Category: Value Investing

April 13, 2021April 13, 2021

Stock Analysis: Brown-Forman

Introduction

Lately I’ve been investigating high quality companies so that I can be prepared during the next market selloff. Union Pacific was the first company I analyzed in this quest. Now in this post, I am analyzing Brown-Forman (I may have sampled some of their products for “research”). What I’m trying to understand is the business model, the company’s products, analyze the financials, and try to do a rough valuation. The goal is to determine if I should put Brown-Forman on my watchlist, or pass on it for a different idea.

Business Description

Brown-Forman (BF) is one of the largest American spirits companies. BF owns a portfolio of brands, but is most known for their Jack Daniels whiskey. The company is family controlled and has two share classes. The family controls most of BF-A which has all the voting power, while BF-B does not have any voting power. Brown-Forman is headquartered in Louisville, Kentucky. The company was founded in 1870, and went public in 1933, so it’s been around for a while.

For a quick history lesson, Brown-Forman’s first product was Old Forester whiskey. Their claim to fame is that Old Forester was the first whiskey to be sold in a sealed glass bottle. Early on, the company bought whiskey from other distilleries and blended them for sale. Eventually, BF purchased their own distillery plant. In the 1950’s, Brown-Forman purchased the Jack Daniels brand, which is now a huge brand. I find it interesting that Old Forester was BF’s original brand, but now Jack Daniel’s is the core of the company.

Product Line

Brown-Forman has many brands spread across the different types of liquor. The following is just the highlights of BF’s product line. Whiskey forms the core of the company, with Jack Daniels. There is also Old Forester, the premium Woodford Reserve line, and the low-end Early Times. Brown-Forman also owns the well known Canandian Mist brand, but they are in the process of selling it. Fairly recently, BF has acquired several scotch distilleries that includes the BenRiach, GlenDronach, and Glenglassaugh brands.

The company owns a California winery, Sonoma-Cutrer, as well as Korbel sparkling wine. In the vodka department BF has the Finlandia brand. As for tequila, they have the el Jimador and Herradura brands.

The Jack Daniel’s “Ready to Drink” products are like a cocktail in a can. These are geared towards younger people to introduce the Jack Daniel’s brand.

The past few years have seen different Jack Daniel’s flavors such as honey or apple being released that have boosted growth. Then you have all the various whiskey age/barrell variety combinations such as Woodford Reserve Double Oak.

Summary Statistics

The table shows various summary statistics of Brown-Forman. The company is about $30B in size, which makes it a mid-cap these days? The valuation ratios indicate that BF is pretty expensive, which we’ll get to later. Right now, the price of Brown-Forman is around $70 a share, but during the March 2020 selloff it was near $50. Return on equity is at 37%, suggesting this is a quality company. The debt levels are fairly reasonable with a D/E around 1 and Debt/EBITDA around 2. Some might say Brown-Forman could/should increase their debt load a bit since they are a quality company and interest rates are low. However I tend to prefer less debt. I’m estimating earnings growth around 4% based on historical growth. I’m not making any fancy projections, but slightly above inflation seems reasonable.

Market Capitalization	$32B
Enterprise Value	$34B
P/E	36
EV/EBIT	33
52 Week Price	$52-82
ROE	37%
D/E	1.07
Debt/EBITDA	1.98
Earnings Growth	~4%

Financials

Here I summarize Brown-Forman’s financials based on their income statement, balance sheet, and cash flow statement. I believe that taking a look at a company’s financials is key before making an investment.

Income Statement

In 2020 Brown-Forman produced revenue of $3.36 billion. It should be noted that their fiscal year ends in April, so these financials are only showing the beginning of the pandemic. Looking at the profit margins, we see a gross margin at 61%, operating margin of 31%, and a net margin of 27%. These are definitely attractive margins, which further supports that BF is a high quality company.

The income statement is summarized in the pie chart below where the entire pie is Brown-Forman’s revenue. It can be seen that the cost of goods sold and SG&A are the main expenses. Income tax, interest, and depreciation make up a pretty small slice of expenses. In summary, the income statement looks pretty straightforward with a healthy net income.

Assets

Next, let’s take a look at Brown-Forman’s balance sheet. The assets are broken down in the chart below (some smaller line items are omitted for clarity). The first thing to note is the $1.1B in cash, making up about 17% of their assets. Inventory is recorded at $1.72B. It’s a bit funny thinking about $1.7 billion in liquor sitting around. The rest of the assets appear reasonable with property and plant taking up a decent chunk. The amount of intangibles is expected from a company with strong brands. Finally, there is some goodwill, reflecting the acquisitions BF has made. The high cash balance would seem to support a strong balance sheet, and the rest of the assets are as you would expect.

Liabilities

For the liabilities side of Brown-Forman’s balance sheet, the main line item is the $2.3B in long term debt. This amount of debt is fine since there is $1.1B in cash available that could wipe out most of it. Short term debt is at $312M, which most of it was raised in 2020. The other thing to note from Brown-Forman’s liabilities is the pension liability, which most companies these days don’t provide a pension. Like the assets, there is nothing out of the ordinary or any red flags with BF’s liabilities.

Cash Flow

The table belows shows a simplified view of Brown-Forman’s cash flow statement. Looking at 2019 and 2020, BF’s operating cash flow is between $700-800M. In both years, capex is about the same being around $120M. It would be useful to find out if this is maintenance capex, or used to build new PP&E that could provide growth. There were no acquisitions in 2019, but a small one in 2020.

Cash from financing first consists of raising $178M of short term debt in 2020. Buybacks were performed in 2019 to the tune of $207M, but none were during 2020. Brown-Forman seems to do sporadic buybacks so I’m not sure if the lack of buybacks in 2020 is COVID related, or just coincidence. Finally, in both years the dividend is a bit north of $300, with BF maintaining their record of increasing their dividend annually. Brown-Forman’s cash flow statement is pretty straightforward. The cash flow statement can provide good insights on the company’s capital allocation, so the simpler the better.

($M)	2020	2019
Cash From Operations	724	800
Capex	(113)	(119)
Acquisition	(22)	0
Cash From Investing	(141)	(119)
Short Term Debt	178	71
Buyback	(1)	(207)
Dividend	(325)	(310)
Cash From Financing	(191)	(599)
Change in Cash	368	68

Capital Allocation

A company’s capital allocation strategy is key to having strong long term performance. Here I will try to summarize Brown-Forman’s capital allocation based on my light research. In 2016, BF sold the popular Southern Comfort brand. The company is currently in the process of selling Canadian Mist. I find it interesting that BF is selling these well known brands, but presumably they are selling them for an attractive price. On the other hand, Brown-Forman has been acquiring assets such as the scotch brands, and the recent acquisition of Ford’s gin. It appears BF has a thought out strategy to reorient their portfolio of brands.

The other key area of capital allocation is return profits back to shareholders. As mentioned above, BF repurchased $207M shares in 2019. Oddly, BF did not repurchase any shares in 2018, but did buyback $571M in 2017. The large 2017 repurchase may be due to the sale of Southern Comfort in 2016. I’m not sure if Brown-Forman is only buying back their share at what they think are attractive prices, or if there is another reason for these sporadic purchases.

On the dividend front, Brown-Forman is a dividend aristocrat, consistently paying a dividend for 76 years, and raising the dividend for 37 straight years. While sometimes it can be suboptimal to pay a dividend, Brown-Forman is a high quality, low growing company, so it seems reasonable. The dividend payout ratio is 37%, which leaves the company with plenty of retained earnings to reinvest.

