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 …

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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. …

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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 …

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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 …

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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 …

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Blind Stock Valuation #3

A company Quan has talked about a lot lately – DreamWorks Animation (DWA) – has a movie out called Madagascar 3: Europe’s Most Wanted. I’ve also chosen Europe as the setting for the third installment of my little series.

One of my favorite blogs, Distressed Debt Investing, recently mentioned the idea of blind stock valuations. I’ve posted two of these practice exercises in the past.

They turned out to be – spoilers ahead – Waltington Waterworks and Wal-Mart circa 1981.

I employed a little trickery in both cases. I figured no one reading the blog would know Watlington Waterworks (it only serves the island of Bermuda). And I figured most people would not recognize Wal-Mart’s record from the 1970s as long as I renumbered the years so it looked like the company achieved that growth record in the 2000s.

I haven’t done anything sneaky this time. The numbers shown here have not been tampered with. I have changed no dates. I haven’t multiplied the numbers by ten, divided by ten, etc. Click the table to make it bigger:

This company uses debt. So, I’m not looking for a per share intrinsic value estimate here.

Just tell me what you think the enterprise value is. Or – if you’re feeling particularly adventurous – try to guess both the market cap and the amount of debt.

While this isn’t a blue chip name – especially for American investors – it is a stock some people reading the blog know. I’ve even mentioned this stock’s name in the past.

So some of you can easily identify the stock if you want to. Resist the urge. And try your best to value the stock blind.

I’ll tell everybody the stock’s name next week.

That’s also when I’ll share a few of my favorite emails attempting to value the stock.…

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If Dividends Don’t Matter – What Does?

Geoff here.

There’s a good blog post over at The Interactive Investor Blog by Richard Beddard. It talks about how divdends are both everything and nothing in investing.

 

Dividends, Value, and Growth Can all Be Sources of Long-Term Returns

The point is that you don’t need to get a return on your investment from dividends. You can get it from someone else – in the form of capital gains – when you sell the stock. You can get it from the company directly – in the form of dividends – when they pay you cash.

For me, there are two extreme views of how investors make money in stocks.

 

The Pure Value Approach

You buy a stock at a discount to its value and expect to sell it when the stock price reaches that static intrinsic value sometime in the future. Your return is therefore the compound annual rate required to close the gap between price and value over the time you hold the stock.

Illustration: You pay a third of what a stock is worth today. Intrinsic value stays the same. Over the next 15 years, the stock price rises to meet intrinsic value. You sell. And make 7.6% a year over 15 years.

 

The Pure Growth Approach

You buy a stock and expect to sell it sometime in the future. The stock has a dynamic intrinsic value. So you hope it will be worth more in the future than it is today. Your return comes from the interaction of the price-to-value ratio you paid today and the intrinsic value growth over the time you own the stock.

Illustration: You pay three times what a stock is worth today. It grows intrinsic value 20% a year for the next 15 years. You sell. And make 11.5% a year over 15 years.

It’s worth mentioning that the item of interest to most academics, society at large, etc. should be the pure growth approach. The value approach is of most interest to practitioners. The entire investing public can benefit from holding growing companies. They can’t benefit (together) from buying businesses at one-third of their value. We can.

These are pure approaches.

Where you buy a stock at a deep discount to its value, the company’s growth can be very poor – and you can still make money.

And when you buy a stock with very fast growth, the price you pay can be very high – and you can still make money.

Most investments fall in between. Value and growth both matter. If instead of getting a stock at one-third of its intrinsic value, a value investor buys a stock at four-fifths – he now has to worry a lot about growth.

Likewise, if a growth investor buys a stock growing 10% a year instead of 20% a year – he now has to be very careful about the price he pays for the stock.

How do we deal with stocks that fall in this gray area? They …

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How to Become a Better Analyst – One Hour at a Time

Geoff here.

Over at Portfolio14, there is a good question about spending time researching new stocks as opposed to just adding to the same old positions:

Charlie Munger always says diversification is diworsification. My dilemma here is whether I should diversify in order to reduce my exposure to one single company. No matter how high my conviction is, there are always “unknown unknowns”. There is also this unhelpful thought urging me to divest: “Earning outstanding returns requires hardwork. If I keep on adding to just the same old position and not spending time to dig deep into other companies, I’m not working hard enough.”

(Portfolio14) 

This is a great question to ponder. On the one hand, I agree that diversification often leads to diworsification. On the other hand, it is important to practice, practice, practice:

A little over a year ago, Geoff Gannon wrote a post where he gave readers the salient financial information of company, but didn’t give the ticker/name of the company. He then had readers guess the stock price. It was an amazing little experiment derived from a quote of Warren Buffett where WEB goes on to say he likes to guess the stock price before looking at the actual price when he analyzes investments.

As always, WEB was well ahead of his time. Much work and study from behavioral finance/economics, like that of Daniel Kahneman, discusses the effects anchoring has on each of us. If we see a stock price before valuing the company, we will unconsciously fix our valuation near the actual price.

Ever since Geoff’s original post I have been fascinated by the experiment. I even went as far as making an Excel program that would randomly generate ticker from the Russell 3000, display the financial information with ticker and price hidden. I could then go about valuing the company and check my work to see how I was doing.

(Distressed Debt Investing)

What’s the solution here?

 

Be Focused in Your Buying – But Omnivorous in Your Research

Should you buy a lot of different stocks? Analyze a lot of different stocks but don’t buy them? Or take the Peter Lynch approach and buy tiny amounts of many stocks just to keep them on your radar – then only load up on the ones you really love?

