Insiders

October 9, 2010 5:50 PM


There are lots of ways to look for interesting stock ideas. I have found that insider buying is one of the best indicators of future stock performance. It operates under a very simple principle. Insiders know more about their business than you do. When they think it’s a good time to buy, it usually is. In fact, it is so simple; I’m surprised that investors do not follow insiders more closely.

Insiders sell shares for all sorts of reasons. Often, it has nothing to do with fundamentals. Insiders are granted stock options all the time. It is part of pay. When these vest, they get sold. Sometimes an insider wants to enjoy the fruits of his labors and sells to buy a house or boat or send his kids to college. There are lots of reasons for stock sales. There is only one reason that insiders buy stock—they think it is going up and they want more exposure.

I have seen lots of studies on insider stock trading and these academics usually miss the mark. They think about it all wrong. If you analyze every insider transactions, the upside bias is marginal. If you segregate the transactions and think about them intelligently, you can find patterns that have value.

Insider Trading

To start with, insiders are fallible—they are human after all. Sometimes, they simply make mistakes. If multiple insiders buy at the same time, it is unlikely that they are all wrong. More likely, they all see the same thing at the same time. When I see one insider buy, I find that interesting. When I see multiple buys in a few week period, I always look closer—there is probably something I need to learn about. Watch for clusters of buying.

If a board member buys a few thousand dollars worth, does it really matter? Sure, it is a vote of confidence. What I really focus on is what management thinks. No matter what, the CEO or CFO will know a lot more about the fundamentals than a board member. The management will also know a lot more about the industry and what is going on in the cycle. Occasionally, you find directors who are the ones really calling the shots. It helps to know the corporate politics of a situation, but 95% of the time, the board is hostage to the management team. It is that management team that you need to watch in terms of insider transactions.

Do small transactions matter? At smaller companies, executives are not paid well. Sometimes, a $10,000 transaction may seem small, but it is quite meaningful to that person. I think of transaction size in terms of take home salary. If an executive is making $90,000 a year, his take home salary is maybe $65,000 after taxes. After living expenses and mortgage payments, a $10,000 purchase may be ALL OF HIS DISPOSABLE INCOME for the year. That means a whole lot more than when a wealthy CEO buys $50,000 worth of stock. I am a nosy fellow. I have no problem with calling the executive up and feeling out his financial situation. These smaller transactions may actually be quite significant in terms of how confident the guy is. I always think of transaction size in terms of take home pay. Small transactions may actually be very big.

good stock chart

Insiders have an intuitive feel for if their shares are cheap or expensive. They watch acquisition multiples in their industry and they know how peers are valued. If their stock starts to plummet, they sometimes step up and buy on the way down. These transactions often mess up the academic studies. Insiders tend to be too early in buying and they tend to underestimate perceived problems in their industry. When you see insiders buying on new lows, it’s bullish in a longer term sense. Unfortunately, it often has little relevance in predicting stock performance in the next few quarters. Every time I have bought when insiders bought new lows, I have been too early. This is valuable for figuring out if a company is cheap—it isn’t a predictor of near term movement.

It is VERY bullish when insiders pay up. When you see insiders buying shares after a big move, it means that they think it’s still a good bargain. Even more likely, they’ve been waiting patiently for the shares to pull back. Finally out of desperation, they’ve thrown in the towel because they want more exposure. Usually, it’s because they expect big news in the near future.  Often, as that news approaches, they enter blackout periods where they cannot buy any more shares. When you see guys buy stock right before a blackout window—you can almost assume that they are trying to jump the gun on big news.

The key is to put these factors together in analyzing a situation. You want to see clusters of insider transactions. You want to see large value to disposable income transactions. You want to see purchases at new highs and you want to see the key employees making those purchases. I never ignore insider sales, but I just don’t give them the same attention as I do towards insider buying.

