I was reminded today about tax loss selling this year. I am still getting the hang of this investing thing. A good rule of thumb - at the same time you are buying Christmas presents, buy some stocks that have lost value during the year. The year's poor performing stocks are likely to be undervalued in December, because investors sell them to "cancel out" their capital gains to avoid paying taxes.
This year the tax loss opportunity is greater than usual, because the market has performed well and because the capital gains tax rate is higher than it has been in many years, so investors have more tax liability that they want to get rid of by taking losses.
Friday, December 6, 2013
Tuesday, November 5, 2013
One trade with good results, one trade with bad results
Here are two more trades I made in the last month, with varying results:
1. Sold Almost Family last month at $19.50 (wrong call, as today it went up to $21.9)
Why? I sold after the CMS released its proposed rebasing for the next three years - it is cutting AFAM's and other home health provider's revenues by 4% per year, or 13% total. In addition, a law passed in September required that home-health aides earn minimum wage when they work overtime or spend many hours at the home of a patient. This will bring revenues down, and may bring costs up, making it very hard for AFAM to maintain its profitability. In addition, analyst Whit Mayo, who is thorough and has been correct on a number of calls regarding home health companies in the past, has an unfavorable view of AFAM's future. AFAM is trading at about 20x earnings. This was a difficult sale because I have owned AFAM for more than three years, and I trust their management and think they are doing an excellent job with the company. But the macroeconomic factors in the industry will make it hard for them to earn money for their shareholders. Today, the stock jumped 12% because AFAM agreed to purchase another home health provider for $75 million, which had $150 million annual revenues. This will bring AFAM's revenues to about $500 million. It will be interesting to see whether management can engineer profits in the tough climate over the next few years. Even though I sold, I would not wager money against them by shorting the stock.
2. Purchased UNTD on Nov. 1 at $12.91; sold today at $17.28.
Why? UNTD was an amalgamation of companies, including NetZero and Juno, internet service providers, classmates.com, and a phone-order floral company. On November 1, the company spun off the floral company, which became FTD. UNTD was left with the internet companies, classmates.com, and various other holdings. Before the spinoff, the company's market cap was about $800 million. The balance sheet had $120 million or so of cash and another $250 million or so of other equity. FTD accounted for about 70% of the company's revenues and 50% of operating profits, with the remainder accounted by UNTD ex-FTD. The company's revenues are shrinking, but FTD is growing. The equity, cash, and debt on the balance sheets after the spinoff would be (approximately) split between FTD and UNTD.
Immediately after the spin-off, UNTD went through a 7:1 reverse stock split, meaning 7 shares of UNTD became 1 share of UNTD, to prop up the stock price. Before the spinoff, there were 92 million shares of UNTD, and now there are about 13 million. Immediately after the merger, UNTD traded at $150 million market cap, while FTD traded at about $650 million.
That UNTD could have half of the cash and assets and half of the operating profits of the pre-spinoff company, and trade at less than 1/4 of the price of the other half (FTD) seemed a bargain to me. So I bought at just under $13. I sold today, because the company began to approach its fair value. I pegged the true value at about $20 per share, but sold early because I don't know enough about the management and the business is shrinking, so I didn't want to tie my money up there for a long time just trying to get another 15% out of the stock.
Lesson: One thing I am learning as I get deeper into trading is that you have to do a significant amount of research to find an irrational market price. Often, the reason a company's price-to-earnings ratio is low is that the company has bleak future prospects. Many people purchase stocks with low p/e ratios and call themselves value investors. But there is no formula or easy way to find an undervalued company, other than lots of research. And knowledge of management is very important in determine a company's future prospects.
1. Sold Almost Family last month at $19.50 (wrong call, as today it went up to $21.9)
Why? I sold after the CMS released its proposed rebasing for the next three years - it is cutting AFAM's and other home health provider's revenues by 4% per year, or 13% total. In addition, a law passed in September required that home-health aides earn minimum wage when they work overtime or spend many hours at the home of a patient. This will bring revenues down, and may bring costs up, making it very hard for AFAM to maintain its profitability. In addition, analyst Whit Mayo, who is thorough and has been correct on a number of calls regarding home health companies in the past, has an unfavorable view of AFAM's future. AFAM is trading at about 20x earnings. This was a difficult sale because I have owned AFAM for more than three years, and I trust their management and think they are doing an excellent job with the company. But the macroeconomic factors in the industry will make it hard for them to earn money for their shareholders. Today, the stock jumped 12% because AFAM agreed to purchase another home health provider for $75 million, which had $150 million annual revenues. This will bring AFAM's revenues to about $500 million. It will be interesting to see whether management can engineer profits in the tough climate over the next few years. Even though I sold, I would not wager money against them by shorting the stock.
2. Purchased UNTD on Nov. 1 at $12.91; sold today at $17.28.
Why? UNTD was an amalgamation of companies, including NetZero and Juno, internet service providers, classmates.com, and a phone-order floral company. On November 1, the company spun off the floral company, which became FTD. UNTD was left with the internet companies, classmates.com, and various other holdings. Before the spinoff, the company's market cap was about $800 million. The balance sheet had $120 million or so of cash and another $250 million or so of other equity. FTD accounted for about 70% of the company's revenues and 50% of operating profits, with the remainder accounted by UNTD ex-FTD. The company's revenues are shrinking, but FTD is growing. The equity, cash, and debt on the balance sheets after the spinoff would be (approximately) split between FTD and UNTD.
Immediately after the spin-off, UNTD went through a 7:1 reverse stock split, meaning 7 shares of UNTD became 1 share of UNTD, to prop up the stock price. Before the spinoff, there were 92 million shares of UNTD, and now there are about 13 million. Immediately after the merger, UNTD traded at $150 million market cap, while FTD traded at about $650 million.
That UNTD could have half of the cash and assets and half of the operating profits of the pre-spinoff company, and trade at less than 1/4 of the price of the other half (FTD) seemed a bargain to me. So I bought at just under $13. I sold today, because the company began to approach its fair value. I pegged the true value at about $20 per share, but sold early because I don't know enough about the management and the business is shrinking, so I didn't want to tie my money up there for a long time just trying to get another 15% out of the stock.
Lesson: One thing I am learning as I get deeper into trading is that you have to do a significant amount of research to find an irrational market price. Often, the reason a company's price-to-earnings ratio is low is that the company has bleak future prospects. Many people purchase stocks with low p/e ratios and call themselves value investors. But there is no formula or easy way to find an undervalued company, other than lots of research. And knowledge of management is very important in determine a company's future prospects.
Wednesday, September 25, 2013
New Trades
Here is an overview of recent trades:
Sold BlackBerry (BBRY) last month at 10.50-11. This was a money-losing investment. I sold soon after the news that the company was putting itself up for sale. I think management has been unsuccessful in implementing its strategy, and my investing thesis was incorrect. More on my thoughts on why this was an unsuccessful investment below.
Sold Nokia (NOK) a couple weeks ago at $6.40. I sold because the capitalization increased about $9 billion after Microsoft purchased all phone assets for $7 billion. In my opinion, the phone assets were worth more than -$2 billion. Therefore, the investing thesis about undervalued assets and operations had mostly played out, based on the catalyst of the Microsoft deal.
Sold Yahoo! (YHOO) a few months ago at $24-25. This sale may have been a little premature. But it was a nice gainer. This was another undervalued asset play. The catalyst that allowed the assets to realize more value was Marissa Mayer's initial success as CEO. I sold because I felt that the assets were no longer undervalued, and she seemed to be spending the cash somewhat rapidly on startup purchases.
Purchased Fiat (FIATY) at $7 a couple months ago (approx $8 billion market cap). My purchase was based on my belief that Sergio Marchionne is a smart business man, and he can bring Chrysler and Fiat together and make both profitable companies. I also believe the assets are undervalued (including 60% share of Chrysler). Fiat uses an interesting method of measuring liabilities on its balance sheet in quarterly reports. I think they emphasizes liabilities more than typical in an American auto company, and this could cause some analysts to undervalue the company. I think that Fiat is well positioned to reach profitability once the European market turns around, hopefully late next year. Marchionne also has an incentive to downplay the value of Chrysler and downplay the value of Fiat because he is still trying to negotiate a deal with the United Auto Workers for purchase of 25% of Chrysler. I think the merger of those two companies could help the stock price increase.
Purchased Google (GOOG) at $900 - $300 billion market cap. Google is trading at 25x earnings. They have a near-monopoly in two very high-profit industries (search and online video) and have many other growing businesses (mobile phone operating system, mapping, web browser, laptop operating system) that are not yet profitable but may be in the future. Additionally, Google is working on new projects that may become profitable in the future (self-driving cars, glass, laying fiber cables across America). I think this is a growth stock, a good, safe business, and is either fairly valued or a little undervalued at 25x earnings.
Purchased Telephone and Data Systems (TDS) at $28 (about $3.1 billion market cap). This is because I think TDS's assets are undervalued. TDS owns about 83% of U.S. Cellular (USM). U.S. Cellular has a market cap of about $3.7 billion. Just accounting for U.S. Cellular, TDS should be trading at $28. In addition, TDS has a profitable business of its own in the wireless, long distance, and cable business. That business is worth about $500 million by my estimation. Finally, TDS has $600 million of excess cash based on U.S. Cellular dividends and business profits. Therefore it appears that TDS in undervalued. U.S. Cellular's value seems very stable, as it owns lots of 700 mhz spectrum. This spectrum is the lowest frequency spectrum that has the ability to penetrate buildings. Spectrum has been at a premium recently, and U.S. Cellular has agreed to two separate transactions where it sold spectrum to larger wireless providers for hundreds of millions of dollars. Some of the spectrum it owns will be devalued temporarily when an upcoming 2400 mhz auction takes place, adding Advanced Wireless Services to the mix. But in the long run, wireless companies are going to need as much spectrum as they can get to keep up with the growing use of 4G cell towers to access the internet. I believe U.S. Cellular should be able to realize the full value of its assets over time.
A note on undervalued asset purchases: Based on my experience so far, my investing philosophy has changed from just investing in undervalued assets, to investing in assets that are slightly undervalued with solid business models and strong leadership to back them up. In one of his early shareholder letters, Warren Buffett cautioned against investing in a cheap business with bad management, because by the time the business is able to realize the value of its assets, the management may have eroded a lot of the excess value through bad decisions. I believe that was my error with BlackBerry. In addition to purchasing cheap companies, I am also taking some time to familiarize myself with the quality of the underlying business and the management of the company, and I can avoid similar mistakes such as the BBRY investment in the future.
What to look for in a company:
Undervalued Company
Solid Operations
Good Management
Upcoming catalyst to bring company to full value
Companies I like but did not invest in:
T-Mobile (TMUS). I believe they have hit a winner in the uncarrier strategy. Their pricing is extremely competitive, and they appear to have good leadership. AT&T and Verizon will be unable to lower prices to match T-Mobile because that will cause them to lose a big chunk of their profits, so T-Mobile has a sustainable niche. The reason I did not invest is that Deutsche Telekom (DTEGY) has a 75% equity share and $11 billion in debt in T-Mobile. I think DTEGY would be a smarter investment than TMUS. But they have other European assets that I did not have time to look into.
TomTom (TMOAY). TomTom has a decent business trading at just over $1 billion market cap. It owns one of the three remaining mapping services along with Google and Nokia. It purchased that mapping service (Tele Atlas) in 2007 for about $4 billion, or 3x its current market cap. Nokia purchased its mapping software around the same time for $8 billion. These mapping systems have lost a lot of value because Google developed its own maps that it does not charge much to license. Additionally, there is now Open Street Map which is free. Still, TomTom's mapping software is used in many mobile phone maps including in the iPhone. Apple is moving away from using Google services because Google makes Android OS, its competitor. We may see an increase in the value of these mapping services in the next few years, as existing licensing deals expire. Garmins' licensing deal with NAVTEQ expires in 2015, with an option to renew through 2019. I will research what other companies may have upcoming license expirations that could operate as a catalyst for TomTom.
Sold BlackBerry (BBRY) last month at 10.50-11. This was a money-losing investment. I sold soon after the news that the company was putting itself up for sale. I think management has been unsuccessful in implementing its strategy, and my investing thesis was incorrect. More on my thoughts on why this was an unsuccessful investment below.
Sold Nokia (NOK) a couple weeks ago at $6.40. I sold because the capitalization increased about $9 billion after Microsoft purchased all phone assets for $7 billion. In my opinion, the phone assets were worth more than -$2 billion. Therefore, the investing thesis about undervalued assets and operations had mostly played out, based on the catalyst of the Microsoft deal.
Sold Yahoo! (YHOO) a few months ago at $24-25. This sale may have been a little premature. But it was a nice gainer. This was another undervalued asset play. The catalyst that allowed the assets to realize more value was Marissa Mayer's initial success as CEO. I sold because I felt that the assets were no longer undervalued, and she seemed to be spending the cash somewhat rapidly on startup purchases.
Purchased Fiat (FIATY) at $7 a couple months ago (approx $8 billion market cap). My purchase was based on my belief that Sergio Marchionne is a smart business man, and he can bring Chrysler and Fiat together and make both profitable companies. I also believe the assets are undervalued (including 60% share of Chrysler). Fiat uses an interesting method of measuring liabilities on its balance sheet in quarterly reports. I think they emphasizes liabilities more than typical in an American auto company, and this could cause some analysts to undervalue the company. I think that Fiat is well positioned to reach profitability once the European market turns around, hopefully late next year. Marchionne also has an incentive to downplay the value of Chrysler and downplay the value of Fiat because he is still trying to negotiate a deal with the United Auto Workers for purchase of 25% of Chrysler. I think the merger of those two companies could help the stock price increase.
Purchased Google (GOOG) at $900 - $300 billion market cap. Google is trading at 25x earnings. They have a near-monopoly in two very high-profit industries (search and online video) and have many other growing businesses (mobile phone operating system, mapping, web browser, laptop operating system) that are not yet profitable but may be in the future. Additionally, Google is working on new projects that may become profitable in the future (self-driving cars, glass, laying fiber cables across America). I think this is a growth stock, a good, safe business, and is either fairly valued or a little undervalued at 25x earnings.
Purchased Telephone and Data Systems (TDS) at $28 (about $3.1 billion market cap). This is because I think TDS's assets are undervalued. TDS owns about 83% of U.S. Cellular (USM). U.S. Cellular has a market cap of about $3.7 billion. Just accounting for U.S. Cellular, TDS should be trading at $28. In addition, TDS has a profitable business of its own in the wireless, long distance, and cable business. That business is worth about $500 million by my estimation. Finally, TDS has $600 million of excess cash based on U.S. Cellular dividends and business profits. Therefore it appears that TDS in undervalued. U.S. Cellular's value seems very stable, as it owns lots of 700 mhz spectrum. This spectrum is the lowest frequency spectrum that has the ability to penetrate buildings. Spectrum has been at a premium recently, and U.S. Cellular has agreed to two separate transactions where it sold spectrum to larger wireless providers for hundreds of millions of dollars. Some of the spectrum it owns will be devalued temporarily when an upcoming 2400 mhz auction takes place, adding Advanced Wireless Services to the mix. But in the long run, wireless companies are going to need as much spectrum as they can get to keep up with the growing use of 4G cell towers to access the internet. I believe U.S. Cellular should be able to realize the full value of its assets over time.
A note on undervalued asset purchases: Based on my experience so far, my investing philosophy has changed from just investing in undervalued assets, to investing in assets that are slightly undervalued with solid business models and strong leadership to back them up. In one of his early shareholder letters, Warren Buffett cautioned against investing in a cheap business with bad management, because by the time the business is able to realize the value of its assets, the management may have eroded a lot of the excess value through bad decisions. I believe that was my error with BlackBerry. In addition to purchasing cheap companies, I am also taking some time to familiarize myself with the quality of the underlying business and the management of the company, and I can avoid similar mistakes such as the BBRY investment in the future.
What to look for in a company:
Undervalued Company
Solid Operations
Good Management
Upcoming catalyst to bring company to full value
Companies I like but did not invest in:
T-Mobile (TMUS). I believe they have hit a winner in the uncarrier strategy. Their pricing is extremely competitive, and they appear to have good leadership. AT&T and Verizon will be unable to lower prices to match T-Mobile because that will cause them to lose a big chunk of their profits, so T-Mobile has a sustainable niche. The reason I did not invest is that Deutsche Telekom (DTEGY) has a 75% equity share and $11 billion in debt in T-Mobile. I think DTEGY would be a smarter investment than TMUS. But they have other European assets that I did not have time to look into.
TomTom (TMOAY). TomTom has a decent business trading at just over $1 billion market cap. It owns one of the three remaining mapping services along with Google and Nokia. It purchased that mapping service (Tele Atlas) in 2007 for about $4 billion, or 3x its current market cap. Nokia purchased its mapping software around the same time for $8 billion. These mapping systems have lost a lot of value because Google developed its own maps that it does not charge much to license. Additionally, there is now Open Street Map which is free. Still, TomTom's mapping software is used in many mobile phone maps including in the iPhone. Apple is moving away from using Google services because Google makes Android OS, its competitor. We may see an increase in the value of these mapping services in the next few years, as existing licensing deals expire. Garmins' licensing deal with NAVTEQ expires in 2015, with an option to renew through 2019. I will research what other companies may have upcoming license expirations that could operate as a catalyst for TomTom.
