Nobody is Right All of the Time

To me, the above statement is pretty obvious. Today a reader left an anonymous comment on my latest post about Google (GOOG) that said the following:

“Yeah, GOOG is up some 13% or so, about the same as KFT is up since you bashed it a couple of months ago saying it was not a good buy. …. Trust me, you will actually gain more credibility with your readers if you admit your mistakes.”

I decided to expand on this issue in a separate post, in addition to my answer to the reader.

First, I think the reader’s characterization of the Kraft (KFT) post is a bit unfair (you can read it here: Kraft Shares Still Not Overly Attractive, Even After Altria Spin-Off Selling Pressure). I didn’t “bash” Kraft stock. The shares dropped from $32 to $30 as investors were set to sell the small pieces they received from the Altria (MO) spin-off. Given the drop was likely to be temporary in nature, I decided to take a look and see if the pullback presented a buying opportunity.

I concluded that the stock didn’t appear to have much value even after the $2 drop. It traded at 18 times forward earnings and was only growing in the low to mid single digits. That type of valuation failed to persuade me to suggest readers take a look at it as a potential purchase. In the two months since that article, Kraft stock has made up the two points it lost and had added two more, taking it to the current price of $34 per share.

The reader is correct in pointing out that I did not write another post alerting everyone that Kraft went up four points. And perhaps there are more people out there that would have preferred that I had done that. However, I’m not sure that the conclusion one should reach from that is that I refuse to admit when I am wrong. I can’t think of a time when I tried to deny being wrong. If you read the post about Kraft when it was $30 and now see the stock at $34, you are well aware that it went up. Just because a stock doesn’t interest me, it doesn’t mean it won’t go up.

The reason I didn’t go out of my way to point out the rally in Kraft shares is pretty simple; nothing changed. The stock still trades at 18 times forward earnings. Nothing is fundamentally different at the company and nothing has changed my opinion on the stock. I still don’t think it is a good value, based on valuation and growth prospects, and I would not be surprised if it continues to trail the market.

As far as Google goes, I tend to write more about stocks I recommend than those I don’t. When I recommend stocks on this blog, some people do wind up buying them after reading my views and doing their own due diligence. Since I know that those people are curious about when my opinions change (they email me and ask), I will often write updates when things change. Google shares rallied more than fifty points in a very short amount of time. I thought it was relevant to let people know that I was not selling, despite the quick move, and how much further I thought it could climb.

By no means does this mean I am unwilling to admit mistakes. If I was, there would be little reason for me to run a blog. My opinions are out there for everyone to see, over 400 posts since I started. I have been wrong a lot and every one of those posts is still sitting in the site’s archives. In the last six months alone I thought Amazon (AMZN) was overvalued in the high thirties, Express Scripts (ESRX) was close to fairly valued in the mid eighties, and liked Amgen (AMGN) at 16 times earnings. Amazon has doubled, Express jumped twenty percent, and Amgen is down to 13 times earnings.

I’m pretty sure the vast majority of my readers understand that writing this blog is the last thing I would do if I wanted to hide the track record of my investment opinions. But since not everyone seems to realize that, I figured I would address the issue. If anyone has any suggestions on how to make the blog better, please let me know. I’m always interested to hear what readers have to say.

Full Disclosure: Long Amgen and Google at the time of writing

Despite Harsh Words from Critics, Share Buybacks Remain a Great Way to Boost Earnings and Share Prices

You might know Herb Greenberg, an often quoted columnist for MarketWatch and a frequent guest on CNBC, as someone who focuses on telling the bearish story on the market. Although I’m about to refute one of Herb’s recent blog posts entitled “AutoZone: Sustainable Model?” regarding auto parts retailer AutoZone (AZO), I will admit that there are not enough people out there telling people what could go wrong. Wall Street is too often about selling stocks to people, and with that comes a bias toward making the bullish case for an investment, not the bearish one. Although betting against stocks stacks the odds against you, Herb makes it his duty to tell the other side of the story.

