the equity discounting mechanism: how it’s working today

Happy Halloween!

discounting at work today

My previous post was about what the equity discounting mechanism is. Today I want to give my take on how discounting is working in today’s US stock market.

The US market has been rising since June, despite the evidence of widespread global slowdown. How can this be?

economic slowdown, but uptrending market??

Several macro reasons:

  1. After five years of decline, the US housing market has been giving strong signs of bottoming for some months and is recently beginning to rise. Housing is important in the US, not only for the construction jobs it brings, but because it’s the largest source of wealth (or potential wealth) for most Americans.
  2. Around mid-year the leadership of the EU seems to have stopped living in denial about the Eurozone’s structural problems and begun to take positive action to address them. Yes, resolution may take a half-decade. Yes, Greece may get tossed out and the UK may voluntarily withdraw. But the basic direction of government policy appears to have changed.
  3. Beijing has already taken a number of measures to reinvigorate its economy. Yes, any dramatic steps will probably await the installation of new top leadership in the Communist Party there. But, again, the basic stance of government economic policy appears to be reversing itself from contractionary to expansionary.
  4. The US Fed has announced that it intends to keep the current extraordinarily-low level of short-term interest rates in place for at least the next 2 ½ years. Ultimately, rising interest rates will be a threat to world bond, and to a lesser extent, stock markets. But that’s not likely to be anytime soon.

two discounting judgments

Two qualitative discounting judgments are involved in the upward move of global indices over the past five months:

–the first is that there’s no longer any percentage in betting that conditions will continue to deteriorate. That’s already been fully, or very close to fully, discounted by the prior price declines.

–the second is that the three macro forces listed above are powerful enough for investors to begin discounting potential future good news into today’s stock prices.

 unusual?

In my view, there’s nothing unusual about this. It’s the standard macro-based anticipatory discounting that has occurred at business cycle turning points over the thirty years or so that I’ve been involved in global stock markets.

To my mind, what is unusual, though, is the apparent disconnect between the macro discounting judgment that the worst is behind us and the very violent micro discounting being done as companies report 3Q12 earnings results.

two separate judgments

In theory, these are two separate kinds of judgments–how benign or hostile the overall economic environment is likely to be vs. what earnings prospects are for individual companies. But in practice, investors, in my experience, tend to ignore poor company results during a transition period between macro trends. The bad numbers are usually dismissed as “old news,” the last artifacts of a trend that has already been relegated to the scrap heap (or, if you prefer, the recycling center).

Not this time, though. Companies that disappoint are being aggressively sold off.

Why should this be?

More important, should this strong micro-related discounting undermine confidence that the macro trend has indeed reversed?

I can think of a couple of reasons macro and micro discounting could be following different paths:

–the most likely, in my view, is the current valuations of business cycle-sensitive stocks. Typical market turning points in the past have been 2009-like affairs. Not as ugly, but conceptually similar. Those bottoms occur at the end of extended bear markets, when overpowering fear is rampant and all stocks have been sold down to levels which—in hindsight—will appear ludicrously low. The most cyclically sensitive will often be crushed, priced as if they’re going out of business.

In the quarters immediately following these market turns, the negative effect of earnings disappointment on individual stock prices is offset by the positive of extremely low valuations.

That’s not the case today. We’re more than three years past the 2009 bottom, and about 100% higher than the absolute lows. So disappointing stocks don’t have the valuation cushion they normally do.

If I’m correct, the selloffs of cyclical stocks on bad earnings doesn’t undermine the macro case that the overall market trend has changed in a favorable way. It just means this upcycle is different and will be more muted than the standard pattern.

–it may also be that both buy-side and sell-side firms are no longer integrated, having both macro and micro researchers, as they have been in the past. In the integrated model, either the chief investment officer or a committee of senior staff would set an overall investment policy. To a significant extent, the overall investment stance, bullish or bearish, would be coordinated with, and reflected in, recommendations about individual stocks.. In an up market, portfolios wouldn’t sell cyclical stocks; disappointing earnings would be ignored. On the sell side, cyclical stocks would continue to be recommended, not downgraded.

In today’s world, in contrast, brokerage firms have dismantled their research departments. Many hedge funds specialize in macro research only. Others run highly concentrated portfolios that hold only a handful of names. There are many more short-sellers, as well.

