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