Why Ad Agencies Should Always Buy Back Their Own Stock
Someone who’s been reading my blog for the past few years emailed me this question:
“With (Omnicom), I particularly like the durability of the advertising agency industry, the nature of the customer relationship (long term in nature and high retention rate), it operates in a rational duopoly environment and good capital allocation policy of John Wren. I also like WPP which also looks attractively valued at around £14 but I prefer OMC as it uses the excess cash to buy back its shares compared to WPP’s acquisitive approach. Would be great to get your thoughts and insights on the following:
– Any significant misjudgment I should consider that could potentially impair OMC’s ability to compound by around 10% in the long term;
– Your thoughts on WPP as a potential alternative consideration to OMC, especially at the current price of around £14 and its market leadership. I like OMC even more now that it is in the low $70s but it would be interesting to get your take on your appraised value of WPP and if there are factors I should favour WPP over OMC apart from the valuation margin of safety and different use of excess cash (share buybacks versus acquisition).”
No. There’s no significant misjudgment on your part that’s going to cause Omnicom to fail to compound at 10% a year while you own it. I’ve looked at ad companies recently and don’t see any changes in the industry that worry me. I’ve gotten a lot of emails – and responded to some of them – about whether ad companies will have a narrower “moat” in the future than they have in the past. I think the concerns are very speculative. And I don’t see any long-term reason for the decline in the share prices of ad companies like WPP and Omnicom.
Obviously, there are cyclical reasons that explain these price declines well.
The big change in advertising is that Google (both the search engine and YouTube) and Facebook are the venues where all incremental ad spending in the world is now going. So, Google and Facebook will have a big share of ad spending in the future. But, that’s not new. Brands have often spent a large portion of their ad budgets at a small number of media outlets.
The new part is that global conglomerates (like Omnicom) made up of different agencies will be doing a lot of their overall buying for clients at just two corporations: Facebook and Google.
I understand it worries other people. It doesn’t worry me. I don’t see anything in the way that the ad industry is developing now that seems like a bigger shift than the rise of TV, the death of newspapers and magazines, or the rise of the internet. Those things already happened by the way. It would be impossible to know that from looking at the financial results of global ad companies. None of those events left the slightest mark on their earnings per share. And they didn’t change the economics of the ad business much at all even though they completely changed where clients spent their money.
So, personally, I’m not worried about the moat around ad companies getting any narrower.
Now, let’s discuss why I’d pick Omnicom over other ad companies if I was to pick just one ad stock to buy and hold.
I tend to make my investing decisions based on four sort of “laws” I guess you could call them.
The first law is: Buy a business with strong and strengthening market power.
The second law is: Buy into a corporation with good and improving capital allocation.
And the third law is: Buy the stock at a discount price to your own appraisal of intrinsic value per share.
So, my 3 objective criteria are: 1) Market power, 2) Capital Allocation, and 3) Discount Price. And, yes, their importance is in that same order.
The most important law of all though is the “zeroth” law. It’s subjective.
The zeroth law is: Bet on the assumption you’re most comfortable with.
Here, the discount price and the market power aren’t very different between WPP and Omnicom. What is different is capital allocation. I’m not sure WPP’s capital allocation will be worse than Omnicom’s. However, I am more comfortable making the assumption that Omnicom’s capital allocation will be close to what I expect. So, it’s Omnicom’s victory on account of the zeroth law: “Bet on the assumption you’re most comfortable with.” I’m most comfortable with the assumption Omnicom will keep buying back its own shares over time. So, if I had to make a bet in the ad industry – that’s the bet I’d make.
Still, there’s no doubt the top two contenders for my consideration would be WPP and Omnicom.
And I do like them both.
In fact, I would recommend the average investor buys them both. But, I prefer to concentrate my investments in just one stock in an industry. For example, among U.S. banks I really like: Frost (CFR), Prosperity (PB), and Bank of Hawaii (BOH).
But, I only bought Frost for myself.
For other investors (who tend to prefer diversification over concentration) I’d recommend splitting your money among those 3 banks or even among 6 or 7 banks (adding BOKF, CBSH, UMBF, and even WFC to that mix).
The reason for that is the zeroth law: Bet on the assumption you’re most comfortable with.
