Warren Buffet's video about security analysis. You can see how he feels about ben Graham.
http://www.gurufocus.com/news.php?id=70961
Monday, October 12, 2009
Wednesday, May 6, 2009
How to invest in banks
It is important for investors to not fight yesterday's battle. I am referring to financial and banking business. Considering all that has happened, it is tempting to avoid financial forever into future but that would be a mistake. Here is why.
1. Once the current crisis passes, banks will still be needed. Their business is ever green and needless to say is tied to economic growth. That is more true now that shadow banking has taken a hit.
2. It is likely that over next 5 or 10 years, banks will not repeat the past mistakes. This will mean banks will take prudent risks going forward and make loans to credit worthy customers. Eventually similar mistakes will be made, but that is not likely anytime soon.
3. There is less competition since some banks have gone out of business or acquired. The shadow banking system is out of business for most part.
4. My sense is that cost of credit will likely rise once government is out of the picture. I don't know when this will happen. But until then banks can make tons of money.
Now, some thoughts about basics of bank investment and what to look for.
1. First, one thing to learn from credit crisis is that it is important that financial be part of your portfolio and not the entire one. However, talented investor one may be, companies that operate with leverage is inherently risky. It depends on trust of others to lend money (customer deposits) and allow it to operate (regulator). So, limiting exposure (but not avoiding) is best for most investors.
2. A bank makes money by spread between the cost of money that it collects from depositors and the lending rate. I have a simple equation.
Profit = (lending or interest income) - (cost of money) - (cost of running a bank) - (loan losses) + Any fee income.
It is worth thinking about this for a minute. Mr. Buffet likes Wells Fargo because of it's ability to collect low cost deposits (cost of money). However, there is more to this. The variables in above equation are not independent. Here is why. Lets say two banks (Bank A and Bank B) have ability to collect deposits at 1.5% and 2.5% respectively. To get the same spread of 2.5%, Bank A would have to lend at 4% while Bank B would have to lend at 5%. Which of the two loans is more risky? The one at 5% is more risky than at 4% for obvious reasons. So loan losses for Bank B will be more than Bank A over a credit cycle thereby, making Bank A more profitable over the cycle. So low cost deposits are important, not only to reduce cost of raw material (cost of money) but also to reduce lending losses.
3. Find a CEO who has a clearly articulated simple strategy and will not follow the crowd. This is key since banks invariably get into trouble in the same area once every two decades. Usually, in an area that creates lot of profits before the bubble bursts.
4. CEO must be in control of the show and must be the chief risk officer. It is true that getting to know the bank management is not an easy job for small investor. However, downturns provide an excellent opportunity to evaluate their past actions. It is not difficult to infer that JP Morgan and Wells Fargo had better managements than few other big banks. So study their record in down markets and likely there is no better way to evaluate their past actions.
5. Prefer a bank that attempts to grow organically and not by big acquisitions. In particular, it is best to avoid merger of equals. Targeted acquisition of a small bank works better. In this downturn, acquisitions have been opportunistic and I think in all most all cases, the acuiring company may have been better off without those. Some exceptions do exist. As Jammie Dimon (JP Morgan CEO) replied in an interview about why he only agreed to pay $2 for Bear Stearns initially. He said there is a difference between buying a home and buying a home that is burning. That illustrates the risks in quick opportunistic acquisitions.
6. Costs do matter. Since banks are commodity business, cost of running the bank is important. Lower the better. All things being equal, lower the cost of running a bank, lower the risk bank needs to take to earn the same spread.
Conclusion:
Finally, all things said, consider banks that focus on profitability than growth. Focus on those that take thoughtful credit risks and never tries to loosen on credit standards. Focus on cost of running a bank. Last but possibly most important, never buy if you do not have a sense of the management capability and temperment to avoid profitable (in short term) but risky ventures.
Good luck and leave your comments.
1. Once the current crisis passes, banks will still be needed. Their business is ever green and needless to say is tied to economic growth. That is more true now that shadow banking has taken a hit.
2. It is likely that over next 5 or 10 years, banks will not repeat the past mistakes. This will mean banks will take prudent risks going forward and make loans to credit worthy customers. Eventually similar mistakes will be made, but that is not likely anytime soon.
3. There is less competition since some banks have gone out of business or acquired. The shadow banking system is out of business for most part.
4. My sense is that cost of credit will likely rise once government is out of the picture. I don't know when this will happen. But until then banks can make tons of money.
Now, some thoughts about basics of bank investment and what to look for.
1. First, one thing to learn from credit crisis is that it is important that financial be part of your portfolio and not the entire one. However, talented investor one may be, companies that operate with leverage is inherently risky. It depends on trust of others to lend money (customer deposits) and allow it to operate (regulator). So, limiting exposure (but not avoiding) is best for most investors.
2. A bank makes money by spread between the cost of money that it collects from depositors and the lending rate. I have a simple equation.
Profit = (lending or interest income) - (cost of money) - (cost of running a bank) - (loan losses) + Any fee income.
It is worth thinking about this for a minute. Mr. Buffet likes Wells Fargo because of it's ability to collect low cost deposits (cost of money). However, there is more to this. The variables in above equation are not independent. Here is why. Lets say two banks (Bank A and Bank B) have ability to collect deposits at 1.5% and 2.5% respectively. To get the same spread of 2.5%, Bank A would have to lend at 4% while Bank B would have to lend at 5%. Which of the two loans is more risky? The one at 5% is more risky than at 4% for obvious reasons. So loan losses for Bank B will be more than Bank A over a credit cycle thereby, making Bank A more profitable over the cycle. So low cost deposits are important, not only to reduce cost of raw material (cost of money) but also to reduce lending losses.
3. Find a CEO who has a clearly articulated simple strategy and will not follow the crowd. This is key since banks invariably get into trouble in the same area once every two decades. Usually, in an area that creates lot of profits before the bubble bursts.
4. CEO must be in control of the show and must be the chief risk officer. It is true that getting to know the bank management is not an easy job for small investor. However, downturns provide an excellent opportunity to evaluate their past actions. It is not difficult to infer that JP Morgan and Wells Fargo had better managements than few other big banks. So study their record in down markets and likely there is no better way to evaluate their past actions.
5. Prefer a bank that attempts to grow organically and not by big acquisitions. In particular, it is best to avoid merger of equals. Targeted acquisition of a small bank works better. In this downturn, acquisitions have been opportunistic and I think in all most all cases, the acuiring company may have been better off without those. Some exceptions do exist. As Jammie Dimon (JP Morgan CEO) replied in an interview about why he only agreed to pay $2 for Bear Stearns initially. He said there is a difference between buying a home and buying a home that is burning. That illustrates the risks in quick opportunistic acquisitions.
