Sunday, December 4, 2011

Growth & Value: Buyers and Sellers Disagree

In my periodic conversations with formerly successful fund managers, I am struck with a comparison to that wonderfully broad comic television program from the 1970s,“Fawlty Towers.” The essence of the program was a depiction of the “Peter Principle” at work in a small seaside hotel. The somewhat disdainful employees who filled the roles of hotel manager, desk manager, and chef all graduated, perhaps too quickly, from entry level jobs. In their roles they assumed the attitudes of what they perceived to be the deportment of professional hotel personnel, with some very humorous (but sad) results.

The formerly successful portfolio managers that I speak with mouth the same platitudes that they attribute to Warren Buffett and others, as well as their own statements of years ago. While these antics are amusing on the screen, they are tragic for the investors in the formerly successful funds.

Repetition doesn’t make it true today

Almost all of these managers vehemently proclaim that they are growth or value or somewhere in-between investors. These are wonderful banners that masses of investors march under, but have little practical meaning today. While all investors want to grow their capital, particularly after inflation and taxes, the original concept of growth investing as articulated by Thomas Rowe Price, Jr., and others in the 1930s was to invest in companies which produced earnings that grew faster than the economy (market). As no one wants to invest in securities that have questionable worth, value investing is buying something at a discount to a readily identifiable value. Contemporaries with Mr. Price, Ben Graham and Dave Dodd (my old Security Analysis professor) focused on securities with large discounts from current values. At its base level, they were speaking of liquidating value, which is why their initial focus was on buying bonds priced way below their value in liquidation. Warren Buffett, a student of Ben Graham, evolved these two approaches to look for investments that were selling well below their future or intrinsic value.

The apparent message from “The Market”

These formerly successful managers are trumpeting how “cheap” current prices are. The principal suppliers of this ammunition come from the sell-side brokers, academics trapped in the past, and talking heads desperate to find encouragement in an effort to hold on to their shrinking audiences. Why don’t the dumb investors and professional buy-side institutional investors accept the “cheap” argument and commit to current prices? As usual the answer is reflected in the numbers. Buyers are not accepting that stocks have as low price/earnings ratios and price/book values as the sales-side trumpets.

Why not?

There are two main reasons for this buyers’ strike. The first is faulty math. One of the very first things that Professor Dodd taught was not to accept published financial statements as a sole basis for making judgments. We spent hours on reconstructing these statements before applying any valuation issues. First, we focused on removing from the balance sheet any asset that was not readily saleable at the stated value. These would include inventories, real estate, goodwill, and intellectual property. In addition, we learned that liabilities are often understated, particularly in what could go wrong. Warren Buffett would add to the balance sheet the brand name value and the deepness of “the moat” that protects the proprietary value. (While these are not easy to calculate, some attempt is needed. Often this is called acquisition analysis which sub-divides into two categories; one for financial buyers and one for operating buyers.) The whole area of real estate utilization requires careful analysis. One needs to look at not only the current value reflected on the books, but also to ask, “are there any sweetheart arrangements with controlling interests that are giving the company a break on costs; or the other way around, with the company in effect paying a selective dividend by overpaying for the use of some property owned by insiders?” In addition, for many organizations with a large number of branches or offices, some of their leases are a competitive advantage in terms of key locations; some were signed during higher rent periods. In many companies this is too important an area not to be carefully examined.

One of the repeated fallacies that I hear from formerly successful managers and pitching analysts, is that if one deducts the cash on the balance sheet, the stock is selling at a very low ratio to its historic price/earnings ratio. This is doubly naïve. First, in many cases 80% of the cash is overseas and there could be lots of taxes to be paid on repatriation. In addition, a good bit of the cash hoard is a requirement of various lenders, buyers, and suppliers. The second naïveté is that when the cash is brought back to the home country, there would be a measurable benefit to the common shareholder. Unfortunately this is not always the case. The current fad with managements is to use the cash to buy back their own stock, disagreeing about the value of their stock with the market. The big advantages of the buyback are to help the management. First, it reduces the float of somewhat disgruntled shareholders, making a raid on the company more difficult. Second, by reducing the balance sheet equity, the management’s ‘incentive’ contracts, (based on return on equity) become easier to achieve. The third “tout” point is that the money could be used for acquisitions. Because so many acquisitions fail, both entrepreneurs and investor should ask, “will the deal ultimately build or destroy value?"

After unfortunately determining that they can not use all their excess cash, the more responsible managements increase their cash dividends, which often are tax effective and useful for the endowment-type shareholders who have grant responsibilities. (We manage the investments of several grant-making foundations where dividends are important.)

Turning to the income statement, a lot more work is needed before one should accept the bottom line net income number. Starting with the revenue components, it is important to understand how and when revenues are recognized. (There is a lot more leeway than many investors realize and there are differences in how competitors report.) Often the next quarter after the annual statement is full of changes from the last annual report, particularly on revenue recognition and the use and value of inventories. The whole topic of “other income” requires study as to the changing nature of its components, particularly if a portion of this revenue comes from lending money to clients either directly or through leases. The value of other income revenue may be different than the value that careful analysts put on sales. On the expense side, the largest single element is often compensation. Is compensation reflected correctly, i.e., what does it really cost to get these people to work for the shareholders? Balance sheet footnotes and proxy statements often give a different or at least an expanded picture on compensation. In my experience as CEO, the cost to continue or terminate employment is often very much higher than the last year’s compensation line on the income statement. Other expenses also need to be reviewed as to their reasonableness from an owners’ point of view.

After all of this work one can get a good approximation of current realistic book value and current earnings power. This is another place where the bulls get it wrong.

The future is not the past retold

Your past travels are not a sound predictor of all of your future travels. The same can be said as to the value of a stock, a portfolio of stocks, and the gauge of a manager’s skills. I manage a separate account investing in financial services stocks for my family and a few selected other clients; in doing so I look at the world through the eyes of the interaction between the financial services segments and the “real world.” The financial service sectors are the roads where capital changes hands and through very careful use of operating and financial leverage, that capital should grow. One of the problems facing investors in general is that the financial sector is shrinking. Due to the combination of operating losses from the use of unwise leverage and increased rearward-looking regulations, the earnings power of the sector has been reduced. This translates to fewer salespeople raising capital for new needs or capital transfers. Until the financial sector leaders figure out new ways to grow, one would expect that the general level of market valuation may well suffer. Further, bank leaders must deal with the realization that the many former ways they earned significant returns are no longer possible. Outside of the financials, other sectors have also changed dramatically, e.g., book publishing and selling.

What does this all mean?

One should not expect to find good investments by applying unexamined financial ratios to historical data.

What I am looking for in managers?

The first thing that I am looking for in a manager is a discipline of detailed, current security analysis, not a record of parroting the past. Normally too much turnover of stock positions leads to poor long-term performance, particularly on an after-tax basis. Today however, I would favor managers that increased turnover to repopulate their portfolios. I would like to see new names, with new stories based on new field work. Like other investors, I want to see new, sound merchandise.

Note: I would also like to replace “growth” and “value” with more accurate terms.
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