Mutual thrift misdirection

I have some other ideas for specific applications of SJG’sideas to analyzing stocks, which may or may not just boil down to common sense.  Mutual thrift conversions are a category of stocks I can look back on in a different light after some reflection.  The quality of the bank is a distraction from capacity to return excess capital.  The quality of the bank is relevant in as much as it gives one confidence to purchase the shares and wait for the excess capital to be returned.  These aren’t growth stories, these aren’t quaint narratives of local firms doing “better banking”, and most of the qualitative appeal simply isn’t there with the crop from the past 2 years. 

The first thing I would look at is the quality of the bank.  It would be difficult to buy a bank on the thesis of excess capital being returned to shareholders without establishing that excess capital will exist in coming quarters.  If it doesn’t exist due to growth, I wouldn’t jump to a negative conclusion, but the growth would have to be qualified on the historical record.  But none of this is where you make money.  This is where you avoid losing money.

I just uploaded this write up of SPBC to scribd, which is more in depth than my post on it several months ago.  As is my hope with every stock I buy, it’s cheap at 65% TBV and slightly underleveraged for a bank at 11% tangible equity/assets.  They’re located in Plano, a solid economy for a bank to be exposed.  Now that the stock is publicly traded, the thinking is there should be incentives to properly manage the company to peer profitability. 

I don’t think this is how you make money though.  It should be returning what is excess capital and post conversion that can almost be the entire market cap.  So say a bank should ideally have a 9% leverage ratio, SPBC has 2% of its assets that can be returned to shareholders and the bank will still operate fine.  That’s about $6m in this case against a market cap of $20m, so a cool 30% gain and the bank still trades at 77% TBV.  If SPBC had a leverage ratio of 16%+ and traded at 65% of TBV, it would be a lot more interesting from this perspective.

The problem is that the world is not perfect.  I shouldn’t expect a $6m check in the mail any time soon.  This is a slim amount of excess capital.  This isn’t a very sound thesis.  SPBC may initiate a dividend and distribute some of the excess capital as they are allowed, but not to the degree that really provides a nice return in a short time frame. 

Abstractly, there are certain thrifts I stayed away from that never met the qualitative requirements, like Naugatuck Valley Financial, which I spoke about a while back.  In hindsight, they also stated a desire to expand, a de facto statement that I wasn't going to see any of that excess capital.  It’s only been several months, so it’s not like I can this based on an outcome, but the ones I bought were bought cheap and of decent quality.  It’s pretty hard to lose money with balance sheet by and large clean at a large discount to TBV.  They've held up well against the recent market swoons.

So like the dome and the spandrel, a quality bank is what holds up the possibility of gobs of excess capital being returned.  Will this always be the case?  No, but it’s more likely than not the proper aspect to be focusing on if you want to make money.  There’s nothing wrong with owning a quality bank at a cheap price, but there is no excess capital being returned which really creates the reward in the aftermath of thrift conversions. 

Stephen Jay Gould on investing

Evolution is competition and adaptation in slow motion.  Really slow motion.  We can never be geologically relevant.  But we can speed this up and compress the time frame to look at companies.  Companies compete in an environment with tons of variation and randomness.  Sometimes there is the advantage of backwardness.  The disappearance of a dominant entity can say more about the increasing capability of weaker entities than a failure at the dominant one.  Looking at evolution and punctuated equilibrium can be an interesting mental model for investors.

Stephen Jay Gould, the scientist that I am aware of being credited with punctuated equilibrium, wrote a book I like called Full House.  I’ve read some articles on SJG criticizing his contribution to the scientific field, but I figure this falls under the broad category of assembling a latticework of mental models.  Full House is a more science-oriented version of The Black Swan.  Gould does explicitly denounce Platonic thinking (like Taleb) and uses the drunkard’s walk as part of his reasoning in explaining it.

The crux of Gould’s argument is that people who believe evolution happens by virtue of some logical progression misunderstand variation and the randomness of the world.  It is much too random to be the product of a Platonic deductive reasoning.  To a man with a hammer everything looks like a nail.  Gould uses evolution as a demonstration of this cognitive flaw since that is where he sees it.  Taleb points this out in financial markets and the broader world of practice.  I like Taleb’s example of trying to figure out what an ice cube looked like before it turned into a puddle as an illustration of the same idea. 

Gould uses the drunkard’s walk to demonstrate how humans evolved.  How this ties into statistics is because the human species represents the right tail on the distribution of variations of organisms.  When people attribute human complexity to some idea of progression or complexity from bacteria to plant to animal to human, they ignore that the greatest variation lies in species of bacteria.  All of the variation represents equal outcomes of evolution in terms of “progress.”  His point in Full House is that we too selectively interpret this data point to suit our ends rather than place it in the proper evolutionary context of randomness.  We’re just one outcome of many and we don't fully appreciate it.

