CHAPTER 11
The Appraisal of Managements and Growth: GARP versus GADCP*
New Framework for the Appraisal of Managements
Managements Attuned to OPMI Interests
Managements as Resource Converters
Growth at a Reasonable Price (GARP)
Growth at Dirt Cheap Prices (GADCP)
The appraisal of managements is, indeed, difficult. In a Graham and Dodd primacy of the income account approach (or any other primacy of the income account approach) managements are appraised almost solely as operators of strict going concerns. Experience tells us that this is not realistic. Superior managements seem to focus on the same things a value investor focuses on as a buy and hold investor, that is, long-term wealth creation. The generation of reported earnings from operations tends to be the least desirable method for creating wealth, simply because reported earnings from operations are less tax sheltered than are other methods of wealth creation. This is one of the reasons why resource conversion activities by corporations seem to have grown in importance at the expense of ordinary going concern activities. Also highly important for long-term wealth creation are attractive access to credit markets and equity markets. Unlike most stock market participants, the primary focus of these managements is not on what periodic reported earnings per share, or periodic earnings before interest, taxes, depreciation and amortization (EBITDA), might be.
In creating wealth, these opportunistic managements realize that there tend to be many ways to create wealth besides enjoying operating earnings. These other methods of creating wealth include enjoying super-attractive access to capital markets; being able to make opportunistic acquisitions of other companies and other assets; being able to opportunistically launch new businesses; and being able to take advantage of basic mispricing in securities markets in order to, inter alia, repurchase outstanding common stock, spin-off glamorous subsidiaries, or liquidate assets in whole or in part.
NEW FRAMEWORK FOR THE APPRAISAL OF MANAGEMENTS
Once it is recognized that superior managements seek long-term wealth creation, and that their businesses generate wealth by being engaged in both going concern and resource conversion activities, it follows that managements should be appraised based on three interrelated dimensions:
We want the managements of the companies in which we would invest to be attuned to the interests of outside passive minority investors (OPMIs); to be competent as day-to-day business operators; and to be competent as wealth creators as resource conversion opportunities emerge opportunistically from time to time.
Experience tells us that we have achieved the best results when associated with superior managements who were able to be opportunistic on a long-term basis, and took advantage of the resources in the business, which included:
Experience has also taught us that the vast majority of misjudgments often revolve around being in bed with the wrong management, rather than purely financial factors.
MANAGEMENTS ATTUNED TO OPMI INTERESTS
As to being attuned to the interests of OPMIs, it can safely be stated that there does not exist any publicly traded company where the management works exclusively in the best interests of OPMI stockholders. Rather, all financial relationships, including those between managements and OPMIs, combine communities of interest and conflicts of interest. The best OPMIs can hope for is that there is a distinct bent by individual managements toward the communities of interest side. It would be naïve to think that any management would forgo management compensation, and management entrenchment, just because some of these management privileges might be perceived as giving rise to a conflict of interest with OPMIs.
It ought to be noted that there tend to be conflicts of interest between short-run, market-sensitive OPMIs and long-term, buy-and-hold OPMIs like us. We are very much against corporate beefing up of quarterly reported earnings per share when, and if, the striving for periodic earnings per share diminishes opportunities for long-term wealth creation. Striving for quarterly earnings per share often tends to reduce wealth creation opportunities when alternative methods of wealth creation might be available. Good examples of managerial emphasis on the short-term effects rather than a long-term view are mortgage lending by Key Corp. and other banks in 2005 and 2006, and the merger of AOL into Time Warner in 1999 at the height of the dotcom bubble.
Example
Operating earnings are taxable, and unrealized appreciation is not taxable. Not paying taxes increases resources available for wealth creation. It makes sense for corporations interested in wealth creation to emphasize earnings per share when such emphasis will give the company better access to capital markets, especially equity markets, than would otherwise be the case. This, however, has virtually no relevance for us since the common stocks in which we would invest are issues of companies with little or no need to access capital markets, especially equity markets.
