The Investment Zoo: Chapter 1: A life Fully Vested

The author, Stephen Jarislowsky, explains who he is and why people might be interested in reading a book authored by him. He wrote this first book at the age of 79 after 50 years of investing experience. He explains some key family traits of a “horror of waste” and a desire to be involved in and control all expenditures.

The author explains some of his childhood, living in the Netherlands, France and the USA. He took an early interest in collecting art books which is explained to be a lifelong passion. He was well travelled, well trained in the classics and proficient in several languages before starting University.

At the age of 16, Stephen enrolled in mechanical engineering at Cornell University in Ithaca, New York. He graduated from Cornell at 19 years of age and applied to the Harvard Business School at 22 years old. The author explains a desire to study issues systematically and in depth and was somewhat disappointed with the case study discussions at business school. The author graduated from Harvard with an MBA (distinction in Finance) in 1949.

As part of the US Counter Intelligence Corps, the author explains his new found interest and intrigue in learning about the East Asian cultures. The experience of studying Oriental culture led Stephen to devoting his life to being an example to others. He explains how he learned about the importance of “precedent” from the Japanese culture and the importance of “leadership” from the Western culture and his idea to bring these two concepts together in the way he lives his life.

Stephen explains a definite difficulty in spending money and still lives in the same house for the past 32 years (sounds a lot like Warren Buffett to me).

After a brief stint as a young rising executive he explained how he grew tiresome of company politics and decided to try starting various enterprises with friends. Eventually he started a statistical service that delivered data on various companies and sold it to brokers and investment dealers. This was the genesis of Jarislowsky-Fraser. Even with 200 subscriptions sold he and his partner saw the need to develop something else in order to make enough money. From their investing industry relationships and their skills in research, the author explains the natural transition to managing pension funds.

The author explains that it took almost 10 years to start earning a decent income. He explains that it is a very slow process if you start from nothing, no clients, no experience and the need to build this up. He and his partner just picked a direction that they believed in and kept moving in that direction. They were never in a hurry, they just kept building piece upon piece in their business. He explains how they have founded their business upon conservative time-proven investing principles and that now their business is one of the five largest private fund management companies in Canada.

Stephen speaks about how their mission and Jarislowsky-Fraser has never been only about business. They have been very strong proponents of good Canadian corporate governance and have fought numerously for what is right for investors, not for self-serving interests. Stephen discusses how over 40 as the chief research analyst in his company how he has covered pretty much every industry and knows a lot about judging a business and appraising the management team. He is a believer in not using exclusively quantitative models but rather to do a thorough analysis of all aspects of a company’s business.

Stephen expresses displeasure in how many clients get taken advantage of in the investment industry for example through high fees. He seems to express some pride in having the lowest fees in the industry purportedly done in the best interests of his clients. He shows disdain for organizations and people that rip off clients and works hard to expose these actions. He dislikes the greed factor present in the investment industry.

He explains how his work has been like his hobby since he loves it so much and asks the question what he should do in retirement since most people look to their hobbies and he is already doing that.

On to the remaining chapters!

Harley-Davidson Reducing Dealer Inventories

In recent years, many analysts have accused Harley of "channel-stuffing". Basically, Harley records revenue (and thus earnings) when a dealer receives a bike. But if Harley ships more bikes to a dealer than the dealer sells to its customers, then the problem is that Harley's earnings are artificially high (because they've "stuffed" the dealer with extra bikes), and sooner or later they'll have to cut shipments to reduce dealer inventory.

Let's take a look at shipments versus retail sales for the last few years to see if this is occurring (numbers in thousands):


(Note that it's difficult to get accurate worldwide retail sales for Buell, so both of these numbers include strictly Harley-Davidson bikes.)

According to the table, since 2004 Harley has tacked onto dealers 28,000+ more bikes than dealers have sold. However, the number of dealerships within the US as well as around the world has continued to grow...so is it possible that these new dealerships have absorbed these bikes as part of their showrooms?

