Geoff Gannon – Page 12 – Focused Compounding

Geoff Gannon June 15, 2015

You Can Afford to Hold Cash

In my last post, I said stocks were too expensive. Instead of putting more of your money into diversified groups of stocks, you should just let cash build up in your brokerage account.

A lot of people have a fear that those lost years of making zero percent on their idle cash can never be made up for.

I’ve created a graph to show how much ground you’d have to make up.

Let’s say you have two choices: one is to invest in an overpriced basket of stocks today and hold that basket from 2015 through 2030. This choice will compound your 2015 money at a rate of 6% a year.

The second choice is to do nothing for all of 2015, 2016, 2017, 2018, and 2019. You just hold cash. That cash earns 0% for those 5 years. In 2020, you finally get an opportunity to make an investment that will return 10% a year from 2020 through 2030.

If your investment horizon extends all the way out from today through 2030, the second approach overtakes the first approach about 15 years from now.

Doing nothing for 5 years and then something smart for 10 years is a better 15 plus year strategy than “just doing anything” today.

Here we define something smart as 10% a year and “just doing anything” as 6% a year. You can decide for yourself whether your something smart is 10% a year or not. That’s subjective. What the “doing anything” returns is a lot more objective. So, let’s talk about that.

Over the last 15 years, the S&P 500 returned about 5% a year. During that time period, the Shiller P/E ratio contracted from 43 to 27. The same percentage contraction – 37% – would be required to get the Shiller P/E down from today’s 27 to a historically “normal” 17.

I see no reason why the S&P 500 should do better from 2015 to 2030 than it did from 2000 to 2015. That means I see no reason why buying the S&P 500 today and holding it through 2030 should be expected to return more than about 5% a year.

(Almost all readers I talk to have a total return expectation for the S&P 500 that is greater than 5% even for periods shorter than 15 years.)

It’s also worth mentioning that while I have no predictions as to when idle cash would earn more than zero percent – the Fed does. And those predictions show cash earning a few percent in 2018 and 2019 instead of zero percent.

For those reasons, the graph in this post is probably an underestimate of how quickly sitting and doing nothing till you can do something smart outperforms continuing to shovel cash into the S&P 500 at today’s prices.

I think the reason people don’t feel secure in waiting for an opportunity to do something smart is that they’re not sure when that opportunity will appear.

Maybe there will be no chance in all

Geoff Gannon June 14, 2015

Stocks Are Too Expensive

We talk about stock picking on this blog. That means we usually talk about specific stocks. The “market of stocks” not the “stock market”. Today, I’m going to talk about the stock market.

It’s too expensive.

You shouldn’t buy it.

If you have an account where you automatically reinvest your dividends – stop. If you are putting money each month into an index fund, or a stock mutual fund, or a bond mutual fund – stop. Those assets are overpriced. Any basket of stocks or bonds is overpriced. If you are saving money regularly – that newly saved money should now be going into cash instead of stocks or bonds.

The simplest rule in investing is that you never buy an obviously overpriced asset. Stocks generally and bonds generally are obviously overpriced right now. So, you need to stop buying them in a general way.

To put a number on this expensiveness, I think the Shiller P/E ratio is about 27 now. It was about 27 when I wrote my December 2006 post arguing stocks were too expensive. You can read that post later down in this one. Or you can click here to see – via the Wayback Machine – what that post actually looked like on the original site in 2006.

I am writing this post because of 3 separate items I noticed recently.

I came across one while reading an earnings call transcript for Frost (CFR). This is a usually conservatively run bank in Texas. It has a lot more deposits than loans. Deposits have kept growing. So, the company needs to put the money somewhere. And where they’ve put it is “Securities”. Frost now holds more money in securities than loans. These securities are high quality. They aren’t going to default. But they are overpriced. To get a yield near 4% on their securities portfolio – the company had to go pretty far out in terms of the maturities it would buy. In normal economic times – let’s say with a Fed Funds rate of 3% to 4% – these bonds would cost less than what Frost paid for them. At some point, there will be a 3% to 4% Fed Funds rate. I have no idea when that will be. You can look at predictions from the FOMC’s own members and see they thought it would be 3 years down the road or so. Now, if that’s true – you obviously aren’t gaining much by making less than 4% a year for less than 3 years if you will be able to make 4% a year on idle cash at the end of that period. Of course, some events may happen that prevent any increases in the Fed Funds rate for that entire 3 year period. In the 1930s in the U.S. and in the 1990s and 2000s in Japan, investors could have easily overestimated the likelihood that rates would rise within the next 3-5 years to a “normal” level. If something like

