Monthly Archives: December 2009

Activision: strong company in a weak industry

December 14, 2009 By in Industry Analysis, Shaping a portfolio for 2010, Stock ideas, Strategy, Technology, Video games Tags: , , , , , Leave a comment

Invest in companies or invest in industries?

Question:  Which is likely to be a better investment–a strong company in a weak industry or a weak company in a strong industry?

(My) Answer:  It depends.  Outside the US, where equity investors tend to focus more on national and international macroeconomic and political issues and less on individual security analysis (many wouldn’t know an annual report if they fell over it), the merits of the industry far outweigh those of the individual company.   Holding the best companies, without regard to the industries they’re in, is a recipe for disaster.

In the US, on the other hand, which has been a pillar of relative macro and political stability, “big picture” issues have tended to be irrelevant.  Instead, everyone is a stock picker.  Holding the best stocks, without regard for their industry, has been the ticket to success.

US equity trading is taking an unusual path, I think

I’m not so sure that this rule of thumb, extremely reliable in the past, has held in the US in the current bull market.  The two clear patterns I see in this year’s stock performance are:

1.  economically sensitive industries have done well; more defensive industries, like telecom, utilities, healthcare and staples, have consistently done badly.

2.  toward the end of the summer, the market narrowed its focus from looking at economically sensitive industries across the board to focussing more narrowly on the strongest members of the strong industries–that is, from value to growth.

In all of this, it seems to me that stocks in weaker industries have just been ignored, no matter what their merits.

ATVI as an example

…which brings me to ATVI (a stock I own).

ATVI closed last Friday at $10.75 a share.  It’s up about 30% from the lows in March, or about half the gain the S&P 500 has achieved.  It kept up with the S&P fairly well until mid-summer and has been fading since.  What’s wrong?

The simplest explanation, and, given that even the best equity investors are wrong almost half the time, is that my analysis of the company has been faulty.  At least in terms of stock performance, it certainly has been.  But at the risk of keeping on deluding myself, I think there’s something more than that.

The shrink-wrapped video game software industry is in trouble, in a number of respects:

1. Some competitors aren’t doing well.  The long-time industry leader, ERTS, has been faltering for a number of years and new management so far seems unable to straighten things out.  Similarly, TTWO, famous for its Grand Theft Auto series, recently announced it was having trouble with the sports game franchise it bought from the former Sega.

2.  Wall Street is worried about the competitive threat of casual gaming, simple games played for short periods of time on mobile phones or through social networking sites.  This is an issue because the cost of creating a console video game has risen far beyond the point where it can be profitable by only selling to hard-core gamers.

3.  Video games generally are proving less recession-resistant than had generally been thought.  Software sales in the US are down 3% year on year.  That isn’t much, but the consensus expectation had been for a rise.

Why should ATVI be any more attractive than ERTS or TTWO?

1.  ATVI’s first person shooting franchise, Call of Duty, launched its newest version, Modern Warfare 2, on November 20th.  Through the end of the month, according to the NPD data collection service, over 6.1 million copies of MW2 had been bought, making it the most successful launch ever or a video game.  True, two expensive games ($90+) for consumers to buy, DJ Hero and Tony Hawk: Ride have been turkeys so far, selling 245,000 and 114,000 respectively through the end of November.  But their negative effect on results will be swamped by MW2‘s positive impact.

2.  ATVI owns Worlds of Warcraft, by far the most widely-played subscription-based online fantasy game.  What makes WoW unusual is its appeal to audiences in the Americas, Europe and Asia–typically markets with widely different taste in games.Subscription revenue seems to be plateauing at slightly north of $1 billion yearly, implying, say, $800 million in annual operating income.

3.  Although long-delayed, ATVI says it will launch a new version of Starcraft in 2010, intending to try to duplicate the online success it has had with WoW. No one knows yet whether ATVI will be successful, but earlier games in the Starcraft franchise have also enjoyed immense worldwide popularity.

4.  The company has no debt and $2/ share in cash.  ATVI will likely add at least $.50/share to that total by the end of the holiday season.  It has been revising its earnings guidance up–doubtless due to the success of MW2 (which it had a strong hint about through pre-orders).  Assuming ATVI could earn $.70 a share in 2010, it is trading at 15x earnings.  If results are indeed being held down by recession at present, an improving economy might push ATVI’s earnings higher.

A wider implication

ATVI may or may not turn out to be a good stock.  Stock-specific risk is the reason you hold a portfolio instead of one stock–to make sure your success doesn’t rise or fall on one name.  But there’s a wider point I want to make.

