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With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

• They earn high returns on the capital they employ.
• They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
• They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers show that Novo Nordisk, the leading producer of diabetes-care products, exhibits EVA Monster characteristics and is thus worthy of your attention. The company’s shares are available directly on Nasdaq Copenhagen under the ISIN code DK0060534915. On American OTC markets, the ADR uses the ticker symbol NVO.

One of the companies in our FALCON Portfolio announced in 2019 that it would discontinue the practice of giving quarterly guidance. That was Illinois Tool Works, and here’s the brief comment that I added to the news:

“I welcome this decision as quarterly guidance breeds short-termism that is the enemy of long-term shareholder value creation.”

In fact, you could read headlines in 2018 that Warren Buffett and Jamie Dimon (the chairman of the Business Roundtable and the chairman and CEO of JPMorgan Chase) joined forces to convince CEOs to end quarterly profit forecasts. They even wrote about the issue in an opinion column in The Wall Street Journal.

What do you think is wrong with the practice of quarterly guidance? Put simply, it shifts management’s focus from thinking about the long term to thinking about the next quarter. Companies forecast sales and profit numbers to Wall Street analysts, who use the data to produce research and stock recommendations for investors.

Missing “the number” can often result in huge and sudden stock moves. Think about Apple’s missed revenue forecast for its fiscal first quarter period that ended on December 29, 2018. CEO Tim Cook kicked off 2019 with a letter to investors describing various difficulties the company experienced during the holiday quarter. The number that analysts immediately focused on was the revised revenue guidance, which was lowered to $84 billion from a range of $89 to $93 billion given during the last earnings call on November 1. The market’s reaction was swift and severe, with the stock price falling nearly 10 percent on January 3.

On the other hand, making a forecast and then hitting the target are seen as a way to manage expectations and eliminate volatility.

While those in favor of guidance say that it improves communications with Wall Street, reduces share price volatility, and boosts a stock’s value, McKinsey & Co. found in a 2006 study that quarterly guidance had no effect on valuation multiples and didn’t reduce share price volatility. Instead, McKinsey found that the practice of giving quarterly guidance took up valuable time from management and made them focus too much on the short term.

Think about this last point! Earnings calls typically take place a month into the subsequent quarter, so analysts expect the management to not only talk about the prior period but to give a sense of how things are going during the current quarter. This essentially means that a month into a quarter, analysts ask executives to look at the first third of the quarter and make projections for the next ~60 days. Because investors pay so much attention to guidance, managers spend significant time thinking about these estimates, and this is time that they are not using to run the actual business!

Executives often feel pressure to make quarterly forecasts because the market appears to demand this, but “it can often put a company in a position where management from the CEO down feels obligated to deliver earnings and therefore may do things that they wouldn’t otherwise have done,” Dimon said in an interview on CNBC. “Quarterly earnings: they’re a function of the weather, commodity prices, volumes, competitor pricing. And you don’t really control that as CEO,” he added. “Sometimes you’re just like the cork in the ocean, but do the right thing anyway, and you’re going to be fine in the long run.” (Here is where the primary mission of long-term shareholder value creation comes into direct conflict with meeting and beating the short-term guidance.)

“When companies get where they’re sort of living by ‘making the numbers,’ they do a lot of things that really are counter to the long-term interests of the business.” (Warren Buffett)

Besides diverting management’s focus from long-term shareholder value creation, the widespread practice of quarterly guidance has another negative effect. When managers provide guidance, this effectively causes Wall Street analysts to crowd around the mid-point of the guided range in their own models. As a result, the variation of estimates is narrower than would be the case if analysts had to do their work. This kind of spoon-feeding does have serious consequences. I came across a well-written piece of opinion on Marketwatch that was titled “Why you can’t trust Wall Street analysts.” Here’s the essence of that writing:

“Many companies provide earnings guidance, which analysts incorporate in their estimates. For companies, guidance is designed to ‘under-promise and over-deliver’ in order to set up earnings beats, which propel the stock higher. Analysts are much more likely to rate stocks buy than sell, and if the beats help push stock prices higher, their track records as stock pickers look better. The conclusion: If you invest in stocks, you had better take analysts’ ratings and earnings estimates with a grain of salt.”

As to the uselessness of analysts’ recommendations, in 2000, Merrill Lynch analysts said there were 940 stocks to buy and only 7 to sell. Salomon said you should buy 856 and only sell 4. First Boston analysts were more negative; they only found 791 stocks to buy and 9 to sell. And Morgan Stanley said there were 780 wonderful businesses to buy and none to sell. This, right before the market plunged as much as 90 percent in some of these recommended stocks. The week that Enron went bankrupt, nine of the fourteen investment banking companies covering the stock had a “buy” rating on it. None said to sell it.

