Stephen Takacsy's Top Picks: September 25, 2023

Stephen Takacsy's Top Picks: September 25, 2023

BNN-Bloomberg...Market Call

Sep 25, 2023

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Stephen Takacsy, president CEO and CIO, Lester Asset Management

FOCUS: Canadian stocks 

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MARKET OUTLOOK:

Equity and fixed-income markets continue to be volatile on fears of sticky inflation, higher-for-longer interest rates, and an economic slowdown. We believe that this volatility has presented some excellent buying opportunities in both stocks and bonds. In equity markets, a handful of tech stocks have been responsible for most of the rise of the S&P 500 Index, with the rest of the market lagging, despite a still strong economy and generally good earnings. In Canada, oil stocks and Shopify are largely responsible for most of the S&P/TSX Composite Index's positive return.

Small to mid cap stocks have really struggled this year and present particularly compelling valuations trading well below intrinsic value. Fixed-income markets currently provide the most attractive risk-return, particularly in short-term corporate bonds which are yielding “equity-like” returns of six per cent to eight per cent with little to no risk. Investors should take advantage of this unique opportunity since these high rates won’t last with inflation coming down from elevated year-ago levels and the economy slowing. We believe that the rate hiking cycle is over, although central banks will continue to maintain a hawkish tone to get inflation back down to the two per cent to three per cent target range.

We believe there will be a “soft landing” in Canada and the U.S. as their economies remain resilient with low rates of unemployment. Investor sentiment has been very bearish which is a great contrarian indicator with lots of cash on the sidelines. Our fixed-income portfolio is mainly comprised of higher-yielding short-term corporate bonds and yields over seven per cent with a duration of only 3.5 years, while our stock portfolio remains well diversified in recession-resistant businesses most of which are generating record profits. We also own many safe high dividend-yielding stocks like telecoms, pipelines, utilities, and banks which look particularly attractive at the moment. We also own companies benefiting from long term trends such as aging demographics (Savaria, Park Lawn, Neighbourly), digitization and automation (CGI, Tecsys, and ATS), and infrastructure (Stella Jones, AG Growth, Logistec). We have been taking advantage of volatility to add to our holdings in high quality companies at more reasonable valuations such as Pet Value, Jamieson Wellness, Richelieu Hardware, CCL and Colliers International.

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Top Picks

SAVARIA (SIS TSX)

Savaria is a global leader in home accessibility equipment and patient-handling products. It manufactures and sells home stair lifts and home elevators, as well as mattresses and ceiling lifts for long term care facilities. In 2021 it purchased Handicare of Sweden making Savaria the largest player of home accessibility in the world. Results in 2023 have shown strong organic sales growth in both home accessibility and patient handling, and increasing profit margins. The company also continues to have a near-record backlog. The stock has pulled back recently on two things. Firstly the second quarter saw a $5 million hit to EBITDA due to the implementation of a new ERP system in its European operations which is a one-time event. Secondly the company recently issued equity to pay down debt which caught the market by surprise. This has created a great buying opportunity as the stock is now trading at around nine times EBITDA, the low end of its historic range. This is a unique growing business that is benefiting from strong long-term tailwinds of aging demographics and the desire to live at home longer. It also pays a 3.7 per cent dividend. This is a long-term core position that we have been adding to.

MDF COMMERCE (MDF TSX)

A beaten up undervalued technology stock with a potential catalyst.

MDF Commerce is an undervalued tech stock. It develops and manages e-commerce platforms for larger corporations such as Sobeys and Aldi, and also owns business-to-government platforms enabling suppliers to bid on government contracts which is called “e-procurement.” MDF is the leader in e-procurement in Canada and is also now the number one player in the U.S. with only a six per cent market share as the U.S. remains very fragmented. It recently announced some significant regional government wins in Arizona, Arkansas, and Hawaii, and has a robust pipeline of states that wish to digitize its procurement systems. Roughly 80 per cent of MDF’s sales are high-margin recurring revenue. The stock is dirt cheap and trades at just over one times revenue. The plan is to unlock value by selling off non-core businesses such as their e-commerce platforms and focusing on the higher multiple faster-growing e-procurement business. Based on recent multiples paid for e-procurement companies, MDF could be worth as much as $12 per share, triple what it’s trading at today at $3.50.  Meanwhile, a U.S. fund noticed how cheap the stock is and has accumulated 12 per cent of the company over the past year.

VELAN (VLN TSX)

Velan is a world leader in designing and manufacturing complex industrial valves and is considered the gold standard in nuclear valves which are manufactured by its subsidiary in France. This is a stock we last recommended at $5 in 2022, and earlier this year the company accepted a $13 take-over offer by a U.S. company called FlowServe. The stock was trading near $13 after the deal was announced but recently pulled back to around $10 on worries that the government of France was going to block the sale because of a change of control in the nuclear valve business. We think this fear is overblown as we see no difference between the company being controlled by U.S. shareholders or Canadian shareholders. Meanwhile, Velan and FlowServe have extended the deadline to close the sale. We sold our stock after the announcement at around $12.75 and have since repurchased shares at around $10. We expect the French government to approve the sale this fall and that the sale of Velan will close at the agreed price of $13 for a quick 30 per cent return. 

