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

(Excerpt from today’s Focused Compounding article)

“…three stocks I like right now (are):

1.       Omnicom (now $72 a share)

2.       Howden Joinery (now 424 pence)

3.       And Cheesecake Factory (now $40 a share)

All are reasonably priced…Omnicom has a P/E of 15. Howden has a P/E of 15. And Cheesecake has a P/E of 14.

All of those sound wrong to me.

These are above average businesses with far above average predictability. They should have above average P/E ratios…

So, why aren’t I buying these stocks right now? Why keep 30% to 35% of my portfolio in cash when these 3 opportunities are available?

…I tend to buy stocks when a business I know I really like trades at about a 35% discount to my appraisal of its intrinsic value…these decisions are arbitrary in terms of the levels you set. If I plan to hold Omnicom stock for let’s say 5 years a difference of 10% in the initial purchase price level isn’t going to make more than a 2% difference in my annual rate of return…How much does that 2% a year really matter to you?

Most people I talk to would be more bothered by missing out on the opportunity to buy a business they like than they would be bothered by paying 10% more for the stock at the start. Most people I talk to about Omnicom say…if I like the stock that much…I should just buy it now.

But, that’s just not my approach.

I’m selective both on the quality of the business…and I’m selective on the price. I don’t like paying more than 65 cents to the intrinsic value dollar even when I like the business a lot.”…

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Why Ad Agencies Should Always Buy Back Their Own Stock

(Excerpt from today’s Focused Compounding article)

“My belief is that the market undervalues the ad agency business model. It doesn’t understand the P/E premium over the market that an ad agency would need to trade at to equalize the likely future return of the ad agency with that of a “normal” business. Every year, an ad agency both grows organically (in line with growth in the ad budgets of its existing clients) and is able to payout 100% of its earnings. Normal businesses can’t do both of these things at the same time. So, they can grow 5% a year, but they can only pay out say 50% of earnings. That means a normal business trading at a P/E of 15 would be priced to return 8.33%. Actual returns in the stock market have not been exactly 8.33%. But, they’ve been close and they’ve been close for the reason I just explained.

The typical stock grows 5% a year organically, it pays out half its earnings in dividends (or share buybacks), and it trades at a P/E of 15. Those conditions will – in the very, very long-run – give you a return of 8.3% a year.

A P/E of 15 is an earnings yield of 1/15 = 6.67%. Half of 6.67% is 3.33%. So, I am saying that to the extent stocks tend to trade at a P/E of 15 and retain 50% of earnings they will tend to have an annual payout (in either the form of dividends or reductions in shares outstanding) of 3.33% of their market price. When you add this “yield” to the growth rate, you get a return for the investor of 8.3%. In some periods, the Shiller P/E – or whatever normalized valuation measure you want to use – will expand and returns may reach 10% or 12% over a certain 15 years. But, in other times valuations may contract and there will be 15 year periods where returns are just 6% or even 4%. For a typical business: what’s really underlying all this is about an 8% to 8.5% increase in intrinsic value (which is normally turned into about 5% sales growth and like 3% to 3.5% dividends and share buybacks).

Now, do the same math with an ad agency and you get a different number. Ad agencies retain no earnings as they grow 5% a year. So, if an ad agency stock trades at the same P/E ratio of 15 as a “normal” stock, it will have a 6.67% yield in terms of what it is going to use on dividends and buybacks. Add that to the growth rate and you get an 11.7% long-term expected return instead of an 8.3% long-term expected return. That’s an inefficient pricing.

How would the market efficiently price ad agency stocks?

The market would need to put a P/E of 30 on ad agencies instead of a P/E of 15. Value investors don’t like hearing this. But, it’s true. If Company A can grow 5% …

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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 …

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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 …

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

(Read the full article)

“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%…

…What’s notable to me looking back at what I wrote then is how little any of the essential analysis changed. Emotions changed. Owning the stock for over 3 years, you might get worn down by the constant barrage of bad news. But, with few exceptions, we laid out what the grim future would be for Weight Watchers over the next couple years and that’s not that different from the grim future that actually materialized….

…In the report, I really laid out a five year thesis – as I pretty much always do – and yet I sold the stock after not much more than 3 years.

Why didn’t I wait another 2 years?

You get tired of sitting through all the volatility in both the business and the stock.

For me, there is also an added difficulty. I don’t just pick stocks for myself. I write about the stocks I pick.

