Ford is going bankrupt. Today, they announced a full year AFTER-TAX loss of $12.7 billion. The fourth quarter loss of $5.8 billion, equivalent to $3.05/share, essentially eliminates all retained earnings! While many of these costs were associated with their restructuring (the "big bath") continuing operations, particularly in North America continue to remain deeply unprofitable. Another major loss in 2008, would take a huge bite out of shareholders equity. Such a year is conceivable, particularly if sales of the F-Series do not pick up.
As you are probably aware, I have a background in the auto industry. As a result, I have resisted making predictions on this blog about the future of the industry, and in particular about the future of specific firms. Since I have left the industry, I will now begin a regular update on the industry from the perpective of a sometime industry "insider".
People who have worked with me know that I have routinely predicted that Ford Motor will Chapter 11 before this decade is out. I first made this prediction in 2004, when most of the news was about the problems at cross-town rival, GM. At that time, I was working for another car company, whose American operations were also undergoing significant restructuring. Most of the discussion surrounded the future for GM. At that time, in fact, Ford was actually making a profit. But it was pretty easy to see that trouble was brewing in Dearborn. Now, of course, Ford looks like the sick child in the family.
My prediction is that Ford will be forced to declare bankruptcy as early as 2008 and no later than 2009. Because of the relative price position advantage that a bankrupt Ford would have will likely lead to a bankruptcy at General Motors as well. At that point, it may be possible for the two automakers to defend their turf (and even retake some) from the Japanese and we would then return to something of a stable market environment.
That they are going bankrupt is a certainty. The two companies simply do not have enough cash to do all of the things a successful manufacturer does: invest (in plant, equipment and r&d), operate (working capital), and offer a return to shareholders. Efforts to maintain operating and shareholder-friendly returns have led the company to starve investing. As a result, their products are weak competitors in the market, supported by huge incentives, which then devalue the products and brand even more. Ford is particularly weak, because its capital structure, with two classes of stock and control of the voting power by the Ford family, limits the company's ability to tie up with partners who could really make a difference.
On top of that, they suffer from lack of strategic focus. The companies regularly change their stated strategy and now lack the resources and time to develop options to develop an effective one.
NOTE: I have to stop writing for now, but will resume later with a review of how we got to where we are and a review of the financial position of the Ford Motor Co to support my conclusions.
Thursday, January 25, 2007
Wednesday, December 27, 2006
Valuations
Charles Dow, who gave his name to the Dow Jones Average and was also the longtime publisher of the Wall Street Journal, the most indispensible publication anywhere, famously remarked that to understand the movement of the stock markets, it was key to understand changes in valuation of stocks. As I look at valuations, unfortunately, they seem mighty high.
High Valuations
With corporate profits at all time highs, the market trades at 18 times (trailing 12 months) earnings. Bulls suggest that on a forward earnings basis this is more like 15 times, which is historic. They are right and wrong. Forward earnings are obviously more important than past earnings (only assets still held by the company that are available for distribution to shareholders count, but more on this in a bit), and 15 times earnings is a historically accurate figure (but for trailing, and not forward, earnings on which basis stocks have have valued closer to 13.8 times).
John Mauldin (check out his website from my links at right) notes that at profit margins from the 1990s(!) stocks would be trading at earnings of 25 times. Margins have improved primarily from two things, one, lower borrowing costs and two lower tax rates. That is, net income has increased from reductions in non-operating expense. Thus, businesses aren't really better today, external factors have aligned to reduce their costs.
Slowing earnings growth
In my last post, I talked about the expecations of relatively low growth in the earnings of assets in the future. The rates anticipated by Buffett and Gross are significantly lower than either the recent rates growth in earnings (the US economy is now in something like its 18th straight quarter of double digit earnings growth), nor anticipation of future earnings (which continue to call for double digit growth for some time, followed by high single digit growth). Some companies, of course, will experience strong growth in earnings like this, but as noted in my last post, all companies cannot grow earnings (corporate income) faster than overall income (GDP) beyond a few years.
Business have used low interest rates and lower tax rates to improve their balance sheets by refinancing and retiring debt, and by retiring equity in the form of stock buybacks. These conditions are often mistaken by bulls to mean that future earnings and cashflows should be much higher. In fact, business decisions are indicative of a very negative investing climate. Rather than use cheap credit to expand operations, they are using cheap credit to alter their capital structure. This is not a bad thing, per se, but it means that rather than borrow to acquire more assets to scale up and increase business activities, it means that they feel their current level of assets is adquate, and that they would rather reduce the claims on those assets. This may help earnings per share, but not earnings.
Their logic goes something like this. Say you are 10 years into a 30 year mortgage. If you take advantage of lower interest rates to refinance your mortgage and stretch payments out over a longer horizon, back to 30 years - and with cheap money why wouldn't you - you now have much higher cashflows than you had before. You have lower interest cost each month (because the balance is now financed at a lower rate, plus, you have smaller principal payments every month, because you are now going to amortize the principal over 30 years instead of 20). The question is what do you do with those cashflows? To keep this example representative, we have to assume that the property on which the mortgage is held is an investment property, and that it is profitably rented.
If all else remains equal - rent collected, etc - as a result of this change, your income will go up (because your interest expense will go down). But the logical thing to do, if the real estate business looks promising, is actually to relever the property by using the lower interest rate and longer payment horizon to keep the same payment, but take money out and use that money to purchase more real estate (thereby expanding operations and earning more money). If you aren't investing in more real estate in that environment, what does that say about business prospects? Might they be worsening? Might that mean that you would have lower income going forward? Even if interest rates remain low, maybe overbuilding or other conditions mean that rents in your area are falling (or are likely to fall, which is why you aren't committing to expanding your holdings).
Instead, businesses are using that higher income to either pay of other debts, increase cash (which improves balance sheet liquidity) or buy out partners (by repurchasing stock). Now, the stock repurchases are mostly a good idea. They reduce capital and assets, and thereby improve returns on equity (assuming that there is no impact on the business, the remaining shareholders should get more money, because the pie can be cut into fewer pieces).
Understand - this is NOT BULLISH!!! If interest rates are falling, why would you pay off debts, unless returns on capital are falling at least as fast? Think of it this way, if you used borrow at 3% and earn 6% on that money, and did so happily, and now you can borrow at 1%, why wouldn't you try and borrow more, even if you could only earn 5%, your margin would be greater. Plus, as you borrowed more and leveraged up, your returns on equity would improve (just like buying back stock). If instead you simply refi-ed your existing loans and took the extra cashflow and bought out your partners, what does that say about your expectation of growth prospects?
Worse yet, what if the favorable tax environment were to change ?
Thus, as investors, we have to assume lower earnings growth going forward. We also have to be willing to put a premium on quality earnings.
Options, the silent killer
So, values are high and earnings are set to slow down. When it comes to valuations there is one final issue - and that is options. If stock is repurchased, and prices rise, this helps option holders because as each share gets a greater portion of the pie, its value increases (and with it the value of the option). Worse, many of these options are not included in calculations of earnings per share (even diluted earnings per share often exclude significant amounts of options outstanding, because of an accounting convention that I will explain in a later post).
I have no detailed analysis on this, outside of the companies I follow, but I can tell you that P/E ratios on those stocks would be about 10% higher than they already are if all options were exercised. In the case of one stock I follow, complete dilution, including the effects of options and convertible prefered stock would push P/Es to above 30! Yikes! (I really should sell - Credit to the reader who figures out which stock it is).
