Saturday, July 14, 2007

Ecolab Followup-Transforming from Soap to Services

About a month ago, I wrote a post on Ecolab (ECL) describing it as a model of consistency. As I quoted Dmitry Siulverstein who covers specialty chemical research at Longbow Research:

I think the biggest appeal of Ecolab is predictability. The company gives you a very narrow guidance for earnings for the year, and a $0.02 range for earnings in the quarter. Quarter-in and quarter-out, they deliver results at the top end of their guidance. This predictability and sustainability of results, combined with the company's excellent position in its market where they are continuing to gain market share and growing significantly above the growth rate of their industry, makes this somewhat of a growth name.

Last week’s edition of The Wall Street Transcript (TWST subscription required) had an interview with Doug Baker, the Chairman, President and CEO of Ecolab. I frequently use TWST interviews to get a deeper picture of the corporate strategy of the business.

Here are some excerpts from that interview that I think help to position the corporate strategy:

“We are the food safety and infection prevention experts. Our promise to our customers is that we will help them create cleaner, safer, healthier products and environments…Our primary drivers are a continued focus on innovative new products and programs backed by unbeatable service support. Today, 40% of our sales are products and programs introduced in the last five years, and those products are backed by more than 13,500 sales and service experts worldwide. We excel at sales and service execution because it's core to satisfying our customers and delivering on our promise to them.”

“We're expanding our pest elimination business, which has the leadership position in the US, and driving it globally…Health care, particularly acute care, is also an area of interest for us and is a place that we've been investing, both through acquisitions and through organic growth of our existing business. Kitchen equipment repair is another target area in the US. It is just as it sounds - fixing cooking and cooling equipment in restaurants. Interestingly, restaurants (our largest market segment) spend as much on kitchen equipment repair as they spend on everything else we sell them, so it's a "double-the-market" idea for us. It's also a fragmented industry that gives us a lot of opportunity to build on our leadership position. We're also helping our customers reduce the amount of water and energy it takes for them to get a clean, safe and healthy environment.”

Mr. Baker describes the primary drivers that have provided Ecolab its dominant position in the marketplace:

"It is a fragmented business. We are the leader in this industry. We have a 12% share of the $40 billion market opportunity. There were several key actions in the past that enabled us to attain this:"

"Development of solid product technology. This is where we took what have historically been liquid products and offered them in a much more convenient and easier to use solid (waterless) form. We can offer a solid product in place of a five-gallon pail of cleaning product, cutting the weight by seven-eighths, from 45 pounds to eight pounds and achieve superior cleaning results. It gave us huge advantages in terms of greater ease of product use, safety, storage, product usage control, lower transportation cost, and reduced customer disposal volume, all of which reduced overall customer costs and developed greater customer satisfaction."

"Development of our chain accounts business…Foreseeing the rapid growth in restaurant and lodging chains, particularly in the US foodservice market."

"The third would be our advanced sales and service concept. We don't just sell products - we couple them with high levels of individualized customer service…Our service capabilities in assisting our customers with solving critical cleaning and sanitizing problems - and protecting their brand names in a world increasingly concerned about food-borne illness."

Food contamination is a serious issue. An estimated 76 million cases of food-borne disease occur each year in the United States. The majority of these cases are mild and cause symptoms for only a day or two. Some cases are more serious, and CDC estimates that there are 325,000 hospitalizations and 5,000 deaths related to food-borne diseases each year.

A new report published in April of this year by the US Centers for Disease Control and Prevention reveals a 50 percent increase in E coli infections since 2004, and a huge 78 percent increase in Vibrio infections - caused by eating raw shellfish - over the past decade.

Food safety is becoming a much more serious issue. Here is a link which highlights the confusion that exists that relates to food safety monitoring and regulation. As the article describes:

“Under current law, food safety monitoring, inspection and labeling functions are spread across 15 agencies in the federal government, including the US Department of Agriculture (USDA) which oversees meat, poultry and egg products; the Food and Drug Administration (FDA) which oversees most other food products; and the US Commerce Department's National Marine Fisheries Service which inspects fish. The agencies collectively administer at least 30 laws."

The General Accounting Office (GAO) has called for legislators to radically amend the system, which the federal auditor said leaves the US food chain open to attack by terrorists.

It seems to me that strengthening of regulatory oversight as well as its unification will force many producers to enhance their food safety procedures, which should only mean continuing demand for Ecolab services.

Large opportunities exist in the healthcare markets as well. Here are some stats from a presentation made to a Credit Suisse conference earlier this year:

“What's interesting about the healthcare industry as shown here is that hospital-acquired infections are the Number 4 killer in the US. And that's more than auto accidents and murders combined. It's something that we think we can make a lot of headway in, improving in the US -- particularly when it involves something as basic as basic sanitation. So we're developing products for the healthcare area, to help them address that. It's a $3 billion market. We just entered it a couple years ago.”

