Why Do You Sometimes Price a Stock Off of Its Free Cash Flow Yield Plus Growth Rate Instead of Just Using its P/E Ratio?
Someone sent Geoff this email:
Hamilton Beach Brands (HBB): A Simple Business and a Super Cheap Stock Facing a Tough Cash Situation in 2020
Hamilton Beach Brands (HBB) looks like a cheap stock. As I write this, the stock is trading at $8.71 a share. The company – or, at least the continuing part of the company now that Kitchen Collection is gone – earned anywhere from $1.50 to $2.00 a share over the last 3 years. That puts the P/E ratio at something like 4-6. Other ways to look at the stock include pricing it off of its EBIT or free cash flow. Over the last 5 years, the continuing portion of the company reported EBIT of between $33 million and $41 million. The company’s enterprise value is about $186 million (just take the market cap and add about $55 million in debt). So, that gives us an EV/EBIT ratio of anywhere from 5 to 6 times. Again, not expensive. A “normal” EV/EBIT ratio given today’s tax rates would probably be about 12 times. Free cash flow has averaged just under $30 million a year over the last 3 years. That gives you an EV/FCF ratio of about 6. All of these point to the stock being pretty cheap. The company also has a plan to one day achieve revenues of between $750 million and $1 billion and EBIT margins of 9-10%. It’s a long-term plan. But, a company that hit even the bottom end of that range could be worth closer to $800 million than the less than $200 million enterprise value at which Hamilton Beach Brands now sits.
The cheapness of Hamilton Beach Brands stock is the good news here. There is some bad news. And I’ll start with the news that concerns me the most – the balance sheet. On the one hand, Hamilton Beach has a solid balance sheet. Current assets exceed total liabilities. That’s usually a great sign. The company is always solidly EBIT profitable. However, it isn’t always very solidly cash flow positive. If we look at the make-up of Hamilton Beach’s balance sheet we can see why. At present, 38% of HBB’s assets are held in the form of receivables. 36% of assets are held in the form of inventory. Less than 1% of assets are in the form of cash. The company’s undrawn portion of its credit line is only about 20% of its total balance sheet as it stands now. In fact, the amount HBB can draw on that line is less than 50% of either its receivables or its inventory. Furthermore, HBB is a seasonal company. It does things like selling its receivables off and drawing on its credit line in a normal year. Normally, HBB builds up inventory during the first half of the year. Things turn around starting in the fall. And then the cash comes flowing in as we go through the holiday season. Will that happen this year? Hamilton Beach has already promised it will. The company had – as of December 31st, 2019 – promised to buy $210 million worth of inventory this year. That’s against …
Read moreWhy Shouldn’t I Count EPS Growth from Buybacks When Valuing a Stock?
Someone sent me this email:
…you mentioned Omnicom, and you said that per share numbers should be avoided when computing growth…as you mentioned Omnicom buys back its stock, therefore why remove this information I have about this company from the implicit hurdle rate? Suppose we have 3 companies: a historically savvy buy backer, an automatic buy backer and a company who doesn’t buyback, shouldn’t we be able to discriminate between them if they were to all have the same FCF yield?
Answer: It’s Best to Assume Future Growth in Earnings Per Share Caused by Buybacks Will Be Tied to the Price at Which Future Buybacks Are Done
The reason I said you shouldn’t use per share numbers is to avoid double counting. Here’s what I mean.
You buy Omnicom at a P/E of 8.6 and a dividend yield of 5%. You know free cash flow is normally equal to or greater than earnings per share. However, in a recession like the one we’re in now for Omnicom – it’s likely free cash flow will come in below reported earnings. This would happen if there was a decline in billings (similar to how an insurer’s “float” drops an insurer takes in less premiums this year than last year).
So, what does that P/E of 8.6 and dividend yield of 5% buy you?
What I’m worried about is investors saying: “Well, 1/8.6 = 11.6%. My earnings yield is 11.6% AND the company has grown sales PER SHARE by 5% a year over the last 10 years. So, My return is 11.6% + 5% = 16.6% for as long as I own the stock.”
Now, I don’t doubt your return if you bought Omnicom today and sold it in the future could be 17% a year or higher. However, you’ll get that return from multiple expansion. Without the P/E multiple expanding, you won’t make 17% a year in this stock.
Why not?
There are two ways of looking at this.
