The following is a writeup I did for Wal-Mart on Sum Zero, included in its entirety below. Also at the end of the post are some charts that show how Wal-Mart has evolved over time. There is no doubt that Sam Walton and Wal-Mart are one of the, if not the greatest success story over the past 50 years. So it’s a great case study to take a look at. (I believe Warren Buffett once said that his greatest error of omission was not investing in Wal-Mart, a business he could understand very well, in its early days–which is clearly seen in the charts below.)

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Wal-Mart is often listed as a cheap large-cap, but is owned by surprisingly few value investors. One reason is that it’s big and well scrutinized and hence its price is more “efficient.”  This is partly true, and you won’t get stellar returns investing in Wal-Mart. But it is a cheap, well-managed company that returns cash to shareholders and should fare well under a number of different macro scenarios.

Competitive Advantages

The U.S. stores division of Wal-Mart (about 3/4 of pre-tax profit) has significant competitive advantages. To consumers, Wal-Mart’s brand represents one thing: low prices. Customers in the vicinity of a Wal-Mart remain loyal because they can be certain that they will have the lowest prices. And as long as Wal-Mart doesn’t slack off in the service and facility departments, there will be no good reason for customers to switch.

Wal-Mart can have the lowest prices because of their (1) efficient operations and (2) economies of scale. Operationally, expenses are lower because of their non-unionized workforce and other shrewd cost management (shrinkage, inbound logistics, etc.). This penny-pinching mentality has been ingrained in the company since it was founded by Sam Walton. The biggest cost advantages are from Wal-Mart’s economies of scale. The most obvious consequence is purchasing power—Wal-Mart can buy products at lower prices because they can purchase in such enormous quantities. But the biggest and most un-replicable scale advantage is geographic concentration. Wal-Mart has a “hub and spoke” system of a distribution centers with 100-150 stores around them, all within about a day’s drive. Because of this concentration, costs can be distributed over a larger base of potential customers: distribution, advertising, regional management, etc. Wal-Mart also has some of the most technologically advanced merchandise and logistics systems in the world. This is something that smaller or more spread-out retailers can’t match.

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I’ve owned BreitBurn Energy Partners (BBEP) both personally and through Braewick Holdings LP for the past year and a half. The following is a clip from my letter to partners explaining our investment in the company:

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BreitBurn is an oil and gas production company structured as an MLP (see my July 2009 letter for a similar discussion of Linn Energy, another MLP). BreitBurn’s business model is fairly simple: their only job is to extract and sell oil and gas from wells they own throughout the U.S. These are wells they have acquired—they don’t take the risk of exploring or drilling for new wells. Basically, BreitBurn is like a portfolio of interest-only bonds—assets (petroleum in the ground) that pay interest (production revenue minus extraction and administration costs) until the bond is paid off (reserves are depleted). Here’s a quick summary of BreitBurn’s goal from their 10-K:

“Our objective is to manage our oil and gas producing properties for the purpose of generating cash flow and making distributions to our unitholders.”

Because BreitBurn wants fairly steady cash flow to fund their distributions, much of their oil and gas production is hedged. That level of hedged production is immune from fluctuations in energy prices. By the summer of 2008 when prices were high, they had managed to hedge about 70-80% of production for three years out. So when energy prices (and the stock market) subsequently collapsed that fall, BreitBurn’s cash flow remained mostly unharmed. However, as with many of the MLPs, Lehman Brothers was both counterparty to their hedges and a large owner of the stock. The “perfect storm” of falling energy prices, a crashing stock market, and Lehman’s liquidation caused BreitBurn’s unit price to fall from over $20 in the summer to under $6 in December.

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Claude Bébéar is the founder and former CEO of the insurance company AXA. I believe the AXA group is currently the third largest insurance company in the world (just behind Allianz and Generali Group). Bébéar built AXA through mergers and acquisitions, most notably the Drouot Group and the American insurer Equitable. More can be found about AXA at Wikipedia.

The following are some excerpts from a great interview of Bébéar done by Michael Villette (mentioned in Malcolm Gladwell’s essay “The Sure Thing”). In the interview, Villette’s goal was to test the common belief that Bébéar took more risks than others (both in business and insurance), was a business innovator, and took advantage of others using insider “industry” information.

