Blog – Page 26 – Focused Compounding

Geoff Gannon November 23, 2017

Risk Habituation and Creeping Speculation

In response to an email a reader sent about some of my recent posts on the difference between investment and speculation, I entered lecture mode…

I am especially worried about the tendency among readers to speculate using the logic that value investors (like me) are sometimes wrong (like in WTW) and these “investments” turn out to be speculations. Therefore, how is buying at 8 times EBITDA in what has historically been a fairly predictable company different from buying at 16 times EBITDA in a company that hasn’t historically been predictable? Aren’t they both speculations since you are always ultimately going to make money or lose money based on how right you are about the future?

Are You Better Off Than You Were 8 Years Ago? – Are You a Better Investor?

I feel this is an issue with the length of the latest bull market. Whether or not stocks are very expensive (and I do find them expensive generally, but this point still stands if I’m wrong about that), most readers of the blog have seen mostly good results from the stocks they’ve chosen to hold over the last 8 years now. Eight years is a long time. Many people have not even been following the same investment strategy for more than 8 years.

Their current approach has never been battle tested.

So, now I hear a lot from people who are more into paying up for higher quality, holding longer, etc. There are ways of implementing a strategy like that which work. But, I think the experience of the “recent” past is what gets them thinking in these directions.

Although I’m “only” 32, I was investing seriously (in terms of how much time I spent thinking about the subject) in 1999-2002 and in 2007-2009. Now, most years are not like 1999-2002 or 2007-2009. But neither are they like the run from the second half of 2009 through to today (the end of 2017). That kind of run is rarely this smooth. And so, when you have not seen a period with P/E multiples of even good stocks contracting 30% or 50% or more – you are less worried about the distinction between investment and speculation.

When you look at something I own like BWX Technologies (BWXT), which has performed well both as a business and as a stock, you see that it is now trading at 31 times earnings. It’s a great business. But, even if it is always recognized as a great business by the market – it may yet be assigned a P/E of 20 instead of 31. Great businesses sometimes trade at a P/E of 20. So, right there, you have the potential for a 35% decline in the price of this stock.

I still own the stock. And I’ll keep owning it till I know for sure that whatever new stock I want to buy is better than holding on to this stock. But, what is always foremost in my mind when …

Geoff Gannon November 21, 2017

You Don’t Need to Know What a Stock’s Worth to Know It’s Cheap

Someone emailed me asking what sources they needed to study to get better at valuing stocks.

My answer was that the ability to come up with accurate valuations for public companies is overrated.

Why? Because…

It’s rarely important to know how to value a company. What’s important is the ability to recognize when a company is clearly selling for less than it’s worth and then acting on that knowledge.

For example, in a write-up I did on my member site (Focused Compounding) explaining why I put 50% of my portfolio into NACCO (NC) when it completed the spin-off of Hamilton Beach (HBB), I said that:

“I think of each share of NACCO as an inflation adjusted stream of free cash flow. As I’ve shown, I think the stream has a ‘coupon’ of greater than $3.25 and I bought it at $32.50. So, the yield is 10% or more and that’s effectively a ‘real’ yield.

The average U.S. stock has a free cash flow yield in the 4% to 5% range and that yield is not as well protected against inflation.

It’s true that NACCO’s yield will eventually decline as coal power plants shut down (although, in recent years, the tons of coal supplied has risen rather than fallen). However, I think of my ‘margin of safety’ as being the fact that it isn’t 100% certain these plants will shut down and they haven’t shut down yet. Till they do, cash will build up on the balance sheet of NACCO (the parent company) or it will pay out dividends, buy back stock, or acquire businesses unrelated to coal mining (as it did in the past).”

It’s important to note that:

1) I never said that NACCO’s cash earning power is $3.25 a share. I said it’s at least $3.25.

2) I never said that the right multiple for NACCO is 10 times FCF. I just said that a normal stock trades for 20-25 times FCF (a 4% to 5% FCF yield) and NACCO trades for no more than 10 times FCF.

In fact, in that same article, I walk through ways of estimating what cash earnings would be in a normal year for NACCO (now that’s it just the coal business). The range of earnings estimates these different methods give you actually cluster around $4.75 to $5.50 a share (not the $3.25 figure I cite). However, I didn’t think those numbers were important when the stock was at $32.50.

Why? Because…

Earnings of $4.75 to $5.50 on a $32.50 stock are overkill. You don’t need to know if a stock has a P/E of 6 to 7. What you need to know is how certain it is that a stock doesn’t have a P/E any higher than 10 to 11.

