Alibaba: Risks and Opportunities

Maybe I am a bit late to the party here, but since I was never likely to get an allocation of the IPO, I don’t feel like there is necessarily a rush. Alibaba (NYSE:BABA) begins trading on the NYSE today, with the IPO having priced at $68 per share. This represent a $168bn valuation–35x LTM EBITDA of $4.8bn and almost 18x LTM revenue. A high valuation for sure, but there is significant growth potential, so looking at trailing multiples is certainly a punitive way to asses value here.

I have not yet formed a full view on the Company, but I thought it would be helpful to lay out the Pros and Cons as I see them today to help reach a better conclusions.

On the positive side: Alibaba is (1) a clear eCommerce leader in China where (2) internet penetration and consumer spending are set to continue to grow dramatically. (3) Unlike its closest US comparable, Amazon.com (AMZN), the Company is highly profitable.

 (1) eCommerce Leader in China: This may be the most obvious and most compelling part of the investment case. With 8.5 million sellers, 279 million buyers and 14.5 billion orders annually (Source: Alibaba Roadshow Presentation, data as of June 30, 2014), Alibaba is the clear eCommerce leader in China. eCommerce is a tough business, where competition can be fierce and margins can be thin–scale matters and the network effects are significant. You want to shop where all merchants are selling, merchants want to sell where all the shoppers are buying and round and round we go. Alibaba shipped 6 billion parcels last year, which represents about two-thirds of all parcels shipped in China, the most populous country in the world.

(2) Internet Penetration and Consumer Spending: This is probably the reason I am most excited about the Company and its market. I can think of almost no stronger predictor of growth than an under-penetrated market in a developing economy. You have the benefit of “seeing how the movie ends” by looking at developed economies and the track record of developing economies following suit is spectacular. Furthermore, internet penetration is one of the best examples of this (one of the key reasons why I am excited about Yandex). The Company draws out attention to four metrics (source: Alibaba roadshow presentation):

Internet penetration: China 46%, US 82%
Mobile penetration: China 37%, US 68%
Consumer spending as % of GDP: China 36%, US 67% (real question mark about non-consumer/government spending in China being over-inflated)
Online shopping penetration: China 49%, US 64% (this is closer than I would guess!)

These are encouraging statistics. My favorite way to look at it however is this:

Source: WolframAlpha.
Source: WolframAlpha.

Looking at the chart above, its is fairly apparent that the internet has another 10 years of penetration tailwinds in China.

(3) Profitable eCommerce model: Alibaba has manages to sustain its massive growth rate while turning a profit. That is more than can be said for its closes US competitor, Amazon.com (AMZN). It is interesting to note that while Amazon has certainly been pushing for growth (and sacrificing profitability in the name of market share land-grab), it has not been able to succeed in China. Maybe this speaks to Chinese cronyism favoring Alibaba more than to Alibaba’s skills and expertise, but properly dealing with the government is a key part of doing business in China after all.

With 50%+ EBITDA margins, Alibaba has a real chance at generating cash for investors. I worry that life as a public company will mean more pressure to grow and the Company could easily head down the path of overvalued, non-strategic acquisitions (‘di-worse-ification’, to use Peter Lynch’s term), but it remains the case that meaningful profitability is a good place to start. While certainly elevated, EBITDA multiples (especially if we look at what is expected in the next 12 months) are actually somewhat reasonable at around 25x–one thing is for sure: I like the fact that we can talk about EBITDA multiples, unlike many of their peers in the technology world.

On the negative side: (1) The valuation is high and requires significant growth to be justified, (2) Investing through a VIE exposes investors to many risks and (3) growth opportunities beyond China are not proven.

 (1) Valuation: I discussed most of these points above (I could not resist!), but the simple reality is that unless the company continue to grow significantly, this valuation is not justified. The Company likely needs to at least triple earnings before this valuation makes a lot of sense. Is that doable? is it likely?

(2) Investing Through a VIE: When you buy shares of Alibaba, you are not buying a stake in the Company directly–the Chinese government does not allow foreign investors to do that. Instead, you are buying into a shell company that has a contract which gives it rights over the Company’s profits. This sounds like it is effectively the same thing, and in some ways it is, but ultimately it weakens the legal position of investor in the event of a dispute. You can argue Alibaba is now high-profile enough that there will not be any funny business, but it is important to remember that as recently as 2011, the Company separated its AliPay business without offering fair compensation to some of its major shareholders (Yahoo and SoftBank were very upset). There is no telling what might happen in the future, but the VIE structure certainly gives the lets the Company move in ways that are not shareholder friendly to a greater extent than in a more traditional ownership construct.

