Warren Buffett and Charlie Munger have talked about thinking in alternatives. A good example is when Warren Buffett says that Wells Fargo (WFC) is the bar against which a new investment is measured. What he means is that before buying a big, new position – like IBM (NYSE:IBM) – he asks himself how that purchase compares to adding to his favorite stock already in his portfolio. For the last few years, that stock has often been Wells Fargo.
I own a couple stocks: George Risk (RSKIA) and Ark Restaurants (ARKR).
I bought George Risk several years ago – at a much lower price. It is up over 60% in that time. And, also in that time, the CEO died. While neither the higher than 60% price increase nor the death of who I thought was an excellent CEO made me want to sell the investment, it obviously makes it a less attractive investment than when I first bought it.
Ark Restaurants is a different story. The stock price is not much different from where I bought it. Certainly not different enough to alter my view of whether it’s worth putting money in. Because I bought the stock, we know that at one time I thought it was the best investment I could make.
What has changed since then?
Not much. The company rejected a takeover offer. After that rejection, there was no follow up from the would-be acquirer. That makes sense considering the amount of stock insiders own at Ark. If they don’t want to sell, there’s little point in trying to convince all the other shareholders.
Little has changed at Ark since I bought the stock – very little that would make me change my view of the stock. Meanwhile, prices of other stocks I like are up a lot more. Overall, this makes the stock a good choice for my “best alternative” already in the portfolio.
That’s our first example of an alternative. We can use it as a thinking tool. Whenever I find a stock I’m interested in – I can compare it to Ark. How can I compare it?
Well, to start with, I will always know a lot less about the company I’m considering starting research on then I do about Ark. So, it’s always an unfair comparison at first. I don’t know the strengths – or weaknesses – of the new business when I start. I can, however, do a quick comparison of some jot checklist type questions. Asking yourself how expensive a new stock you’re considering investigating further is relative to the favorite stock you already own is a quick and easy exercise. It can also splash some cold water on your face when you are veering too far from value investing.
Here we will define value investing as paying low multiples of price-to-assets and price-to-earnings. We should define those measures widely. For example, price-to-assets should mean checking not just price-to-book but also price-to-net current assets and price to a private owner (what the company might sell for in an acquisition). Likewise, price-to-earnings should include a measure of cash flow – perhaps free cash flow or EBITDA depending on the companies being considered.
We also need to consider the issue of “normalization.” Is this a boom or bust year for the stocks you are comparing? Ark is in the restaurant business. They have several restaurants in Las Vegas. While last year’s adjusted EBITDA – which we’ll call $13 million – was about as high as they’ve ever had, this probably isn’t a boom year for their business. If I was comparing Ark to a steel company, we would need to give the benefit of the doubt to the steel company. Steel is in a worse – bustier – place right now than U.S. restaurants. So, just checking this year’s earnings would penalize a steel company too much.
We don’t need to know an actual “normal” owner earnings estimate at this point. But it helps if we know if recent earnings are:
· Peak earnings?
· Boom earnings?
· Bust earnings?
· Typical earnings?
Most years for most companies are pretty typical. That does not – however – mean that most years of the companies you are attracted to as possible investments are typical. In fact, you are – if you like low P/E ratios – likely to start your search for a company by focusing on companies that are coming off a good year. In other words, you’re more likely to analyze a steel company sometime in the 2000s than you are today – because today their P/E ratio might look high. Obviously, you can fight this problem by always averaging out the last 10 years of earnings, etc. This is a little tricky. On average, it accomplishes nothing, because it punishes companies with a positive 10-year trend. Averaging – Shiller style – past earnings for companies does one good thing and one bad thing. The bad thing is ignoring the process of improvement. The good thing is not taking a single data point and making it the number you base everything on.
For countries and industries, a Shiller P/E approach makes a lot of sense. For companies, I’ve always feared it is self-neutralizing. It will show you what “normal” is. But it will also cause you to think that a company on a 10-year downtrend in margins, etc. is equal to a competitor with a 10-year uptrend in margins, etc. This is almost never the case. In fact, if you really do find direct competitors with completely divergent 10 year trends – you want to think real hard on that question.
So, we’ll keep it simple and say that you don’t need to start with a 10-year average. Instead, I want you to start by looking for the average – often median will work best – return on equity figure and return on sales (operating margin) figure for the last 10 years. If you have 15 years of data, you can use that. I only mention 10 because sites like GuruFocus often provide 10 years of data for you in one place – you’ll rarely find 15 years of data without putting the spreadsheet together yourself.
