Motley Fool Hidden Gems Investing - The Investing Mosaic

Episode Date: July 27, 2024

How do you determine what a company’s worth? You pull a lot of information from a lot of different places.  Jim Gillies joins Ricky Mulvey for a conversation on valuation and mosaic theory. They also discuss:  How incentives impact valuation The “new store growth story” at Costco Case studies from a sneaker company and a space company Companies/Tickers Mentioned: WINA, COST, ONON, SPCE Host: Ricky Mulvey Guest: Jim Gillies Producer: Mary Long Engineer: Dez Jones Learn more about your ad choices. Visit megaphone.fm/adchoices

Okay, so now what do we have to do in terms of growth rate to justify a $12 billion value? I have to look at the balance sheet. What does the capital structure look like? What's the debt, if any? What's the tenor of that debt? What have they historically done with their cash flows? Do they own all of their operations? Do they farm out manufacturing to someone else? What is the track record of management here? I'm Mary Long, and that's Jim Gillies, a Fool analyst who heads up our Motley Fool Canada service. A few weeks ago, Jim joined my colleague, Ricky Moldy, for a conversation on valuation. In today's show, Jim walks through mosaic theory, a practice where you're pulling research from a

number of different sources in order to determine a company's value. They also discuss Costco's growth story, how incentives contribute to valuation, and lessons from one company specializing in sneakers and another in spaceships. We can talk a little bit about mosaic theory. It's basically, as an analyst, as an investor, I'm going to use the words interchangeably because, you know, the fool is about people dealing with their own stocks, right? But we are always seeing through a glass half darkly, okay?

We are getting bits and pieces of a story. Like valuation at its core is not dissimilar really from the principles underlying it. If you have a bond where the cash flows are fixed and the maturity is fixed and the discount rate is largely fixed, We can assess what the value of a bond is, a financial instrument, a bond, fairly easily. It's literally spelled out the indenture associated with that bond.

For stocks, however, it is infinitely more complex, even though at its end, the value of any stock, in theory, is the value of the cash flows, all the cash flows that will throw off for the remainder of its life until time immemorial, discounted back to the present at an appropriate discount rate. The problem is buried in there are about 100 million different assumptions of varying size or not. And so as we put together our mosaic, we're looking at what are the things that lead to our cash flow forecast? What are the things that lead to maybe an appropriate discount rate to discount them back? How do we factor in management and management decision making? How do we factor in the macro environment? But again, we are always seeing the world through a glass half darkly, which is then what lends us to the famous concept made famous by Ben Graham, the father of value investing and popularized by Warren Buffett. and that is the concept of margin of safety. Even when you think you've got a reasonable forecast

and a reasonable handle on the company and a reasonable handle on the environment in which it exists and you calculate a value, let's say the stock is trading for $100. It doesn't matter what the stock is. The stock is trading for $100 and you come up and you say, you know what? I think the stock is worth $100. So the trading price is at $100 and all of your hard work and you come out to the exact same price. Should you buy it? Well, maybe. But if you want to go in big, you're going to buy at, say, $80. You're going to wait until they have a bad earnings report or something spooks the overall broad market in general, like a global pandemic or something. And then you're going to buy at a discount, which we're going to call the margin of safety.

and a good analyst, a good investor is going to be finding the little data points. You're not looking at a company in isolation. We don't look at a company for three hours on a Thursday afternoon and then we're done. We buy it and we never look at it again. We're going to be looking and adding to our mosaic. We're going to be looking at future earnings reports. We're going to be looking at financing decisions. We're going to be looking at what the company does with the cash flows it generates. You're gradually adding pieces to the mosaic. I've got companies that I've owned for over 20 years. I've got one that I've owned for over 25 years. It's because I'm adding continuously to my understanding of the company

and even a couple that I'm thinking of, which I've owned for 20 years. My opinion of them has changed over the years. I've added, I've subtracted depending on where I think valuation is going. I've changed how I'm looking at the company. Is it a long-term grower? Is it something that I'm going to use with options to do what's called a covered call strategy? Because I don't think it's going to go anywhere, but I don't want to trigger the capital gains tax necessarily that comes from just selling it outright. There's a lot of things that go into as we build our mosaic to get a better understanding of the company and the organization where we are putting some of our hopefully hard-earned dollars.

So what's it look like in practice for you then, Jim? Is it, you know, you see a decision from a management team that you don't like, and then maybe up the discount rate on the future cash flows? Or what does it mean to put together the mosaic with new information? You can. Quite often, if I see decisions out of management, I've learned. I'm moving closer to a sell decision, frankly, a lot of times. Especially if I feel I'm being lied to. That's one of the dangers, actually, of actually having the ability to interact with management. Management will typically tell you a very sunny story. Not all those sunny stories are true. And occasionally they'll lie to you. And I've had that happen a couple of times in my career. And the cell wreck fell very closely after I felt I was being lied to. But, you know, you are building a model.

You are enhancing a model. You are ideally thinking about one of my favorite things to do. and and it's uh i i give it a fancy name i call it a mass balance because i came out of uh the engineering world and specifically chemistry uh and a lot of times we did a lot of uh electroplating and other types of metal finishing which is very reliant on chemistry uh and so i came up with the concept of mass balance it's you know i'm trying to make it sound cool uh really it's just uh you know you're comparing you know the uh the cat the the major sources of cash coming in and the major uses of cash going out? And on balance, are those flows, both in and out, are they designed to

enhance the overall return of all shareholders? Or, for example, a couple of companies I could name, I'll save the tickers here to spare the guilty, but I could give you a number of tickers that kind of emerged in the last five to seven years, kind of what I'm going to call Tech Bubble II, Electric Boogaloo, largely associated with the... I'm old enough to remember the original tech bubble. I didn't like the sequel. It wasn't as good as the first one. But a lot of them went from cashflow negative, which is no sin, but boy, you better have a plan to get to cashflow positivity so we can build a valuation case for you. But they went from cashflow negative to cashflow positive. But they'd been so expansive and generous with their equity and hosing out

equity to everybody who worked for them, including, you know, the janitor's dog kind of thing, that the largest cash outflow from the company was paying taxes to cover the benefits of all, the company paying taxes for the equity cookies that given to insiders on the way up. Okay. That is not a, that is not a use of cash that is beneficial for all shareholders. um buying back stock however for a company that very clearly and it's even better it's even nicer when management will say this publicly we buy back stock when we believe the valuation warrants doing so and we get whether it's a free cash flow yield from it or they talk about a book value yield in the case of burke or hathaway for example companies that actually buy back stock

deliberately and strategically and have an evaluation case of their own in mind. I can give you a number of tickers where I think they do that. Winmark would be one. MedPace Holdings would be another one. Lesser Extent International Petroleum, which is a Canadian oil and gas company. They might be verging more towards the buyback at any price, but heretofore, they've been reasonably good at it. That is a use of capital that benefits everyone. Dividend paying, special dividend paying. Again, capital allocation. Because this is the thing, right?

We talk about valuation. And valuation, as I said earlier, is forecast the cash flows from now till time immemorial. By the way, you can probably cut it off at about 10 years. Because the cash flow you expect in 53 years is going to be worth precisely zero today, as will your forecast. It will also be worth zero today. But in theory, you forecast cash flows out. time immemorial, discount them back to the present value.

And that's kind of the valuation process. But the other part of it that you need to know, that you need to really appreciate is, what does management do with those cash flows? Like, are they being utilized? Because if they're just going to sit on the balance sheet and do nothing, eh, whatever. Not terribly exciting if they're going to go

to value-destroying acquisitions or value-destroying project growth. again, that's worse than nothing. If they're going to go to acquisitions that enhance our competitive position, if they're going to go to reinvesting in the business, they're going to go to dividends, special dividends, repaying debts as less financial risk for the equity holders. Valuation is step one. Allocation, understanding allocation is step two and understanding what management is doing and realizing you can like a management team. You can like people. I mean, we're privileged in our position.

We can actually get to know some of the management teams on a personal basis, which I hold is kind of dangerous sometimes, especially if you like people in general, because they're going to try to sell you a story and you like people in general, you're probably going to be susceptible to that story. We have to remember, we're not friends with the companies and the management teams of the companies that we own. We're not friends with them, right? We have to have an appreciation for cash flows, the valuation of said cash flows.

and the capital allocation decisions that the management does and try to be as surgical as possible to understand are they doing things that are good for all of us? Are they doing things that are bad for all of us? Or are they favoring one group, usually management? Are they favoring one group over another? Let's go to Costco. Mosaic theory going on there.

Let's go to Costco. Let's go to Costco. Usually a good idea. This is an interesting one. every time you go you post on x that you don't own enough of the stock it's a great it's a great experience everybody loves costco right now it's also at like 50 times free cash flow and like 50 times forward earnings and its market cap went from about 200 billion in january of 2023 to about 370 billion today that's pretty close to a double for a really mature retailer that's already at a

$200 billion. It's not like the store count exploded in that time. Sure. Recently, they raised the membership fees a little bit. But how are you piecing together that mosaic right now? Well, the first thing is I'm going to suggest that a free cash flow multiple is not terribly useful because this is... What are they doing with their cash flow? First of all, A basic free cash flow is cash flow from operations minus CapEx. That may or may not be a good definition for certain companies. It's probably reasonable for Costco. What's their CapEx being spent on? Stores. New store growth. Cool. I would suggest to you that the Costco new store growth story

is not over. And so at the least, if you wanted to come up with a more reasonable free... And the example I will give you is actually Home Depot. Because Home Depot, I'm going to mangle the dates because the dimly lit past is by definition dimly lit. But I think around 2007, 2008, so rather concurrent with the global financial crisis, Home Depot kind of made this decision that we're kind of we're kind of done growing at the at the elevated rate we're doing okay uh and they kind of they kind of said you know what like every american every canadian lives within a 15 minute drive of a home depot the the need to build new stores it's kind of kind of done um so we're going to really drop back our expansionary stores we'll spend a little cap

back we'll build one or two stores a year and kind of growing population centers we're really going to cut back on our new store growth. And what happened to the free cash flow at that time? Well, CapEx fell off a cliff. I think it fell by three quarters over two or three year period. But the stores were just churning out all this cash flow anyway. So free cash flow for Home Depot just accordioned right up, just massive. And then they started following along with giving that cash back to people in a shareholder-friendly manner. Dividends have gone straight up. Dividend growth has been phenomenal. Buybacks, I think they've taken out 40% or 50% of their stocks since 2008. Just tremendous. Why that matters in terms of Costco is, let's say Costco,

and again, I think new store growth is still on the menu. In order to get a better appreciation for free cash flow today, we would have to estimate how much of that capex is going to so-called maintenance capex, refurbishing the stores they already have, and how much is going to new store growth, purchasing land, purchasing building, developing the building, all the stuff that they throw inside the buildings to make your shopping experience wonderful, the freezer cases and the big stacks of warehouse shelving. And so the first thing is, if you say it's 50 times free cash flow, I say, well, the first thing you want to do is you want to value this thing as more of a cash cow thing to get an appreciation because let's say Costco stopped the new store growth

today. What would their free cash flow do? That's the appropriate tool to value a Costco against. The second thing is Costco, I know we've talked about this before and I was yapping about it for the longest time, but I was pointing out simply that Costco had not raised their subscription fees, their membership fees since 2017. They usually went about every five, six years. It was seven plus years now. Within a couple of weeks ago, I think they finally announced they were going to bump it. Perfectly fine. But that's going to boost the next year's worth of earnings. Third thing is they own, again, I'm pretty sure I'm roughly right, but precisely wrong. They own, I think it's 90% of their stores and around 75% to 80% of the land under their stores. okay so imagine a world where there's you know what happens to Costco if they decide to spin off all of those assets into say a REIT what does that look like at the continuing operating business what does that look like if they did a giant sale and lease back transaction

brought all that cash in right and then bought back a whack of stock what does that do I hope they won't do that by the way but they the things are malleable they could do and then the last piece of it, and this is more the mosaic, if you will, is the reason I will, yes, admittedly, guilty as charged, occasionally go to Costco and then tweet out, I don't own enough Costco. The way Costco got into Stock Advisor Canada as a recommendation at around $450, $470, I think, was Ian Butler, who's the head of that product, every time I would go to Costco, I would take a picture of just the insane lines or the bill of some rando or even me occasionally. The guy in front of me showed me his bill. He's got, yeah, I just spent $800. He's not lamenting

that he spent $800 at Costco. He's almost bragging about it. It's a very interesting consumer behavior. You've just spent a large amount of money for a grocery store slash you know, kind of jack of all hunt, um, treasure hunt style, a shopping experience, and you're happy about it. And people are posting that online. And I'm just like, well, that to me is kind of the, the classic, um, Phil Fisher scuttlebutt investing kind of research where like people are going there, like they're going for a bag of milk and a box of eggs and they spent 250 bucks. A bag of milk. Right. Oh, sorry. Canadian. Sorry. A gallon of milk. Yeah. We, we get, milk. We buy milk.