So, I spent more time focusing on the fact that the method of estimating earnings that was most conservative – using this year’s tons of production and multiplying it by the lowest ever profit per ton the company achieved in …

Andrew Kuhn November 17, 2017

Becoming a Better Investor: Reading One 10k After Another

I’m a big process guy. I believe if you have the correct processes in place and develop the right habits over time, you will succeed in whatever it is that you want to accomplish. Geoff and I get asked all the time a variation of: How do I become a better investor? The answer is simple, but not easy. I would say it really boils down to reading. A lot. Okay okay yes, I know if you are a Buffett / Munger fan you probably already know that. But, what should you read to get better? I believe people waste their time reading too many books on theory, when really, they can become a better investor overtime by reading one 10k after another. Geoff said it best in one of his blog posts when he said: if you’re reading more books than 10ks, you’re doing it all wrong. Truth be told, I once fell into this category. I felt like If I read more investing theory books it would help me overall as an investor. While this is true, I feel like once you have the basics down and a solid rational way of thinking about stocks and the market, from there on out all you will need to do is read and learn about different businesses and practice valuing them. If someone came to me today and asked me how to get started in investing, I would point them in this direction:

While reading books of course is beneficial and fun, I believe if you want to get better as an investor the 6 things I just listed above is all you need to know fundamentally speaking. From there you can proceed to reading 10k’s, which is the main activity that will make you better. As you may or may not know, Geoff and I meet 1-2 times a week. This topic of “how to get better” and “focus” is one that we talk about often and is one of great interest to me. Here is some tough love on how to get better. Stop being so lazy. If you want to get better, then get better. The opportunity is 100% there. I always say we are living in the luckiest time in life because of the technology that’s available to us that allows us to get access to whatever it is we want to learn about. Think about how much that has changed within the last 15-20 years. Being in Dallas, I could have a package shipped to China tomorrow if I wanted to. Technology has changed and gotten better, so we must adapt to get better. Think …

Geoff Gannon November 14, 2017

Why Smart Speculations Still Aren’t Investments

I got an email in response to my earlier post about the line between investment and speculation. It’s a good email, so I want to quote it in full:

“Really interesting post today, but I was wondering how you would evaluate the Weight Watchers (WTW) situation.

It seems like an investment that turned into a speculative situation.

I think there are a couple of cases like this where a seemingly safe investment turns into a very speculative situation. Fossil (FOSL) is another one that comes to mind. Even though it had some debt, nobody would think that it would have an existential crisis at some point due to changes in business and the weight of its debt. I don’t think anybody would have called it a speculation 3 years ago at over $100 a share. But on the other hand, it’s speculative now at under $7 a share.

On the other hand you have situations like Facebook (FB) which IPO’d at an extremely speculative price but the business turned out to be so strong that even at that price, it morphed into an excellent investment had the margins not expanded so much.

I’m not saying that’s the case for Amazon or Netflix today, but maybe it’s not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand. If you have the knowledge that it’s almost certain the company will grow into and beyond the current valuation, then perhaps it would be a good investment at what others may consider to be a speculative price.

If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.

In the end, a lot of it depends on what you really know I think.”

George Orwell wrote an essay called “Politics and the English Language”. One passage from that essay is helpful to quote here:

“The word Fascism has now no meaning except in so far as it signifies ‘something not desirable’. The words democracy, socialism, freedom, patriotic, realistic, justice have each of them several different meanings which cannot be reconciled with one another. In the case of a word like democracy, not only is there no agreed definition, but the attempt to make one is resisted from all sides. It is almost universally felt that when we call a country democratic we are praising it: consequently the defenders of every kind of regime claim that it is a democracy, and fear that they might have to stop using that word if it were tied down to any one meaning.”

The word “democracy” has an actual definition, etymology, and history we can trace. The etymology is Greek. It means literally …

