Posts In: Gannon on Investing

Andrew Kuhn May 27, 2020

Should I Specialize in an Industry I Know – Even if it’s a Bad One?

A 12-minute read

Hi Geoff,

 

I think you have touched on this before but I will ask a bit more detailed. Do you think it’s better to be an expert on one industry and the stocks within that industry vs knowing a little about many industries? What about if that industry is a “bad” industry like shipping? Would you still think an investor is better off knowing everything about that industry and the stocks vs being a generalist?

I guess that having a deep knowledge and circle of competence you would have an edge compared to other investors. Being a generalist you don’t really have an edge? 

 

I think it’s usually better for an investor to be a specialist than to be a generalist. If you look at some of the investors who have long-term records that are really excellent – I’m thinking specifically of Warren Buffett and Phil Fisher here – their best investments are in specific areas of expertise. Buffett’s biggest successes tended to be in financial services (banks, insurance, etc.), advertiser supported media (newspapers, TV stations, etc.), ad agencies (also very closely connected to media companies), and maybe a few other areas like consumer brands (See’s Candies, Gillette, Coca-Cola, etc.). Other gains he had came from use of float (which is a concept closely tied to insurance and banking – though he also used Blue Chip Stamps to accomplish this) and re-deployment of capital. At times, he liquidated some working capital positions of companies and put the proceeds into marketable securities (a business he knows well). Overall, the Buffett playbook for the home runs he hit is fairly limited. It is very heavy on capital allocation, very light on capital heavy businesses, and it is pretty concentrated in things like media, financial services, and consumer brands. There are some notable and successful exceptions. It seems that Nebraska Furniture Mart (by my calculation) was a very successful investment. However, Buffett’s other retail investments generally were not. By comparison, he hit several home runs in newspapers – Washington Post, Buffalo Evening News, and Affiliated Publications. Several home runs in non-insurance financial services (owned a bank, owned an S&L, invested in GSEs, etc.). Several home runs in insurance (National Indemnity, GEICO, etc.). If you look at Buffett’s record in holdings of more commodity type companies, when he held broader groups of stocks, etc. – it’s not as good. As far as I can tell, the retail/manufacturing parts of Berkshire today don’t have very good returns versus their original purchase prices. It’s not all that easy to be sure of this given the way the company reports. But, I don’t think there are a lot of home runs there.

 

Phil Fisher talks about how he focused on manufacturing companies that apply some sort of technical knowledge. This is interesting, because people think of him as a growth or tech investor – but, he thought of himself as investing in technical manufacturing companies. But, specifically – manufacturing companies. He didn’t …

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Andrew Kuhn April 19, 2020

Which Kind of Investor Could You Aspire to Be: Graham, Fisher, Lynch, Greenblatt, or Marks?

Hi Geoff, 

 

I am very new to investing and I have most of my savings invested in Vanguard S&P 500. I would love to learn more about the world of investing but I just don’t know where to start. Could you please give me a roadmap to begin?

 

Geoff’s Advice to a Brand New Investor

 

You Need to KNOW YOURSELF First, So…

 

It really depends on what approach would work best for you. You should read about the investor who most speaks to the kind of investor you COULD be. In other words, what are your interests, what is your personality, etc.

 

I would recommend picking from one of five possible investors:

 

1) Ben Graham

2) Phil Fisher

3) Peter Lynch

4) Joel Greenblatt

5) Howard Marks

 

You might want to read one book by each of them. The Ben Graham approach is based on asset values and liquidation value. It is the approach of net-nets, stocks trading below book value, stocks trading at less than 10 times P/E and little debt, etc. You could read the Intelligent Investor (I recommend the 1970s edition – or earlier – but not the edition revised by Jason Zweig. So, find an edition with just Graham’s name on it – not Zweig’s name). I would also recommend reading “There’s Always Something to Do”. This book is about Peter Cundill. It is an easier read than the Intelligent Investor. But, it shows you what the actual work of applying a “Graham and Dodd” approach is. So, to get a taste of the Ben Graham approach I’d recommend reading: First – “There’s Always Something to Do”. If you feel like Cundill’s investing style is one you could copy yourself – then, read “The Intelligent Investor”. If you get something out of “The Intelligent Investor” you can then read the various editions of Security Analysis (1934, 1940, and 1951). Also read: “The Interpretation of Financial Statements”. There are a few other books by Graham that are good (a couple books of his articles and an autobiography called “memoirs”). You can find all of these at Amazon and elsewhere. Buy them used and collect the books for your own review. Keep them forever. Heavily annotate them. Copy the approaches you read about using modern stocks. However: ONLY do this if you read “There’s Always Something to Do” and the Cundill approach resonates with you as something you could do personally. If you read that book – it’s a very breezy read – and don’t feel that approach resonate with you, then skip Graham entirely.

