Someone who reads my blog sent me this email:
Hi Geoff,
My question for you is about the recent market correction. I know you might not be comfortable talking about any stocks you bought, but I'd love to hear anything you can say about how you approached Mr. Market's most recent mood swing; what kind of actions did you take? Did you stick to pre-researched stocks on a watch list or did you go into overdrive with researching new businesses? I guess my question is mostly about mindset and preparedness. How do you prepare for this, and what does your thought process look like while it's happening?
Thanks,
Mike
That's a great question Mike. I haven’t bought any stocks in this correction. Right now I am: 50% in Japan, 25% in the U.S. and 25% in cash.
I like to put 25% of my portfolio in each stock. So I would really like to find one good stock to buy.
There are a lot of options out there. A lot of cheap stocks. Different people have different approaches to buying stocks.
I've mentioned the blog Variant Perceptions before. The author’s approach is to focus on turnaround situations.
Not a bad idea in today's market. But that's not what I do. My favorite stocks are predictable companies. I like free cash flow. And I tend to like businesses where the customer isn't super sensitive about price.
Although I haven't bought anything yet, I’ll take you through a list of stocks I would consider buying. It's a long list. Probably 12 names.
So there will be something for everyone on here. But I'm sure there will also be some stocks you absolutely hate. That's fine. This isn't so much about the specific ideas. It's more about giving you an idea of how I approach having a lot of ideas thrown at me at once.
That's what's happening in today's market. Volatility is great for long-term investors. The more prices change, the better the chance you have of getting a good business at a cheap price.
You asked if I go on overdrive researching new stocks. No. I don't. It's pretty rare for me to find a company for the first time and buy it right away. Usually I'm buying something I've researched before. I usually know the company ahead of time.
Almost all my best investments have worked that way. There are exceptions. There were a couple micro caps I hadn't heard of before buying them. But I can't think of a case where I bought a stock I didn't know almost immediately upon finding it other than situations where the stock was selling for less than its net cash.
I have bought stocks for less than net cash within a couple weeks of first learning about them. That's very fast for me. But there's only so much analysis you have to do when you're buying something for less than its net cash. It's obvious within hours of finding the stock whether it's a really interesting opportunity or not.
The vast majority of stocks don't trade for anywhere near net cash. Right now you only have about 130 net-nets out there. So even if we're talking about net current assets it is still a small list.
Those kinds of situations lend themselves to very quick analysis. A stock selling below net cash may or may not turn out to be a great investment. But it's obvious. It's conspicuous. You don't normally have to do a lot of digging to figure out whether or not it's worth buying. There's usually one or two big risks that are scaring people away. It's not like you have to do a deep analysis of the business’s earning power. Because you're not buying earning power.
I'll talk about net-nets another day. They are such a separate situation. You can find them and buy them pretty confidently within a couple weeks of first learning about the stock. That's not how I work when looking at good businesses. Businesses where I am buying earning power.
So this is going to be a list of 12 stocks you might want to consider buying for their earning power. If any of the names here are new to you, then you probably want to spend some time learning the company.
But a lot of this list is very well-known names. I won't be surprised if a lot of you reading this have read the 10-K for a majority of the stocks I discuss. If you read my past articles, I often mention the same companies over and over again.
There's a reason for that. I try to talk about stocks that I'm looking at. I try not to use examples from stocks I don't know anything about. It's kind of common sense. But that's why the same stocks show up as examples in article after article. It's because I know those stocks better than most stocks.
There's probably a reason why I know them better. They were cheap and interesting at one point. Or they are cheap and interesting now.
We'll talk about 12 companies that are cheap and interesting now. Like I said, I have not bought anything in this correction. But I'm picky. I really want to buy just one company. If you take a more diversified approach, you might be able to move faster.
First I look at demand. Does the company do something I can ballpark normal demand for? I'm talking round numbers here. I'm not talking about predicting what the advertising market will look like next year. But with an advertising company even if we have a 3-to-5-year rough patch, I have a pretty good idea what percentage of GDP advertising will be in 2016, 2017, 2018, etc. That's not too hard.
So Omnicom (OMC, Financial) makes the list. I talked about it before. I won't talk about it again. In 2009 I bought the stock at $28 a share. That turned out to be lucky timing. The stock’s at $39 right now. It got much higher. And I sold it much higher.
Would I buy Omincom today? It definitely looks attractive. But a lot of stocks look attractive right now.
Omnicom has a lot of European exposure. A slowdown in Europe is bad for Omnicom. And advertising is closely tied to GDP.
Omnicom is still cheap. You can do my usual analysis of looking at free cash flow margins and the price to sales ratio. For Omnicom it’s pretty easy. I would be willing to buy Omnicom at a price to sales ratio of one or less. Anytime you can buy Omnicom below its revenues per share I think you are getting a market-beating stock.
So that's one I would consider. And obviously it's not new. I've owned Omnicom in the past. And I talked about it at times in articles. That shows you how I tend to focus on stocks that are familiar to me.
Next up is Regis (RGS, Financial). I talked about the stock before. It runs hair salons. I haven't been happy with management. I think it's cheap compared to the free cash flow it should generate. But you've seen so much bad capital allocation at this company that I personally am not going to buy this stock. They've invested in things then divested them. Issued shares at the wrong time. They’ve just done everything wrong. At the top level of this company, it’s been mismanaged. All the financial stuff has been mismanaged. I’m not interested in owning something like that.
But if you look at the P/S ratio and you look at what kind of free cash flow you generate per dollar sales at a hair salon, the stock looks cheap. It's not for me. But it's an example of something I would look at. If someone came up to me and said there's a company that runs hair salons selling for less than half its per-share revenues, I would be interested. If they had a record on capital allocation that wasn’t this bad — I would buy the stock.
Demand for haircuts is something you can get a handle on. There's consistency there. So all you have to do is buy Regis when it's really cheap on the past average margins, earnings, free cash flow, etc. Again for me it's not a stock I’ll buy. I kind of blacklisted it because I don't like how the free cash flow might be used. I don't like the idea that I might get diluted at a bad time.
But Regis is a good example of a stock that seems real cheap. The fact that I won't buy it doesn't mean you shouldn’t buy it.
Also, there’s now an activist shareholder — Starboard Value — launching a proxy fight. You can read about it here.
Now I can group the rest of the stocks. They happen to fall into nice categories.
Let's start with financial information. Here we have three of the strongest businesses you’ll ever see. I've talked about Fair Isaac before. It’s bounced a little bit. It had been down around $20 a share not that long ago. It’s $23 a share right now. I think it's around 1.5 times sales.
This is a stock that should be worth more than two times sales. I like capital allocation here. This is the opposite of Regis. FICO is a company that did a bunch of things about a decade ago I really didn’t like. From about 10 years ago down to about 5 years ago it was doing things I didn’t like.
And capital allocation is critical at someplace like FICO. Because FICO doesn't really need to add to its invested assets over time. It doesn't add beyond inflation. So you have all this free cash flow being generated. And there's a temptation to do something with it. The right thing to do is buy back stock. Pay a dividend. It's a hard business to grow. It will grow along with its customers. It will grow along with the volume of transactions in financial services. So in the long run there is growth. It's like advertising that way. But it's not some place where you can spend a lot of money to buy growth.
The big reason for that is FICO’s crown jewel: the FICO score. This is the standard credit score in the United States. And so you have dominance there. Operating margins in that segment of FICO’s business are around two thirds. About 60% or higher.
Right now that business is providing a huge amount of FICO’s earnings. And almost all of its economic value added.