Kevin Wilde November 14, 2017

Auto Dealership Groups

Thesis

Auto dealership groups with scale are attractive businesses with good profitability and attractive growth opportunities driven by industry consolidation.
Dealership franchises are protected from competition by regional exclusivity. They earn high margins on vehicle parts & servicing by acting as the warranty arms and parts distributors for their major automaker partners.
Despite similar economics and growth opportunities, U.K. auto dealerships look cheap relative to their global counterparts. Vertu Motors plc (LSE:VTU) looks particularly cheap despite less debt / risk, better past growth, improving margins & profitability, much better cash flow generation, and better growth opportunities.
Vertu Motors has a great management team including a young founder / CEO with skin in the game, a sound strategy / track record of execution, and excellent capital allocation.
The largest dealership groups have the unique ability to thrive in both good times in bad. Profitability is better during downturns in the economy that you’d expect while offering significant opportunities for further industry consolidation at attractive prices.
Key industry risks sound worse than they probably are. Threats to the dealership model are likely overblown because OEMs are unlikely to abolish it and online retailers like Amazon have numerous hurdles to overcome to compete directly with dealerships (eg. Distribution & servicing outlets). It is unclear whether ride sharing is a threat or a boon to dealership sales & profitability and the impacts of autonomous vehicles is farther off than valuations suggest.
OVERALL: Vertu Motors is an above average business, with excellent management, a reasonable risk profile, trading at a very attractive price.

Industry Overview

How do auto dealerships make money?
- Most automotive dealers sell new & used vehicles and automotive services (including maintenance & repair).
- They also often help arrange automotive finance and insurance products for their customers. Many sell parts & accessories as well.
- Ultimately, car dealers have four key goals: sell you a car; sell you a car loan (or get you to lease the car); sell you insurance; and get you back to the dealership for service and eventually a trade in.

What geographic regions did I study?
- I looked at four regions of the world with established auto dealership groups: North America, Europe, Oceania, and the U.K.
What are the business economics like?
- Dealerships get more than half of their revenues from new-vehicle sales, but most of car dealership profits come from the sale of used cars, parts and service, from acting as a middleman in securing loans and leases, and from the sale of so-called Finance & Insurance products like extended-service contracts. The key to the business is less about making huge profits on the sale of new cars and more about the repeat business from servicing those vehicles.
- While there is small need for capital (dealers ‘floorplan’ their operations, with auto finance companies and other lenders owning the cars that have been sold), the initial capital outlay to build a dealership can be immense (in the U.S., a larger auto dealership can cost $20-$30MM to build), and due

Andrew Kuhn November 10, 2017

Green Brick Partners Q3 Earnings: It’s still cheap…

Green Brick Partners reported earnings this past week on November 6^th. For those of you who don’t know much about the company, here is a summary that Geoff wrote about the company back in September:

“Green Brick Partners is a homebuilder that is split close to evenly between Dallas Fort-Worth (it builds homes in places like Frisco, which is right by where I live in Plano) and Atlanta. I don’t know the Atlanta housing market. But, I do know the Dallas housing market. The stock trades at about 1.1 times book value. However, in the homebuilding industry, land is usually held for 2-5 years from the time a homebuilder buys it to the time they sell the finished house on that land. Land prices in Dallas Fort-Worth have risen, so the fair value of their holdings would actually somewhat exceed 110% of book value – meaning, the market value of the company’s assets is slightly greater than the market cap of the company. They have enough net operating loss carryforwards to not pay taxes for another 3-5 years depending on how much they grow earnings. The decision maker (Jim Brickman) is a good homebuilding guy and has a meaningful personal stake in the company. Together with David Einhorn’s Greenlight capital (about a 50% owner) and Dan Loeb’s Third Point (about a 17% owner) people who are insiders/long-term investors of some kind hold about 75% of Green Brick Partners. So, the float is probably no more than $125 million. The stock was, in recent memory, a speculative ethanol type company that was used as the public entity to take this Einhorn/Brickman homebuilding entity public. In investors’ minds, the company is probably not “seasoned” as much as it’s going to get in the sense that if I say “Green Brick Partners” today – you may not have recognized the name and if you did you may not have immediately remembered it’s a homebuilder and even if you did remember that you still might not have remembered where it builds home (Dallas and Atlanta). It’s underrecognized. If you buy the stock in 2017 and plan to sell it in 2022, you’ll probably be selling a bigger, more recognized stock with a higher price-to-book multiple that is then starting to pay taxes.

A homebuilder is not the kind of stock I’d usually buy. Green Brick isn’t a capital light pure homebuilder like NVR (NVR). Nor is it more of a marketing machine like LGI Homes (LGIH). It’s something that buys up land, holds it for up to five years, puts a house on it, and then sells the land plus the house. There’s no cash flow that doesn’t go back into buying up more land. Everything it does is tied to residential land values where it operates. So, this is purely an investment in residential land in Dallas and Atlanta. However, the combination of UNTAXED (for now) cash flow from homebuilding activities going back into buying additional land plus the annual appreciation …

Geoff Gannon November 7, 2017

In 2017: What is the Line Between Investment and Speculation?