If you’re more comfortable assuming that – on average – a basket of those 6 or 7 banks will still be around in 5 years and will have meaningfully higher EPS in 5 years, that’s the bet you should make.
I’m more comfortable with the assumption that Frost will still be around and will be making much more in earnings per share in 5 years than I am with the assumption that – on average – that basket of banks will be around and earning more.
If I was more comfortable with the assumption based on a basket – I’d do it as a basket.
That’s what I did with Japanese net-nets.
I looked at a ton of them. And I picked 6 of them. I didn’t bet on just one.
Because I was more comfortable with the assumption that a basket of 6 Japanese net-nets would – within 5 years – be valued more highly in the future than they were when I bought them than I was about the same assumption regarding any individual Japanese net-net I could find.
Always “bet on the assumption you’re most comfortable with”. Always.
So, let’s apply that to ad company stocks.
For the average investor, there is nothing wrong with buying a basket of all the big ad agency groups like: Omnicom (OMC), WPP, Publicis, Interpublic (IPG), Havas, and Dentsu. Of course, I’d eliminate Havas from that group because of Bollore’s (that is, Vivendi’s) offer to buy Havas at a much higher multiple than the rest of the group now trades at.
But, you could put together a 5-part basket of Omnicom, WPP, Publicis, Interpublic, and Dentsu. I take very concentrated positions. If I was to buy Omnicom, I’d put somewhere between 20% and 25% of my account into it. Most people would be uncomfortable putting 25% of their account in one stock. But, they might be comfortable putting 5% in Omnicom, 5% in WPP, 5% in Publicis, 5% in Interpublic, and 5% in Dentsu – for a total of 25% in ad agencies. If that’s the way to get the average investor comfortable putting 25% of their money in ad agencies – then I’m all for it. That basket will serve them better long-term than any index fund. At today’s prices for those ad companies, you’ll get both higher returns and lower risk than you would in an index fund.
Personally, I like OMC and WPP best. And I know OMC better than WPP. So, I would just put 20% to 25% of my account into Omnicom. My appraisal value for Omnicom was about $95 a share when I wrote my report on that company a while back. The stock has increased its sales per share by about 5% since I wrote that report (mostly through a decreasing share count due to buybacks). So, I’d now value Omnicom at $100 a share. I tend to buy businesses I like when they trade at a 35% discount to my appraisal of their intrinsic value. So, the “trigger” for me on OMC would be about $65 a share. If and when the stock crosses that level (it’s at $73 now), don’t be surprised to see I’ve put 20% of my account into OMC.
Why do I prefer Omnicom over WPP?
I think they’re comparable in quality. And I know OMC better.
I understand Omnicom better because it has a longer history of allocating capital the way it is allocating it now, it has acquired fewer companies in the past, and some other small factors like that. I think WPP is the second best ad group behind Omnicom. And, by the way, WPP’s capital allocation is good. It’s just more flexible and opportunistic. And therefore: less certain.
Now, we have to address a controversial topic.
I’m going to make a strange claim here.
I’m going to say that a hypothetical publicly traded ad company that “dumbly” just dollar cost averages into its own stock by always using 100% of its earnings to buy back shares will likely outperform “smart” capital allocation by someone like Martin Sorrell at WPP.
In the long-run, I truly do doubt that WPP’s actions other than share buybacks can compound value faster than share buybacks alone would. This is just a general long-term rule for all the publicly traded ad companies.
I now have to go on a very long tangent to explain something I believe to be true that will seem odd to hear. I believe the stock market has inefficiently priced the shares of publicly traded ad agencies for about as long (over 40 years in some cases) as those agencies have been publicly traded. It’s as if the market has had 4 decades to learn the right price for a certain business model and yet it’s never figured it out.
My belief is that the market undervalues the ad agency business model. It doesn’t understand the P/E premium over the market that an ad agency would need to trade at to equalize the likely future return of the ad agency with that of a “normal” business. Every year, an ad agency both grows organically (in line with growth in the ad budgets of its existing clients) and is able to payout 100% of its earnings. Normal businesses can’t do both of these things at the same time. So, they can grow 5% a year, but they can only pay out say 50% of earnings. That means a normal business trading at a P/E of 15 would be priced to return 8.33%. Actual returns in the stock market have not been exactly 8.33%. But, they’ve been close and they’ve been close for the reason I just explained.