6. Costs do matter. Since banks are commodity business, cost of running the bank is important. Lower the better. All things being equal, lower the cost of running a bank, lower the risk bank needs to take to earn the same spread.
Conclusion:
Finally, all things said, consider banks that focus on profitability than growth. Focus on those that take thoughtful credit risks and never tries to loosen on credit standards. Focus on cost of running a bank. Last but possibly most important, never buy if you do not have a sense of the management capability and temperment to avoid profitable (in short term) but risky ventures.
Good luck and leave your comments.
Friday, April 10, 2009
American Express - stock analysis and review
Recent share holder letter provides some valuable insight. Here are some that will interest long term investors.
1. Consumer spending pattern: The most important driver of value for AXP is consumer card spending. The US consumer card spending reduced 12% in fourth quarter of 2008. International card spending showed some growth but much less than last year. The reduced spending was particularly visible in luxury goods which is especially important for American Express. The key question is how much of this decline is attributed to secular shift in the consumer spending patterns. Are consumers temporarily withdrawing or will we see a cautious consumer whose prefers to save for next few years. By all accounts, it seems that we will have a cautious consumer at least for next few years. Since American Express depends on consumers spending and transactions, this can have a significant impact on revenue and bottom line.
2. Underwriting decisions: Management is candid about some of their actions that resulted in increased credit loss. First, AMEX card member base is skewed towards states hit hard by real estate crash. [Btw, I understand Discover was more cautious in this regard.]. Second Amex added more card members than industry (higher growth). Third, they have more small business accounts. These decisions are elaborated below as they are significant in my view.
3. Floor for credit losses: The above three actions illustrate that Amex fully participated in the credit boom. This resulted in significant growth in good years which is coming back to bite in bad years. The net result of above actions resulted in middle of the pack past-due and write-off rates (bad loans that cannot be collected). Further, this loss cycle is far from over since unemployment is expected to continue over many months to come. The exact level of credit card losses is difficult to predict in this environment. Historical indicators may be misleading as the current credit bubble induced recession differs from either the valuation driven tech bubble or a general economic slowdown without structural issues. It is difficult to estimate future losses and considering credit card loans are unsecured loans, uncertainty definitely exists in this regard. It is for this reason that I believe that valuing Amex at this point is not possible with any level of certainity.
4. Business model: American Express traditionally commands a higher multiple in the market for a reason. Historically, American express business model is based on spending by high networth customers who will pay the bill rain or shine. The focus is on discount fees from merchants and membership fees from card holders. Increasing balance was not the primary focus. This meant that Amex had low credit risk and market rewarded this handsomely with high multiple. [There is a reason Banks have low multiple for same earnings. One is leverage and other is possibility of credit loss.)
The question to be evaluated now is whether the Amex business model has changed as a result of expansion past few years coupled with poor underwriting decisions (outlined in #2)? The write-off rates are in the middle of the pack for a top quality company. If American Express continues to expand in good times and creates higher write off rates in poor economy, it will be treated more like cyclical business and will not justify premium multiples (correctly so). This affects long term share holder value. The key issue is whether American express moves back to a business model of low credit risk. I suspect Warren Buffet did not anticipate holding a company with middle of the pack write-off rates. If so, that will inevitably mean more subdued growth in the future.
5. Risk conscious culture: The net charge off being in the middle of the pack for a top class company like American express is unacceptable to say the least. Was there too much focus on growth? How did the company miss out on risks during real estate bubble when at least one competitor recognized it? For a financial company, growth can be dangerous if it is not accompanied with sound underwriting. I understand American express has tweaked their models in response to the crisis but it is equally troubling that the culture within the company did not catch this earlier. Holding a financial company is meaningful only if it has risk conscious culture. Any deviations can be fatal and as well difficult to rebuild the culture. I do not see anything else that has changed other than tweaking models. Note models are a result of human decisions anticipating risks not the other way around. This point is key.
6. Compensation: I tried to read through the proxy for compensation details. It was complex to say the least and based on many parameters. I think it should be simple enough and depend on few critical drivers of the business. Some combination of underwriting profit growth and write-offs over a cycle would make sense. In a year like 2008, anything other than base pay is excessive.
7. Credit card securatization: It is an open question as to how the credit card receivable securatization market will function after the current crisis is past? Could it be relied upon for funding? Since credit cards are unsecured loans, it is always possible that this market will freeze whenever investors are nervous. This risk applies to all credit card companies. In this regard, American express has brand advantages to raise capital from other funding sources. However, as a whole, the total credit issued will be reduced in the future as securatization market will demand higher credit quality.
8. Cost expenses: American Express has announced 10% reduction in work force. I think this is in keeping with realistic view of future growth after years of expansion. However, it also shows that future growth is going to be subdued.
9. Regulation: New regulation is inevitable and it is not going to be friendly to credit card companies. It is difficult to predict the nature of this. I suspect regulation will affect the credit card companies whose business model is based on balances more than AMEX.
Conclusion: I think future growth of Amex will depend on a number of factors outlined above. At this time, AMEX is in "too hard to value" pile. Here is a recap why it is so.
First, Amex has to survive the credit losses in the short term without raising expensive equity capital. I do not think we have reached peak write offs and that anyone can predict this with any accuracy since economy is still in poor shape.
Second, will AMEX learn from this downturn and go back to the business model that results in low credit risk across entire cycle? It is an unknown. This will decide the multiple market provides (correctly so).
Third, credit card industry has a number of external factors that can influence it's future like regulation, consumer deleveraging, securatization market etc. These are hard to predict.
Fourth and most important, will management create an environment that is focussed on sound risk management? This is the most important aspect of a financial company and in last bubble risk controls failed the company. Without this, owning financial company is a gamble.
Considering all of the above, I think it is not possible to meaningfully value the company at this point. As a disclaimer: I do own Amex shares and plan to continue to hold. Please leave your comments by clicking the comment button below.
1. Consumer spending pattern: The most important driver of value for AXP is consumer card spending. The US consumer card spending reduced 12% in fourth quarter of 2008. International card spending showed some growth but much less than last year. The reduced spending was particularly visible in luxury goods which is especially important for American Express. The key question is how much of this decline is attributed to secular shift in the consumer spending patterns. Are consumers temporarily withdrawing or will we see a cautious consumer whose prefers to save for next few years. By all accounts, it seems that we will have a cautious consumer at least for next few years. Since American Express depends on consumers spending and transactions, this can have a significant impact on revenue and bottom line.
