Andrew Kuhn May 21, 2017

“Go Where There Are Network Effects”

“Go Where There Are Network Effects” – Zero to One book, Peter Thiel

A business that has a strong and enduring Network Effect can be a great business to invest in. It is one of my favorite tools in my mental-model toolbox, and is one that I look for and think about often. The best part about a business that has a strong network effect is just like compound interest, it only gets better as the numbers get bigger. The simplest way to describe a network effect is when a product or service becomes more valuable as more people use it. For example, companies like Airbnb, Facebook, Microsoft, PayPal, eBay, Match Group and Twitter all have strong network effects. If a business can profit on this effect the rewards can be quite enormous. It can be a great starting point for investors seeking to find a business that has a wide and deep moat and a long runway for many years ahead.

  • People use Airbnb because they know there is a variety of different options to choose from when it comes to renting a place to stay, and “Hosts” list their houses on Airbnb because they know there’s an endless amount of people who are looking to rent instead of staying in a hotel.
  • People sign up and use Facebook because their friends and peers are signed up and use the website as well.
  • People continue to play video games on Xbox live because they know other people are gaming and competing on Xbox live. 
  • PayPal is convenient because it is so popular, which encourages companies to accept payments from it.
  • Buyers use eBay because they know there will be a lot of sellers selling items, and sellers use eBay because they know there will be a lot of buyers buying items.
  • People swipe on Tinder because they know other people are swiping on Tinder.
  • People use Twitter because no one wants to miss Donald Trump’s tweets….  (I’m half-kidding here)

You get the point, right?  Network effects can become significant after a certain number of users have been reached: this is the “Critical Mass” point. When the critical mass point has been achieved, the value obtained from this network effect can be greater than or equal to the price paid for the effect. What does that mean? It’s the point at which a growing company becomes more efficient, and no longer needs additional investment to remain economically sustainable. Charlie Munger always talks about learning the “big ideas” across many different disciplines, and critical mass comes from Nuclear Physics; where critical mass is defined as the smallest mass that can sustain a nuclear reaction at a constant level. When bringing this phenomenon into the investing world, it is about when a business becomes self-sustaining. Aiming to hit this critical mass point is the challenging part of business. This is why most tech companies are so focused on user growth and are often valued by user-progression, as opposed to traditional valuation …

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Geoff Gannon May 18, 2017

Car-Mart (CRMT): Like the Company, Hate the Industry

Car-Mart (CRMT) now trades for $35 a share. I picked the stock for my old newsletter, The Avid Hog (you can read all 27 past issues of that newsletter here), when it was trading at $38 a share back in June of 2014. So, it’s now three years later. And the stock is now 8% cheaper. Do I like Car-Mart more today than I did in 2014?

No.

Ideally, a stock should be:

  1. Cheap
  2. Good
  3. Safe

I’m not sure Car-Mart meets all 3 of those criteria. And I am sure it has a harder time meeting those 3 criteria today than it did back in June of 2014. But, let’s start with the criterion that Car-Mart clearly passes.

 

Receivables Per Share: The Right Way to Value Car-Mart?

Buy and hold investors value a business on its future cash earning power.

So, the correct way to value a business is usually to begin by finding the key determinant – the ultimate source – of a company’s future cash earnings and multiply that number by a second figure. For a timber producer, you’d use the acres of timberland. You might look at a company owning 500,000 acres of timberland and see that buyers normally pay $600 an acre for such land. Based on that, you’d say the business is worth $300 million. If this corporation currently had $120 million in debt on its books, you’d then say all the common stock combined was only worth $180 million. If there were 9 million shares outstanding, you’d say each share of stock was worth $20 a share. In this way, you’ve done an entire calculation for a single share of stock based on something that is:

  • Constant
  • Calculable
  • and consequential

The amount of timberland a company owns varies much less from year-to-year than reported earnings. It’s a “constant” figure. It’s also a very easily “calculable” number. The company states the number of acres it owns in the 10-K each year. Finally, the quality and quantity of acres of timberland owned is clearly the most “consequential” number there is for such a business. Different owners, different managers, different ways of running the business could squeeze a little more profit or a little less profit from the business from year-to-year. But, how much land the company owns and where it owns that land can’t be changed. Clearly, the quality and quantity of acres of timberland owned is the key determinant – the ultimate source – of this company’s future cash earnings.

