Posts In: Gannon on Investing

Andrew Kuhn September 4, 2019 Gannon on Investing 5 Comments

How I Analyze Bank Stocks

By GEOFF GANNON

 

09/04/2019

 

We did a Focused Compounding Podcast episode that was 100% dedicated to bank investing:

 

https://focusedcompounding.podbean.com/e/ep-96-all-about-investing-in-banks/

 

In that podcast notice that I analyze banks completely differently than most value investors. I don’t believe price-to-book is an especially important metric. I value banks based on the amount of their share price, their deposits per share (so P/Deposits so to speak), their growth in deposits, and finally the profitability of those deposits (how low cost are they, how “sticky” are they).

 

I spend very little time on the asset side of the bank except to see if I think it is safe enough for me. I just assume – and this assumption isn’t 100% correct or anything – that money is a commodity, so banks will make roughly similar amounts over time on whatever they lend out, buy bonds with, etc.

 

However – at least among U.S. banks – you have banks that pay very different amounts on their deposits (in interest), and even MORE important very, VERY different amounts in terms of non-interest expenses per dollar of deposits. There are banks in the U.S. that have $50 million per branch and pay HIGHER interest on most deposits compared to banks that have $200 million per branch. The bank with 4 times the deposits per branch brought in with MORE non-interest bearing accounts is going to have such a “all-in” cost advantage over the other bank that it can make fewer loans and buy more bonds, it can make safer loans that yield less, it can buy shorter-term bonds that yield less, etc. and it’ll still make more money than the bank that has to hustle to make the highest yielding loans, buy the highest yielding bonds, etc.

 

My belief is that a strong, durable advantage on the deposits side in terms of economies of scale at the customer level and the branch level especially is what creates value in banking.

 

It’s not impossible to create value in other ways. Prosperity Bank has done this. But, taking in a lot of small deposits from a lot of less wealthy people at a lot of different branches means the only way you can succeed would be extreme penny pinching on the deposit side and then really good lending on the asset side. You’d have to be cheaper than the other guys when it comes to running a customer oriented business and/or you’d have to be smarter, more driven, etc. lenders. I think that’s tough.

 

Recently, I also wrote-up Truxton (TRUX). You can see the same focus on economies of scale here, because:

 

1) Truxton operates BOTH a wealth management business and a private bank out of the location that is ALSO ITS HEADQUARTERS

2) Truxton has about 8x more deposits per branch (it only has one branch) than U.S. banks generally

3) Truxton focuses on RICH clients (this means Truxton might get 10x the dollar amount of deposits from each depositor …

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Andrew Kuhn September 3, 2019 Gannon on Investing 1 Comment

Why You Might Want to Stop Measuring Your Portfolio’s Performance Against the S&P; 500

By Geoff Gannon

December 8, 2017

 

 

Someone emailed me this question about tracking portfolio performance:

“All investors are comparing their portfolio performance with the S&P 500 or DAX (depends were they live). I have asked a value investor why he compared the S&P 500 performance with his portfolio performance…for me as a value investor it makes no sense. A value investor holds individual assets with each of them having a different risk…it’s like comparing apples and oranges.

The value investor told me that…Warren Buffett compares his performance with the S&P 500. But I believe he did it, because other investors…expect it or ask for such a comparison.

How do you measure your portfolio success? Do you calculate your average entry P/E and compare it with S&P500 or Dow P/E to show how much you (over)paid for your assets? Or do you avoid such a comparison and calculate only the NAV of your portfolio?”

I don’t discuss my portfolio performance on this blog.

And I think it’s generally a good idea not to track your portfolio performance versus a benchmark.

It’s certainly a bad idea to monitor your performance versus the S&P 500 on something as short as a year-by-year basis.

Why?

Well, simply monitoring something affects behavior. So, while you might think “what’s the harm in weighing myself twice a day – that’s not the same thing as going on a diet” – in reality, weighing yourself twice a day is a lot like going on a diet. If you really wanted to make decisions about how much to eat, how much to exercise, etc. completely independent of your weight – there’s only one way to do that: never weigh yourself. Once you weigh yourself, your decisions about eating and exercising and such will no longer be independent of your weight.

