When something is going wrong…(ll) value stock problems

As I’ve written in other posts, I’m a growth stock investor.

My initial training and close to my first decade of work were as a value investor, though, and I’ve worked for long periods in organizations where the majority of the senior portfolio managers had a value orientation.  So I do know something about how value works.  Still, I have a much more intimate acquaintance with how growth stock investors go wrong by making the mistakes myself.  In contrast, I’ve learned at least some of how value can go wrong at second hand, by watching others make them.

Having warned you about the state of my knowledge of value, here goes:

Having an investment plan for each stock is important

When you buy any stock, value or growth, you should have a plan for what you expect to achieve from owning it.  Ideally, you will have

–a concept, backed by

–an earnings model that incorporates information that you’ve gotten by researching the company, its products and its industry (10-k filings and annual reports are key here) that give you

–the expectation of substantial gain.

Your plan should give you a catalog of your major assumptions, as well as a roadmap to what good things you expect to happen, in what sequence, and what effect (at least qualitatively) they will have on the stock.

It’s your checklist to diagnose what may be going wrong

The plan will give you your ultimate exit strategy if things go right.  It gives you a checklist to go over–and decide if your assumptions are still valid–if the stock doesn’t perform the way you want.

In my experience, it may take a year or more before you’ve filled in all the details of your plan and feel comfortable that you know a company’s management, be satisfied that it is competent, and are able to anticipate how it will act.

By the way, no professional I’m aware of waits until the plan is completed before buying the stock.  Professionals, myself included, may do a week of research to get the plan structure right and spend the rest of the time putting flesh on the bones.  With a good stock, evidence mounts that you’ve made the right decision.  With a bad stock, the opposite (hopefully) happens.

What makes a value stock

Value investors argue that their stocks are attractive because the stock market does not fully appreciate the value of the underlying companies as they exist today.  (This is in contrast to growth investors, who believe their companies are attractive because the market underestimates the extent or duration of the firms’ future profit growth.)

Why should value stocks be misunderstood?

–Often, investors have an excessive negative emotional reaction to temporary difficulties.  A company may be highly exposed to the business cycle, for example, and investors rush to sell as the cycle turns down, without any thought to the possibility that conditions will someday get better.  We don’t have to go that far back in history–just to last March– to see this idea in action.

–A company may have good products, a great brand name and state-of-the-art production facilities, but weak management that fails to earn the profits the company should make.

–Or the industry it’s in may be hard to understand.

–Or it may be overlooked because it is only growing slowly.

–Or a firm may have had a damaging product recall or made a tactical marketing mistake that Wall Street has overreacted to.

Buy assets at 30¢ on the dollar and sell them at 70¢

The four essential elements of a value plan are:

–calculation of the “true” or “intrinsic” value of a firm,

–determining that the current price is at a steep discount to that number, and

–fixing a target price, and target timeframe, to sell the stock at.

Some deep value investors stop there.  They typically run computer screens to find the cheapest stocks based on price/cash flow or price/book value and buy them.   They argue that the moments of greatest despair are the ultimate buying points for stocks, both individually and as an asset class (think March 2009 again).  They also think that incompetently managed companies that refuse to change will be taken over.

Others want to identify a fourth factor–a catalyst for change–that will start the process of reevaluation along–anything from an uptick in the business cycle to a change in company management.  Personally, I’m much more comfortable with this approach.

Typical problems

a.  getting the intrinsic value wrong

This happens less often than you’d think.  This comes primarily (in my limited experience) from  non-specialists getting involved in industries that are highly regulated, like utilities, or that have no growth prospects, like traditional airlines.  In these instances, the cash flow the firms currently generate is immediately consumed in spending that’s necessary for the firm to survive.  Relying solely on book value as a measure of worth can also be dangerous, since auditors are not always as diligent as they should be in getting their clients to write down assets to true market value.

b.  the catalyst doesn’t catalyze

Think GM.  At one time the company had an unbelievable market position.  It was an American icon and a bellwether of the overall US economy.  It began to steadily lose market share when foreign competition arrived in the US auto market.  Managers developed internally were unable to reverse the company’s fortunes.  The board of directors was equally inept, and also stubbornly resisted advances from outside parties trying to (for a profit of course) be agents of change.

