Someone who reads my articles sent me this email:
Alice Schroeder talks about Buffett requiring a 15% day one return. That is without accounting for any speculative growth. I guess that number has gone down a bit in recent years because I have a very hard time squaring this with the valuation of IBM at the time of his purchases, although that may obviously be due to my own deficiencies.
How do you think about this? I mean Buffett has made obvious tweaks on this, investing in convertibles with a day one return a lot lower than 15% but with huge upside potential later on. I could also imagine situations where you may invest in securities with safe earnings yields of 10% or something like that but with an attached lottery ticket, like legal changes that open up new markets, court cases, FDA approvals etc.
How do you go about valuing things like that and do you try and quantitatively value growth prospects? What's your required rate of return and how do you think of margin of safety in relation to this?
My required rate of return is 10% a year. In the U.S., corporate taxes are around one-third of income.
So an investor who is looking for a 10% annual return is often looking for a company achieving a 15% pre-tax return on its capital. This changes as that capital is leveraged. And it changes as the stock price rises and falls relative to that capital.
I’m not going to bring leverage into today’s talk. But I will mention the obvious point that you can earn more on an investment than the company you are investing in if you buy it at a deep discount to book value. For example, paying 0.5 times book value for an insurer that earns 7% on its equity can lead to an investment that makes you more than 10% a year even though the company is earning just 7% a year.
I try not to think of businesses in terms of multiples of earnings, free cash flow, book value, etc. I think in terms of sales and assets. For a bank, I would think in terms of deposits. I look at some banks. I haven’t owned any banks in a very long time. So, for now let’s stick to sales and assets.
If I want a 10% rate of return – I need to find a company that is getting a good enough return on sales and is selling for a low enough multiple of sales. This is just one way of thinking about investment rates of return. It is probably the main way I look at stocks.
Let’s look at a stock like Omnicom (NYSE:OMC). I do not own Omnicom today. I did own it in the past. I bought Omnicom in 2009 at just under $28 a share. I sold it about a year and a half later. So we know I thought Omnicom met my 10% return hurdle in 2009 around a price of $28 a share. Let’s walk through how I came to that conclusion.
Omnicom is an advertising agency. Actually, it’s an ad conglomerate like the other major owners of ad agencies: Interpublic (NYSE:IPG), Publicis, and WPP.
Client concentration is minimal. Omnicom’s largest client in 2009 accounted for less than 3% of Omnicom’s sales. Omnicom’s top 100 clients provided 47% of sales.
I’m going to refer to Omnicom’s revenue as its sales for the purposes of valuing the stock. In reality, ad agencies do not have sales. They have billings. And they have revenue. Revenue is a small part of billings. The amount of services clients purchase through ad agencies is huge. That number – called billings – does not appear on an ad agency’s financial statements. Revenue does.
Let’s look at the key figures Omnicom published in the 2008 annual report – the last numbers I saw before buying the stock. Revenue was $13.36 billion in 2008. Operating profit was $1.69 billion. There were 315.4 million diluted shares outstanding.
So the operating margin was 12.65%. The average operating margin over the last five years had been 12.8%. The recent past offered no hints about Omnicom’s margins in a recession. Ad agencies had only been hit hard in the early 1990s and then in late 2008. I was buying this stock in early 2009. I expected the ad business would be a bad one for at least the next 3 years. I expected it to return to normal within about five years. So, I was buying a stagnant stock, but one that I thought would be hitting record earnings again by 2014.
Free cash flow regularly exceeds net income at Omnicom. Ad agencies are a very capital light business.
After taxes, shareholders tended to get about 7.5 cents of earnings from every dollar of Omnicom’s revenue. However, free cash flow was much higher. It was around 10.5 cents of free cash flow per dollar of sales when I bought the stock.
Let’s call that 10%. So Omnicom’s free cash return on sales was 10%. Note that organic growth had been positive. And that – aside from acquisitions – sales growth at advertising agencies does not normally require any capital spending be done in advance. In other words, that 10% free cash flow margin was a good estimate of what Omnicom could pay out to owners if it stopped making acquisitions.
The company was not shrinking. Be careful not to give full credit to free cash flow at a shrinking company. It is easy to produce free cash flow in a shrinking business. It is hard in a growing business.
