Ben Graham Defines an Investment

by Geoff Gannon


An investment operation is one which can be justified on both qualitative and quantitative grounds.
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.
Thorough Analysis: The study of the facts in the light of established standards of safety and value.
Safety: Protection against loss under all normal or reasonably likely conditions or variations.
Satisfactory Return: Any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

(Security Analysis, 1940)

 

To have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.

(The Intelligent Investor, 1949)

 

Key Terms

  • Operation
  • Qualitative
  • Quantitative
  • Thorough Analysis
  • Safety of Principal
  • Satisfactory Return
  • Margin of Safety
  • Figures
  • Persuasive Reasoning
  • Body of Actual Experience
  •  


Daily Idea: Village Super Market (VLGEA)

by Geoff Gannon


Village Super Market trades on the NASDAQ under the ticker \u201CVLGEA\u201D.

Google Finance

10-Ks 

Harris Teeter 14A (Background of Merger - Page 25; Opinion of JP Morgan - Page 38)

 

Link

Base Hit Investing (blog I enjoy reading, but haven't mentioned here before)

 

Send Geoff Your One Page Appraisal of Village Super Market (VLGEA)

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Village Super Market trades on the NASDAQ under the ticker “VLGEA”.

10-Ks 

Harris Teeter 14A (Background of Merger - Page 25; Opinion of JP Morgan - Page 38)

 

Link

Base Hit Investing (blog I enjoy reading, but haven't mentioned here before)

 


Weight Watchers (WTW): Excellent Analyst Question

by Geoff Gannon


Remember, 25% of my portfolio is in Weight Watchers (WTW).

An analyst asked a great question in the latest conference call:

How do you think about the growth rate for Weight Watchers? You got this \ntremendous market opportunity yet the key metric of measurements i.e. \nattendance, hasn't really grown for the better part of a decade. You got high \nmargins, strong cash flows, much of which goes to de-leverage the company, which \nis in part, reflective of your majority owners action. How do you think about \nthe growth profile of Weight Watchers on a going forward basis with those \ninputs?

(Transcript

I think it frames the situation perfectly. 

Talk to Geoff about Weight Watchers (WTW) 

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Remember, 25% of my portfolio is in Weight Watchers (WTW).

An analyst asked a great question in the latest conference call:

How do you think about the growth rate for Weight Watchers? You got this tremendous market opportunity yet the key metric of measurements i.e. attendance, hasn't really grown for the better part of a decade. You got high margins, strong cash flows, much of which goes to de-leverage the company, which is in part, reflective of your majority owners action. How do you think about the growth profile of Weight Watchers on a going forward basis with those inputs?

(Transcript

I think it frames the situation perfectly. 

Talk to Geoff about Weight Watchers (WTW) 


Daily Ideas

by Geoff Gannon


I just wrote a GuruFocus article on how to practice valuation. That got me thinking I should give folks something to practice on. So, I’m going to try something new. Each day – I don’t know how long I’ll be able to keep this up – I’ll post the name of a stock that might be interesting to value.

If you want to do a one page appraisal – like I suggest in the article – go right ahead. You can send me your appraisal if you want. Or you can keep it to yourself. Either way, it’s good practice.


What Led to the Weight Watchers (WTW) Purchase?

by Geoff Gannon


Someone sent me an email asking:

What led to the Weight\nWatchers purchase?

Obviously, the 20% price\ndrop is what directly lead to the Weight Watchers purchase. The real question  is: Why had I already researched the stock and\ndecided to buy the moment I saw the price drop?

Quan - who writes the\nblog with me, and who I always talk ideas with - already owns WTW. It\u2019s his\nfavorite stock.

What got me thinking\nabout WTW originally was the history of share buybacks. You\u2019ve probably heard\nMohnish Pabrai say that Charlie Munger told him about \u201Ccannibals\u201D \u2013 companies that\neat their own share count. I screen for them.

