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Geoff Gannon July 30, 2020

Avalon Holdings (AWX): An Unbelievably Cheap Controlled Company that Might Stay “Dead Money” For A Long Time

I’ll be doing write-ups on Focused Compounding more frequently now. This means that the quality of the ideas will be lower. Previously, I’d tried to focus on writing up just stocks that looked interesting enough to possibly qualify as some sort of “stock pick” from me. Now, I’m just going to write-up ideas I analyze whether or not they turn out to be anything approaching the level of an actual “stock pick”. So, keep that in mind. Some of these write-ups – and I’d say Avalon falls into this category – are going to be in more of the “not a stock pick” category. Actually, though, Avalon is a really interesting situation – just, a really interesting situation I’m not at all sure I’d actually recommend.

Avalon is a nano-cap stock. I’ve followed the company in some form for over a decade. It’s often been cheap. But, it’s rarely been as cheap as it is now. Avalon does a bunch of things. It owns some salt water injection wells. Those have been shut down and written off. There’s a ton of info about the court cases around these wells in the 10-Q, 10-K, etc. I’ll leave you to read those for yourself. I’m going to just say the wells are not worth anything positive or negative for the purposes of this write-up. Avalon has a waste management business. There are two parts to this. One is a “captive landfill” run for a customer (on that customer’s land) in Ohio. This is only about 5% of the waste management division’s revenue. And it is just one customer. There isn’t enough info given by the company to evaluate this captive landfill business in any depth. The other thing Avalon owns is a “waste brokerage” business. This is big. Revenue from this is like $45 million. It seems to be about 60% recurring revenue and 40% project revenue (in many years). This waste brokerage business is the source of Avalon’s earnings. In fact, earnings from the waste brokerage business often exceeds reported earnings of the entire company. This is due to losses in the other segments (salt-water injection wells and the “golf” business). Most of the company’s assets are in something it calls the “golf” business. This is potentially a bit of a misnomer. It should just be called “country club”. The company owns 3 golf courses and leases a fourth (Avalon has the right to exercise extensions on that leased property to keep it through 2053). The 4 golf courses are located in Northeastern Ohio and Pennsylvania. The towns they are in are: Warren, OH; Vienna, OH; Sharon, PA; and New Castle, PA. The sites at Warren and New Castle are being renovated right now. New Castle is a new acquisition and very run down. Warren is the company’s oldest location – it’s where the corporate HQ, the hotel, etc. are – and the renovations are to make the resort hotel even more impressive. To the extent Avalon is an asset play …

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Geoff Gannon July 30, 2020

Business Momentum: When is a Value Stock a Value Trap?

One of the biggest risks for a value investor is buying into a business with poor momentum. Not momentum in the since of an upward movement in the price of the stock – that is often a problem, but it’s a difficult one for an investor (as opposed to a speculator) to evaluate and then count on – but, poor business momentum. Value investors – because they focus on the P/E ratio, the P/B ratio, EV/EBITDA, and many other measures of price – often find themselves buying into a business that looks cheap based on past measures of profitability rather than being cheap on future measures of profitability. The problem is that everything we know about a business is about that business’s past. And yet, for an investor, everything that matters about a business is that business’s future. In a previous article, I listed a series of stocks that are typical of value stocks. Value stocks can be defined in many ways. I think the simplest is the “Graham Number”. Ben Graham talked about the importance of not overpaying for a stock in terms of either its asset value or its earning power. There is no completely correct number to gauge earnings power. For a cyclical business, this year’s earnings might not be a good guide as to what normal “earning power” really looks like. Nor is there any one completely correct number to gauge asset value.

