Andrew Kuhn August 21, 2019

How Does Warren Buffett Apply His Margin of Safety?

March 26, 2011

Someone who reads the blog sent me this email.

Geoff,

In a previous email to me you explained how Warren Buffett values a company. The text that your wrote was:

“He wants his investment to increase 15% in value. For every $1 of capital he lays out today he wants a day one return of 15 cents. That means a 15% free cash flow yield or buying a bank with an ROE of 15% at 1 times book or buying something for less than a 15% initial yield as long as it is growing.”

I understand that no problem whatsoever. However, I am just curious. How does he apply a margin of safety (for example 50%) to this fcf yield valuation? Thanks for the help.

Chad

He doesn’t.

Buffett has said that with something like Union Street Railway – bought back in the 1950s – he saw the margin of safety was that it was selling for much, much less than its net cash. For Coca-Cola the margin of safety was the confidence he had in future drinking habits around the world.

Buffett felt sure people would drink Coca-Cola in larger and larger amounts per person per day in countries where Coke had been introduced more recently than in the United States. History was on his side. Per capita consumption of Coke had been rising everywhere for years. In contrast, history was not on the side of Union Street Railway.

Passengers – Union Street Railway

1946: 27,002,614

1947: 26,149,937

1948: 24,224,391

1949: 21,209,982

1950: 19,823,933

1951: 18,736,420

Bad trend.

But Union Street Railway had $73 in cash and investments – not a single penny of which was needed to run the actual business. The stock traded between $25 and $42 during 1951. So, even at its high for the year, Union Street Railway’s stock was trading for more than a 40% discount to its net cash.

At its low, the company’s cash covered its stock price almost 3 times.

Union Street Railway had a big margin of safety.

But so did Coke.

Buffett believed both Union Street Railway and Coca-Cola had an adequate margin of safety when he bought them.

With Coca-Cola it came from human drinking habits. With Union Street Railway it came from the cash and investments on the balance sheet.

Buffett was as confident in Coca-Cola as in Union Street Railway.

It’s just that his margin of safety in one case was people’s buying habits and in the other case it was the cash on the balance sheet.

Buffett doesn’t apply some standard 50% margin of safety to an intrinsic value estimate.

He just looks for situations where he’s confident his investment will earn an adequate return from day one far into the future.

And he wants to pay less than the stock is worth.

But that doesn’t mean it’s necessary to do an actual intrinsic value calculation and then slap on some percentage discount to that value.

It just means seeing the …

Andrew Kuhn August 20, 2019

The Moat Around Every Ad Agency is Client Retention

April 24, 2016

By Geoff Gannon

Moat is sometimes considered synonymous with “barrier to entry”. Economists like to talk about barriers to entry. Warren Buffett likes to talk about moat. When it comes to investing, “moat” is what matters. Barriers to entry may not matter. Thinking in terms of barriers to entry can frame the question the wrong way.

If you’re thinking about buying shares of Omnicom and holding those shares of stock forever – what matters? Do barriers to entry matter? Does it matter if it’s easy to create one new ad agency or a hundred new ad agencies? No. What matters is the damage any advertising company – whether it’s WPP, Publicis, or a firm that hasn’t been founded yet – can do to Omnicom’s business. How much damage can a new entrant do to Omnicom’s intrinsic value? How much damage can Publicis or WPP do to Omnicom? The answer is almost none. In that sense, the barriers to entry in the advertising industry are low but the moat around each agency is wide. How can that be?

First of all, the historical record is clear that among the global advertising giants we are talking about a stable oligopoly. The best measure of competitive position in the industry is to use relative market share. We simply take media billings – this is not the same as reported revenue – from each of the biggest ad companies and compare them to each other. If one company grows billings faster or slower than the other two – its competitive position has changed in relative terms. Between 2004 and 2014, Omnicom’s position relative to WPP and Publicis didn’t change. Nor did WPP’s relative to Publicis and Omnicom. Nor did Publicis’s position relative to WPP and Omnicom. Not only did they keep the same market share order 1) WPP, 2) Publicis, 3) Omnicom – which is rarer than you’d think over a 10-year span in many industries – they also had remarkably stable size relationships. In 2005, WPP had 45% of the trio’s total billings. In 2010, WPP had 45% of the trio’s combined billings. And in 2014, WPP had 44% of the trio’s combined billings. Likewise, Omnicom had 23% of the trio’s billings in 2005, 22% in 2010, and 23% in 2014. No other industries show as stable relative market shares among the 3 industry leaders as does advertising. Why is this?

