Let me make a quick note about the systematic and perpetual misuse of discount rates by many in the financial field, including many so-called "experts".
Often you will see analysts discounting a company's equity earnings at 10-12%, but their bonds are discounted at 4-5%. The reason given for this discrepancy is that debt has a lower "cost of capital" than equity.
Well, that's not always true.
Cost of capital is synonymous with the discount rate used to find the present value of future cash flows. Every set of future cash flows should have a unique discount rate based on the risks of those cash flows. There are two risks that must be considered in every discount rate: 1) The risk that inflation will make the real value of money decrease by the time you are paid; and 2) The risk that you will not be paid as promised. These risks should be evaluated the same way whether your payments come from debt or equity. (The structures and order of payment of debt and equity is, of course, different because debtholders get paid before equityholders. But as you will see below this difference is misunderstood in a lot of cases.) Most people do not understand the difference between debt and equity financing, and place an artificial premium on equity that should not exist.
Here is an example: Company A has existed for 100 years. It makes mirrors. It sells to a variety of retailers with long-term contracts in place to supply mirrors for the 5 years, that are automatically renewed every 5 years. The prices are set based on inflation, and Company A's profit margin is relatively constant, but varies slightly with market ups and downs. Its Beta is 1.0. In 2013 Company A will make $100,000. Let's give two different balance sheets for Company A:
Balance Sheet 1:
Assets: $1,000,000
Liabilities: $0
Equity: $1,000,000
Balance Sheet 2:
Assets: $1,000,000
Liabilities (bonds): $1,000,000
Equity: $0
Here is how an average financial analyst would value Company A with balance sheet 1:
"OK, we've got earnings of $100,000 in year 1 and growing at 3% thereafter. Company A's beta is 1.0, pretty average. Let's discount them at 12% for equity and subtract the growth rate of 3% and you get an enterprise value of $100,000/.09 = $1,111,111." (note that this analyst forgot to add back the realizable portion of book value, as often happens).
Here is how the same analyst would value Company A's bonds on balance sheet 2:
"OK, the 10-year T-bill rate is about 1.9% right now, the Company seems to have pretty stable earnings, corporate bond rates are low. The balance sheet is not ideal. Let's give Company A a risk premium of 3-4% for its bonds, I think the yield on these guys should be about 5%."
Company A then sells its $1,000,000 bonds with a 5% coupon rate, paying $50,000 per year in interest. Now the same analyst values the stock of Company A:
"Well, we've got earnings of $100,000 in year 1 growing 3% thereafter. Subtract $50,000 per year in debt service gives you $50,000 in earnings per year after debt payment. Company A's beta is 1.0, pretty average. Let's discount its earnings at 12% for equity and subtract the growth of 3% (some would say 6% here!) and you get a value of $555,555 (or $833,333!)."
So the same company, with balance sheet 2, created 50% more value for itself. That shows the error of the artificial risk premium for equity. In reality, the equity in balance sheet 1 has nearly the same risk profile as the debt in balance sheet 2. If the company makes money, the equity holders under balance sheet 1 will get paid just like the debt holders in balance sheet 2 will. But the equity holders in (1) will get paid a lot more because of this artificial premium on equity that should not exist. (There are many other details that can affect equity payments such as the company's ability to dilute equity or pay higher salaries to employees and executives, or its option to pay dividends. But if the company's management has integrity these risks should not be too great.) The other benefit of the equity holders is that they get to take advantage of any potential future growth in corporate earnings, while the bond holders do not. The point is that the equity under balance sheet 1 is significantly undervalued.
"No," you say. "That can't be! These analysts are well-trained. They know what they are doing. This is just an example you made up. This would never happen in the real world!"
It happens often. Take a look at Corning (GLW), one example I know off the top of my head because I have some Corning stock. I am sure that in this time of low corporate bond rates there are hundreds of examples just like Corning's.
Corning sells specialty glass for TVs, smartphones, science beakers, and other uses. It consistently earns money every quarter. It has strong profit margins. It has about $20 billion of equity on its balance sheet with lots of cash. Its management acts in the best interest of shareholders, does not waste money, and regularly pays a dividend. Corning has a few series of bonds on the market that mature at various times from now until 2021. The yield on these bonds is currently about 2.5%. That's what you'd make if you invested in them and everything went according to plan. Go here and search for GLW to verify: http://cxa.gtm.idmanagedsolutions.com/finra/BondCenter/Default.aspx
What about the equity? Oh, it's trading at just under 10x earnings. A discount rate of anywhere from 8-14% depending on how much you think earnings will shrink or grow. Yet recently Goldman Sachs of all banks downgraded Corning common stock: http://www.dividend.com/news/2013/goldman-sachs-downgrades-corning-glw/
So there you have it. Discount rate misuse continues. Fortunately this blog is not at all influential in the financial community, so hopefully I can profit off of the misanalysis of cash flows and discount rates without the market being any wiser.
