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.



Disney (DIS) and ESPN: a lesson in analyzing conglomerates

DIS shares went on a fabulous run after the company acquired Marvel in late 2009, moving from $26 a share to $120 in early 2015.  Since then, however, the stock has been moving sideways to down–despite rising, consensus estimate-beating earnings reports in a stock market that has generally been rising.

What’s going on?

The basic thing to understand about analyzing a conglomerate like DIS is that aggregate earnings and earnings growth matter far less than evaluating each business in the conglomerate by itself and assembling a sum of the parts valuation, including synergies, of course.

In the case of DIS, the company consists of ESPN + television; theme parks; movies; merchandising related mostly to parks and movies; and odds and ends–which analysts typically ignore.

In late 2009, something like 2/3 of the company’s overall earnings and, in my view, 80%+ of the DIS market value came from ESPN.

How so?

At that time, ex Pixar, the movie business was hit and miss; the theme parks, always very sensitive to the business cycle, were at their lows; because of this, merchandise sales were similarly in the doldrums.  ESPN, on the other hand, was a secular growth business, with expanding reach in the global sports world and, consequently, dependably expanding profits.

ESPN profits not only made up the majority of the DIS conglomerate’s earnings, the market also awarded those profits the highest PE multiple among the DIS businesses.

At the time, I thought that if truth in labeling were an issue, the company should rename itself ESPN–although that would probably have detracted from the value of the remaining, Disney-branded, business lines.

Then 2012 rolled around.

More tomorrow.


the Sears “going concern” warning

the auditor’s opinion

On my first day of OJT in equity securities analysis, the instructor asked our class what the most important page of a company’s annual report/10k filing is.  The correct answer, which escaped most of us, is:  the one that contains the auditor’s assessment of the accuracy of the financials and the state of health of the company.  The auditor’s report is usually brief and formulaic.  Longer = trouble.

Anything less than a clean bill of health is a matter grave concern.  The worst situation is one in which the auditor expresses doubt about the firm’s ability to remain a going concern.

a new financial accounting rule

In today’s world, that class would be a little different.  Yes, the auditor’s opinion is the single most important thing.  But new, post-recession financial accounting rules that go into effect with the 2016 reporting year require the company itself to point out any risks it sees to its ability to remain in business.

the Sears case

That’s what Sears did when it issued its 2016 financials in late March.  What’s odd about this trailblazing instance is that while the firm raised the question, its auditors issued an “unqualified” (meaning clean-bill-of-health) opinion.

what’s going on?

Suppliers to retail study their customers’ operations very carefully, with a particular eye on creditworthiness.  That’s because trade creditors fall at the absolute back of the line for repayment in the case of a customer bankruptcy.  They don’t get unsold merchandise back; the money from their sale will likely go to interests higher up on the repayment food chain–like employee salaries/pensions and secured creditors.  So their receivable claims are pretty much toast.

Because of this, at the slightest whiff of trouble, and to limit the damage a bankruptcy might cause them, suppliers begin to shrink the amount and assortment of merchandise, and the terms of payment for them, that they offer to a troubled customer.   My reading of the Sears CEO’s recent blog post is that this process has already started there.

It may also be, assuming I’m correct, that the effects are not yet visible in the working capital data from 2016 that an auditor might look at.  Hence the unqualified statement.  But we’re at the very earliest stage with the new accounting rules, so nothing is 100% clear.

breaking a contract?

Sears has complained in the same blog post about the behavior of one supplier, Hong Kong-based One World, which supplies Craftsman-branded power tools to Sears through its Techtronic subsidiary.  Techtronic apparently wants to unilaterally tear up its contract  with Sears and stop sending any merchandise.

Obviously, Sears can’t allow this to happen.  It’s not only the importance of the Craftsman line.  If One World is successful, other suppliers who may have been more sympathetic to Sears will doubtless expect similar treatment.

Developments here are well worth monitoring, not only for Sears, but as a template for how new rules will affect other retailers.




buying an individual tech stock

This is just a brief overview:

–Buying any stock involves both a qualitative and a quantitative element.  That is:  What does the company do that makes this a good stock to own? and How do the numbers–the PE ratio, asset value, dividend yield and earnings growth–stack up?

–For value stocks, the numbers are more important; for growth stocks, the story is the key.  That’s because the primary element in success for value investors is how carefully they buy (because the ceiling for a given stock is relatively clearly defined).  For growth investors, it’s selling before/as the drivers of extra-fast earnings expansion run out of steam.

