Category Archives: growth vs value

When something is going wrong…(ll) value stock problems

October 23, 2009 By in Fixing mistakes, growth vs value, Portfolio management Tags: , , , Leave a comment

As I’ve written in other posts, I’m a growth stock investor.

My initial training and close to my first decade of work were as a value investor, though, and I’ve worked for long periods in organizations where the majority of the senior portfolio managers had a value orientation.  So I do know something about how value works.  Still, I have a much more intimate acquaintance with how growth stock investors go wrong by making the mistakes myself.  In contrast, I’ve learned at least some of how value can go wrong at second hand, by watching others make them.

Having warned you about the state of my knowledge of value, here goes:

Having an investment plan for each stock is important

When you buy any stock, value or growth, you should have a plan for what you expect to achieve from owning it.  Ideally, you will have

–a concept, backed by

–an earnings model that incorporates information that you’ve gotten by researching the company, its products and its industry (10-k filings and annual reports are key here) that give you

–the expectation of substantial gain.

Your plan should give you a catalog of your major assumptions, as well as a roadmap to what good things you expect to happen, in what sequence, and what effect (at least qualitatively) they will have on the stock.

It’s your checklist to diagnose what may be going wrong

The plan will give you your ultimate exit strategy if things go right.  It gives you a checklist to go over–and decide if your assumptions are still valid–if the stock doesn’t perform the way you want.

In my experience, it may take a year or more before you’ve filled in all the details of your plan and feel comfortable that you know a company’s management, be satisfied that it is competent, and are able to anticipate how it will act.

By the way, no professional I’m aware of waits until the plan is completed before buying the stock.  Professionals, myself included, may do a week of research to get the plan structure right and spend the rest of the time putting flesh on the bones.  With a good stock, evidence mounts that you’ve made the right decision.  With a bad stock, the opposite (hopefully) happens.

What makes a value stock

Value investors argue that their stocks are attractive because the stock market does not fully appreciate the value of the underlying companies as they exist today.  (This is in contrast to growth investors, who believe their companies are attractive because the market underestimates the extent or duration of the firms’ future profit growth.)

Why should value stocks be misunderstood?

–Often, investors have an excessive negative emotional reaction to temporary difficulties.  A company may be highly exposed to the business cycle, for example, and investors rush to sell as the cycle turns down, without any thought to the possibility that conditions will someday get better.  We don’t have to go that far back in history–just to last March– to see this idea in action.

–A company may have good products, a great brand name and state-of-the-art production facilities, but weak management that fails to earn the profits the company should make.

–Or the industry it’s in may be hard to understand.

–Or it may be overlooked because it is only growing slowly.

–Or a firm may have had a damaging product recall or made a tactical marketing mistake that Wall Street has overreacted to.

Buy assets at 30¢ on the dollar and sell them at 70¢

The four essential elements of a value plan are:

–calculation of the “true” or “intrinsic” value of a firm,

–determining that the current price is at a steep discount to that number, and

–fixing a target price, and target timeframe, to sell the stock at.

Some deep value investors stop there.  They typically run computer screens to find the cheapest stocks based on price/cash flow or price/book value and buy them.   They argue that the moments of greatest despair are the ultimate buying points for stocks, both individually and as an asset class (think March 2009 again).  They also think that incompetently managed companies that refuse to change will be taken over.

Others want to identify a fourth factor–a catalyst for change–that will start the process of reevaluation along–anything from an uptick in the business cycle to a change in company management.  Personally, I’m much more comfortable with this approach.

Typical problems

a.  getting the intrinsic value wrong

This happens less often than you’d think.  This comes primarily (in my limited experience) from  non-specialists getting involved in industries that are highly regulated, like utilities, or that have no growth prospects, like traditional airlines.  In these instances, the cash flow the firms currently generate is immediately consumed in spending that’s necessary for the firm to survive.  Relying solely on book value as a measure of worth can also be dangerous, since auditors are not always as diligent as they should be in getting their clients to write down assets to true market value.

b.  the catalyst doesn’t catalyze

Think GM.  At one time the company had an unbelievable market position.  It was an American icon and a bellwether of the overall US economy.  It began to steadily lose market share when foreign competition arrived in the US auto market.  Managers developed internally were unable to reverse the company’s fortunes.  The board of directors was equally inept, and also stubbornly resisted advances from outside parties trying to (for a profit of course) be agents of change.

