This post is going to be all about the new newsletter
Quan and I just started. So, if a paid newsletter isn’t something you’re
looking for right now – this post is going to be pretty boring for you.
It’s also going to be pretty long. I have a lot to say
about The Avid Hog. I know most readers of the blog aren’t interested in ever
paying $100 a month for any product. So, I don’t want to clog up the blog with
a lot of little posts about the newsletter. Here’s one big one. If you’re not
interested, skip it. Regularly scheduled (non-promotional) content will resume
next week.
Quan and I have been working on The Avid Hog for over a
year. I’m here in the United States (in Texas). Quan is back in Vietnam. He
went to school in the U.S. And we started work on The Avid Hog in person while
he was still living over here just after his graduation.
Quan moved back to Vietnam. But that did not end
preparations for The Avid Hog. Today, we do everything by email, Skype, etc.
The only difficulty is the time difference. It’s exactly 12 hours. It’s
midnight in Hanoi when it’s noon in Dallas and vice versa. This make picking
Skype times interesting.
The Avid Hog is an unusual newsletter for a few reasons.
The biggest reason is that it’s a product of two people. All the decisions
about what stocks we start research on, what stocks make the cut and get a full
investigation, and what stock makes it into the next issue – these are all
decisions we make together.
It’s easier than you might think. Quan and I don’t
disagree on a lot about stocks. This is both a plus and a minus. The plus is
that it makes it easier to produce The Avid Hog. The minus is that anything I
badly misjudge is something Quan’s likely to misjudge too. We are not very good
at catching each other’s mistakes. We are too similar in our thinking about
stocks for that.
What is our thinking about stocks?
Officially, the label would be “value investor”. But
that’s a rather wide tent. And we tend to be pretty far over on the quality
side of things. If we’re going to compromise on quality or price, it’s always going
to be price. I think we both tend to
agree with Ben Graham. The biggest danger for investors isn’t usually paying
too high a price for a high quality business. It’s paying too high a price for
a second rate business.
The model business we like would be something like See’s
Candies. Read
Warren Buffett’s 2007 letter. There’s a section in it called “Businesses –
The Great, The Good, and The Gruesome”. See’s is given as the example of a
great business.
If you read that section carefully, you’ll understand
what I mean when I say See’s is the kind of business Quan and I like. Buffett
mentions that See’s uses very little net tangible assets – this is a big focus
for Quan and me – and that it has a huge share of industry profits. He also
mentions that unit volume – pounds of chocolate sold – rarely increases. And
that there has been at least as much exiting from this industry as entering it.
Basically, it’s a settled industry.
You might think that a fast growing business would
attract us. Historically, that has not been the case. I doubt it will be the
case very often in the future. There are several reasons for this.
One, fast growing industries are by definition less
settled. For an industry to grow unit volume, it generally has to be growing
the number of customers. Customer growth is always disruptive because the
easiest way for a new entrant to gain ground is with new customers.
There are businesses that experience some constant unit
growth without much customer growth. Obvious examples are businesses where you
are charging your customers based on the amount of work you are doing for them.
An ad agency can grow its top line without adding net new clients if those
clients increase spending every year on average. FICO (FICO) can grow sales without adding customers – which is good,
because just about everyone who could be a client of FICO’s already is – if
their frequency of using a FICO score increases. The company in our September
issue also fits this model. They aren’t going to grow their customer list. They
will do a little more for the same customers each year. And they will charge a
little more for everything they do. But that’s about it.
Those tend to be the businesses we like, because we are
often focused on the idea of a “profit pool”. I’ve mentioned Chris Zook’s books
on the blog before. I recommend all of them. They touch on a subject that is
the key to long-term investing. How does a business gain a large share of an industry’s
total profits? How does it keep that share year after year?
You aren’t going to find Apple (AAPL) in The Avid Hog. I suppose I can’t swear to that. But
I pretty much can. Even if Quan liked the stock – even if it was a lot cheaper
– I’d still veto the idea. The reason has to do with these ideas of market
leadership and “profit pool”.
If you pick a moment in time and a product category – any
product category – in consumer electronics, you can come up with a leaderboard
of companies. You can choose the top 3 companies, top 5, top 10. Whatever you
want. Often, if the industry involves worldwide competition – not a whole lot
of companies beyond the top 3 will be making money.
But let’s put aside profits. Let’s just look at market
share. Take any consumer electronic device (radio, microwave, TV, watch, game
console, cell phone, etc.). Look at the leaderboard. Then fast forward 5 years,
10 years, 15 years. Check it again. How many names stayed the same? How many
changed? How many are in totally different countries?
That’s not the kind of business we want to invest in. I
recently did a podcast about Addressograph as of 1966. Everything looked pretty
good. The stock traded at about 20 times earnings. Over the previous 10 years,
it had traded at 20 to 40 times earnings on average. In about 15 years, it was
bankrupt. That’s a tough business to buy and hold.
Most of Addressograph’s big competitors – including Xerox (XRX), IBM (IBM), and Kodak – had their own problems later on. Many exited
those businesses. New companies – often foreign – gained a lot of share. And
prices came down a lot.
This last part is hard to emphasize enough. I’ll be doing
an information post soon to prepare you guys for the next Blind Stock Valuation
Podcast. As part of that post, I’ll be including the retail price of watches a
mystery company sold in 1966. I’ll also be giving you the inflation adjusted
prices for those watches. In other words, what those 1966 watch prices would be
in 2013 dollars.
Whatever you think watch prices were in 1966 – they were
higher. Of the four brands this company made their middle of the road brand –
the big seller – retailed for an inflation adjusted price of about $380. The
fully electronic watches – remember, this was the 1960s – sold for $800 to
$17,000 in today’s money.
Unless you are assured of future domination of a growing
industry, you generally don’t want the real price of your product to fall by
80% or so. Quan and I have looked at a couple deflationary businesses we liked.
