Street Capitalist: Event Driven Value Investments

I had a chance to interview Zeke Ashton of Centaur Capital and manager of the Tilson Dividend Fund. I think you’ll enjoy the interview. Ashton is a generalist, he is willing to short stocks, and looks across all types of companies — from microcaps to large caps. Plus, he’s based out of Texas. I’ve been hoping to showcase more Texas-based fund managers to prove that we’re not all energy traders down here.

Please give me your thoughts on the interview in the comments section or feel free to e-mail me. I’m always looking for new investors to interview.

You can find more about the Tilson Dividend Fund here or learn more about the fund’s performance via Morningstar.

My questions are in bold.

Can you give us a brief bio of yourself and how you came to run Centaur Capital?

I started my career in the financial software business as a consultant deploying complex treasury and risk management systems for large banks and conglomerates, mostly in Europe. At the time, I thought that my natural career progression might be to become a risk manager for a large bank or insurance company.

Somewhere along the way I developed an interest in the stock market and discovered Warren Buffett’s Berkshire Hathaway letters and was immediately hooked. I also was a big fan of the Motley Fool website, and when I decided that I wanted to change careers to investing, I was fortunate enough to land a job there. I moved back to the States and started working for TMF as an investment writer in early 2000 – just in time for the bear market. I spent two years writing articles and research on investing for TMF, which enabled me to learn and refine my own investing approach.

In 2002, I decided that I was ready to start investing professionally, and moved to the Dallas area and started Centaur Capital Partners. I set up a private limited partnership and opened for business with less than $1 million under management, and it took several years to get to the point where Centaur Capital was a viable business. In 2005, we launched a mutual fund called the Tilson Dividend Fund (TILDX) in partnership with our good friends Whitney Tilson and Glenn Tongue at T2 Partners, and that has done well. We’ve now been in business for eight years, and while it’s not been without its challenges, overall I feel very fortunate to be where I am today.

A while back in 2007 at the Value Investors Congress, you gave a presentation (PDF) about how you think about asset allocation at Centaur. Is it largely the same today? Or has the financial crisis influenced your take on capital allocation?

That VIC presentation was primarily a discussion about portfolio construction, and it was really in reaction to what I thought was a growing pressure amongst value investors to run excessively concentrated portfolios. Keep in mind that this was 2007, and the market had produced a long stretch of good returns from 2003 to early 2007. The book “Fortune’s Formula” had become quite popular, and there were many discussions amongst investors about the potential for employing the Kelly Formula as some sort of secret sauce that would allow investors to increase returns by increasing concentration.

My own view is that most investors are better off running portfolios of 15-25 stocks because such a portfolio would ultimately be a truer reflection over time of an investor’s skill. In other words, a 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor. One of the points of emphasis in that presentation was that concentration shouldn’t be a constant, but rather should be idea and environment dependent. It has always seemed to me that each idea in the portfolio should be sized based on a careful assessment of the body of evidence available for that idea, with particular emphasis on risk factors. This would include factors such as how deeply the security appears to be under-valued, how predictable and reliable the business is, how it is capitalized, the quality and track record of the management team, and even how familiar the investor is with the idea. Also, it should be influenced by the presence of clearly correlated ideas in the portfolio.

I believed then and I believe now that using the flexible 20-stock model portfolio position sizing exercise that I described in the presentation is a very solid framework to start with. In looking back over that presentation today, I wouldn’t change a thing regarding the content of that discussion. But I’d sure like to have the stock picks back – I presented four ideas at that conference and three of the four performed very poorly in the bear market that followed.

How long do you study a potential investment before you decide to buy? After initiating the position, do you continue your research process on the name?

We generally produce a research document that covers all the important components of the investment, both qualitatively and quantitatively, prior to investing. For a simple idea, the document may well be five pages long. For a very complex idea, the report will be longer. But regardless of the complexity of the idea, writing a research document using a fairly standard template serves as both a form of checklist for us and ensures that we both understand the idea and can articulate why the idea meets our criteria for both value and safety. It also allows for a “quality check” in that it can be reviewed by a second analyst internally and even potentially by contacts outside of our shop that may be able to review our work and provide some insight back to us.

You have mentioned in the past that you are increasingly looking at macro data when making an investment. What kinds of macro indicators do you look at? Has there ever been a situation where a stock looked cheap but you did not invest because of the macro?

I wouldn’t say necessarily that we look at macro “data” when making an investment. It is more the recognition that an otherwise compelling idea can get overwhelmed if the larger forces surrounding that idea are negative enough. Going forward, we will probably be a little more cognizant of looking for the larger risks that could really hurt us as investors. As for an example, we basically decided in mid-2008 that we weren’t going to invest in any bank or other leveraged financial business given our concerns about the credit environment, and we sold the one stock he held at that time that qualified, which was American Express (NYSE:AXP). Granted, this was an extreme case, but it did help protect us from the worst of the permanent capital losses that many of our value investing peers suffered in banks and other leveraged financial stocks.

I suspect that our approach going forward when assessing ideas where we have identified a major industry or macro risk would be to use smaller position sizes, demand more compelling prices, or actively look for a way to hedge out any obvious macro risk that we identify if it can be done in a cost-effective way.

When you use valuation methods like DCFs, what kinds of factors do you look at when forecasting? Is it mostly things in the current-year, the past, or your own predictions? How far out do you model?

