The Investment Zoo Chapter 8: A Tale of Three Stocks

In this chapter Jarislowsky lays out his rationale for sticking with premium non-cyclical companies that can reliably grow earnings at around 15% per year. The major reasons include 1) not having to worry about timing market cycles, 2) letting the magic of compounding do its work with your investments and 3) being able to trade far less and delay paying capital taxes.

Jarislowsky does not think capital gain tax is fair because there is no allowance for inflation. The full nominal gain of the investment is taxed even though a big portion is really (as he puts it) an "inflationary mirage". For that reason, he prefers to hold on to investments without selling so that he can maximize the amount invested and collect the dividends on the full investment. If you sell a $100 investment and pay $20 due to taxes, and then reinvest the money, you will only be able to collect dividends on $80 now compared to the $100 before taxes. So paying taxes shrinks your investment funds. This is one of the major reasons he prefers a buy and hold strategy.

He only occasionally invests in cyclical companies. If he does, it will be at or close to market bottoms where he can buy at very cheap prices. The problem with investing in cyclical companies is that they will not appreciate over the long term as well as premium, non-cyclical, 15% earnings growth companies. Therefore, he doesn't think its prudent to adopt a buy and hold strategy with cyclical companies. Rather, he advocates selling a cyclical investment well before the next cycle top so as not to miss the cycle and have to hold onto the stock while it loses money and perhaps cuts dividends. To minimize the capital gain tax on cyclical investments, Jarislowsky recommends using a tax sheltered RRSP account.

With premium non-cyclical high compound growth stocks, Jarislowsky explains that it is not necessary to get out at market tops. Even if your 15%-20% reliable growth stock is overvalued by the same amount, it will make up this ground in the next year. He would rather wait one year then sell and have to pay tax and trading costs just to trim down the investment. Of course, his strategy hinges on finding those premium stocks.

Jarislowsky gives the example of three stocks that he has held for close to 50 years in his portfolio. These three stocks are Reynolds Metals, United Airlines and Abbott Laboratories. He bought Reynolds and United Airlines when they looked like fantastic bets with good growth potential and expanding markets. However, the best investment by far was the rather boring but reliable growth and non-cyclical company Abbott Laboratories. The power of compounding at reliable rates has turned his $2,000 in Abbot to over $1 million, not including dividends. The dividends rose almost every year in the 50 year period.

Reynolds was merged with rival Alcoa and his initial $2,000 was worth $15,000 after the merger. With United, an initial $2,000 would be worth around $47,000 after the acquisition but Jarislowsky had to pay huge capital gains and was left with a substandard annualized return after 35 years invested in the stock.

He advises to be like Warren Buffet who invests in premium, non cyclical reliable growth companies but also admits investing mistakes and takes corrective action. Do not respond to temporary setbacks but if a stock fails to live up to your expectations and reasons for owning it, then admit your mistake and sell.

It's All In The Notes: Leases

Consider two companies operating in the same industry. You've looked up the financial statements of each, and found they both have $1000 in assets and $100 in net income. So each has a return on assets of 10% right? Unfortunately, we don't have the whole story.

You see GAAP does not require that companies place operating leases on their balance sheets, even if they may not be canceled! In effect, an operating lease represents an off-balance sheet asset, since the company is free to use whatever they are leasing to increase profits. At the same time, operating leases represent an off-balance sheet liability, as rather than purchase the asset outright, the company has basically financed it by committing to make payments over a number of years.

In our example, Company A has no operating leases, but Company B has operating leases present valued at $4000. In other words, Company B's return on assets is only 2%, and its debt to equity jumped big-time! But you'd never know it unless you read the notes to the financial statements. (For other gems you can find in the notes, see this page.)

This example was far from an exaggeration by the way. I recently looked at a nursing care provider called Advocat. You wouldn't expect this to be a cyclical company, therefore as we discussed here it can safely carry a higher debt burden. The balance sheet listed debt to invested capital at 70%, but after including operating leases, this number jumped to 96%! Far too high a number for a conservative value investor...

