back to talking about value investing

badly-managed companies

A highly-skilled former value colleague of mine used to say that there are no bad businesses–there are just bad companies.  What he meant was this:  let’s call any revenue-generating activity as a business; when revenue generation establishes a desire for a product or service, there is always a way to make a profit.  What stands in the way is most often bad management, although it might also be a poor configuration of assets.  (There are also highly cyclical firms, which are typically viewed through lenses that are too shortsighted, and firms that have temporarily stumbled.  Let’s put cases like those aside for now.)

 

In the US, it is legally and culturally acceptable to call bad companies into account.  This is usually done either by replacing management or by causing the company to be sold and returning the proceeds to shareholders.

Because of these factors, it makes sense to hold the shares of firms where the share price is substantially below asset value, even if the company is doing poorly.

As reader Alan Kaplan points out in a comment to last Thursday’s post, however, change is occuring at such a rapid rate in the current globalizedl and Internet-connected economy that it’s more difficult to make an assessment of how much assets are worth than it was when the tenets of value investing were being laid down almost a century ago.

a plummeting stock

Anyway, I recently noticed a holding that was sinking like a stone in a fund I’ve recently taken a small position in.  The stock is down about 60% over the past year in a market that’s up by 16%.  The portfolio manager, who doesn’t seem to have had much of a plan where this company is concerned, managed to lose two-thirds of his (i.e., my) money before kicking the stock out.

Seaspan?

The stock in question is Seaspan (SSW), a container ship leasing company.

My first reaction was to think the stock should never have been in a portfolio, based on the industry it’s in.  My experience of shipping is that it’s a snake pit of public subsidy and private double dealing in which an outsider like me will be lucky to escape with any of the clothes on his back.

On the other hand, my experience is also that people who are as horribly wrong about buying a stock as the pm I mentioned above end up also being horribly wrong again when they sell it.  I used to console myself when I was in this position by thinking that the stock would never bottom as long as I held it, so, yes, I was helping new buyers by selling–but I was helping my portfolio as well.  In any event, the last bull capitulating is usually an important positive sign.

SSW is now trading at $6.67.  Book value is $16+.  The dividend has recently been cut but the stock is still yielding 7%.  By the way, that’s not a good thing, in my view.  My preference would be for the payout to have been eliminated entirely, but I’m willing to give management the benefit of the doubt.

I’m still working myself through the financials.  There are potential issues with new ships now being built that SSW has contracted to buy but has as yet found no one to lease them.  There’s also the worry that existing customers will return ships before charters end and simply refuse to pay amounts still owed.  On the other hand, there’s some chance SSW will be able to refinance its existing debt.  And to some degree–not a great degree, but some–book value for older vessels is underpinned by the ability to sell them for scrap.

In sum, this is high-risk deep-value stuff that I would never recommend anyone else should consider.

Still, I’m surprised and intrigued to find a–to me, at least–plausible value story in such an unlikely place.

 

 

 

 

momentum investing

what it is

Momentum investing is a style, if one can call it that, of buying and selling securities based simply/solely on recent price momentum.  If a given stock is going up, buy some.  If it continues to rise, buy more.  If a stock begins to decline, sell it   …or, for very aggressive players, sell it short.  No fundamental data counts.

Day traders and very short-term-oriented algorithmic players are the main people who use this simple buy-if-they’re-going -up, sell-if-they’re-going-down rule.  In my career, I’m only aware of two “professional” investment groups who have practiced momentum investing as their main strategy:  Wood Mackenzie trading oil stocks in the early 1980s, Janus trading tech stocks in the late 1990s.  The former was an almost immediate disaster; the latter had a surprisingly long period of success before going down in spectacular flames.

recent use

The term has come into recent vogue in the financial press as a description of growth investing.

It isn’t one, although it may reflect the jaundiced view a few (narrow-minded, in my view) value investors have of their growth colleagues.

To be clear, growth investors try to make money by finding companies that are expanding faster than the consensus expects.  This is not momentum investing.  Nor is the style of value investing that requires that a company not only be bargain-basement cheap but that there be a catalyst (reflected in positive price momentum) for change before buying.

why write about this?

A few days ago, a regular reader, Small Ivy, characterized my speculative dabbling in Tesla as momentum investing.  Maybe so, maybe not.  More tomorrow.

 

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.

 

 

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.

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.

can activists pay their nominees to target company boards? should they?

Today’s Financial Times points out that 33 major American publicly traded companies have changed their bylaws to forbid board members from taking incentive payments keyed to the firm’s performance from third parties.

What is this all about?

In a sense, this is an aspect of the question of who really owns a company.  In theory, the owners are the shareholders and the company is run for their benefit.  As a matter of practice, most often the top management of the firm is in control.  It is usually happy with the status quo, and doesn’t typically stint on corporate jets, country club memberships and the like for themselves.

That’s where the board of directors comes in.  The board is elected by the shareholders to run the company.  It does so by appointing professional management to actually do the job, while it supervises, sets compensation and approves major decisions.  Control the board and you control the company.

A time-tested way for activist investors (a term which covers a whole raft of characters, from greenmailers and corporate raiders to more respectable operators who simply want to replace incompetent management) to influence the running of a company is through its board.  Activists often wage proxy battles to get their own nominees elected to the board by shareholder vote.  What better way, activists argue, to motivate such nominees to press for improved corporate performance than to pay them bonuses for achieving it?

The idea of activist investors compensating compliant directors potentially strengthens the activists’ hands in the three-way battle for company influence among:  management (which is virtually always backed 100% by individual shareholders, regardless of performance), institutional investors (who want strong stock performance but who suspect activists) and the activists themselves.

Personally, I think suspicion of activists is often warranted.  After all, look at what Bill Ackman did to JCP.  He erased a third of that firm’s revenues and all of its profits, and then sold his stock quickly–with board approval–at much more favorable prices than ordinary shareholders were able to achieve.  Thanks a lot.

So far, activists haven’t had much success with their pay-for-performance strategy, mainly because the incentivized nominees have lost in their board elections. But managements apparently see this tactic as enough of a threat to be quietly closing the door to it.

To me, the most interesting question is why activists feel the need to motivate their hand-picked board nominees with sizable amounts of cash.  From their rhetoric, it appears the answer is that their successful nominees quickly get used to receiving  hundreds of thousands of dollars for attending a few meetings a year, plus free use of the company’s jet fleet, free lunch   …and find the prospect of living the good life up much less appealing than they did when they were standing outside with their noses pressed up against the glass.