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

by Quan Hoang

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

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

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

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

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

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

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

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

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

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

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

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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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

Stock Price Guidelines

by Geoff Gannon

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

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

(The Brooklyn Investor)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  1. Theoretical Sense
  2. Technical Sense

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

Village Supermarket (VLGEA): 41.8%

John Wiley (JW.A): 24.8%

Carnival: 1.1%

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is this what I do?

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

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

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

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

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

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

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

Carnival: 0.31x

Village: 1.10x

John Wiley: 1.84x

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

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

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

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

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

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

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

Here is what he was asking about:

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

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

What do you think?

And here is how I responded:

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

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

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

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

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

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

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

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

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

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

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

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


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


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


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


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


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


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


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

Talk to Geoff about Stock Price Guidelines

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



IMS Health (IMS): 4 Years Later

by Geoff Gannon

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

Here is the S-1.

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

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

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

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

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

The new owners churned through the workforce astoundingly fast:

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

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

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

Talk to Geoff about IMS Health (IMS)

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

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

by Geoff Gannon

Moody's downgraded Weight Watchers (WTW) debt:

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

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

(Moody's Downgrade)

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

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

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


Talk to Geoff about Weight Watchers (WTW)

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

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

by Geoff Gannon

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

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

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

(Press Release)


Talk to Geoff about Barnes & Noble (BKS)

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

Weight Watchers (WTW): Notes PDF

by Geoff Gannon

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

Weight Watchers Notes PDF

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

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

Those items are:

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

The Investor Day Presentation the company put out last fall

The 8-K outlining the company’s credit agreement

Artal’s portfolio (Artal controls Weight Watchers)

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

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

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

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

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

A Closer Look at Weight Watchers (WTW)


Update on Weight Watchers International (WTW)

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

Talk to Geoff about Weight Watchers (WTW)

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The Inevitables

by Geoff Gannon

In his 1996 letter to shareholders, Warren Buffett explained his strategy of investing in “inevitables”:

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables."  Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years…however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime.

I happen to have a Standard & Poor’s Stock Market Encyclopedia published in 1967. So, I figured I could check just how persistent the profitability of these “inevitables” is.

Here are the operating margins of 5 such inevitables.

Talk to Geoff about The Inevitables

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Geoff’s Avid Hog Watchlist: Catering International & Services (CTRG:FP)

by Geoff Gannon

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

Catering International & Services trades in Paris under the ticker “CTRG”. The company was founded in Marseilles, France in 1992. Two families control 71% of the shares. The founder, Regis Arnoux, controls the majority of the company’s shares. He still runs the company. Catering International provides remote site services (mainly catering) in extreme conditions. Revenue is about evenly divided between serving mining customers (51%) and oil & gas customers (47%). Operating profit – but not revenue (more on that later) – is about evenly divided between Asia/Pacific (54%) and Africa (46%). So, we’re basically talking about a company that caters for mines and oil fields in Asia and Africa.

Let’s start with how I found the company.

I ran a screen at Stockopedia looking for E.U. stocks sorted by their gross profits relative to net tangible assets. I then eliminated companies that either had lost money in one of the last few years or that now traded above 8 times EBITDA. I also eliminated companies where the business description suggested they were far from all 3 rings of my circle of competence: 1) consumer habits, 2) business support services, and 3) industry standards. This left a little over 40 stocks. I then looked for English language information on all 40 stocks. About 14 of these stocks had multiple annual reports in English. Catering International was one of them.

A few things appealed to me immediately about Catering International. The business sounded both mundane (catering) and niche (extreme conditions). It’s a business support services provider. Gross profitability was adequate.

A few things also concerned me right away. Catering International serves mining and oil & gas customers. That means the commodities these companies are extracting – their reasons for being at these sites – are at bubble levels. I’m not saying they are in a bubble. The supply of oil and gas is finite. So you can argue that bubble prices relative to the past could be justified throughout the future. But there is no long-term history of prices being this high. Therefore, we don’t have a relevant record of consumer or producer behavior to go on. We don’t know how marginal – high cost and high risk – some of these sites are. Catering International has been a very fast growing company. Some of that growth was driven by customer interest in more extreme conditions which high prices for commodities like oil and gold have to encourage.

The good news is that you don’t have to expect a lot of future growth to invest in Catering International. Using the most aggressive estimates of EBIT and enterprise value you get a price of 6.5 times EBIT for the company. Using the most conservative estimates of EV and EBIT you get a ratio of 8.2 times. Any price less than 10 times EBIT seems quite fair for a company like this – even without a lot of growth.

I need to explain the “estimates” issue for both EV and EBIT. The company has two noteworthy items. First, it has money losing operations in South America. Today, that is Peru and Brazil. South America contributes 18% of the company’s revenue. However, those operations actually cost the company 3 million Euros in losses. We need to consider those losses in our analysis. But, we certainly should not capitalize them. For example, if we assume Catering International is worth 10 times pre-tax profit – we should not lop 30 million Euros off our valuation for contracts the company can simply stop bidding for in the future. So, this raises the question of whether EBIT is 21 million Euros (companywide) or 24 million Euro (profitable segments only).

And now the cash question. Catering International has 16 million Euros of cash in Algeria. The Algerian government does not want Catering International to transfer that money to a subsidiary that would allow us to consider it net cash at the corporate level. If you count all Catering International’s cash around the world – it comes to 38 million Euros of net cash. If you count all the cash except what’s in Algeria – it comes to 22 million Euros.

So, if you value the company at 10 times pre-tax profit, your decisions on how to treat South American operating losses and the Algerian cash could change your valuation of the company by 46 million Euros. Catering International’s market cap is 192 million Euros. So, the questions are significant. But, an analysis for The Avid Hog, could simply present the best and worst cases. It would almost certainly write-off the Algerian cash entirely because we have no ability to predict court cases in Algeria.

All this talk of Algeria – which is Catering International’s largest market at 22% of revenue – is a good place to tangent toward the special headline risks present in owning Catering International. These risk (mostly) don’t concern me. However, they greatly increase the risk of negative publicity for the company. And some of the potential headlines could make investors – especially investors far from both France and the sites where the company operates – quite uncomfortable.

First, there is the special risk that Catering International’s employees could be violently killed. The company’s largest single subsidiary is Cieptal in Algeria. Over 130 local workers – and one French citizen – of this subsidiary were among the 800 hostages taken at the In Amenas gas facility when it was attacked in January. None of Cieptal’s employees were executed. However, the French employee was hidden and presumably would have been killed if found. About 39 foreigners were killed. They worked for or with Cieptal’s customers at the site: Sonatrach (Algeria’s oil company), Statoil, and BP.

This brings up another risk. Catering International works with companies like Sonatrach that are controlled by governments like Algeria. In fact, local investors have minority stakes in some of Catering International’s subsidiaries. The countries Catering International operates in are often corrupt. Catering International is run from France by French citizens who – in very small numbers – rotate through these countries for short periods of time. So there is a risk Catering International’s French employees will bribe people in these countries. When you consider that Catering International bids for contracts and that they have a stated goal of 500 million Euros in revenue by 2015 (up from 316 million Euros in 2012) the incentive to bribe is high. Furthermore, these are French – not local – employees dealing with local (not French) decision makers in a country where bribery is more common than in France and where the French employee will not be living permanently. This is a good recipe for justifying your own bad behavior.

Of course, as I’ll explain in a moment, many of Catering International’s direct customers are multinational oil and mining companies. But in all cases, Catering International has to set up local subsidiaries in these countries. They may sometimes have to take on local investors in these subsidiaries. And there will always be issues like whether they can access their Algerian cash. So there will be constant temptations to bribe.

Finally, there is simply the public relations problem of a French company doing business in very different parts of the world from where it is headquartered. About 9 out of 10 Catering International employees are local men. In France, the company employees equal numbers of men and women. In the rest of the world, it’s about 9 to 1 men versus women. French employees are paid anywhere from about 4 to 11 times more than local employees. They receive plenty of benefits. They work less. And their employment is more secure. Local employees have a very different situation. To a large extent, this just reflects the relative power position of workers in each country. Workers in France have a lot of power. Workers in the countries where Catering International does its catering have very little power. And women are excluded from much of public life.

On an annual – which is not how local workers are employed – basis, wages are about 3,816 Euros a year in Africa, 5,256 Euros a year in Asia/Pacific, and about 10,284 Euros a year in South America. Catering International makes all its profit in Africa and Asia/Pacific. These are places where employees make less than 6,000 Euros a year.