Security Analysis: Chapters 31 to 36

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

We are now into Part V, which takes the reader into an analysis of the income account. The earnings of a company has become the most important element (in some cases the only element) used by speculators in evaluating a stock. The speculator is thus relying on this single and less dependable criterion of a company's value when he completely ignores the balance sheet.

The authors demonstrate how the financial industry has taken a single figure such as earnings per share, and applied arbitrary multiples to it in order to estimate the supposed market value of the stock. But earnings are subject to fluctuation, and are far too easy to manipulate, as demonstrated by several examples.

As such, the securities analyst must be willing to dig deep into the company in question's income statement. Non-recurrent items should be discarded (since it is the earnings power of the company that the analyst is interested in), but determining what is non-recurring and what is a part of doing business must be considered. Graham and Dodd note the challenges of valuing the earnings power of insurance companies, investment trusts, and banks, as these companies invest a substantial portion of their capital in the markets and thus annual income can fluctuate drastically. The ordinary investor is warned to leave such analysis to experts.

Investors must also be aware of improper use of accounting procedures. Rather than reverse the income statement improprieties line by line, investors are cautioned to avoid such companies altogether. The analyst may be able to determine a more "correct" earnings, however, by the time such information comes to bear for the company in question, the information may be out of date. The authors demonstrate several cases of accounting manipulation and demonstrate how the astute analyst would have known about these in advance.

Finally, the authors have a lengthy discussion about depreciation. They offer ways for the investor to determine whether a company has an overly conservative or too aggressive depreciation policy, and methods for the investor to correct for policies that distort the true earnings power of a company.

Danier Leather: A Few Things to Consider

Danier Leather makes leather apparel goods and has been in business for 35 years. After doing some analysis on the company there are a few things that I dislike about the way the company has been managed.

Firstly, both top line and bottom line earnings growth are not moving in the right direction. Since 2003, the total revenues have declined from $175.5M to $158.1M. During the same period, the gross margin has flat lined between 49.4% and 49.7%. Its a bit worrisome that SG&A has increased during this period from 44% to 48% while the number of stores and total retail space has declined slightly. Also, the operating margins have contracted from 9.3% to 2.2% during this same period. From these results we can see the picture that management has not been successful steering the company to improved profits.

Another aspect that I find disturbing about Danier Leather public shares is the dual voting structure present in the subordinate voting and multiple voting common shares. The president and CEO of the company has only paid a nominal amount in contributed capital for 100% of the multiple voting shares (1.244M) giving him effectively 70.4% control of the company. Thankfully, there is a coattail provision that offers some protection to the common shareholders in the event of an acquisition event.

The whole area of effective corporate governance appears a bit suspect at Danier Leather. There are 6 board members, 5 of which have served on the board since 1998 or earlier! Most of the board members have served continuously on this board. Having rotation of board members is generally seen as a positive for corporate governance. Also, introducing a board director acting on behalf of a large outside investor would be good for corporate governance as summarized from Stephen Jarislowsky's book "The Investment Zoo" here. Unfortunately there is no such "outside" board director present on Danier's board.

Lastly, there is an ongoing class action suit against Danier Leather regarding its IPO event where it is alleged that certain information was known but not adequately disclosed by some board members prior to the IPO. I am not a lawyer and do not have an opinion if this class action suit is justified in any way, but the fact that the class action suit came up at all creates some additional doubt in my mind as to effectiveness of corporate governance at Danier Leather.


Disclosure: The author has no ownership of Danier Leather stock

It's Cyclical...So What?

How cyclical a business is plays a large role in determining how much of its capital should comprise equity and how much should comprise debt.

