Category Archives: book value

value investing, American-style–riskier than it seems

March 5, 2014 By in activist investing, activist invstors, book value, Current Market Thoughts, distressed assets, growth vs value Tags: , , , , , 2 Comments

First, my usual caveat when I write on this subject.  I’m a dyed-in-the-wool growth stock investor.  But I my initial training was as a value investor.  And I practiced that craft for my first eight years in the business.  (Then I began to research mid-cap Pacific Basin stocks in earnest.  They had, at the time, a unique combination of extremely low valuations and unusually high growth.  After a couple of years of owning these hybrids I woke up one day and realized I had morphed into a growth stock investor.) Since that time, I’ve worked side by side with value colleagues for most of the rest of my career, though.

Growth investing is all about finding situations where a company is likely to expand its profits much faster than the consensus expects, and/or at an above average rate for much longer than the consensus believes.  It’s about where the company is going, not where it is now.

value investing

Value investing, in contrast, is all about where the company is now.   It’s about finding companies whose equities have been beaten down excessively by overemotional holders who have abandoned ship because of temporary earnings disappointment.  This disappointment can come from any number of causes.  Common ones include:  highly cyclical companies entering the down part of their business cycle, a big misstep by a normally competent management, or flat-out terrible corporate managers.

As an astute former value colleague put it, “There are no bad businesses, only bad managers.”  Put another way, there is enduring worth in a company’s tangible (think:  factories and inventories) and intangible (think: brand names, market positioning) assets that persists despite whatever earnings disappointments the firm may be experiencing at present.

In the first two causes I cite, time will cure the earnings deficiency.  Wayward shareholders will rediscover their zeal for the name and bid the stock price up aggressively.

But what if the management is genuinely awful?  In this case, value investors believe that the incompetents will be shown the door and be replaced by more highly skilled individuals.  The board of directors may do this, because, after all, that’s their job.  Or shareholders may demand a change.  (Fat chance of either of these happening, in my view.)  Or–and this is particularly American–either activist investors or hostile acquirers will swoop in and force a change.

two risks

As far as I can see, this last American idea–that justice will be served and the bad management tossed out–is valid in the US, but almost nowhere else.  Just look at the experience of activist value investors over the past quarter century in Japan or in continental Europe.  Yet, oddly enough, otherwise rational American value investors try the same tactic over and over, each time in the expectation of a different result.

This risk has been around for a long time.  The second hasn’t.

One of the deep underlying assumptions of value investing is that a company’s assets have an enduring economic worth, despite current headwinds.  All we need is some spark, some catalyst that will enable this worth to shine through.  And we can wait, since the value of accumulated assets is unlikely to deteriorate.

This is the sense behind the observation that a stock is trading at a discount to book value–that is, to the total sum of the assets the company owns, after subtracting out anything it owes to the rest of the world.  Calculations of “book” are based on the actual historical cost of acquiring the assets, which very often understates (usually by a lot) what it would cost to replace them.

Two new, still poorly understood, threats to this view:  the internet and Millennials.

Take suburban shopping malls as an example.  Millennials, at least more affluent ones, seem to like to live in cities, not the suburbs.  Internet shopping has reached the point where retailers are openly saying (they’ve probably secretly know this for much longer) that they have too much mall retail space.  Who to sell it to?

In other words, demographic/technological change is accelerating.  This increases the chance that balance sheet assets are writeoffs waiting to happen rather than “straw hats in winter,” needing only a change of season to flower.

 

more on reversion to the mean

October 31, 2013 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, Portfolio management, Strategy, two flavors of value Tags: , , , , , , Leave a comment

Happy Halloween!!!  

Trick or Treating for all!!!

This is a continuation of my post from yesterday.

why value works less well today

I’m a growth investor by temperament.  But I’ve spent more than half of my working career as an analyst and portfolio manager in value shops.  My basic contention is that traditional value investing works much less well in a globalized and post-Internet world than it did previously.

Why do I think this?

