Posts By: Geoff Gannon

The Possibility of Negative Interest Rates in the U.S.

Someone who reads the blog emailed me this question:

“What’s your general thoughts on negative interest rates? Do you just take that out of your consideration for US banks?

I have read about some interesting analysis from smart people that outlines their reasoning for a much lower interest rates going forward than the past, say, 50 years. Most include points like less capital needed ahead because of the lower capital of new tech companies and more savings from around the world with people living longer.

Do you have any thoughts here?”

Yes. I do just take negative interest rates out of consideration when analyzing U.S. banks. I wrote reports on Prosperity (PB), Frost (CFR), Bank of Hawaii (BOH), Commerce (CBSH), and BOK Financial (BOKF). I can’t remember discussing negative interest rates in any of those reports. And they weren’t brief reports. I did discuss a lot of scenarios – like interest rates staying lower longer than I expected. But negative interest rates weren’t discussed.

I think talk of negative interest rates is the result of years and years of low interest rates. People talk a lot about the long-term average price of a barrel of oil, a house, etc. in the early stages of a bubble. Later, when prices have been out of whack for years and years they stop listening to the people who say you’re going to see mean reversion. Instead, they believe the now is normal. When the now is new – people know it’s abnormal. But once the now – in this case, rates near zero – goes on long enough, the recent past erodes their memory of the distant (like 70 years ago) past.

It’s natural for people to project the recent past into the future. Rates are low now. But they were low just after World War Two as well. Look at long-term corporate bond rates in 1946. They were low. Very short-term government bond yields (and the Fed Funds Rate) have been lower in the past few years than at just about any time in the past. But, I’m not sure the things that would matter more to an investor – things like the long-term corporate bond yield – are lower now than they were 70 years ago. And, of course, in between you had some very high yields. A long time ago, I wrote a series of posts about normalized P/E ratios. These are like the Shiller P/E ratio. I looked at normalization over periods longer than the 10 years he focused on. But, I don’t think the result is that different whether you are using a 10-year average, 15-year average, or 30-year average of past earnings. What I found is that the stock market – in normalized P/E terms – tended to get more expensive for about 17 years and then tended to get cheaper for about 17 years. For example, the market (I used the Dow) reached a peak normalized P/E ratio in 1965, it hit the bottom …

The Best Investing Book to Read if You’re Only Ever Going to Read One

Someone who reads my blog emailed me this question:

“Imagine you’re giving advice to a young person (early twenties) who just got their first job and has a 401k match program or has decided to set aside part of their paycheck each month for a tax advantaged investment account. They want to learn enough about investing to not get into trouble while managing their account, but they don’t want to turn this into a hobby or a part time job.

Is there one book or resource they should study to learn how to select suitable investments and manage them within a portfolio over time that you’d recommend? Imagine they’ll never read or think about the subject again, this is your one shot to set them on a good path. What do you recommend for the everyman investor?”

That’s a good question. And a tough one to answer. I can quickly come up with a list of books I’d recommend as a group. Everyone should read Peter Lynch’s “One Up on Wall Street” and “Beating the Street”. Joel Greenblatt’s “You Can Be a Stock Market Genius” and “The Little Book that Beats the Market”. Ben Graham’s “The Intelligent Investor” (the 1949 edition is best). And then Phil Fisher’s “Common Stocks and Uncommon Profits”. Just writing this I’d say that maybe the number one book I’d recommend – if I was only recommending one – is Phil Fisher’s “Conservative Investors Sleep Well.” Now, technically, “Conservative Investors Sleep Well” is included in “Common Stocks and Uncommon Profits”. It was originally published as a separate book. So, if you’re willing to count it as a separate book – even though it’s only available as a really old, used book in that form – I might say “Conservative Investors Sleep Well” is the one book I’d recommend.

Why wouldn’t I make the Lynch books, the Greenblatt books, or the Graham book the one and only book to read? A few of them are too specialized. I’m a big Ben Graham fan. But, Ben Graham is not a good choice for someone who doesn’t want to spend a lot of time picking stocks. His approach takes a lot of time to implement. And it can be dangerous if done wrong. Greenblatt’s best book is “You Can Be a Stock Market Genius”. I think that’s the single best book on investing. But, it’s not the one I’d recommend for someone who isn’t going to focus on investing all the time. His other book “The Little Book That Beats the Market” is the easier one to implement. But, it’s not that different from indexing. That is what Warren Buffett would recommend – the John Bogle approach. If an investor isn’t willing to put in the time to research stocks in depth, he should just buy the S&P 500. I don’t know if I agree with that. There is another way you could make things work I think.