Brown-Forman Valuation

Oftentimes when I value a company, I use a basic discounted cash flow analysis to get a rough fair value. Looking at Brown-Forman’s free cash flow the past few years, a reasonable figure to use in the DCF is about $700M. For the growth rate, I’m using 4% based on BF’s past growth. This growth rate is slightly above inflation, which seems appropriate. Typically, I would use a 10% discount rate, but doing so for Brown-Forman would produce a much lower fair value than what the stock is trading at. In this case, I reverse engineered what discount rate the market is implying. The discount rate I came up with is 4.5%. This is a very low discount rate. However BF is a quality stock, so it makes sense that the market would be discounting it slightly above the risk free rate.

Putting all these variables together, we get a fair value around $65 which is near what the stock is trading at today. The 4.5% discount rate implies that if you bought it today, you would expect to receive a 4.5% return by holding for the long term. This rate of return is far lower than I would be trying to achieve.

But you have to consider that I’m competing against pension funds, endowments, and other institutional investors that are willing to accept lower returns. These funds need a replacement for bonds since interest rates are so low. Therefore, they look at quality companies as an alternative, bidding up the valuation. A quality company that is slightly growing, paying a little dividend, and doing some share buybacks is a lot more attractive than a bond yielding 2%. So all that to say, Brown-Forman is not currently attractive for me, but I understand why it is at this valuation.

Buying the Dip

While Brown-Forman does not provide the most attractive return at its current price, occasionally the stock sells off like March 2020. During that period, BF dropped to about $50 a share. If you were lucky enough to buy it at this low price, you would experience about a 40% gain as the stock reverted back to $70. A 40% gain, then compounding at 4.5% into the future, should produce a decent internal rate of return if held for 5 years or so. Obviously this only works if the stock reverts back to its prior valuation. My conclusion is that if I were to buy some Brown-Forman, I would wait until there was a panic and Mr. Market could offer me a once in ~7 year deal.

Brown-Forman During Inflation

Another aspect I want to consider is how Brown-Forman would perform during an inflationary period. On one hand, BF’s multiple could compress if interest rates go from low to high(er). Since Brown-Forman is so richly valued because of low interest rates, if rates increased then investors would have to increase their discount rates. It would seem reasonable that the share price of BF would take a hit during this period.

On the other hand, Brown-Forman should be able to easily increase the price of its products during an inflationary period. While i need to do more research, I would think that people buying liquor are pretty price insensitive, especially when all brands would be raising prices with inflation. Another point is that BF does not have heavy capex needs. Companies that have to constantly overhaul their factories would be forced to pay ever increasing prices for equipment during inflation.

Based on this, it is possible that Brown-Forman’s business would do ok during an inflationary environment, but the stock price could languish. Perhaps if this scenario played out, it would be a good opportunity to dollar cost average into the company.

Business Risks

While Brown-Forman is a quality company, there are still a few risks worth further researching. One unique problem with liquor is that some of the products need to be aged for 5+ years. This means you have to predict what demand will be like far into the future, which is hard. Over the past 10 years, whiskey has been trendy. If the trend passes, then demand could be much lower in the future.

The Jack Daniel’s brand is vital to Brown-Forman. If somehow, the Jack Daniel’s brand fell from grace, then BF would be in some hard times.

In 2018 the EU enacted tariffs against Jack Daniel’s in retaliation to the Trump administration’s tariffs on steel. I guess they targeted Jack Daniel’s since it is a quintessential American brand. Apparently the EU tariffs are supposed to double in June 2021 if the trade relations do not approve.

Government regulation could negatively impact Brown-Forman. Alcohol has tricky advertising regulations across different countries. Governments could also impose gaudier warnings labels, which could affect sales.

Finally, I have anecdotally heard that cannabis could take market share from liquor companies. I don’t know anything about the cannabis industry, but this threat seems somewhat reasonable. On the flip side, I guess nothing stops Brown-Forman from making a cannabis infused tequila or something.

Conclusion

After analyzing Brown-Forman, I can definitely say that it is a quality company. I would love to own this business, but the valuation is an issue. The best hope to make the type of return that I seek is to wait for a market panic and hope that BF’s price reverts back to normal levels. Given this reality, I am curious if any of the other quality companies in my pipeline will prove to be more attractive than Brown-Forman.

For more value investing content check out:

How Berkshire Acquired National Indemnity

February 13, 2021February 13, 2021

Stock Analysis: Union Pacific

What Drew Me to Railroads

Lately I have been wanting to analyze quality companies so that when they become cheap during the market sell off, I can make a quick buy decision. Railroads were at the top of my list of a business that I wanted to do a deep dive on. I decided to analyze the financials of Union Pacific Railroad (UNP) because they are the largest railroad in the US.

There are several reasons why I’m interested in railroads. First, they’ve been around for 200 years, so they haven’t gone obsolete yet. Railroads enjoy network effects and barriers to entry. It would be nearly impossible to build all new rail lines. Locomotives are also the most efficient way to transport goods across land. Because of these factors, I believe railroads have one of the strongest moats out there.

Qualitative factors aren’t the only reasons to invest in a company, you need to take a look at their financials. When something jumps out at me in UNPs financials, I tried to dig deeper to find an explanation. I documented my train of thought in this post, basically asking questions and trying to draw conclusions. Also, I tried to include a good amount of charts to help visualize trends in the financial statements. In the end, I feel like I have a much clearer understanding of Union Pacific’s business.

Why is FCF CAGR Higher Than Revenue?

One of the first things I take a look at when analyzing a company is the growth rate of revenue, operating income, operating cash flow, FCF, etc. The chart below shows UNP’s 10 year revenue, cash flow from operations, and free cash flow. Over the past ten years, revenue has grown at a CAGR of 1.6%. Revenue grew at a steady pace from 2010 to 2014. At first I wondered if it was due to bouncing back from the 2008 recession. However, revenue was $18B in 2008, fell to $13.3B in 2009, then was back to $17B in 2010.

The revenue growth is probably due to the shale energy boom that was going on back then. A decent chunk of Union Pacific’s revenues comes from transporting frac sand, and the resulting crude, natural gas, and finished products. When oil prices plummeted in 2015, domestic oil production was curtailed. The shale oil bust helps explain UNP’s decline in revenues since 2014.

Despite the low revenue growth, operating cash flow has grown by 3.8% and FCF has grown by 7.9%. The fact that these cash flows have outpaced revenue growth warrants some more investigation. Over a long time horizon, it doesn’t make economic sense that profits would grow faster than the revenue the business is bringing in. Union Pacific’s growth of cash flow from operations can be explained by the improvement of the operating ratio, which I will touch on in a bit.

Since the free cash flow is the operating cash flow, minus capex, it will grow in tandem with the operating cash flow. Additionally, since the free cash flow has outpaced operating cash flow, this implies that capex has proportionally decreased over the course of the past ten years. Looking at the cash flow statement, capex has been about flat for the past 5 years.

Operating Ratio

One of the key metrics used to judge the performance of a railroad is its operating ratio. The operating ratio is simply the operating expenses divided by the revenue. A lower ratio implies the railroad is more efficient, so it’s a never ending quest to lower the ratio.

The chart below shows the operating ratio from 2006-2020. The 80% operating ratio in 2006 seems pretty inefficient compared to the 60% of recent years. This large improvement in efficiency is a large factor of how Union Pacific’s cash flow from operations has grown so fast. Revenue has grown at a mediocre rate, but expenses have dramatically fallen.

Honing in on the next chart, we see individually UNP’s revenue and expenses. Something I noticed was that revenue started growing faster than expenses around 2009 until 2014. Since then revenue and expenses have more or less moved in tandem.

As someone who is potentially interested in owning railroads, I would hope that the operating ratio continues to decline. Union Pacific has declared that their goal is to reach an unheard of 55% ratio. This is a worthy goal, and there are probably efficiencies to be gained from automation and technology. UNP began the Precision Railroading concept in 2018, which should continue to reduce expenses. However, an investor should be cognizant of the possibility that there are diminishing returns in efficiency, or operating income deteriorates somehow (wages, fuel prices increase, more capex?). As an amateur railroad analyst, I have no idea how likely it would be that expenses increase. A stagnant, or increasing operating ratio would impact other areas of UNP’s business, which I will touch on later.