In both cases, the company we looked at had the highest market share, the
lowest costs, and was around since basically the time the industry started. So
far, neither company – they’re Western Union
(WU) and Carnival (CCL) – is
slated to appear in The Avid Hog. In the case of Western Union, the durability
of the business – not their moat relative to competitors – is an open question.
Basically, the internet is opening up a lot of different possibilities for how
Western Union’s niche could be ruined by more general payment solutions. Some
of the things that are really necessary and really hard to do right now (mostly
on the receive side in countries emigrants leave) may be easier hurdles to
clear in the future. Maybe not. We’ll see. But the situation is less clear than
it was a few years ago.
Carnival can’t control the price of oil. It’s a big input
cost for them. If oil prices drop and stay down, Carnival will turn out well as
an investment. If they don’t, it’s very possible the stock won’t do well at
all. And, of course, oil prices could rise. It’s a lot less certain than the
investment we want to make. So, for now, it’s not near the top of the list of
Avid Hog candidates.
These two companies – and their uncertain futures –
illustrate what The Avid Hog is all about. And it’s important potential
subscribers know this. The Avid Hog isn’t exactly a newsletter with stock
analysis. It’s really a business analysis newsletter. Those businesses happen
to be publicly traded. And we happen to appraise the equity value – not just
the enterprise value – at which the business would be attractive. But it’s a
really unusual newsletter. We aren’t looking for reasons for the stock to go up
over the next few months or few years. We’re looking for a business we think is
one you’d want to hold. And we’re looking for an acceptable price to buy it at.
This is where the oddity of the partnership between Quan
and me is most evident. I said we were value investors. That’s true. But I
doubt many of the stocks you hear value investors talk about this year are
going to make it into The Avid Hog.
For one thing, we really do adhere to Ben Graham’s Mr.
Market metaphor. The stock we picked for the September issue wasn’t far from
its all-time highs. I said before I think it was within about 10% to 15% or so
of its all-time highest price. We’re fine with that. We thought it was a
bargain regardless of where it had been priced in the past.
The question we ask is whether we’d buy the whole
business for the enterprise value at which it’s being offered. That’s another
point subscribers need to be warned about. I’m a little more dogmatic on this
one than Quan is. But we both take it pretty seriously.
We appraise the business. We compare the value of the
business – as we appraised it – to the value of the company’s entire capital
structure. We know these are intended to be buy and hold investments. So we
don’t assume we know what the capital structure will be when you sell the
stock.
As a rule, we want subscribers to enter any stock we pick
knowing – absolutely for sure – that they aren’t going to sell for 3 years. We
are very serious about this point. The kind of (business) analysis we do isn’t
something that can be expected to pay off in a matter of months or even a
matter of a couple years.
If you think about what we are doing – analyzing the
durability of a company’s cash flows, counting up those pre-tax cash flows, and
then comparing them to the cost of buying all of a company’s debt and equity –
it’s not that different from how a private equity buyer would look at a stock. They
wouldn’t expect a return in less than 3 years. They might expect it to take
quite a bit longer than that. So do we.
That’s a little unusual for a newsletter. But I don’t
think it should be that unusual to the folks reading this blog. The idea that
you can pick the right business to buy, pick the right price to pay, and pick
the right time to make your profit – we’re not sure you can do more than 2 out
of 3 there.
A lot of our time preparing The Avid Hog for launch over
this last year (actually a little more than a year now) was spent on “the
checklist”.
Checklists are very popular with value investors these
days. So, I’m a little wary of the term. I’ll use it here as a name for a list
of key ideas we always want to discuss. By key I definitely mean no more than
10. Right now, there are 7 sections we consider important enough to include in
every issue:
Durability
Moat
Quality
Capital Allocation
Value
Growth
Misjudgment
This is hardly a novel list. Everybody has read Warren Buffett.
Everybody knows you look for a good business with a durable product and a wide
moat. Those are our top 3 concerns. They are probably the top 3 concerns of
many value investors.
We diverge a little with many value investors – though
probably not Buffett – in putting “Capital Allocation” at number 4. This list
is in order of importance. Basically, failing a section near the top will kill
an idea faster than failing a section near the bottom. There is one exception:
“Misjudgment”. It’s at the bottom not because it’s unimportant – it’s the most
important topic. It’s at the bottom because we can’t know what we don’t know
until we know what we know. So, it’s always the last question we answer.
Capital allocation is ranked ahead of value and growth. I
would guess almost every other value investor would put value ahead of capital
allocation. And quite a few would put growth ahead of capital allocation.
We obviously think capital allocation is more important
than most investors do. It can be a difficult area to judge, because we have to
use past behavior and present day comments to predict future actions. The human
element is particularly large in capital allocation. So, it tends to be viewed
as a squishier subject.
Over time, I’ve learned that capital allocation is a lot
more important than I thought it was. And I started investing believing capital
allocation was a lot more important than most investors think it is. I’ve
become more extreme in my views on capital allocation. This colors our
candidates for The Avid Hog a bit. It tends to eliminate tech companies. Even
when we can judge their future business prospects – we can rarely predict which
businesses they will choose to be in. It is one thing to analyze Google (GOOG) as a search engine. It’s
another thing entirely to analyze Google as a company. The reason for that is
capital allocation. It’s not enough to know how much cash a company will
produce. We also need to know what value that cash will have when it is put to
another use. At some companies, those uses are fairly limited and we can guess
that a dollar of retained owner earnings will add at least a dollar of market
value to the stock over time. At other companies, we can’t do that.
Capital allocation is especially important in buy and
hold investing. If you are right about a company’s quality, the durability of
its cash flows, and how it will allocate its capital – you don’t really need to
be right about anything else. That’s usually enough to tell a good buy and hold
investment from a bad one. It may not be enough to find the very best
investment – value often plays a bigger role in determining your annual returns
(especially how quickly you’ll make your money). But getting quality,
durability, and capital allocation right will often be enough to know you’ll
earn an adequate return.
