Geoff Gannon September 30, 2013

Finding Enough Investment Ideas

Upon seeing that The Avid Hog is a monthly newsletter, someone asked this question:

…how do you expect to find suitable candidates every month? Is the supply of good companies that large?

The supply of good companies is enormous. If you don’t have any restrictions on market cap or country, there are always good companies out there. Supply is never the problem. Knowing that supply well enough is.

Although I consider myself a value investor, I don’t get ideas the way most value investors do. You can see a good example of how a value investor looks for ideas in this video of Michael Price’s presentation at the London Value Investing Conference. Another good example is this quote from Nate’s latest post at Oddball Stocks:

I value banks like I value companies.  I find a bank that’s clearly undervalued, then I work to either confirm or deny the valuation.  This is the opposite of someone who might research and value a company and once the valuation is done look at the market value.  I start with the market value, I’m not looking for franchise companies, I’m looking for companies that appear cheap, and I want to confirm they actually are cheap, if so I invest.  This means I don’t have a Watchlist of banks or companies I’d like to buy if the price were right.  Rather I continually trawl low P/B stocks and pick up what’s on sale that week or month

Let’s contrast that with the ideal I strive for. In a perfect world, my approach looks more like how Warren Buffett described his analysis of PetroChina to Fox Business. He told Fox Business the important parts of his approach are that:

  1. He tries to look at the business first, without knowing the price
  2. He decides what he would pay for the entire company
  3. He compares the price he would pay to what the entire company is trading for in the market
  4. If the price he would pay is a lot higher than what the whole company trades for in the market, he buys it.

That’s the ideal approach for me. I’ve found personally that it’s the one that works best. If I appraise the entire business with fairly little preconception of where the stock should trade, has traded, etc. and then I compare my appraisal to the market price I’m on the firmest footing in terms of knowing I have a bargain.

The hypothetical I often pose when talking to Quan about a stock is:

Imagine you are running a family holding company. The assets of all your family members are tied up in this company’s stock. You can put 25% of the value of your holding company into buying this business in its entirety. Would you do it?

In other words, is this a business you want to be in forever? Is the price good? And would you be willing to put 25% of the money of the people you care most about into it?

This approach raises the threshold in a few areas:

  1. Durability
  2. Moat
  3. Quality

You aren’t going to buy something for keeps unless it’s durable. You are not very likely to buy something without a moat. And you are going to insist on a certain level of quality. It probably doesn’t have to be a great business (high pricing power and no tangible capital requirement) but it does at least have to be an above average business.

If I started with a list of statistically cheap stocks, it would be very hard to keep a good flow of the ideas I’m interested in. Aside from EV/EBITDA, there are relatively few value measures that wouldn’t eliminate companies I’m interested in.

For example, I’m fine with a company with negative net worth. I’m also fine with a company that has high free cash flow but doesn’t report it as earnings. Book value and reported earnings are not deal breakers for me.

So how do we actually end up finding ideas?

Well, you already have some evidence of how we do that. Quan has written about Tandy Leather (TLF) and EPIQ Systems (EPIQ). At the start of each post, he told you where he found the idea. He said Tandy Leather came from a list of ticker symbols I send him each week. And he said EPIQ Systems came from a list of stocks that compounded their share price at 10% or more a year since 1999.

The second list is something I created for Quan at Portfolio123. He requested it. I created the screen. It’s a huge list. There are hundreds and hundreds of companies that achieved a 10% annual return over the last 14 years. And that is just in the U.S.

Tandy Leather is not a new name to value investors. I sent it to Quan because we talk about retailers sometimes. This seemed like one with a strong niche. I tend to like distribution advantages, specialty products, and loyal customers. Tandy looked like it compared favorably to other retailers on those fronts.

Quan had already researched Games Workshop. That’s a U.K. company that owns the Warhammer intellectual property. It makes war gaming miniatures. Gross margins are very high. It sells its products through a chain of small, dedicated hobby shops. Because Quan was familiar with Games Workshop, he may have been more interested in Tandy’s stores than investors who hadn’t researched a company like that.

This brings me to an obvious but key point. We tend to find new companies because we know old companies. People who have sampled the first issue of The Avid Hog know there is a list of 5 comparison stocks in there. That’s not something we created specially because it would make a pretty table. It’s there because we like to look at about 5 comparison companies when analyzing a stock for ourselves.

Now, when I say comparison, I don’t always mean it’s a competitor. For example, if Tandy Leather ever makes it into an issue of The Avid Hog, you can bet Games Workshop will be listed as a comparison company. Not many companies have that kind of presence in a specific niche hobby and sell through dedicated hobby shops like that.

Many investors wouldn’t put Tandy and Games Workshop together in their minds. That’s a mistake. They have a lot more in common than Tandy and Coach (COH), which is the company many websites will toss out as a comparison for a leather business like Tandy.

A lot of ideas come from companies that are in some way connected to companies we already looked at. In oligopolies, we look at everything. If we like Hasbro (HAS) we do just as much work on Mattel (MAT). If we like Carnival (CCL) we do just as much work on Royal Caribbean (RCL).

Sometimes, we discard a company because of capital allocation or price. Well, competitors will tend to have similar business quality, durability, and – sometimes – moat. They will, however, tend to have different management and may not always be equally well liked by Wall Street. That encourages us to look for other comparable companies, when we like a business but don’t like its management or its current stock price.