As an investor, it is key to assume that all options will be excercised (even those that are "under water") because if the investment is a good one, price appreciation will almost certainly result. That is, nearly every good investment assumes that you are purchasing at a discount. The subsequent price rise will likely get options (at least those issued as compensation) above water. On that basis, if my experience is representative, then most companies have about 10% of their stock in options that are not counted in shares outstanding when diluted earnings per share are calculated and therefore the earnings per share is 10% lower than reported, and the P/E must therefore be 10& higher than reported. On a straight basis, that suggests that stocks are trading closer to 20 times earnings today, and on the John Mauldin 1990s margin basis, at 27.5 times.
No wonder finding good investments has been so damn hard.
High Valuations
With corporate profits at all time highs, the market trades at 18 times (trailing 12 months) earnings. Bulls suggest that on a forward earnings basis this is more like 15 times, which is historic. They are right and wrong. Forward earnings are obviously more important than past earnings (only assets still held by the company that are available for distribution to shareholders count, but more on this in a bit), and 15 times earnings is a historically accurate figure (but for trailing, and not forward, earnings on which basis stocks have have valued closer to 13.8 times).
John Mauldin (check out his website from my links at right) notes that at profit margins from the 1990s(!) stocks would be trading at earnings of 25 times. Margins have improved primarily from two things, one, lower borrowing costs and two lower tax rates. That is, net income has increased from reductions in non-operating expense. Thus, businesses aren't really better today, external factors have aligned to reduce their costs.
Slowing earnings growth
In my last post, I talked about the expecations of relatively low growth in the earnings of assets in the future. The rates anticipated by Buffett and Gross are significantly lower than either the recent rates growth in earnings (the US economy is now in something like its 18th straight quarter of double digit earnings growth), nor anticipation of future earnings (which continue to call for double digit growth for some time, followed by high single digit growth). Some companies, of course, will experience strong growth in earnings like this, but as noted in my last post, all companies cannot grow earnings (corporate income) faster than overall income (GDP) beyond a few years.
Business have used low interest rates and lower tax rates to improve their balance sheets by refinancing and retiring debt, and by retiring equity in the form of stock buybacks. These conditions are often mistaken by bulls to mean that future earnings and cashflows should be much higher. In fact, business decisions are indicative of a very negative investing climate. Rather than use cheap credit to expand operations, they are using cheap credit to alter their capital structure. This is not a bad thing, per se, but it means that rather than borrow to acquire more assets to scale up and increase business activities, it means that they feel their current level of assets is adquate, and that they would rather reduce the claims on those assets. This may help earnings per share, but not earnings.
Their logic goes something like this. Say you are 10 years into a 30 year mortgage. If you take advantage of lower interest rates to refinance your mortgage and stretch payments out over a longer horizon, back to 30 years - and with cheap money why wouldn't you - you now have much higher cashflows than you had before. You have lower interest cost each month (because the balance is now financed at a lower rate, plus, you have smaller principal payments every month, because you are now going to amortize the principal over 30 years instead of 20). The question is what do you do with those cashflows? To keep this example representative, we have to assume that the property on which the mortgage is held is an investment property, and that it is profitably rented.
If all else remains equal - rent collected, etc - as a result of this change, your income will go up (because your interest expense will go down). But the logical thing to do, if the real estate business looks promising, is actually to relever the property by using the lower interest rate and longer payment horizon to keep the same payment, but take money out and use that money to purchase more real estate (thereby expanding operations and earning more money). If you aren't investing in more real estate in that environment, what does that say about business prospects? Might they be worsening? Might that mean that you would have lower income going forward? Even if interest rates remain low, maybe overbuilding or other conditions mean that rents in your area are falling (or are likely to fall, which is why you aren't committing to expanding your holdings).
Instead, businesses are using that higher income to either pay of other debts, increase cash (which improves balance sheet liquidity) or buy out partners (by repurchasing stock). Now, the stock repurchases are mostly a good idea. They reduce capital and assets, and thereby improve returns on equity (assuming that there is no impact on the business, the remaining shareholders should get more money, because the pie can be cut into fewer pieces).
Understand - this is NOT BULLISH!!! If interest rates are falling, why would you pay off debts, unless returns on capital are falling at least as fast? Think of it this way, if you used borrow at 3% and earn 6% on that money, and did so happily, and now you can borrow at 1%, why wouldn't you try and borrow more, even if you could only earn 5%, your margin would be greater. Plus, as you borrowed more and leveraged up, your returns on equity would improve (just like buying back stock). If instead you simply refi-ed your existing loans and took the extra cashflow and bought out your partners, what does that say about your expectation of growth prospects?
Worse yet, what if the favorable tax environment were to change ?
Thus, as investors, we have to assume lower earnings growth going forward. We also have to be willing to put a premium on quality earnings.
Options, the silent killer
So, values are high and earnings are set to slow down. When it comes to valuations there is one final issue - and that is options. If stock is repurchased, and prices rise, this helps option holders because as each share gets a greater portion of the pie, its value increases (and with it the value of the option). Worse, many of these options are not included in calculations of earnings per share (even diluted earnings per share often exclude significant amounts of options outstanding, because of an accounting convention that I will explain in a later post).
I have no detailed analysis on this, outside of the companies I follow, but I can tell you that P/E ratios on those stocks would be about 10% higher than they already are if all options were exercised. In the case of one stock I follow, complete dilution, including the effects of options and convertible prefered stock would push P/Es to above 30! Yikes! (I really should sell - Credit to the reader who figures out which stock it is).
As an investor, it is key to assume that all options will be excercised (even those that are "under water") because if the investment is a good one, price appreciation will almost certainly result. That is, nearly every good investment assumes that you are purchasing at a discount. The subsequent price rise will likely get options (at least those issued as compensation) above water. On that basis, if my experience is representative, then most companies have about 10% of their stock in options that are not counted in shares outstanding when diluted earnings per share are calculated and therefore the earnings per share is 10% lower than reported, and the P/E must therefore be 10& higher than reported. On a straight basis, that suggests that stocks are trading closer to 20 times earnings today, and on the John Mauldin 1990s margin basis, at 27.5 times.
No wonder finding good investments has been so damn hard.
Bill Gross on the Alpha/Beta Challenge
Well, I have just returned from beautiful and warm Thailand. Thai must mean "snacks" in Thai, because the country is literally full of them. I have to say, it was pretty interesting having 78 degrees (Fahrenheit, that's 24 degrees Celsius) on Christmas Day. I'm now in Munich again, where it's sunny (if only for a few hours a day), but -3 (Celsius, which is 26 degrees Fahrenheit. It is an adjustment).
Any event, with my return to broadband, I am also catching up on my back reading, which has been severely curtailed by vacation travelling and sightseeing, moving countries, leaving my former employer and gearing up for a year at the University of St Gallen in Switzerland, where we compress a 22 month degree (the MBA) into 12 months.
But to the topic of this article, Gualberto Diaz has written a post about the current arguments between bulls and bears. I just read a great assessment by Bill Gross, the Managing Director at Pacific Investment Management (PIMCO) about the dilemma that we as investors are facing, which also sheds some light on the issue of what sort of markets to expect going forward. He describes it as the Alpha/Beta anemia. It's implications are far-reaching for investing strategy.
