Value investing insight

MCO - Moody's Intrinsic value

2010-09-21T12:00:00.000-07:00

I had written a piece about Moody's earlier this year and this is good time to revisit. It is well known that Moody's future business environment will not be the same as it's past. Some changes are

1. Increased regulation and legal exposure is inevitable. In essence the business will not enjoy as much regulatory and legal protection as before.

2. The profitable structured finance business is drying up and will not come back. After 2 years, management is expecting this part of business to have further declines.

3. We are in a period of long deleveraging cycle and low growth environment.

But, Moody's will still be a good highly (but less than pre-credit crisis) profitable business. It boils down to valuation.

But lets value the business. The earnings expectation for Moody's for 2010 is around$1.85. The current market price is between $25 to $26. It also has debt. This essentially means that the enterprise value is around $30 including debt. So, P/e based on enterprise value is around 16. This is not very high for a capital non-intensive company if future growth prospects are good. Warren Buffet is selling for the past few quarters and this can be justified only if he thinks future earnings prospects are not very good. There are enough uncertainities about future of credit rating agency but they have been very good cash producing machines. But deployment of this cash was not very great. Considering poor stock repurchase choices of the past, I expect minimal value creation based on allocation of capital.

Disclosure: I currently own Moody's and am thinking of selling.

Please leave your thoughts...

Car max update

2010-09-08T12:12:00.000-07:00

I had written about Car Max on May 2008 and an update is due. For those, who are new to Carmax, my earlier blog (from May 2008) is worth brushing up!

http://dollarbillsforless.blogspot.com/2008/05/whats-attractive-about-carmax.html

I will not repeat the strengths/weakness of Carmax in this blog. The focus of this blog is to evaluate it's current position.

Updates of interest from 2010 annual report:

Business:

1. A big plus is that there is no other retailer that follows CarMax's business model. One potential competitor Lithia motor had a similar strategy to sell 'One price auto' but abandoned the strategy after 2008 recession. This shows the difficulty in copying the model. I guess this business model operates against the human nature to not make more money on a car when possible and go for fixed pricing and flat commision per car.

2. The recession has caused some used and new car dealers to close. This is positive for Carmax as well.

3. High unemployment and fragile economy are definite minus.

Management:

1. In the annual report, same set of figures are highlighted whether business results are good or bad in any given year. Numbers of particular interest are ROIC and comparable store unit sales. I have not seen that consistency of focus and highlighting ROIC by many managements in annual letter.

2. Management evaluation of new ideas using ROIC is impressive. For example, Management is planning to open more car buying centers and will decide to expand based on ROIC of the project. The very fact of using ROIC to evaluate projects and mentioning it in annual report provides a good comfort feeling!

3. Equity based compensation is negative strike against management but is expensed due to accounting rules. So, it is neutral for now.

On the whole, Management seems to be focussed on right things.

Growth/Valuation:

1. Growth resumes: A key attraction of CarMax for investor is that it is a profitable retailer that has good amount of geographical growth left. CarMax had suspended it's growth efforts in the wake of credit crisis. Recently, CarMax has stated that it will open 8 to 15 stores over Fiscal 2012 and 2013 (i,e before Feb 2013). This is not huge growth but is in the correct direction. If market improves, this will accelarate further. This has important bearing on valuation.

2. So, why is growth important? CarMax does not provide dividend and keeps all the earnings it generates. So, the return that CarMax produces depends on how well it utilizes it's cash. Car Max return on invested capital is around 10 to 12% if you remove 2008. So, the capital compounds at least at that rate if it retains and opens new stores. Plus with some leverage, ROE is between 15 to 18%. So, if it uses cash wisely and opens profitable stores, earnings can compound around 15% which is a good return. If new store opening stagnates, it will not be able to compound earnings and hence the valuation multiple will correctly be lower.

3. Let's value the business.In Fiscal 2010, the eps was $1.26 with around 100 stores. It can possibly expand to 175 stores over say next 5 years if economy picks up. This will more than double the earnings as recently opened stores mature. Lets say eps of $2.65. Having a P/E of 15 at that time would cause price to be $39 to $40. This is under good to moderate economy. If economy does not pick up much and rolls around same levels, then the stores opened will be much less (lets say store count of 130 over 5 years). The eps will be $1.6 and p/e of 18 is appropriate as more potential exists and price is around $28. So, price after next 5 years can be between $28 to $40 depending on economy. At the current price of $23, it does not provide cushion for new buy but seems like a solid hold waiting for economy to recover.

Disclosure: I bought Carmax at $18 couple of years back.

Please leave your comments. Of late, I have not updated blog regularly but will try to do so in future.

American Express - 2010 - Stock analysis and valuation

2010-04-19T07:59:00.000-07:00

I reviewed the 2009 annual report that Amex sent. I had written in detail about changes in Amex business model last year and it's implications. You may want to refresh that first and here is the link.

http://dollarbillsforless.blogspot.com/2009/04/american-express-stock-analysis-and.html

Here are some thoughts from this year's annual report and it's valuation.

1. First, credit loss is decreasing and write off rates are improving. This is a combination of better underwriting of new cards, closing some cards and agressive action to react to the market (like credit line reduction where appropriate etc). Also, some of it is due the location in credit cycle and some general improvements even though risks like high unemployment remain.

2. In otherwords, the crisis seems to be past to say the least. That is, credit losses is unlikely to require raising equity capital. This is very important for shareholder. It makes no sense to buy back shares at peak prices during good times only to issue shares at bargain basement price when economy falls like some companies have done. On this score, AMEX escaped the worst even though had their share of mistakes in underwriting like issuing cards in areas with peak real estate boom. This point is very important and meaningful good news.

2. Amex hinted at making some subtle shifts and this is good for long term shareholder. Amex is planning to issue lesser number of new lending based cards and limit it to certain premium and co-branded cards where credit performance is better. So, AMEX should get back to better credit underwriting when the next down turn arrives. This impacts the premium market places on AMEX earnings (P/E multiple). In last year's comments, I had serious doubts if AMEX will become a more conscious underwriter and hence suggested a P/E of 14. After this shift, likely AMEX's multiple (P/E) will be better and correctly so. This is good news. We will get to specifics in valuation section.

