Category Archives: growth vs value

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.

 

reversion to the mean

October 30, 2013 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, two flavors of value Tags: , , , , , , , Leave a comment

Mean version has two senses:

1.  The first is important for traders, less so for investors.  It’s that if we construct a trend line or moving average for a stock from past prices, the stock will tend to trade in a reasonably well-defined band or channel around the trend.  In theory at least, one can make money by buying when the stock is at the lower edge of the band and selling when it’s at the higher edge.

2.  The second is a cardinal tenet for value investors.  It’s that over long periods of time stocks in general tend to rise and fall in line with overall earnings performance, which is, in turn, a function of the ebb and flow of nominal GDP.  Some stocks may have episodes where they perform far better than that.  Others may have extended periods when they fall far short of this mark, which in the US probably averages around +8% per year.  The value investor’s argument is that both classes, serial outperformers and serial underperformers alike, will inevitably see their fortunes reverse and their stocks revert to the long-term mean performance.

For high-fliers, this means they’ll, sooner or later, crash and burn.  For the stock market’s junk pile, on the other hand, its denizens will have periods when they’ll rise like the phoenix.  The latter are what value investors look for.

old school value investing

For some value investors, this is it.  This is all they do.  They run screens that find the cheapest stocks based on price/cash flow, price/earnings or price/assets–or some combination of the three.  And then they buy them.

I knew one who systematically went through books of charts looking for stocks that had experienced catastrophic drops (not a good strategy–once they figured out what he was doing, brokers began to send this guy charts with the price axis stretched out and the time axis compressed, so that every stock they touted looked like a train wreck.  Last I heard–I was hired to clean up the unholy mess he created–he was selling real estate in the Philippines).

Every investor is in some sense a contrarian.  At the very least, we all believe that the stock we are buying has more up left in it than the seller does, and the stock we are selling has less.  We also know the cardinal rule is to “buy low and sell high.”  Nevertheless, I think the simple strategy I just outlined, which is at the heart of the value investing practiced a generation ago, no longer works.

Why am I writing about this today?  

I was listening to Bloomberg radio in my car yesterday,when Dave Wilson repeated the observation of a market strategist that the divergence between the strong relative performance of the sector ETF for Consumer Discretionary and the weak outcome for Staples was as great as it was just before the Internet bubble popped in 2000.  What followed was a fierce reversion to the mean by both sectors.

The implication was that this factoid is significant.  As usual for Bloomberg, what or why was not forthcoming.

More tomorrow.

 

 

calculating operating leverage

September 17, 2013 By in operating leverage Tags: , , , , , , Leave a comment

I’ve written a number of posts on operating leverage.  You can use the search function on the blog to get them.

The basic idea is that a company has both fixed costs, which it must pay whether it sells anything or not, and variable costs, which are a function of the number of things a company sells.  Once a company covers its fixed costs through sales, the operating profit on additional sales can be very high.  This is a key source of positive–and negative–earnings surprise.

As a practical matter, though, how can we calculate how operating leverage works in a given company?

For some firms, it’s impossible.   Take 3M (MMM).  It makes a gazillion different items, many of them sold in massive quantities. For an investor, there’s no way to see very deeply inside the company.

We also have to realize that the data we get from any company’s financials is going to be imperfect, at the very least during our initial look.  If we take the time and energy to compare our projections to the actuals the company publishes, listen very carefully during management conference calls for clues, and call the company every once in a while, we may be able to refine the numbers we come up with in a surprisingly significant way.

Nevertheless, for smaller companies that sell only one or two main products, there’s a very simple way to get an idea of whether a firm has significant operating leverage or not:

–take two most recent consecutive quarters

–subtract the revenue reported for Q1 from the revenue reported from Q2

–subtract the operating income of Q1 from that of Q2

–calculate an incremental operating margin by dividing the operating income change by the sales change

–compare that with the operating margin achieved during either quarter.

An example:

Harley-Davidson (HOG–I own shares, despite the fact the ticker symbol spells a word) sells motorcycles, spare parts and branded merchandise.

During 2Q13, the company posted motorcycle-related revenues of $1.631 billion and operating profit of $362.9 million.  The operating margin was 22.2%.

During 1Q13, HOG had motorcycle revenues of $1.414 billion and operating profit of $279.0 million.  The operating margin was 19.8%.

The quarter-on-quarter revenue difference was $217.9 million, and the q-on-q operating profit difference was $83.1 million.  The operating margin on the extra production was 38.1%.

In HOG’s case, we can go on to make a number of refinements.  We can try to separate out the profits from sales of merchandise and spare parts, which are relatively small in revenue in comparison with motorcycles but which carry higher margins.  And we can examine whether the much higher margin on incremental sales comes from manufacturing efficiency or from leveraging SG&A (it’s the latter).

But the main point is clear.  HOG makes almost twice as much on incremental sales as it does on average sales.  And we found this out just by making some simple subtractions.