We use DCFs more as a sanity-check and to reverse engineer current market expectations than to try to produce any kind of precise valuation. When basing our views as far as what the future might look like, we try to look at a longer view of the company’s operating history (normally five to ten years) to see how the business has done over time. As an example, one of our larger current positions is Lab Corporation of America (NYSE:LH). Qualitatively, this is an outstanding business with tremendous barriers to entry. There is something of a Coke / Pepsi dynamic in the laboratory services industry, with competitor Quest Diagnostics (NYSE:DGX) the slightly larger company in the industry and LH being a strong number two in terms of revenues. LH has been a consistent but moderate grower over many years, with revenue growth in the high single digits and free cash flow growth at around 10% for the last five years. In looking at the recent stock price of around $72, when we plug the numbers into a DCF spreadsheet, we find that the market basically assumes that LH will never be able to grow its free cash flow at more than 2% annually going forward forever. Our view of the company’s growth prospects is significantly more optimistic than that.

So that’s our first sign that LH is a potential opportunity for us.

If I drop in even 5% average FCF growth for LH going out for ten years before dropping down to a terminal growth rate of 2% after that, my spreadsheet tells me the stock is worth $96. Because I’ve owned LH in the past and am extremely familiar with the business, I am very comfortable taking the view that the company will be able to grow its FCF much faster than the current market price is discounting. I don’t have to be super precise. When the stock gets to $85-90, it will be a closer call and I will probably respond by reducing our position size somewhat. So we try to use the full body of evidence we have available about a company, but in general we just don’t buy stocks that require heroic growth assumptions to justify the current price.

You operate largely as a generalist. Sometimes that entails investing in unfamiliar industries. Can you give an example of a case where this happened? What were some of the things you specifically did to learn the ins and outs of the business?

Yes, being a generalist means that one needs to have a framework for getting up to speed quickly when looking at a company or industry that is new for us. So we have learned to quickly identify the business model, which gives us a huge head start in terms of how to approach the research. There really probably aren’t more than a dozen or so basic business models in existence and most companies employ a variation of one of them. Then we start our study of the targeted business and some competitors, and we start reading annual reports, industry publications, and whatever we think we need until we feel we have a good handle on the business. One of the good things about this business is that knowledge is cumulative and the longer I’ve been investing, the more businesses and industries I’ve become familiar with and the faster I am able to get up to speed.

What is one company that you think you would be comfortable with buying and holding for 15 years? Why?

That’s an interesting question, and I’m going to have to answer it by changing your question a bit. We’ve come to believe that if your goal as an investor is to compound at high rates (our goal is 15-20%), that a “buy and hold” philosophy for 15 years simply isn’t likely to work except perhaps in very rare cases. To get that kind of return, you have to buy stocks when they are undervalued and sell them when they are fully valued. Therefore, to give you a stock that I’d be comfortable buying and holding for 15 years simply doesn’t reflect our philosophy, since over a 15-year period we’d expect to have the opportunity to buy a stock at discounted prices and sell it back at full prices multiple times. Of course we are prepared to wait a long time if necessary to get fair value for our holdings, and there are other cases where the performance of the company results in ever-increasing estimates of fair value such that we can hold on to the position for a long time. But we are usually hoping that we will be able to get full value for our stocks within 2-3 years of purchasing them.

So let me give you a list of companies that we admire and that we very much like to own when the stocks are cheap: Fairfax Financial (TSE:FFH), because we admire Prem Watsa. Berkshire Hathaway (NYSE:BRK.A / BRK.B) of course. In our current portfolio, I like Lab Corp (NYSE:LH), Dreamworks (NASDAQ:DWA), and a small Canadian company called Ag Growth International (TSE:AFN). In all of these, I either have a great deal of comfort and admiration for the management team, or else the business is extremely unique and enjoys a strong competitive advantage.

One of the things that value investors often talk about with shorting is how it gives you potentially unlimited losses. How do you manage risk with shorts?

Shorting is a very tough business, and we continue to learn new lessons every year. I have come to the belief from talking to several guys who are more experienced than myself on the short side that the best way to manage risk is to keep position sizes small and have a slightly more diversified short book. We also limit the size of our overall short exposure. Unlike the long side, where we have no individual position loss limits, we have historically used a position loss limit on short positions, though over time it has probably hurt us as much as it has helped us.

Can you give an example of a past investment mistake? What do you think happened? What did you learn?

Sure. Rather than give you a specific mistake, I’ll give you a category mistake that we’ve made more than once and that I therefore think is one that investors are extremely vulnerable to. The mistake is one of commitment bias, where for example we will decide that a given idea is very compelling but due to its potential risk is justifiable only as a small position. For example, every once in a while we find ideas where there is a very wide range of possible outcomes, but where either the potential magnitude of the return in the good case scenario is very high or we think the probabilities are favorably skewed in our favor. On balance, we’ve done OK with this kind of idea. The problems have come when we’ve initiated the position at an appropriate position size (say, 1% of the fund, or 2% or whatever) but then the stock declines either because of some new development or for another reason. We’ve often added to the stock and built them to inappropriately large position sizes simply due to the lower price, rather than sticking to our initial game plan of limiting our bet. Because of this, we’ve occasionally made what would have been a small loser into a bigger loser.

Another and similar mistake is reacting immediately to a sharp decline in an existing holding on negative news without taking adequate time to fully review the new information to ensure that making the additional deployment is justified by the new development. We try now to be rigorous in ensuring that each incremental add to an existing position is truly justified by the existence of a widening discount to our expected range of fair value and not due to some embedded commitment to the name.

What are some of your favorite books? Investing or non-investing related.

I kind of like to follow good writers around. For financial-related books, I always like to read anything by Roger Lowenstein, with particular nods to his biography of Warren Buffett as well as his book Origins of the Crash that described the causes of the tech and large cap bull market of the late 1990’s. I think Michael Lewis does fantastic work – his latest of course is The Big Short, but I also loved Liar’s Poker as well as his non-financial books The Blind Side and Moneyball.

