Strategy Shift

You might have noticed that lately I’ve been buying different kinds of stocks than I did in the past.

You might have also noticed that I’m buying bigger positions.

It’s a shift in strategy.

Previously, my focus was on obtaining multiple appreciation from beaten up companies. I didn’t want to hold them for the long-term. The goal was to have a widely diversified portfolio of 20-30 stocks. Buy depressed, beaten up situations (with sound balance sheets) – then sell them when they’re close to intrinsic value. You have to sell because they weren’t the kind of companies that were good businesses for the long haul. The goal was to flip them.

This is a great strategy. It’s a low P/E, low debt/equity strategy that returns about 15% a year in the backtest. I thought I could stick to it.

I couldn’t. The problem emerged in March when lock-downs were creating closures throughout the entire economy. This was the most unprecedented self-imposed economic catastrophe of my lifetime.

The issue is that the businesses I owned weren’t good businesses – they were mostly cyclical situations and I knew it. If the economy were unraveling, how were a bunch of no moat & cyclical businesses going to mean revert?

In terms of value investing, I’m perfectly comfortable with under-performing for a long time period.

What I’m not comfortable with are losses – and beaten up cyclicals are going to result in catastrophic losses during a Depression, which is what I thought was happening in March. You can look at the returns of small value during the Depression and you’ll see this to be true.

When the market recovered, it became clear to me that I had fallen into a trap that I thought would never happen to me: I grew pessimistic with the rest of the crowd. I panicked. I even bought a short ETF. Fortunately, it was a small position and I sold when the market went above the 200-day.

I did this is because the market – by every measure – is insanely overvalued. I still think that’s true and that the index is going to deliver flat to negative returns over the next 10-20 years.

Sure, the rest of the market was overvalued (and still is), but I should have ignored that and pounced on the value where I could find it. I don’t own the market. I own the stocks in my portfolio.

I could react to this realization in two ways.

I could spend the rest of my life as a perma-bear complaining and worrying about macro. Or, I could recognize that macro is unpredictable and I should stick to what I can wrap my brain around.

The purpose of this brokerage account that I track on this blog was to try to go after the wild goal of outperforming the market. To give it my best shot.

I thought the best way to do this was Ben Graham’s classic low P/E, low debt/equity strategy in a 20-30 stock portfolio. Buy a compressed P/E, sell for a 50% pop, then move on to the next target. Repeat. Make sure I own 20-30 positions. Stick with it.

It turns out that when the turds hit the fan, though, that I couldn’t stick with it. What good is an investment strategy if you can’t stick with it?

In many ways, I’m happy I didn’t stick with it. Being 50% cash before the crash was a good thing. My max drawdown this year was only about 20%. Meanwhile, deep value had a nearly 50% drawdown. If I stuck to the stocks I owned and didn’t sell – by my calculations I would have had an even worse drawdown than the deep value universe. Nearly 60%.

Instead, year to date, I’m outperforming all of the value ETF’s because I contained that drawdown.

Selling was a good decision for most of the stocks that I’ve owned through the history of this blog. I wrote a post about how selling all of them was a good decision.

I still think that a 20-30 stock low P/E, low debt/equity stocks and churning it is a good strategy. I still think it will return 15% a year for someone who can stick with it over 20 years.

What emerged in March, though, was that I’m not the investor who can stick with it. Owning these kind of businesses during a severe economic shock is terrifying.

As I sat in cash while the market ripped higher – it became clear that I panicked at the worst possible moment.

This realization caused me to really do some soul searching and check my priors. It quickly became apparent that I was wrong about the macro picture.

It’s partly a product of my own mind. I’m a pessimist at heart and think most people are full of it – this leads me to be naturally drawn to predictions of doom.

It turns out that my instincts about the macro-economy were completely wrong. Perhaps I should have read my old post on the matter, The Dark Art of Recession Prediction, where I wrote “Macro is fun, but it’s probably a waste of time.”

If only I listened to my own advice.

After realizing all of this, I considered moving this account to my asset allocation strategy, the Weird Portfolio.

That’s what I have most of money. I never panicked with that money. From January 1 – March 31, it was only down about 14%. Long term treasuries and gold did their job. I stuck with it and the portfolio recovered, with year to date gains.

With that strategy, an investor will frequently under-perform. That’s not something I really give a damn about. I can watch QQQ investors make bank and I don’t care.