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PAST PICKS: November 7, 2022

NEIGHBOURLY PHARMACY (NBLY TSX)

• Then: $23.42
• Now: $13.74
• Return: -41%
• Total Return: -41%

Rolling up small pharmacies (3rd largest pharmacy chain in Canada with 300 locations) Strategies to consolidate what is still a very fragmented market in Canada. But growth by acquisition stories are unpopular right now as investors are concerned about debt. This  company however is producing strong free cash flow to cover their debt. Record results fueled by steady growth of aging demographics. Sales increasing from increased scope of practice in Ontario and B.C. (Their pharmacies can treat more patients and prescribe more medication). Since IPO at $17.00, revenues and profits have more than doubled to 900 million in sales and 100 million in EBITDA. Asset-light business with good same-store sales and increasing margins with a long-runway for growth. Could be a takeout target down the road. Valuation at a low with just 9 times EDITDA. Currently adding to position.

CARGOJET (CJT TSX)

• Then: $130.35
• Now: $94.57
• Return: -27%
• Total Return: -27%

High margin, high return on capital company. Has 90 percent of Canada's overnight freight market while doing this with little or no risk (guaranteed long-term contracts with heavy volumes servicing Amazon, Canada Post and DHL). Growth has currently slowed in e-commerce market since Covid ended so overnight volumes have contracted a bit. They are still managing their costs very well. Still generating healthy margins. It is as cheap as it has ever been trading at just 7 times EDITDA. Limited competion with high barriers to entry. Volumes are expected to be down for rest of year so was sold at a tax-loss but will likely repurchase it at year end as business remains attractive with good management team.

PARK LAWN (PLC TSX)

Funeral services company. Has owned since it was 6 dollars. Only publicly traded company in Canada in the death industry. 2nd biggest company of its kind in North America but still has only 2 percent of the market due to the fragmented nature of the market. Recession proof business with high margins, high barriers to entry. Huge tailwinds  with aging demographics with the senior population expected to double over the next 20 years. Excellent management team in the U.S. which is focused on organic growth and M&A. Stock of company is down due to correction in the small and Mid-cap space. Great entry point trading at just 8 times EDITDA. Unique business with strong free cash flow. Recently teamed up with Brookfield to buy another company, Carriage Industries which would double the size of Park Lawn but the offer has not been accepted and is till on the table. Adding to positions at these levels.

• Then: $22.30
• Now: $19.39
• Return: -13%
• Total Return: -12%
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Summary of The Most Important Thing by Howard Marks

Summary of The Most Important Thing by Howard Marks

I found this on the internet. It is a nice summary of one of the best investing books I have ever read. If I could recommend the beginning investor to read just one book this would be it…

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Chapter 1

“No rule always works. The environment isn’t controllable, the circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.”

This most important thing is second level thinking. You have to think beyond the obvious (first level thinking). The first level thinker sees favorable circumstances and decides to buy. The second level thinker sees that the investment is over hyped and too expensive to provide a margin of safety.

The first level thinker sees unfavorable circumstances and decides to sell. The second level thinker sees that investors have panicked and driven the price to bargain levels and buys.

Chapter 2

“Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material — mispricings —that can allow some people to win and others to lose on the basis of differential skill.”

The most important thing is understanding market efficiency and its limitations. While it is true that many markets are fairly efficient most of the time, they are not always efficient. Investors allow greed, fear, and other emotions to defeat their objectivity. This leads the way to significant mistakes.

Investors who choose to believe the market can’t be beat leave the inefficiencies for those willing to be second level thinkers. Understanding market inefficiencies is important so that you recognize opportunities that can be exploited for profit.

Chapter 3

“Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time.”

The most important thing is value. Marks talks about the difference between growth and value. Growth is a bet on the future, an uncertain future. Therefore you may be paying for something that does not materialize.

Value is more consistent. Paying less than something is really worth today is less of a risk than guessing what will happen in the future. The best value is when you can buy growth at a value price, but that may not always be available.

Chapter 4

“No asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.”

The most important thing is the relationship between price and value. Investors psychology can cause a stock price to be mis-priced. In the short run, investing is more like a popularity contest.

The most dangerous time to buy an investment is at the peak of its popularity. At that time, all the positive data and assumptions are reflected in the price. Everyone that is going to buy has already bought.

The optimal time to buy an investment is when no one else wants it. At that point, all the negative data and assumptions are reflected in the price. Everyone that is going to sell has already sold.

Buying at a price below the real worth of an investment is the most reliable approach to making an investment profit.

Chapter 5

“The possibility of permanent loss is the risk I worry about.”

The most important thing is understanding risk. There are several misconceptions about risk: Riskier assets don’t necessarily provide higher rates of return or they wouldn’t be riskier. Risk doesn’t come from weak fundamentals because almost any investment, bought at the right price, can be a profitable investment. Risk does not come from volatility; risk comes from how an investor reacts to volatility.

