Category Archives: growth vs value

Is there a “lost generation” of marketers?

April 8, 2010 By in Consumer Staples, economics, growth vs value, Industry Analysis Tags: , , , , , , Leave a comment

The Unilever marketing story:  the “lost generation”

The Financial Times of a couple of days ago had a report of its interview with Simon Clift, who is retiring as head of marketing for Unilever, one of the largest personal care products companies–as well as one of the largest advertisers–in the world, with a marketing budget of $7.2 billion.

In it, Mr. Clift makes a number of, to me, surprising observations, among them that:

–the people Unilever has running its global brands, aged 25-45, have very little knowledge of, or experience with the internet.  They don’t know how the consumers of Unilever’s products gather information or share views online.  As to social networking, they are “a lost generation.”  Armed with a lifetime of television advertising expertise, they continue to cling to the idea that a good commercial solves all problems.

Their subordinates aged under 25 know better because they have grown up using today’s communications media.  Their bosses do too, since they see how their kids behave.  But the guys actually steering the ship “built our business on brilliant use of television.  You can’t immediately change your competence.”  This seems kind of like saying you can lead a horse to water, but…  Is this good enough if you’re the boss and know better?

–Unilever’s brand managers’ counterparts at advertising agencies are apparently in the same bad shape.

–in contrast, public relations agencies “get” the internet and are leaders in effective use of social networking sites.

Can this be right?

For at least the past decade studies have shown that consumers who have grown up with traditional advertising know it well, but consider it distortive and don’t trust it. This might have been news at the end of the last century, but not today.

Again, for at least the past ten years, large advertising agencies have been buying public relations shops as fast as they can, both for the superior earnings growth profile of pr, as well as for the greater persuasiveness of public relations campaigns.  I presume that every ad agency Unilever works with has plenty of pr talent just itching to enter the fray on Unilever’s behalf.  But it seems the ad agencies haven’t offered and Unilever’s brand managers, despite their boss’s insistence, haven’t asked.

The head of marketing at Unilever says that he understands the company’s main communications problem and what the solution is, but that his subordinates are either incapable of doing what he wants, or have refused to do what he has told them.  If true, this really says something, not only about the boss, but about the corporate culture at Unilever as well.

maybe so

…speaking of which…When I entered the stock market in the late Seventies, I had an acquaintance who got his PhD in history just as the Baby Boom finished college and the bottom fell market for young professors.  So he got a job at a consulting firm, writing corporate histories.  The idea was by so doing to help client firms recapture the vigor that they once had.

For him, the pattern for successful companies was clear:

the founders were swashbuckling entrepreneurs.   Succeeding generations of managers became more concerned with preserving gains already made and the company would gradually ossify.  The current set would typically be bureaucrats, punching in at nine, out at five and doing little in between other than seeing to it that the status quo is not disturbed.

So I guess it’s possible that the FT article accurately portrays what’s going on in the consumer products industry.

investment implications

1.  The “lost generation” idea implies that, ten years in, there’s still a lot of scope for growth in internet advertising and for disappointment in traditional media, especially television.

2.  Bureaucratic inertia is a more difficult problem to handle than most investors realize.  GM, which turned a 40% share of the US car market into a bankruptcy filing in about thirty years, is the classic case in point.  The way I see it, successive managements decided they didn’t want to be the ones to be responsible for the down profit years (and consequent lower bonuses) that change would have implied.  And had they opted for change, they may well have been sabotaged by their own employees, who wouldn’t/couldn’t learn new skills.

To me, the case of a large, established company is the most difficult one to be persuaded by the value investor’s argument to buy, in the belief that assets are undervalued and that either management will change or the company will be taken over.

3.  Some investors argue that in an industry that’s behind the times, as the FT asserts the personal care products firms as a whole is, it’s okay to buy a competitor that may not be a great company but is at least better than its peers.  This is a variation on the argument that if your group is being chased by a hungry bear, you don’t need to be able to outrun it.  You just need to be able to run faster than one other group member.

