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Less is Best, on Graco, Inc.

July 20, 2008 | About:
Dan Weiss

Charles Mizrahi

19 followers

Mae West, legendary movie star and sex symbol of the 1930s and 1940s, said that “too much of a good thing can be wonderful.” I’m sure that most people would agree. In fact, Warren Buffett used her quote when writing about taking meaningful positions in businesses that he has a long-term conviction for.1

With so much information available about a company and its stock price, how much information do you really need in order to make a decision? Is too much information a wonderful thing when it comes to selecting stocks to buy? To be good investors, most people have the image of a bespectacled analyst sitting at his desk piled with financial statements and working way into the night. After many hours of crunching numbers in spreadsheets that are filled with complex formulas, our hardworking analyst has a eureka moment after plowing through scores of financial variables and finds that the company’s stock is trading at half the value of the underlying business. If that is your image too, after you read this month’s letter I’m sure you will change your views on how much data you really need in order to analyze a business.

Science or Storytelling

Although I wasn’t born in Missouri, the Show Me State, in this life, I must have been born there in a previous life. I need to see credible studies done in a scientific setting before I accept something as fact. It never ceases to amaze me how many people so readily would believe a story over scientific fact. I see that a lot in people who ingest huge amounts of nutritional supplements. Although most scientific studies have shown that supplements have no effect and sometimes can be harmful, these people still cling to their belief. In other words, they are willing to accept storytelling over science.

If you ask the average stock analysts how much information they need to evaluate a stock, I’m sure you will hear numbers that reach into the mid teens and higher. The Value Line Investment Survey has been published for over 70 years, and tracks 1,700 stocks. A Value Line stock page provides a wealth of information on a given company. The page has over 50 pieces of information. In the statistical array table alone there are 23 different pieces of historical financial data going back at least 10 years. Looking at the Value Line page for the first time can be very intimidating when trying to value a business. But have no fear, you don’t have to focus on all 50 pieces of information. In fact, studies have shown that more is truly less in this case.

Using experts in a variety of fields as test subjects, experimental psychologists have examined the relationship between the amount of information available to the experts, the accuracy of judgments they make based on this information, and the experts’ confidence in the accuracy of these judgments.2 They did the experiments by controlling the information they made available to the experts and they checked the accuracy of their judgments based on that information.

And They’re Off…

One such experiment was done on horse handicappers. Similar to stock investing, there is a myriad of past performance data on horses. For this experiment, they chose eight experienced horse handicappers and showed them a list of 88 variables found in publications like the Daily Racing Form. Data such as races won, speed ratings, weights carried, etc. are published on each horse. Out of the 88 variables, each handicapper was limited to using only five variables that they felt had the greatest importance to handicap a race. They were then asked to limit their selection to the most important 10, 20 and 40 variables.

After they selected their most important variables, they were then given true data (no way for them to identify the horse and the actual race) for 40 past races and asked to rank the top five horses in each race in order of expected win. Each handicapper predicted each race four times–using 5, 10, 20 and 40 variables. In order to measure the confidence of their selections, each handicapper was asked to assign a value to their prediction from 0 (not confident) to 100 (a sure thing).

The result of the handicappers’ predictions compared to the actual results was counterintuitive. The accuracy of the predictions remained the same regardless of how many variables they used. In other words their accuracy using 5 or 40 variables was more or less the same. However, as the number of variables used increased, so did the confidence level of their judgments. They had more confidence in their selections when they used 40 variables than when they used fewer variables, yet their accuracy remained the same. The more data they used to predict the outcome of a race, the more confident they felt about their selection.

The results were not isolated to horse handicappers. Similar tests were done on clinical psychologists asked to make judgments on subjects, medical doctors asked to diagnose patients, and stock market analysts asked to make long-term predictions on stocks. The conclusions were all the same; the accuracy of their predictions was similar regardless of variables, yet the more variables used the more confident they were about their predictions. The conclusion from these studies was an eye opener.