MANAGEMENTS AS RESOURCE CONVERTERS
Managements can and do create wealth by acting as opportunistic investors. This opportunism is often associated with their companies having a strong financial position, which they can use to effect attractive acquisitions.
EXAMPLE
Wharf in 2012 made an attractive investment into the financially strapped Mainland China homebuilder Greentown China Holdings. Wharf invested HK $5.1 billion (U.S. $654 million) into Greentown, half in common stock and half in a convertible debenture. Upon conversion, Wharf will end up with an approximate 35 percent ownership interest in Greentown equity. Greentown is one of the foremost residential builders in Mainland China. Its principal problem seemed to have revolved around a poor financial position. That poor financial position seems to have been cured by Wharf’s HK $5.1 billion capital injection. The purchase price will equal about HK $5 per Greentown share. Greentown common at this writing sells between HK $8 and $9 per share.
One example of management leaving something on the table that could have benefited stockholders involves the 2005 acquisition of Instinet by NASDAQ.
EXAMPLE
In April 2005, Instinet Group entered into a merger agreement with NASDAQ under which Instinet shareholders would receive total consideration of $1.8 billion in cash. As part of the transaction, Silver Lake agreed to buy Instinet’s agency brokerage business for $207 million, which represented a discount to the subsidiary’s tangible book value. In May 2005, Third Avenue Management submitted an acquisition proposal to Instinet in which it offered to “stand in the shoes” of Silver Lake and purchase the agency brokerage for $307 million, subject to limited due diligence but no financing contingency. Instinet rejected the proposal as the board concluded that it was not reasonably likely to constitute a “superior proposal” for the entire company. In December 2005, the merger with NASDAQ (and Silver Lake) was completed. In February, 2007, Silver Lake sold Instinet’s agency brokerage business to Nomura for a reported price of nearly $1.2 billion or a premium of more than five times its purchase price and nearly four times the price offered by Third Avenue.
Mistakes by managements involved with acquisitions are also common.
EXAMPLE
One of the more egregious mistakes might have occurred when in 2008 Bank of America acquired 100 percent control of Countywide Financial Corp. in a merger transaction. In the transaction, Bank of America should have made absolutely certain that it was not assuming any liabilities of Countrywide. Those liabilities would remain the obligations of Countrywide but were not obligations that would attach at all to Bank of America. This appears not to have been the case.
Assuming the liabilities of poorly financed subsidiaries ought to be avoided like the plague by astute management.
EXAMPLE
In 2012 questions were raised by creditors of Residential Capital LLC (ResCap) as to whether or not all of Ally Bank (formerly named General Motors Acceptance Corp) is to be responsible for the obligations of ResCap a wholly owned subsidiary of Ally Bank. The Bankruptcy Court has appointed an examiner to explore the issue.
Realizing current losses on a one-time basis is a recognized method for making future earnings better than they otherwise would be. Many companies that take huge write-downs—largely on injudicious acquisitions and on expansion undertaken during a period of excesses—serve as good examples. Taking those huge write-downs came to be known as big-bath accounting. Examples of companies that took big baths at the outset of the 2008–2009 financial crisis included Merrill Lynch, Citigroup, and General Motors.
EXAMPLE
In 2012, Tellabs took a $106 million charge-off writing off completely its injudicious acquisition of WiChorus in 2009.
Most companies that take big-bath write-downs account for them as nonrecurring, extraordinary events. This bothers many who felt that in reporting profits the big baths should be treated as a normal, recurring event. It seems to us, though, that much of security analysis and much of accounting is directed toward appraising businesses and their managements solely as operations and operators. If so, the big baths are indeed nonrecurring. As we have already pointed out, a feature that differentiates us from conventional business and security analysts is that convention (be it Graham and Dodd or modern capital theory) seems to emphasize operations at the expense of resource conversion factors, whereas we tend to de-emphasize operating factors, or rather, give resource conversion factors greater importance for most companies most of the time.