In the case of AutoZone, here is what Herb had to say about the company on May 22nd:

“Earnings per share beat estimates, yet again, thanks to buybacks. Who cares about sales missing estimates? Who cares about sales per square foot that are either down or flat year-over-year for 12 consecutive quarters? Or inventory turns at a multi-year lows? Or sliding sales per store? Or continued weak same-store sales? All that matters, in a buyback story, is earnings per share. “The point,” says one longtime skeptic, “is whether that’s a sustainable business model. Anybody can do this for some finite period of time, but only the ‘productivity loop’ (as exemplified by Wal-Mart in its heyday and others) has proved sustainable.”

Herb does have his facts right, AutoZone has not been greatly improving their sales or inventory turns for a long time. However, when trying to judge the merit of a bearish argument, you have to ask, does any of this stuff matter? From reading Herb’s post, it is obvious that he, as well as the long-time skeptic he quotes for the piece, believe that it does matter in terms of the future for AutoZone stock.

Noticeably absent from the piece, however, are any reasons why sales, sales per square foot, inventory turns, sales per store, and same store sales do matter, or why share buybacks are bad. He simply states that a business model that focuses on buybacks, and not sales or inventory, is not sustainable. There is nothing there that explains why it isn’t sustainable. Why may that be?

If you do some digging into AutoZone’s financials over the last fifteen years, you will see that the model is sustainable. The company has been focusing on stock buybacks since 1999. This year will mark the ninth straight year that choosing buybacks over sales growth has worked for them. The argument that the model isn’t sustainable simply does not hold water because the evidence, which I will detail below, points to the contrary.

Now, why has the model worked? Why has it proved wise for AutoZone to reinvest excess cash into its own shares rather than new stores, or other projects focused on traditional retail metrics? Because buying back stock will boost AZO’s earnings more than opening a new store, or implementing new inventory management software will. And when it comes to getting your share price higher, earnings are what matters, not sales, or comp store sales, or sales per square foot, or inventory turns.

Herb writes “All that matters, in a buyback story, is earnings per share.” That is only partially correct. All that matters, in the stock market, is earnings per share. Stock prices follow earnings over the long term because owning a share of stock entitles you to a piece of the company’s earnings. Not sales, but earnings.

Let’s take a look at AutoZone in more detail. The company’s history since its IPO in 1991 tells two distinctly different stories. From 1991 through 1998, AutoZone focused on traditional retail metrics, the ones Herb and his skeptic friend believe are important when evaluating a stock’s investment merit. During that time, sales compounded at a growth rate of 22 percent per year, with same store sales averaging 8 percent growth. Stock buybacks were not used, resulting in total shares outstanding rising each and every year due to option grants.

However, in 1999 AutoZone began to focus on stock buybacks, an effort that was very much an idea from a relatively unknown hedge fund manager by the name of Eddie Lampert, who had begun to amass an investment position in AutoZone stock. Lampert understood the retail sector well, and knew that industry experts loved to focus on same store sales and other metrics like that. But he also knew that such metrics had very little correlation to stock market performance, and as an investor, that is all he really cared about.

As a result of pressure from Eddie and other investors, Autozone began to implement a consistently strong buyback program. Total shares outstanding peaked in 1998, fell year-over-year in 1999, and have fallen every year since. Not surprisingly, with a new focus on share buybacks, there was less cash flow left over to improve store performance in ways that would be reflected in same store sales, sales per share foot, and inventory turn statistics. Not surprisingly, since 1999 sales have only averaged 8 percent growth per year, with same store sales compounding at a 3 percent rate. Both of those are far below the levels achieved before the buyback era began at AutoZone.

So the punch line of course lies in what happened to AutoZone stock during these two distinctly different periods. Herb Greenberg and other long-time skeptics would have you believe, without evidence to support their claims, that sales and inventory matter to Wall Street. I am writing this to prove to you that such arguments are wrong.

AutoZone’s stock ended 1991 (the year of its IPO) at $10 per share and reached $26 by the end of 1998, for an increase of about 150 percent. The buyback program reduced share count for the first time in 1999 and today the shares fetch $127 per share, an increase of about 390 percent from 1998. How could this be the case if sales growth and other metrics of retailing health were so much stronger in the earlier period?

The answer lies in the effects of the buyback program. Share count peaked in 1998 at 154 million and now sits below 70 million. So, if you bought 10% of AutoZone at the end of 1998 and held those shares until today, you would now own 22% of the company, without buying a single additional share. And although AutoZone’s sales growth has slowed in recent years, the company is still larger now than it was then, so shareholders not only have seen their ownership stake more than double, but the entire company is worth more today than it was in 1998.

