Tag Archives: geoff-gannon

Closing The Book On Breeze-Eastern

Quan and I did an issue on Breeze-Eastern (NYSEMKT: BZC ) last year. The stock has since been acquired by TransDigm (TDG ). When we did the issue, Breeze-Eastern was priced at $11.38 a share. We appraised the stock at $15.02 a share. TransDigm would later pay $19.61 a share for all of Breeze-Eastern. What lesson can we learn from our Breeze-Eastern experience? Here’s what we said about Breeze-Eastern’s stock price at the end of our issue: “Breeze should – based on the merits of the business alone – trade for between 10 and 15 times EBIT. It is unlikely the stock market will ever put such a high value on Breeze…It is a small company. And 3 long-term shareholders own 70% of the stock. That doesn’t leave a lot of shares for everyone else to trade…Some investors may not like that kind of illiquidity…Breeze is not a fast growing company. And it’s not in an exciting industry. So, it is unlikely to get attention based on anything but its numbers. This might cause investors to underappreciate the qualitative aspects of the company…It is possible that the investment funds that hold most of Breeze’s stock will not hold it for the long-term. They may want to sell the company.” ( Breeze-Eastern Issue – PDF ) Last year, Value and Opportunity did a blog post called ” Cheap for a Reason “: “Every ‘cheap’ stock you will find has problems. Some of those problems might be individual (bad management, too much debt etc.), some of those problems might be more sector specific (oil & gas, emerging markets exposure) or a combination of both. The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.” So, why was Breeze-Eastern cheap? Quan and I thought it was that the company had been spending on developing new projects in the recent past that wouldn’t pay off till the future: “Between 2007 and 2011, Breeze-Eastern’s EBIT margin was depressed by 5 full percentage points as a result of development spending on projects like the Airbus A400M…Breeze-Eastern’s gross margin and operating margin will be higher in the future than they were in the last 10 years.” The merger document for the acquisition includes a projection by the company’s management to its financial advisors that suggests the reason TransDigm – or any other 100% buyer – would pay more for Breeze than the stock market had often valued the company at was because: Breeze will have lower costs as it spends less on development projects AND Breeze will have higher sales as a result of the development projects it spent on in the recent past The projections show EBIT going from $12.9 million in 2015 to $29.3 million in 2021. This is a 15% annual earnings growth rate. The projected growth is largely due to management’s belief that revenue from platforms under development will go from $0 in 2016 to $28 million in 2021. This would seem to suggest that we were right about two things: The stock’s illiquidity made its shares more attractive to a 100% buyer than to individual investors buying just a small, tradeable piece of the company Breeze was cheap today versus its likely future value because the company’s reported results included present day expenses as incurred but did not include the expected long-term payoff from supplying new helicopter and airplane projects that won’t be launched for several years So, maybe the two lessons we should learn from the Breeze takeover being done at a much higher price than the stock traded at or than we valued the company at are: Always value a stock based on what a control buyer would pay for it as a permanent, illiquid investment – never value a stock based on what traders will pay for small, tradeable pieces of the business (Ben Graham’s Mr. Market rule) Look for businesses that have to report bad results today even though you know they will report better results in the future Quan and I weren’t sure if Breeze would have higher revenue from these projects one day. The acquirer here is counting on future projections for revenue. However, we were sure that Breeze would spend less in the future than it did in the past. That was a sure thing. There is one problem with this analysis of the learning experience we got from Breeze. Mr. Market actually did re-value the company upwards before the acquisition – not after. Breeze went from like $12 a share in the summer of 2015 to $20 a share in the fall of 2015. You didn’t have to hold the stock through the acquisition to make money. We were wrong that Mr. Market would never pay up for such a boring, obscure, and illiquid little stock. It’s worth mentioning here that Breeze’s enterprise value had been $160 million in 2009. We even mentioned in the issue we wrote that Breeze fell in EV from $160 million in 2009 to $95 million in 2015. Yet, we didn’t speculate that Mr. Market would once again assign Breeze a $160 million enterprise value. It seemed more reasonable to us that someone would buy the whole company. So, again we proved we are really bad at guessing what Mr. Market will do. And maybe it is better to assume we know nothing about how a stock will be valued by anyone other than a control buyer. Also, we were clearly too conservative in our appraisal of Breeze. At about 7 times what we considered normal EBIT to be, it was a cheap stock when we picked it. And we probably presented it as too much of a value investment and not enough of a quality investment. I think we were biased against Breeze – we ticked off its extraordinary virtues in the text of our issue but still slapped an utterly ordinary EBIT multiple of 10 on the company – due to its small size as a stock and its low growth in recent years. We may have pigeonholed it as “microcap” value. In fact, we knew that based on signs like market structure, relative market share, and the bargaining power Breeze had when dealing with spare parts buyers that its “market power” was among the strongest of any company we’ve covered. Probably John Wiley (NYSE: JW.A ) (NYSE: JW.B ) and Tandy Leather (NASDAQ: TLF ) are as strong. Hunter Douglas ( OTC:HDUGF ) also has an excellent competitive position. Since Breeze is a small company in a very small industry, we didn’t