Monthly Archives: November 2009

More trading down

November 8, 2009 By in Industry Analysis, Recent Market Action, Retail Tags: , , , , , Leave a comment

Catalina Marketing analyses consumer buying behavior using the more than 250 million transactions holders of supermarket and pharmacy loyalty card holders that CM records each week.

The company’s studies of how consumer purchasing habits have changed since the financial crisis make interesting, if grim, reading.  Last June, for example, the Financial Times reported that the average national brand had lost a third of its previously most dependable customers to cheaper store-brand goods during 2008.

The FT has just reported the results of another CM study, this one about changes in the kinds of things Americans are buying in the supermarkets rather just changes in the suppliers chosen.  The findings:

1. impulse purchases are way down.  Sunglasses buys have been cut almost in half and sales of tights are off by nearly a third.

2.  men have left the salons and returned to supermarkets and drug stores for hair-care products

3.  dogs and cats are being reduced to eating dry food instead of the canned “wet” meals they enjoyed in better times

4.  families are apparently spending more time at home, if rising sales popcorn and a 70% year on year jump in purchases of ice cream and cake (comfort food?) are any indication.

The fact of trading down shouldn’t be particularly surprising, since it occurs in every recession.  Even the rapidity of the change in consumer behavior this time around and the large number of areas where trading down has occured may have lost their ability to shock, since we have been reading about–and experiencing them–for some time.

Two observations, though.  I wonder how far can we extrapolate changes in the way consumers are treating everyday purchases now to the way they will treat more expensive, less frequently purchased items when they need/want to buy them.  In other words, how confidently can we bank on an explosion of pent up demand when the unemployment rate begins to fall?

More important, why have big losers from trading down, the packaged goods manufacturers, begun to outperform in the stock market?  Investors aren’t buying utilities or telecom, so I don’t think this is simply a general counter-trend rally.  Can the trading down phenomenon already be fully discounted?  One option this might suggest for an active manager is to underweight other defensives–telecom and utilities–and overweight staples.  Let’s see if this movement has any legs first, though.

Book Value (l)–general

November 6, 2009 By in Basic Concepts, book value, growth vs value Tags: , , , , , 3 Comments

I was reading an article a few days ago which asserted that emerging markets equities were overvalued because they were trading at an average of 2.3x book value vs. an average of 1.8x book for stocks in developed markets.

What does this mean?  Is the argument a reasonable one?

I’m going to cover this topic in two posts.  This one will outline what book value is and the sorts of circumstances where I think it’s useful.  In the second post, I’ll talk about situations where book value is more problematic as a value indicator.

What “book value” is

“Book value” is the value of the shareholders’ investment in a company as shown on the company’s official records, or “books”.

For reporting the condition of their client companies to stockholders,  accountants produce three basic records:

the balance sheet,

the income statement and

the cash flow statement.

Book value comes from the balance sheet.

The balance sheet has two sides.  The entries on each side add up to the same number,  or “balance” with each other. One side lists everything the company owns, from cash, to inventory and receivables, to plant and equipment.  The other has liabilities–loans, preferred stock, credit extended by suppliers and anything else the company owes to others–plus common shareholders’ equity.  Book value is what’s left after subtracting liabilities from assets. It’s another name for shareholders’ equity.

Why it’s useful

Book value is a very basic and traditional measure of value.  It functions in several ways:

1.  liquidation value.  If we assume that the accounting statements are accurate, book value per share is the amount that stockholders would receive if the company’s assets were sold in an orderly way, liability holders paid back, and the remainder distributed to owners.  A company whose stock trades at a steep discount to book value is, at least in theory, under threat of being taken over and liquidated, if its results can’t be improved by the new owners.

2.  a shorthand way of assessing management’s capabilities. In combination with profit data, we can use book value  to calculate ratios like return on capital (annual profit/debt + book value) or return on equity (annual profit/book value).  Years and years of all the data needed for these calculations are available in databases, so companies can be screened and compared very easily.  Comparison can either be across a universe of stocks or for a single company over different periods of time.

If we assume that the specific assets a company owns don’t carry with them a unique advantage over competitors, then variations in return on capital across an industry are most likely due to differences in management quality.  If the analysis is confined to a single industry, the highest results can at least show what returns can be achieved by strong management–and therefore what improvements are possible among laggards.

