Archive for October, 2009

Equity Life Cycle: The Moneyball Approach

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Building a portfolio of stocks is a little like assembling a baseball team. However, unlike a team of real baseball players, constructing a portfolio of stocks can mix low-priced single-A farm players with blue chip Hall of Fame players from the Majors. Billy Beane, the General Manager for the Oakland Athletics, was chronicled in Michael Lewis’ book, Moneyball. Beane creates an amazing proprietary system of building teams more cost-efficiently than his deep-pocketed counterparts by statistically identifying undervalued players with higher on-base and slugging percentages. According to Beane, traditional baseball scouts were overpaying for less relevant factors, such as speed (stolen bases) and hitting (batting percentage).

In the stock world, before you can scout your team, you must first determine where in the life cycle the company lies. If Beane were to name this quality, perhaps he would call it Time-to-Maturity (TTM). Some companies operate in small, mature bitterly competitive industries (e.g. shoe laces), while others may operate in large growing markets (e.g. Google [GOOG] in online advertising and algorithmic search). Some companies because of negative regulation or heightened competition have a very short life cycle from early growth to maturity. Other companies with competitive advantages and untapped growth markets can have very long life spans before reaching maturity (think of a younger Coca Cola [KO] or Starbucks [SBUX]). Like Beane talks about in his book, many young, promising, immature baseball players flame out with short TTMs, nonetheless many scouts overpay for the cache´ such players offer.

Unfortunately, many investors do not even contemplate the TTM of their stock. Buying juvenile stocks (i.e., private companies like Twitter & Facebook – see article) or elderly stocks in and of itself is not a bad thing, but before you price a security it’s advantageous to know what type of discount or premium is deserved. Obviously, I’m looking for undervalued stocks across all age spectrums, however finding an undervalued, undiscovered late-teen just beginning on its long runway of growth combines the best of all worlds. Finding what Peter Lynch calls the “multi-baggers” is easier said than done, like searching for a needle in a haystack, but the rewards can be handsome.

Life Cycle

What creates long runways of growth – the equivalent of winning dynasties in baseball? Well, there are several contributors leading to longer TTMs, including economies of scale, large industries, barriers to entry, competitive advantages, growing industries, superior and experienced management teams, to name a few factors. But like anything, even the great growth companies, including Microsoft (MSFT), turn from teenagers to mature adults. As famed businessman Thomas Brittingham said, A good horse can’t go on winning races forever, and a good stock eventually passes its peak, too.”

There are many aspects to creating a winning team. If Billy Beane were to draw up factors for a baseball team, I’m confident TTM would be near the top of his list. What you pay for the length of the growth cycle is obviously imperative, but since I’m a strong believer in the tenet that “price follows earnings,” it only makes sense that above average sustainable earnings growth should eventually lead to superior price appreciation. As Bob Smith, successful manager from T. Rowe Price states, “The important thing is not what you pay for the stock, so much as being right on the company.” So if you want to recruit a portfolio of winning stocks, like Billy Beane picks successful baseball players, then include the equity life cycle maturity statistic as a factor in your selection process.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management nor its client accounts have no direct position in MSFT, SBUX, KO, Facebook, or Twitter shares at the time this article was originally posted. Some Sidoxia Capital Management accounts do have a long position in GOOG shares. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 15, 2009 at 2:00 am 9 comments

Siegel Digs in Heels on Stocks

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Jeremy Siegel, Wharton University Professor and author of Stocks for the Long Run, is defending his long-term thesis that stocks will outperform bonds over the long-run. Mr. Siegel in his latest Financial Times article vigorously defends his optimistic equity belief despite recent questions regarding the validity and accuracy of his long-term data (see my earlier article).

He acknowledges the -3.15% return of U.S. stock performance over the last decade (the fourth worst period since 1871), so what gives him confidence in stocks now? Let’s take a peek on why Siegel is digging in his heels:

Since 1871, the three worst ten-year returns for stocks have ended in the years 1974, 1920, and 1978. These were followed, respectively, by real, after-inflation stock returns of more than 8 per cent, 13 per cent, and 9 per cent over next ten years. In fact for the 13 ten-year periods of negative returns stocks have suffered since 1871, the next ten years gave investors real returns that averaged over 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all ten years periods, and is twice the return offered by long-term government bonds.

