Posts tagged ‘cash flow’
A Recipe for Disaster
Justice does not always get served in the stock market because financial markets are not always efficient in the short-run (see Black-Eyes to Classic Economists). However, over the long-run, financial markets usually get it right. And when the laws of economics and physics are functioning properly, I must admit it, I do find it especially refreshing.
There can be numerous reasons for stocks to plummet in price, but common attributes to stock price declines often include profit losses and/or disproportionately high valuations (a.k.a. “bubbles”). Normally, your garden variety, recipe for disaster consists of one part highly valued company and one part money-losing operation (or deteriorating financials). The reverse holds true for a winning stock recipe. Flavorful results usually involve cheaply valued stocks paired with improving financial results.
Unfortunately, just because you have the proper recipe of investment ingredients, doesn’t mean you will immediately get to enjoy a satisfying feast. In other words, there isn’t a dinner bell rung to signal the timing of a crash or spike – sometimes there is a conspicuous catalyst and sometimes there is not. Frequently, investments require a longer expected bake time before the anticipated output is produced.
As I alluded to at the beginning of my post, justice is not always served immediately, but for some high profile IPOs, low-quality ingredients have indeed produced low-quality results.
Snap Inc. (SNAP): Let’s first start with the high-flying social media darling Snap, which priced its IPO at $17 per share in March, earlier this year. How can a beloved social media company that generates $515 million in annual revenue (up +286% in the recent quarter) see its stock plummet -48% from its high of $29.44 to $15.27 in just four short months? Well, one way of achieving these dismal results is to burn through more cash than you’re generating in revenue. Snap actually scorched through more than -$745 million dollars over the last year, as the company reported accounting losses of -$618 million (excluding -$2 billion of stock-based compensation expenses). We’ll find out if the financial bleeding will eventually stop, but even after this year’s stock price crash, investors are still giving the company the benefit of the doubt by valuing the company at $18 billion today.
Source: Barchart.com
Blue Apron Holdings Inc. (APRN): Online meal delivery favorite, Blue Apron, is another company suffering from the post-IPO blues. After initially targeting an opening IPO price of $15-$17 per share a few weeks ago, tepid demand forced Blue Apron executives to cut the price to $10. Fast forward to today, and the stock closed at $7.36, down -26% from the IPO price, and -57% below the high-end of the originally planned range. Although the company isn’t hemorrhaging losses at the same absolute level of Snap, it’s not a pretty picture. Blue Apron has still managed to burn -$83 million of cash on $795 million in annual sales. Unlike Snap (high margin advertising revenues), Blue Apron will become a low-profit margin business, even if the company has the fortune of reaching high volume scale. Even after considering Blue Apron’s $1 billion annual revenue run rate, which is 50% greater than Snap’s $600 million run-rate, Blue Apron’s $1.4 billion market value is sadly less than 10% of Snap’s market value.
Source: Barchart.com
Groupon Inc. (GRPN): Unlike Snap and Blue Apron, Groupon also has the flattering distinction of reporting an accounting profit, albeit a small one. However, on a cash-based analysis, Groupon looks a little better than the previous two companies mentioned, if you consider an annual -$7 million cash burn “better”. Competition in the online discounting space has been fierce, and as such, Groupon has experienced a competitive haircut in its share price. Groupon’s original IPO price was $20 in January 2011 before briefly spiking to $31. Today, the stock has languished to $4 (-87% from the 2011 peak).
Source: Barchart.com
Stock Market Recipe?
Similar ingredients (i.e., valuations and profit trajectory) that apply to stock performance also apply to stock market performance. Despite record corporate profits (growing double digits), low unemployment, low inflation, low-interest rates, and a recovering global economy, bears and even rational observers have been worried about a looming market crash. Not only have the broader masses been worried today, yesterday, last week, last month, and last year, but they have also been worried for the last nine years. As I have documented repeatedly (see also Market Champagne Sits on Ice), the market has more than tripled to new record highs since early 2009, despite the strong under-current of endless cynicism.
Historically market tops have been marked by a period of excesses, including excessive emotions (i.e., euphoria). It has been a long time since the last recession, but economic downturns are also often marked with excessive leverage (e.g., housing in the mid-2000s), excessive capital (e.g., technology IPOs [Initial Public Offerings] in the late-1990s), and excessive investment (e.g., construction / manufacturing in early-1990s).