That's really what you're buying when you buy a share of FICO. You’re buying the FICO score.
It's very important to see where the share count is going over time. You want to see FICO buying back stock. I would buy this before I would buy Regis. And it really comes down to capital allocation.
Next up is Moody's (MCO, Financial). Moody’s has a P/S ratio of about 3 right now. So it’s not a low P/S stock. But it is a low price to free cash flow stock. That’s because free cash flow margins are high. This is a business that has often turned 30 cents of every dollar of sales into free cash flow.
That’s an amazing business. One of the best businesses you'll ever see. Look at Moody's free cash flow margins and look at Microsoft's (MSFT). This is a company that doesn't need any tangible equity.
Moody’s is also an extremely controversial business. And it's only going to get more controversial.
Because Moody's is one of the credit rating agencies that is going to be downgrading all this sovereign credit in Europe. So think about this. They may very well end up downgrading the credit of Italy, Spain, Portugal, Ireland, Belgium, etc. That's not going to make those countries happy. You'll see finance ministers come out and categorically reject the ratings downgrade. They will say they disagree with it. And this isn't just companies doing that. So it stirs up feelings of nationalism. It brings politics into it. People will complain about how Moody’s missed the housing bubble. They blame them for the credit crisis. People get fired up. So there is a lot of headline risk in the stock. Maybe regulations will be changed.
Moody's is probably not a stock people reading this are going to go out and buy. It has the best business of the companies mentioned here. But it's extremely controversial. It’s not a stock I would write about. Most of what has been said — pro and con — about Moody’s has already been written by someone else.
Finally in financial information we have Dun & Bradstreet (DNB, Financial). Dun & Bradstreet has some similarities to IMS health. It has a huge database. The DUNS is used to identify a lot of businesses around the world. It's a standard like the FICO score. This is a business with staying power. If you can buy it when it's cheap on an average earnings basis you can make money.
They also have a history of reducing the share count over time. It's definitely a stock worth considering.
Notice I don’t mention banks. That’s because I don’t buy banks. If you want to buy banks read a blog like Variant Perceptions. Read articles by someone who knows what they’re talking about. Don’t read my articles.
There are a lot of people who know a lot about banks. And that's the problem. I'd rather invest in something where I think there are more misperceptions. Where it's really a lot simpler than it's being made out to be. I'm never going to be the smartest guy when it comes to any specific bank.
If you’re interested in banks you should see the interview Bruce Berkowitz did with Consuelo Mack. There was also an interview he did with Outstanding Investor Digest way back in the early 1990s. That was when he bought Wells Fargo (WFC). Buffett also bought Wells Fargo back then. And today Buffett and Berkowitz own Bank of America (BAC).
If I was a shareholder of Fairholme, I wouldn’t sell the fund. I might even consider putting more money into Fairholme. So I'm not saying there's anything wrong with buying the banks right now.
If I was going to own banks I would need someone like Berkowitz to buy the banks for me.
You'll have to come to your own conclusions about that. But I should point out you can make money without buying financials. There’s no requirement that says you have to buy banks. Or materials stocks. Or foreign stocks.
You get to choose what you buy. Just because something is down 30% this year, doesn’t mean you have to pay attention to it. Maybe it isn’t your area of expertise. Leave it to someone else.
There are a lot of stocks on this list I'm talking to you about. Stocks that are cheap right now. None of them are banks. Something could still go wrong with them. They don't all have pristine balance sheets. I hate the management at Regis. This is not a risk-free list.
But it's a list of cheap stocks. And none of them are banks. And none of them are insurers. You can go through this list like a menu. And you can find one stock on it that you can buy and hold. One stock that will outperform the market for the next 5 or 10 years. One stock that will earn you a decent return.
That’s all you need.
My hurdle rate is 10%. I want a stock with a good chance of returning 10% a year to me. Now a lot of stocks can do that if you buy them today and flip them next year. I've got nothing against selling a stock in a year. I've done it plenty of times.
I have a problem with buying a stock and counting on selling it in a year. That’s an exit strategy. It gives you false confidence. You don't need an exit strategy.
You just have to buy something that you could hold for long time and earn solid returns. Every stock on this list has that potential. So for the first time since early 2009 you've got a whole day of stocks in front of you that are worth buying.
I was born in 1985. I got started investing in the late 1990s. There haven't been that many times in my investing life when we've had opportunities like this. When a lot of stocks have been cheap at the same time.
It was true after Lehman failed. It was true in early 2009. We’re talking about half the year.
Stocks could get a lot cheaper. Look at the difference between the earning power of stocks divided by their prices and the yield on bonds in the 1930s. Stocks could get that cheap. It happened once. It can happen again.
I don't operate on that assumption. I don't worry about how low stocks can go. They can always go a lot lower.
I just look at this list. I think that's a good list. And if something on that list that I’m really comfortable with gets to a price I know is crazy cheap, I will buy it.
That’s the way to act. You don’t listen to what the market is telling you. You take advantage of the market. That is the Ben Graham way.
The next little group here is health stocks. These are companies that are pretty predictable in my view. One stock I've talked to death in previous articles is Birner Dental Management Services (BDMS, Financial). It's a micro cap. It's illiquid. It's family controlled. If you can get over those things and you want a stock to just buy and hold I think this is very high on the list. It's cheap on past earnings basis. It pays a dividend. It buys back stock. That's all you really need a stock. If you think that past earnings in something like dentistry are indicative of future results this is the kind of stock you can buy. It looks very cheap on the numbers. And it has long history of returning a lot of money to shareholders. That makes a huge difference. If they didn't have a history of doing that this might not be a stock that I be talking about at all.
Next up is Prestige Brands (PBH, Financial). This is an over-the-counter drug company. There was another company like Prestige brands. It used to be public. It was called Chattem. If you know Chattem, you have an idea what Prestige Brands is all about. If you have never heard of this company, go read the 10-K now. These are really strong, really dull brands. I can't do it justice by just talking about them here. They're things like wart remover. Here are just a few of their brands: Chloraseptic, Luden’s, Clear Eyes, Compound W, Murine, New-Skin and Dramamine. Several of these brand names are synonymous with their product category. They are the Kleenex and Xerox of the drugstore aisle.
One concern here is acquisitions. This is an area where you have a lot of acquisitions. And if the company overpays, all the free cash flow it generates ends up being wasted on paying too much for new brands to buy up. That’s something to worry about. The other thing to worry about is adding inferior brands over time. They started with brands in strong positions. It is usually easier to add second-tier brands over time. These are not categories where you want to pay a lot of money for the also rans.
Next up is VCA Antech (WOOF, Financial). This is an animal health business. It runs animal hospitals and labs for medical tests on animals. We’re talking about pets here. This stuff isn't covered by insurance. Or the government. It's a cash and credit card business. In the long run I think spending on pets is one of the most predictable and one of the most profitable areas to be in. If you ran a Berkshire Hathaway-like (BRK.A)(BRK.B) conglomerate, a business doing something with pets would be the kind of business you would look at acquiring.
Now what about VCA Antech in particular?
Well, this same management team ran up huge debts about 10 years ago. They went private. My biggest concern here would be the human element. I would want to know more about management. You don't want to buy another Regis. At least I don't.
I was surprised the stock got this cheap. Not that long ago I thought VCA Antech would never present this kind of opportunity to buy. There are stocks like that. I talk about McCormick a lot. McCormick doesn't get very cheap very often. It's a business you get to admire from afar. It's not one value investors get to own.
