Spin-offs

A few spin-offs on my radar screen

1) Dr. pepper snapple
2) ticketmaster
3) Brinks security holdings
4) home shopping network inc
5) tree.com

Long Case for American Express

American Express is a leading global payments, network and travel company that offers its products and services throughout the world.


Key Highlights

• Trading at 7X earnings
• Is the largest issuer of cards, with a broad array of charge, credit and prepaid products
• Best credit quality of anyone in the business, with premium customers
• Have successfully shed unrelated business to focus credit card ops
• High ROE (36% in 2007)
• Superior management
• Competitive advantage and long-term growth prospects
• Best service, and reward programs
• #1 in customer satisfaction
• Wide acceptance in US, and internationally
• Should be relatively unscathed by credit crisis
• Should trade at 18-21 times earnings

Investment Thesis

American Express issues charge and credit cards and even operates the transaction and processing side of the business. The business model which the company calls “ spend-centric” is to attract premium customers and drive spending on their cards and this results in significant competitive advantages. The average spending on an AXP card which is 4-5 times those of its competitors represents a greater value to merchants in the form of loyal customers and higher sales. This enables AXP to earn a premium discount rate and invest in greater value-added services for merchants and card members . As a result of higher revenue generated from higher spending, it has the flexibility to offer more rewards to its card members which acts as an incentive for them to spend more on their cards. This results in a positive feedback loop. The higher the rewards the higher the spending per card. This business model alongwith closed loop in which they are both the issuer and the merchant acquirer gives them significant informational advantage which they seek to leverage and provide greater value to it card-members, merchants and issuing partners. It has economies of scale in marketing, advertising and rewards and that is one of the competitive advantages. Credit card network is very difficult to replicate, it has a first mover’s advantage posing a massive barrier of entry for new entrants.

The key risk for AXP is default rate on lending and unable to get liquidity for funding its loans and receivable. However the company believes that it has enough liquidity to operate a year without access to financial markets.
The peak write-offs for AXP`s lending card were 9.6% in 1990-91 recession and 6.0% in 2001. Assuming a worst case scenario of 12% write-off rate, it will still break even.
I believe a very high quality business is available at an extremely cheap price

Value Investors and Cockroaches

In an extremely interesting book “A demon of our Design” author Richard Bookstaber , a Wall street quant with over 20yrs of trading experience explains the behaviour of the participants in the financial markets. While the academic community craved for physics like precision and complicated mathematics in economics and finance. Mr.Bookstaber came up with an interesting biology analogue for the economic behaviour of the participants in the financial market. He wrote a paper with his fellow MIT graduate student, Joe Langsam, entitled “On the Optimality of Coarse Behavioural Rules”.
He explains that the best measure of adaptation to unanticipated risks in a biological setting is the length of time period a species has survived. One that has survived for hundreds of millions of years is considered to have a better strategy to adapt to unanticipated events than the one that has survived for short time period. A species that is prolific and burgeoning but then dies because of some unanticipated event may be considered as having a good strategy for dealing with expected events but not with the unexpected ones.
From that point a cockroach is a prime example because it has survived numerous unanticipated changes in the ecosystem – from jungles turning to deserts and facing different predators and countless other unforeseen changes. But what is extraordinary about cockroach is that it has survived all these unanticipated changes with a simple defense mechanism of moving away from slight puffs of air, puffs that might signal an approaching predator. He refers to this mechanism as a “coarse and sub-optimal behaviour”. This mechanism ignores a wide range of information and risks but still survives for a longer period of time than the other highly adaptable and sophisticated species such as furu, a perch like fish of lake Victoria in Africa which was finely tuned to its environment and developed numerous skills and evolved into a number of species each with its own special skills. however they became extinct when a Kenyan game fisheries officer introduced nile perch into the lake. Its extinction was just a result of dumb luck that someone had introduced an alien species into the lake. This situation seems similar to the LTCM debacle where the default of Russian bonds an unanticipated event became a cause of their demise.
According to Christopher Browne, Managing Director of Tweedy Browne Funds true value investors are cockroaches of the investment world with a simple strategy of eschewing leverage, staying within one’s circle of competence and eventually demanding a substantial margin of safety whereas furu is akin to today’s highly leveraged hedge fund investor seeking to eliminate risk by adjusting his portfolio with the help of numerous complicated probability models at his arsenal

