13% and 15% Pretax Returns Now!

Banks/financials have been announcing earnings and they have been looking pretty good even though there is debate about the quality of some of the earnings (reserve releases etc.).  There is a lot to talk about but I just thought I'd make a quick update on Wells Fargo (WFC) and J.P. Morgan (JPM) as I have talked about them a lot here.

Buffett's 10x Pretax Earnings / 10% Pretax Yield Idea
I am just going to look at the simple Buffett metric; pretax return on investment.  I've mentioned this metric on another WFC post not too long ago.  Buffett has said in a recent annual meeting that he would like to pay 10x pretax earnings, Alice Schroeder (Buffett biographer) has said that that's all Buffett wants to do; make a 10% pretax return on his investment with little risk.  Munger also used WFC as a benchmark investment against which other potential investments would be compared a while ago; is the potential investment more attractive than WFC?  I think he said at the time that WFC is priced at a 10% pretax yield so if something doesn't measure up to that, why bother?

WFC Pretax Earnings
For the past four quarters, here is the pretax earnings trend for WFC:
   
                    Pretax           Preferred                Pretax
                    earnings         dividends               earnings (less preferred dvd)
2Q2013       8,471             247                       8,224
1Q2013       7,640             240                       7,400
4Q2012       7,221             233                       6,988
3Q2012       7,510             220                       7,290
                  30,842             940                     29,902

So on a trailing twelve month basis, WFC has earned $29.9 billion pretax (and after preferred dividends; I ignored minority interest as it is small).

WFC is now trading at around $44.00, so with 5.3 billion shares outstanding, that's a $233 billion market cap; WFC is trading now at a 12.8% pretax yield on a trailing twelve month basis.  12.8% pretax yield in a world of 2.5% interest rates is pretty attractive (of course, I would never price a stock to a 2.5% pretax yield, though!).

I don't think there is any doubt that Buffett still finds WFC attractive at these levels (he has been buying more all year).  Using his 10% pretax yield, or 10x pretax earnings valuation, he would probably be buying WFC (as long as he is allowed to) up to $56.   That's almost 30% higher than here.  And keep in mind, if I understand everything I've read about Buffett, $56/share for WFC is a price that he would be interested in buying the stock, not some notion of intrinsic value, fair value or anything like that.  It's a price that he would be willing to pay.

There are some issue with banks that people worry about, but we'll look at some of that later.

JPM Pretax Earnings
So let's take a look at another favorite on this blog.   JPM also announced pretty good earnings even though some argue that reserve releases make the number not so high quality.

First, let's just look at the numbers:

               Net to
               common                 Income      
               shareholders           tax             "Pretax income"
2Q13      6,101                     2,802          8,903
1Q13      6,131                     2,553          8,684
4Q12      5,322                     1,258          6,580
3Q12      5,346                     2,278          7,624
             22,900                     8,891        31,791

For pretax earnings here, I just took the net income to common shareholders and added back income taxes paid.  JPM is now trading at around $56, so with 3.8 billion shares outstanding that's a market cap of $213 billion.   That's a 14.9% pretax return, not bad at all.  We can see why Buffett likes JPM (assuming he still owns it.  I don't think anything has happened recently to suggest he doesn't own it; the whale loss didn't seem to bother him at all).

Using the above measure, Buffett would pay up to $84/share for JPM (10x pretax earnings); that's 50% higher than here.  Again, this is what Buffett would be willing to pay.

Yes, but... 
I know.  Many don't see current bank earnings as sustainable.  Reserve releases and a friendly Bernanke is really helping the banks (although we can argue that buying bonds is not helping banks as it flattens the curve (offset recently by a refinance boom that is tapering off)).

On the other hand, one can see the economy as still very subdued and not really recovered.  Housing is still running way below historical trends, and of course, the interest margin is arguably at an unnaturally low level that would eventually normalize.  Also, legal and other costs are elevated due to legacy problems from the financial crisis.

Anyway, let's take a look at what JPM says they can earn on a more 'normalized' basis from their investor day presentation earlier this year.

JPM has long said that under a more 'normal' environment (escalated credit and legal costs come down etc.), they can earn $24 billion in net income.  This is the slide from the investor day presentation that shows this:

This is assuming no change in the environment, but just a normalization of the recent big items.  Just for reference, the last twelve months net income for JPM came in at $24.4 billion.

And another slide showed there are growth initiatives that should allow JPM to earn more than $24 billion over time.  Dimon didn't say when earnings would get to $27.5 billion shown below, but said that the initiatives are close to being in place or will be in place soon so are not longer term targets, so he hinted that $27.5 billion can come soon too.  This is not some medium/long-term project/target.

Using the $27.5 billion ''normalized" figure including growth intiatives and $1.3 billion in benefit from a 100 basis point increase in interest rates, that would come to $39.3 billion pretax (assuming 30% tax rate), and deducting $1.5 billion for preferred dividends and "dividends and allocation of undistributed income to participating securities" leaves us with $37.8 billion.   With 3.8 billion shares outstanding and a $56 stock price, that implies an 17.8% pretax yield.  That's pretty interesting.

Again, not wearing rose-colored glasses, but borrowing Buffett's glasses, it looks like Buffett would be willing to buy JPM up to $99/share!  That's 77% higher than the current price of $56.   Another way to put it is that JPM is trading at 60% of what Buffett would pay for it.

The reason why I went back to these slides is to show that recent trends is within what JPM considers a normal range of earnings.  Even though JPM had great earnings due to reserve releases that can't go on forever, it shows that earnings can grow even without that as other areas 'normalize'. Banks may be benefiting in the short term by dramatically improving credit trends before other areas pick up, it doesn't mean that earnings are unsustainably above trend.   Of course, if other areas don't pick up, then recent trends may be unsustainable.

But, but...
Another big issue, of course, is the leverage ratio.  A lot of questions on conference calls is about leverage ratios.  This is obviously a factor.    Many seem to think that higher leverage ratios will mean that banks can't make money as they did before.  But I think this is not linear, necessarily.  There will be an impact for sure, but these will be priced into bank products.

For example, if a bank had 1% return on assets and had a leverage ratio of 5% and therefore earned 20% on capital and then suddenly the minimum ratio was bumped up to 7%.   This will obviously reduce the return on capital from 20% to 14%.  But what will happen over time is that banks will reprice their loans/products such that they make a reasonable return on capital.  In the above case, the banks would have to earn 1.4% return on assets to make a 20% return.   Loan prices would have to rise 40 basis points (actually, loans would be only a portion of total assets so other assets would also have to increase 40 bps).

This is just an example using random numbers to make a point so not realistic.  I may take a closer look once the dust settles on the rules.  I don't think loans/products will reprice immediately to maintain return on capital, and I don't know if they will be able to reprice to go back to the old returns.  But things will move in this direction.

A key point to remember is that this rule will apply to all big banks, so repricing should happen across the board.  It's just another increase in the cost of business that will eventually be passed on to the customer.  In that sense, this will have implications for monetary policy, of course, similar to raising the fed funds rate.

The problem, as Dimon pointed out, is if the U.S. has a more stringent leverage rule, it may put U.S. institutions at a disadvantage against other global banks.

Rising Interest Rates
The other issue is rising interest rates.  We can't really argue both ways.  We can't be upset with decreasing long term rates as it puts pressure on NIM, and then be worried about rising rates because that will kill the refinancing boom.

What do I think?  Well, I like WFC, JPM and other financials, but it's not conditional on interest rates.  For example, I don't say I like JPM with treasuries at 2.0% but hate it at 5.0%.  This really makes no sense to me.  I've been involved in the markets for a long time and I've seen all sorts of interest rate forecasts so the last thing I would do is invest based on a view on interest rates.

(At a firm I worked, I laughed at the resident economist who said that the Fed Funds rate will go down to 5%.  It was 8% at the time.  And then he said it will go to 3% and then I laughed even harder.  etc... You get my point.)

I like these well managed financials because, well, they are well managed. It's not because I think interest rates will stay here, go down to 2.0% or won't go above 3.0% or anything like that.  I have confidence that the management at good banks will do what is best in each respective scenario; I will let them worry about it. If I didn't think they could handle fluctuating interest rates, I wouldn't own them.  And they have been stress tested. Not by the Fed or a regulator, but by a serious financial crisis.

Off-Topic Tangent
OK, so the above thought on interest rates reminds me of a conversation I had recently.  I was talking to a guy who is really into value investing.  He is and has been studying value investing for a few years and it's his main passion/hobby (not his main job).  So I emailed him a whole bunch of stuff including book recommendations, told him to make sure to read Buffett's letter to shareholders, the article "Superinvestors of Graham and Doddsville" and the other usual stuff that we all read.