Geoff Gannon June 13, 2015

How to Judge a Business’s Durability

My last post listed examples of threats to a company’s durability. This post will be about how we assess those threats. You can always imagine a threat. Is it a realistic threat? How do you judge that?

There are some industries where durability is pretty much perfect. The business doesn’t change much. Barriers to entry are high. The future development of substitutes is unlikely. Location advantages are big.

A good example is lime. Lime is reactive and has a short shelf life. You don’t store it speculatively. You don’t import it and export it. Customers need to get their lime from a deposit being worked somewhere within a few hundred miles of them. Over the last 100 or so years, the real price of lime hasn’t changed that much (real price volatility compared to other commodities is quite low). The price right now is perfectly in line with the real average price per ton since 1900. Lime consumption in the U.S. was no higher last year than it was in 1998. The industry is more consolidated and perhaps less competitive than it was in 1998. I don’t think capacity is being fully utilized now. And I do think inflation will always be passed on to customers (as it was over the last 100 years). So, if Quan and I were to research a company like United States Lime & Minerals (USLM), we could probably start by assuming that last year’s EBIT would – in real terms – represent that company’s durable earning power. That could be our starting point for a buy and hold analysis.

That’s usually not the case. Even when we find a company that has a long history of being the leader in its field – say Strattec in car locks and keys, H&R Block in assisted tax preparation, etc. – there is a risk of change. In these two cases, we know there will be change in the product. For example, more people will prepare and file their taxes online in the future than they do now. And more drivers will enter and start their cars with the use of electronics instead of physical locks and keys. What we don’t know is how that will affect the companies.

Take H&R Block. The company competes in assisted tax preparation. In the 1990s and 2000s, many people switched to using software and then online products to prepare their taxes. But who were these people?

Most were people who had always prepared their taxes themselves. I use TurboTax and know a lot of people who use TurboTax as well. But, I actually don’t know anyone who used H&R Block even once in their lifetime and now uses TurboTax. Everyone I know who uses TurboTax used to – decades ago – prepare their taxes themselves using a pen and paper and a calculator. They didn’t use a CPA. And they didn’t use H&R Block.

Now, this is anecdotal. But, if I hadn’t asked the question “who are these people” …

Geoff Gannon June 11, 2015

You Can Always Come Up With a Reason For Why the Stock You Are Researching is Actually About to Go Out of Business

Someone who reads the blog sent me an email asking how Quan and I judge qualitative factors like a company’s durability.

For most stocks, you can easily imagine a future condition that would obsolete the entire business model.

I’ve decided to make this post nothing but a series of examples.

John Wiley

Open access journal articles.

There is a whole Wikipedia page about this one. The idea here is that someone else will pay the cost of publishing journals in place of the subscriber.

Weight Watchers

Apps.

Dieters will use free apps like MyFitnessPal to count calories instead of going to meetings or using websites like Weight Watchers.

HomeServe

Illegal marketing.

Without aggressive marketing aimed at old people – would this product even exist? You can read about the FCA (a U.K. regulator) fine imposed on HomeServe and the reasons for it here.

Ark Restaurants

Leases expire.

Ark may not renew its leases because the casino or other landlord would want to charge a lot more rent now that the location and the restaurant is a proven success. So, Ark as a corporation has a finite lifespan except insofar as management reallocates capital to new sites.

Village Supermarket

Online groceries.

Traditional supermarkets have 3 durability risks people raise: 1) Online groceries 2) Wal-Mart 3) Organic and fresh competitors: The Fresh Market, Whole Foods, etc.

America’s Car-Mart

Securitization.