AAG Insider Buying

AAG Volume

Data Provided By InkResearch.com

Let’s look at Andean American Gold Corp. (AAG: Canada) which should be familiar to readers of this site. In the fall of 2008, CEO John Huguet was in disbelief at the price of his shares. He started by buying 110,000 at $.27 on July 23. Three additional insiders purchased shares as they hit new lows. Remember what I said about insiders buying too soon on new lows. They underestimated the financial crisis and the fact that banks were not willing to finance anything. However, they knew their shares were cheap. This buying convinced me to add to my position. Clusters of buying are always meaningful.

After the shares began to lift, Huguet started buying again, as did other insiders. They were willing to pay up to get more exposure—that’s bullish. Huguet bought shares on May 6 at $.12. On June 17, he bought more at $.20. A new board member, Paulo Bilezikjian made some purchases before joining the company. After getting to know the company better, he became more aggressive in his purchases, and at new highs. On July 20, 2010, he purchased 875,000 shares at $.50. His personal finances are his business, but when an insider buys $437,500 worth of stock, that’s meaningful to me. His purchase in the financing at $.50 sure looked smart. A few days later, the shares were 50% higher.

Recently, Mark Zabel (corporate development) and Paulo Bilezikjian (director) have made additional purchases at $.93 and $.91 respectively. Is it bullish? It certainly isn’t bearish. Why did they buy at these prices? You’d have to ask them. It makes me feel good to know that they still think it’s a good investment. What happens next? No one knows. However, we’ve seen clusters of buying and we’ve seen insiders buying at new highs. It’s all bullish to me.

Insider-Trading

I follow the insider trading like a hawk. Each week, I scroll through the list of transactions. The first dozen or so are meaningless as they’re from big companies. I want to scroll through the little stocks that I’ve never heard of. $5,000 here and $10,000 there start to add up fast if you have multiple buyers reloading at the same company. That’s what I’m looking for. Then I try to figure out what they see that the market is missing. Sometimes, I can figure it out. Sometimes I call them up and ask them about it. If they’re still buying, they may be cagey or they may want to tell me about how their shares are cheap and the business just got a WHOLE LOT BETTER in the past month.

Usually, it’s something that only an insider would understand. Maybe it’s a large competitor who’s going bankrupt, or a sizable contract win or a new product that’s doing well. You cannot figure these things out from the financials—it is forward looking. Ignore valuation scanners. Watch what the insiders are doing. I do not know why anyone would bother with following anything else. Put it this way—if it appears cheap and insiders AREN’T buying, something is probably wrong with the business—you just haven’t figured it out yet. Watch the insiders—they’re the best indicator that I know of.

 

Disclosure: My partnership is long shares of Andean. We may buy or sell shares at any time.

Categories: Investment Strategy
Positions Mentioned: none
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Hidden Value (Advertising Expense)

September 23, 2010 12:06 PM


The equity markets are surprisingly efficient. This is because most people are quite capable of looking at price earnings multiples and finding the ‘cheap’ stocks. Of course, some businesses are better than others. The better businesses normally trade at higher multiples and the worse ones trade at lower multiples. Amazingly, the market is quite capable of sorting this process out. With the addition of supercomputers at many large investing firms, this process is even more efficient. However, the market sometimes completely misses in certain circumstances, especially when there are no profits for a fancy computer to analyze.

I have always felt that the best way to value a business is to think of what a private acquirer would pay for such a business. P/E multiples are a start, but they are just that. There are many factors that impact the true value of a business. When you are a rapidly growing business, you have to spend money to grow. This benefits your future earnings at the expense of current earnings. The stock market often has a hard time understanding this. Let’s look at advertising spend.

advertising for dummies

Companies spend money on advertising because they want someone to buy their product. This is money spent today that may have no value for a long time. It takes a lot of advertising to build a brand and convince someone to buy your product. Afterwards, there’s no guarantee that anyone will continue to buy your product—even if it is good. Advertising is a direct cost; the possible benefit is in the future. If a company spends heavily on advertising, it hurts current profits—sometimes it even produces losses. Advertising can effectively hide real value.