With EBITDA/ interest paid of almost 17 times, this steady demand company is under-levered.

In my original post, I had neglected to mention the 29% ownership of Henkel, the massive German detergents, cosmetics, and adhesives company.

Ecolab's agreement with Henkel limits the German company to owning no more than 35 percent of Ecolab's stock between now and the end of 2010.

Per the most recent proxy statement:

“Henkel’s equity ownership in the Company is subject to an agreement (“Stockholder’s Agreement”) containing certain restrictions pertaining to, among other things, Henkel’s acquisition, transfer and voting rights of our Common Stock. Generally, the Stockholder’s Agreement terminates when Henkel owns less than 2% of our voting shares. Pursuant to the Stockholder’s Agreement, Henkel is precluded from acquiring more than 35% of our outstanding Common Stock or from acting, alone or in concert with others, to control or influence the Company. Henkel may sell its shares of our Common Stock under certain conditions specified in the Stockholder’s Agreement, subject to our right of first refusal. Any disposition by Henkel of any shares of our Common Stock would be effected in an orderly manner....including our right of first refusal."

Henkel could make a takeover bid after that point. Alternatively, Ecolab could purchase Henkel’s stake (at current prices, worth around $3.2 billion) Added to current long term debt of about $550 million, even at a 7.5% interest rate would result in EBITDA interest coverage of 2.8 times.

There is precedent. In October of 2004, Clorox Co. and Henkel KGaA agreed to a $2.8 billion stock swap and cash deal, in which Henkel sold back its 29 percent ownership stake in Clorox in return for $2.1 billion in cash, as well as a handful of Clorox businesses and a position in a Spanish joint venture valued at $745 million.

The company remains on my watch list but I am increasingly intrigued by this company that is transforming itself from soap to services.

Disclaimer: Neither I, my family, or clients have a current position in Ecolab.

Tuesday, July 10, 2007

The Quarterly Earnings Ogre-Creating Mouse Olympics

Here we are again in earnings season. Eddy Elfenbein at Crossing Wall Street took Moodys to task yesterday for its recent report that suggested an advantage of a company going private was that it was freed from quarterly earnings reports and hence, liberating to management. Eddy is so right...private equity investors frequently receive monthly operating and financial data.

But with all due respect (and I greatly respect Eddy's commentary) the real problem is not the frequency of the reporting, it is the guidance and the reliance on guidance by management, by analysts, and yes, by us, the investing public. All paranoia aside, earnings season is a setup for mouse olympics....keeping the hurdles low!! Find an expectation that you can beat, and that's where you set the bar. But like Pavlov's dog, if we keep reacting to quarterlies and quarterly guidance, the feedback mechanism only encourages managements to maintain this charade.

Most earnings guidance is complete and utter B.S. in my view. Get your mind out of the short-term earnings surprise clutter and noise and focus on long-term value creation.

Don't get me wrong....North American disclosures of quarterly earnings are far superior to many European jurisdictions that provide semi-annual reporting. But what should we be looking for from management?

It ain't earnings guidance.
What I want to know is how is management managing the business. What is the impact of competition and how do we stand in the marketplace? What are we doing about it? Justify the capital expenditures and tell me about the rate of return hurdles that justified them.

Although the creation of long-term company value is widely accepted as management’s primary responsibility, much research suggests that managing predominantly for short-term earnings expectations often impairs a manager’s ability to deliver such value to shareholders.

According to a survey (conducted on behalf of the CFA Institute) of more than 400 financial executives, 80 percent of the respondents indicated that they would decrease discretionary spending on such areas as research and development, advertising, maintenance, and hiring in order to meet short-term earnings targets and more than 50 percent said they would delay new projects, even if it meant sacrifices in value creation.In other words, satisfy the analysts and make sure that the accounting number is hit to meet the quarterly expectation. In other words, forget about long term value and working for the owners of the business.

Hitting the "number" by forgoing some value creating opportunities impairs long term value creation. The obsession with the short term number becomes destructive to the ultimate goal most of us should have, a stronger, more viable company that is value creating. An excessive short-term focus creates a disregard for long-term strategy and discourages investment.

Most of us are aware of Buffett's feeling about quarterly guidance...he doesn't, and a number of his portfolio companies have stopped as well. John Bogle ex-CEO of Vanguard expressed his views as well: “the role of management should not be beating abstract numeric estimates but improving the operations and long-term prospects of organizations.”

