Tag Archives: finance

extreme agency issues

November 13, 2015 By in agency problem, Portfolio management Tags: , , , , Leave a comment

The agents that we as shareholders hire to act for us can hurt us in a number of ways:

securities fraud

The 21st-century poster child here is Enron, which created the appearance of earnings growth by fabricating lots of energy trading profits.  A generation ago, the leading name would have been Equity Funding, an insurance company that had a division that made up people it “sold” insurance to.

Many times, such cases are hard to detect, since management has either corrupted or bamboozled its auditors, on whose yearly inspections of  a company’s financial accounts we, as investors, crucially depend.  There’s not much we can do to defend ourselves from fraud, other than to try to have an ear for market rumors and a nose for implausibility.

managers who do really stupid things

The name C. Michael Armstrong comes to mind.  As CEO of ATT, he attempted to diversify the company away from the Plain Old Telephone business.  By my count, however, he masterminded $100 billion worth of dud acquisitions that ultimately drained the company of its ability  to morph into something else (this “performance” earned him a seat on the board of Citigroup, however).

Then there are pets.com, whose signature achievement was its sock puppet mascot, and the gaggle of companies that all leveraged themselves to the sky to create gigantic fiber optic networks–all operating during the Internet Bubble.

 

I don’t think the Valeant Pharmaceuticals story has yet unfolded completely.  The company, a hedge fund favorite, has come under fire for acquiring mature drugs and raising their prices by huge amounts.  The attack on this practice by, among others, Charles Munger, a long-time associate of Warren Buffet, as “deeply immoral” has caused the stock price to plunge.

 

Mylan, a new twist

Drug maker Mylan completed a tax inversion early this year that transformed its country of incorporation from the US to the Netherlands.

In April it made use of a provision of Netherlands law to create a trust, called a stichting, supposedly staffed by completely neutral parties but arguably controlled by company management.  It issued the trust an option to buy new shares equal to all those previously outstanding, at a price of one euro cent each.  It then used this device to fend off a takeover bid, unwanted by management, from Teva Pharmaceuticals.

Subsequently, Mylan defended its actions by saying it had moved to the Netherlands because the US is “too shareholder-centric.”

In addition to the ability to create a stichting, moving to the Netherlands appears also to have insulated the board of Mylan from the possibility of removal by shareholder vote.

It appears to me that Mylan reincorporated in the Netherlands with the intention of disenfranchising shareholders.  In a highly technical sense what Mylan has done may be legal, although media reports suggest the SEC is investigating whether the company adequately disclosed to shareholders what it was doing.  Nevertheless, Mylan’s actions seem to me to be a massive breach of the bond of trust that should exist among business partners.  I’m not sure what the consequences will be.  I can’t imagine, though that they’ll be good for Mylan’s stock, or that any other US-listed company will be able to reincorporate into the Netherlands.

the agency problem

November 12, 2015 By in agency problem Tags: , , , , , Leave a comment

principal – agent

The principal – agent relationship arises when one person, the principal, hires someone else, the agent, to act on his behalf in some matter.

agency problem

The agency problem is that the agent may have a different set of economic interests from the principal and may act on them rather than do the best thing for the client.

examples

Studies seem to show that real estate agents behave differently when they sell their own houses than when they sell for a client.  Working for themselves, they take more time and achieve higher prices.  This is also the issue in the current discussion about whether brokerage financial advisors should be fiduciaries, that is, whether they should have a legal obligation to recommend the best investments for their clients.  At present, they aren’t   …and don’t.

for us as investors

If we hold shares of the common stock of individual companies, we are in some sense owners of the company.  (Note:  we can also hold shares of stock  in individual companies indirectly by buying shares of ETFs or mutual funds.  We can hold the shares in, say, a 401k account sponsored by our employer, too.  These create further layers of principal – agent relations.  In this post, I’m going to ignore them.)

The chief power we have as shareholder-owners of a company is that we vote to elect a board of directors to act as our agents.  The board, in turn, selects a management team (another set of agents) to run the operations of the company in our behalf.

an aside:  stakeholders

Management hires employees, makes ties with suppliers and customers and may borrow money from a bank.  The group comprised of this wider net of interested parties plus us as principals and the two sets of our agents is usually referred to as stakeholders.

potential stockholder – agent conflicts of interest

the board

Where do board members come from?  The slate we vote for is typically put together by the management of the company.  The list will consist of some members of top management, plus “outside” directors.  This latter group may include retired managers from other companies in the industry, or executives from suppliers or customers.  But it may also contain prominent political, military or academic figures, who have little knowledge of business generally–and still less of the particulars of the company on whose board they sit.