In a recent post, Richard Beddard mentions Ben Graham’s speech “The New Speculation in Common Stocks” and particularly how it ends with a quote from the Roman poet Ovid:

“You will go safest in the middle course.”

At the end of that talk, Graham adds: “I think this principle holds good for investors and their security-analyst advisors.”

What Graham is saying is that investors should avoid both stocks that are speculative because the underlying enterprise is speculative and stocks that are speculative because the price is speculative.

I agree with Graham on this one. And I think it helps clear up some confusion that readers have with my own approach to investing. I get a lot of questions from investors – each coming from one of the two opposing philosophical camps – that go something like this: “When I look at the stocks you own, I wonder are you really 100% a value investor?” That’s the question from the Ben Graham value camp. And then the other question goes something like: “When I look at the stocks you own, I wonder are you really 100% a wide moat investor?”

My answer to these questions tends to go something like this:

If you look back at all the stocks I’ve bought, how many times in my life have I ever really paid more than about a P/E of 15?

And, if you look back at all the stocks I’ve bought, how many times in my life have I ever really bought into a company with a weak competitive position?

Those – to me – are the two speculations the average investor slides right into without much thought.

1. He speculates that this business he likes is not just better than other businesses but better enough to more than offset paying a higher than average price for the stock (that is, a P/E over 15).

2. And he speculates that this business he likes will withstand the ravages of competition that are an ever-present part of capitalism.

Now, there are other kinds of speculations you can make. Readers are quick to point out that I own NACCO (NC) which is basically a speculation that no more than one of the coal power plants the company supplies will be shut down in the truly near-term future. I also own BWX Technologies (BWXT) which is a speculation that the U.S. Navy will continue to use aircraft carriers, ballistic missile submarines, and attack submarines – and that those 3 classes will be nuclear powered. I own Frost (CFR) which is a speculation on higher interest rates in the sense that if the Fed Funds Rate was never to rise from the level it is at today, my returns in Frost would be middling.

But when you stretch the word “speculation” that far, you demolish any distinction between investment and speculation in the way Graham used those words. The future is always uncertain. But, we have to be able to define the words “investment” and …

Geoff Gannon November 3, 2017

My New 50% Stock Position is NACCO (NC)

Someone on Twitter mentioned it’s been 32 days since I put 50% of my portfolio into a new stock and said: “I’ll reveal the name of this new position on the blog sometime within the next 30 days”. Since, I promised 30 days this time, I’ll reveal the name now. In the future, I think I’m going to wait a full quarter (3 months) between the time I mention a stock on my member site (Focused Compounding) and on the blog. I want to be open with blog readers. But, I also want the people who provide me financial support through their monthly subscriptions to get real value for their money. The only reason I can afford to spend time writing content on this blog for free is because there are subscribers on the member site. So, the member site will always hear about my new stock ideas first.

Anyway….

On the morning of October 2nd, I put 50% of my portfolio into NACCO (NC) at an average cost of $32.50. That was the first day the North American Coal Company was trading separately from Hamilton Beach Brands (HBB).

NACCO operates unconsolidated (their debt is non-recourse to NACCO) surface coal mines that supply “mine-mouth” coal power plants under long-term cost-plus contracts that are indexed to inflation.

You can learn more about NACCO by reading:

The company’s investor presentation

Clark Street Value’s post on NACCO

NACCO’s first earnings report as a standalone company

You can also listen to the company’s earnings call here

Finally, you can buy a book that provides a complete corporate history of NACCO from 1913 through 2013. The title is “Getting the Coal Out”. The author is Diana Tittle. It’s available used at places like Amazon. You may also be able to order it from the company. I’m not sure about that.

Yes, I do own a copy.

My NACCO position was posted immediately on the member site. I’ve written several articles about it there over the last month, mostly in response to questions from Focused Compounding members.

So, as of October 2nd, my portfolio was:

NACCO (NC): 50%

Frost (CFR): 28%

BWX Technologies (BWXT): 14%

Natoco: 7%…

Geoff Gannon November 3, 2017

Buy Unrecognized Wonder; Sell Recognized Wonder

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

– Warren Buffett

Richard Beddard has an excellent post worrying about whether the stocks in his Share Sleuth portfolio are becoming too popular.

I want to use his post as an opportunity to talk about how an investor – or, at least an investor like me – needs to cycle out of stocks that are getting recognized for what I believe them to be and into stocks that aren’t getting recognized for what I believe them to be.

