Category Archives: from growth to value: the life cycle

growth stock investing and Apple (AAPL)

May 4, 2016 By in from growth to value: the life cycle, growth vs value, Uncategorized Tags: , , , Leave a comment

Apple

The company Apple is one of the great growth stories of the early 21st century, as well as a tale of redemption and return from the ashes.  In a number of respects, however, AAPL is an atypical growth stock.

Ultimately, that’s what I want to talk about.  But I’ve decided to take the long way around and start by writing in general about growth stock investing.

growth stocks

Growth stock investing is all about finding extraordinary companies or industries.

two characteristics

The growth stock investor looks for two things:

–a firm that will expand its earnings per share at a faster rate than the consensus expects, and

–that will do this for longer than the consensus expects.

key judgments

The growth investor has to make two key judgments:

–that a company has the potential for superior growth, and

–that this potential is not yet recognized by the market (meaning is not yet factored into today’s price).

analyzing a growth stock

The analysis of company fundamentals also has two parts:

—qualitative, a description of what makes the company unique and what will defend it from competition as it expands.  Most often, in my experience, this can be condensed into an “elevator speech,”  like “AAPL is the leading maker of high-end smartphones, a huge, rapidly expanding global market.” or “Amazon is the dominant force in Cloud services and in online retail, two fast-growing barely penetrated markets.”

—quantitative, meaning spreadsheets projecting one’s best guess about how the financial statements–income statement, cash flow statement and balance sheet–will play out over the next several years.

open-ended is good

Often, although the spreadsheets have numbers in all the appropriate fields, the quantitative analysis has an open-ended aspect to it.  I may end up concluding that I’m confident eps will be up at least by 25% in the coming year   …but it could easily be 50% or more.  Uncertainty, yes, but of the best possible kind.

why the elevator speech

The elevator speech has two important purposes:

–it forces the analyst to step back from the numbers and pay attention to what the company’s competitive advantage is

–as a growth idea gets long in the tooth, it’s most often the story that breaks down, not the numbers.  So the qualitative analysis ends up being an early warning sign that one should reduce exposure or exit the stock entirely.

 

More tomorrow.

 

 

 

 

a saturated market

November 9, 2015 By in from growth to value: the life cycle, market saturation, mean reversion Tags: , , , , , Leave a comment

market

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

saturation

A 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

October 28, 2015 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, Strategy Tags: , , , , Leave a comment

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

 

selling: different styles

August 10, 2015 By in bond market, Current Market Thoughts, from growth to value: the life cycle, growth vs value, securities markets, stock market Tags: , , , , , , Leave a comment

I’ve been thinking some more about what I wrote last week about selling in Disney(DIS) stock.  The thrust of my reaction to the sharp decline was, and still is, mild bemusement that selling only emerged as the company reported weak results from ESPN.  It’s not that disappointing earnings should not generate selling.  It’s that the handwriting had been on the wall about ESPN–and in vividly hued bold print–for some time before DIS’s 2Q15 earnings report.

Why no stock weakness earlier?  This would have been my strong expectation. I’m not talking about the results somehow being leaked to outsiders by the company.  Rather, I’d have thought that the market would have put two and two together and acted weeks or months ago on publicly available information about the cable industry–like Nielson reporting of subscriber losses at ESPN.

My conclusion was that the sharp fall in DIS shares on its earnings report might be evidence that Wall Street just didn’t know there were problems at ESPN, despite what I consider clear signals of trouble being visible for a considerable time.

I still think it is generally true that the stock market is becoming less efficient–and more like I perceive the bond market to have been throughout my time as an investor.

I’m no longer sure that DIS is evidence for my thesis, though.  Here’s why:

The key to successful investing in growth stocks is being able to sell them at the right time, meaning exiting as the firm is going ex-growth and before the rest of the world realizes this.

To me, the key signal is the breakdown of the conceptual “elevator speech” explanation of what gives the company in question its extraordinary growth potential.  In my experience, if we’re waiting for the first disappointing earnings report, we’re almost always hanging on too long.

The presupposition here is that the potential upside from my exit point is (far) less than the downside from being a holder of the stock when the disappointing earnings are released.  This assumes, of course, that I can recognize the point at which all the possible future good news–and maybe more than that–is already factored into the stock price.

My approach didn’t work so well for me in the case of DIS, where I failed to anticipate the fabulous success the company has had in its non-Marvel, non-Pixar movie business.

There is a second approach to growth stocks.  It argues that a well-managed company normally has more earnings growth tricks up its sleeve than any outsider is able to understand.  Therefore, it’s always too risky to sell when the conceptual story begins to unravel.  Better to wait for actual proof to come in through bad earnings.  Yes, one might lose 10% by selling after the bad report.  But that’s better than exiting at 40% below the stock’s peak.

In fact, I took this second approach myself, early in my investing career.

The difference in my thinking from last week and now:  my first thought was that information is not circulating on Wall Street as fast as it used to; my second thought is that investors may have the same information as always but they’re just using it differently.

Practical implications?  …they may be substantial.  My conclusion is still to look for more evidence.  My tendency is going to be to hang onto growth stocks for a bit longer than I might otherwise, though, figuring that others are going to do the same thing.   So the cost of waiting to find out if there’s another growth spurt left in a maturing company may be lower than it has been in the past. And I may no longer be committing the cardinal investment sin of underestimating the information the other guy has.

exiting a growth stock

June 30, 2015 By in from growth to value: the life cycle, growth vs value Tags: , , , 1 Comment

To paraphrase/summarize my last few posts, the key to value stock investing is to buy when things couldn’t be worse.  For growth stock investing it’s to leave the party when things couldn’t seem better.

Generally speaking, the key to making a successful exit from a growth stock is to always keep in mind the qualitative “elevator speech” whose essence is that it contains what you think gives the firm a special edge.  When that story begins to erode–maybe new competition emerges, or the target market the firm is exploiting gives signs of being saturated, or tastes change–it’s time to edge toward the door.  The important thing to remember is that this erosion occurs long before earnings growth begins to slow.

The first disappointing earnings report is typically followed by continuing bad news, so it’s not to late to get out then.  But that first bad report is typically a long way from the top for the stock.  The leading indicators are what really count.  They differ from stock to stock.

Take Wal-Mart as an example.  Its main business was opening superstores in small towns.  Government statistics could have told us how many such towns there are in the US.  That data allow us to figure out how many years of growth the company has before it’s forced to do something different.

Deviations from the norm are another indicator. Starting a second brand suggests #1 may be getting a bit long in the tooth.  Opening outlets in notoriously difficult markets like Los Angeles or New York might also be a signal.

A PE that’s too high for the firm to ever grow into is a third signal that things can’t get much better for the stock.

 

One caveat, something that makes the situation trickier:  most growth companies are unable to reinvent themselves when their initial good idea runs out.  The best of the best, however, are able to do so.  Some of them can do this multiple times.

Apple, for example, has had several lives.  It was initially the story of a near bankrupt company coming back from the brink (led, ironically by the man who put the enterprise on the road to the precipice in the first place, Steve Jobs).  Then it was the iPod company.  Then it was the iPhone company.   Most recently, it’s the firm Tim Cook saved from the craziness of having a phone that’s too small and a tablet that’s too big.

These situations are rare, however.  And there’s always time to change your mind after reducing a position or eliminating it entirely.  So the possibility that stock X might be another AAPL isn’t enough, io my mind, not to exit once the qualitative story begins to break down.