Wednesday, September 19, 2012

We've Moved to PAULDRYDEN.CO

Dear Readers, 

I've been writing in too many different places, so I decided to consolidate everything into one website organized by a variety of topics that satisfy my far flung interests. 

This morning I launched the eponymous (Why not ".com" you may ask. Because the "m" cost too damn much.) I've moved most of my content over there and it will henceforth be the gathering spot for all future posts. 

I hope you choose to continue following my meandering thoughts there.

Many thanks, 


Sunday, August 26, 2012

An Exchange on ROIC...the Key Measure of Profitability

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
- Charlie Munger
(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

A reader and I shared a recent exchange about the quote above. I thought it was worth sharing some of the thoughts on the blog. Here you go...

Hi Derek, 

It's a Charlie Munger quote, and it's among the most important constructs for any long-term investor to understand. It goes to the heart of the return on invested capital (ROIC) portion of the economic model of a business. (See 3(d) of, "Does the economic model work?" from theMad Men MBA 4-Part Framework for Really Understanding Companies.) 

Consider this...a company has $1M of invested capital (equipment, buildings, accounts receivable, etc.) supporting its business. It earns $60K on that each year, meaning it sports a six percent ROIC. Tell yourself that $1M is cash in a savings account and the $60K is your interest on your principle. The concepts are the same. You can grow your overall interest earned (earnings) by putting more cash into that account (increasing its capital), but the rate of return remains the same...a lousy six percent.

For the company, the earnings can go one of three ways in the future: 1. They decline; 2. They stagnate; or 3. They grow. What happens to those earnings is important, but it's most important in the context of what happens to that base of invested capital at the same time. Let's consider number three, where the earnings grow. (That tends to be the happiest scenario.)

Say the earnings grow ten percent a year, going from $60K to $66K to $73K to $80K, etc. Ten percent growth seems pretty good, but we have to ask how much capital had to be invested in the business to generate that earnings growth. We must always look at earnings in the context of invested capital.

If the invested capital stayed steady at $1M, you're looking at a rosy scenario in which a business doesn't have to add to its capital base to grow. That means it can probably pay out those earnings to shareholders without fear of losing its competitive position in the market and continue to compound its value. It started off earning 6% ROIC, but that number grows with each passing year (6.6%, 7.3%, 8%, etc.). 

You won't find a lot of business like this. The vast, vast majority must plow back capital in order to increase earnings.

How much is this business worth? That's up to the judgment of individual investors, each of whom must attempt to predict the future in terms of whether this growth rate continues. (Are the earnings protected by competitive advantage? That's number two on the Mad Men MBA framework.) My threshold for an investment is a 15 percent yield. That means with earnings of $60K, I want to pay no more than $420K ($60K x about 7). But if I'm confident those earnings will continue growing at 10 percent, I might be willing to look, say, three years into the future, take that $80K in earnings and pay 7x that number (about $560K). But only if I'm confident that ten percent earnings growth (plus little additional capital reinvestment needs) continues deep into the future. 

That exercise is nothing more than an abbreviated form of discounted cash flow. Of course it's unlikely you'll find too many businesses with $1M invested in capital, earning only six percent ROIC, trading for a fraction of its capital. Someone would likely buy the whole company, liquidate it, and take the cash for a fast, hefty, and low-risk return.

But what if earnings are growing at ten percent while invested capital is growing at 15 percent? Now the economic value of the business is being destroyed with each passing year. What would you pay for a business like this? Nothing! Unless you have the power to shut it down and cash it out. As a shareholder, you'll never get the benefit of those earnings because the business has to plow all of it back into property, equipment, accounts receivable, etc. 

Munger's quote is really highlighting the famous dictum from Ben Graham's, "in the short run the market is a voting machine, but in the long run it is a weighing machine." In the short run, investors will have different opinions of the prospect for this business. The different views can lead to wildly different prices each is willing to pay, and that can lead to a lot of volatility in the stock price. 

But over the long run, the economic viability of a business (its ability to compound earnings at a rate AT LEAST equal to its need to reinvest capital) will define its price. That's the weighing machine. If it returns six percent ROIC, even if you buy it at a cheap price, you won't get much better than six percent returns over extended periods of time. If it returns 20 percent (and you think it might be able to keep that up for a while), you can buy it at almost any price and you'll do fine. 20 percent is a powerful rate for compounding any number if you give it enough years to do its compounding work! 

To get a mathematical proof, create an spreadsheet. Start with $1M on the row A. This is invested capital. To its right, multiply it by whatever ROIC you expect the company to earn. Say 1.1 (10 percent) and push that out 19 more rows compounding at the same rate each year. 

On row B, start with $60K for earnings. To its right assign whatever multiple you want for its growth, and push that out 20 years. 

On row C, divide B by A and show it as a percentage. This is your ROIC.

Now, if you select variables in which the growth of the invested capital outpaces the growth of the earnings, you'll see the ROIC creep closer and closer to zero the more years you extend the simulation. The company is eating itself. It has no economic value.

If you select variables in which the growth of earnings outpaces invested capital, you'll see those ROIC and earnings grow the further you push out the model. The business is creating economic value, and it's worth a lot more. 

