Someone emailed me this question:
“You say that you get 90% of the way (to picking a stock) in five minutes. What usually makes you walk away when you decide to abandon an idea?”
That’s a good question. I should mention that the person who emailed me this question is the same person who asked the earlier question about how long I research a stock before buying it. This is the natural follow-up to that question, and I have a confession to make. I actually wrote a fair amount – probably about 1,200 words – in the earlier article that covered this topic. That was in the draft I saw.
The final product you may have read didn’t have anything about what gets me to walk away from an idea. That’s because I deleted everything I wrote on that topic. I deleted it because I named names. I gave examples of stocks I’d eliminated from consideration because of something I read about the company, something the CEO said, etc. I don’t short stocks, and I don’t speak negatively about companies in public. I certainly don’t say bad things about specific members of management.
I decided to delete absolutely everything I had written on the topic. When I got this follow-up email, I re-thought that. I can give you examples. I’ll just anonymize the examples I give. Plenty of you will know which companies, which managers, etc., I’m talking about from context, but at least I won’t have officially singled out anyone in a negative way.
The stories I’m about to tell are about real, public companies. Many of them are well-known companies, but I’m going to leave the company names, stock tickers, etc., out of this particular article. That’s for the most part. In a couple cases, I feel fine using names. Let’s start with one of those examples.
Quan Hoang, who co-wrote the Singular Diligence stock newsletter with me, and I considered DreamWorks Animation (no longer public) as a possible issue for the newsletter and even a possible place to put our own money. We never wrote an issue about the stock. Why not? At some point in the process, we asked a very simple question of each other. If you heard Jeffrey Katzenberg was hit by a bus last night, would you feel comfortable owning DreamWorks Animation stock in the morning? For both of us, the answer was no. We liked DreamWorks Animation as long as Katzenberg ran it. There are only a handful – like fewer than five – people on this planet we’d feel comfortable running an animation studio we were invested in. If Katzenberg wasn’t running DreamWorks, someone else would be. And it wasn’t going to be any of the other people who run animation studios that we trust.
Peter Lynch once said you should buy a business an idiot could run. Well, that rules out animation studios. Animation studios regularly invest up to $150 million in the production costs alone of a major release. They – or their distributor – put close to that same amount into the project again in terms of marketing costs. The total release costs of these films are hundreds of millions of dollars. A successful animation studio may release one to two films a year. A couple of flops in a row could sink an animation studio. The care and intelligence required to run an animation studio is a lot greater than the care and intelligence required to run a major Hollywood studio that releases a dozen or more live action films a year. No head of a major Hollywood studio is going to get you great results, but neither will a studio head bring down the company.
Releasing live action films is just too diversified a business. Making animated movies is different. Quan and I weren’t comfortable with just any random studio head running DreamWorks. Our entire investment thesis depended on Katzenberg being at DreamWorks. There’s no margin of safety in that. We never picked the stock. As it turned out, another studio (Universal, which is part of Comcast) ended up buying DreamWorks Animation, and Katzenberg staying on in an active role was not part of the deal. An acquirer was willing to pay a lot more than we could have spent on DreamWorks stock – and didn’t care whether Katzenberg stayed. You could say we made a mistake by eliminating DreamWorks from consideration. Eliminating a stock as a potential buy does not mean you think it’s a bad idea – you just don’t think it’s the right idea for you right now. You aren’t saying it’s a bad stock. You’re just putting it in the “too hard” pile.
Okay. DreamWorks is a really nice story. We were interested in the company if and only if the founder stayed on indefinitely. What about some more scandalous stories?
The opposite situation from DreamWorks is obviously one where you won’t buy the stock – you won’t even consider it – until the board removes the current CEO. Quan and I considered a stock like this. The company was often in the headlines because of litigation from states' attorneys general and things like that. That was a normal part of the company’s business. We weren’t worried about that. There was also – this company was involved in processing financial transactions – the risk of new technology disrupting the industry. Again, we were fine with those risks, but Quan and I had never been fond of the company’s current CEO. We felt he wasn’t very candid.
