Posts By: Geoff Gannon

Why Ad Agencies Should Always Buy Back Their Own Stock

Someone who’s been reading my blog for the past few years emailed me this question:

“With (Omnicom), I particularly like the durability of the advertising agency industry, the nature of the customer relationship (long term in nature and high retention rate), it operates in a rational duopoly environment and good capital allocation policy of John Wren. I also like WPP which also looks attractively valued at around £14 but I prefer OMC as it uses the excess cash to buy back its shares compared to WPP’s acquisitive approach. Would be great to get your thoughts and insights on the following:

– Any significant misjudgment I should consider that could potentially impair OMC’s ability to compound by around 10% in the long term;

– Your thoughts on WPP as a potential alternative consideration to OMC, especially at the current price of around £14 and its market leadership. I like OMC even more now that it is in the low $70s but it would be interesting to get your take on your appraised value of WPP and if there are factors I should favour WPP over OMC apart from the valuation margin of safety and different use of excess cash (share buybacks versus acquisition).”

No. There’s no significant misjudgment on your part that’s going to cause Omnicom to fail to compound at 10% a year while you own it. I’ve looked at ad companies recently and don’t see any changes in the industry that worry me. I’ve gotten a lot of emails – and responded to some of them – about whether ad companies will have a narrower “moat” in the future than they have in the past. I think the concerns are very speculative. And I don’t see any long-term reason for the decline in the share prices of ad companies like WPP and Omnicom.

Obviously, there are cyclical reasons that explain these price declines well.

The big change in advertising is that Google (both the search engine and YouTube) and Facebook are the venues where all incremental ad spending in the world is now going. So, Google and Facebook will have a big share of ad spending in the future. But, that’s not new. Brands have often spent a large portion of their ad budgets at a small number of media outlets.

The new part is that global conglomerates (like Omnicom) made up of different agencies will be doing a lot of their overall buying for clients at just two corporations: Facebook and Google.

I understand it worries other people. It doesn’t worry me. I don’t see anything in the way that the ad industry is developing now that seems like a bigger shift than the rise of TV, the death of newspapers and magazines, or the rise of the internet. Those things already happened by the way. It would be impossible to know that from looking at the financial results of global ad companies. None of those events left the slightest mark on …

Hold Cash: Wait till You Get Offered 65 Cents on the Dollar

A Focused Compounding member who fears the stock market is expensive posted this comment:

“Hi Geoff,

S&P today is expensive based on TTM PE of 24 and CAPE of about 30. An investor whose holdings consist entirely of stocks outside S&P500, will still see a drop in the prices of her equities if the S&P falls even if she has bought her holdings significantly below their estimated fair values. In your opinion, what’s the best way to position oneself going forward with the goal of course being total portfolio returns outpacing market returns in the long run?

1. 
   change to 100% cash position (to take maximum advantage of potential future price drop)
   2. 20% or so equities and about 80% cash (so as to take advantage of potential price drop)
   3. Ignore the market completely and keep current balance of about 80% equities, 20% cash
   4. Any other thought besides the above three.”

The option that comes closest to what I’d suggest is #3 (“Ignore the market completely and keep current balance of about 80% equites, 20% cash”).

But, let’s walk through why that is.

First, do I think the market is expensive?

Yes.

In an August 29^th post, entitled “The Market is Overpriced: These 3 Stocks Aren’t” I wrote:

“I’ve never seen a time when it’s as difficult to find a good stock to buy without overpaying as what I see right now.

But, I don’t think that means you should be 100% in cash. I think it means you should be in stocks like:

Cheesecake Factory (at $41 as I write this)

Omnicom (at $73 as I write this)

And Howden Joinery (at 412 pence as I write this)

If the market as a whole is overpriced, it will fall. And when it does fall: it will take stocks like Cheesecake, Omnicom, and Howden with it.

In time, they will recover.

And you will be able to look back – 5 years or more down the road – and say that buying stocks like these at today’s ‘not overprice’ levels and holding them wasn’t a mistake.

You don’t need to get out of the market.

But, you do need to be more selective than ever now that the market is more expensive than ever.”

The second question is: how have I positioned my own portfolio?

My account has 30% in cash right now. I expect that to rise to 35% sometime soon (when I sell a small position).

My 30% to 35% cash position is not a market call. I’m going to spend the rest of this article explaining what it really means when you see me holding cash.

With most investors, a 30% to 35% cash levels means they have thought about portfolio allocation and decided that 30% to 35% in cash is a good level to be at right now because of the risk level in the overall market.