(3) Growth Outside of China: The Company’s chairman, Jack Ma, talks a big talk in terms of international expansion. It would certainly be great to see the Company succeed in other large markets in the region (Indonesia, Philippines, the US?), but the fact remains that its model is not proven outside China. One of the big breakthroughs for Alibaba, and an important reason that they succeeded where others failed, is that their of exchange and payments which is basically fraud-proof. Payments are held in escrow and not released until customers confirm they have received the desired goods. This has been crucial for their success in China (a country where fake bags and watches are more prevalent than the real ones), but may be little more than a hinderance to commerce in other economies. One way or another, the jury is still out on this respect, and it is hard to give the Company any credit for this. If anything I worry this could be a major source of ‘di-worse-ification’.

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Portfolio Review: Coach

My investment in Coach is off to a rocky start. It feels like it was an investment somewhat hastily made, but it is not clear if that is just my reaction to being 30% down in such a short period of time.  Either way, it is a good time to review the original thesis and be thoughtful about what to do going forward.

Pretending like I will be able to predict short term fluctuations such as this one is not productive, but it does highlight the risks in trying to “catch a falling knife”. I still believe, however, that being thoughtful in situations like this can be a way to generate outsize returns. The market can overreact to short term trends (both positive and negative ones). If you are dealing with a good business, this can present a long term opportunity. Whether or not luxury handbags is truly a good business is a fair question, but opportunities seldom arise in “obvious” good businesses–or maybe I lack  patience!

Company name: Coach Inc. (NYSE: COH)

Investment thesis: Coach is a (1) leading luxury brand (2) trading at an attractive valuation.

(1) Leading luxury brand: I like companies that enjoy a strong brand. It is one of the few assets that can allow a business to earn above average returns for a long time. Unfortunately, I am not the only investor out there that has noticed this, so companies with strong brands tend to trade at a premium which can easily erode such above average returns. I view Coach as a holder of such a brand, and it’s recent poor performance as an opportunity to invest in the business at a moderate valuation. This does not come without it’s risks. Maintaining and growing a brand requires focused execution. Moreover, in the case of a luxury retailer, if the brand is damaged, you have very little left. A brand like Coach is a great asset, but it may be their only valuable asset.

The luxury industry trades at a premium multiple. I find this to be partially justified because it’s overall growth potential (the rich are getting richer) and it’s ability to generate very high cash flow (high gross margins and operating leverage) when things go right.  Business can be somewhat fickle however, with a strong new entrant or a bad collection possibly having outsized effects. Nobody needs a $400 bag. A lot of people do want one.

Gross margins can be a good indicator of the brand’s power. A commodity product will not be able to sustain a high gross margin–to do so you must enjoy some kind of ‘monopoly’, and a strong brand is one of the few kinds of monopolies that are allowed to exist for the long term. Patents expire, but brands are forever (other examples of sustainable, unregulated monopolies include software platforms and any service that operates under a ‘network effect’, like marketplaces, exchanges or social networks). The char below shows gross margin and price history for coach for the last 14 years:

COH Gross Margin
Source: CapitalIQ.

It is interesting to note how dramatically the stock has reacted to changes in cross margin in the past, especially when you consider it is all within a fairly narrow band (between 70% and 78% in the last 10 years). Note the significant reduction in gross margin (from 78% to low 70s) in 2008-2009 as the company pushed into a more mass market position–this turned out to be a great move, as it significantly broadened the market for the Company. The recent further decline has been a result of heavy discounting and more product going through the outlet stores. I think this has been a result of additional competition on the retail high street, from the likes of Michael Kors (KORS) and Kate Spade. KORS in particular has been rolling out stores aggressively (500 shops per year on a base of 1,560 at the end of FY 2014), which has been tough for COH. There is no denying that the strategy has been working for Michael Kors, but you have to wonder what happens when they hit a ceiling and the brand cools down a bit. The Google Trends chart below paints an interesting picture (too bad there is no data before 2005 to compare to COH’s rise):

Relative Search Frequency. Source: Google Trends.
Relative Search Frequency. Source: Google Trends.