3. The downside of lesser new card members is it's negative impact on earnings growth. AMEX plans to improve earnings by focussing on spending in it's existing cards. However, the new Normal environment means lesser spending by consumers. The impact on earnings growth may be compensated at least partly by multiple expansion and lower risk.

4. Another negative and less advertised fact is higher capital standards from this point on due to new regulation and AMEX becoming bank holding company etc. AMEX is thinking this will result in ROE of 20%'s as opposed to past ROE's of 33%+. This is a significant impact to long term share holder. Basically more capital is required to create the same earnings growth. This causes AMEX to move from superb economics to one that is very good.

5. AMEX is considering to look for growth in other fee based services in payment industry. AMEX seems to be serious about this and has reorganized accordingly. This action may be a direct result of shift in plans to limit issuing new lending based cards. So AMEX is looking for other avenues of growth rather than just relying on increasing spending on existing cards which is not easy in "new normal" environment. My views are conflicted in this. Additional earnings from non credit risk sources are good. But they also mean less growth in core areas where management has better experience. It may be positive since AMEX is not a bad allocator of capital.

6. To summarize: AMEX will become better underwriter due to issuing lesser number of lending based new cards, closing some poor performing cards and improved underwriting model to take real estate into account. These actions will reduce earnings growth but increase p/e.
AMEX will Focus back on driving up spending. Considering new normal and this is difficult.
Higher capital standards will be in force in future resulting in lower ROE. Hence lower earnings growth to be expected and possibly lower payout ratio (unlike 65% in the past for dividends and share buyback).
Internatinal expansion will be positive.
AMEX in general is a better steward of capital than some other companies. It provides good dividends and not focusses only on share buyback to give back capital. I give a B+ (and not A) because some of their buy back does not add much value especially at the peak but helps stock options become valuable.

7. Valuation: ROE of 25% and payout ratio of 50% seems appropriate. This results in earnings growth of 12%. I will settle for 70% of revenues (discount fees + other fees) without big credit risk and 30% of reveunue based on lending model. A p/E of 18 seems appropriate (.7*22 + .3*10).
Settling on normal earnings number is difficult. It should be possible to get to at least 2005 earnings of $2.38. lets say $2.4. This results in valuation of $44. So AMEX is fully valued current market price of $45.23 (4/19/2010).

8. I own shares in AMEX now. My average cost basis is $36. I should have bought more at around $10 in Mar 09. Warren Buffet advised as much in CNBC. I did not have enough cash in hand. So one lesson is to have cash in hand. Other question always is, do you double down or buy another stock that has fallen but is not directly impacted(like Infosys). I guess some of both is not a bad idea if this were to ever happen (I hope it does not!).

Please leave your comments. I will update next year again.

Book about Jammie Dimon

2010-02-14T17:59:00.001-08:00

I recently read a book titled 'The last man standing'. It's a good read to gain insight into Jammie Dimon's (CEO and chairman of JP Morgan chase) work. Few items of interest are listed below from the book.

1. Jammie Dimon likes fortress like balance sheet. Considering banks are leveraged businesses, it is surprising why more such bankers are not around.

2. Likes to be counter cyclical in terms of acquisition. No doubt Wa Mu acquisition is a good example. In contrast, Wachovia bought Golden West at the height of housing bubble. This essentially provides a margin of safety.

3. Jammie's crtierion to buy is as follows. Buy when it makes business sense, price is right and the acquiring company is operationally ready to integrate new business.

3. Cut costs and have lean operations. It somehow always seems that penny pinchers are better stewards of shareholder money. More on this in a later article.

4. Straight forward and no nonsense reporting to share holder. Buffett has appreciated Jammie on his share holder letters. Thats as good as it gets!

5. Jammie is the chief risk officer and has an intutive sense of identifying and acting on risk.

In short, banking is commodity business. In a commodity business, management makes all the difference. Further, the leverage in banking business adds inherant risk. So it is important to have a CEO who understands risk. If you find a small bank with an excellant CEO, it is worth considering for further research. Typically, it is difficult to identify a good manager in banking unless an entire cycle passes.

On the whole, this book helps understand why JP Morgan chase stands tall in this crisis. Simple answer is Jammie Dimon.

Moody's intrinsic value

2010-01-22T07:14:00.001-08:00

This piece attempts to value Moody's (MCO) share price.

My original purchase assumption was that Moody's will earn at least $2.00 eps once credit bubble pops and normal environment returns. This was when the company earned $2.58 in 2007. I did figure that regulatory environment will be tough and their moat may weaken. I figured that even if they turn out to be one of many players, they still have a good chance to get a decent size of the pie. I also thought that Moody's is exporting capital markets to world (think of Coke's world wide expansion!) and is in early stages of global capital expansion. Needless to say, credit market world has changed.

Now it is time to reevaluate what the security is worth. First, Warren Buffet is selling Moody's for the past few quarters. One obvious reason is that he thinks security is fairly valued considering future prospects of the company. It is also possibe that his decision is precipitated by a moral responsibility of being a part owner of the company (up to 20% owner at peak) and not able to influence it's role in credit crisis. If I have to bet, it is not in Mr. Buffet's genie to sell undervalued security. So it is likely a combination of all of the above.

Moody's moat at it's core comes from trust it's customer's place on it's ratings. The credit crisis has shaken that. Moody's is addressing some of the issues but changes are not as drastic as the problem requires. The regulatory environment will be changed and it's shape unknown.

Now lets look at numbers. In 2008, Moody's earned around $1.8 eps. Estimating future growth is tough. World will likely not get back to high levels of leverage any time soon. In particular structured finance business will likely dry up and not return to any where it was in 2006 and 2007 (as stated by CEO in 2008 annual report). Further, 2008 is a baseline year as stated by CEO in 2008 annual report. Company will likely have more competitor's in future in it's regular plain vanila bond rating business. For example, Morningstar has come out with ratings on bonds. Regulation is likely to tighten. If you add all up, Moody's will likely grow few points ahead of inflation because of it's Analytics business and some rating business growth with world economy growth. I will pull up some numbers here. Lets say 5 to 7% revenue growth with 10% eps growth (because of share repurchase).

These figures are not bad. Moody's throws out lots of cash. But the big rub is that shareholders do not benefit from high free cash flow. Moody's repurchases shares regularly instead of giving high dividends. Further, this occurs even when stock price is high. For example, from Oct to Dec 2006, company repurchased 2.2 million shares at around $65 per share. It is not difficult to figure out even in boom period that this price is not a screaming bargain. Share repurchase benefits option holder more than regular share holder. So not much can be expected in terms of value creation due to capital allocation of excess cash. So a lower valuation is warranted.

