Using the Wrong Framework - Again

This process of reviewing my Biggest Mistake of the Day (BMD) is going to make for a painful and humiliating 2016.  I'm hoping that I will have less to write about in 2017 as a result.

Today I was reviewing the financial information of Public Storage (PSA) which is the largest owner and operator of self-storage space in the U.S.  PSA operates as a Real Estate Investment Trust (REIT) which means that it does not have to pay taxes at the corporate level as long as it pays all of its earnings to the shareholders. 

(As an aside on this favorable tax treatment, misconceptions have abounded. REIT operators have claimed that they do not benefit from favorable treatment because the dividends are taxed at ordinary income rates that top out at nearly 40% while normally dividends are taxed at 20%.  This logic is faulty because it ignores that the REIT, unlike a corporation, avoids taxes.  A quick comparison.  Company A is a REIT and earns $10 million and pays out all earnings to its shareholders.  Company A pays $0 in taxes and its shareholders (assuming taxable) pay roughly $4 million.  Company B, in the same business, earns $10 million and pays out all earnings to its shareholders.  Company B has a tax bracket of roughly 35%, so it pays $3.5 million in taxes with the remaining $6.5 million in earnings going to shareholders.  These shareholders (again assuming taxable) pay at roughly 20% and so pay $1.3 million.  Company A earnings end up with tax of $4 million and Company B earnings end up with tax of $4.8 million.  REIT operators do have tax advantages.)

Back to my BMD.  I started closely studying PSA in 2005.  I analyzed it with the wrong framework because I focused on traditional income statement measures such as earnings, cash flow and revenues.  I even looked more closely and used a widely- used real estate measure called "funds from operations" (FFO) which is a measure that takes earnings and adds back depreciation and amortization costs.  Using this measure, I estimated that I would pay $36 per share for PSA.  During 2005, the stock's price ranged from $51 to $72.  I thought, "Wow. This stock is pricey!"

Two times a year, every year since then, I have studied the FFO and revised my pricing as the FFO steadily rose.  The only time PSA's stock price went beneath my buy price was briefly in 2009 as the world moved into fire sale mode.  I blamed the pricing disconnect between my pricing and the stock market's pricing on the huge operating margin of 60%+, in a world where I am happy with margins in excess of 12%.  But, as I discussed in my BMD of 1/1/2016, operating margins are not a relevant metric (despite wide usage - even on the quarterly discussions of the company) on a "balance sheet" company.

PSA is definitely a balance sheet company because its service is its balance sheet of a collection of self-storage units.  Once it is clear that a valuation metric needs to use the balance sheet, it is necessary to find the most useful metric.  In the case of PSA, that is not easy.  The balance sheet is primarily made up of real estate whose value is understated due to a combination of historical values and depreciation.  For this reason, book value and equity are misleading. However, with enough digging and without the wrong framework (again), there are sensible ways to get to a valuation.  This is something I should have done earlier. 

Since 2005, PSA stock has risen over 250% in contrast to the stock market, which on average, has risen about 100%.  That's a big penalty for using the wrong framework.

Using the Wrong Framework

I am starting 2016 with a new resolve. This year I will articulate mistakes that I have made and, more importantly, that I am prone to. Warren Buffett, my standing hero, talked about needing to write reports more frequently if he were to start confessing his mistakes. I figure if I just start to blog about the Biggest Mistake of the Day, I'll be on a good start to a book.

Mistakes is a big category - as they say, errors of omission and commission. I am focusing first on errors of commission, although I am not going to give a financial impact tally. All mistakes are costly, unless they lead to greater insights. So here goes - making stepping stones out of all these stumbling blocks.

In financial analysis, the starting point is gathering a tremendous amount of data. Most of this is already gathered for us in the form of quarterly and annual financial statements that are filed with the SEC. This accounted for data becomes the information that we rely on to get to actionable ideas. As financial statements get longer, as information gets more complicated and as life gets busier, we begin to rely on shortcuts or simple frameworks to save time and energy or simply out of sheer laziness.

I don't think my latest Biggest Mistake of the Day was out of sheer laziness, but it was out of a lack of thoughtfulness. In the analysis of financial statements, it is usual for the company and for me to start with a study of the income statement that details the revenues, expenses and net profits of the company. After familiarizing myself with its content, I start to study ratios, such as "operating margin." This is a measure of how much profit (before "external costs" like taxes) is in every revenue dollar. The higher the operating margin, the more likelihood that the company can withstand the brutal forces of capitalism.

