Here's what Jeff Bezos had to say in the latest Amazon (AMZN) shareholder letter:
"This year, Amazon became the fastest company ever to reach $100 billion in annual sales. Also this year, Amazon Web Services is reaching $10 billion in annual sales … doing so at a pace even faster than Amazon achieved that milestone.
What's going on here? Both were planted as tiny seeds and both have grown organically without significant acquisitions into meaningful and large businesses, quickly. Superficially, the two could hardly be more different. One serves consumers and the other serves enterprises. One is famous for brown boxes and the other for APIs. Is it only a coincidence that two such dissimilar offerings grew so quickly under one roof? Luck plays an outsized role in every endeavor, and I can assure you we've had a bountiful supply. But beyond that, there is a connection between these two businesses. Under the surface, the two are not so different after all. They share a distinctive organizational culture that cares deeply about and acts with conviction on a small number of principles. I'm talking about customer obsession rather than competitor obsession, eagerness to invent and pioneer, willingness to fail, the patience to think long-term, and the taking of professional pride in operational excellence. Through that lens, AWS and Amazon retail are very similar indeed.
A word about corporate cultures: for better or for worse, they are enduring, stable, hard to change. They can be a source of advantage or disadvantage. You can write down your corporate culture, but when you do so, you're discovering it, uncovering it – not creating it. It is created slowly over time by the people and by events – by the stories of past success and failure that become a deep part of the company lore. If it's a distinctive culture, it will fit certain people like a custom-made glove. The reason cultures are so stable in time is because people self-select. Someone energized by competitive zeal may select and be happy in one culture, while someone who loves to pioneer and invent may choose another. The world, thankfully, is full of many high-performing, highly distinctive corporate cultures. We never claim that our approach is the right one – just that it's ours – and over the last two decades, we've collected a large group of like-minded people. Folks who find our approach energizing and meaningful.
One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it's going to work, it's not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there."
One of the more challenging aspects of investing is judging the value of qualitative factors. When the focus is only on the quantitative some of the most significant elements of intrinsic value can be missed.
It's worth noting that qualitative factors do not necessarily only materially add to value; they can and often do subtract in a big way.
Adam
No position in AMZN
Related posts:
Buffett and Munger Talk Retail Businesses, NFM, and Amazon
Washington Post Sold To Jeff Bezos
Amazon, Apple, and Intrinsic Value - Part II
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Showing posts with label Technology. Show all posts
Showing posts with label Technology. Show all posts
Tuesday, April 19, 2016
Monday, September 28, 2015
Behavioral Biases: How They Influence Investment Decisions
When a stock performs well -- and as just one example Amazon's (AMZN) stock, to say the least, certainly has over the long haul -- it's easy to become convinced, at times incorrectly, what ended up happening was obvious all along.
That's hindsight bias -- the belief, after the fact, that something was more predictable than it actually was -- and is just one among the many biases that impact investor behavior and results (and generally not in a good way).
Now, here's just some examples of those who, more or less, previously expressed a favorable view of Amazon as an investment.*
- Amazon 'Undervalued': Portfolio Manager
- Analysts Bullish on Amazon
- Ken Fisher Still Bullish on Amazon
And some from those with a less favorable point of view...
- Not Even Jeff Bezos Would Buy Amazon's Cash Flow
- Three Reasons Why Amazon's Cash Flow Is No Comfort
- Don't Be Fooled by Amazon's Cash Flow
There are, of course, many more examples of thoughtful but opposing views to be found. The same stock but very different views. For those with an open mind this can and should be a good thing. Unfortunately, it's easy to make the mistake of only seeking information that's consistent with one's own thinking.
Of course, investment decisions should never be based upon what someone else thinks. Ultimately, each investor needs to come to his/her own conclusions. Yet it's important to avoid making the mistake of only giving consideration to information that reinforces a particular view -- however flawed or biased it might be -- while mostly ignoring contrary facts and logic.
Keep in mind I'm simply using Amazon as an example. The same thing, in general, can be applied to other stocks though naturally the specific circumstances will always be unique.
Personally, I respect and admire Amazon and Jeff Bezos** but have never considered owning the stock for a simple reason:
I just don't know how to value it within a narrow enough range.
That doesn't necessarily mean I'll be surprised if the company proves to be very valuable over the long run.
In fact I won't be at all.
It simply means I don't understand it well enough especially when compared to alternatives; it means my estimate (within a range) of likely future returns can't be compared in a meaningful way to those things I think I do understand better; it means that if I can't value something with enough warranted confidence, it's by definition impossible to determine what price represents a sufficient margin of safety.
So, as a result, it has never made any sense for me to consider owning Amazon's stock. Behaving otherwise would likely be, at least in my case, a recipe for subpar results or worse in the long run.
Now, lets assume for some reason I had long ago decided to buy Amazon (again, I've always had -- and continue to have -- zero interest in doing so) and it happened to work out well for me. This result would have been mostly, if not entirely, due to pure luck. In other words, not being able recognize when good fortune more so than being right was the reason for the good result will likely lead to future costly mistakes and reduced results.
(Even though, due to luck, the results were favorably impacted by the Amazon investment my view is that the lack of discipline, ultimately, is likely to hurt results.)
It's about knowing and staying within limits.
Those who buy any stock without carefully considering the reasons why things may not go as well as hoped are potentially setting themselves up for permanent capital loss.
Beware of confirmation bias.
Beware of investor overconfidence.
These can prove expensive in the long run.
If not carefully managed these and other biases can lead to big and unnecessary mistakes.
The important thing to remember is that biases are -- in the context of investing -- not just someone else's problem.
For most of us -- if not all of us -- bias blind spot is a real factor.
It's easy to point to what worked well with the benefit of hindsight. For every Amazon -- at least in the real world -- there will be many that seem to have great potential but don't work out nearly so well.
That simply won't be obvious before the fact.
It will only become obvious when looking through the rear-view mirror.
Knowing what to avoid starts with buying only what you understand.
That means, inevitably, sometimes it's necessary to "miss" what after the fact proves to be an excellent opportunity.
Some investors no doubt were able to see Amazon's potential long ago and were rewarded for it.
Still, it's important to try and be objective about the reason something worked out well.
Easier said than done.
Sometimes, an investment might work out well due to brilliant insight and foresight.
Other times, good fortune might have played a significant role.
Knowing the difference can eliminate errors down the road.
Maybe some think Amazon's prospects and intrinsic business value have always been, and remain, plain to see; or maybe that's, at least in part, simply hindsight bias at work.
Adam
No position in AMZN
* Naturally, views such as these are not necessarily static, may have changed, or at some point may change.
** Some concerns and criticisms have also been previously highlighted.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
That's hindsight bias -- the belief, after the fact, that something was more predictable than it actually was -- and is just one among the many biases that impact investor behavior and results (and generally not in a good way).
Now, here's just some examples of those who, more or less, previously expressed a favorable view of Amazon as an investment.*
- Amazon 'Undervalued': Portfolio Manager
- Analysts Bullish on Amazon
- Ken Fisher Still Bullish on Amazon
And some from those with a less favorable point of view...
- Not Even Jeff Bezos Would Buy Amazon's Cash Flow
- Three Reasons Why Amazon's Cash Flow Is No Comfort
- Don't Be Fooled by Amazon's Cash Flow
There are, of course, many more examples of thoughtful but opposing views to be found. The same stock but very different views. For those with an open mind this can and should be a good thing. Unfortunately, it's easy to make the mistake of only seeking information that's consistent with one's own thinking.
Of course, investment decisions should never be based upon what someone else thinks. Ultimately, each investor needs to come to his/her own conclusions. Yet it's important to avoid making the mistake of only giving consideration to information that reinforces a particular view -- however flawed or biased it might be -- while mostly ignoring contrary facts and logic.
Keep in mind I'm simply using Amazon as an example. The same thing, in general, can be applied to other stocks though naturally the specific circumstances will always be unique.
Personally, I respect and admire Amazon and Jeff Bezos** but have never considered owning the stock for a simple reason:
I just don't know how to value it within a narrow enough range.
That doesn't necessarily mean I'll be surprised if the company proves to be very valuable over the long run.
In fact I won't be at all.
It simply means I don't understand it well enough especially when compared to alternatives; it means my estimate (within a range) of likely future returns can't be compared in a meaningful way to those things I think I do understand better; it means that if I can't value something with enough warranted confidence, it's by definition impossible to determine what price represents a sufficient margin of safety.
So, as a result, it has never made any sense for me to consider owning Amazon's stock. Behaving otherwise would likely be, at least in my case, a recipe for subpar results or worse in the long run.
Now, lets assume for some reason I had long ago decided to buy Amazon (again, I've always had -- and continue to have -- zero interest in doing so) and it happened to work out well for me. This result would have been mostly, if not entirely, due to pure luck. In other words, not being able recognize when good fortune more so than being right was the reason for the good result will likely lead to future costly mistakes and reduced results.
(Even though, due to luck, the results were favorably impacted by the Amazon investment my view is that the lack of discipline, ultimately, is likely to hurt results.)
It's about knowing and staying within limits.
Those who buy any stock without carefully considering the reasons why things may not go as well as hoped are potentially setting themselves up for permanent capital loss.
Beware of confirmation bias.
Beware of investor overconfidence.
These can prove expensive in the long run.
If not carefully managed these and other biases can lead to big and unnecessary mistakes.
The important thing to remember is that biases are -- in the context of investing -- not just someone else's problem.
For most of us -- if not all of us -- bias blind spot is a real factor.
It's easy to point to what worked well with the benefit of hindsight. For every Amazon -- at least in the real world -- there will be many that seem to have great potential but don't work out nearly so well.
That simply won't be obvious before the fact.
It will only become obvious when looking through the rear-view mirror.
Knowing what to avoid starts with buying only what you understand.
That means, inevitably, sometimes it's necessary to "miss" what after the fact proves to be an excellent opportunity.
Some investors no doubt were able to see Amazon's potential long ago and were rewarded for it.
Still, it's important to try and be objective about the reason something worked out well.
Easier said than done.
Sometimes, an investment might work out well due to brilliant insight and foresight.
Other times, good fortune might have played a significant role.
Knowing the difference can eliminate errors down the road.
Maybe some think Amazon's prospects and intrinsic business value have always been, and remain, plain to see; or maybe that's, at least in part, simply hindsight bias at work.