America’s Car-Mart sells used cars so it can collect interest on high risk auto loans. The difficult parts of the business are underwriting and collecting loans. If this could be centralized – as it is in lower risk subprime auto loans – then the loans would become commodities.

PetSmart

Online dog food.

The two concerns here are that places like Wal-Mart can sell more dog food and websites like Petflow can sell more dog food.

Atlantic Tele-Network

Guyana can take away their monopoly.

Greggs

British shoppers will stop frequenting high streets. Or, they will eat healthier food instead.

Progressive

Self-driving cars will eliminate accidents and therefore the need for auto-insurance.

Babcock & Wilcox

U.S. utilities will shift away from coal power plants – which use boilers – toward natural gas, wind, and solar power plants which don’t use boilers.

The U.S. Navy could stop using: nuclear powered aircraft carriers, nuclear powered ballistic missile submarines, and nuclear powered attack submarines.

Swatch

People will wear products like the Apple Watch instead.

Movado

Same.

Fossil

Same. Plus, Michael Kors may be a fad.

Western Union

Online competitors like Xoom can replace agent location based money transfers.

Hunter Douglas

Big box retailers like Home Depot and Lowe’s can sell blinds in their stores. Blinds can be sold online. As a result, people will stop going to the independent dealers that Hunter Douglas gets all its sales through.

Strattec

Smart keys and push to start ignitions can eliminate the need for locks and keys used in car doors and the steering column.

…

Geoff Gannon June 9, 2015

Babcock & Wilcox Sets Spin-Off Dates

Babcock & Wilcox (BWC) has set the dates for its spin-off. Those who own the stock on June 18th will get their spin-off shares on June 30th:

“As a result of the spin-off, Company stockholders can expect to receive as a dividend one share of New B&W common stock for every two shares of the Company’s common stock held as of 5:00 p.m. EST on June 18, 2015, the record date. The distribution of New B&W shares is expected to occur on June 30, 2015 and is expected to be tax-free. “

Shareholders will then own two separately traded stocks. The stock with the “BWXT” ticker will be the government business. The stock with the “BW” ticker will be the power plant business.

The press release gives an accurate description of what “BWXT” will be:

“BWXT is the sole manufacturer of naval nuclear reactors for submarines and aircraft carriers; provides nuclear fuel to the U.S. government; provides technical, management and site services to aid governments in the operation of complex facilities and environmental remediation activities; and supplies precision manufactured components and services for the commercial nuclear power industry.”

It gives a poor description of what “BW” will be:

“New B&W will continue to be a leader in clean energy and environmental technologies for the power and industrial sectors. New B&W also will provide one of the most comprehensive platforms of aftermarket services to a large global installed base of power generation facilities.”

BW is really the boiler business. They build boilers and related equipment for power plants. Some of those plants are clean energy plants – but a great many are actually coal power plants.

Babcock & Wilcox was a Singular Diligence stock pick. I own the stock personally. Quan does not. I plan to keep both my “BWXT” shares and “BW” shares indefinitely.

I’ll let you know if that changes.…

Geoff Gannon May 20, 2015

Our November 2013 Issue on Life Time Fitness

Life Time Fitness (LTM) now trades at $71.86. The company’s board unanimously agreed to be taken private at $72.10 a share in cash. The merger is expected to close on June 10th. It is now May 19th. So, I’m going to call this one effectively over as a public company.

Quan and I did an issue on Life Time Fitness for Singular Diligence (back when it was called The Avid Hog) in November 2013. The stock price was then $48.51 a share. We appraised it at $79.69 per share.

With the stock trading right below the going private price – the value’s been fully sucked out of this idea.

So, we might as will give the issue away now.

Enjoy.…

Geoff Gannon May 19, 2015

When Should You Diversify?

Someone who reads the blog sent me this email:

“I have been thinking about portfolio construction lately.

