Shallow Investment Pitches Lead to Strikeouts by A. Michael Lipper, CFA
Book value may not be valuable. Changes in reported earnings per share is not growth. How can we use that insight to select funds?
I am focusing today on the kinds of “elevator comments” that one hears in the lift (to use the British term). These conversations are designed to lead to a purchase of particular stocks or funds. Often the pitcher is pushing growth or value securities based on published corporate numbers and current prices.
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Some of these pitch people earnestly believe that a simple numerical relationship and current prices are all that an investor needs to know to make a good decision. These are very much the kinds of people that Benjamin Graham and David Dodd warned about in their seminal tome Security Analysis.
At this particular time in the market, investors are weighing what to do following the recently successful tactics of buying on dips. The counterpart to this strategy is using any rally as a good time to lighten up their portfolios. They should judge whether they are happy with the quality of the supporting research.
Book value may not be valuable
Occasionally one hears that a stock or a portfolio manager should buy a stock or a fund that is selling at prices below stated book value. In our consumer society, nothing sells more easily than when it is available at a discount. All too often, however, what is being said is that the current price is below the last published book value, without any discussion of what book value means.
Book value, as most readers know, is a single per-share number that encompasses the net worth of the company as stated on the balance sheet. The accountant’s job when preparing a balance sheet is to look at the historic costs of the assets purchased, reduce those costs by periodic deductions for the use of the assets, and portray the known debts owed to determine the net worth.
One of the first things that Professor David Dodd taught me was to reconstitute the balance sheet for current investment purposes. This would exclude all elements of goodwill and raise questions as to the immediate value of elements of inventory, machinery, and buildings, among other items. Furthermore, future liabilities for taxes and pensions (including tenure when appropriate) would quickly reduce the quick-sale value of the company. In periods of rapid price changes and accelerating technological changes, old assets may lose value very abruptly. In today’s world, the costs of bank branches are probably not worth the prices reflected on most bank balance sheets.
This is not always the case. One of my successful investments was in a chain of local cigar stores. In Manhattan, where I grew up, in almost every neighborhood “high street” (to use the British term for retail commercial thoroughfares), these cigar stores had prime corner locations. As tastes were changing, smoking cigars were in a steep decline, and so were the operating earnings of the company — though it did not have much debt outstanding. All of the local shops were in long-term leased space.
When the company finally recognized the inevitable collapse of its business, its prime real estate locations were of considerable value. When the company liquidated, the shareholders were richly rewarded. Many current investors are hoping that will be the future pattern for Sears and Kmart. When a stock that has a reasonable following of qualified analysts is selling at a steep discount to book value (or in the case of banks, a steep discount to net tangible value), I believe that the current market price for the common shares is probably more representative of value than book or tangible value.
On the surface, things sell in relation to where they are currently perceived. But because liquidation is a long process, discounts of 25% from book value are not unreasonable for a negotiated multiple year liquidation. Thus, book value to me is the beginning of the conversation in the elevator, not the end.
Changes in reported earnings per share is not growth
Besides selling at a discount from book value, the other main “elevator pitch” is growth. “This year earnings will be up 15% and more next year; with that kind of growth the stock should sell for at least 10% higher than today’s price,” is the way the story goes. Again, a competent analyst will look at the composition of the expected growth to determine the value that should be ascribed to the shares.
In a recent communication to Deutsche Bank’s US fund holders, the bank showed the composition of its expected 2014 earnings growth for US, European, and Japanese companies. In the United States, the bank expects a 9% gain, with 3% coming from buybacks and no profit margin improvement; for European stocks it is looking for earnings gains of 12%; and for Japanese companies it expects 13%.
In each case, Deutsche Bank is looking for very low buybacks and a 3.4% margin expansion in Europe and 1.5% in Japan. The analyst in me would not give any growth credit for buying back shares, which benefits management more than long-term shareholders. Shareholders would prefer reinvestment into expanding businesses. Thus, I would look to a possible growth increment for US stocks, if their estimates hold up, of only 6%. Considering that both European central bankers and those in Japan are trying to introduce more price inflation into their cyclically depressed economies, I do not take at face value the expected margin improvements in Europe and Japan.