However, there are some numbers that can be helpful. A stock that trades at a meaningful discount to its tangible book value is more likely to be cheap than most other stocks. The likelihood of its cheapness becomes greater if it also trades at a meaningful discount to what would be a normal multiple of its earning power. Earning power isn’t precisely the “e” in the P/E ratio. But, for many typical value stocks – it could be pretty close. So, if we combine the P/E ratio and the P/B ratio – by multiplying the two factors together – we can sort out those stocks that look especially cheap on a combination of both asset value and earning power value. These stocks – the stocks with some of the lowest Graham Numbers – are most likely to be true value stocks. However, the businesses these stocks are in may sometimes be experiencing a great deal of negative business momentum. In fact, that is one of the most common reasons for a low stock price. There are other reasons. But, decelerating earnings growth or declining earnings or shrinking margins or a hundred other poor business “vital signs” are common reasons for why investors – and speculators – abandon a stock. And that abandonment is what leads to a low stock price. So, our job as value investors should be to find those stocks with low Graham Numbers – low P/E ratios and low P/B ratios – where the business momentum is either not that bad or where it is likely to reverse at some …

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Geoff Gannon July 28, 2020

Was Peter Lynch Right? – Does Earnings Performance Drive Stock Performance?

I’m writing today’s Focused Compounding daily from a Best Western in Kansas. By the time you read this, I may already be back in Plano. Today will complete this short – only like four days total – research road trip by me and Andrew. We spent some time in New Mexico, Arizona, and Kansas basically.

While on this trip, I’ve been re-reading some books by a guy who did a lot of these sorts of trips: Peter Lynch. Lynch isn’t exactly a value investor. So, some of the things he says can be particularly interesting for a value investor to hear. One of the most interesting things he says repeatedly is that – in the long run – stock performance tracks earnings performance. So, you just find the stocks that are going to grow earnings a lot over the next 5, 10, 15 years. And then you make sure those stocks don’t have crazy high P/E ratios today. And then you buy them.

This part about how earnings performance drives stock performance tends to be true in the very long run. If you look at list of 100-bagger stocks, they are basically lists of 100-bagger businesses in terms of profits and even earnings per share. You don’t have many 100-baggers where earnings went up only 10 times but the stock went up 100 times. Usually, you need the two working together. So, yes, the multiple goes up 5 times, but the earnings go up 20 times. Or, the multiple triples and earnings increase 30-40 times. There aren’t a lot of pure value stocks on a list of 100-baggers. Nor, actually, are there as many pure growth stocks as you’d think. If a growth stock is something with a P/E of 50, or 75, or 100 – that’s not where hundred baggers usually come from. If it’s a very fast growing business with a P/E of 30 – then, yes, plenty of 100-baggers do come from stocks as expensive as that.

The problem for investors – even pretty long-term investors – is that, in some stocks, the tracking of earnings and price is very weak. In an earlier article, I mentioned FICO (FICO). Over the last 10 years, measures of things like sales per share, earnings per share, free cash flow per share, etc. have basically tripled. Meanwhile, the market cap of the stock has increased about 10 times. The P/E went from about 15 to about 50. Price-to-sales from like 1.5 to 7.5.

The risk for the investor is, of course, that he thinks of the multiple expansion the same way as the earnings growth. Investors rarely tell themselves I bought a stock that increased EPS at 15% a year for 10 years and I bought it at a pretty low starting price (let’s say 15 times P/E). So, I’ve done well in this stock because I bought in at a P/E of 15 and it grew EPS at 15% a year for a long time. Instead, they have one …

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Geoff Gannon July 26, 2020

Surviving Once a Decade Disasters: The Cost of Companies Not Keeping Enough Cash on Hand

A couple days back, I read Tilman Fertitta’s book “Shut Up and Listen”. The book is short. And it’s full of a lot of basic, good advice especially for someone looking to build a big hospitality business (which is what Fertitta did). What stood out to me is how practical the book is about stuff I see all the time in investing, but rarely gets covered in business books. The best example of this is a chapter on “working capital”. Value investors know the concept of working capital well, because Ben Graham’s net-net strategy is built on it. But, working capital is also important as a measure of liquidity.