So, you have the special headline risks of terrorism, bribery, and exploitation. Any coverage of these – or any topic about Catering International – are as likely to have a political angle as a financial angle. So, the experience of holding Catering International may feel a little different than other stocks you own.

With that out of the way, let’s get some basic information about the company. They have 11,600 employees (of which about 88% are local, low-paid men). The company operates at 170 sites in 41 countries. They serve about 120,200 meals a day. Their biggest single market (22% of sales) is Algeria. The subsidiary that now handles all Algerian operations is called Cieptal. It has a website (in French) that you can see here.

Catering International was founded in 1992. It went public in 1998. It has compounded revenue at 40% a year since its founding. Growth in recent years has continued in sales. However, the operating profit picture is fairly mixed (losses in South America have widened). In the latest annual report, the company mentions a sales target of 500 million Euros in 2015. With sales of 316 million in 2012, that would require sales growth of more than 15% a year. If profit growth was anything like that, you’d obviously be paying a very low multiple of 2015 EBIT. Enterprise value – excluding the Algerian cash – is 172 million. EBIT – including losses in South America – is about 21 million Euros. If operating profit grew 15% a year, you’d be paying 5.4 times 2015 EBIT. That’s a very good deal. The reality – because of the South American losses and Algerian cash – might be even better than that. Of course, we don’t know that operating profit will track sales or that sales will grow as expected. However, you can see that by any growth at a reasonable price measure – this is a very, very cheap stock.

Business is conducted in the local currency. Most customers are excellent credits. In fact, legal risk (like the Algerian cash) are probably as meaningful as the risk that a customer would fail to pay due to insolvency. Catering International paid 1.4 million Euros to settle a customer’s claim last year. I imagine this is a company where you will be seeing a lot of items like that from time to time. Last I checked, the company’s Algerian subsidiary was still being prevented from transferring a dividend (of 16 million Euros) out of the country. They filed a claim with the Algerian Supreme Court.

Catering International has a huge list of its subsidiaries. Many are inactive. In the annual report, there is a couple sentence business commentary for many of the active ones. If you’re interested in the company, you should read this list of subsidiaries in the annual report. It’s the highlight of that document.

Instead of reproducing it here, I’ll just focus on a few examples where we know both the name of a Catering International customer and the country where they serve that customer. For a full list of customers, see the back of the 2012 annual report. Almost all are multinational companies active in mining or oil & gas. There are a few exceptions (Nestle is on the list). The exceptions aren’t meaningful contributors to sales.

Examples of customers and countries where Catering International operates are Bechtel in Guinea Conakry, Kinross Gold in Mauritania, Total in Yemen, and Avocet Mining in Burkina Faso.

I think the Yemen business is small. It sounds like they just want to work with Total and show off what they can do outside of catering. Catering International has almost no business in the Middle East. Although they hope to one day do meaningful business in Iraq. Like I said, all profit really comes from mining and oil and gas sites in Asia/Pacific and Africa. None of the other stuff is meaningful.

The company has money losing businesses in both South America (meaningful at 3.8 million Euros in operating losses) and the former Soviet Union (not meaningful). South American operations seem to be ongoing in Brazil and Peru and pretty much just inactive subsidiaries elsewhere. The former Soviet Union includes subsidiaries in Kazakhstan, Turkmenistan, and Russia (the arctic).

The company refers to its employees in New Caledonia (part of France near Australia) in a way that makes it sound like they may be organized. It’s unclear to me whether this “dialogue” has to do with New Caledonia’s special status (and Catering International being a French company) or some past problem with these employees. Generally, my impression of the worldwide workforce is that they are local, low paid men who are not unionized.

So what’s the verdict?

It’s unlikely Catering International will make it into The Avid Hog. The stock is statistically attractive in both a “magic formula” and “growth at a reasonable price” way. It will probably perform well. And it would make an excellent addition to a diversified value portfolio.

However, there is not enough information on how a customer decides to go with Catering International. The company’s customers are very large multinationals who do not provide details on such information in their own reports. The business is far from the consumer. And I do not know a lot of people in this industry or these countries.

This is a research problem. I don’t have – and am unlikely to get – enough info about the actual purchase decision. I don’t see a way to gain enough confidence in the future behavior of customers when it comes to their catering needs. And I know nothing about Catering International’s competitors.

Basically, the annual report wasn’t informative enough about what I most need to know. So, unless someone emails me after reading this to tell me they know a lot about Catering International specifically or catering at these sites generally – I just don’t see a path forward for this company.

So, I’m suggesting Catering International as a stock blog readers should be interested in. But I’m also passing on it for The Avid Hog. This one is a “no”.

Talk to Geoff about Catering International (CTRG:FP)

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New Value Investing Blog: Moatology

by Geoff Gannon

There’s a new value investing blog called “Moatology”. This post on Pulse Seismic is a good example of what the blog does best. Moatology brings you good businesses you haven’t heard of. If you’re looking for a value investing blog to add to your reading list, check out Moatology.

Talk to Geoff about Moatology

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Quan’s Avid Hog Watchlist: Berendsen (BRSN:LN)

by Quan Hoang

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

Berendsen provides textile cleaning and supply services in Europe. Berendsen’s textiles include uniforms for customers from fire fighters to doctors, road workers and chefs. Berendsen provides mat for facilities and linens for hospitals, hotel, restaurants, etc.

The company operates in 15 countries throughout Europe. Most of its business comes from the U.K., Germany, and Scandinavia. Berendsen purchase textiles and then rents them to customers. They then maintain and launder these textiles periodically.


3 Layers of Durability

I think Berendsen is among the most durable businesses I know. Berendsen’s durability has 3 layers.

First, I think in 30 years, people will still need uniforms and linen. You must stay close to customers to collect, launder, and deliver textiles regularly. So, there’s no threat from low cost providers in China.

Second, the local nature of this rental business means Berendsen’s durability is equal to its customers’ durability. Most customers are service providers like hotels, hospitals, and fire departments. So they will stay in Europe forever.

The third layer comes from diversification. Berendsen serves customers from 180 plants. Each plant stays close to a major center of commercial activity and serves customers within a radius of 100 km (62 miles). So, if something happens to a plant, it has less than 1% impact on the company.


Wide Local Moat from Economy of Scale

I think Berendsen has a wide moat thanks to economy of scale. Local scale is important as the management mentioned Berendsen has the highest return where it has density and scale. Local scale maximizes plant utilization and asset turnover.

Also, it’s costly to collect and deliver textiles to customers. Distribution cost is 20% of Berendsen’s sales. A new competitor without local density may have to spend 30% of sales on distribution cost and therefore make little profit.

High plant utilization and good profit margin allow Berendsen to make about a 25% pre-tax return on net tangible assets.

It’s impossible for a new competitor to enter a local area where Berendsen is already big. A competitor must sign contracts with a lot of customers to gain scale. Berendsen has 250,000 contracts around Europe. That’s close to 1,400 contracts per plant. And these contracts last 1 to 3 years. Assuming that a competitor can sign up a new customer whenever a contract expires, it still takes at least 3 years to build up scale. That competitor will surely lose money during the ramp up period.


Capital Allocation Creates Value

Berendsen is really a capital allocation story. The company changed its name in 2010. It was formerly The Davis Service Group. The Davis Service Group acquired Berendsen in 2002. Davis was originally a car dealership in the U.K. They entered the textile rental business through the acquisition of Sunlight Services in 1987.

The company entered and exited different businesses over time. They made a lot of acquisitions. But on average, they created value for shareholders. Since 1998, Berendsen compounded sales and EBITDA by 6.5% and 6.1% respectively. They achieved that by retaining only half of free cash flow. So, Berendsen effectively made 1a 2% return on investment over the period.


A Perfect Candidate for Defensive Investors

The share price is not cheap but is relatively good. At 995 pence per share, the market cap is now £1,650 million. Net debt is £476 million. So, EV is £2,126 million. Berendsen made £146 million EBIT last year. EBIT grew 13% in the first half of 2013. But based on 2012 number, the EV/EBIT ratio is 14.6. That’s about 5% after-tax earnings yield.

A 14.6 EV/EBIT ratio is too high for most companies. But for a predictable company like Berendsen, long-term investors can still make an adequate return.

Berendsen’s growth is tightly related to GDP growth. The company targets 1-2% organic growth ahead of GDP growth. That makes perfect sense given that there’s a huge market potential from customers who have never outsourced. So, organic growth can be 3-4%.

Berendsen makes 25% pre-tax return on net tangible asset. So, they need to retain less than 20% of earnings to grow sales by 3-4%. Therefore, at today’s price, investors can expect about a 7-8% return.

Berendsen won’t actually return 80% of earnings to shareholders. Berendsen historically returned 50% of earnings. They made bolt on acquisitions. I expect those acquisitions to create value as proven in the past. Berendsen usually acquires small competitors that are family-owned. The reason for sales of those businesses is usually generational shift rather than economic factors.

So, I don’t think it’s aggressive to expect Berendsen to grow sales by 6% in the future as they did in the past. Along with today’s 3% dividend yield, the expected return would be 9%.

Investors should also keep in mind that earnings can grow slightly faster than sales. I think margins tend to increase over time in this business. That didn’t happen in the past at Berendsen. But the company is focusing on improving margin in the near term. So, margin expansion can be a nice surprise.

Berendsen is not cheap, but it’s among the most predictable businesses I’ve ever seen. It’s a perfect candidate for defensive investors. At today’s price, I wouldn’t buy the stock. However, Berendsen is definitely among my top candidates.

Talk to Quan about Berendsen

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

How to Quantify Quality

by Geoff Gannon

Someone who reads the blog sent me this email:

I kind of understand the quantitative part of stock analysis (such as number crunching, valuation) but really struggle to understand the qualitative aspects which determine quality. What kinds of questions to ask yourself in order to gain more insights into the qualitative?

A qualitative analysis does not have to be any less evidence based than a quantitative analysis. However, you do have to gather the evidence yourself.

What counts as evidence? How can we separate our own biases, speculation about the future, etc. from actual observations of quality? Evidence is fact based. Facts come in several flavors.



Example: Tiffany’s New York Flagship Store had $305.54 million in sales in 2012. That is $6,671 per square foot. Based on calculation made from data given in Tiffany’s 10-K on percentage of sales at flagship, worldwide net sales, and gross retail square footage of flagship.



Example: John Wiley, Reed Elsevier, Springer, etc. have bargaining power with their customers.

The largest (academic journal) publishers wield the power…as a former colleague of mine once said, ‘the more journals you have, the higher your usage stats are and the more money you can charge.”

Based on discussion with a university press editor.



Example: Over the last 10 years, I have placed an average of one order every 4 to 10 days with Amazon. At no point in the last 10 years, have I ever made less than one order every 10 days. I have been a member of Amazon Prime since 2006. The number of orders made each year has roughly tripled from 2003 to 2013. It doubled after I became a Prime member.

Based on information found in my own order history for 2003 to 2013 at Amazon.



Example: The 4 most successful periods in animation were at 3 companies: Disney (twice), Pixar, and DreamWorks. At the time of their success, these companies were run by Walt Disney, Jeffrey Katzenberg, John Lasseter, and Jeffrey Katzenberg (again). All worked at Disney at some point in their career.

Based on more than half a dozen books on Disney, Pixar, and DreamWorks.




377 participants were assigned to (Weight Watchers), of whom 230 (61%) completed the 12-month assessment; and 395 were assigned to standard care, of whom 214 (54%) completed the 12-month assessment. In all analyses, participants in the commercial programme group lost twice as much weight as did those in the standard care group.

Based on a journal article appearing in The Lancet.


As you can see, there is no need to be less evidence based when analyzing a business’s quality than you are when analyzing its price. However, you have to impose an evidence based discipline on yourself. You have to go through the primary sources and extract the relevant facts on your own. They will not be presented in as easily digestible form like an EV/EBITDA ratio on Yahoo Finance. When it comes to quality, you need to gather the evidence yourself.

Talk to Geoff about How to Quantify Quality

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Quan’s Avid Hog Watchlist: Q-Logic Corporation (QLGC)

by Quan Hoang

Geoff and I actually decided to drop Q-Logic (QLGC) from The Avid Hog’s list of candidates a while ago. Q-Logic doesn’t fit the kind of business The Avid Hog is looking for. But I think it may fit the taste of some readers of the blog. That’s why I’m writing this post.


Parent and Child Turned into Competitors

The story started in 1994 when Emulex spun off Q-Logic. Q-Logic was then focused on disk controllers that help CPUs communicate with disk drives. Emulex focused on its networking business.

Servers in data centers used to have disk drives that are attached directly to them. But as the number of servers deployed in a data center increased, it became more difficult to manage isolated storage resources. Therefore, a new storage architecture named Storage Area Network (SAN) was developed.

SAN allows data center to centralize storage into one place. Servers get data from the storage pool through a network. SAN helps reduce cost because it reduces excess capacity required for each server. SAN also makes it easier to manage storage or add more storage.

A protocol is required for servers to talk to the storage pool. Fibre Channel (FC) is most popular protocol for SAN. FC to SAN is like Ethernet to Local Area Network (LAN).

The development of SAN means the convergence of storage and networking. Emulex with its core in networking made experiments with SAN. Q-Logic with its focus on disk controllers made an early investment in SAN. The parent and child turned into competitors. But that was a lucrative rivalry.


High Switching Cost Results in a Wide Moat

Both Emulex and Q-Logic produce FC adapters. FC adapters sit in servers and help servers talk to the SAN. As is the case in any hot industry, there were dozens of competitors. But the industry eventually settled, and Q-Logic and Emulex together have held over 90% of market share over the last decade.

Both companies’ margins are very high. Q-Logic has about a 67% gross margin. Emulex has about a 64% gross margin. That’s incredible! That means Q-Logic can consistently charge giant customers like IBM, HP, and Dell three times what it cost to make a FC adapter. That’s a good indicator of some competitive advantage.

It turns out that the competitive advantage comes from high switching cost. FC adapter accounts for less than 7% of total SAN cost. Yet, it’s critical to the SAN’s performance. And people who manage the storage are conservative. Their job is to provide reliable and consistent availability of information. They just want to maintain the robustness of the SAN. My discussion with an industry expert illustrates this switching cost:

Expert: For storage environments, companies need to fully test interoperability and performance of a driver with the applications. The testing and validation of a new driver can take over 6 months, so there is a disincentive to change adapters. The operational expenses of managing the environment and maintaining the robustness of the stack typically outweighs any capital costs.
Quan: Are these tests performed during OEMs qualification or performed with each end-customer (enterprise customers)?
Expert: The vendors/OEMs do product interoperability (adapter/server/switch/storage), but customers need to bake their full software stack (applications). This is a per-customer basis.
Quan: When customers upgrade to 16Gbps FC, do they need to install new drivers and a new test that would take 6 months? Or do Q-Logic and Emulex produce new HBAs or CNAs that work with old drivers that customers already had?
Expert: While the 16Gb FC HBAs do have the same drivers, large enterprises typically will still do the testing. There is no "standardized" application stack, so while the OEMs do plenty of testing (enough for some customers), the big customers that buy the bulk of the adapters will still need to verify. From the time that a new generation of adapter is released, it usually takes at least 3 years before 1/3 of sales are the new generation. Baking out the end-to-end takes time (16Gb FC still isn't on most storage arrays today), negotiating new contracts, running through old inventory, etc. The HBA business is an arcane one...
Quan: When large enterprises upgrade their SAN and do the testing, does the testing interrupt the data center's operations? And would they upgrade all components of the SAN (HBAs and switches) at the same time or would they upgrade switches before HBAs?
Expert: Switch upgrades (transparent to the application, no driver) are much easier than HBA. Typically new HBAs are put in new servers, so there is the waiting for a refresh cycle to do it. The whole environment is usually tested in a sandbox.

Once a customer successfully tests a FC adapter, there’s no incentive to switch. Q-Logic wisely make new adapters compatible with existing drivers. So, customers naturally stick to Q-Logic through each upgrade cycle. Also, Q-Logic has a reputation of being the first to market. They were always the first to introduce a new adapter in each upgrade cycle. That helped them gradually increase market share.


Q-Logic Repurchased a Half of Its Shares

The FC adapter business became Q-Logic’s cash cow. Since 2001, Q-Logic generated $1.8 billion of free cash flow, averaging $139 million a year.

Unlike management of most tech companies, Q-Logic’s management just focused on protecting the core. They made some investments adjacent to the core but couldn’t find a new cash cow. Most of free cash flow was used to repurchase shares. Since 2001, they spent $1.9 billion in share repurchase. The share base declined from 185 million in 2001 to 89 million today.


