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2015 a year of realization, refocus, and anti-diversification

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Jan. 4, 2016.  Amateurinvestor beat the market soundly in 2015. The 1 year return was 23.7%; 3 year: 22.1%; 5 year: 21.6% and 10 year: 15.3%. The S&P 1 year return in 2015 was -0.73%. As of 1-5-2016, S&P 3 year return was 11.2%, 5 year return: 9.58%, 10 year return: 4.70%. Therefore I have approximately doubled the S&P returns for 3, 5 and 10 years.

The relative proportions of my holdings are as follows:

MSFT 48.75%
CNI 4.6%
SBUX 19.7%
V 24.7%
ADBE 1.4%

The portfolio is rather focused, in fact the number of stocks dropped from 8 at the beginning of the year to only 5 stocks today. I would like to share some thoughts regarding my sale of 2 companies this year, Cerner (CERN) and Intuit (INTU). I sold these because I realized their purchase was a mistake.

I bought Cerner in October 2013 at $57.75. Cerner is the largest dedicated digital medical records software provider, has an impressive gross margin and a business with a high proportion of recurring revenue and switching costs. I bought it because it has an impressive record of growth for over 35 years. It provides a software platform is a critical part of its client’s business operations. It has staying power and seemed to have a durable competitive advantage. At the time I bought it, I owned just 6 stocks, which seemed to me to be very few, even for a focused portfolio. It seemed wise to diversify into a new strong company I had found. I had a few small doubts at time of purchase. At the time CERN had risen because of recent success in agreements to sell its software and services to major medical centers, particularly Intermountain Healthcare in Utah. I knew it was richly valued. In addition, it regular buys shares to compensate for share based compensation, but still manages to continually increase its share count, which casts doubt on its dedication to shareholder value. Unfortunately, events have shown that because of its high valuation, any miss in analysts’ earnings/revenue estimates are met with a drop in the stock price. There has been some loss of important customers to competitors recently which casts a little doubt on the invincibility of its moat. I decided to sell on August 10. At this point I was uncertain how well it would recover from the market instability of that time. Moreover, I was provoked by a quarterly revenue miss. Overvalued stocks with evidence of weakness in their franchise do not do well in market downturns. I sold at $65.40, at a modest gain, so the damage was limited. On Jan 6, 2016, CERN was at $57.9.

My error in this case was a failure to understand the Cerner business well enough either to a. be convinced that its earnings would continue to grow safely in spite of current overvaluation and related vulnerability to temporary downturns, or b. realize that it’s competitive advantage and dedication to shareholders were lacking and therefore not good enough to earn a place in my portfolio.

Underlying this mistake is a more fundamental and common error, that of impatience. I could have simply taken the necessary time to analyze the company before buying. Had I done so, CERN would have been available at a little less than $50 several months later in May 2014. In any case, the allocation at the time of purchase was approximately 0.8% of the portfolio, so the damage was bound to be limited. I cautiously limited my allocation because of my trepidation regarding valuation and other factors mentioned above. In fact, one might ask what was even the point of investing such a small amount in this company. To this I can only reply that I acted from intuition instead of analysis. The advantage of this is that it certainly limited the damage caused, while adding experience. The avoidance of serious mistakes is an important part of investing success.

Upon reflection, I note that I cautiously limited the size of my allocation, and also that I feel a needed a deeper understanding of the company, and that I could have been more patient. We will revisit these points later.

Intuit is an apparently attractive business, with a dominant share in small business accounting software, and market leading shares in retail DIY tax software and professional accountant tax software. As are Cerner, Microsoft (one of my favorite investments) Intuit was a survivor of the early 1980s boom in computing. As with Cerner, it seemed to be a judicious addition of a long lasting company with clear competitive advantages to my portfolio of so called eternal companies. I bought it in February 2015 at $91.00. It seemed somewhat overvalued but I attributed this to the well-established strength of its franchise. It has introduced Quickbooks Online, a cloud based version of its dominant Quickbooks small business accounting software. Other than Turbo tax, the market leading consumer tax software, the other anchor of its competitive advantage is (was) Quicken, software for home finance management.

In August 2015, again at a time of market turmoil, Intuit management made some capital allocation decisions which shook my confidence in their competence, namely the decision to divest Demandforce and Quicken. Intuit had acquired Demnandforce, an email marketing company for small businesses, in 2012 for $423.5 million. Intuit thought to integrate it with Quickbooks. 3 Years later, CEO Smith explained the abrupt decision to divest this recent acquisition made for over 10% of its 2012 revenue at the related investor presentation. He matter of factly stated that Demandforce and QuickBase [another business divested at the same time) are great businesses, but they do not support the QuickBooks Online Ecosystem and both serve customers that are up-market from our core small business customers.” When asked by an analyst to address Intuit’s record of acquisitions, he stated “many of the larger ones have not gone well”. “…We have a mixed record in terms of bolt-on businesses, new businesses that may not plug-in directly with QuickBooks or tax businesses…” and promised that management had developed a “set of criteria that [future acquisitions] have to meet”. In other words, he was promising that 32 years after its founding in 1983, Intuit would begin to ensure acquisitions make sense for the company before purchase. Obviously these words are not those of a CEO of an eternal company. Quicken was one of its original businesses at the founding and was providing over 20% of revenue in FY 2014. I was surprised by the decision to divest this instead of adapting it and continuing growth.

The poorly planned capital allocation into Demandforce and the abrupt divestiture of Quicken gave me the impression that Intuit management may not be able to adapt successfully to future markets. I had bought in February 2015 at $91.02 and sold in September at 89.26. I found it difficult to pinpoint where I went wrong here. Intuit seemed to be a sound and strong business, providing necessary products which had market leading shares. Perhaps if I had read more of the past financial reports, I would have discovered other episodes of poor acquisitions. Perhaps I should have simply observed its progress over enough time to get a more detailed impression of how it functions. Prior to its purchase, I had considered Intuit to be a strong business with an economic moat which was akin to those I owned. I actually sold shares in Visa and Starbucks, both of which were highly valued by conventional measures such as cash return, to buy Intuit. As happened with Cerner, I felt I lacked deep enough understanding of the company and its management, without which I was vulnerable to nasty surprises.

In the case of both Cerner and Intuit, I felt surprised by adverse company events, and retrenched back to my long term holdings. Therefore, 2015 was a year of realization, that buying companies which seem to be good businesses, and even to have a durable competitive advantage, is not enough. they must be observed to dominate their markets for the foreseeable future, and be observed to demonstrate management competence and respect for shareholders over some time, until one is convinced.

But how is one to judge when the evidence is enough to justify buying and holding forever? Sometimes the clue to a solution to a life problem can be found in a careful reflection upon the experience, and asking the question, “how did it make you feel”. This is because the correction solution is only correct if it is the right one for yourself. In the case of investing, as Benjamin Graham stated, “the investor’s chief problem, and even his worst enemy, is likely to be himself” (Intelligent Investor). The investor will need to be comfortable holding his security in the face of inevitable market fluctuations. In this case, as previously noted, I reflected that I did not feel I had a profound enough understanding of the company to feel comfortable holding in the face of a market downturn. The solution then is to wait and continue to analyze the company until I feel I know it well enough to be able to commit, or not. There are also cases of companies which are actually worthy, but seem overpriced, in which case one would wait for a market downturn even after having come to understand the company sufficiently.

This process of coming to understand the company is not purely intellectual. For example, I doubt a simple analysis of financial statements prepare one for Intuit CEO Smith’s rather absurd explanation of his failed acquisition of Demandforce. I believe rather than one must experience the company as much as is possible via its communications, perhaps its products, and by communicating when possible with clients, customers, employees. One must build a relationship with the company, until one feels one can trust it. This is actually what the legendary investor Philip Fisher (author of the book Common Stocks and Uncommon Profits) termed “scuttlebutt”, the flow of information he held indispensable for analyzing a growth stock.

Exploring a company which seems promising, and might rise in value, while waiting to feel fully comfortable enough to commit before buying, is difficult for two reasons. First, it requires patience. Inevitable, one is afraid of missing a low price. Second, it is surprisingly difficult to be motivated to really experience a company, to form a relationship with it, unless you have an interest in it. This may lie behind the investing approach of the excellent hedge fund ValueAct Capital. The investment staff study a company until it seems to be a good bet, then buy a small share and continue to follow it until they know it well enough to feel they know how it makes money, and what to expect from it. They then deepen the relationship by buying a stake large enough to command a board seat, and continue becoming part of it. Perhaps by buying a small stake in a company, I can be motivated to follow it closely enough to understand it better. Seen in the light of these thoughts, perhaps my cautious forays into new additions to my portfolio may not be faulted too much, but in fact be considered a necessary step to taking the time to come to know a company. And by limiting the size of initial investment, I limited the damage caused by errors. But the benefit is that this might be a way to actually discover new gems. Such was indeed the case with Adobe, a small investment I made which was turned out to be a wonderful investment.