To date, we have seen little evidence of these markers. Certainly there have been pockets of excesses, including overpriced billion dollar tech unicorns (see Dying Unicorns), exorbitant commercial real estate prices, and a bubble in global sovereign debt, but on a broad basis, I have consistently said stocks are reasonably priced in light of record-low interest rates, a view also held by Warren Buffett.
The key lessons to learn, whether you are investing in individual stocks or the stock market more broadly, are that prices will follow the direction of earnings over the long-run. This helps explain why stock prices always go down in recessions (and are volatile in anticipation of recessions).
If you are looking for a recipe for disaster, just find an overpriced investment with money-losing (or deteriorating) characteristics. Avoiding these investments and identifying investments with cheap growth qualities is much easier said than done. However, by mixing an objective, quantitative framework with more artistic fundamental analysis, you will be in a position of enjoying tastier returns.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in SNAP, APRN, GRPN, 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 the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Winning the Loser’s Game
During periods of heightened volatility like those recently experienced, it’s easy to get caught up in the emotional heat of the moment. I find time is better spent returning to essential investing fundamentals, like the ones I read in the investment classic by Charles Ellis, Winning the Loser’s Game – “WTLG”. To put my enthusiasm in perspective, WTLG has even achieved the elite and privileged distinction of making the distinguished “Recommended Reading” list of Investing Caffeine (located along the right-side of the page). Wow…now I know you are really impressed.
The Man, The Myth, the Ellis
For those not familiar with Charley Ellis, he has a long, storied investment career. Not only has he authored 12 books, including compilations on Goldman Sachs (GS) and Capital Group, but his professional career dates back prior to 1972, when he founded institutional consulting firm Greenwich Associates. Besides earning a college degree from Yale University, and an MBA from Harvard Business School, he also garnered a PhD from New York University. Ellis also is a director at the Vanguard Group and served as Investment Committee chair at Yale University along investment great David Swensen (read also Super Swensen) from 1992 – 2008.
With this tremendous investment experience come tremendous insights. The original book, which was published in 1998, is already worth its weight in gold (even at $1,384 per ounce), but the fifth edition of WTLG is even more valuable because it has been updated with Ellis’s perspectives on the 2008-2009 financial crisis.
Because the breadth of topics covered is so vast and indispensable, I will break the WTLG review into a few parts for digestibility. I will start off with the these hand-picked nuggets:
Defining the “Loser’s Game”
Here is how Charles Ellis describes the investment “loser’s game”:
“For professional investors, “the ‘money game’ we call investment management evolved in recent decades from a winner’s game to a loser’s game because a basic change has occurred in the investment environment: The market came to be dominated in the 1970s and 1980s by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with cautious custodians or amateurs who are out of touch with the market. Now he or she competes with other hardworking investment experts in a loser’s game where the secret to winning is to lose less than others lose.”
Underperformance by Active Managers
Readers that have followed Investing Caffeine for a while understand how I feel about passive (low-cost do-nothing strategy) and active management (portfolio managers constantly buying and selling) – read Darts, Monkeys & Pros. Ellis’s views are not a whole lot different than mine – here is what he has to say while not holding back any punches:
“The basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management – fees, commissions, market impact of big transactions, and so forth-85 percent of investment managers have and will continue over the long term to underperform the overall market.”
He goes on to say individuals do even worse, especially those that day trade, which he calls a “sucker’s game.”
Exceptions to the Rule
Ellis’s bias towards passive management is clear because “over the long term 85 percent of active managers fall short of the market. And it’s nearly impossible to figure out ahead of time which managers will make it into the top 15 percent.” He does, however, acknowledge there is a minority of professionals that can beat the market by making fewer mistakes or taking advantage of others’ mistakes. Ellis advocates a slow approach to investing, which bases “decisions on research with a long-term focus that will catch other investors obsessing about the short term and cavitating – producing bubbles.” This is the strategy and approach I aim to achieve.
Gaining an Unfair Competitive Advantage
According to Ellis, there are four ways to gain an unfair competitive advantage in the investment world:
1) Physical Approach: Beat others by carrying heavier brief cases and working longer hours.
2) Intellectual Approach: Outperform by thinking more deeply and further out in the future.
3) Calm-Rational Approach: Ellis describes this path to success as “benign neglect” – a method that beats the others by ignoring both favorable and adverse market conditions, which may lead to suboptimal decisions.