The typical stock grows 5% a year organically, it pays out half its earnings in dividends (or share buybacks), and it trades at a P/E of 15. Those conditions will – in the very, very long-run – give you a return of 8.3% a year.
A P/E of 15 is an earnings yield of 1/15 = 6.67%. Half of 6.67% is 3.33%. So, I am saying that to the extent stocks tend to trade at a P/E of 15 and retain 50% of earnings they will tend to have an annual payout (in either the form of dividends or reductions in shares outstanding) of 3.33% of their market price. When you add this “yield” to the growth rate, you get a return for the investor of 8.3%. In some periods, the Shiller P/E – or whatever normalized valuation measure you want to use – will expand and returns may reach 10% or 12% over a certain 15 years. But, in other times valuations may contract and there will be 15 year periods where returns are just 6% or even 4%. For a typical business: what’s really underlying all this is about an 8% to 8.5% increase in intrinsic value (which is normally turned into about 5% sales growth and like 3% to 3.5% dividends and share buybacks).
Now, do the same math with an ad agency and you get a different number. Ad agencies retain no earnings as they grow 5% a year. So, if an ad agency stock trades at the same P/E ratio of 15 as a “normal” stock, it will have a 6.67% yield in terms of what it is going to use on dividends and buybacks. Add that to the growth rate and you get an 11.7% long-term expected return instead of an 8.3% long-term expected return. That’s an inefficient pricing.
How would the market efficiently price ad agency stocks?
The market would need to put a P/E of 30 on ad agencies instead of a P/E of 15. Value investors don’t like hearing this. But, it’s true. If Company A can grow 5% a year and pay out 3.3% and Company B can grow 5% a year and pay out 3.3% – they’re equalized in terms of future return expectations. Because ad agencies have a 100% earnings payout, they will only reach intrinsic value parity with the market when they trade at a P/E of 30 and the market trades at a P/E of 15. The earnings yield on an ad agency stock should be half the earnings yield on the overall market for it to be correctly valued.
Let’s look at what’s really happened in the past.
I told you there’s a quirk in the stock market where publicly traded ad agencies tend to be inefficiently priced such that they are usually underpriced as long-term buy and hold investments.
Let’s look at some results to see what I mean.
As a very rough sketch type exercise, I’ll just give you Omnicom’s total return from 1979 to now, 1984 to now, 1989 to now, 1994 to now, 1999 to now, 2004 to now, and 2009 to now.
1979: 11.7%
1984: 10.9%
1989: 12.9%
1994: 11.7%
1999: 5.3%
2004: 4.1%
2009: 14.0%
You can see timing isn’t important.
I just started in 1979 and went forward 5 years at a time. I always picked the first week in January as my start date. And we know the end date is conservative. Omnicom trades at a P/E of 15 right now. The market’s P/E is higher. Because I used today’s price (which I think is low) as the end point for all those measurements – I may have understated Omnicom’s true compounding power as an investment for all the periods measured there.
If you just avoided the 1999-2004 bubble type period (where Omnicom’s P/E was astronomical) you would have gotten buy and hold returns of between 11% and 14% a year just by picking Omnicom as a business and then throwing darts at a calendar to decide when to buy into that business. Mostly, the stock’s annual rate of return has been in the 11% to 13% a year range. So, about 12% a year for long-term holding periods.
While the S&P 500 has certainly matched Omnicom’s rate of compounding over some periods (we can cherry pick start dates and get times where the stock doesn’t outperform) it’s also done it with low risk. Omnicom has never lost money. It’s never had negative free cash flow. It’s never really had a bad credit rating. And it has had far less volatility in actual business results (things like margins, sales growth, etc.) than the market as a whole.
There’s no easy explanation for why the shares should outperform the market.
All the usual explanations: higher risk, illiquidity, greater volatility, etc. don’t work. In fact, GuruFocus rates Omnicom a 4.5 out of 5 in terms of predictability. My own method of determining volatility in business results (EBIT margin volatility) shows Omnicom is very close to the most predictable company in the world. Costco (COST) is more predictable. Off the top of my head, I can’t come up with any company other than Costco that has lower volatility in its margins.