To illustrate, compare two businesses in different industries. Each have average earnings of $5/share, but for Company A, earnings fluctuate drastically from year to year, while for Company B, earnings are $5/share year in year out. As a result, Company B can afford to take on more debt: since its earnings are stable, it can safely afford to make its interest payments without much doubt. On the other hand, Company A should be capitalized with mostly equity, since it can't be counted on to make its payments when times are bad, and therefore risks defaulting.

The airline industry is a good example of a cyclical industry. When the economy slows, business and personal travel drops. Further exacerbating the airlines' plight is the fact that many of their costs are fixed (e.g. costs of running, leasing and maintaining airplanes), so when revenues drop, profits take a bit hit and often go negative. On the other hand, utilities are relatively stable, as during recessions, you still use the same amount of electricity in your home.

But what about all the industries in between? Sometimes, it's not so easy to determine how cyclical an industry is, which makes it difficult to know if one of your investments has more debt than it should (which risks your investment!).

Bill Conerly, Ph.D, tries to tackle this problem in his book, Businomics. I haven't read it yet, but Bill assures me he discusses the degree of cyclicality of various industries within it. He also showed me a couple of spreadsheets where he's amassed peak to trough sales data for many sub-industries.

Some of these on the spreadsheet (linked above) are intuitive. For example, pleasure boats and pleasure aircraft rank as among the most cyclical, while electricity usage is near the bottom. But some are more difficult to understand. For example, soap and eggs are near the top of the list, while hotels are near the bottom; I would expect these items to be reversed! I asked Bill about some of these peculiarities but I haven't heard back from him in three weeks...Perhaps he's waiting for me to find the answers in his book, which I hope to do soon!

The Investment Zoo Chapter 7: Investing in the Jungle

Jarislowsky advises young people (in their 20's if possible) to get as early a start as possible with sound investing because of the power of compound growth. Jarislowsky advocates linking an investment action plan with stock investments that will yield a predictable rate of compound growth. He explains what to look for later in this chapter (explained below).

He believes that no one can reliably predict what the market will do, because of the inherent complexities in the market. He is not a believer in market timing but he does believe in comparing historical average P/E ratios and dividend yields to the current rates in order to determine if the market is cheap. He suggests that one way to outperform the market is to buy index market funds when the P/E rates are below the 14 to 15 times average and reduce these funds when the P/E rates are above average say at 24 to 26 times earnings. He believes fine tuning this approach with excellent quality non-cyclical individual stocks will improve the results further. He doesn't believe in excessive diversification but advises to have 4-5 major groups and a few specialty groups in your portfolio.

He explains that high interest rates make for low priced stocks. He concludes that the 1970's and 1980 and 1981 were great times to buy stocks for this reason. He uses inflation, P/E market ratios and dividend yields as signposts for whether the market is cheap or not. He believes that stocks are better investments long term than real estate, bonds and gold based on the analysis he has done.

Jarislowsky's rule is to invest in only top-quality, mostly non-cyclical growth stocks that have a predictable rate of earnings and dividend growth. He equates the stock market to a zoo, with lots of variety, but as an investor he suggests you only need to find a few of the "best species" and build a diversified portfolio. This will provide a sustainable, low risk portfolio with high compound growth.

He comments that very mature industries will bring below average returns. He feels that raw materials and commodity prices have not kept up with inflation and don't make good long term investments. He advises to eliminate holdings that are in fashion and to avoid companies with excessive debt.

He advocates focusing on non-cyclical companies. If you do this, he suggests you only need to look at around 50 of the 1000's of stocks that are available worldwide. He wants to buy companies that can reliably obtain 14% to 16% long term growth with top and bottom line earnings. He avoids cyclical stocks because its too hard to judge when to sell at the top of the cycle before prices come crashing down again and when to buy at the bottom of the cycle. He is also concerned that many of the cyclical stocks won't survive the market down turns. He avoids junior stocks since their margins can easily be ruined by a new market entrant.

