You just joined as a new analyst and your boss slaps this on your desk Adobe 2000 10K. What is the real net income to shareholders? Assume a 35% tax bracket.
You remember from reading in Berkshire Hathaway’s 1992 annual report, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
The End of Accounting An article from the Wall Street Journal. Some may wish to read this book. On the other hand, we all should know the limitations of accounting. Accounting was designed for credit analysis while business analysts must use more conceptual, creative thought to understand the economics of the business they are analyzing. Use the proper tool in the proper way–understand context.
The best long-term investments tend to be companies that can reinvestment over and over again at high rates of return. Those high rates of return attract competitors so you must also understand barriers-to-entry. But first study how to calculate incremental returns on capital or marginal returns on invested capital (“MROIC”). There are several links and documents below to help you. The effort is worth it if you can find: WMT_50 Year SRC Chart (up to 2000). WMT had regional economies of scale until it out-grew them.
One quick and dirty way is to look at the amount of capital the business has added over a period of time, and compare that to the amount of incremental growth of earnings. Last year Walmart earned $14.7 billion of net income on roughly $125 billion debt and equity capital, or just under 12% return on capital. Not bad, but what we really want to know if we are going to buy Walmart is a) how much of their earnings will they retain and reinvest in the business going forward? and b) what will the return on that reinvested capital be?
10 years ago in fiscal 2006, Walmart earned $11.2 billion on roughly $83 billion of capital, or around 13.5%. But in the subsequent 10 years, they invested roughly $42 billion of additional debt and equity capital ($125b invested in 2016 and $83b invested in 2006), and using that incremental $42 billion they were able to grow earnings by about $3.5 billion (earnings grew from $11.2 billion in 2006 to around $14.7 billion in 2016). So in the past 10 years, Walmart has seen a rather mediocre return on the capital that it has invested during that time (roughly 8%).
We can also look at the last 10 years and see that Walmart has retained roughly 35% of its earnings to reinvest back in the business (the balance has been primarily used for buybacks and dividends). As I’ve mentioned before, a company will see its intrinsic value will compound at a rate that roughly equals the product of its ROIC and its reinvestment rate. So if Walmart can retain 35% of its capital and reinvest that capital at an 8% return, we’d expect a modest growth of intrinsic value of around 3% per year. Stockholders will see total returns higher than that because of dividends, but the value of the enterprise will likely compound at roughly that rate. And we can see that over the previous 10 years, Walmart’s stock has grown around 45% not including dividends. So unless you are banking on an increase in P/E ratios, you’re unlikely to achieve a great result buying a business that can only invest a third of its earnings at 8% returns.
This is a really rough measure, and this back of the envelope method works okay with a large, mature company like Walmart. But what you really want to know is what will the business retain going forward and what will the return be on the capital it retains and reinvests? Of course, there are different ways to measure returns (you might use operating income, net income, free cash flow, etc…) and there are many ways to measure the capital that is employed. But hopefully this is a helpful example from a general point of view.
I suppose there is always headline risk with things that have been in multi-year bear markets.
I am curious if you have any thoughts about political consequences of increased isolationist sentiment in the US and Europe? Reply: Actually, the recent sell-off in the shippers this past week (June 17th, 2016) has partially been (I believe) due to Brexit. You always want to look where sentiment is the worst and then try to determine if the price reflects the known news. So on the one hand the rising fears over isolation give me comfort that a lot of bad news is being priced in. Also, if the EU breaks up, why should trade go down? Britain already sells more to the EU than it imports. Switzerland isn’t in the EU and it has one of the strongest economies in Europe. The EU makes no logical economic sense–how can central planning EVER work? Nations have a natural interest to trade with each other since individuals benefit. What Trump says and can do (even if elected) are two separate issues. I really don’t know how to handicap. What I want is terrible news to encourage ship owners not to order new ships and to scrap the ones that they have.