 

Siegel’s bullish stock stance has also been attacked by Robert Arnott, Chairman of Research Affiliates, when he noted a certain bond strategy bested stocks over the last 40 years. Here’s what Mr. Siegel has to say about stock versus bond performance:

Even with the recent bear market factored in, stocks have always done better than Treasury bonds over every 30-year period since 1871. And over 20-year periods, stocks bested Treasuries in all but about 5 per cent of the cases… In fact, with the recent stock market recovery and bond market decline, stock returns now handily outpace bond returns over the past 30 and 40 years.

 

If you’re 50, 60, or older, then Siegel’s time horizons may not fit into your plans. Nonetheless, in any game one chooses to play (including the game of money), I, like many, prefer to have the odds stacked in my favor.

In addressing the skeptics, such as Bill Gross who believes the U.S. is entering a “New Normal” phase of sluggish growth, Mr. Siegel notes this commentary even if true does not account for the faster pace of international growth – Siegel goes on to explain that the S&P 500 corporations garner almost 50% of revenues from these faster growing areas outside the U.S.

On the subject of valuation, Mr. Siegel highlights the market is trading at roughly 14x’s 2010 estimates, well below the 18-20x multiples usually associated with low-interest rate periods like these.

In periods of extreme volatility (upwards or downwards), the prevailing beliefs fight reversion to the mean arguments because trend followers believe “this time is different.” Just think of the cab drivers who were buying tech stocks in the late 1990s, or of the neighbor buying rental real estate in 2006. Bill Gross with his “New Normal” doesn’t buy the reversion argument either. Time will tell if we have entered a new challenging era like Mr. Gross sees? Regardless, Professor Siegel will be digging in his heels as he invests in stocks for the long run.

Read the Whole Financial Times Article Written by Professor Siegel

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

October 14, 2009 at 2:00 am 2 comments

EPS House of Cards: Tricks of the Trade

House of cards and money

As we enter the quarterly ritual of the tsunami of earnings reports, investors will be combing through the financial reports. Due to the flood of information, and increasingly shorter and shorter investment time horizons, much of investors’ focus will center on a few quarterly report metrics – primarily earnings per share (EPS), revenues, and forecasts/guidance (if provided).

Many lessons have been learned from the financial crisis over the last few years, and one of the major ones is to do your homework thoroughly. Relying on a AAA ratings from Moody’s (MCO) and S&P (when ratings should have been more appropriately graded D or F) or blindly following a “Buy” rating from a conflicted investment banking firm just does not make sense.

FINANCIAL SECTOR COLLAPSE

Given the severity of the losses, investors need to be more demanding and comprehensive in their earnings analysis. In many instances the reported earnings numbers resemble a deceptive house of cards on a weak foundation, merely overlooked by distracted investors. Case in point is the Financial sector, which before the financial collapse saw distorted multi-year growth, propelled by phantom earnings due to artificial asset inflation and excessive leverage. One need look no further than the weighting of Financial stocks, which ballooned from 5% of the total S&P 500 Index market capitalization in 1980 to a peak of 23% in 2007. Once the credit and real estate bubble burst, the sector subsequently imploded to around 9% of the index value around the March 2009 lows. Let’s be honest, and ask ourselves how much faith can we put in the Financial sector earnings figures that moved from +$22.79 in 2007 to a loss of -$21.24 in 2008? Current forecasts for the sector are looking for a rebound back up to +$11.91 in 2010. Luckily, the opacity and black box nature of many of these Financials largely kept me out of the 2009 sector implosion. 

WHAT TO WATCH FOR

But the Financial sector is not the only fuzzy areas of accounting manipulation. Thanks to our friends at the FASB (Financial Accounting Standards Board), company management teams have discretion in how they apply different GAAP (Generally Accepted Accounting Principles) rules. Saj Karsan, a contributing writer at Morningstar.com, also writes about the “Fallacy of Earnings Per Share.”

“EPS can fluctuate wildly from year to year. Writedowns, abnormal business conditions, asset sale gains/losses and other unusual factors find their way into EPS quite often. Investors are urged to average EPS over a business cycle, as stressed in Security Analysis Chapter 37, in order to get a true picture of a company’s earnings power.”

 

These gray areas of interpretation can lead to a range of distorted EPS outcomes. Here are a few ways companies can manipulate their EPS:

Distorted Expenses: If a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year. If for some reason the Chief Financial Officer (CFO) suddenly decided the building would last 40 years rather than 10 years, then the expense would only be $250,000 per year. Voila, an instant $750,000 annual gain was created out of thin air due to management’s change in estimates.