Then a few weeks later, during the market decline in June, I ran into him and he was very excited because he told me he sold out right before the sell-off  (I saw him the other day but didn't ask him if he bought back in...).

Well, he did tell me that he is a value investor and not a trader so I was a little surprised.  How can you do all the work and analyze companies, buy them and then just turn around and sell them just because the bond market goes down a little?  If you evaluate and like a business with treasuries at 2.0%, you should feel comfortable owning it with treasuries at 3% or 5%.  If not, then maybe it's not such a great business.  If you won't like a business if rates go up, then one simply shouldn't buy that business to begin with (because rates will go up, eventually).

This also reminds me of a cardinal rule of trading; if you buy something for one reason, don't sell it for another.  Of course, unless the other reason is a really good, valid reason to sell a stock (fraud uncovered, unfavorable management change, long term decline or permanent impairment of business etc.).

Anyway, time and again, I run into people who love and own this or that stock, but then they later tell me they sold because they feared a U.S. debt default, fiscal cliff, meltdown in Greece, bond market crash or some such thing.

Buffett wrote a comment (which Seth Klarman also said) in the "Superinvestors of Graham and Doddsville" article that this value investing idea is something people either get right away or not at all.   Time and again, people will do one thing (rational) and then out of fear or greed turn around and do something that makes no sense. He is so right.

If you do all the work, read the annual reports, 10-k's, 10-q's, understand and like the business and the valuation, then go ahead and buy the stock.  But please don't sell the stock just because everyone says that the bond market is going to crash and that stocks will follow it down!  If a company you are looking at is going to go bankrupt if a recession hits or if interest rates go up to 5%, then the right thing to do is to not buy that stock to begin with.  Don't buy it and try to sell out before the next recession or before rates start really going up because that sort of strategy doesn't work unless you are a really good macro trader (and those are rare!).

Yes, there are people who make a living doing macro trading.  But macro traders spend all of their time looking at macro trends and placing bets according to their own deep analysis of what they think is going on. It makes no sense for value investors who spend their time looking at businesses and financial statements to be a value investor one day and then a macro trader another (buy a stock on business fundamentals one day and then sell on another day for macro reasons).  When you really think about it, the sudden turning of value investors into macro traders is usually emotionally driven (fear), not by logic.

If you look at the great wealth created over time, most of it is created by people who buy and hold good assets; it is not created by dancing in and out of holdings (especially motivated by things that are simply unknowable).

But I know, I am preaching to the choir, but I can't resist as the above scenario happens to me all the time (and I'm sure many readers have the same experience).

Conclusion
I still like the financials.  My only reservation is that they are getting more popular.  But valuations are valuations and they are reasonable.  I looked at WFC and JPM from a slightly different viewpoint from what is common (usually looked at on a P/B or P/E basis) and find it interesting.

There are obviously a lot of risks here.  Interest rates can turnaround and head down and really continue to push NIM down and the economy can stay here or deteriorate making banking a horrible business.  Inflation can pop up and make rates go up in a bad way.  If rates go up due to a strengthening economy, that would obviously be good for banks regardless of what happens in the short term.  Over time a stronger economy would increase loan volumes and help other areas and rising rates would get NIM back up and increase profitability.

Yahoo - Alibaba Group

So I can't believe it's been more than a month since my last post.  This was not an intended leave or anything like that, time just flew by.  Preparing for the summer, going away and things like that.

Anyway, I do intend to keep posting here regularly.  Hopefully I don't have a gap of an entire month too often.

A lot of things are going on now and there are a lot of things to look at and talk about, but for now I just thought I'd look at Yahoo!, or more specifically, the Alibaba Group.

In the earnings release, there was a new slide that I didn't see before which includes the earnings of Alibaba Group.  These figures have always been disclosed in the 10-Q and 10-K's, but I don't remember seeing it in the earnings slides.

It would seem a little odd that something that has been known and disclosed for a long time suddenly gets noticed because it's on a colorful slide.

Anyway, let's take a look at it:

Let's just zoom up on the relevant table on the left:

So, we know that Alibaba Group is doing extremely well.  We all knew that, of course, but it's now even more known.  It's interesting that analysts are now rushing to up their value of Yahoo! based on an increased valuation for Alibaba Group.  I suppose the market/analysts are responding to what looks like some serious operating leverage kicking in (well, it kicked in last quarter too but people didn't seem to get this worked up about it).  Hopefully, that's real operating leverage (that is sustainable).

Anyway, so let's take a look at this thing.  I posted a couple of years ago how some thought that Alibaba Group was worth $32 billion, and last September YHOO sold some shares back to Alibaba Group validating valuations in the $30-40 billion range.

Since then, people have been talking about $100 billion for the valuation of Alibaba Group, and today I think some are saying it's worth $120 billion.

I really don't have any idea how these things are supposed to be valued, but I decided to take a closer look to see if I can get some sort of feel for it.

Alibaba Revenues and Earnings Trend
First of all, here is the trend of Alibaba Group's revenues, operating earnings and net profit (attributable to Alibaba Group):

So this is remarkable.  Revenues have been growing consistently around 70%/year and it has turned profitable since 2011.

Let's take a closer look at this on a quarterly basis:

This is pretty impressive for sure, and you can see why the market is responding to this.  Operating margin is up to over 50%.  We don't have details on Alibaba's financials, so it's hard to say where margins will be over time.  But if they keep growing revenues like they have been and keep margins in the 30%-50% area, this can be a huge market cap company for sure, no doubt about that.  With real earnings, this is no longer just a pipe dream, dot-com.

This is not so safe to do without knowing more details, but if you annualize the first quarter 2013 (ended March 2013) earnings figure that comes to $2.7 billion.  If you value Alibaba at $40 billion, a figure tossed around not too long ago, that would be less than 15x earnings annualized current earnings, which of course is ludicrous for a profitable business growing revenues at 70%+/year.

Taking this $2.7 billion figure, Alibaba would be worth $54 billion at 20x p/e.  20x would still be way too cheap.  OK, instead of looking at it like this, let's make a table out of this.

Alibaba Valuation: 
                     
                                     Value of                             Value per
P/E     Total Valuation    YHOO stake (@24%)      YHOO share
20x     $54 billion           $13 billion                         $13/share
30x     $81 billion           $19 billion                         $19/share
40x     $108 billion         $26 billion                         $26/share
50x     $135 billion         $32 billion                         $32/share
100x   $270 billion         $65 billion                         $65/share

The value is before any taxes that would have to be paid on a sale.   When Facebook came out, it came out at something like 100x earnings and 27x revenues.  At 100x p/e, Alibaba could be worth $270 billion, or $65 per Yahoo share, which is nonsense.

First of all, I am using a figure annualizing the 1Q net income figure which is not always a good idea.  But on the other hand, this doesn't take into account the 70% revenue growth through the rest of the year.  If they continue to grow revenues and maintain or improve margins, then annualizing the 1Q figure would be too low.  There may have been factors that pushed up margins in the 1Q that may not recur.

But anyway, even taking a valuation like 40-50x, which would seem reasonable (not that a value investor would pay that price!) for someone growing revenues so quickly, this would value Yahoo's stake (pretax) at $26-32/share.

YHOO has agreed to sell half of their existing stake in the IPO, so it seems the longer that takes, the more value YHOO can get.

This is really sloppy analysis, but if we push this out a year and assume revenues keep growing at 70% and margins stay up here at 50%, you can just push up the above valuation figures another 70%.  The potential is just insane.

China Crash
One problem that people seem worried about now is the China meltdown.  One thing to keep in mind is that during the financial crisis, companies like Google, Facebook, Amazon and others kept growing and did just fine; they are in growing businesses taking share away from the old economy so the biggest financial crisis / near depression was barely noticeable in their financial statements through the crisis.

In that sense, Alibaba Group exposure may not necessarily carry the same risk as other China-themed investments.

Conclusion
I really don't have any idea if Alibaba will keep growing at +70%/year, or whether 40-50% operating margins are sustainable.  And I didn't intend to fine-tune intrinsic value of YHOO; I just wanted to see what all the hullabaloo was about and in this case, there does seem to be something there.

I have no idea what the proper valuation for Alibaba is, but from the above table, I actually don't think a $100+ billion market cap is a stretch for Alibaba.