 

Phil Fisher. Read “Common Stocks and Uncommon Profits”. Fisher wrote a few other books too. But, read that one. Especially think about his talk of “scuttlebutt”. Is this something you can do? Is this something you want to do? If so: read Fisher’s other books. Focus on the scuttlebutt approach. During coronavirus, it will be difficult to make company visits. But, you can often speak with people …

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Andrew Kuhn April 18, 2020

What Makes a Business Durable?

What Makes a Business Durable?
Hey Geoff,
I noticed in one of the recent videos you mentioned that the durability of the business matters more then the returns. I believe you were answering a viewer question on return on capital for the subject matter. When you mention durability are you talking about recurring revenue, sustainability of the business going forward (like waste collection industry or railroads etc…)?
Answer: A Good Place to Start is With the Oldest Companies in the Oldest Industries
Yes. So, this is something Buffett has said before too – and it’s true. It’s the reason why I’m not a fan of “The Magic Formula”. The Magic Formula is a system that might work empirically – but, it isn’t based on sound logic. That’s different from something like the Piotroski F-Score or Ben Graham’s 2/3rds of NCAV rule. Both of those approaches are logically sound and then can be tested to see if they work empirically. I don’t think it’s a good idea to use a system that has been back tested to show good results, but that doesn’t seem logically sound. I’m unconvinced of the logic of The Magic Formula – because, it is basically buying high current return on capital stocks without asking if they have a moat. It’s not the Buffett approach. It’s actually very different from Warren Buffett’s approach. His approach is to figure out why a company has had a high return on capital in the past, has a high return in the present, and is likely to have a high return in the future. Once he knows the reason for the high return – the company’s “moat” – he can judge how durable that moat is. This is also similar – though slightly different – from the Phil Fisher approach. Phil Fisher’s approach focused more on the organization and whether it is built for the long run: is it investing enough in marketing, is it investing enough in R&D, does it have good enough people at lower levels in the organization, are the markets the company is in likely to grow for a long time to come, has the company had success releasing new products regularly to replace old products, etc. That’s very similar – though from a different angle – to the Buffett approach. Those two approaches – Buffett and Fisher – are qualitative looks into the future. We can debate how accurately a human being can judge the likely future of a company. But, the logic of trying to do that is sound. The logic of assuming that a currently high return on capital is less likely to decline than a medium or low return on capital makes little sense. There has been some research in this area and the answer is – it depends on the industry. Some industries do show high persistence of relative returns among the firms in those industries. So, for example, the leading movie studio or beverage brand or condiment maker might tend to
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Andrew Kuhn April 16, 2020

How Do I Find a Company with a Moat?

Hi, Geoff. I have just recently read your old article titled “How To Find Competitive Advantages In The Real World”. My question is, is that article still relevant at this point in time (because it is quite old)? If any, what would you update or change in that article? And about your comments on books about competition, do you believe that it is still true till today (Or you would like add to other book recommendation on competition besides “Hidden Champions”) ? Is it possible to identify economic moat without scuttlebutt? In your opinion, which is better: screen stocks for cheapness first and determine whether the stock in the cheap screen has quality OR screen for quality first and determine whether the price is right?

Answer: Here are 10 Checklist Items You Can Start With

There’s a checklist you can work through to see. It’s made up of 5 items from Michael Porter and 5 items from Morningstar. You may be able to identify if some of these items might apply to the company you’re looking at. And then, you can judge how durable they are or not. So, here’s the 10-point checklist.