Normally the balance sheet follows the income statement. The balance sheet details what the company owns and what it owes and what the difference is - equity. The reason the balance sheet follows the income statement is that the balance sheet is the means of providing the services of the business. However, there are companies in which the balance sheet is not the means of the service, but is the service itself. I believe that companies whose business is the balance sheet should provide that statement first - and sometimes that does happen (although oddly some companies whose balance sheet is the means of the service puts it first; I don't get that).

When a company provides its balance sheet as the service, ratios like "operating margin" do not matter. For example, the margin of profit between a bank's interest income from borrowers and its interest cost for depositors is not really important. If a bank receives $1 million of income and $ .5 million of cost, the $ .5 million does not really tell us anything. Instead, this information must start with the balance sheet by setting the income and expenses as a % of assets. In banks this is regularly done.

However, in the case of insurance companies, which are also balance sheet service providers, the investment community spends a disproportionate time on "operating margin" issues(aka, "combined ratios") which are not really useful. Instead, as in the case of banks, insurance companies should have revenues analyzed as a percentage of assets. In this way, the truly leveraged nature of insurance companies can be grasped and the sensitivity to small changes can be understood.

I personally fell into this trap as I used "debt" measures, "operating margin" ratios Price to Earnings ratios and "combined ratios" to understand and assess the value of many insurance companies. Instead, it is more important to dissect the Return on Assets and connect it to Return on Equity and, finally, to understand its connection to Price to Book ratios. By using the right framework, the sources of an insurance company's strengths and weaknesses should become more apparent.

Assessing Net Profits

After learning what a business does, the first financial measure I try to understand is the history of the company's net profits. The term "net profits" is often used interchangeably with "earnings." (This use of one or more terms to describe the same thing happens frequently in finance and confirms its reputation for imprecision. I would prefer "earnings" connote "taxable income," but that would not fit well with "earnings per share" in which the usage is identical to "net profits.") Both are often used to describe what's left over for the owners after all other bills have been paid. This seemingly straightforward task is complicated by the regularity of one-time exceptions, such as merger fees or tax adjustments or lawsuit costs. In addition, companies put into the "one-time exception" category regular restructuring costs. These patterns are most noticeable in the consumer staples group of companies, marring otherwise consistent earnings. What's an analyst to do? I think that including these charge-offs as a likely occurrence in the future based on past history is the best course of action, even though that often prevents one from "paying up" for the stock.

Wisdom of a Investment Analysis Checklist

Charlie Munger is famous for his "mental model" approach to investing. As part of that, he has recommended that investors have a list of those issues which are pertinent to an investment decision. By identifying the correct answers, he views that a "mental model" is generated which should lead to higher quality decisions. Mohnish Pabrai, another well-known investor, takes this a step further. By emulating the airline industry, he recommends the development a checklist generated by past mistakes. He groups these errors into five "buckets." These "buckets" are made up of 97 specific questions. He does not identify these, but he does reveal the buckets. They are: leverage, management issues, "moat" issues, valuation and personal preferences. The advantage of Pabrai's approach is that it incorporates a less cerebral, more investment specific discipline. The buckets he has identified are replicable with each investor able to fill those buckets with specific questions related to errors of others or himself.

What it's all about- a reminder from BRK

Reviewing the annual report of Berkshire Hathaway (BRK) refreshes my sense of desire for owning wonderful companies. At times, the ups and downs of the markets can dull my senses and redirect my attention to the non-essential aspects of business. In addition, most of the conversations with clients are concerned with the same aspects; few wish to dwell on the real long-term underlying businesses. In contrast, Chairman Buffett lovingly looks at the characteristics of his businesses: their histories, their competitive positions and their leadership. BRK is basically like a Russian doll of sorts - businesses creating cash to buy more businesses which buy more businesses. Essentially portfolio management is the same thing, but market prices all too often become the source because they determine the entrance and exit points. In contrast, Chairman Buffett retains his positions - allowing him to focus in a pure way on the underlying and long-term aspects of the business. The Chairman also focuses attention on earnings, rather than dividends and share price movement. And yet, the siren call of the day is dividend yield or stock price movement. Neither of these factors are even mentioned! He focuses on earnings even on his non-controlled companies (read stocks), breaking down the actual earnings he would be receiving if the companies were controlled. This is an important and refreshing exercise for all of us who own stocks because it brings the focus to that which is important. By reviewing what my personal earnings are from a stock position, as if I were the total owner, is a valuable aid in gaining scale.