Return on Equity

Here I want to briefly look at UNP’s return on equity. In the chart you can see that ROE steadily went from around 10% in 2006 to about 20% in 2016. Then in 2017, Union Pacific’s ROE spiked to 43%, then fell closer to 30% the past couple of years. These large jumps are due to the railroads change in equity due to a large increase in net income in 2017. The large net income increase was due to the tax cuts. UNP paid about $3 billion in taxes for 2016, but was refunded about $3 billion in 2017. In general, UNP’s upward trend in ROE is from increasing net income, as well as decreasing shareholder equity (which I’ll touch on in a minute).

Why Has D/E Increased Lately?

A company’s debt-to-equity ratio is one of the key metrics I look at to gauge the strength of the balance sheet. Typically I would want a company to have a D/E below 1.0, unless they have very stable earnings. A high debt-to-equity value means the business has a large debt burden, which could mortally wound them during a rough patch in the economy. Seeing the spike in the D/E for UNP required me to dig in further.

UNP Debt

From 2005 to 2014, UNP’s D/E has been around a safe 0.5. More recently, the debt-to-equity ratio has ramped up, ending 2020 at 1.5. These values are fairly high, and the sharp trend upward is a bit concerning. Starting in 2012, UNP has been ramping up debt issuance. Over the last 5 years, they have issued an average of $2.8 billion in debt per year.

UNP Equity

On the equity side, we have seen earlier that shareholders equity has steadily decreased. When the denominator (debt) is increasing and the numerator (equity) is decreasing, it makes sense that the D/E has tripled. Digging into the equity a little more, the two key line items are retained earnings and treasury stock. Retained earnings are steadily increasing, going from $17.15B in 2010 to $51.3B in 2020. This is good because it means the company is consistently profitable.

Treasury stock is the placeholder value for the cumulative dollar amount of share the company has bought back. These share buybacks are considered negative equity, so they count against the shareholder equity value. Treasury stock has gone from -$4B in 2010, to -$40.4B in 2020. The growth in treasury stock, aka their share buybacks, is what is greatly decreasing Union Pacific’s equity. So the key takeaway here is the UNP is increasing debt, while also reducing their equity through share buybacks. This is causing the dramatic rise in D/E. The reduction in equity also explains the recent elevated ROE.

Shareholder Return

As we saw by analyzing the ROE and D/E, UNP is reducing their equity through share buybacks. This is usually beneficial to shareholders, so we can calculate shareholder return. Shareholder return is calculated by adding the dividends paid and the dollar amount of share buybacks. You can then convert this to a per share basis, and figure out your yield based on the price paid for the stock.

These values can be found on the cash flow statement. Here we find that in 2020, UNP paid out $2.63B in dividends while spending $3.71B buying back shares, for a total shareholder return of $6.34B. As a note in 2020 UNP reduced their buybacks by about $1B compared to the previous year. On a per share basis, shareholder return was $9.34 a share. Looking at the past 5 years, we can round a bit and say that UNP has spent $2B in dividends and $5B in buying back shares.

Analyzing the cash flow statement further, we can see that the 2020 free-cash flow per share is $8.26. This is an interesting observation because it means UNP is returning more cash to shareholders, than what the operating business is generating. How is this done? UNP is able to do this by constantly issuing debt. Luckily this is cheap debt. However it would seem reasonable that UNP can not return more cash to shareholders than the business produces forever.

Debt Limits

How long can Union Pacific continue to reward shareholders by issuing debt? Well that is tough to answer, but probably comes down to the risk tolerance of management and the shareholders, UNP’s debt covenants, interest rate levels, and the company’s earnings power. As I mentioned earlier, typically I prefer a D/E ratio below 1.0, however the management may feel comfortable at a higher level since interest rates are low. If that is the case, I would have to decide if I think the stock could weather a recession with that debt load.

I did a little digging into Union Pacific’s debt covenants. At one point in their 10-K, UNP mentions they can not surpass a Debt/EBITDA ratio of 3.5. In their most recent earnings presentation, UNP stated their Debt/EBITDA ratio increased from 2.5 in 2019 to 2.9 in 2020. I’m not sure what a reasonable Debt/EBITDA ratio is for a railroad, but it seems 3.5 is getting into the danger zone. We already observed that debt has been increasing at about $3-5B a year. On the EBITDA side, it has not really increased in the last several years. If this trend continues, then it seems reasonable that UNP will hit their Debt/EBITDA limit of 3.5 within the next few years.

Union Pacific’s Future Shareholder Return

Going forward, it looks like Union Pacific has to increase their earning power to keep the share buyback train going, or eventually slow down the debt issuance and pay down their current debts. The increasing earnings power plan could be a realistic outcome. That is where our friend the operating ratio comes back into play. If UNP can go from an operating ratio of 60% down to 55%, that will provide more EBITDA to keep them under their debt covenant. My naive guess is that there are plenty of efficiency gains to be had from technology and automation. The spoiler would be if expenses increased for some reason, such as fuel cost or labor cost.

If Union Pacific’s earnings power does not materially increase, then eventually they will hit a point where they need to deleverage. The least painful scenario would be to not increase share buybacks/shareholder return every year. Then as earnings grow, the excess can be used to pay down the debt. The more painful situation would be UNP reducing its shareholder return in order to reduce its debt level. If investors are used to getting a relatively high return through dividends and buybacks, they will most likely react negatively if those are dialed back.

What Management is Saying

In Union Pacific’s Q3 earnings call, the management indicated they wanted to reduce debt by $800M in Q4 2020. Looking at their Q4 cash flow statement, $1.22B of debt was paid down in the fourth quarter. Management mentioned in their Q4 earnings call that they would dial back up their share buy backs in 2021 since they let their foot off the gas in 2020. It seems to me like there is some mixed messaging from the management about recently wanting to pay down debt, while at the same time wanting to ramp up buybacks in 2021.

Wrapping Things Up

After digging into Union Pacific’s financials, it leaves me a bit torn. Qualitatively, UNP is a strong company with a wide moat. Railroads provide efficient transportation, and it is nearly impossible to build competing networks. However, to me it seems like this quality operating business is wrapped in a layer of financial engineering. UNP is able to take out cheap debt, then pay more in dividends and buybacks than the cash the business generates. This seems to be a common occurrence with blue-chip companies in this era of cheap debt.

This strategy has worked out very well for the last 5+ years. I wish I would have bought some stock back then. I am worried that the party has to end eventually. Maybe UNP has a few years ahead before they have to reel back the debt. In the meantime, the stock price could continue to perform very well. However, if you’re looking to buy UNP and hold indefinitely, you may have to endure a little rough patch whenever they deleverage. I wanted to believe in Union Pacific, but I think I’ll watch on the sidelines for a bit to see how things play out.

For more value investing content check out:

How Berkshire Acquired National Indemnity

January 9, 2021January 9, 2021

2020 Portfolio Update

Performance Overview

For Q4 2020, the portfolio is up 13.21% and finished the year up 23.47%. The Q4 starting balance was $96,383.61, and finished the quarter at $113,027.88. Contributions to the portfolio during the quarter amount to $3,656.

No stocks were bought or sold during this quarter. During October and November I owned some SPY puts as tail hedges, but I let that position run off in December.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 66.7% of the portfolio is in stocks, while 33.3% is in cash and safe haven assets. I would prefer to deploy more of the cash to undervalued stocks, but I am remaining cautious despite the market ripping higher towards the end of the year.

During the quarter I received $427.04 total in dividends, which is broken down in the table below.