Magical Revenues: Some companies have been known to do what’s called “stuffing the channel.” Or in other words, companies sometimes will ship product to a distributor or customer even if there is no immediate demand for that product. This practice can potentially increase the revenue of the reporting company, while providing the customer with more inventory on-hand. The major problem with the strategy is cash collection, which can be pushed way off in the future or become uncollectible.

Accounting Shifts: Under certain circumstances, specific expenses can be converted to an asset on the balance sheet, leading to inflated EPS numbers. A common example of this phenomenon occurs in the software industry, where software engineering expenses on the income statement get converted to capitalized software assets on the balance sheet. Again, like other schemes, this practice delays the negative expense effects on reported earnings.

Artificial Income: Not only did many of the trouble banks make imprudent loans to borrowers that were unlikely to repay, but the loans were made based on assumptions that asset prices would go up indefinitely and credit costs would remain freakishly low. Based on the overly optimistic repayment and loss assumptions, banks recognized massive amounts of gains which propelled even more imprudent loans. Needless to say, investors are now more tightly questioning these assumptions. That said, recent relaxation of mark-to-market accounting makes it even more difficult to estimate the true values of assets on the bank’s balance sheets.

Like dieting, there are no easy solutions. Tearing through the financial statements is tough work and requires a lot of diligence. My process of identifying winning stocks is heavily cash flow based (see my article on cash flow investing) analysis, which although lumpier and more volatile than basic EPS analysis, provides a deeper understanding of a company’s value-creating capabilities and true cash generation powers.

As earnings season kicks into full gear, do yourself a favor and not only take a more critical” eye towards company earnings, but follow the cash to a firmer conviction in your stock picks. Otherwise, those shaky EPS numbers may lead to a tumbling house of cards.  

Read Saj Karsan’s Full Article

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management has no direct position in MCO or MHP at the time this article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 13, 2009 at 2:00 am 2 comments

Timothy Geithner, the Eddie Haskell Dollar Czar

Geithner Haskell

Treasury Secretary Timothy Geithner recently stated after a meeting of G-7 financial officials that “it is very important to the United States that we continue to have a strong dollar.”

With comments like this, why does Timothy Geithner remind me so much of Eddie Haskell (played by Ken Osmond) from the 1950s suburban sitcom Leave It to Beaver? Eddie Haskell plays the scheming trouble maker who is extremely polite on the exterior around adults, but reverts to a crafty conniver once the grown-ups leave the room.

I can just picture the conversations between Treasury Secretary Geithner and President Obama before a high powered meeting with Chinese administration officials:

Geithner: “Barack, the skyrocketing debt will be no problem, we can we shovel plenty of this paper on these Chinese.”

Barack: “Uh, oh…Hu is here for our meeting.”

Geithner: “Oh hello Mr. President Jintao – what a lovely trade surplus you have. We look forward to keeping a very fiscally responsible agenda here in the United States, so you can keep buying our valuable debt.”

Where did Timothy Haskell get his crafty dollar oration skills?

According to David Malpass, president of the research firm Encima Global and deputy assistant Treasury Secretary, Geithner training came from “using a code phrase, a carryover from the Bush administration. It means that the U.S. approves of a constantly weakening dollar but doesn’t want a disruptive collapse.”

These tactics and rhetoric can only work for so long. Exploding deficits and skyrocketing debt levels will eventually lead to a dumping of our debt, rising interest rates, crowding-out of private investments, and a damaging decline in the dollar. Sure, the weakening dollar helps us in the short-run with exports but eventually major U.S. debtholders will no longer buy our sweet talking.

With all the “U.S. dollar is going to collapse” talk, one would think a shift to an SDR  (Special Drawing Rights)  global currency structure is an inevitable outcome. Just six months ago the governor of China’s central bank argued the U.S. dollar’s role as the world’s reserve currency should be restructured. The SDR model has already been implemented by the IMF (International Monetary Fund), so if the Chinese wanted to create an SDR proxy, they could easily purchase euros, sterling, and yen in proper proportions. Would the Chinese want to make any sudden changes? Certainly not, because any quick adjustments would destroy the value of the Chinese’s existing dollar denominated portfolio. The logistics surrounding a legitimate SDR program would require the IMF or some other international agency to act as a global central bank, which would not only need to determine the appropriate mix of currencies in the SDR, but also decide future global liquidity actions. In order to legitimately run a new SDR program, countries like China would need to give up sovereignty – not a likely scenario.