You have likely heard of the Breathe Right nasal strips that essentially pull your nostrils open and alleviate congestion if you have allergies or a cold. The product can even help to reduce snoring by improving airflow. Until you try the product, it seems unlikely to work. Once you do try it, you cannot imagine fighting a cold or allergies without them. This creates a lot of recurring demand for the product—the trick is convincing someone to use the product for the first time. Enter advertising.

 

CNS, Inc. Annual Results (All Numbers In $USD Thousands Except Percentages)
 200020012002200320042005
Revenues61,77776,24279,07586,98093,732112,644
Advertising Spend39,57934,25630,93033,10129,68434,945
Advertising As a Percent Of Revenue64.1%44.9%39.1%38.1%31.7%31%
SG&A15,13414,58312,51414,22717,29318,914
Operating Income-17,843-2959,63912,74820,05125,600

This is six years of results from CNS, Inc, maker of Breathe Rights. Notice how revenues doubled over this period? It is advertising that is driving this growth in revenue. If you can convince someone to try the product, they will probably use it again. Advertising spend fluctuates a bit, but it is relatively constant in dollar terms. This proves that a lot of demand is recurring. Otherwise, you would need to increase advertising to increase revenues. The key to profitability is that as revenues doubled, advertising spend dropped from 64.1% of revenues in 2000 to 31% of revenues in 2005. The difference is a swing in operating income of $43.4 million ($-17.8 million in 2000 to $25.6 million in 2005).

The problem is; how do you value this business? In 2000, the company lost almost 18 million. Most traditional value investors would say the business is worthless as it is losing money. You need to think about it differently. Let’s say that you need $10 million of advertising spending a year to keep revenues constant. So, let's recalculate operating income. With only $10 million of spending, your operating income is $11.7 million. If you don’t want to grow your business, it is probably worth ten times this number or over $117 million. Ironically, at the end of 2000, it was valued at only $50 million (3.50 a share) and $31 million of that was net cash. Investors gave almost no value at all for the business.

breathe right

Fast forward to early 2003 when I paid $6 a share for my shares. At the time, the company was valued at roughly $85 million or nine times the $9.6 million in operating income it produced in 2002. Maybe that was a fair multiple, but once again, investors failed to consider that the company spent $30.9 million that year on advertising. They also failed to notice that almost half the company’s market cap was made up of cash and marketable securities--it was a silly valuation. If you wanted to stop growing the business and only spend $10 million on advertising, operating income would almost triple to $30.5 million. The company was valued at little more than one times standing still operating income minus cash. Clearly this huge advertising spend was hiding the real fundamentals of the business.

Eventually, GlaxoSmithKline PLC realized this mispricing was silly and in 2006, they bought the company for $37.50 a share in cash. That’s more than six times what I paid for my shares. Clearly, advertising creates situations where the true earnings power of a business is hidden. Even more importantly, this creates great opportunities for investors who can understand this.

breathe right 2

How do you profit from this? There are a few key things to mull over. The first one is that lots of companies waste piles of money on advertising. You need to consider how much is spent compared with how much additional revenue and gross margin it brings in. Then you need to consider if that revenue is recurring. You can promote a gadget, but eventually it becomes obsolete. You can promote a luxury product, but eventually demand fades. The real money is in promoting a product with recurring demand. Buy some for your friends. Find out if they like it. Will they then spend their own money on it? There are very few of these products—make sure you have found one before you move to step two.

Financial engineering is never easy—its guesswork and intuition. What you are trying to do is figure out the bare minimum of advertising needed for the revenues to remain constant. Using this number, you can figure out the ‘core profitability’ of the business. This is horribly subjective, so you need a wide margin of safety. Why did I think that $10 million was the bare minimum of advertising needed at CNS? It was little more than a guess really. I bought some Breathe Rights for a few friends to try and was stunned that they went to the store and bought more. Eight years later, and some of these guys still buy a few boxes a year. It made me think that trial users become life-time users. This means that advertising spend is almost all going towards growth in brand awareness—not towards reminding people to use the product. No one ever needs to remind me—every time I get a cold; I rush to the store for another box.