have precise data to give on market share the way we often do. All we could say was that Breeze had “a greater than 50% global market share” in a “true duopoly” and that “the only reason customers ever seem to switch from Breeze-Eastern to UTC or vice versa is when they get annoyed that a critical spare part is taking too long to arrive.” This last sentence is probably the most important sentence in our issue. We rarely come across companies to analyze where the customers tell us flat out that they just aren’t going to switch providers. The two clearest examples of this are Breeze and John Wiley. Finally, Breeze is a classic example of a “Hidden Champion.” We’ve only done a few truly dominant companies for the newsletter. Tandy and Hunter Douglas are probably the closest to Breeze in terms of market leadership. They’re also similar in that they have no real peers. We try to present “comparable” peers in each issue. We said flat out in the issue that “Breeze has no good peers.” The same thing is true of Tandy and Hunter Douglas. There’s a lesson in here. Look for companies with no publicly traded peers. Analysts cover entire industry groups. And investors like to pick from the top down too. If you started from the top down, would you ever get to the “helicopter rescue hoist industry”? Where does that fit in a portfolio? What about leathercrafting? Most people don’t even know that’s a real hobby. Or shades and blinds? Is that housing related? For me, the biggest lessons from Breeze-Eastern are both about timing. We can time normal earnings. For example, we could see Breeze was under-earning now. This isn’t hard. We know Hunter Douglas will make more in the future than it did in the recent past (since U.S. housing was lower than normal). We know Frost will make more in the future than it did in the past (since interest rates are lower than normal). Often, you don’t know “when” this “normal future” is. But, it’s not hard to notice when the present is abnormal in some way. We can’t time the stock market. Quan and I never would have predicted that Breeze-Eastern’s stock would rise on its own – without a buyout offer – to anything like the level it did. And we never would have expected it’d do it so fast. I think it’s a lot easier to figure out what an acquirer will eventually pay for a company than what the stock market will eventually pay for a stock. So, how do we combine the ideas of finding companies that are under-earning today compared to a normal future year with the idea of ignoring Mr. Market entirely and simply valuing a stock based on what an acquirer would pay for the entire company? I guess we could distill that down to a simple investment recipe: Step One: Fast forward 5 years. Step Two: How much would an acquirer pay for this company (in 2021 not 2016)? Last Step: Work backwards to decide how much you should pay for one share of the stock today assuming the whole company is bought 5 years from today.

The Two Sides Of Total Investment Return

By Quan Hoang I spend about 10-15% of my time crunching data. That sounds tedious but I actually enjoy this task. It forces me to pay attention to details, checking any irregularity I see in the numbers and trying to tell a story out of the numbers. My recent work on Commerce Bancshares (NASDAQ: CBSH ) led me to ponder the relationship between ROIC and long-term return. Over the last 25 years, Commerce Bancshares averaged about a 13-14% after-tax ROE, and grew deposits by about 5.6% annually. Over the period, share count declined by about 1.9% annually, and dividend yield was about 2-2.5%. Assuming no change in multiple, a shareholder who bought and held Commerce throughout the period would receive a total return of about 9.5-10%, which is lower than its ROE. Why is that? Chuck Akre once talked about this topic: ” Mr. Akre: What I’ve concluded is that a good investment is an investment in a company who can grow the real economic value per unit. I looked at (what) the average return on all classes of assets are and then I (discovered) that over 75-100 years that the average return on common stock is around 10%. Of course this is not the case for the past decade but over the past 75-100 years, 10% has been the average return of common stocks. But why is that? Audience A: Reinvestment of earnings. Audience B: GDP plus inflation. Audience C: Growing population. Audience D: GDP plus inflation plus dividend yield. Audience E: Wealth creation. Audience F: Continuity of business. Akre: …what I concluded many years ago, which I still believe today, is that it correlates to the real return on owner’s capital. The average return on businesses has been around low double digits or high single digits. This is why common stocks have been returning around 10% because it relates to the return on owner’s capital. My conclusion is that (the) return on common stocks will be close to the ROE of the business, absent any distributions and given a constant valuation. Let’s work through an example. Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.” The restriction in Akre’s explanation is ” absent any distributions. ” In general, there are two sides of total return: the management side, and the investor side. Management can affect total return through ROIC, reinvestment, and acquisitions. Investors can affect total return through the price they pay and the return they can achieve on cash distributions. The Problem of Free Cash Flow Reinvestment into the business usually has the highest return (this post discusses only high quality businesses that have high ROIC). Problems arise when there’s free cash flow. Management must choose either to return cash to shareholders or to invest the cash themselves. Both options tend to have lower return than ROIC. Cash distributions don’t seem to give investors a great return. Stocks often trade above 10x earnings so distributions give lower than 10% yield. In my example, Commerce Bancshares wasn’t able to reinvest all of its earnings. It retained about 40% of earnings to support 5.6% growth and returned 60% of earnings in the form of dividends and share buyback. The stock usually trades at about a 15x P/E, which is