Geoff Gannon January 7, 2006

On The Great Chicken Debate

Okay, so maybe it hasn’t quite risen to those proportions yet. But, if you’ve been reading this blog, or Shai’s blog, or the Value Discipline blog, you know there has been an ongoing debate about two chicken stocks: Sanderson Farms (SAFM) and Pilgrim’s Pride (PPC).

On January 5th, I suggested that investors should look at Sanderson Farms before looking at Pilgrim’s pride. Shai had invited me to put some of my stuff up on his blog. So, as this was a topic of both “Grahamian Value” and news value (on account of Pilgrim’s earnings warning/price drop), I sent the link over to Shai. He kindly ran it.

Now that would have been the end of it, but there was a comment made to the post ran on Shai’s site that prompted a post from Shai on blogging and investing. It’s a good post and an interesting topic, so I do encourage you to read it (for both posts on Shai’s site, the comments are worth reading as well). However, it really doesn’t have to do with The Great Chicken Debate.

It’s the comment itself that’s most relevant to this topic. In it, the author says a few words about Pilgrim’s Pride. Upon reading the comment, I decided I had no other choice but to take another look at PPC and SAFM (after all, maybe I was wrong). Well, I did take another good look at both companies, and decided I wasn’t wrong. So, I wrote a response to that effect.

The best part of all this was that it lead me to read some posts on Value Discipline, a blog which I am ashamed to say I was not familiar with. It’s a great blog; we need more like it. Of course, if you’ve been reading my blog, you already know that, because on January 5th, I posted a quick note mentioning this great blog and two posts about these chicken stocks.

Today, there’s a new post at Value Discipline entitled “Oh no…not chicken again!”. It’s the best thing I’ve seen written on this topic. Even I have to admit, it’s a far, far finer post than my original one.

I especially want you to note Rick’s use of the free cash flow margin (free cash flow as a percent of sales); this is an important metric, and one I have not yet discussed. It is of less utility over short periods of time and in commodity businesses. Well, that’s not exactly true. I should say it is of less utility in commodity businesses during a period of abnormal business conditions. However, it is an excellent number to use in comparing two or more competitors over a period of five to ten years.

I agree with everything in the post except perhaps with one slight omission. While it is true that interest coverage at both SAFM and PPC is ample at the moment, a review of both firms’ records will show that their …

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Geoff Gannon January 5, 2006

On Chicken Stock Posts

For those interested in more info on Sanderson Farms (SAFM) there are two good posts to be found at a worthwhile value investing blog called “Value Discipline”.

On December 5th, “Value Discipline” discussed Sanderson Farms in particular.

On January 5th (today), “Value Discipline” discussed Sanderson Farms, Pilgrim’s Pride (PPC), and leg quarter prices.…

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Geoff Gannon January 3, 2006

On Chicken Stocks

Chicken stocks were in the news yesterday as Pilgrim’s Pride warned of poor earnings. These stocks may appear cheap, but appearances can be deceiving. It is not a question of if margins will contract; it is a question of when margins will contract. Some value investors will take Pilgrim’s announcement as a buying opportunity. It may be just that.

However, I wouldn’t be buying Pilgrim’s Pride (PPC). When trouble comes, the much smaller, much more conservatively financed Sanderson Farms (SAFM) will be in the stronger position. Sanderson Farms has the better recent record when it comes to earning a good return on capital. On the other side of the scales, Sanderson Farms does trade at a higher price to sales ratio than Pilgrim’s Pride. In a business like this, price to sales can be an important number, because there is little reason to expect any one company to consistently maintain a wider profit margin than the rest of the industry.

I won’t pretend I understand this industry. I don’t. I won’t pretend I have any clue as to what these firms will earn over the next few years. I don’t. What I do know is that if I were looking at chicken stocks, I’d start with Sanderson Farms. I suggest you do the same.…

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Geoff Gannon January 2, 2006

On Formulaic Investing

One question almost every value investor asks at some point is whether it is possible to achieve above market returns by selecting a diversified group of stocks according to some formula, rather than having to evaluate each stock from every angle. There are obvious advantages to such a formulaic approach. For the individual, the amount of time and effort spent caring for his investments would be reduced, leaving more time for him to spend on more enjoyable and fulfilling tasks. For the institution, large sums of money could be deployed without having to rely upon the investing acumen of a single talented stock picker.

