TogaPF Investing Philosophy

I thought about my philosophy: so here it is. There's nothing original here. I generally like Mohnish Pabrai's Dhando Framework, so there's quite a bit of overlap. Anyways, this is all subject to change, and I hope to refine it over time.

1. Stay within my circle of competence

I often fall victim to jumping in too quickly to an investment in a business that I do not fully understand. My initial portfolio had plenty of these types of stocks. To stay within my circle of competence, to pass on ideas that are simply too hard to understand, that's really what investing comes down to.

I don't think this is easy to do. I could always trick myself into thinking that if a business is making money, surely the business model has merit. But who could actually explain why some of these financial companies make money? Or when Internet stocks or BRIC stocks or solar stocks were skyrocketing, could I honestly dissuade myself from jumping in, or explain their performance was rational or justified?

It's important to note that dismissing an idea as too hard to understand does not necessarily indicate intellectual weakness. Sometimes, there are companies or sectors that Mr. Market moves rather inexplicably. If I can't understand the merits of the underlying business, should I be involved, despite the enticing rewards that may be reaped? This is really about staying the course, and sticking to my investing principles.

Of course, I'd like to expand my circle of competence, but its important to know and stay within my limits.


2. Keep it simple, stupid

It's easy to create a lot of work when it comes to investing. I want to invest the time to perform the right analysis, yet I want to keep my lazy side happy as well. The easiest way to adhere to this is to avoid excess work. This means making few infrequent investments. The fewer the better, and the less there is to keep track of. Indeed, I'd want to be fully invested in my best ideas anyway.


3. Invest in businesses with a sustainable, durable competitive advantage

Anything else, and it's just not worth the effort. See Rule #2.


4. Free cash flow - for real

This is to remind myself that ultimately, it's the cold hard cash that is returned to the shareholders that count. Other metrics will sometimes be trumpeted, perhaps revenue growth, perhaps EBITDA, perhaps earnings per share, but none of these have the impact to shareholders the way free cash flow does.

However, there are many ways of calculating this, many accounting tricks that may be applied, and many adjustments that can be made along the way. I need to make sure that the numbers I'm looking at are indeed the numbers I want to be looking at.


5. Margin of safety: 2x in 3 years, 3x in 5 years

I want to find opportunities that will yield outsized returns. Limiting my investments to those that I think can double in 3 years or triple in 5 years should do the trick. If I can find opportunities that also have a margin of safety to those return benchmarks, all the better.

I'm more wary of pure-play value investing situations in which the assets might be sold for more than the stock price, or a sum-of-parts type breakup that might unlock additional value. In these situations, the underlying business often just isn't that attractive anymore. That's why I think simply a 25% discount to intrinsic value is insufficient. There must be a way for that value to be captured or recognized, or else that discount might get baked in for a long time.


6. Don't lose too much money

A play on Buffett's famous rule #1 (and #2) of investing, which is humorous but does not really say much. Along with buy low and sell high, don't lose money is a nice bromide that sounds wonderful in theory but is impossible to put in practice. Ultimately, it makes you want to keep all of your money in CDs and TIPs.

I much prefer Mohnish Pabrai's rule to find opportunities in which, "Heads I win - Tail's I don't lose too much." If I'm to find an undervalued opportunity, I will be risking my capital. The trick is to find opportunities in which the outcome is uncertain, but the downside risk is limited. I think that is a much more reasonable guide than Buffett's advice.


7. Know where the exits are

While I would like to own my stocks for Buffett's preferred holding period of forever, that probably isn't practical until I learn to select stocks the way Buffett does. In the meantime, what happens when I buy something with the intention of holding on forever, but then the business hits some snags? I need to know under what conditions I'm willing to exit, whether its business deterioration, changing industry dynamics, or an excessively rich valuation. I need to know this going in; otherwise, my investment will be stuck in limbo and I won't know what to do with it.

Evaluating the Current TogaPF Holdings

Many of my current holdings are not what I would consider keepers, so I want to evaluate them to see which I would sell to make room for more attractive investments. Here's a quick rundown of where I stand on my current portfolio holdings.

Bank of America - BAC

As a customer for many years, this was a stock that I had been keeping an eye on for quite some time. Valuation-wise, however, the stock had for a long time been too rich for me. At the onset of the current credit market woes, however, the price started dropping, and I started purchasing starting in November 2007. My average purchase price was $36.39; the price at the inception of TogaPF was $32.62, and the current price is $30.70.