Start with a basic (and correct) assumption. Since GDP measures the overall income from domestic sources (domestic assets), over long periods, returns on assets are likely to rise in lock-step with growth in (nominal) GDP. Many investors still long for the "good old days" when double digit investing returns were common. This was due to the fact that from 1970-1985, nominal GDP increased in double digit amounts. (In the 1970s, asset price returns - which can diverge sharply from the growth of the underlying business income - lagged overall GDP growth, setting the stage for asset price growth stronger than GDP growth in later years to restore the correlation), and the period after 1993, when real GDP grew at 4-5% per year for most of a decade. While nominal GDP increased around 8%, any selectivity in investment choices meant that returns above 8% were easily obtained (and were easily magnified by using financial leverage, i.e. buying on margin).
Unfortunately, from one perspective, those days are over, at least, it would appear so. Economic growth (GDP by another name), is averaging much closer to 2.5%, with inflation matching that figure for a nominal GDP rate of 5% or so per year. Assets should return, therefore, something like that figure. Applying financial leverage (debt) might enable investors to push that up by 1 or 2%. Since asset price levels (in the very long term) reflect earning power of the underlying assets, asset prices (investor returns) are likely to be in this range. Incidentally Warren Buffett wrote an article in Fortune a few years back, and said about the same thing - he expected 6% returns going forward.
Are you still with me? In short, what Gross is saying is, asset income growth should be between five and six percent in the future, with the opportunity to use debt to improve returns on equity to six to seven percent per year. This figure, also called "beta" which describes how much of an investment's price movements can be correlated to market price movements (a basket of stocks with perfect market correlation has a beta of 1.0) is simply too anemic for most investors.
Faced with these returns, however, investors are essentially saying, "that's fine for other people, but I need at least nine or 10 percent". There are several reasons for this, Gross mentions only one, which is the fact that six or seven percent returns will not be adequate to fund future liabilities. He does not specify which liabilities he means but my sense is that he means healthcare and retirement expenses. This blog has said as much many times over (see retirment crisis).
As a result, investors are instead seeking out riskier investments, those that tend to have higher "alpha" which is the additional "reward" that riskier investments should offer. But with that effort to find higher return investments (like small-cap stocks, a favorite of "foolish" investors, particulalry right now), the ususal price discounts that these investments offer in return for their high risk (the risk premium) has diminished. In fact, small cap stocks, far from trading at a discount to large issues, trade at a substantial price premium (which, to some degree may be mitigated by the potential for faster growth, but this is what these alpha-seeking investors are all assuming).
You know what happens when people are lining up to buy something, particularly something that is sold at an auction (which is the case with stocks!), buyers overpay.
In short, what has happened is that the price of risk, the risk premium, has declined substantially. The implications are significant. First, periods of significant stability can actually create risk, because over long periods investors become accustomed to being rewarded for making ever riskier bets, until, unfortunately, they aren't. When the tide turns, many investors will find they have been "swimming naked" in the words of Buffett.
Worse, systemmic underpricing of risk means that index-weighted portfolios (which are weighted in large part based on price levels) will always over-invest in over-priced assets, and under-invest in (risk-adjusted) underpriced assets, as the overpriced assets have higher market capitalization relative to earning potential, and underpriced assets, by definition, have low capitalization relalitve to earning potential. Indexers, in other words, far from being protected by "diversification" will discover that diversification has them overinvesting in today's high priced assets. While their losses might not be as spectactular as those of an investor who was 100% invested in "optical networking" stocks in 2000-2001, losses of 30-50% in diversified porfolios will be little comfort.
Gross suggests, I believe rightly, that the only thing an investor can do is seek to concentrate his money in the single few best investments he can find. Those that offer opportunities to earn superior (and here he means 7%) returns with comparably little risk.
He does not believe that assuming addtional financial leverage is a smart move at this point. Basically, there are two options, the first is that the Fed will renew vigilance with respect to inflation and again raise interest rates. This will reduce financial leverage in the system, which _should_ make things safer, but might also lead to a collapse in certain overvalued asset prices, thereby provoking the crisis that the Fed hopes to prevent. Or, the Fed can allow higher inflation, which, while it will prevent (at least in the short term) a credit crisis, inflation also generally leads to lower asset prices as the twin effects of taxes and higher discount rates reduce present values of assets thereby leading to price declines or stagnation (like the 1970s).
Finally, unmentioned by Bill Gross, but mentioned by Gualberto, most businesses are at peak earning cycles. corporate profits' share of GDP is at all time highs (which is one way that asset prices have outstripped GDP growth over the past three years). The trend of business income increasing faster than overall income cannot continue indefinately. Tax levels linger near post-war lows as (unrecognized) government liabilities pile up on balance sheets, which foretells of greater tax burdens in the future; corporate income, already at high levels, is a natural target for revenue raising.
Finally, we have the issue of those other pesky liabilities for which assets earning six or seven percent - the ones I call the Boomer-Lifestyle Liabilities. These are the costs associated with retiring in the style the Boomers imagine themselves living. Let me make this clear, Boomers, as a group, will live a retirment lifestyle well below that which they are living now. There are various ways that they can help to reduce the gap - they can continue to work in retirement (or not retire), they can pick really great investments (but not all of them can) and they can win the lottery (again, not all can do this either), which means that Boomer consumption will begin declining.
Lower consumption (and higher savings) means more money chasing assets of declining quality (less consumption means lower business income). I don't have to tell you where that leads.
What does this all mean? Most of the bull arguments I have seen are really trader/herder mentality. It amounts to "ride the wave", with a focus on recent economic reports and stock market price level movements as a reason to invest. I will not tell anyone not to ride the wave. But I will ask, what happens when the tide turns, as it will, maybe next year, maybe 2009. Are your assets good enough to survive a major change? Even good enough to survive a tsunami? As Thais can tell you, bad things can happen even when the weather seems perfect at the beach.
Any event, with my return to broadband, I am also catching up on my back reading, which has been severely curtailed by vacation travelling and sightseeing, moving countries, leaving my former employer and gearing up for a year at the University of St Gallen in Switzerland, where we compress a 22 month degree (the MBA) into 12 months.
But to the topic of this article, Gualberto Diaz has written a post about the current arguments between bulls and bears. I just read a great assessment by Bill Gross, the Managing Director at Pacific Investment Management (PIMCO) about the dilemma that we as investors are facing, which also sheds some light on the issue of what sort of markets to expect going forward. He describes it as the Alpha/Beta anemia. It's implications are far-reaching for investing strategy.
Start with a basic (and correct) assumption. Since GDP measures the overall income from domestic sources (domestic assets), over long periods, returns on assets are likely to rise in lock-step with growth in (nominal) GDP. Many investors still long for the "good old days" when double digit investing returns were common. This was due to the fact that from 1970-1985, nominal GDP increased in double digit amounts. (In the 1970s, asset price returns - which can diverge sharply from the growth of the underlying business income - lagged overall GDP growth, setting the stage for asset price growth stronger than GDP growth in later years to restore the correlation), and the period after 1993, when real GDP grew at 4-5% per year for most of a decade. While nominal GDP increased around 8%, any selectivity in investment choices meant that returns above 8% were easily obtained (and were easily magnified by using financial leverage, i.e. buying on margin).
Unfortunately, from one perspective, those days are over, at least, it would appear so. Economic growth (GDP by another name), is averaging much closer to 2.5%, with inflation matching that figure for a nominal GDP rate of 5% or so per year. Assets should return, therefore, something like that figure. Applying financial leverage (debt) might enable investors to push that up by 1 or 2%. Since asset price levels (in the very long term) reflect earning power of the underlying assets, asset prices (investor returns) are likely to be in this range. Incidentally Warren Buffett wrote an article in Fortune a few years back, and said about the same thing - he expected 6% returns going forward.
