Tuesday, February 20, 2007

How to find a "penny" stock?

A common mistake among many investors is misdirecting their focus. Many think that to find a winner like Wal-Mart, Coke, or businesses like that is to buy them when they were small or when they were trading at a "cheap" price. By any means, this is a much misconstrued notion for which this article attempts to bring your attention, and hopefully shed some light for you.
To optimize our returns, it is important to sell our mistakes quickly, hold sound companies for a number of years, and then if you can get a great business at a great price, you should maintain your stake in the very best of the lot for a quarter of a century or even forever. The best time to sell shares of a truly superior business is almost never, barring when its valuation is totally driven out of logic. Selling Wal-Mart in the early days after tripling your capital in 1982 would have cost you dearly since it continued to crush the market as the years rolled on. Selling Coke in the early 1986 after more than doubling your original investment in 1983 would also cost you dearly as the years rolled by. For example in Coke, it costs $2 in 1983 and in 1986, it was worth $5. But if you held till 1997 and sold, you will have multiplied your principle by 30 times.
How to find a "penny" stock? Think Wal-Mart.
One way to find a future great is to carefully study the major winners from the past. Relatively few of the multi-decade superstars are technology companies. While I hardly invest in any industry that requires constant changes, I do not avoid them totally. However, it consists of a minority of my holdings. And one of the most classic examples of how a superstar is similar to a penny stock is Wal-Mart. In truth, its stock price was never a penny stock at any time in point.
The story of Wal-Mart’s rise is the stuff of legend. Fortunately with the ease of locating past information facilitated by the internet, I managed to dig out Wal-Mart’s 1972 annual report in the archives. The annual report offers a blueprint of a small company (although not that small after all they operated 51 stores located in 5 states) on the verge of world domination, and along the way bulldozed its larger competitors with inferior business models out of the way. The cover of its 1972 report featured the location of its 51 stores in 5 states, all in the Midwest. Today, there are more than 3800 stores, in 11 countries. Sam Walton then had 2,300 employees. Today, with Sam long gone, there’re 1.8 million associates. Since the early 70’s, the business has grown by almost 1000 times in value from $200 million to $200 billion. By any record, it is the stuff of dreams.
So then, what did they do? How could investors back then tell it could be such a record breaking growth story? There’re certain clues which can ease the process. While flipping the annual report then, there’re 3 traits which kind of jump right at you.
1) Based on top-line growth, the company was going no where but up. From 1969 to 1970, the sales grew 44%. From 1970 to 71, it grew by another 44%. From 70 to 71, it grew by another 44%. From 1971 to 1972, sales grew by an astonishing 76%. Sales were persistently accelerating.
2) Management at the young company was competent and hard working, especially with a fanatic owner like Sam Walton in charge. Return on equity was 35% in 1971. The very next year ROE was an absurd 63%. It shows Sam Walton’s idea of his retail business model is being maximized.
3) Sam had a very clear and compelling vision for Wal-Mart future. That vision included dominant store growth in communities within 300 miles of the distribution center and an efficient business model that could maintain the lowest possible price.
So with the 3 traits, namely, accelerated sales, great management, and a sustainable advantage (otherwise known as moat), Wal-Mart is where they are today.
In 1980, Wal-Mart was trading after accounting for stock-split at an adjusted value of 12 cents. Yes, 12 cents. However, at that point in time, the stock price is $50. So it was never a penny stock. So you may be wondering how it could be 12 cents. That is because a single share of $50 in 1980 is worth 416 shares today. That means a stock in 1980 is split 9 times. So if the stock was never split in 1980, each original stock in 1980 is worth about $20,800 today. It’s thus nearly impossible to become a penny stock millionaire if your idea of a penny stock is literally by purchasing a stock that is indicated by the ticker as a few cents to a few dollars. Because of the stock splits, some investors think they can find the next Wal-Mart while searching among the 20-cent stocks. You won’t. So the title of this article is kind of a mischievous title.
So what has Wal-Mart achieved since 1980, a full decade after it went public?
With the stock traded at above $48 as of the writing of this article, it has returned 400 times in value over the past 26 years. A $10,000 investment would be worth $4 million today. That would have cleaned up many investment mistakes.
But what if we go all the way back to Wal-Mart’s IPO when it became a public company in October 1970? The business was valued at a tiny $21.5 million then. That means the stock went up by an astronomical 10,000 times since. That’s about a compounded growth of 30% a year, and if you had tucked $10,000 then you will be worth $100 million now.
When the company went public then, it raised $4.5 million in cash to pay down debts. Wal-Mart was nothing back then. No one knew about it. Hardly anyone followed it, while dozens flocked to Eastman Kodak - a safe bet then that hasn’t quite matched the rate of inflation since then. None of the big boys on Wall Street really care about it. And that plays right into the intelligent investors’ hands. In 1982, Forbes magazine ranked Wal-Mart first among all American retailers - including chain stores, department stores, jewellers, and variety stores - in financial strength. This is in terms of the past 5 year return on equity, return on capital invested and sales growth. Being big as they are big then in 1982, how apt can its slogan be when they stated "You ain't see nothing yet."
Let's examine what did Sam do right. One of the advantages that can be brought to the business is economies of scale - a central idea to the concept of chain store. Sam concept was "we sell for less." They were there before everyone else joins the wagon in the concept of "Every day low prices." Just as clearly stated above all the concepts that he had was "Wal-Mart has been willing to pay for future benefits and has a strong commitment to avoid any short-term strategy which does not enhance its long term goals."
So with these concepts that he had for the business, Wal-Mart operated with this huge purchasing power which meant that they have lower merchandising cost. This in turn translated to supporting the strategy of "we sell for less" and "Every day low prices." That is one area of specialization which none of his competitions can beat him.
From a single store in Bentonville, Arkansas, against all the giants - Sears, Roebuck - back then, all the name and billions which these giants had mattered for little. Warren like to use the concept of "give any one a billion, but how do you destroy Coke?" How does a single guy from Bentonville with no money blow right by the giants? And amazing all during his lifetime - in fact, he started pretty late during his lifetime because he started out with one little store pretty old.
He played the chain store game harder and better than anyone else. Sam invented practically nothing. All he did was he copied everything anybody else ever did that was smart. And he did it with more fanaticism and better employee manipulation. So he blew right through them. He was like a prizefighter who wanted a great record so that he could be in the finals and make a big hit. So what did he do? He went out and fought 40 gorillas, right? And the result was each time he went out, he knock each out one by one, for 40 times.
Being as shrewd as he was, he basically broke other small town merchants in the early days. With his more efficient system, he might not been able to have tackled some titan head-on then. But with his better system, he could destroy the smaller players before he moves on. And he went out doing it time after time while at the same time, fighting a better opponent after each time. And as time went by, he started destroying the big boys.
That was a shrewd strategy although you may wonder if it was a nice way to behave for he took away the others' livelihood. But what he did was great for civilization as a whole, although in the short term it doesn't seems nice for many others because others probably lost their jobs. But he offered lower cost of living to the general public and at the end of his journey, he offered a million people jobs compared to 2,300 employees in the early 1970's. So what’s so unnice about his behavior?
But well, capitalism seems to be a very brutal game. But personally I think the world is a much better place for having people like Sam around where a superior culture destroyed an inferior system. But sometimes people get defocus for being too nostalgic and getting disillusions. But anyway, the model which Sam has is really a powerful tool when both fanaticism and his central concept of chain store merged.
By reversing the process of construction of this superstar, you can pick out a few other traits which Wal-Mart has in her early days.
1) A few years after going public, it began paying a dividend and never stops. Amazing for a small company.
2) Even more amazing is it started giving dividend in the teeth of a bear market in the early 1970's. A telling sign of her financial strength, even in adverse economic conditions.
3) Wall Street treated the company as if it was a hillbilly, some small time Midwest cowboy. For years, no analyst followed the stock.
4) Institutional ownership was less than 50% for years and years. As stated, no one cared about it.
5) Same owned the majority of the stock. This is an important advantage whereby owner and investors moved in locksteps.
6) Its concept was proven and yet not a completely new concept. Wal-Mart was in business for 8 years before going public with more than 30 stores and $32 million in sales on the day of its listing.
7) He did not sell his shares more than he would take when it went public.
Anyway, this article is not trying to commute to you on reinventing the wheel, because it isn't necessary. There's something on the order of 100 years of researchable history of the stock markets and tons of data available over the past 30 years which can bring you many advantages as an investor. Moreover, many are free and with a little effort, you get a lot more in return.
Interestingly enough, Wal-Mart per share of today is only traded at 6 cents in 1973, 4.5 cents in 1974 and 3 cents in 1975. That is as penny a share you can get but in reality in those years, those shares were never traded at those prices, if not for the action of stock splits.