 

CNS, Inc. Annual Results Adjusted For 'Core Profitability' (All Numbers In $USD Thousands Except Percentages)
 200020012002200320042005
Revenues61,77776,24279,07586,98093,732112,644
Advertising Spend10,00010,00010,00010,00010,00010,000
Advertising As A Percentage Of Revenue16.2%13.1%12.6%11.5%10.7%8.9%
SG&A15,13414,45812,51414,22717,29318,914
Operating Income11,73623,96130,56935,84939,73550,545

 

In the matrix above, you can see where operating income would be if you were to stop the growth of the business and only spend the bare minimum to sustain revenues in any given year. This gives you the ‘core profitability’ of the business. If you figure that the business is then worth ten times that number, you can see that the value of the business increased from $117 million in 2000, to $505 million in 2005. Incidentally, my math isn’t too far away from the $491 million that the company was eventually acquired for in the middle of 2006.

For six years, the public markets undervalued the shares of the company. The markets could never see past the massive expenditures on advertising. This created an opportunity for me to buy shares for a bit over two times prior year ‘core earnings’ in 2003. If you add back the net cash, I paid about one times ‘core earnings.’ Bargains like this should NEVER exist in an efficient market—especially for such a high return on capital business. The only reason this was possible was because the markets are occasionally very inefficient. Look for situations where today’s earnings are masked by growth expenditures. Look for situations with heavy marketing spending. Think about ‘core profitability’ and what a business is really worth. In the end, small companies get acquired by big businesses hungry for growth. Think like one of those big businesses. CNS, Inc. went up six times from where I bought it. Those are outstanding opportunities if you can find them. If you can combine them with other concepts like Gearing, you can really have huge gains. Stop focusing on current earnings. Think creatively about earnings. Focus on what something is actually worth. 

Categories: Investment Strategy
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Just A Little Patience....

July 9, 2010 1:08 PM


Let’s face it. Running a business is difficult. Nothing ever goes as planned. There are surprises. Things rarely happen on time or on budget. You need to be a realist about this. If you invest in a company and it doesn’t work out right away—you aren’t always wrong. Sometimes things just take time.

I cannot emphasize this enough. Many of my best winners took a year, sometimes two, for the business to do what I thought it would. This is especially true when a company is dealing with regulators and compliance issues. You have to ask yourself if the issue is insurmountable. If it is, sell the shares and move on. Usually, it is just a question of time. Be patient.

On many other occasions, the business is doing just fine, yet the shares refuse to recognize this. It is quite remarkable really. You bought something that was growing quickly. It grew for two years and the shares were right where you bought them. You can become frustrated, or you can realize that the shares are now much cheaper than when you bought them. Even though the share price is the same, the business has become more valuable. When this happens, you should buy with both hands. It happens more often than you’d think, and those have been some of the best investments for me.

Patient Bear

As investors, we’re bombarded by television shows that make you think that everything has to be immediate. They are so focused on the next data point; they lose sight of everything else. Then you have the brokers who only make money when you shift your money around. No wonder they’re always putting ‘analysts’ on the airwaves trying to pitch you on some new stock a week after the last one. Finally, you have the hedge funds that have to show positive monthly performance if they are to continue taking in assets. If something doesn’t work in a few weeks, they sell. They just don’t have the same sort of time horizon that sane people should.

You can either get scared watching each tick, or you can do your research, be confident and go read a good book. I prefer the latter. You just cannot over-analyze a business. If it all hinges on next quarter’s earnings, then you’re not investing—you’re gambling. If you think that a .1% change in GDP is a reason to sell everything, then you are going to lose money. If a $50 dollar move in gold makes you think it’s now a bad investment, then you don’t appreciate bargains when they come to you. Once you buy something, ignore the price unless something changes at the business.