Wednesday, September 11, 2013
Short-term market inefficiency
I noticed something interesting about a week ago. At 1:51 PM on Sept 2 or Sept 3, a Schedule 13-D was filed by Perry corp indicating it had taken an additional 3 million share position in JC Penney. Just after 2:00 PM, JC Penney jumped about 40 cents, or 3%. It is interesting that, even with the high-frequency trading that is rampant today, it took about 10 minutes for the market to react to that public information.
Wednesday, July 17, 2013
Liquidity, Scrutiny, and Market Inefficiency
I am a big fan of Michael Burry, and just re-discovered one of his overlooked investing philosophies. It can be summed up with these three statements:
1. I prefer to look at specific investments within the inefficient parts of the market.
2. The bulk of opportunities remain in undervalued, smaller, more illiquid situations that often represent average or slightly above-average businesses
3. It is likely, however, that the investors in the habit of overturning the most stones will find the most success.
Found here http://michaelburryblog.blogspot.com/2012/06/michael-burry-quotes.html
He makes a really good point about inefficient markets and liquidity. The more a stock is scrutinized, the smaller chance there will be that the stock price is far away from the stock's intrinsic value. If you have hedge funds, analysts, and everyone in between analyzing the profit potential of Apple, or Google, it is possible that you can make fantastic profits if you have good timing, but it is more likely that you will perform about even with the market. That is not to say you can never profit in these stocks - Warren Buffett has done very well buying "brand name" stocks such as Coca Cola, American Express, and IBM. But there is more incongruity - and therefore profit potential - in overlooked, small cap, illiquid stocks. Of course there is more risk there, but if you do your research you can minimize your risk.
I am going to try to focus some attention on review of smaller stocks to see if I can improve portfolio performance. Here is one example: IGO, Inc. (IGOI) makes chargers for cell phones and laptops. The company is unprofitable, and I would ordinarily not consider it a good investment. I have followed it for about four years. Recently, a company stated that it will issue a tender offer with Board approval for 44% of IGO shares at $3.95. Before the announcement, the stock was at about $2.70, but it soon jumped to about $3.35. Still 60 cents short of the tender price. Why the difference? First, I think that people are concerned that the tender will be oversubscribed, and investors will only get to cash in a portion of their shares. But more importantly, I think that large-scale investors are scared that the stock is too illiquid (only market cap of $10 million). No one is bothering to buy a lot because they are afraid they won't be able to get out. I recently bought some at $3.45, and I am hoping that the stock will rise to at least $3.85 before the tender takes place (about 12% gain over a month). If it does, I will sell the shares. If it does not, I will tender. This seems to be an example of a more illiquid stock with some profit potential. We will see if it plays out that way or if I am mistaken.
1. I prefer to look at specific investments within the inefficient parts of the market.
2. The bulk of opportunities remain in undervalued, smaller, more illiquid situations that often represent average or slightly above-average businesses
3. It is likely, however, that the investors in the habit of overturning the most stones will find the most success.
Found here http://michaelburryblog.blogspot.com/2012/06/michael-burry-quotes.html
He makes a really good point about inefficient markets and liquidity. The more a stock is scrutinized, the smaller chance there will be that the stock price is far away from the stock's intrinsic value. If you have hedge funds, analysts, and everyone in between analyzing the profit potential of Apple, or Google, it is possible that you can make fantastic profits if you have good timing, but it is more likely that you will perform about even with the market. That is not to say you can never profit in these stocks - Warren Buffett has done very well buying "brand name" stocks such as Coca Cola, American Express, and IBM. But there is more incongruity - and therefore profit potential - in overlooked, small cap, illiquid stocks. Of course there is more risk there, but if you do your research you can minimize your risk.
I am going to try to focus some attention on review of smaller stocks to see if I can improve portfolio performance. Here is one example: IGO, Inc. (IGOI) makes chargers for cell phones and laptops. The company is unprofitable, and I would ordinarily not consider it a good investment. I have followed it for about four years. Recently, a company stated that it will issue a tender offer with Board approval for 44% of IGO shares at $3.95. Before the announcement, the stock was at about $2.70, but it soon jumped to about $3.35. Still 60 cents short of the tender price. Why the difference? First, I think that people are concerned that the tender will be oversubscribed, and investors will only get to cash in a portion of their shares. But more importantly, I think that large-scale investors are scared that the stock is too illiquid (only market cap of $10 million). No one is bothering to buy a lot because they are afraid they won't be able to get out. I recently bought some at $3.45, and I am hoping that the stock will rise to at least $3.85 before the tender takes place (about 12% gain over a month). If it does, I will sell the shares. If it does not, I will tender. This seems to be an example of a more illiquid stock with some profit potential. We will see if it plays out that way or if I am mistaken.
