Category Archives: growth vs value

Berkshire Hathaway and Kraft

April 20, 2015 By in Current Market Thoughts, economics, from growth to value: the life cycle, growth vs value, mergers and acquisitions, stock market Tags: , , , , , , , , , , Leave a comment

A little less than a month ago, Warren Buffett’s Berkshire Hathaway and Heinz (controlled by Brazilian investment firm 3G) jointly announced a takeover offer for Kraft.  The Associated Press quoted Mr. Buffett as asserting “This is my kind of transaction.”  I looked for the press release containing the quote on the Berkshire website before starting to write this, but found nothing.   The News Releases link on the home page was last updated two weeks before the Kraft announcement.  Given the kindergarten look of the website, I’m not so surprised   …and I’m willing to believe the quote is genuine.  If not, there goes the intro to my post.

 

As to the “my kind” idea, it is and it isn’t.

On the one hand, Buffett has routinely been willing to be a lender to what he considers high-quality franchises, notably financial companies, in need of large amounts of money quickly–often during times of financial and economic turmoil.  The price of a Berkshire Hathaway loan typically includes at least a contingent equity component.  The Kraft case, a large-size private equity deal, is a simple extension of this past activity.

On the other, this is not the kind of equity transaction that made Mr. Buffett’s reputation–that is, buying a large position in a temporarily underperforming firm with a strong brand name and distribution network, perhaps making a few tweaks to corporate management, but basically leaving the company alone and waiting for the ship to right itself.  In the case of 3G’s latest packaged goods success, Heinz, profitability did skyrocket–but only after a liberal dose of financial leverage and the slash-and-burn laying off of a quarter of the workforce!  This is certainly not vintage Buffett.

Why should the tiger be changing its stripes?

Two reasons:

—the opportunity.

I think many mature companies are wildly overstaffed, even today.

Their architects patterned their creation on the hierarchical structure they learned in the armed forces during the World War II era.  A basic principle was that a manager could effectively control at most seven subordinates, necessitating cascading levels of middle managers between the CEO and ordinary workers.  A corollary was that you could gauge a person’s importance by the number of people who, directly or indirectly, reported to him.

Sounds crazy, but at the time this design was being implemented, there was no internet, no cellphones, no personal computers, no fax machines, no copiers.  The ballpoint pen had still not been perfected.  Yes, there were electric lights and paper clips.  So personal contact was the key transmission mechanism for corporate communication.

Old habits die hard.  It’s difficult to conceive of making radical changes if you’ve been brought up in a certain system–especially if the company in question is steadily profitable.  And, of course, the manager who decided to cut headcount risked a loss of status.

Hence, 3G’s success.

—plan A isn’t working  

One of the first, and most important, marketing lessons I have learned is that you don’t introduce strawberry as a flavor until sales of vanilla have stopped growing.  Why complicate your life?

Buffett’s direct equity participation in Kraft is a substantial departure from the type of investing that made him famous.  I’ve been arguing for some time that traditional value investing no longer works in the internet era.  That’s because the internet has quickly broken down traditional barriers to entry in very many industries.  It seems to me that Buffet’s move shows he thinks so too.

 

 

 

 

dealing with a rising currency

March 12, 2015 By in economics, growth vs value, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , Leave a comment

As far as the stock market is concerned, there are two main strategies for dealing with a rising currency:

1.  try to make currency work to your advantage

Profit growth will be highest for a company in a changing currency environment if it has its costs in weak currencies and its revenues in strong ones. In today’s world, this means having costs in, say, yen or euros and sales in the US.

The “good” stocks in weak currency countries gain in two ways:   from stronger profit gains and from domestic portfolio managers rotating their holdings toward the “good” industries.

The obvious candidates are export-oriented firms with high labor content in weak currency countries.  In these areas, firms with high strong-currency import content that sell finished products into the domestic market are the worst ones to hold.

 

In strong currency countries, in contrast, purely domestic stocks are the best bet.  They benefit only from portfolio manager rotation, though.  But they avoid currency induced weakness.

