Reasons to sell the Theme Park or the McDonald's
- Fundamental, economic sea change. (Instead of burgers, consumers opt to eat heads of cabbage for lunch on a permanent basis. Consumers opt to visit free, online theme parks or in other words, video games.)
- Erosion of business fundamentals.
- Prolonged, bad management - you just can't trust them and/or they are not capable, they appear to be sticking around.
In the situation of consumers switching to heads of cabbage for lunch, I would have to argue that McDonald's would adjust and accommodate and offer McCabbage. Still though, a permanent consumer taste shift could impact the business and diminish its long term prospects. In the case of a Disney theme park I would argue that Disney provides much more than a mere "theme park" experience through its established, proprietary environment of magical characters and moments establishing a deep, wide moat that is difficult for other businesses to cross.
Which leads to ...
The Erosion of Business Fundamentals
This effect will show up in the quantitative fundamentals of the company. Earnings per share will diminish over time along with return on equity. This will be a long-term, five to 10 year degradation, not an immediate microwaved result. It should be apparent that the business is not going to return to its heyday. In the case of bad management, shareholders and the board of directors should oust them but they may be around to stay.
Any of these situations, if permanent are legitimate reasons to seek higher ground.
If you conclude that you would never sell a McDonald's franchise based on one-time, anomalic events (an outbreak of mad cow disease for instance), why would you ever sell a stock position in the company for the same reason.
Stock ownership after all is business ownership. It represents a portion of the capital structure of the publicly traded business, an equity portion, which entitles the owner to a sliver of returns for the year or the earnings per share. Part of this is paid out as dividends, the rest is retained for a high ROE snowball effect in a wisely chosen business that continues to exhibit superior economics and capable management.
Why would you ever sell a portion of ownership in great businesses such as Coca-Cola, McDonald's or Wal-Mart if they continued to exude outstanding economic strength? Why would you ever sell your Disney theme park if the turnstiles continue to churn rapidly year after year?
Of course, in the McDonald's scenario, if instead of a McDonald's you owned a Rally's and Bob's McDonald's was up for sell at a discounted price, you certainly would want to consider selling the Rally's and purchasing the McDonald's if the ROE trade-off was favorable. Let's say the Rally's generates a 10% return on the invested equity in the business and McDonald's comes in at 20%. Ceteris paribus, the McDonald's franchise appears to be the better investment. The same decision methodology applies to the world of stock ownership.
On the same token, if you literally owned a Disney Theme Park, a theme park located just down the road from your house, would you consider selling the entire theme park because attendance has dropped off for one year? Would you sell after 2 years or 3 years? I believe the answer is no. If the long-term track record illustrated a superior economic power-house, I believe you would wait a number of years to see if the tide has truly turned, and for most of these powerhouses, the superior economic fundamentals will resurface and resume delivering outstanding returns.
Stock ownership under the Buffett methodology is literally the same thing except the ownership portion is fractional as opposed to owning the entire theme park. Still, the owner is entitled to his share. You might not own the entire theme park, but still owning just one ride proves to be highly profitable.
A great business and its EPS is like an equity bond with an expanding coupon. An investment in a Disney equity bond at the time of this writing will yield an approximate 5% rate of return at today's prices with a coupon that is expanding at about 19% a year.
In the example of the McDonald's franchise ownership, the assumption is that a sane rationale person would not sell the McDonald's franchise based on a one-time anomaly event such as a breakout of mad cow disease that effects earnings for one or two years. The same rationale person would conclude that the McDonald's franchise will resume and continue to deliver outstanding results year after year given quality management and barring catastrophic variables.
Furthermore, the same rationale person will realize that Bob (Mr. Market in Graham circles) is being highly irrational in putting a price tag on his business based on today's irrational prices, a low price, and will realize that the relatively predicable earnings of tomorrow can be bought at a deep discount today, thus increasing the return. It is wise to buy dollar bills for 60 cents when possible. The Bob's of the world (Mr. Market) can be a partner, one who presents future earnings at discounted prices from time to time, a servant partner, not a master. When Mr. Market is euphoric and giddy and selling at exorbiant prices, it is best to politely decline. He is never offended and will return with new offers.
In the world of Warren Buffett, a stock represents part ownership in a business. If selected wisely, it represents part ownership in a great business. Tying it back to our Disney theme park and McDonald's franchise examples, if you held ownership in each of these businesses, when would you ever sell it? I would argue never.