Three-year review
I think enough time has lapsed for a portfolio review.
Neutral news:
Over the last three-and-a-half years, my stock picks have been about average with the market.
Good news:
Over the last year-and-a-half, I have outperformed the market. I think a portion of that is luck, but it is encouraging.
Lessons:
The market is NOT efficient. In 2009, believing the efficient market hypothesis I learned in college, I picked a variety of small-cap stocks with minimal research. Those stocks did not perform as well as the market. Starting in mid-2011, I became more careful with the stocks I invested in, and performance has increased.
The real test will be the next market downturn. It's relatively easy to perform well in a good market by simply buying stocks that are more volatile and getting lucky. If you can make money in a good market and weather a downturn with minimal losses, that will show that there's a good chance you have some skill.
Conclusion:
Some room for optimism, but must get better.
Neutral news:
Over the last three-and-a-half years, my stock picks have been about average with the market.
Good news:
Over the last year-and-a-half, I have outperformed the market. I think a portion of that is luck, but it is encouraging.
Lessons:
The market is NOT efficient. In 2009, believing the efficient market hypothesis I learned in college, I picked a variety of small-cap stocks with minimal research. Those stocks did not perform as well as the market. Starting in mid-2011, I became more careful with the stocks I invested in, and performance has increased.
The real test will be the next market downturn. It's relatively easy to perform well in a good market by simply buying stocks that are more volatile and getting lucky. If you can make money in a good market and weather a downturn with minimal losses, that will show that there's a good chance you have some skill.
Conclusion:
Some room for optimism, but must get better.
Wednesday, June 26, 2013
First biography of Kentucky's John Floyd anticipated for release in early 2014
I would like to take a quick detour to discuss some exciting news out of Louisville, Ky. This is not the usual subject of this site, but I live in Louisville and I have been following this story for a while, and I am honored to break the news:
First biography of Kentucky's John Floyd anticipated for release in early 2014
For nearly four years the author of the first comprehensive biography of Kentucky's famous John Floyd has worked to research every aspect of the surveyor and Indian fighter's unduly short life. Although Floyd's name is well known by street names and landmarks throughout the city of Louisville, Kentucky, few know the story of the adventurous man behind the name. Taylor K. Gerlach's voluminous account of Floyd's role in the settlement and protection of the Kentucky region, including the Falls of the Ohio, is anticipated for release in early 2014.
Be on the lookout for this thorough piece of historical scholarship within the next year.
First biography of Kentucky's John Floyd anticipated for release in early 2014
For nearly four years the author of the first comprehensive biography of Kentucky's famous John Floyd has worked to research every aspect of the surveyor and Indian fighter's unduly short life. Although Floyd's name is well known by street names and landmarks throughout the city of Louisville, Kentucky, few know the story of the adventurous man behind the name. Taylor K. Gerlach's voluminous account of Floyd's role in the settlement and protection of the Kentucky region, including the Falls of the Ohio, is anticipated for release in early 2014.
Be on the lookout for this thorough piece of historical scholarship within the next year.
Sunday, January 13, 2013
Discount rates
Let me make a quick note about the systematic and perpetual misuse of discount rates by many in the financial field, including many so-called "experts".
Often you will see analysts discounting a company's equity earnings at 10-12%, but their bonds are discounted at 4-5%. The reason given for this discrepancy is that debt has a lower "cost of capital" than equity.
Well, that's not always true.
Cost of capital is synonymous with the discount rate used to find the present value of future cash flows. Every set of future cash flows should have a unique discount rate based on the risks of those cash flows. There are two risks that must be considered in every discount rate: 1) The risk that inflation will make the real value of money decrease by the time you are paid; and 2) The risk that you will not be paid as promised. These risks should be evaluated the same way whether your payments come from debt or equity. (The structures and order of payment of debt and equity is, of course, different because debtholders get paid before equityholders. But as you will see below this difference is misunderstood in a lot of cases.) Most people do not understand the difference between debt and equity financing, and place an artificial premium on equity that should not exist.