And finally we have entertainment. This is the area that will appeal to the least of you.
A lot of investors don't like entertainment stocks. There is a feeling of fickleness here. Entertainment does not seem serious enough. It is subject to people’s whims. It is hit or miss.
There’s some truth to this.
But the same could be said about consumer products or technology.
I think you can understand the behavior of entertainment company’s customers. And that is the first step in understanding a business.
Our first entertainment company is not a big free cash flow generator. It's Carnival (CCL, Financial). Carnival has to be evaluated on a return on equity basis. This company has about half the worldwide cruise business. Carnival’s next largest competitor is Royal Caribbean. Together they have maybe three fourths of the industry.
This is an asset-heavy business. Cruise ships cost a couple hundred million dollars and up. They are huge investments. And they last for decades. Cruises are amazing logistical feats. Feeding that many people at sea is difficult. The barriers to entry in this business are astounding. It doesn’t get much wider moat than a cruise line. That’s the upside. The downside is the returns on equity.
I think Carnival is a good efficient operator. But you have to be a good efficient operator to make money in this business. If they don't run this business really efficiently you won't make money on the stock. You have to have faith in the operations.
There are some businesses that can be run kind of sloppily. Listen to the interview Warren Buffett gave to the financial crisis inquiry whatever it was called. He talked about how it's almost impossible to evaluate the management team of a company like Moody’s. It's such a good business that an idiot can run it.
Carnival is not that kind of business. If an idiot runs Carnival they could run into the ground. I would say it has extreme similarities with grocery stores that way. It only works if it is run very efficiently. And you have to buy at a reasonable price to tangible book. Right now Carnival is trading at a reasonable price to tangible book ratio. You could make 10% or 12% a year in the stock. But that assumes a lot. That assumes it is run well.
It's also got a lot of European exposure. If things get worse in Europe and the world economy gets worse you'll see a lot of negative headlines about Carnival. A lot of people will not want to own this stock.
That's probably exactly the time to buy it. Carnival’s position in the industry is not threatened. I don't think the long-term future of the industry is threatened. Carnival is too asset-heavy a business to really ever be called a great business. But the Warren Buffett approach of buying a great business when it runs into temporary problems applies here. Carnival is a dominant business. And the things I hear people talking about are temporary problems.
Carnival is a stock I’m very interested in.
It's also unlike almost any other stock that I am interested in. I don't like tangible assets. And buying something like Carnival is awfully similar to buying something like Burlington Northern. The competitive position is excellent. The long-term future is certain. But boy is it an asset-heavy business. And it's hard to make a lot of money per dollar of tangible book in a business like this.
Next we have Dreamworks (DWA, Financial). There’s no point listening to what I have to say about Dreamworks. Andrew August of The Frog’s Kiss said it better in his 14 page report on the company.
Seriously. Don’t listen to me. Read Andrew’s report instead.
Okay. You’re still here. I might as well give you my thoughts on Dreamworks.
This is an intangible business. But it's a very investment-heavy intangible business. Dreamworks invests heavily in big budget movies. It makes two movies a year. It's going to make three movies every other year from now on. So that's 2.5 movies a year. That sounds like a small amount. But these are not small movies. To give you some perspective, the next movie is Puss in Boots. If you watched TV this weekend, you saw the ads. Those ads aren’t cheap. Paramount pays for them. And before Dreamworks can make a profit on the movie, Paramount needs to recoup all its expenses plus pocket 8% for itself. That’s the hurdle a Dreamworks movie has to clear before it even reports any revenue.
A Dreamworks production costs between $135 million and $165 million. Let's call it $150 million. Right now they have a distribution deal with Paramount. And the distribution of the Dreamworks movie is normally supported by a huge amount of marketing. We’re talking another $125 million to $175 million. So the entire undertaking shared by the studio producing the movie and the distributor is about $300 million. These are movies like Shrek, Kung Fu Panda, Madagascar, How to Train Your Dragon, etc.
Like I said, Puss in Boots is up next. It comes out at the end of this month. Officially, Dreamworks put the Shrek series to rest. But Puss in boots is a character from the Shrek movies. So it's really an extension of those movies.
I love this company. You have Jeffrey Katzenberg running it. It gets half of its revenues from overseas. Foreign box office is getting better and better.
You had some tremendous results for Kung Fu Panda 2 in China. Kung Fu Panda 2 was a disappointment in the United States. Not critically. It was a fine movie. Audiences liked it. Critics liked it. But it opened against The Hangover 2.
They go for the big opening weekend at Dreamworks. They look for the week where you have the biggest movie audience going to theaters and you don't have another competing family film. They thought that going up against an R-rated comedy was a safe bet. They were wrong. And they admitted as much on the conference call.
Kung Fu Panda 2 did fine worldwide. And I would expect Dreamworks movies to skew more and more towards the foreign box office in the future. That's partially because of doing sequels. Sequels play better overseas than in the United States. These movies have done great overseas. And they're building more theaters in places like China.
They're scared about the home video market. Studios made a lot of money on VHS, DVDs and Blu-Ray. That's in the developed world. Those have never been big sellers in developing countries. And Dreamworks makes a lot of money from that part of the business. About half of the people who buy a Dreamworks DVD also saw the movie in theaters. So you have some extra profits in there that come from people seeing the movie in theaters and then buying the DVD. That's going to go away over time.
Of course, if movie streaming increases, there will be very strong competition for exclusive content. There will only be a few viable streaming options because of exclusivity. A company like Dreamworks will get paid tens of millions of dollars for each movie it grants streaming rights on if they are sold as an exclusive package. Will that offset DVD sales? It could. At streaming right sales of around $50 million a movie, it might fully offset the profits from DVDs. But streaming competes both with DVDs and with TV rights. So, it would take even bigger payments to offset all those sources of income.
You can do all the math you want. It won’t solve the basic problem. You’re going to guess wrong. The studios thought TV and VHS were both threats to their business. They later turned into big profit sources. And today studios aren’t moaning about a lack of people in theaters — their biggest concerns are home video sales and TV rights. Cable is less interested in movies now that it has its own original series.
When you factor in 3D and the foreign box office, it’s much less clear where revenues per Dreamworks movie are being taken by the course of history. There are trends pushing in different directions. And the biggest long-term trend will be having a much larger worldwide audience for their movies. Will Dreamworks get paid for this content?
Some people say no. Without DVDs, there is no hope for Dreamworks. Movies shown in theaters and streamed to people will not be enough.
What about me?
I'm very positive on this company. It's a stock I would like to buy and hold forever. Is it cheap? This is a hard company to value.
Each movie they make is a very large portion of its total value. As I write this the stock is trading around $17. That's close to an all-time low. The stock has never been below $16.50. They went public in the middle of last decade. It’s down about 50% from where it went public. And yet Dreamworks is clearly a much stronger company today than it was back then.
If you want to know more about Dreamworks you can research every single one of their movies at places like Box Office Mojo. You can look at a site like The Numbers. If you combine the data you find in places like that with the data in Dreamworks 10-K you have a very clear idea of how the business works. There is more data out there about Dreamworks than about any of the companies on this list. The movie business is very transparent if you're willing to put all the data together yourself. The actual filings and conference calls and press releases that studios put out are not particularly transparent.
But Dreamworks is not a conglomerate. It does one thing. It puts out two or three movies a year. And the press reports on those movies. It's an easy company to understand. But it's a risk-taking business. Every movie is a huge project. They take up to four years to develop. There is no established market for an original movie. You have to sell the public on that movie all over again. Every movies is a new product launch. The market cap is only $1.4 billion right now. So each movie they make is risking 10% of that market cap. And Dreamworks is plowing about 25% of their market cap into new movies each year.