Clients almost never leave their ad agency. Customer retention is remarkably close to 100%. New business wins are unimportant to success in any one year at a giant advertising company. The primary relationship for an advertising company is the relationship between a client and its creative agency. The world’s largest advertisers stay with the same advertising holding companies for decades. As part of our research into Omnicom, Quan looked at 97 relationships between marketers and their creative agencies.

I promise you the length of time each marketer has stayed with the same creative agency will surprise you. Let’s look …

Geoff Gannon August 19, 2019

Waste Management (WM): A Capital-Intensive, Wide-Moat Garbage Collector That A Middle-Aged Warren Buffett Would Like

by JONATHAN DANIELSON

Waste Management is not a cheap stock. It does, however, have nearly all the markers of a really good business. And it doesn’t necessarily look overvalued at these levels either. It leads its industry, has consolidated returns that look to be both of high quality and extremely stable in nature, looks to have a wide moat which will be discussed further below, and all easily discernible indications would lead to the conclusion that management is competent and perhaps even value-add. Waste Management might not be a quantitatively cheap stock, but then again it’s the type of stock that never really looks too cheap. As far as valuation multiples go we have to go back to the Financial Crisis to see a time when the P/E touched low double digits. So, it’s the type of stock that takes a true crisis for it get into the “standard” fair value range as far as valuation multiples are concerned. We could classify it as a blue chip stock. Even though most normal day-to-day people are probably not familiar with the company, most investors are certainly aware of it. It would probably get the attention of a 1980s Warren Buffett. In fact, if you’re reading this write-up then you might be aware that site-favorite Allan Mecham (everyone’s favorite hedge fund manager) owned WM back in the early 2000s.

So we know Waste Management is a leader of its market, they also have a long runway for growth, and in addition the market in which they operate is extremely durable and continually generates robust cash flow throughout various economic cycles. The reasoning for this is pretty intuitive. That is, people are going to have trash whether or not the economy grows or contracts by X% in a given fiscal year. Now the degree to which the company is sheltered from the economy is minimal, I want to stress that. But the business isn’t overly cyclical certainly. Compared to most companies – certainly compared to the index – WM is a far more stable business.

Given that the characteristics of this company are such that investors only need complete preliminary due diligence to begin to reach the conclusion that WM is likely to be extremely high quality, the goal of this article is to serve as a comprehensive overview of the business.

Business Overview

Founded in 1971, Waste Management (WM) is a Houston, Texas based company with 43,700 employees and services over 20 million customers. Of the greater than 20 million customers, close to 18 million are residential, 1 million are commercial, and .2 million industrial. No one single customer accounts for more than 1% of total revenue.

Waste Management is its current form is largely the product of the late 1990s merger between Waste Management and USA Waste. Management has described the several years following this merger as the darkest in the company’s history. The entire industry had been on a buying spree as the industry leaders …

Andrew Kuhn August 17, 2019

Insider Buying vs. Insider Incentives

December 17, 2017

by Geoff Gannon

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

Andrew Kuhn August 13, 2019

Parks! America (PRKA): A Gem Trading at a 15% FCF Yield That Should Have 50%+ of Its Current Market Cap in Cash Within 5 Years

by ANDREW KUHN

Parks! America

Price: $0.14

Shares: 74.8m

MC: $10.4m

Cash: $3.2m

Debt: $2.4m

EV: $9.6m

Geoff and I use a checklist that we go through before investing in any company. Let’s go over it here before jumping into the actual business.

Boxes that need to be checked for us to invest:

Overlooked: Parks! America is an illiquid microcap. The stock currently has a market cap of only $10.4m, of which only about 4% of the shares turn over every year – the average daily volume is 12,806 – multiply this by 252 trading days a year and we get an average of 3.28m shares per year that trade – divide this by the 74.8m shares outstanding and we get a yearly share turnover of a little over 4%. In comparison, Facebook’s shares turn over 177% per year and Apple’s 148%. Parks! is overlooked.

High-Quality Business: We look for simple, predictable, free cash flow generative businesses. Parks fits this mold with solid EBIT margins and FCF generation. Their average FCF (EBITDA – Capex) margin since 2012 is 19% with a standard deviation of only 10% and a coefficient of variation of 0.49. This is a very stable business. I estimate that in 5 years the business will have more than half of its market cap in cash (assuming they continue to run the business like it is running currently).

The Stock CAGR Works Over time:

One of the first initial checklist items we do is look at a long-term stock chart to see how the business has performed over time. We want to roll with the tide.