In an interview with Gould, modeling evolution on computers could just be switched out for the stock market:

How do you view the new science of modeling life processes like evolution on computers? You're talking to a man who still writes on an upright typewriter. Artificial life I find interesting, I've read a little of the literature. But I don't know how much it's going to teach us about actual life. It does allow you to iterate a set of simple rules and see what happens. That's not how the world out there works, but that's an interesting thing to do. Natural selection in its pure algorithmic form doesn't happen out there either, but you can do it on the computer. I think it's a very valuable approach. It would be a danger only if people thought that's how the world worked.

Gould discusses a nice range of topics that are worth exploring throughout his career.  The difference between theory and practice is that theories don't always reflect how the world works.  In one of his early papers he discusses the flaw in thinking of evolution as an optimal adaptation, the byproduct of failing to appreciate the randomness.  People were interpreting the complexity of human beings as fully evolved out of necessity.  It's just not how the world works.

In this paper, The spandrels of San Marco and the Panglossian paradigm: a critique of the adaptationist programme, Gould and another scientist, refute the idea of natural selection as resulting in optimal outcomes.  It’s the same idea as Full House presented a little differently and free online.  The Panglossian paradigm is assuming that our noses have evolved to hold eyeglasses taken from Pangloss in Candide.  Gould compares this type of outlook on evolution to the spandrels of San Marco.  A spandrel is a “random” architectural component that emerged to support domes but then achieved a certain artistic relevance in the overall structure.  People made use of it, but people did not include it in the overall architecture to make use of them.

There has been criticism of Gould’s characterization of spandrels and his overall contribution to evolutionary biology.  I can’t really judge the validity of them.  I’m curious about investing.  These ideas are relevant.  In Full House, Gould makes the direct charge that Platonic linear thinking is a flawed method for analyzing such a random event as evolution.  The Black Swan is a more relevant treatise in regards to investing on this type of flawed thinking, but sometimes removing the immediate noise of applying an idea to financial markets can help illuminate them.

What are some other ideas that strike me as useful applications of Gould’s thinking to financial markets?  Well it boils down to people wanting to create narratives for why things are the way they are.  Only because it is quite contrarian to the normally touted reasons for the appreciation in gold prices, Krugman makes the case that the price rise is a deflationary indicator driven by falling interest rates signaling deflation.  I like it.  It makes sense.  I'm not going to do anything about it, but it's an entertaining idea to entertain.  In doing this though, you can appreciate how difficult it is to really apply deductive reasoning to what happens in the real world.

Applying this type of thinking to macroeconomics is exactly what I would counsel against, but it is worth learning from.  We really won’t know who is right for several years, if not decades.   A macro issue where people are focusing on the wrong data point is comparing the US economy to Japan.  Richard Koo is a Japanese economist who is claiming that the US is facing exactly what Japan faces.  Below is a short video that outlines his thinking.  It’s not bad if you are unfamiliar with the argument.

How do you avoid this type of thinking?  How do you separate the forest from the tree or the spandrel from the dome?  One person who has responded in the proper way to this idea of the US equaling Japan 15 years ago is David Merkel.  He just lists the similarities and differences.  

There are some key points that differ.  Focusing on ZIRP and deficit spending is retroactively applying the effect to a cause – like assuming human evolution stemmed from a notion of progress – rather than acknowledging the huge amount of variation in causes and effects.  How do you separate the spandrel from the dome?  Things like ZIRP, deficit spending, or demographics.  Are they spandrels or domes?  Merkel brings up the issue of the aftermath of overconsumption versus over production.  This is more likely the dome equivalent since that is the essence of what is being dealt with and the ZIRP or demographics are just the spandrels that stem from the existence of over consumption or production.

This may boil down to personal capacity, but I find the ability to make macro calls difficult.  I could feel confident saying the US will not look like Japan based on the grounds that Koo is really just a man with a hammer.  It's hard to take anything away from this and apply it to actually investing.  Merkel doesn't prove anything as much as he disproves the thesis that the US is following in Japan's foot steps.  But many people say that investing is a negative action - inaction - since what you don't do is more important than what you do do.

In a similar vein to the discussion of Japan's economy and our misguided fixation on certain outcomes (humans, balance sheet recessions), Charlie Munger brought up a differing explanation to Japan's economic malaise with a mental model that closely resembles Gould's.  According to the Innoculated Investor notes from the 2011 Wesco meeting:

Next, Charlie provided an explanation of Japan’s economic malaise that is not commonly cited.  Japan is an export dependent economy. In the late 1980s and 1990s, Japan got huge and credible new competition from China and Korea. They got this because the traditional laws of economics were working well in China and Korea when they adopted something like free market capitalism. The main competitors got more competitive and this impacted Japan substantially. This is an explanation that you never hear. This is why you need to try multiple approaches to solving problems.

