Ownership Impact

I have been amazed by the impact that ownership has on my thinking. Often I place a price on a security and am unwilling to pay more than this price. Yet, if I have the opportunity to purchase the security at my price and it rises in value on the following day, I am unwilling to sell it. This spread between my willingness to purchase and my willingness to sell is my Ownership Impact.

This Ownership Impact is the basis for a framework to "buy low and sell high." In essence, I am willing to be forced to become an owner if the price is lower than a specified amount and am forced to leave my ownership if the price is above a specified amount. However, this Ownership Impact is somewhat irrational in that if I buy something for $10 and am only willing to sell for $20, why wouldn't $11 be appropriate for new money added? After all, everything I own, am I not essentially repurchasing everyday (assuming frictional costs are negligible).

I discovered a recent article that discussed how deeply hard-wired these behaviors might be. Some researchers at Johns Hopkins focused on how our preferences for something deepen because we chose them. They brought 10- to 20-month-old babies into a lab and gave them a choice of objects to play with - two equally bright and colorful soft blocks. They set each block far apart, so the babies had to crawl to one or the other.

After the baby chose one of the toys, the researchers took it away and came back with a new option. The baby could then pick from the toy he or she didn't play with the first time, or a brand new toy. The baby reliably chose to play with the new object rather than the one they had previously not chosen, as if saying, "Hmm, I didn't choose that object last time, I guess I didn't like it very much." That is the core phenomenon.

It appears that this dynamic is working in reverse to drive my Ownership Impact - that once I have chosen something it is endowed with value. Conversely, once I have not chosen something, I develop an aversion to it. Such lurking biases are important to identify and overcome if good choices are to result.

You Can Only Sell It Once

I heard the phrase "you can only sell it once" from an astute real estate investor. I did not see this wisdom as applicable to the stock market because Mr. Market offers pricing everyday on every security. However, since that time, I have come to see it as partially applicable.

Most businesses are simply businesses. With an adequate amount of capital, these businesses could be replicated. Yet there are some businesses where no amount of capital can replace them. These businesses could be termed "irreplaceables" or franchises. My real estate friend's outlook is applicable to these companies because such franchises accrue value at a return on capital higher than the growth rate of their environment. "Buy, don't sell" could be the subtitle on these companies.

Examples from the past were brands like Coca-Cola or Hershey's. In today's world, the creativity and changing tastes of millennials has made these brands less irreplaceable. More of these irreplaceables are now in the tech world. The sheer scale of  Mastercard's reach or Facebook's address book makes them franchises. More importantly for the appropriate sale of such companies is the identification of a movement to being a replaceable from being an irreplaceable, as occurred to the Washington Post on the advent of the internet.

Financial Ratios: Signposts not Goalposts

Financial ratios are important to the investor and I group them into two categories: operating ratios and market ratios. The former address the operating characteristics of the business, such as "net profit margin." This takes the "net profits" (addressed in a prior post) and divides it by revenues. These ratios are important to understanding the business models itself. 

Market ratios, on the other hand, reveal the general assessment of the value of the business. There are several, but the most attended is the "P/E ratio," which means Price to Earnings. Like any measure, simplification has occurred and is important. Any time a "P/E" is discussed, an investor should ask does this mean Price to last year's Earnings or Price to Trailing Twelve Months Earnings or Price to next year's Earnings. I have seen all of these used almost interchangeably. 

As companies continue to creatively account for and present their results, the investor needs to use these ratios as a passageway to gaining greater qualitative understanding. For years, the "value" investor was simply focused on such ratios as a means of identifying a "margin of safety." In a world of change accelerating by globalization, the internet and cheap capital, such ratios may be misleading if they are not specifically connected to underlying qualities.

Rethinking Real Estate - trouble at CVS?

For years, real estate has been an important component of my investment thought process. In 2002, we computed that Home Depot's value was exceeded by the value of its well-placed and hard to replace real estate. That value provided a "margin of safety" despite the challenges of competing with Lowe's and the vagaries of retailing.

The dynamics of the internet has changed that anchor value of real estate. My first real exposure to this shift was in the car retailing area. In analyzing AutoNation and Carmax, I discovered that car retailers were discovering that car purchasing was driven by online analysis. Gone were the days of driving from car lot to car lot. Instead, purchasers could simply sit at home and narrow down purchase options. When the search was concluded, a purchaser could drive to a less prominent and much less expensive lot and "kick the tires" there. A huge cost saving to auto retailing expenses. Carvana has highlighted this shift.

The Covid crisis has highlighted many of the same trends in other industries. As we have reviewed the healthcare sector, the low stock prices of pharmacy powerhouses CVS and Walgreens has been astonishing. But closer inspection reveals a retailing approach based on expensive real estate located at critical road junctions. In the past, retail discovery has been partially a drive-by convenience. However, if the new drive-by is a Google search, do these real estate locations continue to hold compelling value? If not, these companies may find it difficult to earn their cost of capital and be distorting their business plans by their long-term lease commitments.