What is an adequate return?
This is a critical question for any subscriber to The
Avid Hog. Our newsletter costs $100 a month. That’s $1,200 a year. So, there’s
no point in subscribing unless you can make more than $1,200 a year based on
the content of that newsletter.
We’re not promising anything. Nobody does that. But we’re
not even aiming that high. I don’t think it’s realistic to assume any
newsletter that serves up 12 ideas a year – that’s a lot more than either Quan
or I invest in each year – can do much more than about 10% a year.
We try to limit our picks to stocks that should return at
least 10% a year if bought and held. The second part is key. Maybe you can make
more money flipping them in a year. But, some will obviously decline in price
over just one year. So, that’s not a good way to judge the value The Avid Hog
can provide to subscribers.
The only way to judge that is to look at a holding period
of at least 3 years. Do we think we can pick ideas that will return 11% a year
over 3 years?
That sounds like a good goal to me. Don’t subscribe to
The Avid Hog if you’re looking for more than that. I’m sure you can do better
than 11% a year by focusing on the very best of the 12 ideas. That’s what I
always do when investing my own money. And that’s what I’d recommend to the
folks who can stomach a more concentrated portfolio.
But a list of 12 stocks is pretty diversified. And it’s
not easy to do much better than 11% a year if you’re not concentrating. I don’t
think anyone should expect better than 11% a year from any newsletter – and
certainly not from The Avid Hog.
So, who is the newsletter for then? Is it for
institutional investors or individual investors?
There’s no price difference. It’s $100 a month regardless
of what you use it for. We know the majority of our subscribers – right now –
are either current or former employees of investment firms. Of course, that
doesn’t mean they plan to use The Avid Hog professionally. They have personal
portfolios. Again, we don’t ask what subscribers do with the information we
provide.
The price tag is a bit of a hurdle for individual
investors. But I think the content is a bigger hurdle. The Avid Hog runs about
12,000 words. The first issue had 21 years of financial data in it. Not a lot
of folks without some sort of analyst background are going to be interested in
spending that much time with that much information about one company.
It’s not a breezy read. And it is extremely focused on
just one company. So, it’s meant for a limited audience of equally focused
investors. You have to like spending half an hour to an hour focused entirely
on one company. If you read every line of The Avid Hog – and I certainly hope
you do – you’ll probably need to spend 25 to 50 minutes with the issue. That’s
at a normal reading speed. Some people read a little faster or slower than
that. Most don’t. So the issue isn’t even something you can consume in less
than the time it takes to watch a TV show. If you’re a fast reader, it’ll go by
in about the time it takes to watch a sitcom. If you’re a slow reader, it’ll
run about as long as an hour long drama. There are also charts and graphs, a
bit of arithmetic here and there, etc. We hope you’ll linger with the issue
longer than the absolute minimum time it takes to read the issue. But even that
is on the long side for a lot of people. A lot of newsletters probably read
faster than The Avid Hog. And, of course, most of them cover more stocks. So,
you’re committing to a lot of time focused on one stock when you sit down with
The Avid Hog.
This is really the whole point of the newsletter. Quan
and I – when investing our own money – naturally do this. We focus for weeks at
a time on one stock. It’s how we work. And it’s always been how we worked. I
don’t know another method of analysis that works as well as really
investigating a stock over a couple weeks.
The Avid Hog is really the product of a month of two
people looking at one stock. This is something we always did. But it’s not
something we saw a lot of people selling. There may be a good reason for that.
Maybe the market for newsletters is a market for shorter, more varied reports.
Since we’re focus investors – we wouldn’t be able to write those.
The basic idea of The Avid Hog is to provide you with the
info we use when making an investment decision. We don’t do a perfect job of
that. There was a ton of information we had on the company in our September
issue that didn’t make it into the final issue. But, we didn’t get a lot of
people asking for more information than we provided. A few suggested a little
less would have sufficed.
Over time, I hope this is something we get better at. As
an investor, you have a relationship with a business – a familiarity – that
goes far beyond anything you can easily convey to a reader. This is a constant
problem. It’s the one we are trying to overcome. But it’s still a very tough
problem to solve. You can bet that we have a higher degree of confidence in any
stock we pick than our readers will after reading an issue.
It shouldn’t be that way. We should be able to
communicate our thoughts and analysis in such a clear way that everything we
learned about a company can be as convincing – as great an aid to understanding
– as when we finally digested it in our own heads. It never works out that way.
Something is always lost in translation. And I’m afraid that conviction is a
hard thing to express when your reasons for it are simple but also based on an
accumulation of evidence from a lot of different sources that you’ve gather up
over a month or so.
So, we’re still not perfect at getting across to readers
everything we know. But that’s the point of The Avid Hog. We take a month to gather
up everything we think is relevant. And then we present it to you. If you don’t
have enough information to make an investment decision after reading the issue
– then we’ve clearly failed.
One of my biggest concerns is how people will use The
Avid Hog. Let’s look at a quick example of the math needed to make a
subscription work.
If The Avid Hog can improve your results by 3% a year and
you have a $50,000 portfolio – it works. Once the numbers are less favorable
than that (we can’t improve your results by at least 3% a year, or your
portfolio is less than $50,000) the math just doesn’t add up. It’s not worth
the subscription price unless you can get a 3% annual increase and/or you have
a portfolio of $50,000 or more.
That’s because a subscription is $1,200 a year. And 3% of
$50,000 is $1,500. You can do the math on what kind of advantage The Avid Hog
would need to provide your portfolio to make it worth subscribing. At $25,000,
you’d need a 6% annual lift from our picks. That’s tough. Too tough in my
opinion. So, I’d say folks with a portfolio of $25,000 simply can’t pay the
$100 a month needed to become a subscriber. It’s not worth it for them.