Gould discusses a similar example in Full House with the disappearance of the .400 hitter in baseball.  His claim is that this is the result of an overall improvement in excellence and shouldn't be interpreted as a sign of degrading quality in baseball.  I wasn't aware that people claimed the disappearance of the .400 hitter meant this, but in the book he quotes people who apparently claim so.  What's important is to think deeply about how people become fixated on the spandrels instead of the domes.

All of this does apply to thinking about specific businesses in an intelligent and businesslike manner.  It's important to figure out if the perspective you adopt to look at a data point is really reflecting the reality behind it.  I'm going to stop here and write a separate post on what I think are example and methods for applying this to stock selection.

Sam Zell, an investor who thinks like a businessman

I was watching this interview with Sam Zell the other day and I thought it was reminiscent of businessmanlike thinking, a topic I explored in a recent post.  While it doesn't take much to judge him a success based on outcome, I found myself thinking that he sounded like he had a good process as well.

Note: I embedded the video right here where this sentence now is.  It kept automatically playing when the page loaded and I found it obnoxious.  You'll have to click on the link to see the interview I'm talking about.

One thing I find interesting is this "uncertainty by the administration" meme that has taken root.  It has even taken root in Zell's mind.  Except that when he says that it is causing volatility, the answer to the follow up question is that it isn't affecting him with his investing decisions.

To move off track for just a moment, Howard Marks gives off this vibe as well.  In his book, The Most Important Thing, he talks about second level thinking.  When you know China is going to be a behemoth in 10 years, one has to think about where that isn't being priced in.  There is no money in just buying "China Stock X," and that's assuming they aren't a fraud.  Everyone knows that the Chinese economy will be bigger.  Once everyone knows that, stocks tend to price that in.  The edge in investing in the stock market boils down to knowing/understanding/concluding something that others don't/discount/disagree.  This is the same edge that a businessman has, but the manifestation is not identical.

Back to Zell.  Zell is asked about where he is investing.  He is investing in Mexico and Brazil.  Why?  They have a deficit in housing supply to the tune of several million units.  When the interviewer prefaces a question with the poor performance of the Bovespa, the Brazilian stock exchange, and if that impacts his confidence, he responds that "I'm not investing in the stock market, I'm investing in companies."  He isn't concerned about other people's opinions (the market), but what he is actually doing with his money.

His edge is that he brings something to the game - expertise and capital.  When asked why he isn't investing in Chinese property, he responds that they have plenty of capital and his expertise is of no use to them ("they don't listen").  It's also noteworthy that Mexico is probably not a place people want to invest in based on the headlines currently coming out of there.  His edge is that he knows how to build and operate real estate investments and has the capital to ignore the market.  He is aware of a neglected yet obvious trend.

This can be relevant for investors.  I'm not moving to Mexico any time soon to start building homes, but the sentiment isn't foreign to investing through public markets.  What Zell is doing is the same as sugar water in red cans.  I recently looked at Xylem, the water spinoff from ITT.  The masters of the universe are really sexing this stock up in my opinion.  Water is a theme I see flowing around Wall Street.  FT Alphaville had 2 posts on some Wall Street research on water (here and here).   Businesses will make money in water someway and somehow since that is what capitalism is about.  The who, what, when, where, why of it isn't that difficult - Xylem is at a choke point of pumps, analytics, treatment so it isn't the same as speculating that BYD will command major market share in the electric car market.  There are certainly plenty of other "water stocks" that probably have nice growth rates even just based on their historical record.  Do I have an edge in this?  Not particularly beyond any cheap valuation that arises out of a market panic or volatility.

I'm interested to see the valuation on Xylem that stems from this belief, since Xylem is advertising itself as directly catering to it.  The market is volatile, so the price can become disjointed from value.  But as a starting assumption, it is better to assume that the market is not unaware of this phenomenon.  Being attached to 2 other companies currently, it is hard to tell with Xylem, but I don't think people are neglecting the water theme currently.

One thing Zell mentions that isn't totally relevant to investing like a businessman, but worth noting is that he says there are more SFHs rented than apartments in the US.  That's a unique piece of data if you ask me.  I certainly wasn't aware of that.  Not that I pontificate on macro, but I would think that people think that houses need to be bought and sold for a sign of a recovery in housing.  Apparently this isn't the case, since a rented home takes supply off the market and its quite popular.

Has Zell made mistakes?  Sure.  The Tribune LBO happened at a questionable time in the market considering he was well aware it was frothy - he sold one of his property companies practically at the peak to Blackstone.  Nobody is infallible.  This isn't a complete profile on Sam Zell, but just pointing out an example of what I think is a demonstration of the way to think about and discuss investing.