So it may be that the market for individual stocks is becoming much less uniform in its thinking—and thereby much more volatile–than it has historically been.

–there are other possibilities, but less probable and not worth mentioning here.

the equity discounting mechanism: what it is

SF Giants–World Series Champions!!!

discounting

I’m going to write about this topic in two posts.  Today’s will cover the basic idea.  Tomorrow, assuming Hurricane Sandy has left the cable and electric power lines alone, I’ll apply them to the current situation in world equity markets.

Here goes:

Discounting” is a piece of Wall Street jargon.  It refers to the process in which investors factor into current stock prices their expectations about future events. It’s also used to describe the degree to which this process is complete.

Although most pople don’t think about it that much, the stock market is in many ways a futures market.  For example:

Based on trailing twelve months’ earnings, AMZN trades at a PE multiple of more than 3000x.  That’s over 200 times the PE of the average US-listed stock, which is trading at about 14x.  True, to some degree this is because AMZN uses extremely conservative accounting principles.  But it’s mostly because buyers are basing their purchase decisions on strong positive beliefs about AMZN’s future growth prospects.

In contrast, Seagate Technology (STX) is currently trading at 3.4x eps, implying that investors don’t hold high expectations for its future profits.  If we look at current earnings as a percentage of the current purchase price, a buyer is earning at a current rate of almost 30% of cost per year.  I don’t want to get into valuation metrics in this post but, believe me, but 30% is a lot, if you expect the current earnings level to be sustained or increase.

a qualitative term

Discounting isn’t a quantitative term.  It’s an expression of judgment.  I think the AMZN price is crazy high.  I’d express my reaction a bit more elegantly by saying that I think the AMZN quote already discounts much more profit growth than I can see the company ever achieving.

My impression isn’t worth very much, however.  I haven’t done any careful analysis of the company for years.  It may be that other researchers have, say, recast AMZN’s financials into a more conventional format that shows the PE multiple to be much, much lower than 3000.  The same people may also be envisioning a very sharp growth trajectory for earnings over the next five-ten years–and have a reasonable basis for doing so.  Such researchers would likely  express their judgment by saying that the market has not yet fully discounted AMZN’s prospects.

two forms

Discounting has two general forms:

–macroeconomic, where investors take conclusions about the overall economic environment and use them to draw inferences about the profit prospects for stock market sectors, industries and individual stocks, and

–microeconomic, where investors base their conclusions principally on their analysis of the individual companies they are focused on without much regard for the macro environment, other than as a mild head- or tailwind.

For very mature companies, which are so large that their growth can’t be much different from that of nominal GDP in the areas where they operate, investors typically use a blend of both forms.

For what it’s worth, Americans typically favor a bottom-up micro style for almost everything; Europeans typically prefer a top-down macro style.

two stages

Discounting begins to happen far in advance of facts.  Call this sort of discounting anticipatory.  It can be most easily seen in turns in the business cycle.  Wold stock markets bottomed in March 2009.  World economies reached their nadirs about six months later.

AAPL shares bottomed in relative performance terms in early 2005 at a price of about $40 (Note from April 2015:  this price is adjusted for the stock’s 2/1 split in February 2012, but not for the 7/1 split in 2014)..  During that year it traded at about 30x earnings, or about twice the market multiple.  I remember that one of my then colleagues would visit my office daily urging me to sell, on the argument that every possible future favorable event was already discounted in the price.

In reality, the opposite was happening.  The market was beginning to sense the changes that were occurring in the firm and were bidding up the stock as a result.  It’s up over 17x since.

A second kind of discounting, call it adjusting, happens when an event where opinions about possible outcomes have already been factored into a stock’s price actually occurs.

What follows is a period of recalibration, as expectations are adjusted in light of new facts.  If the actual results are surprisingly good–that is, better than have been already discounted–the stock typically quickly goes up.  If the results are surprisingly bad, the stock typically drops over the following few days–and then usually continues to drift downward over the following weeks and months.

The existence of two stages of discounting is what leads to Wall Street’s Yogi Berra-esque belief that “nothing’s ever fully discounted until the event occurs.”

Tomorrow (Hurricane Sandy willing):  using these ideas to assess the current stock market situation.

 

 

 

 

 

 

Wynn Resorts’ 3Q12: Macau (HK:1128) flat, Las Vegas picking up, big dividend

the 3Q12 earnings report

WYNN reported earnings for 3Q12 after the market close on October 24th.

