back to talking about value investing

badly-managed companies

A highly-skilled former value colleague of mine used to say that there are no bad businesses–there are just bad companies.  What he meant was this:  let’s call any revenue-generating activity as a business; when revenue generation establishes a desire for a product or service, there is always a way to make a profit.  What stands in the way is most often bad management, although it might also be a poor configuration of assets.  (There are also highly cyclical firms, which are typically viewed through lenses that are too shortsighted, and firms that have temporarily stumbled.  Let’s put cases like those aside for now.)

 

In the US, it is legally and culturally acceptable to call bad companies into account.  This is usually done either by replacing management or by causing the company to be sold and returning the proceeds to shareholders.

Because of these factors, it makes sense to hold the shares of firms where the share price is substantially below asset value, even if the company is doing poorly.

As reader Alan Kaplan points out in a comment to last Thursday’s post, however, change is occuring at such a rapid rate in the current globalizedl and Internet-connected economy that it’s more difficult to make an assessment of how much assets are worth than it was when the tenets of value investing were being laid down almost a century ago.

a plummeting stock

Anyway, I recently noticed a holding that was sinking like a stone in a fund I’ve recently taken a small position in.  The stock is down about 60% over the past year in a market that’s up by 16%.  The portfolio manager, who doesn’t seem to have had much of a plan where this company is concerned, managed to lose two-thirds of his (i.e., my) money before kicking the stock out.

Seaspan?

The stock in question is Seaspan (SSW), a container ship leasing company.

My first reaction was to think the stock should never have been in a portfolio, based on the industry it’s in.  My experience of shipping is that it’s a snake pit of public subsidy and private double dealing in which an outsider like me will be lucky to escape with any of the clothes on his back.

On the other hand, my experience is also that people who are as horribly wrong about buying a stock as the pm I mentioned above end up also being horribly wrong again when they sell it.  I used to console myself when I was in this position by thinking that the stock would never bottom as long as I held it, so, yes, I was helping new buyers by selling–but I was helping my portfolio as well.  In any event, the last bull capitulating is usually an important positive sign.

SSW is now trading at $6.67.  Book value is $16+.  The dividend has recently been cut but the stock is still yielding 7%.  By the way, that’s not a good thing, in my view.  My preference would be for the payout to have been eliminated entirely, but I’m willing to give management the benefit of the doubt.

I’m still working myself through the financials.  There are potential issues with new ships now being built that SSW has contracted to buy but has as yet found no one to lease them.  There’s also the worry that existing customers will return ships before charters end and simply refuse to pay amounts still owed.  On the other hand, there’s some chance SSW will be able to refinance its existing debt.  And to some degree–not a great degree, but some–book value for older vessels is underpinned by the ability to sell them for scrap.

In sum, this is high-risk deep-value stuff that I would never recommend anyone else should consider.

Still, I’m surprised and intrigued to find a–to me, at least–plausible value story in such an unlikely place.

 

 

 

 

revisiting (again) value investing

As regular readers will know, I’m a growth stock investor.  That’s even though I spent my first six years as an analyst/portfolio manager using value techniques almost exclusively–and then worked side by side with a motley crew of value investors for a ten-year period after that.

One way of describing the difference between growth and value is that:

–growth investors know when potentially price-moving news will happen (that is, when quarterly earnings are announced) but are less sure what that news will be

–value investors know what the news will be (if they’ve done their job right, they’re holding stocks where the market has already priced in every possible thing that could go wrong.  All they need is one thing to go right).  However, they may have little idea when good news will occur.

 

Each style has an inherent problem:

–for growth, it’s hard to find rising earnings during an economic downturn

–for value, it’s possible that a long time (say, two years) may pass before any of a portfolio’s diamonds in the rough are discovered by the market.  In that case, the manager will likely be fired before the portfolio pays off.  His/her successor will either reap the rewards of the predecessor or will dismantle the portfolio before any good stuff can occur.

 

At times, I do buy what I conceive of a value stocks.  Intel when it was $19, trading at 8x – 9x earnings and yielding almost 4% (I’ve since sold most of what I own) is an example.  But deep value investors would scoff at the notion that this is truly value.