HPQ is another interesting case.  Here the board realized that a once high-tech company had slipped into mid-tech and decided to bring in a high-profile outside manager to turn things around.  Unfortunately, the company chose a marketing executive from ATT, Carly Fiorina, whose greatest talent, from where I sit, lay in marketing herself.  She was fired after several unproductive years and replaced by another outsider, Mark Hurd, who had a strong reputation as an operating manager and cost-cutter at NCR.

Under Hurd, HPQ became an illustration of a value stock that worked, far outpacing the market performance as he reorganized the company.

c.  staying after the party’s over

Value stocks are by and large, mediocre companies behaving badly.  While a turnaround is underway, a firm’s profits may skyrocket and its reputation on Wall Street may soar as well.   But there’s only so much that even the best managers can do.  Once margins have improved to industry-leading standards, growth may decelerate to not much faster than overall GDP.  Once the market realizes this, the stock may being to languish.

By that time, however, the value investor should be long gone.  His calculation is probably something like:  this company is earning $2 a share and trading at 10x eps.  If the company could raise its operating margins to the level of the best firms in the industry, it could be earning $5 a share on the same revenue base and with the existing plant and equipment–and trading at 12x eps.  In other words, if the favorable case plays out, the stock will rise from $20 to $60.

If the $60 price, or some other high value occurs, it will likely happen in year two of a three-year turnaround program–in other words, far in advance of the actual $5 earnings number.  By that time, the market will likely be realizing that the period of earnings acceleration is over and the stock may actually be going down.

Business cycle-sensitive stocks tend to exhibit this pattern.  The value investor judges, based on past cycles, that the stock will peak at, say 10x, peak earnings for the cycle.  Even though the earnings peak may be in year three of the cycle, the stock price peak can occur a year or more earlier.

In this cycle, though, commodity stocks may be an exception to this rule.  Demand from emerging markets and dollar decline may give them more life than an analysis of past cycles would suggest.

An aside:  mechanical rules

Some investors use rules like, “If the stock drops 15% below my purchase price, I’ll automatically sell it.”  or, “If the stock rises 50% above my cost, I’ll take a partial profit.”  Personally, I don’t like rules like this. If the stock’s price action is unfavorable, implicitly telling me I’m making a mistake, I’d prefer to be able to identify the mistake I’m making before acting.

This is at least partly because I’m a growth investor, looking for the next GOOG or AAPL.  My performance tends to be determined by having a small number of very good stocks, so I worry about being shaken out of a long-term winner by a bumpy ride along the way.

Value investors, on the other hand, tend to operate with much clearer, and shorter, timeframes, and with much more easily definable price targets.  So these kinds of rules tend to work better.  As with everything else, you should experiment to see what works for you.

What is an earnings “surprise”?

July 22, 2009 By in earnings surprise, growth vs value, Vocabulary Tags: , , , , , , Leave a comment

When the consensus is wrong

The basic idea behind growth stock investing is to find a company where earnings will be growing faster than the consensus expects for longer than the consensus expects.

For instance…

An example:  Let’s assume a stock is trading at $20 a share.  It had earnings of $1/share last year and is expected to grow by 15% each of the next few years.  This means that, on consensus expectations, it is trading on 20x historic earnings, 17.4x this year’s earnings, and 15.1x next year’s earnings.  As a crude rule of thumb, one might say that fair value for a stock is to have the price earnings ratio equal to the growth rate on next year’s earnings.  On that measure, the stock is fairly valued.

Let’s say the true earnings growth rate is 40%.  That would mean that our stock is trading at 14x this year’s earnings and 10x next year’s.  That’s about a quarter of what our rule of thumb would imply. Apple is a recent instance of this phenomenon.