For me, that’s not true.

The truth is that I like two stocks – …

Weight Watchers (WTW): Mistakes Made Over 4 Years of (Emotional) Volatility

I lost a lot of money in Weight Watchers. Let’s look at why that was.

As I write this article, Weight Watchers (WTW) stock is at $44.30 a share.

I bought my shares at $37.68 a share in 2013 and sold them (in March of 2017) at $19.40. So, I realized a loss of 49%. I also tied up money for about 3.5 years. During this same time period, the S&P 500 returned about 12% a year. I probably could have found something else to buy that would have returned 10% to 15% a year like the overall market did.

So, we have two types of losses here. One, is the lost money. That was about 50% of my investment which in turn was about 25% of my total portfolio – so, a loss of about 12.5% of my portfolio. The other loss is time. Over 3.5 years (the length of my Weight Watchers holding period), an investment that moved about in line with the overall market would have grown to about $1.50 for every $1 I invested. This means my decision to invest in Weight Watchers instead of something else wasn’t really a loss of 49 cents for every dollar I invested. It was more like a loss of 99 cents for every dollar I invested (49 cents in capital losses plus the 50 cents in forfeited compounding).

So, that was the cost of my mistake. For each dollar I could have invested in something else and thereby ended up with $1.50 at the end of 3.5 years, I instead put that money into Weight Watchers and only got 51 cents back. The difference between a $10,000 investment in a hypothetical “something else” (like an index fund) and a $10,000 investment in Weight Watchers would be: $15,000 in the something else or $5,100 in Weight Watchers. So, about a $10,000 difference on a use of $10,000. Talking in terms of $10,000 isn’t hyperbole. Remember, I put 25% of my portfolio into this stock to start.

This may sound like an odd way of looking at the loss, but the fact this investment tied up money for 3.5 years is also important.

Now, we know what my losses were. But, what were my mistakes? I want to separate the evaluation of my investment into two parts. Did I make a mistake in my stock selection? And if so, how bad was that mistake? And then, did I make a mistake in my “hold” approach? And, if so, how bad was that mistake.

In an earlier article, I talked about how my sell decisions haven’t added any value over time. My stock selection over the last 17 years has been good. My actual investment performance has been no better than my stock selection though. None of my performance advantage over the stock market as a whole has come from selling at the right time. All of my outperformance has come from picking the …

Unleveraged Return on Net Tangible Assets: It Only Matters When Coupled with Growth

The best way for you to understand unleveraged return on net tangible assets is to look at the reports in the Library section of Focused Compounding. I’m going to give you the basic formula for return on unleveraged net tangible assets here, but it won’t make as much sense as seeing the calculation for yourself by looking down each yearly column of the “datasheet” on one of the 20+ reports in the Focused Compounding library.

The definition of return on unleveraged net tangible assets is usually approximated as:

Earnings Before Interest and Taxes / ((Non-Cash Working Assets: Receivables + Inventory + Property, Plant, & Equipment – (Working Liabilities: Accrued Expenses + Accounts Payable))

You can then adjust that result by a tax rate of 35% (so, multiply it by 0.65) to get an after-tax figure for U.S. companies.

Again, It’s best for you to look at some sample reports that include this figure long-term. So, here is an example using Grainger.

It’s very important to stress two points:

1) Unleveraged return on net tangible assets is a useful indicator of the actual business’s day-to-day profitability. It ignores things like cash and goodwill because these things are not needed to run the day-to-day business; instead, they reflect past decisions by the board (to make high priced acquisitions or to hoard cash or whatever)

2) You only need to know what unleveraged returns on net tangible assets are within a certain range. Basically, pre-tax returns of worse than 15% are a problem (since, after-tax they can be less than 10% which is roughly the long-term return in the stock market) and pre-tax returns greater than 30% are always sufficient (because, after-tax returns would be 20% or better in that case which is – over the truly long-term – a better record of compounding wealth than all but a very small number of public companies).

What matters is the incremental return on the money retained by the corporation that could otherwise be paid out in dividends or used to buy back stock.

I think return on NTA is a very important number. However, I don’t think you should necessarily prefer a business with a 400% return on NTA over a business with a 40% return on NTA.

Let me explain why. But, first let Warren Buffett explain why:

“…growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.”

–  Berkshire Hathaway Shareholder Letter (2000)

Remember that last phrase “usually a plus, sometimes a minus”. Growth is usually good. But what’s always true is …

How to Read Between the Lines of a 10-K

Question

“I have read some of your Singular Diligence content and one of the most interesting parts of the reading are the notes that you and Quan used and published in those reports.