Insofar as a company is to be appraised as a going concern and managements as operators, it is logical to view the big bath as nonrecurring. Insofar as a company and a management are to be appraised as investors responsible for obtaining a return from the resources entrusted to them by being operators, financiers, and investors in new productive assets and by being specialists in mergers and acquisitions (that is, by viewing them as resource converters), there is no such thing as nonrecurring charges or expenses. Nonrecurring charges are the method used in Generally Accepted Accounting Principles (GAAP) accounting to record past investment mistakes.
TRADEOFFS
No management is perfect. The factors that allow the managements to be opportunistic also bring to light certain shortcomings, at least from the viewpoint of shorter-term stock market speculators. During good times, when interest rates are low, the maintenance of a strong financial position obviously translates into a willingness of management to sacrifice increased return on assets (ROA) and return on equity (ROE) in order to enjoy the safety benefits and the opportunistic benefits inherent in having a strong financial position. Focusing on long-term opportunism rather than periodic earnings per share, as reported, tends to not sit well with most OPMIs. A company with a strong financial position either does not need access to capital markets or else controls the timing as to when they would access capital markets. Given this, the managements tend to be nonpromotional, and at times, hardly interested at all in what Wall Street thinks. For better or worse, we would opt for managements more interested in creditworthiness than enhanced ROE.
The traditional focus on strict going concerns and the resulting view of managers only as operators is pervasive and often leads to misleading conclusions about the dynamics of wealth creation.
EXAMPLE
In the book, Value Investing: From Graham to Buffett and Beyond, by Greenwald, Kahn, Sonkin, and Van Biema (John Wiley & Sons, 2004), there are discussions of net asset value (NAV). An important point in the book revolves around the view that if the market price of a common stock is well above the reproduction value of assets, the company and the industry, in the normal course of events, will draw new competition which will result in diminished returns unless the company can build a moat to insulate itself from new competition (e.g., Coca-Cola, Gillette, and WD-40). From a strict going concern point of view, this observation seems quite valid. From a corporate management point of view, though, it seems to be incomplete. In the hands of a reasonably competent management, an overpriced common stock tends to be an important asset with which to create future wealth by issuing that common stock in public offerings, and in merger and acquisition transactions.
On the opportunism issue, we are convinced it is very difficult for most managements to be opportunistic if their financial positions are such that they have to be supplicants to creditors—whether those creditors are financial institutions, trade vendors, or landlords. As we explain in Chapter 7, a strong financial position—that is, being creditworthy—gives managements options they would not have otherwise. Opportunism is one such option. We also explain that a strong financial position may not be needed when management is associated with and the company is controlled by sponsors who are extremely competent at accessing capital markets on a super-attractive basis even in the face of weak financial positions. We show an example of this situation in Chapter 25.
GROWTH: GARP VERSUS GADCP
In The Intelligent Investor,1 Benjamin Graham defined a growth common stock as a term that applied to one that had increased its earnings per share in the past at well above the rate for common stocks in general and that was expected to continue to do so in the future. He recognized then that these stocks would be attractive to buy and to hold provided the price paid for them was not excessive. Thus, Graham laid out the current day concept of GARP. GARP stands for “growth at a reasonable price.” GARP is a usual standard for growth investing in the financial community by OPMIs, such as mutual funds or individual investors.2 In contrast we advocate the concept of “growth at dirt cheap prices” or GADCP, which is what investors following a fundamental finance approach ought to try to accomplish in making most of their investments.
GARP analysis tends to be quite different from GADCP analysis as we explain below.
GROWTH AT A REASONABLE PRICE (GARP)
GARP analysis focuses strictly on forecasting future flows, whether such flows are revenues, earnings, or cash. An attractive common stock purchase is deemed to exist where future forecasted growth rates are greater than current ratios of price to flows. Thus, a common stock is usually deemed attractive under a GARP analysis if it is selling at 20 times earnings and the forecasted future growth rate for earnings is something more than 20 percent compounded, say 25 percent compounded. However, the same common stock under a GARP analysis would not be attractively priced at 20 times earnings if the future growth rate were estimated to be something less than 20 percent per annum compounded. A summary statistic commonly used in GARP analysis is the PEG ratio.3 The PEG ratio is the ratio of the P/E ratio and the expected future growth rate in earnings. A common stock selling at a PEG ratio lower than one (expected growth rate in earnings is higher than the P/E ratio) is attractively priced under a GARP analysis. The converse is true if the common stock is selling at PEG ratios substantially higher than one.
