Category Archives: growth vs value

a saturated market

November 9, 2015 By in from growth to value: the life cycle, market saturation, mean reversion Tags: , , , , , Leave a comment

market

Let’s say that a market is the total of all actual and potential customers for a product or service.

saturation

A saturated market is one where virtually every potential customer has been turned into an actual one.  At that point, sales gains for a given company can only come from:

–the (slow) growth of the population,

–replacement demand (which can be stimulated by the creation of new versions),

–the sale of maintenance or accessories, or

–taking market share away from competitors.

effect on sales and profits

As a company’s products approach market saturation, sales growth typically slows.  In the terminal phase, expanding as fast as nominal GDP becomes an aspirational goal.  The competitive environment also changes dramatically in a saturated market.  Sales become more costly to obtain, since rivals’ marketing efforts no longer simply expand the market for everyone, but become specifically targeted at taking sales from competitors instead.  This forces every market entrant to spend even more money to defend its present customers.

effect on the stock price

For a growth stock, which is most often trading at an overinflated price earnings multiple as this growth downshift is occurring, the increasing saturation of key markets is especially problematic.  It typically starts to weigh on the PE long before actual saturation occurs.  ESPN, the largest source of earnings for Disney (DIS), and Apple (AAPL) are current examples.

examples

AAPL

The AAPL case is straightforward.  The global market for $600 cellphones is almost completely saturated.  The main demographic cohort in the US that still uses flip-phones is the over 60 (over 70?) crowd.  Technically speaking, one might argue there’s still room to grow.   But for every consumer-oriented technological innovation in my career, this group has been especially resistant to change and tough to crack.  AAPL has never gotten much traction in Europe.  There’s lots of domestic competition in greater China.  The result of worries about an end to growth is the principal reason AAPL shares trade at a sub-market multiple.

DIS

Several years ago, ESPN attempted to expand abroad–a clear signal that it regarded the US market for sports entertainment broadcasting to be saturated.  It was unsuccessful.  Since then, as I see it, DIS has been redirecting cash flow from ESPN to expand its parks and movies businesses.  To my mind, this is the sensible course of action for it.  For a one-product company, which many growth companies tend to be, this is not an option.

 

Tomorrow:  saturation in the e-commerce market in China

falling sales, rising profits…

November 4, 2015 By in activist investing, activist invstors, Discounting, falling sales, growth vs value, rising profits, stock market Tags: , , , , , , , , Leave a comment

…are usually a recipe for disaster on Wall Street.  Yet, in the current earnings reporting season, a raft of companies are reporting this presumably deadly combination   …and being celebrated for it, not having their stocks go down in flames.

What’s happening?

the usual situation

First, why falling sales and rising profits don’t usually generate a positive investor response.

To start, let’s assume that a company reporting this way is maintaining a stable mix of businesses, that it’s not like Amazon.  There, investor interest is focused almost solely on its Web Services business, which is small but fast growing, and with very high margins.  AWS is so valuable that what happens in the rest of the company almost doesn’t matter.

Instead, let’s assume that what we see is what we get, that falling sales, rising profits are signs of a mature company slowly running out of economic steam.

So, where does the earnings growth come from?

Case 1–a one-time event.  Maybe the firm sold its corporate art collection and that added $.50 a share to earnings.  Maybe it sold property, or got an insurance settlement or won a tax case with the IRS.

All of these are one-and-done things. How much should an investor pay for the “extra” $.50 in earnings?  At most, $.50.  There’s no reason to make any upward adjustment in the price-earnings multiple, because the earnings boost isn’t going to recur.

Similarly,

Case 2–a multi-year cost-cutting campaign.  AIG, for example, has just announced that it is laying off 20% of its senior staff.  Let’s say this happens over three years, and that the eliminations will have no negative effect on sales, but will raise profits by $1 a year for the next three years.

How much should we pay for these “extra” $3 in earnings?  Again, the answer is that the earnings boost is transitory and should have no positive effect on the PE multiple.  So the move is worth, at most, $3 on the stock price.

Actually, my experience is that in either of these cases, the PE can easily contract on the earnings announcement.  Investors focus in on the falling sales.  They figure that falling earnings are just around the corner, and that on, say, a stock selling for $60 a share, the non-recurring $.50 or $1 in earnings is the equivalent of a random fluctuation in the daily stock price.  So they dismiss the gain completely.

why is today different?

I don’t know.  Although early in my career I believed that earnings are earnings and the source doesn’t matter, I’m now deeply in the only-pay-for-recurring-gains camp.

