Category Archives: Vocabulary

why is Qantas so cheap? …two reasons

November 9, 2011 By in foreign ownership limits Tags: , , , , , , Leave a comment

Qantas is an undervalued stock

In a Halloween commentary in its Lex column, the Financial Times points out that the Australian airline Qantas is unusually cheap compared with regional rivals.  By the newspaper’s reckoning, Qantas trades at .7x book value and 9x earnings per share, vs. its competitors’ average of 2.5x book and 12x eps.

labor problems

The FT attributes this substantial discount to the labor problems that plague many Australian firms, and Qantas in particular.  I’m sure that this is part of the issue, but I don’t think it’s the entire explanation.  The other factor that the FT is overlooking is the type of foreign ownership restriction Australia has imposed on the airline.

foreign ownership restrictions

It’s not just the fact of a limit on the percentage (49%) of the outstanding shares of Qantas that can be held by foreigners, although that is really a relic of a past that’s long gone.  The way in which the restriction is enforced is considerably more important, in my opinion.

When I first became involved in global investing in the mid-1980s, limitations on foreign ownership of companies a country thought had strategic, national security value–like telecom, media or transportation–were commonplace.  Some still exist.  In addition, however, many smaller countries restricted the ability of a foreigner to own more than a specified percentage of many other–or even all–companies, for another reason.  They feared that wealthy outsiders would snatch up a nation’s birthright for a song.

The Switzerland of post-WWII Europe did so to protect its industry against acquisition by US companies.  In the Pacific, when I began investing there in 1984, dual share systems were already in place in markets like Singapore and Thailand.

This distinction is a relic of a bygone era in most wealthy countries and has been eliminated as an impediment to equity capital raising and to generally having the stock price go up.  I think Australia should follow suit in the Qantas case.  More about this below.

how you implement ownership limits matters

The most widely used method of implementing foreign ownership controls in the Pacific was to allow foreigners to buy ordinary shares in the market.  On settlement day, these shares would be recorded and designated (in the old days, share certificates were physically stamped) as foreign-owned.  Once the ownership limit was reached, the company would no longer register the new ownership of ordinary shares bought by foreigners.

But the “foreignness” of the shares already purchased by non-citizens remained an enduring characteristic of those shares.  This gave new foreigners a legal way of buying stock in a given company.  They could purchase shares already designated as foreign from another foreign holder; the place on the foreign register would transfer to the new owner.  Typically, the stock exchange would make this easy to do by setting up a separate quote for foreign shares.

I remember buying foreign shares of Singapore Airlines, for example, in the mid-1980s for either no premium to the local shares or maybe 0.5% extra. The premium of foreign to local eventually breached 100%.

This was partly due to the indifference of local citizens to equities in general and to airline stocks in particular.  Global investors saw a different picture–stunning growth prospects for Asian airlines, which were trading at far cheaper prices than their much less attractive home-town alternatives.

Australia’s choice

Australia deliberately chose not to take the conventional route with Qantas.  The “foreignness” of foreign shares in Qantas doesn’t stay with the shares.  When the company sees that foreign ownership has reached the 49% level, it stops allowing foreigners to register share ownership (which is legally required, and in any event is necessary to collect dividends).  All foreigners can do at this point is wait for enough other foreigners to sell, making room for them to buy.  But since Australian investors show limited interest in stocks in general and in airlines in particular, once the foreign ownership nears the 49% level the Qantas stock price stops dead in its tracks.

This system makes life more difficult for Qantas.  A relatively low valuation makes it more expensive for the company to raise equity capital or to use stock as a method for compensating employees.  To my mind, this puts the airline at a substantial disadvantage to international rivals.

why?

Why would Australia do this?  And, how would I know?  It turns out that at the time Qantas was being prepared for its IPO I was managing a large portfolio of Australian equities (the Kuwaiti Investment Office held the only larger foreign portfolio I was aware of).  I remember discussing at length with a fact-finding commission the defects I saw in the Australian approach to foreign shares–basically predicting what has occurred.  I also said that although I admired Qantas as a company I wouldn’t participate in the offering.

