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.…

Read more

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.…

Read more

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 …

Read more

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

… Read more

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 …

Read more

Carnival (CCL): No Pricing Power – But Plenty of Value Created Over Time

Geoff here.

Since Quan started writing about Carnival (CCL) here on the blog, we’ve gotten a lot of emails from people saying the cruise business is a bad business – even for the leader – and that these companies only destroy value.

It’s perfectly valid for people to have a different view of the future than Quan and I do. But when it comes to the past – it’s really not possible to argue Carnival has destroyed value.

This  may sound obvious to some. But I’m going to take a moment to explain it – because it’s a really important concept.

 

Carnival Has Zero Pricing Power

Carnival has no pricing power. The product economics of the business are not good. They can’t raise prices relative to competitors and still fill their ships. This is not Wrigley. This is not Coca-Cola (KO). This is not See’s.

But Wal-Mart (WMT) never had a dime of pricing power. Neither did Southwest (LUV). I don’t care if my PC has Intel inside or AMD inside. If Intel doesn’t maintain an advantage in terms of cost, performance or both – which requires constant improvement – it also has zero pricing power.

 

Return on Capital is Driven by Both Product Economics and Competitive Position

Most companies that earn economic profits do not earn them because they are in an inherently better business. Chris Zook’s series – he works for Bain consulting – estimated that two-thirds of economic profits are due to a superior competitive position. Only one-third is due to superior product economics.

I love superior product economics where I can find them. It is better to sell candy than cruises. But even in candy – it is better to be See’s than Russell Stover.

Most companies earn economic profits because they are – at the moment – in a better competitive position. Unfortunately, it is difficult to know whether the competitive position of most companies will get better, worse, or stay the same over the next 5 years, 10 years, 20 years, etc.

But some corporate records – and family fortunes – are built on maintaining a constant competitive lead in an otherwise unimpressive industry.

In no sense can it be said that Wal-Mart, Southwest, or Intel were ever in an industry with good product economics. But in those periods where they earned good returns on capital – they had a competitive lead on the completion.

 

If You Built a Fortune – You Created Value

This is kind of obvious. But it’s worth mentioning. Anyone you see on a list of billionaires either created or inherited a fortune. You can always trace those kinds of fortunes back to some sort of shareholder value creation. No one earns a billion dollars in wages. They earn it from owning something and having that something increase in value.

That obviously doesn’t mean Rupert Murdoch – simply because he’s a billionaire – necessarily created value in the last 10 or 15 years. It doesn’t …

Read more

How to Value a Stock: Is It Even Necessary If You Plan to Buy and Hold Forever?

Geoff here.

Someone who reads the blog sent me an email about how to value a stock. I answered that email with the idea of peer comparisons.

Peer comparisons are really a short-term valuation approach. If you buy Interpublic (IPG) at 0.7 times EV/Sales because you expect it should one day trade in line with the other 3 big advertising companies – which all trade at 1.1 to 1.2 times sales – then you are making a short-term bet. You hope the business will do just dandy. But you are betting on getting a 50% to 60% pop at some point from multiple expansion.

In a situation like that it’s not just the price you paid and the performance of the business that matters. There’s also another issue – how long will you have to hold the stock? Is that 50% to 60% multiple expansion pop going to be spread out over 1 year, 3 years, 5 years, or 10 years?

It matters. A lot.

But not if you plan – Warren Buffett style – to actually buy and hold a stock forever. That’s what I’ll be talking about today.

Most people will tell you to do a DCF. I am against that. I think that in an analysis of a stock’s truly long-term return potential, there are really just 3 critical variables:

1. Earnings yield (Earnings/Price)
2. Sales Growth
3. Return on Investment

If you want to think of the harmonic mean of these numbers as being the best estimate of your long-term returns in the stock – and by long-term I mean buy and hold forever – I think that makes sense.

So, for example, these three numbers at Coca-Cola (KO) are:

• Earnings Yield = 5%
• Sales Growth = 9%
• Return on Investment = 19%

The harmonic mean of 5%, 9%, and 19% is 8%. That’s not a bad guess of what Coca-Cola stock can return to you if you buy it and hold it from now until the end of time. However, the key assumptions are the earnings yield (not controversial in Coke’s case), sales growth (which could be lower in the future than in the past), and ROI (which I just took the most recent year of data).

Assume Your Return Will be Close to the Lowest of the 3 Rates – Not the Highest

Why use the harmonic mean?

When I’ve talked about forever return potential in the past, I’ve used the earnings yield times the sales growth times the return on investment and the cube root of that number to try to make the reason for this kind of calculation clear.

This is a snowball measure. It is about you paying $100 for $5 of earnings today, having those earnings – to the extent possible – put back into the business, having those earnings producing earnings upon earnings, and so on…

I think I did a bad job explaining this. I made it sound more complicated than it really is.

So let’s talk about a mean. …

Read more

How to Value a Stock: The Power of Peer Comparisons

Geoff here.

Someone who reads the blog sent me this email:

Hello,

I’m a college student just learning that I have a desire to learn how to invest. I’ve come across many blogs and found yours to be very helpful. Yet, I still can’t seem to figure out how to value a stock. Do you know of any websites that you can link me to about stock valuation? Anything would help, Thank you!

Lots of websites will show you how to value a stock. I don’t think most of them are helpful. They will tend to use some sort of discounted cash flow (DCF) calculation. Or some approximation of earnings and growth. Many will focus on free cash flow.

 

Problems With Automated Approaches to Appraising a Stock’s Value

Some stocks have no free cash flow. Others have no tangible book value. A DCF needs to have a point where the discount rate is higher than the growth rate. Often this is done by slicing growth expectations into stages. For example, how fast will the company grow sales over the next 10 years, the next 10 to 30 years, and then all years beyond that?