We read a lot of 10-Ks. We each – separately – read a lot about specific companies. I don’t know how much people assume we do on this front. But, I know we do a lot more than you’re thinking.

The reason for this is mostly that we’re doing less of other things than you imagine. My consumption of general business news is really, really low. You wouldn’t get very far talking to Quan or me about the economy. We’re not that up on what is happening in economics, politics, etc. except when we can cite specific examples from companies we’ve researched. For example, I can tell you a lot more about Mediaset than about Berlusconi.

We read more blogs than newspapers. Blogs that analyze companies are our favorites. I read everything that Richard Beddard writes, everything at Value and Opportunity, everything at Oddball Stocks, etc.

It’s difficult to explain exactly how this works. For example, why – if I’m looking for above average businesses – do I read Oddball Stocks? The answer is that any time spent reading an analysis of a company, thinking about that business, and valuing that business is potentially moving you toward good, new ideas.

Some of it comes down to interpretation. I recently wrote an article at GuruFocus about whether you needed to know something the market doesn’t or just need to interpret something differently. I say a different interpretation is more important than different data.

I own a stock called George Risk (RSKIA). I bought it 3 years ago. It was profiled on Rational Walk as a net-net. I bought it because I liked the net-net price. But I only bought it because I like the business quality. I thought it was a really good business. It happened to be at a very low price. But I didn’t analyze it the way I would a net-net. I just used its low price as an obvious indicator that I didn’t have to be really worried about the value part of the analysis here. It was cheap enough. As long as I determined it was durable enough, I could buy it.

This idea of using the same data for different purposes is a big part of what we do. For instance, you may be surprised to know I read up on IPOs. I read the filings. They’re some of my favorites.

I’ve never bought an IPO in my life. I’ve never bought a company within months of it going public. I doubt I’ll ever buy stock in a company that’s been public for less than a year. It doesn’t matter. There’s a lot of interesting info about the business and the industry in those documents.

I mentioned that Quan and I have looked at Carnival. Norwegian (the third largest cruise company) filed some documents with the SEC despite its equity not being publicly traded. We’ve read those.

Now, that sounds like a real bad use of time. I mean, here I am telling you to stay away from CNBC and Bloomberg and all the chatter about the Fed and instead focusing on specific stocks – and I’ll spend time reading about a company that’s not public.

Our feeling was that knowing the cruise industry would be helpful not just in analyzing Carnival at that moment in time, but also it would just be good knowledge to have. It’s not a very fast changing industry. It’s the sort of industry where knowledge of what was happening a few years back is enough to get you pretty far into making an investment decision today.

The list of companies we’ve looked at and are interested in is always long. It’s usually a lot longer than we can handle. Price focuses us a lot. The problem with most companies is that they aren’t obviously cheap. They often seem priced about right.

Now, on this last point, our interpretation of cheap is a little different from what you’ll read about at someplace like Oddball Stocks. We don’t need historically cheap. That’s not a really big selling point for us. The company can be at an all-time high.

For example, I don’t think the stock price of the company we wrote about in our September issue has ever been more than about 10% higher than it is today. That doesn’t matter to us for a few reasons:

  1. The business is more valuable today than it’s ever been
  2. The enterprise value is lower today than it has been in the past
  3. The stock has returned 13% a year over the last 35 years.

This last point is critical. Historical valuations can be important. But they always have to be viewed both with the understanding that tomorrow may be a lot different than yesterday and also with the understanding that some assets have returned a lot more each year. Those assets deserve to trade at higher prices than they did historically.

This even happens in net-nets. I’ve had people mention that a certain net-net has shown up on a screen of net-nets for many years. That’s often true. But there are also a couple net-nets that have increased their share price at 10% or more a year for 10 to 15 years. The market hasn’t done that. So, why should we assume the past price was correct – the historical average is the mean the price should revert to – if holding the stock actually returned a lot more than holding an index fund?

Quan and I look at stocks that way. We don’t feel historical valuations are important unless they are understood in light of historical returns. If some commodity has returned 4% a year over 100 years, I don’t want to own it even at its long-term average price. If a stock has returned 13% a year over its time as a public company, I may want to own it even at a historically “normal” price.

This attitude widens our net in some areas value investors may not imagine. You’re probably not thinking that a stock within 10% of its all-time highs might be a bargain. Sometimes, that’s exactly what we’re thinking.

Quan and I do consider ourselves value investors. However, we certainly don’t consider ourselves contrarian investors. A stock doesn’t have to fall a lot to get us interested in it. We’re willing to look at stocks near highs and near lows.

The scheduled next issues of The Avid Hog will demonstrate this. Based on what we have planned, you’ll get a stock near all-time highs in one of the first issues and you’ll get a stock that dropped a lot in the last year or so.

We actually don’t consider them to be priced very differently. We view the two stocks as being about equally cheap.

So the simple answer is that we don’t do a lot of value screens. We will sometimes turn up ideas that are not very contrarian.

I don’t know all the stocks that will appear in The Avid Hog. But I would guess that if at the end of September 2014, you lined up all the names, you’d probably call it more of a quality list than a value list. I’m sure there would be very little overlap with anything Michael Price owns. So it’s no surprise our approach to generating ideas is different from his.

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