Category Archives: Fixing mistakes

When something is going wrong…(lll) growth stock problems

October 26, 2009 By in Fixing mistakes, growth vs value, Portfolio management, Strategy Tags: , , , , Leave a comment

The main idea behind investing in a growth stock is that the company whose equity you’re buying will show earnings growth that’s much higher than the stock market consensus expects, for much longer than the market expects.

AAPL, MON or COH are recent examples of successful growth companies.  In their day, WMT, CSCO, MSFT, ORCL, even IBM were growth stocks.

Examples of companies that had seemingly good ideas that failed to experience a multi-year period of strong earnings growth also abound.  No one remembers their names, though.

Consensus data less useful for growth stocks

Maybe the most important characteristic of growth companies in my opening sentence is the assumption that the consensus is wrong and has materially underestimated how rapidly the company in question will grow, and for how long.

One practical, straightforward consequence of this is that the kind of computer screening that a value investor routinely uses to find undervalued securities, which uses historical data plus consensus estimates, is of little use.

In consequence, although the growth investor does use historical data and may find the germ of an idea from an industry expert, he most often has to rely on his own research.  Sometimes this comes from his own experience. For example, Peter Lynch of the Fidelity Magellan fund, perhaps the most famous stock investor of the late Seventies and early Eighties, wrote that he became interested in Dunkin’ Donuts, once a growth stock, because he used to buy his coffee there on the way to work.

Qualitative research is important

All research has, in my opinion, a qualitative and a quantitative element.  For value investors, the latter is more important.  For growth investors, though, I think the qualitative description is always the key.  Yes, you have to have spreadsheets that have point estimates of what future revenues and earnings will be.  But for the best growth stocks, there’s always a sense of–the earnings will be up at least 30%, but they could be a lot more than that.  In contrast, the qualitative story–what unique attributes of the company allow it to grow so fast–remain constant.

Rules of thumb for growth investors

There are some historical rules of thumb that you can use in growth investing, however:

1.  the process of establishing itself as a fast grower normally takes several years.   This is a combination of the company developing its operations and of Wall Street gradually coming to recognize the firm for what it is;

2.  as stock market outperformers, growth stocks rarely last more than five years;

3.  the truly great companies, like WMT or MSFT, are able to reinvest themselves and extend the growth period for much longer periods;

4.  growth stocks typically reach their peak of stock market popularity and their highest relative P/E multiple just as growth is beginning to slow;

5.  because of this, when they go ex growth, these stocks often face a protracted period of underperformance;

6.  signs of trouble always, always surface in the qualitative analysis before they make themselves evident in earnings.

Common growth stock errors

1.  selling too soon.  The average yearly return of stocks over very long periods of time is about 10%.  Compared with that, a 30% or 50% return looks good.  Also, from a value stock mindset, 50% may be all that you can expect.  Not so with growth stocks, however.  The key question should be whether the basis growth story for the company is still intact (surprisingly strong growth for a surprisingly long period).  If so, don’t sell.  Remember, too, that good growth stocks don’t come around that often and aren’t that easy to identify.

AAPL is a good recent example.  The qualitative story has been simple:  the iPod would be more successful than most thought;  the retail stores would provide a new, profitable distribution system; and there would be a “halo effect” that would spark new interest in AAPL’s computer offerings.  In the four years from late 2003 to late 2007, the stock rose almost 20x.

2.  missing the signs of “reinvention”. Many–make that: most–growth companies are one-trick ponies.  They have one, admittedly, exceptionally good, idea, but once that is executed, the company has nothing left.  The truly great ones, though, have strong management that recognizes this issue and is actively planning far in advance for what comes next.  AAPL, for example, has the iPhone, which on some measures makes up almost half its current earnings.  AMZN now sells an awful lot more than books, and is a leader in the emerging field of “cloud” computing.  MSFT went from personal computer operating systems, to spreadsheet and word processing software, to the Windows user interface.