 

2. ignore currency and look for secular growth names whose expansion prospects outweigh possible currency losses 

As a growth investor, this is my preferred strategy.  Historically, the majority of such stocks have been in the US.  In today’s world, however, the ideal investment would be in a hot EU tech company with exposure to the US.

Any ideas?

Shaping a portfolio for 2015 (vii): putting the pieces together

December 15, 2014 By in bond market, growth vs value, Portfolio management, securities markets, Shaping a portfolio for 2015, stock market, Strategy Tags: , , , , , , , 2 Comments

I expect 2015 to be a “normal” year, in contrast to the past six.  This is important.

Over the past six recovery-from-recession years, global stock markets have had a strong upward bias.  Yes, outperformance required the usual good sector and individual security selection.  But if “bad” meant up 12% instead of up 15%, most of us would be happy enough with the former.

This year, though, is more uncertain, I thin.  Whether the S&P 500 ends the year in the plus column or the minus depends on importantly on four factors:

–PE expansion.  Unlikely, in my view.  

–interest rates.   Arguably, rising rates may cause PE contraction, ash or bonds become more attractive investment alternatives to stocks

—currency changes.  A rising currency acts much like an increase in interest rates.

—profit growth.  In a normal year, earnings per share growth is the primary driver of index gains/losses.  It will be so for 2015, in my view.

Another point.  Four moving parts is an unusually large number.  There are other strong forces acting on sectors like Energy and Consumer discretionary, as well.  Because of this, unlike the past few years, where one could make a plan in January and take the rest of the year off, it will be important in 2015 to monitor plans frequently and be prepared to make mid-course corrections.

profit growth

Here’s my starting point (read:  the numbers I’ve made up):

US = 50% of S&P 500 profits.  Growth at +10% will mean a contribution of +5% to overall index growth

EU = 25% of S&P 500 profits.  Growth of 0 (due to euro weakness vs. the dollar) will mean no contribution to index profit growth

emerging markets = 25% of S&P 500 profits.  Growth of +10% (really, who knows what the number will be) will mean a contribution of +2.5% to             index growth.

Therefore, I expect S&P 500 profits for 2015 to be up by about 7% – 8%.

interest rates

The Fed says it will raise short-term rates, relatively aggressively, in my view, from 0 to +1.5% by yearend 2015, on the way to +3.5% by yearend 2017.  This plan has been public for a long time, so presumably at least part of the news has already been factored into today’s stock and bond prices.  What we don’t know now is:

–how much has already been discounted

–what the Fed will do if stocks and junk bonds begin to wobble, or emerging market securities fall through the floor, because rates are rising.  My belief:  the Fed slows down.

–is the final target too aggressive for a low-inflation world?  My take:  yes it is, meaning the Fed’s ultimate goal of removing the US from monetary intensive care may be achieved at a Fed Funds rate of, say, 2.75%.

My bottom line (remember, I’m an optimist):  while rising rates can’t be considered a good thing, they’ll have little PE contractionary effect.  Just as important, they won’t affect sector/stock selection.  The major way I can see that I might be wrong on this latter score would be that Financials–particularly regional banks–are better performers than I now anticipate.

If rising rates do have a contractionary effect on PEs, the loss of one PE point will offset the positive impact on the index of +6% -7% in earnings growth.  So the idea that the Fed will slow down if stocks begin to suffer is a crucial assumption.

 

currency effects

The dollar strength we’ve already seen in 2014 will make 2015 earnings comparisons for US companies with foreign currency asset/earnings exposure difficult.  Rising rates in the US may well cause further dollar appreciation next year.  Even if the dollar’s ascent is over, it’s hard for me to see the greenback giving back any of its gains.

Generally speaking, a rising currency acts like a hike in interest rates;  it slows economic activity.  It also redistributes growth away from exporters and import-competing firms toward importers and purely domestic companies (the latter indirectly).

