A business is a depreciating asset

When I was about to graduate college my dad took me car shopping.  He wasn't one for financial advice, probably because his own financial situation wasn't that great.  While test driving a used Honda he uttered the only financial wisdom I'd ever heard from him.  He said "Don't use debt to finance depreciating assets, only use debt to finance things that appreciate."  He expanded to explain that cars depreciate, but since I was a poor college kid I'd have to break this rule and finance the car anyways.

I think back to that discussion often, maybe for its simplicity, and maybe for the significance in my life.  But I think there is a larger aspect to it that applies to markets.

Often stocks are discussed as assets.  On your personal balance sheet cash and stock you own are assets held against any debt you owe.  Stocks are person assets.  We think of assets as things that appreciate because of their value.  Non-financial assets are things like fine wine, land, artwork, rare antiques.

There aren't many assets that appreciate by themselves.  Land and art come to mind, but that might be it.  Otherwise almost everything is constantly depreciating, and that includes the companies that hide behind stock certificates.

In many ways cars are a perfect analogy to companies.  A company requires constant maintenance and upkeep to generate revenue and profits.  You need to fuel a company with sales in order to keep it moving forward.  If driven long enough most moving parts of a car will wear out and need to be replaced.  The same is true for a company, machines break, computers need to be upgraded, processes and techniques change.  Given enough time a company will reinvent itself.

The ownership profile differs depending on the type of vehicle you own.  All vehicles are created to get from point A to point B.  Just like all companies are created to earn a profit.  But owning a 1982 Chevy Cavalier is a lot different than a new Honda Civic.  Sure, both are compact commuter cars, but keeping the Cavalier running will require a lot more care and feeding compared to the brand new Civic.  Yet when the owner steps out of the vehicle at the destination the same task was accomplished.  It doesn't matter whether the Cavalier or the Civic carried them there, they're at their destination.

The key differentiator is whether the maintenance is worth it.  If both vehicles get you to your destination and the end result is the same then why purchase one over the other?  It all comes down to price and preference.  Where a new Civic costs around $20k for a sedan you can find an old Cavalier for around $1k.  The price is the determining factor.  If both get someone to their destination is it worth paying 20x for the same experience?

As mentioned earlier both are depreciating, both require maintenance, and both have the possibility of breaking down.  If the Cavalier was maintained perfectly and lived it's life in California or the Southwest without rust it's possible that it might be just as reliable as the Civic.  But if the Cavalier prowled the rust belt then it's not impossible to imagine dumping $2-3k into the car each year in replacement parts.

If you let both cars sit without any maintenance then within a few years they'll be worth a fraction of their current value.  The Cavalier by nature of being older and cheaper will depreciate less than the Civic, but both will drop.

Let's take this analogy to the business world.  If a company isn't constantly reinvesting in their own business the value will start to fall dramatically.  There is a narrative that companies invest heavily in the beginning and then can back off investment.  Just like a car, you can hold off on maintenance, but eventually you're looking at a large bill to replace something significant.

I'd argue that if a company is investing heavily in the beginning to remain competitive they will need to continue to invest heavily.  If you own a company that requires constant maintenance why would eliminating that maintenance be a good thing?  Likewise there are some companies that run really well without as much investment, and as long as a base level of investment is satisfied they should continue like this.

Just cars both types of companies can be financially viable, but it depends on the price paid.  Ironically in our current market the companies with the highest maintenance needs are priced the highest whereas companies with the lowest maintenance needs are priced low.  This doesn't make sense.

As you look for investments, make sure you don't pay 2018 Honda Civic prices for a 1982 Chevy Cavalier.

The problem with compounders

Given the choice between a new item and a slightly used item there aren't many people who would willingly choose the slightly used item for the same price.  Why purchase something older with a shorter lifespan when the alternative is a brand new unused object with a full lifespan?

This is similar to the argument the market has been making about companies affectionately called "compounders".  These are companies that have reliably turned $1.00 into $1.20 year after year, effortlessly, like money printing machines.  The argument is why purchase a company that turns $1.00 into $1.09 when you can purchase something that turns $1.00 into $1.20?  Or even worse, why purchase something that turns $1.00 into $.95 or less!

