Capital Allocation Collection – Focused Compounding

Geoff Gannon May 1, 2023

How Acquisitions Add Value – Or Don’t

Someone emailed me this question:

How do you think management should analyze acquisition opportunities? For example, how would you like the management of companies you own to think about them and decide to acquire or not (acquire) a company? Because they could, say, value the companies and determine if they are undervalued or overvalued… also they can make the value of them increase by making changes (e.g., such as Murphy did at Capital Cities by significantly increasing the operational efficiency of acquired companies and Buffett did at See’s by exploiting its untapped pricing power) and so on.

It depends on the company and their approach. The best acquisitions are often horizontal mergers where the company (for example, one rolling up smaller businesses in its same industry) acquires companies that have similar distribution channels, customers, suppliers, etc. and may increase market power this way. There are often cost synergies (especially economies of scales in sharing fixed costs across acquired businesses) in this sort of merger. So, a merger might be done at a high price relative to the acquired company’s previous EBITDA, earnings, etc. but at a reasonable price after these synergies are achieved.

The problem with many mergers (including the above) is that the price paid by the acquiring company is often so high that the benefits of the synergies are really being paid to the selling shareholders from the acquired company rather than being captured by the acquirer. For example, I’ve seen cases where a company pays about 12x EBITDA for a business and probably gets the business at about 5x EBITDA after synergies. The selling shareholders are getting 12x EBITDA. The buyers are – if all goes well – getting something purchased at 5x EBITDA which can work if the company uses debt, cash, or overvalued shares to fund the acquisition. If they use undervalued stock, it doesn’t work well.

It might seem like this “cost of capital” factor couldn’t be a deal killer when you’re getting something for 5 times EBITDA after synergies. Management might think this too. The synergies here are so huge – an EBITDA margin of 10% pre-acquisition is going to become 25% post-acquisition – that the currency used to do the deal can’t possibly matter enough to ruin the deal, right? Actually, it still can. For example, the acquirer I mentioned that has done deals like this has actually traded in the market at 5 times EBITDA itself at times. So, even deals where it feels 80% certain it can immediately take the EBITDA margin of the target from 10% to 25% don’t actually clear the company’s own opportunity cost hurdle. Its own stock without any added synergies is actually cheaper than buying something with boatloads of synergies.

In such cases, the company would be better buying back its own stock at 5 times EBITDA than buying something and doing all the work of integrating it – and taking on the real risk integration won’t work quite as well as hoped – just …

Geoff Gannon June 21, 2022

Warren Buffett’s “Market Value Test” – And How to Use It

Someone who listens to the podcast wrote in with this question:

“…(in a recent episode) you mention that you want to know if the capital allocation has created value or not. I was wondering how you do this kind of exercise practically? Do you look at the increase in book value/equity over time and compare that to the average ROE? When book value increased far less over a certain period of time compared with the historical average ROE I suppose that is a sign of bad capital allocation, right? Or do you have a different approach?”

(ASK GEOFF A QUESTION OF YOUR OWN)

There’s no one right approach that is going to work in every situation. The simpler the company and its business model, the easier it will be to see if capital allocation is working. For example, the stock price may tend to follow the earnings per share and the earnings per share may be driven in part by the capital allocation. That would be the case at a company that acquires other businesses for their reported earnings, issues stock, and/or buys back stock. Earnings per share captures all of that.

But, what if you were trying to analyze Berkshire Hathaway (BRK.B) or Biglari Holdings (BH)? In these cases, management might be allocating capital at times to increase earnings per share and at other times in ways where the value received for the capital outlay is not going to appear in the income statement. If capital is allocated to buying stock, land, etc. EPS may not be helpful in evaluating capital allocation. Now, book value would be a good way to analyze those capital allocation decisions. However, at companies like Berkshire Hathaway and Biglari Holdings you have a mix of operating businesses and investments. The operating businesses are held at unrealistic values for accounting purposes – so, an EPS approach works for judging them, but a book value approach doesn’t. And the investments may be held at realistic values for accounting purposes (they’re marked to market) – however, the underlying (“look-through”) earnings won’t show up when judging the EPS growth of the business. As a result, a pure EPS based approach to judging capital allocation will work for part of these conglomerates and fail for the other part. And a pure book value approach will work for judging capital allocation for part of these conglomerates and fail for another part. You need a mixed approach.

Buffett basically suggests this when he used the “bucket” approach for analyzing Berkshire Hathaway. He did this in some past annual letters. You take operating earnings per share (which excludes investment earnings and insurance underwriting). And you take investments per share. Operating earnings per share is a “flow” number. It needs to be capitalized to translate it into a figure that can be combined with investments per share. Investments per share is a “stock” number. You can either look at it as a “stock” number (which makes sense when trying to come …

Geoff Gannon September 24, 2020

Dividends and Buybacks at Potentially Non-Durable Businesses: Altria (MO) vs. NACCO (NC)

A Focused Compounding App subscriber had a question about something I said in a recent podcast:

“In your recent podcast you said you thought a tobacco firm should buy back its own stock rather than pay dividends – you said you don’t think it should pay a dividend at all and instead should avoid acquisitions and buy back its stock.

