Someone who reads the blog sent me this :

Dear Quan, 

I recently came across your blog and find it simple and quite informative. I have noticed myself drawn to speaking to other like-minded investors as their experiences and insights are very valuable in developing my own knowledge and skill set rather than just reading a lot of books on the subject. 

One of the topics that has been on my mind for quite some time is the required rate of return adequate to compensate investors for being equity holders in a business. I have moved away from the mainstream CAPM and WACC models for pricing the cost of equity but find little alternatives. 

From what I understand [Greenwald's class] is that Warren Buffet generally uses 15% for his discount rate, although I am not quite sure how he came up with that number. Also, from some of the class notes from Greenblatt, he mentions using the 10yr bond rate with a 6% floor and compare that to the EBIT/EV of a company. 

So my question is how do you determine what is an adequate rate of return? And how do you apply/adopt that to emerging market companies [as most info relates to US stocks]?

Thank you in advance for taking the time to respond. 

Regards,

Mohammed

I usually value a good and low-risk company at 10 times EV/EBIT. At a 35% tax rate, 10 times EV/EBIT equals 15 times unlevered earnings after tax. To make it simple, I assume after-tax earnings are equal to owner earnings. You may need to make some adjustments regarding the DA part and the actual maintenance capital expenditure. And I'll assume that market cap equals enterprise value.

There are two reasons for using a 15 unlevered P/E. First, an average company often trades at a 15 P/E. So, a better than average company deserves at least 1a 5 P/E. Second, a 15 P/E would mean a 10% nominal return. At a 15 P/E, yield is 1/15 = 6.7%. A good company can raise prices at the inflation rate or higher. That adds up to about 10%. 10% is what the stock market returned in the past. And I think the stock market will return less than 10% in the future.

 

Two Risks to Consider

What are the risks? I'm concerned about business risk and capital allocation risk

Business risk is about whether earnings will decline. Numerous factors may reduce earnings. It can be the business cycle, which requires us to look at normal earnings instead of current earnings. It can be competitive pressure that would change earning power forever. It can be changes in technology or customers that reduce demand forever.

Capital allocation risk is about whether the management will destroy value. A 15 P/E is equivalent to 6.7% yield only when the company returns all earnings to shareholders. That's often not the case in reality. Some of the earnings may be used to repurchase shares or pay dividends. But the rest is usually retained by the company to reinvest in the business, make acquisitions, or simply build up cash. So, if the company simply builds up cash, the company is worth less than a 15 P/E. If the business has a lower than 10% return on capital, and if the company keeps reinvesting in the business, it's worth less than a 15 P/E. If the business has a higher return on capital, or acquisitions create higher return, it's worth more than 15 P/E.

 

Some Good Companies Deserve Higher Valuation

There are companies that deserve a 20 unlevered P/E. I think Weight Watchers (WTW) is worth more than a 20 unlevered P/E. That's because of growth. WTW's return on invested capital is infinite. Working capital is actually negative. That means they need no money to grow. The question is just about how much they can grow. If you think long-term growth is at least 5%, you'll get a 10% return at 20 unlevered P/E. You’ll get about 1/20 = 5% yield from dividend and share repurchase (which increase earnings per share). And organic growth contributes 5% earnings per share growth. That adds up to 10%.

Companies like Coca Cola (KO) and Procter & Gamble (PG) always trade at over a 20 P/E because investors believe in their long-term growth and the stable nature of the business.

I think there should be some value in leverage. A stable business should be valued higher than a volatile business. The reward for being in a stable business is the ability to leverage. But it would be too theoretical to figure out the optimal capital structure. So, I would stick to EV/EBITDA or EV/EBIT. Any wise decision about capital structure by the management would be a bonus to investors.

I would value a company at an enterprise value equal to 15 times unlevered earnings for a company with minimal business risk and capital allocation risk. I don't know how to value a company with more risks than I'm comfortable with.

 

Intrinsic Value and the Price We Pay Are Different

I think we should notice that the rate of return that we want from an investment is different from the hurdle rate that is used to calculate intrinsic value. Intrinsic value is objective. The price we would like to pay is subjective.