How does the market adjust its expectations upward?   Continue reading →

Shaping a Portfolio–Highly Volatile Companies: Cyclicals, Leveraged, “Near-Death Experiences”

April 22, 2009 By in growth vs value, Shaping a portfolio for 2010, Strategy Tags: , , , , , Leave a comment

Cyclicality, Leverage, “Near Death”

The three kinds of companies have two things in common:  their earnings can swing wildly, and their stocks even more so.  They can be like playing with fire, so they’re not for everyone.  In fact, they’re not for most people, even though they usually lead the performance of a bull market in its first year or more.  So you might want to stop reading here.  Or you might keep on going just so you’ll know something more about how these stocks work, even if you won’t own them.

Cyclical companies are ones whose sales follow the business cycle up and down, like homebuilders, technology firms, metals miners or car companies.  Sometimes investors will try to distinguish firms that deal in pure commodities, like lumber or basic chemicals, from those with other sources of value-added by calling the former “deep” cyclicals.

There is also a kind of cyclicality within an industry.  Sometimes, the market leader has such a strong reputation for quality and service that the other market entrants end up being “overflow” producers–that is, they get orders only when the leader has run out of capacity and can’t supply new requests–despite having adequate quality and comparable prices.  Even though the industry as a whole may not be particularly cyclical, it can turns out to be a roller coaster ride for the second-tier firms.

“Leveraged” companies are ones who have structured themselves in a way that small changes in sales, positive or negative, create large changes in profits.  The leveraging comes in two forms, financial and operating.

Financial leverage means debt, either bank borrowings or bonds.

Operating leverage means high fixed costs (fixed costs are those that have to be paid, whether there’s any output or not; variable costs are those directly linked with the production of a specific item).

High fixed costs can result for a number or reasons:

1.  it’s the nature of the business, like a semiconductor factory,  a cement plant or a hotel;

2.  the company’s plant and equipment is no longer state of the art and costs more to run than newer assets;

3.  the plant and equipment isn’t configured in the best way.

Companies can mitigate the effect of leverage by entering into long-term arrangements, either formal contracts or informal agreements, that guarantee customers will always buy a certain portion of their output, though usually in return for a price concession.  Japanese blast furnace steel mills, for example, have traditionally done this with their automotive customers.  In most cases, I think, the industry leader does some form of this.

On the other hand, a company can choose to figuratively revel in its leverage and operate mostly/exclusively in the non-contract or “spot” market.  It argues that the higher prices in good times more than offset the lower prices in bad.  UMC, the Taiwanese semiconductor foundry, is a case in point.  Twenty years ago, most gold mining companies operated this way, as well, but they also made sure they had no debt.

I think of “near death” companies as ones that depend on the kindness of strangers, and which are destined to go into bankruptcy in a world ruled by justice rather than mercy (or, what amounts to the same thing, government support for “strategic” industries).  Computer memory chip makers would be a good example.  PALM (a family member owns shares), pre its rescue by Bono, might be another.  Too much leverage, management ineptitude, too much cyclicality are usually the causes of these companies’ problems.

When To Buy Them–and How Much

How much?  In large amounts, never, in my opinion (a value investor would probably be more enthusiastic, though).

For most people, never may still be the right answer.  For those with a relatively high risk tolerance, small amounts, among the top-tier companies, is probably best.

When to buy? These stocks are often the best performers during the first year or so of a new bull market.  Their performance is typically in inverse order to their riskiness/cyclicality. Why? As you will be able to see from any historical record, these stocks as a group are pummelled in a down market, with the most highly leveraged doing by far the worst.  The stocks are usually trading a steep discounts to asset value, with the second-tier companies at the lowest valuations.  As the cycle turns, however, these “worst” companies (more precisely, those who don’t go into bankruptcy first) get disproportionately large sales gains (the industry leader runs out of capacity, so buyers have to turn to the same #2 and #3 they shunned a few months before) and the threat of bankruptcy recedes.  So these stocks benefit not only from sharply increasing earnings, but also from a perceived decrease in risk.

Professionals typically buy the stocks of these volatile companies when they conclude that conditions can’t get any worse and sell them when they conclude that things can’t get any better.  In effect, this means they buy when there are no earnings and no backlog of new orders and sell when the company is raking money in and the future looks great.

To me, it looks like now is the time.

Where Would I Look?