Let’s say you only picked one stock a year. And let’s …

Getting Back to Blogging Regularly: Call for Questions

I’m eager to get back to blogging regularly again.

But I’m always short of topics to blog about.

So, I’m in desperate need of some questions from readers.

If you have a question you’d like me to answer in a blog post, email me at:

[email protected]

That’s:

[email protected]

Thanks.…

MSC Industrial Direct (MSM): A Metalworking Supply Company

(This post is a reprint of one of the nine sections that make up last month’s Singular Diligence issue on MSC Industrial Direct.)

MSC Industrial Direct is an MRO (maintenance, repair, and overhaul) distributor focused on the metalworking industry. The company’s initials originally stood for Manhattan Supply Company. This is a company MSC’s predecessor acquired many years ago. MSC can trace its roots to Sidney Jacobson’s Sid Tool Company. Sid Tool was founded in 1941 in Manhattan. Sid Tool’s store sold cutting tools and accessories to New York City machine shops. The company moved to Long Island in the 50s. Business grew rapidly after World War Two. But Sid Tool soon became dependent on two key customers. Grumman Corporation and Republic Aircraft made up 90% of Sid Tool’s sales. To diversify its sales, Sid Jacobson started a catalog business. The catalog offered discount prices on imported cutting tools. Since it was a catalog instead of a store, the book was able to offer a wider range of products. Sid Tool’s catalog was launched in 1961. By 1964, it had over 150 pages. Today, MSC’s catalog – known as the “Big Book” has over 4,000 pages.

Within a few years, Sid Tool’s catalog sales were greater than the sales it had been making to those two key customers. Sid Tool was selling products it found at trade shows. Jacobson would visit trade shows and make up lists of the products he wanted to sell. Or manufacturers who saw Sid Tool’s catalog would contact him and ask to be put in the catalog. This allowed the catalog to have a wide range of products. But, it created a problem in the late 1960s. An imported item was out of stock. Sid Tool didn’t have the product on hand – though it was in the catalog – and was told it would take 6 months to fill the order. Jacobson wanted to make sure this would never happen again. So, in 1969, he installed a computerized inventory control system. MSC has been quick to adopt technology to manage inventory and fill orders quickly and accurately ever since.

In 1970, Sid Tool acquired Manhattan Supply Company. This is where the MSC name comes from. MSC opened its first distribution center in 1978. In the 1970s, Sidney Jacobson’s son, Mitchell Jacobson, joined the company and soon took over day-to-day management. Mitchell Jacobson was very young when he took over the company. So, he is actually still with MSC today. He serves as the company’s Chairman. Members of the extended Jacobson family control much of the economic interest – and a majority of the voting power – of MSC to this day.

Under Mitchell Jacobson, MSC started a geographic expansion. It went from 3 branches in the mid-1980s to 26 branches in 1990. That same year, MSC opened a second distribution center in Atlanta. This gave the New York based company better geographic coverage. The company also made same day shipping a priority. By 1991, MSC …

Commerce Bancshares (CBSH) is a Durable Family Run Bank

(This post is a reprint of one of the nine sections that make up the recently released Singular Diligence issue on Commerce Bancshares.)

Commerce has been controlled by the same family – the Kemper family – for over 100 years. In the 113 years since the Panic of 1903, Commerce has survived several financial crises. In 2008, it did not accept TARP money from the U.S. government. Commerce’s net charge off rate peaked at just 1.31% in 2009. Even in that crisis year, loan losses at Commerce were quite low (well less than half a percentage point) in all areas except credit cards, real estate construction, and consumer credit. These 3 areas are high risk loan categories. Right now, about 13% of Commerce’s total loans are in areas Quan and I consider high risk. Credit cards are 7% of total loans, real estate construction (and land) is 4% of total loans, and boat and recreational vehicle loans are 2% of total loans. So, 13% of Commerce’s loans are in areas that would be severely stressed by a financial crisis like the one seen in 2008. The next financial crisis probably won’t look like the last one though. They never do. So, it doesn’t make sense to focus too much on loans that go bad with the housing market and household finances. Just know that about 87% of Commerce’s total loan portfolio is in fairly safe and traditional types of lending. None of these types of loans had charge-off rates above 0.41% in 2009. Those are very low charge-off rates. So, any risk to the durability of Commerce comes from the other 13% of loans that are in credit cards, real estate construction, and marine and RV lending.

