A Tale of Two Fitness Club Chains: Life Time Fitness (LTM) and Town Sports (CLUB)

by Quan Hoang

The Avid Hog (now Singular Diligence) wrote about Life Time Fitness (LTM) and Town Sports International (CLUB) in November 2013 and February 2014 respectively. Life Time Fitness is being bought out for $72.10 a share in cash. Town Sports is exploring strategic alternatives including a sale. So, it’s now a good time to review our theses on these companies.

I think that Life Time Fitness and Town Sports have competitive advantages in their own markets. Life Time Fitness is a category killer in suburban areas while Town Sports has a location-based moat in cities like New York City and Boston.

Circle of convenience is an important concept in understanding these companies. Circle of convenience is the area within which customers are willing to go for a service. In cities like Manhattan, walking distance is important. In suburbs, driving distance is important.


Town Sports Has a Location Based Moat in Cities

About two thirds of Town Sports locations are in areas that are truly urban. These urban clubs include 60 clubs in New York City, 10 in Washington D.C., 7 in Boston, 3 in Philadelphia, 2 in Basel (Switzerland), and 1 in Zurich (Switzerland). Because of difficult traffic, each urban club draws customers from a market defined by a small radius. In Manhattan, Town Sports normally gets customers within 2 or 3 blocks.

Also, urban customers like having access to multiple clubs. For example, 38% of all visits to Town Sports clubs are from members visiting locations that aren’t their home gym. In each key market, Town Sports built a cluster with locations that are conveniently situated near both a member’s home and office.

A competitor must build a cluster of similar scale to compete with Town Sports in a city. Suitable sites in cities are scarce and leases are expensive. So, I think Town Sports’s moat is wide in places like New York City or Boston.


Life Time Fitness Is an Unstoppable Category Killer

Life Time Fitness’s moat is different. Life Time Fitness has 113 big clubs in suburban areas. In suburbs, people travel by car. Circle of convenience is much wider. 25% of Life Time Fitness members are further than 5 miles away from its locations. Life Time Fitness’s moat doesn’t come from location-based convenience, but from economies of scale on the customer experience side.

Life Time Fitness operates very big clubs. The current model of a Life Time Fitness club is 114,000 square feet. For comparison, a basic club with no amenities ranges from 2,000 to 15,000 square feet. Town Sports’ suburban clubs with amenities like swimming pool or basketball courts average 40,000 square feet.

Big clubs don’t result in economies of scale on the cost side. Life Time Fitness can’t sell more memberships per square foot by building a bigger club. However, they can offer 114,000 square feet of amenities to each member. Life Time Fitness offers a lot of programs. These programs include yoga, swimming, running, racquet ball, squash, tennis, pilates, martial arts, and basketball. The average Life Time Fitness member uses 5.5 programs. Big clubs have economies of scale on the customer experience side. That allows Life Time Fitness to differentiate and charge a premium for its service.

As a result, each Life Time Fitness clubs has a local moat. It’s usually surrounded by several small clubs. Small clubs draw customers within a one- or two-mile radius. Barrier to entry is low and there’s a lot of churn and replacement. So, Life Time Fitness gets the biggest share of the profit pool in each local area.

It’s difficult to copy Life Time Fitness. Each club is a mega project. Investment in each project is about $30 million to $50 million. Life Time Fitness designs its own clubs. It has a dedicated subsidiary that just focuses on drawing up the plans for each new club. The operation of each club is complicated. Each club has 300 certified employees and offers 20 programs. The capital and complexity involved is beyond what most fitness companies are used to doing.

So, Life Time Fitness is an unstoppable category killer.


Overleverage Can Kill a Fitness Club Operator

These two companies are also different in durability.

The biggest risk in this business is overleverage. This industry is littered with bankruptcies. Bankruptcy is often the result of using debt and leases to quickly expand. When financial obligations are excessive, chains may need to use all of their cash flow to pay rent and interest. They have little money left for maintenance cap-ex and end up with outdated locations. That results in a vicious circle as uninviting locations start losing customers.

Town Sports has always had low fixed charge coverage. Since 2002, Town Sports’ EBITDAR/(Rent + Interest) has been about 1.5. That’s because rent expenses are high in cities. Town Sports usually spends 18% of sales in rent expenses. In recent years, rent expenses have crept up to 24% of sales.

Town Sports survived the Great Recession. However, low fixed charge coverage is always a big concern for Town Sports in the face of adversity.

On the contrary, Life Time Fitness has very low leverage. At the time we analyzed, the company owned 67 of its sites. And 55 of those clubs have no mortgage. EBITDAR/(Rent + Interest) was about 6. The appraisal value of its real estate is well over $2 billion. Life Time Fitness can always borrow against its real estate if necessary. It has much greater financial flexibility than Town Sports.

The only concern for Life Time Fitness is the CEO. Bahram Akradi has done a great job at building the company. However, he was too aggressive in using debt with his own personal portfolio. In 2008, he had to sell a lot of Life Time Fitness shares at a bad price to meet a margin call. That’s a sign of an appetite to maximize return regardless of the risks involved. Life Time Fitness has always been much more financially conservative than its peers. But there’s a risk that Bahram Akradi is too aggressive and will overextend the company.


Boutique-type Studios Threatens Town Sports

Change is another concern in examining durability of the business. There are often fads in health and fitness. However, I think Town Sports and Life Time Fitness can simply offer new programs in their locations. Town Sports’ CEO Bob Giardina explained:

I think customers get bored…people don’t like to exercise, so you have to have enough variety to keep people moving into different functions. So 25 years ago, some of us may remember step programs. They were popular. Before that, it was Jazzercise. Today it is kettlebells. So the box has to stay flexible, and that is what I love about our product. The box is flexible. What we put in the box can move around. So we have to stay close to the members. We have to understand what their needs are.

Unfortunately, the location based convenience that helped create Town Sports’s moat also threatens its moat. Boutique-type studio is the dominant trend in the last several years. Over 600 private studios like yoga or CrossFit were opened in New York City in the last several years. Giardina talked about the changing customer behavior in the last conference call:

Market research on the industry is also telling us that club members are gravitating toward using multiple workout options. They are joining a traditional fitness club and then using studios to supplement it.

Societal change is a big concern for Town Sports. Private studios seem more accessible to customers both physically and financially. Town Sports’s cluster of clubs may become irrelevant. It’s possible that the boom in private studios will eventually burst. But Town Sports’s high leverage can result in a bad lollapalooza effect.


But Not a Threat to Life Time Fitness

Boutique-type studios also made it difficult for Life Time Fitness to acquire new customers in 2014. Bahram Akradi talked about the impact of studios in a conference call:

So there is a significant amount of fragmentation in the industry. There are a number of studios opening up, from just workout studios to yoga studios, to cycle studios, et cetera. That really has accelerated significantly in the last 12, 24 months. The other types of stores, like the Snaps and Anytime Fitness and the Planet Fitness, they really have not been a factor to our types of member and our types of facilities. But the number of studios that are serving the higher kind of a level customer, the customer who really wants that higher-end, boutique-style classes and programs, have really been ramping up in the last couple of years…

And this has happened for the last 20, 30 years, with variety of different styles of low barrier-to-entry models. And our strategy has been to build something that doesn't -- again, high barrier to entry for our model. And then sometimes, just have to go through these short periods of time. We intend, clearly, to continue to grow our same store.

Life Time Fitness experienced a slight decline in full-access memberships in early 2014 and only had a small growth in the fourth quarter. However, Life Time Fitness’s customer experience-based moat remains intact. The company targets customers who prefer having a lot of amenities. In the long run, these boutiques won’t be different from small clubs that compete with Life Time Fitness. In the short run, Life Time Fitness is trying to improve customer service and retention rate. Membership growth and revenue growth will continue to drive revenue growth.


Different Outcomes

We concluded that Life Time Fitness and Town Sports were undervalued for 2 different reasons.

Life Time Fitness is a good and growing business. We think that the company can grow 10% for 15 years. It’s driven by square footage growth and revenue per membership growth. Last year, total square footage grew 6% and revenue per membership grew 7%.

We also think that the number of membership is below Life Time’s capacity. Last year, membership stayed almost flat despite a 6% growth in square footage. I still think membership is far below normal. Bahram Akradi seems to agree with me.

Private equity firms are paying over $4 billion for Life Time Fitness. Including capitalized leases, the deal value is about $4.3 billion. Bahram Akradi has also committed to invest $125 million in the company. We valued the company at $4.5 billion, including capitalized leases. He and his investors must think Life Time Fitness is worth far more than that to pay $4.3 billion.

Town Sports is different. Town Sports has little growth opportunity outside of its core markets. It’s very popular among value investors as a deep value stock. We noticed the risk of high leverage, but we were attracted by the level of EBITDA Town Sports can generate. However, revenue declined while operating cost increased in 2014. Societal change may destroy its moat. The management is considering a sale of the company. But perhaps its shareholders won’t enjoy a premium like shareholders of Life Time Fitness.

We wrote about Life Time Fitness in November of 2013 when the stock price was $48.51 a share. Today’s share price is $70.75. The stock has gained 46%.

We wrote about Town Sports in February of 2014 when the stock price was $10.50 a share. Today’s share price is $6.23. The stock has lost 41%.


(Signed: Quan Hoang)

Talk to Quan about Life Time Fitness and Town Sports

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Sold Town Sports (CLUB); Bought Babcock & Wilcox (BWC)

by Geoff Gannon

Today, I sold my shares of Town Sports (CLUB) and put the proceeds of that sale – plus some other cash – into buying Babcock & Wilcox (BWC).

My average cost in Town Sports was $8.84 a share. My average sale price was $6.85. This is a realized loss of 23% over an 11 month holding period.

My average cost in Babcock & Wilcox is $27.06 a share. Babcock now represents 18% of my portfolio. The company will split into two separate stocks later this year. I will hold on to both of those stocks.

I may increase my position in Babcock to about 25% of my portfolio. This depends on whether: 1) I am successful in selling the last of my Japanese net-nets 2) Babcock’s share price does not rise too much.

The four non-Japanese net-nets in my portfolio right now are:

  1. George Risk

  2. Ark Restaurants

  3. Weight Watchers

  4. Babcock & Wilcox

These four stocks account for more than 90% of my portfolio.

Toby handles the Singular Diligence model portfolio. This sale has no impact on the model portfolio. Quan also owns Town Sports in his portfolio. Quan did not sell Town Sports and buy Babcock & Wilcox today. If and when Quan makes a change to his portfolio it will be posted here.

The timing of my sale of Town Sports and purchase of Babcock has to do with Babcock – not with Town Sports. Town Sports is the target of an activist campaign. Activist investors control about a quarter of the company’s shares. The board recently adopted a “poison pill” defense and the activists nominated their ticket for this year’s board election. None of these events make it a particularly good time to sell Town Sports. However, we just put out the Babcock & Wilcox issue of Singular Diligence. The publication of that issue freed me up to buy the stock. Quan and I start research on a stock far in advance of the date when that stock appears in Singular Diligence. So, I have been waiting for months to buy Babcock & Wilcox.

It is worth mentioning that I did not – and would not – have sold Town Sports merely to hold cash. I sold Town Sports to buy Babcock. This tells you 3 things:

  1. I prefer Babcock over Town Sports

  2. I believed Babcock was the strongest stock I did not already own

  3. I believed Town Sports was the weakest stock I did own

For example, my sale of Town Sports obviously tells you that I think Weight Watchers is – at today’s price – a stronger stock than Town Sports. Otherwise, I would have sold Weight Watchers instead of Town Sports.

If you subscribe to Singular Diligence you can now read the full issues on both Town Sports and Babcock & Wilcox.

Check out Singular Diligence

Talk to Geoff about Selling Town Sports or Buying Babcock & Wilcox

Singular Diligence: 8 Archived Issues

by Geoff Gannon

These are the 8 archived issues - each is over 12,000 words long - you get immediate access to the moment you subscribe to Singular Diligence.


Singular Diligence – Archived Issues

Life Time Fitness (LTM): Runs 112 (mostly) huge gyms across 25 U.S. states. About half (55) of these clubs are on unmortgaged company owned land. Since our report was published, Life Time Fitness announced it may convert to a REIT.  

Progressive (PGR): A U.S. auto insurer that competes with GEICO online. Also the largest auto insurer in the independent agent channel.

Ark Restaurants (ARKR): Runs a small number of huge restaurants in landmark locations like: Union Station, Bryant Park, Faneuil Hall, casinos, and hotels. Also has an interest in the Meadowlands racetrack in Northern New Jersey as well as the food and beverage concession there.

Town Sports (CLUB): Runs urban gyms in New York City, Washington D.C., Boston, and Philadelphia under the “Sports Club” name.

HomeServe (London – HSV): A U.K. company that provides home emergency repair services using an insurer’s premium based model. Now also in countries like France and the United States.

John Wiley (JW.A): A publisher of books, textbooks, and academic journals. The vast majority of the company’s value is in its academic journals. The Wiley family has controlled the company for 207 years.

Village Supermarket (VLGEA): The second largest operator of “Shop-Rite” supermarkets. Stores are mostly in densely populated Northern New Jersey. Each store does about $1 million a week in sales

Weight Watchers: (WTW): The world’s biggest weight loss brand. Weight Watchers runs group support meetings, the WeightWatchers.com self-help website, sells Weight Watchers products, and licenses the Weight Watchers name.


Talk to Geoff about Archived Issues

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How We Found PetSmart (PETM)

by Geoff Gannon

Someone who reads the blog emailed me asking how Quan and I found PetSmart (PETM):


Did you find PetSmart idea through running a stock screen? If yes, which screener did you use and what parameters ?


And here’s how I answered:


Quan found PetSmart on a list of stocks that returned more than 10% a year over 15 years. I had sent him a list of every stock in the U.S. that returned more than 10% a year over 15 years (it was a bad 15 years for U.S. stocks at that time) and we added it to a watchlist. We didn’t analyze the online threat for some time. But then the stock price dropped. And we focused completely on the stock at that point.


Just to be clear, it wasn’t exactly a screen. What I did is use Portfolio123 to generate a list of U.S. stocks on a certain start and end date with price information (adjusted for splits). And then I figured out how to order them in Excel so I could create lists that compounded their stock price by certain amounts over certain periods of time.