I want to make a distinction between being a cheerleader, an optimist, etc., and not being candid. Quan and I obviously like Katzenberg as a studio head – and Katzenberg was eternally optimistic. This situation was different. The CEO had basically made a promise to Wall Street analysts; he had set a target revenue level for a certain business segment (not a big one) that would be hit by such and such a date. As that date approached, it became clear that the company wouldn’t hit that target. He didn’t withdraw the target. In fact, we felt he was signaling – by sticking to an impossible target – that people lower in the organization needed to do everything they could to hit a target that we didn’t think it was reasonable to expect them to hit. We felt he was encouraging bad behavior by doing that. If you are going to tell people way down the organization that they really need to hit a target, that target better be realistically hittable. This one wasn’t. Quan and I decided we wouldn’t invest in this company – despite its strong competitive position – until the CEO was removed.
A CEO can be ethical and still be someone I don’t really want to invest alongside. I was talking to someone recently who was really interested in a company that had been spun off from a food company. The brands in the business were fine, but the CEO who had been involved in making capital allocation decisions – in this case, capital allocation decisions I really, really didn’t like – at the parent company was now the CEO of the spun-off company. I really had no interest in investing in a spinoff that was being run by a CEO of whose previous capital allocation decisions I didn’t approve. I have no problem with a CEO making mistakes. I do have a problem with a CEO having a worldview that is bad for shareholders. In this case, the CEO couldn’t be counted on to sacrifice size, growth, etc., in order to improve shareholder returns. I wasn’t interested in buying shares in the spinoff until that CEO was out.
Then there are legal issues. Here, I’m going to talk to you about anti-competitive practices. Or, rather, the potential that a company might be engaging in anti-competitive practices that would be a problem if they were forced to stop taking those actions.
Quan and I looked seriously at a company that had the dominant market share in its specific niche. It had long dominated this market. However, there was a lawsuit alleging the company had prevented competitors from entering the business by forcing its distributors to rely exclusively on this company’s products instead of also distributing products from competitors. There had clearly been communications inside the company that supported this claim. Some executives at the company had ordered the destruction or suppression of this evidence.
In this kind of case the court could pass judgment for three times the actual damages. We looked at what the monetary damage could be. We did our best to estimate the possibility of a huge one-time hit to the company. That’s not why we dropped it. We could do the math needed to figure out if the company could pay a huge fine given the time to do so. Why we dropped this company is the risk that it wouldn’t be able to keep its exclusive distribution agreements. We really did feel that every distributor would definitely prefer to carry this company’s products exclusively rather than carry literally everything else in the industry. However, what the distributors would want more than anything is to carry both this company’s products and competing products. That would change the industry structure. We didn’t know what the industry would look like in the future under those conditions so we dropped this idea.
Another example is similar, but much less clear cut. Quan and I looked at an industry where we liked the competitive structure a lot. Over the last three decades or so, the industry had consolidated down to a handful of producers. The value to weight ratio of this particular product – it’s a commodity – is low. Also, it’s not economically feasible – at all – to maintain large inventories of this product. You aren’t going to ship the product far. You also aren’t going to build up speculative excesses of the product that need dumping from time to time.
There aren’t a lot of sites in the U.S. that produce this product, and the import and export of the product is so low as to be meaningless. It is in the interest of the handful of companies that now control most of the production of this product to behave very rationally. The government provides a lot of data about this product. Enough in many cases to know who should submit the winning bid for any point on the map you know a customer is located. There’s also a trade association for this industry. It’s not unreasonable to believe that even if there was no explicit collusion in this industry, all of the producers have enough information about the costs of each competing location to know whether that location is going to bid seriously on a certain piece of potential business.
In some cases, the bids are publicly known. That’s very important because it means that even in cases where producers aren’t communicating directly with each other, it would be quite easy to communicate everything all the other players needed to know simply by bidding honestly with regard to your long-term economic interest. If all production data was hidden from competitors and if competitors actively tried to bid in a misleading way, sure, the industry could be competitive, irrational and cyclical. If there were few secrets in this industry and if competitors were fine bidding in such a way that revealed their true economic interests, well, then, you could pretty much map out which companies should always win which bids where.
