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 in...it 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 GameStop...at 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 Amazon.com 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?