One, you CAN count the earnings per share growth (or sales per share growth if we’re avoiding looking at changes in EBIT margins) and count the dividend. However, if you count the EPS growth – you CAN’T count the money used on stock buybacks. So, it’s a question of EITHER credit the company’s use of stock buybacks as if it’s as good as a dividend OR count the growth in per share figures caused by stock buybacks, but don’t count the growth in EPS caused by the falling share count.
Personally, I prefer counting all of the free cash flow used on buybacks and dividends as your “hold” return in the stock. I have a good reason for doing this that has to do with timing an investment in OMC to maximize your returns.
However, it is theoretically permissible to do the calculations as:
Dividend Yield = 5%
Sales Per Share Growth = 5%
“Hold” Return = 10%
I think this undervalues the stock as of today. But, that is more consistent with
… Read moreHanesbrands (HBI): A Very Cheap, Very Leveraged Stock That’s #1 in an Industry that Changes So Little Even Warren Buffett Loves It
Hanesbrands (HBI) has gotten very cheap lately. In fact, the stock is back at prices that are pretty close to where it was spun-off from Sara Lee back in 2006. I talked a little about the stock back then. It was a spin-off I liked – I haven’t found many of those lately – and I’d assume the business has become more valuable over the last 14 years, not less. We’ll see if that’s true.
The business hasn’t changed much in 14 years. Hanesbrands acquired other businesses. It has grown in athleticwear. And it has grown internationally. However, a lot of this growth was acquired with the free cash flow produced by the innerwear segment. Hanesbrands divides itself into 3 parts: U.S. innerwear, U.S. activewear, and international. By my math, profit contribution is roughly 55% from U.S. innerwear, 25% from U.S. athleticwear, and 20% from international. All segments are profitable. And innerwear has seen shrinking profits over the last several years while international has grown (mostly through acquisitions).
Hanesbrands has a very strong brand position in U.S. innerwear and a pretty strong position in U.S. athleticwear. It also owns a lot of the top brands in various countries through acquisitions made to build up its international business. There may be some synergies between international and U.S. – but, they aren’t brand synergies. This gets into the issues I have with the company: 1) Acquisitions, 2) Debt, and 3) Management / Guidance etc. I’m not necessarily opposed to acquisitions, the use of debt, or management here. But, each of those 3 issues do complicate things a bit. For example, I’m not sure I like what the company has done in terms of acquisitions over the years – but, it’s hard to tell.
So, this is one area that changed over these 14 years. Originally, Hanesbrands seemed like it was interested in taking its core brands: Hanes, Champion, Maidenform, Bali, Playtex, Wonderbra, etc. and exporting them into other countries. This never seemed like a great strategy to me. Underwear brands are sold mostly as “heritage” brands. They’re like chocolate bars and breakfast cereal. There are countless countries around the world that have some very popular chocolate bar or very popular breakfast cereal that they’ve been eating since about 1900 or 1950 or whenever. They love it. The rest of the world hates it. It’s successful in their country. It flops everywhere else. Trying to convert someone who eats Cadbury to switch to Hershey – or trying to get an American to start eating Weetabix instead of Kellogg’s Cornflakes just isn’t going to work. These are commodity products. Do they taste a little different? Maybe. Is one brand of underwear a bit cheaper, a bit higher quality, a bit more comfortable, a bit more stylish – maybe. But, any of those things can and will be tweaked. Any company can invest in some different synthetics or different cotton, can do a slight bit of R&D work combined with a lot of consumer research …
Read moreQuestion: Why Are You 40% in Cash?
Someone sent Geoff this email:
I’m curious why the SMAs are 40% cash. Did that happen once you learned about the potential impact of the virus? Or was that the case beforehand? I know you were fully invested at some point last year, and I would have assumed your strategy was to stay fully invested. So you either sold things last year and never reinvested, or you went cash this year. I’m interested in anything you’d share.
Part of the reason I ask is I am curious how you are framing portfolio management during this turbulent time. I was fully invested coming into the year and didn’t go cash, so my portfolio, which has a decent amount of small-cap and a mid-cap financials that has gotten hit very hard, is down a lot. I’ve written down intrinsic value for some of these businesses, but they are still cheap. I’ve done just a little bit of “value trading”, either moving money to something the same quality but much cheaper, or similarly cheap but much more quality. And I first started seriously investing in stocks in 2015. So this is my first bear market. Psychologically I am doing fine – I’m not stressed or bothered. As I said, I’ve marked down some of my holdings in value but think the price declines have exceeded them. But my questions above are more aimed at understanding how you are thinking about structuring the portfolio in this sort of environment – I don’t have personal experience with this. Perhaps this is simplistic, but my basic strategy has not changed at all. I’ve always aimed to hold durable businesses, so I don’t feel any of my holdings face bankruptcy risk. So, the process is the same: keep holding businesses who offer attractive long-term returns and shift around when prices warrant doing so. But I haven’t gone cash or done a lot of trading yet. Would appreciate any thoughts you have on how to think about this environment.
