you haven’t already. Value investors often neglect looking at these kinds of stocks – just like
they’d neglect NIC – because the stocks are usually too expensive. However, if you research the
business regardless of the stock’s current price – you can then pounce on the stock when it
finally does fall in price. An example I’ve given before is AutoZone. It’s an $800 stock today. It
was about an $800 stock before. But – within just the past 12 months – it plunged to $500 and
rose back to today’s price. If you’d researched the stock ahead of time – you could’ve pounced
on that brief moment of unusually opportune pricing.
So that’s how you find non-cyclical businesses. You start with something like GuruFocus’
predictability star ratings. And you think in terms of products like pizza and coffee. Stuff
millions of people buy every day.
What about businesses that don’t require capital?
Well, supermarkets are out. And restaurants – if they aren’t a franchisor of the concept – are also
likely out. Domino’s and Dunkin are both franchisors. So those two are still businesses I’d
suggest reading about. But take a stock like Ingles Market (IMKTA, Financial). It’s in a
predictable line of business (selling food). But it uses a ton of capital. The unleveraged return on
equity in that business isn’t high. Even with debt, it often hits just an ROE of 10-12%. One of the
highest return supermarket stocks around – in terms of return on capital (not leveraged up) – is
Village Supermarket (VLGEA, Financial). It hasn’t been a predictable business lately. And even
in good times, the return on capital was 20-30%. The business might be able to produce an after-
tax ROE of 15-20% in good times. That’s enough to own the business (it won’t drag you down
over time). But, it hardly qualifies as a “great business.”
And I cheated.
I used Village as my test case for the supermarket industry knowing full well that Village’s
business model produces some of the best returns on invested capital of any generalist
supermarket company in the U.S. In other words, supermarkets qualify as non-cyclical enough
and perhaps predictable enough to be great businesses. But they require too much capital to run.
You are often investing in a 60,000-square-foot building (though some supermarkets lease
instead of buy) and you are always investing in inventory that doesn’t turn fast enough to give
you a negative working capital cycle.
For the most part, manufacturing and retailing businesses can’t be called “great.” What’s a
“great” business?
It’s usually a service business. Domino’s and Dunkin Donuts are really more service businesses
than manufacturing or retail businesses. Here, I mean the company that owns the trademark. So,
you can invest in them and know you own a “great” business.
But, what about Carrols (TAST, Financial)? That’s the biggest Burger King franchisee in the
U.S. It owns something like 10% of all Burger Kings in America.
It’s a non-cyclical business. But it’s too capital heavy to be called a great business.
A “great” business usually has something like triple-digit returns on capital using the Greenblatt
method. Often, free cash flow is higher than reported income. It’s almost always a service
business.
Examples include NIV, Omnicom (OMC, Financial), FICO (FICO), Dun & Bradstreet (DNB),
and also the franchisors we talked about like Dunkin and Domino’s. Websites often qualify.
Google is a great business. So is Facebook (FB). So is Cars.com (CARS). And, of course, so is
Priceline.com (PCLN, Financial).
Priceline.com – really Booking.com – is the modern exemplar of a great business. It is

predictable (GuruFocus gives it 5 stars in terms of predictability). It doesn’t require capital to
grow (the “Greenblatt” ROC is usually 1,000% to 2,000% – in other words, pointless to
calculate).
But what about competition?
This is where businesses like Cars.com and Priceline.com fall short of businesses like Facebook,
FICO, Dun & Bradstreet and NIC.
There’s a lot more competition in car search and hotel room search websites than there is in
credit scores our outsourced state government portals (which is what NIC does).
So, if you do choose to research Priceline.com or Cars.com – you’d focus on this competition
angle. You’ll see a lot of TV ads from competitors. That’s a bad sign. Often, a terrible sign.
Advertising is a form of investing by rivals. It’s a form of competition.
Strong rivalry in an industry is a huge red flag. It’s probably the biggest red flag there can be.
Generally, I want to have a research “pipeline” full of stocks from low- to no-competition
industries.
My advice is to always favor stocks you know face little competition over stocks you know face
a lot of competition. The danger of misjudging a business in a competitive industry is huge
versus the danger of misjudging a company in a non-competitive industry.
If the one thing you take away from this article is to focus on the least competitive industries in
the world – that’ll be enough. That’ll improve your results as an investor. Most investors waste
way too much time analyzing highly competitive industries. These industries are hard to figure
out. And if you guess wrong about the future – there’s a chance you’ll lose everything betting on
the wrong company in the right industry if that industry is highly competitive.
Imagine you knew computers were going to be big in the 1990s and so you bet on Apple at the
end of the 1980s. Imagine you knew smartphones were going to be huge in the 2010s and so you
bet on Nokia in the 2000s.
It’s easier to just focus on businesses with little competition, high retention rates, etc. What’s the
most practical way to do this?
Just skim one little portion of the 10-K. Don’t read the 10-K yet. But, as soon as you hear about a
new public company, look at the “competition” section of the 10-K.
For example, I said NIC doesn’t face much competition. Here, I quote from the 10-K:
“We do not currently have significant competition from companies vying to provide enterprise-
wide outsourced portal services to governments.”
That’s the first line of the “competition” section of the 10-K. Using EDGAR (the SEC filing
search tool) it takes less than 60 seconds to find that first line of that section. It tells you NIC
doesn’t have much competition in its main line of business.
Meanwhile, Priceline.com’s 10-K says this:
“The markets for the services we offer are intensely competitive, a trend we expect to continue,
and current and new competitors can launch new services at a relatively low cost. Some of our
current and potential competitors, such as Google, Apple, Alibaba, Tencent, Amazon and
Facebook, have access to significantly greater and more diversified resources than we do, and
they may be able to leverage other aspects of their businesses (e.g., search or mobile device
businesses) to enable them to compete more effectively with us. For example, Google has
entered various aspects of the online travel market, including by establishing a flight meta-
search product (“Google Flights”) and a hotel meta-search business ("Hotel Ads") that are
growing rapidly, as well as its "Book on Google" reservation functionality.”
Other things equal, always take the company with the 10-K that says it doesn’t face much
competition and put it at the top of your research pile and take the company with the 10-K that
says it faces intense competition and put it at the bottom.
Priceline may end up being a much better stock than NIC. But, I’m telling you now that NIC will
be a better use of your research time. This is because a business that doesn’t face significant
competition is much easier (and quicker) to conclusively analyze than a business that faces
“intense” competition.
So, here’s our three-point checklist for quickly identifying a potentially great business.
1. Is the GuruFocus predictability rank at least 4, 4.5 or 5 stars?

2. Is the “Greenblatt” ROC often in the triple digits?
3. Does the “competition” section of the 10-K start with a line saying competition is “not
significant?"
Look for stocks with predictability ranks of 4 or higher, triple-digit Greenblatt ROCs, and which
don’t have the word “intense” in the “competition” section of their 10-K.
Something like Ingles Market is a bad choice of a business to research next. Something like
Priceline.com is a good choice. But something like NIC is the best choice. It ticks all the boxes.
So, research something like NIC first, something like Priceline second, and then something like a
supermarket stock last.
I’m not saying don’t analyze supermarket stocks. I’m saying approach analyzing supermarket
stocks from the other side of value investing. Research something like NIC even when it’s an
expensive stock. And then remember what you learned about the business for later. Only
research something like Ingles Market when you suspect it’s trading at a discount to its asset
value and a super low P/E ratio.
Two things can attract you to a stock: high quality or low price.
Supermarkets are not high-quality businesses. A service business that doesn’t face “significant”
competition is. So, when looking for potentially great businesses, start with stocks like NIC.
 URL: https://www.gurufocus.com/news/629023/how-to-find-great-businesses-without-
resorting-to-actual-math
 Time: 2018
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2 Ways to Get Super Selective About Stocks in the Bubble Year of 2018
“I'm a retail investor in Hong Kong and like most markets internationally, equity markets here
are… high. In such an environment, I'm in a bit of a dilemma. I'm still [finding] pockets of value
based on asset value or earnings / cashflow, but these stocks are at or near historical highs in
terms of [P/B and P/E]. Personally, I'm worried about the possibility that when an adjustment
comes along, cheap stocks can become cheaper. As a value investor, what is one to do? Should I
ignore the market and invest, or should I be more concerned about the [P/B and P/E] expansion
and wait?”
When the market falls, cheap stocks will get cheaper. They may get a lot cheaper.
You can and probably should continue to buy stocks – even in today’s overpriced market. But,
you should avoid buying stocks – even ones that appear to be a good value based on their
absolute price-earnings (P/E) and price-book (P/B) levels – that are at or near historical highs in
terms of EV/EBITDA, price-sales, price-earnings, and price-book. Always try to buy stocks that
are cheaper now than they were in the past. I don’t mean a lower stock price. Often, I mean
something more like the stock has gone nowhere for five years while sales per share have kept
compounding at 6% a year – so now it’s cheap relative to the P/S ratio it was at in 2012 or 2013.
That’s the kind of stock you should consider.
The riskiest behavior for value investors to engage in during a bubble is allowing themselves to
get “crowded out” of good businesses. What happens is a value investor decides he will only pay
a P/E of 15 or something like that. In bad times for stocks, it’s easy to find even great businesses
briefly trading at 14 times earnings or less (for example: Omnicom had a P/E of 9 in December
2008). So, value investors can buy stocks that Warren Buffett (Trades, Portfolio) would like, Joel
Greenblatt (Trades, Portfolio) would like, and which GuruFocus awards 4 or 5 stars in terms of
predictability. Value investing is easy in “bad times”.
In normal times, value investing gets a little harder. But if most stocks are trading at 15 or 20
times earnings – whatever is out of favor will dip below that market wide level. So, value
investing was really easy in 2009 and 2010. It got harder in, say, 2012 and 2013 in the sense that
a value investor couldn’t just buy the best businesses around – he had to limit himself to looking
at good businesses that were still trading at good prices. But there were always certain industries
that were out of favor and certain counties too. About six years ago, I was able to put together a
basket of Japanese net-nets with very little effort. In fact, I even limited my purchases to “better,
safer” net-nets. I insisted they be profitable for 10 or more years in a row and that they have a
negative enterprise value (sell for less than net cash) rather than just being a net-net (sell for less
than NCAV). That was easy then. It’s harder now. Even Japan – like all other stock markets
around the world – has been going up, up, up.
So, we are now in the point of the cycle (remember, this is a very old bull market – one of the
oldest ever) where value investing is truly hard. A value investor’s “investable universe” has
shrunk from almost everything in 2009 to still quite a lot in 2013 to now just about nothing in
2018.
The danger, like I said, is getting “crowded out” of quality stocks because you are focused on
price. If you want to own 20 cheap stocks – in 2009, they could be 20 cheap and good stocks.
Today, you can own 20 cheap stocks. But, you’ll hold some businesses that are on shakier
ground. That’s not something I’m willing to do. However, I am willing to concentrate a lot in a
handful of stocks (owning just three to five stocks at a time feels fine to me) and buying things
very rarely (buying just one new stock a year feels fine to me). This adds risks to my portfolio
that your portfolio doesn’t have. One bad stock can sink my portfolio in a way it can’t sink
yours. But, it also makes my life a lot easier in avoiding fundamentally weak businesses in
highly competitive industries. In the very last part of a bull market, that’s likely where a value
investor is going to end up. Because the value investor wants a diversified portfolio of cheap
stocks – he ends up lowering his quality and safety requirements till the average stock he holds is
a more marginal competitor in a more highly competitive industry and has more debt than
anything he was buying in 2009. The examples I gave of stocks I owned in 2009 -- Omnicom,
IMS Health, Berkshire Hathaway -- show you that it was once possible to own leaders in an
industry that wasn’t overly competitive – and yet get them at a bargain price.
It’s very hard to do that today.
I recently wrote a post where I said that I believe we’re in a bubble. And that’s true. I think
stocks are in a bubble. And yet I’m 100% invested. If I can find things to do, then I do them
regardless of whether the market is expensive or not. However, I only bought one stock last year
and my top three positions are about 94% of my entire portfolio. So, I am saying – like the title
of the great book about Peter Cundill – that “There’s Always Something to Do” (even in a
bubble). But, I’m also saying that most weeks you just read and think and don’t buy anything.
And then, maybe, once a year you buy something. And you might be able to find three really
good things to own at once.
This is different than non-bubble years. There was a point in early 2009 (from about January till
about the first week of April) where I was turning my portfolio over furiously, selling once cheap
stock to buy an even cheaper stock. I thought Berkshire Hathaway (BRK.A, Financial)
(BRK.B, Financial) was cheap then, but I had to sell some of it to double my position in IMS
Health (IMS) (this is the old IMS Health, before it went private and then public again) at an even
lower price. You had stocks like Omnicom (OMC, Financial) and IMS Health trading at often
something like 13% free cash flow yields while 10-year U.S. Treasury Bonds were at some like
3%. In other words, you were getting 10 percentage points above Treasury bonds before you
factored in any growth in that yield. And, those industries were at a cyclically pretty low point –
not a cyclically pretty high point. So, you could imagine a 13% yield plus a 5% growth rate or
something. The math was telling you that you were going to make 15% a year or more in those
stocks. Today, it’s difficult to find stocks where I really believe the math is telling me
I might make 10% a year. At times like early 2009, I can buy one stock a month. At times like
today, I can buy maybe one stock a year.
Last year, I literally bought just one stock.
But, we have to play the cards we’re dealt.
You could avoid the market entirely. I think that’s a mistake. But, I think you do have to be super
selective. So, how can you become super selective in the stocks you buy during a bubble year
like 2018?
We can attack selectivity from two sides. I recommend a “one a week” approach. Commit to
learning about one stock a week in 2018. Research the stock. Don’t worry if you never buy a
single one of these stocks. But, don’t stop learning just because we’re in a bubble. You can – if
you fail to find anything – stop buying stocks because we’re in a bubble. But, never stop learning
about stocks.
So, route No. 1 to finding good stocks is to start purely from the business side. This means look
for truly “great” businesses. You want businesses with 4 or 5 stars on GuruFocus’s predictability
ranking. Three examples are: Omnicom (OMC, Financial), Cheesecake Factory
(CAKE, Financial), and NIC Inc. (EGOV, Financial). Cheesecake Factory invests pretty heavily
in assets (a new location costs the company more than $8 million in property improvements). It
earns a decent return on capital. Omnicom and NIC Inc. have businesses where returns on
tangible capital will tend toward the infinite because the need for additional tangible capital in
the business tends to be close to zero. So, if you haven’t researched companies like Omnicom (or
any of the other big ad agency holding companies) or NIC Inc., put them on your schedule. It
helps if the stock is at 15, 20 or 25 times earnings instead of 30 or 40 times earnings. But, that’s
not a requirement. Stocks can fall a lot in price even during bull markets. Last year, Autozone
(AZO) suddenly collapsed in price and then just as suddenly regained what it had lost in price. If
you’d been prepared by having researched that company ahead of time – AutoZone is
what Charlie Munger (Trades, Portfolio) calls a “cannibal” (it eats up its own shares) – then you
could’ve jumped on that stock when you got a rare chance to buy it at a good price. AutoZone is
today a nearly $800 stock that kissed $500 in price within the last year. You want to know about
businesses like this ahead of time, so you can pounce when you get the chance.
I don’t recommend just looking at stocks that barely pass a screen. In fact, I’m not a big believer
in screens. Value investors get in a lot of trouble when they think they can buy the No. 2
company in an industry at 13 times earnings when the No. 1 company is at maybe 19 times
earnings. Is that value investing? If done over a huge number of stocks, it can be an effective sort
of “mean reversion” bet I guess. But, that’s not how I think of value investing.
Value investing is about finding a big difference between the price you pay and the value you
get. So, I recommend getting super selective by looking to find businesses where value is
extraordinarily maximized or stocks where price is extraordinarily minimized.
The one screen I do recommend is simply working through a list of all stocks in various
industries that GuruFocus ranks at 4, 4.5 and 5 stars of predictability. There are other ways to
find potentially “great” businesses.
My own approach is to do a Charlie Munger (Trades, Portfolio) style “invert, always invert” and

think of the two things that muck up long-term returns in a business:
1. The need for owners to add more capital.

2. The need to respond to competition (cut prices, improve technology, carry more
inventory, etc.).
So, my advice for finding a good list of businesses to research next is to think of everything that:
1. Requires almost no capital.

2. Faces almost no competition.
NIC Inc. is a good example. I own BWX Technologies (BWXT, Financial) which faces no
competition in its most important business. So, look for business that use almost no capital and
have client retention rates of 90% to 100%. Ad agencies and (some) banks both qualify as far as
retention rates. A “magic formula” type screen can help you find businesses that require almost
no capital to run.
So, fill up your weekly research calendar with businesses that require almost no capital to run
and/or face almost no competition. Then research them regardless of price. If you can research
20 of these in a year – odds are one of those 20 will fall in price by 50% sometime in the next
year. That stock will have been a quality business – but not a value stock – when you found it.
But, it’ll have become a value stock after you researched it. All you’ll need to do then is pounce.
The second method for selectivity is ignoring the question of business quality and looking just at
“likely mispricings.” This is the Joel Greenblatt (Trades, Portfolio) in “You Can Be a Stock
Market Genius” approach.
The one everyone knows is spin-offs. The stock I bought last year was a spin-off (actually, it was
the “remain company” part of the spin). BWX Technologies (which I bought at a much, much
lower price when it was a value stock – not today, when it’s quite expensive) was also a spin-off
(actually, again it was the remaining business, not the spin).
Mispricings often occur with complicated businesses, messy businesses, businesses that have
undergone change, and so forth.
Cars.com (CARS) is a spin-off of a spin-off. It was originally sort of a “captive” business (the
major shareholders were newspaper publishers who were also customers of the company) that
was then sold to Gannett (then a newspaper and TV company) and then Gannett became just a
TV company (the newspapers were separated out) and the following year Cars.com was split off
from that.
BWXT is another example of “messy.” When I bought into the stock it had three parts: the
nuclear business (which I wanted to own), the coal business (which I didn’t really) and a money
losing highly speculative future technology start-up. I honestly believe that if Babcock hadn’t
been spun out of McDermott within five years before I bought it and hadn’t lost money on that
modular nuclear reactor businesses (the speculative tech business) it wouldn’t have been so
cheap. Certainly, we can see from what happened to the nuclear business and the coal (and other)
businesses that investors were avoiding the nuclear business because it came with a coal business
attached.
Look for mispricing situations more than screens. So, look for complicated situations like
Bollore (in France) or Biglari Holdings (BH, Financial). If you look at a stock like Odet (this is a
public company in France that owns a lot of Bollore which in turns owns a lot of other stuff –
much of it publicly listed), you’ll see a lot of confusion in the press, among investors, etc. about
Odet and Bollore and so on. It’s easier just to write about Havas, Viviendi, etc. than try to find
out what parts of the Bollore extended corporate family effectively own stock in themselves and
their “relatives.”
A lot of investors dislike doing this. Because, when you start, you’ll have no idea if Odet or
Bollore or whatever is really expensive, really cheap, about fairly valued, and so forth. But that’s
the point. There isn’t just widely available (like on GuruFocus) info on P/E, P/B and other ratios
on Odet that is going to be meaningful. You need to do a sum of the parts calculation on your
own.
Those tend to be the things that are mispriced. A classic example of this is a stock I wrote about
in 2007. The stock was then called Rex Electronics. It is now called Rex American Resources
(REX, Financial). The stock – in its last years of being Rex Electronics – was dirt cheap. And
you knew – if you read what the company was saying and watched what it was doing – that it
would re-allocate all its capital from failing electronics stores into ethanol. Nothing about either
a failing electronics store or an ethanol stock got me excited. What got me excited was that I felt
pretty sure the stock would be mispriced until it basically announced to the world that it was now
officially an ethanol stock. (It did that, I think, about three years after I wrote that article).
Honestly, this is where you will find bargains regardless of what kind of market we’re in. Look
for stocks that people think are something they aren’t. You’ve probably been reading in the news
about stocks that suggested they are now bitcoin related and popped in price. Well, look for the
inverse of that situation. Look for companies that are really changing on the inside but haven’t
announced that to the outside world.
I’ll tell you a secret: In the earliest stages of deciding which stock to research next – I don’t look
at a lot of numbers.
What I look at is the business model. I read about the franchised business model of Dunkin
Donuts (DNKN, Financial) or Domio’s (DPZ, Financial), and I think: pizza and coffee – that’s
pretty predictable. And franchising doesn’t require capital. So, it’s predictable and capital light –
I’ll learn about it.
Likewise, with NACCO (NC, Financial), you had a cost-plus contract coal mine operator and a
small appliance business yoked together. Even before I knew which business I was interested in
(for me, it was the coal company) – I knew this could be something that’d be mispriced. And not
just the second it was spun-off. It could easily take a year or more before each business model
was really understood by enough people and communicated through analysts or value investors
like those who visit GuruFocus and post on message boards for the narrative of the stock to take
hold in a way it influenced the price.
If I think some people may not understand the business model behind a stock, I get really
interested in analyzing that stock next. You should too.
The only way to be super selective during a bull market is to keep researching stocks. Do it
constantly. Try to work through one new stock a week.
The best use of your time is to research stocks in two categories:
1. Stocks that are immediately recognizable as great businesses.

2. Stocks that are immediately recognizable as likely to be mispriced.
But here’s my warning: Those are two great categories to research. They aren’t two great
categories to actually buy blindly. A great business can often be absurdly overpriced in a bull
market. And a stock the market is confused about can be very mispriced in the sense of it being
priced way too high or way too low.
It’s a lot quicker to find situations with a high probability of being mispriced than situations
where you know which way the stock is mispriced. I felt Babcock and “old” NACCO were
messy, complicated and just unattractive combos of different sorts of businesses – so I instantly
thought they might be mispriced. But it took me a little while to try to figure out the intrinsic
value and see if the mispricing was really there and if it was really the kind – too low a price –
I’m interested in as a long-only investor.
So, this is just a suggestion about where to start your research process. And then you want to
research as many stocks as possible (I suggest one a week). And you want to buy as few stocks
as possible (I suggest never more than one a quarter). If you do this, you’ll always be saying
“no” to at least 11 stocks for every one stock you say “yes” to. If you combine that kind of
selectivity with looking at the stocks others aren’t – especially the weird, the less followed, the
small or the recently spun-off, you should be able to find enough stocks to buy even in a bubble
year like 2018.
 URL: https://www.gurufocus.com/news/627973/2-ways-to-get-super-selective-about-
stocks-in-the-bubble-year-of-2018
 Time: 2018
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How Warren Buffett Squeezes So Much Value Out of So Few Stock Ideas
Charlie Munger (Trades, Portfolio) has said “good ideas are rare.”Â Warren

Buffett (Trades, Portfolio) often talks about the idea of a punch card with just 20 punches on it.
Each time you buy a stock – you use up one punch. Buffett believes anyone who invests that way
will become a better investor. Is that true, though? Just how many ideas does an investor need,
and how much juice can you really squeeze out of just one idea?
The value of a stock idea can come from a combination of four sources:
1. How much money you put in the idea.

2. How cheap the stock is.
3. How fast the stock is compounding its value.
4. How long you own the stock.
The ideal stock would be a business quickly compounding its intrinsic value per share, which
you are able to buy at a deep discount to intrinsic value, which you feel confident allocating a big
chunk of your portfolio to and which you are going to hold for a very long time.
Ideas like that are rare. If you “settle” too much on one of these four measures, you need help
from the other areas to offset your compromised standards – or the idea is not going to be worth
much.
For example, say you put just 5% of your portfolio into a certain stock. The business is not
growing much at all, but it owns land worth $50 a share and you paid $10 a share for it. In this
case, the eventual return from this idea is worth 20% of your starting portfolio. The stock itself is
a “five-bagger,” as Peter Lynch would say (it can go from $10 to $50 a share). But it can only do
this once. And you – for whatever reason – were only willing to put 5% of your portfolio into
this idea. A stock selling at an 80% discount to intrinsic value sounds like an amazing idea, but
we can see in this case it is really nothing special in terms of what it is going to do for your
overall portfolio. Since the stock is not compounding its intrinsic value, you hope to sell it
quickly. There is one “puff” in this cigar butt. In this hypothetical case, it is a huge puff. But
unless you are willing to allocate a lot of money to this idea, the actual return you get could be as
little as just 20% of your starting portfolio (400% return * 5% allocation = 20% value growth in
your total portfolio).
A return of four times your investment is excellent, so this is a good idea. But if that is really
how you would invest in it – put just 5% of your portfolio into the stock, hope to hold it for as
short a time period as possible and then get out – it has very limited upside. Compare this to a
business that was never a deep-value stock but has compounded its intrinsic value per share.
Over the past 10 years, Sherwin-Williams (SHW, Financial) has compounded its earnings per
share by 10% a year. The compounding of earnings power over that time is capable of getting
you a return of 160% on top of your original investment (every $1 of EPS becomes $2.60 within
10 years), but you would have to hold the stock throughout that whole period and you would
have to allocate 100% of your portfolio to Sherwin-Williams to increase your portfolio by 160%
over 10 years. No investor I know of is going to put 100% of their portfolio in one stock and
hold it for 10 whole years, but there is an offset here. Sherwin-Williams’ price-earnings (P/E)
ratio expanded from approximately 12 to approximately 29. This added another 9% a year to the
annual return. If a stock’s earnings go nowhere for 10 years, but the P/E goes from 12 to 29
while you own the stock, you make about 9% a year over 10 years. In this case, your investment
in Sherwin-Williams could have returned approximately 19% a year over 10 years.
But how much value would you have extracted from this idea?
Well, it depends on how much of your portfolio you put into Sherwin-Williams. Imagine you
had a tremendous amount of confidence in a well-known and dominant company like Sherwin-
Williams that you did not have in another stock selling for 20% of the fair market value of its
assets but was not growing. So you decided to put 25% of your portfolio into Sherwin-Williams
back in 2007 and never trimmed the position over the next 10 years. In that case, you have
produced a gain that was about 117% of the total value of your portfolio in 2007 (since 25% *
1.19^10 = 142%, and 142% less the 25% initial investment is a 117% profit).
Even if we argue Sherwin-Williams is not expensive today (and a P/E of 29 certainly looks
expensive historically), we would have to admit the stock was never as cheap as my hypothetical
example of a five-bagger. A P/E of 12 divided by a P/E of 29 gives you a price to appraisal value
of a little over 40% – not as low as the 20% example I gave. Yet, Sherwin-Williams could have
been the more valuable idea for three reasons:
1. The stock compounded its intrinsic value (grew EPS) by 10% a year.
2. It is the kind of stock some people might actually hold for 10 years.
3. It is the kind of stock some people might actually put 25% of their portfolio into.
Someone recently asked me why I said in an earlier article that not investing in Sherwin-
Williams around that time (10 years ago) was a mistake I should not have made. The answer is
not Sherwin-Williams was the best investment you could have made in 2007. Rather, it is that it
was an obvious investment. It was a well-known and long dominant branded business trading at
a P/E of 12 and growing approximately 10% a year (sometimes 5% a year, sometimes 15% a
year – but along that 10% trendline even then). There are some businesses that grew more than
10% a year over the past 10 years, and there are some businesses that had a P/E lower than 12
back in 2007, but very few stocks had the combination of those two things.
The way I try to get a lot out of each idea I have is to bet big.
As of last quarter, my favorite idea was 42% of my portfolio and my second favorite idea was
23% of my portfolio. So the two stocks accounted for 65% of my portfolio. This is the
MungerÂ way. Long ago, Munger decided he could be comfortable owning as few as three
stocks. I am comfortable owning only three stocks right now. Though, to be fair, I hold a lot
more cash than most investors do (about 30% of my portfolio is in cash right now).
In the early days (when running his own money and partnership money), this is how
BuffettÂ invested. He said in 2008:
“Charlie and I operated mostly with five positions. If I were running $50, $100, $200 million, I
would have 80% in five positions, with 25% for the largest.”
And in 1998, Buffett said:
“I can guarantee that going into the seventh one instead of putting more money into your first
one is…a terrible mistake. Very few people have gotten rich on their seventh best idea. So I
would say for anyone working with normal capital who really knows the businesses they have
gone into, six is plenty, and…probably have half…(in) what I like best."
If you look at the 2008 quote, Buffett is saying he would have 25% in his number one idea and
80% in his top five positions. In the 1998 quote, Buffett is saying he would have six stocks total
and 50% in his number one idea. If we take 80% and divide by five (from the first quote), we get
a 16% position size. If we take 100% and divide by six (from the second quote), we get a 16.67%
position size.
In the first quote, he says “with 25% for the largest,” and in the second quote he says “probably
have half (in) what I like best.” So Buffett seems to be talking about a normal position size of
around 16% overall and have 25% to 50% in your favorite idea. Essentially, Buffett is
advocating putting 25% to 50% of your portfolio in your favorite idea and 10% to 20% of your
portfolio in each of the ideas you like a little less. He has never made it quite that formalized –
but that is a fairly good approximation of what he has said.
Munger was at least as concentrated in his investments during the partnership years. Buffett was
not as concentrated an investor once he began working with bigger sums at Berkshire
Hathaway (BRK.A, Financial) (BRK.B, Financial). His stock portfolio was often more
concentrated – until the last decade or two – than a mutual fund would ever be. But it was not as
concentrated even in most of the 1970s and 1980s as his portfolio had sometimes been during the
partnership years. Buffett’s personal portfolio has always been even more concentrated than
when he was running money for other people. For example, his biggest allocation we know of
during the Buffett partnership years was 40% of the portfolio inÂ American
Express (AXP, Financial), butÂ we know years earlier he put 75% of his own net worth into one
stock: GEICO.
So how did Buffett “offset” the greater degree of diversification at Berkshire? If Buffett put 20%
or 25% of his partnership’s money into Sanborn Map and then pushed for change there – he
could get a 10% to 12% return for the entire partnership just from getting a 50% return (50% of
20% to 25% is 10% to 12%). If instead of putting 25% to 50% of your portfolio in your favorite
idea, you are only putting more like 10% to 15% of your portfolio into that idea – you need to
have some way to still get a ton of juice out of a rare idea. If you fail to do this – the only way to
still be a successful investor would be to discover a lot of good ideas. We know Buffett says he
has very few good ideas, so he has to be offsetting the “watering down” caused by diversification
somehow.
Take Buffett’s investment in Coca-Cola (KO, Financial) for example. This was considered a big
bet by Berkshire. By my calculations, however (admittedly, very approximate based on the data I
have), Buffett allocated perhaps just under 20% of his entire stock portfolio to Coca-Cola at the
time he built the position. Despite putting just 20% of his portfolio into the stock in the late
1980s, however, Berkshire ended up not only with a position that today is worth about 13 times
what he originally bought – the one position alone is also worth several times what Berkshire’s
entire portfolio was when he made the Coke investment.
How did he do that?
Let’s look at the four ways to get the most out of a stock idea:
1. You can put a lot into the stock (Buffett put 20% of his portfolio into Coke).
2. You can hold the stock a long time (Buffett has now owned Coke for just under 30
years).
3. The stock can compound is intrinsic value at a high annual rate (Coca-Cola compounded
EPS at about 11% a year for the first 25 years Buffett owned the stock).
4. You can buy the stock when it is cheap (the P/E on Coke went from 15 when Buffett
bought it to 30 recently).
Coke is pretty close to a perfect example of some value coming from all four possible sources of
getting the most out of an idea.
These sources of value you can get from an idea are a good set to look at when deciding whether
an idea is really worth your time and attention.
Ask yourself:
1. Does it seem likely I might feel comfortable putting more of my portfolio into this idea
than any other idea I am looking at right now?
2. Does it seem likely I might end up holding this idea for longer than any other idea I am
looking at right now?
3. Does it seem likely this stock will compound its intrinsic value faster than any other idea
I am looking at right now?
4. Does it seem likely this stock is cheaper than any other idea I am looking at right now?
A big part of Buffett’s return in Coca-Cola came from the fact he was willing to allocate 20% to
this idea and was willing to hold it for the long term.
That only worked up to a point, though.
In the case of Coca-Cola, the value the stock created for Berkshire really came from the first 10
to 12 years. It did not come from the last 15 years.
Still, a 10-year or greater holding period is long for your average investor, and a 20% allocation
to a single stock is big for your average investor.
As investors, we tend to focus on the fact Coke grew its earnings per share by more than 10% a
year and the P/E more than doubled while Buffett owned it. But that is just the objective side of
the investment. The subjective (Buffett) side of the investment is just as important. To make a
killing in Coke, Buffett was willing to put 20% of his portfolio into the stock for over 10 years.
Can you diversify widely and still get a lot of value out of each idea?
Oddly, yes. If the strength of an idea is so great to start with – it can still provide strong returns
after you have watered it down by diversifying.
In fact, I have seen the records of a couple investors that prove it is possible to run a portfolio
almost entirely of “watered-down” ideas. But the only two viable ways to offset a lack of
concentration are:
1. Invest in deep-value stocks (the Walter Schloss approach).

2. Invest in ultra-high-growth stocks (the Motley Fool Rule Breakers approach).
Even then, it is only possible to get much out of a growth idea if you either:
1. Put a large part of your portfolio in that one idea (the Phil Fisher approach).
2. Never sell a growth stock once you buy it (The Motley Fool Rule Breakers approach
again).
We come down to the same combination of four questions that determine the value you will get
from a new idea:
1. How big a position will you take?

2. How long will you own it?
3. How fast is the stock compounding value?
4. How cheap is your purchase price?
As a value investor, the more diversified you become, the more you must either focus on:
1. A longer holding period.
2. Finding “deeper” value stocks (really cheap stuff, turnarounds, etc.).
And as a growth investor, the more diversified you become, the more you must either focus on:
1. A longer holding period (really, a “forever” holding period).

2. An exceptionally high rate of compounding.
The more you maximize one variable, the less you have to worry about another. For example,
Buffett has never been good at finding super-high-growth businesses. However, Buffett never
overpays for a stock, almost always holds a stock for an incredibly long time and usually puts a
lot of his portfolio into each idea. Doing all that means he can afford to miss out
on Amazon (AMZN, Financial) and Starbucks (SBUX). He can just own things like The
Washington Post and Coca-Cola because he was willing to put a lot of money into them, he did
not overpay and the held them forever. If he was trying to invest in 100 stocks at once – he might
actually need to invest in an Amazon or Starbucks to offset the weaker performance of the other
90-plus positions.
A comparison of Fisher and Benjamin Graham using these four factors helps illustrate how you
can use one factor to offset another. Graham’s fund was widely diversified, but it was not an
especially high turnover portfolio (ideas often stayed in the portfolio for three to five years) and
it was a very deep-value portfolio. Some of the stocks were shockingly cheap. This means
Graham could meet or beat the performance of the overall market without turning up more than
about one new idea a month even if he held something like 100 ideas. That is because his returns
came from the 60 good ideas not the 40 bad ones. He also held those 60 good ideas for closer to
five years than five months. This only works if your good ideas are not “a bit cheaper” than
average, but rather dirt-cheap. Graham’s returns came from some truly dirt-cheap stocks.
Extreme cheapness can offset the need for growth in the businesses you own and concentration
in your portfolio.
Fisher did not worry much about price. He could afford to do that because he did two things:
1. He put a lot into his favorite ideas.

2. He held stocks almost forever.
Yes, he also invested in high-growth ideas. But high-growth stocks as a whole do not outperform
the market. It is only the “right” expensive stocks that outperform. If Fisher was investing in 25
to 50 stocks at a time instead of five or 10, his approach never would have worked. Fisher’s
approach depended on the combination of big position sizes and long holding periods – fast
growth alone was not enough.
In his early days, Buffett mostly got huge value from each idea by buying very cheap stocks in
very big allocations. At Berkshire, Buffett mostly got huge value from each idea by buying fairly
rapid compounders and holding them forever.
It is possible, however, to get a lot out of a single idea through any combination of these four
factors:
1. High growth.
2. Low price.
3. Big position size.
4. Long holding period.
Some of the factors do not seem to mesh all that naturally. The worst combinations are probably
low price, long holding period and high growth, big position size. It is worth remembering that if
you cannot or do not want to do any of these four things – for example, you do not know how to
find high-growth ideas or you are afraid of big position sizes – you need to learn to offset that
fact by maximizing the value-creating factors that can offset this.
Decide which factors you are comfortable with and then push these to the extreme. So if you do
not like big positions but you do like long holding periods – try to make yourself a “forever”
investor. Doing so will make it easier for you to have good performance without needing as
much concentration in your portfolio.
If you cannot find high-growth stocks – you really need to look for truly low-priced stocks, not
just good businesses at a good enough price.
The alternative to all this is simply finding more ideas than the other guy over your investing
lifetime, which is a very hard thing to do. Peter Lynch was the master of doing this. However, he
was a professional and burned himself out after just 13 years of this approach. The man retired in
his mid-40s. Turning over more rocks and finding more good businesses and cheap stocks is
certainly possible, but I have met very few people with Lynch’s work ethic. So my suggestion is
to try copying BuffettÂ instead of Lynch. Whether that means “early Buffett” (low price, big
position size) or “late Buffett” (high growth, long holding period) is up to you.
 URL: https://www.gurufocus.com/news/572659/how-warren-buffett-squeezes-so-much-
value-out-of-so-few-stock-ideas
 Time: 2017
-----------------------------------------------------
Should You Buy a Cheap Stock That's at the Very Edge of Your Circle of
Competence?
NACCO (NC, Financial) is spinning off its Hamilton Beach small appliance business this week.
NACCO’s remaining business will be a lignite coal miner (NACoal) that operates mostly
unconsolidated mines under mostly long-term cost-plus supply contracts. In an earlier article, I
explained why this lignite (“brown”) coal-producing business would be inside my “circle of
competence” and the Hamilton Beach small appliance business would be outside my “circle of
competence.” This led some people to ask: But what if Hamilton Brands trades at a deeper
discount to your appraisal value than the post-spinoff NACCO? What if the value is in Hamilton
Beach, not NACCO? You’re a value investor. So you’d have to buy Hamilton Beach, right?
That’s a good question. And, in this case, it’s likely that Hamilton Beach will trade at an
especially low valuation compared to peers. Unlike some value investors, I do a detailed – like to
the exact dollar – appraisal of a company before I invest in it. I have a share price in mind that I
designate as intrinsic value. It’s not that I believe I can precisely value a company. The two
reasons for always doing an explicit intrinsic value calculation are: 1) It forces me to make my
assumptions explicit, and 2) it forces me to be honest about how big my “margin of safety” is.
I try never to pay more than 65 cents on the intrinsic value dollar for a stock I like – no matter
how much I like it. So, for instance, I appraised Frost (CFR, Financial) at about $141 per share a
couple years ago and then I bought that stock at about $49 per share. That’s a discount of about
66%. It’s very unusual for me to find any stock trading at a discount of more than 50% to my
appraisal of intrinsic value. I have probably averaged one such find per year in each of the last
few years. This approach helps explain why I get questions like: if you like Cheesecake
Factory (CAKE, Financial) so much, why don’t you just buy it now? And, if you
like Omnicom (OMC, Financial) so much, why don’t you just buy it now? Omnicom trades at
$75 per share right now. So you can guess – based on the fact I want a 35% discount to my
appraisal value – that I appraise Omnicom at not much more than $115 per share. It might be
less. I might appraise it at about $100 per share. In fact, while I don’t normally talk in too great
detail about the appraisal value I’d personally put on a stock, $100 per share isn’t a bad guess for
how I’d appraise Omnicom. So, yes, I may like Omnicom as a business and be willing to hold it
long term. But I don’t want to pay $75 for something I think is only worth $100.
Cheesecake Factory trades at $42 per share. I haven’t bought it. So you can probably guess that I
don’t think the business is worth much more than $65 per share. This is because $42 / $65 is
about 65%. I want to pay less than 65% of my appraisal value for a stock. You can think of this
as meaning I want a little more than a one-third margin of safety or that I want a little over 50%
upside potential (65 * 1.54 = 100). I just think of it as meaning that when a stock enters my
portfolio I want it to be 65% or less of what I think the business is worth. This is where I expect
a good portion of my returns to come from. Over time, you’d expect something that trades at
65% of what it’s worth to eventually find its way up to 100% of what it’s worth (or even go a bit
beyond that).
Say you hold that stock for 10 years while this process takes place. That adds 4% a year to your
return.
Say you hold the stock for five years while this process takes place. That adds 9% a year to your
return.
Say you hold the stock for three years while this process takes place. That adds 15% a year to
your returns.
I’ve included this last figure – of how big the gain in a multiple expansion can be if the
expansion takes just three years to be completed – to make the case for why something like
Hamilton Beach can sometimes be a better stock to buy than something like the coal half of
NACCO. I’m personally more interested in – and more comfortable owning – the coal half.
However, NACCO is keeping the coal half. The spinoff will be Hamilton Beach.
NACCO as a whole already trades at a reasonable price-earnings (P/E) ratio. You can trust me
on this and skip this next paragraph or you can slog through some simple math with me that
proves it.
The EV/EBITDA on the combined NACCO stock is maybe nine or 10 times. An EV/EBITDA of
nine to 10 often translates into something like a debt-free P/E of 18. However, half of NACCO is
a coal miner. U.S. companies pay federal taxes of up to 35%. However, you’d expect a company
with NACoal’s business model to never pay more than 25% a year in taxes and probably to pay
closer to 20% a year in taxes. This is because NACoal has a reduction in taxes related to
“depletion” of its coal deposits. This tax break isn’t related to the corporate structure. It’s a result
of the basic business activity NACoal is involved in (the surface mining of coal). The depletion
tax break has significant value. Right now, I’d estimate it saves NACCO about $7 million a year
in taxes. The company only has 6.8 million shares outstanding. So the tax code adds about $1 a
share to EPS. I just said an EV/EBITDA of nine to 10 often translates into a debt-free P/E of
about 18. So an extra $1 of EPS can be worth as much as $18 per share to the company’s
valuation. A normal P/E is more like 15. So let’s call it $15 per share in value added from lower
taxes. The EV/EBITDA ratio does not capture this tax break. And investors are not used to
seeing businesses that have high depletion for tax purposes yet have low capex needs for cash
flow purposes.
Investors tend to price businesses off EV/EBITDA or EV/EBIT multiples versus peers. So
there’s a belief that a small appliance maker should trade at a certain EV/EBITDA and a coal
miner should trade at another, different EV/EBITDA. However, the reason companies in the
same industry should trade at the same EV/EBITDA is because their business models are the
same. In industries where different companies have different business models – multiples are not
similar. So, for example, banks like Frost (which I own), Bank of
Hawaii (BOH, Financial)Â and Wells Fargo (WFC, Financial) have very high prices relative to
book value because they generate very high earnings relative to book value. If a business
converts more EBITDA into after-tax free cash flow than its peers, it should be worth a higher
multiple of EBITDA than its peers. I would expect NACoal to have low taxes (as other miners
do) but also low capex (which is the opposite of what most miners have). Inflation would also
work differently for NACoal than other miners because the combination of depletion, low capex
and cost-plus contracts that re-price with inflation is much more beneficial during inflation to a
company that generates revenue from coal mines without sinking capital into coal mines
(NACoal has one mine that works differently – it does cost a lot of capital). So NACoal should
have less ITDA (interest, taxes, depreciation and amortization) than other mining companies.
That makes what it earns before ITDA more valuable.
Some of this may be recognized in the current stock price. We won’t really know till Hamilton
Beach is trading normally on its own. We know how the market appraises NACCO as a whole.
But we don’t yet know how much of that overall appraisal pie goes to NACoal and how much to
Hamilton Beach. As I said, you have a price of like nine or 10 times EBITDA or maybe
something like 13 times EBIT for a business that is just coal mining and small appliances. We’re
talking about a P/E of close to 20 for a combination of coal mining and small appliances. That
doesn’t seem especially cheap.
My hope – since I am interested in the coal business rather than the small appliance business – is
that investors would put a higher value on the spinoff (to trade as HBB) and a lower value on the
remaining business (to continue trading as NC). This would make my decision easy. I like
NACoal. So if NACoal is cheap and I like it, I should buy it.
But what if investors don’t put a high value on Hamilton Beach and instead many investors are
eager to sell the spun off shares they receive? This would make Hamilton Beach the clearly
cheap stock. Should I buy it?
Joel Greenblatt (Trades, Portfolio) would say “yes.” He wrote a great book called “You Can Be a
Stock Market Genius.” That’s not the only book he’s written. But that’s the only book of his you
need to read. In that book, he talks about investing in spinoffs. And he talks about valuing these
spinoffs against comparable companies. Basically, you do a peer valuation.
I did this with every issue of the newsletter I wrote from 2013-2016. I would gather five peers of
the company I was interested in and I’d calculate their prices in terms of EV/Sales, EV/Gross
Profit, EV/EBITDA and EV/Owner Earnings (often an adjusted form of EBIT). The best stocks
to buy were often those that were cheaper than their peers. For example, I used “Price/Deposits”
for banks instead of Price/Revenues. By that measure, Frost was a cheaper bank than most peers
I could find.
The best situation is when you can find a business you think is higher quality than all its peers
selling at a price you think is lower than all its peers. So the combination of NACoal and
Hamilton Beach was trading close to 10 times EBITDA. What if the Hamilton Beach spinoff is
valued in the weeks ahead at just five times EBITDA? Shouldn’t I forget about NACoal and
invest in Hamilton Beach instead?
That would be a tough decision. I like Hamilton Beach less than NACoal. But I know that the
average small appliance maker is definitely not going to be valued at less than eight times
EBITDA. If Hamilton Beach spun off at something as low as five times EBITDA, it would be
selling at a greater than 35% discount to a peer-based appraisal value (5/8 = 63%). In fact, in
today’s expensive stock market, you’d expect a business like Hamilton Beach to be valued more
at something like 8 to 10 times EBITDA. So if it was spun off at something like five to seven
times EBITDA, it would hit my magic number of a 35% discount to appraisal value.
That would make Hamilton Beach a value stock. But would it make Hamilton Beach a stock I
should buy? Surely there are other stocks that trade at a 35% discount to their peers. They’re just
lower quality than their peers. Or they are riskier than their peers. Or their peers are pretty
expensive in the first place. Does that mean we – as value investors – should always buy any
stock that trades at a 35% discount to a group of its peers?
I actually think that’s a pretty good strategy. If you can find a group of five peers and you can
find a stock in that group that is trading for less than all the rest of them – then you know you are
building a portfolio only out of those stocks in the bottom quintile of expensiveness. You’d be
diversified by industry, business model, etc. And you’d be using capitalization adjusted measures
like EV/EBITDA that take debt into account. This approach seems much better than either a low
P/B or low P/E approach – which is what some people think value investing is.
The danger – for me – in investing in something like Hamilton Beach (even if it is spun off at a
value price) is twofold: 1) I’m bad at judging just how much increased competition can reduce a
business’ value, and 2) I’m bad at investing in stocks where analysts, investors, etc., know the
business as well or better than I do.
This next part may sound a bit arrogant. But it’s important for you to understand why businesses
like Frost and BWX Technologies (BWXT, Financial) seem “simpler” to me than something
like Hamilton Beach.
Hamilton Beach makes toasters and BWX Technologies makes nuclear reactors. Surely, I
understand a toaster better than a nuclear reactor, right?
I don’t think I understand the economics of a toaster better than most people do. I do think I
understand the economics of a nuclear reactor better than most people do.
BWX Technologies builds nuclear reactors for the U.S. Navy, does work for existing nuclear
plants in Canada and then provides nuclear-related services to the U.S. government (often having
to do with America’s nuclear weapons program). I tend to know more about nuclear reactors,
U.S. submarines and aircraft carriers, CANDU reactors, nuclear weapons, etc., than the average
analyst, investor, etc., who comes across BWX Technologies. I certainly know more about the
history of all those things than most people do.
Having a better sense of history is probably why I was able to get a good price on stocks like
Frost and BWX Technologies.
Whenever I talked to someone who had read my reports on Frost and Babcock &
Wilcox (BW, Financial) who ended up not buying the stocks, their reason for doing so was
usually not that they passed on the stock after researching it but simply that they found the
research itself too confusing. One person I talked to said, “You know, I tried reading about
BWXT for the second time last night, and my eyes just glazed over. I can’t make myself care
about that kind of business enough to read through the filings.” That’s the advantage of NACoal
over Hamilton Beach. I really don’t feel like I’m ever going to understand Hamilton Beach better
than other people will. I think I’ll be able to understand NACoal better than other people will
because a lot of people will just stop reading about a business like that.
I’ll use Frost as an example. In my report on Frost, I went through a lot of detail about how you
can calculate the true long-term interest rate sensitivity of a bank by analyzing its funding
sources. Frost is funded differently than most banks. It gets more money from customer deposits,
and it pays less interest on those deposits than other banks do. This is important because all
banks make more money on their asset side when the Fed Funds Rate rises, but depending on its
funding sources a bank’s cost of funding can go up either a lot or not very much with higher Fed
Funds Rates. History can show you pretty clearly which banks will make a lot more money when
interest rates are higher in a few years and which banks will make only a little bit more money
when that happens.
This is the part that bored people about Frost. I did a post on my blog just about this topic. And I
think people were bored by all the arithmetic in it. The fact I called the post “Frost: Interest Rate
Expense and Cyclically Adjusted Earnings” probably didn’t help. But it's posts with titles like
that which are usually most valuable to investors.
In the case of Hamilton Beach, its biggest customers are retailers

like Walmart (WMT, Financial) and Amazon (AMZN, Financial). I’m just not going to know
before other people do whether Amazon decides to introduce private label Amazon Basics type
blenders, toasters, slow cookers, coffeemakers, etc. I am an Amazon Prime member. But I don’t
shop at Walmart and a lot of America does and Walmart is 30% of Hamilton Beach’s business.
There are investors and analysts out there who probably use Walmart as their primary shopping
destination, have relatives who work at Walmart, etc. They have a big advantage over me. There
are also people out there who actually care about blenders, toasters, slow cookers and
coffeemakers. They know which brands are good and which aren’t. They know a lot of things I
don’t.
These people would be much more capable of judging any diminishing market power at
Hamilton Beach. Are Walmart and Amazon gaining bargaining power over Hamilton Beach? Is
it staying the same, or are things moving in Hamilton Beach’s favor? I don’t know that better
than millions of other Americans know that.
So I will consider HBB stock if it trades at more than a 35% discount to what I think a control
buyer (like a competitor) would pay for the entire Hamilton Beach business. But I’m never going
to prefer Hamilton Beach over other stocks I think are equally cheap. I understand Omnicom and
Cheesecake Factory and Howden Joinery (LSE:HWDN, Financial) better than I understand
Hamilton Beach.
I’ve said before that the most important thing for me when looking at a stock is evaluating the
business’ market power. If I understand the business’ market power, I understand the business.
I define market power as:
“Market power is 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.”
I feel much better able to evaluate NACoal’s market power than Hamilton Beach’s market
power. I’m really not sure I can evaluate market power at Hamilton Beach. If the stock is spun
off at like five to seven times EBITDA, I guess I will have to spend some time trying to see if
there’s a way for me to get a better grasp on this company’s market power. But without some
understanding of a company’s market power, I just can’t invest in it regardless of the earnings
multiple it trades at.
 URL: https://www.gurufocus.com/news/572009/should-you-buy-a-cheap-stock-thats-at-
the-very-edge-of-your-circle-of-competence-
 Time: 2017
-----------------------------------------------------
Invest Like an Investigative Reporter: Stories From the Qualitative Side
In a previous article, I discussed the importance of thinking like an investigative reporter. I used
several examples – a couple of Chinese frauds, a company that was quickly depreciating its
assets, etc. – but I did not talk much about what kind of research you can do outside of
accounting. In some ways, the examples used in that article could have been titled “invest like a
forensic accountant” instead of “invest like an investigative reporter.” Here, we will explore the
Philip Fisher side instead of the Benjamin Graham side. What kind of “scuttlebutt” have I turned
up when researching stocks, and how can you do the same?
First of all, I want to make the point that qualitative scuttlebutt is anecdotal. It comes from
stories store managers, suppliers, customers, ex-employees, competitors and executives tell you.
You really do have to think like an investigative reporter when hearing these stories because
some of these people have an axe to grind. They are human, so most of what they are going to
tell you is about how important their job is, how smart they are, how dumb the people they report
to are and how everything would be better if they ran the place. A lot of anecdotes will also be
overly personal and somewhat gossipy. I have been told – without asking about it in the slightest
– which executives had substance abuse problems, which companies someone thought was going
to be taken private and so on.
When talking with other people about the scuttlebutt, I have noticed a problematic pattern. If you
have read “The Snowball,” you know Warren Buffett (Trades, Portfolio) was once told: “If
you’re hunting in a golden haystack, you don’t need to find a golden needle.” Meaning, just
because some idea is obscure or it took a lot of work to dig up, does not make it more valuable.
Most unknown information is not useful information. Likewise, a ton of useful information is
widely known but misunderstood.
Most of the really useful scuttlebutt I have gotten was not hard to dig up. It was very close to
being public knowledge. More importantly, all the terribly dangerous scuttlebutt I have found
had the allure of being “insider knowledge” that was hard to get. Luckily, I have never found
myself falling victim to the idea information is more useful just because fewer people have it.
Take the substance abuse example for instance. I did not really care who was running that
company, so it did not matter much to me if the guy at the top was sober or not. If he stopped
being able to function, someone else would take over – and it was the kind of company where I
thought whoever took over would do fine. But a couple sources we – my newsletter co-writer
Quan and I – talked to acted like this was information we would be terribly interested in.
Knowledge about the basic product economics of a business is so much more useful than
knowledge about how great or awful the current CEO is.
So when looking for qualitative scuttlebutt, you are still looking for what I call the 3 C’s: what is
“constant”, what is “consequential” and what is “calculable.”
A bit of information that drives some quarterly result but will even out by next year does not
matter to me; it is not constant. Information about whether a price increase will be 4% this year
or 2% like in most years also is not going to matter much. Unless you can put that into some
pattern, it is not consequential. Maybe it matters if the price increase is for the one and only
product the company sells.
Calculable means information like the company usually raises prices faster than inflation or
traffic usually rises less than the local population. Those are numbers you can plug into back-of-
the-envelope type math.
The first level of qualitative scuttlebutt is – of course – a site visit. I have eaten at Cheesecake
Factory (CAKE, Financial). I have been inside a Tractor Supply Co.Â (TSCO, Financial)
store. I have pulled into a Murphy USA (MUSA, Financial) station. In each case, I went for
research purposes. I brought along some other people for their input. I was trying to get some
context for the business.
I once researched a company called DreamWorks Animation (now owned by Universal). When
talking with some other people who researched the company – and, in fact, put thousands of
dollars into the stock – I was absolutely floored to learn theyh had never seen a DreamWorks
Animation movie in theaters. When I was talking to these people, there was a DreamWorks
movie out. You could pay $10 at night or about $6 for a matinee to go sit in a comfy chair for 90
minutes and see the product this company sunk $150 million or so into. I mean, if you are
thinking about putting a lot of money into Boeing (BA) and a letter comes in the mail inviting
you to the unveiling of their new model – I think you would go. But somehow the idea of going
to your local movie theater to see a kids’ movie seems odd.
The truth is, going to the movie theater with paying customers would be way more valuable than
a press event for some jumbo jet. At the movies, you could see the film with the parents and kids
who are the target audience. These people actually paid. They do not have poker faces. You can
read what they think pretty well. It is like they have put a focus group together for you.
Buffett would have done that.
Around the time he invested in Walt Disney Co.Â (DIS, Financial), Buffett met Walt Disney,
visited Disneyland and saw "Mary Poppins" in theaters. The beauty of researching something
like DreamWorks is they put out so few movies you could learn so much about the overall
company from watching just one. They were pretty much a one product company at the time.
Now, I actually screened every movie DreamWorks ever made as part of my research. But I did
that at home. The really valuable opportunities are when you can see the movie in theaters along
with paying customers.
This is not really even scuttlebutt, but it is research most people do not do. When I was
researching cruise companies, I read all the books I could find about the cruise industry. When I
was researching Babcock & Wilcox (BW, Financial) – I now own the spinoff, BWX
Technologies (BWXT, Financial) – I read a book that gave a little narrative description of every
nuclear disaster in the industry’s history.
It is just common sense to do that kind of research. If your boss assigned you the task of writing
a report on the cruise industry, you would go online or to the library to see if there were any
books you could read on the subject. But some investors act as if it is not sporting to read
anything other investors might not be reading too. It is like the only approved written materials
are the 10-K, articles in financial publications and GuruFocus for 30-year financials – but are
you really supposed to read books on the history of the industry, specific companies in the
industry, the founders and so on? If you can find them, you read them. I read everything I could
find on Jeffrey Katzenberg and DreamWorks.
Here is the rule: any research you would do if you were preparing a bid for the whole company is
research you should do before buying a stock. That is common sense. A bid for a company and a
bid for a stock should have the same due diligence. They are the exact same investment, just on a
different scale. You may not have the resources to do all the research you would want to do, but
the first step is you should want to do all the research you would do if your job was to prepare a
bid for this business in full.
OK. So you are “out in the wild” at this company’s place of business. Now what?
When you visit a location, you often get the chance to talk to a manager of that location. I am not
a very gregarious person, so I usually enlist other people – often people I talk stocks with online
– to go to stores in their area and chat with the manager if that is the sort of thing they like. You
ask these people to help you out. You share what you know with them, and they share what they
know with you.
Let’s talk about the temptation of truly “inside” information. Three times in my life I have been
told a company was likely to get bought out very soon. So far, the universe is zero for three in
actually delivering those buyouts. I would never invest in a stock because I heard a buyout
rumor.
In one of these three cases, however, I actually was interested in the stock. What this person told
me made me feel I had to “recuse myself” from ever considering the stock. He was preparing a
possible bid for the whole company, so he wanted my opinion. Very few people had written
about the company. He could see (through online searches) I had written more than anyone else.
So he was basically doing his scuttlebutt by approaching me. That locked me out of the stock. By
the way, he did not bid for the company in the end.
In two other cases, I was told by employees they believed their company was going to be bought
out. In both cases, I dismissed this information as not being reliable in the sense it did not change
the odds of a buyout in my view at all. Yes, the companies were both cheap enough for me to
consider buying a share – so they were cheap enough for private equity to be interested in. But in
both these cases, the story I was told had to do with the relationship between a top executive and
a potential buyer. In other words, the employee always sees the CEO talking with an investment
banker and assumes he knows what that means. I believe the CEO spoke with the investment
banker. I just do not believe the employee is qualified to know what that means.
The more “inside” you think your information is – the less weight you should give it. This is to
counteract the perverse bias investors seem to have where a “tip," which may or may not be true,
is somehow worth less than the overall public picture of the company that “everyone knows.”
Like I said, I feel I have been good at avoiding this mistake. But most people who have gotten
involved in doing some scuttlebutt with me do get intoxicated with the idea they have turned up
something the market does not know. Once they realize this is not public information, they start
talking about options and other such nonsense. Scuttlebutt can fill in some facts, but the overall
decision on how to frame an investment is always going to be based mostly on very, very public
information combined with some other insights you bring from background knowledge of similar
situations and maybe a bit of scuttlebutt.
Here is the truth: information alone is not important and not that valuable.
What matters is context. I have said before your “edge” is not knowing something the market
does not know. That is silly. Human beings are not good at processing a ton of information and
distilling it to the few key variables that should determine the stock price. Give everyone the
same information and some are going to draw the right conclusions while others are not.
Imagine “the market” knows the CEO has a substance abuse problem. Imagine the market knows
what I just told you – that a man with enough money to buy a company talked to some blogger
(me) about whether he should make a bid.
How do you incorporate that into the stock price? What is the market supposed to do with that?
Interpretation is key. Interpretation matters more than information. My newsletter co-writer,
Quan, knows I repeat a sort of personal mantra a lot in the research process.
I say, “There is no such thing as theory independent data.” Meaning, if we do not have a
hypothesis – if we have not made some guess about what we are going to find and what it means
– we would not even know what is a clue and what is not. You cannot really find the facts first
and come up with a theory later. The human brain is incapable of working that way. You need to
have a theory, test a theory, discard a theory, form a new theory, etc. as you work your way
through the facts. But until you have a theory – you do not know what facts you need.
Take BuffettÂ and American Express Co.Â (AXP, Financial). During the salad oil scandal,

Buffett only needed to know one really important bit of information: did the corporate scandal at
American Express shake consumer confidence in American Express card (and travelers
cheques)? So that is what he set out to learn through scuttlebutt. If he and his associates checked
out what was going on in local restaurants, they would probably have an excellent idea of what
was going on all over America. If people were using the card in Omaha – American Express’
brand would survive the scandal just fine.
Scuttlebutt is very useful in situations like this. For example, someone was talking to me
about Under Armour (UA, Financial) and said the stock was down because teens do not think it
is cool anymore.
That is a problem you can easily solve with scuttlebutt. Talk to them. You know teens or you
know people who know teens. Talk to them.
Why is it important to do this?
Because if you read what a Morgan Stanley analyst or a Barron’s writer or a blogger like me says
about whether teens think Under Armour is cool or not – you are just sticking your head in an
echo chamber. It is very possible the analyst, the journalist and the blogger have not spoken to
any teenagers at all. It is very possible no one in this chain is relying on a primary source of any
kind.
As an investor, you want to severely limit your use of secondary sources. That is what I was
saying about the two buyout rumors I mentioned. That stuff was worse than hearsay. If I had
relied on that information, I would be relying not on what really happened – the CEO meeting
more than once with the same investment banker – but with what the employee (who is not an
expert on CEOs or investment bankers) inferred was the reason for those meetings.
Usually, the information someone gives you in terms of qualitative scuttlebutt is information
they do not know the value of. Employees have a very narrow view of a company. In some
companies, there are only three to five people at the top who have as wide a view of the company
as an investor would. Everyone else is more narrowly focused on their specific function, some
metric they think is important or this one product or business unit. They cannot tell you about the
company as a money-making machine. They have never looked at it that way. You have a
broader view than they do. But what little they do know about the company they know very, very
well.
I will cheat and give you a classic example of scuttlebutt that is not actually scuttlebutt. Before
investing in George Risk (RSKIA, Financial), I read an interview (not widely circulated, but
public) where the then-CEO said the input costs of the material the company was buying were
higher than the price some competitors could sell at.
What we are going to talk about here is interpretation.
On the surface, what that CEO said sounds very, very bad. But I had more context. I already
knew George Risk had not lost a lot of market share. So now I knew some customers were
staying with the company despite there being competitors with much lower cost structures.
As a result, I started thinking: what matters in this business? Is it just price? Or is it on time
delivery? Is it customization?
And that gave me enough confidence in George Risk’s ability to raise prices if it needed to
(because volumes dropped) that I bought the stock.
This is why you do not want to think purely in black and white terms of “good” or “bad.” In fact,
in both cases where the scuttlebutt I heard most convinced me the company I was looking at was
a good business – the person who gave me the information was actually complaining. What they
were complaining about was their powerlessness to do anything if the company raised prices.
Essentially, they were telling me if the company raised prices even faster than they had been –
they would still buy just as much from them. So they were calling the company and its people all
sorts of bad names, but they were telling me there was no substitute for what the company was
giving me.
I will give you an example of a stock right now where scuttlebutt would be useful. I have not
researched Games Workshop Group PLC (LSE:GAW, Financial), but based on what little I
know of the company, I think the key question is: what if Games Workshop keeps raising prices
on "Warhammer?" How long can the loyal fans of this game keep buying?
Now, I know what the fans are going to say. They will say the company is treating them badly
with these price increases and if it does not stop, everyone will evenutally abandon this game.
Of course they are going to say that; and, of course, you should ignore it.
When doing scuttlebutt, you never ask a hypothetical questions like “at what price would you
stop buying this?” Everyone lies when you ask that. They do not know they are lying, but they
still do.
I am sure Americans believe that if the price of gas goes to $6 a gallon, they will do everything
they can to cut back. They will buy a Tesla. Maybe they will, but the truth is they will be very
busy worrying about a lot of things in life at that moment. They will try to think long term. But
in the short term – they will have to fill up and pay whatever the commodity costs. They need to
get to work. They cannot afford a new car just yet – they still owe quite a bit on the one they are
driving.
So back to Games Workshop. What can you really ask?
When doing scuttlebutt, what you want to ask about is always behavior rather than opinion.
Never ask for someone’s opinion. Always ask about how they behaved in the past, why they
think they behaved that way and what might change their behavior in the future.
Always try to frame things in terms of preferences. People are more honest if you do not simply
ask if they like the color blue. Instead, say: “Quick, blue or orange? You have to pick one now.”
So for Games Workshop’s customers, you could try questions like: What other tabletop games
have you tried out? What games might you try out? If Warhammer is as expensive as you say,
why do you keep playing it?
Actually, you never ask the last question I just asked. You use a dirty trick instead.
If you have to ask predictive questions – here is a tip. When polling people, it is natural to ask
questions in the form of: “Which candidate do you expect to vote for in the presidential
election?” and “How much less gas do you think you would buy if it cost $6 a gallon?”
Do not do that.
Instead, ask: “Who do you expect your neighbor will vote for in the presidential election?” and
“How much less gas do you think your adult son would buy if it cost $6 a gallon?”
See, people do not think quite as highly of the consistent rationality of their neighbors and adult
children.
Everyone thinks they are rational. No one is quite sure the rest of the world is.
People have self-images that need to be protected. It is an automatic reflex. So if you have to ask
a question where someone might express an opinion that seems emotional, irrational or not the
“right” answer, you need to let them save face and distance themselves from such a decision.
As investors – we are most interested in the irrational. I can see rationally whether you should
buy product A or product B if the only difference is price.
The questions that really matter are ones like: “Why aren’t you switching bank accounts even
though the place across the street would pay you $100 more a year in interest on your account?”
No one is going to give you a good answer. But, “Why do you think your brother-in-law sticks
with that bank that gives him such crummy service…”
That is a question they will answer.
So here are a few tips.
One, do not get excited by some “informational advantage.” Do not even think in terms of an
informational edge. Your edge is always your interpretation. It is how all the facts fit together. It
is never the one fact you know Â that the market does not.
Two, always ask about specific behavior. Questions like: do you call your broker or does your
broker call you? Is there a meeting where that budget gets decided on? When you cancelled that
one time, what made you do that? And how did you come up with that list of possible vendors?
Three, make it easy for someone to tell you hard truths. So depersonalize the situation. If you
suspect a loan officer would make poor decisions at some point in the cycle – talk to him about
what he thinks the average loan officer in the organization would do, not what he would do.
As a final tip, the first thing I tell anyone I am talking to for scuttlebutt is I do not short stocks
and I would never put their name in print even if they ordered me to. I do not ask if they would
like to be anonymous. I tell them they are going to be anonymous whether they like it or not.
As an individual investor – it will be easier for you. People are very suspicious of anyone who
writes stuff. Other investors, analysts and bloggers are very happy to talk to me because they
think I am a peer they can talk to using the same jargon.
The bad news is people inside an organization think I am a reporter because I write Â on
companies and stocks. So it is always easier to get them to talk to someone who is not a writer
than to talk to me. They will talk to you sooner than they will talk to me.
My best piece of advice is to just re-read two books: Fisher’s “Common Stocks and Uncommon
Profits” and Alice Schroeder’s “The Snowball.” Read those books closely looking for examples
of how to do scuttlebutt. When you read them the first time, you probably were not thinking of
how you could apply what you read in there directly to finding scuttlebutt of your own.
Buffett and Fisher knew how to get scuttlebutt and how to use scuttlebutt. Ape them.
 URL: https://www.gurufocus.com/news/570380/invest-like-an-investigative-reporter-
stories-from-the-qualitative-side
 Time: 2017
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Buy What You Know, Study What You Don't
The concept of “buy what you know” is a Peter Lynch idea. Most investors I talk to think it’s too
simplistic. Like any idea, perhaps it is too simplistic if taken to the extreme. But I’ve found
talking to other investors that they underestimate how much of an advantage you have in starting
your research process on the firm footing of knowing something about the business you are
about to research and how it works in the real world.
First, let’s put the Peter Lynch quote in context. What Lynch was saying is that if a man worked
his whole life in the oil and gas industry why would his first thought be to analyze a
pharmaceutical company? His first thought – not necessarily his last, but certainly his first –
should be to look at oil and gas companies. If the man had made a fortune in the oil and gas
industry and was looking to buy an entire business, he’d never think to buy a whole drug
company. So why would he think to buy a piece of a drug company just because this was a stock
purchase instead of the purchase of a private business in its entirety?
At least start yourself off on the firm ground of background knowledge you already have. If you
know the oil and gas industry, start by looking at oil and gas companies. Otherwise, you’re going
to get quickly overwhelmed by a deluge of data and trust some expert instead of using your own
common sense.
I’ll give you two recent examples. I was talking to one person about a stock he suggested. In
many ways, it’s attractive. The fundamentals looked interesting. And with a fair amount of
research time it would be possible to decide whether or not this was a good stock to buy. So this
isn’t a stock that necessarily would end up in the “too hard” pile. I thought that the two of us –
researching the stock together and chatting about it over Skype – could definitely figure this one
out and come to a decision to buy or not.
But there was a problem. The stock we were looking at was a low-cost airline. So I asked him if
he’d ever owned an airline stock before? No. Had he ever researched an airline before? No.
That’s not an insurmountable problem. But it doesn’t just double the amount of time you’re
going to have to spend researching this stock. It probably quadruples or octuples the amount of
time you need to research this thing.
I gathered together a bunch of links to Warren Buffett (Trades, Portfolio) talking about why he

invested in airlines recently. I sent a link with Glenn Greenberg (Trades, Portfolio) talking about
Ryanair (this was years ago). And I also gathered together a group of four or five peers that I
thought he should research together with this stock. There were questions I needed him to focus
on like: What happens when an airline has trouble getting new planes and new pilots at the terms
they did early on in their development? What happens when a lot of the routes an airline was
flying had no competitor and then a competitor starts flying that same route? I just had a pile of
questions and resources that I dropped in his lap to look at. None of this would have been
necessary if he’d had a previous knowledge of airlines. Now, that’s fine. This can be his first step
into researching airlines. The knowledge he accumulates learning about this stock may serve him
well as background knowledge when he studies a totally different airline in two or five or 15
years. That’s the way investing works. You bring a ton of old background knowledge to any new
idea. And by the time you make a buy decision, it’s often going to be based on at least 50% of
stuff you already knew before you started researching this stock this time around.
The “this time around” part is key. I was talking to someone else about two different stocks
recently: Howard Hughes (HHC, Financial) and Green Brick Partners (GRBK, Financial). It
was a lot easier analyzing Green Brick with him than analyzing Howard Hughes.
Why? Is Howard Hughes more complicated than Green Brick?
It is. There are probably about seven different projects scattered around the country – from
Manhattan to Honolulu and Houston to Las Vegas to Chicago – that you want to appraise when
looking at the company. For Green Brick there is really (for now) only the Dallas and Atlanta
homebuilding markets to consider. But the difficulty in analyzing Howard Hughes with this
investor was that when I asked if he’d ever analyzed a real estate company before – he said,
“No.”
There are specific things about the business model of an airline or a real estate company that you
need to understand well – hopefully, better than the guy selling you shares in this company –
before you can buy the stock. For airlines, you need to think about things like cost per seat mile,
the leases on these planes, what the load factor is in the industry right now, and what deliveries
of planes (changes in industry capacity) are coming soon to airlines that operate the same routes
as the one you’re looking at. For real estate, you need to think a lot about financing and
discounting.
There are a lot of wonderful stocks out there that generate enough free cash flow to fund their
own growth indefinitely. They don’t need to borrow a lot. And you don’t need to think much
about assets on their books. If they have a lot of assets – those assets will tend to be cash,
accounts receivable (net of doubtful accounts) and inventory (stated at the lower of cost or
market). For a well-functioning business, those are liquid and reliable assets. There are positive
and negative aspects to them. Obviously, you’d rather have cash than inventory. So you don’t
want to invest in a company that always puts every dollar of profits it earns right back into
growing inventory. But even a business like that – say a fast-growing retailer with really low
inventory turns – is much more cash generative relative to its long-term needs than something
like Howard Hughes.
On the other hand, Howard Hughes owns some phenomenal undeveloped assets. They still own
large amounts of land in Master Planned Communities that they carefully developed into affluent
suburbs. The residential land on their books will eventually have houses put on it. But when?
A stock like Howard Hughes is going to have a lot of debt (though some of it will be
nonrecourse to the parent company). It’s also going to have a lot of asset sales. But, those sales
aren’t going to be very big if you take cash value of assets sold this year / fair market value of
assets on the book. They might only be selling 5% or 10% of what they own each year. So what
is the 90% to 95% they still own going to be worth? Take a particularly tough assumption here.
Assume they only sell 4% of what they own each year. That means they are going to take 25
years to work through turning all the assets you see on their books into cash. The average asset
on their books today will be sold in 2030 (25 years / 2 = 12.5 years from now). Now, I’m making
this up in the case of Howard Hughes. You can read through what they say about each master
planned community and see that they’ll actually realize a lot of value in just the next couple of
years in a few places and then in like one of the more extreme examples – yes, they’ll still be
selling things in 2030 I believe.
All of this is in investor presentations, the company’s filings with the SEC, etc. But how you
evaluate this information is not. What is an acre of undeveloped residential land in a Houston
suburb worth? What is an acre of undeveloped commercial land in Summerlin, Nevada, worth?
What is the South Street Seaport worth? Not only are these assets in different places. They’re
also going to be monetized at different times. So for the South Street Seaport you may be able to
just value the asset and that’s an accurate idea of what value you should add to your appraisal of
the company. That’s a project that is close to completion. But there is some land in some of these
communities that isn’t going to be developed for like a decade.
What is a dollar in 2027 worth compared to that same dollar in 2017?
There are ways to solve this problem. But it helps if you’ve had practical experience worrying
about things like discount rates and real estate values before. The value of the land is going to be
higher in 2027 than it is in 2017. But the value of receiving $1 in 2027 is lower to us (and
Howard Hughes) than receiving that same $1 today. So we care about the difference between
how much we want to get paid to wait each year and how much the land is going to appreciate in
value each year.
That’s the right way to frame the problem of analyzing Howard Hughes. When I lay it out like
this, it seems simple and intuitive. But I can tell you from experience that when someone first
reads a real estate developer’s 10-K, they don’t immediately cut through all the fog of details and
lay things out like I just did. They often rely a lot on posts at Value Investors Club, blogs, etc., or
presentations by investors who propose this idea as a long at some conference or who propose
this idea as a short at some conference. The more background knowledge you bring to analyzing
a stock, the more comfortable you will be framing the question in a way that makes logical sense
to you instead of the way it’s conventionally done.
If you’re going to bring a different and better approach to valuing a stock – you need to have the
knowledge to know where conventional wisdom is wrong.
For me, this is what happened with banks. For a long time, I did not feel qualified to analyze
banks. One of the biggest reasons why I didn’t feel qualified to analyze banks is that I read what
analysts, bloggers, the financial media, etc., said about how you value a bank stock – and it
didn’t make much sense to me. For example, value investors would say you should value a bank
on price-book (P/B). This didn’t make sense to me because a bank earns money lending out its
deposits not lending out its equity. I had some experience investing in insurance stocks by this
point – and I knew that valuing insurers on their book value was a poor idea in the long run.
Buying an insurer at a low P/B at the right time in the cycle (a bad time) and selling at a higher
P/B at the right time in the cycle (a good time) made sense as a trade. But the really big money in
investing in insurance stocks is not made from buying them at below book value. The really big
money in insurance stocks is made from buying insurers with better business models even when
they trade at a higher P/B ratio than others.
Insurers should be valued based on only two things: premiums and float. An insurer with a
combined ratio less than 100 can make an underwriting profit each year. So for such insurers,
every $1 of premiums adds some number of cents in profit. So price/premiums makes sense
there. And then you also have “float.” Even if an insurer writes at a combined ratio over 100,
they can invest the float. If an insurer can make say 5% a year on their float then you have to
take Float * 0.05 = 5% of float in underlying profit (on investments) and add that to your
estimate of normal earnings.
I owned a small insurance stock once before (bought at a deep discount to book value) which I
believed should not trade below book value. I believed that because it tended to make about an
8% annual underwriting margin. It also had some float. If you add the return on float to the direct
return on underwriting you get a number that says you should pay book value or more. But what
made much more sense to me is you got an appraisal of the company that was based not on book
value but on premiums.
I also analyzed a company called Car-Mart (CRMT, Financial). They sell used cars. But really
what they do is make very risky car loans. I valued them based on price-receivables not P/B.
Once I had a background valuing stocks like Progressive (PGR, Financial) and Car-Mart, I felt
confident enough to go and value banks likeÂ Frost (CFR, Financial), Bank of
Hawaii (BOH, Financial)Â and Wells Fargo (WFC, Financial). I was confident that the
approach I had – looking at the total economic cost of these banks’ deposits – was a better
method than anything based on book value or efficiency ratios or anything like that.
Until you know a subject well enough to think you have your own way of valuing a stock, you
are going to have problems coming up with a correct yet contrarian view. Those are the most
valuable views.
You can also act with more conviction. The person I was talking to about Green Brick had found
that stock on his own and actually owned it in the past. It’s true that David Einhorn and Daniel
Loeb also own the stock. But that’s not what attracted him to it in the first place. With Howard
Hughes, this person had first learned about the company by watching Bill
Ackman (Trades, Portfolio)’s presentation on the company. Ackman is a large shareholder in
Howard Hughes. You are never going to be as confident investing a lot of money for a long time
in an idea that a big shareholder of the company brings to your attention. You’re going to be way
more confident investing in a company that is local to the area (as Green Brick is for this investor
I was talking to) and which you’ve already owned in the past.
In fact, some of the best investments you can make are often “revisits” of stocks you’ve owned
or researched before. Right now, I’m looking at Omnicom (OMC, Financial) around $75 a
share. I bought it for the first time at under $28 a share (like eight years ago now) and I wrote a
research report on it at a higher price than it is at now (about a year ago). Because I feel like I
know the advertising industry in general well and Omnicom in particular well, I’d be willing to
bet big on that stock and hold it long enough for the idea to work out. I also have a more precise
idea of what price I’d like to pay for the stock because I’ve come up with a specific value for
Omnicom twice before in my lifetime.
I’ve also been following Howden JoineryÂ (LSE:HWDN, Financial) and Cheesecake

