Phil Town

M is for Management

One of the toughest jobs we have as investors is to choose a good management team to invest in.  Picking the jockey can be as important as picking the horse. 

A Rule #1 investor does it with passionate, honest, self-effacing - people who are committed to the business over themselves. Think Steve Jobs at Apple.  Well, except for the self-effacing part.  So think the CEOs running virtually all of Buffett's private companies.  They are all rich, but they keep working hard because they love their businesses. 

A great example of a bad example is Rick Wagoner at GM.  I've never met Rick.  He played b-ball at Duke.  Who knows, maybe I'd like him.  Maybe he had issues at GM that no one could fix.  I don't know. 

What I do know is he failed the shareholders on a scale rarely seen in history.  And it's not like he's new to the business: He was appointed the Chief Financial Officer in 1992. He's been at or near the top of the business now for 17 years. GM's problems must be laid at his feet.  But why has it taken all these years to fire him?  Didn't GM have a board of directors?

The Third M

The four M’s of RULE #1, Meaning, Moat, Management and Margin of Safety, are the key to finding wonderful businesses on sale.  The third M – Management – is the hardest to evaluate.  There are no tools to objectively decode the passion, honesty and owner-orientation of the CEO of a business.  You have to do the homework.  And you have to know what you’re looking for.

A good friend of mine, Steve Farber, and I worked together many years ago consulting to executives about becoming better leaders.  Steve just wrote a really great book and I want you to read it.  Its title says it all: Greater Than Yourself. 

That’s what I want my CEO to think and feel about the business I own.  I want him to sublimate himself to the task of making my business successful and a positive contributor to life on earth on all levels – certainly for me, the owner, but also for the people he’s leader, the suppliers, the customers and the environment. 

Steve is a great writer.   His first book, The Radical Leap, was named one of the best 100 business books of all time.   I read Greater Than Yourself in an evening.  It will help you spot a great CEO.  Even better, it will help you be a better leader yourself.

Now go Play.

Phil Town

GE CEO Buys Stock... So Buy GE, Right?

The other day, Mike left a comment here on the blog about GE. Here's a quote from his comment (taken from Bloomberg):

Last year was “a tough year, and we expect 2009 to be even tougher,” Immelt wrote.

The CEO, while accepting responsibility, made it clear he intends to see GE through the crisis. Today, as GE shares dropped to the lowest price since May 1993, he bought 50,000 shares in a show of confidence.

“The current crisis offers the challenge of our lifetime,” Immelt said. “I’ve told our leaders at GE that if they are frightened by this concept, they shouldn’t be here. But if they’re energized, and desire to play a part in transforming the company for the future, then this is going to be a thrilling time to be a part of GE.” [By Rachel Layne, Bloomberg]

Hey, you gotta like it when a multi-millionaire puts up his own money to buy 50,000 shares.  Now if he mortgaged his house and bought 5,000,000 shares I'd get excited.  And check out the financials on GE, right?  Notice the debt has doubled twice in the last ten years while earnings and sales and book value have doubled once or less.  And it would take about 35 years to pay it off out of cash flow.  Red flag there.  Not to mention a 3% ROIC. 

And what were they doing with the debt?  Over 60% of it went to pay dividends or buy stock.  WHAT???

They were borrowing money to prop up their stock price?  You gotta be kidding!  And worse, like GM, they were borrowing to pay dividends.  That is almost criminal. 

No CEO should pay dividends because investors expect one.  They should pay a dividend because they have cash they can't invest with a high enough return.  Period.  Anything else is semi-fraudulent and certainly misleading.

In other words, GE was either being run into the ground by incompetence or by traitors who were acquiring businesses that didn't pay off.  So traitors or incompetents.  Either way, unless they change management, how is this going to improve?

It's cheap, but it also has almost no equity at all right now.  Debt is 5 times the equity.

Phil Town says, "Now go play".

Question from a Reader: Equity, Accounts Receivable and Surplus Cash

A few days ago I received the following question from a reader. I consider this a good "Intermediate Accounting" question for Rule #1 investors to look over.  The basic question: does a growing equity number really mean the company is growing surplus cash?

Phil Town,

Greeting from Shanghai!   Thanks for your book which inspires me a lot!

I am now reading your RULE #1 book the 2nd time.  I am now on Ch9 'Calculate the Sticker Price'.   In the highlighted box on P151, you said 'The growth of the Sticker Price - the value of the business - most closely follows the growth of equity because a growing equity comes from growing surplus cash'.

I am confused.  In my view, increase in equity does not imply increase in surplus cash at all.   For example, a company sold only 1 item of USD10m in a fiscal year and made a profit of USD4m.  Its revenue is USD10m and profit is USD4m.   But its customer failed to pay.   At the year end, the AR increased by USD4m but not the cash.   However, the retained earning still increased by USD4m, and thus the equity increased by USD4m as well.

Please help me to understand.  Thanks in advance.

