evaluating management: Donald Trump and real estate

Last year Forbes published an analysis by James Elkins, a professor in the finance department at the University of Texas, that concludes Mr. Trump has underperformed the average real estate professional in the US by a whopping 57% over his career, despite the boost to returns he achieved by maintaining almost twice the average amount of financial leverage.

The results are highly tentative.  Prof. Elkins uses a REIT index as a proxy for overall real estate returns.  He also employs Mr. Trump’s statement of his starting net worth and the Forbes $4.5 billion estimate of his 2016 wealth (the 2017 estimate is $1 billion lower).

On the industry benchmark, my experience with real estate moguls, mostly outside the US, is that the returns on their private real estate investments are generally higher than those they achieve in their publicly traded vehicles.  In Mr. Trump’s case, his net worth also includes his considerable earnings as a reality show star, as well as the potentially positive effect of debt forgiveness through bankruptcies.

In short, the 14.4% annual return on equity Elkins uses for the industry is probably too low and the 12.5% return he figures for Trump is too high.

 

My question is what the returns on capital are in the Elkins example.

According to Elkins, REITs have an average debt to equity ratio of about 30%.  This means they have a mix of roughly three parts equity, one part debt.  Assume that their average cost of debt has been 8%–a figure that seems reasonable to me but which I’ve just plucked out of the air.  If so, their 14.4% return breaks out into roughly a 12.5% return on capital (actually operating real estate ventures) and 2% from using financial leverage.

This calculation implies that Mr. Trump’s 12.5% return breaks out to something like 9% from real estate and 3.5% from financial leverage.

At first glance, the difference between a 14.4% annual return and a 12.5% return doesn’t seem like much.  Prof. Elkins’ point is that over a career being a relative laggard adds up.  In this case, it translates into having $4.5 billion instead of $23 billion.  Mine is that the numbers flatter Mr. Trump’s planning and management skills, which fall even more deeply below the average in the real estate industry than his overall results.

(5/20/19. Note:  the consensus today is that Mr. Trump never had assets anywhere near the Forbes figure and that in real estate, he added no value–doing little more than preserve in real terms the capital he inherited from his family.  That is, the idea that he made a fifth of the return of the average real estate magnate–and perhaps a tenth of what the best did, he appears to have made nothing.  Even so, that’s without factoring in the personal lifeline he may have received from security holders of his ill-fated Atlantic City casinos.

Together with the tax returns published by the New York Times, the picture that emerges is of a brilliant self-marketer, who has been able to recast the reality of a singularly maladroit businessperson.  Again, even this assessment may prove too flattering, if there is any substance to the money laundering allegations that are now surfacing.

One more thing:  I’ve taken a second look at my return calculations and revised them slightly.  None of my conclusions change:  Mr. Trump’s performance comes out slightly worse than before.)

 

 

evaluating management: return on capital

equity capital

Yesterday, I wrote about return on equity, as it applies to a company that uses only this form of capital, i.e., has no long-term borrowings, no financial leverage.

debt capital

In most places, companies are allowed to employ debt capital in their long-term operating plans as well as equity.

Opinions differ as to whether this is a good idea or not.  Americans tend to approve, on the idea that debt is a cheaper form of capital than equity; investors in the UK and Europe tend to disapprove–arguing that debt is a more expensive form of capital than equity.  In the Islamic world straight debt is not allowed.

My chief comment is old saw that “leverage works both ways;”  that is, during an economic expansion it’s most often a return booster, while in bad times it can be an albatross around the firm’s neck.

example

Let’s say a company goes public by selling 1000 shares at $10 each.

Once it’s public, it issues $10,000 worth of ten-year bonds with a 5% coupon.

Now it has $10,000 in equity and $10,000 in debt.

Let’s say it invests all the money in projects that produce a $2000 annual return. (For simplicity’s sake, let’s make the (unrealistic) assumption that the money is all raised and invested in projects that are instantly up and running on January 1st).  Let’s also ignore taxes.)

At the end of year 1, the firm has earned $2000.

return on capital

Its return on capital is:  $2000 ÷ ($10,000 debt + $10,000 equity = $20,000), or 10%.

return on equity

Its return on equity is:  ($2000 – $500 in interest = $1500) ÷ $10,000 equity  = 15%.

return on leverage

Let’s define another term, return on leverage, as the return on equity minus the return on capital.  In this case, the return (to equityholders) on (or from) leverage is +5%.

Why do so?   Why in the form of a simple subtraction?

As to the form, the sole reason is because it is a simple thing to figure out.

I think it’s important to break down the returns a management is producing for shareholders into two components to quqntify how good it is at two different management skills–how company operations are being run (return on capital) and how those returns are being supplemented by shrewd use of debt financing (return on leverage).