So, we’ve estimated Omnicom’s return on its sales in 2008. I estimated Omnicom would return 10% on sales. To calculate my return on investment, we need to know how much I paid for each dollar of Omnicom’s sales.
At the end of 2008, Omnicom had $13.36 billion in sales. And 315.4 million shares outstanding. So that’s $42.36 a share in sales ($13.36 billion/$315.4 million = $42.36/share).
I paid just under $28 a share for the stock. If we assume a 10% return on sales and we assume I was buying $42.36 in sales – we get owner earnings of $4.24 a share. I paid $28 for each share. That means a return on my investment of 15%.
What about growth?
I didn’t count it. Although I did consider the fact that Omnicom could – after the recession – grow sales at a rate close to nominal GDP growth. This was a qualitative – not a quantitative – factor in my decision.
I never predicted margins for 2009 through 2014. Nor did I predict sales. I expected both would shrink over the next few years. But I came to a conclusion – I made a guess – that by 2014, Omnicom would be back at record earnings levels and would keep growing from there.
I also made a judgment call that Omnicom wouldn’t come anywhere near an operating loss in the downturn. It would keep producing free cash flow through the recession. That was not a hard call to make. But it was a key part of the investment.
A company that would only start earning 15% on my investment five years in the future – and that might lose money at some point in the next few years – would not be an acceptable investment. But I knew Omnicom would have no trouble producing free cash flow even in the worst years ahead.
Finally, I expected Omnicom would keep buying back stock. If I didn’t expect Omnicom would buy back stock while I owned my shares – I wouldn’t have made the investment. Those expected share buybacks were the deciding factor in my investment.
There were some risks at Omnicom. But they were very low compared to other investments offering returns of 10% or more at that time. There was a refinancing issue that was a concern because of the financial crisis. But I had no doubt about Omnicom’s ability to service its debt. Only its ability to market the debt during a panic.
Omnicom is an example of a simple return on investment calculation. Let’s look at George Risk (RSKIA). This is the idea I stole from The Rational Walk. It was a 2010 investment. Unlike Omnicom, I still hold this stock.
I bought George Risk at $4.65 a share. That’s a simplification. It’s an illiquid stock. So that’s my average cost. I bought shares above and below that price. I was buying shares for months. But I’ll use the 10-K filed in July of 2010 as the best illustration of the company’s financial position while I was buying.
There were 5,063,455 shares outstanding. Most were – then as now – owned by the CEO, Ken Risk. This is a controlled company.
George Risk had been profitable in 16 of the last 17 years. The average operating profit throughout that period was around 40 cents a share. After tax, an operating profit of 40 cents a share becomes just 26 cents a share in earnings ($0.40 * 0.65 = $0.26). I paid $4.65 a share. That is not a bargain price relative to earnings. It was about 18 times earnings ($4.65/$0.26 = 17.88).
So why did I pay 18 times earnings for an illiquid micro cap?
The company had $4.59 a share in cash. I paid – on average – about $4.65 a share. My average cost in the stock had to do with the availability of sellers of the stock more than anything. But you can probably guess my thinking here. I was basically willing to pay up to the company’s cash per share. As long as I felt I was getting the operating business for free – I was willing to buy the stock.
My reasoning was that I liked the operating business. It made a product with good economics. And it was positioned well relative to its competition. There were risks. One customer – a distributor – accounted for 43% of sales.
Let’s be honest here. My reasons for liking the operating business were very simple – and frankly they weren’t plural. I liked the business for one reason.
I thought they could raise prices. After I bought the stock – they did.
Why did I think they could raise prices?
The company was paying more for its materials than competitors were charging for the finished product. And yet the company had a 25% operating margin. That 43% customer had been a longtime buyer. And margins hadn’t been wobbly during the housing boom. Furthermore, I knew the industry had been deflationary for the last two decades.
Only one theory explains those facts: George Risk was not competing on price. But they were competing successful.
I’m not an economist. I’m an investor. But I’m going to let you in on a secret about economics as it’s practiced in the real world.
Good businesses do not price their products to maximize their revenue. Because good businesses don’t know what they can charge. Businesses – good and bad – always know two numbers. They know volumes. And they know margins.
