The Value Guys

Some people like to listen to the Car Talk guys on Saturday mornings.  I sometimes catch their show on NPR while I make my trek down to the local coffee shop for my morning espresso.  I’m not inherently a car guy but Click and Clack are entertaining enough to keep my attention after I have turned off my car and I’m sitting in the driveway.   However, since I’m a value guy, what makes a perfect Saturday morning for me is getting a run in, drinking my espresso, reading Barron’s and listening to a podcast I recently discovered.

The Value Guys podcast provides an entertaining overview of stocks by two 30-year Wall Street analysts that took on the secret identities Val Hughes and Moe Mentum.  Val admits to admiring the Car Talk guys and the pair have done a good job providing as entertaining a show while they present three to four stock ideas based on a screen that they have done.   Many of the ideas are intriguing as Val and Moe discuss them after having done no research.  It is clear to me that they are intelligent, experienced and savvy stock pickers.  At the end of each episode, they disclose their favorite stock that was discussed.

Whopper Investments started a brilliant deliberate practice series on his blog.  It motivated me to start practicing what I love to do in a more deliberate fashion.  I thought his project was ambitious.  With my hectic lifestyle, I was finding participating in his deliberate practice series a challenging but rewarding.  Whooper impressed me with his ability to come up with the case studies and the materials for his series.  Whopper is a prolific blogger but it seems that the deliberate practice series has dropped off his radar.  That’s okay.

In the spirit of deliberate practice, I am going to use The Value Guys podcast as a screen for my deliberate practice.  I like Moe but since I’m a value guy, I am going to take Val’s stock pick as my assignment for further research.  After reading the 10-K and any other relevant filings, I will post my research.

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Book Review: Dark Pools

Small Enough to Fail

Knight Securities’ recent $400 million trading loss on the day of the NYSE’s new retail liquidity provider program was a battle lost in the ongoing market microstructure changes that Wall Street Journal staff reporter Scott Patterson characterizes as the algo wars in his recent book Dark Pools:  High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System.

While Knight Securities survived the battle, they were left for dead on the battlefield only to be resurrected by an infusion of capital from outside investors that left shareholders with over a 70% loss.  In Dark Pools, Knight Securities was characterized as “a computer-savvy broker dealer based in Jersey City.”  They were until they weren’t.  Known on the Street as a market maker, there’s not much sympathy from those that have been run and gunned by Knight.  For years they picked up pennies on the street to finally being run over by a bulldozer.

Disruptive Innovators

Dark Pools begins in the late 1980s when a young computer programmer named Joshua Levine enters Wall Street with upstart ideas that challenge the large and powerful incumbents, NASDAQ and the market makers.  Levine designs and builds early portfolio management systems and trading algorithms also known as algos.  The portfolio management systems allow a band of upstart day traders to instantly see their trading positions with their profit and loss allowing them to enter and exit positions quickly.  These day traders, know as bandits, use Levine’s first algo called the Monster Key to jump the queue ahead of orders to “take the offer” or “hit the bid.”  They wreck havoc on the incumbent market makers.  Levine is one of the first disruptive technology innovators to hit the Street.  Jerry Putnam at Archipelago and the new electronic market makers Tradebot, Getco, Citadel and Knight Securities follow Levine and use technology to disrupt the incumbents.

Algo Wars

Price beats time. Two orders placed simultaneously to buy 1,000 shares, the order with the highest price will buy the 1,000 shares at 24-1/4. A loophole existed that allowed a buy order placed with a limit 20% above the ask to be the first order in the queue. Therefore, a buy order with a $29 limit for 1,000 shares would take the 24-1/4 ask price. The market maker could then immediately move to the the 24-1/2 ask. However, often the ask would move to a higher level where the bid might move above 24-1/4. The bandit would then hit the Monster Key again selling the shares by hitting the bid that is higher than the ask price that they took. An example would be the bandit buying at 24-1/4. The bid moves up to 24-1/2 or higher as other buyers scramble and the bandit sells his 1,000 shares back by hitting the bid and having the highest execution priority.

While Levine and his compatriots were putting the Monster Key algo to work in the markets, institutional traders were trading large blocks of stock using institutional broker Instinet’s quote machine dubbed the Green Machine because of it’s green lit monochrome monitors.  Institutional traders benefited from the use of the Green Machine because it connected them electronically to other institutions.  By interacting directly with other institutional traders, commissions were cheaper and information leakage could be curtailed.   The problem was that the quotes on the Green Machine basically were not public.  The SEC wanted to force the quotes out into the open.   The SEC forced quotes not executed on the Green Machine to appear alongside market quotes on NASDAQ.  This was the game changing beginning of the end of human market makers.   New algos would be developed to compete against Levine’s Monster Key algo and to route trades to the new dark pools that would grow to compete against Instinet’s Green Machine.  The algo wars are in full progress today as electronic market makers, exchanges, brokers and institutional investors continually develop their algos to be faster through sheer technological speed or smarter by taking advantage of better routing paths that connect the different dark pools.  Patterson argues the case that the market has become a pool within pools, all connected electronically, forming a single sloshing pool of dark electronic liquidity.

Let the Sunshine In

The book takes us through the labyrinth history of the players and changes in market structure over the last twenty plus years that brings us to the current structure.  The story and history of the changes that occurred in the equity markets is a very worthwhile read for anyone that is engaging in stock trading whether they are speculating or investing for the long-run.  Shining more light on market structure and routing practices will help improve the problems we have with the current system and Dark Pools is a good primer on letting the sun shine on the market.