Factory (CAKE, Financial) for years. Compare this to a stock like AutoZone (AZO) which I
only researched for the first time this year. It would be harder for me to feel confident enough
that I see AutoZone more clearly – that I have a better frame for analyzing the stock – than the
guy selling his shares to me. So I’d be more likely to make a smaller bet on AutoZone (put a
smaller percent of my portfolio into it) and I’d be more likely to sell the stock sooner if
something unexpected happened. That’s not a recipe for long-term success in the stock market.
Unless an idea has the potential to get you to 1) put a lot of your portfolio into it and 2) hold it
for a long time, it’s not worth your time. The value of any idea is Position Size * Years Held *
Annual Return. We value investors often focus too much of our research time on what we think
the annual return in the stock will be and not enough on how big we’re going to make the
position and how long we’re going to hold it. It doesn’t matter much if a stock goes up if: A)
You’ve already sold it or B) you didn’t buy enough of the stock to “move the needle” in your
portfolio.
So start with the stocks you know best. And then expand your potential circle of competence out
to new stocks that are related in some way to stocks you already know. If an idea looks great but
you know nothing about it – educate yourself about the company, its business model, its
competitors and the industry’s history. The most important thing to keep in mind is that
researching a stock in an industry you’ve looked at before is going to take you about 10 times
longer than researching a stock you’ve already studied in the past.
 URL: https://www.gurufocus.com/news/570376/buy-what-you-know-study-what-you-
dont
 Time: 2017
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To Research a Stock, Just Act Like an Investigative Reporter
Warren Buffett (Trades, Portfolio) was once asked about the similarities between investigative
reporting and investing. He said:
"Well, it is interesting that you mention reporting because Bob Woodward I think back in '73 or
'74 when I first got interested in The Post, we had lunch at the Madison and he was saying what
he might do with his money and I said: 'Bob why don’t you assign yourself a story, get up an
hour early every morning and work on a story you’ve assigned yourself? Now a sensible story to
assign yourself would be what is the Washington Post Company worth? Now if [Ben] Bradlee
gave you that story to work on what would you do for the next week or two? You go around and
talk to people at television stations and you would try to figure out what are the key variables in
valuing a television station and you would look at the four (TV stations) that the Post has and
apply those standards.'"
The lack of a “reporter’s instinct” is one of the things that has surprised me the most when
talking to other investors. Most investors rely a lot on information aimed at investors. So investor
presentations, earnings calls, stories in Barron’s, maybe the annual report, the 10-K, the 10-Q,
etc. But they don’t just take that off as their launching point and combine it with other easily
available – and totally public – to answer questions that are important to valuing the company.
They passively wait for information to come to them instead of actively answering the question.
It’s like they assume that just because no one has tracked down the information and put it in print
yet – they can’t either.
Sometimes, I’m not even talking about going beyond the SEC filings. I just mean using them in a
different way. For example, I was talking to an investor who had put together a bunch of
information on a specific stock. He had read the 10-K. And he’d put it together with write-ups on
blog, Value Investors Club, etc. Because of the way this company he was considering investing
in had been formed – the key variable was really just one agreement. What were the terms of that
agreement? How long did the agreement run? Questions like that were key. Because the only real
economic value this company had was being blessed with this favorable long-term agreement.
Anyway, he said that he’d read through all this stuff and nowhere did the company say how long
the agreement ran.
“Seventeen years,” I said.
“Where’d they report that?”
“They’ve never reported that,” I said. “But if you carefully read what they say about how they’re
amortizing the agreement and then you look at the last two years and compare the balance sheet
from one year to the next and compare that to what you see reported in the income statement
during the intervening year, well, we can prove mathematically that it’s impossible for there to
be more than 20 years or less than 15 years left on the agreement – and, if I had to guess, I’d
definitely guess 17 years.”
Now, I understand some people aren’t as confident with a guess like that as they would be with
having the company tell you the length of the agreement. But it’s the best you can do. And by
triangulating a few facts, you can prove that either the company has made an error in describing
how they amortize the deal (this shows up as a footnote in the 10-K), or they made an error on
either the balance sheet or income statement, or you made a mistake interpreting those facts. If
none of those mistakes were made, we do know roughly how long the deal runs.
It’s not unusual for there to be publicly available information released by a company that
analysts and reporters overlook – not just individual investors.
Here’s another example.
I was researching a stock called DreamWorks Animation. It’s now owned by Universal. But it
was a standalone company that had been – by then – split off from the live action DreamWorks
studio. As a result, this company was only releasing one or two movies a year. Everyone knew
which one or two movies those were. They knew the release dates. And the company did
earnings calls each quarter. They had an output deal with HBO where HBO got to run
DreamWorks movies once they left theaters but before other TV channels could get the rights to
the movies.
It was often reported that the terms of that deal were unknown. The terms of that deal weren’t
unknown. My newsletter co-writer, Quan Hoang, and I both knew them. And they weren’t even
“undisclosed.” DreamWorks was publicly disclosing the terms of the deal to anyone who read
their 10-Qs and 10-Ks including the footnotes on when accountants booked certain items. If you
could precisely date when revenue from HBO would appear, you could see exactly how much
HBO was paying for each movie.
True, the deals' terms weren’t published anywhere. But they were precisely knowable.
DreamWorks had a note in its financial statements that said when it recognized revenue from
HBO. It also discussed things like receivables due from different studios. If you knew what date
a certain movie transitioned into the HBO window and you read the statements, you could tell
exactly how much HBO was paying per movie. The same thing was true by the way when
DreamWorks switched from an output deal with HBO to one with Netflix (NFLX, Financial).
This was then muddied when DreamWorks started releasing TV shows made specifically for
Netflix. But until that time, anyone who wanted to know how much HBO or Netflix was paying
DreamWorks for each film could figure it out exactly using nothing but DreamWorks’ own 10-
Ks and 10-Qs.
This is what I mean by acting like an investigative reporter. A lot of investors think that because
a company doesn’t tell you something, you can’t find it out. Sometimes you can find it out
exactly (as in the case of how much DreamWorks was paid per movie for first-run premium TV
rights). Other times, you can guess.
Usually, your guess can be very educated. And you can educate yourself in about a day’s time.
I’ll give another example. I was reading through the 10-K of a company that was – at the time,
this was maybe six years ago – a net-net. So I was just quickly checking through the quality of
assets like cash, receivables and inventory. I noticed slight anomalies as I scanned the footnotes.
Time after time, the company was being unusually aggressive in its depreciation. So if a category
of assets could be depreciated between three and 10 years, you’d see they were doing it in three.
They also owned things you’d expect them to lease. And then they wouldn’t just own the
building. They’d own land around the building that seemed kind of excessive. I got to thinking
that the company was probably understating its earnings and its assets by owning a lot of stuff
that they were depreciating rapidly and then keeping in use. There’s a note in the financial
statements that actually told me the dollar value of assets still in use that had been fully
depreciated. It was a big number. Accumulated depreciation was also a big number.
So I looked at the properties the company owned and I went online to find satellite photos of
where these properties were (this takes 60 seconds to do nowadays). I also found what counties
the properties were in and quickly Googled how to look up property tax records for those
counties.
At this point, I was off on an investigative reporter type hunt. I’d invested less than an hour into
reading and Googling at this point. It might have been a wild goose chase. But it might be
something else.
In this case, it was something else.
I found a property record on one building that showed they were almost certainly carrying the
land, the building, improvements and the equipment inside that building for a small fraction of
the appraisal value of the land for tax purposes. What the land is appraised at for tax purposes
doesn’t prove anything. But I was looking at a picture of the building and it wasn’t old. It was
worth a lot more than what it was carried for. Now, normally that’s not interesting. But,
remember, this stock was already selling below book value when I first found it. And now I’ve
learned that the fair value of its assets is way above book value. When looking at the record and
the satellite photo I noticed something odder than that. There seemed to be two buildings on this
property. The company had – in a previous year – described an “improvement” to the property
but not another building. They were depreciating a second building as an improvement and doing
it as rapidly as they were allowed to depreciate an improvement. As a result, I was looking at a
building that despite not being terribly old was clearly there in the photo but was no longer on
the company’s books at all. And, of course, the cost of that building had passed through previous
years of income statements as a depreciation expense. This makes it look like today’s assets are
lower than they’re really worth. And it also makes it look like yesterday’s earnings were lower
than they really were.
Everything I’ve described for you here was done in one morning sitting in one seat in front of a
computer. I didn’t start my look into this company before 9 a.m. I thought at first it’d just be a
typical net-net. And then, I was done looking at it by noon. And what I found was a pattern of
behavior that understated assets and understated past earnings. Ben Graham would’ve bought
this stock. Walter Schloss would’ve bought this stock. It was something you’d expect to find in
the 1950s in the U.S. or maybe in Japan in the 2000s. But not in the U.S. in 2010.
It’s all the kind of thing a reporter could easily do without leaving their desk. And they would do
it because they think like a reporter not like an investor. I didn’t even call anyone up, email them,
etc. All I did was use one photo from Google, what the company filed with the SEC and online
land records.
The surprises in that case were all positive.
Sometimes, they’re negative.
I don’t short stocks. And I don’t write negative posts about stocks where I learned something
unsettling. I’m not looking for controversy. So if I’m going to say bad things about a company –
as I am here – I won’t mention the specific name. Both of these stocks were Chinese companies
that had gotten on U.S. exchanges through a reverse merger of some kind. In both cases, a
shareholder who owned the stock was emailing me to please assure him it wasn’t a fraud. In both
cases, I couldn’t assure him it wasn’t a fraud because – again, within three hours or less – I was
pretty sure I had found facts that were only consistent with a fraud.
Now, it helps to know accounting. I’m not an accountant. I really didn’t go to either high school
or college. I was basically a dropout after eighth grade. So I don’t have any formal training in
accounting. But I’ve been reading 10-Ks since I was 14. And almost every initial lead I’ve gotten
on a company comes from something accounting related in the 10-K. It’s usually something in
the footnotes. Or, more accurately, it’s a combination of more than one item that seems weird.
For example, in the case of the company that was overdepreciating everything – it was just all
over their financial statements that they were doing the opposite of what you wanted to do if you
were trying to report the highest possible EPS. It was like they were trying to report the lowest
possible EPS. That’s odd for a public company. So I focused on that topic.
Here, I’d been brought two potential frauds. So I decided I would focus on those things that
could quickly establish a fraud. So I scanned the 10-Ks looking for any hard facts that the
company might either forget to fraudulently adjust or literally couldn’t fraudulently adjust. In
other words, I assumed that there definitely was a business here doing things. But it’s possible
the company was inflating everything 1,000 times or something like that. My assumption was:
they aren’t insane – it’s not like they are going to make up the fact they operate a paper plant if
in reality they run a landfill. So I thought that at least some nonaccounting disclosures would be
accurate. Even a liar wasn’t going to lie about stuff they didn’t think needed to be lied about. It
would be pointless and complicated to do that.
Anyway, in one case I found reference to a tax the company was supposed to pay. It was based
on the number of units of something. If you multiplied this per item tax by the number of units
the company said it had sold – it didn’t match. Something was off. And it was off by a few
zeroes. Once you find something like that, I don’t think you can buy the stock. Now, when I tell
a shareholder of a company something like that they often say, “Isn’t it possible that” and it’s
true that there are other possibilities. If I really was a reporter and not an investor I’d try to talk
to someone at the company and try to talk to someone in the Chinese government agency
responsible for collecting this tax and see whether the company was: misreporting the tax per
unit, cheating the government rather than cheating investors, or there was some complex
explanation where a tax benefit of some kind I couldn’t find anywhere in the statements was
muddying the waters so bad it offset what I expected to find. As an investor, I can keep the story
to myself. So I don’t go asking for management’s side of the story. For me, the story ends there.
The other Chinese fraud I was brought had a strange discrepancy with time. Basically, you can
use financial statements to come up with figures like inventory turnover. I’m sure you know that.
But what you might not have thought about before is that metrics like receivable turns, inventory
turns, etc., are giving you more than just usual financial stats, they are actually telling you
something about the time it takes to: sell inventory once you take possession of it, pay bills,
collect payments, the length of employee pay periods (a company that cashes out its staff daily
looks totally different from a company that pays salaried employees just once a month), etc.
Now, with that in mind. Here’s what I found. This company described in a note how and when it
recognized revenue and elsewhere it described its business operations in terms of what it actually
did. The description of what it did made sense to me (I wasn’t knowledgeable about the
product/process to know for sure whether the description was accurate), but the inventory turns
were implying the process happened very, very rapidly (impossibly rapidly in my uneducated
opinion) when the business description was implying the process happened at what seemed a
normal and reasonable speed. I checked everywhere to see if I was misunderstanding when they
actually put stuff into inventory or if somehow they were keeping things on a supplier’s books
till almost the moment they passed that thing on in finished form to the customer. Again, a
shareholder in this fraud could say “Isn’t it possible” and come up with an explanation for how
this company could have made the mistake of incorrectly describing when it recognizes sales,
puts things received from suppliers on its books, etc. It’s possible. But, to me – you forget about
the stock right there. If everything the company was saying was true, it was a fraud. If it wasn’t a
fraud, there had to be something I was misunderstanding or they were explaining badly in how
they prepared their books. And it would have to be something very basic to the essential
functions of the business. For example: they could have been saying they owned something that
in reality they contracted with someone else for and never took possession of. Then, the stock
wouldn’t be a fraud in the way I thought it was a fraud. But, it would still be painting a picture
for investors that was inaccurate.
Of course, if I was a reporter I would have talked to management, talked to suppliers and talked
to ex-employees.
I’m not a reporter. And I’m not a short-seller. So when I see a case like this I just move on. I’m
only writing about it here – and not mentioning the name of the company in any of these cases –
to encourage people to go out and act like a reporter when it comes to researching a stock.
There are tons of stocks where you can do this even today. Anything related to real estate where
you can find comps is really easy. You can do it from behind a desk. You can probably do most
of it with just Google – not ever needing to talk on the phone or email. So not quite like a real
reporter.
In a recent blog post, I mentioned Ingles Market (IMKTA, Financial). It’s a supermarket, but it

owns a lot more assets than a normal supermarket would. Why not assign yourself the story of
what Ingles Markets is really worth? What is all the PP&E on its books worth if sold off?
There’s a company called J.W. Mays (MAYS, Financial). It owns real estate in Brooklyn. I’ve
been to Brooklyn. And I’m guessing Brooklyn’s a nicer place today than when Mays put that
property on its books. Perhaps there’s a discrepancy between fair market value and book value.
Assign yourself the story. Staying in real estate, how about Seritage (SRG, Financial)? We know
BuffettÂ (personally, not through Berkshire [BRK.A][BRK.B]) owns this stock. It was spun off
from Sears (SHLD, Financial). A lot has been written about Sears, and there’s a lot of public
information available about why Sears would separate Seritage, what rates Sears is paying to rent
from Seritage, and also what rates another tenant might pay for the same space. Assign yourself
the story: what is Seritage’s property worth?
You can do this with companies that aren’t involved in real estate. I’ve mentioned Ark
Restaurants (ARKR, Financial) before. In an earnings call earlier this year, the CEO said:
“We are restaurant guys. I (don’t) know what the valuation on our company should be. I just
know that we are trying to build value, but the way I always look at this in my own way was that
we have now some $25 million plus from coming from restaurant operations. We got $11 million
corporate overhead, part of that’s attributable to what’s going into Meadowlands, which now is
probably two years from something happening, but we have $25 million of corporate overhead
for restaurant operating profit and $11 million of corporate overhead. We find the right guy to
sell this to, looking at $25 million worth of restaurant operating profit, not the $40 million we
expect. I don’t know what the multiple should be on that. And I don’t know how Wall Street looks
at that. But we look – if we were to sell, we would look to pair off with somebody who mirrors
our locations with their locations and doesn’t need a corporate overhead.”
He may not know how to value his company, but you can find out how to do it. You can research
the referendum on the Meadowlands that failed last year and learn whether it might be back on
the ballot in New Jersey in 2018. You can Google if anyone ever tried to buy Ark (they did;
Landry’s made a hostile bid years ago) and at what price. So you can research what the chances
of there being gambling in the Meadowlands one day are. And you can research why Landry’s
would make a bid for Ark and what kind of people run Landry’s and how they think and so on.
That’s what a reporter would do. It’s also what BuffettÂ did in the 1950s and 1960s especially. If
you read “The Snowball,”Â you’ll see that Buffett started with getting a lead from the Moody’s
manual or the annual report of a company combined with his knowledge of accounting (like I
suggested you do even today), but then he assigned himself the story of figuring out what the
business was worth. He got friends of his to do some of the leg work for him. Sometimes he
went out into the world and talked to people who’d know the answer to questions he had. And
sometimes he did it in libraries. You can do almost all of it from behind a desk using just an
internet connection today. But you still have to do it.
You have a lot of money riding on your investment. Treat your stock research as seriously as
you’d treat any project your boss assigns you at work. Think like a reporter and learn to
“investigate” a stock instead of just reading what others have written about it.
 URL: https://www.gurufocus.com/news/570288/to-research-a-stock-just-act-like-an-
investigative-reporter
 Time: 2017
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Think of Your Circle of Competence as a Web of Familiarity
The best investment you can make is expanding your circle of competence. Warren
Buffett (Trades, Portfolio) talks about a “circle of competence” as being something that separates
the businesses you personally can understand well enough to value (those inside the circle) from
the businesses you personally can’t understand well enough to value (those outside the circle). I
prefer to think of the circle of competence more as a “web of familiarity”. How familiar are you
with a given company? And then: how similar is a business you haven’t researched before to a
business you have researched before? Generally, you want to focus on analyzing and investing in
those businesses that you can understand better than most people who buy and sell that stock.
That means you want to focus on those businesses you’re most familiar with.
Warren Buffett (Trades, Portfolio) bought Nebraska Furniture Mart. That business was in
Omaha. And Buffett had lived most of his life – with the exception of some time in Washington,
D.C. and New York City – in Omaha. The first insurance company stock he bought was GEICO.
Buffett’s professor, Ben Graham, had invested in GEICO and served on the board. Buffett went
down to GEICO’s headquarters to learn all about the stock. What he got was an hours long
lecture about the insurance business and GEICO’s business model from the CEO of GEICO. The
first insurance company Berkshire bought outright was Jack Ringwalt’s National Indemnity. It
was headquartered in Omaha. Another early investment of Buffett’s was National American Fire
Insurance. It was controlled by the Ahmanson brothers. They were from Omaha:
“I found National American Fire Insurance…NAFI was controlled by an Omaha guy, one of the
richest men in the country, who owned many of the best run insurance companies in the country.
He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The
share price was $27. Book value was $135. This company was located right here in Omaha,
right around the corner from (where) I was working as a broker. None of the brokers knew
about it.”
The point I want to make here is the line where Buffett says “this company was located right
here in Omaha, around the corner from where I was working as a broker. None of the brokers
knew about it.”
Why didn’t any of the brokers know about it? Because they were too busy thinking about stocks
that were far away. You want to combine your unique local knowledge and your unique
knowledge from your non-investing life with the general knowledge that all other investors have
access to (like the 10-K).
Let me give you an example of this from my own teen years.
One of my best early investments – as a teenager – was in a company called Village

Supermarket (VLGEA, Financial). That company operates Shop-Rite supermarkets in New
Jersey. I’m from New Jersey. Most of the Shop-Rites in my local area were run by Village. And
I worked as a cashier at a Village Shop-Rite as a teenager. That have me the confidence to
research and invest in the stock. At the time, the stock was probably trading at less than book
value and less than 7 times earnings or so. I don’t remember the exact figure. But, in the later
1990s, Village was routinely available at a single digit P/E ratio and a discount to book value. It
operated very high volume supermarkets. The location I worked at seemed to be doing – based
on what I saw during my shifts as a cashier – close to $1 million a week in sales. When I got my
hands on the company’s 10-K, I saw that although not all locations were doing quite that volume
– I was probably pretty close to correct in my guess about my location. Would I have bought and
held Village stock if I hadn’t worked there?
No.
Of course, as a value investor, you’d think that a stock selling at a single digit P/E and a discount
to book value would attract you. And it might. I believe you might have bought that stock off a
screen. But, you wouldn’t have held it for 10 years. Holding for a while here was key. From the
time I worked at Village till 10 years later (basically, 1999-2009) the stock returned about 23% a
year. You’re probably not going to have the confidence to stick with a stock like that when it
gets to a normal price multiple if you just found it on a screen. Familiarity with the stock –
having worked there, having shopped there, having seen the locations and their parking lots, etc.
– helps you decide to hold on to a stock. It grounds your thinking in the reality of the specific
business you’re investing in and pulls your thoughts away from speculating about
macroeconomics, the industry overall, etc. This was a supermarket chain using one banner
(Shop-Rite) in one area (New Jersey). That’s what mattered. Larger concerns about the industry,
the economy, etc. didn’t matter. You can see that in the timeline I just laid out. You could make
20% a year in this stock from 1999 to 2009. That wasn’t an especially good 10 years for the
stock market, the economy, etc. If you knew what world events would be happening between
1999 and 2009 (NASDAQ crash, September 11th, a small recession, financial crisis, and then a
big recession) you might not have bought the stock. Certainly, if I knew just how important the
internet would become between 1999 and 2009 (and especially how important Amazon would be
by the end of that period) I might have taken the threat of online groceries (something people
were starting to talk about in 1999 whenever you brought up a stock like this) a lot more
seriously. It’s now 18 years later, and competition from online grocery sales have still had no
impact on the business results of companies like Village.
So, familiarity is important in three ways. One: it helps you analyze and understand the business.
Two: it encourages you to bet big when you see have an “edge” in understanding this business
you’re so familiar with. And three: it gives you the confidence to hold the stock for a long time.
Those are the 3 things you need to have to make a lot of money off a stock idea.
One, you need to be able to tell a good idea from a bad idea. Two, you need to bet big on your
good idea. And three, you need to hold long enough to get the most from your big bet.
The payoff you get from an idea is really: Position Size * Time.
So, you want to do smart things like put 20% of your portfolio in Village Supermarket in 1999
and then hold it all the way till 2009. Even if you don’t have a big portfolio at all – say that
VLGEA in 1999 was a $2,000 bet for you (you had a $10,000 portfolio) – such an idea could
have ended up making you about $13,000 if you sized the position at 20% of your portfolio and
held it for 10 years.
I think most investors allow themselves to focus on the wrong part of a story like this. They think
“where can I find stocks trading at a single digit P/E and a price-to-book less than one?”. In other
words, what should I screen for? Yes, screens would turn up a stock like Village. But, an idea
you find off a screen is neither likely to get you to put 20% into it nor is it likely to get you to
commit to a 10-year holding period. Good ideas from screens aren’t worth very much.
And I say this as someone who does screen. I use GuruFocus’s “All in One” screener and find it
excellent. There’s a screen I run that right now will turn up Omnicom (OMC), Cheesecake
Factory (CAKE, Financial), and AutoZone (AZO). Those are all stocks I’ve researched this
year. For example, if you just screen for companies with 4 stars of predictability or more that are
trading at a P/E of 15 or less – you’ll find a lot of the stocks that I personally have researched
this year. GuruFocus gives you the tools to let you do that.
But, did I find Omnicom or Cheesecake or AutoZone on a GuruFocus screener? No. And if I had
found those stocks on a screener and learned nothing more about the companies – those ideas
wouldn’t be worth much to me. That’s because I wouldn’t be familiar enough with the
companies.
How do you gain familiarity with companies? Let’s look at Cheesecake Factory. I know the
company well. I’ve eaten at the restaurant. I’ve done a little research on two “A” malls where
I’ve been to a particular Cheesecake Factory to get an idea of the quality of the location, whether
they are driving traffic to the mall or drawing traffic from the mall, etc. I researched this stock
with a partner, Quan Hoang (my newsletter co-writer), for a newsletter issue we planned.
However, we shut down the newsletter before doing this issue. So, no issue was released. But,
basically, all the research was done. We’d discussed together it in enough depth and had enough
notes that I could have written a 10,000+ word report on it.
Part of what made it possible for me to write anything about Cheesecake Factory is that I had
already researched and put out 10,000+ word reports on two other restaurants: The Restaurant
Group (a U.K. owner of casual dine-in restaurant chains) and Ark Restaurants (a U.S. owner of
non-chain – so, single location – large format restaurants). I had also researched Greggs (a U.K.
fast food chain). The key thing we had to understand with Greggs is how much same store sales
declines can be driven by lower traffic to food away from home places generally (in a bad
economy) and how much same store sales declines can be driven by lower traffic to the shops in
the vicinity of your locations. Greggs had posted poor results because: a) The U.K. economy
wasn’t good and b) fewer people were visiting “high streets” (sort of equivalent to “main streets”
here in the U.S.). So, I had a lot of familiarity researching the kinds of issues I’d have to think
about with Cheesecake. Let’s list some of the strands in my “web of familiarity” that already
connected Cheesecake (a stock I didn’t yet know well) to stocks like Greggs, The Restaurant
Group, Ark Restaurants, and Village Supermarket.
Village Supermarket: The connection here is food deflation at supermarkets. In the last two
years, food prices at U.S. supermarkets are down about 4% while menu prices are up about 2%.
Cheesecake’s same store sales turned negative recently. The entire industry has negative same
store sales in the U.S. Some analysts believe this is due to a societal shift away from eating out. I
believe it’s completely due to falling prices for food at supermarkets happening at the same time
you have rising menu prices. That’s a rare occurrence in the U.S. And the gap between
supermarket deflation and restaurant inflation is the widest in my investing lifetime. If you were
just looking at restaurant stocks and not looking at supermarket stocks, you’d never consider this
possibility. So, my previous familiarity with the supermarket industry helped me analyze a
restaurant.
Ark Restaurants: The difference between the store level economics of Cheesecake and its
competitors is due to Cheesecake operating larger format locations than any other chain
restaurant in the U.S. I had researched Ark Restaurants which operates very large format
restaurants. Ark has significant corporate level G&A expense. It doesn’t own many restaurants.
So, its economies of scale above the individual restaurant level are very bad. However, the
economics of Ark’s individual locations are often not bad. And I knew this because I had some
experience analyzing the economics of an especially large restaurant. If you were only familiar
with restaurant chains that operate locations with something like 50% less square footage than a
typical Cheesecake Factory location – you’d likely miss this point. Big restaurant locations can
afford to do some things – like have extensive menus and make almost everything fresh at the
location – that small square footage restaurant locations can’t do. It’s very hard to offer a wide
selection of fresh made food outside of a big square footage restaurant.
The Restaurant Group: This is usually what people think about when I say “familiarity”. The
Restaurant Group looks like a peer of Cheesecake. It’s good to have experience analyzing peers.
I normally look at 1 stock and compare it to 5 peers at the same time to get a full view of the
industry. There was a specific lesson in here which was analyzing what would happen if The
Restaurant Group and its competitors were opening a lot of new locations. This is very different
in the U.K. from the U.S. The one thing that really scared me about investing in The Restaurant
Group was the pace of new store openings in the U.K. So, I wanted to know that it was unlikely
Cheesecake would expand too rapidly in the U.S. and also that it was unlikely that competing
restaurants would open near a Cheesecake (so in malls) at an especially fast pace in the years
ahead.
Greggs: The connection here is foot traffic. In the U.K., everyone was afraid that Greggs would
be made obsolete over time because: 1) It was unhealthy and society was more interested in
healthy foods now and 2) It was on “high streets” and society would be shopping elsewhere now.
The concerns at Cheesecake are almost exactly the same. Two of the most common complaints
you hear about Cheesecake as a stock are: #1) It’s in malls – and U.S. malls are dying and #2) It
is known for serving gigantic portion sizes and people don’t want this. The health thing is clearly
not a valid concern. When analyzing Greggs, we knew it was nonsense and when analyzing
Cheesecake I knew it was nonsense. Cheesecake has now posted calorie counts on its menus and
hasn’t seen noticeable changes in behavior. There were already studies showing that people don’t
eat less when they see high calorie counts next to menu items. The high street / mall traffic
decline was the real and valid concern.
I do have a concern that Cheesecake may not be able to find enough good malls to put new
locations in. Management has said they see the opportunity for about 300 Cheesecake Factory
locations someday versus about 200 locations today. However, that means there have to be 100
suitable locations for a Cheesecake Factory that don’t yet have one. We’ll see how malls
develop. The Cheesecake Factory locations I researched in person were in “A” malls along with
other well-known (and often high end) restaurant chains, big movie theaters, and other
entertainment options (bowling, arcades, etc.). I’d expect malls to move more in the direction of
being filled with entertainment more and shopping less. But, I’m not sure there will ever be
another 100 places here in the U.S. where you can put a Cheesecake Factory. This is something
I’m unfamiliar with. I don’t know much about malls because I don’t much about retail.
So, learning about malls is a topic that might help me understand whether or not I should invest
in Cheesecake. And then, sometime down the road, my knowledge of how U.S. malls work will
be a thread in my “web of familiarity” that connects to some stock I haven’t yet researched.
What you learn each time you research a stock today accumulates and let’s you start from a point
that is far beyond square one when you encounter a new stock. You can grow your circle of
competence by moving along these threads that connect some business you already know to a
business you don’t yet know.
 URL: https://www.gurufocus.com/news/570286/think-of-your-circle-of-competence-as-
a-web-of-familiarity
 Time: 2017
-----------------------------------------------------
How to Zero In on Misunderstood Stocks
I’m a concentrated investor. But I’m also a selective investor in the sense that I don’t flip the
stocks I do own very fast. This means I sometimes go a long time without buying a new stock.
For example, at the end of last quarter I had 42% of my portfolio in Frost (CFR, Financial),
23% of my portfolio in BWX Technologies (BWXT, Financial) and 6% of my portfolio in
Natoco. I consider Frost and BWX Technologies to be good businesses that should be fairly
predictable EPS growers in future years. They’re high quality companies. The kind of
thing Warren Buffett (Trades, Portfolio) would be more likely to buy than Ben Graham. They’ve
also both gone up a lot in price. I got my shares of Frost under $50. I got my shares of BWX
under $28. Frost now trades at $91 a share. BWX now trades at $56 a share. I still like the stocks
fine. But I wouldn’t be loading up buying them today. That’s because I don’t just buy stocks I
like when they’re cheap – I usually try to focus my purchases on those moments when the stocks
are especially mispriced.
Generally, I want Mr. Market to offer me a 35% discount to my own appraisal of a stock. And,
generally, that doesn’t happen unless something has caused a stock to be temporarily hated or at
least misunderstood.
A couple years ago, oil prices were down a lot. The Federal funds rate was not yet rising. Frost is
a Texas bank that makes a large amount of loans to the oil industry. It is very interest rate
sensitive. Frost’s loan losses are usually higher when oil prices plummet. Its net interest margin
is lower when the Fed funds rate is low. So when I bought the stock there were some concerns
about oil and Texas and there was not yet conviction on the part of many investors that the Fed
would begin raising rates very soon. Everyone agreed it would happen.
But it wasn’t quite happening yet. That made it possible to buy Frost for about $50 a share
instead of something like $90 a share today. You could call it “timing,” and I wouldn’t object to
that idea. I don’t market time. And I don’t trade around a position at all. For a very liquid stock
like Frost or BWX, I simply put 100% of what I want to own of a stock into that stock all in one
day. Then, I never buy or sell till I’m ready to eliminate the position. This saves me from having
to think about trading. It also means that if I time my purchase to be at a moment when the
market perceives there to be real troubles or even knows the short-term results will be bad – I’ll
do better than if I eased into the stock over time. You can see this with Frost’s historical stock
chart. The stock has rarely traded anywhere near $50 a share.
I think my timing was lucky. But my interest in the stock wasn’t lucky. The timing of when I
bought was luck. But the timing of when I was deep into researching the stock was intentional. I
wanted to research a Texas bank that benefited from interest rate rises at the moment when Texas
and oil were unpopular with investors and yet interest rate hikes hadn’t started yet. Once the
trend seemed like oil prices were gradually recovering and the Fed was gradually raising rates –
the future would seem more comfortable for a stock like Frost. The stock’s price would then
reflect this.
There was something similar at work in BWX Technologies. I didn’t want to wait to buy that
stock till after it was spun off from Babcock & Wilcox. Babcock & Wilcox combined a money-
losing experimental modular nuclear reactor business with a shrinking boiler business serving
coal power plants and a growing nuclear reactor business serving the U.S. Navy. What I always
wanted to own was the growing nuclear reactor business serving the U.S. Navy. However, I was
afraid that if I waited till after the spin-off, Babcock & Wilcox would have gained a lot of
attention and now all investors who liked quality businesses would zero in on that U.S. Navy
nuclear business I really wanted to own. So I bought the stock before there was time for BWX to
trade on its own for a year and report clean standalone numbers. I was afraid BWX would have a
much higher multiple once that happened. So I thought the time to pounce was when the
situation was still a little murky looking on the surface because Babcock & Wilcox was all one
company still, and some parts of it were really attractive and some parts of it were much more
speculative.
Natoco is a leftover from my basket of six Japanese net-nets. Natoco is also a good example of
me prospecting for an especially mispriced stock, however. On March 11, 2011, there was a
tsunami and earthquake in Japan. Later, images of an ongoing nuclear disaster at the Fukushima
Daiichi nuclear plant would be broadcast around the world. The tsunami can be dated to March
11, and I believe the nuclear disaster to between March 12 to March 15, 2011. I wrote a post
entitled “Buy Japan.” The post is dated March 16, 2011. So I had decided to buy Japanese stocks
within one week of this major disaster.
In that post, I wrote:
“…I’m going through the Tokyo Stock Exchange and finding dozens of bargains.
Examples include grocery stores, logistics companies, and gas utilities. Some of these companies
– unlike the vast majority of Japanese businesses – earn unleveraged returns on invested capital
equal to their counterparts in the United States and Europe. Of course, they are all irrationally
underleveraged. Many Japanese companies are.
There are tons of net-nets in Japan.
Some of these companies deserve to remain net-nets forever. Such justifiably permanent net-nets
are very rare in the rest of the world. In the U.S., I can name – at most – about half a dozen net-
nets that are consistently profitable but have such consistently pathetic returns on capital to
deserve a fate of staying a net-net forever. One American example is Duckwall-ALCO (Geoff’s
note: ALCO Stores filed for bankruptcy about four years after this post was written).
...now is the time to buy Japanese stocks.
You can buy them indiscriminately if you want. I won’t. But you’ll probably hear I bought one or
more Japanese stocks very soon.
You can diversify across 5 or 10 Japanese net-nets if you like.

Or you can buy an ETF. Or you can pick just one stock.
Whichever way you do it, do it soon.
If you’re an investor who spends hours and hours every week bargain hunting in the U.S. and
around the world – my advice is to drop everything and focus 100% of your time on Japan’s
cheapest stocks.
The truth is that fortunes – big and small – are made on only a few investment decisions. And the
big opportunities come around very, very rarely.”
I want to talk about that line where I said: “my advice is to drop everything and focus 100% of
your time on Japan’s cheapest stocks.”
More than once, I’ve heard myself saying a line very much like this in person to someone I’m
talking stocks with. We’ll be discussing different stocks and they’ll say I like stock X and stock
Y and stock Z and I’ll say “No, no. Now’s not the time to look at those. Look at stock…”
The “dot-dot-dot” right now is NAACO (NC, Financial). NAACO said it plans to spin off its
Hamilton Beach brands business sometime in the third quarter. The third quarter ends in a week.
I don’t know if this spin-off will happen and when. But, I do know that if you’re interested in a
stock and you know it’s planning a spin-off – you should drop everything and focus on that spin-
off.
As a research candidate: NAACO has similarities to BWX Technologies. The business is

nowhere near as good. But, the possibility of Mr. Market misunderstanding the stock is just as
high. In its present form NAACO includes two businesses – a coal company and a small
appliance maker – that don’t usually appeal to the same shareholder base. It also seems to be
trading at fairly normal price levels as a combined company. And then the size of the spin-off is
potentially quite large relative to the size of the company. Really, this is a break-up. And
investors will have to decide whether they want to dump both stocks, keep both stocks, or pick
which horse to hop on. When they do this, there’s the potential that even if the combined
company’s stock had been correctly valued – there will soon be a mistake made by the market in
assigning how much value belongs to Hamilton Beach and how much belongs to NAACO. For
an investor who only buys stocks (that is, I don’t short) this potential mistake in appraisal is
exciting because you can do your homework ahead of time and have your own personal appraisal
of each company as a standalone stock. Then, when the spin-off happens you can compare your
appraisal value to each of the newly separated stocks. It’s possible both market values will be
below your appraisal, it’s possible one will be below and one will be above, or it’s possible
you’ll have nothing to do because the market either gets it right or overprices both stocks.
So, I don’t know if NAACO is necessarily a good stock. But, I know it’s a great research
candidate. It’s the company to zero in on and spend 100% of your research time this week.
Because compared to stocks that aren’t spinning anything off the chance of you getting an odd
quote from Mr. Market are much higher with NAACO.
This brings me back to Natoco. How did I end up deciding on those 6 Japanese net-nets I
bought? I went through all the stocks I could find in Japan. But, early on I realized that I was
getting much better pricing on smaller and less liquid stocks. Also, stocks on the Tokyo Stock
Exchange were less likely to be as high quality net-nets as stocks on other Japanese exchanges.
What I wanted in a Japanese net-net was many years of profits and more cash than total
liabilities I noticed the same pattern I see in the U.S., which is that bigger and more liquid stocks
that become net-nets are often somewhat less attractive than small and illiquid stocks that
become net-nets. I don’t mean that I can back test and see they underperformed. I mean, ahead of
time, you can see bigger net-nets often look less safe. More exciting maybe. But less safe. Small
net-nets are more likely to look boring but safe. So, big net-nets may work out great if business
rebounds. But, big and better known stocks that become net-nets look less like something Ben
Graham would buy than smaller net-nets.
So it’s a good idea to look for situations that seem dire, complicated, messy, and generally just
overlooked. Smaller is better. But, some bigger stocks can be misunderstood. It’s possible to
understand a business better than the other people trading it. What you want to find is some kind
of misunderstanding. I felt Frost was misunderstood. It wasn’t a bad lender so those energy loans
weren’t going to threaten the bank’s safety. And it was very, very interest rate sensitive. So, if
you believed the Fed Funds Rate would be higher in the future than the present, you should not
just be buying banks indiscriminately. You should instead focus on banks that benefit more from
higher rates. Sometimes the market really does seem to misunderstand even such a crucial point
as that one.
You can see this if you chart the stock price of Prosperity Bancshares (PB) against the stock
price of Frost. These are both Texas banks. I like them both. But, they’re very different in terms
of how their earnings will eventually respond to higher interest rates. Prosperity should be
especially interest rate neutral. It shouldn’t make that much more money with high rates than low
rates. Meanwhile, Frost should benefit far more from higher rates than the average U.S. bank.
This has to do with the way Prosperity and Frost are funded. What do those liabilities cost? And
how do they reprice with higher interest rates? That’s what determines their expenses in different
interest rate environments. Frost happens to be set up in a way where it has unusually low
expenses when interest rates are high. Prosperity isn’t set up that way.
So whenever the odds of the Fed raising rates higher sooner goes up – Frost stock should sprint
out a little ahead of Prosperity. Over time, Prosperity’s a good bank with a great management
team. So, Prosperity can be priced right by the market and still outperform Frost. But, let’s think
about day-to-day changes in market expectations. If those expectations suggest higher rates
sooner, then Frost should do better on that day than Prosperity. It doesn’t. Historically, if you
look for days on which the two stocks react to the Fed – they move almost in perfect lockstep.
Nothing in the price movement of the two stocks suggests that one benefits more from a higher
Fed Funds Rate than the other.
That’s the kind of misunderstanding you are looking for. When I was buying into Frost, the
market seemed to be mispricing Frost and Prosperity in the sense that it didn’t care one was more
interest rate sensitive than the other. I thought they were both good stocks to buy. But, I also
thought the market understood Frost worse than it understood Prosperity.
NAACO is a coal miner with a different business model than other U.S. coal miners. So, you
want to study this stock ahead of the spin-off and then follow it closely to see if NAACO is
priced in line with other coal miners. It shouldn’t be. Day-to-day NAACO’s share price
shouldn’t rise and fall exactly in line with other coal miners. If it does, the market is probably
misunderstanding the situation. It may think NAACO is just another coal miner the way the
market seems to think Prosperity and Frost are both just Texas banks so there’s no need to
consider which is more interest rate sensitive.
With coal miners, the market should be trying to figure out which miners are more sensitive to
fluctuations in the price of coal as a commodity. NAACO is set up to be insensitive to the price
of the commodity. So, for the market to price NAACO correctly – it’ll need to price it differently
from other coal miners.
When you catch the slightest whiff of a possible misunderstanding like that – you need to focus
100% of your research efforts on the situation. Right now, my advice is to focus on
understanding NAACO and Hamilton Beach. You may not get the price you want to buy either
stock. But, you will learn about two businesses that the market has a higher chance of mispricing
compared to most stocks.
 URL: https://www.gurufocus.com/news/570212/how-to-zero-in-on-misunderstood-stocks
 Time: 2017
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In the Long Run, a High-Growth Stock Has to Be a High Return on Capital

Stock
I recently received a couple questions about how to screen for “compounders” and whether it is
better to look for a high growth rate or high return on capital.
First, we need to remember one basic principle. A company is limited to growing at a rate similar
to its cash return on assets (really its incremental return on its net tangible assets) or to using
outside financing. It is the incremental (cash) return on its own assets that matters. The
reinvestment of these cash earnings relative to assets is what fuels the company’s growth rate. If
the company runs out of this fuel, it will need to borrow money, issue shares or stop growing.
There is no way around this reality.
That is something we can know rationally. Now, we can move on to something you would only
be able to discover experimentally.
It is worth noting two statistical (screening) tendencies here.
One, screening for growth stocks normally also turns up high return on net tangible asset stocks
because of this relationship between growth and return on net tangible assets. Today’s return on
net tangible assets is what fuels tomorrow’s growth. So if you look at companies that have grown
the most, they tend to be companies that had the most fuel available to grow.
Two, companies that increase assets tend to see returns on those assets decline, while companies
that decrease assets tend to see returns on those assets increase. For a normal company, returns
on assets are often lowest right after growth in assets had been highest.
It is possible to find many, many companies with high returns on net tangible assets while having
almost no growth. I will use an example: Dun & Bradstreet Corp. (DNB, Financial). The
company has a 15-year return on capital (calculated using the magic formula) of somewhere in
the 100% to 1,000% range every year, yet a revenue growth rate of just 2%. Note, though,
revenue per share growth was over 7% for those 15 years, which actually makes Dun &
Bradstreet not an especially slow-growth stock despite being a no-growth business. In this case,
we can assume the business - in real terms - has truly not grown at all in 15 years. There is
basically no reinvestment opportunity at all. So the corporate top line has grown just 2% a year
and the sales per share have grown a little over 7% a year.
The stock itself has outperformed the S&P 500 over the last 15 years (12% a year versus 4% a
year). So it is possible for a no-growth business with very high profitability to beat the market. It
is unusual, though. I consider Dun & Bradstreet the most unusual example I could possibly come
up with. The business has literally no growth. Returns on capital are close to infinite. The capital
allocation reflects this by simply returning all capital. This capital allocation approach is so rare,
it is often better to look for companies with high returns on capital and some place to put that
capital. Most boards would not just plow all their free cash flow into buying back their own stock
like Dun & Bradstreet does. They would try to go out and acquire stuff.
Can we find a true growth stock that is not a true "quality" stock?
That is harder to do. The best I can come up with is Micron Technology Inc. (MU, Financial).
The company has grown sales by 15% a year for 30 years. That certainly qualifies it as a growth
stock.
Regardless, some factors suggest Micron may be "high growth" but not "high quality." For
example, I said revenue at the company grew 15% a year over 30 years. However, sales per share
grew only 13% a year over 30 years. The stock's return has been 12% a year. Certain assets, like
inventories, have grown much faster than revenues and profits. Inventory has grown 19% a year.
Property, plant and equipment has compounded at 20% a year. We can use Joel
Greenblatt (Trades, Portfolio)'s magic formula approach to calculate return on capital here. Over
30 years, the arithmetic mean is 15% and the median is 5%. Especially in a series like this, the
arithmetic mean far overstates the actual return on capital trend over 30 years. It is probably
much closer to 5% than 15%.
If Micron's internal rate of return is too low to support the level of growth the company achieved
over the last 30 years - where did it find a source of funding for that growth?
Between 1999 and 2001, Micron issued $1.5 billion worth of stock. Some of this stock was
issued at prices higher than where the stock trades today (17 years later). So it took advantage of
a bubble to shift money from mutual funds into semiconductor property, plant and equipment
and inventory. The company briefly paid dividends for a few years in the 1990s, but has not paid
them since. In addition, it had not bought back more stock than it issued until the last couple of
years (really 2015 to 2017).
It also made use of debt at various times. Net debt has grown about 15% a year over the last 30
years.
Now, the end result of all of this - if you held Micron stock for the full 30 years - is a return of
about 12% a year. So you would get a growth stock return over the long run. And that is despite
me saying the business is not high quality and should not be capable of self-funding growth of
12% a year indefinitely.
Does this mean I was wrong?
At first, it seems so. But let’s dig deeper into Micron’s past to see if we can prove my larger
point that only when return on capital is high can a company safely keep growing at a brisk pace.
Micron did survive the entire 30-year period despite growing debt the way it did. The Altman Z-
Score would predict bankruptcy was imminent in 2008-09 (it was 0.4 to 0.5 for about two years
with a Piotroski F-Score of 2), yet Micron recovered.
There is also the possibility we are - right now - at about the top of the cycle in Micron's
industry. This would skew all my calculations severely. For example, if you sold Micron stock
12 months ago after holding it for 30 years, you would have a 9% annual return, not a 12%
return like you would today. If you sold it 18 months ago, you would have gotten a 7% return
over 30 years instead of a 12% return today. However, this is mostly an issue with the stock
performance rather than the business performance. Yes, if I did the same calculation a year ago
or so, you would get about 1% less in your compounded growth calculation for sales and other
metrics over the last 30 years. That is far smaller than the huge difference in your long-term
return as a shareholder, depending on whether you sold the stock two years ago or still hold it
now.
By some measures, the business has done even better than the stock. EBITDA has grown by
probably 13% a year over the last 30 years. That could certainly support a stock return of 12% a
year over 30 years with no problem. However, as I pointed out, some asset items like property,
plant and equipment have grown very close to 20% a year.
That is a disturbing trend. It is also inconsistent with the point I made at the start of this article:
you need a high return on capital to maintain a high growth rate.
So what is the story with Micron? Is this a cyclical blip?
Does it only appear that Micron has compounded value at growth stock-level rates (12% a year
over 30 years) despite having poor returns on capital because we are measuring during a great
period for the industry?
Micron had a better stretch from 1993 to 1997 (in terms of return on capital) than it has had from
2013 to 2017. So this high five-year average ROIC by Micron's standards (12% by the
Greenblatt method) is not a once in 30 years occurrence. It is more like a once in 15 years
occurrence. In the mid-1990s, Micron hit a five-year average return on capital of about 30%.
That would self-fund growth of 20% without any problem. But that period happened once and
lasted five years. Today, it is having a five-year period that would fund growth of 8% a year
without any problems.
So it makes sense Micron could grow a lot in the 1990s (20% a year without any problems), and
it makes some sense Micron could grow at around 8% a year today without any problems. But it
has grown faster than that.
For example, Micron's return on capital so far this millennium (2001 to 2017) has been so poor I
would predict it could only sustainably grow at low single-digit annual rates. In fact, it has grown
sales per share at just 1% a year from 2000 to 2017.
Now, it might be unfair to measure from the top in 2000 to today.
If we used the previous peak in revenue per share (1996) and measure to today, we would get 3%
annual growth in revenue per share. If another cycle peak is happening now, that is a good
measure of Micron's normal growth rate over 20 years.
Wait? How did Micron grow 12% a year over 30 years but only 3% a year over the last two-
thirds of that period? What happened?
The truth is, I think Micron's growth fits with my points about return on capital. From 1988 to
1997, my way of thinking about return on capital would lead you to the conclusion that -
provided there was enough growth in Micron's area of the economy - the company could grow
about 25% a year without issuing stock or borrowing. If there was a little borrowing in there or
taxes were lower than I expected or something, you would quickly get to an eight-fold increase
in the company's size from 1988 to 1997.
Then, based on the return on capital after that point (1998 to 2017), I would say Micron would be
completely dead in the water. It could self-fund growth of only about 3% a year (after some
taxes) and the stock should badly underperform the S&P 500 no matter how fast the area of the
economy it was growing in.
If you look at history - even here - the growth record matches up with the return on capital record
in a way that says return on capital fuels growth. The stock returned about 35% a year for 10
years, while return on capital suggests after-tax ROE should be 25% or better (that is the late
1980s through 1997). And then the stock returned about 2% a year over the next 20 years while
return on capital suggests after-tax ROE should be about 2.5% a year.
The company has tended to put everything it can back into the business. In the 1980s and 1990s,
it could put something like 25% or more of its book value every year back into the business.
Since 1997, it has really only been able to put something like 3% of its book value back into the
business every year. In both cases, Micron was trying to grow as fast as it could. Only, the
economics of the business (the return on capital) meant the fastest you could grow was over 25%
in the 1980s and 1990s and then well under 5% in the 2000s.
The lesson of Dun & Bradstreet versus Micron is a particularly important one. There certainly
was not more growth in demand for Dun & Bradstreet's services from 2002 to 2017 than there
was for Micron's products. In fact, Micron's corporate revenue grew much faster than Dun &
Bradstreet's corporate revenue (13% versus 2%). The difference, however, in revenue per share
growth (9% versus 7%) was much smaller because Micron issued shares while Dun & Bradstreet
bought them back. The latter also - starting in 2007 - paid out 4% of its sales in dividends.
Micron did not pay any dividends.
So it is no surprise Dun & Bradstreet's stock grew 8% a year in price over the last 15 years while
Micron grew only 5% a year. That does not include dividends (which the former did pay and the
latter did not). Additionaly, it does not make any adjustment for the fact I am measuring a period
that ends with Dun & Bradstreet stock down 18% over the last 12 months while Micron is up
105%.
This is the most extreme comparison I could come up with of a company that has all the growth
potential but no return on capital to back it up (Micron), versus a company that has all the return
on capital imaginable but no growth potential (Dun & Bradstreet).
The only time Micron could be a better investment than a company like Dun & Bradstreet was
when the company was also a high return on capital stock. In its best period, the company had
something like 25% unleveraged returns on equity for about 10 years. That is a high return on
capital.
I have said before that once you find a stock that has about a 30% return on capital (so about a
20% after-tax unleveraged return on equity in the U.S.), you do not need to worry about ROC
beyond that. Once you have that, worry about whether it can grow. You do not need more than
20% a year ever.
But - and here is the problem for Micron - I have also said that once you find a stock with a sub-
15% return on capital (so worse than a 10% after-tax unleveraged return on equity in the U.S.),
you do not need to worry about growth. The only thing you need to worry about is return on
capital because no amount of growth at less than a 10% unleveraged return on equity is going to
be worth passing up no-growth but high-quality companies like Dun & Bradstreet or average
growth and average quality companies like the S&P 500 as a whole. Think of it this way: how is
reinvesting at a 9% or worse annual rate of return any better than just paying you a dividend?
In practice, long-term growth companies have to be long-term, high-quality companies. The

return on capital is what fuels growth. A business can only run on fumes for so long before its
growth rate plummets toward the rate of return it gets on its own business.
Return on capital is always a limiting factor for a growth stock, as we saw here with Micron.
So what tends to happen is a stock like Micron will show up on both "growth" and "quality"
screens in the 1990s and then drop off both screens in the 2000s.
 URL: https://www.gurufocus.com/news/569717/in-the-long-run-a-highgrowth-stock-has-
to-be-a-high-return-on-capital-stock
 Time: 2017
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Why Money Managers Don't Own Net-Nets And Why You Should
Someone emailed me recently about net-nets. He found my old post:
“How Did Mohnish Pabrai Not Make Money in Japanese Net-Nets?”
Reading that email, reminded me I haven’t written about net-nets in a while.
I used to write about them a lot.
I've written a lot about net-nets and looked at them a little in Japan and a lot in the U.S. I've done
some backtesting over the years, briefly wrote a net-net newsletter for GuruFocus, and have
emailed ideas back and forth with many blog readers, article readers, and just individuals I know
(some of who are bloggers) about net-nets. So, I think I have a pretty good idea of not just what
net-nets are out there but more importantly how individuals actually do investing in them.
Net-nets can be a good choice for individual investors precisely because they’re not a good
choice for money managers. Money managers don’t like net-nets. They don’t like focusing on
them. You’re not constrained the way money managers are – so you can focus on net-nets.
Why Money Managers Don’t Focus on Net-Nets
Net-nets are not a good choice for money managers to focus on for four reasons:
1. It can sometimes be hard to put enough money in each idea. Though this problem is
smaller than it might seem for many funds. In the U.S., we can assume any fund would be
perfectly comfortable owning 4.9% of a stock for all purposes except liquidity. Liquidity
shouldn’t be a concern at all for an individual investor (since this is money you don’t need now
and are saving for retirement – it’s okay to lock it up for years at a time if necessary). And 20
positions is adequate diversification. Ben Graham himself suggested 10-30 for this kind of
strategy. So, basically a pure net-net fund would be able to invest in companies up to its own
size. In other words, if all the good opportunities in net-nets are in companies bigger than $10
million in market cap and smaller than $100 million in market cap – then a pure net-net fund
should also be $10 to $100 million in size itself. A lot of money managers hope to one day
manage more than $10 million to $100 million in assets. That’s not going to work well if you’re
focused on net-nets. In fact, a smaller fund size – like $30 million total – is likely to work best.
However, even under something as generous as a 2 and 20 type fee structure, such a fund would
only generate maybe $1 million to $1.5 million a year in total fees for the people managing it.
Again, this assumes good performance and a really generous fee structure. That sounds like a lot
of money to make managing a fund. But, it’s capped. The strategy doesn’t scale up. So, I don’t
see how you’d ever end up generating much more than $1 million to $1.5 million a year in fees
no matter how successful you were. If you did end up generating more fees, it’d probably be due
to having grown assets so much you’d severely hurt the future performance of the fund. So, a
worldwide net-net fund with $30 million in assets is definitely doable. If done right, it should be
really successful. And it could definitely produce over a million dollars in fees for a hedge fund
run that way. But, it could never – if successful – be a $300 million fund generating $10 million
to $15 million a year in fees. The strategy can’t scale up. This makes no difference to an
individual investor. It makes a huge difference to a money manager. Most strategies money
managers use could one day generate 10 times the fees they now generate if the fund is
successful. A net-net strategy can’t.
2. Net-nets are illiquid. A fund would have trouble TRADING net-net stocks even if it didn't
have trouble investing in them. For this reason, a pure net-net fund wouldn't want to be an open
end mutual fund. It could be a closed end fund. It could be a fund with permanent capital (like
that provided by an insurer) or it could be a fund like the Buffett Partnership that only allowed
investors to withdraw money once a year. Buffett also didn't tell his partners what they were
invested in. Graham Newman was a closed end fund. It could have been much, much bigger. In
fact, Graham Newman actually traded above net asset value at times because investors put a
premium on the closed end fund instead of a more typical discount. Ben Graham could have
managed much more money than he chose to. His goal was not to maximize assets under
management. So, net-nets were a good choice for Ben Graham. He wanted to maximize
performance in percentage terms and in consistency terms. He didn’t want to maximize his own
fees.
3. Net-nets don't appeal to most kind of fund shareholders. So, the actual individuals and
institutions that might give a money manager capital aren't that excited by net-nets. Even if they
are excited by them as a concept, they aren't excited once they see the actual stock list. So, it
could be as hard or harder to attract money to this strategy as a more typical strategy and
investors would definitely tend to pull their money fast if allowed to.
4. Net-nets don't actually appeal to most kinds of fund managers. Here, I think is the actual
Pabrai problem. I think there were two problems. One, Pabrai likes managing a lot of money. He
doesn't want to refuse people the opportunity to invest with him, doesn't want to return capital to
people, etc. He wants to make a lot of money for himself and to give away a lot of money to the
causes he believes in. That's fine. More assets under management also raises your profile and
does other things some fund managers might want. Second, Pabrai is a very successful fund
manager and often a very concentrated one. He likes having big, quick upside in some of his
ideas. And that's worked well for him. The net-net approach is usually to spread your bets around
- even if you wanted to concentrate in a few net-nets, it can take time to build up positions to the
size you want - and they often lack catalysts. I don't think Pabrai was well suited to investing in
net-nets. His approach is much closer to the Buffett partnership and Munger partnership
approaches than to Ben Graham's approach.
Graham was running much more of a true hedge fund. He was looking for a way to reliably
provide adequate returns to investors regardless of what the market did. Pabrai wants to
compound his money as quickly as possible.
Finally, there’s the question of whether you can actually buy net-nets. Can you get the shares you
want? Not in theory, in some backtest. But, in practice. Will someone actually sell you enough of
the stock you want to fill up your portfolio?
I’ve found this problem to be exaggerated.
I'm not a fund manager. I'm an individual investor. I've only ever put a hundred thousand dollars
into a single net-net, not a million. So, I'm not a good person to judge putting large sums to work
in net-nets. However, I have actually bought very illiquid stocks. So I have some practical
knowledge of the subject – buying illiquid stocks as an investor, not as a trader.
In my practical experience, historical volume hasn't proven to a good indicator of:
 The amount of stock I could buy / sell

 How quickly I could buy it / sell it
 And how much my bid/offer would affect the share price
In the most illiquid stocks I've bought: I've generally found that I could buy more shares, get
those shares quickly, and do so at prices equal to or below what the stock had last traded at. This
is anecdotal. But, I've always gone into illiquid stocks with a calculation that I would have a lot
of my return shaved off through various frictional cots that never materialized.
The caveat here is that I'm never in a hurry to get into or out of an illiquid stock. I'll just name an
exact price and wait all month. But, I've both bought and sold anywhere from an average day to
an average week's worth of stock in a single trade and done so without the last trade price being
changed by my trade even a penny.
I assume the reasons for this are:
1) I name a price and leave it - I don't adjust my bid or offer up or down day-to-day within any
given month
2) I offer to buy or sell my entire position at once - I never look to deal in smaller amounts
If you look at the Buffett partnership, he seems to have often spent months buying a position,
sometimes bought it in blocks form large sellers, etc. So, I'd caution investors to focus on:
1) The smallest net-nets
2) The highest quality net-nets
3) And especially: the most illiquid net-nets
I've had a lot of success with illiquid stocks in all sizes. In fact, from stocks in the $15 million
market cap range to the $1.5 billion range (so, there I mean super illiquid by big stock
standards), I've found some of my best success buying stocks with the lowest percent of freely
floating stock, the least frequently traded shares, etc.
In fact, I'm not really sure whether you should want to buy a highly liquid net-net. I've said
before that some stocks are cheap because of "contempt" and some stocks are cheap because of
"neglect". The best net-nets are the unknown, neglected ones. Net-nets that are well known
would have to be very disliked to be net-nets. Or, occasionally, they might be businesses with a
ton of working capital and very low returns on that working capital - so Ingram Micro
(IM) could be a net-net at times because inventory and receivables are almost all of assets and
the return on assets is low. That’s a huge business that ties up almost all its equity in low-
returning working capital. As a result, it sometimes qualifies as a net-net. But, big stocks like that
which can slip into net-net territory are rare.
Finally, as far as your possible rules for net-net investing, I'd caution to re-balance as
infrequently as you're comfortable with and especially not to sell when a stock reaches NCAV.
So, for example, three rules for selling might be:
1. Only evaluate a net-net for sale every 2 years
2. Sell the net-net completely if it exceeds 100% of NCAV on the day the net-net is scheduled
for you re-evaluate
3. Sell the net-net partially to the reach the targeted portfolio weighting of a normal position on
the day you re-evaluate
In other words, if you want to put 5% into 20 different net-nets, you'd need to re-evaluate 2-3
net-nets a quarter. That's a reasonable amount of selling to be doing. It's not going to be that
beneficial to sell net-nets really quickly. For one thing, bad momentum in the stock's price is one
reason these things got cheap. So, once they start moving up - why not hold on to them for a
while (since they are still very cheap even while blowing by 100% of NCAV) and save yourself
the trading activity?
I really think it's not necessary to re-evaluate net-nets more than once every 2 years. I don't
advocate holding net-nets for 10 years. But, I think trading them the way Ben Graham did
and Warren Buffett (Trades, Portfolio) did means something much closer to a 3 year holding
period on average where some might sell in 1-2 years and some might be held 5-6 years. The
good returns will often be in the stocks where something happened quicker. But, the stock
doesn’t know you own it. So, why sell it just because you’ve owned it for longer than you would
have initially hoped to own it for?
I also think it's really important to be open to the possibility of holding net-nets beyond the 100%
of NCAV level. If you sell right at 100% of NCAV, you are capping your gains at a low level
and you're selling a fundamentally cheap stock (1x NCAV is still absurdly cheap for most kinds
of companies) that has now started moving up in price, getting noticed by others, etc. - why do
that?
So those would be my only suggestions. Illiquid stocks are a good choice and trying to get
comfortable with holding net-nets for a couple years at a time is also a good idea. The one bad
aspect of net-nets for value investors is that they seem to encourage these value investors to
adopt more of a trader's mindset than they would have if invested solely in higher quality
businesses.
 URL: https://www.gurufocus.com/news/525843/why-money-managers-dont-own-
netnets-and-why-you-should
 Time: 2017
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Pick the Winners First Worry About Price Second
I buy very few stocks. Right now, 65% of my portfolio is in two stocks (Frost and BWXT). And
30% of my portfolio is in cash. So I’m less fully invested than most investors want to be. And
I’m less diversified than most investors want to be.
Why is that?
Most people who email me asking about the subject of concentration – and that’s the topic I get
asked about the most – assume I put so much of my account into my best ideas because they
offer the highest returns.
They imagine I do a calculation where stock A offers 10% annual returns, stock B offers 15%
annual returns, stock C offers 20% annual returns, and stock D offers 25% annual returns. The
typical value investor would then put equal amounts into stocks B, C, and D because they all
clearly offer above average returns. Meanwhile, I choose to only buy stock D – because that way
I avoid watering down my returns.
That’s not why I concentrate.
To understand why I concentrate, think of a horse race.
We can ask two questions about a horse race.
Question #1: Which horse is likely to win this race?
Question #2: Which horse offers the best odds?
If you were forced to bet on a single horse race, only the answer to question #2 should drive your
decision. You don’t need to know who the favorite is. If the favorite pays 6 to 5 and you know
his likelihood of winning isn’t high enough to justify such a low payout, you shouldn’t bet him.
Meanwhile, if you find a horse that pays 20 to 1 and you know he should be priced at 5 to 1, you
should bet that horse even though you know he has a low probability of winning the race.
This horse race approach translates well to the stock market if we are talking about simple,
special situations. It works perfectly for things like merger arbitrage.
It doesn’t work for buy and hold.
To understand why not – consider the difference between the decision to buy a race horse and
the decision to bet on that same race horse.
What’s the big difference in your analysis?
I would say the huge difference is evaluating the possible payouts. It’s easy to bet a horse in a
specific race based on the odds – because we have a good understanding of the possible payout
for each and every horse. It’s hard to know which horse to buy based on the odds – that is, to
intentionally buy a lesser horse because he’s cheap enough to offset his lower quality – because
it’s hard to know how big the lifetime payout from racing and breeding a really great horse
would be.
Let me illustrate this point with two stocks I’m on the record picking back in 2006. I made these
picks about 10.5 years ago. I didn’t intend them to be buy and hold picks. Certainly, I never
imagined someone would calculate the performance of those picks over more than a decade. But
that’s exactly what I’m going to do now.
One pick was Posco. The other was Hanesbrands. Hanesbrands was a spin-off. So, I’ll use that
spin-off date as a convenient measuring point for both. In the 10.5 years since that day,
Hanesbrands has returned 15.5% a year. Posco stock has returned 0.3% a year in dollar terms
(it’s a Korean stock). That means an initial investment of $10,000 in Posco has now become
$10,291. And an initial investment of $10,000 in Hanesbrands has now become $45,406.
Hanesbrands is not some sort of phenomenal growth company. And 10 years is hardly a lifetime.
For example, the difference between buying $10,000 worth of Omnicom (OMC, Financial) in
1997 or its ad agency rival Interpublic (IPG) and holding that stock for the next 20 years is the
difference between now having $15,570 in Interpublic stock or having $74,629 in Omnicom
stock.
The payouts for holding the right stock – not buying it, but actually holding it – are so big that
it’s often difficult to believe the retrospective “fair value” for a stock. In the Omnicom example I
just gave, a backwards look now shows that Omnicom needed to trade at a P/E ratio that would
seem absurd for it to return the same amount as the S&P 500 over the next 20 years. In the years
1996 through 1998, Omnicom tended to trade at a P/E no lower than 20 and no higher than 40.
That sounds expensive. The highest priced day I can find for the stock in those years was August
21st, 1998. Let’s say you bought Omnicom on August 21st, 1998 and held it through today.
What would your annual return be? Over the next 19 years, your annual return would be 6%.
But, that’s buying a high P/E stock on the most expensive day of its most expensive year. What
did the S&P 500 do since that same day? The market has done 4% a year over those 19 years
since August of 1998.
What does this prove? I found a stock I knew was a long-term winner. Then, I went back in time
and tried to find the worst possible time to buy that stock. Even so, it outperformed the market if
held long enough.
That last phrase “if held long enough” is key. It’s not hard to find points where a winner’s high
price was enough to cause it to underperform the stock market. For example, Omnicom has done
worse than the market over the last 5 years. If you hold a winner long enough, though, it
becomes difficult to find any points where buying it would cause you to lag the market.
I’m not saying you should pay 30 times earnings for a heavy favorite. True, if you pick the right
business – a true long-term winner – at a P/E of 30 and hold it forever, it will eventually beat the
market. But, that still seems a bad bet to me.
What’s a good bet?
Start by looking for the long-term favorites. Instead of searching for the best odds – first find the
true favorites. What Warren Buffett (Trades, Portfolio) called “The Inevitables”:
“Companies such as Coca-Cola and Gillette might well be labeled ‘The Inevitables.’
Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-
equipment business these companies will be doing in ten or twenty years. Nor is our talk of
inevitability meant to play down the vital work that these companies must continue to carry out,
in such areas as manufacturing, distribution, packaging and product innovation. In the end,
however, no sensible observer - not even these companies' most vigorous competitors, assuming
they are assessing the matter honestly - questions that Coke and Gillette will dominate their
fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen.
Both companies have significantly expanded their already huge shares of market during the past
ten years, and all signs point to their repeating that performance in the next decade.”
 Warren Buffett (Trades, Portfolio)’s 1996 Letter to Shareholders
Once you’ve identified a true long-term favorite, pick the right time to buy it.
In other words, don’t start by saying “I have to buy a stock today, which stock offers the best
odds right now?” Instead, say “I have to buy a long-term favorite eventually, is today the right
day to buy one?”
If you insist on buying something today, you can’t also insist on buying the right merchandise.
And if you insist on buying the right merchandise, you can’t also insist on buying something
today. Something will always be on sale. And the best merchandise will one day be on sale. But,
you can either start by saying “I want to buy something today” or you can start by saying “I want
to buy the right stock eventually”.
The frequency with which you insist on adding a new stock to your portfolio is actually a
constraint on your ability to add top-shelf merchandise to your collection.
There are 3 ways an investor can compromise:
1. He can compromise by paying a higher price than he’d like to

2. He can compromise by buying a lesser quality business than he’d like to
3. He can compromise by not buying anything when he’d rather own something
You could use these 3 compromises as a test of what kind of investor you are.
A growth investor – like Phil Fisher – compromises by paying a higher price than he’d like. He
won’t compromise on quality. So, he has to compromise on price. A value investor – like Ben
Graham – compromises by purchasing a lower quality business than he’d like. He won’t
compromise on price. So, he has to comprise on quality. Finally, a focus investor – like me –
compromises by not owning any stock when he’d much rather be 100% invested.
I always want to be 100% invested. But, if you insist on two criteria:
1. Never compromise on quality

2. Never compromise on price
You have to compromise on:
1. Never being as fully invested as you’d like

2. Never being as diversified as you’d like
That’s a natural consequence of there being few chances to buy high quality at a low price.
Let’s assume you are willing to stress “patience” and “focus” over “value” and “growth”. You
will sometimes buy the same stocks a growth investor would or a value investor would.
However, if you stay true to your patient, focused approach – you should end up owning better
businesses than the value investor and buying them at lower prices than the growth investor. The
trade-off for you will be holding some cash at times and holding more of each stock than you
might want. A patient, focused investor simply can’t make enough decisions to own enough
stocks to be well-diversified all the time.
So, how can you implement such a strategy? How do you start looking for “inevitables”?
One, you look for the right industries. Some industries are more likely to produce long-term
winners than other industries. For a patient, focused investor looking for long-term compounders
to buy and hold – I’ve got 5 industries to recommend searching in right now:
1. U.S. banks
2. Advertising agencies
3. MRO distributors
4. Athletic apparel brands
5. Travel websites
Let’s start with U.S. banks. I’ve written reports about 5 of them:
1. Frost (CFR, Financial) – which I have 40% of my portfolio in