Hopefully this explains why retail metrics like sales don’t really matter when it comes to share price appreciation. Earnings are all that counts, not just in a buyback story, but in any story involving the stock market. I believe Herb when he characterizes his source as a “long-time skeptic” of AutoZone. He likely has been bearish on the company ever since they decided to put buybacks ahead of sales on their priority list eight years ago. However, the skeptics have been wrong for many years and the reason is pretty simple; the buyback model has proven to be quite sustainable.

Full Disclosure: No position in AutoZone at the time of writing

AutoZone vs S&P 500 Since Market Peak in March 2000

Dow Winning Streak Longest in 80 Years

It has truly been a breathtaking run, with the Dow Jones Industrial Average rising in 24 of 27 sessions, the longest streak since eight decades ago in 1927. Unfortunately, Tuesday’s four point drop snapped the streak. How should investors play this? Many are stuck between two prevailing ideas, either ride the momentum to ensure not missing it, or wait for a pullback and buy on the dip. The problem is, there aren’t any dips. We got a 7 percent correction a couple months ago but it was so short-lived that many didn’t have time to get back on the train before it left the station again.

I am sitting on an above-average amount of cash right now, due to an overbought market that I am uninterested in chasing, coupled with a seasonal inflow of deposits. Since I’m a value investor, not a momentum trader, I am content with sitting on cash and waiting for an excellent opportunity. With the broad market rallying so strongly, such a dip might only occur in select names, as opposed to a widespread sell-off that makes many stocks compelling.

Why not just get my money in when short term momentum is strong? There are far fewer bargains now than there were six months or a year ago. Although I might miss some upside in the short term, due to above-average cash positions during a long winning streak, I still believe that buying dips and not rallies will prove to be more profitable when we look back a year from now.

The result could be lagging returns in coming days and weeks, but when we get another pullback and I have the ammunition to jump at true bargains, those purchases will more than likely make up the lost ground and plenty more over the intermediate to longer term.

Finding the Next Starbucks – Part 3 – Compound Interest

“Compound interest is the eight wonder of the world.” – Albert Einstein

The above quote leads off chapter two of Michael Moe’s book, “Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow.” Although we learn about compound interest and the Rule of 72 in our high school math class, sometimes it takes some financial related calculations later in life to really drive the point home, enough so that it will have an effect on our saving and investment habits during adulthood.

Moe uses two compound interest examples that are worth repeating here. Although both cases are impossible to be recreated in the real world today, the dramatic numbers should at least intrigue people enough to run the numbers on their own individual financial plans. The results will still most likely be surprising for many of you.

Example #1

Purchase price for Manhattan Island in 1626 by Dutchman Peter Minuit: $24

Value today if invested at 5.0% annual rate of return: $2.7 billion

Value today if invested at 7.5% annual rate of return: $20.7 trillion

Value today if invested at 10.0% annual rate of return: $128.7 quadrillion

Example #2

You have landed a consulting job for the month of January. Your temporary employer has given you the option of earning $10,000 per week or earning $0.01 on the first day and having your daily pay double each day thereafter for the remainder of the month. Which payment plan should you choose?

Earn $10,000 per week for the month = $40,000

Earn $0.01 on first day, double every day = $21.5 million

While these examples are meant to be fantasy, not reality, compound interest is still a very important concept to consider when you are contemplating your saving and investing plans.

This post is the third in a multi-part series discussing the book Finding the Next Starbucks. You may read Parts 1 and 2 in the series below:

Finding the Next Starbucks – Part 1

Finding the Next Starbucks – Part 2

Finding the Next Starbucks – Part 2 – Definition of Risk

Before I delve into some of the specific investment concepts that Michael Moe covers in his book,“Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow,” I want to talk about one of the passages that appears in the first 10 pages that sets the stage for finding a great growth stock. Despite Moe’s focus on growth, he does an excellent job balancing that objective with a value-oriented, contrarian approach (which is a big reason why I think the book is worthwhile for a value investor as well). Consider the following excerpt from Chapter 1. I want to drill down on one sentence in particular, but these three paragraphs are very important for any investor, regardless of what types of investments they are looking for.