Risk can be greatly reduced by 1) making an accurate assessment of the real value of an investment and 2) making sound decisions based on the relationship of the price to the value. Investments that are overpriced should be avoided or sold. Investments that are underpriced are candidates for purchase.

Chapter 6

“The degree of risk present in a market derives from the behavior of the participants, not the securities, strategies, and institutions.”

The most important thing is recognizing risk. Risk is actually highest when everyone believes risk is low. This is because investors bid up the price of the asset to the point it really is risky. At a high price favorable outcomes have low expected returns and unfavorable outcomes can result in large losses.

Risk is lowest when everyone believes that risk is high. This is because investors have reduced the price to the point it’s no longer risky. At a low price favorable outcomes have high expected returns and unfavorable outcomes result in smaller losses. Investors should recognize risk comes with price; not the quality of an investment. “High quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.”

Related Reading: Perceived Risk vs. Real Risk

Chapter 7

“The road to long-term investment success runs through risk control more than aggressiveness. Skillful risk control is the mark of the superior investor.”

The most important thing is controlling risk. Over an entire investment career, the amount and size of investment losses will most likely have more to do with returns than the magnitude of winners.

Controlling risk is not risk avoidance. The stock market will have more good years than bad years. The fact that the benefits of controlling risk only come in the form of losses that don’t happen, make it hard to measure and easy to succumb to ignoring. It is just at that time that risk meets adversity and punishes you. Controlling risk is a permanent task.

Chapter 8 

“Cycles will never stop occurring. If there were such a thing as a completely efficient market, and people really made decisions in a calculating and unemotional manner, perhaps cycles would be banished. But that’ll never be the case.”

The most important thing is being attentive to cycles. Cycles have a way of being self-correcting. Reversals don’t necessarily need outside events.  They reverse on their own. Success creates the seeds of failure, and failure creates the seeds of success. Periodically investors decide that a trend will never end. When times are good they conclude the trend will continue upward forever. When times are bad they talk about vicious cycles and “self-feeding” developments that will not end. Don’t assume trends will continue forever. Instead be aware of possible major turning points.

Chapter 9

“When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-adverse, prices can offer more return than risk.”

The most important thing is awareness of the pendulum. Markets fluctuate between euphoria and desperation. The “happy medium” is the average. But in reality the market spends very little time at the average. The pendulum swings back and forth, creating opportunities for the astute investor who is aware of the swings (and extremes) in investor sentiment.

Chapter 10

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

The most important thing is combating negative influences. Greed, fear, the tendency to dismiss logic, the tendency to conform, envy, and ego are psychological forces that can be negative influences.

These forces are universal and become very powerful as a group. This is especially true at market extremes and results in mistakes that can damage personal returns for a lifetime. There are several guidelines that increase your odds. Stick to the concepts of intrinsic value and margin of safety. Use the principles in this book (The Most Important Thing) to stay cognizant of the investment environment.

Chapter 11

“To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.” Sir John Templeton

The most important thing is contrarianism. Most investors are trend followers. The best investors   do just the opposite. When there is a broad consensus among investors it means that most have acted and the current price reflects those actions. If the majority of investors have bought because conditions are perceived as favorable the price is high. This leaves lots of risk but little potential for reward. If the majority of investors have sold because conditions are perceived to be unfavorable the price is low. This reduces the risk and provides a large potential for reward.

Chapter 12

The necessary condition for the existence of bargains is that perception has to be considerably worse than reality”.

The most important thing is finding bargains. Investment bargains have nothing to do with quality. A high quality investment can be a good or bad buy. It depends on what you pay for it. A failure to differentiate between good assets and good buys will get most investors into trouble. What it comes down to is that for an investment to be a bargain, perception has to be worse than reality. In other words, if the perceived risk is greater than the real risk the price will be a bargain.

Chapter 13

“You want to take risk when others are fleeing from it, not when they’re competing with you to do so.”

The most important thing is patient opportunism. Sometimes the best action is no action. Waiting for lower prices is often the prudent strategy. Marks provides a tip: Select from a list of things sellers are motivated to sell instead of having a fixation on what you want to own. He points out that in investing you never have to swing (baseball analogy). There are no penalties for patience. Maintain a balanced perception of market conditions. Buy and sell at price points that are favorable to you. That is usually the opposite of the crowd consensus.

Chapter 14

“No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and find other ways to cope than through forecasts”.

The most important thing is knowing what you don’t know. Forecasts about the economy and future twists and turns in stock markets are dangerous and probably worthless in the long run. Pay attention to valuations, balance sheets, and income statements and less on economic forecasts and markets. Have a general idea of where valuations are in terms of cycles and pendulums, but don’t try to forecast the unknowable.

Chapter 15

“We may never know where we’re going, but we’d better have a good idea where we are. That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.”

The most important thing is having a sense for where we stand. We need to be aware of the current environment. Is the outlook for the economy positive or negative? Are the capital markets loose or tight? Are risk spreads narrow or wide? Are investors eager to buy, or eager to sell? Are asset prices high or low?

Use the information we have and know today to make investment decisions based on probability, not forecasts. We should be cautious when others have aggressively driven prices higher. We should be more aggressive when others have panicked and driven prices lower.

