December 2017 – Page 2 – Focused Compounding

Geoff Gannon December 15, 2017

A U.S. Corporate Tax Cut is Not Priced into Stocks

I’ve noticed that in a lot of the emails I’ve been getting recently, the emailer says something along the lines of “of course a U.S. corporate tax cut in 2018 is probably already priced into stocks”.

It’s not.

The Stock Market is Expensive

Stocks markets around the world – and in the U.S. especially – are very expensive right now. They’re overvalued. And no corporate tax cut being discussed would get close to increasing after-tax earnings enough to bring the normalized P/E on the overall market down to a normal level.

So, stocks generally are overpriced now before any tax cut and will still be overpriced after any corporate tax cut.

However, that’s not what matters to a stock picker. A stock picker chooses individual stocks. Factors like the price level of the stock market or the effective tax rate of the S&P 500 are irrelevant to a stock picker.

To a stock picker: it’s the prices of individual stocks and the taxes paid by those individual stocks that matter.

U.S. Stocks that Pay Higher Taxes Than Foreign Peers Aren’t Rising Faster Than Those Peers

The easiest comparison to make is between the big 5 advertising agency holding companies: Omnicom (U.S.), Interpublic (also U.S.), WPP (not U.S.), Publicis (not U.S.), and Dentsu (not U.S.). This is the easiest comparison because the 5 companies are comparable businesses and they are headquartered in different countries – yet they are all “multi-national” in the sense of where their profits come from.

If the market has already priced in a U.S. corporate tax cut – the EV/EBITDA (“DA” is rarely anything more substantial than an accounting charge at advertising companies) – of the U.S. ad agency stocks (that’s Omnicom and Interpublic) should have been rising versus the EV/EBITDA ratios of WPP, Publicis, and Dentsu as a U.S. corporate tax cut looked more and more likely.

What actually happened this year?

Shares in the big 5 global ad companies moved as if these were identical securities. Investors showed no preference for one stock over another. They certainly didn’t start preferring the U.S. ad stocks – Omnicom and Interpublic – over ad stocks elsewhere in the world as we approached year-end.

In fact, I got several emails from people asking whether they should buy WPP instead of Omnicom because WPP is cheaper. None of those emails mentioned that – since the financial crisis – Omnicom has paid much more in taxes than WPP. This may indicate investors are not focused on future tax rates when considering which stock to buy in an industry.

The Highest Taxed U.S. Stocks Aren’t Rising Faster Than Other Stocks

Because investors often think in terms of P/E ratios and other after-tax measures (like EPS), another way a U.S. corporate tax cut could be “priced in” to stocks is for those stocks paying the highest tax rates (that is, those converting the least amount of EBIT into EPS) to rise the most in price. These are

Geoff Gannon December 14, 2017

Why I Don’t Use WACC

A blog reader emailed me this question about why I appraise stocks using a pure enterprise value approach – as if debt and equity had the same “cost of capital” – instead of using a Weighted Average Cost of Capital (WACC) approach:

“…debt and equity have different costs. In businesses with a (large) amount of the capital provided by debt at low rates, this would distort the business value. In essence I am asking why do you not determine the value of the business using a WACC, similar to how Professor Greenwald proposes in Value Investing: From Graham to Buffett and Beyond. The Earnings Power Value model seems theoretically correct, but of course determining WACC is complicated and subject to changes in the future. Nevertheless, your approach of capitalizing MSC at 5% is basically capitalizing the entire business value, including the amount financed by debt, at what is presumably your cost of equity for a business with MSC’s ROIC and growth characteristics. Perhaps I am coming at this from a different angle than you, but it seems a little inconsistent from the way I am thinking about it, and for businesses with more debt this would lead to bigger distortions. AutoNation would be a good example of a business with meaningful…debt that this approach would distort the valuation on.”

When I’m doing my appraisal of the stock – this is my judgment on what the stock is worth not whether or not I’d buy the stock knowing it’s worth this amount – I’m judging the business as a business rather than the business as a corporation with a certain capital allocator at the helm. Capital allocation makes a huge difference in the long-term returns of stocks. You can find proof of that by reading “The Outsiders”. Financial engineering makes a difference in the long-term returns of a stock. You can read any book about John Malone or Warren Buffett to see that point illustrated.