Disclaimer
Sunday, January 13, 2013
Sunday, August 5, 2012
Update
Have not posted in a while. Mostly holding on to the stocks I have now, not making many trades at the moment.
Finished The Intelligent Investor and You can be a stock market genius
On to Common Stocks and Uncommon Profits.
Here is another Seeking Alpha article: http://seekingalpha.com/article/577891-be-aware-of-the-facebook-first-day-trap
Finished The Intelligent Investor and You can be a stock market genius
On to Common Stocks and Uncommon Profits.
Here is another Seeking Alpha article: http://seekingalpha.com/article/577891-be-aware-of-the-facebook-first-day-trap
Tuesday, May 1, 2012
Leverage is not a good way to maximize gains
Another quick thought -
Say you have a stock that went up from $30 to $45. You could have bought a $35 call option six months ago for $2.50. You made 50%, but you could have made 400%. Well, you're right, but you're taking on proportional risk to your investment by putting your money in a call option. Really it's similar to taking a loan for 3x your money and putting it all in one stock: with the loan, if it goes up 50%, you get 200% return. If it goes down 25%, you lose all your money. Beyond that you have to pay. With the option, if the stock stays below $35, you lose all your money. But you don't have to pay ever, which is a benefit over the leverage. The point being, options can be a good strategy if you find an arbitrage or a very cheap risk/reward profile. A lot of times traders use options as simulated leverage to maximize their risk and potential return. That is probably not the best use of the option strategy, and it can lead to heavy losses.
Say you have a stock that went up from $30 to $45. You could have bought a $35 call option six months ago for $2.50. You made 50%, but you could have made 400%. Well, you're right, but you're taking on proportional risk to your investment by putting your money in a call option. Really it's similar to taking a loan for 3x your money and putting it all in one stock: with the loan, if it goes up 50%, you get 200% return. If it goes down 25%, you lose all your money. Beyond that you have to pay. With the option, if the stock stays below $35, you lose all your money. But you don't have to pay ever, which is a benefit over the leverage. The point being, options can be a good strategy if you find an arbitrage or a very cheap risk/reward profile. A lot of times traders use options as simulated leverage to maximize their risk and potential return. That is probably not the best use of the option strategy, and it can lead to heavy losses.
Monday, April 30, 2012
Don't bet against John Malone
I owe a quarterly update. I'll do that on Friday or this weekend, as of 4/28.
For now - quick note.
Barnes and Noble announced an investment by Microsoft today of $300 million for 16%, valuing the Nook business at $1.7 billion. If there is one guy who is smiling right now it's John Malone.
That man has a better track record than Warren Buffett. When it comes to media companies, no one invests better than Malone. His annual return has to be astronomical.
This is the guy who bought Sirius XM radio right before it was going bankrupt - at 5 cents per share. Today that company is trading at over $2.
What is the investing lesson with Barnes and Noble? It's ok to follow someone into a trade if they are really smart and you understand their investment. But you have to read the SEC documents relating to the investment - in the case of Barnes and Noble, Malone purchased preferred shares at $17 a few months ago. The stock tanked to $10 immediately. Reading the SEC document, you can see that Malone gets paid is if the stock goes up. There's no other way for him to compound his return, because his interest rate was 8% annually, not enough to get him to bite unless he liked the underlying stock. So investing at $10 would have been a killer decision.
Today it's at $22, and it still appears to be a good investment. Microsoft just valued the Nook at $1.7 billion (Malone had to have a hand in that deal - the market cap of the whole company before MSFT investment was $800 million, so MSFT could have bought the whole company, then sold off the parts and kept 100% of the Nook business for itself for the same $300 million it just paid for 16%). In addition, Microsoft will promote the Nook app in Windows 8 - a huge deal, because that system will go into millions of homes. And the company's market cap is $1.3 billion as I write, $400 million less than MSFT valued the Nook, that's and not including the retail business which is profitable.
Good job again, Mr. Malone. And BKS is still a good buy.
For now - quick note.
Barnes and Noble announced an investment by Microsoft today of $300 million for 16%, valuing the Nook business at $1.7 billion. If there is one guy who is smiling right now it's John Malone.
That man has a better track record than Warren Buffett. When it comes to media companies, no one invests better than Malone. His annual return has to be astronomical.