What I do give a damn about is losses. That’s something the weird portfolio excels at containing. The Weird Portfolio delivers a satisfactory – but not outstanding – rate of return and contains losses with low volatility.

Of course, that’s not the point of the money I set aside to track on this blog. To put in Ben Graham’s terms, the weird portfolio is for the defensive investor. I’m defensive with most of my money. This account is for the enterprising investor.

The point of this money was to play the game. To try to outperform, as maddening as that can be.

The truth is that I had little conviction in my positions. How can you have conviction in bad businesses with no moat when we’re facing a severe economic downturn?

This led me to a simple conclusion: if I’m going to buy stocks, I need to own businesses that I have long-term confidence in. I need to own businesses where I won’t obsess over the yield curve, unemployment rates, or the CAPE ratio. I don’t want to own a steel company or a bar in Florida and constantly worry about the impact of the macro-economy on those stocks. I want to own better businesses that I’m not going to panic sell when the economy looks like it is headed to the woodshed.

I don’t want to hold mediocre or bad businesses in the hopes of multiple appreciation. While this is a perfectly valid strategy, I think my behavior shows that I don’t have the intestinal fortitude for it.

Of course, the trouble is, there aren’t many high quality companies that sell for a margin of safety. They are rare birds. I certainly can’t fill up a portfolio with 20-30 of these situations, even though I know that’s the optimal portfolio size.

The situations that I want to buy (and can have enough confidence to hold when the economy goes to hell) are rare gems: wonderful companies at wonderful prices.

I want wonderful companies at distressed prices. Biogen is a good example. It’s absurd that a company like that trades at 7x EV/EBIT. Enterprise is another example. There is no reason that a quasi monopoly should trade for 5x cash flow with an 11% dividend yield. That’s the kind of situation I want. As Buffett once put it, I want Phil Fisher companies at Ben Graham prices. Moreover, I want them to be able to resist a recession. I want them to have solid balance sheets with enough cash to survive a recession. I don’t want businesses that are easily crushed by the inevitable recession. I want them to have a moat that resists competition. I want to have it all – high quality at a deep value price. Stocks like this don’t come along very often – but they are available.

This naturally leads me to more concentration because there aren’t many of these situations. My research shows that the first dozen positions does most of the work in eliminating volatility, so that’s what I’m going to aim for.

It’s not optimal for maximizing Sharpe ratios. That portfolio is around 25 stocks.

Of course, I can’t find 25 wonderful companies at wonderful prices that I’m comfortable holding during an economic catastrophe. I’m going to have to be more concentrated now that I’m being more discerning.

The stocks I’ve bought recently fit this mold are:

Biogen

Charles Schwab

Enterprise Product Partners

I made each of these positions approximately 8% of my portfolio – with the goal of finding at least a dozen of these positions when fully invested.

I believe they are wonderful companies at wonderful prices. I don’t need multiple appreciation for them to do well over the next 10 years. I’m confident that the business will deliver strong long term results. I think I’ll get multiple appreciation on top the actual business results, but I won’t need it for my return.

I also realize that I can’t find a dozen of these situations right away. When I started this blog, I filled this account up with 20 stocks. Obviously, I can’t do that with this approach because there aren’t that many of these stocks.

I’m still going to have to hold a lot of cash and sit around and wait for a wonderful company to sell for a wonderful price. That’s fine by me. If I know I hold a great, non-cyclical, business and own it for a price that I think is outstanding – I can hold onto that position with confidence and not sell.

I’m not going to force myself to be fully invested and buy businesses that I don’t have confidence in just to fill up a portfolio.

The best strategy isn’t the one with the best Sharpe ratio or the highest CAGR. It’s the one that you can stick with. I think this is an approach I’ll be able to stick with.

We’ll see.

So, if you’ve noticed a change, you’re right. I’m running a more concentrated portfolio with a bold goal: wonderful businesses at wonderful prices. Let’s hope it works out.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Enterprise Product Partners (EPD)

Key Statistics

EV/EBIT = 11.27x

Dividend Yield = 11.12%

Earnings Yield = 12.5%

Price/Revenue = 1.23x

Debt/Equity = 117%

The Company

Enterprise Products Partners operates pipelines throughout North America. Their pipeline infrastructure moves natural gas, natural gas liquids, and crude oil. They are the biggest midstream operator in the US, with $29 billion in revenue. The next biggest operator is Kinder Morgan, with $12 billion in revenue.