Chapter 16

“Randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully. As a result, the dangers that lurk in thus-far-successful strategies often are underrated.”

The most important thing is appreciating the role of luck. You cannot judge the propriety of an investment decision by the outcome. Some bad decisions produce good outcomes. Some good decisions produce bad outcomes. Some investors build their portfolio to maximize profits based on their forecasts. If by random chance their forecast is correct, they look like a genius. However, since we know the future is unknowable, that investor may have just been lucky. A sound investor will invest defensively based on a broad range of probabilities. High priority will be placed on respect for risk and randomness of events; including attempting to avoid pitfalls that could devastate a portfolio.

Chapter 17

“Investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.”

Most investment managers fail because they are too aggressive; not because they are too careful. Trying to make above average gains through taking on more risk is a fools game for most investors.

In reality, a balanced but somewhat defensive game, based on keeping individual losses to a minimum and avoiding very poor years, makes more sense. The best risk control is insisting on a margin for error. Having a healthy respect for risk, paying a low price, and acknowledging what they don’t know makes the best investment managers.

Chapter 18

“At the important turning points, when the future stops being the past, extrapolation fails and large amounts of money are either lost or not made.”

The most important thing is avoiding pitfalls. Rationales that dominate cycles usually coincide with the belief that “it’s different this time”. They are pitfalls that cause maximum harm to the maximum number of herd followers. These rationales should be recognized and avoided by the second-level thinkers. In the short term, psychological and technical factors can override or subjugate fundamentals. By definition most people join the trend and help create the bubble or crash. These are times it’s especially important to be contrarian and think defensively. Leverage multiplies results but does not add value. Leverage might make sense when purchasing assets at bargain prices with high expected returns. On the other hand, using leverage to buy assets with low expected returns and high risk is a recipe for exaggerated losses.

Chapter 19

“Asymmetry – better performance on the upside than on the downside relative to what your style alone would produce — should be every investor’s goal.”

The most important thing is adding value. Marks advocates being the defensive investor who strives to lose less than the market in downturns, but capture a fair amount of the gains in a rising market.

Beta is a measurement of how much a portfolio moves compared to the market. An aggressive investor (high beta) without skill will gain a lot when the market goes up and lose a lot when the market falls. The defensive investor (low beta) without skill won’t lose much when the market falls, but won’t gain much when the market rises. This kind of investor adds no value. Alpha is a measurement of personal investment skill. This is a measurement of portfolio performance that is unconnected to the movement of the market. Positive alpha would mean that over a down and up cycle the investor does better than the market. A negative alpha would mean that over a down and up cycle the investor underperforms the market.

Chapter 20

“To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently, or do a better job of analyzing them — ideally, all three.”

The most important thing is pulling it all together. You have to be confident in your assessment of value. You have to have the courage to stay disciplined when the price varies from your valuation assessment. You must be strong enough to overcome the powerful psychological influences that will attempt to get you to join the consensus. The risk that matters is the risk of permanently losing your principal. Risk control is the heart of defensive investing. Put a heavy emphasis on not doing the wrong thing. The key to investment success is getting the price and value relationship right. There is no way to know what the future holds, so insisting on a margin for error is the best approach to adding value. The larger the margin for error the higher the probability of success.

My Final Thoughts

This is a thought provoking book. It may be one the best portfolio management books ever written. It’s so simple, yet so hard to implement in real life. If investing were easy, so many would not fail. Howard Marks has provided us the most important things. With a basic understanding of value and the strength to overcome negative psychological influences anyone can be a successful investor. I highly recommend this book!

The BRICS Currency Project Picks Up Speed

The BRICS Currency Project Picks Up Speed

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Tags Central BanksMonetary PolicyMoney and BanksWar and Foreign Policy

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On Friday, July 7, 2023, news broke in the financial market media that the “BRICS” (that is, Brazil, Russia, India, China, and South Africa) will implement their plan to create a new international currency for trading and financial transactions, and that this new currency will be “gold backed.”

Most recently, on June 2, 2023, the foreign ministers of the BRICS—as well as representatives from more than twelve countries—met in Cape Town, South Africa (interestingly at the “Cape of Good Hope”). Among other things, it was emphasized that they wanted to create an international trading currency. Undoubtedly, this is an undertaking that could have consequences of epic proportions.

After all, the BRICS countries represent about 3.2 billion people, approximately 40 percent of the world’s population, with a combined economic output nearly the size of the economy of the United States of America. And there are also many other countries (such as Saudi Arabia, United Arab Emirates, Egypt, Iran, Algeria, Argentina, and Kazakhstan) that might want to join the BRICS club.

The goal of the BRICS countries is to reduce their economic and political dependence on the US dollar, challenging “US dollar imperialism.” To this end, they want to create a new international currency for commercial and financial transactions, replacing the US dollar as the means of transaction unit.

The reason is obvious. The US administration has on many occasions used the greenback as a “geopolitical weapon” and engaged in a kind of “financial warfare”: Washington sanctions enemy countries by denying them access to the US dollar capital market, but above all, it shuts them off from the international US dollar-centric payment system.

