why buying is the key decision for value investors

Value investors like to describe themselves as buying companies worth $1 for, say, $.20 and selling them for $.80.  Less ambitious practitioners say buying for $.30 and selling for $.70.   But the idea is the same–buy at a deep discount, sell at a slight discount.

What remains unexpressed, but what’s crucial for value investors, is that the firm in question is not being assessed on any pie-in-the-sky future developments, but on an evaluation of what the company as it stands now is worth.

Three types of situations get value investors particularly excited:

–periods of general stock market undervaluation,

–overall business cycle slumps, or specific industry group declines, when the market fears that an (inevitable) upturn won’t happen and decides to unload the underperforming stocks into the market for whatever they can get, or

–companies that are industry laggards and which would fare far better if run by more competent managers.

In a sense, all of these situations involve temporarily damaged goods.

In each case, value investors also have plenty of data for figuring out what normal or reasonable prices for now-undervalued companies should be.  The data might be projections from past industry or economic cycles about how far earnings might rebound during an upcycle and how far price earnings multiples might change (usually expand).  In the case of badly run firms, the comparison is with healthy companies in the same industry.

In every instance, however, it’s a relatively straightforward thing to set a target price–what the company would be worth in better times.

The more difficult question is at what price to buy.

Investors will certainly demand a premium, say, 20% or 30%, for taking the risk of making a purchase while a business may be doing badly or while the overall market is cringing in fear.

Beyond that, value investors seem to me to fall into two types:

–those who are willing to buy at what they consider a rock-bottom price, regardless of the near-term outlook, and

–those who are waiting to see an initial ray of sunshine, or a “catalyst,” that convinces them that the worst is past.

In the first case, the skill is in judging the bottom.  In the second, it’s finding the turn upward before the market in general does.  But in both cases, it’s the decision to buy that’s the key to success.

 

 

 

 

comparing growth and value styles

 

Growth                                                        Value

stock volatility high                                   low

character aggressive                                   defensive

upside high                                                    limited

downside can be high                                 low

firms have very bright future                  cheap assets

outperforms bull market                         bear market

benefit from market greed                      market fear

(sell high)                                                       (buy low)

uncertainty extent of rise                        timing of rise

portfolio size 50 issues                            100

 

All this is leading up to talking about why buying is the crucial step for value investors, selling the most important for their growth counterparts.

growth vs. value test: my answers

The growth stock investor’s answer:  Joe’s, of course.  Why?  I pay $18 for the stock now.  At the end of five years, earnings per share will likely be $2.70.  Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.

Look at Bill’s in contrast.  I pay $10 for the stock.  At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here).  Assuming the stock keeps the same multiple, it will be trading at $16.10.  Add in the dividends and the total is $18.60.  That’s a return of 86%, or about half what I would get from holding Joe’s.

One more thing.  Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate.  As a result, the p/e multiple could begin to contract.  Maybe that will happen, maybe not.  But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.

The value stock investor’s answer:  It’s obviously Bill’s.  Joe’s has a much more aggressive  growth strategy.  Maybe it will work, maybe not.  I don’t see why I have to decide.  A lot of the potential reward for success is already built into Joe’s current stock price.  And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.

If Joe’s strategy doesn’t work, then I’m much better off with Bill’s.  On the other hand, suppose it really is the way to go.  In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change.  And the stock will skyrocket.  While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.

It’s a question of temperament.  A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.

Maybe the most salient points to be made about each answer are:

–not that many companies grow so rapidly as Joe’s without any hiccups;

–wresting control from an entrenched management is not that easy (look at the sorry history of  Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation).  It may not be possible, and could be a long and arduous process in any event.

testing for style–growth investing vs. value investing

Yes, I was supposed to be writing about trading.  But I figured it might be useful for readers to figure out whether they tend to like growth stocks or value ones before going further.  Here’s a test I heard about while I was at a value-oriented shop in the early 1990s (it’s a rerun of a one of the first posts I wrote in 2009.  Try not to look back to see the answers, which will appear again tomorrow.):

The Rules

I’ll describe two companies.  Both are retailers, operating in the US and selling identical merchandise.  They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.

Both have first year sales of $1,000,000.

Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.

Therefore, both have first-year earnings of $100,000.

Each firm is publicly traded and has 100,000 shares outstanding.  Earnings in year 1 are $1/share for both companies.

Money reinvested in the business is currently generating $2 in sales for every $1 invested.  There’s no lag between the decision to invest and the generation of new sales.

Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.

Earnings and cash flow are the same (just to keep it simple).

Company 1:  Bill’s Stuff

Bill’s management wants to take a conservative approach to a new business.  It decides that it will:

reinvest half of its cash flow back into the business,

pay a dividend of $.50 a share ($50,000/year),

keep any remaining cash in reserve in a money market fund.

