valuation/concept: where to from here

back to basics

One useful, I think, way of looking at stocks is to weight two complementary factors: valuation and concept.


I understand valuation to be the question of what’s the appropriate price to pay for an ownership interest in a given company. This is a function of several factors: the prevailing level of interest rates, the price/availability of alternatives (including fixed income) and one’s confidence that the basis for current valuation–assets and earning power–are sufficient for the company’s stock to maintain (at least) the current price.

An aside: Cost basis can be another consideration, although I think it’s dangerous to give this too much weight. I can’t help thinking of a friend who inherited a large amount of GE stock. Her cost basis was $1 a share. We were talking about the stock in the early 1990s, a time when it was a bit over $35 (this is before the 2021 1-8 reverse split, so $35 then is the equivalent of $280 today). It was becoming clearer that there was much less actual substance to the company than a brilliant PR presence had made many on Wall Street believe. My friend couldn’t bring herself to sell because of the large capital gains tax she would have to pay. She watched it lose three-quarters of its value in the ensuing years instead.

I have a somewhat similar problem with MSFT. I bought a large–for me, anyway–position on the management change in 2014. The stock is up 10x since (a reason to think the Clippers aren’t NBA champs any time soon). I can feel the same tug as my friend’s not to sell. My solution is to put some of the stock into a Fidelity-run charitable trust.


This is the reasoning behind one’s conclusion that the stock will be a strong performer in the future. Paradoxically, valuation can be the primary concept. If, for example, a stock is trading at 50% of its book value and that book value is a solid indicator of the worth of the net assets the company owns, and there’s every reason to think that asset value won’t deteriorate, then sooner or later some other party is going to seize control and, at worst, liquidate. One caveat: in this scenario, change of control must be possible–meaning no zaibatsu companies in Japan, no companies where dual shares give the founder absolute control.

More typically, concept consists of spreadsheets indicating the company will have surprisingly strong earnings growth + an elevator speech-ish statement of what makes the company special. This may include what you think the stock market in general doesn’t understand. For example, “ASML is the sole source of advanced lithography equipment used in cutting-edge semiconductors. This will be a hot market for years, both because demand for semiconductors will remain strong and because users want to create duplicate capacity in case Taiwan-based TSMC, the world’s only fab at the cutting edge, becomes a political hot potato.”

Generally speaking, in down markets valuation is king; in up markets concept is.

More on Monday.

1Q23 earnings for Target (TGT)

TGT and Walmart (WMT) are the two big general retailers serving middle America. Costco (COST) is the third behemoth, but it has a somewhat different concept and a younger, much wealthier customer.

As I see it, TGT is more aggressive/innovative than WMT, has a larger national presence in the US (WMT has been mostly shut out of the northeast and CA) and is somewhat more upscale. (I own TGT but not the others, which also says something about my risk preferences.)

Anyway, TGT reported 1Q23 (ended 4/29) earnings today. My main takeaways:

–sales were flattish, yoy, with eps down slightly

–daily use items (food, household goods, beauty) were strong sellers, discretionary ones (clothing, furniture, electronics) not so much. Put a different way, staples are chugging along, with more business cycle-sensitive items suffering. Not really surprising

–inventories were down by 16%. This is a combination of a rise in daily use items on hand with a 25% fall in stocks of discretionary goods. I find the wording of the press release is ambiguous, leaving it unclear whether these are quarter on quarter comparisons or year on year. The way I read it, what we’re seeing is the last stage of reduction in the massive oversupply of stay-at-home goods TGT had amassed early last year

–the company clearly wanted to highlight the continuing problem of shrinkage–theft of merchandise, including by organized criminal gangs–which TGT expects to be $500 million higher this year than last

As a shareholder, I think the stock will continue to tread water for a while. I’m not inclined to either buy or sell.

As an analyst, TGT and WMT give a good read on how the economy as a whole is doing. Putting this in (my preferred) simple-minded terms, when the economy is bad, consumers trade down to WMT; when they’re feeling flush, they trade up to TGT. WMT has recently made the point that its food sales are booming, which it attributes to more affluent consumers trading down to WMT’s discount groceries.

