Posts In: Geoff's Writeups

Why I’m Biased Against Stock Options

Someone who listens to the podcast emailed this question:

“I’ve heard Geoff speak about not liking management with tons of stock options but preferring they have raw equity. Could you elaborate on the reasons why? Is it because they have more skin in the game by sharing the downside with raw equity? Thoughts on raw equity vs equity vesting schedule?”

(ASK GEOFF A QUESTION OF YOUR OWN)

This is just a personal bias based on my own experience investing in companies. There is theoretically nothing wrong with using stock options instead of granting shares to someone. And, in practice, later hires are pretty much going to need to be given stock options or some other kind of outright grants. Otherwise, they’ll never build up much equity in the company.

I basically have three concerns about stock options. One is simple enough to sum up in a sentence. Obviously, CEOs and other insiders are very involved in setting the stock options they get. Other things equal, the bigger the option grants the more likely insiders are especially greedy. I’m not sure I want to own stock in a company run by especially greedy people. This might work if you had active control of the company. But, you’re going to be a passive outside shareholder. You don’t really have oversight powers as you would as a 100% private business owner. So, especially greedy insiders are probably ones you don’t want running your company. Big option grants (and low actual stock ownership) can be a symptom of unchecked insider greed.

Okay. We got the simple one out of the way. Now, let’s get into the more nuanced concerns about stock options.

My second concern relates to the influence insiders have on the company’s long-term capital allocation and strategy. The other is simply that I think that from a practical perspective more wealth can be transferred from owners to operators without a shareholder backlash if done via options than via cash.

Let’s talk about concern number one first. Concern number one is that insiders given a lot of options tend not to end up being long-term holders of a lot of stock with a lot of votes attached to it. Therefore, the incentives for insiders are not as long-term as I’d like and the stability of their control over the company is not as secure as I’d like.

When I discuss compensation and stock ownership on the podcast – I’m not really talking about employees. I’m talking about a super select group. My concern is people who are involved – or could easily become involved – in major capital allocation decisions made at corporate. So, basically: the board, C-level executives (especially the CEO and CFO), and major shareholders.

At most companies, it’s narrower than this. Most board members are relatively un-influential and relatively passive. Most major shareholders are institutions that tend to be passive or are shareholders where this stock alone is not large enough to be relevant to their overall performance. So, for …

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Don’t Just “Over-Maximize” One Variable – Find Stocks That Tick a Lot of Boxes at Once

On the day of this year’s Berkshire Hathaway annual shareholder meeting, Andrew and I were in Omaha at a Willow Oak event. Willow Oak is the company that provides a lot of the administrative support functions for our fund. The event was a panel which Andrew moderated and which featured four managers of funds associated with Willow Oak. I was one of those managers. And one of the questions we were asked had to do with what we’ve learned, what we’d have done differently, etc. as investors.

My answer had to do with not “over-maximizing” a single variable when it came to stock selection. There are, of course, other things I may have learned or might wish I’d done differently. Maybe this will become a series of articles where I talk through a few of those. But, on that night, I had only the one answer: not being too focused on “over-maximizing” a single variable. So, that’s the topic we’ll tackle today.

First, what do I mean by “over-maximizing”? A stock may be clearly expensive at 24 times EBITDA, ambiguously priced at 12 times EBITDA, and clearly cheap at 6 times EBITDA. Does that mean you should like it even more at 3 times EBITDA than at 6 times EBITDA? If it’s the same business at the lower price – yes, of course. Other things equal, cheaper is better. But, other things are rarely equal. And the argument that the same business priced at 3 times EBITDA instead of 6 times EBITDA is a better buy doesn’t translate into an argument for starting with the stocks priced at 3 times EBITDA instead of looking at those priced at 6 times EBITDA. If the business is good enough, the management honest and hardworking enough, your knowledge of the industry deep enough, etc. and it’s priced at 6 times EBITDA – that’s probably enough. Often, you may be compromising more than you think on the other softer variables to maximize the hard variable of price.

This doesn’t mean I’d totally avoid stocks whose primary attraction is their price. Of stocks I talk about regularly on the podcast, two stand out as being “maximally” cheap (or, at least they were when I bought them): Vertu Motors (VTU in London), and NACCO (NC). These stocks were not just “cheap enough” on traditional value measures of price-to-book and EV/EBITDA. They were extremely cheap. Basically, they could have doubled in price and still been considered quite a bit cheaper than the average stock. Of course, that’s because they were in industries (U.K. car dealers and U.S. coal miners) where multiples were much lower than other industries.

