Allow me to get right to the point. Here’s an example of a well-run, well-financed company that I really admire, but for which the price just clearly isn’t right.

“CEB,” as it’s known, provides research, support, education, and best-practice studies to corporate executives. The model is interesting in that it also allows executives to learn and benefit from one another through shared problems and guidance. Because much of the work CEB does is shared and almost “templated” so that many clients can benefit from the same solutions, the company benefits from a certain economy of scale, and can pass this to its customers and offer extremely low prices relative to its peers.

Despite its low prices, the company enjoys huge margins and fat returns. Dependent on its intellectual capabilities, the company is not at all capital intensive, yet earns high returns on equity with no debt. The balance sheet is pretty, cash flow is strong, and management is phenomenal.

Which brings me to my next point. I and some colleagues had the good fortune to meet the company’s CEO, Tom Monahan, a few days ago and spoke with him about the business. Mr. Monahan is clearly talented, vibrant, and passionate about his work and CEB. He and the management of CEB are a far cry from the wildly overpaid executives elsewhere who do little to increase shareholder value.

Mr. Monahan discussed the firm’s competitive advantage, which would have been a concern for me had I not understood it a bit better. Because the company (cost-effectively) serves around 80% of the Fortune 500, it can offer its shared solutions for a wide array of business problems, and retains a pitching point enjoyed by virtually no other firm of this kind. This moat allows for easier and easier sales as it grows, and provides immediate legitimacy for potential new clients. Furthermore, the company has over a 92% renewal rate from its customers, demonstrating that CEB’s offerings are adding value for its customers. On the most basic level, it would be difficult for a competitor to displace CEB in its market.

As should be obvious from a quick glance, the company has grown extremely rapidly over the past years. Of course, past performance is no indication of the future, which brings me to the future growth and the (unfortunately high) price. As the company continues adding to its “portfolio” of clients, marginal growth potential must, by mathematical law, diminish. While they certainly haven’t saturated their potential market, 80% of Fortune 500 companies is a good indication that growth is unlikely to be as explosive as in the past, and certainly should not accelerate.

The way I see it, growth can still be driven in a few ways: continue adding clients, tap into previously untapped pricing power (as the “moat” grows, CEB may realize that its prices, which are around a quarter of what some competitors offer for consulting sevices, do not fully capture their customers’ willingness to pay), and adding to the portfolio of smaller clients who otherwise couldn’t afford more pricier traditional consulting services.

That said, the price, at around 48 times earnings, is very high and makes me uncomfortable. For instance, the company would need to grow free cash flow at something like 20% over the next ten years and 3.5% ad infinitum thereafter just to justify its current pricetag. Granted, this can happen and the company does have a low cost of capital, but it’s simply not a big enough margin of safety.

Nonetheless, this one’s on my radar screen, and I’d be thrilled to scoop some up at a better price.

First, a disclaimer: I’m probably a terrible source on that will be “hot” in any short, arbitrary period of time (like 2007, for instance), and I will never make the claim that any company or industry I mention will beat the market in that same arbitrary period of time. In fact, there’s a great chance that everything that follows will indeed underperform in 2007. But that wouldn’t necessarily be a bad thing. Actually, it will make both more attractive purchases. Nonetheless, I wanted to highlight to two industries and one company in particular that I think investors may want to consider. I’ll weigh some of the risks and rewards for the long term (if not 2007).

ORGANIC FOODS – WHOLE FOODS, WHOLE PORTFOLIO?

Spotlight on:

Whole Foods Market (WFMI)

It was the S&P500’s worst stock for 2006. Wall Street beat up its share price last year as expectations met the reality. Believe it or not, same-store sales can’t grow to the sky.

Whole Foods’ CEO John Mackey has also taken a beating, going from hailed industry titan and organic food guru to one of BusinessWeek’s “Worst Leaders of 2006” and the subject of ridicule for the size of his paycheck (though he’s now paid just a $1 token salary).