I do still own YHOO, primarily for the reason I stated in previous posts (sum-of-the-parts valuation), although I have lightened up as YHOO rallied a bunch.  But it's amazing how much value is being created here in Alibaba.

Do I have a view on Marissa Mayer?  Not really.  She does seem supersmart and well-liked.  It's really good that morale is up which is really important for companies.  But whether or not she can turn around YHOO is a tough question.  I have no idea.  I lean towards being optimistic and do think she has a chance, but it's a tough, fast-changing industry.  She certainly seems to be more qualified to run YHOO than other recent CEO's (who were not Silicon Valley 'geeks'.  Bartz was a tech industry executive, but from another era and didn't seem to have the hacker cred that seems so important)

Anyway, YHOO is certainly still very interesting and I will continue to watch this.  After looking at this data in this form, I almost wish YHOO wasn't in a rush to monetize some of these assets.  Imagine what Alibaba could be worth in a another couple of years.  But then again, who knows when things turn.

60% Yield! (CWGL: Crimson Wine Group)

So Barron's had an article about Crimson Wine Group (CWGL) last weekend.  It's a nice, small, ignored Leucadia (LUK) spinoff.  I talk about LUK so much that I feel like I have to say something about CWGL.   I looked at it like everyone else and just sort of shrugged; what am I supposed to do with a winery stock?  I don't have any particular view or opinion about the business other than my understanding that it's a tough business, prone to pests, weather, supply/demand problems etc.

But this article sort of got me thinking about it a little bit and there was an interesting article in the New York Times about wineries in general too, recently, so I thought I'd put them together to see what CWGL might be worth.

Oh, first of all, I have to explain my cheesy title.

60% Yield
OK, I think you can actually get something much higher than 60%, but here's the secret:  CWGL shareholders get a 20% discount on their wine purchases from them.  During the LUK years, this discount applied to both on-site tasting room purchases and wine purchased online and the Barron's article does say shareholders get a 20% discount on wine purchased on it's website.  I never tried, so I don't know if there are volume or frequency limits or anything like that.  Of course, they may stop you from buying bulk, but that's OK.  (During the Leucadia years, it was on an honor system; all you had to do was to say that you were a shareholder and you would've gotten the discount.  What's the return on that?)

If you bought 100 shares of CWGL, it would cost you $900 or so (of course you can buy less and really get a high yield).  Let's say you drink one bottle of wine per week and you like something in the $50 range (come on, I know you guys can afford it).  So that's $2,600 per year in wine purchases.  A 20% discount is worth around $520, so on your $900 cost stock that's a return of 58%!  If you have a taste for pricier wines or drink more, then your return would be even higher.  If you bought less than a round lot, your return would be higher too.

But anyway, I really don't know what the volume/frequency limits are so maybe this is baloney. And if this only applies to tasting room purchases, then only people out west can grab this yield.

Anyway, let's get to the other stuff.


Price-to-Book
One key point in the Barron's article is that CWGL trades at 1.1x price-to-book, but they recently sold some nonstrategic assets for 1.7x book.  These comparisons are a little tricky without knowing more; I wouldn't take one transaction and apply it to the whole, even though I would not be surprised if CWGL was worth more than book.  Comparisons to other listed vineyards may not be so meaningful either as one of the big purchases at CWGL happened as recently as 2011. Older vineyards may have lower cost basis.

But anyway, with Cumming and Steinberg, it would be hard to imagine that they would overpay for assets, even as a vanity play.  From that alone, book value may not be a bad place to start in valuing CWGL.  If they didn't overpay for assets and their accounting is conservative, then it's probably safe to say that CWGL is worth at least book.

$100 million in Sales by 2016
The other interesting thing in the Barron's article is that they quote (via Napa Valley Register) CEO Erle Martin as saying their goal is to double sales to $100 million by 2016.

By the way, I found a datapoint that showed that back in 2007 (yes, the peak), wineries M&A were done at an average of 4.4x EV/revenues.   That drifted down to 2.7x in 2010 and I don't have data after that.  With recent revenues in the $50 million range, that values CWGL currently at around $220 million versus the current EV of $195 million or so (@8.92/share stock price). 

If revenues get to $100 million by 2016, CWGL may be worth $440 million in three years.  But again, that's against the peak valuation (I think that's the peak) of 4.4x revenues.  It's not too prudent to use 'peak' values (or else, again, maybe investment banks would be worth 4x book!).  More on this later as it's not that simple.

Fetzer Vineyards was sold by Brown Forman in 2011 for what looks like 1.5x revenues, but Fetzer is a lot more down-market than CWGL so I don't know how meaningful that datapoint is (Brown-Forman kept the better vineyards in Sonoma etc.). 

New York Times Article
An article I read in the New York Times (April 26, 2013: Boutique Vintners Turn to Private Equity for Help) struck me as relevant to looking at CWGL.  I don't know how relevant it is as I don't have a high comfort level in evaluating vineyards.  But here are some of the details that I thought were interesting.   

The quoted expert on vineyards is Peter S. Kaufman of Bacchus Capital, which is a private equity fund founded by Sam Bronfman II (Seagram's founder's grandson;  Kaufman is a co-founder).  This private equity fund was set up specifically to buy wineries so I assume that's all they spend their time doing; looking at and thinking about vineyards.

So let's borrow their expertise here.

This is what Kaufman (and others) said:

•  Before the financial crisis wineries were selling for the equivalent of 12 to 15x trailing EBIDA (earnings before interest, depreciation and amortization (not EBITDA!)).   It was a level more than they could stomach. Valuations have now come down.
• Fundamentals for wineries are good for high quality producers with right distribution model.
• Wine consumption has been increasing steadily over the past couple of decades and remained robust during the recession (Wine Market Council).
• Baccus Capital thinks there is still plenty of growth, especially for premium wines.
• Bronfman said wineries that can improve their direct-to-consumer distribution through wine clubs and tasting rooms also have tremendous potential.
• Traditional channels (like restaurants and retailers) are still important, but can reduce margins by up to a third.
• Kaufman says a well-run, high-end winery should have gross margins of 60% and EBIDA margins in the 20-25% range.

Leucadia's Last Comments on Crimson
Just as a refresher, this is what Cumming / Steinberg had to say about Crimson in the 2011 Leucadia annual report (sadly, the last report written by this dynamic duo):

So it seems like CWGL is all set to increase volumes and make some profits.  I post this to highlight the fact that the history of losses at CWGL may be just that; history.  Maybe going forward, they grow profitably.


As a cautionary note, here's a snip from the 2010 LUK AR:

Even in good times, it's difficult to make money in wine... jeez...  At least they are good inflation hedges (didn't Steinberg tell LUK shareholders at the 2012 annual meeting that people who don't see high inflation should just sell their LUK shares?).  But at least it looks like volume is going to get ramped up as they said in the 2011 annual report.


Putting This Together
OK, so let's put all of this together.  The above comments by Bacchus Capital seem to describe Crimson Wine pretty well, doesn't it?  Premium wines, focus on improving direct-to-consumer channel (via wine clubs and tasting rooms) to get higher margins etc. 

When I read the article, I immediately thought, gee, that sounds exactly like CWGL.  And it's no surprise that Cumming / Steinberg focuses on an area of growth (premium wines) and focuses on profitability (direct-to-consumer channel).

So let's look at the above numbers and plug them into CWGL.  Kaufman said that good wineries have gross margins of 60% and EBIDA margins of 20-25%.  You know where I'm going with this; in good times (pre-crisis), wineries used to sell at 12-15x EBIDA margins.

Plus we know from the above that CWGL is shooting for $100 million in sales by 2016.  So we have all the pieces we need to get a value for this thing.

Of course, I am going to look at CWGL using the pre-crisis valuation, which might be high.  Maybe it was a bubble.  Or maybe right now we all have PCSD (Post-Crisis Stress Disorder) and can't imagine anything trading at pre-crisis levels anymore.  But a quick look at the stock market, art and other assets should prove otherwise.

But yes, I understand that this valuation may not be 'conservative' or even reasonable.  I'm just doing this to get a feeling for what's going on here.

First of all as a reality check, let's make sure that CWGL has some potential to make the above margins.  In the first quarter of 2013, CWGL had a gross margin of 46.8%, and they had 49% gross margins for the full year 2012.  So 60% looks within reach if CWGL is ramping up production and is going to realize benefits of scale. 

EBIDA margins were 25% in 2012 and 22% in the first quarter of 2013 (excluding other income which was gain on sale of an asset), so that's already within the 20-25% range of a good winery.

