Berkshire Ruminations

Tuesday, May 29, 2007

A Valuation Rumination

Some folks consider themselves value investors if they tend to buy stocks with a low P/E. I think this is superficial, but it highlights what may be a pervasive oversight that all types of investors make: We often forget what stock is and why anyone would be willing to pay money to own it. In the lines that follow, at the risk of ultimately just playing with words, I will try to articulate my opinion of where value comes from and thus what constitutes value investing. At least in the Graham-Dodd sense of the term.

Companies operate to make money. No business would exist, except in some alternate bizzaro (or maybe socialist) world, if that wasn’t its goal. Hence, earnings are important. But they are not all that is important. Further, earnings themselves do not represent value. Rather, they are the source of value. Graham and Dodd cared about earnings only to the extent that they increased the firm’s value and the firm’s value, to Graham and Dodd, came directly from the balance sheet. By adopting their definition of value, return on equity, not earnings alone, is the most important metric of value creation.

Graham and Dodd focused on purchasing companies that traded at a discount to book value. That is, they preferred stocks whose market cap was less than the book value of that firm’s equity. This was logical since they saw the stock as representing a claim – a residual claim, mind you – on the company’s net assets. If the company were to liquidate today, the stock ought to be worth today whatever would end up being paid to the shareholders. Sell the assets, pay off the debt, what ever is left over (net assets) is what the company is “worth.” If we can get it for less than that, we are getting a bargain. So the only real consideration in this simple scenario would be any discrepancy between the actual market value of the assets and the value at which they are booked on the balance sheet.

Think about this concept for a moment. If you knew a company was going to instantaneously liquidate at 3:00 pm this afternoon, how much would you pay for it at 11:00 am this morning? Answer: net asset value per share.

But what if the company doesn’t liquidate today? What if, instead, it liquidates in twenty years? What if it never liquidates? The principles of valuation ought to be the same, Graham and Dodd would suggest, but the calculations get tremendously more difficult. Again, the company is worth the value of its net assets, but now we don’t know what that value will be in the future. Additionally, because of the time value of money, we must discount that unknown value back to the present at some other, also unknown, discount rate. Oh yeah, and the number of periods we are discounting that unknown value at an unknown discount rate is also unknown.

Maybe by now it is clear that, despite the uncertainty, at least we know that what really drives the value of a stock is the claim that the stockholder has on the company’s assets. If not, consider the valuation of a bond, which also represent a claim on the company’s assets. Bonds are simpler to value, though, because there is far less uncertainty as to what the owner will be paid. At maturity, bonds are “liquidated” just as our stock was in the above hypothetical. The value (price) of the bond is simply the discounted value of all those payments.

Earnings are important because they boost the stockholder’s claim on the firm’s assets. This results from retained earnings. As the company books profits, those profits are retained on the balance sheet, boosting asset value without a corresponding increase in liabilities. So shareholders’ equity (book value) increases. We measure this rate of increase by the return on equity. The problem is that we don’t know how much the company will earn so we don’t know how much book value will increase. Note that the payment of dividends is only a minor complication – instead of value being retained by the company for eventual, indefinite payment to the shareholder, it is paid out immediately. Either way, it ends up in the shareholder’s pocket.

But not all earnings are created equal, and this is probably the important part of my musing. Not all earnings boost book value. If net income cannot be retained or paid to shareholders as a dividend, then it can’t increase book value of equity. And there are simply too many ways that net income can be manipulated (willfully or not) so that it does not accurately reflect the value added to the balance sheet. Additionally, that unknown discount rate that I alluded to earlier ought to be based the firm’s cost of equity. If this cost of equity is high, then a firm can actually be destroying value even as its net income grows.

First of all, it is logical to discount future net income at the firm’s cost of equity, rather than its weighted average cost of capital (WACC), because the net income number is already net of the cost of debt. I see a lot of students who have been taught capital budgeting (a similar-but-different exercise) try to discount such numbers at the WACC. Cost of equity is a somewhat abstract concept and is often difficult to calculate. At the very least, though, we can say that it is some modest amount higher than the interest rate the company pays on its senior debt, since equity is much riskier to its owner than is debt.

