Monthly Archives: March 2009

Warren the Impulsive?

buffettIn the summer of 1983, Warren Buffett sauntered into Nebraska Furniture Mart, then Omaha’s privately-owned, market-trouncing behemoth run by Rose Blumkin and her family. After a look around, Buffett asked “Mrs. B” to sell him the place. Mrs. B said sure, for sixty million. Buffett shook her hand, and the deal was sealed.

A familiar story for Buffetteers it is. And told so, it affirms the mystique associated with Buffett’s decisiveness. As he himself has relayed in his annual letters, business owners looking to sell can usually receive an answer from Buffett within five minutes.

Yet, as with most good yarns, the real history rarely runs that way. In the case of Nebraska Furniture Mart, Buffett had been stalking the furniture giant for quite some time, having even made an offer much earlier in his career, which Mrs. B deemed “too cheap.” As Roger Lowenstein recounts in his Buffett: The Making of an American Capitalist (Random House: 1995), Warren had expressed his lust for the Mart to business writer “Adam Smith” in the early seventies, spouting off its operating statistics—volume, floor space, turnover, etc. And this for a private company.

Before that happy day in 1983 (Buffett’s birthday, in fact), Buffett had heard that Mrs. B was entertaining a $90 million offer from a German furniture retailer. Prior to his offer, Buffett had studied the Furniture Mart’s tax returns and found that it had earned $15 million pre-tax in years previous. Buffett had met with her son Louie and discerned the price point that Mrs. B had in mind. He knew that the Mart’s $100 million in sales commanded two-thirds of Omaha’s furniture sales, and its moat so wide that Dillard’s refused to sell furniture in Omaha. Mrs. B “had a toll bridge to the living rooms of Omaha” (Lowenstein 250).

I’ll admit—the familiar story tells better than the truth. But the truth will better serve the fellow investor. Decisive action may give the appearance of reckless impulse, but in the case of Buffett, it is merely a convenient façade that covers detailed preparation and measured calculation.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Valuing Target

target-logo-copy1Friday we compared some big box retailers and argued that Target must serve up its wares with some secret sauce, for it has relatively strong margins. However interesting, if we are to assess Target as a business owner, our analysis should quickly move to its assets and earnings power.

First, the assets. At the close of their fiscal year—January 31, 2009, Target had 44.1 billion in total assets versus 10.5 billion in current liabilities and 19.9 billion in non-current liabilities; shareholder equity then stood at 13.7 billion. Yet, some have argued that Target’s balance sheet currently understates the value of two important assets—their remaining stake in their credit card business, and their real estate property. For example, William Ackman, founder and fund manager at Pershing Square Capital Management, has recently been agitating Target’s management to spin off some of its real estate into a REIT-like structure, with the assumption that the two parts valued separately would demand a higher price than the current aggregate. So what are these two important assets worth?

In 2008, Target sold half of its credit card business to JP Morgan for $3.6 billion; today the remaining half may not fetch the same price, but it is unlikely that it would be worth less than $2 billion. Pershing, in its public presentation on Target, values the remaining credit card receivables at $4.4 billion. A strict average would put a price of about $3.3 billion on the credit card business.

As for the real estate, estimates range widely. In Pershing’s public presentation of its REIT plan on Oct. 29, 2008, they highlight that the gross book value of Target’s owned real estate is $25.2 billion, and its replacement value near $39.1 billion. Were the REIT spun off, Pershing estimates that it would carry an equity value of $29 billion within twelve months (see the Nov 19, 2008 follow-up presentation). Again, a strict average of these three estimates would price the real estate at $31.1 billion.

Of course, there still remains the question of Target’s value as an operating retailer. Any valuation estimate would require some sales and earnings assumptions, but if we take their trailing 5 year average EBIT at $4.5 billion and give it a 6x multiple, we could conservatively value Target’s operating business at $27 billion. In sum, these three parts should carry a fair value of $61.4 billion to a private owner. As of Friday’s close (3/27/09), the market valued the entire company at $25.7 billion.

So, what’s the market missing? If Target is currently valued at less than 50% of its intrinsic value, shouldn’t bargain hunters be snapping up shares?

In my lights, the answer is cash flow. Looking at Morningstar’s numbers, one can see that Target’s free cash flow is quite low, given the wealth of assets that they must use to generate that cash. In fact, it has only broken a billion in FCF once, in 2006. For Target, almost all of its cash flow has been poured back into its business, with capital expenditures consuming at least 75% of its cash flow on an annual basis, for at least the last decade. And the crucial question for the shareholder must be, how long will this endure?

At some point, Target’s FCF does not find its most profitable home in future expansion. Hopefully that point is in the future, but it may be already past. Once Target has built enough stores, future stores will cannibalize the elders. And at that point, capital expenditures will need to come down, and the excess cash flow redirected into more productive endeavors. This is the crucial capital allocation test for retailers; can they transition their strategy prudently? Given Target’s current share price, a good number seem to doubt that they can.