Many of the proposed systems also offer the advantage of matching the inflow of investable funds with investment opportunities. An investor who follows no formula, and evaluates each stock from every angle, may often find himself holding cash. Historically, this has been a problem for some excellent stock pickers. So, there are real advantages to favoring a formulaic approach to investing if such an approach would yield returns similar to the returns a complete stock by stock analysis would yield.

Many investment writers have proposed at least one such formulaic approach during their lifetime. The most promising formulaic approaches have been articulated by three men: Benjamin Graham, David Dreman, and Joel Greenblatt. As each of these approaches appeals to logic and common sense, they are not unique to these three men. But, these are the three names with which these approaches are usually most closely associated; so, there is little need to draw upon sources beyond theirs.

Benjamin Graham wrote three books of consequence: “Security Analysis”, “The Intelligent Investor”, and “The Interpretation of Financial Statements”. Within each book, he hints at various workable approaches both in stocks and bonds; however, he is most explicit in his best known work, “The Intelligent Investor”. There, Graham discusses the purchase of shares for less than two – thirds of their net current asset value. The belief that this method would yield above market returns is supported on both empirical and logical grounds.

In fact, the NCAV strategy currently enjoys far too much support to be practicable. Public companies rarely trade below their net current asset values. This is unlikely to change in the future. Buyout firms, unconventional money managers, and vulture investors now check such excessive bouts of public pessimism by taking large or controlling stakes in troubled companies. As a result, the investing public is less likely to indulge its pessimism as feverishly as it once did; for, many cheap stocks now have the silver lining of being takeover targets. As Graham’s net current asset value method is neither workable at present, nor is likely to prove workable in the future, we must set it aside.

David Dreman is known as a contrarian investor. In his case, it is an appropriate label, because of his keen interest in behavioral finance. However, in most cases the line separating the value investor from the contrarian …

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Geoff Gannon December 31, 2005

On Google’s Franchise (and McCormick’s)

I thought I’d end this year the way everyone else is: by writing about Google (GOOG). Just Google “the year of Google” and you’ll get some sense of the hype around this stock. Of course, if you’ve ever watched Jim Cramer’s “Mad Money”, you’ve already had a heaping spoonful of said hype.

So, why is a value investing blog even mentioning a stock that’s not far from having a triple digit P/E ratio?

I count seeking businesses with a competitive advantage among the tenets of good value investing. Google has a competitive advantage. In fact, one might even say its franchise is web search. I wouldn’t say that. I mean, Google does have a franchise; but, it doesn’t have a monopoly on web search and never will. There are real problems with Google’s model that are often overlooked. It does a poor job of finding certain sites that are difficult to describe in keywords. For this reason, there may still be a market for web search in the form of specialized niche directories and in some of these “social search engines” (e.g., Stumble Upon) for many years to come.

I’m not suggesting any of these services will be as successful as Google; I’m sure they won’t be. I am simply pointing out that there is a difference between a need and the means by which that need is satisfied. Even as the dominant search player, Google will only have a franchise on the means (keyword search); it will not have a franchise on the need (finding stuff on the web). Also, Google can not, at present, rightly be called the dominant search player. There is no dominant player in search. Google is the leading search player. It is also the catalyst for many changes in search. But, it is not yet the dominant player in search the way McCormick (MKC) is the dominant U.S. spice producer.

Looking at McCormick’s franchise is actually a pretty good way of evaluating Google’s. Why do I say McCormick is the dominant player (domestically) in spice, but Google is not yet the dominant player in search?

McCormick has a 45% share of the U.S. retail spice market. Its closest competitor has a 12% market share. We may differ about exactly how the web search pie is carved up. But, I think we can agree that Google’s share of the search market is no greater than 45%, and that at least two of its competitors have a share of the market greater than 12%. So, Google’s position differs from McCormick’s in that the domestic search market is less fragmented than the domestic spice market.

The spice market is an upside down funnel. The few producers are at the top. They feed their products through three distribution paths: retail, industry, and restaurants. In each case, the shape of the upside down funnel remains intact, because the widening happens at the very end. The ultimate consumer of McCormick’s product doesn’t get to choose …

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Geoff Gannon December 29, 2005

On Intrinsic Value

As promised here’s the snippet from Thurdsay’s Podcast:

The intrinsic value of a business can not be determined through clairvoyance or calculus, prescience or projections. For even the best projections sit precariously atop a mountain of complex assumptions. Determining the intrinsic value of a business requires simple arithmetic, common sense, and a careful analysis of the past performance and current financial position of the firm. Most importantly, it requires the separation of those things which are both constant and consequential from those things which are either mutable or meaningless.…

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Geoff Gannon December 28, 2005

On Newspaper Stocks

I admit I’ve been watching newspaper stocks with some interest; but, I am not yet convinced of anything. However, I can say to those who have not yet taken a good look at newspaper stocks that they ought to do so.