In general, great businesses will continue to exude outstanding financial performance and deliver substantial returns to shareholders well into the future. Even though you do not own 100% of the business under partial stock ownership, you certainly hold a fractional interest of the same great business that a McDonald's franchisee owns and thus you are entitled to a portion of the earnings of the overall business. If you owned a Disney theme park in its entirety, you would reap the rewards after expenses of the tickets sold and folks churning through the turnstiles to ride It's a Small World. With stock ownership of the business you are entitled to a "piece" of the gate as well.
A great business and its earnings per share in the world of Warren Buffett is an equity bond with an expanding coupon. In other words, the business with a consistent track record can be expected to deliver a steady "payment" that grows over time.
An investment in a Disney equity bond at the time of this writing will yield a 5.03% return (2012's EPS of $3.13 divided by the current stock price of $62.17) and this return, theoretically, will grow at a rate of 17.77% a year. (This is Disney's historic 10 year EPS growth rate which is found by using a handy dandy BI Financial calculator and computing I/Y using 2002's EPS of $.61 as the present value, 2012's EPS of $3.13 as the future value and 10 for the number of years.) This means that Disney's equity coupon of 5.03% will grow by .894% each year - in 2013 it should deliver a 5.93% return, by 2014 a 6.82% return, by 2015 a 7.72% return, so on and so forth.
For McDonald's, at today's current price of $95.03, the company will deliver an initial rate of return 5.64% that will grow at 18.28% per year, an increase of 1.03% a year. By 2013 the McDonald's equity coupon bond should deliver a 6.67% return, by 2014 a return of 7.7%, by 2015 a return of 8.73% so on and so forth. Again, this growth rate is found by calculating the company's 10-year historic earning growth rate.
Warren Buffett considers the returns of company's such as these to be "bond-like" for three chief reasons:
- The company's in question have strong, consumer monopolies - an economic moat that is not easily crossed.
- Management has a penchant for consistency, honesty and integrity.
- The business has a consistent operating history with a proven track record of earnings, return on equity, low levels of debt, retained earnings, share repurchases and the ability to price with inflation.
Because of this calculus, the investment can be considered an "equity-bond" that is much more of a "surer" thing than its weaker peers. These fundamentals allow an investor to have confidence in the Disney "equity bond" which pays a 5.03% coupon that grows 17.77% per year and the McDonald's equity bound of 5.64% that grows 18.28% a year. At the end of 10 years, at today's prices, McDonald's will pay a coupon of 15.95% coupon and Disney will pay 13.98%. A $10,000 investment in each will result in yearly earnings of $1,595 and $1,398 respectively by year 10.
What this means for you is that for each $10,000 invested in the franchise (theme park, burger stand, falafel chain), the business will generate a consistent (in theory, consistent) $2,000 in earnings or return over the log haul. A $100,000 investment would equate to a $20,000 return, so on and so forth. Let's suppose that the next best deal in town will deliver a 10% rate of return so, all things equal, the McDonald's franchise appears to be the better deal - in addition to the superior rate of return it has sold hundreds of thousands of hamburgers over the last year last year and shows no signs of slowing. (side note: Wal-Mart sells approximately $42 million worth of stuff an hour ... that is by the hour ... not by month, week or day ... $42 million an hour! That is a lot of bean bag chairs and certainly something worth owning a piece of.)
Now, back to our McDonald's stand, let's say that a breakout of mad cow disease causes sales to plummet: the global populace is now scared of all things beef. As a result, earnings tank and ROE for the year comes in at a paltry 3%. (The $10,000 investment generates $300 for the year.)
You are now faced with two options:
- Sell the business at a deeply discounted price - because of the beef scare, the business will be valued at an irrational, lower price. You reason that things are grim and this whole mad cow scare has left you deeply depressed about the future prospects of the business.
- Purchase Bob's McDonald's franchise just down the street because unlike Bob, you understand that the current calamity is merely a hiccup in the long-term track record of a business that has generated a substantial return on equity over the years. Now is the time, you reason, to double down (at a discounted price) on a successful, economic power-house that will most likely continue to deliver substantial returns well into the future.
Can you tell which option I lean towards? Under option number two Bob fears that even though his franchise has been delivering earnings to the tune of about 20% to equity over the years, his short-sighted, panic induced behavior is causing him to act irrationally, and sell at a discount. Bob truly believes that the golden days of strong earnings will never return even though the fundamentals of the business have not changed. Either that or he is a different type of investor, one who was never truly a business owner to begin with. Bob perhaps is a speculator, one who would gamble, place money at the track or play the lottery with the
ingrained belief that gambling is a
legitimate way to progress economically.
Which option would you choose?
In 1919 Coca-Cola's stock was cut in half from the price of $40 a share to $19 a share. Even if an investor had bought the company at the pre-drop price of $40 a share and had held onto it through the 50% drop for the next 90 years, the investment would be worth just over $5 million.
If you owned a Disney theme park, literally owned a Disney theme park that was located just down the street from your house, and if you owned it in its entirety, the whole shebang, and you received a portion of the ticket revenue coming in everyday, can you think of a reason for why you would ever sell the park?
What about McDonald's? What if you owned a successful McDonald's franchise, one that churned thousands of cars through the drive through each and every day, breakfast lunch and dinner. If you owned this McDonald's on your own local Main Street U.S.A., why would you ever sell it?
For argument's sake, let's say the business generated strong, consistently increasing earnings year over year for the past 20 years. This means that the bottom line of the income statement has been improving either through increased sales, expense reduction or a combination over the years. Additionally, the business has turned in an excellent return on equity (the earnings return divided by the public ownership portion of the capital structure) average of 20% for the same time period and the business has little debt.
Bottom line: this business has been putting money in your pocket for some time. It has been generating healthy bottom line earnings based on the amount of equity you have put in the business, some of which you have retained in the business for further 20% ROE investments, some of which you have distributed to yourself as a dividend. (But get this: the portion you have retained in the business has added to value to the equity portion of the balance sheet, so even the portion of earnings you have not put in your pocket has essentially been reinvested in an outstanding business which has subsequently grown in value at a 20% rate of return over the years.)
The Carousel of Progress
In 1964 Walt Disney unveiled a New York City World’s Fair attraction consisting of six theaters with a fixed stage encircled by a ring of rotating seats that transported audience-members through the innovations of the 1900s, 20s, 40s and to a nondescript, future horizon. The “Carousel of Progress” served as part GE commercial but also as a panoramic view of the innovations of yester-year detailing the “towering”, 20-story buildings, moving pictures, gas lamps and soda fountains of the 1900s, the single-engine planes, sports-stadiums, radios and in-door plumbing of the 20s and the automatic dishwashers, televisions, and refrigerators of the 40s. Each “theater-era” represented a different season - spring, summer, fall and winter respectively - all transitioning to the tune of the Sherman Brothers, “There’s a Great Big Beautiful Tomorrow” and revolving to rest on a final act four: a futuristic “family of tomorrow,” on the crest of New Year’s Eve.
The Threshold of a New Year
Over the years the attraction underwent five major updates in 1967, 1975, 1981, 1985 and 1994, which chiefly focused on the family of act four and their “marvelous” technologies. As each era bore down on the animatronic family making them obsolete, it was necessary to upgrade the group with new innovations - satellite TV, the personal computer, virtual reality - in order to keep them ahead of the curve and dangle them out in the future.
The task of deciding what innovations to place in the scene would be a difficult one indeed, but it would prove interesting to be in the shoes of the Disney Imagineer tasked with updating act four of the Carousel of Progress. What representative, future innovations would you place in the final New Year’s Eve scene?
Here’s my list:
The Steve Jobs Textbook
In the fall of 2010, Steve Jobs met with President Obama and expressed his views that America’s educational system was “hopelessly antiquated” and structured to treat teachers as unionized, industrial assembly-line workers instead of professional educators. He suggested that schools should stay open longer and found it absurd that American classrooms were still based on teachers standing at a chalkboard teaching from a textbook.
He envisioned a future in which kids did not have to lug around heavy textbooks that had been filtered through a corrupt certification process and he believed that all “books, learning materials and assessments should be digital and interactive, tailored to each student and providing feedback in real-time.”
Since Jobs’ passing in October of 2011 Apple has carried forward the torch of the textbook revolution. Here’s how they have fared:
An Apple for the Teacher
In January of 2012 Apple held an education event in New York and revealed three key, iPad-centric features, that will help reinvent the old-fashioned textbook: 
1) A partnership with major, educational publishers
2) iBooks 2 and
3) iBooks Author
Although Jobs original vision was to “hire great writers” to create digital textbooks, Apple has decided to partner with the publishing houses that employ them. Apple revealed partnerships with McGraw-Hill, Pearson and Houghton Mifflin Harcourt who when combined publish about 90% of the textbooks in US schools.
In addition to providing many of the key, original iBooks app features such as pinching to zoom, page flipping and book-marking, the new, free iBooks2 app provides an enhanced interactive experience for textbooks. For example, a biology book can have animated 3D cell structure models, DNA animations, tap-on, in-text glossary terms and search features. The app also allows digital, “swipe” highlighting and simple note-taking features which can be transformed into digital index cards for study purposes. Also, in keeping with a key Jobs’ initiative, the books provide real-time, immediate feedback for end-of-chapter review questions.