I believe that much of the effort expended by corporations in providing guidance is misleading and unproductive and creates an unhealthy short-term culture. To quote the CFA Institute study:

"Although there may be certain benefits to providing earnings guidance, the costs and negative consequences of the current focused, quarterly earnings guidance practices are significant, including (1) unproductive and wasted efforts by corporations in preparing such guidance, (2) neglect of long-term business growth in order to meet short-term expectations, (3) a “quarterly results” financial culture characterized by disproportionate reactions among internal and external groups to the downside and upside of earnings surprises, and (4) macro-incentives for companies to avoid earnings guidance pressure altogether by moving to the private markets. Corroborating research identifies the most significant costs of issuing guidance to be management time (which 53 percent of respondents identified as very costly), a focus on short-term earnings (42 percent), and employee time (35 percent). Additionally, earnings guidance contributes to an illusion of complete business predictability, a faulty premise for both companies and their investors. Recent evidence suggests that companies are indeed addressing the shortcomings of the current earnings guidance landscape. The trend is to shift from quarterly to annual guidance and, in some instances, to withholding guidance entirely. According to research conducted by the National Investor Relations Institute (NIRI), the number of companies providing quarterly guidance decreased from 75 percent in 2003 to 52 percent in 2006. The number of companies providing annual guidance has increased to 82 percent from 38 percent over the same period, and the percentage of companies that now provide only annual guidance is 43 percent."

What I think Moody's is saying is that going private gets a company out of producing quarterly guidance which is then subjected to the Wall Street process-distilling the complexities and nuances of a value creation strategy into a single number. That number, for the most part, is still enumerated by management as guidance and is shaded by Wall Street analysts. Performance is scrutinized very carefully by private equity investors, but it does not come down to a single sacred number.

The long term goal of value creation is what is sought, not an accounting number that Joe Kernen or Maria Bartiromo can rebuke or praise based on its fidelity to consensus. Information that provides insight into long term value creation is what private equity investors want and get and what all of us deserve.

I believe that better decision-making will come by having managements' quarterly discussions focus on strategic discussions, cash flow drivers, and more insightful disclosure. Operating data rather than financial data can provide higher quality information that is less subject to accounting manipulation. A lot of production data or sales data can be produced on a monthly basis.

It's tough to get over the sturm and drang of earnings surprise. It's tough to reject what analysts will spend hours composing as a quick and dirty first response to an earnings release. Private investors are getting the numbers that they deserve. The rest of us should too! And all of us should be insisting on getting answers to the right questions about value creation.

Disclaimer: I, my family, or clients have a current position in Berkshire Hathaway.

Angelica and Pirate Capital

In a recent post about Value Creation or Destruction, we had highlighted Angelica (AGL) as a company that in my opinion, was failing to create shareholder value and was consequently, subject to shareholder activism. We had cited Pirate Capital's involvement in the stock.

As we had pointed out, free cash flow had been negative for three of the last five years as a result of increasing capex intensity. The resultant returns on invested capital have not been encouraging with the last two years just between 1% and 1.6%.

Yesterday, Pirate filed another 13-D with an interesting letter to the board of AGL. They highlight their greater alignment with AGL shareholders versus management:

"Contextually, we want to impress upon the Board that Pirate remains a beneficial owner of Angelica stock, with approximately 935,000 shares, or almost 10% of Angelica's outstanding shares. On the other hand, executive officers and directors beneficially own just over 260,000 shares (including restricted stock units), in the aggregate, and have been granted, without purchase, options on just over 440,000 shares, based on the Company's latest proxy statement. Clearly, based on our ownership, we believe that we are more closely aligned with shareholder interests than Angelica's management."

The letter also questions the valuations that management has been willing to pay for its acquisitions vis-a-vis the valuation accorded the stock itself:

"The greatest area of consternation to us, as the second largest shareholder in Angelica, is the disconnect, or the meaningful valuation gap, between the aggregate price that Angelica paid for the 11 bolt−on acquisitions made between 2003 and 2006, which we understand to be in excess of $125 million, or approximately 1x sales, and the current market valuation for Angelica, which closed last night at $22.36 per share, or just over 0.5x fiscal 2006 total gross sales for Angelica."

I can understand their concern. Since the beginning of 2003. AGL has generated a cumulative $124 million in operating cash flow. of which $105 million was sustainable operating cash flow (after debt service and non-recurrings.) About $130 million was expended to support operations through capex and operating related intangibles. Some $76 million in long-term debt has been added. As is clear, free cash flow over the period was negative at -$26 million . Contrast this with the period since the beginning of 1999 through 2002 where $150 million in free cash flow was generated cumulatively and $77 million in long term debt was paid down. Operating cash flow over this previous period was $231 million of which about $186 million was sustainable.

By their nature, capital expenditures can be lumpy and may cause temporary setbacks to free cash flow over time. But over longer term periods, these expenditures tend to smooth out. The trends here are not very encouraging.

Disclaimer: Neither I, my family, or clients have a current position in Angelica.

Sunday, July 08, 2007

How Much in Value versus Growth Stocks- Good Beta versus Bad Beta?

In today's New York Times, there is an article by Mark Hulbert (in the business section p28) that addresses the issue of equity allocation between value stocks and growth stocks. How many times do financial planners get asked about the allocation of a 401 (k) or an RRSP as to what portion should be invested in growth versus value? How many times do individual investors wonder about which box to tick?

