Monday, November 27, 2006

Best 50-year stocks

From Jeremy Siegels "The Future for Investors"

These are the best survivor firms from the past 50 years. Top 10 with annual return.

Stock Annual Return
Phillip Morris 19.75%
Abbot Labs 16.51%
Bristol Myers 16.36%
Tootsie Roll 16.11%
Pfizer 16.03%
Coca Cola 16.02%
Merk 15.90%
PepsiCo 15.54%
Colgate Palmolive 15.22%
Crane 15.14%
Heinz 14.78%
Wrigley 14.65%
Fortune Brands 14.55%
Kroger 14.41%
Schering-Plough 14.36%
Proctor & Gamble 14.26%
Hershey Foods 14.22%
Wyeth 13.99%
Royal Dutch Shell 13.64%
General Mills 13.58%

Note that all are either consumer brand names or pharmaceutical with the exception of Royal Dutch Shell and Crane. There are no tech stocks with the exception of Crane (industrial products). None of these obtained a 20% return by themself. If you wanted to beat Buffett's 22% you needed to buy and sell.

Stock Valuation

I have been trying to figure out a good method for stock valuation. There are of course many models for valuation mostly based on discounted cash flow models DCF. The idea is that a company is worth the sum of all future cash flows to the owners between now and infinity, discounted by some discount rate. This discounting is because money now is worth more than money in the future. If I had money now I could invest it and get about 10% per year so that in 7 years it will double. The discounting of future cash flows accounts for this simple fact.

Here is a good link to an overload of information on variations of DCF.

However for stock picking I think these complex models are not required. If you knew the inputs precisely (i.e. growth rates etc) then it might be good to include all of these details such as changes in working capital and changes in payout ratio. However you don't. I am looking for a good proxy to use for the whole class of stock that I like to invest in. I want a generally useful tool: a jacknife of sorts that I can quickly use to compare all stocks.

So a simple N-stage DCF model should suffice. I have written one in the IDL computer laguage. Of course, you need to pick a discount rate. This is always difficult. They way I figure it, you you simply fix the discount rate and keep it constant for all stocks. This is possible because I am only going to invest in one kind of company: companies with stable earnings and somewhat predictable growth rates. I don't need a variable risk premium, I don't need to work out the correct WACC etc.
I just use 10%. This of course specifies the relative weight I give to earnings now versus earnings in the future. However 10% seems reasonable because it is approximately the average stock return, is not far from the average bond rate (plus a constant risk premium). It is also the number of fingers that I have. This gives a fair value P/E of 10 for a perpetually zero growth company and a fair P/E of 20 for a perpetual growth rate of 4.8% which is about the long term bond rate. The way I figure one most needs a discount rate to decide whether to buy stock at all. Once you have chosen one, just use DCF to decide between stocks. Buy the cheapest relative to the DCF value with a few caveats.

Next choice: which earnings to use. Some just use accounting earnings. The Usual E. Others use DCF with the dividend D in which case P/E becomes P/D or inverse of dividend yield. There is the handy formula for the dividend discount model for constant growth.
Y= D/P = DR-G
where Y is dividend yield (D/P) and DR is the discount rate and G is the dividend growth. This is called the Gordon Growth Model and is easy to derive (it is just a geometric series). This only works for DR > G so that you don't get infinite value D/P = 0. I find this equation useful in that it tells you what the correct discount rate should be. DR= Y + G. If you buy the stock and sell in the future, after dividends and earnings have grown by G, and the valuation D/P stays the same then your anualized return will be R=Y+G which is the discount rate. In other words, the discount rate is your expected return. You want to buy things that give you a rate equal to or better than you expected return. This is somewhat circular but really gives you an idea of what the discount rate should be. 10% is not so bad of a return. Naturally I would like a higher return so if I use DR=10% in my N-stage DCF and find things that are selling for a significant discount to this rate, then I will buy them.

