Case Study: DreamWorks Animation

My previous case study on Virgin America was received with some enthusiasm. I suppose with all this highfalutin discourse on long-term thinking and intrinsic value one naturally craves something a little more practical. I will endeavor to supply this going forward.

DreamWorks Animation (DWA) is a movie studio controlled by Hollywood luminaries Steven Spielberg, Jeffrey Katzenberg, and David Geffen. Their crown jewels are the blockbuster franchises of Shrek, Madagascar, and Kung Fu Panda.

When we talk about great businesses, we tend to banter about pricing power and high margins and asset-lite models. In layman’s terms, it’s getting people to pay for something that costs you nothing. So what’s great about beloved fictional cartoon characters? They never demand a salary. They don’t get embroiled in real-life scandals. They don’t grow old.

Disney understood this almost 100 years ago. This is also why they acquired Pixar, then Marvel, then LucasArts. They all have intangible, indestructible franchises that live forever. Not only can you keep making movies about them, you can sell tons of merchandise and erect entire theme parks around them. All of this, if managed well, can be a perpetual geyser of profit.

It is, however, difficult and expensive to establish these franchises. It costs a lot of money up front to make movies. Accounting principles then dictate film production costs are to be amortized once revenue beings accruing. As such, most of the expenses are front-loaded. This is a quirk but it is not unreasonable – most filmmaking endeavors are boom or bust; they do not have a long tail. Only by thinking a little harder about the nature of animated films, and more specifically, successful animated films, can one come to the realization of the hidden intrinsic value in companies like DreamWorks.

Here are how their movies have fared for the past five years:

You will note: a string of profitable releases, with a number of blockbusters raking in over half a billion in gross receipts. Although it may not be in the league of the Pixars or Marvels or LucasArts, it certainly should be considered as a reliable hit-maker at this point. More importantly, they are strengthening their franchises, franchises headed by immortal and incorruptible animated characters that represent cost-free revenues in the long run.

The stock market, ever schizophrenic, does not seem very impressed. Over that same period, DWA has been as low as $16 and as high as $35 – a 100% swing from trough to peak:

Meanwhile, the world has been changing. Distribution of entertainment, once comfortably ensconced within the movie theater -> VHS/DVD -> network TV paradigm, is being disrupted by Netflix, Hulu, Amazon and their ilk. Content has become more valued in a world where distribution is being commoditized by the internet. You want people to watch your channel or subscribe to your service? Offer exclusive content.
 
You know how this story ends. In late April, Comcast made a bid for DreamWorks for $41 per share, a 50% premium above DWA’s 52-week high. Intrinsic value wins again.

Unlike the Virgin America case study, it was not guaranteed you would bank a great return if you bought DWA anytime within the past five years. If you bought at the peak at the end of 2013, you only made 6.5% annualized return. One would imagine, though, if you had the conviction then, you would have made additional, larger purchases as the stock sold off over the next two years. As such, a cost basis of anything under $25 within the past five years would have yielded a double-digit compounded return. Within the past three years, it would be in the high teens.

DWA was a stock I had watched for a long time. I never pulled the trigger because I never got comfortable enough with the valuation. Intellectually I understood the thesis, but I kept hoping for it to get cheaper. Patience can be difficult – a dual-edged sword, especially in the stock market. Patience in waiting for a security to become fully valued is a virtue, but excess patience in waiting for a security to reach an acceptable price could result in lost opportunities. Neither is preferable: Not taking enough risks is as big an impediment to wealth creation as taking too many dumb risks. Finding the balance is a never-ending quest, a life-long learning experience.

Case Study: Virgin America

If you’ve flown Virgin America before, you know they are legitimately differentiated from the soul-sucking national leviathans. New planes that pulse like a night club, high tech seatback concierge systems, flight attendants who don’t totally hate their jobs, surprisingly competitive prices, etc. They’ve been gobbling up market share ever since their inception in 2007 and went public in November of 2014.

The airline industry has been consolidating aggressively for several years now. Historically an industry that is in the hall of fame of value destruction, M&A (and collapsing crude oil prices) have helped the players settle into an uneasy but profitable oligopoly. Meanwhile, Virgin America’s success has not gone unnoticed, although you’d never be able to tell if you just looked at the stock price. Here’s a chart of VA’s performance since their IPO until late March:

For a year and four months, the stock went exactly nowhere. Chart technicians call this “range bound”, with “resistance” above $40 and “a floor” around $30. But underneath, business was booming. Gross profits grew 24% year over year while operating profits nearly doubled thanks to cheap jet fuel. Their presence at LAX and SFO grew stronger. And two of their competitors began salivating.

On March 23rd, word leaked out that VA was “in play” – Street Lingo for “for sale”. Shares popped 13%. And then, several weeks ago, on April 4th, Alaska Air announced they were acquiring Virgin America for $2.6 billion, or $57 per share after a frenzied bidding war against JetBlue. VA shares shot up another 47% that day:

If you’re following along with your calculator, that’s a cool 83% return in about two weeks. That kind of return is impossible to the proponents of efficient markets. Of course, no one could have (legally) timed it perfectly, but consider:

• If you bought VA at its closing price of $30 on the day it IPO’d, you earned a 54% CAGR.
• If you bought VA at its peak prior to the buyout (~$42.50), you earned a 21% CAGR.

(The calculated CAGR is assuming you didn’t “trim profits” or “cut your losses” at any point in between, an endeavor that, by my estimation, adds no more long-term alpha than a coin flip, but is an endeavor heavily practiced by the vast majority of market participants.)

So any way you slice or dice it, VA shareholders got paid, ranging from handsomely to a flat-out bonanza¹. And while the stock price may not reflect it, value always matters, especially private value, i.e. how much the business is worth to someone as a whole, someone who can control operations or allocate its cash flows. The timing is unpredictable, but eventually, over the long run (count ‘em in years, not months), the market is a fine arbiter of value – a right proper weighing machine.

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¹And here, buried in a footnote, I humbly beseech you to not ask the question begging to be asked, which is “why didn’t we own any VA?” to which the answer will be an averted gaze and some mumbled variant of, well, hrm, I looked at it last April but, ah, it fell off my radar… A costly error of omission resulting in beaucoup regret.

“The First One Now / Will Later Be Last”

Although I, by financial industry convention, report “results” on a monthly basis, I value the shares in companies like you would value your business interests. Occasionally there are opportunities to buy out “impatient partners”, i.e. take advantage of price declines due to wholly non-fundamental reasons.

Our advantage, if I were to sum it up pithily, would be that we are slower than our competitors. Wait, do we really want to be slower? Yes, actually, we do. With fundamental, First Principle-oriented investing, there is zero advantage and quite a host of disadvantages by being “fast” (taxes, commissions, inability to focus, et. al.). We are slow not in the sense of diligence, but in the sense of patience. We are deliberate. We do not hurry. We will be quick if an opportunity presents itself, but we will not hurry.

Being slower is sometimes marketed in the hedge fund world as “time arbitrage” (a bit too highfalutin by half, if you ask me). It is an edge that is structural and sustainable. The stock market has and will almost certainly always cater towards the gun-slinging trader types. Technology only exacerbate such behaviors. See below for a chart on the average holding period of stocks by decade. In the ‘40s through ‘70s, it ranged between 4 to 8 years. But since the dawn of the computer era and especially the internet era, it has collapsed to under 1 year:

And recall the astonishing stat mentioned earlier: the average holding period for the ETF representing the S&P 500, SPY, is a mere six days. That, for shock contrast, is a -99.5% decline from the ‘70s. Investor attention spans have vanished. It’s not that they work less hard, it’s just that their efforts at security analysis have shifted from the fundamental to the technical. Instead of attempting to profit from economic success, it’s become an attempt to profit from their fellow investors’ folly. From a game of value creation to a game of zero sum.

What this means for us is that we will sometimes look bad, possibly for an extended period of time, especially when the general market marches up relentlessly as it has over the past two years. And then there will be moments of opportunities when the market panics a bit, like in 2011 and like in the most recent quarter. We might look even worse then, because we will be at the turret with our cash pile, deploying it towards great assets at great prices – prices that may not be done going down.

But after that, we should start to look much better. It’s hard to say when that will be, but if I have been careful and have avoided big mistakes, we will be duly rewarded within a reasonable period of time.

                                                                                                        “And the first one now,
                                                                                                          Will later be last,
                                                                                                          For the times they are a-changin’.”

                                                                                                                                           —Bob Dylan

On Birds and Bushes

The intrinsic value of a stock, i.e. its “true” value, is the summation of all future cash flows discounted back to the present from their respective periods. It is not a Price-to-Earnings ratio nor is it a Price-to-Book Value ratio nor is it an EV-to-EBITDA ratio nor is it even a Discounted Cash Flow analysis. Indeed, it is nothing that can be funneled into a formula.

It is an unknowable figure because it is always changing, being impacted every day by a myriad of decisions ranging from a salesman calling in sick to the Central Bank governors sitting around a mahogany table pondering interest rate policy. What the aforementioned ratios give are only rough approximations of that mystical unicorn known as intrinsic value.

Buffett once used Aesop's classic aphorism to illustrate the idea. Is a bird in the hand indeed worth two in the bush? Because, consider also: How sure are you that there are two birds in the bush, and how long will it take to get them out? That's intrinsic value in a nutshell.

Mispriced securities either underestimate the value of the bird in the hand or the potential of the birds in the bush. Let me draw a couple of examples of this kind of thinking in action.

We exited our multi-year investment in PMT this past quarter. PennyMac was founded by ex-Countrywide Mortgage executives in 2009 to invest in all the distressed mortgages left from the savage wake of the housing bust. They also harbored aspirations of becoming a major independent mortgage originator as their founders all possessed experience and industry know-how from their prior employer.

We initiated our position around $18 back in 2011. At the time, even though PMT was earning a near 20% ROE on its distressed investments and paying it out to the tune of a 10% dividend yield, few investors had the appetite to invest in anything related to the mortgage industry. PennyMac couldn’t put capital to work fast enough, evaluating a torrent of loans that banks were incentivized to unload due to post-crisis regulation. In this case, we had a situation where there was both a bird in the hand (fat dividends), and more in the bush (a vast multi-billion market of distressed mortgages needing to be worked out).

Fast-forwarding to 2014, much of the stigma has faded. Mortgages are no longer toxic in the eyes of investors. The pool of distressed mortgages have become shallower, and the persistent low interest rate environment has spawned numerous competitors willing to bid more aggressively and accept a lower ROE. Now, we still have the bird in the hand (the fat dividend has increased by 45% over the past three years), but the birds in the bush are more uncertain. Considering the risks and other opportunities, I closed our position, generally satisfied with our overall IRR, inclusive of dividends, in the mid-teens.

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Now, consider the example of one of our current positions: General Motors (GM). At first blush, it may seem like GM and PMT have nothing in common. But consider the backdrop. GM, once upon a time the mightiest company in America, fell into bankruptcy and required a bailout by the government. Then, a few short years after exiting bankruptcy, just when it seemed like they were getting their act together, a scandal involving covering up faulty ignition switches in several models of their older cars which caused multiple injuries and deaths was uncovered.

GM, like PMT, has become a pariah on sentiment alone. It has become “un-investible” for many simply because the story has a past history of unpleasantness. But what are the facts? The facts are that the scandal and recall and the likely billion plus dollar legal in costs have not damaged their brand in any significant way if measured by cars sold. On the back of a multi-year replacement cycle for autos, GM has posted record sales two years in a row, selling over 9.9 million cars in 2014. GM’s newest mid-size truck, the Chevrolet Colorado, won Motor Trend’s prestigious truck of the year award. This timely award has coincided with the plummet in oil and gas prices and are thus driving sales of not just their trucks, but also their SUVs, both which happen to be the highest margin products in their portfolio.

Qualitatively, the scandal and recall may just be what the doctor ordered to drive true cultural change in as big a company as GM. New CEO Mary Barra has told its employees at a townhall meeting that, “I never want to put this behind us. I want to put this painful experience permanently in our collective memories.”¹ Capital allocation, once a secondary consideration behind the amorphous (and oftentimes unprofitable) goal of being The World’s Biggest Carmaker, has become front and center, with management committing to aggressive share buybacks and increasing dividends. Return On Invested Capital (ROIC) has recently become a reported metric, bringing transparency and accountability to the company who now instead strives to become The World’s Most Valued Carmaker.

By my calculations, GM is trading at a valuation that suggests the company ought to be worthless in ten years. To put it more precisely, using conservative assumptions of no growth and no margin improvement, the sum of the cash they generate over a ten year span, discounted at 10%, equals their entire market value. An investor buying shares of GM today are paying nothing for the cash flows GM will generate ten years hence.

With GM, investors believe the bird in the hand is as good as it gets and there are just a smattering of birds in the bush. I, to the contrary, believe there are plenty of birds left in the bush and they’ll happily emerge with a mere song. And if you think Tesla (TSLA) or Apple will come out with some kind of miracle disruptive car that eat up the entire automotive pie, I have a bridge to sell you. Tesla’s goal is to sell 55,000 cars in 2015, or, 0.5% of what GM delivered last year. Investors in TSLA, on the contrary, have no bird in the hand (they have never posted an annual profit) and are betting there is a veritable flock of birds in a bush that will take ten years to hike to².

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¹ “It was clearly the right message, but was jaw-dropping at GM. Retired executive Steve Harris, who started at GM in 1967, observes, ‘Her remarks at that meeting were unlike anything any previous GM CEO has ever said.’” (Source: http://fortune.com/2014/09/18/mary-barra-general-motors/)

² Morgan Stanley’s valuation model appraises 80% of TSLA’s value from cash flows beyond 2025. (Source: http://www.wsj.com/articles/tesla-targets-pull-away-from-profits-1429889005)

Holding Period as a Consideration With Regards To Common Risk Metrics

There is something about the nature of stock markets that attract speculators and traders who do not care about intrinsic value as opposed to investors who do. Correspondingly, much of risk management has focused on short-term volatility that cater to those security slingers. Standard Deviation has become the de facto number to brag about or manage around. Somehow, somewhere along the line, most investors have been brainwashed to believe a low Standard Deviation is as valuable as a high absolute return.

Pzena Investment Management, a respected shop adhering to a classic value-oriented approach, who put the theory through the wringer (http://www.pzena.com/investment-analysis-3q14-2). Unsurprisingly, they found: “Much of the daily or monthly volatility of a portfolio disappears as the vagaries of short term price movements offset each other in the long term and the frequency of loss decreases substantially.”  In other words, Standard Deviation draws an inaccurate picture for long-term investors when focused on daily or monthly timeframes. Zoom out, and what do we find?

On a month-to-month basis, stocks fluctuate, and for the S&P 500, 40% of the time, it will be lower than it was the previous month. But by zooming out, five-year periods exhibit less relative fluctuation and less loss. The trend of lower volatility and shrinking losses is even more pronounced for ten-year periods.

Okay, great, so we know stocks go up in the long term. Not exactly breaking news. But... why don’t most hedge funds seem to know this?

Here, most hedge funds, although they have a lower monthly Standard Deviation than World Equities (stocks), actually have a higher five year Standard Deviation.

And the kicker is they do not have definitively superior performance over the long term! Stocks generally go up in the long-term. Hedge funds? Not as certain.

The explanation is that most active funds cannot help but micro-manage their short-term volatility. Those Masters of the Universe sell themselves by touting an ability to achieve equity-like returns without equity-like risks. In the short-term, they can make a case for being successful. But longer term, it is a miserable strategy that offers subpar returns with higher risks.

Moreover, it is nonsensical. Equities are, almost by definition, a long duration asset class. Managing short-term volatility for an asset intended as long duration is like zig-zagging a ship across the ocean in a vain attempt to avoid waves. It’ll take twice as long to get to your destination and there is simply no way to guarantee there will be no waves along the way.

Basic Principles of Valuation as Exemplified by the Good Old Lemonade Stand

Investing is laying out a dollar today with the expectation of getting back more than a dollar in the future. There are multiple ways to do this, obviously, but the safest is to lend it to the U.S. government. You are guaranteed your dollar back¹ . It has no risk, hence, it is called the risk-free rate.

Everything else we invest in must logically be anchored to the risk-free rate. In business, if you invest in $100 in inventory, you should have the expectation of selling it at a high enough margin that, when everything including taxes are accounted for, earns you more than the riskfree rate. Otherwise, why bother?

Let's trot out the good old lemonade stand as a concrete example. Its business model: buy lemons, sell lemonades. Its costs (a.k.a. investments): raw lemons, a lemonade stand, hourly wage for your workers, etc. The goal is to make more money selling lemonade than it costs to set up and run the enterprise. At the end of the year, you tally everything up, all the cash that was spent and all the cash that was made. If you spent $1,000 and made $1,200, that is a healthy 20% return on your investment.

But what is this business worth? What is your lemonade stand worth if you want to sell it?

The intrinsic value of anything is the sum total of the cash you can extract from it over its lifespan discounted by the risk you're taking. It's a simple definition but it is basically impossible to pin down an exact number due to the subjective and fluctuating variables in the formula² . Even the value of a risk-free U.S. Government Bond is unknown because interest rates fluctuate continually³ . So, the first thing one should admit upfront is that there is no such thing as an accurate intrinsic value. What we should do instead is make conservative assumptions, acknowledging the inherent uncertainty of the future, and arrive at a rough range that approximates an intrinsic value.

So. Back to the lemonade stand. We know the business earned $200 last year in net profits. The next thing we need to know is, is that profit level sustainable? Is it in a competitive neighborhood with entrepreneurial kids, or is it in a retirement community with little risk of competition? Is its proprietor interested in continuing to manage the stand or do you have to find someone else to run it who may not know the business as well? How about the cost of lemons? Wasn't there a shortage recently due to bad weather? How about repairs to the stand, which has suffered some wear and tear? How about the fact that a controversial study blamed lemonade for increasing the risk of heart disease? Will that dampen demand?

Even after just a cursory bit of thinking on the matter, it's probably pretty clear that there's quite a bit of risk. Lemonade is, after all, a commodity – widely available and undifferentiated. Just because the business earned $200 last year is no guarantee it will earn the same or more next year. Thus, a conservative investor would probably not pay very much for the business⁴ .

As simplistic as this sounds, that's basically business valuation in a nutshell. Figure out how it makes money, figure how much it could make in the future, and then add it up and discount it. To contrast the instability (and thus low value) of a commodity business, consider the worth of a business like Disney. Not only do they own one of the most iconic brands associated with happy childhood memories, they also own ESPN and Marvel and a litany of other cultural mainstays deeply ingrained in global culture. Billions of people will always consume their products and feel good and pass on their stories to their kids who will in turn pass it on to their kids. Properly managed, Disney's cash flows will be prodigious and predictable and unassailable. They are worth many multiples of their annual profits because you can be near-certain they will earn it year after year after year.

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Why does this matter in the stock market? Because a stock is a fractional interest in a business. A shareholder has a claim on the profits. The more shares you own, the bigger the claim. Logically, it follows that if you've analyzed a company and purchased its shares at a valuation you deem attractive, you'd salivate at an opportunity to lay a bigger claim at a cheaper price.

But, you might argue, such claims to profits are merely theoretical. There's no way to take those profits and, say, buy a house. You depend on selling shares to monetize your investment, and thus, by proxy, depend on what others will pay for your share, i.e. the whims and volatility of Mr. Market. So, the market’s daily movements matter, right?

To which I'd respond, yes, but only if your need for said monetization is immediate or shortterm. In which case, you shouldn't be investing in stocks at all. In finance, there is a concept called duration. The longer the duration of a security, the more prone it is to price swings because the far-future is more unpredictable than the near-future. Equity is the longest duration security of them all, one with essentially limitless duration, and thus, your timeframe, your obligations that you need to meet with the cash, should match up with what you're investing in.

Over time, as I've often quoted Benjamin Graham, the market is a reliable weighing machine. Businesses that are chronically undervalued on the market implement policies to return capital to shareholders via dividends or share buybacks or get sold for big premiums to private buyers. Mismanaged businesses attract activist investors who oust the board and implement radical changes in efforts to preserve or extract value. The bottom-line is, while there are many ways to skin the cat, prices that are out of sync with value almost always, inevitably, converge.

“If you know the enemy and know yourself, you need not fear the result of a hundred battles.”

