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Key Variables of Investments


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This topic has been on the back of my mind for a long time now, and John Huber's post reminded me again of it. He mentions in his post a few examples, like Wells Fargo's ability to take in deposits cheaper than anyone else, or an obvious one with oil prices and oil companies.

 

I tend to fall in the camp that believes in the power of finding these few key variables for different companies/industries, and focusing the analysis on understanding those first and foremost. Sure, things like management quality and integrity are important, and you can get hints regarding those from the smaller details. But I feel like without the understanding of what are the most important variables for this specific company to turn in decent profits, I'm standing on shaky ground.

 

Because my key variable identification skills are no doubt lacking, I'd be curious to hear people's thoughts on how they go about recognizing the most important variables for different businesses. Do you use some form of a root cause analysis, going back step-by-step and eventually ending up with the "forest" / key variables? Understanding a wide array of different businesses is important, but I tend to think that's not necessarily enough. Thoughts?

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I do the following:

 

(1) Take a step back and imagine how that industry should work (i.e. think of Ray Dalio's "economic machine")

 

(2) Read the conference calls and annual reports for all the companies to see what variables seem to matter most to the operators

 

(3) Try to reconcile (1) and (2)

 

After that, you should have a pretty good sense of the key variables -- some from you, some that you hadn't thought of from the operators.

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There are two sets of variables that will impact your returns:

1) Short term

2) Long term

 

I look for divergence between the short term impacts and the long term impacts. For example:

 

IBM:

- Short term: Forex headwinds, weak emerging markets, software pricing, execution issues

- Long term: Capital allocation, sticky customers, recurring revenue

 

WFC (2013):

- Short term: Low interest rates, regulatory burden, weak mortgage market

- Long term: Growing low-cost deposits, high ROE, cross-selling

 

Vistaprint (2014):

- Short term: Depressed margins, european macro issues

- Long term: Economies of scale

 

Patrick Dorsey's "Little Book that Builds Wealth" gives a good framework for thinking about the variables that truly matter.

 

However, I'm not sure that a single variable is always the key to an investment. For example:

 

Apple (circa 2013):

- Very low EV/EBIT

- Smartphone market growing rapidly

- Relatively high dividend yield and large cash pile likely to be used for buybacks/dividends

- NTT Docomo, China Mobile deals likely to occur

- New iPhone product cycle

- New product categories promised by Cook

- Moat: Sticky ecosystem, Integrated software & hardware, strong brand, Exceptional management, World class supply chain, design

- ...

 

Maybe that's why Buffett would never invest in Apple. But Apple was so cheap that you didn't need everything on the list, you only needed 1 or 2. It doubled because everything clicked (plus Icahn).

 

 

 

 

 

 

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Buffett once talked about the cost of a bottle coke or pepsi in terms of pennies.  Not sure where to find that but as in looking at the costs of Wells Fargo's deposits, looking at a product or service in this way may be more insightful in some ways than looking at reported corporate numbers and ratios.

 

 

"And that’s it. There simply are no other ways to increase returns on common equity." - Warren Buffett

 

Buffett: How inflation swindles the equity investor (Fortune Classics, 1977)

 

by  Warren E. Buffett

 

excerpt:

"Five ways to improve earnings

 

Must we really view that 12% equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation? There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales.

 

And that’s it. There simply are no other ways to increase returns on common equity. Let’s see what can be done with these.

 

We’ll begin with turnover. The..."

 

http://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/

 

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Buffett once talked about the cost of a bottle coke or pepsi in terms of pennies.  Not sure where to find that but as in looking at the costs of Wells Fargo's deposits, looking at a product or service in this way may be more insightful in some ways than looking at reported corporate numbers and ratios.

 

 

"And that’s it. There simply are no other ways to increase returns on common equity." - Warren Buffett

 

Buffett: How inflation swindles the equity investor (Fortune Classics, 1977)

 

by  Warren E. Buffett

 

excerpt:

"Five ways to improve earnings

 

Must we really view that 12% equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation? There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales.

 

And that’s it. There simply are no other ways to increase returns on common equity. Let’s see what can be done with these.

 

We’ll begin with turnover. The..."