2. Bank of Hawaii (BOH)
3. Prosperity (PB)
4. BOK Financial (BOKF)
5. Commerce Bancshares (CBSH)
I was recently asked in an interview why I liked Frost. My answer explains why U.S. banks as a
group are a good place to find long-term compounders:
“The deposit side of banking is…as non-commodity and non-competitive as a business gets.
Customer retention is very high in this industry. For example, Frost retains about 92% of
customers from year-to-year…And unlike insurers, banks tend not to have problems retaining
customers even when they offer interest rates that are clearly lower than their cross-town rivals.
I think a bank can ‘lose’ an existing depositor to another bank. I’m not sure a bank can ‘take’ an
existing depositor from another bank. A satisfied depositor never really enters ‘search mode’, so
they aren’t going to be stolen away as long as the bank they’re at treats them right. Deposit
share shifts are glacial and close to infinitesimal even when one bank clearly has a better
service than another bank. So, the deposit side of U.S. banking just isn’t a competitive industry.
Banks keep the depositors they have out of habit and those depositors add to their accounts
every year. That’s where almost all growth comes from. And it’s not growth banks have to
compete for.”
This same dynamic – extremely high customer retention – helps explain why I also like ad
agencies (which have even higher retention rates than banks do with their depositors) and MRO
distributors.
The big ad agencies are:
1. Omnicom
2. WPP
3. Publicis
4. Interpublic
5. Dentsu
But, there are many other publicly traded ad companies around the world that you can find.
The 3 MRO distributors you should start with are:
1. Grainger (GWW, Financial)
2. MSC Industrial (MSM)
3. Fastenal
I’ve written reports about Grainger and MSC. Fastenal is also good. It just wasn’t cheap when I
was writing my newsletter.
Athletic apparel brands have proven to be amazing long-term compounders. Lou
Simpson (Trades, Portfolio), the former portfolio manager at GEICO, liked Nike (NKE) best of
all the stocks he owned over the years.
Four athletic apparel brands stand out right now:
1. Nike
2. Adidas
3. Lululemon
4. Under Armour
On price – EV/Sales is usually how you should value a durable brand – Under Armour is the
most interesting right now. The company’s non-voting C shares (they trade under the ticker UA
– not UAA) are usually the cheapest way to invest in Under Armour. So, if you ever do buy into
that company – buy the shares with the UA ticker not the UAA ticker.
There are a bunch of publicly traded travel websites out there like:
1. Expedia (EXPE)
2. TripAdvisor (TRIP)
3. Ctrip (CTRIP)
4. Priceline (PCLN, Financial)
Priceline – which really consists of Booking.com as its key asset – is the company that seems to
have the most certain long-term future. These companies are spending a lot on ads, developing
apps, etc. There are signs of customer loyalty – simply out of habit – and network effects
developing in this industry. Meanwhile, the proportion of hotel rooms booked online (which are
now less than half of all rooms in the world) seems certain to double in the next decade or two.
How many industries are likely to more than double in size relative to the global economy over
the next decade or two? And how many of those industries are likely to have the same leaders in
a decade or two as they do today?
So, now you’ve found some industries you think are clear long-term favorites. Maybe within
those industries you’ve even found the specific companies you think are long-term favorites.
What do you do?
You wait.
If you are sure these industries are better than average and these companies are better than
average – you can buy the stock you like most on a very simple valuation basis. When the stock
you like trades at the kind of price a “normal” stock usually trades for – buy it.
So, if a normal stock usually trades for 15 times earnings – wait till the stock you like gets close
to that level (precision isn’t important here) and then pounce. It rarely happens. Most of the time,
you’ll find there’s nothing to buy. But, if you have your list ahead of time and you don’t settle
for buying lesser stocks now – you will have the cash on hand to buy the right stock at the right
price.
Just not today.
 URL: https://www.gurufocus.com/news/525828/pick-the-winners-first-worry-about-
price-second
 Time: 2017
-----------------------------------------------------
Why I Only Own 5 Stocks at a Time
One of the biggest differences between my own investing and what readers really get from what
I write about is the importance of concentration.
People who read my articles put less in the stocks they like than I do. In fact, I haven’t met
someone who bets bigger on the ideas they like most than I do. This has huge implications for
my own investment returns versus the investment returns someone reading and even copying my
stock “picks” gets. For example, I invested in Weight Watchers (WTW, Financial). I bought the
stock probably around $37 per share and sold it probably around $19 per share. I think it touched
$4 per share somewhere in there. For the average people reading my blog, my GuruFocus
articles, etc., and acting on the ideas I had – this would be a big loser as a stock, but it wouldn’t
be a big loser for their net worth. I put 25% of my net worth into Weight Watchers. I lost more
than 12% of everything I owned on this one stock when I finally sold it. The “paper” loss was
even bigger at one point. I probably lost something like 23% of everything I owned on paper.
I don’t have a problem with this. A lot of people do. It’s important to understand if you are the
kind of person who does have a problem with losing anywhere from 12% to 23% of your net
worth on a single stock-picking mistake.
I should say here that we are not talking about what is right and what is wrong mathematically. I
know I’m right mathematically and other people are wrong on this one. There’s just no way that
putting 2% of your portfolio into each stock instead of 20% into each stock can possibly make
sense. I use equal-sized positions of about 20%. I’ll explain in a moment why I do it exactly that
way, but Â the exact sizing I choose is not really important. What matters is that I never do 2%
positions or 5% positions, and I have done 20% and 50% positions. I’ve done 50% positions
rarely and I’ve never suggested anyone but me go over 50%. Still, what we’re talking about is an
“order of magnitude” type difference. That’s what I want to focus on. Should you ever make 2%
bets? Should you ever make 20% bets? My opinion is that 2% bets don’t make any sense and
20% bets do make sense – and that there are pretty much no circumstances under which it would
make sense to bet just 2% of your portfolio on something.
Now, I will admit that buying 2% of a specific security might make sense if you were using a
basket of stocks as a single decision. For example, when I was buying Japanese net-nets, I went
looking for five to 10 net-nets trading in Japan in which I could put about 5% of my portfolio
individually and thus 25% to 50% of my portfolio as a group operation, but it’s very important to
note that this was always conceived of as a 25% to 50% bet on a basket of Japanese stocks that
met two criteria: 1) They had 10 straight years of positive profits, and 2) they had a negative
enterprise value.
I didn’t understand the businesses, the management teams or the industries they were in. I
diversified that risk by looking for 5 to 10 such stocks in which I could put 5% to 10% of my
portfolio. I didn’t feel I was sacrificing selectivity for diversification because I didn’t know how
to tell one Japanese net-net from another. They all shared the risk of being denominated in yen
instead of dollars, and then they had specific risks related to capital allocation, industry
economics, competitive positions, etc. Since I don’t read Japanese and don’t know Japanese
business culture well enough to tell one Japanese company from another in these respects – it
made sense to simply buy them indiscriminately if they met basic quantitative criteria.
The two criteria I decided on were a required combo of negative enterprise value (that is, the
company had to be selling for less than the cash it would have after settling all its liabilities) and
10 straight years of profits. I knew that any company anywhere in the world that met both those
criteria and wasn’t a fraud would eventually trade for more than the price for which it was
selling. Diversifying across five to 10 “sure” purely quantitative bets made sense to me.
Some people still consider this a moment where I diversified more than usual by taking 10%
positions or even 5% positions. I don’t see it that way. I didn’t attempt to pick one of these
Japanese stocks over another so I wasn’t diversifying in the sense of making more stock picks
than a concentrated investor. Yes, there were more stocks in my portfolio, but I wasn’t “picking”
more stocks. I picked the strategy of buying negative enterprise value Japanese stocks with at
least 10 straight years of profits. Once I picked that strategy, I basically just bought everything I
could identify that fit the strategy. I would have been willing to buy four such Japanese stocks or
40 such stocks. Statistically, there’s really no point in buying 400 such stocks even if they do
exist. A sample of 40 isn’t going to be much different than a full population of 400 – if such a
population existed. It didn’t. I went through the Japanese stock exchanges manually – so I might
have missed a few negative enterprise value stocks with 10 straight years of profits, but I knew
there were closer to 10 such stocks than 100 or 1,000.
Let’s stick with this theme of big differences in size rather than small differences in size. What is
the ideal portfolio size? If you’re right, it’s obviously one stock. In the long run, a group of 100
know-something investors will compound capital the fastest by each betting on only one stock at
a time. Some will go broke. Not as many as you’d think (because few will fail right out of the
gates, and early successes can give you room for miscalculations later). But, yes, some will fail.
Investors obviously don’t want to end up with zero. You only live once. You only save for
retirement once. You can’t comfort yourself by saying that a group of 20 one-stock portfolios
will beat a group of 20 three-stock portfolios. You might be that one out of 20 that goes to zero.
What is the right number of stocks in a portfolio?
I use a five-stock portfolio. Warren Buffett has said that’s roughly what he and Charlie
Munger (Trades, Portfolio) liked to use when they were running their partnerships. What he
seems to have meant by this is that 80% to 90% of his portfolio was in five or fewer ideas. Since
I use a five-stock portfolio, let’s think in terms of powers of five. We already considered a one-
stock portfolio. That’s five to the zeroth power. What’s five to the first power? That’s five. And
what’s five to the second power? That’s 25. And five to the third power is 125. We have enough
to work with using just those three “jumps” up in size.
Which works best: a one-stock portfolio, a five-stock portfolio, a 25-stock portfolio or a 125-
stock portfolio? We can safely disregard the 125 (five to the third power) portfolio. It makes no
sense. I’ve never seen an academic study suggest that picking more than 30 stocks (if you’re just
adding to the stocks you pick, not the ways you pick them) adds any material amount of “safety”
in the sense of lowering either stock-specific risk or market risk. Even if we’re talking short-term
volatility in price, 125 stocks aren’t going to look different as a portfolio than 25 stocks. They
are going to require more work, more trades, etc. We can disregard a 125-stock portfolio as
nonsensical when compared to a 25-stock portfolio.
In terms of snapshot-type efficiency – a single bet when considered as the only bet you will ever
make – the one-stock portfolio is undeniably the best. It has been my experience that the one bet
investors would make if only allowed to make one bet is usually among the best bets they could
make. It is almost never among the worst bets. In fact, the thing I notice most when encouraging
investors to shrink the number of positions they have is that they eliminate high risk/high reward
stocks. A lot of investors keep riskier stocks in a 20-stock portfolio than they ever would in a
two-stock portfolio. It’s worth thinking about that.
Does that actually make sense? Investors may tell themselves that it makes sense to take bigger
risks with smaller positions – it’s OK to take speculative risks with a 20-stock portfolio. Is it
really? The results good investors get on concentrated portfolios is pretty good. And it’s pretty
good over fairly long periods of time. It also tends to be concentrated in “high probability bets”
as Buffett would call them. That doesn’t have to be the case. For example, Buffett bought
something like 30 Korean stocks with very low price-earnings (P/E) ratios after the Asian
Financial Crisis in the 1990s. I bought a basket of Japanese net-nets. I consider each of those
Japanese net-nets to have been high probability bets in the sense that being simultaneously priced
below your net cash level and also being consistently profitable almost always leads to a good
outcome for the stock – and yet I didn’t make a concentrated bet on any one of these stocks. I
didn’t have to. I could make a 25% to 50% bet on them as a group. That was my concentrated
bet. It just was concentrated in one strategy rather than one stock. I didn’t see the benefits of
concentration in such a situation. I diversified across a basket of stocks with similar
characteristics.
What is the problem with a one-stock portfolio? I see two problems. The problem you are
probably imagining is that the stock in which you invest will go to zero, and your compounding
will be at an end. Honestly, that is a huge theoretical problem – but I don’t consider it the main
practical problem. If you are an above-average investor who is willing to put 100% of your net
worth into a single stock that goes to zero – some really, really weird external event has to
happen to bring that stock to zero. I have made some very bad stock decisions with 5% and 25%
of my portfolio. I wouldn’t buy any of those stocks with 100% of my portfolio. There are so few
stocks in my life in which I would ever put 100% that this approach would leave me often in
nothing but cash rather than betting on a stock with any meaningful risk of going to zero. What’s
the big problem then?
It’s liquidity. To take advantage of times when there is “blood in the streets” or something like
that you need cash. With a one-stock portfolio you would be 100% invested. If the whole market
dropped 40% in a single year, you’d have to stick with the stock you already owned or sell it at a
big discount to intrinsic value just to buy something else. In fact, that’s the really big problem.
Selling the stock you believe in most in the world – which is all you’d own in a one-stock
portfolio – is really, really hard to do. A one-stock portfolio suffers from two defects. One, it
isn’t as reliable as it could be. There is some chance that you could go completely broke pursuing
a one-stock strategy. This is the scary risk. The less scary sounding risk – but the one that almost
certainly will affect your actual compounding over time –Â is the inflexibility of this strategy.
You would have to sell your favorite stock in the world to switch into something new. A one-
stock portfolio could quickly become buy and hold to a degree that might be a lot less than
optimal. A one-stock portfolio is too unreliable and too inflexible.
Let’s pause to consider “reliability.” Looking at a portfolio – or a business – as it moves through

time, I like to think in terms of reliability and efficiency. The easier concept to quantify and
prove the correct answer to is usually “efficiency.” The most efficient positioning for your
portfolio at any single point in time is to have the biggest possible bet made where the odds are
most in your favor. You always maximize efficiency at a 100% bet on your single best idea.
However, this kind of bet is “unreliable” in the sense that a series of 100% bets will always
eventually end up with you going broke. I mean this in a theoretical sense. It could take a
thousand years for a model portfolio of one-stock bets repeated over and over again to go broke,
but one day it will go broke. We trade efficiency for reliability. How much of a trade do we need
to make?
The reason I choose five equally sized positions of 20% each may surprise you. It’s so I can
always buy something I like. That’s it. Bets much less than 20% don't make much sense. They’re
too small, but I also really like being able to act quickly when I see the odds in my favor. It’s
possible that a three-stock portfolio would be ideal. Munger has suggested three stocks are the
minimum amount with which he’d be comfortable. I agree that the right number of stocks in a
portfolio is almost certainly more than one, and I doubt it’s bigger than five. Three sounds right,
but three may be right in a “hold” only portfolio and yet wrong in a “buy” and hold portfolio.
Why?
The problem with a three-stock portfolio is that you’d always either need to sell one of your
three favorite ideas or hold 33% of your portfolio in cash awaiting a new idea. There also start to
be real liquidity concerns that worry me with a three-stock portfolio. Again, this has to do with
the difference between the ideal “buy and hold” portfolio size versus the ideal “hold” only
portfolio. I tend to believe three stocks might be the ideal hold forever portfolio, but I feel it’s
definitely wrong for me in terms of initiating new buys.
I like illiquid stocks. They often offer some of the best returns. As a smaller investor, the ability
to bet a big percentage of your net worth on illiquid stocks is a huge advantage, but let’s imagine
you find two truly illiquid stocks – things like George Risk (RSKIA, Financial) that may only
trade an average of $3,000 or so a day. In a three-stock portfolio, two illiquid micro-caps would
fill up 67% of your portfolio. If you ever needed to take a fair chunk of money out of your
portfolio because of a family emergency, to pay taxes or simply to reposition your investments –
you’d only have immediate access to 33% of your portfolio. That might be too little to make you
comfortable. For that reason, an investor who holds only three stocks might feel he has to make
two of those stocks “liquid” stocks. That’s a disadvantage.
Meanwhile, an investor with a five-stock portfolio, would be able to own two illiquid stocks and
still have 60% of his portfolio in liquid assets. No one should need immediate access to more
than half of their “savings.” If you need access to more than 60% of the money you have saved,
you shouldn’t be invested in common stocks at all. You should be in cash or maybe government
bonds that will mature reasonably soon. That’s really all you can afford to risk being in if you
might have to spend most of the portfolio sometime soon.
The other advantage of a five-stock portfolio is that I don’t think a 20% cash position – on
average – is excessive. I do think a 33% cash position – on average – may be excessive. I’m not
sure I’d feel comfortable normally leaving one “slot” free in a three-stock portfolio while I
would – and do – feel totally comfortable leaving one “slot” free in a five-stock portfolio. That’s
my default. I want to be 100% invested, but I understand that I’ll probably average being only
80% invested if we look at the portfolio over time. For example, I’ve been 30% to 50% in cash
just because I was bought out of some stock in a going private transaction and didn’t have
another great idea to pounce on right away.
A five-stock portfolio can more flexibly accommodate up to two illiquid stocks (40% of the
portfolio) and some idle cash (up to 20% of the portfolio) that can immediately be put to use
without having to sell anything. Not having any cash means not being able to use “timing” of
purchases at all.
Why not vary the size of positons? Why not take a 50% position, a 25% position, a 12%
position, a 6% position and a 3% position depending on how much I like each?
Again, as a “hold” portfolio this might make sense. It’s true that I – and other investors –
sometimes have pretty strong preferences between our first favorite and fifth favorite ideas. It
would make sense to bet up to 50% in some situations. That’s not a very flexible strategy.
Forming new 50% positions and new 25% positions would be difficult, and those two positions
are 75% of your portfolio in that situation. You’d be creating some problems for yourself in
terms of timing and liquidity. You might miss out on some opportunities.
OK. I personally use a five-stock portfolio with equal position sizes of 20% per stock. Does that
mean I think that’s the best allocation for something like a mutual fund, a pension fund or an
endowment?
No. Actually, I think a 25-stock portfolio is best, but this takes some explaining. Based on
everything I’ve read about diversification in theory and everything I’ve seen about
diversification in practice, I can see a big divide between what makes a five-stock portfolio best
and what makes a 25-stock portfolio best. The portfolio that is likeliest to give you high returns
with low volatility would be in the 25-stock size range, but it has a huge downside. A 25-stock
portfolio is not something you can implement with highly skilled stock pickers. Stock pickers
just don’t have the ability to “express” their skill at high levels when spread over that many
stocks. It may be true that 25 ideas are the best combination for an investor to hold, but it is
definitely not true that 25 ideas are the best number for an analyst. There is a severe dropoff in
idea quality between five ideas and 25 ideas. There is some benefit to diversifying between five
and 25 stocks. However, there really isn’t a diversification benefit beyond 25 stocks.
The ideal way to run a fund would be to find five managers who could each independently select
five stocks and thereby fill a fund with 25 stocks that are all “top 5” ideas for the analysts who
chose them. Can you implement this strategy yourself?
Sure. You could form an investing club with people you meet online at places like GuruFocus.
But would you really trust other people’s ideas with 80% of your assets?
I don’t know about that.
Most individual investors face the trade-off of going beyond having five stocks in their portfolios
and thereby reducing selectivity or surrendering some of the autonomy they enjoy in their stock
picking. Personally, if I liked the other guy, I’d rather fill my portfolio with his five best ideas
than my 21st to 25th best ideas. I’m weird that way, but if your five best ideas are worse than my
21st through 25th ideas, you’re not a good stock picker. Flip that, and you’ll see that if you can
find someone who is a good stock picker – you should put more trust in his top five ideas than in
your 21st through 25th ideas.
I have no such person to trust with my money, and I don’t mind volatility, but if I did mind
volatility, I’d do what I just described above. In the long run, that 25-stock portfolio would
compound at a lower rate than a five-stock portfolio. However, for people who care a lot about
not having volatility much in excess of an index fund, 25 stocks are a better choice than 5 stocks.
You’re not going to reduce volatility by going beyond 25 stocks. There are ways to reduce
volatility below that of an index fund, but simply picking more and more stocks is never going to
do it. Twenty-five stocks will basically get you index fund levels of volatility, and you can’t get
less volatility than an index fund through further diversification.
If you want to reduce volatility, there’s no point owning more than 25 stocks at once. If, like me,
you don’t care about volatility – but you do care about reliability (basically business risk) and
flexibility (basically the ability to buy illiquid stocks and “time” position entry) – you should
own far fewer than 25 stocks. I usually own five at a time, and there’s a lot of anecdotal support
for that in the record of some good long-term investors like Buffett and Munger. They claim that
most of their early record – and remember, their early record was their best record – was
achieved while putting something like 80% or 90% of their portfolios into something like five
stocks at a time.
The topic I haven’t even considered here is the length of the holding. This is where the
concentrated investor can really “concentrate his concentrating.”
A huge mistake investors make when considering portfolio construction is using a snapshot
approach (discrete time) versus a historical approach (continuous time). The reason you’re
investing is to compound your wealth over time. It doesn’t just matter what you buy. Buying
right is a necessary but insufficient driver of your compounding. An investor’s return comes not
from buying right but from holding right. For this reason, I’ve proposed a set of three rules from
which most stock pickers can benefit.
Rule No. 1: Never put less than 20% of your net worth into a stock.
Rule No. 2: Never own a stock for less than five years.
Rule No. 3: If you’re uncomfortable with Rule No. 1 or Rule No. 2, you’re wrong about the
stock.
In other words, I can understand your circumstances sometimes dictating that you put less than
20% into a stock or own it for less than five years. That’s perfectly reasonable, but think hard
about whether something you’d be unwilling to put 20% of your portfolio into or agree to “lock
up” for five full years is safe enough and good enough to put any of your portfolio into. You’ll
have other ideas. Why waste dry powder on something you’re uncomfortable betting on in a big
way for a long time?
There can be good reasons – like not having idle cash right now – for putting less than 20% of
your portfolio into something, but that’s not a reason inherent to the stock idea. It’s a portfolio
consideration. Likewise, there can be reasons – like finding an even better stock – for selling
something you own before you’ve held for five years, but, again, that’s not something inherent to
the stock idea. If a stock idea is inherently attractive as a three-year investment but not as a six-
year investment – that’s clearly not a world-class idea you have there. Likewise, if a stock idea is
attractive when it’s 10% of your portfolio but not attractive when it’s 20% of your portfolio,
something is seriously wrong with that idea.
Not everything has to be a good idea forever. For example, I like Howden

Joinery (LSE:HWDN, Financial) as a five-year investment. I do realize that it will run out of
places to put additional depots inside its home market of the U.K. in about five years. It stops
being a predictable growth stock in about five years. It might get growth from other places – but
that’s not predictable, it’s speculative, and it might start buying back a lot of stock, really upping
the dividend, etc., once it fully saturates the U.K. For now, I’d only be comfortable owning it for
five years as a commitment I can agree to now. If things go well, a five-year investment could
become a 10-year investment, but that kind of situation is enough. If I’m willing to put 20% of
my portfolio into Howden (and I am) and I’m willing to hold it until 2022 (and I am), then
Howden qualifies as a “good idea” even though I’m not sure I would buy and hold it forever.
Howden fits my three rules, and I think it would fit those three rules even if I happened to only
have 10% of my portfolio free at the moment I found it and therefore only got a chance to put
10% into the stock before the price moved or something. In that case, it would be a 10%
position, but I wouldn’t feel I had compromised my selectivity by picking it. It would just have
been some inadvertent diversification.
The important thing is to always focus on holding the fewest possible stocks for the longest
possible time. That’s how you compound wealth.
 URL: https://www.gurufocus.com/news/497168/why-i-only-own-5-stocks-at-a-time
 Time: 2017
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Why Cyclical Stocks Make Tricky Long-Term Investments
“How do you take the industry cycle into your consideration? For example, you say CRMT
shouldn't trade below receivables per share. I believe it does now and people may be worried
that subprime auto loans are in the beginning of down trend (or frothy). I think it may not be a
concern considering the company’s track record and in the long-term view, but I'm curious how
you incorporate the industry cycle into your investment decision.”
One way to think of this question is to divide up what I think about “a cyclical industry” versus
what I think about “a certain point in the industry cycle.” Some businesses are very cyclical, and
for this reason tend to be poor long-term stock holdings. A good example would be oilfield
service providers. In good times, these businesses can look good. These good times can last for
years. During the oil boom, many oilfield service provider stocks looked like they had high
returns on capital, had grown earnings per share year after year and were all around good
businesses. This impression, however, was contradicted by the very long-term record. In the
early 2010s, you could look back and see a good 10-year record at oilfield service providers.
Often, if you looked at the compound annual return in the stock going back more like 30 to 40
years (so taking the record back to the 1970s or 1980s), these stocks actually underperformed the
market. For that to happen, the record had to be truly awful at the bad points in the cycle.
Oilfield service providers have several of the features you see in cyclical businesses with bad
long-term stock returns. One, they are in a long-cycle business. The price of oil fluctuates in a
way that sometimes results in not just five to 15-month periods where prices are particularly
good – but five to 15-year periods where prices are particularly bad. This is a problem for
investors trying to evaluate the stock’s normal earning power in good times. Often, the price-
earnings (P/E) ratio will be at its lowest when the stock is actually overpriced and at its highest
when the stock is actually underpriced. That is because the “E” used in that P/E ratio is last
year’s earnings rather than cyclically normalized earnings. So that is the danger for a value
investor. A value investor may think a cyclical stock is cheap when it is actually expensive. The
danger for a buy-and-hold investor is different.
A buy-and-hold investor may look at 10 years of results and think he has found an above-average
compounder. What he has really found is a business whose compound returns – especially in the
way returns actually “compound” – may be average to below average. When you multiply
together a series of returns on equity – years with negative results or a series of years with very
low growth rates, it will bring the compound annual return in the stock below the median return
on equity. At very consistent companies, all types of averages – median, arithmetic mean,
geometric mean and harmonic mean – will be close to each other. They will also be close to the
compound annual return in the stock. This is not true of extremely variable series of returns on
equity. Imagine a company retains all its earnings. It is going to grow book value by about its
average return on equity. If the return on equity continues to be stable, the new – higher – book
value will produce a similar ratio of earnings to equity. This means if a company retains most of
its earnings with a high degree of consistency in its return on equity – that company is going to
compound book value and earnings per share at a rate close to its average ROE. The stock price
will track ROE fairly reasonably. This is not true at cyclical companies.
The other problem an oilfield service provider has is it is very, very far from the consumer
demand that drives the entire industry. The further a business is from the ultimate consumption
of a product – the longer and more uncertain the cycle can be. The cycle for a company that
builds cruise ships is going to be longer and more dramatic than the cycle for the companies that
use those ships. The cycle for jumbo jets is going to be longer than the cycle for airlines. So you
have to be careful when looking at companies in industries with long cycles. For example,
someone was recently asking me about a cement company in a developing country. It could be a
good deal, but the problem is knowing what the capacity situation is in that country in terms of
cement plants and what the level of building activity has been. The less you know about a
country’s macro cycle and an industry’s cycle, the more careful you have to be.
Frankly, cycles have been the best source of my investment ideas. Warren

Buffett (Trades, Portfolio) says you should invest in great businesses with temporary and
solvable problems. Well, the most solvable problems are those that solve themselves simply
through a self-correcting process in the industry. There are two reasons I was able to buy stocks
like Fair Isaac (FICO, Financial) and Omnicom (OMC, Financial). One reason was the stock
market crashed in 2008, so everything was cheap in 2009. The other reason is Fair Isaac and
Omnicom are companies with stable customer bases and stable competitive positions, but which
vary in the level of activity that clients are interested in. In 2009, there was less need for running
credit scores. Likewise, there were more subdued “animal spirits” among big brands that
advertise a lot. Those are both problems that are temporary and solvable. They are not
competitive pressures.
Many years ago, I picked a stock called Posco (PKX, Financial) for a newsletter I wrote. This
was probably during 2006. The big concern with Posco was it produced steel. Steel is not a good
industry because it is cyclical and has relatively poor product economics. The gross profitability
of the business is not strong. It is very easy for competitors – because this is a commodity
product – to do harm to even the best producer in the region. Posco has plants that – through
transportation of steel – can be in competition with Chinese steelmakers. That worried me a lot.
Steel plants are a sunk cost. The economics of producing steel in any region that has an
overcapacity in terms of maximum possible output of steel if all plants are producing at full tilt is
usually very, very bad.
This is true in other industries as well. For example, the economics of cruise lines are truly
abysmal during periods of oversupply. Passengers actually spend money on board beyond their
tickets. So it is in a cruise line’s interest to sell a ticket at a loss if it means filling a bunk with
someone who will shop, gamble and go on shore excursions once aboard the ship. But the cruise
industry is very, very concentrated, with the top three companies holding most of the meaningful
supply in the areas I care about. The competitors are also often a lot more rational than
steelmakers. So I was very worried about the danger of Chinese steelmakers producing steel at
zero profit for years and years. The point is, I did not invest in Posco long term.
Around the same time, a company called Hanesbrands (HBI, Financial) was spun off from Sara
Lee. The stock was highly leveraged, but I liked its competitive position. Hanesbrands and Fruit
of the Loom (owned by Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)) are really
the only underwear companies in the U.S. with the scale to supply the big retailers. They are also
the two companies with recognizable enough brands that buyers will not feel like they are buying
cheap, knock-off underwear. So it was potentially a fine business. I do not necessarily invest for
11 years (that is about the time since I looked at Posco and HBI), but if I did – I would only
consider Hanes. I would never buy and hold Posco because competition can hurt it even if it is
run well. Competition is not going to do a ton of damage to Hanes. There is competition and
some of the company’s customers have a lot of bargaining power. That constrains profitability,
but is never going to undermine the long-term health of Hanes as a business. Posco is always at
the mercy of a highly cyclical industry. Hanes is not.
Cyclical industries tend to be cyclical because they are irrational. Not enough investors really
understand this. Here is the truth: cyclicality is always the result of a “mistake.” A cycle has to
be caused by an intertemporal miscalculation of some kind. If everyone in an industry made the
correct choice, there would be no cycle. A cycle is a mistake followed by a correction, which
then tends to go too far in the other extreme and needs its own correction, and so on. Some
cycles are super short. If you have too many egg-laying hens in the egg industry – you can fix
that fast. If you order more toys than you should have starting sometime in November – you are
going to be marking them down and getting them off your shelves by February. There are so
many little miscalculations of this sort that we do not think of them as cycles. For instance,
almost all clothes are subject to economic miscalculations very similar to long-term cycles, but
limited to individual fashions and styles and “corrected” for very quickly. At the company level,
this is not really relevant unless you are looking at some sort of closeout retailer or something
that takes big chunks of someone else’s bad inventory and sells it at a really low price.
What worries me atÂ Car-Mart (CRMT, Financial) is not that the company is in a bad point in
the industry cycle right now. It is that irrational competitive decisions by rivals are contagious.
As you know, Car-Mart’s customers are deeply subprime (they really have no credit at all), so
they are in a sort of perpetual recession. For this reason, Car-Mart’s customers cannot have
higher payments when the economy is better. So if cars become more expensive (and used cars
had been increasing in price faster than inflation for a while), you have to extend the number of
months of the loan to keep the regular payment at the same level. That is risky. This particular
cycle is really dangerous because we have seen an increase in all the bad credit metrics at Car-
Mart despite the job market getting better.
Frankly, the labor market right now is super tight. You can see this in the tremendously high
wage increases people who are quitting one job to take another are getting. That should not
happen when there is enough idle labor to fill the regular churn of positions. It means we have
not seen a lot of inflation in wages, but that people who want jobs can get jobs. So now should be
a really good time to keep current in your car loans, yet some people are missing payments and
falling behind. Why? Because in the last few years a lot of people took car loans they cannoy
repay even if they experience no bad surprises.
This last quarter, about 31% of Car-Mart’s receivables were dedicated to a provision for credit
losses. That is a high number compared to a past that often had Car-Mart taking around a 25%
provision. Now at the worst point in a recession, you might understand that, but we are at about
the best point in a job boom. So you know that some of the car loans made during these past few
years were the worst, riskiest loans the industry has ever made and is likely to ever make for a
long time in the future. The catalysts for this were obviously a low federal funds rate for a long
time and lower than normal new car production. These two things happened as a result of the
financial crisis. Keeping the federal funds rate low led to an overly aggressive desire for assets
with yield, especially short-term assets like car loans. Additionally, lower new car production in
the aftermath of the financial crisis obviously led to higher used car prices. Used cars are the
collateral for loans made to purchase Car-Mart-type vehicles. So you had loose credit and
inflated prices on the collateral. If this is a one-time deal, we can analyze the situation and decide
if it can ruin an investment in Car-Mart or not. That is usually not a hard calculation to make.
For example, I looked at what it would take for the oil price bust to cause unacceptable losses in
energy loans at Cullen/Frost Bankers (CFR, Financial). The stocks of some Texas banks
dropped like investors expected the oil price bust to cause meaningful problems for these banks.
There was no justification for that. Frost was only putting about 16% of its loans into energy and
loans were only about half its assets – so people were worried about 8% of the company’s
balance sheet going bad. The bank earns a couple percent on its assets before the provision for
credit losses, so you would need losses in the 25% to 50% range on the energy loan portfolio to
threaten the bank with an insufficient capital position. It just was not a serious problem. But in
addition to that, energy lending is not that important to Frost. While I do not think Frost does
energy lending as well as BOK FinancialÂ (BOKF, Financial) does– they both do OK
compared to how other banks lend in other areas. As a result, I am not worried about energy
lending being a permanently insufficient return business because of lenders' mistakes caused by
the oil boom and bust cycle.
Am I worried about that happening at Car-Mart? Absolutely. The entire rationale for that
investment was based on the rate at which Car-Mart could compound net receivables per share.
In other words, I looked at what the company had in receivables after the provision for credit
losses in each year and asked how quickly it could grow that number per share over the next 5,
10 and 15 years. The rate of growth in net receivables per share is the gain in intrinsic value at
the company. That rate is directly threatened by the behavior of rivals. Overzealous lending by
Car-Mart’s competitors can seriously ding the long-term rate of growth in net receivables per
share. Obviously, the long-term return in Car-Mart’s stock should almost perfectly match the
long-term growth rate in receivables per share. This is much like the way the long-term growth
rate in an insurer's book value should drive the long-term growth in that stock. There are a lot of
areas in insurance where even a very good underwriter and investor cannot drive strong book
value growth if rivals are repetitively and cyclically stupid in their behavior. Most insurers earn
bad returns on equity and underperform as stocks because they cannot insulate themselves from
the cycle caused by the miscalculations of their rivals. I am worried Car-Mart could end up in the
same situation.
On the other hand, now is obviously a good point in the cycle to consider Car-Mart stock. The
stock is priced “normally” on an earnings basis. Earnings are cyclically depressed however. That
tends to be when you should buy a great company facing cyclical problems. The P/E looks
normal to investors, but price-book, price-sales, price-premiums and price-deposits are clearly
wrong. Frost is a good example of that. The P/E was a perfectly normal 15 or 16 when I bought
the stock. The price to deposits was extraordinarily low however. It was a great bank priced at
what even a good bank should not be priced at. Car-Mart is much less insulated from competitor
actions than Frost is however. Therefore, I cannot recommend Car-Mart with the kind of
confidence I can recommend Frost. It is worth mentioning I have 40% of my portfolio in Frost
and 0% of my portfolio in Car-Mart, and there is probably a reason for this. But yes, at this point
in the cycle, now would be the time to start seriously considering Car-Mart.
 URL: https://www.gurufocus.com/news/497166/why-cyclical-stocks-make-tricky-
longterm-investments
 Time: 2017
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How to Get the Most Out of a Great Idea
Some investors I talk to have relatively so-so portfolio returns despite having some very good –
even great – ideas. I want to talk today about how to get the most out of your great ideas.
You want to focus on stocks with a long runway. I wrote in a previous article about doing a five-
year and 15-year future expected return calculation. That’s because in the short term, extremely
good value will outperform just about anything. In the long run, extremely high quality growth
will outperform just about anything. It’s really only in the gray zone of about five to 15 years
that you would need to worry about the trade-off between deep value and high quality growth. I
use the five-year and 15-year approach to approximate a “trade” as something that won’t be
longer than five years and an “investment” as something that won’t be shorter than 15 years.
Doing this lets me frame the problem of selecting which stock to buy in simple mathematical
terms. Let’s talk about the two kinds of runaways a stock can have.
A stock can have big upside in terms of value. I think of this as being the difference between
what I have to pay for a stock today – its “price” – and what I appraise the stock for (its “value”).
For example, a couple years ago, I appraised Hunter Douglas (XAMS:HDG, Financial) – when
it was much cheaper than it is now – at more than twice what it was then selling for. Not long
after that, I appraised Omnicom (OMC, Financial) at 90% of its intrinsic value. If I had to pick
between owning only Hunter and owning only Omnicom for more than 15 years – I’d pick
Omnicom. However, at that time (when Hunter was much cheaper than it is today) I would have
picked Hunter over Omnicom if I knew I was only allowed to hold the stock I picked for five
years.
The “value” runway for Hunter was huge. I thought it could more than double its price without
any increase in its intrinsic value. On the other hand, the “growth” runway for Omnicom was
much longer. I thought Omnicom could grow as fast as 5% per year pretty much forever without
really retaining any meaningful amount of earnings. There was some earnings “retention” in the
sense of free cash flow that would need to be used to buy back stock as an offset to dilution
caused by paying employees, but something like much more than 80% of Omnicom’s free cash
flow could be used to buy back stock, pay dividends or make acquisitions while the company
itself was growing 5% per year. I thought Hunter might grow slower, more like 4% per year.
The much bigger issue is how much earnings I thought Hunter would have to retain. For each
additional penny of growth in earnings per share, I thought the company would have to retain
between 5 cents and 10 cents of earnings. That’s not a bad trade. But if you think a company
might grow as slowly as 4% to 5% per year with a return on equity of between 10% and 20% –
the addition to intrinsic value is small. Growth achieved at much below about a 10% return on
equity doesn’t really add value any faster than if the company paid a dividend out to me and I put
that dividend into the Standard & Poor's 500. It’s really only growth above about a 10% ROE
that matters, and I didn’t think Hunter would grow at 8% per year or anything like that long term.
Omnicom, on the other hand, could grow more like 5% a year without any real “cost” to this
growth because ROE should be close to infinite. Now, this wouldn’t help Omnicom much versus
Hunter for the years 2015 to 2019, but because Hunter was trading at less than 40 euros ($43.31)
per share and I appraised the company at more than 90 euros per share in value – it didn’t need to
create growth in its value to make a good return as a stock. This is the “value” runaway. At
Hunter, the value runway was – in my eyes – a 47% price-to-appraisal value. If you take 1/0.47,
you get an upside of 113%. That’s a big number. Value often wins out in five years or less.
Let’s look at what a 47-cent price reaching a $1 intrinsic value gets you over five years. It’s 16%
per year. That’s the return from value with no growth addition, but I thought Hunter would grow
something like 4% per year. I also thought it would pay a dividend of a couple percent at least.
Add those in – and you can get to a 20% plus annual return in five years or less. High-quality
growth can’t compete with that. Very few businesses keep compounding value at 20% per year
or higher. If you can find a stock you appraise at $100 selling for $47, buy it. The “value”
runway is long enough to get you a lot out of this one idea.
In other words, my advice is to look for stocks trading for a 50% discount to intrinsic value
rather than wasting time on stocks trading at a 20% discount to intrinsic value. A stock trading at
a 20% discount to intrinsic value only gives you a 4% to 5% return from that valuation gap
closing over the next five years. Don’t aim for worse than 5% returns from value – aim for better
than 15% returns. They may be hard to find. For example, in the more than two years I was
writing my newsletter, I found only two to three stocks that we appraised at anything like the
discount we gave Hunter. I was working hard to turn up stocks with deep discounts to intrinsic
value. I was publishing an issue each month.
I had an “idea” each month. Was it a good idea? I thought it was at the time. Was that monthly
idea a “great” idea? In terms of pure quality – I will get to growth in a second – I’d say that only
two to three stocks over close to two years would qualify as “great.” Let’s call that one “great”
value idea every six months to 12 months. I could be wrong about some of these. I’m just saying
they seemed great at that time. It looks like – at best – only 5% to 10% of my “good” ideas
would qualify as “great” ideas. I’m not saying it’s easy to find stocks trading for 50% off what
they are worth. Every month, I could find a stock trading at a 10% to 20% discount to what I
thought it was worth, but only about once a year could I find a stock trading at a 50% to 60%
discount to what I thought it was worth. Don’t confuse your good monthly ideas (the 10% to
20% discounts) with your great yearly ideas (the 50% to 60% discounts). The value “runway” is
huge in the second case.
Now, what about the growth “runway”? Getting great returns from growth requires three things:
1) A high annual sales growth rate, 2) a low annual net tangible asset growth rate and 3) plenty
of room to keep doing what the company is doing even as it gains scale.
I’m going to use Howden Joinery (LSE:HWDN, Financial) as an example because I think it’s

easy to quantify. Howden should be able to grow its same depot sales by no less than 4% per
year over the next five to six years. I use five to six years because if Howden opens 30 depots a
year it will – according to management – fully saturate the U.K. market at 800 depots in about
five to six years. This new depot growth rate (from a little over 600 depots to 800 depots) is
about 4% per year.
The company’s sales growth rate should be no lower than 4% same depot growth plus 4% depots
in the chain growth equals 8% growth. There are economies of scale at both the depot level and
the supply chain level. In fact, Howden manufactures some of its own products; it uses its own
trucks to supply its stores, etc. There should be – and historically there have been – much greater
economies of scale at Howden than at many fast-growing companies. For these reasons, it is not
at all impossible that Howden could grow companywide profit at close to 10% per year over the
next five years even if it only grows sales at about 8% per year. In addition, I expect the
company to shrink its share count at the rate of about 1.5% per year.
We could say that 8% sales growth with no operational leverage and no share buybacks is the
low-end scenario. That’s an 8% annual growth in earnings per share over the next five years.
That should match or beat the U.K. stock market. Howden pays a dividend. It would return more
like 10% if it grew EPS by about 8% a year. The market won’t return 10% a year long term. The
high-end scenario for Howden’s EPS growth is pretty impressive though. If there is some
operational leverage in the company that causes operating income to grow faster than sales and
the company buys back shares at the rate I expect, you get to something like an 11.5% earnings
per share growth. It’s best not to be too exact about these things. In broad strokes, I expect
Howden to be capable of somewhere between 8% and 12% annual EPS growth for another four
to six years.
Now, 8% annual EPS growth for only four years isn’t a ton of upside. It means $100 of Howden
stock today would only be worth $136 when I sold it. However, the high-end scenario has what I
would consider plenty of “runway.” If Howden can grow EPS at closer to 12% per year over
more like six full years, it would mean that $100 of Howden’s value today could become $197 of
value six years down the road. Growth rates of 10% or higher over five years or more are decent
runways for having a “great” growth idea.
I don’t want to pretend Howden is the next Apple (AAPL, Financial) here. I don’t see much
chance for much better than high single-digit growth for half a decade. The current business plan
– replicating the same depot model over and over again within the U.K. – will run out of room
for growth in about five years. This isn’t a Phil Fisher stock. I like Howden because of the high
confidence I have in the low-end scenario and the holding period. I really think Howden can do
4% same-store sales growth and 4% new depot growth while buying back a percent or more of
its stock and paying a dividend yield of 2% of my purchase price. You add those together and
you get something like an 11% annual return over something like a five-year holding period.
This all depends on Howden’s multiple not contracting. That’s a reasonable assumption.
Howden’s P/E ratio is just under 15 while its corporate leverage is essentially zero. Howden has
a pension deficit and leases its locations. However, it has net cash.
I view the company as trading at a totally normal P/E of 15 and a totally normal leverage
situation of close to neither net cash nor net debt. This point – that I don’t think Howden’s
multiple will contract over the next five years – is absolutely critical in getting the most out of
your great “growth” ideas.
Let’s compare Howden to NIC (EGOV, Financial). NICÂ has a P/E of 25. It has a durable

competitive position, and growth costs this company essentially nothing. For those reasons, the
company can – during its fast growth phase – add a lot to intrinsic value per share. The problem
is that I don’t believe that when NIC is fully mature – that is, once it is winning no new net U.S.
states as customers and the average customer has been with NIC for something like three to five
years or more – it will grow faster than Howden when it’s fully mature. NIC’s fully mature
growth rate should be quite low. It could be in the 2% to 5% range. This is because I’m not
sure NIC can carry out any real – above inflation – price increases. Without pricing power, it’s
very hard to command a high P/E as a stock once you are no longer quickly growing your
number of new customers.
My fear is that NIC’s multiple will one day contract from 25 to 15. The question is how big the
company will be when this happens. For this reason, I put NIC in the “too hard” pile and
Howden in the easy enough to understand and invest in pile.
So far, we have two rules for getting the most out of your great ideas:
1. When picking value stocks, look for stocks trading at something like a 50% discount to
your appraisal of their current intrinsic value.
2. When picking growth stocks, look for stocks with P/E ratios that you don’t expect to
contract in the future.
I want to be clear about rule No. 2 here. I’m not saying pick growth stocks with a low P/E ratio.
There are stocks that should always trade at high P/E ratios. Omnicom is about 10% too cheap
now even though it already trades at a P/E of 18. In other words, the stock should “forever” have
a P/E of 20. That’s because it can grow about as fast as other mature companies without adding
to its shareholder’s equity from year to year. I don’t think Omnicom’s P/E will contract from 18
to 15 the way I worry NIC’s P/E will one day contract from 25 to 15.
The next rule is true for both value stocks and growth stocks:
1. When picking long-term holdings, look for stocks with unleveraged returns on net
tangible assets of no less than 10% per year.
This rule is really, really important. It often gets overlooked when investors think about value
investments. It still matters even in deep value. For example, I’ve owned George
Risk (RSKIA, Financial) for seven years now. I bought the stock as a net-net. The company has
been able to compound book value at 6% per year while I’ve owned it while also paying close to
a 4% dividend yield in many years. This ignores the fact I bought it at a good price. The return
on intrinsic value has been about 10% per year. Any closing of the valuation gap between the
low price I paid and the high value I one day hope to extract from the company will add an
above-market rate, but the part of the investment that ensures I’ll get a bondlike return – or even
an index fundlike return – over longer periods of time is the decent return on equity the company
achieves. It’s much better to pay 50 cents on the dollar for a company with an ROE of 10% than
to pay 25 cents on the dollar for a company with an ROE of 5%.
At ROEs as low as 5%, you could lose ground to an index simply by staying invested in a subpar
but undervalued business. In the long run, you can actually stay in stocks like George Risk.
Here’s another example. It’s an even more obscure one than George Risk, but it illustrates my
point. In 2011, I did a “blind stock valuation” about a company called Watlington Waterworks (it
trades in Bermuda). This is a microcap water company on the island of Bermuda. I put up its
financials – multiplied by 10 to disguise the fact it was so tiny – and had blog readers guess how
much it was worth. They almost all picked a price between $20 and $30 per share. The stock
really traded for $14 per share.
Readers were – unconsciously – pegging the discount to intrinsic value at 30% to 55%. Since
this was a group of investors working blind from six years of historical financial results – this
was a good sign the company was really undervalued by about one-third to one-half of its total
value. It wasn’t however a good sign that the valuation gap would close anytime soon. In fact, it
hasn’t. The stock still trades at a 22% discount to book value. Based on the past cash return on
equity and the durable competitive position of the business – it really shouldn’t trade below 1
times book value.
It is still trading at a discount to intrinsic value. The company has really always traded at a
discount to intrinsic value. However, you can see that over the last 18 years the stock’s price has
increased by 9% a year. It has paid dividends for more than the past 10 years. You are talking
about an annual return of probably not less than 10% per year for a stock that – even after an 18-
year hypothetical holding period – still ended the period trading at less than 80 cents on the
intrinsic value dollar. If the stock had finished the period at the price-book (P/B) value I consider
correct, the 18-year return would have been at least 1.5% a year higher.
Yes, it does matter if the valuation gap closes over time, but what matters more is that
Watlington Waterworks has tended to earn about a 10% cash return on its unleveraged tangible
equity and so – as a result – the stock has tended to return about 10% per year over the last
decade or two regardless of whether investors ever embrace the stock as much as I think it
deserves to be embraced. The stock has usually been “cheap” and yet it has still returned about
10% per year because it has still earned about 10% per year.
What do you do when you find a stock like Hunter Douglas (when it was priced at less than 40
euros) or George Risk (when it was priced at around $4.50 per share) or Watlington Waterworks
(when it was priced at about $14 per share) or Howden Joinery (when it’s priced at about 430
pence, as it is right now)?
I have a two-part answer.
One, you bet big on it.
Two, you hold it long enough to let that bet pay off.
Personally, I try to apply a 20% allocation and five-year approach to my bets on “great ideas.”
This means that I try to put no less than 20% of my total portfolio into a new, great idea, and I try
to commit to owning that idea for no less than five years.
I know a lot of investors feel uncomfortable with such a concentrated strategy. That’s fine, but I
would strongly suggest that if you reduce one of those two rules, you up the other one. Most
people have a problem with the 20% of your portfolio. They think that allocation is too big for
any one idea. Fine. Then allocate 10% to each great idea, but if you do choose to allocate only
10% to each idea – up the holding period requirement to 10 years. Why?
The payoff that you can get from a single stock pick is a function of three decisions you make:
1. Do you buy the stock?

2. How much of the stock do you buy?
3. How long do you keep the shares you own?
A lot of investors get question No. 1 right and then flunk questions No. 2 and No. 3. If you find
the Washington Post as Buffett did in the 1970s, you need to both put a lot of money into that
idea and hang on to that idea – or you won’t get everything you can out of the idea.
If you are really committed to as absurdly small allocations as 5% of your portfolio into a single
stock, you can still get a ton out of individual positions if you always hold them for no less than
20 years.
The problem here isn’t really that investors are opposed to extreme concentration or that
investors are opposed to an extremely long-term investment horizon. The problem is that
investors are opposed to both concentration and long holding periods.
You will meet a lot of really smart investors with really great ideas who tend to put about 5% of
their portfolios in each idea and tend to hold those ideas for only three years on average.
If you’re going to do that, you should really just use a statistical method of some sort. The
picking of individual stocks – instead of the favoring of certain metrics, etc. – just won’t have
much influence on your long-term performance. You can have a great idea and yet still not get
much out of it if you either allocate as little as 5% to the position or you hold it for as little as
three years.
This is one of the hardest things of which to convince individual investors, but the logic here is
really unavoidable. Your return in a stock comes from holding that stock. That return depends on
how many shares you own and how long you own those shares.
It’s really, really hard for you to teach yourself to have better ideas.
It’s so much easier to teach yourself to make both bigger bets and longer bets. The amount of
money you can make on a 20% position held for five years is so much bigger than the amount of
money you can make on a 5% position held for three years. If you can’t commit to being an
ultraconcentrated investor, please consider committing to being an ultralong-term investor.
I have one “habit” I always try to get individual investors to take seriously. If you save money
each year – would you consider limiting yourself to picking just one stock per year and holding
that stock literally forever? You’d put all your 2017 savings into just one stock by the end of this
year, and then you’d never touch that stock again. You’d move on to finding something totally
new in 2018 and holding that forever.
I know you will never run your entire portfolio that way, but if you could – as an experiment –
carve out a quarter of your savings each year into this permanent “punchcard” approach, you
would see just how much you can get out of great ideas you put into this focused, long-term
bucket and how little you get out of the same quality ideas that you size and hold the way you
normally size and hold your stocks.
It’s an experiment worth trying.
Here, again are my rules for getting the most out of a great idea:
1. Always pick stocks with long “runways” in general.

2. Focus on “value” ideas with a discount of 50% to intrinsic value instead of say 20%.
3. Focus on “growth” ideas where you don’t expect the P/E multiple to contract.
4. Never buy stocks where the long-term return on equity will be below 10% a year.
5. Allocate the largest percentage of your portfolio into each great idea with which you feel
comfortable.
6. Commit to the longest holding period with which you are comfortable.
And then, if you are really averse to high portfolio concentration – consider offsetting this
timidity with a longer holding period. I don’t recommend the reverse – making bigger, shorter
bets. However, if you had a trader’s mentality – I do have to admit that this approach would also
make sense. If you made very short bets, they’d need to be very big bets to get the most out of
your great ideas.
Since I’m an investor, I really consider holding periods less than about three years to be purely
speculative.
Which rule do I apply personally?
I target a 20% position size and a five-year holding period. That lets me get more out of my great
ideas than almost all the investors with whom I talk. They often put too little into their best ideas
or they sell those great ideas too quickly.
 URL: https://www.gurufocus.com/news/496531/how-to-get-the-most-out-of-a-great-idea
 Time: 2017
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How to Benefit From Brokers, Screens and Web Sites Instead of Getting
Distracted by Them
“I was wondering if you could break down the tools you use for investing and perhaps a step by
step of your general process. For example, what brokerage do you recommend? What screener?
Do you have various custom forms in Excel that you have developed (perhaps for sale)? Are
there software packages that you utilize? Etc.”
Use whichever broker you want. Just use a broker as infrequently as possible. I use a full service
broker. I like that he can buy stocks for me anywhere in the world given enough time, and, most
importantly, I like that I have to call him up on the phone and talk to a real person to place a
trade. This “inconvenience” has saved me more money than any discount broker ever could. If I
could find a broker that would only buy for me if I flew across country to place my order in
person, that would probably be the best broker for me. I’m joking, but, mathematically, I can
actually see that my “joke” is probably not wrong here.
The price of a round-trip plane ticket to New York really could be worth it for me if it had
slowed down my buying and selling activity over the last few years as much as I think it might
have. Frequent trading has cost me more money in bad decisions than in broker commissions.
The problem with online brokers is that they make you – the investor – into a trader. I don’t want
to spend one more second than necessary thinking about the exact quantities of shares I’ll be
buying, my limit price, etc. I want to focus 100% of my energy into finding the right stock to
buy. What I’m buying matters. How I’m buying doesn’t matter.
My only advice as far as brokers go is that I’ve seen more investors “lose” money by “saving” on
discount brokers, saving on taxes and saving themselves the hassle of opening a new account just
to buy a certain stock. Focus on two things. One, buy the best stocks. Two, trade as infrequently
as possible. If you do those two things, fees and taxes and such aren’t going to be important.
Don’t focus on minimizing your expenses. Focus on maximizing the financial gain you get from
your good ideas.
As far as screeners are concerned, I’ve never gotten many ideas off them. GuruFocus has a
Buffett/Munger screen. It also has screens for predictable companies. Looking at predictable
companies is a good idea, but the three stocks I own the most of – Frost (CFR), BWX
Technologies (BWXT) and George Risk (RSKIA, Financial) – are all rated one star or less by
GuruFocus in terms of predictability. The predictable companies screen is probably one of the
best out there. At GuruFocus I’d use the Buffett/Munger screen, the undervalued predictable
companies screen or just sort by predictability myself.
There are other web sites like Stockopedia, Morningstar and Portfolio123 that have screens. I’ve
created screens of my own at all these sites, but, again, I’ve never found screens to be a good
source of ideas. Technically, BWX Technologies (which was then Babcock & WilcoxÂ [BW])
came from a screen, but it was a generic screen, and it was misleading that Babcock even made
the cut. It’s just that Babcock hadn’t been public as an independent company for that long before
it was planning a spinoff so I didn’t know the company well.
Generally, I get ideas from talking to people either offline or online or from reading blogs.
Occasionally, I get ideas from “gurus” and “super investors” like Buffett, Mecham, Greenberg,
etc., but there’s usually not much overlap between my style and their style – and most famous
investors have big portfolios that can’t accommodate the best stocks out there. If I could find
really great investors who manage $100 million instead of $10 billion – I’d pay more attention to
them. The simplest screens are usually the best. Stocks that trade below 8x EBITDA have
annualized returns in the stock for more than 10% per year for more than 15 years, have been
profitable every year for the last 15 years and have reduced their share count every year for the
last 15 (or whatever) years – are the kinds of stocks I find most useful. I get more out of looking
at upcoming spinoffs than at screens.
I do have various custom Excel sheets I use. They aren’t very fancy. I usually gather 20 to 25
years or more of past financials. I am most focused on long-term returns (especially the harmonic
mean), the median level of past returns on capital, margins, etc., and the coefficient of variation
in margins. I’m often looking for predictable companies that will have higher margins, EPS, etc.,
in five years than they do today.
I bought Omnicom (OMC, Financial) and Fair Isaac (FICO, Financial) right after the 2008

financial crisis because their results in 2009-2010 were going to be cyclically bad but the
companies had easy to predict profitability if you looked out to like 2014-2015. Similarly, I
like Howden Joinery (LSE:HWDN, Financial) because you can predict roughly 8% annual
growth in sales for the next five to six years and yet the stock trades at a normal price-earnings
(P/E) of about 15. It shouldn’t have lower margins in five years than it does today. It might have
higher margins. This also highlights gross profitability.
I’m a little different from most investors in that I don’t pay that much attention to things like
recent EPS growth. Instead, I am looking at the level of gross margins, gross profitability (gross
profits/net tangible assets) and the predictability of that both at this company specifically and the
industry generally. If you buy and hold a company with high and stable gross profits in an
industry with high and stable gross profits – you’ll do fine for the long term. Most investors
don’t care enough about consistency and they care too much about the operating number. For
example, Amazon (AMZN, Financial) rarely reports good results on the bottom line, but it’s
actually been a predictable company higher up the income statement (like at the gross profit line)
for a long time. Amazon isn’t a cheap stock, and I don’t own it, but it’s the kind of company that
often doesn’t show up as a good business on a screen but clearly has excellent economics.
GuruFocus’ formula knows this and so Amazon gets 4.5 stars for predictability.
The most important thing here is to keep it simple. That’s why I like things like Value Line and
the web site quickfs.net. It’s simple. GuruFocus has a ton of data. And it’s all wonderful data that
might be useful. If someone was asking me how to quickly find stocks to look at using
GuruFocus – I’d say something like take the Predictability Score, multiply it by the F-Score and
then multiply the product of those two figures by the Z-Score. If it’s really high (like 40), you
might have found a good stock. If it’s really low (like 8), you may not want to spend much time
on that. It’s harder to evaluate stocks with low predictability, low F-Scores and low Z-Score. I’m
not saying it’s impossible, but it’s hard.
I’m being really misleading with all this talk of screens. Honestly, a “screen” for me is more like
hearing a company is still controlled by the founder. If you look at which stocks I tend to be
interested in, it’s stocks that have high and consistent gross profitability (that’s true), but more
than that they are usually family controlled or founder controlled with long-term focused capital
allocation. I did buy predictable, high ROE stocks like Omnicom, IMS Health (IMS, Financial)
and FICO right after the crisis, but I really bought those because they were great, cyclically
cheap businesses that I felt were going to buy back their own stock.
If I was “trapped” in the stock while it went nowhere for five years, I’d actually get a steadily
declining share count that would compound intrinsic value nicely. Without the capital allocation
I expected at those companies, I might not have bought them. I’m not really interested in just a
10% free cash flow yield or something like that – I want a 10% free cash flow yield the company
is using to buy back its own stock, make smart acquisitions, etc.
My mental screens – not screens I run online – are things like seeing a share count that always
goes down, seeing a CEO who was been with the company forever, seeing a family or founder
with a controlling stake and seeing a stock price that has done great things over the last 15 to 30
years. I have nothing against 52-week low lists and five-year low lists, but I’m more interested in
a list of the stocks that have the best compound annual returns over the last 15 to 30 years
because those stocks have – or had – the best businesses.
Unless somethingÂ hasÂ changedÂ dramatically, I usually don’t want to consider a stock that

has returned less than 10% Â year over the very long term. If you can find a stock chart going
really far back and when you plot the stock you’re interested in versus the Standard & Poor's
500, the S&P 500 wins – then, why would you want to buy the stock? This isn’t a rhetorical
question. I mean it seriously. For instance, I picked Breeze-Eastern for the newsletter I wrote. It
hadn’t performed well as a company. It had undergone a transition where it sold off worse
businesses and kept a wonderful core business as the entirety of this newly emerged stock.
Stripped of the dead weight and debt it had previously had – the stock was set to have a good
next 15 years even if it had not had a good past 15 years.
The same is true at something like Interpublic (IPG, Financial). It underperformed other ad

agencies badly in the past, but I can see why it did, and I can see that it might not make those
same mistakes in the future. By the way, Interpublic still outperformed the market over the last
40 years or so. It’s only the record from the 1990s on that looks shaky. Looking at the long-term
stock record is always a good idea. It’s one of the best screens you can run.
For example, I was just talking about ATN International (ATNI) with someone, and he was
going through the various business units and what he thought they were worth and so on. I
stopped him to ask three questions: 1) Did he know the rate at which ATN had compounded
book value over the last 15 years? 2) Did he know the rate at which ATN had compounded its
stock price over the last 15 years? 3) Did he think ATN in 2032 (15 years from now) would look
anything like ATN today? The answers were he knew a lot about the company as it existed
today; he didn’t think that 15 years from now the company would look anything like it does now,
and he didn’t really know the rate of intrinsic value growth at the company in the past, the
history of deals the controlling family had done, etc.
This is the kind of stuff I am usually looking at as my “screens.” For example, someone
mentioned Winmark (WINA) to me and asked if I knew the company. I said I didn’t know that
much about what it looked like today. What I did know was what the chairman (John Morgan)
and Winmark looked like years ago. Someone else mentioned MSG Networks (MSGN) to me.
Now, yes, I do know MSG because I’mÂ originallyÂ from New Jersey. MSG is one of the two
important sports TV networks in the New York City area. The other is the YES network which
broadcasts Yankees games. What I actually knew better was the Dolans (the family that controls
MSG Networks).
I guess my process is much less quantitative than you might think. It’s pretty quantitative where
it matters. I knew ATN’s compound annual growth rate, and I knew what kind of EBITDA
multiples they’d paid for telecom assets they’d bought, etc. I also always know the coefficient of
variation (standard deviation/arithmetic mean) in a company’s operating margin. That figure is
probably one of the two things I always know that usually other people have never seen. I know
a company’s gross profitability (gross profits/NTA) because I always know both gross margins
and net tangible asset “turns.”
Three of the figures that are sort of like “screens” for me in that they help me make snap
judgments about a company are:
1. Gross profits/net tangible assets (higher is better).

2. 15-year (ideally, as long as possible) coefficient of variation in the EBIT margin (lower is
better).
3. 15-year (ideally, as long as possible) compound annual growth rate in the stock (higher is
better).
As a rule, if a company isn’t predictable, why would you buy it? If a business has historically
had low gross profits relative to the net tangible assets it employs, why would you buy it? If the
stock has underperformed over 15 or more years, why would you buy it? And then, if the
company is now doing something different, has a different management team, etc., why would
you buy it?
There are good answers to these questions. Maybe the new management team is better. Maybe
the company has suddenly gained important economies of scale.
In my experience, companies that start life earning inadequate gross profits tend not to grow into
companies that earn adequate gross profits. Likewise, stocks that have underperformed over the
last 15 to 30 years rarely become stocks that will outperform over the next 15 to 30 years. I
would say the main point of “good to great” is that it rarely happens. It does sometimes happen,
but it often requires some sort of “re-founding” by an “outsider” type CEO who cuts out the bad
stuff from a corporation, focuses on the good stuff and then thinks like a long-term shareholder.
The main feature of all the work I do on a company is that it’s historical. You’d be amazed how
little time I spend looking at this year’s results. I’m often more interested in what the company
has done over the last 15 years and what I think it’ll look like five years down the road.
I do use Excel. And if I have any “secrets” it is in those three numbers –Â gross profits divided
by net tangible assets, the coefficient of variation in the EBIT margin and the long-term
compound annual growth rate in the stock. These numbers became more important the more you
trust management. I don’t really talk about myself as a “jockey” investor versus an investor who
bets the “horse.” But, it’s true that the quickest way to get me to ignore a stock is to tell me it’s
run by a fairly typical, fairly short-tenured professional manager. One reason I’ve rarely been
able to invest in Japan outside of net-nets is that I’ve almost never been able to find a manager I
like in Japan. I’ve found a couple, but it just hasn’t happened that the right Japanese manager has
been at the right Japanese business at the right stock price (for me). By far the biggest reason
I’ve invested more in the U.S. than any other country is that I’ve found it easier to get the kinds
of managers I want running the kinds of businesses I want. I’ve found a few in Europe, but even
my track record there is pretty American centric in the sense that my two favorite European
companies are Luxottica (LUX) and Hunter DouglasÂ (XAMS:HDG) – and they both focus on
the U.S. market. I love the way both of those companies have been run. Again, that’s a historical
thing. Without knowing the histories of Luxottica and Hunter Douglas, I doubt I could have
picked either of them for the newsletter.
If I had to sum up my process in one word, it would be “historical.” I’m not sure all investors
would benefit from adopting my historical approach. However, I am sure everyone reading this
could benefit from my unorthodox ideas about brokers. The best broker is the one you’ll use the
least.
 URL: https://www.gurufocus.com/news/496523/how-to-benefit-from-brokers-screens-
and-web-sites-instead-of-getting-distracted-by-them
 Time: 2017
-----------------------------------------------------
How to Estimate Future Growth at a Predictable Company

“How do you estimate the reasonable growth rate for a company? I believe one way is to see the
penetration rate of the product or service in each country and where they are in the current cycle,
also considering the population growth and real spend per household as you did for Hunter
Douglas. What is the general way of thinking about the growth?”
I am not very good at estimating future growth. I try to err on the side of being conservative. I
focus on simple, repeatable growth that seems backed up by the past record. For example, I was
recently trying to figure out the future growth rate ofÂ Howden Joinery
GroupÂ (LSE:HWDN, Financial). The company had – at the time – about 630 depots in the
U.K. It also had about 20 depots in France. There was a depot or two in some other countries as
well. I treated the depots outside the U.K. as irrelevant to this estimate of future growth because
those depots had different economics than the core concept of the depots in the U.K. Howden is
– at the depot level – essentially a local business. It has a local manager of each depot who is in
charge of most of the important operational decisions.
So, Howden – although it does not sell to the public – can be treated as a single retail chain. The
easiest companies in the world to value the growth of are those who do the same volume of
business each year and simply raise their price. The second easiest companies in the world to
value are those who have the same clients every year and do a different volume of business with
those same customers. The third easiest companies to value are those who do a different volume
of business each year with a different set of customers – but who simply replicate a local model
over and over again. Basically, we are talking about a chain of retail stores or a chain of
restaurants. It is important this chain be just one concept.
If I was looking a L Brands (LB, Financial), which owns both Victoria’s Secret and Bath &
Body Works – I would need to consider the growth of each chain separately. This can get
complicated even at relatively small companies. Urban Outfitters (URBN, Financial) is not
some mega-cap stock. It does have offline and online operations however. It also has three
important chains: Urban Outfitters, Anthropologie and Free People. Those are not the only
concepts. Those are just the ones I might bother to model the growth prospects for. Since Urban
Outfitters is a company with three or more different chains, I have to assess the growth of each.
Yet, the market cap of the stock is under $3 billion.
Meanwhile, Cullen/Frost Bankers Inc. (CFR, Financial) is a single bank in a single state

(Texas) that seeks deposits from two groups (Texan households and Texan businesses). Yet,
Frost has a nearly $6 billion market cap. Although Frost is twice the size of Urban Outfitters, it is
also simpler. It has one “concept” (Frost bank) in one state (Texas). There is no doubt Urban
Outfitters – because it can quickly win over new customers by opening stores in different states
and by selling online – can grow much faster than a business like Frost. It is easier for me to
estimate the long-term growth rate of a company like Frost however. You can look at its past
growth in market share (whether they have grown faster or slower than other banks in the cities
they are in) and at the branch level. I try to keep things simple. Say I feel the nominal gross
domestic product of Texas will grow no slower than about 6% a year. Say I also think the bank
will not lose market share and might grow it. In that case, I would simply estimate Frost will
grow deposits by 6% a year.
Let’s look at Howden. The company is effectively a chain. So I would break down growth by
“concept” and by “geography.” In Howden’s case, this means its depots in the U.K. There is no
other concept at the company. And there is no other geography that is particularly important. So I
would simply set aside all the depots outside of the U.K. and focus on Howden depots in that
country. Very often, the management of a company that runs a chain will tell you how many
stores, branches, depots, restaurant locations and so on it eventually hopes to put in that country.
This is the store count level at which a concept has “fully saturated” a country. Howden’s
management has set that figure at 800 depots in the U.K. They had about 630 depots last year
and have been opening new ones at a rate of about 30 per year.
I looked at that situation and said I could estimate the company’s growth from now until the
point of “full saturation” in the U.K. market. I have no clue if Howden the corporation will ever
come up with another concept. I also do not know if it will successfully export this concept to
another country. Like I said, they have about 20 depots in France. The company has disclosed
those depots are profitable at a local level. They are a lot less profitable, however, than its depots
in the U.K. And – because of the higher cost of doing business in France – a chain of depots in
France will never be as profitable (on a return on capital basis) as a chain of depots in the U.K.
So I really do not know where Howden will grow outside the U.K., how big those growth
opportunities are and – most importantly – how profitable that growth will be. For those reasons,
I decided to limit my entire estimate of Howden’s growth to its U.K. depots and to make this
calculation extend out to only the end of 2022.
By the start of 2023, Howden would – if it keeps opening 30 depots a year – reach the point
where it has 800 depots in the U.K. Management has said they see room for 800 depots in that
market. Obviously, they might one day change their mind and say the opportunity is bigger than
they thought, but that is speculative. So let’s limit our estimate of future growth to a pace of 30
new depot openings a year from now through 2022. We will then cut off our estimate there and
say the company is as big as it is ever going to be. That is a lie, but it is a useful one for the
calculation we are going to do.
The growth in a chain has two parts: 1) new store openings as a percent of the existing store base
and 2) the growth in same-store sales. The compound annual growth rate to take 630 stores up to
800 stores over six years is almost exactly 4% per year, so we start with 4% annual growth at
Howden. That is how fast the company would grow its sales if it did not have any same-store
sales growth.
Historically, Howden has had a lot of same-store sales growth. The figures for same depot
revenue growth are roughly as follows: 6% (2006), 9% (2007), 3% (2008), -5% (2009), 4%
(2010), 3% (2011), 2% (2012), 6% (2013), 11% (2014), 9% (2015) and 4% (2016). The
company’s sales are cyclically most related to kitchen renovations in the U.K. The customers are
small builders, so they are not usually building totally new construction. To put this in
perspective, I think about three-quarters of Howden's customers buy $3,000 or less a month from
the company. Howden is often the biggest supplier to these builders and, for some items,
probably their only supplier. So these are not individually very big builders. They are getting
credit extended to them by Howden to buy the stuff they need, install it and get paid by the
customer. They then pay off their balance with Howden and repeat the process with the next job.
So in terms of normalizing things we would need to consider: nominal GDP growth in the U.K.
and anything that would cause big swings in kitchen renovations that are not also swings in
nominal GDP.
Rising housing prices in parts of the United States can sometimes cause people to take out home
equity loans and re-do their kitchens and bathrooms. Therefore, a housing bubble and loose
credit can encourage renovation activity. We have a pretty good sample of time here (2006 to
2016) that includes some not very good periods in housing in the U.K. I am OK with this not
being a cyclically misleading same-store sales record. Now, Howden depots take a while to
mature. It is often the case with a chain that once a store matures, it no longer grows sales much
at all. Howden says stores are unprofitable for the first one to two years and generally grow until
they are seven years old. It does not actually say there is no growth after that time. The numbers
seem to suggest there actually is growth even at truly mature depots. But for the purpose of
estimating Howden’s future same depot growth, I did classify the depots by age.
The company gives the depot count from year to year. So you can divide the existing base of
depots into age groups. Many years ago, Howden’s same-store growth benefited from the fact it
was opening more stores each year relative to its existing store base than it does now. If you look
at the record however, relatively young depots have accounted for about the same percentage of
Howden’s total depot count from about 2012 to 2016. Same-store sales growth in those years
was 2%, 6%, 11%, 9% and 4%. The U.K. population growth is about the same as U.S.
population growth. In the short term, the U.K. might have some economic headwinds from
leaving the European Union. In the long run, it is not clear why the U.K. and U.S. would have
drastically different futures looking at the way their economies are set up, their population
demographics and things like that. I would estimate that nominal GDP growth in the U.K. should
not be much below 4% a year. Even relatively mature Howden locations may be able to roughly
match the nominal GDP growth of their local area. Beyond that, we are only looking out six
years. The way Howden is opening its depots, the proportion of new depots to old depots will
only very gradually shrink over this period. As a result, I feel confident projecting same-store
sales growth of 4% a year through 2022.
It is worth mentioning here what really matters is earnings growth – not sales growth. Part of
what makes me confident enough to take an estimate of 4% same depot sales growth and apply it
out through 2022 is profit at the depot level should actually outpace sales growth a little. You can
see margin expansion in Howden’s past. Because the company is vertically integrated, adding
new depots should – if they have exactly the same-store level economics as the old depots –
cause margin expansion at the corporate level. Anyway, because of the possibility of margin
expansion at the store level as same-store sales grow and the possibility of margin expansion at
the corporate level as the same supply chain serves a larger store base – I am confident adding
the same-store sales growth rate to the new store growth rate and assuming that profit will grow
no slower than sales. For Howden, my estimate over the next six years is the company will grow
the size of its depot network by 4% a year and each depot will grow sales by 4% a year. This will
drive company-wide sales growth of 8% a year for the next six years. That means net income
will not grow slower than 8% a year.
In addition, the company has enough free cash flow – at today’s stock price – to pay a dividend
of about 2.5% a year and still have 1.5% of its market cap left over to buy back stock. As a
result, I would actually expect Howden to grow sales per share by 4% (new depot growth), plus
4% same depot sales growth, plus 1.5% in share buyback rates to equal 9.5% a year. Again,
because there are economies of scale in a vertically integrated store network operated in a single
country, I would expect something like a 9.5% growth in sales per share to drive EPS growth of
10% or better.
The company also pays a 2.5% dividend yield, so I would expect EPS growth to be about 10% a
year over the next six years while you also get a 2.5% dividend yield. Let’s round that down and
call it a 12% annual return projection in the stock. That projection only works if the company’s
price-earnings (P/E) multiple does not contract. The P/E right now is around 15, which is normal
for a stock. The company has a pension deficit and leases its stores. It also has more than 200
million pounds ($251.3 million) in net cash, however, that I have excluded from consideration
here. I do not expect the company to use that cash to pay dividends or buy back stock (it will do
all that from the free cash flow it generates each year), but I do expect it to be enough to plug the
pension deficit from time to time. The company could also borrow money if it really needed to.
As a result, I think it is not aggressive here to treat market cap as if it were enterprise value. In
other words, I am just going to ignore the fact Howden has some liabilities like a pension deficit
– but I am also going to ignore the fact it has net cash when most companies as predictable as it
is would actually carry some net debt. So I would expect the stock to still trade at a P/E of 15 at
the start of 2023. Simply put, I would expect a roughly 12% annual return on the stock over the
next six years.
I used Howden as my example here because I am currently considering buying the stock. I do not
own it, but I expect I will at some point. It is unusual for me in the sense that most of the return
on this stock will come from growth. If you look at my 12% annual return estimate over the next
six years, a full two-thirds (8%) of that return comes from growth. Growth is always a
speculation, so Howden gets 8% of its expected annual return from a speculation on my part.
I do not think it is an especially aggressive speculation considering the company’s past and
management’s belief it can one day have 800 depots in the U.K. I am willing to speculate on this
kind of growth. Note, however, the speculation is limited to one concept (that has already been
successful year after year) and one country (the U.K.).
I have no interest in speculating at all on any possible value in other concepts or other countries.
The downside of this for me is Howden will be all used up as an investment idea in just six
years. It will not be a growth stock anymore. At least, it will not be a growth stock I would bet on
anymore. I think the company would still – even if it stopped opening depots – deserve a P/E of
around 15 in 2023. That is because the free cash flow yield plus the same-store sales growth
should still add up to a satisfactory return at a P/E of 15. If it stopped opening stores, it would
have close to 6% of its market cap (at a P/E of 15) to distribute in dividends or use as stock
buybacks. When you combine that with even a low level (like 2%) of annual same-store sales
growth, you get a decent return that would match the market. Therefore, I am not worried about
multiple contraction.
When a value investor buys a growth stock, his biggest worry should be a contraction in the
multiple. For example, if you have a company that is growing 10% a year now but will only be
growing 4% a year in about five years, that stock’s P/E multiple could easily collapse from 30 to
13. In fact, that would be a fairly normal multiple contraction for a stock with growth that slowed
that dramatically.
That is why I included a discussion of valuation here. It is not enough to know how much a
company will grow sales over the next five years. You also need to have some idea how slowly it
will be growing after that to have an idea of what the multiple contraction risk in the stock is. I
am comfortable with that risk at Howden. As a result, I would be comfortable buying the stock
and holding it for five to six years.
I should also mention my hurdle rate. I do not make investments unless I expect a 10% annual
return over the time I hold the stock. I would rather hold cash than lock myself in something I
expect will earn 9% a year or less. So Howden’s growth rate does not really need to be 4% new
depot growth plus 4% same depot sales growth. It can fall a bit short of that – like 3% new depot
growth and 3% same depot sales growth - and still make me about 10% a year when you add in
dividends and buybacks. That is important. I would never invest in a company where a 1%
change in my estimate of some key variable meant I should no longer buy the stock. Here, there
is enough room for me to be wrong about some of the speculative estimate I am making and still
do OK in the stock.
The most critical part though is, of course, the possibility of margin expansion. I have
intentionally left any possible growth in earnings above the growth in sales (that is, an expansion
in the profit margin) out of my math here. That is not because I did not think about it. I thought a
lot about it, but I really thought of it as an added defense against something like a contraction in
the P/E. I cannot model margin expansion well here. It is more complicated than the four
variables I laid out , which include new depot growth, same depot sales growth, dividend yield
and share buyback rate. I really do not want to speculate beyond those four things. Margin
expansion might provide upside, but P/E contraction might threaten me with downside.
The biggest speculation here is the one I did not mention. My cash is in U.S. dollars. Howden’s
stock trades in pounds. So if I hold Howden for five to six years, I am making a multiyear bet the
pound will not fall relative to the dollar in a big enough way to matter to me. All I know right
now is the pound is not overvalued versus the dollar. But that does not mean it will not get more
undervalued over the next several years. Growth is not the only thing that is speculative in a
stock. Making an investment in a stock that trades in a different currency is also a kind of
speculation. We can never eliminate all speculation from our investments.
 URL: https://www.gurufocus.com/news/495650/how-to-estimate-future-growth-at-a-
predictable-company
 Time: 2017
-----------------------------------------------------
Why Looking 5-15 Years Into a Stock's Future Makes the Most Sense
"I found your use of a multiple to estimate the value of NIC (EGOV, Financial) in five years
interesting (I often do the same thing by using the company’s historical normalized multiple).
The logic is sound, but in a way, isn’t that sort of blending a trading philosophy in with an
investing philosophy?"
Yes. It is like blending a trading philosophy with an investing philosophy. The theoretically
sound way to make an investment is to use a discounted cash flow analysis (DCF). However, a
DCF is not practical. I talk to a lot of investors and even when they tell me their approach is
probably "too simple," it really looks too complicated to me.
I do put past historical data into Excel to see it all in one place and do long-term calculations to
create a "Value Line" type data sheet. I also have a calculator with me at all times to let me
quickly do calculations I might otherwise not bother doing. If your choice of which stock
depends on something Excel calculates for you (as it will in the case of a DCF), it's not simple
enough. Honestly, if it's something you need a calculator for, it's not the right investment. The
"proof" of which stock to buy should be something you can do in your head.
Let's take the NIC example. I'll make up these numbers so I don't need to worry about finding the
exact figures for this example, but it's close enough to illustrate the point and relate to NIC.
Let's say NIC now has a 4% free cash flow yield. However, it is diluting its share count by
something like 1% a year in a normal year. That's 4% minus 1% equals 3%. If NIC uses some of
its free cash flow to offset all of that dilution, that leaves us with 3% of our possible purchase
price (as of today) being paid out in a dividend or used to reduce the share count.
Now, let's say NIC will grow total revenue (so same state revenue plus new federal contracts,
additional states, etc.) by somewhere between 8% and 10% a year for the next five years. That
would mean the stock would return 11% to 13% per year over the next five years. That's only
true if the multiple doesn't contract after that point.
Let's think about the "terminal growth rate" we'd expect in NIC. Inflation is probably around 3%
normally and nominal gross domestic product (GDP) in the U.S. is probably around 5%
(inflation of 3%, population growth a little under 1%, real output growth per person a little over
1%). NIC will try to win some new business. It might be able to do a nominal GDP type growth
rate. It might only be able to do an inflation type growth rate, but it probably won't fall too far
outside those figures. Let's use 3% to 5% per year as the rate NIC will grow in perpetuity after
the last phase of its fast growth period.
What should a stock trade at that grows 3% to 5% a year. Well, NIC can probably grow 3% to
5% a year forever without retaining any earnings. It quadrupled sales over a decade without
really increasing net tangible assets. So, all earnings are potentially able to be paid out in
dividends. That means the stock's "fair value" multiple in the sense of pricing it to perform in
line with the Standard & Poor's 500 would be: (Expected Forward Total Return in the S&P
500Â –Â NIC's Perpetual Growth Rate) gives you the earnings yield at which the stock should
trade. However, it does dilute by about 1%. So, we have to knock 1% off this number. Basically
it's S&P 500 Expected Forward Return minus 2% to 4% equals the earnings yield at which it
should normally trade in the future. The average return in the S&P 500 from 1928-2016 was
about 9%. Let's use that. I expect much lower in the future. This is conservative.
9% minus 2% equals 7%.
And 9% minus 4% equals 5%.
1/7 = 14 (roughly)
And 1/5 = 20.
The stock should trade at a price-earnings (P/E) of 14 to 20 once it is growing as slow as 2% to