I admit there wasn't much in the way of financial analysis here. By that, I mean that I don't have a good sense of what the intrinsic value of BAC ought to be. The purchase decision was based primarily on the strong dividend yield and growth record, as well as qualitative observations on the strength of the business and the brand. I frankly wouldn't know where to start in terms of evaluating the state of their balance sheet, but which I would assume does not differ too significantly from its peers.

The key questions for me are (1) whether they can survive the current downturn and (2) whether they can afford to keep paying $12 billion a year in dividends. On question 1, I would assume that they do survive, that they are one of the banks that are simply too big to fail. Whether they can continue to operate at their current size and rate of profitability is questionable. However, the troubles affecting BAC are affecting the industry as a whole. As Bill Miller points out, at some point the credit crisis will end, the housing crisis will end, consumers will resume spending, and the economy and stock market will move higher. Once that happens, I think BAC will be better positioned when we finally emerge from these troubles, given its resources to survive and the ability to pick up assets like Countrywide on the cheap.

On question 2, the dividend yield is pretty attractive at about 8% right now. It's grown by about 15% annually from 2003, from $1.26 to $2.56 today. While it's been difficult of late to take anything a bank CEO says seriously, the company did confirm the dividend for September. There is still a good chance that the dividend will be cut, but I would think that if BAC really needed to cut the dividend, they would have joined the others that have done so already. Even after a cut, the dividend yield would likely still be higher than the 3.5% promotional yield you could get from HSBC Direct right now. However, the recent volatility in BAC has made the tactic of using BAC to juice cash yields a dicey proposition.

In the long-term, I view this as a pretty attractive investment, although it will never be a home run. Conservatively, I would estimate a dividend yield of at least 5% annually, along with some small level of stock appreciation in the 5% range. That would yield over 10% per year in returns, which will grow over time as BAC resumes its practice of raising its dividend annually.

However, there will likely be more attractive opportunities elsewhere, so I am open to trading out of BAC to make those purchases. Even within financials, I think there are bound to be better opportunities that I need to investigate such as AXP or NYX.


Berkshire Hathaway - BRKB

I'll always keep at least one share of Berkshire in order to receive the annual report and to attend the annual meetings. However, given its size, it's unlikely that it will continue to beat the market. There are also some drawbacks to owning this, including a conglomerate discount due to the unlikelihood of Buffett selling any of his businesses, and a perceived Buffett premium for his being at the helm. He has been diversifying recently though, picking up additional busineses and stepping up to provide financing on major deals like Wrigley / Mars. I would always welcome purchasing this at a good price, but I would also trade out of this if I found a better opportunity.


Columbia Sportswear - COLM

The CEO, Timothy Boyle, and the chairman, Gertrude Boyle (his mother), own close to 59% of this company. Pretty rare to see these days, but it's good that the managers and the shareholders are one and the same here.

I own a few Columbia items (fleece and jacket) and have been pretty pleased with them. I don't know if I'd pay premium prices for them, but their stuff is definitely solid. The financials have also been pretty solid, with FCF generation of about $100M in each of the past 3 years. At a market cap of about $1.4 billion, this is about a 7% FCF yield. Growth has been satisfactory at about 10% a year recently, the current 2008 outlook calls for a 3% sales decline. They have over $300M in cash on the balance sheet, and only $20M in debt. Dividends are only about $20M per year, and they've been buying back stock. They'll probably need to start a new share buyback program soon as they only have about $40M left under the $400M authorization from 2004.

There is huge short interest on this stock, however, at close to 40% of float (but factoring in the Boyles' holdings, short interest is closer to 13%. This short interest is mostly likely due to the fears of reduced consumer spending. It seems to me that given the strong balance sheet and continued FCF generation, there is very little downside to the stock.

Overall, like the product, this is a very solid company without much flash. I really like how it's a family business and how the family still owns a huge controlling stake while managing the company very conservatively. I can see it staying under the radar and showing significant gains over time. Growth opportunities are there outside of the U.S., and each of the 3 geographic regions outside of the U.S. had sales growth in Q2 08: EMEA (13%, 9% due to FX), Canada (18%, 11% due to FX), LAAP (20%, 3% due to FX). I will likely buy more on price dips.


Digital River - DRIV

I've never fully understood how this company makes it money, but their financials certainly are marvelous. They are the leader in providing outsourced e-commerce services, specifically the technology and infrastructure for online stores that sell software downloads, among other digital products. They also provide online marketing services to drive traffic to these online stores. However, there is significant customer concentration with Symantec accounting for close to 30% of sales, and Microsoft likely accounting for another 10%+.