We chose the 10% a year over 15 years simply because Portfolio123 only has data going back like 17 years or so for stock prices. And we sometimes use 10% as an adequate return number. We hoped that just using a long-term stock price compounding test would turn up some stocks we might otherwise miss by using just the kinds of methods value investors normally screen for.


Read Quan’s Notes on PetSmart (PDF)


Talk to Geoff about PetSmart (PETM)


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(All) My Thoughts on Singular Diligence

by Geoff Gannon

With The Avid Hog relaunching as Singular Diligence, I thought now would be a good time to revisit a post I wrote when Quan and I first started this newsletter. What follows is a re-post of “(All) My Thoughts on The Avid Hog” which appeared on October 5th, 2013 on this blog.

But first let me explain why The Avid Hog has become Singular Diligence and what it means.


Reasons for the Relaunch

There is no change in content between The Avid Hog and Singular Diligence. The two newsletters are exactly the same and Quan and I prepare issues of Singular Diligence exactly the same way we prepared issues of The Avid Hog.

There are 5 differences:

  1. The name

  2. The look

  3. The addition of Toby Carlisle of Greenbackd as our publisher

  4. A new website at SingularDiligence.com

  5. The interface at Marketfy

The name change from The Avid Hog (which Quan and I picked out based on Jim Collins’s use of the “hedgehog principle” in “Good to Great”) to Singular Diligence should make it clearer what the newsletter is about. It’s 12,000 words about one stock. The one stock is the singular part. The 12,000 words is the diligence part.

The look is just a change in the design from a landscape format newsletter that separated its 9 sections into individual pages presented like the interior pages of a daily newspaper to a more traditional electronic newsletter format.

Toby Carlisle is our new publisher. He writes the blog Greenbackd. He is also the co-author of Quantitative Value and the author of Deep Value. The blog and both of his books are good. And as a value investor he’s a good fit with the existing team made up of me and Quan.

The website at SingularDiligence.com is professionally designed and looks it. I designed the website for The Avid Hog. And it definitely looked it.

The interface at Marketfy will allow Toby to put up content more frequently. Marketfy is better equipped to process payments and handle customer service than we were.

Those are the only differences. Everything else is the same. And Singular Diligence is certainly the spiritual successor to The Avid Hog.

So, to learn the spirit in which Quan and I created The Avid Hog let’s go back to October 2013 and my post: “(All) My Thoughts On The Avid Hog”…


(All) My Thoughts On The Avid Hog

This post is going to be all about the new newsletter Quan and I just started. So, if a paid newsletter isn’t something you’re looking for right now – this post is going to be pretty boring for you.

It’s also going to be pretty long. I have a lot to say about The Avid Hog. I know most readers of the blog aren’t interested in ever paying $100 a month for any product. So, I don’t want to clog up the blog with a lot of little posts about the newsletter. Here’s one big one. If you’re not interested, skip it. Regularly scheduled (non-promotional) content will resume next week.

Quan and I have been working on The Avid Hog for over a year. I’m here in the United States (in Texas). Quan is back in Vietnam. He went to school in the U.S. And we started work on The Avid Hog in person while he was still living over here just after his graduation.

Quan moved back to Vietnam. But that did not end preparations for The Avid Hog. Today, we do everything by email, Skype, etc. The only difficulty is the time difference. It’s exactly 12 hours. It’s midnight in Hanoi when it’s noon in Dallas and vice versa. This make picking Skype times interesting.

The Avid Hog is an unusual newsletter for a few reasons. The biggest reason is that it’s a product of two people. All the decisions about what stocks we start research on, what stocks make the cut and get a full investigation, and what stock makes it into the next issue – these are all decisions we make together.

It’s easier than you might think. Quan and I don’t disagree on a lot about stocks. This is both a plus and a minus. The plus is that it makes it easier to produce The Avid Hog. The minus is that anything I badly misjudge is something Quan’s likely to misjudge too. We are not very good at catching each other’s mistakes. We are too similar in our thinking about stocks for that.

What is our thinking about stocks?

Officially, the label would be “value investor”. But that’s a rather wide tent. And we tend to be pretty far over on the quality side of things. If we’re going to compromise on quality or price, it’s always going to be price.  I think we both tend to agree with Ben Graham. The biggest danger for investors isn’t usually paying too high a price for a high quality business. It’s paying too high a price for a second rate business.

The model business we like would be something like See’s Candies. Read Warren Buffett’s 2007 letter. There’s a section in it called “Businesses – The Great, The Good, and The Gruesome”. See’s is given as the example of a great business.

If you read that section carefully, you’ll understand what I mean when I say See’s is the kind of business Quan and I like. Buffett mentions that See’s uses very little net tangible assets – this is a big focus for Quan and me – and that it has a huge share of industry profits. He also mentions that unit volume – pounds of chocolate sold – rarely increases. And that there has been at least as much exiting from this industry as entering it. Basically, it’s a settled industry.

You might think that a fast growing business would attract us. Historically, that has not been the case. I doubt it will be the case very often in the future. There are several reasons for this.

One, fast growing industries are by definition less settled. For an industry to grow unit volume, it generally has to be growing the number of customers. Customer growth is always disruptive because the easiest way for a new entrant to gain ground is with new customers.

There are businesses that experience some constant unit growth without much customer growth. Obvious examples are businesses where you are charging your customers based on the amount of work you are doing for them. An ad agency can grow its top line without adding net new clients if those clients increase spending every year on average. FICO (FICO) can grow sales without adding customers – which is good, because just about everyone who could be a client of FICO’s already is – if their frequency of using a FICO score increases. The company in our September issue also fits this model. They aren’t going to grow their customer list. They will do a little more for the same customers each year. And they will charge a little more for everything they do. But that’s about it.

Those tend to be the businesses we like, because we are often focused on the idea of a “profit pool”. I’ve mentioned Chris Zook’s books on the blog before. I recommend all of them. They touch on a subject that is the key to long-term investing. How does a business gain a large share of an industry’s total profits? How does it keep that share year after year?

You aren’t going to find Apple (AAPL) in The Avid Hog. I suppose I can’t swear to that. But I pretty much can. Even if Quan liked the stock – even if it was a lot cheaper – I’d still veto the idea. The reason has to do with these ideas of market leadership and “profit pool”.

If you pick a moment in time and a product category – any product category – in consumer electronics, you can come up with a leaderboard of companies. You can choose the top 3 companies, top 5, top 10. Whatever you want. Often, if the industry involves worldwide competition – not a whole lot of companies beyond the top 3 will be making money.

But let’s put aside profits. Let’s just look at market share. Take any consumer electronic device (radio, microwave, TV, watch, game console, cell phone, etc.). Look at the leaderboard. Then fast forward 5 years, 10 years, 15 years. Check it again. How many names stayed the same? How many changed? How many are in totally different countries?

That’s not the kind of business we want to invest in. I recently did a podcast about Addressograph as of 1966. Everything looked pretty good. The stock traded at about 20 times earnings. Over the previous 10 years, it had traded at 20 to 40 times earnings on average. In about 15 years, it was bankrupt. That’s a tough business to buy and hold.

Most of Addressograph’s big competitors – including Xerox (XRX), IBM (IBM), and Kodak – had their own problems later on. Many exited those businesses. New companies – often foreign – gained a lot of share. And prices came down a lot.

This last part is hard to emphasize enough. I’ll be doing an information post soon to prepare you guys for the next Blind Stock Valuation Podcast. As part of that post, I’ll be including the retail price of watches a mystery company sold in 1966. I’ll also be giving you the inflation adjusted prices for those watches. In other words, what those 1966 watch prices would be in 2013 dollars.

Whatever you think watch prices were in 1966 – they were higher. Of the four brands this company made their middle of the road brand – the big seller – retailed for an inflation adjusted price of about $380. The fully electronic watches – remember, this was the 1960s – sold for $800 to $17,000 in today’s money.

Unless you are assured of future domination of a growing industry, you generally don’t want the real price of your product to fall by 80% or so. Quan and I have looked at a couple deflationary businesses we liked. In both cases, the company we looked at had the highest market share, the lowest costs, and was around since basically the time the industry started. So far, neither company – they’re Western Union (WU) and Carnival (CCL) – is slated to appear in The Avid Hog. In the case of Western Union, the durability of the business – not their moat relative to competitors – is an open question. Basically, the internet is opening up a lot of different possibilities for how Western Union’s niche could be ruined by more general payment solutions. Some of the things that are really necessary and really hard to do right now (mostly on the receive side in countries emigrants leave) may be easier hurdles to clear in the future. Maybe not. We’ll see. But the situation is less clear than it was a few years ago.

Carnival can’t control the price of oil. It’s a big input cost for them. If oil prices drop and stay down, Carnival will turn out well as an investment. If they don’t, it’s very possible the stock won’t do well at all. And, of course, oil prices could rise. It’s a lot less certain than the investment we want to make. So, for now, it’s not near the top of the list of Avid Hog candidates.

These two companies – and their uncertain futures – illustrate what The Avid Hog is all about. And it’s important potential subscribers know this. The Avid Hog isn’t exactly a newsletter with stock analysis. It’s really a business analysis newsletter. Those businesses happen to be publicly traded. And we happen to appraise the equity value – not just the enterprise value – at which the business would be attractive. But it’s a really unusual newsletter. We aren’t looking for reasons for the stock to go up over the next few months or few years. We’re looking for a business we think is one you’d want to hold. And we’re looking for an acceptable price to buy it at.

This is where the oddity of the partnership between Quan and me is most evident. I said we were value investors. That’s true. But I doubt many of the stocks you hear value investors talk about this year are going to make it into The Avid Hog.

For one thing, we really do adhere to Ben Graham’s Mr. Market metaphor. The stock we picked for the September issue wasn’t far from its all-time highs. I said before I think it was within about 10% to 15% or so of its all-time highest price. We’re fine with that. We thought it was a bargain regardless of where it had been priced in the past.

The question we ask is whether we’d buy the whole business for the enterprise value at which it’s being offered. That’s another point subscribers need to be warned about. I’m a little more dogmatic on this one than Quan is. But we both take it pretty seriously.

We appraise the business. We compare the value of the business – as we appraised it – to the value of the company’s entire capital structure. We know these are intended to be buy and hold investments. So we don’t assume we know what the capital structure will be when you sell the stock.

As a rule, we want subscribers to enter any stock we pick knowing – absolutely for sure – that they aren’t going to sell for 3 years. We are very serious about this point. The kind of (business) analysis we do isn’t something that can be expected to pay off in a matter of months or even a matter of a couple years.

If you think about what we are doing – analyzing the durability of a company’s cash flows, counting up those pre-tax cash flows, and then comparing them to the cost of buying all of a company’s debt and equity – it’s not that different from how a private equity buyer would look at a stock. They wouldn’t expect a return in less than 3 years. They might expect it to take quite a bit longer than that. So do we.

That’s a little unusual for a newsletter. But I don’t think it should be that unusual to the folks reading this blog. The idea that you can pick the right business to buy, pick the right price to pay, and pick the right time to make your profit – we’re not sure you can do more than 2 out of 3 there.

A lot of our time preparing The Avid Hog for launch over this last year (actually a little more than a year now) was spent on “the checklist”.

Checklists are very popular with value investors these days. So, I’m a little wary of the term. I’ll use it here as a name for a list of key ideas we always want to discuss. By key I definitely mean no more than 10. Right now, there are 7 sections we consider important enough to include in every issue:

1.       Durability

2.       Moat

3.       Quality

4.       Capital Allocation

5.       Value

6.       Growth

7.       Misjudgment

This is hardly a novel list. Everybody has read Warren Buffett. Everybody knows you look for a good business with a durable product and a wide moat. Those are our top 3 concerns. They are probably the top 3 concerns of many value investors.

We diverge a little with many value investors – though probably not Buffett – in putting “Capital Allocation” at number 4. This list is in order of importance. Basically, failing a section near the top will kill an idea faster than failing a section near the bottom. There is one exception: “Misjudgment”. It’s at the bottom not because it’s unimportant – it’s the most important topic. It’s at the bottom because we can’t know what we don’t know until we know what we know. So, it’s always the last question we answer.

Capital allocation is ranked ahead of value and growth. I would guess almost every other value investor would put value ahead of capital allocation. And quite a few would put growth ahead of capital allocation.

We obviously think capital allocation is more important than most investors do. It can be a difficult area to judge, because we have to use past behavior and present day comments to predict future actions. The human element is particularly large in capital allocation. So, it tends to be viewed as a squishier subject.

Over time, I’ve learned that capital allocation is a lot more important than I thought it was. And I started investing believing capital allocation was a lot more important than most investors think it is. I’ve become more extreme in my views on capital allocation. This colors our candidates for The Avid Hog a bit. It tends to eliminate tech companies. Even when we can judge their future business prospects – we can rarely predict which businesses they will choose to be in. It is one thing to analyze Google (GOOG) as a search engine. It’s another thing entirely to analyze Google as a company. The reason for that is capital allocation. It’s not enough to know how much cash a company will produce. We also need to know what value that cash will have when it is put to another use. At some companies, those uses are fairly limited and we can guess that a dollar of retained owner earnings will add at least a dollar of market value to the stock over time. At other companies, we can’t do that.

Capital allocation is especially important in buy and hold investing. If you are right about a company’s quality, the durability of its cash flows, and how it will allocate its capital – you don’t really need to be right about anything else. That’s usually enough to tell a good buy and hold investment from a bad one. It may not be enough to find the very best investment – value often plays a bigger role in determining your annual returns (especially how quickly you’ll make your money). But getting quality, durability, and capital allocation right will often be enough to know you’ll earn an adequate return.

What is an adequate return?

This is a critical question for any subscriber to The Avid Hog. Our newsletter costs $100 a month. That’s $1,200 a year. So, there’s no point in subscribing unless you can make more than $1,200 a year based on the content of that newsletter.

We’re not promising anything. Nobody does that. But we’re not even aiming that high. I don’t think it’s realistic to assume any newsletter that serves up 12 ideas a year – that’s a lot more than either Quan or I invest in each year – can do much more than about 10% a year.

We try to limit our picks to stocks that should return at least 10% a year if bought and held. The second part is key. Maybe you can make more money flipping them in a year. But, some will obviously decline in price over just one year. So, that’s not a good way to judge the value The Avid Hog can provide to subscribers.

The only way to judge that is to look at a holding period of at least 3 years. Do we think we can pick ideas that will return 11% a year over 3 years?

