Monday, August 20, 2012

How an average business can be a great investment

Value investing is usually described in one of two ways, the first is buying assets at a discount a la Ben Graham.  The second is buying good businesses at low or fairly low prices and letting the superior business compound, the Warren Buffett approach.  I want to explore a third option in this post that's overlooked and misunderstood.

I've heard some value investors describe value investing as "buying something for less than its worth (intrinsic value)."  I was skiing last winter and rode a lift at Solitude with a Kiwi who was a stock broker.  I mentioned I did some investing and searched for undervalued stocks, looking to buy for less than intrinsic value.  The guy laughed and said "that's the name of the game, who isn't trying to do that?"  Which is of course true, what sort of investor looks to buy companies at high prices and hope things work out?

In economic terms a company that earns abnormal returns must have some sort of competitive advantage or as Buffett calls it a moat.  If the business didn't have an advantage entrepreneurs and other companies would see the fantastic returns, enter the business, compete and lower everyone's returns.  I think it's indisputable that some companies have moats, the ultimate moat is a monopoly or oligopoly situation.  Another great form of a moat is government regulation.  A regulator serves as a gate keeper to an industry.  It's no coincidence that Berkshire has been investing in regulated companies over the past few years.

There are plenty of ordinary businesses that earn abnormal returns as well.  Why aren't there competitors reducing the abnormal return down to an economic return?  Consider an example, a bait and tackle shop on the only access road to a state park with a nice lake.  The shop has no pricing power over suppliers, has a low barrier to entry, and doesn't even require specialized skills.  Yet the location of the shop, being the only one on a specific road allows it to charge a bit more and earn above average returns.  The bait shop has a small niche, serving fishermen at the local state park, yet they don't have any classic competitive advantages, there are many businesses like this.

I believe the difference between a niche and an economic moat is the ability to scale.  The bait and tackle shop can earn abnormal returns at their original location it's unlikely they will be able to replicate it unless they find a second location with the exact same characteristics as the first one.  I can think of a few companies off the top of my head that I own that fall into this category.  They operate in a niche and earn excellent returns yet they don't have additional reinvestment opportunities and will most likely remain the same size forever.

Niche companies are moat impostors and most investors get them mixed up.  I'd say the biggest mistake I've seen investors make is to see competitive advantages where only a small niche exists.  Paying a moat price for a niche is a mistake.  If a company appears to have a competitive advantage yet they can't scale their business I would guess the company only has a niche.

The third way

What about all those companies just earning normal returns on equity?  For the most part they're ignored, these are not great businesses.  You'll never wow anyone at a party announcing you own shares of a tiny plastics manufacturer, or a family held leather boot company.  So are companies earning lower steady rates of return un-investable?  I would say definitely not, with a caveat, and additionally they offer great hunting grounds because most investors ignore these companies.

To understand why and how a company with average returns can be a great investment it's helpful to consider a little example:

Example:
A company earns 8% on their equity, pays no dividends, book value grows 8% per year.
Book value is $100 per share
A investor pays $100 per share for a piece of the company.

Each year book value grows 8%, so the first year book value increases from $100 to $108, and then to $116.64, $125.97 and so on.  An investor buying at book value will see their investment compound at 8% a year.

Buying shares in our example company at anything less than book value will result in a higher compounding figure.  So buying shares at $75 p/s will result in 10.6% compounded per year.  Why is this?

Book value is still compounding at the same rate of 8%, but since the investor pays less than book value their basis is lower.  So let's look at the math:

Year 1 the company grows book value from $100 per share to $108 per share an increase of $8.  The key is the investor only paid $75 per share, an $8 return on their $75 investment is 10.6%.

The math here is very simple, buying at lower multiples of book value result in a higher return on investment.  While the company is only growing at 8%, buying at 50% of book value is a 16% return a year.  The bigger the discount to book value the bigger the return on investment.

If this is the first time you've ever seen this you're probably not still reading, you're probably playing with a screener looking for 8% book value growth with a P/B of .5x.  The rest are probably thinking these sorts of investments might exist on paper but not in real life.  I would disagree, I posted a while back about Hanover Foods (part 1, part 2).  They're a very boring frozen food company earning around 8% a year, yet  they're only selling at only 35% of book value.  This means buying at today's price results in a 22% per year return on investment.  A nice benefit of these lower return companies is the investor doesn't have to worry about competition as much, the industry is mature.  There will be innovation, but it's not like every high school kid in a garage is dreaming of how to freeze veggies better, they're all thinking about how to invent the next Facebook.

