Investment Philosophy

The Fallacy of the PEG Ratio

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” -Albert Einstein

Here’s a thought experiment – would you rather pay 10x for a business which will grow at 10% over 10 years (business A) or 20x for a business which will grow 20% over the same time period (business B)?  Some value investors would overlook the 20x business because it wouldn’t pass traditional value screens.  Or, investors would see the two opportunities as equivalents given a similar PEG ratio of 1.0x.  Let’s see how the math actually works.

Let’s say each company earns $1.00 today and both will trade in the market at 10x earnings 10 years from now.  This implies a 50% compression in the trading multiple for business B.  At the end of 10 years, business A will earn $2.59 and business B will earn $6.19.  The compounded returns of an investment in business A will be 10%.  Business B, by contrast, will earn a compounded return of 12%.  What’s incredible is business B will earn a higher compounded return despite a 50% compression in the exit multiple.

There aren’t very many businesses which can compound earnings at 20% for greater than a decade.  Wal-Mart was one company which did so.  Yet, you couldn’t purchase Wal-Mart for less than 20x earnings for most of the company’s trading history.  Despite this seemingly expensive price, Wal-Mart was one of the great buys for 20+ years.  Buffett commented in the past that he forfeited billions on Wal-Mart because he knew enough to make a purchase, but sat on his thumb because the price kept moving up.

Munger understood the power of compounding early on and unlike Buffett, was willing to pay up for the great companies. Given enough time, a seemingly expensive price is neutralized by the earnings power of the business.  Let’s look at Google.  Google went public in 2004 at a $40 billion valuation and 40x earnings multiple.  Today, Google earns nearly $15 billion.  If you buy a business for 2-3x 10 year forward earnings, you will become extremely wealthy over time.  Google has returned greater than 10x for investors over the past decade, a 30%+ compounded return.

The power of compounding, although simple in concept, is difficult to internalize.  We should always think about what the earnings power of the business could be 10 years from now and determine whether what we’re paying today is cheap / expensive in relation to those earnings.

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Checklists

Since Atul Gawande wrote The Checklist Manifesto, investors have increasingly utilized checklists in their investment process.  The purpose of a checklist is to compensate for our human shortcomings.  As humans, we are prone to overlook even the simplest of factors which could lead to a poor outcome.

Due to the rising popularity of checklists, there are a number of templates available for free for budding investors or even the seasoned professional.  I don’t recommend the serious investor to take this route.  An investor should lean on his/her experience and personal idiosyncrasies to craft his/her own checklist.  Going this route will likely lead to better recall and use of the checklist.

My checklist is quite long, numbering 11 pages or so.  For reasons mentioned above, I refrain from publishing my checklist and instead encourage readers to craft their own.  To get started, below are some guidelines on how I approached my checklist.

I – Initial Filters
In this section, I included a brief list of filters to help me quickly weed out opportunities.  Items to consider include (i) can I understand the asset and predict, with reasonable certainty, cash flows 10 years from today, (ii) does the asset have a sustainable competitive advantage, (iii) are the managers of the asset ethical, energetic, and competent, (iv) is valuation in a range of reasonableness, and (v) how could I be wrong.

II – Competitive Advantage
Things to consider here include (i) source of competitive advantage (branding, customer captivity, economies of scale/experience, network effects, intellectual property, sustainable low cost production), (ii) sustainability of the advantage, (iii) nuclear analysis (breaking up a business into its component functions), and (iv) competitive games.

III – Financials
A number of questions surrounding the financial statements.  I pay particular attention to return on tangible assets, market share / market share trends over time, and the capital structure.  For certain industries, I look at a few additional metrics.  For instance, in retail operations, I track sales growth vs. inventory growth to monitor inventory build.

IV – Management
A few questions on management including track record, capital allocation strategy, short term vs. long term focus, ownership, and strategy.

V – Final Check
This is the most important section.  I include a number of questions to challenge my own thinking.  Some include (i) what mood am I in when making the investment decision, (ii) what are bears saying and why are they wrong, (iii) why is the selling shareholder selling me the security at that particular price, (iv) have I thought about the investment using Jacobi’s inversion theory, and (v) am I suffering from confirmation bias, availability-misweighing tendency, impatience, or first conclusion bias.

Crafting a checklist is one of the greatest uses of time for a serious investor.  The base only has to be built once.  Items can be added or subtracted over a lifetime based on experience and observation.