Last week, I warned about the homogeneity of thinking that many value investors harbor. Hulbert, of Hulbert Financial Digest fame, points out the Ibbotson research that since 1969, value stocks have outperformed growth by an average of 2.5% a year. Typically, value stocks were about 15% less volatile than growth stocks as well. Sounds like value stocks win under most circumstances, right?

Not exactly. So why even think about a growth stock? First of all, Buffett insists that growth and value are joined at the hip...i.e. it is feasible to buy a growth stock that is undervalued. A value buyer does not disdain owning a stock that exhibits success and is highly profitable...all that matters is that it comes at an appropriately cheap price.

More subtly however, is a different proportion of a flavor of risk that growth stocks contain as compared to value stocks. Hulbert refers to an article by John Campbell of Harvard and Tuomo Vuolteenaho, now of Arrowstreet Capital. Here is a link to that article, published in 2003 but still certainly worthwhile reading for avid students of markets and CFA's.

They argue that returns on the market portfolio have two components, and that recognizing the difference between these two components can eliminate the incentive to overweight value, small, and low-beta stocks. The value of the market portfolio may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate or cost of capital that they apply to these cash flows. In the first case, wealth decreases and investment opportunities are unchanged, while in the second case, wealth decreases but future investment opportunities improve. These two components should have different significance for a risk-averse, long term investor who holds the market portfolio. Such an investor may demand a higher premium to hold assets that covary with the market’s cash-flow news than to hold assets that covary with news about the market’s discount rates, for poor returns driven by increases in discount rates are partially compensated by improved prospects for future returns.

The "discount rate" risk is essentially the risk that interest rates will rise. Growth stocks, since much of their value occurs from future earnings, are very vulnerable to changes in interest rates. Far off future earnings which are discounted to a present value are worth less when that discount rate increases.

The "cash flow" risk is essentially the risk that a company will not sustain its ability to continue to grow its cash flow, perhaps because of competitive forces, perhaps because of business risk, perhaps because of its own financial leverage and capital structure.

For a long term investment horizon, say ten years or more, discount rate risks are less threatening. Interest rates rise and fall, ebb and flow with business conditions. Hence, growth stocks which fall off because of their greater sensitivity to interest rate hikes should come back over time since these risks are self-correcting. However, for cash flow risks, the comeback trail is very difficult when the competitive advantage period has run out.

Hence, the need to blend both value and growth stocks into a portfolio. Much like a high cholesterol level that consists mostly of "good" cholesterol, portfolios that contain a skew toward the "good" discount rate risk serve long term investors well.

Building on this paper is some research by Luis Viceira and Jakub Jurek of Harvard entitled Optimal Value and Growth Tilts in Long-Horizon Portfolios. Here is a link for that paper.

Here is one of their summations:

"We find that the mean-allocation of equity-only investors is heavily tilted towards value stocks at short-horizons, but the magnitude of this tilt declines dramatically with the investment horizon, implying that growth is less risky than value at long horizons."

If your time horizon is short-and I am not talking about before today's close or settlement date- but say a couple of years. You should place almost your entire equity allocation ( stress-not all your capital but just your equity allocation) into value stocks. An investor with a long-term horizon, say ten years, should be willing to allocate up to half of the equity portion of his/her portfolio to growth stocks.

As the authors describe it:

"We find that on average equity-only investors with short horizons optimally choose portfolios heavily tilted toward value and away from growth, regardless of their risk aversion. Aggressive short-term investors find it optimal to hold long large positions in value stocks offset by large short positions in growth stocks, because the mean return spread between value and growth is positive, and their returns are highly positively correlated. Highly risk averse short-term investors hold large positions in value stocks because of their smaller return volatility and high correlation with growth. However, the optimal allocation to value decreases dramatically— and correspondingly the optimal allocation to growth increases— for investors with longer horizons. This effect is strongest for long-horizon, highly risk averse investors, who hold large long positions in growth stocks. The increasing portfolio demand for growth stocks across investment horizons is driven by inter- temporal hedging motives. Growth stocks are better suited than value stocks to hedge against adverse changes in investment opportunities in the equity market, because they are more highly negatively correlated with changes in aggregate stock discount rates than value stocks are. Thus long- horizon “representative” investors find value stocks riskier than growth stocks, and see the unconditional value spread as a risk premium for bearing this risk."

The importance of understanding the optimal value and growth tilts in the portfolios of long-horizon investors is underscored by the composition of the retail mutual fund universe. Morningstar and Lipper want to put funds into their "appropriate" boxes, a characterization that I have always found quite artificial and misleading. Nevertheless, value and growth tilts are the norm, rather than the exception, in the mutual fund industry that serves the investment needs of most retail investors.Funds with a dedicated value or growth tilt accounted for 78% of total assets under management (36% growth and 42% value).