Here’s another eye-opening statistic from S&P Global Market Intelligence: in a typical quarterly earnings season in the U.S., two-thirds of S&P 500 member companies tend to publish earnings per share that are higher than the consensus estimate among analysts. This is hard evidence of the “under-promise and over-deliver” practice in action as well as the spoon-fed nature of the analyst community who fail to come up with their own forecasts but use the company’s guidance instead. After all, if each analyst had good information to formulate reasonable estimates, the average beat rate would be expected to be somewhere around 50%.

Let me summarize your takeaway. Most managers feel pressure to provide quarterly guidance. Once analysts get these numbers, they are quick to incorporate them into their models, and they most certainly do not want to look stupid by publishing estimates that are meaningfully different from the corporate guidance. Now that the spoon-feeding is done, both the executives and analysts know that it makes tremendous sense to under-promise and beat the heavily influenced Wall Street consensus quarter after quarter since this seems to drive stock prices higher (in the short run).

If you were an analyst familiar with the rules of this game, you would be biased toward issuing buy recommendations since (the highly probable) quarterly earnings beats can propel stock prices higher, thus proving your stock-picking ability and your worth to your employer. As a long-term investor, however, you should realize that short-termism is written all over Wall Street and is part and parcel of the above-detailed quarterly earnings game. Knowing this, you may still read the analysts’ research reports on companies, entire market sectors, or industries to obtain valuable information, but you should never let their recommendations influence your independent decision-making. You either have your own process for stock selection (like that of the FALCON Method), or you can easily fall prey to the predators of Wall Street who are much more eager to push up trading volumes than to boost your investment returns. (In fact, the McKinsey study of 2006 found that the only significant effect of quarterly guidance was increased trading volumes.)

Don’t get me wrong, guidance and disclosure are two different things! While making quarterly forecasts makes no sense, publishing quarterly reports is useful. Truth be told, there is not much that could happen in any single three-month period that could alter the long-term investment thesis of a sensible investor, but it is still good to get some update on how the execution of the announced strategy is progressing. By the way, even a whole year is meaningless for us both in terms of our investment performance and the operating performance of the companies in our portfolio. As Buffett put it in 1966:

“Our investments are simply not aware that it takes 365-1/4 days for the earth to make it around the sun. Even worse, they are not aware that your celestial orientation (and that of the IRS) requires that I report to you upon the conclusion of each orbit (the Earth’s – not ours).”

Now you understand the rules of the game and hopefully accept that by playing the long-term game, we are rather the exception than the rule.

Want to learn more about our stock ranking methodology and evidence-based investment approach? Start with this blog post!

With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

• They earn high returns on the capital they employ.
• They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
• They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers show that ASML Holding N.V., an essential monopoly in extreme ultraviolet (EUV) technology (used for producing advanced chips for applications such as fighter jets, AI supercomputers, and smartphones), exhibits EVA Monster characteristics and is thus worthy of your attention. The company’s shares trade under the ticker symbol ASML on both the Euronext and NASDAQ.

Do you know how Ben Graham, the father of value investing, used to open his famous course at Columbia? According to one of his students, Marshall Weinberg, this is what Graham said at the very beginning: “If you want to make money on Wall Street, you must have the proper psychological attitude. No one expresses it better than Spinoza, the philosopher. Spinoza said you must look at things in the aspect of eternity.” Before elaborating on the importance of these lines, let me invite you to take a quick test.

Vishal Khandelwal teaches value investing in India, and he has some thought-provoking slides, two of which we are about to use here. First, look at these charts and write down which of the three stocks seems to be the best in terms of performance.

The obvious answer is the third, which looks like a one-way ride up. At this point, Vishal reveals to his students that the first two charts are just short periods in the third stock’s long journey. See it for yourself!

What does this have to teach us? In the long journey of the stock of a high-quality business, the short-term price fluctuations that make people nervous are non-events. In the larger scheme of things, most of what worries us is of relative insignificance, and this holds true for all areas of our lives.

After having reached thousands of people with my books, courses, and newsletters on investing, I’m widely aware that most people hate short-term underperformance, so they tend to zoom in on the charts and focus on the short periods instead of the long journey. If investment managers (or newsletter providers) underperform for six months, they start to get questions about the efficacy of their strategy. If the underperformance continues longer, those questions get louder, and by the time the bad period reaches five years, there won’t be many clients left. The problem is that investors try to match long-term strategies with a short-term time horizon and assume that if a strategy doesn’t work over three years, it doesn’t work long term. (Factually incorrect!)