Over the next few years, Moody's non rating business will grow faster than ratings business due to consumption of risk analysis products. This segment has lower operating margins than the ratings business. As of Q3 2009, op margin of Moody's Analytics business is 34% (still healthy) compared to 40% for ratings business. So op margin expansion is not likely.

Another piece of interest is that 2009 has had good growth in Corporate Finance segment of the Moody's ratings business. This is the ratings on investment grade and speculative grade bonds due to company's refinancing. Likely, this level of activity may not not occur every year since company's have refinanced to avoid any near term maturities.

I think it is not unreasonable to give 15 to 20 as P/E without doing DCF. So this translates to valuation between $27 to $36 based on 2008 eps. Mr. Buffet is selling in lower end of this valuation indicating future prospects are not that great. It is best to take note of when Buffet sells based on past experience.

Please leave your thoughts...

Warren Buffet's role in Kraft

2010-01-12T08:41:00.001-08:00

A lot is written about why Mr. Buffet pays part of Burlington North Fe transaction in equity. Check this link if interested (http://www.rationalwalk.com/?p=4035). But the more interesting question is why Mr. Buffet is opposing Kraft's offer of issuing more equity to buy Cadbury's.

Buffet in the past two decades has chosen to be passive investor. His key was to associate with good managements rather than to direct or influence management actions. This has worked well for him in general. His rationale was that managements usually do not listen even if such advice is provided from within the board room. Usually CEO ego takes precedence over advice from elders!

However, investment in Moody's may have changed his opinion. Mr. Buffet was criticized for not taking more active role in Moody's operations during the boom years even though Berkshire owned 20% of the company. In effect, Berkshire was a silent partner in company's role in the credit crisis. In the annual meeting, Mr. Buffet was questioned about this and he gave the same standard answer that managements will not listen.

I think that Mr. Buffet has had second thoughts on this issue. While being a passive investor is still his first choice and correct choice most of the time, he has a responsibility to exercise his responsibility as an owner in circumstances when value is destroyed or when the direction of company is wrong. Ben Graham in intelligent investor asks all investors to take an active role in the companies in which you invest. I think Mr. Buffet may be taking more such active role in future and that is good for all investors who invest along side him or with him.

Please leave your thoughts....

Warren Buffet on Ben Graham.

2009-10-12T07:16:00.000-07:00

Warren Buffet's video about security analysis. You can see how he feels about ben Graham.

http://www.gurufocus.com/news.php?id=70961

How to invest in banks

2009-05-06T07:20:00.000-07:00

It is important for investors to not fight yesterday's battle. I am referring to financial and banking business. Considering all that has happened, it is tempting to avoid financial forever into future but that would be a mistake. Here is why.

1. Once the current crisis passes, banks will still be needed. Their business is ever green and needless to say is tied to economic growth. That is more true now that shadow banking has taken a hit.

2. It is likely that over next 5 or 10 years, banks will not repeat the past mistakes. This will mean banks will take prudent risks going forward and make loans to credit worthy customers. Eventually similar mistakes will be made, but that is not likely anytime soon.

3. There is less competition since some banks have gone out of business or acquired. The shadow banking system is out of business for most part.

4. My sense is that cost of credit will likely rise once government is out of the picture. I don't know when this will happen. But until then banks can make tons of money.

Now, some thoughts about basics of bank investment and what to look for.

1. First, one thing to learn from credit crisis is that it is important that financial be part of your portfolio and not the entire one. However, talented investor one may be, companies that operate with leverage is inherently risky. It depends on trust of others to lend money (customer deposits) and allow it to operate (regulator). So, limiting exposure (but not avoiding) is best for most investors.

2. A bank makes money by spread between the cost of money that it collects from depositors and the lending rate. I have a simple equation.

Profit = (lending or interest income) - (cost of money) - (cost of running a bank) - (loan losses) + Any fee income.

It is worth thinking about this for a minute. Mr. Buffet likes Wells Fargo because of it's ability to collect low cost deposits (cost of money). However, there is more to this. The variables in above equation are not independent. Here is why. Lets say two banks (Bank A and Bank B) have ability to collect deposits at 1.5% and 2.5% respectively. To get the same spread of 2.5%, Bank A would have to lend at 4% while Bank B would have to lend at 5%. Which of the two loans is more risky? The one at 5% is more risky than at 4% for obvious reasons. So loan losses for Bank B will be more than Bank A over a credit cycle thereby, making Bank A more profitable over the cycle. So low cost deposits are important, not only to reduce cost of raw material (cost of money) but also to reduce lending losses.

3. Find a CEO who has a clearly articulated simple strategy and will not follow the crowd. This is key since banks invariably get into trouble in the same area once every two decades. Usually, in an area that creates lot of profits before the bubble bursts.

4. CEO must be in control of the show and must be the chief risk officer. It is true that getting to know the bank management is not an easy job for small investor. However, downturns provide an excellent opportunity to evaluate their past actions. It is not difficult to infer that JP Morgan and Wells Fargo had better managements than few other big banks. So study their record in down markets and likely there is no better way to evaluate their past actions.

5. Prefer a bank that attempts to grow organically and not by big acquisitions. In particular, it is best to avoid merger of equals. Targeted acquisition of a small bank works better. In this downturn, acquisitions have been opportunistic and I think in all most all cases, the acuiring company may have been better off without those. Some exceptions do exist. As Jammie Dimon (JP Morgan CEO) replied in an interview about why he only agreed to pay $2 for Bear Stearns initially. He said there is a difference between buying a home and buying a home that is burning. That illustrates the risks in quick opportunistic acquisitions.

6. Costs do matter. Since banks are commodity business, cost of running the bank is important. Lower the better. All things being equal, lower the cost of running a bank, lower the risk bank needs to take to earn the same spread.

Conclusion:
Finally, all things said, consider banks that focus on profitability than growth. Focus on those that take thoughtful credit risks and never tries to loosen on credit standards. Focus on cost of running a bank. Last but possibly most important, never buy if you do not have a sense of the management capability and temperment to avoid profitable (in short term) but risky ventures.

Good luck and leave your comments.