That sounds like a good goal to me. Don’t subscribe to The Avid Hog if you’re looking for more than that. I’m sure you can do better than 11% a year by focusing on the very best of the 12 ideas. That’s what I always do when investing my own money. And that’s what I’d recommend to the folks who can stomach a more concentrated portfolio.

But a list of 12 stocks is pretty diversified. And it’s not easy to do much better than 11% a year if you’re not concentrating. I don’t think anyone should expect better than 11% a year from any newsletter – and certainly not from The Avid Hog.

So, who is the newsletter for then? Is it for institutional investors or individual investors?

There’s no price difference. It’s $100 a month regardless of what you use it for. We know the majority of our subscribers – right now – are either current or former employees of investment firms. Of course, that doesn’t mean they plan to use The Avid Hog professionally. They have personal portfolios. Again, we don’t ask what subscribers do with the information we provide.

The price tag is a bit of a hurdle for individual investors. But I think the content is a bigger hurdle. The Avid Hog runs about 12,000 words. The first issue had 21 years of financial data in it. Not a lot of folks without some sort of analyst background are going to be interested in spending that much time with that much information about one company.

It’s not a breezy read. And it is extremely focused on just one company. So, it’s meant for a limited audience of equally focused investors. You have to like spending half an hour to an hour focused entirely on one company. If you read every line of The Avid Hog – and I certainly hope you do – you’ll probably need to spend 25 to 50 minutes with the issue. That’s at a normal reading speed. Some people read a little faster or slower than that. Most don’t. So the issue isn’t even something you can consume in less than the time it takes to watch a TV show. If you’re a fast reader, it’ll go by in about the time it takes to watch a sitcom. If you’re a slow reader, it’ll run about as long as an hour long drama. There are also charts and graphs, a bit of arithmetic here and there, etc. We hope you’ll linger with the issue longer than the absolute minimum time it takes to read the issue. But even that is on the long side for a lot of people. A lot of newsletters probably read faster than The Avid Hog. And, of course, most of them cover more stocks. So, you’re committing to a lot of time focused on one stock when you sit down with The Avid Hog.

This is really the whole point of the newsletter. Quan and I – when investing our own money – naturally do this. We focus for weeks at a time on one stock. It’s how we work. And it’s always been how we worked. I don’t know another method of analysis that works as well as really investigating a stock over a couple weeks.

The Avid Hog is really the product of a month of two people looking at one stock. This is something we always did. But it’s not something we saw a lot of people selling. There may be a good reason for that. Maybe the market for newsletters is a market for shorter, more varied reports. Since we’re focus investors – we wouldn’t be able to write those.

The basic idea of The Avid Hog is to provide you with the info we use when making an investment decision. We don’t do a perfect job of that. There was a ton of information we had on the company in our September issue that didn’t make it into the final issue. But, we didn’t get a lot of people asking for more information than we provided. A few suggested a little less would have sufficed.

Over time, I hope this is something we get better at. As an investor, you have a relationship with a business – a familiarity – that goes far beyond anything you can easily convey to a reader. This is a constant problem. It’s the one we are trying to overcome. But it’s still a very tough problem to solve. You can bet that we have a higher degree of confidence in any stock we pick than our readers will after reading an issue.

It shouldn’t be that way. We should be able to communicate our thoughts and analysis in such a clear way that everything we learned about a company can be as convincing – as great an aid to understanding – as when we finally digested it in our own heads. It never works out that way. Something is always lost in translation. And I’m afraid that conviction is a hard thing to express when your reasons for it are simple but also based on an accumulation of evidence from a lot of different sources that you’ve gather up over a month or so.

So, we’re still not perfect at getting across to readers everything we know. But that’s the point of The Avid Hog. We take a month to gather up everything we think is relevant. And then we present it to you. If you don’t have enough information to make an investment decision after reading the issue – then we’ve clearly failed.

One of my biggest concerns is how people will use The Avid Hog. Let’s look at a quick example of the math needed to make a subscription work.

If The Avid Hog can improve your results by 3% a year and you have a $50,000 portfolio – it works. Once the numbers are less favorable than that (we can’t improve your results by at least 3% a year, or your portfolio is less than $50,000) the math just doesn’t add up. It’s not worth the subscription price unless you can get a 3% annual increase and/or you have a portfolio of $50,000 or more.

That’s because a subscription is $1,200 a year. And 3% of $50,000 is $1,500. You can do the math on what kind of advantage The Avid Hog would need to provide your portfolio to make it worth subscribing. At $25,000, you’d need a 6% annual lift from our picks. That’s tough. Too tough in my opinion. So, I’d say folks with a portfolio of $25,000 simply can’t pay the $100 a month needed to become a subscriber. It’s not worth it for them.

On a $100,000 portfolio, just a 1.5% advantage would make the subscription pay for itself. I don’t think there are many people with a portfolio of $100,000 or more who wouldn’t come out ahead subscribing to The Avid Hog. But I’m biased. I think – if you act on our picks – you can make 1.5% more a year.

There is one other area that should be a big benefit. In fact, for some folks, this secondary benefit should more than pay for a year’s subscription to The Avid Hog.

It’s taxes. I’ll just talk about the U.S. here because I know the tax rules. Some people reading this have short-term capital gains in many years. This is very tax inefficient. At times, it can’t be avoided. I had a company bought out a few years ago. Most of my purchases were made within one year of the consummation of that buyout. So, I couldn’t avoid a short-term capital gain.

That’s not an awful position to be in. Only having short-term capital gains in the event of a buyout usually means you at least still end up with a high annual return after-taxes.

As a general rule, American investors need to avoid any short-term capital gains. I can’t think of many situations where you could actually demonstrate the benefit of selling before one year of purchase convincingly enough to make me recommend a sale within one year.

And yet, some people do it. Some people – even some value investors – end up with short-term capital gains.

The minimum intended time frame for any Avid Hog pick is always 3 years. We never want to see a subscriber sell before 3 years are up. They will. We know they will. And we know there’s nothing we can do about it. But, we also know there is at least a strong tax incentive for them to keep a winner for more than one year.

There’s, unfortunately, an incentive to sell a loser within one year as well. We don’t think the incentive there is strong enough to offset the likelihood that selling a pick – at a loss – within just one year is a really, really bad idea.

We can’t tell subscribers how long to hold their stocks. I mean, we can – and we do. We say 3 years at an absolute minimum. And we’ll keep saying that.

But the truth is that the value of our picks is in how you use them. If you have a portfolio of $50,000 or more and you really do devote it to just picks from The Avid Hog and you really do hold each stock for at least 3 years – I’m confident you’ll get more than $1,200 a year out of our newsletter. Honestly, I’m not very confident subscribers will do all those things I just said. I’m not sure the implementation will always be ideal in practice. But you know yourself. And you know if it would be in your case.

So, in theory, the tax savings from moving to a 100% buy and hold approach should be enough to justify a subscription to The Avid Hog for those who have fairly large portfolios and some short-term capital gains. Again, you can do the math on your own portfolio. But moving $7,000 a year from short-term capital gains to long-term capital gains would more than pay for a subscription for investors in the top three U.S. tax brackets.

Of course, you don’t need to subscribe to The Avid Hog to turn short-term capital gains into long-term capital gains. You just need to commit to a buy and hold approach. You can do that on your own. Or you can do it with The Avid Hog.

We hope that subscribers will get some additional lift – some extra value each year – from moving more of their capital gains into the long-term variety. Even if there was no tax advantage in doing so, we’d always want to have subscribers holding for the long-term.

The other benefits of The Avid Hog are less tangible.

The first is simplification. We want to simplify and focus the investing lives of our subscribers. We want to encourage them to turn off CNBC and Bloomberg, put down the Wall Street Journal and The Financial Times – and focus on one business at a time. We’re only asking for about an hour of their time once a month. But we hope that will be focused time.

That’s the word we like best when talking about The Avid Hog: focus. We certainly focus on a specific checklist, on a single stock, etc. We go into greater depth instead of giving you a lot of breadth. That is all fairly obvious in the issues. If you haven’t sampled an issue yet, you can email Subscriber Services and ask for one. There will be an email address at the bottom of this post.

Quan and I don’t want that to be the only focus though. We don’t want The Avid Hog to be only about the two of us focusing on a stock. What we really want is for The Avid Hog to be an oasis of focus in your investment life. We know that anyone who subscribes to The Avid Hog has a less simplified investment life than they’d like. They certainly have a less focused investment life than is ideal for achieving the best long-term returns.

We would like to create a product that – once a month – gives readers the opportunity to forget there are other stocks out there. To forget there is a market. And just to focus on a single business and a single price. It’s a handpicked business and price. So we think it’s an attractive one. But, even if you don’t agree, we hope that hour or so you spend with us each month will be – minute for minute – the best time of your investing month. We hope more than anything that it will be the most focused. It will come closest to the Mr. Market ideal of seeing a quote and using it to serve you rather than guide you.

We know a lot of the folks who will subscribe to The Avid Hog will not be living exactly the investment life they aspire too. They are value investors. And their life situation – often their job at an investment firm – will put certain demands on them that lead them further from the ideals described by Buffett and Graham than they would like.

More than anything, we know they feel overwhelmed. We know they feel like they consume a lot of noise. And don’t get to spend enough time on the stuff that really matters.

We hope paying $100 for an issue will be incentive enough for them to block out a time that they can spend with just one stock.

This is how Quan and I spend virtually all our time. It’s how many great investors spend their time. And it’s really how individual investors should be spending their time too.

But the world isn’t designed to accommodate that kind of focus. Almost every form of financial media is going to bombard you with a lot more breadth than depth.

We’re trying to flip that around for about an hour a month for our subscribers. That’s the thing Quan and I are most interested in doing for subscribers. We’d like to create an environment where they can focus. We’d like to make them feel we’ve simplified their investment life.

Of course, that’s not something we can do alone. Like the matters of returns and taxes – focus isn’t something we can guarantee for subscribers. It’s something they have to work as hard receiving as we do on giving. So it’s an uncertain benefit of The Avid Hog. But it’s the one I’m most hopeful we can provide. It’s the one I think is actually most valuable. If we can provide our subscribers with an hour of intense focus each month, I think we’ll have provided good value for the $100 a month price we charge.

I don’t know how many subscribers will focus on the issue the way we hope. It’s one thing to invest $100 of your money. It’s another to invest an hour of your total focus. For many people, the latter is actually the harder one to give.

Speaking of focus, the focus of The Avid Hog on above average businesses should provide an added benefit for subscribers. It should give them a list of companies they can revisit in later years – even if they don’t buy the stock today.

We don’t sell individual issues of The Avid Hog. All subscriptions are billed monthly at $100. So, from that perspective, it’s like every issue is sold separately. But we don’t like to think of it that way. We like to think of The Avid Hog as being as much about the process as the product.

In a year, we’ll publish 12 issues. As I mentioned, each issue is about 12,000 words. So, you can do the math and see you’re basically reading a book or two a year with The Avid Hog.

We like to think of The Avid Hog more like that. We like to imagine that you are getting 12 chapters you can use later even if you don’t put them to use now. Quan and I certainly won’t put our money into 12 stocks a year. We tend to be more of the “one idea a year is plenty” type investors. A lot of subscribers will want to diversify more. But plenty will still decide to pass on some of our picks.

We hope that doesn’t mean they pass on the businesses. Knowledge of a good business has a certain permanence to it. Or at least it has a longer shelf life than a lot of what you know about investing.

The Avid Hog doesn’t revisit past picks. But we hope subscribers will. We hope that when an above average business we profiled earlier plunges in price, some of our subscribers will be ready to jump in. We hope you’ll be able to build up a personal database of above average businesses. We’ll discuss them at the rate of 12 a year. That should provide a pretty good shopping list in the next market downturn.

That brings me to the market. And to a point I haven’t stressed enough yet. The Avid Hog is not meant to outperform the market. We hope we’ll do that. We expect to do that. But we don’t aim to do that. Quan and I don’t try to beat the market. We just try to find the best above average business trading at a below average price this month. And repeat that every month.

We believe that process will – over time – beat the market. But, we also believe it will underperform in great years for the market. It’ll outperform in some very bad years. But neither will be the result of our actually trying to beat the market in the bad years or holding back in some way in the good years.

The process will always be the same. The relative results will vary because the S&P 500’s returns will vary. And because the opportunities the market serves up will vary.

We don’t target relative results. We think we can – long-term – get good relative results without worrying about them. That has always been my personal experience. But a lot of newsletters – and some investors – do focus on relative results. So it’s important that anyone thinking about subscribing to The Avid Hog knows that we do not – and we never will – target relative results.

What do we target?

My number one focus is always the margin of safety. If there’s no margin of safety, you can’t buy the stock. How big is the right margin of safety?

That’s up to you. Valuing a stock is as much art as science. Exact appraisals vary a bit. On the last page of each issue of The Avid Hog, we print an exact (dollar and cents) appraisal of the company’s shares. We actually write “Company Name (Ticker Symbol): $46.36 a share” or whatever. We’re that precise.

That can be misleading if you don’t see the appraisal in the context of the other stuff on that page.

So, the last page of each issue is called the “appraisal” page. It has a calculation of “owner earnings”. It has an appraisal of the value of each share (using a multiple of owner earnings). And it has a margin of safety measurement. It also presents some data and how the current stock price – and our appraised price – compare to the market prices of some public peers.

I want to focus on the owner earnings calculation, the appraisal, and the margin of safety.

You probably know the term “owner earnings”. If you don’t, you can read the appendix to Warren Buffett’s 1986 letter to shareholders. We use the basic approach he does. We basically want to count pre-tax cash flow. We use pre-tax numbers because we always value a business independent of its capital structure. Only after we’ve settled on a “business value” do we compare that value to the debt and equity of the company. This is pretty typical stuff for a lot of value investors. Like I said, we’re a bit more dogmatic – at least I am, I won’t speak for Quan here – about using capitalization independent (unleveraged) numbers and about using cash flow rather than reported earnings.

It’s very important to mention how unconventional we are here. You should never pick up The Avid Hog expecting to be told about a company’s EPS. We don’t do earnings per share. We don’t talk about earnings per share. I don’t mean we discuss it as one of many things. I mean we literally don’t spend a second on EPS. Whether a company will or won’t be able to report earnings doesn’t mean anything to us as long as the company will be able to harvest that cash flow.