Adam
No position in AMZN
* Naturally, views such as these are not necessarily static, may have changed, or at some point may change.
** Some concerns and criticisms have also been previously highlighted.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Tuesday, June 30, 2015
Earnings Inflation: Why Some Tech Companies Earn Less Than You Think
This Barron's article covers what it calls the "weird world where a wide range of technology companies...encourage investors to ignore the large and very real cost of stock compensation when calculating expenses and earnings."
Remarkably, this kind of "inflated and distorted earnings figure...is widely embraced by analysts and investors in valuing tech companies."
This, in part, reminds me of what Jeremy Grantham once said:
"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' [John Maynard] Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."
Well, if that's the case, then maybe this bodes well for those less influenced by "the institutional world."
Barron's estimates that a dozen large tech companies are not including roughly $ 16 billion of stock compensation expense in their non-GAAP earnings. A table in the article provides a detailed look at the relevant numbers for the twelve companies.
Some things to consider:
- Stock compensation is usually the major difference between reported GAAP earnings and non-GAAP earnings.
- Profit projections from analysts often ignore stock compensation.
- The likes of Microsoft (MSFT), Intel (INTC), Apple (AAPL), and IBM (IBM) are tech companies that report GAAP numbers only with stock compensation included.
- Some companies prefer non-GAAP earnings because they're highly dependent on stock-based compensation and, well, it makes their numbers look better. Analysts, in enough cases for it to matter, tend to use whatever approach the company thinks makes more sense. So, basically, those that don't offer much in the way of stock compensation don't mind reflecting the cost; those that do rely extensively on stock compensation, not surprisingly, choose the non-GAAP approach.
Here's three examples of how much of a difference it can make:
Google (GOOG)
2015 GAAP Estimated EPS: 22.70
2015 non-GAAP Estimated EPS: $ 28.35
2015 GAAP P/E: 24.7
2015 non-GAAP P/E: 19.8
Amazon.com (AMZN)
2015 GAAP Estimated EPS: 0.37
2015 non-GAAP Estimated EPS: 4.14
2015 GAAP P/E: 1,193
2015 non-GAAP P/E: 106
Salesforce.com (CRM)
2015 GAAP Estimated EPS: -0.05
2015 non-GAAP Estimated EPS: 0.71
2015 GAAP P/E: Not Meaningful
2015 non-GAAP P/E: 104
More from Barron's:
"Various justifications are offered for excluding equity compensation from expenses, but none hold up to scrutiny."
The argument that stock compensation isn't a real expense is a weak one at best.
If stock-based compensation expense is generally ignored by analysts and investors guess what's going to happen?
It seems rather probable it will encourage the use of stock-based compensation.
Some will no doubt continue to argue that stock compensation expense can be ignored. Arguments include that it's a non-cash expense and the additional share count captures the cost.
Well, in this case, it's a real expense even if it happens to be a non-cash expense: unless the strike price of an employee stock option fully reflects per share intrinsic value, the company is, when options are exercised, effectively selling shares at a discount (with tax implications fully considered). That discount is a real cost to continuing owners. So, in such a case, the additional share count only partially reflects that expense.*
Another argument essentially is that, since many industry peers ignore stock-based compensation, it makes sense to also ignore it for comparison purposes. Well, it's a real expense no matter how another company decides to logically present their own numbers.
When a company chooses to repurchase shares to just keep the share count from increasing, those funds could have instead been used for the direct benefit of shareholders in other ways. If the strike price is less than the repurchase price then, effectively, the company is buying high and selling low.
The difference can prove a meaningful cost especially for shareholders who intend to stick around.**
Those funds could be used for reducing share count instead of merely offsetting the dilution that occurs from stock compensation.
Those funds could be used for paying dividends.
Those funds could also be put to many other potential high return uses.
Now, if a company needs to use stock compensation to get the best employees, or to help manage cash flows, it may be very wise to do so.
Just count it as the real expense that it is.***
It simply makes little sense to ignore stock compensation for certain companies but include it for others.
When stock-based compensation is deliberately ignored -- especially for the companies who heavily rely on it -- per share intrinsic value and how it's likely to change over time is likely to be overestimated.
Stock compensation is also a real cost for shareholders even if a company chooses to NOT repurchase shares. In many ways employee stock options -- depending on how the strike/exercise price compares to per share intrinsic value -- partially function like a reverse buyback that quietly (and, sometimes, not so quietly) dilutes continuing shareholders. Keep in mind that, upon the exercise of stock options, a company will receive funds equal to the strike price for each option that's exercised plus, depending on how much the options are in the money, a tax benefit. So, effectively some capital is "raised" in the process but what matters for continuing owners is how reasonable that strike price happens to be.
(If these funds are used to buyback stock then the net dilution is reduced.)
It's hard to completely fault the companies when not enough analysts and investors seem to be forcing the issue.
It's easy to choose to not follow suit and always include stock-based compensation when attempting to estimate, within a range on a conservative basis, per share intrinsic value.
None of this necessarily means some of these tech stocks aren't fine businesses. In fact, some are already extremely valuable and will no doubt prove to be even more so. It comes down to:
Will the value per share increase sufficiently?
Does the price paid offers an acceptable or better risk versus reward against alternatives?
Is there sufficient margin of safety to protection against what might go wrong and/or misjudged prospects?
If nothing else, a willingness to ignore stock-based compensation is fundamentally at odds with the margin of safety principle.
It's worth noting that I'm not referring to the speculative buying at one premium price (premium to per intrinsic value) with the hope of later sell at an even higher price. I'm referring to whether the price paid today offers an attractive outcome compared to what these businesses will be intrinsically worth on a per share basis in 10 or 20 years.
Those who successfully buy shares at a premium to value and exit successfully are likely taking on far more risk of permanent capital loss than they realize.
Risk that's not usually obvious until it is.
Adam
Long positions in MSFT and AAPL established at much lower than recent prices; long position in IBM established at somewhat higher than current prices; very small long position in GOOG also established at much lower than recent prices. No position in the other stocks mentioned.
Related posts:
Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Technology Stocks
Time for Dividends in Techland
* There are exceptions. When, for example, the strike price of employee stock options is well above per share intrinsic business value, then stock-based compensation can actually become beneficial to long-term owners. Of course, for these to be of any value to an employee the stock must necessarily be more than fully valued upon exercise. In this narrow (and somewhat unlikely) scenario, the company would be getting more than full value. The situation functions like capital being raised at an attractive price with a tax benefit as a bonus. This doesn't apply to stock-based compensation that's in the form of restricted stock (which is increasingly favored over stock options).
** The actual cost for shareholders is the difference between the lower strike price and the higher repurchase price. For companies where this kind of buy high/sell low behavior is the norm, this can become rather expensive (depending on the specifics of the stock-based compensation plan) for long-term owners when compounding effects are fully considered. In contrast, these still very real costs might be viewed as mere noise for those with shorter holding periods.
*** It's worth mentioning, as I noted in a previous post, it's not as if the GAAP numbers are always a terrific indication of actual business economics. Accounting can be a very useful tool but has its own real limitations.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Remarkably, this kind of "inflated and distorted earnings figure...is widely embraced by analysts and investors in valuing tech companies."
This, in part, reminds me of what Jeremy Grantham once said:
"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' [John Maynard] Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."
Well, if that's the case, then maybe this bodes well for those less influenced by "the institutional world."
Barron's estimates that a dozen large tech companies are not including roughly $ 16 billion of stock compensation expense in their non-GAAP earnings. A table in the article provides a detailed look at the relevant numbers for the twelve companies.
Some things to consider:
- Stock compensation is usually the major difference between reported GAAP earnings and non-GAAP earnings.
- Profit projections from analysts often ignore stock compensation.
- The likes of Microsoft (MSFT), Intel (INTC), Apple (AAPL), and IBM (IBM) are tech companies that report GAAP numbers only with stock compensation included.
- Some companies prefer non-GAAP earnings because they're highly dependent on stock-based compensation and, well, it makes their numbers look better. Analysts, in enough cases for it to matter, tend to use whatever approach the company thinks makes more sense. So, basically, those that don't offer much in the way of stock compensation don't mind reflecting the cost; those that do rely extensively on stock compensation, not surprisingly, choose the non-GAAP approach.
Here's three examples of how much of a difference it can make:
Google (GOOG)
2015 GAAP Estimated EPS: 22.70
2015 non-GAAP Estimated EPS: $ 28.35
2015 GAAP P/E: 24.7
2015 non-GAAP P/E: 19.8
Amazon.com (AMZN)
2015 GAAP Estimated EPS: 0.37
2015 non-GAAP Estimated EPS: 4.14
2015 GAAP P/E: 1,193
2015 non-GAAP P/E: 106
Salesforce.com (CRM)
2015 GAAP Estimated EPS: -0.05
2015 non-GAAP Estimated EPS: 0.71
2015 GAAP P/E: Not Meaningful
2015 non-GAAP P/E: 104
More from Barron's:
"Various justifications are offered for excluding equity compensation from expenses, but none hold up to scrutiny."
The argument that stock compensation isn't a real expense is a weak one at best.
If stock-based compensation expense is generally ignored by analysts and investors guess what's going to happen?
It seems rather probable it will encourage the use of stock-based compensation.
Some will no doubt continue to argue that stock compensation expense can be ignored. Arguments include that it's a non-cash expense and the additional share count captures the cost.
Well, in this case, it's a real expense even if it happens to be a non-cash expense: unless the strike price of an employee stock option fully reflects per share intrinsic value, the company is, when options are exercised, effectively selling shares at a discount (with tax implications fully considered). That discount is a real cost to continuing owners. So, in such a case, the additional share count only partially reflects that expense.*
Another argument essentially is that, since many industry peers ignore stock-based compensation, it makes sense to also ignore it for comparison purposes. Well, it's a real expense no matter how another company decides to logically present their own numbers.
When a company chooses to repurchase shares to just keep the share count from increasing, those funds could have instead been used for the direct benefit of shareholders in other ways. If the strike price is less than the repurchase price then, effectively, the company is buying high and selling low.
The difference can prove a meaningful cost especially for shareholders who intend to stick around.**
Those funds could be used for reducing share count instead of merely offsetting the dilution that occurs from stock compensation.
Those funds could be used for paying dividends.
