value investing and mergers/acquisitions

buy vs. build

When any company is figuring out how it should grow its existing businesses and potentially expand into other areas, it faces the classic “buy or build” problem.  That is to say, it has to decide whether it’s more profitable to use its money to create the new enterprise from the ground up, or whether it’s better to acquire a complementary firm that already has the intellectual property and market presence that our company covets.

There are pluses and minuses to either approach. Build-your-own takes more time.  The  buy-it route is faster, but invariably involves purchasing a firm that’s only available because it has been consigned to the stock market bargain basement because of perceived operational flaws.  Sometimes, acquirers learn to their sorrow that the target they have just bought is like a movie set, something that looks ok from the outside but is only a veneer.

when the urge is greatest

Companies feel the buy/build expansion urge the most keenly at times like today, when they are flush with cash after years of rising profits.

so why isn’t value doing better?

Many economists are explaining the apparent current lack of capital spending by companies by arguing that firms are opting in very large numbers to buy rather than to build.

The beneficiaries of such a universal impulse should be value investors, who specialize in holding slightly broken companies that are trading at large discounts to (what value investors hope is) their intrinsic value.  Growth investors, on the other hand, typically hold the strong-growing companies with high PE stocks who do the acquiring.

On the announcement of a bid, the target company typically goes up.  The bidder’s stock, on the other hand, usually goes down.  That’s partly because the bid is a surprise, partly because the target is perceived to be priced too high, partly simply because of arbitrage activity.

All this leads up to my point.

Over the past couple of years, growth investing has done very well.  Value has lagged badly.  How can this be if merger/acquisition activity continues to be large enough that it is making a significant dent in global capital spending?

 

 

plusses and minuses of using book value

on the plus side…

–book value is a simple, easy to understand, concept.  Discount to book = cheap, premium to book = a potential red flag.

–it’s very useful for financials, which tend to have huge numbers of often complex, short-lived transactions with hordes of different customers, and where financial disclosure may not be so transparent (financials aren’t my favorite sector, by the way).  So the 30,000 foot view may be the best.

…maybe a plus?…

–in the inflationary world most of us grew up in, and that is still reflected in the financials of older companies, historical cost accounting tends to understate the current value of long-lived assets.  Think:  a piece of land bought in Manhattan or San Francisco in 1950 or an oilfield discovered in 1970–or 1925.  Many of the older retail chain acquisitions of the past twenty years have been motivated by the undervaluation on the balance sheet of owned real estate.

…definitely a minus

–in my experience, accountants tend to be very reluctant to compel managements to write down the value of assets whose worth has been impaired by, say, advanced age or technological obsolescence.

–more important, we are living in a period of rapid change.  The Internet is the most obvious new variable, although I think we tend to underestimate how profound its transformative power is.  In the US, we are also seeing a generational shift in economic power away from Baby Boomers and toward Millennials, who have distinctly non-Boomer preferences and a desire to live a different lifestyle from their parents.

Online shopping undermines the value of an extended physical store network.  Software (which by and large doesn’t appear on the balance sheet) replaces hardware (which does) as a key competitive edge between companies.

intangibles…

Warren Buffett’s key innovation as an investor was to recognize the value of intangibles like this in the 1950s.  In his case, it was that the positive effect of advertising expense and strong sales networks in establishing brand power appeared nowhere on the balance sheet.  In a world where his competitors were focused only on price-to-book, he could buy these very positive company attributes for free.  Price to book was still a solid tool, just not the whole picture.

…vs. structural change

The situation is different today.

The Internet is eroding the value of traditional distribution networks and of other physical assets positioned to serve yesterday’s world.  The shift in economic power to Millennials is likewise calling into question the value of physical assets positioned to serve Boomers.

In more concrete terms:

Tesla doesn’t need a car dealer distribution network to sell its cars.  A retailer can use Amazon, or Etsy or a proprietary website, rather than an owned store network.  A writer can self-publish.  These all represent radical declines in the capital needed to be in many businesses today.

Millennials like organic food and live in cities; Boomers eat processed food and live in the suburbs.

This all calls into question the present economic worth, still expressed on the balance sheet as book value, of past capital spending on what were at the time anti-competition “moats.”

Another issue:   I think that the institutional weight of the status quo has pressured managements of older companies into ignoring the need for substantial repositioning–including writedowns of no-longer viable assets–so they can compete in a 21st century environment.  Arguably, this makes low price to book a warning sign instead of an invitation to purchase.

using book value as an analytic tool

historical cost

Generally speaking, all of a company’s balance sheet data are recorded at historical cost (adjustments for currency fluctuations for multinational firms are he only exception I can think of this early in the morning).

book value

If this accurately reflect’s today’s values, and sometimes this can be an IFthen

…book value is an accurate indicator of the market value of shareholders’ ownership interest in the firm.

asset value

That means that price/book (share price divided by book (shareholders equity) value per share) can be an indicator of over/undervaluation.  In particular, if a company’s shares are trading below book, then it could potentially be broken up and sold at a profit.

management skill

We can also use return on book value (yearly net profit divided by book value) as a way of assessing management’s skill in using the assets it controls to make money.  This can be a particularly useful shorthand in the case of, say, financial firms, which tend to have fingers in a lot of pies and to disclose little about many of them.

Notes:

–price/book is not a linear or symmetrical measure.

On the one hand, a basic tenet of value investing is that when the return on book is unusually low either the company’s board or third parties will force change.  So weak companies may trade at smaller discounts to book than one might think they deserve.

On the other, strong performing firms will likely trade at premiums to book.  However, the amount of the premium will depend both on the state of “animal spirits” and more sober judgments about the sustainability of above-average results.

return on book vs. return on capital.  Return on capital is the same kind of ratio as return on book and has the same intent–to assess how well management is using the assets it is entrusted with.  The difference is that ROC factors in any long-term debt a company may have.

Return on capital is defined as:  (net profit + after-tax interest expense) divided by (long-term debt + shareholders equity).

Return on capital and return on book value are the same if a company has no long-term debt.  Return on capital is typically lower than return on book if a company has long-term borrowings, debt capital usually costs (a lot) less than equity capital.

using return on capital

ROC and the spread between ROC and ROB can be important.  We should think of ROC as the profitability of the business enterprise and the difference between it and ROB as the return on financial leverage.

For instance, for a given firm, the ROC may be 10% and the return on book (equity) 15%.  The difference, 5 percentage points, is the result of “financial engineering,” or the leveraged structure of the company.  Those figures may be ok (and, for the record, I’m not against leverage per se).  But if the ROC is 2% and the ROB is 12%, virtually all the profits of the firm come from financial leverage–not from the underlying business.  That’s a risky situation, in my view–one that owners should be aware of.

More tomorrow.

 

 

 

 

 

price to book: a traditional, but flawed, tool

what book value is

It’s another term for shareholders equity, the financial accounting tally of the total amount of money shareholders, as owners have provided management to work with–through purchases of stock from the company and through profits retained in the business.  It’s called “book” value because the figure is taken from the company’s accounting books.

An example:

We form Ace Investment Advice (AIA) by selling 100,000 new shares to backers at $10 each.

Our balance sheet is simple.  We have cash of $1 million on the asset side, no liabilities and net worth (aka shareholders equity or book value) of $1 million, or $10 a share.

Let’s say AIA earns $200,000 in its first year of operation and distributes nothing to shareholders.  At the end of the year, net worth/book value is $1.2 million, or $12 a share.

how it’s used

return on equity and management skill

AIA management took $1 million and earned $200,000 with it during the year.  That’s a return of 20%  (yes, if management earned that money in a linear fashion through the year, the number is slightly lower, but let’s not worry about that refinement here).

I can compare this performance to what the management of similar firms has accomplished to see whether that’s good or bad.

price to book

I can also compare this performance with that of the managements of all other publicly traded companies, to see if this is a stock I should want to own.

