In this podcast, Motley Fool analyst Jim Gillies joins host Ricky Mulvey for a conversation on valuation and mosaic theory. They also discuss:
- How incentives impact valuation.
- The "new store growth story" at Costco.
- Case studies from a sneaker company and a space company.
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This video was recorded on July 27, 2024.
Jim Gillies: Now, what do we have to do in terms of growth rate to justify a $12 million value? I have to look at the balance sheet. What does the capital structure look like? What's the debt, if any? What's the tenor of that debt? What have they historically done with their cash flows? Do they own all of their operations? Do they farm out manufacturing to someone else? What is the track record of management here?
Mary Long: I'm Mary Long, and that's Jim Gillies, a Fool analyst who heads up our Motley Fool Canada service. A few weeks ago, Jim joined my colleague Ricky Mulvey for a conversation on valuation. In today's show, Jim walks through Mosaic theory, a practice where you're pulling research from a number of different sources in order to determine a company's value. They also discuss Costco's growth story, how incentives contribute to valuation, and lessons from one company specializing in sneakers and another in spaceships.
Jim Gillies: We can talk a little bit about mosaic theory. It's basically, as an analyst, as an investor, I'm going to use the words interchangeably, because, the Fool is about people dealing with their own stocks. But we are always seeing through a glass half darkly. We are getting bits and pieces of a story. Valuation at its core is not dissimilar really from the principles underlying it. If you have a bond where the cash flows are fixed, and the maturity is fixed and the discount rate is largely fixed, we can assess what the value of a bond is, a financial instrument a bond, fairly easily. It's literally spelled out the adventure of associated with that bond. For stocks, however, it is infinitely more complex, even though at its end, the value of any stock in theory is the value of the cash flows, all the cash flows it will throw off for the remainder of its life until time immemorial discounted back to the present at an appropriate discount rate. The problem is buried in there are about 100 million different assumptions of varying size or not. As we put together our mosaic, we're looking at, what are the things that lead to our cash flow forecast? What are the things that lead to maybe an appropriate discount rate to discount them back? How do we factor in management and management decision making? How do we factor in the macro environment? But again, we are always seeing the world through a glass half darkly, which is the lends us to the famous concept made famous by Ben Graham, the father of value investing and popularized by Warren Buffett. That is the concept of margin of safety. Even when you think you've got a reasonable forecast and a reasonable handle on the company and a reasonable handle on the environment in which it exists, and you calculated value, let's say, the stock is trading for $100. Doesn't matter what the stock is. Stock's trading for $100, and you come up and you say, you know what? I think the stock is worth $100.
So the trading price is at $100 and all of your hard work, and you come out to the exact same price. Should you buy it? Well, maybe, but if you want to go in big, you're going to buy at say $80. You're going to wait till they have a bad earnings report or something spooks the overall broad market in general, like a global pandemic or something. Then you're going to buy at a discount, which we're going to call the margin of safety. A good analyst, a good investor is going to be finding a little data points, and you're not looking at a company in isolation. We don't look at a company for three hours on a Thursday afternoon and then we're done. We buy it, and we never look at it again. We're going to be looking and adding to our mosaic. We're going to be looking at future earnings reports. We're going to be looking at financing decisions. We're going to be looking at what the company does with the cash flows it generates. You're gradually adding pieces to the mosaic. I've got companies that I have owned for over 20 years. I've got one that's I owned for over 25 years. It's because I'm adding continuously to my understanding of the company, and even a couple that I'm thinking of, which I've owned for 20 years.
My opinion of them has changed over the years. I've added, I've subtracted, depending on where I think valuation is going. I've changed how I'm looking at the company. Is it a long term grower? Is it something that I'm going to use with options to do what's called a covered call strategy? Because I don't think it's going to go anywhere, but I don't want to trigger the capital gains tax necessarily that comes from just selling it out right. There's a lot of things that go in, as we build our mosaic, to get a better understanding of the company and the organization where we are putting some of our, hopefully, hard earned dollars.
Ricky Mulvey: What's it look like in practice for you, then, Jim? Is it, you see a decision from a management team that you don't like, and then maybe up the discount rate on the future cash flows or what does it mean to put together the mosaic with new information?
Jim Gillies: You can. Quite often, if I see decisions out of management, I've learned, I'm moving closer to a cell decision, frankly, a lot of times. Because and especially if I feel I'm being lied to, and that's one of the dangers actually of having the ability to interact with management. Management will typically tell you a very sunny story. Not all of those sunny stories are true. Occasionally, they'll lie to you, and I've had that happen a couple of times in my career, and the sell rec fell very closely after I felt I was being lied to. But you are building a model. You are enhancing a model. You are ideally thinking about one of my favorite things to do, I give it a fancy name, I call it a mass balance because I came out of the engineering world and specifically chemistry.
A lot of times, we did a lot of electroplating and other types of metal finishing, which is very reliant on chemistry. I came up with the concept of the mass balance. I'm trying to make it sound cool. Really, you're comparing the major sources of cash coming in and the major uses of cash going out. On balance, are those flows both in and out. Are they designed to enhance the overall return of all shareholders? Or, for example, a couple of companies I could name, I'll save the tickers here to spare the guilty. But I can give you a number of tickers that emerged in the last 5-7 years, what I'm going to call tech bubble two, Electric Boogaloo. I'm old enough to remember the original tech bubble, I didn't like the sequel, wasn't as good as the first one. But a lot of them went from cash flow negative, which is no sin, but boy, you better have a plan to get to cash flow positivity, so we can build a evaluation case for you. But they went from cash flow negative to cash flow positive. But they've been so expansive and generous with their equity and hosing out equity to everybody who worked for them, including, the Janitors dog kind of thing, that the largest cash outflow from the company paying taxes for the equity cookies that given to insiders on the way up. That is not a use of cash that is beneficial for all shareholders. Buying back stock, however, for a company that very clearly, and it's even better, it's even nicer when management will say this publicly. We buy back stock when we believe the valuation warrants doing so, and we get whether it's a free cash yield from it, or they talk about a book value yield in the case of Berkshire Hathaway, for example, companies that actually buy back stock deliberately and strategically and have an evaluation case of their own in mind. I can give you a number of tickers where I think they do that.
Winmark would be one. Medpace Holdings would be another one, to a lesser extent, International Petroleum, which is a Canadian oil and gas company. They might be verging more toward the buyback at any price, but heretofore, they've been reasonably good at it. That is a use of capital that benefits everyone. Dividend-paying, special dividend paying, again, capital allocation. Because this is the thing, we talk about valuation, and valuation, as I said earlier, is forecast the cash flows from now 'til time immemorial. By the way, you can probably cut it off about 10 years because the cash flow you expect in 53 years is going to be worth precisely zero today, as will your forecast. It will also be worth zero today. But in theory, you forecast cash flows out, time immemorial, discount them back to the present value. That's the valuation process. But the other part of it that you need to really appreciate is, what does management do with those cash flows? Are they being utilized? Because if they're going to sit on the balance sheet and do nothing, whatever, that terribly exciting. If they're going to go to value destroying acquisitions or value destroying project growth. Again, that's worse than nothing. If they're going to go to acquisitions that enhance our competitive position, if they're going to go to reinvesting in the business, they're going to go to dividends, special dividends, repaying debt, so there's less financial risk for the equity holders.
Valuation Step 1 allocation, understanding allocation is Step 2, and understanding what management is doing and realizing, you can like a management team. You can like people. We're privileged in our position. We can actually get to know some of the management teams on a personal basis, which I hold is dangerous sometimes, especially if you like people in general, because they're going to try to sell you a story and you like people in general. You're probably going to be susceptible to that story. We have to remember, we're not friends with the companies and the management teams of the companies that we own. We're not friends with them. We have to have an appreciation for cash flows, the valuation of said cash flows, and the capital allocation decisions that the management does and try to be as surgical as possible to understand. Are they doing things that are good for all of us? Are they doing things that are bad for all of us, or are they favoring one group usually management, over another?
Ricky Mulvey: Let's go to Costco. A mosaic theory going on.
Jim Gillies: Let's go to Costco.
Ricky Mulvey: Let's go to Costco. Usually, a good idea. This is an interesting one. Every time you go, you post on X that you don't own enough of the stock. It's a great experience. Everybody loves Costco. Right now, it's also at 50 times free cash flow, in like 50 times forward earnings, and its market cap went from about 200 billion in January of 2023 to about 370 billion today. That's pretty close to a double for a really mature retailer that's already at a $200 billion. It's not the store count that exploded in that time. Sure. Recently, they raised the membership fees a little bit. But how are you piecing together that mosaic right now?
Jim Gillies: Well, the first thing is, I'm going to suggest that a free cash flow multiple is not terribly useful. What are they doing with their cash flow? First of all, a basic free cash flow is cash flow from operations minus CAPEX. That may or may not be a good definition for certain companies, it's probably reasonable for Costco. What's their CAPEX being spent on?
Ricky Mulvey: Stores.
Jim Gillies: New Store growth. Cool. I would suggest to you that the Costco New Store growth story is not over. At the least, if you wanted to come up with a more reasonable free cash flow, an example I will give you is actually Home Depot. I'm going to mangle the dates because the dimly lit pass is by definition, dimly lit. But I think around 2007, 2008, so rather concurrent with the global financial crisis. Home Depot made this decision that we're done growing at the elevated rate we're doing. They said, you know what? Every American, every Canadian lives within a 15 minute drive of a Home Depot. The need to build new stores is done. We're going to really drop back our expansionary stores. We'll spend a little cap back. We'll build one or two stores a year in growing population centers. We're really going to cut back on our new store growth. What happened to the free cash flow at that time? Well, CAPEX fell off a cliff. I think it fell by three quarters over two or three year period. But the stores were just churning out all this cash flow anyway. Free free cash flow for Home Depot just accordioned write up, just massive.
Then they started following along with giving that cash back to people in a shareholder friendly manner. Dividends have gone straight up. Dividend growth has been phenomenon, buybacks, I think they've taken out 40 or 50% of their stocks since 2008 just tremendous. Why that matters in terms of Costco is, again, I think new store growth is still on the menu. In order to get a better appreciation for free cash flow today, we would have to estimate how much of that CAPEX is going to so called maintenance CAPEX, refurbishing the stores they already have, and how much is going to new store growth, purchasing land, purchasing building, developing the building, all the stuff that they throw inside the buildings, to make your shopping experience wonderful. The freezer cases and the big stacks of warehouse shelving. The first thing is, if you say it's 50 times free cash flow, I say, well, the first thing you want to do is you want to value this thing as more of a cash cow thing to get appreciation because let's say Costco stopped the new store growth today, what would their free cash flow do? That's the appropriate tool to value Costco against. The second thing is Costco, I know we've talked about this before, and I was yapping about it for the longest time, but I was pointing out simply that Costco had not raised their subscription fees, their membership fees since 2017. They usually went about every five, six years. It was seven plus years now. Within a couple of weeks ago, I think they finally announced they were going to bump it perfectly fine. But that's going to boost the next year's worth of earnings. Third thing is, again I'm pretty sure I'm roughly right, but precisely wrong, they own, I think it's 90% of their stores and around 75-80% of the land under their stores.
Jim Gillies: What happens to Costco if they decide to spin off all of those assets and to say a REIT? What does that look like at the continuing operating business? What does that look like if they did a giant sale and leaseback transaction, brought all that cash in, and then bought back a wack of stock? What does that do? I hope they won't do that, by the way, but the things are malleable, they could do and then the last piece of it, and this is more the mosaic, if you will, is the reason I will, yes, admittedly guilty is charged, occasionally go to Costco and then tweet out, I don't own enough Costco. The way Costco got into Stock Advisor Canada as a recommendation at around 450, 470, I think, was Iain Butler, who's the head of that product, every time I would go to Costco, I would take a picture of just the insane lines or the bill of some rando or even me, occasionally, well, the guy in front of me, so show me his bill, he's got, yeah, I just spent $800 and he's not lamenting that he spent $800 at Costco, he's almost bragging about it. It's a very interesting consumer behavior, you've just spent a large amount of money for, a grocery store/Jack of all treasure hunt style, shopping experience, and you're happy about it and people are posting that online and I'm just like, well, that to me is the classic Phil Fisher scuttlebutt investing kind of research, we're like, people. They're going for a bag of milk and a box of eggs and they spent 250 bucks.
Ricky Mulvey: A bag of milk?
Jim Gillies: Sorry Canadian?
Ricky Mulvey: Is that a thing?
Jim Gillies: A gallon of milk, yeah. We buy milk, you buy it in a four-liter pack, but it comes in three bags.
Ricky Mulvey: Alright.
Jim Gillies: Just chalk it up to Canadian [inaudible].
Ricky Mulvey: New every day, look at that.
Jim Gillies: There you go. Anyway, the point is that Phil Fisher types Scuttlebutt investing is not dead, it's harder to do now in an Internet in a connected world where you can't go by a business and you don't count the car, I mean, you can, but it's not terribly useful. Go count the car showing up on a weekend shift, or is the business dead on the weekend and it's a manufacturing business. It's very difficult in a world where how many, I'm just going to pick a name at random, how many American Eagle outlets are there? [OVERLAPPING] I have the faintest idea, but I'm pretty sure it's not going to be terribly useful for me to go to say, do a sampling of 10 or 20% of them and just go see how things are going at a time. You could do that, I suppose, but it's not going to send you the signals that it might have sent when chains were smaller, and you didn't have online sales, it's not going to send the types of signals that you probably would have gotten in the past when Phillip Fisher when he popularized the term Scuttlebutt investing.
Ricky Mulvey: I try to do it still, I went to DICK'S Sporting Goods a few weeks back, picked up some On clouds, which I am enamored with here, look at these.
Jim Gillies: I don't even know what those are, I guess they're shoes.
Ricky Mulvey: They are shoes, I'm not going to ask you directly about the company, but company's on my watch list now, cashier tells me he's seeing a lot of these go across the scanner, in Denver, like a lot more than recognizing the growth of it, the winner of the Boston Marathon just was wearing spray on On Cloud Shoes, which I thought was pretty incredible, companies also more than 2 x, it's operating income since 2022, it's becoming more profitable, sales are increasing a lot, so margins are getting better and sales are increasing, it's about a $12 billion market cap company. This is me just starting to look into it, but what other pieces do you think I should add to this mosaic before I decide whether or not I'm picking up some shares for myself?
Jim Gillies: What are the cash flows? Number 1, try to get an assessment of what they currently are and what management is doing with them, Number 1. Number 2, growth is an important part of any value investing. The separation of value versus growth investing is often silly.
Ricky Mulvey: It's a different show.
Jim Gillies: Yeah, it's a different show, but, look, I mean, growth is an input to valuation, I didn't say value, I said valuation. Because I'm perfectly happy, I've paid up. I've been a Shopify shareholder for years, I've been Amazon shareholder for years, I'm embarrassed to tell you what my cost basis for Mercado Libre might be or Chipotle. I am not adverse to growth or paying for growth, but you have to have at least someplace to put a stake in the ground if you tell me that, and I don't know this company at all, your shoe company is I just have to make up stuff as we go along. You're saying it's a $12 billion company and they were doing 25 million in free cash flow, I'm like, Okay, what growth rates do I need to back into to make and again, I'm making the numbers up Fools, I have no idea I've never looked at this, I'm trying to just pick an absurd example. But if I figure out that they're doing 25 million in free cash flow a year.
Ricky Mulvey: Ten X that.
Jim Gillies: Yeah, if I 10 X that, then the company's worth 250 million.
Ricky Mulvey: They're doing 250 million in free cash flow over the last 12 months.
Jim Gillies: Now, what do we have to do in terms of growth rate to justify a $12 billion value? I have to look at the balance sheet, what does the capital structure look like? What's the debt, if any? What's the tenor of that debt? What did they historically done with their cash flows? Do they own all of their operations? Do they farm out manufacturing to someone else? What is the track record of management here? How are they compensated? There's a company it's no longer public, but I'm going to go in a weird direction here. Reading the proxy statement is something that a lot of people don't do, they even know where it is, it's the annually, it comes out and talks to you about how much management makes, how much the company compensates a board member, for example. What are the incentive programs that management is participating in?
This company, again, it's no longer with us, but they specialize in container ships and container ship market is a very cyclical market because basically, charter rates for container ships plunge when there's too many ships on the water, the container ship operators pull the older and, more beaten down ships off the water and turn them into scrap metal, which takes a bunch of floating capacity off the water, which then starts to spark charter rates to go back up and now all of a sudden, they'll turn around and they'll like, Oh, we have to build more ships and so this CEO of this company that was called C-Span at the time, not the television network, but then they changed their name to Atlas Holdings before they were acquired by Fairfax. The former CEO of this company, he was getting about a million bucks a year salary, that's nice, but he was also getting, like a finder's fee for buying new ships, he was getting paid like 1% of the value or 1.5% of the value of all the new ships that they contracted to build. You can already see where this is going to turn into a problem, because what do you incentivize to do at that point?
Ricky Mulvey: Well, I hope the team on are not buying new ships, but I understand where you're going.
Jim Gillies: No, but as to understand the incentives, how are management there incentivized? Because at this company at C-Span/Atlas, the CEO made a million bucks from his paycheck, but he made 10 plus million ordering new ships, even though they probably should not have been ordering new ships because the industry at that time was presently removing ships from the water. But, of course, when you make 10 million, whose bread, I eat, his song, I sing and so you want to see how people are incentivized, where is their heart going to lie? What are they going to be interested in doing? This is about as good as I can say and, again, I've never looked at this company, but that's what I would do, I would look at. I might even run, we've already alluded to it, what's called a reverse DCF, a reverse discounted cash flow and what that is, is to say, let's assume the current stock price is correct, whatever correct means. What growth rate do I have to assume in whatever today's free cash flow is out, again, to the far distant horizon with whatever the appropriate discount rate we've decided to use, what growth rate equates the current stock price to the calculated valuation? If you find out, and I'm not going to name names, but I'm going to suggest this happened a lot in 2021, and it was generally ignored to deleterious effect by people who ignored it. If you find out, if your math says to you that a company, their present share price is justified by free cash flow that has to go up by 50, 75, 100% a year for the next three decades, I'm going to suggest you're paying a little too much.
Ricky Mulvey: Yeah.
Jim Gillies: Then you can choose to ignore that or not as you will and that's the other thing too, I've used the phrase a number of times, we see through a glass darkly always remember, you are also susceptible to making errors that may be in service of a preconceived notion. You might really want to like a stock. You might think it's cool, you might think what they're doing is cool. The one I like to pull up, as a ridiculous example, because it's the very definition of what the hell were you thinking and that is Virgin Galactic, which came public as a SPAC at, like 10 bucks, Special Purpose Acquisition Corp, basically, they raise money and go in search of a business to buy. Came public at 10 bucks, as all SPACs do and what Virgin Galactic does is basically its space tourism. Hey, you pay us a quarter million dollar, we'll give you a 15-minute flight to low earth Orbit and you're not really orbiting, you'll get a minute and a half of weightlessness, then we'll land you hopefully safely, and we'll call it a day and we'll cash your check. Got to have a lot of really rich people playing and a lot of people willing to drop a quarter million dollar and I don't know if you've heard this, space flights expensive, and this is a company that has never made a dime of cash flow in its life, so it's impossible to value and it didn't stop the stock from going up 3, 400% in the crazy days of 2021.
Today, the stocks down 97% from its high, I think. Hell, I think it's down 97% from its SAC issue price. There was no time there where the valuation made sense. None, zero. In 2021, I know we were under lock and key with the pandemic, but from an investing standpoint, it was a very optimistic time. People were buying almost anything, this is great, this is wonderful and hey, who doesn't think space tourism is cool. If price was no object, I'd be on the next rocket, this would be awesome. But you got to divorce yourself from that type of thinking and stick to the cold hard facts and I deliberately chose a ridiculous company. Forget space tourism that can't earn a penny, and it's a quarter million dollar just to get on board. It's harder when we look at a fashion brand, or we look at a shoe brand like On,. [inaudible] . Even when you look at Costco, like, again, my whole thing with Costco, and I like Costco a lot, do I think Costco has gotten a little frothy? Yeah, probably, but you know when else I've heard Costco overvalued, and you should sell it?
Ricky Mulvey: When?
Jim Gillies: Well, I ain't saying sell.
Ricky Mulvey: Okay.
Jim Gillies: Because I have very fond memories of very smart people, including some of the Motley Fool, telling me it was overvalued at 100 bucks, and 200 bucks, and 300 bucks, and 500 bucks, and 700 bucks. Like, Okay I hear what you're saying and yeah today, there are some optimistic assumptions buried in the price, shall we say. But if a stock trades sideways, or let's say Costco today goes over the next three years goes from you said 50 times forward earnings, let's say it goes to 30 times forward earnings over the next five years and then it restarts its continuous climb and they continue operating Costco as Costco, as they've operated it for decades, I still think you're probably going to be pretty good. We haven't even talked about, that's another thing in consideration. That's one way to put it, I have the misfortune of having most of my Costco in a taxable account. I'm going to be writing a very large check to Revenue Canada or the Canada Revenue Agency if you prefer if I were to exit my position or at least a position that's in a taxable account, that has got to weigh on my decision-making. Because, I'm also, at least, as of this moment, gainfully employed and so I'm making a salary, any taxes there would be, assessed, at my tax bracket, as opposed to say, my father, who's in retirement, if he owns some shares, that also has to come in. If you're going to lose 40% of your investment or 30% of your investment to taxes, boy, you better hope whatever you've sold the overvalued company that you currently own, you better hope that whatever you replace it with does better than that to overcome that and if it doesn't, you're going to regret selling.
Ricky Mulvey: Alright, I always learn more about the process talking to you, on one of these days, we're going to get to the balance sheet, I promise.
Mary Long: As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long, thanks for listening, we'll see you tomorrow.