What I suggest here is not to go blindly into every growth story with audacity and newfound certitude based on these findings. Seek great businesses with earnings power. Look for quality when it is there, not when it may have a chance to develop!

Don't accept high risks with low probabilities with nonchalance. Many "story" stocks are best kept fictional rather than finding the reality of your hard-earned savings in your portfolio.

Don't shun growth ideas if you describe yourself as a value investor. Don't shun value stocks, even if you have a long time horizon. There are great opportunities in both, especially if you have time to allow the magic of compounding to build your wealth.

Thursday, July 05, 2007

Who Knew?

Some interesting action in Hilton Hotels calls pre the announcement.

July 35's traded 3,660 contracts with open interest of 14,038

and July 40's traded 3,312 with open interest of 16,509

Are SEC regulators watching? The whole notion of the SEC was to restore investor confidence post 1929 stock market crash. Keeping a watchful eye over potentially unscrupulous insider trading is part of what SEC enforcement is all about. Have markets become lax in their surveillance and discipline of their members?

Disclaimer: I, my family, and clients do not have a position in any securities mentioned in this post.

Tuesday, July 03, 2007

Value Creation or Destruction-As Simple as (1), (2), (3)- Finding the Value Direction!

As some of you know, I write a monthly post for, an excellent service that is published by Henry To, a fellow CFA. I recommend Henry’s service very highly. I should mention Bill and his many contributions to Henry's service and forum. I play a rather minor, very modest role with a once a month post...a sideshow to the real thing.

Here is an excerpt from my piece published on June 21. I think it may help some of my readers understand what goes into value creation as well as what prompts some corporate activists to rattle their swords.

As a timely example of the value creation / destruction debate, I have selected Angelica, a NYSE listed company as an example that is currently undergoing pressure from an institutional holder, Pirate Capital .

In it, I review some basic tenets of creating a discounted cash flow model by using free cash flow. It strikes me that so often, terms like DCF and FCF just get tossed out to blog audiences without going through an explanation of just what they mean. These are not high fallutin terms. Understanding the creation of value can really be just as simple as (1), (2), (3)

A little review of finance to begin. From first principles we recognize that the value of any company is a function of the Present Value of future cash flows, a Buffett principle if ever there was one, and certainly the basis of most EVA® (Economic Value Added) Theory and corporate finance.


Operating Income (1)

Less: Taxes

= EBIT after Taxes

Plus: Depreciation and Amortization

Less: Capital Expenditures (2)

Less: Changes in Working Capital (3)

= Unlevered Free Cash Flow

The main drivers of free cash flow are as simple as (1), (2), (3), essentially operating margins, the intensity of capital expenditures, and the investment in working capital. These factors work together to provide the valuation of the entire firm. The valuation of the equity of the firm is simply the value of the firm less the value of the debt. Much like a house may be valued for a certain price, the equity is simply the value of the house less the value of the mortgage.

Discounting these future free cash flows back to the present depends on the cost of capital, a cost which moves directly with the cost of borrowed money. Needless to say, the sell-off in government bonds over the last few weeks suggests that a higher discount rate is needed to reflect the cost of money. That in itself is disturbing, but there is more.

As you can see from my calculation of unlevered free cash flow, the combination of downward pressure on operating margins, increased capital expenditure needs, and increased working capital needs put downward pressure on valuation.

A recent Wall Street Journal article of June 19, 2007 (subscription needed) highlights “Companies Fall Behind in Cash Management.” The article suggests that large US companies are stalling in their working capital management and becoming inefficient. As the article indicates:

“Reducing working-capital needs can lead to significant improvements in a company's overall cash flow. And strong cash flow can boost a company's return on assets -- a measure of a company's ability to generate profit and earnings growth through the use of its assets and investment. Reductions in working capital over the past several years have helped buoy stock-market valuations.”

The survey of working capital utilization trends is compiled by a consulting firm, Hackett Group- REL and is published in CFO magazine. Their most recent published survey was last year, compiling year-end 2005 results and showing that for the fourth year in a row, working capital management had improved. Not so this year. Though the results have yet to be published, the WSJ article suggests that inefficiencies are creeping into the system.

I thought it would be useful to pinpoint all three elements of free cash flow generation in order to screen some companies where all three factors were deteriorating i.e. operating margins were falling, working capital intensity was increasing, and capex was increasing. I applied my screening to S&P 1500, the composite of the S&P 500, the S&P mid-cap 400, and the S&P Small cap 600. Only non-financial companies were considered.

S&P 1500 Screen

This is not a list of short candidates necessarily. Many of these companies, despite the one year deterioration in operating margins or the increasing investment, the market may be mis-pricing some of these names, in either direction. In fact, check the disclaimer…I, my family, or clients may own some of these stocks because in my opinion, they represent value. But in aggregate, there’s a lot here that could go wrong here. The aggregate price to free cash flow based on trailing twelve months numbers is 69.2 times representing a free cash flow yield of only 1.45%. At an average 48.51 times operating cash flow (NOT earnings but operating cash flow), there is a lot to be consider.

