Category Archives: growth vs value

Signet (SIG) buying Zales (ZLC): a takeover scorecard

June 3, 2014 By in activist investing, activist invstors, mergers and acquisitions, stock market, takeover rules Tags: , , , , , , , , Leave a comment

Last week, shareholders of mall jewelry company Zales (ZLC) voted to approve the takeover of the firm by its rival Signet (SIG).  SIG, a UK-listed company owns Kay and the more upscale Jared, as well as a number of (much less interesting, in my view) UK brand names.  The acquisition price is $21 a ZLC share, or about $670 million.

When I was working I liked luxury goods in general and the jewelry business in particular.  My portfolios contained Tiffany (TIF) and SIG more often than not, and Bulgari (now a part of LVMH) from time to time.  ZLC never.

What I’m primarily interested in today is to outline ownership percentages that are important in any US-based takeover.

1.  at 80% ownership, the acquirer can file a consolidated tax return, meaning losses in one part of the company can be used to offset otherwise taxable income in another.  As well, funds can pass freely from one part of the combined company to another without being considered (taxable) dividends.

2.  at 90% ownership, under the law in Delaware (where virtually every publicly traded US company is domiciled) the acquirer can force the other 10% to tender their shares.  Not having a minority interest makes running the combined company much easier administratively.  Specifically, the firm doesn’t have to concern itself with a tiny number of shareholders whose sole aim may be to become enough of a nuisance to be bought out at a higher price.

3.  at 90% ownership, dissenting shareholders do have the right to appeal to the Delaware Court of Chancery.  There, they can argue that they–but not the vast majority who have accepted the takeover offer–deserve a higher price.  Whatever the outcome, they are still compelled to sell their shares.

The process can be time-consuming.  It’s also risky.  The dissenters’ funds are tied up while the appeal is being heard–and if they lose, they’ll end up with the takeover price, less their legal expenses and will get the money maybe two years from now.

4.  SIG and ZLC are in the same industry.  If I understand US tax law correctly (a big “if”), this fact makes the accumulated tax losses of ZLC more readily available to SIG than would normally be the case.  This could be important, since my cursory reading of the ZLC 10-k suggests ZLC lost just under $500 million in the US during 2009-2012.  Those losses would be worth around $140 million to SIG if they could be used immediately, even if ZLC already used some of them in 2009 to recapture earlier taxes paid.

this may well be an interesting chancery court case

Several large institutional owners of ZLC shares have voiced their intention not to tender all/some of their shares to SIG and to seek a higher price in chancery court.  This may simply be bluster.  If not, I think the case will be an interesting one.

SIG has said that it expects to improve ZLC’s operating results by $50 million a year by using the SIG sourcing apparatus and by another $20 million by plugging ZLC into SIG’s administrative structure.  It expects a final $30 million from sales growth and repairs.  Then, of course, there’s that $140 million in potential tax benefits.

What I find interesting is that just about all this extra value is created by the fact that SIG is the new owner.  A private equity buyout, for example, wouldn’t have anything like the same positive effect, since it wouldn’t have the appropriate sourcing and repair infrastructure (I’ve visited the SIG diamond vault, by the way).  And their use of ZLC tax losses would be far more restricted.

Are minorities entitled to share in value being created solely from intellectual any physical property owned by SIG?  If it come to chancery court, the argument should be interesting.

 

 

 

 

 

value investing, American-style–riskier than it seems

March 5, 2014 By in activist investing, activist invstors, book value, Current Market Thoughts, distressed assets, growth vs value Tags: , , , , , 2 Comments

First, my usual caveat when I write on this subject.  I’m a dyed-in-the-wool growth stock investor.  But I my initial training was as a value investor.  And I practiced that craft for my first eight years in the business.  (Then I began to research mid-cap Pacific Basin stocks in earnest.  They had, at the time, a unique combination of extremely low valuations and unusually high growth.  After a couple of years of owning these hybrids I woke up one day and realized I had morphed into a growth stock investor.) Since that time, I’ve worked side by side with value colleagues for most of the rest of my career, though.

Growth investing is all about finding situations where a company is likely to expand its profits much faster than the consensus expects, and/or at an above average rate for much longer than the consensus believes.  It’s about where the company is going, not where it is now.

value investing

Value investing, in contrast, is all about where the company is now.   It’s about finding companies whose equities have been beaten down excessively by overemotional holders who have abandoned ship because of temporary earnings disappointment.  This disappointment can come from any number of causes.  Common ones include:  highly cyclical companies entering the down part of their business cycle, a big misstep by a normally competent management, or flat-out terrible corporate managers.