HPQ is another interesting case.  Here the board realized that a once high-tech company had slipped into mid-tech and decided to bring in a high-profile outside manager to turn things around.  Unfortunately, the company chose a marketing executive from ATT, Carly Fiorina, whose greatest talent, from where I sit, lay in marketing herself.  She was fired after several unproductive years and replaced by another outsider, Mark Hurd, who had a strong reputation as an operating manager and cost-cutter at NCR.

Under Hurd, HPQ became an illustration of a value stock that worked, far outpacing the market performance as he reorganized the company.

c.  staying after the party’s over

Value stocks are by and large, mediocre companies behaving badly.  While a turnaround is underway, a firm’s profits may skyrocket and its reputation on Wall Street may soar as well.   But there’s only so much that even the best managers can do.  Once margins have improved to industry-leading standards, growth may decelerate to not much faster than overall GDP.  Once the market realizes this, the stock may being to languish.

By that time, however, the value investor should be long gone.  His calculation is probably something like:  this company is earning $2 a share and trading at 10x eps.  If the company could raise its operating margins to the level of the best firms in the industry, it could be earning $5 a share on the same revenue base and with the existing plant and equipment–and trading at 12x eps.  In other words, if the favorable case plays out, the stock will rise from $20 to $60.

If the $60 price, or some other high value occurs, it will likely happen in year two of a three-year turnaround program–in other words, far in advance of the actual $5 earnings number.  By that time, the market will likely be realizing that the period of earnings acceleration is over and the stock may actually be going down.

Business cycle-sensitive stocks tend to exhibit this pattern.  The value investor judges, based on past cycles, that the stock will peak at, say 10x, peak earnings for the cycle.  Even though the earnings peak may be in year three of the cycle, the stock price peak can occur a year or more earlier.

In this cycle, though, commodity stocks may be an exception to this rule.  Demand from emerging markets and dollar decline may give them more life than an analysis of past cycles would suggest.

An aside:  mechanical rules

Some investors use rules like, “If the stock drops 15% below my purchase price, I’ll automatically sell it.”  or, “If the stock rises 50% above my cost, I’ll take a partial profit.”  Personally, I don’t like rules like this. If the stock’s price action is unfavorable, implicitly telling me I’m making a mistake, I’d prefer to be able to identify the mistake I’m making before acting.

This is at least partly because I’m a growth investor, looking for the next GOOG or AAPL.  My performance tends to be determined by having a small number of very good stocks, so I worry about being shaken out of a long-term winner by a bumpy ride along the way.

Value investors, on the other hand, tend to operate with much clearer, and shorter, timeframes, and with much more easily definable price targets.  So these kinds of rules tend to work better.  As with everything else, you should experiment to see what works for you.

AAPL’s Sept ’09 earnings: what they mean for the market

All or nothing

The short answer:  AAPL’s just-reported earnings mean either a lot, or nothing, depending on your perspective.

First, the nothing.

Even though the September was an exceptionally good one for AAPL, and it was joined by good overnight results from TXN and CAT, the US stock market went down yesterday.

How so?  None of the companies added anything to the picture of the global economy that has already emerged in the earnings announcements of the many companies which have already reported:

the worst of the general economic downturn is over;

consumer-oriented technology is recovering;

Asia is stronger than Europe ex the UK, which is stronger than the UK and US (for AAPL, though, international sales are strong all over).

Of the three firms, AAPL had by far the best report, filled with eye-popping numbers.  I also suspect that AAPL’s near-term prospects are better than the consensus thinks.  But it’s clear that a large part of the company’s performance comes from taking market share from competitors, not from over all economic strength.

What AAPL said

The company reported record sales of Macs and iphones during the quarter.  Sales were $9.9 billion, up 25% from $7.9 billion in the comparable quarter of 2008.  Fully diluted EPS were $1.82, 44% higher than the $.126  earned in the year-ago period.

In looking at the numbers, it’s important to distinguish between “sell in” and “sell through.”  The first is when a product leaves the factory and enters the distribution channel, much of which, in AAPL’s case is done by third parties.  Typically, a company recognizes sales revenue and profits when its manufactured products enter the distribution channel.  “Sell through,” on the other hand, is when the product is purchased by the final consumer.  Any difference between the two numbers represents changes in inventories in the warehouses of firms in the distribution chain.

The difference between sell in and sell through is most important for understanding what is happening with iPhone sales.  AAPL sold a record 7.4 million of them to phone companies during the quarter.  That was up 7% year over year.  Telcos sold 38% more iPhones to customers than in the comparable period of 2008–at a time when overall industry sales were only up 5%.  This last figure is of interest not only to show AAPL’s share gains in the phone market, but because AAPL makes much more money from sharing in subscription revenues than from handset sales.  More about this later.

Macs were also good for AAPL.  Units were up 17% year on year.  Laptops, which comprised about three quarters of sales, were up 35%.  This compares with industry growth of 9%, a healthier number than cellphone growth but again showing that AAPL is making most of its money by taking share away from competitors.  Europe ex the UK was up about 40%, Asia Pacific a little better than that.  AAPL had its best back to school sales ever.

To no one’s surprise, iPods were down, despite 100% year on year growth in the iTouch.

We have to remember that outside factors, and product introduction timing, influenced AAPL’s results in a positive way.  Recession has meant that component and transportation costs have been unusually low.  Continuing manufacturing and service issues at DELL and the failure of MSFT’s Vista have left the laptop door wide open for Macs.  In addition, the fast-selling Snow Leopard OS upgrade came out during the quarter.  And laptop and iPhone 3G shortages may have shifted sales from the June quarter into the September period.

Also, I’m not conversant enough in AAPL-speak to know for sure, but I think I heard management say (nothing like these words though) during the earnings conference call that it is pricing new products aggressively to continue to gain market share, even if margins were a bit lower than they have been historically.

These last two paragraphs might start one worrying that the September quarter marks a kind of high-water mark for earnings.  I don’t think so, however.  Despite management’s famous conservatism in giving earnings guidance, their comment that air transport costs would be unusually high in the December quarter (as AAPL pulls out all the stops to put products into the hands of retailers) suggests AAPL is expecting a blowout holiday sales season.

Why this is everything

In a booming economy, there is enough demand that no one firm can satisfy it.  So the market separates out into big winners and bigger winners.  Rather than wait a month for the product you really want to buy, you may take a competitor’s not-quite-as-good substitute that’s on the shelves today.

In a bad economy, you don’t buy.

In a slowly expanding economy, like the US had in the second half of the Seventies, products from the #1 company in an industry are almost always available, so the “overflow” sales to #2 or #3 don’t happen.  So the stock market separates into big winners and big losers in what might otherwise be a trendless, or only slowly uptrending, market.

As a stock, AAPL has already regained all the ground it lost during the recession.  Whether it outperforms from this point on or not, I think its emblematic of the formula for success in the stock market we’ll have over the next few years:  find the truly great companies.  One caveat:  I’m a died-in-the-wool growth stock investor and I’m describing growth stock Nirvana.

What’s up next for AAPL

As I mentioned above, I think the December quarter will be exceptionally good.

There’s another positive factor at play that may attract new attention to AAPL in the coming year.   It’s subscription accounting for iPhone profits.  I’m going to sketch the broad outlines of the issue here.  The actual details are mind-numbing and of interest to AAPL, me and probably no one else.  Here goes:

1.  The average selling price of an iPhone–AAPL to a telco–is about $600.  Let’s say (I’m making up these numbers, but I think they’re directionally correct) AAPL makes a profit of $35 on the hardware sale.

2.  The telco then sells the iPhone on to a consumer, who pays $200, and agrees to a 24-month contract at $125/month, or $3000 over the two years.

3.  AAPL gets a percentage of that revenue.  Let’s say it amounts to $215 (this number comes from AAPL’s press release).

4.  So AAPL’s total profit from an iPhone sale is $250.

Under accounting rules that prevailed until recently, in its income statements AAPL had to spread that $250 equally over the two-year contract term, or about $31.35 per quarter.

A recent change in accounting standards, however, allows AAPL to recognize most, if not all, of the contract revenue during the quarter when the contract is signed.  AAPL has been providing an alternate calculation of eps under the new standard, which it will adopt sometime in the coming fiscal year.  The eps number for the September quarter is $1.30 a share higher than the figure under GAAP (Generally Accepted Accounting Procedures), at $3.12.

In other words, reported earnings in the coming year could end up being close to twice what they would be on the current accounting standard.  The price earnings multiple for AAPL at today’s price might be about 15–less than that of the average stock.

You may say that the market sees through accounting changes and has already factored this one into the current AAPL price.  My experience is that markets hate subscription accounting and never give the company involved any benefit for using a very conservative way of reporting profits.

This change will, however, bring out much more clearly how highly leveraged AAPL is to the success of the iPhone.  This becomes a two-edged sword, if iPhone sales ever flag.  But my guess is that the change will at least initially bring a groundswell of new interest into AAPL.