Are you still with me? In short, what Gross is saying is, asset income growth should be between five and six percent in the future, with the opportunity to use debt to improve returns on equity to six to seven percent per year. This figure, also called "beta" which describes how much of an investment's price movements can be correlated to market price movements (a basket of stocks with perfect market correlation has a beta of 1.0) is simply too anemic for most investors.
Faced with these returns, however, investors are essentially saying, "that's fine for other people, but I need at least nine or 10 percent". There are several reasons for this, Gross mentions only one, which is the fact that six or seven percent returns will not be adequate to fund future liabilities. He does not specify which liabilities he means but my sense is that he means healthcare and retirement expenses. This blog has said as much many times over (see retirment crisis).
As a result, investors are instead seeking out riskier investments, those that tend to have higher "alpha" which is the additional "reward" that riskier investments should offer. But with that effort to find higher return investments (like small-cap stocks, a favorite of "foolish" investors, particulalry right now), the ususal price discounts that these investments offer in return for their high risk (the risk premium) has diminished. In fact, small cap stocks, far from trading at a discount to large issues, trade at a substantial price premium (which, to some degree may be mitigated by the potential for faster growth, but this is what these alpha-seeking investors are all assuming).
You know what happens when people are lining up to buy something, particularly something that is sold at an auction (which is the case with stocks!), buyers overpay.
In short, what has happened is that the price of risk, the risk premium, has declined substantially. The implications are significant. First, periods of significant stability can actually create risk, because over long periods investors become accustomed to being rewarded for making ever riskier bets, until, unfortunately, they aren't. When the tide turns, many investors will find they have been "swimming naked" in the words of Buffett.
Worse, systemmic underpricing of risk means that index-weighted portfolios (which are weighted in large part based on price levels) will always over-invest in over-priced assets, and under-invest in (risk-adjusted) underpriced assets, as the overpriced assets have higher market capitalization relative to earning potential, and underpriced assets, by definition, have low capitalization relalitve to earning potential. Indexers, in other words, far from being protected by "diversification" will discover that diversification has them overinvesting in today's high priced assets. While their losses might not be as spectactular as those of an investor who was 100% invested in "optical networking" stocks in 2000-2001, losses of 30-50% in diversified porfolios will be little comfort.
Gross suggests, I believe rightly, that the only thing an investor can do is seek to concentrate his money in the single few best investments he can find. Those that offer opportunities to earn superior (and here he means 7%) returns with comparably little risk.
He does not believe that assuming addtional financial leverage is a smart move at this point. Basically, there are two options, the first is that the Fed will renew vigilance with respect to inflation and again raise interest rates. This will reduce financial leverage in the system, which _should_ make things safer, but might also lead to a collapse in certain overvalued asset prices, thereby provoking the crisis that the Fed hopes to prevent. Or, the Fed can allow higher inflation, which, while it will prevent (at least in the short term) a credit crisis, inflation also generally leads to lower asset prices as the twin effects of taxes and higher discount rates reduce present values of assets thereby leading to price declines or stagnation (like the 1970s).
Finally, unmentioned by Bill Gross, but mentioned by Gualberto, most businesses are at peak earning cycles. corporate profits' share of GDP is at all time highs (which is one way that asset prices have outstripped GDP growth over the past three years). The trend of business income increasing faster than overall income cannot continue indefinately. Tax levels linger near post-war lows as (unrecognized) government liabilities pile up on balance sheets, which foretells of greater tax burdens in the future; corporate income, already at high levels, is a natural target for revenue raising.
Finally, we have the issue of those other pesky liabilities for which assets earning six or seven percent - the ones I call the Boomer-Lifestyle Liabilities. These are the costs associated with retiring in the style the Boomers imagine themselves living. Let me make this clear, Boomers, as a group, will live a retirment lifestyle well below that which they are living now. There are various ways that they can help to reduce the gap - they can continue to work in retirement (or not retire), they can pick really great investments (but not all of them can) and they can win the lottery (again, not all can do this either), which means that Boomer consumption will begin declining.
Lower consumption (and higher savings) means more money chasing assets of declining quality (less consumption means lower business income). I don't have to tell you where that leads.
What does this all mean? Most of the bull arguments I have seen are really trader/herder mentality. It amounts to "ride the wave", with a focus on recent economic reports and stock market price level movements as a reason to invest. I will not tell anyone not to ride the wave. But I will ask, what happens when the tide turns, as it will, maybe next year, maybe 2009. Are your assets good enough to survive a major change? Even good enough to survive a tsunami? As Thais can tell you, bad things can happen even when the weather seems perfect at the beach.
Sunday, November 26, 2006
Commodity Prices, what do they Suggest
Well, I am already on record as paying relatively little attention to commodities, but I do pay attention to prices levels of some commodities, particularly gold, because of what it suggests about the purchasing power of the dollar. The news here is not good. The dollar is hitting 20 month lows against the Euro. Worse, the price of gold has quietly crept up to near $640 and it might go higher.
One cornerstone of any successful investing strategy is maintaining (at a minimum) purchasing power in spite of a dollar that loses its value on a regular basis (inflation).
Now I have perhaps taken both sides of this argument in the past, which is to say, I have purchased (and continue to hold) a position in CL becuase of its ability to have strong earnings regardless of the relative strength or weakness of the dollar. At the same time, I have argued that commodity prices should fall with the next US recession, which will, in my opinion, be deep.
Ironically, I see the very rise in commodity prices as a major factor in provoking the recession. The Fed has finally admitted that its monetary policy was far too loose in 2003-2004. As a result prices have begun rising significantly, because there is too much money sloshing around the system, and not enough goods for them to chase.
While this is not bad, what makes this situation a disaster is the resulting credit bubble. Credit bubbles are very, very bad. When there seems like there is little consequence of borrowing (like low interest rates), people borrow more than is prudent. They take advantage of the lower rates possible, by using variable interest rates on their debt. In short, they set themselves up for a credit crunch when money gets tighter (as it inevitably does). The Fed would like to end the credit bubble without bringing economic activity to a standstill. This is an admirable objective, but as price levels are again demonstrating, it is not a probable result.
I felt that the Fed erred in stopping further interest rate rises, which, after a monetary orgy, the likes of which we have not seen in decades, only aggresive policy was likely to really curb the bubble. Instead, the Fed has just slowed down the expansion of credit, rather than rein it in. Therefore, prices are bound to keep rising. But the Fed cannot continue to allow these higher prices. They will be forced not to trim rates, but rather to raise them. In the 1990s, we watched central banks go on competitive devaluations and cut rates. Now, we will watch them go on competitive "protection" positions - each raising in part because it wants to defend the value of its currency. The alternative is to watch commodity prices, in local currency terms, rise to highly inflationary levels.
As banks keep tightening credit, those who borrowed imprudently when money was cheap will begin to have difficulty making payments. You know the story from there. Imagine the impact on housing if the Fed finds itself raising rates to 5.75% or 6% next year! Brutal.
But, with rates headed higher, it still pays to keep savings in short term vehicles. They are already paying higher rates, are protected against principal loss (which will happen if long rates rise to reflect inflation) and offer liquidity for making opportunistic purchases.
One cornerstone of any successful investing strategy is maintaining (at a minimum) purchasing power in spite of a dollar that loses its value on a regular basis (inflation).
Now I have perhaps taken both sides of this argument in the past, which is to say, I have purchased (and continue to hold) a position in CL becuase of its ability to have strong earnings regardless of the relative strength or weakness of the dollar. At the same time, I have argued that commodity prices should fall with the next US recession, which will, in my opinion, be deep.