Knowing how much the S&P 500 has returned this quarter, this year, this decade, etc. is a curse. You aren’t investing in the S&P 500. So, tethering your expectations to the S&P 500 – both on the upside and on the downside – isn’t helpful. The incorrect assumption here is that the S&P 500 is a useful gauge of opportunity cost. It’s not.

Let me give you an example using my own performance. Because of when the 2008 financial crisis hit, we can conveniently break my investing career into two parts: 1999-2007 and 2009-2017.

Does knowing what the S&P 500 did from 1999-2007 and 2009-2017 help me or hurt me?

It hurts me. A lot.

Because – as a value investor – the opportunities for me to make money were actually very similar in 1999-2007 and 2009-2017. In both periods, I outperformed the S&P. However, my outperformance in 2009-2017 was small while my outperformance in 1999-2007 was big. In absolute terms, my annual returns were fairly similar for the period from 1999-2007 and 2009-2017. It is the performance of the S&P 500 that changed.

Many value investors have a goal to outperform the S&P 500. But, is …

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Geoff Gannon August 24, 2019 Gannon on Investing, Stock Ideas

Monarch Cement (MCEM): A Cement Company With 97 Straight Years of Dividends Trading at 1.2 Times Book Value

by GEOFF GANNON This is my initial interest post for Monarch Cement (MCEM). I’m going to do things a little differently this time. My former Singular Diligence co-writer, Quan, emailed me asking my thoughts on Monarch as a stock for his personal portfolio. I emailed him an answer back. I think that answer will probably help you decide whether you’d want to buy this stock for your own portfolio better than a more formal write-up. So, I’ll start by just giving you the email I...

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Andrew Kuhn August 20, 2019 Gannon on Investing 0 Comments

The Moat Around Every Ad Agency is Client Retention

April 24, 2016

By Geoff Gannon

Moat is sometimes considered synonymous with “barrier to entry”. Economists like to talk about barriers to entry. Warren Buffett likes to talk about moat. When it comes to investing, “moat” is what matters. Barriers to entry may not matter. Thinking in terms of barriers to entry can frame the question the wrong way.

If you’re thinking about buying shares of Omnicom and holding those shares of stock forever – what matters? Do barriers to entry matter? Does it matter if it’s easy to create one new ad agency or a hundred new ad agencies? No. What matters is the damage any advertising company – whether it’s WPP, Publicis, or a firm that hasn’t been founded yet – can do to Omnicom’s business. How much damage can a new entrant do to Omnicom’s intrinsic value? How much damage can Publicis or WPP do to Omnicom? The answer is almost none. In that sense, the barriers to entry in the advertising industry are low but the moat around each agency is wide. How can that be?

First of all, the historical record is clear that among the global advertising giants we are talking about a stable oligopoly. The best measure of competitive position in the industry is to use relative market share. We simply take media billings – this is not the same as reported revenue – from each of the biggest ad companies and compare them to each other. If one company grows billings faster or slower than the other two – its competitive position has changed in relative terms. Between 2004 and 2014, Omnicom’s position relative to WPP and Publicis didn’t change. Nor did WPP’s relative to Publicis and Omnicom. Nor did Publicis’s position relative to WPP and Omnicom. Not only did they keep the same market share order 1) WPP, 2) Publicis, 3) Omnicom – which is rarer than you’d think over a 10-year span in many industries – they also had remarkably stable size relationships. In 2005, WPP had 45% of the trio’s total billings. In 2010, WPP had 45% of the trio’s combined billings. And in 2014, WPP had 44% of the trio’s combined billings. Likewise, Omnicom had 23% of the trio’s billings in 2005, 22% in 2010, and 23% in 2014. No other industries show as stable relative market shares among the 3 industry leaders as does advertising. Why is this?

Clients almost never leave their ad agency. Customer retention is remarkably close to 100%. New business wins are unimportant to success in any one year at a giant advertising company. The primary relationship for an advertising company is the relationship between a client and its creative agency. The world’s largest advertisers stay with the same advertising holding companies for decades. As part of our research into Omnicom, Quan looked at 97 relationships between marketers and their creative agencies.