Could you expand on that?

This is somewhat similar to NC, actually, and why this stood out to me. You’ve told me before why you don’t want to see NC buy back stock (although now that we’re in the upper teen price range you may feel differently), because the coal business is challenged and shrinking. I think we may be able to agree that US lignite coal has a shorter life than cigarettes. But still, it seems directionally the same sort of situation with a dying cash generative business.”

I feel cigarettes are a much safer business than lignite coal. Much more durable.

I could be very wrong about this. But, it’s about the extent to which it is integrated into society and the difficulty of removing that. Decades ago, I would have had much more serious doubts. But, the fact people keep smoking cigarettes in the numbers they do even when there are plenty of other methods of getting nicotine widely available now, strong inconveniences to the actual smoking of cigarettes, higher pricing (including taxes) on the people buying the cigarettes relative to their income, etc. It just shows me the durability of cigarettes specifically – as opposed to just nicotine consumption generally – is much higher than I might have guessed decades ago.

This isn’t true with lignite. You are depending on a few corporations as customers instead of millions of consumers. They are eager to substitute to other kinds of power if it is roughly equalized. The customers are probably more rational – more open to considering alternatives. With cigarettes, we’ve seen continued use of cigarettes even when people could substitute to smokeless tobacco, vaping, etc. and even with increasing laws making life less convenient for smokers and rising prices. So, clearly, the degree to which there is seen as being “no substitute” to cigarettes is really high vs. the extent to which there is seen as being “no substitutes” to lignite. Lignite is seen as easily substitute-able. Cigarettes are seen by many customers as having absolutely no substitutes.

Now, it is true that I may have exaggerated the idea of just buying back stock – not paying any dividends – in a cigarette company, because if they never diversify at all by product (at least into other tobacco products) or by geography they could have a meaningful risk of losing everything. There is some risk that cigarettes could actually be outlawed in a single jurisdiction like the U.S. So, you can never have a 0% risk of losing everything if you don’t borrow, don’t pay dividends, but just buy back your stock. I think the risk …

Geoff Gannon July 26, 2020

Surviving Once a Decade Disasters: The Cost of Companies Not Keeping Enough Cash on Hand

A couple days back, I read Tilman Fertitta’s book “Shut Up and Listen”. The book is short. And it’s full of a lot of basic, good advice especially for someone looking to build a big hospitality business (which is what Fertitta did). What stood out to me is how practical the book is about stuff I see all the time in investing, but rarely gets covered in business books. The best example of this is a chapter on “working capital”. Value investors know the concept of working capital well, because Ben Graham’s net-net strategy is built on it. But, working capital is also important as a measure of liquidity.

A lot of value investors focus on the amount of leverage a company is using. The most common metric used is Debt/EBITDA. Certain Debt/EBITDA ratios are considered safe for certain industries. It might be considered fine to leverage a diversified group of apartment buildings at Debt/EBITDA of 6 to 1 but risky to leverage a single cement plant at Debt/EBITDA of 3 to 1. There is a logic to this. And some companies do simply take on too much debt relative to EBITDA. But, that’s not usually the problem that is going to risk massive dilution of your shares, sales of assets at bad prices, bankruptcy etc. in some investment. The usual issue is liquidity. If you borrow 3 times Debt/EBITDA and keep zero cash on hand and all your debt can be called at any time within 1-2 years from now – that’s potentially a lot riskier than if you have borrowed 4 times Debt/EBITDA and are keeping a year of EBITDA on hand in cash at all times and your debt is due in 3 equal amounts 3, 6, and 9 years from today. The difference between these two set-ups is meaningless in good times. As long as credit is available, investors who focus only on Debt/EBITDA will never have to worry about when that debt is due and how much cash is on hand now. However, at a time like COVID – they will. Times like COVID happen more often than you’d think. Fertitta is in the restaurant business. He’s seen 3 liquidity crunches for restaurants in the last 20 years. There was September 11th, the collapse of Lehman Brothers, and now COVID. He got his start in the Houston area. Not much more than a decade before the first 3 of those events I listed above – there was a collapse of the Texas banking system that resulted in a lot of Texas banks (and all but one of the big ones) closing down. That was also a possible extinction level event for restaurants in the state. So, using Fertitta’s 30-40 years in the restaurant business as an example, extinction level risks that depend on a restaurant company maintaining some liquidity to survive seem to happen as frequently as once every 10 years. When looking at a stock’s record over 30 years – the difference between a …

Geoff Gannon February 24, 2020

The “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 …

Geoff Gannon February 22, 2020

Ask Yourself: In What Year Would You Have Hopped Off the Warren Buffett Compounding Train?