I agree, all things being equal I would prefer my dollars are turned into a dollar twenty, verses something less.  The argument follows that if these compounders can consistently turn $1.00 into $1.20 then whatever price you pay for this perpetual money machine is consistently too cheap.  I know this sounds absurd, but I want to walk through the math.

Let's say you are offered interest in one of these money machines at $75.  That means for each $1 invested they earn $1.20 in earnings.  At $75 you're paying 62.5x earnings.  This seems really high, it will take you 62.5 years of earnings to earn back your original amount.  Except the company compounds.  Which means the $1.20 invested this year turns into $1.44, and $1.72 the next and so on.  In 20 years the company will be earning $46 a year, and in 30 years $284!  In 30 years earnings will have grown 284 times from that original dollar.

The theory is that you're paying 62.5x earnings the first year and even if multiples compress to 1x earnings you'll make money.  At 1x earnings in 30 years you'll have an investment that returned 4.5% compounded.  That seems like an absurdly low multiple, so let's say they compress to a disastrous 10x.  Now the investment compounded at 12.8% a year over those thirty years.

The math above is simple, this appears to be a can't fail investing strategy.  You can buy something that compounds at 20% a year at almost any price and as long as the company continues to compound at that rate you will have a market beating return.  The break-even where the compounded return matches the market's historical return is about 200x initial earnings.  That means as long as you pay under 200x earnings you should beat the market.

You can see why this investment strategy is popular.  Pay anything less than 200x earnings for a company growing at 20% a year, sit back and count your stash.

The problem is that there is a small flaw with this strategy.  Finding those companies that can sustain high growth for 30 years.  The issue is we really don't know the future and predicting something thirty years from now is really hard.  In the market we have a solution.  We look at the past and reason that if a company has the type of culture that can grow at 20% for the last thirty years then that culture will likely let them grow at 20% for the next thirty years.  Maybe we don't need a history of thirty years, maybe only five or ten.

But here's where things break down for me.  A company that has grown at such a high rate will struggle to continue to grow at such a high rate for a long period of time.  Why you ask? Simple math.  A company earning $1b today will be earning $237b in 30 years and have a few trillion market cap.  Maybe that's reasonable, I don't know.  But what about a company earning $5b or $10b?  It will be earning $1t, and a company at $10b earning $2t.  Those are large numbers, especially considering that if the US grows at 2.5% our GDP will only be $38t by then.  Some simple reasoning would show that there isn't enough room in the future market for the number of compounders the current market currently has.

And that's a problem.  Hopefully the US economy won't consist of a dozen companies doing everything from selling washing machines, to clothes, to cars, to search advertising.  And that's the problem with this strategy, there isn't much room for more than one or two of the established large companies compounding at 20% a year to exist in thirty years.  Or for compounding at such a high rate to continue.  A company earning $1b a year compounding at 20% will be 100% of the US economy is less than 60 years.

But that doesn't mean this investment strategy is dead!  The math is still fantastic and it seems like we should be able to work something out.  The only thing is buying larger established companies with sizable profits doesn't work.  Time isn't on their side.  So we'll need to do something different.  We'd need to find small companies growing at 20% a year that can compound.  The reason for this is because a small company with a small profit base has a lot more room to grow before their earnings dwarf the US economy.

And here is where the market diverges from where the strategy works.  The market, and investors in general are looking at large, or larger companies that have a history of compounding.  To make this strategy truly work you need to look at the potential to compound, not a history of it.  And discovering this is a completely different skillset.

Let's dive in.  Two factors are needed to compound capital, the first is growing revenue.  The second is a business model that has operational leverage.  This means for each dollar invested above a certain threshold generates incrementally more.  There are a lot of businesses that operate like this, it doesn't really matter what you decide to invest in either.