4) Join ‘em Approach: The easiest way to beat active managers is to invest through index funds. If you can’t beat index funds, then join ‘em.
The Case for Stocks
Investor time horizon plays a large role on asset allocation, but time is on investors’ side for long-term equity investors:
“That’s why in the long term, the risks are clearly lowest for stocks, but in the short term, the risks are just as clearly highest for stocks.”
Expanding on that point, Ellis points out the following:
“Any funds that will stay invested for 10 years or longer should be in stocks. Any funds that will be invested for less than two to three years should be in “cash” or money market instruments.”
While many people may feel stock investing is dead, but Ellis points out that equities should return more in the long-run:
“There must be a higher rate of return on stocks to persuade investors to accept risks of equity investing.”
The Power of Regression to the Mean
Investors do more damage to performance by chasing winners and punishing losers because they lose the powerful benefits of “regression to the mean.” Ellis describes this tendency for behavior to move toward an average as “a persistently powerful phenomenon in physics and sociology – and in investing.” He goes on to add, good investors know “that the farther current events are away from the mean at the center of the bell curve, the stronger the forces of reversion, or regression, to the mean, are pulling the current data toward the center.”
The Power of Compounding
For a 75 year period (roughly 1925 – 2000) analyzed by Ellis, he determines $1 invested in stocks would have grown to $105.96, if dividends were not reinvested. If, however, dividends are reinvested, the power of compounding kicks in significantly. For the same 75 year period, the equivalent $1 would have grown to $2,591.79 – almost 25x’s more than the other method (see also Penny Saved is Billion Earned).
Ellis throws in another compounding example:
“Remember that if investments increase by 7 percent per annum after income tax, they will double every 10 years, so $1 million can become $1 billion in 100 years (before adjusting for inflation).”
The Lessons of History
As philosopher George Santayana stated – “Those who cannot remember the past are condemned to repeat it.” Details of every market are different, but as Ellis notes, “The major characteristics of markets are remarkably similar over time.”
Ellis appreciates the importance of history plays in analyzing the markets:
“The more you study market history, the better; the more you know about how securities markets have behaved in the past, the more you’ll understand their true nature and how they probably will behave in the future. Such an understanding enables us to live rationally with markets that would otherwise seem wholly irrational.”
Home Sweet International Home
Although Ellis’s recommendation to diversify internationally is not controversial, his allocation recommendation regarding “full diversification” is a bit more provocative:
“For Americans, this would mean about half our portfolios would be invested outside the United States.”
This seems high by traditional standards, but considering our country’s shrinking share of global GDP (Gross Domestic Product), along with our relatively small share of the globe’s population (about 5% of the world’s total), the 50% percentage doesn’t seem as high at first blush.
Beware the Broker
This is not new territory for me (see Financial Sharks, Fees/Exploitation, and Credential Shell Game), and Ellis warns investors on industry sales practices:
“Those oh so caring and helpful salespeople make their money by convincing you to change funds. Friendly as they may be, they may be no friend to your long-term investment success.”
Unlike a lot of other investing books, which cover a few aspects to investing, Winning the Loser’s Game covers a gamut of crucial investment lessons in a straightforward, understandable fashion. A lot of people play the investing game, but as Charles Ellis details, many more investors and speculators lose than win. For any investor, from amateur to professional, reading Ellis’s Winning the Loser’s Game and following his philosophy will not only help increase the odds of your portfolio winning, but will also limit your losses in sleep hours.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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 GS, 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.
Shoring Up Your Investment Stool from Collapse
With March Madness just kicking into full gear, there’s a chance that your gluteal assets may be parked on a stool in the next two weeks. When leaning on a bar countertop, while seated on a stool, we often take for granted the vital support this device provides, so we can shovel our favorite beverage and pile of nachos into our pie holes. OK, maybe I speak for myself when it comes to my personal, gluttonous habits. But the fact remains, whether you are talking about your rump, or your investment portfolio, you require a firm foundation.
The main problem, when it comes to investments, is the lack of a tangible, visible stool to analyze. Sure, you are able to see the results of a portfolio collapse when there is no foundation to support it, or you may even be able to ignore the results when they remain above water. But many investors do not evenperform the basic due diligence to determine the quality of their investment stool. Before you place your life savings in the hands of some brokerage salesman, or in your personal investment account, you may want to make sure your stool has more than one or two legs.