Those funds could also be put to many other potential high return uses.
Now, if a company needs to use stock compensation to get the best employees, or to help manage cash flows, it may be very wise to do so.
Just count it as the real expense that it is.***
It simply makes little sense to ignore stock compensation for certain companies but include it for others.
Stock compensation is also a real cost for shareholders even if a company chooses to NOT repurchase shares. In many ways employee stock options -- depending on how the strike/exercise price compares to per share intrinsic value -- partially function like a reverse buyback that quietly (and, sometimes, not so quietly) dilutes continuing shareholders. Keep in mind that, upon the exercise of stock options, a company will receive funds equal to the strike price for each option that's exercised plus, depending on how much the options are in the money, a tax benefit. So, effectively some capital is "raised" in the process but what matters for continuing owners is how reasonable that strike price happens to be.
(If these funds are used to buyback stock then the net dilution is reduced.)
It's hard to completely fault the companies when not enough analysts and investors seem to be forcing the issue.
It's easy to choose to not follow suit and always include stock-based compensation when attempting to estimate, within a range on a conservative basis, per share intrinsic value.
None of this necessarily means some of these tech stocks aren't fine businesses. In fact, some are already extremely valuable and will no doubt prove to be even more so. It comes down to:
Will the value per share increase sufficiently?
Does the price paid offers an acceptable or better risk versus reward against alternatives?
Is there sufficient margin of safety to protection against what might go wrong and/or misjudged prospects?
If nothing else, a willingness to ignore stock-based compensation is fundamentally at odds with the margin of safety principle.
It's worth noting that I'm not referring to the speculative buying at one premium price (premium to per intrinsic value) with the hope of later sell at an even higher price. I'm referring to whether the price paid today offers an attractive outcome compared to what these businesses will be intrinsically worth on a per share basis in 10 or 20 years.
Those who successfully buy shares at a premium to value and exit successfully are likely taking on far more risk of permanent capital loss than they realize.
Risk that's not usually obvious until it is.
Adam
Long positions in MSFT and AAPL established at much lower than recent prices; long position in IBM established at somewhat higher than current prices; very small long position in GOOG also established at much lower than recent prices. No position in the other stocks mentioned.
Related posts:
Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Technology Stocks
Time for Dividends in Techland
* There are exceptions. When, for example, the strike price of employee stock options is well above per share intrinsic business value, then stock-based compensation can actually become beneficial to long-term owners. Of course, for these to be of any value to an employee the stock must necessarily be more than fully valued upon exercise. In this narrow (and somewhat unlikely) scenario, the company would be getting more than full value. The situation functions like capital being raised at an attractive price with a tax benefit as a bonus. This doesn't apply to stock-based compensation that's in the form of restricted stock (which is increasingly favored over stock options).
** The actual cost for shareholders is the difference between the lower strike price and the higher repurchase price. For companies where this kind of buy high/sell low behavior is the norm, this can become rather expensive (depending on the specifics of the stock-based compensation plan) for long-term owners when compounding effects are fully considered. In contrast, these still very real costs might be viewed as mere noise for those with shorter holding periods.
*** It's worth mentioning, as I noted in a previous post, it's not as if the GAAP numbers are always a terrific indication of actual business economics. Accounting can be a very useful tool but has its own real limitations.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, April 29, 2015
Apple's Cash
Apple (AAPL) has been returning, to say the very least, a whole lot of cash to shareholders since August of 2012:
From the inception of its capital return program in August 2012 through March 2015, Apple has returned over $112 billion to shareholders, including $80 billion in share repurchases.
The company's share count is down nicely as a result of the share repurchases and, based upon the expanded program, should continue to drop.* Yet, after returning the $ 112 billion, the company still has net cash and marketable securities of nearly $ 150 billion.
The key word here being "net". Total cash and marketable securities is actually more than $ 193 billion but, after subtracting debt, the number is more like just under $ 150 billion.
Consider the fact that net cash sat at roughly $ 117 billion just before this capital return program began. So the company has still been able to increase its net cash and marketable securities after allocating the $ 112 billion.
What's more astonishing is the fact that the company's net income was $ 1.3 billion on $ 13.9 billion of sales back in 2005.
Compare that to net income of 39.5 billion on sales of $ 182.8 billion in its last full fiscal year.
Those numbers are on track to be even higher in 2015.
I think it's fair to say that's quite a decade plus.
Now, the fact is Apple remains incredibly dependent on regular product innovation. What was highly competitive not long ago requires ongoing improvements just to remain competitive. I mean, they're not exactly selling soft drinks and snacks. Whether or not Apple can maintain its advantages and competitive position over the longer haul is, at least for me, a tough question to answer. The company may still be making great products many years from now but, even if they are, that doesn't guarantee today's outstanding business economics will be persistent.
An innovative company might continue creating quality products but, due to a changing competitive and technological landscape, what were once attractive returns on capital become much less so. It need not be something catastrophic for the core economics to be hurt in a way that's meaningful for long-term investors.
Charlie Munger, at the 2015 Daily Journal (DJCO) shareholder meeting last month, was asked whether companies like Google (GOOG) and Apple have sustainable moats.
Part of his response was this:**
I am not an expert on the moats of technology companies. The reason, by and large, I don't own them is because I do not understand whether or not there are moats that will last or not.
He also added the following:
...anybody who does give you the answer is probably full of you know what.
Occasionally, certain tech stocks (incl. AAPL and GOOG) have sold at a big enough discount to my own (conservative) estimate of intrinsic value that I was willing to purchase some shares.
In other words, the price was such that there was a substantial margin of safety and not much had to go right.
Adam
Long position in AAPL and GOOG established at much lower than recent prices; no position in DJCO.
* Naturally, if the stock at some point sells for a premium to per share intrinsic value the plan to repurchase shares should be altered accordingly.
** From some excellent notes that were taken at the meeting. Well worth reading. Not a transcript.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
From the inception of its capital return program in August 2012 through March 2015, Apple has returned over $112 billion to shareholders, including $80 billion in share repurchases.
The company's share count is down nicely as a result of the share repurchases and, based upon the expanded program, should continue to drop.* Yet, after returning the $ 112 billion, the company still has net cash and marketable securities of nearly $ 150 billion.
The key word here being "net". Total cash and marketable securities is actually more than $ 193 billion but, after subtracting debt, the number is more like just under $ 150 billion.
Consider the fact that net cash sat at roughly $ 117 billion just before this capital return program began. So the company has still been able to increase its net cash and marketable securities after allocating the $ 112 billion.
What's more astonishing is the fact that the company's net income was $ 1.3 billion on $ 13.9 billion of sales back in 2005.
Compare that to net income of 39.5 billion on sales of $ 182.8 billion in its last full fiscal year.
Those numbers are on track to be even higher in 2015.
I think it's fair to say that's quite a decade plus.
Now, the fact is Apple remains incredibly dependent on regular product innovation. What was highly competitive not long ago requires ongoing improvements just to remain competitive. I mean, they're not exactly selling soft drinks and snacks. Whether or not Apple can maintain its advantages and competitive position over the longer haul is, at least for me, a tough question to answer. The company may still be making great products many years from now but, even if they are, that doesn't guarantee today's outstanding business economics will be persistent.
An innovative company might continue creating quality products but, due to a changing competitive and technological landscape, what were once attractive returns on capital become much less so. It need not be something catastrophic for the core economics to be hurt in a way that's meaningful for long-term investors.
Charlie Munger, at the 2015 Daily Journal (DJCO) shareholder meeting last month, was asked whether companies like Google (GOOG) and Apple have sustainable moats.
Part of his response was this:**
I am not an expert on the moats of technology companies. The reason, by and large, I don't own them is because I do not understand whether or not there are moats that will last or not.
He also added the following:
...anybody who does give you the answer is probably full of you know what.
Occasionally, certain tech stocks (incl. AAPL and GOOG) have sold at a big enough discount to my own (conservative) estimate of intrinsic value that I was willing to purchase some shares.
In other words, the price was such that there was a substantial margin of safety and not much had to go right.
Adam
Long position in AAPL and GOOG established at much lower than recent prices; no position in DJCO.
* Naturally, if the stock at some point sells for a premium to per share intrinsic value the plan to repurchase shares should be altered accordingly.
** From some excellent notes that were taken at the meeting. Well worth reading. Not a transcript.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, February 13, 2015
Apple: Market Share vs Profit Share
Those who think it's such a wonderful idea to aggressively pursue market share might want to consider Apple's (AAPL) share of the worldwide smartphone market.
As things currently stand, Apple's share was 15% last year and nearly 20% in the fourth quarter.
More than solid, of course, but that measure doesn't do much to reveal the true economic picture.
According to Canaccord Genuity, roughly 93% of fourth quarter smartphone profits went to Apple while Samsung (005930.KS) captured 9% of the profits. The fact that the profits of Apple and Samsung are greater than 100% means the remaining competitors combined are actually losing money. The rest collectively aren't just eating crumbs, many competitors are essentially at or near the business equivalent of starvation.
Basically, Apple feasts while, other than maybe Samsung, the rest don't even have enough leftovers to share.
Apple had something like 87% of smartphone profits roughly a year ago. So, while the new iPhones certainly contributed a bunch to the fourth quarter performance, Apple was getting more than their fair share of profits well before the new products were launched.
Now, as I've said on prior occasions, I'm generally no fan of technology stocks unless the margin of safety becomes very large.
Yet it's still hard to not admire what Apple has been doing. Describing Apple as exceptional is not only stating the obvious, it's actually a huge understatement.
Here's the tough part: Is that level of profitability is sustainable over the longer haul? For me, that still seems not an easy thing to gauge at all.
The fact that so much of Apple's profit comes from the iPhone is another important consideration.
In other words, a company's accomplishments can be extremely impressive -- as it certainly is with Apple -- but that doesn't necessarily mean estimating per share intrinsic value is easy. Figuring out Apple's value within a narrow enough range is, to me, challenging at best and warrants a significant margin of safety.*
(When I've purchased the stock in the past, my judgment was that the market price at the time offered a great deal of protection against permanent capital loss. Still, it's no favorite -- and likely never will be -- for the longer haul.)
Apple is currently a valuable business but, as far as I'm concerned, the range of outcomes is still rather too wide.