Let me clear this up for you with an example, as this is the single most important reason why most people have difficulty following evidence-based investment approaches like the FALCON Method. Value stocks (those that are priced cheap based on various valuation metrics) tend to outperform the market in the long run. This is a fact that is not to be disputed by anyone who has studied the historical data. Having read this proven statement on long-term performance, would you be upset if your carefully constructed value portfolio underperformed the market in any single year? You shouldn’t be, as this tends to happen 37% of the time, according to the data compiled by author and investor Larry E. Swedroe. In fact, we are currently in a period where the value approach has underperformed for a long time, and statistics show that even this is perfectly normal. The longer the horizon, the lower the odds of underperformance, but it can still happen at horizons of 20 years! According to Swedroe, the value factor underperforms in 14% of ten-year periods, so staying the course during that type of extended underperformance is required to benefit from the long-term outperformance of the approach. Most people can’t do that, and that is why factor investing is much harder than many think. After all, when it comes to judging the performance of an investment strategy, most people believe that three years is a long time, five years is a very long time, and ten years is an eternity. When Ben Graham used the word eternity, he must have had something different in mind.

Investors get paid for experiencing pain. If a certain approach worked all the time, everyone would follow it, and it would eventually stop working. The pain you experience in pursuing a strategy is the price of admission to get its long-term outperformance. Periods of underperformance are part and parcel of the game. Adopting this mindset would most certainly help investors maximize their long-term returns, although I’m not too optimistic about the possibility of this ever happening on a large scale.

Now it’s Mark Hulbert’s turn to draw your attention to another important issue. He has been tracking the advice of more than 160 financial newsletters since 1980, so he does know a thing or two about this industry and its subscribers. Here’s his question: Which of the following two advisers would you more likely follow? (A) An adviser with a decent but unspectacular track record who merely matches the market’s return when it’s going up but loses less when it is declining? (B) Another adviser at the top of the performance sweepstakes, but who suffers big losses in a bear market? Hulbert says, “If you’re like the typical investor, you’d jump for the second one. Yet the first is more likely to help you reach your long-term financial goals. That’s because the key to long-term financial success is sticking with an adviser or strategy through thick and thin. And most investors who follow high-flying advisers end up discovering that they don’t have the level of commitment and intestinal fortitude that are required. As a result, most investors who start following such advisers get rid of them at or near the end of the next bear market. As a result, they suffer almost all of those advisers’ bear market losses yet benefit from only a fraction of their bull market potential. That’s why the first, less glamorous, adviser is to be preferred. Even though his track record appears to be inferior, you most likely will make more money following him over the long term than by going with the one whose track record appears to be superior. To put this another way: Slow and steady wins the race. Most investors know all this already. And yet, they continue to prefer advisers who are like the second one above. Why? Because they’re addicted to excitement.”

Short-termism and excitement addiction undermine your investment performance. You can subscribe to an evidence-based approach, the factors of which have been proven to work for decades (if not centuries), yet, you will most likely abandon it if you keep asking questions about the short-term performance. This is by no means an excuse in disguise to defend the FALCON Method since the last time I looked at the data, our results were respectable.

Do you know what conclusion I draw from these stats? Absolutely nothing! This is a meaningless snapshot, just like looking at the score of a football match in the fifth minute. The odds are on our side, and you don’t need these interim results to be confident of this. (Still, getting to know our underlying stock selection process is a great first step to build up your conviction.)

The best advice I can give you is to zoom out: forget your portfolio’s daily, monthly, and even annual performance! Focus instead on the process and its underlying factors.

Nothing spectacular will happen with the FALCON Method in the coming years, so seek entertainment and excitement elsewhere. “Investing shouldn’t be about glamour,” as Howard Marks puts it, and when he speaks, we all should listen. Buffett states, “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something.”

“Thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. They avoid sharing in the riskiest behavior because they’re aware of how much they don’t know and have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation—but it doesn’t provide much ego gratification in the short run. It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control. Of course, investing shouldn’t be about glamour, but often it is.” These thoughts from Howard Marks highlight how I aim to manage my investing operations along with the FALCON Method.

Want to learn more about our stock ranking methodology and evidence-based investment approach? Start with this blog post!

With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

• They earn high returns on the capital they employ.
• They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
• They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers show that Kering, the French-based multinational corporation specializing in luxury goods, exhibits EVA Monster characteristics and is thus worthy of your attention. (Shares are available directly on the Paris Stock Exchange under the ticker symbol KER, or as an ADR with the ticker symbol PPRUY on American OTC markets.)

Kering is the world’s second-largest personal luxury goods holding company after LVMH. Its flagship brand is Gucci, followed by other high-end fashion houses such as Saint Laurent (YSL), Bottega Veneta, Alexander McQueen, and Balenciaga. Its range of products includes handbags, shoes, and ready-to-wear clothing items designed and manufactured by the company. Besides its core offerings, the firm also markets sunglasses and optical glasses under its Kering Eyewear division. Kering SA (formerly called PPR or Pinault-Printemps-Redoute) was founded in 1963, and is based in Paris, France.