The freezing of Russia’s currency reserves (the equivalent of almost six hundred billion US dollars is currently at stake) has set off alarm bells in many non-Western countries. It has reminded a number of them that holding US dollars comes with a political risk. This, in turn, has prompted many to restructure their international foreign reserves: holding fewer US dollars, switching to other (smaller) currencies, but above all, buying more gold.

But how might the BRCIS manage to swim away from the US dollar? While no details are available yet about how the new BRICS currency might be structured, it should not stop us from speculating about what lies ahead.

The BRICS could establish a new bank (the “BRICS Bank”), funded by gold deposits from BRICS central banks. The physically deposited gold holdings would be shown on the asset side of the BRICS bank’s balance sheet—and could be denominated, for example, “BRICS gold,” where one BRICS gold represents one gram of physical gold.

The BRICS Bank can then grant loans denominated in BRICS gold (for example, to exporters from BRICS countries and/or to importers of goods from abroad). To fund the loans, the BRICS Bank makes a credit contract with the holders of BRICS gold: The holders of BRICS gold agree to transfer their deposit to the BRICS Bank for, say, one month, or one or two years, against receiving an interest rate. What is more, the BRICS Bank, and it can also accept further gold deposits from international investors, who can hold (interest-bearing) BRICS gold deposits this way.

BRICS gold could henceforth be used by the BRICS countries and their trading partners as international money, as an international unit of account in global trade and financial transactions. Incidentally, the new de facto gold currency would not even have to be physically minted but could be and remain an accounting-only unit while being redeemable on demand.

The exporters from the BRICS countries and the other member countries would, however, have to be willing to sell their goods against BRICS gold instead of US dollars and other Western fiat currencies, and the importers from the Western countries would have to be willing and able to pay their bills in BRICS gold.

How do you get BRICS gold? Those demanding BRICS gold must either get a BRICS gold loan from the BRICS Bank or purchase gold in the market and deposit it with the BRICS Bank or a designated custodian, and the gold deposit is then credited to his account in the form of BRICS gold.

For example, in payment transactions, the goods importer’s BRICS gold deposits (held, for example, at the BRICS Bank) are credited to the account of the exporter of goods (also held at the BRICS Bank or at a correspondent bank or gold custodian).

However, the transition, the use of BRICS gold as an international trade and transaction currency, would most likely have far-reaching consequences:

(1) It would presumably lead to a (sharp) increase in the demand for gold compared to current levels, with not only gold prices measured in US dollars, euros, etc. but also in the currencies of the BRICS countries increasing (substantially).

(2) Such an increase in the gold price would devalue the purchasing power of the official currencies—not only the US dollar but also the BRICS currencies—against the yellow metal. Also, the prices of goods in terms of the official fiat currencies would most likely skyrocket, debasing the purchasing power of presumably all existing fiat currencies.

(3) The BRICS countries would build up gold reserves to the extent that they run, or will run, trade surpluses. They would presumably be the winners of the “currency switch,” while the countries with trade deficits (first and foremost, the US) would lose out.

BRICS official gold holdings, in billion US dollars, Q1 2023

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Source: Refinitiv; own calculations. The BRICS gold reserves amounted to 5,452.7 tons in the first quarter of 2023 (market value currently around 350 billion US Dollars).

 

These few considerations already show how disrupting the topic of “creating a new gold-backed international trading currency” could be: the BRICS could well trigger landslide-like changes in the global economic and financial structure. Still, it will be interesting to see how the BRICS countries intend to proceed at their August 22–24 meeting in Johannesburg, South Africa.

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Source

https://mises.org/wire/brics-currency-project-picks-speed

A Good Way to Evaluate a Company

A Good  Way to Evaluate a Company with the help of the book, 'The Outsiders', Warren Buffet and Peter Lynch

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William Thorndike – Author of “The Outsiders” – 2 Qualities that Make a Great CEO

I first heard of the book “The Outsiders” in Berkshire Hathaway’s 2012 letter to shareholders. And who is going to ignore a book that Buffett calls “outstanding!”?

The book goes in detail on 8 different CEOs who excelled at creating exceptional long term returns for shareholders. In fact, the average returns of these companies’ shares outperformed the S&P 500 by a factor of 20 – every $10,000 invested in these companies was worth $1.5 million 25 years later.

What’s their secret? And how can we use those lessons to find today’s great CEOs?

The book makes the point that the reason these companies were so successful was because of the ability of the CEOs to allocate their company’s capital into the areas that produced the highest returns.

Capital Allocation

Sure it’s nice to have a CEO who is charismatic, a great communicator or maybe even one who enjoys a celebrity type status. But what really matters to shareholders? Returns.

And a CEO who is a master capital allocator will ensure that shareholder money is put to the best use, and generates the best returns possible. Capital Allocation done right over decades creates a huge compounding effect – as shown in this book – and compounding wealth for its shareholders.

The CEO’s job is to allocate the company’s two forms of capital, for the sake of this article we are going to refer to these as a company’s “Financial Capital” and “Human Capital”, and take a look at how these 8 outstanding CEOs allocated their capital to produce superior returns.

First lets look at the much easier to define and measure Financial Capital.

Financial Capital Allocation

This is how a company’s CEO spends the company’s money.

Focus on Cash Flow – Not Reported Earnings

The first common theme evident throughout the book is nearly all of these CEOs focused on one thing above all else – Cash Flow. Even at the expense of reportable earnings, these CEOs wanted their businesses to generate cash.

For example, in the chapter on John Malone and his company, TCI, Thorndike says:

“…Malone’s realization that maximizing earnings per share (EPS), the holy grail for most public companies at that time, was inconsistent with the pursuit of scale in the nascent cable television industry. To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to MINIMIZE reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.”

And Henry Singleton, CEO of Teledyne said:

“If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings.”

Finding Companies Focused on Cash Flow

What does this mean for finding your next investment? Instead of evaluating a company based on a ratio using net earnings (such as P/E ratio), look instead at the price of a company based on the cash it generates. Use a metric like Free Cash Flow (FCF) or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) instead, because a CEO focused on cash flow will sacrifice a “good” P/E value in favor of high free cash flow. Combine a company that produces tons of cash with a CEO who allocates that cash wisely (which we will learn to measure in the next few steps) and you may be well on your way to an excellent long term ride.

Read more: “How much is too much to pay for a great business” – Where we explore one company with a P/E of 66…but as we have seen, P/E doesn’t tell the whole story. Look and see how much cash they generate!

Screening based on Price/FCF, Price/EBITDA will find companies that are cheap relative to the cash they generate.

This screening will give you a list of companies to start with. For those that want to play along, here is the start of my list, which we will whittle down as we go through this article. There are too many on this list right now, wait for the next step and we can start to get some solid companies to look into. So don’t write them all down yet, but here is the list of companies (it ended up being 95 total) that; 1) have a price/fcf ratio of 10 or less, 2) are not banks and 3) do not trade over the counter (OTC or “pink sheets”).

(click to enlarge)

Now to narrow that list down:

The Buffett Test – An Evaluation of a CEO’s Allocation Ability

So you found a company that generates a lot of cash. Now you need to find a CEO that has a proven record of investing that cash wisely, to get (or keep) the “snowball” of compounding growth rolling.

One quick test is what has become known as the “Buffett Test”.

The appendix of The Outsiders defines the “Buffett Test” as:

“…a simple test of capital allocation ability. Has a CEO created at least a dollar of value for every dollar of retained earnings over the course of his venture?”

This Buffett Test is discussed further by Buffett in his “Berkshire Hathaway Owner’s Manual”, originally in 1983 he wrote:

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.”

But this was updated later to also include:

“I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.

When the stock market has declined sharply over a five-year stretch, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.

The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If

these tests are met, retaining earnings has made sense.”

So, each of these definitions reads a little bit different to me. Let’s look at each of them:

First, The Outsider’s definition. If we assume that “value” equates to shareholder equity (or book value), then we simply take the change in shareholder equity over the CEOs tenure and divide it by the change in retained earnings. The Book says that Buffett himself has achieved a Buffett ratio of 2.3 over his tenure (meaning that every dollar in retained earnings has created 2.3 dollars in shareholder equity).

How did they get this?

The book was published when Berkshire Hathaway had released its 2007 annual report. So start with 2007 numbers: Retained earnings were $120,733,000,000 and Shareholder Equity was $273,160,000,000. Berkshire’s numbers for 1965 were Shareholder Equity of $22,139,000 and retained earnings somewhere around -$10,000,000.

So,

Which comes out to 2.26, remember any value over 1 “passes” this test. Obviously, the higher the better though.

In Buffett’s definition from his owners manual, he seems to recommend using the companies market cap instead of shareholder equity (Which seems strange to me, coming from a guy who says the market can be inefficient and misprice stocks, and that investors should not worry too much about the share price – which is why I like the first definition better – But no one asked me!)

So, as of October 1964 there were 1,134,776 shares of Berkshire outstanding and was around $18 when Buffett took control, for a market cap of $20,425,968. In 2007 Berkshire had 1,548,000 shares outstanding with a price around $118,000 per share, for a market cap of $182,664,000,000.

Using the retained earnings numbers from the example above we get:

Which gives us 1.50, another passing grade (is there any surprise?)

How many names can we eliminate from our original screen by requiring a “Buffett test ratio” of 1 or greater? My Screener is limited to 7 years of data, so these companies are all screened for their Buffett Test over the last 7 years, using the shareholder equity definition above.

By eliminating all of the names with a Buffett Test of less than 1, we are left with 46 companies left:

46 is still a few too many for me to start pulling up years and years worth of annual reports, 10-ks and conference call transcripts. In order to whittle the list down further, lets look and see some other qualities of great CEOs described in The Outsiders.

Buybacks

Without a doubt, one of the most prominent themes I found in this book is the magnitude of share buybacks between these CEOs. Kathrine Graham of the Washington Post Company (Ticker: WPO) bought back over 40% of the company’s shares outstanding during her tenure, Capital Cities repurchased 47% of shares outstanding, TCI repurchased 40%, and Ralston Purina repurchased 60%!