Ironically, I see the very rise in commodity prices as a major factor in provoking the recession. The Fed has finally admitted that its monetary policy was far too loose in 2003-2004. As a result prices have begun rising significantly, because there is too much money sloshing around the system, and not enough goods for them to chase.
While this is not bad, what makes this situation a disaster is the resulting credit bubble. Credit bubbles are very, very bad. When there seems like there is little consequence of borrowing (like low interest rates), people borrow more than is prudent. They take advantage of the lower rates possible, by using variable interest rates on their debt. In short, they set themselves up for a credit crunch when money gets tighter (as it inevitably does). The Fed would like to end the credit bubble without bringing economic activity to a standstill. This is an admirable objective, but as price levels are again demonstrating, it is not a probable result.
I felt that the Fed erred in stopping further interest rate rises, which, after a monetary orgy, the likes of which we have not seen in decades, only aggresive policy was likely to really curb the bubble. Instead, the Fed has just slowed down the expansion of credit, rather than rein it in. Therefore, prices are bound to keep rising. But the Fed cannot continue to allow these higher prices. They will be forced not to trim rates, but rather to raise them. In the 1990s, we watched central banks go on competitive devaluations and cut rates. Now, we will watch them go on competitive "protection" positions - each raising in part because it wants to defend the value of its currency. The alternative is to watch commodity prices, in local currency terms, rise to highly inflationary levels.
As banks keep tightening credit, those who borrowed imprudently when money was cheap will begin to have difficulty making payments. You know the story from there. Imagine the impact on housing if the Fed finds itself raising rates to 5.75% or 6% next year! Brutal.
But, with rates headed higher, it still pays to keep savings in short term vehicles. They are already paying higher rates, are protected against principal loss (which will happen if long rates rise to reflect inflation) and offer liquidity for making opportunistic purchases.
Wednesday, November 22, 2006
Sites to See
Just because I haven't posting with regularity doesn't mean I am not trying to keep up with what's going on in the finance blogosphere. I have come across a few new sites you should check out.
It's not a secret that I like stocks that pay dividends and repurchase stock. I like companies where the pie is growing, payouts are growing and my share of the growing pie (and payouts) is growing. One site that can help develop a short list is stockinvestingx. The site lists many features about top 100 dividend payers and repurchasers. Beware, however, that just knowing companies making significant repurchases is not enough, you also need to consider the stock and option issuance that is on the other side of the repurchases. You can always find information on equity and option issuance in a 10-K and shareholder friendly companies also include this in a 10-Q.
The other site is from a real estate bull and sometime commentator on this blog, Larry Nussbaum who writes the Millionaire Now Blog. He also has a book. His site writes on a variety of finance and investing topics.
It's not a secret that I like stocks that pay dividends and repurchase stock. I like companies where the pie is growing, payouts are growing and my share of the growing pie (and payouts) is growing. One site that can help develop a short list is stockinvestingx. The site lists many features about top 100 dividend payers and repurchasers. Beware, however, that just knowing companies making significant repurchases is not enough, you also need to consider the stock and option issuance that is on the other side of the repurchases. You can always find information on equity and option issuance in a 10-K and shareholder friendly companies also include this in a 10-Q.
The other site is from a real estate bull and sometime commentator on this blog, Larry Nussbaum who writes the Millionaire Now Blog. He also has a book. His site writes on a variety of finance and investing topics.
Harry Dent Forecast
My friend Jason Tilberg has shared a new Harry Dent forecast. Now, I have to admit that I think the man is far too optimistic about a raging bull market between now and 2009. On the other hand, Dent and I agree that there is a big drop coming and we both believe that it relates to coming changes in Boomer spending habits. After years of "living for today" and spending, spending, spending, Boomers are about to get to "imagine no possessions", because that is what their financial condition will provide them in retirement. The problem is, they are going to take the economy with them.
Boomer consumption is a major driver of economic activity. Since few Boomers will be able to maintain that rate of spending in retirement (in part because their spending already exceeds their income), Boomers will dramatically reduce consumption in retirement. Future generations will not spend the same way and lower aggregate demand will result. The problem will get worse as we get deeper into the Boom.
I actually see the downturn in housing leading to reduced activity starting in 2007, with no boom, and a full on bust in full by 2008 from which there will be no recovery for a decade or more. Stalled earnings growth, or even downright lower earnings should end the rally in the markets.
But maybe Dent has a point. Much depends on Boomer behavior between now and retirement. While there is no way for most Boomers to save enough to maintain their standard of living in retirment (which means future consumption will decline in any event) but Boomers may try and avoid their fate by making major changes in spending and saving habits. Initial moves to increase savings will lead to higher asset prices, most likely in stocks. It won't be enough to prevent the inevitable, the economy simply cannot support that much consumption by non-workers, but as an investor it might be possible to ride that wave.
I continue to urge caution in investing. Downside risks are large, in spite of bullish predictions and claims that equities are cheap. They are not. Bonds are expensive - but you have to ask yourself, why is that savvy bond market so pessimistic.
Boomer consumption is a major driver of economic activity. Since few Boomers will be able to maintain that rate of spending in retirement (in part because their spending already exceeds their income), Boomers will dramatically reduce consumption in retirement. Future generations will not spend the same way and lower aggregate demand will result. The problem will get worse as we get deeper into the Boom.
I actually see the downturn in housing leading to reduced activity starting in 2007, with no boom, and a full on bust in full by 2008 from which there will be no recovery for a decade or more. Stalled earnings growth, or even downright lower earnings should end the rally in the markets.
But maybe Dent has a point. Much depends on Boomer behavior between now and retirement. While there is no way for most Boomers to save enough to maintain their standard of living in retirment (which means future consumption will decline in any event) but Boomers may try and avoid their fate by making major changes in spending and saving habits. Initial moves to increase savings will lead to higher asset prices, most likely in stocks. It won't be enough to prevent the inevitable, the economy simply cannot support that much consumption by non-workers, but as an investor it might be possible to ride that wave.
I continue to urge caution in investing. Downside risks are large, in spite of bullish predictions and claims that equities are cheap. They are not. Bonds are expensive - but you have to ask yourself, why is that savvy bond market so pessimistic.
Monday, November 20, 2006
What the Phelps Dodge Acquisition Means
So, there is little doubt that I am a bear when it comes to asset prices. Many other commentators agree with me with regards to copper. This is reassuring, since I do not study commodity markets.
People who live this business, however, are suggesting that I am wrong. Had I listened to my friend Jason Tilberg, I could have made some nice dough in Southern Copper. But as I noted above, I don't follow commodity markets, so I ignored it (trying to stay in my zone of comfort). Plus, as noted above, I am an asset price bear, so in my mind, commodities, and companies tied to them, are things to avoid.
However, there is increasing evidence that I have erred. The Freeport acquisition of PD is such evidence. Freeport clearly believes that copper prices will remain high enough, long enough for it to basically pay down the new debt it is issuing to acquire Phelps before prices fall. The transaction is actually accreditive to earnings in the first year. This is rare in an acquisition, since the premium paid is usually too high, and new shares issued for the acquisition, plus other acquisition costs usually put a dent in earnings for at least 12 months, before cost cutting synergies and pricing power take root.
Now, even if copper prices fall, Freeport may have gotten a good deal, since as the largest manufacturer, they should also be the low cost supplier to the market (higher market share leads almost inevitably to lower relative cost), and in an oversupplied market, it is the low cost provider (whic can still reduce prices and make money) that wins.
