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 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.

Wednesday, September 17, 2014

Random thoughts about investing

The Wall Street Journal has a fascinating interview with a venture capitalist, Bill Gurley, who says that "the venture-capital community or startup community is taking on an excessive amount of risk right now," i.e. it's a bubble, but that his firm continues to invest in startups because "choosing not to play the game on the field doesn't work."

Many investing gurus laud the benefits of specializing and developing extensive knowledge of one specific industry or asset class, but Gurley's interview demonstrates that specialization has at least one big drawback: if an investor defines himself as doing one thing, he'll have to keep doing that one thing regardless of how unfavorable market conditions become. Gurley is a venture capitalist, so he feels compelled to keep investing in startups even though he knows the risk/reward is terrible.

VIC writeups
I'm wary of VIC recommendations that get high ratings (6+) on a large number of votes. It suggests that all of the event-driven and value funds that would be interested in buying the stock have already bought it. My guess is that the best-performing recommendations have above-average ratings (5.3-5.7) and relatively few votes-- most people don't know about them yet, but the ones who know about them like them.

The housing market
Contrary Investor has a great article describing how investors are fueling the US housing market's rebound. It's a perfect example of reflexivity: investors have piled into "undervalued" real estate because they think it's bottomed, and their piling in has creating the price rise they anticipated.

Lehman Brothers
The Lehman Brothers bankruptcy examiner's report is eye-opening. Lehman's risk limits were meaningless: whenever management wanted to increase risk, the raised the limits or simply ignored them. During 2006, Lehman began dramatically increasing its exposure to leveraged loans but excluded them from its risk calculations. Then management belatedly included them and realized it had exceeded its risk controls for the previous several months.

Lehman's CEO was routinely unaware of important business and balance-sheet issues until other people brought them to his attention. Even if he had tried to stay informed, it would have been difficult for him to understand everything Lehman was doing because "At the time of its bankruptcy filing, Lehman maintained a patchwork of over 2,600 software systems and applications... Many of Lehman’s systems were arcane, outdated or non‐standard."

It's tough for investors to analyze large banks when their own managers can't.

Fifth Third Bank
John Hempton has an older article about Fifth Third Bank that's worth reading. He argues that 5/3 was able to dominate the Midwestern banking market because it had an entrepreneurial culture that rewarded managers for limiting operating costs and loan losses. This let 5/3 undercut its competitors in offering loans to the highest-quality borrowers and still make a lot of money. Eventually 5/3 saturated the Midwest, which left it with two choices: lower its loan standards or expand geographically. It chose both, buying a lot of brokered home equity loans from outside its home market, and suffered the consequences when the housing bubble burst.

My takeaways are that:
• Even the best companies face limits to their growth strategy.
• When they reach those limits, they often make bad decisions in an effort to continue growing at the same rate.

Ebay and Bill Me Later
Ebay's acquisition of Bill Me Later may be another example of a company reaching its growth limits and recklessly pushing past them. Two things give me pause. First, it looks like Ebay seriously overpaid for BML in 2008, which raises the risk that it's growing BML's loans too quickly in order to justify the purchase price.

Second, Ebay finances BML with its offshore cash. Apparently it can do this without paying repatriation taxes. A Reuters article quotes the CEO as saying, "BML is a really productive use of the offshore cash. It earns a lot more than just 1 percent... [We're] taking every opportunity to repatriate cash when we can." Reading between the lines, it seems that being able to use the stranded offshore cash has induced Ebay to make loans it wouldn't otherwise make.

Tuesday, September 2, 2014

Two more Outsider CEOs: Steve Odland and Guido Dumarey

In a previous post, I made a list of investors and CEOs who were once considered great capital allocators but aren't any longer. Steve Odland and Guido Dumarey are two glaring omissions from that list.

Steve Odland 

Odland was the CEO of Autozone from 2001-05 and CEO of Office Depot from 2005-10. He used an Outsiders-style capital allocation strategy at both companies, with wildly different results. While he was CEO of Autozone, its earnings surged and the stock tripled. While he was CEO of Office Depot, its earnings sagged and the stock lost 75% of its value.

Odland's career suggests that Outsiders strategies amplify a business's characteristics. They produce "beta" rather than "alpha." Leveraging up to buy back stock worked well at Autozone because it was a good business in a good economic environment. Office Depot, not so much.

Guido Dumarey

Dumarey was the CEO of Punch International, a Belgian conglomerate with investments in industrial technology and real estate.

Like Chad Wasilenkoff at Fortress Paper, Dumarey followed the Outsiders playbook of using leverage to enhance returns, buying back stock, making opportunistic acquisitions, and having "skin in the game." A VIC writeup from 2007 describes Dumarey as follows: "[Punch's] CEO is one of the smartest and deal-savvy persons I know and on June 28th bought back even more shares on the open market (even though he already controls 38% of the company)."

Unfortunately, that was written near Punch's all-time high. The company's stock fell 98% from peak to trough during Global Financial Crisis and has yet to recover.

It's easy to ridicule passages like that with the benefit of hindsight, but the VIC author had a point: at the time of his write up, Dumarey's track record was enviable. As with Odland, Dumarey's success before the crisis and subsequent reversals demonstrate the risk inherent to Outsiders strategies. They enhance returns during a bull market, and they may produce higher returns on average, but they can be disastrous during periods of financial stress.


Punch also demonstrates the limits of incentives. Since Dumarey owned 38% of his company, he had a strong incentive to avoid bad investments and excessive risk, but that didn't prevent Punch's collapse. The same can be said of Golden West and Bear Stearns. The Sandlers owned a large stake-- nearly all of their wealth-- in Golden West, and that didn't stop it from making bad loans. Jimmy Cayne owned almost a billion dollars of Bear Stearns stock when it collapsed, and other Bear Stearns execs were also big shareholders at the time.

Incentives can be very effective at resolving agency-principal problems, but agency-principal problems aren't the only things that lead to bad decisions. There are several reasons why incentives can fail:
• People's willingness to take risk is partly innate. Some people are very ambitious and will take big risks regardless of financial incentives. The prospect of glory motivates them more than abstract ideas like risk-adjusted return. The Lehman Brothers bankruptcy examiner's report claims that envy of Goldman Sachs motivated Lehman executives to take excessive risks.
• People can make poor decisions if their careers have given them constant psychological reinforcement to make a certain kind of decision. I think this explains the executives at Golden West and Bear: their whole careers had rewarded them for taking risk, so they continued taking the same kinds of risk past the point of diminishing returns.
• Everyone has certain intellectual and psychological limitations that even the best incentives can't overcome. Not everyone gets to be an astronaut when they grow up.