–Sun Tzu

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¹ But unfortunately, you'll earn, in today's environment, a miserly two pennies a year. And that's only if you promise to lend it for 10 years.
² E.g. What is the appropriate discount rate? What are the expected cash flows each year?
³ E.g. Who would buy your bond for the amount you paid if the coupon on that bond is less than the coupon on a newly issued bond?
⁴ Unless the investor owns, say, a national chain of lemonade stands that he/she can integrate it into, shaving off costs via economies of scale

On Finding Investment Ideas

Legendary value investor Michael Price once guest-lectured in one of my classes at NYU Stern back when I was a bright-eyed bushy-tailed MBA student. One of the questions during the Q&A session was: how do you go about finding investment ideas?

A common answer for a typical investor would probably be to run a screen: take a big list of stocks and their financial figures and sort/filter by standard metrics like Price-to-Earnings or ROI. There’s nothing wrong with that approach. Plenty of great investors, including one of my personal heroes, Joel Greenblatt, make heavy usage of creative screens to build portfolios.

But, instead, Mr. Price picked up a copy of the day’s Wall Street Journal lying on the table and said, I’ll show you. He went down the list of stories on the front page, distilling the essence of each article with impressive speed. A piece on rebounding natural gas prices had him musing about the value of drilling rig operators. Another one on new financial regulations triggered a thought about its effects on a specialty lender that he follows. The announcement of a merger prompted him to make a mental note to go over other companies in that sector to gauge the possibility of further consolidations.

Mr. Price, unimpressed by my bright-eyed-bushy-tailed demeanor

Most of the time, the idea-hunting approach that bears the most fruit for me is similar to Michael Price’s demonstration that day: following my nose. The last investment I made originating from a screen was over four years ago when I found Movado Group (MOV) trading below book value at $10 per share. Most of the time, it’s difficult to identify anything truly tantalizing through screens. Absent dramatic stock market dislocations, computer algorithms usually quickly pick-off the obviously cheap names.

Occasionally it is possible to exploit short-term inefficiencies like our aforementioned AAPL trade. But in general, ideas aren’t so much “found” – like pigs hunting for truffles – as they are “formed” – like laying down nutrients in the soil and waiting for rain and photosynthesis. Buffett was once asked how to get smarter, and he held up a stack of paper and said, “Read 500 pages like this every day. That's how knowledge builds up, like compound interest.” He has also bluntly stated, “My job is essentially just corralling more and more facts and information, and occasionally seeing whether that leads to some action.”

And so, I read. On a typical weekday, I skim at least three newspapers: The Wall Street Journal, New York Times, and Financial Times, and try to read them a la Michael Price. A continuous stream of Google Alerts pours in all day, keeping me up to date on breaking news. I subscribe to industry-specific journals, like American Banker or CIO Magazine. And then there is hedge fund gossip, e.g. who’s buying what, who is in trouble, who might be forced sellers, who is playing activist in corporate boardrooms, etc. Twitter’s become an unusually good source although it takes some effort to sort through the hearsay of citizen journalism.

When doing serious due diligence on a security, I spend hours going through SEC filings, reading Management Discussion & Analysis and Financial Statements and press clippings and investor presentations and conference call transcripts. Most of the time, the resulting action item is… nothing. Data and facts get digested and sorted to build a narrative of the company from which I try to analyze and understand and predict its future performance. More often than not, it gets filed away in the “Too Hard” drawer. It is a bulging drawer, but one I dip back into often when new data and facts arrive, hoping for an insight to form an investible thesis around.

Alas, that laundry list only scratches the surface. In this hyper-competitive market, the only way to maintain a consistent edge is to continuously compound our understanding of the world. We have to stay curious. We must build and polish a latticework of mental models¹ against which we test ideas. Every now and then some of them click, and we invest. Otherwise, we simply wait. Value investing is a game won by temperament, not speed or IQ or raw computing power. It requires, above all, a willingness, nay, desire, to basically sit around and read all day. It doesn’t sound glamorous because it isn’t. But I wouldn’t trade it for any other job in the world.

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¹A term popularized by Charlie Munger, who believes in stock picking as a subdivision of the art of worldly wisdom.