But Wall St.’s fickleness is sometimes cause for investor celebration as great companies get hammered, providing bargain purchases for the contrarians. So that brings me to the point of this Whole Thing: is Whole Foods a bargain?

I’ll approach the risks and rewards in list format as best I can before delving into the valuation. Here goes:

PROMISE

- Great business with strong management, lots of room to grow, enjoying an expanding market for its industry.

- Perfect example of “People, People, People” article (management pay improved, one of the most respected leaders in the business in John Mackey, strong attention paid to the customer and shareholder, ranked as one of greatest places to work, most of the executive team has been with the company for over 10-15 years)

- Stores profitable from day one, 88+ stores in the works (with leases signed). Only ~180 now, operating in just 34 states, D.C., the U.K., and Canada. Lots of room to grow.

- Is increasing its brand awareness very successfully. The company is the largest and most well-known of its kind, and customers are willing to pay a little extra for service and experience.

- As they expand in size and brand loyalty, they can benefit from both economies of scale and pricing power, taking advantage of covering costs through higher volume of fresh foods while leveraging their brand and incessant focus on the customer’s experience to charge a premium. This is a competition killing two-punch combo, leading to both higher returns with wider margins over time.

- Their management has been very good at building a competitive moat – with an obsessive focus on the customer, the employees, and the shareholders, along with strong and increasingly growing brand awareness, the company is investing successfully in marketshare of mind, creating a culture that many will benefit from and many will be loyal to. Oh, and did I mention cost savings from economies of scale?

- As Charlie Munger has said, taking a competitive advantage to the extreme often benefits the company and insulates it from competitive pressures. Just as Costco took cost-savings to the extreme, Whole Foods takes its culture and people-friendliness to the extreme. That is their advantage.

- Many compare it to Starbucks in that company’s early days (check out Yaser Anwar’s article).

RISKS

- The question we have to ask is whether the company can really beat the burgeoning competitive landscape – Walmart, Wild Oats Markets, etc — and remain at the top of the industry to actually enjoy those competitive advantages for an extended period of time. Currently, Whole Foods is more successful than any competitor, and given the culture and lifestyle it is forming, I can foresee this being the case for a long time into the future.

- Another related, yet altogether different, question is whether the industry will continue growing given that there is some, though probably small, chance that it’s all a fad.

- Speaking of fads, America’s blitzkrieg on trans-fats, the obesity epidemic, and mounting health issues continue to open new market potential as customers become more educated and grow in number. It is difficult to tell whether this is a lasting societal change or an extended trend that will either be temporarily lived or overcome by another. If the former, the chances are high that growth will continue at a rapid pace over the next ten to fifteen years plus for this outstanding company.

- Though I’m not confident enough to place much money on it (at least not yet), I believe that the industry and the company are in good shape and will stick around in full force for the foreseeable future.

- Despite the big pullback from the $80 per share days, the company still trades at a high PE around 32. We’ll talk about this further in the valuation section.

OTHER PROS/CONS (aka THINGS I LIKE, AND THINGS I DON’T LIKE)

- Stock option plans

PRO – With its generous payouts, employees are digging it and staying happy, which trickles down to the customer

CON – Dilution. The size of the stock option plans mean current investors won’t have as big a claim on future income as otherwise possible.

[Optional Note on Options: Though the grants are expensed on the income statement, I always question the wisdom of valuing them based on the Black-Scholes model. Though this is clearly not the company’s doing, but rather SFAS guidelines, I think the Black-Scholes model is great for pricing short-term options, but poor for pricing LEAPS. Whenever you have a company that is expected to do well and whose share price will increase over the long-term, assumptions like volatility and interest rates that enter into the Black-Scholes model can lead to wide errors in what those options are truly worth (usually understating the value and hence understating the expense while partially hiding the dilutive effect). The company mentions that it intends to avoid dilution greater than 10% in any one year. But even so, that’s still a lot, and with an increase in shares outstanding of around 5% annually over the last few years, it’s something for investors to keep in mind.]