So Dreamworks is an unusual company. But it's at the top of the list of companies I would consider buying and holding forever.
Next is Nintendo. Nintendo is cheap. The stock trades for less than 12,000 yen in Osaka. There are ADRs in the U.S. You need to check the price on ADRs yourself. The price you get will be the price you pay on the number of ADRs needed to equal one share in Osaka. So if you’re buying in the U.S., you have to do your own homework on that.
I'm going to talk about the Japanese shares. In Japan, Nintendo shares trade for under 11,800 yen. The company has 8,500 yen a share in net cash. Average earnings over the last 10 years have been about 1,000 yen a share.
So you can look at it two ways. You're either paying about 11.8 times average earnings. Or you're paying about 3.3 times average earnings. One way is without cash. One way is with cash.
The truth is somewhere in the middle. Cash is nice. But it's not like the company pays you that cash back when you buy the stock. It does have a dividend policy. You can read about it on their website. Nintendo pays out at least half their earnings. It also keeps their share count down. So despite a huge cash hoard, capital allocation is not a problem at Nintendo.
The only problem with capital allocation is that there’s a lot of cash earning nothing. That's a problem. But it's not like Regis. Or Hewlett-Packard. Or some other tech giants that make acquisitions.
Nintendo is the market-share leader in both consoles and handhelds at the moment. But its sales are way behind what would be needed to maintain its market share.
They put out a new handheld. It's called the 3DS. And it was a big flop. They didn't have any good games.
Bloomberg has run articles with Japanese money managers griping about Nintendo. They want to hear Nintendo announce games for your phone.
Nintendo is in the complete opposite business. They make the hardware and software. And the hardware is made specifically for playing games. Don't expect them to change.
A lot of video game companies are public. You have a bunch in Japan. You’ve got Activision Blizzard, Electronic Arts, Take-Two and THQ in the United States. All those companies are public. You can read their 10-Ks. You can listen to their conference calls. And like the movie industry there is a ton of industry info out there on video games. There are weekly sales numbers. And there are all sorts of shows these companies go to. There is no shortage of commentary on the video game industry.
I'll just say that Nintendo has a quarter-century-long history of profitable performance in this area.
It has a clear idea of what it wants to be. That idea may be a bad one. But it's not in doubt. So you know what you're getting here.
Nintendo also has a wonderful investor relations section on its website. Tons of info in English. Absolutely wonderful by Japanese standards. Actually it's great by American standards. The first thing I would check out if you're interested in Nintendo is the company's own website. I don't think I've ever seen a better investor relations section of a website.
Finally there is CEC Entertainment (CEC). This is Chuck E. Cheese. It's an interesting business. It's a niche business. It hasn’t over expanded. And it has a nice capital allocation history. This is another company where the share count tends to go down over time. That's just about the most important issue. If you have a rising share count it doesn't much matter what else you’ve got going for you. A falling share count doesn't cure fundamental problems. But when you combine a falling share count with a really wonderful business the results are spectacular. Chuck E. Cheese is not a spectacular business.
It's got the kind of margins you expect in a restaurant. But returns on capital are good. And the earning power is there.
Chuck E. Cheese has one big advantage that might not be obvious. We talk a lot about competitive advantages. We don't often talk about how companies perceive themselves. The huge advantage for Chuck E. Cheese is how its competitors perceive themselves. Chuck E. Cheese is neither fish nor fowl. Its competitors are all fish and all fowl. They see themselves as restaurants. Or they see themselves as entertainment companies. Chuck E. Cheese is both.
There are concept similar to Chuck E. Cheese all around the United States. I'm not going to name them because the ones in my home state — New Jersey — are not going to be the ones in your home state.
There is no national competitor that matches up directly with Chuck E. Cheese. Why is that an advantage?
Name recognition. A lot of things don't scale. There are few things that do scale. Marketing scales. People look at a cruise ship and see its huge size and think scale. There are economies of scale on each cruise ship to a point. What you're missing is the economies of scale to a cruise line. You have to fill those cruise ships. That's marketing. And marketing scales.
Too often when I say scale people think of the giant ship and not of the giant ad campaign and the travel agents who actually fill those ships. That’s where the real scale is.
It doesn't take much actual marketing spending for Chuck E. Cheese to be a name kids know.
I consider Chuck E. Cheese an entertainment company. It's usually grouped in with restaurants. To me, companies should be grouped the way their customers think about them.
CEC Entertainment is not on the top of my list right now. But it makes the top dozen.
So that's it. Those are the 12 companies that I’m most interested in right now. Ideally, I would like to pick one of them and put 25% of my portfolio into the company. That would be easy to do in 11 of these companies. One is a micro-cap stock. It's hard to put that much money into a stock that small. But most of these companies are actually very big. Which is unusual for me. I’m not a fan of big stocks.
I’ve known these companies for a while. There are not a lot of new names here. That's almost always the way I work in a big market downturn. It’s actually the way I work almost all the time. The exception is sometimes net-nets.
I'm hoping to pick one of these stocks to put all my cash into. I would put 25% of my portfolio into just one of these stocks. That's always the ideal. I don't like to own more than four or five stocks.
Will I do that here? I don't know. I would be very surprised if I end up buying more than one of these stocks. I don't see myself splitting up 25% between two or three of these names.
I focus on a certain kind of company. You can see that in the way these stocks appeared in groups. We have three companies in financial information: Fair Isaac, Moody's, Dun & Bradstreet. We have three companies in healthcare: Birner Dental, Prestige Brands, VCA Antech. And we have four companies in entertainment: Carnival, Dreamworks, Nintendo, and CEC Entertainment.
We all have our circles of competence. Mine is pretty narrow. I don't know a lot about a lot of stocks. And I’m only comfortable buying certain kinds of stocks.
We all work differently.
I love reading Variant Perceptions. I think that kind of investing makes a ton of sense. I love reading what Richard Beddard is doing. Being more diversified. Investing in Ben Graham-type stocks. That makes a ton of sense.
And you’ve probably developed an approach that isn't quite like any of our approaches. That's fine.
The one bit of advice I would offer to everybody regardless of their approach is to start closest to home. Start with the companies you've known the longest. Start with the companies you study the most. Start with the companies that are literally close to your home. The companies in your home state.
Start with what you know.
And stick to what you're comfortable with.
I'm also going to suggest an investing exercise. You can do this with any list of stocks. It could be my list of 12 stocks. It could be your own list of 4 or 40 stocks.
Now imagine you own one of the stocks. Pick a specific stock. Take Dreamworks or FICO or whatever you have on your list. And then imagine the future. Imagine that stock dropping 50% from where you bought it. And imagine they put out a press release that just says, “We fired our auditor.” Nothing else. How sick does that make you feel. You want to do that for each stock. You want to imagine the worst headlines, the worst sentiment out there, and some little whispered rumor. Some uncertainty added to a panicky situation. Imagine the situation that would will be most likely to make you panic.
Now look at all the stocks on your list. And try to pick the stock you would feel most comfortable holding in this darkest moment. The stock you’d be willing to buy more of.
We all admire what Warren Buffett did when he bought the Washington Post. We talked about Buffett's new hire: Ted Weschler. He made a lot of money on W.R. Grace. That wasn’t just from buying the stock. It was from holding it too.
Most of the work in investing is buying the right stock. The other part is holding it.
Make sure you can do both.