What is most important is you find a business with the correct business model that can grow sales.  The sales engine of the company is the most important aspect, and also the one most overlooked by investors and analysts.  Sure, cost structure matters, and business model matters as does "capital allocation", which is what they do with the tiny bit of leftover money, but what matters most is sales.
Herein lies a problem.  How do you determine that a small company with the correct business model will grow sales at a high rate?  The only way to do that is to visit the company and talk to management.  But talking to management isn't enough.  You need to sit down and discuss their sales strategy, understand who their employees are and evaluate the ability to execute on their plan.

This is clearly a dark spot for most analysts and investors.  How do you determine if the sales manager is selling you, or knows what they're talking about?  Especially if there isn't much in the way of results to look at?  I believe it's possible, but instead of having a solid background in financial analysis you need to have sales experience and understand the sales process.  Instead of reading the newest book on investing strategies your bookshelf should be full of books on pricing, call strategies, how to approach demos, and prospecting.  It's also worth remembering that enterprise sales is a different beast from consumer sales, or small business sales.

When you start to put all the pieces of this puzzle together it starts to become more apparent why everyone didn't invest in Starbucks, or Microsoft, or Oracle when they were tiny companies.  To truly catch a compounder when they're in infancy you need a set of skills that few investors possess.  It's not impossible to build out that skill set.  Understanding this paradox also helps to expose the myth that buying high growth companies is a surefire way to success.  Buying high growth companies IS a surefire way to success if you can buy them when they're small enough and their market is large enough.


Vulcan, still plenty of value to be found

I last talked about Vulcan International in September 2015, since then a lot more information has come spilling out about this secretive company.

For the uninitiated, this is a company that is extremely secretive and refuses to release financials to shareholders without a signed NDA.  When this happens it’s usually the case that management is either stealing outright from shareholders, or trying to hide an enormous amount of value.  

The company owns a money losing factory in Tennessee, interest in a building in Cincinnati, and timberland in Michigan.  They also own a sizable amount of marketable securities which dwarf any other asset on their balance sheet.  At the end of 2016 they had $139m in marketable securities, compared to $5m in other assets.

In 2016, the company earned $1.6m, or $1.77 per share, up from $1.235m in 2015, or $1.35 per share.  There are 1,999,512 shares issued and 911,534 shares outstanding.  Comprehensive income, which includes gains from their marketable securities, is significantly higher at $18m in 2016 or $19.73 per share.

The majority of the company’s marketable securities primarily consist of PNC and USB stock.

In the early 2000s a shareholder requested, and received a breakdown of their portfolio of security holdings.  A friend recently went through and updated those old holdings with their 2018 values to include splits and dividends.  As you can see from below, just the security holdings below are significantly more valuable than the company.  It's also worth considering why Vulcan isn't considered an investment company, and regulated as such considering the majority of their value is public stock investments.  (hint, any SEC regulators reading this, and I know that some do, please take a look?).

Utilities Shares Adj Shares Total Dividends Share Value

Vodafone Airtouch PLC (Symbol: VOD) 20016            16,027  $            573,130  $            478,235
Verizon (VZ) shares received in VOD spin 2/24/14 ratio .263 : 1               4,215  $               40,464  $            209,359
Verizon (VZ) 32814            36,608  $            982,960  $         1,818,319
IDARQ spin-off 11/20/06
FRCMQ spin-off 4/01/08
FTR spin-off 7/02/10 ratio .24 : 1               8,786  $               29,747  $              74,329
Bellsouth (now AT&T) (T) 77904          103,222  $         2,090,000  $         3,612,770
acquired 1/3/07--as of 12/29/06 dividends received, 1.325 shares of T            77,904  $            239,170  $                       -  
Cincinnati Bell (CBB) 214100            42,820  $                       -    $            650,864
Convergys (CVG) 182000          182,000  $            329,420  $         4,317,040
Duke Power (DUK) 25000            14,313  $            571,310  $         1,119,596
FPL Group (now NextEra Energy) (NEE) 32375            64,750  $         2,130,000  $       10,500,508
SBC Communications (now AT&T) (T) 109982          109,982  $         2,620,000  $         3,849,370
Qwest Comm. (now CenturyLink) (CTL) 15231 2534  $              45,435
FairPoint Comm. (Verizon spin) (now Consolidated Comm.) (CNSL) 468  $                 5,157
Frontier Comm. (Verizon spin) (FTR) 8214  $              69,490
Enbridge (Spectra Energy (Duke Power spin)) (ENB) 12300  $            361,497
Financial
PNC Financial (PNC) 659090          659,090  $       17,530,000  $       95,574,641
U.S. Bancorp (USB) 783441          783,441  $       10,810,000  $       39,501,095
Other
California Coastal Communities 447 447  $                       -  
Prudential Financial (PRU) 259 259  $              27,749
Principal Financial Group (PFG) 6165 6165  $            376,373
MM Companies 100 100  $                       -  
Piper Jaffray (U.S. Bancorp spin 12/31/2003) (PJC) 7834 7834  $            647,480
Grand total  $       37,946,201  $     163,239,308
Per share $41.63 $179.08

