high margins vs. low

Many traditional growth investors characterize the ideal investment as being a company with substantial intellectual property–pharmaceutical research or computer chip designs or proprietary software–protected by patents.  This allows them to charge very high prices, relative to the cost of manufacturing, for their products.

Some go as far as to say that the high margins that this model generates are not just the proof of the pudding but also the ultimate test of any company’s value.

As I mentioned yesterday, the two issues with this approach are that: the high margins attract competition and that the price of maintaining this favorable position is continual innovation.  Often, successful companies begin to live the legend instead, hiding behind “moats” that increasingly come to resemble the Maginot Line.

In addition, high margins themselves are not an infallible sign of success.  Roadside furniture retailers, for example, invariably have high gross margins, even though their windows seem to be perpetually decorated with going-out-of-business signs.  That’s because furniture is not an everyday purchase.  Inventories turn maybe once or twice a year.  Margins have to be high to cover store costs–and, in normal times, to finance their inventories.

Although I am a growth investor, I’ve always had a fondness for distribution companies–middlemen like auto parts stores, or pharma wholesalers, or electrical component suppliers, or Amazon, or, yes, supermarkets (although supermarkets have been an investment sinkhole that I’ve avoided for most of my career).  My experience is that the good ones are badly misunderstood by Wall Street, mostly, I think, because of a fixation on margins.   In the case of the best distribution companies, margins are invariably low.  So that’s the wrong place to look.

Where to look, then?

the three keys to a distribution company:

–growing sales, which will leverage the fixed costs of the distribution infrastructure,

–rapid inventory turns, measured by annual sales/average inventory.  What a “good” number is will vary by industry.  Generally speaking, 10x is impressive, 30x is extraordinary,

–negative working capital, meaning that (receivables – payables) should be a negative number   …and getting more negative as time passes.  Payables are the money a company owes to suppliers, receivables the money customers owe to the company.  For a healthy firm, its products are in high enough demand that customers are willing to pay cash and suppliers are eager enough to do business that they offer the company generous payment terms.

A simple example:  all a company’s customers pay for everything (cash, debit or credit) on the day they buy.  Suppliers get paid 90 days after delivery of merchandise.  So receivables are zero; payables will end up averaging about 90 days of sales.  This means the company will have a large amount of cash, which will expand as long as sales increase, available to it for three months for free.

not just cash generation

The best distribution companies will also have a strategically-placed physical distribution network of stores and warehouses.

They’ll have sophisticated inventory management software that ensures they have enough on hand to meet customers’ needs + a small safety margin, but no more.  It will also weed out product clunkers.

They’ll have stores curated/configured to maximize purchases.


…the curious case of Whole Foods.




A regular reader asked me the other day to explain why I said I thought the margins of Whole Foods (WFM) are too high.  Here goes:

what they are

Margins are ratios, usually some measure of profits (gross profit, operating profit, pre-tax profit…) divided by sales. (Yes, in cost accounting contribution margin is a plain old dollar amount, not a ratio.  But it’s an exception.  I have no idea why the misleading name.)

when high margins are bad

At first thought, it would seem that the higher the margins, the better off the seller is.  Buy the item for $1, sell it for $2.  That’s good.  Raise your prices and sell it for $5, that’s better.

The financial press encourages this notion with articles that talk up high margins as a good thing.

At some point, however, other people will work out how much you’re making and start doing the same thing.  They’ll typically go for market share by undercutting your prices.  So now you’ve got a competitor who wasn’t there before and you’re facing a price war that will at the very least undercut your brand image.

Creating what analysts call a price umbrella below which competitors can price their products and be protected from you as a rival is one of the worst mistakes a firm can make.

In my experience, it’s infinitely better to build a market more slowly by yourself than to have to try to dislodge a new rival who has spent time–and probably a lot of money–to enter.

One potential exception:  patented intellectual property (think:  Intel or drug companies). Even in this case, however, there’s the danger that once-successful firms become lazy and fail to continue to innovate after initial success.  The sad stories of IBM, or of Digital Equipment, or INTC for that matter, are cautionary tales.