My experience is that a situation like this always ends in tears.  I think that great companies routinely surprise on the upside; weak companies always find new and inventive ways to underperform.  And an industry with five weak competitors is a more attractive target for new entrants than one with only a few.  But then, I’m a growth stock investor.  A value investor would probably write the opposite.

Growth vs. Value: how is this bull market stacking up?

December 3, 2009 By in Constructing a Portfolio, Current Market Thoughts, growth vs value, Recent Market Action, Shaping a portfolio for 2010, Strategy Tags: , , , , , , , , Leave a comment

A typical bull market progression

The first half of a typical bull market belongs to value investors, the second half to their growth counterparts.  The general idea behind this is that the outperforming stocks at any moment are those that are showing the strongest earnings growth.

Value stocks tend to be more sensitive to the rhythms of the overall economy than growth stocks.  So value tends to outperform during the part of the economic cycle when pent-up demand from a just-ended recession starts kicking in and the economy is expanding at a rapid clip.  As the cycle ages and the economy settles down to a slower, but still healthy, expansion rate, growth stocks, with their strong, but less economically-sensitive results, come to the fore.  Growth continues to outperform from this point through the end of the subsequent economic slowdown.

At first, the 2009 bull market looks like this..

On the surface, the 2009 bull market in the US seems to be following the traditional pattern.  With the index (I’m using the Russell 1000 as the benchmark–it’s big cap, like the S&P 500, but has wider coverage) up 62.8% from March 9 through November 30, value stocks (Russell 1000 Value index) are up 66.8%, while growth stocks (Russell 1000 Growth index) have risen 59.4%.

…but it really isn’t

When we look a little deeper, though, the usual pattern breaks down.  Instead of outperforming for a year or more, value stocks lose their relative acceleration after only two months.  They move more or less in line with growth stocks for the subsequent four months, after which they begin to lag.  The numbers are as follows:

————————-3/9-5/7—–5/7-9/16——9/16-11/30

Russell Value                +40.0% +19.1%              -.03%

Russell Growth              +30.0%         +17.9%              +4.0%

What does this mean?

My interpretation

Of course, it’s always risky to draw conclusions from relatively limited amounts of data (on the other hand, this is what stock investors always do–when the total picture is in, the market has long since discounted it).  To me, though, the truncated period of outperformance of value stocks suggests that the market is much more aware than bears would give credit for that this is a very unusual and weak recovery.  Instead of the 5%-7% real economic growth that marks the early quarters of bounceback from a typical inventory cycle recession–and characterized by consumers and businesses rushing to satisfy pent-up demand, the early shunning of value suggests the market has much lower expectations.

It’s also interesting–maybe even correct–to note that about the time that companies were getting a firm sense of what the September quarter would look like, Wall Street started to rotate toward less economically sensitive growth issues.

The message I get from the numbers–one which applies only to the US and must be subject to constant potential revision–is that the market thinks that stocks in general will not go rushing higher from here for some time.  The sectoral rotation in search of laggards that seems to be starting in the market suggests the same thing.  The apparent focus on the stronger, faster-growing market components does too.

This would imply that, although the overall market may provide a stable base for investors to stand on (in other words, the bottom won’t drop out of the market), good individual stock selection will provide the key to investment success next year–or at least until the overall economy regains a lot more of its “normal” strength.

This is not bad news.  In fact, it would be pretty good, if true, considering the horrible beating the US economy has taken from the financial crisis.  The positive message would be that there’s a chance to make good money next year by being in the right stocks.


Book Value (II)–where it doesn’t work so well

November 9, 2009 By in Basic Concepts, book value, growth vs value Tags: , , , , , Leave a comment

As I mentioned in my prior post on book value, using it as a valuation tool works best when the company in question has plain-vanilla assets, and where assembling capital to be able to purchase productive assets–whose worth is accurately shown on the balance sheet–is a key part of its ability to compete.

It stands to reason, then, that problems will arise when this condition isn’t met.