So, my point isn’t to avoid the very low price-to-book and very low EV//EBITDA stocks. That’d be silly. There’s no reason to eliminate super cheap stocks for being too cheap and preferring only the somewhat cheap stocks. But, there is a good reason to focus on analyzing the other aspects of these companies and their industries. In the …

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U.S. Lime (USLM) Deserves Another Look

Geoff wrote about U.S. Lime back on February 18th, 2018. Focused Compounding members can read that article here:  U.S. Lime (USLM): A High Longevity Stock in a Low Competition Industry

U.S. Lime at the time was trading around $75 per share. Today, the stock is at $130ish per share. Why is now a good time to revisit the company?

Consistency.

Irrespective of valuation, I really like this business. Buffett always talks about how he and Munger have filters in their head to decide instantly whether they should pass or move forward with a business. For me, the first filter is competition. This disqualifies about 99% of the businesses I look at. Will I miss a bunch of potential 10 baggers because of this?

Most definitely.

Is this bad?

Absolutely not.

If anyone comes across a company that has stable margins on a durable product and competes mainly on a regionalized bases, shoot me an email — I’ll always be interested to hear about it.

U.S. Lime fits that bill. U.S. Lime describes their competition in their 10-K as:

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Competition. The lime industry is highly regionalized and competitive, with price, quality, ability to meet customer demands and specifications, proximity to customers, personal relationships and timeliness of deliveries being the prime competitive factors. The Company’s competitors are predominantly private companies.

The lime industry is characterized by high barriers to entry, including: the scarcity of high-quality limestone deposits on which the required zoning and permitting for extraction can be obtained; the need for lime plants and facilities to be located close to markets, paved roads and railroad networks to enable cost-effective production and distribution; clean air and anti-pollution regulations, including those related to greenhouse gas emissions, which make it more difficult to obtain permitting for new sources of emissions, such as lime kilns; and the high capital cost of the plants and facilities. These considerations reinforce the premium value of operations having permitted, long-term, high-quality limestone reserves and good locations and transportation relative to markets.

Lime producers tend to be concentrated on known high-quality limestone formations where competition takes place principally on a regional basis. While the steel industry and environmental-related users, including utility plants, are the largest market sectors, the lime industry also counts chemical users and other industrial users, including paper manufacturers, oil and gas services and highway, road and building contractors, among its major customers.

In recent years, the lime industry has experienced reduced demand from certain industries as they experience cyclical or secular downturns. For example, demand from the Company’s steel and oil and gas services customers tends to vary with the demand for their products and services, which has continued to be cyclical. In addition, utility plants are continuing to use more natural gas and renewable sources for power generation instead of coal, which reduces their demand for lime and limestone for flue gas treatment processes. These reductions in demand have resulted in increased competitive pressures, including pricing and competition for certain customer accounts, in the industry.…

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Some Thoughts on Calloway’s Nursery, Inc.

I plan to use Focused Compounding as my investing journal. My “writeups” will be less structured than Geoff’s, but could serve as a starting point for members to research a new stock. My posts will literally be similar to emails that I send to Geoff whenever I have thoughts on a business — basically straight from the stream of my consciousness, lol.

Feedback/your notes/thoughts are highly encouraged in the comment section below.

The first stock that I want to talk about is Calloway’s Nursery, the garden and landscape retail store in DFW/Houston. Here’s a brief history on the origins of the company: taken from http://www.fundinguniverse.com/company-histories/calloway-s-nursery-inc-history/

The garden center industry in Texas underwent significant change during the 1990s as competitors fought for market supremacy–or, at the very least, for survival. Some market participants buckled under the pressure exerted by mass-merchandise, discount chains such as Wal-Mart and Kmart, while other garden center firms consolidated their operations to improve their odds for survival. Caught in the midst of the pitched battle for the garden business of Texas was relative newcomer, Calloway’s Nursery.

