A Wealth Creation Journal

Author: TC (Page 3 of 3)

Weekend reading: essays by Paul Graham

I can recommend the very thoughtful essays of Paul Graham, co-founder of YCombinator. His essays were bundled in the book Hackers and Painters.

The Great Refragmentation

Along with giant national corporations, we got giant national labor unions. And in the mid 20th century the corporations cut deals with the unions where they paid over market price for labor. Partly because the unions were monopolies. [10] Partly because, as components of oligopolies themselves, the corporations knew they could safely pass the cost on to their customers, because their competitors would have to as well.

Economic Inequality

Inequality has no limit when the cause is providing wealth to society (as opposed to zero-sum games)

And while it would probably be a good thing for the world if people who wanted to get rich switched from playing zero-sum games to creating wealth, that would not only not eliminate great variations in wealth, but might even exacerbate them. In a zero-sum game there is at least a limit to the upside. Plus a lot of the new startups would create new technology that further accelerated variation in productivity.

So if you made it impossible to get rich by creating wealth in your country, people who wanted to do that would just leave and do it somewhere else. Which would certainly get you a lower Gini coefficient, along with a lesson in being careful what you ask for.

Book takeaways from McKinsey’s “Four cornerstones of Value” and Mauboussin P/E paper

I recently read the great book from McKinsey & Co. “Value: the four Cornerstones of Corporate Finance”, and a paper from Michael Mauboussin “What does a Price-Earnings multiple mean?”.

The main lesson is obvious, but very important. This is why repetition it is not harmful (actually a lot like of going to church every week).

There are three fundamental concepts that you can take away from the exhibit. First, a company earning its cost of capital will trade at the commodity price-earnings multiple, 12.5 times in this case, irrespective of growth. You can imagine these companies as being on an economic treadmill: You can speed up or slow down the treadmill of growth and it makes no difference, the companies are not going anywhere. Value neutral companies must first figure out how to increase ROIIC before they worry about growth.

As one can see in the below figure, there are two valuation drivers: ROIC and earnings growth.  The most important point: The key valuation driver is the variable at which the company is worst.

Capture.PNG

P/Es given ROIC and earnings growth (assuming an 8% WACC).

 

Value neutral companies must first figure out how to increase ROIIC before they worry about growth.

Second, if a company is generating returns in excess of the cost of capital, growth is good. Indeed, all things being equal, faster growth translates directly into a higher price-earnings multiple. For instance, the warranted price-earnings multiple for a company with a 24 percent ROIIC and 4 percent growth is 16.1 times, whereas a company with the same ROIIC but a more rapid growth rate of 10 percent is worth 25.7 times. The value of high ROIIC companies is extremely sensitive to changes in perceived rates of growth.

Therefore:

A high ROIC company with sluggish growth should focus on growth. A low ROIC growth company should focus on capital efficiency.

Important simplification: we keep ROIC constant for different company sizes (e.g. Amazon improves ROIC by growing).

TC

Takeaways from Joel Greenblatt’s Columbia lectures notes

I will summarize the notes of Joel Greenblatt’s  lectures in Columbia Business School back in ’05. His books are great material for any investor starter or otherwise. These quick reads excel in both great examples and clarity of teaching. I recommend both You can be a stock market genius and The Little book that still beats the market.

Some great lessons from his lectures:

Singular focus on normalized EV / EBIT and ROIC

We (Gotham Partners) know a little bit more than what I wrote in the book (The Magic Formula). But I figured if you could double people’s returns in stocks or close to triple the return in small stocks that was worthwile. We do look for these two things (high ROIC and high earnings yield), but instead of looking at last year’s earnings we use normalized earnings. Most people can’t figure that out. We can’t figure it out for most stocks, but for those stocks where we can figure it out, we are looking for companies with high returns on tangible capital on a normalized basis and high earnings yield based on normalized earnings. That is just very logical.

 

Problems with valuation shorting

My quibble with long/shorts – the guys who do special situations in shorts where it is a scam or the company will run out of money. I like those type of shorts though I am not particularly good at them. If you are doing valuation shorts then I don’t like that. That strategy blows up every seven or eight years – the shorts go up and the longs go down and that happens to every quant guy. I am not saying a long/short hedge fund doesn’t make sense. But I don’t value short term volatility because I take a three or four year view. Then why give up 2.5% a year in returns by shorting. I am not adding value. It doesn’t add value because I am losing 2.5% a year and I don’t care about volatility.

Break out no-growth value & value from growth

Simplify everything – what is it worth now if they just stopped growing? Then if they take some of their incremental dollars capital and buy stuff what kinds of incremental returns do I think they are going to get on that? So I break things into two pieces generally. [..]  I have to make an assumption of what will they do with that cash (on no-growth value).

Go check out the lecture notes here.

TC

Notes on package holidays

We recently took an interest in the business Dart Group plc “DTG”.

