Wednesday, April 26, 2006

Wal-Mart vs. Target (Rule #1)

Last week I wrote that I would be running a few companies through Phil Town’s criteria for Rule #1 investing. To recap,

Town suggests that the way to adhere to Buffett’s first rule is to look at five different things about a company. They are:

  • return on invested capital (ROIC),
  • revenue (sales) growth,
  • earnings per share (EPS) growth,
  • equity (or book value) growth, and
  • free-cash-flow (FCF) growth.
He says that we should be looking for companies with at least 10 years of history, and except no less than 10% per year in each of the growth figures. We should also look for companies with an ROIC of at least 10%.

I decided that the first two companies I’d look at would be Wal-Mart (WMT) and Target (TGT). These are two of the major players in the retail industry.

Unless you’re Paris Hilton, you’ve heard of Wal-Mart. Wal-Mart interests me because so much of the value investing community has become enamored with the company. Wal-Mart concentrates its products for very price sensitive consumers, usually in rural and “non-urban” areas. Although recently, the company has made great efforts to expand its operations into more “city-fied” areas. Target on the other hand, caters to a more urban, fashion conscious consumer. Usually, their consumers are a little higher up on the disposable income scale and are less price sensitive.

Full disclosure: Although I (and the clients of Brick Financial) do not own either company, both are on my watch list. My current outfit however consists of socks, underwear and a belt from Wal-Mart and jeans, a shirt and a watch from Target.

Each seeing the other as a threat, they have recently (in the last few years) found themselves competing more and more with one another. Selling products and services designed to poach the others customer base. Will either be successful? Of course, only time will tell.

Here’s how the stocks of the two companies have performed over the last 5 years. [Click on the image for a larger view.]



As we can see, over the last 5 years, Target has returned over 40% while Wal-Mart has lost market value. To peer into the reasons why this happened, we need to look at how each company has performed operationally over the last few years. Here is where Town’s Rule #1 criteria may help us. For each company, we collected the figures using MSN Money and listed them in the table below. [For most of the multi-year figures, we used a geometric growth rather than an average growth.]

You should note that if I were doing this analysis for actual investment, I would use each company’s actual financial statements. But in order to keep it simple, and to try and follow Town’s book as closely as possible, I just used MSN.

You should take note of two more things. For the free-cash-flow (FCF) figures, I used the more traditional calculation of cash from operations minus capital expenditures. MSN also subtracts out dividends. Additionally, I included Warren Buffett’s calculation of “owner earnings” which is net income plus depreciation and amortization minus capital expenditures. This is his definition of free-cash-flow. These figures are from the latest annual financials statements. [Click on the image for a larger view.]



After looking at these figures, and grading them against Town’s criteria, I would say that each company probably gets a passing grade on the level of a B- or C+.

Wal-Mart averages over 10% in growth for most of the figures except for FCF and owner earnings. These two figures have declined over the last few years. And nearly all of the growth figures have trended downward.

On the plus side, Target’s EPS an equity growth are much higher than Wal-Mart’s and far exceeds Town’s minimums. But its sales growth and ROIC haven’t consistently beaten Town’s 10% floor. Whereas Wal-Mart’s FCF has been declining ever so slightly, Target’s FCF took an astronomical leap in the last year. But I wouldn’t get too excited about that since the previous year’s FCF was so low. (Gotta watch those base year figures.) For the 5 year period, Target only had one year where the company had a positive FCF or owner earnings figure. But the trend in FCF and owner earnings is good, as Target is growing its cash at a faster rate than its capital expenditures are increasing.

From the operational figures, neither Wal-Mart nor Target distinguishes itself from the other (using Rule #1) criteria. Thus, I don’t think these figures give us any insight into why Target’s stock may have performed better over the last 5 years. My guess, without the benefit of looking back, would be that Wal-Mart’s stock was richly valued 5 years ago relative to Target. Or it could be that investors think that Target has a brighter future. Or perhaps, everyone is crazy.

What I also want to know is, at this point, which would be the better investment. I want to know the value investors I admires are raving about Wal-Mart and Target...not so much. This is where the ever important valuation of the companies comes in.

