reading financial newspapers

When I began working as a securities analyst, I noticed that my more experienced colleagues–and especially the most accomplished–had a peculiar reading habit.  They might glance over the front-page headlines and skim the articles.  But they spent most of their time in the back half of the paper, studying smaller pieces about more obscure economic developments or about small-cap companies.

Why do so?

reading back to front

Their idea, which I quickly adopted, was that the headlines dealt with well-known topics, whose importance was most likely already fully factored into stock prices.  The most important thing for an analyst, on the other hand, is to uncover information that is not yet discounted.  That means, of course, going beyond newspaper coverage.  But as far as the newspaper as a source of new ideas is concerned, it means reading the back half much more carefully than the front.

I, too, soon began reading the paper from back to front.

curation

In the online world, that’s hard to do, for two reasons:

–during the day, stories are constantly being rearranged, with the most-read (arguably the least valuable for us as investors) being pushed forward to the beginning pages and the least read gradually fading further and further back.  In addition,

–there’s no easy way to jump to the back of the queue, where the potentially financially valuable news should be increasingly piling up.

physical paper vs. online

The easiest way I’ve found to deal with the problem of online curation is to read the physical paper instead.  However, that isn’t always possible.  Luckily, if you hunt around on major newspaper websites, you can find an option that lets you read the news in the form the original editors laid it out for the physical paper, that is, without curation.  To my mind, that’s not as good as jumping directly into the stuff few people are paying attention to.  But it’s better than having to wade through the larger piles of non-investable stuff that the online edition creates as a “service” to us.

 

Warren Buffett’s bid for Unilever (ULVR)

(Note:  ULVR is an Anglo-Dutch conglomerate with what is for Americans a very unusual corporate structure.  I’m using the London ticker.)

Late last week word leaked of a takeover offer Kraft Heinz (KHZ)–controlled by Warren Buffett and private equity investor 3G Capital–made for Unilever.  Within a day, KHZ withdrew its offer, supposedly because of a frosty reception from the UK government.  Not much further information is available.  In fact, when I checked on Monday evening as I was writing this, there’s no mention of the offer or its retraction among the investor releases on the KHZ website.  Press reports don’t even seem to acknowledge that Unilever is one set of assets controlled by two publicly traded companies.

In any event, two aspects of this situation seem clear to me:

–Buffett’s initial foray with 3G was Heinz, where the Brazilian private equity group quickly established that something like one out of every four people on the Heinz payroll did absolutely no productive work.  Profits rose enormously as the workforce was trimmed to fit the actual needs of the company.

Buffett subsequently joined with 3G in the same rationalization process with Kraft.

For some time, achieving stock market outperformance through portfolio investing has proved difficult for Berkshire Hathaway.  Tech companies are basically excluded from the investment universe; everyone nowadays understands the value of intangibles, the area where Buffett made his reputation.

The bid for ULVR shows, I think, the Sage of Omaha’s new strategy–acquire and rationalize long-established, now-bloated firms in the food and consumer products industries.

Expect a lot more of this, with any needed extra financing likely coming from Berkshire Hathaway.

–the sitting pro-Brexit UK government is showing itself to be extremely sensitive to evidence that contradicts its (questionable) narrative that Brexit is good for the UK.  That seems to me to not be true in the case of UVLR.

Sterling has fallen by 15% or so since the Brexit vote, creating problems for firms, like UVLR, which have revenues in sterling + euros but costs in dollars.  Since the Brexit vote, and before the revelation of the bid, UVLR ADRs in the US had underperformed the S&P 500 since last June by about 20 percentage points.  Yes, UVLR has been a serial laggard, but most of the recent stock price decline can be attributed, I think, to the currency decline brought about by Brexit.

The idea that a venerable British firm would fall into American hands, with layoffs following close behind, appears to have been more than #10 Downing Street could tolerate.

That attitude is probably also going to remain, meaning that weak management teams in the UK need not fear being replaced–and that Buffett will likely have to look elsewhere for his next conquest.