This attitude pervades everything in The Avid Hog. So it’s important that you know ahead of time that reported earnings will never, ever be discussed. I know EPS is a relevant number in a lot of the financial media. It is irrelevant for us. And we never discuss it. Likewise, we tend to discuss prices in relation to enterprise value rather than market cap. We do move on to valuing the equity after comparing the company’s debt to its business value. But we really don’t do P/E ratios at all.

For some subscribers, it’s a bit of an adjustment to only think in terms of enterprise value and owner earnings rather than EPS and P/E ratios. But it’s the only approach that makes sense to us. And Quan and I don’t do anything halfway. We don’t compromise on this point. In a lot of issues, you’re literally going to get 12,000 words without a single mention of EPS. I know that’s unconventional. A lot of The Avid Hog is unconventional in this sort of ways. We present the stuff we think matters. We don’t present information that is customary but ultimately irrelevant.

So we do our little owner earnings calculation. We present it item by item. So, you’ll see items adjusting for non-cash charges, for pension expense, for restructuring, for cash received but not reported (yet) as revenue, and so on. We do it as a reconciliation of reported operating income to owner earnings. Think of it like a statement of cash flows. It’s the same basic idea.

Sometimes there’s very little to reconcile. Right now, it looks like the stock in the October issue has similar owner earnings to reported operating income. Not a lot of big changes.

If you read the September issue, you know the company in that issue has owner earnings that are a lot higher than reported operating income. Again, we don’t care even a little bit about reported operating income. You can see the reconciliation yourself. And you may be inclined to trust reported operating income more than our estimate of owner earnings.

Personally, I think you’d be very, very wrong to do that. But the information is there for you. You can quibble with us line by line. We put every item right there on the page. So, if we count something as earnings that you wouldn’t – go ahead and make your own adjustment.

Everyone’s appraisal of a company’s intrinsic value differs a little. Even Quan and I – who’ve been looking at the same facts and talking about the stock for a month or so – come up with slightly different intrinsic values for the same stock. For the September issue, I think my intrinsic value estimate would be a bit higher than Quan’s. That won’t be true for the October issue. Where we have significantly different methods, we show you both. Generally, we go with the most conservative method that we still consider reasonable. We don’t use unreasonably conservative appraisals. The conservatism should come through insisting on a margin of safety – not through making an unreasonably low appraisal of the stock. But, when in doubt, we err on the side of conservatism. The price printed in the September issue is lower than the appraisal I would put on a share of that stock. If you offered to buy the stock from me at that price, I would turn you down. Logically, if I would reject your offer at that price, that means I’d appraise the stock higher. So, the appraisal in the September issue is lower than what I would have come up with privately. But it’s a number I’m comfortable having out their publicly. That’s what I mean when I say we err on the side of conservatism. We aren’t going to print an appraisal I think makes no sense. But we will print an appraisal that’s on the low side of what I think makes sense. The same goes for Quan. In the case of the September issue, I would’ve been the one arguing for a higher appraisal. In future months, I’m sure our positions will be reversed.

We’re not the Supreme Court. We don’t print dissenting opinions. The figure you see is always a consensus agreed upon by the both of us.

As I said earlier, The Avid Hog is as much about the process as the product. That’s why Quan and I spent a year perfecting the process.

Our process for the appraisal page has been standardized by now. It will be the same in each issue. We calculate owner earnings. Then we come up with a fair multiple of owner earnings. We apply the multiply. We then compare Owner Earnings x Fair Multiple = Business Value to the enterprise value of the company. The excess of business value over the company’s debt is used to calculate the equity value. And, of course, the equity value divided by fully diluted shares is how we get our appraisal price per share. We then measure the margin of safety.

The margin of safety confuses some people. It’s easy to understand if you look at the calculation we show. Basically, the margin of safety is always the percentage amount by which the business could be less valuable than we think. It is not a measure of the difference in stock price between our appraisal price and the market price. That would only occur in instances where the company had neither debt nor cash. In that case, an appraisal value of $70 a share and a market price of $50 a share would result in a 29% margin of safety ($70 - $50 = $20; $20 / $70 = 29%). That’s not normally how margin of safety works, because the company is less safe to the extent it has debt.

Let’s take our October issue – not yet released – as an example. It’s not finalized yet, but I can give you a pretty good idea of what the margin of safety on the stock is by our estimates. The stock trades for about 60% of our appraisal value. So, if it’s a $30 stock, we think it’s worth $50. That’s pretty simple. But the company has debt. So, in theory, the upside on the stock would be about 67% ($50 - $30 = $20; $20 / $30 = 67%). Quan and I don’t calculate the upside. So, that’s not a number you would ever see. It’s a number that reflects leverage. And leverage is only on your side if we are right in our estimate of that $50 (or whatever) appraisal.

The number we actually show you is very different. It’s how much the business value of the stock could decline and still be greater than all of the company’s debt and the price you paid for the stock. Imagine an example where a company has a $30 stock price, $10 of net debt per share, and a $50 business value per share appraisal from us. In that case, the margin of safety is only 20% ($50 - $40 = $10; $10 / $50 = 20%). And that’s the only number you would see. We would never mention the stock has a 20% margin of safety and a 67% upside. We would just talk about the 20% margin of safety.

Our reasoning on this goes back to Ben Graham. But it’s also consistent with what we want The Avid Hog to be. What we’re trying to do is come up with above average businesses at below average prices. We’re trying to do that regardless of how the market performs. So, our focus is not on the upside over the next couple years. Our focus is on getting subscribers in the best possible business to buy and hold and ensuring that there is a margin of safety that protects them from a permanent loss of principal. As long as the purchase price is justified, they will end up in a better than average business. That’s the part that should lead to good long-term returns. Our value calculation is really all about ensuring the presence of a margin of safety. This is the protection you get when you buy the stock. The quality of the company – and the durability of its cash flows and the moat around its business – is what ensures adequate returns over time.

This means we discuss value a bit less than most value investors do. We certainly discuss the upside implied by our valuation a lot less. We don’t make a big deal of paying $45 for a $70 stock. We make a big deal about getting in the right business at a suitable discount to what we think the entire business is worth.

For ease of illustration, I used per share values here. We tend to focus on the value of the entire business right up till the last step – where we divide by the diluted share count. So, we talk about a business being worth $5 billion and having an enterprise value of $3 billion rather than being worth $50 a share and trading for $30 a share. The per share intrinsic value is really only discussed once.

Like I said, different people will come up with different intrinsic values for the same stock. Quan and I discuss ours on the appraisal page. But we also provide the data subscribers need to make their own judgments. This starts on the datasheet. When you first open The Avid Hog – after seeing a cover page, it’s just a teaser drawing that hints at the business we’ll be discussing – you find a datasheet. The datasheet presents the numbers Quan and I care most about.

These are historical financials. The September issue went back pretty far. It had a total of 21 years of financial data. The company we chose has already reported its fiscal year 2013 results. And we had data for the company going back to 1993. Quan and I don’t have a target for how many years of financial data we give you. We simply print everything we use. Generally, we use everything we can get our hands on. In the current issue of The Avid Hog, that happens to be 21 years of data. Next month’s issue will have a lot less. Probably fewer than 15 years of data. The company hasn’t been public for that long. In any case, we’re confident we’ll be providing you with more historical financial data on the company than you’ve ever seen. It’s also probably more data than you can find on that company anywhere other than EDGAR. And EDGAR doesn’t put it into nice rows and columns for you. You have to go back and read the 1993 report for yourself.

What kinds of information do Quan and I care about? What’s in the datasheet?

Again, we’re unconventional in our approach. There is no mention of per share numbers. You won’t see anything about earnings per share, book value per share, etc. It looks a lot like a Value Line page. But that’s just the first impression. The actual numbers presented are quite different.

We focus on sales, gross profits, EBITDA, and EBIT. Balance sheet data is all about the numbers needed to calculate net tangible assets – which we do for you – so that’s receivables, inventory, PP&E, accounts payable, and accrued expenses. There’s also the issue of deferred revenue at some companies. We present the liability side together. It’s usually more important to look at receivables and inventories separately than to look at accounts payable and accrued expenses separately. So we break out the current assets by line. We don’t break out the current liabilities.

Quan and I care a lot about returns on capital. We especially care about returns on net tangible assets. So we provide all the info you need to make that calculation. That means we do margins (Gross Profit/Sales, EBIT/Sales, and EBITDA/Sales) as well as “turns”. We show you the turnover in the business’s receivables, inventory, PP&E, and – most importantly – its NTA. When you put the two numbers together – margins and turns – you get returns. We don’t just calculate EBIT returns. We also do gross returns and EBITDA returns. At some companies, EBITDA returns are quite important. Gross returns are rarely important in the short-term. But as mentioned in some journal articles, they are actually a good proxy for how profitable a business is. Basically, if a company’s gross returns are too low today, they’re likely to always have a problem earning a good return on capital. This is less true of things like EBIT/NTA. That’s a number that some companies can improve a lot by scaling up. But scaling up usually isn’t going to help enough if your Gross Profit/NTA is really low.

The first couple companies we’ll be profiling for you in The Avid Hog have essentially infinite returns on tangible assets. They don’t really use tangible assets. This makes the return figures less important. The turnover numbers are also less important. The margin data may be useful. Regardless of how useful the number is for the particular company, we always include it.

These calculations are done for every year where we can do them. In our September issue, I think we had full calculations of all lines for at least 19 years. Returns on capital can’t be calculated for the first year in a series because you don’t know what the average amount of capital was in a business until you have two balance sheets – a starting and ending one – to work from. We can – and do – obviously calculate margins for all years. So, the September issue had 21 years of gross margins, 21 years of EBITDA margins, and 21 years of operating margins.

Free cash flow data is not shown explicitly in the datasheet. But you can think of the datasheet as really being all about free cash flow. We calculate year-over-year growth numbers for all items. So, you can see – for example – that the company we chose in the September issue increased EBITDA by about 9% a year on average while NTA increased only 6% a year on average. I’m using median as the average here. We present minimum, maximum, median, mean and some variation numbers. If you use only one number – I’d use median. But it’s up to you. Anyway, you can see from the 3% a year difference in a cash flow number compared to NTA that the company will tend to always have higher free cash flow than reported income. This is because the amount of additional cash coming in is always exceeding the amount of growth in net assets. You can see this at a website like GuruFocus or Morningstar for the last 10 years (or whatever) by looking at free cash flow. But you can also see it in our 21 years (or whatever) of data that includes growth rates in NTA versus growth rates in sales, gross profits, EBITDA, and EBIT.

The biggest departures for our datasheet relative to what others like to show you is our focus on gross figures and our focus on net tangible assets. These aren’t the two most important numbers in the datasheet. But they are the two most important numbers you’ll see highlighted in The Avid Hog that you won’t have heard much about when studying the same stock using someone else’s data. This is just a matter of presentation. Everyone provides enough info for you to do these calculations yourself.

I suppose the biggest difference between our datasheet and the data you’ll get elsewhere is how far it goes back. I’m sure a lot of subscribers will doubt the importance of seeing 1990s era data in 2013. What importance could a company’s results in the 1990s have on its future in the 2010s?

It’s a logical sounding complaint. But it’s not supported by the facts. The length of time a company has been consistently profitable is a surprisingly good indicator of what future results will be. In fact, if you asked me for just one criterion to screen on it would be the number of consecutive years of profits. Most investors err badly by assuming that a company that has a couple losses in the last 10 to 15 years is fine because it’s made money now for 6 straight years or whatever. Making money for 20 straight years tells you a lot more than making money for 6 straight years.

There are economic cycles and industry cycles. Some can be short. But some can be long. The longest – something construction related like housing, shipbuilding, etc. – probably run in the 15 to 20 year length rather than the 5 to 10 year length. I’ve never felt that 5 to 10 years of data was sufficient to make a decision about a stock. I would hate to have to decide much of anything on less than 15 years of data. I do think it’s relevant that Apple today has nothing to do with Apple 15 years ago. And I think a company’s long-term financial results show you that.

Again, Quan and I are on the wrong side of convention here. But I think we’re on the same side as Warren Buffett. When he buys a company, he likes to see as many past years of data as they have. But he doesn’t want to see any projections for the future. We like a clear past and a clear future. But only one of those things is verifiably clear. The past actually happened. The future is merely a projection. We think investors could all benefit from seeing a lot more past data than they do now. And we hope that including so much past data in The Avid Hog – and we’ll always include every bit we’ve got – will convince others of the usefulness of that approach.

Now the past data is more useful the more you know about the past. So, it helps to know what were good and bad years for the industry – not just the company. It helps to know what was going on in the economy. We can’t provide you with all of that. But we hope you’ll linger over the datasheet. In fact, we hope you’ll print out the datasheet, carry it around with you, do some exploring of the past yourself. We also think the datasheet makes our explanation of the company’s history clearer. We can’t – in prose – get into the kind of detail we’d like to see on a company’s past. But we can discuss a few qualitative aspects in words. And then we can present the rest to you in numbers on that one datasheet.

The datasheet is another area where I think The Avid Hog offers a lot. But you’re only going to get a lot out of it if you put a lot into it. You can flip through the datasheet in a couple seconds. Or you can spend a lot of time with it. There is a lot to think about in that datasheet. And I hope that it’s an area subscribers won’t just linger on – I hope it’s actually one they’ll ponder. And maybe even go back to the next day. Having that much data would always be the foundation of any investigation of a company for me personally. That is where you start. You start with the numbers. You start with the patterns in them. And then you move to trying to explain those patterns and see which are likely to prove durable.

The datasheet is something that I really wanted to include, because it’s something I always want to see in reports – and never do. Whether I am reading a blog post about a stock, a newsletter, or an analyst report – I’m always eager to see more data than I’m given. That’s why Quan and I are including all the data we can on that datasheet. That’s why we’re going much further into the past than most reports do.

This brings me to the question of why we’re doing this. Why did Quan and I create a newsletter? And why did we create this particular newsletter?

At a $100 a month price tag, the obvious motivation would seem to be money. But when you consider the amount of work that goes into the newsletter – and the small potential audience for a newsletter that focuses in this kind of depth on just one stock – money is less of a motivating factor than you might think. We’d like to get to the point where we have enough subscribers to justify the labor cost. We’re nowhere near that level now. And I’m not sure we’ll ever get to that level. There aren’t a lot of products like The Avid Hog. There are other monthly newsletters that charge $100 a month (a little more, a little less). Some bill annually. We bill monthly. But there’s really not a big difference on those points. There are plenty of other newsletters that come out with a similar frequency (monthly) and charge a similar price ($100 an issue).

