Posts By: Geoff Gannon

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 …

14 Stocks For You To Look At

14 Stocks For You To Look At

The Two Sides of Total Investment Return

A Simple Way to Think about Moat

Moat is really about protecting a company’s profit as Warren Buffett said:

“You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.”

A business may make less profit because of lower sales, lower margin, or both. So, there are two sides of moat: the sales side and the margin side. The sales side can be broken down into customer retention and customer acquisition.

Customer Retention

There are many factors that lead to high retention, including customer behavior, price insensitivity, switching cost, etc.

Customer behavior is subtle. Sometimes customers just don’t think about switching. I used to wonder how small banks can compete with big banks. I realized that a bank’s moat doesn’t come from low funding cost or low operating cost but actually from customer habit. Customers rarely change their primary banking account. So, a small bank may have a low ROE because of its high costs but it can still have stable local market share. Despite their big scale to sell many financial products, big banks can’t steal business from small banks very easily.

Similarly, car owners rarely shop for a new insurer unless there’s a bad experience, there’s a major event in their life (move or marriage) or there’s a spike in the price of their premiums. In fact, insurers like State Farm and Allstate have greater retention rate than Progressive and Geico because they sell bundled products. So, even though Progressive and Geico have a huge cost advantage, they have only low double digit market share after decades of gaining market share. There are simply not many people shopping for new car insurance policies each year.

Price insensitivity helps retain customers in the face of price competition. Customers may pay little attention to price when it’s a tiny part of their total spending. Switching from Coca Cola to a private label cola simply doesn’t save much.

Even better, some customers are willing to pay more for convenience, tailored solutions, product quality, or customer services. I find it interesting that Frost often pays less than one-tenth of the Federal Funds Rate for its interest-checking deposits. For example, Frost paid only 0.47% on its interest-checking deposits in 2007 while many other banks paid about 1.50%. I’m not sure why but perhaps Frost’s customer service is so good that customers simply don’t care about getting interest income on their deposits.

Customer Acquisition

Strong customer acquisition can be achieved through distribution, mindshare, product superiority, or price.

The best example of distribution power is perhaps big food companies. By owning key brands, they have the power to convince retailers to carry new …

Boredom Is a Good Friend of Long-term Investors

Geoff said in the last post that: “simply learning to love illiquidity, boredom, and a lack of headlines in your portfolio might be enough to improve your returns.” The key word is boredom. I think 3 main reasons for a stock to be boring are low growth, lack of catalyst, and a so-so price. A stock with these characteristics is not attractive to growth investors, value investors, and momentum investors. But sometimes these characteristics hide qualities that can generate great long-term returns.

Quality of Growth

I once made a bold statement that Frost promises the best growth investors can find. I think that Frost can have 7-8% growth for the next 20-30 years and I don’t normally find a stock with such high growth potential. My friend was surprised at my claim and he said “you can’t say that because 20% growth is a certainty for companies like Valeant!” What he said represents the attitude towards growth of most people. To them, a single-digit growth isn’t stellar. To me, 7-8% growth is a treasure. That doesn’t mean I’m less demanding. I’m just focused more on quality of growth.

Low growth can be valuable if ROIC is high. Let’s compare Bristow, Frost, and Omnicom.

Over the last 10 years, Bristow’s revenue almost tripled from $674 million in 2004 to $1,859 million in 2014, which translates into an 11% annual growth rate. Annual sales growth was always higher than 10% except for the “bad” years between 2009 and 2011. The problem is that pre-tax ROIC is just about 9%. So, Bristow had to use debt and equity to finance growth. Over the period, net debt increased by $650 million. Share count increased by more than 50% from 23 million to 36 million mostly as a result of the issuance of $223 million in convertible preferred stock in 2007.

Frost is a better business. Frost grew deposits from $7,767 million in 2004 to $22,053 million in 2014. That means intrinsic value has compounded annually by 11% over the last 10 years. Unlike Bristow, Frost can make 18-20% ROE. So, Frost was able to return 40% of total earnings over the last 10 years.

Omnicom is even better. Omnicom grew sales by 5% over the last 10 year while returning 110% of earnings to shareholders. Omnicom doesn’t need to retain earnings to grow. It actually received about $1 billion from the decrease in its negative working capital over the period.

Omnicom’s 5% growth can be as valuable as Frost’s 8% growth.  If we pay 20 times after-tax earnings for both stocks, we can get similar returns. Omnicom can give us 5% growth and 5% yield, adding up to 10% total return. Frost can grow 8% while paying out 50% of earnings. So, it can give us 8% growth and 2.5% yield, adding up to 10.5% total return. A similar calculation shows that we can get 11.67% total return from Omnicom and 11.34% return from Frost if we pay 15 times after-tax …

Should We Care Why the Stocks We Buy are Cheap?