Porter’s 5 Forces

1. Threat of new entrants

2. Threat of substitutes

3. Bargaining power of customers

4. Bargaining power of suppliers

5. Competitive rivalry

Morningstar’s Economic Moat

6. Network Effect

7. Intangible Assets

8. Cost Advantage

9. Switching Costs

10. Efficient Scale

You could start your analysis by just finding a cheap enough stock, finding any stock at all, finding a stock that has strong enough past results, or finding an industry that has strong enough past results.

I suggest finding an industry. The performance of any stock over time might be like 50% or so the stock’s position within its industry. But, the other 50% will be the industry. If you buy a basket of regulated utilities or a basket of bank stocks at the same price-to-book ratio – the basket of bank stocks will outperform the regulated utilities over time. This is because – in the U.S. – banking is a much better business than regulated utilities.

Certain industries are better choices to look for moats. I’d suggest:

Household Products

Personal Products

Food

Beverage

Alcohol

Tobacco

Hotels

Restaurants

Food retailing

Consumer staples retailing

Really – “consumer staples” in general is the best place to look for a moat. Products that are: branded, frequently purchased, and used by people (not businesses) both in the home and away from the home are your best bet to look for a durable competitive advantage.

So, I would focus on those industries. There are other industries that are often not big enough to get included as “industries” by investors but sort of just a subset that are pretty good too. So, for example, I think theme parks tend to be good sources of moats though that doesn’t mean the group they belong to “entertainment” is necessarily as good overall. I think lime and cement companies – especially located in

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Andrew Kuhn April 14, 2020

In a Market Like This – Is It Better to Buy 10 Stocks Instead of Just My 5 Favorite Stocks?

Someone sent Geoff this email:
Hi Geoff,
 
On regular days your focusing on overlooked stocks makes much sense to me and is the right place to look for good companies at a decent price.
 
But in this market selloff, wouldn’t it be better to buy blue chip stocks such as Nike, Disney, BrKb, etc.. if they fall to the right price (and I’m not sure they are there yet…).
 
Also, wouldn’t it be better to diversify? To own 10-12 stocks instead of 5-7.
Answer: It Depends On Which Stocks – Conglomerates like Berkshire and Disney Give You a Lot of Diversification, Some Other Stocks Don’t
 
(Note from Geoff: I’m going to split this email into two responses – this one will talk about diversification, tomorrow’s response will talk about overlooked versus big cap stocks)
I don’t know about whether it makes sense to own 10-12 stocks instead of 5-7. I’m not sure it does. It depends on which stocks you’d add to the portfolio. Remember, there is a lot of diversification in certain stocks already. So, you mentioned Disney (DIS) and Berkshire (BRK.B). Berkshire already gives you more diversification in terms of its underwriting than many insurers do. Plus, Berkshire has a big stock portfolio. Plus it owns a railroad. Plus it owns an electric utility. You could separately buy other insurers, stocks like Apple (AAPL) and Bank of America (BAC) and Wells Fargo (WFC) and Coke (KO). You could buy a publicly traded railroad. You could buy a regulated utility. If you add up what you’d put in all those stocks if they were in a 12 stock portfolio – maybe you’d put 33% of your portfolio or more into recreating what Berkshire already has. So, should you buy a bank, an insurer, a railroad, a utility, etc. – or just buy Berkshire? I don’t know the answer. If you pick the right bank, insurer, railroad, and utility – I’m sure you could beat just buying Berkshire. But, if you think you’re somehow safer putting 10% each into one bank, one insurer, one railroad, and one utility than 40% in Berkshire – I don’t think that’s true.
Disney is similar. The company is diversified across a couple big entertainment segments. It has a big allocation to parks and resorts. This includes things like cruise ships. But, it’s mainly theme parks. Disney has the most visited theme parks in several parts of several different continents . So, you could buy SeaWorld (SEAS), Six Flags (SIX), or Cedar Fair (FUN) – or you could get a similar allocation by owning 3-5 times more of Disney than you would of any one of those companies. If Disney is say 20-33% parks by value (you’d have to appraise the stock yourself to make this decision) then simply buying a 3-5 times bigger position in Disney and you’d get the same allocation to theme parks you would from buying one of those other stocks. Disney has a big movie business (it is now, by
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Andrew Kuhn April 13, 2020

What is a Fair Price to Pay For Omnicom (OMC)?