I will explore these points in a future post.

Wealth and the Commonwealth

I cannot see how the unequal representation which is given to masses on account of wealth becomes the means of preserving the equipoise and the tranquillity of the commonwealth.

-- Edmund Burke, "Reflections on The Revolution In France"

Sunday, April 23, 2006

Inside the Budget of a Millionaire

Did you know that for every 100 millionaires who don't "budget", there are about 120 that do. More than half of the nonbudgeters invest first and spend the balance of their income.

Many call this the "pay yourself first" strategy. These people invest a minimum of 15 percent of their annual realized income before they pay the sellers of their food, clothers, homes, credit and the like.

When asked [of millionaires], "Do you know how much your family spends each year for food, clothing, and shelter?" almost two-thirds of millionaires answer yes.

Source: The Millionaire Next Door, by Thomas Stanley

Friday, April 21, 2006

The "Zealots" Have It Wrong

The following commmentary is an excerpt from Brick Financial Management's February 2006 client letter:

"...The Zealot answer to the problem would be to create a portfolio set with some fixed percentage in stocks, some in bonds and some in cash without regard for valuation. This would be executed through some investment combination in index and actively managed mutual funds. The practice commonly referred to as asset allocation (or the Investment Policy decision), thought by the Zealots to be the most important decision an investor can make. The Zealot believes that the asset allocation decision, and not security selection, is the most important determinant of long term performance.

The Zealots and asset allocation
As proof they reference one (that’s right, one) study. We’ll call the study BHB. The Zealots tell us that BHB says that of the determinants of performance - asset class selection, security selection and market timing – asset selection determines 93.6% of long term portfolio performance. [We find it odd that BHB did not consider management fees, transaction costs and taxes among the determinants.] They also went on to say that security selection determined less than 5% of portfolio performance. The Zealots love BHB as it seems to support EMH which states that security selection is pointless.

Variation in returns is not total returns
But we (the Heretics), being skeptical by nature and being unable to ignore the success we’ve had with security selection, didn’t buy the interpretation of the BHB study. So we actually read the thing. What did we discover? At no point does the BHB study measure total long-term returns. What it measures is the total variation in quarterly (short-term) returns. In other words, BHB measured how much a portfolio went up and down over short periods and not how much money it made in the long term. BHB determined the successful portfolio as one that didn’t fluctuate a lot. Whether or not the portfolio actually made any money was not a determinant of investing success. Hmm…interesting.

Variation in returns means little
We must keep in mind that the variation of quarterly returns alone tells us practically nothing about the prospects of investors achieving their financial objectives. Funding financial objectives comes from portfolio contributions and the compounding of returns over time. In other words, returns should not be ignored, even in the short-term. [Further, even if short term volatility is of utmost concern, we must realize that extreme diversification does not necessarily eliminate it. A more effective technique would be to choose investments that havesimilar returns but do not move in tandem. In other words, they should have a high negative correlation.]

Traditional asset allocation fails
When using the material in the BHB study, and interpreting the results correctly, we find that the asset allocation decision determines only 15 percent of returns over a 10-year period. This little tidbit damages the credibility of the asset allocation process as practiced today, which is to say that long term investors should automatically be invested mostly in stocks and short term investors should automatically be invested in bonds and cash. This portfolio management by autopilot is nonsense. In our Client Education Brochure, we point out thatover 10-year periods, stocks perform better than bonds and cash over 80% of the time. But turned on its head, we see that bonds and cash perform better than stocks 20% of the time. If your time horizon is only 10-years long, wouldn’t you want to know which assets would perform best over the coming period? What you wouldn’t want to do is make an assumption that history will repeat itself. We think it important that we account for those times when stocks underperform.

Using, better yet, misusing the BHB study the Zealots set portfolios with rigidity (i.e., 20% large cap stocks, 10% foreign stocks, 15% small cap stocks, 10% short term bonds, etc). They wind up owning stocks from every corner of the market. Should any one piece of the portfolio advance or decline too significantly away from the original asset allocation, Zealots either buy or sell accordingly. This would seem to make sense if it were not for differing time horizons, valuation and costs.