I have no idea what will happen tomorrow or next week. I am focused on what happens a few years from now. I spend my time finding great little businesses that will profit from the big picture trends that I have identified. I’m usually early—that’s fine with me. Sometimes, I pay too much. That’s life. No one ever buys the bottom or sells the top. If I still like something and it drops, it is an even better bargain now.

patient serial killer

That doesn’t mean that you can ignore the markets or the news from a company you own. It just means that if the shares are down 20% in a day, don’t panic—it’s probably some overleveraged hedge fund getting redemptions. Use these moves to your advantage. Keep extra cash. NEVER use margin. Be patient. Turn off the TV. Stop watching the ticker. It can only make you do something stupid.

Look at the market. In the past month, all we’ve heard about is how the market is collapsing. Meanwhile, it’s at the same price it was 6 weeks ago. I keep hearing about how the Euro is going to zero. Look at the chart—it’s the same price it was back in early May. Is it really going lower? Those who were following things closely were probably pretty scared the world was going to end. A lot of them sold out of fear. Does that make sense?

Of course, you could be a trader and try to figure out every little twitch in the market. Do you know of any rich traders? I mean billionaire traders? There are plenty of really successful investors. I can’t even name five billionaire traders. Maybe there’s a reason—maybe it’s just impossible. So why focus on something that is impossible? Buy good companies, put them away and wait for crazy opportunities to buy more when everyone else is selling. The whole macro world has come unhinged. On a daily basis, there will be scary news. Invest in businesses that will benefit from the macro trends—or ones that are immune to them. I expect a lot more volatility going forward—that creates a lot more opportunities. However, you need patience.

You need patience to let an investment story play out. You need patience to ignore a bad quarter or two if you like the business. You need patience to ignore the volatility. You just need patience. There's a lot of mindless noise out there currently.I cannot think of a good investment decision that I ever made in a hurry. Be patient.

Patience (dog and skunk)

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My Currency Epiphany

May 20, 2010 11:17 AM


I’m in Gundagai New South Wales at a charming café having buttered toast with canned spaghetti on top. I’m told it’s an Aussie delicacy. I’ve driven nearly 500 km from Sydney and have already had my first epiphany. It is said that generals always prepare to fight the last war. This cannot be truer when it comes to investing.

For decades, currencies have fluctuated in multi-year cycles. Once a currency begins to appreciate, that trend usually continues for years—before it reverses. Over time, most currencies do very little. Look at a multi-decade chart of most major currencies. It is a giant sine curve. Some currencies have an overlying trend to them. The Yen has slowly appreciated for years.  Our dollar has slowly devalued. However, the underlying trend is barely noticeable compared to the shorter term swings.  It is those swings that we all try to capture.

25 year dxy chart 25 year GBP chart

25 Year Chart Of The Dollar Index On Top Of A 25 Year Chart Of The British Pound

Over the years, I have made a good deal of money on these multi-year swings. In the shortest time frames, the direction of a currency is very closely tied to the direction of its interest rates. I’m not about to risk a few percent on a currency move to make a quarter of a percent more in interest rates. I want to capture those bigger moves.  I want to play the sine curve. Currency traders like to point to lots of statistics when analyzing a currency. Current account deficits, fiscal deficits, the price of a key commodity, these all matter. However, over the years, I’ve found the most reliable metric to simply be the cost of living in a country.

Devise a mental matrix based on what you think things should cost. This is naturally subjective. A nice dinner in London should cost more than in Reykjavík, Iceland. A sandwich in Sydney, Australia should cost more than one in Lima, Peru. A condo in New Orleans should cost more than one in Merida, Mexico. I don’t know why I believe that—but I intuitively believe that should be the case. These relative values should be static. Base your matrix upon the wealth of a nation, the size of the city and the hidden factors like the cachet of a place. This is a very subjective method—but you likely understand what I mean.

Over time, market forces should normalize these prices so that things cost what you would think they should in relation to other places. However, from time to time, prices in a country seem horribly out of synch. That’s called opportunity. I travel a lot. I notice these trends all the time. They almost always correct. It’s almost embarrassing to say it, but over the years, I’ve made millions of dollars buying and selling currencies based on little more than the relative price of a few beers and a plate of nachos.

