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 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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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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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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Some Books and Websites That Have Been Taking Up My Time

I get a lot of questions from readers about what investing sites I use, what books I’m reading, etc.

So, here are two sites and four books I’ve been spending time with lately.

 

Websites

 

GuruFocus: Buffett/Munger Screener

I write articles for GuruFocus (click the “Articles” link at the top of the page to see all of them). So, it’s a conflict of interest to recommend premium membership to the site. What I will say is that if you are a premium member – I think the most useful part of the premium membership is the various predictable companies screens. There’s a Buffett/Munger screen, an undervalued predictable companies screen, and you can also just filter companies by predictability score (GuruFocus assigns companies 1-5 stars of predictability in 0.5 star increments). I think the best thing GuruFocus ever developed is the predictability score. And it’s a good use of your time to type in some ticker symbols and see which of those companies are high predictability, which are low, etc. Do I personally invest based on predictability? No. GuruFocus doesn’t rate BWX Technologies (BWXT) and it assigns predictability scores of 1 (the minimum) to both Frost (CFR) and George Risk (RSKIA). I have about 85% of my portfolio in those 3 companies. So, I have almost all my money in non-predictable companies according to GuruFocus. The predictability score isn’t perfect. But, for non-cyclical and non-financial stocks that have been public for 10 years or more – I think it’s a pretty good indicator. Use it like you would the Z-Score, F-Score, etc. It’s just a vital sign to check. Don’t just buy a stock because it’s predictable or eliminate it because it’s unpredictable according to GuruFocus’s automated formula.

 

Quickfs.net

I can’t vouch for the accuracy of the data on this site. But, that’s true for summary financial statements at all websites. Once I’m actually researching a stock, I do my own calculations using the company’s financial statements as shown in their past 10-Ks on EDGAR (the SEC website). What I like about Quickfs.net is that it’s simple and clean. Most websites that show you historical financial data give you way too much to look at. When you’re just typing in a ticker you heard of for the first time – which is what I use these sites for mainly – what you need is a “Value Line” type summary of the last 10 years. It shouldn’t be something you need to scroll down to see. As sites age, they get more and more complicated showing more and more financial info. You don’t need more than what Quickfs.net shows you. If you like what you see of a company at Quickfs.net then you should go to EDGAR yourself and do the work. Quickfs.net is for the first 5 minutes of research. The next hours should be done manually by you – not relying on secondary sources like Quickfs.net, GuruFocus, Morningstar, etc. None of them are a substitute for EDGAR.…

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The Difference Between “Moat” and “Durability”

Someone emailed me this question:

“Am I correct in assuming that when you discuss durability, you are referring to the ongoing need or want for an industry’s products or services, whereas when you discuss moat, you are referring to the competitive positioning of an individual company within its industry?”

Yes. Exactly. Durability is about the product and the product economics of the industry. Moat is the ability of the specific company to sell more of the product and have better product economics than competitors.

In Michael Porter’s approach: moat limits rivalry between firms.

And durability is about the relationship between the customers and the firm we are looking at.

So, Corticeira Amorim (Amorim Cork) in Portugal may have low durability and a wide moat at the same time, because it has advantages in the production and especially the distribution of cork compared to other firms. However, there are substitutes for cork including synthetic products and screw tops. Societal shifts in the acceptance of these ways of enclosing a wine bottle would mean that Amorim might not have very good durability.

On the other hand, a company like McCormick (MKC) has perfect durability. McCormick sells a variety of spices. Spices have been part of the food that even households that aren’t very rich have used for well over 2,000 years and they have been used all over the world. It isn’t anything cultural that determines the desire for spices. The spices used may change a little but people all over the world will always want to add spices to their meals. Whether McCormick will always be a leader in spices is a different question. But, 2,000 years from today people will be spicing the food they eat. I’m not a hundred percent sure people will be corking wine even just 20 years from now.