Until a new SDR regime is agreed upon, dollar-reliant countries will continue to have barks bigger than their bites and Timothy Geithner Haskell will continue to sweet talk U.S. dollar owners.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

Hear Eddie (or Treasury Secretary) Speak Here:

October 12, 2009 at 2:00 am 2 comments

Dry Powder Piled High

Flour-Powder

Money goes where it is treated best. Sometimes idle cash contributes to the inflation of speculative bubbles, while sometimes that same capital gets buried in a bunker out of fear. The mood-swing pendulum is constantly changing; however with the Federal Funds Rate at record lows, some of the bunker money is becoming impatient. With the S&P 500 up +60% since the March lows, investors are getting antsy  to put some of the massive mounds of dry powder back to work – preferably in an investment vehicle returning more than 1%.

How much dry powder is sloshing around? A boatload. Bloomberg recently referenced data from ICI detailing money market accounts flush with a whopping $3.5 trillion. This elevated historical number comes despite a $439.5 million drop from the record highs experienced in January of this year.

From a broader perspective, if you include cash, money-market, and bank deposits, the nation’s cash hoard reached $9.55 trillion in September. What can $10 trillion dollars buy? According to Bloomberg, you could own the whole S&P 500 index, which registers in at a market capitalization price tag of about $9.39 trillion. The article further puts this measure in context:

“Since 1999, so-called money at zero maturity has on average accounted for 62 percent of the stock index’s worth. … Before the collapse of New York-based Lehman Brothers Holdings Inc. last year, the amount of cash never exceeded the value of U.S. equities.”

 

Cash levels remain high, but the 60% bounce from the March lows is slowly siphoning some money away. According to ICI data, $15.8 billion has been added to domestic-equity funds since March. Trigger shy fund managers, fearful of the macro-economic headlines, have been slow to put all their cash to work, as well. Jeffrey Saut, chief investment strategist at Raymond James & Associates adds “Many of the fund managers I talk to that have missed this rally or underplayed this rally are sitting with way too much cash.”

With so much cash on the sidelines, what do valuations look like since the March rebound?

“The index [S&P 500] trades for 2.18 times book value, or assets minus liabilities, 33 percent below its 15-year average, data compiled by Bloomberg show. The S&P 500 was never valued below 2 times net assets until the collapse of Lehman, data starting in 1994 show. The index fetches 1.15 times sales, 22 percent less than its average since 1993.”

 

On a trailing P/E basis (19x’s) the market is not cheap, but the Q4 earnings comparisons with last year are ridiculously easy and companies should be able to trip over expectations. The proof in the pudding comes in 2010 when growth in earnings is projected to come in at +34% (Source: Standard & Poor’s), which translates into a much more attractive multiple of 14 x’s earnings. Revenue growth is the missing ingredient that everyone is looking for – merely chopping an expense path to +34% earnings growth will be a challenging endeavor for corporate America.

Growth outside the U.S. has been the most dynamic and asset flows have followed. With some emerging markets up over +100% this year, the sustainability will ultimately depend on the shape of the global earnings recovery. At the end of the day, with piles of dry powder on the sidelines earning next to nothing, eventually that capital will operate as productive fuel to drive prices higher in the areas it is treated best.

Read the Complete Bloomberg Article Here.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

October 9, 2009 at 2:00 am 1 comment

Super Sizing May Be Hazardous to Your Portfolio’s Health

Super Size

You may be familiar with the 2004 Academy Award nominated documentary titled Super Size Me, in which the creator Morgan Spurlock decides to film his 30 day journey of eating McDonalds (MCD) for breakfast, lunch, and dinner, making sure he samples every item on the menu. In addition, any time a McDonald’s employee asked Mr. Spurlock whether he wanted to “Super Size” his beverage or French fry order, he complied by ordering the larger size. What was the result from this gluttonous, month-long, fast food binge?

Mr. Spurlock ended up gaining about 25 pounds in weight, his cholesterol sky-rocketed, his liver function deteriorated dramatically, he experienced heart palpitations, and became depressed, among other symptoms. At one point a doctor told him if he continued overindulging at the same pace, he could die.