The heart of their pipeline network is in Texas, where they connect suppliers (like drillers in Texas & shippers in the Gulf) to end-users via their vast pipeline network, which stretches throughout the United States. They also operate storage facilities and processing plants. Currently, they own approximately 50,000 miles of pipelines.

Natural gas and natural gas liquids are core aspects of their operations. Natural gas is critical to US energy needs, supplying 38% of US electricity generation. Natural gas is also essential for heating. The United States boasts the largest supply of natural gas in the world. We are the Saudi Arabia of natural gas.

Natural gas liquids – liquids separated from natural gas as it is processed – are also crucial to the US economy. Natural gas liquids include propane, ethane, and butane. These are critical to our agriculture needs. Additionally, natural gas liquids are inputs in everything from tires to diapers.

Enterprise is like a hub at the center of the energy needs of the United States.

In recent months, traders destroyed the stock and the rest of the energy sector after the COVID energy shock. I think this company’s stock was crushed via guilt by association.

A return to its 52-week high would be an 80% gain from the current price.

My Take

Despite ESG investors’ wishes, hydrocarbons are here to stay for the foreseeable future and are essential to life as we know it.

Without hydrocarbons, life would not be possible as we know it. I think that ESG investors are creating opportunities (via forced selling) for those who are willing to take the plunge into hydrocarbons. ESG investors are behaving like we’ve invented matter/antimatter reactors harnessed by dilithium crystals when no such innovation has actually taken place.

My views caused me to take a hard look at companies in the hydrocarbon sector. I looked at a lot of duds. Highly cyclical (and leveraged) frackers burning cash and going bust at the slightest energy blow up. Even large and respected companies had significant amounts of leverage and dicey track records. I looked at many companies with high dividend yields and wasn’t sure if they could sustain it if the economy rolled over.

Enterprise was different. Enterprise strikes me as the best available opportunity in the energy sector. It’s a fantastic company with substantial advantages and the stock was sold off via guilt by association. In my opinion, it’s a wonderful company at a wonderful price.

The recent decline in energy consumption is temporary. Ten years from now, with modest growth, we will need more natural gas and oil and it doesn’t matter if your ESG fund manager wants it or not.

Enterprise has a formidable moat. No one else is going to spend the money to compete with their vast nationwide network of pipelines. Even if a competitor wanted to match their network, they would need to overcome regulatory hurdles. Every pipeline has to be approved by the government, and no one wants a pipeline in their back yard. Pipelines also benefit from network effects – the more you own, the more valuable your network is. I imagine regulatory approval will grow even more difficult in the future, especially now that “hydrocarbon” is a dirty word. This further insulates them from competitors.

As the biggest midstream pipeline operator in the US, it is also the best managed. This is best demonstrated by a comparison of profit margins. The moat gives it pricing power compared to the next biggest competitors.

Enterprise also establishes contracts with shippers when building a new pipeline, which can be for 15 years or more. They don’t build a new pipeline if the business isn’t already lined up and the existing pipelines have practically guaranteed streams of business.

The fact that no one can duplicate their network and they have long-term contracts with their clients creates a rock solid stream of business. Most importantly, it’s a rock solid stream of business that is resistant to competition.

The company is essentially an energy toll road, and as long as we continue to use natural gas, natural gas liquids, and oil – that toll road will continue to pay dividends.

Speaking of dividends, I was amazed when I looked at Enterprise’s dividend yield. It is currently 11%. I was more amazed when I realized it was sustainable and the company wasn’t employing significant leverage.

Usually, a very high dividend yield is a sign that something is wrong. It’s a sign of massive leverage, a dividend that will be cut, or a melting ice cube of a company. Enterprise is not a melting ice cube. This is a sustainable dividend yield that can continue even if cash flows decline significantly.

The durability of the dividend is best demonstrated by the track record. Enterprise has been able to increase the dividend each year for the last twenty years.

As for other metrics, the P/E is 8, and it trades at 5x cash flow.

Pre-COVID, Enterprise traded for a premium valuation due to its enviable position, strong management team, moat, returns on equity, and cash flow gushing assets. ROE has averaged 16% for the last 10 years. For most of the last ten years, it has usually sold in the 15-25x range, which seems right for a company of this quality. Currently, on an EV/EBIT basis, it trades at 11x.