Even so, this is a bet on higher copper prices going forward, because the increased fixed charges have to be paid by cash coming from operations. If copper can remain at elevated prices for another year or two, however, and Freeport is disciplined at deleveraging, they have the opportunity to reduce those fixed charges by the time prices begin dropping.
People who live this business, however, are suggesting that I am wrong. Had I listened to my friend Jason Tilberg, I could have made some nice dough in Southern Copper. But as I noted above, I don't follow commodity markets, so I ignored it (trying to stay in my zone of comfort). Plus, as noted above, I am an asset price bear, so in my mind, commodities, and companies tied to them, are things to avoid.
However, there is increasing evidence that I have erred. The Freeport acquisition of PD is such evidence. Freeport clearly believes that copper prices will remain high enough, long enough for it to basically pay down the new debt it is issuing to acquire Phelps before prices fall. The transaction is actually accreditive to earnings in the first year. This is rare in an acquisition, since the premium paid is usually too high, and new shares issued for the acquisition, plus other acquisition costs usually put a dent in earnings for at least 12 months, before cost cutting synergies and pricing power take root.
Now, even if copper prices fall, Freeport may have gotten a good deal, since as the largest manufacturer, they should also be the low cost supplier to the market (higher market share leads almost inevitably to lower relative cost), and in an oversupplied market, it is the low cost provider (whic can still reduce prices and make money) that wins.
Even so, this is a bet on higher copper prices going forward, because the increased fixed charges have to be paid by cash coming from operations. If copper can remain at elevated prices for another year or two, however, and Freeport is disciplined at deleveraging, they have the opportunity to reduce those fixed charges by the time prices begin dropping.
Views on the Housing Market
As regular readers know, I am a housing bear. Together with that, I am actually an economic bear. I believe that this housing bubble collapse will lead to wholesale changes in spending patterns, particularly among boomer households, who are as a group woefully unprepared for the retirement that looms for many.
An asset price decline will lead to a negative wealth effect and coupled with actual income declines (most boomers are planning to have only 60-80% of their pre-retirement income in retirement, while they currently spend more than they earn), will lead to a major depression not seen since the 1930s.
In this article from John Mauldin, A. Gary Schilling, a noted Yale professor (and real estate bear) reviews all the reasons why the bear market in real estate is only getting warmed up. He makes frequent mention of how the real estate bubble resembles that of the 1920s. While Schilling does not seem to believe that we are headed to the 1930s he does mention the possibility. It is critical to understand that the depression of the 1930s was NOT caused by the stock market crash. The crash was indicative of (the decline) of other economic activity. The post-crash connection was made by anti-capitalist politicos who played up populist resentment of Northeastern bankers to win elections in 1932, 1934 and 1936. But here I digress.
The depression of the 1930s resulted from an attempt by the Federal Reserve to unmake a massive inflation in caused with easy money in 1926. In that year, the Bank of England wanted to return to the gold standard, and do so at it´s pre-WWI peg. While this action satisfied British egos, it was monumentally stupid. Wartime expenditures had led to a massive increase in pounds stirling in circulation, and gold supply simply had not kept up. So, when the UK returned to its peg, gold started flowing out of the country. The BoE was in danger of dropping the peg when it prevailed on the Fed to cut interest rates to reverse the outflow of gold. The Fed complied, and dropped nominal rates by over 100 basis points, and gold started flowing out of the US and to the UK where it could be put to work at higher rates.
This drop in rates, however, led to speculative borrowing in the US. It also led to a temporary increase in the price of farm products (which had enjoyed war-influenced high prices since 1915: the war had destroyed significant acreage in Europe, and the Continent was forced to import food, leading to high prices). All of this came to a head at the same time. By 1928, Continental acreage was coming back under tillage, increasing supply, while subsequent increases in interest rates (used to reduce speculative purchases of coastal real estate) meant that farm loans, and their interest payments now exceeded the revenue that family farms could generate. While this may seem laughable today, it was significant in a country where half the population still lived on farms. Banks failed all over the place, but most severely in the Midwest and West, where banking laws forced the Bank of Podunk to take deposits and make loans in Podunk. With such concentration of portfolios, substantially all of the assets of the bank (loans to the farmers of Podunk, secured with mortgages against the farms of Podunk) were devalued together. Once the banks failed, even farmers who weren't in default found themselves with their savings wiped out (remember, there was no deposit insurance).
But, I hear the reader say, we have much more sophisticated risk modelling today: banks have better risk management, they are no longer limited to lending in the neighborhood, through securitization, they can lay off significant risks (and purchase risks from other markets), the Federal Reserve has 80 more years of education under its belt, and we have deposit insurance.
All of these things are true, but what we need to recognize is that we have also transferred risk to individuals on a scale we have not had since before the Bad Deal. While this is not a bad thing (it enables those individuals to profit from the risk premia they have assumed, for instance), many of those risk-takers do not understand the risks they are taking. This means that they may not be insisting on the premiums they require. While there may be deposit insurance on savings, there is no such insurance on the equity and mutual fund portfolios that comprise the vast majority of the financial assets of Americans. The Federal Reserve seems just as willing today to make poor economic decisions in the interest of politics, namely the Greenspan inflation, which I have discussed often. Finally, let us not forget that Japan had all the same advantages when it entered its 15 year "lost decade". Asset prices still have nor recovered to pre-collapse levels. And the US lacks the significant exports and current account surplus that Japan has used to bolster economic activity.
This real estate collapse will be unlike any we have seen. I think Schilling´s projections of a 25% drop in prices is quite realistic. Only a major inflation can prevent it.
I continue to recommend defensive positions. An interesting suggestion of Schilling (who believes interest rates are headed lower as part of the deflation) is to purchase long zero coupon bonds. Prices of such bonds are going to skyrocket if rates decline to 3% as he believes.
I am looking to investigate this option seriously.
An asset price decline will lead to a negative wealth effect and coupled with actual income declines (most boomers are planning to have only 60-80% of their pre-retirement income in retirement, while they currently spend more than they earn), will lead to a major depression not seen since the 1930s.
In this article from John Mauldin, A. Gary Schilling, a noted Yale professor (and real estate bear) reviews all the reasons why the bear market in real estate is only getting warmed up. He makes frequent mention of how the real estate bubble resembles that of the 1920s. While Schilling does not seem to believe that we are headed to the 1930s he does mention the possibility. It is critical to understand that the depression of the 1930s was NOT caused by the stock market crash. The crash was indicative of (the decline) of other economic activity. The post-crash connection was made by anti-capitalist politicos who played up populist resentment of Northeastern bankers to win elections in 1932, 1934 and 1936. But here I digress.
The depression of the 1930s resulted from an attempt by the Federal Reserve to unmake a massive inflation in caused with easy money in 1926. In that year, the Bank of England wanted to return to the gold standard, and do so at it´s pre-WWI peg. While this action satisfied British egos, it was monumentally stupid. Wartime expenditures had led to a massive increase in pounds stirling in circulation, and gold supply simply had not kept up. So, when the UK returned to its peg, gold started flowing out of the country. The BoE was in danger of dropping the peg when it prevailed on the Fed to cut interest rates to reverse the outflow of gold. The Fed complied, and dropped nominal rates by over 100 basis points, and gold started flowing out of the US and to the UK where it could be put to work at higher rates.
