October 2020 – Focused Compounding

Andrew Kuhn October 30, 2020

Weekly Review

Interesting Articles from the Week:

Apple, Google and a Deal That Controls the Internet: Apple now receives an estimated $8 billion to $12 billion in annual payments — up from $1 billion a year in 2014 — in exchange for building Google’s search engine into its products. It is probably the single biggest payment that Google makes to anyone and accounts for 14 to 21 percent of Apple’s annual profits.

https://www.nytimes.com/2020/10/25/technology/apple-google-search-antitrust.html

Charting 20 Years of Home Price Changes in Every U.S. City: At the turn of the century, the average U.S. home value was $126,000. Today, that figure is at a record high $259,000 – a 106% increase in just two decades.

https://www.visualcapitalist.com/20-years-of-home-price-changes-in-every-u-s-city/

Netflix hikes monthly charges for US subscribers: Netflix has hiked monthly charges for its most popular standard plan to $14 and its premium tier to $18 in the United States, the streaming giant said on Thursday.

https://finance.yahoo.com/news/netflix-hikes-monthly-charges-us-191334870.html

What I’m reading

Greenlights by Matthew McConaughey – I can’t express enough how much I enjoyed this book. The definition of “cool” in the dictionary should just say, Matthew McConaughey.

While entertaining/insightful, I also learned about the acting side of the film industry.

To Pixar and Beyond by Lawrence Levy – This was an inspiring read about Steve Jobs building Pixar from a small, money-losing studio into something that changed the entire industry. At the time of Steve’s death, most of his wealth was the result of the work he did at Pixar, which, in the end, was acquired by Disney.

Entertainment Industry Economics by Harold L. Vogel – I came across this title when I was reading To Pixar and Beyond.

In 1994, Lawrence Levy received a call out of the blue from Steve Jobs to see if Lawrence had any interest in joining Pixar as CFO. Lawrence agreed to join, only to realize that he knew absolutely nothing about how movies made money. To learn about the economics of the industry, he purchased the book I am now reading. So far, I am enjoying it.

The Hollywood Studio System, A History by Douglas Gomery – As the title says, this book provides a background on the movie industry from the early days of Adolph Zuker at Paramount Pictures in 1920, all the way to the second film revolution with Lew Wasserman of Universal Studios in the 1960s.

Although this book was very informative about the pioneers in the industry, I felt like it was super dry at times and required extra effort from me to push through to the end. I’m glad I did, though.

The Psychology of Money: Timeless lessons on wealth, greed, and happiness by Morgan Housel – This book is unequivocally one of the best books I have read in 2020. If you have not read Morgan’s book yet, be sure to add it to your batting order.

It will not surprise me if this book is referenced as a must-read on finance and money for decades to come.

Some Final thoughts:

Geoff Gannon October 29, 2020

Hunting for Hundred Baggers: What Stocks Should – and Shouldn’t – Go in a Coffee Can Portfolio

From a “100-bagger” type perspective, the criteria are pretty simple: 1) Is it a small stock (probably a micro-cap, definitely a small-cap)? – We’re talking <$300 million market cap probably, but certainly like $1 billion or so – not multi-billions 2) Does it have a market multiple or lower (so, say most P/Es today are 18 or whatever – is it 18 or less, not above) 3) Does it grow faster than most businesses, the economy, etc. 4) Is it self-funding? There are other things you could look for in a stock that would be good pluses to have. But, those 4 criteria are the really important ones for whether something is immediately disqualified as potential buy and hold forever type stock. Basically, it HAS to be small (if it’s in major indexes like S&P 500 – it’s not a buy and hold forever stock), it can’t have a multiple that will contract while you own it (so, it doesn’t have to be a “value” stock, but it can’t be especially high priced), it has to have strong growth, and then it has to be able to fund a lot of or all of that growth (it shouldn’t be issuing a lot of shares, for example). You could make this into a 4-point checklist to make decisions on the stocks you own.

Once you’ve decided a stock might be a possible coffee can portfolio candidate – it passes the screen of: small market cap, not high P/E, good growth, self-funding – then you can start on the more qualitative checklist.

You have to ask questions like:

1) Is this stock in one of my areas of expertise?
2) Is this an above average industry to be in for the long haul?
3) Is this an above average company within that industry?
4) Is this run by an above average management team?
5) Am I paying a below average price for this business?

Those are the 5 questions I’d ask when deciding whether to add a potentially promising stock to your coffee can portfolio. Honestly, the most important is #1. You want to avoid businesses that are outside the areas where you exercise your best judgment. For example, if someone brought me 4 stocks that had the exact same financial histories and prices but one was in finance, one was in entertainment, one was in medicine, and one was in semiconductors – I would immediately decide not to buy the medical or semiconductor companies because my judgment in those areas is poor.