Here is an example: Company A has existed for 100 years. It makes mirrors. It sells to a variety of retailers with long-term contracts in place to supply mirrors for the 5 years, that are automatically renewed every 5 years. The prices are set based on inflation, and Company A's profit margin is relatively constant, but varies slightly with market ups and downs. Its Beta is 1.0. In 2013 Company A will make $100,000. Let's give two different balance sheets for Company A:
Balance Sheet 1:
Assets: $1,000,000
Liabilities: $0
Equity: $1,000,000
Balance Sheet 2:
Assets: $1,000,000
Liabilities (bonds): $1,000,000
Equity: $0
Here is how an average financial analyst would value Company A with balance sheet 1:
"OK, we've got earnings of $100,000 in year 1 and growing at 3% thereafter. Company A's beta is 1.0, pretty average. Let's discount them at 12% for equity and subtract the growth rate of 3% and you get an enterprise value of $100,000/.09 = $1,111,111." (note that this analyst forgot to add back the realizable portion of book value, as often happens).
Here is how the same analyst would value Company A's bonds on balance sheet 2:
"OK, the 10-year T-bill rate is about 1.9% right now, the Company seems to have pretty stable earnings, corporate bond rates are low. The balance sheet is not ideal. Let's give Company A a risk premium of 3-4% for its bonds, I think the yield on these guys should be about 5%."
Company A then sells its $1,000,000 bonds with a 5% coupon rate, paying $50,000 per year in interest. Now the same analyst values the stock of Company A:
"Well, we've got earnings of $100,000 in year 1 growing 3% thereafter. Subtract $50,000 per year in debt service gives you $50,000 in earnings per year after debt payment. Company A's beta is 1.0, pretty average. Let's discount its earnings at 12% for equity and subtract the growth of 3% (some would say 6% here!) and you get a value of $555,555 (or $833,333!)."
So the same company, with balance sheet 2, created 50% more value for itself. That shows the error of the artificial risk premium for equity. In reality, the equity in balance sheet 1 has nearly the same risk profile as the debt in balance sheet 2. If the company makes money, the equity holders under balance sheet 1 will get paid just like the debt holders in balance sheet 2 will. But the equity holders in (1) will get paid a lot more because of this artificial premium on equity that should not exist. (There are many other details that can affect equity payments such as the company's ability to dilute equity or pay higher salaries to employees and executives, or its option to pay dividends. But if the company's management has integrity these risks should not be too great.) The other benefit of the equity holders is that they get to take advantage of any potential future growth in corporate earnings, while the bond holders do not. The point is that the equity under balance sheet 1 is significantly undervalued.
"No," you say. "That can't be! These analysts are well-trained. They know what they are doing. This is just an example you made up. This would never happen in the real world!"
It happens often. Take a look at Corning (GLW), one example I know off the top of my head because I have some Corning stock. I am sure that in this time of low corporate bond rates there are hundreds of examples just like Corning's.
Corning sells specialty glass for TVs, smartphones, science beakers, and other uses. It consistently earns money every quarter. It has strong profit margins. It has about $20 billion of equity on its balance sheet with lots of cash. Its management acts in the best interest of shareholders, does not waste money, and regularly pays a dividend. Corning has a few series of bonds on the market that mature at various times from now until 2021. The yield on these bonds is currently about 2.5%. That's what you'd make if you invested in them and everything went according to plan. Go here and search for GLW to verify: http://cxa.gtm.idmanagedsolutions.com/finra/BondCenter/Default.aspx
What about the equity? Oh, it's trading at just under 10x earnings. A discount rate of anywhere from 8-14% depending on how much you think earnings will shrink or grow. Yet recently Goldman Sachs of all banks downgraded Corning common stock: http://www.dividend.com/news/2013/goldman-sachs-downgrades-corning-glw/
So there you have it. Discount rate misuse continues. Fortunately this blog is not at all influential in the financial community, so hopefully I can profit off of the misanalysis of cash flows and discount rates without the market being any wiser.
Often you will see analysts discounting a company's equity earnings at 10-12%, but their bonds are discounted at 4-5%. The reason given for this discrepancy is that debt has a lower "cost of capital" than equity.
Well, that's not always true.