This drop in rates, however, led to speculative borrowing in the US. It also led to a temporary increase in the price of farm products (which had enjoyed war-influenced high prices since 1915: the war had destroyed significant acreage in Europe, and the Continent was forced to import food, leading to high prices). All of this came to a head at the same time. By 1928, Continental acreage was coming back under tillage, increasing supply, while subsequent increases in interest rates (used to reduce speculative purchases of coastal real estate) meant that farm loans, and their interest payments now exceeded the revenue that family farms could generate. While this may seem laughable today, it was significant in a country where half the population still lived on farms. Banks failed all over the place, but most severely in the Midwest and West, where banking laws forced the Bank of Podunk to take deposits and make loans in Podunk. With such concentration of portfolios, substantially all of the assets of the bank (loans to the farmers of Podunk, secured with mortgages against the farms of Podunk) were devalued together. Once the banks failed, even farmers who weren't in default found themselves with their savings wiped out (remember, there was no deposit insurance).
But, I hear the reader say, we have much more sophisticated risk modelling today: banks have better risk management, they are no longer limited to lending in the neighborhood, through securitization, they can lay off significant risks (and purchase risks from other markets), the Federal Reserve has 80 more years of education under its belt, and we have deposit insurance.
All of these things are true, but what we need to recognize is that we have also transferred risk to individuals on a scale we have not had since before the Bad Deal. While this is not a bad thing (it enables those individuals to profit from the risk premia they have assumed, for instance), many of those risk-takers do not understand the risks they are taking. This means that they may not be insisting on the premiums they require. While there may be deposit insurance on savings, there is no such insurance on the equity and mutual fund portfolios that comprise the vast majority of the financial assets of Americans. The Federal Reserve seems just as willing today to make poor economic decisions in the interest of politics, namely the Greenspan inflation, which I have discussed often. Finally, let us not forget that Japan had all the same advantages when it entered its 15 year "lost decade". Asset prices still have nor recovered to pre-collapse levels. And the US lacks the significant exports and current account surplus that Japan has used to bolster economic activity.
This real estate collapse will be unlike any we have seen. I think Schilling´s projections of a 25% drop in prices is quite realistic. Only a major inflation can prevent it.
I continue to recommend defensive positions. An interesting suggestion of Schilling (who believes interest rates are headed lower as part of the deflation) is to purchase long zero coupon bonds. Prices of such bonds are going to skyrocket if rates decline to 3% as he believes.
I am looking to investigate this option seriously.
Sunday, November 19, 2006
Personal Update
Regular readers of this blog will note that postings have become somewhat anemic lately. I have to apologize, because my commitment to investing and to this blog have not diminished, but available time has been hard to come by.
I am making some major changes in my life. I am leaving my nice job here in New Jersey working on strategic management in aftersales to increase my international exposure and earn an MBA at the University of St Gallen, one of the top-5 MBA programs in Europe. The school´s website is here. With this degree (and 12 months in Switzerland, which is going to be awesome in itself), I will look to join the ranks of the strategy consultants, hopefully with BCG. We shall see.
Actually, returning to school will probably help the quality of this blog. I will benefit from academic exposure and the time to think about ideas that school offers. The problem has been that I have been in the process of launching some new programs at work before I leave, and simultaneously moving to another country.
I will endeavor to post more in the next few weeks, before I head to Europe on the 6th of December, and thence to Thailand. Once that happens, on the 9th of December, there will likely be few posts until I get settled in Switzerland in the new year.
I am making some major changes in my life. I am leaving my nice job here in New Jersey working on strategic management in aftersales to increase my international exposure and earn an MBA at the University of St Gallen, one of the top-5 MBA programs in Europe. The school´s website is here. With this degree (and 12 months in Switzerland, which is going to be awesome in itself), I will look to join the ranks of the strategy consultants, hopefully with BCG. We shall see.
Actually, returning to school will probably help the quality of this blog. I will benefit from academic exposure and the time to think about ideas that school offers. The problem has been that I have been in the process of launching some new programs at work before I leave, and simultaneously moving to another country.
I will endeavor to post more in the next few weeks, before I head to Europe on the 6th of December, and thence to Thailand. Once that happens, on the 9th of December, there will likely be few posts until I get settled in Switzerland in the new year.
Developments
Nathan Mayer Rothschild, the oldest of the five Rothschild brothers who established the venerable commercial bank in the late eighteenth and early nineteenth centuries, is said to have remarked, "I never buy at the bottom and I always sell too soon." This sentiment is echoed by the American financier (I believe it was JP Morgan), who, when presented with an investment offering 100% returns, remarked, "Well, you can have the first 30% and the last 30% and I will just take the nice safe 40% in the middle." In other words, he wasn´t interested in buying before he was certain that the return would be positive.
I have recently read that the essence of investing is not managing returns, it´s managing risk. First you want to be reasonably sure of a positive return (capital preservation), only then do you want to consider the potential magnitude of the returns. Too many people look at the magnitude of returns first, and only then consider the probability of achieving these returns. This is why the lottery is so popular - it offers a huge return, for essentially nothing. Of course, most purchasers are simply incapable of appreciating the remoteness of the probability that their return will be positive. So they lose 100% every week, occasionally winning a minor pot of $5 or $10 to desensitize them to the dififculty of the odds they face.
This post isn´t about the lottery, however, it´s about TRLG. I mentioned in a prior post that I had left the temple of True Religion. Actually, I left a few weeks too early. I sold at $22.60 on a day when the high price for the day was §22.80. A few weeks later, the stock actually made new all-time highs in the $24.65 range. I lost out on an extra $800 by "selling too soon". But as my calculations from my DCF model suggested, the stock was near its highs at $22.60, and the probability of further gains were remote. Earnings would have to rise even faster than the 50% I projected for this year (35% for next), or operating margins would have to increase. While the first event was possible, I held out no expectations of the latter.
I work for a manufacturer. Like all companies with independent distribution, we regularly consider whether we wouldn´t be better off if we could capture more downstream revenue. Since pricing is usually based on cost-plus margining, capturing retail sales would significantly increase revenue, without actually capturing market share (we would benefit from selling at the retail price, which , for spare parts, is usually 65-100% greater than the wholesale price). The problem is that in order to do this, we would also have to absorb retail inventory, which would significantly increase working capital. We would also have to pay the expenses at retail that the distributors bear, personnel, rent and overhead. Worse, as a manufacturer, we would only really have one product line, whereas most distributors can amortize expenses over a wider product assortment available to them (since they can sell products from many manufacturers). This is essentially the difference between a specialty retailer and a department store. The department store also finds it easier to attract new customers, since it can easily cross-sell shoppers in the store for other promotions or products.
In fact, what we have begun to see from True Religion is that sales outside of the US are flagging, or at least, not increasing. Sales in the US are increasing, but primarily due to growth in the retail segment (i.e. the company is capturing that downstream revenue). However, this means that revenue is increasing faster than product volume, which raises serious questions about the acceptance of the brand on a broader scope. Worse, they are seeing increasing overhead, which management insists is required for future product introductions, but managing a retail chain is difficult. The company has brought in experience for this. The current management team has demonstrated success with retail, but what we are seeing is collapsing operating margins. For a company whose primary value is in future earnings, lower operating margins have to terrify investors.
In fact, while I was in Mexico on a business trip (I was in the buffett line at lunch actually), two other attendees started talking about the collapse of the stock price of TRLG, which has since declined to the mid $15 range. At this price, you might very well be able to round-trip the stock back up to $20, if management can find the new revenues to justify the ramp-up in expenses. But for the first time, management has failed to deliver the goods and so their ability to win converts on the street will come much harder.