So now you have a “typical” year of margin or return on equity. For Ark – where very little tangible equity is needed to run the business – I would focus on a typical return on sales year.
Then we have questions like what was the company’s peak earnings? For growing companies, peak earnings are often the company’s most recent earnings. And the assumption is that each year will be a new peak. It could be. But it’s worth marking down that the company has never earned more than it did last year.
This is pretty much true for Ark’s 2012 numbers. If we ignore the size of the company’s operations, etc. – and we use adjusted EBITDA – last year was basically a peak year. It was pretty much an equal peak – a re-peak – of the company’s results from just before the Great Recession. So, basically, we would look at the company’s 2007 and 2012 results and say those are as good as the company has gotten. They may not be as good as it gets. But so far they are. That means we should be cautious in expecting better in the future.
It also means we can roughly compare the results of those years – 2007 and 2012 for Ark – to the results of a company currently setting a new earnings record right now. There is one caveat. Last year, 2012, was probably not a true boom year for Ark, restaurants, or Las Vegas. We certainly don’t want to assume better results in the future. But we probably don’t want to compare an industry, commodity, etc. that we know is at a peak to what Ark just delivered.
The best early measure for comparing two stocks by earnings is EV/EBITDA. This may not be the measure you’d choose to use at the end of your process. But it’s the one to start with because it’s least likely to lead you wildly astray especially when considering companies in different countries (one using GAAP and the other IFRS), companies with different amounts of free cash flow generation relative to reported earnings, etc.
If we take $13 million of “adjusted” EBITDA as Ark’s earning power and compare it to the company’s enterprise value we get an EV-to-EBITDA of something like 5.2. A normal EV/EBITDA for a restaurant company acquisition is usually about 7 (if we’re talking the buying of a public company – check SEC filings for evidence of this, the best place to look is peer comparisons included in the fairness opinions of past mergers).
A price of about 8 times EBITDA for a public company is fairly normal. I won’t argue it makes more or less sense than 7 or 9 times EBITDA. It depends on factors like how much of EBITDA is actually converted to free cash flow, how much equity is required to run the business, what growth prospects look like, and how confident are we that today’s EBITDA will persist in the future.
Ark is a mixed bag in these regards. Growth prospects are mediocre. Generally, they must open new restaurants – and for them, that means new concepts since they aren’t a chain – to grow sales. Growth beyond nominal GDP is very unlikely without good deals. Without any deals, growth beyond inflation isn’t going to happen. On the other side of the scales, equity requirements are very low. You don’t need much owner money to run this business. You can have high dividend payments if you have low growth. The stock’s 4.8% dividend yield is a good indication of that.
For me, the end result – which is very unscientific – is that I would value Ark’s EBITDA as being about typical. Growth prospects are not good. Long-term consistency of EBITDA is higher – because it’s a multi-concept restaurant company using location as a driver of sales – compared to companies that rely on their own specific product innovations, etc. to compete. Return on equity will tend to be higher at Ark than elsewhere. It’s certainly not an issue. Issues are basically whether there will be any growth whatsoever – however, if Ark pays large dividends, this matters less since you are still getting payment from dividends in lieu of growth from retained earnings – and the risk of lost leases leading to lower EBITDA.
Neither is a deal breaker here because Ark tends to pay out capital it doesn’t need. It’s important to grasp this concept and its relevance here. If Ark was retaining all its earnings – and had a 0% dividend yield rather than a 4.8% yield – to invest in some new restaurant concept, it would be a totally different stock. The importance of growth would be much greater. In fact, such a different capital allocation scheme would change everything about how I viewed Ark. One of the first things you need to do when analyzing a company is to imagine where cash will flow – not just out of the business, but within the business in the future. Given Ark’s capital allocation simplicity – we can look at it in fairly static terms. Many companies can only be viewed from a more dynamic perspective. This tends to make them harder to analyze.
This is a long way of saying that if I was looking at two companies – one I didn’t know and Ark – and they both had an EV/EBITDA of 5 to 6, I’d say they seem to be priced about the same.
This is not true of some companies. For example, if John Wiley (JW.A) was valued at 5 times EBITDA, I would say it’s clearly much, much cheaper than Ark. Why? Because Wiley will grow a bit in the future (might be 1% to 3%, might be 4% to 6% - but it’ll grow) and FCF is very high relative to EBITDA and return on equity is almost infinite. These last facts are especially true in Wiley’s best and largest business segments – Journal publishing as opposed to books for consumers – which has clearly been their focus in recent years.