The officials I spoke with said they didn’t care.  New Zealand Air had listed shortly before, using the conventional structure.  The foreign ownership limit there was quickly reached.  Foreign shares began trading at a substantial premium to local.  New Zealand investors were outraged and complained bitterly to their politicians.   Canberra’s highest priority was to avoid the same outcome.

Yes, a higher foreign-share price is a problem.  In most cases where this has occurred, like in Singapore, the authorities eventually end the foreign-local structure.  The unified share price typically settles at a level much closer to the foreign price once the limits are lifted.

My guess is that ending the two-share structure for Qantas would easily add 10% to the stock price.  I think +20% is more likely.

dark pools and Pipeline Trading Systems

November 8, 2011 By in dark pools, Vocabulary Tags: , , , , , , Leave a comment

dark pools: what they are

the traditional brokerage system

Twenty years ago, virtually all trading between professional investors was conducted through stockbrokers as middlemen.  This traditional system had three big advantages:

–brokers are constantly in touch with a large number of potential buyers and sellers–including other brokers–of a wide variety of securities.  This means that orders can be executed quickly and in large size.

–in some cases, brokers may use their own capital to buy less liquid securities from a customer right away–securities that would otherwise be hard to sell–hoping to trade out of the positions at a profit over a period of time.

–because brokers see lots of orders from very many customers, they may be able to spot trends in the markets faster than an individual investor.  So they may be a source of market intelligence.

Using a broker has one big disadvantage and one smaller one:

–the smaller one is that they’re more expensive than dealing directly with another professional investor would be,

–the larger one is that your broker knows who you are and what securities you’re transacting in.  The more you deal with a given broker, the more insight he will gain about your plans and methods of operation.  In a sense, he gradually comes to “own” them.  He can use this information in his proprietary trading or pass it on to your rival investment managers.

The bigger the institution, the savvier the investment manager, the more valuable this information is–and therefore the more likely it is to be passed on to others.

anonymous trading networks…

Advances in computer technology, both software and hardware, allowed entrepreneurs to create the first anonymous computer trading networks, or “dark pools” for institutional investors about a decade ago.  Investors register with the network operator, but place all their buy and sell orders on the network without revealing their identity.  Nor can they find out who the other side of any transaction is.

The advantages of dark pools are:

–anonymity, and

–very low commission costs.

The main disadvantage is:

–liquidity in a given issue may be low, meaning that execution of a large order may take a considerable amount of time.  An institution can mitigate this problem somewhat by placing orders with a bunch of dark pools at the same time.

…have become very popular

As time has passed and investors have become more accustomed to the concept, the use of dark pools has increased to where some estimates have them accounting for more than one trade in four in the US.  Three reasons:

–more users means better liquidity

–SEC-regulated investors have a positive obligation to seek the lowest-cost executions in their trading.  Using electronic crossing networks demonstrates they’re doing so

–as brokers have deemphasized stock research as a way to cut costs, the need to do enough business with brokers to get full access to research information has diminished.

where Pipeline Trading Systems comes in

Pipeline (PTS) is a broker- dealer who decided to cash in on the dark pool trend by creating one of its own.  It intended to make money, as any dark pool operator would, by charging a fee to anyone using its service.  It opened for business in September 2004.

In its advertising, PTS touted its anonymity and its ability to provide “natural” buyers/sellers for the other side of any trade.  Although, as the SEC notes in its recent cease and desist order, natural doesn’t have a precise legal definition, its use is meant to convey that the other party is another institutional investor, and not a financial intermediary like a broker or short-term trader.

Despite this claim, even before opening, PTS created a wholly-owned trading affiliate to take the other side of trades.  Its idea appears to have been that liquidity in the dark pool would thereby appear bigger than it actually was.

PTS didn’t disclose this to clients.  Quite the opposite.  It continually assured them that this was not the case.

As it turns out, the PTS dark pool was a bust.  In the early years, PTS itself provided well over 90% of the other sides of institutional members’ trades.  And it lost a lot of money doing so.

So PTS decided to put its head trader in charge of the brokerage affiliate, with the task of whittling down the losses.  The in-house broker promptly began to act in a way I see as being against the interests of its institutional clients.  Contrary to what it was telling clients, PTS gave the broker privileged access to the dark pool’s trading data, so it could study customers’ trading patterns; traders were given bonuses for money-making trades; the broker gave suggestions to its parent on how to tweak the dark pool rules in the broker’s favor.

PTS continued to lose money, however, though at a lower rate.  And then it was caught by the SEC.

PTS and two principals were together fined $1.2 million.  They also agreed to stop their illegal behavior.

Although the PTS crew were a hapless bunch, the SEC administrative proceeding against them shows that the agency is finally beginning to examine the operation of dark pools.  At the same time, the case shows that an enterprise like PTS can operate for the better part of a decade without being detected.

the power of media endorsements

October 11, 2011 By in media endorsements Tags: , , , , 2 Comments

what they are

Why to professional investors appear on radio and TV shows?  Why do they give interviews to newspaper reporters?  After all, it takes time, they don’t get paid, the interviewer may be clueless and have his/her own agenda, and they give away information that they normally charge their clients for.  Nevertheless, professionals are eager to do so.

why appear in the media?

Ego is one reason, but that only goes so far.

 

The real reason is that most people have an unusually favorable view of the media.  They think that before you get to appear on a TV show about investing, you have to pass a rigorous screening process that weeds out all but the best and the brightest.  With retail clients in particular, the implied endorsement by the media can be a more important factor in their deciding to hire you as a manager than your experience and track record.

The reality is that a media appearance can simply be the result of a phone call by your public relations company, or the fact that you look good in a suit and can talk in sound bites, or that you can appear on short notice when a comment on your specialty is needed, or that your firm is a big advertiser.  So the appearance is actually more like a product placement in a movie than an independent evaluation of your competence.

Despite this, the sales materials for your products will doubtless feature your media appearance prominently  …because it works.

 

 

earnings surprisingly strong, sales a little light–the stock plunges: why?

August 21, 2011 By in light sales, strong earnings Tags: , , , , , , Leave a comment

strong eps, light sales

Sometimes the way that the mind of Wall Street expresses itself in stock prices strikes casual observers as odd.  A prime example of this is when a company (DELL is a recent example) reports earnings that exceed the Wall Street consensus handily, yet the stock doesn’t go up the way you’d expect.  Instead, it drops like a stone.  The market seemingly ignores the strong earnings and points to revenues as the cause of its unhappiness.

Seems kind of petty.

Is there any sense to this reaction?

Yes  ….and no.

the yes part

Remember, the growth stock investor’s mantra has two features:

–surprisingly strong earnings

—longer than the market expects.

In situations like the one I describe above, it’s the assumed lack of permanence in the earnings gains that the market is making a negative reaction to.  The argument is this:

Companies make money either by selling more stuff, in which case revenues will rise, or by cutting expenses, in which case they won’t.  So earnings without revenues = cost-cutting.  Cost-cutting opens the door to two bad outcomes:

–sooner or later (probably sooner) the company will run out of expenses to cut and earnings will drop back to their pre-surprise level

–the firm may reducing crucial expenditures, such as research and development or customer service to an extent that future earnings prospects are harmed.  Therefore, earnings won’t just drop back to the pre-surprise level, they’ll fall below that.

the no part

The knee-jerk reaction that earnings growth without revenue growth isn’t a good sign will probably turn out to be right in the majority of cases.  But there can be instances where this is a mistake.

As I’m writing this, I’m struggling to find a plausible concrete example to illustrate what I’m about to say–which tells you (and me) something.

Anyway, it’s possible that a company is composed of a fast-growing, high-margin component and a slower-growing, lower-margin (or loss-making) one.  It may be that new products in the high-margin component are what’s creating the slow revenue, fast profit-growth pattern.  It’s even possible that the company in question is preparing to separate into two parts, either by sale or spinoff, in a way that will remove barriers to investors seeing the full potential of the growth component that the mature one creates.

for a positive market reaction?