Stocks for the Short Run

If you are a stock speculator with a short time horizon and you aren’t using the latest market making algos, then you are entirely out gunned.  On the other hand, you are at an advantage if you are an investor with a long time horizon and a healthy dose of patience.  This is well illustrated by the story of Haim Bodek at Trading Machines LLC in the first chapter.  Bodek tells the story of how his trading strategy is no longer working.   He keeps loosing money.  He’s flipping stocks every couple of seconds picking up pennies along the way.  His strategy has made his firm money consistently in the past.  He can’t figure out what is going wrong all of a sudden.  He is lucky enough to have a conversation with a representative from one of the exchanges who told him he should stop routing the trades the way he was.  The exchange had changed the routing rules and Bodek was getting run over by other players.

With much hand wringing and trying to work out problems with his strategy, Bodek ended up closing down his firm because he couldn’t make money.  He wasn’t going to quit and he kept working out of his house to find a solution.  A spoiler alert… his solution is presented in the second to last chapter of the book…  Bodek “started building a new system that involved predicting where stocks would go not in the next few seconds but rather in the next ten minutes.”  Ten minutes!  His solution is to become a “long-term” trader.  I think value investors with a long-term time horizon still have a very bright future.  While implementing trades may be frustrating, I think the patient investor will be rewarded well.   Ten minutes… very humorous… don’t get me wrong, the book is a good read… but ten minutes…  gee, for me one year is a short-term time horizon.  I don’t know what ten minutes would be… I guess that’s computer time.

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Deliberate Practice: Wal-Mart 1990 Follow-Up

Wal-Mart in 1988

Rayneman at Unreasonable Returns made a good point that it looks like it was more likely that Warren Buffett was purchasing Wal-Mart (NYSE: WMT) in late 1987 based on the U.S. News article that Whopper referenced in the deliberate practice challenge.  I tried to ignore the stock price of WMT in 1990 and I didn’t remember the $23 limit price Buffett was quoted as using in the article.  So I was either approaching the challenge with intellectual honesty or ignorantly oblivious to prices referred to in the information given.  My intrinsic value estimate was $21-1/8.  That was far from the range WMT was trading in 1990 but close to Buffett’s $23 limit price.  However, my 1990 intrinsic value estimate is pretty meaningless put up against Buffett’s 1987 limit price.  I am going to roll back my projections to 1987, make a couple of general assumption changes and see how the valuation would look in 1987.

The last time WMT traded under $23 was between October 1987 and January 1988.  The 1988 annual report was for the fiscal year ending January 31, 1988.  I rolled back my projections and made some assumption changes based on data provided in the annual report.  Store openings was changed to 125 Wal-Mart stores and 18 Sam’s clubs from 165 Wal-Mart stores and 25 Sam’s clubs over the next 10 years.  The average cost of a new store in fiscal year 1988 was approximately $4 million compared to $6 million in 1990.  I assumed construction inflation of 3% per year to project capital expenditures (capex).  I didn’t make any changes to the cost structure.

These changes resulted in the following forecast:

The shares outstanding in 1988 were slightly less than in 1990.  The discount rate used remained the same in the valuations.

Using a 10-year time horizon yields an intrinsic value estimate of $37.40 in 1988 compared to the $55.20 estimate I had in 1990.

At first this looks like a dramatic discrepency for just a two year difference but this is consistent with a 21% annual growth rate.

Using a 5-year time horizon yields an intrinsic value estimate of $18.70 compared to the $26.30 estimate I had in 1990.

This is consistent with a 19% annual growth rate in intrinsic value.  

When compared to Buffett’s $23 price limit, neither valuation appears to be how Buffett was approaching valuing WMT.

Using the 10-year time horizon, Buffett would have been purchasing WMT with close to a 40% discount to intrinsic value when he was using a $23 price limit.  I’m pretty sure Buffett wouldn’t have anchored so much on a $23 limit with that size of a discount.

On the other hand, using the 5-year time horizon, Buffett would have been purchasing WMT at a little more than a 20% premium to intrinsic value.  I’m having a difficult time reconciling these differences.

However, I think a clue to Buffett’s thinking is nicely illustrated at Student of Value’s graphs of the 45 year history of WMT.  The amazing consistency of operating profitability that has only declined to 6% from 7% since the company’s early stage and has ranged between 5.4% and 8.6% during the time frame points to a company with a strong franchise and sustainable competitive advantage.  Additionally, Student identifies 1990-1996 as a transitional period where returns fall to a lower and more sustainable level.  Buffett has an uncanny ability to get ahead of inflection points and I have to think he had some sense that WMT was going to transition into international expansion.

Geoff Gannon at Guru Focus makes a good point about viewing growth as a qualitative factor instead of a quantitative factor.  Gannon makes the point about Coca-Cola (NYSE:KO) that Coke is a cola and has no taste memory.  People do not get tired of drinking it.  There is no taste fatigue.  That makes it a franchise where bottling Coke can be repeated day after day after day and each day will be profitable.  It is repeatable.  Like KO, WMT is a franchise because it is repeatable.  Worldwide, people do not grow tired of buying products at the cheapest price possible.  Inexpensive goods never go out of style.  That is one of the reasons that you can count on growth in WMT’s revenues as it expands into new markets.

Wal-Mart in 1990

Going back to my 1990 valuation, I think it is of interest to compare how my assumptions compare to the actual results of the company in 2000.  On the top line, I projected revenues to be $89.9 billion per year which was only half of the $165 billion the company achieved in 2000.  I clearly missed international expansion.  The 1990 annual report had no information regarding international expansion.  However, there may have been channels of information in 1990 that might have given an investor an indication that international expansion was a possibility.

I projected total stores open to be 3,125 versus the 3,989 the company had open in 2000.  Again, this is attributable to international stores.  My projection looks better when compared to the 2,985 U.S. stores open in 2000.

I projected net income to be $3.2 billion in 2000 while the company reported $5.4 billion.  Another miss on my part.  I projected 2000 EPS of $5.64.  Adjusting for both of the two for one stock splits that occurred between 1990 and 2000, the split adjusted projected EPS is $1.41.  This compares to the company’s 2000 reported EPS of $1.20.  I did not project anywhere enough stock issuance during the 10-years as the shares outstanding basically doubled.  That is why my projected EPS was 17% higher than the actual.

