Blog – Page 37 – Focused Compounding

Geoff Gannon January 26, 2016

The Two Sides of Total Investment Return

I spend about 10-15% of my time crunching data. That sounds tedious but I actually enjoy this task. It forces me to pay attention to details, checking any irregularity I see in the numbers and trying to tell a story out of the numbers. My recent work on Commerce Bancshares (CBSH) led me to ponder the relationship between ROIC and long-term return.

Over the last 25 years, Commerce Bancshares averaged about a 13-14% after-tax ROE, and grew deposits by about 5.6% annually. Over the period, share count declined by about 1.9% annually, and dividend yield was about 2-2.5%. Assuming no change in multiple, a shareholder who bought and held Commerce throughout the period would receive a total return of about 9.5-10%, which is lower than its ROE. Why is that?

Chuck Akre once talked about this topic:

“Mr. Akre: What I’ve concluded is that a good investment is an investment in a company who can grow the real economic value per unit. I looked at (what) the average return on all classes of assets are and then I (discovered) that over 75-100 years that the average return on common stock is around 10%. Of course this is not the case for the past decade but over the past 75-100 years, 10% has been the average return of common stocks. But why is that?

Audience A: Reinvestment of earnings.

Audience B: GDP plus inflation.

Audience C: Growing population.

Audience D: GDP plus inflation plus dividend yield.

Audience E: Wealth creation.

Audience F: Continuity of business.

Akre: …what I concluded many years ago, which I still believe today, is that it correlates to the real return on owner’s capital. The average return on businesses has been around low double digits or high single digits. This is why common stocks have been returning around 10% because it relates to the return on owner’s capital. My conclusion is that (the) return on common stocks will be close to the ROE of the business, absent any distributions and given a constant valuation. Let’s work through an example. Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.”

The restriction in Akre’s explanation is “absent any distributions.” In general, there are two sides of total return: the management side, and the investor side. Management can affect total return through ROIC, reinvestment, and acquisitions. Investors

Geoff Gannon January 16, 2016

A Simple Way to Think about Moat

Moat is really about protecting a company’s profit as Warren Buffett said:

“You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.”

A business may make less profit because of lower sales, lower margin, or both. So, there are two sides of moat: the sales side and the margin side. The sales side can be broken down into customer retention and customer acquisition.

Customer Retention

There are many factors that lead to high retention, including customer behavior, price insensitivity, switching cost, etc.

Customer behavior is subtle. Sometimes customers just don’t think about switching. I used to wonder how small banks can compete with big banks. I realized that a bank’s moat doesn’t come from low funding cost or low operating cost but actually from customer habit. Customers rarely change their primary banking account. So, a small bank may have a low ROE because of its high costs but it can still have stable local market share. Despite their big scale to sell many financial products, big banks can’t steal business from small banks very easily.

Similarly, car owners rarely shop for a new insurer unless there’s a bad experience, there’s a major event in their life (move or marriage) or there’s a spike in the price of their premiums. In fact, insurers like State Farm and Allstate have greater retention rate than Progressive and Geico because they sell bundled products. So, even though Progressive and Geico have a huge cost advantage, they have only low double digit market share after decades of gaining market share. There are simply not many people shopping for new car insurance policies each year.

Price insensitivity helps retain customers in the face of price competition. Customers may pay little attention to price when it’s a tiny part of their total spending. Switching from Coca Cola to a private label cola simply doesn’t save much.

Even better, some customers are willing to pay more for convenience, tailored solutions, product quality, or customer services. I find it interesting that Frost often pays less than one-tenth of the Federal Funds Rate for its interest-checking deposits. For example, Frost paid only 0.47% on its interest-checking deposits in 2007 while many other banks paid about 1.50%. I’m not sure why but perhaps Frost’s customer service is so good that customers simply don’t care about getting interest income on their deposits.

Customer Acquisition

Strong customer acquisition can be achieved through distribution, mindshare, product superiority, or price.

The best example of distribution power is perhaps big food companies. By owning key brands, they have the power to convince retailers to carry new …

Geoff Gannon September 10, 2015

Boredom Is a Good Friend of Long-term Investors

Geoff said in the last post that: “simply learning to love illiquidity, boredom, and a lack of headlines in your portfolio might be enough to improve your returns.” The key word is boredom. I think 3 main reasons for a stock to be boring are low growth, lack of catalyst, and a so-so price. A stock with these characteristics is not attractive to growth investors, value investors, and momentum investors. But sometimes these characteristics hide qualities that can generate great long-term returns.