In the money management world, investors typically choose to buy the stool, rather than build it, which makes perfect common sense. Many people do not have the time or emotional make-up to manage their finances. If left to do it themselves, more often than not, investors usually do a less than stellar job. Unfortunately, when many investors do outsource the management of their investments, they neglect to adequately research the investment stool they buy. Usually the wobbly industry stool operates on the two legs of performance chasing and commission generation (see Fees, Exploitation, and Confusion). For most average investors, it doesn’t take long before that investment strategy teeters and collapses.
If the average investor does not have time to critically evaluate managers that take a long-term, low-cost, tax-efficient strategy to investing, those individuals would be best served by following Warren Buffet’s advice about passive investments, “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.”
The Four Legs of the Investment Stool
For DIY-ers (Do-It-Yourself-ers), you do not need to buy a stool – you can build it. There are many ways to build a stool, but these are the four crucial legs of investing that have saved my hide over my career, and can be added as support for your investment stool:
1.) Valuation: I love sustainable growth as much as anything, just as much as I would like a shiny new Ferrari. But there needs to be a reasonable price paid for growth, and paying an attractive or fair price for a marquis asset will improve your odds for long-term success.
“Valuations do matter in the stock market, just as good pitching matters in baseball.”
-Fred Hickey (High Tech Strategist)
2.) Cash Flows: Cash flows, and more importantly free cash flows (cash left over after money is spent on capital expenditures), should be investors’ metric of choice. Companies do not pay for dividends, share buybacks, and capital expenditures with pro forma earnings, or non-GAAP earnings. Companies pay for these important outlays with cash.
“In looking for stocks to buy, why do you put so much emphasis on free cash flow? Because it makes the most sense to me. My first job was at a little corner grocery store, and it seemed pretty simple. Cash goes into the register; cash comes out.”
-Bruce Berkowitz (The Fairholme Fund)
3.) Interest Rates: Money goes where it is treated best, so capital will look at the competing yields paid on bonds. Intuitively, interest factors also come into play when calculating the net present value of a stock. Just look at the low Price-Earnings ratios of stocks in the early 1980s when the Fed Funds reached about 20% (versus effectively 0% today). In the long run, higher interest rates (and higher inflation) are bad for stocks, but worse for bonds.
“I don’t know any company that has rewarded any bondholder by raising interest rates [payments] – unlike companies raising dividends.”
-Peter Lynch (Former manager of the Fidelity Magellan Fund)
4.) Quality: This is a subjective factor, but this artistic assessment is as important, if not more important than any of the previous listed factors. In searching for quality, it is best to focus on companies with market share leading positions, strong management teams, and durable competitive advantages.
“If you sleep with dogs, you’re bound to get fleas.”
-Old Proverb
These four legs of the investment stool are essential factors in building a strong investment portfolio, so during the next March Madness party you attend at the local sports bar, make sure to check the sturdiness of your bar stool – you want to make sure your assets are supported with a sturdy foundation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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 Fairholme, Ferrari, 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.
Creating Your Investment Dashboard
Navigating the financial markets can be difficult in this volatile environment we’ve experienced over the last few years, which is why it is more important than ever to have a financial dashboard to ensure you do not drive off a cliff. If investors do not have the time or focus to drive their financial future, then perhaps for the safety of themselves and others, they may consider taking the bus or hiring a chauffeur. For those committed to handling their finances on their own, the road may become rocky, so here are some important factors to monitor on your financial dashboard:
1) Fundamental Direction: Before you decide on an investment destination, it is important to know whether trends are accelerating (speeding up) or deteriorating (slowing down) – see also Forecasting – Trend Analysis.
2) Are You Going the Speed limit? Nobody wants to get a costly speeding ticket, therefore assessing valuation metrics on your dashboard is a beneficiary tool. If you are speeding along the highway at a 100 miles per hour in an expensive stock (e.g., trading at a 50x+ Price/Earnings multiple), then there is little room for error. When traveling that fast you can forget about the price of a speeding ticket, because hitting a pothole at those speeds (valuation) can be much more costly to your portfolio, if you are not careful.
3) Temperature Outside: There’s a huge difference between driving in the icy-cold snow and in 100 degree heat. Each environment has its own challenges. The same principle applies to the financial markets. On occasion, sentiment can become red hot, forcing heightened caution, whereas during other periods, chilling fear can scare everyone else off the roads, leaving clear sailing ahead.