Fashion is an industry plagued by fad risks. Catching a falling knife has its risks, but I think trying to catch a rising flame is riskier.

(2) Valuation: I made my investment in Coach on 2/18/2014 at $48.36 per share. Since then the Company has disclosed its new strategic plan and the shares have fallen in value about 25%. I think being too focused on a given ‘cost basis’ is one of the biggest biases investors must deal with, so I will try to continue on this assessment independently of my own basis.

On an LTM basis, the valuation looks very attractive. While this is somewhat irrelevant given the business’s current trajectory, I think it is helpful to highlight the kind of returns we might expect if the Company is capable of returning to its prior peak on a sustainable basis:

TEV / LTM EBITDA: 6.5x

TEV / LTM EPS: 13.2x (7.6% earnings yield)

Looking at analyst projections for the year ended June 2015 however, is more sobering:

TEV / June ’15 EBITDA: 9.3x

TEV / June ’15 EPS: 19.4x (5.2% earnings yield)

The more interesting questions however, is what we may expect from Coach in the long term. Their recent restructuring plan gives a bit of insight into their current plans and expectations. The next two years represent a period of significant investment (what thy call “invest and resent”). While that message has definitely fallen on deaf ears in Wall Street, I am intrigued by the idea of a brand like Coach embarking on a significant investment (which will require significant financing) now that interest rates are low and debt is available. If they can execute it well, it could leave them well positioned to be aggressive when the market softens and others are forced to retrench. Again, this is not without its risks: execute poorly and and they could find themselves in a similar or worse position with a looming debt load and no hope of refinancing it.#

It is also interesting to consider rival and Wall Street darling Michael Kors (KORS), a Company currently trading at an EV of $14.5bn (50% higher than COH’s $9.5bn) with an LTM EBITDA of $1.2bn (compared to COH’s $1.4bn). The price to sales differentials are also outstanding (2x for COH vs. 4x for KORS).  The growth prospects for KORS surely look good now, and Coach is set to go through a challenging period, but the valuation gap is quite significant. A lot of things need to go right for the KORS valuation to be justified, while just a couple of things not going ‘as wrong’ for COH would make the stock look like a bargain.

Conclusion: An investment in Coach is not without its risks. Ultimately I come down on the side of it being a quality franchise trading at a depressed valuation. A strong brand, with a rich history that is going through a rough patch as a result of a combination of a poorly timed strategy just as new competitors entered the market. Fashion-focused companies will have their ebbs and flows over time, and it is better to invest when they are down so we may benefit when they come back into favor.

 

 

Portfolio Review: Barrick Gold

“Inflation is always and everywhere a monetary phenomenon” — Milton Friedman

I don’t like being dogmatic about my investments. Many investors (including many value managers) have taken to buying gold in large quantities in the sure belief that currency debasement by countries around the world will erode the value of paper money. The standard paradigms of monetary theory which are the basis for this belief have been pretty fluid lately (see: St. Louis Fed thoughts on Money Velocity), but the threat of money losing its value certainly remains given the unprecedented rises in money supply. I can’t help but hear Milton Friedman’s “inflation is always and everywhere a monetary phenomenon” in the back of my mind.

Commodities are a bad investment for the long term. Commodities don;t produce anything, so you are just betting that a the supply and demand relationship will change over time and the price will rise. In fact you have to bet that the price will go up fast enough to offset the cost of holding a commodity in storage. Gold is no exception, despite its stellar performance over the last 10+ years (Performance looks difference if you look back to the early 80s).

It was with all this in mind that I made an investment in Barrick Gold (NYSE: ABX) on September of last year for $18.28 per share. The stock is down about 10% since then, having traded in a relatively narrow band all year. It is still well below its previous highs of $50+ (when the gold price was topping new highs).

On the one hand, it is hard to escape the fact that investing in a gold miner is inherently a bet on the price of Gold. What I like about it however, is that by investing in a mining business (vs. investing in the commodity directly), you get the optionality that comes along with backing a dynamic business that will adapt to the circumstances. In the short term, there is not denying the impact of the spot price on the Company, but in the long term, Barrick Gold (like most good business interests) will adapt to the environment in which it operates and adjust its operations accordingly. After all, almost no business has complete insulation from the pricing environment of the good they produce.

If the spot price rises dramatically, the Company might race to develop new assets and increase production (like it did in 2012-13), even if that means a rising cost per ounce mined. Conversely in a less favorable pricing environment (like today), the Company will be more cautious, dial back production and focus on its most cost effective assets. The halted development of the Pascua-Lima mine is a case in point.

