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The Paradox of Value Investing and Coke
Posted by: John Emerson (IP Logged)
Date: July 12, 2012 03:22PM

“Sell when you find a much better bargain to replace what you are selling.” — Sir John Templeton

It is a common fallacy that most value investors are inherently buy-and-hold types who rarely turn over their portfolios. The misconception has been reinforced by a Buffett quote which suggests that his favorite holding period is forever.

Certainly, if one is fortunate enough to find and purchase a premium business such as See's Candy, which throws piles of cash while requiring little in the way of capital investment; a life-long holding period would appear to make perfect sense (more on that later). However, relatively few businesses feature such a durable moat and the portfolio of the typical investor frequently contains a number of very average businesses. These average businesses can represent outstanding values when they are purchased at favorable prices during periods of excessive market pessimism or when their earnings are experiencing a temporary downturn.

The classic value investor which we will refer to hence forth as a "Grahamite" is actively engaged in uncovering discounted stocks which provide him/her not only with the possibility of capital appreciation but also a sufficient margin of safety. By definition, the investor's margin of safety in an equity slowly erodes as its stock price appreciates; therefore the Grahamite has little choice other than to sell his stock once it has appreciated beyond its perceived value.

Holding a stock once it becomes fully valued is tantamount to speculation. If the stock moves quickly to its perceived fair value, then the process of the the Grahamite mirrors the process of a short-term trader, although his decision is always based upon valuation metrics. Therein lies the paradox of classic value investing. In the strictest sense, a Grahamite must be an active stock trader unless his investments never approach their perceived value. If that is the case, then the so-called value investor is probably woefully deficient in his stock-selection acumen and would be better served by purchasing index funds.

Buy and Hold Relies on Growth

In the past few decades the dichotomy between value investing and growth investing has become blurred. Buffett and Munger have been instrumental in blurring the traditional separation by incorporating the concepts of return on capital and durable competitive advantage into the lexicon of value investing. To paraphrase, the rallying cry has been we would rather buy a great business at fair price than a fair business at a great price.

Successful buy-and-hold investing requires two distinct elements:

1) The business must have a legitimate long-term competitive advantage.

2) The business most possess the ability to grow earnings on a long-term basis.

Imagine that I own a bar directly adjacent to Wrigley Field. Without a doubt my business holds a durable competitive advantage in regard to most other "water holes" in Chicago. Does that mean that I should never sell the business? Since the business offers limited growth potential the answer is maybe yes, maybe no; it all depends upon the offering price I receive.

On the other hand, suppose I own a small chain of bagel and coffee shops in Nebraska which are successful without regard to a specific location. Every new shop I open attains roughly the same level of profitability, returning about 20% on invested capital. In such a case it makes no sense to sell the business chain. The offering price is irrelevant. Where could one find an alternative investment which would grow returns at such a high rate?

Both businesses had significant competitive advantages, but the bagel shops had extreme growth potential. Therefore, the latter investment is a buy-and-hold proposition.

Classic Value Investing Buys and Sells Average Businesses

Grahamites are not so interested in purchasing premium businesses with superior growth prospects; rather, they are interested in purchasing discounted businesses with the aim of selling their shares when the undervalued company appreciates to its fair value.

In the interim, the Grahamite is perfectly willing to accept the dividend payments which a company offers. However, the dividend payment alone should never become the basis of the investors holding period. Just as the quote from Templeton suggests at the beginning of the article, value investors should always be willing to exchange shares in one stock for another which represents a better bargain.

Low-growth and low-ROC companies are the bread and butter of Grahamites, particularly if they trade at large discounts to tangible book value. Such businesses contain little in the way of durable competitive advantages. Therefore, holding them beyond their fair value makes little sense.

Furthermore, companies which hold little in the way of a competitive advantage realize no additional shareholder value when they attempt to grow their businesses. Instead, they merely trade a dollar of shareholder capital in exchange for a dollar of additional growth. To paraphrase Buffett, in such cases the growth of the business takes precedence over the best interests of the shareholders.

Buffett and Coke (KO)

Buffett is sometimes accused of holding investments and businesses too long. Sometimes the criticism is warranted, although the tax implications of selling such high cash-generating businesses frequently overrides the status of their growth. Certainly the lack of growth in See's Candy would seem to warrant a sale at some point if the offering price was sufficient. It seems that Berkshire Hathaway (BRK.A)(BRK.B) is no longer interested in growing the sales of the legendary confectioner. Many believe that See's could be developed in national rather than a regional brand if their management so desired.

