Tuesday, June 4, 2013

Beach Bum Pt. 2: The Four Pillars of Permanence

Straight from the Nagger's Beak

As a manager, I am constantly reminding my associates to ask questions. Most of us grow up with the idea that there is "no such thing as a stupid question", which was likely planted into our brains "inception-style" by teachers around the globe. While I think this notion is a powerful catalyst for emboldening timid participants, to say that stupid questions don't exist is like saying that fat-free ice cream is healthy or that watching Mythbusters is educational. It makes you feel better, but simply isn't true. There are two types of stupid questions: questions that there are no real answers to (how much wood would a woodchuck chuck..?), and questions you already know the answer to. One of the most frequently asked questions I hear (and ask) falls into the latter category: "Is this permanent?"

The most common answer to this question - "everything is permanent until it changes" - almost directly aligns with my investment strategy (and ironically my dating strategy - though that one worked itself out). So how do you identify permanence in an investment? How do you get to know a company in the up-close and personal way that we got to know Neal and Phyllis?

The Four Pillars of Permanence

Every investor that is looking to beat the market is typically looking for two things: growth potential and permanence. Determining growth potential requires extensive research into the industry or market as well as the companies' R&D (research and development) plans. Even with the research, putting money into a security entirely focused on growth potential is somewhat of a gamble. So instead, focusing on permanence over growth can be a far better long-term strategy. There are four major areas that I look to determine if an investment will last the long-haul - the four pillars of permanence:
  1. Pillar #1 - Economies of Scale: Does the company have depth and diversity? Some of the key factors to look for here are large caps, age, and free cash. If you are thinking, "that sounds like my grandparents", you're probably on the right track. A large, tenured company with substantial cash on hand is a good sign of permanence. A couple other things to look at are a.) how many industries the company is exposed to and b.) a current ratio of >2. This shows the diversity of the company and its ability to pay off short-term debt. Think Microsoft 
  2. Pillar #2 - Dividends: Companies that pay dividends do it for one of two reasons: either they can afford to pay dividends or they are forced to pay dividends. Those that fall under the latter category (such as mREITs, for tax purposes) are not always bad investments, but are certainly more subject to volatility than companies that choose to pay investors. A stable dividend and a history of dividend growth can personify a safe investment - just make sure the earnings have been growing with the dividend! There is a great article that bolsters these first two pillars here.
  3. Pillar #3 - Inelastic Goods: Companies that do not depend on certain social or economic conditions are often the most stable investments. Utilities companies are far less exposed to the woes of the economy, as they provide a service that most people will choose not to cut out of their budget. Southern company, one of the nation's largest utilities, only lost about 30% of its value in the market crash of 2008-2009 and has since bounced back nearly 100%. This is compared to losses of 60-75% across consumer and commodity shares like Honda Motor Company and Alcoa Aluminum. Other companies that fit the mold of "inelastic sales" are grocers (Kroger, Whole Foods, Walmart), tobacco (Altria, Lorillard) and healthcare (Eli Lilly, Johnson and Johnson) amongst others.
  4. Pillar #4 - Strength (or lack) of Competition: In medieval times, castles would be surrounded by deep trenches, often filled with water or sharp, precarious debris, designed to ward off or cripple enemies or rivals. Today, the most frequent use of the word "moat" is in describing the position a company holds within a certain industry. For example, a company with a narrow moat is one that does not have a significant buffer ahead of its competition. For wide-moat companies, think in terms of large companies with only one or two major competitors - like Coca-Cola (KO). The benefit that these companies hold is that they can see competition coming from miles away and use their gargantuan strength to either jump ahead of it or absorb it.
Fig. 1 - The Four Pillars

Putting the Pillars to Use
So now we will use the pillars to analyze three different companies that are currently on my watch list: Western Union (WU), Smith and Wesson (SWHC), and  Qualcomm Inc (QCOM). 

