Posts By: Geoff Gannon

Is Negative Shareholder Equity a Good Thing or a Bad Thing? – No, It’s an Interesting Thing

Someone emailed me this question:

“…how do you consider negative shareholder equity? Is this good, bad or other?”

Before I give my answer, I apologize to the roughly 60% of my audience that I know is made up of non-Americans. I’m about to use a baseball analogy.

Like Warren Buffett has said: the best businesses in the world can be run with no equity now.

I’ve invested in companies with negative equity. Most notably, IMS Health in 2009.

I would always notice negative shareholder equity. It would make me more likely to want to learn about the stock – because it’s odd.

Remember, you are looking for extraordinary investment opportunities.

We can break that search into two parts: “extra”+”ordinary”.

Sometimes, we know whether something is a “plus” or a “minus”. Other times, we only know it’s an anomaly without knowing whether it’s “good odd” or “bad odd”.

As an investor, you always want to investigate anomalies. However, you don’t always want to invest in anomalies. There’s a difference.

Say we’re searching for a good or even a “great” stock. The first thing we know for sure about this hypothetical good or great stock we haven’t yet found is that it’s not ordinary.

Negative shareholder equity is very not ordinary.

In the past, I’ve compared negative shareholder equity to the number of strikeouts a Major League batter has.

We know high strikeout rates are good for a pitcher.

However, there is considerable debate about whether high strikeout rates are good or bad for a batter.

Theoretically, it’s better to have positive equity than negative equity. For example: if IMS Health looked exactly like it did when I found it plus it had billions in extra cash on the balance sheet – that’d be better.

But, that’s like saying it’s better to have a stock with a 17% growth rate and a P/E of 7 rather than just a P/E of 7. In the real world: a P/E of 7 is plenty interesting all on its own.

And, using our baseball analogy: Theoretically, it’s always better to have not struck out rather than struck out (excluding the possibility of double-plays).

Yes, if Babe Ruth had the same number of home runs plus some of his strike outs were instead balls he put into play – he’d be an even better batter. But, let’s face it: if your job was picking the right guy to have on your team – identifying the next Babe Ruth is all you need to do.

So, let’s forget theory for a second. Let’s look at the cold, hard facts.

What does the data say?

The data actually says that some of the best batters in Major League history had unusually high strike out rates.

And the data says that some of the best stocks around have unusually low shareholder’s equity.

So, if I’m a general manager who sees a batter with an absurd number of strike outs, I know I want to learn more. I don’t …

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Looking for Cases of Over-Amortization and Over-Depreciation

A blog I read did a post on goodwill. The discussion there was about economic goodwill. I’d like to talk today about accounting goodwill – that is, intangibles. Technically: accounting goodwill applies only to intangible assets that can’t be separately identified. In other words, “goodwill” is just the catch-all bucket accountants put what’s left of the premium paid over book value that they can’t put somewhere else.

For our purposes though, accounting for specific intangible items is often more interesting than accounting for general goodwill. That’s because specific intangibles can be amortized. And amortization can cause reported earnings to come in lower than cash earnings.

 

Unequal Treatment

The first thing to do when confronting a “non-cash” charge is to figure out if it is being treated equally or unequally with other economically equivalent items.

I’ll use a stock I own, NACCO (NC), as an example. As of last quarter, NACCO had a $44 million intangible asset on the books called “coal supply agreement”.

The description of this item (appearing as a footnote in the 10-K) reads:

“Coal Supply Agreement: The coal supply agreement represents a long-term supply agreement with a NACoal customer and was recorded based on the fair value at the date of acquisition. The coal supply agreement is amortized based on units of production over the terms of the agreement, which is estimated to be 30 years.”

All of NACCO’s customers are supplied under long-term coal supply agreements which often had an initial term of 30 years. These agreements are economically equivalent. However, one of the agreements is being treated differently from the rest.

The amortization of this coal supply agreement is probably meaningless.

Why?

Because: if NACCO acquired a company that had a 29-year coal supply agreement in place, it would record this item on its books as an intangible asset and it would amortize it over the life of the contract. But, if NACCO itself simply signed a coal supply agreement with a new customer – no intangible asset would be placed on the books. And there would be no amortization. What’s the difference between creating a contract and acquiring a contract?