In my 15 EV/unlevered earnings model, the implied hurdle rate is 10%. But you might want a 15% return. So, you can try to calculate intrinsic value of the company to see how cheap the company is. But more importantly, you should have an idea about the return of your investment.

For example, assume earnings per share is $5, and the price is $50. If you think the company is good and should trade at a 15 P/E, and it's safe to assume that would happen in 5 years. If you buy at $50 and sell at $75 in 5 years, you'll get an 8.45% annual return. If you assume they can grow 5% in the next 5 years, the stock price would be 1.05^5 * 5 * 15 = $95.7 or a 13.86% annual return over 5 years.

There is another way to do this. You can start by having some idea about the stock price in 3 or 5 years and discount back using the hurdle rate that you want. The result is the price below which you would buy the stock. There's some assumption/projection in this calculation, but I think that it’s a safe assumption. I think it's a safe bet that a good company will trade at a 15 P/E sometime in the next 3 to 5 years.

 

“Understanding” Risk Affects the Price to Buy

Finally, in calculating the price you would like to pay, you should pay attention to another risk. That's "understanding" risk. How confident are you in your judgment? Against more uncertainty, you’ll need more margin of safety.

I would never buy a company at a 20 P/E even if I think it's worth 20 P/E. I must be right on everything to get an adequate return. If I'm wrong, the P/E can shrink to 15 or even 10. I think a 15 P/E is a safe benchmark. An average company often trades at a 15 P/E. So, a great company is worth at least 15 P/E. If I'm wrong, and the company is actually not so great, it's still likely that the stock would trade at 15 P/E.

 

Same Approach to Emerging Market

I keep the same approach to valuing emerging market companies. I think emerging market to developed market is like hot growth companies to mature companies. But the answer always depend on what the current normal earnings is, and whether retained earnings will create value. I tend to think most growth will destroy value because of too much competition and too much capital required.

The fair unlevered P/E may be different from that in developed markets. That’s because of inflation. Emerging markets tend to have higher inflation than mature economies. That means investors may want a higher nominal return.

For example, investors may want a 15% nominal return in Vietnam. For a bad company without pricing power, a fair P/E would be 6.5. If it has a low return on capital and is growing company, it’s worth less than a 6.5 P/E. A good service company with pricing power may deserve a 15 P/E. Because it can give investors a 6.7% real return. If it has good long-term growth prospect, it may deserve even higher P/E.

So, I think the fair unlevered P/E in emerging market varies with company’s quality more wildly in emerging markets than in developed market. But the market may have the tendency to give companies similar valuations. For this reason, there can be more value traps in emerging market. And there can be more great long-term investments at good prices.

Someone who reads the blog sent me this :

Quan,

What is your process for reviewing an idea?  What do you make sure to read? (documents, news, history of business, industry report, etc?)  I was impressed by your discussion of CCL, and thought that many of the details you had included weren't readily available in a 10-k or company document.  How and where do you go to get that type of data (thing like unit economics, for example)?

Many thanks,

Mostafa

I used to have a fear that I can’t find enough information to analyze a company. I don’t remember when that fear went away. But that’s not because I got more information. That’s because my process improved.

One problem I see in a lot of books is the hammer bias. To a man with a hammer, every problem looks like a nail. I think authors usually start a project with some hypotheses and they look at data and information from that point of view. They give examples and explain by their thesis. But things are usually results of many reasons.

Ten Points to Look at

We can easily fix that problem. As Charlie Munger suggests, the cure is to equip the man with as many tools as possible. My tools are my investment checklist. I have 10 questions to answer in my research:

-      Competitive Position

-      Product Economics

-      Return on Capital

-      Management

-      Organization

-      Capital Allocation

-      Repeatability

-      Future Prospects

-      Safety

-      Understanding

And I have a sub-checklist for each item in the checklist.

Twelve Books to Start

My checklist was initially based on ideas from the books I read. If I started over studying value investing today, I would read these books:

-      by Ben Graham

-      by Phil Fisher

-      by Pat Dorsey

-      by Chris Zook

-      by Chris Zook

-      by Chris Zook

-      by Chris Zook

-      by Geoff Colvin

-      by Jim Collins

-      by Jim Collins

-      by Jim Collins

-      by Jim Collins

Security Analysis and Common Stock and Uncommon Profits are the best investment books I’ve read. The former gives us a complete understanding of value of a company. The latter shows us important aspects of a company to analyze.