I say “supplemented” because in a well-managed business the lion’s share of the returns will come from operations.  Returns from leverage will be the icing on the cake.

Looked at in a different way, what conclusion should we draw if most of the returns come from leverage?  One worry is that the firm’s management doesn’t have the necessary operating skills to be successful and is substituting aggressive risk taking with company financing to cover up for this deficiency.

For example:

Suppose the company described above earns $1200 in year 1.

That’s a 6% return on capital.

The return on equity is ($1200 – $500) ÷ $10,000 = 7%.

The return on leverage = 1%!  This is trouble, because the company is barely covering the cost of its borrowing.

A worse case:

The company earns $400.

The return on capital is 2.5%.

The return on equity is ($400 -$500) ÷ $10,000 = -1%

The return on leverage is -1% -2.5% = -3.5%.  This is a disaster.

 

More tomorrow.

 

 

evaluating management: returns

One of the most straightforward ways of evaluating how a company management is doing is by looking at the returns it achieves on the money it invests on behalf of shareholders.  Like most things in finance, this starts out as a very simple task, but soon enough adds refinements that make the evaluation process look a lot more complex than it actually is.

We’ll start with return on equity.

initial equity

A new company forms and sells 1000 shares to investors at $10 each, for a total of $10,000.  It invests all of that money one January 1 of its first year.

During that year it earns $1000 in net income.

Its return on equity for year 1 is 10% ($1000/$10,000).  At this point it has no long-term debt, so its return on capital (capital = equity plus long-term debt) is also 10%.

equity grows

If the company pays no dividends, it now has $11,000 in equity (capital, too) at the beginning of year 2.  To maintain a 10% return on equity (and capital) it must earn $1,100 in year 2.

book value

The total amount of equity a company has to invest is also called “book value,” because it’s the value of the equity entry on the company’s financial records (books).

All other factors being equal, a company whose management achieves a high return on equity tends to trade at a premium to book value.  One that continually produces sub-par returns tends to trade at a discount.  The financial sector in particular, because it’s hard to figure out the tons of transactions that the big firms routinely execute, tends to trade on price to book.

 

Tomorrow, adding debt to the picture.

Snap (SNAP) non-voting shares (iii)

forms of capital

Traditional financial theory separates a company’s long-term capital into two types:

–debt capital.  This is money the firm has borrowed, either through bank loans or company-issued bonds.  Creditors may have influence over company operations through restrictions spelled out in the loan documents, called covenants.  They generally specify measures to accelerate loan repayment that the company must take if it fails to meet stipulated profit or cash flow measures.  (An example:  the firm may be forced to devote all cash flow to loan repayment if profits decline sharply.  Money can’t be spent on things like capital improvements or dividends unless creditors give the ok.)

–equity capital.  Equity means ownership.  Common stock ownership is typically established by the means equity owners have to assert/protect their interests–usually the ability to vote on appointment of members of the firm’s board of directors.  The board, in turn, hires and evaluates management.

Some companies may also issue preferred stock.   Preferreds qualify for their name because they have some advantage, or preference, over common.  The typical preferences are: higher/more secured dividend payment; and/or priority over common equity in liquidation proceedings.  On the other hand, preferreds typically either have restricted/no voting rights.  In the US, preferreds, despite the equity in their name, typically trade as if they were a form of corporate debt.

SNAP non-voting shares

Where do the SNAP shares fit in this scheme?

They’re clearly not debt    …but are they equity?

They are certainly not traditional equity.  They have no ability to exercise any influence on company operations, and certainly no way to replace an underperforming board of directors.  On the other hand, they don’t appear to have any of the greater security of preferreds.  In fact, they seem to be a hybrid that combines the riskier features of both.

The closest I can come, in my past experience, to US non-voting shares like SNAP’s (or Google’s for that matter) are Korean preferreds and Italian certificates of participation.  In both cases, they traded well in up markets but underperformed very signficantly during market declines.

 

using book value as an analytic tool

historical cost

Generally speaking, all of a company’s balance sheet data are recorded at historical cost (adjustments for currency fluctuations for multinational firms are he only exception I can think of this early in the morning).

book value

If this accurately reflect’s today’s values, and sometimes this can be an IFthen

…book value is an accurate indicator of the market value of shareholders’ ownership interest in the firm.

asset value

That means that price/book (share price divided by book (shareholders equity) value per share) can be an indicator of over/undervaluation.  In particular, if a company’s shares are trading below book, then it could potentially be broken up and sold at a profit.

management skill

We can also use return on book value (yearly net profit divided by book value) as a way of assessing management’s skill in using the assets it controls to make money.  This can be a particularly useful shorthand in the case of, say, financial firms, which tend to have fingers in a lot of pies and to disclose little about many of them.

Notes:

–price/book is not a linear or symmetrical measure.

On the one hand, a basic tenet of value investing is that when the return on book is unusually low either the company’s board or third parties will force change.  So weak companies may trade at smaller discounts to book than one might think they deserve.

On the other, strong performing firms will likely trade at premiums to book.  However, the amount of the premium will depend both on the state of “animal spirits” and more sober judgments about the sustainability of above-average results.

return on book vs. return on capital.  Return on capital is the same kind of ratio as return on book and has the same intent–to assess how well management is using the assets it is entrusted with.  The difference is that ROC factors in any long-term debt a company may have.

Return on capital is defined as:  (net profit + after-tax interest expense) divided by (long-term debt + shareholders equity).

Return on capital and return on book value are the same if a company has no long-term debt.  Return on capital is typically lower than return on book if a company has long-term borrowings, debt capital usually costs (a lot) less than equity capital.

using return on capital

ROC and the spread between ROC and ROB can be important.  We should think of ROC as the profitability of the business enterprise and the difference between it and ROB as the return on financial leverage.

For instance, for a given firm, the ROC may be 10% and the return on book (equity) 15%.  The difference, 5 percentage points, is the result of “financial engineering,” or the leveraged structure of the company.  Those figures may be ok (and, for the record, I’m not against leverage per se).  But if the ROC is 2% and the ROB is 12%, virtually all the profits of the firm come from financial leverage–not from the underlying business.  That’s a risky situation, in my view–one that owners should be aware of.

More tomorrow.

 

 

 

 

 

return on equity vs. return on capital: two important indicators

In a post a few days ago, I wrote about return on equity,  which is a standard measurement of the skill of the management of a company whose stock we might consider owning.  Services like Value Line provide statistical arrays for companies–and for the industries they’re a part of–that have these calculations,and a bunch of others, already done.

Today I want to add an important refinement–return on capital.

two forms of capital

Corporations have two sources of investment capital available to them.  One is equity, which is ownership interests in the firm that the corporation sells to shareholders.  The other is debt.  Debt comes is two flavors:  bonds issued by the company or bank loans that the firm takes out.

Debt holders have a call on corporate cash that’s superior to shareholders’.  On the other hand, as creditors, debtholders have no ownership rights. So, other than if the firm is in dire financial condition, they have no say over corporate operations.

Why take on debt?

It’s easier to raise capital this way, under normal circumstances.  Also, Americans, if no one else, believe that debt is a cheaper form of capital–meaning that shareholders can gain extra return by using it.

On the other hand, financial leverage (which is what having debt is typically called on Wall Street) brings risks with it.  So it’s important for investors to distinguish in a potential investment’s returns the portion that comes from employing capital in the company and the part that comes from using debt.

where return on capital comes in

Return on capital measures the first; return on equity measures the first plus the second.  Subtracting return on capital from return on equity gives return on financial leverage (a term I made up; the number doesn’t have a common name), or return from capital structure/financial engineering.

a simple example

1.  Let’s assume that a company has 100 units of equity and that it’s in a business where investing that 100 creates 100 units of annual sales (these numbers aren’t realistic; their virtue is simplicity).

Let’s also say that the company will earn 20 units of earnings before interest and taxes (ebit) from those sales.   We’ll also say that the company pays tax at 35%.

The income statement looks like this:

sales       100

ebit          20

tax at 35%    (7)

net income       13.

return on equity =   net income ÷ shareholders’ funds   =   13   ÷    100   =  13%.

2.  Same company, but it has borrowed 100 units of debt capital @ 5% interest.

sales       200

ebit          40

debt interest    (5)

tax at 35%        (12.25)

net income      22.75

return on equity  =  22.75  ÷  100    =    22.75%.

A huge difference!!

defining return on capital

return on capital  = (net income + aftertax cost of debt)   ÷  (total capital, i.e. equity + debt)

The aftertax cost of debt:  in the US, and in many other places, interest expense is deductible from otherwise taxable income.  The tax break is:  interest expense times the tax rate.  The aftertax cost of debt is:  interest expense – the tax break.

In our case, the aftertax cost of debt is 5 -1.75, or 3.25.   Return on capital = ( 22.75  + 3.25)  ÷  200 =   13%.

results

In this example, the unleveraged company earns a return of 13% on its invested capital.  This is the return that the company’s management can achieve from operating the business.  This may be good or it may be bad   …depending on the industry and the competition.

The leveraged company produces the same return from the business.  But it amplifies this by 9.75% by using a lot of debt capital.  (By the way, the tax system encourages this behavior by allowing a writeoff of interest costs as a business expense.)