This a good example of the problems with projecting the future and why conservative estimates should be used.  Even with my projections being off as much as they are, a purchase of WMT based on my estimates would have worked out to be a five bagger.  Adjusting the January 31, 1990 stock price of $42.62 for both splits gives a split adjusted price of $10.66 which would have appreciated to $54.75 by January 31, 2000.  Granted, the P/E (Price to Earnings) expansion that occurred was about to start deflating a couple of months later.  However, even if the 45 P/E that WMT was selling at on January 31, 2000 were to contract back to the 22 P/E WMT was selling at on January 31, 1990, a holder of the stock would still be showing a profit after the tech bubble burst.  As Buffett is known to say, “I’d rather be approximately right than precisely wrong.”

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Deliberate Practice: Wal-Mart 1990

This week’s deliberate practice challenge from Whopper Investments was Wal-Mart (NYSE:WMT) in 1990.  As Whopper explains, legendary investor Warren Buffett began buying shares of WMT sometime around 1990 with the intention of purchasing 100 million shares of the company.  Buffett disclosed years later that he only bought 5 million shares because he was “sucking his thumb.”  Buffett used this as an example of an error of omission.  Everyone is familiar with errors of commission, when we do something and things go wrong.  By highlighting this example, he was reminding himself and his shareholders that not doing something, an error of omission, can be just as costly as committing an error.  Buffett estimates that not buying those other 95 million shares cost Berkshire Hathaway (NYSE:BRK.A) $8 to $10 billion.  The challenge was to analyze and value WMT at the end of 1990 using the company’s 1990 annual report.

Company Overview

It was fascinating to go back 22 years and read WMT’s annual report.  WMT was not the ubiquitous company that it is today.  While the company’s associates were recognized as the 1989 Mass Market Retailers of the Year by Mass Market Retailers trade publication, the company only had stores in 29 states, no stores in large states like California and New York and no international presence.  With 275,000 employees and 27 consecutive years of sales and earnings records, the company wasn’t unknown to be sure.  One has to imagine that the company’s growth story was well known on Wall Street but at the same time, it is hard to imagine the late 1980s master of the universe trader getting excited about a discount retailer with headquarters in Arkansas that locates their stores in mostly rural locations.

What did Warren Buffett see in WMT in 1990?

Warren Buffet on the other hand, would be astute enough to get excited about an Arkansas based company with mostly rural locations.  At the first glance of the 10-year financial summary, the consistent growth of the company jumps out.  Year-over-year revenue growth from 1982 through 1990 was 49%, 38%, 38%, 37%, 32%, 41%, 34%, 29% and 25% and year-over-year earnings per share (EPS) growth was 46%, 44%, 52%, 37%, 21%, 36%, 41%, 33% and 28%.  This is a hell of a growth company!  Warren Buffett was buying it?

The first thing that stands out to me is that the growth was trailing off year-over-year in the last two years in the series.  Did the market think the growth story was broken?  Did the market sell the shares off in the shadow of Operation Desert Storm and the first invasion of Iraq?

Using from Robert Hagstrom’s The Warren Buffett Way as a guide, WMT meets many of the tenets that he says Buffett looks for in a business.

Simple and Understandable

WMT buys products in quantity and then distributes and sells them for more than they bought them for.  Pretty simple concept.  This is difficult to implement but if you get really good at operational execution, you can stay ahead of the competition.

Favorable Long-Term Prospects

My favorite graphic other than the dollar signs found throughout the annual report is the background graphic for some the charts that shows a bag of items from WMT with the tag line, Always The Low Price On The Brands You Trust.  There is the recognizable Tide box with a Polaroid box in front of it.  I love seeing that Polaroid box, a company that was a member of the Nifty-Fifty in the early 1970s.  Will it matter to WMT that there will be dramatic technological changes in the next 20 years that will make the instant photos offered by a Polaroid camera obsolete?  No.  Instead, WMT will just sell one of the devices that replaced the need for Polaroid film:  the Apple iPhone.  It is easy to see what WMT will look like in 10 to 20 years.  They will be selling brands consumers trust at low prices.

Return on Equity

The chart also shows WMT’s return on equity averaging above 30% in the previous five years.  We know that Buffett looks to return on equity as a valuable metric since he says in his 1979 Chairman’s Letter,

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.

Clearly, in the past, WMT has been providing excellent returns on equity.  These high returns will attract competition.  At the stage of growth that WMT was in at 1990, it is difficult to say they are ahead of the competition and have a strong moat to protect themselves from competitors.  Instead, WMT was on the offensive while their competitors were most likely being complacent.  Sears and K-Mart were old and napping while WMT was building their moat, a large distribution network with disciplined purchasing.

Buffett looks towards pricing power to identify franchises as he stated in his 1981 Chairman’s Letter,

Such favored business must have two characteristics: (1) An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment in capital.

Buffett’s partner Charlie Munger often quotes the algebraist Carl Jacobi, “Invert, always invert.”  Where WMT might lack in pricing power, they make up in purchasing power.  WMT is building up their presence as the large customer that their vendors have to answer to for survival.  WMT is not beholden to any one vendor but some of their vendors are beholden to them.  This build out puts them in the position as the low cost provider.  Volume begets volume.  I think Buffett saw an inflection point in WMT’s growth.  WMT was beginning to get loolapoolza results in their operations.  They were going to be able to maintain their returns on equity and strengthen their moat through additional investments in new stores and updating existing stores.  Building this moat is likely to allow WMT to continue to achieve high returns on equity in the future.


The starting point for valuation is to calculate what Warren Buffett calls owner’s earnings.  He defines owner’s earnings in the 1986 Chairman’s Letter,

Owner’s earnings …represents (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).