New to the idea of share buybacks? Here’s a quick example:

Consider 2 similar companies with the exact same earnings. The only thing different about them is the number of shares outstanding:

Since one company has half the number of shares outstanding, its EPS (Earnings per Share) is twice as high. And since the companies are very similar (same industry, same growth expectations, etc) they should trade at a similar multiple, or P/E ratio. Since the company with less shares outstanding has twice the EPS to report, based on EPS and P/E ratio alone, company 2 can justify a share price that is twice that of company 1.

There are other benefits too, repurchased shares do not get paid dividends, which may save the company some money and reducing the number of shares outstanding boosts the ownership percentage of the company.

The book gives an example of Buffett’s original purchases of Washington Post stock. Buffett eventually accumulated an ownership stake of 13% of the company, but over time as Graham repurchased the company’s shares, Buffett’s ownership stake in the company would rise to 22%, as the number of shares outstanding decreased.

Of course, share buybacks can actually take away value from the shareholders if the company is buying back shares at a high price.

In Buffett’s 2012 letter to shareholders he said:

“The third use of funds – repurchases – is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the SUREST way to use funds intelligently: It’s hard to go wrong when you are buying dollar bills for 80 cents or less. We explained our criteria for repurchases in last years report and, if the opportunity presents itself, we will buy large quantities of our stock. We originally said we would not pay more than 110% of book value, but that proved unrealistic. Therefore, we increased the limit to 120% in December when a large block become available at 116%.

But never forget: In repurchase decisions, price is all-important. Value is DESTORYED when purchases are made above intrinsic value.”

So how do we search for companies that have bought back their shares? Thankfully, the number of shares outstanding for a company is listed on its balance sheet, and therefore searchable and screenable.

There is a term “Buyback Yield” that represents the percentage of a company’s shares that were repurchased. If a company bought back half its number of shares outstanding, it would have a buyback yield of 50%. Here is the definition provided by my stock screener:

“A stock’s buyback yield is determined by comparing the average shares outstanding of a fiscal period with the average shares outstanding of another fiscal period. The Buyback Yield for the latest fiscal year (Y1) compares the average shares outstanding for the latest fiscal year (Y1) to the average shares outstanding one year ago (Y2). If a stock has 90 million average shares outstanding in Y1 and had 100 million average shares outstanding in Y2, the buyback yield would be 10%. Conversely, if a stock has 100 million average shares outstanding in Y1 and had 90 million average shares outstanding in Y2, it would have a buyback yield of -11%. We then take the simple averages of a company’s buyback yields over the last three, five and seven years. Note that the signs are reversed, so that a positive buyback yield indicates the average number of shares outstanding declining while a negative number indicates the average number of shares outstanding is increasing.”

So we subject an additional screening criteria for our now 46 companies. Now I want to see only the companies that have a positive average buyback yield of the last 7 years.

Down to just 11 names now from our original pool of hundreds. Now I feel like this is a manageable list to start delving into some financial statements, listen to some comments from management, read annual reports, etc.

So we have a set of companies that exhibit some basic Fundamental qualities of the Outsider CEO companies.

But what about our other aspect of capital allocation – Human Capital – how these companies manage their people.

Human Capital Allocation

How a company manages and allocates its personnel can be as important as how it manages its money.

What are some characteristics of great CEOs?

One common trait is a decentralized structure of the company.

The entire publishing operation at Capital Cities (which ran 6 daily newspapers, several magazine groups and some several weekly shoppers) was run by 3 people at headquarters – including an administrative assistant!

In fact, on the inside cover of every Capital Cities annual report read:

“Decentralization is the cornerstone of our philosophy. Our goal is to hire the best people we can and give them responsibility and authority they need to perform their jobs. All decisions are made at the local level.”

Berkshire Hathaway is one famous example of a company with a decentralized structure. The company has 75 subsidiaries, and employs more than 300,000 people. How many do you think make up Berkshire’s headquarters? 25 (including Buffett).

Why is this important? It means Warren Buffett is not calling the shots for a company in Cleveland, Ohio from his chair in Omaha, Nebraska. Buffett has the confidence in his management to run the company themselves, he just allocates their capital.

Other “Outsider” companies: Teledyne – had an HQ of less than 50 people and TCI – which had an HQ of 17 people.

Finding companies with this type of structure is no easy task. The only way I have found it is by reading through annual reports. You could try a screen by looking at low SG&A costs (selling, general and administrative – as listed on a company’s income statement) per revenue, but at this point in the research, I like to get my nose into annual reports.

For example, one company I am in the middle of researching right now:

BINGO!

Which leads us to our next quality (also highlighted by the company above):

Entrepreneurial culture

This entrepreneurial culture is in part, forced by a company with a decentralized structure. As they are forced to manage their business without help from corporate.

But there are other key works to keep a look out for as you read through a company’s reports:

Incentives – such as with stock options. This keeps managers and shareholders interests aligned. If the primary source for a managers pay is to have the company’s stock price appreciate – then he will more than likely act in ways that also benefit shareholders as well.