How do you look at the market cap of a company? Are you less willing to invest in large caps? Do you see more opportunities in one than the other?

No, we don’t care what the market cap is. We are looking to get the best combination of value and safety out of our investment dollars as we possibly can. I do think that large cap, high quality stocks are as cheap now relative to the rest of the market as I’ve ever seen them, and that being the case our portfolio is more heavily weighted to large company stocks than it has been for most of our history.

Can you give us a company that you think is undervalued/attractive right now? What is your thesis there?

Sure. Lab Corp is our biggest position, and I’ve already explained our thinking there. Let me give you an esoteric one. This one is a small position for us, because the stock trades on the pink sheets and isn’t very liquid. Therefore, I’m not making a recommendation, only naming a stock that I personally think is undervalued and attractive. The company is Mass Financial Corp (PINK:MFCAF), and it trades in the U.S. on the pink sheets under the ticker MFCAF. MFC is a merchant bank specializing in a combination of traditional financing services and proprietary investing, primarily involving commodities and natural resources. The business is run by Michael Smith, who is also the chairman of the company formerly known as KHD Humboldt Wedag and is now called Terra Nova Royalty Corporation (NYSE:TTT).

MFC was spun out of KHD in January 2006, and had negligible book value at the time of its spin-off. The stock trades for $9 and change, and has a market cap of approximately $200 million. In the last four years, MFC has averaged over $40 million in net income and over $50 million in free cash flow. Here’s the book value per-share at the year-end each of the last four years, starting basically from zero at January 2006 (note that the book value per share figures are adjusted for a 9% stock dividend issued in late December 2009):

December 31, 2006 $2.43
December 31, 2007 $4.39
December 31, 2008 $5.71
December 31, 2009 $9.72

Going back further, prior to folding MFC into KHD, Michael Smith ran the company (then called MFC Bancorp) from 1984 to 1995, and during that stretch he grew book value from $1.49 per share to $17.09 per share, which is a pretty impressive performance. Overall, we think that MFC is a very intriguing investment at a discount to book value given the impressive track record.

The downside to an investment in MFC is that there is never really any way to know what Michael Smith is up to. Smith’s policy is to report financial results every six months, and only issues press releases when a material development occurs. In addition, the company’s disclosures are not as highly detailed as one might like regarding its merchant banking and direct investment activities. Nevertheless, the performance of the company speaks for itself, and MFC has an extremely strong and liquid balance sheet and uses very little leverage in its activities, making the historical performance that much more impressive. A couple months ago, MFC took over a majority interest in a micro-cap Canadian listed company called Canoro Resources (CVE:CNS), which has some very interesting oil and gas assets in India. As I mentioned, MFC is a small position for us, but I like having it in the portfolio.

Zeke, thank you for taking the time to interview with Street Capitalist

A while back I mentioned that Monsanto might be a company worth looking at because of their competitive advantage in the seed business. Unfortunately, the stock has moved a lot since we first posted about it at the end of June:

Up 21% in a little less than a month! Too bad I didn’t buy it back then.

Monsanto (NYSE:MON) has been a real innovator in their field, here is how they define their business:

Monsanto Company (Monsanto) along with its subsidiaries, is a worldwide provider of agricultural products for farmers. The Company’s seeds, biotechnology trait products, and herbicides provide farmers with solutions to produce foods for consumers and feed for animals. The Company operates in two segments: Seeds and Genomics, and Agricultural Productivity.

The thesis you often hear from agriculture bulls of the company is that if the developing world truly does continue its pace of development, we’re going to need more food to nourish those people and that food is going to be grown with the help of Monsanto’s products. Then, if there is a bull market in agricultural commodities — Mosanto’s products will be needed in order to help give farmers the ability to increase their yield and sell for higher prices.

So then what has been the bear case?

We just got out of an agricultural commodity boom and one of the things Monsanto did was steadily increase pricing on their products as the prices of commodities continued to rise. This made a lot of sense when prices for commodities were high, they were able to capture the benefits from the increased yield in their crops. But Monsanto did not adjust pricing as commodities started to fall. That caused a drop in sales which led to an increase in inventories.

Now, I haven’t had a chance to do much valuation work on Monsanto. I know the company on a more qualitative basis. But, Glenn Busch from ValueInvestingCenter has taken a stab at valuing the company:

The Seed and Genomics division is by far the largest division at Monsanto CO. (MON) based on revenues; it accounts for 62% of Monsanto’s revenue. In fiscal year 2009 the Seed and Genomics division had $7.29 billion in sales. For fiscal year 2009 the Seed and Genomics division had a Gross Margin of 61% and an Operating Margin of 22%. In 2008 Seeds and Genomics had an operating margin of 18%. The increase in margins has been due to the launch of newer- higher margin products. Margins are expected to continue to increase further based on more launches of higher margin products like Genuity VT Triple Pro Corn.

For the discounted cash flow that I will run on this division I will use an operating margin of 20% even though recent margins have been higher and are expected to increase further. I will use current interest expenses and taxes but I will use normalized Statement of Cash Flows line items. For growth rates, I will use the median analyst estimate of 10% and the lowest analyst estimate of 6%. I will use 10% as the discount rate because Monsanto CO. (MON) is a large multi-national company with minimal debt and a leader in its field. Currently, Monsanto Co. (MON) has 545 million shares outstanding and to keep it simple I will not factor in any share buybacks.

Below is the range of values for the Seed and Genomics division.

6% Growth = $51.00
10% Growth = $59.00

With Monsanto Co. (MON) currently trading around $57.00 we’re pretty much getting fair value for the Seed and Genomics division and everything else free.