If management is regularly able to achieve a 20% return on the shareholder funds, I probably do want to be a shareholder.  And I’m likely to be willing to pay a premium to book value–let’s say 1.5x book, or even 2.0x book– to become one.

On the other hand, if AIA consistently earns a 2% return on shareholder funds, then the stock doesn’t look attractive to me at all, at least not at book value.  Maybe I only want to pay 50% of book value for it.  And even then I’m probably betting that the board of directors will find better management to run the firm or that an acquirer will be attracted by the discount to book value and make a bid to take it over.

More on Monday.

 

 

 

 

 

 

 

how traditional value investing has to change

Yesterday I wrote about the Indexology observation that value investing hasn’t worked well over the past decade.  That’s a long time.  Here’s what I think is happening:

Every professional investor, no matter how he describes what he does, looks to buy undervalued securities.  That’s not unique to value investors, no matter how academics may insist otherwise.  Growth stock investors seek this undervaluation in the market’s underestimation of a company’s future prospects, as measured by how fast earnings are growing, how the trajectory is accelerating and how long super-normal growth  may continue.  Value investors look for undervaluation in underestimation of the worth of companies’ here-and-now, based on metrics like price to book, price to cash flow and price to earnings.

 

Most often, value investors are attracted to companies that:

–are suffering from temporary misfortune–the wrong part of the business cycle or a management miscue–that the market mistakenly thinks is a permanent defect, or

–are badly run, but the market doesn’t realize that change is possible, either by action by the board of directors or by third parties forcing change of control.

In either case, the presumption is that cumulative spending on property, physical plant and equipment or on intangibles like brand names, patents, distribution networks or building brand names through advertising and marketing all have an enduring value that will most likely grow with time.  In the worst case, the worth of these assets will erode only very slowly.

 

This assumption is value investing’s chief problem, I think.

How so?

–through e-commerce and social media, the internet continues to erode the value of traditional distribution networks and the power of the decades of advertising and marketing spending that have established and (until a decade or so ago) protected them

generational change.  The gradual but steady replacement of the Baby Boom by younger generations who want to distinguish themselves from their parents means not only a change in what categories consumers spend on but a change in tastes, implying traditional firms may not benefit

the Great Recession.  In my experience, big economic downturns most often trigger changes in behavior.  They’re the reason for reassessing and changing spending habits.  They are also, if nothing else, the excuse for severing traditional relationships.  Some of this is economic necessity, some not.  Gen-Xers, for example, congregate in cities instead of the suburbs where their parents live.  They can’t afford to get sick and miss work, and they can’t afford restaurant meals, so they avoid fast food and make healthy meals at home.  They use mass transportation rather than owning a car.  Macys and McDonalds are the last places you’ll find them.

These three developments all attack the traditional order, and thereby undermine the assumption of the relative permanence of asset value for many firms.  This phenomenon is greatest in consumer-facing enterprises, less so in industrial.

 

The result is, I think, that value investors have to become more like their growth colleagues in investigating in great depth a firm’s ability to withstand the disruptive forces I’ve just listed.  Buying and selling based on screens of low price to book, low price to cash flow and low price to earnings is no longer enough

 

value investing today

S&P’s Indexology blog posted an article yesterday on value investing in the US, titled “Losing My Religion.”

The gist of the post is that both over the past one- and ten-year periods, value investing strategies have generally, and pretty steadily, underperformed the S&P.  The author, Tim Edwards, senior director of index investment strategy for S&P, suggests that this may be because value investing has become too popular.  In his words, “With so much energy directed to exploiting the excess returns available through value investing, maybe the only “value” stocks left are the value traps, those stocks whose prices are low as their prospects are determinedly poor.”