Well, over the years, investors, governments, and corporations have been doing their own form of “Super-Sizing,” but not by eating Big Macs, Apple Turnovers, and Fish Fillets, but rather consuming too much debt, real estate, and other risky assets, like stocks and hedge funds. Now, like Morgan Spurlock, investors are “de-toxing” by saving more and creating a better balanced portfolio diet. Investors have learned their lessons from our “Great Recession” and are dieting on lower risk assets  and consuming a broader set of asset classes. An investor’s diet should cover a broad spectrum of options, including diversified choices across asset class, size, style, and geography. Alternative asset classes, like real estate, commodities, and loans should be evaluated as well.

Meal Diversification 

After the massive crash post-Lehman Brothers, many investors and academics have cast doubts about the relative benefits of diversification, arguing there was no investment class or segment to hide – everything fell equally. There is some truth to the argument, with some exceptions like treasuries, cash, and certain commodities. Globalization and the tighter inter-connectedness between countries can shoulder part of the blame of the synchronized freefall in late 2008 and early 2009. Nonetheless, unless you were short the market, even if you were relatively diversified, pain was spread out generously across many investors.

What countless investors fail to recognize is the constant variability in historical relationship data (e.g., correlations, standard deviation, and covariance) – all the better reason to be broadly diversified. Nobel Prize winners Robert Merton and Myron Scholes know first-hand what can happen when you rely too heavily on historical correlations. Their over-reliance on their quantitative models led to the economic collapse of Long Term Capital Management, which nearly brought the entire economic globe to its knees. Importantly, the magnitude of diversification benefit varies throughout an economic cycle. Since the market rebound in March of this year, we have clearly seen the advantages of diversification.

From a geographical perspective, emerging markets like Russia, which is up over +117% (excluding dividends), are trouncing the domestic averages. Diversification benefits across particular industries and sectors are also evident in areas like technology. For example, the NASDAQ and IIX (Internet Index) are up about +34% and +52% in 2009, respectively. In relation to style characteristics, “Growth” is trouncing “Value” as measured by the Russell 1000 Growth and Value benchmarks. “Growth” is up +25% this year, more than double the appropriate Russell “Value” benchmark. It comes as no surprise that the conservative investments that outperformed in the market collapse, like fixed income and utilities, have generally lagged the other segments.

Like Morgan Spurlock, investors need to resist the “Super Size” temptations in their concentrated portfolios and learn from the binging mistakes experienced by others. A more balanced investment diet across asset class, size, style, and geography will lead to a healthier portfolio and steadier return profile. Now if you will excuse me, I would like to get a bite to eat – perhaps a wholesome McGarden Burger.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management has a short position in MCD at the time this article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 8, 2009 at 2:00 am 2 comments

“Pessimism Porn” Takes a Hit – Emotions of Investing

Dark Clouds

“Every dark cloud has a silver lining, but lightning kills hundreds of people each year who are trying to find it.”

–Tongue-in-cheek quote from motivational poster.

There’s nothing like a little destructive global financial crisis to boost viewership ratings. CNBC benefitted last fall from all the gloom and doom permeating the media outlets, but unfortunately for the cable business channel, a more constructive market environment over the last six months doesn’t sell as well as what New York Magazine called, “pessimism porn.” Tyler Durden at Zero Hedge recently provided statistics showing the impact of more optimistic financial markets. CNBC experienced total viewer year-over-year declines of -37% as measured in mid-September – worse than Mr. Durden’s late July statistics that illustrated a -28% decline.

Small wonder that we now see discussions developing between Comcast Corp. (CMCSA) and General Electric (GE) over a potential partnership with the NBC-Universal assets. Other potential parties may enter the fray, but GE’s shopping of the traditional media unit is evidence ofthe station’s pessimism over a secularly declining business.

Businesses are not the only ones influenced by pessimism – so are individuals. Behavioral economists Daniel Kahneman and Amos Tversky have provided support to the impact pessimism has on peoples’ psyches. Emotional fears of loss can have a crippling effect in the decision making process. Through their research, Kahneman and Tversky showed the pain of loss is more than twice as painful as the pleasure from gain. How do they prove this? Through various hypothetical gambling scenarios, they highlight how irrational decisions are made. For example, more people choose the scenario of an initial $600 nest egg that grows by $200, rather than starting with $1,000 and losing $200 (despite ending up at the same exact point under either scenario).

Of course investors have short memories from a historical perspective. Whether it’s the 17th century tulip mania (people paying tens of thousands for tulips – inflation adjusted), the technology bubble of the late 1990s, or the more recent real estate/credit craze, eventually a new bubble forms.