What To Make Of TWC's "TV Essentials"?

Time Warner Cable (TWC) is testing a new low-cost level of programming called "TV Essentials." The pricing will be $49.95 per month, which is $10 per month lower than the formerly lowest cost-tier. In order to induce participation, TWC is providing a 12-month promotional rate of $39.95 in New York and $29.95 in Ohio. TWC claims that this programming will assist those who are economically challenged to continue using PayTV. I doubt that this is their primary motivation.

The Essentials package will include 39 cable networks, which have much lower programming costs. The narrowed lineup appears to reduce entertainment costs and almost eliminate expensive sports programming, dropping costs from the approximately $22.50 per month of costs to about $7.50 per month. This $15 per month programming cost reduction means that the $10 per month lower subscriber charge is actually more profitable for TWC.

The movement towards an "a la carte" selection process has been resisted by both content and distribution companies. However, the push by programming companies to increase their revenues is creating incentive for the distribution companies to explore new options. If specific programming costs rise high enough to disrupt subscriptions, distribution companies would be better off to allow subscribers to exclude those higher cost programs with a different package. This is what I believe "TV Essentials" is exploring.

The contract between programming companies and distribution companies forces distribution of programming at the 85-90% participation level. This provision has protected programming companies from being "cherry-picked." However, depending on the performance of the new Essentials package, which relies on the participation flexibility, future contracts may be shaped very differently as they come up for renewal.

Cable v Fox: Latest Battle (TWC)

On the heels of the latest battle between Fox Network and Time Warner Cable (TWC), I hooked up my satellite-based television to my cable-based intenet and - voila - I had internet on the big screen. This simple connection is a major step in the evolution of the box in our living rooms from a broadcast one-way tool to a specificast two-way tool and a potent tool in the long running war between content and distribution.

At one time, the "tv" business model was simple and highly profitable. The distribution of programs involved sticking a huge metal pipe into the sky and sending signals from it on specific airwaves. Everyone received these signals through some "ears" on the television. This distribution model kept the capital expenditures low because the pipe in the sky did not become obsolete.

Even better was the oligopoly on the content side. Programming was the domain of the big three: NBC, CBS and ABC. Because these choices were so limited, the audiences were enormous. The least viewed programming of that era had much higher viewership than the highest viewed programming of today's era. As a result, advertising rates were enormous. While prestige might be an issue, even third place in this race ensured high profitability.

The issue of content versus distribution came into focus in 1985 when CapCities stunned the investment world with its purchase of ABC. CapCities was an owner of media properties in the newspaper, radio and television industries. At the time, ownership was limited by the FCC to five television stations which could not overlap in viewership. As CapCities would grow, it would discard a less favorable market as a new market was purchased. When CapCities purchased ABC with financing provided by BRK, it was a sign that distribution had become more powerful than content. But nothing lasts forever.

Ten years later, in 1995, Michael Eisner led The Walt Disney Co. (DIS) to purchase CapCities in order to expand distribution for the increasingly attractive content that DIS owned. The timing was good for CapCities because distribution had shown the first signs of losing its monopolistic hold as the internet, cable and satellite began to demonstrate increasing distribution capacities. To DIS credit, newspapers and radio stations were sold immediately as the focus was on video. Yet, the broadcasting network became the worst performing asset for DIS.

But not all distribution was weakening. Over the next ten years, cable strengthened as being able to deliver diversity while content suffered (at least from a profitability per program) through an increasingly fragmented market; there were more and more specialist shows in different languages and with varying areas of interst. Still markets were shocked when Comcast (CMCSK) made an unsolicited $54 billion offer for DIS.

Now, as the market continues to fragment, but the broadcast networks maintain some strength in mass audiences, Rupert Murdoch wants Fox to get its fair share. As the rhetoric heated up, TWC brandished the weapon of the future: internet-driven programming which will deliver the ultimate in choice of "what I want when I want it" programming. As I watched my big screen play House MD on the internet without a flaw, I was thankful that I don't own shares in satellite tv.