Kering has evolved into the second-largest luxury powerhouse following the acquisition of the Gucci Group in the early 2000s. Besides the namesake brand, the acquired portfolio included Saint Laurent, Bottega Veneta, and Balenciaga, among others. After a few strategic missteps (such as seizing a controlling stake in sportswear manufacturer Puma in 2007, which was almost entirely spun off in 2018), Kering has fully dedicated itself to developing its luxury houses.

A quick glance at the EVA metrics reveals that the firm’s EVA trajectory has been on a steep ascent in the second half of the past decade. This clearly reflects the strengthened focus on its luxury houses, and we believe that the current double-digit EVA Margin and ROC levels are telltale signs of a moaty business.

Kering’s largest brand, Gucci is responsible for 55% of the top line, Saint Laurent makes up 14%, and its third biggest house is Bottega Veneta, with a 9% contribution. In economic profit terms, Gucci’s contribution comes in at ~70% of the company’s overall EVA generation. When we add YSL and Bottega Veneta, the three biggest brands make up ~90% of economic profits.

Kering’s overreliance on Gucci is one of the key risks associated with the company. The brand’s history is not without creative and operational hiccups, and the rapid growth of the recent past implies the risk of overexpansion and customer fatigue, the standard culprits of luxury brands.

Within the personal luxury goods segment, a few traits are required for a brand to carve out lasting pricing power and warrant a price tag often 10x higher than that of comparable items from premium brands. The handful of fashion houses that succeed in doing so possess a respectable heritage, often dating back more than a century. Besides that, it is quintessential to maintain the brand image by controlling the distribution network, while exclusivity must be ensured by a limited supply where price discounts are unthinkable.

As for the supporting megatrend, the personal luxury goods market is expected to grow in line with the seemingly unstoppable trend of the rising number of high-net-worth individuals (HNWIs) globally. While we view the company’s earlier forays into the commodity sportswear segment as a dead end, the strategic focus on building a pure-play luxury empire is bearing fruit.

Since 2005, the business has been led by François-Henri Pinault, the son of the empire’s founder. Overall, Kering has remained a family-controlled holding. While this structure could be a double-edged sword in general, we tend to believe that it is preferable for luxury companies. It is important to prioritize the sustainable, long-term growth of the fashion houses, thereby curbing supply and omitting price discounts at any cost. As a counterexample, a short-sighted management team could double sales in a matter of years, inflicting immense reputational damage.

The firm pays a semi-annual dividend, which tends to fluctuate with earnings, rendering the stock a rather hectic income source. That said, the dividend is not the main attraction here since Kering comfortably qualifies as a longevity moat type of EVA Monster with its seemingly unending EVA growth trajectory. (This is a rare breed!)

When it comes to the stock’s valuation, it is important to note that the firm’s profitability has markedly expanded in the second half of the past decade (as a result of tightening its luxury focus and revamping its major fashion houses). We believe this structural change to be permanent and hence view the current EVA Margin levels as sustainable.

Please see below the valuation metrics of the EVA framework that remedy accounting distortions to give us a clearer picture on where the stock stands in a historical context.

While Kering’s business appears superior to the market from both a quality and growth angle, the valuation component may act as a slight headwind from today’s price level. The “Key Data” table and the 5-year total return potential chart speak for themselves.

Overall, the FALCON Method can identify much better opportunities in the current market, so we are passing up on Kering for now.

The verdict

We love that the company’s target consumer segment is not particularly sensitive to economic cycles. The underlying HNWI growth megatrend is also a powerful tailwind.

Based on Kering’s recent reports, monitoring the Gucci brand’s trajectory in China remains the most important aspect for those interested in the stock. (China is crucially important to the overall growth thesis.)

While we really like the luxury segment, LVMH is our preferred conglomerate in the industry (because of its superior brand portfolio, operational track record, and product diversification). That said, we would also take a smaller (2-3%) position in Kering at the right price.

The company ranked 19th of our 60 EVA Monsters at the time of writing, based on its 5-year total return potential. (Businesses from 12 countries are represented on our EVA Monster list.)

It is safe to say that there are far more attractive EVA Monster stocks to buy in the current market, with the highest-ranking five boasting total return potentials above 16% over our modeled 5-year timeframe. (You can always find the monthly Top 10 in the FALCON Method newsletter along with our entry price recommendations.)

Want to learn more about our ranking methodology? Start with this blog post!

How on earth are we supposed to outsmart professional investors? Mutual fund managers control over 85 percent of the money in the stock market; they live and breathe stocks, so we don’t seem to have a realistic chance. Isn’t it better to simply invest in a low-cost index fund? I get this question in various forms every single month, so I want to put this issue to bed once and for all with this writing.

Historical data unquestionably shows that something is seriously wrong with the fund management business. The overwhelming majority of mutual funds fail to beat the market with any consistency over time. That said, most actively managed funds are collecting enormous fees for a job they do not deliver.

This is common knowledge, yet most people draw wrong conclusions from the factual data.

