Geoff Gannon September 21, 2017

He Who Has the Highest Opportunity Cost Wins (CAKE, NC, GRBK)

Someone who reads the blog emailed me about Cheesecake Factory (CAKE):

Why are you not buying CAKE – it is around 66 cents on the dollar – at 40 dollars (a share)?”

When I answered that to his satisfaction, he asked:

“…So your options right now are most likely OMC, Howden and CAKE? You said in your OMC (stock report) that it was the best business you’ve ever analyzed. Is that still the case, especially compared to CAKE etc.?”

Omnicom is a better business than Cheesecake. However, Cheesecake may have more room to deploy capital within the business for the next 5, 10, 15 years. Apparently, Cheesecake management still thinks they can grow the concept from 200 locations to 300 locations. It’s not unheard of for them to open 8 new restaurants a year. So, that’s probably equivalent to 3% compound annual growth in the number of Cheesecake locations over a period of 10-15 years. Each location may be capable of earning a 10% to 15% after-tax return on the company’s cash investment of say $8 million to $12 million (they also sign a lease, but this does not tie up any shareholder money). Let’s call it $10 million per location in cash the company puts in and they can repeat that same $10 million bet at each of another 100 new locations – that’s $1 billion more in reinvestment done at rates of 10% plus.

To put this in perspective: Cheesecake may be able to re-invest 50% of its current market cap over the next 10 years at rates of return equal to or greater than 10% a year. It can also buy back its own stock. Both companies can do that and I expect both will do that aggressively. But, Cheesecake may have this additional opportunity to invest about 50% of its market cap over the next 10 years in the actual business at good rates of return. For Omnicom to reinvest 50% of its market cap on those same terms, there would need to be something in the $8 billion to $9 billion price range that will earn a year one 10% plus cash return on your investment.

I don’t see how Omnicom can find something like that. Right now, Omnicom can only compete with that kind of value creating capital allocation by buying back its own stock. Omnicom’s stock would have to stay cheap for a long time while the company gobbled up its own shares for OMC’s capital allocation to add as much value as Cheesecake’s capital allocation. So, Cheesecake may grow intrinsic value per share faster than Omnicom. Omnicom’s still the safer bet if you had to own one stock forever. But, if you have to own one stock for the next 10 years – I can’t promise that OMC has a way to deploy as much cash as profitably as Cheesecake might. Again, I stress might (CAKE needs to find good mall type locations to do this).

My options other than Cheesecake are not limited to Omnicom and Howden Joinery.

I look at a lot of stocks.

Yes. The ones recently that stand out as the kind of businesses I would normally buy at the kind of price I normally like are: Cheesecake Factory, Howden Joinery, and Omnicom. Those are the most stereotypical me type stocks.

However, there are other stocks I look at that also seem potentially attractive. I just may not be done researching them enough to know them as well as I know things like Cheesecake, Howden, and Omnicom (all of which I originally researched at least a year ago and in one case – Omnicom – more than 8 years ago.)

Right now, two stocks that stand out as deserving a lot more study are: NAACO (NC) and Greenbrick Partners (GRBK).

NAACO is splitting into what should be a pretty capital light, non-cyclical, and non-competitive coal mining business and the Hamilton Beach small appliances business.

Green Brick Partners is a homebuilder that is split close to evenly between Dallas Fort-Worth (it builds homes in places like Frisco, which is right by where I live in Plano) and Atlanta. I don’t know the Atlanta housing market. But, I do know the Dallas housing market. The stock trades at about 1.1 times book value. However, in the homebuilding industry, land is usually held for 2-5 years from the time a homebuilder buys it to the time they sell the finished house on that land. Land prices in Dallas Fort-Worth have risen, so the fair value of their holdings would actually somewhat exceed 110% of book value – meaning, the market value of the company’s assets is slightly greater than the market cap of the company. They have enough net operating loss carryforwards to not pay taxes for another 3-5 years depending on how much they grow earnings. The decision maker (Jim Brickman) is a good homebuilding guy and has a meaningful personal stake in the company. Together with David Einhorn’s Greenlight capital (about a 50% owner) and Dan Loeb’s Third Point (about a 17% owner) people who are insiders/long-term investors of some kind hold about 75% of Green Brick Partners. So, the float is probably no more than $125 million. The stock was, in recent memory, a speculative ethanol type company that was used as the public entity to take this Einhorn/Brickman homebuilding entity public. In investors’ minds, the company is probably not “seasoned” as much as it’s going to get in the sense that if I say “Green Brick Partners” today – you may not have recognized the name and if you did you may not have immediately remembered it’s a homebuilder and even if you did remember that you still might not have remembered where it builds home (Dallas and Atlanta). It’s underrecognized. If you buy the stock in 2017 and plan to sell it in 2022, you’ll probably be selling a bigger, more recognized stock with a higher price-to-book multiple that is then starting to pay taxes.

A homebuilder is not the kind of stock I’d usually buy. Green Brick isn’t a capital light pure homebuilder like NVR (NVR). Nor is it more of a marketing machine like LGI Homes (LGIH). It’s something that buys up land, holds it for up to five years, puts a house on it, and then sells the land plus the house. There’s no cash flow that doesn’t go back into buying up more land. Everything it does is tied to residential land values where it operates. So, this is purely an investment in residential land in Dallas and Atlanta. However, the combination of UNTAXED (for now) cash flow from homebuilding activities going back into buying additional land plus the annual appreciation of land while it’s on the balance sheet gets you to a good growth in Market Value of Land Per Share which is what the intrinsic value of the company obviously is.

Green Brick Partners is clearly very attractive relative to the market. The S&P 500 is trading at probably twice what it normally does. One times book is not above normal for a homebuilder that operates only in good metro areas. And then I feel sure that on a per share basis Green Brick Partners will grow its book value faster over the next 5 years than the S&P 500 will grow its EPS. So, Green Brick definitely has higher growth and a lower price multiple than the overall market.

It’s an attractive potential investment. And I’d have to compare something like Green Brick to something like Cheesecake to something like Omnicom to decide which to buy.

Most investors would just buy Howden and buy Omnicom and buy Cheesecake Factory and buy Green Brick Partners and buy AutoZone if they felt the way about those stocks that I do.

But then they’d eventually end up with a portfolio of like 20 stocks with 5% in each instead of a portfolio with 5 stocks and 20% in each like I want.

If you’ve read “The Snowball” and looked carefully at how Warren Buffett sized positions in his own portfolio and the partnership in the 1950s and 1960s – that’s more how I operate.

Right now, my portfolio is basically:

40% Frost (CFR)

25% BWX Technologies (BWXT)

35% Cash

I’m very concentrated and very patient. I’m so slow to buy a stock. I mention my high selectivity / concentration in posts all the time, but I don’t think readers really understand how different that makes my decision making from their decision making.

I haven’t bought a stock in 2 years.

Chances are that if I do buy Omnicom, Howden, Cheesecake, AutoZone, Green Brick Partners, or NAACO it will only be one of those stocks. It could be two if I like one best now and then another one absolutely plummets in price.

But, because I buy so few stocks and buy them so rarely – my hurdle is very high. If you see me buy Cheesecake, it means that ultimately I decided I felt more comfortable with Cheesecake as a business and at this price than I did with EACH AND EVERY ONE OF: Omnicom, Howden, AutoZone, Green Brick, NAACO, etc. That’s a high hurdle to clear.

One of the best ways to improve your investment returns is simply to raise your opportunity cost.

If the best idea you DON’T buy is better than most the ideas other investors DO buy – then, you’ll win over time.