The difference is in the product itself. If you’ve sampled The Avid Hog, you know this. It doesn’t look like other newsletters. It looks like a collection of articles on one company. It lacks the variety of other newsletters. We think it makes up for it in focus.

But we’re biased on that point. And this is the real reason Quan and I created The Avid Hog. It’s what we love to do. We would be doing all the research that makes The Avid Hog possible whether or not we were publishing it. We like to spend our time focused on a single stock for a full month. Business analysis is the kind of analysis we like best. Coming up with a list of 10 or 20 ideas doesn’t appeal to us in the same way that focusing on one or two ideas does. It never has. And it never will.

So The Avid Hog is really about trying to do what we like best while making enough money to support the process. As you can imagine, the external costs associated with producing one issue of The Avid Hog are minimal. The cost of a month of creating The Avid Hog is basically $300 in some fixed costs plus the time Quan and I put into it.

There are good and bad sides to this. The good side is that we have almost no costs other than our time investment. This means we can stick with The Avid Hog when it would be – like now – not remotely financially viable because the subscriber count is too low. Through our dedication to the product, we can keep it going for many months when any rational publisher would shut it down.

That gives us the chance to grow an audience and ensure the long-term survival of The Avid Hog.

The downside to not having a lot of costs other than our labor is obviously the price. We’d love to be able to charge a lot less. But you can only do that with a lot of subscribers. Other sites have a much bigger platform – more of a megaphone – from which to announce their product. They have bigger distribution capabilities than we do. And so they will always have a much larger group of subscribers for any product they put out. It will be better for the good products than the not so good products. But even a lousy product put out on a big online platform will sell more copies than the best product we could ever produce.

I can tell you now, the price of The Avid Hog will not drop. I just don’t see anything in what we know about the potential audience size that would allow that to happen. You can run the numbers yourself – after having read a sample – and guess what you think the commitment of labor is to something like that. It’s not a one person product. So, it requires a good deal of revenue to put out a product like that. It doesn’t for the first few months. But that’s only because Quan and I are committed to not getting paid for a long time.

So that’s the good side and the bad side of the cost situation. The good side is that we are committed to working for free on The Avid Hog. And the product doesn’t require much ongoing investment other than our time. So we can keep the thing running. The bad side is that because we are appealing to a very small audience – it’s a very niche product – we are never going to be able to lower our price per issue to a level we’d like to. We’ll never be price competitive with more general, more popular newsletters.

We didn’t design the product with financial considerations in mind. In fact, we didn’t design The Avid Hog with many marketing considerations in mind.

What we did is design the product we would want to read ourselves. And we created the product we love working on. It’s unclear whether there are enough likeminded people to support such a product. And, if there are, whether they read this blog. But it’s a passion project for me and Quan. And I know we will continue it at a loss for longer than most people would keep it going.

I should probably talk a little bit about that passion. Quan and I wanted to work together. And we wanted to work together on a product we could be proud of. I have had the experiences – no, I won’t be naming names – of working on some products I was not proud of. Generally, I think I did the best I could to make those products a lot better than they would have been. And I had to operate under that assumption. I had to believe that making a product better than it otherwise would’ve been was justification enough for the work.

It was not a fun experience for me. That isn’t because the products weren’t good. Nor is it because there wasn’t demand for the products. I think there was a lot more demand for the things I worked on that I wasn’t proud of than there will be on The Avid Hog (which I am proud of). But there was a serious mismatch of the content and the creator. Sometimes – if the content and the customer are matched up well – that can be financially rewarding. But it’s emotionally pretty tough for the creator of the content. I don’t think it leads to a good product. And it’s rarely sustainable. Because the creator will eventually quit regardless of financial rewards.

The Avid Hog is a good product. And it’s sustainable. At least it’s sustainable from a production side. We’ve worked hard to perfect production over the last year. As you can imagine – if you’ve read a sample – our first attempts at production (our pilot programs) failed to get an issue out in a month. Repeated iterations of the entire process were necessary to reduce the time it takes at every stage of production. Today, we’re very confident we can get an issue out each month. As we’ve already hit that target privately (we just haven’t published until now).

How sustainable is The Avid Hog from a demand perspective? This is the tougher question to answer. We are obviously far from the level of subscribers that would be needed to support the labor involved. You have two people – Quan and I – working on this full time. That’s a very high hurdle to clear in terms of revenue. And we’ll see if we’re ever able to clear it.

Subscribers won’t notice one way or the other. We will be burning through our savings to produce the newsletter for the next few months. And it may be for a lot longer than that.

Obviously, this is one of the reasons we only offer subscriptions that are monthly. We don’t want to – as many newsletters do – receive payments up to a year in advance when we expect The Avid Hog to be running at a loss throughout much of that subscription period. We prefer to collect payment when – or actually a little after – we put out the issue we need to deliver for people.

Our commitment to The Avid Hog is certain. Our passion for the product is certain. And – having now put out a finished issue – I can also say that our pride in the product is certain too.

It’s a good product. It may not be to everybody’s tastes. We can’t guarantee you will like it. But we can guarantee that if you like this sort of thing – if a 12,000 word report on a single stock sounds appealing – this one will satisfy you. It would satisfy me as a subscriber. And that’s always what we’ve been aiming at. We’ve tried to create the product we would want to read.

I listed some of the hoped for benefits of The Avid Hog. We’d like it to improve your returns. If we can help you make 3% more a year on a $50,000 portfolio we can justify our subscription price. If not, we can’t. We hope it will save you on taxes. Our American readers should only end up with long-term capital gains. There’s an advantage in that. But it will only materialize if their behavior causes it to materialize. We can promise the possibility of that benefit. We can’t promise you’ll capture the full value of the tax benefit – because we can’t ensure you won’t sell out of stocks we pick far quicker than you should or we would. We know it will provide you with a database – a sort of mental filing cabinet – of above average businesses that you now understand well and can return to in future years. That’s one benefit we can guarantee. We hope it will simplify your investing life. We think it will allow you to focus in a way you may never have before on a single, promising investment idea. We can’t guarantee that. But the $100 sunk cost makes us pretty optimistic you’ll spend time focused on something you paid that much for. So, focus is a benefit we feel pretty confident we can deliver. Finally, we think you’ll become a better business analyst over the months and months you spend reading The Avid Hog. There are other ways to improve those skills. But seeing us analyze real world examples and then questioning and critiquing our approach – making it your own through an analysis of our analysis – is as good a way of becoming a better business analyst as I can imagine. So, again, that’s a benefit we feel pretty sure of.

Our return expectations for The Avid Hog are modest compared to what other newsletters aim for. However, they are immodest compared to what I think most individual investors achieve. We ignore the market. We don’t target any relative outperformance. We hope to provide you with stocks you can buy and then make 10% a year holding. We have no clue what the stocks we pick will do over the next 2 months or even 2 years. But, if you come back to us with a stock we picked 3 years ago and see that it has not done 11% a year – we won’t be able to consider that a success regardless of what the market did. I should warn you: we will have failures. I am sure we will have failures. Nobody is in the business of promising certain returns – for obvious legal reasons – but even if we were, we wouldn’t feel certain about the results of any one stock we picked. It is too much to pick 12 stocks you are individually certain of each year. Quan and I can, however, pick the 12 stocks we are most convinced of. And we can provide a group of 12 stocks each year that we would be confident putting our own money in. Here, at least, we can speak relatively.

Quan and I would certainly feel more confident putting all our money in the 12 stocks we pick each year rather than the S&P 500. We are also confident that you will be better served by going with our 12 stocks than with those 500. That does not mean we think our 12 will always outperform those 500. It does mean we think you will be getting relatively better returns while taking relatively less risk for those returns in the group we pick. I am sure we will underperform in many years. I have always opted for a much more concentrated portfolio than 12 stocks. And I have underperformed in some years in my personal portfolio. Last year (2012), is a good example of that. I would expect The Avid Hog will fare no better in its picks than I have done investing my own money over the years. That means there will be underperformance. And that underperformance may get pretty bad in great years for the S&P 500.

Quan and I have a good process. So, I am not worried about our conviction in the ideas that make it into The Avid Hog. We have a brutal winnowing process. A very large number of initial ideas turns into a very small number of stocks we actually write about.

I am, however, always concerned with the conviction – the trust – our subscribers put in us. I think this is the hardest part in writing a newsletter. There is always a great fear that even if you provide all the information to get great results – your subscribers may not act on that information in a way that justifies your newsletter’s price tag. That is my fear. We may do a good enough job picking the stocks. But we may not do a good enough job “selling” our subscribers on the stocks.

We don’t present a balanced view in the issue. We like these stocks. We wouldn’t write about stocks we don’t think are above average businesses at below average prices. So, we’re not going to try to present the “bear” case in situations where we don’t agree with it. That would never accomplish anything more than setting up a straw man.

So we don’t go for fake balance. But we do try to present the information we think matters. There’s a section near the end of each issue – it’s right before the “Conclusion” – that we call “Misjudgment”. This is obviously a Charlie Munger inspired section. And in that section we tell you all the reasons we might be wrong.

I don’t mean we tell you the risks – the unknowables – that often appear in the front of a 10-K. We don’t tell you about terrorism, global warming, a repeat of the 2008 financial crisis, SARS, or any sort of extraordinary event that could render all analysis of the future meaningless. We just talk about our biases. We talk about how our interpretation of the business may be flawed because we may want to see something that isn’t there.

That is as far as we go with balance. To some extent, that section alone may undermine our ability to “sell” subscribers on a stock. To really communicate our conviction directly to them. I hope that turns out not to be the case. I hope that an honest discussion of the errors we may be making will increase rather than decrease people’s faith in our pick. Past experience tells me it doesn’t work that way. And it’s usually easiest to hide errors in judgment by eliding them rather than analyzing them.

But one of our mantras for The Avid Hog – you may notice we have accumulated quite a few in the year of preparation for the launch – is that we’re producing the report we’d want to read ourselves. For me, that report would include the biases of the people who created the report. I tend to prefer candor to precision. And while I can’t claim we’ve produced a balanced report – these are all “buy” recommendations – I can claim we’ve produced a candid one.

What you get when you open an issue of The Avid Hog is my thoughts and Quan’s thoughts about a specific stock. To the extent we have blind spots, The Avid Hog has blind spots. To the extent we err, The Avid Hog errs.

What I’m proud of is not our ability to eliminate the errors in our judgment – which we can never do – and keep them out of the report. What I’m proud of is our ability to communicate our judgment.

It is the judgment of two people who focused on one stock for a full month. I think it is worth $100 a month. I hope readers of this blog will too.

Talk to Geoff about Singular Diligence

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Weight Watchers (WTW) Added to Archived Issues

by Geoff Gannon

Our issue on Weight Watchers (WTW) – probably the most controversial pick we’ve ever made in the newsletter – has just been added to the archived issues for Singular Diligence. So when you subscribe to Singular Diligence you now get immediate access to our Weight Watchers issue.

Quan and I picked Weight Watchers in October 2013 when it traded at $32.12 a share. The stock has dropped 10% since we wrote that issue. It actually dropped a lot more than 10% at one point. The 52-week low is something like $19 a share. The share price is $28.92 as I write this blog post.

So the price is now 10% lower than when we originally picked Weight Watchers.

For changes that have happened since we wrote that issue in October 2013 you might want to consider…

You can read Weight Watchers’s latest earnings release (Q3 2014) here.

As expected, the company signed a deal with a U.S. health insurer (Humana) to offer the Weight Watchers program as part of employee sponsored health plans.

And for a contrasting (negative) view on Weight Watchers your best choice is Punchcard Investing. Punchcard Investing wrote two posts on Weight Watchers. You should definitely read both of those posts to balance out the issue of Singular Diligence where we picked the stock.

Here is Punchcard Investing’s original August 2013 post.

And here is Punchcard Investing’s update on Weight Watchers published in November 2013.


Talk to Geoff about Weight Watchers (WTW)

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Why CBIZ (CBZ) Is #7 On Our Research Pipeline

by Geoff Gannon

As part of our process for preparing Singular Diligence, Quan and I keep a list of 10 possible stocks to research next which we rank against each other. I shared this list with a subscriber to Singular Diligence who picked out the #7 stock on that list, CBIZ (CBZ), and wanted to know whether the stock is cheap enough to ever make it into an issue of Singular Diligence and why – if we think the stock is cheap enough – it isn’t ranked higher than #7 on our stocks to research next list.


Here is his question:


I have pretty much read through the 10K of CBIZ. I find the company very interesting…After reading through the reports, I tried to use the similar valuation method you guys use, and came up with a range of like $500 - $650 million. I then compare it with the current EV of around $600 million I think. The price is such not very very appealing. The business looks appealing, but the price is not as much so. Is this why it's only number 7 on the list?


And here’s my answer:


Yes. CBIZ is not cheap on an EV/EBIT basis. When Quan collected scores for CBIZ they looked like this:


F-Score: 6

Z-Score: 1.85

Short Interest: 16% (of float)


EV/Sales: 0.9x


EV/EBIT: 9.7x

EV/(Sales * Normal Operating Margin): 9.2x


Net Debt/EBITDA: 2.6x

Net Capitalized Debt/EBITDAR: 4.5x

Net Debt/EBIT: 2.8x

Net Capitalized Debt/EBITR: 4.7x


Consecutive Years of Profitability: More than 13 years

Gross Margin Stability: 0.19 (coefficient of variation)

EBIT Margin Stability: 0.38 (ditto)


Industry: Business Services (which is like maybe 8oth percentile in terms of ROC persistency versus other industries - business services has below average reversion to the mean relative to the U.S. economy generally)


We gather these scores and data on everything we consider for the top 10. Let’s look at the red flags here. Warren Buffett says life tends to break you at your weakest link. The same is true for business and investments. So, let’s focus on the weak links here.


Z-Score: 1.85 (below 3 - huge red flag)

Short Interest: 16% (above average - red flag; although very high short interest may have a “paradoxical reaction” - it can actually mean the stock is overhated)

Net Capitalized Debt/EBITDAR: 4.5x (this is very high)


Okay. So, as far as debt goes - let’s say banks will freely lend to any company that is generally profitable in all years and maintains Debt/EBITDA < 3. In that case, you would want a margin of safety to ensure the company could have access to additional capital in bad times. Using a 1/3 margin of safety, we’d want to see a company keep Debt/EBITDA around 2 times or so. So, any net debt above 2 times EBITDA will make us dig into the question of how solvent the company will be under stressful business conditions hitting at the same time as tight credit.


