Driverless Cars and Progressive's Durability

by Geoff Gannon

Value and Opportunity linked to a Bank of England blog I never would have found on my own. The Bank of England blog did a post on how driverless cars could hurt the future of auto insurers. Last year, we did a Singular Diligence issue on U.S. car insurer Progressive (PGR). A big part of the durability section of that issue was about driverless cars.

So, here is the Bank of England blog post on driverless cars.

And here is Singular Diligence’s discussion of Progressive’s durability…


Originally Published: December 2014

DURABILITY: Progressive’s Focus on a Combined Ratio of 96 or Lower Makes it Durable

Auto insurance is a durable industry. The only risk of obsolescence is driverless cars. Car accidents are caused by human error. If all cars on the road were driven by computers – there would be virtually no car accidents. This would eliminate the need for auto insurance. The technical difficulties of developing driverless cars are not the biggest obstacle to their adoption. Even much simpler safety technologies like front air bags, side air bags, electronic stability control, and forward collision avoidance generally took 10 years from the time they were first introduced on a car sold to the public till the majority of new models sold in a given year included these features. So, the “tipping point” of safety feature adoption by manufacturers is usually around a decade. Complete adoption takes about 15 years. The average car in the U.S. is about 11 years old. This number has increased over time. Cars are more durable now than they were in the past. Based on these figures, it is likely that once the first driverless car is introduced by a major auto maker on a popular model it will take another 15 to 20 years before half of all cars are driverless. 

Auto insurance is required by state law. States will certainly not eliminate this requirement while the majority of cars are still driven by humans. Total adoption of the technology could take up to 30 years. If enough car owners prefer to drive themselves instead of letting a computer drive their car for them, there could be resistance to any laws limiting human drivers. Without such laws, highways would include a mix of human and computer driven cars. Under such conditions, laws might still equally “fault” driverless cars for accidents involving human drivers. These legal complications mean that auto insurance would probably persist into the early stages of a mostly driverless car society.

Today, there are no commercially available driverless cars. So, the end of car insurance would likely be some point 15 to 30 years after the successful introduction of driverless cars. The vast majority of net present value in a stock comes from returns generated within the first 30 years. Even if driverless cars are successfully introduced in the U.S. soon – and that is a completely speculative assumption – it is very likely that auto insurance will persist as a legal requirement for car owners for at least the next 15 to 30 years. So, even if the eventual adoption of driverless cars is a certainty – the durability of car insurers as a long-term investment is still sufficient to generate good returns for today’s investors. The shift to a driverless society is far enough in the future to justify an investment in Progressive right now.

The greatest risk to Progressive’s durability is underwriting error. Progressive writes more insurance – assumes the risk of more losses – relative to its surplus (the capital buffer available to absorb losses) than other auto insurers. One way of judging the underwriting leverage of an insurer is to look at its premiums relative to its equity plus debt (its capital). Progressive writes 2 times its capital in premiums. First Acceptance writes at 1.7 times. Infinity at 1.4 times, Mercury at 1.3 times, Safety at just 1 times, while other insurers – with large non-auto businesses – like Travelers and Chubb write at well below their capital. Underwriting leverage is only a problem when an insurer’s combined ratio – its losses and expenses divided by its premiums – exceeds 100. Companies with underwriting losses in a normal year must be very careful not to write too much insurance relative to the capital that can absorb those losses. 

To understand the risk in Progressive, it is critical to understand the concept of a combined ratio. Insurers generate a “return on sales” (sales are called premiums in the insurance industry) in two ways. One: the policyholder pays more to the insurer than the insurer pays out in corporate expenses, commissions, advertising, and losses. Two: the insurer makes money by investing the premiums paid upfront by its policyholders in securities like common stocks, preferred stock, corporate bonds, municipal bonds, and federal government debt. Different insurers try to make their money in different ways.

Historically, Progressive has generated more than half of its return on sales from its underwriting. This is unusual. In a normal year, the average insurer loses money on its underwriting. But it more than makes up for that by investing its float. Progressive earns a lot from underwriting relative to other insurers. It earns little from investing. And Progressive takes much less investment risk than other insurers. In 2013, Progressive was 75% in bonds and these bonds were actually short-term government debt due in 2 years or less. In the last 20 years, Progressive’s only major investment loss – when the company had more losses than gains on investments for the year – was during the 2008 financial crisis. Progressive held preferred stock in big banks. The company marked these securities to market. Progressive did not realize actual losses on the preferred stock. After the banks were bailed out, they continued to make payments on their preferred stock and these securities rebounded fully in value in the years since. Given today’s conservative investment policy, the investing side of Progressive’s business does not present any risks to the company’s survival even under crisis conditions worse than 2008.

All of the long-term risk in Progressive comes from the underwriting side. Because Progressive takes in double its capital base in premiums each year, any underwriting loss would lead to a hit double that magnitude relative to capital. For example, in 1991 and 2000 Progressive had a combined ratio of about 105. This means the company had an underwriting loss equal to 5% of its sales. Because sales are twice capital, the company lost about 10% of its capital in each of those years. Obviously, investment gains offset some of this loss. Progressive maintains a ratio of debt to total capital of about 25% to 30%. When debt is 30% of total capital, a 10% destruction of capital causes a 14% destruction of equity. This is because debt only absorbs losses after all of a company’s equity has been impaired.

Shareholders should focus on the amount of underwriting losses relative to equity that Progressive can cause in any one year. Assuming premiums are double capital and equity is 70% of capital, it would take a combined ratio of 112 to destroy a third of Progressive’s equity (12% * 2 = 24%; 24%/0.7 = 34%). Theoretically, it is not difficult to imagine a scenario where Progressive’s underwriting loss forced the company to raise capital by issuing stock and diluting its shareholders. In practice, Progressive’s culture minimizes the risk of large underwriting losses relative to the company’s capital cushion.

Progressive has a 96% combined ratio target. It has been remarkably consistent in averaging a combined ratio below this target. Since 1991, the company’s average combined ratio was 92.6%. In the last 20 years, the average was 92.3%. In the last 15: 92.6%. In the last 10 years: 92.5%. And over the last 5 years: 93%.  Since 1991, Progressive has failed to hit its 96 combined ratio 4 times. The company’s combined ratio was 103.6 in 1991, 96.5 in 1992, 98.3 in 1999, and 104.4 in 2000. Progressive has yet to miss its 96 combined ratio since the turn of the millennium. Some of this consistency in underwriting may be due to pricing data. Progressive updates its prices faster than any other auto insurer. It is usually the first company to raise prices. 

The most important element in Progressive’s combined ratio is not competence. It is culture. The company never changes its stated goal of growing as fast as possible while keeping a combined ratio of 96. It has always said that any growth above a combined ratio of 96 must be avoided. 

Here is what Progressive’s CFO said about the 96 combined ratio target in 2013: “(We) often get asked the question, ‘Would you consider changing your 96 combined ratio target?’ Certainly, in the most recent environment with lower interest rates, would we consider changing the combined ratio target? The simple answer to that is no. We feel that it served us well in a number of cycles, with economic cycles, (and) underwriting cycles. And for us it creates a good balance between attractive margins and competitive rates for customers. It’s important that we meet those profitability targets because we are more leveraged to underwriting results…At the end of last year, our premium to equity was close to 2.7 to 1. A peer set of other…companies…were closer to 1 to 1….This combination of disciplined underwriting, ensuring we meet our profit targets, and leverage the underwriting results is how we create good returns for shareholders.”

Talk to Geoff about Progressive’s Durability and Driverless Cars

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You Can Afford to Hold Cash

by Geoff Gannon

In my last post, I said stocks were too expensive. Instead of putting more of your money into diversified groups of stocks, you should just let cash build up in your brokerage account.

A lot of people have a fear that those lost years of making zero percent on their idle cash can never be made up for.

I’ve created a graph to show how much ground you’d have to make up.


Let’s say you have two choices: one is to invest in an overpriced basket of stocks today and hold that basket from 2015 through 2030. This choice will compound your 2015 money at a rate of 6% a year.

The second choice is to do nothing for all of 2015, 2016, 2017, 2018, and 2019. You just hold cash. That cash earns 0% for those 5 years. In 2020, you finally get an opportunity to make an investment that will return 10% a year from 2020 through 2030.

If your investment horizon extends all the way out from today through 2030, the second approach overtakes the first approach about 15 years from now.

Doing nothing for 5 years and then something smart for 10 years is a better 15 plus year strategy than “just doing anything” today.

Here we define something smart as 10% a year and “just doing anything” as 6% a year. You can decide for yourself whether your something smart is 10% a year or not. That's subjective. What the "doing anything" returns is a lot more objective. So, let's talk about that.

Over the last 15 years, the S&P 500 returned about 5% a year. During that time period, the Shiller P/E ratio contracted from 43 to 27. The same percentage contraction – 37% – would be required to get the Shiller P/E down from today’s 27 to a historically “normal” 17.

I see no reason why the S&P 500 should do better from 2015 to 2030 than it did from 2000 to 2015. That means I see no reason why buying the S&P 500 today and holding it through 2030 should be expected to return more than about 5% a year.

(Almost all readers I talk to have a total return expectation for the S&P 500 that is greater than 5% even for periods shorter than 15 years.)

It’s also worth mentioning that while I have no predictions as to when idle cash would earn more than zero percent – the Fed does. And those predictions show cash earning a few percent in 2018 and 2019 instead of zero percent.

For those reasons, the graph in this post is probably an underestimate of how quickly sitting and doing nothing till you can do something smart outperforms continuing to shovel cash into the S&P 500 at today’s prices.

I think the reason people don’t feel secure in waiting for an opportunity to do something smart is that they’re not sure when that opportunity will appear.

Maybe there will be no chance in all of 2015, 2016, 2017, 2018, 2019, 2020, or even 2021 to do something smart. If that’s true – isn’t it possible doing anything now could outperform waiting to do something smart later? If that later is sometime after 2021 – couldn’t it be better to just buy the index today?


I can only point to history.

Pick any year in the past. Then move forward 6 years from that time. In the intervening years, was there an opportunity to do something smart?

The hardest waiting period in history was during much of 1995 through 2007. Although stocks were often cheaper than they are today – the largest and best known American stocks were almost always more expensive than they had been at any time before 1995.

I think this is the real reason why investors I talk to are hesitant to hold cash. Much of their investing lifetime was spent during a time of high stock prices.

There is no advantage in buying something that is unlikely to provide a good long-term return instead of holding cash till something good comes along. If we take 15 years as long-term, we can say that the S&P 500 will not provide good long-term returns if bought today.

You can afford to avoid 5% a year type long-term commitments if you have a real chance at finding 10% a year type long-term commitments sometime in the next 5 years.

You don’t need to know exactly when or where this opportunity will come.

A lot of investors who live outside the U.S. read this blog. They have an advantage. Their home country’s stock market might provide a 10% a year opportunity sometime in the next 5 years. American investors probably won’t notice such an opportunity when it appears.

By buying into an index today, you are really saying you will just take whatever price Mr. Market gives you. You do this because you’re not sure he will ever give you a good price again. Or, if he does, it may come far more than 5 years in the future.

Caving into Mr. Market’s mood is not something value investors think is appropriate when it comes to individual stock purchases. Yet, a lot of the people who read this blog – who are otherwise value investors – feel they have no choice but to continuously add to the actively and passively managed mutual funds in their brokerage account.

The other choice is to hold cash. And the longer “long-term” is for you, the more sense holding cash makes.

It makes a lot of sense right now.

Talk to Geoff about Holding Cash

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Stocks Are Too Expensive

by Geoff Gannon

We talk about stock picking on this blog. That means we usually talk about specific stocks. The “market of stocks” not the “stock market”. Today, I’m going to talk about the stock market.

It’s too expensive.

You shouldn’t buy it.

If you have an account where you automatically reinvest your dividends – stop. If you are putting money each month into an index fund, or a stock mutual fund, or a bond mutual fund – stop. Those assets are overpriced. Any basket of stocks or bonds is overpriced. If you are saving money regularly – that newly saved money should now be going into cash instead of stocks or bonds.

The simplest rule in investing is that you never buy an obviously overpriced asset. Stocks generally and bonds generally are obviously overpriced right now. So, you need to stop buying them in a general way.

To put a number on this expensiveness, I think the Shiller P/E ratio is about 27 now. It was about 27 when I wrote my December 2006 post arguing stocks were too expensive. You can read that post later down in this one. Or you can click here to see - via the Wayback Machine - what that post actually looked like on the original site in 2006.

I am writing this post because of 3 separate items I noticed recently.

I came across one while reading an earnings call transcript for Frost (CFR). This is a usually conservatively run bank in Texas. It has a lot more deposits than loans. Deposits have kept growing. So, the company needs to put the money somewhere. And where they’ve put it is “Securities”. Frost now holds more money in securities than loans. These securities are high quality. They aren’t going to default. But they are overpriced. To get a yield near 4% on their securities portfolio – the company had to go pretty far out in terms of the maturities it would buy. In normal economic times – let’s say with a Fed Funds rate of 3% to 4% – these bonds would cost less than what Frost paid for them. At some point, there will be a 3% to 4% Fed Funds rate. I have no idea when that will be. You can look at predictions from the FOMC’s own members and see they thought it would be 3 years down the road or so. Now, if that’s true – you obviously aren’t gaining much by making less than 4% a year for less than 3 years if you will be able to make 4% a year on idle cash at the end of that period. Of course, some events may happen that prevent any increases in the Fed Funds rate for that entire 3 year period. In the 1930s in the U.S. and in the 1990s and 2000s in Japan, investors could have easily overestimated the likelihood that rates would rise within the next 3-5 years to a “normal” level. If something like that happens and you keep all your money at the Fed instead of in long-term municipal bonds and such – you’d have missed out to the point where you now still have $1 when you could have more like $1.12.

You can afford to miss out on those kind of returns. I actually think Frost can too. But, this isn't a post about Frost.

The other two examples don’t involve an actual investor. They are about the “cost of capital”. The car lock maker Strattec uses an Economic Value Added (EVA) approach. They are funding the company with equity right now instead of debt. So, their cost of capital is the cost of their equity capital. They use 10% as the cost of equity capital. Equity investors aren’t going to get 10% a year from this moment forward. Returns will be closer to 5% a year. So, Strattec is really overcharging itself for capital when it presents EVA in the annual report.

And then the last example is a Morningstar analysis I read. The analyst adjusted the value of the company up a little based on lowering the cost of capital for the company – which also uses only equity capital – from 10% a year to 9% a year. This is a concession to the reality that investors are bidding up stocks. But, the cost of equity capital is not 9%. The S&P 500 is not priced to return anywhere near 9% a year. If companies want to issue dilutive stock or borrow long-term – none of that will actually cost them 9% a year.

I understand why Frost, Strattec, and Morningstar don’t spend a lot of time saying today’s stock and bond prices are much higher than stock and bond prices have been through most of history. But not harping on that can make people forget how abnormal today's stock and bond prices are.

I think there is a big danger of complacency here. Investors seem to be pretending today’s prices are comparable enough to past prices that it’s not worth focusing on. At many points in the past, you could make close to 10% a year in stocks. Today, you can’t. And at many points in the past, it was safe to buy bonds at the market price and not expect a very large drop in their market price. Today, it’s not.

Both the likelihood of 10% returns in stocks and the unlikelihood of large paper losses in bonds was due to their prices. They were lower. As a group, stocks and bonds are the same assets they always were. Increases in the price of those groups simultaneously lowers long-term future returns and increases the risk of short-term negative returns.

A little bit later in this post I’m going to give you the entirety of something I wrote back on December 29th, 2006. That was about 8 and a half years ago. If you had stayed completely in the Dow from that moment till now rather than staying completely in cash from that moment till now the difference would be like 5% a year. Of course, you shouldn't have stayed in cash for 8 years. You should have stayed in cash till prices were "normal" again in late 2008-2010. Listening to Shiller or Grantham or this blog or any value investor would've told you prices were okay again once the crash happened.

I thought stocks were too expensive in December of 2006. The Fed Funds rate went to 0% and stayed there. Stocks are – by the Shiller P/E and other such normalized measures – a lot more expensive than they’ve ever been except for years like 2007, 1999, and 1929. So, all of those factors have helped stock returns from the end of 2006 to midway through 2015. And yet returns were no better than the about 5% or 6% a year I warned was likely back in 2006. They were not the often hoped for 9% or 10% a year that people cite as the “cost of equity” and the return investors in stocks expect long-term.

When you might earn 10% a year in the stock market – the cost of not participating is high. When the best you can hope for is 5% or 6% a year – as the period from high stock prices in 2006 back up to high stock prices again in 2015 shows – you aren’t missing much by sitting out till you get an acceptable price.

I am not saying you shouldn’t pick stocks. If you find a business you like at a price of less than 10 times normal EBIT – you can buy that business. That’s a good price in all environments.

So, you can pick absolute bargain stocks. That means a business you like at less than 10 times EBIT. The danger is settling for relative bargains. If the market trades for 15 or 20 times normal pre-tax earnings - then I can pay 13 times for this business and it's a steal. That's dangerous thinking. What you're really saying is that you can never hold cash. The best you can do is to buy something a bit cheaper than the very high price everything else happens to be priced at right now.

Obviously, you should stop contributing more cash to stock funds, bond funds, etc. Stop reinvesting your dividends. Build up cash till you find a bargain for all times – not just for these very expensive times.

I’m not going to spend the rest of this post arguing about today’s stock market level. It’s clearly too high. And future returns will be much worse than past returns. But, I’ve found it is hardest to argue about the present. It is easier to use an illustration from the past which can serve as an analog for today.

So, I am re-posting my December 29th, 2006 piece “In Defense of Extraordinary Claims”. In that post, I argued that:

“Normalized P/E ratios can fall in several ways. However, there are only two ways that seem reasonable given current conditions. Stock prices can either fall over the short-term or they can grow slowly (at less than 5-6% a year) over the long-term.”


“Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. The great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today's normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.

So, don't use historical returns as a frame of reference when thinking about future returns – and do lower your expectations!”

Just about 8 and a half years later, I want to reiterate those same two points. They are as true now as they were at the end of 2006. We are in the same place. Stocks are too expensive again. They can either drop a lot in the short-term. Or they can rise at less than 5% or 6% a year for the long-term. So, when you ask “Should I hold cash?” instead of adding to my mutual funds, reinvesting my dividends, etc. you should think of 3 possible outcomes: 1) I buy stocks and the market crashes in the short-term 2) I buy stocks and they return less than 5% to 6% for the long-term 3) I hold cash instead of buying stocks.

Because those are the only 3 reasonable outcomes. I’m not suggesting you time the market by selling stocks you already own. Nor am I suggesting you stop buying stocks that are good purchases in any market. I don’t think knowing that stocks are too expensive means you have to sell what you already own. Nor do I think it means you have to give up on buying businesses you like at less than 10 times EBIT. That’s always a good decision.

But, knowing stocks are too expensive right now should lead to you cutting off all additional contributions to your mutual funds and index funds till prices return to their normal historical range.

What is that range?

That’s the question I tried to answer in my 2006 post. Here is that post – completely unedited – and just as relevant in 2015 as it was in 2006.

I have one added note. In what you're about to read you'll see I used my own measure of the "normalized P/E ratio" for the Dow rather than the Shiller P/E for the S&P 500. It doesn't matter which you use. I'd just go with the Shiller P/E myself - and I'm the one who made up the measure you're about to see. Both normalized P/E ratios will usually tell you about the same thing at about the same time.

Shiller uses an inflation adjusted 10-year average. I use a 15-year average with a 6% nominal annual escalator in EPS.

For those who care about this stuff: My method was to apply a 6% growth rate to each of the last 15 years of earnings. So, to predict "normal" earnings in 2015 you simply project actual EPS for every individual year from 2000 through 2014 forward at a rate of 6% a year. You assume the average of all these "past projections" is more normal than what is actually reported as for 2015.


(“In Defense of Extraordinary Claims” – Originally Posted: December 29th, 2006)


About two weeks ago in a post entitled "We Have Some Bearish Bloggers Out There", Bill Rempel wrote, "Personally, I’m in the 'extraordinary claims require extraordinary proof' camp." I'd like to think I am too, because Bill is right – extraordinary claims do require extraordinary proof.

So, before making any extraordinary claims about future long-term market returns (i.e., predicting future returns that differ substantially from historical returns), I'd like to spend this post laying out the case for why current circumstances are extraordinary. After all, extraordinary times call for extraordinary claims.

Essentially, this is a post about why the present is unlike the past and what that means for the future.

In a previous post, I wrote:

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.

Unless they internalize this fact, investors risk assuming that historical returns that existed under special circumstances can continue to serve as a useful frame of reference, even when these special circumstances no longer exist.

Later in this post, I will discuss the possibility of a "paradigm shift" (i.e., a change in basic assumptions within the theory of investment) that began in 1995. The only other period in the 20th century which saw similar upheaval in investment thinking was the 1920s.

Common Stocks as Long Term Investments

That theoretical crisis (and the higher valuations that followed it) has often been partly attributed to a thin volume published in 1924 by Edgar Lawrence Smith. The book was called "Common Stocks as Long Term Investments" and it was based on a study of 56 years of market data (1866 – 1922).

Smith found that stocks had consistently outperformed bonds over the long run. Neither the data in support of this conclusion nor the logical explanation for this outperformance (public companies retain earnings and these retained earnings lead to compound growth) was wrong.

However, a few years after Smith's book was published, the special circumstances of the past disappeared as stocks (which had historically had higher yields than bonds) saw their prices surge and their yields plunge. Soon, stocks had lower yields than bonds – part of the reason for their past outperformance (the initial yield advantage) was gone and the margin of safety which a diversified group of stocks had offered over bonds narrowed considerably.

Simply put, circumstances changed. John Maynard Keynes saw this possibility when he reviewed Smith's book in 1925:

"It is dangerous…to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was."

That has been the objective of this little study from the outset. In this post, I will focus on how the circumstances of the present differ from the circumstances of the past.

I will also endeavor to demonstrate that historical returns were the result of special circumstances, which (logically) need not apply now or in the future. The historical data suggests these circumstances may yet return – and for the sake of net buyers of stocks, I hope the data is right and one day (soon) historical returns can once again serve as a useful frame of reference for the future.

Today, however, historical returns have about as much utility to the investor as the success rate of a procedure performed exclusively on 25 year-old men has for the surgeon who is preparing to operate on a 92 year-old woman.

There is nothing wrong with the data itself. But, there is something wrong with the assumption that data collected from one special case has predictive power when applied to another special case.

Cheap Stocks and Great Returns

Historical returns in equities have been great. However, it's worth noting that throughout the period we're referring to, stocks have often been cheap. How cheap?

Once again, here's a graph of the Dow's 15-year normalized P/E ratio for each year from 1935-2006:


From 1935-2006, the Dow's normalized P/E ratio ranged from 6.88 – 30.84. The Dow's average (mean) normalized P/E ratio for these years was 14.18. The median was 13.91.

Those figures include the 1995-2006 period, which I will discuss in greater detail later. For now, let's start by taking a look at the period from 1935-1994.

Until 1995, the Dow's normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41. In other words, the Dow's average 15-year normalized earnings yield was just over 8%.

I would estimate that in a little under 45% of all years, the Dow was priced such that long-term investors were effectively paying little or nothing for future earnings growth. Most market authorities would disagree with me on this point, because they would require an equity-risk premium.

Equity-Risk Premium – An Aside

This isn't the place to have a long argument about the concept of an equity-risk premium. For now, I will simply say that you can not arrive at the conclusion that there is an equity-risk premium via deductive (a priori) reasoning. If you were locked in a room alone, you would never come up with the idea of an equity-risk premium. It is only in seeing the effect that you would seek out a cause.

You can only come to the conclusion that an equity-risk premium should exist by first knowing that it has existed. You have to work backwards from the effect to the cause. That's troubling, because history consists of a series of special circumstances. It is non-repeatable.

So, the existence of a measurable aversion to stocks over some historical period does not necessarily lead to the conclusion that such an aversion is the result of a general principle (i.e., an inherent equity-risk premium). In fact, such a conclusion could merely be a contrived attempt to explain away an observable effect that has existed under certain circumstances – but needn't always exist.

The equity-risk premium isn't a general theory. It's really little more than the acknowledgement that during the historical period being studied, market participants made choices that reflect an aversion to stocks compared to the choices an optimal return seeking automaton would have made.

It's an interesting observation – but, it's not a theory.

How Common Are Cheap Markets?

Returning to the question of how often the stock market has been cheap, I would estimate that during the period from 1935-2006, the Dow was priced to offer double-digit returns somewhere between 75% and 85% of the time.

Here, I don't mean that the Dow did provide double-digit returns 75% to 85% of the time; nor, do I mean that past performance suggested it should provide such returns. Rather, I simply mean that valuing the Dow as an asset to be held until Judgment Day, would lead a clear-headed observer to conclude that double-digit returns were likely in about 75% to 85% of the years being considered.

I know this 75% to 85% number is a bit hard to swallow. So, if you don't believe me, consider what Warren Buffett wrote on the same topic in his 2002 annual letter to shareholders:

"Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge."

"The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns…we will sit on the sidelines."

Buffett's "50 or so years" of his 61 would translate into just under 82% of the time. He wrote that letter in early 2003. The four years since haven't offered the kind of opportunity he looks for, while the seven years included in the study from before Buffett started investing did offer that kind of opportunity.

So, according to my math, that would work out to be a roughly 80% estimate from Buffett over the full 1935-2006 period. That estimate falls within the 75% - 85% range I cited based on the data.

I think this 75%-85% range is the best estimate you'll find for how often the market has been so cheap as to offer double-digit returns when valued as an asset with a holding period of forever.

Unfortunately, I'm afraid a lot of investors don't realize (or haven't internalized) just how often the stock market has been really cheap. During the 1935-2006 period, stocks were priced as clear bargains in about 8 out of every 10 years. Buffett supports this conclusion with his assertion that stocks could be "purchased at attractive prices" about 80% of the time (50 out of 61 years).

If investors don't start with an understanding of the fact that stocks have been so cheap so often, they won't be able to put the historical data in its proper context. If you have a population that consists of 80% x and 20% y, is it reasonable to assume that data based on the entire population is a good reference point for your subject, if you know your subject is a y rather than an x?

In terms of valuation, 2006 (and thus 2007) is undoubtedly a minority year. Unfortunately, data based on a full population sometimes has little or no relevance when applied to a member of a minority group.

For instance, Turkey's population is 80% Turkish and 20% Kurdish. My guess is that data based solely on the full population of the country (which would consist of 80% ethnic Turks) would tell you very little about any particular Kurd. Now, if you broke the data you had collected down into a Turkish group and a Kurdish group and used the Kurdish group to predict something about an individual Kurd – then, you might be on to something.

A More Detailed Look

From 1935-2006, the Dow's normalized P/E ratio ranged from 6.88 to 30.84. The Dow's average (mean) normalized P/E ratio for these years was 14.18. The median was 13.91. In half of all years, the Dow's normalized P/E ratio fell between 10.53 and 16.43.

Here's a breakdown of how common various normalized P/E ratios were from 1935-2006.

Normalized P/E of 5-10: 18 of 72 years or 25.00% of the time

Normalized P/E of 10-15: 28 of 72 years or 38.89% of the time

Normalized P/E of 15-20: 17 of 72 years or 23.61% of the time

Normalized P/E of 20-25: 5 of 72 years or 6.94% of the time

Normalized P/E of 25-30: 3 of 72 years or 4.17% of the time

Normalized P/E of 30-35: 1 of 72 years or 1.39% of the time

Fifteen Years Later…

For the years with a normalized P/E ratio between 5 and 10, compound point growth in the Dow over the subsequent fifteen years ranged from 4.01% to 15.69%. The average (mean) growth rate was 10.17%. The median growth rate was 10.03%.

For the years with a normalized P/E ratio between 10 and 15, compound point growth in the Dow over the subsequent fifteen years ranged from 0.92% to 12.28%. The average (mean) growth rate was 7.01%. The median growth rate was 8.17%.

For the years with a normalized P/E ratio between 15 and 20, compound point growth in the Dow over the subsequent fifteen years ranged from (0.14%) to 8.93%. The average (mean) growth rate was 2.19%. The median growth rate was 1.76%.

I'd love to show you the same data for the three highest normalized P/E groups. But, I can't.

There is no fifteen year point growth data for years with a normalized P/E over 20, because the Dow didn't record a year with a normalized P/E ratio above 20 until 1996. In fact, until 1995, the highest normalized P/E ratio on record was 17.40 – that high-water mark was reached in 1965. With the benefit of hindsight we now know 1965 was not an ideal year to buy stocks for the long-run.

Rising Multiples?

Today's normalized P/E ratio is extremely high. So what? Hasn't the normalized P/E ratio been rising over time, as investors have come to realize a diversified group of stocks held for the long-run is actually a low-risk, high-reward bet?

I'll let you judge for yourself. I won't even connect the dots for fear of biasing you.

Here's a chart showing the Dow's 15-year normalized P/E ratio for each year from 1935-1994:


Do you see a trend towards higher normalized P/E ratios over time?

I cut the graph off at 1995 for a reason. That's the year everything changed. You'll remember I said the Dow's highest normalized P/E ratio had been 17.40 reached in 1965.

Although I didn't include the data necessary to compute 15-year normalized P/E ratios for years before 1935, I do have enough data to know that the three "peak" normalized P/E ratio years during the 20th century were 1929, 1965, and 1999.

By "peak" years, I simply mean the three highest years that aren't part of a chain of continuously higher normalized P/E years – unless they're the highest year in that chain. Without this qualifier, the highest normalized P/E list would be monopolized by the years from 1995 – 2006. Each year in that group had a higher normalized P/E ratio than every year prior to 1995.

In other words, since 1995, the Dow's normalized P/E ratio hasn't just been above the mean, it's been above the entire normalized P/E ratio range from 1935-1994. You can see that clearly in this graph, which shows the Dow's normalized P/E ratio for each year from 1935 – 2006:


This graph is essentially just a continuation of the earlier graph. In fact, if you cover the points from 1995 – 2006, you can see the familiar outline of that graph with its long undulations and its frothy crest at 17.40. That bound was reached in 1965. In 1995, the Dow broke out of this upper bound and hasn't returned since.

Terra Incognita

In this graph, it certainly does look like there's a trend toward higher normalized P/E ratios. However, that trend only emerged over the last decade – not the last century.

In other words, the Dow's normalized P/E ratio hasn't been rising over time. It simply surged in the 1990s. That surge may be justified. However, it's certainly a departure from the historical data. As a result, there's no reason to believe historical returns from 1935-1994 have any utility whatsoever in predicting market returns in the new era that has emerged since 1995.

All the historical return data from before 1995 was based on lower normalized P/E ratios. Once again, I don't mean the pre-1995 period had lower average normalized P/E ratios – I mean that no year from before 1995 had a normalized P/E ratio equal to or greater than any year from 1995 through today. Simply put, since 1995, market valuations have been in completely uncharted territory.

The only years with normalized valuations comparable to today's occurred during the 1995-2006 period. So, referring to historical return data requires a choice between using data from recent years or using data from dissimilar years.

Paradigm Shift?

Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold.

I won't dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won't enough investors wise up to this fact and cause the so-called "equity-risk premium" to disappear.

If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future returns to fall short of historical returns. But, there's no logical reason why normalized P/E ratios must revert to the mean – future returns can be adjusted down, allowing current prices to remain high.

That's true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear).

At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it's hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option – though it's theoretically possible if long-term interest rates are very, very close to zero.

But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn't necessarily have to fall – they could simply offer much lower returns than they had in the past. This could continue indefinitely – in theory.

I say "in theory", because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data.

Before 1995, the Dow's normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41.

So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm?

Maybe. If we really are in a new era, the old historical return data isn't relevant – it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren't in a new era, the old historical return data is relevant – and normalized P/E ratios must fall.

Adjusting to the Norm

Normalized P/E ratios can fall in several ways. However, there are only two ways that seem reasonable given current conditions. Stock prices can either fall over the short-term or they can grow slowly (at less than 5-6% a year) over the long-term.

The data from 1935-2006 doesn't provide much support to one route over the other. In the past, extraordinarily high normalized P/E ratios have been brought down to more normal levels through crashes and through stagnant markets.

The market can reach a more "normal" normalized P/E ratio by going down fast or going sideways for a very long time. During the 20th century, we saw normalized P/E ratios fall both ways.

To return to the 1935-1994 normalized P/E range, the Dow would need to trade around 10,135. That would simply bring it down to a valuation comparable to 1965.

To return to the average normalized P/E ratio for 1935-2006, the Dow would need to trade around 8,260. If the Dow were to trade at the average normalized P/E ratio for the 1935-1994 period, it would need to trade around 7,230.

Are any of these numbers likely destinations? The truth is stocks have probably been too cheap in the past and they're probably too expensive today. Regardless, the Dow has been above 1965's old normalized P/E high since 1995. So, for a little over a decade now, the market has been in uncharted territory. A normalized P/E ratio of 20-25 (today's is about 21.50) is quite compatible with decent long-term returns for stocks relative to other asset classes.

However, such high normalized P/E ratios are not compatible with the kind of long-term returns seen during much of the 20th century.


Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. The great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today's normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.

So, don't use historical returns as a frame of reference when thinking about future returns – and do lower your expectations!

(End of December 29th, 2006 repost)

How to Judge a Business’s Durability

by Geoff Gannon

My last post listed examples of threats to a company’s durability. This post will be about how we assess those threats. You can always imagine a threat. Is it a realistic threat? How do you judge that?

There are some industries where durability is pretty much perfect. The business doesn’t change much. Barriers to entry are high. The future development of substitutes is unlikely. Location advantages are big.

A good example is lime. Lime is reactive and has a short shelf life. You don’t store it speculatively. You don’t import it and export it. Customers need to get their lime from a deposit being worked somewhere within a few hundred miles of them. Over the last 100 or so years, the real price of lime hasn’t changed that much (real price volatility compared to other commodities is quite low). The price right now is perfectly in line with the real average price per ton since 1900. Lime consumption in the U.S. was no higher last year than it was in 1998. The industry is more consolidated and perhaps less competitive than it was in 1998. I don’t think capacity is being fully utilized now. And I do think inflation will always be passed on to customers (as it was over the last 100 years). So, if Quan and I were to research a company like United States Lime & Minerals (USLM), we could probably start by assuming that last year’s EBIT would – in real terms – represent that company’s durable earning power. That could be our starting point for a buy and hold analysis.   

That’s usually not the case. Even when we find a company that has a long history of being the leader in its field – say Strattec in car locks and keys, H&R Block in assisted tax preparation, etc. – there is a risk of change. In these two cases, we know there will be change in the product. For example, more people will prepare and file their taxes online in the future than they do now. And more drivers will enter and start their cars with the use of electronics instead of physical locks and keys. What we don’t know is how that will affect the companies.

Take H&R Block. The company competes in assisted tax preparation. In the 1990s and 2000s, many people switched to using software and then online products to prepare their taxes. But who were these people?

Most were people who had always prepared their taxes themselves. I use TurboTax and know a lot of people who use TurboTax as well. But, I actually don’t know anyone who used H&R Block even once in their lifetime and now uses TurboTax. Everyone I know who uses TurboTax used to – decades ago – prepare their taxes themselves using a pen and paper and a calculator. They didn’t use a CPA. And they didn’t use H&R Block.

Now, this is anecdotal. But, if I hadn’t asked the question “who are these people” I might have assumed that if tens of millions of people are switching to online tax preparation they are coming from companies that include H&R Block. Maybe they are. But, maybe they are a different segment of the market. If you ask that question: “Who are these people?” you can then start an investigation into how customers are segmented.

But, this still presents two problems. One, even if the migration to TurboTax and its competitors was all from do-it-yourself tax filers – that doesn’t mean that is the only group that will switch.