But it's far less about creating a mathematical proof, and much more about understanding the concept of return on invested capital. A proof might lead you down the path of seeking false precision; searching for that perfect screen that unearths all the best ROIC companies. I think of it more as a way of looking at the world of investment opportunities while thinking in terms of compounded earnings. The more a business can grow its earnings without reinvesting them (as capital) back into itself, the better its ROIC...the more it pays out to its investors (dividends or share repurchases) while continuing to compound.

Kind regards, 


Thursday, August 23, 2012

Mad Men MBA - Heinz (HNZ) Case Study in Competitive Advantage

Doug wanted to get me watching the AMC hit series Mad Men and so proposed a series of case studies on companies featured on the show. He had me at case study. Thus was born the Mad Men MBA, a collection of articles exploring the strengths and weaknesses of the businesses being pitched by the admen at fictional Sterling Cooper Draper Pryce.  We conduct our analysis based on a four-part framework, ("for really understanding companies") outlined here. In the end, we try to make this a practical exercise, estimating a reasonable price for buying the business and deciding whether it's a worthy investment today.

Our first case is H.J. Heinz, Inc. (HNZ), the undisputed champ in today's ketchup market and a key account Don Draper and crew were trying desperately to retain in season five of the show (representing the early-1960's).  In episode five, At the Codfish Ball, Jack Heinz is preparing to take his lucrative Heinz Baked Beanz marketing budget to another ad agency. Draper's young wife catches wind of the defection while powdering her nose with Mrs. Heinz at a dinner meeting, relays the tip to her husband, and sets up a dramatic ad-man pitch to keep Baked Beanz with Sterling Cooper Draper Pryce.

Today baked beans is a big business for Heinz in the UK market but has much less importance globally. The big brand is Heinz Ketchup, providing over $5 billion of its $11.6 billion in 2011 sales and with a global market share close to 60 percent. 

Doug sets up the case study in a recent email:
Heinz's big challenge was defining itself after pure domination in the baked beans market. They were friends to the military and the ease of packaging their product for wartime solidified their position. But they also had the vision to know they needed to branch out into new product territory, especially in times of peace. Ketchup became their big push and more than the product their packaging became signature. Pounding of the glass bottle to get it started and even when it pours out, it is all good. You can never use too much ketchup.
That was the 1960's, let's bring it back to the Heinz of today using our four-part framework for understanding businesses.  

Competitive Advantages: The Heinz Ketchup X-Factor

Competitive advantages serve to protect a company's earnings from attack by other businesses eager to steal their customers and their profits. The best companies are protected by advantages that intertwine around each other, creating greater protection in combination than any one of them could individually. Heinz is a clear beneficiary of the intertwining gestalt effect, distancing it from much cheaper catsup alternatives offered by Hunt's, Del Monte, and countless private labels offered by grocery stores. 

We should start out with what we can only describe as an "X"-factor that protects Heinz's ketchup empire. 

In his excellent 2004 The New Yorker article, "The Ketchup Conundrum"*, Malcolm Gladwell sits down with food-tasting specialists who describe how the human palate possesses some intrinsic attraction to flavors with a specific balance among salty, sweet, sour, bitter, and umami. If a particular food or drink strikes the right harmony - the specialists call it "high amplitude" - it keeps drawing consumers back for more. From Gladwell's article:
When something is high in amplitude, all its constituent elements converge into a single gestalt. You can't isolate the elements of an iconic, high-amplitude flavor like Coca-Cola or Pepsi. But you can with one of those private label colas that you get in the supermarket...Some of the cheaper ketchups are the same way. Ketchup aficionados say that there's a disquieting unevenness to the tomato notes in Del Monte ketchup.
Products with high amplitude resonate so much with consumers that they can eat more and more without ever seeming to grow tired of it. So businesses that somehow stumble upon the right formulation for achieving high amplitude - Coke, Pepsi, Heinz - have some sort of built-in advantage rooted deep in the physiology of the human taste buds.  

This creates such consumer demand for Heinz ketchup that they pick it over the alternatives, pay more for it, and even favor restaurants that allow them to slather their burgers and fries with this particular Heinz condiment. The high amplitude has created a strong consumer preference, giving Heinz an opportunity to combine the flavor preference with an emotional attachment by investing heavily in creating a brand. Heinz has wisely exploited this opportunity, and it's effects are undeniable. It has created a preference so powerful that we can recount multiple experiences of sitting in a restaurant and watching as a waitress picks up one of those iconic glass Heinz bottles (surely a Don Draper recommendation) to refill it with a cheaper alternative like Hunt's. Ketchup counterfeits! The restaurant would only bother to do this if they knew customers had a strong preference for Heinz. It doesn't want to pay extra for carrying the premium brand, but it sure loves the benefits of the Heinz halo effect.  

This high amplitude "X"-factor sounds like a pretty compelling competitive advantage. But it doesn't operate in a vacuum. As we explored in a previous article, Scale Advantage and the Great Coke Scandal (where a secretary at the cola company tried to sell Coke's secrets to Pepsi), the success of even the most delectable of food and drink products are not born solely of taste. It creates demand, but the companies must work tirelessly to build additional advantages to fortify this consumer preference and brand. 

