Update No. 147 – 25/01/14

In early May 2012, I talked about the ‘stock-pickers quandary’, whereby one need to consider ‘franchise’ valuation and long term earnings potential. I would like to revisit that today, because I think it serves as a useful example of how powerful the ‘franchise’ value is.

In the intervening 20 month period (I will ignore currency, assuming they both trade in a common-$, forgetting AU$ & US$) Costco (NYSE: COST) have risen from $86.64 to $112.80 and paid out $9.03 in dividends, for a gain to investors of about 40.6%. In the same period, Woolworths (ASX: WOW) has risen from $26.42 to $33.98 and paid out $2.00 in dividends for a gain to investors of about 36.2%.

At the time, I declared if I was buying on a 3 – 7 year horizon (and these were the only 2 options), I would buy Woolworths because it offered greater downside protection in the event of an unforeseen economic upheaval as its valuation at market was closer to its Intrinsic Value, but if buying with a 20 year+ horizon I would choose Costco, because it was the superior business and despite the Intrinsic Valuation being well below the current market price, the IV of Costco would compound at a higher rate over 20 years.

The change in the IV’s of the companies demonstrates the ‘franchise’ value I was talking about. Based on a pretty similar revisitation of their respective IV’s, I derive $86.70 for Costco (52% up from $57 calculation in May 2012). The Woolworths IV in the same period increased to $30.20 (up 14.3% from the $26.42 calculation in May 2012). In respect of this, it has closed the gap between the IV and market price for these two businesses. Faced with the same choice, I would probably now select Costco for both the 3 – 7 year investment and for the 20 year investment.

This is an admittedly very short period to make this assessment of ongoing franchise values, but the demonstrably superior franchise Costco has shown its advantages fairly swiftly, for despite comparable share price movements, the Intrinsic Valuation of Costco has grown more rapidly. There are obviously business specific considerations to the calculations, Woolworths are rolling out the Masters hardware franchise and have incurred losses as they try to build critical mass to compete with the 800 pound Gorilla that is the Bunnings chain. If Masters can eventually become even a modestly competitive No. 2 player in Australian hardware, there will be a strong uplift in earnings due to this, if for nothing else than the cessation of the drag of losses on Woolworths earnings from Masters. If this happens over the next say 3 or 4 years, the IV growth of Woolworths may outstrip that of Costco in the period. Eventually, the superior long-term franchise of Costco would result in faster IV growth and higher investor returns I expect. Woolworths is still a very good business and likelier than not its performance over any lengthy period will probably exceed that of the market in which it operates, but Costco is better.

The period since I made this assessment was a very good one for equity markets, but the foregoing example bears considering. Charlie Munger has said:

“I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power.”

The investor would do well to consider the power of a good business franchise for the same reason; for I think I could easily get to Charlie’s age and find myself saying:

“I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of a good business franchise, and yet I’ve always underestimated that power.”

If I can find myself saying that, you can be sure we will have been very successful over the 50 intervening years. If I can avoid underestimation, we could do even better – Tony Hansen 25/01/2014

EGP Fund No. 1 Pty Ltd. Down by 0.68%, leading the benchmark by 1.40% since January 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 63.18%, leading the benchmark by 40.52% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}