Finally, 2015 was a year of anti-diversification, the acceptance that there are truly few companies which have exhibited the qualities of an eternal company in a lasting way, and acceptance that there is no need to diversity just for its own sake. In 2015 I sold Visa and Starbucks, which I had owned for years, and which I knew where companies with very strong franchises, to buy a new company, INTU, which I was less familiar with. Having corrected this error, my portfolio was whittled down to 5 companies. This time, I feel happy with the small number.

But again, reflecting upon this retrenchment back into my small collection of investment gems, I find that the high degree of comfort I have with my existing portfolio, continually reinforces the reluctance to invest in new companies. As my understanding of and satisfaction with my exclusive set of existing investments grows, this sets a higher bar for new companies to meet. And this may actually be an anti-diversification mechanism by which focus investing reinforces its own success.

The restaurant experience builds the brand, and the packaged product monetizes it.

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Dec. 9, 2025.  One strategy of competitive advantage is to afford a unique experience that is preferred by the customer.  Food or beverages are good examples of the type of product that can represent this type of familiar, sought after experience because they are intimately experienced by the user, and can become part of the customer’s personal life habits.  In order to possess a competitive advantage the food or beverage must be of a quality unique enough so that it cannot be easily duplicated.  In order to possess pricing power, the quality must be both unique and recognized as being outstanding.  For food/beverage purchased in a restaurant, the atmosphere, clientele and location of the restaurant are part of the experience.  The restaurant environment is controlled to convey a specific experience and this strengthens the consistent branded experience.   Lacking this complex tool to control the customer experience, the packaged beverage industry is extremely competitive.  Brands fight to establish a vivid appeal based on their packaging or advertising.

However, the packaged beverage industry can have relatively high margins.  Assuming the product’s appeal can secure pricing power, margins can be healthy for what is essentially a relatively cheap product based on commodities (sugar, coffee, flavorings…) with some degree of intellectual property in the recipe.  Meanwhile, the restaurant bears the costs of real estate which can be high in sought after locations, as well as costs of the retail operation which are relatively high, particularly for fresh or very high quality product.  So the packaged product is relatively profitable, but struggles to make more than a fleeting connection with the customer.  Meanwhile, the restaurant can foster a bonding experience with the target customer, but bears the costs of real estate and the retail operation.

What if a company could have both appealing restaurants which served delicious and excellent beverages and foods, and also widely marketed packaged products?  The restaurant experience could establish a bond with the customer.  The relatively higher margin packaged product could benefit from the bond that was forged in the more deliberately pleasurable experience of the restaurant.  This bond could never be duplicated in the grocery, supermarket or convenience store aisle.  The company would therefore have a competitive advantage over rivals who do not have that restaurant experience brand building mechanism.  It is said that Brand confers a competitive advantage.  In fact a strong Brand results from a superior product, including the experience by the customer of the product.  What a  strong Brand does make possible is pricing power.  In the present example, the unique restaurant experience enables pricing power for the packaged product.

This is a strategy that Starbucks is using to continue developing its brand experience, while building out a relatively high margin packaged good product that will extend Starbucks sales far more widely than would be possible merely by increasing the number of its restaurants.  Of note, roughly 80% of coffee is drunk out of restaurants, at home.  This market must be addressed with packaged coffee and coffee beverages.

There is another issue with relying solely on a strategy of expanding the base of restaurants in order to grow sales.  A high rate of restaurant expansion risks impairing the quality of the experience, through poorly trained staff or mediocre product.  In order to maintain the quality experience which is crucial in order to nurture the relationship with customers, the quality of the restaurant experience must be preserved and itself nurtured.

Starbucks could leverage the café experience into packaged products to increase earnings over the long term.

SBUX has made several moves recently to increase its store sales, including premium delivery services, ordering in advance on a mobile app to shorten store queues, and strengthening food offerings and adding non-coffee refreshments including wine, to increase sales at various day times.

These speak to an outstanding ability to continue adapting to pursue growth.  But can Starbucks stores retain their Starbucks character if they increase food sales volume enough to become a staple for travelling motorists, as McDonalds is?  Surely in the future, profitability of store sales growth will increasingly depend on increasing volume and lowering costs.  For now, the highest store sales growth is in Asia, where Starbucks are mobbed.  But surely this is due to their novelty, and not something that can be expected to continue indefinitely.

As store sales level off in the future,  it is Starbucks’ Channel Development segment packaged products that will keep earnings growing much farther into the future than would be the case if we were speaking of a pure restaurant company.

Starbucks has a somewhat unique advantage in that it has two distinct ways of approaching the customer.  One is centered in the “Starbucks Experience” of the retail and franchise stores, where pricey, hand crafted, customized coffees and refreshments as well as snacks are offered.  The coffee is of the finest quality, with matching price, and roasted in a specific way that often accentuates a certain “burnt” character.  The store atmosphere is managed, pleasurably social but relaxed, inspiring yet cozy, alive with the fragrance of fresh brewed coffee, and moreover reflects its local community.    The other approach is embodied in the channel development reportable segment (there are four reportable segments:  Americas; Europe, Middle East, Africa (EMEA); China/Asia Pacific (CAP) and Channel Development).  This reports sales from the Consumer Packaged Goods and Foodservice operations.  Channel Development sales include ready to drink versions of some of those same premium beverages (such as Frappuccinos®, Doubleshot®, Refreshers; Tazo® tea and Starbucks branded single serve products, notable the K-cup; roasted packaged coffee, Tazo teas; and standardized brews of its Seattle Coffee mass market brand and other products sold to foodservice accounts.  These are sold in ,  grocery stores, warehouse clubs, specialty retailers, convenience stores, cafeterias, hotels, restaurants and other mass market venues.

With this two pronged strategy, on one hand, painstakingly building its brand, and on the other, selling it in every conceivable venue, Starbucks could be the Ritz Carlton of coffee shops, and a Coca-Cola like supplier of products that signify the Starbucks experience to consumers in the full diversity of their everyday circumstances (“at home, at work or on the go”).

In my view there are two primary keys to the destiny of Starbucks as a long term growth company.  One is preserving the integrity of the Starbucks coffee shop experience, and enriching this to be unique and expressive of the fullest potential of its beverages.    The other is continuing to grow the packaged product business in a cost effective way, preserving control of the brands, recipes and intellectual property, while partnering with manufacturing/bottling or distributing companies to achieve wide distribution.

These two mutually dependent arms are linked by the brand.  The power of the brand to influence consumer behavior relies on the richness and authentic service of the coffee shop experience in which is it rooted.  Years ago, after the Starbucks salted caramel hot chocolate drink had been withdrawn from stores, I commented to a Barista at my local Starbucks that my little son had loved it, and its taste had reminded me of a childhood desert that I could not quite place.  She reflected dreamily for a moment and then hopefully volunteered that “but we can still make it for you from scratch”.  As long as Baristas can make the drink that you dream of for you “from scratch”, Starbucks brand is thriving.  Thus, an office worker drinking a k cup at work is not just drinking ready hastily brewed ready to drink coffee at her desk.  She is thinking of the cozy bustle and aromas of the Starbucks coffee shop and associated pleasant memories. This experience is the crucial basis for the influence of the Starbucks brand. Without the experiential basis of the imperfect, authentic, aromatic Starbucks coffee shop, the Channel Development goods is just another brand of manufactured beverages fighting for consumer attention on the supermarket shelf.

Starbucks retail stores and Channel Development have business models that strengthen each other.  The greater margin of branded packaged drinks can allow the coffee shop business model to provide more luxury and focus on serving each specific customer as fully as possible (Ritz Carlton), freed from the need to maximize volume and commoditize service order to grow profits.  In fact, in order to preserve the authentic quality of the coffee, shop, it may be advantageous to avoid a rate of growth in shops that would lead to the perception of commoditization in the environment, furnishings, or service.

Continued nurture of the actual Starbucks store experience should tend to diminish the dependence on advertising as brand building.  This is borne out by a review of relative advertising expenses of Coca-Cola and Starbucks.  Coca-Cola spent 6.8%, 7.0% and 7.6% of revenue on advertising respectively for 2012, 2013 and 2014.  Whereas Starbucks spent 1.3%m 1.3% and 1.2% of revenue in the same years.

While a company that does not depend on its own retail stores may achieve a higher gross profit, the experientially based Starbucks brand may be more robust than one built purely as an image in TV commercials, billboards and package logos.  The brand may be significantly less affected by changing consumer trends, as it is anchored in the actual daily experience of the coffee shop, where customers can be educated as well as observed.

Perhaps the living spring of Starbucks branding has contributed to recent growth in Channel Development.

Analysis of channel development and total Starbucks consolidated revenue and operating income over the past 10 years from 2005 to 2014 reveals that Channel Development revenue has increased by 6.2 times, from $249.3 million to $1.546B , more than double the rate of growth of total Starbucks consolidated revenue which has grown 2.58 times  from $6.3936B to $16.4478B.

