Posts By: Geoff Gannon

How Do I Find a Company with a Moat?

Hi, Geoff. I have just recently read your old article titled “How To Find Competitive Advantages In The Real World”. My question is, is that article still relevant at this point in time (because it is quite old)? If any, what would you update or change in that article? And about your comments on books about competition, do you believe that it is still true till today (Or you would like add to other book recommendation on competition besides “Hidden Champions”) ? Is it possible to identify economic moat without scuttlebutt? In your opinion, which is better: screen stocks for cheapness first and determine whether the stock in the cheap screen has quality OR screen for quality first and determine whether the price is right?

Answer: Here are 10 Checklist Items You Can Start With

There’s a checklist you can work through to see. It’s made up of 5 items from Michael Porter and 5 items from Morningstar. You may be able to identify if some of these items might apply to the company you’re looking at. And then, you can judge how durable they are or not. So, here’s the 10-point checklist.

Porter’s 5 Forces
1. Threat of new entrants
2. Threat of substitutes
3. Bargaining power of customers
4. Bargaining power of suppliers
5. Competitive rivalry

Morningstar’s Economic Moat
6. Network Effect
7. Intangible Assets
8. Cost Advantage
9. Switching Costs
10. Efficient Scale

You could start your analysis by just finding a cheap enough stock, finding any stock at all, finding a stock that has strong enough past results, or finding an industry that has strong enough past results.

I suggest finding an industry. The performance of any stock over time might be like 50% or so the stock’s position within its industry. But, the other 50% will be the industry. If you buy a basket of regulated utilities or a basket of bank stocks at the same price-to-book ratio – the basket of bank stocks will outperform the regulated utilities over time. This is because – in the U.S. – banking is a much better business than regulated utilities.

Certain industries are better choices to look for moats. I’d suggest:

Household Products
Personal Products
Food
Beverage
Alcohol
Tobacco
Hotels
Restaurants
Food retailing
Consumer staples retailing

Really – “consumer staples” in general is the best place to look for a moat. Products that are: branded, frequently purchased, and used by people (not businesses) both in the home and away from the home are your best bet to look for a durable competitive advantage.

So, I would focus on those industries. There are other industries that are often not big enough to get included as “industries” by investors but sort of just a subset that are pretty good too. So, for example, I think theme parks tend to be good sources of moats though that doesn’t mean the group they belong to “entertainment” is necessarily as good overall. I think lime and cement companies – especially located in …

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Should I Really Just Automatically Ignore High P/E Growth Stocks Even if they Are Amazing Businesses?

Someone sent Geoff this email ( to ask your own question: just send me an email ) :

Hey Geoff,

The last 10 years saw the dominance of ‘growth’ (as quantitatively defined) over ‘value’.

If you were a value (however it is defined) investor, you probably underperformed the relevant indices.

(1) Is there a lesson to be learned here? When I see stocks trading at really high multiples, my immediate instinct is to ignore them – either too hard to value or too expensive.

But by automatically ignoring such stocks, a potential stock picker immediately omitted a lot of profitable stock ideas.

(2) Do you see these high-multiple stocks’ multiples ever regressing to median multiples, potentially hurting future returns? I think arguing that stocks like Google, Visa or Amazon should have median (historical) multiples is a bit misleading since most of these are natural monopolies. On the other hand, it’s not clear to me what the fair value should be.

Answer: High P/E Stocks of Great, Wide Moat Businesses Don’t Worry Me Right Now – It’s the Super Speculative Growth Stocks with No Real Earnings That You Need to Watch Out For

So, first of all, types of stocks that have outperformed for a decade or so are not necessarily going to be great performers in the future even if they continue to be great performers as businesses. In the past, some excellent businesses have underperformed as stocks even while the underlying businesses continued to perform well. The “Nifty Fifty” stocks of the late 1960s and early 1970s underperformed for the next 10 years or so. In fact, as a group, they did not outperform over even a 25-30 years holding period. While some of the reason for that is stocks that looked like great businesses but eventually lost their competitive position – a lot aren’t. They just were expensive. A study of the Nifty Fifty stocks – it used two different lists – looked at performance from 1972 to 2001. It found that there was a strong negative correlation between the 1972 P/E ratio of the stocks on that list and their returns over the next close to 30 years. That’s an important warning. Differences in P/E ratios – even among very good businesses – can still cause differences in the returns you get over holding periods as long as 30 years.