It seems to me that the US market has been bought since March in a top-down, industry-orientation way that would be more characteristic if European equity managers or global bond managers were making the decisions.  Bottom-up, traditional American-style growth stock investing appears to me to have taken a back seat.  This implies that looking through laggard industries–healthcare, telecom, even (gulp) media–may be very worthwhile.

“sell in” and “sell through”: what they are and why they matter

December 13, 2009 By in sell in and sell through Tags: , , Leave a comment

“Sell in”

Many product manufacturers, particularly those who make consumer goods, don’t deal directly with their end-user.  They use a chain of distribution instead.  This kind of company has to market to two audiences.  It has not only to convince the end-user to buy, but it also has to persuade the distributor to stock the item in the first place.

The quantities taken by the distributor are called “sell in.” Typically, the distributor takes physical and legal possession of the product at the manufacturer’s factory loading dock.  When this occurs, the manufacturer considers that the product is sold and credits himself with the associated revenue and profit.

If the manufacturer sells 100 units at $50 each, he may not credit the whole $5000 as revenue, since he has to consider the possibility that not all the units will be sold to end users at full price.  He may set up a reserve for possible returns, based on his historical experience with this type of item and some amount of guesswork.  If he assumes 5 units will be returned, he will only recognize $4750 as income.  His other choice would be to show the entire $5000 in one accounting period but then have to record a loss on the returns in the next.  Why do that?  It would just make the revenue stream look more volatile, meaning that investors would place a lower value on it.

The topic of returns is a complicated one, and practices vary from industry to industry.  I’m going to go into it here only in the briefest way.

On the one hand, there are legal and contractual agreements.  On the other, the issue of maintaining good long-term working relationships sometimes means that the rules are bent a bit.  And of course nothing can ruin a brand name faster than seeing a $1000 retail item being sold for $75 in a close-out store.

Often, to forestall returns of a slow-moving item, the manufacturer will provide a retailer with additional funds for promotion.  The retailer may also be compensated for discounting he may have to do, either through payments or through discounts on future purchases from the manufacturer.

How do we find out about sell in?  The information comes from the manufacturer, either through press releases,  analyst conference calls or SEC disclosures.  How much information a manufacturer is willing to disclose varies.

“Sell through”

“Sell through” is the amount of merchandise that is actually bought by end-users.  Ultimately, sell in should equal sell through + inventories in the distribution channel (less shrinkage).

How do people know this number?  By and large, wholesalers and retailers have point of sale computer systems that record each item sold.  Manufacturers can find this number out from each of their customers and thus have a good idea of how much inventory is left in the distribution channel and what reorders are likely.

What about us, though?  A number of third parties collect POS information from retailers for distribution, often for a fee, to manufacturers (who can then compare sales of their products with those of rivals’), industry analysts and anyone else willing to pay.  The biggest flaw with such data is that WMT figures it would give away more than it gets from this kind of information exchange and won’t release its POS data.  WMT is about 10% of all retail in the US, which is bad enough, but in some categories it can be a third or more.  In those cases, the third-party data must be taken with a grain of salt.

Why they matter

Looking at sell in vs sell through gives an advance look at how business is going, as well as a sense of how solid the revenue and profit numbers are that have already been booked.  If sell through exceeds sell in, then inventories on the shelves are getting smaller and reorders may be on the way.  If sell in exceeds sell through, stocks are piling up.  In a really bad case, writedowns are possible.

This can be particularly important for a smaller company, where one big hit or one real clunker can have a material impact on the manufacturer’s fortunes.  I was just reading the other day about a small UK publisher whose stock I’d owned once but had long-ago lost track of.  It seems that it published and sold in 14 million copies of a Star Wars book, which sold through only 3+ million copies.  The loss created by the 11 million or so returned copies, which maybe cost $140 million to print and were now just recycling, was reportedly enough to send the company scrambling for a merger partner to help it stay afloat.

Government debt trap: how a country’s finances can go bad

December 11, 2009 By in economics, government debt trap, Japanese development Tags: , , , , , , , , Leave a comment

The debt trap

Long-time observers of the Japanese economy are beginning to worry publicly that the country is slowly falling into a government debt trap.  The last time I recall this sort of talk was in the late Eighties, when commentators worried that pre-Euro Italy was in the same bad shape.

What is a government debt trap?  The general idea is that the government debt situation spirals out of control as the cost of servicing government borrowings rises dramatically, through some combination of high interest rates and the volume of government debt outstanding.

Caveats

The easiest way to explain the phenomenon is to give an illustration.  I’m going to keep it very simple.  Governments have become very crafty at keeping items like the cost of a war, or of senior citizen benefits, or explicit or implicit guarantees for failing “government-sponsored” enterprises.  But I’m going to ignore that.