Others naturally might feel more comfortable with judging Apple's future prospects. It won't surprise me if Apple's continues to do very well. It's just that my favorite businesses have more understandable long-term prospects -- and usually that means less dependence on creating/updating brilliant products on a regular basis -- within a comparably narrow range.
How well would one of Apple's products from seven years ago compete against current alternatives?
How well would some trusted brand of soda from seven years ago compete against current alternatives?
Businesses that need to produce one hit after another run the risk of eventually hitting a wall. It's not that the business necessarily fails altogether; it's that remaining competitive long-term necessitates material changes to core business economics (i.e. increased investment and operating costs, reduced pricing power) with serious consequences for owners.
The net result being a range of outcomes -- after a number of product cycles and maybe a technological shift or two -- that's often too wide with the worst case scenario being unacceptable.
Apple, it seems more than fair to say, has earned and deserves huge respect. It's an extraordinary enterprise with, at least at the present time, astonishing economics. What they've created over the years has had an enormous favorable impact on the world. It's just important to remember this guarantees absolutely nothing about future results for a long-term shareholder.
Societal impact and rewards to investors need not necessarily be positively correlated. Over the past decade or so the correlation has clearly been, to say the least, rather very positive for Apple.
This may continue to be the case going forward but is far from a given.
It's understandable that some will pursue the transformational businesses with the potential for spectacular returns. Yet the chance for costly mistakes is usually high. Compounding at attractive (even if less than spectacular) rates of return for a very long time is, for investors, not easy but all-important.
Well, it's tough to be confident the time frame will be a very long time with any business that depends extensively on ingenious innovations being delivered on a regular basis.**
The power of long-term compounding effects can inadvertently become lost in the chase for the next big thing.
The market eventually weighs business success or failure reasonably well even if sometimes the recognition is delayed.
That delayed recognition can, at times, be a very good thing for the long-term owner.
Adam
Long position in AAPL established at much lower than recent market prices
Related posts:
Mr. Market
Buffett on Autos, Airplanes, and Airlines
Warren Buffett on "The Key to Investing"
Technology Stocks
* As always, I have no opinion about how Apple's stock (or any stock) might perform in the near-term or even intermediate-term. In fact, I never have a view on such things. Those who attempt to profit from price action are engaged in an entirely different game (whether or not fundamentals are used in their decision-making). My emphasis is on how price compares to value (based upon the excess cash a business is expected to produce over time), the likelihood that the value will increase at least at a satisfactory clip, and long-term effects. Business prospects are sometimes mispriced -- even for an extended period -- but eventually should be confirmed by, and reflected in, market prices.
** Some quality businesses can maintain substantial competitive advantages over the longer haul without lots of innovation. Still, even the best businesses will face real challenges from time to time.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
As things currently stand, Apple's share was 15% last year and nearly 20% in the fourth quarter.
More than solid, of course, but that measure doesn't do much to reveal the true economic picture.
According to Canaccord Genuity, roughly 93% of fourth quarter smartphone profits went to Apple while Samsung (005930.KS) captured 9% of the profits. The fact that the profits of Apple and Samsung are greater than 100% means the remaining competitors combined are actually losing money. The rest collectively aren't just eating crumbs, many competitors are essentially at or near the business equivalent of starvation.
Basically, Apple feasts while, other than maybe Samsung, the rest don't even have enough leftovers to share.
Apple had something like 87% of smartphone profits roughly a year ago. So, while the new iPhones certainly contributed a bunch to the fourth quarter performance, Apple was getting more than their fair share of profits well before the new products were launched.
Now, as I've said on prior occasions, I'm generally no fan of technology stocks unless the margin of safety becomes very large.
Yet it's still hard to not admire what Apple has been doing. Describing Apple as exceptional is not only stating the obvious, it's actually a huge understatement.
Here's the tough part: Is that level of profitability is sustainable over the longer haul? For me, that still seems not an easy thing to gauge at all.
The fact that so much of Apple's profit comes from the iPhone is another important consideration.
In other words, a company's accomplishments can be extremely impressive -- as it certainly is with Apple -- but that doesn't necessarily mean estimating per share intrinsic value is easy. Figuring out Apple's value within a narrow enough range is, to me, challenging at best and warrants a significant margin of safety.*
(When I've purchased the stock in the past, my judgment was that the market price at the time offered a great deal of protection against permanent capital loss. Still, it's no favorite -- and likely never will be -- for the longer haul.)
Apple is currently a valuable business but, as far as I'm concerned, the range of outcomes is still rather too wide.
Others naturally might feel more comfortable with judging Apple's future prospects. It won't surprise me if Apple's continues to do very well. It's just that my favorite businesses have more understandable long-term prospects -- and usually that means less dependence on creating/updating brilliant products on a regular basis -- within a comparably narrow range.
How well would one of Apple's products from seven years ago compete against current alternatives?
How well would some trusted brand of soda from seven years ago compete against current alternatives?
Businesses that need to produce one hit after another run the risk of eventually hitting a wall. It's not that the business necessarily fails altogether; it's that remaining competitive long-term necessitates material changes to core business economics (i.e. increased investment and operating costs, reduced pricing power) with serious consequences for owners.
The net result being a range of outcomes -- after a number of product cycles and maybe a technological shift or two -- that's often too wide with the worst case scenario being unacceptable.
Apple, it seems more than fair to say, has earned and deserves huge respect. It's an extraordinary enterprise with, at least at the present time, astonishing economics. What they've created over the years has had an enormous favorable impact on the world. It's just important to remember this guarantees absolutely nothing about future results for a long-term shareholder.
Societal impact and rewards to investors need not necessarily be positively correlated. Over the past decade or so the correlation has clearly been, to say the least, rather very positive for Apple.
This may continue to be the case going forward but is far from a given.
It's understandable that some will pursue the transformational businesses with the potential for spectacular returns. Yet the chance for costly mistakes is usually high. Compounding at attractive (even if less than spectacular) rates of return for a very long time is, for investors, not easy but all-important.
Well, it's tough to be confident the time frame will be a very long time with any business that depends extensively on ingenious innovations being delivered on a regular basis.**
The power of long-term compounding effects can inadvertently become lost in the chase for the next big thing.
The market eventually weighs business success or failure reasonably well even if sometimes the recognition is delayed.
That delayed recognition can, at times, be a very good thing for the long-term owner.
Adam
Long position in AAPL established at much lower than recent market prices
Related posts:
Mr. Market
Buffett on Autos, Airplanes, and Airlines
Warren Buffett on "The Key to Investing"
Technology Stocks
* As always, I have no opinion about how Apple's stock (or any stock) might perform in the near-term or even intermediate-term. In fact, I never have a view on such things. Those who attempt to profit from price action are engaged in an entirely different game (whether or not fundamentals are used in their decision-making). My emphasis is on how price compares to value (based upon the excess cash a business is expected to produce over time), the likelihood that the value will increase at least at a satisfactory clip, and long-term effects. Business prospects are sometimes mispriced -- even for an extended period -- but eventually should be confirmed by, and reflected in, market prices.
** Some quality businesses can maintain substantial competitive advantages over the longer haul without lots of innovation. Still, even the best businesses will face real challenges from time to time.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, June 13, 2014
The Growth Trap: IBM vs Standard Oil
Imagine it's 1950 and a decision needs to be made between two common stock investment alternatives:
- IBM (IBM)
- Standard Oil (now ExxonMobil: XOM)
IBM at that time had superior growth prospects compared to Standard Oil.
Below is a quick summary of the growth measures from 1950-2003 for both companies.*
Revenue Growth
IBM: 12.19% per year
Standard Oil: 8.04%
Earning Per Share Growth
IBM: 10.94%
Standard Oil: 7.47%
Dividend Growth
IBM: 9.19%
Standard Oil: 7.11%
Sector Growth
IBM: 14.65%
Standard Oil: negative 14.22%
So the advantage goes to IBM in every category except the one that really counts.
Standard Oil actually produced the better total return.
Total Return
IBM: 13.83%
Standard Oil: 14.42%
Why did Standard Oil's stock perform better? Simply put, it was the difference in valuation and the effect of dividends reinvested.
Average Price to Earnings
IBM: 26.76
Standard Oil: 12.97
Average Dividend Yield
IBM: 2.18%
Standard Oil: 5.19%
Those higher dividends reinvested, over time, in a stock with a more reasonable valuation made all the difference.** The end result being an investor in Standard oil increased their holdings by 15x while an investor in IBM only accumulated 3x more shares. IBM had vastly superior fundamentals over those 50 plus years. In fact, the market value of IBM actually went up more than Standard Oil. Yet, all those additional shares, bought with reinvested dividends, meant that the individual investor in Standard Oil ended up with the better overall result.
"...despite the better fundamentals, investors paid too high a price for IBM, while old Standard Oil was cheaply priced. I call this the 'growth trap.' Investors make the mistake of buying the new thing, irrespective of price." - Jeremy Siegel in an interview back in 2006
This is at least worth consideration the next time there's the temptation to pay a premium for exciting growth prospects. The return comparison is not all that matters, of course. IBM's results depended on much higher sustained growth. More risk was taken in the process simply due to the higher multiple of earnings paid. One of the best tools available to an investor to manage risk is price. That's under an investor's control; what happens as far as future growth goes is not.
Still, both IBM and Standard Oil generated very nice long run investment results. Things worked out well for long-term investors in both companies but, when you pay a high multiple, the margin of safety just isn't there to protect against what might go wrong.***
This naturally reveals nothing about the unique risks, challenges, and opportunities for these two businesses going forward. Future long-term investment results, at least to me, seem likely to be far more modest. No complaints if things turn out a bit better than expected, of course.
As always, it's not just about the absolute return; it's about judging risk versus reward and comparing to alternatives.
Unlike those 50 plus years, these days IBM has a much lower earnings multiple and, apparently, far less exciting growth prospects. Well, at least for now. It's never easy to tell, favorable or not, how those prospects might change over the very long haul. Price paid should assume and reflect the least optimistic scenario. (Especially for technology stocks.)
In other words, the expected outcome should be an attractive one even if nothing great happens.
If the likely worst case can't be judged with high confidence, buying makes no sense.
Adam
Small long position in IBM; no position in XOM.