If you are one of those people that get sucked into “pessimism porn” or big bubbles, then I suggest you grab the remote control, turn off CNBC, and then switch over to The History Channel. You may just learn from the repeated emotional mistakes made by those of our past.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in CMCSA, GE, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 7, 2009 at 2:00 am 3 comments

Nation’s CEOs Suffering Severely: Pay Down -0.08%

Cry Baby

Hold on, let me pull out my violin to play some sympathetic consoling music for our nation’s Chief Executive Officers (CEOs). According to a Corporate Library survey of 2,700 publicly traded companies, CEO compensation declined -0.8% in 2008. I guess that 4th Ferrari and 3rd yacht will have to be put on hold. With some creative perseverance and a little elbow grease, I’m sure the class of underprivileged CEOs can still salvage a healthy package of stock options and restricted stock (to pad the paltry multi-million dollar salaries).

This is what Payscale.com had to say in a report from 2008:

“In 1970, CEO salary and bonus packages were typically about $700,000 – 25 times the average production worker salary; by 2000, CEO salaries had jumped to almost $2.2 million on average, 90 times the average salary of a worker, according to a 2004 study on CEO pay by Kevin J. Murphy and Jan Zabojnik. Toss in stock options and other benefits, and the salary of a CEO is nearly 500 times the average worker salary, the study says.”

 

Of course, Congress and the public are looking for scapegoats to blame for the global financial crisis. There is no better group to blame than highly compensated CEOs.  As a result, we are seeing more “say on pay” proposals brought to shareholder votes, thereby removing power from the hands of self-appointed compensation committees and chummy board members. Currently, a Shareholder Bill of Rights Act is making its rounds through Congress that would establish an annual shareholder vote to approve executive compensation of executive management along with have a separate vote on “golden parachute” payments in the context of a company merger or acquisition.

The U.S. is not the only country to implement these types of shareholder rights. As David Ellis at CNN Money wrote, “In 2002, the United Kingdom embraced the practice, and it has subsequently been taken up in Australia and Sweden.” In the U.S. such proposals being considered are on a “non-binding” basis, which means that if “say on pay” is approved there will be no obligation for management to implement the changes – rather “shame” will be the strategic lever used by shareholders.

Everyone has been impacted in one shape or form by the financial crisis, so when you tuck-in your child or lay your head on the pillow tonight, rest assured our poor corporate CEOs are sharing in the pain…just remember, they only kept 99.2% of their pay last year.

Read More About Corporate Library Survey

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

October 6, 2009 at 2:01 am 2 comments

Amazon: Growing Up to be Wal-Mart

Toddler

Wal-Mart (WMT) got its start almost 50 years ago with its first store in Rogers, Arkansas (1962). Since then, the company has expanded to create a global franchise generating more than $400 billion in revenues with a market capitalization valued at about $190 billion. Amazon.com Inc. (AMZN) is a relative toddler (founded in 1995 by CEO Jeff Bezos) generating about $20 billion in revenue with a market cap about 1/5th that of Wal-Mart. Mr. Bezos graduated summa cum laude, Phi Beta Kappa in electrical engineering and computer science from Princeton University in 1986, and we know he has no problem in thinking big. The evidence can be found in his space travel company, Blue Origin, which is expected to initiate human travel in the upcoming years. Beyond space, Mr. Bezos is presented with a multitude of growth opportunities that have the potential of elevating Amazon from a young toddler into a mature adult like its cousin Wal-Mart.

So how does Mr. Bezos get the company through puberty to adulthood? Well actually, all I believe it will take is just more of the same. The company has created an incredible franchise with huge barriers to entry, if you consider the billions spent on the technology, infrastructure, and its distribution dominance as compared to its e-commerce brethren. Bolting on new categories (whether its jewelry, sporting goods, groceries, private label or digital downloads) can be extremely profitable since unlike Wal-Mart, Amazon doesn’t need to build or reconfigure thousands of stores to expand into new categories. For example, Wal-Mart has opened over 600 Sam’s stores nationally in order to target the wholesale club market. Once a new category is added, the blue-print is rolled out nationally and then eventually internationally. And just like Wal-Mart, as economies of scale are achieved, the cost savings are rolled back into lower prices, which then brings more customers, and even more scale advantages. This virtuous cycle then creates deeper and deeper moats separating itself from competitors.