American Express - stock analysis and review

2009-04-10T16:48:00.000-07:00

Recent share holder letter provides some valuable insight. Here are some that will interest long term investors.

1. Consumer spending pattern: The most important driver of value for AXP is consumer card spending. The US consumer card spending reduced 12% in fourth quarter of 2008. International card spending showed some growth but much less than last year. The reduced spending was particularly visible in luxury goods which is especially important for American Express. The key question is how much of this decline is attributed to secular shift in the consumer spending patterns. Are consumers temporarily withdrawing or will we see a cautious consumer whose prefers to save for next few years. By all accounts, it seems that we will have a cautious consumer at least for next few years. Since American Express depends on consumers spending and transactions, this can have a significant impact on revenue and bottom line.

2. Underwriting decisions: Management is candid about some of their actions that resulted in increased credit loss. First, AMEX card member base is skewed towards states hit hard by real estate crash. [Btw, I understand Discover was more cautious in this regard.]. Second Amex added more card members than industry (higher growth). Third, they have more small business accounts. These decisions are elaborated below as they are significant in my view.

3. Floor for credit losses: The above three actions illustrate that Amex fully participated in the credit boom. This resulted in significant growth in good years which is coming back to bite in bad years. The net result of above actions resulted in middle of the pack past-due and write-off rates (bad loans that cannot be collected). Further, this loss cycle is far from over since unemployment is expected to continue over many months to come. The exact level of credit card losses is difficult to predict in this environment. Historical indicators may be misleading as the current credit bubble induced recession differs from either the valuation driven tech bubble or a general economic slowdown without structural issues. It is difficult to estimate future losses and considering credit card loans are unsecured loans, uncertainty definitely exists in this regard. It is for this reason that I believe that valuing Amex at this point is not possible with any level of certainity.

4. Business model: American Express traditionally commands a higher multiple in the market for a reason. Historically, American express business model is based on spending by high networth customers who will pay the bill rain or shine. The focus is on discount fees from merchants and membership fees from card holders. Increasing balance was not the primary focus. This meant that Amex had low credit risk and market rewarded this handsomely with high multiple. [There is a reason Banks have low multiple for same earnings. One is leverage and other is possibility of credit loss.)

The question to be evaluated now is whether the Amex business model has changed as a result of expansion past few years coupled with poor underwriting decisions (outlined in #2)? The write-off rates are in the middle of the pack for a top quality company. If American Express continues to expand in good times and creates higher write off rates in poor economy, it will be treated more like cyclical business and will not justify premium multiples (correctly so). This affects long term share holder value. The key issue is whether American express moves back to a business model of low credit risk. I suspect Warren Buffet did not anticipate holding a company with middle of the pack write-off rates. If so, that will inevitably mean more subdued growth in the future.

5. Risk conscious culture: The net charge off being in the middle of the pack for a top class company like American express is unacceptable to say the least. Was there too much focus on growth? How did the company miss out on risks during real estate bubble when at least one competitor recognized it? For a financial company, growth can be dangerous if it is not accompanied with sound underwriting. I understand American express has tweaked their models in response to the crisis but it is equally troubling that the culture within the company did not catch this earlier. Holding a financial company is meaningful only if it has risk conscious culture. Any deviations can be fatal and as well difficult to rebuild the culture. I do not see anything else that has changed other than tweaking models. Note models are a result of human decisions anticipating risks not the other way around. This point is key.

6. Compensation: I tried to read through the proxy for compensation details. It was complex to say the least and based on many parameters. I think it should be simple enough and depend on few critical drivers of the business. Some combination of underwriting profit growth and write-offs over a cycle would make sense. In a year like 2008, anything other than base pay is excessive.

7. Credit card securatization: It is an open question as to how the credit card receivable securatization market will function after the current crisis is past? Could it be relied upon for funding? Since credit cards are unsecured loans, it is always possible that this market will freeze whenever investors are nervous. This risk applies to all credit card companies. In this regard, American express has brand advantages to raise capital from other funding sources. However, as a whole, the total credit issued will be reduced in the future as securatization market will demand higher credit quality.

8. Cost expenses: American Express has announced 10% reduction in work force. I think this is in keeping with realistic view of future growth after years of expansion. However, it also shows that future growth is going to be subdued.

9. Regulation: New regulation is inevitable and it is not going to be friendly to credit card companies. It is difficult to predict the nature of this. I suspect regulation will affect the credit card companies whose business model is based on balances more than AMEX.

Conclusion: I think future growth of Amex will depend on a number of factors outlined above. At this time, AMEX is in "too hard to value" pile. Here is a recap why it is so.

First, Amex has to survive the credit losses in the short term without raising expensive equity capital. I do not think we have reached peak write offs and that anyone can predict this with any accuracy since economy is still in poor shape.

Second, will AMEX learn from this downturn and go back to the business model that results in low credit risk across entire cycle? It is an unknown. This will decide the multiple market provides (correctly so).

Third, credit card industry has a number of external factors that can influence it's future like regulation, consumer deleveraging, securatization market etc. These are hard to predict.

Fourth and most important, will management create an environment that is focussed on sound risk management? This is the most important aspect of a financial company and in last bubble risk controls failed the company. Without this, owning financial company is a gamble.

Considering all of the above, I think it is not possible to meaningfully value the company at this point. As a disclaimer: I do own Amex shares and plan to continue to hold. Please leave your comments by clicking the comment button below.

WU - Update and what now?

2009-02-25T07:51:00.000-08:00

The advantages of Western Union (Ticker: WU) business model is fairly well known. It is scalable and generates lot of cash. We are now in a new reality and it is worth checking back if it is worth continuing to be invested. Here are some thoughts...

1. General ongoing environment: It looks like we are in for a period of prolonged downturn and possibly a reset to new level of economic activity rather than return to pre-bubble economic activity. Lets say, two years of painful revenue drops (15% drop) and followed by growth based on inflationary levels from that point. No one knows for sure but evaluating companies with this in mind is always a good start. If it survives this scenario, other scenarios (except great depression II) will be good outcomes.

2. Debt: In this environment, any debt is a bad debt. Western Union had around $2 Billion of debt. First the good news. Much of this debt is due to paying a dividend to First Data and not due to business needs. Western Union generates more than $1 Billion dollar of free cash flow per year. Still that assumes future will be like the past. Plus operating leverage works both ways. Since the network of money transfer is already established, incremental revenue falls to bottom line. The reverse (current situation) is also true. That is, drop in revenue could cause much steeper loss of earnings. I think management must act conservatively first and pay back debt as soon as possible.