I can think of two possibilities, though:

–Suppose Wall Street is coming to believe (rightly or wrongly) that we’re mired in a slow growth environment that will last for a long time.  If so, maybe we can’t be as dismissive as we were in the past of the “wrong kind” of earnings growth.  Maybe company managements that are able to deliver earnings gains of any sort are more valuable than in past days.  Maybe they’re on the cutting edge of where growth is going to be coming from in the future–and therefore deserve a high multiple.

–I’m a firm believer that most mature companies formed in the years immediately following WWII are wildly overstaffed.  I also think that even if a CEO were willing to modernize in a thoroughgoing way–and I think most would prefer not to try–it’s immensely difficult to change the status quo.  Employees will simply refuse to do what the CEO wants.  As a result, this makes companies showing falling sales prime targets for Warren Buffett’s money and G-3 Capital’s cost-cutting expertise.  In other words, such companies become takeover targets, and that’s why their stock prices are firm.

variations on growth investing

October 29, 2015 By in growth vs value, Strategy Tags: , , , , Leave a comment

While I’m on the topic of investment styles, I figure I should say something about growth investing.

I started out as a value investor, concentrating on US companies.  After a few years as a securities analyst, I began assisting a superb value investor who was running a short portfolio, again all US.  A couple of years later, I changed jobs and started working as a portfolio manager in smaller Pacific Basin markets.  There, I was immediately attracted to smaller cap stocks, which at that time had the unusual combination of the best business models, the fastest growth and the lowest PEs in their markets.  What they didn’t have was a lot of market visibility, partly because they were so small and partly because the markets I was working in, like Australia and Hong Kong, were not very highly developed.

Yes, I continued to find stodgy old conglomerates where enormous value could be created by breaking them up and selling the pieces one by one, and others where an infusion of competent management could dramatically reverse declining fortunes. But I became more and more impressed by the raw earnings power of dynamic young firms.  It was only when I was describing my investment process in an interview for another job that I realized I was no longer a value investor.  I had become a growth investor instead!

 

My experience is that there’s a lot of confusion about what growth investing is.  In a sense, this confusion is aided and abetted by us growth investors ourselves, since no one wants to give away professional secrets, especially while he’s still working.

For example, the media talk about momentum investing, meaning buying stocks based solely on the fact that they’re currently outperforming the market.  This is an old offshoot of technical analysis, however, and has nothing to do with growth investing.

Then there’s “pure” growth investing, as practiced by the ill-fated Janus group in the 1990s.  Here the investor (that’s probably not the right descriptive) buys stocks based on accelerating sales and earnings, but without regard to price.  But doing so completely disregards a growth investor’s greatest challenge–knowing when to sell.  To my mind, this is pure speculation, not growth investing.

Growth At a Reasonable Price (GARP) is a genuine, if to my mind odd, growth variation.  Typically, a GARP investor sets a maximum PE ratio, say 25x the earnings likely over the next 12 months, as a maximum price he will pay for any stock, no matter how good the growth prospects.  I’ve sometimes been described as a GARP investor, rather than a “pure” growth disciple.  I find GARP too rigid, however.  For instance, holding firm to 25x would have ruled out Apple for much of its growth period, even though the footnotes to the financials made it clear that the company was using extremely conservative accounting (since changed) to record the profits from its iPhone business.

 

I think genuine growth investing has four facets to it:

–the growth investor buys the stocks of companies he believes will grow earnings faster than the market expects and/or for a longer period than the market anticipates (hopefully, both)

–decisions must be based on meticulous analysis and projections of the financials of the company, done by the investor himself, at least in large part

–judging when to sell is the key to success

–the PE paid should never be higher than the growth rate.

how traditional value investing has to change

October 28, 2015 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, Strategy Tags: , , , , Leave a comment

Yesterday I wrote about the Indexology observation that value investing hasn’t worked well over the past decade.  That’s a long time.  Here’s what I think is happening:

Every professional investor, no matter how he describes what he does, looks to buy undervalued securities.  That’s not unique to value investors, no matter how academics may insist otherwise.  Growth stock investors seek this undervaluation in the market’s underestimation of a company’s future prospects, as measured by how fast earnings are growing, how the trajectory is accelerating and how long super-normal growth  may continue.  Value investors look for undervaluation in underestimation of the worth of companies’ here-and-now, based on metrics like price to book, price to cash flow and price to earnings.