Putting this stuff together:

• CWGL goal is to get to $100 million in revenues by 2016.
• A good vineyard will have 60% gross margin, so let's say CWGL earns $60 million in gross margin
• A good vineyard has EBIDA margins of 20-25%, so EBIDA is in the range of $20 million - $25 million at CWGL in 2016.
• Pre-crisis valuations were 12-15x EBIDA, so CWGL might be worth (using the low multiple on low end of margin range etc.) $240 million to $375 million.

First of all, let's see what happens with these metrics using historical figures.

In 2012, CWGL had sales of around $50 million (close enough!).  We already saw that they had EBIDA margins of 25%, so that's $12.5 million in EBIDA. 12-15x that is $150 million to $188 million.

With 24.4 million shares outstanding and no debt (they had debt in 2012 but that was converted to equity by LUK so there is no debt now), that comes to $6.15 - 7.70/share.  There is around $20 million in cash on the balance sheet, so add that and you get $7.00 - $8.50 in value. 

OK, so sales are growing so you have to take that into account.   Sales grew 18% in the first quarter of 2013 and 24% for the full year 2012.  They are increasing capacity (more on that later), so let's assume they grow revenues at the same rate of 18% for the rest of the year.  I have no reason to believe this is realistic, but we know it's growing and I don't know that there is any guidance on revenues from CWGL itself.

With all else equal, a 25% EBIDA margin and 18% higher sales, CWGL would be worth by the end of the year $8.26 - $10.00/share (this assumes cash stays at $20 million; at 25% EBIDA margin and $6 million in expected capex this year, there should be enough cash to leave cash unchanged if not rise). 

So from the above figures, CWGL doesn't look too exciting.  I think if CWGL is already earning 22-25% EBIDA margins, it may actually be headed higher as sales grow and they get benefits of scale.  In that case, obviously, the valuation would be much higher.

$100 Million Sales by 2016
So let's look at this $100 million sales by 2016 for a second.  That's double what they did in 2012.  Using the same model as the above, we get $20 - 25 million in EBIDA and a fair value range of $240 million - $375 million.  That's a range of $9.80 - $15.40/share for CWGL without taking into account any cash. 

The problem here, of course, is that it will take some investments to get capacity up to 500,000 cases.  At the end of 2012, just adding up the wineries listed in the 10-K, I get current capacity of around 260,000 cases.   The 10-K lists two types of capacity; permitted capacity and fermentation and processing capacity.

Here is the breakdown:
                                                     Permitted           Fermentation and
                                                     capacity             processing capacity  
Pine Ridge Vineyards                 126,000               80,000
Archery  Summit                           21,000              15,000
Chamisal  Vineyards*                   42,000    ->  100,000 by 2013
Seghesio                                      170,000              120,000   ->  170,000 by 2013

(Chamisal doesn't have a separate "fermentation and processing capacity" listed in the 10-K, so I assume permitted and processing capacity are the same for this vineyard).  Double Canyon doesn't have any production facilities, but does sell wine produced elsewhere; I don't know how that fits into our scenario)

So it looks like at the end of 2012, capacity was around 257,000 cases.  Sales in 2012 were 260,000 cases.

They are spending $300,000 this year to increase Chamisal capacity to 100,000 cases from 42,000 and $2,000,000 to up the capacity at Seghesio by 50,000 cases.  These figures are just what they will spend in 2013 to complete the capacity increase so isn't the total cost of expansion.

The 2016 $100 million sales target assumes 500,000 cases of sales.  At the end of 2013, capacity seems like it will be 365,000 cases.   So there will need to be 135,000 cases more of capacity.  An increase this size may have to happen via an acquisition. 

CWGL paid $86 million for Seghesio in 2011 for 120,000 cases of capacity (as of 2012-end; I don't know what the capacity was as of May 2011 when it was acquired).

If $86 million is required to add another 120,000 cases of capacity via an acquisition, the above math obviously doesn't work out.   CWGL does have a $60 million credit line so this may be for acquisitions.

Let's say they did another acquisition just like Seghesio for $86 million and adding 120,000 or so in case capacity.  When they did Seghesio, it was funded more or less 50%/50% debt and equity.  So let's say they do so again.  Assuming they borrow $43 million and issue $43 million in stock (say, for $9.00/share), then in the above scenario, they would have 29.2 million shares outstanding and $43 million in debt, or let's say $23 million in net debt (if they keep $20 million or so cash on hand).

So if the EV fair value range is $240 million - $375 million, the equity value would be:

$240 million minus $23 million net debt divided by 29.2 million shares outstanding = $7.43/share on the low end (12x EBIDA based on 20% EBIDA margin) and $375 million minus $23 million divided by 29.2 million shares $12.05/share on the high end (25% margin and 15x EBIDA).

If EBIDA margins are already 25%, we can just use that and the 12-15x EBIDA range and we get a valuation range of $9.50 - $12.05/share for CWGL in 2016.  Not that super-exciting.

If it's true that CWGL is just getting up to scale and they can start to make more money, it's certainly possible that this 25% EBIDA margin is way on the low side.  It would actually have to be for this investment to be exciting.  At least from what we see in the above analysis.  

But in 2013, when they finish capacity expansion at their current vineyards, capacity will increase by 40%.  If sales grow to use that up with minimal incremental capex going forward, operating leverage can be significant.  I don't know the wine business so I can't tell you how much, but it does feel like it can be substantial.

Sales at Capacity
OK, so looking out to 2016 may require assumptions on how CWGL gets capacity up to 500,000 cases.  So why not just look at this from the point of view of where capacity would be during 2013?

We see from the above that after the 2013 capex, they will have total capacity of 365,000 cases;  40% higher than the 2012 year-end capacity.   These figures are just based on what I see in the 10-K.  Others may have different capacity figures and I may be missing something. 

So let's assume, instead of getting to 500,000 cases by 2016, that at some point within the next couple of years, sales gets up to 2013 capacity of 365,000 cases.   This way, there would be no new capex or acquisition assumptions required (other than maintanence and other non-expansion capex).

So from the $50 million sales from 2012, we will just add 40% because that is how much sales they can grow without an acquisition or expansion capex (other than what's planned for 2013). 

The new sales would be $70 million.  From here, let's just assume 25% EBIDA margin because as I said, they are already there and further sales gains should show some operating leverage and may even go higher.

With sales at $70 million and 25% EBIDA margin, that's $17.5 million, and 12 - 15x that is $210 million - $263 million.  Again, let's leave cash there at $20 million, so add that to the EV figures for a range of $230 million - $283 million. 

With 24.4 million shares outstanding, that's a range of $9.43 - $11.60. 

This may actually be on the low side since the new capacity expansion is at existing facilities, which means there should be some scale leverage at the facility level (and not just SGA leverage from increasing overall volume at the corporate level).  If gross margins move up to 60%, EBIDA margins may well get into the 30s, and if that's the case the above figures could move up by 20% or more.

But I actually don't know as I am not too familiar with this industry.

Other Valuation Guidepost
As usual, I just did a quick search of recent wineries deals and couldn't find much in the U.S.  One very visible one was the Constellation Brands purchase of Mondavi in 2004.

Citigroup used the following comparables for valuation:

Wine Companies:
  Chalone Wine Group
  Vincor International

Australia:
  Lion Nathan Ltd.
  Southcorp Ltd.
  Evans & Tate Ltd
  McGuigan Simeon Wines

Europe
  Baron de Ley SA.

They didn't provide mean, average, high and low as usual, but Citi said the valuation range using the above group for Mondavi would be 10-12x 2004 EV/EBITDA (as of May 2004).

For transaction analysis, they looked at 15 U.S. and 16 non-U.S. deals between 2000-2004, and the valuation range came to 12-14x EV/EBITDA.  Taking out the T would make a 12-14x EV/EBITDA higher than 12-14x EV/EBIDA.

Of course, this is 2004 so pre-crisis (but also pre-super-bubble of 2006-2007).  But unlike banks, which may very well have a reason to have valuations much lower than pre-crisis, it wouldn't be surprising to see winery valuations get back to more 'normal' levels.   Of course, whether this is 'normal' or not is arguable and I don't necessarily have a strong argument either way.

Other Comps
The other listed comparables are Vina Concha y Toro (VCO) and Treasury Wine (TSRYF).  Vina Concha seems to trade at an EV/EBITDA multiple of 16x and 23x p/e.    Subtracting 2012 taxes from ttm EBITDA (so not apples to apples, but close enough for a 'rough' estimate), it seems like VCO is trading at 20x EV/EBIDA (Yahoo Finance data). 