My simple conclusion: on a net basis, no one is trading up …and lots of people are still trading down, away from drug stores to TGT and from supermarkets to WMT. Shrinkage is also a sign of economic stress. So: no reason to be mega-pessimistic about the domestic economy, but NO reason to amp up any bullish feeling.

the debt ceiling

According to the internet, Denmark and the US are the two industrialized nations that have legislated ceilings which set an absolute amount above which the national debt can’t rise. Other countries have similar rules, some hard and fast, some not, that limit aggregate government borrowing to a percentage of GDP. 60% seems to be the most-used figure.

The US is now approaching the limit, as it periodically does. Inflation, if nothing else, is getting us there. Janet Yellen says that in early June we’ll likely reach the point where the government may not borrow to continue to pay for government operations or to pay the interest on existing federal debt.

The usual result of this situation is a lot of political theater, followed by a temporary resolution.

In 2011, however, Standard and Poors downgraded US Treasury debt from AAA to AA+, on the idea that Washington was failing to address the long-term issue of rising government debt and continuing budget deficits.

Back then, the S&P downgrade was significant for two reasons. The first was for what the downgrade said about government debt in the world’s most important currency. The second is more technical, but it least as important, I think. Clients of professional money managers almost always (I’m inclined to delete the almost, but there may be some weird exception) have very specific contracts (the prospectuses of mutual funds and ETFs are an example) that state what securities may be held by the client account. What happens with an account where the contract specifies a certain proportion of bond holdings must be in AAA-rated securities.

In 2011, S&P downgraded, but the other two significant rating agencies–Moody’s and Fitch–retained their AAA designation. Back then, one could argue that in some technical sense Treasuries were still AAA securities, since although the most important rater downgraded, the majority was still AAA. So no action was needed.

What happens if Moody’s or Fitch, or both, downgrade now?

We can already see that foreign national banks have shifted away from Treasuries toward gold over the past several months. Maybe bond managers have as well. Presumably also prospectuses and other contractual documents have been made more wishy-washy since 2011. But maybe not.

I think investors of all stripes recognize that the big threat to the stock market is a downgrade, which produced a 7% market decline back in 2011. But I wonder what happens to bonds if we see another downgrade this time.

office buildings and remote work

Office buildings in urban areas are facing two issues.

One is cyclical. It may take half a decade from architectural drawings to planning commission permission to steel girders emerging from a big hole in the ground. Conventional wisdom is that no matter what the economic circumstances at a given time, it’s always better financially to complete the building–even if oversupply is brewing–once girders are visible.

If the New York Times article I referenced yesterday is correct (I have no reason to believe it isn’t) Albany is aiming to encourage the creation of even more office space on the west side of Manhattan as part of a renovation project around Penn Station. Apparently with large subsidies. Pre-pandemic, this might have made some sense. New capacity wouldn’t be available until late in the decade. And the overarching idea–to attract ever more businesses into NYC–makes more people and firms subject to state and local taxes, and boosts local shopping, eating and entertainment venues.

As I wrote yesterday, in this process older buildings with fewer amenities are the big losers. The new office buildings need a critical mass of tenants so people will feel safe working there and so local service firms will open up in the neighborhood. They get this result in part by offering low initial rents, low enough to lure tenants away from older buildings.

The second is secular, at least potentially. At issue is whether, after three years of remote work, to what degree will businesses revert to the pre-pandemic status quo, with all employees coming back to work in person, five days a week, in the old office. This isn’t 100% clear.

I think the most striking vote against a return to past practice is coming from large, sophisticated real estate investment companies’ They’ve begun to default on workplace mortgages, in effect returning the collateral (an older office building) to the lender. In other words, these savvy real estate people have concluded that rental income won’t ever be high enough again to pay off the mortgage. To my mind, defaulting implies that the decision isn’t a close call, either. It may be that new capacity is the culprit, but I can’t recall having seen what’s happening now in the US before, either here or abroad.

