Category Archives: growth vs value

the traditional growth stock model…

May 5, 2016 By in from growth to value: the life cycle, growth vs value, Uncategorized Tags: , , , 1 Comment

…meaning for the past thirty years or so that I’ve been in the business.

 

What makes a growth stock is faster than expected expansion of earnings per share, that carries on for longer than expected.

Let’s say a stock is now trading for $20 a share.  It earned $.90 a share last year; the consensus of Wall Street analysts is that eps will grow by 11% to $1.00 this year.  Under these assumptions, the stock appears overvalued–one would be paying 20x expected earnings for 11% growth.

Assume, however, that our careful securities analysis, based, say, on the introduction of a badly understood but potentially transformational new product, reveals that eps will grow by 35% (and maybe more) this year–and beyond.  If we’re right, the stock is trading at 15x expected earnings for 35% growth.  It’s  a steal.

Stage 1.  eps acceleration.

a.  The company reports 20% year on year eps growth in 1Q16, vs. expectations of 10%.  The stock goes up, for two reasons:

–stock rises by, say, 20% because beliefs about the level of current earning power are revised up, and

–the stock’s PE ratio expands, meaning the stock rises by another, say, 5% – 10%, on the idea that a permanent upward change in the firm’s earning power may be under way.

b.  The process repeats itself in following quarters as long as expectations lag company performance.

Stage 2.  plateauing

In my experience, plateauing almost always results from a negative change in the qualitative story that’s driving the stock.  Earnings per share still look fine.  But there are indications that the force propelling them is looking long in the tooth.  Let’s say a retailer’s results have been going up for several years, both because of increasing same store sales growth and geographical expansion into new markets.  But now sales in the oldest stores are starting to flatten out, maybe even beginning to decline–and the firm has just entered the last 10% of its potential expansion program.

Typically, this is also the time when the stock’s PE ratio has expanded to crazy-high levels.  So, too, consensus expectations for earnings growth.

 

This is also usually the time when the first portfolio investors in are beginning to make their way to the exit.

Time can be another indicator.  Stages 1 and 2 together tend to play themselves out over five years or so.

Stage 3.  weakening comparisons

a.  The company reports earnings that no longer surprise on the upside.  They may be perfectly fine and in line with company guidance, but they’re less than investors expect.  The realization begins to dawn on holders that the peak of profit growth may have passed.

Now, the stock goes down for two reasons:

–current earnings growth expectations are revised down, and

–beliefs about long-term earnings power come down as well, meaning the PE contracts.

b.  This process continues.

Notes:

–The best growth companies are able to reinvent themselves, sometimes more than once, thereby prolonging their five-year growth cycle.

Microsoft, Cisco, Amazon, Apple are all instances.  In Apple’s case, the company was first the plucky PC company come back from near death.  Then it was the iPod company.  Then it became the iPhone maker.  Each reinvention triggered another growth cycle.

–The fall from grace in Stage 3 is often quite ugly and can last for a long time.  The potential buyers of a fallen angel are predominantly value investors, who are typically only avid purchasers at a discount to some notion of intrinsic value.

More tomorrow.

 

 

 

 

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.

 

 

 

 

plusses and minuses of using book value

April 19, 2016 By in book value, Uncategorized Tags: , , , , , 1 Comment

on the plus side…

–book value is a simple, easy to understand, concept.  Discount to book = cheap, premium to book = a potential red flag.

–it’s very useful for financials, which tend to have huge numbers of often complex, short-lived transactions with hordes of different customers, and where financial disclosure may not be so transparent (financials aren’t my favorite sector, by the way).  So the 30,000 foot view may be the best.

…maybe a plus?…

–in the inflationary world most of us grew up in, and that is still reflected in the financials of older companies, historical cost accounting tends to understate the current value of long-lived assets.  Think:  a piece of land bought in Manhattan or San Francisco in 1950 or an oilfield discovered in 1970–or 1925.  Many of the older retail chain acquisitions of the past twenty years have been motivated by the undervaluation on the balance sheet of owned real estate.

…definitely a minus

–in my experience, accountants tend to be very reluctant to compel managements to write down the value of assets whose worth has been impaired by, say, advanced age or technological obsolescence.

–more important, we are living in a period of rapid change.  The Internet is the most obvious new variable, although I think we tend to underestimate how profound its transformative power is.  In the US, we are also seeing a generational shift in economic power away from Baby Boomers and toward Millennials, who have distinctly non-Boomer preferences and a desire to live a different lifestyle from their parents.

Online shopping undermines the value of an extended physical store network.  Software (which by and large doesn’t appear on the balance sheet) replaces hardware (which does) as a key competitive edge between companies.

intangibles…

Warren Buffett’s key innovation as an investor was to recognize the value of intangibles like this in the 1950s.  In his case, it was that the positive effect of advertising expense and strong sales networks in establishing brand power appeared nowhere on the balance sheet.  In a world where his competitors were focused only on price-to-book, he could buy these very positive company attributes for free.  Price to book was still a solid tool, just not the whole picture.

…vs. structural change

The situation is different today.