The other problem is that I just mentioned I use TurboTax – I don’t use assisted tax preparation. Most people I know don’t either. This means I will have a poor understanding of H&R Block’s core customer. I will make the mistake of assuming that the tax preparation market is made up of customers like me and people I know – when that’s probably half the market or less.

So, I won’t understand why some people get assistance preparing their taxes. And I won’t understand why these people don’t just switch to something like TurboTax.

This is a very common problem. We run into it all the time.

I’ll give you an example of a stock Quan and I wanted to pick for Singular Diligence – but the price got away from us before we could. It’s a U.K. company called “Greggs”. I live in the U.S. Quan lives in Vietnam. The last time I was in the U.K. was more than 15 years ago. The fast food industry in the U.K. has changed since then. So, we started from a position of real difficulty in understanding the customer. Quan and I are foreigners as far as the analysis of Greggs is concerned. And we’re not even there on the ground to do scuttlebutt. So, this was a tough stock to analyze. Now, we benefited from being in contact – via email – with more than one person in the U.K. So, we could have people visit multiple Greggs locations in the U.K. and report back to us. This was helpful.

But, there was another problem. A cultural one. The folks who write about stocks in the U.K. are not – it turns out – the folks who go to Greggs. The people in the U.K. who write about stocks and who work in that industry skew heavily toward being higher income and London based. London is part of the U.K. But, most of the U.K. isn’t London. And quite a lot of Greggs isn’t London.

So, there is a serious danger here. It’s particularly serious because Quan and I don’t live in the U.K. So, if analysts at an investment bank or a New York Times reporter or someone like that says something about America’s Car-Mart I can say to Quan: “That’s irrelevant. People in New York City know no more about Arkansas than you do. And none of these people know anything about not being able to buy a 9-year old used car without credit and not having a credit card to charge it to.”

I know that we need to get in touch with people who know more about the places where America’s Car-Mart operates and the people who buy cars there. I know not to trust a New York based source’s opinion about an Arkansas based business. And I know not to trust a source with a six-figure income about the need for sub-prime borrowing.  

That’s obvious to me when dealing with America’s Car-Mart because I live in the U.S. It’s a lot less obvious when dealing with a stock like Greggs.

This is the number one most important part of scuttlebutt: talking to the customer. To understand durability, we need to understand customer behavior.

Now, sometimes the customer lies or can’t articulate how exactly they make their choices. But, even then – I think they usually give away a lot. For example, when looking at why Weight Watchers members quit – a lot of customers will cite cost.

However, most customers will admit there are other reasons besides saving money. And they will often berate themselves in a way that makes it clear there is a gap between their words and their actions. Cutting out a monthly expense is a good excuse. But, really they want to quit because it is hard or they have already reached their weight goal or something like that. So, in the case of Weight Watchers some customers say they quit to save money – but we don’t believe them. Even though we don’t believe them, we still need to hear from them. Because we can still gain information both about why they claim to be quitting and why we think they are actually quitting from their own words.

For some businesses, Quan and I are able to get a very good explanation of customer behavior. For example, I think we have a pretty perfect 3 part model for how Americans choose which supermarket to go to:

  1. Convenience

  2. Selection

  3. Price

We’re pretty confident that you can explain the vast majority of customer defections in the supermarket industry in terms of a store’s failure of either convenience, selection, or price relative to another local option. In the case of U.S. supermarket shoppers, we can also say that “local” usually means about a 3 mile radius. This last claim has been tested in an academic paper. It is used by a major U.S. supermarket in its 10-K to explain the range in which they think competition occurs. And it is supported anecdotally.

These 4 assumptions were very important for us in deciding whether or not Village Supermarket was a durable business. Village Supermarket operates – mostly quite large – Shop-Rite supermarkets in Northern New Jersey, parts of Southern New Jersey, and now a couple stores in Maryland. New Jersey and Maryland are very densely populated places. New Jersey doesn’t grow much. Barriers to entry in the local markets where Village competes seem to be very high.

I’ll use an anecdote to illustrate. I grew up in a town that is within a Village store’s “circle of convenience”. I lived in that town for about 25 years. For most of those 25 years, you had 3 supermarkets to choose from. For part of those 25 years, you had 4 supermarkets to choose from. All the locations that were supermarkets when my parents moved to that town are still supermarkets today. Some are operated by different companies – but only because they bought the parent company. One location was added. The addition in capacity was much smaller than the increase in local population. The one new store was in a completely newly built shopping center that had previously been undeveloped land (which is quite rare in that part of the country). The existing stores in town invested in expanding square footage, parking, etc. to the extent this was possible.

So, this is an oligopoly where you don’t close the existing sites and you rarely add new capacity. You reinvest in the existing sites as much as possible. But, the number of suitable locations for a brand new supermarket of the ideal size is low. Village leases stores for 20-40 years. It owns some others. So, it’s not like suitable sites for a 60,000 square foot supermarket come up every day in Village’s region.

This information allowed us to ask questions about competition from Wal-Mart, online, etc. We could dismiss Wal-Mart right away. It’s harder to build a Wal-Mart than a traditional supermarket in Northern New Jersey. This market is tougher than the ones Wal-Mart normally competes in. And we knew that Wal-Mart draws from a much tighter “circle of convenience” for its grocery shopping than for its other product categories. Wal-Mart draws from exactly the same circle of convenience as traditional supermarkets. If a Wal-Mart opens 10 miles from a supermarket, it has no impact on the profitability of that supermarket. Remember, 10 miles is a 20 minute drive. You don’t actually average speeds better than 30 miles per hour in your local area. So, Wal-Mart is one threat to durability we did not take seriously.

The next is online groceries. Shop-Rites have competed with Peapod for like a decade now. If you compare the online groceries to in-store groceries in terms of convenience, price, and selection – online has no advantages. You need a scheduled time for delivery. So, it’s no more convenient. You need to tip. Given the size of the average grocery order and the tip people give, you are adding 10% or so to the price of your shopping trip. And, to date, online grocery selection has been narrower than in-store even for companies that use their stores as the distribution point for online.

Finally, there is The Fresh Market. This is a real threat to Village’s durability. The Fresh Market has the best business model for entry into the New Jersey grocery market. Its stores are smaller. The up-front capital costs are lower. The payback period is quicker. And it can siphon off high gross profit sales even if a customer uses The Fresh Market for perishables and Village for non-perishables. Margins are good in perishables. So, The Fresh Market is a big threat. The barrier to entry is lower for The Fresh Market than it is for Wal-Mart, Village, etc. You can put a Fresh Market where you would be unable to put a Village or a Wal-Mart. Generally speaking, a Fresh Market can be as small as half the size of a Village store while a Village store could be half the size of a Wal-Mart.

The Fresh Market has no advantages in price. And it has narrow selection in non-perishables. But, it can be quite convenient and have strong selection for the perishables shopping for a household. A lot of grocery shoppers make more than one trip a week of unequal size. It’s a real danger that a household will split its shopping between a traditional supermarket like Village and a perishables focused format like The Fresh Market.

So, we highlighted The Fresh Market as the biggest risk to Village in our Singular Diligence issue on the stock. And that’s really from thinking about customer behavior and barriers to entry. We disagreed with the arguments in favor of online groceries and Wal-Mart because those options don’t perform especially well in terms of convenience, selection, and price. And because it’s hard to put a Wal-Mart close enough to one of Village’s Shop-Rites to make a difference.

It’s also worth mentioning that opening a Wal-Mart in a local market wouldn’t necessarily have the long-term impact you might expect. If there are 3 supermarkets and you add a Wal-Mart, it’s entirely possible that the now 4th place store will eventually close. In most cases, Village wouldn’t be the operator of the marginal store. We just didn’t feel that the ratio of households to supermarkets in a local area was likely to change except if you added a Fresh Market. That was very likely to increase competition permanently in the town. Because we could easily see how The Fresh Market could enter a town and yet no one else would exit that town. And that would leave the incumbents worse off.

You can also see here that one reason why it’s easier for us to analyze Wal-Mart and online groceries is because they aren’t asymmetric with Village. Village can sell online groceries too. Wal-Mart doesn’t have an easier time adding a location in Village’s markets than Village itself does. And we know Village has a hard time adding locations.

Situations like Greggs and Weight Watchers are different. The competition people were suggesting would be a problem for those companies was positioned quite differently. With Greggs, we would get comments that people wouldn’t want cheap and unhealthy good. They would be willing to pay up for food that is healthier, fresher, etc. And I’m sure some people will. There was just a danger that we were hearing more from that segment of the total customer pool than from the segment that appreciated cheap and filling food.

So, we make a special effort to talk not only with customers of the industry – but some core customers of the company itself.

Western Union is another case where there was tough. Most information out there about Western Union – in the media, on blogs, among analysts, etc. – is written by people who are really, really far from Western Union’s core customers. They don’t have any use for the service. They don’t know people who do have a use for the service. And so they can have a lot of misconceptions.

Now, this one was easier for us because Quan lives in Vietnam and spent several years in the United States. A lot of people from Vietnam take up residence in the U.S. and elsewhere around the world and send money back to Vietnam. So, Quan knew lots of people who use Western Union and competing services.

We were able to talk to these customers. And they were able to explain their behavior. Sometimes, we wouldn’t have correctly imagined customer decision making without talking to them. For example, we would have underestimated the importance of the receiver in deciding which service to use. We knew this was important. But, until we spoke to customers – I don’t think we realized that for most senders they go with the service that the person receiving the money asks them to use. So, if you are sending money back to your mom – you use Western Union because she says there is a location she likes right around the corner. Also, until talking to customers – I underestimated the importance of convenience like the exact hours of the location and whether they will deliver the money to your door and things like that.

I think talking to customers is always the most important part of assessing durability. I also think it’s the most important part of scuttlebutt. People ask all the time if we talk to management. The answer is that we do when we can – but we’ve never found it that useful. I might be overstating that. But, right now, I can’t think of a single time where something a CFO – for example – said was more useful to us than information we got from somewhere else. We’ve quoted CFOs in Singular Diligence a couple times before – but really only because it was a nice, clean, concise quote to use. I can’t think of a time when they gave us information we found particularly useful.

That is not true of customers and the people at the company we’re researching who deal directly with those customers. We got really good information from store managers at America’s Car-Mart. We got good information from customers of Breeze-Eastern and their competitor UTC in helicopter rescue hoists. We get good information from dealers. Actually, independent dealers are probably the best source of information because they deal directly with both the company we’re interested in and with the end users and yet they aren’t employees of the company. Tandy was a very interesting case because Tandy’s biggest customers and biggest competitors are the same people. So, when they told you they bought something from Tandy they were also really telling you why Tandy could sell that particular thing economically and they couldn’t.

Until Majestic Wine made its change in direction by firing its CEO and acquiring an online wine seller – we were definitely going to write about that stock. And that’s another U.K. company. So, despite the difficulties of researching a foreign stock, it’s something we’re still willing to do. I should say researching a company with customers in another country. Because it’s not like we have any difficulty analyzing Ekornes – a Norwegian company – when it comes to sales in the U.S. And Western Union is a U.S. company. But, the receive side is almost always not in the U.S. So, at least half of every transaction is decided by a customer in another country. And the person making decisions in this country was often born in another country – so, Western Union can also be considered a case of difficulty understanding “foreign” customer behavior.

Now, I am going to contradict everything I’ve been saying up to this point. So far, I’ve said the most important part of judging durability for us has been talking to customers. I said we like to get information from the two sides of a deal. If we can find the person inside the company who makes the actual sale – we’d be happy to talk to them. And if we can find the person on the buyer’s side who sits across the table from them – that’s our best source of information on durability.

But, there are two cases that prove we sometimes ignore this source of information. One, is Q-Logic. We got information from folks who operate storage area networks. The information was very good as far as proving Q-Logic’s durability. But, there was a problem. The information was good in explaining why companies who are direct customers of Q-Logic and companies that are the end users would want to stick with their existing solution. The information was not so good in explaining the durability of storage area networks themselves. See, the people we were talking to made their living off storage area networks. They obviously believed they were indispensable. We’ve yet to have a source tell us “This thing I spend every day working on is a total buggy whip. It’ll be gone in 10 years and my job along with it.” No one’s ever said that to us. They might think other parts of their company are doing dumb things. They might think their competitors will soon be extinct. They might even think their suppliers will soon be extinct. But, they never think their own job will ever be in jeopardy. So, that’s a problem. And I just wasn’t sure that we were getting good information on the wider durability issues at Q-Logic. However, the information we did get suggested a lot of “stickiness” in terms of people in IT being reluctant to change their behaviors.

So, that’s an example of where the scuttlebutt on durability was all excellent and yet I wasn’t so sure.

Now, let’s take a look at an example where we had zero scuttlebutt supporting the durability of the business – and yet I was completely sold on the idea the company would last.

We’re talking about Babcock & Wilcox. I’m going to simplify here. I’m breaking down the company into 2 parts instead of the 6 or so it really had. And I’m pretending the only power plants it served burned coal – when really some burned other stuff. So, when we analyzed this business it had two key parts. It made boilers and related equipment for coal power plants in the U.S. and elsewhere in the world. And it made nuclear (fusion) components for use onboard U.S. Navy ships.

The U.S. Navy only uses nuclear power on 3 types of ships: 1) Aircraft carriers 2) Ballistic missile submarines 3) Attack submarines. So, you have to be sure of the durability of aircraft carriers and submarines. You also have to be sure they’ll be nuclear powered. There are huge advantages to using nuclear power on ships you want roaming the globe without the need to refuel. So, let’s put that aside as a given. We’re still left with the a military and political question: “Will the U.S. Navy keep wanting aircraft carriers, ballistic missile subs, and attack subs?” And how can I possibly know they will? I don’t know more about global military strategy than the average person reading this blog post. I don’t know more about the politics of the U.S. Navy’s budget. So, how can I be sure these programs are durable?

And this is where we have to admit it’s all speculative. I read what the programs are and what they are used for. I thought they had some of the greatest strategic importance of any defense programs I could think of. And I asked: “Would you cut these programs or some other programs instead?” And my feeling was that if the U.S. Navy had these 3 programs and little else – it’d still have a lot of weight in the world.

I also thought that the Navy doesn’t have much incentive to reduce its budget. It has less than a for profit buyer.

Can we say Babcock & Wilcox is perfectly durable – either in regard to boilers or nuclear power on ships?

No. But, I think we can compare it to all the other stocks we might buy and compared to almost all of our other choices say it’s more durable. The preferences of the U.S. Navy should change less over the next 30 years than the preferences of most customers in most industries.

But there’s an example of pure speculation. I have absolutely no scuttlebutt to go on when it comes to Babcock & Wilcox. I only have the same reports on coal power plants, the U.S. Navy’s plans, etc. that everyone else can read. We did that issue with no information gained through our own interviews.

Assessing durability is ultimately speculative. I was not sure enough about Q-Logic’s durability even though I had customer testimony in support of that product’s durability. And I was sure enough about Babcock’s durability even though I had no customer testimony in support of that product’s durability.

I still think getting testimony from customers and dealers is important. I think the two people on either side of the actual buyer-seller negotiation are who you want to talk to judge durability. But, I also think that assessing durability is maybe 50% testimony and 50% pure speculation.

In some cases, it’s 100% pure speculation. I speculated on Babcock’s durability with no quotes in support of it being durable. I just assumed based on what I – and everyone – knows about the buyer and the projects that they were durable.

Sometimes I’m not willing to make that speculation. Quan recently pointed me to a good short post on Strattec over at Value Investors Club. I don’t know if Strattec is durable or not. But, I don’t think I can speculate on its durability without customer testimony in support of that durability. So, I’m willing to speculate based only on widely available sources that Babcock is durable. But, I’m not willing to speculate that Strattec is durable.

What’s the lesson from that?

I don’t know. I don’t think Warren Buffett does much scuttlebutt anymore. But, I don’t think he’d be able to do as little scuttlebutt now unless he had done a lot decades ago. Still, he sometimes does. For example, he mentioned that before buying IBM stock he talked to the IT departments at some of Berkshire’s subsidiaries to see how sticky their relationship with IBM was. Quan did the same thing with Q-Logic. But, I wasn’t sure of Q-Logic’s durability.

Some of this may just be bias. Nuclear power is very old and really in a way abandoned tech. Most people have given up on it. Babcock gave up on civilian nuclear in the U.S. after Three Mile Island. If the tech hadn’t been abandoned that way – I don’t think I’d be as interested in Babcock. In both nuclear reactors and boilers, what they do is really engineering rather than technology. But, some people might say IBM is as much a client based professional service firm as it is a tech company. I don’t understand IBM well enough to say one way or the other. My fear is that a lot of people are interested in the ecosystems that IBM and Q-Logic and companies like that compete in. No one is really interested in doing what Babcock does unless they’ve been doing it forever. Nuclear and steam aren’t very sexy.

That’s an explanation Quan and I often fall back on. This industry is safe because no one ever seems to enter it and no one ever seems to want to enter it. It’s really just an appeal to history. If the history of the industry has been that competition is limited – then the future of the industry will be that competition is limited.

Is that a valid way of thinking?

Using history instead of just spitballing possible things that could put the company out of business makes sense. Spitballing doomsday scenarios may seem prudent. But, it’s really just an exercise in paranoia. Companies that don’t change a lot in industries that don’t change a lot are probably safer bets than companies that do change a lot in industries that do change a lot. I’m not sure how prescient you can be unless your prescience consists entirely of just saying “The future will look a lot like the past.” I definitely believe in that kind of prescience. Quan and I always try to come up with a reason or two for why the future won’t look like the past. But, that’s really speculative.

So, there are three approaches you can use to judge durability. One, you could gather testimony about customer behavior. Two, you can go by the history of the industry. Three, you can use a purely theoretical – that is, purely speculative – approach by trying to work out the adoption of future technologies and trends and how that can shift the economics of the industry. I did that for you with Village Supermarket. That discussion was mostly just speculation. It was like something out of a microeconomics textbook. I think that approach has an inherent appeal to most people reading this. It feels like it should be right. And it feels like the kind of work you should be doing. I obviously think it has a place – or I wouldn’t have analyzed Village that way.