Does this mean growth stocks will underperform value stocks in the 2020s?

It depends on what you mean by growth? If you mean Visa and Amazon and Google – I’m not so sure. They are financially sound companies. They have strong market positions. And Google is not even expensive versus the S&P 500 generally. Google’s EV/EBITDA, EV/Free Cash Flow, P/E, etc. are mostly a bit elevated at most compared to the index. It’s not a very expensive stock. Visa is even more elevated. Of those stocks – the one to be worried about is probably Visa. The stock trades at a very, very high EV/Sales ratio. It’s …

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How I Analyze Bank Stocks

We did a Focused Compounding Podcast episode that was 100% dedicated to bank investing.

In that podcast notice that I analyze banks completely differently than most value investors. I don’t believe price-to-book is an especially important metric. I value banks based on the amount of their share price, their deposits per share (so P/Deposits so to speak), their growth in deposits, and finally the profitability of those deposits (how low cost are they, how “sticky” are they).

I spend very little time on the asset side of the bank except to see if I think it is safe enough for me. I just assume – and this assumption isn’t 100% correct or anything – that money is a commodity, so banks will make roughly similar amounts over time on whatever they lend out, buy bonds with, etc.

However – at least among U.S. banks – you have banks that pay very different amounts on their deposits (in interest), and even MORE important very, VERY different amounts in terms of non-interest expenses per dollar of deposits. There are banks in the U.S. that have $50 million per branch and pay HIGHER interest on most deposits compared to banks that have $200 million per branch. The bank with 4 times the deposits per branch brought in with MORE non-interest bearing accounts is going to have such a “all-in” cost advantage over the other bank that it can make fewer loans and buy more bonds, it can make safer loans that yield less, it can buy shorter-term bonds that yield less, etc. and it’ll still make more money than the bank that has to hustle to make the highest yielding loans, buy the highest yielding bonds, etc.

My belief is that a strong, durable advantage on the deposits side in terms of economies of scale at the customer level and the branch level especially is what creates value in banking.

It’s not impossible to create value in other ways. Prosperity Bank has done this. But, taking in a lot of small deposits from a lot of less wealthy people at a lot of different branches means the only way you can succeed would be extreme penny pinching on the deposit side and then really good lending on the asset side. You’d have to be cheaper than the other guys when it comes to running a customer oriented business and/or you’d have to be smarter, more driven, etc. lenders. I think that’s tough.

Recently, I also wrote-up Truxton (TRUX). You can see the same focus on economies of scale here, because:

1) Truxton operates BOTH a wealth management business and a private bank out of the location that is ALSO ITS HEADQUARTERS

2) Truxton has about 8x more deposits per branch (it only has one branch) than U.S. banks generally

3) Truxton focuses on RICH clients (this means Truxton might get 10x the dollar amount of deposits from each depositor relationship as U.S. banks generally – allowing higher ratio of employees to customer but …

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Go Beyond the Financial Statements: Break a Company Down Revenue Line by Revenue Line

One of the biggest issues I come across when talking with people about specific stocks is that while we can have a good discussion of bottom-line numbers like earnings – the discussion of items higher in the income statement is not so good. Andrew and I did a podcast about this recently. It’s the one where we discussed gross profits. But, it’s not just an issue of gross profits. It’s also an issue of what are the customer economics like, what are the store economics like, what are the “unit” economics like. A lot of times, this information is given out by the company – if at all – in ways that don’t guarantee an easy comparison between two companies. The bottom line figure is probably comparable (though not always – note, for example, that different companies in the same industry sometimes depreciate at different rates and so on). However, the way companies discuss their projections for store level EBITDA of a “model” store or customer level economics are going to be different. Does this make them less useful? It makes them more susceptible to fudging. You have to rely more on whether management is being candid, realistic, etc. Is management promotional? Are they always too optimistic? Are they always too pessimistic? Do the numbers they give you as projections of how their business model should work line up nicely with reported results? If not, why not?