He likes the companies he invests in to pay a dividend. As Jarislowsky puts it "everyone gets paid in a company, why not the shareholders who take all the risk?" He thinks dividends should rise as fast or faster as the CEO's salary for this reason. He wants to see top line and bottom line earnings growth since that indicates a well managed company.

Jarislowsky advises to make others happy by selling them your stocks they want so badly at the top of the market and to be helpful by buying the stocks that others can't stand seeing anymore at the bottom of the market.

Starbucks Looks Cheap - Part I

Occasionally, we have guest authors contribute to this blog. The following post was written by Amit Sahasrabudhe, B.A.Sc, MBA. Amit is a Management Consultant at Deloitte.

Starbucks (Nasdaq: SBUX) is probably not the first company that comes to mind when thinking of a value play. As discussed here, small-caps usually offer the best opportunities when it comes to finding stocks trading at discounts to their intrinsic values. With a market cap north of $11B and a large analyst following, one could argue that for Starbucks there is little room for market inefficiency. However, the recent challenges facing Starbucks in today’s weakened economy have likely caused its share price to be unjustifiably over-punished by the markets.

Starbucks has shown an average annual growth in revenues and operating income of 23% and 26%, respectively, since 2003. Meanwhile, over the past year, its stock price has been beaten down from $40 to $15. This relentless fall is usually attributed to its recent challenges: rising food costs, over-saturation of US markets, and new competitors such as McDonald’s and Dunkin’ Donuts entering the premium coffee market.

The harmful effects inflation has on companies is discussed here. For Starbucks, rising prices of milk and other commodities is an issue, but an issue for competitors as well. In a free market, I would expect supply to increase as a result of higher prices, and therefore these high input costs would subside in the long-term eliminating this issue altogether. In the case that high costs sustain for an extended period of time, Starbucks will be forced to find ways to make their menus more cost-effective.

Over-saturation of the US market can be seen with the recent announced closing of up to 600 domestic stores (due to cannibalization of existing store sales). While this news has not had a positive effect on Starbucks’ share price, it is good to see this rationalization taking place sooner than later. With Howard Schultz back in the driver’s seat, he is quickly identifying recently-opened stores that are not making sufficient returns on its invested capital, and therefore not creating long-term shareholder value. Instead, he is redirecting investments towards Starbucks’ growth potential abroad, since only 30% of its current store portfolio is international. Meanwhile, Schultz’s domestic focus will be to increase same-store sales through bringing back the customer experience that has been lost in recent years.

As for the competition, McDonald’s seems to be the current major threat to Starbucks. There is plenty of debate on which coffee tastes better between the two. At the end of the day, I don’t think it matters. What matters is which company has the stronger brand that draws more people to it. McDonald’s will always have customers eating their burgers and breakfast meals. I doubt many people will want to go to McDonald’s solely to have a latte while studying, reading a book, on a date, or on the way to work. At best, better coffee will make McDonald’s a better place to have breakfast. I just don’t see McDonald’s and Starbucks playing in the same ballgame when it comes to the demographic of customers it attracts.

As a result, I see all these challenges being overcome in the long-run, but instead have caused investors to overreact in the short-term. The fears of recession, credit crisis and therefore a weakened consumer have further depressed the stock price.

Starbucks has admittedly grown too fast recently, and is now taking one step back to grow two steps forward in the right direction. Today, Starbucks has some of the most prime locations in the US. It has a strong CEO that has returned to the helm. And finally, it has a superior brand that has become synonymous with coffee. In my recent trip to HK and Tokyo, I saw stores packed with people drinking Starbucks coffee in blistering hot weather; this is the power of branding.

Starbucks’ recent challenges, in conjunction with today’s economy, have resulted in a share price that is definitely near bargain territory, if not already there. The traditional measures of P/E and Market/Book may not meet the criteria of a disciplined value investor as discussed in Graham and Dodd's Security Analysis. However, given its strong earnings power (to be discussed in Part II), Starbucks may be a worthwhile value play.

Disclosure: Author has a long position in SBUX