2. Underwriting decisions: Management is candid about some of their actions that resulted in increased credit loss. First, AMEX card member base is skewed towards states hit hard by real estate crash. [Btw, I understand Discover was more cautious in this regard.]. Second Amex added more card members than industry (higher growth). Third, they have more small business accounts. These decisions are elaborated below as they are significant in my view.
3. Floor for credit losses: The above three actions illustrate that Amex fully participated in the credit boom. This resulted in significant growth in good years which is coming back to bite in bad years. The net result of above actions resulted in middle of the pack past-due and write-off rates (bad loans that cannot be collected). Further, this loss cycle is far from over since unemployment is expected to continue over many months to come. The exact level of credit card losses is difficult to predict in this environment. Historical indicators may be misleading as the current credit bubble induced recession differs from either the valuation driven tech bubble or a general economic slowdown without structural issues. It is difficult to estimate future losses and considering credit card loans are unsecured loans, uncertainty definitely exists in this regard. It is for this reason that I believe that valuing Amex at this point is not possible with any level of certainity.
4. Business model: American Express traditionally commands a higher multiple in the market for a reason. Historically, American express business model is based on spending by high networth customers who will pay the bill rain or shine. The focus is on discount fees from merchants and membership fees from card holders. Increasing balance was not the primary focus. This meant that Amex had low credit risk and market rewarded this handsomely with high multiple. [There is a reason Banks have low multiple for same earnings. One is leverage and other is possibility of credit loss.)
The question to be evaluated now is whether the Amex business model has changed as a result of expansion past few years coupled with poor underwriting decisions (outlined in #2)? The write-off rates are in the middle of the pack for a top quality company. If American Express continues to expand in good times and creates higher write off rates in poor economy, it will be treated more like cyclical business and will not justify premium multiples (correctly so). This affects long term share holder value. The key issue is whether American express moves back to a business model of low credit risk. I suspect Warren Buffet did not anticipate holding a company with middle of the pack write-off rates. If so, that will inevitably mean more subdued growth in the future.
5. Risk conscious culture: The net charge off being in the middle of the pack for a top class company like American express is unacceptable to say the least. Was there too much focus on growth? How did the company miss out on risks during real estate bubble when at least one competitor recognized it? For a financial company, growth can be dangerous if it is not accompanied with sound underwriting. I understand American express has tweaked their models in response to the crisis but it is equally troubling that the culture within the company did not catch this earlier. Holding a financial company is meaningful only if it has risk conscious culture. Any deviations can be fatal and as well difficult to rebuild the culture. I do not see anything else that has changed other than tweaking models. Note models are a result of human decisions anticipating risks not the other way around. This point is key.
6. Compensation: I tried to read through the proxy for compensation details. It was complex to say the least and based on many parameters. I think it should be simple enough and depend on few critical drivers of the business. Some combination of underwriting profit growth and write-offs over a cycle would make sense. In a year like 2008, anything other than base pay is excessive.
7. Credit card securatization: It is an open question as to how the credit card receivable securatization market will function after the current crisis is past? Could it be relied upon for funding? Since credit cards are unsecured loans, it is always possible that this market will freeze whenever investors are nervous. This risk applies to all credit card companies. In this regard, American express has brand advantages to raise capital from other funding sources. However, as a whole, the total credit issued will be reduced in the future as securatization market will demand higher credit quality.
8. Cost expenses: American Express has announced 10% reduction in work force. I think this is in keeping with realistic view of future growth after years of expansion. However, it also shows that future growth is going to be subdued.
9. Regulation: New regulation is inevitable and it is not going to be friendly to credit card companies. It is difficult to predict the nature of this. I suspect regulation will affect the credit card companies whose business model is based on balances more than AMEX.
Conclusion: I think future growth of Amex will depend on a number of factors outlined above. At this time, AMEX is in "too hard to value" pile. Here is a recap why it is so.
First, Amex has to survive the credit losses in the short term without raising expensive equity capital. I do not think we have reached peak write offs and that anyone can predict this with any accuracy since economy is still in poor shape.
Second, will AMEX learn from this downturn and go back to the business model that results in low credit risk across entire cycle? It is an unknown. This will decide the multiple market provides (correctly so).
Third, credit card industry has a number of external factors that can influence it's future like regulation, consumer deleveraging, securatization market etc. These are hard to predict.
Fourth and most important, will management create an environment that is focussed on sound risk management? This is the most important aspect of a financial company and in last bubble risk controls failed the company. Without this, owning financial company is a gamble.
Considering all of the above, I think it is not possible to meaningfully value the company at this point. As a disclaimer: I do own Amex shares and plan to continue to hold. Please leave your comments by clicking the comment button below.
Wednesday, February 25, 2009
WU - Update and what now?
The advantages of Western Union (Ticker: WU) business model is fairly well known. It is scalable and generates lot of cash. We are now in a new reality and it is worth checking back if it is worth continuing to be invested. Here are some thoughts...
1. General ongoing environment: It looks like we are in for a period of prolonged downturn and possibly a reset to new level of economic activity rather than return to pre-bubble economic activity. Lets say, two years of painful revenue drops (15% drop) and followed by growth based on inflationary levels from that point. No one knows for sure but evaluating companies with this in mind is always a good start. If it survives this scenario, other scenarios (except great depression II) will be good outcomes.
2. Debt: In this environment, any debt is a bad debt. Western Union had around $2 Billion of debt. First the good news. Much of this debt is due to paying a dividend to First Data and not due to business needs. Western Union generates more than $1 Billion dollar of free cash flow per year. Still that assumes future will be like the past. Plus operating leverage works both ways. Since the network of money transfer is already established, incremental revenue falls to bottom line. The reverse (current situation) is also true. That is, drop in revenue could cause much steeper loss of earnings. I think management must act conservatively first and pay back debt as soon as possible.
3. The general lack of growth in economy means less activity in construction and employment levels. So in general, Western Union customers have less money to transfer. So revenue can drop off. This is negative like it is for many other companies.
4. Western Union's competitor (Money Gram) is weaker because of issues in their check cashing business. Since money transfer is not capital intensive business, Money gram can still find ways to grow. But not with as much strength to compete against Western Union. If it comes down to it, Western Union can sustain lower prices for longer than Money Gram. So weaker competitor does not hurt but does not help as much as it would in a capital intensive business. Plus perception of strong player is always a plus in anything to do with money.
