A Blog You Might Like

Someone emailed me with a link to a blog I hadn’t read before. It’s called The Graham Disciple. And so far it has posts on Xerox, Dolby, Rheinmetall, and Bijou Brigitte. Each post starts with a quote from Ben Graham.…

Stocks I Don’t Talk About

Everybody is narrow minded in their own way. I’m no different. And this blog suffers for it. But we each have our own style. And it wouldn’t do much good for me to write about stocks that don’t fit that style.

So, today I thought I’d point you to some other bloggers talking about two stocks that wouldn’t appear on this blog – but might just match your style.

The first is Mexican Restaurants (CASA). There is a post at Oddball Stocks. And another at OTC Adventures.

The other is Morgan Sindall. There is a post at Value and Opportunity. And another at Expecting Value.

Both pairs of posts are worth reading.…

Books I’m Reading

I just finished reading Pat Dorsey’s The Little Book That Builds Wealth. This was recommended to me by the blogger who writes Neat Value. It was a good recommendation. The book is short. And simple. And all about moats.

I’m now reading William Thorndike’s The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. This one’s even better. Every buy and hold investor should read it.…

Unrepeatable Moats

A blog I read, csinvesting, has a post about Niche vs. Moat. In my experience, most investors underestimate the frequency of moats and overestimate their size. They assume large companies have moats and small companies don’t.

Most competitive advantages are cost advantages. And most of those don’t last. But they keep excess profits in and competition out for a time.

Cost advantages are inflexible. And so any change in technology, society, industry structure, etc. can destroy them. What’s worse is that the cost advantage often reverses from something that favored incumbents to something that favors entrants. You end up with unions, agents, etc. New entrants do not.

Greenwald stresses the local nature of moats. Local competitive advantages are common. If you look at very high return businesses in areas you wouldn’t expect – banks, grocery stores, etc. – they are due to superior performance at the most local level. Each store and branch is outperforming. And the market share situation in each town deters competition.

Most investors don’t consider that a moat. Because it can’t be repeated. In the next town over, it’s useless.

That’s true. But it’s also different from a big company making a hit tech product. They have nothing that can be defended. The profits are due to scale. But the scale – market share – is threatened by something others can and will try to take away.

There’s a book – in fact a whole series – on repeatability.

You shouldn’t read Greenwald’s book without reading Zook’s books. I recently read another book on moats – The Little Book That Builds Wealth – and it makes the same mistake Greenwald’s book makes.

They both downplay management. On the one hand, they are right to do this. Management is not a moat. On the other, they are wrong. Management often grows a culture around a moat.

In fact, today’s management is often less important than the management that formed the company’s identity. Day to day decision making is not important. Keeping the company focused on the moat is. The key manager doesn’t have to be alive to do that. People just have to remember him.

The most durable advantage a company can have is a cultural identity locked up in a moat. Most companies should not try to be cost leaders in everything they do. But if that is your moat – you shouldn’t spend a minute thinking about anything else.

The reason Southwest (LUV) and Wal-Mart (WMT) built the moats they built is due to the cultures their management created. They had one good idea. And they took it seriously.

Most companies are more scatter brained. If they see a good idea, they act on it. But ideas do not exist in isolation. A chain of good ideas often leads to one really bad habit.

Most companies that have moats are not conscious of those moats. Warren Buffett invested in the Washington Post (WPO). The people at the Washington Post knew how …

30 Obscure, Profitable Stocks

Here are 30 of the most obscure stocks with a history of profits:

1. Superior Uniform (SGC)
2. Bowl America (BWL.A)
3. Seaboard (SEB)
4. Atrion (ATRI)
5. Arden (ARDNA)
6. Micropac (MPAD)
7. Ark Restaurants (ARKR)
8. United-Guardian (UG)
9. Span-America Medical (SPAN)
10. Nortech Systems (NSYS)
11. Air T (AIRT)
12. Mesa Labs (MLAB)
13. Monarch Cement (MCEM)
14. Educational Development (EDUC)
15. Flanigan’s (BDL)
16. George Risk (RSKIA)
17. Tofutti Brands (TOF)
18. TNR Technical (TNRK)
19. Daily Journal (DJCO)
20. Jewett-Cameron (JCTCF)
21. Opt-Sciences (OPST)
22. Paradise (PARF)
23. National Research (NRCI)
24. Earthstone Energy (ESTE)
25. Mexco Energy (MXC)
26. Espey Manufacturing (ESP)
27. LICT (LICT)
28. Scientific Industries (SCND)
29. United States Lime (USLM)
30. Boss Holdings (BSHI

Catalysts Not Included

A blog I read, Value and Opportunity, has a post about Porsche and Volkswagen. There is also a link to a Market Folly post. They are both worth reading. I have no comment on the stock. I know nothing about cars or car makers.