The textbooks are available in Apple’s iBookstore for $14.99 a piece, an already contentious price between Apple and its partner publishers. Jobs wanted them to be free and included with the iPad. 
iBooks Author is a free, simple, drag and drop authoring and self-publishing app used to create the textbooks.
Industries Impacted: Education and Publishing
Educational publishing is an $8 billion industry and publishers seem to see the writing on the iPad and are positioning themselves ahead of the sea-change. iTunes helped to save the music industry by legitimizing the music file download process and it appears that the iPad and iBooks are poised to do the same for publishing. McGraw Hill “admitted that its business would be altered by selling directly to the students at a lower cost, but making it up on volume with non-transferable books that would need to be purchased by every student, every year.”
Item One to be Placed in The Carousel of Progress: an iPad.
The Singularity is Near
Ray Kurzweil and Nanotechnology
Ray Kurzweil is an author, inventor and “futurist” who predicts that by 2045 technologists will have recreated the full power of human intelligence in a machine, resulting in a billion-fold increase in intelligence that allows humans to transcend limitations and reach immortality. This profound change as detailed in his 2005 book The Singularity is Near, stems from a series of steps or epochs of evolution leading to the merger of technology and human intelligence, creating a universal saturation of intelligence. Ultimately, the universe will “wake up.”
Kurzweil is not completely out of left field either: he is the principal developer of the first CCD flatbed scanner, the inventor of the first print-to-speech reading machine for the blind, a member of the Inventor's Hall of Fame and a recipient of the National Medal of Technology.
Two key variables underlie Kurzweil’s theorem:
1. A Law of Accelerating Returns - essentially an enhanced version of Moore’s Law, which indicates that computing power is roughly doubling every year, leading to smarter, smaller and cost-effective technology.
2. Nanotechnology - Epoch Five in Kurzweil’s world in which technology integrates with biology and masters its methods, including human intelligence. 
In 30 or 40 years according to Kurzweil, microscopic machines called nanobots will travel throughout human bodies, repairing damaged cells and organs, effectively wiping out diseases. This technology will also be used to back up memories and personalities and ultimately, we will “replace our frail, ‘version 1.0’ bodies with a greatly enhanced version 2.0.” 
Kurzweil believes that by 2024, instead of time running out, it will be running in and humans will be adding a year to life expectancy for every year that passes, reversing the loss of remaining life expectancy.
Features of Kurzweil’s Nanotechnology
· Enhanced physical and mental capabilities
· Radical life extension through the destruction of pathogens, cancer cells, toxins and debris
· DNA error repair
· Reversal of the aging process. 
· Expanded biological intelligence 
In the Real World
Researchers at MIT are already using nanoparticles to deliver killer genes to battle late-stage cancer and claim they have killed ovarian cancer in mice. Scientists at the University of London recently reported using nanotechnology to blast cancer cells in mice and the tests have shown that the new technique leaves healthy cells undamaged. 
Industries Impacted: Healthcare and Technology
The $5 trillion, world-wide health-care industry will be decimated by a proliferation of life-sustaining, health-enhancing technology such as nanobots while the technology sector, by default, will boom. Patients will receive check-ups from nano-technology specialists instead of doctors and thus, it may be necessary for doctors to receive nanobot, skillset updgrades.
Item Two to be Placed in The Carousel of Progress: a copy of Ray Kurzweil’s The Singularity is Near. (A nanobot would be too small to see. It’s a small world after all.)
A Cure for Cancer
The Story of Steve Jobs and Molecular Targeted Therapy
In 2003 Steve Jobs learned that he had a rare form of islet cell neuroendocrine cancer which, if caught early, had a “real potential for cure.” In lieu of surgery though, Jobs treated the disease with a 9-monh regiment of alternative, dietary restrictions and juices. Subsequent scans revealed that the tumor had grown and in July 2004, Jobs underwent a modified Whipple procedure that removed the right side of his pancreas, gallbladder, parts of his stomach, bile duct and small intestine.
In 2009, Jobs received a liver transplant in Memphis, an indication that the cancer had spread beyond the digestive system. Finally, in 2011, Jobs resigned as CEO from Apple stating that “I have always said if there ever came a day when I could no longer meet my duties and expectations as Apple’s CEO, I would be the first to let you know. Unfortunately that day has come.”
“Although Jobs passed away in October of 2011, a positive result emerged from his treatment: a focus on molecular targeted therapy.
Jobs was only one of 20 people in the world to have the genes of their cancer tumor and normal DNA sequenced in entirety. “By knowing the unique genetic and molecular signature of Jobs’ tumor, his doctors had been able to pick specific drugs that directly targeted the defective molecular pathways that caused his cancer cells to grow in an abnormal manner.”