For the market to have a positive reaction to strong earnings, light sales, I think three things are necessary:

–the company has to communicate clearly what the dynamics of the earnings situation are (it may have competitive reasons for not wanting to do this)

–professional analysts have got to trust what the company is saying and/or find confirming evidence, and

–investors have to be in a relatively bullish mood, so they’re willing to overlook the bearish signal and believe the bullish story.

 

 

reason six why analysts mis-estimate company earnings

July 25, 2011 By in Casinos, earnings surprise, Entertainment, Industry Analysis, internet, reasons analysts mis-estimate company earnings, Technology, using research, Wireless Tags: , , , , , , , , , , Leave a comment

reason #6

In my post from yesterday, I titled this reason “making dumb mistakes.”  I’m not sure what else to call it.  Let me illustrate with two examples of recent huge misses by analysts who should have known better.  They’re the June quarter results from two high-profile companies with plenty of Wall Street coverage, WYNN and AAPL.

Let’s take WYNN first.

WYNN’s 1Q2011

In 1Q2011, WYNN earned $173.8 million, or $1.39 per fully-diluted share.  Look one line higher on the income statement, and you see that the $173.8 million figure is after deducting $52.5 million in “income attributable to non-controlling interests.”  That’s minority interest.  It’s income that belongs to the 27.7% of Wynn Macau that WYNN doesn’t own.  (Wynn prepares its financials as if it owned 100% of Wynn Macau, and then subtracts out the minority interest at the end.)

From the minority interest figure and the magic of long division, you can calculate ($52.5 /.277) that Wynn Macau’s total net income was $190 million. WYNN’s share was $137 million.  Therefore, WYNN, ex its interest in Wynn Macau, earned $36.8 million for the quarter.

One unusual feature of 1Q11:  gamblers at the WYNN tables in Las Vegas had bad luck by historic standards during the quarter.  They lost a bit over 30% of what they wagered vs. historical loss experience of 21%-24%.

Any analyst who follows the company could have found all this out in five minutes of studying the 1Q11 income statement.  Given that the analysts’ consensus for 1Q11 was wildly low at $.73, you’d assume they’d do so to try to figure out where they went so wrong.

turning to 2Q11

In 1Q11, 80% of WYNN’s income came from fast-growing Macau, 20% from slowly-recovering Las Vegas.

From figures the Macau government posts monthly on its Gambling Coordination and Inspection Bureau website, we knew on July 1st that gambling revenue for the market as a whole was 12% higher in 2Q11 than in 1Q11.  If we assume that Wynn Macau grew in line with the market, and that a 12% increase in revenues produced an 18% jump in income (basically, adjusting for normal operating leverage and the fact that Wynn Macau “adds” gambling capacity by raising table stakes), then Wynn Macau would have earned about $225 million in 2Q11.  Of that, WYNN’s share would be about $165 million.  That translates into around $1.35 a share for WYNN in eps during the quarter.

What about Las Vegas?  It chipped in $.25 a share to first quarter earnings.  “Luck” at table games returning to historical norms would probably push that figure back to zero.  On the other hand, room rates at both Wynn and the Encore are gradually rising, so zero might be too low.  But let’s stick with zero from Las Vegas is the most reasonable guess.

In other words, a sensible back-of-the-envelope guess for WYNN’s eps in 2Q11 would be $1.35 + $.00  =  $1.35.  This isn’t necessarily the most conservative forecast, but it is one based on factual data about the Macau gambling market and the assumption that nothing much goes wrong (or right) in Las Vegas.

What did the professional analysts say?

The median estimate was $1.01.  The highest was $1.25; one analyst had the dubious distinction of saying eps would be $.69.  For this last estimate to have come true, WYNN would have had to break even in Las Vegas (it earned about $.25/share) and to have revenues in Macau drop by 25% quarter on quarter, while the market was growing at 12%.

Given that WYNN’s results are so strongly influenced by Macau, even the median was predicting a relative disaster for the company there.  What were they thinking?

(True, they might have been assuming a disaster in Las Vegas, not Macau.  And, I’ll admit, I thought WYNN has done surprisingly well in Las Vegas so far this year.  But Las Vegas isn’t big enough to move the eps needle down to $1.  And the situation is a little more complicated than I sketched out above:  Wynn Macau pays a large management and royalty fee to the parent, almost $40 million in 2Q, so the better Macau does, the better ex Macau looks.)