I do know something about holding companies that trade at a discount to their parts. And I don’t agree with that part of the post. If the underlying assets are compounding nicely – you shouldn’t assume a holding company discount is correct just because the market applies one to the stock. You can’t both beat the market and defer to it.

When analyzing a stock that trades at a discount to net asset value – whether it is an insurer, a closed end fund, or a holding company – you need to look for reasons apart from market perceptions why the stock should be valued that way. If an insurer earns 5% on book value – it should trade at a discount to book. If it earns 10% on book value – it should not.

If the return on assets is satisfactory – the market price of those assets will one day be satisfactory.

Stock pickers should take advantage of market perceptions. Not incorporate them into their analysis. Much of the money you make in a value investment comes from a change in the market’s perception. You buy an ugly stock. And sell a pretty one.

Focus on value and ignore catalysts. Catalysts are made in the imagination. And our imaginations are too small. The future we sketch is always narrower than the future we get.

Who would have imagined Porsche’s past few years?

I made 150% on a Japanese net-net. It was taken private by management. Never once in my search for Japanese net-nets did I consider that a possible catalyst. Everybody knew Japanese companies did not go private. I knew it too.

The great thing about value investing is that you still get paid for upside scenarios you never imagined.…

Rise of the Guardians Has DreamWorks’s Worst Opening Weekend

We’ve talked about DreamWorks Animation (DWA) on this blog before. Last weekend, DreamWorks released a movie called Rise of the Guardians.

Here is a list of original computer animated solo productions by DreamWorks and how each movie opened in the U.S. All amounts are adjusted for inflation.

1. Kung Fu Panda: $67 million
2. Monsters vs. Aliens: $63 million
3. Shark Tale: $61 million
4. Madagascar: $58 million
5. Over the Hedge: $47 million
6. Megamind: $46 million
7. Bee Movie: $44 million
8. How to Train Your Dragon: $44 million
9. Puss in Boots: $35 million
10. Antz: $29 million
11. Rise of the Guardians: $24 million

Rise of the Guardians cost $145 million. DreamWorks has had worse opening weekends. But none were computer animated solo productions. They were either hand drawn movies – which DreamWorks no longer makes – or movies made with Aardman.

DreamWorks’s stock dropped on Monday. Shares now trade at $17.30.…

Why We Can’t Use Owner Earnings to Talk about Stocks

Geoff here.

Someone sent me an email asking about a post I did a while back called One Ratio to Rule Them All: EV/EBITDA.

If I had to use an off the shelf ratio – EV/EBITDA is the one I’d use. Owner earnings matter more. But owner earnings is a tough number to agree on. It’s not something you can screen for.

All price measures are flawed. None approximates the actual returns a business earns. What we are always interested in is the value a company delivers over a year. That is the company’s real earnings regardless of what is reported in terms of net income, EBITDA, free cash flow, book value growth, etc.

It’s Not That EV/EBITDA is So Good – It’s that P/E is so Bad

My point about using EV/EBITDA is that no price measure actually works well in individual cases. But if you are eliminating some stocks on the basis of a price ratio – for example, you are saying a price-to-earnings ratio of 22 is too high so you won’t even start researching such a stock, you can never actually calculate the value ratios that matter.

Let’s look at Carnival (CCL).

How Should Investors Define Earnings

What does this company earn?

For me, Carnival’s earnings are neither EBITDA nor net income. They are:

Cash Flow From Operations

– Maintenance Capital Spending

= Cash available to add passenger capacity, acquire other companies, pay down debt, buy back stock, and pay dividends

That’s earnings. It’s the cash you collected in excess of what you need to spend in cash to collect the same amount of cash next year. It’s a sustainable level of cash flowing through the business.

How is this different from EBITDA?

Carnival’s depreciation expense does not match its capital spending requirements. By my estimates, about 20 years ago, the company was charging off less in depreciation than was actually needed to maintain its competitive position in the industry, have the same number of passenger nights, etc. In its most recent year, this was perhaps no longer true.

It’s a complicated issue. A lot of different facts go into deciding just how much CCL needs to spend to maintain its competitive position and its passenger capacity.

But how do we know what Carnival’s maintenance cap-ex needs are?

We can’t know that until we start researching the company. In fact, it’s not that easy to know until we read about current shipbuilding contracts from CCL, RCL, and NCL. Until we look at what the average real cost per new berth (think of it as 2 cruise berths = 1 hotel room) for CCL, RCL, etc.

Maintenance Cap-Ex is a Complicated Issue

At most companies, it’s very hard to determine maintenance cap-ex. I’m actually cheating by talking about Carnival. Cruise ships are easily identifiable long-lived assets that change hands in control transactions, etc. I’m pretty close to analyzing buildings here.

I mean, they give these ships names. I can trace their history from company …

Blind Stock Valuation #3 – Corticeira Amorim

Geoff here.