Mr. Market Is Extremely Pessimistic about Q-Logic

Q-Logic currently has $433 million of cash. The market cap is $1,080 million. So, they can buy 40% of the company immediately. The reason they didn’t do that is most of the cash is offshore. But it’s totally possible that they would borrow money in the US and repurchase shares like most tech companies. Given potential FCF from the core business, it’s safe to expect that if share price doesn’t go up, Q-Logic can eventually repurchase half of the company.

Q-Logic made only $83 million FCF last year. But they’re in the low point of a cycle. 40% of their business is from the government and financial sectors. Capital spending was weak in those areas in the last year. And it will be weak in the near future. Q-Logic is also spending a lot of money in some new products. R&D is higher than normal. But it’s for growth. Q-Logic can always cut back R&D and improve FCF.

So FCF may one day return to about $139 million a year. That translates into about $3.12 FCF per share. Even at 10x FCF, the stock price in 5 years would be $31.20. If that happened, it would provide a 21% CAGR from today’s $12 per share price.

It seems that Mr. Market doesn’t pay attention to Q-Logic’s cash balance. Q-Logic’s EV is $647 million. That’s close to Emulex’s EV of $586 million. However, Q-Logic has more market share than Emulex and is much more profitable.


The Core Business Is Declining

So, why did we drop Q-Logic?

It’s because of durability. I don’t have a clear view of Q-Logic’s future. There are two main threats to Q-Logic.

The first threat is from iSCSI. iSCSI is a protocol for SAN but using the LAN network. It’s cheaper and more convenient than FC. But it’s not as robust. iSCSI is strong with small enterprises that have fewer than 100 servers. Although iSCSI didn’t make a dent into FC, it did block FC’s growth.

The second threat is from cloud computing. It’s widely accepted that enterprises are shifting computing to the cloud. Unfortunately, cloud service providers may use different storage architectures. Big cloud providers like Google, Amazon, or Facebook use commodity storage instead of the expensive SAN. Other solutions might be iSCSI, network-attached storage, etc.

I think Fibre Channel will stay for many years. Q-Logic’s customers are big enterprises. There’s a huge institutional inertia to move their computing to the cloud. Sequoia’s discussion on IBM shows they have the same expectation:

IBM has said that the cloud is probably its biggest threat. IBM has said it is a $7 billion revenue opportunity but that $4 billion would be a shift of revenue that the company could lose to the cloud. So the management thinks it is a $3 billion opportunity over the current roadmap. That shift would happen — and that is obviously what you would be most concerned about — that shift would primarily happen in hardware because cloud vendors would buy a lot of commodity servers, put them all into a pool and sell by the drip again. Their scale could really further commoditize that business. Luckily, IBM is relatively small in that area. There are also some services that could be obviated. IBM does provide a lot of services to build the internal IT infrastructure, which could be outsourced to the cloud. But typical large enterprises have not just one or two applications, but thousands if not tens of thousands of applications. Today, they often rely on IBM to manage them. Even if a lot of these applications moved to the cloud, they would still require the ones that remain onsite to be able to communicate with the ones that they have moved to the cloud. Companies would still need integration and training to make sure that their business processes work with the new applications. So while there may be some shift away, we still think that IBM services will have work to do even in an era of cloud applications. We think that the trend is quite long-term. As I said, the spending on cloud computing is nascent right now. IBM is cognizant of the fact that over time this will be a more desirable way to consume corporate IT. Recently management has said that outside of a couple of core applications, things that are unique to a company and the company would want to keep in-house, up to 90% of the rest of the applications could be in the cloud, but it will take a very long time. In the meantime customers will want IBM to help them with that transition. IBM, by the way, sells ... you should think of it as, to a significant degree, a software company because 45% of the profits are coming from software. IBM is going to offer that service or all that software as a service over the cloud itself. So IBM will be able to take advantage of that opportunity as well.

Roughly speaking, 90% of servers in big enterprises will be moved to big cloud over a very long time. Meanwhile, small companies or companies growing big wouldn't build a big in-house data center. So, Q-Logic's core business will decline gradually.


The Avid Hog Wants Almost Risk-Free Investments

Q-Logic is definitely not a good buy and hold investment. It might be cheap. A turn in spending cycle may give investors some last (good) puffs. But it may or may not happen.

So, an investment in Q-Logic has high potential return but also high risk. It would fit a diversified investment portfolio perfectly. But it doesn’t fit The Avid Hog. The Avid Hog is interested in investments with almost zero risk. So, we want a sustainable moat. We want durable products. And we avoid “unpredictable” declining businesses.

Q-Logic is in an “unpredictable” declining business. The Men's Wearhouse (MW) might be in a declining business but it’s not unpredictable. There is always demand for suits, and surviving companies don’t necessarily decline. But for Q-Logic and Emulex, we don’t know how fast the demand for FC will decline. And in tech, declining really means dying.

Talk to Quan about Q-Logic (QLGC)

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

Quan’s Avid Hog Watchlist: The Men’s Wearhouse (MW)

by Quan Hoang

(Quan prepared this post before Jos A Bank’s offer for Men’s Wearhouse was made public. The Skype transcript that follows Quan’s original post happened on the day the offer was made public.)

I found The Men’s Wearhouse (MW) in the list of companies with lower than 8 EV/EBITDA and with more than 10 consecutive years of positive earnings. MW sells men’s suits and provides tuxedo rental products.


After-tax Return on Capital Is over 16%

MW’s 10-year financial result is good. Over the last 10 years, sales grew 6.7% and EBITDA grew 9.1% annually. In the meantime, MW generated more than $800 million free cash flow. So, 10-year average FCF is $80 million.

Net tangible assets (NTA) at the end of 2012 FY was $801 million. Obviously, NTA increases overtime, so it’s conservative to say unlevered FCF/NTA is higher than 10%. Along with sales growth, MW’s after tax returns on NTA is more than 16% a year. That return is good enough to make it an Avid Hog candidate.


MW Is a “Category Killer”

MW’s main business includes operating retail and rental stores. Rental stores are smaller with an average of 1,372 square feet. Retail stores average 5,721 square feet. That’s about 10 times larger than my apartment in Texas. If I recall correctly, that’s a lot bigger than the suit section I found in Macy’s stores.

I noticed in the 10-K that advertising spending was $92.2 million, $82 million, and $89.9 million in 2012, 2011, and 2010, respectively. That’s about a half of NutriSystem’s marketing spending in 2008, and close to NutriSystem’s $111 million marketing spending in 2012.

Marketing is very important for NutriSystem. They try to convince people to buy $250 meal plans through TV ads. So, I’m surprised to see that a retailer’s marketing expense is close to that of NutriSystem.

Some more information in Wikipedia shows me how MW reaches customers:

The chain notably ran television and radio commercials featuring Zimmer, and the oft-repeated slogan: “You’re going to like the way you look; I guarantee it.”

I think that people don’t buy suits often. People don’t go to the stores often like people going to Wal-Mart. So, MW advertises to let people know that they can find suits at MW’s stores. People will think about MW when they want to buy suits.

So, I think of MW (and its competitor Jos A Bank) as a “category killer”. They’re similar to Best Buy, Home Depot, PetSmart, etc. They wipe out tiny local competitors by scale. Most local competitors have small store size and no advertising budget. Category killer’s stores are in more visible locations and their ads focus on low price and wide selection.


MW Can Effectively Compete with Department Stores.

Department stores may have a traffic advantage over MW. Men may go to department stores often to buy other things, and notice that they can find suits there.

But department stores have a rent per square foot disadvantage. Department stores that have men’s sections with suits are usually anchor tenants in malls like Nordstrom, Macy’s, etc. Rents in good malls are expensive. Department stores that have really good selection might be more high-end. So, MW can offer a wider selection of suits to the masses.

The traffic advantage of department store may not be very important. A suit is an expensive item. Customer can make a special trip instead of impulse purchase. So, having a good selection might be more important. Jos A Bank and Men's Wearhouse just need to let men know that they can find a wide variety of suits at affordable price in their stores.


There Is No Pricing Power

MW and Jos A Bank may have some competitive advantage in this niche. But unlike Tandy Leather, this is a very competitive market. And suits are expensive so customers pay much attention to price. There’s no pricing power. MW’s gross margin is only about 40% compared to Tandy Leather’s 60%.

I’m surprised at Jos A Bank’s 60% gross margin. I’ll have to look further at the company and discuss it in another post.


