Thursday, October 11, 2012

Portfolio Review

Three months and a few dozen page views into the life of this blog, the tracking portfolio fashionably underwater, it may well be time to do a little review of who’s where and what’s what.

In adopting the concept of look-through earnings , I’ve come up with this: 

If the portfolio were a business (a conglomerate, say), it would, in July of this year, have been a competitive firm earning  20% on its net operating assets, yielding 15%, growing at 13%, and getting better as it grows – that is, earning a greater return on every new dollar of investment than it has in the past.  

This set of circumstances is what I look for and what suits me best: moat + growth + incremental quality mean that intrinsic value is accelerating away from my purchase price, which in turn means that time is on my side. To use a familiar expression, the market can close down for a few years and I can be confident that I will have earned at least the yield, 15%, and probably a great deal more, by the time it reopens.

Since I never* pay for growth, the tricky part has always been assessing whether that which I do pay for, earning power, has legs. And figuring that out, as the owners of Hewlett-Packard, Radioshack, French Connection, Carrefour, and countless others can testify, involves more than looking at historical returns on net operating assets.  

That’s why I like to focus first on the business model – why does this business exist? How and why does it earn its handsome returns on capital? How much would it cost to break it, or to relegate it to obsolescence? Who does it compete with? Where is it in the value chain? And so on. The business model usually tells me what I can expect to see in terms of numbers, and if I like the business model, and the numbers affirm what the business model says they should be, then I look at price.

The no doubt irritating habit I have of writing about the business first, dealing with the financials second, and turning to valuation last, is a mirror of the process that I follow in mulling over the stock in the first place. In fact, I “screen” for candidate stocks by looking laterally within business model types: like F.W. Thorpe and Gerard Lighting; HSN and CJO Shopping Co.; Dunn and Bradstreet and Nice Information Service; Matchtech and Harvey Nash; Electrocomponents and Arrow Electronics; Northbridge and Speedy Hire; Cegid and Cegedim; etc. I don’t screen by price or cheapness.

The margin of safety is in the strength of the business model of the stock that I'm looking at, not in the price tout simple. If the business model is, for example, to buy equipment and rent it out, in whole or in part – Norhbridge, Aircastle, Carnival, Silver Chef, Hawaiian Holdings, Marriott – there had better be a bloody good reason as to why anyone and everyone else couldn’t do exactly the same thing, driving returns down to the cost of capital and below. If there isn’t any good reason why not, thinking that the business is worth twice its operating assets is, in my view, a mistake, and not one that is remedied by buying it at 50% “margin of safety”. One may wait years for the stock to “mean revert” and in that time, the opportunity cost is being metered and charged.

It is this belief – that the margin of safety is in the business model – that leads to me the kinds of stocks that populate the portfolio in its current and future iterations. These are companies with easy-to-understand ways of turning a profit, operating in small, stable, well-defined markets, and earning returns appropriate to the strength of their (local) competitive advantage. Each of them is in a position to grow; the avenues for growth are well-defined, specified in advance; and growth is likely to be value-enhancing because their business models scale well, stretching fixed or sunk costs over a larger revenue base.

And, most importantly, I am not at an informational disadvantage. Small as these stocks are**, no one is going to spend an awful lot of money in an information arms war to gain a slight edge over other market participants. iSuppli doesn't cover Lectra, Tessi, Haynes, or James Halstead. If the price is low, it’s most likely just low, not priced for risk.

There are, I know, retail investors who like taking the other side of the trade on well-watched stocks like Apple, and opaque stocks like Citi, situations in which they know that they are likely at a severe informational disadvantage (in terms of both the known unknowns and the unknown unknowns) armed with the belief (perhaps justified, perhaps true, but nevertheless suffering from a Gettier problem) that professional investors are stupid or myopic or whatever else. I’m not one of them and that kind of trade is not my bag. I like to know at least as much about a stock as any non-insider. Otherwise, and this is a personal thing – necessarily so – I’d feel as silly as if I opened a neighborhood grocery store in the shadow of a Walmart.

In any case, back to the tracking portfolio. It now looks like this:

It’s gotten, on average, both cheaper and better, now earning  22% on its net operating assets, still growing at 13%, and getting even better as it grows. The difference is that it is now yielding almost twice what it was -- 29% rather than 15%.

The area for concern is CEGID. It is now both a bit more expensive and a bit lower quality than it was then.  It's also more complicated than the others, with several different product lines, markets, demand dynamics, and so on. If WEB shorted it, I might wobble, which is something I wouldn't say of the other components of the tracking portfolio. On the other hand, I still think that the investment thesis is intact, that it is worth 28 or so, and that, cyclicality aside, its underlying fundamentals are improving. But I now wonder if there aren't easier ways to earn the same returns. That I'm a little overexposed to France fans the flames of that concern; that I've held it for just shy of a year, only half as long my preferred holding period, dampens them. I dunno. I'm thinking out loud.

The others are fine, their fundamentals behaving more or less as advertised, although Value Investing France, in an excellent blog post, sees GEA differently than I do. 

Disclosure: I have positions in XPO, Hawaiian, Cegid, Gea and Precia.

* I do, however, seem to have paid, or at any rate come close to paying, for some of XPO's future growth. A rush of blood to the head that was a mistakeand that hopefully won't recur.

 ** The sharp-eyed reader will have noted that Hawaiian is hardly small; it is a special case in that every bit of useful information is made available via the DOT/BTS. It is possible, with a bit of work, to reconstruct the unit economics of each route, even each flight, using publicly available information. I have done that work.

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