This raises a very real problem:
Either the market hasn’t – even after 40+ years of experience – correctly learned how the ad agency business model works and incorporated that into the P/E ratio for ad agency stocks…
…or…
…the market is never looking far enough into the future.
I think the second possibility is the answer.
I don’t write a lot about market efficiency. But, what I’ve come to believe through my own experience investing in stocks is that the market is fairly efficient over short periods of time (like the next 3 years) but very inefficient over long periods of time. In some stocks, like Frost (CFR) when I bought it at less than $50 a share and Omnicom (OMC) when it trades at under $75 a share now – I think “the market” is making no attempt to price the stock as a long-term investment.
The market is – perhaps very efficiently – asking what should this stock be priced at to give you the same return as other stocks over the next 3-5 years. However, the market is making no attempt to ask what the stock should be priced at to give you the same returns as other opportunities over the next 15-25 years. I don’t think it’s an issue of efficiency or inefficiency or me being contrarian to the market in my beliefs or anything like that. I just believe the market has no beliefs over 15-25 years. It only has beliefs over 3-5 years.
If that’s true, quality companies will tend to be underpriced.
Let’s say three things work in investing: momentum, value, and quality.
Well, momentum is a strong force in the short-term. Value is a strong force in the medium-term. And quality is a strong force in the long-term. If the market is not making any attempt to correctly price stocks over 15-25 year holding periods instead of just 3-5 year holding periods – then, it’s quality that’s going to be underpriced.
That’s a good argument for buying and more importantly holding ad agency stocks forever.
But, I said this was a tangent about why ad companies that buy back their own stocks will likely do better than ad companies that follow a more diversified approach to capital allocation.
Big ad companies are buying from institutional investors when they buy back their own stock. I believe these investors are not correctly pricing ad agencies. However, the big ad companies are normally not buying publicly traded stocks when making acquisitions. They aren’t buying from institutional investors. They’re often buying out owners who know a lot about ad agencies.
There is sometimes an “arbitrage” in roll-ups of local, boring businesses (like small print shops) where a publicly traded stock that owns 100 of these things is valued at a higher multiple than 1 of these sites would be selling for on its own. So, the market will pay more for a public company that owns one gas station in each of America’s 50 states than for a company that owns just one gas station in one state even though the economics of the business with 50 scattered gas stations may not really be much better than that one owner/operator gas station. In such situations, the public company can issue stock to a private seller and thereby immediately increase its stock’s own value per share. It can give stock worth 5 times EBITDA to a seller and then it has increased its own EBITDA through the acquisition and the market puts an 8 times EBITDA value on this incremental gain to earnings.
Ad companies don’t work that way. They work the reverse way. It’s easier to get a bargain price for an ad agency through buying shares in the open market than it is trying to negotiate a 100% control purchase of an agency. When you consider earn out agreements and things like that, you just don’t get prices on acquisitions that routinely offer as much as buying back your own stock does.
So, I think that if you own an ad company long enough – you’re best off owning the ad company that uses more of its cash flow to buy back stock than any of its peers.
I’m more comfortable with the assumption that will be Omnicom than I am that it’ll be WPP. It might be WPP. Omnicom pays a dividend (I wish it didn’t). And WPP buys back stock now. So, I can’t guarantee Omnicom will buy back more of its shares outstanding than anyone else. But, over longer periods of time, I’m more comfortable with that. And I’m more comfortable assuming that the range of possible returns on those buybacks is narrow for Omnicom. If you hold an ad company long enough and it devotes almost all of its earnings to buying back its stock, you should get close to an 11% annual return over the time you hold the stock.
If you look at Omnicom’s history of buying back its stock, you’ll see why I have more confidence it will devote more of its cash flow to buybacks than its peers will.
Other than that, I think the big ad companies are pretty similar in quality. If you want to put your money into just one ad company, I’d make that decision based on two criteria:
- Which ad company’s stock has the lowest price-to-sales ratio?
- Which ad company seems most likely to buy back the greatest percentage of its own shares over the next 15 years?
The company with the lowest P/S ratio when you buy it and the highest buyback rate while you own it is going to be the best investment.