More tomorrow.

tweaking stock market indices

When I started my career as a professional investor, the providers of stock market indices were a sleepy group inhabiting a financial industry backwater.

The rise of interest in markets outside the US and the increasing prominence of index funds over the past decade have changed all that, however.  Now index providers are movers and shakers in the financial world.

The two issues of the day:

–whether and in what amount to include mainland China-traded A shares in emerging markets indices.

The argument against has been that the Chinese government controls very strictly not only which foreigners can have access to local stock markets, but also in what amounts and whether/how they can repatriate profits.

The argument for is that the recently instituted Stock Connect mechanism has alleviated part of the problem.  Also, at some point one begins to question the legitimacy of an emerging markets or foreign index that has no representation of the largest emerging market of them all.  Further, the first index to include mainland China names is sure to score points with Beijing.

There’s nothing new about this debate, other than the large size of the A-share market means the decision may have significant consequences.  My guess is that the indices will begin by merely dipping a toe in the water and seeing how things go.

–whether to exclude companies that use multiple classes of shares in a way that allows a small group of insiders to control the corporation despite owning a small fraction of the outstanding equity.  Think:  Alphabet (formerly known as Google), Facebook or Snap.

I find it interesting that index providers are even contemplating excluding multiple-class companies from their indices.  I’m sure they regard this as a service, a natural extension of the legal responsibility of index funds to take part in corporate governance on behalf of the investors who own fund shares.

Maybe that’s right.  But I have three reactions:

—-this type of decision comes awfully close to active management

—-who wants a US index, to say nothing of a US tech index, without Google and Facebook?

—-excluding important names makes an index easier to beat for an active manager, who can gain outperformance by holding non-index names.  I imagine that my former colleagues who are still working are praying that the index providers start down the exclusion path.

Whole Foods Market (WFM), again

another bidder?

WFM and Amazon (AMZN) announced late last week that the two firms had agreed to a friendly deal under which AMZN would acquire all the shares of WFM for $42 each in cash.

Since the announcement, WFM share have traded on very large volume and almost continuously at prices above the deal.

What does this mean?

deal mechanics

If I’m a holder of WFM and the current deal stands, I’ll receive $42 a share from AMZN in, say, three months.  The value of that future $42 today is slightly less.  It’s $42 minus the interest I could earn on the money in the intervening three months.  Let’s say that amount is $0.25.

If I believe the deal is a sure thing, then, I should pay no more than $41.75 for an AMZN share today.  However, there’s always some risk that the deal will be called off.  The possibilities may be far-fetched–a government agency might forbid the acquisition, there might be something funky in the WFM financial statements…  This means the $41.75 is a ceiling, not a floor, on the stock price.  Typically, trading starts below the present value of the future payment and gradually approaches it as the deal gets closer, and as possible obstacles are cleared.  The amount below varies from deal to deal, depending on perceived risks.

Ithink WFM should probably be trading, at best, in the $41.25 – $41.50 range now, rather than at around $43.

the difference

The $1.50 difference represents a bet by the market that another, better, offer will emerge.  As a practical matter, most often these bets turn out to be correct.  Maybe it’s because the bettors have deep industry knowledge or maybe because they’re acting on information from/about another potential acquirer you and I are not privy to.

For me, this will be an interesting case to watch, since I can’t figure out who the other buyer might be.



Whole Foods (WFM) and Amazon (AMZN)

I was a big proponent of WFM in its early days but haven’t owned it for a long time.

My quick look at the company’s financials this morning tells me it’s an odd duck among food distributors.  Successful distribution is all about low margins + rapid inventory turnover + shrewd working capital management + rising sales leading to strong profit growth.  WFM exhibits only one of these characteristics:  rapid inventory turnover.  The number I get from the annual report, which I find almost too good to believe, says that WFM’s annual sales are 30x its average inventory.  This compares with 10x for AMZN and 15x for Kroger (KR).

