Wednesday, January 28, 2015

Ninth Pick in the WMD Portfolio - Rolls-Royce Holdings

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.

I tend to like the economics of duopolies - Coke/Pepsi, Visa/MC, Fedex/UPS, Boeing/Airbus. Pricing tends to be pretty rational in these markets. The main suppliers of wide body jet engines  are General Electric and Rolls-Royce. GE is a fairly interesting business at these prices and it pays a solid 3.7% yield. Potentially more interesting is a main supplier for jet engines - Precision Castparts. The fundamentals of PCP are very attractive, however since they are focused on rolling up the supply chain the company prioritizes acquisitions not dividends so that rules it out for the WMD portfolio.

The other half of the duopoly - Rolls-Royce is a company whose investment profile ticks the main boxes for the Wide Moat Dividend portfolio. Rolls-Royce engines are used in the most advanced wide body aircraft today including Airbus A380, Boeing 777, and Boeing 787 Dreamliner. Think its easy to compete on jumbo jet engines? This BBC documentary shows exactly what goes in to building these engines. 

Civil and Military Aerospace account for over 50% of Rolls-Royce revenue. The rest is comprised of Power systems, Marine and Energy.

Rolls-Royce pays a 2.7% dividend which is a healthy premium to the yield on the S&P 500. The company has grown its dividend every year since 2010. Rolls-Royce can easily afford to continue raising its dividend, its payout ratio sits at 18%. 

Its a cyclical business. In the post crisis years the ROE has ranged from 14% (2010) on the low side to 43% (2012) on the high side. In my view the recent lows are not too bad and the good years are very good. The Debt/Equity ratio is 0.3.

Neil Woodford is a fan and has Rolls-Royce as one of the largest holdings in his portfolio.

Unlike most of the market today, Rolls-Royce is a relative bargain which sells at near 2008-09 lows. The current P/E is 7.4 and the P/CF is 8.7. To me this looks like a quality company at a discount price.

Thursday, January 22, 2015

Three Wise Men on Quality Income Investing

Charlie Munger is a guy who knows how to get to the point. I came to investing for dividends via value investing. It took me a long time to appreciate what the important differences are.

Charlie Munger managed to sum it up in on paragraph: "If you buy something because it's undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That's hard. But if you buy a few great companies, then you can sit on your ass. That's a good thing."

Mr. Munger was not specifically talking about dividends,  he was talking about buying quality. But the net result is the same. Value investors have much longer time horizons than most investors. Most value investors I know one year is a short holding time, and three to five years is typical. That is really long compared to most people, but income investors have even longer time horizons than value investors. The really interesting returns come once compounding the dividend income has really had a chance to work. This can easily take more than 5 years. The really interesting numbers start to come more like 8-10 years out. 

Value investors can make great buying mediocre businesses at great prices and then selling them as they approach fair value. Income investors really should avoid mediocre companies because who know if they will be around earning profits ten years out? At various times over the past decade, Crocs would have been a great deep value investment. But a company like Crocs would never pass the quality filter that an income investor needs to earn income a decade plus out. Compare owning Crocs to Berkshire Hathaway's purchase of Coca Cola. Last year, Coca Cola sent $488M in dividend income to Omaha (author's calculations), but Berkshire only paid $1.2B for its Coca Cola stake. That makes for a massive and growing yield on cost.

This distinction matters even more if you have a full time job and cannot worry about tracking market gyrations and numerous decision points. Income investing works great if you have a job, because your "portfolio manager" job involves buying quality - more Coke less Crocs - and sitting on your ass, then you can get back to your real job.

The second wise man, Todd Wenning, really clarified this distinction for me in his Income Investor's Manifesto post which reverse engineers the keys to success in income investing versus value investing:

"income investing has a distinct research process that focuses on a company's ability to sustain and increase its dividend. Where value research typically begins with a company's balance sheet and growth research starts with the income statement, dividend research commences on the cash flow statement.