On a $100,000 portfolio, just a 1.5% advantage would make
the subscription pay for itself. I don’t think there are many people with a
portfolio of $100,000 or more who wouldn’t come out ahead subscribing to The
Avid Hog. But I’m biased. I think – if you act on our picks – you can make 1.5%
more a year.
There is one other area that should be a big benefit. In
fact, for some folks, this secondary benefit should more than pay for a year’s
subscription to The Avid Hog.
It’s taxes. I’ll just talk about the U.S. here because I
know the tax rules. Some people reading this have short-term capital gains in
many years. This is very tax inefficient. At times, it can’t be avoided. I had
a company bought out a few years ago. Most of my purchases were made within one
year of the consummation of that buyout. So, I couldn’t avoid a short-term
capital gain.
That’s not an awful position to be in. Only having
short-term capital gains in the event of a buyout usually means you at least
still end up with a high annual return after-taxes.
As a general rule, American investors need to avoid any
short-term capital gains. I can’t think of many situations where you could
actually demonstrate the benefit of selling before one year of purchase
convincingly enough to make me recommend a sale within one year.
And yet, some people do it. Some people – even some value
investors – end up with short-term capital gains.
The minimum intended time frame for any Avid Hog pick is
always 3 years. We never want to see a subscriber sell before 3 years are up. They
will. We know they will. And we know there’s nothing we can do about it. But,
we also know there is at least a strong tax incentive for them to keep a winner
for more than one year.
There’s, unfortunately, an incentive to sell a loser
within one year as well. We don’t think the incentive there is strong enough to
offset the likelihood that selling a pick – at a loss – within just one year is
a really, really bad idea.
We can’t tell subscribers how long to hold their stocks.
I mean, we can – and we do. We say 3 years at an absolute minimum. And we’ll
keep saying that.
But the truth is that the value of our picks is in how
you use them. If you have a portfolio of $50,000 or more and you really do
devote it to just picks from The Avid Hog and you really do hold each stock for
at least 3 years – I’m confident you’ll get more than $1,200 a year out of our
newsletter. Honestly, I’m not very confident subscribers will do all those
things I just said. I’m not sure the implementation will always be ideal in
practice. But you know yourself. And you know if it would be in your case.
So, in theory, the tax savings from moving to a 100% buy
and hold approach should be enough to justify a subscription to The Avid Hog
for those who have fairly large portfolios and some short-term capital gains. Again,
you can do the math on your own portfolio. But moving $7,000 a year from
short-term capital gains to long-term capital gains would more than pay for a
subscription for investors in the top three U.S. tax brackets.
Of course, you don’t need to subscribe to The Avid Hog to
turn short-term capital gains into long-term capital gains. You just need to
commit to a buy and hold approach. You can do that on your own. Or you can do
it with The Avid Hog.
We hope that subscribers will get some additional lift –
some extra value each year – from moving more of their capital gains into the
long-term variety. Even if there was no tax advantage in doing so, we’d always
want to have subscribers holding for the long-term.
The other benefits of The Avid Hog are less tangible.
The first is simplification. We want to simplify and
focus the investing lives of our subscribers. We want to encourage them to turn
off CNBC and Bloomberg, put down the Wall Street Journal and The Financial Times
– and focus on one business at a time. We’re only asking for about an hour of
their time once a month. But we hope that will be focused time.
That’s the word we like best when talking about The Avid
Hog: focus. We certainly focus on a specific checklist, on a single stock, etc.
We go into greater depth instead of giving you a lot of breadth. That is all
fairly obvious in the issues. If you haven’t sampled an issue yet, you can
email Subscriber Services and ask for one. There will be an email address at the
bottom of this post.
Quan and I don’t want that to be the only focus though.
We don’t want The Avid Hog to be only about the two of us focusing on a stock.
What we really want is for The Avid Hog to be an oasis of focus in your
investment life. We know that anyone who subscribes to The Avid Hog has a less
simplified investment life than they’d like. They certainly have a less focused
investment life than is ideal for achieving the best long-term returns.
We would like to create a product that – once a month –
gives readers the opportunity to forget there are other stocks out there. To
forget there is a market. And just to focus on a single business and a single
price. It’s a handpicked business and price. So we think it’s an attractive
one. But, even if you don’t agree, we hope that hour or so you spend with us
each month will be – minute for minute – the best time of your investing month.
We hope more than anything that it will be the most focused. It will come
closest to the Mr. Market ideal of seeing a quote and using it to serve you
rather than guide you.
We know a lot of the folks who will subscribe to The Avid
Hog will not be living exactly the investment life they aspire too. They are
value investors. And their life situation – often their job at an investment
firm – will put certain demands on them that lead them further from the ideals
described by Buffett and Graham than they would like.
More than anything, we know they feel overwhelmed. We know
they feel like they consume a lot of noise. And don’t get to spend enough time
on the stuff that really matters.
We hope paying $100 for an issue will be incentive enough
for them to block out a time that they can spend with just one stock.
This is how Quan and I spend virtually all our time. It’s
how many great investors spend their time. And it’s really how individual
investors should be spending their time too.
But the world isn’t designed to accommodate that kind of
focus. Almost every form of financial media is going to bombard you with a lot
more breadth than depth.
We’re trying to flip that around for about an hour a
month for our subscribers. That’s the thing Quan and I are most interested in
doing for subscribers. We’d like to create an environment where they can focus.
We’d like to make them feel we’ve simplified their investment life.
Of course, that’s not something we can do alone. Like the
matters of returns and taxes – focus isn’t something we can guarantee for
subscribers. It’s something they have to work as hard receiving as we do on
giving. So it’s an uncertain benefit of The Avid Hog. But it’s the one I’m most
hopeful we can provide. It’s the one I think is actually most valuable. If we
can provide our subscribers with an hour of intense focus each month, I think
we’ll have provided good value for the $100 a month price we charge.
