When you are considering buying growth stocks:
1. Verify the existence of a franchise
2. Earnings return is 1/P/E.
3. Identify cash distribution in terms of dividends and buybacks
4. Identify investment return of retained earnings
5. Identify organic (low investment growth)
6. Compare to the market (representing D/P & growth rate) - is this positive or negative?
I will give you the numbers from three years ago which we applied to a bunch of firms.
We will look at WMT, AMEX, DELL and GANNETT.
Company Business Adjusted ROE
WMT Discount Rate 22.5%
AMEX High-end CC 45.5%
Gannett Local NP & Broadcasting 15.6%
Dell Direct P/C Supply & Logistics Organization 100%
Company Sources of CA Local Economies of Scale
WMT Slight customer captivity Yes
AMEX customer captivity Some
Gannett customer captivity Local
Dell Slight customer captivity Yes
Perspective Return on the US Market
(1) 6% return based on (1/P/E) plus 2% inflation = 8%
(2) 2.5% (Dividends/price) plus 4.7% growth = 7.2% return
Expected Return equals 7%. Range is 7% to 8%.
Wal-Mart. Dell, Gannett and AMEX.
If you are thinking of investing in them, what do you want to know first?
Is there a franchise here?
- Does WMT have CA? Yes, regional dominance and it shows up in ROE, adj. for cash of 22%.
- Amex is dominant in their geographic and product segments. Amex dominates in high end credit cards.
- Gannett is in local newspapers. ROC is 15.6% if you took out goodwill then ROIC would be 35% or higher. --
Ross: CA can’t be just sustained, allow to grow. CA, EOS and CC.
Do you think different type of CA are better for allowing you to grow. They are therefore worth looking at? Are those franchises sustainable.
- When WMT goes outside these Economies of scale they have no advantages.
- If they go against competitors outside their regional dominance, they will be on the wrong side of the trade.
AMEX dominates high end credit cards.
- Do they have customer captivity?
- (Note: Amex has been using more and more debt to generate high ROE, so the risk profile is higher).
- They track well because if you look at reinvestment returns, it is high because people are not investing a lot in equities.
- Look at organic growth which is higher than it is today.
- On the other hand, multiples have gone up.
- There has been a secular increase in multiples of 1% to 2%.
- You have to ask yourself, is it reasonable to earn a 7% to 8% return on equities in the present climate where long bonds are earning 4%? Historically the gap has been 8%.
Should you use a cost of equity of 7% to 9% vs. 9% to 11%. I think that we are talking about real assets. That is a good question.
- One of the things you want to do is use a lower cost of capital than 9%.
- But all of a sudden all these stocks have EPV well above their asset values.
- Now some of that will be in intangibles.
- So it looks like for practical purposes with a market multiple of 16 and 2x book value, the real returns are significantly lower than that.
- So if you have the opportunity to invest in businesses with returns greater than that, you want to value the income streams at 9% to 11% rather than 7% to 9%.
Amex is trading back at 17 times. Growth rate at 15%. A classic growth stock.
- A 6% return.
- They are committed to returning 6% to shareholders, but the 6% cash distribution will be 4%.
- They are reinvesting 2%.
- We know what they are doing with that money. They are lending it to their customers, by and large.
Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf
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