Ticker	Quarterly Dividend
FF	8.28
BBSI	10.50
FRO	81.50
STNG	6.80
FE	48.75
DHT	43.00
RELL	24.30
FRD	7.06
RSKIA	88.62
EMR	42.93
COF	5.50
SPG	59.80
Total	427.04

My Thoughts

2020 in Review

Going into 2020, my portfolio was a mess. Once upon a time, I was going for a multi-asset strategy. My portfolio consisted of value stocks, emerging markets, commodities, precious metals, money market, and tail hedge puts. In mid-2019 I sold my value stocks to buy a house, which created a gaping hole in my portfolio that remained early in 2020. As the market started to react to COVID, I quickly tried to get my portfolio in order. The primary focus was to reorient my portfolio to mostly focus on value stocks, and taking advantage of the market selloff to buy some quality companies at a discount.

One of the key factors that shaped this year’s performance was holding about $500 in SPY put options. The idea is that they would provide a buffer so that the portfolio could break even even if the market dropped by 20%. In late February these options were doing their job, so I sold them at a value of about $9,000. In hindsight I should have held onto them into March, but I can’t complain. The rest of the portfolio was primarily cash, plus stocks from my current 401k, and some precious metals.

The proceeds of this hedging was used to buy the first batch of quality companies. In March, I bought Capital One, Emerson Electric, and Simon Property Group. To my surprise, the market panic didn’t last long, so the deals quickly dried up.

During April and May I jumped onto the oil tanker trade. While the thesis played out, these companies made a ton of money, the stock returns have been abysmal. I probably bought these stocks at the peak, but that’s the way it goes.

The summer months saw me dip my toe into buying deep value stocks. These are stocks that traded at less than 5 times enterprise value over EBIT. Most of the companies I bought were microcaps, which have a market capitalization of less than $300 million. I didn’t know it at the time, but my timing in buying these stocks was great. The deep value universe got slaughtered during the March selloff, down around 50%. During the summer these stocks turned the corner and rallied all year so that they ended the year down only 7%.

In August I bought some First Energy hoping their bribery scandal is overblown. Finally during the fall I started up the tail hedging strategy again in case of worsening COVID, no stimulus getting passed, and election drama. All of those things happened, but the market ripped higher on vaccine news, causing me a small loss on my SPY puts.

It felt like there was a lot of action in 2020, however I also tried to be measured in my capital allocation. Most of the year I carried a large cash balance, waiting for another chance to buy some undervalued stocks. In hindsight I should have gone all in, but I’d rather act conservatively and survive as an investor.

Luck vs Skill

While I am proud of my performance this year, I am trying to reflect on my decision making. Many of my decisions, and outcomes, were the result of some part skill. However, I am aware I had some lucky tailwinds as well. Since I can be jealous sometimes, I also look at other investors and wonder how much of their results were based on luck or skill.

The way I see it, there is a spectrum of complete luck (roulette wheel) to skill (chess), and most things fall in the middle. Everything in investing probably has some degree of luck involved. But there is a difference between making sound, well thought out decisions, and speculating without even being able to provide a thesis besides “stocks only go up” or “it’s different this time”. It is probably impossible to quantify luck vs skill in investing, but I’m going to ramble on a bit anyways.

I’m not sure if it was luck or skill that I was hedged in February. The outcome of this hedging dramatically impacted this year’s performance.

I chalked it up more towards skill that I was buying in March when everyone was panic selling. On the flip side, if Great Depression 2.0 happened, I’d probably be complaining that I pulled the trigger too early.

Perhaps I got on board with the oil tanker trade too late, my timing being bad luck, or maybe it was a lack of skill.

The deep value universe was turning the corner right when I was buying in the summer. I’ll take this lucky timing since Paul Mueller Co, Barrett Business Solutions, Friedman Industries, and Spark Components have really helped me out.

During the summer, Emerson was up 50%. It was tempting to sell it and get those quick gains. However I am trying to be more disciplined and hold my stocks longer, which worked out because now Emerson is up nearly 100%.

I think you can see there are arguments for luck and skill in many of my decisions. As I look around, I wonder about other investors (or speculators). Is betting on government stimulus, accommodative Federal Reserve, record vaccine development luck or skill? Is it luck or skill to buy cruise ships, airlines, Zoom, NIO and the like? Good for the people who made massive gains this year, but it would probably be wise to reflect on your decision making.

One issue with the stock market is that many people focus on the short term. This short termism makes it easy to think the market is just a casino. Instead, I view owning stocks as owning a slice of a business. Holding a stock for the long term reduces the role of luck since the returns are more driven by business economics. I believe having a long time horizon, and taking advantage of behavioral psychology, allows an investor to make their own luck.

Rationality and Wealth

It seemed like a lot of people lost their minds in 2020. I wish more people would think like Charlie Munger when he says “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do”. Too many people fill their minds with toxic information, surround themselves with toxic people, and allow their cognitive biases to be exploited. An idea that I am developing is that you can’t build wealth (whether that is financial, or in mind/body/spirit) without rational thought. By rational, I mean thought based on first principles, facts, logic, reason, and removing your biases from the equation. You can get rich being irrational, but I think you will have a hard time building long term wealth without being rational.

Discretionary Summary

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
COF	63.25	3,478.75	5,436.75	56.28%
EMR	41.00	3,485.00	6,831.45	96.02%
SPG	74.50	3,427.00	3,922.88	14.47%
FE	28.00	3,500.00	3,826.25	9.32%

There has not been a lot of news to report with these stocks. Simon Property Group announced the acquisition of Taubman Centers (TCO), which should close early in 2021. This deal was supposed to happen early in 2020, but it was called off due to COVID19. At least now SPG will pay $43 a share for Taubman instead of the original $52.50.

FirstEnergy drama has deepened this quarter with the firing of their CEO and a couple other executives for misconduct. The company hasn’t disclosed yet what this misconduct was. While FE is looking a little more guilty at the moment than when I made my purchase, the stock has not sold off. I will continue to monitor this company, hopefully the bad news is overblown and the stock will revert back to its pre-scandal levels once the investigation progresses.

Tanker Stocks

Tankers have continued to be disappointing, despite their great profitability this year. Oil tanker spot rates went from a massive peak to a massive trough. Luckily most these companies have used their abnormal profits to shore up their balance sheet. Now that the tankers have to pay less interest on their debt, the break even spot rate is much lower. Recently steel prices have had a large increase, which hopefully means people will be scraping their old tankers soon. One dollar increase in steel prices increases the scrap value of a VLCC by $40k. Plus, less supply of tankers equals higher spot rates to ship the oil.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
DHT	8.17	1,755.90	1,124.45	-35.07%
FRO	10.66	1,738.29	1,013.86	-41.67%
STNG	26.63	1,742.67	760.92	-56.34%
TNK	23.86	1,765.88	814.74	-53.86%

Deep Value

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
BBSI	50.50	1,767.50	2,387.35	35.07%
FF	13.00	1,794.00	1,752.60	-2.31%
FRD	5.10	1,800.10	2,421.58	34.52%
HXL	36.80	1,803.20	2,376.01	31.77%
MUEL	26.00	1,768.00	2,257.60	27.69%
RELL	4.45	1,802.25	1,907.55	5.84%
RSKIA	8.25	1,740.75	2,126.88	22.18%
SPRS	1.31	1,819.30	3,074.70	69.00%

401k and Precious Metals

	12/31/19	12/31/20	YTD Gain (Loss)	YTD Contributions
Precious Metals	$7,861.00	$9,964.00	30.52%
401k	$12,871.20	$32,252.43	14.59%	$14,108.00

Tail Hedging

During October and November I implemented the hedging strategy that I had on early in the year. My initial position in October was buying $495 worth of SPY puts. In November, I sold the first batch of puts for $50, and bought another batch for $487. This second batch was sold in December for $175, and I haven’t bought any more since then. The net loss for this hedging was $757, or about 0.67% of the portfolio.