I mentioned these stable but low returning companies can be great investments with a caveat.  The caveat is to not overpay.  A nice bonus with this strategy is an investor doesn't need to be a genius or even that fast moving to implement it.  Be patient, buy a few steady companies at sizable discounts a year, and be patient.

Conclusion

I like to buy companies at a discount, either a net-net with a tangible asset discount, or a company with a stable return at a discount to book value.  I post more frequently about net-nets, but I really don't have a preference between a stock like I describe above and a net-net, both are profitable.  This method is probably more hands off and will result in lower portfolio turnover, but is just as safe.  The key is to ensure the company is actually growing book value.  Of course if they earn 8% on equity and return 50% of it as a dividend book value only grows at 4%, but as an investor you still get your 8%.

As the universe of net-nets dries up beyond its already parched state I'll probably be posting more about stocks that fit the characteristics of this post.

Talk to Nate

Disclosure: Long Hanover

10 comments:

  1. Good article Nate! In fact I also like stable, mediocre companies. I would prefer above average companies, but unfortunately it is rare, that someone sells them for giveaway prices ;-)

    A remark at the 8% ROE company you buy at 50% discount to book value. I'm not sure if you meant it this way, but one should be aware, that you don't get a 16% return on investment in such a situation. It is true, that the earnings yield on your investment is 16% in the beginning. But all that earnings (if no dividends are paid) are reinvested at 8%, which is a big disadvantage over a company with 16% ROE you buy at book value.

    In fact, if one holds a company for many decades, that completely reinvests its earnings, the annual return of the investor will approximate ROE, regardless of the P/B that was paid in the beginning. (If you buy for a very low P/B it only takes longer, to bring your return near the companies ROE).

    An example with the 8% ROE company before, that pays no dividends. Assume one buys it at book value and holds it for 100 years. Obviously the annualized return will be 8% per year.
    Now assume we buy it for half book value and hold it for 100 years. Our annual return will be 8.75%.

    That is the reason, I like companies to have at least a decent ROE, say 8 or 10%. When they don't achieve this for a long time, I would only consider buying them with a huge discount to NCAV.

    If you take into account dividends, it changes a bit. It doesn't matter, what the ROE of a company is, if they have constant earnings, pay them as dividend completely and reinvest nothing. As you mentioned in your article, an above average profitable company with no growth prospects is not worth paying a premium price. And vice versa a below average profitable company is not worth a lower earnings multiplier, if it doesn't reinvest a part of its earnings.

    As no profitable company should be able to reinvest all earnings forever (even Berkshire must stop that, at the latest when they own the whole universe one day), my examples are a bit hyphotetic. But one should be aware, that companies with below average ROE could be a bad investment, if they reinvest a large fraction of earnings.

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    1. Stefan,

      Thanks for the comment. I agree a company earning 15% on book is different than earning 8% at book at a 50% discount mostly because the first company can reinvest at 15% whereas the second one can only reinvest at 8%. As long as the discount persists the math works the same though, as the company returns 8% it is actually a 16% return per year on your investment.

      A different way to think about this is like a mortgage. If you buy a house for $100,000 and borrow $80,000 with a $20,000 downpayment the math is similar. While the house might appreciate at 3% ($3,000) per year the return on your investment is actually 15% (3,000/20,000). Obviously that ignores borrowing costs, taxes etc, but it's just a simple little example.

      The key to all of this is that at some point someone is going to pay the fair price for book value. Yes if you invest in a company growing book at 8% and a 50% discount persists for 100 years on paper your investment will work, but it doesn't matter the gain is still 8%. So I guess this whole post is predicated on the fact that at some point value will be realized. I believe value is always realized, but depending on that perspective it could change this post.

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    2. Stefan,

      Could you show the math on:

      An example with the 8% ROE company before, that pays no dividends. Assume one buys it at book value and holds it for 100 years. Obviously the annualized return will be 8% per year.
      Now assume we buy it for half book value and hold it for 100 years. Our annual return will be 8.75%

      thanks

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  2. Nate,

    Good article. I think it's worth making clear that, in the case of buying an 8% ROE company trading at 50% of book, while earnings yield may be 16%, the market return is only 8% if the discount to book remains unchanged.

    For example, assuming $100 book value purchased for $50 and the company generates $8 of earnings (all of which is retained in the business). The new book value is $108. Assuming the company continues to trade at 50% of book value, the company's market value is now $54. The investor earned $4 of additional market price on an original purchase price of $50 (8% return).

    Generating above market returns from businesses compounding book value at market (or below market) rates is contingent upon (1) the size of the discount to book value at which you purchase the business and more importantly (2) the speed with which the market price rises to eliminate the discount. As Stefan noted above, there isn't a huge difference in returns when buying at a 50% discount to book value and buying at book value if it takes 100 years for the market to eliminate the discount.

