3 Challenging Scenarios for Quality-Value Investors

One night a few weeks ago, I sketched out my investment philosophy in a “one pager” format. 

I found the process to be useful, so I shared it on Twitter before heading to bed, thinking others might give it a try themselves.

Tried my hand at a one-pager of my investment philosophy. Nothing revolutionary, but an enjoyable exercise. pic.twitter.com/gEklvqr96a

— Todd Wenning (@ToddWenning) September 1, 2017

In the morning, I discovered the post was going viral - at least FinTwit's version of viral. 

The feedback on the post was overwhelmingly positive, which, while appreciated, also made me a little nervous. A cheery consensus around a company or a strategy doesn’t lend itself well to outperformance.

That said, there’s a difference between prescription and practice. Advocating regular exercise is sound and non-controversial, yet the temptation to be remain sedentary can be hard to overcome.

Indeed, part of the motivation for doing the one-pager was to hold myself accountable and stay focused during a bull market when there's pressure to relax standards.

The one-pager isn't meant to be a magic formula of any sort. No company will check off all the boxes. Instead, it serves as a personal framework for evaluating businesses and investment opportunities.

Peeling back a layer

Most of the questions I received about the one-pager regarded the three highlighted sections below.

To be a “strong buy,” I want the company to have an economic moat, be managed by excellent stewards of shareholder capital, and trade at an attractive valuation. 

These opportunities are rare, to be sure, but it's good to know when you might have a "fat pitch" heading your way. 

The highlighted sections address three challenging - and comparatively more common - scenarios that quality-value investors encounter.

In each case, two of the three requirements are present, but one is missing. Here, I’ll address the problem, pitfall, potential, and process for analyzing companies within the three scenarios.

“Quality at any price” (Moat and Management only)

• Problem: Great companies don’t always make great investments.
• Pitfall:  Even if the underlying business performs well, if the company doesn’t live up to high market expectations, you’re in for a bumpy ride. Consider an investor who bought shares of Wal-Mart in September 1999 when the stock traded with a price-earnings ratio over 30 times. Though Wal-Mart as a business grew earnings and dividends per share at an impressive rate over the next decade, the stock price didn't fully follow suit because the business performance wasn’t enough to match lofty initial expectations. Formidable competitors like Costco, Target, and Amazon were also chipping away at Wal-Mart's competitive position. Ultimately, Wal-Mart's price-earnings multiple contracted and the 10-year total return was about 2.4%.
• Potential: Investors can underestimate optionality in a well-run business. Those that considered Amazon, Facebook, or Google wildly overvalued early in their public market histories, for instance, didn’t foresee the new opportunities these businesses would create or discover in the subsequent years. Similarly, firms with existing moats may look expensive now, but if management can further widen the moat, today's price may look cheap in hindsight. 
• Process: Don’t rely solely on relative valuation and market multiples. Instead, make explicit forecasts to determine what the market price might imply. Then, consider whether or not you think management is capable of beating those expectations by introducing new products, entering new markets, becoming more efficient operators, or adding new lines of business.

“Beware quality traps” (Moat and Price only)

• Problem: The market knows something you don’t.
• Pitfall:  Though the stock's premium may have diminished, there could be good reason. The company’s legacy moat could be under assault by new and motivated competition or a disruptive technology. If management is incentivized to protect the old cash-flow-rich operations or if the corporate culture is bureaucratic and stagnant, there could be further to fall. Kodak is a classic example – a former blue-chip darling that had a dominant market position, saw the coming of digital photography in plenty of time, but its culture refused to embrace the change.
• Potential: A management transition could lead to cultural change, which could reinvigorate the business and make it more competitive. To illustrate, a positive cultural change happened at Sealed Air after the board brought in a new executive team following the controversial $4.3 billion acquisition of Diversey in 2011. In the twelve months following the deal's announcement, Sealed Air's stock price dropped about 60%. Despite the poor M&A decision by prior management, Sealed Air (makers of Bubble Wrap) and Diversey still had some durable competitive advantages. The new management team overhauled the corporate culture and got the company back on solid footing.
• Process: Ask yourself if the company has a culture of innovation and change. Could a new management team realistically step in or is the board too close to the CEO and CFO? Review management’s incentives and the board structure and determine whether or not they have enough skin in the game to want to improve operations.

“Avoid turnaround traps” (Management and Price only)

• Problem: Even excellent capital allocators can struggle to fix a broken business.
• Pitfall: Turnarounds have low odds of success. Ultimately, management facing such a situation needs to identify a potential moat source and attack it full force. Then, hope for a lucky break or two. When there are massive secular headwinds in place, this becomes a near-impossible task, even for great management teams. Eddie Lampert at Sears Holdings is a good example. Lampert has done a remarkable job playing a tough hand, but the long-rumored turnaround has struggled as department stores face immense competitive pressures from changing consumer tastes and from online retail.
• Potential: When turnarounds happen, the rewards can be enormous. Steve Jobs' second stint at Apple is one of the best – if not the best – turnaround story of our generation. Though the full story is more complex than this, what Jobs did was make Apple (traditionally a beloved niche personal computer maker) into a premium global consumer brand, starting with the iPod and later the iPhone and iPad. Jobs' efforts, along with the rest of Apple's staff, spawned a brand (intangible asset) advantage that, when paired with the switching costs created by the iTunes platform, led to a solid economic moat.
• Process: Is management facing secular headwinds in their core operations? Are industry dynamics stable and asset growth slow or is capital flooding the industry? Does management attempting a turnaround have to reckon with a debt-laden balance sheet or an under-funded pension plan? 