As an astute former value colleague put it, “There are no bad businesses, only bad managers.”  Put another way, there is enduring worth in a company’s tangible (think:  factories and inventories) and intangible (think: brand names, market positioning) assets that persists despite whatever earnings disappointments the firm may be experiencing at present.

In the first two causes I cite, time will cure the earnings deficiency.  Wayward shareholders will rediscover their zeal for the name and bid the stock price up aggressively.

But what if the management is genuinely awful?  In this case, value investors believe that the incompetents will be shown the door and be replaced by more highly skilled individuals.  The board of directors may do this, because, after all, that’s their job.  Or shareholders may demand a change.  (Fat chance of either of these happening, in my view.)  Or–and this is particularly American–either activist investors or hostile acquirers will swoop in and force a change.

two risks

As far as I can see, this last American idea–that justice will be served and the bad management tossed out–is valid in the US, but almost nowhere else.  Just look at the experience of activist value investors over the past quarter century in Japan or in continental Europe.  Yet, oddly enough, otherwise rational American value investors try the same tactic over and over, each time in the expectation of a different result.

This risk has been around for a long time.  The second hasn’t.

One of the deep underlying assumptions of value investing is that a company’s assets have an enduring economic worth, despite current headwinds.  All we need is some spark, some catalyst that will enable this worth to shine through.  And we can wait, since the value of accumulated assets is unlikely to deteriorate.

This is the sense behind the observation that a stock is trading at a discount to book value–that is, to the total sum of the assets the company owns, after subtracting out anything it owes to the rest of the world.  Calculations of “book” are based on the actual historical cost of acquiring the assets, which very often understates (usually by a lot) what it would cost to replace them.

Two new, still poorly understood, threats to this view:  the internet and Millennials.

Take suburban shopping malls as an example.  Millennials, at least more affluent ones, seem to like to live in cities, not the suburbs.  Internet shopping has reached the point where retailers are openly saying (they’ve probably secretly know this for much longer) that they have too much mall retail space.  Who to sell it to?

In other words, demographic/technological change is accelerating.  This increases the chance that balance sheet assets are writeoffs waiting to happen rather than “straw hats in winter,” needing only a change of season to flower.

 

growth investing and “The Investment Answer”

March 4, 2014 By in Constructing a Portfolio, Getting financial advice, growth vs value, Portfolio management, securities markets, stock market Tags: , , , , , , , , Leave a comment

Yesterday I skimmed the short but valuable book The Investment Answer, by Goldie and Murray.  The late Mr. Murray was an institutional salesman for a number of brokerage firms;  Mr. Goldie is a fee-only investment adviser.

The book, which I think is well worth reading, contains lots of financial planning basics, laid out in clear, simple language.   The first chapter, which deals with the traditional registered representative, is particularly good.

The only real quarrel I have with The Investment Answer is the chart it contains which asserts that value investing generates higher returns than growth investing.  This is a common belief, reinforced by numerous academic studies which claim to “prove” this.

I think this claim is just wrong.

But I had a long, and relatively successful career as a growth stock investor, so of course I’m going to think this.

Worse than that, however, I suspect that demographic and technological change are undermining the fundamental pillars of the traditional value investing style.

About those studies–

–the typical procedure is for an academic to take a universe of stocks, say the S&P 500, and divide it into two parts.  The “value” part will consist of stocks with the lowest price-earnings ratios, lowest price-to-cash-flow ratios and lowest price-to-book-value ratios, all based either on historical data or on consensus Wall Street estimates (in the case future-oriented information is also used).  Put another way, these are the cheapest stocks, based on consensus beliefs.  The “growth” part will be everything else, meaning all the expensive stocks.

The studies then show that the cheap stocks perform better than the expensive ones.  What a surprise!?!

What’s wrong here?  It’s the definition of value vs. growth.  The studies assume the difference is between two mutually exclusive groups separated from one another using a single set of rules.

The reality is that growth and value are not mutually exclusive.  They’re two different ways of looking at the investment world.

The growth investor looks for stocks where he believes the consensus view is mistaken, either by underestimating how fast earnings will grow and/or how long this superior earnings performance will last.  A growth investor may hold many stocks that the academic classifies as “value” (think: the AAPL of a few years ago);  there are many that the academic classifies as “growth” that no self-respecting growth investor would touch with a ten-foot pole.

Why don’t growth investors kick up a fuss about this academic nonsense?  It’s not in their best interest.  Why show your trade secrets for everyone to see?  That would just make your job harder.

More tomorrow.