They think that even the full-time pros are not good enough to produce investment returns that exceed the market average consistently. This is not true. The reasons for failure are twofold, with high fees that drag down the investment performance being the first and short-termism of the entire industry the second. Active investing does work! But not the way most fund managers are forced to do it.

“In fact, the amateur investor has numerous built-in advantages that, if exploited, should result in his or her outperforming the experts, and also the market in general.” (Peter Lynch)

Peter Lynch was one of the most successful fund managers of all time, so he does know a thing or two about that business. When he talks, we all should listen!

Recently, I’ve had lunch with two European fund managers, and quoting some parts of our conversation may highlight the advantages we, as small investors, clearly have over the pros. It shocked me when one of these guys said:

“Whenever I get in the office, my colleagues tease me about the most recent price movements of the stocks in my fund’s portfolio. Short-term performance is everything. My bonus and, basically, my survival depends on it. This job involves extreme pressure.”

Both know the logic behind the FALCON Method, and the other guy added:

“You are lucky that you can invest the way you do. I would do that with my own money as well. You have the luxury to ignore the short-term noise or even profit from it while we cannot afford to make sensible long-term decisions without the risk of getting fired before those decisions could bear fruit.”

These fund managers do have the proper knowledge to achieve superior investment performance, but the system is not built to suit them. (Or any thoughtful long-term investor, for that matter.)

The fund management industry is all about making you believe that you cannot manage your money on your own. They earn billions from commissions and fees as long as they can do this. The one thing to understand, though, is that you don’t have to be smarter than the pros on Wall Street; you just have to play by a different set of rules!

Have you ever thought about how different meanings a steep price drop could have depending on your timeframe? Fund managers follow the crowd. They have to. They cannot hold something that’s going down in price. It will make them look bad to their investors, and then they will eventually lose those investors along with their jobs. These guys are very bright, but have a different drummer to dance to. They are in the business of keeping their clients and gathering more assets to manage while you are in the business of making money for yourself. These two businesses can dictate very different responses to the exact same market situation!

Let me make this perfectly clear with a striking example. What if I offered you a $100 bill for $50? I hope you’d grab the chance. Then would you be upset about your decision to buy that first bill if I offered you another $100 for $25 the very next day? And would you freak out if I offered you a third $100 for $10 later? In fact, you should be excited to buy the first one, more excited to grab the second, and absolutely thrilled to get the third one. This is common sense as long as you are not judged on short-term performance. (Most fund managers, on the other hand, would sell out in such a situation by the time the third offer arrives, regardless of the value of the underlying $100 bills. They wouldn’t want this panic-stricken asset to show up in their quarterly statements causing investors to lose trust. After all, everyone knows that the price of “that thing” is falling like a rock; who in his right mind would hold it in their portfolio? And with this, even the most apparent value considerations get thrown out as managing career risk prevails. Take some time to think about this!)

As an amateur investor, would you be nervous about the price of your asset dropping that steeply? Not with the $100 bill in our example, but somewhat more with a stock, I guess. The reason is simple: while you are totally sure about the value of the $100 bill (and are happy to get that value for a lower price), on some level, you still feel that the price has something to do with the value of the stock. Well, it doesn’t! Price is what you pay; value is what you get. As a do-it-yourself investor, you can play the difference between the wildly fluctuating stock price and the more stable intrinsic value of the underlying business. This is the luxury that fund managers crave as they live and die by the unpredictable price movements of the short term.

The real question is whether you can chill out when the fund managers controlling more than 85 percent of the market are freaking out. Knowledge and experience can give you the peace of mind to feel excited and not nervous when stock prices drop. In fact, I am grateful for every meaningful sell-off since I expect to be a net saver during the next 5-10 years. Many investors get this wrong. Even though they will be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.

The point I wanted to drive home is that active investing does work as long as you are doing it yourself and don’t overpay for actively managed funds plagued by short-termism. As factual data proves, some of them might outperform but not by a wide enough margin to justify their fees.

However, the biggest advantage of the active approach is that you can tailor your investment strategy to your needs. For me, that means a healthy blend of income-producing dividend stocks and quality-growth beasts (we label EVA Monsters in the FALCON Method newsletter.)

Get to know more about our EVA Monster vs. Fallen Angel categorization from these insightful case studies.

Once you let short-term stock price fluctuations affect your mood and direct your decisions, you are playing the big guys’ game where they will crush you. As Warren Buffett said, Mr. Market should be your servant, not your guide. Play by different rules! Make the most of your built-in advantages (e.g., lack of career risk), keep buying those $100 bills for less than their true value, and wait patiently for the bipolar Mr. Market to take his medicine and recheck the price labels on your assets. You cannot go wrong with this strategy as long as you are patient and focus on the value of the underlying businesses instead of the stock market’s wild ride.

One final reality check. Could you go on a device-free holiday for a week without checking the market every day?