Bottom line

Rarely will the stars align so that management, moat, and price are all clear and a strong buy is evident. Much more frequently, quality-value investors must wrestle with one of these three scenarios where one factor is missing - or at least isn't obvious. 

As such, it's helpful to approach the scenarios with both the pitfalls and potential in mind. Weigh the pros and cons, make a decision, and then be patient!

Stay patient, stay focused.

Best,

Todd

The opinions expressed here are the author's and not those of his employer. Todd's family owns shares of Amazon and Costco. For a full disclaimer, please click here. 

Moats & Knights, Part Deux

In December, I wrote about the rare and powerful "moat and knight" combination - a company with a defensible competitive advantage led by top-notch capital allocators. 

Since coming across that concept a few years ago, I've wrestled with the relative importance of the two factors. What's more important: moat or knight?

In a recent post, my former office mate at Motley Fool UK, Maynard Paton (who you should follow), paralleled my current thoughts on the subject quite well:

Years ago I used to believe that traditional business ‘moats’ — such as brands, patents, regulations, economies of scale, network effects, and so on — were the most critical feature of any investment . 

But these days, such ‘barriers to entry’ appear increasingly at risk of being challenged by intrepid startups that can use the Internet to gain customers much more quickly than ever before. This investment paper cites a good example of Gillette and Dollar Shave Club. 

Over time then, I have become far more convinced about the importance of management to an investment. 

Put simply, I’d like to think a business is more likely to enjoy long-term success — and fend off intrepid startups — with a loyal and committed executive at the helm. 

(Indeed, a company’s positive and adaptive working culture — instigated by a loyal and committed boss — can in itself be a difficult-to-replicate ‘moat’.) 

On the other hand, I am no longer so sure about professional ‘salarymen’ executives, who may be quite happy to run things in a customary way and risk becoming complacent when it comes to fresh competition.

Spot on.

There was likely a time when the advice to "go for a business any idiot can run" made sense. Find a wide moat business and be patient. All management had to do was look the part and not screw things up too badly.

That time has passed.

Today's raiders have new siege weapons and it's critical to have a knight - or ideally, a number of knights - implementing nimble defenses.

Run away! Run away!

This isn't to diminish the importance of economic moats - a knight defending a grass hut doesn't do anyone much good - but it is worthwhile to spend more time considering who is manning the ramparts.

Here are five questions you can ask about management before making your next investment.

1. Has management been forthcoming about competitive challenges or do they downplay the threat of new entrants?
2. Does management have the right financial incentives in place or has the board set up low hurdles to make sure large bonuses are realized, regardless of performance?
3. Does management know what the company's advantages are and have plans in place to extend and strengthen those advantages?
4. Does management have meaningful personal ownership in the business (and thus have skin in the game) or are they akin to mercenaries? 
5. Does management have a track record of sacrificing short-term results for long-term results or do they seem to play the quarterly earnings game?

Stay patient, stay focused.

Best,

Todd

Related posts:

• Considering Management's Capacity to Suffer
• 5 Signs of a Good Annual Report
• Don't Overlook This Factor in Your Research Process

The opinions expressed here are the author's and not those of his employer. For a full disclaimer, please click here. 

Moats and Knights

One of my favorite Warren Buffett quotes is a lesser-known one. It comes from a transcribed conversation he had with University of Maryland MBA students back in 2013, where he was asked about Morningstar's work on economic moats. 

Here's part of what he said:

If you have a castle in capitalism, people are going to try to capture it. You need 2 things – a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle. 

Buffett disciples should be well familiar with his economic moat philosophy, but this was the first time I heard him use the metaphor of a "knight" widening the moat.

It's a great concept, isn't it? But this ideal combination of moat + knight is rarer than you might think.

First, the presence of a true economic moat is by definition an infrequent occurrence in capitalism. Right off the bat, then, we can eliminate a majority - 75%-plus - of companies from moat + knight contention.

Second, let's think about what Buffett means by "widening the moat." He lays out his definition in the 2005 Berkshire letter to shareholders:

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. 

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. 

This is a tall order for any executive to achieve - delight customers, cut costs, all while investing in the business - particularly when that executive has to meet Wall Street's quarterly expectations. Focusing on short-term operational performance is one thing, but if a CEO or CFO is overly concerned about how investors might react to 90 days worth of performance, they aren't concurrently focused on widening the moat.

Unfortunately, that eliminates even more companies from moat + knight contention.

