Monthly Archives: June 2015

growth vs. value test: my answers

June 23, 2015 By in book value, cash flow/share vs. earnings/share, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital, two flavors of value Tags: , , 2 Comments

The growth stock investor’s answer:  Joe’s, of course.  Why?  I pay $18 for the stock now.  At the end of five years, earnings per share will likely be $2.70.  Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.

Look at Bill’s in contrast.  I pay $10 for the stock.  At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here).  Assuming the stock keeps the same multiple, it will be trading at $16.10.  Add in the dividends and the total is $18.60.  That’s a return of 86%, or about half what I would get from holding Joe’s.

One more thing.  Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate.  As a result, the p/e multiple could begin to contract.  Maybe that will happen, maybe not.  But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.

The value stock investor’s answer:  It’s obviously Bill’s.  Joe’s has a much more aggressive  growth strategy.  Maybe it will work, maybe not.  I don’t see why I have to decide.  A lot of the potential reward for success is already built into Joe’s current stock price.  And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.

If Joe’s strategy doesn’t work, then I’m much better off with Bill’s.  On the other hand, suppose it really is the way to go.  In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change.  And the stock will skyrocket.  While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.

It’s a question of temperament.  A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.

Maybe the most salient points to be made about each answer are:

–not that many companies grow so rapidly as Joe’s without any hiccups;

–wresting control from an entrenched management is not that easy (look at the sorry history of  Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation).  It may not be possible, and could be a long and arduous process in any event.

testing for style–growth investing vs. value investing

June 22, 2015 By in book value, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital Tags: , , 2 Comments

Yes, I was supposed to be writing about trading.  But I figured it might be useful for readers to figure out whether they tend to like growth stocks or value ones before going further.  Here’s a test I heard about while I was at a value-oriented shop in the early 1990s (it’s a rerun of a one of the first posts I wrote in 2009.  Try not to look back to see the answers, which will appear again tomorrow.):

The Rules

I’ll describe two companies.  Both are retailers, operating in the US and selling identical merchandise.  They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.

Both have first year sales of $1,000,000.

Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.

Therefore, both have first-year earnings of $100,000.

Each firm is publicly traded and has 100,000 shares outstanding.  Earnings in year 1 are $1/share for both companies.

Money reinvested in the business is currently generating $2 in sales for every $1 invested.  There’s no lag between the decision to invest and the generation of new sales.

Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.

Earnings and cash flow are the same (just to keep it simple).

Company 1:  Bill’s Stuff

Bill’s management wants to take a conservative approach to a new business.  It decides that it will:

reinvest half of its cash flow back into the business,

pay a dividend of $.50 a share ($50,000/year),

keep any remaining cash in reserve in a money market fund.

So,  in year 2 Bill’s generates $1,100,000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income.  It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.

Let’s assume the company can continue to operate in this manner for as far as we can see.  Then, the company’s investment characteristics are:

10% earnings growth rate

$.50 dividend payment

no debt; small but growing amount of cash on the balance sheet

Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.

Company 2:  Joe’s Things

Joe’s management believes that expansion opportunities are extraordinarily good right now.  It decides that it will:

reinvest all the company’s cash flow back into the business,

borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.

In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000.  After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..

For year 3, Joe’s can borrow another $4,500 and does so.  Therefore, it reinvests $126,900 in the business.  It generates about $1,500,000 in sales and ebit of $225,000.  After interest and tax, net income is about $149,000 ($1.49/share).

Assuming that Joe’s can continue to expand in this manner indefinitely,  the company’s investment characteristics are:

22% earnings growth rate,

modest and slowly-rising bank debt,

no current dividend.

Let’s assume Wall Street is willing to pay 18x current earnings for the stock

The question:   Which one would you buy, Bill’s or Joe’s?

Answer tomorrow.

two types of orders: market and limit

June 19, 2015 By in buying and selling, fast death vs. slow death, Fixing mistakes, Trading Tags: , , , , , , Leave a comment

As a professional, I always believed that the key to success was to have a sound strategy and good stock selection.  I’m still convinced this is true.