Like Coke, Heinz has developed deep relationships with grocery stores and restaurants to get its ketchup on shelves and tables. That's distribution, a component of customer captivity or the network effect. If Heinz can tie up enough shelf-space with its ketchup, it doesn't leave much room for fresh alternatives to establish a toehold to compete. Heinz invests in this distribution network and guards it jealously. Any new entrant that Heinz deems viable that tries to get into the grocery stores will meet a ferocious counterattack to box it out.  It's very, very hard to break through.

Finally, there's the scale advantage that allows Heinz to practice selective low-cost, low-price tactics. While it charges a premium over other ketchups, Heinz produces such an enormous amount of ketchup that it has all sorts of scale benefits. From buying tomatoes in massive volume, to running more throughput in its manufacturing facilities, to spreading its advertising budget over a much wider base of sales...each of these reduce Heinz's cost per unit of ketchup bottle produced. If push comes to shove and a competitive product tapped into its own "X"-factor (thereby threatening Heinz's market dominance), Heinz could - by virtue of its low-cost scale advantages - undercut the emerging threat. It could push them into a price war, and Heinz's scale advantages would provide it the ability to price its products lower for extended periods of time without threatening the survival of the company.

So we see that Heinz has intertwining advantages to protect those earnings from encroachment by competitors.

Information sources:

* Malcolm Gladwell's excellent 2004 article for the New Yorker, The Ketchup Conundrum, is available on his website:

** Information about Heinz business performance and history is pulled largely from the company websites, and We pulled from the company's strategic overview slides from a 5/24/2012 presentation available on the investor relations website.

Friday, August 17, 2012

The Mad Men MBA: A 4-Part Framework for Really Understanding Companies

My friend Doug is on a mission to get my wife and me watching Mad Men. It would seem we're the last denizens of earth still holding out. His latest tactic has won me over. Doug has proposed using the various companies featured in each episode as case studies for the good, the bad, and the ugly of businesses. He had me at case study. 

So what he proposed with such friendly intent, I've expanded with a barrage of verbosity. I've agreed to his proposal (and we'll borrow his box set of seasons 1-4), and countered with this suggestion that we employ a specific framework for our analysis, one that I use for investment valuations and that I believe forces you to truly understand a business. 

For these purposes, I've dubbed it the Mad Men MBA, and below is the framework I proposed via email.

Provided it doesn't send him running for an escape, perhaps we'll feature one or two of the case studies in a Mad Men MBA series here on the Adjacent Progression. 

Ok, Doug, let's up the ante on the Mad Men MBA discussions. When evaluating any business, whether to invest in it or just to understand it a bit better, it helps to have a framework. A framework organizes your thoughts, lets you sift through the information in a systematic way, and gets you pretty close to making valid comparisons between companies. Without a framework you can pick up bits and pieces of what's good or bad about a company, but unless you have some way to organize all the information you're taking tends to float around in disconnected ways. That's how it works for me at least. A framework helps me retain information, shift it around while looking at its different angles, understand it deeply, and ultimately turn it into a base of knowledge I can build on. 

The great hope is that accumulating knowledge can eventually lead to wisdom. Sweet, sweet wisdom. 

So, grasshopper, here is my suggestion for a framework, posed in the form of questions to ask about each company featured on Mad Men...

1. What is the nature of the company's earnings?

This question forces you to go to the heart of a company's prospects, asking hard questions about the demand for its products or services and the potential for growth. It also forces you to consider whether your starting point (the financial results of a given year) are an aberration from the norm or a signal that a new trend is taking effect. 

Some businesses have cyclical earnings demonstrated by high peaks and low troughs of demand. This makes their earnings really high some years and really low others. Auto companies (the Jaguar discussion from Mad Men) tend to have cyclical ties to the economy. When it's good, they kill it. When it's bad, they have a hard time scaling back operations to meet the decline in demand...they hemorrhage money.

Some business depend on blockbuster success. Think movies, music, video games, even toys. They will have huge earnings in a year when they have a blockbuster seller, but then drop off precipitously if they can't produce another blockbuster. For movies, you have a lot of production companies working on the next hit, but a disproportionate amount of the money goes to only a handful of successes. Economist (and fitness guru) Art DeVany did some research that demonstrated that it's virtually impossible to predict what movies will be huge successes and which will be bombs...even for the studios themselves. 

You have businesses whose earnings are declining over time because technology or habits have just passed them by. (Think some point even the most graphic intensive video games will be played via the internet - and probably on iPhones - rather than on consoles.)

You have businesses whose earnings just stay the same. They're neither growing or shrinking. They have their niche, they make a set profit from it, and they just keep plugging along.

And you have businesses whose earnings are growing over time. The growth companies. Either demand is increasing for their products/services, or they're expanding into adjacent markets, or they're raising prices to generate more profits, or they're reducing costs to generate more profits. 

(Also, see here for a discussion of Owner Earnings, an incredibly important concept to understand as part of the framework.)

2. What competitive advantages exist to protect those earnings against foes trying to steal the company's customers?

This is the most important piece of the framework. In a free market, there is vicious competition for profit. And when a business pops up, demonstrating an ability to make tidy profits, it's only a matter of time before bigger, faster, smarter competitors start gunning for them. They will build similar products, they will undercut pricing, they will exclude them from distribution networks...anything to steal their customers and take those profits for themselves.

