…finally, internet again

I’ve been travelling in the rural Northwest the past week and have had only intermittent internet access   …until now.

Stepping back from the day-to-day, has its advantages, though.  Having little up-to-the-minute data, I’ve been forced to look at the longer-range stock market picture. 
The first two or three months after the election, the dollar and stocks both rose as investors celebrated the presidential results.  The strongest groups were Energy, Materials and Industrials–the ones that would benefit both from an acceleration in economic growth and implementation of the professed Trump agenda of tax reform and infrastructure spending.

This period ended rght around the inaguration.  It was replaced by a market that embraced secular growth areas of Technology and Healthcare.  The dollar began to drift downward, as well.  This sector/currency shift was partly, I think, a rotation from leaders to laggards that happens in every market that’s not going sideways.  Part was also concern that delivering on the Trump agenda might not be as easy as investors had supposed over the previous months.

During 2Q17, the stock market began to understand how deep the problems are that the Republican party and the adminstration are having in getting anything done.  The main direct consequence of this loss of confidence has been a sharp fall in the dollar, I think, on the idea that failure of the administration and congress to engineer fisal stimulus would translate into a slower pace of interest rate increases by the Fed.  A weaker dollar benefits multinationals, so IT continued to be a winner, along with many members of the Staples group, which also has large foreign exposure.

This last movement has also played itself out in recent weeks, I think.  The market as a whole, and major tech stocks in particular, have begun to move sideways, expressing Wall Street’s belief (mine, too) that they’ve gone up enough for now.  As I see it, action has been based chiefly on relative valuation– rotations deeper into IT via smaller stocks and back into the Trump stock winners of late 2016.  
The kind of movement described in the last paragrah doesn’t typically last long.  At some point, the market will return to the question of whether structural reform in Washington is possible.  As I see it, the underlying notion investors now have is that important change can and will happen, although people may have substantially different pictures of how this will occur.  

It seems to me that as long as investors hold this belief, the US stock market will move sideways to up, driven by earnings gains.

evaluating management: Donald Trump and real estate

Last year Forbes published an analysis by James Elkins, a professor in the finance department at the University of Texas, that concludes Mr. Trump has underperformed the average real estate professional in the US by a whopping 57% over his career, despite the boost to returns he achieved by maintaining almost twice the average amount of financial leverage.

The results are highly tentative.  Prof. Elkins uses a REIT index as a proxy for overall real estate returns.  He also employs Mr. Trump’s statement of his starting net worth and the Forbes $4.5 billion estimate of his 2016 wealth (the 2017 estimate is $1 billion lower).

On the industry benchmark, my experience with real estate moguls, mostly outside the US, is that the returns on their private real estate investments are generally higher than those they achieve in their publicly traded vehicles.  In Mr. Trump’s case, his net worth includes his considerable earnings as a reality show star, as well as the potentially positive effect of debt forgiveness through bankruptcies.

In short, the 14.4% annual return on equity Elkins uses for the industry is probably too low and the 12.5% return he figures for Trump is too high.

My question is what the returns on capital are in the Elkins example.

According to Elkins, REITs have an average debt to equity ratio of about 30%.  This means they have a mix of roughly three parts equity, one part debt.  Assume that their average cost of debt has been 8%–a figure that seems reasonable to me but which I’ve just plucked out of the air.  If so, their 14.4% return breaks out into roughly a 13% return on capital (actually operating real estate ventures) and 1.5% from using financial leverage.

This calculation implies that Mr. Trump’s 12.5% return breaks out to something like 9.5% from real estate and 3% from financial leverage.

At first glance, the difference between a 14.4% annual return and a 12.5% return doesn’t seem like much.  Prof. Elkins’ point is that over a career being a relative laggard adds up.   In this case, it translates into having $4.5 billion instead of $23 billion.  Mine is the numbers flatter Mr. Trump’s planning and management skills, which fall more deeply below the average in the real estate industry than his overall results.



evaluating management: issues with financial leverage

Given the possibility to boost return on equity substantially, why is it that every publicly traded corporation doesn’t make extensive use of financial leverage?

Several reasons:

–as I mentioned in my initial post, in some areas of the world investors think using debt capital is a bad thing, either because they believe debt is unethical or (incorrectly, in my American view) that debt is more expensive than equity

Philosophy aside, having debt on the balance sheet has risks:

–debt service (interest and principal repayments) is an immediate subtraction from operating cash flow.  If a company takes on excessive debt, if it makes a mistake in capital deployment, or if it is particularly sensitive to the ups and downs of the business cycle, debt service can become a burden.  In extreme cases, debt holders may have the right to accelerate the repayment schedule, restrict company operations–or even take over management of the firm through bankruptcy proceedings

–having a large amount of debt can hamper a firm’s ability to respond to a changing competitive environment.  Macy’s failure to build an effective online retail presence, for instance, has been attributed to its need to devote large amounts of operating cash flow to debt service.

In addition, Wall Street investors tend to believe (correctly, I think) that it doesn’t take much skill to float a bond issue or get a bank loan.  It’s much harder to employ capital well in running operations.  So while investors may want the extra returns that a leveraged company can achieve, they will pay a much higher price for returns on capital than for returns on leverage.

evaluating management: return on capital

equity capital

Yesterday, I wrote about return on equity, as it applies to a company that uses only this form of capital, i.e., has no long-term borrowings, no financial leverage.

debt capital

In most places, companies are allowed to employ debt capital in their long-term operating plans as well as equity.