3. The general lack of growth in economy means less activity in construction and employment levels. So in general, Western Union customers have less money to transfer. So revenue can drop off. This is negative like it is for many other companies.

4. Western Union's competitor (Money Gram) is weaker because of issues in their check cashing business. Since money transfer is not capital intensive business, Money gram can still find ways to grow. But not with as much strength to compete against Western Union. If it comes down to it, Western Union can sustain lower prices for longer than Money Gram. So weaker competitor does not hurt but does not help as much as it would in a capital intensive business. Plus perception of strong player is always a plus in anything to do with money.

5. While growth due to economic activity will be reduced, we can expect some acquisitions of smaller players. Plus smaller players may find it hard to withstand prolonged recession. This is positive.

6. Since multinational Banks are weaker, they may now start to focus on their core areas and not focus on money transfer. This is positive.

7. Western Union does not carry credit risk and can withstand prolonged recession if it manages it's expenses and debt carefully.

8. The current political climate in Washington may result in meaningful immigration reform which will be positive for Western Union.

In summary, if economy falls into few years of weakness, Western Union will take few hits to it's earnings but will survive. The pain until then is definite. But will remain as one of the last standing players. When economy eventually returns to more normal level, their rise will be remarkable! Or so I hope!

Why stock options misalign incentives

2009-02-02T06:53:00.000-08:00

It is a common cliche that stock options align management and shareholder interests. The story goes something like this. If stock price goes up, both option holder and share holder benefit. If it goes down, stock option holder does not reap any benefit. I think this is a very superficial analysis and needs a little digging. The following discussion will provide reasons why this is not necessarily the case. In a nutshell, I think shareholders are usually better off without stock options and providing high cash bonus.

Warren Buffet has dealt with stock options in 1985, 1992, 1998, 1999,2002, 2004, 2005, 2007 annual reports. Needless to say, it is a must read for those interested in options and seems to be pet subject for the investment guru. We will look at some of those reasoning below along with suggestions to deal with companies using options.

Basics of stock options offered to management as compensation: Managements are usually offered fixed price 10 year stock options. Essentially, the management has the right to buy the company stock at the strike price (usually market price) any time over the next 10 years after the vesting period is over. So if the company stock was $50 at the time of offer and was $100 after 5 years, management can buy the stock for $50 and hence can make a profit of $50. Similarly, if the stock price were to be $25, it has no value to the stock option holder.

So what's to worry about! Let's look at some reasons why stock options do not necessarily put stock option holder and share owner in the same boat.

Where's the downside risk? If the share price were to go to $25 in the above example, share holder lost 50% of his capital. There is no such capital risk for management. It is true that management has invested his/her time and skill with the hope of benefiting on the upside. But they do get base pay and other compensation for their efforts. Stock options are an added bonus for success. So for Stock holder, it is "Heads I win, Tails I lose" and for stock option holder, it is "Heads I win, Tails I did not lose or gain anything". So to summarize, both option holder and stock owner's downside are way different. In fact lack of downside for option holder, may set the stage for taking big risks because upside is great without associated huge downside. For stock owner, success on upside needs to be weighed against downside on failure. Why provide incentives to your management to bet big with your money?

Why does Management benefit from additional capital you add to business every year?
Lets say a company's Return on equity is 15% and no debt. Lets also say that it retains all it's earnings. If the equity per share is $100, company's earnings will be $15. This earnings belong to share holder. Management will deploy the retained earnings (that belongs to share holder) to create earnings growth. For example, management may add additional stores if it is fast growing retailer that contributes to earnings growth. So total capital now deployed next year is $115 per share and lets assume that the new store is as productive as the old store for simplicity. Then 15% return on equity would mean earnings this year will be $17.25 per share (Equity * ROE -->115 * 15/100). As you see, earnings growth between two years is exactly 15% (17.25-15/15). Now share price will appropriately move upwards. Share holder and option holder benefits from share price increase. But note that the management could not have caused earnings increase but for the addition of new store. The new store in turn needed capital which came from retained earnings (that belong to share holder). If share holder had withdrawn the earnings as dividends, where will the growth have come from? If so, the option holder must not benefit from this additional capital retained every year. It is true that management skill in opening and running new store (deploying new capital) is key. But that does not mean all earnings growth is due to management skill. It is ideally a combination of management skill and retained earnings. So one solution is to adjust the strike price for the new capital. I am not aware of many (if any) comapnies that do that. As a side note, it causes management to retain capital in businesses even when it is not wise to expand business operations!

Stock options are granted at market price and not at it's intrinsic value. Market price at the time of grant may or may not be near intrinsic value of a company. Most value investors understand that company's market price may be different from it's intrinsic value. If Mr. Market is in bad mood and prices the company much lower than it's intrinsic value at the time of option grant, then the person receiving option may benefit from market repricing at a future date. This may or may not be the direct result of anything management did. Similarly, the market gets into one of those heady bull markets, the option holder may benefit from general market levels moving higher. Neither of these scenarios are in control of either the management or the Board (who sets compensation). But in either case, the option holder (usually management) benefits for no fault (or work!) of his. Why reward someone for result that they did not produce. If you dont believe market price will be different from intrinsic value, here is one from the master. Mr. Buffet points out in 1985 annual report that when a CEO plans to sell the company or merge with other entity, CEO is unfailing to point out that market price understates the company's worth. Why give piece of your company at anything other than it's fair value ?

Capital allocation misalignment-Dividends Vs Stock buyback decision: Stock option based compensation hinder earnings to be allocated in the best interest of owner. Here is how. The earnings of a company that is left after routine maintenance and "growth projects" can be either distributed as dividends or be used to buy back company shares. For the options holder, anything that increases earnings per share is positive (which share repurchase does). Dividends do not increase earnings per share. Thus, stock option based compensation encourages stock repurchases over dividend without regard to market price of the share.
For a true owner, equation is way different. For the regular share holder, buying back shares makes sense only if the price of stock is less than the intrinsic value calculated conservatively. In other cases, dividends is much better option. In fact buying back high priced shares cause value destruction for the owner. It is like buying dollar bills for dollar and 30 cents.
Thus stock option based compensation encourages repurchase over dividends irrespective of what the share price is. This does not mean managements will always do it that way but why set an incentive that works against you (the owner!).