I “cheated” a little by pulling five more years of previous WMT annual reports so I could properly calculate owner’s earnings.

While five years does not make a trend, an interesting characteristic of the above table is that owner’s earnings appears to be turning positive.  It is as if WMT’s past investments are now starting to pay off.

The next step is to estimate future owner’s earnings and find today’s value.  Buffett explains in his 1992 Chairman’s Letter that,

The value  of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.

Through all of my studies of Warren Buffett, I have yet to come across any information where he explicitly states how he values a company.  While we know that Buffett uses a long time horizon, we don’t know the exact time horizon that he uses when estimating the value of a company.  For the discount rate, we know he references the yield on the 30-year Treasury but there are some conflicting statements regarding how precise he references the yield.  It is clear to me that he is using judgment to determine the discount rate that he uses.  We also know that he has discounted… well… discounted cash flow valuations.  While I am inclined to think that Buffett may use a terminal multiple on his owner’s earnings calculations and do the math in his head, I am going to proceed and refer to the method used by Hagstrom in The Warren Buffett Way due to the lack of any evidence that Buffett does it differently.  I am doing this in the spirit of Whopper’s deliberate practice challenge.  I am deliberating learning more about discounted cash flow valuation methods while at the same time trying to see what Buffett saw in WMT stock with the limited information available to me.

Similar to the Bill Ackman McDonald’s (NYSE: MCD) deliberate practice challenge where I did a near-term and a mid-term valuation, for WMT I am going to do a mid-term and a long-term valuation.  I think this shows an interesting difference between Ackman and Buffett.  Buffett is famous for his long-term view and holding of positions.  On the other hand, Ackman implemented his MCD position with options so a shorter time horizon makes sense for his investment style.

In The Warren Buffett Way, Hagstrom uses what is basically a two-stage discounted cash flow model to value the equity of a company.  Instead of discounted traditional cash flow metrics, he uses owner’s earnings.

I found forecasting 10 years out a little daunting at first.  Hindsight basis possibly comes into play because I already know that not only does WMT survive over the next 20 years but it also prospers.  I tried to keep my head back in 1990.  To project revenue, I estimated that WMT would open 150 Wal-Mart stores and 25 Sam’s Club stores each year over the next 10 years.   This was on the low end of the 165 to 175 Wal-Mart stores and 25 to 30 Sam’s clubs that management was targeting for 1991.  So by the end of 2000, WMT would have 3,125 total stores.  I assumed that depreciation continued at 1.0% of Net Sales which is the same rate it was in the previous five years.  Based on previous capital expenditures (capex) levels, the approximate cost of building a store was around $6 million.  I started with the cost at $6 million and assumed 3% per year in construction inflation so that per store costs were running around $7.8 million by 2000 and resulting in capex of $1.1 billion.

I didn’t see any reason for cost contraction in the annual report.  With hindsight, I know that WMT was about to enter into a period where businesses saw unprecedented productivity improvement through the implementation of information technology (IT) spurred by the boom of the personal computer, networking and the Internet.  I know that WMT has fabulously levered their IT capabilities over the years but I didn’t build that into my projections.  I assumed cost of sales would remain above 77% and Sales, General & Administrative (SG&A) would remain above 16% over the time horizon both of which are on the higher end for WMT in the previous 10 years.

The 30-year Treasury was trading with an 8.25% yield at the end of 1990.  Hagstrom uses 9% discount rate, which is what I am going to use.

The long-term valuation yields an intrinsic value estimate of $55.20.

The present value of the 10-year owner’s earnings is the sum of 10 years of discounted earnings found in the Owner’s Earnings table from 1991 through 2000.  At year 10, I assume growth slows to 3% annually to value the second stage of the growth.  The capitalization rate of 6% is derived by subtracting the 3% perpetual growth rate from the 9% discount rate, a standard method of discounting earnings into perpetuity.  Capitalizing the year 11 owner’s earnings of $3.0 billion by 6% yields a $50.9 billion value at year 10.  This needs to be discounted back to the present and that can be achieved by multiplying $50.9 billion by the discount factor of 0.4224.  Adding the present value of $9.7 billion to the present value of $21.5 billion produces an equity value of WMT in 1990 of $31.3 billion.  With 566.1 million shares outstanding, the intrinsic value per share comes to $55.20.

I have always felt uncomfortable with discounted cash flow valuations that are derived when a long time horizon like 10 years is used.  The valuations always feel high to me when a company has high growth.  To balance the long-term valuation, I also calculated the intrinsic value using all of the same assumptions but using a 5-year time horizon.

This results in an intrinsic value estimate of $26.30.  So the mid-term valuation is $26.30 and the long-term valuation is $55.20.  That is a pretty wide range.  Obviously, there is some long-term upside if WMT is able to continue its strong growth beyond five years.  However, I’m a little uncomfortable assuming WMT can grow that fast.  It looks like Buffett was seeing a potential Growth At A Reasonable Price (GARP)  investment in WMT.

I can see why he was caught sucking his thumb.  Assuming that much growth in a valuation probably made him nervous about the price he paid.  I would go with the $26.30 valuation and require a 20% discount to intrinsic value on the stock.  So I would probably be sucking my thumb with a $21-1/8 buy limit order on WMT back in 1990.

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Deliberate Practice: McDonald’s 2005 Follow-Up

While I did peak at Bill Ackman’s Burger King presentation while doing the McDonald’s (NYSE:MCD) deliberate practice, I did not peak forward to the section on McDonald’s in Ackman’s profile in the recently published book The Alpha Masters by Maneet Ahuja.

In The Alpha Masters, Ahuja comments that Ackman’s principal goal was to convince MCD to sell or spin off the company-operated stores to the more entrepreneurial franchisees.  He goes on to say,

This would have the additional benefit of improving the quality of McDonald’s earnings and cash flow as the assets that remained at McDonald’s would generate cash from rent and a franchise royalty stream from the franchisees.