Follow Geoff at Gannon On Investing
Hi Geoff,
My question for you is about the recent market correction. I know you might not be comfortable talking about any stocks you bought, but I'd love to hear anything you can say about how you approached Mr. Market's most recent mood swing; what kind of actions did you take? Did you stick to pre-researched stocks on a watch list or did you go into overdrive with researching new businesses? I guess my question is mostly about mindset and preparedness. How do you prepare for this, and what does your thought process look like while it's happening?
Thanks,
Mike
That's a great question Mike. I haven’t bought any stocks in this correction. Right now I am: 50% in Japan, 25% in the U.S. and 25% in cash.
I like to put 25% of my portfolio in each stock. So I would really like to find one good stock to buy.
There are a lot of options out there. A lot of cheap stocks. Different people have different approaches to buying stocks.
I've mentioned the blog Variant Perceptions before. The author’s approach is to focus on turnaround situations.
Not a bad idea in today's market. But that's not what I do. My favorite stocks are predictable companies. I like free cash flow. And I tend to like businesses where the customer isn't super sensitive about price.
Although I haven't bought anything yet, I’ll take you through a list of stocks I would consider buying. It's a long list. Probably 12 names.
So there will be something for everyone on here. But I'm sure there will also be some stocks you absolutely hate. That's fine. This isn't so much about the specific ideas. It's more about giving you an idea of how I approach having a lot of ideas thrown at me at once.
That's what's happening in today's market. Volatility is great for long-term investors. The more prices change, the better the chance you have of getting a good business at a cheap price.
You asked if I go on overdrive researching new stocks. No. I don't. It's pretty rare for me to find a company for the first time and buy it right away. Usually I'm buying something I've researched before. I usually know the company ahead of time.
Almost all my best investments have worked that way. There are exceptions. There were a couple micro caps I hadn't heard of before buying them. But I can't think of a case where I bought a stock I didn't know almost immediately upon finding it other than situations where the stock was selling for less than its net cash.
I have bought stocks for less than net cash within a couple weeks of first learning about them. That's very fast for me. But there's only so much analysis you have to do when you're buying something for less than its net cash. It's obvious within hours of finding the stock whether it's a really interesting opportunity or not.
The vast majority of stocks don't trade for anywhere near net cash. Right now you only have about 130 net-nets out there. So even if we're talking about net current assets it is still a small list.
Those kinds of situations lend themselves to very quick analysis. A stock selling below net cash may or may not turn out to be a great investment. But it's obvious. It's conspicuous. You don't normally have to do a lot of digging to figure out whether or not it's worth buying. There's usually one or two big risks that are scaring people away. It's not like you have to do a deep analysis of the business’s earning power. Because you're not buying earning power.
I'll talk about net-nets another day. They are such a separate situation. You can find them and buy them pretty confidently within a couple weeks of first learning about the stock. That's not how I work when looking at good businesses. Businesses where I am buying earning power.
So this is going to be a list of 12 stocks you might want to consider buying for their earning power. If any of the names here are new to you, then you probably want to spend some time learning the company.
But a lot of this list is very well-known names. I won't be surprised if a lot of you reading this have read the 10-K for a majority of the stocks I discuss. If you read my past articles, I often mention the same companies over and over again.
There's a reason for that. I try to talk about stocks that I'm looking at. I try not to use examples from stocks I don't know anything about. It's kind of common sense. But that's why the same stocks show up as examples in article after article. It's because I know those stocks better than most stocks.
There's probably a reason why I know them better. They were cheap and interesting at one point. Or they are cheap and interesting now.
We'll talk about 12 companies that are cheap and interesting now. Like I said, I have not bought anything in this correction. But I'm picky. I really want to buy just one company. If you take a more diversified approach, you might be able to move faster.
First I look at demand. Does the company do something I can ballpark normal demand for? I'm talking round numbers here. I'm not talking about predicting what the advertising market will look like next year. But with an advertising company even if we have a 3-to-5-year rough patch, I have a pretty good idea what percentage of GDP advertising will be in 2016, 2017, 2018, etc. That's not too hard.
So Omnicom (OMC, Financial) makes the list. I talked about it before. I won't talk about it again. In 2009 I bought the stock at $28 a share. That turned out to be lucky timing. The stock’s at $39 right now. It got much higher. And I sold it much higher.
Would I buy Omincom today? It definitely looks attractive. But a lot of stocks look attractive right now.
Omnicom has a lot of European exposure. A slowdown in Europe is bad for Omnicom. And advertising is closely tied to GDP.
Omnicom is still cheap. You can do my usual analysis of looking at free cash flow margins and the price to sales ratio. For Omnicom it’s pretty easy. I would be willing to buy Omnicom at a price to sales ratio of one or less. Anytime you can buy Omnicom below its revenues per share I think you are getting a market-beating stock.
So that's one I would consider. And obviously it's not new. I've owned Omnicom in the past. And I talked about it at times in articles. That shows you how I tend to focus on stocks that are familiar to me.
Next up is Regis (RGS, Financial). I talked about the stock before. It runs hair salons. I haven't been happy with management. I think it's cheap compared to the free cash flow it should generate. But you've seen so much bad capital allocation at this company that I personally am not going to buy this stock. They've invested in things then divested them. Issued shares at the wrong time. They’ve just done everything wrong. At the top level of this company, it’s been mismanaged. All the financial stuff has been mismanaged. I’m not interested in owning something like that.
But if you look at the P/S ratio and you look at what kind of free cash flow you generate per dollar sales at a hair salon, the stock looks cheap. It's not for me. But it's an example of something I would look at. If someone came up to me and said there's a company that runs hair salons selling for less than half its per-share revenues, I would be interested. If they had a record on capital allocation that wasn’t this bad — I would buy the stock.
Demand for haircuts is something you can get a handle on. There's consistency there. So all you have to do is buy Regis when it's really cheap on the past average margins, earnings, free cash flow, etc. Again for me it's not a stock I’ll buy. I kind of blacklisted it because I don't like how the free cash flow might be used. I don't like the idea that I might get diluted at a bad time.
But Regis is a good example of a stock that seems real cheap. The fact that I won't buy it doesn't mean you shouldn’t buy it.
Also, there’s now an activist shareholder — Starboard Value — launching a proxy fight. You can read about it here.
Now I can group the rest of the stocks. They happen to fall into nice categories.
Let's start with financial information. Here we have three of the strongest businesses you’ll ever see. I've talked about Fair Isaac before. It’s bounced a little bit. It had been down around $20 a share not that long ago. It’s $23 a share right now. I think it's around 1.5 times sales.
This is a stock that should be worth more than two times sales. I like capital allocation here. This is the opposite of Regis. FICO is a company that did a bunch of things about a decade ago I really didn’t like. From about 10 years ago down to about 5 years ago it was doing things I didn’t like.
And capital allocation is critical at someplace like FICO. Because FICO doesn't really need to add to its invested assets over time. It doesn't add beyond inflation. So you have all this free cash flow being generated. And there's a temptation to do something with it. The right thing to do is buy back stock. Pay a dividend. It's a hard business to grow. It will grow along with its customers. It will grow along with the volume of transactions in financial services. So in the long run there is growth. It's like advertising that way. But it's not some place where you can spend a lot of money to buy growth.
The big reason for that is FICO’s crown jewel: the FICO score. This is the standard credit score in the United States. And so you have dominance there. Operating margins in that segment of FICO’s business are around two thirds. About 60% or higher.
Right now that business is providing a huge amount of FICO’s earnings. And almost all of its economic value added.
