Sunday, April 13, 2014

Shallow Investment Pitches Lead to Strike Outs

Book value may not be valuable...Changes in reported earnings per share is not growth...Putting into practice fund selection...Where are we now?


I am focusing today on the kinds of “elevator comments” that one hears in the lift (to use the British expression) designed to lead to a purchase of particular stocks or funds. Often the pitcher is pushing growth or value securities based on published corporate numbers and current prices. Some of these pitch people earnestly believe that given a simple numerical relationship and current prices is all that an investor needs to know to make a good decision. These are very much the kinds of people that Benjamin Graham and David Dodd warned about in their seminal tome Security Analysis. At this particular time in the market investors are weighing what to do following what has been successful tactics of buying on dips. Or in contrast, using any rally as a good time to lighten up their portfolios. They should judge whether they are happy with the quality of the supporting research.

Book Value may not be valuable

Occasionally one hears that a stock or a portfolio manager should buy a stock or a fund that is selling at prices below stated book value. In our consumer society nothing sells more easily than saying it is available at a discount. All too often what is being said is that the current price is below the last published book value, without any discussion of what comprises book value. Book value, as most of readers know is a single per share number that encompasses the net worth of the company as stated on the balance sheet. The accountant’s job in preparing a balance sheet is to look at the historic costs of the assets purchased reduced by periodic deductions for the use of the assets and to portray the known debts owed to determine the net worth. 

One of the first things that Professor David Dodd taught me was to reconstitute the balance sheet for current investment purposes. This would exclude all elements of goodwill, raise questions as to the immediate value of elements of inventory, machinery, buildings among other items. Further, future liabilities for taxes and pensions (including tenure when appropriate) would quickly reduce the quick sale value of the company. In periods of rapid price changes and accelerating technological changes old assets may lose value very abruptly. In today’s world the costs of bank branches is probably not worth the prices reflected on most bank balance sheets. This is not always the case. One of my successful investments was in a chain of local cigar stores. In Manhattan, where I grew up, in almost every neighborhood  “high street” to use the British term for retail commercial thoroughfares, these cigar stores had prime corner store locations. As tastes were changing, smoking cigars were in a steep decline so were the operating earnings of the company which did not have much debt outstanding. All of the local shops were in long-term leased space.

When the company finally recognized the inevitable collapse of its business, its prime real estate locations were of considerable value so that when the company liquidated the shareholders were richly rewarded. Many current investors are hoping that will be the future pattern for Sears and Kmart. When a stock that has a reasonable following of qualified analysts is selling at a steep discount to book value or for banks in terms of net tangible value, I believe that the current market price for the common shares is probably more representative of value than book or tangible value. On the surface things sell in relation to where they are currently perceived. However, because liquidation is a long process discounts of 25% from book value is not unreasonable for a negotiated multiple year liquidation. Thus, book value to me is the beginning of the conversation in the elevator not the end.

Changes in reported earnings per share is not growth

Besides selling at a discount for book value the other main “elevator pitch” is growth. “This year earnings will be up 15% and more next year, with that kind of growth the stock should sell for at least 10% higher than today’s price,” is the way the story goes. Again a competent analyst will look at the composition of the expected growth to determine the value that should be ascribed to the shares.

In a recent communication to Deutsche Bank’s US fund holders it showed the composition of its expected 2014 earnings growth for US, European and Japanese companies. In the US, they expect a 9% gain with 3% coming from buybacks and no profit margin improvement; for European stocks they are looking for earnings gains of 12%; and 13% for Japanese companies. In each case they are looking for very low buybacks and a 3.4% margin expansion in Europe and 1.5% in Japan. The analyst in me would not give any growth credit for buying back shares which benefits management more than long-term shareholders who would prefer reinvestment into expanding businesses. Thus I would look to a possible growth increment for US stocks, if their estimates hold up, of only 6%. Considering that both European central bankers and those in Japan are trying to introduce more price inflation into their cyclically depressed economies I do not value at face value the expected margin improvement in Europe and Japan. These brief analyses do not show any increase in the level of risk undertaken, but as Jamie Dimon has said and proven, risk is inherent in their business and I would suggest in all businesses to some extent. Further if the economies are expanding risk appetite will likely expand as well. For JP Morgan effective risk management is a top priority I am not sure that it is an equal concern in most companies.

On a longer-term basis earnings growth will be dependent on whether the companies are serving continuously growing markets and the pace of disruption. There are at least two disrupting trends that will change the dynamics of future earning progress. 

The first is the concept of walk up business for bank branch locations. Banks are redesigning their branches into smaller footprints  which will be more sales stores offering assistance with automated devices may be a way to defeat the newer financial organizations which have no branches. A number of formerly retail clothing locations are increasingly relying on the web as their main sales outlet. Both of these trends have significant implications for mall operators. 

The second trend (which will take a somewhat longer time to be important) is the global energy deflation in terms of costs. Not only is this based on the increased use of natural gas but also more productive sourcing of oil and possibly newer forms of energy. This may well be recognized now as utilities are the only major equity sector that is up on a year to date basis, +8.9%. Because much of utility earnings are regulated the lower cost of energy will lead to savings for their larger customers and possibly to their retail customers.

Putting all into fund selection practice

Again I have two suggestions. The first is to address the accounting issue head on. I am sure that there are a number of analysts who are skilled at reconstituting balance sheets and income statements. One that we have used is Charles Dreifus of Royce Associates, a subsidiary of Legg Mason* who regularly takes deep dives into stocks for both his Small Cap and Multi-cap funds. These are funds that are organized for long-term investors.
* Owned by me personally and/or in a private financial services fund I manage

A second approach which we have practiced for some of our managed accounts in building a portfolio of mutual funds is dependent upon a willingness to accept different performance leadership at different times during the cycle. In its simplest form funds are picked because of their value orientation the way a strategic buyer would look at the underlying holdings, for example secular growth funds that utilize the cyclicality of growth around a positive trend, and funds that are focusing on disruptive products, services, and sales procedures. The art form is modifying the weight of the three components based on client risk appetite.

Where are we now?

As regular readers of these posts know I have been concerned about a forthcoming peak market followed by a significant decline. Up until mid March I did not see the elements of a final parabolic rise that I believed was a precondition for a major decline. I was wrong looking at the market in terms of major aggregates; e.g., Dow Jones Industrial Average rather than sectors and subsectors for incredible performances for major over-valuations. There are ten Biotech companies whose stocks are selling 1000 times current sales. Internet retailers are selling at 5.7 times their current stock prices whereas the S&P 500 is selling at 1.6 times current prices according to a recent column by Jason Zweig in The Wall Street Journal. I am using price/sales as a measure to avoid dealing with questionable accounting or the absence of current profits. This last week we have seen a measurable decline in these extended issues. Only future history will tell us whether these price movements are sufficient to declare a peak in the entire market. If we have experienced a top, the fall is likely to be on the order of 15-20% for the general market, not the supposed once in generational drop of 50% or more as we saw in 2008. The key to watch is whether the subsequent recovery picks up volume and speculators who think of themselves as investors start discounting rosy projections for the latter half of this decade. When and if this does happen it will meet the enthusiasm requirement for a peak.

Question for the week:
How enthusiastic are you on your accounting proficiency?

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