This is the guy who bought Sirius XM radio right before it was going bankrupt - at 5 cents per share. Today that company is trading at over $2.
What is the investing lesson with Barnes and Noble? It's ok to follow someone into a trade if they are really smart and you understand their investment. But you have to read the SEC documents relating to the investment - in the case of Barnes and Noble, Malone purchased preferred shares at $17 a few months ago. The stock tanked to $10 immediately. Reading the SEC document, you can see that Malone gets paid is if the stock goes up. There's no other way for him to compound his return, because his interest rate was 8% annually, not enough to get him to bite unless he liked the underlying stock. So investing at $10 would have been a killer decision.
Today it's at $22, and it still appears to be a good investment. Microsoft just valued the Nook at $1.7 billion (Malone had to have a hand in that deal - the market cap of the whole company before MSFT investment was $800 million, so MSFT could have bought the whole company, then sold off the parts and kept 100% of the Nook business for itself for the same $300 million it just paid for 16%). In addition, Microsoft will promote the Nook app in Windows 8 - a huge deal, because that system will go into millions of homes. And the company's market cap is $1.3 billion as I write, $400 million less than MSFT valued the Nook, that's and not including the retail business which is profitable.
Good job again, Mr. Malone. And BKS is still a good buy.
Wednesday, April 4, 2012
Different= Profitable
I am in a fantasy baseball draft tonight. An auction draft. I was just thinking of how to draft my players. If I value players differently from the rest of the league, I have a better chance to win. Here is a demonstration:
The league is on ESPN. Most managers in the league will be using the ESPN.com predicted player values. Hypothetically:
Player 1: $36
Player 2: $34
Player 3: $30
Now, say I go to the Yahoo! Sports predicted player values instead. Hypothetically:
Player 1: $30
Player 2: $34
Player 3: $36
And then hypothetically, here is the true value of the players:
Player 1: $33
Player 2: $33
Player 3: $33
You can see that both rating systems have the same accuracy; they rate the individual players differently, but as a whole they have the same margin of error. If I use the second rating system, and the rest of the league uses the first system, here's how the auction will turn out:
Player 1: sold for $36 to another manager, worth $33, value captured = -$3
Player 2: sold for $34 to me or another manager, worth $33, value captured = -$1
Player 3: sold for $31 to me, worth $33, value captured = $2
So by using an alternate but equally accurate rating system, my team will be better than the rest of the league.
This principal applies to investing: By using a methodology that is different from what is popular at the time, as long as the methodology is no less accurate, you will make a profit. By following the crowd's reasoning, you will lose money.
The league is on ESPN. Most managers in the league will be using the ESPN.com predicted player values. Hypothetically:
Player 1: $36
Player 2: $34
Player 3: $30
Now, say I go to the Yahoo! Sports predicted player values instead. Hypothetically:
Player 1: $30
Player 2: $34
Player 3: $36
And then hypothetically, here is the true value of the players:
Player 1: $33
Player 2: $33
Player 3: $33
You can see that both rating systems have the same accuracy; they rate the individual players differently, but as a whole they have the same margin of error. If I use the second rating system, and the rest of the league uses the first system, here's how the auction will turn out:
Player 1: sold for $36 to another manager, worth $33, value captured = -$3
Player 2: sold for $34 to me or another manager, worth $33, value captured = -$1
Player 3: sold for $31 to me, worth $33, value captured = $2
So by using an alternate but equally accurate rating system, my team will be better than the rest of the league.
This principal applies to investing: By using a methodology that is different from what is popular at the time, as long as the methodology is no less accurate, you will make a profit. By following the crowd's reasoning, you will lose money.
Tuesday, March 20, 2012
Measurement
To maintain a prediction's integrity, the variable used to predict must be harder to change than than the thing it is predicting.
The very act of measuring something changes the thing being measured. You must measure something big or unusual to get it to stick. To preserve the integrity of your measurement.
One of two conditions must be met: (1) The people who control the prediction must not know about the measurement. or (2) It is nearly impossible for the prediction to be changed based on the measurement, or there is no reward for them to do so (this is rare).
Here are a couple of examples:
Example One
Let's say I want to predict a student's grades. The output is GPA. I believe I can predict a student's GPA in any semester by taking the weighted average of his course grades. This is an unchangeable fact. The integrity of the prediction is preserved, because it is impossible that the prediction could be changed by me or the student.
Say I want to break down the prediction further: I can predict a student's grade in an individual course based on the number of hours he spends studying over the semester. This measurement is not unchangeable. Its integrity is in question. If (1) the student does not know about me tracking his hours, then the prediction is ok. But if (1) is not met, neither is (2): The student, knowing that his GPA can be predicted by his hours, may start to put empty hours into studying, not fully concentrating on the material, thinking that he will get an A by putting the minutes in. The integrity of the prediction has been compromised. Over time, the prediction will become less accurate.