Men’s Wearhouse Is More Durable than Most Retailers.

Although we usually avoid retailers, I think that it can be easier to understand MW than most retailers. MW isn’t vulnerable to fashion trend like most apparel retailers. Suits don’t change much. Trends are more predictable in men’s attire. I’m not worry about inventory risk or picking a hot retailer.

I don’t think online competition would be a big threat. The most important factor when buying a suit is how well it fits you. So, men would prefer to try it on in stores. MW faces a much smaller threat from online competition than some big box stores. MW is even less vulnerable to online competition than shoes stores because the sizing is less standardized.

Geoff told me about the fact that people buy fewer suits overtime:

There is, however, a societal trend you should keep in mind. When my Dad started work at The Bank of New York in Manhattan he probably owned 5 suits. By the time he retired 30 years later, he probably owned one suit (and used it only for client visits). In many industries, American men no longer wear suits to work.

 They are still important for special occasions. And people need suits, etc. for weddings, funerals, and a few other events. This is why you see so much about rentals, etc. People actually wear suits a lot less now.

However, the social trend has largely happened. There may be further declines, but the bigger decline has happened. MW and Jos A Bank grew by gaining market share from smaller, independent stores. There will be fewer companies staying in the business overtime. So, declining market doesn’t mean companies that stay in the business will decline overtime.


MW Is a Good Candidate for The Avid Hog

The price is quite good. Last year’s EBITDA was $284 million. The market cap is now $1,640 million. Net cash is $32 million. So, EV is $1,608, and EV/EBITDA is 5.67. Maintenance CapEx for a retailer is small. Even assuming each dollar of EBITDA turns into 50 cents of after-tax owner earnings, EV/owner earnings is about 11. That’s a good price.

MW’s price is also good if I capitalize rent expense. Rent expense is $169.4 million. Using 8 times rent, capitalized EV would be $2,963 million. Capitalized EV/EBITDAR is about 6.54, which is low in today’s market.

So, from my brief research, MW is a good candidate for The Avid Hog. But until we decide to devote one month to research MW, we’ll have to do a lot of scuttlebutt, and learn more about suits.

(When Jos A Bank’s offer was made public, Quan and I discussed the two companies. Here is the transcript of our discussion on Skype).


Geoff’s Thoughts on Image Positioning

Geoff and I recently discussed about Men’s Wearhouse (MW) and Jos A Bank (JOSB). I learnt about image positioning from the discussion. Image can be important in learning about a retailer’s durability. So, I would like to share our talk to readers of the blog.

Geoff Gannon: Did you see that Men's Wearhouse announced that they rejected a $48 a share offer from Jos A Bank?

Quan Hoang: I didn't hear the news

Geoff Gannon: Yes. You can see an article about it on Bloomberg (and elsewhere) right now. The stock is up 20% or so this morning.

Quan Hoang: I see. It's now $45. It's interesting to see JOSB's price also increased 8%

Geoff Gannon: That's unusual. Usually, the buyer's stock would not go up. Of course, they rejected the offer. But that means the market thinks it would be a good deal for Jos A Bank. Also, the offer was made in (I think) mid-September. Weeks ago. It's just that they went public now. Do you think Men's Wearhouse is right to reject the offer? Do you think it would be a good deal for Jos A Bank?

Quan Hoang: I think so, MW is quite cheap.

Geoff Gannon: Would you be interested in a combined company?

Quan Hoang: Yes, I am. I guess they'll keep two brands separate. But at least the competitive position would improve.

Geoff Gannon: Of course, we don't know if they ever will combine. And we don't know how much would be paid to shareholder of MW to get the deal done. And we don't know what the market price of the combined company would look like. Any other thoughts on Men's Wearhouse and Jos A Bank?

Quan Hoang: I think they're good candidates for The Avid Hog. But now MW is not very cheap, JOSB may be a better candidate. I read something in the internet about the two companies and my impression is that JOSB is a better company. What do you think?

Geoff Gannon: I'm not sure JOSB is the better company. I'm sure they've had more success in recent years.

Quan Hoang: That's from customer's perspective.

Geoff Gannon: Both from the customer's perspective and from Wall Street. Their marketing, etc. worked better. They grew. In retail, customer perspective and Wall Street perspective are often the same. When you are clicking with customers, Wall Street likes you. When you aren't, they don't.

Quan Hoang: Do you think marketing effectiveness is just cyclical like what happen to the big networks?

Geoff Gannon: I don't know. I think Wall Street, retail experts, etc. tend to assume that a company is better because its marketing is more effective. It would be like them saying that CBS has more viewers than NBC because programmers at CBS are smarter than NBC and they always will be. Often, the perception of company quality and management quality is really just the "glow" of the last 3 years results in terms of same store sales.

There is momentum in retail, restaurants, etc. Once you catch a marketing trend that works, you set off word of mouth, improved perception of your brand, etc. One smart decision can trigger a wave that lasts a few years. But it may all go back to just one smart decision. And you may not really be better at making smart decisions than the competition.

Quan Hoang: But these two companies have their stores and the business is not disruptive. So can they always stay in the business and improve the business by some smart decisions?

Geoff Gannon: Maybe. There have been men's clothing stores that failed in the past. Most were never as big as these chains. Because there weren't many national retail chains of any kind - there weren't category killers - back then. But companies like Bond Stores did fail. They were the leading men's clothing store in the 1960s.

Quan Hoang: Are they similar to JOSB and MW?

Geoff Gannon: Nothing was exactly similar back then. But, yes, they were. But it was a more general business back then. So it was more open to direct competition from many sources - because this was more everyday wear for men in cities. I think they suffered when major department stores expanded from a few locations in a city to going national.

Today, the category is more special. And it is more dominated in terms of breadth etc. by these two companies. So I'm not saying it's the same. But there were men's fashion stores - stand alone and as part of department stores - that failed.

Many of the big retailers founded before 1970 are no longer around today. The U.S. retail market is very different today from what it was before about the time WMT etc. started. It was very different in the 1960s and earlier. A lot of things changed that. Computers were part of it, national advertising was part of it, and logistics was a lot of it. But there was a mass extinction of retailers that were strong in the 1950s and 1960s.

What do you think of the durability of the 2 companies? Combined or separate?

Quan Hoang: I don't think there's any difference in durability if they are combined or separate. What do you think?

Geoff Gannon: I agree. The greatest risk to their durability is poor image. A competitor can come along - it can be founded tomorrow - and cultivate a better image that resonates more with modern customers and succeeds. I don't see problems in terms of cost and such. Just the risk of a societal change, image problem, etc.

For example, my Dad went to Jos A Bank. But he would never go to Men's Wearhouse. He would love to go to Brooks Brothers. But they were often too expensive. Once every couple years, he made a special purchase at Brooks Brothers (his favorite). A couple times a year he might go to Jos A Bank (when he saw some sale they were having). And he wouldn't be caught dead in a Men's Wearhouse. Just a matter of image.

Quan Hoang: Customer loyalty seems to be strong. I can feel that. Can it be explained by habit or something deeper?

Geoff Gannon: It's not habit. People rarely go to these stores. It's mindshare. Brooks Brothers is to men's suits what Tiffany is to women's jewelry and what See's is (on the West Coast) to boxed candy. If you are going to buy your wife chocolate for Valentine's Day it will be - if you live in California - See's. If you are going to get her jewelry, it had better come in that blue box (Tiffany). Putting the same piece in that blue box suddenly makes it more valuable to her. And so the company can charge more. This is true both in the U.S. and in Japan. If you are going to buy a suit for your first real professional job in Manhattan or whatever, you are going to "invest" in something from Brooks Brothers.

Now, maybe, if you have to replace something or whatever you are going to consider Jos A Bank and Men's Wearhouse or whatever. But, when you make those big life purchases - with the most emotional importance - they are going to tend to be the See's, the Tiffany, and the Brooks Brothers of the world that you go with.

But it isn't loyalty at all. It's the opposite. You may never have bought a suit. But people you know have. You will rarely buy expensive jewelry. But you know what names you have heard women talk about. It's like that. It is the name and the name alone that creates value. It's like a standard. You may not even know how to compare them. Unlike cars, dishwashers, etc. there are no features to compare. You compare on "quality" as an abstract idea. And so you trust the name everyone trusts.

