Investment on A Philosopher and A Businessman

Stock Picking - Pitfalls for the Unwary

Fri, 26 Feb 2016 00:00:00 +0000

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:

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.
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.
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.
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…
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.
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.
$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.

The Power Of Economic Moats

Tue, 09 Feb 2016 00:00:00 +0000

“Economic moats” isn’t the name of a company specialising in low cost medieval earthworks. An economic moat is a desirable attribute of a business close to the heart of long term investors. You can google “economic moats” to get a technical definition, but I prefer to illustrate their power through everyday things. And, as we’re business people here and often fly around the countryside for important meetings, what better example than air travel.

Brief and inaccurate anatomy of an airline business

Aircraft:

According to the briefest of google searches a 737-800 costs around $50-100m. An Airbus A380 currently costs US$428m. So you can rack up a few $b in capital expenditure for even a modest fleet.

They are so complicated, too. Apparently a 737 has hundreds of suppliers supplying 367,000 parts and all those parts need to be proven to be airworthy. And that’s nothing. The A380 has a staggering 4 million parts, with 2.5 million part numbers produced by 1500 companies from 30 countries around the world.

With the hundreds of km/miles of cables running around an A380 it’s no wonder they got a bit confused putting it all together.

Even the engines by themselves are super sophisticated. They have divisions of companies dedicated to watching them carefully, in real-time, as you fly around the world to make sure they are performing properly and aren’t likely to lose any important bits before you touch down.

All those hundreds of thousands or millions of parts need to be checked and maintained, too. What a ~~nightmare~~ amazing feat of organisation keeping track of what needs to be done to keep an aircraft airworthy.

Pilots:

An airline has highly trained pilots who really have to know a lot to get you to your destination safely. The training continues throughout their career as the industry learns. For example, training in new ways to get an A340 off the ground without hitting its long tail on the runway, new ways to close the cockpit door to keep terrorists out, new ways to close the cockpit door ensuring two or more crew are in the cockpit at all times in case it turns out the pilot was, in fact, the terrorist. And so on. Keeping the pilots up to date with the onslaught of new rules and regulations is a mission in itself. So of course, there are quite a few people employed to do that.

Other Stuff:

A team of financial wizards to raise the capital to buy and renew the fleet.
A sophisticated reservation system to maximise load-factors (aka bums on seats) for each flight.
A team of operations managers to make sure aircraft, landing slots, gates, fuel, crew, food etc, all come together in that amazing choreography of the modern airport.
Catering companies have to churn out hundreds of meals taking into account ovolactarians, vegetarians, vegans, pescatarians, gluten-intolerants, etc, etc. And these have to arrive on time and not look too unfresh.
Frequent flyer points-tracking systems to keep on top of the accrued liabilities. And, no doubt, a team of lawyers, marketers and accountants to figure out how to reduce those liabilities without annoying their most loyal customers. Clearly Singapore Airlines, with their somewhat hasty approach to expiring miles, forgot to include the marketing person in these discussions.

Such a sophisticated operation. Such a well-oiled organisaton. So many shiny new planes painted in wonderful brand colours. What a great business! Who wouldn’t be proud of it.

Brief and inaccurate anatomy of an airport car park business

Patch of Land:

Obviously you need a patch of land to park the cars. Maybe it took a bit of haggling with the local government of the day to get the long term lease set up, and maybe a contractor had to come in to smooth out the bumps and put some tarmac on top. For a really busy airport, maybe a few tonnes of steel and concrete had to be installed to create multiple parking levels.

Ticket Machine And Boom Gates:

Not much to say here really. You need some way to track how long people have parked and a way take money off them when they leave.

Parking Attendant:

Every now and then someone loses their ticket or the boom gate doesn’t work so you need to employ someone with relatively little skill to open the boom gate from time to time, and possibly charge a substantial lost ticket fee.

Other than an accountant and a manager to organise the parking attendants, pay the insurance bill and carry the bags of cash to the bank each day, that’s about it. What a dull, boring, unimpressive business. Nothing to be proud of.

And yet every time I book a week’s parking at the airport I’m staggered to compare the parking bill with the cost of the air ticket. They are often about the same. There are hundreds of millions of dollars in deployed capital, and thousands of moving parts that have to come together for me to fly somewhere. There’s a patch of ground, a boom gate and a parking attendant to store my car for a few days. I would expect the flight to cost at least 20 times more than the car park. What on earth is going on?

Simple. The airport carpark has an economic moat. A sustainable competitive advantage. Once an airport is built there is only one sensible parking option for that airport. Other players can build one down the road, but then you get into the whole “shuttle bus between airport and car” thing which destroys the key reason you drive to and from the airport - convenience. Other players can invest millions building the fanciest car park known to man, but if it isn’t right by the terminal they just aren’t in the game.

On the other hand, given enough capital, it’s relatively straighforward, if somewhat foolhardy, to start a new airline. As a result there is plenty of competition and that drives prices down to subsistence levels. Profitable airline routes are often those served by just one airline. As soon as they get too profitable, another airline steps in to try and take some of that excess profit.

So what is an Economic Moat?

A sustainable competitive advantage that allows you to earn above average rates of return on capital deployed in your business.

Quick “Economic Moat Ready Reckoner”

Supposing you have a nice business that’s earning way in excess of normal returns. There is really only one question you need to ask yourself to check whether it’s sustainable high returns and that you do, in fact, have an economic moat:

If my competitor had a billion dollars to spend on competing with me, what would they do?

Possible answers:

Spend $10,000 paying a local hack to reproduce what you’ve got and spend the change on yachts, cars and fancy office furniture. You don’t have an economic moat. You should probably have a good think about plan B.
Spend $200m trying to reproduce what you have, and a year later have something pretty good. You don’t really have an economic moat. You have a head start.
Spend $20m lobbying their local politician to change the rules in their favour. You have a head start. Hopefully you have good connections with some well-regarded journalists too.
Spend $1.2b and a decade to reproduce what you have. That sounds like a pretty decent economic moat to me.
It doesn’t matter how much they spend, they can’t take any business off you without the help of some thugs with AK47s. This is the real deal. When you find a business like this, hang on tight.

A lot of management literature talks about building competitive advantage through hiring well, marketing better, trimming costs from operations and so on. The problem is, anyone can do that. Economic moats, on the other hand, are sustainable. But building them takes a lot of hard work and often a good deal of luck.

Don’t get despondent if you don’t have an economic moat. You can still make a handsome profit if you continue to work hard and work smart. The problems begin when you stop working hard and smart…

To find out more, “The Little Book that Builds Wealth” by Pat Dorsey is a great read.

Photo credits: Qantas, Sydney Airport