–Most tech stocks fall in the growth category.  My advocacy for Intel a few years ago was one of the rare occasions where a tech story is about under valued assets.

–In most cases, tech companies own key intellectual property–software, patents, industrial knowhow–that is in great demand, and which competitors don’t have and can’t seem to create substitutes for.  As long as that remains true, the company’s stock typically does well.  As I just mentioned, a crucial element in success with tech (or any other growth sector) is to exit before/as the growth story begins to unwind.  One yardstick is that this typically happens five years or so after the super-growth starts.  Yes, the best growth companies, like Apple or Microsoft or Amazon, have an ability reinvent themselves and thereby extend their period of strong earnings success.  But this isn’t the norm.

–Learning to be a stock investor is sort of like learning to play baseball.  There’s no substitute for actually playing the game.  The best way I know to learn about a stock is to buy a very small position and see what happens.  Don’t just sit idle, though.  Read everything on the company website, and the websites of competitors.  Read the last annual report and 10k.  Listen to (or read the transcripts of) the firm’s earnings conference calls.  Find and monitor (at least the headlines) financial newspapers and relevant blogs.  Try to form expectations about what future earnings might be and check this against what actually happens.  Then figure out where/how you went wrong and adjust.  Watch how the market reacts to news.  At first you may be terrible.  I certainly was.  But if you’re honest with yourself in your postmortems, you’ll probably make considerable progress quickly.

–Sooner or later–preferably sooner, learn to interpret a balance sheet and income statement.  A local community college course would probably be good, but you can get the basics of financial accounting (definitely don’t worry about double entry bookkeeping) from a book over a weekend.  Remember, here too there’s no substitute for the experience of trying to work out from a given company’s actuals what future income statements, balance sheets and flow-of-funds statements will look like.


the border tax

too-high corporate tax rate

The rate at which the domestic earnings of US corporations are taxed by the federal government is unusually high by world standards.

Corporate response has been what one would expect:  some firms leave for lower-tax jurisdictions; others engage in elaborate tax avoidance schemes, the bare bones of which I wrote about yesterday; still others spend tons of time and money lobbying Congress for exemptions.  Not a pretty picture.

What to do?

The straightforward answer would be to lower the tax rate and eliminate the special treatment.  Of course, congressmen, lobbyists and the industries receiving tax breaks are all against the latter.

border tax

That’s one reason for the appeal of a flat tax of perhaps 20% on the value of all imports–it leaves the status quo untouched but raises tax dollars to offset those lost through reducing rates.

A border tax would have another advantage, eliminating abuses from transfer pricing.  This is a practice whereby goods imported into the US are first shunted on paper through a tax haven where their price is raised.  The effect is to redirect profits from the US to the tax shelter country.


The biggest theoretical issue with a border tax is the law of comparative advantage, the idea on which most international commerce is based that countries all gain by specializing in what they do best and buying everything else from abroad.  Contrary to what one might think at first, trying to do everything in-country and taxing imports reduces national wealth.

A big practical defect of the border tax, to my mind, is that there are mammoth categories of everyday goods–food, clothing, furniture, toys–that are only available at low cost in the US because they are made abroad.  Another is the question of retaliation, as the US is now doing against Canadian efforts to favor local milk products over imports from Wisconsin.

a rising dollar?

Border taxers reply to the higher-cost-of-imports issue by claiming that implementing a border tax will cause the dollar to rise–maybe even by enough to offset the effects of the border tax in dollar terms.  How so?

The argument is that every day US parties go into the currency markets wanting to exchange dollars for foreign currency.  Similarly, foreigners come with their currency to exchange into dollars to buy US-made stuff.  The interaction of supply and demand sets the exchange rate.

Post border tax, higher prices of foreign goods means less demand in the US for them, which means fewer dollars available for exchange, which means the price of dollars goes up. Some border tax advocates claim the dollar spike could be as much as +25%-30%.


I suppose this line of reasoning could be right. But it seems to assume, among othe things, that, contrary to what we’re doing with Canada, no one retaliates; and that demand for now-higher-priced US goods remains relatively unaffected.  Good luck with that.

