There are a few topics I could write about this week. Microsoft's (Nasdaq: MSFT) decision to drop the price of its new Xbox gaming platform in order to juice sales is big news, as is the Intel (Nasdaq: INTC) decision to drop prices on its Pentium 4 processors by as much as 53%. Or we could talk about Coca-Cola's (NYSE: KO) launch of Vanilla Coke. Instead, I thought it might be best if we go back and do a little cleanup from articles over the last couple of weeks.
But, first, I would like to recommend that you stop reading this article.
Yes, really. We've got some stuff that we can cover here, but I think your time will be better spent reading a truly remarkable piece of journalism that ran in The New York Times on Sunday called "Fighting To Live as the Towers Died." The authors pulled together a series of communications from people who were trapped in the top of the World Trade Center towers on September 11, to create a picture of what it was like for the people who had no hope of escape. You'll be introduced to some heroes who had never taken oaths to serve and protect, and yet tried to do just those things when disaster struck. The story of their sacrifices is much more worthy of your time than anything I can possibly talk about. You'll have to sign up as a subscriber on The New York Times website -- but it's free, and this piece of journalism should not be missed. Go. Read it, you will be glad that you did. If you want to come back afterwards, great.
I was re-reading Benjamin Graham's Intelligent Investor the other day, and had to stop short when I read Chapter 14, "Stock Selection for the Defensive Investor." Graham ran through a series of requirements for stock selection, and with the exception of the dividend requirement, I was startled at how similar the Rule Maker criteria were to the list produced by Graham upwards of 40 years ago.
The one place where we seriously conflicted was that Graham required a company to have decades worth of consistent-to-growing dividend payments to shareholders. Frankly, in today's market, though they have gained a bit of a renaissance over the last two years, dividends are not generally held in such importance as they were in the past. And since investors aren't so demanding of dividends, companies have not tried to keep their dividend payouts at percentage levels nearly as high as in the past.
Also, Graham puts a hard limit on price-to-earnings ratios, which we don't do in Rule Maker. This has as much to do with the changing of the times as with anything else. In Graham's day, one could generally trust the earnings number to give a good picture of corporate performance, something that isn't so true anymore. With everything else, though, our criteria held pretty closely to Graham's.
It just goes to show that there is not much new under the sun. We're trying to make fairly timeless precepts of investing applicable to today's individual investor. One can rightly look at the Rule Maker's performance since inception and say, "Wait a minute, you're comparing yourselves to Graham?!? I'd say you guys are pretty far off the mark."
True. There were two parts of the brilliance of Ben Graham. First, of course, was his ability to communicate and teach, which he did for several decades at Columbia University. The other part, the art, was in the application, the actual stock selection. Ben Graham made more than a few mistakes in his lifetime, and did a few pittance-fortune-pittance round trips en route. But he never stopped honing, learning, improving, and as a result made far fewer mistakes of commission as time wore by. That, in and of itself, is a lofty goal for all investors.
Some backward tracking
Something has bothered me greatly about the article I wrote in April regarding Costco's (Nasdaq: COST) valuation. Recall that I was working a basic model to estimate the net present value of the company's future cash flows, with the proviso that, at present, Costco didn't have any due to its policy of reinvesting substantially all free cash back into the business. No problem there. But I then did something goofy: I opined that we ought to set the company's growth rate at a flat 9%, but at the same time I had already assumed that we could back out the cash reinvestments for growth. Hard to grow at the same historic rate if one is not reinvesting the same amount back into company growth, right?
This is not a huge deal, because I don't think for a second that we ought to be shooting for some exact number. If I come up with a discounted cash flow (DCF) value of $39.28 and the current price is $41.53, that should tell me very little. But if I come up with a DCF of $11, and the price is still at $41 per stub, we may have a problem. At some point, I'd like to speak more about building DCFs, but there is a fundamental problem: Finance is not physics. There aren't a few rules that capture almost all events. That's one of the constraining issues with things such as a DCF: There is no such thing as a strict model one can use. I was trying to make a rough cut. Instead, I did the equivalent of ripping my own arm off and claiming that my resultant weight loss was due to dieting. There's no need to rush through this and oversimplify, so I'll come back to it in the near future.
The great baking soda war
Last week I threw out a bit of flame-bait by calling Church & Dwight (NYSE: CHD) the "perfect" Rule Maker company. I made this declaration in spite of the fact that the company is well below the minimum threshold for Rule Makers in size and Cash King Margin, and in spite of the fact that Church & Dwight is not at a price I'd consider to be cheap.
Church & Dwight's management must be wondering what they did to garner such love from The Motley Fool all at once. This past weekend, CEO Robert Davies had a great interview on the Motley Fool Radio Show to discuss the company's business. Most revealing to me was the fact that Church & Dwight had less than $15 million in annual sales as recently as 1969, compared to more than $1 billion in 2001.
At any rate, on the Rule Maker Strategy discussion board, several readers came at Church & Dwight from different angles to challenge my description of it as being "perfect." Great stuff there -- nothing that I'd really argue with in terms of formulating a risk-reward scenario for this or any company. First and foremost was the risk that the management of Church & Dwight will be unable to resist continuing to make acquisitions in the attempt to make a brand powerhouse. I think this is an extremely good point. To date, the company's acquisitions have been made at excellent prices and were of suitable quality and heft to be additive to the top and bottom line. Altogether good uses of capital.
But what happens down the road when Church & Dwight's management, potentially drunk with power after their recent successes, has another opportunity to acquire further brands? Do they have the discipline to turn down acquisitions that offer more marginal financial gain? Hard to say, and former Masters of the Universe such as Tyco (NYSE: TYC) and First Union, now Wachovia (NYSE: WB) found out the hard way that a long-term strategy featuring acquisitions can turn disastrous in an instant. I've got past behavior to stand on in saying that management has shown discipline, but there is no telling what the future holds.
One thing I'd say is that I like the economics of Church & Dwight's business regardless of any future acquisitions. That's to say that if the company simply focused upon expanding its existing brands, then I think the potential for it to succeed is quite high.
The other question had to do with discounting to come up with valuation. In regard to Church & Dwight, I simply took a Price to Free Cash Flow multiple, though, obviously, there is much more to it than that. We'll come back to this point, and, in fact, Church & Dwight may offer a better basic model than Costco in this regard.
Have a great week, all!
Bill Mann, TMFOtter on the Fool Discussion Boards
[To discuss anything in this article, visit the Rule Maker Strategy discussion board.]
Bill Mann's been known to describe things as being "the most average," or "fantastically not good." At time of publishing, he held beneficial interest in Wachovia Bank. The Motley Fool is investors writing for investors.