Why hire employee's whose salary is unknown: A company benefits if the financial benefit arising from services of an employee exceed the compensation paid. Otherwise it is a loss. This statement is true, whether you use cash or any other form of payment. Stock options uses company shares as currency to pay for employee services. It is a currency whose precise (or even approximate) cost is not known at the time of offer( more on this later). Since the cost of options is unknown, it is not easily possible to figure out whether the employee adds more value than the benefit he/she receives as stock options from the the company. Ironically, this is the same argument (cost of options is unknown) that many managements used to not expense stock options(!). But I would flip this argument and say, this is a good reason to use other forms of compensation when possible. May be a high cash bonus for achieving predetermined goals.

Why 10 year fixed price options without holding period requirement! Managements are usually granted 10 year fixed price options. That is, options can be exercised (any time after vesting period) over next 10 years but not required to hold the shares after exercising the options. First, why provide it for 10 years! As discussed before, the capital added in the form of retained earnings exceed the book value in some companies! The option holder benefits over a 10 year period without having a dime of capital at risk. It is true that many exercise their options before 10 years. To bring some balance, why not require holding period (say 2 to 3 years) for some part of the options exercised? Say 30% of the options need to be held for 3 to 5 years after exercise? It will provide some alignment.

Doesn't Share buyback cancels out effect of option dilution? This is the height of shareholder unfriendly activity. Share buy back costs money. If options cause additional shares to be issued, then buying back additional shares does not offset the effect of options. The money used for buyback comes from share holder money (retained earnings) and is is not free money. So do not accept that share buyback nullifies stock option dilution. In fact, it can make it worse. It induces management to buyback shares when the prices are not attractive. In effect, it doubles down the harm caused to share holder.

The worst kind: Reprice stock options: This is height of misalignment between share holder and investor. If you buy a share at $100 and it's price goes to $50, you lose $50. However, if an employee is offered stock options at $100 and if price goes to $50, the options are way under water. Unlike share owner who has put in capital, employee has put in his time and skill with the hope of benefiting on the upside. Since options are under water, he like share holder will at least not get any return until company's fortune reverses. But this equation is flipped upside down when the management suddenly decides to reprice the already outstanding stock options at $50. This means that if the stock now goes to $75, employee will benefit by $25 per option while share holder who purchased at $100 will lose $25. To add insult to injury, the lower the share price goes before repricing, more the profit for employee and more the expense for the share holder for those options. It simply means that 'Heads I win and Tails I win even more'. Many companies have moved away from this but not entirely. Recently Google repriced their stock options. Their logic likely is that they will lose talented employee if they do not reprice. I would say if you want to pay employee irrespective of stock price ('Heads I win, Tails I want to win still'), do not use options. Provide cash bonus and do not claim alignment with stock holder. Stock option reprice must be viewed with skepticism by investor and usually should reconsider being share holder.

Tell me how an excellant company will treat me ! Before we end, here is an excerpt from Berkshire owner's manual for some cooling of eyes.

o We will issue common stock only when we receive as much in
business value as we give. This rule applies to all forms of
issuance - not only mergers or public stock offerings, but stock
for-debt swaps, stock options, and convertible securities as
well. We will not sell small portions of your company - and that
is what the issuance of shares amounts to - on a basis
inconsistent with the value of the entire enterprise.

Since many company's use options, what can an investor do? It is not possible to totally avoid companies with options. So here are some thumb rules.

1. Stay away from the one's that use options excessively. Even if it means passing up some nice opportunities, you can sleep soundly. Plus there is likely to be other share holder unfriendly activities at the firm.

2. If a firm that does not offer stock options, consider it a shareholder friendly move. Provide weight in your analysis for share holder friendly firms. They need to trade at slight premium to rest (all other things being equal), since share holder can better benefit from wealth created by business.

3. Options can be used properly but is rare. I will not get into this subject since I do not believe that share holder friendly ways of using options will be devised. For those interested, please refer to Warren Buffet's 1985 annual report for suggestions.

4. Prefer companies with CEO or board members with significant stake in the company. You will need to filter out those where CEO's who already have significant stake but reward themselves with additional stock options.

4. How to value effect of options: At this time, companies are forced to value options and treat them as expense. Most use Black Scholes model with varying assumptions. Wall Street Journal's weekend edition (Jan 31, 2009) had a nice article. It stated that option expense is understated by Black scholes model if price of stock appreciates and overstates when price of stock falls. On the whole expensing options does provide investor some built in protection against overestimating earnings. I use a more conservative estimate. Here is how I do.

I aim to generate 14% return from a stock when I purchase including dividends (doubling in 5 years). That does not mean I do it! Lets say price is $50 at purchase and I sell at $100 after 5 years. To keep it simple, lets remove dividends for a minute.
Find the total stock options (say 1 million options) outstanding and their net weighted average strike price (say $35). This information is available in annual reports.

If all options are sold after 5 years, then cost is $65 per option ($100 - $35) after 5 years. So total is $65 million over 5 years. I divide by 5 years for yearly cost and apply tax benefit. This does not take into account time value of money. This usually turns out to be higher than the model but it makes me comfortable. If this is complex, use the model output and use bigger margin of safety.

Also, it will help to note Warren Buffet's comment on impact of stock options on earnings in his calculation. Note that this was written at a time (1998) when option expensing was optional. So now it does not apply completely now that is required to expense it. But provides a window from the Master!

"The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made."

5.The bigger problem is the fact that you do not know how much more stock options company will issue over the next few years of holding period, thereby diluting your holdings! This does create an issue for long term holders of stock.

How to benefit from Retail companies

2009-01-29T07:42:00.001-08:00

Retail is very competitive business and usually has very few competitive advantages. Many retail businesses have low operating margins and make their money by having high turnover of inventory. I view low operating margin for a business as low margin of safety for business errors. If that's the case, why bother playing this segment? The answer lies in some impressive gains if right retail business is acquired. Think buying Walmart even in late 80's! We will look at some factors that can maximize our success in finding good investments in this field.

First, I think there are broadly two types of retail businesses. One is pure play like Walmart or Target. Other is like Starbucks who manufacture a product and sell themselves. This analysis applies broadly to both. Lets first look at some good reasons as to why not to ignore this sector and then move to what to look for.