Other related posts:
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Technology Stocks - May 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* Source: The Future for Investors by Jeremy Siegel
** Dividend reinvestments function like buybacks but, compared to buybacks, are generally less tax efficient. This depends on the type of account. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
*** Both companies, inevitably, ran into plenty of their own specific difficulties over those 50 plus years. Even very good businesses will have their fair share of challenges. Anyone expecting a smooth ride investing in common stocks is, well, guaranteed disappointment.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
- IBM (IBM)
- Standard Oil (now ExxonMobil: XOM)
IBM at that time had superior growth prospects compared to Standard Oil.
Below is a quick summary of the growth measures from 1950-2003 for both companies.*
Revenue Growth
IBM: 12.19% per year
Standard Oil: 8.04%
Earning Per Share Growth
IBM: 10.94%
Standard Oil: 7.47%
Dividend Growth
IBM: 9.19%
Standard Oil: 7.11%
Sector Growth
IBM: 14.65%
Standard Oil: negative 14.22%
So the advantage goes to IBM in every category except the one that really counts.
Standard Oil actually produced the better total return.
Total Return
IBM: 13.83%
Standard Oil: 14.42%
Why did Standard Oil's stock perform better? Simply put, it was the difference in valuation and the effect of dividends reinvested.
Average Price to Earnings
IBM: 26.76
Standard Oil: 12.97
Average Dividend Yield
IBM: 2.18%
Standard Oil: 5.19%
Those higher dividends reinvested, over time, in a stock with a more reasonable valuation made all the difference.** The end result being an investor in Standard oil increased their holdings by 15x while an investor in IBM only accumulated 3x more shares. IBM had vastly superior fundamentals over those 50 plus years. In fact, the market value of IBM actually went up more than Standard Oil. Yet, all those additional shares, bought with reinvested dividends, meant that the individual investor in Standard Oil ended up with the better overall result.
"...despite the better fundamentals, investors paid too high a price for IBM, while old Standard Oil was cheaply priced. I call this the 'growth trap.' Investors make the mistake of buying the new thing, irrespective of price." - Jeremy Siegel in an interview back in 2006
This is at least worth consideration the next time there's the temptation to pay a premium for exciting growth prospects. The return comparison is not all that matters, of course. IBM's results depended on much higher sustained growth. More risk was taken in the process simply due to the higher multiple of earnings paid. One of the best tools available to an investor to manage risk is price. That's under an investor's control; what happens as far as future growth goes is not.
Still, both IBM and Standard Oil generated very nice long run investment results. Things worked out well for long-term investors in both companies but, when you pay a high multiple, the margin of safety just isn't there to protect against what might go wrong.***
This naturally reveals nothing about the unique risks, challenges, and opportunities for these two businesses going forward. Future long-term investment results, at least to me, seem likely to be far more modest. No complaints if things turn out a bit better than expected, of course.
As always, it's not just about the absolute return; it's about judging risk versus reward and comparing to alternatives.
Unlike those 50 plus years, these days IBM has a much lower earnings multiple and, apparently, far less exciting growth prospects. Well, at least for now. It's never easy to tell, favorable or not, how those prospects might change over the very long haul. Price paid should assume and reflect the least optimistic scenario. (Especially for technology stocks.)
In other words, the expected outcome should be an attractive one even if nothing great happens.
If the likely worst case can't be judged with high confidence, buying makes no sense.
Adam
Small long position in IBM; no position in XOM.
Other related posts:
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Technology Stocks - May 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* Source: The Future for Investors by Jeremy Siegel
** Dividend reinvestments function like buybacks but, compared to buybacks, are generally less tax efficient. This depends on the type of account. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
*** Both companies, inevitably, ran into plenty of their own specific difficulties over those 50 plus years. Even very good businesses will have their fair share of challenges. Anyone expecting a smooth ride investing in common stocks is, well, guaranteed disappointment.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, May 23, 2014
Buffett and Munger Talk Retail Businesses, Nebraska Furniture Mart, and Amazon
Warren Buffett and Charlie Munger talked about retail businesses more generally, as well as Nebraska Furninture Mart, and Amazon (AMZN) specifically, in this recent CNBC interview:
MUNGER: I think Warren and I can match anybody's failures in retail.
BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...
MUNGER: Quickly.
BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.
MUNGER: Most of the giants of yesteryear are done.
They go on to talk about a very successful retail business Berkshire's owned since the early 1980s:
BUFFETT: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don't know, the 50th market in the country? This store does $450 million annually. It's doing $40 million during the Berkshire shareholders week. But there's no store that remotely can offer the variety. There's no store that can undersell us. But to achieve that kind of dominance, you can't do it with a chain of stores in Canada when you're competing with Wal-Mart up there and a whole bunch of other people.
Buffett and Munger both share a very favorable view of Amazon.* Here's what they had to say when asked about the company's business model:
MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.
BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.
This certainly isn't the first time accolades have been directed at Jeff Bezos by Buffett.
In fact, last year Buffett said that he was "the ablest CEO in America."
Still, retailing certainly is a tough business.
Figuring out whether a moat can be built and sustained is tough to do but it sure helps to have exceptionally talented leadership.
Of course, these days Amazon has moved beyond strictly being a retailer.
Now, whether Amazon ends up being a great investment is another question altogether.
To me, the respect and admiration for Amazon has been well-earned as noted in prior posts.
(Some concerns and criticisms have also been previously highlighted.)
My main problem has always been valuation. More specifically, I've just never understood how to value the business within an acceptably narrow range.
Tough to value is very different than being overvalued.
Based upon price to earnings the company naturally appears quite overvalued and very well may even be. Yet this company -- almost uniquely -- invests with a long view in mind, often executes very well, and makes brilliant use of its working capital. With this in mind, it seems foolish to underestimate Amazon.
Amazon's business is likely intrinsically worth a lot as of now. How much?
I have no idea.
It also has seems to have a reasonable chance of being worth a whole lot more down the road. How much?
Again, I just have no idea.
In both cases, I'm NOT referring to market capitalization; I'm referring to a rough but meaningful estimate of intrinsic value based upon defensible assumptions and sound logic. If what something is roughly worth -- within a narrow enough range -- isn't clear, it's naturally just not possible to judge what an appropriate margin of safety might be.
(The price paid should be a nice discount to estimated value and protect the investor sufficiently against things not going quite as well as expected.)
This simply means, when it comes to Amazon, I can't figure out whether the returns are likely to be sufficient considering the risks and compared to investment alternatives.
Alternatives that I understand better.
Others may have a way to figure out Amazon's value with enough confidence. Those that can are far better candidates to invest long-term in the company.**
The biggest reason I still always pay attention to Amazon is their ability to potentially disrupt (or damage the economic moat of) some other business or industry. Just because the company doesn't compete directly against someone now, doesn't mean it won't down the road.
In other words, what appear to be solid business economics today, end up being badly eroded down the road.
Clearly, certain businesses and industries are more likely to be challenged some day by Amazon than others.
Though I'm not sure ten years ago many would have imagined or anticipated all the moves that Amazon has made since that time.
Adam
No position in AMZN
Related posts:
Washington Post Sold To Jeff Bezos
Amazon, Apple, and Intrinsic Value - Part II
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks
* Keep in mind they are commenting on Amazon's business NOT necessarily the stock.
** Someone else might find Amazon's intrinsic value easier to estimate, of course. As always, it's knowing what's understandable to you and only investing in those things. This is necessarily unique to each investor. When you stick to what you know fewer errors are likely to be made.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
(5)
MUNGER: I think Warren and I can match anybody's failures in retail.
BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...
MUNGER: Quickly.
BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.
MUNGER: Most of the giants of yesteryear are done.
They go on to talk about a very successful retail business Berkshire's owned since the early 1980s:
BUFFETT: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don't know, the 50th market in the country? This store does $450 million annually. It's doing $40 million during the Berkshire shareholders week. But there's no store that remotely can offer the variety. There's no store that can undersell us. But to achieve that kind of dominance, you can't do it with a chain of stores in Canada when you're competing with Wal-Mart up there and a whole bunch of other people.
Buffett and Munger both share a very favorable view of Amazon.* Here's what they had to say when asked about the company's business model:
MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.
BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.
This certainly isn't the first time accolades have been directed at Jeff Bezos by Buffett.
In fact, last year Buffett said that he was "the ablest CEO in America."
Still, retailing certainly is a tough business.
Figuring out whether a moat can be built and sustained is tough to do but it sure helps to have exceptionally talented leadership.
Of course, these days Amazon has moved beyond strictly being a retailer.
Now, whether Amazon ends up being a great investment is another question altogether.
To me, the respect and admiration for Amazon has been well-earned as noted in prior posts.
(Some concerns and criticisms have also been previously highlighted.)
My main problem has always been valuation. More specifically, I've just never understood how to value the business within an acceptably narrow range.
Tough to value is very different than being overvalued.
Based upon price to earnings the company naturally appears quite overvalued and very well may even be. Yet this company -- almost uniquely -- invests with a long view in mind, often executes very well, and makes brilliant use of its working capital. With this in mind, it seems foolish to underestimate Amazon.
Amazon's business is likely intrinsically worth a lot as of now. How much?
I have no idea.
It also has seems to have a reasonable chance of being worth a whole lot more down the road. How much?
Again, I just have no idea.
In both cases, I'm NOT referring to market capitalization; I'm referring to a rough but meaningful estimate of intrinsic value based upon defensible assumptions and sound logic. If what something is roughly worth -- within a narrow enough range -- isn't clear, it's naturally just not possible to judge what an appropriate margin of safety might be.
(The price paid should be a nice discount to estimated value and protect the investor sufficiently against things not going quite as well as expected.)
This simply means, when it comes to Amazon, I can't figure out whether the returns are likely to be sufficient considering the risks and compared to investment alternatives.
Alternatives that I understand better.
Others may have a way to figure out Amazon's value with enough confidence. Those that can are far better candidates to invest long-term in the company.**
The biggest reason I still always pay attention to Amazon is their ability to potentially disrupt (or damage the economic moat of) some other business or industry. Just because the company doesn't compete directly against someone now, doesn't mean it won't down the road.
In other words, what appear to be solid business economics today, end up being badly eroded down the road.
Clearly, certain businesses and industries are more likely to be challenged some day by Amazon than others.
Though I'm not sure ten years ago many would have imagined or anticipated all the moves that Amazon has made since that time.