Accounting for Stock Options

One of the most elusive accounting concepts for me has been stock options. How does one account for stock options? Should it be expensed from the income statement as a cost? Or should we only increase the number of shares and thus dilute the earnings for the shareholders. Mr. Marty Whitman, Chairman of Third Avenue Funds suggests that from a creditor’s and company’s standpoint stock options should not be expensed as it is not a cash charge and has no effect on credit-worthiness of a company. He certainly believes that stock options are compensation from a stockholders point of view but given that stock options result in dilution, their effect is best reported in the dilutive effect of the earnings per share rather than as an expense for the company. According to him, Mr. Buffett’s view about stock options is an over generalization and that stock options are not a cost to the company.
He believes that it is a fallacy to consider cost of options to the company as equal to the value of the options to the recipient. To drive home his point he even cites an example where a sales clerk buys a $100 sweater for a 40% discount from her department store for $60 and the store incurs $100 as cost because that is what the sweater is worth to the sales clerk even though the actual cost for the sweater might be $35.
But I don’t agree with Mr. Whitman. The above situation is not analogous to stock options.
Options are given with intention of retaining talent and are the cost of retaining talent. So they must be definitely expensed as a cost in the income statement. Its similar to the cost of labour and cost of capital, the cost the company must bear to recruit labour and capital. Even when the store sells sweaters at 40% discount its is incurring a cost of $40 to retain its sales clerk and if it becomes a industry wide practice it would become compulsory for the store to give discounts to its employess and would eventually become a necessary $100 cost to retain employees beacause that is the value of the sweater to the company also. Mr. Whitman has explained his views from two perspectives, one of the creditor and other of the stockholder but from neither standpoint he believes stock options to be expensed as a cost from the income statement. But I believe atleast from a shareholders standpoint its a cost which must be expensed from the income statement.
By the way I read this matter about stock options from Martin Whitman’s letter, 2002

Brands Demystified

Often people misconstrue brands as a form of competitive advantage.Firstly,What is competitive advantage? it means that it allows an incumbent firm to do what its competitors are not able to do or it deters them from emulating the incumbent firms strategy.it is an effective barrier to entry.So, basically barriers to entry and competitive advantage are the same thing. Only incumbent competitive advantage has value and not entrant competitive advantage bcoz entrant competitive advantage implies absence of barriers to entry for the incumbent firm. By definition, a successful entrant becomes an incumbent and then is vulnerable to the next entrant and the process continues with the every new entrant replacing the previous incumbent and this implies that are no competitive advantages neither for the incumbent nor for the entrants.
Now lets consider brands which are often mistaken to be a source of competitive advantage. Branding is like any other asset of a company which requires investment in form of marketing and advertising. By branding a firm can only make its presence felt in the market. It is an important asset of the company and cant be taken in a a loose manner but at the same time it doesnt deserve so much hype it gets compared to other assets. Its just an important asset of the company and by itself it will not drive excellent returns for the business. It wouldnt protect a lousy business. A competitive advantage is something which enables a business to earn high return on invested capital and keeps the rival at bay. It enables it to take away a disproportionate share of the market. A high return on invested capital and a disproportionate share of the market is a tell-tale sign of presence of competitive advantages or barriers to entry. Not many branded products show high returns and dominate their markets. they might show high returns in the short-run but not in the lon-run
It is not branding per se which drives the returns of the business but economies of scale with high customer captivity. Most of the branded products are in a market called monopolistic competitive market where in the long-run they dont tend to be highly profitable because there arent any effective barriers to entry. A monopolistic competitive market is defined as the one where there are large no of firms selling similar but differentiate products which means that the products sold by different firms are close but not perfect substitutes of each other
For example : soft-drink market,apparel market and various other brand oriented markets. Theoretically, in the long run in a monopolistic competitive market firms are not highly profitable and their profitablity tend towards zero.
For instance, consider the soft-drink market where there are a number of brands which differ slightly from each other in terms of taste and to some extent in color. In a study of demand for colas which used a simulated shopping experiment to determine how the market share of a Royal crown and Coca-cola changes in response to its price. In other words how elastic is the demand for a brand.