Revenues came in at $1.2985 billion, flat with $1.298billion collected during 3Q11.  Net income was $149.2 million, 12.5% higher than the $132.6 million posted in the comparable period last year.  Due to a sharp reduction in share count from 125.9 million to 100.9 million, eps showed a much sharper 41% increase, at $1.48 vs $1.05. (The shrinkage in outstanding shares is due to the forced cancellation of 24.5 million shares formerly owned by Aruze USA.)

Results exceeded the Wall Street analysts’ consensus eps estimate of $1.34.

WYNN also announced a special dividend of $7.50 a share to accompany the regular 4Q payout of $.50.  In addition, in its conference call the company said it would increase the regular dividend to $1/share, starting in 1Q13.

details

Property EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) for the quarter was $402.6 million, vs $381.1 million in 3Q11.  That breaks out into $292.2 million achieved in Macau and $110.4 million in Las Vegas.

Macau

If we subtract out from Macau results the portion owned by the investing public (including me) rather than Wynn Resorts, Macau accounts for about 2/3 of WYNN’s profits.  Over the past few years, Macau has also accounted for virtually all the earnings growth WYNN has achieved.

Wynn Macau earnings are now flattish, however, for several reasons:

–an economy-related slowdown in Chinese VIP gambling

–the opening of new casinos by competitors.  If nothing else, the novelty factor draws business to the newest venues, at least for a while

–Wynn Macau is at, or near, the capacity limits of its current physical plant.

Yes, the Macau government has given 1128 permission to build a new casino in Cotai, but that’s not scheduled to open until Chinese New Year in 2016.

In the meantime, we should expect no better than growth in line with the market for the Wynn properties in Macau.  But they will continue to generate huge free cash flow for shareholders and large management fees for the parent.

Las Vegas

EBITDA in Las Vegas is up by $25.2 million, or almost 30%, vs. 3Q11.

Most of the increase comes in casino operations.  About half the casino gain is from a return of the house “win” percentage to normal from last year’s unlucky lows.  The rest is genuine improvement in the amount of money wagered in the Wynn/Encore complex.  That’s a really good sign.

the dividend

As I mentioned yesterday, WYNN is in the unusual position of generating very high free cash flows, while having no current investment projects that need them.  WYNN is certainly not going to expand in Las Vegas, which is still plagued with substantial overcapacity.  The new Cotai project won’t need a lot of money soon, and it’s going to be financed mostly with debt, in any event.  Also, in today’s ultra-low interest rate environment, it makes little sense to repay cheap borrowings (arguably, one should be adding to debt, not subtracting).

So WYNN is electing to distribute much of its excess cash to shareholders.  1128 will likely soon follow suit.

buy or sell?

I hold both WYNN and 1128.   …LVS, too.  I think LVS is the cheapest of the three, and the only one I’d buy at today’s prices.

But I’m happy to hold the other two.  The Macau gambling market will likely be considerably better next year than this, although lack of capacity will be somewhat of a drag on 1128.  Las Vegas, where WYNN has considerably more operating leverage, will continue to make progress, I think.  And, as the cliché goes, with considerable dividend income I’m being paid to wait for earnings to accelerate.

what makes casino stocks interesting investments

I started covering casino stocks as a securities analyst around 1980.  At that time, Atlantic City was still the hot, fast-growing market that investors focused on, although the bloom there was already coming off the rose.  Las Vegas was a backwater.  Neither Singaporean nor Australian casinos existed (legal ones, anyway).  Macau, then a Portuguese colony, was a Ho-family monopoly.

In those days, casino operators basically gave away food, hotel rooms and entertainment.  Non-gaming operations were cost centers, existing solely to induce customers to visit the gaming floors.  That situation has changed dramatically over the years.  In pre-Great Recession Las Vegas, which is the gold standard for today’s global gaming industry, non-gambling operations had risen to equal importance–and profitability–with the gaming floors.

It’s not so much that I find the gambling activities themselves so interesting.  As a professional portfolio manager, they used to remind me a lot of work–but with substantially diminished chances of making money.

Instead, what attracted me to casino stocks as an investor–and still does– is that:

–casinos are very cash generative once they’re up and running, and

–they’re relatively simple to analyze.