The prediction becomes much more muddled when compensation comes into play. Let's say I pay a student per hour studied, thinking that will improve his GPA. Bad idea! Further hypothesis: each student has a stock price tied to his grades. I invest in the students whom are undervalued based on the hours they have put in this semester. Ok. I succeed as long as my method is accurate. Now the market finds out about my prediction method. No good! The market will adjust, incorporating my method, and students with high hours will no longer be undervalued.
Example Two - A Stronger Measurement
I believe I can predict a nation's Olympic Medal Count based on its GDP. Props to Colorado College Prof. Daniel Johnson. It is harder to change a nation's GDP than it is to add to the medal count, so this is a strong predictor that cannot be compromised.
But Professor Johnson found that communist, centralized governments are more likely to get gold medals. If capitalist nations find out about the study, the prediction can go bad because those capitalist nations can mimick the training programs of other types of governments to increase the medal count.
A weak measurement
Any formula for picking stocks is predominantly luck. Say you invest in stocks that have crossed their 50-day moving average. Say you invest in stocks with low P/E only. No single formula to pick stocks has the strength and integrity to withstand the market once the market finds out the method is profitable. There are two ways to go about this: one, you have a small window of opportunity when the market does not realize it is overvaluing or undervaluing a particular formula. So, for example, generally a good time to invest in high-Beta stocks is after the market has gone down a lot. Because people get sick of losing money, and the market moves out of those guys unnecessarily. But if the market were to realize this arbitrage existed, it would disappear. The most sustainable predictor of stock price is to buy assets for less than they are worth. You must analyze the current assets and project the future cash flows of a company, and invest in what is most certain to bring you the most cash for your investment. That is a measure that cannot be corrupted by the market, because that is the heart of a business's value.
The very act of measuring something changes the thing being measured. You must measure something big or unusual to get it to stick. To preserve the integrity of your measurement.
One of two conditions must be met: (1) The people who control the prediction must not know about the measurement. or (2) It is nearly impossible for the prediction to be changed based on the measurement, or there is no reward for them to do so (this is rare).
Here are a couple of examples:
Example One
Let's say I want to predict a student's grades. The output is GPA. I believe I can predict a student's GPA in any semester by taking the weighted average of his course grades. This is an unchangeable fact. The integrity of the prediction is preserved, because it is impossible that the prediction could be changed by me or the student.
Say I want to break down the prediction further: I can predict a student's grade in an individual course based on the number of hours he spends studying over the semester. This measurement is not unchangeable. Its integrity is in question. If (1) the student does not know about me tracking his hours, then the prediction is ok. But if (1) is not met, neither is (2): The student, knowing that his GPA can be predicted by his hours, may start to put empty hours into studying, not fully concentrating on the material, thinking that he will get an A by putting the minutes in. The integrity of the prediction has been compromised. Over time, the prediction will become less accurate.
The prediction becomes much more muddled when compensation comes into play. Let's say I pay a student per hour studied, thinking that will improve his GPA. Bad idea! Further hypothesis: each student has a stock price tied to his grades. I invest in the students whom are undervalued based on the hours they have put in this semester. Ok. I succeed as long as my method is accurate. Now the market finds out about my prediction method. No good! The market will adjust, incorporating my method, and students with high hours will no longer be undervalued.
Example Two - A Stronger Measurement
I believe I can predict a nation's Olympic Medal Count based on its GDP. Props to Colorado College Prof. Daniel Johnson. It is harder to change a nation's GDP than it is to add to the medal count, so this is a strong predictor that cannot be compromised.
But Professor Johnson found that communist, centralized governments are more likely to get gold medals. If capitalist nations find out about the study, the prediction can go bad because those capitalist nations can mimick the training programs of other types of governments to increase the medal count.
A weak measurement
Any formula for picking stocks is predominantly luck. Say you invest in stocks that have crossed their 50-day moving average. Say you invest in stocks with low P/E only. No single formula to pick stocks has the strength and integrity to withstand the market once the market finds out the method is profitable. There are two ways to go about this: one, you have a small window of opportunity when the market does not realize it is overvaluing or undervaluing a particular formula. So, for example, generally a good time to invest in high-Beta stocks is after the market has gone down a lot. Because people get sick of losing money, and the market moves out of those guys unnecessarily. But if the market were to realize this arbitrage existed, it would disappear. The most sustainable predictor of stock price is to buy assets for less than they are worth. You must analyze the current assets and project the future cash flows of a company, and invest in what is most certain to bring you the most cash for your investment. That is a measure that cannot be corrupted by the market, because that is the heart of a business's value.