I don’t know how many subscribers will focus on the issue
the way we hope. It’s one thing to invest $100 of your money. It’s another to
invest an hour of your total focus. For many people, the latter is actually the
harder one to give.
Speaking of focus, the focus of The Avid Hog on above
average businesses should provide an added benefit for subscribers. It should
give them a list of companies they can revisit in later years – even if they
don’t buy the stock today.
We don’t sell individual issues of The Avid Hog. All
subscriptions are billed monthly at $100. So, from that perspective, it’s like
every issue is sold separately. But we don’t like to think of it that way. We
like to think of The Avid Hog as being as much about the process as the
product.
In a year, we’ll publish 12 issues. As I mentioned, each
issue is about 12,000 words. So, you can do the math and see you’re basically
reading a book or two a year with The Avid Hog.
We like to think of The Avid Hog more like that. We like
to imagine that you are getting 12 chapters you can use later even if you don’t
put them to use now. Quan and I certainly won’t put our money into 12 stocks a
year. We tend to be more of the “one idea a year is plenty” type investors. A
lot of subscribers will want to diversify more. But plenty will still decide to
pass on some of our picks.
We hope that doesn’t mean they pass on the businesses.
Knowledge of a good business has a certain permanence to it. Or at least it has
a longer shelf life than a lot of what you know about investing.
The Avid Hog doesn’t revisit past picks. But we hope
subscribers will. We hope that when an above average business we profiled
earlier plunges in price, some of our subscribers will be ready to jump in. We
hope you’ll be able to build up a personal database of above average
businesses. We’ll discuss them at the rate of 12 a year. That should provide a
pretty good shopping list in the next market downturn.
That brings me to the market. And to a point I haven’t
stressed enough yet. The Avid Hog is not meant to outperform the market. We
hope we’ll do that. We expect to do that. But we don’t aim to do that. Quan and
I don’t try to beat the market. We just try to find the best above average
business trading at a below average price this month. And repeat that every
month.
We believe that process will – over time – beat the
market. But, we also believe it will underperform in great years for the
market. It’ll outperform in some very bad years. But neither will be the result
of our actually trying to beat the market in the bad years or holding back in
some way in the good years.
The process will always be the same. The relative results
will vary because the S&P 500’s returns will vary. And because the
opportunities the market serves up will vary.
We don’t target relative results. We think we can –
long-term – get good relative results without worrying about them. That has
always been my personal experience. But a lot of newsletters – and some
investors – do focus on relative results. So it’s important that anyone thinking
about subscribing to The Avid Hog knows that we do not – and we never will –
target relative results.
What do we target?
My number one focus is always the margin of safety. If
there’s no margin of safety, you can’t buy the stock. How big is the right
margin of safety?
That’s up to you. Valuing a stock is as much art as
science. Exact appraisals vary a bit. On the last page of each issue of The
Avid Hog, we print an exact (dollar and cents) appraisal of the company’s
shares. We actually write “Company Name (Ticker Symbol): $46.36 a share” or
whatever. We’re that precise.
That can be misleading if you don’t see the appraisal in
the context of the other stuff on that page.
So, the last page of each issue is called the “appraisal”
page. It has a calculation of “owner earnings”. It has an appraisal of the
value of each share (using a multiple of owner earnings). And it has a margin
of safety measurement. It also presents some data and how the current stock
price – and our appraised price – compare to the market prices of some public
peers.
I want to focus on the owner earnings calculation, the
appraisal, and the margin of safety.
You probably know the term “owner earnings”. If you
don’t, you can read the appendix to Warren
Buffett’s 1986 letter to shareholders. We use the basic approach
he does. We basically want to count pre-tax cash flow. We use pre-tax numbers
because we always value a business independent of its capital structure. Only
after we’ve settled on a “business value” do we compare that value to the debt
and equity of the company. This is pretty typical stuff for a lot of value
investors. Like I said, we’re a bit more dogmatic – at least I am, I won’t
speak for Quan here – about using capitalization independent (unleveraged)
numbers and about using cash flow rather than reported earnings.
It’s very important to mention how unconventional we are
here. You should never pick up The Avid Hog expecting to be told about a
company’s EPS. We don’t do earnings per share. We don’t talk about earnings per
share. I don’t mean we discuss it as one of many things. I mean we literally
don’t spend a second on EPS. Whether a company will or won’t be able to report earnings
doesn’t mean anything to us as long as the company will be able to harvest that
cash flow.
This attitude pervades everything in The Avid Hog. So
it’s important that you know ahead of time that reported earnings will never,
ever be discussed. I know EPS is a relevant number in a lot of the financial
media. It is irrelevant for us. And we never discuss it. Likewise, we tend to
discuss prices in relation to enterprise value rather than market cap. We do
move on to valuing the equity after comparing the company’s debt to its
business value. But we really don’t do P/E ratios at all.
For some subscribers, it’s a bit of an adjustment to only
think in terms of enterprise value and owner earnings rather than EPS and P/E
ratios. But it’s the only approach that makes sense to us. And Quan and I don’t
do anything halfway. We don’t compromise on this point. In a lot of issues,
you’re literally going to get 12,000 words without a single mention of EPS. I
know that’s unconventional. A lot of The Avid Hog is unconventional in this
sort of ways. We present the stuff we think matters. We don’t present
information that is customary but ultimately irrelevant.
So we do our little owner earnings calculation. We
present it item by item. So, you’ll see items adjusting for non-cash charges,
for pension expense, for restructuring, for cash received but not reported
(yet) as revenue, and so on. We do it as a reconciliation of reported operating
income to owner earnings. Think of it like a statement of cash flows. It’s the
same basic idea.
Sometimes there’s very little to reconcile. Right now, it
looks like the stock in the October issue has similar owner earnings to
reported operating income. Not a lot of big changes.
If you read the September issue, you know the company in
that issue has owner earnings that are a lot higher than reported operating
income. Again, we don’t care even a little bit about reported operating income.