After reading the book Confidence Game where I learned that one of Ackman’s favorite books was Quality of Earnings, it would be easy to believe that Ackman’s core thesis was that re-franchising the company-operated stores would increase the quality of MCD’s earnings and therefore the value of the shares.  My reading of Ackman’s Burger King presentation lead me in that direction at first but as I worked out the numbers of shifting revenues from company-operated stores to franchise stores, I wasn’t seeing how that would dramatically improve the value.  I completely agree with Whopper at Whopper Investments when he said in his MCD post,

However, deliberate practice is all about trying to recreate why an investor made their investment. And, in this case, I don’t think strong profit numbers alone will tell the story.

As I went back working through my numbers, I found myself uncovering something I had not seen before.  This is precisely why deliberate practice is exciting even though it can be difficult.

Since I am obsessed with the time value of money, I would have a difficult time putting a $14 billion valuation on the company-operated stores like Whopper does.  I agree that at 1x revenue that the stores would bring in $14 billion if they were all sold to the franchisees at once.  However, these are illiquid assets.  It takes time to sell 9,412 restaurants.  Perhaps I am splitting hairs but one can fall into an overvaluation trap if not careful.  To be fair, Whopper is probably being conservative with 1x sales valuation on the company-operated restaurants so the 1x sales multiple could be considered to be a discounted multiple.

If all the restaurants are sold in a linear fashion over a five year time horizon, my 2009 EPS estimate would drop to $2.05 from $2.74.  However, MCD would collect close to $14 billion in cash over that time.  At a 10% discount rate, the proceeds would have a present value of approximately $11 billion.  Not chump change to be sure.  This would increase my intrinsic value estimate to $40.10 from $28.60.

However, I would have to be more conservative than assuming that all of the value of the company-operated stores could be realized in five years.  Assuming the company were to sell 500 company-operated restaurants per year, then my intrinsic value would only increase to $31.40 from $28.60.  I think this is where Ackman’s missing long-term estimate process would be of interest.  What would the valuation be if MCD was able to convert 2,777 stores from the end of 2004 to the end of 2011?  That’s the difference between the company-operated stores in 2004 versus in 2011.  The MCD story since Ackman’s investment has changed.  The more things change, the more they stay the same.  McDonald’s is described as annuity In The Alpha Masters,

Owning 13 to 14 percent of the gross revenues of every McDonald’s in the world is one of the greatest annuity streams of all time,” says Ackman.  ”Every time someone buys a Coke, McDonald’s get 14 cents right off the top.  It’s an even better business than Coke.”

It’s a little odd that Ackman makes the argument that the company is a great annuity stream while implementing his position through options instead of buying the common shares directly.  Its good to remember that he is known as an activist investor so he is looking for an event to drive his thesis.  It’s going to happen pretty quickly or not at all.  It’s no wonder he took his profits after the stock doubled over two years.  The stock price probably caught up with his long-term valuation.

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Deliberate Practice: McDonald’s 2005

This week’s deliberate practice challenge from Whopper Investments was McDonald’s (NYSE:MCD) in 2005.  Well known value investor Bill Ackman of Pershing Square took a large and successful position in MCD in 2005.  The challenge was to analyze and value MCD at the beginning of 2005 using the company’s 2004 10-K Annual Report, Proxy statement and a handful of exhibits and company press releases.

Company Overview

I think it is safe to assume that we are all quite familiar with MCD so an overview might not be necessary.  However, after peaking at Ackman’s 2012 presentation on Burger King, an overview of MCD in 2005 provides an interesting perspective.  In 2004, MCD was the largest quick-service hamburger chain in the world.  MCD had 31,561 stores in over 100 countries around the world with approximately 58% of systemwide restaurants franchised and $51 billion in systemwide sales.  This compares to Burger King’s much smaller numbers seven years later in 2012 where the king of burgers has 12,512 stores in 80 countries with approximately 92% of systemwide restaurants franchised and $15.3 billion in systemwide sales.  MCD’s massive scale in 2004 gives the company a competitive advantage through their economies of scale and brand recognition.

What did Bill Ackman see in MCD in 2005?

Putting myself in Bill Ackman’s shoes is a daunting task as they are pretty big shoes to fill.  Stumbling around at first, I think I’m starting to get a sense of how he thinks.

I think he saw a company being overlooked because they were changing their strategy.  MCD was shifting from a store growth story to a capital allocation story.  On page 10 of the 2004 10-K the company states:

Strategic direction and financial performance

In 2002, the Company’s results reflected a focus on growth through adding new restaurants, with associated high levels of capital expenditures and debt financing. This strategy, combined with challenging economic conditions and increased competition in certain key markets, adversely affected results and returns on investment.

In 2003, the Company introduced a comprehensive revitalization plan to increase McDonald’s relevance to today’s consumers as well as improve our financial discipline. We redefined our strategy to emphasize growth through adding more customers to existing restaurants and aligned the System around our customer-focused Plan to Win. Designed to deliver operational excellence and leadership marketing, this Plan focuses on the five drivers of exceptional customer experiences—people, products, place, price and promotion.

What is amazing is that the numbers look very good in 2004 yet investors were so stuck on the old story that they weren’t interested in them.  I have not looked back at the numbers but it would not surprise me that MCD might have had a growing store base while same store sales were weakening.  The combination of investors focusing on store openings slowing while same store sales growth became weak probably made investors disinterested in MCD.

The impressive Returns On Incremental Invested Capital (ROIIC) is evidence that management’s restaurant refreshment strategy was working.  The 2004 ROIIC was an impressive 41% which far outperformed the company’s ROA of 8.5% and ROE of 17.4% for 2004.   This indicates that the best capital allocation strategy is to direct capital toward refreshing stores over opening new stores.