Valuing Monsanto Co. (MON) (Value Investing Center)

According to Busch, one of the problems was in Monsanto’s agricultural products division. Monsanto produces a herbicide called Roundup, which featured lower adoption rates due to a flood of competitors (they lost patents) and some customers over pricing. They’ve had to reduce prices to clear out excess inventory which has carried over into their margins. Here is Glenn’s take on the division:

I will value the worst case scenario like a perpetuity using a discount rate of 10%. I’ve chosen to value the worst-case scenario like a perpetuity because Roundup is still the largest selling glyphosate product on the market. Glyphosate is also the largest herbicide in use and has been this way for a long time. Monsanto lost its U.S. Patent in 2000 and still has maintained a high level of Roundup sales. I would expect Monsanto to continue to sell more Roundup than what I’m basing this valuation on.

Below is my value for the worst case scenario.

$3.90

Valuing Monsanto Co. (MON) (Value Investing Center)

So in Glenn’s low case, Monsanto is worth $54.90 all together versus a current price of $57.32. Not a bargain, but it could be if we see another AgBoom because Monsanto could simply increase the prices on their products and reap the benefit. Glenn talks about this towards the end of his write up, which you should read to get the whole picture. I’ve only excerpted part of it.

A couple of days ago I saw this message on Twitter about Global Cash Access Holdings (NYSE:GCA):

That piqued my interest. I’ve had some success in the past with investing in companies after they lose a major customer. In this case, Harrah’s made up 14% of revenues. So, I decided to hop on the conference call and read through the latest 10-K to get an idea of the business and where it stands after losing Harrah’s.

Here’s how GCA describes their business:

Global Cash Access Holdings, Inc. (Holdings) is a global provider of cash access and data intelligence services and solutions to the gaming industry. The Company’s services and solutions provide gaming establishment patrons access to cash through a variety of methods, including automated teller machine (ATM) cash withdrawals, credit card cash access transactions, point-of-sale (POS) debit card transactions, check verification and warranty services and money transfers. The Company operates ATMs at certain customer gaming establishments, where the gaming establishment provides the cash required for the ATM operational needs.

These are some of my notes from the call:

-no detail yet on the Harrah’s cancellation. Less than 14% of revenues, not above avg margins. No material impact on 2010 results.
-Still have strong cash flows
-Gaming customers are under enormous pressure
-no debt covenants triggered by loss of Harrah’s.
-no debt covenants triggered by loss of Harrah’s. No disclosure on other contract times (e.g. with MGM and others)
-buyback authorization kept in place.

A number of analysts expressed their frustration at the management team’s lack of willingness to discuss current market conditions. Their frustration is understandable. One of the common questions that I’ll ask an executive at a business I am looking to invest in is what they are seeing in their market. You do this for two reasons: One, to get a feel for how they are thinking about the business at that moment in time. Two, to check their views versus a direct competitor. I love to do this because you can see what the similarities and differences are in their statements. That way you can check to see if one company is exaggerating or overly optimistic. GCA said that they couldn’t really discuss because they were still in contract negotiations with customers and those are confidential. That might be understandable, but I still felt that they could have provided us with some color.

Doing more reading about GCA, I learned that when the company went public in 2006 they worked hard to sign a big name customer. In the end, they managed to sign MGM but the casino really onerous — the contract was basically break even for GCA. That MGM contract is up for negotiation this year and it was one of the reasons for an earlier sell off in the stock. Losing Harrah’s is another blow to GCA’s business.

GCA’s competition basically consists of GPN (10% of the market) and then a few start ups. Right now, the Vegas casino operators are really hurting and there’s a good deal of pressure for them to cut costs. I think that it is likely that either Harrah’s plans to take GCA’s business on themselves or chose to contract it out to GPN or another start up. Just as GCA signed a break even contract with MGM, many of these other cash processing businesses might be willing to do the same. I am sure that their thought process is that they can sign one of these major casinos at break even during the trough period and then 3 years later, renegotiate at higher rates. To me, this exposes one of the flaws in GCA’s business model. It lacks a substantial competitive advantage and is at the mercy of casino operators.

Now we don’t know what kind of margin the Harrah’s contract had, but on the conference call the CEO said it was at average to below average margins. On the one hand, this means when modeling for the reduction we can probably reduce revenues by 15% and then apply the previous EBIT margin. But that is thinking backwards when we need to look forwards. The greater threat is margin compression. On the call, the CEO said that in any given year about 1/3rd of contracts are up for negotiation. After seeing Harrah’s leave, I think casino operators might threaten to also leave unless given contracts that provide GCA with substantially lower margins. In this case, your dumbest competitor is also your most deadly competitor.

The other issue I see with GCA is their financing situation. In 2-3 years the company has $272.5M in cash obligations due. Here’s their financing agreement with Bank of America:

Treasury Services Agreement. We obtain currency to meet the normal operating requirements of our domestic ATMs pursuant to the Treasury Services Agreement. Under this agreement, all currency supplied by Bank of America remains the sole property of Bank of America at all times until it is dispensed, at which time Bank of America obtains an interest in the corresponding settlement receivable. Because the cash supplied to us under the Treasury Services Agreement is never an asset of ours, supplied cash is not reflected on our balance sheet. At December 31, 2009, the total currency obtained from Bank of America pursuant to this agreement was $428.3 million. Because Bank of America obtains an interest in our settlement receivables, there is no liability corresponding to the supplied cash reflected on our balance sheet. The fees that we pay to Bank of America for cash usage pursuant to the Treasury Services Agreement are reflected as interest expense in our financial statements for the following reasons:

-the Treasury Services Agreement operates in a fashion similar to a revolving line of credit, in that amounts are drawn and repaid on a daily basis;

-the resource being procured by the Company under the terms of the Treasury Services Agreement is a financial resource and in the absence of such an arrangement, the Company would be required to obtain sufficient alternative financing either on balance sheet or off balance sheet in order to meet its financial obligations;

-the fees of the Treasury Services Agreement are assessed on the outstanding balance during the applicable period and include a base rate which is tied to LIBOR and a spread, similar to a credit spread, of 25 basis points; and

-the fees incurred by the Company under the Treasury Services Agreement are a function of both the prevailing rate of LIBOR as dictated by the capital markets and the average outstanding balance during the applicable period as previously noted. The fees do not vary with revenue or any other underlying driver of revenue such as transaction count or dollars processed as is the case with all costs classified as cost of revenue such as interchange expense, and processing fees.