Books I’m Reading

The main book I read this quarter was The Philosophy Book: Big Ideas Simply Explained. Prior to this book, the only other philosophy work I have read was the classic Stoicism work “Meditations” by Marcus Aurelius. Whenever I would venture to Wikipedia to read about a philosophy concept, I would get bogged down by all the jargon. This book finally built the foundation for me to understand the high points of philosophy. In fact, I wish I would have read something like this a long time ago because I found the material extremely interesting. Not only does reading about philosophy feed my natural curiosity, but it applies to investing as well (maybe not the weird metaphysical concepts). Understanding why people do the things they do is very important to navigating the investment world. Maybe soon I’ll dig into a specific philosophical work like “On Liberty” by John Stuart Mills…

Cable Cowboy: John Malone and the Rise of the Modern Cable Business is a book I received for Christmas and read within a few days. This book is about John Malone, and his career building TCI and Liberty Media. I was not familiar with Malone, but I knew he was renowned as a great capital allocator so I was looking forward to learning more about him. Malone took over as CEO of TCI in the early 70’s, and transformed the nearly bankrupt company to a cable giant. Once he sold off TCI, Malone has focused on Liberty Media, which he still controls today. Malone’s capital allocation is different from Buffett’s, he utilized debt and focused on cash flows over GAAP earnings. Reading this book makes me want to dig more into cable and media companies in the future.

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How Berkshire Acquired National Indemnity

December 19, 2020December 19, 2020

How Berkshire Acquired National Indemnity

This post contains affiliate links. If you use these links to buy something I may earn a commission. Thanks for your support.

The book “Capital Allocation: The Financials of a New England Textile Mil l” is a must read for anyone interested in the history of Berkshire Hathaway. One of the first big moves Buffett did once he took control of Berkshire was to acquire the property-casualty insurer National Indemnity. In this post I wanted to go back and review the details of this acquisition, trying to put things into context. Some of the things I was curious about were “how big of an acquisition was this relative to Berkshire?” and “how did Buffett pay for it?”. But first, we must travel back to the mid 1960’s…

Berkshire in 1967

Before we get into the acquisition of National Indemnity, let’s get a picture of what Berkshire looked like in the mid/late 60’s. When Buffett took control of Berkshire in 1966, it was a struggling, capital intensive textile mill. One of Buffett’s first tasks was to optimize the company’s overhead expenses, capital expenditures, and working capital needs. This freed up cash that could be put to better use, like buying marketable securities.

In 1966, the textile business made about $2.6 million in net income, while the investment portfolio produced about $166k in realized gains. The free cash flow for Berkshire in 1966 was about $5 million. For 1967, the textile business actually lost money, with a loss of about $1.3 million. The newly acquired insurance operations and the investment portfolio bailed out the company by allowing Berkshire to have a total net income of $1.1 million. Revenue for the textile operations fell by 24% from 1962 to 1969. Clearly the industry was challenged, so diversifying Berkshires income stream was a wise move by Buffett.

Assets

Berkshire’s investment portfolio ending in 1966 had a market value of $5.4 million, with approximately the same cost basis. A majority of the portfolio, 87%, was in bonds. The high ratio of bonds was probably due to Buffett holding some capital in reserve for an acquisition. Following the acquisition of National Indemnity, Berkshire’s investment portfolio was booked at a cost of $3.8 million. This portfolio had a market value of $6.8 million, a nifty 77.5% gain in one year. The investments were always recorded on the books at cost instead of market value. Berkshire reported a total of $38 million in assets in 1967. This figure would have increased by 7.9% if the securities were booked to market.

Valuation

During this period, Berkshire often traded below book value, getting down to 57% of book value in 1967. The market cap for Berkshire ranged between $16.8 million, and $20.9 million ($167 adjusted for inflation) in the year that it purchased National Indemnity. Next we will take a look at National Indemnity’s business, and see how a $20 million company acquired the insurer for $8.6 million.

National Indemnity

National Indemnity was a property and casualty insurer founded by Jack Ringwalt in 1940. Another insurance company, National Fire & Marine Insurance Company was an affiliate to National Indemnity. Buffett purchased 99% of these two companies in March of 1967 for $8.6 million. For comparison, this equates to $67 million in 2020 dollars.

NI’s Income

During this time, Berkshire was a capital intensive industrial company, which meant it had very low returns on equity. Buffett realized that a smart strategy would be to redeploy cash from the textile business into a business with a higher ROE that didn’t constantly require upgrading machinery. National Indemnity had a decent ROE that averaged about 11%. The insurer was also growing, having grown premiums at 21% and net income by 15% for the last decade. Average net income for NI was $437,000, while 1966 was an outlier with $1.4 million in profits.

Float

When insurance companies receive premiums, they hold it as a reserve called float. This float can be invested to generate extra income for the company, which is another feature that attracted Buffett to the insurance business. Sometimes insurance companies will write policies that are underpriced, meaning that they end up paying out more for damages than what they received in premiums (they would also hope their investment returns bail them out in the scenario). This would indicate that the float has a negative cost. On the flip side, if the insurer wrote good policies, they would make money on the premiums. This effectively means the float will have no cost. The cost of float generated by National Indemnity was cost free for 6 of the last 10 years prior to the acquisition.

The value of the NI’s float at the time of Berkshire’s purchase was about $17.5 million. The investment portfolio of float was mostly made up of bonds. Additionally the company had a stock portfolio that was about the same size as the shareholders equity. From Buffett’s perspective, he is practically buying a portfolio of stocks and bonds that he could surely optimize for better returns. Just by increasing the investment income on the float by 1% would generate an additional $175k in net income for Berkshire.

While Buffett went on to buy other insurers, namely Geico, National Indemnity is where it all started. To put into context Berkshire’s achievement, in 1967 National Indemnity wrote $12.7 million in premiums. State Farm was the largest property-casualty insurer of the era, with premiums totaling $800 million. Fast forward to 2019, and State Farm is still number one in premiums. However Berkshire is right behind them in second place.

The Purchase

So how did Berkshire acquire a company that was nearly half its size? To fund the purchase, Buffett pulled capital out of the textile business, issued some long term debt, and liquidated some of the investment portfolio. For the textile operations, Buffett optimized the accounts receivables, accounts payable, inventory, and PP&E in order to pull out $4.6 million. Berkshire then issued $2.6 million in 20 year debt at 7.5% interest. Finally, the marketable securities portfolio was reduced by $1.6 million. To me, this is a little interesting that Buffett wasn’t afraid to issue a little debt. He is usually says he is against debt. Additionally, the way Warren pulled out that much capital from the textiles goes to show that he deeply understands the operations of a business.

The book Capital Allocation also discusses a unique way to think of this transaction. When purchasing NI, Buffett was getting a company with a tangible net worth $6.7 million. These securities could then be deployed to marketable securities. Now Buffett was already holding a portfolio of marketable securities of around the same size. So in a sense, Warren is trading his portfolio for National Indemnities portfolio, plus chipping in an extra $1.9 million to get to the full purchase price. Using this mental accounting, National Indemnity operating business was bought for this $1.9 million premium. If we compare the subsequent profit generated by NI to this “purchase price”, we see some absolutely astonishing returns.

Conclusion

Capital Allocation is probably my new favorite business history book since I love nerding out over early Berkshire’s financials. This book shed light on one of the seminal moments in Berkshire’s history. Buffett transitioned the company from a capital intensive textile mill to the giant it is today. The acquisition of National Indemnity set the stage for Berkshire to grow from a $20 million textile business that no one cared about, to the $500 billion behemoth it is now.

For more value investing content check out:

Q3 2020 Portfolio Update

November 20, 2020December 15, 2020

Book Review: Buffettology

This post contains affiliate links. If you use these links to buy something I may earn a commission. Thanks for your support.

Woo! My first book review. A while back, I stopped in my local used book store and saw that they had the 1999 classic: Buffettology. This book was a quick and enjoyable read, much like the Warren Buffett and the Interpretation of Financial Statements from the same authors. As a hardcore Buffett fan, most of the concepts in this book were not new for me. However, I believe this book provides an excellent foundation for new investors or those who have only participated in the speculative side of the market. While the book has a lot of good information, in this Buffettology book review I wanted to highlight my two big takeaways: thinking about stocks as a business owner and owning quality businesses.

Business Mindset

One of the key takeaways from Buffettology is that stocks are a fractional share of a business. When you own a stock, you are a partial owner of that enterprise. For example, if a company had 1 million shares outstanding, and you owned 10,000 shares, then you would own 1% of that company.

Realizing that you are a business owner when you own stock helps create a long term mindset. This is opposed to the short term, constant buying and selling commonly associated with the stock market. With a business owner mindset, would you rather own a great business that compounds at 10% a year for decades or sell a stock after six months to make a 20% profit quickly?

Another aspect of thinking of stock as owning a business is that the share price by itself is meaningless. A stock trading at $1,500 a share may be cheap, while a stock trading at $2 a share could be expensive. That is because stock prices are more than just some numbers that fluctuate on a screen. A stock price is telling you what the market currently thinks the business is worth, but that is only useful when you compare it to the profits generated by the company. The $1,500 a share company could have profits of $500 a year, while the $2 company might only generate a penny of earnings. The $2 company is not a bargain.

Since looking at giant corporations can be confusing, I like to think about this concept using a simple example. Imagine your friend is trying to sell you their ice cream stand. Probably before you even looked at the selling price, you would look at its financials. Is this ice cream stand profitable, by how much, and are the profits stable? If the ice cream stand makes $10,000 a year in profit, what would be a reasonable price to pay?

Buffettology explains that the price you pay for a business determines your rate of return. Let’s say you paid $100,000 for this ice cream stand, which would generate a 10% return. Not bad. Alternatively, if you paid $1 million for this ice cream stand because they have this new flavor that is the best thing since Rocky Road, well, you would likely earn about 1% a year. When you can see how much earnings the business has, you can determine the price you are willing to pay for that stock by determining your desired rate of return (there is more to business valuation than this, but it’s a good basic concept).

Thinking about stocks as partial ownership in a business is a key aspect of my investing philosophy. One of my favorite Buffett quotes is, “Investing is most intelligent when it is most business like.” I think for someone new to investing, or someone who trades the market in a speculative manner, Buffettology does a good job introducing investing from a business owner perspective.

Quality Companies

Now that Buffettology has laid down the foundation for how Warren Buffett thinks about stocks, the book spends some time defining what a good business is. Most businesses are mediocre, or just plain bad. Searching for quality companies is like a process of elimination. It can make your life easier because you filter out all the mediocre businesses in order to focus on researching the gems.

The book introduces the concept of “consumer monopolies”. These are businesses that have a popular brand name, patents, or secret formula. Think of companies like Coke-Cola or Nike that have products that are “must have” for some people. Another example was when newspapers existed, a city with a single newspaper had a monopoly on all newspaper ad revenue.

A thought experiment described in Buffettology used to test if a company has a consumer monopoly is to think about what it would take to create a better competitor from scratch. If you had access to billions of dollars and top managers, could you overtake Coke? Probably not.

There are many benefits to consumer monopolies that attract Buffett’s interest. These businesses are typically very profitable. Even better, these profits are consistently increasing. Poor quality businesses have erratic earnings that make it difficult to predict your rate of return. Consumer monopolies are often low tech, and often have products that are easy to make. This differs from companies that must constantly invest in R&D or build complex factories to stay competitive. Finally, consumer monopolies typically have low debt, since they’re business grows just fine without it. Low debt is a major factor I look at when analyzing companies. It’s hard for a company to go bankrupt with no debt.

Warren Buffett often talks about business having a “wide moat” to defend itself from competitors. These moats are the consumer monopolies as described in Buffettology. For my discretionary stock picks like Capital One, or Emerson Electric, I am definitely thinking about whether these are quality companies with consumer monopoly.

Conclusion

Buffettology is now my go-to book recommendation for anyone who wants to be introduced to the value investing philosophy. As a value investing nerd, I have a few nit picks such as the valuation method used, and the implications of low interest rates (the book is talking about 5-7% rates!). Towards the back of the book, there is a list of companies the authors believed are consumer monopolies. One of these days I want to go through this list to see how these consumer monopolies did 20 years after the book was published! Hope you enjoyed my Buffettology book review

For more value investing content check out:

Q3 2020 Portfolio Update

October 14, 2020October 24, 2020

Valuation: Intel vs TSMC vs AMD

Recently, Intel announced the delay of its 7-nanometer integrated circuit process. Affected by the news of Intel’s delay, Intel stock moderately sold off. At the same time, Intel’s competitors AMD (Advanced Micro Devices) and Taiwan Semiconductor Manufacturing (TSMC) have seen their stock prices rise sharply. Given the recent hype in technology stocks, AMD and TSMC stocks have been very hot recently. I think Intel’s sell-off has been exaggerated, while the valuations of AMD and TSMC suggest unrealistic growth. The purpose of this article is to perform a fundamental DCF analysis of Intel and compare it with the valuations of AMD and TSMC.

Background

The narrative is that Intel’s latest chips will be delayed, their rival AMD will gain the lead by selling 7nm devices. AMD does not produce its chips. Instead, AMD signed a contract to produce its circuits with Taiwan Semiconductor Manufacturing Co (TSMC), the largest IC contract manufacturer. As another twist, Intel has stated that if they need a backup plan, they will have TSMC produce some of their chips. The market is interpreting this announcement as Intel is doomed and that AMD and TSMC will grow like crazy. This is reflected in the share price of these stocks, which is shown below.

Both AMD and TSMC stock prices have gone parabolic lately. Part of this is from Intel’s news, while a lot of it is their gains are from the recent tech stock mania.

By doing a rough DCF valuation on these companies, I believe Intel is reasonably valued. As for AMD and TSMC, I believe the market is pricing in unrealistic growth. The narrative may be true, that Intel loses market share. Maybe Intel becomes the next IBM, being less relevant than its glory days. On the flip side, I believe overpaying for a stock is far riskier than scary headlines. Value investors look for times when negative news is overblown, and the stock can be bought at a discount.

Intel DCF

First, let’s estimate the value of Intel using a discounted cash flow model. Intel’s free cash flows for the last few years, plus trailing-twelve-month, are shown in the table below. I’ll use the average of these FCF figures in my model by using $15B as the input. Over the last five years, Intel has grown revenue at 7% a year. I will handicap this a bit by using a 5% growth rate for the next ten years. For the growth rate beyond year 10, I will use a value of 2%. The last input to the model is the discount rate, which I will set to 10%. These values estimate the value of Intel at $51.20 a share. Currently, Intel is trading for around $50 a share.

2017	2018	2019	TTM
10.33B	14.24B	16.93B	21.9B

Intel Free Cash Flow

Based on this analysis, Intel appears to be fairly valued. It may not be a screaming bargain, but it is trading at a reasonable business valuation. I believe the market’s narrative is exaggerating Intel’s troubles. It is quite possible that you could buy Intel, and the business produces a 10% average return. As we will see, I do not believe that is the case with AMD or TSMC.

TSMC DCF

Next, we will perform the same calculation on TSMC. The table below shows TSMC’s recent free cash flow figures. An average free cash flow value of $7.3B seems reasonable, so that will be input into the model. In the last five years, the income growth rate is 8%, so we assume that the cash flow in the next ten years can grow at this rate. The terminal growth rate and discount rate are the same as the Intel example. These DCF inputs yield an estimated value of $27.25, while TSMC currently trades around $79 a share.

