Smart & Final – Return on Equity

A quick way to assess the quality of a business is to look at the return it as able to generate on tangible equity.  Companies which are able to consistently generate high returns on equity typically benefit from a form of competitive advantage.  Calculating ROE is not as formulaic as net income / average equity because accounting treatment often masks the earnings power and capitalization of the enterprise.  Let’s look at Smart & Final as a case study.

Google Finance shows returns on equity for S&F of 2.5% in 2013 and 7.5% in Q4 ’14.  These numbers indicate a weak business with limited competitive strength.  Let’s dive into the numbers to see if this is the case.  Below, I’ve adjusted the balance sheet to determine the amount of equity capital that would need to be in the business to support current operations.  I first convert all the net debt to equity, then strip out intangibles such as goodwill and trademarks.  This gives us an accurate picture of how much equity capital would be in the business today if no acquisitions or debt financings were consummated.

I then turn to the income statement to determine an accurate figure for normalized, unlevered earnings.  I start with EBITDA and add back all the one-time, non-recurring charges to get to an appropriate adjusted EBITDA figure.  Note, many adjustments presented by management are bogus and as such it’s important to be conservative in your approach.  Finally, I adjust the D&A figure to get an accurate picture of steady state earnings.  S&F is spending nearly $100 million of capex per annum, 75% of which is being directed towards growth.  Maintenance capex is a more modest $25 million, or $100k per store.  The income statement should reflect the earnings power of the enterprise based on the amount of equity capital which has been plowed into the business.  As such, $25 million is a more appropriate figure for the calculation because it reflects the ongoing capital needs required to support existing operations.

The numbers, as adjusted, depict a tier 1 enterprise.  For context, the S&P 500 as a whole earns ~12% on equity.

For FY 2014, S&F will likely generate north of $150 million of unlevered, adjusted pre-tax earnings.  This compares to an adjusted market capitalization (assuming all debt is equity) of $1.7 billion, implying a pre-tax trading multiple of ~11.3x.  Buffett has repeatedly said that 10x pre-tax is a good price to pay for a wonderful business so we’re not too far from his measuring stick.

What makes S&F intriguing is the abundant opportunity it has to deploy capital at high rates of return over the next decade.  The company currently operates 252 stores across 6 states and Mexico.  ~190 of those stores are located in California.  The company believes it can open an additional 150 stores in existing markets plus convert ~40 of its existing stores to the higher return “Extra!” format.  Per management’s figures, this will require an additional ~$450 million of capex over the coming years.  If history is a guide, the capital spend should generate 20-25% cash on cash returns.  Bigger picture, once the business starts developing a stronger brand presence, it has an opportunity to expand eastward.

I’ve developed a preliminary hypothesis that S&F is a good business trading at a reasonable price.  It appears to offer customers a great value proposition – low cost, high quality food products in a convenient format.  The company has only had one year of negative comp store sales growth in the past 25 years, including positive growth in 2009.  I still have a fair amount of work to do on the competitive strategy piece and need to go through the checklist, but this has passed through my initial filters and is worthy of further investigation.

Feedback is certainly welcome.


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.


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.

Reinvestment Risk

I’m continuing to explore a few ideas in greater depth, mostly in the energy sector, but haven’t reached conviction on any one idea in particular.  Great opportunities are generally very hard to come by.  There are greater than 50,000 publicly traded companies worldwide.  Most people can probably follow only 30-50 companies while maintaining a high standard of quality.  Therefore, it’s critical to (i) focus on your areas of competence and slowly expand the circle over time, (ii) develop strong filters so ideas can be quickly weeded out, and (iii) bet large sums of money when a superior opportunity is identified.

As mentioned previously, I’ll continue to write on topics which I’m thinking about.  One common perception which I’ve been pondering is that rising interest rates will harm bond portfolios.  The consensus opinion is that interest rates will rise, perhaps dramatically, over the coming years.  It’s interesting to note that this has been the consensus view over the past four years, a time period when interest rates have fallen substantially.  It follows that rising interest rates will harm most assets, particularly bonds.

When thinking of a long term bond, say a 30 year bond, a majority of return does not come from coupon payments.  It comes from reinvestment of the coupons (the interest on the interest).  Therefore, in a low rate environment, a 10% coupon bond will generate a lower yield to maturity than the 10% stated rate since the coupons will likely be reinvested at a rate lower than 10%.  Stated another way, when a bond is purchased at a stated yield to maturity, the implied reinvestment rate in the calculation is the quoted yield to maturity.  However, it doesn’t have to be.  In an environment where treasuries are 3%, it’s not reasonable to assume that all coupons can be reinvested at a 10% rate.  For this reason, the yield to maturity calculation is somewhat illusory.

Most bond investors and insurance company portfolio managers are terrified of rising rates.  Yes, when rates rise, quoted bond prices will fall.  However, if a long term bond is held to maturity, the overall return on the bond will increase in a rising rate environment.

Oil Crash

It’s during moments of mass market liquidation, when asset holders would rather sell than wait for rationality to resume, that buying opportunities surface.  The recent crash in oil prices has sent the whole energy sector into freefall.  Much of the energy complex is tied to oil prices, but certain high quality businesses such as Western Refining and SolarCity could do well long term irrespective of oil prices.

As mentioned previously, I’ve formed a preliminary hypothesis that SCTY is poised to be a large winner in the exponentially growing solar energy sector.  The market value of the company is currently quoted at ~$5bn, implying lofty expectations for future growth.  There certainly isn’t a large margin of safety in the price, but there appears to be a margin of safety in the company’s business model.  However, it may prove to be too difficult a business to reach conviction on as some elements of the analysis may always be a black box – accounting, regulatory environment (subsidies, net metering policy), and competition from utilities and banks.

I’m continuing to do work on SCTY and some other names in the energy sector to see if an investment opportunity exists.