I went to a broker-hosted management meeting this morning with a retailer* (for the usual reasons, I wont disclose the company).
I’m sure non-Australian investors engage in a similar thing too: a broker will wheel out the management team from a particular company in front of a few of their institutional clients. The management team’s hand is held by an Investor Relations person who has gone to the trouble of preparing a glossy ‘Highlights of the Year Presentation’ ahead of time, a document that’s usually long on ‘presentation’ and short of true ‘highlights’. Then, the institutional investors ask some basic questions, the answers to which could have been easily gleaned from reading the annual report. The whole affair is rounded off with an exchange of business cards and hot beverages are provided by our friendly broker (unfortunately, the only person from the company’s side willing to hand over their business card to us investors is usually the aforementioned Investor Relations person).
Sometimes, if a broker really wants commissions, a nice complementary meal is provided afterwards (these meetings are the ones I unashamedly and regularly attend). Sometimes the company will, in an amazing spate of coincidence, use this same broker down the line for a capital-raising or rights issue.
In the relatively few I’ve been to, I’ve never seen a management team forecast prospects downwards (why would they tour the country, informing every investor of the terrible job they are doing?). So, my tactic is always the same: take notes sparingly, listen for comments from management about competitors or the industry or emerging companies/products and observe what other investors are hastily writing notes about.
Occasionally – very occasionally, you get an unintentional insight into a business that you can only understand upon reflection after the meeting. That happened today…
Kahneman’s System I and System II
Daniel Kahneman is the father of behavioural finance. Surely, by now you’ve read his book, Thinking, Fast and Slow – if you haven’t, drop everything, go to Amazon right now and slap yourself after purchasing it for being so slow to obtain this masterpiece in the first place.
In summary, Kahneman states that most of our follies occur because the human brain has two ways of thinking: System I and II. System I is fast, automatic, emotional, frequent, subconscious and stereotypical. It’s the type of thinking we needed to survive as caveman in our prehistoric past. System I is purely instinctive. System II – as you will know, since you’ve now read the book – involves more effort, uses more logic and is, importantly, slower. System II is purely analytical.
The Value Investor’s System I
Investors often use this analogous System I way of thinking too. For value investors, the bias that effects us most arises from Pavlovian conditioning (click for the Wiki page if this term is foreign). Such conditioning has been ingrained into us through years and years of scanning for the ugly, cheap or overlooked. Low P/B, high dividend yield or low EV/EBITDA are all stimulant metrics that ring a value-investor’s Pavlovian bell, causing us to salivate at the opportunity.
This way of thinking isn’t incredibly dangerous to us. Often, our Pavlovian instincts prove to be right. Statistically cheap stocks have been shown to outperform the broader market. However, sometimes it’s flawed. It doesn’t pick up loss-making divisions for example. If one division is earning $12m in EBITDA and another division is losing -$10m in EBITDA, then an Enterprise Value of $30m (15x EV/EBITDA) isnt necessarily expensive. If management shut down that loss-making division, you’d be left with a business generating $12m in EBITDA (for a price of 2.5x EBITDA).
Business logic has a Pavlovian element to it as well. For example, consider the words ‘70% margins’. Anyone, including myself, would be drawn to this if they saw such a proclamation in an annual report. However, purely focusing on high margins misses out on a bigger picture too. For example, high margins are meaningless without considering the degree of operating leverage within a company or the cyclical nature of some industries.
The Gore and Glory of Our System II
Thankfully, both investing and business share a common System II way of thinking: accounting. Accounting is the intricate, logical language of business. Even the most grandiose business strategy must eventually unravel itself in a company’s financial statements. If a company’s is waxing lyrical about it’s “brand”, then it must turn up in the accounts somewhere. Perhaps the company’s yearly advertising expense is higher than competitors, or maybe it can acquire customers for less than competitors, or maybe it’s revenues per-unit (i.e. the average sale price) is consistently higher than competitors – whatever the reason, merely stating you have an ‘excellent brand’ without accounting proof simply isn’t good enough.
Accounting, as much it pains me to say this fellow non-accountants, is also insightful into human behaviour. Every transaction recorded and every assumption used is a gateway into a manager’s mind. If a manager aggressively capitalises an asset today, for example, this assumption must unravel itself through write-downs in the future. Whatever entry a manager tries to dress up today must undress itself tomorrow.
However, this System II way of thinking is hard to adopt for investors too. As an accounting autodidact, this lesson has certainly not been lost on me. Often, converting the nuances of business into what should be seen on the accounting statements over time is a slow, arduous and counterintuitive process.