Quality of Growth

I once made a bold statement that Frost promises the best growth investors can find. I think that Frost can have 7-8% growth for the next 20-30 years and I don’t normally find a stock with such high growth potential. My friend was surprised at my claim and he said “you can’t say that because 20% growth is a certainty for companies like Valeant!” What he said represents the attitude towards growth of most people. To them, a single-digit growth isn’t stellar. To me, 7-8% growth is a treasure. That doesn’t mean I’m less demanding. I’m just focused more on quality of growth.

Low growth can be valuable if ROIC is high. Let’s compare Bristow, Frost, and Omnicom.

Over the last 10 years, Bristow’s revenue almost tripled from $674 million in 2004 to $1,859 million in 2014, which translates into an 11% annual growth rate. Annual sales growth was always higher than 10% except for the “bad” years between 2009 and 2011. The problem is that pre-tax ROIC is just about 9%. So, Bristow had to use debt and equity to finance growth. Over the period, net debt increased by $650 million. Share count increased by more than 50% from 23 million to 36 million mostly as a result of the issuance of $223 million in convertible preferred stock in 2007.

Frost is a better business. Frost grew deposits from $7,767 million in 2004 to $22,053 million in 2014. That means intrinsic value has compounded annually by 11% over the last 10 years. Unlike Bristow, Frost can make 18-20% ROE. So, Frost was able to return 40% of total earnings over the last 10 years.

Omnicom is even better. Omnicom grew sales by 5% over the last 10 year while returning 110% of earnings to shareholders. Omnicom doesn’t need to retain earnings to grow. It actually received about $1 billion from the decrease in its negative working capital over the period.

Omnicom’s 5% growth can be as valuable as Frost’s 8% growth. If we pay 20 times after-tax earnings for both stocks, we can get similar returns. Omnicom can give us 5% growth and 5% yield, adding up to 10% total return. Frost can grow 8% while paying out 50% of earnings. So, it can give us 8% growth and 2.5% yield, adding up to 10.5% total return. A similar calculation shows that we can get 11.67% total return from Omnicom and 11.34% return from Frost if we pay 15 times after-tax …

Geoff Gannon September 2, 2015

Should We Care Why the Stocks We Buy are Cheap?

One of my favorite blogs, Value and Opportunity, recently did a post about how the best value stocks are often those that are not cheap by the most obvious numbers (P/E, P/B, etc.).

The post is entitled “Value Investing Strategy: Cheap for a Reason”. The basic argument of the post is that:

“…Especially in a market environment like now, cheap stocks are cheap for a reason. It is very unlikely that ‘you’ are the first and only one who knows how to run a screener and by chance you are the only one who can buy this great company at 3 times earnings which will quadruple within 6 months…The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.”

This is not at all how I look at stocks.

I usually don’t know why a stock I’m buying is cheap. And I’m not sure I spend much time trying to figure out why someone else would or would not like the stock. I tend to just focus on whether I like the business and how much I’d “appraise” that business for.

I can sometimes come up with possible reasons for why a stock I like is cheap. But, I’m never sure those are the real reasons other people aren’t willing to buy the stock.

I don’t think Quan sees himself – and I know I don’t see myself – as a contrarian investor.

So, I assumed looking to see if a stock was “cheap for a reason” is something I simply don’t do.

At least that’s what I thought before looking through the textual record of what I actually said about each stock I picked.

In my last post, I mentioned 6 stocks that Quan and I picked for Singular Diligence which are now trading at a discount of 34% or greater to our original appraisal value. So, these are the 6 cheapest stocks we know of in intrinsic value – rather than traditional value metric – terms.

I decided to go through the record and check for two things.

One, how cheap are these stocks on the traditional value metrics. I will use Morningstar’s measures of P/E, P/B, and Dividend Yield for this.

Two, what reason did I give (in the issue where I picked the stock) for why that stock might be cheap.

Here are the 6 stocks.

Hunter Douglas

Discount to Appraisal Value: 58%

Forward P/E: 9.6x

P/B: 1.4x

Dividend Yield: 3.6%

Why I Said it Might Be Cheap:

“Hunter Douglas is an obscure stock. The Hunter Douglas brand is American. So, the company’s name is American. However, the stock trades in Europe. The company reports its results in U.S. dollars. But, the stock trades in Euros. The stock is 81% owned by the Sonnenberg family.”

(Note: Quan and I appraised this company – which sells shades and blinds mostly …

Geoff Gannon August 31, 2015

Current Price/Appraisal Ratios for All Our Past Stock Picks (That We Still Believe In)

I was reading an interview with the mutual fund manager Wally Weitz when I noticed he kept mentioning the “price to value” of his portfolio. He calculates what he thinks the intrinsic value of each holding in his portfolio is. Then he compares the market price to his appraisal price. This gives him an updated valuation of his portfolio in terms of his own appraisal of each stock’s intrinsic value.