I promise you the length of time each marketer has stayed with the same creative agency will surprise you. Let’s look …

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Andrew Kuhn August 17, 2019 Gannon on Investing 2 Comments

Insider Buying vs. Insider Incentives

December 17, 2017

by Geoff Gannon


A blog reader sent me this email:

Do you ever pay attention to insider transactions when analyzing a company?”

I do read through lists of insider buys from time-to-time. I follow a blog that covers these kind of transactions. But, I can’t think of any situation where I incorporated insider buying or selling into my analysis.

 

 

Learn How Executives are Compensated

I can, however, think of situations where a change in how insiders were compensated was included in my analysis. For example, years ago, I was looking at a stock called Copart (CPRT). It had a high enough return on capital and generated good enough cash flow that it was going to have more cash on hand than it could re-invest in the business pretty soon. Up to that point, it had been able to plow a lot of the operating cash flow back into expanding the business. However, it seemed like they had gotten too big to keep that up. So, they were going to have to buy back stock, pay a dividend, do an acquisition, or let cash pile up on the balance sheet.

I saw that the Chairman and the CEO (two different people, the CEO is the Chairman’s son-in-law) were now going to be compensated in a form that meant the share price a few years down the road is what mattered (if I remember right: compensation would now be a big block of five-year stock options combined with an elimination of essentially all other forms of compensation for those next 5 years). I had also read an interview with the Chairman (it was an old interview I think) where he didn’t strike me as the kind of person who was going to venture out beyond his circle of competence if and when he had too much cash.

So, I felt the likelihood of big stock buybacks happening soon was high.

To answer your question: no, I don’t really pay attention to insider buying and selling. But, yes, I do pay attention to whether insiders own a lot of stock, how they are compensated (what targets the company has for calculating bonuses), etc.

I can think of one situation where both the company and the CEO were buying a lot of stock at the same time. And, I should have bought that stock. If I had, I would’ve made a ton of money. However, to be honest, even if the CEO wasn’t buying shares and the company wasn’t buying back stock I should’ve seen this was a stock to bet big on.

It was trading for less than the parts would’ve fetched in sales to private owners. It was an obvious value investment. And that’s probably why insiders were buying.

 

 

Insiders Are Like You – Only Confident

Insiders tend to be value investors in their own companies. So, I think outside investors assume that insiders are acting more on inside information and less on

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Andrew Kuhn August 15, 2019 Gannon on Investing 0 Comments

How to Quantify Quality

By Geoff Gannon on November 2, 2013

 

Someone who reads the blog sent me this email:

I kind of understand the quantitative part of stock analysis (such as number crunching, valuation) but really struggle to understand the qualitative aspects which determine quality. What kinds of questions to ask yourself in order to gain more insights into the qualitative?

A qualitative analysis does not have to be any less evidence based than a quantitative analysis. However, you do have to gather the evidence yourself.

What counts as evidence? How can we separate our own biases, speculation about the future, etc. from actual observations of quality? Evidence is fact based. Facts come in several flavors.

Number

Example: Tiffany’s New York Flagship Store had $305.54 million in sales in 2012. That is $6,671 per square foot. Based on calculation made from data given in Tiffany’s 10-K on percentage of sales at flagship, worldwide net sales, and gross retail square footage of flagship.

Quote

Example: John Wiley, Reed Elsevier, Springer, etc. have bargaining power with their customers.

The largest (academic journal) publishers wield the power…as a former colleague of mine once said, ‘the more journals you have, the higher your usage stats are and the more money you can charge.”

Based on discussion with a university press editor.

Anecdote

Example: Over the last 10 years, I have placed an average of one order every 4 to 10 days with Amazon. At no point in the last 10 years, have I ever made less than one order every 10 days. I have been a member of Amazon Prime since 2006. The number of orders made each year has roughly tripled from 2003 to 2013. It doubled after I became a Prime member.

Based on information found in my own order history for 2003 to 2013 at Amazon.

History

Example: The 4 most successful periods in animation were at 3 companies: Disney (twice), Pixar, and DreamWorks. At the time of their success, these companies were run by Walt Disney, Jeffrey Katzenberg, John Lasseter, and Jeffrey Katzenberg (again). All worked at Disney at some point in their career.

