I’ve just updated my Keeping Score page for March and 1Q24.

What follows mostly applies to growth stocks.

In the case of value stocks, which are asset-rich but somehow not able to generate profits, we are betting by owning them that change will happen. In a sense, we are holding a stock despite/because of current management’s inability to employ those assets effectively. We’re waiting/hoping for a catalyst that will unlock this value. Maybe we’re hoping for change of heart; a change in control is more likely, though.

on the plus side: reinvention

The rule of thumb that I’ve used for a long time is that a growth stock typically has a shelf life of about five years of doing the thing that makes it attractive for investors today. To hold it for a longer time, we’ve got to believe that the company can reinvent itself on the fly.

Walmart is a classic example.

It started out by building variety stores at the edge of small towns, undercutting local merchants on price. As it started to run out of new small towns to enter, it expanded into Mexico (a great move) and the UK and Japan (pretty awful). Then it entered the warehouse club market with Sam’s Club. When these arms began to mature, it added groceries, to compete directly against supermarkets.

Then for years it did a bunch of nothing–and, to my mind, became much less interesting as a stock.

Now it seems to me to be trying to transform itself once more, becoming a direct competitor to Amazon as an online merchant. Another potential plus: as WMT grew into a national company, political opposition by incumbent businesses kept it out of California, and lack of available land limited its scope for building its superstores in the Northeast. In a post-pandemic, work-at-home world, this might actually be a benefit.

on the negative: the nobody-will-notice paradigm

I find it hard to generalize about weak managements–both individuals and corporate cultures–other than that they tend to reveal themselves in lack of care about shareholders, the ultimate owners of any publicly-traded company. I suppose this is more a family resemblance thing than a single characteristic common to all bad managers.

two common situations

–Imagine you’ve just become the CEO of a major company, after twenty-some years of intense corporate infighting. You have, say, 3-5 years to cash in in a huge way from bonuses and stock options. You know, going in, the company needs a major retooling to keep it ahead of the competition over the next decade. This will doubtless cause the company to generate losses over the next two years. That will likely put a large hole in your wallet, by lowering the value of your bonuses and stock options. What do you do? The bad solution, but a common one–think, GM, Ford, Chrysler–is to cash in as big as you can and leave the problem for the next CEO to deal with.

–as people become older and wealthier, they become increasingly risk-averse. In a family-controlled company, uncles and aunts, cousins and nieces and nephews of the founders will likely have high-paying jobs there. So making sure this year’s profits is at least equal to last year’s, and not lower, is a much more important objective than making them grow. This is a big reason I find what I see as a more adventurous spirit at WMT so intriguing.

In my experience, however, most of the time it’s been a little thing that triggers my “bad management” reaction. And because it’s a little thing, it’s easily thinkable that I’ll be wrong. On the other hand, it’s a big, wide world, and I’ll be kicking myself around the block if I ignore my instincts. Arguably, too, this “little thing” may just be the trigger that brings to the surface worries I’ve already been having.

examples

–I’ve recently written about Bill Gates saying the most important thing about Microsoft for him was to be able to give jobs to his friends

–in early 2000, I think, the SEC cited both GE and IBM for each having submitted false/misleading financial results for one small division. There was very little immediate stock market reaction. But I was stunned–more for what it said about the corporate culture at these places than anything else

–I remember a debate many years ago at Costco. The company’s financial strategy had been to mark up its products by only enough to cover its costs. All of its profits came from membership fees. A new generation of top managers began to argue that no one would notice if prices were raised by, say, 5%, over a couple of years. The (winning) argument against was threefold: that this was the first step on a slippery slope, that the reputational damage when customers discovered stuff was cheaper elsewhere would be irreparable, and that customers weren’t so stupid that they’d never notice.

–there seems to have been a similar argument at Boeing, that no one would notice a little cost-cutting. But that ballooned into something much bigger and much more harmful. BA has also had a series of former-GE executives as CEO, who seem to have spearheaded the outsourcing.

Investing in emerging companies is always a roll of the dice, certainly when compared with buying shares in an established giant. It’s especially so now, I think, because there are still tons of zombie companies that went public during the heady days of pandemic-time speculation still floating around and cluttering up the small cap valuation landscape. They make it much harder to get a read on what the appropriate price in today’s market of a new high-risk venture might be.

For me, the most important questions to answer are:

–how strong is the need for the new company’s product or service?

–are there competitors and if so, how many and how large? what is my company’s competitive advantage?

–how big is the potential market?

–is the company profitable now?

–how am I going to monitor the company’s progress? in particular, are there any early warning indicators I can use to predict its future earning power?

