AMM Dividend Letter Vol. 27: How to Measure and Know Your Risk Level and a Look at Procter & Gamble

This is from the AMM Dividend Letter released March 11, 2016. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

Consider this proposition:

You are offered a gamble on the toss of a coin.

If the coin shows tails, you lose $100
If the coin shows heads, you win $150
Is this gamble attractive? Would you accept it?

The above problem is taken from Nobel prize winner Daniel Kahneman’s book Thinking, Fast and Slow. His book has become a kind of unofficial behavioral finance bible here at AMM. As we’ve often said in jest, “investing isn’t rocket science, it’s harder”. Harder, not because of the need for advanced math (a basic understanding of arithmetic is generally all that is necessary to read a financial statement), but because markets are composed of individuals who make decisions for a variety of reasons, not always rational and often driven more by sentiment and emotion than anything else.

The above proposition highlights this quandary. As Kahneman puts it, “to make this choice you must balance the psychological benefit of getting $150 against the psychological cost of losing $100. Although the expected value of the gamble is obviously positive, because you stand to gain more than you can lose, you probably dislike it – most people do. For most people the fear of losing $100 is more intense than the hope of gaining $150. We concluded from many such observations that people are loss averse.”

The Loss Aversion Conundrum

Since investing is always about foregoing consumption today in the hope of having more in the future, and since the future is inherently unknowable (i.e. you may hope for more, but in fact receive less if events take a turn for the worse), then the question of risk tolerance becomes a critical component of developing an appropriate portfolio strategy. It is also important to note that risk tolerance and risk acceptance are two different beasts.

To illustrate, while stock markets have NEVER had a 20 year period of negative annualized rates of return, many investors with 20 year time horizons have sold during periods of market decline to “manage risk, stop the bleeding, lock in gains or protect the downside”. So while the time horizon allowed the investor to accept the risks associated with investing in stocks, the investor’s tolerance for risk caused them to sell when markets moved against them.

This might seem entirely reasonable if it weren’t for the fact that this type of behavior is generally associated with poor long-term returns. A famous study on mutual fund flows from Dalbar has shown that investors are terrible timers, with fund outflows reaching their highest levels at market lows, and their highest inflows at market tops. One of our favorite drawings from BehaviorGap highlights this wealth destructive behavior.

Image courtesy of Behavior Gap. Click image to enlarge.
Image courtesy of Behavior Gap. Click image to enlarge.

Reconciling Loss Aversion with Investing in the Real World

We know we must accept risk as part of the investment process, but we also know that we will constantly be tested by the market – feeling confident and risk tolerant when the market goes up, and insecure and risk averse when the market declines. Perhaps the most important thing for any investor to do is to accept and understand this very real psychological obstacle to their long-term investment success. Only by being cognizant of the loss aversion conundrum can one overcome it and sustain the discipline necessary to stick to their investment strategy.

We spend time at the beginning of a client relationship attempting to ascertain appropriate risk levels, generally taking into account things like time horizon, investment objectives and general tolerance for market volatility. In concert with these qualitative assessments, we have more recently begun using a quantitative scoring system to help further our understanding of a clients’ unique risk profile.

The benefits of this approach are:

  1. Incorporates real portfolio values in various win/loss propositions to develop an independent risk score.
  2. The risk score can be tied to actual portfolio investments to verify that your strategy is in line with your unique risk tolerance.
  3. The risk score can be used to help map a probability of achieving retirement/investment goals.

If you haven’t yet gone through this process and are interested in knowing your risk score please contact us and request your complimentary risk analysis.

By definition, the future will remain risky and is certain to be filled with unexpected surprises both good and bad. Just as certain, however, is that most savers need to generate a rate of return higher than the risk-free rate offered at the bank; which means they must take risk. For this reason, knowing your true risk tolerance is critical in helping you navigate both good and bad markets to ultimately achieve your investment goals.