4% per year in terms of earnings per share growth. That's because a stock growing EPS by 2% to
4% a year and paying a dividend yield of 5% to 7% per year will return somewhere between 7%
and 11% per year. That should match the market. Actually, it'll tend to beat it.
What's important here is how simple and conservative this approach is. That's why it's much
more useful than a DCF. Beyond five years, let's see what we've assumed:
* The company will grow overall sales, earnings, etc., at a rate no less than inflation but no more
than nominal GDP.
* The company will pay out 100% of its earnings in dividends or share buybacks.
* The S&P 500 will return somewhere between 7% and 11% per year –Â and we are using that
as our opportunity cost.
* The company will always dilute its shares at 1% a year forever.
None of these estimates is aggressive. Now, that leaves us with the issue of how well NIC stock
will perform over the next five years if it slows down to a growth rate of just 3% to 5% per year
before dilution and 2% to 4% per year (per share) after dilution in five years.
The company is guiding for EPS of 69 cents to 72 cents next year. Since this is lower than its
most recent year of EPS – we'll use that. Let's apply a 7% to 9% (8% to 10% less 1% of dilution)
growth rate for five years to that figure.
69 cents * 1.07^5 = 97 cents per share
72 cents * 1.09^5 = $1.11 per share
I said a long-term normal multiple of 14 to 20 would make sense for a company growing EPS as
slowly as 2% to 4% per year forever but paying out all earnings in dividends.
That's a price range for 2022 on the stock of:
97 cents * 14 = $13.58
$1.11 * 20 = $22.20
The stock is now at $21.05 per share. The stock is overpriced if we expect EPS growth to be as
low as 2% to 4% per year starting as soon as five years from now.
What I just laid out here is very conservative. It's possible NIC could really do something wrong
and lose some contracts or something. Short of that, the stock trading at lower than a P/E of 14 to
20 in sooner than five years is really unlikely.
What we did here is really very similar to a DCF. We broke the company's future into two parts
we think we can understand differently. One, the next five years where we think we know it will
grow faster than many businesses do. And thenÂ – beyond thatÂ – we have it growing quite
slowly. Now, if we made a mistake and said that growth would slow to 2% to 4% per share in
just five years when in reality it will continue to grow at 7% to 9% a year for more like 15 years,
qe have badly miscalculated. Also, if we said per share growth in EPS would be something like
2% to 4% a year forever and it turns out to be 5% to 7% a year foreverÂ – we've badly
miscalculated.
In fact, by my estimates, if NIC could grow free cash flow per share by 5% to 7% a year on a
long-term basis while also paying out all earnings in dividends, it would almost certainly
outperform the S&P 500 even if priced as high as 25 times earnings. That's because the S&P 500
will do worse than 9% a year.
I think it's very fair to say what we've done here is estimate what a five-year trade would look
like, but I think that's realistically as far as we can make any sort of practical estimate here.
I've written before that you should make "point-to-point" estimates of what a stock will return
over anywhere from 5 to 15 years. I don't believe in using calculations that aren't static (in the
sense they involve a definite end point). Calculations that go out less than five years or more than
15 years aren't helpful.
Why aren't calculations of less than five years helpful?
Because value will beat quality, growth, etc. over periods between now and five years from now.
It's just not worth doing the calculation. You should just buy whatever has the lowest valuation
relative to intrinsic value. Let's say I have two stocks: Hunter Douglas (HDG, Financial)
and Omnicom (OMC, Financial). When we picked these for "Singular Diligence," we appraised
Omnicom as selling for 90 cents on the intrinsic value dollar, and we hadÂ HunterÂ selling at 47
cents on the intrinsic value dollar.
What if Omnicom and Hunter Douglas reach intrinsic value 12 months after you buy them?
Annual return in Omnicom is 11% from the one-time value adjustment. Annual return in Hunter
is 113% from the one-time value adjustment.
Reach intrinsic value in two years.
Annual return boost in Omnicom from "value" is 5%. Annual return boost in Hunter from
"value" is 46%.
Reach intrinsic value in three years.
"value" is 29%.
Let's skip ahead to five years.
"value" is 16%. In other words, a 90-cent dollar becoming a 100-cent dollar over five years gets
you a 2% annual capital gain. However, a roughly 50-cent dollar becoming a 100-cent dollar
over five years gets you about a 15% gain. Quality isn’t going to make up a 13% annual return
difference. Over five years or less, you should always buy the 50-cent dollar instead of the 90-
cent dollar.
There's no way a "quality" or "growth" stock can compete with a value stock if your value stock
mean reverts to the correct intrinsic value within a holding period of about five years. Nothing
returns more than about 20% per year long term in terms of its actual compounding of intrinsic
value. Even Berkshire Hathaway (BRK.B, Financial) has often been around 20% in terms of
long-term compounding. Any time your return from a value gap closing is 20% or more per year,
you should just buy the value stock.
That's why I like to look at the situation starting about five years out. If we had a really good
growth stock, something like NIC in its best days or Apple (AAPL) in its best days or whatever
you want to pickÂ – we could imagine a high-quality growth stock that is only slightly
undervalued today running neck and neck with a only so-so quality value stock over five years.
A value stock will outperform a quality stock if the value gap closes in one to four years. For
example, Hunter paid a dividend, too. If you bought Hunter at about 50 cents on the intrinsic
value dollar and expected to sell it in about five years, you'd be looking at around a 20%
expected annual return. That's why value investing works so well. It's very hard to find any stock
that will grow 20% per year for five years and not have its multiple contract by the end of that
five-year period.
Value investing beats quality investing over periods shorter than five yearsÂ – and it's simpler
just to accept this fact and not worry about calculations about the trade-off between value and
growth for holding periods of less than five years. Just find the best, safest stocks you can trading
at about 50 cents on the dollar and hold them for five years. They'll beat everything else. And
there's no higher math needed to know that.
What about periods beyond 15 years? That’s the point where the situation can realistically flip so
quality starts always outperforming value from 15 years on.
Let's say Omnicom will grow EPS (this includes share buybacks) by about 7% per year forever
while also paying out a dividend yield of 2% per year. That means the annual return will be 9%
per year plus the closing of whatever valuation gap there was. Over 15 years, the closing of a
valuation gap from 90 cents on the intrinsic value dollar to the full 100 cents will only be 1%.
The 15-year annual return potential in Omnicom is 10% a year.
What about Hunter Douglas? Let's say that back – at a much lower price, when I picked this
stock for the newsletter – we thought Hunter was trading for 47 cents on the dollar (a 53%
discount to intrinsic value), and we expected Hunter Douglas to pay the same roughly 2%
dividend that Omnicom does, but we expected EPS growth at Hunter to only be about 4% per
year over the next 15 years. This is in the ballpark of what we'd actually expect at Hunter and at
Omnicom (long-term EPS growth of 4% and 6%). Now Hunter has a 2% dividend yield plus 4%
EPS growth rate which equals a 6% continuing buy-and-hold-forever type return.
Over 15 years, how much can a valuation gap closing from 47 cents on the dollar to the full $1 of
intrinsic value get us? It's 5%. Potentially Hunter could return 11% per year over 15 years versus
10% per year for Omnicom.
What if EPS growth is just 1% lower per year? Then they tie. What if Hunter actually only grows
EPS by 2% a year? Then Omnicom wins. Beyond that, we can look at 20 years. At 20 years, the
valuation gap closing would provide less than 4% boost to Hunter’s annual returns. And that's
from a stock that started selling for less than 50 cents on the dollar. It’s hard to find stocks
trading for more than a 50% discount to intrinsic value. It’s hard to ever squeeze more than a 4%
annual return from a value gap closing over periods of 20 years or more. As a result, pure value
investing that involves a holding period of 20 years or more doesn’t make sense. However, value
investing that includes quality and growth makes sense even over holding periods that stretch for
several decades.
For calculations of less than about five years, the stock with the bigger valuation gap wins. That
doesn't mean lower P/E, price-book (P/B), etc. It means the stock is selling for less than what it'll
be worth in five years. A "value trade" over five years. That's a long trade, but, yes, technically
it’s still a trade. When I picked Hunter Douglas I didn’t say you had to hold it forever. I said you
had to hold it for five years. And we picked Hunter before we picked Omnicom. At that moment
in time (Hunter was at a much lower price), we liked Hunter better than Omnicom because
Hunter was so much cheaper. Omnicom was always the better business. But, I didn’t think
Omnicom was the better stock over the next five years. Hunter was so much cheaper that it
seemed the better investment over a five-year time horizon.
And then beyond 15 years, quality wins. If you are holding something beyond 15 years, it's the
buy and hold return that matters. So, I think you only really need to do math comparing low-
growth value versus high-growth quality stocks in the five- to 15-year holding period range. If
you flip everything within five years, buy value. And if you hold everything beyond 15 years,
buy quality and growth.
My approach then is to focus on five years as the shortest possible holding period and 15 years as
the longest possible holding period. Within that period, I want to keep things simple. I'd like to
find stocks that look good both if I buy them and sell them five years from now and also look
good if I buy them and then hold them for a full 15 years. I try not to think too much about the
next one to four years (because everyone else is doing that) and I try not to think about years 16
and beyond (because those are often difficult for me to know, and the stock’s starting price no
longer matters much if I know I'll hold the stock for 20, 30 or 40 years).
We’re mere mortals not machines. It’s simpler for a human to “bound" the problem so it is just a
question of what happens if I hold this stock for five years and what happens if I hold this stock
for 15 years. I can then assume the actual annual return outcome will fall somewhere between
those two extremes. This approach keeps it simple. Otherwise, you fall into the trap of doing a
DCF that extends from now to judgment day. Or you fall into the opposite trap of explicitly
predicting exactly when in the next five years various events will occur. Both of those
approaches are kind of crazy. The stock is tradeable. I’m not going to literally hold it forever no
matter what. And this isn’t arbitrage. This isn’t an event driven investment. So, I shouldn’t be
predicting if I’ll make money in six months or 18 months or 36 months. It’s one thing to predict
certain events will happen. It’s much harder to predict not just what will happen but when it will
happen. Ignoring the truly short term (less than five years) and the truly long term (more than 15
years) keeps the problem manageable from a math perspective. Over five to 15 years, I can do all
the math I need to do in my head.
I like an approach that accepts the reality that you are likely to sell the stock at some point. And
stocks that may generate higher returns in the first five years due to a value gap closing do
deserve extra consideration as an investment because you can flip them within those five years
and get a higher annual return if Mr. Market offers you the opportunity. You should always go
into an investment planning to hold it for the long term, but you should sell one stock and buy a
better stock whenever you get the opportunity regardless of how long you've been holding the
stock you now like less than what you have the chance to buy. For that reason, assuming I will
hold whatever I buy for no less than five years and no more than 15 years is a very practical
approach that works well for me.
 URL: https://www.gurufocus.com/news/489605/why-looking-515-years-into-a-stocks-
future-makes-the-most-sense
 Time: 2017
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How Catalysts Can Boost Your Annual Returns
“Do you ever invest with a catalyst in mind?”
Yes. Although it depends on what you mean by catalyst. My three largest positions are: Frost
(CFR, Financial), BWX Technologies (BWXT, Financial) and George Risk (RSKIA, Financial).
In a sense, all of these investments were based in part on the possibility of something happening
in the future that would cause the market to re-value the stock. Let’s start with George Risk. I
bought George Risk when it was a net-net. This was back in 2010. I probably paid something
like $4.50 a share for a stock with $4.75 a share in net cash (actually investments in mutual
funds, bonds, etc.). There was an operating business too. The operating business had demand that
was somewhat tied to housing. So, in 2010, it was probably underearning what I thought it could
earn. In normal times, I thought it would earn about 40 cents a share pre-tax.
George Risk is a micro-cap that is mostly family owned. It’s illiquid. So, I’d say it probably
tends to get ignored as a stock. For that reason, it might never trade at a “normal” multiple of
about 15 times earnings. However, if it did – you would expect the stock I paid about $4.50 a
share for to be worth about $8.75 a share or something like that. An operating business that earns
40 cents a share pre-tax should be valued at about 15 times after-tax earnings, which is about 10
times pre-tax earnings. So, that’s $4 a share. And then $4.75 a share – or whatever it was – in
investments should be valued at their market value. Here, the question was all about a catalyst. If
I had somehow known ahead of making this purchase that the family intended to make an offer
for all the stock held by minority shareholders, or I had known it was going to pay out all its cash
in a special dividend, or I had known it was going to acquire another business at 10 times pre-tax
earnings – obviously, I would have bought a ton of the stock and known I’d make money.
Anyone would have done that. I didn’t know if any of those things was going to happen. As it
turns out, they didn’t happen. In the almost seven years I’ve owned the stock, it’s basically paid
out what it’s earned in cash dividends. However, the investments it holds have increased in
value. And the company has done nothing to disgorge the cash it already had. So, the securities
portfolio per share is even larger now than it was in the past. The dividend is higher. I think the
dividend yield is now a little over 4% on a stock price that’s a little less than twice what I paid
for the stock. I’d say the annual dividend yield is 7% to 7.5% of my cost in the stock.
The book value of the securities portfolio also grew. So, you can work that out in your head as
meaning that the rate of intrinsic value growth in the stock relative to the price I paid for it was
higher than 7% to 7.5% a year. Let’s say the growth in the securities held per share has been
about 5% a year and the dividend yield has been about 4% on the current stock price and about
7% on my original investment. You can see that the underlying business has performed in a way
that should have delivered returns to me of 9% to 12% a year regardless of what the stock
actually did. If the market valued the stock at a higher price relative to the operating business and
the securities portfolio, my own return would be higher than that 10% plus or minus a few
percentage points a year return. Likewise, if there had been some sort of catalyst – my annual
return would have been much higher than the roughly 10% number I mentioned. So, a catalyst
would have helped. And a re-valuation by the market (a change in sentiment) would have helped.
But, I did the math when I first looked at the stock, and I figured that even if I held the stock for
10 years and there was never any catalyst at all – I still expected to do 7% a year or so. In other
words, I thought my “downside” was an outcome where I was going to make something like 7%
a year from 2010 through 2020 in this stock.
The upside was that something might happen sooner. The market might re-value the stock
upwards. The family might buy out minority shareholders and take the company private. The
family might sell the company. They might pay a big special dividend. Or they might use the
securities portfolio to fund the acquisition of another operating business. Any of those things
could have easily caused a 7% type long-term return in the stock to become more like a 15%
return over a shorter period of time like a 3-5 year holding period. Obviously, that didn’t happen.
Actually, that’s not true. It did happen. The “market” – there isn’t really much of a market in
George Risk stock – did re-value the business up a lot pretty quickly. If we take the mid-point of
a three-to-five-year holding period (so four years exactly) I could have theoretically realized a
15% annual return by selling George Risk stock four years after I bought it. There were also
dividends. So, the actual return could have – even if my selling put a bit of downward pressure
on the stock – been in the 15-20% a year range. There was really no catalyst in this case. So, it’s
possible to make 15% or more a year over four years in a net-net even when there’s no catalyst.
So, yes, a catalyst helps. But, it’s not necessary. In this case, I obviously would have been better
selling George Risk after four years of holding it instead of keeping it for more like the seven
years I now have kept it. Over those seven years, the stock really hasn’t outperformed the
market. But, I always felt better holding George Risk than holding the market. So, there haven’t
really been times where I was tempted to sell the stock. Nor have I really regretted the decision
to buy it. Also, it would be wrong to regret buying it. On a probabilistic basis, it was obviously a
good investment. We are talking about the investment seven years later knowing that no catalyst
ever materialized. The stock still did fine. It caused minimal drag on my portfolio versus the
market – and that was without any catalyst over seven years. The odds of a catalyst happening
had to have been more than 0% back in 2010. So, in hindsight, we can see that the “bad”
outcome did fine. And there was some chance of a better outcome that never happened. So, I’d
have to score George Risk as a correct decision even if it underperformed other things I could
have bought. We only know that in hindsight. There was no way to know that there definitely
wouldn’t be any catalyst.
The catalyst for Babcock & Wilcox was clearer and more certain. This is a stock that I wouldn’t
have bought if there wasn’t a catalyst. Well, that statement is sort of true and sort of not. Let me
explain. I would have kept Babcock if the spin-off had fallen apart. For example, if the IRS had
said the transaction would be taxable, or the U.S. government (Babcock’s key customer) said
they didn’t want the spin-off to happen, or something like that. So, I didn’t need the spin-off.
But, there was a catalyst – in my view – whether or not there was going to be a spin-off. I really,
really liked one part of Babcock. That part is what now trades under the ticker BWXT. I thought
this was an absolutely wonderful blue-chip type business.
I looked at companies like Pepsi (PEP), Coca-Cola (KO), McCormick (MKC), etc. which trade
at like a P/E of 20-30 (so let’s say 25 times next year’s earnings guidance) in the kind of market
we’re in now. I looked at those companies, and I said they’ve all clearly got nothing on BWXT.
If BWX Technologies was a stand-alone business and it had the kind of capital allocation and
focus (the focus part was key here) that I hoped it would – the stock deserved to trade at 25 times
earnings or more. In fact, I actually thought that if it traded at a P/E of 25 today, it would
outperform the market over the next five years. OK. So, that’s what I wanted to own. I also
wanted BWX Technologies to limit itself to certain activities. I didn’t want it to build new
civilian reactors.
I really didn’t want it to acquire the nuclear related business of any of the handful of companies
that are involved in new build nuclear for civilian customers and other speculative activities like
that. I wanted Babcock to build nuclear reactors and provide other key components for the U.S.
Navy’s three most important programs: aircraft carriers, ballistic missile subs, and attack subs. I
was fine with Babcock managing sites for the U.S. government and doing nuclear weapon
related work like tritium production, down blending uranium to the point where it was no longer
weapons grade, and working on CANDU (Canadian) reactors. For historical reasons, the
CANDU business is unlike other nuclear work. So, basically, I wanted Babcock to just focus on
three kinds of U.S. Navy ships, handling nuclear work for other parts of the U.S. federal
government, and maintaining nuclear reactors in Canada (which again, were built to a different
plan than civilian reactors elsewhere). That’s what I wanted. And, it turned out, that’s what
BWX Technologies has seemed interested in so far. It did do an acquisition. But, the acquisition
was CANDU related – which I liked. And it’s talked about doing some more contracts – but
those contracts are really just doing more on the three U.S. Navy ships I like. So, the catalyst of
Babcock’s break-up created the ideal stand-alone company I wanted to own. BWX Technologies
also used some money to buy back stock – which, as you know, I’m always for.
Now, what did I have to endure to get this? One, I had to take shares in B&W Enterprises. I just
sold those at a big loss from where the spin-off happened. The loss is not significant when
compared to the gain in BWX Technologies. Also, Babcock had to stop spending on mPower.
That was a modular nuclear reactor project they had lost significant amounts of money on just
prior to the spin-off. To make the investment in Babcock, I did need to have confidence they
wouldn’t relentlessly pursue mPower for like technology reasons, prestige, etc. At some point, I
needed to know they’d run a DCF and admit that mPower wasn’t – even in the best case – going
to start producing free cash flow soon enough to justify putting any more money into it. They did
that. But, that wasn’t a surprise. My newsletter co-writer, Quan, and I were confident reading
earnings transcripts, things management said, etc. that Babcock was being run the way we
wanted it to be. I should mention that we looked at some peers of Babcock around the world. We
wouldn’t have invested in any of those businesses. They weren’t being run the way we wanted
them to be.
So, BWX Technologies was an investment based on a catalyst. It was based on a catalyst in two
ways. One, I really believe there was no way I would have ever been able to get a positon in
BWX Technologies at such a low-cost basis unless it had been part of a group that included
B&W Enterprises and mPower. I also think the relatively short history of Babcock as an entity –
it had been part of a larger company that needed to divest Babcock due to government rules –
made this investment possible. If Babcock’s U.S. Naval operations business had been a stand-
alone business for 10 years or something reporting EPS and giving guidance each year, it would
have probably had a P/E of like 25 or 30.
Now, you could say the annual return I’ve gotten in BWX Technologies – for example, the stock
has been up 50% over the last 12 months – is due to a catalyst. Basically, we have now reached
the point where BWX Technologies is a “clean” spun-off company that everyone is used to
seeing report alone, guide alone, etc. without any references to its parent or restructurings or
anything. No one cares where it came from now. So, that’s a one-time change. The catalyst is
what caused the gains here to come quickly. But, honestly, I think the stock would work out fine
if the market hadn’t reacted quickly to this catalyst. BWX Technologies just gave full year
results and specific guidance for 2017 and then more general guidance for like the next five
years. If you take the bottom end of their guidance for 2017 EPS and compare it to the stock
price today, it’s about 26 times next year’s earnings. I said a P/E of between 20 and 30 always
sounded right to me for BWX Technologies as a stand-alone company. So, it’s now in line with
where I expected it to be valued by the market. However, it also guided over the next three-to-
five years for “low double-digit EPS growth”. If it can still trade at a P/E of 25 in like five years,
it’s not unreasonable to expect further gains of around 10% a year from 2017 through 2022. I
don’t expect the market to do that.
So, yes, a catalyst may have given you 50% returns in one year. That’s better than you could
hope for in any long-term investment. But, if we take something like a six-year period from the
time of Babcock’s spin-off and use the idea the company might be able to grow EPS by about
10% a year for about 5 years – you’d still get about a 15% return over six years. So, yes, a 50% a
year return over one year is better than a 15% a year return over six years. But, I can live with
either one. Returns are always lumpy. The idea that you can know what is going to give you your
return so quickly you can sell it at a 50% return after one year rather than make more like 15% a
year over five years or so is just unrealistic. I can calculate what a stock should make over about
five years. That’s about as finely as I can slice an investment projection. I can’t guess what it will
do in one year. But, yes, the catalyst of the spin-off obviously provided better annual returns here
than just buying the stock and holding it for five years or so will. I mean, I have no plans to sell
BWX Technologies right now. But, I also know that future returns in the stock will be – if I’m
lucky – more like 10% a year rather than anywhere near 50% a year. So, if you want to make
50% a year – yes, you have to buy things with catalysts.
Finally, there’s Frost (CFR, Financial). Frost is my biggest holding. It’s also sort of a catalyst.
The catalyst here is the Federal Reserve raising interest rates. The simplest way to explain this is
that between about 2008 and 2015, I believe Frost more than doubled in intrinsic value per share.
The stock didn’t double at all. It traded at maybe 10% more than it had 7 years before. Why?
Because interest rates fell. Frost is a very, very interest rate sensitive bank. When interest rates
are at 0% for multiple years in a row, Frost earns a decent ROE. When interest rates are at 5% or
so for multiple years in a row, Frost earns one of the biggest ROEs you’ll ever see on a bank.
Most of the time, the situation is somewhere in between. A couple years ago, I thought the Fed
Funds Rate was as low as it would ever be. I also thought it had been low for a while and so
Frost’s loans and securities portfolio were yielding as little as they ever would. For that reason, I
believed that Frost was earning the least per dollar of deposits it had that it likely ever would. It
was a one-time event that was disguising what I thought was Frost’s earning power in normal
times. Now, I’ve said this many times before. So, I’m sorry if you’re tired of hearing it. But, it’s
the one thing that most differentiates my approach from other investors. I don’t care what a
company reported in EPS last year. I don’t care what a company is guiding for EPS next year. It
could say we lost $1 last year and we’re going to lose $2 next year. As long as I believe the
company is clearly going to earn $10 a share five years from now, I value the company on that
$10 it’s going to earn in five years. That’s all I care about. So, if I look at something trading at 12
times earnings and earning $4 a share, I don’t think of it as having a P/E of 12. I ask: will it be
making $8 a share in five years. And then, when it’s in that situation five years from now, will
investors value it at 16 times earnings. If the answer is yes, I say the stock will trade at $128 in
five years. So, now the only question is what I’m paying today for what I’m getting in five years.
Everyone else is worried about last year and next year. Even value investors are obsessed with
the current P/E ratio. So, I’m specifically trying not to think about those things.
Frost’s price was being influenced by two things. One, the Fed Funds Rate was 0%. Two, oil
prices had dropped from like $100 to $30 or something like that. I figured that in five years, the
Fed Funds Rate was likely to be 3% rather than 0%. I also figured oil was likely to be at $50
rather than $30. Frost makes a lot of energy loans in Texas. These are loans to oil producers.
These producers make nothing at $30 oil. They make a profit at $50 a barrel. So, if you could
really convince investors that the Fed Funds Rate would tend to be 3% in the future and oil
would tend to be $50 a barrel – they’d probably agree with my valuation on Frost. You could say
that there were two catalysts here. I was betting on The Fed Funds Rate going up and I was
betting on crude oil going up.
I kind of think of it as the reverse. To me, investors were valuing Frost in a really weird way.
They were saying the Fed Funds Rate would always be about 0% and oil would always be about
$30. Neither of these arguments make sense. You can’t keep oil at much below $30 for any
length of time, because you can’t find and develop a marginal well of oil for less than $30 a
barrel. Likewise, the Fed would have trouble implementing a negative interest rate. Also, in both
cases, other factors involving the supply and demand for oil and money just seemed to have
always suggested a “normal” Fed Funds Rate was something like 3% and a normal oil price was
something like $50 a barrel. I don’t think of this as betting on a catalyst. Because, historically oil
has often traded between about $30 and $70 a barrel in real terms. And, I’ve been equally
convinced that $30 to $70 was a good range when oil was $100 and when oil was $30. The Fed
Funds Rate should be even easier to predict. It’s unreasonable to believe the odds of rate cuts at
0% are anywhere near as high as rate increases. Therefore, the P/E of an interest rate sensitive
bank should be higher when the Fed Funds Rate is zero than when it is at a more normal figure
like 3%. This is just common sense.
So, here, I think of it more like I would never have gotten the chance to buy Frost unless The Fed
was keeping rates lower for longer and oil prices were falling. Those were the two things that
made the purchase possible. It’s also worth mentioning that for something like 6 months to 18
months, I was “wrong” in the sense that the Fed didn’t start raising rates as quickly as I thought
they would and oil fell a bit further at one point than I thought it would. But, when I say “thought
it would” I just mean what I thought the normal future level would be. I thought long-term
normal for the Fed Funds Rate was 3% and I thought long-term normal for oil was $50 a barrel. I
didn’t actually have any predictions of whether oil could go from $100 to $20 and then to $50 –
or if it got there some other way. Likewise, I didn’t have a prediction about exactly when the Fed
would start raising rates. I probably would have guessed sooner than they did. But, it doesn’t
make a big difference to how much I think Frost is worth.
So, catalysts are an important part of how I invest. The possibility of a catalyst at George Risk
meant it might have market beating upside and would likely have market matching performance
without a catalyst. The break-up of Babcock into B&W Enterprises and BWX Technologies
meant BWX was quickly valued upward. That has made the annual return in the stock much
higher than the annual gain in intrinsic value at the company itself. And then the Fed Funds Rate
near zero was what made Frost’s ability to grow earnings quickly – as the rate rises over the
months and years ahead – a possibility. But, it’s important to note how rare these kinds of
catalysts are. There are a ton of spin-offs each year. I try to look at most of them. BWX
Technologies is the best business segment I’ve ever seen result from such a separation.
Obviously, you could live the rest of your life without ever seeing a Fed Funds Rate as low as it
got after the financial crisis. So, the Fed Funds Rate starting near zero and rising from there is the
kind of catalyst that might literally be a once in a lifetime opportunity. This is something Charlie
Munger (Trades, Portfolio) always talks about. Most value investors understand it intellectually.
But, I’m not sure we internalize the lesson. It’s really rare to see a business like BWX
Technologies or Frost offered at those kinds of prices. Yes, there were the catalysts of a spin-off
and a rising Fed Fund Rate. However, those kinds of catalysts are really rare. You might find
something with a catalyst like that every 2 years or so. Maybe not even that. I haven’t had
success finding something like BWX Technologies or Frost every year.
So, you have to be willing to bet big when you see a good business with a catalyst. You also
have to be willing to do nothing for at least a year. And, really, if you’re looking not just for
good stocks but good stocks with a catalyst – I think you’ll usually be waiting more than one
year between the times you get the chance to do something smart. There are always catalysts out
there. But, I think most of the stocks I see written up with the idea of a catalyst as the rationale
for the investment just aren’t very good businesses. Those kinds of stocks won’t provide great
annual returns unless the catalyst is realized and pretty quickly. It’s better to look for something
that would do okay – return 5% to 10% a year – if the catalyst never happens. Then, you might
make 15% or 20% if the future event you were counting on happens quickly. But, if the catalyst
is slow to materialize, you’ll still feel fine owning the business you bought.
 URL: https://www.gurufocus.com/news/489450/how-catalysts-can-boost-your-annual-
returns
 Time: 2017
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How to Get the Most Out of the Time You Spend Thinking About Stocks
“How do you spend your time (idea generation vs. broad learning vs. in-depth research vs.
discussing ideas and concepts with others)?”
Honestly, I don’t divide my time day to day along category lines. It’s more like a focus switch
that I flip from 0% to 100% on a certain topic. There are some things I have to do somewhat
regularly whether it’s the best use of my attention or not. The three big ones are: 1) drafting,
proofreading and submitting articles; 2) recording and posting audio versions of the articles to
my blog; and 3) checking and answering emails. Those have to be done regularly. And only
some of those activities take 100% of my focus while I’m doing them. The most enjoyable and
most productive one is drafting an article in the first place. That’s a focused task that takes a
relatively short period of time where it’s the only thing I’m doing. It’s not busy work at all. It’s
time well spent.
I try to be more efficient with the less useful, less focused tasks. Proofreading and submitting
articles to GuruFocus, recording audio versions of the articles, etc., I prefer to do in batches, and
I time how long those tasks take so I don’t waste time on busywork. I don’t learn anything from
those tasks. I do learn from writing articles. Emails can be informative too, but you have to be
very, very careful with checking emails.
As those who have emailed me know, they may get a very long response back from me.
However, they shouldn’t count on a quick response. I was talking to someone recently who texts
with me a lot rather than emails. I told him my response time to texts isn’t any faster than my
response time to emails. I always read an email within two days of receiving it. I usually read it
in about one day. I don’t normally respond to emails more than once a day – because, honestly, I
try not to check my emails more than once a day. A lot of people have my email address. It’s a
lower focus, lower intensity activity to read and even respond to emails than it is to write an
article, read a 10-K, etc. The lazy part of you – and I’m very, very lazy by nature – will always
prefer the unfocused, easy-to-get-done-now activity over the activity that asks more of you. You
end up doing what’s “urgent” instead of doing what it’s important.
My general rule is that anything you do risks becoming a habit. Whenever you do anything, you
should ask yourself: “Do I want to do this every day for the rest of my life?” Usually, the answer
is “no.” That means you want to try to minimize or eliminate that task entirely. You also really,
really want to avoid making a habit out of it. It would be very easy to make reading and
responding to emails a habit. I intentionally limit emails.
There are a lot of things I used to do habitually that I’ve eliminated for this very reason. I used to
use Twitter. I’m back on Twitter now, but only to post links to the audio versions of my articles.
I won’t use it for anything else. Almost 10 years ago, I disabled comments on my blog. Reading
and responding to comments wasn’t a good use of my time. I’ve mentioned before that I’ve
never read a single comment to a GuruFocus article, and I don’t intend to ever start reading
comments. I write a lot of articles. It would be a terrible use of my time to read and respond to
comments. I’m better off reading emails from people who have an interesting question and then
turning that question into an article. I get more out of that than responding to a comment. And
the people who read my articles get more out of a brand-new article than they would get out of
seeing me in a comment thread.
I also used to read a lot of business news. I read newspapers, magazines, online news sources,
etc. Now I don’t do any of that. I found that more than 80% of what I got out of reading these
things came from the value investing blogs I liked best. Now I just have a page with the RSS
feeds of the 10 or so value investing blogs I like best. I avoid all other news. Lots of people
– Warren Buffett (Trades, Portfolio) included – find reading news (and newspapers in particular)
helpful. I don’t. I stopped doing it years ago. I haven’t had cable TV for more than five years.
This doesn’t mean I don’t watch as many videos, movies, TV, etc. of some kind as a lot of
people do. I probably watch less and read more than most Americans, but it’s not like I don’t see
anything. I just do it more actively and selectively, and that’s the same idea I apply to news.
I do end up reading some business news. For example, I’ve linked to this excellent article from
Bloomberg called “Is the Chicken Industry Rigged?” I know I’ve shared that article with a
couple of people via email or in person. It’s one of the most important articles of the last year for
an investor to read.
But, mostly, no I don’t read articles about business or investing. Instead, I read SEC filings,
presentations by companies to analysts, etc. There are always companies going public. They file
with the SEC when they do their IPO. I read their IPO filings. There are always companies that
are being spun off. Those companies file with the SEC when they do the spinoff. I read the
spinoff documents. Also, at some point after a merger has been announced, you will get an SEC
document. I think the precise document you are looking for is the “14D-9” in this case. I read
those too. I read the “background to the transaction” section or whatever it is called that
describes the initial contact, the offer made to the board, the back and forth, etc. in a narrative
history.
In the same document, there’s also an opinion from the investment bank that advised the seller. It
often gives the multiples at which past deals in the industry were done. I read that section, too.
Those aren’t short documents. I read IPO filings, spinoff filings and merger (going private, etc.)
filings. At any moment in time, there is some small number of each of these events happening.
There is a steady supply of IPO, spinoff and takeover documents to read. There are often investor
presentations associated with each of these. I read those too. This is what I’d consider the more
“passive” sort of background knowledge reading I do. Other people read The Financial Times,
The Wall Street Journal, Barron’s, Bloomberg, etc., and watch CNBC and Bloomberg and those
sorts of things. For me, these kinds of documents and investor presentations take the place of all
that stuff.
Then there is the reading I do that is specifically focused on some sort of investment idea. This
can either be reading about the company I’m actually interested in or it can be reading about
competitors. Here, I am always going to read the newest and oldest 10-K from the company. I
also like to read the newest and the oldest 10-K from competitors. I read the latest investor
presentations too. Sometimes, if I’m actually interested in one of the companies as a stock, I will
also read the latest quarterly press release. I can listen to the latest earnings call or read the
transcript. I can also read the 10-Q. I don’t do much of that. If I am really considering this stock
as a stock, I will do all these things to check for anything unusual, but I’m not really interested in
quarterly results or the kinds of questions analysts ask. I get a lot more out of reading investor
presentations and 10-Ks than I get out of reading the latest 10-Q.
But, like I said, it’s really a lot more of a focused search than I am portraying here. For example,
I mentioned that article on the chicken industry. I read the article. Before I was done with the
article, I had already decided I would read the newest and oldest 10-Ks for Sanderson
Farms (SAFM, Financial). Sanderson is more of a pure-play chicken producer than some other
companies I could pick. It was a good place to start if I wanted to learn more about the chicken
industry. There was also a presentation available on the company. Right there, I had two 10-Ks
and an investor presentation to read.
I generally print these things out and mark them up with a pen. I always read using a hard copy, a
red pen, a pad of blank paper and a calculator. When I’m done reading about something like
Sanderson Farms, you see a 10-K with questions written in the margins and sometimes these
rough calculations of different “guesses” about normal levels of things and the value of the
company and so on all over pages where I got the idea to start doing that kind of doodling. I just
write these notes to myself so I can think out loud on the page. The notes will be (I’m making
this up, it has nothing to do with Sanderson) something like “assume, conservatively 4% FCF
margin and assume 2012 was a normal year for the industry then” and go on from there figuring
out what the FCF per share would be in that case.
Some of these notes are a little weird. For example, I often calculate the number of employees I
think are doing various things, working in various places, how much revenue there is per
employee, how much profit per employee, etc., even where I’m not sure any of that is relevant. If
a company says it has 120,000 customers and 2,000 employees in sales/marketing – somewhere,
you can be sure I’ll have a note that says 60 customers to a sales associate. I just want to be
aware of situations where there’s a surprising figure like “six customers to a salesperson or
60,000 customers to a salesperson.” This is why I always have a blank pad of paper and a
calculator with me. If you don’t have those things, you just won’t bother making your best
guesses about all the things a company doesn’t say directly in the 10-K but which are very
simple to calculate for yourself.
In some cases, there’s information I always calculate and that I do consider important but the
company doesn’t highlight. The best example of this is deposits per branch. Banks almost never
tell you their deposits per branch. However, banks always tell you how many deposits they have
and almost always tell you how many branches they have. It’s easy to calculate this in all cases
and you should definitely do that.
You mentioned “idea generation.” The truth is that I can’t really tell you how much time I spend
on “idea generation” because I can’t really trace where I get ideas. This isn’t unique to investing.
The question every novelist gets and every novelist has no idea how to answer is “Where do you
get your ideas?” Very often, you can answer exactly where you got a specific idea. That’s not
important though. Generally, you’ve chucked 99 ideas in the trash for every one you’ve kept – so
knowing where you originally got an idea isn’t helpful. I’ve gotten ideas from alphabetical lists
of stocks in a country and I’ve gotten ideas from readers and I’ve gotten ideas from screens and
I’ve gotten ideas from other blogs, articles, etc.
In all cases, though, I’ve gotten something like 19 ideas I hated instantly for every one idea in
which I was even slightly interested. The more useful question to ask is “When did it click?”
That’s true both for novelists and investors. The real question for a novelist isn’t “Where did you
get this specific idea?” it’s “What clicked with this idea in such a way that you suddenly knew
you had a book?” Ideas are cheap. Bad investors and great investors have the same number of
ideas. Great investors just don’t invest in the bad ideas and make sure they do pounce on the
good ideas.
The real question with “idea generation” is searching for the right “frame” for the investment. As
an example, I’ve mentioned Howden Joinery (LSE: HWDN) before. Howden Joinery did not
look cheap to me at first, but I noticed that the company didn’t make money in the first two years
after it opened a depot. I also noticed the company kept opening depots. Now, mathematically,
that has to mean that the company is – in any given year – reporting lower earnings now than it
could report if it stopped opening depots. What matters to the future value of a business – which
is all we care about when we buy the stock – is how much free cash flow the business would
produce under a “steady state” condition. A company that is always losing some money opening
new depots is not in a steady state. It is chronically underreporting normal earnings by some
amount.
When did I get Howden Joinery as an idea? A long, long time ago. I read all of Richard
Beddard’s articles so I’m sure I read about it many times on there and thought the business was a
good one, but I also probably didn’t think it was cheap enough to ever buy. However, when I got
to thinking about how many depots Howden could still open in the U.K. and how long that
would take and then how long it would eventually take for Howden to have all of its U.K. depots
be “mature” in terms of their free cash flow generation, I had a “frame” for the problem that was
far in the future. We’re talking like five to 15 years into the company’s future. It’s not difficult to
make some estimates within a given point five to 15 years down the road and then work back
from that possible future to today and calculate the total return the stock should offer between
those two points.
I would say the “idea” of Howden Joinery must have definitely come from a Richard Beddard
post years back. However, the moment Howden “clicked” as something I should actually focus
on as a possible investment was when I was reading the company’s own description of the early
year economics of a new depot. At that moment, it clicked. And then, beyond that, there was the
statement by management that it could one day have like 800 depots in the U.K. instead of more
like 600. From those two numbers, you can calculate per-store future economics of a
hypothetically fully mature store base and multiply it by 800 of these depots in the U.K.
It’s a very, very simple frame. I’d say that’s truly the “idea” of Howden Joinery. Knowing the
business exists isn’t an idea. Knowing how you are going to think about the business as a stock
you could buy and hold for five or more years is the “idea” as far as I’m concerned. How much
time do I spend on pursuing ideas where I already know how I’m “framing” the problem versus
the amount of time I spend flailing about just reading 10-Ks where I have no way of seeing the
company?
When I have an idea worth pursuing, I drop everything and pursue that idea. Once I had the
“frame” for Howden, I stopped reading 10-Ks, annual reports, etc., of other possible stocks to
buy. I keep talking with people via email, and I keep reading blogs and so on. I also keep up with
spinoffs and IPOs and takeovers in a general background sort of way, but I don’t study two
different industries or two different companies at once. For example, I would never be reading
the annual reports of Howden Joinery one day and then Cheesecake Factory (CAKE, Financial)
the next day. I would already know whether – up to this point – I was a lot more interested in
Howden or in Cheesecake (in my case, It’s Howden) and I focus 100% on that stock.
When I talk to a lot of value investors, they seem to think more about “learning” than I do. I’m
not sure if I should feel guilty about that or not. But, I really don’t spend much time reading
about investing generally, reading business news generally, etc. I’m almost always reading about
a company or an industry that interests me right now. As I said, I’m taking notes and doing
calculations of my own that don’t necessarily have anything to do with the kind of stuff you’d
hear analysts ask about or that would be in an article discussing the company.
Something like “Is the Chicken Industry Rigged?” is a very unusual article. It relates almost
directly to competition in the industry and the level of normal future profitability. Those are the
two things I care most about. Business articles almost never discuss those two things. I shouldn’t
be too harsh on business articles. For example, I did read an article
on Chipotle (CMG, Financial) – don’t have the link right now – that discussed the changes
Chipotle had made in its supply chain as a reaction to its food safety problems. The article really
went into the issue that worried me most – that Chipotle would react to the food safety problem
(which can happen to anyone) with changes that would make the product less fresh, less
produced in store and more like competing products (which would defeat the whole point of
Chipotle’s model). It was a really good article, and it discussed stuff that is knowable. Most
articles focus on things like what caused Chipotle’s problems. Honestly, it’s difficult if not
impossible to know the specific cause of specific food poisoning cases. It’s also the thing that
matters the least to investors in the future. Whatever happened already happened. But changes to
processes and to the culture of the company are what matter more long-term and that’s what
investors should care about. They should be worried that Chipotle might learn the wrong lessons
from their food safety problems.
That was another really great article, but really great business news articles are rare. I really
don’t read business news anymore. Whatever articles I do read are either recommended by the
value investing blogs I read or they are historical articles directly related to a stock or an industry
I am researching.
 URL: https://www.gurufocus.com/news/487911/how-to-get-the-most-out-of-the-time-
you-spend-thinking-about-stocks
 Time: 2017
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What Makes a Stock Risky?
“How do you think about the riskiness of a potential investment?”
My answer isn’t going to be applicable to most people. I am a concentrated investor. I try to limit
myself to buying just one new stock each year. I try to own no more than five stocks at a time. A
normal position size for me is 20% of my portfolio.
Let’s say a “risky” investment is one with a decent chance of permanently losing half its value.
For me, that would mean a risky investment could cost me 10% of my portfolio forever. For that
reason, I have to avoid risky investments. I don’t carefully consider the risk/reward of an
investment and make the bet on a purely probabilistic basis. Instead, I try to focus on a small
number of high probability bets. What do I mean by a high probability event?
No. 1 is obviously lack of competition. Most businesses that fail fail because of competition. The
No. 1 requirement for me when looking at a stock is to find a business where competitors are
unlikely to put this company out of business. Someone I talk stocks with recently brought up a
business called NIC (EGOV). This company runs outsourced portals for the governments of
something like 27 of the 50 states in the U.S. Other companies don’t really do that kind of work.
They do work for specific federal agencies and state agencies and even municipalities. But, they
don’t create a subsidiary in the capital city of a state, staff it with a dozen or two dedicated
employees and offer a statewide portal for businesses and citizens to deal with the state
government.
There isn’t a contractual “moat” around this business. The contracts are pretty short term. They
can be terminated pretty easily by the states. And then the states can basically hand the portal to
another private company that can administer the website for them. There’s no barrier to entry
that way.
Competition in the industry is obviously more limited than in almost any other market you’ll
look at. Most businesses face other companies that are trying to offer essentially the same service
they do. Retail is the classic example of where competition is impossibly intense. You need to
have a really, really good business model to insulate yourself even the tiniest bit from competitor
actions if you’re a retailer.
I rarely invest in retailers. When I have picked retailers they have been companies like Village
Super Market (VLGEA, Financial), Tandy Leather (TLF, Financial), and PetSmart (no longer
public). I don’t think it’s possible for competitors to build supermarkets of the same size – about
60,000 square feet – as a Village-operated ShopRite supermarket within driving distance of
Village’s stores. There is your insulation from competition.
Tandy Leather is much bigger than any of its competitors. There isn’t really market share data
for the leathercrafting industry, but a typical competitor of Tandy might be 90% to 99% smaller
than Tandy. PetSmart is a category killer in pet supplies. A big source of the company’s profit is
premium dog food. In some cases, the suppliers of this pet food – primarily dog food – are
willing to sell the product to PetSmart or to a local or regional pet supply store. However, they
are – for brand integrity reasons – unwilling to sell their goods
to Walmart (WMT, Financial), Kroger (KR, Financial) or even
sometimes Amazon (AMZN, Financial).
There have been cases where a pet food producer decided to sell its brand through a more
general distribution approach – like through a Walmart – and they ended up regretting that
decision. It did harm to the perception of the brand that they couldn’t easily undo. The other
restriction on dog food sales is value to weight. It’s not economical to sell anything but the most
expensive dog food via the internet. The cost per pound to ship dog food is simply too high
relative to gross profit per pound. In fact, my newsletter co-writer and I did some estimates on
the business model of one online source of dog food and decided that the company would never
make any material gross profit – not net profit, gross profit – off the dog food they sold
regardless of scale.
The entire business model of this outlet had to be that it could cross-sell nonfood products (dog
beds, toys, collars, maybe one day some medications, etc.) along with the dog food they sold, but
there was just no way for them to profitably sell dog food. That isn’t true for everyone. Amazon
was in a better position than this company for selling dog food, but even in the case of Amazon,
we felt that what dog food sales we could try to model for the company were not meaningful in
terms of delivering profit – they were just things Amazon wanted its best customers to use as
“Subscribe and Save” type purchases.
Again, the point of the dog food sales still had to be cross-selling. PetSmart’s model was better
than selling dog food through supermarkets, discount chains or online. There were still risks of
competition, and we spent most of our time looking at those possibilities. But, compared to other
retailers, we were more comfortable with the lack of competition in what PetSmart did than we
would be with a department store, with most supermarkets, etc. In general, I’m not interested in
retailers, and I’m definitely not interested in generalist retailers. But, this is only because of the
risk of competition. In a case like Village – where land availability was limited – I was OK with
the risk of competition because I actually felt you couldn’t build new supermarkets near the
company’s existing supermarkets. New entry was unlikely.
The companies I would consider least risky from a competition perspective would be those with
monopolylike type positions and high customer retention. So, I would say that businesses
like Fair Isaac (FICO, Financial), Dun &
Bradstreet (DNB, Financial), Microsoft (MSFT, Financial) and Facebook (FB, Financial) are
less risky than other kinds of companies. Also, businesses that are oligopolistic but where
customer retention is high work much the same way.
Omnicom (OMC, Financial) and the other ad agencies, Union Pacific (UNP, Financial) and the

other railroads, John Wiley (JW.A) and the other academic journal publishers, etc. There are
also companies where new entry is limited for location/size of investment type reasons. So, I
mentioned Village Supermarket as being located in a place where it’s hard to put big, new
supermarkets. Likewise, Ball (BLL) has big beverage container making plants where it’s very
unlikely a competitor would add excess capacity near it. Locally, the beverage container business
should always be oligopolistic at worst. U.S. Lime (USLM) controls lime deposits. You don’t
ship lime very far. And I don’t expect much development of new sites ever. That’s an industry
where locally the situation will always be oligopolistic to more like monopolistic.
ATN International (ATNI) is an interesting example. It sometimes deals with big customers,

governments, etc., that potentially have big bargaining power. On the other hand, it is usually
competing in duopoly-type situations. I’d say the management of ATN International avoids high
competition industries. I’d consider it less risky.
One of the best examples of a company I think is low risk would be BWX
Technologies (BWXT). BWX is in what I would classify as a monopoly/monopsony business.
It’s a one-seller (BWX Technologies) and one-buyer (the United States Navy) market for nuclear
reactors used onboard aircraft carriers and submarines. This is one of the lowest risk investments
you can find in the sense that I feel sure the U.S. Navy will still be building nuclear-powered
aircraft carriers and submarines in 2047 and I feel pretty sure its only realistic source for the
nuclear reactors it needs is BWX Technologies.
What are high-risk businesses? High-risk businesses are anything in a fast-growing industry.
New, unsettled industries are particularly tough. So are any industries where it is easy for a
competitor to enter the market. Also, industries that are considered attractive because they are
big, growing, sexy, etc., are particularly dangerous. ATN International has entered the solar
power business in a way that makes sense. It’s a very boring way to enter the business,
and Berkshire (BRK.A)(BRK.B) is obviously involved in wind, but I’d generally want to avoid
any sort of industry that makes headlines because it’s the future.
One of the attractive things about BWX Technologies is that nuclear is really an abandoned
technology. There are a few countries in the world that have bet on nuclear in their nuclear
weapons programs, their navies and some civilian power production, but the reason these
countries do anything with nuclear usually has roots in the Cold War. It’s not just that it’s
difficult to develop new technical expertise in nuclear without having been working on projects
for years; it’s that not that many companies are actually interested in starting to work in nuclear
if they haven’t done it before.
Actually, the other part of the Babcock & Wilcox (BW) spinoff (B&W Enterprises) is largely
involved in coal power plants – and coal is also something people don't want to enter if they
haven’t already been in the business. That’s always a plus. Smaller markets like the tiny
Caribbean islands where some of ATN International’s businesses are don’t attract competitors
the way a big, developing country could. You want to see barriers to entry, but you also want to
find industries most companies aren’t going to be interested in even if they could enter it.
What are other kinds of risks? Financial risk is the really, really big one. I’d say that, when I’ve
made mistakes that have turned out to be costly, it’s been due toÂ eitherÂ the company having a
lot of financial leverage or operational leverage – or both. When a company has high financial
and operating leverage, a small decrease in sales can cause a big decrease in profits. You can
look at the Z-Score to check riskiness here. Make sure the Z-Score of a stock you are interested
in is always over 3.
Another good rule is that the company’s net debt to EBITDA should be less than 3. Once a
company’s net debt is more than 3 times EBITDA it may have difficulty accessing the kind of
credit a lot of companies take for granted. There are plenty of companies that can raise a lot of
debt at way more than 3 times EBITDA. But, I’m just using that figure as a cutoff between a
highly leveraged business and a more normal business. Any business that requires frequent
refinancing of its debt is risky.
Any business that is borrowing short adds risk to your portfolio. If two companies each have
debt equal to 3 times EBITDA, but Company A has 90% of its debts coming due in the next
three years while company B has 90% of its debts coming due sometime beyond the next 10
years, company B is definitely a lot less risky. The riskiness here for a shareholder is bad timing.
A business that has high financial and/or operational leverage could hit a bad sales patch at the
same time debts come due. That could cause the company to enter bankruptcy, issue shares at a
low price, or refinance its debt at a high interest rate.
For example, Weight Watchers (WTW) issued shares to Oprah Winfrey at a very, very low
price. This dilutes shareholders. The business ran into trouble. That would have happened
regardless of how it was financed, but because Weight Watchers was financed with a lot of debt
and especially with a lot of relatively short-term debt, the company was in a situation where it
needed more money, a new spokeswoman, etc., at exactly the same time its stock price was very,
very cheap. In general, you want to avoid investing in any company that issues shares to do just
about anything.
Even Warren Buffett (Trades, Portfolio) has made mistakes issuing stock in Berkshire. In his

most recent letter to shareholders, he says that issuing some stock to do the Burlington Northern
acquisition was a good deal. However, the stock he issued to buy both Dexter Shoe and General
Re was a big mistake. I’d strongly encourage investors to focus on businesses that reduce their
share count year after year (historically, this has included companies like Omnicom, American
Express [AXP] and IBM [IBM]) and certainly to avoid any company that increases its share
count year after year. Any business that isn’t 100% self-financing is riskier than a company that
self-finances all of its growth.
Other risks include things like customer concentration. Dependency of any kind is always a
problem. Looking at my own portfolio – it’s Frost (CFR), George Risk (RSKIA), BWX
Technologies, Weight Watchers, B&W Enterprises and Natoco (TSE:4627) – the riskiest stock
in that group is clearly Weight Watchers. That stock has high financial and operational leverage.
It also isn’t especially cheap on an unleveraged basis. B&W Enterprises is also somewhat risky.
The company is project driven and has major pension obligations. It is tied to coal and to the
financing of projects outside the U.S.
Natoco and George Risk have strong balance sheets, but the businesses aren’t especially low
risk. For example, George Risk is dependent on a key distributor of its products. I’d say that
Frost and BWX Technologies are the lowest risk stocks in my portfolio. BWX Technologies is
now quite expensive. There’s significant price risk with that one. The stock price could drop by a
big amount without making BWX cheap.
Frost is still cheap. As I write this, the stock price is near $90. In normal times – let’s say 2022
when the Fed Funds Rate is 3% or higher – Frost should certainly be worth more than $120 a
share. Obviously, Frost is extraordinarily highly leveraged – it’s a bank. But, the company
finances something close to 90% of its balance sheet with customer deposits. It probably retains
something like 90% of those deposits from year to year. And then it keeps more of its balance
sheet in bonds than some other banks do (because it keeps less in loans). I’d say that although
Frost is highly leveraged, it’s more like the way Berkshire is highly leveraged with float. The
company isn’t dependent on anyone other than customers to provide it with financing. For that
reason, I’d say Frost is now the least risky stock in my portfolio, BWX Technologies is probably
the second least risky stock, and then George Risk would be the third least risky.
The other stocks – especially Weight Watchers – are pretty high risk. It’s worth mentioning that
about 85% of my portfolio is in Frost, BWX Technologies and George Risk. I’d say that, as a
basket, they are low risk. I wouldn’t prefer the Standard & Poor's 500 over a basket of those
three in terms of riskiness from year to year. The portfolio is low risk.
Having said that, different investors would look at it differently. For example, BWX
Technologies is not in any sense a value stock, and George Risk is illiquid, family controlled and
dependent on one product category and largely one distributor for much of its profits. Finally,
Frost is a bank. Some people would see all three as being risky in some way. Value investors
wouldn’t like BWX. Most investors don’t trust family controlled, illiquid, micro-caps like
George Risk. And a lot of people don’t – especially since the 2008 financial crisis – trust banks
at all. You’ll never get agreement about risk.
Those thee stocks – which are well over 80% of my portfolio – are a low risk basket. But, some
people would say they are high risk. And a lot of people would say they’re a mixed bag that isn’t
especially safe or unsafe relative to other stocks. You have to judge riskiness for yourself. Moat,
financial strength and price are the three big ones. You don’t want to be invested in a stock with
no moat, with questionable financial strength, or where the price is now clearly above intrinsic
value. Those are the three risks to watch out for.
 URL: https://www.gurufocus.com/news/487544/what-makes-a-stock-risky
 Time: 2017
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What Makes You Put a Stock in the 'Too Hard' Pile?
“You say that you get 90% of the way (to picking a stock) in five minutes. What usually makes
you walk away when you decide to abandon an idea?”
That’s a good question. I should mention that the person who emailed me this question is the
same person who asked the earlier question about how long I research a stock before buying it.
This is the natural follow-up to that question, and I have a confession to make. I actually wrote a
fair amount – probably about 1,200 words – in the earlier article that covered this topic. That was
in the draft I saw.
The final product you may have read didn’t have anything about what gets me to walk away
from an idea. That’s because I deleted everything I wrote on that topic. I deleted it because I
named names. I gave examples of stocks I’d eliminated from consideration because of something
I read about the company, something the CEO said, etc. I don’t short stocks, and I don’t speak
negatively about companies in public. I certainly don’t say bad things about specific members of
management.
I decided to delete absolutely everything I had written on the topic. When I got this follow-up
email, I re-thought that. I can give you examples. I’ll just anonymize the examples I give. Plenty
of you will know which companies, which managers, etc., I’m talking about from context, but at
least I won’t have officially singled out anyone in a negative way.
The stories I’m about to tell are about real, public companies. Many of them are well-known
companies, but I’m going to leave the company names, stock tickers, etc., out of this particular
article. That’s for the most part. In a couple cases, I feel fine using names. Let’s start with one of
those examples.
Quan Hoang, who co-wrote the Singular Diligence stock newsletter with me, and I considered
DreamWorks Animation (no longer public) as a possible issue for the newsletter and even a
possible place to put our own money. We never wrote an issue about the stock. Why not? At
some point in the process, we asked a very simple question of each other. If you heard Jeffrey
Katzenberg was hit by a bus last night, would you feel comfortable owning DreamWorks
Animation stock in the morning? For both of us, the answer was no. We liked DreamWorks
Animation as long as Katzenberg ran it. There are only a handful – like fewer than five – people
on this planet we’d feel comfortable running an animation studio we were invested in. If
Katzenberg wasn’t running DreamWorks, someone else would be. And it wasn’t going to be any
of the other people who run animation studios that we trust.
Peter Lynch once said you should buy a business an idiot could run. Well, that rules out
animation studios. Animation studios regularly invest up to $150 million in the production costs
alone of a major release. They – or their distributor – put close to that same amount into the
project again in terms of marketing costs. The total release costs of these films are hundreds of
millions of dollars. A successful animation studio may release one to two films a year. A couple
of flops in a row could sink an animation studio. The care and intelligence required to run an
animation studio is a lot greater than the care and intelligence required to run a major Hollywood
studio that releases a dozen or more live action films a year. No head of a major Hollywood
studio is going to get you great results, but neither will a studio head bring down the company.
Releasing live action films is just too diversified a business. Making animated movies is
different. Quan and I weren’t comfortable with just any random studio head running
DreamWorks. Our entire investment thesis depended on Katzenberg being at DreamWorks.
There’s no margin of safety in that. We never picked the stock. As it turned out, another studio
(Universal, which is part of Comcast) ended up buying DreamWorks Animation, and Katzenberg
staying on in an active role was not part of the deal. An acquirer was willing to pay a lot more
than we could have spent on DreamWorks stock – and didn’t care whether Katzenberg stayed.
You could say we made a mistake by eliminating DreamWorks from consideration. Eliminating
a stock as a potential buy does not mean you think it’s a bad idea – you just don’t think it’s the
right idea for you right now. You aren’t saying it’s a bad stock. You’re just putting it in the “too
hard” pile.
Okay. DreamWorks is a really nice story. We were interested in the company if and only if the
founder stayed on indefinitely. What about some more scandalous stories?
The opposite situation from DreamWorks is obviously one where you won’t buy the stock – you
won’t even consider it – until the board removes the current CEO. Quan and I considered a stock
like this. The company was often in the headlines because of litigation from states' attorneys
general and things like that. That was a normal part of the company’s business. We weren’t
worried about that. There was also – this company was involved in processing financial
transactions – the risk of new technology disrupting the industry. Again, we were fine with those
risks, but Quan and I had never been fond of the company’s current CEO. We felt he wasn’t very
candid.
I want to make a distinction between being a cheerleader, an optimist, etc., and not being candid.
Quan and I obviously like Katzenberg as a studio head – and Katzenberg was eternally
optimistic. This situation was different. The CEO had basically made a promise to Wall Street
analysts; he had set a target revenue level for a certain business segment (not a big one) that
would be hit by such and such a date. As that date approached, it became clear that the company
wouldn’t hit that target. He didn’t withdraw the target. In fact, we felt he was signaling – by
sticking to an impossible target – that people lower in the organization needed to do everything
they could to hit a target that we didn’t think it was reasonable to expect them to hit. We felt he
was encouraging bad behavior by doing that. If you are going to tell people way down the
organization that they really need to hit a target, that target better be realistically hittable. This
one wasn’t. Quan and I decided we wouldn’t invest in this company – despite its strong
competitive position – until the CEO was removed.
A CEO can be ethical and still be someone I don’t really want to invest alongside. I was talking
to someone recently who was really interested in a company that had been spun off from a food
company. The brands in the business were fine, but the CEO who had been involved in making
capital allocation decisions – in this case, capital allocation decisions I really, really didn’t like –
at the parent company was now the CEO of the spun-off company. I really had no interest in
investing in a spinoff that was being run by a CEO of whose previous capital allocation decisions
I didn’t approve. I have no problem with a CEO making mistakes. I do have a problem with a
CEO having a worldview that is bad for shareholders. In this case, the CEO couldn’t be counted
on to sacrifice size, growth, etc., in order to improve shareholder returns. I wasn’t interested in
buying shares in the spinoff until that CEO was out.
Then there are legal issues. Here, I’m going to talk to you about anti-competitive practices. Or,
rather, the potential that a company might be engaging in anti-competitive practices that would
be a problem if they were forced to stop taking those actions.
Quan and I looked seriously at a company that had the dominant market share in its specific
niche. It had long dominated this market. However, there was a lawsuit alleging the company
had prevented competitors from entering the business by forcing its distributors to rely
exclusively on this company’s products instead of also distributing products from competitors.
There had clearly been communications inside the company that supported this claim. Some
executives at the company had ordered the destruction or suppression of this evidence.
In this kind of case the court could pass judgment for three times the actual damages. We looked
at what the monetary damage could be. We did our best to estimate the possibility of a huge one-
time hit to the company. That’s not why we dropped it. We could do the math needed to figure
out if the company could pay a huge fine given the time to do so. Why we dropped this company
is the risk that it wouldn’t be able to keep its exclusive distribution agreements. We really did
feel that every distributor would definitely prefer to carry this company’s products exclusively
rather than carry literally everything else in the industry. However, what the distributors would
want more than anything is to carry both this company’s products and competing products. That
would change the industry structure. We didn’t know what the industry would look like in the
future under those conditions so we dropped this idea.
Another example is similar, but much less clear cut. Quan and I looked at an industry where we
liked the competitive structure a lot. Over the last three decades or so, the industry had
consolidated down to a handful of producers. The value to weight ratio of this particular product
– it’s a commodity – is low. Also, it’s not economically feasible – at all – to maintain large
inventories of this product. You aren’t going to ship the product far. You also aren’t going to
build up speculative excesses of the product that need dumping from time to time.
There aren’t a lot of sites in the U.S. that produce this product, and the import and export of the
product is so low as to be meaningless. It is in the interest of the handful of companies that now
control most of the production of this product to behave very rationally. The government
provides a lot of data about this product. Enough in many cases to know who should submit the
winning bid for any point on the map you know a customer is located. There’s also a trade
association for this industry. It’s not unreasonable to believe that even if there was no explicit
collusion in this industry, all of the producers have enough information about the costs of each
competing location to know whether that location is going to bid seriously on a certain piece of
potential business.
In some cases, the bids are publicly known. That’s very important because it means that even in
cases where producers aren’t communicating directly with each other, it would be quite easy to
communicate everything all the other players needed to know simply by bidding honestly with
regard to your long-term economic interest. If all production data was hidden from competitors
and if competitors actively tried to bid in a misleading way, sure, the industry could be
competitive, irrational and cyclical. If there were few secrets in this industry and if competitors
were fine bidding in such a way that revealed their true economic interests, well, then, you could
pretty much map out which companies should always win which bids where.
There’s a problem here. A collusive conspiracy and what I just described would look exactly the
same to an outside observer like me. Obviously, no amount of talking to anyone inside the
industry would disprove such a collusive conspiracy. I might eventually find evidence that there
was collusion, but that doesn’t help me because I’m interested in buying the stock – I’m not
interested in whether there is or isn’t a legal case against some producers.
You can see this was a hopeless situation for the analyst. The thing that you needed to prove –
that there was no collusive conspiracy, there was just cooperation that was the result of
individual firm behavior based on publicly available info – was the very thing you could never
prove. We dropped this stock idea.
I can use names of actual companies for the next two examples: QLogic (QLGC, Financial)
and Teradata (TDC, Financial). We eliminated these two stocks fairly quickly after learning
about storage area networks. The problem here is just that we didn’t know what the broader
picture about how big corporations would store data was going to look like in five years. We
knew some companies were already trying out some things on a small scale alongside the
traditional way of doing things that could – given enough time – erode the durability of what
QLogic and Teradata do. It’s not that they aren’t good at doing what they do, and it’s not that
anyone else was going to replace them. It was just that we would never be sure if the thing they
were doing was actually going to be the way things had to be done five, 10 or 15 years down the
road. I can’t invest in a business for which there may be no need in the medium term. We
eliminated those stocks.
Now, I do want to caution that I have bought stock in companies that showed signs you might
say were similar to some of the anonymous examples I just gave.
For example, let’s look at some “anti-competitive” type industries. We picked two companies
– Tandy Leather (TLF, Financial) and John Wiley (JW.A, Financial) – where customers of the
company complained to us that they have no defense against the market power of their supplier.
Customers of both Tandy and Wiley were happy to volunteer that they had no resort to actions
taken by these companies on price or on the possibility of cutting off their supply. In both
academic journals and leather, it was really clear that people in the industry felt there was way
too much power in the hands of way too few firms and that there was nothing they could do
about it. We picked both stocks.
We have no problem with a noncompetitive industry, a cooperative industry or an industry with

“limited” competition. Also, we considered ATN International (ATNI, Financial). We never
picked it because the price didn’t get to the level we wanted to pay for the stock, but we had no
problem with the fact competition is often limited in the markets where ATN competes, and the
management team seems to actively avoid highly competitive areas and to seek out market
niches where competition will be limited.
I like industries with limited competition, but these have to be industries where I think the
subdued level of competition can stay subdued permanently. A good example of this is Warren
Buffett (Trades, Portfolio)’s investment in the four biggest U.S. airlines. He thinks the industry’s
structure has changed. He bought railroad stocks for the same reason. If he’s right, it’s not the
sort of limited competition that can be undone by a single court case. It doesn’t matter what
antitrust action is taken against the big airlines. The structure of the industry is such that better
returns on capital over a full cycle will be the natural result of industry structure and not the
result of specific actions taken by specific airlines that could be undone by a court case, a change
in the CEO position, etc.
So, there you are. I normally eliminate a stock from consideration because: 1) I’m not sure the
need for the company’s product is durable; 2) I don’t trust current management; 3) I don’t feel I
can trust any manager other than the current one to run the company; and 4) I’m afraid the
industry structure might collapse and end up becoming more competitive.
In his 1977 letter to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders,

BuffettÂ gave his four criteria for a stock purchase: “(1) one that we can understand, (2) with
favorable long-term prospects, (3) operated by honest and competent people, and (4) available at
a very attractive price.”
I didn’t mention price, but my other reasons for eliminating a stock are pretty much just the
antithesis of what Buffett is looking for. Sometimes, I don’t understand a company’s long-term
prospects (QLogic and Teradata), sometimes I don’t trust management (the food company
spinoff and the financial transaction processor), and sometimes I don’t know if the industry
structure will be favorable in the long-term (the company with exclusive distribution deals and
the commodity producer I mentioned).
Do I ever eliminate a stock because of price? Sure, but that’s complicated. For example,
someone suggested a stock to me last week that trades at 30 times earnings. It looks like it might
be a bargain at that price. That’s extraordinarily rare. In that case, it’s because the company
grows without needing additional tangible assets. The growth rate plus the free cash flow yield
can be as good at 30 times earnings as a more typical company’s total return would be at 15
times earnings. I’m not sure there is any strict cutoff with regard to price. I want the stock to
offer at least a 10% per year annual return if held pretty much forever. That’s really my only
hard and fast price requirement.
 URL: https://www.gurufocus.com/news/487542/what-makes-you-put-a-stock-in-the-too-
hard-pile
 Time: 2017
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How to Brainstorm Stock Ideas
“How do you source your ideas?”
My answer to this question might not be that useful to you. If I remember right, Phil Fisher once
wrote about where he got his best ideas – and the answer was from financial analysts who knew
him and the kinds of companies in which he was interested.
The same is pretty much true for me. It’s not necessarily financial analysts. I do sometimes talk
to analysts, but more often I talk to other value investors. Some of these people are individual
investors, some manage other people’s money, some write about stocks on their own blogs, and
some write about stocks on other people’s websites. What they all have in common is they spend
some time looking for stock ideas. They share those ideas with me, and I share ideas with them.
I have a blog where I put up podcasts and I always include my email address. I also write articles
for GuruFocus, and I always include my email address at the ends of those articles, too. I’ve been
writing about stocks online for over a decade now. A lot of people have my email address (you
can email me here), and a lot of people like to talk to me about stocks they already own or are
thinking about buying. I don’t allow comments on my blog, and I have never read a single
comment at GuruFocus.
That’s intentional. I’m interested in what people have to say to me if they want to engage in the
kinds of conversations people have offline. I don’t care what comments people want to make. I
only care if they are interested in a give and take of ideas. People are much more personal and
polite in emails than in comments. If you want to get a conversation started that might involve
the exchange of stock ideas back and forth between the two of you for years and years to come –
the way to do that is privately via email not publicly via a comments section
or Twitter (TWTR, Financial) or something like that.
It’s good to have a partner with whom to brainstorm. When Quan Hoang and I were working on
the Singular Diligence newsletter, we probably emailed each other close to once a day, and we
certainly talked via Skype for hours and hours once a week. I’d say we usually spent something
like three to seven hours messaging about specific stocks on Skype. There’s no substitute for
having an opportunity like that. You can spend the rest of the week thinking about stocks on your
own. That’s good and necessary work, but it’s more fun and often more of a challenge to your
own notions to talk it out with someone else.
Quan worked very hard on the newsletter, and we were pretty much sympatico on most of our
thinking about investments. It was a good and easy match, but that’s not really the most
important thing. It’s a help just to be able to hear yourself think and to interrogate someone else’s
ideas through a series of questions. You will be more explicit in your thinking when talking with
someone else than when you are just doing research on your own. Research that you carry out
with someone else is usually going to be more active than research you carry out on your own.
Another person is able to bring ideas to your attention that you’d never considered before.
This process isn’t that helpful if the other person doesn’t know you well. I don’t mean they need
to know you as a person. That’s not important. They just need to know how you think about
investing. I write about investing so I pretty much think aloud on the page. The people I meet
online who want to meet offline with me and talk investments or who want to email back and
forth already know how I think. These people are less likely to waste my time with ideas that just
aren’t in my circle of competence than a general investing audience would.
Anyone you talk to about investments needs to start with an understanding of what you’re
looking for in a stock. Otherwise, the conversations aren’t going to get that deep. There needs to
be some common ground.
For example, I have a broker I use who I talk to on the phone from time to time to place trades.
We talk about the market in the most superficial way. There’s nothing wrong with that. It’s just
that what he does and what I do are different things, and we understand that. He doesn’t try to
suggest any idea to me ever – he knows I have no interest in that. We can talk about an
upcoming IPO or something because he knows I will have read the SEC documents for that
company. But, he also knows I don’t buy IPOs and that I’m not interested in doing anything but
talking a little about the business as a business. We don’t have a lot of common ground in terms
of the kinds of investments we spend time looking at. Even if we had all the time in the world to
chat, there wouldn’t be much point in it.
That’s why you need to find some people who share some – not necessarily all but some – of
your investing interests. Different people have different areas on which they focus. There are
people I talk to via email almost exclusively about microcaps, and there are people I talk to
almost exclusively about net-nets, etc. I talk to some people in different countries. They often
have more to say about the stocks in that country than anyone else would. I talk to people who
live in Scandinavian countries, the U.K., Hong Kong, Australia, Canada, etc.Â – also, some
countries in Latin America, some countries in Europe, and of course there are people who live in
India.
I talk to a lot more people from English-speaking countries because my articles are written in
English. I wouldn’t say I buy foreign stocks all that often, but I usually am knowledgeable
enough or can quickly read up on a country to talk to someone from almost any country about at
least a few companies in that country. If I can’t do that, I can at least compare the stocks in
which they are interested to peers from other countries.
If someone wants to email me about a brewery in Europe, I can at least talk to them about
breweries in the U.S. I’m the one giving out my email address. They’re the ones contacting me.
Generally we talk about whatever they want to talk about. Selfishly, that works out better for me
because it means they are bringing me information about countries, industries, companies, etc.,
that I’ve probably never seen.
The best source of my ideas is just talking to other people. As I said, this is usually by email.
Sometimes it goes beyond that. There’s someone local here in Texas who contacted me when he
realized we lived one town over from each other. He asked if we could meet. I said sure. He had
interesting things to say about stocks. He was passionate about value investing. We decided to
meet in person from time to time.
That’s along the same lines as what happened with Quan. He contacted me out of the blue after
reading things I had written. He asked if he could help me research stocks – for free, he didn’t
want pay. He included a resume. It was a good resume, but it was a highly mathematical
background – and so not really what I was interested in. If he had just sent the resume, I
wouldn’t have followed up, but he sent his educational info and job experience along with an
actual email where he talked a bit about investing. I could tell he was passionate about value
investing. I decided we should keep talking.
Generally, that’s all it is. Someone emails me and we get to talking a bit. When I can tell
someone is really passionate about the subject, I try to respond to the emails in more and more
depth and tailored more and more to what I’ve learned about the person's investing interests. We
get a bit of a conversation going. If people are at all interested in value investing and I can tell
they’re passionate about the subject, it should work out. There’s no reason we can’t be emailing
from that point on whenever they have something they want to say.
I’m pretty clear about my investing philosophy in my articles. It’s a self-selection process. No
one who is mainly a trader, into technical analysis, into momentum, etc., is going to email me in
the first place. The people who email me tend to be a little more buy and hold, more into quality
businesses, more into small stocks, more into value investing, etc., than the general population.
We start from a lot of common ground.
Now, of course, I have an unfair advantage. I write articles about investing. I give out my email
address. People come to me. How are you going to find people with whom you can share ideas?
You can email me. I include a link with my email address at the end of every article I write. It’s
easy to find. If you have a question that I can answer in a helpful way, I probably will. If you
have noticed anything interesting in a specific country, industry, stock, etc., and bring that to my
attention, that’s even better. A good first rule when contacting anyone – including me – you only
know from reading their stuff online is to indicate you are passionate about whatever they are
interested in and then offer them something without asking for anything in return.
Remember, I give out my email address. Most emails I get all day are going to be from people
asking for something from me – review their books, recommend their websites, give them stock
tips, solve their problems, etc. – and not communicating with me the way they would talk to
someone in real life.
Emails are a little better than comments. That’s why I don’t allow comments on my blog and
why I completely ignore them on GuruFocus. I’ve literally never read a comment on one of my
articles – and I never will. I’m sorry if you comment and expect an answer from me, but that’s
why I always provide my email address. I long ago learned that the quality of conversations
conducted via email are better than the quality of conversations conducted in a comments thread.
I don’t waste my time with comments threads.
The same is even more of true of conversations taken offline. If you can move from emailing
someone with whom you talk stocks to talking with them by phone, by Skype or – best of all – in
person, you should definitely do that. You won’t regret it. You will become a much better
investor by getting yourself some sort of investment partner.
What if you don’t want to find someone with whom to talk stocks? What if you just want to
passively listen to someone else’s ideas without engaging in the more socially demanding give
and take of two-sided conversation?
You can read blogs you like. You can also follow the portfolios of investors who share some of
your interests. I notice that a lot of investors read widely and especially with a focus on recent
news. They also tend to be too deferential to authority. They aren’t as focused as they should be
on paying attention to their own tastes. You are probably already reading articles, blogs, etc.,
written by different people. Which blogs are consistently your favorites? Which make the most
sense to you? Focus more on those. Go through the backlist of everything that author has written.
Read it all once or even two or three times. Your time will be better spent focusing on the people
whose ideas are most compatible with your own way of thinking.
The same is true with “gurus.” Don’t waste your time looking at what 100 different “gurus” have
bought. Pick the 10 gurus you like best. Focus on learning everything you can about the stocks
they own. For example, I said I met in person with someone who had read my articles. He
brought up Allan Mecham. We both know Mecham’s portfolio. We both follow it. We could talk
about the stocks in that portfolio. I was able to mention one that I had written about in the past
and suggest that industry (MRO distributors) as a group this person might be interested in. There
are only maybe a dozen investors – Mecham is one of them – that this person could have named
I would have been able to remember which stocks were in his portfolio and talk a little about
them. I really don’t know what most “gurus” own because the style of most gurus just doesn’t
overlap with the kinds of stocks I look for. Don’t bore yourself with slogging through a
diversified list of stocks that don’t mean much to you. If you really like Mecham’s style or
Greenberg’s style or Warren Buffett’s style or Bruce Berkowitz’s style or whoever’s style – zero
in on that guy’s portfolio.
Over a month, you can work your way through preliminary research on literally everything they
own, and you can try to understand not just the business as an objective thing you might buy but
also their own subjective reasons for buying that stock. You learn both about the investors and
the stocks in which they are invested. In this way, you can have a one-sided conversation with
them. You can steal the ideas they have that you like best.
It’s not as good as finding an investment partner of your own. The best way to get stock ideas is
to find like-minded investors and just talk stocks with them as often as you can for as long as you
can. That’s the route I suggest for anyone willing to follow it. As I said, just scroll down and
you’ll see a link with my email in it. Find something I’ve written about in the past, mention your
thoughts on it to me and strike up a conversation. If you have interesting things to say about
investing, I’m sure I’ll email you back. I get as much out of these conversations as readers do.
 URL: https://www.gurufocus.com/news/487077/how-to-brainstorm-stock-ideas
 Time: 2017
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Can Snap Decisions Ever Be Good Decisions?
“One thing that’s been bothering me lately is if I’m spending enough time researching my
stocks. Would you mind sharing with me how many hours you spend researching something
before you buy it?”
This is a tough question to answer. The truthful answer is that I know very quickly – a lot more
quickly than you’d think – whether I might buy a stock. Usually I can tell within a matter of
minutes (often five minutes or less) and definitely I can tell within an hour of research whether
this stock idea should go to the front of the idea queue and be the thing I focus on or whether it’s
more of a typical idea that might be good but isn’t instantly appealing.
Now I like to be inactive when it comes to buying and selling stocks. For example, I try to limit
myself to just one new stock per year. That rule keeps me from flitting from stock to stock
whenever I get an idea I like. Having said that, I will admit that when it comes to a stock I will
eventually buy, I usually get more than 90% of the way to “yes” within the first 60 minutes. As I
said, very often I’m 90% of the way to “yes” within the first five minutes. I know that’s not what
you’re supposed to say. You’re supposed to say that you’ve carefully and objectively considered
a stock idea without any preconceptions about whether it is or isn’t any good – and then you’ve
appraised it as best you can and finally you’ve compared the current stock price to your appraisal
price.
Then – and only then – does the impulse to buy come into play. In my experience, the decision
process is nothing like that. I’m attracted to a good stock idea within the first five minutes, or I’m
probably never going to be attracted to that idea. It really does work that way.
There are exceptions. The key here is the “frame” through which you are looking at the stock.
That frame is going to be different for different people, and it’s even going to be different for the
same person at different times. There are stocks I have looked at over and over again where my
understanding of that business has evolved over time. It’s not usually an overnight thing.
Sometimes it is. I read something John Huber (of Base Hit Investing) wrote
about Apple (AAPL, Financial) recently and that got me thinking about the stock in a different
way. It wasn’t the only thing that got me thinking differently about Apple, and I’m still pretty
sure I’ll never buy Apple stock, but I can trace some changes in the way I “framed” the Apple
problem to what Huber wrote.
Likewise, I pay attention to what Warren Buffett (Trades, Portfolio) does. When he bought

railroads that got me to try to use “intellectual empathy” to put myself in Buffett’s way of
framing the problem of whether or not to invest in railroads even if I didn’t see them that way.
The same was true of Buffett’s investment in IBM (IBM, Financial). I’m never going to buy that
stock, but I took some time to try to see IBM the way Buffett sees IBM.
Airlines are a more nuanced situation. I was interested in airlines – specifically Southwest
Airlines (LUV, Financial) – long before Buffett bought stock in them. Airlines are something I
might have pushed for putting in the idea pipeline when Quan and I were writing the Singular
Diligence stock newsletter. About four years back, I got interested in finding businesses that I
thought were fundamentally fine, but their earnings power had – for many years during the 2000s
– been in some way disguised by high oil prices. I was sure oil prices would collapse at some
point (though I had no idea when). I was often pushing businesses that used oil as fuel
like Carnival (CCL, Financial) and Southwest Airlines.
When Buffett bought all the major airlines the same way he once bought into almost all the
major railroads, that just got me more interested in stocks I was already considering as
potentially interesting. A few days ago, I think I mentioned reading an excellent Bloomberg
article about the chicken industry. The chicken industry is very cyclical, but it’s a very short
cycle. It’s also still very fragmented. The three largest producers
are Tyson (TSN, Financial), Pilgrims Pride (PPC, Financial) and Sanderson Farms (SAFM),
but I'll bet the three of them together don’t account for more than 40% of the total pounds of
chicken produced in the U.S. each year. The fourth-largest producer probably only has like 5%
market share. You have 60% of the industry in the hands of competitors with 5% or less of the
market. That’s not a great structure for rational behavior. There is a lot of temptation for
companies that have 5% or less of the market – which, in the chicken industry is most of the
overall production – to engage in behavior that they think will benefit them in the short term but
will make the market worse for everyone in the long term.
On the other hand, the product economics of actually processing chickens is not bad. And
chicken is a cheap protein in the U.S. that has been gaining share versus beef and pork for
probably half a century. Much of the cost of chicken – like feed – is also part of the cost of
competing meats. It’s a very durable business in the sense that people are going to want to eat
meat, and chicken is going to be the cheapest meat. Long term, the industry is fine as a place to
invest. However, it has these very short, very violent cycles that can be bad for the businesses in
it.
On the other hand, you look at the record over the last 20 years at Sanderson Farms – I use 20
years because the company mentions in its 10-K that it changed corporate strategy in 1997 – and
you see that it’s an excellent record. The average profitability has been solid. The return in the
stock has probably been something like 13% per year over 20 years. Where previously I
“framed” the problem of the chicken industry as purely this perfectly competitive industry in the
long run, reading this article about the amount of information sharing between the companies in
the industry led me to rethink the possibility that the industry could behave more rationally (and
more like a cartel, implicit or explicit) rather than being this hopelessly cyclical industry.
Then when you look at the financial results of a company like Sanderson, you can see evidence
of a very decent business there. Now, of course, there will be cycles and within the next couple
years you can – and should – assume Sanderson will post an actual loss. For a long-term
investor, that doesn’t matter though. What matters is whether the industry is going to be more
like a perfectly competitive industry or more “rational” as the players in the industry would
describe cooperative rather than competitive behavior. If the answer is that the industry is going
to be more rational, then Sanderson would be an excellent long-term investment at today’s price.
At this point, I doubt I’ll buy Sanderson Farm, but I know I’d be “framing” the problem
differently if it wasn’t for that Bloomberg article about the antitrust lawsuits now happening in
the industry.
How can you make a decision so quickly? How can you know within five minutes or – let’s
make this easier – one hour of first meeting a stock that it’s something that should jump right to
the front of your idea line?
The three biggest positons in my portfolio are Frost (CFR, Financial), BWX

