Graco, Inc.

I love big companies that no one has heard of. Graco (GGG) strikes me as this type of company. It is similar to two other of my favorites, Leggett and Platt in its pervasiveness yet general anonymity, and also to Walgreen in its steady, long history of earnings growth. But the kicker in this case is that the stock may be cheap.

The company makes equipment used in fluid handling. This means such things as paint sprayers, newsprint ink transfer systems and the tool that injects Hershey’s kisses with caramel. Management boasts that Graco equipment is used on products all around us. For instance, CEO David Roberts points out that anyone who has had their home professionally painted likely had Graco products used. Anything that needs to be "glued, sealed, painted, or finished" will probably involve the use of a Graco product.

When I request an investor packet from a company’s investor relations department, I always consider it a good sign when included with the materials is a ten or fifteen-year summary of the company’s financials. It is usually only the companies with long, impressive histories of growth that will voluntarily provide such information. This is just what happened recently when I sent off for Graco’s materials.

Generally manufacturing firms like this are relatively less appealing as they ordinarily require high levels of capital investment. The machinery and equipment used to make its products are usually expensive. Fortunately, Graco is strong enough to easily finance its capital expenditures internally, and even end up with cash left over for expansion and distribution to shareholders. This translates in to a balance sheet with no debt yet a return on equity that has averaged well over 40% over the last ten years. With no debt, its return on invested capital is not much less, and since a mere 15%-30% of this return is spent in the form of capital expenditures, this company is clearly creating value a rapid rate. But then again it has been for many years.

What attracts me to the company today is that it looks beaten down. The 1-year chart below shows just when this happened, in mid-July of last year. This coincides with the company's acquisition of Lubriquip, Inc. from IDEX Corp (IEX). Unfortunately the terms of the Lubriquip acqusition were not released so it is difficult to assess if the company overpaid. The stock price reaction seems to indicate that at least a sizable fraction of investors think so.

What we do know about Lubriquip is the following. Its 2005 sales were approximately $30 million. It is less profitable than the rest of Graco, as the company, in its 2006 8-K, directly attributes a 0.3% drop in operating margin to the Lubriquip acquisition. There were no other major acquisitions in 2006 yet the goodwill account increased by about $15 million, and most importantly "acquisitions of businesses, net of cash acquired" amounted to $30.6 million. Also coincidental is Graco's $25 million credit agreement with US Bank, announced the day before the acquisition. Given all this information, I surmise that Graco probably paid about $30-$35 million for Lubriquip.

So, was this too much? Well IDEX tends to trade at less than 0.5 times revenue, while Graco (with its superior profitability) trades at near 4 times revenue. Regardless, the acquisition is not all that significant to a $3 billion company. Nonetheless Graco lost over $605 million in market value around the time of the acqusition. So unless the market sees the acquistion as indicative of poor managerial decision making that might ultimately cause the firm to flounder, I can only assume that this was a terrific overreaction. The stock fell from $46 to $37 in July but has only regained about half of the loss since.

It will be very interesting to read the 2006 Annual Report and see what the company has to say. There is plenty more analysis to be done on this company, but so far things are looking good from my perspective.

I welcome any comments or insight.

FD: I own shares of LEG, WAG and GGG, but have no position in IEX.

What market efficiency is, and what it isn't.

As an academic-in-training as well as an advocate of a value-investing philosophy, I am in quite a peculiar and awkward position. This probably comes as no surprise to those familiar with the teachings of scholarly work in the field, the disdain Warren Buffett has shown towards those teachings, or both. But as I have learned more about ideas such as market efficiency, you will be happy to know, my allegiance to the Graham/Buffett credo has not been diminished.

The most controversial academic theory is something called Efficient Market Theory (EMT). Academics love it, real-world practitioners hate it. Why? Well, it makes life much easier researchers who can rely on the assumption that market prices are the best guess we have of true value because it means we can apply all sorts of other tests to stock prices that we otherwise couldn’t. But EMT also suggests that the real-world practitioners add no value – that a monkey throwing darts can do as good a job as they can at picking stocks. Hence the conflict. (Do you think Mr. Buffett appreciates being compared to a monkey?)

So first, I would like to clear up the most common misperception of all. Market efficiency is NOT the notion that every stock price is correct, as I often hear both students and the business press suggest. That is far too simplistic. Market efficiency is the idea that, on average, stock prices are correct and that, for any particular stock, we don’t know if it is overpriced or underpriced. The difference between these two ideas is enormous. The theory also holds that we cannot systematically choose stocks that will perform differently than the market. To me this is the crucial caveat, as it leaves open the possibility that we can unsystematically identify firms with characteristics that we feel will lead to successful investment. Alas, science has met art.

Whenever we try to value (or price) a stock, such a valuation comes with some degree of imprecision. Statisticians will call this imprecision error or residual. By definition, the sum of these errors will be zero, so we will never know whether the error with regard to a particular stock is positive or negative. Take for instance the all-but-debunked Capital Asset Pricing Model. This model suggests that a stock’s price is a function of a multiple, based on the stock’s past volatility, of the market’s “risk premium.” Everything else not explained by this multiple ends up in the error term. Since CAPM has been shown to provide little real ability to price stocks, new factors such as size and book-to-market have been added to the equation that reduce that error term.

In many cases this has made such pricing models more effective, but the obvious limitation of such models that they rely on measurable and easily accessible information. I remain of the opinion that there are times when stock prices clearly are overpriced or underpriced due to factors, like irrational exuberance, that cannot be quantified. Obvious example: the tech bubble, when the S&P 500 Composite Index temporarily sustained a P/E of over 44. Unprofitable companies like JDS Uniphase sold for $250 a share. The academic literature has struggled to make sense of this phenomenon since it happened, and thus the emergence of behavioral finance as a respected area of study coincided with this struggle. But I believe we can, in some situations, say with greater than 50% confidence that a stock price will rise at a rate greater than that of the market. Not because the book-to-market ratio or some measure of momentum dictates so, but becuase we see a firm with qualitatively positive attributes trading for less than it "should," whatever "should" means. (Passing this theory off on the financial scientists of the world is likely a futile effort that I will not make.)

Now, having said all this, let me warn everyone that to write off “market efficiency” in such a general sense is a huge mistake. Unfortunately I think many individuals unfamiliar with what exactly the term means, make blanket statements like “The market is not efficient.” As a favorite professor of mine has explained, the market should be assumed efficient until proven inefficient. Sometimes it will be inefficient, but more often than not it does a pretty good job of pricing stocks. And that is why we must be both careful and vigilant. One of my personal triumphs of late is my purchase of Coach (COH) shares early last summer at $26. The stock of this fast-growing company had fallen sharply for no real reason other than a general pessimism towards retail apparel. At $48 today, I have a nice 80% gain. (I’m not bragging, I swear!) But because the market is often very efficient, these opportunities will continue to be rare, so when we see them we must act. As Warren Buffett has advised, “Make large bets on high-probability events.”

FD: I own shares of COH, but have no position in any other stock mentioned in this post.