Opinions differ as to whether this is a good idea or not.  Americans tend to approve, on the idea that debt is a cheaper form of capital than equity; investors in the UK and Europe tend to disapprove–arguing that debt is a more expensive form of capital than equity.  In the Islamic world straight debt is not allowed.

My chief comment is old saw that “leverage works both ways;”  that is, during an economic expansion it’s most often a return booster, while in bad times it can be an albatross around the firm’s neck.


Let’s say a company goes public by selling 1000 shares at $10 each.

Once it’s public, it issues $10,000 worth of ten-year bonds with a 5% coupon.

Now it has $10,000 in equity and $10,000 in debt.

Let’s say it invests all the money in projects that produce a $2000 annual return. (For simplicity’s sake, let’s make the (unrealistic) assumption that the money is all raised and invested in projects that are instantly up and running on January 1st).  Let’s also ignore taxes.)

At the end of year 1, the firm has earned $2000.

return on capital

Its return on capital is:  $2000 ÷ ($10,000 debt + $10,000 equity = $20,000), or 10%.

return on equity

Its return on equity is:  ($2000 – $500 in interest = $1500) ÷ $10,000 equity  = 15%.

return on leverage

Let’s define another term, return on leverage, as the return on equity minus the return on capital.  In this case, the return (to equityholders) on (or from) leverage is +5%.

Why do so?   Why in the form of a simple subtraction?

As to the form, the sole reason is because it is a simple thing to figure out.

I think it’s important to break down the returns a management is producing for shareholders into two components to quqntify how good it is at two different management skills–how company operations are being run (return on capital) and how those returns are being supplemented by shrewd use of debt financing (return on leverage).

I say “supplemented” because in a well-managed business the lion’s share of the returns will come from operations.  Returns from leverage will be the icing on the cake.

Looked at in a different way, what conclusion should we draw if most of the returns come from leverage?  One worry is that the firm’s management doesn’t have the necessary operating skills to be successful and is substituting aggressive risk taking with company financing to cover up for this deficiency.

For example:

Suppose the company described above earns $1200 in year 1.

That’s a 6% return on capital.

The return on equity is ($1200 – $500) ÷ $10,000 = 7%.

The return on leverage = 1%!  This is trouble, because the company is barely covering the cost of its borrowing.

A worse case:

The company earns $400.

The return on capital is 2.5%.

The return on equity is ($400 -$500) ÷ $10,000 = -1%

The return on leverage is -1% -2.5% = -3.5%.  This is a disaster.


More tomorrow.



evaluating management: returns

One of the most straightforward ways of evaluating how a company management is doing is by looking at the returns it achieves on the money it invests on behalf of shareholders.  Like most things in finance, this starts out as a very simple task, but soon enough adds refinements that make the evaluation process look a lot more complex than it actually is.

We’ll start with return on equity.

initial equity

A new company forms and sells 1000 shares to investors at $10 each, for a total of $10,000.  It invests all of that money one January 1 of its first year.

During that year it earns $1000 in net income.

Its return on equity for year 1 is 10% ($1000/$10,000).  At this point it has no long-term debt, so its return on capital (capital = equity plus long-term debt) is also 10%.

equity grows

If the company pays no dividends, it now has $11,000 in equity (capital, too) at the beginning of year 2.  To maintain a 10% return on equity (and capital) it must earn $1,100 in year 2.

book value

The total amount of equity a company has to invest is also called “book value,” because it’s the value of the equity entry on the company’s financial records (books).

All other factors being equal, a company whose management achieves a high return on equity tends to trade at a premium to book value.  One that continually produces sub-par returns tends to trade at a discount.  The financial sector in particular, because it’s hard to figure out the tons of transactions that the big firms routinely execute, tends to trade on price to book.


Tomorrow, adding debt to the picture.

new CEO for Tiffany (TIF)

TIF has languished for a number of years, for several reasons:

–the waning of the important Japanese market

–the shift of Chinese jewelry buyers away from foreign firms and toward local creations

–the recession, which lowered spending on jewelry worldwide

–perhaps most important, a lack of success in providing new designs for regular customers.

The company’s greatest strength is its brand name.  It’s unique in being able simultaneously to appeal to ultra-wealthy customers spending $10,000+ a pop and to ordinary people looking for a $200 trinket to have wrapped in the iconic blue box.

Oddly, in the discussion of TIF’s merchandising as being “tired” that I’ve been reading, analysts and (especially) reporters have been referring to this ability to serve low-end customers while still retaining the aura of exclusiveness that attracts the wealthy as a weakness.  Hard to understand.

At the same time, what’s being missed is the hole that has long existed in the TIF merchandise lineup–items that appeal to customers wanting to spend $2,000-$10,000. This middle ground is dominated by firms like Bulgari, which coincidentally have little presence among TIF’s customers in either of its market segments.

That’s wha’s so intriguing about the appointment of Allessendro Bogliolo, a former Bulgari executive, as TIF’s new CEO–something no one’s mentioning.