Tag Archives: Portfolio management

owning property vs. leasing: investment possibilities

May 24, 2013 By in asset light, Current Market Thoughts, economics, Portfolio management Tags: , , , , , , , Leave a comment

asset heavy to asset light

A generation or two ago, the style in the US was for companies to own the premises their businesses operated in–hotels, department stores, restaurants and the like.  One major disadvantage of this approach, however, is that it takes a huge amount of capital to be able to expand.

About the time I was entering the stock market, American hoteliers had worked out that they could sell their properties to the local doctor, dentist, accountant, or oil sheikh and take back a management contract.  They found the buyers were more interested in the prestige of ownership than in profits.  They were willing to pay very high prices for the properties, while ceding virtually all the hotel cash flow back to the management company.  The “asset light” movement was born.  (Around a decade later, European hotel firms caught on and began to do the same thing.)

Hotels are admittedly an extreme example.  In my experience it rarely has made economic sense to own a hotel.  Better  an office building if you want to own real estate.  Still, asset light is the current style in many industries.

hybrids are potentially interesting

Many hybrids–a mix of leased and owned properties–remain, however.  They can sometimes present interesting investment opportunities.

An example:

At one time a friend pointed out the W Company (not the real name) in Hong Kong.  It was (and still is) a publicly traded, family run department store in Hong Kong, located in the heart of the high-end Central district.  The financials showed that the company was consistently, and highly, profitable.

But when I went to visit the department store itself, it looked more like K-Mart than Neiman Marcus.  The merchandise was undistinguished, the premises dowdy, customers few and far between (observing this last on a company visit is seldom a reliable indicator, though).  The store was surrounded by more modern, glitzy alternatives.  And Hong Kong is all about glitz.

How could this straw-into-gold story be true?  Looking a little closer, I noticed that the department store showed no rental expense on its income statement.  That’s because the company itself owned the building it operated out of.

I checked rents on nearby retail premises.  It turned out that W would probably be paying HK$100 million to a third party to rent the space it was in.  But the department store was only making HK$30 million in annual operating profit. (I don’t remember the exact numbers so I made these ones up.  But they’re roughly correct.)

The economic reality …

…was that W had two separate businesses:

–property ownership, which should have been generating HK$100 million in income, and

–department store retailing, which should have been adding to that.

The company was actually losing HK$70 million from retailing and subsidizing the department store by forgoing the rent it could have earned.

That was, in theory at least, the investment opportunity.  Either the family elders would wake up one day and realize they could triple their profits by closing down the department store and renting out the premises, or a predator would come along and bid for the firm.  The big question in the second case was whether the family would sell.

not alone

In the case of W when I was looking at it, my impression was that the family had never analyzed its business and was perfectly happy with the status quo.  When potential bidders came calling, the elders just said no.

My first instinct is to say that this behavior is crazy.  On the other hand, except for the location and the family owners blocking a change of control, this is the J C Penney story in a nutshell.

equity, debt and leases: an important balance sheet change in prospect

May 23, 2013 By in Constructing a Portfolio, Current Market Thoughts, leases Tags: , , , , , , , Leave a comment

financial strength

There’s a line of thought in academic finance that argues it doesn’t matter for a publicly traded company’s stock price how much of the capital in the business comes from equity (the owners’ cash) or debt (borrowed funds).

In the real world, that idea couldn’t be much more wrong.  Banks won’t lend to a firm that has too little cash put up by the owners.  They may even make a new equity offering a prerequisite for further loans.

Also, one of the main reasons I’m so fanatical about making a projected cash flow statement is to make sure that a company I’m interested in will have the money to service its debt, pay the dividend and still run the business.  My own rule of thumb, based on experience with a wide variety of companies, is that if a firm has so much debt that if it were to devote all its cash flow to paying back loans but couldn’t do so within three years, it’s potentially in real trouble.

debt vs. leases

Oddly, traditional financial accounting doesn’t consider leases as debt.  Even though leases may be ironclad promises to rent property or equipment for decades at a fixed price, they don’t appear on the balance sheet of the lessee as liabilities.  Lease information is disclosed, but there isn’t as much data as for bank loans or bond offerings.  What there is contained in the footnotes to the financial statements, not on the balance sheet itself.  Or course, every sensible investor should read the footnotes carefully as a matter of course.  But the reality is that even some professional securities analysts don’t.  And only the most expensive data services for screening stocks–out of the financial reach of individuals like you and me–will allow you to include leases when calculating debt/ equity ratios.

capital vs. operating leases

One exception:  at some point before my time on Wall Street began, someone got the bright idea of dressing loans up to look like leases, so they wouldn’t appear on the balance sheet.  The lessee would then appear (to anyone who didn’t read the footnotes) to be in better financial health than it actually was.