EXAMPLE
Apple, Inc. common stock is often cited as one selling at very attractive prices under a GARP analysis. At the beginning of August 2012, Apple Computer common was selling at a NTM PEG ratio of 0.55, which indicated that the expected short-term growth rate in earnings for the company was almost twice its market P/E ratio of 15 times.
In GARP analysis, heavy weight is placed on the past earnings record. Indeed, in much of GARP analysis it is assumed, in linear fashion, that future growth rates will approximate the growth rates achieved over the past one to five years. Rarely, if ever, is any weight at all given to balance sheet considerations in making forecasts, whether those balance sheet considerations involve the quality of resources in a business or the quantity of resources existing in a firm.
GARP analysis tends to revolve around a very short-run focus. If the immediate revenue, earnings, or cash flow outlooks are poor, common stock investment is to be forgone regardless of long-term prospects. A corollary of this is that the typical GARP securities buyer is short-run oriented and tries to buy at, or near, bottoms for securities prices.
Industry identification is very important in GARP; the securities buyer wants to get into industries that are generally recognized as growth industries in the financial community, say social media. Quite often, there is no independent analysis of growth potential, but rather only an acceptance of the generally recognized consensus. The underlying problem with going along with the generally recognized consensus is that the investor tends to buy what is popular when it is most popular. In other words, the investor has to pay up. Historically, buying what is popular when it is most popular has been a prescription for disaster for investors, whether it was acquiring RCA Common in 1929, real estate tax shelters in 1985, junk bonds in 1988, dotcom companies in 1999 and social media companies in 2012.
GROWTH AT DIRT CHEAP PRICES (GADCP)
In GADCP, there is no emphasis on estimating future flows. Rather it is recognized that growth in common stock prices can come, and frequently does come, from sources other than corporate operations. Growth can come from judicious acquisitions (Capital Southwest Common); creating unrealized, and unrecorded, appreciation in asset values (Forest City Enterprise Common, Hopewell Holdings Ordinary); creating hidden assets in the form of increases in adjusted book value (Carlyle Group); having companies taken over by others at premium prices (Brookfield Asset Management); and possibly participating in corporate restructurings (Nabors Industries).
In forecasting future flows of revenues, earnings, or cash flows, no exclusivity in making these forecasts is given to the past earnings record under a GADCP analysis. It is recognized under GADCP that the quality of resources in a business and the quantity of resources in a business tend to be equally important, and for some companies are more important than the past record in making reasonably accurate forecasts of future flows. This is simply giving recognition to ROE and ROA as part of the forecasting process with Equity and Assets being balance sheet items.
EXAMPLE
Society Corporation’s position in the early 1960s is one example of this. Society Corporation was a bank holding company based in Cleveland, Ohio. At that time, banks’ ROE was between 8 percent and 12 percent. Society, with a net worth of about $50 a share, was earning about $1.50 a share from operations when it converted from a mutual savings bank to a commercial bank holding company in 1962. This equaled an ROE of only 3 percent. A market participant could reason with a fair degree of confidence that over time Society probably would be earning a return on its equity close to that which was being achieved in the commercial banking industry in general. At least, there did not appear to be any insurmountable problems preventing this. Furthermore, book value, too, would be steadily increasing. The anticipated results occurred; reported earnings increased year by year, and by 1966 operating earnings were $5 per share (or a 35 percent annual compounded rate of growth) on a year-end book value of $62. The prediction of Society Corporation’s future earnings growth could not have been based on the past earnings record. An examination of the asset values and the belief that such asset values would be used much the way other commercial bank holding companies used theirs were the basis for the earnings growth forecast. This approach is probably better described as a resource conversion approach to analysis rather than a strict going concern one. Why? The key item in evaluating Society Corporation was the probability that it would convert its assets to more productive uses, not that it would continue using them in the same way as in the past.