That's really what you're buying when you buy a share of FICO. You’re buying the FICO score.
It's very important to see where the share count is going over time. You want to see FICO buying back stock. I would buy this before I would buy Regis. And it really comes down to capital allocation.
Next up is Moody's (MCO, Financial). Moody’s has a P/S ratio of about 3 right now. So it’s not a low P/S stock. But it is a low price to free cash flow stock. That’s because free cash flow margins are high. This is a business that has often turned 30 cents of every dollar of sales into free cash flow.
That’s an amazing business. One of the best businesses you'll ever see. Look at Moody's free cash flow margins and look at Microsoft's (MSFT). This is a company that doesn't need any tangible equity.
Moody’s is also an extremely controversial business. And it's only going to get more controversial.
Because Moody's is one of the credit rating agencies that is going to be downgrading all this sovereign credit in Europe. So think about this. They may very well end up downgrading the credit of Italy, Spain, Portugal, Ireland, Belgium, etc. That's not going to make those countries happy. You'll see finance ministers come out and categorically reject the ratings downgrade. They will say they disagree with it. And this isn't just companies doing that. So it stirs up feelings of nationalism. It brings politics into it. People will complain about how Moody’s missed the housing bubble. They blame them for the credit crisis. People get fired up. So there is a lot of headline risk in the stock. Maybe regulations will be changed.
Moody's is probably not a stock people reading this are going to go out and buy. It has the best business of the companies mentioned here. But it's extremely controversial. It’s not a stock I would write about. Most of what has been said — pro and con — about Moody’s has already been written by someone else.
Finally in financial information we have Dun & Bradstreet (DNB, Financial). Dun & Bradstreet has some similarities to IMS health. It has a huge database. The DUNS is used to identify a lot of businesses around the world. It's a standard like the FICO score. This is a business with staying power. If you can buy it when it's cheap on an average earnings basis you can make money.
They also have a history of reducing the share count over time. It's definitely a stock worth considering.
Notice I don’t mention banks. That’s because I don’t buy banks. If you want to buy banks read a blog like Variant Perceptions. Read articles by someone who knows what they’re talking about. Don’t read my articles.
There are a lot of people who know a lot about banks. And that's the problem. I'd rather invest in something where I think there are more misperceptions. Where it's really a lot simpler than it's being made out to be. I'm never going to be the smartest guy when it comes to any specific bank.
If you’re interested in banks you should see the interview Bruce Berkowitz did with Consuelo Mack. There was also an interview he did with Outstanding Investor Digest way back in the early 1990s. That was when he bought Wells Fargo (WFC). Buffett also bought Wells Fargo back then. And today Buffett and Berkowitz own Bank of America (BAC).
If I was a shareholder of Fairholme, I wouldn’t sell the fund. I might even consider putting more money into Fairholme. So I'm not saying there's anything wrong with buying the banks right now.
If I was going to own banks I would need someone like Berkowitz to buy the banks for me.
You'll have to come to your own conclusions about that. But I should point out you can make money without buying financials. There’s no requirement that says you have to buy banks. Or materials stocks. Or foreign stocks.
You get to choose what you buy. Just because something is down 30% this year, doesn’t mean you have to pay attention to it. Maybe it isn’t your area of expertise. Leave it to someone else.
There are a lot of stocks on this list I'm talking to you about. Stocks that are cheap right now. None of them are banks. Something could still go wrong with them. They don't all have pristine balance sheets. I hate the management at Regis. This is not a risk-free list.
But it's a list of cheap stocks. And none of them are banks. And none of them are insurers. You can go through this list like a menu. And you can find one stock on it that you can buy and hold. One stock that will outperform the market for the next 5 or 10 years. One stock that will earn you a decent return.
That’s all you need.
My hurdle rate is 10%. I want a stock with a good chance of returning 10% a year to me. Now a lot of stocks can do that if you buy them today and flip them next year. I've got nothing against selling a stock in a year. I've done it plenty of times.
I have a problem with buying a stock and counting on selling it in a year. That’s an exit strategy. It gives you false confidence. You don't need an exit strategy.
You just have to buy something that you could hold for long time and earn solid returns. Every stock on this list has that potential. So for the first time since early 2009 you've got a whole day of stocks in front of you that are worth buying.
I was born in 1985. I got started investing in the late 1990s. There haven't been that many times in my investing life when we've had opportunities like this. When a lot of stocks have been cheap at the same time.
It was true after Lehman failed. It was true in early 2009. We’re talking about half the year.
Stocks could get a lot cheaper. Look at the difference between the earning power of stocks divided by their prices and the yield on bonds in the 1930s. Stocks could get that cheap. It happened once. It can happen again.
I don't operate on that assumption. I don't worry about how low stocks can go. They can always go a lot lower.
I just look at this list. I think that's a good list. And if something on that list that I’m really comfortable with gets to a price I know is crazy cheap, I will buy it.
That’s the way to act. You don’t listen to what the market is telling you. You take advantage of the market. That is the Ben Graham way.
The next little group here is health stocks. These are companies that are pretty predictable in my view. One stock I've talked to death in previous articles is Birner Dental Management Services (BDMS, Financial). It's a micro cap. It's illiquid. It's family controlled. If you can get over those things and you want a stock to just buy and hold I think this is very high on the list. It's cheap on past earnings basis. It pays a dividend. It buys back stock. That's all you really need a stock. If you think that past earnings in something like dentistry are indicative of future results this is the kind of stock you can buy. It looks very cheap on the numbers. And it has long history of returning a lot of money to shareholders. That makes a huge difference. If they didn't have a history of doing that this might not be a stock that I be talking about at all.
Next up is Prestige Brands (PBH, Financial). This is an over-the-counter drug company. There was another company like Prestige brands. It used to be public. It was called Chattem. If you know Chattem, you have an idea what Prestige Brands is all about. If you have never heard of this company, go read the 10-K now. These are really strong, really dull brands. I can't do it justice by just talking about them here. They're things like wart remover. Here are just a few of their brands: Chloraseptic, Luden’s, Clear Eyes, Compound W, Murine, New-Skin and Dramamine. Several of these brand names are synonymous with their product category. They are the Kleenex and Xerox of the drugstore aisle.
One concern here is acquisitions. This is an area where you have a lot of acquisitions. And if the company overpays, all the free cash flow it generates ends up being wasted on paying too much for new brands to buy up. That’s something to worry about. The other thing to worry about is adding inferior brands over time. They started with brands in strong positions. It is usually easier to add second-tier brands over time. These are not categories where you want to pay a lot of money for the also rans.
Next up is VCA Antech (WOOF, Financial). This is an animal health business. It runs animal hospitals and labs for medical tests on animals. We’re talking about pets here. This stuff isn't covered by insurance. Or the government. It's a cash and credit card business. In the long run I think spending on pets is one of the most predictable and one of the most profitable areas to be in. If you ran a Berkshire Hathaway-like (BRK.A)(BRK.B) conglomerate, a business doing something with pets would be the kind of business you would look at acquiring.
Now what about VCA Antech in particular?
Well, this same management team ran up huge debts about 10 years ago. They went private. My biggest concern here would be the human element. I would want to know more about management. You don't want to buy another Regis. At least I don't.
I was surprised the stock got this cheap. Not that long ago I thought VCA Antech would never present this kind of opportunity to buy. There are stocks like that. I talk about McCormick a lot. McCormick doesn't get very cheap very often. It's a business you get to admire from afar. It's not one value investors get to own.
And finally we have entertainment. This is the area that will appeal to the least of you.