My guess, and that is all it is, is that office workers who have, say, followed the artist community away from NYC to the Hudson Valley or eastern Pennsylvania now own property, and have an easier lifestyle and a much lower cost of living. They’re not eager to go back.

A first thought is that, if I’m correct, older buildings will be converted into residences. Experiments are happening right now. The more recent the building vintage and the bigger the structure, however, the harder, and more expansive, this will likely be. The issues: windows that don’t open; lack of windows in the center; insufficient water, sewage, electricity infrastructure.

real estate and the US stock market

Real estate is very important for the US economy. There’s comparatively little direct stock market exposure, however. This is in contrast with most other major world stock markets, where real estate development and real estate investment firms have major index weightings. In smaller, but historically important, markets like Tokyo, Hong Kong and Singapore, real estate has overwhelming influence.

Perhaps as a result of this, the US finance literature on real estate that I read in business school and over the first ten or fifteen years of my investing career (after which I stopped) was underwhelming The basic idea was the real estate was the king of asset classes. The reasoning? …real estate produces not only a larger return than other asset classes but much smaller volitility of return (the academic measure of risk) than stocks or bonds.

How embarrassing for the finance PhDs who wrote this–and who presumably never owned a house or an apartment. As any homeowner soon becomes aware, real estate transactions dry up in an economic downturn. There are few potential buyers, because they can’t get financing at a reasonable price. No one wants to sell in a downturn, either, at the steep discount the few active buyers will demand. So there are basically no transactions. The academic world of the 1980s-90s dealt with this lack of liquidity and the resulting dearth of actual price data by ignoring it, and assuming that prices remained at their boom time highs. This false assumption of price strength during downturns is at the root of the academic coronation of real estate as a superior investment.

The real world has always known better.

There are a number of listed homebuilders in the US stock market, as well as hotel companies. And of course there are REITs. But most exposure is indirect–financial institutions that service borrowers with real estate collateral or whose investment arms manage real estate portfolios for others; or building materials, equipment or maintenance providers.

Around the world, prime office space in urban centers has been regarded as the best–highest-return and most secure–type of real estate investment. That’s followed by upscale hotels and resorts (the main drawback here is sensitivity to the business cycle), with commercial real estate and housing bringing up the rear.

The factors favoring prime office space are:

–tenants are typically large, financially sound corporations

–contracts are for large amounts of space and usually extend for five years+

–landlords can mitigate risk by staggering the lease periods for different tenants

–the amount of available class A urban space is usually limited

–moving costs for tenants are high, and alternatives usually limited

–pre-pandemic, overall demand for office space has been rising, making existing projects increasingly valuable.

There is business cycle movement within office space. Typically during expansions, demand for office space expands from the city center into the outskirts of a city, but contracts back toward the center during recessions. And the overall long-term movement has been expansionary.

The peak of a cycle is typically marked by the completion of a mega- project, like Hudson Yards in Manhattan right now, that supplies massive amounts of new office space into a market that is levelling off and just about beginning to contract.

I was listening to a Bloomberg interview of the owners of Hudson Yards over the weekend. Management spoke of huge demand for office space in the complex. The New York Times tells a somewhat different story and points out that NY state is proposing large increases in office space around Penn Station, a few blocks away. What the HY owners didn’t talk about is the other big variable in evaluating real estate, the rental rate. Typically during a downturn, office buildings may keep the official rental rate unchanged. But they either offer deep discounts or other offsets like rent-free periods to lower the effective rental rate to induce tenants in older buildings to trade up.

The overall effect is that while the prime areas may do little more than break even, older buildings, especially in marginal areas, get clobbered. Some may never recover and will need to be repurposed. One issue is that it may be prohibitively expensive to convert bespoke office space into residences (the traditional solution).

The elephant in the room, of course, is the reluctance of remote workers to return to the office.

more tomorrow