| enance Cap-Ex | | | | Equipment has been cut by two-thirds. |
| The nice thing about having low capital spending, is | | | | The reason? Advertising. The majority of the |
| the pleasant surprise it creates. You find a | | | | company’s operating expenses are |
| company that is earning more (economically) than | | | | advertising expenses. Let me put the difference |
| other companies with the same GAAP numbers. | | | | between the intangible asset of the |
| So, the P/E ratio tends to exaggerate how | | | | 1-800-PetMeds brand and all of the |
| expensive the business is. | | | | company’s tangible assets into |
| This is kind of like finding a business with excess | | | | perspective. In 2005, depreciation expenses |
| cash. While it's true that a business can have too | | | | totaled less than 0.5% of sales while advertising |
| much cash from an efficiency point of view, | | | | expenses totaled more than 15% of sales. In |
| finding more cash on the balance sheet than you | | | | previous years, advertising expenses were even |
| expected is always a good thing, right? The point | | | | greater as a percentage of sales. |
| in each case is that the headline numbers (EPS, P | | | | My point is simply that some of this advertising |
| E, etc.) sometimes lie - and an inordinate number | | | | spending (and I’m guessing a whole lot) |
| of bargains are found where such "lies" exist | | | | creates economic benefits in future periods. In |
| – simply, because others aren’t | | | | other words, economically, part of that advertising |
| looking there (it’s a less conspicuous | | | | spending is an investment, not an expense. |
| bargain). | | | | I’m not saying GAAP accounting should |
| "Wouldn't it mean the company wasn't reinvesting | | | | treat the advertising as an investment in an |
| in P&E?" | | | | intangible asset, I’m just saying, the |
| Some businesses have a very strong relationship | | | | advertising is such an investment. |
| between the value of the assets in the business | | | | So, the pleasant surprise is the phantom |
| and earnings. | | | | investment. GAAP earnings in previous years |
| Others have almost no correlation between the | | | | were lower than economic earnings, because an |
| two. For an example of a business that will likely | | | | investment in future growth was treated as an |
| have very different ROAs from year to year | | | | operating expense. |
| (and longer-term) look at Forward Industries | | | | Again, I think this is, in fact, how the item should |
| (FORD). A less extreme example is Craftmade | | | | be treated by accountants. However, investors |
| International (CRFT), further down the spectrum | | | | need to recognize the distinction and adjust their |
| (but still very asset light) you have companies like | | | | expectations accordingly. |
| Timberland (TBL) and K-Swiss (KSWS). | | | | To better explain what all this talk of accounting |
| For an example of a business, that long-term at | | | | for advertising is about, I’ll provide an |
| least, has to add to assets to add to earnings | | | | excerpt from the company’s 10-K: |
| look at Village Supermarket (VLGEA). In this case | | | | The Company's advertising expense consists |
| (as in the case of most retailers), the long-term | | | | primarily of television advertising, internet |
| correlation between assets and earnings is | | | | marketing, and direct mail/print advertising. |
| somewhat obscured by operating leverage; | | | | Television costs are expensed as the |
| however, logically at least, you do recognize that | | | | advertisements are televised. Internet costs are |
| a supermarket’s earnings will be | | | | expensed in the month incurred and direct mail |
| determined in large part by the number (and size) | | | | print advertising costs are expensed when the |
| of the stores being operated. | | | | related catalog and postcards are produced, |
| Also on this side of the spectrum (businesses with | | | | distributed or superseded. |
| a strong long-term correlation between assets | | | | Simply put, the hit to earnings is immediate, while |
| and earnings) you have various businesses that | | | | the full economic benefits are only realized over a |
| own distinct, identifiable assets such as: theme | | | | period of many years. |
| parks, pipelines, parking lots, bowling alleys, golf | | | | That’s what I meant when I said the EPS |
| courses, hotels, etc. Of course, you also have | | | | number (and thus the P/E ratio) |
| asset-heavy manufacturing businesses, especially | | | | “sometimes lie”. This is one of |
| in price sensitive, commodity-like products. | | | | those times. An owner would see the advertising |
| Both of these types of businesses tend to have | | | | spending differently than the GAAP portrayal. |
| more predictable returns on assets (at least on | | | | Therefore, he would believe the true P/E ratio |
| the margins). I add the qualifier, because | | | | was lower than it appeared to be. |
| it’s a rare business that is both capital | | | | The Value of Intangibles |
| intensive and highly profitable - although I'm sure | | | | Intangible assets are often harder to reproduce |
| you could name a handful of such conglomerates. | | | | than tangible assets. |
| Some asset-light businesses have predictable | | | | There is a nearly infinite potential supply of new |
| returns on assets – not so much because | | | | plants and stores if a competitor wants to build |
| there is a strong correlation between assets and | | | | them - and they can usually be built at the same |
| earnings, but rather because there is the absence | | | | cost regardless of who builds them. |
| of disruptive change and some real protection | | | | Already, if a competitor wanted to reproduce the |
| from price competition. An example would be | | | | 1-800-PetMeds or GEICO brands, they would |
| McCormick (MKC) – a business that has a | | | | have to spend considerably more than those |
| fairly predictable ROA largely because it’s | | | | companies did, because both brands are fairly |
| simply a great business (albeit a slow growth | | | | entrenched within our minds - they've staked a |
| business). | | | | claim to the territory in our mind where we think |
| One of the greatest investing conundrums is the | | | | "pet meds" or "auto insurance". |