Adam
No position in AMZN
Related posts:
Washington Post Sold To Jeff Bezos
Amazon, Apple, and Intrinsic Value - Part II
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks
* Keep in mind they are commenting on Amazon's business NOT necessarily the stock.
** Someone else might find Amazon's intrinsic value easier to estimate, of course. As always, it's knowing what's understandable to you and only investing in those things. This is necessarily unique to each investor. When you stick to what you know fewer errors are likely to be made.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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Monday, March 31, 2014
eBay 10 Years Later: Business Performance vs Stock Performance
There was a time, a bit less than 10 years ago, that the enthusiasm for eBay's (EBAY) prospects rivaled some of today's high flyers.
Also, much like today's highest flyers was a stock price that reflected that enthusiasm.
The stock was selling, give or take, for roughly 100x earnings in 2004.
Now, the company has run into it's fair share of challenges -- as even the very best business do -- while management was both smart and fortunate to buy PayPal when they did at a price that, at least with the benefit of hindsight, looks rather cheap. Still, even if it has been a bumpy ride at times, nearly ten years later the company has delivered some fine results.*
2004 2013
Revenue $ 3.3 billion $ 16.0 billion
Net Income $ .78 billion $ 2.9 billion
I think it is reasonable to say that financial performance qualifies as not too bad at all. Though what matters, naturally, is what those numbers indicate, if anything, about the company's future prospects and trajectory.
It's worth noting that the revenue and net income increases have been backed by solid free cash flow**. The company has, more or less, over that time also maintained a healthy balance sheet. So it's just not hard to argue they've put together more than a pretty solid decade.
So the business did just fine but, in 2004, those who were buying eBay's stock at prevailing prices were assuming the recent positive trajectory would continue for, at the very least, quite a long time.
Buyers of the stock back then were willing to pay a very high multiple of earnings in the hopes those earnings would rise dramatically and, well, very quickly.
(It's been long enough that some might forget eBay was once viewed as a high flyer not unlike some of today's favorites.)
The end result being that, while eBay put together quite a nice decade of business performance, the buyers who paid those prevailing late 2004 prices expecting to get an attractive investment result (in contrast to those who might have been betting on a good speculative outcome) have not been rewarded.
At ~ $ 55 per share now, the stock now sells at a price that's not much different than back in late 2004.
The point being, of course, is it's no fun to own a business that delivers good business results over a decade or so yet delivers an unsatisfactory return to the owners.
(The S&P 500's total return has been nearly a double over that same time frame with none of the business specific risks.)
By the way, I'm only using eBay as an example. There are a number of examples over the past 10-15 years of, to varying degrees, an enterprise with good prospects but a valuation that was unlikely to compensate the investor sufficiently (though the most exceptional surely did reward investors).
Again, even very good businesses run into real difficulties from time to time. There's almost certain to be an ebb and flow and it's unwise as an investor to not expect as much. Sometimes, near-term price action is merely a reflection of perceived prospects based upon recent news not actual changes to intrinsic worth.
That's true in both directions.
Emotions and psychology more generally rule price action in the shorter run; intrinsic values drive prices over the longer run.
There is no doubt some high flyers today that are good businesses with fine prospects. Yet, due to the upfront price that must be paid, the returns are also likely to not compensate the long run owner sufficiently.
Of course, some of these high flyers will perform well; others will end up disappointing. Telling them apart beforehand is much easier said than done (or easier to describe after the fact). In fact, a too high risk of permanent capital loss usually exists in or near the same neighborhood as the potential big winners. A wilder ride, maybe, but the combined net impact of those winners and losers will too often offer a less than impressive overall result.
Back in 2004, alternatives to eBay had not only less difficult to judge prospects (and, yes, less exciting price action), but also were priced in a way that increased the likelihood of a nice investment outcome.
Investment must always be viewed in the context of opportunity costs. It's not whether a business can eventually "grow into its valuation". (A description or justification that's so often associated with the high-flyers.) It's whether something well understood is judged likely to deliver -- considering the specific risks and relative to alternatives -- attractive absolute forward returns. If an investment does end up someday validating an initial seemingly high valuation, it doesn't logically follow that the risk of permanent capital loss compared possible rewards was well managed. Sometimes, for example, the price is so high that just about everything has to go right. So it might be a perfectly good business, but justifying the price paid depends on lots of continued good fortune. Well, in those instances, an extreme valuation will too often offer no protection against permanent capital loss if there's an unforeseen bump or two in the road. The price paid should, as a principle, always protect the investor against such unforeseen and often mostly unforeseeable things.
(Another way to think about this: even if eBay had delivered a positive return over those ten years or so, it still might not be a sufficient return considering risks and alternatives.)
The world is always uncertain; pay a price that reflects this reality and protects against surprises (or, at least, all but the very worst outcomes).
Some of the current highest flyers are selling for what certainly looks like extreme valuations. No doubt a number of these will do great things in terms of business performance over the next decade or longer.
More than a few will also inevitably run into business challenges; some that will get sorted out and, well, some that will not.
In enough cases to matter, I'm guessing that the current dreams that are propping up prices will come no where near being realized.
The most exceptional ones, once again, might actually even exceed what now seem like lofty expectations.
The problem is that it's often not at all easy to predict these long-term outcomes; to reliably foresee which high flyers have sustainable advantages and prospects on a scale that ends up making sense of what, in too many cases, now looks like nonsensical valuations. Speaking generally, putting capital at risk based on an optimistic long-term forecast is usually a fool's errand. This becomes especially unwise when the capital at risk depends on consistently and correctly predicting what the economics of businesses in the most dynamic industries will look like many years down the road. It moves from being unwise to just plain financially dangerous when what's paid upfront depends on the best possible outcomes.
Placing capital at risk that's dependent on consistently correct long-term predictions is folly; developing a robust investment process and based upon sound principles is not. The investor may not be able to control outcomes, but still can increase the likelihood of good results with a sound approach.
(Including the development of what Charlie Munger calls "a latticework of models".)
The approach is under investor control. What ultimately happens is not.
For investors, it's just generally more wise to focus less time and energy on that former "p" and more on the latter two.
Margin of safety is, of course, just one of the many essential investment principles but seems rather appropriate to highlight here. It's a recognition of an investor's limitations -- the inevitable mistakes that get made -- and, to varying degrees depending on the business, an uncertain range of future outcomes for the business itself.***
Now, since those high eBay market prices prevailed back in 2004, many opportunities arose to buy shares of the company at more reasonable valuation levels.
In fact, at least in my view, the company's shares sold several years back at a significant discount to intrinsic value for an extended period.
(Though, at or near current prices, to me the shares are very far from being cheap.)
This happened, at least in part, when eBay's perceived prospects changed in the minds of apparently rather impatient market participants (with an assist from the financial crisis). Now, the company did have to transition through some very real difficulties (again, this is almost inevitable from time to time), but its sound core business economics remained mostly intact even if growth, for a time, became subdued. So the very fast growth that some like to pay a premium for wasn't there but, crucially, they continued to produce lots of free cash flow at a high return. They've had a fine business throughout -- even if with real difficulties -- but the price of admission changed dramatically. It's been essentially the same business, but what makes sense to buy at one price makes no sense at another. Business prospects can't be viewed in a vacuum; the price paid dictates risk and reward.
Durable high return on capital in the long run trumps modest growth especially if the right price is paid in the first place.
Of course, the investor who bought eBay's shares when cheap and hung in there had to endure, over several years, many very real unresolved business challenges and the inevitable lousy headlines that followed. Nothing like hearing and reading how stupid it is to own a particular stock day after day to test conviction.
(BTW - possessing a high level of unwarranted conviction is obviously never a good thing. Stubbornness combined with confirmation bias is a great way to lose a lot of money.)
So, beyond buying shares at a plain discount to intrinsic value, owning eBay's shares several years back required lots of patience in combination with the ability to ignore the noise and terrible price action. Attractive discounts don't usually exist when the headlines are rosy and future prospects are clear.
(Though sometimes a business has problems that are just plain intractable. Correctly separating, beforehand, the sound business with real but fixable problems from those that are truly broken is easier said than done.)
Today, eBay's stock appears rather expensive -- though not at all as much so as some of the current highest flyers, or the company's own extreme valuation a little less than a decade ago -- but their overall business prospects continue to appear not too bad at all.
In other words, intrinsic value would seem likely to increase just fine over time. It's just that compensation isn't likely to be sufficient considering risks and alternatives. It's just that margin of safety isn't, at least for me, as plain to see.
The fact is, near the current valuation, risk/reward is nothing like what it was several years back. That's a simple matter of the price one now has to pay, not the prospects for eBay itself.
Still, I won't be surprised at all if eBay does quite well as a business over the long-term. If so, valuation will follow.
In any case, this is not a view of what the shares might do in the next days, weeks, or even several years. Trying to figure out that sort of thing is mostly a waste of time and energy.
"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch
Having said that, my preference is to generally not sell shares of a somewhat overvalued but otherwise good business -- one that was bought at a nice discount in the first place -- unless the opportunity costs are high; my preference is for increases to per share intrinsic value to be the primary driver of returns. To me, attempting to generate satisfactory or better outcomes via the clever trading into and out of various marketable securities is folly. In fact, I'd argue that just about the opposite behavior is what generally gets results, especially when done in a thoughtful and persistent manner.
That usually means, in order for selling to be warranted, the shares need to be plainly expensive -- selling for a significant premium to intrinsic value -- and/or something else well understood needs to become very mispriced on the low side. At times, an investment that has a substantial margin of safety must be funded by another investment that lacks such a margin of safety. When a switch is warranted, the advantage in terms of risk and reward between the investment alternatives should be very obvious.
(Though, reducing the size of a position as the shares become more fully valued often makes sense to me. I've, in fact, recently done just that with eBay. Where I tend to NOT do this is with shares of my favorite businesses. Well, eBay surely does not fall into that category even if it does possess a number of attractive business characteristics.)
Trading into or out of something because it is merely somewhat mispriced makes little sense. Minimizing moves in a portfolio isn't just about reducing frictional costs, it's about reducing mistakes.
Focusing on the upside of a move but not carefully considering the downside of a move is an easy mistake to make.