Examples:

Companies with powerful brand names or distribution networks. This was Warren Buffett’s essential insight a half-century ago.  If  for twenty years a company spends 3% of sales each year on advertising a given product, it will in all likelihood have established customer awareness of its brand.  The brand may not be Tide or Cheerios or Lexus (although it may be), still the brand probably has a considerable value.  But not only doesn’t that expense not show up anywhere on the balance sheet, it has reduced profits, and therefore the shareholders’ equity account, for all that time.  Takeover bids for companies with brand names almost always come at a sizable premium to book for this reason.

One of the great retailing stories of the last fifty years has been the demise of the department store, department by department, by specialty retailers, who distributed in highly focused, single-purpose stores in suburban locations.  Toys R US, Limited and Bed, Bath & Beyond are only a few examples.

Almost no one has heard of Child World or Lionel’s Kiddie City. That’s because they lost the race to establish the first national toy store chain to Toys R Us.  But even as TOY crossed the finish line first, dooming the others, their books values weren’t that dissimilar.

In today’s world, one might argue that the difference between Barnes and Noble and Borders is the former’s superior internet distribution.  Amazon beats them both for the same reason. Yet this difference is more one of management decision than balance sheet construction.  At .6x book value, it’s not clear to me that BGP is cheap.

2.  natural resources companies. This is really a specialist topic that I’ll eventually write more about.  This is the version done with crayons.

In the simplest terms, resource reserves are defined as what can be produced at a profit using today’s extraction technology.  As prices go up and as technology gets better the amount of economically recoverable oil, gas, gold, copper…a company has rises. But the company’s balance sheet list them only at the (depreciated) cost of finding the deposits.  That may have been fifty or even a hundred years ago.

As a result, the balance sheet metrics that apply to non-mining companies may have little relevance.  ExxonMobil, for example, carries its oil and gas reserves on its balance sheet at $67.6 billion but lists the present value of it reserves, calculated using the SEC method, at $86.0 billion.  In my estimation, this is an extremely conservative number.

Other mining companies typically only “prove up,” i.e., formally document and establish, reserves they may need to collateralize bank borrowing.  They may only be a small section of a huge orebody, but if the entire extent hasn’t been drilled to establish the mineral composition, the undrilled portion is technically not “reserves”– and therefore reported only as unexplored acreage.

3.  service companies. That is, companies that don’t manufacture goods, but provide services instead.  Software companies like Microsoft are a good example.  MSFT, which now trades at about $28 a share–in its heyday, it was as high as $60–has a book value of about $4 a share.  The price is 7x book.

But there’s nothing on its balance sheet for its brand name, or its domination of personal computer productivity software and operating systems.  It’s research and development expenditures are by and large expensed rather than put on the balance sheet.  So, like the case of advertising expense above, they reduce rather than add to book value.  Price/cash flow is probably a better measure here.

4.  companies that issue new stock. This could be to fund internal capital expansion or the purchase of a rival.  The stock issuance can change book value significantly.

Assume a company has 100 shares outstanding, book value of $10 a share and is trading at $20 a share.  If it issues 100 shares of new stock at $20 (yes, an issue this large is unlikely, but it illustrates the point), then it has book value of $1000 from the initial shares and book of $2000 from the new shares.  In other words, it’s new book value is $15.

5.  auditors’ practices in writing assets up or down. Most auditors, in my experience, are loathe to insist on writedown of impaired assets beyond the extent that company managements are content with.  Auditor practices vary, I think, as do management tolerances for writedowns.  As a result, so too do writedowns.  This is something to at least consider when doing company to company comparisons.

In addition, some countries–not the US–suggest/require that companies write their  assets up to fair market value periodically.  This sometimes makes book value comparison of companies domiciled in different countries, but with similar assets, problematic.

Book Value (l)–general

November 6, 2009 By in Basic Concepts, book value, growth vs value Tags: , , , , , 3 Comments

I was reading an article a few days ago which asserted that emerging markets equities were overvalued because they were trading at an average of 2.3x book value vs. an average of 1.8x book for stocks in developed markets.

What does this mean?  Is the argument a reasonable one?

I’m going to cover this topic in two posts.  This one will outline what book value is and the sorts of circumstances where I think it’s useful.  In the second post, I’ll talk about situations where book value is more problematic as a value indicator.