The Internet is eroding the value of traditional distribution networks and of other physical assets positioned to serve yesterday’s world.  The shift in economic power to Millennials is likewise calling into question the value of physical assets positioned to serve Boomers.

In more concrete terms:

Tesla doesn’t need a car dealer distribution network to sell its cars.  A retailer can use Amazon, or Etsy or a proprietary website, rather than an owned store network.  A writer can self-publish.  These all represent radical declines in the capital needed to be in many businesses today.

Millennials like organic food and live in cities; Boomers eat processed food and live in the suburbs.

This all calls into question the present economic worth, still expressed on the balance sheet as book value, of past capital spending on what were at the time anti-competition “moats.”

Another issue:   I think that the institutional weight of the status quo has pressured managements of older companies into ignoring the need for substantial repositioning–including writedowns of no-longer viable assets–so they can compete in a 21st century environment.  Arguably, this makes low price to book a warning sign instead of an invitation to purchase.

using book value as an analytic tool

April 18, 2016 By in book value, return on equity, return on equity vs. return on capital, Uncategorized Tags: , , , , , , , Leave a comment

historical cost

Generally speaking, all of a company’s balance sheet data are recorded at historical cost (adjustments for currency fluctuations for multinational firms are he only exception I can think of this early in the morning).

book value

If this accurately reflect’s today’s values, and sometimes this can be an IF, then

…book value is an accurate indicator of the market value of shareholders’ ownership interest in the firm.

asset value

That means that price/book (share price divided by book (shareholders equity) value per share) can be an indicator of over/undervaluation.  In particular, if a company’s shares are trading below book, then it could potentially be broken up and sold at a profit.

management skill

We can also use return on book value (yearly net profit divided by book value) as a way of assessing management’s skill in using the assets it controls to make money.  This can be a particularly useful shorthand in the case of, say, financial firms, which tend to have fingers in a lot of pies and to disclose little about many of them.

Notes:

–price/book is not a linear or symmetrical measure.

On the one hand, a basic tenet of value investing is that when the return on book is unusually low either the company’s board or third parties will force change.  So weak companies may trade at smaller discounts to book than one might think they deserve.

On the other, strong performing firms will likely trade at premiums to book.  However, the amount of the premium will depend both on the state of “animal spirits” and more sober judgments about the sustainability of above-average results.

—return on book vs. return on capital.  Return on capital is the same kind of ratio as return on book and has the same intent–to assess how well management is using the assets it is entrusted with.  The difference is that ROC factors in any long-term debt a company may have.

Return on capital is defined as:  (net profit + after-tax interest expense) divided by (long-term debt + shareholders equity).

Return on capital and return on book value are the same if a company has no long-term debt.  Return on capital is typically lower than return on book if a company has long-term borrowings, debt capital usually costs (a lot) less than equity capital.

using return on capital

ROC and the spread between ROC and ROB can be important.  We should think of ROC as the profitability of the business enterprise and the difference between it and ROB as the return on financial leverage.

For instance, for a given firm, the ROC may be 10% and the return on book (equity) 15%.  The difference, 5 percentage points, is the result of “financial engineering,” or the leveraged structure of the company.  Those figures may be ok (and, for the record, I’m not against leverage per se).  But if the ROC is 2% and the ROB is 12%, virtually all the profits of the firm come from financial leverage–not from the underlying business.  That’s a risky situation, in my view–one that owners should be aware of.

More tomorrow.

 

 

 

 

 

price to book: a traditional, but flawed, tool

April 15, 2016 By in book value, Uncategorized Tags: , , , , Leave a comment

what book value is

It’s another term for shareholders equity, the financial accounting tally of the total amount of money shareholders, as owners have provided management to work with–through purchases of stock from the company and through profits retained in the business.  It’s called “book” value because the figure is taken from the company’s accounting books.

An example:

We form Ace Investment Advice (AIA) by selling 100,000 new shares to backers at $10 each.

Our balance sheet is simple.  We have cash of $1 million on the asset side, no liabilities and net worth (aka shareholders equity or book value) of $1 million, or $10 a share.

Let’s say AIA earns $200,000 in its first year of operation and distributes nothing to shareholders.  At the end of the year, net worth/book value is $1.2 million, or $12 a share.

how it’s used

return on equity and management skill

AIA management took $1 million and earned $200,000 with it during the year.  That’s a return of 20%  (yes, if management earned that money in a linear fashion through the year, the number is slightly lower, but let’s not worry about that refinement here).

I can compare this performance to what the management of similar firms has accomplished to see whether that’s good or bad.

price to book

I can also compare this performance with that of the managements of all other publicly traded companies, to see if this is a stock I should want to own.

If management is regularly able to achieve a 20% return on the shareholder funds, I probably do want to be a shareholder.  And I’m likely to be willing to pay a premium to book value–let’s say 1.5x book, or even 2.0x book– to become one.

On the other hand, if AIA consistently earns a 2% return on shareholder funds, then the stock doesn’t look attractive to me at all, at least not at book value.  Maybe I only want to pay 50% of book value for it.  And even then I’m probably betting that the board of directors will find better management to run the firm or that an acquirer will be attracted by the discount to book value and make a bid to take it over.

More on Monday.