There is none.

Now, that doesn’t mean the economic reality is that NACCO’s earnings never need to be replaced. Many of the contracts NACCO has in place only run for about 13-28 years now. And, far more importantly, the power plants NACCO supplies with coal might close down long before their contracts expire. So, earnings really will “expire” and need to be replaced. But, this has nothing to do with whether a certain coal supply agreement is or is not being amortized. The amortization charge is irrelevant. But, the limited remaining economic lifespan of NACCO’s customers – which isn’t shown anywhere on NACCO’s books – is relevant.

Therefore, two adjustments need to be made. One, amortization has to be “added back” to reported EPS to get the true EPS for this year. And, two, that EPS number has to …

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Insider Buying vs. Insider Incentives

A blog reader sent me this email:

“Do you ever pay attention to insider transactions when analyzing a company?”

I do read through lists of insider buys from time-to-time. I follow a blog that covers these kind of transactions. But, I can’t think of any situation where I incorporated insider buying or selling into my analysis.

 

 

Learn How Executives are Compensated

I can, however, think of situations where a change in how insiders were compensated was included in my analysis. For example, years ago, I was looking at a stock called Copart (CPRT). It had a high enough return on capital and generated good enough cash flow that it was going to have more cash on hand than it could re-invest in the business pretty soon. Up to that point, it had been able to plow a lot of the operating cash flow back into expanding the business. However, it seemed like they had gotten too big to keep that up. So, they were going to have to buy back stock, pay a dividend, do an acquisition, or let cash pile up on the balance sheet.

I saw that the Chairman and the CEO (two different people, the CEO is the Chairman’s son-in-law) were now going to be compensated in a form that meant the share price a few years down the road is what mattered (if I remember right: compensation would now be a big block of five-year stock options combined with an elimination of essentially all other forms of compensation for those next 5 years). I had also read an interview with the Chairman (it was an old interview I think) where he didn’t strike me as the kind of person who was going to venture out beyond his circle of competence if and when he had too much cash.

So, I felt the likelihood of big stock buybacks happening soon was high.

To answer your question: no, I don’t really pay attention to insider buying and selling. But, yes, I do pay attention to whether insiders own a lot of stock, how they are compensated (what targets the company has for calculating bonuses), etc.

I can think of one situation where both the company and the CEO were buying a lot of stock at the same time. And, I should have bought that stock. If I had, I would’ve made a ton of money. However, to be honest, even if the CEO wasn’t buying shares and the company wasn’t buying back stock I should’ve seen this was a stock to bet big on.

It was trading for less than the parts would’ve fetched in sales to private owners. It was an obvious value investment. And that’s probably why insiders were buying.

 

 

Insiders Are Like You – Only Confident

Insiders tend to be value investors in their own companies. So, I think outside investors assume that insiders are acting more on inside information and less on just pure confidence than is really …

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So: Am I Keeping Stocks Forever Now – Or Not?

There is a discrepancy between two posts I wrote. One is this post at Focused Compounding. Another is yesterday’s post here on this blog. A reader pointed this out:

 

In your post on NACCO from 15 December 2017, you state: “I don’t trade around a position. I buy all my shares at one point and sell all my shares at another.”

 

However in your post from 29 May 2017, your verdict is: “Geoff will never voluntarily exit a position entirely. Once he owns a stock, he’ll keep owning at least some of that stock forever unless that company is taken over or goes bankrupt. He will simplify things down to a true “buy and hold” approach. No thought will be given to selling a stock ever again.”

 

Don’t you think that these two statements are contradictory? Do you have a true “buy and hold” approach?

 

I don’t have a true buy and hold approach. I’m not a buy and hold investor. I’m always 100% open to selling a stock because I no longer like something about the business, the balance sheet, the management, the capital allocation, etc.

 

However, I’m not really open to selling a stock because it’s gotten too expensive.

 

Keep in mind: I find new stocks to buy over time. There are dry spells. Recently, I went almost two years without buying anything. But, my tendency to feed new ideas into the portfolio – in big initial position sizes – means that old ideas tend to become a smaller part of my portfolio over time.