But, for me…

My appraisal of Berkshire Hathaway is my appraisal of the business independent of Warren Buffett. Now, knowing Warren Buffett controls Berkshire Hathaway would make me more likely to buy the stock and to hold the stock. So, it’s an investment consideration. But, it’s not an appraisal consideration for me. When I appraise Berkshire Hathaway, I appraise the businesses without considering who is allocating capital. Otherwise, I’d value Berkshire at one price today and a different price if Warren died tomorrow. I don’t think that’s a logical way to appraise an asset. Although I do think that buying an asset that’s managed by the right person is a good way to invest.

A good example of this is DreamWorks Animation (now part of Comcast). Quan and I valued DreamWorks Animation at a level that was sometimes more than double the stock’s price.

There was a point where we could have bought the stock at probably 45% of what we thought the business was worth.

However, we asked each …

Geoff Gannon December 9, 2017

Stocks You Can’t Buy

The always interesting Japanese stock blog (it’s written in English), Kenkyo Investing, has a post on a negative enterprise value stock called Hokuyaku Takeyama. The reason this stock is cheap is because it trades on the Sapporo Stock Exchange – not one of the more popular exchanges like Tokyo or Osaka. Very few stocks only trade on the Sapporo Stock Exchange. So, very few investors make the special effort to do business with a broker who will give them access to this exchange.

Watlington Waterworks (Bermuda Stock Exchange)

I wrote about a similar situation in March of 2011. That stock was called Watlington Waterworks. It’s a water company on the island of Bermuda. Because it’s on the island of Bermuda – a rich, densely populated remote island with no fresh water – the economics of Watlington Waterworks are generally superior to all other water companies around the world. And yet – in March of 2011 – the stock traded for lower multiples of earnings, book value, etc. than other water companies. In the 7 years since I wrote about Watlington Waterworks, the stock has risen in price by about 9% a year. It also paid a dividend. So, holders of the stock got 10%+ owning something that was a true diversifier in their portfolio (Watlington’s price doesn’t move based on how the Dow Jones, Nasdaq, or S&P 500 are doing). In fact, on many days, it doesn’t move. What’s more impressive is that Watlington returned more than 10% a year over 7 years while finishing that period with a P/E ratio less than 12, a price-to-book ratio less than 1, and a rock solid balance sheet.

Many stocks have returned more than 10% a year over the last 7 years. However, very few stocks that returned more than 10% a year now have a P/E under 12, a P/B under 1, and a solid balance sheet. Meanwhile, many companies that now have a P/E under 12 and a P/B under 1 have returned far worse than 10% a year over the last 7 years. In other words: Watlington is rare in the sense it combines a 7-year total return performance that has been adequate with a stock price that has always remained at an investment level rather than straying into speculative levels like most stocks. Basically, it’s been a decent “set it and forget it” investment. The business has never really performed badly. And the stock’s price has never really been anything but cheap.

Also worth mentioning is the way I presented Watlington Waterworks. I showed the company’s recent financial results on this blog – but didn’t give out the company’s name or business description. Readers then guessed where the stock traded. Back in 2011, almost everyone came up with a guess in the $20 to $30 price range. At the time, the stock traded at $14.

What Ben Graham Would Really Be Buying Today

These are the kinds of stocks you want to find …

Geoff Gannon December 8, 2017

Why You Might Want to Stop Measuring Your Portfolio’s Performance Against the S&P; 500

Someone emailed me this question about tracking portfolio performance:

“All investors are comparing their portfolio performance with the S&P 500 or DAX (depends were they live). I have asked a value investor why he compared the S&P 500 performance with his portfolio performance…for me as a value investor it makes no sense. A value investor holds individual assets with each of them having a different risk…it’s like comparing apples and oranges.

The value investor told me that…Warren Buffett compares his performance with the S&P 500. But I believe he did it, because other investors…expect it or ask for such a comparison.

How do you measure your portfolio success? Do you calculate your average entry P/E and compare it with S&P500 or Dow P/E to show how much you (over)paid for your assets? Or do you avoid such a comparison and calculate only the NAV of your portfolio?”

I don’t discuss my portfolio performance on this blog.

And I think it’s generally a good idea not to track your portfolio performance versus a benchmark.

It’s certainly a bad idea to monitor your performance versus the S&P 500 on something as short as a year-by-year basis.

Why?