The Perils of Diversification

The more I study and observe success and failure in life, the more I realize how important focus is.  Our system encourages breadth over depth, trial over commitment, and activity over patience.  The average middle class kid spends her childhood engaging in a slew of extracurricular activities, from ballet to soccer to music to martial arts.  Kids are dragged from one activity to the next and become dizzied by the flurry of activity and wide ranging options available to them. Some activities are dropped for others and most are given up after partial pursuit.  Then, once school begins, she will spend the next 15 years taking general education courses, acquiring much knowledge which will soon be lost due to use-it-or-lose-it tendency, only to have to learn a new set of skills once she enters the workforce. Along the way, she will meet many people and devote substantial time to dozens of relationships.  In the end, however, only a handful will turn out to be truly meaningful.  She unfortunately will have spent too much time nurturing vacuous relationships, and too little time impacting the lives of those who truly love her. One of the most powerful things we can control in life is how we choose to spend our time, and we often spend too much time on activities which are unlikely to have a long term positive impact on us.

In short, we diversify too much.  Rather than engaging kids in 10 different activities, why not quickly narrow it down to 1 or 2 and have them dedicate substantial time to it?  Instead of exposing our youth to a torrent of general education courses, why not encourage them to specialize earlier in life?  Importantly, why not create a set of filters for the people we want to associate with early on and stay true to those filters as we move through life? Contrary to popular belief, much of life follows a power law distribution – a few things account for most of the value.  The one skill we have which we are more adept at than most others, the hobby or side pursuit (e.g. playing a musical instrument) which brings much meaning to our lives, and the spouse or the two key friends who help us through tough times and make us a better human being.

There’s no hard and fast rule and there certainly are examples of well rounded individuals achieving singularity in their lives. It’s in our very nature to explore, learn, and experience as many things as we possibly can.  Charlie Munger espouses worldly wisdom and learning the basic tenets from all the academic disciplines. I’m not suggesting we tune out the knowledge of the world, I’m only suggesting we develop better filters so we can spend more time pursuing high impact activities. We should spend some time learning the basic principles from the various academic disciplines for it will make us better thinkers and decision makers; these principles, however, can be learned and internalized through focused effort, and don’t require 15 years of general education in the format provided by our school system. These concepts should be presented as a broader thinking toolkit, and not learned rote for the sake of passing exams.

From my observations, however, it’s the people who choose a very few things to focus on and pursue it with rigor, determination, and commitment, that are able to make the most of their potential and have the highest level of satisfaction in life.  What they are able to do better than anyone else is say “no”, tune out the world, and engage whole heartedly in deliberate practice of the craft they are trying to master. Rather than trying to do a little bit of a lot, we should be doing a lot of a little. It’s more likely to give us a sense of accomplishment at the end of our lives.

I believe this theory extends to portfolio management as well.  Most portfolios also follow a power law.  There just isn’t enough time nor are there enough opportunities in the market to develop 15-20 unique insights in a given year.  We’re lucky if we are able to find more than a few.  What has distinguished the great money managers from average ones is their willingness to bet big when the odds are in their favor.

CDW Corporation (NASDAQ: CDW)

An interesting area to look for excess returns in the equity markets are public LBOs.  These are moderate to highly leveraged businesses (typically with debt amounts greater than 4x cash flow) which benefit from both growth in earnings and rapid debt repayment.  When thinking about debt repayment, the returns on cash deployed typically are not very high.  A 4x leveraged business in today’s credit environment carries a borrowing cost of 7.5%-8% all in, which after tax, costs shareholders ~5%.  This is clearly a much lower return amount than most corporations are able to earn on equity.  However, highly levered entities engaging in debt repayment offer some unique benefits to shareholders.

  • Equity holders have the benefit of owning the corporation with much fewer dollars deployed.  For example, CDW currently trades at a market capitalization of $5.8 billion with net borrowings of $3.1 billion.  This means prospective owners can buy into an $8.9 billion corporation for $5.8 billion.  When looking at prospective returns, if the company were debt free, book value would grow by a projected ~$500 million in 2014, or 5.6% on $8.9 billion (assuming P/BV multiple stays constant).  When considering current debt levels of $3.1 billion, book value would grow by a projected ~$360 million (taking into account after-tax cost of interest), or 6.2% on $5.8 billion.  The return figures are affected by a few variables, namely equity value in relation to enterprise value, return on equity capital, and the cost of borrowing.  But, generally, low cost leverage serves to increase equity returns and is a large factor driving private equity and real estate returns.
  • As debt is repaid and the balance sheet is “de-risked” valuation multiples tend to improve, providing an additional boost to returns.

A slew of private equity portfolio companies have come to the public markets over the past two years due to (i) a spate of behemoth LBOs from the 2005-2007 vintage which are now being monetized and (ii) very favorable valuations present in the public market.  I’ve been searching through some of these issues for investment candidates.