For our newsletter, Quan and I pick one stock a month. We end each issue with an “appraisal price” for that stock. So, it’s easy to calculate today’s price as a percentage of our original appraisal price for each of our past picks.

You can see that calculation in the table below.

Stocks with a price/appraisal percentage in green have an adequate margin of safety. Stocks with a price/appraisal percentage in yellow are somewhat undervalued. Stocks with a price/appraisal percentage in red are overvalued.

Here are all our past picks for Singular Diligence that we still believe in:

Stocks with an adequate margin of safety (34% or more) are in green.

We consider two of our past picks to be mistakes: Town Sports (CLUB) and Weight Watchers (WTW). They do not appear in this table as possible stocks for you to consider (as we don’t think you should consider them – they’re simply too risky to recommend).

Note: As of today, Quan and I don’t own any shares of CLUB. But, we do both still own shares of WTW. So, we’re being hypocrites in regards to Weight Watchers. We haven’t sold the stock ourselves. But, we’re not suggesting anyone else should buy it. You can decide for yourself whether you should pay more attention to our money or our mouths on that one.

Also, Life Time Fitness was picked but does not appear in this table. It went private. So, you can’t buy it anymore. Sorry.

Finally, the “original appraisal prices” for the two parts of the Babcock & Wilcox spin-off (BWX Technologies and BW Enterprises) are after the fact re-calculations. The original issue gave one appraisal price for all of the old Babcock & Wilcox. That stock split into two separately traded parts after we wrote the issue. However, it was relatively easy to re-calculate the values we would have assigned each part had they been separate on the day we wrote the issue. So, Quan and I consider the price/appraisal you see for those two parts of the former Babcock & Wilcox to be accurate.

At today’s prices, we really do think BWX Technologies (BWXT) is an overvalued stock and BW Enterprises (BW) is an undervalued stock.

I’ll have a post about “Good Babcock” and “Bad Babcock” for you soon.

Geoff Gannon July 17, 2015

UniFirst (UNF): Maybe Too Expensive; Maybe Just Right

Here’s a stock trading for 1.4 times sales. We’re sure of that. What we can’t be sure of is whether it’s trading at 10 times normal pre-tax profits or 14 times normal pre-tax profits.

That word “normal” is the problem.

UniFirst provides uniforms and protective clothing to American and Canadian businesses of all sizes. These businesses typically sign a 3 to 5 year contract. UniFirst then personalizes, cleans, and delivers whatever uniforms the business needs. The ongoing task is basically showing up at a customer location once a week to deliver fresh uniforms and collect the dirty ones.

Quan and I have probably talked about most publicly traded uniform and textile rental companies in the U.S., U.K., and E.U. at some point. Sadly, they haven’t been cheap enough for us to buy. We like the industry.

If capital allocation is good and the stock is not clearly selling at a premium price – we’d be willing to consider buying almost any of them.

At the right price.

We’ve decided that “right price” is 10 times pre-tax profits.

Luckily, UniFirst does trade for about 10 times pre-tax profit. However, the price is closer to 14 times pre-tax profit if normalized a certain way. I’ll explain that “certain way” in a second – but first an aside.

When we investigate a business in depth we come up with a unique way of normalizing earnings that is appropriate to that company. For example, Hunter Douglas made $200 million last year but we think it can make $300 million in a normal year and $350 million in a good year for housing. That’s not surprising because its sales are lower in both the U.S. and Europe than they were in 2006 and 2007. Its market share isn’t. The U.S. market for blinds and shades should in a cyclically normal year – assuming the same real prices per window covering and the same demand for window covering per person – be more than 25% higher now than it was 10 years ago. That’s because of population growth and inflation. It’s an easy estimate to calculate. And I’m confident in it. America isn’t going to have a lot fewer windows per person. And blinds and shades aren’t going to cost a lot less in real terms. So, in the case of Hunter Douglas we were aggressive in saying that future earnings will be much, much higher than any year from 2008-2014. That’s a no brainer.

UniFirst’s earnings are not as simple to normalize.