equivalent to a 6.67% yield. The retained earnings had good return, but the cash distributions had low underlying yield. The average return was just about 10%. Unfortunately, many times returning cash to shareholders is the best choice. Hoarding cash without a true plan on using it destroys value. Expanding into an unrelated business for the sake of fully reinvesting doesn’t make sense. Similarly, acquisitions often don’t create a good return. The problem with acquisitions is that they’re usually made at a premium so the underlying yield is likely lower than the yield that would result from share buybacks. The lower underlying yield can be offset by either sales growth or cost synergies. Studies show that assumptions about cost synergies are quite reliable while sales growth usually fails to justify the acquisition premium. To illustrate this point,let’s take a look at 3 of the biggest marketing services providers: WPP, Omnicom, and Publicis. Omnicom is a cautious acquirer. It spends less and makes smaller acquisitions than peers. Its average acquisition size is about $25 million. Over the last 10 years, Omnicom spent only 16% of its cash flow in acquisitions while WPP and Publicis spent about 44% of their cash flow in acquisitions. Publicis is a stupid acquirer. It makes big acquisitions and usually pays 14-17x EBITDA. WPP is a smart acquirer. Like Omnicom, it prefers small acquisitions. When it did make big acquisitions, it paid a low P/S and took advantage of cost synergies. For example, it paid $1.75 billion or a 1.2x P/S ratio for Grey Global in 2005. That was a fair price as WPP was able to integrate Grey and achieve WPP’s normal EBIT margin of about 14%. To compare value creation of these companies over the last 15 years, I looked at return on retained earnings, a measure of how much intrinsic value per share growth created by each percent of retained earnings. As these advertising companies have stable margins, sales per share is a good measure of intrinsic value. Retained earnings in this case is cash used for acquisitions and share buyback, but not for dividends. As expected, Publicis created the least value: It’s interesting that the smart acquirer WPP didn’t create more value than Omnicom. That’s understandable because acquisitions aren’t always available at good prices. So, it’s very difficult for management to generate a great return on free cash flow. Therefore, the value of a high-ROIC business is limited by the capacity to reinvest organically. Free cash flow tends to drag down total return to low double-digit or single-digit return. The Investor Side of Total Return It’s very difficult to make a high-teen return by simply relying on management. The capacity to reinvest will dissipate over time and free cash flow will drag total return down to single digit. However, there are two ways investors can improve total return. First, investors can shrewdly invest cash distributions. When looking at capital allocation, I usually calculate the weighted average return. For example, if a company invests 1/3 of earnings in organic growth with 20% ROIC and 1/3 in acquisitions with 7% return on investment, and returns 1/3 to shareholders, how much is the total return? It depends on how well shareholders reinvest the money. If we shareholders can reinvest our dividends for a 15% return, the weighted average return is 20% * 1/3 + 7% * 1/3 + 15% * 1/3 = 14%. This number approximates the rate at which we and the management “together” can grow earnings (actually if payout rate is high, combined earnings growth will over time converge to our investment return on cash distributions.) Second, an investor can buy stocks at a low multiple. The benefit of buying at a low multiple is two-fold. It can help improve yield of earnings on the initial purchase price. It also creates chance of capital gains from selling at a higher multiple in the future. Warren Buffett managed to make 20% annual return for decades because he was able to buy great businesses at great prices and then profitably reinvest cash flow of these businesses. Small investors can mimic Buffett’s strategy as long as the stock they buy distributes all excess cash. They can reinvest dividends for a great return. In the case of share buybacks, they can take and reinvest the cash distribution by selling their shares proportionately to their ownership. That’s how Artal Group monetizes Weight Watchers (NYSE: WTW ). Share Repurchase at Whatever Price This discussion leads us to the topic of share repurchases. I think many investors overestimate the importance of share buyback timing. It’s nice if management buys back shares at 10x P/E instead of 20x P/E. But what if share prices are high for several years? Would investors want management to wait for years – effectively hoarding cash – to buy back stock at a low price? Good share buyback timing can help build a good record of EPS growth but EPS growth doesn’t tell everything about value creation. It’s just one side of total return. What investors do with cash distributions is as important. So, I think management should focus more on running and making wise investments in the business and care less about how to return excess cash. I would prefer them to repurchase shares at whatever price. By doing so, management effectively shares with investors some of the responsibilities to maximize total return. Share buyback gives investors more options. Investors must automatically pay tax on dividends but they can delay paying tax by not selling any shares at all. If they want to get some dividends, they can sell some shares and pay tax only on the capital gain from selling these shares instead of on the whole amount of dividends. Or they can simply sell all their shares and put all the proceeds into better investments if they think the stock is expensive. Conclusion I do not believe in buying a good business at a fair price. If the management does the right things, holding a good business at a fair price can give us 10% long-term return. But great investment returns require a good job of capital allocation on the investor’s part: buying at good prices and reinvesting cash distributions wisely.