Calloway’s Nursery was founded in 1986 by three former senior executives at Sunbelt Nursery Group. Formed in 1984, Sunbelt Nursery was created to help expand Pier 1 Imports’ Wolfe Nursery Inc. concept. Selected to lead the company toward such an objective were Jim Estill, Sunbelt Nursery’s president and chief executive officer; John Cosby, the company’s vice-president of corporate development; and John Peters, its vice-president of operations. Together, the three executives helped develop the company into a regional force with more than 100 stores in a five-state area. After a change in ownership at Sunbelt Nursery, the trio disagreed with the new owners about the future direction of the company. In March 1986, they formed Estill/Cosby Enterprises to facilitate the creation of their entry in the garden center market, Calloway’s Nursery.

Although Estill, Cosby, and Peters were veterans of the industry, they consulted the patriarch of the garden center industry in the Southwest, 65-year-old Sterling Cornelius, before starting out on their own. Sterling Cornelius’ father, Frank Cornelius, started the family nursery business in 1937, initially occupying a portable building that measured only slightly larger than 100 square feet. Except for a four-year stint in the U.S. Navy during World War II, Sterling Cornelius was employed by his father’s company from its start, witnessing the addition of Turkey Creek Farms, a nursery operation, in 1951 and the company’s development into a favorite among Houston’s lawn and garden enthusiasts. Estill, Cosby, and Peters solicited the help of Sterling Cornelius because, by their own admission, they wished to copy the operating strategy used by Cornelius Nurseries. “We saw an opportunity to create a different kind of nursery in Dallas-Fort Worth, and quite honestly, Cornelius was our pattern,” Estill remarked in a November 26, 1999 interview with Dallas Business Journal. “Cornelius was always the group in Houston that went after the upper-income customer, and there wasn’t anything like that in the Dallas-Fort Worth area.”

After Sterling …

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Kingstone Companies (KINS): A Homeowner’s Insurance Company Focused on Selling Through Agents in Downstate New York

From time-to-time, I research a company where I think I’ll do a write-up of the stock and then discover it isn’t as interesting a situation as what I first thought. That’s the case here. Kingstone (KINS) seemed fairly cheaply priced on the surface. And seemed like an easy enough business to understand. But, several of the things I found – while not individually all that serious – added up to a pass for me. Instead of writing about the company, the valuation, etc. in a lot of detail – I’ll just go over what I found that were hurdles I couldn’t clear.

We can start with valuation. Value investors are often attracted to insurers where the stock is trading below tangible book value. As of the last 10-Q, Kingstone had about $88 to $89 million in tangible equity. Shares outstanding are about 10.6 million. So, tangible book value is a bit north of $8.30 a share. The stock last traded at a price a bit below $7 a share. So, you are getting in at a discount of something like 15% of tangible book value.

There are two ways of looking at this.

One, it gives you upside. If a company can compound at 10% a year and you buy it below tangible book value – you can get an earnings yield higher than 10% a year and you can get an additional capital gain from the increase in the price-to-book multiple over the time you own it.

This is the “Davis Double Play”. You buy at say 8 times earnings. Earnings compound at 10% a year. After a number of years, you sell at 16 times earnings. Over 10 years, a doubling of the earnings multiple provides a 7% a year return. The business itself only has to grow at a “modest” 8% a year for this combination (7% plus 8%) to add up to a 15% a year return over 10 years. That’s a low-ish hurdle to clear for a very nice, very market beating return. So, that approach appeals to value investors.

Two, tangible book value can provide downside protection. An insurer could make an attractive acquisition target for another insurer if the price-to-book multiple of the acquired insurer is below that of the acquiring insurer and if it’s below book value. If paid in cash, an acquirer gets more assets by paying less than book value. If paid in shares, an acquirer gets more assets than it gives up because the shares it is giving up in itself have less asset backing than the shares it is acquiring.

There’s a third way of looking at it.

This is the “Buffett” approach. When Buffett bought National Indemnity (an insurer) for Berkshire Hathaway – he thought of his purchase price as only the amount he was paying over the investments held by the company. This is because he was going to own cash, stocks, and bonds anyway. And once he bought National Indemnity, he’d have control of the …

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Jewett-Cameron (JCTCF): A Stock That Grew in Value Even When the Business Didn’t Grow in Size  

Over the last 10 years or so, Jewett-Cameron (JCTCF) has roughly quintupled its stock price while the company’s total revenue has remained basically the same.

There are some interesting signs here. But, I haven’t learned enough to say anything definitive about this company.

I can summarize what we know from the SEC filings though.