In a later post, I may take a closer look at VCO, TSRYF and whatever other comps from the above Citigroup list still exists.

But just from the fact that VCO is already trading at 20x EV/EBIDA (and they have much lower gross margins) seems to indicate that it might not be too far-fetched to assume that U.S. winery prices get back to 12-15 EV/EBIDA or even higher for profitable, high quality wineries (which would seem to suggest some upside for CWGL after all).

Conclusion
I didn't intend this post to be a really close, comprehensive look at CWGL (nor did I think it would be this long!).  I just wanted to do two things:

• point out the investment return (admittedly not scalable) one can get by being an owner of CWGL (20% discount; you can't eat outperformance, but you can drink this yield!) and also
• to put the expert thoughts on wineries by the folks at Bacchus Capital to use and put it together with what we know about CWGL to see what pops out.

In a later post, I may take a closer look at some of the comps and get a better feel for winery valuations from around the world.  I know wineries also tend to be valued per acre and other 'asset' measures, but I have nothing to contribute on that front.  You can google and get all sorts of per-acre valuations, but I have no idea what applies to CWGL so I would have no conviction on those kinds of valuations.

I tend to look at comps as important information, of course, but as an investor myself it's more important that I understand the economics of the business and see what the profits to shareholders are going to be.  Sure, it's fine if an industry trades at 20x EV/EBIDA or EV/EBITDA, and if something trades way below it, there can be profits to be had if valuations move up.

But I'm usually more comfortable with something simple, like, if I buy this what is my pretax return on investment?  When the two together fit well, that's great.  When it doesn't, then I am a bit more reserved.  

Also, CWGL is tiny at $50 million in sales.  So comparing them to other larger entities might not be that meaningful.  Again, I really don't know this industry.

Anyway, this post is way longer than I intended so I want to get this out. 

I may (not guaranteed!) post a followup to this after looking closer at the comps and some simple earnings model to get at a regular p/e ratio.

Although I have no real interest in this industry, I think it's worth the time to look at it because:

• It's a spinoff, and one from a company I really like (Leucadia)
• It's tiny so not worth the time for most institutions (which means we should look at it!)
• Run by two incredible managers with big ownership
• Industry is not viewed favorably (at least I don't think it is)

In any case, the key driver for this year and next is going to be the ramp up in volume due to the expansion of Chamisal and Seghesio and the leverage that will kick it at the facility level and the corporate level (leverage SGA).  It's possible that 25% EBIDA margin is way, way, too laughably low for CWGL (in which case it would be worth far more than the above analysis!).

The Greatest Investment Book Ever Written

No, I'm not talking about Security Analysis or Intelligent Investor by Benjamin Graham or even Greenblatt's You Can Be a Stock Market Genius.  I'm talking about Doyle Brunson's Super System: A Course in Power Poker. 

OK, so the title of this post is a bit of an exaggeration and yes, there are probably tons of better poker books out there now post-extended-poker-boom.  The first edition of this book was published in 1978.  The connection between poker and trading is nothing new.  Just google "poker and trading" and there's a lot of stuff out there; how poker guys started hedge funds, how a hedge fund guy became a poker guy, how they are similar/different, what can be learned from one or the other etc.   And the connection between gambling and trading was well documented in Fortune's Formula.

But I just wanted to make a post about this book because I'm starting to reread it again (don't ask).  I am not a poker player, but I remember reading this book a few years ago having borrowed it from a poker-playing friend.  Knowing that many traders and investors are very good poker players, I wanted to see what I can learn from reading about poker.

I remember falling out of my chair at the similiarites between poker and investing.  I come from more of a trading background than an investing one and what was written in this book, particularly the early chapter "General Poker Strategy",  has great advice that applies to traders and investors too.   I would make that chapter required reading along with the other investment "must reads".

Anyway, here are some comments about what Brunson talks about in this chapter by sections.  I only comment on some of the stuff so this isn't a summary of the chapter by any means.

Pay Attention... and it will pay you
Here Brunson talks about paying attention to other players during a poker game.  Watch and listen carefully even if you are not playing for the pot and you will pick things up. 

He also suggests bluffing to see what someone does to learn more about him.  We might think we can't do that in the markets, but bigger hedge fund managers actually do test the market.  They can try to buy a big lot of bonds or sell it to get a sense of where the weakness might be; they are probing the path of least resistance.  But most of us can't do that, and long term investors would have no interest in such market operations.

But the advice, to pay attention, is applicable to all of us in the markets.  We have to pay attention to what's going on in the market.  We always like to say, ignore Mr. Market, or ignore the macro, but we have to pay attention to what's going on.  Maybe if I paid more attention, I would have bought some Liberty Media in late 2008.   OK, enough of that.  Get over it.

But it's true.  We have to pay attention.  There might be a tendency, when we own positions we are happy with to get lazy and ride it out.  But then what do you do when things get to fair value or above?   Or there might be better things out there even if we are happy with what we own.

So we must pay attention.

Brunson also says, "A man's true feelings come out in a Poker game".   He says you'll learn a lot about a person's temperament by watching a ballgame he has bet a lot of money on; how well he can take disappointment etc.  He says it's the same in poker, and it's the same in trading and investing too. 

Talk to people at the height of a bull market or at the lows of a bear market and you will really know what kind of temperament the person has.   I'm sure all of us with professional experience have anecdotes about traders and investors on their big up and down days.    I tend to trust the guys where you talk to them on any given day and you have no idea if they are up or down on the day.  The ones you can tell from across the room are the ones I would tend not to trust... (well, there are overly emotional, screaming/yelling, phone-breaking-monitor-throwing great traders, and then the quiet people who just blow up with no early signs, I suppose but...)

You can really learn a lot about yourself, too.  You can't really observe other people in the investing world, so you can just observe yourself and learn a lot about yourself and who you really are and what you might or might not be cut out for.

Play Aggressively It's the Winning Way
Here he talks about the difference between a "tight" player and a "solid" player and how many people seem to be confused about it.  In poker, a tight player is a conservative one and won't play too many hands.  A "loose" player is the opposite; like a drunk player that plays every hand, calls every bet.  But a "solid" player is not the same as a "tight" player.   A "tight" player is a conservative player that will play tight all the time, but a solid player will play tight, but when he plays, he will play aggressively.

There is "tight" and "loose" in investing too.  We've all met someone who will buy almost any stock on any tip (loose), and others who won't buy anything, or will rarely buy anything.  When I first started investing for myself, I was very tight too.  I read a few Buffett books and figured, OK, I'll just by Coke in the next bear market at 8x P/E.  It's a great idea, but the only problem is, Coke doesn't get to 8x P/E, ever (and when it does, you may not want to own it!).

I just figured if I had a Buffett-like stock (high ROE, high-moat business) and bought it for really cheap, I can't lose.  Well, this is correct in theory, but that's like wanting to wait for a royal flush before ever betting.  It didn't take me long to realize that this approach won't work.

Now I like to see myself as a "solid" investor.

I would put people like Buffett, Greenblatt, and any of the great traders/investors as "solid".  They will pick their shots and not play too many hands, but when a good hand comes along, they will go in big.

Brunson says, "Timid players don't win in high-stakes Poker".  This is true in the markets too.  But that doesn't mean you have to be "loose" or that you should ignore risk.

I think there are a lot of smart and competent investors and traders that don't do well because they don't have this sort of killer instinct.  They are way too timid.   They love a stock and they have 2% of their AUM in that stock, for example.  I read a decent book on investing not too long ago and was impressed, but when I looked at the author's portfolio (no names!), it looked more or less like an index.  There is no way this portfolio is going to outperform the index by more than a percent or two with that sort of diversification in the largest cap stocks. (Yes, Peter Lynch and others have been known to have a large number of names in their portfolios but my impression is that those portfolios contained smaller and midcap names, not the largest companies.  This is why they were able to outperform despite the high degree of diversification).

We know how focused Buffett is (and was during the partnership years), and many of the other great investors/traders.

I remember talking about Soros once and someone who was close to him said something to the effect that Soros is not that different in terms of analyzing markets and finding trade ideas than others, but he had the ability to put on huge size.  In other words, he was no smarter than anyone else, but he had the biggest balls (more on courage later).

And the great thing about the markets is that the markets can't fold on you.  If you go "all in" in a poker game, you might scare people away.  But not in the markets.