–how long do my spreadsheets say it will take for the stock at today’s price to be at a reasonable PE multiple (say, 20x eps). Is it a year? three years?

–will the company need more funding to grow to the size I’m guessing it can attain in the next year or two or three?

–what new information would cause me to sell?

–if this doesn’t work out, what would cause me to cut my losses?

examples of possible leading indicators

–there’s an inverse correlation between interest rates and housing starts

–housing starts lead carpet and furniture purchases

–many years ago, when Intel made its prescient move away from memory chips to microprocessors, its chips were so hot they had to be put in ceramic casings to prevent motherboard meltdowns. Kyocera was the sole supplier of these casings …and its results led INTC’s by about a quarter

–fewer years ago, but still a lot, Apple launched its iPod music player, which was an epic seller for years (and most likely, I think, saved AAPL from Chapter 11). Same general story as INTC. The heart of the iPod was a small form factor hard disk drive. Only two manufacturers of these in the world. But both used the Japanese manufacturer that was the sole source for the spindles around which the disks spun inside the hdds. Again the information on spindle orders was publicly available.

DCF = Discounted Cash Flows. It’s a shorthand way of saying that the current price of a share of stock in a given company should be the sum of the value in today’s money of all future all expected (let’s say, annually) cash flows, divided by the number of shares outstanding.

The big plusses of this approach are that:

–it’s simple

–it focuses on money, arguably the essence of all investing, so you don’t have to be an expert on any given industry, or in microeconomics in general,

–it applies to all companies,

–it’s similar to the way bond values are determined, and

–it allows quick computer-driven evaluation of large numbers of companies.

There are significant minuses, though:

–the present values can get very high, relatively quickly. The first practitioners quickly realized that that they could not allow substantial growth in cash flow to continue in their models for more than, say, ten years (I’m making this number up, but it’s something like that) or else everything would become deeply undervalued, and a foaming-at-the-mouth buy. The “one decision” stocks of the Nifty Fifty in the early 1970s (which included gems like Simplicity Pattern, Eastman Kodak, SS Kresge, Xerox and Schlitz Brewing) are perhaps the prime example of this phenomenon. The NF traded at around 100x current earnings on the idea they would grow forever. Whoops.

–the standard solution has come to be to allow a short period of super growth, then fade that back to GDP-like for another period, and project essentially no growth after that. …sort of like securities analysis, without the analysis. The issue here is that the NF also contained gems like Coca Cola and Walmart that received the same treatment.

–even the most sophisticated users of DCF have found that while, with well-crafted input, the calculations were able to identify areas of significant undervaluation, it might take half a decade (or more) for them to disappear. So unless a manage had extraordinarily patient clients, DCFs weren’t useful.

–as I see it, there’s a very small group of excellent securities analysts and a very large group of wannabes who are not so great at forecasting earnings. So getting good data to run DCF models is a major issue.

–stuff happens. For example, two things did Xerox in: cheaper, better copiers from Japan; and although its Palo Alto Research Center essentially invented the PC, top management opted to concentrate on real estate limited partnerships instead.

what a DCF is

A DCF is basically a fixed income valuation technique. The simplest case is a government bond that pays a fixed interest rate, with interest paid once a year in arrears. The rate is set at the time of purchase. Buying one now, you’d give the government $1000, in return for which you’ll get a payment of $42.20 at the end of each year until in year 10 you’ll get not only the interest payment but also your $1000 back.

If rates don’t change over the ten years, the final payment would be worth about $660 today and the present value of the interest payments would amount to the other $340.–although in dollars of the day as they were paid, they’d be worth $422.00.

If, on the other hand, rates rise to 7% the day after you commit and stay there for the next decade, the present value of the final payment drops to just over $500–and you’ve lost a bunch of money. On the other hand, if rates drop to 2% and remain there, the final payment spikes to $820, and you’re up considerably.

using DCFs with stocks

The argument for doing so is that the sum of the present value of all the projected future cash flows for a given publicly-traded company is pretty much like the payments you’d get by buying a bond. You could also make a more elaborate spreadsheet, in which you examine the effect on a DCF of different interest rate scenarios for different economic environments. You can “age” a company by having cash flows to reflect vigorous earnings-rich youth, followed by a more sedate middle age where results move in line with overall GDP growth. And you can “kill” the company by putting in zeros after a certain date.

You can also do similar calculations for, say, the S&P 500 as a whole, and use that to create a relative value matrix of potential stock market winners and losers, rather than absolute results. This would hopefully hedge against the possibility that your overall economic growth expectations prove way off the mark.

Life isn’t this simple, though.

More tomorrow