There’s a problem here. A collusive conspiracy and what I just described would look exactly the same to an outside observer like me. Obviously, no amount of talking to anyone inside the industry would disprove such a collusive conspiracy. I might eventually find evidence that there was collusion, but that doesn’t help me because I’m interested in buying the stock – I’m not interested in whether there is or isn’t a legal case against some producers.
You can see this was a hopeless situation for the analyst. The thing that you needed to prove – that there was no collusive conspiracy, there was just cooperation that was the result of individual firm behavior based on publicly available info – was the very thing you could never prove. We dropped this stock idea.
I can use names of actual companies for the next two examples: QLogic (QLGC, Financial) and Teradata (TDC, Financial). We eliminated these two stocks fairly quickly after learning about storage area networks. The problem here is just that we didn’t know what the broader picture about how big corporations would store data was going to look like in five years. We knew some companies were already trying out some things on a small scale alongside the traditional way of doing things that could – given enough time – erode the durability of what QLogic and Teradata do. It’s not that they aren’t good at doing what they do, and it’s not that anyone else was going to replace them. It was just that we would never be sure if the thing they were doing was actually going to be the way things had to be done five, 10 or 15 years down the road. I can’t invest in a business for which there may be no need in the medium term. We eliminated those stocks.
Now, I do want to caution that I have bought stock in companies that showed signs you might say were similar to some of the anonymous examples I just gave.
For example, let’s look at some “anti-competitive” type industries. We picked two companies – Tandy Leather (TLF, Financial) and John Wiley (JW.A, Financial) – where customers of the company complained to us that they have no defense against the market power of their supplier. Customers of both Tandy and Wiley were happy to volunteer that they had no resort to actions taken by these companies on price or on the possibility of cutting off their supply. In both academic journals and leather, it was really clear that people in the industry felt there was way too much power in the hands of way too few firms and that there was nothing they could do about it. We picked both stocks.
We have no problem with a noncompetitive industry, a cooperative industry or an industry with “limited” competition. Also, we considered ATN International (ATNI, Financial). We never picked it because the price didn’t get to the level we wanted to pay for the stock, but we had no problem with the fact competition is often limited in the markets where ATN competes, and the management team seems to actively avoid highly competitive areas and to seek out market niches where competition will be limited.
I like industries with limited competition, but these have to be industries where I think the subdued level of competition can stay subdued permanently. A good example of this is Warren Buffett (Trades, Portfolio)’s investment in the four biggest U.S. airlines. He thinks the industry’s structure has changed. He bought railroad stocks for the same reason. If he’s right, it’s not the sort of limited competition that can be undone by a single court case. It doesn’t matter what antitrust action is taken against the big airlines. The structure of the industry is such that better returns on capital over a full cycle will be the natural result of industry structure and not the result of specific actions taken by specific airlines that could be undone by a court case, a change in the CEO position, etc.
So, there you are. I normally eliminate a stock from consideration because: 1) I’m not sure the need for the company’s product is durable; 2) I don’t trust current management; 3) I don’t feel I can trust any manager other than the current one to run the company; and 4) I’m afraid the industry structure might collapse and end up becoming more competitive.
In his 1977 letter to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders, BuffettÂ gave his four criteria for a stock purchase: “(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.”
I didn’t mention price, but my other reasons for eliminating a stock are pretty much just the antithesis of what Buffett is looking for. Sometimes, I don’t understand a company’s long-term prospects (QLogic and Teradata), sometimes I don’t trust management (the food company spinoff and the financial transaction processor), and sometimes I don’t know if the industry structure will be favorable in the long-term (the company with exclusive distribution deals and the commodity producer I mentioned).
Do I ever eliminate a stock because of price? Sure, but that’s complicated. For example, someone suggested a stock to me last week that trades at 30 times earnings. It looks like it might be a bargain at that price. That’s extraordinarily rare. In that case, it’s because the company grows without needing additional tangible assets. The growth rate plus the free cash flow yield can be as good at 30 times earnings as a more typical company’s total return would be at 15 times earnings. I’m not sure there is any strict cutoff with regard to price. I want the stock to offer at least a 10% per year annual return if held pretty much forever. That’s really my only hard and fast price requirement.
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