But, I don’t think that you should give more weight to theory than you do to scuttlebutt and history. Industry history is a record of the economic interactions that really – not just theoretically – happened. And scuttlebutt can provide an insight into customer behavior which is really what product economics is all about. If you talk to customers, they will tell you about their willingness to pay. And they will especially tell you how “sticky” they are and why they stick with their current choice instead of going and searching for an alternative.

So my advice for how to judge durability is: talk to customers, study as much of the industry’s history going as far back as you can, and try to sketch out the economics of entering the market.

The biggest caveat is not to have too much faith in your calculations on industry economics. You can probably determine who has relatively high costs, who uses relatively high amounts of assets, etc. But don’t put too much faith in the quantities involved. The relationships between players are what matters – the numbers are less important.

Talk to Geoff about How to Judge a Business’s Durability

Check Out Singular Diligence




You Can Always Come Up With a Reason For Why the Stock You Are Researching is Actually About to Go Out of Business

by Geoff Gannon

Someone who reads the blog sent me an email asking how Quan and I judge qualitative factors like a company’s durability.

For most stocks, you can easily imagine a future condition that would obsolete the entire business model.

I’ve decided to make this post nothing but a series of examples.


John Wiley

Open access journal articles.

There is a whole Wikipedia page about this one. The idea here is that someone else will pay the cost of publishing journals in place of the subscriber.


Weight Watchers


Dieters will use free apps like MyFitnessPal to count calories instead of going to meetings or using websites like Weight Watchers.



Illegal marketing.

Without aggressive marketing aimed at old people – would this product even exist? You can read about the FCA (a U.K. regulator) fine imposed on HomeServe and the reasons for it here.


Ark Restaurants

Leases expire.

Ark may not renew its leases because the casino or other landlord would want to charge a lot more rent now that the location and the restaurant is a proven success. So, Ark as a corporation has a finite lifespan except insofar as management reallocates capital to new sites.


Village Supermarket

Online groceries.

Traditional supermarkets have 3 durability risks people raise: 1) Online groceries 2) Wal-Mart 3) Organic and fresh competitors: The Fresh Market, Whole Foods, etc.


America’s Car-Mart


America’s Car-Mart sells used cars so it can collect interest on high risk auto loans. The difficult parts of the business are underwriting and collecting loans. If this could be centralized – as it is in lower risk subprime auto loans – then the loans would become commodities.



Online dog food.

The two concerns here are that places like Wal-Mart can sell more dog food and websites like Petflow can sell more dog food.


Atlantic Tele-Network

Guyana can take away their monopoly.



British shoppers will stop frequenting high streets. Or, they will eat healthier food instead.



Self-driving cars will eliminate accidents and therefore the need for auto-insurance.


Babcock & Wilcox

U.S. utilities will shift away from coal power plants – which use boilers – toward natural gas, wind, and solar power plants which don’t use boilers.

The U.S. Navy could stop using: nuclear powered aircraft carriers, nuclear powered ballistic missile submarines, and nuclear powered attack submarines.  



People will wear products like the Apple Watch instead.






Same. Plus, Michael Kors may be a fad.


Western Union

Online competitors like Xoom can replace agent location based money transfers.


Hunter Douglas

Big box retailers like Home Depot and Lowe’s can sell blinds in their stores. Blinds can be sold online. As a result, people will stop going to the independent dealers that Hunter Douglas gets all its sales through.



Smart keys and push to start ignitions can eliminate the need for locks and keys used in car doors and the steering column.



The cloud will eliminate the need for storage area networks.

Talk to Geoff about Durability

Check Out Singular Diligence

Babcock & Wilcox Sets Spin-Off Dates

by Geoff Gannon

Babcock & Wilcox (BWC) has set the dates for its spin-off. Those who own the stock on June 18th will get their spin-off shares on June 30th:

"As a result of the spin-off, Company stockholders can expect to receive as a dividend one share of New B&W common stock for every two shares of the Company’s common stock held as of 5:00 p.m. EST on June 18, 2015, the record date. The distribution of New B&W shares is expected to occur on June 30, 2015 and is expected to be tax-free. "

Shareholders will then own two separately traded stocks. The stock with the “BWXT” ticker will be the government business. The stock with the “BW” ticker will be the power plant business.

The press release gives an accurate description of what “BWXT” will be:

“BWXT is the sole manufacturer of naval nuclear reactors for submarines and aircraft carriers; provides nuclear fuel to the U.S. government; provides technical, management and site services to aid governments in the operation of complex facilities and environmental remediation activities; and supplies precision manufactured components and services for the commercial nuclear power industry.”

It gives a poor description of what “BW” will be:

“New B&W will continue to be a leader in clean energy and environmental technologies for the power and industrial sectors. New B&W also will provide one of the most comprehensive platforms of aftermarket services to a large global installed base of power generation facilities.”

BW is really the boiler business. They build boilers and related equipment for power plants. Some of those plants are clean energy plants – but a great many are actually coal power plants.

Babcock & Wilcox was a Singular Diligence stock pick. I own the stock personally. Quan does not. I plan to keep both my “BWXT” shares and “BW” shares indefinitely.

I’ll let you know if that changes.

Read the Babcock & Wilcox (BWC) Press Release

Check out Singular Diligence

Talk to Geoff about Babcock & Wilcox (BWC)



Our November 2013 Issue on Life Time Fitness

by Geoff Gannon

Life Time Fitness (LTM) now trades at $71.86. The company’s board unanimously agreed to be taken private at $72.10 a share in cash. The merger is expected to close on June 10th. It is now May 19th. So, I’m going to call this one effectively over as a public company.

Quan and I did an issue on Life Time Fitness for Singular Diligence (back when it was called The Avid Hog) in November 2013. The stock price was then $48.51 a share. We appraised it at $79.69 per share.

With the stock trading right below the going private price – the value’s been fully sucked out of this idea.

So, we might as will give the issue away now.


Singular Diligence: Life Time Fitness Issue - November, 2013 (PDF)

Swatch's Moat

by Geoff Gannon

The stock picked for the latest Singular Diligence issue was Swatch. Each issue of Singular Diligence includes articles on: 1) Overview, 2) Durability, 3) Moat, 4) Quality, 5) Capital Allocation, 6) Value, 7) Growth, 8) Misjudgment, and 9) Conclusion.

Here is one of those 9 articles – the moat article – from this month’s issue on Swatch.



Swatch, Richemont, and Rolex Will Always Dominate Swiss Watchmaking

Swatch’s moat varies depending on the price category. Swatch’s moat is widest for brands that retail between $800 and $10,000. The moat is narrower for watches that cost more than $10,000 or less than $800. This is because there are several distinct sources of moat in the watchmaking business. The greatest combination of moats happens in the watches in the middle price categories. These watches are expensive enough that the “Swiss Made” label and the brand name are important. However, they are inexpensive enough that manufacturing still involves mass production in some sense for some of the parts. This is not true of very expensive watches. Some watchmakers who focus on watches over $10,000 can make very, very few watches each year. So there are few production advantages in this category. The watches are also so expensive that a boutique mono brand store can be opened in just a few high end retail stores in cities around the world. So distribution power is not as important. Swatch has more production advantages than any other Swiss watchmaker. Rolex also has strong production capabilities as will be explained in a moment. Some other companies – like Richemont – have some production capabilities. They are much more than mere assemblers. But they are not as self-sufficient as they might appear. Swatch is vertically integrated. It does not need any outside company to exist for it to be able to produce its brands.

Let’s start with production. There are no production advantages in low-end mechanical movements that are not “Swiss Made”. A Japanese or Chinese company or a manufacturer of licensed brands that does not care if the watch carries a “Swiss Made” label can easily get a supply of foreign (non-Swiss) mechanical movements. The governments of both China and India encouraged the production of mechanical movements in the hopes of stimulating a domestic watchmaking industry. So, if a watchmaker does not care about the “Swiss Made” label they can buy movements from a Japanese company like Seiko or Citizen or from a movement maker in China or India. As a result, there is no production advantage – no moat for Swatch – in watch categories that do not rely on the “Swiss Made” label. For watches that do rely on the “Swiss Made” label, Swatch has a big production moat. To earn the “Swiss Made” label a watch must meet several requirements. One of these requirements is that the movement must be made in Switzerland. There are very few Swiss movement makers. It is difficult to get information on mechanical movement market share in Switzerland. But a 2011 analyst report provides a good guess. That report estimated that the market is about 5.5 million mechanical movements. Swatch’s ETA makes about 55% of those movements. Sellita has an 18% share. Sellita uses a lot of expired ETA patents. It also uses parts it gets from ETA in about half of its movements. So, ETA’s indirect share of the market – based on everything it provides critical supplies for – might be closer to 65% than 50% of the market. Rolex has a 16% share. However, Rolex uses its movement manufacturing for internal supply purposes. Rolex is supplying its own watches. It is not selling to outside companies. Soprod has 4% of the market. Everyone else combined would have something like 5% to 10% at most. So, ETA supplies about half to two-thirds of all movements in the sense that watches using these movements include parts from ETA. Rolex is actually vertically integrated and separate from the rest of the industry in this particular aspect of watchmaking. So, the 55% estimate of ETA’s role in mechanical movement making is actually an understatement in two respects. One, Sellita uses ETA as a supplier. Two, Rolex supplies itself – not external customers. If you take half of Sellita’s supply out and all of Rolex’s – you are left with Swatch being the key supplier of movements.

And movements are actually easier to make than assortments. The technical requirements of movement making is minimal. Technical knowledge is not the barrier to entry. Most watchmakers don’t make their own movements because it is too much overhead to absorb. It’s a volume based business. So, the cost of having the capability to produce good movements is similar regardless of how many movements you are making. There is an initial investment requirement for even a small manufacturer. The more volume a company does, the lower its per unit cost for movements will be. So, it would cost a small watchmaker more per unit to make its own movements and there would be no quality improvement. Mass production is helpful in movement making because it reduces cost without reducing quality. If a company like ETA is willing to sell you mechanical movements – it is in the interest of everyone except those companies of the size of Swatch, Richemont, and Rolex to buy the movements. You can make your finished watch for less. And you couldn’t build a better movement yourself.

The technical bottleneck is in assortments. Swatch has another subsidiary called Nivarox that makes assortments. Nivarox’s share of assortments is greater than ETA’s share of movements. And unlike movements, the barrier to entry here is not just an initial investment in property, plant, and equipment. Even other movement makers like Jaeger-LeCoultre and Patek Philippe get assortments from Swatch. Rolex is one of the very, very few companies that makes assortments like the hairspring. Assortments are regulating elements like the balance wheel, hairspring, escapement, and pallets. A watch’s accuracy depends on these regulating elements. For example, the hairspring is what causes the balance wheel to oscillate. The constant rhythm of the oscillation is what ensures the accuracy of the watch. Swatch makes assortments which it sells to others.  Rolex makes assortments. And then some small manufacturers make only tens of thousands of assortments a year.

Swatch’s use of its market power was restrained through much of the 2000s by Swiss regulators. In 2011, Swatch was finally allowed to reduce deliveries of finished movements to 85% of its 2010 levels and bring that number to as low as 0% in 2019. So, Swatch will be allowed to completely cut its competitors off from their supply of ETA movements by 2019 if it wants to. Swatch was also allowed to cut its supply of assortments by 5%. This change will be tough on Sellita. The difficulty in obtaining assortments will probably be more of a problem than the difficult of obtaining movements. Movements just require some sort of alliance that provides for sufficient scale in production to spread the costs for the customers of that manufacturer to a level that would be lower than if each company went it alone. Assortments actually require technical knowledge. The problem is more than one of cost. It can mean that the supply is not of sufficient quality. Overall, the future is likely to be grimmer for Swiss watchmakers other than Swatch, Richemont, and Rolex once Swatch is allowed to cut its supply of movements and assortments as low as it wants to.

The three biggest players in Swiss watches are: Swatch (34% market share), Richemont (29%), and Rolex (22%). All other companies have just a 15% share. Swatch has strong production capabilities. Rolex is capable of supplying itself better than any other company besides Swatch with everything it needs. So both of those companies have certain vertical integration strength. Brand strength is also important. But distribution is about more than just having strong brands. These three companies – Swatch, Richemont, and Rolex – have the greatest distribution power of any watchmakers.

Distribution is less important at the highest and lowest ends. Cheap watches can be sold around the world online and in department stores. One reason Swatch is weak in the U.S. is probably because of the power of department store chains and online outlets for affordable luxury watches. A company like Movado is simply better at selling to Americans than Swatch is because it is not focused on a different model in the rest of the world. So the $800 to $10,000 categories are where Swatch’s moat is greatest. This is where brand, distribution, and production capabilities are all important. Watches in this price range need a lot of points of sale. Tissot has 13,500 points of sale. Longines has 4,000. Omega has 1,800. Big groups like Swatch, Richemont, and Rolex have power over distributors and retailers. LVMH has trouble getting distribution equal to these companies because it does not have as big a watch business. These companies usually ask retailers to carry multiple brands from the same group. Having several strong watch brands at different price levels can be an advantage. These companies can also offer after-sales services. Quartz watches are easy to repair (you just replace the battery). Mechanical watches using ETA movements can also be easier and cheaper to maintain. The less common the parts in a watch are the more expensive it can be to maintain. Longines has over 1,000 service centers. Omega has 450. Very high end watches have very few service centers. Patek Philippe has 57. Bregeut has 45. And Richard Mille – a super expensive brand – has just 3 service centers. Swatch’s moat in true luxury watches is not as great. Each brand has a moat around it. But the distribution moat is narrow. And there is no production moat. The $800 to $10,000 category is the widest moat part of the business. In this category, Swatch has a wide moat in production, brand, and distribution. It has strong brands. It can mass produce the parts – movements and assortments – needed in these brands. And it has the distribution clout of a Richemont or Rolex. For these reasons, it is likely that the fattest Swiss watch companies – Swatch, Richemont, and Rolex – will get fatter over time in the $800 to $10,000 price category. It is less clear what will happen in the under $800 category. In the over $10,000 category, old brands with a strong heritage should continue to do well. But it is possible for new brands to pop up and get distribution as Richard Mille proves. Hublot is another example of a successful entrant into very high end watches. This category does not require either mass distribution or mass production. The hardest category to enter and succeed in is $800 to $10,000. This is where Swatch excels. And it should now be able to use the market power from its production monopolies or near monopolies in movements and assortments to squeeze competitors. So, this is a wide moat business. And the moat could get wider if regulators allow it.

Talk to Geoff about Swatch’s Moat

Check out Singular Diligence




When Should You Diversify?

by Geoff Gannon


Someone who reads the blog sent me this email:


"I have been thinking about portfolio construction lately. 

…due to the strict standards you have, I thought it was very natural to just hold mainly four stocks…unfortunately, this method has shown its short comings lately. Both because of (your) mistake in picking CLUB/WTW instead of the other winners discussed in Avid Hog/Singular Diligence, and also because I am currently getting in touch with a lot more very cheap opportunities in the Asia region…I have also been rereading Buffett's partnership letters and was reminded he once held like 40 stocks. Even though he concentrated at his top several positions sometimes and also he sometimes put 30% to 40% of his portfolio into the workout category, he did say they usually have fairly large positions (5% to 10% of their total assets) in each of five or six generals, with smaller positions in another ten or fifteen. (This) of course is a far cry from the 20%/25% position sizing we usually talk about…


What are your thoughts? Is it actually better to spread our portfolio a bit more?...I am getting more and more the feeling that finding the right stock is not the most important part, but picking the right ones to actually put money in is the key. Would (being) willing to spread a bit more make this key job easier? The very cheap stocks I am finding these days may not fit something you will invest in as they are likely not good buy and hold investments. Yet they are also not exactly like cigar butts, i.e. not of very, very low quality stuff. Is it wise for me to ignore them in my personal portfolio and just pick those that are more like the buy and hold category?"


I hold 4-5 stocks because I find that is most comfortable for me. You want to combine an approach that makes enough objective sense to work for anyone in theory with an approach that makes enough subjective approach for you to carry it out in practice. I found owning 20 stocks was not practical for me. I spent more time watching what I owned than coming up with a good list of new stocks to research. I didn’t spend enough time focused on what I was buying. When I owned 20 stocks, I spent too much time on the HOLDING and the SELLING and not enough time on the BUYING. It’s no accident that the only thing we do for Singular Diligence is tell you which stock to buy. We never revisit it. We never tell you to sell. It’s all focused on a one-time buy decision. I think that’s the decision that really matters. If you get that moment right the next 5 years or more will take care of themselves. There’s just a heck of a lot of time spent on stuff other than worrying what to buy next when you have 20 stocks. When you have 5 stocks, you can spend all your time thinking about what you want to buy next. I don’t want a situation where someone asks me “So what stocks do you own” and I go: “Oh, let me just check this list here.” That’s a problem unless you choose to embrace almost total neglect of what you own. I think Ben Graham mostly did that. It’s okay to own a lot of stocks if once you buy them you just forget about them. It’s not okay if you spend a lot of time wondering whether you should sell. And if you own 20 stocks, there will always be one or two you’ll be thinking you should probably sell because their price has risen so much or something has changed. Pretty soon you are thinking as much about selling as stock picking. I don’t like that.


At many times, I held many more stocks than I do now. These were usually special situations, micro-cap value stocks, etc. I find the experience less comfortable for me. For many other people, the reverse is true. They prefer holding more stocks. I think that is fine.


I don’t think the big issue is whether you HOLD a lot of stocks or HOLD very few stocks. I think the issue is whether you BUY a lot of stocks in any one period.


Most people I talk to could benefit from higher selectivity and lower activity.


Some of these people buy 12 stocks a year and sell 12 stocks a year. That means they are making a buy or sell decisions once every 15 days or so. That’s a lot of work. It is too little thinking and too much acting.


On the other hand, you can own 30 stocks and be relatively inactive. Let’s say you own 30 to 50 stocks and you hold a stock for an average of 5 years. If you hold 30 stocks for an average of 5 years, that means you only need to buy one new stock every 2 months. That is more manageable. And you can eliminate the sell decision by just waiting 5 years and then selling.