The important thing to recognize is that leverage alters the risk profile of the business, in two ways:

–the principal amount of the debt must eventually be repaid.  If the debt is a bank loan, it could be subject to a repayment demand on extremely short notice, and

–a downturn in sales will squeeze profits for the leveraged company more than for the unleveraged, since the interest expense remains a constant.  In my experience, the negative effects of leverage working against you are much more severe than this simple example suggests.

return on equity (II): cleaning up a mess

a company as a project portfolio

Every company can be seen as a collection–maybe a portfolio–of investment projects, each with its own risk and return on investment characteristics.  This is not the only way of looking at a business.  And it’s probably not the best way, as the ugly collapse of the conglomerate craze in the US during the 1960s illustrates.  Nevertheless, looking at the business as a project portfolio highlights an issue that the top management of a firm can face.

the BCG growth/cash matrix

One common way of sorting projects  is to use the growth/cash generation matrix invented by the Boston Consulting Group in the 1960s: stars = high growth, high cash generation cash cows = low growth, high cash generation questions marks = high growth, low cash generation dogs = low growth, low cash generation. loaded with canines What do you do if you’re a company with a boatload of dogs?  ..or just one really big dog. To see the issue clearly, let’s simplify: –let’s say that equity is your only source of funding (no working capital or debt), and –let’s say you have only two projects, with 100 units of equity invested in Project 1, which earns 20/year, and 100 units in Project 2, which earns 1/year. the problem: the sterling 20% return on equity of Project 1 is obscured by the near breakeven status of Project 2. The overall return on equity for the company of 10.5%. Why is this bad? Wall Street loves high return on equity–and loathes low return.  And the computer screens that even many professional investors use to narrow down the vast universe of available stocks into a more manageable number to investigate will toss a company like this on the reject pile.  So you’ll be overlooked. What should management do? The possibilities: 1.  eliminate inefficiencies in Project 2 and in doing so raise the ROE to a respectable figure 2.  if that’s not possible, sell Project 2 to someone else who, mistakenly or not, thinks he can do #1 3.  close Project 2 down and write the equity off as a loss, or 4.  divide the company in two, and either (a) spin Project 2 off as a separate entity (that is, give it to shareholders) or (b) gradually sell it to the investing public.

cutting to the chase

Let’s skip down to #4, since what we’re ultimately concerned with is what motivates a company to create a REIT.

why #4?

How can a company get into a situation where solution #4 is the best alternative? In my experience, this almost always involves long-lived assets, where the investment is big, and a company puts all the money in upfront, in the hope of getting steady income over 20 or 30 years.  Examples: a chemical plant, container ships, hotels, or mineral leases. One of two things happens –either the company soon discovers it has wildly overpaid for the assets, or –some unforeseen change, like technological change or a sharp increase in input prices, alters the economics of the project in a fundamentally negative way.

two forms of cash generation

Any project generates cash in two ways: –a return of the capital invested in the project, and –profits. In describing Project 2 above, I said it produces 1 unit of profit per year.  But that profit is after subtracting an expense of, say, 5 as depreciation and amortization. D&A are ways of factoring into costs the gradual wearing out of the factory, the machines or the other investment assets that are used in making the project’s output. In the case of a motel, D&A is a charge for the gradual deterioration of the structure over the years, until the building is too shabby to be used any more and must be razed and rebuilt.  Similarly, big machines either wear out or become technologically obsolete. The key fact to note is that depreciation and amortization aren’t actual outflows of cash–they’re inflows.  But they’re classified as return of capital, not as profit.  (I think this make sense, but I’ve been analyzing companies for over 30 years.  Don’t worry if it doesn’t to you.  Fodder for another post on cash flow vs. profits, and why it makes a difference to investors.)

In the case of Project 2, the actual cash inflow is probably 6/year (depreciation and amortization of 5 + profit of 1).  That’s a 6% yield.  But it’s also a millstone around the neck of the company that launched the project.  It’s return on equity–a key stock market screening factor–will be depressed for as long as it owns the project. On the other hand, to an income-oriented buyer a yield of 6 units/year for the next 20 years is nothing to sneeze at.  At a price of 85, the yield would be an eye-popping 7%.

this has happened before

In the early 1980s, T Boone Pickens, a brilliant financial engineer if no great shakes as an oilman, wildly overpaid for a number of oil and gas leases in the Gulf of Mexico.  Once he realized these properties would struggle to make back his initial lease payment and would never make money, he repackaged them as a limited partnership and spun it off. Around the same time, Marriott did the same thing.  It made a similarly unwise decision to build a number of very expensive luxury hotels.  When bookings started to come in, the company saw the properties would provide large cash flow–but never any profits.  So it rolled them all up into a limited partnership, which it sold to retail investors. In both cases, management “repurposed” assets to emphasize their cash generation characteristics rather than their lack of profitability.  Both also used a tax-minimization structure to enhance the assets’ attractiveness to income-oriented individual investors. REITS do the same thing. More tomorrow.