Compound Annual Returns

YTD: -12%

1 Yr: -11.95%

2 Yr: +18%

3 Yr: +40%

4 Yr: 46%

5 Yr: 47%

6 Yr: 29%

Cheapness:

Current

P/E: 8x

EV/EBIT: 6x

FCF Yield: 15%

Parks! America is the perfect example of a stock that is overlooked and operates in a niche market. Since 1991, the business has owned and operated drive and walk through wild animal safaris. Combined, the company owns two parks – one in Pine Mountain, Georgia and the other in Stafford, Missouri. The Missouri park was acquired in 2008. Both parks are named Wild Animal Safari. Here are a few videos to get a visual tour from people who have vlogged the experience and uploaded it to YouTube:

https://www.youtube.com/results?search_query=wild+animal+safari+pine+mountain+ga+

Both parks combined have over 100 different species and over 900 animals. Together, the uniqueness of having a true animal safari in Georgia and Missouri with affordable admission prices makes Parks a business that people genuinely enjoy attending.

The trip advisor reviews for both parks are 4.5 stars with over 1,000 reviews.

Although people seem to love both parks equally, the economics of the two could not be more different. In 2018, the Georgia park did $5.1m in revenue with a 47% EBIT margin while the Missouri park only booked $923k with a -15.6% EBIT Margin. This is not anything new as the Missouri park has pretty much …

Andrew Kuhn August 13, 2019

Why I Don’t Use WACC

December 14, 2017

by Geoff Gannon

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

Geoff Gannon August 11, 2019

FFD Financial (FFDF): A Conservative Community Bank with a High ROE Trading at Less than 10x Net Income

by REID HUDSON

FFD Financial Corp. (FFDF) is a small Ohio bank holding company that owns all the outstanding shares of First Federal Community Bank. It is headquartered in the town of Dover, Ohio, where it also has its two largest branches. The bank has a market cap of just under $54 million and is listed on the OTC Pink Sheets. It is extremely illiquid, with average daily volume over the past year at 173 shares, representing around .02% of shares outstanding (although that daily average has jumped to 232 shares in the last three months). The bank delisted from the NASDAQ stock exchange in 2012, pursuant to relaxed reporting requirements put in place by the JOBS Act for companies with less than 1200 shareholders. This allowed FFD to save money by avoiding periodic filings with the SEC as well as NASDAQ compliance. The company does, however, still file annual reports with the SEC and posts them on its website.

FFD is an interesting potential investment because of the way it has been able to vastly outperform almost all community banks and most large commercial banks when it comes to return on average equity (ROAE) and return on average assets (ROAA). The bank has also decreased the cost of its deposit base since the financial crisis, with CDs as a percentage of total deposits going from 54% in 2008 to around 30% in the third quarter of FFD’s fiscal year 2019.

FFD just released its unaudited financial statements for the fiscal year-end 2019. Its total assets stood at just under $414 million, its loans at about $336 million, its deposits at around $371 million, and its shareholders’ equity at just over $39 million. Also, FFD’s borrowings are down significantly, standing at just $257,000 compared to over $13 million at year-end 2018. This financial data, however, is unaudited.

The bank’s fiscal reporting year ends on June 30 each year, and its audited financial statements, as of June 30, 2018, show total assets at $382 million, total loans at around $306 million, deposits at about $332 million, and shareholders’ equity at about $34 million. FFD’s audited financial results only go back to 2004, so that is the earliest year I will be able to reference in this report. From 2004 to 2018, FFD’s assets grew at a CAGR of 7.66%, its loans grew at 7.28%, its deposits at 8.5%, and its shareholders’ equity at 5.1%. These results have increased in recent years because of the company’s higher returns which it is able to retain to fuel deposit and loan growth. In the last five years, FFD’s deposits have grown at a rate of 9.3%.

FFD’s 2018 year-end ROAE was at 15.3% and its ROAA was 1.35%, and its unaudited year-end 2019 ROAE was at 17.4% and its ROAA at 1.59%. Obviously, as a small bank this is very impressive, especially considering FFD has been able to achieve this by utilizing only a traditional banking business model. Most small banks you find that …

Geoff Gannon August 11, 2019

How Safe Can You Really Make a 5-Stock Portfolio?

By GEOFF GANNON

Investors often overestimate the reduction in volatility they will get from diversification and underestimate the reduction in volatility they will get from simply owning stocks with a beta less than 1.

Over the last 10-11 years, I’ve owned 5 or fewer stocks in about 90%+ of all quarters. My portfolio’s returns have had a lower standard deviation in terms of returns than the S&P 500. And in terms of just “downside volatility” – which is what most investors mean when they say volatility (they aren’t bothered by big moves to the upside – only the downside) – the difference is even larger.

I’m sure there’s an element of luck to that. And, historically, I hadn’t intentionally focused on low beta stocks. Though – on average – my stocks would have always had lower betas than the market.