Geoff’s answer: I’m A Lot More Concerned About Business Performance in 2020 and 2021 Than Most Other Investors and Experts Are
The decision to be 40% in cash was mainly NOT a decision made because of the virus. I had decided earlier this year – after making several mistakes in the past couple years – that I would stop trying to force myself to be 100% invested and only be invested if I liked the stock and the price. This is how I had run things when managing money for myself and others before. However, clients tend to prefer being 100% invested – or, at least, they tend to have strong opinions about how invested you are or aren’t. I’ve just bought so many stocks over the years that haven’t worked out well when I had more cash than ideas. If I was managing my own money – I might put 33% in each of 3 stocks and thus be 100% invested. But, for clients, we don’t do more
… Read moreBunzl (BNZL): A Distributor with 20 Straight Years of EPS Growth and 27 Straight Years of Dividend Growth – Facing a Virus That’ll Break At Least One of Those Streaks
Bunzl (BNZL) is a business I’ve known about for a long time. However, it’s not a stock I’ve thought I’d get the chance to write about. The stock is not overlooked. And it rarely gets cheap. EV/EBITDA is usually in the double-digits. It had a few years – the first few years of the recovery coming out of the financial crisis – where the EV/EBITDA ratio might’ve been around 8 sometimes. It’s back at levels like that now. Unfortunately, the risks to Bunzl are a lot greater this time around than in the last recession. Why is that?
First, let me explain what Bunzl does. This is actually why I like the business. The company is essentially like an MRO (maintenance, repair, and overhaul) business. It’s a little different from them. In fact, I think it’s a little better than businesses like Grainger, MSC Industrial, and Fastenal. But, it offers its customers the same basic value proposition: we’ll take the hidden costs out of you procuring the stuff you buy that isn’t really what your business is about. What do I mean by that? Well, with Bunzl – the company is basically a broadline distributor of non-food, not for resale consumables. So, you go to a supermarket. You get a bagel out of the little bagel basket, glass case, whatever in your supermarket – you throw it in a brown paper bag. Bunzl doesn’t supply the bagel. It supplies the brown paper bag. You pick out some tomatoes and put them in a plastic bag and add a little green wrapper to the top to seal off the bag – Bunzl might supply the clear bag and the twist thing, it won’t supply the tomatoes. Obviously, I’m using examples of stuff the customer might come into contact with. Bunzl actually supplies a lot of stuff you wouldn’t come into contact with that also gets used up. But, the point is that Bunzl is neither a manufacturer of anything nor a seller of anything that goes on to be re-sold. It’s a pure middleman. It buys from companies that produce products that businesses will use – but won’t sell. It does bid for these contracts (like Grainger does with its big accounts). But, it’s unlikely that the price of the items is the most important part of the deal. Stuff like whether the company can do category management, deliver direct to your door (or, in some cases, beyond your door and into your stores and factories and so on), order fill accuracy, order delivery speed, consolidating orders, consolidating everything on one invoice, etc. is important. The case for using a company like this is usually not that you save a penny on some product they buy in bulk – instead, it’s that you eliminate the work that would be done inhouse by finding a bunch of different suppliers, comparing prices, tracking inventory, etc. That’s why I say Bunzl is like an MRO.
However, Bunzl would normally be probably more resilient than …
Read moreGAN Plc – A Player Account Management Software providers for Casinos and Sports Gaming
GAN PLC
GAN is a supplier of internet gambling solutions to the US land-based casino industry. GAN has developed an internet gambling enterprise software system, which it licenses to land-based US casino operators as a turnkey technology solution to launch an online and mobile presence.