 

Bain’s “A World Awash in Money” (II)

August 22, 2013 By in Current Market Thoughts, growth vs value, hedge funds, Portfolio management, Private equity, Strategy Tags: , , , , , , , Leave a comment

Let’s assume that Bain is correct that the world will be awash in capital over the next decade or so, and that this money will be coming both from investors in the developed world and–increasingly–from the emerging world as well.

I draw two conclusions from this (keeping in mind that Bain may, or may not, be correct):

1.  Interest rates won’t rise as much as the Wall Street consensus expects.  The Fed is saying that the normal rate for overnight loans in the US is 4%+.  This implies that 10-year Treasuries should yield at least 5%, probably more.  If Bain is correct, these figures are much too high  …and, therefore, the rise in bond yields following Fed hints that monetary tightening is on the horizon may have already achieved as much as half the total rise that tightening will bring.

2.  Consider the factors of production:

–capital

–labor

–land/materials/resources and

–knowledge (technology, entrepreneurship, craft skill).

Which of these will be in short supply relative to the others?   I.e., which will be the most valuable?

If Bain is correct, it won’t be capital.

The natural resources boom of the past decade has resulted in mining companies making massive investment in new capacity.  Shale oil and gas are beginning to provide new low-cost sources of energy.  So the shortage factor is probably not land etc.

There’s still massive amounts of unskilled labor in emerging economies.  There’s also significant unutilized labor in the US and EU.  So labor isn’t the key factor.

That leaves knowledge, either as technology, craft skill or entrepreneurship as the factor of production in short supply.

 

For investors, the main takeaways are that:

–the current monetary tightening cycle may not be as negative for bonds or stocks as the consensus fears

–like the Internet, ready availability of capital undermines the defensive position of large companies with significant manufacturing capabilities and established brand names.  Think:  Hewlett-Packard, Dell, Barnes and Noble, J C Penney.

There’s a second point to this list, as well.  In all of these cases, finding leaders with the right knowledge base to put the firms’ substantial assets to work has proved to be very difficult.  It may be that in an environment where capital is easy to come by, talented entrepreneurs have much better alternatives than masterminding turnarounds for financial buyers.  If so, the value investor tactic of buying shares in asset-rich companies and waiting for something good to happen may not retain its traditional allure.  So-called value traps will outnumber successful turnarounds by a lot.

selling a stock (iii): it’s done its work

July 26, 2013 By in Constructing a Portfolio, growth vs value, Portfolio management, selling a stock Tags: , , , , Leave a comment

To the extent that we, as individual investors, hold specific stocks rather than an index ETF or fund, each stock should have a specific purpose.  Most times, it’s that we think the stock in question will outperform the index.  (That’s not always true.  Some investors, for example, will hold stocks that pay a large dividend.  For them, the stock is a substitute for a bond.)

The rationale for holding an individual stock generally falls into one of two patterns:

1.  the company is mature and slow-growing.  For one reason or another, it has fallen out of favor with Wall Street and is unusually cheap compared with either its breakup value or its future earnings prospects.  This routinely happens with companies whose businesses are highly sensitive to the business cycle.

Here the analysis is pretty straightforward.  You establish a target price and sell when (or if) the stock reaches it.

You might, for example, think that Barnes and Noble has a breakup value of, say, $25 a share (I don’t, but clearly some people think the number is at least that high).  If so, you would presumably have sold it when the rumor surfaced in TechCrunch that MSFT was preparing a bid for the Nook division.

Or you might observe that, say, a farm equipment maker typically trades at 8x peak earnings during an upcycle and that it’s trading today at 5x your estimate of peak earnings.  So you buy in anticipation of a 60% gain–and sell if/when the stock hits your target price.  (That’s typically long before earnings hit their peak level.)

2.  the company is small, fast-growing and, many times, trading at a high multiple of today’s earnings.  Here the sell decision is more subjective and less clear-cut.  At one time, WMT was a stock like this, as was IBM, ORCL, CSCO, MSFT or CHS (Chico’s).

In each case, there’s a qualitative or “story” aspect to the name.  In WMT’s case, it was that it made a ton of money by building superstores on the outskirts of US towns that had a population of under 250,000.  At some point–long before the financials began to signal a slowdown in growth–WMT began to run out of small towns to build new stores in.  That “qualitative” deterioration is usually the time to sell.  The sell decision is a little more complicated in each case, but that’s the general rule.

two notes

Even if you sell at the perfect time, that doesn’t mean that the stock doesn’t continue to go up.  If the overall market continues to advance, that movement will drag just about every stock along with it.  The “losers” will be stocks that don’t rise as fast as the market.  But they too will have higher prices.

The two types of stocks I’ve described above are typically called value stocks (#1) and growth stocks (#2).  You can read lots more about their characteristics by searching for “growth” or “value” on this blog.