As for the stocks in our FALCON Portfolio, I could even go on a five-year trip around the world without internet access since I didn’t buy lottery tickets but partial ownership stakes in wonderful businesses that don’t require any activity on my part to produce more cash (and pay more dividends) by the end of my imaginary trip. You’ll need the same kind of conviction about your portfolio to stick with it when times get tough.

Take the first step today by learning more about our evidence-based stock selection process with this free report.

With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

• They earn high returns on the capital they employ.
• They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
• They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers show that Intuit (INTU) exhibits EVA Monster characteristics and is thus worthy of your attention.

Intuit is a diversified software company providing various services to small and medium-sized enterprises and individual customers. Its core offerings include the QuickBooks accounting suite and the TurboTax tax filing toolset. In addition to migrating its legacy desktop solutions to a cloud-based software-as-a-service (SaaS) model, the company has recently broadened its portfolio through major acquisitions. The Credit Karma personal finance platform and the Mailchimp email marketing solution are its most significant additions. The company was founded in 1983 and is headquartered in Mountain View, California.

A quick glance at the EVA metrics reveals that Intuit boasts strong double-digit EVA Margin and ROC figures, which are telltale signs of a high-quality business.

We believe the firm’s flagship specialized software solutions, QuickBooks and TurboTax warrant a wide-moat rating. These make up over 70% of its top line and the overwhelming majority of the EVA generation.

QuickBooks, the bookkeeping tool, is the undisputed leader in the U.S., ruling with an 80% share of the small business accounting software market and a total subscriber base of almost 6 million accounts. Intuit is also the undisputed leader of the online DIY tax preparation market, commanding a 60%+ share. On top of that, the firm’s TurboTax Live, an assisted solution, serves as a further differentiator compared to its peers, where customers can access a tax professional to guide them through the filing process. Growing rapidly, this has become a billion-dollar business within Intuit in just a few years.

As for growth prospects, TurboTax operates in a mature market (with the number of U.S. tax filings staying roughly flat over the past decade), while QuickBooks is still in the early innings of growth (serving a little shy of 6M accounts with a total addressable market of 75M small business customers).

There’s nothing wrong with Intuit’s core business, as the capital-light operations gush out lots of cash at great ROC levels. Between 2006 and 2020, the reinvestment rate stood at 15%. However, the new CEO’s tenure brought a swift change in capital allocation policy, and this is where the picture becomes murky. Before that, Intuit had completed only a single billion-dollar deal since its founding nearly 40 years ago. Then, Goodarzi went on an all-out acquisition bonanza in the last few years, scooping up Mailchimp for a hefty ~$12 billion, only nine months after the firm closed the ~$8 billion deal to acquire Credit Karma.

Our judgment regarding these purchases is mixed. Although we understand that there might be some cross-selling opportunities and strategic advantages by combining these businesses, like providing a one-stop-shop solution for SMBs, we don’t think Intuit needed these deals to prosper. Furthermore, the price tags are tough to justify (for instance, Mailchimp was bought at 15 times revenues), and the related share issuances to fund these deals resulted in meaningful dilution to shareholders. Within the EVA framework, the huge added capital charge associated with these transactions causes the EVA Margin outlook to be very blurry going forward.

Regarding repurchases, the firm spent more than $12 billion on buybacks over the past decade, yet the share count has basically stayed the same. We cannot come to grips with Intuit’s share-based compensation expense, as it seems way out of touch. (Buybacks are also far from opportunistic, with management repurchasing $2.5 billion worth of stock in fiscal 2022 at nosebleed valuation levels.)

As for the stock’s valuation, although Intuit loves to tout non-GAAP financial measures, those might be hugely misleading because of excluding the expense of the egregious share-based compensation. The EVA framework remedies this distortion, along with many others.

Despite the core business appearing to be superior to the market from both a quality and growth angle, even after assuming an EVA Margin rebound over the next five years, the valuation component acts as a meaningful headwind from today’s price level. The chart of 5-year total return potential speaks for itself.

All in all, the stock is too expensive for our taste at the moment.

The verdict

TurboTax and QuickBooks appear to be resilient, wide-moat businesses, with the latter enjoying healthy long-term growth opportunities thanks to a large total addressable market. If only these two units made up Intuit, with a laser-focused management team and meaningful capital distributions thanks to the capital-light model, we would surely be up for the ride at the right price. However, the current management team must prove first that the two “mega” deals were not a mistake at those price tags.

To be clear: there is a sizeable capital allocation risk associated with the current leadership team. Integrating the Credit Karma and Mailchimp deals will require significant time, energy, and resources. Ultimately, the expected synergies and cross-selling opportunities might never materialize or not to the extent that would justify the lofty price tags. If value-destroying acquisitions were to continue, that could put further pressure on Intuit’s EVA Margin (although fancy presentations about deals being “accretive to non-GAAP EPS” may be enough to sell any story on Wall Street).