Dividend Stock in Focus

Procter & Gamble (PG): $81.78*
*price as of the close March 11, 2016

William Procter was an English immigrant candle maker. James Gamble was an Irish immigrant soap maker. A little luck, both good and bad, found them both living in Cincinnati in the early 1800s.

William Procter’s first wife became ill while they traveled down the Ohio River and a few months after they arrived in Cincinnati she died.

When he was 16 James Gamble and his family were headed east to Illinois. James became ill and the family had to stop in Cincinnati and eventually decided on settling there.

William Procter eventually remarried to Olivia Norris, the daughter of a local prominent candle maker. He worked at a bank and made candles on the side to help make ends meet. James Gamble, who by this time had his own soap and candle shop, married Olivia’s sister, Elizabeth Norris.

Their new father-in-law, Alexander Norris, noticed that his two new son-in-laws were competing for the same resources and customers. Mr. Norris suggested the two work together. On October 31, 1837 the Procter & Gamble company was born with total assets of $7,192.24. Procter & Gamble now has over $129 billion in total assets, a market capitalization of $224 billion, and does over $72 billion in revenue a year.

Dividend History:

Procter & Gamble fits into our dividend stalwart category. It has consistently paid and raised a dividend every year for many years. It is a member of the S&P Dividend Aristocrat index. To qualify a company has to have paid and raised its dividend for at least 25 years. Procter and Gamble has done so for 58 years.

Over the last 9 years, Procter & Gamble has grown their dividend at a compound annual rate of 8.14%. We’re usually looking for double digit growth but we’ll sacrifice a couple of extra percentage points of growth for consistent growth. If Procter and Gamble maintains 8.14% growth its dividend, your income, will double in 8 years.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

Procter & Gamble’s payout ratio is currently high around 85%. Procter and Gamble recently took a one-time charge to earnings as it further undergoes its restructuring. We expect this payout ratio to drift back down towards 60% as PG finishes its plans.

Catalysts for Dividend Growth and Price Appreciation:

Divestment

Procter & Gamble got too big. It had way too many brands and it distracted the company from focusing on its fastest growing brands and its very profitable core brands. P&G has been divesting itself of 100 brands.

Revenue will be lower as Procter and Gamble continues divesting itself of non-core brands. The divestment will reduce operating costs and improve profitability as the company focuses its resources on its better brands and growing them around the world.

The ultimate goal is 10 categories focusing on 65 brands.

Increasing Returns

The divestment plan is in part to improve Procter & Gamble’s returns on equity, assets, and capital. Over the last 10 years, Procter & Gamble’s brand bloat has reduced the returns it generates.

Click image to enlarge.
Click image to enlarge.

Improving the brand mix and bringing profit margins back up to old levels will increase returns and the capital it can return to shareholders.

Splitting Procter & Gamble Up

Long-term clients and readers of the AMM Dividend Letter are well aware of our love of spin-offs. We think Procter & Gamble should be split up. Spin-off benefit both the company spun-off and the parent. Both companies reduce their operating size and become more focused on their key markets. Spin-offs have been shown to increase sales and profits at both the old parent company and the new spin-off by creating the best operating environment for each.

Barron’s recently outlined a 3-way split-up of Procter and Gamble and highlights the math that shows Procter & Gamble is worth more separate than together.

Table from Barron's. Click image to enlarge.
Table from Barron’s. Click image to enlarge.

While we would like to see Procter & Gamble embark on a spin-off strategy we think this strategy is a couple years away, at least. Management has to finish their current divestment plan, corporate restructuring, and increased efficiency plans before they really consider splitting the company up.

Pre-Mortem (Potential Risks to our Thesis):

Razor Subscription Services

Procter & Gambles highest margin business is its grooming division which houses its razor business. It was supposedly King Gillette that came up with the strategy now known as the razor/razor blade model. Sell the razor cheaply and then sell the disposable razor blade at a higher price and with high-profit margins. The story is a myth but Gillette’s business model transformed into it over the years. Grooming is Procter & Gamble’s highest margin division with consistent operating profit margins in excess of 30%.