I was looking for a good way to illustrate and visualize this, and I came up with the concept of “All-in Sustaining Profits” (or “AISP”) for a given level of gold price realized. I don’t pretend that this little model is predictive of near term results, but I think it is indicative of the long term profit potential of the current stock of mining assets.  The idea is based on the Company’s published All-In Sustaining Costs (“AISC”) for its gold core mining assets, and it simply assumes that in the long run mines that can be operated as AISC below the realized gold price (i.e. “profitable mines”) will operate at production capacity, while those which would not be run profitably will not be run at all.  AISC takes into account sustaining capex, and therefore my estimate of total AISP is roughly corresponding to EBIT.

The table below outlines the key statistics provided by the Company for its key assets for the last 3 years (2014 = midpoint of the Company’s “2014 outlook”) and shows the calculation of AISP based on realized gold prices for the respective years:

Source: Company Filings.
Source: Company Filings.

I think it is worth emphasizing again, that this is a rough and indicative measure. There are lots of issues with it, including: AISC may rise and fall over time, the Company may be able to realize lower AISC at lower production levels (i.e. my “binary” assumption of whether a mine is run or not is poor) and mines that have received heavy investment might have cash costs that are low enough to keep operating them, even if the total AISC might categorize them as unprofitable—just to name a few. Notice that despite my comment above comparing my AISP to EBIT, looking at 2013 and 2012 at the Company’s average realized gold price for those periods it represents 85% of EBIT (2013 EBIT: 4,703m) and 75% of EBIT (2012 EBIT: 6,606m) respectively.

The chart below shows AISP and production levels based on the Company’s 2014 outlook at various levels of the Gold price. If anything, I think it is helpful to note that even at very low price levels, the Company would likely still be able to run profitably in the long run, even if that means being a smaller concern, exploiting a smaller set of assets

"All-In Sustaining Profit" and assumed production at various level of gold price.
“All-In Sustaining Profit” and assumed production at various level of gold price.

Value

In many ways the “value play” in this investment has a lot more to do with the original point regarding currency debasement. If this will prove to be a great investments, then some part of that thesis will be correct. The other face of the argument is ultimately more about downside protection and safeguarding against loss (a very important factor!).

Assuming 10x long term sustainable EBIT multiple (i.e. AISP in my example), The Company would retain its full current value even if Gold prices settled around $1,000 per ounce. Again, this is not to say that if the gold price dropped to $1,000 tomorrow and stayed there the Company’s stock would not go lower, but rather to imply that if that were a long term scenario, the chances of at least breaking even on the investment would be good. If I further assume that AISP should be “grossed up” to EBIT based on it representing 85% of it (again, a very rough assumption), then the gold price level at which the long term value of ABX remains attractive is even lower.

Portfolio Review: Apple

Being the largest company in the world by market capitalization, there is a lot written about Apple. Obviously the Company is widely followed, and you would expect the market for its shares to be as close to efficient as a market can be, so what chance of outperformance is there? I am consistently surprised by how volatile the shares of such a large company can be: Over the last 18 months or so, the shares have traded for as high as $100 and as low as $64, while arguably nothing major has changed with respect to the long term value of the business.

Company: Apple Inc.

Investment Thesis: Apple is (1) a solid company with great stable of products. (2) it trades at a reasonable valuation and (3) there is great optionality in the future of the business.

(1) Solid Company with Great Stable of Products: I won’t dwell too much on this point. By some metrics, Apple is the largest company in the world. It’s main products are iPhone (53% of 2013 sales), iPad (19% of sales), Mac Computers (12% of sales) and iPod (5% of sales). It is a market leader and category definer across the board, sporting very high gross margins (37.6% in 2013) to prove it. It distributes through a variety of channels, including its own retail stores (13% of sales in 2013).

(2) Valuation: Apple trades at 15.7x trailing earnings. That is right around the long term average for the stock market and a fair value for business of the scale and clout Apple offers. The business is highly cash generative and has been actively returning capital to shareholders. Apple started paying a dividend  in 2012 and has grown it significantly since (current yield of almost 2%).  The Company has also been deploying significant capital towards share repurchases ($33.9bn over the last 12 months), especially while its share price has been somewhat depressed.

