AAII December 2015 meeting December 12, 2015
DISCLAIMER Before making an investment decision, investors are advised to read carefully the Offering Memorandum, including the description of the risks, fees, expenses, liquidity restrictions and other terms of investing in the funds. Performance data has not been prepared to meet any specific requirements applicable to the presentation thereof and should in no event be viewed as predictions or representations as to actual future performance. Investment may involve a high degree of risk and should be considered only by investors who do not require access to their capital and can withstand the loss of all or part of their investment. Return targets in this document are subjective determinations and do not reflect either actual past performance or a guarantee of future performance. Referenced benchmarks may fail to provide a meaningful comparison. Forward looking statements are based upon assumptions which may differ materially from actual events. This information should not be relied upon in making an investment decision.
Key Objectives Today • Learn how to properly analyze a company in the following industries: • Differentiated Manufacturing • Property & Casualty Insurance • Learn how to minimize your downside risk in those industries
Agenda • Differentiated Manufacturing • Summary of key qualitative and quantitative points • Valuation guidelines • Protecting your downside • Case Studies • Property & Casualty Insurance • Summary of key qualitative and quantitative points • Valuation guidelines • Protecting your downside • Case Studies
Differentiated Manufacturing
Differentiated Manufacturing Explained • Non-commodity, branded consumer products • Examples: • Cars • Paint • Smart Phones • Furniture • Carpet • Fashion Accessories • Anything you buy at any store or online • Excludes B2B input goods
Summary of What We Look For Qualitative Quantitative • Strong Distribution • Operating Margin • Bargaining Power >10% with customers and • ROIC > 10% suppliers • FCF/Revenue > 5% • Successful R&D • TATO > 1.0 • Good allocators of capital • Industry low cash conversion cycle • Solid Brand
Looking for Durable Competitive Advantage • Qualitative and Quantitative focus points all geared toward determining whether or not the company has a durable competitive advantage (“DCA”) • Existence of a DCA helps company sustain and grow revenue profitably • Consumer products company without a DCA can see sales evaporate quickly
Strong Distribution • Highly underappreciated by most investors • Includes where product is sold and how it gets there • Cannot sell what customers cannot easily find • Best companies tout their distribution network • Prefer “dedicated retail” • Company-owned stores • Exclusive dealerships
Bargaining Power with Customers and Suppliers • Dominant customer or supplier can dictate terms • Examples: • Apple – GT Advanced • Wal-Mart – Rubbermaid • Avoid companies with greater than 20% of sales to one customer • Cash conversion cycle good indicator of bargaining power
Cash Conversion Cycle (“CCC”) • A cash flow calculation that attempts to measure the time it takes a company to convert its investment in inventory and other resource inputs into cash. • CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding • CCC of zero means you pay your suppliers the exact day you collect on accounts receivables • Rare • Varies by industry but tends to be at least 40 • Negative CCC is indicative of a moat • Should result in negative non-cash working capital since turning inventory and collecting on receivables before paying suppliers
Successful R&D • Required to stay competitive • Rare for one company to be ahead of peers for long • Product refresh cycle • Prefer longer refresh cycle – lower risk of obsolescence • Carpet vs Smart Phones • Generally R&D/Sales of greater than 5% indicates R&D intensive industry
Good Allocators of Capital • Management is the steward of shareholder capital • Capital allocation includes acquisitions, buybacks, dividends, investments in new or existing product lines, expansions into new geographical areas, expansion of distribution network, etc. • Risk of institutional imperative • Focus on ROIC over time, especially before and after acquisitions • Good allocators can create tremendous shareholder value • Warren Buffett & Charlie Munger
