Thursday, December 4, 2008

Concentration vs diversification

The argument between whether to concentrate investments or diversify is sometimes taken to extreme as if one or the other is the correct way and that it is always true.

Lets look at what Mr. Buffet has said. Warren has outlined two different strategies based on the type of investor. Warren has said that in cases where an investor can bring intensity to the game("know something investor"), concentration would be beneficial. In cases where the investor wants to participate in stock market returns but is either not interested or not trained ("know nothing investor"), it is best to buy an index fund that broadly gets market return. Do not automatically assume that smart money will outsmart dumb money. Warren adds that when dumb money acknowledges it's limitation (and invests in index fund), it will in many instances outsmart the "smart" investor. Beating the market is no easy task over long periods of time in any significant margin.

To me, both these make sense. So what do I do. For my retirement accounts(401K, IRA), I pick mutual funds. On my personal account, I pick stocks and this is usually focussed on 10 to 15 companies bought over a period of 2 to 3 years. These are well run businesses that produce cash and have decent growth prospects and are not highly priced. I do my own investing because I like to study, learn and understand investing in good businesses. I will not consider studying a business waste of time even if I decide to not invest in it. So as long as I enjoy investing, this dual strategy works well for me. This mixed strategy gives me the best compromise. If I mess up my personal accounts, the retirement accounts will at least be safe. If I do well, it will produce a meaningful return.

I think there is another piece of treasure I heard from Bill Miller interview that is meaningful for this downturn. This advice adds another dimension which is market pricing. When the market is selectively cheap (one company or a group of companies), it is meaningful to concentrate on those few investments. However, if the market is cheap across the board, then excessive concentration is not necessarily a smart strategy. When market recovers, most stocks will have decent upside. So in this case, some diversification is called for because this will produce returns similar to concentration but at the same time limiting certain stock specific risk.

During this downturn, I feel Bill Miller's strategy is applicable. I have purchased companies that are new to portfolio. In addition, I have also reshuffled some within my portfolio for tax reasons.

Bottom line play the game only if you are both interested to spend time as well as have the necessary aptitude. Even then, do not feel compelled that you need to do choose one or the other. Do what works best for you. Note Berkshire Hathaway itself is highly diversifed and it has moved in that direction from day one though not necessarily for this reason alone.

Tuesday, September 2, 2008

How to intelligently buy Financial firms

I have attended the past two Berkshire Hathaway annual meeting in Omaha. They are great lessons for anyone interested to learn about investing. The 2008 meeting had a question about investing in financial firms. Warren Buffet's reply was classic.

Warren said that he would invest in financial sector only if he has confidence about the management. He added that in a sector where the earnings are nothing more than guesstimates, management character is the most important attribute.

This is a profound statement that merits closer attention. Many full time analysts have gone through balance sheets of big banks but did not forsee such big write offs. In some cases, the sheer complexity of some of the loan products made it difficult to make meaningful judgement of asset quality. This is further compounded by off balance sheet nature of loans plus relying on financial models that assumed housing price will not decline did not help either. Irrespective of reasons, end result is huge write offs resulting in dilutive capital raisings or firms going bankrupt.

An example of complex product is CDO (Colaterized debt obligation). A CDO is made up of so many different combinations of Mortgage backed security that it is almost impossible to figure out credit quality intelligently. If it is difficult for a full time analyst, think how difficult it is for part time investor!

So what does an average investor do to invest intelligently in financial firms. Here are few things that an investor can do that were derived from Warren's advice.

1. Culture of an organization: This is difficult to evaluate for an outsider. But getting a handle on this is priceless. CEO sets the culture from top. One way to evaluate is by reading up as much about CEO as possible. The annual letters are a good start to verify if the CEO provides a thoughtful evaluation of future or just presents only rosy scenario.

2. CEO must be the chief risk officer: Warren stated that CEO must be the chief risk officer. An organization with CEO who is risk conscious will invariably respond by being risk conscious. Risk metrics in that case are no longer abstract tool output but management task.

3. Keep it simple. Complexity is enemy of a good investor and a good manager. Complex dervatives, CDO's, off balance sheet SIV's and so on are not easy to follow for a reason. They cannot be judged easily. Less complex assets ensures that management as well as the investor will have better handle. My thinking in this line is also to be careful before investing in huge financial entities that are difficult to manage even for a CEO much less for an investor to get an handle. Exceptions always exist like Berkshire Hathaway.

3. Leverage: Financial companies by definition have leverage. But it is best to stay away from those with huge leverage or at least understand what you are doing when you buy a company with huge leverage.