The Little Book that Builds Wealth is a good introduction to moat. There’s a lot of interesting examples. But there’s a weakness. Pat Dorsey underrates the role of management. He looks at a moat in static terms. I think we should look at a moat in dynamic terms. That’s why I think it’s important to read Chris Zook’s books.

Chris Zook’s books are about repeatability. The idea is to utilize organizational capabilities to adapt to changes in the market or to repeat success in growth opportunities like a new customer segment, a new geographic markets, or adjacent products.

I find that Talent is Overrated is a good addition to Chris Zook’s book. Great performers are those who repeat practicing in learning zone. That also applies to business. Companies that repeat sharpening their key capabilities will widen their edge over competitors.

I think investors undervalue Jim Collins’ books. He broke some myths about management. I think the books show how to build a great organization. It’s helpful for investors to judge management.

Improve My Checklist from Real-life Observation

But more important is practice. Each company is a real example. Analyzing each company helps me realize what’s important to each checklist question. And I just keep updating my sub-checklist. My process improves after each research.

For example, I didn’t have a clear idea about how to judge an organization. But overtime, I realized unionization and internal promotion are something to look at. It’s helpful to see if the organization is sales-driven or research-driven or operation-driven. The distance from front line employees to CEO and the company location are also useful.

Reading interviews, earnings call transcripts and compare what the management said with results also make me better at judging people. I can easily find that Royal Caribbean’s management is quite promotional. Carnival’s Micky Arison is honest and blunt. Or Western Union’s management is competent but overly optimistic.

Practice also improves my understanding of moat, even though it’s a topic that economists and investors pay a lot of attention to. For example, I think customer behavior doesn’t get as much discussion as it deserves. Perhaps that’s because it isn’t easy to describe customer behavior in a formula like economies of scale or network effects. Many times, customer behavior is explained by psychology. Again, a checklist is a powerful tool.

For example, looking at frequency and purchase price is helpful. High frequency with low purchase price is good. Customers are rational only when they first choose a product. Once they are satisfied with their choice, they’ll be loyal. They don’t want to think and choose every time they buy the product. They rely on habit instead. That’s why consumer products are such a good business.

Low frequency with high purchase price is bad. Customers are rational. They spend a lot of time to compare alternatives. That’s why I think selling to business customers is difficult. That’s why I don’t like consumer electronics companies.

Low frequency makes auto part retailers like AutoZone (AZO) a good business. Customers don’t buy often so they don’t know much about price. Auto part retailers don’t compete on price. They compete on service instead. AutoZone focuses on “Yes rate”.  AutoZone doesn’t want to say No to customers. It wants customers to know that AutoZone will solve their problems. So, frequency is low but the awareness is high.

On the contrary, low frequency makes fine dining restaurants like Ark Restaurants (ARKR) a difficult business. Customers go to these restaurants on special occasions. There might be a lot of planning. Customers may not be loyal. But once the service is bad, customers will never come back. So, despite the crisis and rising food cost, Ark couldn’t reduce payroll. They must maintain good service.

Among my 10 points, I didn’t find much discussion about product economics in books. But it’s very important. Strong competitive position with bad product economics is bad. Railroads has strong moat but bad product economics. They earn only an adequate return on investment.

So, it’s important to see whether costs are fixed or variable; whether the business requires a lot of capital investment; whether growth requires much capital; whether the product cycle is long or short; or whether cash collection is faster than cash payment; etc. The list of questions just keeps expanding as I gain more experience.

I Didn’t Get More Information, My Eyes Just Get Keener

As I mentioned above, the information I look at didn’t change. I read all conventional sources. I read 10-Ks, transcripts, and interviews. I try to read all books about a company. I read all articles I can find about a company. I read from the oldest to the most recent article. That helps me see how the company evolved over time.

I do the same thing to customers and competitors. So, it’s a good idea to analyze end-customer and go up the value chain.

I look at data and information with my checklist (and sub-checklist) in mind. I make notes or do calculation with data whenever I see something relevant. I update my checklist after each research. And I’ll reduce the amount of important information I miss in later research.