Nachos

Why does this happen? Look at the Euro. For years now, Europe has been expensive. It’s been horribly expensive. Is it any surprise that the currency is now dropping? Sure, the proximate cause is a debt crisis in Greece. However, the expensive currency likely had a lot to do with the deficits that Greece has run. Tourism has been weak and that’s because of the strong Euro.  As the Euro gets cheaper, people are more willing to visit, tax revenue increases and the deficits decrease. It’s self correcting, with giant lags at times. Where will the Euro drop to? Let’s just say that it’s not cheap yet in Europe. I’m not trying to buy it when it’s fairly valued. I’m trying to buy it when it’s cheap compared to other currencies. I don’t know if it will ever get there. I may never own Euros. That’s fine with me.

At the same time, you do not want to have a washout. The Mexican Peso has been cheap for years. Mexico is cheap to live in. I like it there. However, they do not respect their currency. Every so often, there’s a currency crisis and you get hurt bad. The currency is cheap almost in anticipation of that. So look for cheap currencies, but look only amongst those that will respect you as an investor. That leaves you with about two dozen currencies that are safe enough to own. That’s plenty of options.

20 Year MXN Chart

20 Year Mexican Peso Chart. MXN has always been cheap for a reason

Picking up a bit of extra yield sure is attractive, but you should be buying cheap currencies, not the ones that pay the best. Look at the Icelandic Krona. For years, Iceland had interest rates in the mid-teens. It was seductive—until the music stopped and those holding the currency lost a third. If the investors had been there, they would have known it was expensive. I was there in the spring of 2009, AFTER the crisis. It was unfathomably expensive. It made London appear cheap. The Krona has a long way to drop from here.

Remember, currencies are not like stocks. There are no earnings or catalysts that force the currencies to do anything. You aren’t looking to make spectacular profits either. I don’t use leverage. I barely even think of it like I’m investing in currencies. Rather, I am merely changing the percentage of the various currencies that I denominate my fund’s equity in. I want it to always be in the cheapest currencies and always in a few of them for diversity’s sake. If I can add 5% a year by swapping amongst the cheapest currencies, I’m a happy hedgie.

 For a decade, these have been my rules. They have worked well for me. For the last five years, I’ve mainly owned Australian (AUD) and Canadian Dollars (CAD). I was even short some British Pounds (it’s so expensive in London). I sold some of my AUD and CAD in early 2008 as they were getting very expensive on a living standards basis. The US dollar seemed cheapest, and I owned that (hesitantly). By early 2009, I was again a big owner of Canadian, Aussie after they collapsed. I also picked up some New Zealand Dollars (NZD) for the first time around 51c. A few months back, I sold some of my non US Dollar (USD) currencies as they again got expensive. I have owned quite a bit of USD for the past few months. Look at the charts. I am not saying I nailed the tops or bottoms (I didn’t), but I bought as they got cheap, sold as they got expensive and picked up some nice currency appreciation along the way.    

5 Year AUD Chart 5 Year CAD Chart

5 Year Australian Dollar Chart On Top Of A 5 Year Canadian Dollar Chart

As I travel around Australia, I realize just how expensive it really is. The lady serving me my spaghetti sandwich says that she’s heading to the US next month to buy stuff. She says that even after spending on airfare and hotel, she will still save money when it comes to electronics and luxury goods. That’s how these processes correct themselves. I now own the most Dollars that I have owned in over a year. Normally, I would be copacetic. The USD is cheap. I always want to own the cheapest currency. Except, I’ve had this epiphany over toast and spaghetti. The rules of currencies are in flux. I need to adjust my rules in tandem.