What is the ultimate source of Car-Mart’s future cash earnings?

What one number can we find that is: 1) constant, 2) calculable, and 3) consequential? We need to find the “essential earnings engine” for Car-Mart.

It’s receivables per share.

Here’s how I explained the right way to value Car-Mart, back in 2014:

“Car-Mart’s value over time should mirror its per share loan balance. This loan balance is what creates value for Car-Mart. So, it is receivables – net of the provision for …

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Geoff Gannon May 10, 2017

Grainger (GWW): Lower Prices, Higher Volumes

The Original Pick

I picked Grainger (GWW) for a newsletter I used to write. The pick was made in April of 2016. Grainger traded at $229 a share when I picked it. Today, the stock trades for $188 a share. That’s one reason to look at the stock now.

Reason #1 for considering GWW:

I picked the stock when the price was 22% higher than it is now.

There’s another. Over the last twelve months, here’s how Grainger’s stock performed versus the shares of is two closest peers.

  • Grainger: (16%)
  • Fastenal (FAST): (2%)
  • MSC Industrial (MSM): +19%

I picked MSC Industrial for the newsletter too. Last year, one of the questions I had to ask myself was which stock I liked better: Grainger or MSC Industrial? Back then, it was a tough question. Today, it should be a lot easier to answer.

Reason #2 for considering GWW:

Grainger is now 14% cheaper relative to Fastenal and 29% cheaper relative to MSC Industrial than it was a year ago.

So, is Mr. Market right? Does Grainger really deserve a downward re-valuation of 14% versus Fastenal and 29% versus MSC?

Before we can answer that question, we need to know why I picked Grainger in the first place.

 

Reason for Picking Grainger in the First Place

I thought Grainger was a Growth At a Reasonable Price (GARP) stock. Here’s what I wrote a year ago:

“…Grainger can grow sales by at least 5% a year. Profit growth should be more than 5% and less than 8% a year. At that pace of growth in sales, Grainger would return two-thirds of its earnings each year. So, if you bought Grainger at around a P/E of 16 or 17, the company would pay out 4% of your purchase price each year in buybacks and dividends while companywide profit would grow 5% to 8% a year. Your return in the stock would be in the 9% to 12% a year range. This is far better than you’ll get long-term in the S&P 500. So, Grainger is a ‘growth at a reasonable price’ stock even when priced as high as 17 times earnings and when growing sales as slowly as 5% a year. The combination of margin expansion and share buybacks mean the company could grow sales as slow as 5% a year and yet grow earnings per share at close to 10% a year. The ‘growth’ in ‘growth at a reasonable price’ that an investor should care about is only earnings growth and only in per share terms. It doesn’t matter whether companywide sales grow 10% a year or 5% a year if EPS growth is 10% a year in both scenarios, the stock is no more or less valuable due to the difference in sales growth. Companywide sales growth doesn’t benefit shareholders. Only growth in earnings per share makes any difference to an investor. So, by that measure, a stock with a P/E of 15 or 20 …

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Andrew Kuhn May 10, 2017

It’s All About the Long Term: Amazon’s 1997 Shareholder Letter

“Jeff Bezos is the most remarkable business person of our age, I’ve never seen a guy succeed in two businesses almost simultaneously that are really quite divergent in terms of customers and all the operations.” – Warren Buffett

I really do agree with Warren in the statement above. Anyone who knows me, knows I am a complete Amazon advocate. Not only does my firm own Amazon stock, but I am a frequent user of the website and really have developed into some sort of fanboy. It is a company that, in my opinion, is virtually certain to be bigger 5-10 years from now than it is today. Every year it leaves me flabbergasted that Amazon continuously knocks it out of the park. Companies that are doing 100B+ in revenue annually should not be continuously growing sales by 25+% per year. To me it is extraordinary. And it is certainly a case study in action that we can all learn from and add to our investing-wisdom toolbox, whether you are a shareholder or not. But before we talk about the present, I think it can help all of us as investors to go back to the beginning and study the company. After all, investing is all about pattern recognition. The beauty of hindsight is that it’s always 20/20. Let’s use this hindsight to our advantage and learn from it.