GAN has developed a Player Account Management (PAM) system where highly sensitive customer and player activity is stored and processed. A PAM, among other things houses all customer data within the state, bears responsibility for identity verification, processing payments, determining that the user is located in a place where gambling is legal, produces regulatory reports and is licensed by each states regulators, provides a dashboard to operators for monitoring purposes and integrates with third party online casino games and sports book, effectively serving as the accounting platform for the casino operator. In a way, the Player Account Management system is to an online casino what the core
processor is to a bank: An operating and accounting system that keeps track of all transactions. In addition to the PAM, GAN also sometimes develops the front-end interface for Online Casino, Sports Betting and Simulated Gaming websites and apps.
Other add-on elements of a platform can include a sportsbook transaction engine, gaming content, payment services, marketing services, trading services and other activities. Outside of the sportsbook, GAN supplies some of these services to some of its customers.
GAN primarily supplies this software in the US where an increasing number of states are legalizing online sports betting due to the Supreme Court of the United States issuing a ruling that struck down the Professional and Amateur Sports Protection Act (PASPA), the 1992 federal law that had prevented states from regulating sports betting. The passage of PASPA in 2018 left it to states to legalize online gambling activity, rather than gambling being regulated federally. After the passage New Jersey quickly legalized online gambling, followed by Pennsylvania, Indiana and Michigan. Other states are expected to follow suite.
GAN received a patent in 2014 for linking a US casino clients’ loyalty account to an online gambling account. The patent covers integration of both social casino gaming and real money gambling with casino loyalty programs and has licensed this patent to FanDuel for a five-year term in return for a Patent license fee.
GAN has several distinct revenue streams:
- Real Money Gaming Revenue Share (38% of revenues). This consists mainly of revenue share agreements with local casinos for running their online platform. This segment grew 103% YoY.
- License Revenue (27% of revenues). One-off licensing revenue mostly for licensing to Flutter plc. This licensing revenue derives from GAN plc’s technology and patents integrating loyalty programs with online gambling. Instead of subscribing to the entire GAN platform, these customers just license this specific part. While it is one off revenue , there are large casino groups that could benefit from licensing GAN plc’s technologies and patent.
- Platform development revenue (8% of revenues). These are one-off software development revenues that GAN receives for developing its online
How Can Long-Term Value Investors Make the Most of This Week’s Short-Term Volatility?
Andrew and I just did a podcast about volatility. And, of course, when we say “volatility” I want to remind everyone that’s a codeword for “downside volatility”. Nobody minds upside volatility. There are basically two topics worth discussing when it comes to volatility and how you as an investor should behave. One is how to “handle” volatility – psychologically and such. The other is how to take advantage of volatility. If we go back and think about Ben Graham’s Mr. Market metaphor – it’s really all about volatility. Mr. Market’s existence really only benefits you if he is giving you wildly different quotes over some period of time. Sure, it doesn’t have to be day-to-day. But, if all stocks are rising by similar, gradual amounts over time – a public quote for your shares doesn’t give you much benefit in selling one thing and buying another. You need either relative moves among stocks – where you own an airline stock down a lot and a healthcare stock that’s rising in price – or you need very different quotes on the same stock depending on the day. There’s an old article (but a good one) up on the Focused Compounding site that talks about the concept of “value trading”. This is where a value investor owns maybe 5 stocks he really likes for the long-run. But, in any given year – one of these stocks will rise a lot closer to his estimate of intrinsic value while others will fall. For example, Warren Buffett’s stock portfolio at Berkshire Hathaway rose something like 40% last year. Obviously, the underlying business’s earnings power barely budged. Maybe it rose 5%. Maybe not even that. You’ll notice that Berkshire’s wholly owned businesses didn’t have any increase in their operating earnings. I think Berkshire’s partially owned businesses did a lot better. But, they didn’t do 40% better. So, in a year like that, you have some of your stocks rising a lot closer to your estimate of intrinsic value while others don’t. The obvious example at Berkshire of a stock that rose far faster than its intrinsic value last year would be Apple (AAPL).