Most serious investors are privy to Buffett's outstanding purchase of KO shares several decades ago. His 2011 annual letter reveals that his investment has appreciated approximately 11-fold while supplying Berkshire with hundreds of millions of dollars in additional dividends. Everyone should be so fortunate to have a similar investment in their lifetime.

All that said, does KO currently represent a prudent buy-and-hold proposition based on its current valuation? Or would investors be better served to invest their money elsewhere?

KO Growth and Valuations

No one would deny that KO owns a valuable franchise with a legitimate durable competitive advantage; the question remains whether the future growth of the company can justify its current multiple. Bear in mind that the larger a company becomes the more difficult it becomes to maintain high growth rates. With that in mind let's take a quick look at the valuation metrics for KO.

According to GuruFocus' 10-Y financials, KO has grown its revenues per share at a CAGR of 9.2% and currently trades at a trailing price to sales ratio of 3.8 times its market capitalization. The growth rate is illuminating; however, the P/S ratio is meaningless when viewed independently of a company’s operating margins.

P/S ratios must be viewed in the context of operating margins to yield any beneficial information. In other words, a high P/S ratio is perfectly fine so long as the business commands a sufficiently high operating margin. Low P/S ratios are typical of low-margin companies which possess little in the way of competitive advantages. That said, companies with high P/S ratios and only mediocre historical operating margins or operating margins that are steadily declining should generally be avoided. Here are the average P/S ratios for KO over the past ten years.

INDUSTRY: Beverages - Soft Drinks


AVG P/E PRICE/ SALES PRICE/ BOOK NET PROFIT MARGIN (%)
12/1118.13.495.0118.4
12/1011.24.374.8633.6
12/0916.74.285.2922
12/0821.63.315.1118.2
12/07214.966.5420.7
12/0620.34.716.6121.1
12/05214.185.8421.1
12/0423.34.656.322.3
12/03255.998.7920.8
12/0231.15.569.1820.3


During that period KO had operating margins that ranged from a high of about 28% in 2002 to a low of about 22 % in 2011. The steady downward trend in operating margins is troubling in light of Coke's high P/S ratio.

KO has averaged about $2.42 per share in free cash flow for the trailing 10 years, with per-share CAGR of 6.5%. The stock currently trades at over 26 times trailing free cash flow. In the last several years the free cash flow of the business has not come close to matching its accrual earnings.

If we use accrual earnings instead of FCF, the trailing PE of KO is about 20 times its market cap. Using EV/EBITDA, KO currently trades at about 14.7x, compared to about 17.2x at the close of 2002. Almost 15 times EBITDA is quite expensive for a company which is growing sales at a rate of less than 10% of its cyclically adjusted average (10 years).

In the last year KO has appreciated to a level near its all-time high which it recorded in the late 1990s while growing its dividend from $0.80 in 2002 to its current level $1.88 per share. In reality, the dividend is all that investors have captured in approximately the last 15 years unless they purchased the stock in late 2008 or early 2009 when it fell to its most favorable valuation.



Such is the peril of buying blue chip stocks at inflated prices even if they have enormous moats.

Conclusion

It is a common fallacy that value investing requires a buy-and-hold mentality. Buy-and-hold investing is only suitable for companies which have strong durable competitive advantages and are likely to grow their earnings at a suitable rate for the foreseeable future.

On the other hand, Grahamites are actively engaged in seeking out and purchasing averaged companies which are temporarily undervalued. To be successful in the long term, it is incumbent upon the Grahamite to sell these average companies when they approach or exceed their fair value.

The process appears akin to the trading activities of a market speculator; however, the process is based upon pricing rather than speculation.

All investors need to pay attention to the price they pay for equities. Companies which hold large competitive advantages and exhibit steady growth can be poor buy-and-hold propositions if their valuations are too rich.

Coke (KO) is a classic example of a great company which has been a poor buy-and-hold stock in the last fifteen years due to its near-terminal overvaluation.