Today Channel Dev revenue and operating income rank second among the Starbucks segments,  but still only 9.4% of total consolidated revenue.  Operating income at 557.2 million is 18% of total OI of 3081.1 million.

Channel Development sales are made mainly via joint ventures and licensing arrangements with large consumer products business partners. This operating model leverages the business partners’ existing infrastructures and as a result, the CPG segment reflects relatively lower revenues, a modest cost structure, and a resulting higher operating margin, compared to the Company’s other two reporting segments, which consist primarily of retail stores.  As such, Relative operating costs for the channel Development segment are much smaller than for the retail store segments, because store related costs are absent.  As a result,  operating income/total revenue ratio in the channel development segment has always been higher, currently has the highest operating margin of all Starbucks segments, now almost double at 36%, that of Starbucks as a whole at 18.7% .  Channel Development products are now sold in 39 countries.

As recounted in the recent Annual Shareholders’ Meeting, recent Channel Development growth is driven particularly by K cups. Starbucks K cups have achieved better than market growth rate since launch in late 2011 and Starbucks has achieved a leading market share, sales grew 34% from 2013 to 2014.  More broadly, since 80% of coffee is drunk in places other than coffee shops (mainly at home), Starbucks leadership aims to expand into this market.  single-serve is the fastest growing segment of the at-home coffee market in the U.S., which is led by K-cup packs. Packaged coffee is another important product in home brewed coffee.  While grocery store coffee sales are increasing at 10% annually, Starbucks packaged coffee sales are growing at 18%, with a 22% share of the U.S. premium coffee market, which is the leading market position in both premium roast and ground and the single-serve categories.

The expansion of single serve and packaged coffees is fueled by introduction of innovative flavors and high quality varieties such as single origin coffees.  The market for Ready to drink coffee beverages, followed by packaged coffee, for home consumption, is large and growing internationally as in US.  Starbucks aims to be the market leader in premium coffee market globally.  In fact, as described by Michael Conway , president of the Channel Development segment at Shareholders Meeting.  Starbucks aims to double international ready-to-drink business over 5 years. One of the biggest opportunities is in China, where the ready-to-drink coffee beverage market is a $6 billion category and is forecast to grow by 20% over the next 3 years. The China stores have been extremely popular and foment an awareness of and desire for Starbucks products, as well as serving as distribution centers hitherto. today, you can buy bottled Frappuccino is distributed in SBUX retail stores and grocery or convenience stores.

Starbucks is aggressively ramping distribution of ready to drink coffee in China.  At the Annual Shareholders Meeting, Mr. Conway announced a strategic partnership with Tingyi, one of China’s largest beverage players with products in over 1.1 million stores in China. Tingyi will provide local manufacturing, sales and distribution throughout while Starbucks will contribute “coffee expertise” (presumably IP including recipes) and brand recognition.

Tingyi Holding Corp launched in 1992, its Group of Subsidiaries produces and distributes instant noodles, beverages and instant food products in PRC.  Since 2012 the Group has had an exclusive alliance with PepsiCo to manufacture, bottle, package and distribute PepsiCo drinks in PRC.  According to its 2013 financial statements, the Group has leading market shares in instant noodles, ready to drink teas, bottled water, juice and egg rolls.   It held a number 2 market share in carbonated drinks with Pepsi.

The Group distributes via an extensive network of sales offices, warehouses serving over 30 thousand wholesalers and over 110 thousand direct retailers.  The Group leadership aims to strengthen its logistics and sales network in the PRC to attain market dominance.

A brief review of the 2013 Tingyi financial statement reveals that because of the need for substantial capital investment, while revenue has more than doubled from $5B in 2009 to $10.9B in 2013, profit was unchanged at approximately $500 million. In that time, property plant and equipment, lease payments, debt more than doubled.

This insight shows why it makes sense for Starbucks to partner with Tingyi while avoiding the expense and hazards of building out a competing world-class distribution network.

Channel Development aims to grow top line by 60% and nearly double profit by 2019.  It aims to “connect people to Starbucks around the world where they live, work and play. ”  That is, it allows the widest possible number of consumers to experience the Starbucks brand, in the full range of their daily activities.

There are likely issues in the future perhaps related to differing tastes in different regions, competition by other already existing or new brands.  The expansion of ready to drink Starbucks beverages is scarcely a sure thing.  However it is perhaps slightly less of a gamble than the prospect of established a booming coffee shop business in a nation of culturally devoted tea drinkers, which Starbucks has already achieved.

Cash return (Free Cash Flow/ Enterprise Value) of 3.1%, is not impressive. The PE is 28.2.  Excluding 2012, average PE in past 10 years was 32.4.  Given the rate at which Starbucks is increasing earnings, although there is no margin of safety in the sense that the stock is not undervalued, future performance, assuming the company continues to perform as it has, should give a corresponding rate of return, subject to the vagaries of the market.   Most likely best would be to wait for a dip in the market if one’s intent is to obtain a market beating return.  Alternatively one could invest a relatively small sum with a plan to wait an extended period for the investment to achieve a return powered by the Starbucks earnings machine unaided by the starting boost of a favorable price.

Between 2005 and 2014, revenue increased from $6.369B to $16.448B, net income from $494 million to $2.068B, and because of regular share buybacks, EPS grew from $0.61 to $2.71, for an average annual growth rate of 13.23% .

Management must defend and extend competitive advantage

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Dec. 8, 2015.  The first criterion for an eternal investment is the presence of a durable competitive advantage.  This means other companies are not able to compete with the company in its markets.    But there a critical second two aspect of this feature. An impregnable competitive advantage by itself is not enough to confer everlasting earnings growth.  A second critical facet of this feature is that management consistently anticipates or reacts to changes in the market or competitive landscape by finding profitable ways of extending the company’s competitive advantage into new markets that are tangibly related to its current markets. As technology evolves to change markets and create new markets, the company adapts to meet new demands. Otherwise, other so called “disruptive” companies will meet the demands of those new markets. in some cases, new technology can abruptly threaten a company’s product with obsolescence. Then, the company must either change its business to adapt to the new market, change to serving a market related to its original product, or fold. The cash built up through its current strong franchise, and expertise in serving the current market, should give the company a head start in adapting to change. But in order to execute this, management must maintain a culture which detects looming changes, proactively develops new initiatives and enforces profitability. Indeed, it is management culture that establishes dominance in different, evolving markets over the history of a long lived, “eternal company”. The continuation of a company’s competitive advantage into the future is not guaranteed, but shaped by management culture.

One might say that no competitive advantage is truly eternal.  The foreseeable future inevitably gives way unforeseen innovations.  Competing companies use these to erode the formerly dominant company’s market share.  Undoubtedly this does occur, and recently there is much talk of “disruptive innovation”.  In many cases the problem may be more that management of company A does not efficiently enable utilization of novel tools to maintain its domination.  Or, does not imaginatively envision how the new tools can be used to extend its markets. This might apply to Microsoft in the years between 2000 and 2014, when it seemed to focus more on maximizing profit from the windows, office, server franchise, rather than expanding into new markets for its software afforded by digital readers and mobile phones. In fact, arguably Microsoft’s own management which impaired its revenue growth, as much as the strength of Apple or Google.  In other words, it is not that android or iOS phones have destroyed the market for Microsoft Office products, far from it.  Rather, they have created a large new market for mobile computing, a market related to Microsoft’s market for its productivity software.  And Microsoft has failed to extend its dominance into this new, related market.  In 2014, in a vigorous departure by new CEO Nadella, Microsoft began making a concerted attempt to forge into the market for mobile productivity software, for example by releasing Office for iOS and Android.  More interestingly, work on this software had begun under the previous CEO Balmer.  But more interestingly still, the strategy of creating Microsoft applications for other companies’ platforms had been heavily utilized in earlier Microsoft history, so it was actually part of the engineering and management culture.

AmateurInvestor 15.4% 10 yr return beats S&P (5.2%), Berkshire Hathaway (8.69%) for Oct 2015.

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Nov. 27, 2015.  My portfolio beat the market this year as well as for the past 10 years. I also beat the 10 (8.69%), 5(10.92%), 1(-8.77%) and YTD (-10.49%) returns of Berkshire Hathaway (Brk.a).  Just saying.

This year’s outperformance is partly due to a realization that the focused portfolio is focused for a reason.  In late 2013 and early 2014 I added some stocks which seemed to fit the criteria to be an Eternal Company, but I could not explain fully why they did.  I did this because owning no more than 4 stocks (V, SBUX, MSFT, PM) felt a little unsettling.  I felt that stringently requiring that they manifestly exhibit the required criteria seemed unrealistic, given that so few companies with these qualities exist.  And so I acquired some more companies, described below, and later sold them. Performance will have been improved by pruning  these companies.

The good results were also related to investments in new additions to the portfolio  which have become permanent investments and have contributed to growth.

In 2015 my portfolio ended with 5 stocks, V, SBUX, MSFT, ADBE, CNI.