Art and Science: Playing Great Poker Takes Both
Brunson says poker is more art than science, and that's why it's difficult.  Knowing what to do, the science, he says is 10% of the game, and the art (knowing how to do it) is 90%.  He says in the introduction that a computer can be programmed to play blackjack well, but not poker (even though I hear that bots win a lot of money playing poker online these days).

It's similar to the world of investing/trading.  People have used computers for years to create trading models, and many of them do make money.  But the models are programmed by humans, reprogrammed, recalibrated, adjusted etc. according to market conditions.  I don't think there is a self-learning/improving computer trader/investor out there (yet).

Money Management
In this section, there's an interesting comment:

"Any time you extend your bankroll so far that if you lost, it would really distress you, you probably will lose.  It's tough to play your best under that much pressure."

This is exactly what Joel Greenblatt said in an essay soon after the financial crisis.  He was talking about how many people thought the error in their investment was that they didn't foresee the crisis and so didn't sell stocks before the collapse.  Greenblatt insisted that this couldn't be done anyway and that the real error was that these people simply owned too much stocks.  If you own so much stock that a 50% decline is going to scare you and make you sell out at precisely the wrong moment (and as Greenblatt says, and Brunson says in this book, you are almost guaranteed to sell out at the bottom), then you owned too much stock to begin with.  Greenblatt said the mistake wasn't that they didn't sell before the crisis, but that they sold in panic at the bottom.  This was the error.

So the key defense against inevitable (and unpredictable) bear markets is to not extend yourself so much that it will distress you when the markets do fall (and they will).  Buffett says that if it would upset you if a stock you bought declined by 50%, then you simply shouldn't be investing in stocks.  As I like to say all the time, more money is probably lost every year in trying to avoid losing money in the stock market than actual losses in the stock market!

Brunson also suggests thinking about chips as units and not as money.  This is so very true in trading and investing too.  If you think about money as money, then it may impact the way you invest.  If you think of a loss as real money, it might upset you.  For example, if a stock tanked and you lost money on it, it's easy to think, "gee, I could've bought a Porsche with that money...".  Or if a loss is thought of as next month's rent, you won't be able to focus on the process; you will be distracted by the reality of the money.

Courage: The Heart of the Matter
Brunson says, "I'm asking you to walk a very thin line between wisdom and courage, and keep a tight rein on both".  He says that courage is "one of the outstanding characteristics of a really top player".  He points out that some people play really badly after losing a big pot while others play much harder.

He says that one of the elements of courage is realizing that money you already bet is no longer yours regardless of how much you put in.  This is similar to investing where people do tend to get caught up in their cost (I'll get out when it gets back to break even, etc...).  If it doesn't make sense to call, then one shouldn't call.  People probably tend to look at what they put in the pot and they might call not wanting to lose what they already bet.  Similarly in a stock, if you buy something and it's no longer a good idea, it's not good to wait for break even or even buy more just to get the average cost down so you can break even sooner.

As I said in the above about being aggressive, I think that one of the big differences between OK investors/traders and great ones is courage, or balls (is this appropriate blog language? I don't know).

But Brunson, in the section on being aggressive, distinguishes between being aggressive and being stupid.  He sites an example of a player trying to bluff someone out of his money with a losing hand, and he calls that stupid, not aggressive.

There is sometimes a fine line, maybe, between stupid and aggressive in the investing world too.  I'm sure to insurance company executives (in charge of investments), Buffett's backing up the truck on American Express during the salad oil scandal might have looked stupid or reckless at best.

There is a tendency to assume that "diversified" equals "safe" and "focused" equals "risky", just as there is a misconception that "beta" (or stock price volatility) equals "risk".  This is not true at all.  As Howard Marks says in his great book, The Most Important Thing, risk is not a function of these things.  Overpaying for high quality companies can sometimes be riskier than paying a very low price for a mediocre company etc.


The Important Twins of Poker - Patience and Staying Power
This is very obvious too in the world of trading and investing.  You have to have patience.  Ian Cummings at the last LUK annual meeting (in 2012) put it like this:   You should sit on a porch, watch the world go by and then if you see something succulent, jump on it.

Buffett talks about his 10-hole punch card, or waiting for the perfect pitch (there are no strikes in investing. There are no antes either so it doesn't cost you anything to fold right away).


Discipline
Brunson talks about not drinking here; hopefully nobody reading this makes investment decisions while drinking.

There are a few other pieces of good advice (look for weaknesses in your play and fix them etc...) but an interesting point here he says,

"Maintaining confidence is your strongest defense against 'going bad'. When you start to go bad or just start to think you're going bad, you become hesitant...  Allowing your confidence to be shaken can turn a simple losing streak into a terrible case of going bad". 

He reminds us that we still have to be open to the idea that something may be wrong with our play. 

This is very interesting because watching value investors during the crisis, it feels like a lot of people lost confidence.  One investor who was a focused investor decided to diversify more after taking big losses only to go back to a focused approach after the markets recovered.

Many other value investors seemed to question the idea of value investing itself and sound these days more like macro investors.  Many seem to have lost their faith in the stock market overall.

Controlling Your Emotions
Brunson advises, "never play when you're upset".  We all know that the biggest detriment to successful investing is our own emotions.  But I saw it over and over again during the crisis; people throwing in the towel at the worst possible moment because they lose faith.  Too many 'bad' bankers and corrupt politicians etc.  It sounded like people were selling stock not only out of fear, but out of anger.  Brunson would tell these people, "don't make investment decisions when you're upset!".


The Other Similarity
There are many similarities and I don't intend to list them all up, but the other thing that struck me about poker and investing (and this is not from the Brunson book) is that in both, there are two types of participants;

• perpetual loser
• improving / studying winner

That's kind of a sloppy way to put it, but I notice that in the stock market, many participants (particularly individual investors) often don't put too much effort in trying to learn about how to become a good investor or trader; they just punt / speculate.  When they make money, they are smart and brilliant and when they lose, the Fed screwed them.  Or the greedy banks caused a great recession and that's why they lost money.  They were unlucky.  In other words, it's not their fault.

This is similar to what people say about poker players.  Many of them do no work to improve, but they take pride in their wins, and when they lose, it was just bad luck. 

Both poker and investing have enough of an element of luck for people to keep fooling themselves in this way (nobody would lose a chess game and say it was bad luck, for example).  And there is enough element of luck such that people will tend to win every now and then with no preparation, and this gives them enough to sustain their 'hope'.  And this is what they lean on, not any serious work.

And there's enough luck involved that many believe that it's all luck (efficient market folks thinks it's impossible to beat the market etc...).  So therefore there is no attempt by these folks to work on their game. 

And this is why it's possible to win; this is why the pros constantly walk away with the money, whether at the poker table or the stock market.


Conclusion
Anyway, none of this stuff is new to experienced traders and investors (and of course poker-playing traders/investors).

But I wanted to highlight some of the things that really struck me (actually, it struck me the first time I read it a few years ago, but...).  Also, it's interesting to look at what we do through sort of a different lense.  Am I playing too tight?  Too loose?  Am I being aggressive enough?  Am I really a solid player or just tight?  Or am I being timid?

Looking at your portfolio this way may tell you a lot about yourself and may even suggest ways to improve your investment performance.
 

Charter Communications (CHTR)

During the financial crisis I did pretty well.  I bought up some financials and other things and did pretty well coming out (having done well going into it too), but one of my biggest misses was Liberty Media.  I have no excuse for missing that as I did own it in the past and did very well with it and so was very familiar with John Malone and his various assets.  I sold out when I thought media assets were overpriced with deals being done at 15, 20, 30x EV/EBITDA (or something like that).

But during the crisis I was so focused on the financials and was so convinced that the biggest gainers coming out would be the financials that survive (and the financials seemed to be the scariest sector to even look at, which I liked) so it didn't even occur to me to look at Liberty.  I did buy CBS and other stocks in other sectors and did very well with them too, so I guess it's not so much that I was only looking at financials.  I don't know why, I just totally missed it.   I think the Yacktman fund nailed this one.

Here is a description of Liberty Media's stock price performance from the LMC 2012 annual report (it's interesting to note that Berkshire Hathaway recently took a stake in Liberty Media.  Weschler (One of BRK's new fund managers) has owned it in the past in his own fund, I think)):

 

So if you invested in Liberty back in May 2006, you would have earned 33%/year through March 2013.  That's an astounding rate of return no matter how you look at it.   And this stock was down a ton during the crisis and I didn't buy it, knowing that it was run by one of the greatest operators of all time! That's pretty shameful.

