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Geoff Gannon December 31, 2005

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 …

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Geoff Gannon December 29, 2005

On Intrinsic Value

As promised here’s the snippet from Thurdsay’s Podcast:

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.…

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Geoff Gannon December 28, 2005

On Newspaper Stocks

I admit I’ve been watching newspaper stocks with some interest; but, I am not yet convinced of anything. However, I can say to those who have not yet taken a good look at newspaper stocks that they ought to do so.

I have no greater insight into the future than those who are selling these stocks. But, I do know that at times like these, when a general consensus is reflected in the quotations of certain stocks, those few investors whose analysis is both correct and unpopular will be rewarded, if and only if, they have the courage to eschew the flock and act upon their own judgment.

While there are not as many stocks trading at astronomical evaluations as there were half a decade ago; there are not many cheap stocks either. This is not the sort of market you throw darts at. Newspaper stocks are a rare oasis of pessimism in a desert of optimism. Whether that pessimism is undue or not is a matter for you to decide.

If you’ve already considered this matter, please share your thoughts with us by commenting below. For those who have yet to delve into the matter, you’d best get started now. I can suggest five stocks of interest: Daily Journal CorporationGannettJournal Register CompanyJournal Communications, and The New York Times Company.

I’m not saying these are necessarily any more promising than the rest of the group. But, if you are looking for bargains, they are a good place to start.

Happy hunting.…

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Geoff Gannon December 26, 2005

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,

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Geoff Gannon December 24, 2005

On Business Risks and Market Risks

Investors in stocks are faced with two very different types of risks: business risks and market risks. Business risks can be managed through selectivity and spatial diversification. First, only the best (and best understood) firms are selected. Then, an investment is spread over several of these firms to ensure that the very small risk of a loss of principal inherent to each of these stocks does not adversely affect the portfolio. Five to ten stocks are more than adequate, provided they are businesses of the finest quality obtained at bargain prices. Market risks should not be combated with spatial diversification, because this forces the investor to accept issues of inferior quality. Instead, market risks must be managed through temporal diversification. Eventually, the market will recognize a firm’s intrinsic value. Therefore, a superior business will always command a superior price – in time. As long as an investor can hold a stock forever, he needn’t worry about market risks, and can devote himself entirely to an analysis of business risks.…

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Geoff Gannon December 23, 2005

Against The Top Down Approach

If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for a moment, you will recognize how truly foolish it is.

A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high – yield bond.

Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.

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. Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it’s false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he’s comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher’s handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher’s handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You needn’t determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is

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Geoff Gannon December 23, 2005

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 takeRequesting 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!…

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