When margins and volumes are progressing nicely – prices seem right to management. When volume slips, prices seem too high. When margins slip, prices seem too low.
I felt the housing boom had disguised an opportunity to raise prices. And I felt that a housing bust would unmask that opportunity.
I couldn’t quantify it. But I could use that information to judge the quality of the operating business. I judged it to be a high quality business.
And then I looked at the situation as I control buyer might look at it. I looked at $4.59 a share in cash. And I looked at 40 cents in operating earnings. I felt that an honest appraisal of such a combination of assets would be about $8.50 a share. I felt that’s what the family thought the corporation was worth.
I would never pay anything remotely close to $8.50 a share for the stock. But when I do an appraisal I don’t think about the stock as a stock. I think about it as a collection of assets. Here, I thought you had a business worth about $4 a share and cash worth about $4.60 a share.
I knew I needed to do a calculation to see what would happen if I got stuck in the stock. What happens if there is – as The Rational Walk said – simply no catalyst here?
I figured the worst case upside scenario was owning the stock for 10 years. The “cash” the company had was actually an investment portfolio. They owned stocks and bonds. I figured the company would earn nothing on its investments. They would not compound.
I assumed operating earnings would be 40 cents a share, taxes would be 35%, and so we’d be adding about 25 cents a share to that cash pile each year. This was the worst case scenario. A dividend or share buybacks would be another, better use of the cash. I ignored those options.
If 25 cents a share was added to the cash pile for 10 years, it would add $2.50 to the current pile of $4.60 a share. That would mean $6.85 a share in cash at the end of 10 years. The operating business – I assumed – would be steady but stagnant on average. It would be worth $4 at the end of the next 10 years.
The combination would be worth $10.85 in 10 years. And I was paying $4.65 today. That would mean a return of 9% a year.
Does that mean I didn’t clear my hurdle?
Well, if the portfolio returned just 4% a year, my return would be 11% a year over 10 years. Likewise, if the “value gap” was closed – some catalyst appeared – in just 7 years, my return would be 13% a year.
In other words, if I really did believe the cash was as good as cash and the operating business was as high quality as I thought it was – it was hard to come up with a scenario where you made less than 10% a year in the stock.
It was possible. The investment portfolio could really return nothing. The company could really pay zero dividends and buy back zero shares of stock – at the time, it actually was paying dividends and buying back stock.
And it really could take 10 years for a stock’s price to rise toward what I believed its intrinsic value to be.
In my experience, the gap between price and intrinsic value tends to close in more like 1 to 3 years rather than 10 years. And, in my experience, cash piles do not keep piling up forever. Something happens. Nobody knows what or when. But it does.
You can argue that I lowered my 10% hurdle for George Risk. I don’t think I did. But I do want to make one important point about net cash stocks.
If I thought George Risk’s operating business was mediocre – I wouldn’t have bought the stock. Not even at $4.65 a share.
There was zero safety in the cash alone. And there was zero safety in the operating business alone.
But taken together, I believed the cash and the business added up to a 50% margin of safety. I also believed that while there was little downside in the stock – the upside was likely at least 10% a year.
Finally, I should mention that George Risk owned stocks and bonds. So, if it turned out the stock market was going to roar ahead at a much, much faster than my 10% return hurdle – I’d actually benefit a little from high rates of returns in stock and bonds. The relative underperformance risk was lessened a bit because George Risk was kind of both a business and a closed end investment fund.
I didn’t like the closed end investment fund part of it. I would have rather owned the business and gotten a $4.60 special dividend. But I felt I could live with owning them both. And I figured I could earn 10% a year while I did.
So that’s how I would look at the idea of a required rate of return in two very different investments. In George Risk, it was about a one-time value gap closing. In Omnicom, it was more a matter of a perpetual annuity – and whether that annuity would tend to be at least 10 cents for every $1 I paid for the stock.
The calculation had to be different because Omnicom was purely a matter of earning power. George Risk was a combination of assets and earnings.
Every stock is unique. It’s more important to look at them in an honest way than in an identical way. There’s no one formula that works. But a required rate of return – and a required level of safety – should always be in the front of your mind.
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