This chapter resulted in a few lessons learned.  In the search for Eternal Companies, possibly it is difficult to be adequately motivated to research the company unless you have an ownership stake.  I am reminded that the ValueAct Capital hedge fund acquires a small stake in prospective investments after having done preliminary research, and then continues to perform intensive investigation sufficient to enable a profound understand of how the company makes money and the issues facing growth, before making a definitive investment.  ValueAct is a focused fund.  I suppose I will need to find a way to be more conscientious about researching new opportunities.

The reality that there are very few qualified Eternal Companies does not mean that  investments made in companies that fail to qualify as such will still be as good.  Rather, the dearth of Eternal Companies means an investment strategy focused on these will indeed result in a relatively focused fund.  There is no way around this.  Having proved this more fully to myself, I now feel more content remaining with my exclusive selection of companies.

Another lesson is that I am still capable of making errors.  Fortunately, I am scrutinizing my own execution fully enough to correct errors before they cause serious damage.  Conversely, I am still capable of learning.

Here may lie the most important lesson. Namely, that I can improve the way I invest.  What tools might be best to address the issue at hand, that of picking a company which does not demonstrably meet the required criteria?  One tool might be to write out the reasons justifying investment, as well as any weaknesses with the company, prior to buying.  The narrative would cover a checklist of criteria critical for a good investment. Judgement regarding the criteria is gained by reading, as well as experience. The final analysis should be subject to a critical reading, in which the key assessment can be characterized as asking the question, “does this investment jump out at me as an obvious great investment?” There should be no doubt.

What are the most important qualities of an Eternal Company?  First, the existence of a durable competitive advantage.  This means other companies are not able to compete with the company in its markets.  Second, management consistently  anticipates or reacts to changes in the market or competitive landscape by finding ways of extending the company’s competitive advantage into new markets in a profitable way.

Note that this is entirely different from simply using its financial strength in a attempt to establish a foothold in markets which are entirely new to the company.

Below is a comparison of my returns with those of some renowned value investing mutual funds.

Fund/index Expense ratio (%) 10y (%) 5y (%) 1y (%) Ytd (%)
S&P 500 5.12 11.75 1.06 1.46
Amateur Investor   15.4 22.4 22.0 21.14(as of 11-25-15, est.)
Oakmark Select Fund (OAKLX) 0.95 7.68 14.67 -2.08 -1.08
Sequoia Fund (SEQUX) 1.0 7.28 12.14 -7.71 -8.68

Data is taken from Morningstar.

Following is a brief outline of the qualitative changes to the portfolio in the last couple of years. The companies I bought and subsequently sold at minimal loss – to  – modest profit were as follows:   Fomento Economico Mexicano (FMX, the Mexican Coca Cola bottler and owner of the Mexican convenience store chain Oxxo); Ebay (EBAY, operator of the online auction platform, online conventional merchant marketplace and PayPal, the latter subsequently spun off); Cerner (CERN, the largest dedicated electronic medical records provider); Intuit (INTU, with a dominant market share in desktop personal finance software with Quicken, small business accounting software Quickbooks, as well as growing businesses in consumer electronic tax returns with TurboTax.

I discovered two companies which have become permanent investments.  One is a true Eternal Company, Canadian National Railroad (CNI, one of the seven remaining class I railroads in North America, has the lowest operating ratio of any rail on this planet, and other features that enable it to grow by focusing on growing their customer’s and their own business as opposed to competing on price).

The second addition to my portfolio is Adobe (ADBE software dominates the market for creative professionals, Adobe is now increasing profitability as well as market by shifting from permanent to subscription licensing in the cloud, and in a related market has created software to manage digital media campaigns which is growing in dominance.

Finally, I sold, with some sadness, an Eternal Company for which growth in earnings has recently become stunted partly by a slowing of its market growth, and in addition by the effect of the strong dollar, since its earnings are all outside  the US: Philip Morris International (PM, which has the strongest portfolio of cigarette brands outside the US and is innovating in reduced risk cigarettes).  It cannot match the growth of my other stocks.

Philip Morris Intl., for the first time, an actually better product, and better for you!

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Nov. 1, 2014.  Like everything else, competitive advantages are not everlasting. Even the strongest company must sooner or later defend its business against competition. Moreover in a changing economy presenting threats and opportunities, it must adapt by extending its market dominance into new markets or modifying its products and brand to meet new market needs. Philip Morris International Inc. is successfully taking on such a challenge, and is likely to gain market share as a result.

In the last 20 years, the cigarette markets has been profoundly shaped by public health concerns over health effects of smoking.  Governments have increased excise taxes, used minimum price laws and restricted smoking in public places or social locations.  Smokers have faced greater expense, decreased liberty to smoke in many locations, and stigma.

The governmental push for curtailment of conventional cigarette use presented a challenge to cigarette makers to produce a cigarette alternative which is less harmful.  Meanwhile, the growth of e-vapor cigarette alternatives is driven by lower price particularly for e-liquid products, and smoker desire to avoid the health hazards of smoking, the smoke, ash and unpleasant smells associated with their habit. However while smokers show much interest, these devices do not fully respond to adult smoker preferences due to lack of taste and sensory satisfaction, nicotine absorption being much slower than in cigarettes.

PM has engineered a comprehensive and innovative response to these challenges.  As recounted at the Philip Morris International Inc. Investor Day conference on June 26 2014, PM anticipated the need for reduced risk products (RRPs) and pioneered their development, having set out building RRP capabilities in 2003.  Their approach was not merely to build another e-cigarette.  They understood that success depended on two factors: first, evidence of risk reduction based on sound scientific research.  This would enable compliance with regulatory requirements.  Second, preservation of key expects of the smoker experience, to as to secure acceptance by smokers.  Failure in either of there would leave the new products vulnerable to regulatory curtailment, or would fail with smokers.

PM built a unique capability to develop RRPs, investing $2B on research, development, scientific substantiation and adult smoker understanding.  In addition to hiring over 300 world class scientists and engineers in key areas, they built a regulatory affairs group to guide their efforts in the emerging government regulation of RRP in all jurisdictions.

These comprehensive efforts resulted in a unique series of products.  Like the makers of other cigarette alternatives, PM’s reduced risk efforts rely on the fact that it is not nicotine that is primarily responsible for adverse health effects of smoking, rather, these are caused by the myriad substances contained in the smoke itself.  But unlike current e-cigarettes, PM’s devices achieve a rate of absorption of nicotine which is as quick as with a combustible cigarette.  This results in the anticipated “hit” that is key for smoker acceptance, and which current e-cigarettes lack.  PM research suggests that while current smokers commonly try out e-cigarettes, few stick with them.  This indicates a large potential market for PM’s reduced risk products among smokers who are dissatisfied with current e-cigarettes.

The series of products that PM has created will be released in coming years.  The first to market will be iQOS.  This consists of a Marlboro branded tobacco “heat stick” similar to a cigarette that is heated but not burned in order to liberate inhaled nicotine vapor bearing the full tobacco flavor.  A second heat-not-burn product termed Platform 2 is undergoing clinical studies and will launch as a pilot in cities in 2016. Platform 2 preserves even the lighting up phase of the cigarette ritual. It contains a capsule of pressed carbon which burns, but is separated from the tobacco stick portion of the cigarette like design, which is heated without burning. Clinical studies are underway and city pilot studies are planned for 2016.

PM also has two e-cigarette designs in development, using novel aerosolization technologies that give nicotine delivery profile superior to existing e-vapor devices. These will target current users of e-liquid or e-cigarettes.

PM’s aspiration is to demonstrate that their products has a risk reduction profile approaching that of cessation.  Toxicological and short-term clinical studies for Platform 1 showed that biomarkers of exposure in users of Platform 1 were much reduced/similar to smoking cessation.  This supports a claim that iQOS use results in exposure to potentially harmful products which is much reduced compared with conventional cigarettes.  Longer-term reduced exposure studies are ongoing.  These will measure the changes in clinical risk endpoints including biomarkers of exposure.  Similar clinical studies for Platform 2 are planned.

Development of PM RRPs has been executed in accordance with the Modified Risk Tobacco Product Applications Guidelines of the U.S. Tobacco Control Act of 2009. This and mandated the FDA to regulate products standards and require scientific evidence for claims of modified risk tobacco products. The more recent EU Tobacco Products Directive regulates e-cigarettes as tobacco-related products, and established a category of tobacco products, called “Novel Tobacco Products,” requiring manufacturers to submit scientific data prior to marketing some of which are similar to the data required by the FDA in an MRTP Application.

Many public health advocates who have long opposed tobacco products are supporting tax regimes and marketing rules that would encourage switching from cigarettes to RRPs.  As regulation applying to reduced risk cigarette alternatives evolves, PM plans to be the leader in compliance, enabling early leadership in this emerging market which may represent the future of the tobacco industry.