When something is going wrong…(l) General

Finding and fixing mistakes is very important…

Most equity professionals will tell you that it’s at least as important to identify and fix mistakes as it is to find and hold stocks that will outperform.  Yes it’s a cliché, but that’s another way of saying it’s really and obviously true.

…but it’s harder than it seems

It’s less likely that a professional will tell you how hard this is to do.  It may be they’re unaware themselves.

I picture the situation as being like a professional baseball hitter coming up to bat.  On the one hand, he is absolutely convinced that he is going to hit the ball safely and get on base.  On the other hand, if you ask him what his chances are of hitting .400 for the year (that is, hitting safely in 40% of his at bats), he would probably laugh and say that no one in the major leagues has done that in over fifty years.

Similarly, every time an investment professional, or any of us, for that matter, makes a trade, we all think–whether we are conscious of this or not–that we know better than the guy on the other side.  If we’re buying a stock we think the seller is foolish to part with it; if we’re selling, we think the buyer is overpaying.  At the same time we know, at least intellectually, that two-thirds of the professional active managers in the US underperform the S&P 500.

Why am I going on about this?…because the character trait that makes any of us able to enter a buy order, our strong conviction that we know more than the other guy, is the same characteristic that stands in our way when we’re trying to figure out whether we’ve made a mistake.

The hard part is recognizing a mistake

The important issue for an investor is not how to fix a mistake–that’s easy: you sell the stock, you make your portfolio look more like the index.  The really key issue is how to recognize that you’re making one (before you’ve lost half your money).

Three posts on this topic

I’m going to write about this topic in three posts:  this one contains general comments; the other two will be what techniques a value investor typically uses and what techniques his growth counterpart employs.

Luckily, we’re not baseball players

Yes, investing is a lot like baseball–both experience-intensive craft skills.  But when it’s the baseball player’s turn at bat, he has to go up to the plate and swing, whether the pitcher is an All Star who never gives up a hit, or a rookie who can’t get anybody out and is just about to be sent back to the minor leagues for more seasoning.

We don’t.  We have the luxury of picking the pitchers we want to face.  We can sit on the bench and eat sunflower seeds until we see one we like.  Brokers may encourage us to transact, because that’s how they make their money, but we don’t have to.

One of the most important things I think any investor has to learn is that he doesn’t have to have a opinion about everything–and express that opinion in buying and selling.  This is a recipe for failure.

A few things we know a lot about, not a lot of things we know a little about

We should be just the opposite.  We need to have a few well-reasoned and well-researched ideas that lead us to stocks/mutual funds/ ETFs that we conclude are worth more than the market now realizes.  It’s better to have one or two things that we know a lot about than it is to have two dozen half-baked ideas.

First, create a safety net

There a number of basic investment planning steps you can take that, among other things, will help you detect where one of your investment ideas may be going wrong.  You should:

1.  have a plan and write it down–a “strategy,” if you will.  If you document your reasoning and your expectations, it’s easier to compare the outcome with them.  See my posts on Constructing a Portfolio.

2.  in your planning, establish maximum position sizes, based on your risk tolerance.  Keep to them when implementing your plan.  This will ensure you don’t put all your eggs in one basket.  Again, see Constructing a Portfolio.

3.  Monitor your performance, position by position, regularly.  This will prevent your eyes from “accidentally” skipping over the clunkers in your portfolio.  See my posts on Measuring Performance.

4.  especially for positions that may not be performing as you expect, watch how they are doing against peers (for a stock, Google Finance seems to me to have the best peer groupings).  Look at performance on very sharply up days and on down days.  If the position is weak relative to the market on both sorts of days, that’s usually a strong indication of trouble.  See my post on Down Days.

5.  know yourself.  Everyone has different strengths and weaknesses.  Over time, you’ll see that there are some arenas, say technology or the consumer, where you’ll do well, and others, say, biotech, where you will have little success.  Or it might be that you’re comfortable with larger capitalization stocks and not so much with smaller, riskier issues.

The first sign of impending trouble will be when you venture into areas where you have not been successful in the past.  I’m not saying don’t do this.  How else will you learn?   But you will want to have a small position size and the willingness to make a fast exit, if need be.

That’s it for today.  In my next posts, I’ll deal with how value investors and how growth investors typically find and deal with mistakes.