At the same time, good execution of my plan through competent trading–buying and selling the stocks in my portfolio–while a secondary objective, could add or subtract a percentage point from my overall performance during a year.  Given that the typical active portfolio manager underperforms the S&P 500 by around one percentage point yearly, good trading can be worth its weight in gold.  Having been blessed with good traders most of my career, and cursed with one horrible trader I couldn’t get rid of for about a year, believe me I know the difference between the two.

The main tool we as individuals have to control the trades we do is our choice between limit and market orders.

types of orders

A market order is one where our instructions are to buy a certain amount of a stock at the market price, that is, the price at the time the human or computer that will transact for us receives the order.  Except in the most unusual circumstances–I can’t remember this ever happening with an order of mine–the transaction will always occur.  Sometimes, the price will differ a little from what we’ve seen on the screen a moment before entering the order, but in practical terms we’ll always buy/sell the stock.

A limit order, on the other hand, is one where we specify the exact price where we want the transaction to happen.  That may or may not occur on a given day.  Limit orders take two main forms, day  and GTC (Good Til Cancelled).  GTC orders are, technically speaking, really not exactly what the name says.  They most often are tagged with a time limit, say, three or six months, after which they expire if not renewed. When entering an order online, a message will typically pop up giving an expiration date.

choosing one

As regular readers will know, I’m a growth stock investor.  For people like me, I believe firmly in the cliché that the more important decision is how we sell, not how we buy (more about this on Monday).

buying

I tend to buy in two or three transactions.  I’ll almost always use a market order, for about a third of what I ultimately intend to own ,just to establish a new position.  I’ve found over the years that owning a small amount of a stock focuses my mind on it in a way that simply thinking about it, or having it in a paper portfolio, doesn’t. This also protects me a bit from the stock running away on the upside before I’ve finished buying.

My intention will be to buy the rest in one or two more transactions, hopefully at progressively lower prices.  If the market allows me, I’ll use limit orders to acquire the rest. I may decide, however, that I don’t have enough time to do so before others discover the stock.  If so, I’ll buy the rest at market.

selling

If I change my mind about a stock, that is, if I realize that my favorable view is probably wrong, I’ll sell all I own at market–and relatively quickly.  On the other hand, if the stock has gone up a lot, and my sale is motivated by price, I’ll usually use limit orders.

For example, one of my sons and I own both own Tesla (TSLA), at his suggestion.  We decided to sell half of our holding at $260 (I’m thinking the rest should go at $275, but I haven’t broached the subject with him yet).  We placed a limit order about a week ago.  It hit yesterday.  (For what it’s worth, I think a large convertible bond offering is imminent and that, like last year, it will mark a near-term top in the stock.  And, of course, we can’t forget that this is a highly speculative, if intriguing, issue.)

More on Monday.

 

 

MSCI and China’s A shares

June 18, 2015 By in Asian economic development, China, emerging markets, Hong Kong, Purchasing power parity (PPP), securities markets, short selling, Stock Connect, stock market Tags: , , , , , , , Leave a comment

A few days ago, MSCI, the premiere authority on the structuring of stock market indices around the world, declared that it had been carefully considering adding Chinese A shares to its Emerging Market indices–and concluded that it would not yet do so.

What is this all about?

MSCI

MSCI (Morgan Stanley Capital International) creates indices that investment management companies use to construct their products–both index and actively managed– and to benchmark their performance.

Having a certain stock, or a set of stocks, in an index is a big deal.   For passive investors, it means that they must hold either the stocks themselves or an appropriate derivative.  Either way, client money flows into the issues.

For active investors, they’re forced to at least research the names and keep them on their radar.  If they don’t hold a certain stock or group, they’re at least tacitly betting that the names in question will underperform.

 

If we measure economic size using Purchasing Power Parity, China is the largest in the world.  It seems odd that the country not be fully represented in at least Emerging Markets indices.

 

China

Beijing, in the final analysis, would like to have international investors studying A shares deeply and buying and selling them freely.

How so?