 

http://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/

 

 

Dupont Analysis. Very powerful. Helps give insight into the business if compared with competitors and when compared against own history. If you get nothing out of it, you at least go with eyes open on what is driving the company.

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Thanks everyone for the responses, interesting points from different angles.

 

merkhet: If you don't mind, it'd be great to hear an example of how that process worked for you with some industry/company.

 

KCLarkin: I tend to think that things like capital allocation, valuation, balance sheet/leverage are more or less always important things. Though I assume I understand what you are after for example when putting capital allocation under IBM; that it is especially important in the case of IBM because a lot of their returns are coming from capital allocation. For example with Vistaprint and depressed margins, do you think it'd be reasonable to go a step or two forward, and think what are the variables affecting those margins? I don't know the company, but since you said "economies of scale", would the thing that you need to follow be whether or not their sales grow above some threshold (although it's not an exact number)? And then what would be thing(s) to look at to get an idea whether they're being successful about reaching that threshold?

 

KinAlberta & rpadebet: Dupont analysis is great. Perhaps my wondering is about finding the drivers behind for example sales growth, and if there's a few key things. Easiest to illustrate with the example of oil companies and oil. Oil comps' returns, among other things, are driven by increases/decreases in sales. One of the primary drivers of those changes is the price of oil. I think Dupont gives you the first level (though a crucial, yet simple first level), and then you can try and move to the next levels from there?

 

To give a recent example: I've been reading about Colfax. It has three different operations in it with ESAB (welding), Howden (gas handling) and Colfax (fluid handling). I could say with reasonable confidence that Colfax as an investment case depends largely on sales growth + margin expansion. What I'm less clear about it is what could be the few key things that I could try follow to get a grasp of whether those two are materializing or not. For margin expansion I don't know if there's a lot else than just looking at Q numbers and whether they're executing on the CBS etc. improvements.

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The easiest and most immediate one was banking. If you restrict it to retail banking...

 

(1) Figuring out how the machine works

 

You figure that a bank works by taking in money (deposits) and putting out money (loans). The way to make money from that is to make sure you pay less on your deposits than you earn from taking on loans. Moreover, you can, hopefully, grow your business by taking on more deposits.

 

(2) Comparing your mental model to the world

 

When you read the annual reports, conference calls and presentations of the "Big Three" (JPM, WFC, BAC), you learn a little bit more about how to adjust your mental model. First, you realize that while your model is roughly correct, it's missing some stuff. Banks can make money on both net interest income (loans) and non-interest income (fees). On top of that, it's important to make sure that you don't spend very much money servicing your accounts, which is represented by the efficiency ratio (non-interest expense over revenues from net-interest income and non-interest income).

 

You'll also learn (or, rather, understand more deeply) that we're in a low interest rate environment. If you read the presentations, conference calls and reports, you'll start to realized that there's something called the net interest margin. (If you somehow missed it, and yet you read constantly, you probably would have picked this up from the JPM Warrant writeup that was posted here from some small group of investors.) Now, while you might think that the spread would stay relatively constant, that's not actually the case. It turns out that while the interest you pay is based off where interest rates are, the interest you get paid is based off some opaque combination of where interest rates are and where "demand" for loans stands. So, when interest rates go up, all things equal, the spread shouldn't open up, but since all things aren't equal, as more people start chasing a "limited" amount of loanable capital (restrained by various regulations, prudence, etc.), the spread does open up.

 

The next step is to figure out how their deposits, and by corollary, their loans grow -- since deposits, up to some regulatory cap (assuming that you don't have people trying to get around the cap), are the bottleneck for loan growth. Cross-selling is pretty useful because it's likely easier for both economic and psychological reasons to sell to someone who's already a part of your accounts than trying to go for someone new. Moreover, deposits will likely naturally grow as individual circumstances improve. (There may even be a virtuous cycle where an improving economy increases deposits while loan demand goes up.) If you're a smaller bank, embarking on opening up more branches (or if you're a non-branch bank, more advertising) will help grow your deposits. If you look at Zion, they were rather bright (if a little spendy) in picking up Amegy Bank in 2005 so that they could participate in loans to the oil & gas sector, so that's another strategy as well.