High margins attract competition. In the last couple of years, two companies have taken on Procter & Gamble’s razor business, Dollar Shave Club and Harry’s. The cost to manufacture comparable razor blades has declined along with the cost to sell directly to consumers on a subscription basis. It allows companies like Dollar Shave Club and Harry’s to sell their razors at much lower prices and accept lower margins of profitability to grab market share in a $6+ billion men’s grooming market.

Private Label vs Name Brand

It’s not just with razors that Procter & Gamble charges a higher price when compared to competitors. For example, Tide is the highest priced liquid detergent on the market. As the chart below from UBS via Quartz highlights.

Click image to enlarge.
Click image to enlarge.

Brand loyalty and pricing power were two of the main investment themes for Procter & Gamble over the years. Consumers used to be willing to pay up for name brands because of the quality the brand name implied. Brand loyalty has reversed over the years and consumers are no longer shunning private label/generic brands.

Nearly 70% of store brand shoppers report trusting certain store brands more than others, and 64% are likely to try other store products once they’ve tried one. Brand trust is particularly strong for millennials, who are more likely to buy store brand foods in general (97% compared with 94% of all shoppers).

This trend dampens Procter & Gamble’s ability to continue raise prices faster than the rate of inflation on its name brand products.

Emerging Markets

Why does America’s leading diaper company, Procter And Gamble place a made in Japan sticker on the diapers it sells in China? Procter & Gamble misread the Chinese market. P&G believed that Chinese consumers would want value and marketed their diapers as such. Chinese parents wanted high-end diapers and the Japanese diaper maker Kao offered them. Procter & Gamble is addressing this issue with higher-end diapers that are made in Japan.

Selling a consumer good globally involves getting the branding and the value proposition correct for each market. P&G’s china misstep was a big one. China is the growth market for consumer goods right now. If P&G stumbles or fails to gain a large presence in other emerging markets then its future growth will be hindered.

Conclusion:

Our estimate of fair value for Procter & Gamble is $85 per share. We used current operating margins, a 4% growth rate, and a 10% discount rate. If Procter & Gamble succeeds in its divestment and restructuring plans then margins will improve and our estimate of fair value will increase. Increased revenue growth will increase our estimate of P&G’s intrinsic value too.

As of right now, Procter & Gamble is fairly valued. This does not mean we expect below average returns or negative returns. It simply means at today’s price we’re not expecting above average returns. A lower stock price gives us a chance to buy more Procter & Gamble at a price that offers us the potential for above average returns. This is why we like stock market corrections. It is not a time to panic but a time to look for opportunity.

As we outlined above, if Procter & Gamble can achieve its restructuring operating targets while fending off threats to its core brands then P&G’s intrinsic value is likely more than our current estimate.
All previous letters are archived here.

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

What I Wish I Wrote ~ Mar. 11, 206

Separating value investments from value traps. (Desai Capital via Sum Zero)

Speaking of value traps. Is Amercian Express (AXP) one? (Value and Opportunity)

A deeper dive on the changing payment landscape. American Express’ (AXP) pain. Synchrony Financial’s (SYF) gain. (Punchcard Investing)

Quality companies versus cheap companies. (Intrinsic Investing)

What you don’t want to hear about dividend investing and dividend stocks. (Meb Faber)

Why are individual investors so bad at investing? (Innovative Advisory Group)

A bunch of links to the research and writings of Michael Mauboussin. A link to a bunch of links. So meta. (Hurriance Capital)

Has the pain train ended for value investing? (Alpha Architect)

If you use any sort of budgeting program like Mint, check out how much money you’ve spent all-time on your vice(s). How one guy turned his vices into $35,000 in savings. (Grow from Acorns)

Why Fin Tech is the worse. Start-ups are hoping to disrupt the finance industry but they may be drastically overestimating their prospects. (Medium)

And Fin Tech start-ups may be overestimating their total addressable market. (The Reformed Broker)

The anit-reading list. (Morgan Housel)

The two stages of Warren Buffett’s investing career. His very successful early career and a mediocre recent career. (The Evidenced Based Investor)

Some large global demographic trends to pay attention too. (Conservable Economist)

The benefits of operating your life with low overhead. (The Waiter’s Pad)

China Baby Boom or Bust?

