Posts By: Geoff Gannon

Investing in Trusts: Why Andrew and I Don’t Own Them, Why You Probably Won’t Want to Too – And How to Get Started if You’re Sure This is Really an Area You Want to Explore

Investing in Trusts: Why Andrew and I Don’t Own Them, Why You Probably Won’t Want to Too – And How to Get Started if You’re Sure This is Really an Area You Want to Explore

Someone asked me a question about trusts:

“I was watching one of your past podcasts and you mentioned you would not buy dividend stocks for an income portfolio you would buy trusts. How would I go about or is it possible to research and possibly purchase these? I found that idea fascinating.”

The best trusts are usually illiquid and a bit difficult to find. You have to do a little research on them and what backs them. Some examples of the kinds of trusts I was talking about are:

Beaver Coal (BVERS) – Mainly royalties on met coal, timberland, and rental income (variety of business, etc.) in and around Beckley, WV

Mills Music Trust (MMTRS) – Royalties on old songs like “Little Drummer Boy”

Pinelawn Cemetery (PLWN) – Interest in proceeds from sales of burial plots in one cemetery on Long Island, NY

Things like that.

Many investors avoid these because they complicate your taxes. You’ll need an additional form from each trust you own (they should send it to you, if they don’t – you’ll contact them and request the form). And it may sometimes cause you to request late filing of your taxes.

For this reason, partnerships (like the one Andrew and I run) and professional investors running managed accounts (like the ones Andrew and I manage) will avoid buying these trusts simply because they don’t want to lose clients through annoying the client with additional tax work for the client. As a result, many professional investors who may know of and like these trusts (and even own them personally) won’t buy them for clients. This can keep the price of the trusts reasonable. These stock prices (technically they are trust certificates, not stocks) tend to bounce around in price.

It is best to only buy them when the yield on the trust (making sure you check to see if the distribution recently is similar to what it is normally) less the rate you’d pay on taxes still makes it make sense. For example, say you want an 8% annual return in the trust certificate and you pay 30% in taxes on income from a trust, then you don’t want to buy when Distribution/Price is anything worse than 11.5%.

Often, your total return in the trust is not going to be great compared to buying and holding a stock that is actually retaining its earnings.

However, it is true that for income purposes only – these trusts will often yield more than the dividend yield you can get on other kinds of stocks, the yield you can get on preferred stocks, the interest rates you can collect on bonds, etc.

But, keep in mind five things:

1) Owning these will complicate your taxes

2) Income from trusts is usually less tax efficient – …

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Why I Wouldn’t Worry About Risk-Adjusted Discount Rates

Someone asked me a question about using risk-adjusted discount rates when valuing stocks. Here’s my answer.

The discount rate for a stock should be the opportunity cost of putting money in it instead of something else. For your average investor, the next best alternative to where they’d put money instead of this stock would seem to be an index. If they don’t buy this stock, they wouldn’t buy a government bond – they’d buy an index. So, the discount rate shouldn’t be a government bond. It should be an index.

When writing up stocks, the opportunity cost I use is the expected return in the S&P 500. In theory, I think the right discount rate for a stock would just be the return you expected from an index you could otherwise invest in. You could use other measures. For example, it is not really honest for me to use as my discount rate the return I expect on the S&P 500, because the actual returns of stocks I’ve bought since I’ve been investing (20+ years) have not been similar to the return of the S&P 500 during the same time period. So, in theory – I should be calculating opportunity cost as the compound annual growth rate I think I could make with other stocks I could pick. I suppose, in theory, it would be best to tie this to my actual returns over time. However, this isn’t a very good way to talk about stocks with other people. For example, if investor A has averaged 5% a year over his 25 years of investing and investor B has averaged 15% a year and the index has averaged 10% a year all over the same 25 years – I don’t really think the general public should use a 10% rate and our two hypothetical investors should use rates of 5% and 15%. Instead, we should probably try to apply a discount rate that takes into account what we think an index will return in the future. What should that number be? I’m not sure. About 8% would make sense to me. To be on the safe side, 10% would be fine. Indexes haven’t really returned much more than 10% over the very long term. So, unless you had reason to believe the index you are using as a benchmark is incredibly cheap at the moment – it wouldn’t make sense to use a rate greater than 10%. I think using a 10% discount rate as your hurdle would tend to undervalue stocks going forward. But, that’s just an opinion. What I mean is I think that if you buy a stock assuming it will return 10% a year over the next 15 years or so – you’re likely to be getting a better bargain in that stock than if you bought into the S&P 500.