Cost of capital is synonymous with the discount rate used to find the present value of future cash flows. Every set of future cash flows should have a unique discount rate based on the risks of those cash flows. There are two risks that must be considered in every discount rate: 1) The risk that inflation will make the real value of money decrease by the time you are paid; and 2) The risk that you will not be paid as promised. These risks should be evaluated the same way whether your payments come from debt or equity. (The structures and order of payment of debt and equity is, of course, different because debtholders get paid before equityholders. But as you will see below this difference is misunderstood in a lot of cases.) Most people do not understand the difference between debt and equity financing, and place an artificial premium on equity that should not exist.
Here is an example: Company A has existed for 100 years. It makes mirrors. It sells to a variety of retailers with long-term contracts in place to supply mirrors for the 5 years, that are automatically renewed every 5 years. The prices are set based on inflation, and Company A's profit margin is relatively constant, but varies slightly with market ups and downs. Its Beta is 1.0. In 2013 Company A will make $100,000. Let's give two different balance sheets for Company A:
Balance Sheet 1:
Assets: $1,000,000
Liabilities: $0
Equity: $1,000,000
Balance Sheet 2:
Assets: $1,000,000
Liabilities (bonds): $1,000,000
Equity: $0
Here is how an average financial analyst would value Company A with balance sheet 1:
"OK, we've got earnings of $100,000 in year 1 and growing at 3% thereafter. Company A's beta is 1.0, pretty average. Let's discount them at 12% for equity and subtract the growth rate of 3% and you get an enterprise value of $100,000/.09 = $1,111,111." (note that this analyst forgot to add back the realizable portion of book value, as often happens).
Here is how the same analyst would value Company A's bonds on balance sheet 2:
"OK, the 10-year T-bill rate is about 1.9% right now, the Company seems to have pretty stable earnings, corporate bond rates are low. The balance sheet is not ideal. Let's give Company A a risk premium of 3-4% for its bonds, I think the yield on these guys should be about 5%."
Company A then sells its $1,000,000 bonds with a 5% coupon rate, paying $50,000 per year in interest. Now the same analyst values the stock of Company A:
"Well, we've got earnings of $100,000 in year 1 growing 3% thereafter. Subtract $50,000 per year in debt service gives you $50,000 in earnings per year after debt payment. Company A's beta is 1.0, pretty average. Let's discount its earnings at 12% for equity and subtract the growth of 3% (some would say 6% here!) and you get a value of $555,555 (or $833,333!)."
So the same company, with balance sheet 2, created 50% more value for itself. That shows the error of the artificial risk premium for equity. In reality, the equity in balance sheet 1 has nearly the same risk profile as the debt in balance sheet 2. If the company makes money, the equity holders under balance sheet 1 will get paid just like the debt holders in balance sheet 2 will. But the equity holders in (1) will get paid a lot more because of this artificial premium on equity that should not exist. (There are many other details that can affect equity payments such as the company's ability to dilute equity or pay higher salaries to employees and executives, or its option to pay dividends. But if the company's management has integrity these risks should not be too great.) The other benefit of the equity holders is that they get to take advantage of any potential future growth in corporate earnings, while the bond holders do not. The point is that the equity under balance sheet 1 is significantly undervalued.
"No," you say. "That can't be! These analysts are well-trained. They know what they are doing. This is just an example you made up. This would never happen in the real world!"
It happens often. Take a look at Corning (GLW), one example I know off the top of my head because I have some Corning stock. I am sure that in this time of low corporate bond rates there are hundreds of examples just like Corning's.
Corning sells specialty glass for TVs, smartphones, science beakers, and other uses. It consistently earns money every quarter. It has strong profit margins. It has about $20 billion of equity on its balance sheet with lots of cash. Its management acts in the best interest of shareholders, does not waste money, and regularly pays a dividend. Corning has a few series of bonds on the market that mature at various times from now until 2021. The yield on these bonds is currently about 2.5%. That's what you'd make if you invested in them and everything went according to plan. Go here and search for GLW to verify: http://cxa.gtm.idmanagedsolutions.com/finra/BondCenter/Default.aspx
What about the equity? Oh, it's trading at just under 10x earnings. A discount rate of anywhere from 8-14% depending on how much you think earnings will shrink or grow. Yet recently Goldman Sachs of all banks downgraded Corning common stock: http://www.dividend.com/news/2013/goldman-sachs-downgrades-corning-glw/
So there you have it. Discount rate misuse continues. Fortunately this blog is not at all influential in the financial community, so hopefully I can profit off of the misanalysis of cash flows and discount rates without the market being any wiser.
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