Category Archives: mean reversion

why buying is the key decision for value investors

June 25, 2015 By in distressed assets, growth vs value, mean reversion, two flavors of value Tags: , , , , , , Leave a comment

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

June 24, 2015 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, two flavors of value Tags: , , 1 Comment

 

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.

growth vs. value test: my answers

June 23, 2015 By in book value, cash flow/share vs. earnings/share, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital, two flavors of value Tags: , , 2 Comments

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.

testing for style–growth investing vs. value investing

June 22, 2015 By in book value, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital Tags: , , 2 Comments

Yes, I was supposed to be writing about trading.  But I figured it might be useful for readers to figure out whether they tend to like growth stocks or value ones before going further.  Here’s a test I heard about while I was at a value-oriented shop in the early 1990s (it’s a rerun of a one of the first posts I wrote in 2009.  Try not to look back to see the answers, which will appear again tomorrow.):

The Rules

I’ll describe two companies.  Both are retailers, operating in the US and selling identical merchandise.  They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.

Both have first year sales of $1,000,000.

Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.

Therefore, both have first-year earnings of $100,000.

Each firm is publicly traded and has 100,000 shares outstanding.  Earnings in year 1 are $1/share for both companies.

Money reinvested in the business is currently generating $2 in sales for every $1 invested.  There’s no lag between the decision to invest and the generation of new sales.

Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.

Earnings and cash flow are the same (just to keep it simple).

Company 1:  Bill’s Stuff

Bill’s management wants to take a conservative approach to a new business.  It decides that it will:

reinvest half of its cash flow back into the business,

pay a dividend of $.50 a share ($50,000/year),

keep any remaining cash in reserve in a money market fund.

So,  in year 2 Bill’s generates $1,100,000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income.  It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.

Let’s assume the company can continue to operate in this manner for as far as we can see.  Then, the company’s investment characteristics are:

10% earnings growth rate

$.50 dividend payment

no debt; small but growing amount of cash on the balance sheet

Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.

Company 2:  Joe’s Things

Joe’s management believes that expansion opportunities are extraordinarily good right now.  It decides that it will:

reinvest all the company’s cash flow back into the business,

borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.

In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000.  After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..

For year 3, Joe’s can borrow another $4,500 and does so.  Therefore, it reinvests $126,900 in the business.  It generates about $1,500,000 in sales and ebit of $225,000.  After interest and tax, net income is about $149,000 ($1.49/share).

Assuming that Joe’s can continue to expand in this manner indefinitely,  the company’s investment characteristics are:

22% earnings growth rate,

modest and slowly-rising bank debt,

no current dividend.

Let’s assume Wall Street is willing to pay 18x current earnings for the stock

The question:   Which one would you buy, Bill’s or Joe’s?

Answer tomorrow.

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.