 

 

 

 

breaking companies apart: the cons

February 10, 2014 By in activist invstors, economics, hedge funds, Portfolio management Tags: , , , , , , 3 Comments

Many times, separating a conglomerate into its component parts creates value.  Sometimes, it can produce enormous gains.  Spinoffs of corporate stepchildren are often particularly lucrative.  Take Coach (COH) for instance.  Its stock rose by 40x in the first five   years after it was spun off, unloved and starved for expansion capital, from Sara Lee.

There are other instances, however, where breakup can be disastrous.  This may not be evident at first in the stock price action of the separate components, but the ultimate bad news can happen in a number of ways:

1.  Onerous corporate liabilities–debt, lawsuit liabilities, incompetent executives…may all be shunted into one of the new parts, which is more or less designed to fail.  No one will say this, of course.

The first place to look for this kind of imbalance is in the part where the CEO and other top executives aren’t going.  Often, executives in the disfavored part of the split will be so excited to finally be the top dog that they’re delusional about their ability to deal with the negatives they’re being loaded down with.  After all, Davy Crockett might have survived the Alamo if he’d been a step quicker;  the Donner party might have gotten through those mountains…

2.  Sometimes a proposed split will end up forcing apart two businesses which need each other to be successful.  In the current hedge fund era, when individuals with little operating experience can wield large amounts of financial capital, this is a particular danger.  Activists. for example, have wanted Target (TGT) to sell/divest its credit card operations a couple of years ago.  Yes, TGT would receive a large one-time payment, and its stock would probably go up.  But its credit-related operating costs would rise.  And the company would have lost the considerable “Big Data” advantage that it gets from being able to see all the credit transactions of its cardholders–not merely transactions done at Target stores.

I think the current talk of splitting up Microsoft (MSFT) is well worth monitoring in this regard.  Sure, spin off  the consumer device business.  To my mind, though, splitting Windows, Office and the cloud from one another is just asking for trouble.

3.  Another issue that has emerged in recent years–the activists may be bunglers.  Look at J C Penney (JCP).  Activists correctly saw that JCP was crediting profits it got from its control of valuable real estate to its retailing operations.  That covered up the true weakness of the company’s retail offering.  But their attempt to “fix” retailing before breaking up the company went horribly awry.  Worse, they persisted in their mistaken direction so long that they created a downward spiral the company has yet to pull out of.  The stock, which some speculated could be worth $50 a share, has dropped from around $30 to $5 or so as a result of their “stewardship.”

why stocks moving in lockstep in 2013 was unusual

January 22, 2014 By in growth vs value, Portfolio management, Recent Market Action, Shaping a portfolio for 2014, Strategy Tags: , , , , , , Leave a comment

Speaking in very general terms, the stock market is the place where the hopes and fears of investors meet the objective characteristics of publicly traded companies and express themselves in the prices and price movement of little pieces of paper.  In today’s world, it’s really the movement of electronic impulses.

More prosaically, supply and demand meet and express themselves in stock prices.

Investors are a diverse lot.  We range from day traders to those with five-year horizons.  There are institutions and individuals, professionals and amateurs, market timers and the always fully invested, the purely rational (a rare breed) and the highly emotional, the risk averse and even a few risk takers.  (A pedantic note:  a risk taker transacts in order to acquire risk;  he doesn’t care about return.  A risk averse person transacts when he sees a favorable risk/reward relationship.  What counts as favorable can very widely.)

Despite this diversity, there are recognizable patterns to stock investment.  One of them is the way stocks behave at different points in the business cycle.

–stocks in the US tend to start to rise, often very sharply, about six months before the business cycle begins to turn up

–once investors who have been sitting with cash on the sidelines realize that the market has turned, they start to shift that idle cash into stocks.  They may do so by buying stock index futures, or they may buy individual stocks–or both.  In any event, their main goal is to get a lot of money on the train as fast as possible.  Getting the best possible seat can come later.

Not every investor is like this.  But there are enough trying to get very large amounts of money reallocated into stocks at the most favorable prices that buying is pretty much across the board.

During this period, stocks are relatively closely correlated.

–as this initial surge into the market subsides, the market gradually shifts toward differentiating among stocks based on their anticipated growth rates and on their pricing.

In other words, as the business cycle matures, stocks become less correlated with each other.  The style-agnostic shift from value stocks to secular growth names.

what makes 2013 strange

2013 was the fifth year of the bull market.  Yet stocks were more highly correlated with each other than they were in 2009 or 2010.  Given the way the stock market usually works, the opposite should have been the case.

Tomorrow:  what I think is going on.