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On Paying a Fair Price

A reader recently sent me an email about Procter & Gamble (PG); that email prompted this post.

You’ll often here people say it’s okay to pay a fair price for a great business. Don’t listen to them. An investor never pays a fair price for anything. There is nothing fair about investing. Remember, there are two sides to every trade. A good investor makes his living by ripping other people off.

That is, after all, what Ben Graham’s Mr. Market metaphor is really all about – a sane man taking advantage of a lunatic. Despite the media’s coverage of the markets, we investors are not all in the same boat together. Investing is a zero – sum game. If you want to match the market, buy an index fund. If you want to beat it, you need to forget about fair prices.

All investments are ultimately cash to cash operations. Owning a great business has no value in and of itself. So, paying a fair price for a great business means you’re giving up as much as you’re getting. There’s no logic in that.

An investor may be wise to buy a great business at a higher price – to – earnings multiple than he is willing to pay for most businesses. But, that isn’t the same thing as paying a fair price. If your intrinsic value analysis shows a stock is currently trading at or above its true value, don’t buy it. It’s really that simple.

Performing an intrinsic value analysis is nothing like slapping a P/E multiple on a stock. A great business may justifiably command a higher price – to – earnings ratio, because of its growth factor. Let me reprint here what I had written in the Value Investing Encyclopedia about a company’s growth factor, because I’m sure many of you haven’t seen it.

A business’ growth factor consists of two parts: the return on capital and the amount of unrealized growth within the franchise. The former governs profitability; the later governs growth.

Only a company that earns an extraordinary return on capital and can deploy additional capital within the franchise can be said to have a truly profitable growth factor. If a business’ return on capital is less than or equal to the average return on capital in the economy, then it does not have a positive growth factor regardless of its earnings growth rate. A company with a very high return on capital and no room left to deploy capital within the franchise will likewise not have a positive growth factor.

I hope to address the issue of just how valuable growth can be in my next post. I’ve only hinted at this before. For instance, I wrote that at a price of just over twenty times earnings, PetMed Express (PETS) was clearly a bargain. My intrinsic value analysis showed it was very cheap. Still, I didn’t buy it. That was a dumb mistake caused by relying on the crutch …

Coke vs. Space Dev

You can win a copy of Benjamin Graham’s “Security Analysis” (1940 edition)

Please send in your email votes for the latest pair of wide moat picks. The two companies mentioned in the Gannon on Investing Podcast: “Phil Fisher” were Coca – Cola (KO) and Space Dev (SPDV). The voting will close Sunday at 11:59 p.m. (eastern).

Remember, the author of the best email of the entire contest will win a copy of Benjamin Graham’s Security Analysis (1940 ed.).

Please note: I have not confirmed the ticker symbol for Space Dev. Always double check the ticker symbols I use. They are included primarily to facilitate searches of the blog using the search box on the sidebar to the right.…

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 …

On the Value Investing Encyclopedia

I have been slowly adding to the Value Investing Encyclopedia. A new encyclopedia entry for Joel Greenblatt has just been added. It is difficult for me to provide complete and accurate entries on my own. If you have any information relating to any subject within the encyclopedia, please let me know.

For instance, in the entry for Joel Greenblatt, I was unable to include an accurate date of birth. For now, I have listed his date of birth as 1958? to provide some idea of his age. If you know when Mr. Greenblatt was born, please comment below or email me. Likewise, if you have reason to believe there are any inaccuracies or omissions in the entry, please let me know.

I hope the Value Investing Encyclopedia will become a useful resource in time. Any help you can offer will be greatly appreciated.

Read the Value Investing Encyclopedia Entry for Joel Greenblatt…

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 …

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 …

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 …

Quarterly Newsletter

In addition to this free website, I also publish a (print) quarterly investment newsletter. The newsletter is only distributed to those individuals who pay for a single issue or a one-year subscription.

Each issue of the Gannon On Investing Newsletter consists of a brief commentary on the quarter, a summary of changes to my personal portfolio, and a discussion of the rationale behind each purchase. Most of the newsletter is devoted to detailed evaluations of individual companies.

You may now subscribe to the Gannon On Investing Newsletter via PayPal. I believe this payment option will prove more convenient for most subscribers. Of course, those who prefer to pay by check may continue to do so.

There is no charge for shipping. However, if you are living overseas, and are concerned new issues will not reach you as quickly as you’d like, please send me an email asking for details on international shipping speeds.

Disclaimer
The Gannon On Investing Newsletter is not intended, nor should be used, as investment advice.

Learn more about the Gannon On Investing Newsletter…

Marketocracy Clubs Open

I just want to let everyone know that I’ve changed the Marketocracy Clubs to “open” from “protected”. I was continually accepting applications and yet those applicants were not being admitted into the club. Until Marketocracy fixes this problem, I think it would be best to leave the clubs open to everyone. I don’t expect the open status to cause a problem. I can always exclude members later.

If you applied to join one of the clubs, but have yet to be admitted, please go join that club now. It should work.

Let me know if anyone has a problem with this new arrangement.…

On Overstock’s Fourth Quarter

I know some of you would rather I didn’t keep posting on Overstock. Unfortunately for you, I think it’s one of the best bargains out there. So, I’m following up on Overstock by breaking down the results of Q4. All quotes are from Overstock’s President, Patrick Byrne.

For those who hate these Overstock posts, you’ll be happy to hear I plan to post an analysis of the Journal Register Company (JRC) tomorrow.

On Tuesday, February 7th, Overstock.com (OSTK) reported its fourth quarter revenue and full year financial results. The headline numbers were a net loss of $25 million or ($1.29) per share for 2005 vs. a net loss of $5 million or ($0.29) per share in 2004, and total revenue for 2005 of $804 million vs. total revenue for 2004 of $495 million.

For the year, revenues grew by 63%. The rate of growth decelerated throughout the year. Revenue growth was 102% in Q1, 72% in Q2, 64% in Q3, and 44% in Q4. Management expects revenue growth to be much slower in 2006. “During this time that we are hardening our new systems, we will reduce growth to industry rates. Our emphasis in 2006 will be on an improved customer experience – – even if at the expense of growth.”

The three most important figures to watch in evaluating Overstock are revenue growth, gross margins, and traffic data.

Overstock’s traffic data for the fourth quarter of 2005 was encouraging. As one would expect, most of the traffic to Overstock came in the first half of December. Overstock’s traffic numbers were strong in both absolute and relative terms for the first three weeks of December, and then dropped off very sharply thereafter. Notably, Overstock achieved its highest traffic rank to date during the Christmas shopping season. The trends in Overstock’s fourth quarter traffic data were consistent with those found in other major online retailers. Traffic data should be treated as a qualitative rather than a quantitative consideration. It is most useful as a negative indicator. There was nothing troubling in Overstock’s fourth quarter traffic data; so, it adds little to the present discussion.

Overstock’s revenue growth for 2005 was also encouraging. For the year, revenue grew by 63%. My $1.5 billion valuation of Overstock was based on a five year annual growth rate of 15%. Revenues will grow much more slowly in 2006. The deceleration in revenue growth throughout the year neither surprises nor alarms me.

Management entered 2005 with some very high growth expectations. “I said that my goals in 2005 were to grow revenues 60-100% and break even +/- 1%. We achieved the first, but I failed on the second. 2005 started fairly well, but ended weakly.” I did not share management’s expectations, and thus was quite content with the growth achieved.

Overstock’s average customer acquisition cost increased 33%. This looks like an alarming number, but a closer look at the company’s financial results suggests the increase was largely unnecessary, or at …