 

Most often, value investors are attracted to companies that:

–are suffering from temporary misfortune–the wrong part of the business cycle or a management miscue–that the market mistakenly thinks is a permanent defect, or

–are badly run, but the market doesn’t realize that change is possible, either by action by the board of directors or by third parties forcing change of control.

In either case, the presumption is that cumulative spending on property, physical plant and equipment or on intangibles like brand names, patents, distribution networks or building brand names through advertising and marketing all have an enduring value that will most likely grow with time.  In the worst case, the worth of these assets will erode only very slowly.

 

This assumption is value investing’s chief problem, I think.

How so?

–through e-commerce and social media, the internet continues to erode the value of traditional distribution networks and the power of the decades of advertising and marketing spending that have established and (until a decade or so ago) protected them

—generational change.  The gradual but steady replacement of the Baby Boom by younger generations who want to distinguish themselves from their parents means not only a change in what categories consumers spend on but a change in tastes, implying traditional firms may not benefit

—the Great Recession.  In my experience, big economic downturns most often trigger changes in behavior.  They’re the reason for reassessing and changing spending habits.  They are also, if nothing else, the excuse for severing traditional relationships.  Some of this is economic necessity, some not.  Gen-Xers, for example, congregate in cities instead of the suburbs where their parents live.  They can’t afford to get sick and miss work, and they can’t afford restaurant meals, so they avoid fast food and make healthy meals at home.  They use mass transportation rather than owning a car.  Macys and McDonalds are the last places you’ll find them.

These three developments all attack the traditional order, and thereby undermine the assumption of the relative permanence of asset value for many firms.  This phenomenon is greatest in consumer-facing enterprises, less so in industrial.

 

The result is, I think, that value investors have to become more like their growth colleagues in investigating in great depth a firm’s ability to withstand the disruptive forces I’ve just listed.  Buying and selling based on screens of low price to book, low price to cash flow and low price to earnings is no longer enough

 

value investing today

October 27, 2015 By in Absolute vs. relative performance, book value, growth vs value, mean reversion, Strategy, two flavors of value Tags: , , , , , , 2 Comments

S&P’s Indexology blog posted an article yesterday on value investing in the US, titled “Losing My Religion.”

The gist of the post is that both over the past one- and ten-year periods, value investing strategies have generally, and pretty steadily, underperformed the S&P.  The author, Tim Edwards, senior director of index investment strategy for S&P, suggests that this may be because value investing has become too popular.  In his words, “With so much energy directed to exploiting the excess returns available through value investing, maybe the only “value” stocks left are the value traps, those stocks whose prices are low as their prospects are determinedly poor.”

my semi-random thoughts

  1.  Value investing has been around at least since the 1930s and is the dominant investment style for professionals worldwide.  Growth stock investing may be a close second to value in the US but is a non-starter elsewhere.
  2. Value investing does not mean buying stocks that are cheap relative to their future prospects, i.e., bargains.  Rather, it’s a rule-governed process of buying–depending on the flavor of value an adherent espouses, the rule can involve the stocks with the lowest price to earnings, price to cash flow or price to net assets ratio–on the idea that the market has already factored into prices the worst that can possible happen, and then some.  If so, once the market begins to turn an objective eye toward such stocks once more, their prices will rise.  At the same time, downside is limited because the stocks can’t fall off the floor.
  3. As a dyed-in-the-wool growth stock investor (who has worked side by side with value colleagues for virtually all of his professional career),  my observation is that value stock indices routinely include growth stocks.  Growth indices, in contrast, are often salted with stocks that are well past their best-by date and that are ticking time bombs no self-respecting growth stock investor would own.  Academics use these mischaracterized indices to “prove” the superiority of value over growth.  Indexers use similar methodologies.  Be that as it may, this is another reason for surprise at the years-long underperformance of value.
  4. Early in my career I became acquainted with a married couple, where the husband was an excellent growth stock investor, the wife a similarly accomplished value stock picker.  She outperformed him in the first two years of a business cycle; he outperformed her in the next two years.  Their long-term records were identical.  This is how value and growth worked until the late 1990s.

The late 1990s produced a super-long growth cycle that culminated in the Internet bust of 2000.  That was followed by a super value cycle that ran most of the next 4-5 years.  Both were a break with past patterns.  The strength of the second may be a reason value has looked so bad since.

5.  Still, what I find surprising about the past decade is the persistent underperformance of value, despite the birth of a post-Great Recession business cycle in 2009.  The cycle turn has always been the prime period of value outperformance.  Why not now?     …the Internet.

More tomorrow.