Based on data within the annual reports, I estimate Harley has increased its number of dealerships by about 42 since the end of 2003. Spreading those 28,000 bikes across the 42 new dealerships gives us about 679 bikes per new dealership. Considering analyst Craig Kennison at Robert W. Baird estimates US dealers carry about 50 bikes each (source: 2008 Q2 Conference Call), 679 is a bit excessive, suggesting earnings since 2004 for HOG have been higher than what is sustainable.

But in the first half of 2008, it appears Harley has already more than reversed this trend. First half retail sales are almost 34,000 more than shipments, bringing shipments over retail sales to a negative 5,000 since 2004. That means on average each dealer is carrying 3 bikes less than it was in 2004.

Could this be good news for HOG going forward? Well the US economy is still behaving badly, bringing down Harley's worldwide retail sales in the quarter by 3.6% year over year, so challenges still remain. But at least the overhang of a shipment reduction due to channel-stuffing is behind us.

Disclosure: Author has a long position on HOG

Security Analysis: Chapters 16 and 17

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

In these two chapters, the authors discuss various other types of fixed-income investments (apart from straight bonds and preferred stocks).

Income bonds sit somewhere between straight bonds and preferreds. They have a definite maturity at which point the principal must be paid back. (In this regard, they are similar to bonds.) However, interest payments are discretionary. They're supposed to be paid as long income is sufficient, but in actuality, companies can set aside money for capital expenditures or other items before having to make these payments.

Despite the seniority income bonds enjoy over preferred stocks, their track records have been awful in comparison to both bonds and preferred stocks. The authors theorize that this is because this form of investment is only used when companies are in dire straights. The very fact that interest payments need to be based on income suggests the income itself is in doubt.

The authors also discuss the benefits and drawbacks of guaranteed issues. These issues are backed by at least one other company. Graham and Dodd remind investors that guarantees are only as good as the viability of the guarantor. Investors are also cautioned to be wary of the type of guarantee: often, a guarantee will cover only interest payments, not principals.

Joint guarantees are fully backed by several individual companies. This rare occurrence is quite a valuable form of guarantee, as it can happen that one company is unable to follow-through on its guarantee, but unlikely that several cannot at one point in time.

A popular type of guaranteed security is common in the real-estate mortgage market. A bank will sell investors a mortgage, and will guarantee payments on that mortgage. Unfortunately, for this type of self-guarantee to be worth anything, the following principles must be kept:

1) Loans must be conservatively financed
2) The guarantee must come from a company well-diversified

If loans are not conservative, then declines in real-estate values will result in deterioration in loan values. If the guarantor is not diversified, a general decline in real-estate values will serve to place the guarantor in receivership, which makes for a most dubious guarantee.

As simple as these principles are, in practice problems have arisen. In the roaring 20s, new and aggressive firms provided loans at levels so as to leave very little equity in the mortgaged property, despite the fact that appraisals were made at dubiously high levels. In order to compete with these firms, reputable ones would be forced to lower their standards. The industry spiraled out of control, and guarantees turned out to be useless in the ensuing carnage as firms were forced into receivership.

Finally, the authors discuss required lease payments. Two companies may appear to have similar financial statements, but if one has large leases that may not be canceled, it sits in a precarious position. When rental rates drop, or when business declines, such a company is in the unenviable position of wanting to shrink but being unable to.

It's All in the Notes: The Importance of Reading Notes to Financial Statements

Wilmington Capital Management (TSE: wcm.a) is a company that acquires and leases property to generate cash flow. This company made my value screen so I decided to analyze their historical financial statements in order to determine an approximate intrinsic value as of early 2007. I give credit to the management team at Wilmington for putting together easy to read annual financial statements. However, these annual financial statements act as a sobering reminder of why financial notes are an absolute must read for proper evaluation of public companies.