So, let’s say you own 30 stocks and hold each for 5 years and then sell. Now, every 5 years all you have to do is make 30 buy decisions and no sell decisions. That is just one decision every 2 months.


The benefits of diversification beyond 30 stocks is minimal. The dangers for holding a stock for too long when you sell automatically in 5 years is low. So, I think you can be a selective stock picker who holds 30 stocks. The way to do that is to forget about selling. And to hold stocks for 5 years.


Let’s take an example of a stock I’ve been “stuck” with. George Risk. The business has done fine. The stock was cheap - on an EV/EBIT basis - when I bought it. It is still cheap today. This is the classic example of a no catalyst stock. It is dead money. But, otherwise it was not a bad stock pick. I was not wrong about the business’s future. I did not overpay. It was safe when I bought it. It’s safe today. So, it is a financially strong company selling at a cheap price. This was true then and now. But, as many were right to point out when I bought it - there’s no catalyst.


I've held George Risk shares for about 5 years. It paid some dividends during that time. Let’s go back exactly 5 years - not the precise date I bought, but it works well for this example. George Risk stock is up 80% over those 5 years. The S&P 500 is up 92%.


So, George Risk underperformed. This can be a selection problem. Maybe the lesson is never to buy a stock without a catalyst. Don't buy a stock where management is piling up cash year after year after year. Or it could be a matter of luck. Maybe George Risk is the kind of stock that will have a catalyst if I bought today and held for the next 5 years - but it didn't for these 5 years. Obviously, if the family chose to pay a special dividend or sell the company or something - the return would be big and instant. This is an $8 stock with $6 in cash.


Diversification can fix this problem. You find maybe 5 stocks like George Risk - I’m not sure there are 5 stocks like George Risk, but let’s pretend that's not the problem - and you split your money between them. If you want to hold say 25 stocks, then you simply diversify by putting 20% of your portfolio into “George Risk type stocks” rather than putting 20% of your portfolio literally into George Risk.


I think that’s fine. I even think it’s a good idea. I think any time you can find 5 stocks of a certain “type” it is a good idea to split your money between them.


Right now, I own:


  • Babcock & Wilcox
  • Ark Restaurants
  • Weight Watchers
  • George Risk


I could easily own something like Tandy or Ekornes instead of one of those stocks. See Quan’s post on “Stocks Picked and Lessons Learned” for details of the stocks that we picked for Singular Diligence and therefore could be in the portfolio.


Quan broke some of those stocks down by category. I think it’s a wonderful idea to diversify by category. So, if you really like net-nets and you really like franchise (wide moat) stocks and so on you divide your portfolio not in stocks - but into categories.


You can do the same thing with countries. A lot of countries move together though. So, I don't think this provides as much diversification as the financial press and mutual fund marketers would lead you to believe. If you own Dow Jones type companies in the U.S., U.K.., France, Japan, etc. I am not sure you get that much diversification aside from currencies. And it’s a lot of work for you. And you don't know the cultures. And you don't speak the language. And there are different laws. And your selectivity could suffer.


But, I think it's a wonderful idea for an investor to split his portfolio into half domestic and half foreign. So, if you live in France keep half your portfolio in Euros and half in Pounds and Dollars and Yen and so on. This gives you some diversification away from your currency. It gives some diversification against the risk that your specific country at this specific time is in a bubble or something and you don't see it.


So, let's review. I think a half and half diversification among foreign and domestic is good if you can do it. And I think a 5 instead of 1 diversification by category - net-net, growth, franchise, value, turnaround, etc. - is good. When Quan and I were looking at Carnival, I wanted to invest in Carnival because I believed that oil prices - which were then close to $100 a barrel for the Brent type stuff Carnival was buying - should tend to be priced around $60 or so in the future. I looked at oil and said I can see the sense in $30 prices and the sense in $70 prices. There's no sense in $100 prices. And so I was eager to buy Carnival because it was in a business with durable demand in terms of volume and it had a good cost structure when you took out fuel. But, notice, you could have said the same thing about Southwest. A lot of the arguments against Carnival and Southwest were that their costs weren't good when you included fuel and that they weren't cheap on recent earnings. Also, their ROEs were low. But, if the price of oil falls from $100 to $50, then suddenly their costs are better, their ROEs are good, and their P/Es are nice and low enough. So, Carnival and Southwest were in the same category. And I see no problem with saying instead of putting 20% in Carnival you put 10% of your portfolio in Carnival and 10% in Southwest and say it's one 20% bet that will go wrong if oil never plummets.


We can do the same thing today with Progressive (PGR), and Valley (VLY). We did a Singular Diligence report on Progressive. We mentioned how we thought future earning power would be higher because their investment assets which are a lot of short-term government backed debt pay next to nothing now but will pay more in the future. Let’s say they are mostly in two year notes that yield 0.5% right now. Well, in normal times, the yield on that same debt would be 5.5%. The long-term history of Progressive's investment portfolio is about 5.5% returns or something like that. You'd expect 5% to 6% returns. And yet you have some people looking at the stock and saying the portfolio may only make 2% a year till rates move. So, why invest now?


Valley National has the same problem. If you read the Morningstar analysis - for instance - they complain that Valley's efficiency ratio is not good anymore.


The problem with the efficiency ratio as used in banking is that it is a ratio of expenses to revenue. It is not a ratio of expenses to assets. Nor is it a ratio of expenses to deposits.


Really, the cost side of banking should be the ratio of expenses to deposits. Deposits may be liabilities but they are the ultimate source of all earning power. This is the same way that float is the ultimate source of all of Progressive's investment earning power.


The efficiency of Progressive’s investment business should be judged by the cost of its float - not the investment income generated by the assets it finances with float. Likewise, Valley's efficiency or lack of efficiency should be judged by its cost of deposits not its expenses divided by revenue. Valley does not control its revenue - which is set mostly by interest rates - any more than Progressive controls its investment income.


So, here we have two stocks - Valley and Progressive - that aren't cheap on today's numbers. But, if we imagine interest rates of 6.5% on the 10-year bond instead of 2.25% today - you have a different earnings picture on the same dollar amount of loans.


Therefore, Progressive and Valley are both part of the same category of stocks that would be cheap if interest rates were “normal” but are not cheap today. So, just like you could split your money into Carnival and Southwest and admit the risk - that oil prices would never plunge - was the same in both stocks, you can buy both Progressive and Valley today and admit the risk - that interest rates will never “normalize" - is the same in both stocks.


So, I would endorse that kind of diversification. I would endorse putting 10% of your portfolio into Carnival and 10% of your portfolio into Southwest instead of 20% into only one if you felt oil prices should drop by half and the stock market price for oil consuming companies didn't reflect this.


I would also endorse putting 10% of your portfolio into Progressive and 10% of your portfolio into Valley instead of 20% into only one if you felt that interest rates will skyrocket from here and the stock market price for interest collecting companies doesn't reflect this.


Just recently, we published a Singular Diligence issue on Swatch. Swatch is the cheapest really good watch company. It has a huge business in China. It is big in the actual production of components for watches. It is a manufacturer - not an assembler. Movado is the opposite. It is not as high quality a business as Swatch. But it's an even cheaper stock. It is big in America and small elsewhere. It has a big licensed brand business. It is an assembler - not a manufacturer. It is not big in components like Swatch is.


I think both Swatch and Movado are good long-term values. They both look like excellent relative values.


So, if by diversification you mean instead of something like a portfolio that includes this:


  1. Carnival: 20%
  2. Progressive: 20%
  3. Swatch: 20%


You want a portfolio that looks more like this:


  1. Carnival: 10%
  2. Southwest: 10%
  3. Progressive: 10%
  4. Valley: 10%
  5. Swatch: 10%
  6. Movado: 10%


I think that's great. I think you are still making the same bets - oil prices will fall, interest rates will rise, some watch companies are too cheap - without putting as much money in any one stock.


But, there's also a selectivity element here. I only approve of this kind of diversification because Southwest has a similarly excellent 30 year past record as Carnival. Because Valley has a similarly excellent underwriting record as Progressive. Because Movado - although a one brand company plus licenses and big only in the U.S. - has great mindshare where it does compete. In its price category and country (the U.S.) the Movado brand is actually much stronger than anything Swatch sells here.


So, I don't think the deterioration in quality - the compromise brought on by less selectivity - is high in picking both Carnival and Southwest instead of just Carnival, or both Progressive and Valley instead of just Progressive, or both Swatch and Movado instead of just Swatch.


But, let's stop now and talk about an instant where the compromise in quality was great and the results of diversification dangerous.


We made a mistake buying Town Sports (CLUB). Quan and I both bought this stock. And both of us have since sold it. We also wrote a Town Sports issue for Singular Diligence. So, our subscribers suffered as well.


We actually picked two gym stocks for Singular Diligence. One was Town Sports. The other was Life Time Fitness. You can read about those two gym stocks in Quan’s blog post.


For Singular Diligence, we made a diversified mistake. Town Sports stock did very badly. Life Time Fitness did well. At the time Quan wrote that blog post, Town Sports was down 41%. Life Time Fitness stock was up 46%. The net result of those two picks is bad. If you put $5,000 in Town Sports and $5,000 in Life Time Fitness – you did badly.


But some of our subscribers did worse. They bought Town Sports but did not buy Life Time Fitness. Quan and I did the same. We bought Town Sports. We did not buy Life Time Fitness. Actually, Quan owned Life Time Fitness at one time. But, that’s not relevant to this discussion here other than to show he was smarter than me in recognizing the virtues of Life Time Fitness but not smarter in recognizing the vices of Town Sports.


Now, we could say this is a diversification problem. Subscribers who put even amounts of money into all our newsletter’s picks would do better than those who bet only on Town Sports but not Life Time Fitness. Buying an even amount in every stock we pick gives you safer results.




But there’s a problem. Quan and I bought Town Sports but not Life Time Fitness. We did that with our own money. We also wrote about both Town Sports and Life Time Fitness in Singular Diligence. So, we – by diversifying – gave our subscribers the opportunity for better net results than we ourselves got. They could put one egg in each basket. We picked the bad basket for ourselves.


Here’s the catch. If you had told either Quan or me that we could pick only one gym stock for Singular Diligence – we both would’ve answered: “Life Time Fitness”. If we could only ever buy and hold one gym stock – there’s no question we would’ve said “Life Time Fitness”.


So, you have three different ways of selecting. When given the “Punch card” rule of having a card with only 20 punches for a lifetime of investing – we are forced into the stock that did better. If we had only one “punch” to use on a gym stock – we’d use it for Life Time Fitness. Life Time was the better buy and hold than Town Sports. We knew that even when we picked them both.


So, too many punches can results in picking one good and bad stock versus just one good stock. If we were “stuck in one gym stock forever” we would make sure that gym stock was Life Time Fitness. No doubt about that.


But then why did Quan and I buy Town Sports?


We focused on the upside. In our own portfolios, we looked at the highly leveraged and very cheap Town Sports and the anti-leveraged (they actually owned a bunch of land that wasn’t fully mortgaged up at the time) Life Time Fitness and we chose based on upside potential. We were greedy. We weren’t fearful. Fear would have forced us into Life Time Fitness. Greed lured us into Town Sports.


So, what’s the lesson?


If you think in terms of which stock in an industry would you pick if you had to buy and hold it forever – you would be more likely to pick a stock like Life Time Fitness.


If you think in terms of diversification – you’d pick both Life Time Fitness and Town Sports.


If you think in terms of immediate upside potential – you’d pick Town Sports.


In our own portfolios, Quan and I applied Warren Buffett like levels of concentration. Yet, we included a stock Buffett would never pick. Might he own Life Time Fitness? Maybe, I guess. Might he own Town Sports? No. Definitely not. Let’s put it this way: if Warren Buffett was ever going to buy a gym stock – and I’m not at all sure he ever would – there’s no doubt that gym stock would be Life Time Fitness.


So, maybe greater diversification is the safest bet. Or, maybe greater selectivity is. Certainly, thinking in terms of moat and financial strength and which stock would you rather own forever leads to safer stock picking. Focusing on the upside adds risk. Focusing on the downside lowers risk. Focusing on the short-term adds risk. Focusing on the long-term lowers risk. Diversifying waters down risk and return. So, it reduces risks that you take that the rest of the market doesn’t.


Let’s look at our other disaster: Weight Watchers. This is a debt story. If you asked Quan and I what weight loss company would we buy if we had to hold it forever – we’d say Weight Watchers. If Warren Buffett had to buy one weight loss stock, which would it be? No doubt. It would be Weight Watchers. Now, he might never buy any weight loss stock. That would make perfect sense. But, if you are going to buy a weight loss stock the only claim any of them has to any sort of moat or franchise is Weight Watchers.


Buffett would certainly never have bought Weight Watchers when we did. It was up to its nose in debt. That was our mistake.


Quan and I both still own Weight Watchers. We like the business better than Town Sports. We did when we picked those stocks. And we still do now.


Weight Watchers has done horribly as a stock though. The business has done badly. The stock has done worse. You can read Punch Card Investing’s post in August of 2013 to see how right Punch Card was and how wrong Gannon and Hoang were on Weight Watchers.


That’s a mistake. We’ll make them. We’d make them whether or not we diversified. As we’ve said on the blog before – Quan and I certainly regret picking Weight Watchers for Singular Diligence. You can’t have a stock down 75% or more and expect subscribers to stick with it. We both still own the stock ourselves though. If we thought Weight Watchers was a mistake to buy in our own portfolio – you might guess we’d sell it by now. We haven’t. I won’t say that means we don’t think it’s a mistake. But, I would say we consider our error in buying Town Sports to be clear in a way our error buying Weight Watchers was not and still is not. Town Sports was a much worse mistake than Weight Watchers. This is from our perspective. For the market result, Weight Watchers was a truly terrible error.


Diversifying can reduce the loss in something like Weight Watchers. If you owned 20 stocks instead of 5 – you’d cut a 20% stake in Weight Watchers to 5%. If you had a 75% loss in Weight Watchers you’d lose 15% of your portfolio in a 5 stock portfolio and just 3.75% of your portfolio in a 20 stock portfolio.


The truth here is pretty simple. Avoid making 75% losses. The way to do this is easy. Don’t buy stocks that are leveraged at like 5 times EBITDA. If you buy stocks with no debt – you aren’t going to lose 75% on the stock if you are at all good at picking the company. The reduction in Weight Watcher’s enterprise value is a lot less than the drop in its market cap. This was a highly leveraged stock. Buffett would never, ever buy something with so much debt. We shouldn’t have picked a stock with so much debt for Singular Diligence. In the future, we will never do that. You’ll never see as highly leveraged a stock as Weight Watchers be a Singular Diligence pick in the future.


Town Sports also had a lot of operating leases. Rent expense is what has sunk that company. So, the lesson from both Town Sports and Weight Watchers is probably avoid companies with debts and leases. Don’t buy leveraged companies.


Is there a lesson about diversification in there somewhere?


I don’t see it. If Weight Watchers had been debt free when we bought it, we’d be holding it quiet calmly right now as I hope most of our subscribers would. It’s the debt that worries us with Weight Watchers. With Town Sports, we have a direct comparison. Town Sports had a lot of rent expense. It didn’t own any of its properties. There is one exception. Meanwhile, Life Time Fitness owned its properties. Its real estate portfolio was very, very safe. So, we had one unusually high leverage gym stock in Town Sports. And we had one unusually low leverage gym stock in Life Time Fitness. If there’s a lesson there – it’s a lesson in leverage, not diversification. Quan and I should have eliminated Town Sports because of its leverage. And we should have – in our own portfolios – preferred the no leverage stock to the high leverage stock. We should’ve thought about downside instead of upside. We should have thought about the long-term rather than the short-term. Long-term we knew the downside in Life Time Fitness was lower. If the long-term downside in a stock is lower – that’s probably the stock you should prefer. We didn’t. We picked the highly leveraged, cheaper stock. A lot of value investors do that. A lot of big value investing losses come from very highly leveraged stocks with low multiples.


If you want to avoid something like Weight Watchers, there are three ways. One, you can diversify. This can turn a 15% of your account loss into a less than 4% of your account loss if you just expand your portfolio from 5 stocks to 20 stocks. This may work fine for many people. I won’t condemn it. Two, you can avoid an industry like gyms all together. Many of our subscribers did this. We published issues on Life Time Fitness and Weight Watchers and Town Sports. And they responded by saying: “I’m not going to buy any weight loss business or any fitness business. They’re too faddish.” So, maybe you can avoid fads by ignoring an entire industry. There is a good logic to this. Weight Watchers and Life Time Fitness and Town Sports all have very high customer attrition rates. They lose 30% to 50% or more of their customers every year no matter how good a job they do. People just quit on self-improvement a lot. That will always be the case. It’s better to sell junk food and cigarettes and alcohol than to sell weight loss and fitness. It’s easier. Products in the first group are a lot more compelling. You don’t exercise on impulse. So, you can stick with the sin stocks and avoid the self-improvement stocks. I actually think there’s a lot of logic to that. I would tend to favor that approach over diversification. Stick to stocks that retain their customers. Avoid stocks that depend on people’s willpower being strong for them to stay a customer. That’s great advice. It applies to Weight Watchers, Town Sports, and Life Time Fitness. The third way to avoid a Weight Watchers type disaster is to look at the balance sheet. Just don’t buy companies with that much debt.

A separate question here is whether it’s okay to own a lot of stocks simply because you have a lot of ideas. My answer to that is yes. If you have a lot of equally good ideas – spread your money around evenly.


But are the ideas actually equally good?


My test is whether I can or can’t discern between the quality of the stocks involved. It’s a subjective and personal test. I know I can’t exactly predict which of 5 possible good ideas will work best and which will work worst. That’s predicting the future.


And that’s not what I mean. But, in our Swatch issue we mentioned 6 companies. We mentioned Swatch (obviously) which trades at about 11 times EBIT. We mentioned LVMH which trades at 15 times EBIT. Richemont trades at 17 times EBIT. Fossil at 8 times EBIT. Movado at 7 times EBIT. There are 3 Japanese watch makers. We mentioned only two. They trade between 10 and 14 times EBIT.