I use John Wiley as an extreme example. You’ll almost never find a company more unusual in terms of ROE and free cash flow and moat. The exception being direct competitors doing much the same thing (see Reed Elsevier). Wiley at 8 times EBITDA may be a lot better than most companies at 6 times EBITDA. In fact, I tend to think it is. I’d always buy John Wiley at 8 times EBITDA rather than a typical company at 6 times EBITDA.
So, that is your first step when deciding whether to explore a new stock opportunity in depth. How does it compare to the best thing I already own?
Here are some questions to ask:
· Is the EV/EBITDA of this stock higher or lower than the EV/EBITDA of my favorite stock I already own?
· Should it be higher or lower?
o (Hint: Wiley’s should be higher than Ark’s. Most companies should not. So this is a snap judgment of the inherent business quality.)
· Is the price-to-assets of this stock higher or lower than the price-to-assets of my favorite stock I already own?
o With the exception of acquisition value, this is irrelevant at a company like Ark – all the value is in the leases. You can value the leases – some are assignable and at below market rents – but not in an article this short. However, sometimes you’ll want to look at:
§ Price-to-tangible book
§ Price to appraised value (check property records, past deals, etc.)
· Are there other direct comparisons I can make?
o What is the dividend yield of the two companies?
o Which company would be worth more to an acquirer in the same industry?
You want to look at logically important questions that work well together. Think in the opposite terms of a dilemma. A dilemma is a problem you don’t want to solve (your choices are limited and disagreeable). Imagine a Gordian knot cutter. We want a pair of questions that when used together can cut through a complicated tangle and give us a simple, but definitively logical answer.
This is common sense. But you mighty accidentally overlook how powerful a question pair you can come up with. I’ll give you a good example of how you can pair two questions to get a quick answer.
When I first bought George Risk, it was much cheaper. It traded around its net cash value. And it was below its net current assets. So, when I owned George Risk and had to consider buying another company I asked two questions:
· Do I like this company as much as George Risk (is it of equal quality, competitive position, etc.)?
· Does it trade for less than net cash?
Unless the answer to one of those questions was yes, you could make a convincing case I’d be better off adding to George Risk. After all, why would you put money into a stock trading above net cash that you liked less than a stock trading below net cash?
The only valid argument would be diversification.
See how you can take a complicated tangle – two different companies, with all sorts of things going for and against them – and simplify it into sharp terms. Is the company trading above net cash better than the company trading below net cash? If not, why go any further in your analysis?
The reason most people do go further in such an analysis is because they fail to frame the problem at the outset. Find a sharp, logical contrast. Only after it looks like your new stock “lead” can stand up to such stark framing should you move on to digging into all the complexities.
The simplest question to start with are usually ones of: price, quality, and comfort.
Is the new stock cheaper than my favorite stock I already own? Would I feel as comfortable owning it? And is it a better quality company?
You need at least two out of three “pros” on that list to move further. If it’s cheaper and safer, it might be worth buying. If it’s cheaper and higher quality it might be worth buying. If it’s just cheaper – it’s probably an indeterminate investigation you are about to embark on. In such situations, your comparison is likely to remain “open to interpretation” right to the very end.
A lot of investors overlook this possibility. They assume an analysis of two options always results in choosing A or B. Very often, it doesn’t. It results in seeing situations where A may be preferable and other situations where B may be preferable and no way to prove which situation is the actual future you will face. That’s why I use the term indeterminate. You can “read” the future two ways. Both are rational. Both are potentially valid. You can justify either but prove neither.
New investors tend to end up doing exhaustive analysis that concludes in nothing better than such indeterminacy. You want to find ways to frame a problem early on so you know you are not heading down a long chain of reasoning that will result – at best – in not knowing which choice is actually best, only knowing under which conditions A would be better than B and vice versa.
This is a huge problem. It’s the most likely reason a new investor will do diligent work and still be unable to answer an investment question when he reaches the end point of his analysis. But it’s probably too big a problem for me to tackle in one article. I certainly won’t be tackling it tomorrow.
Tomorrow, I’ll go much simpler and talk about the other way of comparing a stock to its alternative – not the alternative you already own, but the best idea you’re thinking about investigating next.
In other words, you’ve got two new “leads" you like as much or better than a stock you already own – which do you pursue first?
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