One of the two basic premises of value investing is that a firm’s investment in plant, equipment, distribution networks and brand name have a value that is substantial and that endures despite current mismanagement or battering by the business cycle.  The Internet has upended a lot of this, and the ability to move production to the emerging world has done more.

(The second premise is that change of control–either though action by the board of directors or by outside influences–is possible.  True in the US, but very often not elsewhere.  Twenty five years of activist investor failure in Japan is the most notable example.  But continental Europe is just the same.)

flavors of value

I’ve written about this before.  Basically, some value investors buy stocks simply because they’re very cheap, period.  Others wait to identify a catalyst for change before they jump in.

Personally, I believe that in today’s world the latter is the far safer course.  Yes, you may miss the absolute bottom.  But you also have greater assurance that you’re not booking passage on a latter-day Flying Dutchman that is doomed to never go up.

growth and value cycles

Through most of my thirty years in the investment business, periods of value outperformance and growth supremacy were each relatively short and both contained within a four-year business cycle.  For the past fifteen years or so, the periods of one style or the other being in vogue have been much longer.  I don’t know why.  But this phenomenon may make slavish devotion to one style or the other riskier than it has been in the past.

Consumer Discretionary vs. Staples

Back to the uninformative Bloomberg discussion of Consumer Discretionary vs. Staples.  Is there anything to the idea that Staples may make a recovery vs. Consumer Discretionary?

Yes and no.

yes

I think conditions are beginning to come into place for Staples stocks in the US to begin to do well again.  Many Staples stocks have large international exposure, much of that in the EU.  Europe appears to finally have moved past the bottom of its Great Recession and to be beginning to recover.  So revenues for Staples companies there should begin to perk up.  More important, the euro has moved up by about 7% against the dollar since July.  So the dollar value of those recovering sales to a US firm with EU exposure will, I think, be surprisingly high.

It’s possible that a continuation of economy-damaging politics as usual in Washington will make even slow growth in the EU look relatively attractive.  A renewed global investor interest in Europe may well cause its currency to remain firm.

On the other hand, Consumer Discretionary has less foreign exposure and a greater tilt toward the Pacific.  China’s recent economic reacceleration is therefore a plus.  But there’s less chance of currency gain.

no?

If portfolio managers begin to reallocate money to Staples, where will the funds come from?  It’s not clear to me that it will come from Consumer Discretionary.  It might well come from Energy, Materials, Technology or Industrials–all more cyclical industries than Consumer Discretionary.  If so, both Discretionary and Staples might do well.  In fact, although I haven’t thought this through enough, my hunch is that this is what will happen.

To me, the relevant points are that Staples are statistically cheap and that there’s a reason to think better times are in store, at least for US-based firms.  Whether this potential outperformance comes at the expense of Discretionary is much less important.

 

reversion to the mean

October 30, 2013 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, two flavors of value Tags: , , , , , , , Leave a comment

Mean version has two senses:

1.  The first is important for traders, less so for investors.  It’s that if we construct a trend line or moving average for a stock from past prices, the stock will tend to trade in a reasonably well-defined band or channel around the trend.  In theory at least, one can make money by buying when the stock is at the lower edge of the band and selling when it’s at the higher edge.

2.  The second is a cardinal tenet for value investors.  It’s that over long periods of time stocks in general tend to rise and fall in line with overall earnings performance, which is, in turn, a function of the ebb and flow of nominal GDP.  Some stocks may have episodes where they perform far better than that.  Others may have extended periods when they fall far short of this mark, which in the US probably averages around +8% per year.  The value investor’s argument is that both classes, serial outperformers and serial underperformers alike, will inevitably see their fortunes reverse and their stocks revert to the long-term mean performance.

For high-fliers, this means they’ll, sooner or later, crash and burn.  For the stock market’s junk pile, on the other hand, its denizens will have periods when they’ll rise like the phoenix.  The latter are what value investors look for.

old school value investing

For some value investors, this is it.  This is all they do.  They run screens that find the cheapest stocks based on price/cash flow, price/earnings or price/assets–or some combination of the three.  And then they buy them.