Now, if you said you’d like to diversify by buying all the Japanese watch makers – I’d say fine. I don’t particularly like any of them at today’s prices. But if I did like one – I’m not sure how different I’d feel about Citizen, Seiko, and Casio. So, if you wanted to diversify among those 3  - that’s fine. I’d pass on all 3. I’m not sure I can choose between them.


Likewise, if you said you wanted to buy Richemont and LVMH – I can see how you might think they are similar. I’m not sure I’d agree. And I would spend more time looking at those companies. They really aren’t that similar. And they are expensive.


The 3 watch companies I think it would be okay to diversify among are Swatch, Movado, and Fossil. I’m not sure I like Fossil as much as Swatch or Movado. Fossil relies a lot on Michael Kors. It’s an unusually hot watch brand. It also skews incredibly female. So, a really big portion of Fossil’s profit comes from sales of women’s watches under the licensed name: “Michael Kors”. That’s unusual for a watch company. A watch brand is usually not as young as Michael Kors in terms of its history. Most watch brands are really old. Some licensed brands aren’t. But – putting aside Michael Kors – each licensed brand for Fossil and Movado is normally quite small. No one brand matters that much other than the owned brand that the company has. In the case of these two companies that’s the Fossil and Movado brands.


I think a basket of Swatch, Movado, and Fossil would be fine. I don’t think I’d want to buy Fossil alone. But, maybe Fossil will be the best performer long-term. Fossil is strong in licensed brands. They can be the best home for a lot of licensed brands in the future. So, they can win licenses that eventually become hits. And we can’t predict what brands those will be. But Fossil is in a good position to get them. So, while I consider Fossil more speculative than Swatch and Movado – I wouldn’t blame anyone for creating a basket of all three watch companies.


So, let’s say instead of putting 20% of your portfolio in Swatch you put 6% or 7% in Swatch and 6% or 7% in Movado and 6% or 7% in Fossil.

That kind of diversification is fine. I’m all for that. On an after-tax basis (Swatch pays low corporate taxes) they are all nice and cheap. If you imagine a one-third and one-third and one-third blend of those 3 companies – you’re getting a high quality, low priced watch stock with little debt. And by dividing 20% of your portfolio into equal parts and putting it in these 3 companies you are relying less on Michael Kors than a 20% bet on Swatch would. And you are relying less on China than a 20% bet on Swatch would. Swatch gets a huge amount of its profit from China. Most of the company’s growth has come from Asia for a long time now. Swatch doesn’t get a lot of sales from the U.S. and licensed brands while Fossil and Movado do. So, that’s a very nice form of diversification. And you are still paying a mix of a high single digit EV/EBIT by our calculations for all 3 companies. That’s a good kind of diversification. But, notice that I excluded Richemont for being way too expensive. I also excluded all the Japanese watch makers because I think their business quality is not high and their stock prices are not low.


So, I still took about 7 watch companies (Swatch, Movado, Fossil, Richemont, Casio, Seiko, and Citizen) and narrowed them down to just 3 acceptable buys (Swatch, Movado, and Fossil). Personally, I like Swatch and Movado and think Fossil is a bit speculative due to Michael Kors. But, if someone asked me “Should I buy a stock basket of equal parts Swatch, Movado, and Fossil?” – I’d say yes.


So, in that sense, I’m in favor of diversification. Watches have good product economics. These 3 companies are good relative bargains when you consider their high quality and low price. If you buy a basket of these 3 and promise to keep them for 5 years – I think that’s wonderful. I think the average investor might do better in a combination of all 3 than in just one. They – like I did with Town Sports – might otherwise pick the wrong stock in a group with one or more good stocks in it. Most importantly, lots of people feel safer having 7% of their portfolio in Swatch, 7% in Movado, and 7% in Fossil instead of 21% in one of them. If that feeling of safety makes them a longer-term investor, then I’m for diversification.


The other obvious time to diversify is when you are a quantitative investor like Ben Graham. Warren Buffett isn’t normally. I’m not normally. But, when Warren Buffett bought stocks in Korea he diversified widely. He told a group of Kansas University students:


My broker at Citigroup told me to look through this Korean version of the Moody’s guide. He said it would look just like 1951. He was right. I began flipping through the pages and found a lot of good companies trading at very low multiples. In 5-6 hours I put together a small portfolio of 20-25 stocks – about $100 million total. One example was DaeHan Flour Mills. It has a 25% market share in wheat flour in South Korea. Book value was 206,000 Won and the company had 201,000 Won in marketable securities and was trading at 2x earnings. The market is clearly not efficient all the time. There are certain opportunities that can make you fabulously rich.”


So, he put about $5 million into about 20 companies. When I looked at Japan a few years ago, I was originally going to find something like 20 stocks. That was my plan. But, then I winnowed a list down and came up with two groups. One, was net-nets that had been consistently profitable for a while. There were about 15 of these. I sold a report on the blog with those 15 net-nets in it. The other group was stocks with negative enterprise values that had been consistently profitable for 10 straight years or so. That was a sub group. Maybe 5 of the 15 stocks were in that group. So, I had to decide do I buy a big basket of say 30 or whatever stocks in Japan that are really low priced “value” stocks. Or, do I stick to just 15 net-nets with no losses in recent memory. Or, do I pick from this even smaller group of maybe 1 out of every 3 of those net-nets that actually have a negative enterprise value.


I decided I would put only 50% of my portfolio in Japan, because I didn’t want more than 50% of my portfolio in the Yen. It was an overvalued currency at the time. And I wasn’t going to hedge. That was fine. These stocks were cheap enough that if the Yen fell – and, in fact, it did fall – the U.S. dollar returns were still going to be fine. And the returns were fine.


I think they would’ve been fine any way I did it. I think picking those 15 net-nets I put in the little statistical report would’ve given you a fine portfolio. I think that the stocks Nate at Oddball Stocks wrote about and bought did absolutely fine. And I think that if you hedged the Yen you did well obviously. But, if you didn’t hedge the Yen your returns in dollars were also just fine. And these little Japanese net-nets didn’t behave like the stocks most people have in their portfolios. And obviously the Yen moving against the dollar doesn’t have all that much to do with the average American investor’s portfolio. So, you had a nice basket that was a diversified value investment. And I think you would’ve had that basket if you hedged or didn’t hedge the currency and if you picked 10 or 30 net-nets or just the 5 negative enterprise value stocks with 10 straight years of profits that I settled on. Basically, Japanese micro-cap value did fine for a few years. And it did fine in Yen. But it also did fine in U.S. dollars.


So, should you have diversified or not?


I knew nothing about Japanese companies. I was never going to pick just one stock. Many didn’t have information in English. And that doesn’t even matter that much. I read reports in English from Japanese companies – and I still don’t feel I understand them well enough to buy them alone. If I was going to buy Nintendo then I would’ve bought just Nintendo. But, I wasn’t. I was doing a Ben Graham type operation. It was similar to what Graham did all his life. It was similar to what Buffett did in the 1950s in the U.S. and again in Korea in the 2000s. And it’s what I did in Japan. Like I said – it’s also what Nate at Oddball Stocks did. I’m sure my results weren’t better than his. And he may have diversified way beyond 5 stocks. So, there was no real harm in diversifying in Japanese net-nets.


Oddly, Mohnish Pabrai didn’t really make money in Japan. I still have no idea what that was about. I think that might have been more of an attention deficit disorder issue on his part than anything to do with selection. He wanted to put bigger sums to work. And he seems to have bought and sold faster than I did.


In fact, I have a very small position in one Japanese net-net left over. I wrote the “Buy Japan” blog post on March 16th, 2011. So, it’s been over 4 years now. And these Japanese net-nets are up a big amount. And yet I still have a really small piece of one of them I never sold. I was going to sell it to buy something else and then I never got a good price for it in Japan. So I just held on to it. One day, the stock will pop again and will sell it. It’s such a tiny position because I was able to sell most of it at the price I wanted. It’s just illiquid. And so I didn’t get the price I wanted after that. My point is that I’m not in a real hurry to sell a stock. I’ll just leave it there doing nothing for a long time. I don’t know exactly how Nate at Oddball Stocks runs his own account. But, I think it’s also a bit less actively than Pabrai might have been in Japan.


So, I think it’s fine to own 100 stocks, 50 stocks, 30 stocks, 20 stocks, 10 stocks, or 5 stocks. If the stocks you own seem equally good to you on the criteria you use to buy them – then your portfolio works for you. If you look at your portfolio and realize that 5 of these 25 stocks you have are much, much better companies than the other 20 – then I think you have a problem. I think you are watering down your stock picking.


But, if there had been 15 stocks in Japan with negative enterprise value and no losses in the last 10 years – I would’ve bought 15 stocks instead of 10. I mentioned George Risk earlier. I bought George Risk at around net cash. You paid for the $4.50 or $4.75 or whatever the cash per share was and then you got the business for free. The business is a good one. It makes money every year. It would have an unleveraged ROE of over 20% year after year if the company didn’t hold all that cash. So, you had a box of cash and investments – it’s actually a mix of equity mutual funds, cash, and municipal bonds – and then you had the business. If I could find stocks in the U.S. that were consistently profitable – like, they made money every year for 15 years and their pre-tax ROC was like 15% a year or something – trading for their net cash per share, I’d buy every single one of them. If there were 30 companies that were like George Risk in the sense they were consistently profitable businesses trading for their net cash position, I’d buy every single business that met those criteria.


If you can find profitable, negative enterprise value stocks in Asia right now that you don’t think are frauds – then just buy them. Buy them all. If there are 50 of them, put 2% in every stock. If there are 10 of them, put 10% in every stock. Don’t buy anything else. Don’t be picky. A profitable company selling for net cash is a bargain of a lifetime. Buy it. And don’t judge between them.


But, in normal times in the U.S. I don’t find any stocks like that. You don’t normally find even one. It’s often zero. That wasn’t true when Buffett was investing in the U.S. in the 1950s. It wasn’t true during Ben Graham’s career. But, I was born in 1985. It’s been true for most of my life. There are brief crisis moments where it’s not true. And sometimes some micro caps get neglected. And specific countries – not the U.S. – sometimes end up with a lot of very, very cheap stocks. But, remember, Japan’s economy and stock market had done pretty badly for about 20 years when I found those net-nets. That’s why they were there. Business was going sideways for 20 years. And then they were just paying down debt and piling up cash over a couple decades. And nobody in Japan really noticed or cared or saw a catalyst in the stocks. And they were tiny stocks. So, they get neglected. If you can find 50 stocks like that instead of 5 – you have my blessing. Buy all 50 of them. It’s fine.


Talk to Geoff about Diversification


Check out Singular Diligence

What I Hate and Love about Singular Diligence

by Quan Hoang

Recently I went out to a restaurant I like. Unfortunately, the restaurant went out of business. That reminded me how tough it is for small business to survive and led me to some thoughts on Singular Diligence.

It’s been 1.5 years since we launched The Avid Hog (the predecessor to Singular Diligence). Geoff and I actually worked on the newsletter for 3 years. Somehow we still survive, building up an archive of well over 1,000 pages of research and notes. Only passion and perseverance can lead us this far. And there are things I hate and love about the newsletter.

I simply hate the pressure. Geoff and I want to work together. He had the idea of writing a newsletter in early 2012. I never thought it’s possible. Warren Buffett says he’ll “settle for one good idea a year”. How can we come up with a good idea a month?


Make Priorities

We must make priorities. We give priority to downside protection over upside. So, clients won’t lose money if they act today. We also give priority to business quality over cheapness. Business quality doesn’t change fast so a qualitative research can be timeless. If clients read our research today, they’ll be ready to act quickly in the future. Clients will make the best return if they see the newsletter as a tool instead of as investment advice.


Choose Candidates Better

In the early days, our focus was on improving the research process. We frequently ran into “crisis” when we don’t have the next stock to analyze. There were also times when I realized that a company isn’t good enough only after 2 or 3 weeks of research. I had to drop the stock. So, it’s a big risk to choose a wrong candidate.

We started building a process to maintain a candidate pipeline in September 2014. Geoff and I have a candidate meeting every week. We look at our watch list, screen, or other blogs to find ideas. We try to pick the best 2 or 3 stocks to discuss about in the meetings. We focus the discussion on risks and normal earnings. It’s important to have financial data for these early discussions. So, I type data from all 10-Ks of each stock into an excel template. This is a powerful process because we discuss about 100-150 stocks each year.

We maintain a list of top 10 candidates. The unbreakable rule is that a stock must be below 15 times EV/After-tax Normal Unlevered Earnings to appear in the list. The rule makes sure candidates trade at a below average price. This means we won’t pick stocks where we love business quality and prospect so much that we compromise on price. The rule makes our job difficult in today’s environment when people are talking about new low normal interest rates. Sometimes we have only 8-9 candidates in the top 10 list. But it helps push ourselves to actively search for new candidates.

To reduce the risk of choosing the wrong stock, we do a lot of basic research on top candidates. We do scuttlebutt in this stage. Some clients help us do scuttlebutt by talking to employees or learning about customers and products. Afterwards, we can contact the management if necessary. We also read Investor Day transcripts. My experience is that analysts tend to ask short-term oriented questions in quarterly earnings call. There’s not much useful information there. But there’s usually great information in Investor/Analyst Day conferences. So, instead of reading 1,000 pages of earnings call transcript, I read only 50 pages of Investor Day transcript in this stage.


Price Movement Is a Headache

Our weakness is long lead time. There are months from the time a stock enter the top 5 candidates to the time I start analyzing the stock. I do research for a month and send my notes to Geoff. Geoff does further research and writes the final report in another month. A stock can stay in our inventory for several months because we have some restrictions. For example, we try not to write about two obscure foreign stocks in two consecutive months because that upsets clients who prefer buying U.S. stocks. We can’t write about two micro-cap stocks in two consecutive months because clients may hate illiquidity.

We’re subject to price movement because of the long lead time. It’s heart-breaking to see the price moves so much that we’re unable to publish a report. Some examples are PetSmart or Greggs. Sometimes the stock price increases by 20% even before I finish my notes. I just talk to myself “no, I hate this job.”

One solution is to increase the speed we do research. I think we’ve increased our productivity by triple-digits since when we started. But we just reinvest productivity gains in further depth of research. Three years ago, it took me a month just to read and analyze all the information I can find about a stock. Today, I learn also about competitors, customers and suppliers.

Another reason that restrains our pace is procrastination. It’s always tempting to read some more instead of starting to write. So, I don’t think that we can analyze a stock in less than a month. And price movement remains our biggest risk.

That’s what I hate about Singular Diligence. People say that if you choose a job you love, you’ll never have to work a day in your life. But when you have to race against the deadline and struggle to make money, it’s not fun at all. Sometimes I just hate what I like to do.


The Best Way to Learn Is to Practice

But there are good reasons for loving this job. First, I think this is the best way to learn. I have a college friend who loves investing but doesn’t read investment books. He said that reading investment books doesn’t teach us how to make money because otherwise the authors wouldn’t share. I agree that we don’t become a better investor by reading books. But books prepare us to become a good investor. We get knowledge from books. And we start learning when we practice.

I always learn something new from each research. I can practice techniques that I learned from books. One example is we all learn that there’s a red flag when inventories grow faster than sales. I see that at Swatch (VTX:UHR). In 2014, sales grew 3% while inventories grew 10%. In 2013, sales grew 8% while inventories grew 23%. Is it a short sign? The answer isn’t that simple.

Tom Russo talked about working capital in a recent interview. He said that Wall Street analysts and some activist investors usually prefer lower working capital and higher cash flow. But long-term investors welcome more capital being reinvested in a great business.

I find that Swatch’s inventory turnover declined consistently from 3.1 in 1998 to 1.5 in 2014. There can be some fundamental changes. Swatch might have grown retail operations in this period. They might be investing in infrastructure in emerging markets. So, it’s useful to talk to management about this topic. It’s necessary to compare Swatch’s inventory turnover with Richemont’s during this period. The two companies are different so we should also compare finished inventory turnover.

So, the actual exercise is much more complicated than the technique we learn in a book.


Things that Books Can’t Teach

There are also things that books don’t teach us. Books about moats can’t help us analyze Majestic Wine (MJW: LN). They don’t have the purchasing power of supermarkets like Tesco. They can be killed by online competitors. But analyzing Majestic Wine’s business model and cost structure can tell a different story.

Similarly, I never read a good book that teaches us how to estimate normal earnings. That’s because each actual situation requires a specific approach.

When Babcock & Wilcox (NYSE:BWC)’s government contracts are in serial production, they do the same thing every year. Costs are visible so past margin can be a good benchmark for future expectation. But we must be careful if they do a prototype project.

Swatch is run by a long-term oriented management. They’re willing to spend today to grow their portfolio of watch brands. Moreover, EBIT margin is cyclical but has a long-term upward trend. What should we do? Should we use current earnings or peak earnings? Should we estimate earnings using EBIT margin? If yes, how do we estimate the normal margin? A good answer requires us to understand why margin increased and have some expectation about future revenue.

Sometimes we have to delve into product economics to estimate normal earnings. America’s Car-Mart (NASDAG:CRMT) sells and finances used cars in small towns in South-Central states like Arkansas, Oklahoma, and Missouri. They don’t lend money but cars. The investment laid out isn’t in receivables on the balance sheet, but in the cars that they lend to customers. So, sales and EBIT margin are meaningless.

Encore Wire (NASDAG:WIRE) is another example. Encore Wire makes copper wire. The copper cost is almost 70% of revenue. So, the copper wire price mostly tracks the commodity copper price. Copper went from less than $1 per pound in 2003 to over $3 per pound today. So, it’s hard to estimate Encore Wire’s normal earnings by looking at sales and margin. The better approach is based on EBIT per copper pound of product.


Familiarity with One Company Can Help Analyze Another Company

I also love the chance to study a new industry each month. I can learn about nuclear components for one month and then move on to the most comfortable recliner in the world the next month. I can also develop new interests in wine or mechanical watches. That does help reduce the stress of racing against the deadline.