Think of it this way: What is the risk of making the wrong choice? You are going to spend a lot of money at any of these stores. It might be a relative bargain. But it’s still a huge purchase. It's still either a durable purchase or a really big occasion. So, the concern is not screwing it up. Do you want to pay $600 for a suit that might be good enough or $1,100 for a suit you feel sure will be good enough. It's that kind of thinking.

Quan Hoang: I see, mindshare, that's the word. Is it difficult to replace a customer's mindshare? Or you can only hope to create mindshare with new customers?

Geoff Gannon: The good news is that men's CONSERVATIVE fashion rarely changes. Women's CONSERVATIVE jewelry rarely changes. Boxed chocolate rarely changes. Very fashionable stuff changes a lot. But, what men wear to work, what women want as engagement and anniversary jewelry etc. rarely changes.

It's difficult to create mindshare. Brooks Brothers is one of the oldest retailers of its kind. It's been well known for over a century. Same with Tiffany. In all the time Berkshire owned See's it never succeeded in growing mindshare East of the Mississippi. A huge portion of profits still come from California. Tiffany is super successful in the U.S. and Japan. It's a little mixed elsewhere.

Quan Hoang: but I mean is it difficult to replace the mindshare Jos A Bank has with your dad (after brook brother)?

Geoff Gannon: I think that really comes down to "positioning". My Dad thought in terms of Men's Wearhouse (low end), Jos A Bank (middle range), and Brooks Brothers (high end). And then he saw himself as a middle range sort of guy. It's like watches. He would buy a $200 watch (like a Movado or lesser) not a $2,000 watch. But he also wouldn't buy a $50 watch.

It has to do with perception of quality versus perception of how much - given his income, etc. - is simply too much to spend. Probably some of it came from where other people at his work, etc. got their suits. There's a peer pressure element and there is a self-image element.

Also, Jos A Bank employed a sales approach rather than everyday low prices. So he may have liked the idea he was getting a bargain.

Quan Hoang: how can Men's Wearhouse reverse the image?

Geoff Gannon: JC Penney tried. It's easy to change your image. It's hard to change your image, attract new customers, and still keep your old customers.

Quan Hoang: Do you mean it's easy to create new image with new customers? But is it easy to create new image with someone who has some bias like your dad?

Geoff Gannon: You can change image with everyone. But you will alienate your existing customers. It is like changing the menu at a restaurant. You may bring new people in, but you will drive some existing customers away. JC Penney didn't hurt its image with new customers. It just annoyed and confused its existing customers.

If people come expecting sales every weekend then Jos A Bank better keep doing sales. If Wal-Mart has everyday low prices, they better not start doing higher prices combined with frequent sales. That's what I mean about the difficulty of changing your positioning. You have a "position" people are interested in. It's hard to change that unless you are willing to lose the customers who like you now.

Geoff Gannon: Some companies have successfully changed their position over time. It's easiest if you have a bland position. It's easy to turn something pretty blank into something memorable. It's also possible with small incremental changes. Some restaurants like McDonalds and Domino's changed their image a bit over time. Mostly, they were able to introduce some incremental quality improvements combined with different messaging while keeping enough of what people liked about them.

Quan Hoang: It's like incremental changes or disruptive changes

Geoff Gannon: Yes. But here's the important thing. In terms of "position", you are not just saying what the price of your product is. You're saying who it is for. Abercrombie & Fitch can't change their position. It's very clear. Very specific. But that's not just a price issue. It's not like they can introduce totally different style at the same price. They've actually created an image of who their customer is. Some people are attracted to being that customer. Some are repelled by the image they have created.

If the customer doesn't consider themselves a Men's Wearhouse sort of guy, it's not just a matter of pricing. Jos A Bank and Men's Wearhouse could charge the same but have created different images - in the customer's mind - of the sort of person who shops at each place. People shop where they think other people like them (and other people who are like the person they'd like to be, see themselves as) shop. They don't go where they think people they don't want to be like shop. That's the full impact of what I mean by "position".

Some people go to Target instead of Wal-Mart simply because they don't see themselves as a Wal-Mart person. Not because they think the selection is worse.

Quan Hoang: A&F sells more fashionable stuffs than something like suits, so would they be stuck with the kind of customers their position defines?

Geoff Gannon: Yes. They are still stuck with a specific position. That's why they had to create Hollister. It couldn't be market under the same brand. They needed two separate brands: preppy (A&F) and surf (Hollister). You can't mix preppy and surf/skate/etc. Actually, if you look at teen retailers they all compete on fashion but they each try to position themselves a little more focused on one specific subculture or signature piece of apparel.

I don't know the exact numbers, but American Eagle makes a lot more money on their denim (jeans) than the other teen retailers. That kind of fact tends to stay true even through the fashion cycle. So there is both a fashion issue fluctuating all the time but also some positioning issues that stay true longer term.

Quan Hoang: Yes. But how can American Eagle make more money on their denim than other retailers? how does their positioning help them make more money on their denim?

Geoff Gannon: I assume they succeeded best with the most fashionable jeans. And people who wanted them went to American Eagle. And they became known for it. Nordstrom started as a shoe store and even today people think they are better at shoes than other places. It's a question of focus for the company, perception of the customer, etc. I don't know. Apple is known for its design. Part of that is good design. The other part is people who appreciated good design became loyal to Apple.

I don't have a better answer than the idea that you have a specialty - something you do well - and then that attracts a customer base that really loves that specialty and then you try to please them. Almost all fashion designers end up making most of their money from a few specific items they are best known for. They may attach their license to a lot of things. But they become known for perfume, for leather goods, for ties, for glasses. It's a mindshare thing but it's also a feedback loop. You focus on what you do best.

Quan Hoang: Like I have the impression that Guess has good jeans, just because some of my friends say that, and I do see their jeans are good.

Geoff Gannon: Yes. Guess is a good example. That's what they're known for. They may have tried many other things too. But that's what caught on. And, yes, I associate them with that too.

The good news about MW and JOSB is that they are very slow changing areas of clothing. What matters most to durability is actually how attached you become to some specific trend and whether that changes.

For example, Hanes and Fruit of the Loom are the two biggest underwear companies in the U.S. They have been for many, many decades. During that time, underwear fashion changed completely for both women and men. But it didn't matter. They were able to change - slowly - what items they produced. So, for example, they once produced a lot of hosiery for women and now produce very little. They once produced almost no boxers for men. Now that is their best-selling item in a lot of age groups. Colored T-Shirts people wear without anything over them were very unusual in the mid-20th century. They are now a huge item for both companies. The change was huge over decades. Year to year it was small. And neither Hanes nor Fruit of the Loom was too associated with any one particular item, kind of customer, etc. in anyone's mind. So they were able to keep market share even when fashion changed completely.

Quan Hoang: I think MW and JOSB are in a slow changing area of clothes. That's why I'm interested in them

Geoff Gannon: Are you as confident in their durability as PETM, HD, auto parts retailers, and TLF?

Quan Hoang: If they can compete effectively with department stores, I think it's durable. What do you think?

Geoff Gannon: I think it's durable. But I do worry that image matters. No one thinks books at Barnes & Noble were less good because they were cheaper. But some people think cheaper suits are inferior suits. I am concerned that there is more stigma with a category killer in this area than with home improvement, books, etc.

I think - provided suits stay part of the society - there will always be a place for these kinds of stores. The highest end stores need to have an image of exclusivity. You can't put a Brooks Brothers in every suburb even if they could support those prices. That dilutes the brand. So, I think there is durability here. But, I think we don't normally look at retailers. So we have to be very careful.

Quan Hoang: Men’s Wearhouse and Jos A Bank might be stuck with their images. But there's always need for "cheap" suits (or suits for the masses) right? So should we say the image of Jos A Bank and Men’s Wearhouse is durable?

Geoff Gannon: Yes. I think there will always be a place for a mass, low price approach that spans the country rather than just exclusive shops.  We just have to be careful because most people who think and write about retailers as investment don't share our focus on durability. We need to be very careful in not relaxing our standards. It is not as easy to predict the market position of a retailer as of John Wiley or Carnival. Other people do not care about that. We do. So we must always keep in mind that retail is always a less settled industry than many of the mature oligopolies we study.

Quan Hoang: Yes

Geoff Gannon: Anything else about MW and JOSB?

Quan Hoang: Not right now, we will go back to these companies in the future.

Talk to Quan about Men’s Wearhouse (MW)

Check out The Avid Hog

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

(All) My Thoughts on The Avid Hog

by Geoff Gannon

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.