Based on more than half a dozen books on Disney, Pixar, and DreamWorks.

Experiment

Example:

377 participants were assigned to (Weight Watchers), of whom 230 (61%) completed the 12-month assessment; and 395 were assigned to standard care, of whom 214 (54%) completed the 12-month assessment. In all analyses, participants in the commercial programme group lost twice as much weight as did those in the standard care group.

Based on a journal article appearing in The Lancet.

As you can see, there is no need to be less evidence based when analyzing a business’s quality than you are when analyzing its price. However, you have to impose an evidence based discipline on yourself. You have to go through the primary sources and extract the relevant facts on your own. They will not be presented in as easily digestible form like an EV/EBITDA ratio on Yahoo Finance. When …

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Andrew Kuhn August 13, 2019 Gannon on Investing 0 Comments

Why I Don’t Use WACC

December 14, 2017

by Geoff Gannon


A blog reader emailed me this question about why I appraise stocks using a pure enterprise value approach – as if debt and equity had the same “cost of capital” – instead of using a Weighted Average Cost of Capital (WACC) approach:

 

“…debt and equity have different costs. In businesses with a (large) amount of the capital provided by debt at low rates, this would distort the business value. In essence I am asking why do you not determine the value of the business using a WACC, similar to how Professor Greenwald proposes in Value Investing: From Graham to Buffett and Beyond. The Earnings Power Value model seems theoretically correct, but of course determining WACC is complicated and subject to changes in the future. Nevertheless, your approach of capitalizing MSC at 5% is basically capitalizing the entire business value, including the amount financed by debt, at what is presumably your cost of equity for a business with MSC’s ROIC and growth characteristics. Perhaps I am coming at this from a different angle than you, but it seems a little inconsistent from the way I am thinking about it, and for businesses with more debt this would lead to bigger distortions. AutoNation would be a good example of a business with meaningful…debt that this approach would distort the valuation on.”

 

When I’m doing my appraisal of the stock – this is my judgment on what the stock is worth not whether or not I’d buy the stock knowing it’s worth this amount – I’m judging the business as a business rather than the business as a corporation with a certain capital allocator at the helm. Capital allocation makes a huge difference in the long-term returns of stocks. You can find proof of that by reading “The Outsiders”. Financial engineering makes a difference in the long-term returns of a stock. You can read any book about John Malone or Warren Buffett to see that point illustrated.

 

But, for me…

 

My appraisal of Berkshire Hathaway is my appraisal of the business independent of Warren Buffett. Now, knowing Warren Buffett controls Berkshire Hathaway would make me more likely to buy the stock and to hold the stock. So, it’s an investment consideration. But, it’s not an appraisal consideration for me. When I appraise Berkshire Hathaway, I appraise the businesses without considering who is allocating capital. Otherwise, I’d value Berkshire at one price today and a different price if Warren died tomorrow. I don’t think that’s a logical way to appraise an asset. Although I do think that buying an asset that’s managed by the right person is a good way to invest.

 

A good example of this is DreamWorks Animation (now part of Comcast). Quan and I valued DreamWorks Animation at a level that was sometimes more than double the stock’s price.

 

There was a point where we could have bought the stock at probably 45% of what we thought the business was

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Geoff Gannon August 11, 2019 Gannon on Investing

How Safe Can You Really Make a 5-Stock Portfolio?

By GEOFF GANNON Investors often overestimate the reduction in volatility they will get from diversification and underestimate the reduction in volatility they will get from simply owning stocks with a beta less than 1.   Over the last 10-11 years, I’ve owned 5 or fewer stocks in about 90%+ of all quarters. My portfolio’s returns have had a lower standard deviation in terms of returns than the S&P 500. And in terms of just “downside volatility” – which is what most investors mean when they...

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Andrew Kuhn August 11, 2019 Gannon on Investing 0 Comments

When Should You Diversify?

MAY 19, 2015 by Geoff Gannon

 

Someone who reads the blog sent me this email:

 

“I have been thinking about portfolio construction lately. 