So,  in year 2 Bill’s generates $1,100, 000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income.  It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.

Let’s assume the company can continue to operate in this manner for as far as we can see.  Then, the company’s investment characteristics are:

10% earnings growth rate

$.50 dividend payment

no debt; small but growing amount of cash on the balance sheet

Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.

Company 2:  Joe’s Things

Joe’s management believes that expansion opportunities are extraordinarily good right now.  It decides that it will:

reinvest all the company’s cash flow back into the business,

borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.

In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000.  After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..

For year 3, Joe’s can borrow another $4,500 and does so.  Therefore, it reinvests $126,900 in the business.  It generates about $1,500,000 in sales and ebit of $225,000.  After interest and tax, net income is about $149,000 ($1.49/share).

Assuming that Joe’s can continue to expand in this manner indefinitely,  the company’s investment characteristics are:

22% earnings growth rate,

modest and slowly-rising bank debt,

no current income.

Let’s assume Wall Street is willing to pay 18x current earnings for the stock

The question:   Which one would you buy?

Answer tomorrow.

Berkshire Hathaway and Kraft

A little less than a month ago, Warren Buffett’s Berkshire Hathaway and Heinz (controlled by Brazilian investment firm 3G) jointly announced a takeover offer for Kraft.  The Associated Press quoted Mr. Buffett as asserting “This is my kind of transaction.”  I looked for the press release containing the quote on the Berkshire website before starting to write this, but found nothing.   The News Releases link on the home page was last updated two weeks before the Kraft announcement.  Given the kindergarten look of the website, I’m not so surprised   …and I’m willing to believe the quote is genuine.  If not, there goes the intro to my post.

 

As to the “my kind” idea, it is and it isn’t.

On the one hand, Buffett has routinely been willing to be a lender to what he considers high-quality franchises, notably financial companies, in need of large amounts of money quickly–often during times of financial and economic turmoil.  The price of a Berkshire Hathaway loan typically includes at least a contingent equity component.  The Kraft case, a large-size private equity deal, is a simple extension of this past activity.

On the other, this is not the kind of equity transaction that made Mr. Buffett’s reputation–that is, buying a large position in a temporarily underperforming firm with a strong brand name and distribution network, perhaps making a few tweaks to corporate management, but basically leaving the company alone and waiting for the ship to right itself.  In the case of 3G’s latest packaged goods success, Heinz, profitability did skyrocket–but only after a liberal dose of financial leverage and the slash-and-burn laying off of a quarter of the workforce!  This is certainly not vintage Buffett.

Why should the tiger be changing its stripes?

Two reasons:

the opportunity.

I think many mature companies are wildly overstaffed, even today.

Their architects patterned their creation on the hierarchical structure they learned in the armed forces during the World War II era.  A basic principle was that a manager could effectively control at most seven subordinates, necessitating cascading levels of middle managers between the CEO and ordinary workers.  A corollary was that you could gauge a person’s importance by the number of people who, directly or indirectly, reported to him.

Sounds crazy, but at the time this design was being implemented, there was no internet, no cellphones, no personal computers, no fax machines, no copiers.  The ballpoint pen had still not been perfected.  Yes, there were electric lights and paper clips.  So personal contact was the key transmission mechanism for corporate communication.

Old habits die hard.  It’s difficult to conceive of making radical changes if you’ve been brought up in a certain system–especially if the company in question is steadily profitable.  And, of course, the manager who decided to cut headcount risked a loss of status.

Hence, 3G’s success.

plan A isn’t working  

One of the first, and most important, marketing lessons I have learned is that you don’t introduce strawberry as a flavor until sales of vanilla have stopped growing.  Why complicate your life?

Buffett’s direct equity participation in Kraft is a substantial departure from the type of investing that made him famous.  I’ve been arguing for some time that traditional value investing no longer works in the internet era.  That’s because the internet has quickly broken down traditional barriers to entry in very many industries.  It seems to me that Buffet’s move shows he thinks so too.

 

 

 

 

value investing, American-style–riskier than it seems

First, my usual caveat when I write on this subject.  I’m a dyed-in-the-wool growth stock investor.  But I my initial training was as a value investor.  And I practiced that craft for my first eight years in the business.  (Then I began to research mid-cap Pacific Basin stocks in earnest.  They had, at the time, a unique combination of extremely low valuations and unusually high growth.  After a couple of years of owning these hybrids I woke up one day and realized I had morphed into a growth stock investor.) Since that time, I’ve worked side by side with value colleagues for most of the rest of my career, though.