4. Management has skin the game: This does not make the company immune from disasters. But atleast you know that management has incentive to take only those risks that are prudent.

5. Cost conscious CEO/organization: I add this based on reading Warren Buffet's biography as well as his preference for organizations with low over head (including his own). Warren likes entrepreneurs who are very conscious of cost. There is a story of an entrepreneur coming late to a meeting with Warren in order to find unexpired parking meter. This cost conscious nature permeates other aspects of decision making and results in a prudent risk taking. I do not have solid evidence but this attribute seems to be more important than the obivios cost savings it produces. It highlights a culture.

5. Bottom line, Do not buy if you do not have very high confidence on the management. With out that, it is difficult to get a handle on risks. Except CEO, no one else can resist the urge to make huge profits in a division even if they will result in future losses. So CEO is your best margin of safety.

On a personal note, I stayed away from AIG because I did not know enough about management. I read that Chris Davis (Selected fund manager) called for new management to be hired from outside the board. I could sense a lack of satisfaction with management selection. So I stayed away. Short of this, there is no other reason to stay away from bargain priced AIG at that time. It is possibly luck and limited of funds too! But a visit to Berkshire always pays for itself!

Welcome your thoughts....

Tuesday, June 10, 2008

RV - Winnebago and Tho industries

It is no secret that high gas prices, high food prices and slow economy results in reduced discretionary spending. Recreational vehicles are purchases that can definitely be delayed or even avoided during a slow economy. So why am I interested? One word, prices. Lets look at other aspects of this business.

Business or competitive advantages:

WGO produces motorized homes.

1. WGO owns leading market share in Class A and Class C combined (18.8%). Second higherst market share in Class A (21.6%) and next only to Fleetwood which is 23%. Highest markets share in Class C (24.5%).

2. Has good brand equity and name recognition in the industry. WGO has received Quality Circle awards for past 11 years. Quality is achieved by state of art technology and manpower.

3. The leading market share, brand name, high product price and quality points closer to franchise type business rather than commodity type business. Since many of WGO customers are well to do and since the product prices range higher than $60,000 price is not the only consideration during purchase. It is a luxury item and does not lend to competition on price alone.

4. RV Business will have a need as long as people take vacations. While fuel prices and slow economy can be a damper in the short run, people will continue to take vacation 5 or 10 years from now. If fuel prices increase, it will increase transportation cost for all means of transport and RV will likely be comparable to others. Plus the high end customers that WGO targets are less affected by gas prices than the average Joe.

5. Company is not unionized and hence can shutdown plants to remain profitable during soft markets.

Growth drivers:

1. The demographics is in WGO's favor. The 50 year and older market is increasing and every year and this segment is the one most likely to choose RV. The current baby boomer population is between ages 44 to 62 years.

2. Fragmented market: The current market is weak and WGO is profitable even in soft 2007 market. 2008 will also likely be soft. Many other competitors are weak. This can lead to their going out of business or being acquired resulting in lesser competition when economy turns around.

3. Company has leading market share in Class C which is smaller and more likely attractive under higher gas prices.

Tuesday, May 27, 2008

Whats attractive about Carmax

I recently received Carmax annual report and in any investment, few important factors determine it's success. I have tried to distill few important items that may attract you towards further research.

Moat or whats special :

1. Carmax primarily sells automobiles that are 1 to 6 years old. It's main competitor is new car dealer franchise. Independent dealers usually sell cars with average of 100,000 miles or more and are not direct Carmax competitor. In fact Car max auctions off older cars to these independent car dealers.

2. A new car dealer on average sells around 110 new and old cars per month. A Car max location sells around 425 used cars per month. The higher per location sales results in leverage of fixed costs. This results in scale. In addition, customers can choose a car from a different location and transfer it to their site using their website. Overall both these attributes provides much better scale than new car dealers.

3. Carmax's another advantage is no haggle pricing for customer thereby providing a plesant customer experience while buying a car. (Think last time you were in new car dealer.)

4. Car max sales associate's incentives are structured based on volume. They receive the same commision irrespective of whether they sell an expensive car or a economy model. So they do not gain by pushing one car over other or more expensive ones that the customer does not want. In addition, sales associates do not make any money from financing and hence help customer with the plan that suits them best. Overall a pleasant consumer experience.

5. Carmax prides in selling only high quality cars in it's retail outlet. Anyone shopping for used car knows the importance of buying quality cars (think peace of mind!).