From the consolidated statement of earnings, there is a reference to the item "Income tax recovery" (note 8) for the amount of $11.23M. This is more than 10 times the net income before income taxes value! Investors in Wilmington counting on the net income per share value of $2.06 as likely in the future may be unpleasantly surprised.

We notice that the line item in question is recorded as operating earnings which is normal considering it is a tax related item. However, to value a company based on its free cash flows, we will want to use sustainable values that have a high probability of being repeatable into the future. If one works out free cash flows starting from the net income figure for Wilmington 2006, it will have included the massive income tax recovery value in the valuation. Is this income tax recovery item sustainable? Not likely but lets look at the financial notes to see what is going on here.

In note 8 to financial statements the corresponding disclosure is that this income tax recovery income item is actually in recognition of previously unrecognized tax assets. Great, how much more of those do they have? If there are substantially more tax assets available, we could account for these as reductions on future tax when we calculate future cash flows. Looking through all the fine print in note 8 we find that all tax assets are fully accounted for now on the books. There is a $0.2M future income tax asset on the balance sheet included under "Other assets" and that is it. No more delightfully huge "previously unrecognized tax items" ready to pop up and magically grow net income by a factor of 10.

Think of the Wilmington 2006 net income figure to remember that financial statements notes are a must read to understand the quality of existing earnings.

Diageo: Spirits Anyone?

Diageo PLC (public limited company in the UK) is an international producer of premium alcohol based brands, including Smirnoff vodka, Johnnie Walker Scotch whiskies, Captain Morgan rum, Baileys Original Irish Cream liqueur, JeB scotch whisky, Tanqueray gin and Guinness stout. Yikes, after mentioning all those great brands I am starting to notice a definite thirst coming on.

I believe that premium alcohol beverage producers are fantastic businesses to own (on the cheap of course). Firstly, premium spirits are associated with strong brand loyalty amongst consumers. Secondly, the premium global spirits industry is quite concentrated (the word "oligopoly" comes to mind). Probably my favorite reason for liking the premium spirit business is that operating margins are generous and demand for the products do not appear to be highly cyclical with economic conditions. The logic of "why not drink more when times are bad" has a certain appeal.

Diageo has been focusing on the premium alcohol beverage business and improving their margins. They are achieving sales growth both organically and via acquisitions. Their operational efforts have been contributing towards an increasing operating margin over the past several years. Their average operating margin over the past 4 years is around 26%. I believe these operating margins are sustainable going forward based on their excellent brands, global operations, customer loyalty and management's operational focus (they have been exiting lower margin fast food businesses).

Diageo has also been buying back its own shares in the company. So if you believe in the "signalling theory" of share buybacks, it is instructive to observe that 141M shares were purchased in 2006-2007 for an average price (including fees) of approximately 996 pence per share. Converting to US dollars and adjusting for the 4:1 ratio between LSE shares and the ADR shares (NYSE: DEO), this would make the share re-purchase price today somewhere in the neighborhood of $79.50 per share. Currently shares are trading for $73.40 on the NYSE. This is a potential indication that the stock is trading cheap to its intrinsic value.

If Diageo repeats the share repurchase of 141M shares, that would represent just over 5% of the total shares outstanding. In addition, Diageo has been increasing their dividend payments over (at least) the last 10 years and is currently yielding a 3.6% dividend payout. If you could buy Diageo stock with a margin of safety on their intrinsic business value and see the share float decrease by 5% and receive a 3.6% dividend, that's not bad!

In my next post I will present my calculation of the intrinsic value of Diageo's earning power to determine if this stock is currently priced attractively in the public markets.

Disclosure: The author has no shares in this company

Should You Bet on William Hill?

William Hill Plc is one of the largest gaming companies in the UK. Its wide-ranging gambling activities include sports betting and casino games, which can be accessed through the phone, on their website, or at what they call Licensed Betting Offices (LBOs), which are retail locations scattered throughout the UK.