For a long time, you bought the cheapest one and didn’t think much of it. Sure, often the currency was cheap for a reason. But it was rarely a serious problem. Maybe there was an election, or it was a bad balance of trade, or some politician mouthing off about something he didn't understand. Sometimes, a currency was just out of vogue for whatever reason. Usually a cheap currency helped local businesses and was responsible for slowly alleviating whatever problem was supposed to exist. Now I think the rules are different. You buy a currency that will exist in a few years. You no longer buy the cheapest—just the sturdiest. There are too many fiscal problems in the world. I do not want to have a currency that will collapse in the next decade.

This is very problematic for me. It’s dangerous to throw out rules that have been so lucrative and there are rarely new paradigms. However, I grudgingly am coming around to accepting facts. I have known this for some time actually. It’s the reason why I have continued to own AUD and CAD even as they got expensive. Australia and Canada have problems. They have deficits and unfunded liabilities, but they are in much better shape than most countries. Maybe I need to be a bit more forgiving—I also need to look further abroad. Only in Asia are currencies both cheap in terms of living costs AND not likely to depreciate too badly over the next few years.

Besides, the Japanese Yen, I have never owned any of these currencies. I have always felt that they were too tied to the USD. Some of them are directly pegged to the Dollar actually. However, I don’t think the local elites will allow their net worth to disappear just because the US wants to print itself out of liabilities. It is time that I learn more about Asian currencies. I need to travel there and get a feel for the financial culture.

Right now the USD is appreciating. It will likely appreciate a bit further. However, I will need to choose something to swap into soon. The USD is no longer a store of value—neither is the Euro. These two will be depreciating for years to come. I don’t know what I want to own—but I want one that will survive—not just be cheap. The USD has become the New Peso. It reminds me of the time in Peru when I got change and the coins had Nuevo Sol printed on them. So I asked what happened to El Viejo Sol? No one wanted to talk about it.

Nuevo Sol

Categories: Investment Strategy
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Gearing

April 19, 2010 1:40 AM


Let’s talk operating leverage—or as I like to call it, gearing. Think of your car, you start in neutral, shift up to first, then second. The real speed is when you hit fifth. It takes time and momentum to get there. Gearing is where the real money is made.

Gear Shift

When you are investing in little companies, you want to look at rapidly growing businesses. Earnings growth is what creates upside. Unfortunately, most companies find it hard to grow a business quicker than 40% a year. I don’t know what it is, but when you start to grow at rapid rates, problems develop. You need middle management. You need more complex accounting and reporting systems. You need better infrastructure. It’s hard to race ahead and eventually companies that grow too quickly stumble. Usually, these ‘growth stocks’ are priced for perfection. When they stumble, their share prices implode. So how do you get lower risk growth?

For starters, remember that investors pay for earnings growth—not revenues. Where does earnings growth come from? Gearing. Think of a business. There are a lot of fixed costs. Then there are the variable costs that increase based on revenues. If incremental revenues carry very high margins, small increases in revenues can have a very big impact on earnings. Let’s look at how this works.

There’s an internet company that sells a product with a 50% gross margin. It costs $20 million a year to run the company. That money covers management’s salaries, servers, research and everything else an internet company does. Look at how the pre-tax income line explodes with small changes in revenues. All numbers in millions.

 
 Year 1Year 2Year3
Revenue506090
Gross Margin253045
Fixed Costs202020
Pre-Tax Profits51025

Notice how a 20% increase in revenues to $60 million led to a doubling in profits? Notice how when revenues increased by 50% to $90 million, the profits more than doubled? This is gearing. In four years, our company has less than doubled the size of the business in terms of revenues. However, the income has gone up five-fold. That’s powerful earnings growth. More importantly, it’s low risk growth.

Investors repeatedly get burnt buying into hot growth stories that falter. However, the company above is growing a bit over 20% a year. That’s manageable. It is less likely that management will screw it up. They have time to plan ahead and think about the needs of their company.

Gearing

In my decade of investing, it is these gearing businesses that have made me the most money. I am always stunned by just how well a business can sometimes gear. All businesses gear to some degree. However, there are some businesses that gear a whole lot better than others.  I will talk about a few of these in the future. Just remember, operating leverage works both ways. If revenues start dropping, profits will decline even faster.

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