Intuit’s stock is a comfortable pass for us at the current valuation.

The company ranked 33rd of our 60 EVA Monsters at the time of writing, based on its 5-year total return potential. (Businesses from 12 countries are represented on our EVA Monster list.)

It is safe to say that there are far more attractive EVA Monster stocks to buy in the current market, with the highest-ranking five boasting total return potentials above 16% over our modeled 5-year timeframe. (You can always find the monthly Top 10 in the FALCON Method newsletter along with our entry price recommendations.)

Want to learn more about our ranking methodology? Start with this blog post!

Let me share one of my favorite stock market-related analogies. A middle-aged woman is walking through Central Park, and she has a very active dog with her.

My Hungarian vizsla (Lara) would fit well in this story. Here she is to help you imagine the story.

If you just looked at the lady, you would notice that she is taking normal steps, going in a straight line, walking upright at a moderate pace. Nothing exciting, indeed.

Now let your eyes pan down a little bit, and look at the dog. The vizsla is going crazy. It is chasing birds, digging up clumps of mud, running at trees, and peeing all over the place.

As you may have guessed, the dog is the stock market, and the woman is the economy.

So if you’re watching the dog (the more entertaining stuff), you’re losing sight of the economy (the underlying business performance that determines values in the long run). As long as you can’t get your eyes off the dog, you’re observing the manifestation of hundreds of millions of people’s greed and fear, their buying and selling. But you’re not watching an actual representation of how the economy is doing, and this is a crucial point to keep in mind.

That said, under normal circumstances, the dog periodically checks where the woman is and what direction she is taking. So the dog and the lady, or the stock market and the economy, are somewhat connected, but they most certainly do not look the same or act the same, even if they are walking in the same direction.

Looking at this relationship, sometimes it seems as though the dog has completely lost interest in the woman; it runs far ahead and doesn’t even seem to care that the woman may need to take a break to catch her breath. Make no mistake; the dog still needs the lady; their connection may only loosen temporarily, so the question is where the two will meet again. The dog may choose to sit down or sniff around while staying in the same place (stagnating stock prices) until the woman catches up, or it can run straight back to her (falling stock prices).

Nobody knows how the next chapter of the story will unfold, but pundits would certainly not bet on an outcome where the middle-aged woman could sprint to catch up with her agile dog. That would be impossible with a vizsla, believe me. (Lara was clocked running at ~40mph, which is 60+ km/h.)

The economy, the underlying business performance, tends to move slower than the stock prices. As Joel Greenblatt says:

“Prices fluctuate more than values—so therein lies opportunity.”

When the dog is far ahead of the woman (prices are way higher than intrinsic values), value-conscious investors find hardly any opportunities and tend to underperform until the pair are reunited.

In fact, a value investor’s market would be where the dog is left behind sniffing while its owner is marching ahead at a steady pace.

If you think this has nothing to do with investing, you can check out how even the world’s most reputable value investor, Warren Buffett, couldn’t outperform the stock market over a 25-year timeframe.

Yes, that’s a quarter of a century, and the period is picked somewhat arbitrarily to illustrate the point that prices and fundamentals can decouple for longer than you’d think. (Note that Berkshire’s performance is measured against the S&P 500 total return index, which assumes that all dividends are reinvested into the index. As Berkshire pays no dividend, this total return index helps us make an apples-to-apples comparison.)

Taking our analogy one step further, if you are the contemplative type like me, you can imagine that thousands of pairs of dogs and owners are walking through Central Park, together making up the whole stock market. A sensible investor’s task is to spot a pair where the dog lags behind, and the owner looks healthy enough to keep walking along.

It’s not an easy job, but that’s what we are helping you with at the FALCON Method using institutional-level data inaccessible to retail investors.

Hand on your heart, are you guilty of just watching the dog?

Take the first step to getting over this costly mistake by learning more about our evidence-based stock selection process with this free report.

W.W. Grainger (GWW) first appeared in the FALCON Method newsletter in August 2017 when we bought the stock at $170.35. Fast forward ~5.5 years to March 2023, when we exited this position at $704.88, realizing an annualized total return of 30.0%. This equals turning $10K into $43.4K, including dividends harvested. No victory lap here; I’d rather like to illustrate the thought process behind both the buy and sell decisions to provide some value for thoughtful long-term investors.

What we knew back in 2017

Grainger was a Dividend Champion with a 46-year dividend-raising streak, so it comfortably qualified as a reliable income vehicle.

The stock offered a 3% entry yield, a rare opportunity in historical context.

The financial metrics revealed that Grainger was an above-average company, most likely facing temporary headwinds. Mr. Market was quick to write off the firm as Amazon seemed to disrupt its business model. As a reaction, Grainger scaled down the number of stores and ramped up distribution centers to grow their e-commerce business. Management believed their operating margin would decline in 2017 and 2018 but begin to grow again in 2019.

