Base Hit Investing - Calculating the Return on Incremental Capital Investments.

[KCLarkin]

I was doing some work on TSCO (Tractor Supply not Tesco).

 

I went on VIC to see if there was a writeup. The only writeup is from 2001. The stock was trading at 6x forward earnings. The author, Bill67, made a great trade (not clear when he sold but he was out for a "long time" as of October 2003).

 

Since that write-up TSCO has compounded (according to FASTGraphs):

EPS @ 23.9%

TSR @ 40%

 

A $10,000 investment in 2001 is now worth $1,657,726.53 and pays a $14,000 dividend every year.

 

If Bill67 had just bought TSCO and held on, he would have one of the greatest investment records of all time. But like many on this site, he'd already went looking for the next puff.

 

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Interestingly, Charlie479 (who is a famous VIC author who was eventually seeded by Greenblatt) commented on the TSCO writeup:

 

It seems to me that it's competitive strategy is precisely the one that anchors it to mediocre returns on capital. If the stores' attraction (indeed, the key to their 5-10 year survival against the big boxes) is the hard-to-find, slow-turning item that the Home Depots or Lowes won't stock, then a large inventory is a permanent part of this company's operating model. This large working capital requirement translates into high capital requirements for the business, which translates into a 13% after-tax return on equity. Not bad, but on the other hand, not a great ROE for a leveraged company.

 

Overall, this was a very good, thorough writeup. The valuation is low and the potential impact of even a small improvement in inventory could be large. I would not stick around, though, after the inventory benefit as I think the economics of the business will produce only average market returns over the long term.

 

Even a great investor can have one of the greatest compounders of the past 20 years in the palm of his hands and completely miss it.

 

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The other interesting thing about this compounder is that it had modest (but improving ROIC) and a boring business. This is a common thread in long-term compounders. TSCO, Alimentation-Couche Tard, Stella-Jones... These are all boring businesses. Everyone wants to buy the next Amazon or Microsoft. Nobody is looking for the next Tractor Supply Company.

 

I don't think compounders are over-rated. But you need the judgement to recognize them and the discipline to hold on even when the stocks become volatile or overpriced.

 

Anyway, compounders aren't easy to find (especially early). But Mr. Market does put them on sale fairly often. If Bill67 and Charlie479 were only looking for compounders, they might not have missed this one.

[Jurgis]

KCLarkin,

 

Ah, but Bill67 and Charlie479 were right to exit TSCO in 2003. The stock went nowhere from 2003 to 2009. ;)

 

OK, I am kidding. Or partly kidding, since that's one of the reasons why people don't get the compounder returns: it's wicked hard to hold for 6 years with zero return.

 

I've had stocks in companies that were good FCF/ROE cash cows going nowhere for years. And sold them before they finally hit a rerating because of something. Looking backward they were "compounders". Looking forward it became hard for me to expect that at some point. (And in at least one case a somewhat known hedgie also sold out before the rerating).

 

 

Regarding boring vs. Amazon/Microsoft. There are couple factors at play. Yes, there's glitz (vs. boredom). But another part is that it's rather easy to understand Amazon/Microsoft or let's say Tesla. Somewhat easy to understand restaurants (PNRA) or retail story (LULU). But with companies like MSM or NDSN, the issue is not boredom, the issue is that it is hard to understand and hold on to the company when you don't know its products and you don't have a story. Persuading yourself that NDSN adhesive thingamagingies are competitive, needed and will grow at high rate is hard. Unless you're really in the industry, you don't know what they are and how competitive they are. And so possibly harder to buy and hold through any adverse results. In other words, I get Coke, Geico and Burlington Northern. But I don't really get Lubrizol. (On the other hand, the story may lie: it's easy to get Salomon Brothers or NetJets or BusinessWire. And then results are not what you expected.)

 

Anyway, just some thoughts based on your post and from going through the list of possible compounders above.