Ultimately, though, I think that, whatever the strength of its conceptual underpinnings, the border tax is an attempt to avoid attacking the rats nest of special interest exemptions in the tax code while still lowering the headline rate. So it’s “fixing” one tax distortion by creating another.  That’s vintage Washington.  But making taxes more complex, not less, is a recipe for trouble.



the Trump tax plan

President Trump has submitted the outline of his income tax plan, reportedly in bullet points on a single sheet of paper, to Congress.  Although some have derided the lack of detail provided, the submission at least makes it very clear what is going on–and will likely help underscore the allegiance to special interests that opponents to what I considr a no-brainer tax fix may be serving.

On the corporate side, the reduction of the top rate to 15% will address three very important tax issues, all spawned by the fact that US corporate income tax (for those unable to cut a sweetheart deal) is higher than just about any other place on earth.  The current problem areas I see them are three:

inversions, where a company paying full freight in the US reincorporates on paper, usually through a merger with a foreign firm, in a low-tax country like Ireland (where the tax rate is in the low teens).  Pharmaceutical companies, which have few ways of reducing their taxable income, have been the most prominent group doing this.  At the stroke of a pen, their after-tax income goes up by 30%.

transfer pricing, a long-time standby of multinationals.  That’s where goods made by a third party in, say, China and destined for ultimate sale in the US are bought for, say, $10 each by the on-paper subsidiary of a US firm.  The goods are marked up by Hong Kong to $20 and sold for that to the US parent.  Since foreign firms doing business in Hong Kong pay no corporate tax, that $10 markup, which probably remains in a bank in Hong Kong, allows the parent to avoid paying $3.50 or so in tax to the IRS.

intellectual property transfer, a variation on transfer pricing.  A US firm transfers its patents, ownership of its brand name… to a subsidiary in a low-tax jurisdiction.  Ireland is a favorite destination.  It pays royalties to the subsidiary for the use of the intellectual property, generating an expense that reduces US income otherwise taxed at 35%, while paying less than half that to the country where the intellectual property is now domiciled.

One major effect of these strategies is that all of the cash saved is trapped abroad.  This is because IRS regulations require corporations repatriating such foreign income to pay tax on the transfers equal to the difference between the US and foreign tax rates.  That’s the reason multinationals are constantly lobbying Congress to declare a tax holiday for repatriations like these.

It will be interesting to see what happens.


Note:  the one virtue of what I consider the otherwise loony border tax is that it would remove the appeal of the extensive network of transfer pricing/IP transfer schemes already in place.  More about this tomorrow.


Trump on corporate income taxes

I think corporate tax reform is potentially the most significant item on the Trump administration agenda, as far as US stocks are concerned.

The Trump plan appears to have two parts:

–reduce the top corporate tax rate from 35% to, say, 20%.  For a firm that has 100% of its income in the US and which has no substantial current tax breaks, reducing the corporate tax rate would mean a one-time 23% increase in after-tax profit.

–eliminate foreign tax reduction devices.  American multinationals, facing high domestic corporate taxation, have resorted to two general types of tax avoidance devices.  They have: (1) transferred intellectual property (brand names, patents…) to low-tax foreign jurisdictions like Ireland, and (2) located distribution subsidiaries in similar places.  Hong Kong, where the income tax on profits generated by foreign companies is zero, is a favorite.

How this structure works:  a US-based multinational uses a Hong Kong subsidiary to pay a contract manufacturer in China $150 for a mobile telecom device.  The Hong Kong subsidiary sells the device to its US marketing subsidiary for $250.  The US company pays the Irish subsidiary a $100 royalty for the use of the firm’s proprietary technology and brand name.  It sells the device to a US customer for $600, recognizing, say, a $200 pre-tax profit in the US, and paying $70 in federal income tax.  Without Hong Kong and Dublin, the firm would have a pre-tax profit of $400 and pay $140 in tax.

If I understand correctly, President Trump’s intention is to tax this hypothetical multinational on the entire $400 of pre-tax earnings on sales made in the US–no longer allowing cash flow to be syphoned off to foreign tax havens.  At a 20% rate, the firm would pay $80 in federal income tax.

The bottom line:  while tax reform of the type I think Mr. Trump has in mind might leave large multinationals no worse off than they are today, it would be a significant benefit to small and medium-sized firms, which tend not to have elaborate tax departments and to be much more US-focused.  Just as important, it would eliminate the motivation to create offshore profit centers.

As/when the timing of corporate tax reform becomes clearer, I’d expect further rotation on Wall Street away from multinationals and toward domestic-oriented stocks.  A quick-and-dirty way of locating beneficiaries–look for corporate tax rates at or near 35%.