3.  a guide to stock market valuation. Another way of looking at book value is that it’s what it would cost to reconstitute a given company by buying similar assets and taking on similar liabilities.  By this measure, a stock trading at a discount to book value should be cheap.  Conversely, a stock trading at a premium to book should be expensive.  One of the rules Benjamin Graham, the father of value investing in the US, used to use was that a stock was potentially attractive if it traded at below 2/3 of book value.

A corollary of #1 and #2 is that a company whose stock is trading at, say, 2x book because returns are very high is likely creating an artificially high pricing umbrella which will draw competitors to the industry, eventually undercutting the “expensive” firm’s profits.

Screening

Because you’re only looking a one simple variable, it’s possible to screen large numbers of companies in an instant, as well as to compare firms in different industries with one another.

Advocates would also argue (this is not a majority view, however) that there’s no chance of being seduced into buying overvalued stocks by smooth-talking managements with fancy powerpoint presentations.  You’re dealing with hard, cold facts–the numbers.

What you need to believe

The basic assumptions you make when using book value as a tool are:

1.  when a company buys long-lived assets like property, plant and equipment, or makes a long-term investment in another company, it basically gets its money’s worth–in other words, the purchase price recorded is a fair assessment of value,

2.  while there may be differences in the bells and whistles decorating a given factory or the manufacturing equipment located inside, these assets are functionally equivalent to superficially different assets competitors may hold–so a comparison of carrying values is legitimate,

3.  these assets have enduring value that, if it changes, does so only slowly–so carrying value doesn’t lose its relevance as time passes,

4.  the auditors are doing their job of ensuring that the company writes down the carrying value of worn-out or obsolete assets,

5.  something can and will happen with a company trading at a deep discount to book to force the stock price up so that the discount disappears- in other words, action will be taken by shareholders, the board of directors or outside activist investors, to achieve this result.

Under these assumptions, then, when you locate a company whose stock is trading at a big discount to book, you’re looking at a deeply undervalued–and very attractive–security.

One other thing.  The industry itself must be viable–no buggy whips or whale oil processing.  In today’s world, many book value-guided value investors avoid airlines for this reason.

The basic metaphor

The basic metaphor is a manufacturing one.  A company has valuable tools that it employs workers and managers to utilize.   Assets are seen as commodity-like.

Firms are seen as achieving a competitive advantage by having been able to obtain enough capital to buy its productive assets in appropriate size the first place, and by achieving economies of scale by operating them efficiently and reinvesting profits in their expansion.

Where it works

Since the idea behind using book value as an investment tool is industrial, it makes sense that it should generally work best for companies that produce goods, not services.

The concept is useful in evaluating a very wide range of companies, from general industrials to oil refiners or cement makers or shipyards (or ship owners), or office buildings–to name a few.  Anything with physical assets.

It applies especially well, I think, to manufacturers of semiconductors, computer components and other IT hardware.  How so?  The industry is very capital intensive.  The companies in question are all relatively young.  Their plant and equipment has been purchased in the recent past.  As a result, the playing field for comparison is level and the figures are probably highly accurate.  There’s little chance of making an apples-to-oranges comparison between brand new plant carried at full purchase price and perfectly adequate plant bought at lower prices twenty years ago and already partly depreciated.

Book value has also been the tool of choice for assessing financial companies, especially brokers and other trading companies.  Results using book over the past few years have, of course, been disastrous–Bear Stearns had reported book value of above $80 a share just as is was collapsing.

The idea was that it’s impossible to understand, transaction by transaction, what is going on inside any financial company.  But what they do is invest shareholder’s money.  The money they have to work with is book value.  What an investor can do, however, is calculate the return a company achieves on book value.  If a company consistently earns, say, 20% annually on book, I can pay up to 2x book value for the stock–getting me a 10% earnings yield.  If the return is a Goldman-like 25%, then I can pay 2.5x book

What happened to the financial industry was, I think, not so much an indictment of the use of book value as it was an indictment of managements and auditors who used dubious accounting tricks to present a grossly distorted picture of their firms.

What about intangibles?

It may be that a company gradually builds up a reputation for quality and service that allows it to charge premium prices for its goods.  This will presumably translate into higher profits and a stock price that substantially exceeds book.  Won’t a book value screen toss out a firm like this?

