Stock Picking - Pitfalls for the Unwary

I didn’t intend to publish another investing article so soon after the last one, particularly as this blog is meant to be about business and philosophy rather than investing. However, understanding how a long term investor looks at things is useful to see how to build sustainable success. There are many great resources online and in print covering many angles. It is, though, sometimes useful to illustrate these points using a very simple family business. What follows is a lightly edited (very long) forum post I wrote in reply to a question on stock picking. Enjoy!

Part I - Business Basics

Suppose your dad has a business running a small grocery store. The store takes in $500K per year, and rent, insurance and the cost of the goods sold comes to a total of $400K.

That leaves a gross profit of $500-400 = $100K. This would be called “EBITDA” - earnings before interest, tax, depreciation and amortisation.

The shop has a load of fittings and other things needed to run the business, plus a delivery van. These need replacing from time to time because they get old and wear out. An additional non-cash expense encapsulates the rate at which these things wear out. This is called depreciation. In theory it represents the money you should set aside each year to replace things you need to run the business. A building will typically wear out over 40 years so if you have a building which cost $1M to build you will charge depreciation at 2.5% = $25,000. After 40 years you should have set aside $1M to replace the building. Of course, by the time you get there it now costs $5M to replace a building, but that’s another story.

Anyway, back to the store earnings. We have $100K of gross earnings (EBITDA). We deduct another $20K of depreciation to cover things wearing out. This leaves $80K of EBIT (earnings before interest and tax). In case you are wondering where the amortisation went, it’s basically the same as depreciation, but for non-tangible assets (i.e. not buildings, computers, vehicles etc, but things like trademarks, valuation of brands - I’m sure an accountant will ping me on this).

So we have $80K of EBIT. Because we’re a conservative family business we don’t have any debt so we aren’t paying interest on loans. However, we do pay tax - let’s say at 25% to keep the numbers easy. This leaves $80K - ($80K * 25%) = $60K.

So our net earnings are $60K. This is often called NPAT - net profit after tax.

We have three choices what to do with this. We can pay it to the business owners - this is the dividend. In this case the owner is your dad, so he pockets a $60K dividend. We can retain it in the business as retained earnings sitting in the bank not doing much (except attracting interest from professional litigators) or we can retain it in the business to invest in growth. We can, of course, do a mix of all three.

For the sake of this example, let’s say we pay $30K to the owner as a dividend and keep $30K to buy a fancy new espresso machine and build a small deck with some nice tables and umbrellas at the front of the store. The “dividend payout ratio” is 50% because half of the earnings for the year are paid to the owner.

Let’s also say, for the sake of the example, that your uncle actually owns 30% of the business and there were 100 shares originally created. So your father owns 70 shares and your uncle owns 30 shares. The “dividend rate” is $30k/100 = $300 per share.

Now the shares, when the business was first created, were issued at $1 each. It was a long time ago. The dividend yield at the original share price is $300 / $1 = 30,000% !!! Outrageous. However, your uncle wants out. He shows your brother-in-law how great the dividend is and sells the shares to him for 10x the dividend rate, so $3000 per share. The new valuation per share (i.e. what the “market” will pay for them) is now $3000 rather than the original $1 that they were issued at. This makes the current “dividend yield” $300 / $3000 = 10%.

Your uncle, meanwhile, has made a handsome capital gain of $3000 - $1 = $2999 per share. And the taxman has made a handsome sum on this capital gain.

Part II - Capital (Mis)Management

Now, back to the $30K that your dad spent on the espresso machine. Although he is careful with his expenditure, most of the neighbourhood is not, so he sells 200 coffees a day at a $2/cup profit margin. This adds $400/day = $100K per year (give or take) added to EBITDA. Let’s say this ends up being $60K additional net earnings.