At this point, I am sitting on lots and lots of cash. Buffett notes that this is no fun, and I concur, but at the same time, its better to sit on cash than watch your positions collapse. I am still looking for another investment that I find as attractive as TRLG. Right now, the only investment I consider worthwhile is BAC. I am even beginning to doubt the CL. Since I purchased in October 0f 2004, I have watched the stock price rise 50%, from $44 to $66, at the same time, I have earned nice dividends, which have been hiked twice, from 24 cents to 32 cents a share (for a 33%) increase over the same period. My shareholdings have increased by nearly four percent, giving me a total return of over 56% for the period (If you are wondering why my return isn´t 54%, the sum of the two, the reason is that the shares purchased from dividend reinvestment have also benefitted from rising prices, so my total return exceeds the price increase plus dividend payments).
Generally speaking, your return should reflect the dividend yield plus the rate of increase of dividends. (I have another post explaining why this is so, but essentially, with dividend paying stocks, prices tend to increase at the same rate as dividend increases). With CL price increases have outstripped dividend increases, so the dividend yield has fallen. This suggests lower returns going forward. Indeed, to return to the dividend rate of Oct 2004, when I purchased, dividends would have to increase about 17% or 5 cents per share, from here with no increase in the stock price. This would then offer a return of about 2.6% (the dividend yield at 37 cents per share, per quarter). Such a dividend increase is actually quite probable. The company tends to maintain a dividend payout ratio of around 50% of earnings, with much of the remaining money going to repurchase stock, both preferred and common. In the latest quarter the company earned $0.73 per share. With forward earnings expected to run about $0.80 per share per quarter the company could raise to 38-39 cents per share per quarter. Organic growth, plus benefits from the company´s restructuring make these very reasonable projections. But even with this strong dividend increase rate, the stock should have only moderate price appreciation. Of course, as I have suggested many times, I own the stock because it offers a reasonable return with a high degree of safety, but even stocks like KO can take big dives (granted, at its all-time high Coke was trading at a ridiculous 45 times earnings).
The real kicker with CL is that it trades at 27 times earnings, but that is before the stock is fully diluted. There are 39 million options on the stock. While repurchases are easily oustripping option issuance, redemptions and forfeits are reducing the overall stock of ourstanding options, but with all options exercised, the stock trades at over 30 times earnings. There have to be better options. Unfortunately I haven´t had the time to find them.
I have recently read that the essence of investing is not managing returns, it´s managing risk. First you want to be reasonably sure of a positive return (capital preservation), only then do you want to consider the potential magnitude of the returns. Too many people look at the magnitude of returns first, and only then consider the probability of achieving these returns. This is why the lottery is so popular - it offers a huge return, for essentially nothing. Of course, most purchasers are simply incapable of appreciating the remoteness of the probability that their return will be positive. So they lose 100% every week, occasionally winning a minor pot of $5 or $10 to desensitize them to the dififculty of the odds they face.
This post isn´t about the lottery, however, it´s about TRLG. I mentioned in a prior post that I had left the temple of True Religion. Actually, I left a few weeks too early. I sold at $22.60 on a day when the high price for the day was §22.80. A few weeks later, the stock actually made new all-time highs in the $24.65 range. I lost out on an extra $800 by "selling too soon". But as my calculations from my DCF model suggested, the stock was near its highs at $22.60, and the probability of further gains were remote. Earnings would have to rise even faster than the 50% I projected for this year (35% for next), or operating margins would have to increase. While the first event was possible, I held out no expectations of the latter.
I work for a manufacturer. Like all companies with independent distribution, we regularly consider whether we wouldn´t be better off if we could capture more downstream revenue. Since pricing is usually based on cost-plus margining, capturing retail sales would significantly increase revenue, without actually capturing market share (we would benefit from selling at the retail price, which , for spare parts, is usually 65-100% greater than the wholesale price). The problem is that in order to do this, we would also have to absorb retail inventory, which would significantly increase working capital. We would also have to pay the expenses at retail that the distributors bear, personnel, rent and overhead. Worse, as a manufacturer, we would only really have one product line, whereas most distributors can amortize expenses over a wider product assortment available to them (since they can sell products from many manufacturers). This is essentially the difference between a specialty retailer and a department store. The department store also finds it easier to attract new customers, since it can easily cross-sell shoppers in the store for other promotions or products.
In fact, what we have begun to see from True Religion is that sales outside of the US are flagging, or at least, not increasing. Sales in the US are increasing, but primarily due to growth in the retail segment (i.e. the company is capturing that downstream revenue). However, this means that revenue is increasing faster than product volume, which raises serious questions about the acceptance of the brand on a broader scope. Worse, they are seeing increasing overhead, which management insists is required for future product introductions, but managing a retail chain is difficult. The company has brought in experience for this. The current management team has demonstrated success with retail, but what we are seeing is collapsing operating margins. For a company whose primary value is in future earnings, lower operating margins have to terrify investors.
In fact, while I was in Mexico on a business trip (I was in the buffett line at lunch actually), two other attendees started talking about the collapse of the stock price of TRLG, which has since declined to the mid $15 range. At this price, you might very well be able to round-trip the stock back up to $20, if management can find the new revenues to justify the ramp-up in expenses. But for the first time, management has failed to deliver the goods and so their ability to win converts on the street will come much harder.
At this point, I am sitting on lots and lots of cash. Buffett notes that this is no fun, and I concur, but at the same time, its better to sit on cash than watch your positions collapse. I am still looking for another investment that I find as attractive as TRLG. Right now, the only investment I consider worthwhile is BAC. I am even beginning to doubt the CL. Since I purchased in October 0f 2004, I have watched the stock price rise 50%, from $44 to $66, at the same time, I have earned nice dividends, which have been hiked twice, from 24 cents to 32 cents a share (for a 33%) increase over the same period. My shareholdings have increased by nearly four percent, giving me a total return of over 56% for the period (If you are wondering why my return isn´t 54%, the sum of the two, the reason is that the shares purchased from dividend reinvestment have also benefitted from rising prices, so my total return exceeds the price increase plus dividend payments).
Generally speaking, your return should reflect the dividend yield plus the rate of increase of dividends. (I have another post explaining why this is so, but essentially, with dividend paying stocks, prices tend to increase at the same rate as dividend increases). With CL price increases have outstripped dividend increases, so the dividend yield has fallen. This suggests lower returns going forward. Indeed, to return to the dividend rate of Oct 2004, when I purchased, dividends would have to increase about 17% or 5 cents per share, from here with no increase in the stock price. This would then offer a return of about 2.6% (the dividend yield at 37 cents per share, per quarter). Such a dividend increase is actually quite probable. The company tends to maintain a dividend payout ratio of around 50% of earnings, with much of the remaining money going to repurchase stock, both preferred and common. In the latest quarter the company earned $0.73 per share. With forward earnings expected to run about $0.80 per share per quarter the company could raise to 38-39 cents per share per quarter. Organic growth, plus benefits from the company´s restructuring make these very reasonable projections. But even with this strong dividend increase rate, the stock should have only moderate price appreciation. Of course, as I have suggested many times, I own the stock because it offers a reasonable return with a high degree of safety, but even stocks like KO can take big dives (granted, at its all-time high Coke was trading at a ridiculous 45 times earnings).
The real kicker with CL is that it trades at 27 times earnings, but that is before the stock is fully diluted. There are 39 million options on the stock. While repurchases are easily oustripping option issuance, redemptions and forfeits are reducing the overall stock of ourstanding options, but with all options exercised, the stock trades at over 30 times earnings. There have to be better options. Unfortunately I haven´t had the time to find them.
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