Warren Buffett is a big advocate of investing like a businessman.  Many months ago, I highlighted a video of a speech by Alice Schroeder that more or less details exactly how he approaches an investment and values it.  Recently I stumbled into a blog that is compiling a great collection of talks and presentations on value investing.  There is a transcript of the speech in the video on the blog, which takes about 10 minutes to read instead of the 48 minutes for the video.  The historical perspective gained from reading some of the other transcripts on that site from investment pitches given several years ago is also nice.  Worth browsing if you are into that kind of stuff.

It's peachy at State Bank & Trust, y'all.

Scribbified for my formatting ease.  State Bank & Trust (STBZ) is a messy looking Georgia bank that's cheap and and has nice prospects for which I need not pay at current prices.

State Bank & Trust (STBZ) Write Up

Long STBZ

Trying to think like a businessman with ITT

One question I kept asking myself when reading about the ITT split up (Xylem and Exelis write ups from the other week) was if any of this made sense.  Not the business, but what the business is doing.  I addressed some examples of how one does this in my previous post.  Does this split up make sense when I strip away the noise?  I wrote about this in my post on where I've gone wrong with spinoffs, but will rehash it in terms related to ITT.

Everything equal, my take on the ITT situation is that it is a pretty nice tax free way to sell the industrial business, get the water business to be a sexy stock, and remove the negative sentiment towards the defense business from 2/3 companies.  From a "corporate strategy," shareholder, and investment banking perspective, this all sounds wonderful.  The total cost of this "transaction" is $500m.  Transactions entail fees (there are some impairment charges in the mix too).  This is a big fee that doesn't fundamentally change the earnings power of the underlying business.  At the margin you have higher debt costs, regulatory expenses, and less robustness.  If I owned the business to myself, would I be doing this?  Would I do anything differently?  Let's consider taxes.

On the face of it, ITT is paying $500m to unlock ~$1bn of value through market perception.  That's a 100% ROI taken at face value.  One thing to think about are the tax implications, which I view as important in spinoffs.  For a moment, take that Exelis and Xylem are worth $6.5bn as a fact.  That implies $1.5bn for the industrials business that I think is worth $2.5bn.

ITT currently trades for about $8bn.  I thought that defense business was worth around $3bn and the water business $3.5bn.  That's $6.5bn.  The industrials business, which I haven't and won't write up, is probably worth around $2.5-3bn in a buyout at 10-12x EV/EBIT on 12% EBIT margins with around $2bn in TTM revenue.  It will have zero debt and enough cash to cover to remaining projected asbestos liability.  So the total is around $9bn.

Consider if ITT stayed together and returned all the money generated from selling the industrials business.  Total assets in the motion & flow division are $1.3bn.  Hypothetically, their cost is $1.5bn and they sell it for $2.5bn.  That's a gain of $1bn (I don't really know the cost, but the cost is likely lower and a lower cost would result in a higher taxable gain).  Taxed at 35%, ITT is left with $2.15bn.  They then return this to shareholders who get to keep $1.82bn of that after taxes.  So that makes the business staying together but being oblivious to taxes worth $8.3bn - around current prices.  So at current prices, assuming no $500m transaction cost, I net myself $200m.  That's $6.5bn for Exelis and Xylem plus $1.8 in cash from selling the industrial business.  Well, that would be much ado about nothing, and Xylem and Exelis could very well be worth less than I think they are worth.  

So lets consider what happens with the spin.  Post spin, an all cash buyout for $2.5bn would result in $2.12bn for long term owners or $1.62bn for short term owners.  So from a businessman's perspective, buying it today just doesn't really make much sense since $6.5bn of Xylem + Exelis with $1.6bn is basically the current price.  It's basically just $500m down the drain since the total value of the parts is where we are now assuming Xylem and Exelis remain unchanged.  In this instance, I want to point out that buying this business today and entering this transaction is not the same thing as having bought this business over a year ago and agitating for this transaction.

The long term shareholders who agitated for a shake up are in a better position, but I can't replicate a passage of time.  If I seem wedded to the idea that the industrial business gets bought out within a year, it's because I am.  I wrote about Treasury Wine Estates, which was spun out of Fosters.  It was a wine company spun out of a beer company.  As a standalone beer company with strong market share in a developed country, SABMiller probably thinks they have tons of synergies and that stuff to gain.  They want to buy it badly.  Once TWE was out of the picture, Fosters became much more attractive.  Within a matter of months, it had its courter.  Does the same narrative play out with the industrial business?

Now I don't like to do horse trading.  Nobody is ever going to put accurate odds on the industrial business being bought out in +/- 12 months.  ITT's industrial business will be sought after when looking at potential outcomes.  There are several things I'm reading into when I establish this.  First, it is not being spun out.  This has tax consequences for the entire spin transaction, since a takeover triggers tax consequences.  I think that means something.  ITT Industrials is also being left with no debt and cash to cover the remaining asbestos liability.  To me this all screams, "come and get me."  Does it happen within the next 12 months?  I have no clue.  Interest rates are low, valuations have come down in recent months, corporations have strong balance sheets, and ITT industrials has a reasonable competitive advantage and complimentary product lines for many industrial firms.  Does an acquirer knowingly extend the finalisation of the acquisition until 366 days after the spin?  I don't know, but then that seems like a long time to be involved in an arbitrage play where anything can happen.  Even if the acquisition is announced in 6 months and intentionally delayed until 366 days after the spin, I'd likely sell the business at a slight discount to the closing price.  

