YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

Early Lessons

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Back in 1997, all my friends were constantly shopping at The Gap. This was during my early days of learning about the basics of investing. It was clear to me that Gap Inc. (GPS) was going to be a fast growing company. As most people do, I assumed this high growth meant it would turn out to be a fabulous stock investment. So, I told my father he should consider buying the stock for The Yacktman Funds. That day, my father wanted to teach me three lessons.

First and foremost, he taught me a great business bought at a high price is a poor investment. He explained that while I may be right that Gap will grow quickly in the ensuing years, if I overpay for the stock, it’s as if I’m selling away all the growth. He said everybody saw the growth potential, and as such, Gap was expensive. As Buffet has been known to say, “You pay a very high price for a cheery consensus.”

Initially, I thought I had perhaps outsmarted my mentor. At the end of 1997, the stock was trading around $15.50/share and one and a half years later it was trading above $51/share! In fact, over the next three years, revenues/share at Gap compounded at an annual rate of 30%. But looking at the long-term, he gave some sage advice. Let’s take a look at the numbers from 1997-2007 (I’m not including 2008 to avoid any effects of the recent downturn). Using Valueline figures, revenue/share and earnings/share compounded annually at 11.3% and 12.8%, respectively. However, an investment in Gap (including dividends) would have returned 3.1%.

Talk about selling away the growth! Despite great growth, as an investment, you would have just barely beaten inflation over that decade. True, you could have done very well buying and selling a year and a half later, but this lesson has taught me the dangers of what I like to refer to as “tidal wave” investing. Sometimes you ride the wave well, other times you crash and burn. It’s more a function of correctly guessing emotions – also referred to as the greater fool theory – I can always count on there being somebody dumber than me that is willing to pay a higher price.

The second lesson: a fast growing business on the top line doesn’t always translate to fast growth on the bottom line. He referenced the airline industry. Over the past century, this has been one of the fastest growing industries. However, if you sum up all the profits in the industry since Kitty Hawk, they are negative! While there are many reasons for this, one of the main reasons is because of the capital intensity. For every $1 invested, you only earn 60 cents in revenue! Essentially, every dollar they earn goes right back into the business to keep on surviving. But it doesn’t prosper and throw cash off to the shareholders. Talk about a lousy business! But in the case of Gap, they passed the test. From the statistics above, you can see EPS compounded nicely.

The final lesson: always be careful in the clothing industry. It is fad-like and thus more unpredictable…the winners can be uprooted as quickly as they became popular. For Gap’s sake, fortunately they’ve done quite well in changing styles enough to avoid becoming obsolete. So far, their brand has seemed to stand the test of time.

Thus, in the end, while Gap survived lessons two and three, it was the all important lesson number one that fortunately prevented me from committing capital here – don’t overpay!!!

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | March 25, 2009 | Permalink

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