the Market Basket saga: taking Arthur S’s position

Market Basket is a privately held New England discount grocery chain controlled by two third-generation branches of the founding family.  One branch, owning 50.5% of MB, is led by Arthur S. and has no role–other than being on the board of directors–in the day-to-day running of the firm.  The other is led by the largest single shareholder, Arthur T.

MB recently deposed Arthur T. as CEO and replaced him with two non-family members.  Warehouse and delivery workers struck when they heard the news (with the encouragement of Arthur T., some have suggested), preventing the 71 stores from restocking and effectively hamstringing the firm.  Recently, the Arthur S. branch has agreed to sell its shares of MB to Arthur T. for $1.5 billion.

Throughout this highly public dispute, Arthur T. has been portrayed as a benevolent retail genius, creating an immensely successful business with fanatically devoted employees and extremely loyal customers.  Arthur S., on the other hand, has been seen as a money-grubbing child of privilege who wants to fund his yacht and string of polo ponies by pillaging the workers’ retirement plans.

A lot of this may be true, for all I know.  And the issues rocking MB are all pretty routine third-generation family owned company stuff (see my earlier post on MB).  But in the feel-good story line being taken by the media, one fact is being overlooked.  From what little has been in the press about MB’s profits, it doesn’t appear to be a particularly well-run company.  Arthur S. is probably right that Arthur T. isn’t a good manager.

the case for Arthur S.

Let’s say I’m a member of the Arthur S family and I hold 5% of MB’s outstanding stock.  I receive a yearly dividend of $5 million.  My genetic good fortune is significantly better even than winning the Megamillions jackpot.  So in one sense I should have no complaints.

On the other hand, my share of the assets of MB is worth about $175 million.  Therefore, my annual return on that asset value is 2.9%.  That’s about half the return on assets that Kroger achieves.  It’s also just over a third of what Wal-Mart generates, but I’m confident MB doesn’t aspire to be WMT.

I presumably also know that good supermarket locations are extremely hard to find in New England and that those MB has established over prior generations are immensely valuable.  It’s conceivable that if MB were to conceptually divide itself into two parts, a property owning one and a supermarket operating one, and have the property arm charge market rents to the stores, MB would see that the supermarket operations lose money and are only kept afloat by subsidies from the property arm.  (This situation is more common than you’d think.  It was, for example, the rationale behind the hedge fund attack on J C Penney.  That fact that inept activists botched the retail turnaround doesn’t mean the underlying strategy was incorrect.)

Even back-of-the-envelope numbers suggest something is very wrong with the way MB is being run.  Personally, my guess is that the inefficiency has little to do with employee compensation or with merchandise pricing, although the former has apparently been the focus of the AS’s discontent.  I’d bet it’s in sourcing and in how shelf space is allocated.

At the same time, Arthur T is presumably blocking my every attempt at finding stuff out and is rebuffing board suggestions that he bring in help to analyze why his returns are so low.  If MB were a publicly traded company, I could sell my shares and reinvest in a higher-return business.  I’m probably not able to do this with MB.  Even if I were, the public intra-family feuding would suggest the stock wouldn’t fetch a high price.

I have two choices, then.  I can accept the status quo, or I can try to create a consensus for the family to sell the firm.  That latter is what Arthur S. chose to do.

information asymmetry

That’s the fancy name for the situation where either you know more than the other guy or vice versa.  Think:  buying a used car, or competing in a game/sport with someone who has only half your experience and skill.

In investing, cases like the first are ones that everyone not an auto mechanics wants to  avoid.  We should, however,be spending a lot of our research time seeking out the second type.

practice vs. academic theory

One of the odder things about financial theory taught in MBA programs is the professors’ insistence–despite overwhelming evidence to the contrary–that such situations don’t exist in investing.  Officially at least, they maintain that everyone possesses the same information.

There are several odd aspects to this state of affairs:

–professional investors are happy not to rock the boat, since, to the degree that students actually believe this stuff, business schools churn out large amounts of “dumb money” to be taken advantage of,

–if all market participants have precisely the same information, how is it an ethical enterprise to charge thousands of dollars a credit to inform students that they already know everything?

–in some deep sense, professors know they live in a Copernican world despite the fact they teach Ptolemy to get a paycheck.

When I was a student at NYU, the finance faculty had a number of eminent tenured theoreticians, as well as one semi-retired portfolio manager who was an adjunct teaching for fun.  One professor proposed a contest:  faculty members would each provide $10,000 of their own money into either a portfolio managed by the theoreticians or one managed by the adjunct “practitioner.”  Over, say, a year or two that would provide a practical illustration of the superiority of theory over vulgar practice.  Unfortunately, the test never got off the ground.  No one was willing to give real money to the professors; everyone wanted to back the working portfolio manager.