There are still other choices for earnings. I think using free cash flow (FCF) is probably the best. Buffett calls this Owner Earnings and in my code I use OE as FCF per share. This is cashflow-capital expenditure. The trick here is knowing whether the capital expenditure is really different from expenses and different from real investment. I don't have a good feel for this. Should I simply just trust the accounting line "Capital Expenditure" and subtract that off? If you do that you see that Home Depot has significant OE but Walmart does not. I doubt these two companies are that different so I am not sure if this is just differences in accounting.

So for a company reinvesting all of its money, use OE as earnings and look at growth in OE for the growth rates, G. For price I use enterprise value (EV). This is what you use if you were going to buy the whole company for market value and I think this is the right way to think about buying stocks. You get whatever cash and cash equivilents that the company owns and are stuck their debt as well. So EV = P - Debt + Cash. So now OE/EV is the measure of valuation that I estimate with DCF.

What about dividends? I still need to figure how to include these properly. I think you can simply augment the growth rate by
the dividend yield. This is because you can just buy more shares which is equivilent to having a faster growth rate. If a stock is growing OE at 12% with a dividend yield of 2% then use 14% for G. Not sure if this is entirely correct but will do for now.

The final question is how many stages. You clearly need at least two since most companies that I look at grow at something close to or greater than DR=10%. There is no point in getting carried away and having more than four. For a stable company like JNJ I use 2 or 3. Sometimes I get creative with stocks like homebuilders which should see a decline in earnings and then a turn around. You can still use DCF for this.

The hard part of DCF of course are the growth rates. Garbage In = garbage out as they say. Here, you don't want to over estimate growth or you could end up paying way too much. I think the best way to do this is to use the historic growth rates over 10 years. I get these from S&P though my scottrade account. I think a good thing to do is to take the ten year pattern and divide into 2 five-year segments and get the growth rate for each. Use the lower of thr two and take off 2 percent to be conservative. By doing this you aren't assuming it can grow any faster than it already has. Avoid new companies that have grown quickly because they had no earnings to begin with. Avoid cyclicals that have just come off a huge bull market. Don't ever input very high growth rates like G=40% since they are not sustainable. In fact I want to find companies with high ROE since this tells you the sustainable growth rate. G = ROE (1-p) where p is the payout ratio. That is I will avoid the Googles and the unproven internet stocks etc with huge growth rates and low ROE. I would rather buy a company with G=10% and low valuations since these kind of growth rates are likely to persist and getting the growth rate correct as well as the period of growth is less important.

Finally an example. Johnson & Johnson (JNJ). A perfect company for me (see "My rules for investing" post).

Annual growth in OE over the past 10 years is 13.4% (by exponential fitting) and 14.8% (point to point). The two five year periods are
G=13.5% (first) and G= 17.6% (most recent) as determined by exponential fitting. The lesser is 13.5%. The dividend yield is
Y=2.3%. So I will use G=13.5+2.3-2=13.8%. I will use a 3-stage model with
N Years | Growth
10 13.8%
10 8.0%
20 4.0%

In IDL I simply type:
IDL> dcf,[10,13.8,10,8.0,20,4]
Using default DR 10.0000
12.1112 12.7136 13.6629
total V/E = 38.4878

This reports that the Value to Earnings of 38.5. That pretty high but I think reasonable for a great company like JNJ. Over the next 40 years that predicts a growth in earnings (dividend adjusted) of 17 or 7.7 adjusted for 2% inflation. Taking out the dividends it says that the company must grow by a factor of 6 or so in 40 years which I think is very reasonable considering that the developing world is getting richer and will desire the same level of health care as the developed world and also the developed world is ageing rapidly. The key to trusting high valuations that come out of DCF is to ask whether the company is truely great and is likely to remain a strong company in the extreme distant future. I am fairly certain Coke, JNJ and Budweiser will be around in 100 years unless they are bought by another company. I have no idea what will happen to Google or Yahoo.

So how much does JNJ cost? Since we are working with owner earnings, it is EV/OE that we look at for valuation. The inverse of this I call free yield FY=OE/EV. JNJ has FY = 5.43% or OE/EV=18.41. This is not too different from the usual P/E which for JNJ is 17.29.