The Z-Score under 3 is a huge concern. Now, to be fair, the Z-Score is a very poor measure for a company that is service oriented and especially for a company that has any sort of float. The Z-Score punishes companies for float and rewards high working capital. So, companies with minimal current assets and very high retention rates - multi-year supply agreements, etc. - always score badly on the Z-Score. For example, if you look at the beverage can makers: Rexam, Crown, and Ball - only Ball has a Z-Score better than 3. They are manufacturers but they don't engage in speculative manufacturing of anything. Working capital is essentially speculative in nature. Business that retain nearly all their customers from year to year or only build plants and produce product once they have a supply agreement in place for their output have different solvency risks than businesses that create inventory on the speculation they can sell it. We have picked companies with Z-Scores below 3. John Wiley had a Z-Score below 3. We didn’t believe it had a solvency risk. And so we essentially overrode the Z-Score veto. John Wiley collects money up front, retains nearly all of its customers from year to year, and never reduces prices. None of these things are true of manufacturers. Customers pay after the sale is made, many customers are not retained, and manufactured products sometimes decline in price per unit.


But we have checklists for a reason. And I think that sacrificing the potential reward of picking companies with a Z-Score below 3 does not outweigh the gain you get from eliminating the risk of truly catastrophic losses from picking some companies with a Z-Score below 3 where you misjudge their solvency.


Going forward, it would be incredibly rare for me to allow Singular Diligence to pick a company with a Z-Score below 3. There is a chance I will block CBIZ in discussion with Quan specifically because of the Z-Score.


Short interest is easy to look at. As you know, Quan and I go looking for short thesis posts on companies we are interested in. So, we would go to places like Value Investors Club and search online for blogs and find whatever short posts we can.


I’m not sure why CBIZ has a high short interest except for its past. But that past is very distant. The company was run very differently in the 1990s than it was in the 2000s. As you can see from the stock chart, the stock has never returned to the price it had 15-20 years ago.


They do a lot of acquisitions. And so we would look closely at the accounting and the prices paid. The easiest company to analyze is one that never makes acquisitions. The second easiest company to analyze is a serial acquirer of small businesses in its own industry. Horizontal mergers of troubled or private competitors are usually the best acquisitions a company can make. They have a high success rate. There are cost synergies. And the market for private control of small businesses generally undervalues those companies relative to the market for control of a public company (where the premium for control is so high that cost synergies are often cancelled out by the premium the buyer has to pay).


Until the last year or two, CBIZ's share count had declined every year. That's a huge deal for us. If they were using a constantly rising share count to finance these deals - we’d never consider this stock. Quan and I are both focused on the trend in share count. I’m probably even more of a hardliner on this one than Quan is. Even if a company adds value when issuing shares, I definitely investigating a rising share count with skepticism it will benefit shareholders long-term. Capital markets tend to benefit sellers at the expense of buyers. I really don't care how good an IPO looks or what it's priced at - I’m not going to buy it. Likewise, the first thing I will look at is a spin-off because it often means the company couldn't sell the business unit at a fair price. Probably the two biggest rules I have for my first glance at a company are: 1) Never lose money 2) Never issue shares. A lot of investors overthink these issues. If you want to avoid big losses, you can eliminate most of the possible problem stocks simply by making sure the stock you buy will never post an annual loss or dilute your ownership. A huge amount of harm done to shareholders come from just those two sources: 1) Losing money 2) Issuing shares.


My next biggest concern about CBIZ - behind the Z-Score - is that the CEO (Steven Gerard) will retire in 2016. He is staying on as Chairman. And the transition will be a long one (they announced his 2016 retirement in 2014). But, this is a big deal.


He ran the company for 15 years. And management - at the very top - is more important at CBIZ than at most companies. Free cash flow is very discretionary here. They can't reinvest cash earnings in their offices. They have to acquire other things, paying down debt, buy back stock, or pay dividends with that money. They just don't have sufficient need to retain earnings (organically) to soak up their free cash flow. So the capital allocation philosophy of the CEO and the board is what matters here.


Now, I should point out the next CEO is simply the Chief Operating Office since 2000. So, basically you had a new management team filling both the CEO and COO roles in 2000. And 15 years later, the COO is simply replacing the CEO. It’s the least amount of change you can have when changing your CEO. But it's definitely a subject Quan and I would look at and talk about quite a lot if we ever dig into CBIZ in depth.


You mentioned the price not being that good. For me, the number I'd use would probably be the long-term average operating margin times today's sales. It’s a little north of 9 times normal EBIT using that measure. That's not cheap. Quan and I never pick stocks above 10x pre-tax owner earnings. That's a hard ceiling for us.


With CBIZ, the price is more of a margin of safety concern than a future return concern. With the right capital allocation, the stock could go up quite a lot without any multiple expansion in terms of EV/EBIT because you can increase EPS very, very fast relative to organic sales growth (which is minimal in this industry).


For example, from 2004 to 2012, the company grew earnings per share by about 20% a year. And the way the company grows EPS wouldn't really require putting more assets into competitive service. There's no reason for results to get progressively poorer unless the acquisition targets and price terms get poorer. Because you are buying out companies that already exist not adding anything new to the industry. The best companies are usually those that can grow EPS as fast as possible while growing assets in their company and in the industry as slowly as possible. Fast asset growth is the last thing you want to see in a business or an industry. It's the harbinger of doom. With doom here being low returns on sales and assets in the future.


I think CBIZ could be a little difficult to analyze and very difficult to write about. Those are concerns when you are writing a newsletter. Can I explain this business - how it actually works day-to-day - to subscribers? It's easier to describe a consumer facing business than a business that serves other businesses. And it's easier to describe a product than a service. It's also much easier to describe a business with a few very big customers than a business with a lot of very small custom.


CBIZ has 50,000 business clients (90,000 clients total). Most are between 100 and 2,500 employees with sales between $5 million and $200 million. Most of those kinds of companies are invisible to the general public. Many are local or regional. And many are not high profile consumer businesses. Their biggest customer- Edward Jones - was only billed a little over $20 million. And only a very small part of their business is "national practices". So, CBIZ is essentially invisible to the general public. That can make it hard to write about. And that's another reason why CBIZ is not near the top of the list.


So, my concerns about CBIZ are:


  1. Does it have too much debt?
  2. Do we know why people short it?
  3. Will the new CEO continue the policies of the old CEO?
  4. Is there a margin of safety at 9x EBIT?
  5. How hard will it be to research and explain CBIZ to subscribers?


Those aren't uncommon concerns for us to have. But they are very real questions. If the stock market wasn't so incredibly expensive right now, CBIZ wouldn't be on our top 10 at all. The bottom half of our top 10 is weak right now. CBIZ is now at #7 on our research pipeline. The stocks at #8, #9, and #10 all get close to half their sales from one industry or one customer we have concerns about. CBIZ doesn't have that problem at all. It's very diversified by customer.


Our approach is to pit our best ideas against each other. Do I love the price of CBIZ? No. Not all. But there are only 6 cheaper stocks I like better right now that Quan hasn't yet written notes on. That's why CBIZ is at #7 in our research pipeline. There just aren't a lot of cheap stocks out there


Talk to Geoff about CBIZ (CBZ)


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Quan's Notes on PetSmart (PETM)

by Geoff Gannon

Here are Quan’s notes on PetSmart (PETM).

Quan finished these notes on June 6th, 2014. At that time, one share of PetSmart was going for about $58 a share. PetSmart recently agreed to be bought out for $83 a share in cash. So these notes are entirely unactionable. But I thought some blog readers might enjoy seeing the kinds of notes Quan prepares as part of the newsletter process. And lots of you may have read articles about the PetSmart leveraged buyout and wondered about the industry, the company, its future, the price being paid here, etc. These notes – the PDF is 105 pages – give more detail on the company than press reports do.

We always have some notes that Quan has prepared but have never been used in a Singular Diligence issue. This happens for a couple reasons. One, when Quan and I discuss the notes we may come to the conclusion we were wrong about the company and the stock in our initial assessment – it’s not actually appropriate for the newsletter because of risks to the company or because the price is higher than we first thought. Two, the price of the stock can go up between the time Quan writes the notes and the time we would publish an issue.

That’s what happened in the case of PetSmart. PetSmart was going to be featured in an issue of The Avid Hog – the predecessor to Singular Diligence – during the summer. But, activist investors pushed for the company to put itself up for sale. PetSmart’s board announced they were reviewing strategic alternatives – and so the stock price rose.

The stock price went on to rise a lot more from that point, because the price ultimately paid in the LBO was higher than what traders originally speculated after the announcement.

Whether or not PetSmart was a good speculative bet at that point – it turns out it was – it was no longer a good investment to present to subscribers. The same can be said now about the leveraged buyout. The calculus for an LBO is different than it is for Quan and I deciding on a passive stake in a publicly traded buy and hold investment. PetSmart was a good buy and hold investment at $58 a share. It was not a good one at the $70 and up prices that the stock traded at after the market knew the company was for sale. The LBO might be a good deal at $83 a share for the buyers. But we wouldn’t recommend buying PetSmart at $83 a share.

As you can see in the “Value” section of the notes, we valued PetSmart at 13 times normal EBIT. That works out to something like 9.7 times EBITDA.  I want to be clear – we were not suggesting anyone should pay 9 to 10 times EBITDA for the stock – we were saying that at a price of 9 to 10 times EBITDA the future returns in PetSmart for investors would be similar to the returns they could get in the market as a whole. In fact, the quote from the notes would be “At 13 times EBIT, investors can get an adequate return in PetSmart”.

We generally want a stock to be trading at about two-thirds of our appraisal price to recommend it. So, even if we thought PetSmart was worth $90 a share – we’d want to recommend it when it traded at something like $60 a share.

As a result, both of these statements are true:

  1. After PetSmart announced it was reviewing strategic alternatives, the stock was too expensive to present in our newsletter

  2. The buyers of PetSmart who are now paying $83 a share in cash may not be overpaying

Read Quan’s Notes on PetSmart (PDF)

Talk to Geoff about PetSmart (PETM)

Check Out Singular Diligence



Archived Issues: Progressive, Ark, Town Sports, John Wiley, HomeServe, and Village

by Geoff Gannon

Now that the Avid Hog newsletter that Quan and I write has relaunched as Singular Diligence, we’ve changed how issues are made available. With Singular Diligence, as soon as you subscribe – you get access to the archived issues Toby puts up at Marketfy.

Also, unlike how we handled things with The Avid Hog, we are going to actually tell everyone what companies we’ve covered in past issues. So here are the archived issues that you get immediate access to when you subscribe.


Singular Diligence – Archived Issues

Progressive (PGR): A U.S. auto insurer that competes with GEICO online. Also the largest auto insurer in the independent agent channel.

Ark Restaurants (ARKR): Runs a small number of huge restaurants in landmark locations like: Union Station, Bryant Park, Faneuil Hall, casinos, and hotels. Also has an interest in the Meadowlands racetrack in Northern New Jersey as well as the food and beverage concession there.

Town Sports (CLUB): Runs urban gyms in New York City, Washington D.C., Boston, and Philadelphia under the “Sports Club” name.

HomeServe (London – HSV): A U.K. company that provides home emergency repair services using an insurer’s premium based model. Now also in countries like France and the United States.

John Wiley (JW.A): A publisher of books, textbooks, and academic journals. The vast majority of the company’s value is in its academic journals. The Wiley family has controlled the company for 207 years.

Village Supermarket (VLGEA): The second largest operator of “Shop-Rite” supermarkets. Stores are mostly in densely populated Northern New Jersey. Each store does about $1 million a week in sales.


If you have any questions about Progressive, Ark, Town Sports, HomeServe, Wiley, or Village – feel free to email me.

Talk to Geoff about Progressive, Ark, Town Sports, HomeServe, Wiley, or Village

Check Out Singular Diligence

The Avid Hog is Now Singular Diligence

by Geoff Gannon

The Avid Hog has been reformatted and renamed SINGULAR DILIGENCE, reflecting a singular focus on business diligence. The defining idea behind The Avid Hog of finding and profiling "a wonderful business at an attractive price" for buy-and-hold investors has been continued in SINGULAR DILIGENCE. Geoff Gannon and Quan Hoang have teamed up with Tobias Carlisle as the publisher and the newsletter is being hosted at Marketfy

The attached special report on America's Car Mart, profiled in the The Avid Hog back in June, explains why we selected that stock. It also give you a look at the depth of analysis and extent of the data that appears in every newsletter.

The current issue of SINGULAR DILIGENCE is Progressive Insurance. If you sign up now, you can read our December issue, Progressive Insurance, right away, and also be assured of getting the next issue when it comes out on January 1st. 

Read the America's Car-Mart (CRMT) Sample Issue (PDF)

Visit the New Singular Diligence Website

Adidas Announces Share Buyback

by Geoff Gannon

Adidas announced plans to spend up to 1.5 billion Euros over 3 years buying back its own stock. The company will take on debt (it has no net debt) and continue to pay a dividend. Dealbook quotes the company's CFO as saying:

"We believe that our shares are currently significantly undervalued and this provides an excellent opportunity to optimize the company’s cost of capital, deploy cash and create further value for our shareholders"


At the current share price, the company could buy up to 10% of its own shares over 3 years. Bloomberg also has an article on the buyback and it focuses more on the possibility of activist investors targeting the company. The article speculates activists would want the company to replace its CEO and spin-off Reebok and TaylorMade.

Adidas is very cheap compared to its two best known - and expensive - peers: Nike (NKE) and UnderArmour (UA).

Adidas is valued more in line with the company with which it shares a founding family: Puma.

When looking at the history of those 4 companies and their cultures - it is difficult to argue that Adidas is truly comparable to either Nike or Under Armour.

Regardless, Adidas is cheap given the level of stock prices generally and the multiples at which athletic apparel companies normally trade.

Talk to Geoff about Adidas

Babcock & Wilcox (BWC): Considering Separation into Two Companies

by Geoff Gannon

Babcock & Wilcox (BWC) just announced it is considering separating into two companies:

"...Board of Directors is evaluating the separation of the Company’s Power Generation Business and Government & Nuclear Operations Business into two publicly traded companies. The Board’s goal is to determine whether a separation creates the opportunity for enhanced shareholder value and business focus. B&W has retained JPMorgan as its financial advisor and Wachtell, Lipton, Rosen & Katz and Jones Day as legal advisors to assist in this process."