Technologies (BWXT, Financial), and George Risk (RSKIA, Financial). Not all of them have
been winners. I’ve owned George Risk since the summer of 2010. In that time, it’s probably
underperformed the stock market and has certainly underperformed other stuff I could have
bought instead, but all three of those decisions were made really quickly. I brought Frost to
Quan’s attention – and he was very interested in the idea within an hour of hearing me talk about
it. Quan brought Babcock (this was before the spinoff) to my attention. I wasn’t 100% sure we
could understand the business, but I agreed that if we could understand it we’d definitely buy it.
Even though I wasn’t sure I could understand technical aspects of what the company did, I could
tell right away that Babcock as a whole definitely wasn’t a bad business, and it definitely wasn’t
expensive. That decision took less than an hour. In the case of George Risk, it was maybe a five-
minute decision. It took me longer to learn a little about the business, but George Risk was a net-
net. I read a blog post over at The Rational Walk about the stock. By the time I had finished that
article, I was 90% of the way to “yes” with George Risk. I just needed to read the 10-K and learn
a little about the business, the family, etc., to make sure there were no deal breakers that the
article hadn’t considered.
By the way, the article I read actually wasn’t entirely pro-George Risk. The conclusion of the
article was that the stock had no catalyst; it was cheap, but it was a “pass.” The no catalyst part is
true. I still own the stock 6½ years later, and not that much has changed with it. As I said, I was
probably 90% of the way to “yes” with Frost, BWX Technologies and George Risk within one
hour of “meeting” the stocks. I would go on to do research for another week to a month with
each of those stocks. In the case of something like Frost, I actually waited maybe six months to
buy the stock, but that’s typical of me. I often decide to buy something or sell something and
then I’m in no hurry to actually carry out the purchase or sale. I like to be as inactive as possible.
As I said before, I try to limit myself to one stock purchase per calendar year. In the case of
Frost, I was hesitating because I was deciding whether I would put about 20% of my portfolio
into the stock or about 50% of the portfolio.
I decided on 20% of my portfolio. I’m not sure that was the right decision, but that’s what took
me about six months to decide. Deciding how much of the stock to buy took six months.
Deciding I was probably going to buy the stock happened within 60 minutes.
There’s often a period during which I am still researching a stock but even I have to admit that
I’m at least 90% of the way to “yes.” Howden Joinery (HWDN, Financial) is the clear example
now. I don’t own the stock, but I know that for a couple months now I’ve been 90% of the way
to “yes.” I’ll probably buy Howden sometime soon, and I probably knew that within a few days
– at most – of suggesting the stock as a newsletter idea that Quan and I should research.
We shut down the newsletter before doing an issue on Howden. If we had kept doing the
newsletter, our next issueÂ probablyÂ would have been Howden. It’s a good example of how I
can be focused on one particular stock I like better than all other options right now and yet not
actually buy the stock yet. In fact, that’s the whole point of my one new stock per year rule. It’s
to make me take a long time between being 90% of the way to yes and actually buying a stock. I
don’t want to do too much buying and selling, but that hasn’t stopped me from recognizing the
stocks I love as opposed to the stocks I might like within the first 60 minutes or so of learning
about them.
My answer is that there’s no harm in doing a ton of research and waiting a long time before
buying. However, if you’re an experienced investor, you’re going to be instantly attracted to the
best ideas you have within the first hour of hearing about them. That’s just how it happens. Good
ideas are simple. They’re obvious. You know them when you see them. It happens really fast.
That doesn’t sound prudent and full of the kind of due diligence we’re told we’re supposed to
practice, but it’s the truth. A great investment is usually something you fall in love with the day
you first find it. It doesn’t take months. You know pretty much right away.
 URL: https://www.gurufocus.com/news/486383/can-snap-decisions-ever-be-good-
decisions
 Time: 2017
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How I Research Stocks
“Do you use checklists or research templates, and if so, what sorts of things are on them?”
For a couple years, I wrote a stock newsletter. The structure of that newsletter reflected the way I
think about stocks. Basically, I just did my typical research process for a stock and published it.
Each issue started with a data sheet. The two key parts of that data sheet were a very long-term
historical record – as long-term as I could get – showing the income statement and balance sheet
ratios, growth rates, etc. for the business. It wasn’t unusual for us to publish 20-25 years of data.
That wasn’t for show. It wasn’t something we did because we though subscribers might like it. I
always look at the company’s financial history going as far back as possible. I’m not interested
in future projections. But, if you had fifty years of financial data on some company – I’d be
interested in seeing all fifty years. In fact, one of the first things I do when looking at any stock is
to read the most recent annual report (or 10-K) and to read the very oldest annual report (or 10-
K) I can get my hands on. Companies that have been public for a long time have data on
EDGAR (it’s a website run by the SEC) going back to about the mid-1990s. So, it’s possible to
have about 20-25 years of financial data for most companies that have been public for a long
time. There are a few companies – examples include Southwest Airlines (LUV) and Wal-Mart
(WMT) – that archive even older financial data on their own websites. I believe Southwest
Airlines has annual reports going back to the 1970s. The first thing I did when researching
Southwest was to read the most recent annual report and to find the oldest annual report on the
company’s website and read that one too. You can find historical financial data at sites like
GuruFocus and QuickFS.net. You can also enter the data yourself using EDGAR. Like I said,
EDGAR goes back to the mid-1990s. So, you should always also check the investor relations
section of a company’s website. There may be annual reports going back before the oldest 10-K
you can find on EDGAR. And, if you haven’t tried it before, I definitely recommend testing out
the idea of reading the newest and oldest 10-K as the first part of your research into a company.
It’s a habit I find very useful.
The second part of the data sheet was a peer comparison. Basically, we picked five peers for the
company we were interested in. We then presented price ratios like enterprise value to sales,
enterprise value to gross profit, enterprise value to EBITDA, and enterprise value to EBIT. The
best investment ideas are often companies that are better than their peers in terms of quality but
priced lower than their peers. Those ideas always get me excited. It’s also a good idea to collect
peer data simply because one idea can lead to another. Many times, we moved from researching
one stock in an industry to researching another related stock. We ended up writing reports on
maybe five different banks. That process all started when we wrote about Frost (CFR, Financial).
Frost led us to banks in the same area like Prosperity (PB), which is a Texas bank. It also led us
to look at banks that do the same sort of lending as Frost – energy lending – such as BOK
Financial. And then researching BOK Financial and banks like that led us to look at other banks
like Commerce (CBSH). The Kemper family runs Commerce. And a different branch of that
same Kemper family runs UMB Financial (UMBF). And then studying certain aspects of Frost’s
deposit base got us interested in Wells Fargo (WFC) – which we never wrote a report about. It
also got us interested in Bank of Hawaii (BOH). And we did write a report about that bank. So,
I’d say that research which started with Frost eventually led me to consider about six more
banks. That was all due to peer comparisons. As it turns out, I like Frost as much or better than
any U.S. bank. I only own one bank stock and it’s Frost. So, based on my actions, you’d have to
say Frost is my favorite bank stock. Frost also happens to be the first bank stock I considered.
But, I don’t think researching another half dozen or so bank stocks was a mistake at all. I liked
those stocks more than non-financial stocks. Researching them went much faster because I had
already researched Frost. So, I consider the selection of peers and the comparing of a stock I’m
interested in to a group of about five peers to be a useful part of my investment process. That’s
why I always include peer comparisons in the newsletter.
You could say there was a third part to the data sheet. We always included a graph showing the
long-term gross profit margin, EBITDA margin, and EBIT margin. If you’ve read some of the
stuff I’ve written in the past, you may know I have a bit of an obsession with the stability of
long-term margins. I’m also very interested in potential long-term margin expansion and
economies of scale. I care a lot about gross profitability. A company that has long had very good
gross profits but was once a lot smaller or less well run at the corporate level may be able –
through organic growth, through changes in management, or through horizontal mergers – to
improve its net profit over time. However, a business that has long had poor gross profitability –
and especially an industry that has long had poor gross profitability – is far less likely to turn
things around. So, I am always interested in whether gross profitability has been high even if net
profitability hasn’t been. And then I’m always interested in the amount of variation in the
company’s margins. I prefer to invest in companies that have a long history of profitability and
have especially stable margins compared to their industry and to other stocks.
After the data sheet, the newsletter was just a series of written sections. The first section was
called the “overview”. This was mostly just a historical description of how the company got
started and how it had developed. I’m always interested in learning what I can about the
historical development of a company and an industry. So, the overview section was basically
historical. Then there was a “durability” section. That section is different than moat. Usually,
whenever I’ve eliminated a company from consideration – either as a newsletter pick or as a
personal investment – I’ve done so because of some threat to the company’s or the industry’s
durability. A good example is something like Q-Logic (QLGC, Financial). I did plenty of
research into this company, its product, and the industry. A lot of the research showed up really
good signs. But, one thing I couldn’t be sure of is that the need for the company’s products
would be as great in the future as it had been in the past. This wasn’t really a competitive
position risk. It was a risk related to the wider issue of how storage area networks would be
organized and used. I found a similar situation in Teradata (TDC, Financial). There was plenty of
scuttlebutt showing that Q-Logic and Teradata had strengths. But, there just wasn’t information I
trusted giving me a good idea that things would be done the same way five years down the road
as they are done today. I always do a “durability” check for a company. Sometimes I am aware
of a risk to a company’s durability, but I don’t think it’s a big problem mathematically in terms
of a discounted cash flow analysis. I never do a DCF. But, I’m aware of the principle when
investing. Progressive (PGR, Financial) presented a special problem in terms of durability. On
the one hand, Progressive and GEICO both still have much lower shares of the overall auto
insurance market than they have of the truly new business in the industry. If a company has say a
12% share of the auto insurance market but has a 25% share of the new business in this industry
– we can pretty safely assume it will one day be capable of having twice the share of the market
that it does today. So, you have a big tailwind for direct insurers like Progressive and GEICO.
But, you also have the threat of driverless cars. And here we aren’t just worried about cars that
don’t require a human driver at all. We also need to be aware of the possibility that technology
will continually reduce accident frequency. In fact, that’s what had been happening for years.
The situation has become less certain lately with some evidence that texting has increased
accidents generally and fatal accidents specifically. Regardless, there are some kinds of accidents
– like a driver falling asleep and hitting the car in front of them on the highway – that the use of
computers can easily eliminate entirely without even being a true “driverless” car. So, I took a
good look at how long it might take for driverless car technology to be adopted by a popular,
mainstream auto manufacturer on one of its top-selling models. Then, I looked at the history of
how long it has usually taken for a safety feature introduced by one company to become standard
on all new cars. And then, finally, I considered how long it would take for half of the cars
actually on the road – since most cars are pretty old – to be driverless cars. All of this was very
rough and theoretical. It was an approximation. But, what it showed to me was that even if
driverless car technology was ready now and eagerly embraced by consumers, most of the
damage it would do to the auto insurance industry would come fifteen or more years from now.
In a DCF type analysis, years 16 and on are a lot less important than you might think. I was also
pretty sure that companies like Progressive and GEICO would have a much greater piece of the
overall auto insurance pie when the industry was finally hit with this obsolescence risk. So, I
assessed Progressive’s durability as being imperfect but adequate for a long-term investor. I
didn’t feel I had to rule out Progressive just because driverless cars would reduce accident
frequency in the medium term and perhaps obsolete the auto insurance industry entirely in the
very long-term.
After the “durability” section, I did a “moat” section. I’m sure you’re familiar with Warren
Buffett (Trades, Portfolio)’s definition of a company’s “moat”. So, I won’t bore you with a
discussion of the “moat” section of the newsletter. Just know that moat is something I look at
whenever I analyze a possible stock investment. There was a “quality” section. For me, a big part
of a company’s quality is its unlevered return on net tangible assets. I always had a “capital
allocation” section. This is a topic I focus on more than almost any other investor I know. I am
often first attracted to a company because it has made smart acquisitions, paid a special dividend,
pays a regular dividend, or has regularly bought back stock for years and years. In some cases,
like with the selection of Omnicom (OMC, Financial) for the newsletter – capital allocation was
the primary reason for picking the stock. Omnicom is a high quality, adequate growth stock. It
rarely trades at a low P/E ratio. If the company had more typical capital allocation, it would just
be an okay stock. However, Omnicom has long focused on buying back more of its own stock
than other ad agencies do. The business model of an ad agency is far superior to that of the
average public company. Therefore, an ad agency that devotes as much of its free cash flow as
possible to repurchasing its own shares can add a lot of value over time. About seven years ago, I
bought Omnicom stock for myself. And then I picked it for the newsletter too. In both cases, I
wouldn’t have considered Omnicom if not for its capital allocation.
You probably consider me a value investor, so it’s no surprise I had a section in the newsletter
called “value”. I always do an appraisal of a stock. So, I don’t just determine it’s cheap. I
actually look at the stock and come up with what I think it would be worth in normal times.
Sometimes the difference in my appraisal and the market price is big. A good example of this is
Frost. I still own the stock. That surprises some people because it probably rose 50% or so from
where I wrote about it. However, I think Frost was trading at about $60 a share when I picked it
for the newsletter and I put a “normal year” (meaning a year in which the Fed Funds Rate was at
least 3%) appraisal on the stock of about $140 a share. It’s very rare for me to find a situation
where the market value of the stock is less than 50% of my appraisal of the business. In the last
few years, the only non-financial stock that leaps to mind is Hunter Douglas. I believe I
appraised that stock at more than twice its stock price. Again, there was a cyclical reason for that.
I do a “normal year” valuation. I don’t pay attention to what earnings will be this year or next
year. So, my appraisal of Frost was based on a year in which the Fed Funds Rate had recovered
to historically normal levels and my appraisal of Hunter Douglas – which is indirectly related to
housing since it makes shades and blinds for windows – was based on a year in which the U.S.
housing market had fully recovered.
I also do a section on “growth”. I do consider likely future growth at the companies I research.
This isn’t a very important part of my research process. I have sometimes picked one stock over
another because of better growth prospects. For example, I prefer Texas banks over banks in
other states because I think Texas will grow faster than a state like Hawaii. One reason I own
Frost and not Bank of Hawaii is that I feel certain Frost will grow its deposits faster than Bank of
Hawaii will. Growth is also a factor when I consider investing in a chain like a retailer or a
restaurant. I will pay more for a restaurant chain that has fewer present day locations compared
to how many locations I think it can one day have in the country in which it operates.
I always include a “misjudgment” section. The misjudgment section is where I consider my

potential biases, errors, etc. I’m not sure how useful it is. But, it’s something I always do. It’s
different from the other parts of my investment process in the sense that it’s purely subjective –
focused on me and my thinking – rather than objectively focused on the stock itself.
Finally, there was the “future” section of the newsletter. In many ways, I consider this the most
important part of my investment process. I’ve said this many times. But, it’s still worth
repeating. I don’t care what a business will report in earnings this year or next year. I also don’t
pay any attention to what I think the market will value the business at. I don’t care about trying
to predict what will change market sentiment. That’s too hard for me. I always frame the
question this way. One, what will the business look like in five years? Two, what would an
acquirer pay for such a business? That’s it. And that’s what I mean by future. For example,
Kraft-Heinz just made a bid for Unilever. So, if I was analyzing Mondelez – which used to be
part of Kraft – I’d ask what Mondelez would look like in 2022 and how 3G and Kraft-Heinz
would value such a business. I really don’t think about how much Mondelez will earn in 2017,
2018, or 2019. That’s what a trader worries about. I also don’t look at what Mr. Market is
valuing the business at now. I do collect data on peers. They’re public peers. So, I see how the
market feels about the industry that way. However, I pay at least as much attention – and maybe
more – to the multiples at which acquisitions have been done in the industry. I don’t pay more
attention to what the market values a food company at today in terms of EV/EBITDA or P/E
than I do to what one food company paid to acquire another food company bank in 2015 or 2012.
That’s my process. It is standardized in terms of my major concerns. And it’s fully standardized
in terms of collecting and presenting historical data. It’s not really very structured beyond that.
So, I guess you could say I have a checklist that reads: “durability”, “moat”, “quality”, “capital
allocation”, “value”, “growth”, “misjudgment”, and “future”. I also always compare the
company I’m interested in to publicly traded peers. And, most importantly, I always look at
historical financials going as many years into the past as possible. I’d say I’m usually working
from about 20 to 25 years of past financial data. That data is the bedrock of my process. It’s the
quantitative part. Everything else is basically qualitative.
 URL: https://www.gurufocus.com/news/485297/how-i-research-stocks
 Time: 2017
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How to Diversify Without Selling Stocks You Already Own and Love
“I'd like to hear you talk about position sizing, cash size and the buying or selling pressures they
put on an investor (in a general sense, I'll just add my specific current situation as a potential
starting point). My retirement account right now has three positions and a 32% cash balance,
the largest holding has recently appreciated to the point where it's 36% of the account.
I've considered selling a bit of my biggest holding, but I'd still rather have $X of this stock than
$X of USD, especially while I already have an appreciable cash balance.
It doesn't seem like fixing my too large (but still undervalued) position by making my cash
balance too large, or putting it in some other company that I feel is less undervalued and stable
than this stock is a good idea. How is an investor meant to square this circle? I guess just
turning over more rocks until I can find a place to deploy some of the cash I would get from
paring back my largest position.
In a theoretical sense, though, what if this stock went up another 20% while I continued to not
find any more satisfactory investments? At some point it seems as though the numbers would
indicate that the most prudent action would be to sell this and have too much cash, or deploy
some/all of the proceeds in an investment I'm not thoroughly convinced is a great use of cash.”
I’m going to start by directing this to your specific situation. You said your account now has
“three positions and a 32% cash balance.” I’ll assume some positions – like the largest – have
risen faster than others. Since you are concerned about your biggest position now being 36%, I’ll
assume you’re not comfortable with a position being on average about 35% of your portfolio. In
other words, you only own three stocks right now, but you’d like to own more than three stocks
if you were fully invested. In your case, it sounds more like you might want four to five stocks
when you’re fully invested. If that’s the case, I’d suggest starting your positions out in the 20%
to 25% range and then just letting them grow to whatever they grow to. In other words, if you
find that you keep having this problem of one position being too big – don’t sell that position
now. Instead, just make a change to your future process to start positions out even smaller.
Let’s pretend you started this position that is now 36% of your overall account out as a 25%
position. If that’s the case, I wouldn’t sell any of this stock right now. Instead, I’d make a note to
only put 20% of your portfolio into the next stock you buy. From now on, you’ll start out at 20%
and then the same rise in the stock – of about 40% in this case, will only get this position to say a
28% position instead of a 36% position. This way, it will take longer for a stock to get to a level
you’re uncomfortable with. If this problem keeps happening, keep lowering the level you start
your positions out at. If you find that you are still too concentrated in your best performing stock,
lower the level you start your positions at to just 15%.
A lot of people are going to disagree with this advice. If you think about it, my advice here is
really counterintuitive. You’re saying you already have too much in one stock and I’m telling
you that the next time you buy a stock, you should buy less of it than you had been planning to.
That means you won’t be diversifying as quickly as you otherwise would be. The knee-jerk
reaction here would be to sell positions that get too large. In fact, this is what Sequoia fund
announced they’d be doing in the future. I remember reading the transcript of Sequoia’s investor
day where they spent most of their time discussing their losses in Valeant (VRX, Financial).
They decided part of their mistake was in letting that Valeant position get too big. They didn’t
sell a stock that had gone up too much. Now, I agree this was a problem. But, I don’t think the
problem is exactly what most people think it is. So, let me explain what I think some of the risks
in Valeant came from.
One, Sequoia bought Valeant. This was a “jockey” stock. It’s an execution dependent business.
It’s not a business an idiot can run – at least it’s not a business model an idiot could carry out.
That’s tough, and I’ve talked about this before. It’s a difference between how I feel comfortable
investing and how Sequoia is comfortable investing. There are a lot of smart value investors
– Bruce Berkowitz (Trades, Portfolio), Glenn Greenberg (Trades, Portfolio), etc. – who also
focus a lot on who the management is and what they are saying. I don’t do as much of that. I
think I’ve mentioned before that Quan and I considered picking DreamWorks Animation (no
longer public) for our newsletter. We decided not to for a pretty simple reason. We asked the
question: What if we woke up tomorrow and read that Jeffery Katzenberg had been hit by a bus.
Someone else would be running DreamWorks? Would we buy the stock? Would we even
consider it? The answer was no. I’d consider buying Berkshire Hathaway (BRK.A, Financial)
(BRK.B, Financial) even if Warren Buffett (Trades, Portfolio) wasn’t running it. But, I’d never
consider buying an animation movie studio with the wrong guy in charge. That’s a completely
execution dependent business. I’m not saying Katzenberg is the only person we trusted. But, the
track record we would care about was the movies that CEO – whoever he would be – had been
involved in producing. If the wrong CEO is at the top of a movie studio, we have no interest in
buying it. That’s the first risk Sequoia took with Valeant. It was an execution dependent business
model and you had to put faith in management.
The second risk I think Sequoia took with Valeant is they listened to the CEO. They heard about
the company from management. Now, they do that with most of the companies they invest in.
And I think some of their biggest ever successes have been betting on the “jockey” so to speak.
So, I’m not necessarily saying Sequoia shouldn’t talk to management. I’m just saying that
spending a lot of time talking to management is probably part of what went wrong here.
Then finally, I do think the increase in stock price was a big problem, but not in the sense of the
stock getting too concentrated. That’s obviously a risk. But, I think there’s another problem with
a stock whose price has risen while you own it – that stock feels like a winner. You bet on it
when others weren’t betting on it, and then those other people came around to your way of
thinking and confirmed you were right. If the stock had gone up before you bought it, you might
not feel this way.
This is a lot like – though not exactly the same as – a problem I see and think about a lot. I think
of it as “risk habituation.” Basically, there are risks out there that people keep telling you about
over and over again. At first you listen, but eventually you get used to hearing the warnings and
not seeing anything bad happen. The example I use a lot is oil prices. But housing prices are
another good example from the past. Interest rates could be an example for the future. Whenever
I talked to other investors about oil prices back before they collapsed, people would say that, yes,
they were maybe $100 and should be more like $70. But nothing was on the horizon that was
going to bring them down fast. Then these people didn’t really talk about the possibility that if
oil prices could easily rise $30 above what they thought the intrinsic value of oil was, they could
also fall $30 below the level they thought was right. Very often, the people I talked to about oil
prices didn’t actually have a different opinion than I did about oil. But oil prices had been so
high for so long that they stopped listening as closely to what their own gut was telling them
about the cost of finding and developing a marginal source of oil.
Whatever Sequoia’s concerns were about Valeant, they weren’t new. Sequoia has been right for
a long time about Valeant even while other people were predicting that what the business was
doing wasn’t sustainable in the long-run. Those critics weren’t really wrong about Valeant. But
they were early. That happens all the time. I mean, if you had asked me three years ago to give
you my best guess as to what the Fed funds rate would be at the end of 2016 and what level the
Dow would be at, I wouldn’t have picked 0.50% to 0.75% and 20,000. I would have picked a
higher interest rate and a lower stock price. I don’t think I was wrong to think it’s really risky to
bet on either low interest rates staying that way forever or the Shiller P/E staying as high as it is
now forever. There’s a danger that you look at how you were wrong about the timing and you
say, well I must be wrong about some underlying reality here. But I don’t think there’s really any
reason to do that in a lot of these cases.
Valeant’s model was always sustainable to a point. It was eliminating R&D, raising prices and
adding to debt. That’s a very powerful strategy for fueling a cycle of really rapid earning per
share growth. It will work – and it did work – for years. The same thing was always true for oil
prices. They take time to adjust. When Quan and I were researching Carnival (CCL, Financial)
and the other cruise lines, we saw that they were reducing fuel consumption, but we also saw
how high oil prices had to be for how long to cause them to do this. If oil prices rise for what
they think will be only a few years, they aren’t going to change business practices. Likewise, you
aren’t going to see a lot of development of oil in the U.S. unless people actually believe oil prices
are going to stay high for a while. So, for the first three years or so that oil prices are high, it
seems like there is no balancing force that is either causing declining demand or increasing
supply. But, if prices stay high for more like six years, then you’ll start to see big changes in
long-term decision making. And then – as is always the case with these things – there will be a
lingering over adjustment. Even three years after producers and consumers have started making
adjustments, prices may only just then be reaching the correct, “normal” value for the future.
Well, this happens with stocks. It happens all the time. Let’s take the example
of Frost (CFR, Financial). I owned this stock two years ago. It didn’t go up. I owned it last year.
It was up close to 40% last year. What happened last year? The Fed raised rates a bit and said
they’d raise rates a lot more. Oil prices – Frost is a big energy lender to Texas oil producers –
weren’t in free fall. They rose a bit. That’s fine. But, let’s be clear about two things here. One,
interest rates are still lower than what I thought “normal” would be in the future. And oil prices
are now at the lower end of about what I thought “normal” would be. In other words, neither
interest rates nor oil prices recovered as quickly as I expected them to when I bought Frost. Or, at
least, they didn’t surprise me. This is about what I thought needed to happen for interest rates
and oil prices to get back to normal. So, I thought they were both really below normal last year.
Now they are still not above normal. In other words, there hasn’t really been anything surprising
about interest rates or oil prices. Yet instead of Frost making slow progress each year – or rising
by 20% the first year and 20% the next year or something – it had a huge part of its gains in just
the last few months.
The danger here is that I would feel more confident in Frost now than I was last year. I think that
danger is especially big when you are talking about a stock you owned a lot of for a long time
and it kept going up, up, up like Valeant did for Sequoia.
I would warn you to be extra careful about your largest position, not because it’s too big a
position, but because you might start feeling more confident about it now than you were in the
past.
But, don’t – whatever you do – just sell the stock because it went up. Warren
Buffett (Trades, Portfolio) once quoted Peter Lynch on this point. He called selling your winners
to buy your losers “cutting the flowers to water the weeds.” I agree with that point. In the very
long-term – we’re talking three to 15 years here, not three to 15 months – the best stocks to own
are probably those that have done best for you in the past. There’s nothing wrong with holding
on to the biggest position you have. Don’t trim it now. But, think seriously about lowering the
initial amount you invest when you first buy a stock. That will help you avoid this situation in
the future.
The level you pick is a personal one. I’d have no trouble starting at 20% to 25%. But, honestly, I
have no problem if my best performing stock ends up being 50% of my portfolio. If your
tolerance for concentration is let’s say 33% being the highest you ever want to see a good
performer reach, then you probably want to start your positions off at more like 15%. But don’t
change your position size now. Change your process for the future.
 URL: https://www.gurufocus.com/news/476959/how-to-diversify-without-selling-stocks-
you-already-own-and-love
 Time: 2017
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How to Steal Another Investor's Style
“Many investors seem to be characterized by a single distinctive style throughout their careers.
How can we train to be good at all the following —Â great-businesses-at-fair-prices-type,
special-situation-type, net-net-type —Â depending on the opportunities that the market presents
at any point in time so that we can outperform the market most of the time?”
What you’re describing here are sort of what I’d call “sub-genres” of value investing. Just like
there are mystery writers who are best when writing hardboiled stuff and there are mystery
writers who are best when writing “cozies,” there are value investors who are best when they are
buying great businesses, and there are value investors who are best when they are buying into
special situations. There is cross-over. Investors can progress over their career so they are
focused mainly on a different sub-genre. Elmore Leonard started the 1960s by writing
Westerns. Warren Buffett (Trades, Portfolio) started the 1960s by investing in “cigar butt” type
deep value stocks. By the end of the 1980s, Leonard was writing crime novels and BuffettÂ was
buying great businesses. So, they switched genres. But did they change their styles?
Not as much as you’d think. You have a style that’s all your own. Genre isn’t important. The
“style box” that Morningstar puts your portfolio into isn’t important. I bought George
Risk (RSKIA, Financial) when it was a micro-cap net-net with no catalyst. I bought Babcock &
Wilcox (BW, Financial) when it was a big cap with a catalyst (a spin-off) ahead of it. But, I think
both purchases fit the same style. George Risk had a core business that I thought was a solid one.
That operating business was generating after-tax returns on tangible net assets of close to 30%. If
that was all you were getting, it wouldn’t be a cheap stock. But you were also getting a pile of
cash, bonds, mutual funds, etc. The combination of these two things – the good operating
business and the random pile of surplus funds – was worth more than the stock was selling for.
To me, it was clearly a value stock. But it was also a high-quality business. It wasn’t a melting
ice cube, but it was a net-net.
Now, what about Babcock & Wilcox? To me, it looked very much the same. If you just screened
for a cheap stock, you wouldn’t turn up Babcock & Wilcox. I thought the business that is
now BWX Technologies (BWXT, Financial) was very high quality. It had a wide moat. It
should have traded at a very, very high P/E ratio year after year. And then I thought the business
that is now B&W EnterprisesÂ was fine. It might have been cyclically cheap. It had a good
competitive position and it had fine economics. But the industry it was serving might shrink in
the future.
Then there was also a business called mPower that had lost money in recent years – it was an
experimental moonshot type project (modular nuclear reactors – so very, very small power plants
you could deliver by railroad to a job site and run for years without refueling). Quan and I were
convinced that Babcock would shut this business down and not lose much money on it. So, you
had three parts here. You had mPower, which had some slightly negative value in our view.
Then you had B&W Enterprises, which was a solid business but probably going to shrink in the
future. And then you had BWX Technologies (BWXT, Financial), which was a fine business
that we thought would grow sales and earnings consistently for decades to come. The
combination of these three businesses – a money pit, a solid but shrinking business and a great
and growing business – added up to a stock price that we thought was well below the value of
those three businesses if they’d been auctioned off to three separate control buyers.
Honestly, that’s how I looked at the situation, and it's the same way I looked at George Risk.
When I bought George Risk, I think it was trading for about $4.50 a share. It had a little over
$4.50 a share in financial assets – cash, bonds, mutual funds, etc. – and it had a business I
thought could earn close to 40 cents a share pre-tax in normal times. What if you auctioned those
two things off? Let’s say there was close to $5 in investment assets. Well, why wouldn’t a purely
financial buyer – someone who could liquidate the portfolio – pay between $4 and $5 for that
stuff? You might not be able to unload the entire portfolio at the market value shown on the most
recent 10-Q. But, you could certainly unload any group of liquid, plain vanilla assets for 80 cents
on the dollar given a little time. That’s a very, very conservative way of looking at it.
Likewise, a very conservative way of looking at an operating business that I thought could make
40 cents a share pre-tax in normal times would be to say a control buyer would certainly pay $2
to $4 a share for such a business. Who wouldn’t pay five to 10 times pre-tax earnings (about
eight to 15 times after-tax earnings) for a solid business. This business seemed solid to me. Small
and not fast growing at all. But, solid. It deserved a P/E of 8 to 15. So, there you have a valuation
of $6 ($4 plus $2 a share) to maybe $9 ($5 plus $4 a share) on a stock that was selling for around
$4.50 a share. Super conservatively, I thought it was worth 30% more than it was selling for.
And then not very conservatively at all (but still honestly), I thought it might be worth 100%
more than it was selling for.
Many investors define value investing according to the established sub-genres. So, they would
see George Risk and Babcock & Wilcox as being two totally different kinds of investments.
George Risk was family controlled, illiquid, tiny (a sub $100 million market cap), and a net-net.
Babcock & Wilcox was not family controlled, was very liquid, was a big stock (well over $1
billion market cap), and not really a value stock on a purely quantitative basis (it wasn’t a net-
net, low P/E, low P/B, etc.) I mean, Babcock wasn’t expensive by any measure. But it wasn’t the
kind of thing that would show up on a screen because it had a single-digit P/E or qualified as a
net-net or was trading below book value.
That’s why I think both these picks – George Risk and Babcock – were actually made in the
same style. My style. My style is basically to look at a stock as it exists today and then decide to
ignore the next five years. What do I think the business – the corporation – will look like in five
years? And then what do I think a control buyer – not the market – would pay for the entire
business?
In the case of George Risk, it was 2010 and the stock was housing-related. I figured that the
housing market in 2015 would be fine. It wouldn’t be 2005 fine. But it might be 1990s fine. I had
data on George Risk going back to the 1990s. So, I never thought about what George Risk would
earn in 2011. I only thought about how much cash and securities it would have per share in 2015
and what the operating business would be earning in 2015. Like I said, I figured 40 cents pre-tax
would be normal. There’s stuff I didn’t know. Would they buy back stock (I doubted it, the stock
was incredibly illiquid). Would they take the company private? Maybe. Would they pay a special
dividend? Would they raise the regular dividend? Would they pile up actual cash? Or would they
add to bonds, mutual funds, etc.? And then what would the value of marketable securities rise by
just in terms of stock market gains and losses. But, basically, that’s what I did. I made my best
guess as to what the business would look like in 2015.
I did the same thing with Babcock. I knew they were planning a spin-off. I figured mPower
wouldn’t exist anymore, BWX Technologies and B&W Enterprises would be separate, emerging
markets might be better in five years (investors were a little uneasy about them around the time
Babcock was splitting up) and then I thought competitors to coal – basically natural gas – would
probably be a lot more expensive in five years. But, also, that electricity demand might be a little
higher but the installed base of coal in the U.S. would be lower (since smaller, inefficient plants
would shut down rather than do any cap-ex spending to meet environmental regulations). Then
once you have that picture, you ask what another defense contractor might pay to own something
like BWX Technologies. You ask what some engineering company doing a lot of business in the
U.S. but also around the rest of the world would want to pay for B&W Enterprises. Again, in
both the case of Babcock and George Risk, I didn’t ask how much I thought the stock market
would value these businesses at.
Those are the two parts of my style that I think separate me from most investors. I don’t care
what the company earned last year or expects to earn next year. I only care what I think it’ll be
earning five years down the road. The other part of my style is I don’t ask what I think the
market as a whole would value the company for. I only think about what an acquirer would pay
for the whole thing if it was shopped around a bit. Sometimes there is style drift in my investing.
I own Frost (CFR, Financial), and it’s hard to do much in the way of calculating what someone
else would pay for a bank. Banks mostly just merge with each other. You can’t go after them in a
hostile way for regulatory reasons. I think the banks I like best – Frost and Bank of
Hawaii (BOH, Financial) are good examples – would be pretty valuable to a nationwide bank
without much of a presence in Texas or any presence in Hawaii (actually, no nationwide bank
has a meaningful presence in Hawaii – so buying a Hawaiian bank would be the only way to
enter that market).
Therefore, you could say there was some style drift there, but only with the “what would an
acquirer pay” part of the process. The “what will the business look like” part of the analysis was
exactly the same. I just wrote an issue about Bank of Hawaii a couple months ago. So, we’re
talking fall of 2016. Yet my discussion of that bank’s earning power was all about what I thought
it’d make in 2021 when I figured the Fed funds rate would be around 3%.
Now, these are huge “genre” moves. George Risk, Babcock and Frost are all in completely
different buckets in terms of how most value investors think about what types of investments you
can make. George Risk was a net-net, Babcock was a spin-off and Frost is a cyclical “reversion
to the mean” normal earnings type financial stock. In fact, many value investors consider
financial stocks separate from non-financial stocks. But, I think of all three of these investments
as being in the same style. They all fit my personal style of asking what the business will look
like in five years and what a control buyer would bid for such a business at that time.
Can you learn to change your style? Yes. I think you can. And I think the way to do that is just to
ape someone else’s style. I mentioned Elmore Leonard before, who intentionally aped Ernest
Hemingway’s style. But if you read Elmore Leonard and you read Ernest Hemingway, you’ll
notice that Leonard is funny and Hemingway isn’t. Likewise, Warren Buffett (Trades, Portfolio)
says he learned by trying to incorporate as much of Ben Graham’s approach and then Phil
Fisher’s approach into his investment process. But, if you read the books by either Graham or
Fisher, you’ll notice Buffett’s approach is actually really different from those two.
For example, BuffettÂ has invested a lot in branded businesses that serve households. Even his
biggest financial investments are Wells Fargo (WFC, Financial), American
Express (AXP, Financial) and Bank of America (BAC, Financial). Those are businesses that
make plenty of money from households instead of serving big corporations. They have well
recognized brands and aren’t exclusively consumer finance companies. But they’re closer to
being focused on consumers than on big businesses.
If you look overall at Buffett’s biggest investments, you’ll see Kraft-Heinz (KHC, Financial)

and Coca-Cola (KO, Financial) at the top of the list. One of his earliest, most famous purchases
of an entire business was See’s Candy. That’s a branded, heavily gifted product. Buffett’s own
example of his best ever investment – because he made it three times – was GEICO. GEICO is
entirely focused on households. Yes, it’s an insurance company. But, it’s about as famous a
brand as an insurance company can ever have. And it’s about as “consumer” focused as a
financial services company can get. Neither Ben Graham nor Phil Fisher was particularly
attracted to brands or consumer focused businesses. Many people think Buffett just moved from
being a Ben Graham type investor to becoming a Phil Fisher investor. Really, that’s not true. If
you mean he moved from low price to high quality – that’s true. But, Buffett’s definition of high
quality isn’t that close to what Phil Fisher focused on.
For example, Buffett looks a lot more at brands, competitive economics, etc. Fisher focused
much more on the caliber of top management and the overall organization strength. He was
much more a corporate culture investor than BuffettÂ is. Buffett bought Coca-Cola in part
because of the capital allocation of Goziueta and Keough. But he also bought it for the Coca-
Cola brand name rather than the Coca-Cola organization. Likewise, he definitely bought
Moody’s because it was part of an oligopoly rather than because he loved top management. I
don’t think Buffett knew much or cared much about the corporate culture at Moody’s. What he
cared about was the market power – the ability to raise prices – that Moody’s had over its clients.
That is a huge part of Buffett’s approach. You’ll notice that it’s neither a feature of Graham or
Fisher’s approach.
Is there really a value style box and a quality style box? Or is it more complicated than that?
Buffett is more of a quality investor than a value investor these days. But, he’s not a quality
investor in the same way Phil Fisher was. Buffett is much more focused on industry structure
than either Fisher or Graham ever was. You could say that it’s possible to learn as much about
Buffett’s approach by reading Michael Porter as by reading Ben Graham or Phil Fisher.
That’s why I think we need to think in terms of personal style instead of wider genres. You can
learn how to do things you don’t yet do by studying up on the investors you admire most who do
something you can’t yet do. So, if you really admire long-term investors but aren’t a long-term
investor yourself – learn everything you can from studying Tom Russo (Trades, Portfolio)’s
portfolio, his speeches, etc. If you are a buy and hold type investor who doesn’t make big,
concentrated contrarian and cyclical type bets, you might want to learn as much as possible
about Mohnish Pabrai (Trades, Portfolio). His style is totally different from my style. So, I could
learn a lot more from studying Pabrai than I could from studying Tom Russo (Trades, Portfolio).
That’s what Elmore Leonard did with Ernest Hemingway. It’s what Warren
Buffett (Trades, Portfolio) did with Ben Graham and then Phil Fisher. He soaked up everything
he could about their approaches. He tried to ape them as best he could. But then he also noticed
the places where they were lacking. Leonard noticed Hemingway wasn’t funny. He learned what
he could from him, but he also looked for other people he could study who could help him
expand his style in ways he wanted to.
Buffett greatly admired Ben Graham. But he saw the limitations of Graham’s approach when he
realized you could buy and hold some companies for the long-term and then you’d only need to
make one right decision that would pay off for a long time. Some other investors – like Walter
Schloss – never learned that lesson. They didn’t have to. Because it’s a matter of style.
So, know your own style. Be honest about it. Then find those investors you admire most. The
true investing masters out there, not just the guys with good records, but the guys you personally
have admiration for. The guys you want to learn from. Then study up on all the ways they are
different from you. Look for those places where their beliefs challenge your beliefs. Then start
trying to ape their style. At first, it will be awkward. You’ll be copying someone else. It’ll be
unoriginal. But, eventually you may be able to fuse some aspects of their style with aspects of
your style. You’ll never become them; don’t try to be. And don’t ever try to be a master of all
trades. That’s kind of the question you’re asking. How do I become equally good at everything?
Answer: You don’t. You shouldn’t want to be good at everything. You don’t need to do
everything well. All you need to do is find those little edges of your circle of competence that
bumped up against the edges of the circle of competence of some investor you admire. Look for
those borders where you can expand your circle of competence by actively aping what the other
guy is doing. Learn by studying him first. But then be humble enough – and unoriginal enough –
to simply copy that guy’s ideas when they seem good to you. Eventually, you can fuse some of
your style with his style. You’ll never become the other guy. But you’ll eventually become
maybe 15% less you and 15% more him. If you keep doing that, your style will keep evolving
without ever stopping being your style.
 URL: https://www.gurufocus.com/news/476957/how-to-steal-another-investors-style
 Time: 2017
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Be Careful Learning From Your Own Mistakes
“My other big initiative lately is collecting a list of investment mistakes (both my own and
investors I admire) and implementing them into my research process. So if you ever find the
time, I’d be really curious to hear how you implement learnings into your investment process
and whether you use a checklist or set template?”
This is a topic where I think I differ a bit from a lot of other investors. Especially since the
publication of Atul Gawande’s “The Checklist Manifesto,” I feel like there has been a lot of
focus on learning from your own – and other people’sÂ –Â mistakes. That’s a good goal. Like a
lot of things in investing there’s this divide between the theoretical and the practical. How do
you make a checklist practical? How do you know what matters and what doesn’t matter – and
keep the list simple, easy to follow? How do you make it a habit?
The other problem is the risk of learning too much from your mistakes. Ask writers to quote
from bad reviews they’ve gotten – and they can always do it. Ask writers to quote from good
reviews they’ve gotten – chances are they don’t remember. It’s the same in investing. You’re
likely to remember your mistakes a bit too well. Let’s say – just as a hypothetical here to
illustrate a point – that you’re the kind of person who feels a loss twice as intensely as you feel
the same gain. That’s going to really screw with your memory. The losses are going to “pop” in
your memory. The gains aren’t.
I’ve made plenty of mistakes. I bought Barnes & Noble (BKS, Financial), Weight

Watchers (WTW, Financial), and Town Sports (CLUB, Financial). Those were mistakes. I
even lost meaningful amounts in Town Sports (a position I sold) and Weight Watchers (a
position I haven’t eliminated yet). Weight Watchers in particular was a controversial pick. A lot
of people told me it was a bad idea to buy it. They were right. It was heavily shorted. I could use
that information to be more careful – guarding against arrogance and all that – in picking stocks
that a lot of other people were betting against, telling me I was wrong to invest in, etc.
Here’s the problem with that. When Quan and I were writing a newsletter, we looked back at our
past picks. We included stocks we were going to pick – but on which we (purely for scheduling
reasons) never got a chance to publish an issue. We looked at data on those stocks from the time
we were considering buying them. We weren’t using hindsight as much as investors normally do.
We did a full catalog of all the stocks we’d considered investing in and then we collected the
same data on those stocks so we had a truly comparable breakdown in an Excel sheet.
Guess what we found? Short interest wasn’t a reliable indicator of anything. Yes, some of the
most heavily shorted stocks we looked at ending up performing badly. But some of our best-
performing picks were also heavily shorted. If you plotted short interest against outcome – you
didn’t get any sort of pattern. Also, if you tried to look for other similarities between poor-
performing stocks – there were several symptoms our poor performers were more likely to share
than short interest. The conventional wisdom would be that heavily shorted, controversial, etc.,
stocks are dangerous. We should be careful picking them. Some mistakes – like Weight
Watchers – had these problems.
But other data we collected like Z-Score, F-Score and fixed costs (things like debt and
capitalized leases / EBITDAR) were better indicators of possible bad outcomes than short
interest was. In fact, companies that were financially sound, had improving ratios versus last
year, etc., and yet were heavily shorted actually formed a really good group of possible picks.
Short interest, level of controversy, etc., wasn’t actually a good indicator of risk at all. The only
reason short interest seemed like a good indicator is because people naturally shorted financially
risky stocks. It makes sense for them to do that, but they sometimes also shorted financially
sound stocks.
For example, PetSmart (PEM, Financial) had a fair amount of short interest. If you looked at

Weight Watchers’ financial ratios without knowing the short interest, you could guess it was
probably heavily shorted. If you didn’t know which business you were looking at and just saw
the stats on PetSmart, you’d never guess it would be shorted at all, and yet it was. In fact, those
were the stocks that were often the best picks. Stocks that the numbers told you were fine but
were being shorted for some reason.
I should mention, this pattern isn’t unique to the stocks that we considered. There’s been
research into short interest as an indicator of future poor performance for stocks – and the record
is mixed. Momentum can sometimes be a good indicator of some short-term poor performance
lying ahead for a stock. And, in that way, short interest would also indicate some pretty negative
sentiment. But it’s just not a good indicator of risk.
Something else we looked at was “beta.” It would make sense that stocks that move around a lot
are riskier. We should – perhaps – avoid these kinds of stocks. Likewise, there have long been
suggestions that some value stocks outperform because they are risky and that beta represents a
form of risk of the price bouncing around a lot and making investors feel sick – that could help
explain why some stocks are so cheap.
About five years ago, I took a good look at net-nets and which ones worked and which ones
didn’t and why they might be cheap. I wrote a net-net newsletter for GuruFocus for a little while.
One thing that concerned me was the pattern I saw from readers who emailed me telling me
which net-nets they were buying and which ones they weren’t. We picked a net-net a month. I
had to pick a stock every month – so I had to pick some net-nets I liked less than others. The
pattern I saw from readers is that they consistently bought the net-nets I liked least and they
consistently avoided the net-nets I liked most. What were they doing?
They were avoiding boring stocks. Now, I’m not saying that boring stocks always outperform
exciting stocks. The first issue Quan and I did for Singular Diligence was on a stock called John
Wiley (JW.A, Financial). It’s a boring stock. And it didn’t outperform the Standard & Poor's 500
from the time we picked it to today. Likewise, I bought George Risk (RSKIA, Financial) about
six years ago. It was a boring net-net at the time. That stock also didn’t outperform the S&P 500
from 2010 to 2016. If you knew the market was going to perform as well as it did from 2010 to
2016, it would make plenty of sense to avoid boring stocks like John Wiley and George Risk.
This is what most investors I talk to do. They don’t like boring stocks, they don’t like illiquid
stocks, they don’t like stocks they hadn’t previously heard about (can’t get much information on,
etc.), and they don’t like stocks that they have to talk to their broker about (stocks in another
country, currency, etc.). For this reason, it seems exciting, liquid, well-known, U.S. stocks
should be more expensive than other kinds of stocks.
For these reasons, I thought beta would make sense as information to keep track of in Excel
when considering which stocks to buy. But the more I kept track of beta, the less useful it
seemed to be. Here’s why. Take net-nets. It’s true that lower beta net-nets were the ones I liked
better. This had nothing to do with their beta though. You could just as easily come up with a list
of “low risk” net-nets by testing for the number of years of profits in their past and by testing for
the level of their liabilities.
In fact, two numbers that seemed to make a lot more sense to me were simply the number of
years of positive EPS in the company’s history, the Z-Score, etc. So, if a net-net had a profit in
10 of the last 10 years and a Z-Score of 10 it was safer than another net-net that had reported a
profit in six of the last 10 years and had a Z-Score of 4. These measures have nothing to do with
beta, short interest, etc. These are pure measures of the business as apart from the stock. And
they seemed to work at least as well – better in fact – in predicting how risky a stock was. This is
important, because if you asked most people for an explanation about what makes a stock risky,
they’d talk to you about things like beta, short interest, etc.
In fact –Â I’ve mentioned this before – but simply looking at the number of consecutive years of
profitability is a very easy way to gauge the safety of a business. And yet it’s something I almost
never hear talked about. For example, which airline stock is the safest one to buy? There are
plenty of ways you could try to figure that one out. I’d say the answer is Southwest
Airlines (LUV, Financial) because it has the best long-term record of profitability. It also has a
good credit rating, stronger financial position, etc. If you just looked at the last 10 to 20 years for
every stock you considered buying and eliminated those that weren’t profitable in every year –
you’d eliminate most of the potential mistakes you could make.
Not all of them. When I bought the stock, Weight Watchers hadn’t had a loss in a long time. Its
financial position was weak. And – here’s the critical thing as far as Quan and I were concerned
– its customer retention rate was abysmally low. Those are the two factors that created the risk in
that stock. It had a lot of debt. And it depended a lot on attracting new customers each year.
Those are good lessons to learn. Those are valid things to look out for. I don’t think short interest
is a valid thing for me to look out for. Why not? Couldn’t it be a good indicator of risk? Even if
it has a lot of false positives – it wouldn’t hurt too much to avoid stocks with high short interest,
right?
Wrong. See, the problem with eliminating either high short interest or high-beta stocks from
consideration, is that these are likely to be some of the best values. Stocks that aren’t shorted,
aren’t controversial and have more stable share prices are less likely to be mispriced for long
enough that I can find them, research them and buy them before their share prices rise again.
I’ll give you an example of learning too much from your mistakes. The obvious mistake a lot of
people would say I keep making is buying into a business that is exposed to some disruption in
the industry, societal shift, etc. Buying a “buggy whip” business.
Quan and I considered that possibility. We looked at our best performing candidates for further
research and our worst performing candidates for further research. Both the best and worst
performing stocks fell in the high risk of “societal shift” category. I’ve picked both good and bad
stocks that had a high risk of societal shift. Bad performers include stocks like Barnes & Noble,
Weight Watchers and Town Sports. Good performers include such stocks
as Greggs (ASX:GRG, Financial), PetSmart and Babcock & Wilcox (BW, Financial). Hindsight
is a problem in separating these cases. When Quan and I looked at Greggs, there was plenty of
talk about how the reason for that stock’s decline in same-store sales was the type of food
(unhealthy) it was selling. This kind of thing happens all the time.
A great example is LuxotticaÂ (LUX, Financial). This is from so long ago that no one will
remember it, but decades ago there was a rise in contact lens use. There was a lot written about
the risks that contacts posed for Luxottica’s business of selling eyeglass frames. No one writes
about this anymore. That’s not because contact lens use has declined. It’s just because the
company has grown its earnings for so long that the threat from contacts became old news. So
people stopped talking about it.
This is what happens in all these cases. If a company reports improving earnings, has a rising
stock price for a couple of years, people stop writing about the risk of some cultural change and
technological obsolescence. Unless you go back into the news archives (as Quan and I always
did when researching a stock), you wouldn’t even know about all the risks analysts, investors
and business reporters saw on the horizon for stocks that now appear to have had completely
smooth historical growth trajectories.
It’s important to learn from your mistakes. But you have to learn in a way that allows you to
make a process improvement. I have lost money investing in stocks that were harmed by change.
I have also made money betting on stocks that other people thought would be harmed by societal
change – and then they weren’t harmed, and the stock price rebounded quickly. There is no way
for me to make a process improvement. If I avoided stocks where the general perception was that
the company would soon face societal change – I’d miss out on both losers and winners. This
kind of knowledge isn’t helpful. It might make me feel a little better to implement the change. I
wouldn’t make the same mistake in the future as I did in the past, but I wouldn’t actually be
improving my process.
There’s no reason to believe the change would net out to a benefit for me across a series of say
10 such bets, and that’s all that matters. I’d be avoiding both some future losers and some future
winners. It would just net out to be change for change’s sake. I don’t have any evidence it would
be a process improvement. It would just be something I could change and might or might not
help. There’s no reason to make a change like that and, frankly, that’s the kind of change I see
most investors make. They learn from their mistakes. They learn not to do what led to one or two
bad outcomes.
It’s not an actual process improvement – because it teaches them to miss out on winners as well
as losers in the future. An actual process improvement would have to be something that helped
you pick fewer losers while causing little or no reduction in the frequency with which you picked
winners. I know that implementing a “societal change” screen would – in my case – cost me a lot
of big winners.
It’s the kind of lesson I try not to learn.
 URL: https://www.gurufocus.com/news/473102/be-careful-learning-from-your-own-
mistakes
 Time: 2017
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Should You Always Keep Stocks for a Full 5 Years?
“Buying just one stock a year and holding for five years does have its strong merit, but to
immediately move to this approach, what kind of flexibility one will have to adopt.
I got the basic idea, i.e. to buy as few stocks for as long a period as possible.
But, then, should one absolutely lock-in the stocks, or can one shift to some other securities in
the meanwhile…that could become more attractive?”
Theoretically, there’s nothing wrong with switching out of a stock you own for a better stock you
don’t own. It’s always a good idea to move from more expensive stocks to cheaper stocks and
from good businesses into great businesses. The problem here is the difference between what
works in theory and what works in practice. A purely rational investor doesn’t need any sort of
rules, principles, etc. to make good decisions. He is just rational all the time. And his rationality
leads to always making the best decisions given the information he has. In my experience, people
aren’t rational. They have a bias toward more activity instead of less. So, when an investor owns
a stock for a few years – he starts to get bored with it. He starts to get bored waiting for the stock
to move.
I’ll give you an example. I’ve owned Frost (CFR, Financial) for a couple years now. In 2015,
the stock did absolutely nothing for me. In 2016, it was probably up something like 40% while
the S&P 500 was up maybe 10%. What was different about 2016 from 2015? For Frost as a
business, 2016 wasn’t better than 2015. It’s not like the business underperformed my
expectations in 2015 and then outperformed my expectations in 2016. It’s just that bank stocks
were more popular in 2016 than they had been in 2015. Investors were more interested in buying
bank stocks in 2016 than they had been in 2015. Why? Probably because they felt the Fed was
more likely to raise rates sooner. In 2015, rate increases seemed a distant and uncertain prospect.
Now, at the start of 2017, rate increases seem very near and very certain. That’s what caused
Frost's stock to rise.
A lot of people would get bored holding Frost stock through 2015. They might sell the stock
before 2016 ever came around. Before you buy a stock, you often have this idealized view of the
future. So, if you expect a stock to return between 10% and 20% a year over the next five years,
you don’t really think that will come in the form of a 10% drop in the stock price in year one, a
50% rise in the stock price in year two and then a very flat performance in the three years after
that. But that’s exactly how it happens sometimes. A lot of investors will miss out on the years
where a stock is up something like 50%. But even pretty boring stocks – Frost is a pretty boring
bank – have years where they rise almost 50%. If you miss out on owning the stock in a year like
that, you can miss out on most – or even all – of what that stock will return over five years or so.
I think it’s best to commit to the idea of holding a stock for a certain period of time on the day
you buy it. So, I think it’s a good idea when buying a stock in 2015 to plan to hold that stock
through 2020. I also think it’s a good idea to judge your performance in that stock choice based
on how it does over the full period you intended to hold it for. In other words, if you bought
Frost at the start of 2016 and it went up 40% or so, and then it doesn’t do anything for the next
four years – I think you have to look at that as if your stock pick was only good for a less than
10% a year gain over five years, rather than a nearly 50% gain over one year. I think that’s true
even if you sell the stock right now. That’s a strange thing to say. Shouldn’t you judge your
performance based on your actual buying and selling of stocks?
I don’t think so. That’s how a trader should look at their performance. But, an investor should
look at how their stock pick did as an investment, not as a trade. A one-year holding period isn’t
an investment. Anything you buy and sell within one year is a trade. Something you hold for five
years is an investment. If the stocks you pick have only mediocre five-year records, but they do
well over the time you actually own them – that’s great. It means you’re very smart. But it means
you’re a very smart as a trader. You’re not a very smart investor. A smart investor would have
picked stocks that would continue to do well over an investment type holding period.
Look, you’re going to break your own rules. That’s bound to happen. So, when I say you should
have a rule that you always hold a stock for a full five years, I know that isn’t going to translate
into you never selling a stock within five years. But, I also know that if you don’t have any sort
of rule at all, you’re going to sell much sooner than you think you will.
I’ve talked via email with lots of value investors; these are people who consider themselves long-
term buy and hold type investors. When they actually look at the turnover in their portfolio, they
always find that it’s higher than they would have guessed. These investors think they are holding
stocks for three to five years on average, when in reality they’re holding stocks for more like one
to three years on average. If most people hearing this were to go back and look at the turnover in
their own portfolios, I think they too would find that they trade more and invest less than they
think they do. I certainly know that’s true for me.
There are some stocks I’ve owned for a long time. For example, I still own shares of George
Risk (RSKIA, Financial). And I bought shares in George Risk in the summer of 2010. So, the
holding period there is now up to about six and a half years. George Risk hasn’t outperformed
the S&P 500 during that time period. Therefore, this wasn’t a good investment in hindsight. But
I’ve never been worried about holding it, because the stock has always seemed cheap relative to
the S&P 500. It never really went up in price very fast. And the S&P 500 did get progressively
more expensive while I owned George Risk. So, I never regretted making the purchase. The
stock just didn’t get bid up all that much. That happens. The reverse happens too.
Let’s look at an example of the opposite happening. Let’s talk about BWX

Technologies (BWXT, Financial). My stake in this company was a result of buying Babcock &
Wilcox prior to that company breaking up into two parts: B&W Enterprises (BW, Financial) and
BWX Technologies (BWXT, Financial). BWXT is the “good” Babcock. It’s focused on things
like nuclear reactors for the U.S. Navy. B&W Enterprises is the “bad” Babcock. It’s focused on
things like boilers for coal power plants. This is an over-simplification of the two businesses. But
it helps explain what happened after Babcock’s spin-off. BWXT stock really took off. It became
very expensive very fast. Babcock as a whole wasn’t expensive at all before the spin-off. BWXT
was rewarded with a blue-chip type valuation. B&W was penalized for its reliance on coal. The
market reaction was very strong, very fast. What happened is basically what we expected to
happen.
When I wrote the newsletter issue about the Babcock spin-off, I spent a lot of time talking about
how high quality and predictable Babcock’s nuclear work for the U.S. Navy was. This part of the
company wasn’t being given as high a valuation as it might be as a stand-alone company. Quan
(my newsletter co-writer) and I both really liked the idea of breaking up Babcock. We liked the
capital allocation plans the company had.
I rarely invest in companies with “catalysts.” George Risk is a good example of a cheap stock
that lacked a catalyst. Babcock is a good example of a somewhat less cheap stock that had a
catalyst. You could argue that this shows investing in companies with a catalyst is the better
choice. And I’d agree with that – if you could find a reliable supply of companies like Babcock
with catalysts. You can’t, however, it’s really rare. If you look at a list of all the spin-offs that
have happened in the last few years, there are very few parts of any of those companies that had
anywhere near the quality of Babcock’s U.S. Navy nuclear business.
I was fine buying Babcock with or without the spin-off. It’s not like I bought the company pre-
spinoff and then I sold one of the new companies and kept the other. I kept my stock in both of
the companies. I like Babcock’s U.S. Navy nuclear business better than something like its U.S.
coal power plant installed base. Now, that’s not all B&W Enterprises has. It also does new build
in other countries that is unrelated to coal. It also does environmental work. Regardless, I like the
industry BWXT is in better than the industry B&W is in. But there’s nothing wrong with either
company’s competitive position. So, I bought Babcock without needing to know the company
was definitely going to go ahead with the spin-off. If they’d decided not to do the spin-off, I
would have kept stock in the combined company. The catalyst was nice, but I didn’t think it was
necessary.
Now, obviously, you could say there’s no need to hold BWXT stock for five years. The shares
went up a lot and fast. So, the company became expensive quickly. It might make sense to hold
B&W Enterprises for as long as five years, because that stock hasn’t performed well compared to
what Quan and I thought it would be worth on its own. In theory, I don’t disagree with this. In
practice, it’s a little more complicated.
Let’s get real here. Can I find another company with as strong a competitive position as BWXT?
A lot of BWXT’s earning power now comes from a monopoly position serving a government
customer. That government customer thinks the projects BWXT works on are among the most
important projects it has. So, I can’t easily replace BWXT’s quality through the purchase of
some defense contractor. Companies like General Dynamics (GD, Financial) and Huntington
Ingalls work on some of the same ships that Babcock does. But they don’t provide as important
components and they don’t have a monopoly. In fact, I’d say the government prefers having two
potential suppliers in General Dynamics and Huntington Ingalls.
Meanwhile, the U.S. Navy has accepted the fact there’s no alternative to Babcock as a supplier.
There really aren’t other defense projects that I have as much faith in long-term as either nuclear
powered subs or nuclear powered aircraft carriers. And even in the cases where I can find a
defense project that I’m sure will be around a couple decades from now, I can’t know for sure
who will be supplying the military’s needs. It could be General Dynamics or it could be
Huntington Ingalls. It could be Boeing (BA, Financial) or it could
be Lockheed (LMT, Financial). So, I can’t replace BWXT in the sense of finding another
company with as strong a competitive position, as high returns on capital, etc. to put in my
portfolio.
For that reason, I never sell a stock like BWXT just to hold cash. I will, however, sell a stock like
BWXT to raise cash for a better purchase. That stock would have to be something I’d be willing
to own for a full five years. Those kinds of stocks don’t come around very often. But, I do get
ideas of that caliber every once in a while. For much of this year, I’ve been seriously considering
Howden Joinery. It’s a U.K. stock that is reasonably priced. It also has more room for growth in
sales and especially earnings over the next five years than BWXT does. It’s possible I’d sell a
stock like BWXT to buy a stock like Howden Joinery.
My rule is to buy anything – even a stock with a catalyst like Babcock had – with the intention of
holding it for five years. That doesn’t mean I’ll never sell a stock within five years. I’d consider
selling stocks like George Risk, BWXT, etc. to buy something like Howden Joinery. So, yes, I
do sell stocks much sooner than five years after I buy them. I do it all the time. Far more than I’d
like. But, I try to go into every stock purchase with the idea that I’ll hold it for five years no
matter what the stock price does.
When I have more ideas than money, I have to sell what I own to buy something I don’t. That’s
unavoidable. But, I do my best to sell stocks as rarely as possible. And I especially try not to “re-
evaluate” a position until five years have passed. I think of buying a stock as electing that
business to a five-year term in my portfolio. Over time, I’ve become more and more dedicated to
the idea of owning as few stocks as possible for as long as possible. That’s the ideal. I usually
fall far short of it. But, over the years, I have succeeded in inching closer to that ideal.
 URL: https://www.gurufocus.com/news/472852/should-you-always-keep-stocks-for-a-
full-5-years
 Time: 2017
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Talking to Customers Is More Useful Than Talking to Management
“Do you listen (to) or read quarterlies? Do you find the management's spin and guidance
helpful or detrimental to your investing?”
I do read earnings call transcripts. Sometimes I find them very useful. When Quan and I were
writing the newsletter, Quan would start by collecting all the earnings call transcripts he could
find on a company. Then he would take notes on those parts of the transcripts he thought were
most important. Quan and I would then discuss his notes on the transcripts.
Yes, earnings call transcripts can be useful, but there are a few points to make here. One, we
were always looking at transcripts going as far back into the past as possible. We were as
interested in reading what the management of Frost (CFR, Financial) said in 2007, 2008 and
2009 as what it had to say in 2014. The last issue of Singular Diligence we did was on Bank of
Hawaii (BOH, Financial). I think I used a quote in that issue from the early 2000s. I know I
talked about Bank of Hawaii’s turnaround that started right around the turn of the millennium.
So we go back in time. We are interested in what management says in these transcripts that gives
us an insight into the business. We aren’t interested in what management is guiding for next
quarter, next year, etc. Personally, I’d prefer that management not provide any earnings
guidance. There are some things it can be useful to provide guidance on. For example, giving
hints about what debt levels the company is comfortable with, how much stock it plans to buy
back, etc. We find those kinds of discussions useful. Longer-term discussions of the business’
possible growth can also be useful.
In the issues we wrote, I’m sure we cited management’s guidance on things like the total number
of stores it hoped to one day have in a country. For example, Howden
Joinery (LSE:HWDN, Financial) has something like 630 depots right now. In the past, it said it
could one day reach 700 depots in the U.K. More recently, I think it has said that number could
be 800 depots. Howden also gives information on the break-even point for a depot and the fully
mature sales level of a depot. If you know the number of depots Howden hopes to one day have
in the U.K. (800) and you know the “mature” sales level of a depot –Â 2.2 million pounds ($2.75
million) –Â you can calculate the total U.K. opportunity for Howden.
You could value Howden based on a sales ceiling of 1.76 billion pounds in U.K. sales. You’d
need to think about what the operating margin might be at that time and how much of the
operating profit could be converted into sales if the company stopped growing. That kind of
“guidance” is very important. When a company is growing, it can be difficult to know what it
would look like if it stopped growing.
Transcripts also include a lot of discussion of things like same-store sales growth, constant
currency growth, breaking out organic versus acquired growth, etc. These are useful things to
look at. But transcripts are generally too short-term oriented to interest us. Analysts almost never
ask any of the questions that I’d ask. Analysts are mostly interested in knowing how to fill out
their EPS models for the next quarter, year, etc. I’m more interested in what the company will
look like in five years, what normalized earnings are, etc.
However, I do have to say that I’ve often heard useful tidbits from management during an
interview. For example, I read an interview where the then-CEO of George
Risk (RSKIA, Financial) – he has since died – made a useful comment about the company’s
competitive position. It wasn’t an earnings call transcript. It was an interview with The Wall
Street Transcript. It does some interviews with CEOs, chief financial officers, etc. – especially
with executives at very small public companies.
Anyway, the CEO, Ken Risk, said that some competitors had prices that were lower than George
Risk’s material costs. In other words, the company couldn’t compete on price. I knew it was
successful in terms of market share, operating margin, etc. It had a good gross margin. This
comment was important in getting me to consider whether price was as important a competitive
factor as I originally thought it would be in the industry. I’m not sure I would have bought the
stock – and I’m sure I wouldn’t have put as much into the stock – if I hadn’t read that comment.
The reason for this is odd. It’s a framing issue. I found George Risk as a net-net. So, I expected it
to be a bad business. I did my usual long-term historical financials spreadsheet. And what I
found was that George Risk’s profitability, predictability, etc. – everything but growth – were at
levels associated with blue-chip companies rather than net-nets. And yet it had a net-net price.
I wasn’t sure the business was a good business until I read the interview. After reading the
interview, I looked for some other information on the company and the housing market. And I
concluded that during the housing boom, nobody in the industry had been raising prices.
However, once the level of unit output dropped at a company like George Risk, the gross costs
would rise.
Basically, George Risk was doing a lot of the same things in the same place. There was probably
significant fixed cost absorption. If price was the main reason George Risk’s customers were
customers – this wouldn’t be a good business in the bust. However, if price was not the reason
George Risk’s customers were its customers, then the company could just raise prices to bring its
gross margin to the same percentage level on a lower unit volume. The stock was a net-net either
way. I’m not saying I wouldn’t buy it if I hadn’t read that interview, but I wouldn’t have put as
much of my portfolio into the stock if I didn’t read the interview.
I am trying to think of other situations in which something that was said in an earnings call
transcript, interview with management, etc., was important to an investment decision I made.
Quan and I sometimes tried to talk to people who knew a lot about a company but were not part
of the management team. We often got more useful information from competitors, branch
managers and customers of a company than from the management of the company. For example,
some information we got from insurance agents who sell Progressive (PGR, Financial)
insurance as well as competing policies was useful. We talked to someone who knew a lot
about Tandy’s (TLF, Financial) market power in the leather crafting accessories industry. The
same was true of Wiley.
We didn’t quote heavily from these sources because we considered the conversations
confidential. The information we got wasn’t the kind of information a lot of investors think
they’ll get from doing “scuttlebutt.” Nothing anyone told us would be helpful in predicting next
quarter’s earnings or next year’s earnings. But what we did get was confidence. I’m not sure we
could have written about either Ekornes (OSL:EKO, Financial) or Hunter
Douglas (XAMS:HDG) unless we spoke to dealers. The stores that sold Stressless and Hunter
Douglas products made it clear to us that they could make more money selling those products
than any competing products.
Hunter Douglas and Progressive were both interesting that way. We wouldn’t have understood
how strong the distribution of these two companies was in the U.S. if we didn’t know how the
“retailers” of Progressive’s independent channel and Hunter Douglas’ blind business in the U.S.
felt about selling these companies’ products. It’s often easier to get information from the
company’s perspective and from the end users’ perspective. It’s harder to get information
explaining why a retailer chooses to stock one product over another product. We got a lot of
quotes from agents who sold Progressive policies, a lot of stores that devoted most or all their
blinds and curtain space to Hunter Douglas, etc.
Ekornes, Progressive and Hunter Douglas are somewhat unusual cases I guess. They all have
somewhat limited distribution compared to the way investors think of competition. We tend to
think that all end customers get to see all their options at one time and compare them. That’s
rare. It’s very rare offline. A customer who buys a Stressless recliner, Hunter Douglas blinds or a
Progressive insurance policy through an agent is only seeing a small number of other alternatives
at the same time.
Distribution is often the most important aspect of a business that investors don’t really
understand. How a product is sold and to whom is important. It’s also hidden from an investor’s
view. Investors tend to focus on things like price and brand. Realistically, the reason why you
buy a certain soda, razor, toothpaste, etc., is maybe 20% price, 20% your own preference and
60% where the product is stocked. You buy the product because the place you go to shop carries
it.
The big question is: why does a retailer choose to carry one product over another? The simple
answer is that one product is easier to sell than another. The more involved answer is that one
product is likely to produce more gross profit per square foot of selling space. For insurance
agents who sell Progressive, the three explanations they gave were: 1) Progressive gives them a
quote on some clients for which other insurers don’t provide any quote; 2) Everybody knows the
Progressive name so no client hesitates the way they sometimes do with a no-name regional
insurer; 3) Progressive provides them with better systems and support than other insurers. Could
we have guessed those were the three reasons without hearing insurance agents talk about
Progressive? Maybe.
I’d say this issue of why someone who is not a member of the public but some sort of specialized
businessman prefers one solution over another is the most important question we have to
research. If we’re researching Southwest Airlines (LUV, Financial) or Greggs (LSE:GRG), we
can easily model who the customers are and what factors go into their decisions to pick that
company over a competitor. When we’re researching something like Breeze-Eastern (BZC), a
maker of search and rescue hoists for helicopters, or Babcock & Wilcox (BW), a maker of
boilers for coal power plants, we don’t have much insight into why the decisions maker at the
client firm makes the decision he does.
For example, Breeze-Eastern and Babcock both make a ton of money in the aftermarket. They
provide maintenance, replacement parts, etc., on original equipment they sold in the past. When
they need maintenance, do clients always use the company that worked on the original project?
Or do they go through another selection process?
That’s an important question that is rarely discussed in enough detail in 10-Ks. A 10-K will
discuss competition. It will say that a client puts out a request for bids from a handful of
qualified providers, etc. It may say what factors the client considers when deciding which bid to
accept. For example, the 10-K will mention if clients are governments who must accept the
lowest bid or if they are allowed to make the decision based on factors other than price.
Sometimes I have found earnings call transcripts useful. They are most useful when they are
discussing the basis on which a typical customer chooses between the company and its
competitors. However, I have never found earnings call transcripts to be as useful as talking to
the purchasing people at the client firm, a branch manager, the agents and retailers who sell the
company’s product to the public, etc. In almost all cases where we spoke to members of
management (such as the chief financial officer) and to people closer to the customer, it was the
front-line employees who were closest to the customer who provided the most useful
information.
If I had the choice between spending an hour talking to Progressive’s CFO or spending an hour
with a focus group of half a dozen independent agents who sell Progressive policies – I’d choose
the agents every time. There’s nothing the CEO, CFO, etc., of Ekornes can tell us that is going to
be more helpful than hearing from a dozen dealers who sell Stressless recliners.
Access to management is always less useful than “scuttlebutt.” I can’t think of a single situation
in which something management said was more useful than something the company’s customers
said.
 URL: https://www.gurufocus.com/news/461354/talking-to-customers-is-more-useful-
than-talking-to-management
 Time: 2016
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What Does 'Understanding' a Business Really Mean?
“Would you invest in a deeply quantitatively undervalued company but whose qualitative nature
you may have some trouble fully understanding?”
Not intentionally. I’ve bought into stocks where it turned out I didn’t understand some things
about customer behavior, societal trends, etc. You said “whose qualitative nature you may have
some trouble fully understanding.” There are a few ways to think about that. When I say I
understand a business, I mean I understand the economics of the business. We are talking about
things like customer behavior. I would invest in a business where I don’t understand some
technical aspects of what they do. Let me give some examples.
Babcock & Wilcox
I wrote about Babcock & Wilcox (BW, Financial) for the newsletter. I bought it for myself, and
then I owned it through the spinoff. It spun off into BWX Technologies (BWXT, Financial).
BWX Technologies is focused on things like nuclear reactors for U.S. Navy submarines and
aircraft carriers. B&W Enterprises is focused on things like boilers for coal-fired power plants in
the U.S. and similar equipment for things like waste-to-energy plants in the rest of the world. I’m
simplifying. Each of the two separated businesses does other things, too.
To summarize the key markets they control: B&W Enterprises probably has an installed base of
between 30% and 40% of boilers at coal plants in the U.S. The aftermarket is profitable. It makes
a lot of money doing maintenance on coal power plants it helped build in the first place. BWX
Technologies is involved with the U.S. military’s use of nuclear technology. Mainly, it provides
almost all the important parts needed to have nuclear reactors on ships. The U.S. Navy – unlike
almost all other naval forces in the world – has a lot aircraft carriers (all huge) and submarines.
U.S. aircraft carriers and submarines are always nuclear powered. Because of their strategic uses,
this is kind of necessary. It’s not strictly speaking necessary for the attack subs. But some U.S.
subs are ballistic missile subs. They carry nuclear weapons, and they are the last line of defense
in the case of a second strike. Basically, no country in the world could ever carry out a nuclear
attack – no matter how large and how well-planned in advance – that could destroy all of the
U.S.’s ability to respond with enough nuclear weapons to devastate the attacker in return.
Foreign governments know where some U.S. nuclear weapons are. It’s not hard to guess. But
they don’t know where the ballistic missile subs are. This is an important part of not just the U.S.
Navy’s strategy but the U.S. global strategy as well. And, honestly, it’s an important part of the
defense of U.S. allies – like NATO members. Very few U.S. allies have much of an ability to
deter a nuclear attack on themselves. A couple do. If we put aside countries like Israel, France
and the U.K. – most allies of the U.S. are counting on the U.S. having ballistic missile subs and
carrier groups even though they don’t.
I’m not especially knowledgeable about military matters, U.S. domestic politics, geopolitics, etc.
My guess as to whether the U.S. will ever phase out attack subs, ballistic missile subs or carrier
groups is not better than yours. It might be worse. You could say that I don’t understand the
politics of how the U.S. Navy makes decisions. I understand it well enough to know that there’s
an oligopoly of countries who are members of the nuclear club – and that number is unlikely to
decrease. As long as that’s the case, I don’t expect the U.S. to build fewer numbers of each of the
classes of ships that Babcock’s reactors go into than the current long-term plan projects. The
U.S. Navy puts out a long-term plan for assets like carriers and subs. We have some guidance
going out a couple of decades. I thought there was a lot of earnings visibility. I think the U.S.
Navy feels it needs these ships and feels it can’t get the reactors from anyone but Babcock. I felt
I understood the business.
But think about this technically for a moment. Do I really know the technical issues involved in
what BWX Technologies does? The work it does is things like building nuclear reactors for the
Navy, co-managing (as part of various consortiums) nuclear sites that are important to national
security, doing uranium down blending. These are technical activities that I don’t know anything
about. I have no science background. Honestly, I’ve never taken even a high school level course
in basic physics. I never took a single science course in college.
I did read a few books while researching Babcock. I read some books on atomic energy generally
and a book on just above every major accident in the history of nuclear power was useful.
Babcock isn’t involved in civilian nuclear power anymore. Not long after Three Mile Island, it
sold its civilian reactor business in the U.S. If I had to understand things like whether the U.S.
would ever build nuclear plants again for civilian power generation, it would have been too hard.
It would have been too technical. Likewise, if I had to – as you would when analyzing a defense
contractor – compare competing designs for a fighter jet, submarine, etc., that would have been
too technical, too.
We wrote about Breeze-Eastern (no longer a public company) for the newsletter. Breeze is the
leading duopolist in the search-and-rescue helicopter rescue hoist industry. At the time we picked
the stock, Breeze had been – for years – working on new projects like cargo-loading equipment.
One of the projects involved the Airbus A400M Atlas. The market potential for that project
could be big. But my newsletter co-writer and I couldn’t judge how big it could be. There had
recently been a deadly accident involving an A400M. That wasn’t the issue for us. Those
accidents happen with new planes. For all we knew, it could’ve been human error, a software
error, something that was easy to fix, etc.
We didn’t think the project was going to be killed by that, but we can’t tell the difference
between a new plane, helicopter, etc., that might eventually hit 100 or 200 deliveries and a new
plane, helicopter, etc., that might one day eventually hit 1,000 or 2,000 deliveries around the
world. If Airbus (AIR, Financial) has one design and Boeing (BA, Financial) has another
design, we don’t know which one will be adopted.
Likewise, I wouldn’t have been able to invest in Babcock in say 1946 to 1960. Right after World
War II, it wasn’t clear whether all U.S. Navy carriers, subs, etc., would eventually be nuclear.
More than that, it wasn’t clear what the design would be. There were engineering trade-offs that
were still to be settled. For example, there was originally a great deal of concern that the world
didn’t have enough uranium to fuel everything the U.S. wanted to do. This turned out to be
totally false. But it might not have been obvious early on that rationing of uranium was not
important.
Likewise, there was initial resistance to using steam on submarines. The original plans for
nuclear powered subs were unlike what ended up being the dominant design. This was an
unsettled market. When a market is unsettled, those technical aspects are important. If there’s a
format war between two standards – two different models of airplanes, two different reactor
designs, etc. – I can’t make any sort of judgment. I don’t have the technical know-how to tell you
whether VHS will outlast Betamax or the reverse. I can’t tell you whether electricity will run on
alternating current or direct current. I would need to wait until a dominant design was chosen,
other companies were supporting that design, the company was in serial production of the
design, etc. At that point, technical issues are no longer relevant. It’s possible to judge the
economics without looking at the technical issues.
Waters
I’ll give you another example of a company I think I can understand economically – but I have
no idea what it does technically. Waters (WAT, Financial) makes analytical instruments. I think
the way it markets those products is an important part of the business. I’ve talked to some people
who work at universities that have these instruments and allow different people at the university
to use them. I have some idea of how important some of these instruments are to the work they
do. But if I took you through the various things that these instruments do, I wouldn’t be able to
describe what the instrument is doing without paraphrasing Wikipedia. That means I don’t
understand what “high performance liquid chromatography” is. I don’t understand the technical
aspects of the product Waters is selling. Does that matter?
It matters if some technical aspect a Waters product has and a competing product doesn’t have is
a material advantage for Waters. It matters if a technical advantage drives earning power. I don’t
think that’s the case at Waters. It’s not like it has one particular way of doing things and a
competitor has a different way of doing it – and that difference is what drives its earnings. I don’t
invest in businesses like that.
Warren Buffett (Trades, Portfolio) bought into IBM (IBM, Financial) stock. Now, obviously,