fishman said...
This comment has been removed by the author.
fishman said...

hi berkshire,

interesting post!

some questions if you don't mind.

How do you identify a good business model that would become coke or wal-mart of tomorrow? Good business model today could have seem totally radical 20,10 or even 5 years ago and condemn to failure by most. Do you think is it possible to quantify business models for easy comparision?

I've thought of using the Porter's 5 forces framework of doing just that. What do you think?

Berkshire said...

Hi Fishman,

I have no idea what is Porter 5 forces. It could be some theories that is practiced by the business schools that goes along the line of SWOT analysis?

Anyway, I think to identify a good business is to first of all understand what you know of the business. In essence, it is to answer with certainty to an extent of how certain the business will look in a few years or even up to 20 years down the road.

By and large, to sniff out businesses like Wal-Mart or Coke in their infancy is very difficult, in fact, even for Buffett, it hardly happens. Buffett only bought Coke in the year of 1988 and Coke was founded a few years before 1900. He only started to own some Wal-Mart shares fairly recently.

I got to add that what is condemn by all others, especially Wall Street or investment bankers count for ZERO in most cases. You should in fact take note when they market to you things which they think will grow, Enron, Worldcom, What is the predeccessor of Centillion?

That is a LARGE reason why Warren says it does him really good to stay away from New York where people will always whisper things into his ears and it gets to him in a negative way.

To point out, one of the way to quantify a great business model is the way how Chain Store concept will do to its business. Very successful chain stores are Wal-Mart, Walgreens, Lowes, Home Depot, Target, Costco, Tesco and so on. If you read Walgreens annual report in 2006 and i think in 2000. You can find the reason why investors who read their report in those years are able to predict their earnings a few years down the road. Then from there, you will have an edge of how much you will pay for each share in those years with anticipation of what the business will be able to produce a few years later.


The notion that all stocks that trade below 5 dollars never become successful companies is false. What about apple the stock traded below 5 dollars in 1998 today the stocks at 450 so you might say oh thats just a rare exception to the rule is it what about Netflix the stocks traded at just 3 dollars a share in 2002 today its trading at 180 yes you heard right 180. And theirs one more stock that traded at just above 2 dollars a share in the year 2000 Petsmart. Petsmarts stock trades at 62 dollars today. So their goes the theory down the drain alright that stocks that trade below 5 dollars make bad investments. And those three stocks are just a few exapmles theirs many more.