Disclosure: No position

Retailing and Moats

target-logo-copyFew retailers benefit from an enduring economic moat because many goods stocked on their shelves reside at their competitors. Seemingly the only thing to distinguish their goods is the price. Hence in retail, the widest and best moat is found around the business that consistently offers the lowest price. As Charlie Munger observes, “retail is a very tough business. [Warren and I] realized that we were wrong. Practically every great chain-store operation that has been around long enough eventually gets in trouble and is hard to fix. The dominant retailer in one twenty-year period is not necessarily the dominant retailer in the next.”*

Though only fools would dare position themselves contrary to Munger, it is striking, when one surveys the American retail space, how many retailers appear to thrive. Of course, Circuit City and Linen ‘n Things have recently taken the fall, but the majority still remain, even amid this dire economic environment. Yet, when I survey the survivors, it is hard to discern any economic moat, much less a wide one. The washing machines at Lowe’s, at Sears, and at Best Buy appear virtually indistinguishable; the same Dockers line the walls of Sears, Kohls, and JCPenney. Yet, more of our family’s dollars find their way to Target than any other, even though Wal-Mart often offers better prices. Are we doubly fools, or does Target offer something which its competitors do not?

Looking at the numbers, Target has 351,000 employees, which produce 64.95 billion in sales, at a gross margin of 28.6% and an operating margin of 6.78%. Sears is likely their most similar competitor—in inventory, assets, and sales—and it has 324,000 employees, producing 46.77 billion in sales, at a gross margin of 27.05% and an operating margin of 1.31%. Wal-Mart, with its gargantuan 405 billion in sales, brings a lower gross margin of 24.52% and an operating margin of 5.6%. (So that’s what we should mean when we say we will make it up on volume.)

With these numbers, Target’s excellent margins leap from the page—an observation which seemingly runs contrary to our opening thesis: that offering the lowest price produces the best competitive advantages in retailing. So the question is: how can Target sell the same stuff for higher prices than its competitors?

My hypothesis is that Target offers a unique shopping experience, one which many women in their 20s, 30s and 40s particularly love. I say women largely based on my own idiosyncratic anecdotal evidence. For one, my wife and her sisters craft their weekends and shopping needs around a weekly excursion to Target, and it is indeed an excursion, because most of the trip involves just walking around, picking over shoes, accessories, clothes, baby gear, towels, sheets, and household décor. For all of these items, I have never seen any of them make a purchase from Wal-Mart or Sears. And of course, once you’re in the door, the convenience brings household goods and groceries into your cart.

Perhaps more interesting and illustrative is a simple Google search for “I love Target” or “Why I love Target.” Compared to competitors, the fan base is quite remarkable. “Target Brand Boxed Riesling is packaged in such an irresistibly cute green box that I could not resist it.” “Tonight I popped in Target after teaching a Kindermusik class… I ran across these shoes [picture].” “This is why I love Target… I want to kiss the person who designed them and make out with the person that decided to only charge me $30! LOVE IT! [link]” Sure, such banter is fun, spontaneous, and whimsical, and not too much should be drawn from it. But it does strike me that Target has established a shopping experience, shared by many, that compels sales of superfluous goods at profitable prices.

Fans talk about wide, uncrowded aisles, the shoe designers, the lighting, the employees. The reasons are multiple, but the passion is earnest. When thinking about the prospects of Target’s moat, it is hard to interpret the competitive advantage expressed by this passion. But certainly something is there that other retailers are missing.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

* Schroeder, Alice.  The Snowball: Warren Buffett and the Business of Life (Random House, 2008): 332.

‘Buffettology’ Review

buffettologyToday I spent some time with Mary Buffett and David Clark’s Buffettology (Simon & Schuster, 1997), which highlights Buffett’s divergence from his teacher Ben Graham over the years, leaving behind the “cigar butt” approach to investing in favor of buying excellent businesses at good prices.

Though the book offers few quotes from Buffett and is rather impressionistic, it does seem to fairly represent his approach. Of course, we took particular interest in Buffett and Clark’s description of excellent businesses.

They observe that an excellent business either: 1) “[makes] products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business,” 2) “provide a repetitive service manufacturers must use to persuade the public to buy their products,” and 3) “provide repetitive consumer services that people and business are consistently in need of” (119).

One obvious similarity is that recurring revenues are key. Not only do repeat customers imply that they have a deeply felt need for the products, but they ensure that long-term capital expenditures can profitably return capital. However, rather than invest in the retailers of such products (they get lots of repeat customers after all), one must concentrate investment capital in manufactures, for buyers want Coca Cola and couldn’t care less about the venue that sells it to them. The retailer then needs the product, more than the manufacturer needs the retailer, and thus the retailer holds little leverage against the manufacturer to negotiate on price.