More importantly, familiarity with a company/industry can help analyze another. Studying the decline of the Omega watch brand in 1970s and 1980s can tell us to pay attention to the management when we analyze Ekornes (EKO:NO).

Familiarity with Coach or some other luxury brands can help us understand the distribution side of Swatch’s business. It also teaches us about the importance of scarcity in luxury.

Sometimes the connection is indirect. Reading about George Risk (RSKIA) shows the tendency of customers to re-order from the same supplier if they deliver on time. That can gives us some clue to the behaviors of contractors who buy copper wire from Encore Wire.

I see some similarity between Progressive (NYSE:PGR) and Encore Wire. About ½ of Progressive’s business is sold through the direct selling channel like Geico. Direct sellers have durable cost advantage because competitors are stuck with the agency channel.

Encore Wire is the second largest manufacture of electric wire in the US. They started in 1989. Today they have about 25% market share. They grew organically. They never made an acquisition. All earnings were reinvested into the manufacturing complex in McKinney, Texas. They have only one distribution center there. Their order fill rate is over 99.9%. They deliver to all customers within 7 days. They offer customization like selling 825 feet of copper wire instead of the 1,000-foot standard put-ups.

Encore Wire’s competitors tend to grow through acquisitions. They can have 3 or 5 plants and 10 distribution centers (DC). They ship from multiple plants to multiple DCs, and from multiple DCs to customers. So they have to handle shipping many times. Competitors’ shipping cost as % of sales can be 3% to 6% higher than Encore Wire.

Encore Wire also offers better service. Competitors are closer to customers. But there are 10,000 SKUs. They can’t hold full inventories in all 10 distribution centers. For an order, they can fill 50% from the nearest DC, 30% from a farther DC, and 20% from an even farther DC. They can take weeks to fill order. And it’s difficult for them to offer customized orders.

Encore Wire has the lowest cost in the industry but has the highest price because they offer great service. Meanwhile, competitors are stuck with their distribution model. They can’t close plants and concentrate on just one like Encore Wire.

Both Progressive and Encore Wire are the low cost players in their respective industries. They are both very cautious in pricing. They both do best when there’s cost inflation.

Another example is that understanding QLogic (NASDAG: QLGC) can help analyze Breeze-Eastern (NYSE:BZC). QLogic makes fiber channel adapter. Fiber channel adapter is a critical component in a storage-area network but is a tiny portion of the total cost. It takes a long time to go through OEM qualification and testing. QLogic has about 54% market share.

I see the same thing at Breeze-Eastern. They make rescue hoist. This is a mission critical component in a helicopter that pulls people up and down in search and rescue missions. The qualification process with a new airplane model is incredibly expensive and time-consuming. Breeze-Eastern has about 50-60% market share.


The Fountainhead

The last reason I love this job is simply I love value investing and I like to work with Geoff. I draw inspiration from Howard Roark in my favorite novel, The Fountainhead. Howard Roark is a visionary architect. He has his own philosophy. He works with his mentor Henry Cameron because they share the same philosophy. Their designs are unpopular and they make minimal amount of money. But they keep sticking to their philosophy because they believe there are some clients interested in their designs. Howard Roark gives me the courage to follow what I believe. And I’m happy to have a small group of like-minded clients reading Singular Diligence.

Talk to Quan about What He Hates and Likes about Singular Diligence

Check out Singular Diligence


Why We Canceled Our Majestic Wine Issue - For Now

by Quan Hoang

Geoff and I had scheduled Majestic Wine as the May 2015 stock pick for our Singular Diligence newsletter because it looked like an affordable stock with the best competitive position in its small niche (multi-bottle wine purchases in the U.K.). But a transformative acquisition and a change of CEO makes us doubt the board intends to maintain the corporate culture that lead to Majestic’s success. So we’ve scrapped the issue on Majestic for now. We picked a simpler, safer stock for May. Majestic is still an interesting company. And it might be a good stock for some blog readers - just not for Singular Diligence right now. So, here’s my take on the company.

Majestic Wine is the largest specialist retailer of wine in the U.K with 215 stores. Majestic stores are about 3,500 square feet carrying 800-900 types of wines. That’s small compared to U.S. wine stores. In the U.S., an upscale supermarket can carry 2,000 types of wines but having 800 types of wines is a lot to U.K. consumers. Only Waitrose carries a similar range. U.K. retailers offer fewer types of wines perhaps because supermarkets control most of the market share. Supermarkets might want to concentrate purchasing power, and maximize sales per square foot so they don’t carry many types of wines.

Majestic doesn’t try to sell the cheapest wines. They focus on premium wine. Majestic sells on average £7.94 per bottle (or $12), which is 40% higher than the industry average of £5.38 per bottle (or $8.14). The differentiation is the 6 bottle-purchase minimum. Majestic’s average transaction is £129 (or $195) or 16.25 bottles per transaction. The high revenue makes it feasible for great in-store service. Knowledgeable employees can give customers advices about wines. They carry wines to customers’ cars and offer free home delivery. Stores also offer free tasting. Majestic sells good wines and good service at competitive price.


Wine Retailers Enjoy Favorable Product Economics

Unlike in beers or liquors, product economics is better for wine retailers than for brand owners. Brand is less important in wine. Customers choose wine by origin, grape variety, and price range. Selecting wine is like selecting a mutual fund. There are hundreds of choices and each choice tastes different. Price visibility is low. So, customer relationship is better built at store level than at brand level. As a result, retail mark-up on wine can be 30% compared to 10% on beers and spirit.

Wine retailers have strong power over winemakers. Wine retailers are more concentrated than consumers and suppliers. Premium wines are usually made at small scale. Majestic is the #1 or 2 buyer from each producer. My estimate is that Majestic buys about 25% to 50% of each producer’s capacity. As an example of Majestic’s power over suppliers, Majestic asked suppliers to pay 4 pence per bottle between October 2014 and April 2015 when they built a new warehouse.

Favorable product economics, along with efficient operations, allows Majestic to make about 8% EBIT margin. By turning assets 4 to 5 times, Majestic can make 30-40% pre-tax ROIC. From 2000 to 2014, annual sales growth was 9.2% and annual earnings per share growth was 12.3% while Majestic retained only 48% of earnings.

Majestic has 215 stores today. They target to have 330 stores by opening 12-16 stores per year. That would result in high single digit growth for many years while paying about 60% of earnings in dividends. During my research, the share price was around 320 pence per share, which implies 9x EV/Pre-tax Normal Earnings. Majestic pays about a 23% tax rate so that translates into less than 12x After-tax Normal Earnings. Majestic seems like a good “Growth” candidate.

Like I said in the last post, the key to analyzing Growth stocks are durability, moat, and debt. Majestic has almost no debt. Rent is so cheap that EBITR/Rent is about 3.7. The solvency risk is minimal. Durability and moat seem good.

There are two main risks to durability. One, wine brands become more important and the profit pool is shifted from retailers to brand owners. Two, Majestic loses the role of connecting consumers with producers.


Retailers Helps Connect Small Wine Producers with Consumers

There’s little risk that wine brands become more important for some reasons.

First, economies of scale in wine production aren’t significant. 80% of capital investment is highly variable in equipment like refrigeration system, fermentation & storage tanks, or cooperage (barrel, racks, etc.) Some studies show that most of the decline in unit costs are gained when capacity is increased to 10,000 cases (1 cases = 12 bottles of 750ml). Economies of scale become less important for wineries with capacity over 10,000 cases. So, production cost isn’t the problem for small producers. That means there are always many small producers to buy wines from.

The problem of small winemakers is marketing. Small producers don’t have scale to reach end-consumers in each end-market. Oyster Bay is one big premium brand. Oyster Bay’s gross margin is over 60%. They spend 30% of revenue in marketing. Most wine producers can’t spend that much.

So, for many small wine producers, Majestic is the best route to U.K. consumers. Majestic has store employees to explain new wines to consumers. In fact, one third of Majestic’s wines are replaced each year.


High Barrier to Entry

The risk that Majestic loses the role of connecting consumers with suppliers comes from competition. Majestic competes with supermarkets, high street wine specialist, and distant sellers like mail-order or online retailers. Supermarkets control over 80% of market share but are more focused on cheap wine. High street wine specialists are weak and losing market share. Many wine specialists went out of business during the Great Recession. Online wine retail is a hot area.

Barrier to entry is high in the brick-and-mortar channel. It’s difficult to replicate Majestic’s warehouses. Entry was easiest in early 1980s. After 30 years, it’s difficult to replicate Majestic’s buying power and efficient operations. It’s also difficult to compete with supermarkets. Supermarket market share is concentrated in a few players. Except for growing discounters like Aldi and Lidl, there’s little change in that channel.

Barrier to entry is low online, but it’s very difficult to build a viable online business. Many wine e-retailers come and go quietly. They couldn’t get enough scale to pay for fixed costs. The problem is that pure online retailers don’t have a cost advantage over traditional retailers like Majestic. They’re actually at a cost disadvantage.


Majestic Model

Majestic has an extremely efficient model. Each store has 4 or 5 employees and 1 or 2 vans. Employee’s jobs include lifting lots of boxes of wines, giving customer advices, managing store’s web page, carrying cases to customer cars and delivering wine to customers. Store employees deliver about 40% of sales to customers’ home.

This level of service is possible because each store fulfill an average 30 orders per day. So, stores aren’t busy. Yet, staff and credit card processing expenses are on average only 7.9% of sales. That’s thanks to the high revenue per transaction, which is a natural result of Majestic’s policy to sell by cases.

Majestic stores are usually located away from high street (focal point for shops in U.K. town and city centers.) and between where affluent people work and live. Many are converted garages, pubs, or petrol stations. Average store size is about 3,500 square feet. Each store has free parking for 10-12 cars. Rent expense is just 3.4% of sales.

Big stores allow Majestic to keep inventories at stores instead of distribution centers (DCs). Majestic has only one national warehouse that is in the same building with Majestic’s headquarters where cardboard boxes crowd the reception area. The national warehouse passes through inventories quickly to stores. Each store holds enough inventories for 11 or 12 weeks.

I think Majestic’s model is even more efficient than supermarkets like Tesco. Tesco doesn’t keep a lot of inventories in stores so they have to replenish stores frequently from 28 regionals DCs. Tesco ships a big amount of wine to regional DCs, and then ships a small amount of wine from regional DCs to stores frequently. Meanwhile, Majestic ships a big amount of wines to stores much less frequently. Including store occupancy cost, the cost of getting wines to stores and delivering to customers is just 8.4% of Majestic’s revenue. That’s impressive. Also, inventory cost is financed by suppliers because Majestic gets 75-day credit from suppliers.

Majestic spends about 5.2% of sales in administrative expense. So, total operating expenses is 21.5% of sales. Adjusted gross margin, which considers only cost of wine, duties, and carriage cost in cost of sales, is about 29-30%. So, Majestic can make about 8% EBIT margin.

Online Competitors Don’t Have as Low Costs

Naked Wines is the most successful competitors. Revenue has grown very fast. Revenue was £4 million in 2009, £11 million in 2010, £22 million in 2011, £35 million in 2012, £53 million in 2013, and £74 million in 2014. Naked Wines made £3.3 million EBITDA loss in 2014. However, EBITDA in the U.K. was about £2.1 million, which translates into about 5% EBITDA margin.

In its best year, operating expenses is well over 30% of sales. Naked Wines spends about 16% of sales in selling and distribution expenses, 11% of sales in administrative expenses, and over 6% of sales in customer acquisition.

Selling and distribution expenses are highly variable. Naked Wines’s best chance to reduce cost is to gain operating leverage in administrative expense, and to achieve high customer retention rate (thus reducing customer acquisition cost over customer lifetime value). But it’s perhaps impossible to match Majestic’s efficiency of spending only 21.5% of sales in operating expenses.

That’s understandable because wines are heavy so it’s expensive to ship a few cases from a central warehouse. Also, revenue per transaction is so high that centralizing customer service and order fulfillment doesn’t save that much.

Online competitors are unlikely to have lower cost of wine than Majestic. Majestic has about 4% market share. However, Majestic’s CEO said in an interview in 2011 that 80% of wine sold off-trade in the U.K. was below £5. That means Majestic may have close to 20% market share in premium wines. They have 13% market share of wines from Argentina, 12% market share of wines from Bordeaux, 12% market share of wines from New Zealand, and 10.5% market share of Champagne. So, Majestic has strong buying power.

Majestic is also a tough buyer. Most of business is conducted at trade fairs. Majestic’s wine buyers usually spend 15 minutes talking to a winemaker and taste all of the wines. They don’t socialize or fraternize. They taste and say to winemakers “that wine and that wine I like. Send me a sample and your best price.”

So, I don’t think competitors can have lower cost of sales than Majestic. Some actually said that Naked Wines sell £1 or £2 more than should be. Most critics say that Naked Wines’s wines are bottled very young.

There is evidence that other distant sellers are less efficient than Majestic. For example, Laithwaites is a mail-order wine merchant since 1969. Laithwaites revenue is about £350 million. Laithwaites has over 1 million customers Half to 2/3 of customers are regular customers. Laithwaites sells wine at a higher mark-up than Majestic. One wine critic in the U.K. told me that Laithwaites sells lower quality wines than Majestic. However, Laithwaites EBIT margin is just 2-3%. That suggests high operating expenses, perhaps because of high shipping cost and high customer acquisition cost.

So, it’s easy to establish an online wine retailer but it’s very hard to build a profitable business. It took Naked Wines 4 years to break even. And after 6 years, Naked Wines’s EBITDA in the U.K. is merely £2.1 million. Majestic is in a better position than online competitors because 40% of sales are already delivered by local stores.


Majestic Wine Can Co-Exist with Supermarkets

The biggest competitive risk actually comes from supermarkets. They are trying to sell more online. And they’re trying to sell better wines.

Majestic has some protection. First, Majestic has inherent cost advantage over online retailers as discussed above. Tesco online may have greater scale to match Majestic’s efficiency. Tesco may underprice Majestic by taking lower margins. But that’s all. Online retail of wine isn’t a winner-take-all situation. Different e-retailers don’t carry the same types (or labels) of wines. Price comparison is very difficult. There’s room for several winners. And Majestic has only about 4.2% market share.

Supermarkets can also underprice Majestic in the brick-and-mortar channel. Some Majestic’s employees told us that Waitrose sells similar wines somewhat cheaper than Majestic because they sometimes sell wines as a loss leader.

Pricing competition from supermarkets isn’t a big problem. Majestic has never tried to offer the lowest price. They offer great service at competitive price. The differentiation is 6-bottle purchase minimum. About a half of customers go to Majestic stores once a year to buy wines for events like BBQ, Weddings, Christmas, etc. They buy from supermarkets for the rest of the time. The other half of customers are regular customers. They may visit Majestic stores once every 2 months.

Customers go to Majestic because of product availability and services. Supermarkets don’t normally carry several cases of the same wine. Majestic offers party services like free glass loans or free return of unopened bottles. Supermarkets don’t offer free tasting like Majestic. Supermarkets may try having wine experts in-store but consumers aren’t used to store employees approaching them in supermarkets. Supermarkets definitely don’t help carry wines to customer’s cars.

Price is important but there are always customers willing to pay a bit more for better services. Majestic will be fine as long as they keep prices competitive while maintaining a high level of customer service.


Volatility Creates Opportunities

One more thing I like about Majestic is price volatility. EV/EBIT moved by 5 units in most years since 2001. For example, the lowest EV/EBIT was 8.5 and the highest EV/EBIT was 13.8 in 2012. Recently, the price went from 400 pence per share in early January 2015 to 301 pence per share on March 01, 2015, and to 382 pence per share today. Business fundamentals can’t move that much. Smart investors can make great profit by trading in and out of the stock.


The Inherent Risk in U.K. Stocks

Majestic has one risk that’s typical of U.K. companies. U.K. companies have a tendency to hire external CEOs. But I thought that Majestic had a unique culture. When Tim How, the first CEO, retired in 2008, Majestic didn’t look for external candidates. They had actually appointed Steve Lewis as COO in 2007 to prepare for Tim How’s retirement. Steve Lewis joined Majestic in 1985 as a store employee right after graduating from college. He spent his entire career at Majestic. That’s a strong evidence for the continuity of a culture.

Steve Lewis has done a good job. He took Majestic through the Great Recession unscathed. Majestic’s recent performance isn’t good. They gained market share but expected flat earnings this year. Margins declined because of pricing pressure from supermarkets. I think that’s fine. Majestic is still growing and is now more competitive. Margins declined but are still higher than historical level (and my expected normal margins).

But Steve Lewis was suddenly fired in February 2015. Majestic said they wanted to find a CEO with online expertise. That worried me. It’s true that Majestic is slow in growing the online business but I expect an evolutionary instead of a revolutionary change. An online executive may know nothing about wine warehouse and offline customer service.

Finally, Majestic announced the acquisition of Naked Wines in April 2015. They’ll make Naked Wines CEO Rowan Gormley the new CEO. Majestic will pay £50 million cash, which is financed by debt, and £20 million in shares based on performance over the next 3 years.

I think acquiring Naked Wines make great strategic sense. There’re cost and product synergies between a wine warehouse and a wine club or an online wine store. Last year, Naked Wines made £74 million revenue, £2.1 million EBITDA in the U.K., and -£3.3 million EBITDA overall. If Majestic helps Naked Wine reduce cost of wine, administrative expense, and distribution cost, they can make 8% EBIT margin on Naked Wines’s sales. If that works, the price they paid isn’t high at all. The two companies combined can also offer stronger offerings to consumers.

My concern is that Majestic made Rowan Gormley the new CEO. To me, he’s more of a salesman than a value builder. His experience over the last 15 years has always been with wine e-retailer start-up. He might have spent more time at raising money or PR than creating value. He may not understand what brought Majestic success and may kill Majestic’s culture. I would prefer Steve Lewis to stay as the CEO of the merged company.

