Tuesday, December 30, 2014

Eighth Pick in the WMD Portfolio - Diageo

The more real they are, the more fun blogs are to follow. So in that spirit, rather than talking about ideas in the abstract I maintain a hypothetical portfolio to track ideas where I'll semi-regularly (and hypothetically) invest and track buying (and where required selling) shares.

For tracking purposes I will use $1,000 to keep it nice and simple. The overall goal is long run income and dividend growth. Portfolio page with goals and tracking is here.

The previous two portfolio picks, Spectra and Oxy, are both in the energy industry. There are still lots of bargains to be had in energy, that should pay off eventually. For my next pick I am going a little more simple than trying to predict what the Saudi do, how OPEC reacts, and when energy prices run back up; in the case of Diageo its a simple matter of brand and distribution excellence meets global consumer preferences for quality beverages. 

Despite an overall solid year for the stock market as a whole, Diageo shares have been left behind. The S&P 500 is up about 13% year to date as of now Diageo shares are down around 10%. That's a wide gap. But why? One reason is that Diageo relies on emerging markets for growth and that has slowed. Another is that China has been on a concerted effort to reduce corruption and high priced booze is an easy target. 

But Diageo has the brands and global scale to weather these events. Diageo owns number one and/or number brands in most categories for example:
  • Vodka - Smirnoff, Ketel One
  • Scotch - Johnnie Walker, Caol Ila, Talisker
  • Gin - Tanqueray, Gordon's
  • Rum - Captain Morgan
  • Canadian Whisky - Crown Royal
  • Tequila - Don Julio

This is just to give you a taste, they own a lot more besides the above. Plus Diageo owns Guinness which a National Geographic photographer friend who has been everywhere says is his first choice beverage because you can rely on it pretty much wherever you are in the world. Diageo does have a hole in its portfolio for bourbon and American whisky, but beyond that its a dominating player in the categories its in. When he invested in Harley-Davidson, Warren Buffett remarked that he liked buying into brands where the customers tattoo the name on their chest. Some Diageo brands have a similar following. I wonder how many people have Guinness tattoos?

Diageo's current yield is 2.98%. That's a yield 50% better than the market for a company that is not an average company. Diageo's five year average Return on Equity is 38.7%. 

The company does operate with some leverage, its Debt/Equity ratio is 1.1 which is higher than I normally like. However Diageo has excellent interest coverage ratio at 5.7. It can afford to pay off its debt. And its one of the few companies where acquisitions can make sense because they have the distribution network across the world to push brands through. The dividend is safe at a 54% payout ratio.

Diageo has grown its dividend at 7.5% annualized over the last five years. Still, the price is not cheap at a P/E of 20, but these kind of companies do not really go into the bargain basement.  The overall quality and yield make it a good combination to add to the WMD portfolio.

Monday, December 22, 2014

The Profit Gets to the Heart of What Matters in Business

For busy people there is not much time to sit around and watch TV. On the plus side, there is not much on TV that's worth watching! One happy exception is CNBC's "The Profit." The lessons that are packed into this one hour show combine to give you about half of the most important things that you may learn from an entire MBA program.

A lot gets written on "teaching kids to invest." Before you skip ahead to teaching your high schooler what P/E ratios are, remember that investing is buying into part of a business. For most people understanding businesses is an abstract concept at best. But learning how businesses function is very educational, not just for those specific businesses but indeed how much of the world functions.

The Profit focuses on businesses that are up against some kind of threat, perhaps liquidity or product or customer or legacy issue. The Profit aka Marcus Lemonis, goes to great pains to point out that he is not a consultant, but he clearly has learnt the old consulting rule of thumb - its never process problem, its never a tech problem, its always a people problem.

The shows give you a slice of life in a wide variety of businesses from Key Lime pie companies to auto sales to coffee roasting and a lot more. What the show excels at is quickly getting a clear picture as to the value (if any) that exists in the company, and then efficiently figuring out where the blockers are. The main lens is people, process, and product to slice and dice where the strengths and weaknesses are. But its the people that must be genuinely convinced to participate, both the business owners to do the deal and Marcus Lemonis that the deal is worth doing.