2017	2018	2019	TTM
8.56B	8.41B	5.16B	5.16B

TSMC Free Cash Flow

As you can see, there is a significant discrepancy between my estimate of what TSMC’s business is worth compared to what the market thinks. Perhaps I underrated TSMC’s growth rate since the narrative is that it will gain market share on Intel. Let’s try redoing the calculation by using a 15% free cash flow growth rate instead of 8%. This produces a value of $42.80 per share. Ok, how about we try an even more optimistic growth rate of 20%. The DCF outputs a value of $59.15 per share for TSMC, still significantly below what it currently trades at.

Another technique I like using when looking at stocks is performing a reverse DCF. This is done by specifying the current cash flow, discount rate, and current stock price. Then address the growth rate instead of the business value. This can help investors understand what kind of growth the market is pricing in stocks. Through this exercise, based on TSMC’s current prices, the market estimates a ten-year growth rate of 25%.

I believe a 25% growth rate for TSMC is rather optimistic. Many companies can grow at high rates for short bursts, but it is difficult to sustain greater than 20% growth for ten years. It is possible TSMC could pull it off, but I assign a pretty low probability to this.

AMD DCF

Finally, in our Intel 3-way show off, we will calculate the value of AMD. The recent cash flows are shown below, and we can see 2017 and 2018 cash flows are negative. The 2019 FCF figure is slightly positive, and the TTM number is the highest in this series of data. To be generous, we use the round number of $600M. In this example, I will use a 7% growth rate, which is why AMD’s revenue has been growing in the last five years. With these inputs, the DCF produces a whopping $9.70 for AMD’s shares…AMD currently trades at $78.

2017	2018	2019	TTM
-101M	-129M	276M	611M

AMD Free Cash Flow

To give AMD the benefit of the doubt, let’s recalculate its value using higher growth rates. Using a 15% growth rate produces a value of $15.95, while a 20% growth rate yields $21.90 a share. Both of these are well below what AMD currently trades at.

Using the reverse DCF, we can see how much growth the market is pricing in. This technique shows that AMD would have to grow at 40% per year for ten years straight to justify its value. This growth rate is completely unrealistic. Sure, the stock price of AMD has skyrocketed lately, but the business hardly makes any money. The price of AMD makes no sense when looking at it as a business. Instead, the market is valuing AMD based on its narratives, making increased profits from AI, self-driving cars, cryptocurrency mining, and, most recently, gaining market share from Intel. These could all come true, but an investor must pay a reasonable price for growth.

Conclusion

As a value investor, I try to find situations where the market hates a stock or industry. Usually, these narratives are exaggerated, which creates opportunities. The market has also exaggerated potential growth, which has resulted in stock transactions that are much higher than actual growth rates. With this post, I tried to show that the market is pessimistic towards Intel. Still, it is trading at a decent business valuation. Intel’s competitors, however, are trading at values that imply unrealistic growth. AMD and TSMC may continue to do well in the short term, but valuations matter over the long term.

For more value investing content check out:

Q2 2020 Portfolio Update

Intro to DCF Analysis Part 2

October 12, 2020January 8, 2021

Q3 2020 Portfolio Update

This post contains affiliate links. If you use these links to buy something I may earn a commission. Thanks for your support.

Performance Overview

For Q3 2020, the portfolio is up 4.49% and is up 9% year to date. The Q3 starting balance was $89,241.80, and finished the quarter at $96,383.61. Contributions to the portfolio during the quarter amount to $3,135.

No stocks were sold during this quarter, but nine new positions were added. The nine companies I have bought are Barrett Business Services (BBSI), Hexcel (HXL), Friedman Industries (FRD), George Risk Industries (RSKIA), Paul Mueller Co. (MUEL), Richardson Electronics (RELL), Surge Components (SPRS), FutureFuel (FF), and FirstEnergy (FE).

FirstEnergy is a sizable position, while the rest of the purchases were smaller allocations. FRD and RELL were net-nets (trading below net current asset value) at purchase. The rest of the smaller positions make up my foray into deep value investing, meaning they trade at very low EV/EBIT ratios. Many of these stocks are microcaps, meaning their market capitalization is below $300 million.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 69.8% of the portfolio is in stocks, while 30.2% is in cash and safe haven assets. I would prefer to deploy more of the cash to undervalued stocks, but I am remaining cautious despite the market surging during the third quarter.

During the quarter I received $318.08 total in dividends, which is broken down in the table below.

Ticker	Quarterly Dividend
FF	8.28
BBSI	10.50
FRO	81.50
STNG	6.80
DHT	103.20
EMR	42.50
COF	5.50
SPG	59.80
Total	318.08

My Thoughts

This quarter has been pretty drama free for my portfolio. The pandemic and economic difficulties have appeared to mellow out…but I wouldn’t be surprised if there is more trouble on the horizon. Despite my cautiousness, I did some buying this quarter. My goal of building out about 20 deep value positions started this quarter, with my purchase of eight companies. For the foreseeable future, I want to move towards an allocation of 70% stocks, 30% safe haven assets. I believe this will allow me to put some cash to work, while also having some ammo if the market corrects again.

As for the market, it still appears irrational. Everyone and their plumber is making easy money in the market right now. Everything seems easy when the market keeps going up, but let’s not forget everyone freaking out in March. I strongly believe there is a difference between ~~gambling~~ speculation and investing (ok oil tankers are a speculation, but at least there’s a reasonable thesis behind it). I’m here trying to build wealth, not make quick gains.

Also, the election is coming up, which I’m sure will be completely drama free…but if you think your portfolio is going to tank because the other guy won, well, you’re doing it wrong. As Buffett has said, don’t bet against America. Our businesses and country have been the place to be for 200 years. And if you’re that worried about a Great Depression 2.0, then you can always invest in a resiliant multi-asset portfolio.

Discretionary Summary

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
COF	63.25	3,478.75	3,952.3	13.61%
EMR	41.00	3,485.00	5373.45	59.93%
SPG	74.50	3,427.00	2975.28	-13.18%
FE	28.00	3,500.00	3,588.75	2.54%

FirstEnergy

FirstEnergy (FE) is an Ohio based electric utility company. FE services Ohio, Pennsylvania, West Virginia, Virginia, Maryland, New York and New Jersey. The reason FE is cheap is because it has been caught up in a bribery case involving Ohio Bill HB 6. FirstEnergy contributed to a political action committee to support this bill. This piece of legislation deals with the bankruptcy of FirstEnergy’s previously owned nuclear power plants.

These nuclear plants were spun off from FE a few years ago, into a new company called First Energy Solutions (now named Energy Harbor). FirstEnergy’s management separated from spin off three years before the HB 6 bill was proposed, and FirstEnergy Solutions went bankrupt a year before HB 6. FE management claims they did nothing wrong. Based on the info so far, it appears FE washed their hands of the nuclear plants years before the bill, and the legislation does not benefit FE that much.

Part of my strategy is to find stocks that are heavily sold off from negative news. These situations can create opportunities because oftentimes the market becomes overly pessimistic on the stock. I believe FE has a good chance of coming away clean from these allegations, but I will monitor the situation in the coming quarters.

This holding could either be a “value flip” or a longer term, bond substitute that will protect against inflation. Once this negative news gets settled, it is possible FirstEnergy will revert back to its pre-selloff price. I purchased FE at $28 at share, and it was trading around $45 a share before the negative headlines. While I wait for this reversion, I will get a safe 5.5% dividend yield and hopefully enjoy the low volatility typically associated with utilities.