Growth investing is all about finding situations where a company is likely to expand its profits much faster than the consensus expects, and/or at an above average rate for much longer than the consensus believes.  It’s about where the company is going, not where it is now.

value investing

Value investing, in contrast, is all about where the company is now.   It’s about finding companies whose equities have been beaten down excessively by overemotional holders who have abandoned ship because of temporary earnings disappointment.  This disappointment can come from any number of causes.  Common ones include:  highly cyclical companies entering the down part of their business cycle, a big misstep by a normally competent management, or flat-out terrible corporate managers.

As an astute former value colleague put it, “There are no bad businesses, only bad managers.”  Put another way, there is enduring worth in a company’s tangible (think:  factories and inventories) and intangible (think: brand names, market positioning) assets that persists despite whatever earnings disappointments the firm may be experiencing at present.

In the first two causes I cite, time will cure the earnings deficiency.  Wayward shareholders will rediscover their zeal for the name and bid the stock price up aggressively.

But what if the management is genuinely awful?  In this case, value investors believe that the incompetents will be shown the door and be replaced by more highly skilled individuals.  The board of directors may do this, because, after all, that’s their job.  Or shareholders may demand a change.  (Fat chance of either of these happening, in my view.)  Or–and this is particularly American–either activist investors or hostile acquirers will swoop in and force a change.

two risks

As far as I can see, this last American idea–that justice will be served and the bad management tossed out–is valid in the US, but almost nowhere else.  Just look at the experience of activist value investors over the past quarter century in Japan or in continental Europe.  Yet, oddly enough, otherwise rational American value investors try the same tactic over and over, each time in the expectation of a different result.

This risk has been around for a long time.  The second hasn’t.

One of the deep underlying assumptions of value investing is that a company’s assets have an enduring economic worth, despite current headwinds.  All we need is some spark, some catalyst that will enable this worth to shine through.  And we can wait, since the value of accumulated assets is unlikely to deteriorate.

This is the sense behind the observation that a stock is trading at a discount to book value–that is, to the total sum of the assets the company owns, after subtracting out anything it owes to the rest of the world.  Calculations of “book” are based on the actual historical cost of acquiring the assets, which very often understates (usually by a lot) what it would cost to replace them.

Two new, still poorly understood, threats to this view:  the internet and Millennials.

Take suburban shopping malls as an example.  Millennials, at least more affluent ones, seem to like to live in cities, not the suburbs.  Internet shopping has reached the point where retailers are openly saying (they’ve probably secretly know this for much longer) that they have too much mall retail space.  Who to sell it to?

In other words, demographic/technological change is accelerating.  This increases the chance that balance sheet assets are writeoffs waiting to happen rather than “straw hats in winter,” needing only a change of season to flower.

 

growth investing and “The Investment Answer”

Yesterday I skimmed the short but valuable book The Investment Answer, by Goldie and Murray.  The late Mr. Murray was an institutional salesman for a number of brokerage firms;  Mr. Goldie is a fee-only investment adviser.

The book, which I think is well worth reading, contains lots of financial planning basics, laid out in clear, simple language.   The first chapter, which deals with the traditional registered representative, is particularly good.

The only real quarrel I have with The Investment Answer is the chart it contains which asserts that value investing generates higher returns than growth investing.  This is a common belief, reinforced by numerous academic studies which claim to “prove” this.

I think this claim is just wrong.

But I had a long, and relatively successful career as a growth stock investor, so of course I’m going to think this.

Worse than that, however, I suspect that demographic and technological change are undermining the fundamental pillars of the traditional value investing style.

About those studies–

–the typical procedure is for an academic to take a universe of stocks, say the S&P 500, and divide it into two parts.  The “value” part will consist of stocks with the lowest price-earnings ratios, lowest price-to-cash-flow ratios and lowest price-to-book-value ratios, all based either on historical data or on consensus Wall Street estimates (in the case future-oriented information is also used).  Put another way, these are the cheapest stocks, based on consensus beliefs.  The “growth” part will be everything else, meaning all the expensive stocks.

The studies then show that the cheap stocks perform better than the expensive ones.  What a surprise!?!

What’s wrong here?  It’s the definition of value vs. growth.  The studies assume the difference is between two mutually exclusive groups separated from one another using a single set of rules.

The reality is that growth and value are not mutually exclusive.  They’re two different ways of looking at the investment world.

The growth investor looks for stocks where he believes the consensus view is mistaken, either by underestimating how fast earnings will grow and/or how long this superior earnings performance will last.  A growth investor may hold many stocks that the academic classifies as “value” (think: the AAPL of a few years ago);  there are many that the academic classifies as “growth” that no self-respecting growth investor would touch with a ten-foot pole.

Why don’t growth investors kick up a fuss about this academic nonsense?  It’s not in their best interest.  Why show your trade secrets for everyone to see?  That would just make your job harder.

More tomorrow.