To remedy this abuse, the Financial Accounting Standards Board, the financial accounting industry watchdog, developed four tests to detect loans in lease clothing.   If the lease:

1.  calls for the leased asset to be turned over to the lessee at the end of the lease term, or

2.  allows the lessee to buy the asset at a bargain price at lease end, or

3.  lasts more than 75% of the useful life of the asset, or

4.  has payments with a total present value of over 90% of the purchase price of the asset,

then the lease is classified as a capital lease and has to appear as a liability on the balance sheet.

Leases that don’t meet any of the four criteria are called operating leases and can remain in the footnote shadows of the financials.

…until now

I haven’t made much of an attempt to find cases where the current way of accounting for leases creates a problem in company analysis.  But…

–most strip mall big box stores are stuck with long-term lease commitments for much more store space than they need.  If they can’t sublease store locations they’d like to close, however, or sublet portions of the locations they want to keep, they’re stuck paying for space they can’t use.  Borders is a case where this was an unusually difficult issue.

–on the other hand, one of the attractions of JCP (though not the most important) to its current hedge fund holders is its bargain-priced leases on retail locations.

new FASB rules…

…now in the process of being formulated would require that all leases that extend for more than a year must be shown on the balance sheet.

why this is important

Two reasons:

1.  The risks to bricks-and-mortar retailers contained in their long-term leases will become much more apparent once the new rules are in place.  Same thing for restaurant chains.  Airlines, too.  Small, fast-growing firms will likely be the worst impacted.

2.  This is a geeky, under-the-radar topic.  It probably won’t get much publicity until late this year.  Lots of time to check the lease footnotes for stock we own to make sure there are no nasty surprises lurking there.

the FT’s “listen to gold” op-ed

May 22, 2013 By in Constructing a Portfolio, Current Market Thoughts, Gold, Portfolio management, Strategy Tags: , , , , , , , , , 2 Comments

The other day the Financial Times carried an op-ed column titled “We should listen to what gold is really telling us.”  It was written by regular contributor Mohamed El-Erian, the  marketing voice of bond fund giant, Pimco.

I usually skip over what Mr. El-Erian writes.  His prose style is weak and the solution to every economic or financial worry he discusses is to buy more bonds.  In this case, I made an exception.  I was curious to see whether Pimco would be in the old-school camp that says gold is money or whether, like me, Pimco would maintain that it’s an industrial metal that new mine development has put into chronic oversupply (just like in the 1980s).

The article isn’t really about gold, though.  It’s about the fact that when more money than is needed is sloshing around in the world economy–and central banks around the globe continue to print new money at a rapid rate–some (all?) of the excess finds its way into speculative investing.  Sometimes, according to Pimco, even though the overall speculative tide has not yet crested, some prices become so divorced from reality that localized bubbles still burst.  Three examples:  gold, AAPL and FB.

At this point in the article, I thought what would come next would be an assertion that these three are harbingers of the behavior of all sorts of financial investments once monetary stimulus starts to be withdrawn.  If so, I thought to myself, Pimco will have a hard time ducking the issue of the popping of the biggest bubble of them all, the bond market.

That’s not the tack Mr. El-Erian takes, though.

He asks what happens if all the global monetary stimulus fails to reignite economic growth.  Put in a different way, what happens if world economies begin to roll over and enter recession?  The money taps are already wide open, so there’s nothing central banks can do to cushion the fall.  Fiscal policy is the only tool available.  But that takes time to work–and requires well-functioning legislatures to understand what’s going on and act both appropriately and quickly.  Fat chance.

This is a really scary scenario.  There’s absolutely no current evidence I can see that it’s likely.  El-Erian just poses the question and doesn’t say what he thinks.

Still, from a financial planning perspective, it’s something we all have to consider and be on the alert for the signs of.  Of course, conveniently for Pimco, this is the only situation I can think of where it makes sense to be holding government bonds.

the US Census Bureau on immigration (and GDP growth)

May 17, 2013 By in Basic Concepts, Current Market Thoughts, economics, Portfolio management, Strategy Tags: , , , , , , , , Leave a comment

gauging GDP growth potential

Over the years, I’ve found that there’s a very simple and effective rule for quickly gauging a country’s GDP growth potential.  Here it is:

Output can rise in one of two ways:

–either more people are at work, or

–workers are more productive.

My first boss in the financial markets was as close to a nineteenth-century capitalist as I’ve ever encountered.  He maintained that increasing productivity is solely a function of employees spending more time at their desks.  Although this suited his penny-pinching mentality, it’s not true.  Productivity gains come primarily from the employer investing in better equipment, and from better worker education/technical training.