Two points:

1.  You can use the trading history of this sort of company’s stock vs. book value to judge when it it may be time to buy during a downturn or to sell during an upturn.  The idea would be that the stock has never in the past traded below .9x book in recession, so when it hits that level in a downturn it’s pretty safe to buy.  or that it peaks at 3x book in an upturn.

2.  If you’re worried about this, you’re not  a value investor–who are the primary users of book value as a tool.  Value investors argue that the real money, and the low-risk money is going to be made by finding the laggard company in the same industry that’s trading at a deep discount to book.  When the board of directors or activist investors force a change of management in that company, and when the new management works the company’s assets harder, the profits will soar (at least to the industry average and maybe beyond) and the stock will skyrocket.  That’s where you should be looking.

That’s it for today.  My second post will talk about situations where one has to be careful about using book value.

The Galleon hedge fund, and trading on inside information

November 5, 2009 By in Current Market Thoughts, hedge funds Tags: Leave a comment

Galleon surprises

Newspapers have been full of stories about the rise and fall of the Galleon hedge fund run by Raj Rajaratnam, former research head at Needham.  Among the more striking revelations, to me at any rate, are:

1.  the level of annual brokerage commissions the group generated.  The $250 million figure mentioned by reporters would be 3.6% of the group’s peak assets of $7 billion.  That’s easily 10x the fees paid by a traditional fund management group dealing in equities.

2.  the speed with which the group’s assets have been unwound–implying that Galleon dealt primarily in plain-vanilla stocks and bonds.

3.  the fact that indicators of potential ethical or legal problems had been around for years, but not picked up on by the regulators.  The papers have cited a JP Morgan memo from 2001, as well as previous prosecution of the woman who is now the government’s chief witness against Galleon, in a case where Galleon was reportedly involved but not investigated.

4.  the list of senior executives, from Intel, IBM and McKinsey, among others, who the government asserts had been supplying Galleon with inside information for years.

5.  the–to me, anyway–curious lack of motivation cited so far for these executives to risk the loss of their careers and the chance of jail by providing Galleon with information they were obligated to keep secret.

Where’s the motive?

The only hint of possible motivation I’ve sen so far for prominent tech firm executives to have given company secrets to Galleon from an article in the Financial Times. It says that a number of the executives in question had personal investment accounts with Galleon.  The article questions whether having a Galleon account constituted a conflict of interest.  It also points out that there are no real standards governing executives’ private investing activity and that what rules corporations may have are often only laxly enforced.

What the article seems to imply is that the executives figured that the inside information would improve Galleon’s results, and thereby increase the value of their Galleon investments.  That’s kind of a stretch, though.

I suspect the Galleon affair may develop along the same lines as the investigation of former junk bond king, Michael Milken.  In fact, the story of a disgraced Fidelity junk bond portfolio manager from that time, Patricia Ostrander, appears strangely similar to what we’ve heard so far about the Galleon providers of inside information.

When the authorities were closing in on Milken, one of his associates told them about the “MacPherson partnership,”  an investment vehicle Milken set up and supposedly used as a reward to junk bond portfolio managers whose funds participated in worthless IPOs.  Portfolio managers would “invest” $5000-$10,000 in MacPherson and in short order cash out for $750,000 or so.

There’s also a simpler possibility.  So far there’s no information about the performance of the accused tippers’ Galleon accounts.  They may all turn out to be mini-MacPhersons.  If so, let’s hope the SEC is looking.

The place of emerging markets in your stock portfolio

November 4, 2009 By in Current Market Thoughts, Strategy Tags: , , , , , , Leave a comment

The short answer

The short answer is:  it may be that this upcycle will feature emerging markets more prominently than in the past.  But you should own only as much as will allow you to sleep soundly at night.  In all likelihood, that will be less than an optimal weighting, but knowing and respecting your tolerance for risk is more important.

A somewhat picky aside (very skippable)

The term “emerging markets” has some ambiguity to it.  For as long as I’ve been involved in stocks, investors have called Singapore an emerging market even though citizens there are on average as well-off as those in the US or Western Europe.  In contrast, they’ve called Germany a developed market, even though Germans by and large don’t have great interest in equities and very little of the economy is publicly listed.

