Category Archives: growth vs value

value investing and rapid technological change

July 3, 2013 By in Basic Concepts, book value, Current Market Thoughts, distressed assets, growth vs value, Strategy Tags: , , , , , , , Leave a comment

value investing

The best of the many value investors I’ve worked with in my career used to explain what he did by saying, “There are no bad businesses.  There are only bad managements.”  He defined “business” as any endeavor that produces revenue.

In other words, the tools needed to make money–plants with machinery in them, sales forces, distribution centers, brand names, consumer goodwill…–are all there inside a company for management to set in motion.  Whether on not the firm makes a profit depends on how skillfully management uses this toolkit.

the value opportunity

Take two companies in the same industry and with identical assets.  Both have $100 million in annual revenue.  Company A makes $10 million in profit; Company B makes $3 million.

Value investors buy company B.  They either wait for or instigate change that will toss out incompetent management and put in new guys who will use the toolkit better.  (By the way, I wrote a lot about growth vs. value a few years ago.  Try my style test.)

what has to work

Two basic assumptions value investors make are that:

–change is possible.  Not a problem in the US.  Japan, where Western black ships are now toothpicks along the shore, is the obvious counterexample.

–the assets endure and can prosper in better hands.  Therefore metrics like price/book value or price/cash flow are reliable measures of a company’s worth.

the pace of change…

Look at the computer industry.  The mainframes of the 1960s gave way to the minicomputers of the 1970s.  The latter, in turn, lost out to the PC, whose dominance is now being undercut by mobile devices.  That’s 60+ years of history in two sentences   …that’s plenty of time for a nimble value investor to operate successfully.  But it’s also pre-Internet.

…is accelerating

Take Ouya.  It’s a $100, Android-based videogame console.   The idea is to play casual games on your TV, at a fraction of the price of a Nintendo, Sony or Microsoft console.

You can also play prior-generation games of all sorts on Ouya.  You can use old XBox 360 controllers, too.  Try games for free before buying.  (Developer tools come in the Ouya box, too,just  in case.  Revenues get split 70/30 in developers’ favor.)  There’s also the possibility of apps like Netflix, Hulu…

Maybe Ouya will be successful, maybe not.

What I think is more important is that Ouya has overcome the barriers to entry that supposedly ensure the permanence of the “toolkits” of incumbent firms:

–Financing:   Ouya set out to raise $950,000 through Kickstarter to get going.  It took in $8.6 million.

–Advertising:  social media  (In the UK, Ouya sold out in seconds;  in the US, it sold out on Amazon in eight hours.)

–Factories:  outsourced

–Game content:  all third-party.

Ouya’s biggest problem, as I see it?  It’s not XBox One, PS4 or Wii U.  Ouya’s low cost is likely to put downward price pressure on the price of all these traditional machines.  Ouya’s biggest worry is that its greatest competitive edge is its first mover advantage.  Low-cost competitors Gamestick, Game Pop and Project MOJO are are speeding down the same Internet-enabled trail Ouya has blazed.

What’s a value investor to do in this new world?

going ex-growth: the (most times) arduous trip from growth stock to value stock

January 23, 2013 By in economics, from growth to value: the life cycle, Portfolio management Tags: , , , , , , , Leave a comment

growth stocks

Growth stock investors are dreamers.  They try to find stocks that will grow faster than the consensus expects, for longer than the consensus expects.

As a good growth stock reports surprisingly good earnings results, the stock price typically rises.  Two causes:

–the stock adjusts up for the better earnings; and

–expectations for future growth rise, leading to price earnings multiple expansion.

If, for example, the stock is trading at 15x expected year-ahead earnings before the report, after the report it may end up trading at 18x the new, higher, level of expected earnings.

At some point, this explosive upward force becomes spent.  The reason may be technological change, or maybe new competition, or maybe the market for the company’s products is completely saturated  (a fuller discussion).  As this happens, the supercharged upward path I’ve just described begins to go into reverse.  The company reports disappointing earnings.  The stock moves downward to reflect new, lower, earnings expectations, and the price earnings multiple contracts.

Today’s question:  how/when does this negative process stop?