If we pluck a number out of the air and say that a country can achieve a constant 1% increase in worker productivity per year (I’m not trying to be precise; I want to get a simple picture that gets the general idea.  Also, a 1% annual gain is a pretty good number), then a country’s ability to grow economically becomes a direct function of one thing   …the expansion of its population.

the Census Bureau Annual Population Projections

That’s what makes the Census Bureau’s latest population assessment so interesting.

Two days ago the Bureau, an arm of the Commerce Department, issued its 2012 Annual Population Projections.  It says that in the US, net births/deaths are currently adding about 0.75% annually to the population.  By 2030, that figure will drop to 0.50%.  By 2050, it will shrink to about 0.35%.

Two reasons the figure is so low:  as people become more prosperous, they tend to have fewer children, and people are living longer.

projecting US GDP

So, what’s the trend growth rate of GDP in the US, according to my simple rule?   …2%- per year, or about what we have now.

how to make growth higher

Can we make the economic picture brighter?

Yes, in two ways–both of which, unfortunately, are questions of policy coming out of Washington.

–We can allow foreigners to come to the US to work, either permanently or by increasing the number of work visas awarded to highly skilled foreigners who want employment in the US for a period of time.

Republicans oppose the first,  Democrats the second (for reasons that escape me).

–We can attract productivity-enhancing capital investment to the US.  This is primarily a function of tax policy, which neither party in Washington appears to want to change.

We can also make out schools better.

implications

This isn’t really new news, but thinking about long-term GDP growth suggests, to me, two investment conclusions:

–investors anticipating a rapid expansion of GDP from the current level are likely to be disappointed (look for that in Asia, or from exposure through US-based multinationals), and

–superior earnings growth–and stock performance–will come from companies that have unique products or services that are in high demand.  In other words, the environment favors growth stock techniques rather than value.

(Note:  I realize that it’s not really the population that counts.  It’s the workforce.  But looking at the workforce introduces complications that I don’t think change the overall picture, but which can easily obscure it.  Stuff like:  the influence of the Baby Boom, the decline in female participation, long-term unemployed…)

 

 

 

I’ve been VERY wrong about the Japanese stock market

May 16, 2013 By in Asian economic development, economics, Japanese development, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , Leave a comment

The Liberal Democratic Party retook control of the national government in Japan late last year on a platform of massive monetary stimulation aimed at shocking the economy out of its quarter-century of torpor.

Most economic effects have been as expected.  The ¥ has lost about a quarter of its value.  This has given export-oriented industries a big boost.  The price of imports has risen by enough, however, that the overall effect of devaluation on Japan has been slightly negative so far.  The trade balance will doubtless improve as Japanese citizens adjust to the tremendous drop in their standard of living that the devaluation has brought about.

Where I’ve been wrong has been in handicapping the behavior of the Japanese stock market.  In the only other recent episode of a big fall in the ¥, the Topix index (Tokyo large caps, the index professional investors use) rose as the currency declined, but only by enough to keep a dollar-oriented investor from losing money.  Yes, export-oriented stocks did better than Topix, but the overall index was unchanged in dollar terms.  I thought something similar would happen again.

Not this time, though.

Since the Abe administration took office and made it clear it would carry out its campaign promise, the Topix is up by 66% in local currency terms, meaning a dollar-oriented investor in the index has made a 25% gain.  Buyers of down-and-out consumer electronics firms like Sony have made twice that.  The long-Topix, short-¥ trade has made a killing.

As I see it, the rise in the Topix has been driven by foreigners.  Locals–never, in my experience, the canniest of investors–have  been mostly using the opportunity offered by devaluation to declare victory in their foreign investing forays and are bringing money home to put into things like real estate.

Press reports indicate new investors in Japanese stocks, including high-profile Western hedge funds, believe very strongly that the change in money policy also heralds a new era of openness to structural economic reform by Tokyo, and that foreigners will be allowed to play a significant role in the latter process.

My view, based on almost 30 years of watching Japan, is that Tokyo insiders regard devaluation as a substitute for reform, not a precursor.  I’d point to the experience of former Prime Minister, Junichiro Koizumi, who was given an overwhelming electoral mandate for reform but who resigned as PM after five mostly fruitless years (2001-2006) of trying to effect change.  As soon as he left, the Diet immediately began to reverse the progress he was able to make.

For Japan’s sake, I hope I’m wrong again.  But I’m not willing to bet on the possibility.  As for the new wave of foreigners, I find it hard to figure whether they have a much more sophisticated read on the political process in Tokyo than I do or whether they’re completely clueless.  Given that reversal of the deep social/political aversion to disruptive change should make me wildly bullish about Japan, in some sense I must think the latter is more probable.  My official position, though, is that I don’t choose to bet.

 

 

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