Recently I read . The book talks about human irrationalities. It’s a great business related psychology book. I found two ideas relevant to why I like companies with unique products. The two ideas are about relativity and anchoring.

We Always See Things in Relation with Others

The human brain is not equipped with a meter that measures absolute value. So we usually rely on relativity. We look at things around and compare. The picture below demonstrates this idea:

The two middle circles are the same size. But the one surrounded by bigger circles looks smaller than the one surrounded by smaller circles. We have no idea how big a circle is. We just look around and compare.

My personal example is when I looked for a phone recently. I just need a phone to make calls and send messages. I don’t need a smartphone. So, I used a simple, old phone for many years. But recently it broke. I decided to buy a smartphone.

I found a used Google Nexus One on Amazon. It’s in very good condition sold by a highly rated seller. It costs only $100. I was totally impressed with its design at first sight. The specs look great for my need.

But it took me several hours to make a decision. That’s because I compared it with other phones. A bigger screen would be better. A strong battery would be useful. A Quad-core processor is definitely more powerful. Jelly Bean looks cooler than Gingerbread.

Considering my need, I don’t think those phones are different. But I still compared and had the urge to buy the best phone. Finally, I chose Google Nexus One. (I’m quite a rational buyer!) I’m totally satisfied with it although it seems obsolete compared with other phones.

My point is that we always look at things around us in relation with others.

We Rely on an Arbitrary Anchor

Beside relativity, people’s views on things are usually influenced by some anchors. When it comes to price, we don’t know the value. So we tend to rely on some arbitrary benchmark.

One example would be bargaining. In Vietnam, we always bargain when shopping. If the listed price is $50, I would propose $30. If the listed price is $30, I would like to pay $20. I have no idea about value. I just know that it’s worth less than the listed price.

The U.S. version of this example would be a sale. Most people want to buy clothes at 40-50% off the sticker price. They feel they overpay when they pay the full sticker price. I think there are two anchors here. The first anchor is the sticker price. The second is the percent discount we usually get.

Customers Won’t Know If a Product is Expensive without Comparison

We usually use both comparison and an anchor to value something. We look at relative value between things and base our estimates on some basic anchors

I think anchoring causes some misconception about Western Union (WU). When Geoff asked me to analyze WU, my quick answer was “it might be too hard, the service is expensive, and there can be a lot of changes.” But after I looked deeper, I realized it’s not as hard as I thought. The service is not expensive like most people think. Why did I think it’s expensive?

That’s because I always use PayPal to do money transfer with friends. It’s free when I link my PayPal account to my bank account. My experience with PayPal makes me think a money transfer fee should be close to 0%.

It’s different from the perspective of customers. I talked to my cousin who went to work in Taiwan. He uses Western Union to send money home every month. He’s highly satisfied with the service. Customers only think a product is expensive when there’s a much cheaper alternative. Western Union has a small price premium over competitors, but they keep the price competitive. And PayPal is not cheap. PayPal International transfer from bank accounts costs 0.3-3.3% fee and currency conversion. It costs over 3.4% to send from debit card/credit card.

Demand Can Be Manipulated

The idea about anchoring raises a problem in the fundamental rule of supply and demand. There are two curves. The supply curve tells how many units are available at each price. The demand curve tells how many units customers want to buy at each price. The intersection of the two curves indicates market price. The implication of the rule is that supply and demand are two independent forces. But the idea about anchoring says that demand can be easily manipulated by supply.

That’s why I think anchoring and relativity are relevant to the profitability of selling unique products. Companies with unique products can manipulate demand more easily.

Breaking Old Anchors by Being Unique

The example in the book is Starbucks (SBUK). We can be initially anchored to the price of coffee at Dunkin’ Donuts or drinking coffee at home. How did Starbucks break that anchor?

They make themselves unique through store ambience. For example, their shops are fragrant with the smell of roasted beans, which are of higher quality than those at Dunkin Donuts. They have fancy product names for size like Short, Tall, Grande, and Venti, or for coffee like Caffe Americano, Caffee Misto, Macchiato, and Frappuccino. The store experience is so different that the previous anchor is no longer relevant.