All three companies have a strong pillar #1, although Western Union has a much lower proportion of total cash available to current liabilities. Both Western Union and Qualcomm are strong in pillar #2, where Smith and Wesson is lacking. Western Union is the only company that did not see significant impacts to profits during 2008-2009, putting it up into the "inelastic" tier, where the other two fell short. Pillar #4 showed Western Union and S&W with fewer major competitors, and therefore less competition. It must be taken into account that S&W has a greater number of privately owned companies directly competing with it in the personal security sector. The telecommunications market is very crowded these days, but Qualcomm has a nice foothold as the industry leader and LOTS of cash - giving it a fairly wide moat. 

In conclusion, I like all three of these companies (which is why they are on my watch list) but I can only recommend Western Union and Qualcomm at this time. The lack of dividend with S&W is dangerous, especially with all the question marks surrounding gun control these days. The moat is not wide enough and the biggest competitor is the government (scary!). Western Union and Qualcomm seem well-positioned for continued growth, both in the stock price and the dividend.

Disclaimer: I have positions in LO, KO, WU, and may initiate a position in QCOM within the next 72 hours. The Four Pillars of Permanence are not a guarantee of permanence and are subject to the same Generally Accepted Accounting Principles that brought down Enron. Remember - everything is permanent until it changes!

Beach Bum Pt. 1: Neal and Phyllis

Let me take a break from all the facts and figures and tell you one thing I love about the beach. It has nothing to do with the sand or the waves. It has nothing to do with the salty air or the crisping of my skin; instead, it has everything to do with the people.

Insert Neal and Phyllis.

As we pulled into our beachfront duplex on the narrow strip of Emerald Isle this week, I was greeted by an aged mustache, paired with a toothy grin and a strong (I'm talkin' straaaaawng y'all) country accent.

"I guess y'aller our neighbors - you look  like friendly enough folks." He said.

"We'll try and live up to that initial impression - even though I'm not sure what we did to deserve it. I'm sure you'll let us know if things get too rambunctious for you?" I replied.

"We ain't got no problem with ram-bunction - teerust me," his enormous smile grew even bigger, to the point that I thought the corners of his mouth might poke him in the eyes, "you see, I can be friends with anybody - unless you're married to me and you ain't my type - but even then tolerance is the lowest limbo bar."

As I stared blankly trying to figure out what that meant, a petite, middle-aged woman poked her head out from around the other side of the van.

"Lord knows you were lucky to find someone to marry you at all. Not everyone's as attracted to robust waistlines and hairy backs as I am!"

Neal and Phyllis.

What's great about the beach is that it is one of the few places that you can simultaneously know everything about a person and nothing about a person. The beach presents a unique opportunity to get to know people without their clothes on. Instead of being defined by the stuff they own or the places they work, first impressions are more subject to face-to-face interactions and family dynamics (and perhaps a tattoo or two).

Wednesday, May 22, 2013

The Power of Investing Generously

Historical Philanthropy

My recent sabbatical from blogging has given me ample time to dwell on what I believe to be an important topic for anyone with the means to invest: giving. This may be a bold statement, but  regular giving can be one of the most powerful catalysts to your long-term financial goals. I'll tell you how in a moment, but first let's take a look at America's charitable history.

To put things into perspective, charitable giving typically grows at about one-third the rate of the stock market - approximately 3% annually. This is about 1% less than the inflation rate, and 2.2% less than the combined inflation rate and population growth rate. So what does this mean? It means that, per household, Americans are only giving 46.73% of what they were giving in 1975.  Inflation-adjusted private giving in the US has remained stagnant at $298B from 2001 to 2012 - why? There are many different theories as to why the steady decrease is happening (which we will not discuss here), but ultimately it has resulted in an increase in what I call "filtered giving". Since most of this readership are of an intelligent, blog-reading nature, I'm certain you can deduce what I mean by this. Simply put, less money is being directly poured into needful hands and more is going into charitable for-profit companies (like Tom's) and ginormous, 16-trillion-dollar-debt elephants in the room.