Sunday, March 18, 2012
Some trading action
Sold BAC.
Added to NYT, YHOO.
BAC still has room to go up potentially. But I sold it because it is a position that I followed somebody into. I don't know much about the stock, other than it was beaten down and cheap. Then Warren Buffett took preferred shares with a conversion at $7. So when the opportunity came to buy at $6.50, I said yes. I only do that for investors who I am confident know what they are doing. But my general rule is that when I merely follow someone into a trade, without fully understanding the business, I sell after a 20% gain. So out goes BAC with a nice, but small, profit.
In goes NYT. I really like them. They are differentiating themselves from the rest of print media. The paywall is genius. The writing is superb. The quality of research is excellent. The company is making money. It has a $1 billion market cap, and they own about.com (worth maybe $50 million), shares in the Red Sox (worth about $100 million), and the Boston Globe and International Herald Tribune (worth maybe $150 million). So the underlying business is selling for $700 million. They have about $550 million in employee pension liability. $3 billion in annual revenues. Profits are rising because of the paywall, and advertising is starting to bounce back. When you look at the newspaper industry, the Times stands at the top of all papers in the world, without a doubt, along with the Wall St. Journal and a couple others. They are well-managed. Trading at a 11x forward earnings. Large growth prospects if the paywall is managed correctly. I like it.
YHOO I am mostly following Dan Loeb into this trade. They own parts of Yahoo! Japan, Alibaba, and other international web sites worth more than their market value. He bought at $15, and the chance to buy months later at the same price is a nice opportunity. There are some tax regulations they would have to avoid if they were to sell the shares of their international companies. But he has a large position and a seat on the board and I trust his due diligence that he will be able to unlock the shareholder value. Like most of my "follow in" trades, if it gets to $18 (20% gain) I'll sell it. Another reason I like Yahoo! is because of the phenomenal research the Yahoo! Sports department does, which shows there is some value in the American branch of the company's operations. Yahoo! Finance is also a nice web site.
[Note - this was originally posted in March 2012. I am editing it in January 2013. It is interesting how far off I was on the value of About.com. The Times recently sold About.com for $300 million. If I had paid better attention to the quarterly reports I would have been able to value the About group better. Sometimes it helps to be lucky.]
Added to NYT, YHOO.
BAC still has room to go up potentially. But I sold it because it is a position that I followed somebody into. I don't know much about the stock, other than it was beaten down and cheap. Then Warren Buffett took preferred shares with a conversion at $7. So when the opportunity came to buy at $6.50, I said yes. I only do that for investors who I am confident know what they are doing. But my general rule is that when I merely follow someone into a trade, without fully understanding the business, I sell after a 20% gain. So out goes BAC with a nice, but small, profit.
In goes NYT. I really like them. They are differentiating themselves from the rest of print media. The paywall is genius. The writing is superb. The quality of research is excellent. The company is making money. It has a $1 billion market cap, and they own about.com (worth maybe $50 million), shares in the Red Sox (worth about $100 million), and the Boston Globe and International Herald Tribune (worth maybe $150 million). So the underlying business is selling for $700 million. They have about $550 million in employee pension liability. $3 billion in annual revenues. Profits are rising because of the paywall, and advertising is starting to bounce back. When you look at the newspaper industry, the Times stands at the top of all papers in the world, without a doubt, along with the Wall St. Journal and a couple others. They are well-managed. Trading at a 11x forward earnings. Large growth prospects if the paywall is managed correctly. I like it.
YHOO I am mostly following Dan Loeb into this trade. They own parts of Yahoo! Japan, Alibaba, and other international web sites worth more than their market value. He bought at $15, and the chance to buy months later at the same price is a nice opportunity. There are some tax regulations they would have to avoid if they were to sell the shares of their international companies. But he has a large position and a seat on the board and I trust his due diligence that he will be able to unlock the shareholder value. Like most of my "follow in" trades, if it gets to $18 (20% gain) I'll sell it. Another reason I like Yahoo! is because of the phenomenal research the Yahoo! Sports department does, which shows there is some value in the American branch of the company's operations. Yahoo! Finance is also a nice web site.
[Note - this was originally posted in March 2012. I am editing it in January 2013. It is interesting how far off I was on the value of About.com. The Times recently sold About.com for $300 million. If I had paid better attention to the quarterly reports I would have been able to value the About group better. Sometimes it helps to be lucky.]
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