There are serious problems with these approaches. The very best, most durable businesses actually may not have expected growth rates below the discount rate you should be using. For example, Moody’s 30-Year BAA corporate bonds – investment grade, but not the safest bonds out there – yield 5% right now. Over the last 10 years, Coca-Cola (KO) grew earnings per share by almost 9% a year.

That’s a problem. Should you arbitrarily assume Coca-Cola will grow at 4% a year at some point? Or should you use a rate different from the BAA yield? What’s the justification for doing that? Yes, a bond has legal protection for you. But Coke’s earnings power has some really strong customer behavior protection.

I would argue it makes much more sense to look at Coca-Cola without doing a discounted cash flow analysis.

The two approaches that make the most sense are finding similar merchandise available at the present time, in the recent past, in other countries, etc. And calculating your likely return if you bought and held Coca-Cola stock forever.

 

How I Look at Stocks – More Angles, Less Precision, But More Confidence

Those are my two go to approaches. I look at what peers – or companies that are comparable in some way – trade for. And I look at how fast I can expect my investment in this stock to compound if I hold it forever.

You can look at these as a kind of short-run limit and a long-run limit. The short-run limit is the stock price adjusting to match the valuation given to its peers. This is a “reversion to the mean” type of approach. Very standard value investing stuff.

The long-run limit is pretty much the company’s own capacity to reinvest and earn high returns on reinvestment. This is Phil Fisher type …

Read more

Why Capital Turns Matter – And What Warren Buffett Means When He Talks About Them

Geoff here.

Someone asked me what Warren Buffett meant when he talked about a company turning over its capital “x” number of times a year.

When Buffett says capital turns he means Sales/Net Tangible Assets.

Most websites, etc. tend to just use assets. And they may even be including cash assets as part of that ratio. Based on the way Buffett has talked about return on investment at Berkshire subsidiaries in the past – it’s clear he uses the net amount of tangible capital invested in the business. In other words, he nets tangible assets against accounts payable and accrued expenses. He gives a company credit for these zero interest liabilities – rather than assuming shareholders are really paying for all of a company’s assets themselves.

A lot of the businesses Buffett has bought for Berkshire actually don’t have very high margins. What they have is higher sales per dollar of assets. Distributors for instance. Once a company in a business like that can achieve higher sales per dollar of assets it is hard for others to compete – because even if they have the same margins, they have lower returns on capital.

 

The Advantages in Always Moving Product

Buffett has talked about survival of the fattest before. A high volume, low margin business can sometimes turn into a survival of the fattest situation. That’s because everybody has to start with just a trickle of product moving through their pipes. This is not a recipe for catching up to the leaders who are already moving flood like quantities through their infrastructure.

We’ve talked about movie studios – mostly DreamWorks (DWA) – on this blog before. That’s a bit of a survival of the fattest situation. The best way to distribute a movie is to distribute 12 of them a year – not 2 of them. But the best way to make movies is to make 2 of them a year – not 12 of them. A producer’s dream situation is to make 2 blockbusters a year. A distributor’s dream situation is to always be distributing something. Over the last three quarters of a century there hasn’t been much change in who distributes movies. In fact, from a competitive economics sense – when we say “studio” we mean “distributor”. That’s where the oligopoly exists. You’ll notice that where someone new did became a major studio – Disney – they did it by succeeding on different terms as a producer first and then succeeding as a distributor. Basically, they cheated.

It’s an interesting question whether the integration of production and distribution influences the movies that are made. My belief is yes – it does. And that the historical evolution of the movie industry lead to a situation where more smaller, lower quality movies were made than would otherwise be the case. I actually think there were always huge incentivizes to make blockbusters. They’re just weren’t huge incentives for distributors to focus exclusively on blockbusters – because maximum efficiency in distribution can’t be …

Read more

How Today’s Profits Fuel Tomorrow’s Growth

Over at Adjacent Progression, there’s a post called “The Profitability Bias”.

Adjacent Progression asks:

When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there’s money left over, it’s a profitable company. And the bigger the profits, the better the company.

And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you’re using a framework to understand and assess businesses, it’s fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.

Our focus on net profits is probably excessive. Perhaps we need to move up the income statement.

For me, there are two elements to consider with any business’s returns – sales margins and capital turns.

1. How much can you make per dollar of sales?
2. How much can you sell per dollar of capital you tie up?

Most investors and analysts pay too much attention to margins and too little attention to capital turns. In Alice Schroeder’s discussion of Warren Buffett’s investment in Mid Continent Tab Card Company, she mentions that Buffett looked at margins and capital turns.

 

Gross Profitability Matters More Than Most Investors Think

It is not necessary for a company to have high margins – and certainly not pricing power – to achieve truly remarkable returns on capital. And it’s definitely not necessary to have a high net profit margin from the business’s earliest days.

But you do need some basic evidence of a strong business model. What is a strong business model?

There are countless qualitative ways of looking at a business model. I’ll propose one basic quantitative check:

Gross Profits / ((Receivables + Inventory + PP&E) – (Payables + Accrued Expenses))

This number should start looking good – and keep looking better pretty early in a company’s history.

Look, Amazon (AMZN) is an expensive stock. I’m not going to argue otherwise. And it’s got low margins. But it also doesn’t tie up capital in the business. And it’s got the same gross margins Wal-Mart (WMT) does.

So, to me, Amazon is a proven business model quantitatively. And qualitatively I feel its competitive position will be better in five years than it is today. I think Wal-Mart’s will be worse.

Now, Amazon’s operating margin is worse than Wal-Mart’s. But I’m not sure Amazon’s business is worse. And I actually suspect it’s better.

This is what I mean when I say we …

Read more