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Re The Paradox of Value Investing and Coke
Posted by: LwC (IP Logged)
Date: July 12, 2012 01:16PM

Hi Mr. Emerson,

Once again you provide an interesting read. I hope that you don't mind if I point out that apparently Graham in fact practiced a much wider range of investment than might be obvious in his books about security analysis. It appears to me to be common for many "value investors" to argue that Buffett no longer adheres to "classic" Graham investment practice, but Buffett himself repeatedly states that he still does it the way Graham taught him to do it:

"[Graham and Dodd] laid out a roadmap for investing that I have now been following for 57 years. There's been no reason to look for another." - Warren Buffett (2009)

(I mean no disregard to comments by Buffett about Phil Fisher's influence, but IMO the real impact of Fisher's influence on Buffett has been overstated by many. AFAIK Buffett hardly ever mentions Fisher as an influence while he often refers to Graham's influence. In one interview, when pressed, Buffett said that he was 85% Graham and 15% Fisher.)

AFAIK Graham didn't limit himself to "cigar butt" investing. Nor did he eschew "growth" companies; he just was concerned about how much to pay for the future growth which he considered to be relatively uncertain. An good example might be GEICO, which Graham and his partners and investors owned for 25 years or so. Graham himself apparently said that he and his partners made more money on the GEICO investment than all their other investments together.

Regarding KO, In a Buffett interview several years ago I heard him say that with hindsight maybe he should have sold shares back in the late '90s when KO was selling at a very high price relative to its historic pricing levels. However it was complicated: Buffett's own selling activity was likely to impact the market price; after paying large capital gains taxes he would be left with the need to find a replacement investment as good or better with the after tax capital from the sale available to invest and he thought that might have been difficult. He specifically pointed out that when he considered the dividend yield as calculated based on the expected after tax value of the invested capital, it would be hard to replace.

If you haven't read it, may I suggest that the book Benjamin Graham on Value Investing by Janet Lowe might be of interest to you because IMO it provides some insight into Graham's wide ranging investment "operations" as Graham liked to call it. One of my favorite quotes in the book:

"Graham himself once said that his books: ' have probably been read and disregarded by more people than any book on finance that I know of '." William Ruane

Good luck.




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Re The Paradox of Value Investing and Coke
Posted by: sww (IP Logged)
Date: July 12, 2012 02:22PM

Benjamin Graham said in his speech: Toward a Science of Security Analysis

pg 91. The Rediscovered Benjamin Graham by Janet Lowe
...
I suggest that the end product of our work falls into four different categories, as follows:

1. The selection of safe securities, of the bond type.
2. The selection of undervalued securities.
3. The selection of growth securities, that is , common stocks that are expected to increase their earning power at considerably better than the average rate.
4. The selection of "near-term opportunities," that is, common stocks that have better-than-average prospects of price advance, within, say, the next 12 months.

There is no paradox here.



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Re The Paradox of Value Investing and Coke
Posted by: AlbertaSunwapta (IP Logged)
Date: July 12, 2012 02:28PM

"Holding a stock once it becomes fully valued is tantamount to speculation."

I disagree on the quote above. Beyond the obvious taxable account and transaction cost considerations (which I'd hope would be factored into a price or market value), I believe the Buffett said 'value and growth are two sides of the same investment coin'. One's quantitative calculation of "fully valued" (a time adjusted price) will almost always depend upon a fairly short (5-10-15-20 yr) time horizon. Any such calculation is almost certainly flawed and that should be recognized by anyone doing the calculation. That's where I'd guess that qualitative assessments should be used to estimate some probability of positive or negative surprises beyond any quantitatively viable forecast horizon.

Buffett in his 1993 Shareholder letter: (See also the Essays of Warren Buffett)

"Through my favorite comic strip, Li'l Abner, I got a chance during my youth to see the benefits of delayed taxes, though I missed the lesson at the time. Making his readers feel superior, Li'l Abner bungled happily, but moronically, through life in Dogpatch. At one point he became infatuated with a New York temptress, Appassionatta Van Climax, but despaired of marrying her because he had only a single silver dollar and she was interested solely in millionaires. Dejected, Abner took his problem to Old Man Mose, the font of all knowledge in Dogpatch. Said the sage: Double your money 20 times and Appassionatta will be yours (1, 2, 4, 8 . . . . 1,048,576).

"My last memory of the strip is Abner entering a roadhouse, dropping his dollar into a slot machine, and hitting a jackpot that spilled money all over the floor. Meticulously following Mose's advice, Abner picked up two dollars and went off to find his next double. Whereupon I dumped Abner and began reading Ben Graham.

"Mose clearly was overrated as a guru: Besides failing to anticipate Abner's slavish obedience to instructions, he also forgot about taxes. Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $22,370. Indeed, had he kept on both getting his annual doubles and paying a 35% tax on each, he would have needed 7 1/2 years more to reach the $1 million required to win Appassionatta.