You can see the reconciliation yourself. And you may be inclined to trust
reported operating income more than our estimate of owner earnings.
Personally, I think you’d be very, very wrong to do that.
But the information is there for you. You can quibble with us line by line. We
put every item right there on the page. So, if we count something as earnings
that you wouldn’t – go ahead and make your own adjustment.
Everyone’s appraisal of a company’s intrinsic value
differs a little. Even Quan and I – who’ve been looking at the same facts and
talking about the stock for a month or so – come up with slightly different
intrinsic values for the same stock. For the September issue, I think my
intrinsic value estimate would be a bit higher than Quan’s. That won’t be true
for the October issue. Where we have significantly different methods, we show
you both. Generally, we go with the most conservative method that we still
consider reasonable. We don’t use unreasonably conservative appraisals. The
conservatism should come through insisting on a margin of safety – not through
making an unreasonably low appraisal of the stock. But, when in doubt, we err
on the side of conservatism. The price printed in the September issue is lower
than the appraisal I would put on a share of that stock. If you offered to buy
the stock from me at that price, I would turn you down. Logically, if I would
reject your offer at that price, that means I’d appraise the stock higher. So,
the appraisal in the September issue is lower than what I would have come up
with privately. But it’s a number I’m comfortable having out their publicly.
That’s what I mean when I say we err on the side of conservatism. We aren’t
going to print an appraisal I think makes no sense. But we will print an
appraisal that’s on the low side of what I think makes sense. The same goes for
Quan. In the case of the September issue, I would’ve been the one arguing for a
higher appraisal. In future months, I’m sure our positions will be reversed.
We’re not the Supreme Court. We don’t print dissenting opinions.
The figure you see is always a consensus agreed upon by the both of us.
As I said earlier, The Avid Hog is as much about the
process as the product. That’s why Quan and I spent a year perfecting the
process.
Our process for the appraisal page has been standardized
by now. It will be the same in each issue. We calculate owner earnings. Then we
come up with a fair multiple of owner earnings. We apply the multiply. We then
compare Owner Earnings x Fair Multiple = Business Value to the enterprise value
of the company. The excess of business value over the company’s debt is used to
calculate the equity value. And, of course, the equity value divided by fully
diluted shares is how we get our appraisal price per share. We then measure the
margin of safety.
The margin of safety confuses some people. It’s easy to
understand if you look at the calculation we show. Basically, the margin of
safety is always the percentage amount by which the business could be less
valuable than we think. It is not a measure of the difference in stock price
between our appraisal price and the market price. That would only occur in
instances where the company had neither debt nor cash. In that case, an
appraisal value of $70 a share and a market price of $50 a share would result
in a 29% margin of safety ($70 - $50 = $20; $20 / $70 = 29%). That’s not
normally how margin of safety works, because the company is less safe to the
extent it has debt.
Let’s take our October issue – not yet released – as an
example. It’s not finalized yet, but I can give you a pretty good idea of what
the margin of safety on the stock is by our estimates. The stock trades for
about 60% of our appraisal value. So, if it’s a $30 stock, we think it’s worth
$50. That’s pretty simple. But the company has debt. So, in theory, the upside
on the stock would be about 67% ($50 - $30 = $20; $20 / $30 = 67%). Quan and I
don’t calculate the upside. So, that’s not a number you would ever see. It’s a
number that reflects leverage. And leverage is only on your side if we are
right in our estimate of that $50 (or whatever) appraisal.
The number we actually show you is very different. It’s
how much the business value of the stock could decline and still be greater
than all of the company’s debt and the price you paid for the stock. Imagine an
example where a company has a $30 stock price, $10 of net debt per share, and a
$50 business value per share appraisal from us. In that case, the margin of
safety is only 20% ($50 - $40 = $10; $10 / $50 = 20%). And that’s the only
number you would see. We would never mention the stock has a 20% margin of
safety and a 67% upside. We would just talk about the 20% margin of safety.
Our reasoning on this goes back to Ben Graham. But it’s
also consistent with what we want The Avid Hog to be. What we’re trying to do
is come up with above average businesses at below average prices. We’re trying
to do that regardless of how the market performs. So, our focus is not on the
upside over the next couple years. Our focus is on getting subscribers in the
best possible business to buy and hold and ensuring that there is a margin of
safety that protects them from a permanent loss of principal. As long as the
purchase price is justified, they will end up in a better than average
business. That’s the part that should lead to good long-term returns. Our value
calculation is really all about ensuring the presence of a margin of safety.
This is the protection you get when you buy the stock. The quality of the
company – and the durability of its cash flows and the moat around its business
– is what ensures adequate returns over time.
This means we discuss value a bit less than most value
investors do. We certainly discuss the upside implied by our valuation a lot
less. We don’t make a big deal of paying $45 for a $70 stock. We make a big
deal about getting in the right business at a suitable discount to what we
think the entire business is worth.
For ease of illustration, I used per share values here.
We tend to focus on the value of the entire business right up till the last
step – where we divide by the diluted share count. So, we talk about a business
being worth $5 billion and having an enterprise value of $3 billion rather than
being worth $50 a share and trading for $30 a share. The per share intrinsic
value is really only discussed once.
Like I said, different people will come up with different
intrinsic values for the same stock. Quan and I discuss ours on the appraisal
page. But we also provide the data subscribers need to make their own
judgments. This starts on the datasheet. When you first open The Avid Hog – after
seeing a cover page, it’s just a teaser drawing that hints at the business
we’ll be discussing – you find a datasheet. The datasheet presents the numbers
Quan and I care most about.
These are historical financials. The September issue went
back pretty far. It had a total of 21 years of financial data. The company we
chose has already reported its fiscal year 2013 results. And we had data for
the company going back to 1993. Quan and I don’t have a target for how many
years of financial data we give you. We simply print everything we use.
