March 1, 2015

Brown-Forman Is One of the Best Businesses I’ve Ever Seen

Before I start talking about Brown-Forman, it is important to make a distinction between a stock and a business.  A company may be an excellent company that you would be happy to hold for decades but be trading at such a high price, it is not attractive.  This was the case with virtually all of the mega-capitalization blue chip corporations back in 2000 when the earnings yields of giants such as Johnson & Johnson were at 2.95% compared to a 5.07% Treasury bond yield; an almost certain recipe for disaster or, at the very least, sub-par returns.  Just because a business is excellent does not mean the stock is an excellent investment due to any number of factors such as an excessively high valuation, excessive dilution of existing stockholders due to new equity issuance, etc.  With that said …

Brown-Forman and Its Dual-Class Stock

In recent days, I have been immersing myself in the annual reports and other filings of a company called Brown-Forman.  The company, which manufactures Jack Daniel’s whiskey, Chambord vodka, Korbel Champagnes, and other brands of spirits, is still controlled by the family that has owned it for more than a century, with two classes of stock trading on the New York Stock Exchange.  The Class A Brown-Forman shares have voting rights and the Class B Brown-Forman shares have no voting rights.  The Class A shares are held almost entirely by members of the Brown family and provide much lower liquidity than the Class B shares so they, paradoxically, trade at a lower price despite having voting power.  

Jack Daniel's Tennessee Whiskey Product Line by Brown Forman

As per my habit of having a company's products in front of me when I immerse myself in the business to make it real and tangible, just as if I were investing in a family apartment building or a local firm, I had a range of the Jack Daniel's Tennessee Whiskey Products on my dining room table as I read through years worth of SEC data, annual reports, proxy statements, etc. until 2 in the morning.

In terms of business, Brown-Forman is exactly the sort of enterprise I’d be content to hold for the rest of my life, even if it meant the shares took up a big part of my entire family’s net worth.  It has fantastic gross margins, strong operating margins, high returns on capital, a very reasonable debt-to-equity ratio, a consistent history of dividend payouts, shareholder-friendly capital allocation policies, and a stable of brands that would be difficult (though not impossible) for a competitor to assail.  I love it.  The business is the economic equivalent of finding a spouse with whom you might want to spend the rest of your life.

A Good Business Isn’t Enough … You Need a Good Price

That leaves the question of price.  As Benjamin Graham taught us: “At what price, and on what terms?” are the questions an investor must make his mantra.  Regardless of the quality of the business, if you overpay, your returns will suffer.  That is where it gets tricky.

To keep it simple, and to avoid having to introduce another example, we’ll compare Brown-Forman to General Electric, which I discussed a couple of days ago.  General Electric is trading at an estimated 9.73x forward earnings after yesterday’s increase in share price, spurred by the Federal Reserve vowing to keep interest rates low through 2013.  Earnings have already been hit hard by the recession so any gain in the overall macroeconomic climate in the next few years will likely be kind to GE’s bottom line.  Brown-Forman Class B shares, on the other hand, are trading at a forward p/e of 16.36x earnings.  

That means that in 2012, if the forward earnings estimates turn out to be correct, you will have:

  • General Electric generating an earnings yield of 10.28%
  • Brown-Forman generating an earnings yield of 6.11%

All else being equal, if the stocks had the same growth rate in diluted earnings per share, General Electric would be a far better bargain.  But all else is not equal; the companies operate in different industries, have different capitalization structure, are vastly different in size and scope, and do, in fact, have different growth rates.  The bottom line, though, is that it takes only a few seconds of research to deduce that the stock market is expecting higher growth from Brown-Forman than it is from General Electric.  

Brown Forman Stock BrandsAs an investor, your job is to answer the question:”Which equity bond would I rather have?  One that pays a look-through “coupon” of 10.28% and grows at x% or one that pays 6.11% and grows at y%?”  The key is figuring out for yourself what the growth rate in the coupon is going to be and not overestimating due to optimism (one study I read stated that a survey of analyst predictions on Wall Street indicated the average analyst projected 12% growth in earnings per share over a multi-year period when actual growth averaged 6%, or half the expected rate).