One of my favorite blogs, Value and Opportunity, recently did a post about how the best value stocks are often those that are not cheap by the most obvious numbers (P/E, P/B, etc.).

The post is entitled “Value Investing Strategy: Cheap for a Reason”. The basic argument of the post is that:

“…Especially in a market environment like now, cheap stocks are cheap for a reason. It is very unlikely that ‘you’ are the first and only one who knows how to run a screener and by chance you are the only one who can buy this great company at 3 times earnings which will quadruple within 6 months…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.”

This is not at all how I look at stocks.

I usually don’t know why a stock I’m buying is cheap. And I’m not sure I spend much time trying to figure out why someone else would or would not like the stock. I tend to just focus on whether I like the business and how much I’d “appraise” that business for.

I can sometimes come up with possible reasons for why a stock I like is cheap. But, I’m never sure those are the real reasons other people aren’t willing to buy the stock.

I don’t think Quan sees himself – and I know I don’t see myself – as a contrarian investor.

So, I assumed looking to see if a stock was “cheap for a reason” is something I simply don’t do.

At least that’s what I thought before looking through the textual record of what I actually said about each stock I picked.

In my last post, I mentioned 6 stocks that Quan and I picked for Singular Diligence which are now trading at a discount of 34% or greater to our original appraisal value. So, these are the 6 cheapest stocks we know of in intrinsic value – rather than traditional value metric – terms.

I decided to go through the record and check for two things.

One, how cheap are these stocks on the traditional value metrics. I will use Morningstar’s measures of P/E, P/B, and Dividend Yield for this.

Two, what reason did I give (in the issue where I picked the stock) for why that stock might be cheap.

Here are the 6 stocks.

Hunter Douglas

Discount to Appraisal Value: 58%

Forward P/E: 9.6x

P/B: 1.4x

Dividend Yield: 3.6%

Why I Said it Might Be Cheap:

“Hunter Douglas is an obscure stock. The Hunter Douglas brand is American. So, the company’s name is American. However, the stock trades in Europe. The company reports its results in U.S. dollars. But, the stock trades in Euros. The stock is 81% owned by the Sonnenberg family.”

(Note: Quan and I appraised this company – which sells shades and blinds mostly …

Current Price/Appraisal Ratios for All Our Past Stock Picks (That We Still Believe In)

Stocks with an adequate margin of safety (34% or more) are in green.

UniFirst (UNF): Maybe Too Expensive; Maybe Just Right

Driverless Cars and Progressive’s Durability

Value and Opportunity linked to a Bank of England blog I never would have found on my own. The Bank of England blog did a post on how driverless cars could hurt the future of auto insurers. Last year, we did a Singular Diligence issue on U.S. car insurer Progressive (PGR). A big part of the durability section of that issue was about driverless cars.

So, here is the Bank of England blog post on driverless cars.

And here is Singular Diligence’s discussion of Progressive’s durability…

Originally Published: December 2014

DURABILITY: Progressive’s Focus on a Combined Ratio of 96 or Lower Makes it Durable

Auto insurance is a durable industry. The only risk of obsolescence is driverless cars. Car accidents are caused by human error. If all cars on the road were driven by computers – there would be virtually no car accidents. This would eliminate the need for auto insurance. The technical difficulties of developing driverless cars are not the biggest obstacle to their adoption. Even much simpler safety technologies like front air bags, side air bags, electronic stability control, and forward collision avoidance generally took 10 years from the time they were first introduced on a car sold to the public till the majority of new models sold in a given year included these features. So, the “tipping point” of safety feature adoption by manufacturers is usually around a decade. Complete adoption takes about 15 years. The average car in the U.S. is about 11 years old. This number has increased over time. Cars are more durable now than they were in the past. Based on these figures, it is likely that once the first driverless car is introduced by a major auto maker on a popular model it will take another 15 to 20 years before half of all cars are driverless.

Auto insurance is required by state law. States will certainly not eliminate this requirement while the majority of cars are still driven by humans. Total adoption of the technology could take up to 30 years. If enough car owners prefer to drive themselves instead of letting a computer drive their car for them, there could be resistance to any laws limiting human drivers. Without such laws, highways would include a mix of human and computer driven cars. Under such conditions, laws might still equally “fault” driverless cars for accidents involving human drivers. These legal complications mean that auto insurance would probably persist into the early stages of a mostly driverless car society.

Today, there are no commercially available driverless cars. So, the end of car insurance would likely be some point 15 to 30 years after the successful introduction of driverless cars. The vast majority of net present value in a stock comes from returns generated within the first 30 years. Even if driverless cars are successfully introduced in the U.S. soon – and that is a completely speculative assumption – it is very likely that auto insurance will persist as a legal …