Note, however, that this means if you are aiming for much higher returns – you’d kind of be using a higher discount rate. I don’t …

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Why Appraising a Stock Based on “Relative Valuation” vs. Peers Isn’t Enough to Guarantee You’re Getting a Bargain

Someone asked me a question about relative valuations:

“There are a couple of instances when we can value the stock based on comparables. However, for me, I feel that there is something in the middle that I can’t figure out. There is a big assumption that the stock with the cheaper valuation will go up to get close to the market. Is there an embedded assumption such as, if the stock being compared are similar in growth/roe, or basically we just are hoping for mean to reversion?

I found two similar companies in the same sector in the different country…P/B ratios are (1.5-2.0) and (2.0-3.0). P/E ratio range for the past 3 years are (9-15) and (40-60). ROE 14% vs 7% (yes, the first company has a better ROE and yet is cheaper). Both are growing at similar rate.

If I said that stock A is a good buy, because it is much cheaper in relation to B, do I miss anything in the middle? Since the investment return is largely reliant on the stock A being rerated higher.

How do you approach the relative valuation then?”

So, yes, I do use relative valuation. For example, I’ve mentioned before I own Vertu Motors (VTU). It is a U.K. car dealer. I believe the core economics of car dealer groups in the U.K. and U.S. are similar. I wasn’t able to find much evidence of differences in the way the businesses work, how they make money, how much they make, etc. There are legal differences. But, I couldn’t find any evidence these legal differences translate into actual differences in the economics, because the legal stuff didn’t seem to be the primary reason for the competitive advantages of certain incumbents in each market. A lot of the other economics seemed the same. Like, the scale economics seemed the same. The sales mix of what each dealer is selling and how much sales of other products (financing, warranties, etc.) they are doing and stuff like that seemed to work the same in one country vs. the other. A lot of the unleveraged returns on capital for similarly situated companies in each country seemed the same. It didn’t seem obvious to me that there was a material advantage to owning a U.S. based car dealer vs. a U.K. based car dealer. However, the U.S. based car dealer stocks traded at much higher relative valuations (higher P/B ratios, EV/EBITDA, ratios, etc.). Why?

One, the U.S. car dealers sometimes had greater scale. So, you would have to adjust for that. The market had – historically – seemed to reward companies sort of after the fact for scale. So, if you had improving margins, returns on capital, etc. now because you’d begun scaling up earlier – the market seemed to reward the companies when the actual earnings per share growth and such came in. They would then give them higher multiples. They wouldn’t necessarily give higher multiples to smaller dealer groups that said they’d scale up, even …

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Since It’s One of Warren Buffett’s “Inevitables”: Is it Okay to Pay a High P/E Ratio for Low Growth Coca-Cola (KO)?

Someone asked me this question:

“Warren Buffett had commented that Coca-Cola has a durable competitive advantage. It is one of his ‘inevitables’. I am curious what is your thought on the investment merit of a business that may not grow much in an absolute sense, but has a durable competitive advantage like Coca-Cola?

Coca-Cola may not have be able to grow their sales at 10% a year like in the 1990s, but would it make sense to focus on sales per share going forward? Assuming the free cashflow margin is stable and predictable in the long-term because of its durable competitive advantage, the company can reduce the shares outstanding over time and still benefit shareholders.”