Enterprise is also in healthy financial condition, with a debt/equity ratio of 117%. This is more than I typically go for (I prefer less than 50% for small caps, and less than 100% for large caps), but it’s conservative compared to the rest of the energy sector. The cash flows that Enterprise generates – even in recessionary years – are more than enough to sustain the company and the dividend.

At current prices, this is an opportunity to buy an 11% dividend yield that is sustainable and likely to grow in the future. The dividend is currently only 52% of EBITDA.

The main risk to Enterprise is a deterioration in the economy, which will reduce the demand of end users. Even if that were to occur, I doubt Enterprise would post actual losses. Even during the Great Recession, Enterprise continued to generate positive operating income with moderate losses in EPS. It continued to stay profitable during the energy bust of 2015-16. In Q2 2020 (the COVID quarter), they still posted earnings per share of $.47, suggesting that they will be able to handle further economic challenges.

In my opinion, this is a unique opportunity to buy a wonderful company at a wonderful price with limited downside risk, the potential for substantial multiple appreciation, and a fat sustainable dividend yield.

Of course, that doesn’t mean that there won’t be more short term pain. It’s possible that we’ll face further troubles in the economy. It’s possible that investors will continue to irrationally sell hydrocarbon stocks (while they sit in a home heated by natural gas, fly around in planes that guzzle fuel, use electricity generated by natural gas, eat food that was made possible by natural gas liquids, and have packages delivered to them via gasoline-powered trucks). There are a lot of short term potential troubles, but I think that this is a safe company to own for the long haul with favorable prospects. Even if pain occurs in the short run, an investor will continue to collect that nice dividend.

Random

Phil at at his best.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

VLGEA

I sold 85 shares of VLGEA at $25.11. I bought it because I thought it would benefit from COVID-driven grocery store sales, which have already materialized and it’s not a company I want to hold long-term now that the world is snapping back to normal. I made a modest 5.7% on the position.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Charles Schwab Corporation (SCHW)

Key Statistics

Price/Book = 1.82x

Return on Equity = 14%

Earnings Yield = 6.67%

Debt/Equity = 38%

Summary

Charles Schwab has long been a financial industry powerhouse. With the merger with TD Ameritrade, it is going to become the dominant player in this market.

Schwab’s origins are as a discount brokerage. They offered cheap commissions for DIY investors. Perception around the stock is that this is what Schwab’s business still is. The truth is that brokerage commissions were a trivial component of Schwab’s business, which is why they were so quick to cut it to zero in an effort to clobber their competitors. They continue to make money on trading activity, via order flow. The financial media gets incensed about this, but I don’t think anyone really cares.

They cut commissions to zero to clobber their competition, which is rapidly disappearing. By merging with TD Ameritrade, the only serious challenger to their business is Vanguard. The sheer scale gives them the ability to cut costs and offer services at a lower fee. In my mind, this is a moat. They’re like Wal-Mart in 1990 taking on small mom and pop retailers, Clover, and Bradlee’s.

The stock is cheap for a simple reason: interest rates are low and investors think that will last forever. When clients leave cash in a brokerage account, Schwab offers the client little interest, and then they invest that cash in short duration fixed income products. With interest rates low, that income is reduced. There are also jitters about the merger with TD, but I think that the merger is only going to strengthen their competitive position.

My Take

I don’t think that the trend of investors cutting expensive mutual funds and expensive financial advisors is going to stop. There is a lot of money wrapped up in high fee financial services. As younger investors inherit that money, they’re going to invest it themselves and I think much of it is going to continue migrating to Schwab and Vanguard.

I don’t see how this trend stops. It’s hard to imagine how much of this money won’t migrate to Schwab one way or another.

There are challengers to Schwab, but I don’t see how they succeed.

There is Betterment, which offers robo-portfolios, but they’re a small player of an industry where scale matters more than anything. Additionally, an automated portfolio of asset classes tailored to age & risk tolerance isn’t an amazing innovation and it is easy to duplicate. In fact, Schwab already has automated investing portfolios of their own.

There is also E-Trade, but E-Trade is losing this war, which is why they sold to Morgan Stanley.

There is also Robinhood, but I think Robinhood’s emerging reputation as the home of Millennial and Gen-Z gun-slinging daytraders is not going to help them attract future capital, particularly after this insane market inevitably rolls over. It’s a reputation that they need to shed and I’m not sure if they will succeed.

I think Robinhood’s strategy is to lock in younger investors in now. Then, those investors will continue to accumulate assets as they save and inherit money – and they’ll keep it in Robinhood.