These numbers are often more important for the long-term investor than the current earnings results. Current earnings – and whether they miss or beat analyst estimates and market expectations – are very important in determining short-term results in the stock. But, they are less important in determining long-run results. This is because just knowing the bottom line result is less helpful in projecting the future of the business than in having more detailed trend information.

The same stuff I’ve been saying about the “bottom line” also applies to the “top line”. For example, OTCMarkets (OTCM) reported results recently. Both bottom line and top line numbers were right in line with what I might expect. But, the mix of what areas of the business were up a lot and what areas of the business were flat or down was different than I’d expect. So, it could’ve looked like a typical quarter if you look only at: revenue, gross profit, operating profit, etc. But, it looked atypical if you focused in on what specific product lines were up by what percentage amounts over last year. They had a very bad showing – no growth, actually a bit of shrinkage (which is unusual for this company) – in the actual number of companies that pay for “corporate services” (sort of like being listed on OTCM – although, technically, OTCM is not an actual stock exchange). Meanwhile, revenue that is driven by trading activity grew way more than you’d normally expect. Now, none of this should’ve come as a huge surprise to me given the level of …

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Business Momentum: When is a Value Stock a Value Trap?

One of the biggest risks for a value investor is buying into a business with poor momentum. Not momentum in the since of an upward movement in the price of the stock – that is often a problem, but it’s a difficult one for an investor (as opposed to a speculator) to evaluate and then count on – but, poor business momentum. Value investors – because they focus on the P/E ratio, the P/B ratio, EV/EBITDA, and many other measures of price – often find themselves buying into a business that looks cheap based on past measures of profitability rather than being cheap on future measures of profitability. The problem is that everything we know about a business is about that business’s past. And yet, for an investor, everything that matters about a business is that business’s future. In a previous article, I listed a series of stocks that are typical of value stocks. Value stocks can be defined in many ways. I think the simplest is the “Graham Number”. Ben Graham talked about the importance of not overpaying for a stock in terms of either its asset value or its earning power. There is no completely correct number to gauge earnings power. For a cyclical business, this year’s earnings might not be a good guide as to what normal “earning power” really looks like. Nor is there any one completely correct number to gauge asset value.

However, there are some numbers that can be helpful. A stock that trades at a meaningful discount to its tangible book value is more likely to be cheap than most other stocks. The likelihood of its cheapness becomes greater if it also trades at a meaningful discount to what would be a normal multiple of its earning power. Earning power isn’t precisely the “e” in the P/E ratio. But, for many typical value stocks – it could be pretty close. So, if we combine the P/E ratio and the P/B ratio – by multiplying the two factors together – we can sort out those stocks that look especially cheap on a combination of both asset value and earning power value. These stocks – the stocks with some of the lowest Graham Numbers – are most likely to be true value stocks. However, the businesses these stocks are in may sometimes be experiencing a great deal of negative business momentum. In fact, that is one of the most common reasons for a low stock price. There are other reasons. But, decelerating earnings growth or declining earnings or shrinking margins or a hundred other poor business “vital signs” are common reasons for why investors – and speculators – abandon a stock. And that abandonment is what leads to a low stock price. So, our job as value investors should be to find those stocks with low Graham Numbers – low P/E ratios and low P/B ratios – where the business momentum is either not that bad or where it is likely to reverse at some …

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Was Peter Lynch Right? – Does Earnings Performance Drive Stock Performance?

I’m writing today’s Focused Compounding daily from a Best Western in Kansas. By the time you read this, I may already be back in Plano. Today will complete this short – only like four days total – research road trip by me and Andrew. We spent some time in New Mexico, Arizona, and Kansas basically.

While on this trip, I’ve been re-reading some books by a guy who did a lot of these sorts of trips: Peter Lynch. Lynch isn’t exactly a value investor. So, some of the things he says can be particularly interesting for a value investor to hear. One of the most interesting things he says repeatedly is that – in the long run – stock performance tracks earnings performance. So, you just find the stocks that are going to grow earnings a lot over the next 5, 10, 15 years. And then you make sure those stocks don’t have crazy high P/E ratios today. And then you buy them.