As agents, the board has its own set of interests and priorities.  More important, though, it can easily have a much closer attachment to the management that nominated them than the anonymous group of shareholders who voted for them and are technically their bosses.   And, of course, management may seek rubber stamps instead of gadflies.

If individual shareholders had a problem with the composition of the board, how would they take effective action?

management

Let’s say a CEO has spent 25 years rising to the top spot in a corporation, where he has, say, five years to collect high salaries and bonuses and cash in on stock option awards.

Suppose our CEO sees a severe structural problem with the business, which can be papered over for a while but which will begin to erode market share and profit margins within, say, six years.  The problem can be fixed, but only by a restructuring that will crush profits (and maybe the stock price) for at least the next two years but which will pay huge dividends toward the end of the decade.

What does he do?    …restructure and risk turning his $60 million five-year day in the sun into $25 million, or simply paper over and collect the higher sum?

 

Tomorrow:  the latest twist.

 

 

 

a saturated market

November 9, 2015 By in from growth to value: the life cycle, market saturation, mean reversion Tags: , , , , , Leave a comment

market

Let’s say that a market is the total of all actual and potential customers for a product or service.

saturation

A saturated market is one where virtually every potential customer has been turned into an actual one.  At that point, sales gains for a given company can only come from:

–the (slow) growth of the population,

–replacement demand (which can be stimulated by the creation of new versions),

–the sale of maintenance or accessories, or

–taking market share away from competitors.

effect on sales and profits

As a company’s products approach market saturation, sales growth typically slows.  In the terminal phase, expanding as fast as nominal GDP becomes an aspirational goal.  The competitive environment also changes dramatically in a saturated market.  Sales become more costly to obtain, since rivals’ marketing efforts no longer simply expand the market for everyone, but become specifically targeted at taking sales from competitors instead.  This forces every market entrant to spend even more money to defend its present customers.

effect on the stock price

For a growth stock, which is most often trading at an overinflated price earnings multiple as this growth downshift is occurring, the increasing saturation of key markets is especially problematic.  It typically starts to weigh on the PE long before actual saturation occurs.  ESPN, the largest source of earnings for Disney (DIS), and Apple (AAPL) are current examples.

examples

AAPL

The AAPL case is straightforward.  The global market for $600 cellphones is almost completely saturated.  The main demographic cohort in the US that still uses flip-phones is the over 60 (over 70?) crowd.  Technically speaking, one might argue there’s still room to grow.   But for every consumer-oriented technological innovation in my career, this group has been especially resistant to change and tough to crack.  AAPL has never gotten much traction in Europe.  There’s lots of domestic competition in greater China.  The result of worries about an end to growth is the principal reason AAPL shares trade at a sub-market multiple.

DIS

Several years ago, ESPN attempted to expand abroad–a clear signal that it regarded the US market for sports entertainment broadcasting to be saturated.  It was unsuccessful.  Since then, as I see it, DIS has been redirecting cash flow from ESPN to expand its parks and movies businesses.  To my mind, this is the sensible course of action for it.  For a one-product company, which many growth companies tend to be, this is not an option.

 

Tomorrow:  saturation in the e-commerce market in China

3Q15 for Tesla (TSLA); do an extra 4,000 cars make a difference?

November 5, 2015 By in Autos, earnings conference calls, Stock ideas Tags: , , , , , , , Leave a comment

Yesterday, TSLA shares were up by 11% after reporting an in-line quarter the night before.  This was in a market that was down slightly.

The reason?

The company modified its full-year guidance for production from 50,000 – 55,000 units to 50,000 – 52,000 units.  With 4Q15 almost half over, investors took this new guidance as relatively reliable.  But the key factor is that the guidance, while down, was not the 45,000 – 50,000 that Wall Street had been fearing.

Wild gyrations are a fact of life for highly speculative stocks like TSLA (I own a small position).  That’s not the interesting part.  After all, what sustains the sky-high valuation of the stock is not the current results is the dream that one day the company will be selling millions of units and earning billions.

What is an important investment lesson is the reason that a production difference of around 5,000 cars in a quarter, which sounds like a small amount, should make such a difference to investors.

It’s all about cash burn, or the question of how long a company that ‘s using more cash than it’s taking in can sustain itself without turning cash flow positive.  This also happens to be one of the few things in a “dream” stock that’s important and that we can know for sure.