The company reports its results in 4 segments (one of which is the experimental money losing mPower - tiny nuclear generator - business). So it is easy to analyze what the company will look like post any possible break-up. The stock is up 7% as I write this.

It still looks cheap.

Talk to Geoff about Babcock & Wilcox (BWC)

Barnes & Noble (BKS) Will Separate Retail from Nook

by Geoff Gannon

Barnes & Noble (BKS) announced it plans to break up the company:

 With the objective of optimizing shareholder value, the Company’s Board of Directors has authorized management of the Company to take steps to separate the Barnes & Noble Retail and NOOK Media businesses into two separate public companies.  The Company’s objective is to take the steps necessary to complete the separation by the end of the first quarter of next calendar year. 

The company provided a PDF giving segment performance.

Over the last year, Retail had positive EBITDA of $354 million. College had positive EBITDA of $115 million. Nook had negative EBITDA of $217 million.

The company ex-Nook would have $6.04 billion in sales, $1.78 billion in gross profit (29% gross margin), and $469 million in EBITDA (8% EBITDA margin).

(I do not own any shares of Barnes & Noble. I bought shares in August 2010 and sold them in December 2010).



What is the Fair Value of America’s Car-Mart (CRMT)?

by Quan Hoang

The following stock may appear in a future issue of The Avid Hog.

In the last post, Geoff mentioned the use of common sense to estimate the fair value of a stock. In this post, I’ll write about a specific example of using common sense. The stock I’m talking about is America’s Car-Mart (CRMT).

Car-Mart sells used cars in small towns in South-Central states like Arkansas, Oklahoma, and Missouri. But Car-Mart isn’t exactly a car dealer. Car-Mart lends used cars to poor people with limited credit history.

The average car price Car-Mart sells is about $9,721. Customers pay a 7% down payment on average. The remaining balance is financed at a 15% interest rate. Customers go to Car-Mark’s stores to make weekly or bi-weekly payment for the next 29 months. The average bi-weekly payment is about $175.

The focus of Car-Mart is not selling cars. The focus is collecting payments.

When Car-Mart sells a car, the car price is recognized in revenue. The principal balance also increases by the same amount, and allowance for credit loss increases by an estimated amount.

Whenever customers make payments, the part of payment composed of interest is recognized in revenue. The rest of the payment is subtracted from the principal balance.

When a customer defaults, Car-Mart repossesses the vehicle. The fair value of the vehicle is added to inventories. Car-Mart also subtracts the fair value of the vehicle from the remaining principal of the loan. That would be the amount that Car-Mart writes off.

According to these accounting policies, reported earnings are not a good measure of Car-Mart true earnings. Car sales are not cash revenue. Car-Mart can overstate the price of the car they sell to overstate revenue. Or for the same payment stream, Car-Mart can reduce the interest rate to get a higher car price that is recognized in revenue.

Loan originations are not cash spent either. Car-Mart doesn’t lend money to customers to buy cars. Car-Mart lends cars to customers.

This is where we need common sense to calculate owner earnings. The true cash flow in the business is:

CFFO = Receivable Collections - Cost of Goods Sold - G&A - Tax - Increase in Working Capital.


Excluding sales of repossessed cars at costs, Cost of Goods Sold + G&A is about 74% of Car Sales. I'll consider repossessed inventory a type of receivable collections rather than inventory. Working capital is about zero. So, we only need to calculate Receivable Collections.


As we're interested in normal earnings, we'll calculate Receivable Collections in a no growth situation. We're in Year 3 with revenue R. Year 1 and Year 2 both have revenue of R.


Receivable Collections = Collections of Year 1 loans + Collections of Year 2 loans + Collections of Year 3 loans


Collections of loans in each year = collections of successful loans + collections of payments before default + proceeds from repossession.


Car-Mart is lending at 15% and the term length is about 29 months. A $10,000 loan like that with $0 down payment would require 62 bi-weekly payments of $192 for a total of $11,923. So, a successful loan of $P can result in a total collection of 1.19 * P.


CRMT says they normally repossess about 40% of units sold (and over 40% in 2013). The average age of an account at charge-off is 10.6 months. Accounts are on average 71 days past due at the time of charge-off. So, we can say that CRMT can collect 17 bi-weekly payments before default. For the 40% of loans that end up with charge-offs, CRMT can collect 0.4 * 1.19 * R * 17/62 = 0.1305 * R before default.


The recovery rate is currently 30%. I looked at the industry benchmark and the recovery rate is about 32-33% of remaining principal. The remaining principal of a $10,000 loans after 17 bi-weekly payments is $7,602.70. So, the recovery amount would be 30% * $7,602.70/$10,000 = 22.8% of the face value. A 40% default rate would mean the recovery amount is 0.0912 * R. Car-Mart’s "inventory acquired in repossession and payment protection claims"/Average Principal Balance was stable at about 11-12%. So, it's conservative to say the recovery amount is 0.0912 * R.


Let's assume the amount of loan originations to be the same every two weeks. That means total loans generated in each bi-weekly payment is R/26. Excluding the 40% defaulted loans, 60% of loans originated in the first bi-weekly payment will have 10 payments in year 3 for a total of 0.6 * 1.19 * 10/62 * R/26. Similarly, loans generated in the second bi-weekly payment will have 11 payments in year 3 for a total of 0.6 * 1.19 * 11/62 * R/26, and so on.


Total collections of successful loans in year 3 would be 0.6 * 1.19 * 1567/62 * R/26 = 0.6941 * R


So, Receivable Collections is 0.6941 * R + 0.1305 * R + 0.0912 * R = 0.916 * R.


However, the down payment is 7% of principal instead of 0%. So, Receivable Collections is actually 0.07 * R + 0.93 * 0.916 * R = 0.92 * R


So, CFFO is 0.92 * R - 0.74 * R = R * 18%. As maintenance CapEx is insignificant, pre-tax FCF margin is about 18%.


This calculation has its limitations. First, there can be more than 60% of loans originated in year 2 and year 3 that are still performing in year 3. That would increase collections of successful loans and reduce pre-default collections or proceeds from repossessions. But the net effect would be positive to cash flow in year 3. The bigger limitation is that the total amount of loans originated in each bi-weekly period varies while I assume they're all equal.


If I assume the repossession rate to be 45%, pre-tax FCF margin would be 15.3%. If I assume the repossession rate to be 40% but there are 65 bi-weekly payments, pre-tax FCF margin would be 17%. So, we can see that Car-Mart would make less money with a longer loan term. And the easiest way to improve profit is to reduce the default rate.


It’s hard to estimate Car-Mart’s earnings power accurately. But these calculations show that pre-tax FCF is at least 15% of car sales.


This finding is consistent with Car-Mart’s growth record. From 1995 to 2002, Car-Mart grew sales by 20% annually. From 1998 to 2012, Car-Mart grew sales by 14% annually without using additional debt or equity. The true cash investments in this business are in Cost of Goods Sold and SG&A. A 15% pre-tax FCF margin results in about 9.75% after-tax FCF margin. As COGS + SG&A is about 74% of car sales, 9.75% after-tax FCF margin can fuel 13.18% (9.75/74) growth in COGS + SG&A. From 2003 to 2013, the annual growth rate of COGS + SG&A was 13.1%.


So, 15% is a good estimate of the pre-tax owner earnings margin.


At this point, what is the fair value of Car-Mart? My favorite yardstick is an enterprise value equal to 10 times pre-tax owner earnings. For Car-Mart, that’s equivalent to a ratio of 1.5 times car sales.


But wait! What if Car-Mart can grow 10% over the next 10 years? If that’s true, Car-Mart is worth at least 12 times pre-tax owner earnings, or 1.8 times car sales.  


The reason is simple. If today’s pre-tax owner earnings are $1, they will be 1.1^10 * 1 = $2.59 after 10 years. After 10 years, Car-Mart would be worth $25.90 based on an enterprise value of 10 times pre-tax profits. If we pay $12 for Car-Mart today, we would still get an 8% annual return. Also, at a 10% growth rate, Car-Mart would have excess cash to repurchase shares. That would add 1% or 2% to our investment return.


But again, don’t worry too much about what’s the fair multiple. It can be 12, 13 or 14 times pre-tax owner earnings for Car-Mart. The bigger questions are about qualitative factors. Is Car-Mart durable? Does Car-Mart have a strong competitive position? If yes, is the competitive position sustainable? How likely is it for Car-Mart to lose underwriting discipline? Is Car-Mart’s capital allocation good or bad? And does Car-Mart have favorable future prospects?


If the answers to all these questions are positive, we know that we would get a good bargain paying an enterprise value of 10 times pre-tax profits.


Talk to Quan about America’s Car-Mart (CRMT)


Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

Stock Price Guidelines

by Geoff Gannon

A recent blog post at The Brooklyn Investor discusses whether Warren Buffett pays 10x pre-tax earnings for both private companies and public stocks:

It's amazing how so many of the deals cluster around the 10x pretax earnings ratio despite these businesses being in different industries with different capital expenditure needs and things like that. Even the BNI acquisition, which many thought was overpriced (crazy / insane deal! Buffett has lost his marbles!) looks normal by this measure; a price that Buffett has always been paying. And yes, right now I'm the guy swinging around a hammer (seeing only nails), but I notice a pattern and think it's really interesting.

(The Brooklyn Investor)

I’m often asked what’s a fair price to pay for a good business? This is a tough question, because people seem to mean different things when they say “fair price” and different things when they say “good business”.

I will suggest one awfully automatic approach to deciding what stocks are acceptable candidates for long-term investment. The simplest approach I can suggest requires 2 criteria be met. To qualify as a “good business” the stock must:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry

In other words, we are defining a good business as a stock in a “defensive” industry with at least 10 straight years of profits.

If those two business quality criteria are met, what is a fair price to pay for the stock? I suggest three yardsticks:

  1. Market Cap to Free Cash Flow: 15x
  2. Enterprise Value to Owner Earnings: 10x
  3. Enterprise Value to EBITDA: 8x

These are “fair” prices. A value investor likes to pay an unfair price. So, these are upper limits. They are prohibitions on ever paying more than 15 times free cash flow, 10 times owner earnings, or 8 times EBITDA.

At Berkshire, Buffett is willing to pay a fair price – 10 times pre-tax earnings – for 2 reasons:

  1. Berkshire amplifies its returns with leverage (“float”)
  2. Buffett has learned to find a margin of safety in places other than price

For example, Buffett talks about Coca-Cola (KO) as if the margin of safety was the profitable future growth of the company. He was paying a fair absolute price (it was a high price relative to other stocks at the time), because he knew it was a good price relative to earnings a few years out.

Let’s take a look at the 5 guidelines I laid out:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry
  3. Market Cap to Free Cash Flow: 15x
  4. Enterprise Value to Pre-Tax Owner Earnings: 10x
  5. Enterprise Value to EBITDA: 8x

Implementation of this – or any – checklist approach requires one additional thing: common sense.

Common sense often finds itself at odds with two other types of sense:

  1. Theoretical Sense
  2. Technical Sense

Technical sense is when you notice that Carnival (CCL) trades at more than 8x EBITDA and more than 10x Pre-Tax Earnings and disqualify the stock right there. Technically, you have applied the checklist correctly. However, let’s look at 3 companies and their 10 year average tax rate:

Village Supermarket (VLGEA): 41.8%

John Wiley (JW.A): 24.8%

Carnival: 1.1%

Common sense tells you that – when it comes to taxes – Carnival is a special case and needs to be examined as such. You must apply the spirit of the above laws rather than the letter. The letter of the law was not written with a company that pays no taxes in mind.

Theoretical sense is when you catch yourself thinking thoughts that while conceptually true are habitually dangerous. These are usually thoughts that are provable by mathematics but leave the human in you a little queasy for having thought them.

For example: let “a fair price” equal the price at which a buy and hold forever investor would earn the same return in this stock as he would in the S&P 500.

I want you to take two stocks I just mentioned: Village and John Wiley. Both companies have been public since the 1960s. Now go to your favorite data source and look up the oldest stock price you can find for each company. For example, choose Google Finance (which goes back to 1978) and use 1978 to today as your holding period. Then, plot each of these stocks against an index. You can also calculate the CAGR of the stock and the CAGR of the index. Now, work back from these calculations to find what multiple of the then current price you needed to pay for the stock to equalize its future return with that of the S&P 500 over the full holding period from then till today.

I think it will surprise you. It won’t be 1.5 times the then market price. It’ll be more like 3 or 4 times the price. In other words, if the stock had a P/E of 12 back then, it turns out it really should have had a P/E of 36 or 48 or some other absurd multiple.

Buffett’s Coca-Cola investment is well known. Go back to 1988 and try to figure out what a “fair” price for Coca-Cola stock would’ve been if we define fair to mean the price that equalizes long-term future returns between the stock and the S&P 500. Imagine this number in terms of what the P/E, EV/EBITDA, etc. would need to be to make holding Coca-Cola merely a “fair” investment from 1988 through today.

Based on these calculations, you can then go back in time and say that there were times when John Wiley or Village or Coca-Cola (or a great many other public companies) had a margin of safety of 75% or 80%.

I’ll admit this makes theoretical sense. But I won’t admit it makes common sense.

It is a dangerous habit to pay those kinds of multiples. Not because they aren’t justified. And not because the future is unknowable. Per capita consumption of Coke was going to grow. Buffett knew that.

It is dangerous to pay high multiples, because it complicates rather than simplifies you process. It requires more quantification rather than less.

The whole point of having a rule of thumb like “we pay 10 times pre-tax earnings” is to make taking the correct action easier. Warren Buffett is a focused investor – especially in the sense that he makes relatively few new purchases (of private companies or public stocks) each year. He spends a lot of time looking for things to buy and presumably passes on most. So, for Buffett, the approach that makes taking a correct action easier is one that eliminates most errors. It doesn’t matter as much to Buffett if he eliminates a lot of potentially good investments as long as he limits the number of false positives.

I think the same is true for most buy and hold investors. Try using common sense and these 5 guideposts:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry
  3. Market Cap to Free Cash Flow: 15x
  4. Enterprise Value to Pre-Tax Owner Earnings: 10x
  5. Enterprise Value to EBITDA: 8x

I think it will allow you to focus more quickly on those businesses that may be above average in quality and below average in price.

Is this what I do?