3.  missing the signs that the party is ending (the reverse of #2)

a.  focussing solely on earnings. Emphasizing the quantitative over the qualitative can get you into trouble in another way.  Strong earnings growth can be sustained for a number of quarters even as the market for a company’s offerings is nearing saturation or as new competition is preparing to enter the market.  Scanning the competitive environment for threats, or looking a company-specific metrics, like the rate of growth of new orders, or sales growth experience with recently-opened stores, will likely turn up signs of slowing growth before they turn up in reported results.

b.  accepting a stratospheric (30x+) price/earnings multiple as normal. In the early years of a company’s life as a fast grower, a very high multiple is typical and usually well-justified.  But a high multiple  means higher investor expectations, which require high, and accelerating, earnings performance to be maintained.  In, say, year four of rapid expansion, surprisingly high earnings growth becomes more difficult to achieve.

Why?  Any firm (not run by crazy people) attacks its best growth opportunities first.  As it expands, those get used up and the company has to turn to progressively less lucrative possibilities.  At the same time, the increasing size of the company means that a lot of work has to be done just to achieve higher profits than the year before.

At some point, a market reaches saturation–that is, no new customers want or need a product.  A one-idea company shifts from the situation of having more customers than it can service, to dealing only with replacement demand.  Look at the pattern of AAPL’s iPod sales, for example, or SIRI’s satellite radio experience.

A very high P/E isn’t by itself a sell signal.  But it is a warning sign to check growth assumptions extremely carefully.  And the highest multiple often comes just as earnings performance is set to flag.


When something is going wrong…(ll) value stock problems

October 23, 2009 By in Fixing mistakes, growth vs value, Portfolio management Tags: , , , Leave a comment

As I’ve written in other posts, I’m a growth stock investor.

My initial training and close to my first decade of work were as a value investor, though, and I’ve worked for long periods in organizations where the majority of the senior portfolio managers had a value orientation.  So I do know something about how value works.  Still, I have a much more intimate acquaintance with how growth stock investors go wrong by making the mistakes myself.  In contrast, I’ve learned at least some of how value can go wrong at second hand, by watching others make them.

Having warned you about the state of my knowledge of value, here goes:

Having an investment plan for each stock is important

When you buy any stock, value or growth, you should have a plan for what you expect to achieve from owning it.  Ideally, you will have

–a concept, backed by

–an earnings model that incorporates information that you’ve gotten by researching the company, its products and its industry (10-k filings and annual reports are key here) that give you

–the expectation of substantial gain.

Your plan should give you a catalog of your major assumptions, as well as a roadmap to what good things you expect to happen, in what sequence, and what effect (at least qualitatively) they will have on the stock.

It’s your checklist to diagnose what may be going wrong

The plan will give you your ultimate exit strategy if things go right.  It gives you a checklist to go over–and decide if your assumptions are still valid–if the stock doesn’t perform the way you want.

In my experience, it may take a year or more before you’ve filled in all the details of your plan and feel comfortable that you know a company’s management, be satisfied that it is competent, and are able to anticipate how it will act.

By the way, no professional I’m aware of waits until the plan is completed before buying the stock.  Professionals, myself included, may do a week of research to get the plan structure right and spend the rest of the time putting flesh on the bones.  With a good stock, evidence mounts that you’ve made the right decision.  With a bad stock, the opposite (hopefully) happens.

What makes a value stock

Value investors argue that their stocks are attractive because the stock market does not fully appreciate the value of the underlying companies as they exist today.  (This is in contrast to growth investors, who believe their companies are attractive because the market underestimates the extent or duration of the firms’ future profit growth.)

Why should value stocks be misunderstood?

–Often, investors have an excessive negative emotional reaction to temporary difficulties.  A company may be highly exposed to the business cycle, for example, and investors rush to sell as the cycle turns down, without any thought to the possibility that conditions will someday get better.  We don’t have to go that far back in history–just to last March– to see this idea in action.

–A company may have good products, a great brand name and state-of-the-art production facilities, but weak management that fails to earn the profits the company should make.

–Or the industry it’s in may be hard to understand.

–Or it may be overlooked because it is only growing slowly.

–Or a firm may have had a damaging product recall or made a tactical marketing mistake that Wall Street has overreacted to.

Buy assets at 30¢ on the dollar and sell them at 70¢

The four essential elements of a value plan are:

–calculation of the “true” or “intrinsic” value of a firm,

–determining that the current price is at a steep discount to that number, and

–fixing a target price, and target timeframe, to sell the stock at.