So according to DCF it is underpriced by 50%. Quite a steal!

What will my return be? Over the next 20 years this is a rise of about 7.75 in earnings. If valuation stays the same that is an 11% annulaized return. Not bad. However as I mentioned, I think the right valuation is twice as high. So if it takes 10 years to obtain the right valuation this will be a 13% return. If it takes 10 years it is 19%. If it only takes 3 years, it is a 37% annualized return although over a shorter period. I figure this is a sure thing to obtain a 10% annulized return over some future interval and possibly as high as 30% as long as I hold on through any ups and downs. I will buy now and sell whenever it becomes overpriced. I would probably sell if P/E > 35 but may sell after a year if there are even better opportunities.

Of course the growth rates could be wrong. Lets try a simple 2-stage with 10% initial growth.
IDL> dcf,[10,7,20,5],val,e,de
Using default DR 10.0000
8.61628 9.64537
total V/E = 18.2617

That comes closer to the price but requires 10 years of only 7% growth followed by 20 years of 5%. I don't see anyone could think that JNJ would see such terrible growth rates especially with the demographics that we have. JNJ is definitely underpriced. A definite BUY. The only question is whether there are better buys out there which is always the source of all my stress.

My rules for investing

Here is my list of rules for buying stocks. These will probably evolve with time. I will refrain from investing in any company which fails ANY of these rules. If a company passes these tests then I will buy it if it well priced compared to my personal valuation models.

1) I understand the business reasonably well. I know where profits come from and what drives earnings growth.

2) The company has little to no risk of failure.

3) The company has stable postive earnings and decent earnings growth over long periods of time, say 10 years.

4) The company's earnings growth is sustainable. It's growth is fed by high returns on equity. ROE > 15, minimum, preferably much higher.

5) This high ROE is maintained by some apparent competitive advantage.

6) The company has low or no debt or at least high interest coverage for it's level of earnings volatility. This should be reflected in low leverage and high ROA and ROIC. Shows strong financial strength.

7) The company produces free cash flow and/or dividends.

8) The company is well managed. Management hold shares in the comany and act rationaly as owners.

9) The company returns excess cash to shareholders though dividends or buybacks. Exceptions are when company can reinvest in the business as very high ROIC.

10) The company has a good long term outlook. There is no chance of becoming obsolete by new technology or fundamental changes is the world economy. It is poised to benefit from important megatrends of our time: ie globalization, demographics. Macro ideas may enter here but should not dominate other factors.

11) The company is not burdened by organized labor or unfunded pension liabilities or any other off balance sheet items
including major lawsuits.

12) The company's earnings are not heavily regulated by the government.

13) Insiders are buying or some Superinvestor is buying or I am just VERY confident about the stock.

14) The company can be purchased at a good price (see "Stock Valuation" post).

The tug of war - inflation versus deflation

I find it best to think of the monetary environment as a great tug of war. On one side is inflation which threatens to blow price asset bubbles, raise worker wages as well as prices and set in place an expectation of further inflation. Unchecked, this leads to hyperinflaton, destruction of the currency and eventually economic collapse. Think Weimar Germany of the 1920 or more recently Argentina. Pulling against inflation is deflation, a dropping of prices due to either excess supply or deficient demand. This leads to industry shutdowns, unemployment, lower wages and also loss of corporate profits. Think the Great Depression.

While many people tend to concentrate on warning of one or the other, I like the tug of war analogy. There are plenty of inflationary as well as deflationary forces in the world. The key is whether or not they are balancing each other or whether one is getting the upper hand. Usually there is a back and forth as one side begins to gain ground and the other gives it followed by a reversal as the losing side pulls back. The great fear of the bears on either side is that one side will win, dragging the losers through the mud and causing an economic collapse.