Sanderson Farms (SAFM) is another good example of the distinction between durability and moat. The durability of chicken is excellent. There are only a handful of domesticated animals that have been as selectively bred and extensively used as meat – mainly cattle and pigs – throughout human history. The product economics of processing chicken are also fine, you can earn a decent ROE doing it. I also think chicken should continue to be a cheaper protein than other alternatives. So, while I can’t guarantee humans will be eating chicken in 2,000 years – I’m sure they’ll be eating about as much or more chicken in 20 years. And I wouldn’t be surprised if people are still eating more chicken than almost any other meat even 50, 100, or 200 years from now. So, I think the durability of SAFM’s product and the business model – the things the firm actually does day-to-day – are both durable in terms of providing value for customers. The question is rivalry between firms. Fifteen years from today, someone will be doing what Sanderson is doing. But, how much profit will the firms that process chicken actually make? That’s why I compare …

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Sold Weight Watchers (WTW) and B&W; Enterprises (BW)

Today, I sold my entire positions in Weight Watchers (WTW) and B&W Enterprises (BW).

My Weight Watchers position was eliminated at an average sale price of $19.40 a share.

My B&W Enterprises position was eliminated at an average sale price of $10.22 a share.

My Weight Watchers position had an average cost of $37.68 a share. So, I realized a loss of 49% on Weight Watchers.

My B&W Enterprises position had an average cost of $15.48 a share. So, I realized a loss of 34% on B&W Enterprises.

Note: I got my shares of B&W Enterprises as part of the Babcock & Wilcox spin-off. I bought that stock ahead of the spin-off. I still retain my shares in BWX Technologies (BWXT). My BWXT position is about 10 times the size (in market value) of the BW position I just eliminated.

My portfolio is now:

Frost (CFR)

BWX Technologies (BWXT)

George Risk (RSKIA)

Natoco (a Japanese stock)

and

Cash

In rough terms, Frost is about 40% of my portfolio, BWX Technologies is about 25%, and George Risk is about 20%. Natoco is less than 5%. The rest is cash.

So, about two-thirds of the portfolio is just Frost and BWX Technologies and more than six out of every seven dollars is in just three stocks.

Why did I sell WTW and BW?

Weight Watchers, B&W Enterprises, and Natoco combined were now only about 10% of my portfolio. I had no intention of buying more of these stocks. I like individual positions to be about 20% of my portfolio. So, both Weight Watchers and B&W Enterprises had become distractions I wanted to eliminate at some point.

Also, this portfolio is taxable. Three stocks account for 85% of the value of my portfolio and those three stocks are anywhere from 80% to 150% higher than where I bought them. I hope to buy a new stock sometime this year. To make room for that stock, I’ll have to trim some positions with large capital gains.

Today’s sales provide me with capital losses.

As a side note, you may have noticed WTW stock was up over 30% today and B&W Enterprises was down over 30% today. My Weight Watchers position was several times the size of my B&W Enterprises position, so today’s rise in WTW’s stock price may have had some influence on my decision to sell right now. However, I could have opted to eliminate just WTW and keep BW – and I didn’t. So, I’d still say the sale is mostly not due to short-term price movements.

I really just wanted to:

1. Eliminate positions that were less than 10% of my account

2. Realize capital losses

3. Raise cash for a future stock purchase

Talk to Geoff about his Sales of Weight Watchers (WTW) and B&W Enterprises (BW)…

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Analyzing Stocks With a Partner

Someone who reads the blog emailed me this question:

“Buffett has Munger, and you have Quan. It seems like in this industry, a collaboration of minds can be a potent formula for long-term success if approached correctly. That said, how would you recommend investors/ aspiring portfolio managers to find a suitable partner who not only is able to shine light on your blind spots, but who can also be of one mind and culture?”