Overall, Commerce makes all types of loans. Consumer and mortgage loans are 41% of total loans. Real estate is 47% of total loans. Real estate is diversified among: business real estate (20% of total loans), personal real estate (16%), home equity (7%), and construction (4%). There are many ways to break down a bank’s loan portfolio. In Commerce’s case we can look at some big and fairly traditional forms of lending and see what they add up to. Business loans (non-real estate – so commercial loans) are 35% of all loans. Business mortgages are 20%. Personal mortgages are 16%. So, right there, you have 71% of loans from those 3 categories. These loans are very typical of what banks we’ve talked about before make. Then, we get down to some categories of loans that Commerce makes which are less important at other banks – or even non-existent. We have 8.5% car and motorcycle loans, plus 1.3% RV loans, plus 0.4% boat loans equals 10.2% vehicle loans of some kind. We have 7% credit card loans. And we have 6.6% home equity loans. Home equity loans are fairly common at other banks. Auto loans and credit card loans are often a lot smaller at the banks we’ve talked about then at Commerce though.

Commerce’s …

Distributors Like Grainger (GWW) Can Benefit From Their Biggest Corporate Customers Wanting to Consolidate Suppliers for Decades to Come

(This post is a reprint of one of the nine sections that make up the Singular Diligence issue on Grainger.)

Grainger distributes the products needed to keep a large business running smoothly. It sells light bulbs, motors, gloves, screwdrivers, mops, buckets, brooms, and literally thousands of other products. About 70% of the orders customers place with Grainger are unplanned purchases. By unplanned we mean things like the filter in an air condition system, the up / down button on an elevator’s control panel, the motor for a restaurant kitchen’s exhaust fan. The customer knows these things break eventually. But, they don’t know when they will break. These aren’t cap-ex purchases made when the place first opens. And they aren’t frequent, predictable purchases. Things like light bulbs, safety gloves, and fasteners – a key part of Fastenal’s business – are bought more frequently in greater quantities as part of planned orders. Grainger sells to both large customers and small customers. And customer orders are sometimes planned and more frequent, sometimes unplanned and less frequent. But, the biggest part of Grainger’s business is unplanned purchases made by large business customers who have a contract with the company. Almost all of the company’s profit comes from the U.S. So, when you think about what Grainger does – think unplanned purchases by big U.S. businesses.

Grainger was founded by William W. Grainger (hence the W.W. in the company’s name) in 1927 in Chicago. The company is still headquartered in Illinois. It started as a wholesale electric motor distributor. At the time, manufacturers were switching their assembly lines from a central DC driven line to separate work stations each with their own AC motor. Grainger focused its business on customers with high volume electric motor needs. It was a catalog retailer. The original “Motorbook” catalog was just 8 pages. Today, Grainger’s “Red Book” catalog is over 4,000 pages. It features more than 1.4 million stock keeping units. Grainger started opening branches in the 1930s. From Chicago, it expanded into Philadelphia, Atlanta, Dallas, and San Francisco. By 1937, it had 16 branches. In 1953, Grainger started a regional warehousing system. The company added distribution centers to both replenish stock at the branch level and to fill very large customer orders. The company eventually added distribution centers in Atlanta, Oakland, Fort Worth, Memphis, and New Jersey. As alternating current became standard throughout the U.S., Grainger focused on doing more than just selling motors to American manufacturers. It sought out smaller scale manufacturing customers, service businesses, and other parts of the economy. Today, Grainger’s customer list is very diversified. It is much less dependent on the manufacturing sector than publicly traded peers like MSC Industrial and Fastenal. Grainger basically sells to any U.S. business customer who makes a lot of small orders. So, high frequency combined with low volume per order. Grainger is best at dealing with big customers. The company’s competitive position is strongest where the customer has a contract with Grainger and is served by a …

The Moat Around Every Ad Agency is Client Retention

(This post is a reprint of one of the nine sections that make up the Singular Diligence issue on Omnicom)

Moat is sometimes considered synonymous with “barrier to entry”. Economists like to talk about barriers to entry. Warren Buffett likes to talk about moat. When it comes to investing, “moat” is what matters. Barriers to entry may not matter. Thinking in terms of barriers to entry can frame the question the wrong way.

If you’re thinking about buying shares of Omnicom and holding those shares of stock forever – what matters? Do barriers to entry matter? Does it matter if it’s easy to create one new ad agency or a hundred new ad agencies? No. What matters is the damage any advertising company – whether it’s WPP, Publicis, or a firm that hasn’t been founded yet – can do to Omnicom’s business. How much damage can a new entrant do to Omnicom’s intrinsic value? How much damage can Publicis or WPP do to Omnicom? The answer is almost none. In that sense, the barriers to entry in the advertising industry are low but the moat around each agency is wide. How can that be?

