Friday, 5 June 2015

What is a Franchise/Moat?

One of the concepts that I've struggled with is identifying a sustainable franchise/moat.  A reasonably prudent investor, once committed to a stock, wants to ensure that he/she can sleep at night without worrying too much about the possible future path the stock may take. After having committed to buying a stock, it's awkward discovering after the fact that the company in who's shares you've bought is sorely lacking in sustainable franchise/moat.

Ben Graham suggested that investors should be prepared for adverse movement in their holdings, and that a -30% move in any one (or a combination) of an investors holdings is not within the realm of the unexpected.

One method of coping with/synthesizing the risk of adverse movement in any one (or a combination) of holdings is to diversify.  If an investor is sufficiently diversified, he/she may be more likely to cope with adverse movement in any one particular stock in the context of the overall portfolio.  But diversification, in my opinion, is a misnomer and is misunderstood.

An investor who has structured a portfolio predicated on thirst for dividend yield first and foremost may actually end up being un-diversified. Case in point, the Canadian equity space is concentrated in resource/commodity focused stocks, but this exposure may stem beyond the direct culprits in the resource/commodity space in the event of an exogenous event impacting the underlying commodity. Anything in energy services, junior energy exploration, drilling, and production, midstream pipelines, oil sands, and even integrated oils, is now offering dividend yields which are substantially higher than they were before September 2014.

An investor who's primary criteria is a dividend yield in excess of say, 4%, may go about purchasing two energy services companies servicing different sectors of the energy space, one midstream pipeline company, and one integrated oil company or one oil sands company, all offering attractive yields in excess of 4%, and by doing so, may have inadvertently quadrupled his/her concentration of risk. At first glance, although each of the companies offers a distinct product or service, their bread and butter all comes from the same place.

The same investor may then go about purchasing two commercial REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies.  Each REIT offered yields in excess of 5.5%.  Easy money right?

The same investor may then go about purchasing a railroad yielding 3%.  Railroads are stalwart, long-standing, oligopolies.  They own millions of kilometres of railyway tracks nationwide and there are huge barriers to entry.  And yet, railroads are dependent on the energy space for a significant portion of their revenues.

The same investor may then go about purchasing a bank stock with significant loans to junior energy producers, energy service companies, and oil sands companies.  The bank stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years.

If this investor constructed this portfolio well before September 2014, the portfolio may have apeared reasonably diversified.  The portfolio would have included:
  • Two energy service companies servicing different sectors of the energy space.  Perhaps one company operates trucking and logistic services in Western Canada, and the other provides a suite of drilling diagnostic data products.  Each company yields 3.5% and has grown both earnings and dividends combined at 10% over the last 10 years.
  • One midstream pipeline company which has a substantial backlog of pipeline projects expected to add new capacity over the next 5 years, and which  as a result of this supplemental capacity, expects to substantially inrease free cash flow sufficient to repay the cost of funding the new capacity and increase the dividend.  The pipeline yields 4.5%
  • One integrated oil company which has been operating for the last 50 years, and which has weathered previous cycles in the past.  This company yields 3%.
  • Two REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies, and the other of which runs self storage facilities in Western Canada.  Both REITs yield 5.5% and have conservative mortgage to property ratios.
  • One national railroad which has been operating for 100 years, and which yields 3%.
  • One bank with significant loans to junior energy producers, energy service companies, and oil sands companies.  The stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years.
This 8 stock portfolio would have hummed along uninterrupted, paid a yield of around 4%, and showed the investor both capital appreciation and dividend appreciation, all prior to September 2014.

So what could this hypothetical investor have changed in terms of approach?

I believe that the answer comes back to understanding franchise/moat in the context of correct diversification.

Borrowing from Base Hit Investing, here's an interesting anectdotal clip demonstrating the difficulty inherent in understanding franchise/moat:

"Munger talked about moats a couple times during the meeting. The first time he recited a few examples of formerly great companies that had significant competitive advantages, but due to the nature of capitalism, eventually wound up bankrupt:

“The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very 

Darwinian—it’s tough out there. Technological change is one of the toughest things.”