The great deflationary force today (perhaps a better term is disinflationary force) is globalization. This introduces more and more workers into the world economy and keeps wages down, prices down and corporate profits up. Against this is the greater demand for commodities as the world develops and the high profits spawning price asset bubbles. The US trade deficit and growing national debt seems to require a dollar decline which would lead to inflating prices for the US consumer. For the most part, these forces act to cancel each other out. Despite the fact that each team is pulling harder than before, things haven't moved much. The last two decades have seen low and stable inflation.

There are the gold bugs who think that paper money is the root of all evil and that the promoters of this great evil are the Federal Reserve and other central banks who aim at positive inflation. Their prediction is always hyperinflation where gold will soar in dollar value and the gold bugs themselves will become imensely rich. So far these gold bugs have had miserable returns as they missed the great bull market in stocks from 1982 to 2000 even considering the rather impressive gain in gold of the past few years.

On the other hand are the deflationists. Gary Shilling comes to mind as their chief proponent. At least with Gary Shilling we find someone who has made some excellent returns with his predictions. Gary made the excellent decision to buy zero coupon 30 years treasuries at their yield peak in 1980 and keep buying them (even on margin) through all of the great bond 25 year bull market. His return has been over 20% anualized since bond yields have fallen due to the change from the high inflation 70s to the low inflation 80s and 90s. Shilling still predicts that the disinflationary forces of globalization will dominate and cause outright deflation. He predicts a popping of the housing bubble and a decline of US house prices by as much as 30%.

Who is right? I tend to side with Shilling who makes some excellent arguments. However I also wonder if there is something else at work which makes the inflation/deflation distinction, the wrong way to look at things. Certainly I see the housing bubble deflating. This is clearly deflationary and will lead to a US recession. But what of the rest of the world. I think they are unlikely to decouple and will follow the US into a world recession. But what of the dollar? It does seem that the trade deficit cannot get much larger and that foreign holders will eventually dump dollars driving up interest rates. So can one be a dollar bear and still a deflationist? Shilling is not a dollar bear as far I understand. How can he deny the dollar weakness? Can't the Fed simply inflate the currency and reflate asset prices if they choose. This seems to be what PIMCO bond guru, Bill Gross predicts. Of course this can cause inflation just as the Fed bailed out the NASDAQ crash in 2000. But then again, if a world recession hits, no country will want too strong a currency. So perhaps the Fed can ease significantly without the world dumping dollars. Perhaps investors will pull out sharply from foreign investments to buy safer US assets which will prop up the dollar. I think this is Shillings idea. The US dollar is a safe haven. Asian currencies are not. So how does this all work out? I find this quite perplexing. I see great danger in financial markets but am unsure of how to avoid it.

My solution so far is to buy some safe, large multinational US stocks like JNJ, KO, MO concentrating on the less economically-dependent areas like health care and consumer staples. I figure that these seem rather hedged against either senario and are
reasonably priced. About 60% of my money is still collecting 5% in the money market due to indecision and fear of these threatening global imbalances.

Saturday, November 25, 2006

The macro environment

I try to select stocks without making too many asumptions about the economy. However, I wonder if one can't ignore the economy for certain sectors. For example, you cannot just buy homebuilders without some feel for how the economy is going to behave. Well, I suppose you could but really the earnings of home builders for the next five years will be greatly affected by whether or not the US sinks into a recession and whether this pulls the rest of the world along. Even more so for banking which is more highly leveraged.

Buffett always claims to ignore the economy but I am not sure that I believe him. He seems to have avoided many of the past recessions. I suppose he would claim that it was simply over-valuation that tipped him off and not the economic outlook. Recently he has been outspoken about the fact that the US dollar must decline. That is pretty macro for Buffett.

Perhaps it is best to go against the prevailing view of the economy. For example it is probably true that people overestimate economists ability to predict the direction of the economy. If so then the prevailing view will have biased valuations in that particular direction. If so, then then market is not exactly macro-efficient but rather macro-biased. There must be money to be made simply by ignoring the popular economic view and insisting that we know nothing of the where the economy is going. Just use prior information not posterior information (in Bayesian language). I think the same principle applies to microeconomics. Ignore the analysts and just look at past earnings, histoic ROE and use common sense. If analysts are pessimistic then you have a buying opportunity because the market will discount their bogus information. This is probably the guts of contrarian stock picking. But is it right?