…due to the strict standards you have, I thought it was very natural to just hold mainly four stocks…unfortunately, this method has shown its short comings lately. Both because of (your) mistake in picking CLUB/WTW instead of the other winners discussed in Avid Hog/Singular Diligence, and also because I am currently getting in touch with a lot more very cheap opportunities in the Asia region…I have also been rereading Buffett’s partnership letters and was reminded he once held like 40 stocks. Even though he concentrated at his top several positions sometimes and also he sometimes put 30% to 40% of his portfolio into the workout category, he did say they usually have fairly large positions (5% to 10% of their total assets) in each of five or six generals, with smaller positions in another ten or fifteen. (This) of course is a far cry from the 20%/25% position sizing we usually talk about…

 

What are your thoughts? Is it actually better to spread our portfolio a bit more?…I am getting more and more the feeling that finding the right stock is not the most important part, but picking the right ones to actually put money in is the key. Would (being) willing to spread a bit more make this key job easier? The very cheap stocks I am finding these days may not fit something you will invest in as they are likely not good buy and hold investments. Yet they are also not exactly like cigar butts, i.e. not of very, very low quality stuff. Is it wise for me to ignore them in my personal portfolio and just pick those that are more like the buy and hold category?”

 

I hold 4-5 stocks because I find that is most comfortable for me. You want to combine an approach that makes enough objective sense to work for anyone in theory with an approach that makes enough subjective approach for you to carry it out in practice. I found owning 20 stocks was not practical for me. I spent more time watching what I owned than coming up with a good list of new stocks to research. I didn’t spend enough time focused on what I was buying. When I owned 20 stocks, I spent too much time on the HOLDING and the SELLING and not enough time on the BUYING. It’s no accident that the only thing we do for Singular Diligence is tell you which stock to buy. We never revisit it. We never tell you to sell. It’s all focused on a one-time buy decision. I think that’s the decision that really matters. If you get that moment right the next 5 years or more will take care of themselves. There’s just a heck of a lot of time spent on stuff other than worrying what to buy next when …

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Andrew Kuhn August 9, 2019 Gannon on Investing 0 Comments

All About Edge

December 23, 2017

by Geoff Gannon


Richard Beddard recently wrote a blog post about company strategy. And Nate Tobik recently wrote one about how you – as a stock picker – have no edge. I’d like you to read both those posts first. Then, come back here. Because I have something to say that combines these two ideas. It’ll be 3,000 words before our two storylines intersect, but I promise it’ll be worth it.

 

Stock Picking is Like Playing the Ponies – Only Better

Horse races use a pari-mutuel betting system. That is, a mutual betting system where the bets of all the gamblers are pooled, the odds adjust according to the bets these gamblers place, and the track takes a cut regardless of the outcome.

At the race track, a person placing a bet has a negative edge. He places a bet of $100. However, after the track takes its cut, it may be as if he now “owns” a bet of just $83.

At the stock exchange, a person placing a buy order has a positive edge. He places a bet of $100. However, after a year has passed, it may be as if he now “owns” a bet of $108.

All bets placed at a race track are generically negative edge bets. All buy orders placed at a stock exchange are generically positive edge bets.

In horse racing, the track generally has an edge over bettors. In stock picking, the buyer generally has an edge over the seller.

 

In the Long Run: The Buyers Win

The Kelly Criterion is a formula for maximizing the growth of your wealth over time. Any such formula works on three principles: 1) Never bet unless you have an edge, 2) The bigger your edge, the more you bet and 3) Don’t go broke.

In theory, the best way to grow your bankroll over time is to make the series of bets with the highest geometric mean. Math can prove the theory. But, only in theory. In practice, the best way to prove whether a system for growing your bankroll works over time is to back test the strategy. Pretend you made bets in the past you really didn’t. And see how your bankroll grows or shrinks as you move further and further into the back test’s future (which is, of course, still your past).

Try this with the two “genres” of stock bets:

1)      The 100% buy order genre

2)      And the 100% sell order genre

Okay. You’ve run multiple back tests. Now ask yourself…

Just how big was your best back test able to grow your bankroll over time by only placing buy orders – that is, never selling a stock. And just how long did it to take for your worst back test to go broke only placing buy orders.

Now compare this to back tests in the sell order genre.

Just how big was your best back test able to grow your

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