From there, my thinking\nwas:

  • Weight Watchers is the\nmost psychologically powerful general weight loss program I know of
  • WTW is basically a\npublicly traded LBO
  • The stock is much more\nvolatile than the business
  • Investors treat\nmarketing misses the way they treat fashion misses in apparel retail - so\nyou should buy the stock when they mess up marketing
  • WTW has a high free cash\nflow yield (low price to 10-year average earnings, etc.)
  • Doesn't require net\ntangible assets to run the business - can pay out 100% of reported earnings\n(and then some)
  • Stock dropped 20% right\nbefore I bought
  • High short interest\nrelative to float  (most trading is short-term and institutional)
  • Stock price is the same\nit was 10 years ago. Company has doubled in size. Each share has doubled in\npercentage of ownership. There are now 4 times more sales per share than 10\nyears ago - but the price is the same. Most stock are more expensive than they\nwere 10 years ago. This one is 75% cheaper.

Against this:

  • They have a lot of debt.
  • Business performance\nnext year will definitely suck. It may suck for the next few years.

How I framed it:

  • Write-off the next 3+ years
  • Imagine what the stock\nshould trade for in a \"normal\" January 2017.

Under normal\ncircumstances, I saw no justification for a price below $52 a share. This is 15\ntimes what I expect reported earnings would be in 2017 ($3.50 a share ). Free cash flow would be\nhigher than EPS. That's a 10% return over 3 years. I could live with that.

Do I think they will\nproduce zero free cash flow for 3 years?

No.

Do I think they will\nbuy back zero shares for 3 years?

No.

Do I think it will take\na full 3 years for sentiment to turn?

No.

Therefore, I felt the\nupside was somewhere between 10% a year and a lot. The cost of getting a\nchance at the \u201Ca lot\u201D is 3 years of volatile discomfort.

In my experience, it\nrarely takes 3 years. But I always tell myself it will.

What could derail this?

The debt:

  • If WTW issues shares, I will lose money. 
  • If WTW uses all free cash flow to pay down debt, I won't beat the market. 

Both are\npossible when you owe more than 4 years of EBITDA \u2013 and you expect EBITDA to\ndecline \u2013 as WTW does.

The debt is a big risk. If the market cap was the same and there was no debt, I would have bought this stock a long time ago.

We are not talking about a low EV/EBITDA stock here. WTW is not a value stock. 

Talk to Geoff about What Led to the\nWeight Watchers Purchase

","wysiwyg":{"source":""}}" data-block-type="2" id="block-cd5f57d42cf834c5ed4d">

Someone sent me an asking:

What led to the Weight Watchers purchase?

Obviously, the 20% price drop is what directly lead to the Weight Watchers purchase. The real question  is: Why had I already researched the stock and decided to buy the moment I saw the price drop?

Quan - who writes the blog with me, and who I always talk ideas with - already owns WTW. It’s his favorite stock.

What got me thinking about WTW originally was the history of share buybacks. You’ve probably heard Mohnish Pabrai say that Charlie Munger told him about “cannibals” – companies that eat their own share count. I screen for them.

From there, my thinking was:

  • Weight Watchers is the most psychologically powerful general weight loss program I know of
  • WTW is basically a publicly traded LBO
  • The stock is much more volatile than the business
  • Investors treat marketing misses the way they treat fashion misses in apparel retail - so you should buy the stock when they mess up marketing
  • WTW has a high free cash flow yield (low price to 10-year average earnings, etc.)
  • Doesn't require net tangible assets to run the business - can pay out 100% of reported earnings (and then some)
  • Stock dropped 20% right before I bought
  • High short interest relative to float  (most trading is short-term and institutional)
  • Stock price is the same it was 10 years ago. Company has doubled in size. Each share has doubled in percentage of ownership. There are now 4 times more sales per share than 10 years ago - but the price is the same. Most stock are more expensive than they were 10 years ago. This one is 75% cheaper.

Against this:

  • They have a lot of debt.
  • Business performance next year will definitely suck. It may suck for the next few years.