Also curious about your thoughts on the surge in low-cost vessels that came from Chinese ship makers in the last several years. Reply: This has been one of the reasons this shipping cycle has been the worst in forty years. Easy credit/subsidized loans created a boom in Chinese ship builders (See May 7th, 2016 Economist issue and http://www.economist.com/news/leaders/21698240-it-question-when-not-if-real-trouble-will-hit-china-coming-debt-bust. Now some Chinese ship builders are close to bankruptcy. So, yes, this oversupply will make this cycle–already a long one–drag out, but who knows for how long?.
I subscribed to Trade Winds (shipping trade magazine) a couple of years ago, to keep abreast of the industry and try to find when industry sentiment started to pick up. So far, it’s still been abysmal, although this years spike in iron ore was pretty interesting. Especially because Wall Street analysts are still telling everyone iron ore is going lower and this is just a blip. Reply: Wall Street just tells you AFTER the fact or projects the trend/obvious. As one ship owner said (Diana Shipping) said, “The bulk shipping market will turn when no one believes it will turn.”
Ordered the book just now. Really interested to learn more about the industry, and it’s cool that it’s in novel form. I think some of these shippers may start getting close to scrap value pretty soon. Reply:The Shipping Man was an educational and enjoyable read. I may even search for other book like Viking_Raid_Excerpt
Just remember that the shipping industry has big demarcations. A company like Navigators’ Holdings (an LPG shipper) has different market dynamics than a dry-bulk shipper like Scorpio Bulkers. One shipper operates in more of a oligopoly market than a purely competitive one though both, obviously, are cyclical.
I highly recommend the 800 page opus, Maritime Economics (3rd Edition) by Martin Stopford. If you wish to dig into the shipping industry, then read the annual reports/presentations of several shippers. I have a ways to go to understand this market. The author: https://youtu.be/e2TToPf5iDs
Speculating in shippers is a bit like playing poker. You don’t want the ship owners to start ordering new ships if freight rates start to rise. You want the other owners to disbelieve a sustained rise. When supply is constrained for a few years coupled with a spike in demand, the shipping market explodes like in 2007–no wonder a large supply of ships eventually came into the market and the boom went to bust. The SIZE of the prior boom has led the depth of this bust.
I am not suggesting this as an investment for YOU, but seek out disconnects like this. Despite rising earnings, the market may be worried about lower oil prices because lower oil prices may affect the demand for the products that NVGS ships and/or the capex that NVGS is bearing with delivery of new ships. The question for an investor would be: “Has the market over-discounted the fears of low oil prices or over-supply of ships?” This company is VERY different than a standard dry-bulk shipper. These are highly-specialized/expensive ships. Knowledge reduces risk, so really understand the management and its goals.
From 1975-2001: ROI for T-Bills was 6.6%, S&P 500 14.1% with a 15% std. dev., Bulk Shipping 7.2 with a 40% std. dev., and Tanker Shipping 4.9% with a 70.4% std. dev! (Source: Maritime Economics, 3rd Edition)
Who in their right mind would invest in the shipping business? Well, if you can buy low, then fortunes can be made. Recently, the Baltic Dry Index (BDI) hit a thirty-year low of 291, BDI Index and note the long-term chart below. Always look at MANY years of past data. The boom of 2007/08 will probably not be seen again for many years.
“Dry bulk is a screaming buy; one of the best entry points in the cycle in the last thirty years. But be prepared to sustain a prolonged period of poor freight market conditions and have plenty of cash reserves and low leverage. In other words, you have to have a longer-term perspective than most investors–three to five years at least.
Isaac sowed seeds into the land during a drought. –Leon Patitasas
“That’s the funny thing about ships. They are actually more attractive to buy at 20xs EBITDA, or even negative cash flow, than they are at 4xs EBITDA,” Coco said.
“So you are telling me that investors should seek out money losing shipping deals?” she asked incredulously.
“Correct. And sell the ones that are making lots of money. Itis like that little Napoleon said….”Buy on the sound of cannons and sell on the soundsof trumpets.” (Source: The Shipping Man by Matthew McCleery).