Buffett doesn’t understand most of what IBM does. But he thinks he understand the economics
of IBM. That means he understands the relationship the company has with its biggest clients. I
felt the same way about a company like Omnicom (OMC, Financial)
or Grainger (GWW, Financial). Omnicom is entangled with the marketing operations of its
biggest clients in a way in which clients are unlikely to leave Omnicom. I expect Omnicom to
increase its earnings at about the pace its biggest clients increase their marketing spending.
Likewise, I expect that once a big customer of Grainger – a national account-type business –
starts using Grainger heavily, it’s going to become more and more dependent on Grainger and do
less and less sourcing of MRO products elsewhere. What’s happening here is that Buffett –
although he doesn’t understand the technical aspects of what IBM does – thinks he understand
the relationship between IBM and its largest clients. Sometime, this relationship may be too
technical in nature to understand. I’ll give you an example of a company that has some
similarities to IBM but in which I don’t feel confident.
Teradata
Years ago, I might have been able to buy Teradata (TDC, Financial). I researched it a bit. I have
an idea of what it does for its biggest clients and why that is important. I also see technical
aspects of the business – other ways of doing much of what Teradata does – that could start
allowing clients to mix Teradata with other solutions. Once they start doing that – experimenting
in a small way with other possibilities –Â they may slip completely away over time. And what
Teradata does is in an area in which some big tech companies may want to dedicate a lot of
resources. I don’t like to own a business like that. One thing I liked about Breeze Eastern is that
it had a 50% or better market share in a market that was too small for other aerospace companies
to want to enter. It would be hard to displace Breeze – and it wouldn’t be remotely worth it.
This is also what I like about Atlantic International (ATNI, Financial). Most of the markets

Atlantic International is in are small. So, they are often in a duopoly type position in a market
that is too small to be worth the time of bigger telecom companies. Atlantic International’s
markets aren’t prizes that other telecom companies want to win.
I avoid companies like Teradata. To be honest, I also avoid businesses like IBM. I understand
why Buffett made that purchase. However, I’m too nervous that too many other companies want
to spend time and money and focus on exactly what IBM does for its biggest clients. I don’t want
to be invested in a stock where lots of other companies want to do what that company is already
doing.
Something like Babcock is attractive because nuclear and coal are two areas in which no one
wants to be involved. It has already peaked in terms of new build. There’s an installed base. It is
not expected to take off as a technology like wind, solar, etc. I’d rather be invested in a company
with a strong competitive position in coal and nuclear than in wind or solar.
The technical aspects of what a company does in coal or nuclear probably don’t matter. Not
many people are thinking about new ways to compete in coal and nuclear. Lots of people are
thinking up new ideas to implement in solar and wind.
I’d avoid emerging technologies and focus on settled markets where the technical aspects of a
business are less likely to be important to the economics of the business.
 URL: https://www.gurufocus.com/news/461297/what-does-understanding-a-business-
really-mean
 Time: 2016
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Why I Concentrate
“What is the maximum concentration you would employ in any single stock, why, and under
what conditions, qualitative and quantitative, would you do so?”
This is a tough question because I’m not sure I want to recommend what I would do as the right
practice for others to follow. I am more comfortable holding a smaller number of stocks – and
putting more in each stock – than most people are. My ideal is to buy one stock per year and hold
each stock for five years. That means the portfolio for which I am always aiming would have
five positions each sized at 20% of my whole account.
I’m not sure if that is right for other people. In fact, it’s wrong for some people. I get plenty of
emails from people talking to me about a stock they own that has declined a lot. For example, I
own shares of Weight Watchers (WTW, Financial). I bought them years ago at a much higher
price than the one for which the stock now trades. People have contacted me who invested in that
stock. They’ve talked to me when it was down maybe 20% from where they bought it and when
it was down more like 90% from where they bought it.
Let’s say – for the purposes of this discussion – that the average people who emailed me about
Weight Watchers put 20% of their accounts into the stock. And then the stock lost 50% of its
value. It lost a lot more than that at one point. Obviously, a lot of people put less than 20% of
their portfolios into Weight Watchers. But it’s not a bad estimate for the purposes of this
discussion to assume the people who are emailing me put 20% of their accounts into a stock and
then that stock lost – perhaps permanently – 50% of the original purchase price. Let’s go with
that assumption. That’s a 10% loss in the overall portfolio. This is painful. But let’s put this in
perspective.
The Shiller price-earnings (P/E) ratio – a measure of the stock market’s price to normalized
earnings – is now 27. A normal Shiller P/E is about 16. One should expect a decline – in fact, a
permanent decline – in the portfolio of 11 points on the Shiller P/E. If you own an index fund
right now you should be prepared to lose about 40% of the value of your account. That’s not a
one-time loss, either. It’s a permanent adjustment. On average, the Shiller P/E should be 16
rather than 27. We are talking here about 27 minus 16 equals 11. And 11 divided by 27 equals
41%. Let’s call it a 40% decline. Even if your portfolio is now 50% cash and 50% the Standard
& Poor's 500 – you should still expect a loss of 20% of your account if the market adjusts to a
normal Shiller P/E. That’s double the loss I talked about in Weight Watchers.
Again, assume you put 20% of your account into Weight Watchers and lost 50% of the value of
the stock. You have a 10% loss. What if it’s a total loss? Weight Watchers has a ton of debt.
Plenty of people think it will start losing subscribers again. It’s heavily shorted. Let’s say it does
go to zero. If you put 20% of your account into a stock and it loses 100% of its value, you lose
20% of your account. The stock market is priced to drop about 40% to get to a normal Shiller
P/E. To duplicate your complete loss in a stock like Weight Watchers you’d need to have 50% of
your account in cash and 50% in an index fund.
Most people have a lot more than 50% of their account in stocks generally. Stocks generally are
priced to lose 40% of their value. Is it really that big a risk to put 20% of your account into a
stock? Yes. It’s risky. Any time you buy stocks when the market is above a Shiller P/E of 16 you
are taking a risk. The average investors don’t believe they are taking much of a risk when they
buy an S&P 500 index fund today. However, they would think it was a huge risk to put 20% of
their account into two different stocks – each of which could, in some scenario, conceivably
decline to zero.
The downside risk is the same in these two situations. Putting 20% of your portfolio into Stock A
which has some chance of going to zero and putting 20% of your portfolio into Stock B which
has some chance of going to zero can’t possibly be riskier than putting 100% of your money into
an index that has a good chance of declining 40%. For me, the long-term base case for the S&P
500 is a decline of 40%. Now, you aren’t going to invest in two different stocks where you think
the base case is a total loss. You’re going to be taking less risk.
Most people don’t see it that way, and they certainly don’t feel it that way. The loss on a single
stock they picked feels different than a big decline – like the 2008 decline – in the S&P 500 in
which all investors share. There are several reasons for this. You are looking at the magnitude of
the loss in terms of the amount you allocated rather than the amount of your total portfolio. A
40% decline in all your stocks somehow feels different than a 100% loss in 40% of your stocks.
Both losses are – of course – the same in terms of where they leave your portfolio after the loss.
The other way the loss feels different is that a stock you pick on your own and loses money is a
loss where you were operating “outside the herd.” It’s an egregious loss. Meanwhile, a loss
because you own the same stocks as everyone else and those stocks decline is an “inside the
herd” decline. It’s the same sort of loss everyone else is feeling. There is no culpability.
That is how a lot of people feel. I don’t feel that way. I feel you are equally culpable for buying
the S&P 500 when it’s clearly overvalued as for making a mistake in judging the moat around
some specific stock you pick. What we are concerned about here is the financial loss. We
shouldn’t be worried about feelings of guilt, shame, etc. What if others were right and you were
wrong? Being wrong when anyone else is wrong isn’t any less financially harmful than being
wrong when everyone else is right.
You asked about diversification and concentration. My answer included a discussion of the
overall market valuation. That might seem off topic. Talking about something like the risk
people are taking buying into an elevated Shiller P/E right now explains why it’s OK to
concentrate. We take a lot of different risks when we invest. For whatever reason, we tend to
think of some risks as normal, appropriate, etc., for an investor to take.
At the same time, we condemn other risks as arrogant. People will say it is arrogance to bet 20%
of your portfolio on one stock – especially a contrarian stock others are shorting. They will say
it’s reasonable and understandable – though wrong in hindsight – to buy into clearly overvalued
assets like U.S. stocks which are now clearly overvalued. There’s no difference. Joining in with
the crowd by ignoring an obvious risk is not smarter, more moral, etc., than making a large bet
that others think is risky.
Some of this has to do with the power of story and the power of morality. After the fact, it’s
easier to explain losses by putting them in the form of some sort of story with a hero, a villain,
moral defects, etc. This has no place in investing. Losing a lot of money buying the S&P 500
today or buying into oil stocks a few years ago or housing stocks a decade ago, etc., is no
different than putting something like 20% of your portfolio into Weight Watchers and losing half
or all of it. We are talking about taking the same sort of risks in terms of size. And yet people
will treat bubbles in oil, housing and stocks as these things you can’t foresee and in which you
must not blame yourself for getting caught up.
I wouldn’t spend much time blaming myself for either kind of mistake. They’re the same. You
deserve the same amount of blame, praise, etc., regardless of how many people joined you in a
good decision or how many people were smarter than you in avoiding a bad decision. To me, it’s
just a matter of the math.
There are some advantages in diversification at the level of five and 10 stocks. If you diversify
by country, stock size and industry – it can make sense to diversify as widely as 10 stocks. It’s
fine for people to own 20 stocks if they really want to. If it makes you feel better, do it. I’m not
sure there’s any real advantage in owning 20 stocks instead of 10 stocks. You haven’t reduced
risk much. Not the kind of risk there is in all your stocks.
Owning stocks outside your own home currency and not hedging them can add diversification.
Adding stocks that benefit from higher interest rates – since all the other stocks in your portfolio
suffer from having lower P/E ratios when rates rise – helps you diversify. And owning
completely illiquid stocks – like George Risk (RSKIA, Financial) –Â helpsÂ youÂ diversify.
My two biggest holdings are George Risk and Frost (CFR, Financial). Frost benefits from higher
interest rates. George Risk is illiquid to the point where the beta on the stock – a measure of how
it moves in relation to the S&P 500 – ranges from quite low to negative. A negative beta on a
stock is rare. It means the stock’s movements are not positively correlated with the overall
market. If you look at your portfolio, you’ll notice that a lot of your stocks have positive betas
around 1. That indicates movements similar to the overall market. Likewise, you’ll notice that
few of the stocks in your portfolio benefit from higher interest rates. Stocks
like Progressive (PGR, Financial), Bank of Hawaii (BOH, Financial) and Frost do. Most stocks
don’t. Most investors are – without thinking about it – heavily exposed to the risk of rising
interest rates in almost each and every stock in their portfolios.
The risk is a contracting P/E multiple. The biggest risks that most investors face are that the
stocks in their portfolios are generally: 1) overpriced and 2) likely to decline as interest rates rise.
Rising interest rates and declining investor sentiment (market momentum) can harm all their
stocks equally. You can own five stocks, 10 stocks, 20 stocks, 40 stocks, 80 stocks or 160 stocks.
Those two risks will still be there.
They are easiest to avoid the smaller your portfolio is. That’s my reason for putting a lot in one
stock. I’m not someone who thinks about the Kelly Formula or betting big on my favorite ideas.
I put a lot into one stock because I want to own very few stocks. It’s not that I want to put more
money into my favorite idea than my seventh-favorite idea. It’s that I want to eliminate my
seventh-favorite idea entirely. The more stocks I pick, the more risks I never even thought about
will creep into my portfolio.
That’s why I concentrate my investments. What’s the most I’d ever put in one stock? Normally, I
only put 20% to 25% in one stock. I don’t sell the stock as it rises. If one stock rises a lot while
the rest of my portfolio falls – it could end up accounting for a large percentage of the account. I
almost never put more than 20% to 25% of my account into a stock when I buy it.
The most I ever put into one stock was Bancinsurance. This was a very illiquid, micro-cap stock.
I had been following it for years but had never bought the stock. It went through some temporary
trouble. The company was a niche insurer. It wrote some insurance outside that niche. I think it
managed to destroy about 25% of its equity doing so. The company’s auditors resigned. The
SEC opened an investigation into the company. And A.M. Best lowered its financial strength
rating for the company.
The biggest concern for me was the third one. An insurer like this needs a decent A.M. Best
rating. The stock dropped to probably $4.50 per share at some point. Eventually, the SEC closed
its investigation without taking any action. The controlling shareholder (and CEO) offered to buy
out the minority shareholders at $6 per share. I think the company had like $8.50 per share in
book value at that point. I had started – just barely – to nibble at the stock before the offer was
made. I wasn’t sure whether the deal would go through at $6 per share, there’d be a higher offer,
or the CEO would just withdraw the offer. I was fine with any of those three scenarios. I thought
it was maybe 50/50 (my totally unscientific gut judgment) that the deal would simply be done at
$6 per share. But I bought as much stock as I could up to the latest offer the CEO had made.
During the process, the offer was raised twice. The stock would have dropped if the offer had
been withdrawn, but then I’d own a lot of shares – more than I otherwise could’ve gotten in such
an illiquid company – at a fraction of book value. If the deal was done at $6 per share, I would
have made a small – possibly very small – arbitrage profit. I think I ended up with an average
cost about 3% less than the original offer. If the deal was done at the original offer, I would have
made 3% raw return and maybe something in the 6% to 12% annualized range depending on
how quickly the deal was closed. As it turned out, I was able to put close to 50% – but a lot less
than I wanted – of my account into the stock. Book value kept rising while negotiations were
ongoing.
The final deal was done about 40% higher than my cost in the stock. It took less than a year. It
was a good deal in the sense that I put about 50% of my portfolio into a stock that gained about
40% in less than a year. That added about 20 percentage points of overall portfolio performance
to one year’s result. A good outcome. Better than I ever expected.
That’s the circumstance under which I’d make the biggest bet. I was willing to put virtually
unlimited amounts of my portfolio into Bancinsurance. For a Buffett example, look at American
Express (AXP, Financial). He bought that stock during the salad oil scandal. I think he maxed
out at 40% of the partnership’s portfolio. Originally, Buffett had a self-imposed limit of putting
no more than 25% of the partnership’s money in one stock. For the average investor, 20% is a
good limit. I’ve met few people who are as willing to concentrate as Buffett was in the 1960s or
as I am now. My newsletter co-writer, Quan, feels the same way I do about concentration. Even
though we were doing one idea per month for the newsletter’s subscribers – the two of us were
each only looking to find one good idea per year in which to invest.
That’s always my own goal. I look for one good idea per year, and I hope it’s an idea I’ll hold for
five years. So I target five stocks each sized at 20%.
 URL: https://www.gurufocus.com/news/461075/why-i-concentrate
 Time: 2016
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Should You Keep Idle Funds in Cash, an Index Fund or Berkshire Hathaway?
“Does it make sense to use index funds (when appropriate, based on multiyear historical trailing
P/E for example) as part of the portfolio allocation when picking stocks (assuming the stock
picker is above average)? Or does this stock picker have no business looking at index funds at
all?”
I honestly don’t think it makes sense to use index funds if you are an above-average stock picker.
Also, it’s not just a matter of skill. It’s a matter of focus. If you are spending time buying index
funds, you are spending time thinking about the overall market instead of specific stocks. There
are some situations where I could imagine someone who is a stock picker also owning an index
fund. But they aren’t in the situations of which you are probably thinking.
Let’s start with how I’ve used index funds. I started investing when I was 14. When I started, I
used index funds. Instead of just having a bunch of savings in cash and then picking stocks in
which to invest a certain portion, I put everything in stocks initially. I just put all my savings in
an index fund. Whenever I found a stock I liked, I would sell about 20% of the index fund and
put the proceeds into a stock. In this way, I would end up with no more than one-fifth of my
account in any one stock even though I didn’t have five stock ideas yet. Once I had two stock
ideas, I was 20% Stock A, 20% Stock B and 60% index fund. Eventually, I got to the point
where I was 100% stocks I had picked and 0% index funds.
This is a terrific way to use index funds. And I suggest that every new investor start out this way.
Figure out how diversified you’d like to be. I suggest picking from one of three options: low
diversification (five stocks), medium diversification (10 stocks) and high diversification (20
stocks). Very few investors hold fewer than five stocks. And there is little benefit to holding
more than 20 stocks. It just doesn’t reduce risk. You’d be better off splitting a 20-stock portfolio
into different pockets of portfolios with a different focus.
Instead of going from a 20-stock portfolio to a 40-stock portfolio in an effort to add to

diversification – you should just split your 20 slots into 10 U.S. stock slots and 10 foreign stock
slots. Or you could split your portfolio up into five slots of U.S. micro-caps, five slots of well-
known U.S. stocks, five foreign micro-caps and five well-known foreign stocks.
That kind of diversification will do more to diversify away the specific risk you are still seeing in
a 20-stock portfolio. If you are interested in index funds, I suggest you use a 20-stock portfolio
instead. You may want to be diversified by size of the stocks you are looking at – micro-cap
versus mid-cap, big-cap, etc. And you may want to be diversified by the country those stocks are
in – U.S. versus foreign.
I would start by putting everything in an index fund. If you are planning to always own 10 U.S.
stocks and always own 10 foreign stocks – I’d suggest instead buying two index funds. One is a
U.S. index fund. The other is some index fund that does not include the U.S. And then you can
sell 10% of one of these two funds whenever you find a specific stock belonging to that category.
Let’s say you start out with a portfolio that is 50% U.S. index fund, 50% foreign index fund and
then you buy Luxottica. Luxottica (LUX, Financial) is an Italian stock. You’d sell 10% of your
foreign stock index fund, you’d put that 10% into Luxottica. The resulting account would be:
50% U.S. index fund, 40% foreign index fund, and 10% Luxottica. This is how I think investors
should use an index fund. You can use it to increase selectivity. One problem I notice with
investors – especially new investors – is that they want to be diversified, but they don’t have
enough good ideas yet. They make the mistake of picking too many stocks too quickly in their
first few years as investors. The same thing happens if they change strategies. If they shift from
more of a Ben Graham investor to more of a Warren Buffett (Trades, Portfolio) investor or more
of a Phil Fisher investor or something like that they are too active in buying and selling stocks
for that one year. Instead, they could sell whichever stocks they no longer believe in and put that
money in an index fund as a holding cell. An index fund can be a staging area.
You could also do something else. And this is the thing I’d recommend a lot of value investors
do. You can just buy Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Berkshire
Hathaway is diversified. It’s a lot like an index fund. Berkshire is cheaper than the Standard &
Poor's 500 right now. And it has a better capital allocator (Buffett) at the top than the average
S&P 500 stock. This is a matter of personal preference. In your gut, would you feel safer owning
an S&P 500 index fund or Berkshire Hathaway? Or would you feel equally comfortable with
both?
If you’re starting a new portfolio, and you’d feel more comfortable with Berkshire than with the
S&P 500 – put 100% of your portfolio into Berkshire and then sell Berkshire piece by piece (at a
rate of 5%, 10%, or 20% of your portfolio – depending on how concentrated you want to be) as
you replace Berkshire with a stock you like better than Berkshire. I think that’s a good exercise
for most investors. Then you are comparing the stock you have found yourself with what Buffett
has built. If you don’t like the stock you’ve found better than Berkshire – then why not just own
Berkshire? Berkshire can be your staging area. It can be where you keep your money until you
find someplace to put it to work for yourself. And that someplace has to be better than Berkshire
to make the switch worthwhile.
That makes a lot of sense. Starting with a 100% Berkshire portfolio and then shifting it as you
find stocks is a good approach. Starting 100% in an index fund also makes some sense. To me, it
makes less sense than owning Berkshire. As of today, the S&P 500 is clearly inferior to
Berkshire Hathaway. I’m not sure why anyone would prefer owning an S&P 500 index to
owning Berkshire. But some people may feel there are risks at Berkshire (Buffett dies, an
insurance subsidiary makes some terrible mistakes, etc.) that can’t be diversified away by the
structure of that company. The S&P 500 is more diverse than Berkshire.
My suggestion would be to imagine a 50% decline in the S&P 500 and a 50% decline in
Berkshire Hathaway. All your money is in the S&P 500; it drops 50%. How do you feel now?
What do you do? Buy? Sell? Hold? Now, imagine all your money is in Berkshire Hathaway. It
drops 50%. How do you feel now? What do you do? Buy? Sell? Hold? Compare the two gut
feelings you are imagining. In which scenario did you feel sicker to your stomach? Put your idle
money in the one that made you feel less sick.
You can also split the difference. You can start with an account that is 50% Berkshire Hathaway
and 50% S&P 500 index fund and then you can sell – for a 10-stock portfolio – one-tenth of each
position to fund the latest stock you’ve found.
For a stock picker, the only advantage I see to an index fund is that it reduces the number of
decisions you have to make. There’s a danger of complete loss if you make a mistake picking a
single stock. That danger doesn’t exist in an index fund. The S&P 500 is never going to go to
zero. It may drop 50%. Berkshire may also drop 50%. But the S&P 500 will always – eventually
– recover from a 50% drop. A specific stock may not. I’ve owned Barnes &
Noble (BKS, Financial) and Weight Watchers (WTW, Financial). If they dropped 50%, I’m not
sure they’d ever make that money back.
That’s the risk with an individual stock pick. It’s the risk with an individual business. Buffett
bought into the original Berkshire Hathaway textile company. It closed 20 years later. It was
eventually a complete loss. He bought Dexter Shoe. It was a complete loss. He bought Bank of
Ireland common stock. It was a complete loss. If Buffett manages to find one total wipeout of an
investment at least once a decade (and he’s come pretty close to that) then so will you. You can
expect that one of your stocks will go to zero at least once a decade. For that reason, you may
want some diversification.
Let’s say you are comfortable with a 20-stock portfolio. That’s great. I own far fewer stocks. But
I think 20 is a great number for the average investor. How quickly can you fill up this portfolio? I
don’t think you can do it in less than five years. I think it’s totally unreasonable to expect to find
a good enough – safe enough – stock idea more than once a quarter. Set a goal of finding the best
stock idea you can each quarter and then – at the end of the quarter – buying that stock. Let’s
look at how this would work for a totally new investor with the goal of owning 20 stocks.
The investor would put 100% of his money in an index fund. He could start looking at stocks
now. But, he won’t buy any until the end of the first full quarter he’s devoted himself to
investing. We’ll say the first purchase will be made at the end of March 2017. You spend the
months of January, February and March looking for the best stock you can find. You rank them.
Whatever is No. 1 at the end of March is what you buy. On the last day of March you sell 5% of
the S&P 500 index fund you own and put that 5% into whatever stock you’ve decided is the best
one out there. You repeat this process every quarter. At the end of 2017, you’ll be 5% Stock A,
5% Stock B, 5% Stock C, 5% Stock D and 80% S&P 500 index fund. At the end of 2018, you’ll
be 40% hand-picked stocks and 60% S&P 500 index fund. Then it’s 40% index fund in 2019,
20% index fund in 2020 and finally 100% hand-picked stocks in 2021.
This is an approximation. The reality is that you’ll have less in hand-picked stocks than I
suggested here. In my experience, the “takeout” rate for stocks I pick is pretty high. You may
lose 10% to 20% of your portfolio to mergers, going private transactions, etc. Things that create
turnover in your portfolio without any action on your part. That means that you’re not going to
have much more than 60% of your portfolio in handpicked stocks at the end of 2021. It’s hard to
come up with an exact number. I don’t know how many stocks you pick will be taken over. But
I’ve never had a portfolio that lost less than 10% a year to various takeovers. It’s usually been a
going private transaction with my stocks. There haven’t been many takeovers at all. But I’ve
always lost more than 10% of my portfolio to going private transactions. So, I wouldn’t be able
to reach 100% handpicked stocks within five years.
Nevertheless, this is the right “slow and steady” approach to take to stock picking. I try to limit
myself to buying just one stock per year. I’ve never been disciplined enough to stick with that
idea for long. But it’s a goal I am always reaching for. For most investors, I’d suggest a quota of
one stock purchase every quarter. It should take you three months times the number of stocks
you want in your portfolio to fill up a portfolio. It’s not a good idea to go from owning no stocks
to having all hand-picked stocks in just one year. It’s a better plan to take three to five years to
build your own hand-picked portfolio.
An index fund can be the green room where you keep cash before moving it into your own ideas.
Berkshire Hathaway can better serve that purpose for many value investors.
 URL: https://www.gurufocus.com/news/461074/should-you-keep-idle-funds-in-cash-an-
index-fund-or-berkshire-hathaway
 Time: 2016
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Investing Overseas: Look for a Cheap Currency and Long History of High
Returns on Equity
“Can you give your thoughts on looking at international markets now with the strength of the
dollar. The pound has dropped so much as well as the euro against the dollar it seems to be a
good opportunity. Many predicable consumer names are on sale even more so with the strength
of the dollar.”
First, I should say that I am considering buying a U.K. stock right now. If I do, I will not hedge
the currency risk. So, I would be happy to swap my U.S. dollars for British pounds right now.
But, I would have to find the right stock – not just the right country – to invest in. For most
people reading this, I think the country to focus on right now is the U.K. The currency is
reasonable on a purchasing power parity basis because the U.S. dollar has been rising and
because of the U.K.’s decision to leave the European Union. The business culture in the U.K. is
good. There are U.K. companies that are comparable in quality to U.S. companies. So, I think the
U.K. is the market to focus on right now. I would not buy a U.K. index fund or a basket of U.K.
stocks. But, instead of just looking everywhere in the world for a good business at a good price –
I would limit my search to the U.K. for now.
I always want to find more foreign stocks for my portfolio. I never have enough. I would like to
be at least 50% invested in stocks outside the U.S. whenever possible. I have this hope that at
least 50% of the stocks in my portfolio would be non-U.S. and at least 50% of the stocks in my
portfolio would be micro-cap stocks. Big, U.S. stocks are rarely mispriced when the market is
expensive. They can be excellent investments, but they are usually good buys when either the
overall stock market is down or there is pessimism about their industry.
When I was writing the newsletter, we did pick some non-U.S. stocks. We
picked Swatch (XSWX:UHRN, Financial) (a Swiss company), Ekornes (OSL:EKO, Financial)
(a Norwegian company), Homeserve (LSE:HSV, Financial) (a U.K. company), Hunter
Douglas (HDUGF, Financial) (a Dutch company) and LuxotticaÂ (LUX, Financial)(an Italian
company). Now, the country designations I just gave are where those companies trade – not
necessarily where they do a lot of business. For example, the U.S. is the single most important
market for both Luxottica and Hunter Douglas. So, you can find companies listed in other
countries that do a lot of business in the U.S. You can also find a lot of companies in the U.S. –
especially predictable, consumer names – that do a lot of business in other countries. If these
U.S. listed multinationals are not hedged, they will report higher earnings in U.S. dollars when
the local currencies they operate in rise against the dollar. Currency moves can also affect
competitiveness. But, this is not usually a big issue for the kinds of companies I am interested in.
I tend not to look at businesses where price competition is a key concern. So, for example, we
wrote about Swatch at a time when the Swiss franc was rising a lot against the dollar and
therefore also against currencies in Asia – like the Hong Kong dollar and Chinese yuan – that are
pegged either in a hard or soft way to track the dollar. In fact, because Chinese tourists buy a lot
of Swiss watches when visiting the U.S., the combination of sales made in U.S. dollars, Hong
Kong dollars and Chinese yuan was big. So, movements of the Swiss franc against the U.S.
dollar cause a huge indirect lack of competitiveness for Swiss watchmakers. I am not sure this is
important though. Almost all watches sold on the basis of price aren’t Swiss. And almost all
Swiss watches are sold on some basis other than price. There are some brands – like the Swatch
brand itself – that are obviously made less competitive in the U.S. by the rise in the Swiss franc
versus the U.S. dollar. However, the Swatch brand and the U.S. market are small parts of
Swatch’s earnings. The company earns a lot more selling luxury brands in China. But, it
competes against other Swiss watchmakers. And those watchmakers also raise their prices in
local currency terms when costs rise for them in Switzerland. So, that kind of company is not
going to be affected the same way a maker of a product that competes on price with exports from
other countries will be affected. This is why currency movements are complicated for investors
in specific stocks.
Let’s take the examples of Luxottica and Hunter Douglas. Luxottica’s manufacturing costs are
all in Italy. Likewise, Ekornes (they make Stressless recliners) has all its costs in Norway. But, a
company like Hunter Douglas is different. Hunter Douglas is listed in the Netherlands. But,
Hunter Douglas is really two companies. The Hunter Douglas brand manufactures and sells in
the U.S. The Luxaflex brand manufactures and sells in Europe. The stock is listed in the
Netherlands and reports its earnings in euros. However, most of the company’s sales and profits
do not come in the form of euros. So, if you are an American investor interested in the Hunter
Douglas brand, the complications here are that maybe 40% of the business is Luxaflex, which
does business in euros. And then the other complication is that the stock is priced in euros even
though much of the earning power originates in dollars. So, if the dollar rises against the euro,
then next year’s expected earnings in euros will have risen. The stock price – in euros – may or
may not rise by the correct amount when this happens. Very often it does not. The short-term
movements in a stock listed in one country but generating a lot of earnings in other countries
does not seem to be efficient to me. You could see this clearly when the Brexit vote happened. A
lot of U.K. stocks dropped in price. That might seem to make sense at first. But, for a lot of
companies – a stock price decline in British pounds does not make a lot of sense if it happens at
the same time as a decline in the price of the pound versus other major currencies. A U.K. stock
is not just falling in price. It is falling in price in a specific currency. So, if a company in the U.K.
gets a decent amount of earnings from outside the U.K. and then its stock price drops in pounds
at the same time the pound itself is dropping – you can see the problem. The stock is way over-
reacting to the situation.
Some companies can suffer a lot from something like Brexit. Obviously, an importer that must
compete with possible substitutes could be in real trouble. But, it is not always clear if there is a
real substitute that would not also be increasing in price. For instance, use the example
of Howden Joinery (LSE:HWDN, Financial). Howden Joinery serves trade account clients –
builders – that install kitchens for U.K. homeowners. Unlike in the U.S., a U.K. company may be
importing a fair amount of building material. However, Howden is not at any disadvantage
compared to other importers. So, Brexit can hurt homeowners by making them less likely to
want a new kitchen at the higher (due to pricier imports) cost of the kitchen and the lower
confidence they may have in their economy. So, people may want to build fewer kitchens. And
builders would then want to buy less from Howden. That is possible. Likely even. But, the
decline in Howden stock after Brexit was big. And yet Howden is just a retailer – to trade
accounts – in the U.K. So, its gross margin might be hurt for a time. But, Brexit should not do a
lot to weaken Howdens’ competitive position inside the U.K.. It should just hurt all the
companies selling to builders.
When doing the newsletter, we looked at Europe a lot and we did not see a lot of opportunities.
We found more opportunities in the U.S. Even the European stocks we liked best – Hunter
Douglas and Luxottica – do most of their business in the U.S. One reason for this is that Quan
(my co-writer) and I use PPP (purchasing power parity). We are not thinking about whether a
currency has dropped a lot over the last three months or three years. We are just worried where
the currency is in terms of purchasing power parity, which is essentially the price at which you
could buy equal amounts of stuff in the two places. You are probably most familiar with it in the
form of the Big Mac Index. If a Big Mac costs $5 in the U.S. and $2.80 in China – then we can
say that the Chinese currency is undervalued versus the U.S. currency in terms of purchasing
power parity. There is an argument that higher income countries tend to be overvalued in terms
of pure purchasing power parity and lower income countries tend to be undervalued in terms of
pure purchasing power parity. So, maybe it is OK for Big Macs to cost more in the U.S. than in
Mexico. And maybe you have to adjust for this income level difference. But that is tricky to do.
It is tricky to disentangle a country’s lower income status from its government policies, ability to
attract capital, etc. Most lower income countries are not attractive destinations for capital, have
bad government policies for investors, etc. Most higher income countries are attractive
destinations for capital, have good government policies for investors, etc. So, I think you can
use purchasing power parity as you would use the discount to NAV on a closed-end investment
fund. Some closed-end funds will – and should – always trade at a discount to NAV. Likewise,
some countries have currencies that will – and should – always trade at a discount to purchasing
power parity. For example, Quan (my newsletter co-writer) is from Vietnam. I am from the U.S.
We have talked about the economies of those two countries many times before. To be honest, we
have not come up with any reason why in the long-term Vietnam would be able to have a fully
open trade and capital relationship with countries like the U.S. and not have capital leave it
continuously. We would expect Vietnam to sometimes have a rising currency. In the long run, it
would just be expected to continually devalue its currency. It would not be a one-time event. It
would be something the country would be doing repeatedly.
I just do not see how the real returns on capital in Vietnam are going to be as high as the real
returns on capital in the U.S. So, if someone in Vietnam could take their Vietnamese dong,
exchange them for dollars at the official exchange rate and then invest all those dollars in U.S.
stocks and keep them forever – they should. Now, they cannot do that because it is not allowed.
But, you see my point. Vietnam may have a currency that is undervalued versus the U.S. dollar
at this moment. But, the person holding U.S. dollars is always in a better situation going forward
– he can use his dollars to buy assets that will have higher long-term real returns – than someone
holding Vietnamese dong. This is true for a lot of developing countries. I do not know how their
public companies can generate as high after-inflation returns on shareholder money as U.S.
companies can. So, it does not make sense to “invest” in their currencies. It only makes sense to
trade their currencies. Countries like the U.K., Switzerland, Sweden, Belgium and Germany have
a lot of companies with long-term real returns on equity that come much closer to U.S.
companies. It is reasonable to have little to no preference between holding a sampling of high-
quality American, Swedish, Belgian, Swiss or British companies. When we move down the list
to places like Germany, it gets a little tougher to say there is no long-term difference. There are
plenty of smaller German companies that I think are fine, but giant German corporations do not
have as good a long-term record as American companies. France and Japan are often considered
comparable to the U.S. in terms of their development – but their business cultures are not
comparable. French and Japanese companies do not earn as good real returns for their
shareholders as American companies do. Now, if you can find a great family-owned company in
any of these countries that is run along the lines you would want your American investments to
be run – that is great. I like the way Hunter Douglas, Luxottica and Swatch are run. There are a
couple Japanese companies that are run in a way I like. But, yes, there are plenty of countries in
Europe that have good long-term records for return on equity. Public companies in Northern
Europe – especially the U.K., Sweden, Belgium and the Netherlands – are good. Basically, the
places where the industrial revolution started have still been – in the centuries that followed –
good places to invest. However, there has not been a convergence of business culture between
countries that came later to industrialization and those that started very early. We can see this a
bit in the income levels of workers. A lot of countries that came later to industrialization have
much lower GDP per hour worked (at PPP). And they have lower returns on equity. The real
returns on equity of a country’s companies are critical. That is all you care about as a long-term
investor. So, I would pay attention to what the very long-term history of real return on equity
(ROE) has been in a country and I would pay attention to what purchasing power parity levels
are now. But, I would not be excited by Mexico being cheap on a purchasing power parity basis
versus the U.S. if I also knew that over the last 100 years Mexican companies have delivered
much lower real returns on equity for their shareholders. Most of the countries I like best in
terms of their public companies are the most expensive in terms of purchasing power parity. This
has been true for several years.
Right now, I would say the U.K. is the most interesting place to look for ideas in terms of the
combination of a reasonably low exchange rate relative to purchasing power parity levels and a
good enough long-term history of delivering ROE for British shareholders. There are cheaper
currencies, but right now I am not sure there is a better combination of a cheap currency and
good companies than the U.K.
 URL: https://www.gurufocus.com/news/459646/investing-overseas-look-for-a-cheap-
currency-and-long-history-of-high-returns-on-equity
 Time: 2016
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Should You Buy Dividend Achievers or Intrinsic Value Achievers?
“What is your take on a Dividend Growth strategy? Buying large cap businesses with a decent
initial yield and a track record of dividend growth.
It's seems very attractive to me to own a portfolio of large, safe US based companies that have
solid dividend growth prospects.
If an investor is patient and chooses his portfolio carefully, they may be able to get 10% "yield
on cost" after only 10 years. That seems like a powerful investing position to be in. And the
"yield on cost" number gets insane after 20 or 30 years.”
A dividend growth strategy makes sense. So, does a high-quality strategy. A predictable
businesses strategy. A consistent EPS growth strategy. And even a consistent share buyback
strategy. People are attracted to the dividend approach more than some other strategies. So, I’d
just caution that there’s nothing special about dividends. A company that increases its dividends
per share by say 7% a year every year while increasing its EPS by about 7% a year on average
over every rolling five-year period is a good stock if you buy it at a good price. But, is it a good
stock because it pays a high dividend? Is it a good stock because it grows its dividend? Or is it a
good stock because it grows its free cash flow?
Consistent dividend growth tells you about two things: One, it tells you about historical free cash
flow growth. In the long-run, dividends tend to track free cash flow. Two, it tells you something
about capital allocation. And then a dividend yield tells you something – not a lot, but something
– about valuation. So, if you buy a company with a decent enough dividend yield in year one and
the promise that it will keep growing that dividend – you should know you are buying a stock
that is: cheap enough (as shown by yield), has high enough free cash flow growth (otherwise it
wouldn’t be raising the dividend), and has good enough capital allocation (since it is choosing to
pay more and more in dividends each year).
To be honest, I don’t think the dividend part of this is important at all. In other words, if you
could find a stock with those three traits: 1) Good enough price 2) Good enough annual growth
and 3) Good enough capital allocation – you should buy it regardless of whether it pays a
dividend or not. Berkshire Hathaway is a good example. Berkshire doesn’t pay a dividend. It
hasn’t paid a dividend in 50 years. So, it’s not any sort of dividend stock. But, Berkshire is
reasonably priced. It has good growth in intrinsic value for a stock its size. And it has great
capital allocation. So, Berkshire checks all the same boxes that I think drive the success of a
dividend growth strategy. And yet Berkshire doesn’t pay a dividend.
The same is true of companies that consistently buy back their stock instead of paying much in
the way of dividends. Omnicom (OMC, Financial) is a good example. Omnicom is an ad agency
stock. Historically, those stocks have been underpriced relative to the market. They’ve traded at
a premium P/E. But that P/E hasn’t been quite “premium” enough to stop the group from
outperforming the overall market over decades. This is because they have a high combination of
free cash flow yield and free cash flow growth. We can approximate this by just looking at free
cash flow yield and sales growth. Margins are stable at most ad agencies. So, in the long-run,
free cash flow tracks sales. Let’s say you find an ad agency that trades at 20 times free cash flow
and grows sales by 4% a year. A price-to-free-cash-flow of 20 isn’t low. And a growth rate of
4% isn’t high. But, ad agencies don’t have to retain any earnings to pay dividends, buy back
stock, etc. So, the stock will return about 9% a year in this scenario. It will have 5% of its stock
price to pay out in dividends, use on share buybacks, etc. this year. And the sales (and thus free
cash flow) at the company will grow organically at 4% a year. So, that’s 5% plus 4% equals 9%.
The S&P 500 isn’t going to do better than 9% a year. So, an ad agency priced at 20 times free
cash flow and growing as slow as 4% a year can still outperform the S&P 500. If the stock is
priced to outperform the S&P 500, it’s better for continuing shareholders (those that don’t sell
the stock) for the company to devote all its free cash flow to buying back stock instead of paying
any dividend at all.
When I was writing a newsletter, we picked Omnicom. And we talked a little about capital
allocation. Why did Omnicom tend to outperform WPP and why did WPP tend to outperform
Publicis? If you looked at the long-term return of these stocks, the order was Omnicom, then
WPP, then Publicis. Why? It had nothing to do with the underlying businesses and everything to
do with capital allocation. Omnicom spent more on buybacks than other companies. WPP spent
more on acquisitions done at low prices. And Publicis spent more on acquisitions done at high
prices. That explained basically all the difference in performance between the stocks. If WPP had
just bought back its own stock instead of making any acquisitions – it would have done a little
better in terms of the total return of the stock. It made smart acquisitions at smart prices. But, the
return on those acquisitions simply couldn’t match the return on an actual stock buyback of
WPP’s own shares. Likewise, Publicis could have improved its total return for shareholders if it
only did lower priced acquisitions or if it only bought back its own stock. We are talking about a
difference of a couple percentage points a year over a decade or two. The difference between
having say a 9% return on everything you don’t pay out in dividends and an 11% return on
everything you don’t pay out and a 13% return on everything you don’t pay out is huge. And
that’s the kind of differences we are talking about. Similar businesses with similarly priced
stocks can return 9% a year or 13% a year depending on whether they are totally disciplined or
totally undisciplined about capital allocation.
What does this have to do with dividends? Let’s use the 9%, 11%, and 13% example I just gave.
It’s imperfect. Because all of these companies did pay some dividends. So, the return on earnings
not paid out in dividends is not exactly the return on the stock. But, in the very long-run your
destiny in a stock you hold forever is going to be the return the company gets on its own money.
Dividends are a way to mitigate this. Dividends are a safety valve.
Companies have free cash flow. They must allocate that free cash flow. If they have debt, they
can pay that down. And they can pile up cash. But, these are only short-term swings. A company
can’t pay down debt forever or add to cash forever. That’s not realistic. So, free cash flow can
only be used for 4 things. One, it can be used to expand the core business. Two, it can be used to
acquire other businesses. Three, it can be used to buy back the company’s own stock. Four, it can
be used to pay out a dividend. That’s it. How a company uses its free cash flow is critical.
Dividends are rarely the best use of free cash flow. But, they’re also rarely – in fact, almost never
– the worst use of free cash flow. AT&T (T, Financial) is trying to buy Time Warner (TWX).
The deal includes a cash component. Now, the share part of the deal is complicated to value. If
AT&T is overvalued relative to Time Warner, this can be a good deal for its shareholders as far
as the stock part of the deal is concerned. But AT&T is also using cash to make this offer. How
likely do you think it is that AT&T using that cash to buy Time Warner will create more value
for shareholders than simply paying that much cash out in a special dividend? I think it’s very,
very unlikely that the cash part of the Time Warner offer can be more valuable to an AT&T
shareholder than a special dividend would be. That means it would be better for shareholders if
AT&T paid out more in dividends and spent less cash on making acquisitions.
That’s true for a lot of companies. There are mergers that create value. There are plenty of such
mergers. They tend to be horizontal mergers that are done all in cash. So, if Berkshire Hathaway
wanted to buy Progressive using cash – that would be an example of a horizontal merger. There
are synergies between GEICO and Progressive. They are the two biggest companies in the direct
auto insurance business. So, GEICO (really Berkshire) buying Progressive using cash could
easily be a good deal. AT&T buying Time Warner is much harder to do in a way that can
possibly be worth as much to shareholders as a simple special dividend for the same amount of
cash would be worth. So, dividends are a safety valve. They are a guard against bad capital
allocation. Dividends are also a hindrance to great capital allocation though.
Let’s use my example of 3 ad agencies over 10-20 years. Company A buys back its own stock. It
gets a return of 13% a year from doing this. Company B makes inexpensive acquisitions. It gets
a return of 11% a year on this activity. And Company C makes expensive acquisitions. It gets a
return of 9% a year from this activity. The companies it buys aren’t bad businesses. They are
good businesses. And there may even be synergies in buying them. But, because Company C is
always paying a premium of 30% to 50% over the P/E ratio its own stock trades for – it can
never do as well buying other companies as it could do buying its own stock.
What does changing each of these company’s capital allocation policies towards just dividends
do? The more Company A spend on dividends, the more its total return as a stock will drift
toward 10%. The same is true for Company B and Company C. Investors can’t make 13% a year
– especially after paying a tax on dividends – by taking a dividend from Company A and buying
something else in their brokerage account. So, a company like Omnicom makes its shareholders
poorer to the extent it pays out more in dividends. A company like Publicis might make its
shareholders richer the more it pays out in dividends. I think the more AT&T were to pay out in
dividends, the richer it would make its shareholders. But this is only because I think it’s hard for
AT&T to come up with anything to do with its billions in free cash flow that can return more
than the company’s shareholders could earn for themselves buying other stocks with a dividend.
Healthy dividend growth and a high dividend yield are fine things to look for. But, high free cash
flow growth and good capital allocation are what underlies this. Berkshire isn’t wrong not to pay
a dividend. I wouldn’t necessarily want a company like ATN International (ATNI, Financial) to
pay out more in dividends – although it has raised dividends at a good clip – because I think the
management at that company tends to make decent capital allocation decisions. The less I trust
management to make good capital allocation decisions, the more I want to see paid out in
dividends. But there is no reason to prefer dividend growth over share buyback growth. In fact, if
the stock you are interested in is a good business in a good industry – it should spend more on
buybacks and less on dividends. Bank of Hawaii (BOH, Financial) is a bank. Most banks focus
on paying out dividends and buy almost no stock back. I’d rather BOH focused entirely on
buying back its own stock and didn’t worry about dividends at all. The company targets a
tangible equity to total assets ratio. It keeps about 7 cents of tangible shareholder’s equity for
every $1 of total assets it has. Everything else is surplus. As long as I knew BOH wasn’t going to
buy any other banks and as long as I knew it wasn’t going to allow tangible equity to rise much
above 7 cents a share for every one dollar of assets – I’d be fine with either dividends or stock
buybacks. The bank would have to grow whatever it chose to do (dividends or buybacks) at
about the rate of deposit growth. If it failed to do this, it would start building up too much
tangible equity.
So, again it’s a growth and capital allocation issue. Consistent dividend growth is a sign.
Growing dividends are a symptom both of decent growth and decent capital allocation. If a
company can’t grow at all – it can’t increase its dividends. And if a company has truly atrocious
capital allocation – it’s not going to allocate anything to dividends. But I don’t think dividends
per se are important.
It’s a good idea to investigate any company that has consistently grown its dividend. But, you
shouldn’t focus too much on the dividend. Instead, you should focus on what the price to free
cash flow is.
What should you ask instead? Ask: What’s the free cash flow yield rather than what’s the
dividend yield. Ask what’s the free cash flow growth rate rather than what’s the dividend growth
rate. And ask how good is capital allocation overall rather than just how high is the dividend
payout ratio.
 URL: https://www.gurufocus.com/news/458294/should-you-buy-dividend-achievers-or-
intrinsic-value-achievers
 Time: 2016
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Should You Buy Net-Nets or 'Desert Island' Stocks?
Someone who reads my blogÂ emailed me this question:
“Do you think it's better for a small-time investor (to) buy cigar butts (Net-Nets) or to buy great
companies at fair prices?"
I realize Warren Buffett started out as a Graham-style cigar butt investor but over the years has
moved to excellent businesses at fair prices, where his holding period is forever assuming the
company has good prospects and growth and honest management, etc.
I'm reading the book "The Snowball," and it shares that Buffett and Charlie Munger used to do a
thought experiment where they would pretend they were going to be stuck on a desert island for
10 years and could only buy a single stock before leaving. Which company would they pick and
have confidence that it would still be around in 10 years and would likely have higher earnings
power 10 years from that day?
That approached helped them to focus on "great" businesses vs. most businesses. Do you employ
this approach in your own investing?”
A lot of people ask this question. It kind of divides value investors up into groups. The truth is
that the right answer depends on your own situation. What are the toughest constraints you face?
Buffett’s toughest constraint over the last 40 years has been the amount of capital he had to put
to work. Berkshire (BRK.A, Financial)(BRK.B, Financial) is a lot bigger today than it was in
the 1970s. But even in the early 1970s – for example, when Buffett bought into the Washington
Post – he had to find investment opportunities that were much bigger than what the average
individual investor needed.
Most investors overstate their need for liquidity. An individual with hundreds of thousands of
dollars or even millions of dollars to invest doesn’t have real constraints in terms of the sizes of
the stocks he can buy. Not if he’s an investor. If he’s a trader, that’s a different story. But, I’ve
bought into stocks as small as Bancinsurance (a stock that no longer trades) and George
Risk (RSKIA, Financial). I owned Bancinsurance stock until it was taken private. I’ve held
George Risk shares for six years. They had market caps in the $30 million or so range.
Obviously, market cap depends on price.
They had smaller market caps when I bought in than they did later, but these are micro-cap
stocks, and they were half or more controlled by a founding family. The float was maybe half the
market cap. We are talking about floats of $10 million or less, and people weren’t exactly
furiously trading these stocks. But, if you are going to hold them until they go private or for six
years or whatever, there’s no liquidity problem for anyone with even a few million dollars to
invest. Now, if you have tens of millions of dollars – or more – to invest (as almost all fund
managers do) then it’s a different situation. So, yes, if you have tens of millions of dollars or
more to invest – you’re limited in terms of the net-nets you can buy.
Even in the 1940s and 1950s, when Ben Graham was running Graham-Newman, he kept the
fund smaller than he had to. He could have attracted more investors if he wanted. He didn’t want
to. And part of the reason why he didn’t want to was that he didn’t have – even in those much
cheaper times for stocks – enough opportunities in net-nets, arbitrage, etc., to sop up an
unlimited amount of capital.
I once wrote a report about Japanese net-nets. In other countries, there are sometimes more net-
nets. Sometimes there are good reasons for this (fraud, corruption, etc.). Sometimes there are a
lot of unexciting, dead money type stocks – but not a lot of risks. Japan is like that. Back when I
wrote that report – you could find more than a dozen net-nets that were consistently profitable.
These are Ben Graham type net-nets. If Ben Graham was around today and he was managing a
small amount of money, he might buy baskets of net-nets in places like Japan. I don’t think he’d
be buying the net-nets you see on U.S. net-net screens.
The U.S. stock market is expensive right now. It’s been expensive for awhile. Good net-nets
show up after a market has been going down or sideways for a long time. Japan is where you
would want to look for net-nets not the U.S. If I was managing money in Japan, I’d buy net-nets.
If I was managing money in the U.S., I wouldn’t buy net-nets. The net-nets in the U.S. often
have more severe problems.
I’ve written a little about net-nets before. I don’t want to rehash everything I’ve had to say. But
one thing you want to look for in net-nets is a long corporate history, a profitable past and low
leverage. There are a few easy checks for this. As a rule, I’d say a net-net should have at least six
or more years of profits in the last 10 years. I don’t think you want to buy any company that has
lost money – I’m talking about an operating basis (EBIT) – in more years than it has made
money. I also think retained earnings should be positive. You can find a “retained earnings” line
on a stock’s balance sheet. It should be in every 10-K and 10-Q. It’s a silly thing to talk about.
At a good business I wouldn’t care one iota if retained earnings was positive or negative. But, a
net-net is different. The companies you are looking at are public. They have tapped public capital
markets at some time. People have put money into the business. If shareholders, bondholders,
banks, etc. have put most of the money into the company that it finances itself with, that doesn’t
prove the business is self-sustaining. A stock can be a net-net if it just goes public as a
speculative dot-com or something and raises $100 million and then the stock’s market cap drops
to $50 million and it still has most of that $100 million in proceeds in cash, receivables,
inventory, etc. That’s not the kind of net-net in which Ben Graham was interested.
The point of the net-net approach is that you have an operating business that is worth something
– it’s turning a profit – and yet it’s selling for less than it could be liquidated for. You see that in
Japan sometimes. I saw that in George Risk when I originally bought it. The stock was selling
for about $4.50 and had about $4.50 (maybe a little more) stashed away in mutual funds, bonds,
bank deposits, etc. On top of this, I thought the company could make like 40 cents per share
pretax in normal times. A business that can make 40 cents pretax could be worth as much as $4.
A pile of securities with a fair value of $4.50 per share could be worth as much as $4.50. You
could be paying $4.50 for something that could – theoretically – be worth as much as $8.50.
That’s what you want to do with a net-net, and then it’s just an issue of waiting. Maybe the long-
term return is poor because the company doesn’t do anything with the cash it has, maybe the
business doesn’t grow, etc. But, at least it turns a profit each year, and it doesn’t destroy value.
It’s safe.
If you can – as I did in Japan – find five to 15 of these kinds of stocks, then you’ve got a Ben
Graham-type group operation going on. Except in times of real market stress – like after the dot-
com bust and after the 2008 financial crisis – I couldn’t find enough decent net-nets to do a
group operation in the U.S.
That doesn’t mean the net-net basket approach doesn’t work in the U.S. There has been some
research and anecdotal evidence showing it does work. But, it works differently than what
Graham was doing. It’s more risky, speculative, contrarian, etc. What Graham was doing was
more like what I did with the Japan net-net report. You can read more about net-nets over at
Oddball Stocks. Nate Tobik bought some Japanese net-nets. And he wrote about his experiences.
I also think Mohnish Pabrai (Trades, Portfolio) might have bought some Japanese net-nets. I
don’t think his experience was positive.
If you’re looking for Ben Graham-style net-nets, I’d look for bargains in places like Japan. It’s a
lot of drudgery. It’s Walter Schloss-type work. There’s nothing wrong with it. And I think a
basket of good, decent, historically profitable net-nets in places like Japan can be a good
diversifier. But it’s hard to come up with a consistent supply of them. And it’s nearly impossible
to focus only on net-nets in just the U.S.
The approach I’d suggest with the highest return potential is more like what Joel
Greenblatt (Trades, Portfolio) describes in “You Can Be a Stock Market Genius.” You can buy
into spinoffs, special situations, things like that. If you’re very disciplined and you’re willing to
concentrate your bets – this is the approach that will pay off best. I wrote a newsletter that was
not catalyst focused at all. But, some of the best returns were in things like Babcock &
WilcoxÂ (BW, Financial) – a spinoff into a company the market was comfortable owning and a
company the market was uncomfortable owning.
Likewise, when we picked Breeze-Eastern (no longer a public company), we knew that it had
underreported its normal earnings because it had been doing R&D-type work on long-term
projects and then the first sales it would make on these projects were the very low gross margin
original equipment while the sales it would make in later years were high gross margin
replacement part sales. Everyone knew this. We read the transcripts. We tried to talk to some of
the big shareholders. But it’s not like the earnings transcripts, interviews, etc., told us stuff that
wasn’t obvious from the company’s own discussions.
Phil Fisher mentions this kind of thing. You’re going to get opportunities like this in small cap
stocks (Breeze was probably technically a micro-cap stock although bigger than the other two I
mentioned earlier). Stocks that analysts cover shouldn’t have this problem. Because earnings
estimates for future years should take this kind of thing into account. A lot of these fall into the
sort of “temporary problem” category. Babcock was about to break up, and it had been losing
money on a speculative modular nuclear power venture that we knew would be scaled down to
almost nothing or eliminated. You had a loss-making unit that was going to go away. And then
you had a monopoly that was going to be split off from a business that was heavily exposed to
coal. It’s the kind of stock GreenblattÂ would buy.
So, the “You Can Be a Stock Market Genius” approach is the one I’d suggest to individual
investors who want to put in the legwork and want to maximize returns. I think a buy-and-hold
approach is right for most investors. But the best approach is to study up on great businesses and
then buy them when there is some kind of temporary problem. Sometimes it’s that the market
doesn’t like that kind of stock. In the wake of the financial crisis, I bought IMS
Health (IMS, Financial) (it’s since gone public again, but it went private in
between), FICO (FICO, Financial), and Omnicom (OMC, Financial).
IMS Health was a health care stock when Obamacare was coming. It also had some headline risk
related to politicians attacking the use of anonymized data. FICO is credit scoring. It makes
money based on the number of times its customers make use of the product. When banks,
insurers and other financial institutions aren’t looking to approve new credit applications, they
don’t need FICO scores. As for Omnicom, advertising takes a big hit in a recession. It falls first
and harder than the overall economy and then it recovers faster and stronger than the overall
economy. These are sort of temporary problem stocks. Some would say they are more along
the Richard Pzena (Trades, Portfolio) – normalized earnings – approach. Good examples of
stocks that could fall into this category now are Hunter Douglas (XAMS:HDG) (trades in
Amsterdam, but is mostly an American company) and Frost (CFR, Financial).
Hunter Douglas sells shades and curtains. It does better when more people are moving into and
redecorating their homes. Frost is a Texas based bank. It has a lot of low cost checking and
savings deposits. It uses these deposits to make loans to businesses in Texas and to buy
municipal bonds in Texas. A low federal funds rate depresses the yield on loans to businesses
and yields on bonds. The Fed has less influence over the rate Frost pays for its deposits. Frost
earns a lot less in a low interest rate environment than it does in a high interest rate environment.
What is Frost? It’s not a net-net. Is it a GreenblattÂ “You Can Be a Stock Market Genius” type
stock? Is it a PzenaÂ normalized earnings type stock? A Buffett-type stock? I certainly think
Buffett would buy a bank like Frost if he wasn’t instead in the business of owning shares in giant
banks like Wells Fargo (WFC, Financial). Wells Fargo is a better lender and cross-seller than
Frost. Frost is equal to or better than Wells in almost every other way though. And Wells is
limited by having about as many deposits nationwide as it will ever be allowed to have. Frost can
grow for decades if it wants to. Texas will also grow probably twice as fast (or more) than the
U.S. economy. It’s the kind of bank Buffett would buy if that’s the size of opportunity he was
looking at.
But Buffett bought Wells during a crisis. California loan losses were real bad when he bought
into Wells about 26 years ago. Frost isn’t in any sort of crisis. It’s just faced low interest rates for
the last seven years. I’m probably fooling myself when I think it’s the kind of stock Buffett
would buy. He’s more selective than that. He often holds his fire until a stock is cheap because of
temporary problems.
Yes. I do think about the question: “What’s the one stock I would buy if I went to a desert island
for the next 10 years?” The first question I ask is always: “Would I be comfortable owning this
business forever?” Most of the mistakes I’ve made in the past have been cases where I bought
into a stock – like Barnes & Noble (BKS) – that I was only willing to hold for a few years even
if everything went well. I’d be comfortable owning a stock like Frost for 10 years even if I was
on a desert island. That doesn’t mean it’s the best stock. Just the one I’d be comfortable owning.
The other big bank in Texas – Prosperity (PB) – probably has a better management team than
Frost. It has a great corporate record. It could certainly outperform Frost. And it’s much more
interest rate neutral. So, it’s not a speculation on the Fed the same way Frost is.
If Prosperity announced it was changing both its CEO and chief financial officer, I’d want to sell
the stock immediately. This is like when Quan and I were writing the newsletter and we were
discussing DreamWorks Animation (since taken private). One of the questions we asked was:
“What if Jeffrey Katzenberg was hit by a bus tomorrow?” We both agreed on the answer. We’d
never even consider DreamWorks in that situation. DreamWorks was never a desert island stock,
and Prosperity isn’t a desert island stock. I don’t think I own any stock that’s as much of a desert
island stock as things like the Washington Post (in the 1970s) and Coca-Cola (KO, Financial) (in
the 1980s and 1990s) were for Buffett. I sold Babcock’s nuclear reactor (submarines and aircraft
carriers) spinoff, BWX Technologies (BWXT). But that would be a desert island stock.
The U.S. isn’t going to abandon the nuclear triad. It isn’t going to do away with carrier groups.
And the only place it can get the parts it needs for those ships is from Babcock. So, BWX
Technologies – at the right price – would be a desert island stock. Frost is probably the closest
thing to a desert island stock I own right now. I’m less of a desert island investor than Buffett.
 URL: https://www.gurufocus.com/news/458118/should-you-buy-netnets-or-desert-island-
stocks
 Time: 2016
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Expanding Your Circle of Competence
“What is the best way to grow a circle of competence in a given field? Is it reading a bunch of
annual reports? Is it trade magazines? Is there an online resource that provides detailed education
on different industries?”
The best way is picking specific stocks to study. A lot of people do too much what I’d call
“passive” learning They hope to be like a sponge reading Warren Buffett (Trades, Portfolio)’s
letters, “The Intelligent Investor,” a new book on some economic issue, a book on behavioral
finance, etc. And they do this without a pen, paper, and calculator in hand. They don’t ask
questions. They don’t make the subject their own. They are too detached and objective about it.
The right way to increase your circle of competence is not about what you choose to study. It’s
about how you choose to engage with that material.
Here’s what I’d suggest to investors who wants to grow their circles of competence. First, think
of the stock in your portfolio you know best. The business you are most comfortable with. I
don’t own Omnicom (OMC, Financial). But I have in the past. Let’s use that as an example.
Omnicom has some obvious public
peers: Interpublic (IPG, Financial), Publicis (XPAR:PUB, Financial), WPP (LSE:WPP, Financ
ial) and Dentsu (TSE:4324, Financial). That’s five companies right there. There are plenty of
other companies we could talk about. We could talk about Havas (XPAR:HAV, Financial)
and BrainJuicer (LSE:BJU, Financial) and so on. But five is enough.
Now, make yourself a schedule. Time yourself. Most people spend too much time with too
divided an attention. They don’t focus enough on the subject they want to study. You probably
don’t know how long it takes you to read an annual report. A lot of people have no idea how
quickly they read. Do you think you read at 150 words a minute, 300 words a minute, or 450
words a minute? Some people have no idea. There’s no reason not to know this. It’s easy to
figure out what a normal pace is. How many pages there are in an annual report may determine
how long it takes you to read the report. But we can use a sample of these five stocks and the
median result of how long it takes you can be a pretty good guide to how long it will normally
take you.
Set yourself a schedule. For the next five days: read the annual reports of Omnicom (Monday),
Interpublic (Tuesday), Publicis (Wednesday), WPP (Thursday) and then Dentsu (Friday). You
have no idea how long it will take you to get through each annual report. So, this time you’re
going to need to set aside a lot of time. You might need something absurd like a block of three
hours each day this first time. But you’re only going to need this once. After we have the timed
results of these five annual reports, you’ll be able to measure how long it normally takes you to
get through an annual report.
Set a timer. I have an Amazon (AMZN) Echo where I work. But you can use a phone. Or, you
can use a computer. My one caution about using a computer is that I’m going to have you print
out the annual report. I don’t want you reading the annual report on the computer. That only
encourages distraction.
The tools you are going to need are the 10-K or annual report itself, a calculator (for your hand,
not on your phone or computer) and a pen (to write notes). I have a pad of blank paper with me
(it’s just printer paper clipped to a clip board) at all times. Other people just write all over the 10-
K itself. I think this is how BuffettÂ does it. I will write questions on the 10-K or circle things.
When I want to do longer calculations I use a blank sheet of paper to write down the values with
which I am working.
The most important thing is the questions you ask. This is directing your attention. The
“experience” of reading an annual report is not objective. It’s subjective. As you work your way
through an annual report and I work my way through an annual report we are going to have
different experiences. We are going to notice different details. We are going to ask different
questions. It’s important to ask questions to which you don’t know the answer. It’s even OK to
ask questions you can’t answer and aren’t sure how to get the answer just yet.
I have Asperger’s. Compared to other people unusual details are going to pop out to me. The
average person is going to tend to see the “forest” more and the individual “trees” less. If you
give average people columns of numbers or paragraphs of text, what jumps out to them is more
like “what’s the overall theme here, what’s the purpose of this stuff” whereas what jumps out to
me are the individual errors in arithmetic, spelling, etc. Unusual details.
There are advantages and disadvantages to integrative versus disintegrative (analytic) thinking.
Different people will fall in different places on this spectrum. Some people are very detail
oriented. Others are very gist oriented. Even if you are gist oriented, you’re going to want to zero
in on the specific details that tell you more than what the company is trying to communicate.
Usually, you aren’t going to be good at picking out specific details and drawing analogies
between companies until you read the reports of several different companies that are related in
some way. Write down all the questions you have as you have them. And work your way
through all five of the ad agency groups I mentioned. Time yourself.
Now that you know how much time it takes you on average – let’s say it took you between 60
minutes and 120 minutes to work your way through each annual report and the median time was
80 minutes. In the future, I’d definitely set a timer for 120 minutes when picking up an annual
report. And I’d seriously consider setting the timer for more like the median (in this hypothetical,
80 minutes) time. This is to ensure you stay focused. Most people aren’t able to stay focused for
long periods of time. It’s unrealistic for the average person to spend more than maybe three to
four hours of their day actually focused. And they are rarely going to be able to sustain focus for
longer than 90 minutes. Work periods of more like 45 minutes to one hour are more reasonable.
If you can find a way to break your study time down into one-hour chunks, I’d definitely do that.
Know ahead of time the exact task you are going to tackle and then set a timer for the time you
are going to work. If you finish before the timer – fine, you’re done. If you don’t finish before
the timer – you’re still done, at least for today. Be realistic in setting the timer. The idea is not to
rush. I’m not trying to get you to read an annual report and take notes, ask questions, etc. as
quickly as possible. What I’m trying to get you to do is to be 100% focused on the work you’re
doing while you’re doing it. This is critical. That’s why you are working from a printout.
Otherwise, you will have tabs open in your browser, you might even check email, take a call, etc.
There is no substitute for focused attention. That means focus in terms of not doing anything else
while you are working on studying some investment. But, it also means focus in terms of what
you are studying. I don’t want you “thinking about the market” willy nilly. Or about advertising.
Or about anything as broad as that. On Monday, you are going to think only about Omnicom. On
Tuesday, you are going to think only about Publicis. And so on. You are also going to be alone
with the primary source and your own thinking. I don’t want you reading anything I wrote about
Omnicom, or something written about ad agencies over at Value Investor’s Club, or anything as
mentally undemanding as that.
You are doing focused work here. Mental heavy lifting. It’s a lot more pleasant to read other
people’s ideas and then either nod or shake your head on the inside. This doesn’t lead to any
insights. It doesn’t help you come up with your own way of seeing stocks, companies, situations,
etc. You have to be focused. And you have to be alone with your own thoughts to do this. I can’t
stress this enough. This is the sort of thing that I’m sure BuffetÂ does and that I’m sure almost
everyone I talk to via email does not do. There are plenty of people who spend as much time as
BuffettÂ thinking about investing. But, they don’t spend as much quality time. The quality of the
time you spend is the focus you bring to bear on some specific question.
OK. This isn’t supposed to be a discussion of focused work; it’s supposed to be a discussion of
circle of competence. How do you expand it? First, you verbalize things. You actually write your
questions right there in the margins. You make the material your own. The 10-K itself isn’t
important. The way you see and frame and understand the 10-K is what matters. Every 10-K you
read changes you.
Once you detect a possible opportunity – you can work in a web of familiarity. For that first
week, I gave you a rather rigid schedule. It’s organized in terms of genre. The genre here is
industry and its big, giant, public ad companies. You are going to read about Omnicom, Publicis,
WPP, Interpublic and Dentsu. This isn’t necessarily the best way to increase your circle of
competence. But it’s a fine way to start. It’s an easy category to identify. When I was writing a
newsletter, my co-writer and I did this a lot. We looked at Grainger (GWW) and MSC
Industrial (MSM) back to back. We looked at U.S. regional banks
like Frost (CFR), Prosperity (PB), Bank of Hawaii (BOH), BOK Financial (BOKF)
and Commerce (CBSH). A lot of times one bank would lead us to another.
For example, I liked Frost. Frost is the biggest bank in Texas. Quan liked Prosperity. Prosperity
is the second-biggest bank in Texas. Frost and BOK Financial are two of the biggest energy
lenders around (one is in Texas, the other is in Oklahoma). Frost and Bank of Hawaii are similar
in terms of having very high deposits per branch. That’s a figure I care a lot about.
We also looked at Wells Fargo (WFC). In some ways, Wells Fargo is like a nationwide regional
bank. It looks a little like Frost and Bank of Hawaii in some ways but not in other ways. And
there were enough differences that we never picked Wells for the newsletter. But we had an
established process for looking at these banks. And we got better at that process as we went. The
two huge advantages we had though were that we talked about these banks and we wrote about
these banks. I can’t overstate how important verbalizing your thinking process is.
If you can find someone to talk your investment ideas through with, do it. BuffettÂ had
his Charlie Munger (Trades, Portfolio). Get one. Maybe there’s a blogger you really like. Email
him. Ask him what he thinks of some idea of yours. It’s not real important what he says. Don’t
act like he’s an expert and you’re a newbie and you are seeking guidance from him. Act like he’s
a peer and you are pitching an idea. It doesn’t much matter if he emails you back, likes your idea,
etc. The key here is to hear yourself talk the idea aloud. Everybody needs a sounding board. You
need someone to bounce ideas off. Who that person is doesn’t matter. What matters is hearing
yourself talk aloud.
If you aren’t writing a blog, you should be. If the whole blog idea doesn’t appeal to you, start an
old school journal, but get out a piece of paper and write down why you are buying the stock.
Give your reasons.
Maybe you aren’t ready for any of that yet. Maybe you just want to focus on “studying” to
increase your circle of competence. That’s fine, but don’t let it be passive study. And don’t let it
be unfocused. Most people are too passive and too scatterbrained in their study of value
investing. Pick a group of stocks. I mentioned multinational ad agency holding companies. I
mentioned regional banks. I mentioned MRO distributors. Fastenal (FAST) is another one. So, if
you want to study MROs – there are three to get you started: MSC Industrial, Grainger and
Fastenal. You don’t have to decide if any of them are worth buying.
But you can certainly read the latest 10-K of each of these three companies and then you can
write a blog post or a journal report explaining which you think has the best: 1) business model,
2) growth prospects, 3) customer base, 4) capital allocation, 5) management and 6) stock price. If
you had to buy one of these three stocks, which would it be? If you had to short one of these
three stocks, which would it be?
Here are some clusters of stocks to study.
Watch stocks: Movado (MOV), Fossil (FOSL), and Swatch (XSWX:UHRN).
Bank stocks: Frost, Prosperity, BOK Financial, Bank of Hawaii, Commerce Bancshares, UMB
Financial (UMBF) and Wells Fargo.
MRO distributors: Fastenal, Grainger and MSC Industrial.
Advertising giants: Omnicom, Publicis, WPP, Interpublic and Dentsu.
Pick any of these groups. Work through one annual report a day for three to seven days of study.
Talk to another investor. You can do this in person, on the phone, via Skype or via email. Talk to
me if you want. I promise I’ll read your email – no matter how long – and I’ll send you some
kind of answer in return. Then, once you’re done studying a group of these stocks and done
using another human as a sounding board, put your own reasoning down on paper. If you’re shy,
put it in a pen and paper journal that no one else ever needs to see. If you’re more gregarious, put
it in a blog post. Turn the comments off or learn not to read them. You don’t need to hear
people’s superficial, knee-jerk reactions to what you write. It’ll dispirit you. How other people
judge your ideas isn’t important. That’s not the point of the exercise. The point of the exercise is
to get comfortable hearing yourself think.
Of course, there’s nothing magical about 10-Ks. Some investor presentations are pretty good. If
you want to make more work for yourself, I’d suggest reading both the latest annual report and
the latest investor presentation (not a result presentations – but like an Investor Day or an
investment banking conference or something similar). Don’t read the earnings transcripts. I do
read earnings transcripts. We used these heavily in the newsletter I wrote. But, what we’d do is
work from a huge stockpile of like 5-10 years of past transcripts and take a long-term view. This
is very time intensive. There’s no point reading the latest earnings call transcript or listening to
an earnings call. Just work from 10-Ks (or annual reports) and investor presentations. Study
stocks in groups.
My four rules for expanding your circle of competence are:
1. Study a series of related stocks.