Not exactly. I was recently talking to someone who noticed that in a past issue of The Avid Hog I gave a much higher “normal” EBITDA number than the company had actually generated from 2008 through 2012. Wouldn’t it be more conservative to use an average of the recent past?

I answered: “Yes. It would be more conservative. But it would also be intellectually dishonest.”

Simply put, I did not believe that the period from 2008 through 2012 was normal. I could mention the recent past. But, I couldn’t suggest it would have anything to do with the future.

This brings me to the place where I split off from the guidelines I suggested above. When selecting a stock – and when attempting to appraise a stock – I do not think about the price in terms of today’s EBITDA, owner earnings, or free cash flow.

I don’t care what the earnings of a stock are when I buy it. I care what the earnings are when I sell it. In the example I just mentioned, I was thinking in 2013 what the EBITDA of that company was likely to be in 2016 to 2018 (3 to 5 years from my purchase date). I did not believe that the period from 2016 to 2018 would be at all like the period from 2008 through 2012. So, I did not consider the recent past to be a terribly helpful guide.

In most years, this will not be such a big problem. The more normal the economic climate is when you are selecting a stock and the more stable the industry you are looking at is – the more you can trust the most recent EBITDA and pre-tax earnings.

Of course, what I care about is free cash flow. Let’s take another look at the same 3 companies. This time I want to talk about the 10-year average ratio of free cash flow to net income as calculated by Morningstar:

Carnival: 0.31x

Village: 1.10x

John Wiley: 1.84x

In an average year, Carnival turned $1 of earnings into 31 cents of free cash flow. Village turned $1 of earnings into $1.10 of free cash flow. And John Wiley turned $1 of earnings into $1.84 of free cash flow.

I don’t agree with these exact numbers. Morningstar – and almost every other finance website – calculates the free cash flow of publishers incorrectly. However, this pre-publication item does not cause most of Wiley’s free cash flow excess over net income. In reality, Wiley does turn $1 of reported earnings into $1.50 of free cash flow. In an economy with inflation, $1 of earnings at most companies actually converts to less than $1 of free cash flow. This suggests companies that can be counted on to consistently turn $1 of earnings into $1.50 of free cash flow should trade at 50% higher price ratios. Theory says the EV/EBITDA cap of 8 should become an EV/EBITDA cap of 12 for these companies.

I want to stop here and highlight this fact: What I just said is true. It’s theoretically true. You can actually prove the point. There is no arguing that fact. Now, the question I want you to consider is whether the fact this point makes theoretical sense forces you to concede it also makes common sense. I’m serious. Think about this. Really ask yourself whether what I just said about paying 8 times EBITDA for some businesses and 12 times EBITDA for other businesses is an insight you can safely incorporate into your own investing habits. There’s a tendency for folks to either accept that because something is true it’s useful to them or conversely to start by rejecting its usefulness to them and then feeling obligated that because they’ve rejected its usefulness they now need to disprove its truth. Something can be true and useless. Whenever you think about investing, your top priority should be finding a really useful habit to pick up.

So let’s keep talking usefulness. What limits the usefulness of these ratios? I want to point out the problem with using any one ratio – Market Cap/Free Cash Flow, EV/EBIT, EV/EBITDA, etc. – by using those 3 very different companies (Carnival, Village, and Wiley). Their tax rates range from 1% to 42%. Their earnings to free cash flow conversion rates range from 31% to 184% (really more like 150%). These are make or break differences for an investment.

That is why you need to use common sense. These ratios are not flawed. It is only when they are applied in an obviously reckless way that they become flawed.

I recently exchanged emails with someone who had this sort of problem. He had done the return on capital calculation exactly the way an analyst is taught to – and yet, something was nagging at him.

It turns out the tickle he was feeling was common sense.

Here is what he was asking about:

…sells a very large chunk of their receivables at a discount. That has a very positive effect on ROIC and free cash flow as it reduces working capital without a negative impact on the EBIT - the discount paid for selling the receivables is considered a financial expense.

It doesn't seem very fair to me and I get the feeling I could be overvaluing this company if I don't include the discount into the operating income (and consequently free cash flow) calculations. Selling a great part of their receivables is business as usual for them; they definitely take the discount into account when pricing their merchandise, for instance.

What do you think?

And here is how I responded:

... The key is not to follow the rules you learned for how to do a generic ROIC calculation. It is to describe the specific business you are analyzing. If you believe the factoring of receivables is a core part of how this business operates, then be up front about it. Tell yourself this is a company that is dependent on factors to provide financing for its operations….

…Be as specific as possible. If you then need to compare this company to others, do it two ways. Prepare a calculation of ROIC that is the most favorable to the company and ROIC that is the least favorable. The truth is one or the other or it is something in between. This is the best description of the actual business. It will help your understanding.

Remember, this is real life problem solving you are going to base a buy/sell decision on using your own money. This is not a word problem in math class. The goal is not to get a single, correct quantifiable answer. The goal is to have confidence in your reasoning and have that reasoning be enough to take a money making action.

The truth is that 10 times pre-tax earnings is a perfectly fair price to pay for a business you understand, like, and intend to hold for the long-term.

However, it is always possible to use ratios to lie to yourself. Value investors can find that the EV/EBITDA ratio of an asset heavy company at the peak of its cycle will justify an otherwise dodgy purchase. If you want to buy into an overleveraged company, just focus exclusively on the Market Cap/Free Cash Flow ratio while ignoring enterprise value entirely.

I think guidelines are great. In fact, I think anything that gets investors away from a focus on quantities and toward a focus on reliability is a wonderful tool. A lot of investors would benefit from trying to prove two separate cases:

  1. {C}Is this an above average business?
  2. {C}Am I paying a below average price?

Rather than trying to quantify the precise extent to which the business is above average or the price is below average.

We shouldn’t spend a lot of time worrying about whether we are paying 3 times EBITDA or 5 times. Either will do. Nor should we spend time worrying about whether the business earns a 33% return on capital or a 99% return on capital. Both will get you a better than 20% after-tax return without leverage. That’s better than Berkshire.

The Brooklyn Investor began the post tackling the idea that Buffett pays 10 times pre-tax earnings. Another Buffett quote explains why the exact price paid may not be the most important consideration:

One of the things you will find, which is interesting and people don’t think of it enough, with most businesses and with most individuals, life tends to snap you at your weakest link. So it isn’t the strongest link you’re looking for among the individuals in the room. It isn’t even the average strength of the chain. It’s the weakest link that causes the problem.

For most investors, price is the weakest link in their process. Most investors are not value investors. They simply pay too much for popular stocks. They may have other weak links. They may trade too much. They may be greedy when others are greedy and fearful when others are fearful.


Remember, you aren’t most investors. Most investors aren’t reading this blog. You are. That means price probably isn’t your weakest link.


So, don’t focus on price. Just figure out a way to make sure the price you pay is good enough. And then work on correcting the errors you've historically made.


I’ve made a lot of mistakes as an investor. I can’t think of any case where my mistake was paying too high a price relative to some measure of earnings. I can’t look at any investment that went badly and say: “Oh, if only I’d gotten that at an EV/EBITDA of 4. That would’ve solved everything.”


I’ve misjudged people. I’ve misjudged societal change. I’ve misjudged solvency. I’ve sold too soon. And I’ve tried to do too much.


Those are potential weak links for me. And so my quality assurance time is better spent carefully checking those problem areas than worrying about price.


This is not true for everyone. I’m very unlikely to get so excited about a business, I’ll pay any price for it. I’ve followed businesses I love trade publicly for 5-10 years and never touched them because of price. If you’re like me in that respect, price is something you shouldn’t obsess about.


Have your standard. Apply it using common sense. But, don’t worry about whether the right multiple is 9, 10, or 11 times pre-tax earnings. If your investment case snaps, it probably won’t be because of price. And it certainly won’t be because you were off by 10%.

Talk to Geoff about Stock Price Guidelines

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IMS Health (IMS): 4 Years Later

by Geoff Gannon

I bought shares of IMS Health (IMS) in early 2009. The company went private in 2010. That buyout (involuntarily) ended my investment in the stock. Now in 2014, IMS Health is going public again. I don’t invest in IPOs. So, I’m not interested in the stock. But, I am interested in what has happened with the company. Some things have changed. Others have not.

Here is the S-1.

While under TPG’s control, IMS Health bought a lot of stuff. In 3 years (2011 through 2013), IMS Health spent $900 million on 22 acquisitions, “internal development programs”, and “capital expenditures”.

I’m not sure if they are including “additions to computer software” in that number. I treat it as a capital expenditure when analyzing IMS Health (or any database company) but it is reported on a separate line of the cash flow statement. Additions to computer software is always a bigger number for IMS Health than other capital expenditures. Over the last 3 years, software capital spending has averaged $73 million a year while other capital expenditures have been just $38 million a year. You will notice that capital spending (which we just said was $111 million a year plus acquisitions) and depreciation are totally unrelated. This is a good place to mention that GAAP numbers are irrelevant at IMS Health. You always want to focus on your expectations of normal future free cash flow. The business is very stable, so there’s little need to “normalize” anything on the customer side.  

This quote from the S-1 sums up what interested me in the stock originally:

The average length of our relationships with our top 25 clients, as measured by 2013 revenue, is over 25 years and our retention rate for our top 1,000 clients from 2012 to 2013 was approximately 99%.

This is IMS Health’s moat. It is the one thing about the company you want never to change if you’re going to hold the stock for the long-term.

The new owners churned through the workforce astoundingly fast:

Since the Merger…we added approximately 7,600 employees…and oversaw the departure of approximately 5,200 employees…We estimate that about 60% of our approximately 9,500 employees have joined us since the Merger...

So, IMS Health – a 60-year old company with an average customer relationship of 25 years – is now mostly made up of employees who have been with the company for less than 3 years.

I can’t recommend looking at IMS Health as a possible investment. However, I do recommend reading the S-1. It offers some insight into both a company with a competitive position I really like and what a private equity owner does to a once and future public company.

Talk to Geoff about IMS Health (IMS)

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Moody's Downgrades Weight Watchers (WTW) Debt to B1 With Negative Outlook

by Geoff Gannon

Moody's downgraded Weight Watchers (WTW) debt:

Moody's expects a sharp drop in 2014 revenue and EBITDA to about $1.4 billion and $325 million, respectively, even with management plans to initiate cost reduction programs. As a result, debt to EBITDA (after Moody's standard adjustments) may increase to above 7 times, which is high for the B1 CFR. Moody's anticipates Weight Watchers will remain profitable but down considerably from earlier expectations and generate at least $100 million of free cash flow. Lowered free cash flow and in Moody's view financial covenant constraints will limit Weight Watchers access to about $50 million of its revolver, so the Speculative Grade Liquidity rating was revised to SGL-3. Liquidity is considered adequate.

The negative ratings outlook reflects Moody's concern that evidence of business stabilization may not appear in 2014, which could imply further deterioration of financial leverage and cash flow.

(Moody's Downgrade)

The "Debt" section of our notes always assumed Weight Watchers would only have access to $50 million of revolving credit. Interest costs increase 0.25% ($6 million a year) when rated below Ba3 by Moody's (B1 is lower) and Standard & Poor's. See the debt section of our notes for details.

Separately, Morningstar downgraded the "moat rating" for Weight Watchers from "wide" to "narrow". You can find our discussion of free apps (the reason for Morningstar's downgrade) near the end of the notes PDF.

I promised I would tell you if Quan or I changed our position in Weight Watchers. Today, Quan added to his position.


Talk to Geoff about Weight Watchers (WTW)

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G Asset Management Makes 2 Offers for Part of Barnes & Noble (BKS)

by Geoff Gannon

G Asset Management put out a press release announcing 2 different offers for different parts of Barnes & Noble (BKS):

 ...a proposal to acquire 51% of Barnes & Noble, Inc., valuing the company at $22 per share, a ~30% premium to the current market price.

Alternatively, GAM has proposed to acquire 51% of the Nook segment, valuing the segment at $5 per share. GAM  stated in its proposal that it was extremely confident that if the Nook segment is separated from the profitable retail and college business, substantial shareholder value would be created.

(Press Release)


Talk to Geoff about Barnes & Noble (BKS)

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Weight Watchers (WTW): Notes PDF

by Geoff Gannon

The main point of this post is to provide the Notes PDF from which The Avid Hog issue on Weight Watchers was prepared:

Weight Watchers Notes PDF

A lot of people emailed me about Weight Watchers (WTW) after the company reported earnings and the stock dropped about 25% last week. Some of the people asking about Weight Watchers were subscribers to The Avid Hog. Others were not. For the first few issues of The Avid Hog (including the issue in which we picked Weight Watchers) we did not put out a “Notes” PDF with the issue.

Since a lot of people said they were “rethinking the thesis” or “considering selling” or “thinking about doubling down” on Weight Watchers at today’s price, I thought we should post some items with information that might be useful.

Those items are:

The “Notes” we used in preparing the issue of The Avid Hog where Weight Watchers was picked (PDF)

The Investor Day Presentation the company put out last fall

The 8-K outlining the company’s credit agreement

Artal’s portfolio (Artal controls Weight Watchers)

Weight Watchers is down 49% from where Quan bought it, 44% from where I bought it, and 35% from where we picked it for The Avid Hog. Quan and I still own the stock. We have no plans to sell it. We’ll let you know if that changes.

The notes have been updated to reflect the most recent (much lower) stock price and to discuss the 3 topics most often asked about in emails: 1) Debt 2) Free Apps 3) Artal.

If you want to know our thoughts on the company, please read the “Notes” above. They capture our thinking better than I could in a blog post. For information about Weight Watchers’s debt please read the “Debt” page of the notes. You should also read the actual 8-K explaining the credit agreement. For management’s thoughts on the company and the “turnaround plan” please read the Investor Day Presentation and either listen to the last 2 earnings calls or read the transcripts. You can find them on the company’s website, at earningscast.com, at Seeking Alpha, etc.

Like I said, if Quan or I change our positions in Weight Watchers in any way – we will update you the moment we do so.

For a negative view of Weight Watchers see Punch Card Investing’s posts:

A Closer Look at Weight Watchers (WTW)


Update on Weight Watchers International (WTW)

Once again, here are the complete notes we used to prepare the Weight Watchers issue of The Avid Hog. They have been updated to include information not available at the time the issue was published (a lower stock price and info from The Investor Day).

Talk to Geoff about Weight Watchers (WTW)

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