Naational Debt Cartoon

Let me throw in a quick disclaimer - I don't have a problem with Tom's, my wife loves Tom's. But let's be real, buying Tom's shoes is not giving. Don't argue - it isn't. According to this intriguing article, Tom's profited $4.6 million in 2009 - during the financial crisis! Which means that a large portion of this amount plus the cost of their trademark "one-for-one" shoes could have been directed towards targeted direct-giving opportunities. Once again - not saying Tom's is bad, but at $60 for a couple straps of cloth and a slab of neoprene, I would dare to say that Walmart may be the more charitable of the two.

Living without Abiguity

So how do we bridge the gap between what we were giving as a nation 35 years ago versus what we are giving now? Apart from electing solid government officials and praying for more discretionary income, there are several ways to ramp up your giving potential:
  1. Make your favorite inelastic-goods companies donate for you: 
    1. Invest in a company with historical dividends and dividend growth such as Johnson and Johnson (JNJ), Kraft (KRFT), or Eli Lilly (LLY).
    2. Have the dividends injected directly into the organization of your choice. Many large brokerage firms have this option available, and it works the same as a direct funds transfer*. 
  2. Prepare and manage your post-retirement fund: Nope, you didn't read it wrong - what is your plan for after retirement? Well, it won't last forever; something to think about.
  3. Budget for "discretionary giving": Instead of saving what's left over, create a budget category for saving and write yourself a check for that amount each month. Start with a baseline of 10% of post-tax income and move up or down depending on your situation and what you are comfortable with. The idea is to stretch yourself in this category in order to see where you can cut in other areas. Then resolve yourself to give what is left over at the end of each month. Hence, discretionary giving.
Obviously, the first step to any of this is locking in a regular income. I have to admit, I am somewhat bias to the seemingly antiquated notion that there will always be work for those willing to sweat, but hard times befall the strongest of men. Therefore leave the judging to the Judge and throw your excess to the hungry. After all, sheer joy is nothing short of an unexpected gift in a time of need.

Next Post: The Wises Build a House

 Government Seeks to Limit Charitable Deductions: How Could They?
*Learn more about partnering with Fidelity on their charitable giving page

Sunday, April 21, 2013

Is this Fruit Prime for Plucking?

It is 11:40am at the Richmond airport. My 10:50 flight to Chicago has just disappeared into the hazy sky, full of passengers likely to be re-distributed all over the world. I sigh, repining from the woes of standby flight. I stand next to the charging station (I hate to sit in airports), and then something extraordinary happens: I think. While it is not uncommon for me to think in day-to-day activities, the realization quickly comes that I often view airports as an opportunity for a mental vacation. As I think about thinking, my brain wanders to a recent training session that I presented to some rising leaders in our company.

“True or False,” I asked. “As a leader in the company, I should organize my time so that I can accomplish multiple objectives at once.”

A smattering of hesitant responses rang out, but the general consensus was “true”.

My left eyebrow twitched as I tried in vain to keep it from rising, but it floated to the top of my forehead like a beach ball in the Dead Sea. “False,” I said. I repeated the word one more time and paused for a few seconds, hoping realization will sink in.

If I were in the Miss America pageant (they have yet to accept my application), my answer to the “what are you passionate about” question would be simple: effective utilization of time in airports. Seriously, think about how much more fit our country would be if we did one pushup for every minute we waited in an airport. Currently there are 24 people sitting in my vicinity. Out of those 24, two are playing angry birds, two are working on the computer (including myself), four are on tablets watching movies, three are browsing the web on their phones, one is reading on a Kindle, and twelve are staring off into space. If you are asking yourself, “did he creepily walk around and observe what all those people were doing?” you are correct. In 2012, airlines carried 812 million passengers to destinations worldwide. That's a lot of Angry Birds. At an average of two hours of time spent at the airport per passenger, enough hours are accumulated at airports each year to keep McDonald's worldwide operations running for a year and a half (over 400,000 employees).