I like “wide moat”, predictable businesses. But, I can’t afford to pay the kind of prices that stocks with recognized moats and recognized predictability trade for. So, I need to find unrecognized moats and unrecognized predictability.

The top three stocks I own are: NACCO (NC), Frost (CFR), and BWX Technologies (BWXT). The best performer among that group is BWX Technologies. That good performance is the result of increased recognition of what BWX Technologies is. When I bought Babcock & Wilcox pre-spinoff (and then later sold my BW shares but kept my BWXT shares) I was seeing the company differently than the market was. Today, the market sees BWXT the same way I do.

Let’s look at this in chart form.

Today, the market values BWX Technologies about 120% higher than it valued the combined Babcock & Wilcox. The stock you are seeing here spun something off (so it disposed of value) and yet it still more than doubled its market price.

The stock now has a P/E of 32. The return here is due to multiple expansion. BWX Technologies – as part of Babcock & Wilcox – went from being valued as an average company (a P/E around 15) to being valued as a wide-moat, predictable company (a P/E around 30). BWXT’s biggest business is being a monopoly provider to the U.S. government under cost plus contracts indexed to inflation. That’s not new information. The market just sees the same old information differently now that BWXT is reporting its own clean, independent EPS and giving long-term guidance for EPS growth as far as 3-5 years out.

The price on this stock (a P/E of 30+) indicates the market sees this business much the way I see this business. If we have the same understanding of the business – it’s time for me to consider selling.

Now, I don’t sell a stock just to have cash. But, if I want to buy anything new – I should buy something that’s a wide-moat, predictable business that has yet be recognized for being that and fund the purchase by selling BWXT which is also a wide-moat, predictable business but is now recognized as such.

The next chart is Frost. You can read an explanation of how I see the stock here.

The stock has about doubled. Here, though, it is not appropriate to use the P/E ratio for

Geoff Gannon November 3, 2017

NACCO (NC): First Earnings Report as a Standalone Company

Two days ago, NACCO (NC) released its first quarterly results as a standalone company. Yesterday morning, the company had its first earnings call as a standalone company. The stock dropped 10% following these events. I’m not going to write about NACCO each quarter. But, some people asked for my thoughts on the quarter and the stock drop. So, I’ll do it this once.

Overall, the earnings call and the stock drop reinforced my belief that it could take a year or more of NACCO trading “cleanly” as a separate company before it’s well understood by investors. More on that at the end of this post.

First, the earnings release. Here, everything was as expected.

You can – and should – read NACCO’s full earnings release here. These are the items I highlighted:

“After the completion of the spin-off, NACCO ended the third quarter with consolidated cash on hand of $93.9 million, debt of $58.7 million and net cash of $35.2 million. The cash on hand included a $35 million dividend received from the housewares business prior to the completion of the spin-off.” So, the company now has $5.13 in net cash per share.
“NACCO’s board of directors will evaluate and determine an ongoing dividend payout rate at its next regularly scheduled meeting in November. When doing so, the board will consider the financial conditions and prospects of NACCO and North American Coal following the spin-off of the housewares-related business.” We’ll see what they decide to start the dividend at. The “financial conditions” are strong. The “prospects” are bleak.
Not a highlight, but a note: The after-tax numbers are meaningless here because of a very unusual tax timing situation. The company had a 44% tax rate on continuing operations. In the future, I expect the normal tax rate for NACCO as a standalone company will be 23%. So, ignore all after-tax numbers.
Centennial is NACCO’s consolidated (so NACCO bears all the risk) failed mine: “Centennial will continue to evaluate strategies to optimize cash flow, including the continued assessment of a range of strategies for its remaining Alabama mineral reserves, including holding reserves with substantial unmined coal tons for sale or contract mining when conditions permit. Cash expenditures related to mine reclamation will continue until reclamation is complete, or ownership of, or responsibility for, the remaining mines is transferred.”
NACCO confirmed that the customer will bear the risks related to the Kemper plant / Liberty mine failure and NACCO will be paid to do the mine closure work: “The terms of the contract specify that Mississippi Power is responsible for all mine closure costs, should that be required, with the Liberty Mine specified as the contractor to complete final mine closure. Should the decision to suspend operations of the gasifier and mine become permanent, it will unfavorably affect North American Coal’s long-term earnings under its contract with Mississippi Power.”
“…capital expenditures are expected to be approximately $21 million in 2018.”
“While the current regulatory environment for development of new