 

 

a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.

 

 

 

 

 

 

 

Disney (DIS): the valuation issue

Long-time readers may recall that I became interested in DIS in late 2009, the company acquired Marvel Entertainment, a stock I held, for stock and cash.

corporate structure

I hadn’t looked at DIS for years before that.  I quickly learned that DIS was a conglomerate, that is, a type of company where the most useful analysis comes taking the sum of its constituent parts.

I knew the company’s movie business had been struggling for some time and the theme parks were being hit hard by recession.  Still, I was more than mildly surprised that ESPN (plus other media that we can safely ignore) made up somewhere between 2/3 and 3/4 of DIS’s operating earnings.  Why did they still call it Disney?

multiples

Given that the parks are a highly cyclical business and movies moderately so–meaning the PE applied to those earnings should be relatively low–and that ESPN was showing all the characteristics of a secular growth business–meaning high PE–I thought that ESPN represented at least 80% of the market capitalization of DIS.  (That’s despite the fact that the market would apply a higher than normal multiple to cyclically depressed results).

So DIS was basically ESPN with bells and whistles.

ESPN’s turning point

In 2012, ESPN made a major effort to enter the UK sports entertainment market.  To my mind, this wasn’t a particularly good sign, since it implied ESPN believed the domestic market was maturing.  Worse, ESPN lost the bidding, closing out its path to growth through geographic expansion.

It seemed to me that DIS management, which I regard as excellent, understood clearly what was happening.  It began to redirect corporate cash flow away from ESPN and toward the movie and theme park business, which had better growth prospects, and where it has since had unusually good success.

2014-16 results

Over the past two fiscal years (DIS’s accounting year ends in September), the company’s line of business results look like this:

ESPN +        revenues up by +11.9%, operating earnings by +6%

parks           revenues up by +12%, op earnings  +24%

movies        revenues up by +30%, op earnings +74%

merchandise   revenues up by +4.6%, op earnings +33%.

the valuation issue

ESPN has gone ex growth.  This implies these earnings no longer deserve a premium PE multiple.  To me, the fact that ESPN now treats WWE as a sport (!!) just underlines its troubles.

The other businesses are booming.  But they’re also cyclical.  So while improving efficiency implies multiple expansion, earnings approaching a cyclical high note implies at least some multiple contraction.

Because the two businesses are so different, I think Wall Street is making a mistake in treating earnings from the two as more or less equal.

calculating…

DIS will most likely earn $6 a share or so this fiscal year.  That will be something like $3 from ESPN and $3 from the rest.

Take the parks… first.  Let’s say I’d be willing to pay 18x earnings for their earnings.  If that’s the right number, then these businesses make up $54 a share in DIS value.

Now ESPN.  If we assume that the worst is over for ESPN in terms of subscriber and revenue-per-subscriber losses, we can argue that the future earnings stream looks like a bond’s.  If we think that ESPN should yield, say, 5% (a 20x earnings multiple), that would mean ESPN is worth $60 of DIS’s market cap.  If we’d still on the downslope, that figure could be a lot too high.

$54 + $60 = $114.  Current stock price:  $109.

my bottom line

My back of the envelope calculation for the parks… segment may be a bit too low.  I could also be persuaded that my figure for ESPN is too rich, but it would take a lot to make me want to move the needle higher for it.

Yes, most of DIS’s earnings are US-sourced, so the company could be a big winner from domestic income tax reform.

But if I were to be holding a fully valued stock on the idea of a tax reform boost, I’d prefer one with more solid underpinnings.  At $90, maybe the stock is interesting.  But I think ESPN–the multiple as much as the future earnings–remains a significant risk.

 

 

 

 

Trump on corporate income taxes

I think corporate tax reform is potentially the most significant item on the Trump administration agenda, as far as US stocks are concerned.