This molecular targeted therapy approach allowed doctors to shed traditional chemotherapy, which attacks the division of all of the body’s cells, and instead select more effective drugs which at times, according to Job’s biographer Walter Issacson, appeared to be a silver bullet allowing them to stay ahead of the cancer.
This treatment is not new, but certainly, Job’s regimen has placed a spotlight on the treatment and created enthusiasm in the medical community: Dr. Matthew H. Kulke, a physician at Harvard-affiliated Dana-Farber Cancer Institute in Boston states that drugs such as these are “exciting alternatives to conventional chemotherapy that has been the mainstay since the early 1990s” and “they have been shown to cut the growth of metastatic pancreatic neuroendocrine cancer in half.”
It is not much of a leap to envision a time in the near future when advanced cancer treatments such as molecular targeted therapy and nanotechnology converge to effectuate a solution for cancer.
Industries Impacted: Healthcare
Healthcare will again be impacted by this innovation and as technology scales and manufacturers are able to mass-produce targeted, effective drugs, costs should diminish.
Item Three to be Placed in The Carousel of Progress:
Disney has somewhat beat me to the punch on this one. With the renovation of Epcot’s Spaceship Earth in 2007, a bearded, long-haired man who looks like Jobs working in a California garage on an early version of the personal computer, has been added to the end of the attraction. The company claims that it is not in fact Steve Jobs but a composite of all the early pioneers who worked on the first personal computers. I believe the presence of even a “composite-Jobs” in the attraction serves as a reminder of his contributions but also as a reminder that perhaps a solution to cancer lies on the near-horizon. I of course would move the figure to the Carousel of Progress.
The Bottom Line - Now is the Time
The future is difficult to predict just as it is nearly impossible to keep the Carousel of Progress’s “Family of Tomorrow” up-to-date and relevant. Although it may seem trivial to figuratively place items in the den of the New Year’s Eve family, the exercise to me seems to indicate that we stand on the precipice of extraordinary breakthroughs in science, healthcare and technology, innovations that create a gate-way to a great big beautiful tomorrow.
 http://jeffwartman.com/steve-jobs-on-education/ - from Walter Isaacson’s bio on Steve Jobs
 http://jeffwartman.com/steve-jobs-on-education/ - from Walter Isaacson’s bio on Steve Jobs
 http://jeffwartman.com/steve-jobs-on-education/ - from Walter Isaacson’s bio on Steve Jobs
 Issacson, Walther. Steve Jobs
Why Warren Buffett?
He takes partial if not whole ownership interests in consumer monopoly companies with strong and steady earnings, healthy returns and the ability to reinvest earnings for continued compounding. The bottom line is, if you invest like Buffett, you can count on capital gains with cash flow regularity, similar to a quality “rental property” with consistent returns. Dividends will serve as icing on the cake.
The recommendation then, in order to make the transition from the cash flow world to an “acceptable” world of mutual funds is to:
· Invest in mutual funds that invest like Buffett, buying into major Berkshire holdings such as Costco, Coke and Wal-Mart.
· Invest in funds that invest in Berkshire Hathaway.
· Invest in Index Funds as Warren Buffett recommends if you choose to not play the single stock game.
Warren Buffett Versus the Cash Flow Investor – Round One
If Warren Buffett were here he would say, “I want to invest in a consumer monopoly company that exhibits a strong track record of earnings with the ability to retain those earnings at a high rate of return.” He would go on to state, “Why would I withdraw the return from my investment as cash flow and suffer the consequences of having the tax-man over for supper? I will leave the gains within the vehicle thank-you very much.”
And our cash flow investor will say, “But I need cash flow to be financially independent. I must cover $3,000 in monthly expenses otherwise I will be stuck working at this rubber chicken factory the rest of my life.”
But, the cash flow investor will also agree with Warren Buffett on many key points: “Buffettology” involves investing from a business perspective which includes evaluating an investment’s profit and loss statement for consistent earnings and rate of return. A cash flow, rental property investor will construct a pro forma income statement using rents as income and vacancy losses, property management fees, repairs, maintenance, insurance, taxes and principal and interest payments as expenses and evaluate for “cash flow” and rate of return based on the initial investment. Both agree that earnings and not speculative growth lead to appreciation, and that a lower price will increase the return. Thus, an important bridge forms a connection between the cash flow investor and the stock universe, the business perspective investment methodology of Warren Buffett, and it is not too much of a logical leap to approach mutual funds as a cash flow vehicle from this beachhead.