It was found that Royal crown is much less price elastic than coke i.e its demand is not much reponsive to price increases. The study seems to suggest that consumers are more loyal to royal crown and it has more brand loyaly than coke. But even because of higher brand loyalty it is not more profitable than coke. Profits depend on fixed costs and volume, as well as price. Coke will generate more profit beacause it has a much larger of market. Its the economies of scale which enables coke to spend heavily on advertising,marketing and distribution and this practice over a long period of brand reinforces the brand and keeps new brands at bay. Competitive advantages are supposed to protect profits and brand loyalty doesnt pass on that terms. Its the inherent characteristic or nature of the product which makes the customer more loyal to it than brands. people in america are habituated to coke and that is because of the first-mover advantage for the coke and the scale which enables it to sells at such a low price- the price difference between coke and any other brand is few cents and that prevents its consumer from switching to alternate brands just for price difference of a few cents.
Being a first mover in the market is more important thand brands.
At the end of the day brands are just necessary cost of doing business and making a presence in the market , nothing more and nothing less.

Innovation doesnt seem that Innovative

Professor William Duggan teaches strategy course at Columbia wherein he attempts to explain the strategic success in the realm of all human endeavors right from business to politics to war. He set out to discover why the word strategy was not used until 1810, a time when napoleon was at the zenith of his power. At the same time a German military analyst began his treatise called On war in which he endeavors to explain the key elements of napoleon’s success. He attributes napoleons success largely to what he calls coup d’oeil, which in French means “glance”. According to Clausewitz napoleon had an encyclopedic knowledge of military history which enabled him to apply successful tactics of past generals to new situations. He didn’t pursue territorial objectives but sought opportunities where he could replicate successful tactics of past battles. It was just a new way of combining past ideas and adjusting it to new situations. It was as if he was looking for some recognizable pattern wherein he could apply the same old successful ideas instead of any novel ones.
Research on expert intuition suggests that in urgent situations people make decisions by combining analysis of past experiences with a flash of insight. In the 1990s psychologist gary klein studied the decision making processes of people which were usually involved in some emergency situation or the other like nurses, firemen and soldiers in battles. Initially they attributed their decision making to insight however further probing revealed that they actually combined past experiences from their memories to the situation at hand. Our brain tends to take whatever it can and then it compares it with the things already present and when it finds a combination we get an insight. This process is opposite to innovation but this is the way innovation actually happens.
One can actually have a strategic framework wherein one first needs to stock his memory shelves with as much examples as one can pertaining to that field and then to open the mind to coup d’oeil one requires presence of mind which is to expect the unexpected and avoid forming any preconceived notions about the solution. This implies refraining from creating any plan prior to deciding a goal. But instead one must keep searching for opportunities and include an element of flexibility i.e willingness to move forward without detailed plan and also to change direction if better opportunity presents itself. Instead of starting with the question, What’s the goal? One must start with, What’s a good goal? And a good goal is the one to which one can see some way of reaching. One must not decide a goal on the basis of appeal but on the basis of some way to achieve it. The idea of having multiple possible directions is much more realistic in life and gives many more options. Just remember that some opportunity may arise that will take you somewhere better.

For Further Reading
Napoleons Glance by William Duggan