If we assume that we are discounting that future income at the cost of equity, then the firm must boost its book value at a rate greater than this cost of equity if it is to create value. That is, it must earn a return on its equity that is higher than its cost of equity. Otherwise, even though we have future positive net income to add it to our current book value, after discounting to reflect its cost it is worth zero or less.

Graham and Dodd’s notion of value has several other implications. One is that a profitable company should not sell for less than the market value of its net assets. If it does, it is a bargain. But the market does some quirky things and occasionally this happens. It happened frequently when information gathering was as difficult as it was in Graham and Dodd’s era, but probably happens far less often today. Graham and Dodd idealized a bargain in what they called a “net net stock,” one that sold for less than the value of its net working capital. These were tremendous bargains that are all but nonexistent in today’s market.

I guess the bottom line is that ROE, not P/E is the most important ratio in stock analysis. A value investor, though, realizes its importance because he realizes where the value of a stock comes from.

Wednesday, May 23, 2007

Berkshire Ruminations now has an RSS feed

I finally tried to figure out what exactly an RSS feed is. I feel dumb for not knowing about this system earlier, but because I didn't know I simply never bothered to look into it. Although I still don't really understand how it all works, I believe I have one now, its on the sidebar at the bottom. Enjoy.

Monday, May 21, 2007

Sell GGG - They recalled their baby toys!

On this blog, just as a matter of principle, I have tried to avoid simply republishing previously published news bites or other bloggers’ postings. But this one was just too outrageous to pass up. It was brought to my attention on the Google Finance message boards by Dr. Bob Kiser. Dr. Kiser pointed out that Google Finance listed news of the Graco Children’s Products Inc. recall of its Soft Block Tower Toys alongside the Graco Inc. stock quote. The funny thing is that these two companies, although they share a similar name, have absolutely nothing else to do with one another.

Graco Inc. (GGG), the fluid-handling systems manufacturer, is a company I have been following for several months now. This no-debt company has averaged an ROE of over 40% for ten years and spends little in the way of capital expenditures. I wonder if periodic bad news from the other Graco sometimes has an adverse impact on the stock of this Graco when rash investors confuse the two…

Such a postulation is not as ridiculous as it may seem at first glance. Last year, when Jim Cramer mania was at its peek and a mere Mad Money endorsement was all it took to move a stock by five or ten percent, several stocks that were confused with the actual recommendations traded in concert.

This phenomenon is nothing new and has generally been attributed to the presence of ignorant “noise traders,” those that don’t do their homework before making a trade. The Harvard Business School dissertation of Michael S. Rashes, later excerpted in the Journal of Finance, documents the similar trading patterns of two securities with similar ticker symbols that are otherwise unrelated. In the late 1990s, MCI Communications traded on the Nasdaq under the ticker symbol MCIC. The ticker symbol MCI was an NYSE ticker reserved for a closed-end fund called Massmutual Corporate Investors. Clearly, these two securities have no relationship beyond their ticker symbols, yet Rashes shows an extraordinary amount of comovement between them.

During the period of the study, MCI Communications was in frequent merger negotiations with a number of different firms. (Of course, eventually it was acquired by Worldcom.) This gives Rashes many big news days to examine the corresponding behavior of Massmutual. He finds that on days of good news for MCI Communications, volume for Massmutual increased as well. Further, through regression analysis, he finds that the returns for Massmutual are actually a statistically significant explanation for the contemporaneous returns of MCI Communications, even though the returns of other telecom companies, such as AT&T, are not. Rashes estimates that as many as 1% of the trades in MCI during 1996 and 1997 were erroneous MCIC trades.

Graco Children’s products is not publicly traded – it is owned by Rubbermaid (NWL) – so ticker symbol confusion couldn’t cause the type of blatant mispricing mentioned above. But it nonetheless would seem feasible that there are individuals, even perhaps overwhelmed portfolio managers, reckless enough to sell GGG shares short upon hearing about the Soft Block Tower Toys recall. If this is the case, maybe we should watch Graco Children’s as part of our monitoring of Graco Inc.

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

Thursday, May 03, 2007

Paying for Growth: The Value Investor's Quandary

This is the story of two great growth stocks, one that I bought, one that I should have bought and both of which just released blowout earnings of (coincidentally) 38 cents a share.