Net earnings has grown from $60K to $120K - 100% growth. Furthermore, the return on the additional capital invested ($30K) is 200% - Totally awesome. If you could buy shares in a growth business like this you are home and hosed, but they are very hard to find at a decent scale and publicly traded. This is what offices full of analysts spend their days searching for.

Now, not understanding how to pull apart the finances of a business can end in trouble. Here are a couple of scenarios with this example business to illustrate what can go wrong:

1. Instead of buying an espresso machine your dad gets the business to spend $30K on a fancy new car. This adds nothing to the revenue of the business but does add a fair bit of cost as it is a thirsty beast. $30K down the drain which could have been paid to shareholders. You see this every day with corporations. Big new architect-designed offices, sponsoring yacht races etc. Warren Buffet talks about corporate waste in the Berkshire Hathaway annual reports. You could get a lot worse education than reading through those.

2. Your dad misreads the market and it turns out he’s in Las Vegas where, apparently, no-one knows what a decent espresso tastes like. Especially at the convention centre. Rather than selling 100 a day he only sells 5 on average to a few folk from Boulder sneaking across the state border in their Subaru Foresters for a covert session at the tables. $30K invested yields $2500. Not bad, but not really worth getting out of bed for.

3. Your dad doesn’t invest in staff training so the barista doesn’t know how to dial in the grind, how to tamp the grounds properly, how to time the pour, how to texture the milk etc. Consequently a bad product is shipped to the customer. Word gets around. Same effect - 5 coffees per day sold to folks with no taste buds.

4. Your dad (with a vote from your mum - the other board member) awards himself a $30K bonus for great performance. Together with the $30K spent on the espresso machine there is nothing left as a dividend to the other shareholders. Brother-in-law is not happy. This happens very frequently too - the executive management, in cahoots with the board, create remuneration plans which strip the profits before they are even reported. In Australia there is an exec remuneration section in the annual report for publicly listed companies which spells out who gets what. It may not stop the practice, but at least you know how bad it is…

5. The majority owners of the business decide they want a fat dividend. They pull the whole $60K profit out leaving nothing to invest in growth. The $100K per year of additional earnings possible through the espresso machine is lost for the sake of an extra $30K of dividend distributed once. This typically happens when major institutional investors demand a certain dividend rate. For businesses that can effectively deploy cash to fuel growth this is a hidden killer.

6. Possibly the worst crime of all. The business made $60K profit, the owners demand a $100K dividend. The business borrows money or raises additional capital through creating and selling more shares to pay for the shortfall between profits and dividend payout. Although this is blatantly stupid it does happen. Not only has the business not reinvested into growth, it has taken on debt and the associated servicing costs which will eat away at future profits and eventually cripple the business.

7. $20K of the profit is booked because Mrs Meggs comes in and orders 16 tonnes of cabbages for the next 12 months. She will pay after they are delivered. That $20K is paid out as dividend because it is reportable as profit even though the cash hasn’t hit the bank yet. As a result the bank account is stripped clean and your dad can’t pay his suppliers. The company is now insolvent due to timing of when profit is reported, when cash is received and when supplier payments are due. This is a silly example, and one where the accountant should first be fired, then sued for letting it happen. But things like this happen all the time. Services companies, particularly ones which are growing aggressively, often have a big lag between work in progress being recognised as revenue and when the cash arrives. They can’t delay their expenditure because it is payroll and high paid consultants tend to quit if they don’t get paid on time. Net result is a cash-flow hole which leads to big trouble. The cash-flow statement will indicate whether this kind of thing is going on.

Those are some examples of some of the things which can go bad in a business. There are, of course, many, many more.

If you are going to invest in individual shares you need to learn to read balance sheets, profit and loss statements, cash flow statements and the boring notes which clarify how the numbers were derived. You can see most of these problems from the financial statements. However, it is hard to judge long term viability and growth potential just from the financial statements - for that you need qualitative data too. Phil Fisher had a lot to say about that. If you are seriously going to attempt share-picking you should get your hands on his books and read them carefully.