Third, management must be in it for the long haul and they must love the business. Note that in the above quote, Buffett is talking about building a stronger business decades from now. In stark contrast, there are far too many mercenary executives today with great resumes who are in their roles to maintain the status quo, collect big paychecks, get a car allowance and country club membership, and look the part. Executives with one eye on the door do not make good knights. Or squires for that matter.

One of my favorite college basketball players growing up was Xavier University's Brian Grant, who was drafted by the Sacramento Kings in 1994. I remember reading that when Grant was asked how much he wanted to be paid, he said $2.50, "enough for a Dr. Pepper and a bag of chips." The guy just wanted to play basketball at the highest level*. If you find that kind of passion in a CEO or CFO, you might have found yourself a knight.

Finally, management must have a knack for capital allocation. I've been fortunate in my career to speak with a lot of different companies and I've learned that the ones who truly "get it" regarding capital allocation are few and far between. Sure, there are plenty of teams that can keep the trains running on time (and plenty who can't!). The ones who have a clear and repeatable process, however, for reinvesting capital (internally or through M&A), returning cash to shareholders, and making their companies tougher to compete with are unusual.

So what are we left with? Maybe 5% of all companies having a moat + knight combination? It might even be lower than that. Whatever the rate may be, the key takeaways are:

1. The moat + knight combination is a powerful one.
2. Moats are rare.
3. Knights are rare.
4. Moats + knights are extremely rare. 
5. When you think you've found a moat + knight combination trading at a reasonable price, be sure to capitalize on the opportunity.

Stay patient, stay focused.

Best,

Todd

@toddwenning 

*Despite his low first offer, Grant made $808,000 in 1994.

The opinions expressed here are the author's and not those of his employer. For a full disclaimer, please click here. 

Lessons From Buffett's Tesco Mistake

As I read through the 2014 Berkshire Hathaway letter last weekend, one section stood out to me as being full of great investing lessons.

Here's the passage: 

Attentive readers will notice that Tesco, which last year appeared in the list of our largest common stock investments, is now absent. An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling.

At the end of 2012 we owned 415 million shares of Tesco, then and now the leading food retailer in the U.K. and an important grocer in other countries as well. Our cost for this investment was $2.3 billion, and the market value was a similar amount. 

In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.) 

During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives. 

While it was nice to hear Buffett's thoughts on his mistake with Tesco, I was surprised that he started the story at year-end 2012, as it's important to consider the full timeline of the investment.

Buffett started his position in 2006 and owned 3% of the company by the end of that year. At the time, Tesco was led by CEO Terry Leahy who, over a 14-year tenure, more than quadrupled the company's pre-tax profits and its store count. The company set its sights on international expansion in the U.S. and Asia and established a dominant share of the U.K. grocery market. Things were looking up for the business.

In June 2010, however, Leahy surprised the market by announcing his retirement. He was replaced by lifelong Tesco employee and head of international operations, Phil Clarke. 

Tesco struggled over the next eighteen months, as the U.S. operations floundered and U.K. discount grocers began chipping away at Tesco's market share on its home turf. And despite a profit warning after a bad 2011 Christmas trading season, Buffett increased his stake in Tesco to 5.2% in January 2012. Many observers, including yours truly, thought that this investment amounted to a vote of confidence in Tesco management and its business prospects. 

Around the same time, however, Neil Woodford, a well-known UK fund manager, announced he had sold his entire Tesco stake after owning shares for the better part of 20 years. He also laid out a compelling case for why Tesco had lost its way, wasn't practicing smart capital allocation, and was battling structural headwinds.

I point this out to illustrate that there were some well-founded and known concerns about Tesco's management and competitive advantages -- two core components of Buffett's investment philosophy -- in early 2012. I would be interested to know at what point between his increased investment in 2012 and when he began to "sour" on management in 2013 that Buffett began to rethink his Tesco thesis. 

Here are some of the key lessons I take from Buffett's Tesco mistake:

• Every investor makes mistakes. Even Buffett. The key is to recognize them, correct them as quickly as possible, and learn from them. 
• CEO changes matter. When a very successful CEO retires or leaves a company, it's time to reassess your investment thesis. Specifically, it's important to figure out the quality of the hand the new CEO has been dealt (i.e. how strong is the business?) and the skill with which the new CEO can play the hand (i.e. how strong is the CEO at capital allocation?) 
• Doing nothing is doing something. It's important to be patient, of course, but even though you may not be buying or selling a stock, you're still making an active choice to hold. If you have concerns about key points in your thesis, doing nothing and hoping the problem goes away on its own isn't a good strategy.

Related posts:

• Top quotes from the 2013 Berkshire letter
• Learn to love your investing mistakes
• Why I sold this dividend stock for a loss 

What I've been reading this week:

• Takes on the 2014 Berkshire letter - Cullen Roche, Interactive Letter (WSJ), Epicurean Dealmaker, Monevator, 25iq
• Revisiting a thesis on Constellation Software and a missed opportunity - Valueventure
• Scarcity - Reformed Broker
• Remembering 109-year old investor Irving Kahn - Telegraph
• The blind forecaster - Morgan Housel
• How the driverless car could impact the insurance industry - WSJ
• The man who could own Aviva France - FT Alphaville
• Competitive advantage and annual letter - Matt Brice
• There are no guarantees when it comes to life (or investing) - Abnormal Returns
• A trust that's held the same stocks for 80 years - ValueWalk

Stay patient, stay focused.