A lot of value investors focus on the amount of leverage a company is using. The most common metric used is Debt/EBITDA. Certain Debt/EBITDA ratios are considered safe for certain industries. It might be considered fine to leverage a diversified group of apartment buildings at Debt/EBITDA of 6 to 1 but risky to leverage a single cement plant at Debt/EBITDA of 3 to 1. There is a logic to this. And some companies do simply take on too much debt relative to EBITDA. But, that’s not usually the problem that is going to risk massive dilution of your shares, sales of assets at bad prices, bankruptcy etc. in some investment. The usual issue is liquidity. If you borrow 3 times Debt/EBITDA and keep zero cash on hand and all your debt can be called at any time within 1-2 years from now – that’s potentially a lot riskier than if you have borrowed 4 times Debt/EBITDA and are keeping a year of EBITDA on hand in cash at all times and your debt is due in 3 equal amounts 3, 6, and 9 years from today. The difference between these two set-ups is meaningless in good times. As long as credit is available, investors who focus only on Debt/EBITDA will never have to worry about when that debt is due and how much cash is on hand now. However, at a time like COVID – they will. Times like COVID happen more often than you’d think. Fertitta is in the restaurant business. He’s seen 3 liquidity crunches for restaurants in the last 20 years. There was September 11th, the collapse of Lehman Brothers, and now COVID. He got his start in the Houston area. Not much more than a decade before the first 3 of those events I listed above – there was a collapse of the Texas banking system that resulted in a lot of Texas banks (and all but one of the big ones) closing down. That was also a possible extinction level event for restaurants in the state. So, using Fertitta’s 30-40 years in the restaurant business as an example, extinction level risks that depend on a restaurant company maintaining some liquidity to survive seem to happen as frequently as once every 10 years. When looking at a stock’s record over 30 years – the difference between a …

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Geoff Gannon July 21, 2020

The Graham Number: What Makes a Value Stock a Value Stock?

In recent years – and especially recent months – many stocks have gotten a lot more expensive. Especially among bigger U.S. stocks, the “value” category has shrunk. I did a quick check of the biggest stocks in the U.S. – basically the top 40% of stocks by size in the S&P 500 – and I’d say that about 85% of these stocks can now be clearly labeled “non-value stocks”. A non-value stock might not be expensive. It might turn out that Amazon (AMZN) will grow so fast and so profitably for so long to justify an above-average multiple. But, we can’t call something with an above average multiple a “value stock”.

The easiest way to define a value stock is to use what I’ve – a couple times on the podcast now – called the “Graham Number”. This is my word for it. Some people call a different number the Graham number. But, having read Ben Graham’s writings – I’d say this is the number that most deserves his name. It’s a simple product of two factors: 1) The price-to-earnings ratio and 2) The price-to-book ratio. Graham suggested – in the Intelligent Investor – that you shouldn’t buy a stock with a “Graham Number” over 22.5. He probably got this number by using a P/E ratio of 15 as “normal” and then he asked how high or low a P/B is acceptable based on that P/E ratio of 15. So, for example, a stock with a P/E of 15 and a P/B of 1.5 would be considered a “normal” price level for a stock. This would then – through simple multiplication – tell you that a “Graham Number” of 22.5 marks the dividing line between a “value” and a “non-value” stock.

So, let’s start with some extreme examples of clear value stocks. Among stocks I’ve mentioned frequently on the podcast, two stand out. One is NACCO (NC). According to, NACCO – at about $23 a share – has a P/E of 5.3 and P/B of 0.6. This gives you a Graham number of 3.2. That’s a stunningly low number. Anything under 5 is pretty rare. Is it a good idea to buy stocks with Graham Numbers that low? No. I don’t think you should favor stocks with a super low Graham Number of 5 or less over stocks with a Graham Number of 15. A Graham Number of 15 would equate to a one-third “margin of safety” versus the “normal” Graham number of 22.5. This is because 15/22.5 = 0.67. Graham frequently used a one-third margin of safety as a sort of nice, round figure for what you should look for in a stock. I think it’s fine to do the same. It’s probably better – and, in fact back tests I’ve done for the two decades ending in 2020 show it’s been empirically better – to buy good companies at as high a Graham Number as 15 instead of just focusing on buying everything with a Graham Number …

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