My issue is that GCA is a company you might have to hold onto for years if their customers start squeezing their margins. The danger of holding it for so long is that interest rates are likely to rise in a few years. So not only would GCA face difficulties getting good prices out of their customers, but they would also have to pay out higher rates to their bankers.

To me, that potential for margin compression creates complications for the company with so much cash being due in just 2-3 years. Now, it is entirely possible that GCA could amend their credit agreements to get terms that are more favorable, especially if the trough market for casino operators persists. But I don’t want to depend on debt negotiations for an investment to work. The other thing that could work in GCA’s favor is if the profits for casino operators return to pre-financial crisis levels. That’s entirely another good possibility and it is something that might be worth watching for — especially when management releases some guidance with more clarity on the state of their market.

For now though, I am putting GCA in the too hard pile. For a different perspective, look to the Inelegant Investor blog for a bull-case on GCA.

Bill Miller has an article over at Morningstar where he argues that large cap stocks are more undervalued than ever:

A few weeks ago I sent a little note to our staff about Exxon Mobil. It pointed out that Exxon Mobil was on the 52 week low list, and was actually lower than it was during the depths of the panic in the fall of 2008. It had (and still has) a yield greater than the 10 year treasury, trades at a multiple well below the market, has returns on capital above the market, has grown the dividend over 9% per year the past 5 years, and uses its prodigious free cash flow to shrink its shares outstanding by between 300 and 400 million shares per year. If it keeps this up for the next 15 years, it will be just about out of shares. Yet it languishes at 5 year lows. When it was last trading here in 2005 oil was $50 a barrel. The math is fairly simple: a sum of the dividend yield, growth rate and share shrink could represent an attractive annual return even if the valuation stays the same, and the valuation is among the lowest the company has traded at in years. Cash returns zero, the 5 year treasury is now trading at one of the lowest yields in history, the 10 year yields 2.93% and that yield will not go up. Yet what do people want: treasuries. What do they not want: Exxon Mobil and most other large capitalization U.S. stocks with similar characteristics.

Exxon Mobil is the largest company in the U.S. equity market, and one of the highest quality companies in the world, yet no one seems to care. When I mentioned this to a hedge fund manager a few weeks ago, he said that the oil stocks have underperformed this year, that the oil spill had cast a pall over all energy equities, that regulations on energy companies were going to increase, that subsidies may decrease as governments seek more revenue, and that the Congress is now going to take up a new energy bill, which is why Exxon Mobil is not attractive. Well the math is the math, no matter what the near term sentiment. I then asked him about Kimberly Clark, with a 4% yield, an 8% dividend growth rate, buys back shares, etc. So is Congress going after diapers and Kleenex next?

Bill Miller: Large Cap Stocks Represent a Once in a Lifetime Opportunity

To me, I never understood the fervor around buying BP (NYSE:BP) when you could purchase Exxon (NYSE:XOM).

Exxon Margins

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BP Margins

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Exxon is consistently more profitable than BP and is without all of the headline risk associated with BP’s oil spill. Yes, the likelihood of increased restrictions on drilling in the gulf is high – but Exxon has operations globally and I think they’ll be better suited to cope with the increased regulations. To me, it is at least the better buy when compared to BP.

The other one worth watching is Johnson and Johnson (NYSE:JNJ). So far, JNJ has hit new 52 week lows on concerns over product recalls. JNJ has had some experience with these before and I don’t see them crippling the company. The Financial Times’ Lex column has a great article on the company:

The three negative storylines for US drug companies this year are the weak euro, Obamacare and patent cliffs. J&J, with its strong medical devices and consumer product franchises and relatively attractive drug pipeline, should face a far smoother ride than pure large-capitalisation pharmaceuticals manufacturers. This justifies a premium not only to the likes of Merck, Pfizer and Eli Lilly, which face the most daunting gaps in future revenue, but also Abbott Laboratories and Bristol-Myers Squibb.

J&J’s product recalls are no small matter, having cut its US consumer revenue by more than 14 per cent in the last quarter, but this is more than amply reflected in its 2010 valuation. All else being equal, a recovery in sales should flatter its results starting early next year. Likewise, the drag on the quarter of its sales that come from Europe should fade from its dollar results by next year barring serious continued weakness in the euro, whose average exchange rate was 6 per cent lower last quarter compared with the year-ago period. Its US peers are similarly exposed to Europe.

At just 12 times prospective earnings and with prodigious cash flow enabling it simultaneously to keep up its pace of small acquisitions while still repurchasing shares, the market may soon realise that its diagnosis of J&J was overly dire.

Johnson & Johnson (FT Lex)

Previously, I’ve mentioned that this is usually a good place to buy the stock. This chart is a little outdated since the stock has hit new lows, but you get the idea.

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The real question that investors wrestle with is how to implement large caps into their portfolio. These aren’t companies that are going to double or triple. One thing I’ve thought about is using these stocks as placeholder investments. At current prices they appear better than holding cash because of their current valuation and dividends.