Back then, I wrote: “Given the company’s outstanding relations with its customers and the valuable services it provides, it doesn’t have to be the cheapest to stay alive. While a lot of retailers are currently fighting declining sales and struggling to get rid of their inventories, Grainger’s top line is actually rising each year while the inventory stays virtually unchanged. Demand for the firm’s products is still strong. GWW is the epitome of the selective contrarian buy for me. If you believe its business will not be totally commoditized by Amazon, this is a stock you should definitely own. I foresee an annualized total return between 9-12% in the overly conservative scenarios I examined.”

In hindsight, I was way too conservative with that forecast, but better safe than sorry. My short assessment from the August 2017 issue of the newsletter read: “Whenever Grainger offered a starting yield above 3%, the total returns that followed were extraordinary. Coverage ratios are fine, and even with a temporary (?) slowing growth, this stock can be the cornerstone of a portfolio that focuses on reliable dividends.”

The shareholder yield (the sum of the dividend, net buyback, and net debt paydown) sat at 10.0%, making me even more comfortable with this purchase, resulting in a somewhat oversized position.

The Patient Holding Phase

Let’s take a look at how Grainger’s business performed during our holding period.

As you see, sales increased by ~50%. What’s much more impressive, though, is the margin performance. At the time of our purchase, the firm could convert 3.8% of its top line into real profits (Economic Value Added, cleared from all accounting distortions, as you can learn here). By the time we sold Grainger, its EVA Margin had shot up to ~10%. The company’s management was right about the margin trajectory.

More EVA production tends to entail higher stock prices, and Grainger didn’t embarrass in this regard. Look at how the red bars increased in lockstep with the company’s market value.

You can learn more about the Enterprise Value Components from this piece.

Grainger also delivered on the dividend front, announcing annual increases like clockwork.

While all was well on the fundamental side of the business, the stock’s valuation became somewhat concerning as Mr. Market changed his tune on Grainger.

Why we sold

In general, we have two main reasons to sell: (1) the fundamentals don’t work out as expected, so the investment thesis seems broken, or (2) the stock gets overvalued, from which level the forward total return potential becomes muted and the risk-reward characteristics unfavorable.

In Grainger’s case, the first explanation doesn’t apply, as the company grossly outperformed our expectations on the fundamental business performance front. As for the valuation side, at a $700+ level, it became almost impossible to justify holding GWW any longer.

Besides doing our independent EVA-based financial modeling, we also tend to look at external sources before making sell decisions like this. Morningstar considers Grainger significantly overvalued over $635. (This was their one-star price when we sold the stock.) Based on the historical dividend yield profile, one could argue that GWW was a sell above $550. So why didn’t we exit this position sooner?

Because Grainger was a Fallen Angel pick of above-average quality, and dumping such stocks too soon usually comes back to bite you. (Back when we didn’t differentiate between EVA Monsters and Fallen Angels, I sold Microsoft on a historical valuation basis instead of looking at its formidable forward total return potential. Lessons learned. By the way, you can learn about our EVA Monster vs. Fallen Angel classification here.)

Here is what we saw with Grainger at the time we sold:

The annualized total return potential came in at ~4% over a five-year holding period when risk-free US Treasuries yielded above 4%!

The waterfall charts of our two modeled scenarios show the composition of expected total returns. As you see, Grainger has a ~5% fundamental return potential, while the risk of a margin contraction (from the elevated levels) is far from non-existent. On top of this, the valuation may act as a severe headwind in our conservative scenario and would only slightly contribute to the total return potential in our enterprising scenario. The mid-point total return potential of 4.1% was simply too low to justify keeping GWW in our FALCON Portfolio.

That said, the sentiment can always become more extreme before returning to normalcy. Just look at what happened after we sold Target (TGT) at $175 in November 2020, realizing a ~45% annualized return. The share price promptly shot up to $260 before coming back down to meet up with the fundamentals (or, shall I say, reality?).

Identifying the tops and bottoms is not the business the FALCON Method is involved in. Fortunately, that is not only impossible but also unnecessary for good investment returns. In fact, you can see from the summary table of our sold positions (as of March 2023) that the annualized return we earned with Grainger was not a one-off.

Courtesy of FAST Graphs, you can see how all three components of the total return formula worked in our favor with our Grainger investment.

• Earnings grew threefold (and EVA increased even more, as you could see),
• we pocketed growing dividends,
• and the valuation multiple also expanded (i.e., the sentiment got better after Mr. Market realized that Amazon didn’t kill Grainger, but the challenge posed made it a better company).

As a result of all the above, we could generate a market-beating total return with this Fallen Angel of better-than-average quality.

If you liked this piece, you can learn more about the FALCON Method by taking a look at this free report.