4) Optimal Tire Pressure: Low pressure or bald tires can lead to treacherous driving conditions. A company with healthy cash flow generation relative to its market capitalization can make your investment ride a lot more stable (see also Cash Flow Register). Dividends and share buybacks are generated from healthy and stable cash flows…not earnings.
5) Driver Skill Level: People generally believe they are better than average drivers, however statistics tell a different story. By definition, half of all drivers must be below average. If you are going to put your life’s retirement assets into stocks, you might as well select those companies led by seasoned management teams with proven track records.
Many investors drive blindly without relying on a dashboard. In the investment world, visibility is not very clear. Often, weather conditions in the financial markets become rainy, dark, and/or foggy. If you don’t want your portfolio to crash, it makes sense to build a reliable dashboard to navigate through the hazardous investment road conditions.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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 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.
Microsoft Makes Dividend Splash
Source: ActingLikeAnimals.com
I’ve talked about growing profits and cash piles for a while now (read more), but at some point investors and board members get restless and demand action (Steve Jobs has not yet). The most recent blue-chip company to make a splash, when it comes to capital management, is Microsoft Corp. (MSFT), which just announced a significant +23% increase in its dividend in conjunction with $4.75 billion in debt offerings. These capital structure changes still leave plenty of room for additional share repurchases and acquisitions.
Debt Offering – Are You Sure?
Huh? What in the heck is Microsoft doing borrowing money? I mean, does a company with $44 billion in cash and investments, generating a whopping additional $22 billion in free cash flow in fiscal 2010 (ended in June), really need access to additional capital? The short answer is “NO.” But a company like Microsoft borrowing $4.75 billion is like Donald Trump borrowing $50 on his credit card. Well wait, “The Donald” has actually had some hair and Chapter 11 problems, so the more appropriate analogy would be Bill Gates borrowing $20 on his credit card. Not only is it a rounding error, but it’s a good financial management practice for corporations to take advantage of the debt tax shield (read definition).
What makes Microsoft’s debt issuance that much more incredible is the astonishingly low rates the company is paying investors on the debt. According to Dealogic, Microsoft set a record low for yield paid on corporate unsecured debt. For the separate maturities ranging from 2013 to 2040, Microsoft paid a stunningly low 25-83 basis point spread over Treasuries. I don’t want to get into government credit worthiness today, but who knows, maybe Microsoft will pay lower debt rates than the U.S. Treasury, in the not too distant future?!
Regardless of the array of capital structure management strategies used by other companies, Microsoft is not alone in dealing with its cash hoarding problems. Cisco Systems Inc. (CSCO), another blue-chip cash printing press, just announced the initiation of a 1-2% dividend to be paid by the end of their fiscal year ending in July 2011 (read more about dividend cash “un-hoarding”).
But Who Cares?
Who cares about Microsoft’s wimpy 2.62% yield anyway? Well, for one, I sure care! A 10-year Treasury Note is yielding a measly, static 2.55%. If Microsoft continued on the same dividend path growth over the next five years as it did over the last five years, investors could potentially be talking about a 5.2% yield on our initial investment, and this excludes any potential stock price appreciation. With only roughly a 25% payout ratio on Microsoft’s fiscal 2010 free cash flow, the company has a lot of freedom to hike future dividends, even if earnings don’t grow. Microsoft has also enhanced shareholder value by putting its money where its mouth is by purchasing over $30 billion of company stock over the last three years.
Nice trend in dividend growth.
The extreme case of dividend growth is Wal-Mart Stores (WMT), which if purchased in 1972 would provide a +2,300% yield on the original investment, excluding any benefit from the massive price appreciation ($.05 split-adjusted per share to $53.65). Microsoft is no young chick like Wal-Mart 40 years ago, but you get the gist (read Dividend Sapling to Fruit Tree).
So while strategists and economists fret about the possibilities of a “double dip” recession, in the interim there have been 179 companies in the S&P 500 index that have hiked dividends in 2010 (versus only 3 companies that have cut). Microsoft has been no slouch either, growing revenues by +22% and EPS (Earnings Per Share) by +50% in their most recent fiscal fourth quarter. Although Microsoft’s stock is down -20% for 2010, the capital management and dividend splash recently announced by Microsoft (and other companies) should eventually capture the eye of investors currently earning squat on overpriced bonds and almost worthless Certificates of Deposit.