I knew one who systematically went through books of charts looking for stocks that had experienced catastrophic drops (not a good strategy–once they figured out what he was doing, brokers began to send this guy charts with the price axis stretched out and the time axis compressed, so that every stock they touted looked like a train wreck.  Last I heard–I was hired to clean up the unholy mess he created–he was selling real estate in the Philippines).

Every investor is in some sense a contrarian.  At the very least, we all believe that the stock we are buying has more up left in it than the seller does, and the stock we are selling has less.  We also know the cardinal rule is to “buy low and sell high.”  Nevertheless, I think the simple strategy I just outlined, which is at the heart of the value investing practiced a generation ago, no longer works.

Why am I writing about this today?  

I was listening to Bloomberg radio in my car yesterday,when Dave Wilson repeated the observation of a market strategist that the divergence between the strong relative performance of the sector ETF for Consumer Discretionary and the weak outcome for Staples was as great as it was just before the Internet bubble popped in 2000.  What followed was a fierce reversion to the mean by both sectors.

The implication was that this factoid is significant.  As usual for Bloomberg, what or why was not forthcoming.

More tomorrow.

 

 

value investing and rapid technological change

July 3, 2013 By in Basic Concepts, book value, Current Market Thoughts, distressed assets, growth vs value, Strategy Tags: , , , , , , , Leave a comment

value investing

The best of the many value investors I’ve worked with in my career used to explain what he did by saying, “There are no bad businesses.  There are only bad managements.”  He defined “business” as any endeavor that produces revenue.

In other words, the tools needed to make money–plants with machinery in them, sales forces, distribution centers, brand names, consumer goodwill…–are all there inside a company for management to set in motion.  Whether on not the firm makes a profit depends on how skillfully management uses this toolkit.

the value opportunity

Take two companies in the same industry and with identical assets.  Both have $100 million in annual revenue.  Company A makes $10 million in profit; Company B makes $3 million.

Value investors buy company B.  They either wait for or instigate change that will toss out incompetent management and put in new guys who will use the toolkit better.  (By the way, I wrote a lot about growth vs. value a few years ago.  Try my style test.)

what has to work

Two basic assumptions value investors make are that:

–change is possible.  Not a problem in the US.  Japan, where Western black ships are now toothpicks along the shore, is the obvious counterexample.

–the assets endure and can prosper in better hands.  Therefore metrics like price/book value or price/cash flow are reliable measures of a company’s worth.

the pace of change…

Look at the computer industry.  The mainframes of the 1960s gave way to the minicomputers of the 1970s.  The latter, in turn, lost out to the PC, whose dominance is now being undercut by mobile devices.  That’s 60+ years of history in two sentences   …that’s plenty of time for a nimble value investor to operate successfully.  But it’s also pre-Internet.

…is accelerating

Take Ouya.  It’s a $100, Android-based videogame console.   The idea is to play casual games on your TV, at a fraction of the price of a Nintendo, Sony or Microsoft console.

You can also play prior-generation games of all sorts on Ouya.  You can use old XBox 360 controllers, too.  Try games for free before buying.  (Developer tools come in the Ouya box, too,just  in case.  Revenues get split 70/30 in developers’ favor.)  There’s also the possibility of apps like Netflix, Hulu…

Maybe Ouya will be successful, maybe not.

What I think is more important is that Ouya has overcome the barriers to entry that supposedly ensure the permanence of the “toolkits” of incumbent firms:

–Financing:   Ouya set out to raise $950,000 through Kickstarter to get going.  It took in $8.6 million.

–Advertising:  social media  (In the UK, Ouya sold out in seconds;  in the US, it sold out on Amazon in eight hours.)

–Factories:  outsourced

–Game content:  all third-party.