 

To rub it in, let's look at a chart. This chart is from the Liberty 2012 10K:

 



 

 

...and this is the actual chart of Liberty Media (which spun off LMC and changed into Starz):

 



If you bought some stock back in early 2009, you would have had a 25-fold gain.  Makes buying Bank of America look stupid in comparison; even the LEAPs.

 

If you even put just 10% into Liberty and 90% was held in cash (or investments that did nothing), you would have gained 36%/year since then.

 

Sure, there's no point in shoulda, woulda, coulda's.  There are tons of those.  We can't ever always get everything.  I know.  But this one was sitting right under my nose.  I've owned it before, I've owned Discovery Communications, I've always been a fan of content and never had any doubt that content would have value (and would increase value over time as more and more people would need it), knew who John Malone was etc.  There is no excuse for that.

 

Anyway, this would have been a career making investment (and surely it was for some; it's just that we don't hear all the stories!); kind of like Ted Weschler's W.R. Grace trade (or maybe Weschler bought a bunch in 2009!).

 

Next time you sit around and people are talking about finding the next subprime trade (black swan), next great bubble to short or people whining that markets are too efficient now to make the old Buffett partnership or Greenblatt-type returns, go back and look at this chart and say to yourself, "where was I and what was I doing?!"

 

OK, enough of that.

 

I may come back and take a look at Liberty and some of the other pieces of the Malone Media Complex later on.

 

Charter Communications (CHTR) / Malone Inteview on CNBC

But for now, what I actually wanted to do was to just post a summary of Malone's interview on CNBC not too long ago.  It was an extended interview and it was fascinating for many reasons.  It's not often that we get to hear a great investor talk about what he did and why he did it.  In this case, David Faber of CNBC asked Malone why he invested so much in Charter Communications (CHTR). 

 

We all know Malone built his wealth in the cable industry so it's not surprising that he is going back to it.  But it is sort of surprising in that for a long time, I have looked at the content providers as where the value was in the business and the pipe-owners as not so valuable (as competition keeps increasing).

 

Anyway, here are some notes from that interview.

• Malone feels that 7-8x post-synergy EV/EBITDA multiple is very cheap if you can borrow at 3%.  Given super-cheap capital, sustainable cash flow businesses look very attractive to be bought on leverage.
• You can't leverage a manufacturing company.  Maybe you can do 2x (debt / EBITDA).  But cable companies can go up to 5x leverage.  CHTR will operate at 5x leverage. Malone says that's where his other companies are, Discovery, QVC etc...
• Malone believes that 80% of subscribers will reject sports programming at wholesale prices.  If that is the case, the current bundling of cable channels is an unsustainable model.  Cable is getting too expensive for too many households.  He thinks the old model will be gone in five years.

 

And specifically on CHTR:

• CHTR has great management.  Rutledge, by all accounts, is the best operator/manager in the business.
• Has been an undermanaged, underinvested asset for a number of years (implies potential for improvement).
• Has been a victim of a lot of market share stealing by the satellite guys.
• Faces the weakest competition terrestially.  Majority of systems not in Verizon or ATT universe/areas.
• We are at a point in history where high speed connectivity is important.  There is a big appetite for speed.   Cable technology is the most cost-effective way to increase speed.  Cable will go to gigabyte-type connectivity speed in a couple of years.
• Key is doing it cost-effectively at scale.  Malone says FIOS didn't work (losing money).  Overbuilding just broadband won't work.
• Malone is personally convinced that cable can get to gigabyte speed with very little incremental capital.

 

The other way to look at CHTR (as Malone put it):

• Great management team
• Very large tax position
• Unique position to be consolidator in the space
• debt is very cheap
• credibility of cash flow stream in cable has been growing so leverage is available

On TCI sale to ATT:

• Malone didn't want to sell; it broke his heart to sell.
• When someone offers a 40% premium you can't turn it down; responsibility to shareholders.
• In retrospect, he wishes he hadn't done it.

Back to CHTR:

• Unique opportunity to take a vehicle and grow it.
• Through both superior marketing and promotion, internal/organic growth can be exceptionally strong for a number of years.
• Particularly, the rate of growth of free cash flow can be very, very strong.
• Allows it to access leverage market in order to do rollups/transactions, particularly when there are horizontal synergies.  Kind of like the old TCI model.
• Horizontal acquisitions, synergies, growth scale, opportunities to work with other cable companies to form consortia (like the old "cable mafia" as Faber said).
• Malone said he wants to bring back the old days of @Home, Ted Turner etc.  Back then they were able to create national scale.  Now he thinks they can create global scale.

Interesting Situation
So this is an interesting situation.  Malone just bought in and is just beginning to do something here.  Tom Rutledge just joined a little over a year ago.  This is also a post-bankruptcy play as one of the stocks we talk about here (Oaktree) sold a big stake in CHTR to Malone.  I suppose it's not so much a post-bankruptcy play anymore since it's up 3x or so since reemergence.

But the fact that it is reemergent, the stock seemed to be hated and despised (due to the leverage, view that old cable is dead etc...), they got a new CEO that is "by all accounts the best operator/manager in the business" and then the greatest investor/operator in the business just bought a giant stake (and wants to do something with it), and it has big tax loss carryforwards makes it pretty interesting.

Of course, this is also risky in that it is very leveraged.  A lot of people think interest rates are going to go a lot higher and that leveraged companies will get into trouble sooner or later.  This is definitely not BRK at book value or JPM at tangible book.  I tend not to think that rates are going higher as I am a little biased to the deflationary side (Japan-style). 

It's an interesting opportunity to get on board with some amazing people in the early stages of something, but there is risk here.

I was going to do some work on the valuation but I think so much of the value here is what Rutledge and Malone can do going forward (and the deals that will come down the pike).  Otherwise, the key factor in valuation is the net operating loss, which we know Malone and Co. will figure out how to use.  For other money losing operations it's hard to think NOL's will ever be realized, but when you get Malone involved, you know it will be realized sooner or later.

More Special Situations

Anyway, the stock market has come a long way since I have been sort of pounding the table on it since starting this blog in late 2011 (I loved financials, the stock market, and hated gold.  Not to brag or anything...  well, I hated Japan and Sony too, but I did expect a hard bounce on any weakening of the currency so it was not too surprising even though the speed and magnitude were.  I'm still on the fence about Japan; every few years there is this renewed enthusiasm that seems to fade.  I remember the Koizumi boom too...  Maybe I will make a post about Japan some other time).

 

And I will keep covering and talking about the financials since I do feel comfortable talking about them.  But since they may be getting into more 'normal' territory than 'cheap' (well, they are still cheap, but they've come a long way), I think I should start looking at other stuff.  I do look at other stuff, but posted mostly about financials.

 

I always wanted to talk more about special situations here, but frankly, since late 2011, the special-est situations to me were the financials.  They were great companies with great managements trading for really cheap for irrational reasons.  That is less and less the case these days so I want to look around at other stuff. 

Since markets are no longer so unloved as I thought it was in 2011, I will have to dig around a bit more to find stuff to write about (and invest in, even though I am still long a lot of financials).

So stay tuned!

Corporate Profits-to-GDP: Why Doesn't Buffett Care?

I haven't posted in a while but that's because I was busy with all the conference calls, annual reports, and of course, keeping up with all the stuff coming out of the Berkshire Hathaway annual meeting.

Anyway, there is plenty of stuff out there on the annual meeting and I don't have much to say about it; it seems like the usual, same old stuff.   It was great that Buffett invited a short to ask questions.  People have often complained about the softball questions that Buffett has gotten, and the often non-Berkshire-related questions over the years.  So he got journalists to sort out questions ahead of time and then invited professional securities analysts to ask questions that might satisfy the more hard core Berk-heads.  That was a good idea.  And to make it even more interesting and have tougher questions asked, he invited a short this year.  Unfortunately, I don't think any of the questions the short asked were very interesting and I could've answered those questions exactly as Buffett did (this is what happens when you follow Buffett for years; you tend to know what he is going to say before he says it).

OK, this is not the topic of this post.  Let's get back on topic.

Stock Market Overvalued Due to High Margins?
People have been saying for the past few years that the stock market is overvalued despite reasonable looking p/e ratios because earnings are abnormally high now.  The usual chart shown is the corporate profits-to-GDP ratio.  This has been trending up and it is unsustainable.  Even Buffett said a while ago that to think corporate profits can stay above 6% of GDP is fantasy (it is now over 11% according to the chart below from the St. Louis Fed).  Someone asked this question at the annual meeting and Munger said that just because Buffett said something a long time ago doesn't make it carved in stone (or something like that), and he added that he thinks 6% is a little low.