Jewett-Cameron is an illiquid microcap. The company files with the SEC. In fact, it also files with SEDAR (because it’s incorporated in Canada and used to trade on the Toronto Stock Exchange). Today, Jewett-Cameron is listed only on NASDAQ. And, although incorporated in Canada, it’s really an American company.

The business description for Jewett-Cameron describes the company as being involved in industrial wood products, products tied to pets and garden and lawn, and seed and seed processing. Older descriptions of the company also mentioned a discontinued industrial tool business (it was liquidated last year). I think these are somewhat misleading descriptions of the company. They give the impression this is more of a lumber business and more of a diversified business than it really is.

I don’t know a lot (yet) about the long-term history of this company. But, based on the dates given for when each business segment was created – it seems it started out as more of a lumber business and gradually moved further and further into what I think it is today: a pet, garden, and lawn business with the “pet” part (dog kennels, fencing to keep dogs enclosed, etc.) being the most important. No segment other than “pet, garden, and lawn” consistently contributes meaningful profits to the company. In fact, in recent years, this company would have earned about 10 cents per share more if it consisted only of the “pet, garden, and lawn” business.

So, over 100% of the EBIT you are seeing here is from “pet, garden, and lawn”. Also, the majority of sales in that segment (like 70%) are for metal products rather than wood products. I should mention the segment accounting here is a little different than you’re probably used to seeing. Jewett-Cameron separates out its corporate function and charges its subsidiaries for corporate services provided. It then shows a profit on the corporate line. As a result, all of the segments here look worse than they tend to when broken out by most public companies – because, most public companies are showing you segment data without charging each segment for corporate functions. The figures shown here probably better represent what each segment would look like if it was broken off from Jewett-Cameron and made a separate business. Really, the only meaningful business for an investor to consider is the “pet, garden, and lawn” business which did about $4 million in EBIT last year against an enterprise value of about $30 million here. So, the entire company is selling for like 7-8x what that one segment did in pre-tax income. Given that over 100% of EBIT comes from that segment and that the market cap and enterprise …

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Universal Insurance Holdings (UVE): A Cheap and Fast-Growing Florida Hurricane Exposed Insurer I’m Going to Pass On

This is a stock I talked about on a podcast with Andrew. It looked cheap based on the simple ratios you might use to decide if something’s a value stock. And the business of writing homeowner’s (and renter’s) insurance in Florida seemed like something that could be good enough (in some years) and simple enough for me to understand and possibly invest in.

However, what I found when looking into Universal is a lot of stuff I don’t really like. Having said that, the stock is cheap. It is very leveraged to good underwriting results. So, in a good year (especially a tame year in terms of Florida hurricanes) the stock could easily go up a lot. It is a value stock. It’s cheap. But, it’s unlikely to be something I’d buy.

Let’s start with how cheap it is. If you look at something like QuickFS.net you’ll see that UVE is trading at around book value. The P/E doesn’t look good. But, the “E” part of an insurance company like this is going to involve both investment results and underwriting results. Underwriting results at UVE are going to depend mostly on the loss ratio (the expense ratio shouldn’t vary a lot here) and the loss ratio is going to depend a lot on weather. UVE uses a lot of reinsurance. However, the way these reinsurance agreements are set up – UVE is very exposed to the frequency (not so much the magnitude) of hurricanes in Florida. As a result, I suspect that recent weather related losses for UVE are larger than you might expect. You’d expect them to be manageable because there haven’t been a lot of really bad hurricanes in a while. However, there actually have been a lot of events. You can read about the reinsurance deals in the company’s investor presentation. I’ll sum it up by saying that UVE stands to lose fairly similar amounts – much more similar amounts than I expected before reading about the reinsurance deals – from each event per year than you might think. So, you might be scared off by the risk of one really big hurricane and underestimate the impact of several medium sized hurricanes.

This brings me to the company’s “plan” and its guidance. This is the first thing I don’t like about UVE. The company does earnings calls. And it gives guidance. I don’t think it’s a good idea for a company like this to guide. UVE is guiding on the basis of weather performing “to plan”. So, it is basically plugging in something like 10% of each premium into weather related losses. But, some years the actual losses could be 30% of premiums instead of 10%. In another year, it could be almost nothing. On a recent call, an analyst asked about the fact that the company had performed below plan for many consecutive quarters in a row. That’s the problem with guiding around normal weather. It’s actually not as abnormal as it might sound to have …

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