Read complete Microsoft dividend story
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, CSCO, nd WMT, but at the time of publishing SCM had no direct position in MSFT, 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.
EPS House of Cards: Tricks of the Trade
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.
Taking Facebook and Twitter Public
Facebook CEO Mark Zuckerberg
Valuing high growth companies is similar to answering a typical open-ended question posed to me during business school interviews: “Wade, how many ping pong balls can you fit in an empty 747 airplane?” Obviously, the estimation process is not an exact science, but rather an artistic exercise in which various techniques and strategies may be implemented to form a more educated guess. The same estimation principles apply to the tricky challenge of valuing high growth companies like Facebook and Twitter.
Cash is King
Where does one start? Conceptually, one method used to determine a company’s value is by taking the present value of all future cash flows. For growth companies, earnings and cash flows can vary dramatically and small changes in assumptions (i.e., revenue growth rates, profit margins, discount rates, taxes, etc.) can lead to drastically different valuations. As I have mentioned in the past, cash flow analysis is a great way to value companies across a broad array of industries – excluding financial companies (see previous article on cash flow investing).
Mature companies operating in stable industries may be piling up cash because of limited revenue growth opportunities. Such companies may choose to pay out dividends, buyback stock, or possibly make acquisitions of target competitors. However, for hyper-growth companies earlier in their business life-cycles, (e.g., Facebook and Twitter), discretionary cash flow may be directly reinvested back into the company, and/or allocated towards numerous growth projects. If these growth companies are not generating a lot of excess free cash flow (cash flow from operations minus capital expenditures), then how does one value such companies? Typically, under a traditional DCF (discounted cash flow model), modest early year cash flows are forecasted until more substantial cash flows are generated in the future, at which point all cash flows are discounted back to today. This process is philosophically pure, but very imprecise and subject to the manipulation and bias of many inputs.
To combat the multi-year wiggle room of a subjective DCF, I choose to calculate what I call “adjusted free cash flow” (cash flow from operations minus depreciation and amortization). The adjusted free cash flow approach provides a perspective on how much cash a growth company theoretically can generate if it decides to not pursue incremental growth projects in excess of maintenance capital expenditures. In other words, I use depreciation and amortization as a proxy for maintenance CAPEX. I believe cash flow figures are much more reliable in valuing growth companies because such cash-based metrics are less subject to manipulation compared to traditional measures like earnings per share (EPS) and net income from the income statement.
Rationalizing Ratios
Other valuation methods to consider for growth companies*:
- PE Ratio: The price-earnings ratio indicates how expensive a stock is by comparing its share price to the company’s earnings.
- PEG Ratio (PE-to-Growth): This metric compares the PE ratio to the earnings growth rate percentage. As a rule of thumb, PEG ratios less than one are considered attractive to some investors, regardless of the absolute PE level.
- Price-to-Sales: This ratio is less precise in my mind because companies can’t pay investors dividends, buy back stock, or make acquisitions with “sales” – discretionary capital comes from earnings and cash flows.
- Price-to-Book: Compares the market capitalization (price) of the company with the book value (or equity) component on the balance sheet.
- EV/EBITDA: Enterprise value (EV) is the total value of the market capitalization plus the value of the debt, divided by EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Some investors use EBITDA as an income-based surrogate of cash flow.
- FCF Yield: One of my personal favorites – you can think of this percentage as an inverted PE ratio that substitutes free cash flow for earnings. Rather than a yield on a bond, this ratio effectively provides investors with a discretionary cash yield on a stock.
*All The ratios above should be reviewed both on an absolute basis and relative basis in conjunction with comparable companies in an industry. Faster growing industries, in general, should carry higher ratio metrics.
Taking Facebook and Twitter Public
Before we can even take a stab at some of these growth company valuations, we need to look at the historical financial statements (income statement, balance sheet, and cash flow statement). In the case of Facebook and Twitter, since these companies are private, there are no publically available financial statements to peruse. Private investors are generally left in the dark, limited to public news related to what other early investors have paid for ownership stakes. For example, in July, a Russian internet company paid $100 million for a stake in Facebook, implying a $6.5 billion valuation for the total company. Twitter recently obtained a $100 million investment from T. Rowe Price and Insight Venture Partners thereby valuing the total company at $1 billion.
