Category Archives: two flavors of value

growth vs. value test: my answers

June 23, 2015 By in book value, cash flow/share vs. earnings/share, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital, two flavors of value Tags: , , 2 Comments

The growth stock investor’s answer:  Joe’s, of course.  Why?  I pay $18 for the stock now.  At the end of five years, earnings per share will likely be $2.70.  Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.

Look at Bill’s in contrast.  I pay $10 for the stock.  At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here).  Assuming the stock keeps the same multiple, it will be trading at $16.10.  Add in the dividends and the total is $18.60.  That’s a return of 86%, or about half what I would get from holding Joe’s.

One more thing.  Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate.  As a result, the p/e multiple could begin to contract.  Maybe that will happen, maybe not.  But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.

The value stock investor’s answer:  It’s obviously Bill’s.  Joe’s has a much more aggressive  growth strategy.  Maybe it will work, maybe not.  I don’t see why I have to decide.  A lot of the potential reward for success is already built into Joe’s current stock price.  And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.

If Joe’s strategy doesn’t work, then I’m much better off with Bill’s.  On the other hand, suppose it really is the way to go.  In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change.  And the stock will skyrocket.  While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.

It’s a question of temperament.  A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.

Maybe the most salient points to be made about each answer are:

–not that many companies grow so rapidly as Joe’s without any hiccups;

–wresting control from an entrenched management is not that easy (look at the sorry history of  Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation).  It may not be possible, and could be a long and arduous process in any event.

can activists pay their nominees to target company boards? should they?

December 30, 2013 By in activist invstors, from growth to value: the life cycle, growth vs value, two flavors of value Tags: , , 1 Comment

Today’s Financial Times points out that 33 major American publicly traded companies have changed their bylaws to forbid board members from taking incentive payments keyed to the firm’s performance from third parties.

What is this all about?

In a sense, this is an aspect of the question of who really owns a company.  In theory, the owners are the shareholders and the company is run for their benefit.  As a matter of practice, most often the top management of the firm is in control.  It is usually happy with the status quo, and doesn’t typically stint on corporate jets, country club memberships and the like for themselves.

That’s where the board of directors comes in.  The board is elected by the shareholders to run the company.  It does so by appointing professional management to actually do the job, while it supervises, sets compensation and approves major decisions.  Control the board and you control the company.

A time-tested way for activist investors (a term which covers a whole raft of characters, from greenmailers and corporate raiders to more respectable operators who simply want to replace incompetent management) to influence the running of a company is through its board.  Activists often wage proxy battles to get their own nominees elected to the board by shareholder vote.  What better way, activists argue, to motivate such nominees to press for improved corporate performance than to pay them bonuses for achieving it?

The idea of activist investors compensating compliant directors potentially strengthens the activists’ hands in the three-way battle for company influence among:  management (which is virtually always backed 100% by individual shareholders, regardless of performance), institutional investors (who want strong stock performance but who suspect activists) and the activists themselves.

Personally, I think suspicion of activists is often warranted.  After all, look at what Bill Ackman did to JCP.  He erased a third of that firm’s revenues and all of its profits, and then sold his stock quickly–with board approval–at much more favorable prices than ordinary shareholders were able to achieve.  Thanks a lot.

So far, activists haven’t had much success with their pay-for-performance strategy, mainly because the incentivized nominees have lost in their board elections. But managements apparently see this tactic as enough of a threat to be quietly closing the door to it.

To me, the most interesting question is why activists feel the need to motivate their hand-picked board nominees with sizable amounts of cash.  From their rhetoric, it appears the answer is that their successful nominees quickly get used to receiving  hundreds of thousands of dollars for attending a few meetings a year, plus free use of the company’s jet fleet, free lunch   …and find the prospect of living the good life up much less appealing than they did when they were standing outside with their noses pressed up against the glass.

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.