The iQOS and other RRPs are not merely a response to the threat of regulation related to the public health concerns of governments.  As Mr. Calantzopouolos stressed, they represent a potential paradigm shift for the tobacco industry, public health and adult smokers.  In the new model, smokers will enjoy products with radically reduced or minimal risk to their health, but still enjoy the ritual and flavor of tobacco or satisfying e-cigarettes.  This would be the first time in tobacco history that smokers switch to a product because it is in fact better, and in fact better for you than conventional cigarettes.

It seems likely that PM will increase market share for two reasons.  In accordance with the U.S. Tobacco Control Act Guidelines, the reduced risk products will be specifically targeted at smokers, they are not intended for non-smokers.  Second, these products give smokers the key aspects of what they are accustomed to expect from smoking, without the unwanted aspects and stigma.  PM confirmed the potential of iQOS during our extensive adult consumer research conducted in several markets.  For example in Japan and in Italy, after four weeks of usage, respectively 30% and 12% of the adult smokers who used the product, adopted it, strongly suggesting a success with smokers when introduced to market this Fall initially in a testing phase in Italy and Japan.  And, iQOS will have access to the large U.S. market.  In December, 2013, PMI provided Altria Group, Inc. (MO) exclusive licensing to commercialize the heat-not-burn RRPs in the United States.  Altria provided PMI with an exclusive license to commercialize Altria’s e-vapor products internationally; both companies are to cooperate on scientific assessment, regulatory engagement and sharing improvements regarding those products.

In October, Andre Calantzopoulos, PM’s CEO, announced the opening of a pilot plant for producing RRPs.  The full scale production facility currently in construction will be fully operational by end of 2016.  Combined annual production will be up to 30B units (for perspective, PM shipped 880B cigarettes in 2013).  Sales are expected to potentially add additional margins of $720 million to $1.2 billion per year once volume of 30 – 50 billion units is achieved. (These additional earnings equal approximately 5.5% to 8.8% of 2013 operating earnings of 13.5$B).

For the past several decades, tobacco companies have relied increasingly on the price inelasticity of demand for cigarettes to continue increasing their revenue and profits.  In the case of PMI, the upcoming reduced risk products represent a potential opportunity to increase market share and lead a new chapter in the tobacco history.

Summary:

For over 10 years, PMI has anticipated the challenge of reduced risk cigarette alternatives.  PMI has developed reduced risk products that are should be satisfying to smokers.  It has invested substantially in development capabilities to bring these to market.  Meanwhile, PMI development efforts have been shaped by the need to be first to comply with emerging regulatory regimes governing cigarette alternatives, as these rules emerge.  For the previous century, cigarette market share was achieved primarily by marketing art and distribution execution.  For the first time, smokers will be offered a product that is actually better, as well as less harmful.  In undertaking the prolonged and painstaking development of iQOS and other RRPs, PMI is extending its competitive advantages  of brand market dominance and unparalleled research and regulatory compliance infrastructure into a key emerging tobacco market.

Sustainable competitive advantage drives the choice of investment. CNI: a toll bridge investment on steroids.

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Oct 27, 2014.  Competitive advantage does not mean a company earns high returns on capital just because the management is smart. It means that competitors are not able to match its returns on investment. There may be a barrier to market entry, or switching costs for customers are relatively high. The company with competitive advantage can sell its goods at prices well above its cost of sales, without fear that competitors will flood the market and attempt to undersell it. This is reflected in healthy gross margin that is sustained over an extended time, and steady or increasing returns on capital investment.

In the metaphorical toll bridge investment, customers must pay to use the company’s product in order to obtain something they demand. In the literal example of a toll bridge, customers must pay for access to the bridge to a destination. Assuming the demand to reach that destination is persistent enough to justify building the unique bridge, the shares of the company are bid up because of the durability of this demand. The problem with toll bridge investments is that unless demand to reach that destination continues to increase, the company shares will not continue to rise over time. Since the company management recognizes this, it will likely pay a dividend in order to keep investors, as long as earnings continue to support it. Assuming there is no alternative bridge, the company’s competitive position is hard to attack, and management does not have to be world class. Earnings do not rise any faster than economic growth at the bridge destination, the stock price will reflect this. In an attempt to increase earnings more quickly, Management may allocate some income to attempted expansion into other markets, but there it does not possess a competitive advantage and will do no better and possibly worse than competitors who are dominant in those different areas. An example of this is Hawaiian Electric (HE), a regulated electric utility that supplies virtually all power on the Hawaiian Islands. Its growth is limited to the growth of power demand on the Islands.

What if over time demand for reaching the destination not only increased with growth of the most stable economies in the world, but also with the growth of the most rapidly growing economies (thus growing at a rate exceeding the average growth of the world GDP)?

What if the company had exclusive use of 2 toll bridges, with different markets clamoring for access to them? What if the management in fact did not merely rely on the advantaged position afforded by their non-reproducible franchise, but was driven by a historic struggle for economic survival to run the most cost efficient toll bridge possible, therefore focusing its capital allocation on improving its transportation speed and the capacity of its bridges? What if management was systematically incentivized to grow return on invested capital, earnings, free cash flow, and expected to purchase ownership in the company?

What if the toll bridge investment was Canadian National Railway (CNI)?

CN is one of 7 Class I (Freight) railroads remaining in North America (in 1900 there were 132):  BNSF Railway, Canadian National Railway, Canadian Pacific Railway, CSX Transportation, Kansas City Southern Railway, Norfolk Southern Railway, Union Pacific Railroad.

The CN network is a relatively scarce resource.  CN in its current state is a product of approximately a century of transitions to and from government control, mergers and bankruptcies. In the second half of the 20th century successive CN leaders strove to reduce extent of railway track, increase efficiency, and institute technical and labor modernization.  As a result, the profitability of the railway materially improved while the railway assets became much scarcer and therefore more indispensable to the customer, hence the emergence of the toll bridge investment scenario.  While railroad has the lowest cost of land transport to customers, CNI is subject to relatively limited competition because of the limited extent of existing railroads, and the fact that new railroads will not be built because of expense and right of way issues.

The CN network is advantaged by its specific geographic range.

By late 1990s (CNI went public in 1995 as the largest privatization in Canadian Government history), CN leadership had built the distinctive Y shaped map of CN rails.  This stretches from the Port of Prince Rupert on the Pacific Coast, and Port of Halifax on the Atlantic, through Chicago, the transportation hub of North America, and down to the Gulf Coast at New Orleans. Because of a 1998 alliance with Kansas City Southern Railway Company (KCSR), customers can ship from Chicago though out the KCSR network south to Missouri, Oklahoma, Mississippi, Texas, and to Mexico’s largest railway system, Transportacion Ferroviaria Mexicana, S.A. de C.V. which has a separate alliance with KCSR.

Finally In 2008 CN acquired most of the Elgin, Joliet & Eastern Railway Company (EJ&E) around Chicago.  This allows CN to avoid severe rail congestion in the Chicago hub which afflicts other Class I railroads in the area.  Reportedly previously it sometimes took as long to get through Chicago’s 30-mile hub as it did to get there from Winnipeg.

CN rail has exclusive access to ports on the Pacific (Port of Prince Rupert) and Atlantic (Port of Halifax), moreover these ports are privileged in their location.

Although Port of Prince Rupert and Port of Halifax do not have the highest traffic in North America, they rely on CN exclusively for rail link.  Because of its location on the Northwestern coast of Canada, Prince Rupert is closer to Asia than any other North American port by up to 58 hours.  It has the deepest natural harbor depths on the continent.  This allows usage by the very largest and most modern container ships, super post-Panamax cargo ships.  It has little traffic congestion, and this makes it increasingly attractive to shippers compared to congested ports on the U.S. Pacific coast.

Container traffic was added to bulk commodities in 2007 with the first dedicated intermodal (ship to rail) container terminal in North America.  Currently Prince Rupert is expanding the number of super post-Panamax cranes to 8, and adding train tracks.  According to the Prince Rupert Port Authority, surging Asian trade is projected to increase container volumes by 300% into North America by 2020.  The planned expansion will expand the container capacity of the terminal from 0.75 to 2 million TEUs, making it the second largest handling facility on the West Coast.  CN Rail is the only way to take cargo in or out of Port of Prince Rupert.

Development and modernization of the container terminal is funded mostly by Canadian Federal and Provincial Government and Prince Rupert Port Authority; while CNI has paid only a fraction of costs, for rail related development.  Development of this port directly promotes CN revenue but CN pays only a fraction of the required capital investment.

Port of Halifax on the Atlantic coast is the deepest, wide, ice-free harbor (with minimal tides) on the North American Atlantic Coast and is two days closer to Europe and one day closer to Southeast Asia (via the Suez Canal) than any other North American East Coast port.  It is 3 days faster from Rotterdam than NY harbor, 2 days faster from Singapore to NY via Suez Canal.   In addition, it is one of just a few eastern seaboard ports able to accommodate and service fully laden post-Panamax container ships using the latest technology and world class security.

The Halifax Port Authority has invested over $100 million over the past three year on infrastructure and efficiency improvements.