More tomorrow, on making information asymmetry work for you and me.

why I don’t like stock buybacks

buyback theory

James Tobin won the Nobel Prize for, among other things, commenting that company managements–who know the true value of their firms better than anyone else–should buy back shares when their stock is trading at less than intrinsic value.  They should also sell new shares when the stock is trading at higher than intrinsic value.  Both actions benefit shareholders and add to the firm’s worth.

True, but not, in my view, a motivator for most actual stock buybacks.

Managements sometimes say, or imply, that share buybacks are a tax-efficient way of “returning” cash to shareholders, since they would have to pay income tax on any dividends received.  I don’t think this has much to do with buybacks, either.  It also doesn’t make a lot of sense, since a majority of shares are held in tax-free or tax-deferred accounts like pension funds and IRAs/401ks.

the real reason

Why buybacks, then?

Years ago I met with the CEO of a small cellphone semiconductor manufacturer.  We had a surprisingly frank discussion of his business plan (the stock went up 20x  before I sold it,  which was an added plus).  He said that his engineers were the heart and soul of his company and that portfolio investors like me were just along for the ride.  He intended to compensate key employees in part by transferring ownership of the company through stock options from outsiders to engineers at the rate of 8% per year!!

Yes, the 8% is pretty extreme. In no time, there would be nothing left for the you and mes.

Still, whether the number is 4% or 1%, the managements of growth companies generally have something like this in mind.  They believe, probably correctly, that they won’t be able to attract/keep the best talent otherwise.

The practical stock option question has two sides:

–how to keep the portfolio investors from becoming outraged at the extent of the ownership transfer and

–how to keep the share count from blowing out as stock options are exercised.  A steadily rising number of shares outstanding will dilute eps growth; more important, it will alert portfolio investors to the fact of their shrinking ownership share.

The solution?   …stock buybacks, in precisely the amount needed to offset stock option exercise.

is there a better way?

What I don’t like is the deception that this involves.

However, would I really prefer to have companies allow share count bloat and have high dividend yields?  What would that do to PE multiples?   …nothing good, and probably something pretty bad.

So, odi et amo, as Ovid said (in a different context).

 

 

when the gold mine opens…

…the company’s stock falls apart.

a Wall Street parable:

A group of geologists forms a gold mining company and raises money from investment managers at $8 a share.  It goes public a few months later at $10 a share, having bought a bunch of mineral rights with the initial seed money.

Shortly thereafter, the company announces it has identified a potentially attractive ore body on one of its leases and has begun drilling to confirm the presence of gold ore and the extent of the find.  The stock rises to $15.

The company announces that has found gold.  Rumors begin to circulate that the ore body is much bigger than expected.  The company is sending ore samples to a laboratory for analysis.  The stock goes up to $20.

It turns out the ore samples are richer in gold content than initially thought.  Rumors circulate that the ore contains significant byproduct amounts of silver and other metals–which would imply that mining costs will be unusually low.  The stock reaches $30.

The company begins to build a processing plant and says production will commence in six months.  The stock rises to $40.

 

During this entire period, very little hard and fast information is available.  Analysts fill the void with bullish speculation about the extent of the find, the high purity of the ore grade and the possibility of very high byproduct credits.  Their spreadsheets show “best case” profits rising to the moon as each analyst tries to out-bullish his rivals.

Then the mine opens.

There are initial teething problems with the mine, so production is low.  The ore grade is high, but less rich than analysts’ speculations would have had it.  Byproduct credits are not as great as analysts had typed into their spreadsheets.

The stock falls to $20, as actual data puncture the speculative balloon Wall Street had inflated.  Where the stock goes from there depends entirely on how the numbers pan out.

relevance?

This is an extreme example of investors letting their imaginations run away with themselves in advance of, and in the absence of, real operating data.

It happens more often than Wall Street would like to admit.   Euro Disney is a perfect example of this phenomenon in action in the non-mining arena.  The stock peaked just as the park opened and the turnstiles started recording actual visitors.  (Note:  if you check out a Euro Disney chart, remember that the stock had a 1-for-100 reverse split in 2007, which the online charts I’ve checked don’t adjust for.  So that 3.4 euro price is really 3.4 euro cents!)

To some degree, every growth stock eventually gets overhyped and reaches an unsustainably high price-earnings multiple.  Normally, the inevitable multiple contraction begins as investors sense the company’s growth rate is slowing.  But sometimes–as in the case of AAPL–it happens earlier.  In the fictional case above, the overvaluation happens right out of the box.  This is also what the 1999 Internet stock boom was all about.

In today’s world, I think Amazon (AMZN) could be another potential case in point.    …attractive concept, lots of whispers, little hard data, a multiple that–even adjusting the company’s (conservative) accounting to make the financials look more comparable to other publicly traded companies–looks very high to me.