On the other hand, WFM’s operating margin is more than 50% higher than KR’s and nearly triple AMZN’s.  The excess of payables (what a firm owes to suppliers) over receivables (what customers owe the merchant)–and a key measure of operating strength–is about 1% of sales for WFM, while 3.6% for KR and about 15% for AMZN.  In addition, WFM is no longer growing–the main reason, I think, the company’s PE has been cut in half over the past couple of years from about 40x to 20x (pre-AMZN bid).

WFM’s problem isn’t simply that its margins are too high to induce people to buy more than they do of what the company has to offer.  Nor is it the assertion by some that WFM is very inefficient and should be making a higher margin than it actually does.

Rather, it’s that the current market situation is highly unstable, on several fronts:

–WFM-like offerings are increasingly available from less expensive chains like Trader Joe’s or even regular supermarkets

–having severely damaged the profits of incumbent grocers in the UK, deep food discounters from Germany–Aldi and Lidl–have both announced that their next target is the US.  Even if the two are unsuccessful, increased competition is bound to mean lower prices

–AMZN has decided that the time for online food delivery on a large scale in the US has come.  It’s also possible that it too is worried about the potential effect that Aldi and Lidl may have and has sped up its food distribution plans.


how will the takeover work out?

It’s hard to know.  WFM’s management hasn’t covered itself in glory over the past decade.  It needed to be bailed out from operating difficulties by Green Equity Investors in late 2008.  And it doesn’t seem to have responded well to increased competition since.  On the other hand, AMZN’s experiments in food delivery have had indifferent success so far. At the very least, though, AMZN brings a strong record in controlling distribution operations, expertise which WFM seems to me to need; WFM brings a brand name and the grocery equivalent of Amazon lockers.

My thoughts:  the one thing I’m confident of is that food prices will generally be lower for consumers in a couple of years than they are now.  I’d prefer to look for places where extra discretionary income can be spent than to try to play food directly.


the curious case of Toshiba and the Mitsui keiretsu

The Financial Times, now owned by the Nihon Keisei Shimbun (the Nikkei)–and which should therefore have a particularly sharp insight into goings on in corporate Japan, had an interesting article the other day about Toshiba.

Toshiba is facing possible bankruptcy and potential delisting from the Tokyo Stock Exchange as a result of the disastrous performance of its nuclear power business.  To avoid this fate, it has decided to sell its flash memory business, which is a world leader in this important class of semiconductor devices and owns essential intellectual property for their manufacture.

The Japanese government is intervening in the matter, with the aim of ensuring that this important asset remains in Japanese hands.  What is distinctly not happening, as pointed out in an FT article two days ago, is any aid being offered by other members of the Mitsui industrial group.  This is very unusual.


At the core of Japanese economy in the first half of the twentieth century stood a number of powerful industrial conglomerates, called zaibatsu, which emerged from the samurai culture of shogun-era Tokyo.  The zaibatsu were outlawed after WWII for their role in Japan’s participation in that conflict.  But their dissolution was in name only.  The groups continue to exist in substance but were referred to as keiretsu.

One of the principal features of the keiretsu is mutual assistance in times of trouble.

For example,

Some years ago, Mistubishi Motors tried to buy its way into the US car market with a “0-0-0” financing campaign.  That meant zero down, a zero interest rate on 100% financing, and no loan repayment for the first year.  As it turned out, there was also a fourth zero–no credit checks.  And very large number of buyers (if you can call them that) simply made no payments when the time came.  They continued to drive the cars until they were repossessed.  Mitsubishi Motors as a whole, not just the US subsidiary, was faced with financial failure as a result.

What happened?

The other members of the Mitsubishi group injected hundreds of billions of yen into the auto company so that it remained afloat.  I remember speaking about this at the time with the chairman of Mitsubishi Corp, the group’s trading company.  He was deeply unhappy about having to invest in the auto arm of the group, and knew that this made no economic sense, but felt that his honor demanded that he do so.


Fast-forwarding to today and Toshiba     …not a peep from other Mitsui group members.

There may be something unusual about Toshiba.  More likely, the zaibatsu concept, a vital aspect of the samurai culture, may have finally passed its best-by date.  Interesting, too, that this should come while a descendant of the samurai is the prime minister.