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Quality, Capital Allocation, Value and Growth
Posted by: Geoff Gannon (IP Logged)
Date: August 3, 2013 07:46PM
In my last article I talked about the first 3 of the 7 things I look for before buying a stock – understanding, durability and moat. Today, I’ll talk about the other four areas I focus on.
First up is quality. We can look at quality a couple ways. One way – which I remember from reading Greenbackd and the book Quantitative Value Investing (which cites an article on the subject) – is using a metric from high up the income statement. Something like gross profits divided by NTA.
This is a good first check. A business should have high gross profitability. Most of the companies I look at have fairly high gross margins. However, all of these subjects are a little tricky because of the accounting definition of sales. Sales are defined in accounting terms for a company in ways that might not make sense from an economic perspective.
For example, Omnicom (OMC) doesn’t record billings as sales. Nor does DreamWorks (DWA) record box office as sales. However, some companies that buy and quickly resell – at very, very low margins – do count the transaction as a purchase and sale rather than a contracted service. I’m not knocking any of these approaches to accounting – we need one definite way of measuring sales. But it’s important to keep in mind that you can sometimes restate sales without restating anything – like earnings, cash flow, etc. – that actually matters.
What matters is the economic profits a company earns. Sales can be very useful comparisons between companies that use similar accounting. But, I’m not sure gross profitability means the same thing across all industries. For example, I would not be concerned with gross profits at ad agencies, defense contractors, or drug distribution. This is just common sense. For example, AmerisourceBergen (ABC) hasn’t posted a gross margin above 5% at any point in the last 10 years. Yet, return on equity has rarely been below 10%. That’s unusual. And it reinforces the need for using common – human – sense rather than relying on a screen.
When looking at a company economically – rather than as an accounting entity – we often want to ask what spending at the end of the chain is on these products, what sales by others dependent or controlled by the company etc.
Economically, a DreamWorks movie should be broken down from the ticket price collected from the moviegoer, then we look at the take for the theater, the agreement with the distributor, and then finally DWA’s revenue number comes into play.
In other words, we can – using widely available data that isn’t in the financial statements – easily create a picture of how a movie makes money. We should do that. Just as we should consider the quality of an auto parts maker in terms of the price of their product relative to the price of the product it’s going into and what it adds.
But I’m sure you also want hard and fast rules – things you can screen by. Math.
I use a couple little bits of arithmetic. One, I do actually use gross profits divided by net tangible assets. In fact, I always look at gross profits divided by net tangible assets, EBITDA divided by net tangible assets, and EBIT divided by net tangible assets. In many cases, it hardly matters which you use. Focus on the exceptions.
For example, a microcap that lacks a lot of scale but already had high gross profitability relative to assets may be interesting. A giant company that has mediocre gross profitability – and always has – is something you may want to avoid. That’s hard to overcome.
The next thing I look at is the return on capital. However, I do this a little different. I invert it.
I actually don’t focus on whether a company can earn a 15% ROE. Instead I focus on the idea that to grow earnings by $1 the company will need to get $6 from somewhere (usually retained earnings – but sometimes always increasing debt).
What number should you focus on? You can look at anything. If you’ve read The Outsiders, you can guess that many of those CEOs would probably focus on something like how much increasing EBITDA by $1 per share would take in terms of assets – and how could they finance those assets.
My reason for inverting return on capital, is that I’m not usually investing in very fast growth companies. Even then, I’m not sure how important knowing the return on equity is – because it’ll usually be very close to the growth rate (since they’re retaining everything in those situations).
My reasons for focusing on the lack of needed capital as a good thing rather than the return on capital is obvious in the stocks I own.
Right now, I own three stocks: George Risk (RSKIA), Weight Watchers (WTW), and Ark Restaurants (ARKR).
(I bought Weight Watchers yesterday).
In each case, you can probably guess – if you run Joel Greenblatt style ROC numbers – that my reason for buying those companies is that I thought they traded at low or average multiples and ought to trade at average or above multiples. Why? Because, they can pay out all their earnings.