 

It’s a huge help to have someone to talk stocks with. But, I’m not sure it’s a help in quite the way people think it is. I think people believe that Buffett is less likely to make a big mistake if he has Munger to talk to, that I’m less likely to make a big mistake if I have Quan to talk to, and so on. I’m not sure that’s true. I know from my experience working with Quan that our thinking was more similar than subscribers thought. For example, one question I got a lot was who picked which stock. And that’s a hard question for me to answer. Some of that might be the exact process we used. I can describe that process a bit here.

 

When I was writing the newsletter with Quan, we had a stock discussion via instant messaging on Skype. We did this every week. The session lasted anywhere from maybe 2 hours at the very shortest to maybe 8 hours at the very longest. A normal session was 4-5 hours. So, we were talking for let’s say 4 hours a week about stocks. We weren’t talking about stocks we had already decided on. Instead we were just throwing out ideas for stocks we could put on a “watch list” of sorts. We called it our candidates pipeline. It was really a top ten list. So, instead of saying “yes” or “no” to a stock – what we did is rank that stock. We always had the stock Quan was currently writing notes on, the stock I was currently writing an issue on, and then 10 other stocks. In almost every case, once I started writing an issue – that issue did end up going to print. In most (but not all) cases, whenever Quan started writing notes on a stock – that stock eventually became an issue. But, there were probably 3 to 5 times that he started writing notes on a stock and yet we didn’t publish an issue on that stock. This was rare. Most stocks we thought about but eliminated were eliminated in the “top ten” stage.

 

So, we’d have a list of ten stocks that we weren’t yet doing but that we planned – if nothing better came along – to work on next. Let’s make up a list here. Let’s pretend #1 is Howden Joinery, #2 is UMB Financial, #3 is Cheesecake Factory (CAKE), #4 is Kroger (KR), #5 is Transcat (TRNS), and #6 is ATN International (ATNI). It would go …

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How to Find the Most Persistently Profitable Companies

“GuruFocus provides data on predictability of a business. Do you like this metric? Do you use this metric in your analysis? It seems to me that the more predictable a company’s historic earnings, the easier it should be to calculate the intrinsic value of the company. Do you agree with this assessment?

The problem with this for value investors is predictable businesses tend to not get nearly as mispriced (at least highly followed large cap stocks).”

I do use predictability in a general sense. I don’t want to talk about GuruFocus’s measure of predictability specifically – because GuruFocus publishes some of the stuff I write. So, I’m biased. If I say something good about a GuruFocus feature – you won’t believe me. And I wouldn’t want to say something bad because they’re kind enough to publish my writing. I’ll just say that “predictability” is a good measure to look at. And that is what the GuruFocus predictability rank is trying to do. So, it’s trying to do a good thing. And you’re not going to come to any harm by looking at it. And you might get something positive out of looking at GuruFocus’s predictability score for a company. So, yes, I like the metric of predictability.

 

Now, what do I use personally? I enter a company’s financial data into Excel myself. I’ll look at the data at places like GuruFocus. But, I want to go to the historical 10-Ks and pull the numbers out myself and adjust them as I see fit. This is to get comfortable with the numbers. There’s a difference between when you are relying on something a computer has done and when you are doing the data entry yourself. So, I set up an Excel sheet with 15 years or 20 years or 30 years of financial data. I prefer 30 years where 30 years of data exists. I also like to read the very oldest and very newest annual report from the company. Sometimes I read other specific past annual reports (like the 2008 financial crisis year) that were unusual for the company, the industry, or the country it operates in.

 

One thing I have Excel calculate is the variation in EBIT margin. So, if you have say 30 years of financial data for EBIT, and the EBIT margin is positive in every single year – you’ll be able to calculate both the standard deviation and the (arithmetic) mean in the series. Excel can give you other types of averages too. It does geometric and harmonic means which investors use rarely. But something like the harmonic mean is actually a useful measure for the very long-term return on capital, because as a rule – a company’s compounding in its intrinsic value will not be less than the long-term harmonic mean of its return on capital. It could – especially if it’s in a very cyclical industry – be much lower than the arithmetic mean. I bring this up because it’s sort of …

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