I’m also not going to have the country in my illustration grow over the years.  Naturally, if GDP–and therefore tax receipts–grow, but government expenditures remain flat (fat chance!), then the situation I’m about to describe may gradually improve.  If, on the other hand, government expenditures grow at the same rate as tax receipts, the situation becomes worse.

Also, in theory at least, governments run deficits in downturns and surpluses in upturns, so that over a business cycle they are breakeven.  I’m going to ignore this reality as well. (This is kind of scary.  It’s like I’m turning into an academic!  I hope it wears off soon after this post.)  Take the “years” I’m talking about as being an average of what happens over a business cycle.  Bear with me through the initial part.  I’ll inject a dose of realism at the end.

Here goes–

Illustrations

Let’s make the following assumptions about a country:

CASE  1

annual GDP         100

tax receipts             30

govt expenditures        35

govt debt        0

interest rate on govt debt       5%.

This situation is relative benign.  The government runs a primary deficit (tax receipts minus government expenditures, before debt service) of 5.  Interest expense on that debt is .25, so the overall deficit is 5.25.  Interest expense makes little difference to the overall deficit.  The deficit is also structural, not cyclical; that is to say, it won’t go away as the business cycle develops.

Let’s look at something more interesting.

CASE 2a

Everything is the same as in case 1, except that government debt is now 100.(this might arguably be the UK or US in a few years).

The primary deficit remains 5, but now we also owe bondholders another 5 in interest expense.  So the government has to borrow 10 to cover expenses.

In year 2, we have the primary deficit of 5, but government debt is now 110, so interest expense is 5.5.

If this same situation persists through year 10, then government debt is over 200 and interest expense alone is 10.

At this point, in order to get the budget into primary balance, the government would have to cut expenditures by about 15%.  To get into overall balance, expenditures would have to go down by 40%. What are the chances of that happening?

CASE 2b

The same as case 1, except interest rates are 10% and outstanding government debt is 150.  (This is, more or less, the Italy of the late 1980s.)

In year 1, the primary deficit is 5 and interest expense is 15, so the government has to borrow 20 to cover expenses.

In year 2, the primary deficit is 5, interest expense is 17 and total debt rises to 216.

If we follow this progression out to year 5, debt rises to 270 and interest expense is 24.

In year 7, interest expense exceeds tax receipts!!!

Who’s going to lend to this country, even in year 1?  Well, there are the people who lent to Nakheel in Dubai, but they’ve got enough trouble as it is.  And, PT Barnum’s beliefs to the contrary, would there be enough of them in any event?

CASE 2c

The same as case 1, except debt is 200 and interest rates are 1.5%.  (This is more or less today’s Japan)

In year 1, the primary deficit is 5 and interest expense is 3.  Total government debt rises to 208.

In year 5, the primary deficit is 5, interest expense is 3.6 and total debt is just under 250.

In year 10, the primary deficit is 5, interest expense is 4.2 and total debt is just under 300.

In this case, the overall government debt is gigantic, equalling 10 years’ tax receipts.  How will the government ever be able to pay this money back? Note, however ,that the government can achieve overall budget balance relatively easily, by cutting expenditures/raising taxes by a little over 10%.  The biggest danger is that bondholders decide not to roll over existing debt at current interest rates.  If interest rates–and therefore interest expense– go up, or if the government is unable to pay current maturities from the proceeds of new debt sales, big trouble arises very quickly.

(A little) realism injection

1.  If we can figure out, at least in general directional terms, the possibility of severe future trouble in just a few minutes, so too can any potential government bond investor.  So the government in question begins to have difficulty in rolling over existing debt long before the year 10 situations emerge.

2.  Legislators, or their aides, understand the developing problems as well.  But their desire to bring government largesse to their constituents–and thus assure their reelection–typically overwhelms and desire to cut expenditures or raise taxes.  In the “benign” case, they stick their collective heads in the sand.  In the worse case, they deliberately foster inflationary policies, on the thought that this lowers the real value of what the government needs to pay back.  This throws gasoline on the fire.

3.  Off balance sheet liabilities make the debt situation worse.

4.  All the bond issuance by itself is inflationary, as is the currency weakness that ensues as foreigners sell their holdings an repatriate the money, or simply hedge the local currency exposure they have.

5.  It makes a difference whether the government is bought by locals or foreigners.  In the first case, the current generation is borrowing from its sons and daughters, saddling them with debt that finances current consumption.  Foreign buyers can come and go much more quickly, so the need to finance a portion of the government’s debt externally usually makes the situation more volatile.  One exception:  my observation (and, remember, I’m a stock guy) is that in past debt crises in the US, domestic investors have been much quicker to withhold their funds than foreigners.