The one that I bought is Green Mountain Coffee Roasters (GMCR), one of my all-time favorite companies (see “The Best Investment I ever made”). The one that I should have bought is Chipotle Mexican Grill (CMG), one of my all-time favorite restaurants.

GMCR reported fantastic numbers this morning for its second quarter. Net income doubled over the year ago quarter on sales growth of about 77%. Analysts had expected EPS of $0.34, and GMCR came in with $0.38. This represents an ROE of 13.4%. The stock shot up 10% this morning. As I have written about before, this company has some of the most level-headed and seemingly honest folks running it of any company with which I am familiar. After a decade of watching the company grow at a fast, but not ridiculous, rate I am now witnessing a true explosion of value.

There are at least two factors at work here. The first is that GMCR has created itself a niche that is protected by intellectual property rights. This gives it a wide moat that competitors, even those as strong as Starbucks, will have trouble penetrating. I am referring to their development and acquisition of the patented Keurig K-Cup brewing system. A K-Cup is plastic container, about the size of a shot-glass, that is filled with Green Mountain Coffee and sealed on the top with foil. When used with the (also patented) Keurig brewers, the cup is pierced and the coffee is brewed in the cup, producing one serving of perfectly brewed coffee. This has proven extremely popular in office settings, where the dreaded “coffee-burn” phenomenon has hindered the appeal of coffee pots for years.

The second factor is the company’s new relationship with McDonald’s. McDonald’s launched its “Premium Roast Coffee” campaign last summer with great success, immediately challenging Starbucks on taste and convenience. The coffee is usually branded under the McDonald’s name, but in a select number of stores in the northeast McDonald’s actually sells Green Mountain’s Newman’s Own Organic Coffees as such. Not only does this position Green Mountain to potentially supply the largest restaurant chain in the world, it also gives the coffee exposure to a constituency it otherwise wouldn’t.

The market seemingly has high hopes, as the stock has traded at very lofty multiples for several years now. This can be difficult for the value investor to accept. GMCR must grow at its current clip to justify its valuation, and that simply introduces a great deal of risk in to the investment. Should I, as a value investor, really take a position in a company that trades at PEs upwards of 50? Usually I won’t. In fact, this is exactly the reason I failed to dive in to the stock of my favorite lunch destination, Chipotle Mexican Grill.

At this university, I think most people would agree that Chipotle is unequivocally the most popular place to eat on or around campus. Every day a long line stretches around and towards (sometimes out) the door – both at lunch and dinner time. Friends of mine eat there every day. I even recall an article in the student newspaper entitled something like “I love Chipotle.” The food is delicious and the customers are loyal. I know this because when a similar Mexican food competitor opened next door, hardly anyone switched. The lines at Chipotle remained just as long as they had ever been.

So when I heard McDonald’s was selling its interest in Chipotle, I was immediately interested. For several months I watched for updates at, but was disappointed when the IPO was announced. The stock would go public at about 30 times earnings. For a company posting a return on that new equity balance of only 10.5%, this seemed to be too dangerous. High multiples like this make the cost of equity very high, and force comparably high returns if value is to be created.

Nevertheless, I have watched from the sidelines as the stock nearly doubled. It doesn’t take much research to figure out that the reason is that the company continues to expand and grow at rates higher that even Wall Street’s lofty expectations. Compounding the stock’s growth is the treasured “multiple expansion,” the market’s reaction to its realization that growth may be even better than it thought. Whereas the P/E of 30 sounded high to me a year ago, CMG now trades at a ttm P/E of over 50! The forward P/E may look more reasonable, but is still high at about 44.

So am I just hardened by the tech-bubble crash when high-multiple stocks suddenly fell to more normal levels, or should I really be considering these high-growth, but correspondingly high-priced, stocks? It is a test of discipline. CMG is very expensive, but it also is a very strong company. Thus, I need to convince myself that it is creating value despite its lofty price. I cannot convince myself of that, since the returns that it is earning are simply not high enough to offset the high cost of equity capital implied by the current stock price.

FD: I own shares of GMCR, but have no position in CMG or MCD.