How I framed it:

  • Write-off the next 3+ years
  • Imagine what the stock should trade for in a "normal" January 2017.

Under normal circumstances, I saw no justification for a price below $52 a share. This is 15 times what I expect reported earnings would be in 2017 ($3.50 a share ). Free cash flow would be higher than EPS. That's a 10% return over 3 years. I could live with that.

Do I think they will produce zero free cash flow for 3 years?

No.

Do I think they will buy back zero shares for 3 years?

No.

Do I think it will take a full 3 years for sentiment to turn?

No.

Therefore, I felt the upside was somewhere between 10% a year and a lot. The cost of getting a chance at the “a lot” is 3 years of volatile discomfort.

In my experience, it rarely takes 3 years. But I always tell myself it will.

What could derail this?

The debt:

  • If WTW issues shares, I will lose money. 
  • If WTW uses all free cash flow to pay down debt, I won't beat the market. 

Both are possible when you owe more than 4 years of EBITDA – and you expect EBITDA to decline – as WTW does.

The debt is a big risk. If the market cap was the same and there was no debt, I would have bought this stock a long time ago.

We are not talking about a low EV/EBITDA stock here. WTW is not a value stock. 


Bought Weight Watchers (WTW)

by Geoff Gannon


I just put 25% of my portfolio into Weight Watchers (WTW). My average cost is $37.68 a share.

I now own 3 stocks: George Risk (RSKIA), Ark Restaurants (ARKR), and Weight Watchers. I have 22% in cash.

Talk to Geoff about Buying Weight Watchers (WTW)


The Right Multiple to Pay for a Stock

by Quan Hoang


Someone who reads the blog sent\nme this email:

Dear Quan, 
I recently came across your blog and find it\nsimple and quite informative. I have noticed myself drawn to speaking to other\nlike-minded investors as their experiences and insights are very valuable in\ndeveloping my own knowledge and skill set rather than just reading a lot of\nbooks on the subject. 
One of the topics that has been on my mind for\nquite some time is the required rate of return adequate to compensate investors\nfor being equity holders in a business. I have moved away from the mainstream\nCAPM and WACC models for pricing the cost of equity but find little\nalternatives. 
From what I understand [Greenwald's class] is\nthat Warren Buffet generally uses 15% for his discount rate, although I am not\nquite sure how he came up with that number. Also, from some of the class notes\nfrom Greenblatt, he mentions using the 10yr bond rate with a 6% floor and\ncompare that to the EBIT/EV of a company. 
So my question is how do you determine what is\nan adequate rate of return? And how do you apply/adopt that to emerging market\ncompanies [as most info relates to US stocks]?
Thank you in advance for taking the time to\nrespond. 
Regards,
Mohammed

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

There are two reasons\nfor using a 15 unlevered P/E. First, an average company often trades at a 15\nP/E. So, a better than average company deserves at least 1a 5 P/E. Second, a 15\nP/E would mean a 10% nominal return. At a 15 P/E, yield is 1/15 = 6.7%. A good\ncompany can raise prices at the inflation rate or higher. That adds up to about\n10%. 10% is what the stock market returned in the past. And I think the stock\nmarket will return less than 10% in the future.

 

Two Risks to Consider

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

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

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

 

Some Good Companies Deserve Higher Valuation

There are companies\nthat deserve a 20 unlevered P/E. I think Weight\nWatchers (WTW) is worth more than a 20 unlevered P/E. That's because of\ngrowth. WTW's return on invested capital is infinite. Working capital is\nactually negative. That means they need no money to grow. The question is just\nabout how much they can grow. If you think long-term growth is at least 5%,\nyou'll get a 10% return at 20 unlevered P/E. You\u2019ll get about 1/20 = 5% yield\nfrom dividend and share repurchase (which increase earnings per share). And\norganic growth contributes 5% earnings per share growth. That adds up to 10%.