Some deep value investors stop there.  They typically run computer screens to find the cheapest stocks based on price/cash flow or price/book value and buy them.   They argue that the moments of greatest despair are the ultimate buying points for stocks, both individually and as an asset class (think March 2009 again).  They also think that incompetently managed companies that refuse to change will be taken over.

Others want to identify a fourth factor–a catalyst for change–that will start the process of reevaluation along–anything from an uptick in the business cycle to a change in company management.  Personally, I’m much more comfortable with this approach.

Typical problems

a.  getting the intrinsic value wrong

This happens less often than you’d think.  This comes primarily (in my limited experience) from  non-specialists getting involved in industries that are highly regulated, like utilities, or that have no growth prospects, like traditional airlines.  In these instances, the cash flow the firms currently generate is immediately consumed in spending that’s necessary for the firm to survive.  Relying solely on book value as a measure of worth can also be dangerous, since auditors are not always as diligent as they should be in getting their clients to write down assets to true market value.

b.  the catalyst doesn’t catalyze

Think GM.  At one time the company had an unbelievable market position.  It was an American icon and a bellwether of the overall US economy.  It began to steadily lose market share when foreign competition arrived in the US auto market.  Managers developed internally were unable to reverse the company’s fortunes.  The board of directors was equally inept, and also stubbornly resisted advances from outside parties trying to (for a profit of course) be agents of change.

HPQ is another interesting case.  Here the board realized that a once high-tech company had slipped into mid-tech and decided to bring in a high-profile outside manager to turn things around.  Unfortunately, the company chose a marketing executive from ATT, Carly Fiorina, whose greatest talent, from where I sit, lay in marketing herself.  She was fired after several unproductive years and replaced by another outsider, Mark Hurd, who had a strong reputation as an operating manager and cost-cutter at NCR.

Under Hurd, HPQ became an illustration of a value stock that worked, far outpacing the market performance as he reorganized the company.

c.  staying after the party’s over

Value stocks are by and large, mediocre companies behaving badly.  While a turnaround is underway, a firm’s profits may skyrocket and its reputation on Wall Street may soar as well.   But there’s only so much that even the best managers can do.  Once margins have improved to industry-leading standards, growth may decelerate to not much faster than overall GDP.  Once the market realizes this, the stock may being to languish.

By that time, however, the value investor should be long gone.  His calculation is probably something like:  this company is earning $2 a share and trading at 10x eps.  If the company could raise its operating margins to the level of the best firms in the industry, it could be earning $5 a share on the same revenue base and with the existing plant and equipment–and trading at 12x eps.  In other words, if the favorable case plays out, the stock will rise from $20 to $60.

If the $60 price, or some other high value occurs, it will likely happen in year two of a three-year turnaround program–in other words, far in advance of the actual $5 earnings number.  By that time, the market will likely be realizing that the period of earnings acceleration is over and the stock may actually be going down.

Business cycle-sensitive stocks tend to exhibit this pattern.  The value investor judges, based on past cycles, that the stock will peak at, say 10x, peak earnings for the cycle.  Even though the earnings peak may be in year three of the cycle, the stock price peak can occur a year or more earlier.

In this cycle, though, commodity stocks may be an exception to this rule.  Demand from emerging markets and dollar decline may give them more life than an analysis of past cycles would suggest.

An aside:  mechanical rules

Some investors use rules like, “If the stock drops 15% below my purchase price, I’ll automatically sell it.”  or, “If the stock rises 50% above my cost, I’ll take a partial profit.”  Personally, I don’t like rules like this. If the stock’s price action is unfavorable, implicitly telling me I’m making a mistake, I’d prefer to be able to identify the mistake I’m making before acting.

This is at least partly because I’m a growth investor, looking for the next GOOG or AAPL.  My performance tends to be determined by having a small number of very good stocks, so I worry about being shaken out of a long-term winner by a bumpy ride along the way.

Value investors, on the other hand, tend to operate with much clearer, and shorter, timeframes, and with much more easily definable price targets.  So these kinds of rules tend to work better.  As with everything else, you should experiment to see what works for you.