(3) Optionality in the future: Apple is not a bargain, it is fairly priced.  What makes the investment attractive is that we can earn a fair market return and get an option on the Company’s future developments. I feel confident Apple can continue to innovate enough to maintain its current level of earnings over a long time, and that alone would represent a good return on my investment. I really like the idea of buying a business at a fair price that will earn a decent return under regular circumstances, but have some upside in the event that a new product introduction is successful.

I think the chart below is instructive to see the effects of a successful product introduction:

Apple Revenue Growth since the introduction of the iPod (Source: CapitalIQ and Company data)
Apple Revenue Growth since the introduction of the iPod (Source: CapitalIQ and Company data)

The “next one” may or may not come. If it doesn’t then I expect my investment in Apple to have a mediocre but acceptable return.

Conclusion: Apple offers a good return for the level of risk in the long term. The Company has great products and generates a lot of cash. One new successful product launch in the next 10 years would be enough to make this a great investment. Even if that does not happen, I expect the company would generate an acceptable return.

 

Portfolio Review: General Mills

I made my investment in General Mills (GIS) in late November 2013 and paid $50 per share. The shares have not moved significantly since then and I believe the original thesis for the investment holds, but given that I have not written about it yet, I want to take this opportunity to describe it in more detail.

Company: General Mills (GIS)

Investment Thesis: General Mills is (1) a market leading in several strong food categories. (2) It is well positioned to grow internationally. (3) It’s current valuation is attractive given its growth potential.

(1) Market leader in good categories: General Mills is the owner of several markee brands including: Cheerio’s, Nature Valley, Yoplait, Progresso, Pillsbury and Old El Paso.

Cereal: Ready to eat cereal is the Company’s biggest segment, representing $3.9bn of worldwide net sales, and it is a good one. Cereal is the #1 food eaten for breakfast at home (28%; the next is fruit at 14%) and most people eat breakfast at home (80%) (Source: 2014 Investor day presentation, The NPD Group’s national eating trends). Moreover, it is a sector where brands really matter, and General Mills owns many leading brands.

Yogurt: Greek yogurt changed the landscape in this category and this hurt Yoplait’s overall leading positioned. General Mills may have been ‘late to the party’, but they have added a full range of Greek yogurt offerings and are getting good traction. They have now captured 10% market share of the Greek yogurt market. There are also good signs that the decline in original style yogurt has now stopped and that business should be stable to growing going forward. Yogurt in general is a great product–people who consume it tend to do so regularly.

Better-for-you snacks: This has been an area where most food companies have been struggling to meet consumer’s rapidly changing tastes. Seems like there is a new health craze every day, and it is hard to keep up. General Mills has a good set of products and a fairly methodical approach. They have been successful with a few key brands including Larabar and Nature Valley. These products represent a significant portion of the Company’s snacks business, which is encouraging.

(2) International  growth potential: The Company generated $6.6bn of net sales outside the US in 2014 (35% of sales). $5.4 billion in their direct international segment (excluding JVs) broken out below:

 

International Sales Breakdown (Source: 2014 AR)
International Sales Breakdown (Source: 2014 AR)

This has grown significantly over the last few years, although 2014 represented a year of slow growth:

International Sales and Operating Profits over time (Source: 2014 Investor Day Presentation)
International Sales and Operating Profits over time (Source: 2014 Investor Day Presentation)

 

(3) Valuation: A 3.1% dividend yield is a great place to start. I like investing in companies for the long term, but I am also susceptible to feeling like I am “wasting my time” with capital tied up in a company whose valuation is not going anywhere. A decent dividend yield pays you to wait, which I see as a plus for many reasons: It rewards shareholders who are patient, it encourages shareholders to be patient (not the same thing!) and it signals a real commitment from the company to deliver value to shareholders over time.

Given the Company trades at a premium to the market, and therefore needs to grow into its valuation, it is helpful to be rewarded for this patience. I think it is helpful to think about the eventual likely prospect that a company like General Mills will trade for 15x (the long term market average) and be crisp about what we need to believe will be the development of the business that would earn a satisfactory return under this scenario.

GIS BoE Math

 

The numbers above certainly do not make my sock go up and down. I am left thinking that this kind of return is all you can expect in this kind of market (after all, this represents 2 times what a government bond would yield!). Nevertheless, there is not much point in putting capital at risk if the prospects for a decent return are limited. Will the Company grow faster? perhaps the market believes this kind of ‘safe bet’ will trade at a premium forever, but that kind of thinking relies too much on ‘greater fool theory’ for my taste.