It’s important to realize that professional growth stock investors have seen this movie of mayhem and destruction many times before.  They know the plot lines well.  There may initially be some doubt about exactly when the downturn is commencing.  But growth investors know that how they sell a stock is the most crucial determinant of their long-term performance.  So once they become convinced that the salad days are done, they’ll be quick to sell.

The initial buyers will likely be non-professionals who see a decline as a chance to buy a stock they’ve heard about from the financial press or from friends and which appears on the surface to be less expensive than it previously was.   Or they may be members of the growing class of professional traders, many of them associated with hedge funds, who are not particularly interested in company fundamentals, but who buy and sell for short-term profits, either “reading” stock price charts or using their “feel” for the rhythms of the markets to make their decisions.  Eventually both groups also figure out the bloom is off the rose.  In my experience, the traders sell to cut their losses; the non-professionals continue to hang on.

The eventual home for former high-fliers is with value investors, who specialize in companies with flaws where the stock has been beaten down in an excess of negative emotion.  Typically, value investors use computer screens to identify the lowest, say, quintile of the market measured by price/cash flow or price/book value.  That will be the universe they study more closely to make their stock selections.  Many times, these stocks will be in highly business cycle-sensitive industries,  or ones that show little growth.  Companies may be laggards in their industries, either because of poor management or other fixable problems.  Value investors typically say that they buy $1 worth of assets/earnings for $.30 and sell it at $.80.

The point is it usually takes a long period of time, and enormous deterioration of a growth stock’s fundamentals, before the fallen angel sinks low enough to catch the value stock investor’s attention.  Also, like their growth stock counterparts, value investors have industries that they have studied carefully for years and which constitute their comfort zone.  The two areas of familiarity are pretty close to mutually exclusive.  So it may take an extremely cheap price for a value investor to take the risk of buying, say, a tech company instead of a presumably safer–or at least better understood–cement plant, auto parts maker or steel mill.

As I’ve written many times before, the one exception to this pattern that I’ve seen is AAPL, whose price earnings deterioration began five years or more ago (depending on how you count) despite continuing explosive earnings gains.  In fact, at present, AAPL shares are trading at a 25% discount to the market median PE multiple, according to Value Line.  True, there are qualitative signs that AAPL’s growth heyday may already be in the rear view mirror.  But the market’s bad treatment of the stock seems excessive to me.  Price action after the upcoming earnings report will be instructive.

what’s wrong with AAPL?

January 15, 2013 By in growth vs value, Industry Analysis, Stock ideas, Technology, Wireless Tags: , , , , , , , Leave a comment

AAPL shares have been steadily underperforming the S&P 500 since late September, losing 30% of their value relative to the index over this span.

I think several factors are involved:

1.  potential income tax law changes.

In the recent debate over increasing tax rates, suggestions were circulating that the tax preference on long-term capital gains vs. ordinary income should be eliminated.  That would have raised the Federal tax on long-term gains from 15% to over 40%.  The worry that this would happen was the trigger for taxable AAPL holders with large profits (meaning just about everyone) to realize at least part of their gains in 2012.

I think this was a big reason for downward pressure on AAPL shares during 4Q12.  However, the relative weakness has continued pretty consistently so far in 2013, other than during the first couple of hours of trading in the new year.  So it can’t be the whole reason.

2. a slowdown in iPhone 5 sales?

 Component suppliers to AAPL have been saying for a month or so that the company is deferring orders for iPhone 5 parts.  The latest such announcement comes in the Nikkei newspapers in Japan, usually an extremely reliable source.  AAPL orders to Japanese makers of  iPhone 5 screens for 1Q13 have supposedly been halved to 33 million (I read about it online and in the WSJ and FT).

In itself, this is not such a big deal, in my view.  It’s not clear whether AAPL has excess inventories or whether it’s shifting business to alternate suppliers in, say, Taiwan or mainland China.  And it’s also possible that any slowdown will only last a quarter or two.  I don’t know, but it’s possible.

3.  Who are the new buyers?    

This is one of those odd stock market phenomena.

Individuals and hedge funds caught on to the AAPL  story before many mutual funds.  But the damage to relative performance from not owning AAPL, or from having less than the market weighting became so severe that virtually every mainstream professional has already been forced to build a huge position in the stock.