GROWTH OPPORTUNITIES

Besides just the natural expansion of users purchasing more online and Amazon adding to existing categories, here are some other fertile areas for future growth:

  • Amazon Prime (Free shipping membership is driving incremental revenue and usage).
  • Kindle (This digital reader is already estimated to account for 35% of Amazon’s book sales and some analysts see $2 billion in Kindle revenues by 2012).
  • Zappos.com (This acquisition provides instant dominance in shoes and adjacent product lines).
  • International Expansion (Joyco.com acquisition in China is an example of how Amazon is expanding into emerging markets).
  • New Categories (There are virtually limitless potential categories, but the migration to digital will be key).
  • Cloud Computing, Storage & Other Services (EC2 cloud computing, S3 storage, and other outsourced technology services offer promising opportunities).

TREND IS AMAZON’S FRIEND

Source: U.S. Department of Commerce

Source: U.S. Department of Commerce

E-Commerce sales account for only about 3.6% of total retail sales ($32.4 billion in Q2’09), but as you can see from the chart, the upward sloping trend is the friend of Amazon. With the proliferation of broadband and the natural aging of our next generation of computer-savvy internet users, not only is the number of online shoppers increasing, but the amount of time spent online is escalating as well. If you consider catalog sales (e.g. Land’s End, L.L. Bean, Eddie Bauer, etc.) have represented about 7-8% of total retail sales, there is a lot of head-room left for online sales to catch-up or replace these  sales. Mr. Bezos believes online industry sales can ultimately reach 15% of total retail sales (double catalog sales). Top-rate online franchises like Amazon will be natural beneficiaries of these trends and funnel shoppers through their internet aisles, as a function of these demographic and behavioral tailwinds.

CAPITAL ADVANTAGE

Even when you account for the significantly higher revenue growth rates and growth initiatives (e.g., Kindle, E3, digital, etc) for Amazon relative to Wal-Mart, the capital intensity (as measured by CAPEX/Sales) is still about 70% higher for Wal-Mart as compared to Amazon. For one thing, Amazon does not need to support the some 8,100 stores in 15 countries that Wal-Mart is saddled with, and in turn Amazon can redeploy that capital into areas such as new products, services, and lower delivery costs. Surviving the dot-com bubble bursting, along with paying down billions of debt has afforded Amazon even more capital flexibility.

VALUATION

Valuation can be tricky, especially when you’re talking about a high growth company like Amazon. The exercise becomes a little easier once you realize Amazon is generating about $1.5 billion in free cash flow per year, with $4.3 billion in cash/investments on the balance sheet with virtually no debt in the middle of one of the worst recessions in a generation. At roughly $90 per share, AMZN is trading at over 53x’s Wall Street analysts’ projected earnings of $1.68 for 2009. Jeff Bezos and the rest of the management make it very clear the company is managing their business to one key goal – maximize free cash flow per share (music to my ears – see my article on cash flow). On that basis, AMZN trades at about 25x’s trailing free cash flow and closer to 22x’s if you strip out the $4 billion+ in cash on the balance sheet. If AMZN can grow 15% for the next 5 years (not a given), the valuations just mentioned above could be chopped in half, if price levels and share count remained constant.

With the large run-up in 2009, I have locked in some gains this year, but tactically I will be doing what “Deep Throat” advised in the movie All the President’s Men, and that is to follow the money (cash). If Bezos and Amazon can continue on its current growth trajectory in the coming years, this toddler will mature into a company more closely resembling its cousin Wal-Mart.

Wade S. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management and client accounts do have direct long positions in AMZN and WMT at the time article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 5, 2009 at 2:00 am 2 comments

Strong Advice from Super Swensen

Muscle Man

Playing the financial markets is a challenging game, and over the last decade we’ve witnessed events we will never see again in our lifetimes. Through these muscle aches and pains, listening and paying attention to powerful, seasoned industry veterans, like David Swensen, becomes paramount. Mr. Swensen has proven his durability – he has managed the Yale endowment for 24 years and has overseen the growth of the university’s portfolio from $1 billion to $17 billion. For the decade ending in June 2008, the Yale portfolio averaged an incredible 16.3% annual return.

So what commanding advice does Mr. Swensen have to share? Here are a few nuggets regarding equities as discussed in his May interview published in The Guru Investor (TGI):

“With a long time horizon you should have an equity orientation, because over longer periods of time, equities are going to deliver better results,” he says. “If they don’t, then capitalism isn’t working. And we could well be at a point where investments in equities are going to produce returns going forward that are higher than what we’ve seen in the past five or ten years.”