- Returns

The company’s average returns on capital over 5 years are high relative to the grocery industry (around 12% versus the industry’s 9.6%). They do this with basically no debt, save for some small line items. Capital has historically been internally generated cash flow that is reinvested in the business along with equity from the issuance of shares to “team members.” These returns are not objectively very high, but for grocers it is.

VALUATION

I’ll try to keep this as simple and short as possible. Let’s assume that the company’s free cash flow of $215 million in last FY (Net inc of $204 + Depreciation of $156 – Maintenance Capex of $145) will continue to grow at 15% over the next ten years. After that, the company will grow FCF at 5% per year. Assuming a WACC of around 10% (probably high), we get a value for the company of $9.8 billion (its current market cap is around $6.6 billion). That would represent a 33% discount from intrinsic value.

But is this realistic? Well, again, that depends how you weigh the risks and likelihood that the company continues its growth trajectory as we know it.

The company is ambitious in opening new stores and is aiming for sales of $12 billion by 2010. With a (simplistic) calculation that this would mean earnings of around $420 million (based on the company’s consistent net profit margin around 3.5% and not accounting for the possibility that this margin could improve based on economies of scale and pricing power, as mentioned above), which would, in turn, mean that the 15% growth rate may be low.

But, on the other hand, if the competition, big and little, starts eroding market share and pressing margins and operating results, a value near $10 billion might well be as good as from thin air.

While this may seem anticlimactic, this brings me to an important point. DCF, multiples analysis, or any other valuation method is pointless unless we first size up the business’s true long-term potential. Whole Foods is a promising enterprise, with great management, a solid business model, and strong financials. It seems reasonable (though not necessarily a no-brainer), that the company can justify its high PE and, in fact, still be a bargain.

Because it doesn’t strike me (yet) as a no-brainer, I personally have no money in it.

That said, I will be watching Whole Foods very closely in 2007, and if prices begin to leave investors with a wider margin of safety, you can rest assured I’ll be on it.

[Another Optional Note: if investors wish to get really fancy and want to bet on Whole Foods dominance vis-à-vis competitors, as distinct from Whole Foods being undervalued per se, they may wish to take a look at the fact that competitors like Wild Oats (OATS) and Hain Celestial (HAIN) trade at PEs close to WFMI. By shorting competitors and buying WF (or buying calls on WFMI and puts on competitors), investors could, in theory, still make money if WFMI underperforms, so long as OATS and HAIN underperform even more. This is pretty risky and I wouldn’t do it, but for someone looking for a nifty trade, it’s a thought…]

THE HOMEBUILDERS – BUYING WHEN NO ONE WILL

Let’s cut to the chase: Everyone hates the homebuilders now, and the short-term outlook isn’t good. Many pundits predict the market has yet to bottom, and given their already hugely out-of-favor standing and un-promising future, their stock prices have suffered big-time in the last year. You know what that means for me: take a look for bargains.

Since I just chewed your ears off with Whole Foods, I’m going to keep this discussion short, and instead provide a link to someone who describes the opportunity better than I could. Though the link is from August, much of it is still relevant to today. Also, although the Absolutely No DooDahs links are no longer active, the post is informative and I highly recommend it.. Suffice it to say that I agree with him, as I seem to on many things.

Scroll down to the “On Homebuilders” article and read:

http://www.gannononinvesting.com/2006/08/

One Final Note: I do not own shares in any company mentioned in this article.

A special thanks to Dave J. for the following take on Aeropostale, a well-managed company with a bright future:

Aeropostale (ARO) is a fast growing clothing retailer similar to the bigger and better known Abercrombie & Fitch (ANF). Their idea is to sell affordable clothing to the fickle teen market. The company was spun off from Federated Department stores in 2002 and took with it some impressive managers including CEO Julian Geiger who has managed the company for 10 years. The company is very profitable, ROE in the 30-40 range with no debt and plenty of cash. ROA in the 15-20 range. They operate with lower margins than ANF but higher turnover. The idea is to be as fast moving and nimble as possible which is key for this target audiance. Earnings are growing at rates of 30% over the last few years.