Recently, the stock has gotten pummeled, from a high of £6.76 last last year to its current price of £3.05. So what happened? They had a few operational issues in 2007 which appear to have shaken investors. Their internet site is getting pummeled by the competition, and while they spent millions trying to improve it, they ended up giving up on that project and taking a write-down on it, after spending exorbitant consultant fees for a little advice. As a result of these issues and more, management offices have had a bit of a revolving door lately.

Nevertheless, this company has valuable licenses and a strong retail presence within a highly protected/regulated industry. It might be worthwhile to see whether there is value to be found here as a result of a depressed stock price due to a doom and gloom outlook from investors.

Yes their internet site is getting beaten up, but this company's strongest business line is its retail operations. More than 80% of both its revenue and its profits come from its 2,294 LBO locations, and in 2008 this operation should continue to be strong, as the company benefits from regulations allowing for longer operating hours.

The company has been buying back shares, pays a dividend yield of 5%, and has a P/E of less than 7. Seems like a clear buy, doesn't it? Unfortunately, there are a couple of risks that make this investor unwilling to place a wager on this company.

In 2007, the UK unveiled a new Gambling Commission, and as such has clarified the rules concerning the granting of new licenses. In fact, if you want a UK gaming license, just apply here! William Hill has enjoyed decent returns on capital in the last few years, but as new entrants apply for and receive new licenses (so that they too can achieve these returns), their returns should be driven to more normal levels. Considering the stock still trades at at more than 4 times book value, there's still a ways to fall if competition gets intense.

Another worry is the company's debt level. With debt representing 85% of invested capital, there isn't a lot of leeway to allow for a downturn in this company, either due to competition or a downturn in the economy. Many people believe that this industry is immune from economic cycles, but they are sorely mistaken according to Dr. Bill Conerly, whose research in his book, Businomics, suggests that gambling is a cyclical industry. (An article he wrote on the subject is here for those who are interested.)

The stock looks cheap, but the risks are too high. This one's a no buy.

Security Analysis: Chapters 14 and 15

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

Still on the subject of fixed-income investing (for a description of the various groupings of investment types, see Chapter 5), Graham and Dodd add some special notes for investors when it comes to preferred stocks.

In most cases, preferred stocks (at par) enjoy the privileges of the worst of both worlds. They carry no upside (like bonds), yet offer no guarantee of payment (like stocks). As such, by their very setup, they are an unattractive form of investment.

Studies carried out by the authors demonstrate that pref shares have fallen from economic peaks to troughs far more than have bonds, despite the fact that both are ordinarly "fixed-income" type investments.

Nevertheless, in the finance industry, preferreds are considered close in form to bonds. If a company does well, preferred dividends are paid easily, and if a company does poorly, the bonds don't get paid either, and as the authors have discussed, liens are worth little. However, this argument fails to take into consideration the middle-ground: companies that are neither great nor poor. In practice, pref dividends are often withheld merely when payment is inconvenient as opposed to impossible. This results in wild fluctuates in market values of pref stocks, and as such does not make sense for an investor looking for stable fixed-income investment.

Therefore, before making fixed-income investments in preferred shares, the authors require that the prefs not only meet all the requirements of a safe bond (as discussed in Chapters 8 to 11), but have a larger margin of safety such that dividends will likely always be paid, and that the company's stability be of utmost importance, since during bad years if earnings turn downward or negative, the pref dividends will take a hit.

The authors' analysis of public markets demonstrates that only 5% of preferred shares actually meet these requirements. In such cases, the companies would be better off issuing bonds in order to obtain tax benefits and a lower cost of capital. History shows, however, that these safe preferreds are left over from a time when the companies were not as strong as they are today, and so they were not in a position to issue bonds.

In most cases, therefore, preferreds are an unattractive form of investment, as they lack the upside of common shares, and lack the stability of bonds. The fixed-income investor must search for the exceptions: where the stability and coverage of earnings is so high that prefs behave as though they are bonds.

A list of the remaining chapters