Revenues have grown from $220M in 2005, to $349 M in 2007, to 2008 guidance of $401M with $202M in the first half. They've been one of the few companies that has continued to perform well in a weakening economy. Capital expenditures have been pretty small and have been about 4 to 6% of revenues. The business has generated over $100M in free cash flow in each of the past 3 years. They bought back $138M in stock in Q108 and still have $587M in cash and investments, although $195M in debt outstanding.

The stock appears to be fairly valued. The current 2008 EPS guidance of $2.00 implies about a 22x PE ratio, which seems reasonable given the growth rate. Based on a market cap of $1.7 billion, the FCF yield is about 6-7% and should continue to grow in the future. With their financials and their business position, they should be able to weather any prolonged downturns and should be able to pick up a few acquisitions at depressed prices. They themselves may also be an attractive acquisition target further down the road. I'm holding onto DRIV for now.


eBay - EBAY

I made a big investment 2 years ago at $27 per share and haven't done anything since then. The thesis then hasn't changed much. They still have a dominant online auction business and a potentially huge business in PayPal. PayPal has a run rate of about $2.4 billion in revenue, with 45% growth in international vs. 30% in the U.S. Skype was never much of a factor in my original analysis and eBay did take a huge $900M impairment charge a mere 2 years after the acquisition, but Skype still has a $500M revenue run rate (Q2 08 annualized) and has 338 million users overall.

The auctions business hasn't been very pretty recently, growing only 13% in Q2 08. I've never been a heavy eBay user, but it's always seems like there's room for improvement. Despite all the press about how dissatisfied the core eBay users are and the lack of attendance at the most recent eBay Live event, the fact remains that people go to eBay because that's where all the listings are. Certainly, the new management needs to take care of its core customers but it looks like they are trying. All attention seems focused on Marketplaces, but the share of revenue from Marketplaces has steadily declined. Of total revenue, Marketplaces now accounts for 57%, PayPal 26%, Marketing Services 11%, Skype 6%.

Meanwhile, every quarter the company generates at least $500M in free cash flow. On top of that, they have $4 billion in cash on the balance sheet with no debt, though $2.9 billion of the cash sits outside the U.S. For 2008, the company is guiding close to $9 billion in revenue, and about $2.4 billion in free cash flow. With a market cap of $34 billion, that implies about a 7% FCF yield.

Unless new competing services start gaining traction, eBay's businesses are still the dominant offerings within their respective markets. At its current price, it looks like there is limited downside to the shares. I will look to add to my position.


Heartland Payment Systems - HPY

This company provides bank card payment processing services to merchants such as restaurants, gas stations, retailers and hotels.

The CEO Bob Carr owns close to 24% of the company, and the CFO Bob Baldwin owns another 3%. Really like that owner operator structure. Moreover, they don't pay themselves all that much either, approximately $350 to $450k in each of the past 3 years.

They recently introduced a new stock option plan for senior management and IT workers, except employees can't convert the options to shares for 5 years, and can only do so if HPY's revenues grow at an annual rate of 15% and EPS grows at a rate of 25% in those 5 years. While I'm not sure if those are the criteria I would use, I certainly like it better than simply a plain vanilla stock option plan. The plan ostensibly would incent the key employees to stick around for 5 years to see this through, which is quite a long time. However, if the options fall underwater on any of these criteria, I wonder what detrimental effects there may be.

In 2007, they had diluted EPS of $0.90, and net revenue of $303 million. By 2012, assuming the stock option plan criteria are met, this would imply diluted EPS of $2.75 and net revenue of $610 million. A PE multiple of 10x-20x would imply a stock price between $27.50 to $55. However, there is also a good chance that they'll exceed those criteria as well, in which case the upside could be higher. The company recently affirmed their $1.13 to $1.17 EPS guidance for 2008.

They currently have $40M in cash, and close to $115M in debt, which is a little on the high side for me, though $75M was due to financing the Network Services acquisition in May. They generated $12M in FCF in Q2, and spend about $3M in dividend payouts.

This is a company I need to spend some more time understanding. However, the growth prospects, owner/management, and business all point to potential outsized market returns. At $900M market cap, this could be a compelling opportunity.


Intel Corp. - INTC

Maybe this should go in the too-hard pile for me. I don't really have any interest in semiconductors, don't really follow the market, don't really understand it.

But what I do understand is the market leadership position, the high operating margins, the huge cash flow generation, the solid balance sheet. The forward dividend yield is now 2.3%, and the payout ratio is only 40%. They also have a good track record of buying back huge amounts of stock.

However, I wouldn't mind trading out of this stock. It's been very profitable, but it's also very cyclical and very capital intensive. Revenue growth has been less than 10% recently. I'm not going to get much in excess returns from owning this. I might as well diversify my risk and get a similar return and dividend from the S&P 500.