These brief analyses do not show any increase in the level of risk undertaken, but as Jamie Dimon has said and proven, risk is inherent in their business, and, I would suggest, in all businesses to some extent. Furthermore, if the economies are expanding, risk appetite will likely expand as well. For J.P. Morgan, effective risk management is a top priority; I am not sure that it is an equal concern in most companies.
On a longer-term basis, earnings growth will be dependent on whether the companies are serving continuously growing markets and the pace of disruption. There are at least two disrupting trends that will change the dynamics of future earning progress:
- Walk-up business for bank branch locations. Banks are redesigning their branches into smaller footprints, which will result in more sales stores offering assistance with automated devices. This trend may be a way to defeat the newer financial organizations that have no branches. A number of formerly brick-and-mortar retail clothing locations are increasingly relying on the web as their main sales outlet. Both of these trends have significant implications for mall operators.
- Global energy cost deflation (which will take a somewhat longer time to be important). This is based not only on the increased use of natural gas but also on more productive sourcing of oil and possibly newer forms of energy. The market may well have recognized this by now, as utilities are the only major equity sector that is up on a year to date basis (+8.9%). Because much of utility earnings are regulated, the lower cost of energy will lead to savings for their larger customers and possibly for their retail customers.
Putting it all into fund selection practice
Again I have two suggestions. The first is to address the accounting issue head on. I am sure that there are a number of analysts who are skilled at reconstituting balance sheets and income statements. One that we have used is Charles Dreifus of Royce Associates, a subsidiary of Legg Mason* who regularly takes deep dives into stocks for both his small-cap and multi-cap funds. These are funds that are organized for long-term investors.
A second approach that we have practiced for some of our managed accounts in building a portfolio of mutual funds is dependent upon a willingness to accept different performance leadership at different times during the cycle. In its simplest form, funds are picked because of their value orientation the way a strategic buyer would look at the underlying holdings; for example, secular growth funds that utilize the cyclicality of growth around a positive trend and funds that are focusing on disruptive products, services, and sales procedures. The art form is modifying the weight of the three components based on client risk appetite.
Where are we now?
As regular readers of these posts know, I have been concerned about a forthcoming peak market followed by a significant decline. Up until the middle of March, I did not see the elements of a final parabolic rise that I believed was a precondition for a major decline.
I was wrong to look at the market in terms of major aggregates; for example, Dow Jones Industrial Average rather than sectors and subsectors for incredible performances for major over-valuations.
There are ten biotech companies whose stocks are selling 1000 times current sales. Internet retailers are selling at 5.7 times their current stock prices, whereas the S&P 500 is selling at 1.6 times current prices according to a recent column by Jason Zweig in The Wall Street Journal.
I am using price/sales as a measure to avoid dealing with questionable accounting or the absence of current profits. This last week we have seen a measurable decline in these extended issues. Only the future will tell us whether these price movements are sufficient to declare a peak in the entire market. If we have experienced a top, the fall is likely to be on the order of 15–20% for the general market, not the supposed once-in-a-generation drop of 50% or more that we saw in 2008.
The key to watch is whether the subsequent recovery picks up volume and speculators who think of themselves as investors start discounting rosy projections for the latter half of this decade. When and if this does happen, it will meet the enthusiasm requirement for a peak.
How enthusiastic are you on your accounting proficiency?
* Owned by me personally and/or in a private financial services fund I manage
This was previously published on Inside Investing at the CFA Institute.
Copyright © 2008 – 2014 A. Michael Lipper, C.F.A.
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A. Michael Lipper is a CFA charterholder and the president of Lipper Advisory Services, Inc., a firm providing money management services for wealthy families, retirement plans and charitable organizations. A former president of the New York Society of Security Analysts, Mike Lipper created the Lipper Growth Fund Index, the first of today’s global array of Lipper Indexes, Averages and performance analyses for mutual funds. After selling his company to Reuters in 1998, Mike has focused his energies on managing the investments of his clients and his family. His first book, MONEY WISE: How to Create, Grow and Preserve Your Wealth was published by St. Martin’s Press. Mike’s unique perspectives on world markets and their implications have been posted weekly at Mike Lipper’s Blog since August, 2008.
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