Geoff Gannon December 10, 2008

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.…

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