Exercises like this represent only an opening salvo in your analysis. A more complete understanding of the working capital dynamics and competitive industry dynamics will tell you a lot more about the reasons that valuation should be under pressure. The deterioration could represent a short term phenomenon reflecting a recent acquisition, or it could suggest something more difficult and deep-rooted.

Finally, the appropriate discount rate used to discount these cash flows must be chosen carefully. I am modeling companies based on a base case of 6% government bond yields plus a risk premium that is determined by the volatility of the cash flow stream and the quality of the balance sheet. Is 6% too high a base case? Better safe than sorry.

And that is my bottom-line here. I am still finding companies that are worth buying (at least I hope so!) But the “wall of worry” that many people are willing to clamber has a lot of chasms in it. The “animal spirits” certainly seem to be there in spades when we look at the Blackstone IPO which reportedly was six to ten times over-subscribed despite the great uncertainty about the firm’s taxation and pro-forma compensation assumptions. As one observer cites, “If you have enough orders there's no point in waiting.” Since that time, another alternative asset manager has filed to go public. Och-Ziff Capital Management Group filed its proposed IPO yesterday hoping to raise $2 billion. The decision to pursue an IPO infers that the proposed tax changes Congress suggested last month for hedge and private equity funds may not deter more of them from going public.

Bill Gross at Pimco may well be onto something as far as seeing a 25 year bull market in bonds drawing to an end. The effect on the cost of capital is obvious.

The (1), (2), (3) of corporate finance is incredibly important in deciphering the “value direction” of a business. When those three factors turn south, you should recognize that management is destroying value rather than creating it.

Great investors develop a sense of the value building or value destroying behaviors of businesses or as I call it, the value direction. The work of corporate activists often relates to changing the capital intensity (both working capital and fixed capital) of a business. As well, corporate activists will work to change the cost of capital usually by increasing the amount of debt on a balance sheet. The cost of debt is reduced by the tax deductibility of interest payments. Consequently, lowering the cost of capital by increasing debt will increase the value of the firm (so long as the debt is manageable.)

Angelica Corp (AGL) is a case in point.

An activist investor, Pirate Capital LLC sent a letter to Angelica Corp.'s board Monday, July 1st encouraging it to explore all strategic alternatives, including the sale of Angelica, according to a regulatory filing Monday.

In its letter, signed by Manager Thomas Hudson Jr., Pirate Capital wrote: "For the past several years, Angelica's management has failed to improve its operating results, and in fact its net income has declined precipitously... We believe this failure has significantly hampered value generation for shareholders. ...

"Specifically, we, as a substantial holder of Angelica stock, demand that the company engage a nationally recognized investment banking firm to explore all strategic alternatives to increase shareholder value, including, but not limited to, the sale of the company, sales of assets, or another extraordinary transaction, and that the board of directors publicly identify the investment banking firm and its mandate."

Let’s have a look at Angelica’s cash flow drivers:

Angelica Cash Flow Drivers Spreadsheet

Sustainable free cash flow has been negative in 3 of the last five years, and down substantially from levels attained in 2002. (row 23 of the spreadsheet) The compound annual growth rate of revenues over the ten year period has been -1.34%. The compound annual growth rate of operating profit has been -12.7%. (rows 7 and 8 of the spreadsheet)

Gross margins in 2007 were up slightly from 2006 levels but are about half of what they were just five years ago. Fortunately, SG&A expenses have also dropped off significantly. The operating cushion (essentially operating margins without depreciation and amortization expense) is at the worst level in ten years. (rows 28, 29, and 31)

Moving onto working capital intensity, there has in fact been considerable improvement in working capital management. Working capital to revenues has trended down from levels of low to mid 30% ten years ago to current levels of 12% of revenues…an all time low. (row 40) Most of this benefit has occurred through better inventory management (row 35)

However, fixed capital investment tells a different story. Capex to revenues is at an all time high of 9.2%. The last few years have been fairly intensive capex years especially when compared to the years prior to 2003 when capex was generally about 2% of revenues. (row 55)

Capex does not appear to have been especially productive with returns on invested capital for the last few years looking like this:

Jan 2007 1.60 %

2006 1.00

2005 4.70

2004 5.30

2003 6.70

2002 3.20

2001 2.90

2000 2.10

A company only creates value when its return on invested capital exceeds its cost of capital. Clearly, the company does not appear to have earned any reasonable return over its cost of capital for some years.

What is the remedy here? It appears that interest coverage is okay at 2.88 times EBITDA to interest. However, there are also rent payments and cash taxes. Taking these into account provides coverage of about 1.9 times (cash taxes + interest + rents) I am not sure that one could safely add much incremental leverage to reduce costs of capital.