If you’re satisfied, you’ll go back to the store. Once you get used to spending $2.20 on a small cup, you may see $3.50 for a medium or $4.15 for a Venti as normal. That’s because you have an anchor price for a small cup. Paying some more for a bigger cup is normal.

I’m amazed at how Zara changes customer behaviors. They introduce thousands of designs every year. But they produce limited copies for each design. They usually sell out a design within 2 weeks. So, customers know that if they don’t buy, the item would be sold out quickly. And they know Zara rarely offers sale. With little time to look for alternatives to these unique items, customers tend to buy immediately (at full price!).

Price is Usually Determined by an Established Anchor

Sometime, price is determined by an established anchor. That’s common in content business. Products are unique, and companies don’t compete on price. If people like a product, they’ll pay a common price. That’s why movies don’t compete on price at movie theaters. That’s why a video game usually costs $40-$60.

The established anchor can also be changed. That’s my concern with Nintendo (NTDOY). They make casual games, not hard-core games like Call of Duty. With the rise of mobile games, people may get used to a new price range for casual games. It’s a big problem for Nintendo if the anchor their games are compared to drops from $40 to $2.

A Good Anchor Improves Perceived Value

Anchoring explains the retail strategy for fashion brands. Companies want to anchor the value of their products as high as possible. Prada wants to open stores next to Gucci. Gucci wants to be next to Prada. They both want to keep themselves far away from Zara while Zara want to be as close to them as possible.

The similar example in Predictably Irrational is when James Assael, the king of pearl, introduced Tahitian black pearls. He bought advertisements in the glossiest of magazines, which put Tahitian black pearls among diamonds, rubies, and emeralds.

On the contrary, I think it’s a stupid idea for Hulu to hope to convert free service customers into using pay service. They anchor customers with a free service. That’s a very hard anchor to break.

The value of free is astronomical. Amazon (AMZN) was able to boost sale when they offer free shipping for order over $25. That’s because customers may want to buy unnecessary books just to get free shipping. But when they offer 10 cent shipping for order over $25, sale didn’t improve at all. So, I would guess the free anchor is very hard to break.

It’s different from giving a free trial. Giving a free trial is a great idea. It doesn’t create an anchor. It actually helps to increase perception value thanks to value of ownership. Basically, when you own something, you value it more. We tend to value things that we own by fear of loss. Customers after the free trial period may value the service more and are more likely to subscribe.

Uniqueness Can Result in Pricing Power

Companies with unique products may also have pricing power. When the products are not anchored to any price, the company can have more freedom to increase price. It’s harder when there are comparable products or substitutes.

That’s why I prefer Games Workshop to giant Mattel (MAT) or Hasbro (HAS).

Hasbro and Mattel produce toys for the mass market. Their pricing power is limited. Each toy is unique but it’s still a toy. Toys as a category have to compete with other entertainment products. The price of other products is out of Hasbro’s and Mattel’s control. And people can compare those products with toys.

Also, there’s an anchor for toy prices. The price sweet spot is from $10 to $20. Hasbro saw volume decline when they increased price from $19.99 to $21.99. I think this has something to do with the way people buy toys. Parents and grandparents usually buy toys on holiday. They tend to buy several gifts at a time. A family with 2 kids may want to buy 5 toys. They have a budget for toys because they also buy gifts for their spouse or friends. So, they may not want to spend over $20 for a toy.

Games Workshop is another story. Those unfamiliar with Games Workshop should read the discussion about the company at Interactive Investor. Games Workshops produces hobby products instead of toys. People are willing to spend a lot of money on a hobby. I don’t think that people dedicate time and money to more than one hobby. Even if they do, Warhammer is cheaper than most hobbies. By positioning Warhammer as a hobby, Games Workshop aligns pieces of plastic with hobby products like golf clubs. People don’t value a hobby product by how much it costs to produce. They value it by the enjoyment they get. So, Game Workshop increases price every June. Hobbyists complain but they still buy and enjoy.

So, I think relativity and anchoring are powerful ideas in learning customer behaviors. I think companies with unique products can have pricing power thanks to the lack of comparison and price anchor. They can also improve value perception by getting closer to other high value unique products. And when there’s no comparison, companies just need to maximize the price they can sell, and make sure that customers enjoy the products.