Solid Brand • Listed last because least important • Brand Bubble, published in 2008 • Brand trustworthy ratings dropped almost 50% from 1998-2007 • Esteem and regard for brands fell by 12% in 12 years, and very few brands were widely regarded across general population • Awareness of brands fell by 13% in 13 years • Brand quality perceptions fell by 24% 1994-2007 • Only 7% of prime time commercials were found to have a differentiating message • Very few brands create a competitive advantage • Apple, John Deere, Disney, Coca Cola • Main focus is a brand that isn’t tarnished
Significance of Key Metrics • Operating Margin > 10% & FCF/Rev > 5% • Above average profit margin indicates above average operations • Good distribution, bargaining power, capital allocation, and brand • Compare to competitors by line item to understand how efficient the operations are • ROIC > 10% • Excess value created when ROIC>WACC, which is generally under 10% • Total Asset Turnover Ratio > 1.0 • Measures ability to utilize assets to generate sales • $1 of assets should generate at least $1 of sales
Valuation Guidelines • ~12.5x sustainable Free Cash Flow (“FCF”) • Assumes 11% discount rate and 3% perpetual growth • FCF normalized • If ROIC>WACC, value is NBV at a minimum • The capital employed is realizing a rate of return greater than the cost of that capital, so the company is worth more than net book value
Protect Your Downside • Price you pay is key • Avoid stocks trading for 20x FCF or higher unless you are very confident growth will be 20% annually for at least 5 years • Avoid companies with ROIC below their WACC unless you expect ROIC to increase substantially in the near future • Avoid value traps • Looks inexpensive but competition driving sales down rapidly • Multi-year declining operating margin might indicate DCA erosion • FCF elevated due to changes in working capital or lower than required R&D or CAPEX
Case Studies • Apple (AAPL) - bought • LeapFrog (LF) – passed • See additional case studies in Appendix
Apple (AAPL) • Mac, iPhone, iPad, iTunes, iPod, and Apple TV • Stock had dropped 30% from recent high by the end of 2012 on fears that Steve Jobs was the sole reason for Apple’s success • Apple has a September year-end, so we had the newly issued 2012 10-K to start with
Apple (AAPL) • 5 years prior to our investment, through FY 2012: (in billions) Category 2008 2009 2010 2011 2012 Revenue $32.5 $42.9 $65.2 $108.2 $156.5 Growth 35% 32% 52% 66% 45% Op Margin 19.3% 27.4% 28.2% 31.2% 35.3% FCF/Rev 25.8% 20.9% 25.2% 27.8% 26.5% • 5 year revenue CAGR = 45% • Smartphones and tablets still in early stages with long growth ahead • Exceptional margins clearly indicative of a DCA
Apple (AAPL) • Exceptional distribution • First tech manufacturer to successfully open and operate it’s own stores around 2000 • Over 200 stores accounting for over 10% of revenue by 2012 • No customer greater than 10% of sales • Incredible bargaining power with customers and suppliers Category 2008 2009 2010 2011 2012 CCC -59.6 -47.6 -49.5 -52.0 -52.0 • Successful R&D Category 2008 2009 2010 2011 2012 R&D/Rev 3.4% 3.1% 2.8% 2.2% 2.2%
Apple (AAPL) • Exceptional stewards of capital Category 2008 2009 2010 2011 2012 ROIC 27.2% 30.2% 34.7% 41.0% 42.0% TATO 1.00 .99 1.06 1.13 1.07 • WACC estimated to be 8-9% • Strong balance sheet with $134B of cash and no debt • Market cap was $440B gross and $306B ex-cash • P/FCF, ex-cash, was a mere 7.4 • Priced for zero growth • Valued at a minimum of 15x FCF, plus cash, or $730B • 66% upside potential with limited downside
Apple (AAPL) • Protect our downside checklist: • Reasonable price paid? Check • ROIC above WACC? Check • Margins maintaining? Check • FCF not artificially elevated? Check
Apple (AAPL) • Performance over ensuing 3 years: • Revenue grew 14% annually • Op margin averaged 29.3% • FCF/Revenue averaged 28% • ROIC averaged 28% • Most importantly, stock price appreciated 58%, or 16.5% annually plus an annual dividend yield of ~3% • Had appreciated 83% at peak earlier in 2015 • Stock still undervalued, trading for under 8x FCF, ex-cash
LeapFrog (LF) • Leader in educational entertainment for children • Stock was down 30% from it’s recent peak in August 2013 when we analyzed it in June of 2014 • Coming off one of the best years for any toy manufacturer in 2012, when it had 3 of the 10 best selling toys for Christmas
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