Unlike Port of Prince Rupert, cargo volume at Port of Halifax is not growing steadily yet since the recession nadir in 2009.  9.6M metric tonnes in 2009, 8.6 M metric tonnes in 2013.  Again, the absence of congestion here compared with more southerly ports bodes well for future traffic loads, all to be carried exclusively by CN, when the global economy finally recovers from the effects of the Great Recession.

Management at CNI is a product of a century long struggle to increase efficiency and profitability and this tradition is carried on today.

For decades in the second half of the 20th Century, A succession of company Presidents fought to build a more efficient railroad which could fulfil its potential and be profitable even though it was controlled indirectly by the Canadian Government and therefore treated by its directors as a tool for political or development goals rather than a business.

When CN acquired Illinois Central Railroad in 1998 in order to add the network extension down through Chicago, it recruited Hunter Harrison, former head of Illinois Central, who took control of day to day operations as COO.  A veteran railroad man, Harrison was credited with drastically improving efficiency by implementing “scheduled railroading,” whereby freight trains were operated on a more controlled schedule designed for efficiency.  CN became a scheduled railway, increasing utilization of locomotives, freight cars, and train crews.  Previously, Illinois Central had the lowest operation ratio* in North American railroads, this title soon passed to CN.

Harrison’s recruitment into CN leadership (he became CEO in 2003) is part of a long preoccupation at CN with improving the company’s efficiency and agility as a railway business.  It is this culture which drives CN to continue achieving record margins and efficiency even after having seemingly won the fight against competition.  An interesting place to view this culture of obsession with efficiency is the Management Information Circular and Notice of Annual Meeting of Shareholders of April 2014.  Here we see that CNI aligns management compensation with corporate value creation and profitability.

Because of the advantaged competitive situation of toll bridge assets, management can become complacent because the indispensable nature of the company services means it is relatively protected against competition for the foreseeable future.  In the case of CNI, an overview of non-employee management compensation reveals a focus on rewarding behavior that tangibly increases returns on investment for the company’s capital investment and in turn shareholders.

For example, 70% of the annual incentive bonus is based on attainment of performance objectives: Revenues (25%), Operating Income (25%), Diluted Earnings per Share (15%), Free Cash Flow (20%), Return on Invested Capital (15%).

Individual performance contributes 30% of the incentive bonus.  This is scored based on attainment of personal business-oriented goals considered to be the strategic and operational priorities related to each executive’s respective function, with a strong overall focus on: balancing operational and service excellence, delivering superior growth, opening new markets with breakthrough opportunities, deepening employee engagement and stakeholder engagement.

Long-term incentives include Performance Share Units, PSU, and conventional stock options.  PSU are company shares which vest conditional to the attainment of target ROIC and target increase in share price over a 3-year performance period.  Stock options granted in the same proportion as PSUs, vest over 4 years.

CNI requires management to invest in the company on the same terms as every other investor.  CN specifies minimum required stock ownership by management, to be attained with 5 years from onboarding and then maintained. Stock ownership must be purchased on the open market, or using PSUs or deferred bonuses and held until retirement.  Stock options do not count towards share ownership requirements.

All management subject to the plan exceeded their share ownership requirement at the end of 2013.  CEO Claude Mongeau held over 25x his base salary in shares, and his requirement was 5x his base salary.

CNI suffers minimal compensation related stock dilution, and maintains a strong rate of stock buyback.  As of 2013, about 7.6 million shares are to be issued under exercise of options, less than 1 % of the outstanding shares on the market.  In 2004 there were 1159 million shares on the market, in 2013 there were 834 m shares, a reduction of approximately 28%.  There are no preferred shares.  CN has one class of stock.  Management own the same stock and have similar voting power as myself or other shareholders.

In sum, not only does CN possess assets which will not be duplicated, and a very strong barrier to competition, but in addition management is incentivized to make these assets work profitably for shareholders.  This results in a synergistically beneficial effect on returns on investment for the company and shareholders.

Financial results and valuation

CNI 3rd quarter 2014 earnings of C$1.04 missed analyst estimates by C$0.01, and revenue of C$3.12B (15.6% increase) missed by C$30M.  The headlines might equally as justly have read: “analysts inaccurately estimated CN earnings”.  I do not think of quarterly earnings as a reason to make buy/sell decisions.  However the earnings call contained some items that illustrate the strengths of CN.

CN is growing much faster than GDP growth.  This is expected since international trade increases in complexity and volume out of proportion to GDP growth. CN is in a secular growth market, moreover is not dependent on the health any specific industry.

Revenues and carloads (1.5 million) reached all-time records.  International revenue increased close to 25% while domestic revenue was flat.  International revenue was driven by Pacific Coast (Port of Prince Rupert) traffic, where emerging markets export to North America, with strong traffic into the US Midwest.

Operating ratio reached new record of 58.8%, continuing to be the lowest of all North American railroads.  Incredibly, revenue ton miles, RTM, grew 15.4% at no incremental cost.  These illustrate the unparalleled efficiency of CN rail.

Fuel costs shrank by 3%.  CN plans to increase prices at least 3%, noting that North American rail capacity remains “snug”.  CN is able to raise prices fundamentally because of its economic moat. Management is incentivized to continue attempting to shift service from lower to higher value cargo.

While the strong traffic drove increases expenses for labor, equipment leasing and costs including new locomotives and maintenance, these were significantly less than the increase in operating income of 19% and net earnings of 21%.

Some thoughts on performance in the past decade.  Looking at revenue over 10 years from 2004 ($6.458 B) to 2013 ($10.575B), an increase of x1.61, we see a steady increase, except for a dip of approximately 15% from 2008 to 2009.  This occurred in context of the Great Recession, so is not unexpected, railroad revenue is definitely related to GDP growth.  The steady increase in revenue over a considerable time suggests CNI is dependable as a money maker.  Net income rose from $1.259B to $2.612B, an increase of x2.07 outpacing revenue growth.  Because of stock buy backs, diluted earnings per share increased from $1.08B in 2004 to $3.09B in 2013, an increase of 2.86x or 18.6% per year.  Free cash flow increased from $1.069B in 2004 to $1.575B in 2013, an increase of 1.47.

CNI generated free cash flow of $1.575B in 2013, with FCF/sales of 14.89%.  The lowest such ratio in 10 years was 7.16% in 2008.  The lowest ROIC in the last 10 years was in 2004 at 10.59%, the highest was in 2012 at 16.66%.  Gross margin hit 84.7% in 2013.

Valuation. While CNI possesses unquestionably valuable assets and franchise, its stock has been bid up in recent years.  The cash return measure of valuation tells how much free cash a company generates from its capital, both equity and debt (cash return is FCF plus interest expense divided by enterprise value. Enterprise value is market cap, plus debt, minus cash, that is, cost of the company to a private buyer). For CNI, cash return is 2.8%, not impressive.

Buy decision.  The investment worthy qualities of CN Rail, a wonderful business with a wide economic moat, excellent management respectful of shareholders, have been put in place in approximately the last 10 years or more.  Growth in trade with emerging countries will maintain a secular bull market for CN services for the foreseeable future.  As this has been recognized by investors and the media, the stock price has increased at a rate of growth greater than earnings over that time.  The stock price increased from 12.4 on October 2 2004 to about 70 on October 1 2014, an increase of 5.6 times, while earnings per share increased approximately 2.86 times.  The lowest PE in the last 10 years was 8 in 2009 (10 years earlier in 1998 it was less than 4), currently it is almost 23, the highest ever.

This is a case of a good business with sound prospects that has become expensive relative to its past prices. Investing depends partly on what the future holds, and in judging what to expect here, there are a few variables to consider.  First, will the quality of the business change?  CN Rail has a wide moat and it is unlikely this will change for the foreseeable future.  Second, will investors continue to admire the prospects?  Media and investor sentiment can be affected by factors that do not tangibly change the company.  If there is a change in investor sentiment caused by global events which do not actually reduce CN traffic or ability to price profitably, the stock price might drop and result in a buying opportunity.  Third, will the market for CN services actually change?  Should a global event cause a tangible economic slowdown that reduces CN business, I think we can rest relatively assured that the recession will end, and CN will regain business after an interval.  This again would create a buying opportunity for the patient investor.  Fourth, will investor sentiment remain enthusiastic for CN?  It is possible for popular companies with a recognized wide moat to stock prices that are expensive relative to the underlying business, for a prolonged period of time.  However, this is not susceptible to prediction.  The disadvantage of relying on this is that the stock price holds little margin of safety.  However, if we ask the question, will CN earnings be significantly greater in 10 years than they are now? I think the answer is unquestionably “Yes”.

Performing a simple DCF analysis using current EPS $3.09, growth rate of 18% for 10 years, terminal growth rate 3% for 10 years, discount rate 8$, discounted share price is $99.95.  Using an EPS growth rate of 9%, discounted share price is $58.86.

It might be reasonable to place a relatively small stake on a highly priced business with good prospects.  Otherwise, one might wait, study and learn about the business, building confidence in the value of the business that will enable one to buy with appropriate commitment in the face of future market downturns.