I am not a big fan of investing in a business like Coca-Cola (KO) today. It does make sense to focus on sales per share (assuming free cash flow margin stays pretty stable). The problem that I see with something like Coca-Cola – no matter how inevitable it is – is that the company has only grown like 2-4% a year over the last 10+ years. Basically, it has grown at the rate of inflation. I’ve talked before about the idea of “free cash flow plus growth”. What I mean by this is that your return in a stock can be calculated where you ask “how much growth will I get each year in this stock?” and “what is the free cash flow yield I am getting in this stock”. This is a way of thinking of a stock like a perpetual bond. A perpetual bond would be something that pays a “coupon” each year (so $40 on a $1,000 face bond would be a 4% coupon rate) but never matures. So, in the example I just gave of a $1,000 face value bond that pays you $40 a year forever – you never get the $1,000 back.

Imagine this was the case with Coke. Say Coke stock is 100% safe with no risk of going to zero, no risk of earnings ever declining, etc. Okay. Most stocks and even bonds have some risk we have to account for. But, if this was truly as risk free a coupon as like a perpetual government bond then we could imagine that if you want to compound your money at 10% or better a year forever – all you have to do is buy a Coca-Cola type “earning coupon” at 10x earnings (this is a 10% earnings yield).

Because stocks retain part of their earnings, you can actually afford to pay a price-to-free cash flow higher than 10x. But, how much higher.

If the growth we are about to talk about was truly perpetual growth – it will never slow down or turn negative, then we can do a calculation that’s very simple:

Desired Rate of Return < Free Cash Flow Yield + Growth — then, buy the stock and hold forever

Say you want a 10% return. Then, free cash flow yield plus growth must be …

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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 …

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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 …

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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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A Question for Passive Investors: If You’d Buy 100% of the Business at Today’s Price – Should You ALWAYS Buy the Shares?

One of Warren Buffett’s basic tests for buying a stock is the idea that if you wouldn’t buy the whole company at this price – market cap, enterprise value, etc. – you shouldn’t buy the stock. Not even to hold it for just a week, month, or year. Does the reverse hold true though? If you would buy the entire company – does that mean you should buy the stock?

If you like the management, controlling shareholders, etc. and you like the way they’ve been allocating capital and are likely to be allocating capital in the future – then, the answer would be yes. But, what about the much more common situation where owning an entire business and controlling all of its cash flows yourself might be more attractive than buying a piece of it as a passive, minority shareholder. This situation is more common than you think. Andrew and I can usually find some business somewhere that we’d be happy to acquire 100% of at the current market cap – or even at some fairly large premium over that – but, are less sure we’d be happy as passive, minority shareholders. Why does that happen? Are we really so much more confident in our ability to allocate capital than those of most management teams?

No. The reason it happens is price. Good businesses do sometimes – though often not for long – trade at big discounts to what they would be worth to a private buyer. Sometimes very illiquid stocks, very misunderstood businesses, currently unpopular industries, etc. are also a reason why a public company might trade at a big discount to where it would sell in a private, negotiated transaction. But, a much more common reason for extremely persistent cheapness is the capital allocation. Controlled companies aren’t any better or any worse capital allocators on average than non-controlled companies. But, whatever they are – good or bad – is amplified tremendously by their control. The reason for this is the long duration of a stock as compared to most bonds you’ll come across. A lot of a stock’s value comes from the discounted future cash flows out many, many years in the future. Your average public company retains a lot of earnings. It could be 30%, 50%, or 75%. I know 30% sounds low. But, if a company is retaining one-third of its earnings each year and it’s growing, and it’s selling at 10 times earnings (a typical “value stock” type P/E) – that business will re-allocate way more than its current market cap over the next 30 years. And 30 years – given today’s extremely low interest rates – is probably a good time frame to think of the value of a stock over. You’re unlikely to hold the stock for 30 years. The stock may even be unlikely to stay public for 30 years. But, the period over which the discounted cash flows are still relevant on a present value basis is likely to be as …

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