MV: Explain to me how starting in 1981 you managed to carry out an uninterrupted sequence of acquisitions in France and then in other countries. I would like an explanation with no magic, with facts and figures.

CB: There’s no magic in any of it, nothing extraordinary. The first coup was Drouot, which we bought at a bargain price, because of the panic after the left won the elections.

On the Drouot acquisition:

… the result: we acquired for 250 million francs a company that was valued at 5 billion francs four years later. . . .

MV: Why was Drouot worth so little to start with and so much later?

CB: It’s just like Equitable. People study the issues very poorly. They look at things superficially. Drouot was a company with a very good business that had done some stupid things in real estate. It was taken over hastily by Bouygues. Bouygues knew nothing about the profession of insurance, so he stuck with thinking like a financial analyst, that is, in the short term. He said to himself: “Oh, there’s a hole in this business, it’s terrible!” He didn’t see the value of the underlying business. We bought at a very low price because it seemed to be a company practically on the skids, but since we were insurance professionals, we restored the business immediately, we increased premiums, and so on, and the business took off very quickly. When we bought it, it was losing 200 million. The following year, the budget was balanced, and the third year it earned 200 million.

On the Equitable acquisition:

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I wrote the following article for partners of Braewick Holdings LP and readers of this blog. The article is on the story of Steak n Shake, Sardar Biglari, and what it takes for a restaurant to succeed. I’ve included the introduction here, but the entire article is in PDF format through the link below:

“The Restaurant Investor” by Max Olson

In March, 2008, Sardar Biglari won the most important victory of his life. In an activist campaign to gain control of the board of directors of The Steak n Shake Company, Biglari and his partner received nearly triple the number of votes of the directors they were replacing.

It hadn’t been easy—their proxy fight with incumbent management had been going on for more than six months. Biglari and the entities he controlled first purchased seven percent of Steak n Shake during the summer of 2007. In August, the initial filing was made with the S.E.C. stating that Biglari had been in discussions with management. At this point, as with many activist investors, Biglari hoped that management would be open to his suggestions and criticisms of the company. He was the third largest owner of Steak n Shake at the time, holding more shares than all executive officers and directors combined. Only days earlier, C.E.O. Peter Dunn had unexpectedly resigned, stating his intent to “pursue other interests.” It seemed like the perfect time to reform the faltering restaurant chain.

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Chart: Bond Yield over Equity Yield. 10-year treasury yield minus inverse of Graham P/E Ratio (10-year average equity earnings yield).
Current value: -2.8% (5/4/2009)
Low value: -4.9% (3/9/2009)

Chart: Trailing 10-year return.
Current value: -3.8% (5/4/2009)
Low value: -5.9% (3/9/2009)

Chart: 10-year trailing Graham (“Real”) P/E Ratio. Price of the S&P 500 divided by the 10-year average of earnings, inflation adjusted.

Current value: 16.1x (5/4/2009)
Low value: 11.9x (3/9/2009)

One conclusion from the above charts is that based on the 128-year average, the market (as represented by the S&P 500) is fairly valued. (Data from S&P, Robert Shiller, and the St. Louis Fed.)

See also: Market Valuation Charts: 10/08

The Black-Scholes model does an admirable job at valuing short-term options. If an option expires in a few weeks, the current price of the underlying stock and its recent volatility have a good deal of influence on the outcome of the option investment. A simple Black-Scholes calculation has a lot of flaws (none of which I’ll go over), but in my opinion it does alright on the short-term options. However, the further away the expiration date, the worse it gets.

Value investors know that the historic volatility of a stock has nothing to do with its long-term value, and therefore should never be used when making a purchase. However, when purchasing equities, value investors have the luxury of waiting however long they need until price eventually reaches fair value.

If a stock is worth $30, that doesn’t mean a call option with a strike of $20 is worth $10. The option value must also depend on the duration of the option: the further out the expiration, the greater the underlying valuation should affect the option price (and the less volatility should matter). A lot of value investors purchase LEAPs, or options a year or more out, for this very reason.

The Graham-Olson Option Valuation Model

In honor of Benjamin Graham, I put forth the following equation as the value of a call option:

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