Our standard way of normalizing the earnings of a company we know nothing about is to simply take the most recent year’s sales and multiply that by the median EBIT margin over as many years of history as we have for the company. This is far from perfect. But, it’s also very good at eliminating cyclically overearning stocks from our list. In recent years, UniFirst has had a 13% return on sales. Today, it’s up to a 14% EBIT margin. However, if you

Geoff Gannon June 21, 2015

Driverless Cars and Progressive’s Durability

Value and Opportunity linked to a Bank of England blog I never would have found on my own. The Bank of England blog did a post on how driverless cars could hurt the future of auto insurers. Last year, we did a Singular Diligence issue on U.S. car insurer Progressive (PGR). A big part of the durability section of that issue was about driverless cars.

So, here is the Bank of England blog post on driverless cars.

And here is Singular Diligence’s discussion of Progressive’s durability…

Originally Published: December 2014

DURABILITY: Progressive’s Focus on a Combined Ratio of 96 or Lower Makes it Durable

Auto insurance is a durable industry. The only risk of obsolescence is driverless cars. Car accidents are caused by human error. If all cars on the road were driven by computers – there would be virtually no car accidents. This would eliminate the need for auto insurance. The technical difficulties of developing driverless cars are not the biggest obstacle to their adoption. Even much simpler safety technologies like front air bags, side air bags, electronic stability control, and forward collision avoidance generally took 10 years from the time they were ﬁrst introduced on a car sold to the public till the majority of new models sold in a given year included these features. So, the “tipping point” of safety feature adoption by manufacturers is usually around a decade. Complete adoption takes about 15 years. The average car in the U.S. is about 11 years old. This number has increased over time. Cars are more durable now than they were in the past. Based on these ﬁgures, it is likely that once the ﬁrst driverless car is introduced by a major auto maker on a popular model it will take another 15 to 20 years before half of all cars are driverless.

Auto insurance is required by state law. States will certainly not eliminate this requirement while the majority of cars are still driven by humans. Total adoption of the technology could take up to 30 years. If enough car owners prefer to drive themselves instead of letting a computer drive their car for them, there could be resistance to any laws limiting human drivers. Without such laws, highways would include a mix of human and computer driven cars. Under such conditions, laws might still equally “fault” driverless cars for accidents involving human drivers. These legal complications mean that auto insurance would probably persist into the early stages of a mostly driverless car society.

Today, there are no commercially available driverless cars. So, the end of car insurance would likely be some point 15 to 30 years after the successful introduction of driverless cars. The vast majority of net present value in a stock comes from returns generated within the ﬁrst 30 years. Even if driverless cars are successfully introduced in the U.S. soon – and that is a completely speculative assumption – it is very likely that auto insurance will persist as a legal …

Geoff Gannon June 15, 2015

You Can Afford to Hold Cash

In my last post, I said stocks were too expensive. Instead of putting more of your money into diversified groups of stocks, you should just let cash build up in your brokerage account.

A lot of people have a fear that those lost years of making zero percent on their idle cash can never be made up for.

I’ve created a graph to show how much ground you’d have to make up.

Let’s say you have two choices: one is to invest in an overpriced basket of stocks today and hold that basket from 2015 through 2030. This choice will compound your 2015 money at a rate of 6% a year.

The second choice is to do nothing for all of 2015, 2016, 2017, 2018, and 2019. You just hold cash. That cash earns 0% for those 5 years. In 2020, you finally get an opportunity to make an investment that will return 10% a year from 2020 through 2030.

If your investment horizon extends all the way out from today through 2030, the second approach overtakes the first approach about 15 years from now.

Doing nothing for 5 years and then something smart for 10 years is a better 15 plus year strategy than “just doing anything” today.

Here we define something smart as 10% a year and “just doing anything” as 6% a year. You can decide for yourself whether your something smart is 10% a year or not. That’s subjective. What the “doing anything” returns is a lot more objective. So, let’s talk about that.

Over the last 15 years, the S&P 500 returned about 5% a year. During that time period, the Shiller P/E ratio contracted from 43 to 27. The same percentage contraction – 37% – would be required to get the Shiller P/E down from today’s 27 to a historically “normal” 17.

I see no reason why the S&P 500 should do better from 2015 to 2030 than it did from 2000 to 2015. That means I see no reason why buying the S&P 500 today and holding it through 2030 should be expected to return more than about 5% a year.

(Almost all readers I talk to have a total return expectation for the S&P 500 that is greater than 5% even for periods shorter than 15 years.)

It’s also worth mentioning that while I have no predictions as to when idle cash would earn more than zero percent – the Fed does. And those predictions show cash earning a few percent in 2018 and 2019 instead of zero percent.

For those reasons, the graph in this post is probably an underestimate of how quickly sitting and doing nothing till you can do something smart outperforms continuing to shovel cash into the S&P 500 at today’s prices.