John Chew: Here is where I wonder if this post helps readers’ understanding of investing because is this investing or speculating? Note as much as what Warren Buffett does NOT do. He doesn’t invest in mining or shipping stocks. He has already had poor results with the airline industry. So why even mention an industry in massive distress with historically sub par returns and huge volatility? I would prefer businesses with great reinvestment opportunities or great capital allocators at the helm like Markel (MKL), but a horrific business going from a distress price to a bad price may give much better returns depending upon the price paid. Also, the worst bear market in freight rates in the past 30 years for dry bulkers means unusual opportunity just as the worst bear market in gold miners in the past 100 years offered bargains galore.
Readers know that I ventured into the miners in mid-to-late 2013, subsequently suffering back-to-back declines of about 25% before seeing the portfolio rally about 100%. So I still do not have a great return (12% after three years), but I bought miners with a five-year-to-seven year outlook and I am only three years into the investment. With Junior miners you can expect to see a 50% decline before they rally five to 10 times (assuming you chose the ones that survive! –Rick Rule). In a land of negative-to-low interest rates, I have to look further for bargains.
Readers can pipe in what they would like to learn in future posts–let me know.
Five years of declines in gold mining stocks and then…..
Are you investing or speculating by dry-bulk shipping stocks? These are stub stocks where the equity is a small fraction of the enterprise values due to the shrunken market cap and the large debt taken on to finance ship purchases. But if you buy a few well-managed and relatively well-financed shipping companies that can survive the trough of the cycle–two to four more years?– you can tolerate a few going to zero if the ones remaining multiply many-fold. Not for the weak-kneed. Scorpio Bulkers (SALT) has ALREADY diluted shareholders and has taken drastic action to survive. Note management buying shares at $3.00 Scorpio Bulkers Inc. Announces Financial Results for the First Quarter of 2016. An ugly past, but we invest for the future in terms of mean reversion. I have not yet invested in any shipping stocks!
Here is what I love about the shipping business. 10 ships and 11 cargoes, then a BOOM. 11 ships and 10 cargoes, then a BUST. You are also on the SAME footing as the most experienced ship owners in the world. NO ONE knows when the cycle will turn. This is like a poker game where the investor that has the ships when others have thrown in the towel takes a lot of the marbles. The worse the freight rates and the outlook, the better IF you can carry the costs until the cycle turns, and it WILL turn due to the laws of supply and demand.
I view this as intelligent speculation. I allocate five tranches of investment into five shipping companies. Say $5 units each. One unit goes to zero (ouch!), the next to $2 (Boo!), the next to $1 (Damn!), the next to $3 and the next to $50 (Homerun!) and it takes three years. There is a 31% compouned return. Though I have no idea if this is realistic because I must study the shipping industry thoroughly. I am just formulating a possible strategy IF I find the right companies at the right prices. But I am drawn to the shipping companies because some companies are trading below depressed net asset values. As Mr. Templeton suggests, look where the outlook is most dire.
Emotional crowds dominate market volatility (nothing new here). Emotions trump arbitrage. If you learn anything from this post may it be that you concentrate on your best ideas and do not overdiversify beyond ten or twelve stocks. Also, understand randomness. Teams hurt performance. Avoid closet- indexers.
And here is a secret not to be shared with others: If you are going to have a behavioral edge, then don’t do what the mass of investors are doing–invest with a at least a five-year time horizon so you can give mean regression to work if you buy non-franchise companies (assets like cyclcial mining, manufacturing, etc.) or allow your franchise companies time to compound because of a slow mean reversion.
But holding stock five years or more is SCARY because of the VOLATILITY. Not so:
Novagold Annual Report 2015 This annual report’s shareholder letter including the links provides an excellent example of how several investors view the capital cycle for an asset. History does provides a guide.
The above article should be a sobering reminder of how difficult it is to choose exceptional stocks. Remember when reading about great compounding machines like Wal-Mart in its early days (1970 to 1999) that you must take into account survivorship and hindsight bias.