APPLE

AAPL’s 2Q11 (ended in March)

During 2Q11, AAPL earned a profit of $6.40 a share.  Its business broke out as follows:

Macs     3.76 million units     $4.98 billion in revenue

iPod      9.02 million units     $3.23 billion (includes iTunes)

iPhone     18.6 million units     $12.3 billion

iPad     4.7 million units     $2.84 billion

Other                                         $1.3 billion

Total                   $24.7 billion

turning to 3Q11

Let’s try a back-of-the-envelope forecast for AAPL’s 3Q11.  To make things ultra-simple, we’ll ignore operating leverage, which will bias our estimate to the low side.

Macs  growing, but slowly in a developing world where overall PC sales are flattish.  Let’s say $5 billion in sales.

iPod  flat, $3.2 billion in sales

iPhone     industrywide smartphone unit sales are growing at 80% year on year.  All the growth is coming from half the market, Android and iPhone, with Android growing faster; Nokia and RIM are taking on water and sinking fast.  Let’s pencil in 19 million units at $660 each = $12.5 billion.

iPad  this is the tricky one.  We know that AAPL is capacity constrained, is adding manufacturing capacity as fast as it can, and sold 4.7 million units in 2Q11.  Let’s put in 6 million units at $600 each, the average price from 2Q11.   That’s $3.6 billion.

Other Leave it flat at $1.3 billion.

Add all these numbers up, and we get $25.6 billion.  If we assume constant margins–i.e., no operating leverage (which a really terrible example to set–working with margins instead of unit costs, but I’ll do it anyway), then earnings will come in at $6.60-$6.75 a share for the quarter.

As events turned out, my guess is way too low.    …oh well!   AAPL reported eps of $7.79.  The big difference?  The iPad sold 9.2 million units and brought in $6 billion in revenue.  That alone adds more than $.60 a share in earnings.  The rest is bits and pieces.

So I missed badly.  That’s not really the point.  The real question is how my ten-minute approach stacks up against the work of the 45 professional analysts who follow the company for a living–and for whom AAPL is probably their most important stock.  Check them out and I’m starting to look pretty good.

the analysts

The median estimate of the 45 was $5.82 a share.  The low was $5.10, the high $6.58.

How could they consensus be projecting an almost 10% quarter on quarter drop in earnings?

APPL’s main business, smartphones, which accounts for 50% of total company revenue, and a higher proportion of profit, is exploding. The category is growing by 80%.  Rivals NOK and RIMM are not only going nowhere, they’re getting worse by the day.   In fact, NOK’s smartphone sales in the June quarter fell year on year–probably by a third. So AAPL’s continually taking market share from them.  Quarter on quarter sales were likely up.

We don’t know what 2Q11 iPad revenues could have been, only that they flew off the shelves as fast as AAPL put them on.  So product sales had to be up, maybe substantially, in 3Q11.

If both iPhone and iPad were flat, quarter on quarter, the only way to get company results to be down 10% would be if Mac sales, which represent about a fifth of the company’s business, were cut in half.  Hard to fathom, given that the PC industry is growing, if only slightly, and Macs have been gaining significant market share from Windows-based PCs.

what did I do differently?

I think everybody ignored AAPL’s “guidance” of $5.03.  WYNN doesn’t give guidance.

I did five things:

I gathered industry information from the internet.

I read the prior-quarter results carefully.

I used a line of business table to make (very primitive) quarter on quarter projections.

I ignored macroeconomic forecasts of slow growth for the US, since both firms target the affluent here–AAPL more so than WYNN, I think.

I didn’t worry about missing on the high side.  I didn’t want an estimate that was deliberately too conservative.

What didn’t the analysts do?

I only have guesses.

It’s possible that they were influenced by downbeat general economic news.  Even so, I don’t see how you could have gotten to the consensus figures for either APPL or WYNN if you did a line of business table.  But that’s one of the first lessons in Security Analysis 101.  Maybe the analysts in question were out that day.