Well, simply monitoring something affects behavior. So, while you might think “what’s the harm in weighing myself twice a day – that’s not the same thing as going on a diet” – in reality, weighing yourself twice a day is a lot like going on a diet. If you really wanted to make decisions about how much to eat, how much to exercise, etc. completely independent of your weight – there’s only one way to do that: never weigh yourself. Once you weigh yourself, your decisions about eating and exercising and such will no longer be independent of your weight.

Knowing how much the S&P 500 has returned this quarter, this year, this decade, etc. is a curse. You aren’t investing in the S&P 500. So, tethering your expectations to the S&P 500 – both on the upside and on the downside – isn’t helpful. The incorrect assumption here is that the S&P 500 is a useful gauge of opportunity cost. It’s not.

Let me give you an example using my own performance. Because of when the 2008 financial crisis hit, we can conveniently break my investing career into two parts: 1999-2007 and 2009-2017.

Does knowing what the S&P 500 did from 1999-2007 and 2009-2017 help me or hurt me?

It hurts me. A lot.

Because – as a value investor – the opportunities for me to make money were actually very similar in 1999-2007 and 2009-2017. In both periods, I outperformed the S&P. However, my outperformance in 2009-2017 was small while my outperformance in 1999-2007 was big. In absolute terms, my annual returns were fairly similar for the period from 1999-2007 and 2009-2017. It is the performance of the S&P 500 that changed.

Many value investors have a goal to outperform the S&P 500. But, is this a useful goal?

I don’t think so. …

Geoff Gannon December 8, 2017

The Cheesecake Factory (CAKE): A Second Opinion

Guest write-up by Vetle Forsland

Introduction

The Cheesecake Factory operates 208 restaurants primarily in the US. Of these locations, 194 of them are The Cheesecake Factory-restaurants, 13 are under the Grand Lux Café-brand, and one under the RockSugar Southeast Asian Kitchen mark. Additionally, they have 15 Cheesecake-branded restaurants in other parts of the world. These are all upscale casual dining restaurants. The customer eats freshly prepared food in the restaurant while a waiter provides table service. On average, a check from their restaurants was $21 (per person) in 2015, and $20.20 in 2016. The overwhelming majority (91 %) of the company’s sales comes from The Cheesecake Factory chain. The Cheesecake Factory restaurants offer high-quality food at moderate prices, with more than 200 items on their menu including 50 or so cheesecakes. It is known for its ginormous portion sizes and high-calorie dishes. Their core menu offerings include appetizers, pizza, seafood, steaks, chicken, burgers, pastas, salads and sandwiches, and they review and update their menu twice a year. The locations are large, open dining areas with a modern design. This means that Cheesecake Factory locations require higher investment per square foot than typical casual dining restaurants – but Cheesecake also has higher sales per square foot than competitors.

The Cheesecake Factory originated in 1972, when a small bakery opened in Los Angeles by Evelyn Overton. In 1978, her son, David Overton (who is still CEO of the company) opened the very first Cheesecake Factory restaurant. It was a huge success, with long lines on opening day. Overton quickly expanded the concept to other parts of the country, and in 1992, the company was incorporated as The Cheesecake Factory Incorporated in Delaware. Since 1997, Cheesecake has opened 11 restaurants a year, meaning an annual restaurant count growth of 15.8 % (7.4 % for the past 10 years). Management believes there is room for 300 Cheesecake restaurants in the US. Basically, this means that they will be able to open ~7-10 restaurants of their crown jewel a year for the next 10-15 years. In addition to this, the company is pursuing several incremental growth opportunities.

The stock price has fallen from a 52-week high of $67/share to $45/share (after dipping to $38 earlier this fall). This dramatic sell-off is most likely caused by declining same-stores sales. In May, Cheesecake reported a like-for-like growth of 0.3 %, and a -2.3 % decline in traffic. Restaurant chains often go through years of consecutive growth in same stores sales, with periods of consecutive quarters of declining same stores sales in between. So this is not very unusual in this business. The company also reported a decline of 0.5 % in Q2, which caused further sell-offs. Cheesecake stock has fallen about 35 % since the Q1 announcement. Furthermore, they are currently forecasting comparable sales decline of about 1 % for the full fiscal year.