Similarly, rather than invest in the vehicles of communication (cable, radio, and newspapers), better to buy the advertising agencies which build the “conceptual bridge” between manufacturers and customers. Network television and newspapers have lost numerous eyeballs and substantial revenue to the Internet, but advertising companies are still needed to shape a message, regardless of how it is ultimately delivered.

Lastly, Buffett and Clark argue that it is better to invest in companies that provide repetitive consumer services—like tax services, or credit card networks, or pest services—than dispensable services. In a slow macroeconomic environment, some may give up personal conveniences, but they will still need tax expertise, credit cards, and insect control.

Given this emphasis on recurring revenues, the majority of the book’s examples derive from basic consumer goods—Coca Cola, Philip Morris, Kraft, Conagra, The Hershey Company, Campbell Soup, Pepsi, Kellogg’s, Sara Lee, McDonald’s, and WD-40. Though few would deny that these are excellent businesses, this recognition is about as basic and common as could be, and all of these companies accordingly trade at premium valuations (even in the midst of a bear market).

All told, the most interesting and illustrative example was their description of Buffett’s purchase of General Foods in 1979. Buying shares between $28 and $37, Buffett’s stake was eventually bought out by Philip Morris for $120 in 1985. Here was a company selling well-known brands of consumer goods, purchased at six to seven times trailing earnings, when Treasury bonds were yielding 10%. Because General Foods could grow retained earnings at an above average rate (and protected the investor from paying tax on the full share of earnings), it ultimately outperformed the bonds. In this, General Foods looks similar to Buffett’s later purchase of Coca Cola. In both cases, the equity was not obviously cheap (relative to other investment options), yet both still beat the market’s returns.

Follow Thy Neighbor (if he’s Buffett)

influence1Today we take a third lesson from Dr. Cialdini and his book Influence: Science and Practice (2nd Ed., HarperCollins, 1988). In the first lesson, we observed the mental mistakes that can follow from perceptual contrast; in the second, we saw how our penchant for unflagging commitment may push us to fall in love with our worst investments.

A third form of influence that can be detrimental to investment performance is social proof. That is, when “we determine what is correct by finding out what other people think is correct” (110). In general, social proof looks sensible; if one doesn’t know what to do, presumably someone else does, so he should follow another’s cue. As Cialdini notes, “as a rule, we will make fewer mistakes by acting in accord with social evidence than by acting contrary to it” (111). Applied to public security markets, social proof entails respecting the market price of a given instrument. What more social proof do you need than the current market-clearing price? The market has spoken. That’s what the business is worth.

Yet, a fairly basic problem lurks here. Out there in the world some actors know what they are doing, but other prominent actors clearly do not (e.g., Lehman, AIG, Madoff). Of course, it is not easy to discern which is which, but it is clear that if we could follow the savvy smarts and disregard the duds, we would be better off (in life and in investing). For example, if we pay particular attention to how Tiger Woods prepares for and plays golf, we’ll do better than if we follow Wide Moat. And we can confirm this because their results consistently diverge over time. Likewise for investing, if we follow the footsteps of Buffett and train our minds to be like his, we will do better than if we were to follow the Beardstown Ladies. While the principle of social proof pushes us to follow any and all leaders, the truth is that we just need to find and follow a good leader.

Of course, in the markets, this assumes that there are better and worse investors, and that we have some tools to reliably differentiate them. Further, it suggests that the successful investor must have the chutzpah to invest contrary to the majority of market participants when they are wrong.

So how does one resist the tendency to join the crowd? For one, the valuation of a given business should take place, as far as possible, before reading news articles, research reports, and blogs. If one can value a business independently, the hooks of social proof will likely not snare him. Second, one must find a way to reliably distinguish the best investors from the crowd–I give my vote to demonstrated, audited, and long-term results. And third, one must not take the consensus view on a security to be decisive. Given our interest in Sears, it is surprising to us that Sears is the most hated stock whose market cap exceeds $250 million. Of course, today’s consensus may ultimately be correct; crowds can be right. But until the cash flow numbers show even greater deterioration, we’re going to stick with our positions.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

Add a Dose of Ready Mix?

bannerleftOne interesting microcap I’ve been studying recently is Ready Mix, Inc., a supplier of ready mix concrete, sand, and gravel products based out of Phoenix, AZ. As of Feb. 25, 2009, 3.81 million shares were outstanding, and 69.4% of those held by Meadow Valley Parent Corp., which was recently acquired by Insight Equity I LP. At Monday’s close of $2.42 per share, the market values the company at $9.22 million.

