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Geoff Gannon March 10, 2017

How to Find Stocks With Good, Predictable Capital Allocation

Someone emailed me this question:

“How do you evaluate the capital allocation skill by the management? I do so by looking at the FCF yields for the acquisitions and share repurchases or ROIC for internal investments.”

I want to focus on what will have the most influence on my investment in the company going forward. For this reason, I’m less interested in knowing quantitatively what the past return on investment of management’s actions were – and more in simply how management will allocate capital going forward.

 

Let’s start with who the manager is. If the manager is the founder, that’s the easiest situation. We can assume the founder will stay with the company for a long time. The average tenure of a professional manager – nonfounder – CEO at a Standard & Poor’s 500 type company is short. It’s maybe five years. If you think about that, it means odds are that the CEO you now see at the company you are thinking of investing in will be gone within two to three years (because chances are he’s already been running the company for two to three years by the time you buy the stock). It’s just not worth thinking about such a manager. In this case you’d want to focus on the board of directors or the chairman. Ideally, you want to find situations where the founder is still the CEO, the chairman or has some position in the company. This will make figuring out future capital allocation plans easier.

In situations where you don’t have a founder present, ongoing participation by a family is useful. In situations where you don’t have the presence of either a founder or his family at the company, you may still have first-generation managers who worked with the founders before they became CEOs.

Those three situations will make future capital allocation easier to predict. One, the founder influences capital allocation. Two, the controlling family influences capital allocation. Three, a manager who worked directly for the founder early in his career now influences capital allocation. If you don’t have any of those three scenarios, there are still two others that can lead to some predictability. You can have a long-tenured CEO. For example, the big ad agency holding companies are usually run by a CEO who has been at the company forever. I know Omnicom (OMC, Financial) best. The CEO there – John Wren – has been at the top position for 20 years. For most of those 20 years, the chairman of the company and the chief financial officer (CFO) were also the same.

In terms of capital allocation, if you have a lot of consistency in the offices of chairman, CEO and CFO, you’re able to more easily count on future capital allocation looking like past capital allocation. The last of the five scenarios that can lead to predictable capital allocation is the presence of a “refounder.” This is someone who comes in and reshapes an existing business …

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Geoff Gannon March 9, 2017

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.…

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Geoff Gannon March 2, 2017

The Difference Between “Moat” and “Durability”

Someone emailed me this question:

“Am I correct in assuming that when you discuss durability, you are referring to the ongoing need or want for an industry’s products or services, whereas when you discuss moat, you are referring to the competitive positioning of an individual company within its industry?”

Yes. Exactly. Durability is about the product and the product economics of the industry. Moat is the ability of the specific company to sell more of the product and have better product economics than competitors.

In Michael Porter’s approach: moat limits rivalry between firms.

And durability is about the relationship between the customers and the firm we are looking at.

So, Corticeira Amorim (Amorim Cork) in Portugal may have low durability and a wide moat at the same time, because it has advantages in the production and especially the distribution of cork compared to other firms. However, there are substitutes for cork including synthetic products and screw tops. Societal shifts in the acceptance of these ways of enclosing a wine bottle would mean that Amorim might not have very good durability.

On the other hand, a company like McCormick (MKC) has perfect durability. McCormick sells a variety of spices. Spices have been part of the food that even households that aren’t very rich have used for well over 2,000 years and they have been used all over the world. It isn’t anything cultural that determines the desire for spices. The spices used may change a little but people all over the world will always want to add spices to their meals. Whether McCormick will always be a leader in spices is a different question. But, 2,000 years from today people will be spicing the food they eat. I’m not a hundred percent sure people will be corking wine even just 20 years from now.

Sanderson Farms (SAFM) is another good example of the distinction between durability and moat. The durability of chicken is excellent. There are only a handful of domesticated animals that have been as selectively bred and extensively used as meat – mainly cattle and pigs – throughout human history. The product economics of processing chicken are also fine, you can earn a decent ROE doing it. I also think chicken should continue to be a cheaper protein than other alternatives. So, while I can’t guarantee humans will be eating chicken in 2,000 years – I’m sure they’ll be eating about as much or more chicken in 20 years. And I wouldn’t be surprised if people are still eating more chicken than almost any other meat even 50, 100, or 200 years from now. So, I think the durability of SAFM’s product and the business model – the things the firm actually does day-to-day – are both durable in terms of providing value for customers. The question is rivalry between firms. Fifteen years from today, someone will be doing what Sanderson is doing. But, how much profit will the firms that process chicken actually make? That’s why I compare …

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Geoff Gannon March 1, 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

Talk to Geoff about his Sales of Weight Watchers (WTW) and B&W Enterprises (BW)…

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