So one of the most remarkable things that I have noticed in the notes is that you did not use a lot of information in the annual reports. And this sounds intriguing to me since I am a regular reader of your blog and you have always emphasized how important it is to read (the) 10-K, annual reports, (and) quarterly reports. Having said that, it would be good to understand why did you not use more info from those sources. Moreover, I was actually curious how do you allocate your time when doing research? I am currently also doing research so I was looking to see which sources you prioritize?”

Answer

It depends on what you mean by prioritize? If a top priority is the thing you read first, then I make 10-Ks a top priority. If a top priority is the thing you spend the most time on, then SEC filings are a low priority. And then, if a top priority is something you quote a lot – as you mentioned – SEC filing are a very low priority for me.

I’ve said before that I always read the newest 10-K and the oldest 10-K of a stock I’m researching. So, imagine I am researching a U.S. stock that has been public for a long time. The SEC’s database of company filings – which includes 10-Ks (annual reports), 10-Qs (quarterly reports), and “going public” or spin-off documents if the company has any of those. If the company has been public in its current form for a long time, the oldest annual report (10-K) will be something from maybe 1994-1996. That’s around the time companies started being required to file electronic copies of their 10-Ks with the SEC. As a rule, a U.S. company that has long been public will now have about 20 years of annual reports for you to read in full.

Don’t do that. I just read the 2016 (last year’s) annual report and then the 1994 or 1995 or 1996 – or whatever the oldest report you can find is – annual report. I want to get a sense of how the business has changed.

The 10-K – when read on its own – is of limited value when making an investment. All of the financial data that Quan and I used to create the “datasheet” of a Singular Diligence comes from the 10-K. So, the financial statements – especially the income statement, the balance sheet, and the cash flow statement – are useful. The datasheet we presented was usually a 15-25 year history of a company’s finances. It’s by far the most important thing in those reports. It may be possible to make an investment based purely on the financial statements if you have both income statement and balance sheet data for …

How to Judge a Company’s Bargaining Power With its Customers and Suppliers

A Focused Compounding member asked me this question:

“…what are the factors we should be thinking about when assessing the bargaining power of a given business relative to its customers and suppliers?”

In an earlier memo, I talked about “market power”. My definition of market power is the ability of a company to make demands of its customers or suppliers without fearing that such demands will end their relationship. Why would a supplier or customer agree to demands without considering ending the relationship?

Dependency.

Recently, it was reported that Wal-Mart will start fining suppliers for delivering early as well as delivering late. Wal-Mart wants to manage inventory in their stores. So, they want to make sure that orders arrive on-time and in-full. Many suppliers to a retailer like Wal-Mart don’t have a good track record when it comes to making sure 100% of the order is there on the scheduled day. This causes problems for retailers. For example, I was at Costco last week and picked up the very last box of Eggo waffles available in that store. A few days later, there were several dozen boxes of Eggos – all containing 72 waffles each – stacked sky high. Everyone who came to Costco after I did was either looking for their usual supplier of frozen waffles and didn’t get them – or they have no idea Costco even sells Eggo products. Getting a supplier to deliver on time and in full sounds like a small thing, but a business model like Wal-Mart depends on keeping inventory at the right level. Wide selection in store is Wal-Mart’s main advantage. In most of the towns Wal-Mart is in it’s the offline “everything store” that Amazon aspires to be online. It is the only place to make a true one-stop shopping trip. If shelves are bare of any items at all – shoppers go away disappointed. Too much inventory obviously causes problems for shareholders – it ties up more capital and lowers free cash flow for the year – but it’s also a problem for employees. Because of the way Wal-Marts are run, employees spend a lot of time in areas shoppers don’t see. Sometimes, those areas aren’t the most pleasant places to work. When they are overcrowded with inventory, they became very unpleasant places to work.

Wal-Mart has a lot of bargaining power with some suppliers. Mostly, these seem to be suppliers that have gradually become dependent on Wal-Mart over time. This could happen for a few reasons. One of the most common reasons you see is chasing high growth in slow growth industries. So, if a company was in the soda business or the cereal business and Wal-Mart was quickly expanding around the nation during the 1970s, 1980s, 1990s, and early 2000s – such a company might have tried to grow faster than its category by selling a greater share of its product to faster growing retailers like Wal-Mart. This sounds like a good idea at the time. It allows …