Another way to do it would be with a heavy allocation to large cap blue chips and then a smaller allocation to cigar butt companies that are trading at really high >20% free cash flow yields. You’re trying to use quality companies to help put a floor on your portfolio and then using cheap low quality companies to increase your upside. Sort of a value investor’s approach to the portfolio strategy prescribed by Nassim Taleb in the Black Swan — where he advocated doing 90% cash and 10% in out of the money options or high risk (technology, biotech) stocks.

Joanna Pachner at Business Without Borders has a fantastic article profiling Bruce Flatt and his company Brookfield Asset Management:

As a rule, the CEO of Brookfield Asset Management is studiously non-controversial. He rarely appears in public and has little to say to the media. Put-downs? Bravado? “We don’t brag,” he says earnestly. “It always bites you afterwards.”

Instead, Flatt seems to go out of his way to paint Brookfield as boring. “We own 129 office buildings. Some are a little taller, some are a bit shorter,” he says laconically. The strategy? “We’re in the business of buying assets of great quality at less than replacement cost.” The company’s remarkably consistent objective over the years simply has been to earn a 12% to 15% compound annual return per share. “We have no goal to be large or significant,” says Flatt. “If [reaching our objective] meant we should shrink in size, we’d do that.” Even Brookfield’s logo is understated, and its 2009 annual report looks like something thrown together at Kinko’s. Move along, everyone, nothing to see here.

The reality is that this slender 45-year-old executive runs a conglomerate that manages $108-billion worth of real estate, utilities and infrastructure across the planet. In the eight years Flatt has been in charge, Brookfield has emerged as the world’s biggest owner of prime office space—including some of the most prestigious towers on the Manhattan skyline—and its 165 power plants constitute one of the largest hydroelectric portfolios. But what has really impressed observers is how Brookfield weathered the crushing downturn that crippled many of its rivals. Over two years, as its stock plunged by two-thirds along with the markets, the company didn’t panic or go into hype mode. Instead, it quietly added to an already thick cushion of capital. And waited.

…The business landscape is littered with companies that gambled with cheap money and got caught with their shares down and their loans called. Brookfield, meanwhile, has amassed a nearly $10-billion war chest of its own and institutional investors’ cash and has gone hunting. After devouring an Australian port and railway giant and a few real estate portfolios, it’s now tracking perhaps its most succulent prey: General Growth Properties, the second-largest mall operator in the U.S., which adopted the spendthrift ways of its customers, stockpiled a glittering array of trophy properties on credit, and when the markets seized, toppled into bankruptcy. Enter Brookfield, offering up its capital and restructuring expertise in exchange for control of the company.

Whether or not Brookfield secures the deal—the outcome may not be known until this fall —it’s an important chapter for the company, says a close long-time observer who requested anonymity. “This could be a huge new platform for them. Or it could be a huge profit.” Some see it as an unusually risky play for careful Brookfield. But they don’t appreciate its predatory ways.

A Perfect Predator (Business Without Borders)

Be sure to read the entire article. It’s wonderful and details how Flatt has reoriented Brookfield since taking over as CEO.

Brookfield is an interesting business in that much of its revenue stream in that its properties throw off a substantial amount of free cash flow (about $1.5B annually). Some of their properties are more economic sensitive than others – particularly the office buildings and potentially the malls that they would acquire from General Growth Properties. But that would be offset by their infrastructure investments.

For investors hoping to find a savvy team of deal makers who will invest opportunistically in real estate, Brookfield is a good place to start. There aren’t a whole lot of value oriented real estate groups like Brookfield. A lot of the players simply try to buy and sell into bubbles.

Pachner compares Flatt and Brookfield’s approach to investing as similar to the entrepreneurs cited in Michel Villette and Catherine Vuillermot book From Predators to Icons: Exposing the Myth of the Business Hero. This is a good comparison. For the most part, Flatt has been able to steer Brookfield into investing conservatively during bubbles which enables them to build up cash hordes and purchase distressed properties at a discount to their margin of safety when there are few other real competitors.

The most difficult thing about analyzing Brookfield is probably their size. While it helps when they are getting involved in special situations and deals, but it creates difficulty for an analyst attempting to value the company with precision. I think that if you use the intrinsic value estimates that Brookfield provides, along with that average free cash flow figure of $1.5B. You can then get an approximation of what Brookfield is really worth and compare it to its trading price. Ideally you want to obtain a margin of safety and then get the kicker of their investing prowess which should compound intrinsic value.

Jeremy Grantham has a great essay over at Morningstar which gives us some insights into how he is looking at investing GMO’s funds:

Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future…

At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1) suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus infl ation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when fixed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Running at the same rate of change in attitude as both the market and general opinion is both frustrating and unprofitable. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.

Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable filler for a global equity portfolio. Forestry remains, in my opinion, a good diversifier if times turn out well, a brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.

Summer Essays: Finance and Portfolios (Morningstar)

I’ve posted recently that I am also seeing value in large cap stocks many of which seem to have strong exposure to emerging markets and franchises that should be able to withstand tremors in the global economy. Grantham’s point about deflation is interesting. Unlike with inflation — where certain businesses can simply raise prices, deflation creates a downward pressure that is harder to tackle. I’ve noted in the past that Seth Klarman believes in deflationary environments we should seek a wider margin of safety. So if you used to buy at 60 cents on the dollar, maybe you start buying at 40-50 cents.

Sorry about taking so long with the Red Robin post, I am still getting together the charts/models to present.