Figure 1: 812MM passengers in 2012. Source: Bureau of Transportation Statistics T-100 Market data.

 Chart 1: The above chart is based on a sample size of 24, therefore the projected accuracy may be somewhat skewed.

A semi-applicable example, but I believe there is something to be said about specificity and driving one precise area (say, time spent in airports) to a goal at a time.  The squeaky wheel gets the grease; but if too many wheels are squeaking, you just wind up with a greasy mess.

Eat Your Fruits and Veggies:

If you read my previous post, you are probably wondering where I am going with all this. The truth is I don’t know. I never know. But you are reading this and historically it seems to work out alright, so I’ll keep typing.

How do you determine the health of a company? Today’s investors love to dive deep. There is a tendency to look at everything from supplier sales to dividend growth to China’s manufacturing index to determine if a stock is a good buy. Though there is nothing wrong with a full diagnostic sometimes it is notoriously easy to be steered to or from a company based on the fact that Big Mac sales in Luxembourg are down 0.7%. It is imperative to keep an eye on the vitals at all points in the decision-making process – so what are they?

Let’s look at a company that everyone is talking about – Apple (AAPL). Steve Jobs’ vision came to fruition throughout the 2000s after he took over the business as CEO in 1998. Following the crash in late 2008, Apple became the darling of Wall Street – constantly beating earnings projections while maintaining an air of mystery and excitement around their products. The stock price peaked in Sept. 2012 after a nearly flawless run to the top. It has since fallen over 40%.

Chart 2: Source - Marketwatch.com

Reduction in revenue growth and slowing demand for products are the major factors driving this chart downward. These are perfectly legitimate reasons to run away from a stock…in most situations. In most situations:
  • Companies that see growth similar to Apple’s are valued much higher than what their earnings are telling you. This is clear with companies like Amazon (AMZN), where the stock is currently valued at over 1000 times earnings. This is based on the assumption that the company will continue to grow. If growth were to stop or slow, there would be a lot of negative pressure on the stock because it was valued so highly. Apple has had an average valuation of 16x earnings over the past 5 years, so it has maintained a fair value all the way to the top.  
  •  Companies that see growth similar to Apple’s do not pay dividends. The profit margins are often much more slim for growth companies, so until they are firmly established a dividend is not an option. Apple was both firmly established and growing faster than the kill count in Rambo.
In addition to these situational factors, Apple currently has two secret weapons that investors seem to have forgotten: Brand and Cash.

First let's talk about brand. How did Apple succeed in making itself one of the most recognizable companies in the world? It was through perfecting one piece of the puzzle at a time. Apple hooked consumers with the iPod in 2001 and continued to develop this product ahead of the competition.Once they had earned the loyalty of the market, they moved on to personal computers, then to phones, then to tablets, growing their brand and consumer dedication. now rumors are swirling about an iTV or an iWatch. That excitement surrounding Apple products has yet to go away, and it has been three years (iPad) since Apple had a major charge into a new market.

When it comes to a company's piggy bank, "some cash" = good, "lots of cash" = better, "lots of cash and no debt" = nearly unheard of. Apple is in the latter category. With nearly $30 Billion in cash, the company merely needs to invest in a profitable acquisition to maintain growth.

 Figure 2: Comparison or Trailing Twelve Months (TTM) figures for AAPL, GOOG, MSFT, and INTC. Source - Fidelity.com

Now is a great time to buy Apple at a discount, as it seems that most investors are losing focus on the vitals of the company. The fundamentals are still very strong and this is not a company that will turtle-shell and let others charge the market. I maintain that Apple still has room to run - simply based on the simple things.

Disclosure: I own shares of AAPL.

Next Post: Choosing a winner in different industries.