After 35 years China ended its one-child policy. Companies with exposure to China’s baby market like Mead Johnson (MJN) and Procter & Gamble (PG) jumped in price on the news. A Chinese baby boom is around the corner. Or is it?

China already had special districts that were not a part of the one-child policy. They were small experiments set-up at the start of the one-child policy. The birthrates within these zones were as low as other zones that were subject to the one-child policy. However, these special zones did not experience the large gender imbalance nor the high infanticide and gendercide rates.

In 2006, families in the town of Jiangsu were permitted to have 2 children if one parent was a Dandu (an only child). How many signed up? One-tenth of those eligible did.

In 2013, the Dandu policy was applied across all of China. Only 35% of eligible couples signed up. Way below Chinese government expectations. The reason often cited for not participating was the high cost of raising a child.

As a country becomes wealthier, more educated, and less agrarian the average birthrate drifts lower. Pre-Cultural Revolution China had an average birth rate of 6 per family. Right before the one-child policy was enacted China’s birthrate dropped to 3. Then in part to boost per capita GDP Chinese officials wanted to slow population growth even further and the humanitarian crisis known as the one-child policy was born.

The irony is the one-child policy was designed to boost the Chinese economy but it may be its undoing as China’s population ages. Policy-makers finally realized this threat and the one-child policy was scrapped. China needs population growth. But now China and its citizens are much wealthier as a whole and the need and desire to have multiple kids has declined. The Chinese baby boom some investors are expecting may be a bust.

Information on China obtained from the book One Child: The Story of China’s Most Radical Experiment by Mei Fong

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What I Wish I Wrote ~ Mar. 4, 2016

We’re in a world of abundance. Is it leading to too many malinvestments? (The Reformed Broker)

A good breakdown of Berkshire-Hathway’s 2015 from Warren Buffett’s latest annual letter to shareholders. (The Aleph Blog)

Speaking of Berkshire-Hathaway, in 1999 Yahoo! was worth more and 19 other things that actually happened in 1999. (Dividend Reference)

The three paths to outperformance. (Morningstar)

“The most important financial services company you’ve never heard of”. (Intrinsic Investing)

Investing professionals should meditate. (Jason Voss on LinkedIn)

“It’s hard to believe that $65.7 billion of Warren Buffett’s $66 billion net worth came after his 50th birthday”. And other hard truths investors have a hard time wrapping their heads around. (Morgan Housel @ The Motley Fool)

Investing in you self. The 100 things list. (Budgets are Sexy)

How to be frugal and still enjoy life. (Dividend Mantra)

How safe is Chevron’s (CVX) dividend? (The Div-Net)

A bunch of links all focused on Warren Buffett and his recent comments on Berkshire-Hathaway and its portfolio of companies. (Value Investing World)

Lesson learned from Richard Thaler on behavioral economics. (25iq)

Radical investment advice. Do nothing. (Jason Zweig @ WSJ)

Software is the new oil. (AVC)

Book review on Quality Investing: Owning the Best Companies for the Long Term. (Value and Opportunity)

What makes life worth living in the face of death? Try and not to shed a tear after reading the 2nd to last paragraph. (Farnam Street)

HSN, Inc. (HSNI) a New Dividend Payer with Attractive Returns, a Built-In Price Catalysts, and a Valuation Estimate

HSN, Inc. (HSNI) falls under our new dividend payer category. HSNI initiated a dividend in 2011. We also think it can turn into a dividend stalwart, a company with a long track record of paying and increasing its dividend every year. But we also need to make sure we are not overpaying for HSNI and its future dividend growth.