Of course, it may be better to buy a company with better growth prospects than those companies.
For me, quality is a question of profitability. Profitability generally means good pricing power and low capital needs. I tend to think in terms of capital needed rather than return on that capital. This is different from most investors. I find it very helpful. And I recommend you try it out and see if that little inversion – looking at a 20% ROC as actually a $5 capital requirement to grow $1 – is helpful in tackling old problems from new angles.
This is a huge one for me. In part, that’s because I tend to buy companies with high free cash flow relative to their market cap. Free cash flow is discretionary spending. The board gets to decide what to do with it. What they choose to do is incredibly important to me.
I always prefer buy backs. This is common sense. If you are – at this very moment – putting your own money into a stock, then you obviously want the company to do the same.
But if the stock is your best investment opportunity right now, then it’s hard to come up with a good argument for why you wouldn’t want the company to buy back its own stock.
I like dividends less. And I like piling up cash less. I differ from a lot of value investors in how much less I like piling up cash.
The worst way to spend money is to lock yourself into a low return. Interest rates are low right now. It’s fine to pile up cash. It would be worse – in many cases – to make a permanent investment in something (new ventures, acquisitions, etc.) that might realistically offer 9% a year as a good outcome and carry some risk. In scenarios like that – or worse – I’d rather you just keep the cash on the balance sheet.
Some capital allocation can also have negatives beyond just the simple return math. I don’t want management to split their attention. I don’t want a lot of big new projects going on at once. A lot of tiny projects are often fine – but they won’t make any difference to capital allocation.
It sounds simple, but overwhelmingly I’m looking for stock buybacks. Again, this isn’t because they make sense for most companies (they don’t). It’s because I’ve already decided this stock – at this price – is the best place for my money. Therefore, I want the company to double down for me. When that stops being the case, I might want to consider selling the stock.
That’s a good test to give yourself. If you don’t want the company to use all its free cash flow to buy back stock – why do you still own the stock? What does preferring a dividend really mean? Does it mean you wouldn’t put new money into this stock? And if a stock isn’t worthy of new money, is it really worthy of old money? Should you still be in it?
I’d ask those questions. Generally, I only sell a stock to replace it with a better stock. I don’t sell because of valuation.
Let’s talk value. This one is simple. I look for a clear line in the sand. If there is a number I feel sure the company is worth more than, I want to pay that price.
I mentioned one times sales for Omnicom. I mentioned one times book for DreamWorks. I’d also use one times tangible book for something like Carnival (CCL). There is a simple, logical argument you can make for why the company is certainly worth more than this.
That’s very different than intrinsic value. I have a hard time putting a precise intrinsic value on stocks. Comparing the stock to others is often a shortcut. It’s not an actual valuation method. It’s just another way of trying to prove the stock is undervalued.
I’d use about two-thirds of your favorite measure. Stocks often trade at 15 times earnings. Free cash flow should be worth more than earnings (because most companies have less free cash flow than reported earnings). Therefore, if you have a good company – it should trade at 15 times free cash flow.
I would try to buy it around 10 times free cash flow. It’s not worth that. But that’s what I’d like to pay.
Likewise, using an EV/EBITDA screen – 8x EBITDA would be pretty normal (since it’s equivalent to about a P/E of 15). I’d try to pay 5x EBITDA. That’s a common screen I use in the U.S. and U.K. I just look for a list of every company that makes money year in and year out that trades for 5x EBITDA or less.
It’s not a big list right now.
Keep in mind a couple points specific to my approach. One, I’m looking at companies that generally make money every year. This has two huge implications. One, I’m not looking for major mean reversion in margins, EPS, etc. I’m not assuming they can earn more in the future than they do now. I’m assuming now is pretty normal.
Two, I don’t have to – if you assume the future will be like the past – be as conservative in using any one year’s earnings numbers. If a company routinely loses money a couple times in a decade – boy, you need to bring those multiples down a lot.