I don’t think it will work this way. My guess is that Millennial and Gen Z investors will see Robinhood as the wild person they dated when they were 23, but not the person that they’re going to marry.

The year is 2025. You’re 30 years old. Let’s say that you inherit $100,000 from a dead relative. Are you going to put it in Robinhood – where your 25 year old friend lost a bunch of money daytrading in 2020 and made a bunch of TikTok videos about it? No. You’re going to figure out a “serious” way to invest it. This isn’t $500 on an app that you’re fooling around with. This is $100,000. This is serious money. Your desire to invest “seriously” will probably lead you to Schwab or Vanguard.

If you don’t want to DIY it, then you’ll turn to Schwab or Vanguard for advice, which is a lot cheaper than hiring a traditional financial advisor. In fact, Schwab offers a flat consultation fee of $300 to set up your portfolio, and then they can roll it into one of their automated solutions for $30/month. This is where much of the Boomer & Silent money currently getting charged 1-2% of AUM in an ocean of high fee mutual funds is going to migrate to.

Here is another scenario. Let’s say you worked for a company for 10 years, you get a new job, and have a nice amount stashed in a 401-k. Let’s ask the same question: where are you going to roll over that 401-k into? Chances are it will go to two places: Schwab or Vanguard.

Are you going to entrust this money with a financial advisor at a bank? Boomers might have done this in 1989, but Millennials hate banks. They’ve had an adversarial relationship with banks for most of their adult lives. Banks are the institutions that charged them 30% on their credit cards and a $35 fee when they accidentally went over in a checking account because the Netflix renewal hit before payday. They hate banks and don’t trust them.

The irony is that Schwab is structurally a bank (they take deposits and earn interest on it), but that’s not how they are perceived, and they’re not an institution that most people have had a negative experience with. They’re not engaged in the risky behavior that many banks routinely find themselves making headlines for (trading scandals, risky loans, stupid nonsense with derivatives, clashes with regulators, breakdowns in risk & controls, aggressive practices). They’re not a bank that set up a fake account or that charged you a crazy rate on a credit card. As a result, Schwab is more reputationally sound than most banks.

The main worry with Schwab is over interest rates – which is the concern hanging over the entire financial sector. I see this as a temporary problem. Investors seem to think that interest rates will be low forever. They think this because of what the Fed tells them. In my opinion, the Fed’s word is worth very little. If inflation emerges as a problem, the Fed will be forced to raise interest rates. It’s hard for modern investors to fathom this because most living investors have invested during a 40 year period of declining rates.

Interest rates are obviously something out of Schwab’s control. Schwab should simply focus on increasing the size of the assets that it manages, which is something that will continue to happen naturally due to its size and reputation.

Over time, interest rates are going to do their own thing. Schwab should focus on what it can control: increasing the assets that it manages and scaling up the business. This lowers prices and eliminates competitors. This is exactly what management is doing.

Schwab is incredibly cheap relative to its history due to the interest rate worries and jitters over the merger.

For the last decade, it usually trades in a range of 2-4x book value. It currently trades at 1.8x book. Meanwhile, I think the book value will continue to grow. In terms of multiple appreciation, I could see this easily returning to 4x book value if interest rates increase even a little bit.

Meanwhile, over time, I think that secular trends will make that book value continue to grow regardless of what happens to rates.

Schwab has earned 10-17% on equity for the last decade (a decade of low interest rates), and I don’t see how that doesn’t continue in the future. If interest rates remain low, it will earn the low end of that ROE, while the equity will continue to grow organically.

This means that even without multiple appreciation, Schwab should offer a satisfactory rate of return over the next 5-10 years via increasing book value and strong ROE. With multiple appreciation, it will offer a fantastic rate of return.

I also look at the size, reputation, rock solid balance sheet, and strong management as factors that will prevent a permanent loss of capital and make this a safe long-term holding.

Random

I’ve been listening to a lot of Prince lately. 1984’s Purple Rain has to be one of the best albums of all time.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Wonderful Companies at Wonderful Prices

Wonderful Companies at Wonderful Prices: Is It Possible?

Many think that value investors can’t buy great businesses.

I’ve even fallen into this trap, thinking that I will never buy a long-term wonderful company if sticking to strict value criteria.

Why would the market ever price a great company at less than 10 EV/EBIT, for instance? Surely if you want to buy a great company, you have to pay up. Right?

Warren Buffett likes to say that it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price. Modern investors have taken this too far, in my opinion. They buy wonderful companies at any price.

I have been doing a lot of fresh thinking about this topic after looking at the dismal results of my portfolio over the last three years. I’ve re-read all of my posts and it’s often humiliating how wrong I got many things. The most glaring example is my mistake made in March by not buying many great businesses selling for wonderful prices because I was too frightened by the macro picture and the overvaluation of the broader market. I still sit on a lot of cash as I think through these things, and the market continues to rip higher.

Rather than participate in the madness, I went back and re-read the Buffett letters. I also re-read Buffettology and The Warren Buffett Way.

These books have led me to think about a question: Why can’t we have it all? Is it possible to buy a wonderful company at a wonderful price? Is it so crazy to try to do this?

And note I’m not talking about a wonderful price in the sense that you did a DCF with high growth rates to justify a high multiple.

A DCF is much like torture and torture is not effective. Usually, the victim will tell you whatever you want to hear to make the pain stop.

It’s not like 24, where Jack Bauer quickly extracts a confession, yells Damnit Chloe!, and stops the villain before the episode is over. In the real world, it doesn’t work. DCF’s are the same, in my opinion.

By the time you approach your spreadsheet to perform a DCF, chances are you are already in love with the company and will mess with that spreadsheet until it gives you want you want to hear.

I’m talking about actually statistically cheap. A low multiple, such as below EV/EBIT 10. Does that ever happen with a great company?

I decided to take a look at some great businesses & great performers over the last decade. Did they ever sell for wonderful prices?

I turns out that they all have, at one time or another.

Apple

A great example is Apple.

Apple is without a doubt a wonderful company. It has a 10 year median return on invested capital of 31%. Operating margins are usually above 25%, implying pricing power. Earnings per share have grown at a 25% clip over the last 10 years.

The stock price has reflected the growth & quality of the business, advancing at a 32% CAGR over the last decade.

In February of 2016, Apple got down to 8x EV/EBIT. All of this information was already known about the business, but the price was still cheap over doubts whether the business would continue delivering these results.

Did any value investors pounce on this opportunity? Did anyone actually use fundamental analysis to identify this opportunity?

Warren Buffett did. Berkshire began acquiring Apple in 2016 when it was at this crazy price. It was also written up in value investor’s club at the same time.

Mastercard

Mastercard is a wonderful company. Mastercard’s operating margin is typically astronomical, over 50%. They have a moat around payments and have benefited as our society becomes increasingly cash-less. Free cash flow has advanced at a 40% CAGR over the last decade.

Mastercard went below 10x EV/EBIT in 2009. It also dipped below 10x a few times in 2010 and 2011. It didn’t get beyond 15x (still reasonable for a company with that kind of moat & quality) until 2014.

Did any value investors pounce? Turns out they did. In 2010, it was written up in value investor’s club. It was also purchased by Randolph McDuff, a fascinating value investor who utilizes EV/EBITDA in valuation criteria. I read about in The Warren Buffetts Next Door. His blog can be read here. This is a good article about him from 2008 in which his Mastercard investment is discussed.

Dominos

Domino’s is one of the best performing stocks of all time. Domino’s debuted on the public markets at the same time as Google. Shockingly, Domino’s outperformed. Since 2005, Domino’s has advanced at a 27% CAGR while Google has advanced at a 20% CAGR.

Over the last 10 years, Domino’s has grown free cash flow at a 17% CAGR. It has grown revenue at a 10% CAGR. Operating margins are consistently around 16-18%, a sign of a great business.

Shockingly, Domino’s – the stock that has outperformed Google – has traded for cheap multiples in the past. In 2011, Domino’s got down to an 8x EV/EBIT multiple. This is after they already adjusted their pizza recipe and after the stock already demonstrated excellence performance since their 2005 debut.

Did any value investor recognize this? Turns out that some did. Domino’s was written up in value investor’s club at this time.

It Is Possible

There are many other examples of this, particularly in the small cap space. I picked Domino’s, Mastercard, and Apple because they are mega cap stocks and everyone is already aware of their success. A truly efficient market would have never priced these widely followed wonderful companies below 10x EV/EBIT.

This all suggests to me that it is possible to have it all. Wonderful companies do sometimes sell for wonderful prices. Investors just need to be patient and move aggressively when these rare opportunities present themselves.

Random

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Biogen

Key Statistics

Enterprise Value = $48.05 billiion

Operating Income = $6.301 billion

EV/Operating Income = 7.62x

Earnings Yield = 12%

Price/Revenue = 3.49x

Debt/Equity = 53%

Free Cash Flow/EV = 13%

The Company

Biogen is a biotech firm. They sell high-margin drugs that treat a variety of different illnesses. Much of their pipeline is acquired through research & development and they also achieve growth through acquisitions.

They run a phenomenal business. Their gross margins are presently 87% and their operating margin is is 48%. Revenues & profits consistently grow every year.

Each of their blockbuster high-margin drugs has a similar lifecycle. Massive amounts of money will be spend for years attempting to develop a new drug. It’s uncertain if the drug will be successful. It’s also unknown if it will be approved. Eventually, if the drug is approved and it is successful, it will experience explosive growth. Eventually, generics will come along, and that will eat into the profit margins, and revenues will decline.

A good example of this product life cycle is evident in TYSABRI. TYSABRI is a drug that treats multiple sclerosis and Crohn’s disease.

TYSABRI’s life cycle is typical for that of many blockbuster drugs. It experiences explosive growth in the beginning. It may be approved for use in one country, then expands to others. As generics are released, revenues decline and revenues & margins start to fade away.

Therefore, a firm like Biogen must constantly invest in R&D to develop new blockbuster drugs that can serve as new sources of revenue.

Fortunately, Biogen accomplishes this. They have a rich research pipeline and are constantly developing new drugs and new sources of revenue, resulting in strong growth in revenue and earnings per share.

Due to Biogen’s rapid growth from 2010-2015 thanks to drugs like TYSABRI, the stock price and valuation experienced rapid growth in the mid-2010’s. In 2014, the company traded at an absurd multiple of 60x EV/EBIT.

Since those lofty heights, the multiple has contracted even while the company continued to grow. The stock price has mostly remained stuck in a trading range while revenues, cash flow, and earnings have grown.

My Take

Biotech stocks in the mid-2010’s went through a bubble. Thanks to their rapid growth and high margins, investors relished these stocks and bid them up to absurd valuations.

It is much like what occurred in the 2000’s to companies like Microsoft. At the peak of the internet bubble, Microsoft traded at a EV/EBIT multiple of 50. Throughout the 2000’s, Microsoft’s stock went nowhere even while the business continued to grow. The multiples continued to decline as the business grew into the valuation. By 2012, Microsoft traded at an absurdly cheap multiple of 7x EV/EBIT.

I think the same thing is happening with Biogen. Biogen was bid up into an absurd bubble. As growth began to wane for a bit, investors dumped the stock, but the business continued to execute. Now, it trades for a bargain basement multiple.

Biogen has multiple drugs at different stages of their lifecycle and they have a robust research pipeline, with multiple drugs in development. Drugs like TYSABRI are waning, but there are also drugs in earlier stages of their product lifecycle that are still growing.

Current drugs that are still growing are:

SPINRAZA (treats spinal muscular atrophy)

BENEPALI (treats arthritis), IMRALDI (treats psoriasis), and FLIXABI (anti-inflammatory, treats arthritis).

Biogen trades like it is never going to develop another blockbuster drug again. Fortunately, they have drugs that are currently in their growth phase of their development. They also have a rich research pipeline, shown below, with multiple drugs at various stages of their development.

One of the most promising drugs in development is Aducanumab, a novel treatment for Alzheimer’s disease. It has shown tremendous promise in clinical trials, which you can read about here. The FDA recently accepted Biogen’s application on August 7th and expects to reach a decision in the first quater of next year. You can read about this here.

If approved next year, Aducanumab is a potential catalyst for the valuation to rise again.

Even if that doesn’t happen, Biogen is a strong company at an absurdly cheap valuation with many different drugs in the research pipeline so that it can continue growing.

7.62x EV/EBIT seems like an absurd valuation for such a high quality company. There are retail stocks in secular decline that trade at this type of multiple. Meanwhile, the balance sheet is safe and there is a high degree of financial quality, limiting the downside risk. Debt/equity is 53% and the Altman Z-Score is 4.24, implying practically zero bankruptcy risk.

They are also aggressively returning capital to shareholders. Total share count has declined by 12% in the last year.

Random

I’ve been listening to a lot of Ladytron.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.