Warren Buffett’s annual letter to Berkshire Hathaway shareholders was released today. It starts – as always – with the table comparing the annual percentage change in Berkshire Hathaway with the annual percentage change in the S&P 500 with dividends included. Long time readers of the Buffett letter will remember when the change in book value of Berkshire Hathaway was included. That’s been removed. We are left with the change in per-share market value of Berkshire Hathaway.

Today, I’m just going to focus on this table. Over the next few days, I’ll talk about a few different parts of Buffett’s letter I found interesting. But, one of the most interesting pages in the letter is the very first one. The one with the table showing Berkshire’s performance vs. the S&P 500.

What’s notable about this table? One, Berkshire has outperformed the S&P 500 by about 10% a year over more than 50 years (1965-2019). Berkshire has compounded its market value at about 20% a year while the S&P 500 has done 10% a year. What’s also notable is the many very big years for Berkshire as a stock. On my print out of the letter, I circled some years that stood out to me. Basically, I just assumed that it’s incredibly rare for the S&P 500 to ever have a return of around 50% a year. Generally, an amazing year for the S&P 50 would be one like what we saw last year (up something over 30%). If you are completely in the S&P 500 index, your portfolio is not going to have up years of 40%, 60%, or 120%. Berkshire’s stock price sometimes does go up that much. Or, rather – it sometimes did. It hasn’t lately.

Berkshire had amazing up years – as a stock, these don’t necessarily match up with business results – two times in the 1960s, three times in the 1970s, three times in the 1980s, twice in the 1990s and then never again since the late 1990s. Berkshire’s stock has gone over 20 years with no what I’d call amazing up years. Any good year Berkshire has had as a stock in the last 20 years has been the kind of up year an index like the S&P 500 is also capable of. This obviously tamps down on Berkshire’s long-term performance potential. Most stocks that have amazing long-term compounding records will achieve those records with a bunch of short-term upward spurts in their stock price like Berkshire had in the 1970s, 1980s, and 1990s. In the last 20 years, Berkshire has had several years where returns were in the 22-33% range. Those are great years. But, they are years the S&P 500 is also capable of having (it was up 32% last year). The disappearance of these very big up years – the “lumpy” outperformance – in Berkshire as a stock explains a lot of why the stock performed so well versus the S&P 500 for its first 30 years under Buffett and so much …

Geoff Gannon March 10, 2017

How to Find Stocks With Good, Predictable Capital Allocation

Someone emailed me this question:

“How do you evaluate the capital allocation skill by the management? I do so by looking at the FCF yields for the acquisitions and share repurchases or ROIC for internal investments.”

I want to focus on what will have the most influence on my investment in the company going forward. For this reason, I’m less interested in knowing quantitatively what the past return on investment of management’s actions were – and more in simply how management will allocate capital going forward.

Let’s start with who the manager is. If the manager is the founder, that’s the easiest situation. We can assume the founder will stay with the company for a long time. The average tenure of a professional manager – nonfounder – CEO at a Standard & Poor’s 500 type company is short. It’s maybe five years. If you think about that, it means odds are that the CEO you now see at the company you are thinking of investing in will be gone within two to three years (because chances are he’s already been running the company for two to three years by the time you buy the stock). It’s just not worth thinking about such a manager. In this case you’d want to focus on the board of directors or the chairman. Ideally, you want to find situations where the founder is still the CEO, the chairman or has some position in the company. This will make figuring out future capital allocation plans easier.

In situations where you don’t have a founder present, ongoing participation by a family is useful. In situations where you don’t haveÂ the presence ofÂ either a founder or his family at the company, you may still have first-generation managers who worked with the founders before they became CEOs.

Those three situations will make future capital allocation easier to predict. One, the founder influences capital allocation. Two, the controlling family influences capital allocation. Three, a manager who worked directly for the founder early in his career now influences capital allocation. If you don’t have any of those three scenarios, there are still two others that can lead to some predictability. You can have a long-tenured CEO. For example, the big ad agency holding companies are usually run by a CEO who has been at the company forever. I know Omnicom (OMC, Financial) best. The CEO there – John Wren – has been at the top position for 20 years. For most of those 20 years, the chairman of the company and the chief financial officer (CFO) were also the same.

In terms of capital allocation, if you have a lot of consistency in the offices of chairman, CEO and CFO, you’re able to more easily count on future capital allocation looking like past capital allocation. The last of the five scenarios that can lead to predictable capital allocation is the presence of a “refounder.” This is someone who comes in and reshapes an existing business …

Geoff Gannon August 3, 2013

Quality, Capital Allocation, Value and Growth

In my last article I talked about the first 3 of the 7 things I look for before buying a stock – understanding, durability and moat. Today, I’ll talk about the other four areas I focus on.