2. Give each stock your absolute undivided attention – focus like you’ve never focused
before (it’s fine if you can only do this for like 45 minutes at a time).
3. Put your thoughts into writing.
4. Bounce those ideas off another person.
Once you get through these four steps, you’ll have a ton of questions; you’ll be so energized by
the discussion that you’ll be ready to go right back to Step 1 with a new group of related stocks.
You’ll be talking about some aspect of banks and the other guy will tell you about how that’s
similar to something he saw with this insurer. Once you get a discussion going, you’ll find a lot
of new threads to follow. Just stay focused and stay engaged. And try to do a little every day.
If you can devote even 30 minutes of total focus a day to this task – you can grow your circle of
competence. That’s over 180 hours of intense study in one year. It’s much better than looking at
stocks and markets randomly in unfocused dribs and drabs as headlines come in. Expanding your
circle of competence doesn’t take much time. It does take dedication. Make it a focused, daily
habit.
 URL: https://www.gurufocus.com/news/458116/expanding-your-circle-of-competence
 Time: 2016
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How to Avoid the Same Mistakes Your Heroes Made
"I still remember clearly that I asked you about Valeant (VRX, Financial) during their heydays.
You said you would never consider it. I understood your logic but just couldn't refuse the
temptation to study it more closely. I didn't put any money in it. My point is, unlike you, I got
caught up with all its positives still.
"You seem to be so good at staying the course, focusing and just thinking more independently.
Have you always behaved like this since you began investing in your early teens? Or did you
learn to be more so through experience and time?
"The more I learn about investing, the more I understand how much a negative art this is, maybe
more so than a positive one. Saying no to things is just so incredibly important in this game."
OK. A few points here. One, some really bad news. I was better at saying no when I first started
investing. I started investing my own money when I was 16, and I knew I didn’t know anything.
But then I read Ben Graham and Warren Buffett (Trades, Portfolio) and all the others. I read
about net-nets and low price-book (P/B) and merger arbitrage. And I read about different
strategies and “rules” and so on that value investors have.
A little knowledge is a dangerous thing. And it certainly was for me. I was probably at my worst
when I was reading the most. I think that’s true for a lot of investors. And for a lot of novices in a
lot of fields. People do not start out blindly following bad ideas. But then they start reading these
books and start falling into groupthink. Even value investors are a herd.
I like Sequoia Fund. And I like Glenn Greenberg (Trades, Portfolio). And they both owned
Valeant. The reason I wouldn’t consider Valeant doesn’t have to do with me being better or
worse than you at seeing these things. It has to do with where our blind spots are. I’ve made
plenty of mistakes. I bought Barnes & Noble (BKS, Financial), Weight
Watchers (WTW, Financial) and Town Sports (CLUB, Financial). Those were all mistakes.
Everybody makes mistakes.
BuffettÂ bought Bank of Ireland. He’s made a couple of investments when he probably lost
close to everything he put into the stock. Graham made mistakes. You can read about some of
them in his memoirs. Each of us has our different blind spots. The value investors who liked
Valeant most tended to be those who paid a lot of attention to management.
I co-wrote a newsletter with Quan. And we had the opportunity to talk to management at some
companies. He exchanged emails with some chief financial officers. If you read the newsletter,
you might never have known this. We tended not to include comments management made to us.
I tended not to be that interested in talking to management at all. We were always more
interested in talking to the people (customers) who made purchasing decisions or the store
managers or something like that. We just aren’t very focused on the “jockey.” We make plenty
of mistakes. They’re just different mistakes than someone who would buy Valeant stock would
make.
In fact, you could say that not thinking enough about the “jockey” was part of my mistake in
buying Barnes & Noble. I bought into Barnes & Noble during a proxy fight between Len Riggio
(the founder) and Ron Burkle. I knew someone who worked at Barnes & Noble. Talked to him
quite a bit about the stock, the company, the industry and the Riggios. I might have even known
more about the culture of the place than the average investor who was short the stock knew. I
should have known that the No. 1 priority wasn’t going to be shareholder value.
Barnes & Noble – in the founder’s hands – wasn’t just a corporate cash cow. It was a force in the
book industry. Management wanted it to stay relevant – not just commercially but culturally. It
didn’t want to effectively put the stores in runoff and re-invest the free cash flow. So it bet big on
money losers – but potential saving throws – like the Nook.
If I had been more of a “jockey” than a “horse” investor, I wouldn’t have touched Barnes &
Noble. But I was attracted by the free cash flow I thought it would throw off in the years of
relevance the stores had left. I’ll remind you here we were talking about 2010 not 2016. Barnes
& Noble had some years of decent cash flow ahead of it.
I knew free cash flow would run well ahead of reported earnings. The proxy vote was close. I
mean, it’s rare to even challengeÂ a company's founding management when it controls so much
of the stock. But Burkle lost. And then I was stuck with a horse with a price I liked, but it had the
wrong jockey. That’s the kind of mistake I’d make that someone who invested in something like
Valeant wouldn’t make.
Quan (my newsletter co-writer) and I would do post-mortems from time to time. We’d look at
our successes and our failures and see what traits were unique to our failures. What mistakes did
we keep making? We bought stocks that were too highly leveraged. This is the result of stock
prices being historically high at the time we were writing the newsletter. We’re such value
investors in terms of things like price-earnings (P/E) and price to free cash flow that we were
more willing to buy a heavily indebted company (like Weight Watchers) rather than some
unleveraged, high quality stock with a P/E of 30.
This has happened to me before. I bought some stocks with too much financial risk in the last
years (2006-2008) of the pre-financial crisis boom. Not predicting the financial crisis wasn’t the
issue for me. Choosing leveraged stocks over expensive stocks was my mistake. You can pay too
much for a stock. It’s not the problem I have. I’ve lost money in specific stocks before. But it’s
never because I paid too high a price for an otherwise good stock. Plenty of other investors make
this mistake.
You must look back at your own history and see which mistakes you make. Think of risk as a
subjective measure rather than an objective measure. Some people might think that a high beta
on a stock or a high short interest are the signs for which to watch. When Quan and I looked
back at our past decisions, that wasn’t true. Short interest is a good example. Some of our big
mistakes had high short interest. But so did some big successes. In fact, when we broke down all
our past decisions, there wasn’t any consistent pattern in terms of short interest predicting bad
outcomes. Some stocks that seemed by all measures to be safe – and which hindsight vindicated
– had high short interest.
Short interest wasn’t a good predictor of mistakes for us. We included it on a list of warning
signs. But short interest was never as useful as things like Z-Score, Net Debt/EBITDA and F-
Score.
F-Score is another example of a good measure objectively that didn’t have much meaning
subjectively. When talking to other investors, I always encourage people to check the F-Score
and Z-Score on all stocks in which they are interested. It’s a good idea for most investors to
eliminate every stock with either a Z-Score below 3 or an F-Score below 5. I also encourage
most investors to avoid any stock that posted an operating loss (negative EBIT) in any of the last
10 years.
For Quan and me, this didn’t matter much. We found when we looked at the list of stocks that
we would naturally pick that we almost never suggested investing in stocks with an F-Score
below 5 or with an operating loss in the last decade. We were naturally or instinctively screening
those stocks out. But we weren’t instinctivelyÂ screening out high debt stocks. Using something
like Z-Score and Net Debt/EBITDA was useful.
Some investors are independently minded. Others less so. I’d say that I’m pretty independently
minded when it comes to rejecting the ideas of value investors I like a lot. Quan has said that
GreenbergÂ might be his favorite investor. Yet, when the topic of Valeant came up, Quan had no
doubt. He wasn’t interested in that stock. It was one of Greenberg’s biggest holdings. But Quan
didn’t even want to look at it. Likewise, Quan and I decided – this was probably sometime after
doing an issue on Progressive (PGR, Financial) – to focus on U.S. banks. We thought a bunch of
them were cheap. And we ended up doing issues
on Prosperity (PB, Financial), Frost (CFR, Financial), Bank of
Hawaii (BOH, Financial), Commerce (CBSH, Financial) and BOK
Financial (BOKF, Financial). You’ll notice we didn’t do an issue on Wells
Fargo (WFC, Financial). Why not?
It’s not because we didn’t think Wells Fargo was high quality. In fact, we said in the Frost issue
that while Frost was better than Wells in some measures, Wells was the higher quality bank
overall. It had better fee income. It had a better loan portfolio. It could cross-sell. We thought
Wells was at least as high quality as Frost. When we did issues on Bank of Hawaii and Frost, we
used Wells as the best benchmark for a bank with an awesome low-cost deposit base.
We also did some calculations on which banks were cheapest. We thought – although this part is
a little speculative – that Wells Fargo was at least as cheap as Frost (if you put growth aside). We
thought Wells Fargo was one of the highest quality banks in the U.S. And we thought it was one
of the cheapest banks in the country. It is also Buffett’s biggest investment. It’s his favorite bank.
When asked about banks, he’s said that although he owns both Wells and Bank of
America (BAC), Wells is his favorite. Charlie Munger (Trades, Portfolio) runs investments
at Daily Journal (DJCO) and that company concentrated in a big way in Wells Fargo stock.
Other investors we like – like Tom Russo (Trades, Portfolio) – own plenty of Wells.
Why didn’t we write about Wells? We did issues on five different banks. Isn’t Wells safe? Isn’t
it cheap? Don’t we trust Buffett and Munger? The answer to all those questions is yes. But we
simply couldn’t understand Wells. Not really. It’s a lot more complicated than the banks we
picked. The banks we wrote about were simpler, regional banks. Frost doesn’t even really make
loans to households. It collects deposits from households and businesses and then it lends to
Texas businesses and buys state of Texas (and related) municipal obligations. It was easy to look
at the loan portfolio and the bond portfolio and apply some tests like what would happen if rates
rose by a certain amount or loan losses in energy were 50% for one year. We could apply
extreme tests like that if we wanted.
Wells was trickier. Quan and I talked a lot about the bank. And, frankly, we didn’t come away
thinking the bank was simple enough. We found the interest rate risk – the risk of higher rates in
the future – an especially difficult one to work out in our heads. We never said that Frost was a
better investment than Wells. I’d never say that. But I would say that I feel more comfortable
owning Frost than I would owning Wells. And the only reason for that is independence. I trust
Buffett and Munger and Russo know what they are talking about when they talk about Wells.
But I can’t talk about Wells as easily as I can talk about Frost. And that means I don’t understand
Wells enough independently of these other investors. I can repeat what they say. But I can’t say
much of my own. That’s not a good sign.
Some people disagree with me on this one. They think coattail riding makes a lot of sense.
They’d say it’s much safer to buy Wells than to buy Frost. Maybe that’s true. But Quan and I
thought Wells had too much regulatory risk (too big to fail, deposit market share limit, etc.),
made too many different kinds of loans and had too complex a risk position in terms of exposure
to movements in things like mortgage rates. We never definitively disproved the idea of
investing in Wells. We never uncovered stuff we were worried about. We just couldn’t get
comfortable with it in the same way we were comfortable with something like Frost. That
doesn’t make Frost objectively better than Wells. It just means we felt subjectively more
comfortable with Frost than with Wells.
Being a good investor doesn’t mean ignoring your feelings or not having feelings. Ultimately,
you make investment decisions based on feelings. We felt greater comfort with Frost than with
Wells. So we wrote about Frost instead of Wells.
We can be stubborn that way. And sometimes we’re too stubborn. When we started the
newsletter, Quan and I just knew, knew, knew that we’d never ever write about a single bank
stock. We ended up writing about five. When we started the newsletter, I’d tell you the industry I
knew the least about was banking. But, over time, we got comfortable moving from an analysis
of one stock to the next to pick banks.
Some of it was that we didn’t see a lot of opportunities in businesses that weren’t suffering from
low interest rates. We were pushed into considering banks and insurers and housing stocks and
furniture stocks and so on because they were underearning in the wake of the financial crisis.
That’s part of it. But oil fell way below my best guess of what the long-term real price per barrel
should be – and yet we never picked oil stocks for the newsletter. There was something about
banks we felt we could understand in a way we couldn’t understand oil.
Let’s recap. One, you aren’t necessarily going to make less risky decisions as you learn more
about investing. I found that total ignorance can make you pretty safe. A little knowledge is a
very dangerous thing. The more I read about value investing, the more tempted I was to do
things outside my circle of competence. You must be constantly vigilant when it comes to risky
behavior sneaking into your stock selection process.
Two, I make riskier decisions when stock prices are high and opportunities are rare. You
probably will, too. It’s easy to make safe choices when there are a lot of high return
opportunities. When the average stock is trading at 20 times earnings rather than 10 times
earnings – you’re going to take bigger risks than you should. Everybody does.
Three, I have a bad tendency to prefer highly leveraged but cheap (on a leveraged basis) stocks
over unleveraged but expensive (high P/E) stocks. That’s a mistake. It’s better to pay 30 times
earnings for a company like Luxottica (LUX, Financial) than 10 times earnings for a company
like Weight Watchers. The value investor in me – the stuff I learned from the books I read in my
teens – rebels against the idea of paying a high P/E for anything.
Four, everybody has his own blind spots. Yours will be different than mine. Look through your
own past behavior and come up with a list of the ways you always manage to screw things up.
Five, you must be independently minded. You must pay attention to your gut. If you’ve ever
seen the movie "Double Indemnity," Edward G. Robinson is an insurance claims investigator
who has this “little man” (his gut) who starts bothering him whenever a phony claim comes in.
You need to pay attention to that “little man.” If you’re looking at Valeant or Wells or anything
else and that “little man” starts acting up, go ahead and put the stock aside. You can afford to
miss out on the opportunities of which other value investors take advantage. In the long run,
cultivating your own healthy subjective sense of risk will be more valuable than buying when
Buffett, Munger or Greenberg do.
 URL: https://www.gurufocus.com/news/457961/how-to-avoid-the-same-mistakes-your-
heroes-made
 Time: 2016
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When Is a Company's Growth Repeatable?
Someone who reads my blog asked me this question:
“How do you get comfort that when a company is spending for growth it will yield results? This
may be spending on an existing geographic or product market or on a new geographic or product
market.”
That’s a great question. It’s answered better in the Chris Zook books (one of them is titled
“Repeatability” I think) than I can answer it in this article. You can go off and read those books
if you want the few hundred-thousand-word answer. I’ll stick to the couple-thousand-word
answer here.
Repeatability. Has the company done this before? Let’s take Howden

Joinery (LSE:HWDN, Financial) as an example. Howden is a U.K. company. It sells only to
local builders. It provides them with the stuff they need – granite countertops, private label
appliances, etc. – to do a kitchen. It sells the stuff on credit. But it doesn’t sell to the public.
There are – as I write this – probably something like 600 of these centers in the U.K. They aren’t
all the same size. They aren’t identical or anything. But they’re pretty independent. There’s a
manager to handle each one. Customers go to their local center. They don’t have national
accounts the way a company like Grainger (GWW, Financial) does.
Each Howden location is just the repetition of a theme. It’s repeatable. It’s predictable. You just
look for signs of oversaturation. That can happen. When Howden first talked about how many of
these centers it could have, I’m not sure it said 800 or more. It says that now though. Maybe it is
right. Maybe there isn’t cannibalization by going from 600 to 800 of these in the U.K. But that’s
not the only kind of growth in which Howden is investing. The other kind is on the continent.
Howden now has a few centers in places like France and Belgium.
I’m not saying it can’t have success in these countries. Another U.K. company I wrote a report
about – HomeServe (LSE:HSV, Financial) – has had success in places like France and the U.S.
It was very dependent on the U.K. market at first. But a lot of its business proved repeatable. It
could market its services through water companies in the U.S. and France. And now those
businesses are worth a lot. They are potentially at least as good as – maybe better than – long-
term markets than the U.K.
That was part of the reason we wrote the report. HomeServe’s renewal rates in the U.K. had
dropped, and new sign-ups were running at basically nil. The company’s marketing had been too
aggressive. It ran afoul of regulators. Paid a fine. And – for a time – basically shut down its
outbound marketing operation. Naturally, this meant it wasn’t signing up new customers. The
negative headlines probably increased cancellation rates in the U.K. for a year or two. And the
dis-economies of scale that kicked in were obviously bad. But it already had these markets in
France and the U.S.
We were especially interested in the U.S. business. The U.S. is huge compared to the U.K. –
about six times bigger by population and richer, too – and has a much more fragmented utility
industry. There was the hope if HomeServe could have success in one U.S. state by signing up
the local water utility to co-brand its insurance products in Florida or New Hampshire or
wherever, it could do the same thing in Colorado and Nevada and each of the 50 states. There
was no reason why it couldn’t. One U.S. state is pretty much like every other U.S. state.
So is Canada. In retail, restaurants, etc., what works in Virginia will work in California and what
works in California will work in British Columbia and Ontario, too. That’s the kind of growth in
which you want a company to invest. I think of this as sort of “Peter Lynch” growth. It’s the kind
of company he’d buy. You find a great restaurant concept in your local area, and you know it can
roll out across all 50 states. That’s the best kind of growth you can ever find. What’s the worst?
Spreading out into other countries is tougher. I didn’t write that report on HomeServe until the
business was already better than break even in both the U.S. and France. The company tried
entering markets like Belgium – and failed. We didn’t get our hopes up about any market where
the company hadn’t yet achieved critical mass.
The same was true when we wrote our report on Grainger. Grainger is a U.S. company. It has a
big stake in a Japanese company. It’s basically a subsidiary thatÂ is publicly traded in
JapanÂ instead of being consolidated. You can buy the stock over there. Don’t. It always trades
at a very, very high price. It’s a super-fast growth stock. But Grainger took the same model that a
Japanese MRO distributor uses, and it applied that approach to its low-end U.S. market. This is
the small customer business. Basically, it’s the part that competes
with Amazon (AMZN, Financial). These are not the national accounts. And it’s just the
repetition of the same model that worked in Japan applied to the U.S. I’d bet on that. I’d bet on
repeating the same approach in one country in another country when those two countries are as
similar as the U.S. and Japan.
You know where Grainger didn’t have success? China. China has a totally different MRO
business. There’s a good reason for this. Labor is cheap in China. It’s expensive in the U.S. It’s
expensive in Japan. But it’s really cheap in China. When you run out of some random thing –
light bulb, mop, generator, batteries, you name it – you send someone out as a go-fer to a big
open-air market and search for that item.
You don’t do that at a U.S. company because then you’d screw up the logistics of your company.
You don’t want any employees hanging around doing nothing specific with their time and then
being reassigned to totally different tasks like that. But you can do it in China. Grainger has only
had success in high GDP per hour worked type countries. That’s the limit of its market
opportunity. If you compare the U.S. and China – you can see that, yes, the U.S. is much, much
richer on a per capita basis.
That understates the situation for a Grainger customer because the number of people working
relative to the total population is lower in the U.S. And the number of hours those people are
working is lower, too. Each hour of work by an employee in the U.S. is really expensive. You
need to treat that as a precious resource in the U.S. In China, you don’t. They don’t need to
ration a worker’s time. They have more workers supplying more of their time than they know
what to do with. A Chinese company can afford to allocate some of its workers’ time to very,
very low productivity tasks like hunting down miscellaneous items.
You want to be skeptical of growth into markets that are different. Don’t assume a company in a
developed country can enter a developing country – or vice versa. People make very different
uses of their time in these places. On the other hand, there are societal trends that do translate
well from one country to the next.
Let’s take a fast food or another restaurant concept in the U.S. Can it travel to the rest of the
world? Maybe. All countries are going to follow the same trend of increasing the percentage of
household income allocated to food away from home. In other words, every country – except the
top countries in this category, like the U.S. – is going to have restaurant growth above the rate of
nominal GDP growth. How do we know if a concept will catch on in this other country? KFC is
huge in China, but it’s not huge everywhere. Starbucks (SBUX, Financial) is in a lot of
countries, but it’s not in every country.
The easy answer is to wait for critical mass in a certain country. Is the business break even? Does
it look like it has financial metrics like what we saw in the home country at the start? Think of
HomeServe. Does the business in France and the U.S. look a lot like the business in the U.K.
looked at the start of its development? Answer: Yes. I think it’s OK when a company like that
says it is going to invest more in those geographies.
What about Howden? Howden’s trickier. If you look at how those centers in France have done
compared to the U.K. – so far, the answer is not so good. Now, I don’t know enough about the
relative rate of growth in kitchen remodeling, etc., in the U.K. versus France. I know the U.K.
economy has often outperformed the French economy during the period when Howden was in
both countries. But I also know looking at the comparable sales figures that Howden’s U.K.
centers have grown same-store sales faster than the French depots (in constant currency terms)
despite the average French depot being younger than the average U.K. depot. I’d say Howden’s
plans to grow outside the U.K. are “unproven,” not necessarily disproven. But I wouldn’t assign
any value to the business outside the U.K. Not yet.
On the other hand, I would – and I’ll admit this is speculative, but it’s honestly what I’d do –
assign value to the 200 centers in the U.K. Howden thinks it can add. When I look at Howden
Joinery, I don’t look at it as it exists today. I look at it as it will exist when it has 800 fully
mature centers in the U.K. The company will invest some of that money in other countries, but I
won’t count on that growth. I’ll assume – for my purposes – that Howden will just grow to 800
mature stores in the U.K. It’ll never grow beyond that.
Here we come up against a capital allocation question. It’s one thing to be conservative by not
assuming any international growth. That’s fine. It’s good. It’s a proper value investing technique.
But think about it. Is it conservative enough? We know that Howden will try to grow in other
countries. If it’s going to fail, that’s not just going to be value neutral for the stock. It’s going to
destroy value, right?
This is why I always included a section called “Capital Allocation” in the reports I wrote. You
need to look at how the company thinks about capital allocation. How is management
compensated? Does it talk in terms of sales growth, EPS growth, return on capital? Does it own
shares in the company? Does it have options? On what is its performance reward (bonus) based?
If given the choice to buy stock in AT&T (T, Financial), Verizon (VZ, Financial) and ATN

International (ATNI, Financial) – I’d pick ATN. Why? Because of capital allocation. I don’t
trust the people allocating capital at AT&T and Verizon to do a good job. I do trust the Prior
family at ATN to do a good job. Why? Because I’ve seen what it did in the past. I saw how it
shut some things down. I saw the mergers it did, and I’ve read the annual reports.
It seems to me to be focused on allocating capital toward those areas with low enough
competition. It Â doesn’t run toward the sexy growth opportunities a lot of companies do – it
runs away from them. Now, yes, it has entered some risky businesses. It started out as a
monopoly in Guyana. To this day, that business has huge political risk. And when it entered the
solar business it went into India. Doing solar in the U.S. would have had less risk. I’m not sure
the returns would have been good enough.
Also, it has had a big cash balance – like Berkshire (BRK.A, Financial)(BRK.B) – at times, and

it hasn’t blown that money too quickly. If you look at companies like AT&T and Verizon –
they’re often eager to do big, transformative deals even when they don’t have enough cash to
buy the target outright. I’d always pay the higher multiple for ATN than for AT&T or Verizon.
That’s capital allocation.
Capital allocation is especially important in capital intensive industries like railroads, cruise lines
and telecom because those growth investments – both the good ones and the bad ones – will
generate positive cash flow. It’s easy to know when you should shut a restaurant down. When
it’s bleeding cash, you shut it down. How about a cruise ship? It’s not going to burn cash. The
capital allocation mistake is never going to manifest itself that way. Instead, here’s what’s going
to happen. You are going to spend $1 billion on a new cruise ship. That ship will generate $40
million a year of free cash flow. That’s a 4% return on your investment. You obviously made a
mistake. But you can’t undo it. The ship is making you money. You are going to keep it in
service.
You must be careful when the management in a capital-intensive industry talks to you about
growth. It can make mistakes like this. Industries that aren’t capital intensive – ad agencies,
software, media, restaurants, etc. – are different. Management will realize its mistake early on.
You can often be conservative just by using the approach I suggest you apply to Howden. The
U.K. business model is proven. Assume Howden can reach saturation in the U.K. Assume it can
have 800 mature centers in the U.K. But don’t assume it will ever have a moneymaking business
outside the U.K. For capital intensive industries, you just have to avoid absolutely every stock
where you think management is too aggressive in its growth seeking behavior. If ATN were
controlled by someone else, I wouldn’t be interested in it. The only reason the stock is interesting
to me is because of who controls the company.
 URL: https://www.gurufocus.com/news/457874/when-is-a-companys-growth-repeatable
 Time: 2016
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Don't Buy the Business That Is; Buy the Business That Will Be
I’m going to assume here that you are a value “investor,” not a value “trader.” You are investing
over the kind of timespan that Warren Buffett (Trades, Portfolio) invests over (buy and hold
forever) or maybe just the kind of timespan Ben Graham invested over (buy and hold for a few
years).
If you look at the Graham-Newman letters to partners – they are really mostly just a list of
positions – you’ll see the turnover rate is quite low. It may be 20% one year. It might be 40%.
But it’s never 50%, 75%, 110% – like many mutual funds and many brokerage accounts are
today.
I’m going to use five years as my standard for an investment. You can use three years. It doesn’t
matter much to what I’m about to talk about. Either way, when you’re buying a stock, what the
business looks like today doesn’t matter.
Let me explain that. The stock market is always forward looking. Let’s say Starbucks (SBUX)
just reported earnings and talked about its rewards program and so on. The market doesn’t really
care. Mr. Market doesn’t get himself worked up about what Starbucks just reported last week.
Mr. Market cares about what Starbucks is going to earn next quarter and next year. But that’s the
way a trader thinks. You’re an investor. Why does that matter?
Let’s say you are buying a stock today and planning to sell it in three years. You’re buying in
2016, and you’re going to sell in 2019. Now, I’d say this might just be a long trade. Or maybe
it’s a short investment. Either way, what matters here? Is it what the stock is going to report in
earnings in 2019?
Probably not. Especially not if we are talking about a big, liquid stock. There will be analysts
covering this stock. The company may be giving guidance. In November 2019 – when you’re
thinking about selling this stock you bought in 2016 – the market is going to be focused on 2020
and maybe even 2021. Mr. Market won’t care at all about 2019 anymore. Even if you are buying
a stock today and only planning to hold it for three years and then sell – you should be thinking
about what that stock is going to report in earnings four or five years from now. The present isn’t
what sets the price at which you sell. The expected near future is what sets the price.
Some value investors – like Graham and Richard Pzena (Trades, Portfolio) – think in terms of

“normal” earnings. If we were looking at a stock like Carnival (CCL, Financial) when oil is
priced at $40 a barrel and yet we believe $60 a barrel oil is normal, we’d have to adjust that
stock’s earning down to reflect the 50% higher fuel expense in a normal year. If we’re thinking
about a lender to subprime car buyers, like America’s Car-Mart (CRMT, Financial), we might
think that underwriting results will be unusually bad right now because competition in this space
is unusually high.
Credit is super loose in that space. A few years from now, more subprime auto loans might be
going bad. More lenders might be pulling out of this space. But America’s Car-Mart will still be
there. And when credit is tighter, the company might be able to demand tougher terms. It may
have loans with shorter lengths in months. That would lead to lower losses. We might normalize
for something like oil prices or losses in industries where underwriting is cyclical (insurance,
lending, etc.).
I’ve talked about normalizing bank earnings before. The two biggest banks in Texas
are Frost (CFR, Financial) and Prosperity (PB, Financial). Frost is interest rate sensitive. Low
rates hurt Frost. High rates help. Prosperity is interest rate neutral. That bank reports similar
earnings regardless of where the Fed Funds Rate is. It might appear that Frost and Prosperity are
similarly priced. In fact, they may be in terms of price-earnings (P/E) and dividend yield and yet
really be differently priced in normal times. That’s because Frost would earn a lot more if the
Fed Funds Rate was 3% right now.
If you think a Fed Funds Rate of between 3% and 4% is normal – as it has been over the last
century or so – then you’d think Frost is much cheaper than Prosperity. This kind of
normalization is easy for investors to understand. It’s especially easy for value investors, I think.
It fits the Graham mold. But now I’m going to talk about something that might seem a little more
speculative. We aren’t going to talk about adjusting results to reflect the historical average level
of oil prices, loan losses or interest rates. Instead we are going to talk about what would happen
if a company was run on autopilot.
I’m going to use a pair of businesses for this comparison. Both are publicly traded, and both have
excellent business models. If you haven’t researched either of these companies yet, I encourage
you to read their annual reports right now. These are two stocks you want on your watch list.
They are interesting businesses. They are the kinds of businesses a long-term investor might
want to buy and hold. That doesn’t mean they are priced right for a value investor now. I’m not
going to discuss their prices. What I’m going to discuss is their inevitable futures.
The stocks are Cheesecake Factory (CAKE, Financial) and Howden Joinery (LSE:HWDN), a

U.K. company. Cheesecake and Howden are both kind of category killers. Cheesecake is a U.S.
restaurant chain. It’s not very big by number of sites, but each site is huge. Cheesecake has some
of the highest square footage per store and some of the highest sales per square foot of any full-
service restaurant you’ll ever see. As a result, Cheesecake has high sales per site. That’s fine. But
what interests us in this discussion of a stock’s “cruise control” future is how quickly
Cheesecake generates those sales.
The opening of a new Cheesecake location is an event. The company doesn’t need to spend a lot
on advertising because its grand opening is the advertising. It has buzz. Landlords want
Cheesecake to move to their malls. They ask to be the next mall to get a Cheesecake location. It
brings traffic. Cheesecake can fill its restaurant from the first day. The location starts making
money right away.
What’s the difference between what a Cheesecake will earn in the first month of its first year and
the first month of its third year? Answer: not much. Cheesecake doesn’t tend to get more traffic
in later months than it does in its opening month. In fact, when a Cheesecake Factory location
first opens, it may actually be more full at first than it will be later. It opens the way a
blockbuster movie opens. It has a lot of opening weekend buzz. And then it tapers off a bit from
there and normalizes at a very high but slightly lower level. OK. What does that mean for
growth?
A Cheesecake Factory location doesn’t generally have any traffic growth. It doesn’t seat more
people this year than it did last year. The same-store sales growth of the location is going to be
equal to menu price inflation. Let’s say Cheesecake raises prices by 2% this year. Let’s say it
raises prices by 2% next year. And then it raises prices by 2% the year after that. Well then what
will this location be making in 2019 relative to what it made in 2016 when it first opened? It’ll
be making about 106% (a little more) of what it made when it first opened.
This isn’t something we even have to factor into our analysis much at all. The age of
Cheesecake’s locations doesn’t matter. From the moment they open, they really only grow sales
at the rate of menu price inflation. When we are researching Cheesecake’s growth prospects, we
don’t really need to inquire much about whether the average location has been open two years,
four years or eight years. In all cases, if menu price inflation is 2%, then same-store sales growth
is going to be 2%.
Now, let’s talk about Howden Joinery. A new Howden Joinery location doesn’t open the way a
blockbuster opens at your local multiplex. It doesn’t open like Cheesecake. Howden doesn’t
serve the public at all. It only serves builders. It sells what builders in the U.K. need to install
kitchens in homes. It has granite countertops and its own private label appliances and so on. It
provides credit to these trade account clients. Each location is run rather independently. It has its
own manager. It takes time to build up repeat business with these kitchen installers in the local
area. There is no buzz.
A Howden Joinery location is like the rollout of a little indie film. It opens with a couple of
screenings (customers), then a week later it’s in a few more theaters (has a few more customers),
and it keeps growing the customer list. But it’s slow. There’s nothing high profile about the
grand opening of a Howden Joinery location. This is important to the per site economics. A
Cheesecake Factory is already firing at 100% of its “normal” sales capacity in the first month.
Want to guess how long it takes a Howden Joinery location to hit 100% of its potential? Seven
years.
A new Howden Joinery location usually loses money in its first year after opening. Then it
reaches the break-even point sometime near the end of year 2. The location then starts
contributing to the company’s earnings in years 3, 4, 5, 6 and 7. Now, let’s think about what this
means for the corporate result. Let’s be somewhat conservative. We’ll assume a new Howden
Joinery location loses money in year 1 and breaks even over all of year 2. That’s not the way the
company explains it. It says a location starts breaking even by the end of year 2. And the
company also says that the location keeps growing for seven years.
We’ll assume it hits max (real) sales potential on day one of year 7. If those are the facts – here’s
how we can think about drag and acceleration from new locations. All year 1 Howden locations
cause drag on the corporate performances. In any given year, Howden’s earnings are worse off to
the extent it opens centers. Let’s say Howden opens 50 centers this year. If it opened 25 centers
instead, it would report higher earnings for the entire year. The less Howden grows its store
count, the better its present-day earnings picture will be.
Year 2 Howden centers are neutral as far as earnings. I think they also probably cause net drag.
But we’re being conservative here. Now, what happens in years 3, 4, 5 and 6? We know Howden
centers in Year 1 lose money. And they don’t make money in Year 2. They do make money in
years 3, 4, 5 and 6. They also make money in year 7 and beyond. However, the centers are
“mature” by year 7. They are profitable but immature in years 3, 4, 5 and 6.
What does this mean? It means Howden’s “cruise control” rate of earnings growth will be
highest when it has the greatest proportion of centers in the 3-, 4-, 5- and 6-year-old age group.
Actually, that’s not quite what it means. Because the rate at which very new centers switch from
losing money to making money might provide a big corporate boost. And then there’s the issue
of how many centers are being opened. Let’s find a simpler way to put it.
How can Howden report the highest possible rate of earnings growth right now?
It can stop opening new centers. If Howden has, say, 600 centers, and it opened 60 of those in
the last two years – the worst thing for the company to do as far as this year’s EPS is concerned
would be to open another 60 stores. The best thing would be to stop opening stores all together.
The young centers have a high natural rate of same-store sales growth. The old stores don’t.
Those 60 young centers might have same-store sales growth in the 5% to 10% range while old
centers have growth in maybe the 0% to 5% range. New stores lose money. Stopping all new
depot openings and letting your money-losing new depots turn into moneymakers will drive the
best EPS growth.
Of course, Howden should never actually do this. GEICO loses money in the first year or two
after signing up business. That’s how the business model of companies like GEICO
and Progressive (PGR, Financial) work. They should never stop trying to sign up new
customers. But we – as investors – need to remember that GEICO and Progressive and Howden
– especially when they are growing quickly – are underreporting their future earnings in a way
Cheesecake isn’t.
If Cheesecake stopped opening new locations, it would only grow EPS a little faster than menu
price inflation. If Howden stopped opening new locations, it would grow EPS a little faster than
same-store sales. At first – when a lot of its centers were still just newly opened – this EPS
growth could be something like 10% a year for a couple of years without the company seeming
to do anything.
In this sense, Cheesecake’s current P/E ratio is an accurate representation of its price. Howden’s
current P/E ratio is not an accurate representation of its price. It’s not speculative to assume that
all a company’s existing locations will “mature” along the lines its past locations did. If
Cheesecake stopped opening new sites, its growth would limp along at the rate of inflation over
the next five years. If Howden stopped opening new centers for the next five years, its EPS
would grow at rates you’d normally expect from a growth stock.
That’s why you shouldn’t – as a long-term investor – look at what Cheesecake is earning today
and what Howden is earning today. If you are buying these stocks now and holding them for
three or four or five years – what matters isn’t what these companies will look like in 2016. It’s
what they will look like in 2021. In other words, you need to adjust Howden’s centers for
“maturity” the same way you need to adjust Progressive’s business to make sure you’re looking
only at “seasoned” business.
New business is a drag at first for these companies. It only becomes profitable in later years. If
you don’t make this adjustment, you’ll think that Howden is normally priced when it’s actually
cheap. It doesn’t matter what Howden earns today. It matters what Howden would be earning in
2021 if it were in a “steady state” at that point. Don’t worry what a stock is earning when you
buy it. Only worry about what a stock will earn when you sell it.
 URL: https://www.gurufocus.com/news/457598/dont-buy-the-business-that-is-buy-the-
business-that-will-be
 Time: 2016
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Read Financial Results for 30 Years Instead of 10
Warren Buffett (Trades, Portfolio) has talked about how he has sometimes read a stock’s annual
report year after year – like IBM (IBM, Financial) for sure and Coca-Cola (KO, Financial) I’d
assume – and then suddenly something clicks, and he sees the stock differently.
It just becomes clear to him in a way it wasn’t before. The investment case becomes clear. What
we are talking about here is “finding the right frame.” This is often the biggest part of any kind
of problem solving. It’s easy to start brute forcing something – plugging in numbers and doing
work – but that doesn’t lead anywhere. Figuring out a stock’s EPS estimate a few years hence to
the last cent is not going to help much. Finding a new way to look at something familiar is the
way to get a new insight.
How do you do this? The first thing I suggest to absolutely every investor is to collect all the past
years of data you can. A lot of investors – and all traders, of course – find this insane. But when
Quan and I were writing our newsletter, we’d sometimes include data going back to 1989, 1990
or 1991. Why’d we stop there? Usually because that’s all that could fit on one page of data using
the smallest font you could still read. We crammed all those numbers in there for subscribers to
read. Some appreciated it. Others didn’t. What does data from 25 years ago matter?
It can tell you a lot. Sometimes you get perspective. Two of my favorite banks – in terms of
competitive position at least – are Bank of Hawaii (BOH, Financial)
and Frost (CFR, Financial). Bank of Hawaii just does business in Hawaii. Frost just does
business in Texas. Quan gathered about a quarter century of data for both stocks. I don’t
remember exactly how many years we chose to show subscribers. But I know that when I was
studying up on the stocks, I was looking at financial results – loan loss rates and that sort of thing
– going back to at least the late 1980s. For these two banks, that was valuable stuff.
Everybody thinks the 2008 financial crisis was the worst thing since the Great Depression. For
some states it was. For most banks it was. But it wasn’t the worst thing to hit Texas. It wasn’t the
worst thing to hit Hawaii. The oil bubble that started in the 1970s and burst in the 1980s is the
worst thing that ever hit Texas. It devastated Texas banks. As we mentioned in the issue we did
on Frost – Frost is the only bank in Texas that was of any real size back in the oil bust and still
exists as an independent Texas bank today. Everything else went under or merged with out-of-
state banks. Texas was very dependent on the oil industry back in the 1980s. And a lot of banks
did some energy lending. But that’s not what the problem was. The problem was land. Land
values collapsed in places like Midland where it had all been driven by the boom.
Hawaii was the same way. That bubble wasn’t driven by oil. It was driven by Japan. In the late
1980s there was a huge asset bubble in Japan. The Nikkei had insane price multiples on it. Land
was extraordinarily overvalued. I’d compare it to something in the U.S. like 1929, 1999 or 2008
– but the comparison wouldn’t even be close. The asset bubble in Japan was of a different scale
entirely. It’s no surprise then that Japan hasn’t recovered from that binge anywhere near as well
as the U.S. recovered from The Great Depression. Hawaii is most tied to the U.S., of course. But
it has the second-closest economic ties to Japan. Tourism and such. Over the last 25 years,
Hawaii – like Texas – has become a more diversified economy.
Today, Hawaii gets more tourists and business from outside Japan and outside the U.S.
mainland. But there wasn’t much of that in the late 1980s. The people who went to Japan – as
tourists and as homebuyers – were American and Japanese. And Japan was going through this
crazy bubble. The Japanese bubble spread to Hawaiian land prices, too. If you take a piece of
land in Hawaii circa 1991 and then look at that same piece of land in 2001 – the real value of the
property would be lower in the second year. So you had a negative real return in land over 10
years. That’s a bust.
Frost and Bank of Hawaii had these periods in their past where they had been tested more than
they were in 2009 and 2010. That’s important. It’s important to know that. Because if you don’t
have data going back to the 1980s, you think this is the worst thing to ever happen to these
banks. It’s not even the second-worst period – 2008, 2009 and 2010 – in Bank of Hawaii’s
history. That bank went through a period of di-worsification. It got involved in mainland loans.
Any time Bank of Hawaii has strayed from a focus on Hawaii it has lost money in those areas.
This isn’t unique to that bank. A competitor – Central Pacific Financial (CPF, Financial) – got
involved in a lot of California construction lending just before the 2008 financial crisis. That
basically destroyed CPF. Bank of Hawaii was completely refocused on Hawaii by the financial
crisis because it went through a whole turnaround process in the early 2000s. That may have
saved the bank. If it had followed in Central Pacific’s footsteps, it could have had similar losses
during the crisis. My point here is that the two banks I like most – Bank of Hawaii and Frost –
each had their toughest periods long before the 2008 financial crisis. If I’d been looking at just
five-year or 10-year data, I wouldn’t have the right frame for the investment case. Almost no
websites I’ve come across show data going back more than 10 years. They should. Focusing on
just the last 10 years may force you to frame the investment in the wrong way.
I can think of two other investments where having a much longer than 10-year history was
critical in finding the right frame. One is Bancinsurance. This stock is no longer publicly traded.
But it was a niche insurer – so niche I’m not going to bother describing the exact kind of
insurance it wrote. The company had a long history of writing this same kind of insurance. It was
trading for less than book value. That interested me because in probably nine of the last 10 years
it had a combined ratio in the low 90s on average.
An insurer’s combined ratio is like an inverse profit margin. So, an insurer with a combined ratio
of 92 has an underwriting margin of 8% in the sense that it collects $1 of premiums for every 92
cents it pays out in losses and all other expenses. In other words, this insurer was making a profit
– before counting any income on its investments. Now, plenty of insurers trade for less than book
value, and plenty should.
Let’s say a life insurer has a combined ratio of 105. That means it is paying 5% to get its float. It
can invest that float. But, obviously, this can’t be as good a business as Frost or Bank of Hawaii.
Those banks can get their deposits – their “float” – at closer to 3% than 5%. So, an insurer
should trade for below book value when it is expensively financed. But an insurer that usually
has a combined ratio below 100 shouldn’t trade below book value because it has a negative cost
of float. In other words, policyholders are paying the insurer to invest their money and keep the
proceeds. That’s a good deal. Why did I need to see more than 10 years of data in this case?
Bancinsurance had lost a very big percentage of its net worth. I’m going to say – I’m working
from memory here – that it might have destroyed as much as 25% of its tangible equity in a
single year. This isn’t necessarily the biggest deal if it’s a one-time loss (an isolated incident) and
the insurer is considered well enough capitalized for A.M. Best and policyholders to be fine with
it. That’s because an insurer doesn’t earn profits on equity. If it has a big underwriting profit –
like Bancinsurance did – it earns its profit on premiums. So, if the insurer is going to collect $40
million in premiums and have an 8% underwriting margin, then it’s going to make $3.2 million
pretax even before it makes any money on its investments.
It can build up equity quickly this way. It just has to stop paying a dividend. The question here
was whether Bancinsurance did this a lot. I knew it had entered a new line of business (bail bond
insurance), and it had lost a ton of money in that rather than in the line it normally wrote. So, I
went back through the company’s oldest filings – the first ones to be put up on EDGAR – and
found references going back about 30 years. I had the company’s combined ratio for 30 years. I
saw it had a positive combined ratio in 28 of the last 30 years. In fact, it had a combined ratio
below 95 (a 5% or better underwriting margin) in 18 of the last 30 years.
There were some other concerns with this stock. Its auditor had abandoned it, and the SEC had
opened an investigation into the company’s top management which it hadn’t yet said was closed.
While I was researching the stock, the SEC sent the company a letter saying the investigation
was closed. But A.M. Best had already increased the company’s financial strength rating. That
was the important one for me. Would I have bought Bancinsurance stock if I had only seen 10
years of financials?
No. I needed those 30 years of combined ratios to make the decision. Insurance is cyclical. And
the macroeconomy is cyclical. When you are covering risks related to things like autos and
unemployment – it is easy to think a few good years or a few bad years are the norm. Oil prices
have not been normal for most of the last 15 years. Interest rates have certainly not been normal
for the last seven years. You need data much longer than that to frame an investment case in a
bank, oil producer, insurer, etc.
The other case I can think of where having more than 10 years of financial results was critical
was Greggs (GRG, Financial). Greggs is a U.K. food-on-the-go type company. There’s no exact
peer in the U.S. But if you’re imagining a cross between Starbucks (SBUX, Financial) and
Subway – that’ll do. It’s not upscale stuff, and it’s not known for being healthy. Quan and I
started looking at the stock when it got real cheap on some bad same-store sales numbers. The
price-earnings (P/E) on the stock was reasonable. And we knew a little bit about the U.K.
economy’s trends.
For example, we could see that Greggs’ reported same store sales declines weren’t bad
considering what traffic patterns had to be near the stores themselves. A lot of Greggs were on
“high streets.” The U.S. equivalent would be “main street.” But there’s really no U.S. equivalent
anymore. Malls – both indoor malls and “power centers” – have transformed the U.S. over the
last 30 to 40 years in a way they haven’t changed the U.K. So we looked at the same store
numbers for Greggs and we Googled where Greggs locations were and we looked at trade
association numbers for traffic in the U.K. – and we decided that relative to other stores in the
same locations, Greggs wasn’t really seeing any company specific declines at all. It was just mis-
located for the future. Greggs had declining sales because fewer people were walking past the
stores.
What we did was collect data on Greggs going back as far as we could. This was easy because
the company includes a 15-year financial summary in all its annual reports. You go and find the
annual report for 10 years ago, you combine it with this year’s annual report and – between the
two – you now have 25 years of financial info. What impressed me about Gregg’s long-term
history is that the company had a very, very stable operating margin. It also had – this was in
2013, I think – the lowest operating margin in 25 years. If same-store sales were to rebound a bit,
the operating margin would rebound even more. The stock was cheap. This was purely reversion
to the mean.
Now, what did I need to make this decision? I needed the high street traffic data I found. And I
needed 25 years of financial history. U.K. consumers had it easy for much of the 2003 to 2013
period. So, 10 years wasn’t going to be enough. But having data going from the late 1980s
through 2013 gave me confidence that the operating margin was consistent because the business
model at the store level was consistent. Even for a noncyclical retailer, having 25 years of data is
a lot more helpful than having 10 years.
If you don’t believe me, consider the example of Buffett. He has said that, before he buys a
business in whole, he tells it not to bother with sending him any projections at all – but please
send historical financial data going as far into the past as possible. Why does he want to see data
from the 1980s when making a purchase in the 2010s? He wants to find the right frame through
which to see the investment.
 URL: https://www.gurufocus.com/news/457519/read-financial-results-for-30-years-
instead-of-10
 Time: 2016
-----------------------------------------------------
What to Do When Your Stock Doesn't Move
Sometimes stocks don’t move much.
I own a stock called George Risk Industries (RSKIA, Financial). I’ve owned it for – I think – a
little over six years now. It’s done fine. It was more expensive at one point than it is now. But
there has never been a catalyst with this stock. It has earned about what I expected it to earn each
year. It’s paid a good dividend yield of 4% or 5% a year. And any earnings beyond that have just
piled up in cash.
At the time I bought the stock, I think it was trading around $4.50 a share and had about $4.50 a
share in cash and investments. Money in mutual funds. That sort of thing. So, you were getting
the business for free. And it was a profitable business. It earned – or would earn, in normal times
(not 2010) – maybe 40 cents a share.
Well, over the last six years, the stock has paid dividends. And the yield on the stock has been
higher than the yield on a government bond would be. It has piled up maybe a little more cash.
We are talking maybe $5 to $6 a share in cash and investments now. But that is largely the result
of things like mutual funds going up in value.
So you’ve gotten your dividend. And the cash box part of the business – again, it’s not really
cash (it’s investments) – has grown a bit along with the market. But you are still talking about a
stock where the operating business is not selling for much of anything above the value of what
the company has on its balance sheet. So, say the stock goes for $7.25 a share. Say the company
has $5.50 to $6 a share in net cash and investments. Then the value the market puts on the
business – which might be earning 40 cents pre-tax – is somewhere between $1.25 and $1.75.
Less than 5 times pre-tax profits. I am using round figures. The stock is illiquid. It often moves
in increments as big as 25 cents whenever there’s a trade. And then the fair market value of the
investments obviously moves constantly. So the numbers are a little different with every 10-Q.
But, you see the situation. It hasn’t outperformed the S&P 500 over the six years I’ve owned it.
Now, personally, I’m okay with that. The S&P 500 was cheap to fairly valued from 2010
through about 2012. The last three years it’s been expensive. A lot more expensive than George
Risk. So, I’ve never been tempted to sell the stock unless I found something better to buy. And
I’ve yet to find something better to buy. And so I’ve held on. But, nothing much has happened
with the stock for about six years.
So, are we talking about a value trap?
In this case, perhaps not. And that is because the stock is profitable. It is safe and it is profitable
both. The operating business has always turned a profit. And the company has always had a ton
of net cash and investments. Liabilities are close to nil. There’s no debt. So, it’s safe and
profitable. Those are not the traits of a true value trap. The stock isn’t a melting ice cube. But, it
can be dead money. How long is too long to wait for a position to work out?
This isn’t an issue you only have to worry about with illiquid stocks. I own a very liquid stock –
Frost (CFR, Financial) – that has something of the same issue. I was talking to someone who
owns a lot of Frost shares in his portfolio (bought because I talked to him about that stock a year
back) and he went on and on about how the stock had been doing the last couple months or so –
where it was finally moving. So, I had to tell him: “That doesn’t mean anything. Ignore it. It’s
just because of the Fed.” The stock moves a lot on short-term expectations of when exactly the
Fed will raise rates.
Now, Frost is a very, very interest rate-sensitive bank. The two most interest rate-sensitive banks
I know of are probably Frost and Bank of Hawaii (BOH, Financial). They both are funded almost
entirely by customer deposits. And they both pay very little interest on those deposits. Most
importantly, they both have huge amounts of deposits per branch. So their operating expense
(non-interest expense) as a percent of deposits is very low.
In a high interest rate environment, these banks would have much higher returns on equity than
the average bank. In a near-zero environment, a lot of banks will all earn about a 10% ROE
regardless of how valuable their deposit base is.
So buying Bank of Hawaii and Frost – and I do suggest you buy both if you don’t own them
already – is a speculation on interest rates. But it’s not much of a speculation on when the Fed
raises rates. What I mean by this is easier to explain if you think about the George Risk example.
I bought George Risk in 2010 and still own the stock in 2016. Now, imagine I buy Frost stock
this year and hold it as long as I’ve held George Risk. I’d still own the stock in 2022. So my
speculation is on where the Fed Funds Rate will be in six years rather than six months. That’s my
bet. But the stock doesn’t move based on the bet. Day to day, week to week, and month to month
– Frost shares are reacting to where investors think the Fed will have rates in May of 2016, not
November of 2022. They are thinking six months ahead, not six years ahead.
In this kind of situation, what should you do? Imagine you bought Frost a year or two ago.
Unemployment was already quite low. You might have expected the Fed Funds Rate to be higher
by now than it is. So you’ve been sitting there in disappointment – just waiting without a catalyst
– for a year or two now. It can feel like the Fed will never raise rates.
I remember facing the same situation with oil prices. A few years back, I was talking to the co-
writer of a newsletter I did about researching cruise line stocks. I wanted to research Carnival
(CCL, Financial) and Royal Caribbean (RCL, Financial) as possible stock picks. The reason for
doing this was simple. Carnival and Royal Caribbean weren’t earning much. Their ROE was
poor. But they were paying a lot for fuel. And when you looked at their results before fuel
expenses – they hadn’t diminished the way their overall financial results appeared to. In other
words, something the companies couldn’t control – oil prices – was causing their EPS to look
worse now than it had in the past.
The next question was whether oil prices were “normal.” At this time, Brent was over $100 a
barrel. That obviously wasn’t normal. It might be reasonable to do an analysis of a cruise line
with $70 Brent as your assumed cost input. And it might be reasonable to do an analysis of a
cruise line with $30 Brent as your assumed cost input. More than $100 a barrel made no sense.
You could develop new sources of oil – people were in Texas and elsewhere in the U.S. – for
much less than $100 a barrel. This was not difficult to see.
But there was a problem. Oil was – at that moment – priced above $100 a barrel. There was
nothing in my investment case for Carnival and Royal Caribbean that would start benefitting
shareholders till oil prices dropped. So, it was a speculation on oil prices. I had no problem with
saying that $70 oil was reasonable and $100 oil was unreasonable. That was a speculation I was
comfortable making. So, I suggested we do a report ignoring the fact that oil was $100 and using
$70 as our cost input in the analysis. This is the Ben Graham approach. True earnings
normalization. It made sense to me. But, my co-writer was reluctant. And I think subscribers
would have been very, very reluctant to embrace the idea. Why? Because oil wasn’t $70 a barrel.
It was more than $100 a barrel. How could you ignore that reality? How could you just fast
forward to a future that is – as any future must be – speculative?
I think we can only invest for normal times. You may want to short Chipotle because you think
same store sales will continue to decline. Another investor may want to buy Chipotle
(CMG, Financial) because he believes same-store sales will recover. The one thing that makes no
sense is to take today’s sales and use today’s operating margin as normal. Either sales will
decline, and the operating margin will get much, much worse. Or sales will improve, and the
operating margin will recover to the kind of levels that were normal in the past. I have no
opinion on Chipotle. Except I do have the opinion that looking at the stock’s 2016 sales and
earnings makes no sense. Those figures are irrelevant. This isn’t a normal year for Chipotle.
When oil is $100 a barrel, I think you can say it is not a normal year for airlines, or cruise lines,
or oil companies. And you can safely disregard the current year’s EPS. It doesn’t matter. The
same is true for Frost and Bank of Hawaii. It doesn’t matter what they report in EPS for 2016.
The Fed Funds Rate is much lower now than it will be in a normal year. So, we don’t need to pay
attention to their earnings.
This approach might make sense to you. I hope it does. Because it’s the only approach that
makes sense to me. Investing on the assumption that $100 oil or 0% interest rates or anything as
abnormal as all that will last sounds odder to me than investing in a company that has never
turned a profit. We – as value investors – don’t do that. But even we know that a growing
company that has never turned a profit will – if its gross profit margin is sufficiently high –
eventually generate profits at some future size. It is a theoretically sustainable trajectory. Oil at
$100 a barrel or interest rates at 0% are not sustainable. But, we don’t know when these
“bubbles” will burst – do we?
So, it is easy to think this way in the finding and buying stage. It is easy to believe in Frost
before you buy Frost. It becomes harder if say you expect the Fed will raise rates in December
and then they don’t. That would be a surprise, wouldn’t it? And it might cause some short-term
problems for the stock. You’re a value investor – not a value trader. So, short-term problems
aren’t a problem for you. But, what if the Fed doesn’t raise rates through all of 2017? How
would you feel then? Would it feel like a short-term problem? Or would it feel like you had
invested in a dead money stock?
There is nothing wrong with a dead money stock. There is something wrong with a melting ice
cube. I have owned both. And there’s a big difference between say George Risk and Barnes &
Noble (BKS, Financial). Barnes & Noble was always going to have a declining business. I
bought into it on the assumption that the free cash flow its stores were producing could be used
to pay dividends, buy back stock or acquire an unrelated, non-print book business. It was also
possible that Ron Burkle would win his proxy fight with Len Riggio. Burkle lost. And I sold the
stock soon after that proxy vote. Why? Because Barnes & Noble was doubling down on Nook.
Unlike the retail stores, Nook wasn’t a shrinking business – it was a money-losing business. It
burned cash. And so, the safety of my investment was at risk. This wasn’t a dead money
investment. It was a melting ice cube. It was a value trap.
The right time to sell a melting ice cube is as soon as possible. The right time to sell a dead
money stock is only when you find something better. A dead money stock is still cheap.
In the newsletter I used to write, we picked a stock called Breeze-Eastern (BZC, Financial). It

was a small business. Three investment funds owned most of the company. Their positions were
illiquid. They couldn’t easily sell out to the public. So, not surprisingly in hindsight, they sold
out to a 100% control buyer. But, until that moment, Breeze-Eastern seemed to have no catalyst.
When the deal was announced, it was no longer dead money. A few months earlier, the biggest
question people asked us about Breeze-Eastern was, “What if nothing ever happens with the
stock?” Then it turns out like George Risk.
Obviously, it is better to find a Breeze-Eastern than a George Risk. But it’s not always easy to
know the difference between a Breeze-Eastern and a George Risk. It’s easy to know the
difference between a George Risk and a Frost and a Barnes & Noble. The risks are different. The
risk of losing money should always be a top concern. The risk of having to wait six years and
still not have much to show for your investment – that’s a risk value investors can afford to take.
 URL: https://www.gurufocus.com/news/457322/what-to-do-when-your-stock-doesnt-
move
 Time: 2016
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How to Be More of an Investor and Less of a Trader
A lot of people reading this consider themselves value investors. There are two parts to that
designation: the “value” part and the “investor” part.
I want to talk about the “investor” part. What is the difference between investment and
speculation? Ben Graham answered that question 82 years ago. See “Security Analysis.” That’s
not the distinction I’m worried about here. Some of what Warren Buffett (Trades, Portfolio) has
done would be considered “speculation” by Graham. But it would still be considered “long term”
by everyone.
So BuffettÂ is an investor in the sense that he is not a trader. What is the difference between
“investing” and “trading”? Time. The difference is time. A trader has an exit strategy. A trader
wants to flip his position. An investor wants to hold. An investor has lower turnover in his
portfolio. He has a longer average holding period.
What is your average holding period? I’m sure you don’t know. I don’t know. But we can start
with a pretty simple test. Look at your portfolio as it exists now. Go into your brokerage account
and find every single position you have. Print out the “Portfolio Holdings” page if you have to.
Then do a little research on your own past behavior. Look up when exactly you bought each of
those positions. That won’t give you a true measure of the average holding time for you as an
investor. Obviously, you aren’t selling all those positions today. But it will give you a minimum.
If you have 20 stocks in your portfolio and the 10th-longest held stock was bought back in 2013,
then you tend to hold stocks for three years or longer. Is that investing? Or is it trading?
I’d call three years trading. There’s a logic to this which I’ll explain in a second. But I want to
stop here and say that, of course, it doesn’t matter what I call investing and what I call trading.
You define it however you want to define it. This article is about how you can – if it’s something
you’re looking to do – extend your average holding period. This article is for people who think
of themselves as long-term “buy and hold” type investors in theory but then find they are more
like “value traders” in practice. They buy a stock at a low price-earnings (P/E) or price-book
(P/B) or EV/EBITDA ratio or whatever and then they sell that stock when it hits a high P/E or
P/B or EV/EBITDA ratio. They are trading on a multiple expansion. They aren’t making their
return from owning the stock. How can people like that become more investorly and less traderly
in their approaches?
I have a six-part investment process that might help. There’s nothing special about these six
steps. You can find a better set of six that work for you. But these six will start you thinking the
right kinds of thoughts. What we are focused on here is practice. We are thinking practical
thoughts – talking habits – rather than theoretical thoughts.
Okay. What are these six steps?
 Question One: “Is this a business I’m comfortable owning forever?”
If your answer is “No,” then you eliminate the stock from consideration right there. For me, this
eliminates about 95% of stocks. If I read a 10-K a day for about three weeks, I come across one
idea that passes this test. It’s about a 1 in 20 sort of business that is going to pass this first test for
me. For you, it might be different. Maybe it is 10% of all stocks. I’d believe that. Could it be
20%? I guess. Could it be 50%? No. It can’t be 50%. Most people are not comfortable owning
most businesses forever. So, if you read a 10-K a day for three weeks and you find that 12 of
those (12 out of 21) are businesses you’d be comfortable owning forever – you’re probably lying
to yourself.
If your answer is five out of 21 or three out of 21 or one out of 21 – you’re probably being honest
with yourself. Or at least you’re being more honest with yourself than most stock pickers are. So,
let’s start with that. I could list a ton of businesses I’d probably be comfortable owning forever.
For example: I’d be comfortable owning Omnicom, Frost, Grainger, Hunter Douglas and John
Wiley forever. What do these businesses have in common? They tend to have high rates of
customer retention. Frost is a little over 90% customer retention. Omnicom is – like other major
advertising agency holding companies – probably in the 95% to 99% of major accounts range.
Grainger is an MRO distributor. That industry – especially among large accounts, on which
Grainger focuses – has a high customer retention rate.
In Wiley’s journal publishing business, it tends to retain university library clients indefinitely. In
fact, when I was researching Wiley I spoke to one buyer of Wiley’sÂ journalsÂ – and Elsevier's
and Springer's and so on – and asked what would happen if a company like Wiley raised prices
on him. He said he’d stop buying a competitor’s journals. I said, “Wait, what? A competitor’s?”
And he said, “Yeah, when one of the top three or four or five publishers with their bundles of top
journals raises their prices I have to eliminate smaller journals from smaller publishers. How it
works is I have a list of all the journals I want to subscribe to. And I have a budget. The ranked
list doesn’t change. And my budget doesn’t change. So when the top journals cost me more – I
cut the bottom journals.”
In other words, he doesn’t switch providers because of price. Likewise, Omnicom’s clients aren’t
going to switch to another ad agency because of price. And Frost pays much, much lower interest
on its accounts than many banks yet its customer retention rate is higher than the banks that pay
more for their deposits. That is the kind of business – the kind of industry – I’d be most
comfortable investing in forever. For me, personally, I don’t want to own a business forever in
an industry where price is a reason customers switch providers. I want to be in an industry where
customers either don’t switch providers or where customers switch for reasons other than price.
But that’s me.
You might feel comfortable owning a business with real, hard assets forever. Maybe you want to
own ExxonMobil or U.S. Lime or Southern Copper or Union Pacific forever. You’re looking at
the supply side instead of the demand side. You’re asking: Who is ever going to build another
railroad in the U.S.? Answer: no one. Or how much does it cost to find, develop and exploit a
new source of oil? Or get the permits and so on for a new limestone quarry. That isn’t usually my
kind of thinking. But it makes sense to me. It’s rational. I wouldn’t think it odd if people said
they were comfortable owning a business with a limited supply situation forever. We have
businesses where clients don’t switch providers or when they do switch providers they don’t
switch because of price. And we have businesses where competitors can’t enter the business on
the same terms that the existing players did.
Then we have Buffett’s favorite businesses. We have “habit” type businesses, businesses with
mindshare. We are talking Gillette and Coca-Cola and See’s Candy and Wrigley. They may have
other advantages too. Obviously, Coke and Gillette have some pretty impressive distribution
systems over the entire globe. But they also have the advantage that when you are in a restaurant
and the waiter comes up to you, you say, "I’ll have a Coke." You never say, "I’ll have an RC."
Mindshare.
There are three examples of classes of businesses you might be willing to hold forever. This first
step is the most important. “Am I comfortable owning this business forever?” is the most
important question a long-term investor can ask. It makes up most of what being a long-term
investor is all about.
Next, let’s look at question No. 2.
 Question Two: “What will this business look like in five years?”
To me, this is the question that separates the value investor from the value trader. There is
nothing wrong with being a value trader. But that’s not what this article is about. A value trader
looks at a stock that is cheap right now. The P/E is 11 or the P/B is 0.9 or the EV/EBITDA is 6.
He compares these figures to peers. Is this stock cheap on an absolute basis? Does it have a low
P/E, P/B, EV/EBITDA, etc.? And then: Is this stock cheaper than those public companies that
are most like it?
Say we are looking at Southern Copper. We would ask how much does Southern Copper trade
for in the stock market per ton of reserves. And then we’d ask if other copper miners trade for
more or less per ton of copper reserves. It is easy to do these kinds of comparisons. One of the
appealing aspects of Frost – for me – is how cheap that bank is in terms of price to deposits. The
market cap of that bank is low per dollar of deposits. It’s not low on a P/E basis. But it is low on
a price-to-deposits basis. If interest rates were at a different level – just as if copper prices were
at different levels for Southern Copper – the earnings picture would be different. This is a short-
term – or I guess most people would say medium-term – speculation. It’s just a bet on higher
copper prices or higher interest rates or something like that. It’s different from believing Frost
will be able to grow its deposits per share, per branch, etc., at a good pace for the next decade.
BuffettÂ is thinking more in those terms. He is asking: how quickly can Wells Fargo grow its
share of wallet with customers, its deposits per branch, its deposits per share, etc., over the next
15 years? He’s not just thinking about how much Wells would be making in 2020 if the Fed
Funds rate was 3% by then.
 Question Three: “What would that business be worth in five years?”
This is about pricing the future business instead of the present-day business. Let’s say I think that
through a combination of interest rate increases and organic deposit growth, Frost could grow
EPS per share by 10% a year over the next five years. Then, what I do is I look at the business as
it exists today and take Today’s EPS * 1.10 ^ 5. That is the business I think about. The tomorrow
(five years from now business) rather than the today business. This is part of what separates the
investor – who intends to hold the business for the long term – from the trader who might be
selling in just three years’ time. I don’t care what the business looks like today. I’m not selling
the stock today. If I’m an investor – I’m not even going to be thinking about selling for five
years. So, what matters is what the business looks like in five years. What it looks like today
doesn’t matter.
 Question Four: “How much am I paying today for that?”
This is the value part of “value investor.” But it’s a little different than looking at P/E ratios and
P/B ratios. It is a DCF-type approach.
Let’s say I have a stock today that is earning $1 per share. But I think it will grow more than
10% a year. It will be earning 65% more per share within five years. Then we aren’t going to
compare today’s price to the $1 EPS today. We are instead going to compare what we are putting
down today to own a business making $1.65 per share in 2021. Now, I don’t think any sort of
actual DCF type approach is needed here. Instead, a purely relative approach can work. Put taxes
aside for a second. We can ask how much do I have to invest to have $1.65 in earning power in
2020.
If a stock is trading at $15 per share today and will produce $1.65 per year in EPS in 2020, then
we can say it costs me $15 per share today to have $1.65 per share in EPS In 2020 when I invest
in this stock. Another stock may be trading at $10 per share and producing $1 in EPS. Then the
question becomes how much does it pay out in dividends. And how can I reinvest those
dividends to get that same $1.65 in EPS In 2020?
It can be a simple comparison between different alternatives. But it must be future focused. You
must pick a time in the future. I suggest five years as the minimum. Any investment you hold for
at least five years is going to be considered long-term by most people. Starting with comparisons
that use five years as the time frame you are measuring will put you in an investor’s mindset.
If stock A is cheaper in years 1, 2, 3 and 4 but falls behind the EPS production of stock B (for the
same initial cash outlay on your part), then stock B is the better investment for you because you
are an investor. Note that stock A is the better trade for the trader. There is no objective answer
to which stock is the better “value” stock. It depends on the reference frame. In the trader
reference frame, stock A is cheaper. In the investor reference frame, stock B is cheaper. It’s
relative. You pick a different frame and you get a different answer.
Here, we are concerned only with the subjective reference frame of “investor.” We are
discarding the trader frame. To do that, we are disregarding how much more earnings an
investment will produce per dollar of your money in years 1, 2, 3 and 4 and just asking which
stock will be ahead in terms of earning production starting in year 5. This keeps you focused on
the long term.
 Question Five: “What’s the best stock I don’t own yet?”
Let’s say I like Hunter Douglas, but I don’t own Hunter Douglas. But I know that if I had to buy
something today – if you put a gun to my head – that something would be Hunter Douglas.
That’s my opportunity cost. That’s what we compare the stock we’re considering to. It must
clear the “Hunter Douglas” hurdle.
 Question Six: “Do I really think this is the best opportunity I’m going to get all year?”
We’ve cleared the opportunity cost hurdle. We know the stock we’ve found is the best thing we
could buy right now. But should we buy something right now? Answer: usually not. On most
days, we as investors don’t want to be doing anything at all. How do we build inaction into our
selection process? We can use a modified sort of form of Buffett’s “punch card.” He said if he
gave you a card with 20 punches on it and each time you bought a stock, you used up one of your
punches and that card had to last you the rest of your life – that limitation alone would improve
your stock selection process. I agree.
But how do we build that into the here and now instead of lifelong thinking? We limit ourselves
to one stock purchase per year. You can only buy one stock this year. If you buy this stock, you
aren’t allowed to buy any other stock this year. This will reduce your turnover rate. And a lower
turnover rate will lead to a higher average holding time in your portfolio. It will make you more
of an investor and less of a trader. So, limit yourself to one punch per year.
 URL: https://www.gurufocus.com/news/457158/how-to-be-more-of-an-investor-and-less-
of-a-trader
 Time: 2016
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Do You Need to Know Something the Market Doesn't?
This is a popular question among value investors. I’ve heard many value investors talk about
why a stock is cheap. I’ll be honest. I don’t think I can explain why a stock is cheap.
There are several areas of investing where I have no expertise. I don’t think I add any value
when deciding to sell a stock. Your guess is as good as mine on selling. I don’t think I add value
on position sizing. Over time, I’ve decided the best approach is just to make each position the
same size. I’ve seen no ill effects from this. And it lets me focus on the buying part. I also have
no skill when it comes to knowing when I will get paid. I don’t know what actual catalyst will
cause a stock to reach my estimate of its intrinsic value. I have invested in situations where I
believed I knew what the catalyst was, what the timeframe for realization was, and what the
value realized would be. I’ve always been wrong on this. Usually, I have been too pessimistic on
the final price someone will pay for a stock. Unfortunately – when there was an obvious catalyst
present – I’ve usually been too optimistic about how quickly that value will be realized.
So I don’t do selling well, or position sizing, or recognizing catalysts. I also don’t think I bring
any special skills to knowing why a stock is cheaper than it ought to be. In other words, I don’t
think I’m any better at explaining the seller’s rationale for trading his shares for my cash when I
buy.
Is this a necessary skill?
It seems like it should be. It seems like – to make a winning investment – you need to know
something the market doesn’t. However, I don’t believe that’s true. Because I don’t believe
knowledge has much to do with how people invest.
Knowing is usually an intermediate step. Investors incorporate facts into their interpretations of a
stock. I don’t think you need to know different facts than other investors. You just need to
interpret the same facts differently.
There is one value approach that almost always seems to work for me. And, in a sense, it is based
on the idea of a different interpretation of a stock. But it’s not at all based on different facts.
I’m not an expert on why other investors choose to buy and sell stocks. But I have noticed a
tendency to focus a lot on reported results. Next year’s earnings are a big concern.
So, using a combination of 3 different facts – facts you’ll often agree with the market on – you
may be able to come up with a different interpretation.
The 3 facts I find most helpful in interpreting a stock different are: 1) Owner earnings, 2)
Enterprise Value, and 3) What happens in year 4?
Let’s start with the last one, because it’s the most difficult to explain. The market is often
focused on what just happened last year and what will happen next year. Analysts and investors
are always looking ahead. But, are they often looking more than 3 years ahead?
It’s now 2013. One of the first things I ask when trying to value a stock is what it will look like –
assuming a normal environment – in 2017. The reason for this is obvious. The market may put
extreme importance on expected results in 2013, 2014, and 2015. But unless these results
indicate a pattern that will continue right through 2017, 2019, and 2020 – they aren’t likely to
make or break a long-term investment in the stock.
A lot of the value in a stock will come from cash flows after the next 3 years. A lot will also
come from cash flows in the next 3 years. But everyone is trying to predict those.
Likewise, everyone is trying to predict what margins, etc will be in an industry environment that
looks a lot like today or their expectations for the next few years. Fewer people will be looking at
what the net interest margin of a particular bank will be in 2017, what the fuel costs of a cruise
company will be, etc.
If you can figure these things out – and you can’t know any of them, you can only make
educated guesses – will you know something the market doesn’t?
I don’t think you will. You will focus on something the market is not focused on. But I think
your facts will often be quite similar.
I was reading an analyst report recently of a stock that I just analyzed myself. The analyst valued
the stock at $50 a share. I valued the same stock at $68 a share. Since the stock trades in the 40s
this is a meaningful difference of opinion. The analyst thinks the stock is quite fully valued. He
sees no margin of safety. I see an almost 30% margin of safety.
Do we have different facts?
Not really. His report includes most of the same facts I considered important. Some of our future
estimates were also nearly identical. For example, he assumes a roughly 2% annual sales
increase. I assume a roughly 3% annual sales increase.
There are some differences though. He projects sales growth and margins till 2017. He doesn’t
consider either number beyond that.
I can’t disagree with his 2% sales growth estimate for the next few years. In fact, I feel pretty
strongly that this stock – which I consider a good buy – actually can never grow its profits faster
than nominal GDP. The company does almost all of its business in Europe and the U.S. So, if
you predict nominal GDP of less than 4% a year, sales growth can’t be higher than that.
Of course, that estimate is very much focused on the last few years and the next few years. In
periods where there was a bit more inflation – in other words, almost any other time in the last
century – and nominal GDP growth, sales grew faster than this analyst’s estimate.
I don’t disagree at all with his estimate. I have no basis on which to disagree with an estimate
like that over a timeframe like that. Economic growth has been pretty low since the financial
crisis. It’s been hard to raise prices. The only way this company makes money over time is by
raising prices. So, I have to agree that if nobody is raising prices on anything for the next few
years – this company is going to have a hard time creating any profit growth.
So our facts are the same. And I think our opinions – to the extent we have opinions on the same
subjects – are actually identical. I wouldn’t disagree with his short-term estimates. They are
reasonable. They might turn out to be low. But mine might turn out to be high.
Where do we differ?
In our interpretation. The framework he used was to model out through 2017 and then stop. The
framework I used was to ask: What does this company look like in normal times? What would
nominal GDP growth look like? What would inflation look like? How much could they raise
prices then? Could profits rise faster than sales? And could free cash flow rise faster than profits?
His analysis ended in 2017. Mine really started in 2017. Not because 2017 is likely to be more
“normal” than 2013, but because I am interested in “earning power” rather than reported
earnings. In a normal environment, how much can this company charge?
The next area where the two of us had different interpretations was price. He used a perfectly
reasonable P/E ratio of 15. However, he used a P/E ratio. I think that’s wrong. I think it makes no
sense to value a company like this on its P/E ratio.
I use owner earnings. I always do an owner earnings calculation. And I don’t care whether
earnings can be reported or not. For example, in this situation the company’s operating earnings
would be about 15% higher if you added back amortization of intangibles. You obviously need
to add back amortization of intangibles. It’s cash flow the company gets each year. And these are
intangibles from acquisitions that don’t need to be replaced.
If you’re focused on reported earnings, there’s a problem with this amortization. It’s going to go
on and on for many years. Some of these intangibles are being written off over a period of 20
years. Some were pretty recently acquired. That means – even if the company never acquires
another business – it’s going to be taking large amortization charges far into the next decade.
You could look at this from an EPS perspective as a natural source of EPS growth. As
intangibles are written off, the amount of amortization required next year declines. So, EPS
automatically rises. I think that’s meaningless. Cash flow is the same before and after the write-
offs. But reported earnings aren’t the same. Because of the declining intangibles balance, EPS
naturally rises without the company doing anything.
It’s a silly observation. But if you are trying to estimate EPS, it’s one of the key inputs for what
EPS will be in say 2017. It will be several percentage points higher simply due to a lower
intangibles balance that needs to be amortized.
Again, I don’t think this analyst and I disagree on these points. I’m sure he doesn’t view the
amortization as a real economic charge. His estimate of free cash flow would be identical to
mine. But he uses a P/E ratio. I use an EV/Owner earnings ratio.
This brings me to the last of the 3 perspectives where you can really differ from the market
without actually knowing anything the market doesn’t. I only look at a company’s price in
relation to its pre-tax owner earnings. And I only care about enterprise value.
A lot of value investors also use this approach. But some folks disagree with me on this one.
They feel that it rewards companies that hoard cash. And it punishes companies that rationally
leverage up the balance sheet to provide more free cash flow to equity.
I would agree with that assessment in a world of unstoppable inertia. I don’t agree with it in the
real world. I don’t agree with it because the capital structure you are looking at is not necessarily
what the stock will be a part of when you sell it, nor even what it will be a part of for most of the
time you own it. The capital structure is just what it looks like today.
A company with no debt can go out and – without diluting your equity – leverage up the balance
sheet and almost double its size overnight. Conversely, an overleveraged business can – without
ever risking insolvency – use almost all of the free cash flow you anticipate to pay down the debt
in front of your common stock. It can also – if insolvency ever becomes a problem – end up
issuing a lot of shares.
Capital allocation is terribly important. I pay a lot of attention to it. But I don’t believe that
today’s capital structure tells you as much about future capital allocation as the company’s past
behavior, management’s statements, etc.
I especially like to focus on companies that lower their share count year after year. I find this to
be more of a predictor of future uses of capital – of what my returns may be in the stock – than
simply calculating the leveraged free cash flow on today’s stock price.
That doesn’t mean I won’t buy a leveraged stock. I own Weight Watchers (WTW). It’s very
leveraged. But it’s also – at about 9 times my estimate of its pre-tax earning power – a fair price
to pay on an EV/Owner earnings basis for what I think is a wide moat business.
Notice that I don’t care what the P/E ratio is (even though it’s low). And I don’t care what next
year’s earnings will be. I care deeply about the company’s solvency through the next few years.
And I care about what owner earnings will be in a “normal” looking 2017.
I don’t think I know anything the market doesn’t. I do think I may be framing the question a bit
differently.
We can all agree that superior knowledge without superior interpretation is not profitable. And
superior interpretation without superior action is equally unprofitable.
It may sound like that means the chain of doing something different from the market has to begin
with knowing something different. But I disagree. I think you can fork off later in the process.
You may know the same facts, but interpret them differently. Sometimes, this can lead you to a
different and correct action.
 URL: https://www.gurufocus.com/news/230165/do-you-need-to-know-something-the-
market-doesnt
 Time: 2013
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Doing the (Focused) Work
In my last article I talked about how to practice valuation. My biggest bit of advice was to
actually do the work. Don’t just watch other people value things and comment on those
valuations. Sit down and try to appraise a company yourself. And do your own work. Don’t rely
on somebody else’s.
To that end, I’ve started something new on my blog (for those who don’t know – I write a blog
with Quan Hoang called “Gannon and Hoang on Investing,” there will be a link at the bottom of
this article). Each day, I’m posting a “daily idea.” It’s not a stock pick. It includes zero
comments from me. It’s just a name you can practice on. It’s not chosen at random. These names
will reward appraisal practice more than picking stocks at random.
The first two names were:
· Greggs (GRG)
· Tandy Leather Factory (TLF)
Pick either stock. Or do them both. Try to give a one page appraisal of what the company’s stock
is worth – and whether there is a margin of safety. You can email me your one page appraisal
(there will be a link at the bottom of the article). Or not. Either way, it’s good practice.
The important thing is that you do practice. That you do the work yourself. And you do it your
own way.
This will cause you to face practical problems. What is Greggs’ return on capital? Should I
capitalize the leases? If I do capitalize the leases, does this change the value of the stock, my
margin of safety, my upside potential in the stock, just my downside risk – which is it?
You have to decide for yourself. Do you focus on ROE? Or on return on capital? How do you
capitalize the leases?
You’ll find yourself checking how other people treat leases. You’ll find yourself scanning other
10-Ks, annual reports, etc., for hints on how companies treat this problem.
You’ll also find yourself getting into theory. For example, it’s fine to answer what the return on
capital of the business is – but are you buying the business? You’re not their landlord. You’re
valuing the equity. How do you do that? Do you value it relative to peers, what it would be worth
in a takeover, or some discounted cash flow (I strongly recommend no on this one) approach? In
that case, do you value it on a leveraged (equity only) or unleveraged (enterprise value)
approach?
We could talk about these things in theory. It is better to face them head on in practice. If you
analyze a retailer, a restaurant, a bank, a real estate company, etc., you’ll start to really ask
yourself these questions. Why do people do a return on capital calculation for retailers who lease
their property but focus on return on equity for a bank? Isn’t a bank using its customers'
deposits? Why are those safer than leases? And is safety what determines how we treat the use of
other people’s money? What about trade credit?
You probably know that analysts net out working liabilities against working assets to get net
working capital. But why do they do this?
We can talk all day about this. But it won’t be as informative as you dealing with a company
with a lot of working capital, a company with negative working capital, and a company with a
normal amount of working capital. Seeing the spectrum of actual experience in the wild will
teach you the most about how to deal with issues like that.
So, the first thing you need to do is find something to practice on. I already gave you two names:
Greggs and Tandy Leather. And for some time – I’m not sure how long – I promise to post a new
name you can practice on at my blog each day. It’s a rare investor who flies through multiple
valuations in one day. So, if you just check my blog each day, you should have a steady flow of
companies to practice on. And, if you send me your appraisal (and keep it to something that
would fit on one page), I’ll reply to your email with the questions I’d follow up with.
Regardless of whether you are working with someone else – emailing them your work for follow
up questions to point you in the right direction – or working blind, you’re going to need to
actually work. And you’re going to need to focus.
You may have a job that requires intense focus. Most people don’t. Most people have jobs that
require a fair amount of multitasking. Don’t do that when you tackle investing. Take one task.
And take it seriously.
I suggest starting with a 10-K of a company you are interested in. Make sure you have a notepad,
pen, highlighterand calculator before you sit down. If you forget any of these, you will risk
breaking focus or being lazy. For example, if you don’t have a calculator, you’ll skip over doing
math that would be helpful. If the company mentions its number of locations and total operating
profit – and you have a calculator – you’ll breakdown the per location profit, sales, etc., right
then and scribble it in the margin. You’ll only do this if you come prepared. Otherwise, you’ll be
lazy and not do the work. If the calculator is in the other room – you won’t get up and get it.
You’ll figure this calculation isn’t really important.
So, come prepared. Always have all the tools you need in front of you. Otherwise, you’ll have to
break focus.
What do I mean by focus?
If you can roughly keep track of time while doing an activity, you are definitely not focused. For
example, if I am in bed and not yet asleep – I can very easily guess it’s been about 10 minutes. A
quick glance at the clock confirms this. I may be off by three minutes on either end. But it won’t
have been 33 minutes if I thought it was 13 minutes.
If you have any sense of time while working on the 10-K, doing your research, etc., you’re
working but you’re not focused. You’re underperforming the level of efficient work you could
be getting done. And it’ll show.
At first, some people will have trouble achieving the kind of focus that means you have no idea
how long you’ve been doing the activity. In fact, when you’re really focused you’ll measure how
long you’ve been working by knowing the pace you normally work at.
If I’m 1,000 words into this article, I know roughly what that means in time, because I know how
fast I write. Without knowing I’m 1,000 words into the article – I only know this because I have
word count constantly updating on my screen in Word – I’d have no idea how long I’d been
writing. That’s what focus feels like.
Your goal should be to work on one task and achieve that level of focus. You won’t the first few
times you do this. So just scribble down the time you start reading the 10-K right now. Then,
when you’re finished with all the reading and note taking and everything at a nice, normal pace –
write down the time you put down the 10-K.
Was it less than 90 minutes?
If it was, that’s a manageable chunk for you. Anyone can focus for up to 90 minutes. So, in the
future, you can always rest assured that sitting down to work on a 10-K is a fine single activity
for you.
A task that takes you five hours is not appropriate to focus on. Don’t try to focus for five hours.
You’d need to break that task down into smaller chunks and tackle them at different times. It’s
possible to binge work for five hours. People do this in their day jobs all the time.
But it doesn’t lead to the kind of results we want in investing. The bar for investing insights – for
the analysis you’ll be doing here – is a lot higher than for a normal hour of office work. For one
thing, you’re going to be spending less time investing than on your day job. And yet it’ll still be
important to your financial future. If you really think about the time investment on this areas of
your life versus what you’re risking here – it’ll scare you. You need to perform well. The bar
here is more at the level of an athletic competition than daily office work.
It’s high. So, you need to come to your practice each day like it’s a competition. I’m not going to
tell you how long a task should take you. That’s unimportant. I just want to make sure you are
fully focused throughout the task. So, don’t bite off more than you can intently chew.
Never attempt more than 90 minutes of focus. You may succeed. But you won’t come back to it
tomorrow. I want daily practice out of you. I want you to sit down – it can be for 30 minutes of
intense focus – and really practice valuation work each day. I don’t want you to do two hours
every other Tuesday. That’s no good.
Monitor your behavior. Break down your process into individual tasks that you can focus on. For
example, do you go out looking for ideas?
For now, eliminate that step. I’m putting one idea a day up on my blog. Just take that one. I
saved you time. This is just for practice purposes. And your practice time – at first – is better
spent doing active work on an idea than passively trawling for ideas.
Do you like to put things in a spreadsheet? Many investors do. I do. I use a standard form. Break
that into a task. Data entry requires a low amount of focus. It can also – once you have a system
for checking EDGAR, have a blank worksheet you reuse in Excel, etc., be done very fast.
We already talked about reading the 10-K. That can be a long process. I also read the 14A and
10-Q and S-1 (if available). This is what I do with every stock I seriously consider. Picking up
each report is a habit for me. It doesn’t have to be for you. Maybe you just want to do the 10-K
for now. I think that’s a good choice.
One you’ve read the 10-K what else will you need to do every time to practice?
You have to value the company. Unless you are writing down an actual per share stock price,
you aren’t getting the most out of this practice. You’re working. But you aren’t learning like you
could be.
We want to maximize the amount of learning you accomplish versus the amount of time you
spend working.
So get in the habit of always doing a one page appraisal of the stock.
For me, such an appraisal has to meet these requirements:
· Fits on one page
· Calculates an exact per share appraisal (example: $67.05 a share)
· Calculates an exact margin of safety (example: 28%)

· Makes explicit, logical statements
· Provides evidence in support of statements
· Shows the actual arithmetic
It’s possible you can find an approach that will teach you as much – or more – and doesn’t
follow all those steps.
I’m not suggesting anything elaborate. Evidence for me is simply an appeal to actual experience.
It’s citing a real-life observation. Not using theory. So, Company B trades at 0.7x sales and
Company B is comparable to what I’m analyzing is evidence.
Logical statements can be very simple. I opened my appraisal of John Wiley by saying “John
Wiley has 3 businesses: 1) Journals 2) Textbooks 3) Books.” I then proceeded to value each. The
logic here is clear. I am saying the value of John Wiley is the sum of the value of its assets. The
company’s assets are its three business segments. I then value each segment.
This is practice. It is not what I would put in an article. It may not even be persuasive. Often,
stories are more persuasive. Even portfolio managers seem to like hearing stories. I don’t like
including stories in my appraisals, etc. – really in anything I work on for myself, because I am
suspicious of the power of stories. They have a special hold over humans. If you want to sell
someone a lie, you create a story to justify it.
So, for me, stories are not part of the practice process. Likewise, I try to keep moral judgments to
a minimum. I find that the most common examples of sloppy thinking in investing come from
four sources:
1. Not doing the work
2. Lack of focus while doing the work
3. Seduced by a story
4. Blinded by moral judgments
So my advice on practicing investing is to focus on valuation work (what I call appraisal). Try to
practice every single day. It’s better to practice for 30 minutes seven days a week than 60
minutes for five days a week – because five soon becomes dour and then three, but seven stays
seven.
Rule No. 1 of practice is: Do it everyday.
Rule No. 2 of practice is: When you work, you focus.