[johnhuber]

I think the calculation is undervaluing dividends. The dividends get valued at face value after the 10 year period but of course they are paid out during the period at which point I can reinvest them somewhere else at the same ROIC! I'm not arguing against a compounder but if a company does not have high ROIC investment opportunities and it distributes the excess cash via dividends to me, at which point I invest it with a high ROIC (which could be again investing in a business without good reinvestment opportunities, provided it's significantly undervalued) I can get similar results as investing in a compounder in the first place!

 

Of course, one gets mediocre results if a company without good ROIC reinvestment opportunities deploys the cash at bad ROIC or (even worse) just keeps it on the balance sheet. It needs to distribute the cash so I can deploy it somewhere else to achieve good investment returns.

 

+1. I don`t know if it was Buffet who said that, but the best investment is one that grows without reinvestment of capital like See`s Candy and throws of a lot of free cash on its way. This whole compounder stuff is way overrated since ROIC is mean reverting. Number one determinant of future rate of return is price paid, every backtest that i have seen confirms that. ROIC doesn`t even have an impact on returns, this was highlighted in "Deep Value".

 

Good points.  I think there is so much interest around the compounders because we've gone through a multi-decade bull market and everyone sees a TDG, POOL, BRK, etc, and they think how much better it must be to buy something to compounds tax deferred forever. Well yeah, of course that's better.  But actually investing the bulk of your portfolio in a compounder at the end of a 25 year bull market in both stocks and bonds is not an easy task.

 

I know it's in bad form to take someone from this forum as an example, but take a look at gio.  He's posted like 6000 times so it's a decent sample size.  He's picked out all these "compounders" in the past, and almost every one mean reverted.  He bought into Apple, and now it looks like he bought right as iPhone sales peaked.  He bought into Oaktree, then realized it wasn't that great.  He bought into Nomad, then realized it wasn't great.  Bought into Valeant, and then realized it wasn't great.  Now he's buying into Google, Nike, Amazon, etc.  In the search of finding compounders I don't think he's stuck with a single one?  That just defeats the purpose of investing in compounders.  You might as well have found a crapload of cigar butts over that time frame.  Now it just looks like he's long the S&P 500 at peak everything. 

 

Buffett probably identified less than 20 "compounders" over his entire lifetime that he was able to buy at the right price.  But he did it during one of the biggest economic bull markets in history.  That's a hell of a tailwind to be long a compounder.  And he's probably 50x better than most of us at finding something that can keep compounding.  How long will you wait to invest your portfolio in these compounders and be willing to sit through nasty bear markets, changes in the economy, changes in competitive advantages, you name it.  It's incredibly hard.  Look at something like Walmart today.  It looked like a great compounder back in 1995 and now no one wants to own it.

 

Anything that looks like a good compounder today is incredibly expensive.  30x, 50x, or 1000x for AMZN.  It would be nice to find the next WBA, BDX, CHD, XOM or MO but it's nearly impossible to do in practice.

 

But if you guys come across any cool compounding machines that isn't Amazon, let me know.  Out of the thousands of threads on this board, I'm not aware of any others that look like real high ROIIC compounders.

 

These are some great points Picasso. Finding the truly great compounders is extremely tough. You only need a few of them to make a career, but there is no guarantee even of that.

 

I've spent a lot of time thinking about two "buckets" of investment opportunities. I prefer limiting my investments to good business (with the occasional exception when it comes to some sort of oddball situation or bargain security). But almost always, I feel more comfortable with the businesses whose intrinsic values will be higher 5 years from now. But within this category of "good businesses", I think there are many opportunities to buy them during times of general pessimism and sell them when the market values them more fairly. The so-called "time arbitrage" where you buy these companies when they represent a decent discount to steadily rising fair values, and then sell them when the market eventually corrects itself. It seems that once or twice a year, Mr. Market offers this up due to some macro event or just general market pessimism, and occasionally there is an opportunity to buy into a company-specific short-term problem.