"But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 27 1/2 times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, about $130 million after-tax. For that, Appassionatta would have crawled to Dogpatch. Of course, with 27 1/2 years having passed, how Appassionatta would have looked to a fellow sitting on $130 million is another question."




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Re The Paradox of Value Investing and Coke
Posted by: AlbertaSunwapta (IP Logged)
Date: July 12, 2012 02:43PM

"Holding a stock once it becomes fully valued is tantamount to speculation."

"Buy-and-hold investing is only suitable for companies which have strong durable competitive advantages and are likely to grow their earnings at a suitable rate for the foreseeable future."

I disagree on the first quote above and wholeheartedly agree with the second, with the second including some index funds.

Beyond the obvious taxable account and transaction cost considerations (which I'd hope would be factored into a price or market value), I believe the Buffett said 'value and growth are two sides of the same investment coin'. One's quantitative calculation of "fully valued" (a time adjusted price) will almost always depend upon a fairly short (5-10-15-20 yr) time horizon. Any such calculation is almost certainly flawed and that should be recognized by anyone doing the calculation. That's where I'd guess that qualitative assessments should be used to estimate some probability of positive or negative surprises beyond any quantitatively viable forecast horizon.

Buffett in his 1993 Shareholder letter: (See also the Essays of Warren Buffett)

"Through my favorite comic strip, Li'l Abner, I got a chance during my youth to see the benefits of delayed taxes, though I missed the lesson at the time. Making his readers feel superior, Li'l Abner bungled happily, but moronically, through life in Dogpatch. At one point he became infatuated with a New York temptress, Appassionatta Van Climax, but despaired of marrying her because he had only a single silver dollar and she was interested solely in millionaires. Dejected, Abner took his problem to Old Man Mose, the font of all knowledge in Dogpatch. Said the sage: Double your money 20 times and Appassionatta will be yours (1, 2, 4, 8 . . . . 1,048,576).

"My last memory of the strip is Abner entering a roadhouse, dropping his dollar into a slot machine, and hitting a jackpot that spilled money all over the floor. Meticulously following Mose's advice, Abner picked up two dollars and went off to find his next double. Whereupon I dumped Abner and began reading Ben Graham.

"Mose clearly was overrated as a guru: Besides failing to anticipate Abner's slavish obedience to instructions, he also forgot about taxes. Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $22,370. Indeed, had he kept on both getting his annual doubles and paying a 35% tax on each, he would have needed 7 1/2 years more to reach the $1 million required to win Appassionatta.

"But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 27 1/2 times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, about $130 million after-tax. For that, Appassionatta would have crawled to Dogpatch. Of course, with 27 1/2 years having passed, how Appassionatta would have looked to a fellow sitting on $130 million is another question."




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Re The Paradox of Value Investing and Coke
Posted by: John Emerson (IP Logged)
Date: July 12, 2012 04:44PM

I appreciate all individuals who take the time to read and scrutinize my columns; particularly the ones who comment.

LcW, I wrote a column last year that detailed how Graham made a high percentage of his outstanding annualized returns on Geico.http://www.gurufocus.com/news/144627/graham-buffett-geico-and-growth-investing

I understand why Buffett continued to hold KO when it was extremely overvalued and I agree with your comments. That said, the average investor does not face those considerations and should move out of extremely overvalued blue chip stocks without regard to their durable competitive advantage.

Sww, I borrowed the term Grahamite from James Montier to reference the method of classic value investing vs growth investing. I did not intend to pidgeon hole Ben Graham into a one-dimensional mind set.

I am aware of Graham's many accomplishments outside of so-called "cigar butt" investing theory.
Last year I took the time to write about his ideas on a commodity-reserve currency and buffer stock system. http://www.gurufocus.com/news/146620/graham-on-a-commodityreserve-currency-and-buffer-stocks

Alberta, You made some good comments about the value of deferring taxes, just remember that IRAs account for significant proportion of most peoples investment funds.

In regard to the speculation quote, I was strictly referring to average companies with little or no competitive advantage. Further I would adhere to holding them to the point of becoming long-term capital gains if that is feasible. I generally try to hold stocks for at least one year but sometimes they simple move too fast and become too overvalued.

For instance I once bought ENG @ 2.15 and it ran to 9.00 in just a few months. At that point Cramer began touting the stock and I felt it was prudent to sell. It eventually ran to about 15 dollars per share after some pullbacks before it fell off a cliff. Look at the stock now, it trades for a buck and half, seven years later.