So, what competitive advantage (or "advantages" plural...the more it has, the better) does the business have that makes it difficult for bigger, faster, smarter competitors to steal customers? The four main categories are these:

a. Low-Cost, Low-Price. Think Southwest Airlines (or Amazon, or Costco). Customers prefer paying less instead of more. (So if you're charging a higher price than your competitor, you better give them a really good reason to pay more.) Companies possessing this competitive advantage usually have some sort of scale benefit from being large. They've passed that tipping point where they can produce more of a product and thereby do it for less on a per unit basis. The best of these are fanatical about keeping costs down and equally fanatical about passing the cost savings on to customers in the form of lowest prices (think Sam Walton).

b. Network Effects/Customer Captivity. It's a matter of making your product or service "sticky" so customers either can't or don't want to leave you. Facebook is the textbook example of this right now, and the case is made when you compare it to what Google is trying to accomplish with Google+. It's arguably a better service, but not enough people use it to get other people using it. Google can't pull people from Facebook because that's where all their friends are. And all their friends are there because all their friends are there. They're stuck! That makes it really hard for Google to make inroads.

My favorite example, however, is online banking with their billpay features. I have stuck it out for way too long with a bank whose other services I can't stand because I didn't want to go through the hassle of switching my bills over. That's a sticky feature.

c. Brand. This is the hardest to define, but you tend to know it when you see it. The hallmark of a great brand is that have such an emotional connection to it that they'll pay a premium to buy the product over a competitor's offering that costs much less. Coke and Apple come to mind for consumer brands. IBM has a powerful brand in corporate IT. A great test of a brand is how well its products do when it gets serious competition from a lower priced competitor. There's a great case study of Richard Branson trying to make Virgin Cola a legitimate contender against Coke and Pepsi. As we know, he failed. It's hard to take on established brands. 

d. Legal Protections. It's always a nice advantage when the government tells your competitors they aren't allowed to go after your customers (legalized monopolies like local cable providers), or you have airtight patent protection for your product (pharma), or you have exclusive rights to an asset like FCC-managed bandwidth (local tv franchises). 

The big debate about competitive advantage is how and whether innovation fits on here. It is, unquestionably, a competitive advantage. Apple is the best example. (See my previous write-ups here, here, and here.) They have a long string of innovation successes that have differentiated their products from the competition, allowed them to charge a premium, and made them amazingly profitable. But how durable is that advantage? Innovation is very, very hard to sustain over long periods of time. Competition will study your success, and they will eventually figure out how to do it. If your earnings depend on constant innovation (as tends to be the case in consumer electronics) - and you don't have other forms of competitive advantage protecting you - I don't call that a durable advantage. You'll stumble at some point. 

3. Does the economic model of the business work?

This is where you get more into the finance and accounting stuff. Basically, you want to know if the basic economics of the business make sense. The questions seem almost too elementary, but you have to ask them. If you're considering an investment in the business, you have to go through them like a check-list. They're critical. 

a. Gross Margin Model. Does the company cover the costs of making the goods by the price it charges for them? i.e., Does its business allow it to create a gross profit? Again, elementary, right? Sure, but there are so many things you can learn by watching a company's gross margin. 

For some early-stage and growing companies, sometimes they won't produce a gross margin despite having demand for their products. Their costs for acquiring and transporting materials might be too high, but it will go down as they hit scale and can procure raw materials in high volumes. 

A declining gross margin can show that a business is being attacked by the competition and must therefore reduce prices so it doesn't lose customers. It makes you ask the important questions about competitive advantage.

An increasing gross margin might suggest that the company has some form of pricing power where it can raise prices without losing market share. Maybe its brand is just that good. 

Gross margin is the highest line-item of profit on the income statement, and it's the one that can be least manipulated by accounting tricks. It's the pure one that can tell you a lot about what's happening with a business, so it's worth paying attention to.

b. Operating Margin Model. From the gross profit (above), a company will subtract its operating expenses (overhead, marketing, selling, etc.) to come up with an operating profit. What I'm looking for here is that the business can cover its operating expenses with the amount of gross profit it generates. For a mature business, this is the true sign of control over expenses. Discipline. It also gives you the first hint of what the company might have left over to reinvest in itself or to payout stakeholders (the government, owners of its debt, and then owners of its equity).

c. Net Margin Model. This is the bottom line number. Though it should tell us what the business should have left over the payout to shareholders, accounting standards actually force us to spend time with the statement of cash flows and balance sheet to really figure out that number. Consider it a discussion for another long, boring email. Suffice it to say, the net margin model is really forcing us to look at required debt payments to see if it leaves anything over to pay equity owners. 

d. Return on Invested Capital Model. I've left the most important - and least understood - one for last. It, too, would require its own lengthy discussion. While everyone spends their time frittering away on a-c above, they forget (or just don't know) that the true sign of economic viability is a company's ability to produce earnings in excess of the amount of capital that is invested in the business...and the amount of money that must be reinvested in the business over time so it can maintain its competitive position. 