 

(3) Miscellanea

 

There's more stuff around the periphery that also matters. For instance, there are also various benefits of scale where people need the ability to either (a) get at their money from a teller or (b) get at their money from an ATM, preferably yours. There's also economies of scale, but that's likely rolled into a particularly low efficiency ratio.

 

One of the things that people are learning from Bank of America is that the current regulatory structure penalizes finding the "cheapest" bank versus the market leader -- which is counterintuitive for an investor. While Bank of America is certainly cheaper than JP Morgan and Wells Fargo, they can only benefit towards closing that valuation gap rather than being able to both close the valuation gap AND have proper capital allocation through share buybacks -- so if you're comparing the three, you'll have to make a judgment call as to whether closing a larger valuation gap (BAC) is going to make you more than closing a smaller valuation gap combined with freer capital allocation for buybacks (WFC, JPM). This is likely going to be determined by (A) your sense of how long it will take to close the larger valuation gap and (B) how long you plan on holding the investment.

 

Also, the risk level of their loan portfolio matters, and a lot of that is a bit fuzzy to analyze. While you can look at how their NPLs are doing and take a look at how they're diversified across sectors and sizes of companies, that's statistics rather than causation -- in other words, you're probably going to have to develop a sense of what the culture is like at the company through viewing what's emphasized at the top -- and this will come from conference calls, shareholder letters, etc.

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KCLarkin: I tend to think that things like capital allocation, valuation, balance sheet/leverage are more or less always important things. Though I assume I understand what you are after for example when putting capital allocation under IBM; that it is especially important in the case of IBM because a lot of their returns are coming from capital allocation. For example with Vistaprint and depressed margins, do you think it'd be reasonable to go a step or two forward, and think what are the variables affecting those margins? I don't know the company, but since you said "economies of scale", would the thing that you need to follow be whether or not their sales grow above some threshold (although it's not an exact number)? And then what would be thing(s) to look at to get an idea whether they're being successful about reaching that threshold?

 

Actually, what I am saying is that there are quantitative variables that will impact your investment in the short term. These tend to get quickly priced into the stock and will be discussed in every earnings release. There are sector specific variables and more generic variables. But there are qualitative aspects that will determine your long term returns and these are less efficiently priced. For retail stocks, same store sales growth and new store openings are key variables. But there are qualitative differences between ANF and TJX which made TJX a much better investment. Yet Mr. Market actually gave ANF a slightly higher multiple over the last 20 years.

 

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The easiest and most immediate one was banking. If you restrict it to retail banking...

 

Thanks for the example merkhet. Frankly, banking is one of those where I feel like I have a certain understanding of what is important and what is more or less noise. Anyway, I agree with your whole post, and think it's a good explanation of what drives the banking industry. It is a relatively simple industry to understand as a big picture, but as you too mentioned, comes with some things that are close to impossible to figure out with reasonable certainty (balance sheet/loan quality, litigations).

 

KCLarkin: I tend to think that things like capital allocation, valuation, balance sheet/leverage are more or less always important things. Though I assume I understand what you are after for example when putting capital allocation under IBM; that it is especially important in the case of IBM because a lot of their returns are coming from capital allocation. For example with Vistaprint and depressed margins, do you think it'd be reasonable to go a step or two forward, and think what are the variables affecting those margins? I don't know the company, but since you said "economies of scale", would the thing that you need to follow be whether or not their sales grow above some threshold (although it's not an exact number)? And then what would be thing(s) to look at to get an idea whether they're being successful about reaching that threshold?

 

Actually, what I am saying is that there are quantitative variables that will impact your investment in the short term. These tend to get quickly priced into the stock and will be discussed in every earnings release. There are sector specific variables and more generic variables. But there are qualitative aspects that will determine your long term returns and these are less efficiently priced. For retail stocks, same store sales growth and new store openings are key variables. But there are qualitative differences between ANF and TJX which made TJX a much better investment. Yet Mr. Market actually gave ANF a slightly higher multiple over the last 20 years.

 

Agreed on the quantitative vs qualitative assessment. I may be repeating myself needlessly (and perhaps expressed it unclearly at first), but initially I was looking for the key variables causing for example SSS growth for clothing retailers. In a sense, going down the ladder in a search for the few (qualitative) root causes; TJX sales growth -> new stores + SSS growth -> amount of money consumers have for spending on clothes, something else..

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