6. Carmax has a wide selection of cars of all makes and model. This will easily beat the selection at a new car dealer.

7. One of the competitor that Carmax cannot beat on price is private party transactions. In this case, the customer has to do due diligence (check the vehicle with mechanic), negotiate price and wait for the right vehicle to appear in market. This requires lots of time and patience for both buyer and seller. Other than price, Carmax can compete favorably on other factors (like wide selection, no haggle pricing, high quality vehicles and one stop financing) with private transactions. Having said that, private party transactions will still be a viable competition that will co-exist and the market place is big enough to provide enough opportunities for Carmax.


8. Carmax has won many awards for ethical behavior towards customers, employees and shareholders. This throws light on culture of the place and is less prone to poor management.

9. Management has said that growth will be slowed if performance at stores are reduced. They have done this in the past and is a positive indication of management quality. That is, growth only when it makes sense. (Think what fast growth did to Krispy Kreme.)

Growth Drivers:

10. Carmax currently has 89 superstores. They cover roughly 43% of population now. So at the minimum, they can become slightly more than 2 times their current size. My guess is it can be more than that.

11. Carmax plans to expand 15% per year. So it will be at least 5 years before their growth slows down.

12. New stores mature in 5 years. So same store sales should be robust as stores mature. Management expects 4 to 8% same store sales though it wont be even in all years.

13. In mature markets, Carmax owns 8% market share. It is possible to grow this too!

So growth drivers are new store opening, maturing of recently opened stores and increase market share.


14. Return on invested capital is around 10 to 12%. I think this figure understates real return because newer stores mature over 5 years. So after maturity, this figure will be higher.

15. ROE is decent and between 14 to 18% depending on year.

16. Their debt is not much of a concern. Their long term debt to equity is less than 25%. Long term Debt (including other long term debt) to earnings is less than 2 times earnings . Much of the growth is equity financed. They retain all the earnings.


17. Assuming, Carmax rolls out as planned and doubles it's store count in 5 years (likely scenario), then it's earnings will double. Likely it will be more than double due to same store sales growth of newer stores.

Currently for 2009, Carmax is forcasting $.78 eps to $.92 eps. Note that 2009 Fiscal is a slow economy year and hence normal year eps should be higher than this. Lets assume eps in normal year will be $.90. So it is not unreasonable to think that in 5 years it will double it's eps (conservative estimate) due to store count doubling plus same store sales growth of 4% will result in eps of $2.

Lets assume P/E after 5 years will be 18 (which as per DCF would mean free cash flow increases by 3% per year from that point and 10% discount rate). This is reasonable assumption considering newer stores will still be maturing over 5 year period. So valuation after 5 years will be $36. So if Carmax is purchased at around $18, it will result in nice 14% per year return. Note that we have made conservative estimates.


18. Davis advisors own 15%, Berkshire owns 10% and Dodge and cox holds 7%. Never buy because others buy but when all value investors aggregate, it is atleast worth looking further!

Let me know your feedback and if you will be interested in more such writing.

Wednesday, January 16, 2008

Check list for new investment

The purpose of this checklist is to evaluate different aspects of an investment in a methodical fashion. Each investment is different and it is unlikely any single investment will meet all the criteria listed in the checklist. However, it does help an investor to methodically think through different aspects of an investment. This is well suited for long term buy and hold investor.

Think like a business man:

Identifying good businesses is the most important decision for a long term buy and hold investor. A good business can make money inspite of mistakes by management and investor. Here are few items to think about related to business.

1. Is the business a commodity type business or a franchise or something in between? Either business can make money but understanding the difference is critical.

2. What are the competitive advantages for the business and are they sustainable over extended periods of time (say over next 5 years)? Warren Buffet has laid out a question that will help us answer this question. If you ask yourself, what will prevent a well financed competitor from taking business away, usually answer should start to come out.

3. Will the product or service sold by the company still be in demand after 5 or 10 years? The obsolence risk is key as it can mean the investment could be wiped out. This is not limited to technology companies. Think impact of Amazon on barnes and Noble.

4. Who are company's primary competitor's and what are their strengths? Is a competitor getting stronger? What are the chances of competitor breaking the competitive advantage of the company in question? Think what HP did to Dell. I will admit this is easy in hindsight but is worth thinking about.

Growth drivers

Stong moat based business is essential but that does not guarantee share holder returns every year going forward. Buy and hold investors need earnings to increase year after year to benefit from an investment. So having ample growth opportunities for the business is critical. Plus it prevents management from allocating capital to value destroying projects. Here are some growth drivers to think about...

1. International opportunities: Need I say more here...

2. Favorable demographics for the product...

3. Market is fragmented and possibility of market share increase from small players by either acquisition or competition.

4. Pricing power: This is easy way to increase earnings if the product has strong franchise characterstics. Think See's candy...Not much growth but big rise in profits...