 

For some time, I’ve been maintaining that value investing has lost its appeal in the 21th century.  Two reasons:

–the stronger one is that the shelf life of physical plant, traditional distribution networks and brand names is no longer “forever” in a globalized, Internet-driven world.  So buying companies that are rich in such assets but not making money is much, much riskier today than it used to be.  Such assets can erode in the twinkling of an eye.

–a weaker claim would be that while there are still value names, it’s hard/impossible to fill out a portfolio of, say, 100 of them, which is the traditional value portfolio structure, in today’s world.

 

I’m rehashing the growth/value debate here because I’m thinking the stronger position isn’t as unassailable as I’ve believed.

More tomorrow.

 

Snap (SNAP): non-voting shares (ii)

Two potentially important issues arise with non-voting shares.  The underwriters and prospective investors in SNAP are clearly not worried about them.  Granted, they’re unlikely to emerge as actual issues in the near future, but here they are:

–value investors often buy shares in companies they believe are undervalued by virtue of  having bad management.  Their rationale is that management will change in one of several ways:  existing managers will learn from past mistakes and improve;  the board of directors will replace existing managers with better ones; shareholders will vote out current directors and replace them with better ones; the company will be taken over by a third party, which will toss out the incumbents and replace all of them with more competent individuals.

In the case of SNAP, management, the board and the voting shareholders are basically one and the same.  The likelihood of them firing themselves is pretty small.  And the chances of a hostile takeover are zero.  So the value investor argument for eventually buying SNAP shares that there’s a level below which they can’t go without triggering change of control doesn’t apply here.  So if things turn south with SNAP, the chances of rescue are small.

The results of this situation are plain to see in the Japanese stock market, where disenfranchised shareholders have had to watch their investment in family-owned company shares lie dormant for decades.

–change of control can happen voluntarily.  But does an acquirer have to buy non-voting shares in order to take the reins?  I don’t know.  But I don’t think the answer is clearly “Yes.”  Say Amazon decided to bid for the voting shares of SNAP at double the price of the publicly traded, non-voting ones.  AMZN could presumably then replace management and the board of directors and guide the company in any direction it chose–without buying a single non-voting share.  If this were to happen, my guess is that non-voting shares would plunge in value.  Years of expensive legal wrangling  would decide the issue one way or the other.

A third musing:   Can SNAP declare dividends for voting shares but not for non-voting?  The answer should be in the prospectus, which I haven’t read carefully enough to have found out.  But then I’m not interested in taking part in the IPO.

value investing and mergers/acquisitions

buy vs. build

When any company is figuring out how it should grow its existing businesses and potentially expand into other areas, it faces the classic “buy or build” problem.  That is to say, it has to decide whether it’s more profitable to use its money to create the new enterprise from the ground up, or whether it’s better to acquire a complementary firm that already has the intellectual property and market presence that our company covets.

There are pluses and minuses to either approach. Build-your-own takes more time.  The  buy-it route is faster, but invariably involves purchasing a firm that’s only available because it has been consigned to the stock market bargain basement because of perceived operational flaws.  Sometimes, acquirers learn to their sorrow that the target they have just bought is like a movie set, something that looks ok from the outside but is only a veneer.

when the urge is greatest

Companies feel the buy/build expansion urge the most keenly at times like today, when they are flush with cash after years of rising profits.

so why isn’t value doing better?

Many economists are explaining the apparent current lack of capital spending by companies by arguing that firms are opting in very large numbers to buy rather than to build.

The beneficiaries of such a universal impulse should be value investors, who specialize in holding slightly broken companies that are trading at large discounts to (what value investors hope is) their intrinsic value.  Growth investors, on the other hand, typically hold the strong-growing companies with high PE stocks who do the acquiring.

On the announcement of a bid, the target company typically goes up.  The bidder’s stock, on the other hand, usually goes down.  That’s partly because the bid is a surprise, partly because the target is perceived to be priced too high, partly simply because of arbitrage activity.

All this leads up to my point.

Over the past couple of years, growth investing has done very well.  Value has lagged badly.  How can this be if merger/acquisition activity continues to be large enough that it is making a significant dent in global capital spending?

 

 

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.