The Business

CDW is a company I’m familiar with from past experience.  It is the leading direct market reseller (DMR) of technology products in North America.  In simple terms, CDW partners with blue chip technology providers (e.g. HP, Cisco, Lenovo, VMware, Apple, EMC, Microsoft, and many more) to sell hardware and software products to 250,000+ customers including small and medium sized businesses, governments, healthcare institutions, and educational institutions.  CDW sells these products through a sales force of 4,400 coworkers, including 1,800 field sellers, skilled technology specialists, and advanced service delivery engineers.

CDW operates in a commodity business, cataloging and selling such products as PC laptops and desktops, servers, software licenses, and networking equipment.  It is trying to build up a value added solutions business (converged infrastructure, cloud solutions, virtualization, etc.), but solutions only accounts for 3% of total revenue.  The numbers tell a fascinating story.  Since 1993, the company has grown sales by 20%+ annually (8.5% since 2000), while slightly improving margins.  The company has outpaced the market and its primary DMR competitors and has increased market share every year.  I was very curious to know how a commodity reseller has been able to consistently improve market share while enjoying greater than twice the operating margin of its peer group.

We can silo the company’s operations to determine whether any competitive advantage exists.  At its core, CDW is engaged in three distinct operations: (i) procuring and managing commodity technology products, (ii) selling, marketing, and providing customer service to a large customer base, and (iii) investing in and managing working capital.  When you think about the nuclear units of the business, it becomes evident that the company has developed strong competitive advantages over time.

Scale is an important advantage in this industry and CDW’s size relative to its peers (larger than its four closest competitors combined) bestows it with important benefits in procurement.  Technology partners are primarily focused on moving greater volumes of product and provide substantial incentives to channel partners who can sell in vast amounts.  CDW benefits from significant vendor rebates, cooperative advertising arrangements, and favorable payment terms, which is reflected in its superior gross margin (16.5%) relative to peers (13.5%).

The company also runs the most productive and efficient sales force in the industry.  Revenue per sales employee of ~$2.5 million compares favorably to ~$1.5 million for peers.  The company has found the most effective way to organize and incentivize its sales team and has also been able to sell a larger variety of products through a narrower team of coworkers.  The net result of these efforts is an operating margin of ~7% vs. 3% for competitors.  CDW is also the industry standard bearer for managing the cash conversion cycle; it generates the highest returns on working capital in the industry.

The company’s margin advantage gives it a significant cost advantage over its peers, particularly tiny resellers.  It can offer the greatest breadth of product and service, match any price offered by competitors, and provide extremely well paid account managers to serve customers’ needs.  These factors explain CDW’s ability to outgrow the market and take share.

Key Long Term Risks

  • Technology: The consumption of technology changes rapidly and it’s therefore difficult to predict the impact of future development on the company’s revenue streams.  Most resellers have been quick to adapt to the latest trends in the market.  In the early 1990s, CDW made its living selling Apple Macintosh and IBM PCs, Windows software, and computer peripherals.  Today, it sells everything from routers to cloud software to converged infrastructure solutions.  If the world were to fully migrate to the cloud, where Chromebooks were omnipresent, it could have a meaningful impact on CDW’s business.  Thus far, the cloud has only served to benefit the company as it’s provided a boost to its Chromebook business, servers, storage, and cloud solutions.  As long as overall IT spend is growing with GDP, CDW will be well positioned to capture a share of the market.
  • Dell / HP:  The technology solutions market is still dominated by the direct channel, where customers purchase directly from vendors. For small and midsize businesses, however, channel providers such as CDW are valuable as they are a one stop shop for purchases, warranty, servicing, advice, and technology solutions.  It becomes very costly for a small IT department to manage multiple vendors, product defects, servicing, contracts, licenses, and warranties. Nevertheless, HP and Dell are in the process of reinventing themselves and are re-positioning their businesses to focus on business IT solutions.  They have been building out their account specialist teams and adding software solutions to their suite of offerings.  In the hardware channel, CDW is an important partner for HP, moving $2 billion of product annually, and is unlikely to face direct competition from its key vendor partner.  Dell, on the other hand, only sells direct and is focused on controlling the customer relationship.  As a private company, Dell is now able to make as much investment in this area as it deems necessary to compete.  Despite Dell’s push into this area, it will not be easy to displace CDW as there is a certain level of stickiness among customers who are accustomed to working with long tenured account managers.  Where Dell and HP are likely to win long term is in the value added solutions business, which is a growing, albeit tiny portion of CDW’s revenue base.