Durability

The restaurant industry is a very durable industry. The demand for eating out is consistent in the US, and …

Geoff Gannon December 7, 2017

The Risk of Regret: NACCO (NC)

Someone emailed me this question about NACCO (NC):

“If you don’t mind me asking, why do you so strongly recommend other people not buy the stock given your obvious high conviction? It seems like a classic value situation where a company in a hated industry (coal) with a long-term bleak outlook has an individual player (NC) where the cash flow characteristics are more than enough to justify the current stock price. If you prefer not to answer because your answer is embedded in your member-only site, I totally understand, but I am quite intrigued. For what it’s worth, I am not at a point where I am seriously considering NC for potential investment – I am more interested in Frost (CFR), although I would prefer it to come down more. I am just trying to understand the business and what a fair price for it is. It seems to me that if we had 100% certainty that all the contracts would remain viable for a couple of decades, then NC is easily worth say double where it trades now, but the name of the game is in handicapping the risks of the mines closing, and I would be interested in your thoughts about doing that. It’s obvious that you view this risk as worth the price paid, but I am curious why you do not think others should take the same risk.”

I’ll quote from the write-up I did on the Focused Compounding member site. I had sub-titled sections in this write-up. So, let’s just bullet point the headlines that appeared in the article.

They were:

* All value comes from the unconsolidated mines

* There are risks

* NACCO’s business model

* Each share of NACCO is backed by 5 tons of annual coal production

* NACCO makes anywhere from 57 cents to $1.75 per ton of coal it supplies

* Side not: amortization of coal supply contracts

* NACCO vs. NACoal

* Quality of earnings

* Risk of catastrophic loss

* How I “frame” NACCO

* Why I don’t recommend NACCO shares

You asked about “why I don’t recommend NACCO shares” and that’s one of the section headers. So, let’s look at that part:

“I put 50% of my portfolio into NACCO. But, I think people reading this should put 0% of their portfolio into NACCO. As long as electricity demand in the U.S. is declining and natural gas production is rising, coal power plants will shut down. As a shareholder of NACCO, you could wake up any morning to the news that the company has lost 35% of its earnings overnight. I don’t think this is a risk most investors can handle.

Therefore, I don’t recommend anyone invests in NACCO even though it’s now my biggest position.

Let me be clear: I’m not just saying this is a ‘perceived’ risk you may want to avoid.

It’s a real risk.

NACCO is a risky stock.

I absolutely can’t prove that all …

Geoff Gannon December 6, 2017

Do I Think About Macro? Sometimes. Do I Write About Macro? Never.

When writing about a stock, it’s always easier to use a more conventional estimate so you don’t have to argue with people about your “model”. This is one way in which writing about investing – showing your work publicly – is bad for your own investment process.

Regarding macroeconomic variables – the expected rate of nominal GDP growth, the Fed Funds Rate, the price of oil, etc. – the conventional assumption is usually the most recent reading modified by the recent trend. So, if the price of oil was “x” over the last 3-5 years, some people think 0.75x is reasonable and some think 1.25x is reasonable. But, estimates of 0.5x and 1.5x and beyond are considered unreasonable.

This “recency” issue makes it hard to have macroeconomic discussions. The level and trend of the recent past becomes the conventionally accepted answer for future estimates. The problem for you as an investor is that any application of conventional wisdom is useless. If the conventional wisdom is that the Fed Funds Rate will be 1.5% fairly soon – and you also believe the Fed Funds Rate will be 1.5% fairly soon – you may be correct, but your correctness will do you no good. Stocks are already “handicapped” according to the conventional wisdom.

The only macro assumption that can do you any good as an investor is a belief that is both:

1) Correct and

2) Out of step with conventional wisdom

Sometimes, I do have such beliefs. But, they’re never any fun to write about. So, I try not to write about them. However, in terms of my actual investing behavior – I can’t help myself from buying something I believe to be incorrectly “handicapped”. So, you will sometimes see indications of macro assumptions in my actual investments even though they don’t appear in my writing.

Fed Funds Rate

When doing my own (private) work on Frost, I can assume a normal Fed Funds Rate of 3% to 4% without any problem. But, when writing about Frost for others – I have to spend a ton of time justifying something I think seems obvious. A lot of my Frost report was wasted on discussing the Fed Funds Rate instead of discussing Frost. In my own head: I spent very little time worrying about where the Fed Funds Rate would be and when.