Like too many microcaps these days, Ready Mix trades far below its book value of 26.44 million (as of Dec. 31, 2008), with 6.04 million in long term debt and $4.2 million in cash. This substantial discount to book is most likely because their revenues and earnings were down from 2007, with annual revenues off about 20%, and earnings per share swinging from 36 cents in 2007 to a loss of 77 cents in 2008. Earnings and revenues were down in 2008 largely due to the decrease in construction spending in their primary markets of Phoenix and Las Vegas. Though management acknowledges that residential construction will not add significantly to their business prospects in 2009, one should note that housing permits were down 59% YOY in 2008, and that annual housing permits are currently at all-time lows (since the Census began tracking starts in 1959). Though residential construction will not bounce quickly in their markets, it is highly unlikely that housing starts will fall much from these levels. If that prediction proves true, Ready Mix may be currently hovering just above its trough level of earnings, and far underrepresenting its true earnings potential.

In the face of a tough construction market, Ready Mix has taken steps to further tighten its belt, even though they did close the year cash flow positive in 2008, due to $4.69 million in annual depreciation expense. For one, Ready Mix has trimmed their administrative salaries and bonuses in recent months. As of Dec. 31st, they only had 24 full-time salaried employees, with the remaining 211 employees hired on an “as-needed” basis. Furthermore, in their most recent conference call, management confirmed that no significant capital expenditures will be made in 2009.

However, the most intriguing piece of this puzzle is Meadow Valley’s majority stake. At current market prices, the remaining portion of Ready Mix is only selling for $2.82 million (i.e., 30.6% of their current market cap). In February’s conference call, management acknowledged that the cost of remaining a public company costs Ready Mix about half a million dollars per year. At current prices, Meadow Valley could take Ready Mix private and make up the capital outlay in less than six years, essentially getting the remaining assets and future earnings for free. Furthermore, it is likely that a Meadow purchase would yield additional SGA savings, as overlapping administrative functions could be streamlined or trimmed. With the Insight Equity deal now closed, Meadow Valley’s management now has the freedom to get back to growing its business and making acquisitions. Given its current stake, Ready Mix looks like an attractive candidate at a cheap price.

Disclosure: No Position

Loving the Loser

influenceHave any dead equities to cull from your portfolio? Has the recent market rally thrust you into the role of the butcher? If so, why did you wait, or why are you waiting? Is the delay reasonable and prudent? Must you wait until you get back to even?

As many studies have shown, investors consistently stumble over the same mistakes: they sell their best performing stocks too quickly, they hold their worst performing stocks too long, and they trade too frequently. Today we will take a look at the second mistake—let’s call it “loving the loser.”

Dr. Robert Cialdini, in his Influence: Science and Practice (2nd Ed., HarperCollins, 1988), describes an important psychological principle that may be the culprit for foolish loves—many people find comfort in mindless consistency. In complex societies that demand daily decisions, opportunities for anxiety abound. Patterned behavior and principled thought may alleviate some anxiety, but researchers have observed that this bliss may come at a cost, because opportunistic sales personnel can take advantage of our habits.

For example, Cialdini narrates how toy companies purposely over-market and under-stock the most desirable toys of the holiday season. Knowing that children will nag their parents for the desired treat, and expecting that a few earnest parents will promise and fail to deliver, toy companies can exploit our love of consistency and propel more sales. For if the most desirable toys are out of stock in December, parents will have to buy something else. But the child’s memory will not wane, and the committed parent will return in January or February to make good on his word.

Of course, Cialdini acknowledges that, in the right situations, commitment and consistency are considered virtues, and they should be. The problems occur though when others exploit consistency for their personal gain and the other’s harm. For example, in the Korean War, Chinese interrogators had much more success in getting American POWs to divulge secrets than the Japanese did in WWII. This was because their strategy involved getting the POWs to make seemingly innocuous, or mildly critical, statements about the United States and then commit those words to writing. Over time, the interrogators would ask them to read their words aloud to other POWs, and defend their claims. Over time, in a desire to be consistent with their past proclamations, the POWs began to see themselves as “collaborators,” and their resistance ultimately wilted.

In investing, the desire for consistency may be at the root of loving the loser. Desperately wanting to believe that our initial judgment about a business was correct, we wait until the market price confirms it. Too often though that time never arrives. And as the prospects of a company or industry continue to worsen, our passivity in mindless consistency saps our portfolio returns.

So what should one do? One solution may be that, before every investment, one should put down in writing the primary reasons why the security is undervalued. Then one should also note potential eventualities that may cause the business’ competitive advantage or financial situation to weaken. If one can determine in advance and commit to writing down the relevant factors that may change an investment thesis, our commitment tendency can then work in our favor, rather than against us. Ideally, one would be able to rationally evaluate a business’ prospects at periodic intervals and sell off those investments whose fundamental characteristics have worsened. Yet, given our penchant for mindless consistency, perhaps writing down potential weaknesses in advance may be a highly profitable second best.