    Unless you are a control buyer, you must wait for the market to correct the price in order for you to realize your return. This correction may take a very long time, or never materialize at all. All the while, the investor has capital tied up in a business compounding book value at mediocre or below-market rates. In such a situation, time is not your friend.

    I don't know if this has been your experience. Perhaps you have seen that the market typically corrects its mistake (on average) within five years or so of purchase. Assuming you can buy a portfolio of businesses for 50% of book, you can expect to double your money in five years from accretion of the book value discount alone. I'd be interested to hear your thoughts on this last point.

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    1. Weezy Breezy,

      Yes, as you and Stefan mention if the discount is static forever this doesn't work. The whole premise is that eventually the discount is closed and value realized. So that's really step one, figure out if the discount is warranted, if not then this post applies.

      I should mention I've walked away from a few companies where this technique makes them compelling, but the discount looked appropriate, and there was a structure in place where it was very hard if not impossible to sell the company, and management was resistant to any such move.

      So after reading these two comments I guess I should have mentioned a few other factors:
      1) The discount eventually closes
      2) The size of the discount matters, small discount needs to close quicker than a bigger one
      3) Dividends

      In something like Hanover at 35% to book value and paying a dividend I don't care if I have to wait 10 years. At 85% to book without a dividend it's a much different decision, although at that point I'd expect the company to be earning more.

      As to your last point, I have found that value is usually realized in four to five years. I did some backtesting on net-nets and found even some companies that had were perennial net-nets did grow in share price equal to or at a greater rate than book value growth. So even at the end of a time period if they were still a net-net they'd appreciated along with book value growth. The big catch with value being realized in a few years is sometimes it takes four years to realize the price paid was actually fair value, and the stock wasn't undervalued. There's a company I own that was like that for me. I though (emphasis) I was buying at a discount, well over the years I realized I had actually purchased at fair value, so now I own this company growing at 5% basically doing nothing. I get the full growth in a dividend, but that's about it.

      Nate

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  3. The worry is that too many investors confuse and good investment like Hanover with a poor investment like Corticeira Amorim.

    In marginal but stable businesses, it's best to buy the payout yield -- very little can go wrong if an investor buys Hanover at 20% payout yield, for example.

    For a crappy business like Corticeira, however, one must surely insist on a much higher yield than 20% since it is not paying its way.

    Book is a red herring for these type of companies: they're not going to liquidate any time soon; they'll keep on keepin' on, whether it makes economic sense or not, esp. if they are family-controlled.

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    1. A lot is price you pay as well. I like Corticeira, but I liked it a lot more at my purchase price €.99 or 47% of BV. At the current prices…Hanover is a much better opportunity for sure.

      Then again COR does somewhat prove this point, the gap between price and BV has closed after the 50% run. When I purchased them they had a FCF yield of 33%, P/B of .47x and a 10% dividend. A 10% ROE wasn't a deal breaker when I was getting that for 50% off. It really hits what this post is all about. I'm hoping Hanover works out the same and runs up 50% on me in a year. Would I buy more COR today at the current price…there are better ideas out there much cheaper.

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  4. I like to keep a watchlist of (normalized) FCF/Payout yields for ROC < 11% businesses so that when I'm interested in one I can compare its yield to similar yielding stocks on the list to make a qualitative decision about which is better/safer.

    In that vein, in 2010, I remember looking at COR and comparing it to GSOL which is more my kind of business (100% ROIC and growing) which was yielding 38%. I picked GSOL.

    One of the things that worried me about COR is that its average FCF over a full business cycle is under 3 cents per share (2010 was a very unusual year)which, for a mature, no growth business, is simply not good enough. With Hanover, if the market shut down, one would wait for four or five years to get one's initial investment back; with COR, however, it would be be 40 years (or, more likely, never).

    That's all a long-winded way of agreeing with you on price being paramount, but emphasizing the caveat that marginal differences in quality matter a whole lot more in the ROIC 6% to 10% range than they do at the ROIC 30% to 35% range.

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    1. I completely agree, and looked at the long term for COR, well as you say it isn't the prettiest thing in the world.. On a normalized basis it probably wasn't as attractive as it appeared when I purchased, but I guess you can say I got lucky.

      In the case of Hanover the market is almost shut down anyways…shares barely trade! A Hanover type of situation is really ideal, I'd love to have a few companies like this in the portfolio.

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  5. Difference of 75 bps over a 100 years is astronomical. $10k investment grows to $44 million if compounded at 8.75%. Same $10k grows to $22 million at 8%. That 50% discount to book is pretty meaningful in the authors original example.

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