Experts overestimate the importance of factors that have only a minor impact on their judgment and underestimate the extent to which their decisions are based on a few major variables (editor-italics mine). [T]he analyst is typically unaware not only of which variables should have the greatest influence, but also which variables actually are having the greatest influence.3

Buffett’s Four Filters

While researching these studies and reading the conclusions, it didn’t come as too much of a surprise to me. Over 30 years ago, Warren Buffett wrote that he only uses four variables when selecting a stock or a business for acquisition:

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.4

What is notable is that over the past three decades, when asked the same question, Buffett has always been consistent about the four variables he uses. If a business or equity can pass through all four filters, Buffett takes a sizeable position.

The Moat

One of the variables that most investors have trouble identifying is finding a business with favorable long-term prospects. Buffett has spelled it out over the years and now refers to it as a business with an enduring competitive advantage, or moat. Patrick Dorsey, Morningstar’s director of research, recently came out with The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (Wiley 2008). In it, he answers the question of how one can accurately identify companies that are great today and likely to remain great for many years to come.

By being able to identify a company’s competitive advantage and purchasing its shares at reasonable prices, one can build a portfolio of solid businesses that will be worth more over the long term. On his website, www.findingmoats.com, Dorsey lists four variables to determine the competitive advantage of a company: net margin, return on assets, financial leverage, and return on equity. Companies that have competitive advantages will have solid returns on capital that will get better over time.

One of the stocks in the Prime Time portfolio, Graco, Inc., has all the characteristics of a company with a competitive advantage: increasing net margins and excellent returns on capital, while not being too leveraged.

Graco, Inc. (NYSE:GGG)

 

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

TTM

Net Margin

10.9%

13.4%

14.2%

13.8%

15.5%

16.2%

18.0%

17.2%

18.3%

18.2%

18.2%

Return on Assets

19.0%

25.3%

29.6%

25.4%

23.9%

23.0%

28.3%

30.8%

31.3%

29.2%

25.9%

Financial Leverage

25.1

3.8

2.2

1.6

1.5

2.3

1.6

1.6

1.6

2.2

2.7

Return on Equity

57%

164%

81%

46%

36%

42%

54%

48%

48%

53%

69%

Source: www.findingmoats.com

Conclusion

You don’t need a lot of information to make a decision on investing in a good company. Too much information doesn’t improve accuracy and instead can make you overconfident when you have no reason to be. There are times that additional information does contribute to more accuracy but the studies have shown that it will most probably decrease rather than increase your accuracy.

Follow Buffett on the amount of information you need to make a decision; in this case less is best. Getting a big overview of the company and not focusing on too many variables will make you a happier and wealthier investor.

  1. Berkshire Hathaway Letter to Shareholders, 1989
  2. Heuer Jr., Richards J., Psychology of Intelligence Analysis. Center for the Study of Intelligence, Central Intelligence Agency, 1999, p. 51.
  3. Ibid. p. 56.
  4. Berkshire Hathaway Letter to Shareholders, 1977.

About the author:

Charles Mizrahi
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.2/5 (13 votes)

Comments

budlab
Budlab - 6 years ago
Charles, I like the way you weaved Buffett and Munger's "Four Filters" into this story. Graco Inc. (Graco) is an interesting business that provides fluid handling solutions to organizations involved in manufacturing, processing, construction and maintenance throughout the world. Graco Inc. and its subsidiaries sell a line of products in the Americas (North and South America), Europe (including the Middle East and Africa), and Asia Pacific. During the fiscal year ended December 28, 2007 (fiscal 2007), sales in the Americas represented approximately 60% of the Company’s total sales, sales in Europe approximately 25% and sales in Asia Pacific approximately 15%. My fear is with an arbitrary automatic warning, ( above 0.5 ) on this current debt to equity level of .89

Graco Incorporated, GGG has a (5-year annual average) net income growth rate of 15.11 . What competitive advantages does it have? Brand, Technology, Cost of Production, Distribution Network? Are possible advantages sustainable? Does GGG have a solid mix of Product, Pricing Power, Placement, and Promotions? When buying companies or common stocks, look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements.

