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Geoff Gannon September 17, 2017

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

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Geoff Gannon September 16, 2017

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.…

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Kevin Wilde September 14, 2017

Cheesecake Factory (NAS:CAKE)

The Cheesecake Factory (NAS: CAKE) 14-SEP-2017 (EV $1.82B; Mkt Cap $1.88B; 49.0MM shares outstanding; $40.29/share) STATUS At end of 2016, CAKE had a total of 208 company-owned restaurants (all U.S. based): 194 Cheesecake Factory restaurants 13 Grand Lux 1 Rock Sugar Pan Asian NOTE: Each restaurant has sales of ~ $10.5 annually. Maintenance CapEx over the last 3 years has been between $26MM and $29MM per year.  Bakery & Training center capex has averaged $11MM annually over the last 3 years. 2016 sales of $2.276B....

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Geoff Gannon September 6, 2017

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 …

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Geoff Gannon September 6, 2017

Hold Cash: Wait till You Get Offered 65 Cents on the Dollar

A Focused Compounding member who fears the stock market is expensive posted this comment:

“Hi Geoff,


S&P today is expensive based on TTM PE of 24 and CAPE of about 30. An investor whose holdings consist entirely of stocks outside S&P500, will still see a drop in the prices of her equities if the S&P falls even if she has bought her holdings significantly below their estimated fair values. In your opinion, what’s the best way to position oneself going forward with the goal of course being total portfolio returns outpacing market returns in the long run?


  1. change to 100% cash position (to take maximum advantage of potential future price drop)
    2. 20% or so equities and about 80% cash (so as to take advantage of potential price drop)
    3. Ignore the market completely and keep current balance of about 80% equities, 20% cash
    4. Any other thought besides the above three.”

 

The option that comes closest to what I’d suggest is #3 (“Ignore the market completely and keep current balance of about 80% equites, 20% cash”).

But, let’s walk through why that is.

First, do I think the market is expensive?

Yes.

In an August 29th post, entitled “The Market is Overpriced: These 3 Stocks Aren’t” I wrote:

“I’ve never seen a time when it’s as difficult to find a good stock to buy without overpaying as what I see right now.

But, I don’t think that means you should be 100% in cash. I think it means you should be in stocks like:

Cheesecake Factory (at $41 as I write this)

Omnicom (at $73 as I write this)

And Howden Joinery (at 412 pence as I write this)

If the market as a whole is overpriced, it will fall. And when it does fall: it will take stocks like Cheesecake, Omnicom, and Howden with it.

In time, they will recover.

And you will be able to look back – 5 years or more down the road – and say that buying stocks like these at today’s ‘not overprice’ levels and holding them wasn’t a mistake.

You don’t need to get out of the market.

But, you do need to be more selective than ever now that the market is more expensive than ever.”

The second question is: how have I positioned my own portfolio?

My account has 30% in cash right now. I expect that to rise to 35% sometime soon (when I sell a small position).

My 30% to 35% cash position is not a market call. I’m going to spend the rest of this article explaining what it really means when you see me holding cash.

With most investors, a 30% to 35% cash levels means they have thought about portfolio allocation and decided that 30% to 35% in cash is a good level to be at right now because of the risk level in the overall market.

For me, that’s not true.

The truth is that I like two stocks – …

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Geoff Gannon September 6, 2017

Hold Cash: Wait till You Get Offered 65 Cents to the Dollar

(Excerpt from today’s Focused Compounding article)

“…three stocks I like right now (are):

1.       Omnicom (now $72 a share)

2.       Howden Joinery (now 424 pence)

3.       And Cheesecake Factory (now $40 a share)

All are reasonably priced…Omnicom has a P/E of 15. Howden has a P/E of 15. And Cheesecake has a P/E of 14.

All of those sound wrong to me.

These are above average businesses with far above average predictability. They should have above average P/E ratios…

So, why aren’t I buying these stocks right now? Why keep 30% to 35% of my portfolio in cash when these 3 opportunities are available?

…I tend to buy stocks when a business I know I really like trades at about a 35% discount to my appraisal of its intrinsic value…these decisions are arbitrary in terms of the levels you set. If I plan to hold Omnicom stock for let’s say 5 years a difference of 10% in the initial purchase price level isn’t going to make more than a 2% difference in my annual rate of return…How much does that 2% a year really matter to you?

Most people I talk to would be more bothered by missing out on the opportunity to buy a business they like than they would be bothered by paying 10% more for the stock at the start. Most people I talk to about Omnicom say…if I like the stock that much…I should just buy it now.

But, that’s just not my approach.

I’m selective both on the quality of the business…and I’m selective on the price. I don’t like paying more than 65 cents to the intrinsic value dollar even when I like the business a lot.”

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Geoff Gannon September 6, 2017

Why Ad Agencies Should Always Buy Back Their Own Stock

(Excerpt from today’s Focused Compounding article)

“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%

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Geoff Gannon September 5, 2017

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 …

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Geoff Gannon September 5, 2017

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 …

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Geoff Gannon September 5, 2017

Weight Watchers (WTW): Mistakes Made Over 4 Years of (Emotional) Volatility

(Read the full article)

“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%…

…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….

…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 combinedIt is very unpleasant to write about a volatile stock, a controversial stock, a heavily shorted stock, etc…

…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…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.”

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