Now, Buffett can’t “value trade”. Or, at least, he shouldn’t try to. Buffett has to put more and more cash to work each month, quarter, and year. If he sells any of his Apple stock – he has to find somewhere else to put it. And, because he owns such big chunks of the public companies he’s in – that’s a problem. This is a problem even for much smaller investors. Andrew and I run a fund where we have allocations to specific stocks that are in part based on how much of the fund we’d like in those stocks – but, also partially based on simply how much of those stocks we can own. This issue mostly crops up when a fund has more assets under management than the market cap – or, at least, the “float” – of the company …
Read moreThe “Element of Compound Interest”: When Retaining Earnings is the Key to Compounding and When it Isn’t
In my first two articles about Warren Buffett’s letter to Berkshire Hathaway shareholders, I talked about Berkshire’s year-by-year results as a stock and about Warren Buffett’s approach to holding both stocks and businesses. Today, I want to talk about a very interesting section of Buffett’s letter that doesn’t (directly) seem to have all that much to do with either Berkshire or Buffett. This section starts with the name of a man Buffett has mentioned before “Edgar Lawrence Smith”. It also mentions a book review Buffett has mentioned before. In 1924, Smith wrote a book called “Common Stocks as Long Term Investments”. Keynes reviewed that book. He said two very interesting things in that review. The one Buffett quotes from this year goes:
“Well-managed industrial companies, do not, as a rule distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest operating in favor of the sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
This is obviously the most important concept in stock investing. It is the entire reason why stocks outperform bonds over time. Investors – even after this book was published – tend to overvalue bonds and undervalue stocks. Academics call this a “risk premium” for stocks. But, on a diversified basis – it doesn’t make a lot of sense to say it represents long-term risk. It does represent volatility. It also represents uncertainty as to the exact size of performance and the timing of that performance. But, in most years, there really hasn’t been a lot of uncertainty that a 25-50 year old putting his money 100% into stocks will end up with more value when he’s 55-80 than the 25-50 year old putting his money 100% into bonds. The market doesn’t usually undervalue the dividend portion of stocks. Sometimes it does. There have been times – most a very, very long time ago – where you could buy a nice group of high quality stocks yielding more than government bonds (and even less commonly, corporate bonds). To this day, individual stocks sometimes do yield more than bonds. I can think of a few countries (a very few) where you can buy perfectly decent, growing businesses yielding more than the government bonds in those countries (though this is usually due to very low bond yields, not very high dividend yields). And I could think of a few stocks that yield more than some junk bonds right now. But, there’s an important caveat here. The stocks that seem safe and high yielding retain very, very little of their earnings and grow by very, very low amounts. In other words, the element of compound interest is often smallest in the stocks with the highest …
Read moreHow Buffett Holds: The Incredible Importance of the “Contrasting Trajectories” of Long-Term Winners and Losers
In my first article about Warren Buffett’s annual letter to Berkshire Hathaway shareholders, I talked about how difficult it would’ve been to hold Berkshire stock during all the years when it rose so much so fast. That’s one underappreciated part of how successful Berkshire has been as an investment. Buy and hold often sounds like a simple strategy to follow. Berkshire has returned 20% a year compounded over more than 50 years. It would’ve been easy to hold the stock if it rose 20% a year every year. But, sometimes it got far ahead of itself – jumping 100% or more in price in a single year. And then, other times, the stock price lagged the intrinsic value gain for several years in a row. But, the long-term trend in Berkshire Hathaway’s results was one of compounding at about a ten percentage point a year advantage over the S&P 500. Today, I want to talk about a different underappreciated aspect of Berkshire’s compounding. Yesterday, we talked about how uneven the compounding was over time. Today, we’re going to talk about how uneven the compounding is in terms of sources.
Berkshire’s results are fueled a lot by its insurance operations. As an insurer, Berkshire tends to turn an underwriting profit. This gives Buffett a cost free form of money called float. Berkshire uses some of this float to invest in stocks and to buy entire businesses. The company uses its retained earnings to finance the rest of these two portfolios – one made up of private businesses 100% owned and the other made up of minority stakes in publicly traded companies. The underappreciated part of what Buffett does that we’ll be talking about today is exactly how he buys these businesses and these stocks. How he buys businesses is pretty normal. Most acquisitions done by big U.S. companies are done the same way. You buy basically 100% of a company using a combination of debt you raise, cash you have on hand, and maybe (Berkshire does this only occasionally) shares of your own stock. You make the purchase at one single point in time. Sometimes you might draft some kind of earn-out agreement where the former owners (who often stay on to manage the business you now own) make more money if the business they sold to you hits certain targets over the first few years you own it. But, that’s a very small part of the overall purchase price. We can simplify this by assuming you pay “x dollars” for the stock upfront in cash and then hold the business forever. That’s how most acquisitions work.
What a lot of investors don’t appreciate is that Buffett runs his stock portfolio a lot like he runs his stable of 100% owned businesses. Buffett buys and holds his shares in a company in a totally different way from almost any other investors out there. And this has some pretty big implications when it comes to just how the compounding of his …
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