 

 

the two (possibly three) flavors of value: with and without a catalyst for change

May 3, 2011 By in book value, cash flow/share vs. earnings/share, growth vs value, two flavors of value Tags: , , , , , , , , , , , 1 Comment

As you know if you’ve been reading this blog for a while, I’m a growth investor.  But I started out my career as a value investor and spent over half my working years in shops that had either a value orientation or a substantial value presence.  For an outsider, then, I think I have a reasonable grasp of what value investors think and do.  I’m also laying the groundwork in this post for writing tomorrow about the titans of the personal computer industry, AAPL, INTC and MSFT.

how all value investors operate

Value investors like to invest in companies whose stocks are trading at very low ratios of price to book value (shareholders’ equity), price to cash flow, price to earnings and/or price to assets.  Many times such companies have gotten to low valuations because their managements have made strategic missteps.  Sometimes, though, the environment in which they work is highly cyclical and the cycle has turned against them.  Or it may just be that the industry in which the company operates is boring and seldom catches investors’ eyes.

In their pursuit of very cheap companies, value investors hold to two ground-level beliefs, namely:

–you can’t fall off the floor, and

–everything reverts to the mean, sooner or later (but mostly sooner).

The first dictum suggests that if a company’s stock is already all beaten up, at some point it just won’t go any lower.  So if buyers can locate and act at around this level, they have limited downside risk.

The second idea is that the company will eventually overcome the mistakes it has made–either with present management, new leadership, or as a division of a larger company.  In any of these events, the stock will go up …or the business cycle will turn in the company’s favor …or investors may just spontaneously wake up one morning and find the company’s industry much more fascinating (maybe as the first market entrant is taken over).

In any of these cases, the severe negative market emotion that has driven the stock to extremely low levels will dissipate and the stock will return to a more normal valuation–that is, one more in line with its past trading and with what companies with similar financial characteristics in other industries sell at.

All value investors believe this.

What sets them apart from one another?

For one thing, different investors may use somewhat different metrics.  One may be deeply convinced that he should only pay attention to price/book.  Another may be equally committed to price/cash flow.  A third may want to have another company in the same industry that’s very well run, whose (higher) margins may give a strong clue as to how good things might one day get.

In the final analysis, however, I don’t think these differences mean all that much.  Where I see the big divide for value practitioners is between those who want to see some catalyst that will encourage/force favorable change in the firm being analyzed before they’ll buy it, and those who don’t.

no catalyst

I understand the argument that the “no catalyst needed” camp makes.  They say that when things start to go bad for a company, investors can (and usually do) have a violent negative reaction that far exceeds anything that the (deteriorating) fundamentals justify.  The stock gets battered in a way it never will again, once the sellers are able regain a bit of their self-control.  Therefore, by buying when the blood is flowing the thickest in the streets, you get by far the best prices. You’re more than compensated for the risk early buying entails.

I understand the argument, but temperamentally I could never just look at the price/book (or whatever other metric) screens and jump in.  What if the stock turned out to be GM, or Enron, or Global Crossing?  As a result, I’ve never tried to investigate whether the approach works.  Unfortunately, I have seen it fail, though.

catalyst required, please

The second camp of value investors are those who insist on being able to see some sign, or catalyst, that convinces them that change for the better is under way.  It may not have to be much.  The retirement of a CEO and the appointment of a more capable successor might be enough   …or an activist investor approaching another laggard in the same industry   …or indications that the business cycle is changing in the company’s favor.  Although I’m not that interested in a regular diet of value names, I’m much more comfortable with this second approach.  But that’s just me.

where does GARP stand?

There is a third style that stands on the border between growth and value.  It’s called Growth at a Reasonable Price, or GARP.  I’ve often had colleagues describe me as a GARP investor, mostly, I think, because I don’t see a compelling reason to live exclusively on the bleeding edge of growth (with emphasis on bleeding).  But I’m not a GARP investor in the way value players would understand it.

As growth, GARP means having a forward PE that’s equal to or lower than the forward growth rate.  As value, in contrast, being a GARP investor means that you determine a forward PE level, say, 15x, above which you refuse to make a purchase, no matter what you think the forward growth rate will likely be.

For example, I have no problem paying 22x earnings for a company that will grow earnings at a 28% annual rate for at least the next few years.  In fact, I’d consider myself lucky to have discovered the stock before the PE rose further. I’d also be happy to pay 40x for a company that could grow at a 50% rate.

A value-oriented GARP investor, in contrast, would have drawn a line in the sign in the sand, probably between 15x-20x–certainly no higher, and would refuse to buy either.

That’s it for today.  Tomorrow, let’s apply this to INTC and MSFT.