3M Company - MMM

In one of my management classes, this company was singled out as the paragon of innovation, with a track record of over 100 years. Overall, this is about as solid a company as they come. Steady growth, excellent margins, 50/50 split between international and U.S. revenue, very long record of dividend payouts and dividend increases, strong balance sheet. Valuations right now are as low as I've ever seen them (which doesn't really say much) at 14x LTM PE and 12x 2009 PE. This is a company I feel comfortable owning for a long time, adding to my position on dips in the stock price.


Pfizer - PFE

This is another dividend play for me. They have close to $30 billion on the balance sheet, and dividend payouts are about $8 billion per year. Free cash flow generation is also $11+ billion annually.

The question marks here have been around several key drugs coming off patent protection (primarily Lipitor) and the state of the pipeline and growth. I have no idea how to evaluate their pipeline, but then few outside of Pfizer would be in a good position to do so. My thinking has been that Pfizer is always in the position to acquire new promising drugs and does not have to rely on internal development.

In any event, I'm quite ready to place this in my too-hard pile and cash out of this position. The dividend yield, however, looks quite juicy and fairly safe given their solid financial position, so I'm holding it steady in the meantime.


Whole Foods Market - WFMI

I'm preparing a much more detailed writeup of this company. Suffice it to say that this one has intrigued me for many years, and it is now at a price that I wouldn't have dared to dream of even a few months ago. However, the recent suspension of the dividend, the downgrades by Moody's and S&P further into junk territory, reduced store growth investment driven by a lack of capital and financial strength, and a lingering antitrust issue, makes me wonder if there are simply too many red flags here.

Actually, I agree with many of the moves made. They do need to shore up their balance sheet, which has too much debt ($840M) and not enough cash ($25M). They were basically running at FCF breakeven with all the expenditures needed for new store development. Now that new store expansions have been slashed, they can return to generating positive FCF, assuming the weakening economy does not prevent people from shopping there.

I still feel that the business model works, and that many of their key markets are undersaturated. The big question for me is financial viability. I'd love to see some more cash on the balance sheet, but not sure if they'll be able to raise it. There's definitely the risk that this could turn into a falling knife. I plan on holding on for now, and look to future quarters to see whether their balance sheet starts to improve. If they continue bleeding cash, I may have to sell.


Conclusion

This wasn't very encouraging. There are some decent holdings here, but the portfolio isn't where I'd like it to be. There will be some changes coming pretty soon.

Based on my above commentary, here is my current ranking:
1. EBAY
2. COLM
3. HPY
4. BRKB
5. MMM
6. DRIV
7. WFMI
8. PFE
9. INTC
10. BAC

Setting up the TogaPF Portfolio

I finally got around to putting up the portfolio. I'm including approximately $49,000 in cash and securities. My benchmark has been and will remain the S&P 500.

The holdings here are stocks that I've owned from my prior portfolio. I haven't kept up-to-date on each of these, so I'm not sure if holding each of these investments still makes sense for me. Ideally, I'd like to hold a smaller number of stocks, something in the 6 to 8 range. I don't think I have the inclination to keep track of too many more stocks than that.

TogaPF Portfolio

For TogaPF, I've reset my holdings as though I had purchased all of these securities at today's (Aug. 4, 2008) prices. I've assumed a $10 expense for each stock as the cost of establishing the position.

I started my original portfolio back in October 2004. My portfolio IRR since October 2004 has been approximately 7.5% versus 1.0% for the S&P 500. I calculate portfolio IRR to account for all of my cash inflows and outflows. This is before any capital gains taxes and after commission expenses for purchases. I benchmark against the S&P by assuming the same stream of cash flows are invested in the S&P 500. I assume transaction costs and holding costs for the S&P 500 are $0.

To calculate portfolio returns, I employ a model that is similar to that of a mutual fund. I assume that the portfolio has an initial share price of $100, which translates to a purchase of 488.97 shares of the TogaPF portfolio. The share price of the portfolio fluctuates as the underlying stock holdings fluctuate. Future inflow and outflow transactions occur at the share price on that date.

For example, let's say I want to invest $10,000 in a year's time. If the portfolio stays at $100 per share, I can by 100 shares at that time. However, if the stocks appreciate and the implied TogaPF share price increases to $120 in one year's time, my $10k investment would buy only 83.333 shares. Since I plan to add more funds over time, this approach allows me to calculate my returns from each investment date.

The below table shows that my TogaPF shares are now $99.80, as a result of factoring in my opening commission costs.

TogaPF Returns