Someone Geoff  this email ( to ask your own question: just send me an email ) :

My question is a simple one.

“What do you think is a fair price to pay for Omnicom?”

Answer: Omnicom (OMC) Could be Worth Anywhere Between 1 to 1.5 Times Sales – so, About $70 to $100 a Share – But: You Probably Want At Least a 35% Margin of Safety, So Try Not To Pay More than $45 a Share for Omnicom

This is a simple question. But, it’s tougher to answer than it appears. I see 3 big factors to consider:

1) What is the organic growth (or decay) in Omnicom’s business likely to be?

2) How much will stock buybacks drive growth in earnings per share that’s higher than organic growth?

3) How bad and how long will an ad recession be?

Because Omnicom uses so much of its free cash flow to buyback stock, there’s an element of circular logic to valuing the stock. Bizarrely, the cheaper the stock gets today – the more valuable it should be in the future. Assume Omnicom uses 50% of its EPS to buyback stock. I’ll also assume there is 1% share dilution normally before buybacks. This means that the formula that tells us how much Omnicom’s EPS will grow BEYOND its organic growth is:

(0.5 * Earnings Yield) – 1% = Inorganic EPS growth caused by stock buybacks

Let’s run this number for the following P/E ratios:

P/E = 4

P/E = 6

P/E = 8

P/E = 10

P/E = 12

P/E = 14

P/E = 16

P/E = 4 (this would be like 50% cheaper than today’s price) makes the formula…

(0.5 * 25%) – 1% = 11.5% CAGR in EPS

P/E = 6 gives us…

(0.5 * 17%) – 1% = 7.5% CAGR in EPS and so on. The “and so ons” work out as follows..

P/E 4 => 11.50%

P/E 6 => 7.50%

P/E 8 => 5.25%

P/E 10 => 4.00%

P.E 12 => 3.17%

P/E 14 => 2.57%

P/E 16 => 2.13%

Now, if we assume organic growth is equal to 0% – which may or may not be an accurate assumption – then, we can keep the fair value formula pretty simple. In theory, Omnicom should be worth its stream of dividends. EPS can be ignored as a direct thing. Instead we just assume that 50% of EPS is paid out in dividends and 50% is used to do buybacks. Again, I assume 1% is just constant share dilution in the form of stock grants to employees.

That means only two things matter. One is the buyback rate. I’ve shown that above. It ranges from a little over 2% to something like 11-12% a year depending on whether the stock trades as low as a P/E of 4 or as high as a P/E of 16. The dividend yield – if we assume a 50% dividend payout – is really easy to calculate. We just take …

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Andrew Kuhn April 9, 2020

Should I Really Just Automatically Ignore High P/E Growth Stocks Even if they Are Amazing Businesses?

Someone sent Geoff this email ( to ask your own question: just send me an email ) :
Hey Geoff,
The last 10 years saw the dominance of ‘growth’ (as quantitatively defined) over ‘value’.
If you were a value (however it is defined) investor, you probably underperformed the relevant indices.
(1) Is there a lesson to be learned here? When I see stocks trading at really high multiples, my immediate instinct is to ignore them – either too hard to value or too expensive.
But by automatically ignoring such stocks, a potential stock picker immediately omitted a lot of profitable stock ideas.
(2) Do you see these high-multiple stocks’ multiples ever regressing to median multiples, potentially hurting future returns? I think arguing that stocks like Google, Visa or Amazon should have median (historical) multiples is a bit misleading since most of these are natural monopolies. On the other hand, it’s not clear to me what the fair value should be.
Answer: High P/E Stocks of Great, Wide Moat Businesses Don’t Worry Me Right Now – It’s the Super Speculative Growth Stocks with No Real Earnings That You Need to Watch Out For
So, first of all, types of stocks that have outperformed for a decade or so are not necessarily going to be great performers in the future even if they continue to be great performers as businesses. In the past, some excellent businesses have underperformed as stocks even while the underlying businesses continued to perform well. The “Nifty Fifty” stocks of the late 1960s and early 1970s underperformed for the next 10 years or so. In fact, as a group, they did not outperform over even a 25-30 years holding period. While some of the reason for that is stocks that looked like great businesses but eventually lost their competitive position – a lot aren’t. They just were expensive. A study of the Nifty Fifty stocks – it used two different lists – looked at performance from 1972 to 2001. It found that there was a strong negative correlation between the 1972 P/E ratio of the stocks on that list and their returns over the next close to 30 years. That’s an important warning. Differences in P/E ratios – even among very good businesses – can still cause differences in the returns you get over holding periods as long as 30 years.
Does this mean growth stocks will underperform value stocks in the 2020s?
It depends on what you mean by growth? If you mean Visa and Amazon and Google – I’m not so sure. They are financially sound companies. They have strong market positions. And Google is not even expensive versus the S&P 500 generally. Google’s EV/EBITDA, EV/Free Cash Flow, P/E, etc. are mostly a bit elevated at most compared to the index. It’s not a very expensive stock. Visa is even more elevated. Of those stocks – the one to be worried about is probably Visa. The stock trades at a very, very high EV/Sales ratio. It’s
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Andrew Kuhn April 8, 2020