Using Ackman’s 2012 Burger King presentation, I am going to value MCD in a similar manner.  Ackman shows a near-term valuation and mid-term valuation.  The near term is using one year estimates and the mid-term is using EPS estimates five years out.  What is interesting to me is what Ackman leaves out.  Where is the long-term estimate?  I have to imagine he has one and it would be fascinating to see a long-term estimate by Ackman that goes out seven to ten years.  In his mid-term estimate, he gives his five year price target.  That gives us an expected return but not his intrinsic value estimate.  I need an intrinsic value estimate in order to know where to buy or sell.  That is a core aspect of my investment process.

Both my near-term and mid-term valuation assume the company hits the high end of their targets as the company states in the 2004 10-K:

The long-term goal of our revitalization plan was to create a differentiated customer experience—one that builds brand loyalty and delivers sustainable, profitable growth for shareholders. Looking forward, consistent with that goal, we are targeting average annual Systemwide sales and revenue growth of 3% to 5%, average annual operating income growth of 6% to 7%, and annual returns on incremental invested capital in the high teens. These targets exclude the impact of foreign currency translation.

The near-term valuation uses a multiple of EBITDA – Capex.  Ackman uses a sensitivity analysis to present a range for the near-term valuation.  My 2005 EBITDA – Capex estimate is in the range of $3.3 billion to $3.8 billion and using a multiple of 13.5x to 15.5x EBITDA – Capex gives a per share equity valuation range of $29.15 to $40.55 as seen in the table below.

My mid-term valuation uses an adjusted EPS and terminal multiple estimate in 2009.  If management hits the high end of their targets I would estimate 2009 EPS at $2.74 assuming management repurchases enough stock to get shares outstanding down to approximately 1.18 billion.  Using a 15x terminal multiple, the target price is $41.

What is left out by Ackman’s Burger King presentation is the valuation of dividend payments.  He is assuming no dividend payments in his upside.  A target price is not sufficient in my opinion since MCD pays a dividend and had raised its dividend every year for nearly 30 years and they are embarking on a capital allocation strategy.  Assuming a 35% payout ratio in 2009 and a 10% required return, I get an intrinsic value of $28.60.  Ackman uses a 20 multiple in his Burger King valuation so if I apply that multiple, I get an intrinsic value of $37.10.  That gives a mid-term valuation range of $28.60 to $37.10.  Based on the information I have, I don’t have a valid reason to assign a 20 terminal multiple so I would estimate my intrinsic value at $28.60.  I would require a margin of safety of a 20% discount to intrinsic value before purchasing shares so I would consider purchasing shares at prices below $22.90.

Since Whopper requested we estimate the Enterprise Value (EV) of the company for the exercise, I would estimate the equity value of the company at $36.4 billion.  Adding net debt of  $7.8 billion, I get an EV of $44.2 billion.

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Deliberate Practice

I recently read a Whopper Investments blog post on deliberate practice.  Whopper issued a deliberate practice challenge to analyze various companies that have been investments of well known value investors in the past.  The first challenge was Warren Buffett’s purchase of Dairy Queen in 1997 and the second challenge was Buffett’s purchase of Coca-Cola (NYSE: KO) stock in 1988.

I have been interested in digging into the investments of some of the best value investors to better understand their approach and process.  I have not gotten around to that work and now is a good time to begin.  Additionally, this project is coupled with the idea of deliberate practice.  I’m at a point in my investment education where I have reached a plateau and adding deliberate practice will help me move forward.

I first encountered the idea of deliberate practice in Malcolm Gladwell’s book Outliers.  While Gladwell focused on 10,000 hours as a benchmark for expertise, it is clear to me that it takes more than time.  Is the 10,000 hours time well spent?  It is best to work smart.  Focusing on the right areas will accelerate the process.

Many other bloggers signing up for Whopper’s challenge appear to be looking for similar improvement that I am looking for.  For me, just reading is not enough for me to move forward.  I need to write and ideally receive feedback on the writing.

The next time I encountered the idea of deliberate practice was while reading Geoff Colvin’s book Talent is Overrated.  Colvin explains,

Deliberate practice is characterized by several elements, each worth examining.  It is activity designed specifically to improve performance, often with a teacher’s help; it can be repeated a lot; feedback on results is continuously available; it’s highly demanding mentally, whether the activity is purely intellectual, such as chess or business-related activities, or heavily physical, such as sports; and it isn’t much fun.

Taking on Whooper’s deliberate practice challenge fits many of these elements.  The activity is specifically for improving investment performance but unfortunately there is not a teacher.  Hopefully, the wisdom of the crowd of bloggers involved in Whopper’s project will act as a proxy for a teacher.  It can be repeated a lot and so far it has been a weekly challenge.  The feedback is continuously available through comments from other bloggers.  Of course, trying to determine if a company is a good investment is highly demanding mentally.

Luckily, I have fun researching companies.  On the other hand, tight deadlines are not fun.  Doing a weekly analysis with limited time and information is not fun.  However, in this case, I see it as an important part of the deliberate practice process.  These limitations should help me focus on the most important drivers for the investment thesis.  Like most analysts, it is easy to want to collect more and more data before making a decision.  It will be better to deliberately focus on the most important things.

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Book Review: The Most Important Thing

Howard Marks wrote an instant classic with the publishing of his first book, The Most Important Thing:  Uncommon Sense for the Thoughtful Investor. The Chairman of Oaktree Capital Management in Los Angeles, Marks impressively puts together forty plus years of experience on the complex subject of investing into a concise book.   Well known in investment circles for his periodic memos to investors, Marks draws from over twenty years of memos to put together a list of twenty of the most important things for an investor to succeed.  Each item is equally important to investment success like each brick is necessary for a brick wall to stand firmly.  Without explicitly stating it, Marks provides the reader with a 30,000-foot checklist for investing.  It is a checklist that must be completed for consistent success.  Each item is relatively simple but successfully fulfilling each one is hard.