 

I think there are many more opportunities to engage in these types of investments than there are trying to locate the next 10 bagger. If you are willing to wait 2 or 3 years for your result (often, the result happens sooner than that, but having that kind of time horizon is usually necessary to capture the opportunity), I think you could simply build a list of these so-called compounders, and just wait. If you have a list of 50 of them, there are probably opportunities on 2 or 3 of them at any given time.

 

I think a guy like Allan Mecham has built his successful track record on this type of general concept. He has fairly low turnover, but he seems to find these (often large) good companies at a decent discount, and then patiently holds them for a year or two, and then sells them later once the market values it more fairly.

 

A friend and I call this "cigar butt investing 2.0". Basically, instead of cigar butts, they are good businesses. Both approaches require maintenance and a fairly steady flow of new ideas, but it seems a practical solution to the ever present problem of locating the next CMG, HD, or AMZN. In the meantime, you can always keep hunting for the next 10-bagger.

 

Just some random thoughts.

John

[Picasso]

I think that the riskier part of classic cigar butt investing is that there's some probability the market value of a security never trades close to intrinsic value, and intrinsic value keeps falling which eventually leads to a permanent loss.  But I also think that risk is lessened by understanding what that probability might look like, getting a sense for what can drive that gap to close before intrinsic value starts falling too quickly, and then managing the amount of capital you have spread into those types of trades.  A lot of securities can stay cheap for insanely long periods of time, and during that time anything bad can happen. 

 

A lot of investors point to these cigar butts and say "look it went from $2 to $10, but back down to $2!"  But I don't think the move back down to $2 means that it was a bad investment.  The whole idea of buying cigar butts is to expose yourself to potential upside with a relatively high probability of success (sometimes you have to ask yourself how high that probability can be when the market is pricing it so low), without taking on a lot of downside risk.  It's not so much luck as managing probabilities across a certain strategy.  You're going to get lots of potential outcomes but as long as you're getting compensated for the risk I don't think it's any worse than buying a compounder at as below average price.  But the successful cigar butt strategy takes a lot more skill (there's probably several more considerations to make) than buying a cheap compounder.  Bad investment discipline can be very costly in classic cigar butts as well.  Like not being willing to take a loss when it's time to take a loss.

 

This sort of thing happens a lot in bonds too.  To reference one on this board, LUK had some 6% bonds trading for $80.  You knew that every year that went buy it was worth 6% more.  Eventually the bond will get back to $100 (absent negative credit events like a default), so buying quality bonds for a nice total return isn't too much different.  They're now back at $100.  There were a lot of quality energy bonds trading at $55-65 earlier this year that are now back at $90-100 (RRC, CNX, PAA, CLR, APC etc) which have produced something like 50% total returns without a lot of downside risk (each had different situations, but all seemed fairly low risk given the market prices).  But if you sell now you lose those 10-15% yields that you locked in order to roll a 50% profit.  Best case scenario I compound 10-15% if I leave them alone to maturity.  But I can sell them for 50%+ (which I have started to) to start rolling into some other ideas.  Buying and holding a compounding stock is not too much different.  You have to be very certain about the long term prospects because you miss out on redeploying that capital throughout the life of holding that stock.  If you waiver any time during that period, boom, you get hit with taxes and restart the tax deferred compounding clock.

 

The other side to this is thinking what Buffett would be worth had he constantly arbitraged quality stocks for several decades.  When factoring in that tax hit, he'd probably be worth a lot less than he is today.  Or maybe he would have somehow done better than 23% for 50 years.  I'm not so sure of that.  Which sort of leads me to my thinking that you need to be incredibly flexible at identifying opportunities over many decades or stick your capital into something you'll hold forever. 

 

There's a lot of different ways to arbitrage these gaps in value, and a lot of it depends on your personality and skill set as an investor.  I know for myself I'm a lot better at investing in special situations than identifying high quality businesses.  I tend to change my mind about that high quality business far too frequently to make it a viable long term strategy.  So why not invest in securities that have the best return potential as long as you're properly managing risk?

 

Welcome to the board.  There's a rule where every new board member has to go through the entire VRX and SHLD thread.  There's a pop quiz on some of the more classic material, so be prepared.