The Trump plan appears to have two parts:

–reduce the top corporate tax rate from 35% to, say, 20%.  For a firm that has 100% of its income in the US and which has no substantial current tax breaks, reducing the corporate tax rate would mean a one-time 23% increase in after-tax profit.

–eliminate foreign tax reduction devices.  American multinationals, facing high domestic corporate taxation, have resorted to two general types of tax avoidance devices.  They have: (1) transferred intellectual property (brand names, patents…) to low-tax foreign jurisdictions like Ireland, and (2) located distribution subsidiaries in similar places.  Hong Kong, where the income tax on profits generated by foreign companies is zero, is a favorite.

How this structure works:  a US-based multinational uses a Hong Kong subsidiary to pay a contract manufacturer in China $150 for a mobile telecom device.  The Hong Kong subsidiary sells the device to its US marketing subsidiary for $250.  The US company pays the Irish subsidiary a $100 royalty for the use of the firm’s proprietary technology and brand name.  It sells the device to a US customer for $600, recognizing, say, a $200 pre-tax profit in the US, and paying $70 in federal income tax.  Without Hong Kong and Dublin, the firm would have a pre-tax profit of $400 and pay $140 in tax.

If I understand correctly, President Trump’s intention is to tax this hypothetical multinational on the entire $400 of pre-tax earnings on sales made in the US–no longer allowing cash flow to be syphoned off to foreign tax havens.  At a 20% rate, the firm would pay $80 in federal income tax.

The bottom line:  while tax reform of the type I think Mr. Trump has in mind might leave large multinationals no worse off than they are today, it would be a significant benefit to small and medium-sized firms, which tend not to have elaborate tax departments and to be much more US-focused.  Just as important, it would eliminate the motivation to create offshore profit centers.

As/when the timing of corporate tax reform becomes clearer, I’d expect further rotation on Wall Street away from multinationals and toward domestic-oriented stocks.  A quick-and-dirty way of locating beneficiaries–look for corporate tax rates at or near 35%.

reading a financial newspaper

Early on in my investing career, I came to realize that it’s better to read financial newspapers by starting on the back page and working toward the front.

How so?

As investors, we’re searching for information that is potentially important but not yet well known.  Arguably, the best information won’t yet be in print.  But as it does appear, it will usually come in the form of small articles on the back pages.  Typically, when information is on the front page, or when it appears as a magazine cover, investors normally begin to think hard about adopting the contrary stance.

At first blush, reading from back to front is hard to do with online news services.  Worse,  the order of online news is constantly being curated, meaning that the most popular items are pushed toward the front.  The less well-received–that is, the more interesting for us–are progressively pushed toward the rear.

Interestingly, the Wall Street Journal and the Financial Times both have introduced what is being described as a “new” way of reading the newspaper, a digital form of the print newspaper.  Personally, I prefer the print newspaper.  But I find this digital form just as useful when I’m on the road.

US corporate tax reform (ii)

There are likely to be losers from corporate income tax reform.  They’re likely to be of two types:

–companies that currently have sweetheart tax deals, which, as things stand now (meaning:  subject to the success of intensive lobbying), will go away as part of reform.  A related group is multinationals who’ve twisted their corporate structures into pretzels to locate taxable income outside the US

–companies making losses currently and/or that have unused tax-loss carryforwards.  The value of those unused losses will likely be reduced by a lot.  This is a somewhat more complicated issue than it seems.  In their reports to public shareholders, money-losing firms can use anticipated future tax benefits to reduce the size of current losses.  The ins-and-outs of this are only important in isolated cases, so I’ll just say that for such firms book value is likely overstated

Another potential consequence of tax reform is that investors may begin to take a harder look at tax-related items on the income and cash flow statements.  Could markets will begin to apply a discount to the stocks of firms that use gimmicks to depress their tax rate?  Thinking some what more broadly, it may mean the markets will take a dimmer view of other sorts of financial engineering (share buybacks are what I personally hope for).  It might also be that companies themselves will reemphasize operation experience rather than financial sleight of hand when choosing their CEOs.