These were two awesome comments from yesterday’s post that deserve highlighting. One of the issues an analyst struggles with is the sometimes adversarial nature between the company and the analyst when it comes to financial statements. Often, companies will employ certain accounting quirks that distort the economic reality. This is why it is important to make sure you read the footnotes.

The first is from Rabbit:

It’s worth placing special attention to accounting and corporate structure gimmicks related to franchising. DineEquity is a great example as they adjusted their business model in 2003. Prior to that year, they included franchisee funds earmarked for advertising as “revenue”, and they seller financed the upfront area and franchise fees and charged rental income for equipment and land. You can imagine how opaque their financials were during a period of fast franchisee growth. You get the natural SSS growth as new restaurants settle into their area, and you get the bonus “revenue” that doesn’t directly hit the bottom line.

Then, Rishi followed up with another example:

An additional note on accounting as related to leases.

If the company leases its locations and reports them as an operating lease, then it will show higher profits in the early years, higher return measures in early years, and a stronger solvency position than an identical company reporting an identical company as a finance lease. The company reporting the lease as a finance lease will show higher operating cash flows because a portion of the lease payment will be reflected as a financing cash outflow rather than an operating cash flow. When comparing companies, it is important to make adjustments to the financial statements by capitalizing the operating leases. The disclosures are very important to understand its off-balance sheet obligations via operating leases.

Also, if the company franchises its locations, it can be a lessor of the restaurant building to the franchisee. This has the potential to create certain shenanigans too. A company will record much more income in the first year of a sales-type lease than in the first year of an operating lease. If the company is fast growing, it can front-end this revenue every year.

There are other tricks that the company can play around with leases, but I’ll refer to the book ‘Financial Shenanigans’ by Howard Schilit pages 226-229 for the details.

I’ll be sure to post any other examples that are brought to my attention. You should keep these examples in your memory because they tend to come up again but in slightly different forms.

One of the brightest fund managers I’ve ever met once explained to me that in value investing, it is important to pick your spots. Operate as a generalist, but try to find a few industries where you can get a really deep understanding. He told me that some industries are actually closely related if you think about it. That makes our job even easier.

Take restaurants for instance. He told me that a restaurant is really just a big box. You come in, order food, eat, and leave. From there, you can gradually build on that model to analyze similar businesses. Like a retailer. Retailers are pretty similar, you walk into a box, buy some clothes, and exit. Clothes replace food in our model. From there, you can take the idea to department stores, which are really like a huge retailers. Instead of selling one type of clothes, they are sourcing from many different manufacturers. But it is mostly the same idea. You come into the box, you make a purchase, you leave.

(I am probably not the best teacher because I’ve taught myself most of how I look at and analyze companies. As a result, I might do things a little differently than the norm. If you disagree or have a different approach with the perspective that I am outlining here, feel free to e-mail me or leave a comment. That way we can improve on this and help out other novice investors who might be interested in looking at restaurants.)

If we accept our box analogy, what are some key factors to look at when analyzing a restaurant business?

1. The Box

(Flickr:forklift)

First there is the box, the actual restaurant building. Sometimes a company might own the underlying real estate – that will be on the balance sheet. If the company is just leasing the location, you still own everything that is actually inside of the restaurant, that will be under property, plant, and equipment. You’re going to incur expenses to rent that location (occupancy costs) or use capital expenditures to purchase new properties and equipment. So you’ll want to look for that on the income and cash flow statement. Some of your equipment is going to degrade each year which will be recorded as depreciation and amortization. Purchasing new restaurants or reinvesting in existing locations will typically be found on the investing section of the statement of cash flows, usually recorded as capital expenditures.

The first thing I do when looking at the box is take a look at if they own the underlying real estate and when they made the purchase. The balance sheet typically employs the cost approach which means asset values are recorded using the price that was paid for them. Then, depreciation might also bring down the recorded value of a building to a level that is actually below its true worth. So you need to watch out for cases like this where the accounting may inaccurately represent the value of the company’s assets.

The individual restaurants have value as well. If you were to sell an established location to a franchisee, the company could fetch a good price because much of the uncertainty that comes from a new restaurant location is gone. So what I do is compare the mix of owned locations to franchised locations and see if there might be any value that could be unlocked by shifting to a more franchise driven model. From a cost perspective, restaurants record a cost on the income statement for “operations” — costs associated with doing repairs, procuring supplies, and the utilities that need to be run for keeping the restaurant open. These would be shifted to a franchisee.

I experienced this first hand with Steak N Shake, a business I purchased at $10 a share which had about $10 of value from their real estate holdings underneath. 80% of the restaurants were company owned (McDonald’s is the opposite with 80% franchised 20% company owned), which meant that management could have sold some locations off to generate cash. As the financial crisis intensified, they used this strategy to make sure they did not breach any debt covenants.

Shifting to a franchise-driven model makes sense because you end up lowering the capital intensity of the business, since you are cutting out the actual costs associated with operating a restaurant. Your efforts become focused on developing new food products, marketing, advertising, and other corporate related expenses. You end up with less expenditures which means more cash for buybacks or dividends and potential for higher returns on invested capital.

2. Food

(Flickr:roboppy)

Then there is the matter of food. Food and labor are your primary expenses in a restaurant. On the balance sheet you will find inventory listed as a current asset. Food is recorded on the balance sheet as inventory, and then you might also have an accounts payable line which records how much is owed to food suppliers. On the income statement, cost of sales gives you the cost of the food and beverages sold at the restaurant.

To prepare the food at the restaurant, you need workers. You’ll see their wages recorded as labor or payroll as an expense on the income statement and accrued payroll on the liabilities section of your balance sheet. Browsing the 10-K of Red Robin Gourmet Burgers (NASDAQ:RRGB), you’ll see that food and labor combined are 60% of restaurant revenues. So there are major costs associated with actually producing the food served in restaurants.