Oil Prices

In some cases, the mental toll writing and defending such justifications takes on you just isn’t worth it. So, you don’t write about that topic. For example, people who discussed stocks with me privately – like Quan – long knew that I was using assumptions of $30 to $70 a barrel for oil even when Brent was trading at $110 a barrel. In fact, since I started this blog 11 years ago, my assumptions for the price of oil have never changed. My process has always been “plug in $30 a barrel” and see what you …

Kevin Wilde December 6, 2017

Safestyle UK PLC (LSE:SFE)

Safestyle has the #1 position in the UK replacement window and doors segment.
The company has a simple, proven business model that has seen them grow market share for 12 consecutive years (up from 4.1% in 2005 to 11.2% in 1H2017).
Safestyle has a Fort Knox balance sheet with net cash position of 17MM GBP.
The business is highly cash-generative with negative working capital. Long-term median returns on tangible capital are greater than 200%.
An increasingly regulated market suits larger business’ that have the infrastructure to operate within the regulations.
Fragmented market + structural competitive advantages + superior proposition = sustainable market share gains + opportunities for margin enhancement.
Market should grow at long-term nominal GDP of 3-4%, but through market share gains, Safestyle should grow revenues at >4% and earnings at >6% per annum over the next cycle.
Long-time CEO with skin in the game and history of good execution.
Historical P50 P/E of 15 and P50 EV/EBIT of 11.7 for a company with net cash, very good profitability, and good growth seem very conservative, but the current P/E of 10.9 and EV/EBIT of 7.8 seems way too cheap.
5-year annualized return of 19 to 24% seems possible (9-10% FCF yield + 4-6% earnings growth + 6-8% multiple expansion).
The main risk is an economic slowdown in the UK that sees a reduction in renovation, maintenance, & improvement (RMI) spending. There are already signs of this occurring in the segment; however, Safestyle has historically taken market share in tough market conditions and is well placed to do so again.

Geoff Gannon December 6, 2017

The Cheesecake Factory (CAKE)

Guest write-up by Jayden Preston

Fellow Focused Compounding member Kevin Wilde has written two posts on The Cheesecake Factory (over at the “Idea Exchange”). I suggest you read his posts first to get a better glimpse at the company’s financials. This article is intended to be a more qualitative one.

Overview

Originated in 1972, the predecessor of The Cheesecake Factory was a bakery operation founded by the parents of Chairman David Overton in Los Angeles. In 1978, David Overton led the creation and operation of the first The Cheesecake Factory restaurant in Beverly Hills, California. This essentially led to the inception of the upscale casual dining segment in the US.

Fast forward nearly 40 years, The Cheesecake Factory now operates 209 Company-owned restaurants, comprised of 195 restaurants under The Cheesecake Factory brand name; 13 restaurants under the Grand Lux Café mark and one restaurant under the Rock Sugar Pan Asian Kitchen name. Internationally, 18 The Cheesecake Factory restaurants are operated through licensing agreements by their partners overseas. The Company also has a baking segment, running two bakery production facilities in the US. All the cheesecakes served in their restaurants, including international licensees and third party bakery customers, are made at either of these two facilities.

Operating in the upscale casual dining segment, their average check per customer, including beverages and desserts, is above $20 per customer.

In Nov 2016, they have also invested $42 million for minority stakes in two concepts, North Italia and Flower Child, and will provide growth capital for them going forward.

As restaurants bearing The Cheesecake Factory brand still delivers most of the value in this company, we will focus our following analysis on them.

Major Differentiation Points

Their restaurants are different from most restaurant chains in the following ways:

Except their desserts being produced at their bakery facilities, substantially all other menu items are prepared from scratch locally at their restaurants, with fresh ingredients.
Their restaurants are huge with size ranging from 8,000 square feet to 12,000 square feet.
The capital investment per square foot for each of their restaurant is thus higher than most, even in the casual dining industry. It usually costs $8 million or more to set up one new restaurant.
Offsetting point number 3 is the unusually high sales per square foot generated in their restaurants. Particularly, the average The Cheesecake Factory restaurant generates above $10 million in sales per year, averaging close to $1,000 in sales per productive square feet.
Extensive menu covering a huge variety of dishes, appealing to a diverse customer base across a broad demographic range. The Cheesecake Factory menu features more than 200 dishes. The menu is updated twice every year.
Higher percentage of sales from desserts than average. Dessert sales was 16% of revenue in FY2016.

Durability

The business of restaurants is durable as long as humans exist, because I believe eating out will never go extinct. Instead, a …

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