5. While growth due to economic activity will be reduced, we can expect some acquisitions of smaller players. Plus smaller players may find it hard to withstand prolonged recession. This is positive.
6. Since multinational Banks are weaker, they may now start to focus on their core areas and not focus on money transfer. This is positive.
7. Western Union does not carry credit risk and can withstand prolonged recession if it manages it's expenses and debt carefully.
8. The current political climate in Washington may result in meaningful immigration reform which will be positive for Western Union.
In summary, if economy falls into few years of weakness, Western Union will take few hits to it's earnings but will survive. The pain until then is definite. But will remain as one of the last standing players. When economy eventually returns to more normal level, their rise will be remarkable! Or so I hope!
1. General ongoing environment: It looks like we are in for a period of prolonged downturn and possibly a reset to new level of economic activity rather than return to pre-bubble economic activity. Lets say, two years of painful revenue drops (15% drop) and followed by growth based on inflationary levels from that point. No one knows for sure but evaluating companies with this in mind is always a good start. If it survives this scenario, other scenarios (except great depression II) will be good outcomes.
2. Debt: In this environment, any debt is a bad debt. Western Union had around $2 Billion of debt. First the good news. Much of this debt is due to paying a dividend to First Data and not due to business needs. Western Union generates more than $1 Billion dollar of free cash flow per year. Still that assumes future will be like the past. Plus operating leverage works both ways. Since the network of money transfer is already established, incremental revenue falls to bottom line. The reverse (current situation) is also true. That is, drop in revenue could cause much steeper loss of earnings. I think management must act conservatively first and pay back debt as soon as possible.
3. The general lack of growth in economy means less activity in construction and employment levels. So in general, Western Union customers have less money to transfer. So revenue can drop off. This is negative like it is for many other companies.
4. Western Union's competitor (Money Gram) is weaker because of issues in their check cashing business. Since money transfer is not capital intensive business, Money gram can still find ways to grow. But not with as much strength to compete against Western Union. If it comes down to it, Western Union can sustain lower prices for longer than Money Gram. So weaker competitor does not hurt but does not help as much as it would in a capital intensive business. Plus perception of strong player is always a plus in anything to do with money.
5. While growth due to economic activity will be reduced, we can expect some acquisitions of smaller players. Plus smaller players may find it hard to withstand prolonged recession. This is positive.
6. Since multinational Banks are weaker, they may now start to focus on their core areas and not focus on money transfer. This is positive.
7. Western Union does not carry credit risk and can withstand prolonged recession if it manages it's expenses and debt carefully.
8. The current political climate in Washington may result in meaningful immigration reform which will be positive for Western Union.
In summary, if economy falls into few years of weakness, Western Union will take few hits to it's earnings but will survive. The pain until then is definite. But will remain as one of the last standing players. When economy eventually returns to more normal level, their rise will be remarkable! Or so I hope!
Monday, February 2, 2009
Why stock options misalign incentives
It is a common cliche that stock options align management and shareholder interests. The story goes something like this. If stock price goes up, both option holder and share holder benefit. If it goes down, stock option holder does not reap any benefit. I think this is a very superficial analysis and needs a little digging. The following discussion will provide reasons why this is not necessarily the case. In a nutshell, I think shareholders are usually better off without stock options and providing high cash bonus.
Warren Buffet has dealt with stock options in 1985, 1992, 1998, 1999,2002, 2004, 2005, 2007 annual reports. Needless to say, it is a must read for those interested in options and seems to be pet subject for the investment guru. We will look at some of those reasoning below along with suggestions to deal with companies using options.
Basics of stock options offered to management as compensation: Managements are usually offered fixed price 10 year stock options. Essentially, the management has the right to buy the company stock at the strike price (usually market price) any time over the next 10 years after the vesting period is over. So if the company stock was $50 at the time of offer and was $100 after 5 years, management can buy the stock for $50 and hence can make a profit of $50. Similarly, if the stock price were to be $25, it has no value to the stock option holder.
So what's to worry about! Let's look at some reasons why stock options do not necessarily put stock option holder and share owner in the same boat.
Where's the downside risk? If the share price were to go to $25 in the above example, share holder lost 50% of his capital. There is no such capital risk for management. It is true that management has invested his/her time and skill with the hope of benefiting on the upside. But they do get base pay and other compensation for their efforts. Stock options are an added bonus for success. So for Stock holder, it is "Heads I win, Tails I lose" and for stock option holder, it is "Heads I win, Tails I did not lose or gain anything". So to summarize, both option holder and stock owner's downside are way different. In fact lack of downside for option holder, may set the stage for taking big risks because upside is great without associated huge downside. For stock owner, success on upside needs to be weighed against downside on failure. Why provide incentives to your management to bet big with your money?
Why does Management benefit from additional capital you add to business every year?
Lets say a company's Return on equity is 15% and no debt. Lets also say that it retains all it's earnings. If the equity per share is $100, company's earnings will be $15. This earnings belong to share holder. Management will deploy the retained earnings (that belongs to share holder) to create earnings growth. For example, management may add additional stores if it is fast growing retailer that contributes to earnings growth. So total capital now deployed next year is $115 per share and lets assume that the new store is as productive as the old store for simplicity. Then 15% return on equity would mean earnings this year will be $17.25 per share (Equity * ROE -->115 * 15/100). As you see, earnings growth between two years is exactly 15% (17.25-15/15). Now share price will appropriately move upwards. Share holder and option holder benefits from share price increase. But note that the management could not have caused earnings increase but for the addition of new store. The new store in turn needed capital which came from retained earnings (that belong to share holder). If share holder had withdrawn the earnings as dividends, where will the growth have come from? If so, the option holder must not benefit from this additional capital retained every year. It is true that management skill in opening and running new store (deploying new capital) is key. But that does not mean all earnings growth is due to management skill. It is ideally a combination of management skill and retained earnings. So one solution is to adjust the strike price for the new capital. I am not aware of many (if any) comapnies that do that. As a side note, it causes management to retain capital in businesses even when it is not wise to expand business operations!