I promised an email link where you can sample the current issue. Just email Subscriber Services and ask to sample the current issue of The Avid Hog.   When you click that email link, you’ll be talking to my Dad. He handles customer service for Quan and I (who know nothing about that topic). My Dad is retired now. But he spent his career in customer support at financial services companies. I won’t tell you how long he worked in the industry. But, I will tell you that in the early years he ran call centers. Those call centers were in New York City and New Jersey. So, it was a different time. Anyway, he’s quite comfortable talking with customers. You can email him any questions – not just a sample request – and he’ll get back to you. You can also call him if you prefer to talk on the phone. You can find his contact info at TheAvidHog.com.

That’s the website we set up for the newsletter. I created it, so it’s not very pretty. But it has some of the info you might need. And I will be adding to it piece by piece over time. If you’re interested in The Avid Hog, that’s the site to bookmark. We won’t discuss the nitty gritty of subscriptions, billing, etc. on this blog anymore. The product is launched. We’ll discuss it to the extent it has to do with companies the folks who read this blog might be interested in. But, most people reading this blog are never going to subscribe to The Avid Hog. So we’ll keep the technical information over at TheAvidHog.com.

Well, those are (all) my thoughts on The Avid Hog. Some of you reading this and noticing just how long it was running might have had a sneaking suspicion there was more to the length than met the eye.

There is. If you’ve read every word of this blog post – you’ve read about 12,000 words. You’ve read the equivalent of one issue of The Avid Hog. So, you should now be able to gauge your appetite for that much text. If you enjoy gorging yourself like this each month, The Avid Hog might be the newsletter for you. Like I said, it’s a niche newsletter. If you’re not a voracious reader – this isn’t the report for you.

Questions about subscriptions, samples, etc. are best directed to Subscriber Services (again, that’s my Dad – his name is Harvey, I’m Geoff). But questions about the newsletter more generally can be sent my way. I’m always happy to answer any emails you send. Just click the link below.

Finally, I want to thank our subscribers. I know signing up on the first issue of a new newsletter is taking a big risk. Quan and I appreciate your faith in us. And we look forward to sending a lot of great issues your way in the months ahead.

Talk to Geoff about His Thoughts on The Avid Hog

Check out The Avid Hog Website

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

Blind Stock Valuation Podcast #1: Addressograph-Multigraph (1966)

by Geoff Gannon

In the first ever episode of the Blind Stock Valuation Podcast, I start by explaining how the podcast works: I post stock information – mostly historical financial data, but also a quick description of the business – without the stock name. You try your best to value the stock. You send in your appraisal. I share you appraisal with listeners. I then talk about how the market actually valued the company and what happened to the stock from that point on.

The subject of episode one is Addressograph-Multigraph as of 1966. I talk about why the P/E ratio on the stock was higher than blog readers estimated it would be. A little time is spent comparing Addressograph to Xerox (XRX). I recommend Jim Collins’s “Good to Great” in which Addressograph is used as the comparison company for Pitney Bowes (PBI). Finally, I talk about how Pitney Bowes survived to this day while Addressograph filed for Chapter 11 within about 15 years of this 1966 snapshot.  

Sponsor: The Avid Hog

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

How The Avid Hog Works

by Geoff Gannon


At The Avid Hog, we do not offer trial periods. Nor do we make old issues available for free. However, you may sample the current issue of The Avid Hog. Sampling is done on the honor system. You do not need to enter your credit card information. Just call or email Subscriber Services and ask to be sent the current issue. If you are satisfied with your sample, please come back to the site and pay for the product you just enjoyed by clicking the subscribe button. If you are unsatisfied, think of it as an (unwanted) gift.

Talk to Subscriber Services



Any subscriber who is unsatisfied with an issue will receive a $100 refund. If you cancel because The Avid Hog no longer meets your expectations, your last $100 payment will be refunded. We do not issue refunds greater than $100.



Subscriptions are billed through a $100 recurring monthly PayPal charge. You are charged $100 each month on the same day of the month on which you subscribed. For example, if you subscribe to The Avid Hog on October 3rd, you will be charged $100 immediately on October 3rd. You will then be charged another $100 on November 3rd, then again on December 3rd, and again on January 3rd, and so on until you cancel.



A new issue is released each month. Issues are sent as a PDF attachment via email. Issues are sent to all subscribers on the day the issue is published. The day the issue is sent is the same for all subscribers regardless of their billing date.



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Finding Enough Investment Ideas

by Geoff Gannon

Upon seeing that The Avid Hog is a monthly newsletter, someone asked this question:

…how do you expect to find suitable candidates every month? Is the supply of good companies that large?

The supply of good companies is enormous. If you don’t have any restrictions on market cap or country, there are always good companies out there. Supply is never the problem. Knowing that supply well enough is.

Although I consider myself a value investor, I don’t get ideas the way most value investors do. You can see a good example of how a value investor looks for ideas in this video of Michael Price’s presentation at the London Value Investing Conference. Another good example is this quote from Nate’s latest post at Oddball Stocks:

I value banks like I value companies.  I find a bank that's clearly undervalued, then I work to either confirm or deny the valuation.  This is the opposite of someone who might research and value a company and once the valuation is done look at the market value.  I start with the market value, I'm not looking for franchise companies, I'm looking for companies that appear cheap, and I want to confirm they actually are cheap, if so I invest.  This means I don't have a Watchlist of banks or companies I'd like to buy if the price were right.  Rather I continually trawl low P/B stocks and pick up what's on sale that week or month

Let’s contrast that with the ideal I strive for. In a perfect world, my approach looks more like how Warren Buffett described his analysis of PetroChina to Fox Business. He told Fox Business the important parts of his approach are that:

  1. He tries to look at the business first, without knowing the price
  2. He decides what he would pay for the entire company
  3. He compares the price he would pay to what the entire company is trading for in the market
  4. If the price he would pay is a lot higher than what the whole company trades for in the market, he buys it.

That’s the ideal approach for me. I’ve found personally that it’s the one that works best. If I appraise the entire business with fairly little preconception of where the stock should trade, has traded, etc. and then I compare my appraisal to the market price I’m on the firmest footing in terms of knowing I have a bargain.

The hypothetical I often pose when talking to Quan about a stock is:

Imagine you are running a family holding company. The assets of all your family members are tied up in this company’s stock. You can put 25% of the value of your holding company into buying this business in its entirety. Would you do it?

In other words, is this a business you want to be in forever? Is the price good? And would you be willing to put 25% of the money of the people you care most about into it?

This approach raises the threshold in a few areas:

  1. Durability
  2. Moat
  3. Quality

You aren’t going to buy something for keeps unless it’s durable. You are not very likely to buy something without a moat. And you are going to insist on a certain level of quality. It probably doesn’t have to be a great business (high pricing power and no tangible capital requirement) but it does at least have to be an above average business.

If I started with a list of statistically cheap stocks, it would be very hard to keep a good flow of the ideas I’m interested in. Aside from EV/EBITDA, there are relatively few value measures that wouldn’t eliminate companies I’m interested in.

For example, I’m fine with a company with negative net worth. I’m also fine with a company that has high free cash flow but doesn’t report it as earnings. Book value and reported earnings are not deal breakers for me.

So how do we actually end up finding ideas?

Well, you already have some evidence of how we do that. Quan has written about Tandy Leather (TLF) and EPIQ Systems (EPIQ). At the start of each post, he told you where he found the idea. He said Tandy Leather came from a list of ticker symbols I send him each week. And he said EPIQ Systems came from a list of stocks that compounded their share price at 10% or more a year since 1999.

The second list is something I created for Quan at Portfolio123. He requested it. I created the screen. It’s a huge list. There are hundreds and hundreds of companies that achieved a 10% annual return over the last 14 years. And that is just in the U.S.

Tandy Leather is not a new name to value investors. I sent it to Quan because we talk about retailers sometimes. This seemed like one with a strong niche. I tend to like distribution advantages, specialty products, and loyal customers. Tandy looked like it compared favorably to other retailers on those fronts.

Quan had already researched Games Workshop. That’s a U.K. company that owns the Warhammer intellectual property. It makes war gaming miniatures. Gross margins are very high. It sells its products through a chain of small, dedicated hobby shops. Because Quan was familiar with Games Workshop, he may have been more interested in Tandy’s stores than investors who hadn’t researched a company like that.

This brings me to an obvious but key point. We tend to find new companies because we know old companies. People who have sampled the first issue of The Avid Hog know there is a list of 5 comparison stocks in there. That’s not something we created specially because it would make a pretty table. It’s there because we like to look at about 5 comparison companies when analyzing a stock for ourselves.

Now, when I say comparison, I don’t always mean it’s a competitor. For example, if Tandy Leather ever makes it into an issue of The Avid Hog, you can bet Games Workshop will be listed as a comparison company. Not many companies have that kind of presence in a specific niche hobby and sell through dedicated hobby shops like that.

Many investors wouldn’t put Tandy and Games Workshop together in their minds. That’s a mistake. They have a lot more in common than Tandy and Coach (COH), which is the company many websites will toss out as a comparison for a leather business like Tandy.

A lot of ideas come from companies that are in some way connected to companies we already looked at. In oligopolies, we look at everything. If we like Hasbro (HAS) we do just as much work on Mattel (MAT). If we like Carnival (CCL) we do just as much work on Royal Caribbean (RCL).

Sometimes, we discard a company because of capital allocation or price. Well, competitors will tend to have similar business quality, durability, and – sometimes – moat. They will, however, tend to have different management and may not always be equally well liked by Wall Street. That encourages us to look for other comparable companies, when we like a business but don’t like its management or its current stock price.

We read a lot of 10-Ks. We each – separately – read a lot about specific companies. I don’t know how much people assume we do on this front. But, I know we do a lot more than you’re thinking.

The reason for this is mostly that we’re doing less of other things than you imagine. My consumption of general business news is really, really low. You wouldn’t get very far talking to Quan or me about the economy. We’re not that up on what is happening in economics, politics, etc. except when we can cite specific examples from companies we’ve researched. For example, I can tell you a lot more about Mediaset than about Berlusconi.

We read more blogs than newspapers. Blogs that analyze companies are our favorites. I read everything that Richard Beddard writes, everything at Value and Opportunity, everything at Oddball Stocks, etc.

It’s difficult to explain exactly how this works. For example, why – if I’m looking for above average businesses – do I read Oddball Stocks? The answer is that any time spent reading an analysis of a company, thinking about that business, and valuing that business is potentially moving you toward good, new ideas.

Some of it comes down to interpretation. I recently wrote an article at GuruFocus about whether you needed to know something the market doesn’t or just need to interpret something differently. I say a different interpretation is more important than different data.

I own a stock called George Risk (RSKIA). I bought it 3 years ago. It was profiled on Rational Walk as a net-net. I bought it because I liked the net-net price. But I only bought it because I like the business quality. I thought it was a really good business. It happened to be at a very low price. But I didn’t analyze it the way I would a net-net. I just used its low price as an obvious indicator that I didn’t have to be really worried about the value part of the analysis here. It was cheap enough. As long as I determined it was durable enough, I could buy it.

This idea of using the same data for different purposes is a big part of what we do. For instance, you may be surprised to know I read up on IPOs. I read the filings. They’re some of my favorites.

I’ve never bought an IPO in my life. I’ve never bought a company within months of it going public. I doubt I’ll ever buy stock in a company that’s been public for less than a year. It doesn’t matter. There’s a lot of interesting info about the business and the industry in those documents.

I mentioned that Quan and I have looked at Carnival. Norwegian (the third largest cruise company) filed some documents with the SEC despite its equity not being publicly traded. We’ve read those.

Now, that sounds like a real bad use of time. I mean, here I am telling you to stay away from CNBC and Bloomberg and all the chatter about the Fed and instead focusing on specific stocks – and I’ll spend time reading about a company that’s not public.

Our feeling was that knowing the cruise industry would be helpful not just in analyzing Carnival at that moment in time, but also it would just be good knowledge to have. It’s not a very fast changing industry. It’s the sort of industry where knowledge of what was happening a few years back is enough to get you pretty far into making an investment decision today.

The list of companies we’ve looked at and are interested in is always long. It’s usually a lot longer than we can handle. Price focuses us a lot. The problem with most companies is that they aren’t obviously cheap. They often seem priced about right.

Now, on this last point, our interpretation of cheap is a little different from what you’ll read about at someplace like Oddball Stocks. We don’t need historically cheap. That’s not a really big selling point for us. The company can be at an all-time high.

For example, I don’t think the stock price of the company we wrote about in our September issue has ever been more than about 10% higher than it is today. That doesn’t matter to us for a few reasons:

  1. The business is more valuable today than it’s ever been
  2. The enterprise value is lower today than it has been in the past
  3. The stock has returned 13% a year over the last 35 years.

This last point is critical. Historical valuations can be important. But they always have to be viewed both with the understanding that tomorrow may be a lot different than yesterday and also with the understanding that some assets have returned a lot more each year. Those assets deserve to trade at higher prices than they did historically.

This even happens in net-nets. I’ve had people mention that a certain net-net has shown up on a screen of net-nets for many years. That’s often true. But there are also a couple net-nets that have increased their share price at 10% or more a year for 10 to 15 years. The market hasn’t done that. So, why should we assume the past price was correct – the historical average is the mean the price should revert to – if holding the stock actually returned a lot more than holding an index fund?

Quan and I look at stocks that way. We don’t feel historical valuations are important unless they are understood in light of historical returns. If some commodity has returned 4% a year over 100 years, I don’t want to own it even at its long-term average price. If a stock has returned 13% a year over its time as a public company, I may want to own it even at a historically “normal” price.

This attitude widens our net in some areas value investors may not imagine. You’re probably not thinking that a stock within 10% of its all-time highs might be a bargain. Sometimes, that’s exactly what we’re thinking.

Quan and I do consider ourselves value investors. However, we certainly don’t consider ourselves contrarian investors. A stock doesn’t have to fall a lot to get us interested in it. We’re willing to look at stocks near highs and near lows.

The scheduled next issues of The Avid Hog will demonstrate this. Based on what we have planned, you’ll get a stock near all-time highs in one of the first issues and you’ll get a stock that dropped a lot in the last year or so.

We actually don’t consider them to be priced very differently. We view the two stocks as being about equally cheap.

So the simple answer is that we don’t do a lot of value screens. We will sometimes turn up ideas that are not very contrarian.

I don’t know all the stocks that will appear in The Avid Hog. But I would guess that if at the end of September 2014, you lined up all the names, you’d probably call it more of a quality list than a value list. I’m sure there would be very little overlap with anything Michael Price owns. So it’s no surprise our approach to generating ideas is different from his.

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What The Avid Hog Means to Me

by Quan Hoang

According to Jim Collins, a great company exists to fulfill its core purpose. Making profits is important but not the purpose. Profit is the blood for the organization to live and follow its purpose.

The Avid Hog’s only purpose is to do the best possible business analysis. That leads to our hedgehog concept. In chapter 5 of “Good to Great”, Jim Collins talked about the hedgehog concept. Geoff and I answered 5 questions posed by him to define our hedgehog concept:

1. What is our one – simple, crystal clear – hedgehog concept?

Answer: Presenting an above average business at a below average price.

2. What can we be the best in the world at?

Answer: Doing buy and hold investment analysis.

3. What drives our economic engine?

Answer: The lifetime value of each customer (gross profit per customer month multiplied by customer lifetime in months.)

4. What are we deeply passionate about?

Answer: Business analysis.

5. If you could pick one and only one ratio – “profit per X” – to systematically increase over time, what “X” would have the greatest and most sustainable impact on your economic engine?

Answer: Profit per customer lifetime or the number of months each customer stays with The Avid Hog.

The Avid Hog will need to make money to sustain itself. But we don’t intend to maximize revenue. We just need to make an adequate profit. So, we don’t want The Avid Hog to be a mass investment newsletter. We want it to be a premium newsletter.

We only want to have a small number of customers. We’ll try our best to keep them satisfied. We think it’s easier to keep a small number of satisfied customers with 100% retention rate than to have many customers with a high churn rate.

That’s because of our absolute focus on quality. Each report is one month of effort of 2 analysts. We do in-depth business analysis. We try to back up our thesis with facts, quotes, and data. We only issue reports on companies that we think will outperform the market over a 3 to 5 year time frame.

We try to build The Avid Hog into a long-lasting organization.

That means we must create value for customers. We don’t want customers to buy individual reports. We want customers to think of our offering as a package of 12 ideas a year for $1,200. If they are able to pick even one winner out of those 12 ideas, they’ll make a lot of money.

The Avid Hog will certainly evolve. But our products will always be built around business analysis. That’s our corporate DNA. We know one big thing: Doing business analysis.

Talk to Quan about What The Avid Hog Means to Him

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