First of all, the historical record is clear that among the global advertising giants we are talking about a stable oligopoly. The best measure of competitive position in the industry is to use relative market share. We simply take media billings – this is not the same as reported revenue – from each of the biggest ad companies and compare them to each other. If one company grows billings faster or slower than the other two – its competitive position has changed in relative terms. Between 2004 and 2014, Omnicom’s position relative to WPP and Publicis didn’t change. Nor did WPP’s relative to Publicis and Omnicom. Nor did Publicis’s position relative to WPP and Omnicom. Not only did they keep the same market share order 1) WPP, 2) Publicis, 3) Omnicom – which is rarer than you’d think over a 10-year span in many industries – they also had remarkably stable size relationships. In 2005, WPP had 45% of the trio’s total billings. In 2010, WPP had 45% of the trio’s combined billings. And in 2014, WPP had 44% of the trio’s combined billings. Likewise, Omnicom had 23% of the trio’s billings in 2005, 22% in 2010, and 23% in 2014. No other industries show as stable relative market shares among the 3 industry leaders as does advertising. Why is this?

Clients almost never leave their ad agency. Customer retention is remarkably close to 100%. New business wins are unimportant to success in any one year at a giant advertising company. The primary relationship for an advertising company is the relationship between a client and its creative agency. The world’s largest advertisers stay with the same advertising holding companies for decades. As part of our research into Omnicom, Quan looked at 97 relationships between marketers and their creative agencies.

I promise you the length of time …

Don’t Pick Between Prosperity (PB) and Frost (CFR) – Buy them Both

An investor interested in Texas banks should simply buy both Prosperity and Frost. These two biggest Texas based banks are among the best banks in the U.S. They each have their risks. Frost makes energy loans. And Prosperity does not have especially high capital levels. But, these risks should be small because of the conservative attitudes toward lending and acquisitions at each bank. Frost doesn’t make big, transformative acquisitions. And Prosperity is a serial acquirer that has never had high loan losses despite acquiring many different Texas banks.

We can certainly compare Prosperity and Frost. But, my advice and Quan’s advice would be not to buy Prosperity without also buying Frost and not to buy Frost without also buying Prosperity. Unless you have a very, very concentrated portfolio – there is little reason to focus on buying only one bank and not the other.

Prosperity is less interest rate sensitive than Frost. And Prosperity doesn’t make energy loans. So, if your two big concerns are that oil prices will stay low for many, many years to come and the Federal Reserve will keep interest rates at or below zero for many, many years to come – it makes sense to buy Prosperity instead of Frost. I understand some investors may have a feeling about where oil prices or interest rates are headed in the next few years. And they may want to bet on that feeling. But, oil below $30 a barrel is cheap long-term. And a Fed Funds Rate under 1% is low in normal times. So, it doesn’t make much sense to bet against either an increase in oil prices or an increase in the Fed Funds Rate. Buying both Prosperity and Frost can diversify whatever risks Frost has in terms of energy loans and low interest rates. But, I can’t suggest picking Prosperity over Frost. Because, actually, it’s reasonable for rates to rise over the next 5 years and for Frost to benefit far more from that than Prosperity. As for energy loans, the truth is that while Frost might have to write-off a lot of energy loans if oil stays below $30 for years – those losses would not bring Frost’s tangible equity levels lower than Prosperity’s. In other words, Frost can charge-off a lot of its energy loan portfolio and still have higher tangible equity to total assets after doing so than Prosperity does now. So, it’s not logical to prefer a bank with lower tangible equity levels over a bank with higher tangible equity levels just because the bank with higher tangible equity might charge-off loans that would still leave it more highly capitalized than the bank that doesn’t charge-off any loans. So, again, I see no reason to prefer Prosperity over Frost because of energy loans. Low oil prices will cause bad headlines at Frost and not at Prosperity. But, bad headlines don’t necessarily make for a bad stock.

What about interest rates? This one is speculative. But, it’s also a meaningful difference …

26 Small Stocks

Over the last two years, Quan and I failed to find as many good, small stocks for the newsletter as we should have. We did Breeze-Eastern which was small. We also picked Ark (ARKR), Tandy Leather (TLF), and Village Supermarket (VLGEA). All of those are under $500 million in market cap. America’s Car-Mart (CRMT) is also on the small side. But, it’s a financial stock.