Marks starts off each chapter with a relevant quote and explains his views of each of the most important things.  He often quotes the specific memo where he originally wrote something about the concept.  The nice thing about the book is that Marks clearly did not just regurgitate his memos.  He did much more work using the memos as a basis to work from and write a book that very nicely sums up the ideas.   Quotes from the previous memos are used appropriately and in each chapter through the book.  Some chapters are more memorable than others but Marks makes strong arguments for each that are difficult to deny.  It is likely the type of book that will deserve a periodic reread where less memorable chapters will stand out in the future as the reader experiences new market conditions and investing problems.

While Marks does not explicitly acknowledge it, he seems to list each most important thing in order of highest importance.  After all, there is a reason Marks starts Chapter 2 with a Yogi Berra quote,

In theory there’s no difference between theory and practice, but in practice there is.

I think Marks would be the first to admit that in theory, each of the twenty most important things are equally weighted but in practice, some may actually be a little bit more critical than others.  The first four important things presented are Second-Level Thinking, Understanding Market Efficiency (and Its Limitations), Value and The Relationship Between Price and Value.  As a fairly hardcore value investor, I wondered why Value or The Relationship Between Price and Value were not the first things discussed.  To me those are the cornerstones of investing yet Marks discusses Second-Level Thinking first.  Why was that?  The answer finally came to me far later in the book while reading about the most important thing being Investing Defensively.

Many people seem unwilling to do enough of anything (e.g. buy a stock, commit to an asset class or invest with a manager) such that it could significantly harm their results if it doesn’t work.  But in order for something to be able to materially help your return if it succeeds, you have to do enough so that it could materially hurt you if it fails.

It occurred to me that the only defense from this problem is deep research and second-level thinking.  I was immediately reminded of the presentation by Steve Leonard of Pacifica Capital and his large Starbucks (NASDAQ:SBUX) position in the late 1990s.  In some ways, Leonard’s large Starbucks position had a defensive element to it because he had second-level thinking on his side.  He first viewed the company through the eyes of a real estate developer instead of a retailer.  He coupled that with deep research as he kicked the tires of stores around the world in his travels.  At the Value Investing Congress, someone even asked Leonard how he could purchase Starbucks stock when the price was rising rapidly versus his estimate of intrinsic value.  His answer was that the company was expanding and growing so fast that paying plus or minus ten percent really didn’t matter.  In hindsight, he was right.  More important than hindsight, at the time of the investment he had to have known he had a very high probability of being right because he had second-level thinking and deep research to back him up.  It also is compelling evidence that second-level thinking might trump value.  It is certainly something to consider especially when allocating precious time to a problem.  However, I would argue that second-level thinking only trumps value in the hands of a skilled and rational second-level thinker.

The last chapter is the least satisfying as it tries to pull it all together.  In an ironic way, a short chapter does not do such a beautifully concise book justice.  The book itself is a summing up of the most important things of the investment process so an attempt to sum up the summing up of the investment process is inherently going to be weak.   This does not take away from the first 172 pages, which is possibly the most coherent and concisely explained book on investing.  Only Joel Greenblatt’s The Little Book That Beats the Market rivals this book as best in class for a concise presentation of investing.  Actually they would make great companion pieces as The Most Important Thing gives you a 30,000-foot investment process view while The Little Book That Beats the Market gives you the 10-foot on the ground business valuation view needed to successfully pick individual equity securities.

The Most Important Thing is a well thought out and written book on investing that belongs on the shelf of every investor from the novice to the seasoned professional.  Marks gives the reader an excellent view of the most necessary overall factors required for investment success.  Marks accomplishes what he set out to do.  This isn’t how to book.  This is a book about how to think about investing.  It’s a great checklist for all investors to look at to make sure they are thinking correctly.

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It’s Déjà Vu All Over Again

I about fell out of my chair at my local coffee shop while reading Seth Klarman’s Margin of Safety.  As a novice student of financial history, I have always operated under the apparently misattributed quote by Mark Twain, “History doesn’t repeat itself, but it does rhyme.”  This is always how I have viewed how history repeats itself.   You look at history to get an idea of how the current dynamics will play out going forward.   So in the past as we have seen credit expand beyond a certain point, we have seen bubbles burst.  That is the type of lesson to learn regarding the past as opposed to taking a stock chart from the 1929 crash and superimposing it on the tech crash.  The charts are interesting to look at but mostly irrelevant for helping to decide how to position for the future.

I couldn’t believe when I read Klarman’s discussion on collaterized junk-bond obligations during the 1980s that we had repeated history with such precision.  If history wasn’t just simply repeating itself during the first decade of the new century, it rhymed with such precision that Mr. Market simply rhymed cat with mat.

I caution you to put your coffee down before reading the following excerpt from Seth Klarman’s Margin of Safety.

One of the last junk-bond-market innovations was the collaterized bond obligation (CBO).  CBOs are diversified investment pools of junk bonds that issue their own securities with the underlying junk bonds as collateral.  Several tranches of securities with different seniorities are usually created, each with risk and return characteristics that differ from those of the underlying junk bonds themselves.

What attracted underwriters as well as investors to junk-bond CBOs was that the rating agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment-grade rating.  This means that an issuer could assemble a portfolio of junk bonds yielding 14 percent and sell to investors a senior tranche of securities backed by those bonds at a yield of, say, 10 percent, with proceeds equal to perhaps 75 percent of the cost of the portfolio.  The issuer could then sell riskier junior tranches by offering much higher yield to investors.

The existence of CBOs was predicated on the receipt of this investment-grade credit rating on the senior tranche.  Greedy institutional buyers of the senior tranche earned a handful of basis points above the yield available on other investment-grade securities.  As usual these yield pigs sacrificed credit quality for additional current return.  The rating agencies performed studies showing that the investment-grade rating was warranted.  Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancings.  Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses.  In other words, a pile of junk is still junk no matter how you stack it.