One of my best friends listened to my advice and bought NutriSystem (NTRI). NTRI shares recently dropped more than 30% and he asked me about my thoughts. I feel like I should stop writing completely. But I’ll try an honest evaluation of my idea.

Let’s start with the reasons I like the stock:

• Business model
• Marketing
• Products

Profitable Business Model

I like NTRI’s business model. NTRI doesn’t manufacture food. They develop recipes and outsource manufacturing. The business requires little additional capital to grow. To sell more, they need more inventories. But more inventories can be offset by more accounts payable.

I prefer businesses that spend on advertising instead of on PPE. If you spend on PPE, you have to replace the used-up PPE every year. If you spend on advertising, the value can stay. That’s brand value. And it’s not reported on the balance sheet.

I think NTRI’s marketing is good. It’s appropriate to run 2 minute TV ads. It’s the right amount of time to convince people to look at the product.

Not So Good Product Economics

 I think NTRI has interesting products. They provide a variety of low-carb foods. The taste seems not good but they can improve. It’s the most convenient and the quickest way to reduce weight. Although their main customers are women 40-50 years old, I imagine that the products are great for single men.

The product economics are not very good. It takes much marketing effort to get a customer but he/she stays on the program for only 2 to 3 months. NTRI always has to find new customers.

Some customers will gain weight and return to NTRI in the future. But this isn’t a great way to make profit. I prefer a business that makes money by making customers happy.

It’s true that a lot of customers are happy when they’re successful with NTRI. But I’m not sure that’s true when customers gain weight after they stop using NTRI several times. I didn’t learn enough about customer behavior.

Hard-to-sell Products

NTRI diet is convenient but can be difficult to follow. McDonald’s (MCD) sells unhealthy food but customers enjoy it when they eat it. On the contrary, it takes a lot of discipline to use NTRI diet. A lot of people were successful with NTRI but perhaps I looked at a skewed sample.

I recently read the “Power of Habits” and “Mindless Eating”. I felt the difficulty faced by those who failed with the NTRI diet. It’s really difficult to change a habit. You see some cue, mindlessly repeat a response, and you get rewards. It’s like every day at 3PM, you get up from your desk, and go to the cafeteria to get some cookies. But you’re not hungry at all. You just feel stressed and want to go out. Or you’re working on your laptop with a box of chocolate beside you. You just keep eating. But you can eat a lot healthier if you simply replace the box of chocolate with fruits.

I think Weight Watcher (WTW) can help with that. WTW has a better model. WTW’s meetings are more effective for changing a habit. There’s peer pressure and sharing of experience in dealing with problems in reducing weight. And hopefully, people can get into the habit of going to the meetings. I know people who continue going to the meetings after they achieved their target weight.

I think each product fits a different lifestyle. Some people find NTRI program difficult to follow. Others find it easy. The reason I’m interested in NTRI is that the market is huge. Nutrisystem just needs a small share to succeed. I look at the earnings in 2007 as proof. I think NTRI will return to growth when the macroeconomics condition gets better.

Facts Disproved My Original Thesis

But now, I’m questioning my thesis. Is it possible that NTRI’s past success was due to a fad? Maybe. A difficult to sell product can enjoy huge success as a fad and then lose people’s interests.

I raise this question because of NTRI’s protracted underperformance. The economic condition got better this year, but Nutrisystem’s sales just got worse. What’s wrong with NTRI?

I can’t answer. I tend to think Nutrisystem’s past success was due to a fad. That could be unfair. A lot of customers were satisfied. But the result seems to disprove my original thesis. I find it safer to sell the stock right away.

Turnaround Situation

The management says they are modifying the marketing. NTRI is now a turnaround situation. The success is based on marketing effectiveness instead of pure product appeal.

I’m still interested in NTRI. But I remember Peter Lynch only bought companies that were getting better. Even with cyclicals, he only bought when there were signs of turning around. I have no indicator other than sales growth. So, I’ll sell the stock right away.

I’ll still watch NTRI. I’ll see if NTRI will improve or if they’ll keep declining. It’s a good learning experience.