…due to the strict standards you have, I thought it was very natural to just hold mainly four stocks…unfortunately, this method has shown its short comings lately. Both because of (your) mistake in picking CLUB/WTW instead of the other winners discussed in Avid Hog/Singular Diligence, and also because I am currently getting in touch with a lot more very cheap opportunities in the Asia region…I have also been rereading Buffett’s partnership letters and was reminded he once held like 40 stocks. Even though he concentrated at his top several positions sometimes and also he sometimes put 30% to 40% of his portfolio into the workout category, he did say they usually have fairly large positions (5% to 10% of their total assets) in each of five or six generals, with smaller positions in another ten or fifteen. (This) of course is a far cry from the 20%/25% position sizing we usually talk about…

What are your thoughts? Is it actually better to spread our portfolio a bit more?…I am getting more and more the feeling that finding the right stock is not the most important part, but picking the right ones to actually put money in is the key. Would (being) willing to spread a bit more make this key job easier? The very cheap stocks I am finding these days may not fit something you will invest in as they are likely not good buy and hold investments. Yet they are also not exactly like cigar butts, i.e. not of very, very low quality stuff. Is it wise for me to ignore them in my personal portfolio and just pick those that are more like the buy and hold category?”

I hold 4-5 stocks because I find that is most comfortable for me. You want to combine an approach that makes enough objective sense to work for anyone in theory with an approach that makes enough subjective approach for you to carry it out in practice. I found owning 20 stocks was not practical for me. I spent more time watching what I owned than coming up with a good list of new stocks to research. I didn’t spend enough time focused on what I was buying. When I owned 20 stocks, I spent too much time on the HOLDING and the SELLING and not enough time on the BUYING. It’s no accident that the only thing we do for Singular Diligence is tell you which stock to buy. We never revisit it. We never tell you to sell. It’s all focused on a one-time buy decision. I think that’s the decision that really matters. If you get that moment right the next 5 years or more will take care of themselves. There’s just a heck of a lot of time spent on stuff other than worrying what to buy next when you have 20 stocks. When you have …

Geoff Gannon May 19, 2015

Swatch’s Moat

The stock picked for the latest Singular Diligence issue was Swatch. Each issue of Singular Diligence includes articles on: 1) Overview, 2) Durability, 3) Moat, 4) Quality, 5) Capital Allocation, 6) Value, 7) Growth, 8) Misjudgment, and 9) Conclusion.

Here is one of those 9 articles – the moat article – from this month’s issue on Swatch.

Moat

Swatch, Richemont, and Rolex Will Always Dominate Swiss Watchmaking

Swatch’s moat varies depending on the price category. Swatch’s moat is widest for brands that retail between $800 and $10,000. The moat is narrower for watches that cost more than $10,000 or less than $800. This is because there are several distinct sources of moat in the watchmaking business. The greatest combination of moats happens in the watches in the middle price categories. These watches are expensive enough that the “Swiss Made” label and the brand name are important. However, they are inexpensive enough that manufacturing still involves mass production in some sense for some of the parts. This is not true of very expensive watches. Some watchmakers who focus on watches over $10,000 can make very, very few watches each year. So there are few production advantages in this category. The watches are also so expensive that a boutique mono brand store can be opened in just a few high end retail stores in cities around the world. So distribution power is not as important. Swatch has more production advantages than any other Swiss watchmaker. Rolex also has strong production capabilities as will be explained in a moment. Some other companies – like Richemont – have some production capabilities. They are much more than mere assemblers. But they are not as self-sufficient as they might appear. Swatch is vertically integrated. It does not need any outside company to exist for it to be able to produce its brands.

Let’s start with production. There are no production advantages in low-end mechanical movements that are not “Swiss Made”. A Japanese or Chinese company or a manufacturer of licensed brands that does not care if the watch carries a “Swiss Made” label can easily get a supply of foreign (non-Swiss) mechanical movements. The governments of both China and India encouraged the production of mechanical movements in the hopes of stimulating a domestic watchmaking industry. So, if a watchmaker does not care about the “Swiss Made” label they can buy movements from a Japanese company like Seiko or Citizen or from a movement maker in China or India. As a result, there is no production advantage – no moat for Swatch – in watch categories that do not rely on the “Swiss Made” label. For watches that do rely on the “Swiss Made” label, Swatch has a big production moat. To earn the “Swiss Made” label a watch must meet several requirements. One of these requirements is that the movement must be made in Switzerland. There are very few Swiss movement makers. It is difficult to get information on mechanical movement market share in Switzerland. …

Geoff Gannon January 21, 2015

Sold Town Sports (CLUB); Bought Babcock & Wilcox (BWC)

Today, I sold my shares of Town Sports (CLUB) and put the proceeds of that sale – plus some other cash – into buying Babcock & Wilcox (BWC).