Well once I realized this, it got me thinking about the entire transaction a little more.  When I looked at Exelis and compared it to L-3, I intentionally included unfunded pension liabilities as a form of debt in the enterprise value.  I went back into the nitty gritty to look at pension assumptions since I still remain dumbfounded by compound interest and pensions are probably a good example of where it hurts rather than helps investors.  I have on good faith from my friend Warren, that pensions are an area where a lot of fudging is going on minus the chocolate goodness.  Here's a simplified table outlining the effects of their respective projected returns and discount rates on their pension assets.

	Pension Asset	Projected Return	Future Value Year 10	Discount Rate	NPV
Exelis	1,000	9.00%	2,367.36	5.62%	1,370.26
L-3	1,000	8.55%	2,271.42	6.26%	1,237.66
Difference			96		133

I just used the pension assets in this example because both have unfunded liabilities.  I just want to show what an all else equal example shows about the gaps that can emerge.  Even based on just these two examples, Exelis is already a fudger.  Correct me if I'm wrong, but both of these projected returns are kind of high.  I'm under the impression that standard corporate practice - already fudged in general - is an 8% return.  I don't know what the standard discount rate is, which does play a key role in the maths of it all as well.  Judging from the established credibility of assuming a 9% return, a 5.62% discount rate doesn't offer firm ground to stand on and it is again aggressive compared to L-3.

The point is that every dollar in Exelis's pension fund is the equivalent of $1.133 in L-3's.  A dollar contributed to Exelis's pension is not the same as a dollar contributed to L-3's.  So that's a pretty big deal when Exelis has a $1bn unfunded pension liability, because that means it's understated.  Unfunded pension liabilities are the norm for many defense companies, but that doesn't make it right.  

This is a flaw that can arise in relative valuations.  Just because everyone has the same problem does not make that problem not a problem.  I think from a businessman's perspective, the obfuscation and implicit leverage from the unfunded liability make it less interesting.  While I included the stated value of the unfunded liabilities in my original analysis, this needs to be upped at least another $100m to match L-3's standards, but L-3 also has a $780m unfunded liability.  Their standards likely aren't conservative enough either since the incentive is clearly to understate the liability to boost short term earnings.

This was less risky when done at old ITT.  Even if the defense industry is in the doldrums, which seems to be the current course, other businesses could pick up slack in pension contributions.  When I realized this, I started to reconsider the stand alone risks.  While filling in the gap would be around 1 year's FCF, it is closer to 2 years at Exelis and that is being kind with the lower revenue and margins they face in coming years.

Xylem will likely not face much financial risk as is, but they are taking on $1.2bn in debt that is about 3x EBIT.  This is manageable.  The business produces tons of FCF.  Then I started to consider some risks.  In my original write up, I highlighted their sales force and service centers foot print as a competitive advantage in every day business and quite possibly in positioning it to acquire companies.  While ITT has never really done transformative acquisitions, they are a consistent bolt-on acquirer.  Xylem seems to have similar intentions to get into some additional product lines.

There is nothing wrong with this idea.  Acquire additional products, slice off the head of the company, plug it into your existing sales infrastructure.  Xyelm will generate tons of FCF.  Does debt get paid down?  Does debt increase?  With 40% of their sales from Europe, there is clearly downside risk.  While water is a sexy long term theme, long term trends still go through cycles (ahem, China).  The business is plenty healthy to survive a downturn, but the potential downside requires more of a margin of safety than 20-30% for the entire business on the bull case.  In 5 years, the industrial business and Xylem will be more valuable than they are today, and Exelis should be fairly stable.  

So I decided that I would rather own the businesses as a whole under one roof.  If they are undervalued on a sum of the parts basis, why not just spend $500m on buying back stock at a depressed price.  That is a pretty savvy long term investment to make assuming you agree with their implicit statement that the stock is undervalued.  If the market doesn't agree with that move and punishes the stock, buy back even more stock.  So I don't want to own ITT at this point in time, but it's 3 stand alone businesses in the future might be of interest.