So who’s left to buy?  Almost no one, in my view.

In fact, early supporters, who have enjoyed outperformance for most of a decade from holding a lot of AAPL must be thinking that the way to distinguish themselves from rivals today is to be underweight the stock.  This can happen in two ways–either by selling shares of AAPL or by just not buying any more as new money comes in.

Maybe this sounds a little crazy to you, but I think this is the main issue the stock is struggling with today.

4.  Is the AAPL growth story “broken”?  

Typically as a growth stock continues to report surprisingly strong earnings, its stock price moves sharply higher.

Two reasons:

–the market adjusts to the higher level of profits and

–the price earnings multiple expands, as investors raise their expectations for future growth.

As earnings begin to disappoint, as they sooner or later must, this process goes into reverse.  The stock price adjusts to lower current earnings and the price earnings multiple, usually sky-high by this time, begins to contract.  Multiple contraction is, in my view, the worse of the two.

AAPL’s case is unusual, however (in fact, it’s the only stock I’ve seen exhibit this behavior).

The company’s earnings are 10x what they were five years ago.  During the entire earnings expansion, however, AAPL’s PE has been contracting.  Yes, an accounting change may have caused part of this.  Still, the stock traded at 30x earnings in 2008 and trades at 12x now!  In other words, a slowdown in growth has been baked into this Wall Street cake for a long time.

I don’t think there’s any expectation in today’s stock price that AAPL will ever produce another spectacular product like the iPod or the iPhone.  As I read it, the current quote expresses doubt that AAPL will be able to defend its market position against competitors like Samsung.  That seems a little harsh to me   ..but I haven’t done careful research to convince myself that this is the case.

 

 

 

 

the Intel (INTC) 3Q12 preannouncement: studying operating leverage

September 12, 2012 By in Constructing a Portfolio, margins, operating leverage, Portfolio management Tags: , , , , , , , , , Leave a comment

the preannouncement

As I wrote about yesterday, INTC preannounced weaker than expected 3Q12 earnings.  The main culprit?  …worldwide general economic slowdown.

The company said it now expects revenues of $13.2 billion for the quarter, down by 7.7% from the $14.3 billion it guided to when it announced 2Q12 earnings two months ago.  The gross margin will come in at 62% instead of 63%.  Virtually all other cost items will remain the same.

looking at leverage

This isn’t much data.  But it’s enough for us to see two things about the company, manufacturing leverage and leverage on SG&A (Selling, General and Administrative) expenses.

manufacturing leverage

two kinds of costs

In the simplest terms, in every accounting period employees get paid and the accountants apportion costs for the use of the factory and the machinery in it, whether or not anything gets build.  So, in a sense these are indirect costs of manufacturing.  In the short run, they’re relatively fixed.

In addition, there’s the cost of the materials–electricity, gas, silicon, who knows what else–that get used up in making INTC chips.  These are direct costs.   Their total in any period is variable, depending on how many chips get made.

Accountants assign each chip a total cost that depends on two factors:  the out-of-pocket cash (variable cost) spent making it plus its share of indirect costs, a figure that depends on how busy the factories are.

gross margin

Total cost ÷ sales price = gross margin.

separating the two

Is there a way to find out how much of the total cost is variable and how much depends on how well sales are going in a given quarter?  In INTC’s case, yes.

Management has just told us that sales will be $1.1 billion less than anticipated and that this fact will lower the gross margin by a percentage point.  That’s not because the variable cost of making a chip has changed; it’s because the indirect (or fixed, or overhead) costs of running the factories are being distributed over a smaller number of chips.  (It’s a little more complicated than that, but not a worry in this case.)

Another way of saying this is that in order to get to the new, lower, sales and operating profit estimates, INTC has subtracted the sales price of the extra chips it won’t sell and only the variable cost of making those chips.  If we calculate the change in estimated gross profit and divide by the change in sales, we’ll get a variable cost margin for those “extra” chips.

Here we go:

$13.2 billion x .62  =  $8.18 billion in gross profit

$14.3 billion x .63  =  $9.01 billion in gross profit

The difference is $.83 billion, the gross profit lost from lower sales.   This gross profit   ÷ $1.1 billion in lost sales   =  75.5%.