“Ultimately, in sports, gambling, investing, and life, there is little value in knowing what happened yesterday. The largest rewards come from anticipating what will occur in the future. As Warren Buffett once said, ‘If history books were the key to riches, the Forbes 400 would consist of librarians.

Fundamental in our pursuit of attractive investment opportunities is my philosophy of risk and reward. I view risk as measuring the potential for permanent capital loss, not short-term quotational loss, and assess the probability of that against what we think the value of the business will be in the future.

It is with this perspective that I fly right in the face of conventional wisdom, which suggests the bigger the return, the more risk one has to assume. From my point of view, large returns will occur when we find an opportunity where the upside potential is substantial, yet the price we pay for it is not. My goal is to find a stock whose price is below what I think the appraised value should be, not what the quotational value is as indicated by the current market price.”

Much of that may seem logical and obvious to a value investor. However, to a growth investor it may be a bit off-topic. After all, they focus on growth first, with valuation often trailing in importance. By combining the two, as Moe suggests, you can significantly boost your chances of finding the next great growth stock.

I want to expand on one part of that passage:

“Conventional wisdom, which suggests the bigger the return, the more risk one has to assume.”

It amazes me that “risk” is almost always defined as how volatile a stock is. If you open a college level finance textbook , risk is almost always defined as how much a stock moves up and down relative to some other benchmark. In most cases, a stock’s beta is used to compare an individual stock’s “risk” with that of the overall market, the S&P 500 index. So, a tech stock with a beta of 1.50 is much more “risky” than a utility stock with a beta of 0.50.

I strongly disagree with this assertion, and it appears Michael Moe also objects to this conventional wisdom. Should the words “risk” and “volatility” by synonymous? I don’t believe so and let me explain why. Consider two stocks you are evaluating for a one year investment horizon. Both stocks currently trade at $50 per share. After doing a careful analysis you determine that:

*Company A has a 70% chance of rising to $60 in one year, and a 30% chance of falling to $40 in the same time frame. The stock’s beta is 1.50.

*Company B has a 50% chance of rising to $55 in one year, and a 50% chance of falling to $45 in the same time frame. The stock’s beta is 0.75.

Which stock is more risky?

If you consider risk to be volatility, you are going to say Company B is less risky. If you calculate the expected value of Company B stock in a year, you get $50.00 per share, a zero percent gain.

If you consider risk , as I do, to be the odds of permanent capital loss, you will conclude that Company A is less risky. Not only is your expected value in a year higher ($54.00, a gain of 8 percent), but the odds of losing money are only 30 percent, versus 50 percent for Company B.

I would argue that Company A is less risky despite the fact that the betas of each stock imply that Company A will move twice as much, in percentage terms, during the typical trading day. In my view, risk and volatility are different animals. For me, risk is defined as the probability that I lose money during my desired time horizon for a particular investment.

If I’m investing for one year, I want to minimize the odds that after the year is up, I am underwater on the investment. How volatile the share price is during that year is pretty much irrelevant to me because if my analysis is correct, the stock will be worth more than I paid for it after a year’s time.

This post is the second in a multi-part series discussing the book “Finding the Next Starbucks.” You may read Part 1 in the series here: Part 1 and be sure to stay tuned for more posts in the series.

 

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Finding the Next Starbucks – Part 1

I just crossed another book off of my Amazon Wish List and got the idea to feature monthly book reviews on The Peridot Capitalist. It might be a stretch to pin myself down to reading a new book each and every month, so I won’t make any promises. But let’s just say that I will plan on sharing positive reading experiences with you all in the future. I won’t commit to a specific review frequency in order to ensure that I make suggestions because they are worth your time, not just because the calendar flipped to a new month.

Anyway, I just finished “Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow” by Michael Moe, founder and CEO of ThinkEquity Partners. At first I was leery of the book simply because of the title. In my opinion, many investors obsess over finding the next Microsoft or Google, when in reality, the odds of doing so are close to zero. The end result is people getting caught up in “story stocks” without any regard for the stock’s valuation relative to what a reasonable growth assumption would be.