Summary

CN Rail reveal evidence of durable competitive advantage, with outstanding gross margin, as well as operating ratio, good return on investment measures, growing free cash flow.  Management is incentivized to maintain the ability of the company to obtain outstanding returns on investment, and respects shareholder interests.  CN Rail manages assets that are unique and indispensable, for which CNI does not pay all the cost of capital investment.  Moreover, the market for CNI services produces with these assets is growing inexorably, with no damaging competition perceptible on the horizon.  Unfortunately, CN’s top of class status is well recognized by the market and shares have been bid up, to all time high PE levels, so it no longer affords a bargain price.

*Operating Ratio:  the yardstick of railroad profitability, equal to operating expenses as a percentage of revenue.

Amateur Investor 10 year annualized return (14%) beats S&P (8.12%) in September 2014.

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Sept. 17, 2014.  As I have learned more about investing over the past 14 years, my performance has improved, giving me some confidence. In view of this outperformance, I may hope my experience may be of use to others. First of all, this performance shows that an individual investor, spending some hours per week reading and thinking, can beat the market as well as some respected paid professionals (see below).

Personally, I did not have the opportunity to learn about investing until relatively late. It is worthwhile for young people to learn about investing for two principle reasons. First, investing in securities can secure your financial position and afford you the liberty to pursue opportunities that would be much more difficult without available funds to invest in them. Second, investing is in essence, making choices about allocating capital. In learning about how companies go about growing successfully by investing in themselves or by making acquisitions, the investor can learn how to select ways of spending his or her time which will yield the best return in investment. If your parent tells you to study hard because it will be worthwhile, that is one thing. If, based on your investment self-education, you can foresee a good outcome from making certain investments in yourself, then that is entirely more convincing.

The approach that leads to this outcome is based on a few principles. Avoid overpaying for hot stocks. Pay for companies that have a strong business and a long history of the same. Train yourself to ignore market fear, so as to buy those strong business while others are selling them. Know your businesses so you can keep in mind why your contrarian decisions are justified.

A comparison of my returns with those of some respected value investing mutual funds:

Fund/index Expense ratio (%) 10y (%) 5y (%) 1y (%) Ytd (%)
S&P 500 8.12 15.93 19.99 8.93
Amateur Investor   14.00 22.10 25.90 11.90
Oakmark Select Fund (OAKLX) 0.75 8.75 22.50 32.55 11.13 (as of 6/30/14)
Sequoia Fund (SEQUX) 1.02 8.67 19.13 18.45 0.91 (as of 6/30/14)

Note that mutual fund returns are before fees. The expense ratios are noted.

Of course I have some advantages relative to the commercial mutual funds. For me, there are no panicked mutual fund investors demanding that I sell at the bottom of the market in 2009. I can have an extremely focused fund. I can truly ignore the crowd of media and Wall Street with its questionable advice.

Nevertheless this performance is not bad, for an Amateur.

The above information comes simply from my account site online at Vanguard. The mutual fund and index returns are obtained via Vanguard and Morningstar respectively. As I find the time, perhaps I will provide data regarding dates of purchases, sales, and holdings, so as to provide some historical basis and explanation for this performance.

For now, I will note that the portfolio is extremely focused. There is one main portfolio and two much smaller ones. The total number of stocks is 7.

Young people who do not follow the crowd can reach their full potential

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For a vivid account of early Microsoft history and the tale of how a couple of intelligent, determined youngsters, who thought out of the box and had the courage to act on their convictions, created what would become one of the most formidable companies in history, read the splendid Hard Drive: Bill Gates and the Making of the Microsoft Empire
by James Wallace and Jim Erickson.

Microsoft: leveraging and extending its competitive advantage into the future

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September 14, 2014.

My approach to investing in individual companies starts with identifying the rare companies with a sustainable competitive advantage.  While the existence of a durable competitive advantage is manifested in quantifiable features of the financial statement, the ultimate judgment of whether the current competitive advantage will last for the foreseeable future is qualitative, relying on an understanding of the nature, competitive environment and history of the business.

To adapt to an ever changing future, vigilant companies make trial investments in new related markets. The longest lasting companies are those who finally invest only in those areas in which they can maintain a competitive advantage, and hence continue to earn better than average returns on investment for the foreseeable future.   Many companies watch their once impregnable advantage decline as events shape history’s final judgment.  For example, Kodak was dominant in photographic film and in the 1970s had a 90% market share.  It then participated in the invention of digital photography and had the opportunity to integrate its own digital photo technology into PCs in the 1980s.  But Kodak did not pro-actively build a new basis for market dominance in the new markets.  Competitors caught up and passed, Kodak faded and finally filed for Chapter 11 Bankruptcy in 2012. It turns out that rare companies do the work to create bridges to future franchises, using their current market dominance to shape and outcompete in new markets.  Microsoft (MSFT) is such a company.

For the past 10 or 12 years, Microsoft has frankly been unloved by the fashionable tech media, and increasingly by the professional investing crowd.  Under this surface air of decayed greatness is an irrepressible, tenacious organism that adapts by thrusting into new territories, taking root only in areas in which it may extend its competitive advantage, and then proceeding to compete as if its life depended on it.

Recently, MSFT has put in motion a few approaches to increase its competitiveness, and these are now beginning to bear fruit.  These include low balling the price of its Windows OS;  developing its applications for cross platform markets;  partnering with 3rd party software/platform providers that may be competitors; and transitioning its market dominance to the cloud.

MSFT has used these strategies before. For example, in the early 1980’s Multiplan, the predecessor of Excel, was coded for a software emulator that would be interpreted for different OEM PCs. Thus it was sold to more than a hundred different OEMs selling to businesses, in an ultimately successful end run around Visicalc, which had locked up the retail market.  When MS-DOS was released in 1981, it was virtually given away to OEMs building IBM PC clones for a flat fee.  Clearly, MSFT viewed this as a race to sell applications (also including the programming languages that comprised its main business) as opposed to the OS.

For a vivid account of early Microsoft history and the tale of how a couple of intelligent, determined youngsters, who thought out of the box and had the courage to act on their convictions, created what would become one of the most formidable companies in history, read the splendid Hard Drive: Bill Gates and the Making of the Microsoft Empire
by James Wallace and Jim Erickson.

As announced in April at Build 2014 conference, Windows is now free to OEMs for smartphones and devices of screen size 9 inches or less, and windows now has lower processor and storage requirements. While Windows still has roughly 90% market share in PCs, the overall variegated market of computing devices has vastly increased in the last 10 years, so that Windows has less than 20% market share of that wider universe.  There are large markets for MSFT software.

OEMs have responded vigorously to this overture. For example, more than 11 (up from 3) signed up for Windows phone in the first quarter of this year.  It is important to note that since android OEMS must still pay license fees to MSFT, a $0 Windows Phone license costs them less than Android.

A lower cost Windows opens up markets on devices, as in the past, to Microsoft apps. These include both consumer oriented apps such as Xbox music, video and games, productivity apps including office 365, and services to manage devices for businesses. Over 2 years ago MSFT began writing a version of Office for iOS. When finally released in late March, it was  downloaded almost 30 million times in less than two months.  CEO Satya Nadella has articulated the vision of “Cloud First, Mobile First”, and that Microsoft will focus on “platforms and services”.  From the vantage point of BYOD, this means that businesses will use MSFT productivity applications on popular devices, on the respective different platforms, and manage mobile devices with MSFT Cloud based subscription services such as Microsoft Intune.

A third way MSFT is increasing competitiveness is by partnering with competing software service and platform providers. For the past 2 years, because there is demand for services from other providers in the public cloud, Windows Azure has increasingly accommodated services on 3rd party platforms running on Linux or from other providers such as Salesforce, SAP, Oracle and many, many others. This has produced a hockey stick upshift in Azure revenue growth.  See here for more on how Microsoft is levering its market dominance in productivity applications and services to gain market share in the Cloud, from which it wields the Cloud First, Mobile First strategy.

Microsoft: Extending its Competitive Advantage into the Cloud

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September 11, 2014. The public cloud offers unprecedented scale, low cost, and global distribution. Other than Microsoft Azure, there are two other hyper scale cloud competitors, Amazon Web Services (AWS) and Google (Google Cloud). Google Cloud is distinguished in that unlike the others, it primarily does not provide infrastructure as a Service (IaaS), that is, software running on Google Cloud must use the Google platforms. Azure represents a long term competitive campaign by MSFT that goes much further than simply matching competitors’ array of 3rd party service availability on their cloud. Compared to the other hyper scale providers, MSFT has several competitive advantages in the current watershed event of computing history, the move to the cloud. I will be discussing MSFT’s position chiefly relative to the two other hyper scale cloud companies.