Therefore, 75.5% is the profit margin from producing/selling an extra chip during the quarter.  That’s the manufacturing leverage INTC gets at current production levels for getting/losing additional sales.

Note, too, that the new operating profit is 9.1% less than the original estimate.  That compares with a 7.7% drop in sales.  So, while there is operating leverage in the manufacturing operation, but at current production levels it’s not huge.

SG&A leverage

INTC has two types of SG&A.  One is R&D.  The other is the typical SG&A that any industrial company has. The two items are roughly equal in size.  This quarter they’ll amount to $4.6 billion.

Let’s subtract that from both the original gross profit estimate and the new guidance.

$8.18 billion  –  $4.6 billion  =  $3.58 billion in operating income

$9.01 billion  –  $4.6 billion  =  $4.41 billion in operating income

Now calculate the percentage drop in operating income that our 7.7% decline in sales produces.

It’s 18.8%!

To recap, the 7.7% fall in sales produces a 9.1% drop in gross profits and an 18.8% contraction in operating profits.  Of the 11.1 percentage point differential, 1.4 comes from the manufacturing process, 9.7 from SG&A leverage.

In other words, the operating leverage at INTC is coming from SG&A, not manufacturing.  If INTC wanted to reduce costs in a way that would affect current reported profits the most, it would attack either R&D or “normal” SG&A.

operating leverage (III)

August 29, 2012 By in Accounting, growth vs value, operating leverage, working capital Tags: , , , , , , Leave a comment

You may notice that I’m working my way down the income statement in discussing operating leverage.  Yesterday I wrote about the leverage that comes from product manufacturing.  The key to finding this leverage is identifying fixed costs.

All the profit action takes place between the sales and gross profit lines.  This is also the most important place to look for operating leverage for most firms.

operating leverage in SG&A

Today’s topic is the operating leverage that occurs in the Sales, General and Administrative (SG&A) section of the income statement.

The general idea is that large parts of SG&A expense rise in line with inflation, not sales.  So if a company is growing at 10% a year while inflation is 2%, SG&A should slowly but surely shrink in relative terms.  And the company will have an additional force making profits grow faster than sales.

For many non-manufacturing companies, this is the major source of operating leverage.

why this leverage happens

There are several reasons for SG&A leverage:

–most administrative support functions reside in cost centers, meaning their management objective is to keep expenses in check.  Employees here are not directly involved in generating profits, so they have no reason to demand that their pay rise as fast as sales.

–as a company gets bigger and gains more experience, it will usually change the mix of administrative tasks it performs in-house and those it outsources, in a way that lowers overall expense.

–a small company, especially in a retail-oriented business, may initially do a lot of advertising to establish its brand name.  As it becomes larger and better-known, it may begin to qualify for media discounts and be able to afford more effective types of advertising.  At the same time, it will be able to rely increasingly on word-of-mouth to gain new customers.  In addition, it will also doubtless be shifting to more-effective, lower-cost internet/social media methods to spread its message.

negative working capital

Strictly speaking, this isn’t a form of operating leverage.  It has its effect on the interest expense line.  And in today’s near-zero short-term rate environment, it’s not as important as it normally is.  But, on the other hand, one day we’ll be back to normal–when being in a negative working capital situation will be more important.  It’s also one of my favorite concepts.

If a company can collect money from customers before it has to pay its suppliers, it can collect a financial “float” that it can earn interest on.  The higher sales grow, the bigger the amount of the float.  If the company is big enough (or, sometimes, crazy enough) it can even use a portion of the float to fund capital expenditures.  The risk is that the float is only there if sales are flat or rising.  If sales begin to decline, either because of a cyclical economic downturn or some more serious problem, the float begins to evaporate, as payments to suppliers exceed the cash inflow from customers.

Lots of businesses are like this.  For example, you eat at a restaurant.  You pay cash.  But the restaurant only pays employees and suppliers every two weeks.  And it pays is utility bills at the end of the month.

Hotels are the same way.  Utility companies, too.  Amazon and Dell, as well.