The most recent example of this was Sirius Satellite Radio (SIRI). For months it was the stock I got more questions about than any other. I wrote about it several times back in 2004 and 2005, explaining how the shares were trading at levels that couldn’t be justified with any degree of confidence as far as future financial projections were concerned.

Still, you could tell many people really thought Sirius could be the best performing stock of the next decade and they just had to own it. The single digit price tag fueled the urge even more, as they thought the stock was so cheap. Well, today Sirius stock fetches a mere $2.77 a share (down about 70% in less than three years) and is fighting to merge with their only competitor in order to stay afloat. Sirius and XM Satellite (XMSR) were worth more than $20 billion combined back then. Today that figure stands at just a little over $7 billion.

Despite my initial skepticism, Michael Moe really never started to lead readers down the path that usually results in buying Sirius at 9 bucks. As a result, I was pleasantly surprised with the book because it was able to focus on growth investing, but also did not ignore the valuation component. Too often people assume that if a company grows fast enough, they will make a killing regardless of the price they pay. The book outlines some very good lessons to follow when investing in growth companies, and although I didn’t agree with everything contained in the 300 plus pages, Finding the Next Starbucks is definitely worth a read.

Since it will take quite a bit of space for me to discuss the major points I think are important in the book, I will spread out my comments over several posts in coming days. Stay tuned for more to come and perhaps we can get a solid discussion going as well.

Don’t Get Caught Up in Optimism from Company Management

Aside from company-specific issues at Yahoo! (YHOO), the main takeaway from the search giant’s poorly received first quarter earnings report should be to take what management says with a grain of salt. Yahoo! stock soared from the high 20’s to the low 30’s after CEO Terry Semel went on the record saying how great its new online advertising system, Panama, was going to be. Obviously, when investors saw poor results and a lackluster outlook from the company, they felt blindsided.

Why would Terry Semel be so optimistic when the numbers didn’t reflect that optimism? Because he’s the CEO. Management always sees the glass half-full. Many of them believe it is their job to be company cheerleaders. Very few executives refrain from trying to spin anything to be as positive as they can. Investors need to keep that in mind. Don’t go out and buy a stock just because you saw the CEO on television and he or she was bullish.

It can be hard to ignore that sometimes. After all, if you watch shows like Jim Cramer’s Mad Money, these guys are always brought on camera to defend their company against negative press or to hype their next big thing. A lot of these people are pretty darn good at telling their stories.

Since management will often spin the truth, does that mean that investors should dismiss everything a CEO or CFO ever says? Absolutely not. This is how I would judge these comments. Don’t just take what they say as gospel. Managers should earn your trust. Carefully monitor what they say over an extended period of time and compare that to what actually happens.

If you follow this logic, only managers that tell the truth and consistently understand their businesses should earn your trust. Armed with this knowledge, namely a management’s track record talking to investors, you know who to listen to and who to dismiss as merely a cheerleader.

Successful investing is not easy. If you could just watch TV and make money like Jim Cramer says, everybody would be rich. However, we know that doesn’t work. After all, most professionals can’t consistently beat the market. If you want to be in the small group that does, be skeptical when company management teams start telling you how great things are unless you have reason to believe they know what they are talking about.

Full Disclosure: Short shares of YHOO at time of writing

Sam Zell Epitomizes Contrarian Investing

There is a reason you won’t see any day traders, market timers, or technical analysts on the Forbes 400 list of richest Americans. Those strategies simply have not proven to be consistently successful ways to make money over the long term. You will, however, find Sam Zell’s name in the 52nd slot on the 2006 list. If you are wondering what type of investment philosophy Zell abides by, you only have to look at the moves he has made so far in 2007.

After building his commercial real estate company, Equity Office Properties, into an industry Goliath, Zell sold it to the Blackstone Group for $23 billion earlier this year. Given that it was the largest real estate investment trust (REIT) deal ever, coupled with Zell’s brilliance, many have suggested the deal signaled the top in the red hot commercial real estate market. Regardless of whether or not that proves true, it is certainly apparent that Zell felt it was a prudent time to cash out of Equity Office when times were good. By definition, very much a contrarian move on his part.