Back to Mad Men and the Jaguar example...The nature of earnings for automobile companies tends to be cyclical, high in good economies and low in bad. When the economy is especially bad, car companies have a very hard time scaling back their operations (reducing costs) so they don't bleed out all the profits they accumulated in the good times. Scaling back, unfortunately, tends to mean laying off a lot of employees. That's why you have governments stepping in for bail-outs. They're far less interested in whether GM, Chrysler (or Jaguar in the 70s) survive as viable businesses and much more interested that 1. important union constituents aren't out of jobs and 2. that the unemployment of massive workforces won't lead to a ripple effect in the economy, making a vicious downward spiral. Those are important points to understand in terms of the nature of Jaguar's earnings.

For its return on invested capital model, the auto companies engage in high-stakes combat with each other that involves putting obscene amounts of capital to work in building and maintaining production lines in their factories. The constant competition led them to create new models for nearly all their cars every year, and to introduce brand new models every few years. Each time they do that, they must invest capital to change or completely overhaul their production lines. And these are HUGE investments that don't always create the most reliable returns. (Some car lines succeed, others are black holes.)

That additional invested capital they plow back into the business would otherwise go to shareholders in the form of dividends or share buybacks or acquisitions that generate more earnings in the future. Instead, they must put all that money back in the business in a way that doesn't necessarily even create more earnings in the future. It's the worst kind of heavy capital reinvestment...the kind you must make just keep running in place, to stop competitors from taking market share from you.

Even while those car companies might produce a tidy profit in any given year, the brutal truth is that shareholders will probably see very little of it. The car companies must hold onto it (retained earnings) and reinvest it back into the business even though it won't necessarily make for bigger earnings in the future.

That's the nature of a capital intensive business. Over periods of several years, its return on invested capital model will demonstrate that it's not a very good place to invest money. Because you just don't get much of it back... 

If a company can invest capital in itself and produce higher earnings as a result (and I mean higher than you think a reasonable investor could get by putting the cash into a safe investment somewhere else), than you're onto something good. That means it passes this measure of profitability. It can grow and create value in doing so. It will be worth more further down the line than it is now.

If it invests money in itself while the earnings stay the same or shrink, it fails this test. It's probably not worth investing in. Hell, it's likely to be out of business before too long.

4. (For investment purposes)...Does the price make sense?

The three questions above help you establish whether or not the company is a high quality business. This last one tells you whether or not the business is worthy of your investment. Even the highest quality businesses (those with growing earnings, durable competitive advantages, and economic models that make sense) can be priced so high that they don't make sense as an investment. That happens all the time.

The price question forces you to combine elements of what you discovered answering all the questions above. In the end, the value of a company is roughly what cash you can expect to get out of it over the long-term. Once you estimate the value (and since it involves predicting the future using very complex variables, it's NEVER a precise number), you see if the market is offering the company to you at a price that's comfortably below that value.

a. Flat Earnings. If the framework questions demonstrate that the nature of the company's earnings are flat (neither growing nor shrinking), plus protected by some combination of competitive advantages, plus they don't have to reinvest tons of their earnings into keeping the company going (i.e., their economic models make sense)...then you've learned a lot and can probably make a good guess about its value and therefore what you should be willing to pay for it. 

In the above scenario (flat but protected earnings), I would generally pay something around 7x earnings. These tend to be cash cow companies, and since the markets recognize them as steady and true producers of cash, they don't tend to have much fluctuation in the stock price. But because they're so predictable, they tend to fetch premiums above that 7x mark. You have to be patient and prepared to catch them trading for what you want.

b. Shrinking Earnings. If the framework demonstrates shrinking earnings, be very careful. All you know for sure is that the value of the company is in decline, but rarely will you know how quickly the decline happens. Think GameStop again. I'm an investor even though the business will necessarily shrink over time. How can that possibly make sense? Because the price of owning it is low when compared to what the company is paying me while it shrinks. It's market share is currently a bit over $2 billion. As of yesterday, it offers a 5.5% dividend and has committed essentially all the earnings/cash it generates over the next two years to paying dividends and buying back stock. It estimates that amount to be $2 billion, meaning if the stock price stays where it is...GameStop management says it will essentially buy back the whole company using its cash flow.

Except in situations like these, I shy away from shrinking earnings. Unless you REALLY know the company and its market, it's like trying to catch a falling knife...chances are good you'll cut yourself up when you grab it.

c. Cyclicals and Blockbusters. I tend to shy away from these unless I really understand the business, the industry, and the cycles in which they operate. The trick here is to have the discipline to only buy at a low point in the cycle or in a non-blockbuster year (but you anticipate - with good reason - that the company will produce more block busters in the future). Never, ever, ever buy at the high point of earnings. You'll overpay and get burned when the earnings drop.

d. Growing Earnings. A business with growing earnings, protected by durable competitive advantages, and with profitable economic models (especially when it comes to returns on invested capital) is the holy grail. These are the compounding machines that take capital in, apply the eighth wonder of the world, and make that capital really grow. Most investors, naturally, want their money with these companies, and so they tend to be overpriced. Sometimes to ridiculous levels.