What “book value” is

“Book value” is the value of the shareholders’ investment in a company as shown on the company’s official records, or “books”.

For reporting the condition of their client companies to stockholders,  accountants produce three basic records:

the balance sheet,

the income statement and

the cash flow statement.

Book value comes from the balance sheet.

The balance sheet has two sides.  The entries on each side add up to the same number,  or “balance” with each other. One side lists everything the company owns, from cash, to inventory and receivables, to plant and equipment.  The other has liabilities–loans, preferred stock, credit extended by suppliers and anything else the company owes to others–plus common shareholders’ equity.  Book value is what’s left after subtracting liabilities from assets. It’s another name for shareholders’ equity.

Why it’s useful

Book value is a very basic and traditional measure of value.  It functions in several ways:

1.  liquidation value.  If we assume that the accounting statements are accurate, book value per share is the amount that stockholders would receive if the company’s assets were sold in an orderly way, liability holders paid back, and the remainder distributed to owners.  A company whose stock trades at a steep discount to book value is, at least in theory, under threat of being taken over and liquidated, if its results can’t be improved by the new owners.

2.  a shorthand way of assessing management’s capabilities. In combination with profit data, we can use book value  to calculate ratios like return on capital (annual profit/debt + book value) or return on equity (annual profit/book value).  Years and years of all the data needed for these calculations are available in databases, so companies can be screened and compared very easily.  Comparison can either be across a universe of stocks or for a single company over different periods of time.

If we assume that the specific assets a company owns don’t carry with them a unique advantage over competitors, then variations in return on capital across an industry are most likely due to differences in management quality.  If the analysis is confined to a single industry, the highest results can at least show what returns can be achieved by strong management–and therefore what improvements are possible among laggards.

3.  a guide to stock market valuation. Another way of looking at book value is that it’s what it would cost to reconstitute a given company by buying similar assets and taking on similar liabilities.  By this measure, a stock trading at a discount to book value should be cheap.  Conversely, a stock trading at a premium to book should be expensive.  One of the rules Benjamin Graham, the father of value investing in the US, used to use was that a stock was potentially attractive if it traded at below 2/3 of book value.

A corollary of #1 and #2 is that a company whose stock is trading at, say, 2x book because returns are very high is likely creating an artificially high pricing umbrella which will draw competitors to the industry, eventually undercutting the “expensive” firm’s profits.

Screening

Because you’re only looking a one simple variable, it’s possible to screen large numbers of companies in an instant, as well as to compare firms in different industries with one another.

Advocates would also argue (this is not a majority view, however) that there’s no chance of being seduced into buying overvalued stocks by smooth-talking managements with fancy powerpoint presentations.  You’re dealing with hard, cold facts–the numbers.

What you need to believe

The basic assumptions you make when using book value as a tool are:

1.  when a company buys long-lived assets like property, plant and equipment, or makes a long-term investment in another company, it basically gets its money’s worth–in other words, the purchase price recorded is a fair assessment of value,

2.  while there may be differences in the bells and whistles decorating a given factory or the manufacturing equipment located inside, these assets are functionally equivalent to superficially different assets competitors may hold–so a comparison of carrying values is legitimate,

3.  these assets have enduring value that, if it changes, does so only slowly–so carrying value doesn’t lose its relevance as time passes,

4.  the auditors are doing their job of ensuring that the company writes down the carrying value of worn-out or obsolete assets,

5.  something can and will happen with a company trading at a deep discount to book to force the stock price up so that the discount disappears- in other words, action will be taken by shareholders, the board of directors or outside activist investors, to achieve this result.

Under these assumptions, then, when you locate a company whose stock is trading at a big discount to book, you’re looking at a deeply undervalued–and very attractive–security.

One other thing.  The industry itself must be viable–no buggy whips or whale oil processing.  In today’s world, many book value-guided value investors avoid airlines for this reason.

The basic metaphor

The basic metaphor is a manufacturing one.  A company has valuable tools that it employs workers and managers to utilize.   Assets are seen as commodity-like.