Generally, we use everything we can get our hands on. In the current issue of
The Avid Hog, that happens to be 21 years of data. Next month’s issue will have
a lot less. Probably fewer than 15 years of data. The company hasn’t been
public for that long. In any case, we’re confident we’ll be providing you with
more historical financial data on the company than you’ve ever seen. It’s also
probably more data than you can find on that company anywhere other than EDGAR.
And EDGAR doesn’t put it into nice rows and columns for you. You have to go
back and read the 1993 report for yourself.
What kinds of information do Quan and I care about?
What’s in the datasheet?
Again, we’re unconventional in our approach. There is no
mention of per share numbers. You won’t see anything about earnings per share,
book value per share, etc. It looks a lot like a Value Line page. But that’s
just the first impression. The actual numbers presented are quite different.
We focus on sales, gross profits, EBITDA, and EBIT. Balance
sheet data is all about the numbers needed to calculate net tangible assets –
which we do for you – so that’s receivables, inventory, PP&E, accounts
payable, and accrued expenses. There’s also the issue of deferred revenue at some
companies. We present the liability side together. It’s usually more important
to look at receivables and inventories separately than to look at accounts
payable and accrued expenses separately. So we break out the current assets by
line. We don’t break out the current liabilities.
Quan and I care a lot about returns on capital. We
especially care about returns on net tangible assets. So we provide all the
info you need to make that calculation. That means we do margins (Gross
Profit/Sales, EBIT/Sales, and EBITDA/Sales) as well as “turns”. We show you the
turnover in the business’s receivables, inventory, PP&E, and – most
importantly – its NTA. When you put the two numbers together – margins and
turns – you get returns. We don’t just calculate EBIT returns. We also do gross
returns and EBITDA returns. At some companies, EBITDA returns are quite
important. Gross returns are rarely important in the short-term. But as
mentioned in some journal articles, they are actually a good proxy for how
profitable a business is. Basically, if a company’s gross returns are too low
today, they’re likely to always have a problem earning a good return on
capital. This is less true of things like EBIT/NTA. That’s a number that some
companies can improve a lot by scaling up. But scaling up usually isn’t going
to help enough if your Gross Profit/NTA is really low.
The first couple companies we’ll be profiling for you in
The Avid Hog have essentially infinite returns on tangible assets. They don’t
really use tangible assets. This makes the return figures less important. The
turnover numbers are also less important. The margin data may be useful.
Regardless of how useful the number is for the particular company, we always
include it.
These calculations are done for every year where we can
do them. In our September issue, I think we had full calculations of all lines
for at least 19 years. Returns on capital can’t be calculated for the first
year in a series because you don’t know what the average amount of capital was
in a business until you have two balance sheets – a starting and ending one –
to work from. We can – and do – obviously calculate margins for all years. So,
the September issue had 21 years of gross margins, 21 years of EBITDA margins,
and 21 years of operating margins.
Free cash flow data is not shown explicitly in the
datasheet. But you can think of the datasheet as really being all about free
cash flow. We calculate year-over-year growth numbers for all items. So, you
can see – for example – that the company we chose in the September issue
increased EBITDA by about 9% a year on average while NTA increased only 6% a
year on average. I’m using median as the average here. We present minimum,
maximum, median, mean and some variation numbers. If you use only one number –
I’d use median. But it’s up to you. Anyway, you can see from the 3% a year
difference in a cash flow number compared to NTA that the company will tend to
always have higher free cash flow than reported income. This is because the
amount of additional cash coming in is always exceeding the amount of growth in
net assets. You can see this at a website like GuruFocus or Morningstar for the
last 10 years (or whatever) by looking at free cash flow. But you can also see
it in our 21 years (or whatever) of data that includes growth rates in NTA
versus growth rates in sales, gross profits, EBITDA, and EBIT.
The biggest departures for our datasheet relative to what
others like to show you is our focus on gross figures and our focus on net
tangible assets. These aren’t the two most important numbers in the datasheet.
But they are the two most important numbers you’ll see highlighted in The Avid
Hog that you won’t have heard much about when studying the same stock using
someone else’s data. This is just a matter of presentation. Everyone provides
enough info for you to do these calculations yourself.
I suppose the biggest difference between our datasheet
and the data you’ll get elsewhere is how far it goes back. I’m sure a lot of
subscribers will doubt the importance of seeing 1990s era data in 2013. What
importance could a company’s results in the 1990s have on its future in the
2010s?
It’s a logical sounding complaint. But it’s not supported
by the facts. The length of time a company has been consistently profitable is a
surprisingly good indicator of what future results will be. In fact, if you
asked me for just one criterion to screen on it would be the number of
consecutive years of profits. Most investors err badly by assuming that a
company that has a couple losses in the last 10 to 15 years is fine because
it’s made money now for 6 straight years or whatever. Making money for 20
straight years tells you a lot more than making money for 6 straight years.
There are economic cycles and industry cycles. Some can
be short. But some can be long. The longest – something construction related
like housing, shipbuilding, etc. – probably run in the 15 to 20 year length
rather than the 5 to 10 year length. I’ve never felt that 5 to 10 years of data
was sufficient to make a decision about a stock. I would hate to have to decide
much of anything on less than 15 years of data. I do think it’s relevant that
Apple today has nothing to do with Apple 15 years ago. And I think a company’s
long-term financial results show you that.
Again, Quan and I are on the wrong side of convention
here. But I think we’re on the same side as Warren Buffett. When he buys a
company, he likes to see as many past years of data as they have. But he
doesn’t want to see any projections for the future. We like a clear past and a
clear future. But only one of those things is verifiably clear. The past
actually happened. The future is merely a projection. We think investors could
all benefit from seeing a lot more past data than they do now. And we hope that
including so much past data in The Avid Hog – and we’ll always include every
bit we’ve got – will convince others of the usefulness of that approach.
