Sunday, September 28, 2014

Value investing in tech and retail

While value investing is usually a great investing strategy, I think it's much less likely to succeed for technology and retail companies than for other kinds of businesses. The past few years have given us numerous examples of tech and retail value traps: BBRY, DELL, NOK, ARO, BODY, RSH, SHLD, and TSCO.uk among others. Each of these stocks had a low P/E ratio during its decline, or it was cheap on some other metric like price to book or price to sales.

To accurately value a business, investors need a guide as to what margins and economic returns it will earn. Past results are often the best guide: if an industry has earned a 10% average return on equity over multiple economic cycles, but it's currently losing money because of a recession or overcapacity, then it's likely to earn a 10% ROE again at some point. Some companies in the industry may go bankrupt, but the survivors will profit when supply and demand adjust. In other words, the typical industry reverts to the mean.

By contrast, new technology standards and products replace old ones all the time. Instead of reverting to the mean, struggling tech companies usually revert to non-existence. The same is true for retail: what people like to buy and where they like to buy it change constantly.

This means that tech and retail investors can't assume that earnings will revert to prior levels. They also can't assume that asset value will give them a margin of safety. In tech, finished products that have become obsolete or non-standard may be impossible to sell, and raw materials tend to depreciate rapidly.

Many retailers have the same problem: if a product goes out of style, its market value will be only a small fraction of its carrying value. Likewise, the typical retailer has a lot of its asset value in leasehold improvements, and these have minimal liquidation value.

Some people who invest in declining retailers think that the retailers' real estate value provides a margin of safety. In an interview with The Manual of Ideas, Guy Spier offers several counterpoints to that idea:

• It's difficult to liquidate a large collection of properties at once. A retailer's real estate may be worth a certain amount, but the present value of that real estate in a liquidation will be much less.
• Real estate in city centers is extremely valuable, but in many parts of the country there's no shortage of land and property.
• Retailers' real estate is heavily customized. This includes not only leasehold improvements but the layout of the property itself. One kind of store can differ significantly from another, and all stores differ from the typical office building.
• Real estate often has contingent liabilities that lower its liquidation value.
• Real estate values are cyclical. If a retailer needs to liquidate property because an economic downturn has curtailed its business, that property will sell for much less than under normal circumstances.

Nate Tobik has described many of the same problems of liquidating real estate:

"Land can be valuable, if you own the only empty plot in Midtown Manhattan you're sitting on a fortune.  But those cases are rare.  More likely for a net-net is a company owns a plot of land in Altoona, PA or Eaton, OH where land is in ample supply... 

The curse of real estate is that to sell incurs a high transaction cost and takes a long time. It's hard to unload a lot of real estate quickly at market rates.  If a seller tries to liquidate their real estate holdings quickly it's likely they'll only realize fire sale values."


Consumer discretionary

What's true for retail seems to be true for other kinds of discretionary spending. As Carlo Cannell says about restaurants:

"Look at the restaurant industry... which is characterized by a high rate of mortality. It’s just a fact that almost all restaurants that come public go out of business. If you opened randomly a Fortune magazine from 1947, or 1973, and read any stories about restaurants that were hot growth companies, it would make you laugh –  in hindsight it seems so clear why they didn’t make it."

Bruce Greenwald has made a similar argument about brands. He says that while top consumer brands may appear to be durable and uniquely valuable, this appearance is misleading. For every brand that was introduced fifty or a hundred years ago and remains popular today, there are many others brands that were introduced at the same time, became popular, but ultimately lacked staying power.

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