Firms are seen as achieving a competitive advantage by having been able to obtain enough capital to buy its productive assets in appropriate size the first place, and by achieving economies of scale by operating them efficiently and reinvesting profits in their expansion.

Where it works

Since the idea behind using book value as an investment tool is industrial, it makes sense that it should generally work best for companies that produce goods, not services.

The concept is useful in evaluating a very wide range of companies, from general industrials to oil refiners or cement makers or shipyards (or ship owners), or office buildings–to name a few.  Anything with physical assets.

It applies especially well, I think, to manufacturers of semiconductors, computer components and other IT hardware.  How so?  The industry is very capital intensive.  The companies in question are all relatively young.  Their plant and equipment has been purchased in the recent past.  As a result, the playing field for comparison is level and the figures are probably highly accurate.  There’s little chance of making an apples-to-oranges comparison between brand new plant carried at full purchase price and perfectly adequate plant bought at lower prices twenty years ago and already partly depreciated.

Book value has also been the tool of choice for assessing financial companies, especially brokers and other trading companies.  Results using book over the past few years have, of course, been disastrous–Bear Stearns had reported book value of above $80 a share just as is was collapsing.

The idea was that it’s impossible to understand, transaction by transaction, what is going on inside any financial company.  But what they do is invest shareholder’s money.  The money they have to work with is book value.  What an investor can do, however, is calculate the return a company achieves on book value.  If a company consistently earns, say, 20% annually on book, I can pay up to 2x book value for the stock–getting me a 10% earnings yield.  If the return is a Goldman-like 25%, then I can pay 2.5x book

What happened to the financial industry was, I think, not so much an indictment of the use of book value as it was an indictment of managements and auditors who used dubious accounting tricks to present a grossly distorted picture of their firms.

What about intangibles?

It may be that a company gradually builds up a reputation for quality and service that allows it to charge premium prices for its goods.  This will presumably translate into higher profits and a stock price that substantially exceeds book.  Won’t a book value screen toss out a firm like this?

Two points:

1.  You can use the trading history of this sort of company’s stock vs. book value to judge when it it may be time to buy during a downturn or to sell during an upturn.  The idea would be that the stock has never in the past traded below .9x book in recession, so when it hits that level in a downturn it’s pretty safe to buy.  or that it peaks at 3x book in an upturn.

2.  If you’re worried about this, you’re not  a value investor–who are the primary users of book value as a tool.  Value investors argue that the real money, and the low-risk money is going to be made by finding the laggard company in the same industry that’s trading at a deep discount to book.  When the board of directors or activist investors force a change of management in that company, and when the new management works the company’s assets harder, the profits will soar (at least to the industry average and maybe beyond) and the stock will skyrocket.  That’s where you should be looking.

That’s it for today.  My second post will talk about situations where one has to be careful about using book value.

When something is going wrong…(lll) growth stock problems

October 26, 2009 By in Fixing mistakes, growth vs value, Portfolio management, Strategy Tags: , , , , Leave a comment

The main idea behind investing in a growth stock is that the company whose equity you’re buying will show earnings growth that’s much higher than the stock market consensus expects, for much longer than the market expects.

AAPL, MON or COH are recent examples of successful growth companies.  In their day, WMT, CSCO, MSFT, ORCL, even IBM were growth stocks.

Examples of companies that had seemingly good ideas that failed to experience a multi-year period of strong earnings growth also abound.  No one remembers their names, though.

Consensus data less useful for growth stocks

Maybe the most important characteristic of growth companies in my opening sentence is the assumption that the consensus is wrong and has materially underestimated how rapidly the company in question will grow, and for how long.

One practical, straightforward consequence of this is that the kind of computer screening that a value investor routinely uses to find undervalued securities, which uses historical data plus consensus estimates, is of little use.

In consequence, although the growth investor does use historical data and may find the germ of an idea from an industry expert, he most often has to rely on his own research.  Sometimes this comes from his own experience. For example, Peter Lynch of the Fidelity Magellan fund, perhaps the most famous stock investor of the late Seventies and early Eighties, wrote that he became interested in Dunkin’ Donuts, once a growth stock, because he used to buy his coffee there on the way to work.