Now the past data is more useful the more you know about
the past. So, it helps to know what were good and bad years for the industry –
not just the company. It helps to know what was going on in the economy. We
can’t provide you with all of that. But we hope you’ll linger over the
datasheet. In fact, we hope you’ll print out the datasheet, carry it around
with you, do some exploring of the past yourself. We also think the datasheet
makes our explanation of the company’s history clearer. We can’t – in prose –
get into the kind of detail we’d like to see on a company’s past. But we can discuss
a few qualitative aspects in words. And then we can present the rest to you in
numbers on that one datasheet.
The datasheet is another area where I think The Avid Hog
offers a lot. But you’re only going to get a lot out of it if you put a lot
into it. You can flip through the datasheet in a couple seconds. Or you can
spend a lot of time with it. There is a lot to think about in that datasheet.
And I hope that it’s an area subscribers won’t just linger on – I hope it’s
actually one they’ll ponder. And maybe even go back to the next day. Having
that much data would always be the foundation of any investigation of a company
for me personally. That is where you start. You start with the numbers. You
start with the patterns in them. And then you move to trying to explain those
patterns and see which are likely to prove durable.
The datasheet is something that I really wanted to
include, because it’s something I always want to see in reports – and never do.
Whether I am reading a blog post about a stock, a newsletter, or an analyst
report – I’m always eager to see more data than I’m given. That’s why Quan and
I are including all the data we can on that datasheet. That’s why we’re going
much further into the past than most reports do.
This brings me to the question of why we’re doing this.
Why did Quan and I create a newsletter? And why did we create this particular
newsletter?
At a $100 a month price tag, the obvious motivation would
seem to be money. But when you consider the amount of work that goes into the
newsletter – and the small potential audience for a newsletter that focuses in
this kind of depth on just one stock – money is less of a motivating factor
than you might think. We’d like to get to the point where we have enough
subscribers to justify the labor cost. We’re nowhere near that level now. And
I’m not sure we’ll ever get to that level. There aren’t a lot of products like
The Avid Hog. There are other monthly newsletters that charge $100 a month (a
little more, a little less). Some bill annually. We bill monthly. But there’s
really not a big difference on those points. There are plenty of other
newsletters that come out with a similar frequency (monthly) and charge a
similar price ($100 an issue).
The difference is in the product itself. If you’ve
sampled The Avid Hog, you know this. It doesn’t look like other newsletters. It
looks like a collection of articles on one company. It lacks the variety of
other newsletters. We think it makes up for it in focus.
But we’re biased on that point. And this is the real
reason Quan and I created The Avid Hog. It’s what we love to do. We would be
doing all the research that makes The Avid Hog possible whether or not we were
publishing it. We like to spend our time focused on a single stock for a full
month. Business analysis is the kind of analysis we like best. Coming up with a
list of 10 or 20 ideas doesn’t appeal to us in the same way that focusing on
one or two ideas does. It never has. And it never will.
So The Avid Hog is really about trying to do what we like
best while making enough money to support the process. As you can imagine, the
external costs associated with producing one issue of The Avid Hog are minimal.
The cost of a month of creating The Avid Hog is basically $300 in some fixed
costs plus the time Quan and I put into it.
There are good and bad sides to this. The good side is
that we have almost no costs other than our time investment. This means we can
stick with The Avid Hog when it would be – like now – not remotely financially
viable because the subscriber count is too low. Through our dedication to the
product, we can keep it going for many months when any rational publisher would
shut it down.
That gives us the chance to grow an audience and ensure
the long-term survival of The Avid Hog.
The downside to not having a lot of costs other than our
labor is obviously the price. We’d love to be able to charge a lot less. But
you can only do that with a lot of subscribers. Other sites have a much bigger
platform – more of a megaphone – from which to announce their product. They
have bigger distribution capabilities than we do. And so they will always have
a much larger group of subscribers for any product they put out. It will be
better for the good products than the not so good products. But even a lousy
product put out on a big online platform will sell more copies than the best
product we could ever produce.
I can tell you now, the price of The Avid Hog will not
drop. I just don’t see anything in what we know about the potential audience
size that would allow that to happen. You can run the numbers yourself – after
having read a sample – and guess what you think the commitment of labor is to
something like that. It’s not a one person product. So, it requires a good deal
of revenue to put out a product like that. It doesn’t for the first few months.
But that’s only because Quan and I are committed to not getting paid for a long
time.
So that’s the good side and the bad side of the cost
situation. The good side is that we are committed to working for free on The
Avid Hog. And the product doesn’t require much ongoing investment other than
our time. So we can keep the thing running. The bad side is that because we are
appealing to a very small audience – it’s a very niche product – we are never
going to be able to lower our price per issue to a level we’d like to. We’ll
never be price competitive with more general, more popular newsletters.
We didn’t design the product with financial considerations
in mind. In fact, we didn’t design The Avid Hog with many marketing considerations
in mind.
What we did is design the product we would want to read
ourselves. And we created the product we love working on. It’s unclear whether
there are enough likeminded people to support such a product. And, if there
are, whether they read this blog. But it’s a passion project for me and Quan.
And I know we will continue it at a loss for longer than most people would keep
it going.
I should probably talk a little bit about that passion.
Quan and I wanted to work together. And we wanted to work together on a product
we could be proud of. I have had the experiences – no, I won’t be naming names
– of working on some products I was not proud of. Generally, I think I did the
best I could to make those products a lot better than they would have been. And
I had to operate under that assumption. I had to believe that making a product
better than it otherwise would’ve been was justification enough for the work.
It was not a fun experience for me. That isn’t because
the products weren’t good. Nor is it because there wasn’t demand for the
products. I think there was a lot more demand for the things I worked on that I
wasn’t proud of than there will be on The Avid Hog (which I am proud of). But
there was a serious mismatch of the content and the creator. Sometimes – if the
content and the customer are matched up well – that can be financially
rewarding. But it’s emoti