As we just mentioned, there are occasions when both bonds and cash perform better than stocks, usually during extended bear markets. Thus the problem arises when arbitrarily selling (or buying) a portion of a portfolio that has advanced (or declined) significantly. The problem is exaggerated when valuations of the securities and the time horizon suggest just the opposite action should be taken. Extreme diversification, as traditional asset allocation requires, would always have the client in some asset that was underperforming. At best theportfolio would do about average with the market. As Heretics we can’t shake the belief that we should try and can do better than the market.

Value allocation succeeds
Brick Financial believes that most investors should have some exposure to stocks, bought at low valuations, at all times. But when we create portfolios we will let the valuations of groups of stocks, bonds and cash, determine the asset allocation. This process is sometimes called “Tactical Asset Allocation”(TAA). A more fitting title would be “Value Allocation” (VA) which accounts for valuation of securities, investment time horizon, costs and fees..."

Read the entire commentary by clicking this link>>

Tuesday, April 18, 2006

Rule #1

A friend passed a book on to me this past weekend. Phil Town’s Rule #1. For the uninitiated, “Rule #1” is a reference to Warren Buffett’s first rule of investing which is “Don’t lose money”. Using Buffett’s rule (and investment process) Town transformed himself from a beef jerky eating, river canoeing, rattle snake wrestling adventure tour guide to a book writing, public speaking, millionaire blogger. I’ll reserve comment on whether or not I think the book is a read since I just sort of skimmed it. But I was able to ferret out the punch line – following Buffett’s Rule #1 will lead to superior returns.

Town suggests that the way to adhere to Buffett’s first rule is to look at five different things about a company. They are:

  • return on invested capital (ROIC),
  • revenue growth,
  • earnings per share (EPS) growth,
  • equity (or book value) growth, and
  • free cash flow growth.

He says that we should be looking for companies with at least 10 years of history, and except no less than 10% per year in each of the growth figures. We should also look for companies with an ROIC of at least 10% as well.

Sounds reasonable. I thought it’d be interesting to take a few companies on our watch list (perhaps some in our portfolios) through the Rule #1 paces. So I’ll be doing that over the next few days and posting the results here. Stay tuned.

In the meantime check out the book for yourself:



The Little Book That Makes You Rich!

The following commentary is taken directly from Brick Financial Management's November 2005 letter to clients.


The Little Book
Instead of getting into the details of our portfolios this month, we thought we’d change things up a bit with this letter. Recently, a neat little book hit bookstores. Written by hedge fund manager, Joel Greenblatt, The Little Book That Beats the Market explains value investing in (mostly) layman’s terms. The book touts a “magic formula” that Greenblatt says will help any investor beat the returns of the market. A review from the University of Western Michigan Library states:

“Using basic math skills and simple concepts, Greenblatt shows you how to achieve investment returns that beat the pants off even the best investment professionals and the top academics… Through entertaining anecdotes and practical pearls of wisdom, the book explores the basic principles of successful stock market investing and reveals the secrets to buying good companies at bargain prices automatic… The (magic) formula has been tested over hundreds of different periods and thousands of stock picks and has been proven extremely profitable for those who are willing to stick with it...”
Good companies at bargain prices
The book is of particular interest to us and the clients of Brick Financial because it so clearly lays out basic value investing principles that we follow every day. Basically the book is about how to find superior companies at bargain prices. Greenblatt’s magic formula helps investors identify those companies.

Following the formula requires caution
Greenblatt goes to great lengths to explain to the reader that the magic formula is not a panacea. The formula is bound to lead to some years of underperformance. [Even proven investors have down years.] Those that don’t have the conviction or where-with-all to stick with it are bound to abandon the approach. Thus, following the formula requires faith in the underlying principles of value investing. It requires the ability to endure the long-term. And it requires, as Warren Buffett has stated, a “quality of temperament…not a high IQ”.