In GADCP, though, there is strong recognition given to the fact that most forecasts, no matter what techniques are used to make them, are going to prove to have been inaccurate. It is just too difficult to properly put into forecasts factors such as competitive forces, technological innovations, inexperienced managements, business cycles, access to capital markets and acts of God. Knowing of the inherent unreliability of its forecasts, we restrict our common stock investments to issues that enjoy very high-quality resources where we can acquire its interests at prices that represent a meaningful discount from the estimated quantity of resources that exist in a business.
GADCP is inherently long-term conscious. Indeed, securities markets tend to be efficient enough that a GADCP investor is unlikely to find issues at attractive prices unless the near-term outlook is poor to clouded.
Industry outlooks are as important for GADCP as they are for GARP. However, under GADCP, industry outlooks are based on independent analysis rather than conformity with a general consensus. We concluded a few years back that semiconductor equipment companies would have to participate fully in the growth of the Internet and telecommunication industries simply because the Internet and telecommunications could not come close to realizing their potentials unless there also occurred a dramatic increase in demand for increasingly sophisticated semiconductor chips. At that time, there was no recognition of this thesis within any Wall Street general consensus. We therefore could acquire the common stocks of well-financed semiconductor equipment companies such as Applied Materials or Intel at prices that were probably lower than a first-stage venture capitalist would pay were these corporations being financed as start-ups.
Many of these growth stocks do not have general recognition, and so they sell at very modest prices. Examples in mid-2012 included Applied Materials, Intel, Brookfield Asset Management, Cheung Kong Holdings, Hang Lung Group, and Wheelock & Co.
A large variety of factors enter into forecasts of future growth in NAV. Each set of factors is particular to the company being analyzed. For example, a principal element for forecasting growth for various Hong Kong companies in 2012 is the belief that mainland China, where each company has massive presences, is more likely to grow in the next three to five years than almost any other industrialized part of the world, whether Europe or North America. These Hong Kong companies are Wheelock & Company, Henderson Land, Cheung Kong Holdings, and Hang Lung Properties. The forecast of growth for Brookfield Asset Management, on the other hand, is based largely on an appraisal of management, whom we believe is super-skilled. A similar appraisal of management is key to our belief in the NAV growth potential for Capital Southwest Corporation.
SUMMARY
The view of businesses as pure going concerns has led to appraising managements only as operators. Once one recognizes that businesses generate wealth both through going concern and resource conversion activities, it becomes apparent that managements should be appraised not only as operators but also as investors and financiers. It is our experience that investment success is more often related to being associated with managements who are opportunistic and take advantage of the resources of the business than by any other financial factor.
The current paradigm of growth investing is GARP or growth at reasonable prices. We identify limitations of GARP, which stem from its underlying assumptions including: the view that businesses are pure going concerns, heavy weight is given to the past earnings record when forecasting future earnings growth, industry identification is important to GARP, acceptance of the generally accepted consensus of growth potentials rather than reliance on independent appraisals of growth potentials, a tendency towards buying what is popular when it is most popular. In contrast, we advocate using GADCP investing, or growth at dirt cheap prices investing. In GADCP we give no primacy to flows in forecasting future growth but rather consider the quantity and quality of resources in a business as well as managements’ appraisals as investors and financiers, and potential resource conversion opportunities while being extremely price conscious. A large variety of factors enter into the determination of growth potentials and we provide examples that highlight such factors.
* This chapter contains original material, and parts of the chapter are based on ideas contained in the 2004 4Q letter to shareholders. This material is reproduced with permission of John Wiley & Sons, Inc.
1 Benjamin Graham, The Intelligent Investor (New York: Harper & Row, Publishers, Inc., 1973).
2 The GARP concept appears to have been popularized by Peter Lynch in his 1989 One Up on Wall Street (New York: Fireside, 1989).
3 This ratio was developed by Mario Farina in his 1969 book A Beginner’s Guide to Successful Investing in the Stock Market (Palisades Park, NJ: Investors’ Press).