Ouya’s biggest problem, as I see it?  It’s not XBox One, PS4 or Wii U.  Ouya’s low cost is likely to put downward price pressure on the price of all these traditional machines.  Ouya’s biggest worry is that its greatest competitive edge is its first mover advantage.  Low-cost competitors Gamestick, Game Pop and Project MOJO are are speeding down the same Internet-enabled trail Ouya has blazed.

What’s a value investor to do in this new world?

return on equity vs. return on capital: two important indicators

August 21, 2012 By in return on equity vs. return on capital Tags: , , , , , , 1 Comment

In a post a few days ago, I wrote about return on equity,  which is a standard measurement of the skill of the management of a company whose stock we might consider owning.  Services like Value Line provide statistical arrays for companies–and for the industries they’re a part of–that have these calculations,and a bunch of others, already done.

Today I want to add an important refinement–return on capital.

two forms of capital

Corporations have two sources of investment capital available to them.  One is equity, which is ownership interests in the firm that the corporation sells to shareholders.  The other is debt.  Debt comes is two flavors:  bonds issued by the company or bank loans that the firm takes out.

Debt holders have a call on corporate cash that’s superior to shareholders’.  On the other hand, as creditors, debtholders have no ownership rights. So, other than if the firm is in dire financial condition, they have no say over corporate operations.

Why take on debt?

It’s easier to raise capital this way, under normal circumstances.  Also, Americans, if no one else, believe that debt is a cheaper form of capital–meaning that shareholders can gain extra return by using it.

On the other hand, financial leverage (which is what having debt is typically called on Wall Street) brings risks with it.  So it’s important for investors to distinguish in a potential investment’s returns the portion that comes from employing capital in the company and the part that comes from using debt.

where return on capital comes in

Return on capital measures the first; return on equity measures the first plus the second.  Subtracting return on capital from return on equity gives return on financial leverage (a term I made up; the number doesn’t have a common name), or return from capital structure/financial engineering.

a simple example

1.  Let’s assume that a company has 100 units of equity and that it’s in a business where investing that 100 creates 100 units of annual sales (these numbers aren’t realistic; their virtue is simplicity).

Let’s also say that the company will earn 20 units of earnings before interest and taxes (ebit) from those sales.   We’ll also say that the company pays tax at 35%.

The income statement looks like this:

sales       100

ebit          20

tax at 35%    (7)

net income       13.

return on equity =   net income ÷ shareholders’ funds   =   13   ÷    100   =  13%.

2.  Same company, but it has borrowed 100 units of debt capital @ 5% interest.

sales       200

ebit          40

debt interest    (5)

tax at 35%        (12.25)

net income      22.75

return on equity  =  22.75  ÷  100    =    22.75%.

A huge difference!!

defining return on capital

return on capital  = (net income + aftertax cost of debt)   ÷  (total capital, i.e. equity + debt)

The aftertax cost of debt:  in the US, and in many other places, interest expense is deductible from otherwise taxable income.  The tax break is:  interest expense times the tax rate.  The aftertax cost of debt is:  interest expense – the tax break.

In our case, the aftertax cost of debt is 5 -1.75, or 3.25.   Return on capital = ( 22.75  + 3.25)  ÷  200 =   13%.

results

In this example, the unleveraged company earns a return of 13% on its invested capital.  This is the return that the company’s management can achieve from operating the business.  This may be good or it may be bad   …depending on the industry and the competition.

The leveraged company produces the same return from the business.  But it amplifies this by 9.75% by using a lot of debt capital.  (By the way, the tax system encourages this behavior by allowing a writeoff of interest costs as a business expense.)

The important thing to recognize is that leverage alters the risk profile of the business, in two ways:

–the principal amount of the debt must eventually be repaid.  If the debt is a bank loan, it could be subject to a repayment demand on extremely short notice, and

–a downturn in sales will squeeze profits for the leveraged company more than for the unleveraged, since the interest expense remains a constant.  In my experience, the negative effects of leverage working against you are much more severe than this simple example suggests.