There is an old adage in the business…the best way to get yourself out of a hole is to stop digging. I have no idea where the capex is going but at least the numbers tell me it isn’t demonstrating any profitability as of yet. It appears at least from an initial examination to be a program that is not working. Beyond that, perhaps some additional cost efficiencies can be garnered to improve operating profitability. Who knows? Maybe there are some additional efficiencies that can be garnered from working capital management beyond what has already been achieved.

In my opinion, the three most important steps an investor can take in understanding what it is he or she owns is incorporated in the technique I have shown. The old basic (1), (2), (3) will provide a lot of information about what direction value is heading and whether management is adding or subtracting.

Disclaimer: I, my family, and clients do not have a current position in Angelica Corporation. There are numerous securities mentioned in the screen that is part of this post. Relating to that, I, my family, or clients have a current long or short position in Amgen, Becton Dickinson, Bed Bath and Beyond, Chattem, Compuware, Fiserv, Foot Locker, Furniture Brands, Global Payments, Jones Apparel, Lexmark, Mentor, Merck, Pharmaceutical Product Development, Southwest Airlines, TTM Technologies, and Yahoo.

Sunday, July 01, 2007

The Dangers of Homogeneous Thinking

One of my favorite aphorisms is, “When everybody is thinking the same, nobody is really thinking!”

Sometimes I think value investors fall into this kind of a thinking trap, universally accepting a single-minded approach to a stock, an industry, or a market without fully thinking it through. For example, in the early 1980’s, I fully embraced a low P/E approach to investing after becoming a disciple of David Dreman’s approach described in his original book on Contrarian Investing. I regard low P/E approaches as being generally sound in helping to keep you out of trouble. Unfortunately, when used too rigorously, such approaches also keep you out of a lot of higher growth, high ROIC kinds of businesses as well. I can recall at the time of Buffett’s initial investments in Coca Cola (KO) that many low P/E “value” investors thought that Buffett was losing his discipline in paying what seemed like a riotously expensive 13 times for this at the time considered relatively dull business, especially when so many companies at the time were selling at 8 or 9 times earnings.

Most of us as value investors tend to look down at most other methods of investing, in fact ridiculing most others as lacking rationality or being too emotion centered. Lockstep adherence to a single dogma or doctrine can lead to peculiar self-justified beliefs that get reinforced by restricted focus on the behaviors or portfolios of others “drinking the same Kool-aid.” In short, many value investors simply become too imitative rather than exercise their own judgment.

James Surowiecki, author of The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations spends a lot of time discussing this phenomenon. There can be wise crowds as opposed to the “mob” that characterized the Internet or real estate bubbles. What characterizes the wise crowd? According to Surowiecki:

I) Diversity of opinion

Each person should have private information even if it's just an eccentric interpretation of the known facts.

II) Independence

People's opinions aren't determined by the opinions of those around them.

III) Decentralization

People are able to specialize and draw on local knowledge.

IV) Aggregation

Some mechanism exists for turning private judgments into a collective decision.

Note that a wise crowd consists of decentralized specialists drawn from differing diverse backgrounds that apply their independent thinking and localized knowledge to address the problem. Information drawn is not centralized; rather each person gleans his own private information.

Michael Shermer of Scientific American refers to the intellectual attribution bias, where we consider our own actions as being rationally motivated, whereas we see those of others as more emotionally driven. Our commitment to a belief is attributed to a rational decision and intellectual choice ("I'm for value investing because the long run statistics demonstrate that growing cash flow streams are ultimately recognized by the market."); whereas the other person's is attributed to need and emotion ("he's for technical analysis because he's a always followed the crowd and doesn’t want to do the fundamental spadework."). Be very wary of this thinking, there are many rational choices available which may or may not agree with yours!

Surowiecki stresses the need for diversity within a crowd to ensure enough variance in approach, thought process, and private information. He warns of the dangers of the information cascade…a situation in which every subsequent actor, based on the observations of others, makes the same choice independent of his/her private signal. In an informational cascade, everyone is individually acting rationally. Still, even if all participants as a collective have overwhelming information in favor of the correct action, each and every participant may take the wrong action. The tendency to rely on others to assess the information and merely copy is very strong in my view among many investors. It is more efficient for everyone else to simply copy those around them.

The great investors have applied a mosaic of thinking processes to come up with their conclusions. Charlie Munger is an intellectual jewel who relies on a vast and diverse knowledge base to support his investment thinking. Mohnish Pabrai incorporates such thinking in his portfolios and has written extensively about this in Mosaic: Perspectives on Investing and in Dhando Investor. Bill Miller of the renowned Legg Mason Value Trust has also described the importance of a diverse thinking process in his investment approach and exhibited it in spades with very non-traditional equity choices that are investments in his mutual fund. Much of this thinking is outlined in the Legg Mason Value Trust 25th anniversary review which is here. I highly recommend reading this very useful but lengthy essay.