Translation Issues in the Language of Business
This gets me back to today’s meeting with the retailers (finally… sorry about the convolution). The retailer’s management team boasted that their goal was to stay “the lowest priced retailer” within the particular market they serve. “So far, I think we’ve succeeded”, gloated the CEO glancing up from his deck of powerpoint slides. “As a company”, he continued, “our position is getting stronger as the dominant player within this market… we have managed to implement gross margin increases for three consecutive years. If we continue like this, rapid increases in profitability will hopefully follow”.
The institutional investor’s cheered, congratulating him on his valiant effort. I too was initially impressed – retailing is a tough business and improving margins in the post-bricks-and-mortar world is no small achievement. But it was only on the way back to the office that I realised a discrepancy (ok, I’m sure you’ve picked this up ahead of me).
Basically speaking, gross margins are your selling prices minus what it cost you to acquire the goods from your suppliers (mathematically; Revenue – Cost of Goods Sold). If your margins are constantly improving, then you are selling goods for more and more each year than what it costs for you to purchase them. If your sole aim is to offer customers the lowest prices in the industry, then you have to pass on whatever savings you negotiate straight to your customers. So, ideally, your gross margins should remain the same or decrease every year if you wanted to build a true sustainable competitive advantage.
Low cost retailers drive their gross margins down to the lowest level possible in an attempt to boost turnover. It’s ok not to earn much money per customer, but if you can get the most customers, then you can still be extremely profitable. This is why they often operate from massive, dystopian warehouse-like stores: they can stock more inventory per-square foot and spread their operating costs over a larger floorspace. The customer wins because such a store has the best prices. The shareholders win because the company uses its humungous floorspace, combined with its low-overhead per-square-foot, to drive massive amounts of volume through the store and, ultimately, this rockets it’s returns on capital through the roof.
Further, having the lowest costs drives more volume – since more customers are attracted to the store’s prices – more volume implies more haggling power over suppliers (ok, a lot more haggling power: click for link**). More haggling power, you guessed it, means lower prices still. This business model is an incredibly virtuous cycle.
The somewhat theoretical “lowest-cost retailer” statement from the CEO seemed cognisant of a System I way of thinking and the “increasing margins consistently” seemed completely devoid of any System II logic.
A (Small) Hypothesis Test
I didn’t believe myself (after all, maybe it was me using System I thinking). Could it really be that this retailer’s margin strategy was actually doing the opposite of what they desired? Then I found this graph plotting the margins of ‘the father of all low-cost retailers’, Wal-Mart (taken from www.studentofvalue.com):
Click picture to enlarge
The top blue line is Wal-Mart’s (WMT) gross margin since it’s IPO. In WMT’s early years of rapidly growing dominance, gross-margins clearly remained stable or fell. If I told you ahead of time that by owning a company which dropped it’s gross margin every other year, Sam Walton would become one of the richest men in history, would you believe me? I wonder how many value-investors, forever swayed by their System I/Pavlovian bells, steered clear of this stock early on?
Interestingly, WMT’s margins started increasing rapidly from, say, 2002 onwards. This margin expansion occurred up until around 2010. Now, I’ve (unfortunately) taken enough statistics subjects in my time to know the difference between ‘correlation’ and ‘causation’. I also know that there are a billion influences on a company over time, but: eerily, between 2002 and 2010 (inclusive of the great market rally of ’03 to ’07) WMT’s stock went nowhere (unadjusted for dividends) as it’s margins increased over the same period.
Ok, enough conspiracy, my basic realisation is this: ‘improving’ margins don’t always mean ‘increasing’ margins… and ‘cheap’ stocks don’t always mean ‘statically cheap‘ stocks. Investing in a world of low-cost brokerage accounts, complex stock screening software, dizzying-Excel-spreadsheets, CNBC’s, Bloomberg phone apps and, dare I say it, investment blogs can often tempt us into relying on System I thinking much more than we realise. Maybe, more often than is actually done nowadays by us new and snobby value-investors, our portfolios would be far better off if we sat down, took deeper breaths, turned off our screens and used our System II tools before rushing out to buy the next low-cost retailer. “All man’s miseries”, explained Blaise Pascal, “derive from not being able to sit in a quite room alone”.
*after numerous comments, I realise I may have been too vague/inaccurate in my description. This retailer was pursuing a low-price strategy in an “everyday low prices” sense of the word. The retailing industry commonly refers to this as a low-marup, high volume model. Sorry for any confusion
** this link in no way implies that the company I met with today is either Coles or Woolworths.