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

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

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

 

Intrinsic Value and the Price We Pay Are\nDifferent

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

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

For example, assume earnings\nper share is $5, and the price is $50. If you think the company is good and\nshould trade at a 15 P/E, and it's safe to assume that would happen in 5 years.\nIf you buy at $50 and sell at $75 in 5 years, you'll get an 8.45% annual return.\nIf you assume they can grow 5% in the next 5 years, the stock price would be\n1.05^5 * 5 * 15 = $95.7 or a 13.86% annual return over 5 years.

There is another way\nto do this. You can start by having some idea about the stock price in 3 or 5\nyears and discount back using the hurdle rate that you want. The result is the\nprice below which you would buy the stock. There's some assumption/projection\nin this calculation, but I think that it\u2019s a safe assumption. I think it's a\nsafe bet that a good company will trade at a 15 P/E sometime in the next 3 to 5\nyears.

 

\u201CUnderstanding\u201D Risk Affects the Price to Buy

Finally, in\ncalculating the price you would like to pay, you should pay attention to\nanother risk. That's \"understanding\" risk. How confident are you in your\njudgment? Against more uncertainty, you\u2019ll need more margin of safety.

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

 

Same Approach to Emerging Market

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

The fair unlevered P/E\nmay be different from that in developed markets. That\u2019s because of inflation.\nEmerging markets tend to have higher inflation than mature economies. That\nmeans investors may want a higher nominal return.

For example, investors\nmay want a 15% nominal return in Vietnam. For a bad company without pricing\npower, a fair P/E would be 6.5. If it has a low return on capital and is\ngrowing company, it\u2019s worth less than a 6.5 P/E. A good service company with\npricing power may deserve a 15 P/E. Because it can give investors a 6.7% real\nreturn. If it has good long-term growth prospect, it may deserve even higher\nP/E.

So, I think the fair\nunlevered P/E in emerging market varies with company\u2019s quality more wildly in\nemerging markets than in developed market. But the market may have the tendency\nto give companies similar valuations. For this reason, there can be more value\ntraps in emerging market. And there can be more great long-term investments at\ngood prices.

Talk\nto Quan about the Right Multiple to Pay for a Stock

","wysiwyg":{"source":""}}" data-block-type="2" id="block-c451b0927c4fb42b97e5">

Someone who reads the blog sent me this :

Dear Quan, 
I recently came across your blog and find it simple and quite informative. I have noticed myself drawn to speaking to other like-minded investors as their experiences and insights are very valuable in developing my own knowledge and skill set rather than just reading a lot of books on the subject. 
One of the topics that has been on my mind for quite some time is the required rate of return adequate to compensate investors for being equity holders in a business. I have moved away from the mainstream CAPM and WACC models for pricing the cost of equity but find little alternatives. 
From what I understand [Greenwald's class] is that Warren Buffet generally uses 15% for his discount rate, although I am not quite sure how he came up with that number. Also, from some of the class notes from Greenblatt, he mentions using the 10yr bond rate with a 6% floor and compare that to the EBIT/EV of a company. 
So my question is how do you determine what is an adequate rate of return? And how do you apply/adopt that to emerging market companies [as most info relates to US stocks]?
Thank you in advance for taking the time to respond. 
Regards,
Mohammed

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

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

 

Two Risks to Consider

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

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

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

 

Some Good Companies Deserve Higher Valuation

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

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

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

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

 

Intrinsic Value and the Price We Pay Are Different

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

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

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

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

 

“Understanding” Risk Affects the Price to Buy

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

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

 

Same Approach to Emerging Market

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

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

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

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


Two Posts Worth Reading

by Geoff Gannon


Here are two posts worth reading.

One is about the outperformance of \"glamor\" over \"value\" stocks these last few years. I've felt this. On a relative basis, the last couple years have been the hardest time ever for me to pick stocks. 

Value Badly Lagging Glamour

The other post is about Sanborn Map. It's a classic Buffett investment. And the post does a good job of breaking down the logical arguments that were probably running through Buffett's head.  