Munger had this story when asked to identify a moat:

Question: What is the least talked about or most misunderstood moat?
Munger: You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “Yes, but I didn’t run around asking people how to do it”."

Bruce Greenwald in "Value Investing: From Graham to Buffett and Beyond", presents an interesting conceptual framework for understanding the concepts under-pinning franchise/moat.

According to Greenwald, sustainable franchise/moat seems to encompass the characteristics of Porter's 5 forces model, such as barriers to entry, pricing power, economies of scale either in  procurement or production, and structural competitive advantage.  The book is fascinating and is a must read for any aspiring dividend investor.  Greenwald goes on to quantify how to caclulate franchise value using a number of approaches (sum of the parts, discounted cash flows, etc).

The point of all of this is that constructing a portfolio of correctly diversified stocks has to include more than a cursory analysis of the prior decades worth of earnings growth, dividend growth, payout ratio, valuation, or even relative valuation.  It has to include consideration of sustainable franchise/moat in order to safeguard against permanent loss of capital.

I believe that a properly diversified portfolio of companies that are not just fundamentally strong, but that also pass the litmus test of "potential" sustainable franchise/moat will allow an investor the ability to cope with/synthesize the risk of adverse movement in any one (or a combination) of their holdings.

In consideration of the above portfolio, I have added the following litmus test checks in italics after each holding (assuming I'm looking to invest in these 8 stocks today).  My litmus test is a simple, "Y" for sustainable franchise/moat, "N", for none, and "?" for maybe.  Notice how this changes the consideration of candidates for a portfolio before committing.  Assume that each of the candidates for consideration has grown eps and dividends at 10% over the last 10 years uninterrupted, and is currently trading at a PE below it's 10 year average PE.

  • Two energy service companies servicing different sectors of the energy space.  Perhaps one company operates trucking and logistic services in Western Canada "N", and the other provides a suite of drilling diagnostic data products "?"  Each company yields 3.5% and has grown both earnings and dividends combined at 10% over the last 10 years.
  • One midstream pipeline company which has a substantial backlog of pipeline projects expected to add new capacity over the next 5 years, and which  as a result of this supplemental capacity, expects to substantially inrease free cash flow sufficient to repay the cost of funding the new capacity and increase the dividend.  The pipeline yields 4.5% "?"
  • One integrated oil company which has been operating for the last 50 years, and which has weathered previous cycles in the past.  This company yields 3%. "?"
  • Two REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies "N", and the other of which runs self storage facilities in Western Canada "N".  Both REITs yield 5.5% and have conservative mortgage to property ratios.
  • One national railroad which has been operating for 100 years, and which yields 3%. "?"
  • One bank with significant loans to junior energy producers, energy service companies, and oil sands companies.  The stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years. "N"
Out of the 8 candidates, I get 4 "no's" and 4 "maybe's".  Not one definitive "yes", which goes back to my initial point.  One of the concepts that I've struggled with is identifying a sustainable franchise/moat.

Why "maybe" in the context of the diagnostic data company, the pipeline, the integrated oil, and the railroad?

Well maybe, the diagnostic data company has a suite of products which it has exclusive copyright over, and which is used by 80% of existing drilling companies.  But perhaps the suite is prohibitively expensive and in the face of falling capital budgets by its customers, sales are expected to drop 30% unless the company drops it's prices.

Maybe the pipeline has firm commitments from producers over the next 5 years and is the only pipeline from the oil sands to the West coast.  But what if 50% of the producers are oil sands juniors?

Maybe the integrated oil company has the lowest cost structure in Canada.

Maybe the railroad has millions of km's of track built 30 years ago and has exclusivity over useage.  But perhaps 60% of the track needs to be upgraded over the 5 years and the track runs parralel to the new pipeline capacity.

All of the above changed the way I think.




Thursday, 4 June 2015

The Canadian Shareowner Investments Experiment Part Two

Continuing the Canadian Shareowner Investments Experiment:

To recap, I purchased the following initial basket of stocks through my first buy program at Canadian Shareowner Investments, in the following proportions, in October of 2014.

