Posts tagged ‘cash flows’
Hunting for Tennis Balls and Dead Cats
When it comes to gravity, people understand what goes up, must come down. But the reverse is not always true for stocks. What goes down, does not necessarily need to come back up. Since the 2008-09 financial crisis there have been a large group of multi-billion dollar behemoth stocks that have defied gravity, but over the last few months, many of these highfliers have come back to earth. Despite the pause in some of these major technology, consumer, and internet stocks, the overall stock market appears relatively calm. In fact, the Dow Jones Industrials index is currently sitting at all-time record highs and the S&P 500 index is hovering around -1% from its peak. But below the surface, there is a large undercurrent resulting in an enormous rotation out of pricier momentum and growth stocks into more defensive and yield-heavy sectors of the market, like utilities and real estate.
To expose this concealed trend I have highlighted a group of 20 stocks below, valued at close to half a trillion dollars. Over the last 12 months, this selective group of technology, consumer, and internet stocks have lost over -$200,000,000,000 from their peak values. Here’s a look at the highlighted stocks:
With respect to all the punished stocks, the dilemma for investors amidst this depreciating price carnage is how to profitably hunt for the bouncing tennis balls while avoiding the dead cat bounces. By hunting bouncing tennis balls, I am referring to the identification of those companies that have crashed from indiscriminate selling, even though the companies’ positive business fundamentals remain fully intact. The so-called dead cats reflect those overpriced companies that lack the earnings power or trajectory to support a rebounding stock price. Like a cat falling from a high-rise building, there may exist a possibility of a small rebound, but for many severely broken momentum stocks, minor bounces are often short-lived.
For long-term investors, much of the recent rotation is healthy. Some of the froth I’ve been writing about in the biotech, internet, and technology has been mitigated. As a result, in many instances, outrageous or rich stock valuations have now become fairly priced or attractive.
Profiting from Collapses
Many investors do not realize that some of the greatest stocks of all-time have suffered multiple -50% drops before subsequently doubling, tripling, quadrupling or better. History provides many rebounding tennis ball examples, but let’s take a brief look at the Apple Inc. (AAPL) chart from 1980 – 2005 to drive home the point:
As you can see, there were at least five occasions when the stock got chopped in half (or worse) over the selected timeframe and another five occasions when the stock doubled (or better), including a +935% explosion in the 1997–2000 period, and a +503% advance from 2002–2005 when shares reached $45. The numbers get kookier when you consider Apple’s share price eventually reached $700 and closed early last week above $600.
These feast and famine patterns can be discovered for virtually all of the greatest all-time stocks. The massive volatility explains why it’s so difficult to stick with theses long-term winners. A more recent example of a tennis ball bounce would be Facebook Inc (FB). The -58% % plummet from its $42 IPO peak has been well-documented, and despite the more recent -21% pullback, the stock is still up +223% from its $18 lows.
On the flip side, an example of a dead cat bounce would include Cisco Systems Inc (CSCO). After the bursting of the 2000 technology bubble, Cisco has never fully recovered from its $82 peak value. There have been many fits and starts, including some periods of 50% declines and 100% gains, but due to excessive valuations in the late 1990s and changing competitive trends, Cisco still sits at $23 today (see chart below).
It is important to remember that just because a stock goes down -50% in value doesn’t mean that it’s going to double or triple in value in the future. Price momentum can drive a stock in the short run, but in the long run, the important variables to track closely are cash flows and earnings (see It’s the Earnings, Stupid) . The level and direction of these factors ultimately correlate best with the ultimate fair value of stock prices. Therefore, if you are fishing in the growth or momentum stock pond, make sure to do your homework after a stock price collapses. It’s imperative that you carefully hunt down rebounding tennis balls and avoid the dead cat bounces.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), AMZN, long NFLX bond, short NFLX stock, short LULU, and long CSCO (in a non-discretionary account), but at the time of publishing SCM had no direct position in TWTR, GRPN, YELP, ATHN, AVP, P, LNKD, BBY, ZNGA, WDAY, WFM, N, SSYS, JDSU, COH, CRM, FB 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.
Operating Earnings: Half-Empty or Half-Full?
A continual debate goes on between bulls and bears about which earnings metric is more important: reported earnings based on GAAP (Generally Accepted Accounting Principles) or “operating earnings,” which exclude one-time charges and gains, along with non-cash charges, such as options expenses. Bulls generally prefer operating earnings (glass half-full) because they are typically higher than GAAP earnings (glass half-empty), and therefore operating earnings make valuation metrics more attractive. This disparity between earnings choice is even broader over the last few years due to the massive distortions created by the financial crisis – gigantic write-downs at the vast majority of financial institutions and enormous restructurings at non-financial companies.
Options Smoptions
The options expense issue can also become a religious argument, similar to the paradoxical question that asks if God can create a rock big enough that he himself cannot budge? Logic would dictate that operating earnings should adequately account for option issuance in the denominator of the earnings per share calculation (Net Income / Shares Outstanding). As far as I’m concerned, the GAAP method reducing the numerator of EPS (Earnings Per Share) with an expense, and increasing the denominator by increasing shares from option issuance is merely double counting the expense, thereby distorting reality. Reading through an annual report and/or proxy may not be a joyous experience, but the exercise will help you triangulate share issuance estimates to forecast the drag on future EPS.