About a week ago I posted a blind stock valuation. That’s where I give you some financial data from a public company without revealing the company’s name. Then you try to value it.

Here are the numbers I provided:

The company is Corticeira Amorim. It’s a public company. It trades in Portugal.

Nate Tobik of Oddball Stocks did a great 2 part series about Corticeira Amorim.

Corticeira Amorim

It’s a cork company. Amorim is the name of the family that runs the company. Corticeira is Portuguese for cork. Corticeira Amorim was briefly mentioned in my favorite business book: Hidden Champions of the 21^st Century.

Amorim has 25% of the worldwide cork stopper market. Cork stoppers are used to bottle wine. Amorim’s share of other cork products is even bigger. It has 55% of the composite cork market, 65% of the cork floor market, and 80% of the cork insulation business.

As I mentioned when I posted this blind stock valuation – the company uses debt. It has bank debt and commercial paper.

Your Thoughts

I got a lot of emails from readers giving their intrinsic value estimates for the company based solely on the financial data.

Here are my 3 favorite responses.

Response #1: Low Quality Business – Probably Using 1 to 1 Leverage

(Estimated Market Cap: 163 million Euros; Enterprise Value: 327 million Euros)

This is a low quality business: assume a 30% tax rate and it is earning an average of just 5.4% on its operating capital.

Its only strengths, such as they are, seem to be an (i) an ability to avoid significant gross profit erosion in the 2007-2009 cycle; and (ii) either a reluctance, or an inability, to grow.

I suspect it is the latter, because the very large swings in EBIT/GP ratio for an otherwise stable business indicates managers with very little discipline. And undisciplined managers generally want to grow, if they can.

(I assume that these swings are either related to marketing and/or SGA bloat in good times, and retrenchment in bad times; foresighted, intelligent managers generally do it the other way around).

So why can’t it grow? Niche market played out? Local market saturated? Or it’s a supplier to one or two big clients who have these problems?

In any case, the managers of this business will want to take on significant debt to (a) make its ROE look better and (b) to reduce its cost of capital. How much debt? Probably 1:1 with equity – in order to get the ROE above 10%.

So, estimating the EV and market cap should be logical and straightforward:

ROC = 5.4%,

• average operating capital = $429m
• cost of capital (assuming half the capital is debt) = 7%

And, following from that, market cap = ½  x 327 = $163

Or, put another way: $163m in debt will generate $5m in after-tax interest expense which implies equity earnings of approx $20m which, in turn, implies a yield

How to Lose Money in Stocks: Look Where Everyone Else Looks – Ignore Stocks Like These 15

This isn’t an article for traders. It’s meant as advice for long-term value investors.

I’ve been reading Howard Marks’s The Most Important Thing. This got me thinking about risk. And how I don’t talk about risk enough on the blog.

I don’t want to talk about risk in theory. I want to focus on the practical risks value investors – especially long-term value investors who focus on picking specific stocks – face each and every day.

How do value investors screw up?

How can they have the right philosophy and yet implement it so badly, they actually lose money in some of their investments?

One way is to buy and sell stocks at the wrong times. I’ll talk about that tomorrow. Today, I want to talk about the umbrella category that falls under: acting like everyone else.

It’s risky to act like everyone else.

And one way investors can act like everyone else is by looking at the same stocks everybody else looks at.

Another way is by entering and exiting stocks along with the crowd.

Both are risky mistakes.

How Mutual Fund Investors Manage to Do Worse Than the Funds They Buy

Mutual fund investors are masters of bad timing. Usually, they are pretty good at knowing what fund is best. It’s no secret that Bruce Berkowitz is a good investor. But even investors who know that – and who therefore trust Berkowitz with their money – manage to destroy the profit potential in partnering up with a superior investor.

Morningstar keeps data on just how bad mutual fund investors are when it comes to timing their entrances and exits. For example, over the last 10 years, Bruce Berkowitz’s Fairholme Fund (FAIRX) has returned 9% a year. The average Fairholme investor has earned just 1.7% a year.

New money enters the fund just before performance goes bad. And money exits the fund just before performance turns right back around.

I’ll talk about the issue of terrible timing in another post. Today, I just want to use this terrible timing as evidence. It’s evidence that following the crowd is not safe.

Following the crowd is so risky that even if you are right about which fund manager to invest with, you can be wrong enough in your entrances and exits that you fritter away 7% a year on nothing but needless activity.

Does the Average Investor Really Match the Market?

I’ve never believed this for a second. The truth is that if you can find an entirely arbitrary allocation (50% bonds/50% stocks) or a hedge fund or a program or system or whatever that keeps you invested enough at all times in good enough assets – you’ll do better than most investors.

Most investors think their problem is figuring out what assets have the best long-term returns, which managers are the best investors, and what approaches to investing work.

Investing is More about Practical Psychology than Theoretical Efficiency

My constant contention has been that investing is …