GGG has a current market price is 39.84 Using an assumed growth rate of 7 percent, the estimated Intrinsic Value is 47.83 per share from ValuePro.net, and this may or may not indicate a bargain of 8 dollars. Is it a possible Value Trap? If the growth assumptions used in estimating the Intrinsic Value are accurate and sustainable, this may or may not indicate a price-to-value ratio of .83 , and a possible margin of safety of 17 percent.

The current price/earnings ratio = 16.7

It's current return on capital = 35.91

Using a debt to equity ratio of .89, Graco Incorporated shows a current return on equity = 54.8

Some industries have higher ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. Generally, capital-intensive businesses have higher barriers to entry, which limit competition. But, high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. Growth benefits investors only when the business in point can invest at incremental returns that are enticing; only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor. The wonderful companies sustain a competitive advantage, produce free cash flow, and use debt wisely. The current debt to equity level of .89

Does Graco Incorporated make for an intelligent investment or speculation today? Time is said to be the friend of the wonderful company and the enemy of the mediocre one. Before making an investment decision, seek understanding about the company, its products, and its sustainable competitive advantages over competitors. Next, look for able and trustworthy managers who are focused more on value than just growth. Finally ask: Is there a bargain relative to its intrinsic value per share today? Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misapraised. In terms of Opportunity Cost, is GGG the best place to invest our money today? What about growth in Free Cash Flow or Debt levels? According to http://www.quicken.com/investments/strategies/?p=GGG&strategy=hagstrom GGG's long-term debt/shareholder's equity ratio has risen above the Diversified Machinery industry's average within the last five years. While this is not necessarily a bad thing, tell us a bit more about the GGG story, and what is going on with the company and its competitive and debt positions. This is an interesting company worthy of study and discussion.

Bud Labitan

Labitan Partners

budlabitan@aol.com

www.frips.com
tkervin
Tkervin - 6 years ago
Bud,

Looks like you are more comfortable with 40 variables.........:-)
budlab
Budlab - 6 years ago
I got a little wordy in that GGG evaluation above. In general, I can tell a lot about a business by simply looking at FCF (Free Cash Flow) and Debt levels. Then, apply Buffett and Munger's "Four Filters" process to an idea.

In the GGG eval above, I agree with Mizrahi in that there are significant positive things to say about the Graco picture. So, Graco is worthy of examination and discussion.


dmangan
Dmangan - 6 years ago
David Dreman has a lengthy discussion in his book about this, that more information isn't necessarily better. It's knowing how to weight the information available that counts.
svoleti7
Svoleti7 premium member - 6 years ago
I own Graco, although I closed half of it last week to buy BAC at around $20.

The industry: Graco participates in the market for fluid handling services. The company has been in this business for 8 decades and has innovated its way from spray guns into a variety of equipment. While the market for spray guns may not be impenetrable (3M recently acquired aero), it does provide significant cash flows for several reasons. Firstly, it is a razor blade business. Note that Graco earns 50% of its money from consumables. The second reason for these good cash flows comes from Graco's approach to the business and adherence to a single CORE COMPETENCE.

Durable competitive advantage (ie Graco's position in the market): Graco, is at its core, an specialized engineering company, rather than a traditional manufacturer. That is why it has such high ROE and is able to protect its moat over long periods of time. Graco utilizes its engineering skill to constantly innovate products around customer's needs. They stick to their knitting (fluid handling) and are able to deliver significant innovation with signifcant financial value to the end customer. How? Primarilty because Graco utilizes a unique "CTP" or "cost to produce" metric to measure performance and also to incentivize employees. It is the a major part of Graco's culture. So, Graco uses its engineering "know how" - which in my opinion, lies at the depth of Graco's durable competitive advantage - to create the best products at the lowest cost. Although they produce a number of mundane items, all are technologically superior to competitor products and are based on Graco's higly effective and proprietary engineering know how. Graco cannot maintain dominance in all markets because technological know how attracts competition. So, Graco finds other niche markets where is can apply its technology to create less expensive but higher performance products, in niche spaces, where it is unlikely to attract comptetition immediately. So long as Graco can apply its 'formula' to new markets, it can mainain its margins. profitablitiy, return on capital and MOAT. They buy companies uising a value based approach (CASH FLOW) and then re-engineer the products for increased profitability AND increased value to the consumer.