6.  Case 2b is the more “normal” development path of debt running wild.  Case 2c, Japan, is unusual in that Japanese savers continue to commit money to the bond market despite very low nominal interest rates.  Observers have attributed this to a self-reinforcing circle of economic weakness, as follows:

a.  Government policy expresses the social desire to preserve a traditional way of life.  So Tokyo’s actions tend to preserve the status quo.  In particular, highly inefficient, money-losing companies are not allowed to fail or to be bought by more competent management.  This action damages the prospects for healthier firms and results in low economic growth and possible deflation.

b.  To stimulate growth, the government engages in (basically worthless) public works projects, which require public borrowing.  Because the economy flirts with deflation, nominal yields are low.

c.  Citizens recognize the situation and save heavily, rather than consume, in order to have funds for retirement.  Since most publicly-traded companies have poor profit prospects, the equity market is seen as too risky.  Bank deposit rates are effectively zero.  This leaves government bonds, even with a 1.5% coupon, the best alternative.

The big risk to Japan, therefore, is that one day domestic savers find another vehicle for their savings and want their money back.  This is unlike the “normal” case, where rising nominal interest rates are typically the country’s undoing.


Development of retailing in the US (ll): discount stores and the internet

December 10, 2009 By in Industry Analysis, Retail Tags: , , Leave a comment

Discounters

About the same time as the first specialty retailers were emerging on the retail scene, a second new type of store, the discount superstore, was also showing up.  The most famous and successful are Wal-Mart, Target and K-Mart. As with any other form of endeavor, there were many other competitors who couldn’t survive competitively.  Look at almost any moribund, half-filled strip mall of a certain minimum size and you are likely to see the remains of one of these.

The discount stores were originally intended to serve more or less the same function among the array of choices available to the consumer as the department store, only in areas that didn’t have the population density or affluence necessary to support the higher-end merchandise that a department store would typically carry.

Wal-Mart had a very straightforward development strategy.  It initially focused on places with a population of 250,000 or so.   It would open a superstore on low-cost real estate on the outskirts of town.  Its low prices would win it lots of business that had previously gone to local downtown merchants.

When the US market began to approach saturation (local retail interests have pretty much kept it out of California; that opposition plus the scarcity of sites big enough have done the same for most of the Northeast), Wal-Mart expended internationally and opened Sam’s Warehouse Clubs. Its next big move, followed by Target, was to create much larger stores to sell a full line of groceries as well as general merchandise.   This brought both into direct competition with the major supermarket chains in the US.

Important effects of their prominence

The discounters have risen to be the biggest factors in size in the entire retail industry in the US.  This prominence has had (at least) two important indirect effects on the retailing industry:

1.  Unlike traditional department stores, discounters vary the size of their “departments,” often dramatically, by season.  And because they carry such a wide array of merchandise, they can heavily discount some items–even sell them at no profit or a loss–just to build traffic (in the old days, this was foot traffic; in today’s world it means website traffic as well).  Two recent examples:  Wal-Mart is discounting a group of video games for the holiday season, as well as selling a group of popular hardback books at below their cost.  This latter decision has drawn loud cries of protest from mom and pop booksellers.

For many years, during the yearend holiday season the discounters have expanded tremendously the shelf space they devote to toys.  They also offer “hot” toys at deeply discounted prices.  What has this done to Toys R US? Pretty much the same thing that the drug stores did to Fotomat years ago (see my first retailing post for the story).  Toys are a highly seasonal business, with most of the profits made in the fourth quarter.  During the Eighties, when WMT, TGT and Toys were all taking market share from small independent toy stores, Toys could afford to keep its stores open all year long but make all its money at Christmas.  By the mid-Nineties, however, when the independents were a spent force, Toys began to feel the full brunt of competition from WMT and TGT.

2.  The discounters’ decision to sell a full line of groceries in their biggest stores continues to send waves of disruption through the traditional supermarket industry.  I was at a retailing conference a few years ago where a number of supermarkets presented.  A lot of the discussion revolved around WMT.  One firm said that although his stores would lose something like 20% of sales when a WMT superstore opened in the vicinity, within two years the supermarket revenues were back to where they were pre-WMT.  “What about profits?” asked someone in the audience.  It turned out they only bounced back to half their prior level.

This probably explains why local merchants are so vehement in their opposition to allowing WMT stores into their markets.  The major WMT advantages vs. the supermarkets, as I see them, are:  the WMT stores are very efficiently run and the company; WMT’s supply and inventory control systems are state of the art; and WMT has a very strong brand (standing for good quality and cheap prices), while the US supermarkets have names over the doors but very weak brand significance.