 

I find it difficult to argue with him. Perhaps we still have a ways to go, but the equity markets had an explosion after the 1966-1982 hiatus. Perhaps the 2000-2009 period isn’t long enough to mark bottom, but at a minimum, the spring is coiling based on history.

When it comes to diversification, TGI summarized Swensen’s asset allocation as follows:

“He recommends that investors have 30% of their funds in U.S. stocks, 15% in Treasury bonds, 15% in Treasury Inflation-Protected Securities, 15% in Real Estate Investment Trusts, 15% in foreign developed market equities, and 10% in emerging market equities. As investors get older, they should keep this type of allotment for a portion of their portfolio but begin to decrease the size of that portion, putting part of their portfolios into less risky assets like cash or Treasuries.”

 

Many investors were taking excessive risk in 2008 (within their asset allocations), and they were not even aware. Let’s hope valuable lessons have been learned and investors adjust the risk levels of their portfolios as they age.

David Swensen (Michael Marsland/Yale University)

David Swensen (Michael Marsland/Yale University)

Mr. Swensen has some choice words for the mutual fund management industry as well:

“The problem is that the quality of the management in the mutual fund industry is not particularly high, and you pay an extraordinarily high price for that not-very-good management,” he says. Swensen cites one study performed by Rob Arnott that measured mutual fund performance over a two-decade period. The study found that you’d have had a 15% chance of beating market after fees and taxes by investing in mutual funds — and that includes only funds that were around for the entire period; many other weaker funds didn’t last, meaning the results have a survivorship bias.

 

Tough to disagree, and as I’ve written in the past, I believe there are only so many .300 hitters in baseball (a study in 2007 showed only 12 active career .300 hitters in the Major Leagues – highlighted in my previous Ron Baron article). Outside of baseball, there are consistent alpha generators in the market too. However, I’d make the case that identifying the alpha generators in the financial markets is much more difficult because of the extreme fund performance volatility. Even the best managers can string some bad years together.

Swensen doesn’t stop there. He expands on the reasons behind mutual fund manager underperformance:

Taxes and fees are the big culprits, Swensen says: “Why are the tax bills so high? Because turnover’s too high. The mutual fund managers are trading the portfolios as if taxes don’t matter, and taxes do matter. And they’re trading the portfolios as if transactions cost and market impact don’t matter, and they do matter. And as they trade the portfolios, basically what’s happening is Wall Street is siphoning off its slice of the pie … and that’s at the expense of the investor.”

 

One thing we learned from the real estate and financial bubble that burst over the last few years is that incentive structures were misaligned. Manager compensation, whether you are talking hedge funds or mutual funds, is based on too short a time horizon, and therefore incentive structures encourage abnormal risk-taking. In baseball terms, you have those that take excessive risk and swing for the mega-bucks fences (loose cannons) and the bunters (benchmark huggers) who seek the comfort of “lower” mega-bucks. Swensen is a much bigger believer in passive strategies (as am I), using passive investment vehicles like ETFs (Exchange Traded Funds).

Mr. Swensen continues his critical perspective by targeting investors too:

Individuals and institutions who buy mutual funds “take this mutual fund industry which produces a bunch of products that are not great to start with, and then they screw it up by chasing hot performance and selling after things turn cold.”

 

The 1984-2002 John Bogle data (Vanguard) included in my “Action Dan” article hammers that point home.

Where should investors go now?

Asked what the one recommendation he has right now for investors is, Swensen cited TIPS. “We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation, or at least pretty substantial risk of inflation … down the road at some point,” he said.

 

Ditto, once again – I’m a believer in having some inflation protection in your portfolio. Of course there is no free lunch in the investment world, and so there are certainly some risk factors in Swensen’s alternative investment strategy (e.g. hedge funds, private equity, and real estate). Certainly, due to significant illiquidity and other factors, many of these areas got absolutely hammered in 2008.

The best investors prepare their portfolios for these strenuous times. Do yourself a favor and work on your muscle tone too – and listen to the strong advice of David Swensen.

Read the Full TGI Article Here

Wade W. Slome, CFA, CFP

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management and client accounts do have direct long positions in TIP at the time article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 2, 2009 at 12:59 am 2 comments

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