This part about how earnings performance drives stock performance tends to be true in the very long run. If you look at list of 100-bagger stocks, they are basically lists of 100-bagger businesses in terms of profits and even earnings per share. You don’t have many 100-baggers where earnings went up only 10 times but the stock went up 100 times. Usually, you need the two working together. So, yes, the multiple goes up 5 times, but the earnings go up 20 times. Or, the multiple triples and earnings increase 30-40 times. There aren’t a lot of pure value stocks on a list of 100-baggers. Nor, actually, are there as many pure growth stocks as you’d think. If a growth stock is something with a P/E of 50, or 75, or 100 – that’s not where hundred baggers usually come from. If it’s a very fast growing business with a P/E of 30 – then, yes, plenty of 100-baggers do come from stocks as expensive as that.

The problem for investors – even pretty long-term investors – is that, in some stocks, the tracking of earnings and price is very weak. In an earlier article, I mentioned FICO (FICO). Over the last 10 years, measures of things like sales per share, earnings per share, free cash flow per share, etc. have basically tripled. Meanwhile, the market cap of the stock has increased about 10 times. The P/E went from about 15 to about 50. Price-to-sales from like 1.5 to 7.5.

The risk for the investor is, of course, that he thinks of the multiple expansion the same way as the earnings growth. Investors rarely tell themselves I bought a stock that increased EPS at 15% a year for 10 years and I bought it at a pretty low starting price (let’s say 15 times P/E). So, I’ve done well in this stock because I bought in at a P/E of 15 and it grew EPS at 15% a year for a long time. Instead, they have one …

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The Graham Number: What Makes a Value Stock a Value Stock?

In recent years – and especially recent months – many stocks have gotten a lot more expensive. Especially among bigger U.S. stocks, the “value” category has shrunk. I did a quick check of the biggest stocks in the U.S. – basically the top 40% of stocks by size in the S&P 500 – and I’d say that about 85% of these stocks can now be clearly labeled “non-value stocks”. A non-value stock might not be expensive. It might turn out that Amazon (AMZN) will grow so fast and so profitably for so long to justify an above-average multiple. But, we can’t call something with an above average multiple a “value stock”.

The easiest way to define a value stock is to use what I’ve – a couple times on the podcast now – called the “Graham Number”. This is my word for it. Some people call a different number the Graham number. But, having read Ben Graham’s writings – I’d say this is the number that most deserves his name. It’s a simple product of two factors: 1) The price-to-earnings ratio and 2) The price-to-book ratio. Graham suggested – in the Intelligent Investor – that you shouldn’t buy a stock with a “Graham Number” over 22.5. He probably got this number by using a P/E ratio of 15 as “normal” and then he asked how high or low a P/B is acceptable based on that P/E ratio of 15. So, for example, a stock with a P/E of 15 and a P/B of 1.5 would be considered a “normal” price level for a stock. This would then – through simple multiplication – tell you that a “Graham Number” of 22.5 marks the dividing line between a “value” and a “non-value” stock.

So, let’s start with some extreme examples of clear value stocks. Among stocks I’ve mentioned frequently on the podcast, two stand out. One is NACCO (NC). According to QuickFS.net, NACCO – at about $23 a share – has a P/E of 5.3 and P/B of 0.6. This gives you a Graham number of 3.2. That’s a stunningly low number. Anything under 5 is pretty rare. Is it a good idea to buy stocks with Graham Numbers that low? No. I don’t think you should favor stocks with a super low Graham Number of 5 or less over stocks with a Graham Number of 15. A Graham Number of 15 would equate to a one-third “margin of safety” versus the “normal” Graham number of 22.5. This is because 15/22.5 = 0.67. Graham frequently used a one-third margin of safety as a sort of nice, round figure for what you should look for in a stock. I think it’s fine to do the same. It’s probably better – and, in fact back tests I’ve done for the two decades ending in 2020 show it’s been empirically better – to buy good companies at as high a Graham Number as 15 instead of just focusing on buying everything with a Graham Number …

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All About Edge

Richard Beddard recently wrote a blog post about company strategy. And Nate Tobik recently wrote one about how you – as a stock picker – have no edge. I’d like you to read both those posts first. Then, come back here. Because I have something to say that combines these two ideas. It’ll be 3,000 words before our two storylines intersect, but I promise it’ll be worth it.