So much of business is taught (and practiced!) as a bloodless operation, I think that's a real turnoff, sure numbers matter, but unless the people side is working you won't get the numbers over the long haul. Real world business is incredibly personal. The show does a great job showing the human side, good and bad, of business.

As we're still in the middle of the uneven post 2008 recovery, its especially fraught with emotion and meaning as you watch business owners fight to save their creations and employees fight to save their jobs.

There are a lot of great lessons embedded in the show. Some that stand out:

  • Find diamonds in your backyard - a recurring theme is employees going to heroic lengths to keep businesses rolling. This happens in a lot of small businesses (and all successful ones), what's missing often is that investment in people will pay off more than any other 
  • Know when to say no and walk away - its easy to get swept up in the dealmania, only look at the upside, but some deals just do not make sense
  • Be decisive - small businesses do not have layers and layers of bureaucracy, its all hands on deck. Whether its chucking old merchandise that won't sell or closing stores that don't make sense, tough calls have to be made and acted on efficiently
  • Simplify then scale - a number of the businesses have solid cores but extended in too many directions at once. Marcus Lemonis leads the businesses through a process of simplicity first. There is a good episode on a South Carolina Barbecue restaurant with huge customer demand. Instead of adding another location, Marcus Lemonis has them get one location right and then plan to scale from there. Walk in to a Chipotle, the menu could not be much simpler. I recall interviews with Chipotle CEO/Founder Steve Ells when they became successful asking him what is next? Breakfast? Late night? Bigger menu? Ells replied 'we are not going to do any thing new. We are going to do what we already do and we are going to do it better.' In software development we say "one is more than none" don't overengineer out of the gate. That's a crucial business message that comes through in many The Profit episodes. 
There are other business shows on TV, but none that get to the heart and head of business. Shark Tank can be fun, but its too often a bloodless VC conversation and while its fun to see all the different business ideas, you do not get the day to day operations or any visibility into the people that make the business tick. Here again The Profit gets to the heart of what matters.

Sunday, December 21, 2014

Seventh Pick in the WMD Portfolio - Occidental Petroleum

The more real they are, the more fun blogs are to follow. So in that spirit, rather than talking about ideas in the abstract I maintain a hypothetical portfolio to track ideas where I'll semi-regularly (and hypothetically) invest and track buying (and where required selling) shares.

For tracking purposes I will use $1,000 to keep it nice and simple. The overall goal is long run income and dividend growth. Portfolio page with goals and tracking is here.

The previous pick in the WMD Portfolio was Spectra Energy. I am taking further advantage of falling energy prices with Occidental Petroleum. I have no idea if this is the bottom and it probably isn't. For all I know oil prices could go much lower and stay low for years.

But we have to balance the positives. Oxy has simplified its business model. At the end of November Oxy spun off its California assets into a separate company (California Resources). Oxy also plans to sell off its Middle East/ North Africa assets. Those transactions will leave Oxy as a focused player in the Permian basin.

Since, I have no idea what oil prices will do, Balance Sheet safety is paramount. Levered players are already starting to get washed out. Oxy has a Debt/Equity ratio of 0.2 they can weather low prices.

During the financial crisis, Oxy continued to raise its dividend. In 2004, Oxy paid $0.55/share in dividends and today its $2.80/share. That is excellent dividend growth. The current yield is 3.5%.

Oxy is a very shareholder friendly company. They have steadily brought down the share count. Management plans a major buy back which could result in retiring almost 10% of its shares. Since Oxy is trading at its lowest P/E valuation since 2008 this should be an excellent time to shrink the share count.

All in all, even with the vast uncertainty around oil markets, Oxy's simpler business model, safe balance sheet, and shareholder friendly actions make it a good addition to the WMD portfolio. 