On a trailing 12-month basis (Sep’09 – Sep’10), Standard & Poor’s calculated reported earnings with about a -9% differential from operating earnings, equating to approximately a 1.5 Price/Earnings multiple point differential (17.8x’s for reported earnings and 16.2 x’s for operating earnings). For the half-glass full bulls, the picture looks even prettier based on 2011 operating earnings forecasts – the S&P 500 index is priced at roughly 13.6x’s the 2011 index earnings value of $95.45.
Forward More Important Than Backwards
As I make the case in my P/E binoculars article, the market is like a game of chess – a good player doesn’t care nearly as much about an opponent’s last moves as he/she cares about the opponent’s future moves. Financial markets operate in the same fashion, future earnings are much more important than prior earnings. From a practical standpoint, GAAP earnings are relatively useless. Market purists can evangelize about the merits of GAAP earnings until they are blue in the face, but the fact of the matter is that investors are whipping prices all over the place based on Wall Street EPS forecasts – based on operating earnings (not GAAP). In many instances, especially throughout much of the financial crisis, operating earnings will more closely align with the cash flows of a company relative to GAAP earnings, but detailed fundamental analysis is needed.
As far as I’m concerned, much of this GAAP vs Non-GAAP earnings debate is moot because both reported earnings and operating earnings can both be manipulated and distorted. I prefer using cash flows (see Cash Flow Statement article) because cash register accounting – the analysis of money coming in and out of a company – limits the ability of bean counters to use smoke and mirror strategies traditionally saved for the income statement. In other words, you cannot compensate employees, do acquisitions, distribute dividends, or buyback stock with GAAP earnings…all these functions require cold, hard cash. The key metric, rather than EPS, should be free cash flow per share. Growth companies with high return prospects should be given some leeway, but if the projects don’t earn a return, eventually cash resources will dry up. When EPS is materially higher than free cash flow per share, yellow flags fly up and I do additional research to understand the dynamics causing the differential.
These earnings-based arguments will likely never get resolved, but if investors focus on bottom-up analysis on individual security cash flows, determining whether the glass is half-empty or half-full will become much easier.
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 security referenced in this article. The trailing 12 month data was calculated by S&P as of 1/19/2011. Forward 2011 operating earnings were calculated as of 1/18/2011. 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.
How to Make Money in Stocks Using Cash Flows
There you are in front of your computer screen, and lo and behold you notice one of your top 10 positions is down -11% (let’s call it ticker: ABC). With sweaty palms and blood rushing from your head, you manage to click with trembling hands on the ticker symbol that will imminently deliver the dreadful news. A competitor (ticker: XYZ) just pre-announced negative quarterly earnings results, and an investment bank, Silverman Sax, has decided to downgrade ABC on fears of a negative spill-over effect. What do you do now? Sell immediately on the cockroach theory – seeing one piece of bad news may mean there are many more dreadful pieces of information lurking behind the scenes? Or, should you back up the truck to take advantage of a massive buying opportunity?
Thank goodness to our good friend, cash flow, which can help supply answers to these crucial questions. Without an ability to value the shares of stock, any decision to buy or sell will be purely based on gut-based emotions. Many Wall Street analysts follow this lemming based analysis when whipping around their ratings (see The Yuppie Bounce & the Lemming Leap). As I talk about in my book, How I Managed $20,000,000,000.00 by Age 32, I strongly believe successful investing requires a healthy balance between the art and the science. Using instinct to tap into critical experience acknowledges the importance of the artistic aspects of investing. Unfortunately, I know few (actually zero) investors that have successfully invested over the long-run by solely relying on their gut.
A winning investment strategy, I argue, includes a systematic, disciplined approach with objective quantitative measures to help guide decision making. For me, the science I depend on includes a substantial reliance on cash flow analysis (See Cash Flow Components Here). What I also like to call this tool is my cash register. Any business you look at will have cash coming into the register, and cash going out of it. Based on the capital needs, cash availability, and growth projects, money will furthermore be flowing in and out of the cash register. By studying these cash flow components, we gain a much clearer lens into the vitality of a business and can quickly identify the choke points.
ACCOUNTING GAMES
The other financial statements definitely shed additional light on the fitness of a company as well, but the income statement, in particular, is subject to a lot more potential manipulation. Since the management teams have more discretion in how GAAP (Generally Accepted Accounting Principles) is applied to the income statement, multiple levers can be pulled by the executives to make results look shinier than reality. For example, simply extending the useful life of an asset (e.g., a factory, building, computer, etc.) will have no impact on a company’s cash flow, yet it will instantaneously and magically raise a companies’ earnings out of thin air…voila!
“Stuffing the channel” is another manipulation strategy that can accelerate revenue recognition for a company. For example, let’s assume Company X ships goods to a distributor, Company Y, for the exclusive purpose of recognizing sales. Company X wins because they just increased their sales, Company Y wins because they have more inventory on hand (even if there is no immediate plan for the distributor to pay for that inventory), and the investor gets “hoodwinked” because they are presented artificially inflated sales and income results.
JOINT STRATEGY
These are but just a few examples of why it’s important to use the cash flow statement in conjunction with the income statement to get a truer picture of a company’s valuation and “quality of earnings.” If you don’t believe me, then check out the work done by reputable academics (Konan Chan, Narasimhan Jegadeesh, Louis Chan, and Josef Lakonishok) that show negative differentials between accounting earnings and cash flow are significantly predictive of future stock price performance (Read more).
So the next time a holding craters (or sky-rockets), take an accounting on the state of the company’s cash flows before making any rash decisions to buy or sell. By doing a thorough cash flow analysis, you’ll be well on your way to racking up gains into your cash register.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