I would consider the finance and entertainment businesses though. This is because my judgment in the areas of finance and entertainment is “expert” enough that I know it’s better than most buyers and sellers of those stocks. I will, of course, still make mistakes. You’ll make mistakes from time to time in all areas. But, you’ll make fewer mistakes in your areas of expertise. For me: finance and entertainment are areas of expertise – medicine and semiconductors aren’t. For …

Geoff Gannon October 23, 2020

Hingham (HIFS): Good Yield Curve Now – But, Always Be Thinking About the Risk of the Bad Yield Curve Years to Come

I’m writing again about Hingham (HIFS), because someone asked me this question:

I was wondering how long it would take Geoff to talk about Hingham savings, seems to tick all his boxes – very low cost of funding on the operations side and a capital conscious manager with Buffett fetish. What more could you want ?

It does have a very low operating cost. But, it doesn’t have a very low interest cost. It does now that rates have been cut to nothing. But, it probably got down to about a 2% net interest margin just before the end of the housing bubble about 13-14 years ago. It had a very rough 2006-2007.

So, the bank is set up very differently than most banks I would be interested in that I’d consider very safe. Hingham is running some serious risks by being 100% real estate focused. This is because you end up with almost no “self-funding” of your lending, because your borrowers are going to be small to mid-sized (and maybe a couple big sized) relationships where they just want a lot of money all the time to invest in more and more real estate. They aren’t going to deposit a lot of money with you. Compare this to something like the C&I side of Frost where it is going to be about 100% funded by an equal amount of deposits and borrowing coming from your customers on the commercial and industrial side. So, something like Hingham is going to need to use CDs and FHLB borrowing to operate. It is going to be very, very sensitive to cost of liabilities on the very short-term. What it is basically doing is borrowing short wholesale and then lending long against real estate. That’s very good right now. It’s just gotten to be a lot better business, because the cost of its liabilities has dropped to close to 0% with Fed Fund Rate cuts in the last year. But, that is going to be a temporary situation.

So, what more would I want to know?

Does the bank understand how it is running a unique business model that has unique risks in terms of liquidity. Like, do they understand that they can have almost no credit losses and the lowest operating expenses in the banking industry and STILL face some risks? If they said to me: “Oh. We don’t really worry about that liquidity stuff. There’s always been funds available to borrow. Etc.” Then, I might worry.

I kind of follow the Buffett approach that Alice Schroeder has talked about where I START with asking “what’s the catastrophic risk here?” and then go from there. So, if I think there’s a meaningful risk of catastrophe – then, I might pass on an idea right away that looks like it might have good risk/return odds in most environments, but could go broke in unusual circumstances.

What are the unusual circumstances that are a risk here?

…

Geoff Gannon October 17, 2020

Hingham Institution for Savings (HIFS): A Cheap, Fast Growing Boston-Based Mortgage Bank with a P/E of 9 and a Growth Rate of 10%

This is the one “higher quality, more expensive” bank I mentioned in the podcast Andrew and I did where we talked about like eight or so different U.S. banks. Hingham’s price-to-book (1.7x) is very high compared to most U.S. banks. It is, however, quite cheap when compared to U.S. stocks generally. This is typical for bank stocks in the U.S. They all look very cheap when compared to non-bank stocks. There are many different ways to calculate price multiples: P/B, P/E, dividend yield, etc. The easiest way to calculate a high quality, stable, growing bank’s cheapness or pricey-ness is simply to take the most recent quarterly EPS and multiple it by 4. You then divide the stock price into EPS that is 4 times the most recent quarterly result. The reason for this is that bank’s aren’t very seasonal. But, sometimes events – like COVID – and normal growth (HIFS is a fast grower) can cause the full past twelve month earnings figure to be out of date So, how cheap is HIFS?

“Core” earnings per share in the most recent quarter – I’ll discuss what “core” means at Hingham later, but for now trust me this is the right number to use – was $5.68. Multiply this by 4. We get $22.72 a share. That’s our 12-month look ahead “core” earnings. The stock now trades at $206 a share. So, $206 divided by $22.72 equals 9. Hingham is trading at a “forward” P/E of 9. The “PEG” ratio (price-to-earnings / growth) here may be around 1 or lower. Hingham compounded book value per share by 15% a year over the last 5 years. Growth rates in the 10-15% range have been common since this bank’s management changed about 30 years ago. A lot of balance sheet items – like total assets, loans, and deposits – all grew about 10%+ over the last 12 months. So, a growth rate of about 10% and a P/E of about 9 seems likely here. One thing to point out is the high return on equity. Core return on equity is running at about 18% here. If ROE is about 15-18% while growth in loans and deposits and so on is in the 10-12% range, then the bank will eventually need to pay out one-third of its earnings as dividends and buybacks. Historically, it has not done this. It has found ways to grow much faster than the area (Boston) in which it operates and much faster than the balance sheets of its existing clients. Usually, that kind of thing can’t be kept up forever. Once that kind of growth can’t be kept up, the bank either becomes overcapitalized or it pays out a lot more in dividends and in buybacks. This brings up the other way we can look at a bank like Hingham. We can think in terms of dividend yield and growth. So, let’s say the dividend yield is 1%. The question then becomes how much do we think that dividend …

Geoff Gannon October 10, 2020

How is a Bank Like a Railroad? – And Other Crazy Ideas Geoff Has About Investing In “Efficiency Driven Businesses”

Someone sent in this question:

When deciding to look for a bank, where do you start? What is your initial approach when finding a bank?