You Can Afford To Hold Cash

In my last post, I said stocks were too expensive. Instead of putting more of your money into diversified groups of stocks, you should just let cash build up in your brokerage account. A lot of people have a fear that those lost years of making zero percent on their idle cash can never be made up for. I’ve created a graph to show how much ground you’d have to make up. (click to enlarge) Let’s say you have two choices. One is to invest in an overpriced basket of stocks today and hold that basket from 2015 through 2030. This choice will compound your 2015 money at a rate of 6% a year. The second choice is to do nothing for all of 2015, 2016, 2017, 2018, and 2019. You just hold cash. That cash earns 0% for those 5 years. In 2020, you finally get an opportunity to make an investment that will return 10% a year from 2020 through 2030. If your investment horizon extends all the way out from today through 2030, the second approach overtakes the first approach about 15 years from now. Doing nothing for 5 years and then something smart for 10 years is a better 15-plus year strategy than “just doing anything” today. Here, we define something smart as 10% a year and “just doing anything” as 6% a year. You can decide for yourself whether your something smart is 10% a year or not. That’s subjective. What the “doing anything” returns is a lot more objective. So, let’s talk about that. Over the last 15 years, the S&P 500 (NYSEARCA: SPY ) returned about 5% a year. During that time period, the Shiller P/E ratio contracted from 43 to 27. The same percentage contraction – 37% – would be required to get the Shiller P/E down from today’s 27 to a historically “normal” 17. I see no reason why the S&P 500 should do better from 2015 to 2030 than it did from 2000 to 2015. That means I see no reason why buying the S&P 500 today and holding it through 2030 should be expected to return more than about 5% a year. (Almost all readers I talk to have a total return expectation for the S&P 500 that is greater than 5%, even for periods shorter than 15 years.) It’s also worth mentioning that while I have no predictions as to when idle cash would earn more than zero percent, the Fed does. And those predictions show cash earning a few percent in 2018 and 2019, instead of zero percent. For those reasons, the graph in this post is probably an underestimation of how quickly sitting and doing nothing till you can do something smart outperforms continuing to shovel cash into the S&P 500 at today’s prices. I think the reason people don’t feel secure in waiting for an opportunity to do something smart is that they’re not sure when that opportunity will appear. Maybe there will be no chance in all of 2015, 2016, 2017, 2018, 2019, 2020, or even 2021 to do something smart. If that’s true, isn’t it possible doing anything now could outperform waiting to do something smart later? If that later is sometime after 2021, couldn’t it be better to just buy the index today? Yes. I can only point to history. Pick any year in the past. Then move forward 6 years from that time. In the intervening years, was there an opportunity to do something smart? The hardest waiting period in history was during much of 1995 through 2007. Although stocks were often cheaper than they are today, the largest and best-known American stocks were almost always more expensive than they had been at any time before 1995. I think this is the real reason why investors I talk to are hesitant to hold cash. Much of their investing lifetime was spent during a time of high stock prices. There is no advantage in buying something that is unlikely to provide a good long-term return instead of holding cash till something good comes along. If we take 15 years as long term, we can say that the S&P 500 will not provide good long-term returns if bought today. You can afford to avoid 5%-a-year type long-term commitments if you have a real chance at finding 10%-a-year type long-term commitments sometime in the next 5 years. You don’t need to know exactly when or where this opportunity will come. A lot of investors who live outside the U.S. read this blog. They have an advantage. Their home countries’ stock markets might provide a 10%-a-year opportunity sometime in the next 5 years. American investors probably won’t notice such an opportunity when it appears. By buying into an index today, you are really saying you will just take whatever price Mr. Market gives you. You do this because you’re not sure he will ever give you a good price again. Or, if he does, it may come far more than 5 years in the future. Caving into Mr. Market’s mood is not something value investors think is appropriate when it comes to individual stock purchases. Yet, a lot of the people who read this blog – who are otherwise value investors – feel they have no choice but to continuously add to the actively and passively managed mutual funds in their brokerage account. The other choice is to hold cash. And the longer “long term” is for you, the more sense holding cash makes. It makes a lot of sense right now.