Despite this record high corporate profit-to-GDP ratio showing abnormally high margins at U.S. corporations, Buffett said that the stock market is reasonably valued.  Howard Marks said that too in one of his recent memos.    Are they blind?  Don't they see that current earnings are bloated and unsustainable?

I looked at this a while back and concluded that none of the big blue chips companies have this trend in profit margin (corporate profits-to-GDP is not the same as profit margin but is used as a macro proxy...); I made a post about this a while ago (see here). 

So I comforted myself by saying that if there is a stock I own that is showing rising and unsustainably high profit margins, I should watch out and lighten up.  Having not seen that in my companies, I didn't care.  In fact, since I was mostly interested in financials, most of them showed below trend profit margins.   This big chart of profit margins was not relevant to me at all.

I still don't care too much about it as I don't look at stocks as part of a stock market, but more as a piece of a business (would you sell the restaurant you love and built over the years just because the S&P 500 index is trading at, say, 50x p/e?  Nope.  If someone offered you 50x p/e for the restaurant itself, then you would have to think about it, of course!).  If I like the business, how it's doing and it's current valuation is reasonable, who cares what some GDP ratio shows?

Having said that, I was still curious how people can keep saying (including myself) that the stock market is reasonably valued despite this fact.

Actually, the question is more why people like Buffett are not more worried about the market (we know he ignores market predictions but still) with this crazy looking chart.   Why does he keep buying Wells Fargo every month (well, I told you he will keep buying WFC all the way up to $50/share. see Wells Fargo is Cheap!)?

Anyway, let's get to the picture:

There are a lot of these charts all over the internet; people have been talking about this for a long time now.  I'll use the St. Louis Fed's chart since they probably won't come after me for copyright issues.

After-Tax Corporate Profits / GDP Ratio

The chart is certainly staggering.  I too tend to get acrophobic when I see charts like this with something shooting way out of range.  Corporate profits has been in the range of 4-6% or maybe 5-7% for a very long time but is now above 11%.  This can't continue. The argument is that if profits went back to 5-6% instead of 11%, then the stock market p/e ratio of 15x (or whatever it is currently) would actually be 30x on a 'normalized' basis.

Scary for sure.  I do agree with the fact that these things do tend to mean-revert, and I also realize that there may be factors (international business of U.S. corporations) that might make this trend up over time. 

But I don't want to get into the details of that now. The point of this post is much simpler. 

What Are We To Do?!
The question is, with this ratio at such abnormally high levels, what the heck are we investors supposed to do?  "Experts" tell us to get out of stocks or lighten up as profit margins are unsustainable and the market is expensive on an 'adjusted' basis.

As I said before, my personal reaction is to do nothing and just look at my holdings and see if I have a problem with any of them.  If I owned a company that typically earned 10% operating margins and that went up to 20% due to some supply constraint that made the product prices spike up and input costs were lower than usual and the stock price reacted and is priced as if 20% margins is 'normal', then I might lighten up or sell out completely.  If that is not the case, I would hold on.  Who cares what the 'national' level profit margins are?

If you owned Berkshire Hathaway in August 1987 and were convinced that the market would crash soon, would you sell out?  How many times would you have sold due to various reasons over the past few decades?  And out of those times you would have sold, would you have gotten back in? 

Anyway, let's get back to the above chart.  Profit margins seemed high back in the late 40s and into 1950.  Interest rates were probably below 2.5% back then, and profit margins were pretty high.  If you knew for a fact that the corporate profits-to-GDP ratio is going to head down, would it have made sense to stay out of the market and wait for it to get to a level that is more comforting?

Here is the S&P 500 index from 1950 or so onwards:

 S&P 500 Index 1950 - 2013

...and just for fun here's the Dow in the last century:

Dow Jones Industrial Average 100 Years (1900-2012)

So, check this out; from 1950 on, corporate profits as a percentage of GDP headed straight down all the way until it bottomed out in the mid-1980s.  You can draw dots in February 1950, 1955, 1960, 1970, 1980 and 1985 and except for 1980, the ratio is lower than it was the dot before.   I am eye-balling this so I may be off a little here and there.  But the basic message is the same.  Corporate profits-to-GDP went down all throughout that period.

OK, so here's the fun part.  You saw the S&P 500 and Dow charts so you already know where I'm going with this.  Let's see what happened to the stock market since February 1950.  I used February since that was the earliest datapoint on Yahoo Finance for the S&P 500 index.  I do have complete data somewhere, but I didn't bother to look for it as I think this is good enough.

Let's look at what happened from February 1950 onwards to the S&P 500 index:

                               S&P 500               annualized
                               level                      return since 1950
February 1950         17.22
February 1955         36.76                   +16.4%
February 1960         55.49                   +12.4%
February 1970         89.50                     +8.6%
February 1980       113.66                     +6.5%
February 1985       182.19                     +7.0%

Keep in mind these returns exclude dividends.  It's only the change in the index.

So if you somehow had perfect foresight and you knew that the profits-to-GDP would head down in future years (back in 1950) and waited, when would you have bought stocks?  If you waited until it bottomed out in 1985 (actually, I think it bottomed a little later, but...), you would have had to pay 11x as much as you could have paid for stocks in 1950.

If you waited five years, you would have missed out on +16.4%/year in returns.  If you waited a decade, you would have missed +12.4%/year in returns etc.

So even if you knew for certain that profits-to-GDP would head down in the future, you still would have had no idea what the stock market will do.  This is the essence (or one of many) of Buffett's approach to these macro things; even if you knew exactly what the unemployment number would be one year from now and what the GDP would be, you would still have no idea where the stock market would be.  There are just too many unpredictables, or what he calls unknowables.

Please excuse my very rough eye-balling, but let's look at what happened during the time that profits- to-GDP went down versus the time it went up.  As we saw in the above table, in the 35 years between 1950 and 1985, the ratio went down a lot, but stock prices rose 7%/year.  Since 1985 through February of this year when profits-to-GDP went straight up to the current, obscene, unsustainable level, (just to keep the Feb-to-Feb comp constant), the S&P 500 index went up 7.9%/year. 

So the market went up during the years when profits-to-GDP went down, and the market went up when this ratio went up.  Is the profits-to-GDP really such a good indicator for stock market timing?

You can also try plotting the highs and lows of the profit-to-GDP chart and match it to the stock market.   Maybe you would have gotten out in 2006 or 2007 and then gotten back in in 2009.  But then maybe you sold out in 2010 or 2011.   Not bad.  But then, over time, you might have bought in 1970 and then sold in 1978 only to get back in in 1985 or 1986.   You get my point.

Buffett has this sort of long term perspective on things and that's why he is not alarmed or overly concerned with these things.   It's not always easy to do, but sometimes you have to look at the whole picture, not just the big picture.  People, myself included, sometimes get mesmerized by certain graphs and charts and make them overly weight it and distract us from making good, rational decisions.

Interest Rates
We can make a similar argument about interest rates too.  People say correctly that the stock market had a massive wind at its back with interest rates going down from double digits in 1980-82 all the way until today.  They say that this wind at its back is now a headwind.  Combine that with the abnormally high profits-to-GDP and the stock market is dead money, at least, for a very long time.

But again, in 1950, interest rates were 2% or whatever.  That went up to double digits.  I think rates peaked out in 1982, but since we already did the work for 1980, let's look at that.  The S&P 500 index went up by 6.5%/year from 1950 to 1980 despite interest rates going from 2% to 10% or so.  And that 6.5%/year includes the stock market being flat pretty much since 1965 through 1980.   And remember, these stock market return figures exclude dividends.

Conclusion
So here we are today with interest rates at unsustainably low levels and profits-to-GDP at unsustainably high levels.  Putting those two together, it's hard to imagine the stock market moving higher.  At best, it seems like it will be flat for a long time to come.

But looking at the whole picture and not just at cherry-picked charts here and there that look scary, we see why Buffett says that the market will keep going up and will be substantially higher over the next few years even though he admits he has no idea what the market will do next week, next month or next year.

I am not arguing that stocks will go straight up and will always do so.  I look at these charts and do believe in mean reversion and all that, and I don't entirely disagree with the bears out there.  But I just like to take one step further and ask myself, well, what would have happened if I used this as an indicator to get in and out of the market?  Would I do better than just holding on to great businesses or buying special situations? A little digging shows that maybe not.

I don't think these charts are irrelevant either.  It's just that there are so many factors that are not knowable that we can't really predict what is going to happen based on one or two (or even five to ten) really, really convincing charts.