Here in the Northeast, it has been interesting to see recent WMT commercials with the somewhat startling message that in communities where a WMT store opens, the average family’s annual bill for WMT-sold things goes down by $3000+, whether the family becomes WMT customers or not. It will be interesting to see if the message that you’re being wildly overcharged by your current retailers sinks in.

The internet

This is a complex, still-evolving topic.  So far, with the notable exception of AMZN, the stock market is more filled with losers to changes the internet has brought than with winners who have benefitted tremendously from internet presence.  I have only a couple of (mostly very obvious, sorry) observations:

1.  distribution. In the old world, the most daunting problem faced by an entrepreneur with a new product to sell was how to get it into a place where potential buyers would become aware of it.  This would involve persuading some firm that already had a distribution network–that is, a brand name established through years of advertising, and a bricks-and-mortar presence where consumers went to make purchases–to take the product on.  The price for getting distribution would likely have been for the entrepreneur to cede most of the profits to the distributor.

Today, you can set up a generic on-line store and start buying keywords for next to nothing.

2.  marketing and the blogosphere. In the old world, you had to purchase advertising in newspapers, magazines , TV or radio; do a public relations campaign;  hire someone who could get you on Oprah or the Today Show.

Today you may get the same publicity from a website, a Facebook page, and cultivation of some high-profile bloggers.  I was surprised recently, although I probably shouldn’t have been, when Secretary of the Treasury Geithner invited twenty economic bloggers to Washington for a private briefing on government policy.  Just shows how deeply the new media has penetrated into even the stodgiest of activities.

3.  information as a product Yes, we do have online iterations of magazines, newspapers and Consumer Reports. But we also have new things, too–like the coupon sites, the price comparison sites, and the advertising-driven retail-oriented blogs.

December is an odd month for stocks

December 9, 2009 By in Current Market Thoughts, Portfolio management, Recent Market Action, Shaping a portfolio for 2010 Tags: , , , , Leave a comment

Mark Twain on December

Mark Twain wrote in Pudd’nhead Wilson, “October:  this is one of the peculiarly dangerous months to speculate in stocks in.  The others are July, January, September, April, November, May, March, June, December, August and February.”

He was certainly right about October, although this is due less to Twain’s analytic skills and more to the US government allowing mutual funds to shift the end of their tax years from December to October in the late Eighties.  He’s also correct that each month has its own oddities.  But I think he’s wrong to stick December so close to the bottom of his list.

Why he underrates this month

Why?  Three reasons:

1.  First of all, almost all other taxable investors, like banks and insurance companies, end their tax years in December.  Prior to the rise of mutual funds,  year-end tax selling by this group of institutions was the key market mover to watch.  This action usually begins in December.  The same general rules apply as to mutual funds.  A taxable investor wants to match gains and losses so that they offset one another.  In order to do that, he has to sell both securities.

2.  Portfolio manager performance is normally judged on a January-to-December basis.  The manager’s results versus his benchmark index, as well perhaps as those versus his peers, determine whether he receives a bonus–and, if so, how much.  In a good year, bonuses can be many times a manager’s base salary.  Often, this situation affects the manager’s behavior in December.

A competent portfolio manager typically uses December to reorganize his portfolio to take advantage of what he thinks will happen in the coming year.  In particular, if the manager has had a very good year (so his bonus is secure) or a very bad year (so there’s no hope for a bonus), he has every incentive to make changes in December, even if he does this a bit prematurely and loses a bit of relative performance.  He’ll be certain to enter the new year with a forward-looking portfolio, rather than one filled up with last year’s ideas.

Only when the manager is on the cusp of some important performance or financial objective does it make sense for him to stand pat in the hope of squeezing out the last few basis points from what is likely a portfolio with aging market relevance.

3.  Retail investors also do their tax planning in December, matching sales of winners and sales of losers.  Many times, this occurs in the small-cap arena.  This selling forms much of the basis for the “January effect,” the strong outperformance of small caps to open the year, which is often just the bounce back of the previous year’s losers in the tax-selling derby.

My expectations…

I had expected this month to be strong in the beginning, followed by a gradual fade to the holidays (the last two weeks of the year is the only time a portfolio manager really has time to rest).  This may still turn out to be the case, but if the first quarter of the month is any indication, the ride will be a bit bumpier than I thought.

…aren’t that important

Although the daily ups and downs of the markets may be mesmerizing, remember that they’re not the important thing.  Our key task for this months is to put the finishing touches on a strategy for 2010.  More on this topic in later posts.