In this series, we are going to go back and review every Annual Letter to Shareholders written by Jeff Bezos. I really encourage everyone to do this yourself here. I have printed off every Shareholder Letter and have read them multiple times and, like any good literature, I take away something new from it each time. When reading, I encourage everyone to continuously ask yourself this: “Is there any information in this writing that I can take with me to make myself a better investor?” One of the greatest things about investing is that we are constantly learning and all information in life is relative –meaning you can read books completely unrelated to business, read newspapers, watch movies, you name it, and still take away some sort of insight or wisdom that can relate to investing. That’s essentially what we are trying to do here at Focused Compounding; compounding both capital and wisdom. If you have not already, I deeply encourage everyone to read the book “The Everything Store” by Brad Stone. It is a great book that will help you get familiar with the beginnings of Amazon, and more specifically with Jeff Bezos as a CEO.

Let’s go back to 1997 when Jeff Bezos wrote his first letter to shareholders. Anyone who is familiar with the company will know this letter serves as the groundwork of principles that Amazon still embodies today. In fact, Jeff has posted the 1997 letter at the end of every Letter to Shareholders every year since writing it to keep the standards top of mind.

A manager who doesn’t just talk the talk but actually walks …

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Geoff Gannon May 10, 2017

Geoff’s Mental Model #1: “Market Power”

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
– Warren Buffett

A business with market power is a good business. A business without market power is a bad business. In that quote, Buffett gives a clear definition of market power when he says: “if you’ve got the power to raise prices without losing business to a competitor” you’ve got a very good business. Basically, if you’ve got the power to raise prices without losing business to a competitor, you’ve got market power.

Market power is not an internal advantage. It is not a technological advantage, a better corporate culture, or a process improvement your competitors have yet to figure out. Market power is external. It is a strong bargaining position versus those folks a company must sit across the negotiating table from.

Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.

Market power is often misunderstood as being an advantage one competitor has over another. That’s the wrong way of thinking about it. Businesses don’t squeeze profits from competitors. Businesses squeeze profits from customers and suppliers.

Often, competitors engage in rivalry that undermines each other’s bargaining position with customers and suppliers. In such industries, customers can play one competitor off against another. By doing this, they can negotiate for higher product quality, lower prices, longer payment terms, etc.

However, there are industries free from that kind of rivalry.

As investors, those are the industries we want to focus on. The best businesses in the world are in the best industries in the world. And the best industries in the world are those where the rivalry between competitors does not undermine the market power these businesses have over their customers and suppliers.

 

Dependency: Mini-Monopoly

All publishers have a mini-monopoly over each title they publish.

In children’s books, if you’re a bookstore that wants to carry Harry Potter – you have to pay Scholastic (SCHL) whatever Scholastic wants to charge for that title. Scholastic is your sole source of Harry Potter books. The only power you have in the market for Harry Potter books is to either accept or decline a take-it-or-leave-it offer from one seller. There are no competing offers you can consider.

In videogames, if you’re a gamer who wants to play World of Warcraft – you have to pay Activision-Blizzard (ATVI) whatever monthly fee Activision wants to charge for that MMORPG. Blizzard is the sole source for your WoW fix. The only power you have in the market for World of Warcraft access is to either accept or decline a take-it-or-leave-it-offer from one seller. Those who decline the …

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Geoff Gannon May 10, 2017

EBITDA and Gross Profits: Learn to Move Up the Income Statement

“In lieu of (earnings per share), Malone emphasized cash flow…and in the process, invented a new vocabulary…EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash generating ability of a business…”

  • William Thorndike, “The Outsiders”

 

“I think that, every time you (see) the word EBITDA you should substitute the word bullshit earnings.”

  • Charlie Munger

 

The acronym “EBITDA” stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

A company’s EPS (which is just net income divided by shares outstanding) is often referred to as its “bottom line”. Technically, EPS is not the bottom line. Comprehensive income is the bottom line. This may sound like a quibble on my part. But, let’s stop and think about it a second.