About a decade ago I bought a substantial amount of CAMT as low as .30 a share, I think my average was well under a buck. It ran to about eight and I never sold a share until it was creamed. I ended up showing a tiny overall profit after holding the stock for many years. I guess I thought CAMT was the next Geico even though I piled into it when it was a net/net. A fool and his money.....



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Re The Paradox of Value Investing and Coke
Posted by: LwC (IP Logged)
Date: July 12, 2012 05:59PM

Hey Mr. Emerson,

Thanks for that reference to your earlier article about Graham et. al. investment in Geico; I must have missed it when you posted it. I am confused about something: you stated that the investment firm held the shares until they were forced by the SEC to distribute the shares to individual shareholders in 1972.

In my copy of The Intelligent Investor it does not state that the distribution occurred in 1972, only that they were forced to distribute the shares but no date was referenced.

Please allow me to point out that in fact since Graham-Newman was disbanded in the mid fifties, almost certainly it's safe to assume that the Geico shares were distributed to the investors during the wind up. However, I recently read somewhere that in fact the Geico deal was originally brought to Graham-Newman by Robert Heilbrunn. As best as I can remember the story was that Graham-Newman initially rejected the investment because regulations at the time didn't allow the firm to own such a large proportion of shares in an insurance co. According to that story it was Heilbrunn who then proposed that the solution was for Graham-Newman to buy the interest and then immediately distribute the shares to the firm's investors, not in 1955 or 1972. Unfortunately I don't remember where I read that story, but I will bring it to your attention again if I find the source.

Regards.




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Re The Paradox of Value Investing and Coke
Posted by: John Emerson (IP Logged)
Date: July 12, 2012 08:40PM

Thank you for the correction, as you state the shares of GEICO would have had to be spun off to shareholders before the dissolution of Graham-Newman. The Intelligent Investor footnotes by Jason Zwieg read that in 1972 the value of one hundred shares of GEICO purchased in 1948 by the firm would have been worth 1.66 million. The cost of those one hundred shares in 1948 was 11,413 dollars.

If your memory serves you correctly the shareholders would have received their shares in 1948 when Graham-Newman bought the 1/2 interest in GEICO for $712,500. I wonder how many of them held their shares until the 1970s? Sort of reminds me of the early Berkshire shareholders.



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Re The Paradox of Value Investing and Coke
Posted by: batbeer2 (IP Logged)
Date: July 13, 2012 04:16PM

Thanks for another article worth reading.

>> In the strictest sense, a Grahamite must be an active stock trader unless his investments never approach their perceived value.

It depends on your definition of active trading. If you look for stocks with the widest margin of safety (less than 25 cents for a dollar of value) you reduce portfolio turnover.

1) These bargains usually take a little longer to reach IV
2) You are less likely to be switching into cheaper stocks very often.

In short, the ardent "classic" value investor probably has a relatively low portfolio turnover.

Most "value" investors I know can name a dozen stocks that they are quite certain are trading at discounts of 10%-20%. If you can find those, you can also find stocks trading at a 75% discount. It's the same proces, just a bit more work.

In practice:
LVB in 2009, Estimated IV of roughly $40. IMHO IV hasn't changed much since then........
[www.gurufocus.com]

IMHO, if the oldest stock in your portfolio is less than 3 years old, you a certainly not growth investing and probably not an ardent value investor either.



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Re: Re The Paradox of Value Investing and Coke
Posted by: LwC (IP Logged)
Date: July 13, 2012 06:06PM

Well, I decided to look up the Geico story in Janet Lowe's book and I guess not surprisingly there's a whole chapter. That story that I remember reading about Heilbrunn's involvement might not be accurate since he is not mentioned in this version, though the part about the shares being distributed soon after the investment is supported by it. Regardless IMO Lowe's version is a good read, with a fair amount of detail that at least gives the impression of being fairly definitive, including a couple quotes from Walter Schloss, who was there.

I also re-learned (I last read this book many years ago) that many of the Graham-Newman investors not only still owned substantial shares at the price peak in the early seventies; some of them still held some of their shares through the price crash that followed in the mid seventies, including both Graham and Dodd.

According to Lowe some of Graham's shares passed on to his grandchildren, and she refers to one of them who was using Geico shares from his grandfather to pay for his university during the early nineties.




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