Some sophisticated restaurants will use derivative contracts to hedge the movements in commodity prices, but many smaller restaurants do not. For these smaller restaurants, it is entirely conceivable that on a year-to-year basis, your margins might slightly fluctuate if commodities are particularly volatile.

When I look at restaurants, the food is definitely something that I analyze qualitatively. Food is what brings people into restaurants and it is also transparent to competitors. Wendy’s (NYSE:WEN) was the first nationwide chain to serve meal-sized salads and their major competitors (McDonald’s, Jack in the Box, Burger King) all quickly followed with their own meal-sized salads. So finding a competitive advantage in food is difficult because it is bound to get copied.

Besides the overall unique recipes, food related competitive advantages tend to come from the economies of scale that the business possesses. McDonald’s (NYSE:MCD) once thought about putting shrimp in one of their salads, but they realized that ordering a sufficient quantity of shrimp would have caused a global shortage. That is buying power and it means McDonald’s can achieve cost savings and advantages that give them a leg up against smaller upstarts. This is especially when you look at low margin value menu items.

3. People

(Flickr:newyork808)

We have a rough idea of the box, the food that is sold in the box, but what about the people? The customers are what drives a restaurant’s results. To monitor customer activity, there are a few useful metrics. Most restaurants will provide data on same store sales or comparable store sales which get us an idea of how sales activity has fluctuated on average. You have to compare this data on a YoY basis because seasonal effects such as winter storms or summer vacations might impact the data on a month to month basis. You also need to take into account aberrations or outlier events that may have occurred for the year.

Most restaurants will give you sales data on a monthly basis. As an investor, you really don’t want to get too bogged down by focusing on revenues. We care about the earnings and cash flows. Sometimes restaurant management teams will get too glued to revenues and expand too much, into weak markets. Ultimately, this hurts earnings.

So then why do I mention same store sales? It is a useful metric for seeing how a restaurant is doing. Typically, we are going to be looking at distressed restaurants, where sales have dipped and the company is posting a loss or barely breaking even. I use sales figures to get an idea of whether or not a turnaround is working. If management rolls out a few promotions and new menu items to entice people to return to the restaurant, I’ll see if the effects carry through into the sales figure. Ultimately it is a simple metric that can help tell us a lot about the business.

The way consumers get notified about new menu items is through advertising. You can find annual advertising expenditures in the SG&A line of the income statement. In the footnotes they will break out how much is being used for advertising within the larger SG&A figure. It is useful to monitor how this figure fluctuates, in order to see if SG&A is rising due to salaries or due to ad spending. Then, you can also track how increases in ad spending are translating to same store sales.

Distressed Restaurants

In order for us to find a restaurant that meets our value criteria, something usually has to be wrong about it. There are a few ways restaurants can run into trouble.

A. The Economy

Most restaurants blame the economy or weather, basically factors that they claim are outside of their control for poor performance. There is some legitimacy to the economy argument. If times get hard, people are going to cut back on their spending and trade down. Trading down can mean different things to different people. For one person trading down might mean eating less at Red Robin and more frequently at McDonald’s. For another, it might mean eating less at McDonald’s and eating more at home.

How can a restaurant counter-act the effects of the economy? By bringing value to customers. Usually, you will see restaurants roll out new promotions that are supposed to entice you to come in. McDonald’s is truly awesome at doing this. For example, they rolled out their $1 menu which features certain menu items which have thin to no margins, such as the McDouble. To help balance that out, they are also offering any all soft drinks for only $1. The idea here is that you might opt for one low margin item (McDouble) with higher margin items (soft drinks, french fries) — creating a net benefit. Burger King (NYSE:BKC) did this successfully with their $1 Buck Double paired with their ribs (>$6). Going up the chain, Red Robin is using a strategy where they are selling a bacon cheeseburger for about $7.50. The average cheeseburger on their menu is around $9.50 so it is a price reduction.

B. Debt

The second most common issue I’ve seen with restaurants has to do with debt. Management teams will sometimes keep their eyes so glued to their restaurant count that they become empire builders. They start building out more and more units, even though the cash flows coming in cannot support those types of expenditures. So then they take on debt. Normally, this can work but if the economy goes to negative and the company is not prepared to make the right decisions, the situation can rapidly deteriorate.

When something like that happens, you need to pay careful attention to the balance sheet and conservatively analyze the assets on there to see if they would have potential value if sold. That might allow the company to shed certain assets and amend debt covenants or reduce overall indebtedness. Whenever analyzing in a leveraged company, sit down and research the terms of the debt covenants.

C. Catastrophes

I think the classic catastrophe example in the QSR business is Jack in the Box (NASDAQ:JACK) with the E. coli outbreak in 1993. Four children died and sales plummeted, millions had to be paid out in lawsuits, and their debt rating was cut to junk status. I keep this same example in my mind whenever I invest in a restaurant because it is still a very real risk.

So how do I handicap towards that risk? The best way is to try to do research into what sorts of cleanliness and food safety measures are employed by the company and gauge employee perception around that. You can usually find this out by talking to employees or restaurant industry experts. I’ve found that people are generally pretty willing to help.

For bigger chains, there might be more scrutiny which would lead them to enact a rigorous safety procedures that are uniform across the chain. Some chains have a truly global reach, such was Yum! or McDonald’s which diversifies away from being too tied to any one city.

Homework

If you have a chance, read the latest 10-K from Red Robin and the presentation that they have on their website. With the shareholder activists involved and the quality of their product, Red Robin might be attractive right now. I plan to have a post that goes in more detail on Friday.