Some Thoughts on Sanborn Maps

 

","wysiwyg":{"source":""}}" data-block-type="2" id="block-5cff2849653c0abdeced">

Here are two posts worth reading.

One is about the outperformance of "glamor" over "value" stocks these last few years. I've felt this. On a relative basis, the last couple years have been the hardest time ever for me to pick stocks. 

Value Badly Lagging Glamour

The other post is about Sanborn Map. It's a classic Buffett investment. And the post does a good job of breaking down the logical arguments that were probably running through Buffett's head.  

Some Thoughts on Sanborn Maps

 


Armanino Foods of Distinction (AMNF)

by Geoff Gannon


\u200BA few people have emailed me asking for my thoughts about Armanino Foods of Distinction (AMNF). I don't have any right now. But Whopper Investments does:
I think Armanino is undervalued at today\u2019s prices. It\u2019s growing pretty fast and creating tons of value from that growth, so that value gap should (hopefully) grow over time. And, as an added kicker, there\u2019s the potential for a merger at a huge premium, which would be easily supported by the synergy potential, and/or a big special dividend to lever the company up.\u200B

I lied. I do have one thought. At one point, Whopper says:

\u200BI tend to think that their frozen products fall more into the \u201Ccommodity\u201D segment than the \u201Cbranded\u201D segment, but their returns on capital actually suggest other wise. Pre-tax returns on capital are well over 50% and gross margins are in the 35% range. Those tend returns tend to indicate some form of brand strength or competitive advantage.

That's true. However, it is imperative that when you find empirical evidence of a competitive advantage you back it up with a rational explanation for that competitive advantage.

You always want to combine abstract reason with concrete evidence to prove something's practical existence. \u200B

If you fail to do this, you will end up taking the magic formula approach. Many companies earn excess returns. Some have durable moats. Others do not. It may work out on average to simply assume moats based on high returns on capital. \u200BIn fact, the historical data Greenblatt used says that the approach did work in the past.

But you must never beg the question. You must never argue that this company has a moat because only a company with a moat could earn the returns this company is now earning.

Instead we must look for both a rational theory and empirical data that are reasonable when considered separately and agree when put together. \u200B

\u200BArticles

Is Quality as Good as Growth?\u200B

Where Does a Stock's Future Return Come From?

Should Buy and Hold Investors Worry about EV/EBITDA?\u200B

How Today's Debt Lowers Tomorrow's Returns

Why I'm Pessimistic about Stocks

\u200B

Talk to Geoff

","wysiwyg":{"source":""}}" data-block-type="2" id="block-806fcaa3ae544e98e6b4">

A few people have emailed me asking for my thoughts about Armanino Foods of Distinction (AMNF). I don't have any right now. But Whopper Investments does:

I think Armanino is undervalued at today’s prices. It’s growing pretty fast and creating tons of value from that growth, so that value gap should (hopefully) grow over time. And, as an added kicker, there’s the potential for a merger at a huge premium, which would be easily supported by the synergy potential, and/or a big special dividend to lever the company up.

I lied. I do have one thought. At one point, Whopper says:

I tend to think that their frozen products fall more into the “commodity” segment than the “branded” segment, but their returns on capital actually suggest other wise. Pre-tax returns on capital are well over 50% and gross margins are in the 35% range. Those tend returns tend to indicate some form of brand strength or competitive advantage.

That's true. However, it is imperative that when you find empirical evidence of a competitive advantage you back it up with a rational explanation for that competitive advantage.

You always want to combine abstract reason with concrete evidence to prove something's practical existence.

If you fail to do this, you will end up taking the magic formula approach. Many companies earn excess returns. Some have durable moats. Others do not. It may work out on average to simply assume moats based on high returns on capital. In fact, the historical data Greenblatt used says that the approach did work in the past.

But you must never beg the question. You must never argue that this company has a moat because only a company with a moat could earn the returns this company is now earning.

Instead we must look for both a rational theory and empirical data that are reasonable when considered separately and agree when put together.

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