Monday, November 20, 2006

Bargaining Power

One of the important things that I look for in a company or even industry is bargaining power. In a free market, prices are generally set by the action of bargaining between players. The player that benefits the most is the one with the most bargaining power. For example, I believe that Walmart has enormous bargaining power. It's size allows it to get the lowest prices on products that it buys. When Walmart says no to one of its suppliers, you see a huge drop in that suppliers revenues. Walmart can simply buy that product from some other manufacturer. This is why Walmarts loves to introduce new products of a more generic nature. As long as Walmart shoppers are willing to buy the lowest price item, Walmart holds a powerful hand.

Brand name suppliers like Procter and Gamble, resist the tyranny of Walmart by offering strong brands. No other supplier can sell Walmart Tide detergent, Tampax tampons or Gillette razors. But generic suppliers hold little bargaining power with Walmart and there are so many of them thoughout Asia and the world.

Another example is banking. I just read a book by Ron Chernow called "The Death of the Banker". He suggest that one can make a bar chart with three bars. In the middle is banking which is the intermediary of the other two: the providers of capital and the consumers of capital. More on this in my blog on "The Death of the Banker". His thesis is that today the banker is much weaker than in the previous times of the Rothschilds and J.P. Morgan when they virtually controlled world finance.

One could also consider a similar chart with the retailers like Walmart and Target in the middle with the suppliers on one side and the consumers on the other. I would argue that the retailers are rising in power and hold considerable sway over the two other sides. If you won't pay Walmart prices, you are unlikely to get the products you want. Who can profitably, sell them cheaper? Similarly, if you're a supplier, you are unlikely to get many of your products to the market if you refuse to sell to Walmart under their terms. In many ways Walmart looks like this century's Monster of Morgan.

I think it is fruitful to look at many industries in this same way. Buiild a graph of bar charts showing who in the chain has the most bargaining power. Often there are more than three players. For example consider the Pharmaceutical industry. There is the branded pharmaceutical maker, the generic drug maker, the insurance company, the goverment, the hospital, the patients etc. Big pharma has held considerable bargaining power for years. Much of that has to do with the patentability of drugs and the high barriers to entry. Will this remain the case? Many argue that the recently elected Democrats wish to put an end to this. I wish them luck but I am putting my money with Big Pharma.

picks: Pfizer (PFE), Bristol Myers Squib (BMY), Johnson and Johnson (JNJ)

Friday, November 17, 2006

Utah Medical Products (UTMD)

Utah Medical Products (UTMD) is a great small cap medical products company from Salt Lake City. Primarily they make disposable or reusable products for neonatal, obstetrics, fetal monitoring etc.

Here are three plots of interest for this company.

The top is the "owner earnings" (Buffett's term for per share free-cash-flow) over ten years. Note the nice growth rate of 16-17%. Note also the two-stage growth slowing from 24% to 9.6% in the two five year intervals. Back to that in a moment.

The second plot is return on equity (ROE). It flucuates between 20 and 40 which is excellent. They say they aim for at least 25.

The third plot is most interesting. This is shares outstanding. They buy back shares like crazy. They are reducing share count by 8.6% per year over ten years. In addition, they just started paying a dividend which is growing rapidly. The thing with this company is that they do not really grow much. They are simply very profitable and they use nearly all their earnings to buy back shares which raises EPS. This keeps them a microcap, only $132M. They are a great little cash machine that Wall Street ignores simple because they are too small for big mutual funds to buy.

This company was nearly shut down two years ago by the FDA due to some false accusation about safety violations that was thrown out by a judge. The stock crashed. They lost customers. They spent a ton in legal fees that they are now trying to recover from the FDA. That is now done. This hurt them financially. You can see this in their growth rate above (first plot). The second five year period is much slower growth 9.7 versus 24. With all of this behind them, they should be able to growth EPS at that higher rate of 24%. After all, why not? They are not really any bigger than 10 years ago. Most companie's earnings slow because they get bigger. This company stays the same size and buys back shares and will probably raise its dividend and hopefully make some smart aquisitions. Why shouldn't they be able to regain that level of profitability?