Under most circumstances, growth in gambling revenue is a direct function of two variables.  They are:  the increase in nominal GDP of the area where target customers live; and any increase in casino floor space.  So gains in gambling earnings are highly predictable.   Resort profits aren’t as easy to project, but they’re not much more difficult, either.

One caveat:  like many commercial property-based businesses, expansion of Las Vegas-style casinos only comes in $1 billion-plus increments.  So the gaming industry can be subject to periodic bouts of overcapacity, when, after a run of profitable years, everybody in a certain area decides to make a major expansion at the same time.  Think of the current situation in Las Vegas–although that’s by far the worst overcapacity I’ve ever seen.

Funnily enough, it’s precisely the disastrous last-decade expansion in Las Vegas and the current slowdown of gambling in Macau, where the Big Three of American casinos (Wynn, Sands and MGM) all have operations, that make WYNN and LVS attractive.  (As regular readers will be aware, I’m not a fan of MGM.)

Why?  The companies are generating tons of cash and they have no place to plow it back in to new casinos.

In the case of LVS, this means it’s repaying borrowings much faster than I think the consensus realizes.  As for WYNN, the company has just announced a special dividend of $7 a share.  It’s increasing the regular quarterly payout as well, from $.50 to $1.  This means the shares have a prospective yield of  3.4%.

More on WYNN tomorrow.

 

I’ve just updated Current Market Tactics–what DD’s earnings miss signifies

I’ve just updated Current Market Tactics  to address the question of what the market selloff induced by weak earnings from majore chemicals firms means.

China in 2013

leadership change

China is currently in the process of its once a decade change in the top leadership of the Communist Party.  Official nominees for the highest posts will be officially announced in about two weeks.  They’ll be ratified in a pro forma vote next March.

New leaders often mean new policy directions.  While the old leaders are on the way out and the new ones are waiting to be anointed, the most prudent stance for lower-level Party functionaries (read: basically everyone) is to do as little as possible that could conceivably be second-guessed later on.

During the six- or nine-month transition period, the Chinese economy slows.  It reaccelerates as new leaders clarify what their priorities are.

I expect the same will happen this time around.  But as I try to imagine what I would do if I were running China, I’m beginning to think that the character of China’s growth from this point on may differ substantially from what it has been to date.

How so?

is the developing country growth model broken?

The standard developing country growth model that helped the EU and Japan recover after WWII and which has been duplicated by every successful emerging economy since, is broken.

The model, which I’ve written about extensively, has two parts:

1.  gear your economy toward exporting to the huge, healthy, fast-growing US, and to a lesser extent the EU, and

2. peg your currency to the US$ so foreign exchange movements won’t erode your labor cost advantage.

The breakdown has come in both areas:

1.  aging of the Baby Boom is reducing the long-term growth rate of the US to around 2%.  The need to repay immense government debt suggests to me that 2% will be a ceiling over the next few years, not a floor.  And the EU, China’s largest export market, probably won’t show much life for the next half-decade.

2.  keeping the currency peg means more or less mirroring US monetary policy, which is now calibrated for an economy in intensive care, not one in full bloom.  Keeping the local currency in sync implies maintaining domestic monetary policy that’s much too loose.

In addition to this, there are signs in China that, at least on the more heavily industrialized east coast, it is running out of the cheap labor needed to fuel the export-oriented development model.

reorienting growth

For all these reasons, I think the new Chinese leadership is going to make a substantial effort to re-orient growth away from exports to the US and EU (where there’s little growth to be had).   Exports will continue to go to other developing nations.

The two other areas for development are the domestic service economy and higher value-added manufacturing.  In free-market economies, forces of the status quo (labor-intensive exports) typically use their substantial political clout to stifle progress here.  And there are certain to be similar efforts made in China.  But Party control of the Chinese economy suggests the status quo will be less successful.

investment implications

If this shift in priorities is underway, and is successful, the biggest winners will be suppliers of products and service for average Chinese consumers. Luxury goods will continue to do well, I think, but mass-market products will do better.  The trick will be finding ways to play them.

On the other hand, suppliers of export-oriented industrial machinery–to some degree domestic, principally overseas-based–to Chinese firms seem to me to potentially be the biggest losers.  (We may already be seeing this phenomenon in 3Q12 earnings results and in management guidance.