Valuation

By my estimate, current valuation in the market is fair for the company.  The stock is up nearly 80% since its IPO in July 2013, and the whole enterprise trades for 10.5x 2014 operating income.  It took the company 15 years to get to $5 billion of revenue and 9 more years to get to $10 billion.  It’s reasonable to think that CDW could get to $19 billion of revenue by 2025 (from $11 billion today).  Assuming slight margin improvement from today’s levels (there’s very little operating leverage in the business), the total equity IRR comes out to ~10%.  This doesn’t meet our hurdle of a minimum 15% return.

Conclusion

CDW is a franchise business, possessing a durable margin advantage and economies of experience with regards to its sales operation.  These advantages should snowball as further scale is achieved.  Management has historically been extremely prudent with capital, only making 2 small acquisitions in the company’s 25+ year history and operating successfully with a significant debt load.  Management has also focused on its core geographic strength in North America and not spent precious shareholder capital chasing potentially low return international opportunities, where CDW has no incoming advantage versus incumbents.  Further, the business only requires investments in working capital (and to a lesser extent IT systems) to grow, and the incremental returns on this capital are in the stratosphere (90%+).

The one constraint with this business is the lack of operating leverage.  The company must hire additional sales representatives to grow its business; there’s eventually a limit to the amount of business a single account manager can handle.  In addition, the more an account manager sells, the more commission he or she earns.  Operating margins have improved by a paltry 70 bps over the past 17 years.  As such, operating income will tend to grow with revenue, which in turn should grow a few points above GDP.  In my view, it’s unlikely this business can achieve an exponential outcome in earnings performance.

At current valuations, the opportunity is uninteresting.  Nevertheless, it’s a wonderful business and worthy of putting on the tracker.  At the right price, it would be a worthy name to add to the portfolio.

Feedback and conversation is most welcome.

Be a Business Analyst

“Be a business analyst, not a market, macroeconomic, or security analyst.” -Charlie Munger

This concept, although a very simple one, has taken me a long time to internalize.  For many years, I approached investments from a market or macroeconomic perspective.  As I result, I suffered from psychological misjudgements which prevented insights from surfacing.  What does it mean to be a business analyst?

  • When studying a new investment, security analysts first look at stock charts and trading history.  Business analysts read the annual report.
  • Security and market analysts spend mornings looking at the futures market and price action in certain stocks.  Business analysts read financial reports and relevant company/industry news, and speak with experts they can trust.  When no new information is available, which is usually the case, business analysts sit still and spend time researching other opportunities.
  • Security analysts spend a lot of time calculating financial ratios such as price/earnings, free cash flow yield, compound annual growth rates, valuation vs. peers, etc.  Business analysts determine whether they can understand the business and whether the business has a sustainable competitive advantage.
  • After earnings releases, security analysts pay close attention to the price action in the stock and the company’s results vs. street expectations.  Business analysts focus on whether the long term thesis is still in tact, whether the company is extending its advantage in its core market, management’s ability and credibility, and whether other key metrics (e.g. market share, unit cost, investment in r&d, brand awareness) are improving.
  • Security analysts use historical and one year forward valuation metrics when evaluating the suitability of an investment.  Business analysts carefully study the long term record of the company, then try to see 5-10 years into the future.  Business analysts view a company as an unfolding movie, not a still photograph.
  • Security analysts let price action dictate their views and moods.  Business analysts understand that the market is there to serve them and instead focus on business fundamentals.
  • Macroeconomic analysts worry incessantly about inflation, interest rates, China, Europe, the debt bubble, etc.  Business analysts purchase fractional ownership in businesses which provide a large margin of safety, can survive (and even benefit from) market cycles, and will outperform over a long time horizon.
  • Security analysts run screens for low price/earnings ratio, 52-week lows, high free cash flow yield, high returns on investment capital, etc.  Business analysts read Value Line and annual reports, building a database of targets in their mind.

Business analysts approach investments as if there were no daily trading in the market.  They have an almost myopic focus on business fundamentals and do not let Mr. Market dictate their mood.  In the past, I suffered from first conclusion bias by approaching investments as a security, market, and macroeconomic analyst.  I committed errors of commission by buying stocks which traded at low multiples and high free cash flow yields, or by buying businesses which I thought would benefit from a loose theory of where the macroeconomic environment was heading.  Similarly, I committed errors of omission by avoiding high multiple stocks, stocks which had run up 50-100% in the prior 12 months, and businesses which would be harmed by high interest rates or a slowdown in Europe.  Often times, heuristics lead to the wrong conclusion.  I could have avoided many of these misjudgements had I taken the approach of a business analyst.

As Howard Marks says, the job of the analyst is to know the knowable: securities, businesses, and industries.  If a wonderful business is acquired at a reasonable price, the investment should perform commendably given a sufficient time horizon.  Be a business analyst.