And I get tired of answering emails about the stock. By the time I sold Weight Watchers it was not one of my biggest positions at all, and yet it accounted for probably more email questions from readers than all of my other stock picks combined…It is very unpleasant to write about a volatile stock, a controversial stock, a heavily shorted stock, etc…

…Would I have held my Weight Watchers stock till now if I hadn’t made my investment in the company public?

I don’t know.

But, I do know I’m more likely to sell a controversial stock because I have to write about what I own and talk to people about what I own.

The truth is that there isn’t really that much to say about Weight Watchers other than what I said in that 2013 report…there’s been big changes in my emotions and in the stock price and there’s been some changes with the business – most notably, Oprah’s investment – but if I was going to make a decision to buy, sell, or hold Weight Watchers today I would still base 90% of my decision on what I wrote in 2013.”…

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The Market is Overpriced: These 3 Stocks Aren’t

Most stocks are now overpriced.

Historically, a normal price for a stock has been about a P/E of 15.

And historically, stocks have outperformed other assets.

Therefore, it makes sense to buy above average businesses when their shares trade at a P/E of 15.

Right now, I see 3 above average businesses trading at about a P/E of 15:

• Cheesecake Factory (CAKE)
• Omnicom (OMC)
• Howden Joinery

I’m not buying any of these stocks personally right now.

However, if you asked me right now whether or not I think you should buy a certain stock, I’d say “no” to 99% of the stocks you can name.

Those 3 belong to the 1% of stocks I’d say “yes” to.

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 overpriced” 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.…

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My Investing Goal

Someone emailed me this question:

“For the past months I’ve dug into your posts on Gurufocus…in this article you write about Warren Buffett’s early years:

‘Warren Buffett was thinking about compounding wealth. He was interested in getting rich.’ 

This sentence piqued my curiosity a little. What (are) your goals and objectives in the stock market? Is it getting rich, saving for retirement, or something not money related?”

I have zero interest in getting rich. Investing is a purely intellectual exercise for me. I love writing and I love investing. My only financial goal is to make enough money so I never have to do any work that isn’t either writing or investing.

A lot of people email me asking if I’d ever be interested in managing money.

The answer is no.

If I was interested in getting rich, the answer would be yes. The way to get rich in the stock market is to manage other people’s money and manage it well. That’s what Buffett did.

For myself, I’d be really happy if I could:

• Save some money every year
• Put all the money I saved that year into just one new stock
• Keep that stock for the rest of my life
• Repeat annually till dead

I can do the likely compound math and see that would ensure an adequate result in my case. I’d like the intellectual challenge of picking one and only one stock a year and never being able to reverse that decision. But what I’d really love would be never being troubled by the constant irritation of active portfolio management.

The only thing I like about investing is picking stocks. Nothing else about it appeals to me.

So, those bullet points are the routine I’d follow if I was just investing for myself and not having to write about it for anyone else.…

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Did You Invest in Weight Watchers (WTW)? Call for Quotes/Comments: Weight Watchers Re-Visit

I planned to do a quick re-visit of my own experience investing in Weight Watchers (WTW). However, since announcing my plan to do that, I’ve gotten a lot of emails from people telling me about their own experience either investing in that stock on their own or following me into it.

So, I’ve decided to do a post that includes those experiences. If you owned Weight Watchers stock – or even considered buying the stock but ultimately deiced to pass – at any time between 2013 and 2017, please send me an email detailing your experience.

Try to include:

1.       How did you first find out about the stock? (Was it my blog, my newsletter, someone else’s write-up online, a news report, your own experience trying to lose weight, Oprah’s investment, etc.)

2.       When did you buy the stock? (what date, at what price, etc. – to the best of your memory)

3.       What factors drove your buy decision?

4.       When did you sell the stock? (what date, at what price, etc. – to the best of your memory)

5.       What factors drove your sell decision?

6.       And most importantly: How did holding this stock make you FEEL? (what emotions did you cycle through and what influence did these emotions have on your decision to buy, hold, or sell?)

7.       Do you think you learned anything from this experience?

I will quote from the emails sent to me. I will edit only for clarity and brevity.

Please rest assured: I will anonymize all quotes. Your name will not appear anywhere in the post.

I’m in the midst of summer vacation. So, you have till the end of August to send in your personal history investing in Weight Watchers stock. I will post this at the start of September regardless of how much feedback I get. I don’t want to hold off any longer than that. So, if you want to submit – submit now.

If you invested in Weight Watchers, please do consider submitting your thoughts.

I think you’ll find the experience of summarizing your experience and sending it off to me to be cathartic.…

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