Among the “big data’ recent listings, more 21st-century gold mines may also be lurking.

Caveat emptor, as they say.

 

 

the Market Basket supermarket feud

I decided to write about my sense of the stock market tomorrow.

Instead, I’m going to write about the struggle for control of the family owned, privately held New England supermarket chain, Market Basket.  That’s both because it says something about the value of supermarkets in the Northeast, and because the fight is typical of what happens in family owned firms in the second or third generation.

The story:  Two branches of the Demoulas family own Market Basket.  One, led by Arthur S. has no involvement in running the business; the other, led by Arthur T., does–or did until a short time ago.

As a result, according to Bloomberg radio, of some past impropriety on the part of the ATs, the ASs have voting control of Market Basket.  Last week the board voted to oust Arthur T. as CEO and replace him with two outsiders who presumably have a mandate to cut costs and prepare the 71-store chain for sale.

Hearing this, warehouse and delivery workers walked off the job, demanding Arthur T’s reinstatement.  Many other workers have staged protests.  Store shelves haven’t been restocked.  The chain is reported by the Boston Globe to be losing $10 million a day.

this is typical family owned company stuff

Many family owned businesses are started by one or two entrepreneurial relatives.  Firms like this tend to have:

–high financial leverage

–lots of family on the payroll

–content to have economic rewards come through salaries/perks for family members rather than paying out dividends

–concerned more about stability than growth.

By the second or third generation, ownership is diffused.  Grandchildren probably don’t want to be in the family business.  Recognizing the value of the stock they hold, they want to cash out.  They come into conflict with other family members, whose lives, heritage and hefty salaries are tied to the business.

New England supermarkets are valuable 

The Globe says Market Basket could be worth $3.5 billion.  There are apparently about a dozen shareholders.  That would imply something like a $100 million payday for even the smallest holders if the firm were sold.  Until recently, the firm had been distributing dividends of about $100 million a year, for about a 3% yield.

I haven’t tried to confirm any of these figures myself.

One important thing about New England, though, is that it’s a mature, heavily developed region.  This has two positive implications for Market Basket:

1.  It’s impossible for Wal-Mart, the ultimate supermarket killer, to get a strong foothold.  It simply can’t assemble parcels to build on or get local planning commission authorization to start construction.

2.  For the same reason, Market Basket’s 71 store locations have immense potential value to a competitor.

A side note:  in my town, the supermarkets are small, dingy and very dated.  Twenty years ago, a major chain purchased a large parcel of land which it thought was zoned for a supermarket, and on which it intended to build a superstore.  The project is still tied up in litigation spurred by “concerned citizens,” funded, I’m told, by the existing markets.

bones of contention with Market Basket

Store employees are reportedly much better paid than typical supermarket workers.  Starting pay is $4 an hour higher than the minimum wage.  Experienced cashiers can earn double the industry average of around $20,000 a year.  Market Basket puts 15% of wages into an employee 401k.  Arthur T. also apparently projects a sincere concern for employees’ welfare.

Employees assume, doubtlessly correctly, that Arthur T.’s ouster spells the end of above-average salary and benefits.  This for two reasons:

–Arthur S’s family understands that a dollar of wages to an employee is money that would otherwise be dividended to shareholders, meaning it’s money that comes directly out of their pockets.  If we assume that the average employee earns $4 an hour more than the industry median and that the 25,000 workers average 20 hours a week, then the  total “excess salary” paid by Market Basket yearly is $107 million.  My suspicion is that this is too low.  Still, a ballpark figure is that dividends to shareholders could double if wages and benefits are chopped back.

–Presumably, a trade buyer would pay less for a company if it had to take the reputational black eye of reducing staff and cutting compensation.  Market Basket could sell to a financial buyer, a private equity firm that would do the pruning.  In my view the equity owners have decided to maximize their personal payout by doing this unsavory task themselves.

To my mind, this is all par for the course for family owned businesses.  What is truly remarkable in this case, though, is how much publicity the ouster of Arthur T. has gotten.  The way employee sentiment has been galvanized is also noteworthy, although workers have a very clear–and large–economic interest in defending the status quo.

Company warehouse workers and truck drivers are playing a key role in the dispute, since their job action is the reason stores can’t restock.  Some press reports have even suggested that Arthur T., who is apparently one of a number of potential buyers of Market Basket, somehow helped them along in making their decision to walk off the job.  I have no idea whether this is correct, or whether it’s part of a movement to deny AT sainthood.

 

 

 

evaluating stocks vs. bonds

In theory, there’s no demand for stocks.  There’s also no demand for bonds.  There is, however, a demand for liquid forms of saving, a category that includes stocks, bonds and cash.