Conclusion: Having reviewed the investment thesis for the Company has been helpful, but I am still on the fence about what to do. General Mills is a very nice company, with a great product portfolio and good prospects going forward, but the valuation is high. There is some reason to be optimistic, but not overly so. In many ways, I see this investment as a bit of a hedge–a company that is well positioned in the even of a bear market–but given a relatively high valuation, I question whether that is the case.  For the time being, I will hold on to the shares until I find a more compelling investment in the food space.

 

Portfolio Review: Dr. Pepper Snapple Group

I made an investment in Dr. Pepper Snapple Group (DPS) in June 2013 at $46.37 per share. The shares are up 30% since then, which is a much higher return than I would have expected in a year. Valuation was key to the original thesis, so I thought now would be a good time to revisit the company.

Company: Dr. Pepper Snapple Group (DPS)

Investment Thesis: Dr. Pepper Snapple Group is (1) a great business with a stable, repeating revenue base (2) at an attractive valuation. (3) The Company strategy to return capital to shareholders is also very attractive.

 (1) Great business model with stable revenues: The Company is focused on the flavored non-alcoholic beverages category and owns several well-known brands such as 7up, Canada Dry, Dr. Pepper, Mott’s apple juice, Orangina and Snapple. One of the things I love about this Company is that it is not chasing after fads in the market. Case in point is that they do not have an energy drink offer (which some analysts ‘fault’ them for). That means less growth and ‘excitement’ about them, but I see their revenues as much higher quality. People who drink Canada Dry, have it as part of their routine–nobody walks by a display of drinks, sees a Canada Dry and thinks “oh, some ginger ale sounds lovely!”. You get the Canada Dry because you were looking for some Canada Dry. Chances are you have even bought it there before.

Revenues are have been remarkably steady around $6bn and expectations are of sub 2% growth (Source: Company filings and analyst reports). I think it is encouraging that volumes have been quite steady as well, so this is not a case of price increases making up for lost volumes. I am not expecting this to change going forward, but I will say this: I like the idea that if revenues grow any faster for whatever reason (a core brand that was out of fashion comes back in vogue, a new market getting traction), they have a good chance of remaining at the higher level. Generally speaking, I expect revenues to grow with inflation, which is one of the great things about investing in a business, rather than a fixed income instrument.

Perhaps the one area where there is most room to grow is in Latin America Beverages. This segment has been growing at a nice rate and represents a real opportunity to ride the rise of a consumer class in those economies. ultimately, however, it represents only about 8% sales today, so it will be a while before it is a meaningful contributor to earnings.

(2) Valuation: Shares have traded up significantly since my original investment, so I want to be especially crisp about my view on the current valuation. Some key data points:

TEV / LTM EBITDA: 10x

TEV / LTM EBIT: 12x

P / LTM EPS: 17x

I think these are acceptable multiples for high quality business like DPS. I am not expecting to make enormous returns out of this investment, but rather a reasonably consistent, inflation protected return of 5-10%. At current valuations (earnings yield of 6%) it may be reasonable to assume that it may be closer to the bottom of this range.

One other things I find encouraging is that Depreciation & Amortization has been running ahead of Capital Expenditures (which are modest) for some time. This should provide some EPS tailwind over time as D&A normalizes:

D&A and CapEx (Source: Company Filings and CapitalIQ)
D&A and CapEx (Source: Company Filings and CapitalIQ)

While overall fundamentals about the Company have not moved dramatically over the last year, it’s share count has decreased by almost 5% as a result of share buybacks (source: Company filings). While multiples have expanded slightly, that has been combined with healthy a combination of share buybacks and some fundamental improvements/business growth to deliver capital returns over the last year. This combined with a healthy and increasing dividend (yield: 2.7%) makes for good shareholder returns, which brings me to:

(3) Returning capital to shareholders: It is quite rare to see a company with such a clearly stated strategy to return capital to shareholders. It takes a particular kind of manager to be both good at running a large business efficiently and humble enough to think that the business is big enough, and its returns belong to the shareholders. The Company’s management constantly reiterates its commitment to return excess cash to shareholders and has been doing so efficiently with mix of dividends and share repurchases for years. CEO Larry young once said: “We aren’t the biggest, but we tell people what we are going to do and we do it. We generate a lot of cash and give it back to shareholders.” I like that attitude. Looking at the numbers, this commitment comes through.

