One of the most striking observations (well, to me, anyway) is that very few investors take time out to re-calibrate their historical expectation settings with reality.
What I mean by that is that very few take a good hard look at what their expectations and forecasts were about a given stock at a given time, and to see where they made mistakes compared to events and outcomes that actually transpired, with a view to learning from those mistakes in the hope that they might avoid similar assumptions errors in the future, hence making them better investors.
One of the most valuable exercises that I have taught myself to do is to go back in time - sometimes many years -and audit some for the assumptions I had been making in assessing the quality and value of businesses, as well as compare the forecasts that I had made back then with what actually transpired in reality.
Given that forecasting is such an imprecise science, yet getting it right is so critical to investing wisely, one would think that investors spent more time honing their forecasting skills by reconciling from time to time whether they are making systematic errors one way or another.
For example:
- Am I consistently too optimistic, or vice versa? - Do I have certain confirmation biases? If so, what identifies them? - Am I too subjective? How will my investments fare in the “If-An-Alien-Landed-from-Mars” reasonableness test? - Can I effectively filter out “noise” and remain focused on the two or three critical drivers of shareholder value that each company has? - When things change, does my investment thesis change? - Do I take the viewpoints of so-called stock market specialists as being unequivocal truths - How much HOPE exists in my investment process, as opposed to structural and fundamental understanding of the businesses in which I invest (I happen to believe that 90% of investing is HOPE-based, and this is one of the biggest traps investors continuously fall into...there are several key warning symptoms when HOPE becomes the dominant driver of investor philosophy and one day when I am motivated enough, I will post an impassioned essay on the subject, because I believe people are blissfully unaware that it even exits, or how to identify it. Or how counterproductive it is. - Do I, in fact, HAVE an investment process, other than flicking through some charts, pictures and bullet points contained in company presentations and reading a few posts on HotCopper?
WES is a useful case study in this regard, and the debate that has been raging around WES for about half a decade now – since the controversial Coles acquisition – is whether or not they would be able to extract shareholder value out of the business, and if so, how much and at what rate?
As I always do from time to time, over the past few days I took the liberty in doing a bit of re-visiting some of the modelling input assumptions that I had made for WES two or three years ago – specifically for its Food and Liquor business, and comparing these with what has been delivered.
By sheer coincidence, at about the same time someone e-mailed me to remind me about the “somewhat futile” (her words, not mine) WES vs WOW debate that occurred on HotCopper some two years ago.
She (a self-confessed worshipper at the WES altar) pointed out that most followers of WES have been consistently too conservative.
I duly dug out one of the old posts on the WES thread (circa October 2010) with a view to re-calibrating my settings against reality:
The post involved a dsicussion between myself and another HC member, and compares assumptions made back then with subsequent outcomes over a range of parameters:
EBIT MARGIN: ASSUMPTION C55: "assume (conservatively, given the turnaround will only have started to have an impact) that Coles margins continue to improve at the rate of 40bp per annum. Given the considerable sales line of $30bn pa, this margin enhancement alone translates into incremental EBIT of $120m". AN Other: “I think 40bp/annum is achievable.”
EBIT MARGIN: ACTUAL OUTCOME It turns out we were both too conservative: the annual uplift in EBIT margin in food & Liquor has been closer to 60bp.
It warrants noting that while the additional 20bp above expectation might not sound a lot, when applied to $35bn of sales, it comes to an extra $70m in EBIT, a not-insignificant quantum in the context of overall Food & Liquor EBIT today of $1.3bn
SALES GROWTH: ASSUMPTION C55: "Add to that the incremental contribution from underlying sales growth (4.9% in the September quarter), which translates into incremental EBIT of $60m (4.9% of additonal sales on $30bn at a margin of 4.1% [3.7% plus 0.4%]). AN Other: “even with store revamp i can't see Coles maintaining 4.9% growth rate. My estimate 3.2%”
SALES GROWTH: ACTUAL OUTCOME Again, expectations have been handsomely exceeded on this critical parameter.
Not only was the 4.9% maintained, but it was exceeded by a factor of 1.1x since then.
Average Total Sales Growth has averaged 5.5% over the past three years, and same-store sales growth has averaged 5.0%.
Sales growth (same store figures in brackets) FY10: 5.6% [5.0%] FY11: 6.3% [6.3%] FY12: 4.6% [3.8%]
And strikingly, this has been achieved in an environment where the consumer has been on a protracted and deep shopping strike, with consumers sentiment remaining sluggishly trapped at multi-year lows
COMPETITIVE LANDSCAPE: ASSUMPTION C55: “So that's $180m ($120m + $60m) in incremental EBIT from Coles alone. For further context, this is equivalent to almost 20% EBIT growth for Coles (Coles FY10 EBIT was $962m). Any business delivering that kind of earnings momentum is unlikely to be met with much market hostility, in my opinion, especially when it is likely that that rate of growth is likely to be delivered for several years to come.” AN Other: “Whilst WES's retail sector revamp is bearing fruit, things are no so promising elsewhere. Caol section already taken 100m hit in Sept quarter due to rain. Poor weather continues and another (perhaps larger) hit is likely in Dec qtr. These alone wipe-out the 180m gain mentioned. Fertilizer: WES's sales almost exclusively in WA. Winter cereal crop 2010 is worst in 10+yrs. Fert sales were reduced. What fert has been sold has in many cases remained in farmer's shed ready for 2011. Hence, fert sales will be down from FY10. Just as importantly the 600lb gorilla (IPL) will begin selling nitrate ferts in WA by about mid 2011.... from a greenfield factory in Collie WA. This will be a game-changer. Insurance: Severe Perth hail storm in late 2009 hammered WES. Unlikely to be repeated. Bunnings has been an outstanding success. WOW are coming-in all guns blazing from late 2011 in time for Christmas. Plus WOW revved-up margins when Coles was in strife. This allowed both chains to make exceptional EBIT in general retail. This won't be repeated imo. Competition will be intense”.
