Buy Unrecognized Wonder; Sell Recognized Wonder

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

–          Warren Buffett

Richard Beddard has an excellent post worrying about whether the stocks in his Share Sleuth portfolio are becoming too popular.

I want to use his post as an opportunity to talk about how an investor – or, at least an investor like me – needs to cycle out of stocks that are getting recognized for what I believe them to be and into stocks that aren’t getting recognized for what I believe them to be.

I like “wide moat”, predictable businesses. But, I can’t afford to pay the kind of prices that stocks with recognized moats and recognized predictability trade for. So, I need to find unrecognized moats and unrecognized predictability.

The top three stocks I own are: NACCO (NC), Frost (CFR), and BWX Technologies (BWXT). The best performer among that group is BWX Technologies. That good performance is the result of increased recognition of what BWX Technologies is. When I bought Babcock & Wilcox pre-spinoff (and then later sold my BW shares but kept my BWXT shares) I was seeing the company differently than the market was. Today, the market sees BWXT the same way I do.

Let’s look at this in chart form.

Today, the market values BWX Technologies about 120% higher than it valued the combined Babcock & Wilcox. The stock you are seeing here spun something off (so it disposed of value) and yet it still more than doubled its market price.

The stock now has a P/E of 32. The return here is due to multiple expansion. BWX Technologies – as part of Babcock & Wilcox – went from being valued as an average company (a P/E around 15) to being valued as a wide-moat, predictable company (a P/E around 30). BWXT’s biggest business is being a monopoly provider to the U.S. government under cost plus contracts indexed to inflation. That’s not new information. The market just sees the same old information differently now that BWXT is reporting its own clean, independent EPS and giving long-term guidance for EPS growth as far as 3-5 years out.

The price on this stock (a P/E of 30+) indicates the market sees this business much the way I see this business. If we have the same understanding of the business – it’s time for me to consider selling.

Now, I don’t sell a stock just to have cash. But, if I want to buy anything new – I should buy something that’s a wide-moat, predictable business that has yet be recognized for being that and fund the purchase by selling BWXT which is also a wide-moat, predictable business but is now recognized as such.

The next chart is Frost. You can read an explanation of how I see the stock here.

The stock has about doubled. Here, though, it is not appropriate to use the P/E ratio for Frost (because earnings rise faster than deposits as interest rates rise). The better way to value Frost is price-to-deposits. So, that’s share price divided by deposits per share. For Frost we use “earning assets” – which are loans, bonds, and money left at the Federal Reserve – as a proxy for deposit funded assets. At Frost, these assets are about 93% funded by deposits (the rest is funded by shareholder equity). When I bought Frost, it had about $25.91 billion in earning assets and 63.18 million shares outstanding. So, it had $410 a share in earning assets. I bought at a price just under $50 a share. So, I paid 0.12 times earning assets ($50 / $410 = 0.12). Today, the bank has $28.34 billion in earning assets and 63.16 million shares outstanding. So, it has $449 in earning assets per share. The stock price is just under $98 a share. So, the market now values Frost at 0.22 times its earning assets ($98 / $449 = 0.22).

Again, the rise in the stock price is due to multiple expansion. Frost’s stock price is now 96% higher than when I bought it. However, the amount of earning assets per share is just 10% higher. Where did the other 86% increase in market value come from? The market now values Frost at 0.22 times its earning assets instead of 0.12 times its earning assets.

So, has the market fully recognized what I saw in Frost about two years ago?

Not fully, no. In the report I wrote on Frost, I said that a valuation of 0.35 times earning assets (not 0.22 times like today) would be appropriate for Frost in “a normal interest rate environment”.

That phrase is key. Frost trades at a P/E of 19. So, it is fully recognized as a good bank given today’s interest rates. However, I believe a “normal” Fed Funds rate is about 3 times today’s Fed Funds Rate. I see a 3% to 4% Fed Funds Rate as normal. The market does not. So, the market doesn’t yet see Frost quite the same way I see Frost.

Since the market doesn’t fully recognize everything I see in Frost – the way it does with BWXT – I should cling harder to my Frost shares than I would to my BWXT shares.

What would cause me to sell Frost?

Well, we have a good example of that. About a month ago, I got the chance to buy NACCO at $32.50 a share. I sold one-third of my Frost shares to help fund that new position.

What does this mean?

It means I think I see something in NACCO that is not as recognized by the market as what I see in Frost.

Do I like NACCO better than Frost?

That’s not the right way to ask the question. The market operates on a handicapping system. Everyone thinks Netflix has a brighter future than Viacom – they “like” Netflix better as a business. But, Netflix stock is saddled with an incredibly high price (its enterprise value is more than 8.2 times sales) while Viacom isn’t carrying much weight at all (its enterprise value is 1.5 times sales). The question is whether Netflix can outrun Viacom when Netflix is carrying more than 5 times as much weight.

So, what’s the right question to ask?

You can ask – at the same price – would I prefer BWXT over Frost and Frost over NACCO?

Probably.

But they’re not at the same price.

NACCO is my biggest position, Frost is my second biggest position, and BWX Technologies is my third biggest position – because I think the market recognizes all of what I like about BWXT but only recognizes some of what I like about Frost and doesn’t recognize any of what I like about NACCO.

It’s a great goal to own the best businesses you can. But, you can’t afford to pay the price everyone else pays for wonderful businesses and still hope to do better than everyone else.

Don’t just look for wonderful businesses. Instead, look for businesses where you see something wonderful about them that the market doesn’t yet recognize.