The only way for me to really puch home the point about the INTRINSIC VALUE of Graco's engineering platform and CTP is through the numbers. If the returns were average, more study would be required. Graco's earnings power is so much in excess of it Book value that in no way can an outside investor compete with Graco by simply buying assets. Graco's earnings power far exceeds its book value because it takes more than just money to compete with this business.

Management: Managemnt is clearly aligned with shareholders. Anybody can see that through a cursory study of capital policy, including debt levels and dividend.

Price: Graco is a great company and is worth at least today's price. The business will, over time, provide a margin of safety for any investor. I was not eager to sell, but I have very little taxable gain (the position was established at $45 or so) and B of A trading at what I percieve to be 3-4x 2012 earnings was just too good to pass up.
bobkgouc
Bobkgouc - 6 years ago
Graco is actually a higher quality company than an initial analysis of the numbers would indicate. For example, Graco recently took on some long-term debt and the debt/equity ratio jumped. However, part of the increase is a bit misleading because Graco has been buying back a fair number of common shares. This tends to overstate the debt/equity ratio. In fact, Graco has more than enough free cash to easily handle the interest on the debt, making it a much safer company than many that would have a lower debt/equity ratio. I would only become concerned if they were to continue to increase their leverage over a long period of time.
corp7mn
Corp7mn - 6 years ago
I too read David Dreman's book and comments on this. Interesting.

--------------------

http://www.freebeezndealz.com

budlab
Budlab - 6 years ago
Bobkgouc, Could you explain this a bit more and break it down with some estimated numbers: "Graco recently took on some long-term debt and the debt/equity ratio jumped. However, part of the increase is a bit misleading because Graco has been buying back a fair number of common shares."

I have two basic questions. How much leverage? Who is the fiercest competitor?

Thanks.

wiglebot
Wiglebot - 6 years ago
About this approach:

This theory of Less is better has two angles, both described in the Tipping Point and Blink by Malcolm Gladwell



First: And Expert often does not know why they know things. They spend their life studying something and sometimes become extremely good at what they do. When they are pinned down and tested in an attempt to discover why they are good: they often fail in the explanation of their talents or fail in the models set up to reverse engineer their talent.

Second: The non-Expert is better off with limited information and cannot rely on the expert to convey what is relevant. This is a tough situation and has been statistically proven from tennis players to stock traders. But Investors like WEB have proven accuracy / performance correlation, but these guys are rare. George Soros has been accused of trading from the intensity of his back pain and not applying his theories, but he was right in his actions.

This is a huge issue: "less is better" implies fewer rules. Those few rules need to have a process of making them quantifiable. And then accurate on the system applied (the market itself).
bobkgouc
Bobkgouc - 6 years ago
Responding to Budlab's question. In 2007, Graco took on about $107 million of long-term debt. Previously, they had no long-term debt. They used the borrowed money, along with their free cash flow, to buy-back about $230 million of common shares (let's not debate the merits of using borrowed money to buy-back shares and whether this was a good use of the funds). This reduction goes directly against retained earnings and reduces shareholder equity, thus both the numerator and denominator used in calculating the debt/equity ratio were affected. Anyone now looking at the debt/equity ratio might be concerned about it. However, my point was that it isn't as bad as it looks because Graco can easily pay the new interest expense with its free cash flow. Graco, to me, just isn't as risky as it might appear from the higher debt/equity ratio. I might change my mind if Graco keeps borrowing long-term to buy back shares, but until that occurs, the company looks undervalued to me, assuming the housing/economic downturn in the U.S. doesn't last too long.

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