SymbolName% of totalYield
DGXQuest Diagnostics4.29%1.82%
DLTRDollar Tree4.29%0.00%
GPSThe Gap4.29%2.32%
HRSHarris Corporation4.29%2.37%
KKellogg4.29%3.12%
KRFTKraft 4.29%2.60%
MCDMcDonalds4.29%3.50%
PETMPetsmart4.29%1.00%
PFEPfizer4.29%3.11%
SYMCSymantec4.29%2.44%
TWXTime Warner4.29%1.60%
UNHUnited Health4.29%1.25%
TSE:CJR.BCorus Entertainment Inc4.29%1.25%
Total cost55.80%
Cash44.20%
100.00%


What follows is a discussion of how I distinguished between the top ranked combinations on the Canadian Shareowner Investments list, and my actual purchases.  For the sake of reference, here is the list of my database of top ranked combinations, circa late September 2014:

CompanyROCRankEBIT (ttm)EV (test)E/YRankCombined Rank
Weight Watchers International, Inc.281%4               461       1,339.6934%15
MTY Food Group958%1                 68           630.0011%2425
Coach, Inc.88%28           1,120       9,398.3512%1543
UnitedHealth Group Incorporated210%7           9,623     95,943.1110%3744
The Buckle, Inc.87%31               257       2,175.9112%1647
Philip Morris International, Inc.118%18         13,515   130,046.7010%3149
PetMed Express, Inc.112%20                 28           273.6510%3252
Kraft Foods Group, Inc.87%30           4,699     43,123.5711%2353
ManTech International Corporation67%50               140           901.6916%555
Viacom, Inc.118%19           3,929     42,692.389%4564
Apple Inc.196%9         48,999   590,816.148%6069
Constellation Brands Inc.64%61           2,827     23,250.9212%1374
LHC Group, Inc.60%64                 61           480.0913%1175
The Western Union Company86%33           1,107     11,624.1010%4275
Penn National Gaming Inc.53%77               361       1,904.9219%279
Harris Corporation65%57               882       8,020.7111%2279
International Game Technology69%45               572       6,141.179%4388
Symantec Corporation99%24           1,453     17,690.898%6589
The Gap, Inc.53%76           2,149     18,849.9311%2197
CF Industries Holdings, Inc.47%92           2,412     17,937.5413%8100
Kellogg Company62%62           2,833     29,089.5110%40102
Bed Bath & Beyond Inc.48%87           1,615     13,816.2812%17104
Corus Entertainment Inc.149%12               221       2,940.008%94106
Laboratory Corp. of America Holdings60%65               991     11,095.319%49114
Microsoft Corporation214%6         27,886   384,356.667%108114
Pfizer Inc.92%27         16,366   211,955.788%88115
Jacobs Engineering Group Inc.51%78               669       6,744.3910%38116
International Business Machines Corporation61%63         19,599   225,714.629%53116
Quest Diagnostics Inc.74%42           1,001     12,399.598%74116
Oracle Corporation87%32         14,983   192,252.418%86118
EZCORP, Inc.40%118               139           796.0217%3121
Ross Stores Inc.54%73           1,343     15,761.529%57130
PetSmart, Inc.45%97               693       6,897.2310%36133
United Technologies Corporation56%70           9,209   112,994.698%70140
General Mills, Inc.68%48           2,961     38,820.128%93141
Staples, Inc.37%136           1,242       8,455.7915%6142
Lockheed Martin Corporation69%46           4,505     60,346.557%96142
National Oilwell Varco, Inc.40%117           3,423     32,178.6111%26143
Jack Henry & Associates Inc.107%22               312       4,486.177%121143
Cisco Systems, Inc.143%15           9,763   142,613.547%129144
Raytheon Company47%93           2,938     33,669.849%52145
EMC Corporation73%43           4,374     59,394.427%102145
General Dynamics Corporation47%91           3,693     43,114.049%56147
Valmont Industries, Inc.36%137               473       3,806.9912%12149
