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 also 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 12.5% return on capital (actually operating real estate ventures) and 2% from using financial leverage.

This calculation implies that Mr. Trump’s 12.5% return breaks out to something like 9% from real estate and 3.5% 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 that the numbers flatter Mr. Trump’s planning and management skills, which fall even more deeply below the average in the real estate industry than his overall results.

(5/20/19. Note:  the consensus today is that Mr. Trump never had assets anywhere near the Forbes figure and that in real estate, he added no value–doing little more than preserve in real terms the capital he inherited from his family.  That is, the idea that he made a fifth of the return of the average real estate magnate–and perhaps a tenth of what the best did, he appears to have made nothing.  Even so, that’s without factoring in the personal lifeline he may have received from security holders of his ill-fated Atlantic City casinos.

Together with the tax returns published by the New York Times, the picture that emerges is of a brilliant self-marketer, who has been able to recast the reality of a singularly maladroit businessperson.  Again, even this assessment may prove too flattering, if there is any substance to the money laundering allegations that are now surfacing.

One more thing:  I’ve taken a second look at my return calculations and revised them slightly.  None of my conclusions change:  Mr. Trump’s performance comes out slightly worse than before.)

 

 

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.

example

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.

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?

 

 

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.

 

 

 

 

 

growth vs. value test: my answers

The growth stock investor’s answer:  Joe’s, of course.  Why?  I pay $18 for the stock now.  At the end of five years, earnings per share will likely be $2.70.  Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.

Look at Bill’s in contrast.  I pay $10 for the stock.  At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here).  Assuming the stock keeps the same multiple, it will be trading at $16.10.  Add in the dividends and the total is $18.60.  That’s a return of 86%, or about half what I would get from holding Joe’s.

One more thing.  Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate.  As a result, the p/e multiple could begin to contract.  Maybe that will happen, maybe not.  But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.

The value stock investor’s answer:  It’s obviously Bill’s.  Joe’s has a much more aggressive  growth strategy.  Maybe it will work, maybe not.  I don’t see why I have to decide.  A lot of the potential reward for success is already built into Joe’s current stock price.  And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.

If Joe’s strategy doesn’t work, then I’m much better off with Bill’s.  On the other hand, suppose it really is the way to go.  In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change.  And the stock will skyrocket.  While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.

It’s a question of temperament.  A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.

Maybe the most salient points to be made about each answer are:

–not that many companies grow so rapidly as Joe’s without any hiccups;

–wresting control from an entrenched management is not that easy (look at the sorry history of  Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation).  It may not be possible, and could be a long and arduous process in any event.