In many ways, the story of the growth of the Chinese economy over the past three decades has been one of slow replacement of the central planning attitude of large, stodgy state-owned enterprises with the dynamism of more market based rivals.  The heavy lifting has been done by constant political struggle against powerful entrenched, backward-facing, political interests that even today control some state-owned enterprises.  It would be nice for a change to have the market do some of the work–by bidding up the stocks of firms that increase profits and punishing those that simply waste national resources.

 

In addition, Beijing now seems to believe that freer flow of investment capital in and out of China can act as a safety valve to counteract the extreme boom/bust tendency that the country’s domestic stock markets have exhibited in the past.

 

the burning issue?

Foreign access to the A share market is still too limited.

Fir some years, China has had a cumbersome apparatus that allows large foreign institutions to deposit specified (large) sums of money inside China and use the funds to buy and sell stocks.  But becoming a so-called qualified foreign institutional investor and operating within government-set constraints is a pain in the neck.  It’s never been a popular route.

Recently, Beijing has begun to allow investment money to flow more freely between Hong Kong and Shanghai.  A HK-Shenzen link is apparently also in the offing.

In MSCI’s view, this isn’t enough free flow yet.  I think that’s the right conclusion.  Nevertheless, weaving A shares into MSCI indices is only a question of time.

my thoughts

As professional securities analysts from the US and elsewhere turn their minds to A shares, there stand to be both big winning stocks and equally large losers.  The big stumbling block will be getting reliable information to use in sorting the market out.

Abenomics and outside corporate directors

June 17, 2015 By in Asian economic development, Japanese development, stock market Tags: , , , , Leave a comment

The original plan—and, in my opinion, fatal flaw—of Abenomics regarding reform of industry in Japan to make it more profitable was to depreciate the yen in a significant way that would supposedly compel now-more-profitable corporation to invest in expansion.  That would increase the number of employed and boost wages for all.  This would, in turn, generate a positive, self-reinforcing spiral of economic activity.

The depreciation has happened.  The hoped-for wage increases, employment gains and new investment haven’t.  This has been devastating for ordinary Japanese citizens, for whom a sharp decline in the currency has only meant an increase in the cost of living and a tremendous loss of wealth.

Tokyo has recently decided to try to force recalcitrant firms to use the increasing piles of cash that depreciation has brought them.  The vehicle is new legislation that mandates that publicly traded concerns install board members who are not insiders—that is, who have no connection with the firm.

The idea is that these fresh eyes and new voices will somehow compel companies to change their ways.  The initiative has received lots of praise from brokerage firms and the financial press.  For Japan’s sake, I hope they’re right.  Unfortunately for the country, my guess is that this enthusiasm is misplaced.

My son-in-law and I were talking about this the other day.  He immediately said what I have been thinking from the start—“What about Olympus?”

The Olympus in question if Olympus Optical (8831).

Several years ago, the head of that company’s European operations was made CEO of the entire company.  An outsider but an accomplished businessman, the new CEO found that he was not given the full access to corporate information he (justifiably) expected.  His requests for certain data were routinely deflected by the rest of the board.  Through a combination of whistleblower information and forensic accounting he conducted in secret, the CEO discovered a massive accounting fraud Olympus had been perpetrating since the early 1990s.  (The company hit hard times in the late 1980s.  Embarrassed, and unwilling to restructure, Olympus decided to supplement profits with stock market speculation.  The company, of course, experienced massive losses and covered the whole mess up.)  After confronting key board members, he ended up resigning and fleeing the country, saying that he feared for his life.

I’m not contending that the introduction of outside board members it going to create a whole raft of new Olympus-like incidents (although if there were a way to wager a small amount that there would be at least one, I’d be willing to bet).

I am saying that I think the culture of protecting the status quo and of regarding any sort of restructuring as meaning creating/enduring life-shattering shame is still pervasive in Japan–and that simply adding a few outside directors won’t be enough to change that.

To my mind, the obvious thing to do is to dismantle the legislation enacted in the 1990s to protect Japanese companies from potential foreign acquirers–and therefore from activists.  But I don;t see that as on the cards any time soon.