 

So, even if a stock does become more expensive, I’d still be selling some shares of that stock over time just to fund new purchases. The stock could rise as a percent of my portfolio, but I’d still have sold shares in it. Two good examples are Frost and BWXT. Frost is a more than 25% position now (so, it’s slightly bigger in percentage terms than when I first bought it even though I’ve sold shares) and BWXT is close to a 15% position now while it was only originally part of a 20% position that got broke up (I bought Babcock & Wilcox stock pre-spinoff). I’ve sold about a third of BWXT and Frost, and yet they’re both just about the same percentage of my portfolio as when I first bought them.

 

Having said that, it should tend to be the case the the “stale” ideas in my portfolio will tend to get sold down and the “fresh” ideas in my portfolio will tend to be the biggest positions. The one exception to this would be if something in my portfolio was rising in price at a really unusual – probably very momentum driven – way.

 

It’ll be an interesting test of my resolve not to sell based on price if and when that ever happens.

 

So, I’m always open to selling a stock because I no longer like that stock (however, …

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Why I Spend 95% of My Time Thinking About New Stocks

I’ve done a couple posts recently that have too many “rules” type statements in them. As investors: it’s less important what we tell ourselves we’re doing and more important what we’re actually – habitually – doing.

So, how do I spend my day?

If I told you I spend 95% of my time thinking about new stock ideas and 5% of my time thinking about the stocks I already own – I’d be exaggerating how much time I spend thinking about the stocks I already own.

I’m on a constant quest to find new stocks. That might not be obvious judging by how rarely I buy something new. But, that’s how I spend my days. I’m always looking to buy something new.

I don’t really think about what I own. And I don’t really think about “selling right”.

I just think about “buying right”.

Which really consists of:

1)      Picking the right business to be in

2)      Paying the right price

Using NACCO as an example, I decided early on in my research on that spin-off that the coal business was the business I wanted to be in and the small appliance business was the business I didn’t want to be in. It then became a question of the price I was willing to pay.

In very rough terms, I’d decided that I wanted to pay less than $40 a share for the coal business. When I first looked at the price after the spin-off, the coal business was selling for about $32.50. So, I bought it.

The truth is: I’m not really going to re-visit NACCO at all – except sometimes to write a little about it – till the end of 2018.

Someone asked me recently if writing about stocks made me a better investor or a worse investor. I’ll answer that question on the first Q&A episode of my new podcast (reminder: read this post, and send us a question if you get a chance).

It certainly makes me a different investor. The investor part of me spent all my time thinking about NACCO before buying it. The writer has spent all his time thinking about NACCO after buying it.

If I wasn’t writing about the stock, I would’ve bought it in October 2017 and then only checked in again with it around December 2018.

I’ve always thought my attention is best spent focused 100% on finding new ideas. And I know from past experience that thinking a lot about what you own is as likely to hurt your returns as to help those returns.

I know that a lot of attention and effort spent on a stock in the research phase generates better returns. I’m not sure that extra attention and effort spent on a stock you already own generates better returns.

For some people, I think it leads to worse returns.…

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A U.S. Corporate Tax Cut is Not Priced into Stocks

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Why I Don’t Use WACC

A blog reader emailed me this question about why I appraise stocks using a pure enterprise value approach – as if debt and equity had the same “cost of capital” – instead of using a Weighted Average Cost of Capital (WACC) approach:

 

“…debt and equity have different costs. In businesses with a (large) amount of the capital provided by debt at low rates, this would distort the business value. In essence I am asking why do you not determine the value of the business using a WACC, similar to how Professor Greenwald proposes in Value Investing: From Graham to Buffett and Beyond. The Earnings Power Value model seems theoretically correct, but of course determining WACC is complicated and subject to changes in the future. Nevertheless, your approach of capitalizing MSC at 5% is basically capitalizing the entire business value, including the amount financed by debt, at what is presumably your cost of equity for a business with MSC’s ROIC and growth characteristics. Perhaps I am coming at this from a different angle than you, but it seems a little inconsistent from the way I am thinking about it, and for businesses with more debt this would lead to bigger distortions. AutoNation would be a good example of a business with meaningful…debt that this approach would distort the valuation on.”