What the term “emerging markets” should mean is “stock markets in emerging economies,” typified by countries like the BRICs, Brazil, Russia, India and China.

Emerging markets are attractive…

The attractions of emerging markets–and their stocks–are:

1.  their economies, or at least some large portion of them, are growing extremely rapidly, as they try to catch up with the developed world,

2.  their growth is that much faster because they are typically following a development path blazed by others, and

3.  foreigners who have already lived through similar, though perhaps slower and lengthier, development phases can appreciate the emerging economies’ growth potential far better than locals.  Therefore, in most instances the stocks are cheap.

…but it’s risky

Investing in emerging markets is much riskier than investing in one’s home market, though:

1.  the local political framework may not be stable–and it may not be particularly favorable to foreigners.  This “unfavorable” aspect can range from the relatively benign restrictions every country has on foreign ownership of key industries (remember, Rupert Murdoch had to become a US citizen before he could build his American media empire) to the bumiputra program–and, more recently, capital controls that prevented foreign investors from exiting the country–in Malaysia.

2.  for any developing economy that has hitched its growth star to US or European customers, both the economy itself and the publicly-listed stocks may be very sensitive to the ups and downs of GDP growth in the developed world.  So they can be ultra-cyclical.

3.  perhaps most important, for many emerging markets the big buyers and sellers are foreigners.  When foreigners decide the cycle is turning and it’s time to divest emerging markets stocks and replace them with (defensive) G 7 bonds, there are few, if any, local pension plans or mutual fund groups to absorb the selling.  So stocks go down a lot.

I think investors tend to forget #3 because the last two emerging markets crises–Mexico in the early Nineties and Asia ex Japan in the late Nineties–were caused by big-time macroeconomic mistakes by the countries involved.  But the fact still remains that stock markets in countries where average citizens don’t earn enough to think about stocks as investments for themselves are at least partially hostage to the whims of foreigners.

The traditional take on investing in emerging markets

The typical thought pattern for a portfolio manager in, say, the US , who believes the worst of an economic downturn is past and he/she should become more aggressive is:

I’m loaded up with slow-growing, large-cap, dividend-paying, economically less sensitive stocks–the ones that look and act as close to government bonds as I can get.  That was great during the downturn, but now I’ve got to add risk to benefit from the upturn.  I’ll sell some of what I’ve got and replace it with economically sensitive domestic stocks, plus small-cap, then international and finally–at the far end of the risk spectrum–emerging markets.  When it’s time to head back into the storm shelter, I’ll just reverse my steps.

Investors are taking a different approach in this cycle, I think

Individual investors, and professionals as well–to the degree that their mandates from clients allow–seem to me to be going through a somewhat different thought process in the current upcycle.  I think it’s something like this:

When I look at the MSCI World Index or its FT equivalent, I see that 45%+ of the market cap is the US, and 10%+ each is the next two largest markets, the UK and Japan.  So two-thirds of what I get from the developed markets index is either the epicenter of the financial industry meltdown (US + UK) or exposure to an economy and stock market that have been more or less asleep for 20 years.  That’s an awful lot of dead weight to carry around.

As to the emerging markets, their economies are an awful lot bigger than they were ten years ago (see my posts on purchasing power parity GDP for details).  If the US and UK do well, emerging markets should do very well.  But if, on the (more likely, in my opinion) other hand, the US and UK just limp along, the emerging economies are now big enough to have a good shot at growing, from the strength of their trade with each other and from their own domestic demand.  So, for the next couple of years at least (as far as we need to worry about today), there are more possibilities for emerging markets do well than there are for most of the developed world.

And, who knows–it may be that foreigners won’t have their usual panic attack and dump out their emerging markets exposure when the cycle turns down again.

The same argument, put a different way:

in creating a portfolio, your strongest convictions don’t have to be about the areas you want to overweight.  Your strongest beliefs can easily be about what you want to avoid.  In the latter case, you establish your overweights almost by default.  So, if you think the world is entering a period of economic expansion and you don’t think you’ll participate fully in it if you hold US, UK or Japanese securities, then you underweight them and overweight everything else–namely, continental Europe and emerging markets.

Anyway, although investors around the world have been buying emerging markets stocks for some time now, the next development–and the next real surprise to the market–may be that they buy more rather than reduce their positions.