A lot of investors don't like entertainment stocks. There is a feeling of fickleness here. Entertainment does not seem serious enough. It is subject to people’s whims. It is hit or miss.
There’s some truth to this.
But the same could be said about consumer products or technology.
I think you can understand the behavior of entertainment company’s customers. And that is the first step in understanding a business.
Our first entertainment company is not a big free cash flow generator. It's Carnival (CCL, Financial). Carnival has to be evaluated on a return on equity basis. This company has about half the worldwide cruise business. Carnival’s next largest competitor is Royal Caribbean. Together they have maybe three fourths of the industry.
This is an asset-heavy business. Cruise ships cost a couple hundred million dollars and up. They are huge investments. And they last for decades. Cruises are amazing logistical feats. Feeding that many people at sea is difficult. The barriers to entry in this business are astounding. It doesn’t get much wider moat than a cruise line. That’s the upside. The downside is the returns on equity.
I think Carnival is a good efficient operator. But you have to be a good efficient operator to make money in this business. If they don't run this business really efficiently you won't make money on the stock. You have to have faith in the operations.
There are some businesses that can be run kind of sloppily. Listen to the interview Warren Buffett gave to the financial crisis inquiry whatever it was called. He talked about how it's almost impossible to evaluate the management team of a company like Moody’s. It's such a good business that an idiot can run it.
Carnival is not that kind of business. If an idiot runs Carnival they could run into the ground. I would say it has extreme similarities with grocery stores that way. It only works if it is run very efficiently. And you have to buy at a reasonable price to tangible book. Right now Carnival is trading at a reasonable price to tangible book ratio. You could make 10% or 12% a year in the stock. But that assumes a lot. That assumes it is run well.
It's also got a lot of European exposure. If things get worse in Europe and the world economy gets worse you'll see a lot of negative headlines about Carnival. A lot of people will not want to own this stock.
That's probably exactly the time to buy it. Carnival’s position in the industry is not threatened. I don't think the long-term future of the industry is threatened. Carnival is too asset-heavy a business to really ever be called a great business. But the Warren Buffett approach of buying a great business when it runs into temporary problems applies here. Carnival is a dominant business. And the things I hear people talking about are temporary problems.
Carnival is a stock I’m very interested in.
It's also unlike almost any other stock that I am interested in. I don't like tangible assets. And buying something like Carnival is awfully similar to buying something like Burlington Northern. The competitive position is excellent. The long-term future is certain. But boy is it an asset-heavy business. And it's hard to make a lot of money per dollar of tangible book in a business like this.
Next we have Dreamworks (DWA, Financial). There’s no point listening to what I have to say about Dreamworks. Andrew August of The Frog’s Kiss said it better in his 14 page report on the company.
Seriously. Don’t listen to me. Read Andrew’s report instead.
Okay. You’re still here. I might as well give you my thoughts on Dreamworks.
This is an intangible business. But it's a very investment-heavy intangible business. Dreamworks invests heavily in big budget movies. It makes two movies a year. It's going to make three movies every other year from now on. So that's 2.5 movies a year. That sounds like a small amount. But these are not small movies. To give you some perspective, the next movie is Puss in Boots. If you watched TV this weekend, you saw the ads. Those ads aren’t cheap. Paramount pays for them. And before Dreamworks can make a profit on the movie, Paramount needs to recoup all its expenses plus pocket 8% for itself. That’s the hurdle a Dreamworks movie has to clear before it even reports any revenue.
A Dreamworks production costs between $135 million and $165 million. Let's call it $150 million. Right now they have a distribution deal with Paramount. And the distribution of the Dreamworks movie is normally supported by a huge amount of marketing. We’re talking another $125 million to $175 million. So the entire undertaking shared by the studio producing the movie and the distributor is about $300 million. These are movies like Shrek, Kung Fu Panda, Madagascar, How to Train Your Dragon, etc.
Like I said, Puss in Boots is up next. It comes out at the end of this month. Officially, Dreamworks put the Shrek series to rest. But Puss in boots is a character from the Shrek movies. So it's really an extension of those movies.
I love this company. You have Jeffrey Katzenberg running it. It gets half of its revenues from overseas. Foreign box office is getting better and better.
You had some tremendous results for Kung Fu Panda 2 in China. Kung Fu Panda 2 was a disappointment in the United States. Not critically. It was a fine movie. Audiences liked it. Critics liked it. But it opened against The Hangover 2.
They go for the big opening weekend at Dreamworks. They look for the week where you have the biggest movie audience going to theaters and you don't have another competing family film. They thought that going up against an R-rated comedy was a safe bet. They were wrong. And they admitted as much on the conference call.
Kung Fu Panda 2 did fine worldwide. And I would expect Dreamworks movies to skew more and more towards the foreign box office in the future. That's partially because of doing sequels. Sequels play better overseas than in the United States. These movies have done great overseas. And they're building more theaters in places like China.
They're scared about the home video market. Studios made a lot of money on VHS, DVDs and Blu-Ray. That's in the developed world. Those have never been big sellers in developing countries. And Dreamworks makes a lot of money from that part of the business. About half of the people who buy a Dreamworks DVD also saw the movie in theaters. So you have some extra profits in there that come from people seeing the movie in theaters and then buying the DVD. That's going to go away over time.
Of course, if movie streaming increases, there will be very strong competition for exclusive content. There will only be a few viable streaming options because of exclusivity. A company like Dreamworks will get paid tens of millions of dollars for each movie it grants streaming rights on if they are sold as an exclusive package. Will that offset DVD sales? It could. At streaming right sales of around $50 million a movie, it might fully offset the profits from DVDs. But streaming competes both with DVDs and with TV rights. So, it would take even bigger payments to offset all those sources of income.
You can do all the math you want. It won’t solve the basic problem. You’re going to guess wrong. The studios thought TV and VHS were both threats to their business. They later turned into big profit sources. And today studios aren’t moaning about a lack of people in theaters — their biggest concerns are home video sales and TV rights. Cable is less interested in movies now that it has its own original series.
When you factor in 3D and the foreign box office, it’s much less clear where revenues per Dreamworks movie are being taken by the course of history. There are trends pushing in different directions. And the biggest long-term trend will be having a much larger worldwide audience for their movies. Will Dreamworks get paid for this content?
Some people say no. Without DVDs, there is no hope for Dreamworks. Movies shown in theaters and streamed to people will not be enough.
What about me?
I'm very positive on this company. It's a stock I would like to buy and hold forever. Is it cheap? This is a hard company to value.
Each movie they make is a very large portion of its total value. As I write this the stock is trading around $17. That's close to an all-time low. The stock has never been below $16.50. They went public in the middle of last decade. It’s down about 50% from where it went public. And yet Dreamworks is clearly a much stronger company today than it was back then.
If you want to know more about Dreamworks you can research every single one of their movies at places like Box Office Mojo. You can look at a site like The Numbers. If you combine the data you find in places like that with the data in Dreamworks 10-K you have a very clear idea of how the business works. There is more data out there about Dreamworks than about any of the companies on this list. The movie business is very transparent if you're willing to put all the data together yourself. The actual filings and conference calls and press releases that studios put out are not particularly transparent.
But Dreamworks is not a conglomerate. It does one thing. It puts out two or three movies a year. And the press reports on those movies. It's an easy company to understand. But it's a risk-taking business. Every movie is a huge project. They take up to four years to develop. There is no established market for an original movie. You have to sell the public on that movie all over again. Every movies is a new product launch. The market cap is only $1.4 billion right now. So each movie they make is risking 10% of that market cap. And Dreamworks is plowing about 25% of their market cap into new movies each year.