My average cost in Town Sports was $8.84 a share. My average sale price was $6.85. This is a realized loss of 23% over an 11 month holding period.

My average cost in Babcock & Wilcox is $27.06 a share. Babcock now represents 18% of my portfolio. The company will split into two separate stocks later this year. I will hold on to both of those stocks.

I may increase my position in Babcock to about 25% of my portfolio. This depends on whether: 1) I am successful in selling the last of my Japanese net-nets 2) Babcock’s share price does not rise too much.

The four non-Japanese net-nets in my portfolio right now are:

George Risk
Ark Restaurants
Weight Watchers
Babcock & Wilcox

These four stocks account for more than 90% of my portfolio.

Toby handles the Singular Diligence model portfolio. This sale has no impact on the model portfolio. Quan also owns Town Sports in his portfolio. Quan did not sell Town Sports and buy Babcock & Wilcox today. If and when Quan makes a change to his portfolio it will be posted here.

The timing of my sale of Town Sports and purchase of Babcock has to do with Babcock – not with Town Sports. Town Sports is the target of an activist campaign. Activist investors control about a quarter of the company’s shares. The board recently adopted a “poison pill” defense and the activists nominated their ticket for this year’s board election. None of these events make it a particularly good time to sell Town Sports. However, we just put out the Babcock & Wilcox issue of Singular Diligence. The publication of that issue freed me up to buy the stock. Quan and I start research on a stock far in advance of the date when that stock appears in Singular Diligence. So, I have been waiting for months to buy Babcock & Wilcox.

It is worth mentioning that I did not – and would not – have sold Town Sports merely to hold cash. I sold Town Sports to buy Babcock. This tells you 3 things:

I prefer Babcock over Town Sports
I believed Babcock was the strongest stock I did not already own
I believed Town Sports was the weakest stock I did own

For example, my sale of Town Sports obviously tells you that I think Weight Watchers is – at today’s price – a stronger stock than Town Sports. Otherwise, I would have sold Weight Watchers instead of Town Sports.

If you subscribe to Singular Diligence you can now read the full issues on both Town Sports and Babcock & Wilcox.…

Geoff Gannon December 23, 2014

Singular Diligence: 8 Archived Issues

These are the 8 archived issues – each is over 12,000 words long – you get immediate access to the moment you subscribe to Singular Diligence.

Singular Diligence – Archived Issues

Life Time Fitness (LTM): Runs 112 (mostly) huge gyms across 25 U.S. states. About half (55) of these clubs are on unmortgaged company owned land. Since our report was published, Life Time Fitness announced it may convert to a REIT.

Progressive (PGR): A U.S. auto insurer that competes with GEICO online. Also the largest auto insurer in the independent agent channel.

Ark Restaurants (ARKR): Runs a small number of huge restaurants in landmark locations like: Union Station, Bryant Park, Faneuil Hall, casinos, and hotels. Also has an interest in the Meadowlands racetrack in Northern New Jersey as well as the food and beverage concession there.

Town Sports (CLUB): Runs urban gyms in New York City, Washington D.C., Boston, and Philadelphia under the “Sports Club” name.

HomeServe (London – HSV): A U.K. company that provides home emergency repair services using an insurer’s premium based model. Now also in countries like France and the United States.

John Wiley (JW.A): A publisher of books, textbooks, and academic journals. The vast majority of the company’s value is in its academic journals. The Wiley family has controlled the company for 207 years.

Village Supermarket (VLGEA): The second largest operator of “Shop-Rite” supermarkets. Stores are mostly in densely populated Northern New Jersey. Each store does about $1 million a week in sales

Weight Watchers: (WTW): The world’s biggest weight loss brand. Weight Watchers runs group support meetings, the WeightWatchers.com self-help website, sells Weight Watchers products, and licenses the Weight Watchers name.…

Posts By: Geoff Gannon