This development reminded me of Sequoia’s discussion on Rolls-Royce in the recent letter to shareholder:

Rolls-Royce, our largest UK position, seems willing to destroy shareholder value in the name of diversification. Rolls-Royce has a world class business making engines for wide body jets. These engines are often sold at breakeven prices, or even a loss, but come with long-term Total Care service contracts that are quite profitable. Rolls shares a duopoly with General Electric in wide body engines and the barriers to entry for any newcomer would be formidable. Not only is the business intensely regulated, but a new player selling jet engines without an installed base of profitable service contracts likely would lose billions of dollars to capture market share from GE and Rolls. Not surprisingly, Rolls earns more than a 20% return on invested capital in civil aviation and its installed base of service contracts and strong backlog suggest Rolls should grow profitably for years to come.

And yet Rolls’ board of directors decided that it wanted to diversify deeper into the marine engine and power generation businesses, competitive sectors that are being encroached by low cost Asian players. To pursue this strategy, the board appears to have pushed out a sitting CEO who had crafted the successful Total Care service contract selling model, and replaced him with John Rishton, a board member who, in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated.

Rolls’ stock declined more than 30% in sterling during the year as investors lost confidence in management. We held our shares in the belief that Rolls’ wounds are self-inflicted and reversible. The recent share price does not properly value the civil aviation business even if we ascribe little value to the marine and energy businesses. However, management and the board seem stubborn and entrenched, and it may take a tough-minded activist to force strategic change.

A Singular Diligence issue on Majestic was scheduled for May 2015. But there’s a risk that Majestic is changing for the worse like the story Sequoia thinks Rolls-Royce is. So, Geoff and I decided not to publish an issue on Majestic in the near future. There’s too much change and it’s too early to tell. To me, Majestic chairman Phil Wrigley looks like an idiot. But I can be wrong and he may prove a genius. So, I’ll keep watching the developments at Majestic. But for now, we can’t afford any speculation in our newsletter.

This experience also teaches us to be careful of European stocks in general. Independent Chairmen are strong in European countries. European companies tend to hire chairmen and CEOs externally. That results in a risk of change in a company’s culture or direction. It’s perhaps safer to pick good family-controlled companies when investing in European stocks.


Stock Picks Review and Lessons Learned

by Quan Hoang

(Geoff’s Note: The blog post you’re about to read is Quan’s discussion of the results of stocks he wrote notes on and the two of us scheduled for a Singular Diligence issue. Results were calculated as of March 31st, 2015. The newsletter’s publication schedule is set several months in advance. So these results are a review of our process. They are not a review of the newsletter’s record. These are not the results a newsletter subscriber would have gotten by buying each of our picks the day the issue came out. For example, no issues were ever published on Greggs and PetSmart because the stock prices rose before their turn in the publication schedule came up. We picked them internally. We never published them externally. So subscribers couldn’t benefit from those picks. Note also that Atlantic Tele-Network is now $68 versus the $58 when it was planned as an issue. A stock like that could – especially if the price falls back toward $58 – become a future issue of Singular Diligence. We definitely reserve the right to publish on stocks like Greggs and Atlantic Tele-Network if they ever get back to a price we like.)


It’s been 1.5 years since we launched The Avid Hog (now Singular Diligence). We think that’s long enough to review the performance of the stocks we picked. The purpose is to see what worked and what didn’t to improve our process. I calculated the total return of each stock pick in the following table:


We have 2 losers, sadly by a huge amount and 12 winners. The median return is 24%. We have 4 stocks that returned more than 40% (Greggs, PetSmart, Car-Mart, and Life Time) and 6 stocks that returned between 15% and 40% (Wiley, HomeServe, Village, ATNI, Babcock, and Ark). Progressive and Ekornes are two recent picks. WTW and CLUB are disasters.

We actually published only 11 issues. We analyzed PetSmart (PETM), Atlantic Tele-Network (ATNI), and Greggs (GRG:LN) and these stocks were scheduled for July, August, and September 2014. However, we didn’t publish our research on these stocks because share prices went up significantly before and during the transition to Singular Diligence. I think it’s helpful to look at both these stocks and the winners to see what worked.

It’s also worth mentioning three companies that aren’t included in the table. I analyzed FirstGroup (FGP:LN), Higher One (ONE) and Neustar (NSR) but we didn’t pick these stocks. If we did and if our clients bought these stocks, they would have lost more than 50%. Let’s call these stocks “Near Misses”. I think it’s useful to look at both Near Misses and Losers to analyze errors.

One or two years are a short period of time to judge performance of individual stock. Some stocks can go up not because of improvements in business fundamental but because of Mr. Market’s optimistic mood. So, we’ll only take a brief look at group performance and pay more attention to our Losers and Near Misses.

We can categorize our stock picks into 3 groups:

Growth: Greggs, PetSmart, Car-Mart, Life Time, and Home Serve

Value: Village, ATNI, Ark, and CLUB

Franchise: WTW, Ekornes, Progressive, Babcock, and Wiley


For the lack of a good word, we will simply call the first group “Growth” stocks. These are stocks with concepts that can expand geographically. Peter Lynch would love to buy these stocks.

This is the best performing group with an average return of 51%. This is much better than I expected. I only expected investors to make double-digit returns by holding these stocks for 10 or 15 years. I underestimated how quick the multiple would change.

I think there’s one reason for the outperformance. These stocks can have many years of growth as long as their concepts are relevant. That results in high “perception elasticity of multiple.” Whenever same store sales or some other data are negative, the market sentiment turns pessimistic and multiples collapse.

All of the stocks we picked had some concerns. Greggs had weak same store sales performance. PetSmart faces online competition. Car-Mart experiences competition from used car loan securitization. Life Time has weak recruitment due to competition from private studios. HomeServe has a crisis in the U.K.

However, the multiple expands quickly when more upbeat data comes out. I think that’s the case for Car-Mart, Greggs, and HomeServe. For PetSmart and Life Time, business performance wasn’t strong but private equity buyers are confident in the long-term prospects.

Business fundamentals of these stocks didn’t change as much as stock price. I think the key to analyzing these stocks are moat, durability, and debt.


The Value group includes stocks with a strong core but little opportunity for redeployment of capital. They have moat and conservative capital allocation (except for CLUB). They tend to hoard cash. The group’s average return is 8%. Excluding CLUB, the group’s average return is 22%. CLUB deserves special attention as we’ll discuss later.


The Franchise group includes stocks with wide moat and steady long-term growth, say 3-5%. They tend to have competitive advantages that allow them to hold or gain market share over time. They’re boring stocks with little catalyst. If we forced Warren Buffett to buy 3 stocks out of 14 stocks we picked, he would have bought Wiley, Progressive, and Babcock. These stocks are all in the Franchise Group. They are safe enough to hold “forever”. Competitors can’t really kill them. Only they can kill themselves.

WTW and Ekornes are a bit different. They’re more of a niche player that attracts a small number of total customers. And WTW can really kill itself because of the debt it took. But both WTW and Ekornes have qualities of a franchise. They’re durable and can make more money overtime.

Wiley is the oldest pick in this group and returned 30%. Progressive, Babcock, and Ekornes are the latest picks. Babcock returned 18% for no obvious reason. Babcock will have a spinoff in Mid-2015 so that can be a catalyst. Long-term, I expect Progressive and Ekornes will perform like Wiley. WTW is a disaster and we’ll discuss it in the next section.


Two stocks we picked have declined by a huge amount. Our original thesis on WTW still holds. We think we made a mistake in CLUB. But let’s look at our Losers and Near Misses to see what we can learn.

We picked CLUB at around 5.6 times EV/2013 EBITDA, 7.6x EV/Pre-tax Owner Earnings, and 6.5x Market Cap/FCF. We thought that the business was durable because of barrier to entry in cities like NYC and Boston. We noticed that customers aren’t really happy with CLUB. But we thought that it’s okay because CLUB is a “necessary evil”. We saw a very low fixed charge coverage ratio but we thought that CLUB was in the strongest financial position in its history. They survived the Great Recession. They had a lower debt level than in the past. There were also rumors that they would sell a property in NYC for about $70 million. They eventually sold it for $82 million.

Yet, what killed our thesis was the rise of private studios. We had a blind spot to societal change with change in new studios, habits, and the ease of this happening.

People are lazy. They don’t like to workout. That’s the problem in the fitness club industry. To grow, a chain usually has to recruit more than 1/3 of lost members each year. Private studios are more “mentally” accessible to people who don’t like to workout. That makes recruitment more difficult for traditional clubs. Combined with high operating leverage and debt, that’s a formula for disaster.


Our thesis on WTW still holds. All recent statistics I looked at show that free apps or activity trackers help people reduce on average less than 2 pounds. If the 80-20 rule applies, 20% of people account for most of total weight loss. In other words, 80% of people achieved almost zero pound loss on average. And the other 20% of people still reduce less than 10 pounds on average. Meanwhile, studies show that 35% of WTW members achieved at least 10% weight loss. So, I think most people still need support in reducing weight. In the long run, efficacy will prevail.

The biggest problem with WTW is debt. I was fond of the pattern of WTW’s capital allocation. They tend to increase debt every few years and use the proceeds to repurchase shares. And then they focus on reducing debt. The last time they levered up the balance sheet was in 2012. I thought that they will have fewer shares over time.

I knew that the business would decline for several years. But I was looking out to 2018 and I expected that they would make record earnings that year. I forgot that high leverage would magnify the impact of declining EBIT on share price in the short run. So, it’s been a tough ride for clients who bought WTW.

Debt also reduces financial flexibility of WTW. Fortunately most of their debt is due in 2020. It’s quite a long time for a turnaround.


Neustar is a stock that we almost picked. Neustar makes most of its money by providing routing information to telecoms in the U.S. When a customer of Verizon calls a customer of AT&T, Verizon must access Neustar’s database to know where to route the call. Neustar provides the service under a contract with North American Portability Management (NAPM), a telecom industry consortium. Neustar has been the sole provider for over 15 years.

The switching cost is huge. It’s estimated that it costs billions of dollars for carriers to transition to a new provider. The current contract is due to expire in June 2015. Neustar’s management was so confident that they asked for a high price when bidding for the next contract.

I had as much confidence Neustar would keep the contract as the executives did. Geoff was reluctant because of the big customer concentration risk. And his reluctance saved us from a big mistake. Neustar surprisingly lost the contract to Telcordia, the only other bidder. Neustar’s share price has declined by more than 50%.

Neustar has been lobbying aggressively. The FBI and CIA basically told the FCC to pay more attention to security risk. The FBI and CIA said they won’t be able do their work if there’s any disruption during the transition. So, it’ll be interesting to watch the final outcome.

Higher One

I spent about a month on Higher One (ONE). I looked at the company because my favorite investor Glenn Greenberg put about 7% of his portfolio into the company at that time. Higher One basically sells debit cards to students. Effective marketing can make this business very profitable.

But Higher One makes money by charging hidden fees like overdraft fees. That makes students unhappy. And I feared that making money this way would damage its image at each school and reduce marketing effectiveness in later years. We didn’t have a lot of past financial results to learn about its durability. So, we decided to drop the stock.

That turned out to be the right decision. The business later deteriorated. The share price has declined by about 75% ever since.


I looked at FirstGroup in May 2013 (before we launched The Avid Hog.) FirstGroup is a transport operator. They have rail franchises in the U.K. and operate local buses in some U.K. cities. They also run student busing and Greyhound in the U.S. I was attracted to the stock because of the low EV/EBITDA at around 4.

I spent about two weeks on FirstGroup. I was uncertain. The business didn’t have a good unlevered return on capital. They only achieved great growth by using debt. Also, the price wasn’t really good based on my estimate of maintenance capital expenditure.

When I was unsure if I should continue analyzing FirstGroup, they suddenly announced a recapitalization plan. They raised money through a rights offering to reduce debt. Existing shareholders would experience dilution if they don’t participate. The share price declined over 40% in a week, and has performed poorly ever since.

Two Noticeable Traits of Losers and Near Misses

The two noticeable traits of Losers and Near Misses are debt and customer problem.

Debt led FirstGroup into the recapitalization. WTW’s debt reduces financial flexibility in the turnaround. It also depress share price when the business declines. CLUB is even worse. CLUB has both a lot of debt and high fixed operating costs.

CLUB, WTW, Neustar and Higher One all have customer problems. CLUB and WTW have low retention. Neustar makes most of its money from one big contract. Higher One makes money off unhappy students.

How to Analyze Customer Problems

To analyze customer problems, Geoff suggested 3 questions:

  1. Is the customer fickle?

  2. Is the customer happy?

  3. What is the buyer/user situation?

And I add one final check:

  1. Is customer concentration high?

Each poor answer raises a warning. It’s not necessarily bad when there’s one warning. But two or more warnings combined can create a big problem.

Is the Customer Fickle?

Customer is fickle when there’s a lot of quitting and signing up. WTW shares this problem with CLUB. Dieters are quick to quit, and quick to follow fads. If WTW doesn't replace most customers who attrite in 9 months, they’ll have a problem quickly. That makes WTW a cyclical franchise instead of a stable franchise that Warren Buffett would love to buy.

On the contrary, car insurance buyers aren’t fickle. They tend to take the new price for the policy they’re given. They only switch when they have a bad experience with their insurer or when they have a life-changing event like marriage. Similarly, Wiley’s customers aren’t fickle at all. A university librarian doesn't change the journals he subscribes to without a very good reason like a budget cut.

Is the Customer Happy?

Both Life Time and CLUB have fickle customers. They have to replace lost members all the time. There are 3 types of people they recruit. The first type is people who have just moved into the area. The second type is people who go to clubs for the first time. The third type is people who go to clubs again.

CLUB provides a basic product. There’s nothing memorable about CLUB’s customer service. There’s no good word of mouth. Customers aren’t really happy with the rundown gyms. The key selling point is convenience. When private studios offer a more convenient option, CLUB is doomed.

Life Time has happy customers. Unlike other fitness chains, they don’t sell annual subscriptions to retain members. Life Time sells only monthly subscriptions. They retain members through customer engagement. It’s possible that Life Time has very strong word of mouth. I suspect that partly explains why Life Time performed better than traditional clubs.

Business is full of unknowns. When customers are happy, there can be lower risk of having weaknesses in the business armor that no competitor has really attacked yet. This reminds me of Jim Collins’ Built to Last. To last, one can't just focus on profit-making. There must be a balance between value created for customers, employees, and shareholders. This is exactly why we dropped Higher One.

What Is the Buyer/User Situation?

Sometimes buyers aren’t the end-users. Problems can arise when interests of buyers and users aren’t aligned, and one or the other is unhappy or fickle. In such a situation, competitors can try to change who to sell to. For example, they can try to serve the user better.

Higher One is an example. Colleges and universities are happy with Higher One because Higher One helps distribute financial aids to students for free. But some students are unhappy with the hidden fees. Even worse, students are usually activists. Unhappy students can kill High One’s image in each school fairly quickly.

Wiley doesn’t have that problem. Wiley’s end-users are much less likely to complain than Higher One’s. Even better, professors and students may complain if they don’t have access to the scientific journals they need.

Is Customer Concentration High?

The last issue with customer problem is high customer concentration. I don’t have a better answer than to pay special attention to moat in addition to the three questions above.

We walked away from most candidates with big customer concentration. Babcock is an exception. Most of Babcock’s nuclear business is manufacturing nuclear components for nuclear plants in submarines and aircraft carriers of the U.S. Navy. Let’s take Babcock through the 3 questions.

Is customer fickle? No, the U.S. Navy has a 30-year plan to procure weapons.

Is customer happy? Yes, there has been no nuclear accident in the history of U.S. Navy

What is the buyer/user situation? The U.S. Navy is the user and the negotiator. They want to build a certain number of submarines and aircraft carriers based on their long-term strategic plan. Submarines and aircraft carriers are their top priority program. They discuss with suppliers and propose a budget to the Congress. The Congress has a committee to consider the budget. The committee often consists of some congressmen from areas that make the weapons. Letting jobs in these areas go means letting their own votes go.

Finally, Babcock has a monopoly position. There’s no alternative. There’s no commercial nuclear provider in the U.S. after the Three Mile Island accident in 1979. There are few foreign competitors because a few foreign governments have scale to have a home grown nuclear program. And the U.S. government just can’t trust a foreign supplier.

At this point, I think Babcock has strong bargaining power. I’m comfortable with Babcock even if they have only one customer.

Risk Control

After this review, we decided to implement some measures to control risk.

First, we updated our excel template to calculate metrics like Z-score, Debt/EBITDA or EBITDAR/ (Rent + Interest). That helps raise a flag whenever a candidate has high leverage. Actually, all of our recent stock picks or candidates in the research pipeline have little debt.

Second, we’ll have two additional sections in the notes I prepare for Geoff in each research. One section is about financial strength. Another section is about customer problem. We avoided Neustar and Higher One in the past. But now we have a formal procedure to eliminate these mistakes.

I hope that there’ll be no loser in the future.

Our Reflection

Value investing is risky. We screen for cheap stocks. But cheap stocks usually have some problems. The trick is to avoid real problems. Famous investors always tell us to watch the downside and the upside will take care of itself. Unfortunately, there are things that we can only learn from our own experience. Fortunately, we’re much more downside-conscious now.

Our short experience with Singular Diligence turned our preference to Franchise stocks. It’s not an issue of maximizing return. We tend to find Franchise stocks and Growth stocks at the same valuation, say 8 EV/EBIT. Growth stocks tend to be more attractive because of higher growth potential. Near-term return can be higher because perception elasticity of multiple is higher.

However, Growth stocks may attract more competition and change than Franchise stocks. We would have to follow a Growth stock more closely than a Franchise stock. But we already find it hard just to do research and find new candidates to deliver one good idea a month. We don’t really have time to revisit the stocks very often. So, it’s safest to buy Franchise stock that we can hold for 20 years like Progressive.

Ideally, we would love to pick only Franchise stocks for Singular Diligence. That way, there’ll be fewer occasions when our clients panic and sell because Mr. Market is pessimistic about our picks. But there aren’t that many opportunities. We’re sure that our future stock picks will be evenly distributed between the 3 groups. That’s just a natural result of our work.

Talk to Quan about Past Stock Picks and Lessons Learned From Them

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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 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

  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 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.

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