Category Archives: from growth to value: the life cycle

Berkshire Hathaway and Kraft

April 20, 2015 By in Current Market Thoughts, economics, from growth to value: the life cycle, growth vs value, mergers and acquisitions, stock market Tags: , , , , , , , , , , Leave a comment

A little less than a month ago, Warren Buffett’s Berkshire Hathaway and Heinz (controlled by Brazilian investment firm 3G) jointly announced a takeover offer for Kraft.  The Associated Press quoted Mr. Buffett as asserting “This is my kind of transaction.”  I looked for the press release containing the quote on the Berkshire website before starting to write this, but found nothing.   The News Releases link on the home page was last updated two weeks before the Kraft announcement.  Given the kindergarten look of the website, I’m not so surprised   …and I’m willing to believe the quote is genuine.  If not, there goes the intro to my post.

 

As to the “my kind” idea, it is and it isn’t.

On the one hand, Buffett has routinely been willing to be a lender to what he considers high-quality franchises, notably financial companies, in need of large amounts of money quickly–often during times of financial and economic turmoil.  The price of a Berkshire Hathaway loan typically includes at least a contingent equity component.  The Kraft case, a large-size private equity deal, is a simple extension of this past activity.

On the other, this is not the kind of equity transaction that made Mr. Buffett’s reputation–that is, buying a large position in a temporarily underperforming firm with a strong brand name and distribution network, perhaps making a few tweaks to corporate management, but basically leaving the company alone and waiting for the ship to right itself.  In the case of 3G’s latest packaged goods success, Heinz, profitability did skyrocket–but only after a liberal dose of financial leverage and the slash-and-burn laying off of a quarter of the workforce!  This is certainly not vintage Buffett.

Why should the tiger be changing its stripes?

Two reasons:

—the opportunity.

I think many mature companies are wildly overstaffed, even today.

Their architects patterned their creation on the hierarchical structure they learned in the armed forces during the World War II era.  A basic principle was that a manager could effectively control at most seven subordinates, necessitating cascading levels of middle managers between the CEO and ordinary workers.  A corollary was that you could gauge a person’s importance by the number of people who, directly or indirectly, reported to him.

Sounds crazy, but at the time this design was being implemented, there was no internet, no cellphones, no personal computers, no fax machines, no copiers.  The ballpoint pen had still not been perfected.  Yes, there were electric lights and paper clips.  So personal contact was the key transmission mechanism for corporate communication.

Old habits die hard.  It’s difficult to conceive of making radical changes if you’ve been brought up in a certain system–especially if the company in question is steadily profitable.  And, of course, the manager who decided to cut headcount risked a loss of status.

Hence, 3G’s success.

—plan A isn’t working  

One of the first, and most important, marketing lessons I have learned is that you don’t introduce strawberry as a flavor until sales of vanilla have stopped growing.  Why complicate your life?

Buffett’s direct equity participation in Kraft is a substantial departure from the type of investing that made him famous.  I’ve been arguing for some time that traditional value investing no longer works in the internet era.  That’s because the internet has quickly broken down traditional barriers to entry in very many industries.  It seems to me that Buffet’s move shows he thinks so too.

 

 

 

 

stocks were “unusually highly correlated” last year–meaning? implications?

January 21, 2014 By in Constructing a Portfolio, from growth to value: the life cycle, Portfolio management, Shaping a portfolio for 2014, stock market, Strategy Tags: , , , , , , , 1 Comment

A number of brokers have pointed out in their yearend reviews of the US stock market that stocks were unusually highly correlated with one another last year.  What does this mean?

Think of a stock as an abstract thing, as a bundle of different economic attributes or characteristics that you get when you buy it.  Some of these attributes–like that you get an ownership interest in a corporation that aims to make continually growing profits–are common to all stocks.  Others–that the underlying company you own an equity interest in makes yoga pants, mines gold, or sells online advertising, and grows faster/slower than most–are specific to that stock.

The “highly correlated” observation means that, much more than usual, what counted in 2013 was the fact the thing you own is a stock; its individual characteristics didn’t make much difference.  Check out my Keeping Score for December 2013 to see how closely aligned the performance of various industry groups was last year.

Note how clustered together the various sectors are around the S&P.  In simple terms, an investor got +30% just for owning the S&P 500.  He got an extra 8 percentage points for selecting Healthcare, and he lost 7 if he picked Energy.  But neither decision meant anything close to as much as just being in stocks.

Yes, there were two truly poisonous sectors, Telecom and Utilities, which just barely made it into the plus column for 2013.  These two sectors together make up only about 5% of the S&P, however.  So from a statistician’s point of view, they’re irrelevant.  That’s cold comfort for someone who bet the farm on either sector last year, although I think you’ve got to admit that being absent from 95% of the market is an extremely risky thing to do.

Tomorrow:  why is the 2013 outcome is strange.

Apple (AAPL) today

January 16, 2014 By in from growth to value: the life cycle, growth vs value, Recent Market Action, Stock ideas, Technology, Wireless Tags: , , , , Leave a comment

the stock vs. the company

the company

As a company, Apple has in most respects followed the typical pattern for businesses of high-flying growth stocks.

The company stabilized itself as a computer maker, after a brief flirtation with bankruptcy, with the return of Steve Jobs as CEO.  It took a chance on making the iPod, which a geeky DJ apparently brought to it.  That produced a series of big profit increases that lasted several years and doubled this size of the company.  Just as the iPod wave was cresting, Apple reinvented itself again, as the iPhone company.  Another huge profit surge followed, which crested as the global market for expensive smartphones matured.

Yes, Apple has reinvented itself again as the iPad company, but each blockbuster must be progressively larger to move the profit needle for a firm whose income has grown exponentially over the past decade.  The iPad doesn’t have enough oomph to do so.  Heartless as it may seem, Apple has gone ex-growth.

Look at IBM, or Oracle, or Cisco, or Wal-Mart  …or, on a smaller scale, the Cheesecake Factory or Chicos or PF Chang.  Same pattern.

the stock

What has been strange about Apple has been the behavior of its stock.  Typically, as a company’s earnings begin to accelerate, the price-earnings multiple begins to expand as well.  So the positive effect of the earnings growth is magnified.  When (or just before) earnings growth beings to disappoint, as it sooner or later will the PE begins to contract.–and the stock plunges.  Timing this shift is the key issue for growth investors.

Not so much with AAPL.  Its PE peaked in 2008, four years prior to the peak in earnings (which were, by the way, almost 8x the 2008 level).  The multiple contraction has been pretty continuous, moving from 30x ( and 1.8x the market multiple) in 2008 to 12.3x (and a .7x relative multiple) for 2013.

an investment thesis

Growth investors, who are searching for the next AAPL, have abandoned ship andgone elsewhere, leaving the field to their value counterparts.

For value investors, I think the key question revolves around the PE.  When growth stocks fall from grace, the multiple typically contracts severely–and over a long period of time.  The decline ends in an overreaction on the downside.

Looking at AAPL,nine months of stock price pain (late 2012 – mid-2013) would be unusually short period of time.  But, then, the AAPL multiple has already been contracting for five years.

Although I’m not a value investor (read: although I’m no good at making these judgments), my sense is that the AAPL PE is too low.  I don’t feel an overpowering urge to buy the stock.  But 10% earnings growth + one point of multiple expansion this year doesn’t sound so bad, either.

 

 

 

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

December 30, 2013 By in activist invstors, from growth to value: the life cycle, growth vs value, two flavors of value Tags: , , 1 Comment

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.

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.