Stock options are granted at market price and not at it's intrinsic value. Market price at the time of grant may or may not be near intrinsic value of a company. Most value investors understand that company's market price may be different from it's intrinsic value. If Mr. Market is in bad mood and prices the company much lower than it's intrinsic value at the time of option grant, then the person receiving option may benefit from market repricing at a future date. This may or may not be the direct result of anything management did. Similarly, the market gets into one of those heady bull markets, the option holder may benefit from general market levels moving higher. Neither of these scenarios are in control of either the management or the Board (who sets compensation). But in either case, the option holder (usually management) benefits for no fault (or work!) of his. Why reward someone for result that they did not produce. If you dont believe market price will be different from intrinsic value, here is one from the master. Mr. Buffet points out in 1985 annual report that when a CEO plans to sell the company or merge with other entity, CEO is unfailing to point out that market price understates the company's worth. Why give piece of your company at anything other than it's fair value ?
Capital allocation misalignment-Dividends Vs Stock buyback decision: Stock option based compensation hinder earnings to be allocated in the best interest of owner. Here is how. The earnings of a company that is left after routine maintenance and "growth projects" can be either distributed as dividends or be used to buy back company shares. For the options holder, anything that increases earnings per share is positive (which share repurchase does). Dividends do not increase earnings per share. Thus, stock option based compensation encourages stock repurchases over dividend without regard to market price of the share.
For a true owner, equation is way different. For the regular share holder, buying back shares makes sense only if the price of stock is less than the intrinsic value calculated conservatively. In other cases, dividends is much better option. In fact buying back high priced shares cause value destruction for the owner. It is like buying dollar bills for dollar and 30 cents.
Thus stock option based compensation encourages repurchase over dividends irrespective of what the share price is. This does not mean managements will always do it that way but why set an incentive that works against you (the owner!).
Why hire employee's whose salary is unknown: A company benefits if the financial benefit arising from services of an employee exceed the compensation paid. Otherwise it is a loss. This statement is true, whether you use cash or any other form of payment. Stock options uses company shares as currency to pay for employee services. It is a currency whose precise (or even approximate) cost is not known at the time of offer( more on this later). Since the cost of options is unknown, it is not easily possible to figure out whether the employee adds more value than the benefit he/she receives as stock options from the the company. Ironically, this is the same argument (cost of options is unknown) that many managements used to not expense stock options(!). But I would flip this argument and say, this is a good reason to use other forms of compensation when possible. May be a high cash bonus for achieving predetermined goals.
Why 10 year fixed price options without holding period requirement! Managements are usually granted 10 year fixed price options. That is, options can be exercised (any time after vesting period) over next 10 years but not required to hold the shares after exercising the options. First, why provide it for 10 years! As discussed before, the capital added in the form of retained earnings exceed the book value in some companies! The option holder benefits over a 10 year period without having a dime of capital at risk. It is true that many exercise their options before 10 years. To bring some balance, why not require holding period (say 2 to 3 years) for some part of the options exercised? Say 30% of the options need to be held for 3 to 5 years after exercise? It will provide some alignment.
Doesn't Share buyback cancels out effect of option dilution? This is the height of shareholder unfriendly activity. Share buy back costs money. If options cause additional shares to be issued, then buying back additional shares does not offset the effect of options. The money used for buyback comes from share holder money (retained earnings) and is is not free money. So do not accept that share buyback nullifies stock option dilution. In fact, it can make it worse. It induces management to buyback shares when the prices are not attractive. In effect, it doubles down the harm caused to share holder.
The worst kind: Reprice stock options: This is height of misalignment between share holder and investor. If you buy a share at $100 and it's price goes to $50, you lose $50. However, if an employee is offered stock options at $100 and if price goes to $50, the options are way under water. Unlike share owner who has put in capital, employee has put in his time and skill with the hope of benefiting on the upside. Since options are under water, he like share holder will at least not get any return until company's fortune reverses. But this equation is flipped upside down when the management suddenly decides to reprice the already outstanding stock options at $50. This means that if the stock now goes to $75, employee will benefit by $25 per option while share holder who purchased at $100 will lose $25. To add insult to injury, the lower the share price goes before repricing, more the profit for employee and more the expense for the share holder for those options. It simply means that 'Heads I win and Tails I win even more'. Many companies have moved away from this but not entirely. Recently Google repriced their stock options. Their logic likely is that they will lose talented employee if they do not reprice. I would say if you want to pay employee irrespective of stock price ('Heads I win, Tails I want to win still'), do not use options. Provide cash bonus and do not claim alignment with stock holder. Stock option reprice must be viewed with skepticism by investor and usually should reconsider being share holder.
Tell me how an excellant company will treat me ! Before we end, here is an excerpt from Berkshire owner's manual for some cooling of eyes.
o We will issue common stock only when we receive as much in
business value as we give. This rule applies to all forms of
issuance - not only mergers or public stock offerings, but stock
for-debt swaps, stock options, and convertible securities as
well. We will not sell small portions of your company - and that
is what the issuance of shares amounts to - on a basis
inconsistent with the value of the entire enterprise.
Since many company's use options, what can an investor do? It is not possible to totally avoid companies with options. So here are some thumb rules.
1. Stay away from the one's that use options excessively. Even if it means passing up some nice opportunities, you can sleep soundly. Plus there is likely to be other share holder unfriendly activities at the firm.
2. If a firm that does not offer stock options, consider it a shareholder friendly move. Provide weight in your analysis for share holder friendly firms. They need to trade at slight premium to rest (all other things being equal), since share holder can better benefit from wealth created by business.
3. Options can be used properly but is rare. I will not get into this subject since I do not believe that share holder friendly ways of using options will be devised. For those interested, please refer to Warren Buffet's 1985 annual report for suggestions.
4. Prefer companies with CEO or board members with significant stake in the company. You will need to filter out those where CEO's who already have significant stake but reward themselves with additional stock options.
4. How to value effect of options: At this time, companies are forced to value options and treat them as expense. Most use Black Scholes model with varying assumptions. Wall Street Journal's weekend edition (Jan 31, 2009) had a nice article. It stated that option expense is understated by Black scholes model if price of stock appreciates and overstates when price of stock falls. On the whole expensing options does provide investor some built in protection against overestimating earnings. I use a more conservative estimate. Here is how I do.
I aim to generate 14% return from a stock when I purchase including dividends (doubling in 5 years). That does not mean I do it! Lets say price is $50 at purchase and I sell at $100 after 5 years. To keep it simple, lets remove dividends for a minute.
Find the total stock options (say 1 million options) outstanding and their net weighted average strike price (say $35). This information is available in annual reports.
If all options are sold after 5 years, then cost is $65 per option ($100 - $35) after 5 years. So total is $65 million over 5 years. I divide by 5 years for yearly cost and apply tax benefit. This does not take into account time value of money. This usually turns out to be higher than the model but it makes me comfortable. If this is complex, use the model output and use bigger margin of safety.
Also, it will help to note Warren Buffet's comment on impact of stock options on earnings in his calculation. Note that this was written at a time (1998) when option expensing was optional. So now it does not apply completely now that is required to expense it. But provides a window from the Master!
"The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made."
5.The bigger problem is the fact that you do not know how much more stock options company will issue over the next few years of holding period, thereby diluting your holdings! This does create an issue for long term holders of stock.
Warren Buffet has dealt with stock options in 1985, 1992, 1998, 1999,2002, 2004, 2005, 2007 annual reports. Needless to say, it is a must read for those interested in options and seems to be pet subject for the investment guru. We will look at some of those reasoning below along with suggestions to deal with companies using options.
Basics of stock options offered to management as compensation: Managements are usually offered fixed price 10 year stock options. Essentially, the management has the right to buy the company stock at the strike price (usually market price) any time over the next 10 years after the vesting period is over. So if the company stock was $50 at the time of offer and was $100 after 5 years, management can buy the stock for $50 and hence can make a profit of $50. Similarly, if the stock price were to be $25, it has no value to the stock option holder.
So what's to worry about! Let's look at some reasons why stock options do not necessarily put stock option holder and share owner in the same boat.
Where's the downside risk? If the share price were to go to $25 in the above example, share holder lost 50% of his capital. There is no such capital risk for management. It is true that management has invested his/her time and skill with the hope of benefiting on the upside. But they do get base pay and other compensation for their efforts. Stock options are an added bonus for success. So for Stock holder, it is "Heads I win, Tails I lose" and for stock option holder, it is "Heads I win, Tails I did not lose or gain anything". So to summarize, both option holder and stock owner's downside are way different. In fact lack of downside for option holder, may set the stage for taking big risks because upside is great without associated huge downside. For stock owner, success on upside needs to be weighed against downside on failure. Why provide incentives to your management to bet big with your money?
Why does Management benefit from additional capital you add to business every year?
Lets say a company's Return on equity is 15% and no debt. Lets also say that it retains all it's earnings. If the equity per share is $100, company's earnings will be $15. This earnings belong to share holder. Management will deploy the retained earnings (that belongs to share holder) to create earnings growth. For example, management may add additional stores if it is fast growing retailer that contributes to earnings growth. So total capital now deployed next year is $115 per share and lets assume that the new store is as productive as the old store for simplicity. Then 15% return on equity would mean earnings this year will be $17.25 per share (Equity * ROE -->115 * 15/100). As you see, earnings growth between two years is exactly 15% (17.25-15/15). Now share price will appropriately move upwards. Share holder and option holder benefits from share price increase. But note that the management could not have caused earnings increase but for the addition of new store. The new store in turn needed capital which came from retained earnings (that belong to share holder). If share holder had withdrawn the earnings as dividends, where will the growth have come from? If so, the option holder must not benefit from this additional capital retained every year. It is true that management skill in opening and running new store (deploying new capital) is key. But that does not mean all earnings growth is due to management skill. It is ideally a combination of management skill and retained earnings. So one solution is to adjust the strike price for the new capital. I am not aware of many (if any) comapnies that do that. As a side note, it causes management to retain capital in businesses even when it is not wise to expand business operations!
Stock options are granted at market price and not at it's intrinsic value. Market price at the time of grant may or may not be near intrinsic value of a company. Most value investors understand that company's market price may be different from it's intrinsic value. If Mr. Market is in bad mood and prices the company much lower than it's intrinsic value at the time of option grant, then the person receiving option may benefit from market repricing at a future date. This may or may not be the direct result of anything management did. Similarly, the market gets into one of those heady bull markets, the option holder may benefit from general market levels moving higher. Neither of these scenarios are in control of either the management or the Board (who sets compensation). But in either case, the option holder (usually management) benefits for no fault (or work!) of his. Why reward someone for result that they did not produce. If you dont believe market price will be different from intrinsic value, here is one from the master. Mr. Buffet points out in 1985 annual report that when a CEO plans to sell the company or merge with other entity, CEO is unfailing to point out that market price understates the company's worth. Why give piece of your company at anything other than it's fair value ?
Capital allocation misalignment-Dividends Vs Stock buyback decision: Stock option based compensation hinder earnings to be allocated in the best interest of owner. Here is how. The earnings of a company that is left after routine maintenance and "growth projects" can be either distributed as dividends or be used to buy back company shares. For the options holder, anything that increases earnings per share is positive (which share repurchase does). Dividends do not increase earnings per share. Thus, stock option based compensation encourages stock repurchases over dividend without regard to market price of the share.
For a true owner, equation is way different. For the regular share holder, buying back shares makes sense only if the price of stock is less than the intrinsic value calculated conservatively. In other cases, dividends is much better option. In fact buying back high priced shares cause value destruction for the owner. It is like buying dollar bills for dollar and 30 cents.
Thus stock option based compensation encourages repurchase over dividends irrespective of what the share price is. This does not mean managements will always do it that way but why set an incentive that works against you (the owner!).
Why hire employee's whose salary is unknown: A company benefits if the financial benefit arising from services of an employee exceed the compensation paid. Otherwise it is a loss. This statement is true, whether you use cash or any other form of payment. Stock options uses company shares as currency to pay for employee services. It is a currency whose precise (or even approximate) cost is not known at the time of offer( more on this later). Since the cost of options is unknown, it is not easily possible to figure out whether the employee adds more value than the benefit he/she receives as stock options from the the company. Ironically, this is the same argument (cost of options is unknown) that many managements used to not expense stock options(!). But I would flip this argument and say, this is a good reason to use other forms of compensation when possible. May be a high cash bonus for achieving predetermined goals.
Why 10 year fixed price options without holding period requirement! Managements are usually granted 10 year fixed price options. That is, options can be exercised (any time after vesting period) over next 10 years but not required to hold the shares after exercising the options. First, why provide it for 10 years! As discussed before, the capital added in the form of retained earnings exceed the book value in some companies! The option holder benefits over a 10 year period without having a dime of capital at risk. It is true that many exercise their options before 10 years. To bring some balance, why not require holding period (say 2 to 3 years) for some part of the options exercised? Say 30% of the options need to be held for 3 to 5 years after exercise? It will provide some alignment.