What Kind of Competition Will Car Dealers Face for the Sale of Used Cars and for Their Parts and Service Business?

Someone sent Geoff this email (to ask your own question: just send me an email):
I think that car dealers face a lot of competition, especially for used cars and service, that I could never thoroughly understand the competitive advantages. But car dealers tend to have very stable margin. So I do think that they have certain competitive advantage thanks to location, long-time presence, as well as customer relationship built up through its new car business. So, I’d like to ask you about your thoughts on the competition for car dealers in:
1. Used cars where car dealers have to compete not only with franchised dealer of another brand in the same area but also with independent used car dealers.
2. Parts and services where car dealers have to compete with independent auto service shops and chains.
Answer: I Think Big Car Dealer Groups Have Certain Advantages in Capturing Additional Profits from a Customer Relationship Based on a New Car Sale – But, the Internet May Change Things Over Time
It’s a good question. I think it’s possible that an independent seller of just used cars might be a better business – especially if it combined locations with a really, really strong internet presence.
Big car dealer groups do have to compete with service shops. And perhaps they have lost share. But, the number of dealer locations relative to the amount of population (and certainly to drivers) has been declining throughout much of the history of the industry. So, I think the business has tended to get better not worse.
What’s the big difference?
I think two things benefit dealers.
Once, they potentially have a better source of leads for their new, used, and service businesses – in the form of a new car territory they control for a brand. So, often, when someone is in the market for a new Toyota they trade in their old Toyota. The dealer can take the trade in (getting a better supply of used cars than others might) and can get the possibility that the owner of the new car will buy financing products etc. through them and – most importantly – stay with them for servicing. So, they are in a better position than some to turn a new car sale into out sources of revenue – a possible service relationship, a good price on a trade-in used car, etc. This is why I think it’d be hard to compete in new cars even if there wasn’t the dealer system that there is. New cars are largely just a good way to have a customer relationship that can make you more money form things over time.
Second – and I think for most dealers, this is the bigger issue – I think dealer groups that include new car sales, used car sales, and servicing in one operation have a lower cost of capital than competitors would. It has been very easy for new competitors in the industry to succeed in stuff
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Geoff Gannon April 8, 2020

Middleby (MIDD): A Serial Acquirer in the (Normally) Super Steady Business of Supplying Big Restaurant Chains with Kitchen Equipment

Middleby (MIDD) is a stock I was excited to write-up, because it’s rarely been cheap. I’ve seen 10-year financial type data on the company. I’ve seen it show up on screens. And now the government response to coronavirus – shutting down so many of the restaurants that Middleby supplies – looked like a once in a lifetime opportunity to buy the stock. The company also has quite a bit of debt. That can make a stock get cheap quickly in a time like this. So, I was looking forward to writing up Middleby.

I’ll spoil this write-up for you now and tell you I didn’t like what I found. The company’s investor presentation, 10-K, etc. was a disappointing read for me. And I won’t be buying Middleby stock – or even looking into it further. Why not?