When something is going wrong…(l) General

October 19, 2009 By in Constructing a Portfolio, Fixing mistakes, Portfolio management Tags: , , , Leave a comment

Finding and fixing mistakes is very important…

Most equity professionals will tell you that it’s at least as important to identify and fix mistakes as it is to find and hold stocks that will outperform.  Yes it’s a cliché, but that’s another way of saying it’s really and obviously true.

…but it’s harder than it seems

It’s less likely that a professional will tell you how hard this is to do.  It may be they’re unaware themselves.

I picture the situation as being like a professional baseball hitter coming up to bat.  On the one hand, he is absolutely convinced that he is going to hit the ball safely and get on base.  On the other hand, if you ask him what his chances are of hitting .400 for the year (that is, hitting safely in 40% of his at bats), he would probably laugh and say that no one in the major leagues has done that in over fifty years.

Similarly, every time an investment professional, or any of us, for that matter, makes a trade, we all think–whether we are conscious of this or not–that we know better than the guy on the other side.  If we’re buying a stock we think the seller is foolish to part with it; if we’re selling, we think the buyer is overpaying.  At the same time we know, at least intellectually, that two-thirds of the professional active managers in the US underperform the S&P 500.

Why am I going on about this?…because the character trait that makes any of us able to enter a buy order, our strong conviction that we know more than the other guy, is the same characteristic that stands in our way when we’re trying to figure out whether we’ve made a mistake.

The hard part is recognizing a mistake

The important issue for an investor is not how to fix a mistake–that’s easy: you sell the stock, you make your portfolio look more like the index.  The really key issue is how to recognize that you’re making one (before you’ve lost half your money).

Three posts on this topic

I’m going to write about this topic in three posts:  this one contains general comments; the other two will be what techniques a value investor typically uses and what techniques his growth counterpart employs.

Luckily, we’re not baseball players

Yes, investing is a lot like baseball–both experience-intensive craft skills.  But when it’s the baseball player’s turn at bat, he has to go up to the plate and swing, whether the pitcher is an All Star who never gives up a hit, or a rookie who can’t get anybody out and is just about to be sent back to the minor leagues for more seasoning.

We don’t.  We have the luxury of picking the pitchers we want to face.  We can sit on the bench and eat sunflower seeds until we see one we like.  Brokers may encourage us to transact, because that’s how they make their money, but we don’t have to.

One of the most important things I think any investor has to learn is that he doesn’t have to have a opinion about everything–and express that opinion in buying and selling.  This is a recipe for failure.

A few things we know a lot about, not a lot of things we know a little about

We should be just the opposite.  We need to have a few well-reasoned and well-researched ideas that lead us to stocks/mutual funds/ ETFs that we conclude are worth more than the market now realizes.  It’s better to have one or two things that we know a lot about than it is to have two dozen half-baked ideas.

First, create a safety net

There a number of basic investment planning steps you can take that, among other things, will help you detect where one of your investment ideas may be going wrong.  You should:

1.  have a plan and write it down–a “strategy,” if you will.  If you document your reasoning and your expectations, it’s easier to compare the outcome with them.  See my posts on Constructing a Portfolio.

2.  in your planning, establish maximum position sizes, based on your risk tolerance.  Keep to them when implementing your plan.  This will ensure you don’t put all your eggs in one basket.  Again, see Constructing a Portfolio.

3.  Monitor your performance, position by position, regularly.  This will prevent your eyes from “accidentally” skipping over the clunkers in your portfolio.  See my posts on Measuring Performance.

4.  especially for positions that may not be performing as you expect, watch how they are doing against peers (for a stock, Google Finance seems to me to have the best peer groupings).  Look at performance on very sharply up days and on down days.  If the position is weak relative to the market on both sorts of days, that’s usually a strong indication of trouble.  See my post on Down Days.

5.  know yourself.  Everyone has different strengths and weaknesses.  Over time, you’ll see that there are some arenas, say technology or the consumer, where you’ll do well, and others, say, biotech, where you will have little success.  Or it might be that you’re comfortable with larger capitalization stocks and not so much with smaller, riskier issues.

The first sign of impending trouble will be when you venture into areas where you have not been successful in the past.  I’m not saying don’t do this.  How else will you learn?   But you will want to have a small position size and the willingness to make a fast exit, if need be.

That’s it for today.  In my next posts, I’ll deal with how value investors and how growth investors typically find and deal with mistakes.