Best,

Todd


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Don't Overlook This Factor in Your Research Process

"Culture is not the most important thing. It's the only thing." - Jim Sinegal, Costco co-founder & former CEO

When was the last time you read a stock report that included a discussion of the company's culture?

I bet it's been a while.

Perhaps part of the reason for this is that investors as a group prefer to focus on the quantifiable factors that can be entered into our spreadsheets - earnings, free cash flow, return on equity, etc.. More qualitative factors like culture are often unfairly dismissed as fluff.

Another reason could be that when we hear the term we associate it with the dull and lifeless, Office Space definition of "corporate culture."

And remember, next Friday is Hawaiian shirt day

Whatever the reasons why we tend to overlook corporate culture in our research process, we're doing ourselves a disservice by ignoring it. That's because, when a vibrant and authentic culture complements a company's durable competitive advantages, it can yield great results for shareholders.

Aligned interests

An example of a company with a great culture in my own portfolio is U.K.-based insurer, Admiral Group (ADM.L), which prides itself on being a low-cost operator. Indeed, in 2013, its U.K. business's expense ratio of 15% was about half the market average. It's true that there are other, more operational factors that anchor the company's low-cost advantage, but Admiral's culture also strengthens it in a number of ways.

For one, Admiral is frequently voted one of the top employers in the U.K. and in other markets in which it operates. By making it a fun place to work, the company attracts top talent and keeps costly employee turnover well below its competitors' attrition rates. Further, each employee - regardless of pay grade - has received £3,000 of free shares each year since the company went public in 2004. All else equal, employee-owners of the business should care more about cutting expenses than employees who only collect a paycheck. No one washes the rental car, after all. 

One of my favorite anecdotes about Admiral's low-cost culture is that when it opened its first U.S. office in 2009, employees were required to do a push-up in view of the CEO's desk whenever they used the printer so as to keep paper costs to a minimum and encourage employees to first consider cheaper alternatives. 

All adds up

To some, these may seem like nice-but-ultimately-inconsequential items, but as Buffett pointed out in his 2005 letter to Berkshire shareholders, the little things that companies do each day matter over time:

If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength...On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.  

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as "widening the moat." 

Culture matters precisely because it enables these small actions and can thus have a tremendous impact on a company's competitive position. Companies like Costco, Whole Foods, and Southwest Airlines have leveraged their unique corporate cultures to stand apart and build brand loyalty in highly competitive industries. Suffice it to say that patient investors have also done quite well with these companies.

Click to enlarge

As long-term, business-focused investors ourselves, it's well worth our time to consider culture as part of our regular research process and how it may contribute to - or, in cases of a poor culture, even detract from - the company's ability to create shareholder value for years to come.

Related posts

• The Difference Between a Good Company and a Great Company
• Philip Fisher's 15 Points to Look for in a Common Stock
• A Simple Formula for Investing Success

What I've been reading/watching this week:

• Robert Vinall's latest shareholder letter (always a great read) - RV Capital
• If you can easily name ten of a company's competitors, don't invest in it - Sova Group
• The truth about investing - Mortality Sucks
• Buy low and then buy higher - MicroCapClub
• Keynes: A great investor who probably would have been fired today - A Wealth of Common Sense
• The first casualty of a bear market - Reformed Broker
• Mindfulness, meditation, and investing - Abnormal Returns
• Is active investing a zero sum game? - Monevator
• Pat Dorsey discussing economic moats at Google - YouTube
• Maybe you should invest in boring companies - MarketWatch

The book I'm currently reading:

• The Last Lion: William Spencer Churchill: Visions of Glory (1874-1932)

Stay patient, stay focused.

Best,

Todd

3 Components of Multi-Bagger Success

Earlier this week, I was searching for the recent Charlie Rose interview with Peter Lynch and stumbled across an incredible 1990 interview that featured both Peter Lynch and Sir John Templeton.

As you can imagine, there are a number of great quotes from the interview and some of the investor concerns at the time -- high government debt, weak leadership in Washington, etc. -- reminded me a lot of today. The audio/visual is a bit grainy, but I'm just happy someone had the foresight to record this on VHS and then was gracious enough to share it on YouTube. It's well worth a watch.

What I was originally after when searching for the Charlie Rose/Peter Lynch interview was the following quote from Lynch about investing for multi-bagger opportunities (i.e. stocks that go up many-fold in value).

You want to get in in the first, second, third inning, not when they're drawing up the line-up...you could have bought Wal-Mart 10 years after they went public and they would have went up 50 fold.

There are three key takeaways from this quote:

1. Before investing in a smaller company, make sure the company has a viable business model
2. It's even okay if you're a few years late to the game as long as there's a lot of game left to be played
3. You have to be patient to reap large rewards

In the 1990 interview, when asked how investors should begin to research stocks, Lynch said investors should first make sure the company has sales and profits. The audience laughed, but Lynch was half-serious. 

Too often investors are after the "next big thing" when they're investing in small companies -- whether it be renewable energy, e-commerce, cloud computing, etc. -- and don't check to see if the company with a great story also has a viable business model. There's no point in investing in any company before it's proven its strategy.

To Lynch's second point, even if you recognize the company's promising business model a few years late, as long as the company continues to have a long growth runway, there's still an opportunity to buy. 

This is something that I myself need to put into practice. I've watched a number of promising companies -- Tractor Supply in early 2009 being the most prominent -- run away from me after I did all the research but missed the original opportunity and thought I'd missed the boat.

Great companies with long growth runways don't come along often. If you think you've found one early in its growth cycle, don't be afraid to take a chance.

The final component of Lynch's multi-bagger strategy is to be patient. There's a gem of a quote from the 1990 interview where Lynch says, 

My best stocks have been the third year, the fourth year, the fifth year I've owned them. It's not the third week, the fourth week. People want their money very rapidly, it doesn't happen.

It's easy to get this point confused in markets like we've had over the last two years where volatility has been low and stocks only seem to go up. I think this is part of the reason that retail investors are only now coming back into stocks following the financial crisis -- they see easy money being made and they don't want to miss out. If you want to benefit from a multi-bagger investment, it's absolutely essential to be patient and expect to hold for a number of years. 

Bottom line

Some investors will prefer to avoid swinging for the fences and focus entirely on getting base hits, and that's totally fine. If you are going to swing for the fences, however, Lynch's three-pronged strategy for multi-baggers is the best approach in my opinion.

Will Lynch's strategy always work out? No, not always, but one early investment in a Wal-Mart, Apple, etc. that was patiently held could have more than made up for the investments that didn't go to plan. Something to keep in mind. 

Good Reads this Week

• How to Get Rich, Feel Rich, and Stay Rich - Morgan Housel
• Decoding Mutual Fund Brochures - Reformed Broker 
• Floating Rate Bonds as a Hedge Against Rising Interest Rates - Monevator
• 12 Steps to Fix Your Firm's Investment Committee - Ann Marsh 
• The 180 Rule and Shorting Stocks - Dasan

Quote of the Week 

The main thing that people need to learn is that selecting assets is totally different from almost every other activity. If you go to 10 doctors and they tell you the same medicine that's the thing to take, if you go to 10 engineers to build a bridge that's the bridge but if you go to ten investment advisors and they pick out the same asset you better stay away from it. - Sir John Templeton

Best,

Todd
Follow @ToddWenning

Use the Market's Short-Termism to Your Advantage

Here's a general criticism that I often hear about investing in companies with economic moats:

Companies with economic moats always look expensive and they trade with premium multiples to the market. How can we invest with a suitable margin-of-safety and generate superior returns if we're consistently buying expensive stocks? 

It's a fair criticism. Indeed, companies that can consistently out-earn their costs of capital should trade with premium multiples and frequently do. In bull markets such as this one, quality doesn't come cheap and good moat-buying opportunities seem far and few between.

But here's the key thing to remember -- economic moats affect value in the long-term while the market's focus is on short-term results.

Why does this matter? Because if we're patient investors -- and if you're reading this blog, you're probably in this camp -- we only need to wait for the market to overreact to some short-term news (a bad quarter, etc.) that doesn't impact the company's competitive position and then look to capitalize on the opportunity. In other words, use the market's short-termism to our long-term advantage.

Opportunities to buy quality companies at good prices do present themselves over the course of the business cycle -- and purchasing premium companies at market average prices is a strategy I'll gladly endorse.

Best,

Todd
@toddwenning

How to Find a Good Dividend Growth Stock - Part 3

Over the last two weeks, we've been searching for promising dividend growth stocks that trade on the U.S. markets. Our original objective was to identify "quality dividend-paying small- to mid-cap companies with sustainable competitive advantages and the potential for 7%+ annual dividend growth over the next 7-10 years."

After running a broad screen to reduce the number of initial contenders, we put six companies through the Dividend Compass spreadsheet to get a better feel for the health of the companies' dividends. 

Of course, all of that work was based on historical data. Today, we'll dig deeper into the two finalists -- MTS Systems and WD-40 Company -- to determine how those names might perform going forward. Further, the research we've already done shows that both companies have solid balance sheets, are consistent generators of free cash flow, and have established good dividend track records. As such, we won't spend too much time digging into those data points today.

Instead, we'll look at the two companies' competitive advantages (if they indeed exist), management quality, and consider their current valuations to determine whether or not they're worthy of investment right now.

The finish line is in sight

After digging into WD-40 and MTS this week, it's clear that the screening and Dividend Compass process uncovered two promising companies. Indeed, they check off a number of Peter Lynch's 13 signs of a perfect stock. Among them: little analyst coverage (officially, MTSC has two analysts, WDFC has four analysts), they each have a niche, and the companies are buying back stock (though this isn't always a great thing, in my opinion).

As with most endeavors, the hardest part of the investing process is the last stretch. Most investors go through the screening process and read historical financial statements. Where you can separate yourself as an investor is in this last stretch of research -- digging for the qualitative factors and getting a feel for valuation.

MTS Systems (MTSC)

What does the company do? 

MTS Systems supplies test systems and industrial sensors to a number of end-markets such as the automotive, aerospace, fluid power, and manufacturing sectors (i.e. mostly cyclical industries). About 80% of revenue comes from the test segment, which designs force and motion systems for determining a new product's mechanical properties; MTS commands a 16% market share of the global testing product and service industry. The sensors segment helps customers improve the efficiency and safety of their automated manufacturing processes and also measures fluid displacement and liquid levels; MTS has a 6% share of the global sensors market. 

Source: MTS

MTS also has a wide geographical reach, with an established presence in the world's major manufacturing centers.

Source: MTS

Does it have sustainable competitive advantages?

Historical financials seem to suggest that MTS has a sustainable competitive advantage. It may lie in the "mission critical" nature of its products. Firms investing many millions of dollars in large industrial products simply cannot afford to forgo strenuous mechanical and fatigue testing before rolling the new product out to customers. The warranty or recall risk from a flawed piece of equipment may well outweigh the testing cost. Further, some products may be required to undergo such testing due to government regulation. But these could simply be industry-level advantages rather than a specific advantage to the firm. 

Where MTS may set itself apart is with its established brand and reputation in the industry for doing quality testing, particularly for larger-scale projects. I'd imagine that most smaller-scale product testing can be done internally and that the competition for smaller-scale projects is pretty fierce. Larger-scale testing projects can last up to three years, however, and there are probably only a few companies that can handle such work -- MTS being one of them -- and customers are unlikely to switch providers halfway through the testing period. As such, I'd say MTS has a slight advantage stemming from switching costs for larger projects, but the depth of the moat will fluctuate along with demand for these larger-scale projects. 

How about management?

The MTS leadership team is relatively new, by which I mean less than two years in their roles. It seems a few years ago that the company got in a little trouble regarding some disclosure items relating to government contracts. This appears to have been one of the primary drivers behind the August 2011 resignation of the former CEO and the re-shuffling of the executive suite. Such dramatic moves are necessary when there's been an ethics issue, but it also likely means that the company will be in transition mode for a few years. Unless you know a lot about the new management team (I don't) and the effect the changes are having at the ground level (again, I don't), it's hard to make a bold turnaround call (so I won't).

Short-term cash bonus metrics are based on EPS, EBIT, revenue, and orders. Not my favorite set of metrics, but not terrible given that MTS remains squarely in the growth stage of its lifecycle. In time, I'd prefer to see less emphasis on top-line growth and more emphasis on free cash flow and profit growth.

Biggest concern? 

With 40% of testing orders coming from Asia, I have some concerns regarding the Chinese economy -- specifically, how the shift from an investment- and manufacturing-driven economy to a customer-driven one may affect demand for MTS's testing services in the region. MTS aims to double its revenue to $1 billion by 2018 and robust demand from the Chinese market will likely be necessary to achieve that goal. 

Is it a good buy today?

MTS's average return on equity over the last five years is about 18% and its dividend policy is to pay out approximately 30% of earnings, implying a back-of-the-envelope sustainable growth rate of between 12-13%. Not bad against a P/E ratio of 18.6 times (~1.5 PEG), but not a slam dunk, either. 

Doing some DCF work on MTS with a range of reasonable growth assumptions, I'd put a base case fair value near $60 per share, which is in-line with today's market price. I'd need a margin-of-safety of at least 20% with this type of business, so a good entry point might be closer to $48. 

MTS is definitely a good one to watch in the event of a market pullback and there's significant dividend growth potential, but given my uncertainty around its sustainable competitive advantages and a newer management team, I wouldn't make it more than 2% of my portfolio.

WD-40 Company (WDFC)

What does the company do? 

Anyone who's spent time in a garage, fixing squeaky hinges around the house, or worked on bicycles has likely used a WD-40 product. In fact, the vast majority of the company's revenues are based on the original WD-40 formula (WD-40 stands for “Water Displacement perfected on the 40th try”) and the company's documented over 2,000 uses for the secret formula. The company also owns a number of related consumer/industrial cleaning products such as Lava soap and X-14 mildew stain remover. Its products are sold in 187 countries, so the company does have a wide geographic reach (about 40% of sales are U.S.-based).

Does it have sustainable competitive advantages?

For starters, the WD-40 brand name is extremely valuable. I can't even name a substitute product. It's a trusted brand, can charge a premium price, and I'd even argue that there's a slight emotional connection to the brand (i.e. "this is the brand that my dad always used in the garage"). Beyond the brand, the company's ability to build upon a single secret formula and create multiple products is an example of economies of scope. This results in a cost advantage that would-be competitors would struggle to match if they attempted to go head-to-head with WD-40 on a certain product line. 