Doesn't Share buyback cancels out effect of option dilution? This is the height of shareholder unfriendly activity. Share buy back costs money. If options cause additional shares to be issued, then buying back additional shares does not offset the effect of options. The money used for buyback comes from share holder money (retained earnings) and is is not free money. So do not accept that share buyback nullifies stock option dilution. In fact, it can make it worse. It induces management to buyback shares when the prices are not attractive. In effect, it doubles down the harm caused to share holder.
The worst kind: Reprice stock options: This is height of misalignment between share holder and investor. If you buy a share at $100 and it's price goes to $50, you lose $50. However, if an employee is offered stock options at $100 and if price goes to $50, the options are way under water. Unlike share owner who has put in capital, employee has put in his time and skill with the hope of benefiting on the upside. Since options are under water, he like share holder will at least not get any return until company's fortune reverses. But this equation is flipped upside down when the management suddenly decides to reprice the already outstanding stock options at $50. This means that if the stock now goes to $75, employee will benefit by $25 per option while share holder who purchased at $100 will lose $25. To add insult to injury, the lower the share price goes before repricing, more the profit for employee and more the expense for the share holder for those options. It simply means that 'Heads I win and Tails I win even more'. Many companies have moved away from this but not entirely. Recently Google repriced their stock options. Their logic likely is that they will lose talented employee if they do not reprice. I would say if you want to pay employee irrespective of stock price ('Heads I win, Tails I want to win still'), do not use options. Provide cash bonus and do not claim alignment with stock holder. Stock option reprice must be viewed with skepticism by investor and usually should reconsider being share holder.
Tell me how an excellant company will treat me ! Before we end, here is an excerpt from Berkshire owner's manual for some cooling of eyes.
o We will issue common stock only when we receive as much in
business value as we give. This rule applies to all forms of
issuance - not only mergers or public stock offerings, but stock
for-debt swaps, stock options, and convertible securities as
well. We will not sell small portions of your company - and that
is what the issuance of shares amounts to - on a basis
inconsistent with the value of the entire enterprise.
Since many company's use options, what can an investor do? It is not possible to totally avoid companies with options. So here are some thumb rules.
1. Stay away from the one's that use options excessively. Even if it means passing up some nice opportunities, you can sleep soundly. Plus there is likely to be other share holder unfriendly activities at the firm.
2. If a firm that does not offer stock options, consider it a shareholder friendly move. Provide weight in your analysis for share holder friendly firms. They need to trade at slight premium to rest (all other things being equal), since share holder can better benefit from wealth created by business.
3. Options can be used properly but is rare. I will not get into this subject since I do not believe that share holder friendly ways of using options will be devised. For those interested, please refer to Warren Buffet's 1985 annual report for suggestions.
4. Prefer companies with CEO or board members with significant stake in the company. You will need to filter out those where CEO's who already have significant stake but reward themselves with additional stock options.
4. How to value effect of options: At this time, companies are forced to value options and treat them as expense. Most use Black Scholes model with varying assumptions. Wall Street Journal's weekend edition (Jan 31, 2009) had a nice article. It stated that option expense is understated by Black scholes model if price of stock appreciates and overstates when price of stock falls. On the whole expensing options does provide investor some built in protection against overestimating earnings. I use a more conservative estimate. Here is how I do.
I aim to generate 14% return from a stock when I purchase including dividends (doubling in 5 years). That does not mean I do it! Lets say price is $50 at purchase and I sell at $100 after 5 years. To keep it simple, lets remove dividends for a minute.
Find the total stock options (say 1 million options) outstanding and their net weighted average strike price (say $35). This information is available in annual reports.
If all options are sold after 5 years, then cost is $65 per option ($100 - $35) after 5 years. So total is $65 million over 5 years. I divide by 5 years for yearly cost and apply tax benefit. This does not take into account time value of money. This usually turns out to be higher than the model but it makes me comfortable. If this is complex, use the model output and use bigger margin of safety.
Also, it will help to note Warren Buffet's comment on impact of stock options on earnings in his calculation. Note that this was written at a time (1998) when option expensing was optional. So now it does not apply completely now that is required to expense it. But provides a window from the Master!
"The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made."
5.The bigger problem is the fact that you do not know how much more stock options company will issue over the next few years of holding period, thereby diluting your holdings! This does create an issue for long term holders of stock.
Thursday, January 29, 2009
How to benefit from Retail companies
Retail is very competitive business and usually has very few competitive advantages. Many retail businesses have low operating margins and make their money by having high turnover of inventory. I view low operating margin for a business as low margin of safety for business errors. If that's the case, why bother playing this segment? The answer lies in some impressive gains if right retail business is acquired. Think buying Walmart even in late 80's! We will look at some factors that can maximize our success in finding good investments in this field.
First, I think there are broadly two types of retail businesses. One is pure play like Walmart or Target. Other is like Starbucks who manufacture a product and sell themselves. This analysis applies broadly to both. Lets first look at some good reasons as to why not to ignore this sector and then move to what to look for.
1. Judging growth potential: If a retail concept works in one city, it is likely to work out in other towns and cities in US. So growth potential can be evaluated with some level of certainity.
2. Easy to understand: It is fairly easy to understand how a retail business makes money. It is also possible to check out the retail locations and shop to get a feel for service, merchandise selection and whether you love or hate it!
Lets look now at what to watch out for. Usually, if you like a retail concept, you will need to evaluate if it has some intangible that cannot be easily copied like benefits of scale, first mover advantage, brand, low cost and excellant management. Assuming there is some barrier to entry and competitor's have not mushroomed, here are items to watch out for.
1. Look for companies in early stages of growth. This cannot be over stated in retail companies. The following will explain some of the reasons.
2. Same store sales: Market is usually fixated on same store sales growth of stores open at least 12 months. However, many retail locations take few years (5 years for Car Max) to mature and get to full potential. So for initial few years the same store sales growth of new stores ( older than 12 months but less than maturity age) will provide tail wind for this number. Once a store matures, it is difficult to maintain the same level of same store sales growth.
3. During initial growth years, earnings benefit from double-dip, delivered partly by new stores as well as same store sales growth (aided by stores approaching maturity but older than 12 months). The earnings growth will be a treat to watch and stock price will move accordingly. If you like the retail concept and are convinced that there is enough room to grow and like the management, buy when the company or market hits a snag and stock is on sale.