5. Depressed market demand for the product due to current economic conditions that is likely to change in the near future. This needs to be differentiated from secular demand reduction.

6. Cost reductions is also a driver but must be combined with one of the above factors to be meaningful.

I particularly welcome thoughts about other growth drivers....

Lets check the numbers!

While evaluating numbers, it is critical that one thinks about business attributes that drive the numbers. ROA greater than 10% must immediately ask what causes the businesss to earn such superior returns. Also, it is important to remember, that numbers represent past performance and an investor must evaluate whether business fundamentals are intact to create similar numbers in future.

1. ROE > 15% and ROA > 10% [for non financial companies] over past 5 years provide a quick look at how well the business is doing and also how well the management is allocating new capital. Is ROA and ROE decreasing from past? If so, is it due to management's poor capital allocation or business fundamental changes? It is important to distinguish between cyclical factors (economic slowdown) vs secular changes. It is an interesting excercise to screen for these two factors and you will not find many businesses that meet this threshold over past 5 years.

2. Getting a decent ROIC( return on invested capital) provides a good proxy for determining whether the company adds value or destroys. If possible, identify return on incremental capital. ROincrementalC will decide future earnings growth. This number is difficult to figure out but changes in ROIC is a good proxy for ROIncC.

3. Long term debt: Looks for companies with no or mimimal debt. Usually companies in good business can grow without too much outside debt. So better to avoid companies with too much debt. As a thumb rue, say debt of more than 3 times yearly earnings is an orange flag and more than 5 times earnings is a red flag. Exceptions exist but for part time investors, it is not worth getting into gray area.

4. For non retail consumer companies, look at operating margin. This provides an indication towards the strength of the franchise. If a company can sell it's product at a premium, it also implies, that company has some strong competitive advantages and possibly pricing power. In contrast, retail companies have thin margins and make money by high turnover.

5. Increasing revenue and earnings over past 10 years. This will not occur every year but the trend showing upwards indicate increased demand for company products and services and general growth culture.

6. Prefer small cap companies. This is not hard and fast rule.


The idea here is to identify managements that think like owners. That is easier said than done. But some pointers are listed below...

1. Management experience: Peter Lynch said buy a business even an idiot can run because eventually one will. This speaks to buying simple and strong businesses. While management can make enormous difference in the outcome for a shareholder, one area needs particular emphasis. A commodity type business needs very able management and may not survive missteps. So do not buy commodity type business without a feel for the management ability.

2. Insider ownership: If it is so good an opportunity as the annual report suggests, why will the insiders not want a piece of it. It is even better if their stake is obtained by purchases in the market as opposed to options.

3. Share holder communication: Management should at least take time once a year to clearly explain the business prospects to shareholders. If you do not follow how the company makes money after reading the annual report, make no mistake. It is not your fault. Annual report is a report and not a marketting document.

4. Capital allocation: Capital allocation is the most important job of top management. It can take few years some times to see the results. Use both numerical (decline in ROE or ROA could be a sign) and business analysis (too many mergers or acquisitions without past success) to make a judgement.

5. Does management graph ROIC (Return on invested capital), ROE and/or ROA in addition to eps growth? I find that if annual report has a graph for ROIC for past 5 years or so, it is usually a good sign that management is not just focussed on growth but on profitable growth.

6. Kudos from other good value managers. It is worthwhile looking at all past news stories and articles to both understand business aspects as well as about management. If a fund manager talks highly of a manager, usually keep your ears tuned. If Warren Buffet appreciates a CEO (like he did about Ken Chanault, Jeff Emelt, Fastenal and COSTCO CEO's), you get an endorsement that is worth keeping in mind.

For small investor, assessing management's quality is not easy but not impossible.

7. Management talks about spinoff rather than merger: Managements usually like to build empire rather than dismantle it. But if management voluntarily talks of spin off, it is a good sign to look at.

8. Management compensation: Rather than size of it, look for alignment of incentives. Compensation must look at ROIC as well as eps growth.

A high ROIC but no eps growth means that management is not adding much value and is just operating the business to milk cash. This may be ok for saturated businesses and not for a business with good growth prospects.

A diminishing ROIC with eps growth means that incremental growth is not profitable. So some combination of these two must decide compensation incentives.

Also, equity capital is not free but is usually treated as such. Even a bank acount will earn more interest if additional capital is added. An ideal compensation does not treat share holder capital as free money. I find very few examples but here is one from Thor industries proxy. Thor industries compensates it's subsidiary as follows. It is no surprise that CEO owns 30% of the company stock.