If your biggest problem with sifting through small stocks is getting rid of the low quality and high risk stocks in the group – there’s an easy screen for this.

Just look for stocks that:

1. Have been public a long time
2. Have a long history of profitability
3. Have an adequate Z-Score
4. Have an adequate F-Score

This won’t leave you with a list of good stocks. But, it will remove the junk. This is a value investing blog. So, we’ll insist on an enterprise value no higher than 10 times EBIT (ideally, it would be 10 times peak EBIT – but that’s harder to screen for).

If we apply these 5 criteria – 1) didn’t go public recently, 2) decent history of past profits, 3) decent Z-Score, 4) decent F-Score, 5) decent EV/EBIT – we are left with 26 U.S. stocks with a market cap under $500 million:

• Armanino Foods of Distinction (AMNF)
• Jewett—Cameron (JCTCF)
• Medifast (MED)
• Span-America (SPAN)
• Espey Manufacturing (ESP)
• IEH (IEHC)
• Educational Development (EDUC)
• Chase (CCF)
• Shoe Carnival (SCVL)
• Air T (AIRT)
• Flanigan’s (BDL)
• Comtech Telecommunications (CMTL)
• Eastern (EML)
• Miller Industries (MLR)
• ADDvantage Technologies (AEY)
• Collectors Universe (CLCT)
• Houston Wire (HWCC)
• Wayside Technology (WSTG)
• Lakeland Industries (LAKE)
• Taylor Devices (TAYD)
• Zumiez (ZUMZ)
• Core Molding (CMT)
• Natural Gas Services (NGS)
• Universal Truckload (UACL)
• Acme United (ACU)
• Preformed Line (PLPC)

This list excludes stocks I’ve already picked. Tandy, Village, and Ark would be on the list if that wasn’t the case.

Sorting through that list then becomes a matter of personal preferences and biases. For example, I’d be less likely to research Zumiez – which is a specialty retailer (it’s basically a mall based chain of stores selling skateboarding related clothes, etc. aimed at teens) because Quan and I rarely consider investing in retailers. I might be more likely to look at Collectors Universe and Miller Industries because they have big market share in their niches (collectibles grading and tow trucks respectively).…

Closing the Book on Breeze-Eastern

Quan and I did an issue on Breeze-Eastern last year. The stock has since been acquired by TransDigm (TDG). When we did the issue Breeze-Eastern was priced at $11.38 a share. We appraised the stock at $15.02 a share. TransDigm would later pay $19.61 a share for all of Breeze-Eastern.

What lesson can we learn from our Breeze-Eastern experience?

Here’s what we said about Breeze-Eastern’s stock price at the end of our issue:

“Breeze should – based on the merits of the business alone – trade for between 10 and 15 times EBIT. It is unlikely the stock market will ever put such a high value on Breeze…It is a small company. And 3 long-term shareholders own 70% of the stock. That doesn’t leave a lot of shares for everyone else to trade…Some investors may not like that kind of illiquidity…Breeze is not a fast growing company. And it’s not in an exciting industry. So, it is unlikely to get attention based on anything but its numbers. This might cause investors to underappreciate the qualitative aspects of the company…It is possible that the investment funds that hold most of Breeze’s stock will not hold it for the long-term. They may want to sell the company.”

(Breeze-Eastern Issue – PDF)

Last year, Value and Opportunity did a blog post called “Cheap for a Reason”:

“Every ‘cheap’ stock you will find has problems. Some of those problems might be individual (bad management, too much debt etc.), some of those problems might be more sector specific (oil&gas, emerging markets exposure) or a combination of both.

The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.”

So, why was Breeze-Eastern cheap?

Quan and I thought it was that the company had been spending on developing new projects in the recent past that wouldn’t pay off till the future:

“Between 2007 and 2011, Breeze-Eastern’s EBIT margin was depressed by 5 full percentage points as a result of development spending on projects like the Airbus A400M…Breeze-Eastern’s gross margin and operating margin will be higher in the future than they were in the last 10 years.”

The merger document for the acquisition includes a projection by the company’s management to its financial advisors that suggests the reason TransDigm – or any other 100% buyer – would pay more for Breeze than the stock market had often valued the company at was because:

1. Breeze will have lower costs as it spends less on development projects
2. AND Breeze will have higher sales as a result of the development projects it spent on in the recent past

The projections show EBIT going from $12.9 million in 2015 to $29.3 million in 2021. This is a 15% annual earnings growth rate. The projected growth is largely due to management’s belief that revenue from platforms under development will go from $0 in 2016 to …