Thursday, December 4, 2014

Investing in what lies clearly at hand

Today is Thomas Carlyle's birthday. Charlie Munger cites his philosophy and its influence on operations at Berkshire Hathaway.

From Charlie Munger's comments the Wesco 2004 annual meeting

"And there has never been a master plan. Anyone who wanted to do it, we fired because it takes on a life of its own and doesn’t cover new reality. We want people taking into account new information.

It wasn’t just Berkshire Hathaway that had this attitude about master plans. The modern Johns Hopkins [hospital and medical school] was created by Sir William Osler. He built it following what Carlyle said: “Our main business is not to see what lies dimly in the distance but to do what lies clearly at hand.”

Look at the guy who took over the company that became IBM. At the time, it had three equal sized business: [a division that made] scales, like those a butcher uses; one that made time clocks (they bought this for a block of shares, making an obscure family very rich); and the Hollerith Machine Company, which became IBM. He didn’t know this would be the winner, but when it took off, he had the good sense to focus on it. It was enlightened opportunism, not some master plan.

I happen to think great cities develop the way IBM or Berkshire did. I think master plans do more harm than good. Anyway, we don’t allow them at Berkshire, so you don’t have to worry about them."

There are plenty of people who invest with the hope of finding the next big, disruptive thing. Or playing some big investment "theme." But there is more than one way to invest. The Carlyle/Munger approach.

As to themes, the top down mentality has its limits, it can work for certain people, but macro tends to be pretty unpredictable. Just in the last couple of years we have heard peak oil, the decline of the dollar, the decline of US economy, rise of the BRICs and numerous other plausible sounding grand theories offered by smart people, but none of these have really played out as predicted. I prefer a bottom up approach. It may not be as neat and orderly appearing as a top down approach where you allocate 10% to ten different industry sectors or countries or some such, but if each company in your portfolio has sustainable earnings power does it matter if there are 25% more consumer defensive stocks than energy? I do not think so.

The other dimension this brings to mind is a quote from Howard Marks "If we avoid the losers, the winners will take care of themselves." Notice the shift in mindset from how many investors work. Many investor look for the next Tesla, but that assumes you can predict a long list of things that will happen. It also assumes that you go in with a big enough purchase to make a real difference. If instead you assume that its not practical to guess the winner 10 years down the road and just focus on looking at dealing with the risks clearly at hand, you end up with a fundamentally different portfolio.

Wednesday, December 3, 2014

Sixth Pick in the WMD Portfolio - Spectra Energy

The more real they are, the more fun blogs are to follow. So in that spirit, rather than talking about ideas in the abstract I maintain a hypothetical portfolio to track ideas where I'll semi-regularly (and hypothetically) invest and track buying (and where required selling) shares.

For tracking purposes I will use $1,000 to keep it nice and simple. The overall goal is long run income and dividend growth. Portfolio page with goals and tracking is here.

With all the churn in energy prices, prices reverting back to long term lows, there will be winners and losers. We are already starting to see losers shake out of the process. But what about winners? The big integrated companies like Exxon and Chevron are weathering the storm pretty well. I would like to add one of these type of companies to the WMD portfolio at some point, but at the same time the fact they are weathering the storm means the shares are not as cheap relative to the rest of energy. What about smaller E&P? These are pretty risky and while I am sure there are bargains, I am also sure I am not smart enough to know which ones are the right ones to pick.

But whether through ETFs or bots or other reasons, there does seem to be interesting knock on effects in many parts of the energy space. Pipeline operators are also getting blown away, but some of these have limited direct exposure to the price of oil or gas at any given time. One of these is Spectra Energy, which is mainly in natural gas, not oil.

Spectra's pipelines give it the ability to move natural gas across most of the eastern US and beyond.

Spectra's yield is at 3.7%, the company announced a 10.5% dividend increase for Q4. The company has a long list of projects in motion and a well covered distribution so it should be able to deliver double digit dividend growth for near to mid term. I am sure there are better bargain prices in energy than  Spectra. But Spectra's 3.7% yield offers a fair deal for quality income over the long haul.