Source: WD-40

The company's ability to consistently generate double-digit returns on capital is another indication that an economic moat is likely present. Finally, another telling statistic: in 2012, WD-40 generated nearly $1 million in revenue per employee. I like to see at least $250,000 in revenue per employee, so this is definitely a sign of a strong company. 

How about management?

One thing that I really like about WD-40's management team is that all seven corporate officers been with the company for more than 15 years. My personal preference is for the companies I own to promote from within and to have a deep bench of talent in the event an executive leaves or retires. This is particularly true for a company with a strong corporate culture, as it supports cultural continuity. Now, a company with a rotten corporate culture may need to hire an outsider to shake things up, but all else equal I prefer internal promotion in the executive suite. 

CEO Garry Ridge has been with the firm since 1987 and the CEO since 1997. During his tenure, the stock is up 319% cumulative, or about 9.2% annualized, compared to a 200% gain, or 6.9% annualized, for the S&P 500 over the period. The stock's also outperformed the S&P 500 by about 40 percentage points over the last five years. All this is to say that long-term shareholders should be fairly happy with the way the company's performed under Ridge's leadership. WD-40 also keeps the chairman position separate from the CEO role, which is textbook best practice for corporate governance. 

I'm not crazy about management's bonus incentives, which are primarily linked to EBITDA. EBITDA is one of my least favorite financial metrics (Buffett called trumpeting EBITDA a "pernicious practice" in the 2002 letter; Munger called it "(expletive) earnings") because interest, taxes, and depreciation are natural and recurring shareholder expenses that shouldn't be ignored. I could rant on about EBITDA, but I'd much prefer this otherwise high quality company to use more shareholder-focused incentive metrics such as net income, free cash flow, and/or economic value added (EVA).

Biggest concern? 

A potentially limited growth runway. With its products already in 187 countries and a sizeable portfolio of products already built around the WD-40 brand, what will drive top-line growth in the medium-term? I have no doubt that consumers will continue to buy WD-40, but can the company deliver high-single digit/low-double digit earnings growth without becoming more active on the M&A front? 

Is it a good buy today?

WD-40's consistency and high quality hasn't been overlooked by the market and the stock has historically traded at a premium. WD-40's five-year average P/E is 19.1 times versus 17.2 times for the S&P; today it's trading at 22.7 times. Not exactly cheap on that basis. But what about growth? Based on the company's five-year average return on equity near 19% and its dividend payout ratio near 50%, the "sustainable growth rate" is about 9-10%. An implied PEG ratio near 2x isn't great, either. Its current dividend yield of 2.1% is also well-below its five year average closer to 3%. 

Running a quick valuation on WD-40, I put a fair value on the shares at $52 (currently $58.52). I'd look to buy with at least a 15% margin-of-safety, so a good buy-around price today would be $44. 

I really like WD-40 as a company. Hopefully the EBITDA-based incentive metrics go away, but otherwise I'd be happy to own WD-40 in the event of a market pullback. Ideally, I'd like to pick up the stock with a yield closer to 3%, which is about what I'd get if the stock traded near $44. 

Bottom line

MTS Systems and WD-40 are both intriguing dividend growth candidates, but neither appears to be a good value at the moment. MTS has more dividend growth potential than WD-40, but also carries more risk. 

All in all, I think this was a worthwhile exercise. We dug into two promising dividend growth opportunities and now have two good names to keep on our watchlists.

What do you think? Please let me know in the comments section below. Note: I switched the comments format back to the normal setting as the Google+ format was simply not working well. You can also reach me @toddwenning on Twitter.

Other posts in this series:

How to Find a Good Dividend Growth Stock: Part 1
How to Find a Good Dividend Growth Stock: Part 2

How to Find a Good Dividend Growth Stock: Part 3

Thanks as always,

Todd

@toddwenning

5 Ways to Avoid Permanent Losses

Earlier this week on Twitter, Carl Richards (+Behavior Gap) -- who you really should be following if you're not already -- started an interesting conversation about investing and risk:

As Homer Simpson would say: "It's funny 'cause it's true." And for two reasons. First, and most obviously, because statistics can be confusing and second because the industry's statistical definition of risk is too academic and doesn't get at the root of what keeps investors up at night.

Finance textbooks and trading models might define risk in statistical terms based on volatility, but such definitions are incomplete for patient, business-focused investors.

If we've done our homework, purchased a stock at a good price, and remain confident in our thesis, how the quoted stock price moves on a day-to-day or month-to-month basis shouldn't be of any concern. You'd be hard pressed to find an investor who cared about the following type of volatility:

Different definition

Instead, what long term investors are really concerned about is permanent loss of capital. As the name implies, a permanent loss of capital differs from a temporary loss of capital that's due to market volatility and it occurs when an investment's value has declined so much that getting back to break-even within a few years is unlikely. Effectively, an unrecoverable loss.