If EBITDA is “bullshit earnings” because it is earnings before:

  • Interest
  • Taxes
  • Depreciation and
  • Amortization

Then shouldn’t we call EPS “bullshit earnings”, because it is earnings before:

  • unrealized gains and losses on available for sale securities
  • unrealized currency gains and losses
  • and changes in the pension plan?

I think we should. I think both EBITDA and EPS are “bullshit earnings” when they are the only numbers reported to shareholders.

Of course, EPS and EBITDA are literally never the only numbers reported to shareholders. There is an entire income statement full of figures shown to investors each year.

Profit figures further down the income statement are always more complete – and therefore less “bullshit” – than profit figures further up the income statement.

So:

  • EBITDA is always less bullshit than gross profit.
  • EBIT is always less bullshit than EBITDA.
  • EPS is always less bullshit than EBIT.
  • And comprehensive income is always less bullshit than EPS.

Maybe this is why Warren Buffett uses Berkshire’s change in per share book value (which is basically comprehensive income per share) in place of Berkshire’s EPS (which is basically net income per share). Buffett wants to report the least bullshit – most complete – profit figure possible.

So, if profit figures further down the income statement are always more complete figures, why would an investor ever focus on a profit figure higher up the income statement (like EBITDA) instead of a profit figure further down the income statement (like net income)?

 

Senseless “Scatter”

At most companies, items further up the income statement are more stable than items further down the income statement.

I’ll use the results at Grainger (GWW) from 1991 through 2014 to illustrate this point. The measure of stability I am going to use is the “coefficient of variation” which is sometimes also called the “relative standard deviation” of each series. It’s just a measure of how scattered a group of points are around the central tendency of that group. Imagine one of those human shaped targets at a police precinct shooting range. A bullet hole that’s dead center in the chest would rate a 0.01. A bullet hole that …

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Geoff Gannon April 27, 2017

Geoff Being Interviewed

I was interviewed by Eric Schleien for his Intelligent Investing Podcast.

We talked about Frost (CFR), BWX Technologies (BWXT), and Howden Joinery along with a lot of other stocks.

I also mention a new website I’m working on.

So, to hear me blabber on about stocks for a little over an hour – click here.

Listen to Geoff’s interview on the Intelligent Investing Podcast

Talk to Geoff about his interview…

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Geoff Gannon April 27, 2017

Constantly Concentrating: Why I Sold George Risk (RSKIA) and Weight Watchers (WTW)

I’ve gotten a lot of questions regarding my sales of Weight Watchers (WTW) and George Risk (RSKIA).

 

Interestingly, literally no one emailed me about selling Babcock & Wilcox Enterprises (BW).

 

I’ve picked out two questions as representatives of the larger group.

 

 

Question #1: George Risk

 

“Really interested in why you decided to suddenly sell RSKIA.

 

I mean it’s still obviously undervalued. You could have sold it in the beginning of 2014 for a better price than $8.40. Stocks in general were obviously cheaper at that time than they are now.

 

So logically it means you’ve found a better opportunity now than you could find in 2014 relative to the current price of RSKIA. That just seems really surprising to me.

 

The only logical conclusions are that you either lost patience with RSKIA, now have a different view on the risk of the markets, or really did find something better than what you could in 2013/2014.

 

If it’s the latter, I can’t wait to hear what it is when you decide to post it…”

 

 

 

I sold George Risk, because I am planning to buy Howden Joinery.

 

I don’t like to take positions that are smaller than 20% of my portfolio. The total amount I had available in cash, Natoco, and Weight Watchers combined was less than 20% of my portfolio. So, I sold George Risk to make room for Howden Joinery.

 

I try to only sell one stock to make room for another. The reason I hadn’t sold George Risk before is that I hadn’t found a stock I liked better than George Risk. I’ve now decided I like Howden Joinery better than George Risk.

 

Yes, I could have and should have realized this a couple years ago. I’ve known about Howden for years. Howden shares were cheaper in the past than they are now. George Risk shares were more expensive in the past than they are now. I’d have been better off if I made the swap sooner. But, it took me a while to come to this decision. I don’t own Howden yet. But, I expect to buy it soon.