One additional quibble is that a subdivision from the fluid segment and the motion & flow segment are being swapped.  The only logic behind this is to make the fluid segment more of a "pure-play water business," but still maintain some balance between all 3 business divisions.  A pure-play water stock sounds lovely.  It's a real easy pitch to brokerage clients and appeals to all the fear about water resources these days.  But then I thought to myself, why do I have to own this business?  If it's because it's a "pure-play water business," then I should be looking at the whole industry and whatever I buy should be cheap on an absolute basis (Pall's business is 75% consumables, so that sounds nicer than Xylem's 15% of business from replacement parts).  Abstractly, this made it evident that I was being sold something not based on the dry fundamentals of the business but on the grounds that this $500m transactions had to be sold to people - the theme, the trend, the sex factor.  Bankers, advisors, auditors, and consultants do something to earn their money.

So I recognized I have no edge in this business.  If I feel pretty comfortable that signs point to a sale of the industrial business, I'm not alone.  It's only 25% of ITT though, so there are a lot of other factors that can play a role in the outcome that are beyond control.  So I'll follow it and revisit it when the spin price is established.  Part of the transaction is based on removing the stigma of the defense segment.  Well, I'm certainly not alone in realizing this either.  Will the defense segment get priced poorly and see even more selling pressure post-spin?  Maybe.  Again, it's worth following and waiting for a cheaper price since they have issues.  Will Xylem be sexy and trade at 20x earnings?  I don't think it's really worth that much - a 5% return on a cyclical company with exposure to public utility spending doesn't equate a margin of safety.  

I have done work on the businesses and have a grasp of the fundamentals.  If things get worse - and spinoffs can be predictably unpredictable with their trading in the first few months - then I can revisit them.  There are some tax implications to buying ITT now in regards to potential returns.  There are individual issues that would be better addressed at a conglomerate from a cash flow perspective.  So who knows?  Maybe some of these chickens will come to roost in coming months, a more attractive Stock Market Genius spinoff scenario will emerge, and I'll be ready.

How to think like a businessman

Investing like a businessman is an idea that often is only paid lip service by people, myself included.  I will in effect end up parroting Warren Buffett, but my research on ITT made me think of this.  Graham was also fond of saying investing is most intelligent when it is businesslike.  The more I wrote about ITT, the less sense it made.  I think this largely has to do with looking at the split up from the perspective of a businessman - you know, what am I actually buying and what are the return implications.

The biggest mistake I make in attempting to be an investor is grounded in epistemology.  How do I know what I know?  I don't visit companies.  I occasionally email a company for clarification about something they said on a conference call or in a press release and rarely get a response.  Yes, one can look at historical margins, free cash flow, book value, and competitors to get a grasp of what is being bought.  The problem is that many people think of a share as a piece of paper and really have a weak case for knowing if something is cheap - although it rarely prevents people from thinking it.  People mindlessly believe share buybacks are an absolute positive, but it is really just an ordinary business decision that can turn out poorly like any other.  What's important is not how we know what we know, but figuring out what exactly it is that we want to know.  When it comes to understand how to wrap one's arms around the epistemic problem posed in stock selection, I turn to my good friend Warren.

Warren Buffett said this about gold:

“If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States…For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”  

People tend to see what they want and so most people said "but of course, he is saying gold is a bad investment."  It should be looked at differently.  He is just doing what he always does.  He is thinking like a businessman.  The subject matter of gold is irrelevant and practically useless since I think most people who heard what he said already agreed with his conclusion, but it is how he reached it that is important.  

What if he owned all the gold in the world?  He looked at it in totality and compared it to what else he could buy.  While you could dismiss his argument as an absurd reduction, that is the point.  Reducing investment decisions to the absurd seems like the best way to create a genuine understanding of what is being bought.  The logical conclusion is to think as if you owned the entire business.  Selling sugar water in red cans is fundamentally a superior business to selling sugar water in blue cans.  A dry assessment of reality - for whatever reason, people have a nearly unshakeable emotional affinity for sugar water sold in red cans that creates a huge competitive advantage for the seller.  

Just to bring in the perspective of a lesser known, but equally astute businessman.  Here is what Jeff Harp from Trinity Bank, which I've written about, about his decision to buy back some of Trinity's stock (letter here):

"For the second quarter of 2010, Trinity Bank had nearly $20,000,000 in short-term investments earning 1.24%.  That return is even lower today.  For the same time period, each share of Trinity Bank common stock earned 12.35%.  In a stock repurchase, we take dollars earning 1.24% before taxes and buy shares of stock earning over 12% after taxes.  We paid $24.10 for the stock, which is about 1.6 times book value of $14.62.  Since we paid more than book value of the stock, it actually reduces our return to the 8% range.  So would you take $700,000 earning 1.24% before taxes and buy $700,000 of common stock earning 8% after taxes?  That is the economic decision in about as simple an explanation as I can come up with."

It's just a business decision.  Opportunity costs are considered.  The returns are calculated.  That's it.  Simple.  Sound.  No trumpeting EPS growth.  No corporate litany about returning money to shareholders. 