Take for a moment. Today the market values it at 240 per share. That's about 300 times its reported earnings over the previous 12 months. Ludicrous, right? Probably. I mean, you know I'm fascinated by this business. Its earnings will undoubtedly grow over time. (They're currently depressed because of all of Amazon's investments in growth.) It has low-cost, low-price, network, and brand competitive advantages protecting its earnings. It's hard to see someone being able to take those away. And its economic model is profitable, especially for returns on invested capital (despite the depressed earnings, it invests very little capital to create higher earnings). 

But to pay 300 times earnings is a tough pill to swallow. It requires that you assume the current earnings will grow at a rate (and for an extended period of time) that very few large companies have ever accomplished. Not an impossible feat, mind you. But tough. 

So here's my investing prime directive, a sub-heading of the "price question" in this framework... 

Never, EVER buy anything when the market is optimistic about its future prospects. Only buy in pessimism, and preferably in dark pessimism. 

(See the Buffett quote at the end of this article.) 

I still want high quality companies, but I want to buy them when the price is depressed. This creates a margin of safety for your investment. For Amazon, people are very heady on that business right now. They understand its dominant position in web retailing, and they see how it's expanding its competitive advantages. But Amazon's earnings are bumpy. Not in a bad way, but in a way that's just natural for a fast-growth business. The market HATES bumpy earnings, and if it sees a couple of quarters of falling earnings it may decide that a downward trend is in play and quickly change from optimism from dark pessimism about its fortunes. When that happens, the stock tanks. 

I'm on the sidelines of Amazon, knowing that it will likely show a loss in next quarter's earnings report, just waiting for the optimism to turn dark. When/if that happens, that current 300x earnings valuation will likely drop in breath-taking fashion. Which will create an buying opportunity for anyone that has studied the business and understands it according to the framework above...anyone who recognizes that its earnings will grow substantially over time, be protected from competitors, and show a nice return on invested capital. 

But it takes a strong stomach to buy even the highest quality companies when the market says they're junk.

The best way to use the framework questions is to lay it on top of any company that you want to understand better, practice using it, and make sure to consider the questions in an intertwining (as opposed to "siloed") way. In other words, the answers to one question will help you better understand the answers to another question. 

So, what's the next Mad Men case study?

Thursday, August 2, 2012

Why Is Price the Ultimate Competitive Advantage? (Playing Games)

This is a shared post with (here). Forgive the self-plagiarism, but I think you'll see how the idea is tied tightly with many of the investment ideas (especially the string of what actually makes for a competitive business advantage) discussed on Adjacent Progression.

There are two forms of pricing power: the ability to raise prices and the ability to lower prices. 

The ability to raise prices for your offerings - demanding a premium over competitors’ products based on something you do better than they do - is an excellent indication that your business offers some form of competitive advantage. Otherwise you probably couldn’t charge a higher price. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must satisfy some consumer desire for functionality, novelty, or style. 

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term, or whether it's fleeting and likely to dissipate with time. And, of course, most advantages do go away with time. New fashion designs get mimicked, and the public’s taste for a particular style is fickle. Innovation in technology may provide a lead over the peloton of competitors for a while, but it has a tendency to figure out your tricks, duplicate your product features, and draw you back into the pack over time. 

Most competitive advantages are decidedly NOT enduring. 

But when a company dedicates itself to offering the lowest prices (and maintaining a low cost structure to boot), it has a durable advantage that is very, very difficult to compete against. It is the ultimate competitive advantage, better than those that allow a business the ability to charge higher prices. 


Consider this statement attributed to David Glass, the former Walmart CEO: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. *

To understand Glass’s point, we have to dabble a bit here in a rough (very rough) game theory scenario. (My apologies in advance to actual game theorists.) Let’s reduce the totality of competitive capitalism - that unrelenting tug-o-war among firms to gain the slightest of edge over rivals - to the following matrix (the Price-Cost Matrix) and assume that a company must fit into one of the squares. We’ll further assume that no company possesses an insurmountable competitive advantage over another. Any one company might stumble upon a popular fad that drives sales, or its engineers might cobble together a product whose innovation wows customers. But competitors will eventually figure out the advantage and replicate it. Again, the peloton sucks everyone back in. 

So, in this game, the only true differentiation, over the long-term, is price. Who can offer the lowest price?

Price-Cost Matrix

Your prices can either be high relative to competitors, or low. Same with your costs. So we get four possible combinations to define the companies: High Price, High Cost; Low Price, High Cost; High Price, Low Cost; and Low Price, Low Cost. 

Conventional wisdom says you want to be in the top left hand quadrant (High Price, Low Cost) with the power to raise prices. That’s where the fat profit margins reside, that exalted place where you have low costs to acquire or produce your products yet can sell them with a big markup. Everyone loves profits. In fact I’d go so far as to say most people are blinded in their business decisions by an overwhelming profitability bias

The problem with profits is that competitors notice them. Nothing grabs more attention than high profits. And they’ll want a piece of the action. They’ll enter your market and go after your customers. And in this game scenario of ours, they’ll woo your customers with the offer of a better price. You get sucked into a price war. 

The game theory part of this exercise (and this is ultimately David Glass’ point) is this: you must extend any business competition to its furthest – and even most absurd – logical conclusion. If it’s a price war, you must imagine which player can engage in battle the longest and prevail. 