I’ve run a portfolio for over a decade with 5 stocks that had less volatility than a portfolio (the S&P 500) with 500 stocks. So, whatever the theoretical math is – I can tell you that in real world performance having 1/100th the number of positions if they have 8/10ths or 2/3rds or half the beta or whatever may end up being no more volatile than the overall market.

If you go from 5 to 500 positions – you will basically go to a beta of 1 (it will be 1 if the 500 are the S&P 500). If you are getting 50%+ of the diversification benefit from just 5 positions – I’m not sure how likely you can improve on reducing the volatility of your portfolio by increasing the number of stocks you hold (because you’d have to find other low beta stocks to keep the beta of your individual stocks lower than the market).

I don’t pay attention much to diversification, beta, etc. But, if you are looking to reduce volatility – especially downside volatility – without reducing returns (and especially without lowering the chance you outperform the market in the long-run) all the research I’ve seen would suggest that holding fewer positions with lower betas would do more for an investor than holding more positions with betas closer to 1. Of course, holding a lot of stocks all with low beta would reduce volatility the most.

So, I don’t think diversifying into more stocks with higher betas actually reduces volatility as much as individual investors expect it too. These investors overestimate the importance of diversification in reducing volatility and underestimate the importance of simply owing low volatility (low beta) stocks.

Does that mean there’s no point to diversifying?

Actually, I think most investors will feel much better diversifying. This is not because their portfolio with more stocks will be a lot less volatile. It’s because diversification has 4 main psychological benefits:

1) It may make some investors more likely to just let some positions sit there. If an investor has only 3, 4, or 5 positions – he …

Andrew Kuhn August 9, 2019

All About Edge

December 23, 2017

by Geoff Gannon

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

Geoff Gannon August 5, 2019

Innovative Food Holdings (IVFH): Specialty Food Distributor Trading At Sharp Discount To Larger Peers, Attracting Activist Attention

Writeup by Thomas Niel

Innovative Food Holdings (OTC: IVFH), is a micro-cap specialty foods distributor selling at a sharp discount to its peers. This discount is not irrational, as the company has two material risks:

IVFH is dependent on a third-party (US Foods) to distribute its specialty food products to restaurants and other food service customers. This contract is year-to-year, but limits the company’s appeal as a takeover candidate to US Foods’s rivals.
IVFH has made two acquisitions in order to diversify into the e-commerce space. Given IVFH’s lackluster M&A track record, investors assume this current endeavor will not pay off for shareholders.

The investing public have conveyed their displeasure via a large sell off in IVFH shares in the past 18 months. But in the chaos, one activist investor sees opportunity. James Pappas’s JCP Investment Management has acquired more than 10% of outstanding shares.

Will this activist be able to help realize IVFH’s intrinsic value? Is the business truly undervalued, or is the current market discount rational? Are there strategic or financial buyers out there to buy out IVFH, or at least buy its non-core units? Read on to see if IVFH presents a strong opportunity for your portfolio!

Background

Innovative Food Holdings is largely the creation of its CEO, Sam Klepfish. Klepfish previously worked in small-cap investment banking before taking the reins at IVFH in 2006. In the past 13 years, he has built the business via roll-up acquisitions. Some of these deals have worked, while others (The Fresh Diet) have destroyed shareholder value.

Company History

Innovative Food Holdings formed in 2004, the result of a reverse merger between public shell Fiber Application Systems Technology and privately-held Innovative Food Holdings. Subsequent to this creation, IFVH acquired Food Innovations in an all-stock deal.

In 2012, IFVH acquired Artisan Specialty Foods for $1.2m, as well as The Haley Group, a brand management company.

In 2014, IFVH merged with The Fresh Diet, Inc. in a $14m all-stock transaction. This deal proved to be a bust, with IVFH selling 90% of the unit to its former founder in 2016.

Since 2014, several bolt-on acquisitions have followed:

2014: Organic Food Brokers

2017: Oasis Sales and Marketing

2018: iGourmet

2018: Mouth Foods

Operating Segments

IVFH operates through these several units, covering several areas of the specialty foods industry (distribution, eCommerce, Brand Management).

Distribution (Direct To Chef)

IVFH’s Food Innovations, Inc. business is heavily supported by its logistics partner, US Foods Inc. Via its deal with US Foods, the company is able to source niche food products, then distribute them to end users (restaurants, hotels, casinos, hospitals, and other food service buyers) within 24-72 hours.

The distribution segment focuses on the gourmet side of the niche food business.Through Food Innovations and Artisan Specialty Foods, IFVH distributes over 7,000 perishable and specialty food and food products (including delicacies such as alligator and antelope). This segment produced 79% of revenues in 2018.

e-Commerce

Since 2018, IVFH has …