I think the reason people don’t feel secure in waiting for an opportunity to do something smart is that they’re not sure when that opportunity will appear.

Maybe there will be no chance in all

Geoff Gannon June 14, 2015

Stocks Are Too Expensive

We talk about stock picking on this blog. That means we usually talk about specific stocks. The “market of stocks” not the “stock market”. Today, I’m going to talk about the stock market.

It’s too expensive.

You shouldn’t buy it.

If you have an account where you automatically reinvest your dividends – stop. If you are putting money each month into an index fund, or a stock mutual fund, or a bond mutual fund – stop. Those assets are overpriced. Any basket of stocks or bonds is overpriced. If you are saving money regularly – that newly saved money should now be going into cash instead of stocks or bonds.

The simplest rule in investing is that you never buy an obviously overpriced asset. Stocks generally and bonds generally are obviously overpriced right now. So, you need to stop buying them in a general way.

To put a number on this expensiveness, I think the Shiller P/E ratio is about 27 now. It was about 27 when I wrote my December 2006 post arguing stocks were too expensive. You can read that post later down in this one. Or you can click here to see – via the Wayback Machine – what that post actually looked like on the original site in 2006.

I am writing this post because of 3 separate items I noticed recently.

I came across one while reading an earnings call transcript for Frost (CFR). This is a usually conservatively run bank in Texas. It has a lot more deposits than loans. Deposits have kept growing. So, the company needs to put the money somewhere. And where they’ve put it is “Securities”. Frost now holds more money in securities than loans. These securities are high quality. They aren’t going to default. But they are overpriced. To get a yield near 4% on their securities portfolio – the company had to go pretty far out in terms of the maturities it would buy. In normal economic times – let’s say with a Fed Funds rate of 3% to 4% – these bonds would cost less than what Frost paid for them. At some point, there will be a 3% to 4% Fed Funds rate. I have no idea when that will be. You can look at predictions from the FOMC’s own members and see they thought it would be 3 years down the road or so. Now, if that’s true – you obviously aren’t gaining much by making less than 4% a year for less than 3 years if you will be able to make 4% a year on idle cash at the end of that period. Of course, some events may happen that prevent any increases in the Fed Funds rate for that entire 3 year period. In the 1930s in the U.S. and in the 1990s and 2000s in Japan, investors could have easily overestimated the likelihood that rates would rise within the next 3-5 years to a “normal” level. If something like

Geoff Gannon June 13, 2015

How to Judge a Business’s Durability

My last post listed examples of threats to a company’s durability. This post will be about how we assess those threats. You can always imagine a threat. Is it a realistic threat? How do you judge that?

There are some industries where durability is pretty much perfect. The business doesn’t change much. Barriers to entry are high. The future development of substitutes is unlikely. Location advantages are big.

A good example is lime. Lime is reactive and has a short shelf life. You don’t store it speculatively. You don’t import it and export it. Customers need to get their lime from a deposit being worked somewhere within a few hundred miles of them. Over the last 100 or so years, the real price of lime hasn’t changed that much (real price volatility compared to other commodities is quite low). The price right now is perfectly in line with the real average price per ton since 1900. Lime consumption in the U.S. was no higher last year than it was in 1998. The industry is more consolidated and perhaps less competitive than it was in 1998. I don’t think capacity is being fully utilized now. And I do think inflation will always be passed on to customers (as it was over the last 100 years). So, if Quan and I were to research a company like United States Lime & Minerals (USLM), we could probably start by assuming that last year’s EBIT would – in real terms – represent that company’s durable earning power. That could be our starting point for a buy and hold analysis.

That’s usually not the case. Even when we find a company that has a long history of being the leader in its field – say Strattec in car locks and keys, H&R Block in assisted tax preparation, etc. – there is a risk of change. In these two cases, we know there will be change in the product. For example, more people will prepare and file their taxes online in the future than they do now. And more drivers will enter and start their cars with the use of electronics instead of physical locks and keys. What we don’t know is how that will affect the companies.

Take H&R Block. The company competes in assisted tax preparation. In the 1990s and 2000s, many people switched to using software and then online products to prepare their taxes. But who were these people?

Most were people who had always prepared their taxes themselves. I use TurboTax and know a lot of people who use TurboTax as well. But, I actually don’t know anyone who used H&R Block even once in their lifetime and now uses TurboTax. Everyone I know who uses TurboTax used to – decades ago – prepare their taxes themselves using a pen and paper and a calculator. They didn’t use a CPA. And they didn’t use H&R Block.

Now, this is anecdotal. But, if I hadn’t asked the question “who are these people” …