 

 

Question #2: Weight Watchers

 

“With regards to your long term stake in WTW, I am just curious about the WTW sale, since WTW has announced growing subscription numbers and has Oprah as a Board Member, so things look rosier than last year.”

 

Yes. Weight Watchers is doing better now than it was in the past. Oprah Winfrey is a great spokeswoman and a good board member for WTW.

 

I didn’t sell my shares in Weight Watchers because I like the stock less now than I did last year. I sold my shares of Weight Watchers because I looked at what percent of my portfolio the stock made up and then considered whether or not I’d like to buy more.

 

Here’s what I said in a previous post:

 

“Weight Watchers, B&W Enterprises, …

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Geoff Gannon April 2, 2017

Sold George Risk (RSKIA)

Last week, I eliminated my entire position in George Risk (RSKIA).

This position was about 20% of my portfolio. It is now 0%.

My average sale price was $8.40 a share.

My average purchase price had been $4.66 a share (back in 2010).

I held the stock for about 6.5 years. So, the stock price compounded at about 9.5% a year while I held it.

George Risk also paid a dividend. The yield was rarely less than 4% a year. So, my total return in the stock was about 13% a year over my entire holding period.

My return in George Risk was not better than the return I could have gotten by simply holding the S&P 500 for the same 6.5 years.

However, the stock was cheaper than the S&P 500 when I bought it. I believe it remains cheaper than the S&P 500 today.

Right now, George Risk’s dividend yield is about 4.2%. And the stock has $6.36 a share in cash and investments versus a share price of $8.40 a share.

I didn’t sell George Risk because I no longer like the stock. Rather, I sold George Risk to make room in my portfolio for a totally new position.

I try to only buy one new stock a year. So, when I do finally buy this new position – it’ll be a big moment for me.

I’ll let you know once I’ve added the new position.…

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Geoff Gannon March 10, 2017

How to Find Stocks With Good, Predictable Capital Allocation

Someone emailed me this question:

“How do you evaluate the capital allocation skill by the management? I do so by looking at the FCF yields for the acquisitions and share repurchases or ROIC for internal investments.”

I want to focus on what will have the most influence on my investment in the company going forward. For this reason, I’m less interested in knowing quantitatively what the past return on investment of management’s actions were – and more in simply how management will allocate capital going forward.

 

Let’s start with who the manager is. If the manager is the founder, that’s the easiest situation. We can assume the founder will stay with the company for a long time. The average tenure of a professional manager – nonfounder – CEO at a Standard & Poor’s 500 type company is short. It’s maybe five years. If you think about that, it means odds are that the CEO you now see at the company you are thinking of investing in will be gone within two to three years (because chances are he’s already been running the company for two to three years by the time you buy the stock). It’s just not worth thinking about such a manager. In this case you’d want to focus on the board of directors or the chairman. Ideally, you want to find situations where the founder is still the CEO, the chairman or has some position in the company. This will make figuring out future capital allocation plans easier.

In situations where you don’t have a founder present, ongoing participation by a family is useful. In situations where you don’t have the presence of either a founder or his family at the company, you may still have first-generation managers who worked with the founders before they became CEOs.

Those three situations will make future capital allocation easier to predict. One, the founder influences capital allocation. Two, the controlling family influences capital allocation. Three, a manager who worked directly for the founder early in his career now influences capital allocation. If you don’t have any of those three scenarios, there are still two others that can lead to some predictability. You can have a long-tenured CEO. For example, the big ad agency holding companies are usually run by a CEO who has been at the company forever. I know Omnicom (OMC, Financial) best. The CEO there – John Wren – has been at the top position for 20 years. For most of those 20 years, the chairman of the company and the chief financial officer (CFO) were also the same.

In terms of capital allocation, if you have a lot of consistency in the offices of chairman, CEO and CFO, you’re able to more easily count on future capital allocation looking like past capital allocation. The last of the five scenarios that can lead to predictable capital allocation is the presence of a “refounder.” This is someone who comes in and reshapes an existing business …

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