You buy it in a four-liter pack, but it comes in three bags. Just chalk it up to Canadians. Learn something new every day. There you go. Anyway, the point is that Phil Fisher-type scuttlebutt investing

is not dead. It's harder to do now in an internet and a connected world where you can't go buy a business and count the car. I mean, you can, but it's not terribly useful um go count the cars showing up on a weekend shift or is the business dead on the weekend you know like and and it's a manufacturing business uh it's very

difficult in a world where um how many i'm just gonna pick a name at random how many american eagle outlets are there american eagle outfitter outlets are there right it's probably going to be kind of difficult for the i've i've the faintest idea but i'm pretty sure it's not gonna be terribly useful for me to go to, I'm going to say, do a sampling of 10 or 20% of them and just go see how things are going at a time. I mean, you could do that, I suppose, but it's not going to send you the signals that it might've sent when it was chains were smaller and you didn't have online sales. It's not going to send those types of signals that you probably would have gotten in the past when, you know, when Philip Fisher was doing his, you know, when he popularized the term

scuttlebutt investing i'm i try to do it still i went to um so i went to dick's sporting goods a few weeks back picked up some on clouds which i am enamored with here look at these look at these i i don't even know what those are i guess they're shoes okay sure they're shoes so i'm not going to ask you directly about the company but it's companies on my watch list now cashier tells me he's seen a lot of these go across the scanner in Denver, a lot more than recognizing the growth of it. The winner of the Boston Marathon just was wearing spray-on on cloud shoes, which I thought was pretty incredible. The company's also more than 2x its operating income since 2022. It's becoming more profitable. Sales are increasing a lot. So margins are getting better and sales

are increasing. It's about a $12 billion market cap company. This is me just starting to look into it. But what other pieces do you think I should add to this mosaic before I decide whether or not I'm picking up some shares for myself? What are the cash flows? Number one, try to get an assessment of what they currently are and what management is doing with them. Number one. Number two, growth is an important part of any investing value investing is you know the the separation of value versus growth investing is often kind of silly i mean all it's a different show yeah it's a different show but look i mean growth is an input to valuation okay i didn't say value i said valuation because you know i'm

perfectly happy i mean i've paid up you know i've been i've been a shopify shareholder for years i'm an amazon shareholder for years i'm embarrassed to tell you what my cost basis for mercado libre might be or chipotle like i am not adverse to growth or paying for growth right but you have to have at least some place to put a stake in the ground so if you tell me that um and i don't know this company at all your shoe company so i just have to make up stuff as we go along uh but if you told me that uh you're saying it's a 12 billion dollar company and they were doing $25 million in free cash flow, I'm like, okay, what growth rates do I need to back into to make... And again, I'm making the numbers up, fools. I have no idea. I've never

looked at this. I'm trying to just pick an absurd example. But if I figure out that they're doing $25 million in free cash flow a year. 10x that. And they're valued at 12. Well, yeah, if I 10x that, then the company's worth $250 million, right? They're doing $250 million in free cash flow over the last 12 months. Okay. So now what do we have to do in terms of growth rate to justify a $12 billion value? I have to look at the balance sheet. What does the capital structure look like? What's the debt, if any? What's the tenor of that debt? What have they historically done with their cash flows? Do they own all of their operations? Do they farm out manufacturing to someone else?

What is the track record of management here? How are they compensated? There's a company, it's no longer public, but I'm going in a weird direction here, but it's just reading the proxy statement is something that a lot of people don't do. They don't even know where it is. It's the annually comes out and talks to you about how much management makes, how much the company compensates a board member, for example. What are the incentive programs that management is participating in? This company, again, it's no longer with us, but they specialize in container ships. Container ship market is a very cyclical market because basically charter rates for container ships plunge when there's too many ships on the water. When there's too many ships on the

water the container ship operators pull the older and you know more beaten down ships off the water and turn them into scrap metal which takes a bunch of floating capacity off the water which then starts to spirk charter rates to go back up and now all of a sudden you know they'll turn around and they'll like oh we have to build more ships and so the ceo of this company that was called c-span at the time not the television network but then they changed their name to atlas holdings before they were acquired by fairfax um the former ceo of this company he was getting about a million bucks a year salary you know that's nice um but he was also getting like a finder's fee for buying new ships he was getting paid like one percent of the value or one and a half percent of the value

of all the new ships that they contracted to build right and you can already see where this is going to turn into a problem, right? Because what are you incentivized to do at that point? Well, I hope the team at On are not buying new ships, but I understand where you're going. Well, no, but it's to understand the incentives. How are management there incentivized? Because at this company, at C-SPAN slash Atlas, the CEO made a million bucks from his paycheck, but he made 10 or 10 plus million ordering new ships even though they probably should not have been ordering new ships because the the industry was you know the industry at that time was presently removing ships from the water and if you but of course you know when you make 10 million

whose bread i eat his song i sing right uh and so you want to see how people at on are in incentivized what where where where is their heart going to lie right what are they going to be interested in doing. And this is about as good as I can say when, again, I've never looked at this company. But that's what I would do. I would look at, and I might even run, I've already kind of alluded to it, what's called a reverse DCF, a reverse discounted cash flow. And what that is, is to say, let's assume the current stock price is correct, whatever correct means. Okay. What growth rate do I have to assume in whatever today's free cash flow is out to, again, to the far distant horizon with whatever the appropriate discount rate we've decided to use?