Perhaps even more interesting was the news on Monday morning that Zell had been victorious in launching an $8.2 billion takeover bid for Tribune (TRB), owner of the Chicago newspaper that bears its name and the Chicago Cubs, among many other businesses. The deal is striking because of how many people have called the newspaper business dead, or on the brink of death anyway. Again, Zell is showing an extreme bias toward contrarian investing; selling Equity Office when everybody loved it and buying Tribune when everybody hates it.

Following what Zell is doing is important because the guy is one of the smartest investors around. His place on the Forbes 400 is notable, not just because he is rich, but because the tactics he has used to accumulate wealth are exactly the ones that have proven to be the most successful over time. It’s a very important lesson for everyone, especially if you are a proponent of contrarian investing.

Full Disclosure: No position in Tribune at the time of writing

Blackstone IPO Signals Private Equity Market is “As Good as it Gets”

Throughout history, what has been one of the worst types of investments to buy? If you answered IPOs, you’re correct. Before commenting on the $4 billion IPO of private equity behemoth Blackstone Group, let’s review why exactly IPOs are such bad investments.

Companies sell stock when demand for shares is high, and they buy stock when interest is lacking. If things are going great, demand will be high and an IPO is the preferred way to cash in. The “smart money” as it’s called, sells to the dumb money.

Well, guess what? Steve Schwarzman and the rest of the Blackstone Group gang is very “smart” money. If they want to sell a piece of their management company to you, it’s probably for a good reason. If they thought the bull market in private equity had a few more years left in the tank, they certainly wouldn’t choose to sell now.

This event, unlike the Fortress Investment Group (FIG) IPO (which I don’t think marks a top in hedge funds), signals that the bull market in private equity, and perhaps in the stock market in general, is running thin. Think back to the Goldman Sachs (GS) IPO. Like Blackstone, Goldman refused to go public for years, but when things got so good, they couldn’t resist anymore. In case you don’t remember, Goldman’s IPO was in 1999 and the market peaked less than a year later.

Much like the bull still ran a bit after GS went public, I don’t think the market will necessarily peak coincidentally with the Blackstone IPO. However, it’s important to understand that IPOs are traditionally bad investments for a reason, and it’s that reason and that reason alone that explains why Blackstone has chosen to go public. Also, be aware that Blackstone is selling a piece of its management company, so investors in the IPO are buying ownership of their 2-and-20 fee income. The IPO proceeds is not going to be used to fund more private equity deals.

Of course, the irony is that private equity’s whole game is convincing companies that the public market isn’t worth the trouble and they would be better suited going private. You know if Blackstone wants to go public there is a pretty good reason why. In this case, that reason is dollar bills. Four billion of them, in fact.

Full Disclosure: No positions in the companies mentioned at time of writing

Great Companies Don’t Always Make Great Stocks

Many times one will look at a value investor’s portfolio and wonder why on earth they own some of the stocks they do. Usually the answer lies in the fact that the manager understands that just because a firm isn’t considered to be a great company, it could very well be a great stock going forward. Stock market investing is about buying a share for less than it will ultimately be worth in the future. It is not about buying stocks of great companies and waiting for the cash to roll in. If the stock isn’t cheap, it won’t outperform consistently over the long term.

I think this is one of the reasons why sell-side analysts tend to be very poor stock pickers. More often than not, they don’t want to have a “sell” rating on Best Buy (BBY) and a “buy” on RadioShack (RSH), for instance. The average person will look at that dichotomy and laugh. They might even ask, based on their shopping preferences, “How can RadioShack be a better stock than Best Buy?”

The reason I bring this up is because of an article I read in the March 5th issue of Fortune. It talked about the performance of America’s most admired companies versus the least admired. When I see the term “most admired” I equate that to what many investors consider a “great company,” a so-called blue chip.

Well, looking at a 1-year chart of the two, we can see who would have been right:

Accordingly, the results of the study cited in the article weren’t surprising to a value investor like myself. The mean annualized return from 1983 through 2006 was +17.8% per year for the least admired, versus just +15.4% for the most admired.

Why was this the case? Because stocks trade based on valuation over long periods of time, not according to the underlying company’s popularity or brand name. In fact, the article also cited the average price-to-book ratios of the two groups of stocks being examined. Most admired: 2.07 times book value. Least admired: 1.27 times book value. Hence, the outperformance over a 23 year period of time.

Full Disclosure: Long shares of RSH at time of writing