| fact that it is usually easiest to reinvest retained | | | | You can't reproduce those brands at the same |
| earnings at past rates of return in a poor business | | | | cost. Furthermore, in both of these cases, you'd |
| and hardest to reinvest retained earnings at past | | | | have to lose money or accept a much narrower |
| rates of return in a good business. | | | | margin while you did build the brand up. So, while |
| In other words, many of the least limited | | | | the barriers to entry may not be obvious, the |
| businesses tend to be the least profitable, and | | | | barriers to profitability and dominance are quite |
| many of the most profitable tend to be the most | | | | clear. |
| limited. That’s why you hear me talk so | | | | Both companies already own a little piece of your |
| much about “franchises” and | | | | mind. That’s valuable real estate – |
| “niches”. | | | | even if it doesn’t show up on the books. |
| I may not have played this point up as much as I | | | | Hidden Bargains |
| should have. But, if I were forced to invest every | | | | How does one parse the numbers to find these |
| dime I had in a single business and hold it for the | | | | hidden bargains? |
| rest of my life, the first characteristic I would | | | | There is no purely quantitative way of doing this. |
| look for is a business with virtually no need for | | | | Qualitative considerations loom large in any |
| maintenance cap-ex. | | | | estimate of cap-ex requirements, because the |
| The Pleasant Surprise | | | | nature of the business and the competitive |
| The pleasant surprise is finding that the GAAP | | | | position of the firm are key determinants of how |
| earnings are lower than the actual amount of | | | | effective new cap-ex spending is. |
| cash a 100% owner would be able to extract | | | | If you can't explain why one company spends |
| from the business, if he chose not to expand it | | | | less on cap-ex than its competitors, you have to |
| (via additional spending). | | | | assume the current skimping on cap-ex is not |
| A lot of companies have depreciation charges | | | | sustainable. |
| that adequately mirror maintenance cap-ex | | | | One important caveat though: many companies in |
| requirements. That isn’t to say the two | | | | the same industry are not competitors, and |
| items are necessarily the same amount; but, the | | | | therefore cap-ex comparisons between them are |
| extent to which they diverge from each other is | | | | of little use. For example, Strattec (STRT) and |
| not terribly specific to the business. The most | | | | Lear (LEA) both make auto parts. However, they |
| obvious reason for a major divergence is inflation. | | | | aren't competitors. Lear makes interiors; Strattec |
| Regardless, stocks with similar P/E ratios generally | | | | makes locks. |
| also have similar “owners’ | | | | The lock business is not the same as the interior |
| earnings” multiples. | | | | business. The industries aren't equally profitable |
| This isn’t true if the assets on the book | | | | and they aren't equally competitive. You have to |
| don’t really need to be replaced to | | | | analyze each business separately - just as you |
| maintain the same earnings power. Some | | | | can't lump (AMZN) and 1-800-PetMeds together, |
| businesses do have assets that need to be | | | | even though they both sell a lot of stuff on the |
| maintained (brand, technology, etc.) – but, | | | | web. |
| these assets are maintained as a part of daily | | | | Any consideration of cap-ex spending and how it's |
| operations and are not broken out as a separate | | | | really divided between "maintenance" and |
| item (it would be nearly impossible to separate | | | | "investment" has to begin with your assessment |
| “brand maintenance” from other | | | | of the nature of the industry in general and the |
| expenses anyway). | | | | specific competitive position of the company |
| The most conspicuous examples of such brand | | | | you're looking at. |
| maintenance are all the ads you see for GEICO, | | | | Then, you can start making cap-ex comparisons. |
| 1-800-PetMeds, etc. At least in these two cases, | | | | But, don't allow yourself to become unduly wed |
| there is no doubt such advertising creates an | | | | to the numbers. Bring your understanding of |
| economic asset that helps generate earnings in | | | | what's needed to maintain and expand the |
| future periods. | | | | particular business and what competitors are likely |
| Such spending is not treated as a capital | | | | to do (and the unintended consequences those |
| investment. Therefore, GAAP accounting tends to | | | | likely actions will produce). |
| exaggerate the actual cost of day-to-day | | | | Some industries are easy. Unless you have a |
| operations for these businesses and understate | | | | very special case, a steel company's cap-ex will |
| the amount of additional investment in the | | | | be determined by the long-term economics of the |
| business (both GEICO and 1-800-PetMeds are | | | | steel industry (which is not extraordinarily |
| heavily investing in future growth – | | | | profitable). You aren't going to find one company |
| it’s just that those investments | | | | that can skimp on capital spending - they all have |
| aren’t in the form of tangible assets such | | | | to ante up each round. |
| as a new plant). | | | | At any one time, the numbers for the last few |
| I’m sure it sounds like I’m taking | | | | years may not make this fact obvious, but you'll |
| quite a leap here. After all, there have been | | | | know it, because of the qualitative judgments you |
| businesses that argued for the amortization of | | | | bring to your analysis of any particular steel |
| certain operating expenses that clearly did not | | | | company. Just as your qualitative judgments |
| have much of a useful life. You may remember a | | | | about 1-800-PetMeds would have helped you |
| few such instances from the late 90s. However, a | | | | realize the low cap-ex spending there was |
| review of the past financials for PetMeds Express | | | | perfectly fine, because the real investment was |
| (PETS) illustrates my point. Since 2000, the | | | | the advertising. These are the things the numbers |
| company’s revenues have increased | | | | alone can’t tell you. |
| roughly tenfold while net Property, Plant, and | | | | |