The coffee is hot isn’t it?  I warned you to put it down before proceeding.

Perhaps I’m wrong about superimposing stock charts.  I’m shocked but excited to see just how perversely market participants repeat the same mistakes.  I have to keep my eye out for those easy pickings offered up by the market and continue studying history.

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Investing, Speculating and Gambling

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest.  We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.  And there are some, I believe, who practice the fourth, fifth and higher degrees.

- John Maynard Keynes, General Theory of Employment Interest and Money

I read the transcript of Warren Buffett’s interview with the Financial Crisis Inquiry Commission prior to attending the Berkshire Hathaway (NYSE:BRK.A) annual meeting.  The interviewer asked Buffett to explain the difference between investing and speculating.  It was the first time I have read Buffett frame the discussion in the way that he did when he answered.  He discussed the issue further at the annual meeting when he discussed types of investments.  In light of current market conditions with the fear of inflation looming, significant price action in the commodities space and the dramatic LinkedIn (NYSE:LNKD) IPO last week, it will be helpful to review and get a good handle on the differences between investing, speculating and gambling.

I often hear people say the stock market is just a casino.  Usually, I get a blank stare as I explain that, no it is not a casino but instead a place where you can buy fractions of real companies.  These companies can be valued and your appraisal of that value can be compared to the price in the market, which allows you to estimate the return you can receive by owning shares of the company.  You can compare your estimate of the return and the risk taken to other opportunities for your money.  You can then decide if you want to leave your cash in savings or use it to try to get a better return by owning a fraction of a company.

Buffett reconciles the blank stare I often see by saying, “I look at it in terms of the intent of the person engaging in the transaction.”  This is helpful because it is quite possible for me to approach an asset with investing in mind while someone else might approach the same asset with speculating in mind.  While I prefer to invest, I don’t mind speculation in the marketplace.  In Buffett’s testimony, he never condemns speculating for what I believe are two good reasons.  First, Buffett probably occasionally engages in transactions that he would consider having a speculative element.  Second and more importantly, Buffett is most often in the position of the investor and he has an advantage in the marketplace if the other side of the transaction is in the position of the speculator.  This is where investors often exploit market inefficiencies.  Most importantly, you are setting yourself up for trouble if you think you are investing when you are really speculating.

Investing is an operation where you look to the asset to determine your decision to commit your money now to get more money later.  You are committing money to the operation of the asset such that the operation of the asset returns more than you put in.  You are looking at what the asset produces.  You are looking at fundamentals of the asset.  In the case of stocks, you are looking at the financial statements and the competitive position of the company.  You don’t need a liquid market so you don’t care if the market is closed for an extended period of time.  You are not playing Keynes’ beauty contest, you are just using fundamental judgment to pick the prettiest face.  If you pick correctly, the market will realize it over time.

Speculating is when you look at the price action of an asset to determine your decision to commit your money now to get more money later.  You are committing money to the asset such that the price action of the asset returns more than you put in.  You are not looking at what the asset produces but hope someone will pay more for it in the future.  You are looking at non-fundamental factors of the asset.  In the case of stocks, you are looking at a stock split, an increase in dividend or quarterly earnings surprises.  You want a liquid market so you can unwind your position quickly so you care if the stock market is open tomorrow.  You don’t have a reference point of value so you don’t know where the price is going to go.  You are playing Keynes’ beauty contest.

Gambling is when you engage in a transaction that doesn’t need to be part of the system.  The transaction has no necessity for existing in an economic framework.  When gambling, you are even farther removed from the asset than when you are speculating.  You are focused on the transaction alone.  Betting on a football game is gambling because the outcome of the game is not dependent on the bet.  We are now at one end of the spectrum that runs from investing to gambling.  This end of the spectrum has terrible odds but human nature has a strong urge to gamble.  Betting on a sports event is only gambling.  You are not speculating or investing no matter how you approach it.  Gambling is Keynes’ animal spirits at its maximum combined with some fourth, fifth or higher degree of Keynes’ beauty contest.

However, Buffett discusses October wheat as an example of a transaction that is not artificial to the economic framework.  Someone is on the other side of the transaction planting wheat in the ground.  You would be speculating if you bought October wheat futures if you thought there was going to be a poor harvest this year.  However, I would argue you would be gambling if you bought October wheat futures by just looking at price action on a computer screen with no regard to the wheat harvest report.  It would be akin to picking red at the roulette table because the last five spins were red.  So certain assets can fall on different positions of this spectrum of intent.  An expert futures speculator might be able come close to investing when they transact in October wheat futures but most market participants are speculating at best.

LinkedIn is a real company that provides a real service, produces real revenues and is on the cusp of making real profits.   LinkedIn stock is a type of asset that I would classify as one that can be invested in.  While buying an asset like October wheat futures can only be speculating or gambling; buying an asset like LinkedIn stock can be investing, speculating or gambling.  It can run the full gamut of the spectrum.

The approach that the market participant takes determines if he is an investor, a speculator or a gambler.  LinkedIn stock is so overpriced at current levels that you probably really don’t need to make the effort to calculate the intrinsic value. At current prices, LinkedIn stock falls somewhere between speculation and gambling right now.  With the stock closing at $94.25 or 592 times earnings and 29 times sales, the only participants that could arguably say they are investing are the short sellers.

When CNBC sets aside an orange corner of the television for a single stock price, the gamblers swarm to it like a mobile home mamma to the ringing slot machines on a riverboat casino.  The way LinkedIn stock has turned over, there clearly is some gambling going on.  Investors should know their assets and step aside when the gamblers show up.  As far as the short sellers are concerned, they should be careful, it’s the gamblers that stays irrational long enough to make you insolvent.  Animal spirits are back.

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