Mispricings, on both the high and low side, can occur when recent success or difficulties is used to extrapolate forward what something might be worth. Sometimes what's growing takes a pause. The opposite is also true. Paying a premium price that assumes growth will continue indefinitely is just asking for trouble. The fact is it's nearly impossible to foresee what challenges or opportunities might arise much further down the road. If the price paid depends not on continued good fortune to get an attractive result, there'll be no complaints if prospects turn out to be somewhat, or maybe a whole lot, better.
I'd add that a good investment outcome should never depend on selling at a premium price. Those who need to sell at a premium price to achieve a good outcome make themselves vulnerable to something they have no control over. A modest multiple of, conservatively estimated, future per share normalized earning power -- at least 7-10 years down the road and, ideally, even much longer -- should be all that's required, considering risks and alternatives, for a nice overall investment result.
For most assets, it will not be possible to figure out future earnings power. When that's the case it's best to just move on. That doesn't mean the opportunities never appear on the radar with some patience. When they do appear -- and confidence is both high and warranted -- that patience must to be followed by decisive action.
A sound investment approach, applied consistently over a long period of time, still guarantees nothing but can, at least, increase the likelihood that good things more frequently happen and overall results improve.
It's at least worth mentioning -- as I have before on more than a few occasions -- that there's really no pure technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries; that's precisely what makes them unattractive long-term investments. It's the fact that the range of possible outcomes is often just too wide to get, on a consistent basis, the valuation at least mostly right.
Now, while technology is very important to eBay, it seems not difficult to argue that the company is a very different animal than the most pure of technology businesses.
Adam
Long position in eBay established at very much lower than current market prices. This once larger position (bought years back when eBay was experiencing some difficulties) has been reduced to a smaller position near and above recent prices. Generally speaking, my preference is to absolutely minimize buying/selling but, as eBay's margin of safety has decreased (at least by my math and assumptions which, of course, could prove to be very wrong) the position has been trimmed consistent with how I view risk/reward and current alternatives. Those funds will be redeployed if and when shares of an attractive business becomes cheap enough to buy again. We are, in general, surely a long way from the valuation environment that existed 3-5 years ago.
Related posts:
eBay's Valuation
eBay's Free Cash Flow
Technology Stocks
* Rev. (billions $) 2004-13: 3.3, 4.6, 6.0, 7.7, 8.5, 8.7, 9.2, 11.7, 14.1, 16.0;
Net Inc. (billions $) 2004-13: .78, 1.1, 1.1, .35, 1.8, 2.4, 1.8, 3.2, 2.6, 2.9
** Though I'm not a fan of how expensive eBay's stock-based compensation actually is, though I realize some choose to treat it -- and I'd argue incorrectly -- as a non-cash expense. Well, the specific cash cost might not be easy to estimate upfront but that makes it no less real. One alternative way to roughly, but meaningfully, show the true cash cost of equity compensation plans at eBay (and at a number of other companies) is to add up what's been spent on buybacks over several years then compare it to how the share count has been impacted. In eBay's case lots of cash has been expended on buybacks over the past five years yet there's been no reduction in share count. Well, if the share count isn't reduced much (or, in this instance, not at all), that cash used -- to simply offset equity compensation related dilution -- can no longer be returned to or benefit shareholders. So this is hardly some non-cash expense; it's, instead, a very real cost. Naturally, one could simply choose to consider the GAAP stock-based compensation as a useful, if imperfect, way to estimate this cost in the first place. Still, there is certainly no way to do more than very roughly estimate this cost going forward. The above alternative approach is simply one way to help reveal that the equity compensation eventually ends up having a very real economic impact. When stock options are initially granted, and for a period of time after that, the real cash cost is generally not going to be clear but must be accounted for some way to get the economics as right as is possible. So, while it's true that estimating these stock related expenses isn't easy to do upfront, that's hardly a reason to assume they don't exist at all then look past them altogether. (To me, it's still rather amazing that many choose to, when it comes to valuation, ignore what ends up being very costly for long-term shareholders.) When reasonable adjustments are made for these expenses, eBay's free cash flow is meaningfully less than it might first appear to be (though it is still impressive). Keep in mind that, even if share count drops due to a buyback, yet insufficiently compared to the cash used, an adjustment to free cash flow still needs to be made for the cash expended in excess of what should have been needed -- at reasonable prices per share compared to intrinsic value per share -- to lower the share count. In any case, ignoring these costs makes little sense. Naturally, my way of valuing the company takes these real expenses fully into consideration. Put another way, the price to free cash flow (or adjusted P/E) becomes quite a bit higher when the cost of equity compensation is taken into account. In addition, a company that relies on lots of equity compensation -- since the ultimate future impact is difficult at best to estimate -- necessarily leads me to require a larger margin of safety and, all else equal, the preference for a smaller position size. Now, eBay certainly isn't alone in this regard. For many tech and tech related businesses (of more or less quality), these costs must be carefully considered in order to understand the core business economics and to estimate value. As it turns out, there's a number of earnings estimates that do not take into account such costs.
*** I am referring to paying a price now where, let's say 10-15 years down the road, what the business produces -- it's intrinsic worth (incl. dividends, if applicable) on a per share basis -- leads to a good result. I am not referring to near-term or even intermediate-term price action. Once something is barely anchored by value and, instead, maybe is driven more or less by difficult to nail down but exciting future possibilities, just about anything goes. Stocks that sell at apparent speculative prices can easily become 2x, 3x, 4x, and even much more than that speculative amount. Now, I'm not a big believer that speculative activities in the market will end up being particularly lucrative for most, but no doubt some know how to do such things successfully. Buffett recently wrote about, among many other things, his own skepticism about speculating successfully on a sustained basis. From his latest letter: "If you...focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so."
Also, much like today's highest flyers was a stock price that reflected that enthusiasm.
The stock was selling, give or take, for roughly 100x earnings in 2004.
Now, the company has run into it's fair share of challenges -- as even the very best business do -- while management was both smart and fortunate to buy PayPal when they did at a price that, at least with the benefit of hindsight, looks rather cheap. Still, even if it has been a bumpy ride at times, nearly ten years later the company has delivered some fine results.*
2004 2013
Revenue $ 3.3 billion $ 16.0 billion
Net Income $ .78 billion $ 2.9 billion
I think it is reasonable to say that financial performance qualifies as not too bad at all. Though what matters, naturally, is what those numbers indicate, if anything, about the company's future prospects and trajectory.
It's worth noting that the revenue and net income increases have been backed by solid free cash flow**. The company has, more or less, over that time also maintained a healthy balance sheet. So it's just not hard to argue they've put together more than a pretty solid decade.
So the business did just fine but, in 2004, those who were buying eBay's stock at prevailing prices were assuming the recent positive trajectory would continue for, at the very least, quite a long time.
Buyers of the stock back then were willing to pay a very high multiple of earnings in the hopes those earnings would rise dramatically and, well, very quickly.
(It's been long enough that some might forget eBay was once viewed as a high flyer not unlike some of today's favorites.)
The end result being that, while eBay put together quite a nice decade of business performance, the buyers who paid those prevailing late 2004 prices expecting to get an attractive investment result (in contrast to those who might have been betting on a good speculative outcome) have not been rewarded.
At ~ $ 55 per share now, the stock now sells at a price that's not much different than back in late 2004.
The point being, of course, is it's no fun to own a business that delivers good business results over a decade or so yet delivers an unsatisfactory return to the owners.
(The S&P 500's total return has been nearly a double over that same time frame with none of the business specific risks.)
By the way, I'm only using eBay as an example. There are a number of examples over the past 10-15 years of, to varying degrees, an enterprise with good prospects but a valuation that was unlikely to compensate the investor sufficiently (though the most exceptional surely did reward investors).
Again, even very good businesses run into real difficulties from time to time. There's almost certain to be an ebb and flow and it's unwise as an investor to not expect as much. Sometimes, near-term price action is merely a reflection of perceived prospects based upon recent news not actual changes to intrinsic worth.
That's true in both directions.
Emotions and psychology more generally rule price action in the shorter run; intrinsic values drive prices over the longer run.
There is no doubt some high flyers today that are good businesses with fine prospects. Yet, due to the upfront price that must be paid, the returns are also likely to not compensate the long run owner sufficiently.
Of course, some of these high flyers will perform well; others will end up disappointing. Telling them apart beforehand is much easier said than done (or easier to describe after the fact). In fact, a too high risk of permanent capital loss usually exists in or near the same neighborhood as the potential big winners. A wilder ride, maybe, but the combined net impact of those winners and losers will too often offer a less than impressive overall result.
Back in 2004, alternatives to eBay had not only less difficult to judge prospects (and, yes, less exciting price action), but also were priced in a way that increased the likelihood of a nice investment outcome.
Investment must always be viewed in the context of opportunity costs. It's not whether a business can eventually "grow into its valuation". (A description or justification that's so often associated with the high-flyers.) It's whether something well understood is judged likely to deliver -- considering the specific risks and relative to alternatives -- attractive absolute forward returns. If an investment does end up someday validating an initial seemingly high valuation, it doesn't logically follow that the risk of permanent capital loss compared possible rewards was well managed. Sometimes, for example, the price is so high that just about everything has to go right. So it might be a perfectly good business, but justifying the price paid depends on lots of continued good fortune. Well, in those instances, an extreme valuation will too often offer no protection against permanent capital loss if there's an unforeseen bump or two in the road. The price paid should, as a principle, always protect the investor against such unforeseen and often mostly unforeseeable things.
(Another way to think about this: even if eBay had delivered a positive return over those ten years or so, it still might not be a sufficient return considering risks and alternatives.)
Some of the current highest flyers are selling for what certainly looks like extreme valuations. No doubt a number of these will do great things in terms of business performance over the next decade or longer.
More than a few will also inevitably run into business challenges; some that will get sorted out and, well, some that will not.
In enough cases to matter, I'm guessing that the current dreams that are propping up prices will come no where near being realized.
The most exceptional ones, once again, might actually even exceed what now seem like lofty expectations.
The problem is that it's often not at all easy to predict these long-term outcomes; to reliably foresee which high flyers have sustainable advantages and prospects on a scale that ends up making sense of what, in too many cases, now looks like nonsensical valuations. Speaking generally, putting capital at risk based on an optimistic long-term forecast is usually a fool's errand. This becomes especially unwise when the capital at risk depends on consistently and correctly predicting what the economics of businesses in the most dynamic industries will look like many years down the road. It moves from being unwise to just plain financially dangerous when what's paid upfront depends on the best possible outcomes.