From the cash flow statement, for instance, we can determine free cash flow coverage, earnings coverage, how the company approaches dividends versus buybacks, debt repayment trends, acquisition trends, and more.

This analysis is critical in determining a company's dividend health and therefore the cash flow statement is the necessary starting point for dividend research."

Todd Wenning says income comes first in income investing tenets - 

"1. Income first: Naturally. The most important difference between income and the value and growth strategies is that its primary focus is on income generation, with capital gains being a secondary concern. More specifically, the focus is on generating a sustainable and growing stream of cash flow (at least the rate of inflation) and avoiding dividend cuts. If this can be accomplished, capital gains should take care of themselves over time.

I would go one step further and say that Quality Income comes first. Quality income comes from quality in the business producing the income, there's no sense in buying dividends that are at risk to be cut because coverage is too low. The intersection of low quality plus high current yield is often a warning signal. On the other hand,  Coca Cola at a current yield in the high 2s versus Coca Cola yielding near 33% on cost seem like fundamentally different propositions to me. The difference is not in the stock itself its in the time, that's down to the staying power of the company and the investor to reach that goal.

The third wise man, Josh Peters, recently summarized his ten years running dividend portfolios are Morningstar. The lessons he derived are great because he shares what did not work as well as what did. The portfolios earned annualized total return of 9.4% versus 7.7% for the S&P 500. That beats the field by a wide margin. 

Josh Peters' key insight that really struck a chord with me was this - let the companies do the work:

"Our best results have been from high-quality companies--sometimes where we paid nearly fair prices, not bargain prices--that have created a tremendous amount of value for shareholders just because they have good management and good assets. Let those companies do the work. Let your winners run. It doesn't mean you take your eye off the ball in terms of valuation; but the best dividend investing, the best management of a stream of income for total return turns out to be very much that buy-and-hold strategy that a lot of people look down on and have some concerns or qualms about these days. Let the companies do the work."

In value investing, you are relying on the investor's ability to spot bargains. In income investing its the ability to spot quality that counts. The function of cheapness is central to value investing, the cheaper the better. The function of price in income investing is different, the Nestle's of the world are never all that cheap. The function of price in income investing is not get a bargain but rather to ensure that you do not overpay.

So distilling the wisdom of these three wise men - count the cash flow, check the coverage levels, and then sit on your ass and let the companies do the work.

Thursday, January 15, 2015

Value of a Global Supply Chain

Its one thing to say that your company has a global addressable market. Who doesn't like lots of product selections at fair prices? Its another thing to be able to pull off servicing that market once you cross the border. Think its easy to do business internationally? Its a lot harder than it looks. Wal-Mart had many fits and starts before getting it right. Even Target, popular across the US had issues translating its brand to Canada, which is not exactly far afield.

Contrast that with these recent photos from the small islands (Cayes) in Belize. Not so easy to do distribution on tiny islands where everyone is driving golf carts, instead of trucks you have distribution via John Deere

Yet that's exactly what Coca Cola and Diageo  have done. Coca Cola is available basically everywhere. The only hold outs are Cuba and North Korea. Across the whole globe, only two places you cannot drink a Coke.  Given the recent events, hard to believe that Coca Cola is going to be enjoyed very soon in Havana.

Diageo brands have extensive scale as well. Guinness is available in over 100 countries. Johnnie Walker, Tanqueray and the like are widely distributed. Diageo has all manner of creative brewing and bottling strategies for different countries. Some spirits and brews are made locally, one exception is Scotch that is made in Scotland and then shipped.

Both Coca Cola and Diageo know how to not just analyze markets and consumer preferences, they know how to close out the last mile to get their beverage within reach of where their customers are. No small feat.

You can value a stock many different ways with many statistics- earnings, cash flow, and on and on. If you like income that's tied to the idea that income rises globally and that people in developing economies rising income translates to increased demand for refreshment, then these are two companies that work to help investors earn dividends on that every day.