Geoff Gannon September 10, 2015

Boredom Is a Good Friend of Long-term Investors

Geoff said in the last post that: “simply learning to love illiquidity, boredom, and a lack of headlines in your portfolio might be enough to improve your returns.” The key word is boredom. I think 3 main reasons for a stock to be boring are low growth, lack of catalyst, and a so-so price. A stock with these characteristics is not attractive to growth investors, value investors, and momentum investors. But sometimes these characteristics hide qualities that can generate great long-term returns.


Quality of Growth

I once made a bold statement that Frost promises the best growth investors can find. I think that Frost can have 7-8% growth for the next 20-30 years and I don’t normally find a stock with such high growth potential. My friend was surprised at my claim and he said “you can’t say that because 20% growth is a certainty for companies like Valeant!” What he said represents the attitude towards growth of most people. To them, a single-digit growth isn’t stellar. To me, 7-8% growth is a treasure. That doesn’t mean I’m less demanding. I’m just focused more on quality of growth.

Low growth can be valuable if ROIC is high. Let’s compare Bristow, Frost, and Omnicom.

Over the last 10 years, Bristow’s revenue almost tripled from $674 million in 2004 to $1,859 million in 2014, which translates into an 11% annual growth rate. Annual sales growth was always higher than 10% except for the “bad” years between 2009 and 2011. The problem is that pre-tax ROIC is just about 9%. So, Bristow had to use debt and equity to finance growth. Over the period, net debt increased by $650 million. Share count increased by more than 50% from 23 million to 36 million mostly as a result of the issuance of $223 million in convertible preferred stock in 2007.

Frost is a better business. Frost grew deposits from $7,767 million in 2004 to $22,053 million in 2014. That means intrinsic value has compounded annually by 11% over the last 10 years. Unlike Bristow, Frost can make 18-20% ROE. So, Frost was able to return 40% of total earnings over the last 10 years.

Omnicom is even better. Omnicom grew sales by 5% over the last 10 year while returning 110% of earnings to shareholders. Omnicom doesn’t need to retain earnings to grow. It actually received about $1 billion from the decrease in its negative working capital over the period.

Omnicom’s 5% growth can be as valuable as Frost’s 8% growth.  If we pay 20 times after-tax earnings for both stocks, we can get similar returns. Omnicom can give us 5% growth and 5% yield, adding up to 10% total return. Frost can grow 8% while paying out 50% of earnings. So, it can give us 8% growth and 2.5% yield, adding up to 10.5% total return. A similar calculation shows that we can get 11.67% total return from Omnicom and 11.34% return from Frost if we pay 15 times after-tax earnings for both stocks.

So, growth can be more valuable than numbers suggest. Adjusted for quality, Omnicom’s 5% growth is equivalent to Frost’s 8% growth, and is much superior to Bristow’s 11% growth.

Consistency also contributes to quality of growth. Geometric means are always smaller or equal to arithmetic means. Therefore, low-growth years tend to pull compounding growth more than high-growth years. In other words, of two firms with the same average (arithmetic mean) growth, the one with more consistent growth has the higher compound annual growth rate.

To illustrate this point, let’s look at Frost’s deposit growth over the last 10 year and Select Comfort’s sales growth from 2002 to 2012:

Frost’s annual growth: 13% 11% 3% 18% 13% 8% 14% 11% 14%

Select Comfort’s annual growth: 37% 22%    24% 17% -1% -24% -11% 11% 23% 26%

Over the 10-year periods, Frost’s average growth was 11.8%, and compounding growth was 11.0%. Select Comfort’s average growth was 12.3% and compounding growth was 10.8%. Select Comfort’s growth looks fancy. It was higher than 20% except for recession years. But Select Comfort’s average compounding growth was actually lower than Frost.

A serial acquirer like Valeant may have a great platform to create value from acquisitions. But we never know when the party will end. At some point, smaller acquisitions can no longer move the needle. Bigger acquisitions can be more expensive. The company may become too big for adequate management. So, Valeant’s growth is repeatable but not predictable.

I prefer companies with consistent growth drivers. Some drivers are company-specific and some are external.

Store expansion is a reliable internal growth driver. If a company is disciplined in picking new locations that fit its model, and if it successfully replicates its competitive advantage, performance will be consistent. Growth is predictable. We can pick a conservative number of stores the company can open, and pick a conservative number of years for it to fill in the opportunities. For example, America’s Car-Mart (CRMT) will keep opening stores in small town with populations from 20,000 to 50,000 in South-Central states. It has huge competitive advantages over mom-and-pop operators in these areas. Car-Mart now has 141 locations. It may double store count in 10 years. So store openings can lead to 7.2% growth. With 3-5% same-store sales growth, it can have double-digit growth for the next 10 years.

The driver I’m most comfortable with is market share gain. Some companies have durable weapons to consistently gain market share. For example, Progressive (PGR) and Geico have low-cost advantage to gain market share almost every year. Industry growth is usually predictable so betting on market share gainers allows me to sleep well at night.

Industry tailwinds can make market share gainers more attractive. For example, banking is a better business than car insurance. Total deposits tend to follow GDP growth while car insurance policies face deflationary pressure as technology reduces accident frequency. Texas GDP grows about 1% faster than the U.S. GDP so banks in Texas have 1% higher growth than the average U.S. bank. Frost is a great franchise in Texas. It’ll keep growing its relationships with small businesses. It’ll keep attracting consumers for being a Texas bank and for great customer service. So, it’s safe to expect 7-8% annual growth far into the future.

Omnicom also benefits from changes in the industry. Marketing budget is stable as a percentage of sales at most companies. So, total marketing spending tends to follow GDP growth. However, marketing is becoming more and more fragmented due to the rise of new channels like online, mobile, social media, etc. Marketing spending will shift from traditional media to new mediums. That means more and more work for agencies. Omnicom has done a great job at building new capabilities or making small acquisitions to serve client needs. Another trend is that marketers want to deal with fewer vendors, leading to account consolidation. These two trends allow Omnicom to capture more % of clients’ spending over time. So, Omnicom’s organic growth is about 1% or 2% higher than GDP.

Margin expansion can make growth better than it looks. Margin expansion usually happen when gross margin is high, price competition is low, and fixed cost is significant. Watches are a good example. A watch isn’t a timepiece. It’s a fashion piece or a jewelry piece. Watch brands don’t really compete on price. People have a price range for their watches and they choose the brand and style they like most within that range. So, even cheap Chinese made watches that Fossil (FOSL) sells have 50-60% gross margin. Fixed costs of designing, distributing and advertising watches for a brand are quite significant. So, bigger brands have higher margin. Fossil’s 16% EBIT margin is higher than Movado’s 12% because Fossil has higher revenue per brand.

Within Fossil, Michael Kors possibly makes 30% EBIT margin. Revenue from Michael Kors watches was over $900 million last year. But Michael Kors can be a fad. It can rise and fall, and has a big impact on Fossil’s EBIT margin.

Margin expansion is better when combined with consistent growth. It causes EBIT to grow faster than sales. So, mid-single digit sales growth may mean high single-digit earnings growth. Of the candidates I’m looking at, Grainger (GWW) is potentially a company with both margin expansion and consistent growth. If that’s true, it can have low double-digit earnings growth for many years and deserves a high multiple.

So, investors should be skeptical of high growth, and be positive about low growth. High growth can be a problem if it’s unpredictable and leads to high expectations and thus a high multiple. Low, boring growth can be a treasure if it’s consistent and supported by high ROIC and margin expansion.


Lack of Catalyst

A lack of catalyst can cause even value investors to neglect a stock. Two of the least controversial stocks we’ve analyzed are Progressive and Frost. Most people agree on their moat and quality, and most don’t think the stocks are cheap. Geoff and I didn’t realize how cheap they were until looking deeply at them. Higher interest rates can be a catalyst but most responses I get from people are “interest rates may stay low for a while” or “how quickly earnings will increase?” What’s interesting is that no guru owns these stocks while many own Wells Fargo. According to Morningstar, most concentrated shareholders are ETFs or institutions that put a small % of total portfolio into Frost. So, it’s possible that most professional investors just look casually at the stock.

I’m not sure how important catalysts are. It’s easy to imagine catalysts and get excited. People tend to overestimate the chance of catalysts happening and underestimate the chance of unexpected events. In my short experience, I’ve seen stocks we’ve picked like Ark Restaurants (ARKR), PetSmart, and Lifetime Fitness get acquired or buyout offers. Such events happened more often than I expected.

I don’t think there’s any problem with the lack of a catalyst. Time is such a good friend that good businesses don’t need a catalyst. We’ll do fine as long as we buy businesses that can compound intrinsic value.

That said, I do see catalysts work in some special situations. Sometimes catalysts are playing out but the market is so inefficient that the stock price doesn’t reflect the ongoing developments. That’s true for the two best performing stocks we picked this year: Babcock & Wilcox and Breeze-Eastern (BZC). Babcock returned about 30%. Breeze-Eastern returned about 22% since our issue on the stock was published, and about 40% since when I began analyzing the stock in May.

Babcock is a spin-off. I’m really surprised because value investors follow spin-offs closely. I started analyzing the stock in October 2014. There were several presentations about the spin-off and I was worried that the price would move a lot before we published the issue. Yet, it stayed flat for months. And then it worked out exactly as Joel Greenblatt taught us about spin-offs: the good Babcock (BWXT) is expensive at 13.4x EV/EBIT, and the bad Babcock (BW) is cheap at 5.4x EV/EBIT.

Breeze-Eastern was lucky timing. I analyzed the stock when it was finishing some long-term projects. So, R&D expense was going down and revenue was ramping up. Years of under-earnings were coming to an end. Anyone could expect Breeze to make more profit. But few people acted until it released quarterly earnings.

It’s worth noting that some investors (who are now among the company’s biggest shareholders) bought Breeze-Eastern on the same thesis in 2011. But they had to wait until 2015. So, I was lucky to analyze Breeze-Eastern in 2015 when I saw that R&D had been declining.

Right now I think Ekornes is another special situation. Ekornes keeps most production in Norway. A lot of cost is in Norwegian Krone (NOK). But Ekornes gets 95% of revenue outside of Norway. So, most of revenue is in U.S. dollars, Euros, or other currencies. For years, Ekornes was badly impacted by the overvalued NOK. But the recent crash in oil price caused NOK to decline against U.S. dollars and Euros. On the surface, currency is a risk. American investors buying Ekornes today may sell Ekornes and convert into fewer $ if NOK weakens. But weaker NOK is actually a boon for Ekornes because revenue in $ or € will be converted into much more NOK while costs in NOK won’t change. As a result, margin can expand by a huge amount, and the NOK-based stock price appreciation will far outweigh NOK valuation.


So-so Price

Value investors can have different styles but they all buy stocks on the same principle: they minimize downside.

Buy-and-hold investors seek safety in business quality. They ask themselves if they buy a stock at current market price and hold forever, what is the very conservative expected return they can get? If the expected return is adequate – say 10% – the stock is very safe.

How can they make more than 10%?

They can get more than 10% return as long as they buy a good business at a lower than average price. Sometimes they’re luckily to buy a good stock very cheaply. For example, paying 10 times unlevered P/E for a business that can grow 5% while paying out all earnings can result in 15% total return. More realistically, they can only buy at 12-15x unlevered P/E. That’s still good because the stock – if it’s truly a good business – will soon trade at the normal 18-20x P/E. Even if it takes 3 years for the multiple to expand from 15x to 18x, the expansion still generates 6.3% annual return. Adding 5% annual growth and 6% cash return results in over 17% annual return.

So, just like growth, price can be better than it looks if we consider quality.


Low Expectation

One great lesson I learnt from Geoff is to keep expectation low. He says if he does everything right, he might be able to get 10% a year long-term.

I do think that keeping expectation low is the key to learning to love boredom. 10% sounds low to most investors. Investors like things that can double in 2 or 3 years. In pursuit of high return, they embrace dirt-cheap price or fancy growth. My view is that there’s no certain 20% return. Big upside comes with high risk. There are a few certain 15% returns. And there are some certain 10% returns. So, I stay with such certain boredom. If I’m lucky I can get 15-20% return in my career. But without luck, I can still make 10%. I’m really comfortable with luck-independent 10% return.