1. Judging growth potential: If a retail concept works in one city, it is likely to work out in other towns and cities in US. So growth potential can be evaluated with some level of certainity.

2. Easy to understand: It is fairly easy to understand how a retail business makes money. It is also possible to check out the retail locations and shop to get a feel for service, merchandise selection and whether you love or hate it!

Lets look now at what to watch out for. Usually, if you like a retail concept, you will need to evaluate if it has some intangible that cannot be easily copied like benefits of scale, first mover advantage, brand, low cost and excellant management. Assuming there is some barrier to entry and competitor's have not mushroomed, here are items to watch out for.

1. Look for companies in early stages of growth. This cannot be over stated in retail companies. The following will explain some of the reasons.

2. Same store sales: Market is usually fixated on same store sales growth of stores open at least 12 months. However, many retail locations take few years (5 years for Car Max) to mature and get to full potential. So for initial few years the same store sales growth of new stores ( older than 12 months but less than maturity age) will provide tail wind for this number. Once a store matures, it is difficult to maintain the same level of same store sales growth.

3. During initial growth years, earnings benefit from double-dip, delivered partly by new stores as well as same store sales growth (aided by stores approaching maturity but older than 12 months). The earnings growth will be a treat to watch and stock price will move accordingly. If you like the retail concept and are convinced that there is enough room to grow and like the management, buy when the company or market hits a snag and stock is on sale.

4. Management in early years: Management will have huge effect on the outcome in retail especially in early years. In early years, you want management who have business savvy in retail plus big stake in the company (a founder with big holdings in the business) is ideal. Think Sam Walton. In particular you need to be careful about compensation based managements who focus exclusively on earnings growth. Quick growth with leverage benefits management more than share holder. Leverage can come back to bite very quickly when economy goes through a cyclical downturn. Needless to say, you want Walmart or Star bucks rather than krispy Kreme. Look for managements who treat their business as their baby(if you are lucky to find one!) and who plan to grow steadily and with as less leverage as possible.

[As an aside, I find that CEO who are thrifty turn out to be good stewards of share holder money. I do not know why this is but seems to be a good attribute to watch for. Examples include Warren Buffet, Sam Walton, charlie Munger etc. In fact Warren Buffet likes this in a manager. He has mentioned about a manager looking for free parking spots when coming to sell his business. Needless to say, he was thrilled !]

5. Saturation: Bad word in retail! At some point the game runs out on new stores. At this time, usually management used to promising the sky need to think of soft landing. They need to think of slowing growth expectations and also focus more on dividends. Usually though managements do not do this. Blame it on Management compensation. Management compensation usually does not reward shareholder dividends as much as per share earnings growth.

So the story goes like this. They put up additional stores cannibalizing the sales of neighboring stores and provide a variety of good justifications. Management finds out that inevitable happens. New stores placed close to existing stores do not turn out to be that productive. In addition, at this point the same store sales growth slows because the newer stores (> 1 year but less than maturity age) are much smaller part compared to fully matured stores. A combination of these factors cause the earnings growth to slow. Market punishes crushingly. Management focusses on cost cutting next or try new lines of business!

6. Selling is not a bad thing! To avoid this fate, one needs to have an understanding what level of stores cause saturation. Look at similar retail outlets. When it is close, be satisfied with the profits and get out.

7. Value trap: In the final phase of a company, it is important to watch out for value traps. The retail company may look cheap based on past growth expectations. It is best avoided at this time unless the price is so cheap even assuming no future growth. In that case, you will benefit if any additional growth does turn out. If not, you may still get the one time benefit of market reevaluating the price. But usually it is better to avoid this cigar butt scenario.

Bottom line, focus on buying retail concepts with growth left in them. Do not forget to focus on price and excellant management. Also, avoid value traps towards the end. Watch how management compensation is set and if they have skin in the game (real money not funny money like options) so much the better.

Please leave your thougths....

Concentration vs diversification

2008-12-04T06:50:00.001-08:00

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.

How to intelligently buy Financial firms

2008-09-02T07:09:00.000-07:00

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....

RV - Winnebago and Tho industries

2008-06-10T07:53:00.000-07:00

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.

Whats attractive about Carmax

2008-05-27T06:55:00.000-07:00

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.

Management

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.

Numbers

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.

Valuation:

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.

Other

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.

Check list for new investment

2008-01-16T06:58:00.001-08:00

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.

Management:

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....

Creating value by growth.

2008-01-10T06:15:00.000-08:00

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.

Value Vs Price

2007-12-27T12:33:00.000-08:00

As per efficient market theory, price of a stock reflects the current value of the stock incorporating all known information in the price. However, value investors disagree with this proposition. Warren Buffet wrote in one of his annual reports that while stock market is usually efficient, that does not mean it is always efficient. The difference between usually and always is 'night and day'.

It is instructive to understand that why would market misprice a stock when investors (many of whom are highly educated ) focus enormous amount of time to analyze a stock. The simple answer is emotion and time horizon. Lets take this one by one.

First the basic of human emotions that affect stock price is fear and greed. Market has a tendency to swing to extremes during both good and bad times. It is not unusual for the market to extrapolate both good and bad times into distant future.

A case in point about too much optimism in good times is tech stocks during late 90's. Tech stocks like Cisco were very good companies making lots of money. But their stock price reflected enormous optimism about future and that was not achievable. This even extended to tech stocks that did not have earnings or just went public. The late 90's provide an extraordinary learning opportunity to learn for value investors.

Similarly pessimism about future too can be taken to new heights. Currently credit agencies like Moody's or Mcgraw hill (MHP- owns S&P credit rating agency) seem to reflect a gloomy future forever. At some point housing will recover to ordinary levels if not to the extraordinary levels of 2005 and 2006. Similarly capital markets will likely return to normal levels at the very least.

Take the case of Moody's. It's price fell from high of $76 to around $36+ dollar within a matter of months. It is difficult to believe that the value of the company was 100% more than today's price just a few months earlier. Either market over estimated earlier high price or is discounting the current value significantly or bit of both. Either case, market misprices during uncertain (read fear or greed) times. Only time will tell if Moody's price is under valued. But it does show that market takes wide swings and value of solid companies usually do not swing that much in short order of time.