Valuing growth companies is quite different than assessing traditional value companies. Because of the earnings and cash flow volatility in growth companies, the short-term financial results can be distorted. I choose to find market leading franchises that can sustain above average growth for longer periods of time (i.e., companies with “long runways”). For a minority of companies that can grow earnings and cash flows sustainably at above-average rates, I will take advantage of the perception surrounding current short-term “expensive” metrics, because eventually growth will convert valuation perception to “cheap.” Google Inc. (GOOG) is a perfect example – what many investors thought was ridiculously expensive, at the $85 per share Initial Public Offering (IPO) price, ended up skyrocketing to over $700 per share and continues to trade near a very respectable level of $500 per share.
The IPO market is heating up and A123 Systems Inc (AONE) is a fresh example. Often these companies are volatile growth companies that require a deep dive into the financial statements. There is no silver bullet, so different valuation metrics and techniques need to be reviewed in order to come up with more reasonable valuation estimates. Valuation measuring is no cakewalk, but I’ll take this challenge over estimating the number of ping pong balls I can fit in an airplane, any day. Valuing growth companies just requires an understanding of how the essential earnings and cash flow metrics integrate with the fundamental dynamics surrounding a particular company and industry. Now that you have graduated with a degree in Growth Company Valuation 101, you are ready to open your boutique investment bank and advise Facebook and Twitter on their IPO price (the fees can be lucrative if you are not under TARP regulations).
DISCLOSURE: Sidoxia Capital Management and client accounts do not have direct long positions AONE, however some Sidoxia client accounts do hold GOOG securities at the time this article was published. 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.
Time to Take Out the Trash: From Garbage to Cream
As we saw with the +50% move in the 2003 NASDAQ recovery when there was a flight to garbage (lower quality stocks), eventually the cream rose to the top in the later stages of the 2002-2007 bull market. Usually investors get what they pay for, yet many of the companies that were left for dead in 2008 (including bankruptcy fears) have rebounded the fiercest. As the “anti-Great Depression” trade has paid off handsomely for those low quality stocks, high quality stocks have patiently waited on the sidelines eager to jump along for the escalating ride. Ben Levisohn, Business Week writer, thinks it’s time for high quality stock’s to outperform their junky brethren. Here’s what Mr. Levisohn had to say:
“The stock market has gained 58% since its bear-market low Mar. 9, but the rally hasn’t lifted all equities equally. As is typical in many market bouncebacks, the worst recovered first. Low-quality companies, those with weak or nonexistent profits, mediocre return on equity, and less-than-stellar balance sheets, outpaced their more solidly profitable peers by nearly a 2-to-1 margin, according to research from Baird Private Wealth Management.”
Intuitively, the “garbage” rally makes sense from the standpoint, the harder you fall, the faster you will bounce. However, the sustainability of such rapid, fierce moves should be questioned. Eventually, fundamentals move up investors’ priority list and the “cream” (quality stocks) rises to the top.
Mr. Levisohn further highlights the disparity between “garbage” and “cream” by noting:
“Baird found that companies not earning a profit gained 92% from the Mar. 9 lows through the end of August, compared with a 47% rise for companies that had the highest profit margins. Companies with the lowest return on equity outperformed those with the highest by more than 2 to 1, according to Baird.”
With the sickly stock rally and the removal of the “global meltdown” scenario apparently behind us, I concur with Mr. Levisohn that now is the time to focus on “quality” stocks. What does “quality” mean? From a quantitative perspective, concentrating on those companies with high returns on invested capital (ROIC), high returns on equity (ROE), companies with low levels of debt (leverage), generating healthy levels of cash flow (See Cash Flow Article), represents “quality” investing to me. From a fundamental standpoint, management teams with a clear track record of success, and companies with deep barriers to entry, and a healthy pipeline of growth opportunities are other quality characteristics I look for.
Companies retaining these higher quality traits generally are not held hostage to the capital markets and banking system (i.e., no bailouts necessary). As a result, these companies have the flexibility to invest additional resources into areas like research & development, marketing, manufacturing, and mergers & acquisitions. Superior companies have the ability to step on the throats of weaker competitors, thereby extending their competitive advantage and garnering additional market share.
We have experienced a massive rebound in the markets since the March lows, but now it’s time to take out the garbage. As I search for high quality stocks through my computer terminal, I’ll be enjoying my delicious coffee…with extra cream.
Read Entire Business Week Article Here
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
Investing Caffeine 