First, let me say I’m only beginning to do the research anyone would need before actually buying one of these, but I think three areas (the “usual suspects,” for me) are potentially interesting:  hotels like HOT, MAR or IHG and casinos (I own WYNN already); semiconductor fountries, especially TSMC ; and industrial machinery companies like CAT or DE.

Usually I get worried about a stock symbol that spells a word–this isn’t a joke–because I think it shows top management is spending more time trying to be cute than running the business.  But CAT is the start of the company’s name, and the management that picked HOT isn’t there any more.  I do have unresolved/unresearched worries about both, though:  CAT’s financing operation and HOT’s timeshares.

If you’re sticking to a plan of index funds + sector funds + individual stocks, you may decide that the cyclical area is too much trouble to deal with directly and find a sector fund to get exposure here instead.

What the Risk-Averse–That’s Almost Everyone– Should Avoid

“Risk averse” doesn’t mean conservative.  It means expecting to be paid for taking risk and not embracing risk as an end in itself.  Anyway, even the deepest value investors I’ve known would say to avoid industries in secular decline.  That would certainly include airlines and newspapers.  I’m sure you can come up with more.

I was listening to CNBC the other day and heard a reporter say a certain group of equity-oriented hedge funds had lost money over the past six weeks or so because they were long (i.e., they owned) high-quality companies and were short (i.e. had borrowed and sold, effectively betting the stock would underperform) low-quality companies.  He didn’t know, but you should, if you’ve read this far, that the hedge funds in question were betting the market would continue to go down.  Why?  because low-quality, leveraged, cyclical companies outperform in the early stages of an up market.

Growth vs. Value: V. What’s Your Style?–a test

March 15, 2009 By in Basic Concepts, growth vs value Tags: , , , , Leave a comment

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 income.

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

The question:   Which one would you buy?  (Don’t turn the page until you decide!)

Continue reading →

Growth vs. Value: IV. International Issues With Both

March 14, 2009 By in Basic Concepts, growth vs value Tags: , , , , Leave a comment

In the US, I think the main difference between growth and value investors is one of individual temperament,  Obviously, investment objectives are slightly different and managers of each stripe will attract slightly different customers.  But I think the choice for an investor comes down to what types of companies he/she feels most comfortable studying and what level of volatility he/she is willing to experience.  Outside the US, however, the situation is a little different.

The overwhelming majority of growth stock investors work in the US market.  Maybe Americans are more happy-go-lucky than their foreign counterparts.  But, although Americans don’t think much about it, we live in a political and economic environment where growth-oriented companies can enjoy considerable success and are able to raise money in the the financial markets.  That’s not always true abroad.

 *In many foreign areas, capital is not as widely held as in the US but is in the hands of a relatively small number of wealthy individuals and companies.  These entities act as theory tells us they will–as they become wealthier, they become more risk averse.  In extreme cases, especially in less wealthy economies, investors view stocks as a risky kind of bond (as we did in the Thirties-Fifties).  So multiples are low and payment of a large cash dividend is expected.  So only mature companies can list.

*The US is unusual both for the high wealth level (relative to the rest of the world) of the average citizen and for its wide geographical expanse.  Many specialty retail concepts depend on this wealth for their sales and the ability to expand form one region of the country to another for the duration of their growth.  In, say, Japan, not only is consumer behavior different, but also total national penetration is probably a two or three-year phenomenon instead of ten years.

*In many foreign countries, there are very substantial formal and informal barriers to changes to the status quo.  These range from the “Licence Raj” in India to complex laws on locating retail stores throughout Europe and Japan.  Barriers can be informal, as well–from the power of the keiretsu or chaebol in Asia to behind-the-scenes maneuvering to control competition by governments and by groups of institutional investors.

This last point is perhaps the greatest obstacle for value investors working outside the US.  In some value strategies, the thinking is that if the present management and board of directors won’t use the company’s assets effectively, they can and will be replaced.  Of the larger markets, perhaps the worst is Japan, as many US value investors have learned to their sorrow, this is extremely difficult.  Laws make takeover by foreigners difficult and punitively expensive.  Even local value investors find that institutional shareholders refuse to vote for change.  Though not as extreme as in Japan, one can expect many of the same difficulties in continental Europe.