What's even more interesting is how I obtained the company's financials last year.  The sister of the Chairman sent them to me in an unmarked envelope.  No NDA, no description, just raw financials.

Maybe there is some discord in the family and some of the siblings want something to happen?  Who knows.

What stands out when you look over the financials (link here) is that this company needs to dump their Tennessee operations.  The company loses money before dividends primarily due to their manufacturing subsidiary.  A few years ago I spoke to a shareholder who noted that it's been a few decades since they made money on manufacturing.  Just think of all the money incinerated from that factory, it's mind-numbing.

But beyond the ball and chain hanging around this company's ankles the rest of their assets are extremely valuable.

As a friend put it, (paraphrase) "A company like this is like buying gold in North Korea, it has value, but will you be able to get it out?"  Now that North Korea is opening up it's possible to say that anything can happen.  Maybe Vulcan is next!

Disclosure: Long a single share

Two recent media appearances: A podcast and the Benzinga PreMarket show

First off I was interviewed by Eric Schleien on his Intelligent Investing podcast.

Podcast

In the podcast we talked about investing in banks as well as investing in dark stocks and other oddball type names.

The podcast is about an hour long and can be found here:Intelligent Investing Podcast

Benzinga

Second I was on the Benzinga Premarket show a few weeks ago talking about banks and my outlook for the market.  I also highlighted a bank with exposure to Bitcoin as a way to play the Bitcoin trade without  buying the coins themselves.

You can find that interview here: Benzinga Intervivew

Bank Book

Did you know I recently released a book, The Bank Investor's Handbook?  If you liked the Intelligent Investor podcast and want to learn more then you can purchase the book on Amazon, both in paperback and Kindle versions.

I'm giving away all of my bank investing secrets..

It might surprise you to find out that the most frequently visited page on this blog is a post I wrote in February 2013.  It was called A Banking Primer, where I gave a very high level summary of how to analyze a bank.  Almost four years later and that post still receives 30+ views a week.  It's safe to say that investors are interested in learning about banks.

Instead of putting together a series of posts that are hard to follow, I decided to do something different.  I decided to write a book on how to find, analyze, and invest in bank stocks.  This was a project I started shortly after my bank primer post that I finished recently.  The result is The Bank Investor's Handbook.

The Bank Investor's Handbook lays out a complete framework on how to approach bank stocks.  From finding potential investment candidates, to analyzing banks, valuing banks, and finally building a portfolio of bank stocks.

We set out to create the definitive guide to investing in bank stocks.  Most books on banking are as exciting as reading a dictionary.  This book is different.  It presents banks not as opaque entities best left to the experts, but instead as tangible companies that can be understood by anyone with familiarity with financial statements. 

This isn't a glossary of banking terms, or dense hard to understand charts and tables.  But rather a guide that walks you through a bank's financial statements.  You'll learn how to spot red flags, and how to identify a high quality bank.  You'll also learn different ways of valuing banks, as well as a comprehensive approach to analyzing them.  And we hope you'll be entertained too.

It won't do the work of finding, analyzing or investing for you, but it will give you the information and knowledge to start.



You can find the table of contents here.