So Dreamworks is an unusual company. But it's at the top of the list of companies I would consider buying and holding forever.
Next is Nintendo. Nintendo is cheap. The stock trades for less than 12,000 yen in Osaka. There are ADRs in the U.S. You need to check the price on ADRs yourself. The price you get will be the price you pay on the number of ADRs needed to equal one share in Osaka. So if you’re buying in the U.S., you have to do your own homework on that.
I'm going to talk about the Japanese shares. In Japan, Nintendo shares trade for under 11,800 yen. The company has 8,500 yen a share in net cash. Average earnings over the last 10 years have been about 1,000 yen a share.
So you can look at it two ways. You're either paying about 11.8 times average earnings. Or you're paying about 3.3 times average earnings. One way is without cash. One way is with cash.
The truth is somewhere in the middle. Cash is nice. But it's not like the company pays you that cash back when you buy the stock. It does have a dividend policy. You can read about it on their website. Nintendo pays out at least half their earnings. It also keeps their share count down. So despite a huge cash hoard, capital allocation is not a problem at Nintendo.
The only problem with capital allocation is that there’s a lot of cash earning nothing. That's a problem. But it's not like Regis. Or Hewlett-Packard. Or some other tech giants that make acquisitions.
Nintendo is the market-share leader in both consoles and handhelds at the moment. But its sales are way behind what would be needed to maintain its market share.
They put out a new handheld. It's called the 3DS. And it was a big flop. They didn't have any good games.
Bloomberg has run articles with Japanese money managers griping about Nintendo. They want to hear Nintendo announce games for your phone.
Nintendo is in the complete opposite business. They make the hardware and software. And the hardware is made specifically for playing games. Don't expect them to change.
A lot of video game companies are public. You have a bunch in Japan. You’ve got Activision Blizzard, Electronic Arts, Take-Two and THQ in the United States. All those companies are public. You can read their 10-Ks. You can listen to their conference calls. And like the movie industry there is a ton of industry info out there on video games. There are weekly sales numbers. And there are all sorts of shows these companies go to. There is no shortage of commentary on the video game industry.
I'll just say that Nintendo has a quarter-century-long history of profitable performance in this area.
It has a clear idea of what it wants to be. That idea may be a bad one. But it's not in doubt. So you know what you're getting here.
Nintendo also has a wonderful investor relations section on its website. Tons of info in English. Absolutely wonderful by Japanese standards. Actually it's great by American standards. The first thing I would check out if you're interested in Nintendo is the company's own website. I don't think I've ever seen a better investor relations section of a website.
Finally there is CEC Entertainment (CEC). This is Chuck E. Cheese. It's an interesting business. It's a niche business. It hasn’t over expanded. And it has a nice capital allocation history. This is another company where the share count tends to go down over time. That's just about the most important issue. If you have a rising share count it doesn't much matter what else you’ve got going for you. A falling share count doesn't cure fundamental problems. But when you combine a falling share count with a really wonderful business the results are spectacular. Chuck E. Cheese is not a spectacular business.
It's got the kind of margins you expect in a restaurant. But returns on capital are good. And the earning power is there.
Chuck E. Cheese has one big advantage that might not be obvious. We talk a lot about competitive advantages. We don't often talk about how companies perceive themselves. The huge advantage for Chuck E. Cheese is how its competitors perceive themselves. Chuck E. Cheese is neither fish nor fowl. Its competitors are all fish and all fowl. They see themselves as restaurants. Or they see themselves as entertainment companies. Chuck E. Cheese is both.
There are concept similar to Chuck E. Cheese all around the United States. I'm not going to name them because the ones in my home state — New Jersey — are not going to be the ones in your home state.
There is no national competitor that matches up directly with Chuck E. Cheese. Why is that an advantage?
Name recognition. A lot of things don't scale. There are few things that do scale. Marketing scales. People look at a cruise ship and see its huge size and think scale. There are economies of scale on each cruise ship to a point. What you're missing is the economies of scale to a cruise line. You have to fill those cruise ships. That's marketing. And marketing scales.
Too often when I say scale people think of the giant ship and not of the giant ad campaign and the travel agents who actually fill those ships. That’s where the real scale is.
It doesn't take much actual marketing spending for Chuck E. Cheese to be a name kids know.
I consider Chuck E. Cheese an entertainment company. It's usually grouped in with restaurants. To me, companies should be grouped the way their customers think about them.
CEC Entertainment is not on the top of my list right now. But it makes the top dozen.
So that's it. Those are the 12 companies that I’m most interested in right now. Ideally, I would like to pick one of them and put 25% of my portfolio into the company. That would be easy to do in 11 of these companies. One is a micro-cap stock. It's hard to put that much money into a stock that small. But most of these companies are actually very big. Which is unusual for me. I’m not a fan of big stocks.
I’ve known these companies for a while. There are not a lot of new names here. That's almost always the way I work in a big market downturn. It’s actually the way I work almost all the time. The exception is sometimes net-nets.
I'm hoping to pick one of these stocks to put all my cash into. I would put 25% of my portfolio into just one of these stocks. That's always the ideal. I don't like to own more than four or five stocks.
Will I do that here? I don't know. I would be very surprised if I end up buying more than one of these stocks. I don't see myself splitting up 25% between two or three of these names.
I focus on a certain kind of company. You can see that in the way these stocks appeared in groups. We have three companies in financial information: Fair Isaac, Moody's, Dun & Bradstreet. We have three companies in healthcare: Birner Dental, Prestige Brands, VCA Antech. And we have four companies in entertainment: Carnival, Dreamworks, Nintendo, and CEC Entertainment.
We all have our circles of competence. Mine is pretty narrow. I don't know a lot about a lot of stocks. And I’m only comfortable buying certain kinds of stocks.
We all work differently.
I love reading Variant Perceptions. I think that kind of investing makes a ton of sense. I love reading what Richard Beddard is doing. Being more diversified. Investing in Ben Graham-type stocks. That makes a ton of sense.
And you’ve probably developed an approach that isn't quite like any of our approaches. That's fine.
The one bit of advice I would offer to everybody regardless of their approach is to start closest to home. Start with the companies you've known the longest. Start with the companies you study the most. Start with the companies that are literally close to your home. The companies in your home state.
Start with what you know.
And stick to what you're comfortable with.
I'm also going to suggest an investing exercise. You can do this with any list of stocks. It could be my list of 12 stocks. It could be your own list of 4 or 40 stocks.
Now imagine you own one of the stocks. Pick a specific stock. Take Dreamworks or FICO or whatever you have on your list. And then imagine the future. Imagine that stock dropping 50% from where you bought it. And imagine they put out a press release that just says, “We fired our auditor.” Nothing else. How sick does that make you feel. You want to do that for each stock. You want to imagine the worst headlines, the worst sentiment out there, and some little whispered rumor. Some uncertainty added to a panicky situation. Imagine the situation that would will be most likely to make you panic.
Now look at all the stocks on your list. And try to pick the stock you would feel most comfortable holding in this darkest moment. The stock you’d be willing to buy more of.
We all admire what Warren Buffett did when he bought the Washington Post. We talked about Buffett's new hire: Ted Weschler. He made a lot of money on W.R. Grace. That wasn’t just from buying the stock. It was from holding it too.
Most of the work in investing is buying the right stock. The other part is holding it.
Make sure you can do both.
Follow Geoff at Gannon On Investing