So, I don’t really have one specific thing I look for in a bank stock. The way it usually works is that I read about a bank somewhere. I’ve gotten a couple good bank stock ideas off the Corner of Berkshire and Fairfax “investment ideas” thread (I read every post in that thread). Now, the truth is that it’s never been a very long thread about the bank. In fact, there are like 3 banks in all the time I’ve been reading Corner of Berkshire and Fairfax’s “investment ideas” thread that jumped out at me. The numbers someone cited just jumped out at me immediately as unusual. Now, unusual doesn’t necessarily mean good. But, it does mean do more research on it. So, the basic numbers where being especially high or low or whatever for the bank would make it really, really interesting would probably be:

– ROE (higher is better)
– ROA (higher is better)
– Efficiency ratio (lower is better)
– Deposits/branches (higher is better)
– Leverage (lower is better)
– Dividend payout ratio (lower is better)

Many banks are going to look awfully similar on these measures. That’s because banking is in some sense a commodity business. To me, banking is most similar to insurance. It also – in some ways – can be a little similar to things like railroads too. I know that’s hard to believe. But, I would say that there can be potentially some similarities between things like: banking, insurance, telecom, power, water, and railroads. Why?

These businesses work really, really differently from most businesses investors are used to analyzing. Most investors are used to analyzing big tech, media, restaurants, retailers, consumer brands, etc. Capital is relatively unimportant in those industries. Intangibles are important. Competition is fierce. The industry changes quickly. So, competitive position can be very, very important in those industries. Whereas capital is less important. And then oddly efficiency is less important as a differentiator. Efficiency becomes very important as a differentiator if you are in a more capital intensive and less competitive business. Like, a monopoly cable company can have all sorts of different returns depending on who is running it. John Malone runs it – it’s a great
business. Average family running it in the early days of cable – it was an okay business. It grew fast and such, but it may not have been very highly leveraged (so it paid taxes) and it was probably spending more than it needed to in terms of expenses (so EBITDA margins were worse) and so on. Businesses like banking, insurance, railroads etc. are very efficiency driven because the return accruing to owners is further removed from the value you can extract from the customer. If you have a great brand – it’s going to either be a good business or bad business primarily based on …

Geoff Gannon October 7, 2020

Is There a Difference Between Being a Good Investor and a Good Stock Picker?

On a recent episode of the rundown – a weekly YouTube show with Andrew Kuhn and Vetle Forsland – Andrew asked the question of whether you could be a good investor without being a good stock picker and vice versa.

To answer this question, I’m going to use an analogy I made on a recent podcast between picking stocks and playing poker. If, in a game of Texas Hold ‘em – you are dealt the hole cards Ace / Ace, you have a better chance of winning the hand than if you are dealt 7 / 2.

However, the truth is that a great many hands of Texas Hold ‘em will never get to the point where two players turn over their cards and we see who wins. For that reason, it’s perfectly possible to do well playing the other players with 7 / 2 (since they can’t see your cards, it can’t make a ton of difference what those cards actually are). Does that make not folding 7 / 2 a good move as long as you can outplay the other players irrespective of the cards? Likewise, you can be beat with your Ace / Ace if the hand does result in two or more players comparing their hands. We could call this bad luck. We could say it’s a pretty obvious observation. But, I think there’s something more to this analogy. In a sense, your return on 7 / 2 would have to be of a speculative nature – guessing how other players will react to what you do – rather than an investment nature (what your cards are versus what is on the board). There is an element of the cards and the play that matters with either set of two hole cards (great or terrible). But, the element of the cards could potentially be much more important with Ace / Ace and the element of the players more important with 7 / 2.

Does investing – or stock picking – work the same way?

In a sense, I think it does.

We can break your CAGR as a stock picker into two parts: the return you can get from judging the business right (which I’ll compare to judging the cards you are dealt and the cards on the board as they appear) and judging the other market participants right (which I’ll compare to judging the players at the poker table).

Multiple expansion is ultimately about judging the other players right. If you know you are very, very right about how other current and potential future holders of a stock will behave – you don’t actually need to own the right business. You can win with 7 / 2. You could buy a junk company as long as you correctly predict that the market will award a higher multiple to the stock. Now, some will say you need a positive development in the business that exceeds the current expectations of the market. My experience investing has taught …

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