So let’s imagine it from the perspective of the game’s predator: Low Price, Low Cost. He will source his merchandise at the lowest possible cost, he will maintain the lowest possible overhead, and he will work with evangelical zeal to uncover inventive ways to make both even lower. Then, he will turn around and put a frighteningly slim markup on his items. He offers everything at the lowest price he can muster, and he keeps his costs below those of everyone else. 

He is a fanatic, and he has an insatiable appetite for growth. How do players in the other quadrants fare in a price war against Low Price, Low Cost?

Low Price, Low Cost Starts a Price War

In our game, Low Price, Low Cost goes on the offensive. First, he attacks Low Price, High Cost. This skirmish is easy. Low Price, High Cost is a terrible business that’s stuck, for some reason, in the unenviable position of having to sell its products at a low price yet incapable of revising its cost structure. It’s limping along on tiny margins. All the predator must do is make his prices just a bit lower (enough that a price match would get rid of any remaining profits from Low Price, High Cost), and then wait it out as the wounded competitor goes out of business. It cannot afford to lower prices enough to compete, and so Low Price, Low Cost wins these customers. 

Next is High Price, High Costs. This battle would be easier than the first, expect that High Price, High Costs has some cash on its balance sheet (from earning decent margins over the years) and is foolhardy enough to spend it on the fight. The predator makes his price dramatically lower, the prey tries to match, but in the end it must relent. Its high cost structure means it cannot afford to offer low prices for long. Low Price, Low Cost wins these customers. 

Finally we have High Price, Low Cost. This is a long, drawn-out battle. High Price, Low Cost has plenty of cash to fight, having built deep reserves over the years from its fat profit margins. It price matches the predator, even ups the ante by lowering its own prices further and challenging the predator to match. It can afford this because its costs are so low. But over time its resolve is tested. It had grown used to that big margin (more importantly, its investors had grown accustomed to the profit). It tries to reinvent its culture to dedicate itself to low prices, too. Alas, cultures are very hard things to change. 

The competitors go back and forth on price, creating a war of attrition with both sides taking deep losses. But in the end, the predator remains fanatical about his cost structure. He lowers it more and more, and High Price, Low Cost just can’t keep up. It goes broke, perhaps just five percent before the predator would have. But that doesn’t matter in the end. At the end of the game, Low Price, Low Cost is the only player still standing. 

You may argue that this game is unrealistic. And, of course, it is. The practice of competition is much more nuanced than a hypothetical game. But history shows that, over time, the competitive advantages that protect businesses and allow them to earn high margins…well, they grow weaker as competition learns the secrets. In the long run, everything is commoditized. 

And in the light of this extreme game – one taken to its absurd logical conclusion - we can reconsider David Glass’ words: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. 

The companies that want the most enduring competitive advantage commit themselves to staying in the bottom left quadrant in the Price-Cost Matrix, as far below and to the left of the competition as they can. To do it, they muster a fanatical devotion to staying low price and low cost. More on that next…

This is the fifth post in a series about Amazon's Feedback Loop, the mechanism most responsible for the company's success. See also the previous posts, The Growth Levers in Retail: Price, Selection, ConvenienceUnlocking the Broad Middle (Hint: Price Is the Key)Sam Walton, Panties and Power Laws; and The Productivity Loop (Walmart's Feedback Loop).

* Quote from Charles Fishman's excellent The Wal-mart Effect

Thursday, July 19, 2012

EBay, Mr. Market, and Amazon's Q2 Results

This is a shared post with, re-posted here because of its obvious ties to the Shleifer Effect, Mr. Market, profitability bias, and other investing concepts we discuss. 

Mr. Market is a funny dude. At this writing AMZN is trading up about five percent on the day. The reason? eBay.

Well, eBay plus lofty expectations that Amazon's current positive trend continues through its Q2 earnings announcement next Thursday. A look over the last few quarters of the relationship among earnings expectations, actual earnings, and Mr. Market's reaction...let's just say it shows an interesting dynamic.

The eBay Angle

eBay announced its Q2 results last night and exceeded every consensus expectation on the metrics Wall Street uses to gauge its performance. (See Scot Wingo's always well-informed discussion of the results at eBay Strategies here.) Mr. Market has pushed its price up over 10 percent on the day, touching - ever so briefly - its own 52-week high.

One of those important Wall Street metrics is eBay's Gross Merchandise Value (more or less its auction and marketplace revenue) growing at 15 percent, which pretty much matches the growth rate of the overall e-commerce market.

So here comes Mr. Market's logic...

Since Amazon has been crushing the e-commerce growth rate, outpacing it 2:1 with Q1 results in April when Amazon increased revenue 34 percent. And...with eBay showing it can match industry growth in the most recent quarter, then there must be some good tailwinds for e-commerce right now. Ergo...Amazon is going to kill it with Q2 results next Thursday! So let's bet on Amazon! 

Well, Mr. Market, you may be right. I'll grant that Amazon will probably outpace industry growth yet again. But what happens if earnings - once again - don't follow revenue growth? Moreover, what if earnings  (gasp!) disappear altogether for Q2 as Amazon has suggested is a distinct possibility?