COMPETITIVE LANDSCAPE: ACTUAL OUTCOME What is becoming increasingly clear that competition between these two grocery behemoths is anything but intense.
It is limited to merely the charade of “price wars” that placate the media and populist politics.
[”Down, Down, Prices are Down, my ar_e!”]
Cumulative EBIT uplift over the past three years from Food and Liquor alone will be over $500m.
BOTTOM-LINE GROWTH: ASSUMPTION C55:"So, even before WES' numerous other major businesses contribute to group growth, underlying bottom-line is growing at 7.5% pa. AN Other: :I can't see anything like 7.5% for WES in FY11 as outlined earlier.”
Again, the thing that hits home hardest is the fact that this superior, expectation-beating growth is all occurring at a time that the consumer is on his knees. With the RBA now clearly moving to vacate space in the economy that had been crowded out by the mining sector over the past 2 or 3 years, the consumer will find himself in a less anxious position over the next two years, I suspect.
COLES FOLLOWING WOOLWORTHS’ PRECEDENT: ASSUMPTION C55: “And there is a lot of precedent to draw on: take a look at what happened to WOW margins over the past decade as it invested on back-of-store efficiencies”: AN Other: “Yes, BUT WES is not WOW! Woolies have been champion Ozzzie retailer for 14 straight years. They are unlikely to surrender their crown.”
COLES FOLLOWING WOOLWORTHS’ PRECEDENT: ACTUAL OUTCOME It’s happening, without doubt.
INVESTOR PERECEPTION: ASSUMPTION C55: "Knowing how institutional investors think, they will be thinking that margin increases for Coles will not be simply a one-off, flash-in-the-plan exercise, but that once the transformational benefits start to have impact, they tend to develop a life of their own and the margin enhancement continues for a protracted period. While I think it to be premature to think this way, I am 100% sure that several fund managers will be attracted right now to the potential "optionality" of Coles approaching WOW margins". AN Other: “The SP of WES demonstrates that funds have indeed bought the WES growth story. But will they continue at above $32? I doubt it until outlook becomes clearer. WES persist in refusing to make a forecast for FY11.”
INVESTOR PERECEPTION: ACTUAL OUTCOME Investors not only bought the Wes growth story up to $32, they’ve bought it up further to $38. And as long as the growth story continues to be just that – and it will – investors will continue to buy it.
The funny thing is that the EV/EBITDA today – 8.8 times – is exactly what it was two years ago.
What’s changed is that the EBITDA has gone up, and in the EV part of the equation, some of the Net Debt has given way to increased market capitalisation in the form of a higher share price.
UNDERLYING PROFITABILTY VELOCITY: ASSUMPTION C55: "For the entire WES group, this would equate to a dramatic 35% increase to FY10 NPAT! Now I'm not saying that sort of improvement is in any way imminent, I am sure some influential insitutional enthusiasts of the stock will be happy to keep buy into that prospect, especially as the margin improvement is evident in each upcoming financial period, which I am sure it will be". AN Other: “As you note... more 'evidence' is required for buyers to continue.”
UNDERLYING PROFITABILTY VELOCITY: ACTUAL OUTCOME My expectation was that Group NPAT would be 50% higher (with the same issued share capital) over a five-year period starting in FY10 (FY10 NPAT was $1.7bn.
Within that ambit forecast, FY13 needed to be around 35% higher than FY10.
Based on consensus forecasts of FY13 NPAT of $2.35bn, that equates to a 39% uplift.
CONCLUSION: So what have I learnt from this exercise?
Well, that what really matter for WES is the Food & Liquor business, and within that, two critical variables, viz. Sales growth and resulting EBIT margin (self-evidently). [Yes, Bunnings is also a big earnings determinant, but Bunnings is well-understood and the differences in opinion on Bunnings is not nearly as diverse as it has been for Coles, so gaining a differentiated understanding the Coles part of the business is where the “edge” was in forming an accurate investment view of the company.
And then, specifically, in terms of my own forecasts, I was light on in both my sales growth and my margin expectations. And, I stress again, that this outperformance by the business verses what I has been anticipating, occurred during a sharp and nasty downturn in the consumer population in Australia, thereby rendering my forecasts doubly conservative.
Hopefully some people will find this sort of exercise useful as a sanity check and that it will help them become better investors.
Cam
WES Price at posting:
$38.01 Sentiment: Buy Disclosure: Held
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