My point is that it is quite easy to get caught up in a lot of noise - gold:silver ratio, EPS growth, total shareholder return - that don't really reveal what I want to know.  It's quite hard to describe how exactly one thinks like a businessman, but Buffett and Harp are articulate enough to provide a nice window into their thinking as businessmen behind capital allocation.  

This will tie into my next post where I apply this thinking to ITT.

Buy Side Readers

I graduated early from Northwestern University in December 2010.  There's really nothing I enjoy more than reading, writing, and thinking about stocks and business.  I want to wait to find a job that won't feel like one rather than rush into something.  I'm fortunate enough to be in a position to be patient, let my work speak for itself, and know that the right people will find me.  My short term goal is to work at a buy side firm with a value bent where I can work with great people and continue to learn.  I'm passionate about this stuff, self-motivated, and self-taught.

Here are 4 write-ups that should give you a good idea of what I'm about:

- Xenith Bankshares (XBKS)
- DreamWorks Animation (DWA)
- Fortune Brands Home & Security (FBHS) (this was before Bill Ackman presented the idea)
- Eagle Materials (EXP)

Some shorter, but researched and thought out posts on specifics stocks:
- Treasury Wine Estates (TSRYY)
- HomeFed Corporation (HOFD)
- Exelis (XLS)
- Xylem (XYL)
- Peapack-Gladstone Financial (PGC)

I'm looking for somewhere that I'd be surrounded with humble and ambitious investors willing to be mentors and colleagues.  I want to work somewhere conducive to turning over tons of rocks and just waiting for the right price or opportunity.  I assume Ben Graham isn't reading this, but if you are a similarly passionate person about investing, I'd love to work with you.

Margin of Safety is probably my investing bible and what has informed my approach over the years among pretty much any other book recommended by investors I admire (all the usual suspects).  Clearly Warren Buffett has been a major influence and I have taken his advice to heart about doing what you love, cultivating the right habits, and trying to copy the actions of those you admire.  I enjoy sitting on my ass, reading, and thinking.  I always ask myself "what if I'm wrong?" because that's what really matters, not convincing myself how right I may be.  I taught myself everything from opening up books and 10-k's, reverse engineering ideas, and just being willing to work on something until I thought I understood it.  I have tried to internalize most of the ideas of value investing in my mind and don't treat it like some derivative action I mimic from a textbook.

Don't hesitate to shoot me an email.  I'm fairly mobile and open to relocating.  I'm a Value Investor's Club member, which is a decent credential for a kid of otherwise lackluster credentials.  They let me in, so it can't be that impressive.  According to a Value Investor Insight interview with Greenblatt from 2006, if you get in, you would get an A+ in his class in the MBA program at Columbia.  I don't have an MBA though, so I offer some great relative value in that respect.

For thought.

A lesson in the difficulty of winning in retail: Winn-Dixie

Winn-Dixie gives off the whiff of an interesting turnaround and a cheap stock.  It is a supermarket with stabilized sales, but ephemeral profits.  They claim to have hit on the right store format to boost their sales to the necessary scale to earn money for shareholders.  The large cash balance, seeming lack of debt, discount to book value and positive cash flow made me take a closer look.  This is essentially a case study related to my post on specialty clothing retailers that looks at the broader business of retail and its difficulties.

While retail and supermarkets in specific are simple businesses to understand, operating supermarkets is a difficult business to consistently be successful with.  Winn Dixie is good proof of that.  They went bankrupt in 2006 and emerged in 2007 after closing 534 stores from 2005-2007.  They’ve posted sporadic profits since.  This isn’t a post about how they are the next A&P.  This is about how 5 years into a turnaround and hundred of millions spent, the company is still struggling.

From fiscal 2008-2011, Winn Dixie has spent $734m in capital expenditures against a current market capitalization of $400m.  Revenue in 2008 was $6,975m in 2008 with 521 stores and $6,881m in 2011 with 484 stores.  While that is an improvement in unit revenue, it only amounts to growing average revenue per store from  $13.31m to $14.2m – 6% growth. 

That’s unspectacular when you consider just basic food inflation over that period has been at the same level.  So realistically, most of the returns on investment in revenue growth have occurred without any real gain in customers or higher unit throughput in their stores.  There is nothing wrong with this in a vacuum, but it reveals that their investments aren’t really investments.  It’s just helping them tread water.

Do you realize what a massive sum that is to throw at a problem and get basically nothing in return?  This isn’t some jackpot or bust business like A123, a battery technology company trying to establish itself as the battery maker for an electric car future.   This is selling people water injected ham, raisin bran, and maybe some Pringles.  It's worth reflecting on.