The reverse is true for weak currency countries.  At some point, therefore, companies in weak currency countries begin to exhibit surprisingly strong earnings growth–something to watch for.

growth, not value

Typically, value stocks make their best showing as the business cycle turns from recession into recovery.  During more mature phases (read: now) growth stocks typically shine.

themes

–Millennials, not Baby Boomers

–disruptive effects of the internet on traditional businesses.  For example: Uber, malls, peer-to-peer lending.  Consider an ETF for this kind of exposure.

–implications of lower oil prices.  Consider direct and indirect effects.  A plus for users of oil, a minus for owners of oil.  Sounds stupidly simple, but investing isn’t rocket science.  Sometimes it’s more like getting out of the way of the oncoming bus.

At some point, it will be important to play the contrary position.  Not yet, though, in my view.

–rent vs. buy.  Examples:  MSFT and ADBE (I’ve just sold my ADBE, though, and am looking for lower prices to buy back).  Two weird aspects to this: (1) when a company shifts from buy to rent, customers are willing to pay a lot more for services (some of this has to do with eliminating counterfeiting/stealing); (2) although accounting for rental operations is straightforward, Wall Street seems to have no clue, so it’s constantly being positively surprised.

 

 

Tesco, Coke and IBM, three Buffett blowups

October 23, 2014 By in Current Market Thoughts, growth vs value, Portfolio management, Recent Market Action, stock market Tags: , , , , , , , Leave a comment

Warren Buffett of Berkshire Hathaway fame is perhaps the best-known equity investor in the United States.

What made his reputation is that Buffett was the first to understand the investment value of intangible assets like brand names, distribution networks, training that develops a distinctive corporate culture.

Take a soft drinks company (I’m thinking Coca-Cola (KO), but don’t want to dig the actual numbers out of past annual reports).  Such a company doubtless has a secret formula for making tasty drinks.  More important, it controls a wide distribution network that has agreements that allow it to deliver products directly to supermarkets and stacks them on shelves.  The company has also surely developed distinctive packaging and has spent, say, 10% of pretax income on advertising and other marketing in each of the past twenty (or more) years to make its name an icon.  (My quick Google search says KO spent $4 billion on worldwide marketing in 2010.  Think about twenty years of spending like that!!!)

Presumably if we wanted to compete with KO, we would have to spend on advertising and distribution, as well.  Maybe all the best warehouse locations are already taken.  Maybe the best distributors already have exclusive relationships with KO.  Maybe supermarkets won’t make shelf space available (why should they?).  And then there’s having to advertise enough to rise above the din KO is already creating.

 

What Buffett saw before his rivals of the 1960s was that none of this positive stuff appears as an asset on the balance sheet.  Advertising, training, distribution payments only appear on the financials as expenses, lowering current income, and, in consequence, the company’s net worth, even though they’re powerful competitive weapons and formidable barriers to entry into the industry by newcomers.

Because investors of his day were focused almost totally on book value–and because this spending depressed book value–they found these brand icons unattractive.  Buffett had the field to himself for a while, and made a mint.

 

This week two of Mr.Buffett’s biggest holdings, IBM and KO, have blown up.  They’re not the first.  Tesco, the UK supermarket operator, another firm right in the Buffett wheelhouse, also recently fell apart.

what I find interesting

Every professional investor makes lots of mistakes, and all of the time.  My first boss used to say that it takes three good stocks to make up for one mistake.  Therefore, she concluded, a portfolio manager has to spend the majority of his attention on finding potential blowups in his portfolio and getting rid of them before the worst news struck.  So mistakes are in themselves part of the territory.

Schadenfreude isn’t it, either.

Rather, I think

1.  Mr. Buffett’s recent bad luck illustrates that in an Internet world structural change is taking place at a much more rapid pace than even investing legends understand

2.  others have (long since, in my view) caught up with Mr. Buffett’s thinking.  Brand icons now trade at premium prices, not discounts, making them more vulnerable to bad news, and

3.  I sense a counterculture, Millennials vs. Baby Boom element in this relative performance, one that I believe is just in its infancy.