As the following table shows, when a stock loses 40% or more of its value, it takes a substantial recovery to get back to even:

To put this in some perspective, consider a 50% paper loss on an investment. While it's certainly possible for the stock to stage a huge recovery and double in value over the next year, if we assume historical equity returns of 9% per year, it would take about eight years for the stock to get back to even on a nominal basis.

Though you might patiently wait for this to happen, that investment from eight years prior was in essence wasted capital that could have been invested more effectively elsewhere.

How to avoid such a fate

Invest long enough and you'll have a permanent loss of capital at some point. It's bound to happen as we're all human, but it's critical to make large losses infrequent events as they can seriously weigh on your portfolio's long-term returns.

Here are five things you can apply to your investment process to reduce the likelihood of permanent losses of capital:

1. Buy with an appropriate margin of safety. This may seem obvious -- buy a stock for less than it's worth and you'll reduce the odds of permanent losses -- but (a) we as investors are prone to buying into stories, individual attributes (high yields, low PE, etc.), or a hot tip and fully disregarding valuation and (b) when we do adequate valuation work we often make inappropriate margin of safety assessments before buying. 

What I mean by the latter point is that we should demand a larger margin of safety when buying a business with a higher degree of uncertainty and vice versa. It's one thing to buy a large cap defensive company like Coca-Cola with a 10% discount to fair value, but a 10% margin of safety isn't likely enough for a small-cap stock in a cyclical industry. You're more likely to lose your shirt feeling too confident in your assessment of the small-cap's value than you are of Coca-Cola, so a larger margin of safety is required.

2. Use a checklist. Online investing and low-commissions, as great as they are, also cater to impulsive decision-making. It's easy to read a few company filings, get excited about what you're reading, and press the buy button. As a check on your emotions, make use of an investing checklist (like this one) before placing a trade. If the latest idea doesn't check off all the boxes on your list, figure out why that's the case. There could be a good explanation, but if there's not, consider passing on the idea for now. 

The important point here is that checklists can save us from making stupid decisions based on emotion. For more checklist ideas, +Stockopedia has a great set of checklists based on different styles of investing.

3. Ask the right questions. Before buying a stock, fully consider alternative theses and perhaps more importantly what other bulls are thinking, as this can save you from missing giant red flags and blindly following the herd. In other words, we need to ask different questions than our fellow market participants if we aim to make good investments and avoid permanent losses of capital. 

Howard Marks of Oaktree Capital calls this "second-level thinking". In his book The Most Important Thing, he provides the following example:

First-level thinking says, "It's a good company; let's buy the stock." Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell."

Each investment will have specific questions to ask, but if you're looking for a good place to start, here's my list of five questions to ask before buying a stock.

4. Focus on trends in competitive advantages. The market has become incredibly focused on the short-term. For example, the average stock mutual fund turnover rate have jumped from an average of 17% between 1945 and 1965 (implying an average holding period of about five years) closer to 100% today (implying an average holding period of about one year). Naturally, then, market participants seek short-term information advantages -- e.g. "Will this company beat next quarter's consensus estimates?" -- at the expense of gathering helpful long-term information.

In his book More Than You Know: Finding Financial Wisdom in Unconventional Places, Michael Mauboussin notes:

My fear is that much of what passes as incremental information adds little or no value, because investors don't properly weight information, rely on unsound samples, and fail to recognize what the market already knows. In contrast, I find that thoughtful discussions about a firm's or an industry's medium- to long-term competitive outlook are extremely rare.

Spend more time in your research process thinking about where this company might be three- to five-years from now. A simple way to get started is with a "SWOT" analysis -- listing the company's strengths, weaknesses, opportunities, and threats. Then ask how the company might enhance its current strengths, reduce its weaknesses, capitalize on opportunities, and respond to competitive threats.

5. Avoid cult stocks & sectors that are in the market spotlight. Jason Zweig had a great post for the WSJ this week on his mission to save investors from themselves by helping them avoid speculative periods in the market. Also the commentator on the revised edition of Benjamin Graham's Intelligent Investor, Zweig has the rare ability to spot market irrationality and stand behind his convictions even when they're not popular at the time.

The perennial refrain from critics is: You just don’t get it. Internet stocks / housing / energy prices / financial stocks / gold / silver / bonds / high-yield stocks / you-name-it can’t go down. This time is different, and here’s why.

But this time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor. (My emphasis)

Bingo. Can't say it any better than that. Consistently follow this advice and it will help you avoid permanent losses of capital.

Bottom line

The best definition of risk for long-term investors isn't volatility, but permanent loss of capital. Every investor will have permanent losses over his or her investing career, but the key is to minimize their frequency. Hopefully these five suggestions will help you avoid some of them. 

Good reads/videos this week:

• Howard Marks on the proper definition of risk (a must-read)
• The aforementioned Carl Richards on avoiding behavioral investing traps (video)
• Michael Mauboussin on the roles of skill and luck in investing (video)

Have a great weekend!

Best,

Todd

@toddwenning