Tanker Stocks

Tankers have continued to be disappointing, despite their great profitability this year. I probably bought these stocks at the top, which is frustrating, but I’ll continue to push through the pain. Frontline and DHT have been rewarding shareholders with juicy dividends, so that somewhat alleviates the sting. The Twitter account @calvinfroedge has been a great resource for oil tanker investors, and he nicely sums up tankers so far this year:

Tankers, let's review:

– Made years worth of earnings in 9 months
– Lowered net debt by as much as 50%
– Bought back up to 10% of shares
– Shares trade in some cases at / near all time lows
– Fuel demand is normalizing after covid shock
– Best fleet growth picture in 20 years
— 🏴‍☠️ (@calvinfroedge) October 7, 2020

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
DHT	8.17	1,755.90	1,109.40	-36.82%
FRO	10.66	1,738.29	1,059.50	-39.05%
STNG	26.63	1,742.67	752.76	-56.8%
TNK	23.86	1,765.88	802.16	-54.57%

Deep Value

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
BBSI	50.50	1,767.50	1835.40	3.84%
FF	13.00	1794.00	1569.06	-12.54%
FRD	5.10	1800.10	1643.95	13.74%
HXL	36.80	1803.20	1643.95	-8.83%
MUEL	26.00	1768.00	1836.00	3.85%
RELL	4.45	1802.25	1688.85	-6.29%
RSKIA	8.25	1740.75	2557.70	29.70%
SPRS	1.31	1819.30	1869.75	2.77%

401k and Precious Metals

	12/31/19	9/30/20	YTD Gain (Loss)	YTD Contribution
Precious Metals	$7,861.00	$9,964.00	26.75%
401k	$10,962.24	$23,687.33	11.36%	$10,863.00

Interesting Articles

If you think this post is boring, then check these articles I read this quarter.

Monopolies are Distorting the Market

Buying Stocks Trading Above 10x Sales A Good Idea?

Books I’m Reading

A few weeks ago I went to the local used book store for the first time since the pandemic and found a copy of the classic Buffettology. This book contains a lot of info that Buffett die hards will have seen elsewhere. However, I think it is a great book for a newer investor to gain the right mindset about investing. One of the main points is thinking about a stock like owning a piece of a business, which is something I totally agree with. The book presents an interesting business valuation method. A gripe I have is that I think this method suffers from some hindsight bias, so I’m not sure how practical it is to use.

Another book I read this quarter was Capital Allocation: The Financials of a New England Textile Mill 1955 – 1985. This book is the history of Berkshire Hathaway in the decade prior to Buffett taking control, and his capital allocation decisions up until the mid 80’s. Capital Allocation tells the story of how a struggling textile mill became one of the strongest companies in this country. My favorite part of this book is the deep dive into the financials of Berkshire and its early investments that I have not seen elsewhere. I loved nerding out over all of the financial statement snippets. Capital Allocation has a new place in my top 5 investing books.

For more value investing fundamentals check out:

Q2 2020 Portfolio Update

Intro to DCF Analysis Part 2

September 26, 2020September 26, 2020

Intro to DCF Analysis Part 2: How to Calculate a DCF

In part 1 of this series, I introduced the discounted cash flow model and its four input variables. These variables were cash flow of the business, short term growth rate, terminal growth rate, and investors discount rate. In this post, I will show how to calculate a DCF by running the numbers on Emerson Electric (EMR). Emerson is an established business that is not rapidly growing, and is not overly cyclical. Using a DCF is more suitable for a business with these characteristics.

PV of Future Cash Flows

Performing DCF analysis consists of three parts. The first part is looking at the company’s financials to determine the values we should use to plug into the model. Next is the calculation of the present value of future cash flows from the business. This means we have a black box that produces a certain amount of cash flows far into the future. The DCF equation allows us to place a value on this stream of cash flows. The last step is to make some adjustments so that we get the value of the company on a per share basis.

Determining Cash Flow

The first step is to determine what cash flow value to use. In this example I am using EMRs free cash flow (FCF). The FCF for the last few years, plus the trailing-twelve-month figure is shown in the table. Typically I average the last few years of FCF to use as the input to the model. In this instance, let’s use $2.5B as our starting cash flow.

Choosing a Short Term Growth Rate

Next, we have to determine a reasonable growth rate. Emerson is a diversified industrial company that sells HVAC units, tools, and the InSinkErator brand. These products are going to produce a low sales growth rate. Probably increasing a few percent a year at the rate of inflation. EMR also has an industrial automation division that could have a bit higher sales growth going into the future. For this example, let’s assume EMR can grow their free cash flow at a rate of 3.5% a year.

The Terminal Growth Rate

As described in part one of this series, I discussed the difference between short term growth rate and terminal growth rate. Terminal growth rate assumes the business will decline to a steady state growth rate that is about the rate of inflation. In my DCF models, I typically use a terminal rate of 2%.

Specifying a Discount Rate

The last piece to the DCF model is the discount rate. As a refresher, the discount rate is the investors desired rate of return. This desired rate of return affects the future cash flows of the business. One dollar is worth more today than it does 10 years from now. Because of inflation and because we can invest that dollar. Mathematically, the discount rate has an interesting effect on the future cash flows. However, I’m trying to keep light on the math in this series so that can be a tale for another day. For my models, I use a discount rate of 10%. Don’t forget that a higher discount rate will mean the stock needs to trade cheaper. And a low discount rate means you could pay up for that stock (you’d be getting less of a return).

Performing the Calculation

Bringing it all together, we are now ready to do the DCF calculation. I use the calculator from Old School Value, which is a paid service, to do my DCF analysis. However, there are many online DCF calculators, or you can do it in Excel. Inputting the four variables described above, the DCF spits out a present value of EMRs future cash flows equating to $27B.

What this means is that we have a black box that is throwing out $2B in cash that is growing at a rate of 3.5% a year. If we paid $27B for this black box, we would expect a 10% return on investment. In order to arrive at a per share value of EMRs future cash flows, we need to do a few adjustments to this $27B.

Converting to Equity

The last step in showing how to calculate a DCF is to convert the DCF output into a value per share. The number that the DCF calculation produces is really the value of the entire enterprise. The enterprise is commonly made up of equity (the stockholders) and debt (bond holders). Since we are buying the stock, we need to adjust the $27B enterprise value of Emerson to reflect the equity holders’ share of the pie. To illustrate this, let’s say the enterprise was made up of 50% equity and 50% debt. It is not fair to say that the equity holders get 100% of the cash generated by the enterprise. You have to make debt interest payments, and pay off the bonds when they come due.

To arrive at the equity value, you take the enterprise value and subtract the value of the long term debt the company has. In some cases, it is applicable to also subtract capital lease. Emerson has $7B in debt, so we subtract that from the $27B. The next step is to add back the current amount of cash the company has. This means we can add $2.5B to our $20B. This resulting figure of $22.5B is the value of Emerson’s equity.

From here, we can obtain the value of EMR at a per share basis by dividing the $22.5B equity value by the amount of shares outstanding. Currently, Emerson has 600 million shares outstanding. This results in a per share value of $49.90 for Emerson’s stock.

DCF Example Summary

To summarize, if we could buy EMR stock at $49.90, and our DCF assumptions held true, we could expect a 10% average rate of return. Now that we have determined a back of the envelope value for EMR, we can check what it’s trading for in the market. When I entered my position in EMR, I paid $41 a share. Currently, Emerson is trading for about $70 a share, so you probably would expect a lower return if purchased at that price. Buying below the value calculated from the DCF provides some margin of safety in case our assumptions on Emerson’s cash flows or growth rates are wrong.

Conclusion

With this two part series on discounted cash flow analysis, I hope to provide a foundation for business valuation by showing how to calculate a DCF. Understanding that a stock is really a business that produces a stream of growing cash flows instead of a price that fluctuates is key to being a successful investor. Even though DCF valuations are not perfect, they do capture the growth of the business where a simple P/E ratio does not. Going forward, I want to occasionally highlight examples stocks are overhyped and trade at valuations that do not make sense, even if they can produce a high rate of growth.

For more value investing fundamentals check out:

What is Value Investing Anyway?