I have no greater insight into the future than those who are selling these stocks. But, I do know that at times like these, when a general consensus is reflected in the quotations of certain stocks, those few investors whose analysis is both correct and unpopular will be rewarded, if and only if, they have the courage to eschew the flock and act upon their own judgment.

While there are not as many stocks trading at astronomical evaluations as there were half a decade ago; there are not many cheap stocks either. This is not the sort of market you throw darts at. Newspaper stocks are a rare oasis of pessimism in a desert of optimism. Whether that pessimism is undue or not is a matter for you to decide.

If you’ve already considered this matter, please share your thoughts with us by commenting below. For those who have yet to delve into the matter, you’d best get started now. I can suggest five stocks of interest: Daily Journal CorporationGannettJournal Register CompanyJournal Communications, and The New York Times Company.

I’m not saying these are necessarily any more promising than the rest of the group. But, if you are looking for bargains, they are a good place to start.

Happy hunting.…

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Geoff Gannon December 26, 2005

On Conviction and the Value Gap

Recently, Tommy Hilfiger Corp (TOM) accepted an offer of $16.80/share from private investment company Apax Partners. Not long after hearing this, I was talking to someone who I had suggested the stock to almost a year ago. I asked him if he still had his shares. “No”, he said – he’d already sold.

Now, it would be easy to let the blame for this rest solely upon the impatience of that investor. However, I have to admit I deserve the lion’s share. You’ll rarely be successful buying a stock on someone else’s advice unless you understand the logic behind the purchase. I did a god awful job of explaining the logic behind buying shares of Tommy Hilfiger.

I never believed Tommy Hilfiger was a great company. Nor, did I have any illusion it would perform well in the long – run. I simply recognized that the company was selling for less than it was worth. All the profit from such a purchase would be derived not from the firm’s ongoing success but from a one time increase in the stock to close the value gap (between the market price of the stock and the intrinsic value of the business). As you can see on the right side of this three year stock chart for Tommy Hilfiger, that’s exactly what happened.

My mistake was confessing my lack of confidence in Tommy’s future prospects, without adequately explaining why this investor needed to hold onto those shares. I should have insisted upon showing him a balance sheet and statement of cash flows; I should have explained to him why the intrinsic value of the business still exceeded the market price despite the firm’s mediocre prospects. I didn’t. I just told him it was cheap, but it wasn’t a company I had any confidence in going forward. That was a terrible mistake.

Whenever you make a stock purchase for yourself or (in my case) when you recommend a stock to someone else, you have to clearly and simply state the argument that the intrinsic value of the business far exceeds the going price. In the case of Tommy, that argument was very clear to me, but not to the investor I was talking to. That’s because while estimates of Tommy’s discounted future cash flows were etched into my mind by the process of research and analysis, I never explained to this poor investor why there are times when the purchase of a mediocre or even sub par business can make sense.

I could have, and should have, taken the statement of cash flows and Tommy’s market cap, written them down on a piece of paper, and circled the value gap that was so clear in my mind. I didn’t. Remember, clarity and honesty are essential to good investing.

You can purchase a stock expecting your returns to come entirely from a one time run up that erases the value gap. As long as you’re honest with yourself – that is,

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Geoff Gannon December 24, 2005

On Business Risks and Market Risks

Investors in stocks are faced with two very different types of risks: business risks and market risks. Business risks can be managed through selectivity and spatial diversification. First, only the best (and best understood) firms are selected. Then, an investment is spread over several of these firms to ensure that the very small risk of a loss of principal inherent to each of these stocks does not adversely affect the portfolio. Five to ten stocks are more than adequate, provided they are businesses of the finest quality obtained at bargain prices. Market risks should not be combated with spatial diversification, because this forces the investor to accept issues of inferior quality. Instead, market risks must be managed through temporal diversification. Eventually, the market will recognize a firm’s intrinsic value. Therefore, a superior business will always command a superior price – in time. As long as an investor can hold a stock forever, he needn’t worry about market risks, and can devote himself entirely to an analysis of business risks.…

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Geoff Gannon December 23, 2005

Against The Top Down Approach

If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for a moment, you will recognize how truly foolish it is.

A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high – yield bond.

Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.

All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical. Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it’s false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he’s comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher’s handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher’s handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You needn’t determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is

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