You can find companies that have the incentives in place by looking at insider ownership (how many shares certain managers own – which is listed in a company’s annual report) or at manager and executive pay (as noted in a proxy report). Are executives and managers getting a high salary, but own little to no stock? That may be a big red flag.

Or are the manager’s getting meager salary, but a fair amount of stock options that will only be worthwhile if the company’s share price appreciates? Now you can be certain management and shareholders are on the same page.

Incentives could also mean bonuses based on performance, which one could argue is not as promising as stock, but at least performance bonuses will keep employees hungry to perform. For example Teledyne typically offered bonuses of up to 100% of salary!

Conclusion

Now we have a much better picture on how great companies in the past have been run and managed, and an idea on how to search for today’s companies that will hopefully become great companies tomorrow.

What is surprising to me is how “basic” this seems. Companies shouldn’t have waste by supporting massive corporate headquarters, companies should keep their managers and shareholders interests aligned, companies should spend their money wisely and not waste it by overpaying on acquisitions or the latest and greatest technology.

It takes a special kind of CEO to sacrifice the fame and celebrity status that could come with an elaborate corporate headquarters (see Facebook or Apple’s new headquarters, or “campuses” as they call them), higher than expected earnings numbers or headline grabbing acquisitions.

But it’s not easy to find a rational, pragmatic person these days, let alone one running a public company.

Thankfully with the help of William Thorndike’s book – we start to realize what is important, what creates LONG TERM shareholder value, what to avoid and how to identify great management.

Honestly this book is one of my top reads so far this year. Before writing up this article I just read through it for the third time to get all the information out I missed the first couple times. It’s an easy read, and one of the most educational resources I have found in a long time. Don’t miss out! Used copies on amazon are about $8 as I write this – worth every penny!

Also used in this article is Berkshire Hathaway Letters to Shareholders, which can be found online here: http://www.berkshirehathaway.com/letters/letters.html

Or, if you want the collection in book form (and letters from 1965 to 1976 which are NOT available on Berkshire’s website) – Look here!

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Source

https://www.begintoinvest.com/william-thorndike-author-of-the-outsiders-2-qualities-that-make-a-great-ceo/

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Peter Lynch - Balance Sheet For Beginners

PETER LYNCH

Any company’s operations can hit an air pocket from time to time. You got to make sure your company can survive tough times. The balance sheet tells you about the company’s financial structure, how much debt it has, how much cash it has, and how much equity its shareholders have.

There is nothing scary about a balance sheet. No story is complete without a check of the balance sheet. The basic concept of a balance sheet is that everything a company owns, its assets, are listed on one side. On the other side you find everything a company owes, its liabilities. The difference between what it owns and what it owes is its equity. Also called its net worth.

Go ahead and explore this fictional balance sheet. Click any of the items on this balance sheet for an explanation of it. When you are ready to move on, click either the debt or cash buttons for a discussion of the two most important items on any balance sheet.

Does the company have a lot of cash on hand, that’s great? A company with a lot of cash can buy more stock, make an acquisition or pay off all its debt. All moves that shareholders love to see.

A company should have at least enough cash to pay off its short-term debt. If it doesn’t, it could have to keep borrowing more and more. If you subtract cash from short-term debt and long-term debt and the total is only one quarter of net worth, the company has a decent balance sheet.

However, if short-term debt and long-term debt combined minus cash equals or exceeds net worth, then the company has a weak balance sheet. It is simple to recognize a strong balance sheet. No debt and lots of cash.

Suppose a company has 20 million dollars in cash after subtracting all debt. If the company has 4 million shares outstanding, it has 5 dollars of cash per share of stock. If you buy the company at $10 a share, you are paying only $5 for the company and you are getting $5 a share in cash. That is a really amazing price. In fact, that means your real price is $5.

If this company has a very solid predictable business, this extra cash is quite valuable. But if the company has lots of cash and is losing money, you still have to evaluate how quickly will they run through all that cash. That is all you really have to know. It is not much, but you should know it. 

If you don’t check your company’s survivability, you are not only skimping on your research, you are gambling. That is not why you invest in the stock market.

Check the debt. Most companies have some debt. But how much is too much? Add up the company’s long-term debt and total equity. That’s a good approximation of the company’s total capitalization, the money the company has available to grow its business in the future.

Now, compare the long-term debt to total capitalization. If total debt equals half of the company’s capitalization or more, beware, that’s quite a bit of debt. To service that much debt everything has to work right. Things don’t always work just right. If debt equals 20% of capitalization or less, that is better. That’s fairly low debt.

As usual, there is no rule without some exception. Debt in some industries like banking insurance and financial services routinely runs much higher than 20 to 50%. Know the industry and what is normal for it when you evaluate a balance sheet.

In many industries such as retailing and restaurants, companies have leases. They have commitments on buildings to rent for long period of time. Often, this form of debt will only appear in the footnotes. This is a very substantial form of debt. Look into the footnotes. See if you can see capitalized lease obligations. Add this back. This is an important exercise.

(Source: https://youtu.be/cRMpgaBv-U4)

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Source

https://www.yapss.com/post/collection-peter-lynch-47-balance-sheet-for-be

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