a saturated market

market

Let’s say that a market is the total of all actual and potential customers for a product or service.

saturation

saturated market is one where virtually every potential customer has been turned into an actual one.  At that point, sales gains for a given company can only come from:

–the (slow) growth of the population,

–replacement demand (which can be stimulated by the creation of new versions),

–the sale of maintenance or accessories, or

–taking market share away from competitors.

effect on sales and profits

As a company’s products approach market saturation, sales growth typically slows.  In the terminal phase, expanding as fast as nominal GDP becomes an aspirational goal.  The competitive environment also changes dramatically in a saturated market.  Sales become more costly to obtain, since rivals’ marketing efforts no longer simply expand the market for everyone, but become specifically targeted at taking sales from competitors instead.  This forces every market entrant to spend even more money to defend its present customers.

effect on the stock price

For a growth stock, which is most often trading at an overinflated price earnings multiple as this growth downshift is occurring, the increasing saturation of key markets is especially problematic.  It typically starts to weigh on the PE long before actual saturation occurs.  ESPN, the largest source of earnings for Disney (DIS), and Apple (AAPL) are current examples.

examples

AAPL

The AAPL case is straightforward.  The global market for $600 cellphones is almost completely saturated.  The main demographic cohort in the US that still uses flip-phones is the over 60 (over 70?) crowd.  Technically speaking, one might argue there’s still room to grow.   But for every consumer-oriented technological innovation in my career, this group has been especially resistant to change and tough to crack.  AAPL has never gotten much traction in Europe.  There’s lots of domestic competition in greater China.  The result of worries about an end to growth is the principal reason AAPL shares trade at a sub-market multiple.

DIS

Several years ago, ESPN attempted to expand abroad–a clear signal that it regarded the US market for sports entertainment broadcasting to be saturated.  It was unsuccessful.  Since then, as I see it, DIS has been redirecting cash flow from ESPN to expand its parks and movies businesses.  To my mind, this is the sensible course of action for it.  For a one-product company, which many growth companies tend to be, this is not an option.

 

Tomorrow:  saturation in the e-commerce market in China

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.

why selling is the most important for growth investors

Value investors make money by finding companies that are undervalued based on the state of their business today.  Their capabilities typically become undervalued because of bad management, a temporary misstep in judgment or a cyclical downturn.  Any of these factors will usually trigger an excessively negative emotional reaction by the market–creating the buying opportunity.

Growth investors like me, on the other hand, are dreamers.  We try to find companies that will likely be expanding their profits at a faster rate than the market expects, and for a longer time than the market expects.

Where the value investor asks “What can go wrong in the here and now from this point on?” and answers “Nothing that the market hasn’t already discounted three times over,” the growth investor asks “What can go right over the next few years that market is unwilling to pay for today?”

 

A generation ago, the classic growth stock was Wal-Mart (WMT), a company that built superstores on the outskirts of small towns with under 250,000 population and prospered by taking market share away from inefficient mom and pop local merchants.  It started in Arkansas and grew…and grew…and grew, for a long as there were new small towns to attack.

In this generation, we might think of Apple (AAPL) or Google (GOOG).  In the former case, it was the ability of a highly skilled management to resuscitate the brand and produce the iPod and then the iPhone that the market didn’t understand when the stock was at $25.  With GOOG, it’s the power of search that was vastly underestimated.

If a stock is going to reach, say, $100 a share–the growth investor’s dream–whether we pay $10 or $12 or $20 isn’t the crucial decision.   Getting on the train at some early stop is all that matters.

Selling at the appropriate point, however, is much more crucial.

How so?

what goes up…

Let’s say the market expects that a certain company is going to grow profits at 15% per year for at least the next several years.  The next quarterly earnings report comes in at +20% in profit growth; management says it thinks it can continue to grow at the higher rate.

Two positive things typically happen:

–the stock rises to adjust for the higher reported earnings, and

–the price earnings multiple expands, as the market begins to factor in the idea that the firm can grow more quickly than it thought.  In other words, the price rises more than simply the good earnings report would justify.

Let’s say that the quarter after that, earnings come in at +25%–and that management continues to make bullish comments about its future.

The same thing–two levels of upward price adjustment, higher earnings, higher multiple–happens again.

For a true growth stock, a WMT or an AAPL or a GOOG, this process of upward adjustment can go on for years.

At some point, though,

must come down

…the stock market gets tired of being wrong on the downside.  It makes an emotional swing to the upside that can’t possibly be justified by the company’s fundamentals   …ever.

Typically, this is expressed as a sky-high price earnings multiple.

In addition, in my experience, the life span of a typical shooting star earnings grower is about five years.  After that, earnings growth begins to slow.  The crazy multiple expansion comes toward the tail end of the super growth period.

 

As the market senses that slower growth is in the offing, the process of upward adjustment goes into reverse.  The stock declines to reflect weaker than anticipated earnings, and the price earnings multiple begins to contract.

This is usually a very ugly process, with the stock declining much more than one might ordinarily expect.

 

The trick for a growth investor is to exit the stock, at least in large part if not totally, before this happens.

 

More on Monday.

 

 

 

why buying is the key decision for value investors

Value investors like to describe themselves as buying companies worth $1 for, say, $.20 and selling them for $.80.  Less ambitious practitioners say buying for $.30 and selling for $.70.   But the idea is the same–buy at a deep discount, sell at a slight discount.

What remains unexpressed, but what’s crucial for value investors, is that the firm in question is not being assessed on any pie-in-the-sky future developments, but on an evaluation of what the company as it stands now is worth.

Three types of situations get value investors particularly excited:

–periods of general stock market undervaluation,

–overall business cycle slumps, or specific industry group declines, when the market fears that an (inevitable) upturn won’t happen and decides to unload the underperforming stocks into the market for whatever they can get, or

–companies that are industry laggards and which would fare far better if run by more competent managers.

In a sense, all of these situations involve temporarily damaged goods.

In each case, value investors also have plenty of data for figuring out what normal or reasonable prices for now-undervalued companies should be.  The data might be projections from past industry or economic cycles about how far earnings might rebound during an upcycle and how far price earnings multiples might change (usually expand).  In the case of badly run firms, the comparison is with healthy companies in the same industry.

In every instance, however, it’s a relatively straightforward thing to set a target price–what the company would be worth in better times.

The more difficult question is at what price to buy.

Investors will certainly demand a premium, say, 20% or 30%, for taking the risk of making a purchase while a business may be doing badly or while the overall market is cringing in fear.

Beyond that, value investors seem to me to fall into two types:

–those who are willing to buy at what they consider a rock-bottom price, regardless of the near-term outlook, and

–those who are waiting to see an initial ray of sunshine, or a “catalyst,” that convinces them that the worst is past.

In the first case, the skill is in judging the bottom.  In the second, it’s finding the turn upward before the market in general does.  But in both cases, it’s the decision to buy that’s the key to success.

 

 

 

 

comparing growth and value styles

 

Growth                                                        Value

stock volatility high                                   low

character aggressive                                   defensive

upside high                                                    limited

downside can be high                                 low

firms have very bright future                  cheap assets

outperforms bull market                         bear market

benefit from market greed                      market fear

(sell high)                                                       (buy low)

uncertainty extent of rise                        timing of rise

portfolio size 50 issues                            100

 

All this is leading up to talking about why buying is the crucial step for value investors, selling the most important for their growth counterparts.