What growth rate equates the current stock price to the calculated valuation? And if you find out, and I'm not going to name names, but I'm going to suggest This happened a lot in 2021, and it was generally ignored to deleterious effect by people who ignored it. If you find out, if your math says to you that a company, their present share price is justified by free cash flow that has to go up by 50%, 75%, 100% a year for the next three decades, I'm going to suggest you're paying a little too much. And you can choose to ignore that or not as you will. And that's the other thing too.

I've used the phrase a number of times. We see through a glass darkly. Always remember, you are also susceptible to making errors that may be in service of a preconceived notion. You might really want to like a stock. You might think it's cool. You might think what they're doing is cool. And the one I like to pull up as a ridiculous example, because it's the very definition of what the hell were you thinking. And that is Virgin Galactic, which came public as a SPAC at $10.

Special Purpose Acquisition Corp. Basically, they raise money and go in search of a business to buy. Came public at $10, as all SPACs do. and then and and what virgin galactic does is uh basically it's space tourism right hey you pay us a quarter million dollars we'll give you a 15 minute flight to to low earth orbit and you're not really orbiting you'll get a minute and a half of weightlessness then we'll land you hopefully safely and we'll call it a day and we'll cash your check um gotta have a lot of really rich people playing and a lot of people willing to drop a quarter million dollars and i don't know

you've heard this space flights expensive and you're you know and this is a company that has never made a dime of cash flow in its life so it's impossible to value and it didn't stop the stock from going up three four hundred percent in in the crazy days of 2021 today the stock's down 97 percent from its high i think hell i think it's down 97 percent from its from its spec issue price And there was no time there where the valuation made sense. None. Zero. But in a world that was 2021, I know we were under lock and key with the pandemic, but from an investing standpoint, it was a very optimistic time. You know, people were buying almost anything, right? This is great. This is wonderful.

And hey, who doesn't think space tourism is kind of cool, right? If price was no object, I'd be on the next rocket. Like, this would be awesome. But you got to divorce yourself from that type of thinking and stick to the cold, hard facts. And I deliberately chose a ridiculous company, right? And it's harder when, forget space tourism that can't earn a penny and it's a quarter million dollars just to get on board. It's harder when we look at a fashion brand or we look at a shoe brand like on. Even when you look at Costco, like again, my whole thing with Costco and I like Costco a lot.

Do I think Costco has gotten a little frothy? Yeah, probably. But you know when else I've heard Costco is overvalued and you should sell it? When? Well, but I ain't saying sell because I have very fond memories of very smart people, including some at The Motley Fool, telling me it was overvalued at $100, at $200, at $300, at $500, at $700. Like, okay, I hear what you're saying, and yeah, today there are some optimistic assumptions buried in the price, shall we say. But if a stock trades sideways, or it goes, let's say Costco today goes from, over the next three years, goes from, you said 50 times forward earnings, let's say it goes to 30 times forward earnings over the next five years. And then it restarts its, you know, continuous climb.

And they continue operating Costco as Costco, as they've operated it for decades. I still think you're probably going to be pretty good. We haven't even talked about it. That's another thing of consideration. I have the misfortune. That's one way to put it. I have the misfortune of having most of my cost go in a taxable account. right um i'm going to be writing a very large check to revenue canada or the canada revenue agency if you prefer uh if i were to exit my position or at least a position that's in a taxable account that has got to weigh on my decision making okay uh because you know i'm also at least as of this moment gainfully employed um and so i'm making a salary so you know this any taxes there would be assessed at my tax bracket as opposed to, say, my father who's

in retirement if he owns some shares. So that also has to come in. If you're going to lose 40% of your investment or 30% of your investment to taxes, boy, you better hope whatever you've sold the overvalued company that you currently own, you better hope that whatever you replace it with does better than that to overcome that. And if it doesn't, you're going to regret selling. All right. I always learn more about the process talking to you. One of these days, we're going to get to the balance sheet. I promise. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against,

so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.