The compounding you get from always having positive earnings – never taking a step back – and for having all of those earnings be available to be distributed to shareholders (in cash) is huge. I tend to focus on companies that do both. They tend to be profitable every year. And their profits tend to understate their free cash flow.
Most companies lose money occasionally. Almost all companies have less free cash flow than earnings. So, adjust your own approach if you’re looking at other kinds of businesses.
This is a subject I know nothing about. Chance are, if you’re reading this, you know more than me. Or you at least have more definite views on the subject.
I’m bad at estimating future growth. I don’t pay for growth. When I make an investment, it needs to be justified even if the business doesn’t grow. It doesn’t need to be a home run if it doesn’t grow – I certainly benefit from growth – but it needs to be a base hit without growth.
I generally ask these questions:
· Can earnings grow faster than sales?
· Can unit volume grow faster than population growth?
· Can prices grow faster than inflation?
· Can this product grow as a share of GDP?
Spending on food in the U.S. is not going to grow faster than GDP. Therefore, you need market share gains at a grocer to increase sales more than 5% to 6% a year. Operating leverage in the business can be huge though. So, a grocer that’s getting better – competitively – can easily grow EPS 10% a year on 5% a year in sales growth.
Generally, the surer you are the industry will grow, the less sure you are of future market share.
I can’t think of many situations where I really made an investment believing I was going to get growth greater than nominal GDP.
Of course, if you don’t need capital to get that growth, you’ll often do fine with such “low” growth. Most big caps, only grow like 6% a year over the decades.
Let’s say you could get 6% a year growth. And let’s say it was in a company that needed very little added capital to support that growth. In the most extreme case – where you need no added capital – you could see the company supporting a P/E of something like 25 even while growing no faster than the economy. That’s because it could have a 4% dividend yield and a 6% growth rate. A stock with those attributes would look good in some interest rate environments.
That’s an extreme example. I would never assume a company could support a P/E of 25. Let’s use a P/E of 15 as a better example.
Assume a company could grow 6% a year. In theory, my most recent purchase of Weight Watchers fits this description because weight loss spending can grow as a share of GDP over time. At a price of 15 times free cash flow – and truly no capital needed for growth – you would have an attractive investment. For example, the company could use the 6% FCF yield to buy back 6% of its outstanding shares and then sales could grow 6% on average. In that case, sales per share – and presumably earnings per share – would grow more than 12% a year.
Still, I’d want to pay 10 times free cash flow rather than 15. At 15 times free cash flow, if the growth doesn’t materialize – you won’t make any money.
Finally, it’s important to consider growth over the long-term in sales rather than just cyclical rises and falls. For example, WTW’s sales will be down over 10% this next year. That’s a marketing miss. It’s equivalent to a same-store sales decline at a retailer. We don’t assume the weight loss industry or restaurant spending or apparel sales or whatever actually changes 10% in a year. We assume the company just overachieved or underachieved.
It could turn out to be a bad investment because they’ll keeping having years like that. But, if they rebound at some point – that will not be growth. That will be a marketing success. It has nothing to do with the long-term trajectory of the business.
That’s what I mean when I say growth. I’m talking about the “earning power” of the company. What it’s capable of earning in a neutral year for the company, the industry, and the economy.
Mostly, I’m imagining the past 10 years and the future 10 years and wondering what a trend line through that would look like. Is that trend line rising 6% a year.
But, I’m the last person to listen to about growth. I know so little about growth that I’m unwilling to pay for it.
I just treat the lack of growth as a negative. I consider growth qualitatively. Decay is terrible. Stagnation is bad. Average growth is okay. Better than average growth is good.
I’ve never been successful making finer distinctions than that.
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Stocks Discussed: OMC, DWA, ABC, WTW,
Re: Quality, Capital Allocation, Value and Growth
Posted by: mmeagher (IP Logged)
Date: October 11, 2013 05:25PM
Re: WTW, What are your thoughts on their high debt load and negative equity position....as an owner, do you see this as a risk? Also - Artal's holding...is this a further risk or positive for you?
Stocks Discussed: OMC, DWA, ABC, WTW,