my semi-random thoughts

  1.  Value investing has been around at least since the 1930s and is the dominant investment style for professionals worldwide.  Growth stock investing may be a close second to value in the US but is a non-starter elsewhere.
  2. Value investing does not mean buying stocks that are cheap relative to their future prospects, i.e., bargains.  Rather, it’s a rule-governed process of buying, depending on the flavor of value an adherent espouses, the stocks with the lowest price to earnings, price to cash flow or price to net assets ratio–on the idea that the market has already factored into prices the worst that can possible happen, and then some.  So once the market begins to turn an objective eye toward such stocks once more, their prices will rise.  At the same time, downside is limited because the stocks can’t fall off the floor.
  3. As a dyed-in-the-wool growth stock investor (who has worked side by side with value colleagues for virtually all of his professional career),  my observation is that value stock indices routinely include growth stocks.  Growth indices, in contrast, are often salted with stocks that are well past their best-by date and that are ticking time bombs no self-respecting growth stock investor would own.  Academics use these mischaracterized indices to “prove” the superiority of value over growth.  Indexers use similar methodologies.  Be that as it may, this is another reason for surprise at the years-long underperformance of value.
  4. Early in my career I became acquainted with a married couple, where the husband was an excellent growth stock investor, the wife a similarly accomplished value stock picker.  She outperformed him in the first two years of a business cycle; he outperformed her in the next two years.  Their long-term records were identical.  This is how value and growth worked until the late 1990s.

The late 1990s produced a super-long growth cycle that culminated in the Internet bust of 2000.  That was followed by a super value cycle that            ran most of the next 4-5 years.  Both were a break with past patterns.  The strength of the second may be a reason value has looked so bad since.

5.  Still, what I find surprising about the past decade is the persistent underperformance of value, despite the birth of a post-Great Recession                    business cycle in 2009.  The cycle turn has always been the prime period of value outperformance.  Why not now?     …the Internet.

 

More tomorrow.

 

 

two aspects of securities analysis: quantitative and qualitative

quantitative analysis

The quantitative aspect is easier to describe.  It, however, is much more complex and detailed and may take months to complete.  As a professional, I always thought part of the art of portfolio management was in deciding how much of this I had to do before I bought a stock, how much I could obtain from brokerage house securities analysts, and how much I could leave to fill in after I established a position.

The quantitive plan consists in a projection of future company performance–revenues, operating profits, interest, depreciation, general expenses, taxes…–for each line of business and for the company as a whole, over the next several years.  Creating spreadsheets this detailed is an ideal that’s striven for but seldom reached in practice.  That’s because companies rarely disclose this much information in their SEC filings.

Lengthy reports, called basic reports, issued by old-fashioned (i.e., “full service”) brokerage houses are the best example of what a quantitative analysis should look like.  Signing up for Merrill Edge discount brokerage will get you access to such reports.

The most important thing about them, in my view, is the analytical work, not necessarily the opinion.  I think the Merrill analyst covering Tesla, for instance, does extremely good work.  All the relevant issues and numbers are clearly laid out.  Last I read, he thought that fair value for the stock was around $75 a share.  Although he provides very valuable input, and he may ultimately be proven correct, I think he’s way too pessimistic about the stock.

qualitative analysis

This is the general concept behind an investment.  It’s extremely important–more important than the exact numbers, in my view–but it may be as short as an elevator speech.  In most cases, the shorter the better.

Examples, many of which are not current:

–Wal-Mart builds superstores on the outskirts of US cities with a population of 250,000 or less.  They offer better selection and lower prices than downtown merchants do, so they take huge market share everywhere they open.  There are a gazillion such towns left to exploit.

–J C Penney is trading at $25 a share. It owns or controls property that has a value, if rented to third parties, of $50 a share, plus a retail business that is making money.  The latte is worth more than zero as-is.  Let’s say $5 a share.  Taking control of JCP and breaking it up could double our money.

–Adobe is changing from a sales model for its software to a rental one.  This will eliminate counterfeiting, which is probably much more extensive than anyone now realizes.  We know from other industries that going from buy to rent probably doubles profits, even without considering eliminating theft. No one seems to believe this.   Therefore, ADBE’s profit growth over the next two or three years will be surprisingly good.

–Company X is a cement company.  It’s currently beaten down by an economic slowdown and is trading at 40% of book value.  At the next economic peak, it will likely be trading at 100% of book–which will be 20% higher than it is today.  Therefore, the stock should triple in price.

More tomorrow.