It’s a tricky question. To gain experience you need to do something similar over and over again. But it can’t be exactly the same. Otherwise, you will become experienced just at that one task. If you become an expert at analyzing Microsoft (MSFT) – you will know how to analyze Microsoft, not how to analyze stocks generally.

 

Use Real World Examples to Master Abstract Concepts

There’s another complicated issue that has to do with patterns.

I think two of the surest signs of real mastery of a subject are:

• Ability to talk fluently about the subject in everyday language without use of jargon; ability to use short sentences; having

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Why I Concentrate on Clear Favorites and Soggy Cigar Butts

Geoff here.

The choice between concentration and diversification is a personal decision. But it is also a process decision.

There is nothing wrong with having 50 positions – if you can do that well – or 20, or 10.

I think people fool themselves into thinking they need to have 25 or 50 ideas. But there is nothing wrong with choosing to have that many.

 

Our Investing Heroes Thought Longer and Traded Slower – Check Their Turnover

Ben Graham and Walter Schloss both owned more than 50 stocks for most of their careers.

However, they turned their portfolios over much less frequently than people do today. So, even when operating at what was for them a frentic pace, they were still probably only adding one new position a month. Certainly not much faster than that. And sometimes much, much slower.

I think there is a limit to how many amazing decisions you can make in a month, a year, etc.

Running a portfolio in a way that requires a good idea every couple weeks is far beyond my abilities.

 

Limit the Number of Good Ideas Required – Not Necessarily the Number of Stocks Owned

But there are many ways to solve that problem. You can increase concentration. You can increase how long you hold a stock. Or you can buy entire groups of stocks at once. Buying a group of stocks sometimes qualifies as a single decision. I bought 5 Japanese net-nets at once, because I did not know enough about Japanese business to discriminate between Japanese companies that were both:

1. Profitable
2. Selling for less than their net cash

So I just bought up 5 such stocks at once. That was my way of making really just one big decision – going more than 40% into Japanese net-nets – without actually having to put 40% or 20% or something into a single Japanese stock.

There was no Japanese stock I felt comfortable putting 20% of my portfolio into. And I did not know how to get comfortable doing that – having never visited Japan and not being able to speak Japanese.

Language was actually the least of my problems investing in Japan. The divide in business culture between Japan and the United States was my biggest problem.

Sometimes, this can be a big issue in Europe as well. Especially when analyzing some companies in southern European countries.

 

There are Little Exceptions Hiding Everywhere – Europe, Asia, the Midwest

But it is best not to paint countries with too broad a brush.

I think a foreign investor’s image of American business includes stock analysts, earnings calls, and press releases. But there are thousands of public American companies – often far from either New York of Los Angeles – that are as tight lipped as any company you’ll find in less bombastic parts of the world.

I have found Japanese companies with the kind of business culture an American can understand and I have found Portuguese companies with the …

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One Good Idea a Year is All You Need to Beat the Market

Geoff here.

Someone who reads the blog asked me a question about why I don’t just use Joel Greenblatt’s Magic Formula to invest instead of picking my own stocks.

This lead to a discussion of what kind of results you can achieve picking your own stocks.

It’s a question closely related to portfolio concentration. I’ve never figured out how to perform well while holding a lot of stocks. When I’ve outperformed the market, that outperformance has really boiled down to just a few decisions.

Over the last 3 years, I’ve averaged less than one such performance powering investment.

 

The Power of One Good Idea a Year

I started managing a new account in January of 2009. That’s close to the perfect timing imaginable for having good returns. So these numbers are wildly inflated over what anyone can expect in the future.

Because it’s a single account, I have exact results for each year. Here are my returns:

2009: 41%

2010: 33%

2011: 21%

YTD: 0%

You can see I’m underperforming the S&P 500 this year.

The average number of stocks I’ve held has been about 5. The highest I ever owned at once was 11 – and that included some positions that never reached the size I wanted. My lowest number of positions at one time was 1, but that was when the majority of the account was in cash.

My outperformance was driven entirely by a few major successes:

1. IMS Health
2. Bancinsurance
3. Sanjo Machine Works (and Japanese net-nets generally)

 

IMS Health

IMS Health was a fairly large – over $1 billion market cap – stock with a wide moat. It was selling for less than 10 times free cash flow when I first bought it. Eventually, it was bought out by a private equity firm.

 

Bancinsurance

Bancinsurance was a niche property and casualty insurance company. It usually had a combined ratio under 100. Meaning it made a profit on underwriting. Not just on its investments. It was selling at about 60% of book value when I first bought it. Eventually, the CEO bought it out.

 

Sanjo Machine Works

Sanjo Machine Works was a Japanese company. I first bought it around 50% of its cash.  Eventually, the CEO bought it out.

 

Japanese Net-Nets (Generally)

My Japanese net-net investments were a departure for me in that I diversified across 5 stocks at once. They did better in Japanese Yen than I ended up doing because the Yen fell against the dollar. They still did fine. Sanjo was the star performer. The rest had modest positive results in dollar terms.

 

3 Years of Outperformance Really Just Due to 3 Decisions

I made other investments over the last 3 and a half years. But very few of them mattered. There were no big losses. Many of the other investments slightly outperformed or slightly underperformed the market while I owned them. But, together, they were pretty much a wash relative to the stock market.

So, my entire outperformance …

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