Whatever the company has been doing the past several years has just not worked.  Winn-Dixie has a new plan that is supposed to be “transformational”. They are targeting affluent customers who want a superior shopping experience and really rolling out the stops in their stores.  They are planning to spend $125m on store remodeling, which includes 17 transformational stores, and an additional $75m on maintenance cap ex in Fiscal 2012.  They are still remodeling stores in the same manner they’ve done in the past, while pushing forward with the transformational remodels in certain locations.  I don’t know what to make of the somewhat unfocused strategy, but their expenditures in the past have yet to bear much fruit.  From the most recent conference call:

As you'll recall we provided extensive updates on our remodel program on the fourth quarter call. We plan on providing a similar update at the end of the fiscal year as well with three status updates on the program each quarter. Our remodel stores are continuing to outperform the chain since the programs inception, 179 offensive remodels has generated a waited average sales increase of 6.7% on a cumulative basis since the grand reopening, which includes an increase in transaction count of 2.9% and an increase of basket size of 3.7%.

And our 51 defensive store remodels, waited average sales has decreased 6.2% on a cumulative basis. However, when you adjust for the impact of the new competition we estimate those stores have generated a waited average sales increase of 4.1% on a cumulative basis. Our new stores have come into the market continues to exceed our sales expectations.

The $1.5m spent on each store on average is misleading because not every store has been remodeled.  It’s been closer to $3.2m per store if only the remodels are considered to be the beneficiaries of capital expenditures and in some cases – the defensive models – sales have still declined.  I believe Greek poet Homer said it best in regards to results so far, “d’oh!” 

What I first thought when I look at Winn Dixie was that at glance they had a net cash position and a turnaround plan.  That meant there might be a decent chance of a positive outcome.  With $7bn in sales, if they could achieve even a measly 0.50% net profit margin against indebted peers achieving 1%+ margins – all the more achievable since they will effectively never pay taxes due to $1.8bn in NOLs – that would mean $35m in net income, which is about 11x earnings at this price.  Not terribly exciting, but worth a look.

If you net out the cash though, you end up closer to 7x earnings with ample growth opportunities by reinvesting in their current stores.  Their current store base currently underperforms based on sales per square foot, which is essentially what is driving the poor performance.  Even if they achieve margins subpar relative to the industry but start growing revenues, we can entertain even cheaper scenarios with a longer holding period and varying degrees of optimism. 

Except that this doesn’t reflect reality.  The cash is not unencumbered.  To start, Winn Dixie keeps $144m of letters of credit off the balance sheet.  This is alright as long as Winn Dixie remains a going concern, but it encumbers the cash.  Additionally, Winn Dixie self-insures against certain risks.  I don’t quite understand the rationale behind this, but it creates a liability of $185m in reserves.  There is no contra asset for this though, so this further restricts the cash on the balance sheet.  They can’t give out meat slicers from the deli counter as worker’s compensation.  Just to shine more light on the liabilities, there is $1.3bn in operating leases carried off the balance sheet.  This all means that the balance sheet offers a lot slimmer of a margin of safety than first glance.

My point is that the cash is simply not a cushion in the valuation or for the company’s turnaround.  When I first glanced at the financials, I thought to myself they weren’t doing bad considering they were reinvesting in their stores conservatively by just using their cash flow and maintaining a nice net cash balance.  The cash balance exists because it has to as a function of how the business operates, not as a buffer.

I’m going to refer to their preferred measure – adjusted EBITDA – to show how rough it is for even basic improvement in the business to occur.  Adjusted EBITDA was $114m in fiscal 2011, $150m in 2010, $164m in 2009, and $101m in 2008.    This essentially represents the cash generated from operations that can be reinvested in the company.  I don’t think malinvestment is the proper description, but clearly the company is not getting much of its capital expenditures in years past.  As they continue to spend on remodeling, declining cash flow is clearly not encouraging.

So the company has been spending tons of money and will continue to do so, yet is barely moving the revenue needle and seeing decreasing cash flow.  This doesn’t sound like it's going according to plan.  The company had the benefit of a bankruptcy proceeding to tidy up its affairs, a relatively unburdensome set of liabilities, and 5 years of spending to get its house in order.  Has it failed?  Who knows.  As Walmart continues to do what it does, dollar stores begin selling food (and Winn-Dixie sued one of them if that indicates what a threat they see it as), and Publix continues to churn out revenue growth, Winn-Dixie's travails indicate they face obstacles to success of their own making.  

While I often roll my eyes at people who claim a company hasn’t done anything in the past years, so failure or inaction will naturally continue in the future, Winn Dixie seems vulnerable to such a charge.  Their cash flow has declined despite tons of investment.  If such investment isn’t generating positive results after 5 years, what makes year 6 any different?  Everyone else is solidly marching forward, while Winn-Dixie flounders.

Winn Dixie is a turnaround where the verdict still isn’t entirely out.  Does it look promising?  Maybe at a first and fleeting glance.  Considering the sums invested already and the results so far, Winn Dixie is in a very rough business with very tough competitors.  If anything, it is interesting to see that in what is a mundane industry, even a boatload of money can’t necessarily allow a company to revert to the mean.