What makes a down day interesting–even for long-only investors, which is most of us anyway

I’m writing from about 10:30 am to noon, New York time, on Friday October 16th.

Although I have “down day” in the title of this post, I don’t really mean just down days.  I mean counter-trend days.  But, inevitable corrections along the way notwithstanding, I think the major stock market trend is up and will be up for at least the next year.  So I’m satisfied with the title.  You’d follow an analogous procedure for an up day in a down market.

What’s important in a down day

It isn’t so important that the day stays down, or ends down.  What is important is that some ugly counter-trend opinion that you can study and think about gets expressed in prices.

Two useful tasks

There are two useful things you can do on a day like this:

–you can “read” the stock prices to get an insight into what investors in general are thinking by observing what they are actually doing, and

–you can take your own investment temperature to see how emotionally involved you are in your portfolio or your stocks (that’s a bad thing).

“Reading” the prices

On a day like this, you should expect that short-term investors will take profits in sectors and stocks that have gone up a lot over the past few months.   You should expect profit-taking to be especially strong for sectors/stocks that have gone up sharply over the past short while–month-to-date, or even a couple of days.

On the other hand, although they may be dragged down again today with the rest of the market, you should expect stocks that have been poor performers and that people have been selling for an extended period of time to perform better than the averages.  After all, for these stocks, a day like today is nothing special.

Actuality vs. expectations

That’s the picture to expect.  What you should do is look for sectors/stocks that are not performing in line with the past two paragraphs.  Such stocks will probably fall into two categories:

serial clunkers (underperforming stocks that continue to underperform today–usually a very bad sign) and

very strong, continuing winner, stocks (usually a very good sign).

Your intention shouldn’t be to get an absolute, can’t-be-wrong reading on the market, but rather to notice what is happening that doesn’t fit–either with the typical market pattern on a day like this or with your strategy for the market.  You may be able to raise your conviction for some ideas and perhaps get an early warning of changes you need to make.

Turning to today’s market,

One thing that really jumps out to me is that although energy stocks have been the best-performing group in the S&P so far this month, and are up as a group almost 10% since the end of September, they’re down considerably less than the market today. Materials, another economically sensitive group, is doing unusually well also, although not performing as strongly as energy.  I think the important thing about both these groups is that they are bets on global economic recovery, without having to bet specifically on recovery in the US.

Another is Harley Davidson (HOG).  I haven’t owned this stock for years.  As I picture it, the company’s customers are almost all Americans.  They’re either biker outlaws or aging accountants/dentists who have read On the Road or seen Easy Rider too many times and are trying to relive–or just plain-old live–their youth.

The products are expensive and easily postponable purchases.  On the surface, the earnings they reported two days ago were poor.  Yet, after an initial dip, the stock was up strongly yesterday and is (so far) up again today.

I’m not really interested in buying the stock, although I’l admit to be contemplating buying a Harley t-shirt.  As you may know from Keeping Score, I lost my enthusiasm for the consumer discretionary sector at the end of August.  But here’s a consumer discretionary–really discretionary–stock doing well.   I’ve looked a F and scrolled through a series of retail names and all are weak today, except TGT and WMT.  Everything else seems to fit with a weak US consumer.  Still, HOG is a data point I wouldn’t have expected and is therefore worth thinking about.  I’ll have to be alert for any similar data.

Another notable stock is WYNN, which I own. It has been very weak over the past week and is underperforming today, too.  It’s trading in line with other casinos, but that’s cold comfort.  As a group, casinos are now doing worse than hotels.  I’m not going to do anything for now, but I’ve got to watch this stock more closely.

I could go on, but I’m sure you get the idea of what you should be doing.

“Know thyself”

The second thing you can do is examine yourself.  Are you willing to look at prices and perform the kind of check I’ve just been describing about the strategic layout of your equity investments?  Are you able to think about, and perhaps actually make, changes to your portfolio based on data you collect?  If so, everything is probably fine.

If not, if, on the other hand,  you become really emotional–you refuse to look, or are uncomfortable at the thought of  (even temporarily) loss-making investments, then you may have a problem.   It could be as simple as having had too much caffeine this morning.  Or you may have built more risk into your portfolio than you believe you should have, or are temperamentally suited to have.  Or you may have some stocks that, deep down inside, you know you should sell but you can’t seem to pull the trigger.  In any event, you may want to start from the ground up examining your strategy.  You might also want to read my thoughts on constructing a portfolio.