Placing capital at risk that's dependent on consistently correct long-term predictions is folly; developing a robust investment process and based upon sound principles is not. The investor may not be able to control outcomes, but still can increase the likelihood of good results with a sound approach.
(Including the development of what Charlie Munger calls "a latticework of models".)
The approach is under investor control. What ultimately happens is not.
For investors, it's just generally more wise to focus less time and energy on that former "p" and more on the latter two.
Margin of safety is, of course, just one of the many essential investment principles but seems rather appropriate to highlight here. It's a recognition of an investor's limitations -- the inevitable mistakes that get made -- and, to varying degrees depending on the business, an uncertain range of future outcomes for the business itself.***
Now, since those high eBay market prices prevailed back in 2004, many opportunities arose to buy shares of the company at more reasonable valuation levels.
In fact, at least in my view, the company's shares sold several years back at a significant discount to intrinsic value for an extended period.
(Though, at or near current prices, to me the shares are very far from being cheap.)
This happened, at least in part, when eBay's perceived prospects changed in the minds of apparently rather impatient market participants (with an assist from the financial crisis). Now, the company did have to transition through some very real difficulties (again, this is almost inevitable from time to time), but its sound core business economics remained mostly intact even if growth, for a time, became subdued. So the very fast growth that some like to pay a premium for wasn't there but, crucially, they continued to produce lots of free cash flow at a high return. They've had a fine business throughout -- even if with real difficulties -- but the price of admission changed dramatically. It's been essentially the same business, but what makes sense to buy at one price makes no sense at another. Business prospects can't be viewed in a vacuum; the price paid dictates risk and reward.
Durable high return on capital in the long run trumps modest growth especially if the right price is paid in the first place.
Of course, the investor who bought eBay's shares when cheap and hung in there had to endure, over several years, many very real unresolved business challenges and the inevitable lousy headlines that followed. Nothing like hearing and reading how stupid it is to own a particular stock day after day to test conviction.
(BTW - possessing a high level of unwarranted conviction is obviously never a good thing. Stubbornness combined with confirmation bias is a great way to lose a lot of money.)
So, beyond buying shares at a plain discount to intrinsic value, owning eBay's shares several years back required lots of patience in combination with the ability to ignore the noise and terrible price action. Attractive discounts don't usually exist when the headlines are rosy and future prospects are clear.
(Though sometimes a business has problems that are just plain intractable. Correctly separating, beforehand, the sound business with real but fixable problems from those that are truly broken is easier said than done.)
Today, eBay's stock appears rather expensive -- though not at all as much so as some of the current highest flyers, or the company's own extreme valuation a little less than a decade ago -- but their overall business prospects continue to appear not too bad at all.
In other words, intrinsic value would seem likely to increase just fine over time. It's just that compensation isn't likely to be sufficient considering risks and alternatives. It's just that margin of safety isn't, at least for me, as plain to see.
The fact is, near the current valuation, risk/reward is nothing like what it was several years back. That's a simple matter of the price one now has to pay, not the prospects for eBay itself.
Still, I won't be surprised at all if eBay does quite well as a business over the long-term. If so, valuation will follow.
In any case, this is not a view of what the shares might do in the next days, weeks, or even several years. Trying to figure out that sort of thing is mostly a waste of time and energy.
"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch
Having said that, my preference is to generally not sell shares of a somewhat overvalued but otherwise good business -- one that was bought at a nice discount in the first place -- unless the opportunity costs are high; my preference is for increases to per share intrinsic value to be the primary driver of returns. To me, attempting to generate satisfactory or better outcomes via the clever trading into and out of various marketable securities is folly. In fact, I'd argue that just about the opposite behavior is what generally gets results, especially when done in a thoughtful and persistent manner.
That usually means, in order for selling to be warranted, the shares need to be plainly expensive -- selling for a significant premium to intrinsic value -- and/or something else well understood needs to become very mispriced on the low side. At times, an investment that has a substantial margin of safety must be funded by another investment that lacks such a margin of safety. When a switch is warranted, the advantage in terms of risk and reward between the investment alternatives should be very obvious.
(Though, reducing the size of a position as the shares become more fully valued often makes sense to me. I've, in fact, recently done just that with eBay. Where I tend to NOT do this is with shares of my favorite businesses. Well, eBay surely does not fall into that category even if it does possess a number of attractive business characteristics.)
Trading into or out of something because it is merely somewhat mispriced makes little sense. Minimizing moves in a portfolio isn't just about reducing frictional costs, it's about reducing mistakes.
Focusing on the upside of a move but not carefully considering the downside of a move is an easy mistake to make.
Mispricings, on both the high and low side, can occur when recent success or difficulties is used to extrapolate forward what something might be worth. Sometimes what's growing takes a pause. The opposite is also true. Paying a premium price that assumes growth will continue indefinitely is just asking for trouble. The fact is it's nearly impossible to foresee what challenges or opportunities might arise much further down the road. If the price paid depends not on continued good fortune to get an attractive result, there'll be no complaints if prospects turn out to be somewhat, or maybe a whole lot, better.
I'd add that a good investment outcome should never depend on selling at a premium price. Those who need to sell at a premium price to achieve a good outcome make themselves vulnerable to something they have no control over. A modest multiple of, conservatively estimated, future per share normalized earning power -- at least 7-10 years down the road and, ideally, even much longer -- should be all that's required, considering risks and alternatives, for a nice overall investment result.
For most assets, it will not be possible to figure out future earnings power. When that's the case it's best to just move on. That doesn't mean the opportunities never appear on the radar with some patience. When they do appear -- and confidence is both high and warranted -- that patience must to be followed by decisive action.
A sound investment approach, applied consistently over a long period of time, still guarantees nothing but can, at least, increase the likelihood that good things more frequently happen and overall results improve.
It's at least worth mentioning -- as I have before on more than a few occasions -- that there's really no pure technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries; that's precisely what makes them unattractive long-term investments. It's the fact that the range of possible outcomes is often just too wide to get, on a consistent basis, the valuation at least mostly right.
Now, while technology is very important to eBay, it seems not difficult to argue that the company is a very different animal than the most pure of technology businesses.
Adam
Long position in eBay established at very much lower than current market prices. This once larger position (bought years back when eBay was experiencing some difficulties) has been reduced to a smaller position near and above recent prices. Generally speaking, my preference is to absolutely minimize buying/selling but, as eBay's margin of safety has decreased (at least by my math and assumptions which, of course, could prove to be very wrong) the position has been trimmed consistent with how I view risk/reward and current alternatives. Those funds will be redeployed if and when shares of an attractive business becomes cheap enough to buy again. We are, in general, surely a long way from the valuation environment that existed 3-5 years ago.
Related posts:
eBay's Valuation
eBay's Free Cash Flow
Technology Stocks
* Rev. (billions $) 2004-13: 3.3, 4.6, 6.0, 7.7, 8.5, 8.7, 9.2, 11.7, 14.1, 16.0;
Net Inc. (billions $) 2004-13: .78, 1.1, 1.1, .35, 1.8, 2.4, 1.8, 3.2, 2.6, 2.9
** Though I'm not a fan of how expensive eBay's stock-based compensation actually is, though I realize some choose to treat it -- and I'd argue incorrectly -- as a non-cash expense. Well, the specific cash cost might not be easy to estimate upfront but that makes it no less real. One alternative way to roughly, but meaningfully, show the true cash cost of equity compensation plans at eBay (and at a number of other companies) is to add up what's been spent on buybacks over several years then compare it to how the share count has been impacted. In eBay's case lots of cash has been expended on buybacks over the past five years yet there's been no reduction in share count. Well, if the share count isn't reduced much (or, in this instance, not at all), that cash used -- to simply offset equity compensation related dilution -- can no longer be returned to or benefit shareholders. So this is hardly some non-cash expense; it's, instead, a very real cost. Naturally, one could simply choose to consider the GAAP stock-based compensation as a useful, if imperfect, way to estimate this cost in the first place. Still, there is certainly no way to do more than very roughly estimate this cost going forward. The above alternative approach is simply one way to help reveal that the equity compensation eventually ends up having a very real economic impact. When stock options are initially granted, and for a period of time after that, the real cash cost is generally not going to be clear but must be accounted for some way to get the economics as right as is possible. So, while it's true that estimating these stock related expenses isn't easy to do upfront, that's hardly a reason to assume they don't exist at all then look past them altogether. (To me, it's still rather amazing that many choose to, when it comes to valuation, ignore what ends up being very costly for long-term shareholders.) When reasonable adjustments are made for these expenses, eBay's free cash flow is meaningfully less than it might first appear to be (though it is still impressive). Keep in mind that, even if share count drops due to a buyback, yet insufficiently compared to the cash used, an adjustment to free cash flow still needs to be made for the cash expended in excess of what should have been needed -- at reasonable prices per share compared to intrinsic value per share -- to lower the share count. In any case, ignoring these costs makes little sense. Naturally, my way of valuing the company takes these real expenses fully into consideration. Put another way, the price to free cash flow (or adjusted P/E) becomes quite a bit higher when the cost of equity compensation is taken into account. In addition, a company that relies on lots of equity compensation -- since the ultimate future impact is difficult at best to estimate -- necessarily leads me to require a larger margin of safety and, all else equal, the preference for a smaller position size. Now, eBay certainly isn't alone in this regard. For many tech and tech related businesses (of more or less quality), these costs must be carefully considered in order to understand the core business economics and to estimate value. As it turns out, there's a number of earnings estimates that do not take into account such costs.
*** I am referring to paying a price now where, let's say 10-15 years down the road, what the business produces -- it's intrinsic worth (incl. dividends, if applicable) on a per share basis -- leads to a good result. I am not referring to near-term or even intermediate-term price action. Once something is barely anchored by value and, instead, maybe is driven more or less by difficult to nail down but exciting future possibilities, just about anything goes. Stocks that sell at apparent speculative prices can easily become 2x, 3x, 4x, and even much more than that speculative amount. Now, I'm not a big believer that speculative activities in the market will end up being particularly lucrative for most, but no doubt some know how to do such things successfully. Buffett recently wrote about, among many other things, his own skepticism about speculating successfully on a sustained basis. From his latest letter: "If you...focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so."
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