In 2011, HSNI started paying a quarterly dividend of $0.13 per share. It now pays $0.35 per share a compound annual growth rate of 24.62%. This doesn’t include the special one-time dividend of $10.00 per share paid in February 2015.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

Buybacks

HSNI has also reduced its shares outstanding by 10.32% over the last 5 years.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

ROE, ROA, ROIC

Returns on equity, capital, and assets have been consistently high.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

HSNI also generates returns on tangible capital (Joel Greenblatt’s metric) over 50% and cash returns on invested capital over 24%.

Less Exposed to Recessions Versus Other Retailers?

HSNI is obviously very dependent on the discretionary spending of the U.S. consumer. But how they sell to consumers is a master class in how to use psychology (link is for QVC but they use the same tactics) to get us to buy even when we probably shouldn’t be spending money. This is what is attractive about HSNI’s business model. During the 2008 financial crisis when discretionary spending was drastically cut,  HSNI only experienced a 5.45% decline in revenue from 2007 to 2009.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

However, HSNI’s operating income declined 60% during the financial crisis so it is not completely immune.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

Liberty Interactive Ownership Stake

Another attractive aspect of HSNI is Liberty interactive (QVCA) owns 38% of HSNI. QVCA owns and runs HSNI’s direct competitor QVC.

Liberty Interactive's HSNI ownership Stake. From Liberty Interactive's asset list.
Liberty Interactive’s HSNI ownership Stake. From Liberty Interactive’s asset list.

This creates the potential catalyst of Liberty Interactive (QVCA) buying the rest of HSNI. QVCA’s management said in the past that they are interested in buying the rest of HSNI at the right price. HSNI isn’t trading at that price.

Barton E. Crockett
FBR Capital Markets & Co., Research Division

Okay. And then just one final thing here. Relative to HSN, you guys have in the past expressed, I think, limited interest in buying in the stake in HSN that you don’t own at these valuations. That seems to stock up some capacity. Should we assume that your stance towards HSN is similar to what it’s been the past?

Gregory B. Maffei
Chief Executive Officer, President, Director and Member of Executive Committee

Well, I think you should first start with the proposition that we look to reinvest our free cash flow in the most attractive place. And you’ve seen us do that over the last few years on our own stock. Just as a matter of math, that has gotten by most measure to get less attractive. We’re at a higher multiple than we were in 2009 — than we were in 2010. We have the luxury of continuing that. Even though it’s less attractive, we still consider it attractive and investing here in something that we think will generate higher rates of return for the benefit of our shareholders and be strategic. So all attractive on all measures. HSN is a great company. We’re proud to have them in the Liberty family. But when we look at the profile of its growth rate, which looks more similar to our own, versus the multiple not only of EBITDA but even more of free cash that it’s trading at, we don’t consider that attractive versus our own stock and certainly not versus the opportunity to join with zulily.
From 8K Released August 19, 2015

Until recently HSNI was trading at a premium multiple of EV/EBITDA when compared to QVCA. Even though QVC is the larger of the two and has international exposure. HSNI’s premium multiple was in part due to the potential of QVCA buying them.

HSNI recent price decline has brought its multiple more in line with QVCA’s. However, this is still too high a price Liberty Interactive wants to pay for the rest of HSNI.

Valuation

Liberty Interactive thinks they can grow at 5% top line and they think HSNI will do the same. Looking 5 years out, using a 5% growth rate, HSNI’s current operating margins, and discount rates of 12-15%,  we get to fair value around $56 per share.

HSNI margins are much lower than QVCA’s. HSNI’s EBITDA margin is 9.69% and its EBIT margin is 7.7% compared to QVCA’s EBITDA margin of 20% and EBIT margin of 13%. If HSNI can improve its margins and/or increase revenue faster than it is worth more. This is just a starting estimate of what HSNI is worth. We’ll need to do more work to see if management can improve margins or grow revenue faster than 4-5%. Maybe even divest its lower margin Cornerstone Brand?

HSNI is currently trading around $54 per share. HSNI is trading around our estimate of fair value, if we’re right. Our valuation is probably off. Fair value could be higher or it could be lower and we don’t know by how much. This is why we ideally want to buy a company at a good discount to our estimate of fair value. It gives us a margin of error to work with.