4. Management in early years: Management will have huge effect on the outcome in retail especially in early years. In early years, you want management who have business savvy in retail plus big stake in the company (a founder with big holdings in the business) is ideal. Think Sam Walton. In particular you need to be careful about compensation based managements who focus exclusively on earnings growth. Quick growth with leverage benefits management more than share holder. Leverage can come back to bite very quickly when economy goes through a cyclical downturn. Needless to say, you want Walmart or Star bucks rather than krispy Kreme. Look for managements who treat their business as their baby(if you are lucky to find one!) and who plan to grow steadily and with as less leverage as possible.
[As an aside, I find that CEO who are thrifty turn out to be good stewards of share holder money. I do not know why this is but seems to be a good attribute to watch for. Examples include Warren Buffet, Sam Walton, charlie Munger etc. In fact Warren Buffet likes this in a manager. He has mentioned about a manager looking for free parking spots when coming to sell his business. Needless to say, he was thrilled !]
5. Saturation: Bad word in retail! At some point the game runs out on new stores. At this time, usually management used to promising the sky need to think of soft landing. They need to think of slowing growth expectations and also focus more on dividends. Usually though managements do not do this. Blame it on Management compensation. Management compensation usually does not reward shareholder dividends as much as per share earnings growth.
So the story goes like this. They put up additional stores cannibalizing the sales of neighboring stores and provide a variety of good justifications. Management finds out that inevitable happens. New stores placed close to existing stores do not turn out to be that productive. In addition, at this point the same store sales growth slows because the newer stores (> 1 year but less than maturity age) are much smaller part compared to fully matured stores. A combination of these factors cause the earnings growth to slow. Market punishes crushingly. Management focusses on cost cutting next or try new lines of business!
6. Selling is not a bad thing! To avoid this fate, one needs to have an understanding what level of stores cause saturation. Look at similar retail outlets. When it is close, be satisfied with the profits and get out.
7. Value trap: In the final phase of a company, it is important to watch out for value traps. The retail company may look cheap based on past growth expectations. It is best avoided at this time unless the price is so cheap even assuming no future growth. In that case, you will benefit if any additional growth does turn out. If not, you may still get the one time benefit of market reevaluating the price. But usually it is better to avoid this cigar butt scenario.
Bottom line, focus on buying retail concepts with growth left in them. Do not forget to focus on price and excellant management. Also, avoid value traps towards the end. Watch how management compensation is set and if they have skin in the game (real money not funny money like options) so much the better.
Please leave your thougths....
First, I think there are broadly two types of retail businesses. One is pure play like Walmart or Target. Other is like Starbucks who manufacture a product and sell themselves. This analysis applies broadly to both. Lets first look at some good reasons as to why not to ignore this sector and then move to what to look for.
1. Judging growth potential: If a retail concept works in one city, it is likely to work out in other towns and cities in US. So growth potential can be evaluated with some level of certainity.
2. Easy to understand: It is fairly easy to understand how a retail business makes money. It is also possible to check out the retail locations and shop to get a feel for service, merchandise selection and whether you love or hate it!
Lets look now at what to watch out for. Usually, if you like a retail concept, you will need to evaluate if it has some intangible that cannot be easily copied like benefits of scale, first mover advantage, brand, low cost and excellant management. Assuming there is some barrier to entry and competitor's have not mushroomed, here are items to watch out for.
1. Look for companies in early stages of growth. This cannot be over stated in retail companies. The following will explain some of the reasons.
2. Same store sales: Market is usually fixated on same store sales growth of stores open at least 12 months. However, many retail locations take few years (5 years for Car Max) to mature and get to full potential. So for initial few years the same store sales growth of new stores ( older than 12 months but less than maturity age) will provide tail wind for this number. Once a store matures, it is difficult to maintain the same level of same store sales growth.
3. During initial growth years, earnings benefit from double-dip, delivered partly by new stores as well as same store sales growth (aided by stores approaching maturity but older than 12 months). The earnings growth will be a treat to watch and stock price will move accordingly. If you like the retail concept and are convinced that there is enough room to grow and like the management, buy when the company or market hits a snag and stock is on sale.
4. Management in early years: Management will have huge effect on the outcome in retail especially in early years. In early years, you want management who have business savvy in retail plus big stake in the company (a founder with big holdings in the business) is ideal. Think Sam Walton. In particular you need to be careful about compensation based managements who focus exclusively on earnings growth. Quick growth with leverage benefits management more than share holder. Leverage can come back to bite very quickly when economy goes through a cyclical downturn. Needless to say, you want Walmart or Star bucks rather than krispy Kreme. Look for managements who treat their business as their baby(if you are lucky to find one!) and who plan to grow steadily and with as less leverage as possible.
[As an aside, I find that CEO who are thrifty turn out to be good stewards of share holder money. I do not know why this is but seems to be a good attribute to watch for. Examples include Warren Buffet, Sam Walton, charlie Munger etc. In fact Warren Buffet likes this in a manager. He has mentioned about a manager looking for free parking spots when coming to sell his business. Needless to say, he was thrilled !]
5. Saturation: Bad word in retail! At some point the game runs out on new stores. At this time, usually management used to promising the sky need to think of soft landing. They need to think of slowing growth expectations and also focus more on dividends. Usually though managements do not do this. Blame it on Management compensation. Management compensation usually does not reward shareholder dividends as much as per share earnings growth.
So the story goes like this. They put up additional stores cannibalizing the sales of neighboring stores and provide a variety of good justifications. Management finds out that inevitable happens. New stores placed close to existing stores do not turn out to be that productive. In addition, at this point the same store sales growth slows because the newer stores (> 1 year but less than maturity age) are much smaller part compared to fully matured stores. A combination of these factors cause the earnings growth to slow. Market punishes crushingly. Management focusses on cost cutting next or try new lines of business!
6. Selling is not a bad thing! To avoid this fate, one needs to have an understanding what level of stores cause saturation. Look at similar retail outlets. When it is close, be satisfied with the profits and get out.
7. Value trap: In the final phase of a company, it is important to watch out for value traps. The retail company may look cheap based on past growth expectations. It is best avoided at this time unless the price is so cheap even assuming no future growth. In that case, you will benefit if any additional growth does turn out. If not, you may still get the one time benefit of market reevaluating the price. But usually it is better to avoid this cigar butt scenario.
Bottom line, focus on buying retail concepts with growth left in them. Do not forget to focus on price and excellant management. Also, avoid value traps towards the end. Watch how management compensation is set and if they have skin in the game (real money not funny money like options) so much the better.
Please leave your thougths....
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