Going Back in Time (But Just a Little)

Let's go back in time to look at Mr. Market's previous reactions to Amazon's earnings. We'll use some charts based on Wall Street analyst estimates of Amazon's performance (provided here by Businessweek) and go backwards from most recent.

Last quarter, Q1 results, Amazon surprised Mr. Market by earning .28 cents per share. This after his consensus estimate was .07. The stock shot up about 15 percent in the two trading sessions immediately following the news. It was the second such positive report, which leads us to...

Q4 of 2011 Amazon reported .38 cents per share. Mr. Market has expected .18. A 110 percent upside surprise. The stock actually fell seven percent on the news. Maybe that's because Mr. Market still had not recuperated from the hangover caused by the previous quarter's different kind of surprise...

In Q3 of 2011 Mr. Market had high hopes for Amazon. He was expecting .25 per share after Amazon had posted a hefty .41 cents per share in the previous period. He was hoping for the trend to continue, and in anticipation of it he had run up the stock price by about ten percent since the last earnings announcement. Amazon only earned .14 cents per share. Mr. Market's great hopes were dashed, and he punished Amazon, sending its stock price plummeting from about $225 to about $200 within a couple days. It went as low as $173 before starting to climb back up again.

Over this past year, Amazon has been nothing if not volatile. Google Finance is quick to highlight its 52-week range as 166.97 - 246.71. That's a wide spread, indicative of Mr. Market and this game of expectations he likes to play...and the bi-polar extremes that take over depending on whether Amazon has lived up to his expectations.

Q2 2012 and the Profitability Bias

Well Mr. Market's expectations for next week's results are not too lofty. At least as conveyed by the consensus estimates. It's at .03 cents per share (though the range is quite wide: .17 cents on the high side and .23 LOSS on the low side).

But the reaction today to eBay's results suggest to me that there exists loftier expectations than he's letting on to with the estimates. I think he secretly expects HUGE revenue numbers that will wow investors into paying even more for the privilege of owning shares.

I wouldn't bet against that happening. But even if the big revenue numbers come in and earnings disappoint, this faith in Amazon's upward performance trend is going to be dashed. And Amazon losing money in Q2 is a very real possibility. (Its guidance from the Q1 press release said this: "Operating income (loss) is expected to be between $(260) million and $40 million, or between 229% decline and 80% decline compared with second quarter 2011.") We know how heavily the company is investing in growth, and how willing it is to let those growth costs eat up profits. (See Amazon's Rapid Sales Growth...Buying the New Business?)

So, even if revenue growth blows us away, losses tend to shake investors' faith. Why? The profitability bias. It's almost as if we have an instinctive visceral reaction to seeing losses in a business that was previously showing earnings. We just can't help but think more losses are coming, that there's something wrong with the company, and that the losses will extend into future quarters. We have very weak stomachs for these things. Even if we know the business has staying power, is investing heavily in initiatives to make even better profits in the future, or is just going through a temporary funk. We just get spooked. We overreact and send the price down.

That's the basis for the Shleifer Effect

Note that I'm making no predictions for Amazon's results next week. I am, however, highlighting the appearance of high expectations combined with the POSSIBILITY (nothing more than that) of Amazon not satisfying those expectations. Plus, we've seen what happens to the stock price when Mr. Market's expectations are dashed.

I'll end with this incredibly inappropriate teaser...

Amazon finished today at 226.17. That's almost exactly where it was immediately prior to the Q3 2011 update when it disappointed and proceeded to fall to its year lows over the next three months.

What Would You Buy If Price Didn't Matter? (Take Two)

Somehow, inexplicably to me, this blog has generated a modest (and believe me, my humility in using the term "modest" is well-deserved humility) readership. And here I thought it was an echo chambers for my ears only. Go figure.

A theme you might notice in the blog is that I want to challenge the limited way of thinking inherent to the acolytes of value investing. Before the torches and pitchforks come out, let me say defensively...I'm one of you!  Well, mostly. Probably 90 percent. But the absolute fixation on price to the neglect of those other traits of a good business and a good investment...well, that just keeps me spinning in my own circles, flirting with the (gasp!) growth-story stocks.

I'm using price more as my last box to check off in my investment checklist. I'm interested first in the qualities of the business itself. Does it have a profitable economic model? (i.e., returns on invested capital, cash producing...even if we have to look into the future to see it) Does it possess real competitive advantages? (i.e., scale-price advantage, brand, network effect or other means of making captive demand, or legal protections) And does it have a big market to grow into to compound its earnings?

And then, within the context of those questions, is Mr. Market offering it at a price that's either reasonable or discounted?

Margin of safety is not strictly a function of price. It's provided by the interconnectedness of competitive advantages, economic profitability, and ability to grow.

Perhaps I get burned and the strict-value minds feel vindicated. If that's the case, I will probably never admit it publicly because I'll be too busy panhandling the streets of my small town. 

So, for anyone new or interested, I wanted to re-issue my thought challenge. 

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.

So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?

The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...

1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)

What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I'll keep a running update on the blog.



You can email me at pauldryden (at) gmail.

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
- Charlie Munger
(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)