 

Stock Picking is Like Playing the Ponies – Only Better

Horse races use a pari-mutuel betting system. That is, a mutual betting system where the bets of all the gamblers are pooled, the odds adjust according to the bets these gamblers place, and the track takes a cut regardless of the outcome.

At the race track, a person placing a bet has a negative edge. He places a bet of $100. However, after the track takes its cut, it may be as if he now “owns” a bet of just $83.

At the stock exchange, a person placing a buy order has a positive edge. He places a bet of $100. However, after a year has passed, it may be as if he now “owns” a bet of $108.

All bets placed at a race track are generically negative edge bets. All buy orders placed at a stock exchange are generically positive edge bets.

In horse racing, the track generally has an edge over bettors. In stock picking, the buyer generally has an edge over the seller.

 

In the Long Run: The Buyers Win

The Kelly Criterion is a formula for maximizing the growth of your wealth over time. Any such formula works on three principles: 1) Never bet unless you have an edge, 2) The bigger your edge, the more you bet and 3) Don’t go broke.

In theory, the best way to grow your bankroll over time is to make the series of bets with the highest geometric mean. Math can prove the theory. But, only in theory. In practice, the best way to prove whether a system for growing your bankroll works over time is to back test the strategy. Pretend you made bets in the past you really didn’t. And see how your bankroll grows or shrinks as you move further and further into the back test’s future (which is, of course, still your past).

Try this with the two “genres” of stock bets:

1)      The 100% buy order genre

2)      And the 100% sell order genre

Okay. You’ve run multiple back tests. Now ask yourself…

Just how big was your best back test able to grow your bankroll over time by only placing buy orders – that is, never selling a stock. And just how long did it to take for your worst back test to go broke only placing buy orders.

Now compare this to back tests in the sell order genre.

Just how big was your best back test able to grow your bankroll over time by only placing …

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Are We in a Bubble? – Honestly: Yes

“Are we in a bubble?”

Right now: This is the most common question I get. For a long time, my answer to this question has been: “yes, stocks are overvalued but that does not mean the stock market has to drop.”

This exact phrasing has been my way of hiding behind a technicality. Technically, logic allows me to argue that just because stocks are overvalued does not mean they have to drop – after all, stock prices could just go nowhere for a long time.

And history does show that the combination of a sideways stock market in nominal dollars and high rates of inflation can “cure” an expensive stock market (see the late 1960s stock market Warren Buffett quit by winding down his partnership).

Unfortunately, the question asked was “are we in a bubble” not “do all bubbles pop with a crash”.

So, as of today: I will stop hiding behind that technicality.

 

What Today’s Bubble Looks Like

To get some idea of how expensive U.S. stocks are check out GuruFocus’s Shiller P/E page.

For a discussion of the psychological aspects of whether or not we are in a bubble, read two 2017 memos by Howard Marks: “There They Go Again…Again?” and “Yet Again?”

I don’t have much to say about the psychology of bubbles other than:

1.       When we’re in a bubble: I tend to get emails asking about the price of stocks rather than any risks to the economy or fears of a permanently bleak future.

2.       When we’re in a bubble: the emails I get tend to acknowledge that prices are high but then assert that there is no catalyst to cause them to come down.

3.       When we’re in a bubble: people tend to talk about their expectation for permanently lower long-term rates of return rather than the risk of a near-term price drop.

4.       And finally: when we’re in a bubble, people ask more about assets that are difficult to value.

This last point is the one historical lesson about the psychology of bubbles I want to underline for you.

Eventually, manic and euphoric feelings have to lead investors to focus on assets that are difficult to value.

It’s easier to bid up the prices of homes (which don’t have rental income) than apartment buildings (which do have rental income). It’s easier to bid up the price of gold (which doesn’t have much use in the real economy) than lime (which is mined for immediate use).

Generally, assets which are immediately useful are the most difficult to bid up in price.

Stocks without earnings are easier to bid up than stocks with earnings.

And stocks in developing industries are easier to bid up than stocks in developed industries.

The less present day earnings and less of a present day business plan a company has – the more a manic or euphoric investor can project on to the stock. The asset takes on a Rorschach test quality.

The 3 topics …

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