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.

Verizon (VZ) and Disney (DIS)

A short while ago, rumors began circulating on Wall Street that VZ is interested in acquiring DIS.

Yesterday, the CEO of VZ said the company has no interest.

some sense…

The rumors made a little sense, in my view, for two reasons:

–the cellphone market in the US is maturing.  The main competitors to VZ all appear to be acquiring content producers to make that the next battleground for attracting and keeping customers, and

–the Japanese firm Softbank, which controls Sprint, seems intent on disrupting the current service price structure in the same way is did years ago in its home country.

…but really?

On the other hand, it seems to me that DIS is too big a mouthful for VZ to swallow.

How so?

–DIS and VZ are both about the same size, each with total equity value of around $175 billion.  If we figure that VZ would have to offer (at least) a 20% premium to the current DIS stock price, the total bill would be north of $200 billion.

How would VZ finance a large deal like this?  VZ’s first instinct would be to use debt.  But it already has $115 billion in borrowings on the balance sheet, so an additional $200 billion might be hard to manage, even though DIS is relatively debt-free.

Equity?  …a combination of debt and equity?

An open question is whether shareholders in an entertainment company like DIS would be content to hold shares in a quasi-utility.  If not, VZ shares might come under enough pressure for both parties to want to tear up a potential agreement.

dismember DIS?

VZ might also think of selling off the pieces of DIS–like the theme parks–that it doesn’t want.  The issue here is that all the parts of DIS, except maybe ESPN, are increasingly closely interwoven through cross-promotion, theme park attractions and merchandise marketing.  So it’s not clear the company can be neatly sectioned off.

Also, as the history of DIS’s film efforts illustrates, the company is not only a repository of intellectual property.  It’s the product of the work of a cadre of highly creative entertainers.  Retaining key people after a takeover–particularly if it were an unfriendly one–would be a significant worry.

From what might be considered an office politics point of view, VZ’s top management must have to consider the possibility that after a short amount of time, they would be ushered out the door and the DIS management would take their place running the combined firm.  Would key DIS decision makers want to work for a communications utility?

my bottom line

All in all, an interesting rumor in the sense that it highlights the weakness of VZ’s competitive position, but otherwise hard to believe.




bonds …a threat to stocks?

I read an odd article in the Wall Street Journal yesterday, an opinion piece that in the US bonds are a current threat to stocks.  Although not explicitly stated, the idea seems to be that the US is in the grip of cult-like devotion to stocks.  One day, however, after a series of Fed monetary policy tightening steps, the blinders we’re wearing will drop off.  We’ll suddenly see that higher yields have made bonds an attractive alternative to equities   …and there’ll be a severe correction in the stock market as we all reallocate our portfolios.

What I find odd about this picture:

–the dividend yield on the S&P 500 is just about 2%, which compares with the yield of 2.3% on a 10-year Treasury bond.  So Treasuries aren’t significantly more attractive than stocks today, especially since we know that rates are headed up–meaning bond prices are headed down.  Actually, bonds have been seriously overvalued against stocks for years, although they are less so today than in years past

–from 2009 onward, individual investors have steadily reallocated away from stocks to the perceived safety of bonds, thereby missing out on the bull market in stocks.  If anything there’s cult-like devotion to bonds, not stocks

–past periods of Fed interest rate hikes have been marked by falling bond prices and stock prices moving sideways.  So stocks have been the better bet while rates are moving upward.  Maybe this time will be different, but those last five words are among the scariest an investor can utter.


Still, there’s the kernel of an important idea in the article.

At some point, through some combination of stock market rises and bond market falls, bonds will no longer be heavily overvalued vs. stocks and become serious competition for investor savings.

Where is that point?  What is the yield level where holders of stocks will seriously consider reallocating to bonds?

I’m not sure.

Two thoughts, though:

–I think the typical total return on holding stocks will continue be around 8% annually.  For me, the return on bonds has got to be at least 4% before they have any appeal.  So the Fed has a lot of interest-rate boosting work to do before I’d feel any urge to reallocate

–movement in yield for the 10-year Treasury from 2.3% to 4.0% means that the price of today’s bonds will go down.  So, while there is a clear argument for holding cash during a period of interest rate hikes, I don’t see any for holding bonds–and particularly none for holding bonds on the idea that stocks might fall in price as rates rise

Of course, I’m an inveterate holder of stocks.  And this is an interesting question to ask yourself.  What yield on bonds would make them attractive to you?



the Blue Apron (APRN) offering

Meal delivery service APRN (originally named Petridish Media) went public yesterday at an offering price of $10 per share through an underwriting syndicate led by Goldman Sachs.

The original pricing range was reportedly $15 – $17, but was reduced to $10 – $11 after Amazon and Whole Foods announced their intention to merge.

The stock traded as high as $11 yesterday, before fading back to the offering price later in the day.  I didn’t watch the stock and there’s surprisingly little price information from yesterday’s trading available this morning, but it seems as if the underwriters made few (if any) “stabilizing” purchases at $10 to keep the stock from closing below the offering quote.

Today APRN opened at $9.98, slipped to $9.50, and is trading at around $9.70 or so as I’m writing this.

Although I have zero interest in owning APRN at this point, I think it’s an interesting issue from a number of perspectives:

–the concept is, I think, for APRN to be the “first mover” in home meal kit delivery.  Doing so would give it brand recognition and scale that rivals starting up later would find difficult to match.  Whether APRN can achieve this position remains to be seen

–as I read the prospectus (meaning: I find it hard to believe what I’ve read), 100% of the proceeds from the offering are going to the company.  None of the VC backers or otheer insiders are cashing out any portion of their positions.  If so, this is either very good (they think APRN is a gold mine) or not so much (they don’t want to scare away buyers)

–APRN is an “emerging growth company,” listing under the provisions of the Jumpstart Our Business Startups Act (JOBS).  JOBS allows early-stage companies to go public without meeting all the SEC-mandated disclosure requirements for public companies.  This makes the financials hard to interpret.  Still, it seems to me that there may be a serious deterioration in APRN’s working capital during 1Q17

–the main metrics/issues for APRN are the cost of acquiring a customer and its ability to retain one once acquired.  Again, it’s hard to get a good read, but Wall Street’s apparent worry–apart from AMZN/WFM–is that the answers to these questions are “high” and “low.”

All in all, the risks of APRN are too high for me, but this will be an informative one to watch.