 

When I’m doing my appraisal of the stock – this is my judgment on what the stock is worth not whether or not I’d buy the stock knowing it’s worth this amount – I’m judging the business as a business rather than the business as a corporation with a certain capital allocator at the helm. Capital allocation makes a huge difference in the long-term returns of stocks. You can find proof of that by reading “The Outsiders”. Financial engineering makes a difference in the long-term returns of a stock. You can read any book about John Malone or Warren Buffett to see that point illustrated.

 

But, for me…

 

My appraisal of Berkshire Hathaway is my appraisal of the business independent of Warren Buffett. Now, knowing Warren Buffett controls Berkshire Hathaway would make me more likely to buy the stock and to hold the stock. So, it’s an investment consideration. But, it’s not an appraisal consideration for me. When I appraise Berkshire Hathaway, I appraise the businesses without considering who is allocating capital. Otherwise, I’d value Berkshire at one price today and a different price if Warren died tomorrow. I don’t think that’s a logical way to appraise an asset. Although I do think that buying an asset that’s managed by the right person is a good way to invest.

 

A good example of this is DreamWorks Animation (now part of Comcast). Quan and I valued DreamWorks Animation at a level that was sometimes more than double the stock’s price.

 

There was a point where we could have bought the stock at probably 45% of what we thought the business was worth.

 

However, we asked each …

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Stocks You Can’t Buy

The always interesting Japanese stock blog (it’s written in English), Kenkyo Investing, has a post on a negative enterprise value stock called Hokuyaku Takeyama. The reason this stock is cheap is because it trades on the Sapporo Stock Exchange – not one of the more popular exchanges like Tokyo or Osaka. Very few stocks only trade on the Sapporo Stock Exchange. So, very few investors make the special effort to do business with a broker who will give them access to this exchange.

 

Watlington Waterworks (Bermuda Stock Exchange)

I wrote about a similar situation in March of 2011. That stock was called Watlington Waterworks. It’s a water company on the island of Bermuda. Because it’s on the island of Bermuda – a rich, densely populated remote island with no fresh water – the economics of Watlington Waterworks are generally superior to all other water companies around the world. And yet – in March of 2011 – the stock traded for lower multiples of earnings, book value, etc. than other water companies. In the 7 years since I wrote about Watlington Waterworks, the stock has risen in price by about 9% a year. It also paid a dividend. So, holders of the stock got 10%+ owning something that was a true diversifier in their portfolio (Watlington’s price doesn’t move based on how the Dow Jones, Nasdaq, or S&P 500 are doing). In fact, on many days, it doesn’t move. What’s more impressive is that Watlington returned more than 10% a year over 7 years while finishing that period with a P/E ratio less than 12, a price-to-book ratio less than 1, and a rock solid balance sheet.

Many stocks have returned more than 10% a year over the last 7 years. However, very few stocks that returned more than 10% a year now have a P/E under 12, a P/B under 1, and a solid balance sheet. Meanwhile, many companies that now have a P/E under 12 and a P/B under 1 have returned far worse than 10% a year over the last 7 years. In other words: Watlington is rare in the sense it combines a 7-year total return performance that has been adequate with a stock price that has always remained at an investment level rather than straying into speculative levels like most stocks. Basically, it’s been a decent “set it and forget it” investment. The business has never really performed badly. And the stock’s price has never really been anything but cheap.

Also worth mentioning is the way I presented Watlington Waterworks. I showed the company’s recent financial results on this blog – but didn’t give out the company’s name or business description. Readers then guessed where the stock traded. Back in 2011, almost everyone came up with a guess in the $20 to $30 price range. At the time, the stock traded at $14.

 

What Ben Graham Would Really Be Buying Today

These are the kinds of stocks you want to find …

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Why You Might Want to Stop Measuring Your Portfolio’s Performance Against the S&P; 500

Someone emailed me this question about tracking portfolio performance:

“All investors are comparing their portfolio performance with the S&P 500 or DAX (depends were they live). I have asked a value investor why he compared the S&P 500 performance with his portfolio performance…for me as a value investor it makes no sense. A value investor holds individual assets with each of them having a different risk…it’s like comparing apples and oranges.

The value investor told me that…Warren Buffett compares his performance with the S&P 500. But I believe he did it, because other investors…expect it or ask for such a comparison.