Middleby is in an industry I like. The company has 3 segments. The biggest profit contributor is commercial foodservice – supplying restaurant chains like: Burger King, IHOP, Chili’s, etc. – with kitchen equipment. The company sells equipment that cooks, bakes, warms, cools, freezes, stores, dispenses, etc. It sells a very broad range of equipment. A lot of it is good equipment. A lot of the brands the company carries are well known. Plenty of them are pretty innovative. However, I think that innovation most likely happened before – not after – Middleby bought those companies. Middleby talks a lot about innovation – but, it only spends about 1-2% of its sales on research and development. That’s not a high number for a company in an industry like this. Middleby is building this stuff itself – in the U.S. and around the world (in both owned and leased facilities – and it’s making it for some pretty large scale orders. Plenty of the chains Middleby serves have thousands of locations. Gross margins in the commercial foodservice business are 40% or a bit better. Although most of this stuff is sold under just a one year warranty – some is under warranty for up to 10 years. Plenty of these products do last longer than 10 years. For a company making 40%+ gross margins on sales of key capital equipment to big business customers – Middleby doesn’t do a lot of R&D. That fact bothered me a little. It started to bother me a lot more when I looked closer at the company’s acquisitions.

Middleby has bought some leading brands. Chances are – if you’re reading this – you know more about home kitchens than commercial and industrial kitchens. You may eat at Chipotle. But, you don’t know what equipment Chipotle cooks on. You do – however – know brands you might find in home kitchens. Several years ago, Middleby bought the Viking brand and later the Aga brand (Aga is a big, premium brand in the U.K. – it’s less well known in the U.S.). In the company’s investor presentation, they show the EBITDA margins for these acquisitions at the time they were made …

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Andrew Kuhn April 7, 2020

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:

 

Dear Geoff,
In this video   you mention a PE of 26 for OTC and yet use an implicit growth rate of 6% which is not the inverse of 26. I would like to understand why that is.
Answer: If a Company Converts 100% or More of Its Earnings Into Free Cash Flow While Also Growing – a Normal P/E Ratio Would Deeply Undervalue the Stock
I’d assume it’s because 10% = (1/26) + 6%
In other words…
10% – 6% = 4%
And 1/25 (not 26) is 4%
OTCMarkets is unusual. What matters for a stock isn’t actually earnings – it’s truly free cash flow. So, a stock that retains 100% of its earnings and grows 6% a year while doing that still isn’t worth more than many stocks growing 0% and paying all earnings out.
Some stocks – OTCMarkets is one – have a lot of “float”. As a result, they are capable of paying out 100% (actually more than 100% while they are growing) of their earnings in dividends and buybacks while growing. They don’t actually have to retain earnings. You can see that with OTCM. The asset that has grown over time is cash. A tip-off to this fact is that ROIC is often calculated as being very high, infinite, or even negative by some websites (a negative ROIC means that the company’s cash balance is greater than what it has actually invested in the business in stuff like PP&E, receivables, inventory, etc.).
So, my point is that if OTCMarkets grows by 6% a year and you need a 10% return as your discount rate…
Well, OTCMarkets can grows at 6% a year AND pay a 4% a year dividend yield if priced at 25 times P/E.
Note that OTCM does not actually pay such a high dividend though. So, it’s somewhat debatable what the stock is worth if management keeps cash on the balance sheet rather than using all FCF to buy back stock and pay dividends.
For comparison, look at Omnicom (OMC). It actually does pay out dividends and buy back stock equal to at least 100% of reported earnings. So, the calculation there is simple. Assume OMC grows at 0%. Assume your discount rate is 10%. What is the correct price for OMC?
It’s a 10x P/E. Because OMC at 10 times EPS, OMC will pay you dividends and buy back stock equal to 1/10th of your purchase price. What this will actually do is make EPS grow – even when the company’s actual earnings don’t grow, just because share count is falling – plus you get the dividend. If the combination of the dividend and the EPS growth equals 10%, you’ve hit your hurdle rate.
So, what I said about OTCM is somewhat unique to that company and other business models like it, generally:
– Ad agencies
– Subscription services
– Some software companies
– Etc.
Usually, you have to be doing something fairly intangible (you can’t
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