Further Warren once said that it is important to note that these emotions are here to stay. As a whole human race does not get any wiser with respect to these emotions. These will occur many times in future. That is good news (not bad) for value investors who seek to find mispriced stocks.

Time horizon introduces some mispricing because of the way Wall street operates. I have found that if a business has a temporary problem and has a very bright future and will return to creating value in two to three years, Wall street usually will leave it for "dead". It is called "dead money" and the stock is beaten down. Wall street will plan to get back on the stock once it gains "traction"! I am always surprised why this occurs but it is an indirect effect of compensation systems. Most compensation system operates on quarterly or yearly rewards. compensation systems drive behavior and usually this results in intelligent people doing things that they would not normally do. This provides unusual opportunity for those willing to wait. This is the critical information that provides regular investors a leg up over Wall street.

The key point for a value investor to take away is price of a stock is not necessarily it's value. Price is set by auction type market by all market participants which by it's very nature is affected by emotion and time horizon of it's participants. Value of a stock instead is derived by discounting it's future cash flows to present. When they coincide or when price is greater than value, value investors need to walk away. When value is significantly higher than price, swing your bat. Also, usually market is good at recognizing value and will match it's price with value.

It is intructive to read Warren Buffet's lecture on this topic and can be had by
http://www.tilsonfunds.com/superinvestors.html

I hope this seals the discussion about market mispricing. Happy value investing...

Western Union - Whats the catch! - Is it a value trap?

2007-12-17T11:10:00.001-08:00

WU has a number of well known competitive advantages like huge distribution network that dwarfs competitors, very high profit margins and growth that is not capital intensive. In spite of these advantages, Berkshire sold it's entire stake in Western Union. What could we be missing that Berkshire recognized?

I have to confess that Berkshire selling stakes in WU got me thinking more about what could be wrong with WU's business model. Obivously, no one Knows why Berskshire sold it's stake in WU. It could very well be a distaste for small positions (around $300 million originally...yes it is small for Mr. Buffet!). But it is worth thinking about other aspects as well.

I read WU's annual report to find out. One sentence captured my interest. In it, it is stated that due to pricing actions, revenue reduced 3% and further that this trend will continue into future. In the recent quarter, the management said that revenue reduced 3.3% due to pricing action. This kept me thinking as to why WU will have to reduce price if they have such a strong brand and further that why such price reductions will need to be ongoing. This needs additional thought.

WU has the biggest distribution network among all money transfer firms (3 times bigger than their immediate competitor Money Gram). In exclusive money transfer corridors (where there is little or no competition), they have enormous pricing power. But that is not the case in corridors where they compete with other money transfer companies, especially a big one like Money gram.

Money Gram (MGI) is expanding it's network at a fast rate and as a by product of that, WU starts to lose exclusive corridors of money transfer. This in turn results in Western Union losing pricing power. It is well known that Money gram prices just below western union. While WU has first mover advantage, it is far from being a permanent advantage. This loss of exclusive money transfer corridors results in reduction in pricing and hence revenue. I think that over long term, both operators can co-exist but not at profit levels that WU is currently experiencing.

Oracle of Omaha does like pricing power as a result of strong brand. Brand is just a means to pricing power and is not end all by itself. Think GM vs Coke. Both are powerful brands and only one of them carry pricing power. The key question then is whether WU's brand helps it maintain pricing power which can become a more sustained advantage?

WU's brand symbolizes reliability and convenience. But the relevant question to me is whether Western Union's brand is strong enough to convince a customer to pay a premium price (higher than competitor) and use Western union even when a viable cheaper alternative exists (Money Gram). Or in otherwords, will customers pay a higher price to transfer money through WU if Money gram agent is available in the both send and receive locations? This question is key to determine long term pricing power and share holder returns.

If the answer to above question is 'Yes', it's advantages are sustainable and loss of exclusive corridors don't matter much and Western Union will continue to earn excess returns over long periods of time. If the answer is 'No', it's returns are dependent on competitor having rational pricing and other factors affecting the industry (or in other words, starts to resemble commodity type business over long run).

My view is that it does lose pricing power as as Money Gram expands. But longer term, both companies can co-exist (like Coke, Pepsi or UPS and FEDEX). But it will need to be at lower margins than Western Union currently has. So it will be somewhere between excellant business (franchise as Warren Biffet would call it) and commodity type business.

The money transfer business is high fixed cost and low variable cost. So the last dollar earned goes directly to bottom line. So 3 % revenue lost in pricing actions are going to directly affect the bottom line.

Some offsets to revenue reduction in medium term could be faster international growth or Money gram stumbles in execution due to subprime issues etc. It is true that international segment margins are lower. But that does not explain the 3% reduction in revenue due pricing action.

All in all, I think WU is a good business but will likely not be a great business as it was in the past. Disclaimer, I do own WU. I think it has decent prospects due to international segment (especially Asia and middle east) and due to low capital requirements. But likely will not be a great business as it's numbers currently imply. Any thoughts on this is welcome!

Welcome to blog

2007-12-17T11:00:00.000-08:00

Welcome to value investing blog. Yes! this blog as some would have figured out by it's name deals with value investing.

So what do we mean by value investing? Value investing at it's core is simple. You attempt to buy dollar bills for less than a dollar. Hence the name. Different value investors use different strategies to achieve that goal. Some use bankruptcies to pick up gems, some use spin off situations and some prefer buying fallen down quality stocks, some buy companies with the hope of enhancing value and so on. But the general idea is same... that is buy stocks or business with value greater than their selling price. Ben Graham's simple but powerful concept is true today as it was many decades ago.

Postings in this blog will be of two types. One will focus on value investing, it's different methods, thoughts and links from other great investors related to this topic. You could call this theory behind investing.

The second type of posts will deal with investments that the author considers under valued. We will also cover some cases where we think the low price is infact a value trap.

Needless to say, author does not have any crystal ball about the future. Investing is essentially forward looking. You know the past but need to make a reasonable estimation of future which inherantly no one has control over. So use this site for learning and to possibly get a few starting ideas (if you are lucky) to do your own due diligence. This is not just a regular legal disclaimer. It is much more than that. It is very important for you to understand completely what investments you are getting into especially when things dont go as you expected (which occurs more than you would think!).

Lastly, welcome to this blog again and I hope you leave this blog a little wiser than you came and that is a high bar!