Citigroup’s deferred taxes–what Mike Mayo is saying

November 3, 2009 By in Banks, deferred taxes, Industry Analysis, Vocabulary Tags: , , , , , Leave a comment

The Wall Street Journal reported on Friday that long-time Wall Street bank analyst Mike Mayo told clients in a conference call he expects Citigroup will write off $10 billion in deferred tax assets in December.

Who is Mike Mayo?

He’s an experienced, well-respected sell-side bank analyst.  I don’t think I’ve ever met Mr. Mayo, who now works for French broker Calyon, but I’ve known and used his research for years.  We may even have worked for the same firm for a brief period.

Mr. Mayo periodically draws the ire of bank managements–with not always positive career consequences for himself–for his research findings.  His conclusions, which I think have generally proven to be correct, at times call attention to previously unnoticed company missteps.  Or they may just not be sufficiently bullish to suit company managements that regard analysts as extensions of their public relations efforts, rather than independent researchers.

To understand what he’s saying about Citigroup now,  you have to know some thing about what deferred taxes are.

Deferred taxes

Publicly listed companies keep several sets of books.  Among them are the tax books they use in reporting to the Internal Revenue Service and financial reporting books they use in reporting to shareholders.  Taxable income is typically lower in the reports to the IRS than in those to shareholders.  Deferred taxes are a way of reconciling the two sets of books.

An example:

Let’s say a company has a pre-tax loss of $1 million, and has used up its ability to receive a refund from the government for taxes paid in prior years.  For the IRS, this result is reported as an after-tax loss of $1 million.  The company is able to carry forward this loss, however, and use it to offset future years’ taxable income.  Rules vary from country to country.

In its financial reporting, the company will record a pre-tax loss of $1 million, just like it will for the IRS.  But, in contrast to the IRS filings, it will also record–as a reduction of the current loss–the value of future tax benefits that this loss potentially gives the company.  In this case, let’s say that’s $350,000.  Under financial accounting rules, then, the company will report a net loss of $650,000 to shareholders and record the $350,000 on the balance sheet.

If the company makes $1 million pre-tax next year,

1.  it will record the $1 million in taxable income in its IRS filing, but subtract the $1 million tax loss carryforward and pay $0.

2.  To shareholders, it will report $1 million in pretax income, subtract $350,000 in deferred taxes from that (and remove the balance sheet entry) and report $650,000 in aftertax profit.

Notice that the overall result in both cases is zero. The effect of deferred tax accounting is to make a loss-making company’s results look better in the loss-making years, at the expense of making future profits look worse.

One exception

In order to use deferred tax accounting, a company–and its accountants–have to be convinced that the firm will be able to make enough future profit to actually use the tax loss carryforwards it is taking credit for on the financial reporting books.

In particular, if a company’s fortunes deteriorate after having used deferred taxes to minimize current losses, and it finds it won’t be able to earn enough to actually employ them, it has to write them off.

Finally, to Citigroup

Citigroup had a little over $44 billion in deferred tax liabilities on its books at the end of last year.  According to Mr. Mayo, the company will write off $10 billion of them at yearend.

Typically, a firm’s auditors compel the company to make a writedown like this.  And, unlike Mr. Mayo, accountants are, in my experience, concerned enough about the egos of a client’s top management that they will not do so unless there is overwhelming evidence supporting their conclusion.

So what Mr. Mayo’s statement, if correct, implies to me is that:

1.  the auditors now realize that Citigroup will be significantly less profitable in the future than they had thought less than a year ago,

2.  past earnings have been inadvertently overstated by $10 billion, and

3.  the burden of proof has shifted, away from thinking that the other $34 billion is a conservative number, to worrying about that, too.

Normally, writedown of deferred taxes is an ominous sign for a stock.  And $10 billion is about a tenth of Citigroup’s market cap.  It’s unclear to me in this case, however, whether the writedown Mr. Mayo talked about is an industry phenomenon or something specific to Citigroup.

It also isn’t clear to me even how one could figure out the possibility of such a writedown for a complex multinational business like Citigroup.  My best guess is that this relates to some (unknown to me) legal or regulatory change in the UK, where US firms domiciled much of their activity in toxic assets.

Stay tuned.