Cash flow from Operations and major uses of cash over 5 years (Source: Company Filings and CapitalIQ)
Cash flow from Operations and major uses of cash over 5 years (Source: Company Filings and CapitalIQ)

The spike in cash flow in 2010 is related to a large licensing deal signed with CocaCola and Pepsi that year. The additional cash was used to fund additional share repurchases in 2010 and subsequent years. Looking at 5 years cumulative sources and uses of cash provides a clear portrait of the Company’s strategy to return capital to shareholders:

5 years cumulative sources and uses of cash (Source: 2013 Annual report)
5 years cumulative sources and uses of cash (Source: 2013 Annual report)

The chart above is my favorite part of their annual report and illustrates one of the key reasons I think the Company is a solid investment for the long term.

Conclusion: The Company may not be particularly exciting, but it has a solid business and a great track record of shareholder returns. The current valuation is modest and should deliver a good return over a long time horizon. This is a great Company to own for 10 or 20 years. I would strongly considering adding to this holding if the price drops significantly, but for now I will hold on to the shares I own.

1994

Read “Risk in Today’s Markets” by Howard Marks. It reads like it could have been published this week, but it was published on February 7, 1994. The market took a hit a few weeks later (prompting Marks to publish”Risk in Today’s Markets: Revisited“) and it was generally mixed for most of 1994. But who remembers 1994? It certainly doesn’t evoke the images of overpriced markets and subsequent busts that we associate with ‘2007‘ or ‘1999‘.

Part of the reason is the end of 1994 was the beginning of the 5-year long bull market that led to the 1999 tech bubble, with PEs expanding for around 15-20x (well within historical norms) to more than 30x (a level never before seen). Stock market valuation multiples expanded at a rate of over 10% per year for the subsequent 5 years–earnings and the macro-economy can do whatever they want and you will still be in the black with that kind of tail wind.

Does having 5 years of incredible, irrational multiple expansion justify paying elevated prices today? Seems like a classic case of ‘greater fool’ theory, or what little kids call a game of hot potato. It seems easy to answer ‘No’, but that begs the questions of what is one to do at a time like 1994. There are great benefits to staying invested over the long term; continuing to own stakes in good businesses will generate a return, even if it is a moderate one, while holding cash will not. Staying out of the market between 1994 and the bottom of the tech bubble (i.e. “waiting for valuations to come back to a reasonable level”) would have been a big mistake. If you bought a broad index in 1994 and sold it at the worst possible time at the bottom of the market in mid-2002, you would have made an 89% return. It would have been a wild rollercoaster ride, but that is actually a pretty decent return! Sustained periods of both overvaluation and earnings growth like the 1990s really accentuate this issue.

Another easy answer is to say we should only invest in undervalued assets, even if the broad market is overvalued. There is certainly some truth to that, but as it turns out, that is easier said than done. It is especially hard, given that a generally overvalued market has a tendency to push up all prices in unison and reduce the dispersion of valuations. See chart below:

 

Multiple Dispersion (Source: Business Insider)
Multiple Dispersion (Source: Business Insider)

While the tech bubble was an exception (high overall market value was mainly driven by astronomical valuations in the tech sector), generally elevated pricing environments tend to exhibit lower dispersion in valuations. This is certainly the case today, with valuation dispersion at their lowest point in over 20 years. A difficult task becomes harder.

So what is a prudent investor to do in a time like this? I try to maintain some discipline with the following goals in mind:

  • Buy securities that are fairly priced: You may not find absolute bargains out there, but if you buy the securities of companies with a solid business at a price where you feel comfortable you can earn a decent return over a long horizon,  then you protect yourself on the downside.
  • Stay invested: I struggle with this, but a little struggle can be a healthy thing. If you can avoid taking excessive risks, then making sure you earn some return on your capital will pay off in the long term. As Albert Einstein said “Compound interest is the eighth wonder of the world”.
  • Know where you stand: Just because we can’t predict where the market will go next, doesn’t mean we should pretend like all times are the same. There are times to be cautious and there are times to be courageous–It is usually best to do the opposite of what everyone else is doing (yet another difficult task!).

Let me book-end this post with one more Howard Marks memo, as he has some great comments on the very last point I made:You can’t predict, you can prepare, published on November, 2001.