Anti-Trust: Does It Work?

I was recently watching an Amazon Prime program titled "The Men Who Built America." It was well-done by editing out vast amounts of detail while honing a story connecting Vanderbilt, Rockefeller, Carnegie, Morgan, Edison and Tesla.

The most striking takeaway was the dynamic growth of a world without mountains of regulations. I have often wondered if the continuous slowdown in growth is a function of scale - that growth of larger entities simply becomes more difficult. While this may be a factor, there is nothing inherently so. Our slowed growth is likely due to regulatory inhibitions.

The next most striking takeaway was the uselessness of anti-trust. Teddy Roosevelt is featured in the program. In it, his populism is on display as he grabs the narrative of William Jennings Bryan to demonize these wealthy capitalists. Roosevelt focuses on Rockefeller and in 1911 wins a seminal anti-trust case against Standard Oil. 

Rockefeller's company is broken into 34 pieces, in which the parts become much more valuable than the original whole and as a result, Rockefeller goes on to become the wealthiest man in the history of the U.S. My takeaway was that the result of the anti-trust action did not: 1) reduce Rockefeller's wealth or power, 2) result in better outcomes for the consumer or 3) restore power to suppliers. 

Given this poor result, I reflected on anti-trust effectiveness and, on further study, I did not discover a single example of effectiveness. Instead, the competitive dynamics of capitalism serve to create change in 1) who is the wealthiest, 2) better consumer experiences and 3) a new group of suppliers. All anti-trust actions have simply slowed the marketplace in achieving the very things that anti-trust target.

Big Tech and Antitrust: Part 1 - Where's the Line?

I put "Part 1" in the title because I am certain that the most important business issue of the next decade will be the antitrust approach to the growing power of Big Tech. Facebook, Amazon, Apple, Google and Microsoft (FAAGM) are the most powerful and profitable companies that I have seen in my investing career and I believe are the most powerful on the history of the planet. John D Rockefeller can only roll in his grave with spasms of jealousy.

If FAAGM are more powerful than Standard Oil and Standard Oil was a violation of antitrust, how is it that these companies are not? The basis of our antitrust is consumer in orientation. Typically, a monopolistic business is injurious to consumers because it holds the prices of goods, products and services at elevated levels. However, in the FAAGM world, many of the services are free. Google's increase in scale only causes consumers to be happy at the combination of free and more comprehensive.

In the FAAGM world, the squeeze is more on the suppliers than it is on the consumers. By gaining scale, these companies squeeze suppliers into an integrated and more seamless experience. Each of these companies is more valuable to the consumer by its increase in scale. Facebook is of more use the more others are available for connection. Despite the increase in benefits to the consumer, capitalism requires competition to avoid the rapid movement from "doing for" to "doing to" consumers. The next important stage economically is to understand the direction of antitrust. The coronavirus issues have only accelerated that process.

For that reason, Circuit Judge Consuelo M. Callahan's language, reversing the District Court’s ruling that Qualcomm was guilty of antitrust violations, is important. She states: "This case asks us to draw the line between anticompetitive behavior, which is illegal under federal antitrust law, and hypercompetitive behavior, which is not." What kind of line is that? Without going into Qualcomm's case, it seems as if businesses are competitive if there are limited barriers to entry. The barriers to entry for FAAGM are simply insurmountable and thus, I could argue, any behavior is "anticompetitive." If the consumers are winning currently, does that justify identifying "anticompetitive" behavior? I have no idea, but an important ruling has occurred.

Dealing Drugs in Decline? Walgreens (WBA)

For years, Walgreens (WBA) was a sound investment with a consistent investment formula. Their motto of "crawl, walk, run" highlighted the steadiness with which they adopted new trends on a profitable and culturally coherent strategy. Yet despite that history and consistently improving metrics, WBA's stock is trading at less than seven years ago. What gives?

Warren Buffett typically breaks down his analyses into unit characteristics, such as the profit per bottle of Coca-Cola. In doing this with WBA, the profitability per store is roughly $350,000 - down slightly from 2019 but up from 2005, when it was $315,000. Despite improving profits per store, the return on capital has declined as stores have gotten more capital intensive (cost of locations and build-out). Intuitively the profits per store don't seem compelling given capital, complexity, retail and legal challenges.

Given the power of the Walgreens brand and the scale of their operations, it is clear that the business model is challenged. The market seems to be marking down those businesses which rely on traditional real estate locations. The most challenged of their customers are home-bound and affected by chronic conditions. Unlike CVS, which is moving to a neighborhood healthcare model, WBA persists in a more capital intensive neighborhood retail model.

As retail and pharmacy moves online, it appears that the market is skeptical of WBA's ability to pivot. For years, WBA has been discussing a movement to digital but has made little progress. Sporting a P/E of less than 8 and a 4.5% dividend yield, WBA bears watching. But in the current environment, the tech-based, asset-light business models seem to be excelling while the "omni-channel" approaches of physical and digital seem to struggle with cognitive, cultural and operational dissonance.