He is also adamant in saying that you should not be investing directly in stocks if you do not know the principles of accounting, forecasting, and basic financial principles. If you can not confidently work your way around a company’s financial statement then, according to Greenblatt,
“You have no business investing in individual stocks on your own!... Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
Highlights of The Little Book
Some of the main points of the book, and those that are most relevant to clients of Brick Financial, follow:
  • There is a place where they sell businesses for half price all the time. And it doesn’t take a genius to figure out where to find them. The trick to finding these one dollar bills for 50 cents is that you as the investor must believe that these “dollars-on-discount” exist.
    Everyone should endeavor to save money. There are places an investor can put his money – under a mattress, in the bank, in government bonds or in corporate bonds. Some investments are better than others though.
  • Buying a stock means buying a percentage share in a business which entitles you to your proportional share of that company’s future earnings. Estimating the current value of the business requires guessing what the future earnings of the business will be. Your investment in any company should offer you more of a return than you might get in “safer” alternatives like the mattress, bank, or bonds.
  • Most stock investors are irrational and speculative which is one reason why the prices of stocks swing wildly in short periods of time. For instance, GM’s stock price can go from $30 to $60 in just a few months. It is improbable that the value of the GM would double in that time. Does this phenomenon make any sense? No! But all we as investors need to know is that it occurs and attempt to exploit it. We don’t need to know why it occurs.
    Even though it is difficult to value business, we must make our best guess. And when we do decide to invest, we are best served to wait for the moment when the stock price of the company is below our guess of the business’ intrinsic value. Benjamin Graham coined this action as buying with a margin of safety.
  • It is better to buy a company that earns more money relative to the amount you paid for it. In other words, if company A earns $2.40 per share per year and company B earns $1.20 per share per year, yet both companies cost you $12 to purchase, which is the better buy? Company A of course. You’re getting more earnings for your money. Company A’s earnings yield is 20%, while company B’s is only 10%.
  • An investor would also be keen if he bought only good business. How do you tell which are the good business? As an example, let’s say it cost both company A and B $400,000 to build each of their widget stores and get up and running. Let’s further say that company A earns $200,000 but company B only earns $10,000. Which is the better business? Company A once again. Company A’s return on invested capital (ROIC) is 50% while company B’s ROIC is a paltry 2.5%.
  • If an investor stuck to buying good business (high ROIC) at cheap prices (high earnings yields) he’d do well with his investments.
  • Buying good businesses at bargain prices works as an investment strategy. Not only has it worked in the past but because its principles are sound, it will work in the future. There will always be better business than others and there will always be better values than others. But the investor must have faith in the principles.
  • The “magic formula” as well as any well reasoned investment strategy will occasionally fail to do well in the short-term. The short-term can often mean years, not days or months. It is extremely hard to stick with a strategy that may not work for several years in a row. Which is a good thing. If the formula worked all the time, everyone would use it and it would eventually cease to work. The trick is to have a long-term mindset. Long-term in this case means three, four, or even five years or more!
  • Although you want an investment strategy that has worked in the past, a good track record will not ensure results in the future. A good track record will not keep you following if the results are not as good. You should follow an investment strategy if the principles are sound. Buying good businesses at bargain prices is a sound principle and is the definition of value investing.
  • If an investment strategy is sound, the longer the time horizon, the better the chances for success. Time horizons of 5, 10 or 20 years are ideal. Such a time horizon will give an investor a large advantage over most other investors.
  • As much as 95% of the trading that occurs in the stock market is completely unnecessary and meaningless.
  • The stock market offers the best possibility for high investment returns over time. However, most people that should invest should not invest on their own. So it is difficult to know where to start. Stockbrokers generally have NO idea how to help investors. They’re only trained to sell products at the investor’s expense. Mutual funds would be fine but the vast majority of mutual never beat the market. A hedge fund may be a viable option but their high fees are usually not justified by their performance.
  • Since there are so few good avenues for investors to participate in the stock market, the best choice is most often an index fund. Or he may use an easy to use “magic formula” like the one in the book.

Be sure to get the book
Finally, we encourage you to read this book. You can click this link to pick up a copy.

You can also view a review by The Wall Street Journal here.