How do you measure your portfolio success? Do you calculate your average entry P/E and compare it with S&P500 or Dow P/E to show how much you (over)paid for your assets? Or do you avoid such a comparison and calculate only the NAV of your portfolio?”

I don’t discuss my portfolio performance on this blog.

And I think it’s generally a good idea not to track your portfolio performance versus a benchmark.

It’s certainly a bad idea to monitor your performance versus the S&P 500 on something as short as a year-by-year basis.

Why?

Well, simply monitoring something affects behavior. So, while you might think “what’s the harm in weighing myself twice a day – that’s not the same thing as going on a diet” – in reality, weighing yourself twice a day is a lot like going on a diet. If you really wanted to make decisions about how much to eat, how much to exercise, etc. completely independent of your weight – there’s only one way to do that: never weigh yourself. Once you weigh yourself, your decisions about eating and exercising and such will no longer be independent of your weight.

Knowing how much the S&P 500 has returned this quarter, this year, this decade, etc. is a curse. You aren’t investing in the S&P 500. So, tethering your expectations to the S&P 500 – both on the upside and on the downside – isn’t helpful. The incorrect assumption here is that the S&P 500 is a useful gauge of opportunity cost. It’s not.

Let me give you an example using my own performance. Because of when the 2008 financial crisis hit, we can conveniently break my investing career into two parts: 1999-2007 and 2009-2017.

Does knowing what the S&P 500 did from 1999-2007 and 2009-2017 help me or hurt me?

It hurts me. A lot.

Because – as a value investor – the opportunities for me to make money were actually very similar in 1999-2007 and 2009-2017. In both periods, I outperformed the S&P. However, my outperformance in 2009-2017 was small while my outperformance in 1999-2007 was big. In absolute terms, my annual returns were fairly similar for the period from 1999-2007 and 2009-2017. It is the performance of the S&P 500 that changed.

Many value investors have a goal to outperform the S&P 500. But, is this a useful goal?

I don’t think so. …

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The Risk of Regret: NACCO (NC)

Someone emailed me this question about NACCO (NC):

“If you don’t mind me asking, why do you so strongly recommend other people not buy the stock given your obvious high conviction? It seems like a classic value situation where a company in a hated industry (coal) with a long-term bleak outlook has an individual player (NC) where the cash flow characteristics are more than enough to justify the current stock price. If you prefer not to answer because your answer is embedded in your member-only site, I totally understand, but I am quite intrigued. For what it’s worth, I am not at a point where I am seriously considering NC for potential investment – I am more interested in Frost (CFR), although I would prefer it to come down more. I am just trying to understand the business and what a fair price for it is. It seems to me that if we had 100% certainty that all the contracts would remain viable for a couple of decades, then NC is easily worth say double where it trades now, but the name of the game is in handicapping the risks of the mines closing, and I would be interested in your thoughts about doing that. It’s obvious that you view this risk as worth the price paid, but I am curious why you do not think others should take the same risk.”

I’ll quote from the write-up I did on the Focused Compounding member site. I had sub-titled sections in this write-up. So, let’s just bullet point the headlines that appeared in the article.

 

They were:

 

* All value comes from the unconsolidated mines

* There are risks

* NACCO’s business model

* Each share of NACCO is backed by 5 tons of annual coal production

* NACCO makes anywhere from 57 cents to $1.75 per ton of coal it supplies

* Side not: amortization of coal supply contracts

* NACCO vs. NACoal

* Quality of earnings

* Risk of catastrophic loss

* How I “frame” NACCO

* Why I don’t recommend NACCO shares

 

You asked about “why I don’t recommend NACCO shares” and that’s one of the section headers. So, let’s look at that part:

 

“I put 50% of my portfolio into NACCO. But, I think people reading this should put 0% of their portfolio into NACCO. As long as electricity demand in the U.S. is declining and natural gas production is rising, coal power plants will shut down. As a shareholder of NACCO, you could wake up any morning to the news that the company has lost 35% of its earnings overnight. I don’t think this is a risk most investors can handle.

Therefore, I don’t recommend anyone invests in NACCO even though it’s now my biggest position.

Let me be clear: I’m not just saying this is a ‘perceived’ risk you may want to avoid.

It’s a real risk.

NACCO is a risky stock.

I absolutely can’t prove that all …

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