" The management of each operating subsidiary is provided with incentive based cash compensation through the Company’s Management Incentive Plan (“MIP”), which provides for an annual bonus pool equal to a percentage of their operating subsidiary’s pre-tax profits in excess of a threshold established by the Company’s Chief Executive Officer. Pre-tax profits of an operating subsidiary are determined by reference to the income statement of the operating subsidiary after deducting an interest factor based on the amount of capital, if any, utilized by the operating subsidiary during the fiscal year. We believe that we have been successful in attracting, motivating and retaining management of our operating subsidiaries in large part due to our policy of providing cash compensation based upon the profitability of our operating subsidiaries."

While this does not take ROIC into account, it does take into account that equity capital used in the year to generate growth.

How much to pay:

More on this to follow....

Keep your comments coming....

Thursday, January 10, 2008

Creating value by growth.

For buy and hold investor in public companies, it is important to make sure company has additional avenues for growth in it's line of business. It is often easy to overlook this important aspect while reviewing Warren Buffett's investment criteria. Lets first take a minute to review Warren Buffet's investment criteria.

To put it simply, buy businesses with sustainable competitive advantage(s), run by honest and competant managers and selling at a fair price. Warren adds that to evaluate these qualities, the company needs to be within one's circle of competance.

I would add that in addition to these qualities, it is also important for buy and hold investor in public companies to also look for potential growth opportunities that the company has in it's line of business.

It is instructive to look at a question that was asked in May 2008 Berkshire share holder meeting. The question was whether Warren would prefer a company like See's candy (with moat and high profit margins) but not many opportunities for growth or a candy company with 14% profit margin but lots of growth. Warren replied that he does not mind either. He has no preference between the two. This implies that growth is not necessarily that important in an investment. This is true but Berkshire business model is different from other companies and it is worth looking at that closer.

If a company like See's candy generates lots of cash without growth opportunity, the best course of action is to distribute that cash to shareholders. In the case of Berkshire, Warren would deploy the profits from See's candy in other businesses that have opportunities for growth. But most companies operate in single line of business and are forced to either distribute the capital to shareholders or to allocate capital within the current line of business. Since management is paid for growth, returning capital to share holder is not on top of their mind. So Management usually deploys the earnings in a lot of value destroying projects rather than returning the capital to share holders. Over long term this reduces return on invested capital and eventually share holder return.

To avoid this dilemma, pick a company with opportunities for further growth and management will at least have some place to meaningfully allocate capital rather than dream up meaningless projects. For buy and hold investor in a public company (unlike Berkshire), it is better to identify companies that have good growth potential in addition to competitive advantage.

A company having sustainable competitive advantage can protect it's turf but if it operates in a saturated field without opportunities for further growth, it will likely not create long term value for the stock owner. Don't mistake me here. There is a possibility of making one time excess return if the company is under valued. But after that, it does not create long term value. Based on DCF, if discount rate of 10% is assumed and if company distributes all it's earnings and does not grow it's earnings, it is valued at 10 times earnings. So if you buy at 5 times earnings, you may make a great one time return but after that it does not create excess return.

But to truly create value over long term, a company must not only have sustainable competitive advantages but also have room to grow. Or in other words, it needs to be able to use it's advantages to deploy retained earnings at a very high rate of return. Sustainable competitive advantages are very important. But for buy and hold investors in public companies, future opportunities to grow using those advantages are equally important. Thus one must also evaluate how much growth opportunities exist for the company's products before investing. Otherwise the company's moat may not result in long term share holder value.

I recently read Jack Welch's book 'Straight from Gut' (Ex-chairman of GE). One of the mantra's of Jack was to only own businesses in GE that were number one or two. The reasons are obvious. If they are No.1 or No.2, those businesses obviously have some inherent competitive advantage. But there was an unintended consequence. That is, the business leaders started to define categories so narrowly that their products were No1. or No.2. Essentially this narrow definition limited future growth because of fewer opportunities to further expand. Or in other words, it is not only important to have competitive advantage but also to have opportunities to use those advantages to expand further. That creates true long term value.

One of the reasons for Warren buying Coke in late 80's apart from it's low valuation was because of it's huge international opportunities. To be sure, this is not a new concept and has been documented in Phil Fischer's book 'Common stocks and uncommon profits'. But when reviewing Warren's criteria, this aspect could be easily missed by part time investors like me.

In the next article, we will try to dwelve deeper into what growth drivers one could look at. If I get an opportunity to ask Warren, I would ask a list of growth drivers that he usually looks for. Until then, lets come up with a few that can help us. See you next time with a list of growth drivers.