They sell for P/E=20.2 wheras ANF sells for P/E=17.6. One might ask why would anyone buy ARO when they can buy the more established and safer ANF for a lower price? First of all, ANF is also a great buy at these levels in my opinion. But actually ARO is actually cheaper. P/CF is 10.2 versus ANF’s 12.3. A better measure is EV/EBITDA which is in the 8% range for both companies. Because ARO is 1/3 as big it has more room to grow. Both companies are considerably smaller than the GAP. Market saturation is well into the future.

The retail environment at this time looks scary. The housing market is collapsing and Americans are getting pushed deeper into debt. A recession is likely in my opinion which will probably lead to lower retail sales for everyone. So sell the retailers, right? Wrong. People will still buy clothes, especially lower priced ones. The hardest hit population will be the late 20 and 30 year old crowd. They don’t have teen children anyway. A recession will mean lower real estate prices and more mall store vacancies which is great for any radidly expanding and profitable business like ARO which needs to build more stores.

People might dump these two stock if they get scared enough. That is when we happily pick up more shares at the lower price and giggle like teenage girls. People overestimate the danger in investing in companies that serve the famously fickle teen market. When teens change their minds they simply need to adapt and change their styling. With good management and fast inventory turnover they can quickly adapt and go with the flow. These companies have erratic sales and inventory but in the long run remain consistent growers. One reason is that their strategy is fairly simple. Sell clothes that teens want. Take profit and build more stores.

We missed a nice 6% day a few days ago but it is still a bargain in my mind for anyone who can ignore the only people more fickle than teens: wall street investors. Joel Greenblatt has nearly half his money in this company with the other half in Walmart which is a nice vote of confidence from one of today’s great investors.

USG has gotten a fair deal of press given Warren Buffett’s holding in the company and its emergence from Chapter 11 Reorganization to handle its asbestos liability claims. Plenty of folks are calling it a bargain, and some are itching to keep buying, but to temper myself I took a more in depth look at the company to get a feel for what it’s worth.

First things first. In summary fashion, the plan of reorganization and the company’s own plan to finance it are as follows: The company has paid $3.95 billion to a trust established under section 524(g) of the Bankruptcy Code which will be used to fund all past, present, and future asbestos liabilities. With over 100,000 cases previously brought against the company, at least they won’t have to bother with them again.

The company is financing this large sum with a combination of available cash, the use of an approximately $1.1 billion tax loss carryback expected in 2007 thanks to net operating losses incurred in connection with establishing the original asbestos reserve, and proceeds from a “Rights Offering,” in which shareholders had the right to purchase an additional share at $40 for each share they owned. With Berkshire Hathaway backstopping the offering, almost 45 million shares were sold, for net proceeds to the company of $1.7 billion. Despite the dilutive effect of the rights offering, I believe this combination was an intelligent way to finance the nearly $4 billion liability (of course, it helps that $1.1 billion of the liability is going to be financed by benefits received from the original loss incurred by it).

With this success and Buffett’s purchase and commendation of the company, it’s no wonder many are tempted. So now let’s look at the operating business, independent of the now bygone liabilities. USG is the top producer of gypsum wallboards and boasts a strong brand image (ever heard of Sheetrock?), low-cost producer status, and great economies of scale. It’s qualitative moat, if you will, rests on the fact that anyone, even with tremendous resources, will have difficulty achieving the scale, distribution, and cost structure of USG’s main product lines, and will probably have a tough time replacing Sheetrock’s brand image. Given management’s experience and its top-notch performance in bankruptcy court, you can rest assured that the company is in good hands.

Regular operations (prior to distored earnings from last year) sport a high return on equity and strong cash flows. The company has been successful in expanding its top and bottom lines over the long term. While plenty of pundits predict slowdowns in the residential property sectors and hence USG’s sales, the company draws over half of its revenues from commercial buyers. And regardless, the long-term, big picture is more important than trying to predict the next swing in the housing market. So, what about the valuation.