If they do this stock will have a great run. Even if they don't improve much they are fairly priced at P/E=17. This would be a great compnay for JNJ to buy. I have bough some shares and will probably buy more soon. Keep an eye on the insider transactions.

Graco (GGG)

This is a spectacular company. They manufacture equipment for handling fluids: spraying, pumping, dispensing all kinds of fluids. They dominate this niche market. Much of their usefullness is in adding cheap but high-value-added properties to products. For example, spraying the coat of paint on a new car doesn't actually cost the car maker that much compared to say making the engine of the car. However customers expect an excellent coat of shiny paint. It is what they see after all. A cheap paint job which may save the car company $100 will devalue the car by $1000 in the eye of the customer. It simple isn't tolerated. Car companies will pay for quality paint equpment since it is crucial to making their cars.

Similarly, a factory that dispenses a fluid (say Hershey's chocolate, a Graco customer) needs to do this is a precise way. They need to put a precise amount of the fluid into packages. They need to be able to keep the equpment running. They have no tolerance for pumps that jam, sprayers that get clogged, or equipment that otherwise breaks. They also don't want to spend their time solving these kind of problems. They hire Graco who is the world expert on solving these problems. Pumping fluids around is exactly the kind of thing that is a weak link. Whatever the factory is, you can bet that if they can't provide the right fluid (oil, water, chocolate, tomato paste, paint, adhesive, solvent, lubication whatever) at the right place at the right time, then their whole operation shuts down. The need the job done right and they call Graco to deliver the solution.

This enables Graco to attain high profitablity making a huge variety of products that are variations on a similar set of well understood ideas. They have been growing at about 17% for a decade. They are well mananged and return a significant amount of earnings to share holders. Average return on equity (ROE) is an incredible 50% over the past 10 years.

They trade at about 19 times earnings which is a reasonable price if not exactly cheap. Free cash flow yield is about 5% and per share FCF is growing at 18% with capital expenditure showing no long term upward trend. I will probably acquire some GGG in a week or so. Hoping for a downturn of a few percent. This would probably be a better stock to pick up during a recession which may finally come in 2007.

Meritage Homes (MTH)

I think the best publically traded home builder is probably Meritage Homes

Here is a plot of the book value of MTH over the past 10 years. Look at how stable this growth is, about 37%.

They have one of the highest Return On Equity (ROE) of the builders, about 30%. They retain all earnings and grow at about their ROE which is good. Debt level and leverage is reasonable. P/B is about 1.2. Earnings yield (EBIT/EV) is about 24% although earning of all hombuilders is plummetting. The only home builder with better numbers is NVR which has management ethics problems.

The only problem with Meritage and the reason that the market gives them a lower valuation then say Centex or Toll Brothers is that they are not very geographically diversified. They build houses in just 6 states. Texas, Arizona, California, Colorado and Florida and Nevada. These states may be some of the more bubbly ones and so people think this is a riskier stock. However these are also the best states to be in. These markets will have the most growth over the coming decade and that is why they are there and this is partly why there are more profitable than the others. Buying a home builder now only has one real risk. That is liquidity risk. They can go bankrupt. This happened to big home builders before. US Homes, NVR and UDC all went bankrupt. NVR just started out and walked right into than crash of 1991-1992. After coming out a bankruptcy they became one of the best stock to own over the 10 year period of 1995-2005; their stock price grew by a factor of 53. Home builders in general look like great long term investments right now. They just need to avoid going bankrupt due to a liquidity crisis during this crash. For that they need, low debt to equity, a decent available line of credit which nearly all big builders have (maybe TOA the exception).

Other home builders that I am looking at are TOL, RYL and HOV. I think the trick is not to pick the biggest and most diversified but rather look for the most profitable and best managed which will do the best over the long term. It probably would pay a bit to diversify a some between a few home builders since you never know.