Qualitative research is important

All research has, in my opinion, a qualitative and a quantitative element.  For value investors, the latter is more important.  For growth investors, though, I think the qualitative description is always the key.  Yes, you have to have spreadsheets that have point estimates of what future revenues and earnings will be.  But for the best growth stocks, there’s always a sense of–the earnings will be up at least 30%, but they could be a lot more than that.  In contrast, the qualitative story–what unique attributes of the company allow it to grow so fast–remain constant.

Rules of thumb for growth investors

There are some historical rules of thumb that you can use in growth investing, however:

1.  the process of establishing itself as a fast grower normally takes several years.   This is a combination of the company developing its operations and of Wall Street gradually coming to recognize the firm for what it is;

2.  as stock market outperformers, growth stocks rarely last more than five years;

3.  the truly great companies, like WMT or MSFT, are able to reinvest themselves and extend the growth period for much longer periods;

4.  growth stocks typically reach their peak of stock market popularity and their highest relative P/E multiple just as growth is beginning to slow;

5.  because of this, when they go ex growth, these stocks often face a protracted period of underperformance;

6.  signs of trouble always, always surface in the qualitative analysis before they make themselves evident in earnings.

Common growth stock errors

1.  selling too soon.  The average yearly return of stocks over very long periods of time is about 10%.  Compared with that, a 30% or 50% return looks good.  Also, from a value stock mindset, 50% may be all that you can expect.  Not so with growth stocks, however.  The key question should be whether the basis growth story for the company is still intact (surprisingly strong growth for a surprisingly long period).  If so, don’t sell.  Remember, too, that good growth stocks don’t come around that often and aren’t that easy to identify.

AAPL is a good recent example.  The qualitative story has been simple:  the iPod would be more successful than most thought;  the retail stores would provide a new, profitable distribution system; and there would be a “halo effect” that would spark new interest in AAPL’s computer offerings.  In the four years from late 2003 to late 2007, the stock rose almost 20x.

2.  missing the signs of “reinvention”. Many–make that: most–growth companies are one-trick ponies.  They have one, admittedly, exceptionally good, idea, but once that is executed, the company has nothing left.  The truly great ones, though, have strong management that recognizes this issue and is actively planning far in advance for what comes next.  AAPL, for example, has the iPhone, which on some measures makes up almost half its current earnings.  AMZN now sells an awful lot more than books, and is a leader in the emerging field of “cloud” computing.  MSFT went from personal computer operating systems, to spreadsheet and word processing software, to the Windows user interface.

3.  missing the signs that the party is ending (the reverse of #2)

a.  focussing solely on earnings. Emphasizing the quantitative over the qualitative can get you into trouble in another way.  Strong earnings growth can be sustained for a number of quarters even as the market for a company’s offerings is nearing saturation or as new competition is preparing to enter the market.  Scanning the competitive environment for threats, or looking a company-specific metrics, like the rate of growth of new orders, or sales growth experience with recently-opened stores, will likely turn up signs of slowing growth before they turn up in reported results.

b.  accepting a stratospheric (30x+) price/earnings multiple as normal. In the early years of a company’s life as a fast grower, a very high multiple is typical and usually well-justified.  But a high multiple  means higher investor expectations, which require high, and accelerating, earnings performance to be maintained.  In, say, year four of rapid expansion, surprisingly high earnings growth becomes more difficult to achieve.

Why?  Any firm (not run by crazy people) attacks its best growth opportunities first.  As it expands, those get used up and the company has to turn to progressively less lucrative possibilities.  At the same time, the increasing size of the company means that a lot of work has to be done just to achieve higher profits than the year before.

At some point, a market reaches saturation–that is, no new customers want or need a product.  A one-idea company shifts from the situation of having more customers than it can service, to dealing only with replacement demand.  Look at the pattern of AAPL’s iPod sales, for example, or SIRI’s satellite radio experience.

A very high P/E isn’t by itself a sell signal.  But it is a warning sign to check growth assumptions extremely carefully.  And the highest multiple often comes just as earnings performance is set to flag.