L-3 Communications Holdings Inc.41%109           1,258     13,135.4510%41150
Hewlett-Packard Company39%122           8,143     78,126.4310%30152
Time Warner Inc.55%72           6,605     83,547.258%80152
Dollar Tree, Inc.48%89               970     11,879.378%67156
The TJX Companies, Inc.54%75           3,351     42,396.878%81156
Fluor Corporation36%138           1,190     10,351.5611%19157
Energizer Holdings Inc.49%84               740       9,185.798%75159
Crane Co.50%82               351       4,424.618%79161
Expeditors International of Washington Inc.66%55               561       7,671.237%106161
Metro43%101               602       7,265.008%61162
Capella Education Co.43%103                 60           724.508%62165
Eli Lilly and Company49%85           6,067     77,393.678%83168
Emerson Electric Co.44%100           3,942     48,337.058%69169
CVS Health Corporation51%79           8,037   104,435.528%90169
CI Financial354%2               601       9,880.006%172174
Whirlpool Corp.37%134           1,249     13,702.389%46180
McGraw Hill Financial, Inc.148%13           1,405     22,792.896%169182
Paychex, Inc.108%21               983     15,808.226%166187
Shaw Communications Inc.39%125           1,366     16,570.008%63188
Verizon Communications Inc.29%165         31,944   304,029.6311%27192
Chevron Corporation22%189         39,505   246,646.1216%4193
Exxon Mobil Corporation23%186         57,720   417,761.3514%7193
The Clorox Company66%54               961     14,472.157%140194
Dolby Laboratories, Inc.88%29               245       3,934.716%165194
AT&T, Inc.27%176         30,479   265,337.4911%20196
Altria Group Inc.42%107           8,084   104,827.408%89196
The Mosaic Company23%184           2,196     18,256.8512%14198
The Jean Coutu Group56%71               302       4,370.007%127198
3M Company49%83           6,666     95,361.987%118201
Magna International Inc.28%169           2,049     20,348.5210%34203
W.W. Grainger, Inc.44%99           1,297     17,722.327%105204
The J. M. Smucker Company40%113               929     12,171.098%92205
Johnson & Johnson79%37         18,957   305,354.076%168205
Cash America International, Inc.20%200               210       1,571.9913%9209
Cummins Inc.34%146           2,133     25,912.588%64210
Toromont Industries36%139               174       2,140.008%71210
QUALCOMM Incorporated83%36           7,230   119,358.446%174210
ConocoPhillips20%201         15,058   112,854.2713%10211
The Boeing Company51%80           6,562     96,562.887%132212
Visa Inc.132%17           7,239   126,075.766%197214
CGI Group, Inc.132%16               628     10,957.886%198214
CME Group Inc.200%8           1,637     29,359.626%207215
Church & Dwight Co. Inc.65%59               622       9,811.336%157216
IGM Financial107%23           1,073     18,440.006%193216
CH Robinson Worldwide Inc.65%58               674     10,689.146%161219
Anixter International Inc.24%181               344       3,507.8910%39220
Fiserv, Inc.193%10           1,061     19,165.716%210220
ScanSource, Inc.20%204               109           946.7712%18222
Rogers Communications Inc.26%178           3,011     32,562.789%44222
Fresenius Medical Care AG & Co. KGAA39%123           2,256     30,522.147%100223
NetApp, Inc.75%41               822     13,885.596%182223
Automatic Data Processing, Inc.78%38           2,225     37,729.766%186224
McDonald's Corp.31%160           8,764   107,167.898%66226
Panera Bread Company42%108               314       4,495.427%119227
Patterson Companies, Inc.45%98               345       5,043.597%130228


There are a few things to point out right off the bat:


  1. My original ranking system (using fundamental data from a combination of sources, including finviz, gurufocus, yahoo finance, Sedar, and actual SEC filings), produced top heavy combined rankings in retail oriented companies.  I wasn't comfortable having a lot of exposure to retail oriented companies as I believe that over time, retail is a tough business to operate in.  It's highly competitive and subject to non-stationary consumer preferences.  Retail also requires high fixed cost investment and high upfront investment in working capital (inventory).  I suspect that the prevalence of retail oriented companies was a function of these companies getting cheap relative to all the other non-retail oriented companies in the Canadian Shareowner Investments list.
  2. The combined rankings didn't tell the whole story in terms of capital structure or business prospects of the highest ranked companies.  Interestingly enough, Weight Watchers topped the relative rankings in terms of a superficial analysis of good and cheap.  The company showed a 34% earnings yield and a 281% return on capital!  To me, this meant something must have been wrong with my data, and I was right, my data wasn't picking up the enterprise value correctly.  Weight Watchers had a market cap of $1.4B, but had debt of $2.2B, so my EV should have been $3.6B, which, post adjustment, would have dropped the earnings yield down to 12% and would have changed the rankings. A further analysis would reveal that while trailing 2013 EBIT was $461M, EBIT dropped by almost 1/3 throughout 2014 relative to 2013.  An analysis of cumulative quarterly results from December 31, 2013, along with an analysis of management's outlook for fiscal 2014 would have warranted caution in extrapolating $461M going forward.  Using forward EBIT of $299M, forward earnings yield drops to 8%.  An analysis of the balance sheet would have revealed that included in intangibles were $761M of acquired franchise rights.  My thoughts are that these franchise rights are one of those grey area long lived assets which can either get included or excluded from the return on capital calculation.  My conservative preference is to include them, as in the absence of these franchise rights, the company doesn't operate as it currently does.  This inclusion drops the return on capital down to 60% from 281% and changes the rankings.  Finally, if the above wasn't enough to merit caution in considering Weight Watchers, Tim McAleenan Jr. has an interesting article on the company here: Some Stocks are Ticking Time Bombs
  3. Just because I happened to run an arbitrary screen trying to determine relative combinations of cheapness and goodness vs. the remaining stocks in the Canadian Shareowner Investments list didn't guarantee that the top ranked candidates were actually cheap.  They may have been cheap relative to the bottom ranked stocks in the universe, but if the bottom ranked stocks traded at a PE of 100x fwd earnings and the top ranked stocks traded at a PE of 30x fwd earnings, it's debatale as to whether or not the top ranked stocks were worthwhile candidates.
  4. The screen in and of itself was a starting a point for additional research.  It returned many of the top large cap blue chip companies in the S&P500 as top ranked candidates, but it also returned some small and mid-cap candidates for further research. You could justifiably make an argument that, excluding the concentration of retail oriented companies in the top 20, you could construct a reasonably conservative portfolio of candidates including Johnson & Johnson, Microsoft, Phillip Morris or Altria, Kellogg, Kraft, Pfizer, IBM, United Technologies, Chevron or Exxon Mobil, AT&T, J.M. Smucker, Mcdonalds, Visa, Rogers, and Apple, earn a 3% to 4% overall annual yield, reinvest the dividends (one of the other fantastic benefits of investing with Canadian Shareowner Investments is that all dividends are automatically reinvested), check the portoflio once or twice a year, and basically compound at somewhere between 6% and 8% on autopilot.  Funny, all this work on screening and ranking and I ended up with the equivalent of the DJIA (minus the banks)!
  5. Once I came to this realization, I made my eventual choices by selecting a combination of what I perceived to be auto-pilot stocks (such as McDonalds), and by doing further in-depth research on companies like Petsmart (which subsequently got acquired), Symantec (I felt that as a consequence of the upcoming spin-off, the sum of the parts value was being obscured in the combined entity), Quest Diagnostics, Dollar Tree (in the process of acquiring Family Dollar Stores and substantially cheaper relative to Canada's own Dollarama), Kraft Foods and Kellogg (this was pre-Berkshire Hathaway's Heinz/Kraft deal), etc.  My worst choice was Corus Entertainment which I subsequently sold, because I came to the realization that, although my kids love the company's content, with the onslaught of readily available online (and free) content, the growth prospects for developing and delivering traditional cable media content were limited.
After I made my initial purchases, I began to re-evaluate my entire approach.