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.

Shrinking Orange (HD)

The management at Home Depot (HD) continues to cut expenses so that shareholders do not experience the pains of "deleveraging" - a normally positive term which describes paying off debt, but used here to describe the negative effects of expenses becoming disproportionately large as revenues drop. In an earlier post (March 2008), I complimented the management's sanity in their "reversion to the mean" graph which indicated that markets were overreacting. Well, the markets weren't; instead, management was simply hoping. This graph indicates what others have often said - that markets overshoot before they revert to the mean:




As is evident from the pronouncement at the bottom: "worst of correction behind us," the management has not learned the perils of unqualified pronouncements. A political "may" or "might" could be a good tool for their toolbox.

HD has undoubtedly been moving through a horrendous environment, but in a case similar to the Biblical Joseph and the Pharoah, HD has had nearly 15 fat years of growth before these two lean ones. But after pioneering the "big box" retailer in home building products, HD let a huge lead become an equal race with Lowe's (LOW). Now, HD and LOW have commoditized each other's businesses so that what remains is a real estate play.

HD has over 2,200 stores. These stores are primarily in the U.S., but are also in Canada, Mexico and, incredibly, China. (Think of the distribution advantages with all those empty containers going to China!) These stores are costly - with sizeable pieces of land, additional sitework and paving, topped by a 100,000 sq.ft. building that is filled with furniture, fixtures and equipment. Total costs exceed $20 million. As long as returns on these stores are high, which is the job of the operations, then it's no problem. But commoditizing competition and a difficult environment have combined to create mediocre returns.

In 1978, Warren Buffett wrote the following about BRK's textile mills: "As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed." While HD has not moved pricing to direct operating costs, the decline in profitability to average real estate returns demonstrates that the prospects for superior returns on capital employed are, at best, cyclical and, at worst, historical. Perhaps HD could declare itself a REIT, drop its taxes and increase the dividend to shareholders.

How To Measure Danaher (DHR)

Danaher (DHR) is an extraordinarily well-run instrumentation and tool business. Its stock has outrun Berkshire Hathaway's (BRK), while operating on similar principles. Just as Warren Buffett seeks to acquire companies in order to grow, so does the management of DHR. Year by year, very little growth is organic. Instead, the vast majority is acquisition-driven.

So what makes this method work? To make acquisitions work accretively (meaning adding to earnings) over time, one must either have access to cheap capital - such as low interest rates or high priced stock issuance - or be a better owner. BRK has long trumpeted the fact that its management cannot add value - they simply purchase home run hitters and let them hit home runs. DHR, on the other hand, has a rigorous business system to which all acquisitions are held.

The proof is in the pudding. DHR has successfully made acquisitions pay for themselves when made on a cash basis - a rarity. By focusing the business and cutting excessive expenses, DHR is able to make the increased profitability repay the use of cash. The Danaher Business System creates about a 16% "free" cash flow margin. These excellent margins provide the funds fueling future acquisitions. I put the word free in quotations because interest and taxes must be paid.

Closer scrutiny shows that DHR's "free" cash has been getting freer. While the markets have accorded consistent and high multiples on earnings and book value to the stock for at least 15 years, the multiple paid on revenues has been increasing. When I sought to understand the reason, DHR has moved from 40% tax rates to lower than 25% rates currently - something to be careful about.

International Oil Companies (IOCs)

International Oil Companies (IOCs) are also known as Integrated Oil Companies because these companies combine the activities of Exploration and Production (E&P) and Refining and Marketing (R&M).

Before the days of OPEC, price increases on oil were difficult to get. Oil is a commodity and without a price setting (or fixing) mechanism, like OPEC (and the Texas Railroad Commission before that), prices tend downward. This graph illustrates the point:

Trying to avoid price competition, the oil companies tried to create the perception of value. Not only were there ads to "put a tiger in your tank," but businesses were vertically integrated so that brands and supply control could be developed.

No longer do the companies need to be integrated. Although none of the IOCs have dis-integrated, there are E&P only companies, such as Anadarko Petroleum (APC) and R&M only companies, such as Valero Energy (VLO) for analysis. By studying the characteristics of each, some of the IOCs might be understood by a component valuation approach.