Each of us will choose a basket containing a somewhat different proportion of the three, depending on factors like age, wealth and risk tolerance.  But for all of us, a change in price of any of the three will probably persuade us to shift away from the more expensive investments and toward the now-cheaper one.

Given that the Fed has been signalling for some time that a rise in interest rates–meaning a change in the price of cash–is on tap for next year, the question of how this will affect the price of the other two, bonds and stocks, is probably the most important near-term investment issue for you and me.

One way of starting to look at this issue is to look at what the current price relationship between stocks and bonds is.  The typical way this is done is to compare the interest yield on Treasuries (either the 10-year or the 30-year) with the inverse of the PE on a market index like the S&P (academics call 1/PE the “earnings yield,” because it measures the portion of total profits that each share has a claim to, divided by the share price).

Over my investment career, Wall Street has taken stocks and bonds to be at roughly equivalent value when the interest yield = earnings yield.  (During the 1950s bonds traded at a considerable premium; during the Great Depression, dividend yields exceeded coupon payments on bonds.  But I don;t think either period is relevant today.)

As I’m writing this, the S&P 500 stands at about 1930.  EPS for the index in 2014 will probably come in at about $110.  Thus, the PE of the market on 2014 earnings is about 17.5x.  This means the earnings yield is 5.7%.

EPS for the S&P in 2015 will likely rise to $125+, implying a market PE of 15.4x and an earnings yield of 6.5%.

In other words, the S&P already seems to be discounting a 250 bp increase in the yield on the 30-year Treasury.  Arguably, this is more than the long bond yield is likely to rise in the coming normalization of interest rates by the Fed.

I don’t think this guarantees that stocks will have smooth sailing throughout the interest rise process.  But I do think it argues against the idea that stocks will either mirror the fall in bond prices–or simply collapse.  During the Great Recession and the subsequent recovery, equity investors badly underestimated the severity and the duration of the downturn.  As a result, Wall Street was always on guard against the possibility of imminent interest rate rises.  It never fully discounted the actual interest rate lows–something that will serve stocks well during the normalization process.

Two other points:

–this stock market behavior is not that unusual.  In past periods of Fed tightening, stocks have gone sideways to up.

–on my Current Market Tactics page, I wrote last month that I thought the market stall we’re in now is purely based on valuation and not on worries about rising interest rates.  If that were wrong, the first place to look for deterioration would be in income-oriented stocks, which are in effect quasi-bonds.

 

 

new money market fund regulations

Yesterday, the SEC announced new rules for US money market funds, which in the aggregate hold $2.6 trillion in investors’ money.  Of that amount, two-thirds is in funds catering to institutions and high net worth individuals; one-third is in funds serving the mass market.

Why the need for new rules?  

Two reasons:

–today’s aggregate money market assets are large enough to be a risk to the overall financial system if something goes badly wrong, and

–the funds are typically sold as being just like bank deposits, only with higher yields.  However, like most Wall Street claims that  “x is just like y, only better,” it’s not really true.  The differences only become important in times of market stress, when normally sane people do crazy things, and when “yes, but…” is a sign for panic to begin.  So there’s a chance that “badly wrong” can happen.

The differences?    …bank deposits are backed by government insurance that insulates depositors from investment mistakes a bank may make.  Also, the Fed stands ready to rush boatloads of cash to a bank if withdrawals exceed the money a bank happens to have on hand.  Money market funds have neither.

Yet many holders are unaware that it’s possible for a money market fund’s net asset value to fall below the customary $1.00 per share, or that a fund might be overwhelmed by redemptions and forced to sell assets at bargain-basement prices to meet them.

the fix

Fixing this potential vulnerability has two parts:

–giving the finds the ability to halt or postpone redemptions during financial emergencies, and

–requiring funds to have floating net asset values, not the simple $1.00 a share.  This would mean marking each security to market every day.  …which would likely require hiring a third-party to price securities that didn’t trade on a given day.

The first of these would avoid the government having to step in the case of a run on a fund.  The second should reinforce that money market funds aren’t bank deposits.

the new rules

Of source, the organizations that sell money market funds have been strongly opposed to anything that would ruin their “just like…, but better…” sales pitch.  Their lobbying has blocked action for years.

So it should be no surprise that yesterday’s SEC action was a compromise measure:

–all funds will be able to postpone redemptions in time of emergency, but

–only funds that cater to big-money investors will have to maintain a variable NAV.

Personally, I don’t understand why money market funds that serve ordinary investors should be exempt from having to calculate a true daily NAV.  You’d think that this is the group that most needs to understand that the (remote) possibility of loss is one of the tradeoffs for getting a higher yield.  Arguably, sophisticated investors already know.  But the financial lobby is incredibly powerful in Washington, and this may have been the price for getting anything at all done.

 

 

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