 

In the TSLA case, the firm realized–at the start of 2015, in my view–that the multi-billion dollar bond offering it made in 2014 wouldn’t be enough to sustain it until it began to generate more cash than it used.  Contact with investment bankers resulted in a spate of glowing reports being issued by brokerage house analysts–and then a $750 million stock offering.  What investors has been panicking about a few weeks ago (and may begin to worry about again;  who knows?) is that this extra three-quarters of a billion dollars might not be enough.

If we figure that a fully loaded Tesla retails for $100,000 ( figure I just plucked out of the air), a shortfall of 4,000 cars translates into a cash shortfall of $400 million.  So, “Poof!,” half the cash cushion created by the recent equity offering is gone.  (I’m assuming that everything else for TSLA remains the same, which is probably too pessimistic.  But the exact dollar amount isn’t the point.)

Arguably, TSLA could simply issue more stock or bonds to raise extra cash.  However, if TSLA were actually seen to be needing a loan, the terms it could expect to get would probably not be as favorable as before.  Another offering so soon after the last equity raising would also risk shattering the investor “dream” of the inevitability of TSLA’s success.

TSLA now expects to turn cash flow positive during 1Q16.  This does not imply that it will be cash flow positive for the entire quarter, or for the quarter as a whole.  Instead, it means that it will begin taking in more money than it spends by March 31st at the latest.  We’ll know more when Tesla reports 4Q15.

falling sales, rising profits…

November 4, 2015 By in activist investing, activist invstors, Discounting, falling sales, growth vs value, rising profits, stock market Tags: , , , , , , , , Leave a comment

…are usually a recipe for disaster on Wall Street.  Yet, in the current earnings reporting season, a raft of companies are reporting this presumably deadly combination   …and being celebrated for it, not having their stocks go down in flames.

What’s happening?

the usual situation

First, why falling sales and rising profits don’t usually generate a positive investor response.

To start, let’s assume that a company reporting this way is maintaining a stable mix of businesses, that it’s not like Amazon.  There, investor interest is focused almost solely on its Web Services business, which is small but fast growing, and with very high margins.  AWS is so valuable that what happens in the rest of the company almost doesn’t matter.

Instead, let’s assume that what we see is what we get, that falling sales, rising profits are signs of a mature company slowly running out of economic steam.

So, where does the earnings growth come from?

Case 1–a one-time event.  Maybe the firm sold its corporate art collection and that added $.50 a share to earnings.  Maybe it sold property, or got an insurance settlement or won a tax case with the IRS.

All of these are one-and-done things. How much should an investor pay for the “extra” $.50 in earnings?  At most, $.50.  There’s no reason to make any upward adjustment in the price-earnings multiple, because the earnings boost isn’t going to recur.

Similarly,

Case 2–a multi-year cost-cutting campaign.  AIG, for example, has just announced that it is laying off 20% of its senior staff.  Let’s say this happens over three years, and that the eliminations will have no negative effect on sales, but will raise profits by $1 a year for the next three years.

How much should we pay for these “extra” $3 in earnings?  Again, the answer is that the earnings boost is transitory and should have no positive effect on the PE multiple.  So the move is worth, at most, $3 on the stock price.

Actually, my experience is that in either of these cases, the PE can easily contract on the earnings announcement.  Investors focus in on the falling sales.  They figure that falling earnings are just around the corner, and that on, say, a stock selling for $60 a share, the non-recurring $.50 or $1 in earnings is the equivalent of a random fluctuation in the daily stock price.  So they dismiss the gain completely.

why is today different?

I don’t know.  Although early in my career I believed that earnings are earnings and the source doesn’t matter, I’m now deeply in the only-pay-for-recurring-gains camp.

I can think of two possibilities, though:

–Suppose Wall Street is coming to believe (rightly or wrongly) that we’re mired in a slow growth environment that will last for a long time.  If so, maybe we can’t be as dismissive as we were in the past of the “wrong kind” of earnings growth.  Maybe company managements that are able to deliver earnings gains of any sort are more valuable than in past days.  Maybe they’re on the cutting edge of where growth is going to be coming from in the future–and therefore deserve a high multiple.

–I’m a firm believer that most mature companies formed in the years immediately following WWII are wildly overstaffed.  I also think that even if a CEO were willing to modernize in a thoroughgoing way–and I think most would prefer not to try–it’s immensely difficult to change the status quo.  Employees will simply refuse to do what the CEO wants.  As a result, this makes companies showing falling sales prime targets for Warren Buffett’s money and G-3 Capital’s cost-cutting expertise.  In other words, such companies become takeover targets, and that’s why their stock prices are firm.