Wednesday, March 30, 2011

Klarman: Trophy Properties vs Fixer-Uppers

Amazon (AMZN) has a great business and a great story.

Wal-Mart (WMT) also has a great business but the story's a tougher sell.

 Of course, in investing whether a story sells only matters over the short-to-intermediate term. In the long run, core economics of the business and the price you pay for it win out.

From Seth Klarman's annual letter to investors:

Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a "hold" at a higher price, and a "sell" at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments. Because investors are not usually penalized for adhering to conventional practices, doing so is the less professionally risky strategy, even though it virtually guarantees against superior performance.

Among equities right now, there are quite a few "trophy properties" that are, well, priced like trophy properties. Amazon is certainly one* but there are many others. It's not hard to find stocks with great stories selling for 50-100x earnings (and higher).

The good news is you don't have to look very far to find "fixer-uppers" selling at compelling prices. More than decent to even very good franchises selling at 7x to 12x earnings are not hard to find (many of these same businesses had an Amazon-like earnings multiple just a decade ago). Of course, most have not-so-great stories (usually "yesterday's news" or something similar) but viable businesses that, in some cases, happen to have a real but fixable problem. Dell (DELL) and Cisco (CSCO) come to mind and are certainly priced like fixer-uppers but whether they are truly fixer-uppers is debatable. Both businesses have enormous free cash flows and cash on the balance sheet that gives them quite a runway.

Now, Wal-Mart is a stock that I'm pretty sure is not a fixer-upper at all but seems priced like one.

So Wal-Mart is boring and hasn't done anything in a decade, right?

The stock? Yes.

The business? No.

As far as I can tell Wal-Mart's problem is that it's not Amazon. It's mature and boring. Amazon is not.

Some numbers.

In the past decade, Amazon has gone from losing money to making just over a $ 1.1 billion with lots of promise ahead.

From a standing start that's a good decade of work by any measure.

Amazon's Market Value = $ 80 billion

In the past decade, Wal-Mart has gone from earning $ 6.3 billion to earning $ 15.3 billion.

An incremental $ 9 billion of earning power in one decade is not so bad either considering how large Wal-Mart already was entering the decade. While not growing like Amazon, the future of Wal-Mart is not exactly dire. The company has an enormous economic moat.

Wal-Mart's Market Value = $ 185 billion

After that impressive decade of work, Amazon now earns in a year what Wal-Mart earns every 3.7 weeks. The funny thing is, even though they had a great decade, in economic terms Amazon has actually fallen further behind in earning power compared to Wal-Mart on an absolute basis.

So Wal-Mart has an extra $ 14.2 billion of demonstrated annual earnings that's still growing nicely.

That means Wal-Mart has approximately 14x more earning power than Amazon ($ 15.3 billion/$ 1.1 billion) yet only 2.3x ($ 185 billion/$ 80 billion) the market valuation.
(It's worth noting that in the past decade Amazon's shares outstanding have grown from 364 million to 456 million diluting shareholders. In contrast, Wal-Mart's shares outstanding shrunk from 4.46 billion to 3.56 over that same time frame).

So, once again, you'll hear the refrain these days that Wal-Mart has been dead money as a stock for a decade and that is true.

True, but certainly not because of Wal-Mart's business performance.

It's been dead money because a little over a decade ago Wal-Mart sold for an inflated earnings multiple much like the one Amazon has now. It took the decade for Wal-Mart's intrinsic value to catch up to price.

The price you pay matters.

As Klarman says, "perhaps the single most important criterion".


* I think there's plenty of evidence from experience that what seems like an expensive stock tends to get more expensive and will often stay that way for a very long time. Even if it is a good business like Amazon, I've never tried to predict when valuation will normalize. I just avoid all things that seem expensive. Knowing what is likely to happen is easy. Knowing when is not. The risk of missing upside is easily outweighed by the possible risk of permanent capital loss. Occasionally, something like Amazon will end up justifying the valuation and that's certainly possible in this case. Though merely justifying valuation seems hardly a huge win.  Risking capital for the privilege of seeing a company someday just fulfill its "promise" is not the path to high returns (successful speculative trades excluded).
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