The unique approach that Miller utilized in embracing technology stocks at a time that most of us failed to consider them is outlined:

“In late 1999, Bill spent a fair amount of time discussing the fundamentals of technology stocks and how we valued them. Many traditional value investors had chosen to ignore technology companies or to maintain minimal exposure to them despite long data trails and compelling evidence that the sector had the ability to create substantial, long-lasting shareholder wealth. Our research was based on the belief that although technology changes reasonably rapidly, it didn’t follow that such changes were random or unpredictable. And we believed, based on our analysis of financial services companies and health care companies, that technology companies often created change and instability in other unrelated businesses. Focusing our research in the area of technology and trying to understand the valuation of companies in that space led to considerably better performance for the Fund than if we had simply employed simplistic backward looking valuation methods.”

“In another 1999 letter to shareholders, Bill incorporated the work of William James from his essay “The Will to Believe.” Bill discussed James’s argument that in many cases one was justified in believing something well in advance of what others may consider sufficient evidence. The argument as it relates to owning a stock, in Bill’s view, is that the level of evidence one needs to believe something is a function of how important it is not to be wrong. The evidence bar will be set higher the more important it is not to make a mistake. If being right has a high value and being wrong a low value, then the evidence needed for belief can be a lot lower since being wrong is not very costly, and being right has a high payoff.”

This parallels the probability weighted theory that Pabrai describes in Dhando Investors well as the “decision-tree” description that Munger has used in marveling about Buffett’s thinking patterns.

We learned today of the Buffett lunch auction being “won” (if $650 grand for a lunch is a win) by Pabrai and another money manager, Guy Spier of Aquamarine Capital Management. Spier has the following link on his website, The Ignorance of Crowds. I think that those of us who try to develop investment talent at investment management firms can gain some valuable insights from this article.

It describes the Linux phenomenon of an open source development model. This level of collaboration works because “it dramatically increases the speed with which problems, or bugs, is uncovered and fixed. When only a relatively small number of programmers work on a complex program, debugging consumes huge amounts of time and causes lots of delays — and many bugs still manage to sneak through. When you mobilize hundreds or thousands of people, however, they find and fix bugs much more quickly and thoroughly.”

“The power that a crowd of contributors has to solve problems derives not just from its sheer size, although that is important, but from its diversity. It’s only because the members of the crowd have, as the author put it, “differing agendas and approaches” that they’re so effective at finding so many bugs so quickly. If the participants shared similar outlooks, they’d all end up looking for the same things in the same places. What an unorganized, fairly random group of people provides is not just a lot of eyeballs but a lot of different ways of seeing. As University of Michigan professor Scott Page writes in his new book, The Difference: How the Power of Diversity Creates Better Groups, Firms, Schools, and Society (Princeton University Press, 2007), ‘When solving problems, diversity may matter as much as, or even more than, individual ability.’”

But diversity does not imply egalitarianism. “The open source model — when it works effectively — is not as egalitarian or democratic as it is often made out to be. Linux has been successful not just because so many people have been involved, but because the crowd’s work has been filtered through a central authority who holds supreme power as a synthesizer and decision maker. As the Linux project has grown, Torvalds has gathered a hierarchy of talented software programmers around him to help manage the crowd and its contributions. It’s not a stretch to say that the Linux bureaucracy forms a cathedral that coordinates the work of the bazaar and molds it into a unified product.”

Ideas can be drawn from a wise crowd where they can be openly debated and uncovered. Drawing such ideas from the masses will work provided you have independent inputs and avoid the problem of information cascades where “nobody is really thinking.” The greatest breakthroughs will always begin with “one good idea in one person’s head,” and the greatest products will always reach perfection through the concerted efforts of a highly skilled team, a meritocracy that chooses the best contributions, synthesizes the best ideas and melds them together for a final investment decision.

Individual value investors should celebrate the diversity of the marketplace, there are, as Buffett describes, many ways to get to heaven. Don’t merely be imitative of some guru, or some approach. Find yourself; find your own independent thinking pattern. Think in terms of payoffs…what is the risk if I am completely and totally wrong? And conversely, what is the gain if I am correct. Don’t get too stewed by your own juices, by the intellectual pew in which most value investors seek comfort. Look for flaws, look for opinions contrary to your own and try to understand them, not merely dismiss them. Yours may not be the only rationally motivated opinion! In this way, your thinking will be shaped from a quilt of numerous thought patterns, a mosaic that is finally unified into an investment idea.

I describe what some may think is a very arduous process. Yet, it truly is not. It is a wondrous intellectual challenge, a puzzle that requires you to draw a piece from every philosophical exposure you have thought about in life. Avoid homogeneous thinking and lockstep imitation. Celebrate diversity!

< ? Market Blogs £ >