My notes on the Package Holiday industry, as the high growing segment of DTG is Jet2holidays:

  • Necessary adjustments – the package holiday industry suffered as new tech competition (e.g. Booking, Expedia and later Airbnb) grew offering customers more choice:
    • Assimilation – One key advantage of online competitors for customers is customization (exact holiday length, start/end date, type of hotel room). The industry adjusted by offering more choice.
    • Consolidation & bankruptcies – TUI and Thomas Cook have increased their market share since the financial crisis. Size has brought some two-sided power on price.
    • Control – Recent strategy has been to increase control over customer experience by expanding assets on the balance sheet (hotels, planes). Large package holiday firms might scoop up a low-cost airline like DTG to increase control. Note: Jet2Holidays is very focused on customer experience (e.g. see news on unique resort check-in).
    • Differentiation – package holidays to remote places where booking websites are not as penetrated yet (First Choice’s strategy as early as 2005). A move away from commoditised package holidays boosts margins. In 2012, 3/4th and 2/3rd of TUI’s Nordic and British customers respectively booked such highly tailored holidays (2/3rd of German customers was “still” buying mass-market packages).
  • Renaissance – In part because of these adjustments, there has been a renaissance since ’08. Mintel forecasts a further 10% rise in demand by 2020. As of 2016 however, total package holiday demand is down 25% since its peak in the early 2000’s.

 

On all-inclusive package holidays:

  • value proposition
    • being spoiled by free lunches
    • peace of mind
      • holiday sorted out
      • no unexpected expenses
      • being looked after if holiday goes wrong (e.g. terrorism)
  • Growth  all-inclusive grew from 8% of worldwide holidays to 12% in the period ’10 – ’13 (PhoCusWright via Economist)

 

One last remark: Booking/Expedia/Airbnb charge quite high commissions (10-20%). This offers leeway for existence to others. It could also be a risk down the road if these commissions fell.

Notes on the European airline industry might follow.

 

 

References

A history of package holidays – Independent

A new package  – Economist

Tour operators are down but not out – Economist

Horrible holidays – Economist

Travelling on the same ticket – Economist

The return of the free lunch – Economist

From satanic mills to sundecks – Economist

Tour operators are down but not out – Economist

Thomson and First Choice to merge – FT.com

Different Towels – FT.com

Travel groups brace for holiday booking decline – FT.com

Tui to sell Hotelbeds Group for €1.2Bn – FT.com

 

SABMiller – AB Inbev deal

This week the Inbev offer for SABMiller shareholders closes.

While SABMiller trades at 45 pounds, i.e. the cash offer consideration, there’s also a partial share offer option that has become more interesting after Brexit currency volatility. By electing the partial share offer, one gets future Brussels listed Inbev shares with a five year lockup, and a small sum of cash upfront. Have a look at this great company presentation for background.

I imagine that the lockup clause is to discourage as many non-family holders of SABMiller as possible of taking this sweeter option and pay less for a successful merger. AB Inbev management is notorious for being frugal. If you are a real long term investor, this is true time arbitrage to take advantage of.

I made a Google Excel sheet with live updated prices to analyze the economics of this offer.

What I found is a pre-tax IRR (as of Oct. 4th) of 2.8% p.a. above the return one gets by just holding AB Inbev (ABI in Brussels) in the same period.

This positive carry is created by

1) paying only 80c on the dollar for ABI restricted stock,

2)  getting the extra dividend on this incremental 20c of ABI stock.

A 25% dividend tax subtracts less than 10 basis points p.a.

I am still hesitant to participate. On the one hand I am a big fan of these large positive carries. On the other hand I have doubts about the valuation of public mega-cap companies today. This brings me to very interesting letters of the hedge fund Horizon Kinetics about the unsustainable index ETF boom (see here here and here)

Because my portfolio is not levered at all (I am about 90% invested, and 10% in cash), there is room to participate and hedge my exposure by shorting AB Inbev as the short borrowing cost is zero. As my restricted stock is unlisted, this can only be done at a small percentage of my portfolio to avoid margin call mayhem in case Inbev stock rallies heavily.

If I participate and hedge my exposure, it will most probably be at a percentage of NAV < 5%.

Best,

TC

“If” by R. Kipling

How should one go about investing and life in general?

Please enjoy this great poem by Kipling.

If

If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
If you can wait and not be tired by waiting,
Or being lied about, don’t deal in lies,
Or being hated, don’t give way to hating,
And yet don’t look too good, nor talk too wise:

If you can dream—and not make dreams your master;
If you can think—and not make thoughts your aim;
If you can meet with Triumph and Disaster
And treat those two impostors just the same;
If you can bear to hear the truth you’ve spoken
Twisted by knaves to make a trap for fools,
Or watch the things you gave your life to, broken,
And stoop and build ’em up with worn-out tools:

If you can make one heap of all your winnings
And risk it on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breathe a word about your loss;
If you can force your heart and nerve and sinew
To serve your turn long after they are gone,
And so hold on when there is nothing in you
Except the Will which says to them: “Hold on!”

If you can talk with crowds and keep your virtue,
Or walk with Kings—nor lose the common touch,
If neither foes nor loving friends can hurt you,
If all men count with you, but none too much;
If you can fill the unforgiving minute
With sixty seconds’ worth of distance run,
Yours is the Earth and everything that’s in it,
And—which is more—you’ll be a Man, my son.

 

 

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