First up is quality. We can look at quality a couple ways. One way – which I remember from reading Greenbackd and the book Quantitative Value Investing (which cites an article on the subject) – is using a metric from high up the income statement. Something like gross profits divided by NTA.

This is a good first check. A business should have high gross profitability. Most of the companies I look at have fairly high gross margins. However, all of these subjects are a little tricky because of the accounting definition of sales. Sales are defined in accounting terms for a company in ways that might not make sense from an economic perspective.

For example, Omnicom (OMC, Financial) doesn’t record billings as sales. Nor does DreamWorks (DWA) record box office as sales. However, some companies that buy and quickly resell – at very, very low margins – do count the transaction as a purchase and sale rather than a contracted service. I’m not knocking any of these approaches to accounting – we need one definite way of measuring sales. But it’s important to keep in mind that you can sometimes restate sales without restating anything – like earnings, cash flow, etc. – that actually matters.

What matters is the economic profits a company earns. Sales can be very useful comparisons between companies that use similar accounting. But, I’m not sure gross profitability means the same thing across all industries. For example, I would not be concerned with gross profits at ad agencies, defense contractors, or drug distribution. This is just common sense. For example, AmerisourceBergen (ABC, Financial) hasn’t posted a gross margin above 5% at any point in the last 10 years. Yet, return on equity has rarely been below 10%. That’s unusual. And it reinforces the need for using common – human – sense rather than relying on a screen.

When looking at a company economically – rather than as an accounting entity – we often want to ask what spending at the end of the chain is on these products, what sales by others dependent or controlled by the company etc.

Economically, a DreamWorks movie should be broken down from the ticket price collected from the moviegoer, then we look at the take for the theater, the agreement with the distributor, and then finally DWA’s revenue number comes into play.

In other words, we can – using widely available data that isn’t in the financial statements – easily create a picture of how a movie makes money. We should do that. Just as we should consider the quality of an auto parts maker in terms of the price of their product relative to the price of the product it’s going into and what it …

Geoff Gannon December 5, 2012

Capital Allocation Discounts

Value and Opportunity has an excellent post on holding company discounts. The key point of the post is the division of holding companies into 3 types: value adding, value neutral, and value destroying.

Excellent point. I would take it a step further. The issue with the discount that should or shouldn’t be applied to holding companies is capital allocation. Capital allocation has a huge influence on long term returns in a stock.

But not just holding company stocks. All stocks. A company that buys back stock when it’s cheap deserves to trade at a premium to other stocks. A company that issues stock when it’s cheap deserves to trade at a discount.

I recently looked at a list of good, cheap U.K. businesses. I passed on most of them. Not because they were too expensive. Most were cheaper than similar quality U.S. companies. I passed on the U.K. companies because they tended to issue shares over the last 10 years.

Some of these U.K. share issuers traded around enterprise values of 6 times EBITDA for much of the last decade. Interest rates were not high during the last 10 years. Issuing stock at 6 times EBITDA is criminal. I don’t care what you were acquiring. You can’t make money doing it by issuing such cheap currency.

Capital allocation at non-holding companies is critical. And often overlooked. Because it’s complicated. Take Western Union (WU). Western Union made several acquisitions over the last few years. They overpaid.

That’s the bad news. The good news is that Western Union never stopped buying back its stock. And when they needed money – they borrowed. They didn’t issue stock.

Let’s take a look at CEC Entertainment (CEC). This is Chuck E. Cheese. The stock has returned 8% a year over the last 15 years – versus 4% for the S&P 500. That’s impressive for 2 reasons. For most of the last 15 years, Chuck E. Cheese’s operations have been getting worse – not better. Margins have dropped virtually every year for the last decade. And the stock is cheap right now. EV/EBITDA is about 5. It’s hard for any stock that cheap to show good past returns – an incredibly low end point is incredibly hard to overcome.

I doubt anyone is applauding CEC’s board. But they should be. It would’ve been very easy to deliver returns of zero percent a year over the last 15 years.

Operating income peaked 8 years ago. Earnings per share kept rising for the next 7 years. Shares outstanding decreased 57% over the last 10 years. Those are Teledyne like number.

Some might argue the return on those buybacks has been poor. And they would have been better off paying out dividends. Maybe. But let’s consider another alternative – the one most companies actually take. CEC could’ve invested that cash – not in buybacks or dividends – but in expanding the business.

Investors make an arbitrary distinction between operating companies and holding companies. They …

Geoff Gannon June 22, 2012

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 …

Posts In: Capital Allocation Collection