(Update Note: I actually bought more shares of General Electric, Johnson & Johnson, and Berkshire Hathaway for some of my personal accounts this morning, taking advantage of the further slide in equity prices.)

Read the Brown-Forman Annual Report

There is no question that Brown-Forman is now sitting on my permanent watch list and, when and if the price ever becomes attractive based upon my estimate of intrinsic value, it will be bought.  I would love to make a significant investment in the stock.  Given the economy, I’m optimistic I’ll get my price and have that opportunity.  It is just so well run and I consider the presence of family control, in this case, to be a huge strategic advantage.

But that isn’t the point of this post.  Those of you who are interested in a truly excellent business as an academic model need to get the PDF version of the 2011 fiscal year Brown-Forman annual report and study it.  Even the presentation is done so well that it breaks down the components of “owner earnings”, for those of you who know the formula, such as LIFO inventory reserves, maintenance capital expenditures, etc., making the process of calculating intrinsic value very simple.  

This is what you are looking for.  This is the type of asset you should be trying to go through life picking up and adding to your family’s holdings.  The earnings quality is among some of the highest I’ve seen at any firm, anywhere.  If I were trying to write a case study showing a business that displayed all of the characteristics that mattered such as huge gushers of excess cash, low reinvestment requirements, strong brand names, good stewardship of shareholder capital, opportunistic share repurchases, higher dividend distributions over time, growth in the core franchise, Brown-Forman would be it.  

  • Anonymous

    Looked at the financial data. Wow, doesn’t take a genius to see  that it is beautiful. I have no idea how to value a company but this is perfect.

    By the way, I live in Louisville, KY. I hear Brown-Forman is like UPS, over the top benefits, great pay, work you to death. People don’t leave often. Just in case you were curious about the rumor around the street.

  • calegp

    Wow, did you see the fall in August 2012? I just re-looked at the stock and I see 0 news. I’ll have to look into it.

  • Scott McCarthy

    Joshua –

    Since you posted this, the Class A shares now trade at a premium to the Class B shares. If you look at the historical chart of both classes, which class trade at a premium to the other seems to change periodically.

    My question to you is how do you go about valuing the control premium of the A shares vs the liquidity premium of the B shares – not specifically with regards to Brown-Forman, necessarily, but with any company that is structured this way?

    Obviously, there is always potential for someone so inclined to engage arbitrage-driven pair trading, but I’m talking more about how it impacts your calculation of intrinsic value for the respective classes.


    • Joshua Kennon

      If they are the same price, I always go with the class that has the most voting power, even if it means lower liquidity.

      Otherwise, it depends on the terms of the bylaws. A company like Berkshire Hathaway, for example, has passed resolutions so that it would be impossible for the Class A shareholders to be paid more than the Class B shareholders on anything other than a 1-to-1,500 ratio as a way of protecting the latter class once Buffett is gone. Not all firms have those protections.

      All else equal, I prefer the voting power, but will often go with the cheaper of the two shares if it is more than a meaningful amount – say 5%.

      • Scott McCarthy

        Yeah, I tend to be a lot more accepting of low liquidity, given that I don’t yet have enough capital to really move the needle significantly when I place a trade anyway. The problem I’ve run into in the past is that if the voting shares are trading at a discount or at parity with non-voting shares, I’ll happily take the class with voting rights.

        But if voting shares trade at a premium, I’ve never been able to figure out how to properly value just how much the voting rights are worth – especially with companies like Brown-Foreman, where equity compensation for management is paid in non-voting stock, making them (presumably) more aligned with non-voting shareholders in negotiating any potential M&A offer. Not that management would throw the voting shareholders under the bus, but there’s less concern that a transaction would be negotiated that gave the voting shareholders a disproportionate premium.

        Definitely an issue I need to keep studying.