Before getting too giddy about Buffett’s buying, investors should consider 1) that he originally purchased shares at bargain basement prices in 2001 and 2) that his recent accumulation of shares was done at $40-45 (as opposed to the current $55 pricetag). Also, keep in mind that his costs were partially offset by USG’s $67 million fee to Berkshire Hathaway for backstopping the rights offering. Thus, enthusiasm tempered, we can try to look at a DCF.

Generally speaking, I don’t like quoting anything near precise figures for any DCF, since the output is only as good as the inputs, and because if the analysis doesn’t scream at me as giving a huge margin of safety, I’m not too interested anyway. That said, I estimate the value of the shares to be somewhere between $50 on the low end and $85 on the high end. I know, I know, that’s a wide discrepancy, but like I said, I think seeking a high degree of safety (a margin of error) is paramount to seeking a high degree of precision. Considering the limited downside and potential 60%+ upside, investors looking to coat-tail Mr. Buffett may still do reasonably well in USG, though no one should expect many-fold increases with high probability (though I’m the first to admit it is possible).

Forest City is an $8 billion (asset) real estate operating company, which operates through three business divisions — commercial, residential, and land development. The company is not traditional in the sense that it is one of the few publicly traded real estate companies that does not have REIT status.

This may seem like a tax disadvantage, but it actually confers a competitive advantage since their large depreciation charges result in low tax payments anyway and because it enables the company to reinvest its free cash flow into the business (whereas REITs are required by law to distribute 90% of their income to shareholders).

The compay has several other competitive advantages, most notably its extraordinarily low cost of the mortgage debt they primarily use to finance their properties. With largely fixed-rate, nonrecourse mortgages with a weighted average rate of around 6.1%, the company isolates risk almost entirely at the property level while leaving open the possibility of refinancing when advantageous. Most importantly they have a consistent and illustrious track record of maintaining what every real estate company aims for, that is a wide, positive spread between cash returns and the cost of producing that cash.

The most important valuation metric for the company is an accurate calculation of Net Asset Value. Clearly, taking stated Shareholders Equity is a naive way to do this. Forest City has (obviously) real estate listed as its big asset, which means that values are listed on their balance sheet at cost. With the weighted average square foot of all their properties purchased around 1997 prices as per my calculation, there will clearly be a significant downward bias in stated NAV. We have several options for adjusting it.

First, we can try to estimate NAV on a “fair value” and comparable property sales basis. This would require something like figuring out a value per square foot for each property owned based on similar property sales by the company or another investor. This is probably overly ambitious since the data is not terribly robust and the company owns hundreds of properties, meaning that guesswork will be a big part of the valuation. Nonetheless, I’ve attempted such a valuation using comparable sales data from a large consulting firm, and arrived at an NAV of around $48/share.

Second, and more reasonably, we can use the valuation metric that commercial real estate professionals themselves use when valuing properties. Analogous to a DCF, the “capitalizing net operating income” method takes earnings before interest, deferred taxes, depreciation, amortization, etc. and discounts the figure at an appropriate rate based on the firms cost of capital and the anticipated growth rate of NOI. With NOI around $540million for their two largest divisions (combined), a cost of capital around 6%, an anticipated continuing growth rate of 1.5%, and liabilities of $7 billion, we reach a net asset value of [540/(.06-.015)] - $7,000 = $5 billion. The firm has a bit less than $1 billion in other net assets from the land development group, which we can add on to reach a total firm valuation of $6 billion, just around its current market cap.

For those seeking safety and small upside potential, I feel the stock is safe given its financing strategy, diversified real estate portfolio, and strong, shareholder friendly management. Those who have held through the last few years have done quite well, but there is no substantial discount in FCE and further big advances are unlikely. Nonetheless, it’s a great company to have on the radar screen in the event of price declines opening the door for buying opportunities.