The last two pieces of advice are to be aware of your innate human weaknesses. You are overly
interested in stories and morality. Put them aside when you enter your practice zone.
And don’t binge. That’s advice for later. It won’t be an issue at first. But once you really enjoy
practicing you’ll want to do it for three hours at a time. Bad idea. Do it for 90 minutes at a time
two or three times a day. Don’t work yourself up into a manic state. If you do that, you’ll find
you won’t come back to it tomorrow. Instead, you’ll start doing all your investment reading in
great big gulps once a week, once a month, etc.
That’s no one way to practice. You want to stay in constant contact with investing. You want to
make doing the actual work completely routine.
You do that by making sure you completely focus on the right task every day. It doesn’t have to
be for long. And it can be literally one task. You can accomplish just reading a 10-K today. Or
just doing a one page appraisal today.
If you do it with total focus and you do it everyday – you’ll get good at this.
 URL: https://www.gurufocus.com/news/225394/doing-the-focused-work
 Time: 2013
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7 Areas I Look at Before Buying a Stock
Value investors talk a lot about checklists. I assume this is due to the book “The Checklist
Manifesto” and Mohnish Pabrai ’s talks on the subject. It might also be due to Charlie Munger
using the term. I’m not sure I want to call these seven areas I look at a checklist. It’s too broad to
be called a checklist. A checklist should really be a list of quick actions you can take. These are
more like aspects of a stock to analyze. However, many investors probably skip some of these
aspects. The order in which I present them may also be informative.
First, the list:
1. Understanding
2. Durability
3. Moat
4. Quality
6. Value
7. Growth
Then some caveats:
This is not a pure value approach. Many of the stocks I buy are value stocks. But that can be seen
pretty quickly. As I like to say, I own some “conspicuously cheap” stocks. But you don’t need a
long list to see they are cheap. Ben Graham and Walter Schloss-type stocks are instantly
identifiable.
So this analytical checklist of sorts is meant for a more qualitative approach. I tend to analyze in
words. I make very few predictions. Basically, my analysis is a combination of:
· Logic
· Stats
· Direct Comparison (Ranking of alternatives)
So, when I say I look at an area – I mean I try to sketch out how to frame my thinking about that
aspect of the stock in logical terms. I use stats – especially 10 to 15 years or so of historical data
for the company. And I make a lot of comparisons – especially to stocks I already know well.
This last part sets my approach off from what lots of other folks do. I tend to rely on direct
comparison – actually forcing myself to rank one stock against another on each point. So, instead
of just saying for “value” that a stock’s P/B is x, its P/E is y, etc. I write down an actual question.
I think about a stock I know and believe to be cheap. For example, I now own George Risk
(RSKIA) and Ark Restaurants (ARKR). So, I’m always going to compare the EV/EBITDA of
a new stock I’m looking at directly to those stocks.
Explaining how I analyze stocks on that micro a level is too detailed for this article. And it’s
personal. It’s how I do it. I feel most comfortable being explicit about:
· Logic
· Stats
· Ranks
I feel least comfortable being explicit about future predictions. In fact, you’ll find very few
predictions with actual numbers attached in any of my analysis. I do, however, use what I’d refer
to more as thought experiments. Basically, I take a possible complaint – like this stock is “dead
money” – and work out the basic math to see just what it would take to make that objection valid
and persuasive. This is very different from predicting. For example, I might say a company will
simply pile up cash for 15 years and then the market will suddenly decide it should trade at a
normal EV/EBITDA, or the board will pay all the cash out in a special dividend, or it will be
acquired, or…
This is obviously not a prediction. It’s just sketching out a logical limit to an argument. For
example, it’s unreasonable to make a dead money argument that relies on the stock price and
capital allocation policies of the board being unfavorable for 15 years. I’ve never seen that occur
in real life. In fact, my experience has been that prices and policies adjust a lot faster than that –
often without explanation.
So, before taking a look at the seven areas I focus on – keep that in mind. I don’t predict. I
describe. And then I try to sketch out the logical ways to frame the investment. That’s almost
always how I operate.
You can look at these seven areas in one of two ways. One, you can consider them dangers. You
can treat them as possible failure points that disqualify a stock. Two – and this is more how I
think of them – you can think of them as potential defenses against loss. You can think of each
area as a possible strongpoint you can fall back on to protect your principal. If a company is high
enough quality, if you buy it cheap enough, etc. you can afford to miscalculate a bit in your
analysis of some of the other areas and still not lose money.
This is how I think. But again, this is a personal list created through a personal process.
Finally, remember it always changes. I used to include other areas and I eliminated them. I used
to explicitly focus on management and organization – two separate questions – and now I don’t.
This is more of a research issue than anything. I found that while I could gather plenty of info on
those aspects of a company – they didn’t lead to decisive conclusions. So, they had to be treated
under different areas.
Likewise, I used to think in terms of “product economics” and “return on capital” and
“competitive position”. I found these were good ways of listing stats, etc. but bad ways of
coming to conclusions. Now, my “qualitative” concerns are divided into more conclusion
friendly categories:
1. Durability
2. Moat
3. Quality (including product economics, organization, and management)
In fact, just one of my seven areas to look at encapsulates almost everything Phil Fisher writes
about. That tells you I’m not as thorough as Phil Fisher. This also helps you understand that a list
of 7 areas of interest could easily be expanded into probably 100 questions. For example, Phil
Fisher lists 15 points that almost all have to do with quality. I mention just one word: quality.
Let’s take a look at the full list again:

1. Understanding
2. Durability
3. Moat
4. Quality
6. Value
7. Growth
Remember, I am a concentrated investor. I like to own no more than 5 stocks at once. I usually
expect to own a stock for a minimum of 3 years. This has a huge influence on the 7 areas I look
at. If I was a wider diversifier and focused more on the next 1-3 years, I would rank value at the
top.
Let’s take it section by section. Just knowing 7 words doesn’t tell you much about my actual
approach. Describing what I think each word means will tell you more.
Understanding
This is very personal. I tend not to understand commodity companies and financial companies.
Some commodities – and some financials – are harder for me to understand. Soft commodities
are the most difficult for me to understand. And banks are the most difficult financial stocks for
me to understand. I can understand certain insurers.
Likewise, at the right prices, I feel I could understand oil companies, copper miners, etc. Lately, I
haven’t seen prices at which I could understand them because the prices for those commodities
have been unusually high relative to the real prices of those commodities over the last century or
so.
Does that mean they are overpriced? No. It might just mean there will be inflation in the future.
Or that demand for certain commodities will be sustained. I worry about societal waves.
Generally, that means I’d have trouble buying things tied to China, global trade, healthcare, and
higher education. All of those things have grown a lot faster in the timeframe I’d look back (10-
20 years) than I can be sure they will grow going forward.
I don’t understand technology real well where there are viable alternative approaches possible –
though perhaps not yet commercialized or even imagined. In general, I’m more comfortable with
the least physical – most pure data like – technology.
There are exceptions to every rule. For an example of a commodity company I’d feel totally
comfortable understanding see U.S. Lime & Minerals (USLM). For banks, see those with low
cost deposits, other obvious advantages. For example, Bank of Hawaii (BOH).
Durability
This kills a ton of value ideas for me. When I read value blogs, the biggest objection I tend to
have within a couple seconds is durability. Now, durability is very speculative.
What do I think is durable?
Sports, entertainment, media, food, data, pets, etc.
Examples: International Speedway (ISCA), DreamWorks Animation (DWA), John Wiley

(JW.A), Village Supermarket (VLGEA), Dun & Bradstreet (DNB), VCA Antech (WOOF),
etc.
Here I am talking about demand for the product – not the exact way it is delivered, etc.
Let’s look at some examples of companies that do something that might – even if they are
successful relative to competitors – not prove to be in demand forever.
Examples: Dell (DELL), Lexmark (LXK), Q-Logic (QLGC), Barnes & Noble (BKS), Haynes

Publishing, etc.
Notice how subjective this is. I have a bookseller – Barnes & Noble – listed as a durability risk.
Meanwhile, I have John Wiley listed as an example of a durable company – and it’s a publisher.
John Wiley earns very little from books. It sells some books. But the shareholder value clearly
comes from academic journal publishing. A lot of people – in academia, technology, etc. – think
that may not be a durable business, or at least the for-profit model for publishers may not be. I
disagree. And I expect the biggest publishers of academic journals will make a lot of money –
and nearly infinite returns on capital – for a long time to come. Pretty much forever, in fact.
You may disagree. And you may be right. It’s a speculative and subjective issue. I will –
however – add one more “s” word to the list. Scuttlebutt. Durability can sometimes be helped by
learning more about the customers. That’s the kind of thing I did with John Wiley. I came away
thinking it was a durable, essential product. In other cases – like Haynes Publishing – I came
away with the opposite conclusion.
It’s also important to make a distinction here between corporate durability, demand durability,
competitive durability, and profit durability.
Plenty of companies survive their products being obsoleted. This is normal. It’s part of the Phil
Fisher approach. In analyzing tech companies, you often assume the products will be made
obsolete and new products will be developed.
Demand durability means people want the product. Music has durable demand. I still hear tons
of music. People still crave tons of music. The business – of music publishing – makes money
for a couple companies who dominate it. But, the profits in that business turned out to be less
durable – they’ve declined even while the need they fill hasn’t changed one bit. People are pretty
much as addicted to music as ever. The dealers just make less money selling it.
Competitive durability is something I consider mostly in “moat”. Profit durability is why I have a
hard time understanding some commodity companies, financial companies, and almost
everything that makes money off the federal government (defense contractors are a rare
exception). I know their product will be needed. I’m less sure of the spread at which they’ll be
able to sell it. Often, it is unclear if competition and regulation could whittle down margins,
returns on capital, etc. The product is durable – the profit may not be. It can have really good
climates and really bad climates that last a decade or more at a time. Analysts can usually read
the industry tea leaves better than I can.
Moat
This is one of the most overused terms in value investing. Also, it’s one of the most important.
I think I see moats differently than a lot of folks. The biggest moats are around specific locations,
customers, standards, and habits.
I think advertising agencies have moats – with existing clients. I think some stores, mines, transit
systems have moats – in specific locations.
I see many more moats than the average investor. However, I see very few expandable moats.
This is partly due to my microcap focus. I look at things like “Hidden Champions”.
Plenty of companies can earn good returns on capital. They just can’t earn good returns on $1
billion of capital.
You pretty much have to be lucky to achieve that. You can’t just win. You have to win in an area
that can support a goliath. Microsoft has a moat around a huge business. There are other
companies similar to Microsoft. They are usually very small. It’s weird to have almost the whole
world – of businesses, consumers, etc. – running one system. But there are plenty of little
industries where people use one system.
I’ve already mentioned several companies – see my examples list – that have huge market share
in a specific industry or product (Dun & Bradstreet, Q-Logic, etc.) and in a specific location.
In addition to thinking about moats, I think about unique strategic assets. Is this company
something competitors, new entrants, etc. would rather buy than build. Do suppliers, customers,
etc. fear the company, try to create alliances against the company, want to prop up a competitor,
make a strategic investment, etc?.
If you look at the examples I gave – you’ll find a few examples where those clues were present.
You have a strong market position if customers and suppliers are obsessed with talking about
you instead of their own businesses.
One difference between how I see moats and how many investors see them is that I take a much
more favorable view of distribution based moats. In fact, I tend to think that standardization and
distribution are two of the biggest sources of moats.
Finally, I separate moats from product economics. Some products have better economics than
others. I try to focus on products where price consciousness is low, quality concerns are high,
etc.
Example: I tend to think that computer animated movies are simply better products than live
action movies. They have better economics. Maybe Pixar, DreamWorks, Blue Sky, Illumination,
etc,. can have wide moats or not. But a wide moat in live action is probably worth less than a
wide moat in computer animation.
An animated product simply has more potential to be unique.
But competition can ruin good product economics. The reverse is rarely true. If product
economics are extraordinarily poor – think steel – it’s hard to have such a strong competitive
position that you can overcome this. Location is an exception.
Like I’ve said before, I’d rather own the #2 razor blade company than the #1 steel company. It’s
important not to confuse slight advantages relative to competitors with a moat. The idea of a
moat is wider than just a peer comparison.
That’s only half the list. I’ll tackle the other four areas I look at:
4. Quality
6. Value
7. Growth
In my next article.
 URL: https://www.gurufocus.com/news/225133/7-areas-i-look-at-before-buying-a-stock
 Time: 2013
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How to Handle Stock Ideas
Someone emailed me asking how to do a stock analysis. What are the different parts? What is
most important? It’s a good topic. And I intended to answer it today – after explaining in my last
article that a good write-up is not the same thing as a good investment. But I realized I had to
deal with another topic first: how to handle stock ideas.
Before you can write-up a stock for your own purposes – and that’s what we’re talking about
here, not doing analysis for someone else – you need to have a stock in my mind. How do you
get a stock idea?
There are probably about 10,000 stocks to choose from in the U.S. There are at least that many –
probably more – available to you in the rest of the world. If you limit yourself to big stocks – say
$100 million or $200 in market cap or higher – you probably cut that number in half. But even if
– like many investors – you ignore microcaps entirely, you’re still talking about thousands and
thousands of stocks to choose from. Even an investor who ignores all micro caps and all non-
U.S. stocks will still have a few thousand stocks to choose from.
So stock ideas are plentiful. Good stock ideas may not be. I mentioned in a previous article that I
ran a backtest – looking back 15 years, my idea of a truly long-term investment – and found
about 700 American stocks that more than met my requirements for good returns in both relative
and absolute terms. That’s a backward looking test. You can only tell in retrospect that about 700
American stocks performed well enough from 1998 through 2013 to be labeled – in hindsight –
good stock ideas. It does, however, give you some idea of just how many good ideas there are. In
that case, more than 1 out of 20 stocks (in fact, closer to 1 out of 10 stocks) performed
adequately in both relative and absolute terms. This was a bad time period for U.S. stocks
generally. That made relative comparisons easy. But it made absolute returns hard to come by.
I don’t think you can call a stock idea a good one unless you expect it to return at least 10% a
year over the time you hold it – and it outperforms your benchmark. So, for many investors
reading this, that means you’re looking for a stock that can return 10% a year and beat the S&P
500.
That will be tough going forward, because I doubt the S&P 500 will return 10% a year in the
future. It may return that this year, next year, and the year after that. But if – as I like to do – we
think in terms of something like three years forward at the shortest and 15 years forward at the
longest – returns of 10% a year from here seem very unlikely. This is due to high prices. They
may be justified by low interest rates. But, will interest rates be as low in three to 15 years?
Probably not.
So the absolute return odds are stacked against us. In fact, it doesn’t look like a much more
opportune time to be picking stocks in the U.S. than it was back in 1998. Still, if we remember
my backtest, hundreds and hundreds of stocks performed well enough over the last 15 years to be
labeled “good stock ideas” in retrospect.
We’d expect at least an equal number of good ideas to be out there now. While I’m not
optimistic about the future for U.S. stocks – because they’re overpriced right now – I’m no more
pessimistic than I would be if presented with 1998 prices. So I’m sure there are at least as many
good ideas out there now as there were in 1998. Maybe more.
In ballpark numbers, we are probably looking for the best 1 idea out of 10. How hard is that to
find?
For a new investor – and a wide diversifier – it’s very hard. But there are some things you can do
immediately to improve your odds of zeroing in on good stock ideas.
Read these books:
· Joel Greenblatt ’s “You Can Be a Stock Market Genius”
· Peter Lynch’s “One Up On Wall Street” and “Beating the Street”
· Ben Graham’s “The Intelligent Investor”
· “There’s Always Something to Do”
· “Hidden Champions of the 21st Century”
· “The Outsiders”
The last two books will introduce you to two categories of stock ideas you might not have
considered before. The other books are more personal – and more practical.
The best way to get good stock ideas is very simple – and very hard for most investors reading
this to do. Basically, you have a group of other investors – a network of sorts – you know and
trust. You meet with them from time to time, you chat on the phone, you trade emails, etc. This
is by far the best way to get good stock ideas. It’s how many of the best ideas I’ve ever gotten
came to me – someone else (someone who knew me) suggested them.
Even Phil Fisher admitted that – in retrospect – his best ideas did not come from CEOs or
scientists. They came from other investors. They especially came from people who knew him.
This last part is critical. Stock ideas come in different flavors. It is no good giving a Ben Graham
idea to a Phil Fisher investor. It is no good suggesting a microcap to someone who has no
experience investing in them. I’ve tried talking to otherwise intelligent investors about net-nets
or foreign stocks or other things they’ve never sampled – there’s no point. It’s not the idea that
matters. It’s the connection between the idea and the investor.
You could try to get me to go to a great horror movie. You could do a great job pitching it. It
could be a great movie. It wouldn’t matter. I’m so extraordinarily unlikely to be interested –
there’s really no point in trying to pitch me something that far out of the kind of movie I enjoy.
It sounds silly, but investing works exactly the same way. We may prize ourselves on being open
minded. But, generally, we’re just fooling ourselves. Until you have some experience that bumps
up against the kind of interesting idea you’ve just run into – it’s not going to click with you. It
may be an interesting idea. But you won’t recognize it as such.
So you can’t leap genres entirely. You can’t try to find the best net-net ideas if you’ve never
explored that area of investing. What can you do?
You can stop reading general interest financial news, watching CNBC, Bloomberg, etc. This
time is better spent focusing on a few specific areas.
One, start reading value investing blogs.
Two, focus on negative news and other short-term worries. I am not a contrarian investor. I like
quality companies. But the best ideas are rarely those stocks that are in favor now.
Look for stocks that are being spun-off, that have hit temporary difficulties, etc. Think like a
contrarian.
Don’t look for bad businesses. Sometimes bad businesses will be so cheap they will be worth
buying. But that’s not what I’m suggesting when I say you should be a bit of a contrarian.
Look for stocks where the business, industry, and stock has perhaps performed poorly for the last
one year, three years or five years. Not 10 or 15 years. There’s a difference.
Spin-offs are a good example of this. They – since they’re kind of the opposite of IPOs – often
have performed worse, grown less and gotten less interest from analysts and investors in the last
three years or so. Not always much beyond that.
Remember the quote from Horace that Ben Graham used. Companies aren’t in favor or out of
favor forever. They are seen as good for one decade, then bad the next. Sometimes the
underlying business has changed a lot. More often, perspective has changed even more.
Doing all this – reading those books, trading all your general financial news reading for value
blog reading, and taking a contrary mindset – will probably only get you to the point where you
can pick maybe the best idea out of three. You can probably see which of three stocks is – at a
glance – likely to be most interesting.
I have a very fast – and very, very effective – shortcut for you. Put much of your effort into
historically profitable companies – a good test is 10 straight years of profits – trading at
reasonable multiples. Anything above 8 times EBITDA is not reasonable. It might be justified.
But it can only be justified by quality.
In tough times for stock, you’ll be able to find plenty of stocks – often unglamorous, but still
consistently profitable – hovering at closer to 5 times EBITDA than 8. At times like now –
expensive times for stocks – it’s hard enough finding consistently profitable companies trading
around 8 times EBITDA.
Why 8 times EBITDA?
Here’s a very quick rule of thumb. Take a stock’s EV/EBITDA. Double it. The normalized P/E
ratio will be less than that. It’s not a perfect rule. But it’s a very good tool to use. If you see a
stock trading at 7 times EBITDA, that’s probably a stock trading at no more than 14 times its
normal earnings – adjusted for leverage.
Because financial stocks, utilities, railroads, etc. use leverage – this rule won’t help you with
them. It will help you with industrial stocks. It’ll help you with most simple businesses – that
you don’t want to reward for added leverage – around the world.
You can also use a similar tool to approximate return on capital. I use a simple rule of thumb for
calculating net tangible assets and a company’s unleveraged ROE. Remember, I care about
owner earnings – not reported earnings under GAAP – that’s why I’m using EBITDA and NTA.
I take a stock’s inventory and receivables and PP&E. Then I subtract that stock’s accounts
payable and accrued expenses. The resulting difference – usually, but not always positive – is a
pretty good idea of the net tangible assets the business uses.
Take EBITDA. Divide by NTA. Then divide that number by 2. It’s a pretty good bet the
normalized return on equity – after-tax – of the business will be greater than that number.
For example, a stock with EBITDA of $2 a share and NTA (inventory plus receivables plus
PP&E minus accounts payable and accrued expenses) of $5 a share will have a normal return on
equity of at least 20%. Basically, the unleveraged return on equity will often be 20% or higher.
What about cash, debt, etc? You can cover that later in your analysis. At this point, you want to
know what the business earns – not what the corporation earns. They are too different questions.
The more permanent issue is the economics of the business. The way the corporation is financed
matters too – but it’s not the first thing you need to check.
Why mention these two rules?
I use them all the time. They cut to two of the most important questions you want to answer with
any stock.
How cheap is it? And how much does it return on the equity it uses?
What other questions matter?
Generally, growth and capital allocation. But their relationship is usually too hard to resolve
when you first spot a stock idea. A stock can be a good investment purely on its dividend yield.
It can be a good investment purely on its stock buyback. And it can be a good investment purely
on its growth. If growth is high enough – you don’t need the other two (though you do need
return on capital).
Is return on equity always important?
Almost always. It’s not important if the company redirects the capital. This is extraordinarily rare
in the wild. Read “The Outsiders” for examples – like Berkshire Hathaway
(BRK.B, Financial) and Teledyne – where this happened. It’s important to recognize these
situations when you see them. But they are so rare that if you buy a low ROE stock and hold it
for the long term, your results will tend to deteriorate – on an annualized basis – over time
because the company will reinvest too much in the business.
Companies almost always choose to grow more than what would actually serve shareholders
best. Your best defense against this is a high ROE. Another good defense is excellent capital
allocation.
At this point – after we’ve checked the EV/EBITDA and gotten some idea of the company’s
ROE – we have really transitioned into the start of our analysis.
Everyone has their own analytical checklist. Mine tends to focus on seven worries:
1. Understanding
2. Durability
3. Moat
4. Quality
6. Value
7. Growth
Should you use the same process?
It depends on how similar you are to me as an investor and how similar the stocks you analyze
are to the ones I analyze.
A lot of people put value and growth near the top of their checklist. For me, they are at the
bottom. I’ve basically ranked my analytical concerns from quickest way to kill and idea (No. 1 I
don’t understand it) to least likely to kill an investment idea (No. 8 it’s not going to grow at all).
I’m not going to buy something I don’t understand. Given the right circumstances, I’m totally
fine buying a company that doesn’t grow.
I’ll explain why when I run through the seven points of my analytical checklist in the next
article.
As far as handling the stock idea – and deciding whether or not to move on to analysis – there are
four questions you should always ask (and a zero question I find very helpful):
0. Who referred the idea to you?
1. Did the idea “click” with you?
2. Has the company been consistently profitable?
3. Is the EV/EBITDA reasonable?
4. Is the ROE (EBITDA/NTA) adequate?
If you like the answers to those questions, move on to analyzing the stock. If the stock already
falls flat in this first stage – it’ll be very hard to come up with convincing reasons to buy it
anyway. At least as a long-term investment.
Personally, I would scrap a stock idea that fails on these four points.
URL: https://www.gurufocus.com/news/225038/how-to-handle-stock-ideas
 Time: 2013
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Great Investments Make Boring Write-Ups
The best investment ideas are often the simplest. And the simplest investment ideas are often the
least interesting ones to read about. This is a problem for anyone who – like me – both invests
and writes about investing. The stocks that are most interesting to talk about are rarely the stocks
that I’m most likely to invest in.
I’ve been thinking about this topic for three reasons:
1. Someone emailed me asking how to create a good investment write-up for their own use.
2. Nate posted a “good idea, boring write-up” type stock at Oddball Stocks.
3. Value and Opportunity has a very interesting write-up – which ends with the decision not to
buy the stock.
Yesterday, I mentioned two stocks that would make wonderful write-up subjects – Carnival
(CCL) and DreamWorks Animation (DWA). I also said both were pretty hard to actually come
to a decision on. It wouldn’t be easy to decide whether or not to buy them. In the case of
DreamWorks, I thought intrinsic value would prove squishy and the deciding factor would be
certain speculative issues – like the value of their eventual TV(Netflix) series business and their
operations in China. With Carnival, I said that the price of oil was a major factor in the success
of that investment long-term. I consider that a speculative concern. If you knew what the price of
oil would be with any great certainty – there are a lot of ways other than investing in Carnival
where you could make money.
But it would be easy to write pages and pages and pages of analysis about both companies. The
industries are very public. You can easily gather data on every ship Carnival owns, every movie
DreamWorks has ever made, etc. There are easy comparisons with other public companies.
Books have been written about the companies. The economics, accounting, etc. of the businesses
are interesting subjects to dig into. They are fascinating companies. They’d make for great write-
ups. But would they be my first choice as an investment?
No. We can see this in the two stocks – both of which are much less interesting to read about –
that I do own. They are George Risk (RSKIA) and Ark Restaurants (ARKR). The rest of my
money is in cash. Right now, cash is about half of my account. That’s unusual. But it’s happened
before.
An investment analysis of George Risk – at the time I bought it – wouldn’t be very interesting. In
fact, you can read the 2009 write-up at Rational Walk for yourself. That’s a pretty good snapshot
of the investment case for the company – although the author concludes (in that blog post) that
it’s not a good investment because it lacks a catalyst. By the way, the last part has proven true. In
the following 4 years, there was no catalyst to unlock value. The stock rose 75% and paid out a
lot – like another 20% of the purchase price – in dividends since then.
This is a pretty good lesson on catalysts as well. They are obviously important since they can
greatly increase your annualized results by speeding up your holding time and getting you the
same end result. But are they a good subject for a write-up? Should you spend a lot of time on
catalysts?
In my experience, the answer is almost always no.
I bought Barnes & Noble (BKS) in 2010. I went to great lengths to look at the proxy fight,
Burkle, etc. Riggio won the proxy fight. Barnes & Noble invested much, much more heavily into
the Nook than I expected. After those two events, I judged that the risk to the stock had increased
a lot. I sold. A few years later – in 2013 – Barnes & Noble decided to scrap direct investment in
the Nook. And Riggio has said he wants to buy the company.
You see the problem. In 2010, you could have been asking yourself who will win the proxy
fight? Will Burkle try to buy the company? Will Riggio? And so on. You might be right or
wrong. Personally, I think no one could have predicted exactly how that proxy fight would end.
It was one of the closest – especially when you consider how some institutions decided to vote
their shares – I’ve ever seen. You probably could have predicted parts of it. There was a poison
pill and a court case on that issue. Those are things you can research and see what is likely. But
that was a proxy fight that was almost as hard to call as a political contest. And – if you
remember – it could have ended at the last moment with a negotiated settlement between the
parties, granting some board seats, etc.
I just think a catalyst like a proxy fight – while fascinating to read about – is awfully hard to
factor into your analysis. Its existence is relevant. It’s worth mentioning that anything could
happen as a result. And – if you’re dealing with a truly cheap company – action that stirs things
up in any way can be a positive. But most of the words that’ll be spent on the topic will be more
interesting than informative to an actual investor. The important parts are whether or not the
stock is cheap, whether it is a strategic asset in the industry, whether one or more parties are
interested in buying it, and whether a contest is underway.
Sticking with the Barnes & Noble case, you’ll then remember that – subsequent to my
investment – there were 3 other investors interested in owning part of the company: John
Malone, Microsoft (MSFT), and Pearson.
Could this have been foreseen?
I don’t think so. Not in exact terms. Again, the idea of Barnes & Noble as having some strategic
value – beyond pure financial interest for some companies – was clear. I mentioned that idea
when I wrote about the company. I felt that Amazon (AMZN) and Barnes & Noble were the
avenues other folks would need to get their books sold either in print or digital. Especially as
Borders was a much weaker competitor. And then Borders failed completely. If anything,
consolidation increased as shelf space for books decreased at general retailers, etc. So the
strategic value was something worth thinking about. But could you have guessed which partners
might be involved, on what terms, etc?
I think those questions would be way too hard to answer.
Barnes & Noble had a lot of catalysts and a lot of complexity. But maybe that’s specific to one
company. Let’s revisit a few of my other investments and see.
I owned a stock called IMS Health. I bought it on a pretty simple basis. I figured it was a wide
moat – really a monopoly in parts – business that was buying back its own shares using its high
free cash flow yield. That’s all. It had a double-digit free cash flow yield. And it was buying
back almost as much stock as its free cash flow would allow. This was in early 2009 – when
many companies were putting buybacks on hold. The stock was – for such a wide moat business
– very cheap. It probably sold for about half of what a company of that quality sells for in normal
times.
IMS Health never got to buy back most of those shares. Instead, they went private in an LBO.
What had been planned as a long-term investment – certainly something more like 3-5 years, as
Obamacare was in the news at this time and there was some other legal issues specific to privacy
concerns in some states – turned out to be more like 3 to 5 months. One sad part of this story is
the tax treatment. It was impossible for me – even holding till the deal closed – to make it past a
one year holding period.
Normally, if I hold a stock for less than one year it means I failed. I sold Barnes & Noble within
one year, because I was wrong. I was wrong about the risks and especially about their
willingness to lose large amounts of money – to burn cash – investing in Nook. So, I sold the
stock. I’ve held plenty of stocks for less than one year. They’ve rarely been winners.
I can give you one example of a case where the stock was a winner, I held it for less than one
year, it had a catalyst, and that catalyst could be analyzed.
That stock was Bancinsurance. To give you some idea of how I’d analyze it, you can see my
letter to the Board of Directors. I never talk to management of a company. Never, never, never.
It’s just something I feel isn’t necessary. And it’s obviously something you can do at microcaps.
Many microcap investors – Nate at Oddball Stocks, Richard Beddard at Share Sleuth, etc. like to
do it. And they may be right to do it. But I don’t do it.
If I don’t talk to management, you can bet I don’t write letters to boards. I did in that one special
case. I’m sure it had zero influence on the outcome. Regardless, it was a good outcome relative
to the original offer.
In that case, there was a clear catalyst. The CEO had made an offer to buy the company. I didn’t
feel it was a realistic offer in the sense that anyone could possibly appraise the company’s value
in a negotiated sale – to someone other than the CEO – at such a low level. That didn’t mean the
sale wouldn’t go through. There was a risk it would go through at that price (but you wouldn’t
lose money if it did – just time), there was a risk it wouldn’t go through (in which case, the stock
price would fall, but you’d be holding a stock trading well below intrinsic value), and then there
was a possible reward that you’d get in the form of an increased bid and a deal closing quickly
(like within a year and resulting in a high annualized return).
That is one case where I see how a write-up breaking down the situation in such probabilistic
terms – or at least laying out the possibilities – would make sense. As it turned out, such an
analysis would match actual events. You can see this by considering what kind of write-up you’d
create when the CEO first made the offer and then compare this to the board’s discussion – in the
merger document found at EDGAR – of the actual process, questions considered, offers made,
etc.
Bancinsurance was a special situation and could be analyzed as one. You could foresee the short-
term future in the sense that you could list some possibilities.
I never expected the actual outcome. It was much fairer to minority shareholders than I
anticipated. In my own mind – I put the odds of a deal at a token increase over the initial offer as
being the most likely outcome. So, I’m not sure I could have done a really accurate write-up. But
I could have laid out the possibilities that actually did come into play.
Next, let’s consider my basket of Japanese net-nets. There was no way I could do a write-up of
any of the companies involved in that one. It was a purely statistical exercise. It was a total Ben
Graham basket. It made sense to me. And it made sense to me to represent those investments – to
myself – as a simple pair of two rules:
1. Negative enterprise value (Cash > Market Cap)
2. 10 straight years of profits (No operating losses in the last decade)
And then a summary of each stock’s balance sheet and 10-year history. I knew what industries
they were in, what their dividend yields were, etc. But no decisions were made on that basis. And
attempting a write-up in words would have been intellectually dishonest. Those investments
were made using two rules, a couple rows of data, and a group approach. They are best explained
written in pen on a napkin not typed out over a few thousand words with charts and graphs.
I think that’s usually true. Warren Buffett says you should be able – before buying a stock – to
write out your reasons for buying it on one sheet of paper.
It’s probably one sheet of paper or less. It rarely makes for riveting reading. But if you are simple
in your math, clear in your logic, and honest about your emotions – nobody needs more than a
page to explain a great investment.
 URL: https://www.gurufocus.com/news/224892/great-investments-make-boring-writeups
 Time: 2013
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How to Frame an Investment Problem
We can break the investment process down into a few steps. One, you get an idea. Two, you
analyze the idea. Three, you choose whether or not to buy the stock. This makes it sound like the
last step is the only one that requires choosing. But you are actually choosing at each step along
the way. It’s rare to have only one potential stock idea – one candidate for research – on your
radar.
Choice starts from the very beginning of the investment process. And it’s hard. What makes
choosing hard?
As long as you keep your options open – as long as there doesn’t seem to be any risk of making a
mistake – choosing seems pretty easy. If I asked you to sit down and list 10 stocks you might be
interested in researching, you wouldn’t find that very taxing.
If I asked you to cross off one of those names, you’d find it a bit harder. If I asked you to cross
off 9 of those names – you’d find it very hard to do.
In a sense, though, that’s what you’re doing even at the very start of your investment process. It
takes me a good chunk of time to research a stock fully. Sometimes I’m focused on a single
stock for a few weeks. That means ignoring other stocks – crossing them off my list – during that
time. In that time, they might increase in price. Other ideas might appear. There are a lot of ways
that a stock – once I decide to put off researching it – might end up never getting my attention.
So how should you choose which ideas to focus on?
Circle of competence is a good place to start. How familiar are you with this kind of company?
The more familiar you are, the better a place this might be to start. Conspicuous cheapness is
another. If a stock doesn’t look obviously cheap, you might be wasting your time. You’ll find it’s
wonderful in many respects – almost all respects – other than price. Often that means you’ll learn
a lot about the company, but you still won’t buy the stock. This is a dead end to avoid if you
have stocks that are obviously cheap you’re also interested in.
The next question is a process question. It’s a matter of specialization. Do you know how to
analyze net-nets? Have you done it before? Do you have an explicit checklist? An unwritten
routine?
If you do, net-nets are a good place for you to start.
Process itself is a matter of choices. It starts with framing the problem. This is one of the biggest
parts of the investment process. A lot of investors probably don’t give it much thought. But it
determines how long your research will take and how clear a conclusion you’ll be able to come
to.
Framing the problem means trying to define – often in simple, logical terms – the basis on which
you will or won’t make an investment. Comparing a new stock to a stock you already own is a
good way to frame the problem.
I’ve mentioned a stock I own – George Risk (RSKIA, Financial) – as an example of this

framing before. When I first bought the stock, it was trading a bit below net cash. And I thought
it was a fairly high quality company. So once the stock was in my portfolio the test that any new
stock had to pass was simple:
Does this stock trade below net cash?
OR is this stock higher quality than George Risk?
If the answer to both questions seemed – at first glance – to be no, then that was probably a stock
it wasn’t worth following up on. After all, I could just buy more of the stock I owned and knew
better.
If the stock passed one of the two tests – for example, it traded below net cash but was lower
quality than George Risk – then it might warrant a follow up. In that situation, the difference is
easier to quantify. Something that’s easy to quantify is often easier to analyze immediately. So, if
the stock was trading at a 10% discount to net cash while George Risk was trading at only a 5%
discount, any deficiency in the quality of the company would probably eliminate it. A small
quality difference can easily make up for such a tiny discrepancy in price.
Qualitative differences are harder to immediately analyze. So they’re usually not the first way
you want to frame a problem. And when you do frame a problem using a qualitative distinction,
it’s often best to use a relative distinction.
One of my favorite tests of whether a stock is worth researching is a combination of two

questions – both of which must be answered in the affirmative:
Is it an above average business?
Is it selling for a below average price?
Here we have two questions that can be answered relative to something else. Is it an above
average business? That’s often easy enough to answer in cases of clear quality. Is Copart
(CPRT) an above average business?
I think so.
Is Carnival (CCL, Financial)?
That’s hard to say. Lately, the financial results suggest not. The competitive position – and
performance before oil prices rose in the early 2000s – would say definitely yes. And so that’s
how you’d have to elaborate on that analysis. It would quickly become a question of framing
where you are looking at whether the future will be like the recent past, the distant past, or none
of the above.
Personally, I find that frame a tough one to provide a clear conclusion. It involves issues like oil
prices. Parts of the analysis are easy enough to answer. For example, the capacity of the industry
– the supply of beds for passengers – is very easy to answer. There are only a few major
competitors, and they all provide details about what ships they have contracted for several years
out.
In most industries, you wouldn’t be able to predict supply so well. In the cruise industry, it’s very
easy.
But, in most industries, you’d be able to predict input costs – here, we’re talking bunker fuel – a
lot better than at Carnival. Carnival doesn’t control that cost. And – if you could predict oil
prices – why not make money in oil futures, oil stocks, airlines, etc. rather than betting on
Carnival’s stock price.
This doesn’t mean you can’t invest in Carnival. But, for me, it means that framing the problem
so that I know Carnival is an above average business is too hard. As a result, when the stock
trades much above book value – as it almost always does – it is probably too hard an analytical
problem to solve.
You don’t need to do a full analysis over several weeks to realize that problem. It is clear when
you choose the frame to see the problem through. If you know the price-to-book is well above 1,
then you know you need to believe this is clearly a high quality company. Otherwise, there’s no
margin of safety. This framing choice allows you to decide quickly whether the stock is worthy
of a deep analysis. If it’s a company you can evaluate qualitatively or it’s trading well below
book value, an analysis shouldn’t be hard.
We can see a similar price issue with DreamWorks (DWA, Financial). Right now, I think the
company is way too hard to analyze as a stock. This isn’t because the business’s competitive
position, etc. is especially difficult to evaluate. It’s because intrinsic value is very squishy here.
You have to choose a number – a line in the sand – that you can hypothetically prove the stock is
more valuable than.
It would be very hard to prove DreamWorks is clearly worth more than $24 a share. It would be
easy to prove it is worth more than $12 a share. I don’t mean you need to do the analysis to prove
this. You actually don’t – at first – need to look very hard at DreamWorks to figure out the actual
intrinsic value. That’s not necessary. What is fairly easy to do is to look at the existing intangible
assets – not what’s on the books, but what economic assets you think the company actually has
in terms of franchise rights, etc. – and compare this to the stock price.
The stock might be worth more than it currently trades for. But, if it is, it’s because of the ability
to make money in TV (or with Netflix) and in foreign countries that are growing fast.
It’s not hard to frame an analysis in a way where you can dig into exactly what DreamWorks is
worth – and possibly prove it is worth well over $20 a share. But it will have to be a speculative
– forward looking – analysis. It will have to depend on questions like:
· How much do I think Kung Fu Panda 3 (etc.) can make in China?
· Can DreamWorks exploit the Classic Media content it bought?
· Will the Chinese joint venture create a lot of value?
These are speculative questions. They are growth oriented. They aren’t value oriented. That
doesn’t mean they are wrong. It just means that unless you are prepared to ask and answer
speculative questions – you probably shouldn’t follow up on this stock at this price.
You can see that immediately if you think about how to frame your analysis. The way you frame
an analysis is by asking:
· What questions will I have to get answers to – and what will those answers have to be – to
prove I should buy this stock?
· And what questions could I ask – and what answers could I get to those questions – that would
prove I should not buy the stock?
In other words, what would make this stock rocket to the top of your favorite investments list?
And what would kill the idea?
This is something you can see in how you initially frame the problem.
That probably sounds wrong to you. It probably sounds like you should gather all the evidence –
without any questions, theories, etc. – and then analyze the data.
That sounds scientific.
But it’s not. The best approach is first to design an experiment. And only then gather the data.
The idea of evidence independent of a theory to hang it on is appealing – but it’s not practical.
For one thing, there’s simply too much data to gather. Simply by picking a dozen areas of
interest about how some company works you’ll be closing off much of what you could be
analyzing.
I don’t consider a dozen different factors when making an investment. I always narrow it down
further than that. My point is that even if I did go as absurdly wide as trying to answer 12
questions at once – just deciding on those 12 questions is already applying a frame. It’s already
deciding how you will see the problem. What you will investigate.
You might think you don’t design a frame for each investment problem you face. In that case,
it’s very likely you are just using the same frame over and over again. You are applying one
frame to all problems. You approach every investment like a net-net, like a wide moat company,
like a growth company, etc.
That might be fine for you. In fact, I think that is fine – if you know you’re specializing. Some
investors have a few frames they use by rote. A common combo is Ben Graham style value
stocks and special situations. The two frames are different. But they tend to appeal to the same
sorts of investors.
Most of the great investors you’ve read about:
· Warren Buffett
· Charlie Munger
· Ben Graham
· Phil Fisher
· Joel Greenblatt
· Peter Lynch
Had only a few frames. Some had basically one (Phil Fisher). Some had a couple (Ben Graham
had net-nets and special situations).
For a good discussion of different frames, read Peter Lynch’s books. He breaks down his
investments into a sort of playbook of different types of situations. This is probably something he
had to do because his favorite investments – small, growing companies – were not a good way to
make money with a big fund.
Warren Buffett evolved into using different frames over time. Much of that evolution – again –
was probably spurred by the necessity of managing large amounts of money.
Individual investors don’t face this problem. If you’re really great at solving problems framed as
special situations (thinking like an arbitrageur) then go for it.
There are a few keys to framing investment problems:
1. Monitor your actual behavior – make your favorite categories explicit
2. Admit when you are using a favorite frame – accept man with a hammer syndrome applies to
you too
3. Don’t force yourself to use a certain frame out of a desire to impose a certain self-identity
This last one sounds odd. I think it’s the most important. Some folks want to see themselves as
long-term investors focused on moats – but their actual actions tell a different story. This is why
monitoring your behavior is key.
A record is a mirror. It forces you to see yourself as you are rather than as you’d like to see
yourself. You can always change your actual self to better mesh with what you want to be.
But that’s not the same as trying to force yourself into framing problems a certain way – because
you want to be like Charlie Munger.
If your transaction log shows you invest like Ben Graham and your self-identity says you’re a
Charlie Munger style investor – you’re in trouble. You probably aren’t admitting the frames you
actual use. You are using a lot of unspoken process rules rather than making your process
explicit.
Once you monitor and break down your actual analytical process you’ll be able to see the frames
you really use. And you’ll be able to focus your efforts on honing the tools you actually use – not
the ones you claim to use.
See Ben Graham’s “The Intelligent Investor” for a good example of this. Graham started out
doing all sorts of things. He even did long/short pairs. He realized only a few categories – net-
nets, special situations, and control investments – drove almost all of his returns. He decided to
focus on those frames.
You can do the same.
 URL: https://www.gurufocus.com/news/224819/how-to-frame-an-investment-problem
 Time: 2013
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Microcaps: Should You Fear Controlled Companies?
One of my favorite value investing blogs, Oddball Stocks, recently did a post called “Why Micro
Caps”? It’s a good post. And a good question. I don’t look at big cap stocks any more than I look
at micro caps. How odd is this?
Let’s quantify. I don’t have exact figures in front of me – but I’m pretty sure I can ballpark this. I
would put the median market cap in the U.S. at around $150 million or so. In my experience –
and this depends what databases you are screening in – if you use a dividing line of a $100
million market cap, you’ll find most public companies in the U.S. will be above that line. You’ll
get more non-microcaps than microcaps in your sample if you define a microcap as a stock under
$100 million. If you define it as a stock under $200 million in market cap, you’ll tend to get
more microcaps than non-microcaps. Therefore, the median is probably somewhere in between.
I’m talking very roughly here. I run actual screens – I don’t test for what the median market cap
in a database is. But, in my experience, whether I screen for quality or cheapness or years of
history or any other quirky metric I can think of – I tend to find that about half the companies in
that screen have a market cap under $200 million. Maybe more than half.
For a lot of investors, $200 million sounds like a small company. A market cap of $100 million
certainly does. And yet, in the U.S., that’s a “normal” market cap. It’s pretty average.
That means the vast majority of most people’s time is spent thinking about a small minority of
publicly traded companies.
For me, big cap value investing is either taking advantage of:
· Negative headlines (stock specific fear)
· Cheap markets (country specific fear)
Fear is perhaps too strong a word. Sometimes it’s more like malaise. Or fatigue. But it’s often a
matter of being greedy when others are fearful – or interested when others are bored.
When I’ve bought big cap stocks – like in early 2009 – they’ve tended to fit that mold. When
I’ve bought a basket of stocks – even if they were microcaps – like in Japan, they fit the country
specific category. Japan’s stocks had done badly for decades. Then there was a natural disaster.
Then there was a nuclear disaster. I bought after those events.
Even then, I bought microcaps.
Why?
I actually started by looking at pretty big Japanese companies. Especially exporters. Most – with
the exception of something like Nintendo – didn’t interest me. They were not as cheap as small,
domestically oriented Japanese companies. They were complex. And their management was at
least as difficult to understand. What I could understand – like capital allocation – I didn’t like.
This also tends to be true for me in Europe. Given a choice between large or small French
companies – I’d buy the small ones. This is true regardless of price. Having spent some time
looking at large and small French companies, I have zero preference for the large. I’m sure there
are some wonderful large French companies. But there’s no reason for me to pay a premium for
them. I like the management of the small companies at least as much. Much of what I don’t like
about French business is as much an issue – I actually think a bigger issue – in their largest
corporations.
Is this true in the United States?
I’m not sure. My biggest concern from a management perspective in the U.S. is always the same.
I’m worried about short-sightedness and a focus on what Wall Street wants. In theory, this is less
of an issue at small companies than large companies.
However, there are reasons a small company’s management might not care about shareholders.
The result would be equally bad. Ideally, I want management to be focused on increasing value
longer term for shareholders. If they don’t care about shareholder value at all, that’s bad. And if
they care about the short-term too much – as many American CEOs do – that’s bad too.
Overwhelmingly, this has lead me to prefer situations where there is a controlling shareholder.
Even when I have mentioned larger American companies – DreamWorks (DWA), Berkshire,
Carnival, John Wiley (JW.A), even Barnes & Noble – they have controlling shareholders.
Barnes & Noble may be a clear example where a controlling shareholder can be a bad thing. The
proxy fight was a big part of my investment thesis. Riggio’s victory – and decision to stick with
the Nook, since reversed – were what made me sell that investment.
These are some of the negatives people list about microcaps. Management can screw you. To be
honest, my view is that management can always screw you. A CEO who can push through
dilutive mergers etc. – whether that means they are using soft powers of persuasion with a board
or actual votes they control in a shareholder meeting – is the greatest threat to you as a
shareholder.
When you look at cases like Time Warner and AOL, Hewlett-Packard (HPQ), Yahoo
(YHOO), Dell (DELL), etc. I find it hard to say that being a big or small stock – having a
controlling shareholder or not – is what determines the harm a board can do.
In my experience, there are really 4 factors that determine how you will be treated by
management:
· Worldview
· Honor
· Shame
· Laws
All managers – like all people – have certain worldviews. They are sometime upfront about
them. If you invest with Jeff Bezos and expect quick profits and instead get losses – that’s your
fault, not his. He’s been very upfront about how Amazon (AMZN) is run.
Many microcaps are not run with optimal leverage. They sometimes have debt when they buy
things. They often pay this down. Families frequently prefer to operate at around an even net
debt/net cash position.
Honor is integrity. I mean this in the personal sense. How someone behaves when they aren’t
sure if someone else is looking. Some CEOs like to get paid a lot, but don’t like to take money
when the company does poorly. They want options. You may not agree with that approach. But
it may fit their sense of honor. I can’t think of many extreme examples of honor and candor –
they usually go together. But I can think of a few. I know of one microcap CEO who warned his
shareholders that he was worried the company’s stock price was getting too high and new
shareholders would be disappointed even if the company executed well. In big caps, Warren
Buffett is the classic example.
Shame is probably the most effective regulator of management mistreatment of shareholders.

This is why I try to avoid countries perceived to have high corruption. A corrupt manager in a
society with low corruption is ashamed. Anyone who participates – or even has knowledge – of
such corruption is conflicted. They know they are doing wrong. And they know they can’t just
claim everyone else does it, it’s normal. In less corrupt societies, corruption is shameful. It
actually eats away at you.
In corrupt societies, not so much. You may be more concerned with jail time. This doesn’t sound
like a big issue – but it actually is. It’s a huge issue with the folks on the periphery of any
corruption – lawyers, accountants, people who come across fraud when checking what seems to
be a data entry error. How do they react?
In China – a corrupt country – there were several major accounting scandals. There have been
accounting scandals in societies perceived as less corrupt like the U.S. and even Japan.
That’s not the problem. Bad people can do bad things anywhere. The problem is how some of
that fraud was carried out in China.
The egregious part of these frauds was that – for several years – the accountants had not
independently verified bank account of the company with the actual banks.
I mentioned my Mom was part of the top management of a family controlled company – a
couple brothers owned 90% of this company – when I was growing up. There were no outside
shareholders in this company. Only employees and executives owned stock. The auditor was not
a big accounting firm.
They always verified the accounts with the bank – they never allowed communication from the
company directly. You couldn’t have the bank mail a document to the company and then have
the company mail it to the bank.
Why did they do this?
They weren’t better people than auditors in other countries. They weren’t under a lot more
scrutiny. In fact, for most of the history of this company, the audits weren’t even being used by
outside parties. At times, banks were using them.
These were habits. They were things that could be broken – maybe would be broken with enough
incentive – but they were clearly creating a line between normal procedure and this is something
shameful for me to do.
I always worry about this in countries where foreigners are the main investors in the companies.
It seems a lot easier to defend mistreatment of shareholders when they aren’t local.
To reiterate, I don’t avoid countries with high corruption because I’m worried about
management. I actually avoid countries with high corruption because I’m worried that folks on
the outside – employees who come across evidence of this corruption, lawyers, accountants,
bankers, etc. – are less likely to react in a way that imposes a heavy social cost on any
misconduct.
You can be corrupt in any country. You can only be corrupt with a clear conscience in a society
that is less likely to treat corruption as something truly shameful.
Laws are the last defense. I think they – I’m speaking mostly from my experience in the U.S.
here – may help with board behavior. When I say laws, I mostly mean getting sued. Don’t
confuse laws with justice. In almost all cases I can think of, the laws probably encouraged a good
process – never a good outcome. Cynically, you could say laws ensure a show of process not
equitable treatment.
But a show of process at least requires people to go through some steps. They at least have to
justify things to others. And – most importantly – to themselves.
When you treat someone badly, you must convince yourself that it’s okay to do so. That you’re
not really such a bad person. You may be taking a bad action. But it’s necessary. You may be
taking a bribe – but everyone does that. You may be paying the CEO way too much – but look at
that compensation comparison with peers.
This is the last point I’ll make. Conduct is relatively moral. It’s not absolutely moral. With very
rare exceptions, people don’t set out to be good. They set out to be good enough.
This depends a lot on your perspective. Personally, I feel shareholders are too quick to condemn
management as people. They believe them to be immoral when generally they are behaving
much as anyone in that situation might.
The problem is situational. You are a shareholder – you want your dividends. You don’t want the
company piling up cash for no reason.
The CEO of a microcap company sees it differently. Maybe he owns stock. Maybe he cares (a
little) about you, his shareholders. But he also cares a great deal about the survival of his
business. He probably does not want to fire people when there is a slight downturn. He may have
– you’ll have to investigate this – lived through times when the company was in constant contact
with bankers and survival didn’t seem so assured.
I mentioned Carnival earlier in this article. Carnival – before it went public – was not an
investment grade company. It was often very short of funds. It relied a lot on customer deposits.
This history is never entirely absent from the mind of folks – like the Chairman of the company
today – who were with the company back then.
If you read a book by Richard Branson, you know how close he came to ruin because of his
company’s early borrowing. Logic won’t erase memory.
It is easier for shareholders to forget that management has a lot of different desires – a lot of
different fears. They probably want to be the best in their industry, they probably want to keep
their job, they definitely don’t want to fire people, etc.
Some of these desires conflict with yours. For example, the best way not to fire people is to grow
unit volume. Virtually every company – regardless of what they actually say – really does, deep
down want to grow unit volume every year. They would like to do more business. They would
even give up a smidge of profit (unconsciously perhaps) and accept a lower return on your
investment if it meant they could always be increasing the workforce – always be having some
room for upward mobility – and always providing a bit of job security.
A shrinking company lacks that.
The math for shareholders is different. I’ve often looked at a company and what it was doing and
decided that it frankly wouldn’t matter to my investment if they grew or paid out a dividend or
bought back stock.
It matters to the company. Just like it matters whether they have a few years’ worth of free cash
flow piled up.
Managers – like investors – are as lazy as they can afford to be. They will try to do as little hard
decision making and make themselves as safe as possible. That means they will give in to habits
and inertia.
In my experience, the best way for investors to deal with this is to use past actions – not future
projections – as their guide. To me, the character of management is the sum total of their past
actions.
This is as true in microcaps as in big caps. If you are looking at a microcap with a controlling
shareholder – as I often am – it’s way more important. That’s because management at a major
American company is only going to last something like 5 years. By the time you have much of a
record to go on, that guy will be gone. And the board generally doesn’t warn you who will
replace him.
That’s why I’ve not found that management at microcaps is worse than at big caps. It’s just more
concentrated. A very bad manager at a very small company can do terrible things. At a large
company, unless they are engage in a lot of M&A – especially issuing shares – they simply have
less ability to alter the existing institutional inertia. Big companies turn slowly. So they’re pilots
matter less.
Managers matter more at small companies – for better or worse.
 URL: https://www.gurufocus.com/news/224766/microcaps-should-you-fear-controlled-
companies
 Time: 2013
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Familiarity: Stretching Your Circle of Competence
Two of the first factors I look at when deciding whether to follow a particular stock “lead” or not
are conspicuous cheapness – which I wrote about yesterday – and circle of competence. I’ll be
writing about that today. The term is obviously Warren Buffett ’s. I’ll also use “familiarity” to
mean much the same – but not quite the same – thing.
Here’s how I think of it. You have a web of ideas in your mind. In the center of that web there
are a few key ideas you know really well. They have a lot of strings shooting out of them – and a
lot of strings attach to them. There are dense connections here in the center. So, when I talk
about stocks you’ve owned for years and years, industries you’ve analyzed a few times before,
places you’ve worked, etc., these are in the midst of your web and connected to many related
ideas.
When I say “familiarity” I mean these strands shooting off from this idea and connecting it to all
these other ideas. I’m talking about relations. You can see how some idea relates to others. You
can see how some company relates to others.
Now, a company is a complex thing. So, we can often think of a company not as a single object
with a single aspect – but rather a single object with several aspects.
Think of the face of someone you know. Maybe you can talk about the face generally. But you
can also break it down into eyes and ears and mouth and nose. And especially the way those
parts are different – unusual, noteworthy – from similar elements of other faces.
Stocks and companies can be like that. But if you noticed I didn’t say “parts” or “elements;” I
said “aspects” of an object. Why would I think about familiarity in terms of aspects? What does
that mean?
To me, an aspect implies a bit more subjectivity. It suggests the presence of something – sure –
but it also suggests a way of looking at that thing. Companies – and stocks – are too complex to
be broken down into the same few parts every time. We can’t carve them up analytically leaving
nothing out and carefully considering – in equal measure – all the parts we have separated out.
Instead, we have to come to each company, industry, etc., with a few key things we focus on. I
don’t want to put any magic number on how many aspects we’re likely to consider. However,
five to 10 is a lot more likely than 50 to 100. If you think you’re keeping 50 to 100 ideas in your
mind at once when considering a stock – you’re doing it differently than I do it.
Now, you may consider something like 50 to 100 different issues for a moment when analyzing a
stock. If you do, you are probably doing this in a checklist fashion – and not at the same time.
You aren’t trying to see how 50 different items relate to each other. Rather, you are – one at a
time – ticking off 50 different rote concerns you have with stocks generally (what is total debt to
EBITDA, what is the F-Score, how long has management been at the company, what is R&D
spending as a percent of sales, what is market share, etc.). You can’t really be relating all those
ideas in any ways. You’re just – at that point – running through a list of independent questions.
That’s not what I’m talking about when I’m talking about familiarity. Familiarity – circle of
competence – is above all a way of framing things, of seeing things.
One of the biggest differences between situations within your circle of competence and situations
outside your circle of competence is the extent to which you can work at a higher level. When
looking at situations far outside your circle of competence you definitely can tick off 50 or 100
possible problems. But you can’t put them together.
When you’re working inside your circle of competence you tend to work much more with
analogs. You tend to see how this situation is similar to other situations you’ve seen before. And
you tend to take whole chunks of relations – mostly unaltered, but perhaps slightly reshaped –
from other situations you’ve seen and apply them to this one.
Basically, you use metaphors.
The best metaphors are always the ones you come up with yourself. These are the ones you
shouldn’t doubt. They are unlikely to be bad metaphors because people are lazy and rarely invent
terms of their own to use in situations where a technical jargon they know already exists.
Take this article for instance. I’m using Warren Buffett’s idea of a “circle of competence”. That
should make you worry. It’s his idea. Not mine. I’m stealing from him. Is that good or bad?
Generally, it’s bad. While it’s good to steal ideas from other people – other people’s ideas aren’t
as internalized for you. You have the definition of what they mean. You may even have some
examples in mind. But, let’s face it, Warren Buffett knows “circle of competence” better than
you do, because Warren Buffett kept bumping up against the idea in his work – kept turning it
over in his mind, sharpening his thoughts on the subject – till he invented the term. So Buffett
knows circle of competence better than you do.
I use lots and lots of ideas that were invented by other people – circle of competence, moat,
hidden champion, margin of safety, etc. This is fine. But you want to be careful. Using the
accepted jargon of a profession – like value investing – is not really a sign you understand what
you’re talking about.
When you find situations where you can’t quite articulate your ideas in that jargon – but have to
rely on past examples from your own analysis of companies – that’s where you probably are
closer to the center of your circle of competence.
Familiarity to me is about how far you have to take an idea – a bit of knowledge – from the place
where it’s all connected right now to the place you’re learning about. In other words, how hard is
it to take this idea sitting near the center of my web of relations and move it over to this new
stock I’m learning about?
Understanding is transferring old ideas to new situations.
When I say you’re familiar with a company – I don’t really mean you know that company well.
Generally, we’re talking about companies, industries, etc., that aren’t as well known to you as
stocks you already own. That’s just how investing works. Otherwise, you’d be going over the
same stocks again and again.
What I’m saying when I say something is familiar is that it’s got some strands of thought
connecting it to stuff I do know. These strands can help me work by analogy and take something
on the edge of my web of knowledge and tie it in to the stuff at the center.
Let’s use the examples I mentioned in a recent article:

· Thermador
· Logistec
I said Thermador (THEP, Financial) was more familiar to me. I don’t know either stock. But, if I
had to start with one – since they are both conspicuously cheap – I’d start with the one I thought
I could get to know faster. That was Thermador.
Why?
I’m an American. So, you’d think that a company operating in Canada and the U.S. would be a
shorter stretch for me. Logistec is that company. So why didn’t I pick Logistec?
First of all, it’s a port operator that doesn’t operate the ports I know best. I grew up in New
Jersey. So, I know the “Port of New York and New Jersey” best. When I think port, that’s what I
think. To be fair, so do a lot of people. It’s big and iconic. I think it’s one of the biggest natural
harbors in the world. It’s still an important economic area today. And, historically, it was of
immense importance.
If you say “port” to me, I start with my ideas about New York (really New Jersey since that’s the
side I’m from). Some of you might. A lot of you won’t. If you’re from Asia – I don’t think you
will (there are plenty of big Asian ports to think of). If you grew up near a port, I’m sure that’s
the one you’ll see in your brain – whether it’s Baltimore or Miami or wherever – you won’t start
with New York.
I’m not saying that when you say port, I say the words “New York” or “New Jersey”. I’m saying
I start with that idea. Then as you describe the size, location, type of cargo, etc. I alter my idea
(which is really just the port of New York) and shave away at it till my round peg fits in your
square hole. I go as far as needed in altering my idea to make it congruent with what you seem to
be describing to me. I take an existing example and then resolve the clashes.
That’s what I mean when I say we think in metaphors.
This brings me to the next important topic. When we talk about an idea we often define it. That’s
okay. But it’s somewhat misleading.
Think of the word “grandmother”.
We can define it – I’m not using a dictionary here, so it may be a pretty bad definition – as “a
woman who has a child who has a child”. That’s a grandmother.
It’s a clear, technical definition. It’s a rule. You can either pass or fail when put up against it. I
am not a woman. You don’t need to know anything more about me to know I’m not a
grandmother. A woman without a child fails the test immediately as well. And so on. It looks
like the definition works.
And it does. But it also hides something about how we actually think about “grandmother”.
Can two people – both demonstrably grandmothers by our definition – be unequally

grandmotherly?
Yes.
If I gave you two names of grandmothers – one in her 50s and best known to you as a movie star
– and one in her 70s and retired for many years, you’d definitely say the second one is more
grandmotherly. You’d say this even as you acknowledged that they are both grandmothers. Both
meet the definition of grandmothers, but one is more of a grandmother than the other.
This is true for almost everything. We can design experiments where we ask people to define a
chair, show them two chairs, get them to admit both are chairs, and then find that a strong
majority of the people – when forced to choose – say one chair is more of a chair than the other.
The fact they won’t split 50-50 is important. It proves an idea is more than a definition. It may
come with a definition. But that’s not all it comes with.
This is much more important to investing than you might think.
Thermador and Logistec are good examples of that. The Value and Opportunity post says –
explicitly – several things that bring analogs to my mind:
· Hidden Champion
· Boss Screener
· Wholesaler
I’ve talked about “hidden champions” many times. I’ve read the two books – the second is just
an updated edition of the first – on the subject. I think it’s one of the best investing books out
there (even though it isn’t marketed as an investing book). I think a “hidden champion” is a
powerful idea. A good metaphor. So, I have a huge store of examples of hidden champions in my
brain. And I’m always looking for more.
Boss screener is a term that’s specific to Value and Opportunity. I read the blog. So I know what
kind of stocks tend to appear on that screen. So, immediately, when I hear a stock scores high on
that specific screen – a bunch of ideas leap to mind. Basically, I have a stereotype of a “boss
screen” company in my mind just like I have a stereotype of a “hidden champion” in my mind.
Finally, wholesaler. Now, I have to admit that this one is not explicit. I actually didn’t think
“wholesaler” when I read what Value and Opportunity wrote. In my mind, I rejiggered what was
said to fit “distributor”.
Why?
The bullet points that Value and Opportunity lists are more consistent – to me – with a company
like say Parker-Hannifin (PH, Financial) than with someone like a wholesaler of computers,
etc. to the federal government. Both are wholesalers – but their business is actually quite
different.
Why?
There are a few reasons. The biggest is the number of customers. A distributor that might interest
me is one that sells to a large number of usually smaller customers. Now, this gets a little
complicated. In fact, the size of the companies is not what’s important. The size of their
purchasing of specific product categories is important.
The next question is price or availability. A distributor becomes more interesting – to an investor
– to the extent that wide selection, immediate availability, quick delivery, and integration with
customer inventory systems increases. When all factors combine, you tend to have a very wide
moat.
For a bunch of reasons, distribution tends to be a choke point. Within a local region – like France
– one distributor, once established, can snowball in its competitive advantages.
Distribution often goes unnoticed by the general public. For example, the movie business – the
studios – are based entirely on their distribution positions. But if you read about the movie
business, you’re mostly going to be reading about production.
Again, this doesn’t mean Thermador is a good company to investigate. It just means that the
combination of the blog post saying it’s:
1. A hidden champion
2. Ranked highly on the boss screener
3. A distributor
Triggered 3 different ideas for me. It brought up existing examples I could work from. It gave
me a way to tie this new company to the web of ideas I already have in my mind.
That’s what I mean by familiarity. And that’s how you stretch your circle of competence. You
take concepts you know and you look at things you don’t know, but that could possibly be tied to
what you do know. Then you try to transfer the knowledge you’ve got in the center of that web
along those metaphorical strands and connect new ideas to the existing web.
When you see lots of possibilities for making connections, you start with that company. Where
you see few possibilities, you put that stock aside for now.
 URL: https://www.gurufocus.com/news/224618/familiarity-stretching-your-circle-of-
competence
 Time: 2013
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Thinking in Alternatives: New Stock vs. Old Stock
The main cost in investing is usually your opportunity costs. Opportunities are hard to define.
And hard to measure. But a simple approach of listing actual examples of other options you are
considering can help you frame problems in a way that makes thinking in alternatives a natural
habit for you.
Warren Buffett and Charlie Munger have talked about thinking in alternatives. A good example
is when Warren Buffett says that Wells Fargo (WFC) is the bar against which a new investment
is measured. What he means is that before buying a big, new position – like IBM
(IBM, Financial) – he asks himself how that purchase compares to adding to his favorite stock
already in his portfolio. For the last few years, that stock has often been Wells Fargo.
I own a couple stocks: George Risk (RSKIA) and Ark Restaurants (ARKR).
I bought George Risk several years ago – at a much lower price. It is up over 60% in that time.
And, also in that time, the CEO died. While neither the higher than 60% price increase nor the
death of who I thought was an excellent CEO made me want to sell the investment, it obviously
makes it a less attractive investment than when I first bought it.
Ark Restaurants is a different story. The stock price is not much different from where I bought it.
Certainly not different enough to alter my view of whether it’s worth putting money in. Because
I bought the stock, we know that at one time I thought it was the best investment I could make.
What has changed since then?
Not much. The company rejected a takeover offer. After that rejection, there was no follow up
from the would-be acquirer. That makes sense considering the amount of stock insiders own at
Ark. If they don’t want to sell, there’s little point in trying to convince all the other shareholders.
Little has changed at Ark since I bought the stock – very little that would make me change my
view of the stock. Meanwhile, prices of other stocks I like are up a lot more. Overall, this makes
the stock a good choice for my “best alternative” already in the portfolio.
That’s our first example of an alternative. We can use it as a thinking tool. Whenever I find a
stock I’m interested in – I can compare it to Ark. How can I compare it?
Well, to start with, I will always know a lot less about the company I’m considering starting
research on then I do about Ark. So, it’s always an unfair comparison at first. I don’t know the
strengths – or weaknesses – of the new business when I start. I can, however, do a quick
comparison of some jot checklist type questions. Asking yourself how expensive a new stock
you’re considering investigating further is relative to the favorite stock you already own is a
quick and easy exercise. It can also splash some cold water on your face when you are veering
too far from value investing.
Here we will define value investing as paying low multiples of price-to-assets and price-to-
earnings. We should define those measures widely. For example, price-to-assets should mean
checking not just price-to-book but also price-to-net current assets and price to a private owner
(what the company might sell for in an acquisition). Likewise, price-to-earnings should include a
measure of cash flow – perhaps free cash flow or EBITDA depending on the companies being
considered.
We also need to consider the issue of “normalization.” Is this a boom or bust year for the stocks
you are comparing? Ark is in the restaurant business. They have several restaurants in Las
Vegas. While last year’s adjusted EBITDA – which we’ll call $13 million – was about as high as
they’ve ever had, this probably isn’t a boom year for their business. If I was comparing Ark to a
steel company, we would need to give the benefit of the doubt to the steel company. Steel is in a
worse – bustier – place right now than U.S. restaurants. So, just checking this year’s earnings
would penalize a steel company too much.
We don’t need to know an actual “normal” owner earnings estimate at this point. But it helps if
we know if recent earnings are:
· Peak earnings?
· Boom earnings?
· Bust earnings?
· Typical earnings?
Most years for most companies are pretty typical. That does not – however – mean that most
years of the companies you are attracted to as possible investments are typical. In fact, you are –
if you like low P/E ratios – likely to start your search for a company by focusing on companies
that are coming off a good year. In other words, you’re more likely to analyze a steel company
sometime in the 2000s than you are today – because today their P/E ratio might look high.
Obviously, you can fight this problem by always averaging out the last 10 years of earnings, etc.
This is a little tricky. On average, it accomplishes nothing, because it punishes companies with a
positive 10-year trend. Averaging – Shiller style – past earnings for companies does one good
thing and one bad thing. The bad thing is ignoring the process of improvement. The good thing is
not taking a single data point and making it the number you base everything on.
For countries and industries, a Shiller P/E approach makes a lot of sense. For companies, I’ve
always feared it is self-neutralizing. It will show you what “normal” is. But it will also cause you
to think that a company on a 10-year downtrend in margins, etc. is equal to a competitor with a
10-year uptrend in margins, etc. This is almost never the case. In fact, if you really do find direct
competitors with completely divergent 10 year trends – you want to think real hard on that
question.
So, we’ll keep it simple and say that you don’t need to start with a 10-year average. Instead, I
want you to start by looking for the average – often median will work best – return on equity
figure and return on sales (operating margin) figure for the last 10 years. If you have 15 years of
data, you can use that. I only mention 10 because sites like GuruFocus often provide 10 years of
data for you in one place – you’ll rarely find 15 years of data without putting the spreadsheet
together yourself.
So now you have a “typical” year of margin or return on equity. For Ark – where very little
tangible equity is needed to run the business – I would focus on a typical return on sales year.
Then we have questions like what was the company’s peak earnings? For growing companies,
peak earnings are often the company’s most recent earnings. And the assumption is that each
year will be a new peak. It could be. But it’s worth marking down that the company has never
earned more than it did last year.
This is pretty much true for Ark’s 2012 numbers. If we ignore the size of the company’s
operations, etc. – and we use adjusted EBITDA – last year was basically a peak year. It was
pretty much an equal peak – a re-peak – of the company’s results from just before the Great
Recession. So, basically, we would look at the company’s 2007 and 2012 results and say those
are as good as the company has gotten. They may not be as good as it gets. But so far they are.
That means we should be cautious in expecting better in the future.
It also means we can roughly compare the results of those years – 2007 and 2012 for Ark – to the
results of a company currently setting a new earnings record right now. There is one caveat. Last
year, 2012, was probably not a true boom year for Ark, restaurants, or Las Vegas. We certainly
don’t want to assume better results in the future. But we probably don’t want to compare an
industry, commodity, etc. that we know is at a peak to what Ark just delivered.
The best early measure for comparing two stocks by earnings is EV/EBITDA. This may not be
the measure you’d choose to use at the end of your process. But it’s the one to start with because
it’s least likely to lead you wildly astray especially when considering companies in different
countries (one using GAAP and the other IFRS), companies with different amounts of free cash
flow generation relative to reported earnings, etc.
If we take $13 million of “adjusted” EBITDA as Ark’s earning power and compare it to the
company’s enterprise value we get an EV-to-EBITDA of something like 5.2. A normal
EV/EBITDA for a restaurant company acquisition is usually about 7 (if we’re talking the buying
of a public company – check SEC filings for evidence of this, the best place to look is peer
comparisons included in the fairness opinions of past mergers).
A price of about 8 times EBITDA for a public company is fairly normal. I won’t argue it makes
more or less sense than 7 or 9 times EBITDA. It depends on factors like how much of EBITDA
is actually converted to free cash flow, how much equity is required to run the business, what
growth prospects look like, and how confident are we that today’s EBITDA will persist in the
future.
Ark is a mixed bag in these regards. Growth prospects are mediocre. Generally, they must open
new restaurants – and for them, that means new concepts since they aren’t a chain – to grow
sales. Growth beyond nominal GDP is very unlikely without good deals. Without any deals,
growth

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GANNON COMPILATION, 2005-2022

Moat and Durability

1. Why I’m Biased Against Stock Options

2. Go Beyond the Financial Statements: Break a Company Down Revenue

3. Is Negative Shareholder Equity a Good Thing or a Bad Thing? – No, It’s an

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

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?

1. The Best Investing Books for a Budding Value Investor to Read

2. Some Books and Websites That Have Been Taking Up My Time

4. Books I’m Reading

5. What Books Should You Read About Ben Graham?

7. Investing 101 Toolbox: 12 Books, 3 Lectures, 4 Blogs, and 5 Interviews for

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?

1. Warren Buffett’s “Market Value Test” – And How to Use It

2. Dividends and Buybacks at Potentially Non-Durable Businesses: Altria

3. The “Element of Compound Interest”: When Retaining Earnings is the Key

4. Surviving Once a Decade Disasters: The Cost of Companies Not Keeping

5. Capital Allocation Discounts

6. If Dividends Don’t Matter – What Does?

8. How to Find Stocks With Good, Predictable Capital Allocation

9. Quality, Capital Allocation, Value and Growth

1. “Farmer Mac” A.K.A. Federal Agricultural Mortgage Corporation

3. A-Mark Precious Metals (AMRK): A Dealer and Lender in Physical Gold

5. Flanigan’s (BDL): A Cheap, Complicated Restaurant Chain Focused on

6. Bonal (BONL): An Extremely Tiny, Extremely Illiquid Stock that Earns a

7. Bunzl (BNZL): A Distributor with 20 Straight Years of EPS Growth and 27

8. Babcock & Wilcox Enterprises (BW): A Risky Stock Getting Activist

9. BWX Technologies (BWXT): A Leveraged, Speculative, and Expensive

10. Geoff’s Thoughts on Cheesecake Factory (CAKE)

14. Car-Mart (CRMT): Like the Company, Hate the Industry

20. Gamehost: Operator of 3 “Local Monopoly” Type Casinos in Alberta,

21. Green Brick Partners (GRBK): A Cheap, Complicated Homebuilder

22. Grainger (GWW): Lower Prices, Higher Volumes

23. Hanesbrands (HBI): A Very Cheap, Very Leveraged Stock That’s #1 in an

28. Interpublic (IPG): An Ad Agency Holding Company Trading at 10 times

29. Investors Title Company (ITIC): A Strong, Consistently Profitable