  1. As Scott Guthrie, Executive Vice President, Microsoft Cloud and Enterprise group (Chief of Microsoft Azure) reiterated most recently at the September 3rd Citi Global Technology Conference, the MSFT public cloud preeminently enables computing at hyper scale. Today, clusters of datacenters are positioned in 17 regions globally including People’s Republic of China, where it is the first and so far only public cloud provider. Each region contains up to 600,000 servers housed in up to 16 data center buildings each the size of a football field. MSFT, AWS and Google Cloud are the providers of public cloud services at so called hyper scale. That being said, according to Mr. Guthrie, MSFT has datacenters located in twice the number of geographical regions as AWS and 5X that of Google Cloud. Is Amazon cutting prices to compete? This scale allows MSFT to cut prices “continually” in order to compete back.

2. MSFT operates in the hybrid cloud, running applications or services both in on premises datacenters and in the public cloud. For example, Windows Server runs in a private datacenter server, or on a server on Azure. In the hybrid cloud, on premises datacenters (the private cloud) connect with public cloud to optionally extend capacity or enjoy capability of specific public cloud computing advantages or business applications or services which reside on the cloud while preserving the private control of data and resources.

The hybrid model provides advantages because businesses that have been operating historically, are approaching the cloud from the on premises starting point and are not ready to move proprietary and otherwise sensitive data and applications to the cloud all at once and irrevocably. They do not want to be locked in.

Examples of hybrid cloud advantage include enabling services run on Azure to communicate with software and data that is still controlled within the on premises datacenter. Easyjet (largest airline carrier in the UK) keeps reservations data with passenger identities in on premises mainframes. However passengers book flights on the web site, which runs on Azure to accommodate global distribution. The hybrid application makes use of on premises and cloud data.

On premises datacenter workloads or data can be extended to platforms in the public cloud as an option. Azure provides disaster recovery solutions whereby the on premises data center is automatically backed up to Azure. This is available for physical or virtual servers on Windows or Linux, competitor VMware and others. Storage of specific subsections (tiers) of data can be optionally moved from on premises to the cloud, reducing storage costs roughly 50%. The data is moved on dedicated cables and is encrypted on site before moving to the cloud (Microsoft’s acquisition of storage companies StorSimple in 2012 and just recently InMage, play a role in these capabilities).

3. MSFT enjoys an advantage in its dominant market share in the on premises datacenters from which businesses are shifting to the hybrid cloud. Windows Server has 75% market share in business servers. Currently, 95% of businesses globally run on Windows Server Active Directory. Businesses want to use the same software on the cloud. When a virtualized Windows Server runs on AWS, MSFT receives revenue from Amazon (In fact, AWS advertises 750 free hours of virtual windows server instance per month when signing up for EC2. Thank you Amazon!). Perhaps this is contributing to growth in Hyper-V (virtual Windows Server machines) share, which is now at 30.6% and has helped grow datacenter additions, the Windows Server and System Center both up more than 40% for the year (2014 (Q4 earnings call). Here, MSFT wins through growth of either AWS or Azure.

4. Another advantage is MSFT’s dominant share in commonly used productivity applications. Purchasing Office and related productivity applications as a service running on Azure (Office 365) relieves businesses of the cost of maintaining datacenters, gaining the agility to increase or decrease usage with work load fluctuation, while increasing security and availability globally. Moreover, this move to software as a service is more profitable for MSFT. The reduction in revenue to datacenter IT service provider is replaced by new revenue to MSFT. Obviously, AWS does not compete in widely used business productivity apps and Google is competing from well behind.

Recently MSFT has made a concerted effort to make its productivity apps available on other mobile platforms such as Android and iOS, increasing market share of the MSFT apps. For instance, two years ago development of Office for IOS began, finally released in late March and downloaded almost 30 million times in less than two months. Once a business moves to Office 365, its users are managed via Active Directory and the devices are efficiently and securely managed using Windows Intune (for which there are over 10,000 paying corporate customers since release in late April 2014) within the Enterprise Mobility Suite. Yes, that means all those iOS and Android as well as Windows devices. This is another point of competitive advantage for MSFT, in that the device business (with relatively low gross margins) is intrinsically less attractive than the type of mission critical software with switching costs that MSFT is using to manage the devices and enable them to be productive in a secure way.

The ability of services run on Azure to accommodate various cross platform devices at incredible scale was exampled in the largest content streaming event in history, the Sochi Winter Olympics. Content was streamed via over 6 million app installations cross platform on mobile devices, and over 500 million web pages were viewed with more than 25 billion requests to Windows Azure virtual machines.

MSFT dominance in historical productivity services and apps means hybrid cloud represents an extension of MSFT’s durable competitive advantage into the future. Here MSFT is leveraging its franchise in office to extend its competitive advantage to the cloud, in a way that competitors cannot. By enabling customers to keep managing their data flexibly and continuing to use established management software, MSFT is keeping the high margin productivity software business as customers gradually transition to the cloud with software as a service (Saas) such as Office 365. Meanwhile, MSFT is competing with AWS and Google Cloud by lowering prices in infrastructure as a service (Iaas). AWS and Google have fewer high margin businesses to move to the cloud.

5. For the past 2 years, because businesses demand services from providers other than Microsoft in the public cloud, Windows Azure has increasingly accommodated services on 3rd party platforms running on Linux or from other providers such as Salesforce, SAP, Oracle and many, many others. These disparate services and platforms can be accessed on Azure via a single sign on credential using Active Directory, allowing businesses to efficiently and securely manage access to services by staff worldwide. In fact, 3rd party platforms or services are easily managed within a graphical user interface. As Azure accommodates the platforms and services that are demanded in global business, this has produced a hockey stick upshift in Azure revenue growth.

6. Emerging classes of applications on the cloud include business intelligence (BI) and machine learning. (ML). In BI, cloud applications can process large amounts of data from MSFT and non-MSFT platforms running in Azure and present it in useful ways to the customers. This was demonstrated using Salesforce in the recent WPC 2014. In machine learning, amounts of data that are too large or physically separated to process on the business’s own datacenter are analyzed in the cloud to make predictions. For instance, a retailer might upload data from customer purchase behavior to be analyzed in Azure ML, to guide targeted email marketing to target offers based on predicted next purchases. Machine Learning is the basis for the newly announced Delve, which provides up front display of the most relevant information for the user within Office 365, thereby keeping track of relevant events and new information from the entire enterprise for the user. BI and ML are being introduced to the widely used applications within Office to integrate the power of cloud computing to enable more complex questions to be answered simply, in everyday business.

Recent revenue growth in Azure and related software is a result of the ability of Azure to enable innovative agility, scale and distribution to Microsoft software applications that have switching costs with captive customers. Even though Microsoft has not been the first to the public cloud, it is succeeding because of previously existing competitive advantages. Moreover, openness to 3rd party platforms and applications enables access to novel markets.

Over 57% of Fortune 500 companies are now deployed on Azure. Synergy Research Group reported that in the second quarter of 2014, Azure revenue grew three times faster than the other hyper scale cloud providers: MSFT at 164% yoy, AWS 49%, Google 47%. In the 2014 Q4 Earnings Release \ it was announced that Commercial Cloud revenue (Azure) had grown 147% since the year previous Quarter, at a run rate of over $4.4B. The attractions of the cloud (low cost, scale, agility, global reach) are helping MSFT applications. Over 25% of global businesses have now licensed Office 365.

Summary:
The emerging generation of cloud driven apps brings the power of hyper scale computing to everyday business applications. But the path to that new era runs from on premises datacenters through the hybrid cloud. MSFT is using its dominant market position in productivity apps to forge a strong share in IaaS hosting 3rd party platforms and becoming a one stop shop for enterprise software. Over a period of likely more than a decade, MSFT can bring businesses to MSFT platforms in the cloud as a PaaS provider, to cement its control of business “plumbing”, the standards for business processes. Then, it will control its economic future in the public cloud. An investment in MSFT represents a part ownership in this massive future market. In 20 years when we say, “business today runs on the cloud”, to what extent will this imply, “runs on MSFT software”? Notwithstanding, surely there will always be partners as well as competitors at all levels.

Finally, where does this leave us regarding a purchase decision? I will not add an exhaustive valuation analysis of MSFT here. In fact, for years the investing community has had low enthusiasm for Microsoft and therefore valuation of MSFT is relatively safe.

MSFT had Free Cash Flow (FCF) of over $26B in 2014, with FCF/sales of over 30%. The lowest such ratio in the past 10 years was 27%, in the teeth of the recession in 2009. PE is 17, midway between the high PE of 25 and low of 9 in the past 10 years. One of my favorite valuation measures is also extremely simple: Cash Return. This is the cash a company generates, as a percentage of its capital, both equity and debt. Cash Return equals FCF plus interest expense divided by enterprise value. Enterprise value (EV) is market cap, plus debt, minus cash. EV is in fact the price an investor would need to pay to purchase the entire company. According to Morningstar, MSFT Cash Return is 8.5%. Excellent, considering this is a company with clear competitive advantages that should continue to generate an above average return on its investments well into the foreseeable future as it has in the past, without important changes to its capital investment requirement.