David

Here is my response to David:

3 Ways Not to Solve the Financial Crisis

"No. 1 Billionaires, ante up. No. 2 The health insurance and pharmaceutical companies need to be taken over by the federal government before they are the next ones whining to be bailed out. They have failed to create a private plan to care for the American people and that means they don't get to be the only game in town. Eliminate the middle man. Especially since the middle man is a thief. No. 3 All payments to CEOs are suspended in the oil industry until a full investigation of pay practices takes place. Maybe a good way to do it to save time would be to tell them to give back the money and we won't send you to prison. Maybe we could hold the ones who won't cooperate or already spent their billions in Guantanamo with the rest of terrorists."
—    Sharon Keller

These suggestions for solving the current financial credit crisis was written today, Sep 25 2008 by an American citizen in response to an editorial in the NY Times today by Tim Egan decrying the bailout.  I'm starting to think that the opinion of this woman is shared by quite a lot of people, so I'm going to try to explain what will happen if she gets a little bit of her suggestions implemented.

Rule #1 Question of the Week: What About Apple?

This week's question for Phil Town comes from Dave, about Apple (AAPL):

Dear Phil Town,

A coworker recommended your Payback Time book to me as a smart way to get into the market.  I must say I agree with her, the book as fantastic and I've learned a lot about how things work out there. That being said, I've started analyzing some companies and one in particular has me stumped. The company in question is Apple. As for the 4 Ms, Apple has meaning for me (I own several of their products and I work in the tech industry), has a moat based primarily on Brand, has exceptional management (Steve Jobs), and appears to have a good MOS.

Here are the numbers I've gathered to this point (straight from MSN):

Checking The Big Five Numbers on a Quarterly Basis

I received an email the other day from Brian, who felt that I could get into more detail on how to redo the sticker price of a company on a quarterly basis.

As Brian pointed out,

"...It completes the entire process of investing in a wonderful company at an attractive price and following the company quarterly until it is no longer a desirable investment.  Without knowing the value of a company on a quarterly basis after doing the initial research, one would be investing blindly.  Essentially, you would only be left with the 3 Tools as your only means of protection against loss until you are able to evaluate the company again.  This evaluation would only come once every fiscal year since it appears that MSN Money only publishes this data on an annual basis.  Will you help us out in determining the quarterly value of a business?"

Thanks, Brian, for staying on me to get this issue clarified.  We DEFINITELY want to keep up on the Big Five Numbers on the businesses we own or are watching on a quarterly basis.  It's just part of the homework of owning a business, gang, so get used to it. 

One of the most important things you can do as an owner is to catch problems before they bite you.  Checking the ROIC and Growth Rates quarterly is the most efficient way to see changes and challenges happening.

War of the Worlds, Part Two: Good Biz, Bad Biz

To recap: I got in a battle with a guy from Kiplinger on Maria Bartiromo’s show, Closing Bell. He said that individual investors can only succeed if they diversify (easily done with mutual funds) and hold through the drops in the market because the little guy can’t pick wonderful businesses that are on sale, nor know when to get out.  Maria was also skeptical that the little guy could successfully use technical tools to get in and out when the Big Guys get in and out.  Let’s see if we can convince our doubters, shall we?

The first step of knowing when to buy and when to sell is to know the business that you are buying well enough to be able to put a value on it.  It is absolutely basic to Rule #1 investing that the business is wonderful. 

Wonderful businesses are easily found, but you do have to know what "wonderful" looks like.  I could write a book about it.  Oh, wait.  I did write a book about it.  So read it.  But I’ll cover the main points here for you anyway.  I call the main points "The Four M’s”, the first 3 of which are all about "wonderfulness".

Starbucks - Is it a 4M Company?

A few days ago Al wrote in to ask me about his analysis of Starbucks.

Here was his question to Phil Town:

Finished Rule #1 three weeks ago trying to get other friends on board to help in the quest for good companies. Watch list is around ten companies and growing started to get frustrated, until 10:30 pm yesterday, SBUX Starbucks. Please verify the big five numbers.

Sticker Price
Current EPS $0.75
Est EPS Growth $ $5.30
Est. PE 10 years 44
Future Stock Price $233.27
Sticker Price $57.66
MOS $28.83
21.6 % used for EPS growth

Management looks good, brand moat. Insider trading very active and a little confusing to interpet. What do you think?

Here's how I responded (you can also read my response in the Comments):

Rule #1 Question of the Week: How Do You Calculate the Big 5 After a Merger or Acquisition? (Part II) -- A.K.A. What is Whole Foods Worth After Acquiring Wild Oats?

This week's post is Part II to last week's.

Acquisitions and mergers play havoc with valuations in more ways than one.  Mr. Buffett once said, "When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact."

Which brings us to the purchase of Wild Oats by Whole Foods.  John Mackey and team have a reputation for brilliance.  Did they just buy a business that has a reputation for poor fundamentals?  Let’s see what the Big Five say about this biz: