Wednesday, August 26, 2015

Another Market Crisis? My Survival Manual/Journal!

I would be lying if I said that I like down markets more than up markets, but I have learned to accept the fact that markets that go up will come down, and that when they do so quickly, you have the makings of a crisis. I find myself getting more popular during these periods, as acquaintances, friends and relatives that I have not heard from in years seem to find me. They are  invariably disappointed by my inability to forecast the future and my unwillingness to tell them what to do next, and I am sure that I move several notches down the Guru scale as a consequence, a development that I welcome. To save myself some repetitions of this already tedious sequence, I think it is best that I pull out my crisis survival journal/manual, a work in progress that I started in the 1980s and that I revisit and rewrite each time markets go into a tailspin. It is more journal than manual, more personal than general, and more about me than it is about markets. So, read on at your own risk!

The Price of Risk
For me, the first casualty in a crisis is perspective, as I find myself getting whipsawed with news stories about financial markets, each more urgent and demanding of attention than the previous one. The second casualty is common sense, as my brain shuts down and my primitive impulses take over. Consequently, I find it useful to step back and look at the big picture, hoping to see patterns that help me make sense of the drivers of market chaos.

It is my view that the key number in understanding any market crisis is the price of risk. In a market crisis, the price of risk increases abruptly, causing the value of all risky assets to drop, with that drop being greater for riskier assets. While the conventional wisdom, prior to 2008, was that the price of risk in mature markets is stable and does not change much over short periods, the last quarter of 2008 changed (or should have changed) that view. I started tracking the price of risk in different markets (equity, bond, real estate) on a monthly basis in September 2008, a practice that I have continued through the present. Getting an a forward-looking, dynamic price of risk in the bond market is simple, since it takes the form of default spreads on bonds, and FRED (the immensely useful Federal Reserve Database) has the market interest rates on a Baa rated (Moody's) bonds going back to 1919, with data available in annual, monthly or daily increments. That default spread is computed by taking the difference between this market interest rate and the US treasury bond rate  on the same date. Getting a forward-looking, dynamic price of risk in the equity markets is more complicated, since the expected cash flows are uncertain (unlike coupons on bonds) and equities don't have a specific maturity date, but I have argued that it can be done, though some may take issue with my approach. Starting with the cumulative cash flow that would have generated by investing in stocks in the most recent twelve months, I estimate expected cash flows (using analysts' top down estimates of earnings growth) and compute the rate of return that is embedded in the current level of the index. That internal rate of return is the expected return on stocks and when the US treasury bond rate is netted out, it yields an implied equity risk premium. The January 2015 equity risk premium is summarized below:
Implied ERP Spreadsheet (January 2015)
That premium had not moved much for most of this year, with a low of 5.67% on March 1, and a high of 6.01% in early February, and the ERP at the start of August was 5.90%, close to the start-of-the-year number. Given the market turmoil in the last weeks, I decided to go back and compute the implied equity risk premium each day, starting on August 1.
ERP By Day
Note that not much changes until August 17, and that almost all of the movement have been in the days between August 17 and August 245 During those seven trading days, the S&P 500 dropped by more than 11% and if you keep cash flows fixed, the expected return (IRR) for stocks increased by 0.68%. During the same period, the US treasury bond rate dropped by 0.06%, playing its usual "flight to safety" role, and the implied equity risk premium (ERP) jumped by 0.74% to 6.56%. 

I did use the trailing 12-month cash flows (from buybacks and dividends) as my base year number, in computing these equity risk premiums, and there is a reasonable argument to be made that these cash flows are too high to sustain, partly because earnings are at historic highs and partly because companies are returning more of that cash than ever before. To counter this problem, I assumed that earnings would drop back to a level that reflects the average earnings over the last 10 years, adjusted for inflation (i.e., the denominator in the Shiller CAPE model) and that the payout would revert back to the average payout over the last decade. That results in lower equity risk premiums, but the last few days have pushed that premium up by 0.53% as well.

My computed increases in ERP, using both trailing and normalized earnings, overstate the true change, because the cash flows and growth were left at what they were at the start of August, a patently unrealistic assumption, since this is also an economic crisis, and any slowing of growth in China will make itself felt on the earnings, cash flows and growth at US companies. That effect will take a while to show up, as corporate earnings, buyback plans and analyst growth estimates are adjusted in the months to come, and I am sure that some of the market drop was caused by changes in fundamentals. The argument that a large portion of the drop comes from the repricing of risk is borne out by the rise in the default spread for bonds, with the Baa default spread widening by 0.17%, and the increase in the perceived riskiness (volatility) of stocks, with the VIX posting its largest weekly jump ever, in percentage terms.

The Repricing of Risky Assets
When the price of risk changes, all risky assets will be repriced, but not by the same magnitude. Within mature markets, you should expect to see a bigger drop in stock prices at more risky companies than at safer ones, though how you define risk can affect your conclusions. If you define risk as exposure to the the precipitating factor in the crisis, I would expect the stock prices of  companies that are more dependent on China for their revenues to drop by more than the rest of the market. Since I don't have data on how much revenue individual companies get from China, I will use commodity companies, which have been aided the most by the Chinese growth machine over the last decade and therefore have the most to lose from it slowing down, as my proxy for China exposure. The table below highlights the 20 industry groups (out of 95) that have performed the worst between August 14 and August 24:


Notice that commodity companies comprise one quarter of the group, with a few cyclical and technology sectors thrown into the mix.

Looking across markets geographically, changes in the equity risk premium in mature markets will be magnified as you move into riskier countries and thus it is not surprising to see the carnage in emerging markets over the last week has exceeded that in developed markets, with currency declines adding to local stock market drops.

Percentage Return in US dollar terms
In the picture below, I capture the percentage change in market capitalizations between August 14, 2015, and August 24, 2015 in U.S. $ terms, with the PE ratios as of August 14 and August 24 highlighted for each country:

via chartsbin.com
Note that this phenomenon of emerging markets behaving badly cannot be blamed on China, since it happened in 2008 as well, when it was the banking system in developed markets that triggered the market rout.

A Premium for Liquidity?
There is another dimension, where crises come into play, and that is in the demand for liquidity. While investors always prefer more liquid assets to less liquid ones, that preference for liquidity and the price that they are willing to pay for it varies across time and tends to surge during market crisis. To see if this crisis has had the same effect, I looked at the drop in market capitalization, in US $ terms, between August 14 and 24 for companies classified by trading turnover ratios (computed by dividing the annual dollar trading value by the market capitalization of the company):
Liquidity classes, based on turnover ratio = $ Trading Value/ $ Market Cap
Surprisingly, it is the most liquid firms that have seen the biggest drop in stock prices, though the numbers may be contaminated by the fact that trading halts are often the reactions to market crises in many countries, that are home to the least liquid stocks. If this is the reason for the return divergence, there is more pain waiting for investors in these stocks as the market drop shows up in lagged returns.

To the extent that market crises crimp access to capital markets, the desire for liquidity can also reach deeper into corporate balance sheets, creating premiums for companies that have substantial cash on their balance sheets and fewer debt obligations. To test this proposition, I classified firms globally, based upon the net debt as a percent of enterprise value, and looked at the price drop between August 14 and August 24:
Net Debt/EV = (Total Debt- Cash)/ (Debt + Market Cap - Cash)
The crisis seems to have spared no group of stocks, with the pain divided almost evenly across the net debt classes, with the largest price decline being in the stocks that have cash balances that exceed their debt. Note, however, that the multiples at which these companies trade at both prior and after the drop, reflect the penalty that the market is attaching to extreme leverage, with the most levered companies trading at a PE ratio of 3.11 (at least across the 15.76% of firms in this group that have positive earnings to report). If your contrarian strategy for this market is to screen for and buy low PE stocks, this table suggests caution, since a large portion of the lowest PE stocks will come with high debt ratios.

As the public markets drop, the question of how this crisis will affect private company valuations has risen to the surface, especially given the large valuations commanded by some private companies. Since many of these private businesses are young, risky startups and that investments in them are illiquid, I would guess they will be exposed to a correction,  larger than what we observe in the public marketplace. However, given that venture capitalists and public investors in these companies will be self appraising the value of their holdings, the effect of any markdown in value will take the form of fewer high-profile deals (IPO and VC financing).

What now?
A market crisis bring out my worst instincts as an investor. First out of the pack is fear pushing me to panic, with the voice yelling "Sell everything, sell it now", getting louder with each bad market day. That is followed quickly by denial, where another voice tells me that if I don't check the damage to my portfolio, perhaps it has been magically unaffected. Then, a combination of greed and hubris kicks in, arguing that the market is filled with naive, uninformed investors and that this is my time to trade my way to quick profits. I cannot make these instincts go away, but I have my own set of rules for managing them. (I am not suggesting that these are rules that you should adopt, just that they work for me..)
  1. Break the feedback loop: Being able to check your portfolio as often as you want and in real time, with our phones, tablets and computers, is a mixed blessing. I did check my portfolio this morning for the damage that the last week has done, but I don't plan to check again until the end of the week. If I find myself breaking this rule, I will consider sabotaging my wifi connection at home, going back to a flip phone or leaving for the Galapagos on vacation.
  2. Turn off the noise: I read the Wall Street Journal and Financial Times each morning, but I generally don't watch financial news channels or visit financial websites. I become religious about this avoidance during market chaos, since much of the advice that I will get is bad, most of the analysis is after-the-fact navel gazing and all of the predictions share only one quality, which is that they will be wrong. 
  3. Rediscover your faith: In my book (and class) on investment philosophies, I argue that there is no "best' investment philosophy that works for all investors but that there is one for you, that best fits what you believe about markets and your personality. My investment philosophy is built on faith in two premises, that every business has a value that I can estimate, and that  the market price will move towards that value over time. During a crisis, I find myself returning to the core of that philosophy, to make sense of what is going on.
  4. Act proactively and consistently: It is natural to want to act in response to a crisis. I am no exception and I did act on Monday, but I tried to do so consistently with my philosophy. I revisited the valuations that I have done over the past year (and you can find most of them on my website, under my valuation class) and put in limit buy orders on a half a dozen stocks (including Apple, Tesla and Facebook), with the limit prices based on my valuations of the companies. If the crisis eases, none of the limit orders may go through, but I would have protected myself from impulsive actions that will cost me more in the long term. If it worsens, all or most of the of the limit buys will be executed, but at prices that I think are reasonable, given the cash flow potential of these companies.
Will any of these protect me from losing money? Perhaps not, but I did sleep well last night and am more worried about whether the New York Yankees will score some runs tonight than I am about what the Asian markets will do overnight. That, to me, is a sign of health!
The Silver Linings
Just as recessions are a market economy's way of cleansing itself of excesses that build up during boom periods, a market crisis is a financial market's mechanism for getting back into balance. I know that is small consolation for you today, if you have lost 10% or more of your portfolio, but there are seedlings of good news, even in the dreary financial news:
  1. Live by momentum, die by itIn trading, momentum is king and investors who play the momentum game make money with ease, but with one caveat. When momentum shifts, the easy profits accumulated over months and years can be wiped out quickly, as commodity and currency traders are discovering.
  2. Deal or no deal? If you share my view that slowing down in M&A deals is bad news for deal makers, but good news for stockholders in the deal-making companies, the fact that this crisis may be imperiling deals is positive news.
  3. Rediscover fundamentals: My belief that first principles and fundamentals ultimately win out and that there are no easy ways to make money is strengthened when I read that carry traders are losing money, that currency pegs do not work when inflation rates deviate, and mismatching the currencies in which you borrow and generate cash flows is a bad idea.    
  4. The Market Guru Handoff: As with prior crises, this one will unmask a lot of economic forecasters and market gurus as fakes, but it will anoint a new group of prognosticators who got the China call right as the new stars of the investment universe. 
If a market crisis is a crucible that tests both the limits of my investment philosophy and my  faith in it, I am being tested and as with any other test, if I pass it, I will come out stronger for the experience. At least, that is what I tell myself as I look at the withered remains of my investments in Vale and Lukoil!

Spreadsheets

Monday, August 24, 2015

My Valuation Class: The Fall 2015 Model Preview

It is almost September and as the academic clock resets for a new year,  I get ready to teach a new valuation class. With three hundred registered students, it is about as diverse a class as any I have every taught, with a mix of full-time  and part-time MBA students, law and engineering graduate students and a few dozen undergraduates. And with a market meltdown framing discussions, it will be interesting to see how the class plays out. As always, I cannot wait for the class to start and as I have, each semester, for the last few years, I invite you to follow the class, if you are so inclined. 

Setting the table
Valuation is an intimidating title for a class, stirring up visions (and nightmares) about spreadsheets, accounting statements and financial theory. This may be the default version of the class and it serves experts in the topic well to preserve this air of mystery and intimidation. I have neither the expertise nor the desire to  teach such a class, and I hope that you will not only take my class, no matter what your background and experience, but that you will also learn to enjoy valuation as much as I do. The best way for me to start describing my class is to tell you what it is not about, rather than what it covers. So, here we go: 
  1. It is not an accounting class: Much of the raw data in my valuations comes from accounting statements, but once I get that raw data, I lose interest in the rest of the accounting details. In fact, one of my first in-practice webcasts (short webcasts about practical issues in valuation) uses the Procter and Gamble 10K to illustrate how little of a typical accounting filing gets used in valuation and how much is irrelevant or useless. I admire people who can forecast our full financial statements (income statements, balance sheets and cash flow statements) decades out, but I have never ever felt the urge to do so and I am not sure that I have the accounting skills to even do so.
  2. It is not a modeling class: As someone who did his first valuation on an old fashioned columned paper sheet with a calculator, I have mixed feelings about spreadsheets, in general, and Microsoft Excel, in particular. I like the time that I save in computational details, but I have to weigh that against the time I lose, playing pointless what-if games with the data that I would never have considered in my calculator days. I admire Excel Ninjas but I have also seen what happens when analysts become the spreadsheet's tools, rather than the other way around. Needless to say, I have never taught a session (let alone a class) built around Excel spreadsheets, though I have no qualms about using one to illustrate fundamental valuation principles.
  3. It is not a financial theory class: To be able to teach this class at a research university, I had to go through the rites of passage of a Finance doctoral student,  traversing the path that finance has followed, starting with Harry Markowitz and modern portfolio theory, moving through its Greek phase (with alphas and betas dominating the conversation first and then leading on to the expropriation of the rest of the Greek alphabet by the options theorists) to the counter-revolutionaries of behavioral finance. Unlike some who make you choose whether you are for financial theory or against it, I view it as a buffet, where I can partake on the portions of the theory that I find useful and leave behind that which I do not. In my valuation class, in particular, I would be surprised if I spent more than 5% of my time on financial theory, and if I do, it is only because I am trying to get to some place more interesting.
Now that I have established what the class is about, let me lay out the five themes around which this class is built. 
  1. Valuation is a craft, not an art or a science: I start my class with a question, "Is valuation an art or a science?", a trick since the answer, in my view, is neither. Unlike physics and mathematics, indisputably sciences with immutable laws, valuation has principles but none that meet the precision threshold of a science. At the other extreme, valuation is not an art, where your creative instincts can guide you to wherever you want to go and geniuses can make up their own rules. I believe that valuation is a craft, akin to cooking and carpentry, and that you learn what works and what does not by doing it, not by reading or listening to others talk about it. That is the reason that each week during the course of the semester, I post my valuation of a company, with a Google shared spreadsheet for everyone in the class to try their hand at valuing the same company and coming to a very different conclusion than I do.
  2. Valuing an asset is different from pricing it: I will not bore you by repeating this distinction that I drew first in this post but have returned to over and over again. It is my belief that much of what passes for valuation, in practice, is really pricing, sometimes disguised as valuation and sometimes not, but I also think that there is nothing wrong with pricing an asset, if that is what your job entails. Thus, though the bulk of this class is built around intrinsic value and its determinants, a significant portion of the class is dedicated to better pricing techniques, through the judicious use of multiples, comparable assets and statistics.
  3. Anything can be priced and most almost anything can be valued: This may be stubborn side speaking, but I have always believed that you can value any cash-flow generating asset (as I have attempted to, in these posts on valuing tracking stock on a professional athlete, a sports team, a trophy asset and young companies) and that you can price any asset (as I tried to to, in these posts on Gold and Bitcoins). While this class is centered around valuing publicly traded companies, I deviate from that script often enough, that by the end of the class, you should be able to value and price any asset.
  4. Valuation = Story + Numbers: As readers of this blog, you have heard me get on the soapbox often enough, but to me the essence of valuation is connecting stories to numbers. As I noted in this most recent post of mine, this requires me to push people out of their comfort zones, encouraging numbers people to tell more stories and stories people to work more with numbers. No matter how far on either end of the numbers/ story spectrum you are, I think that no one is beyond reach.
  5. Valuation without action is pointless: I have never felt the need to use a case study in my valuation class or value a widget company in my class, because I not only find valuing real companies  in real time more interesting, but I can act on my own valuations and I usually do, though not always with conviction. Investing requires faith in both your capacity to value companies and in markets correcting over time and I try to let people see both the source of my faith and challenges to that faith. 
I did put together a short (about two minutes) YouTube video of my class that summarize my perspective on this class. 

So, both number crunchers and story tellers, welcome to the class and we can learn from each other!

Prepping for the class
As a realist, there are a few skills that will stand you in good stead in this class and none of these skills are difficult to acquire.
  1. Read financial statements: For better or worse, our raw data comes from accounting statements and you need to be able to navigate your way through these statements. If you have a tough time deciphering the difference between gross, operating and net income, and don't quite understand what goes into book value of equity, you will have a tough time valuing companies. Don't remember your accounting classes? Don't want to go back there? Never fear! I have a primer on accounting that takes you through the absolute basics (which is about all I know anyway) and you can get to it by clicking on this link.
  2. Understand basic statistics: Statistics, I was taught in my first class, is designed to help us make sense of large and contradictory data. Since that is precisely our problem in pricing assets today, i.e., that we have too much data pulling us in too many directions, it may be time to dust off that statistics book (I hope that you did not sell it back or burn it after your last statistics class) and reacquaint yourself with simple statistics. So, start with the averages, medians and standard deviations, move on to correlations and regressions and if you can handle it, to statistical distributions. If you are lost, try this link for my statistics primer.
  3. Get comfortable with rudimentary finance: I have always found it unfair that to take some classes, you have to take the equivalent of a lifetime in pre-requisites. While having taken a corporate finance class eases the way in valuation, it is not required, nor is any other finance course. That said, your life will be easier if you have nailed down the basics of time value of money and computing present value, as well as understand the roots of modern portfolio theory, even if you don 't quite get the specifics. This link has my time value of money primer.
Getting down to Specifics
It's taken me a while to get to specifics, but the class starts on September 2, 2015 and classes are every Monday and Wednesday from 10.30 am -11.50 am (with Sept 7, 14 and 23 being holidays) until December 14. The calendar for the class is available at this link.  The class content will follow a familiar path, starting with a big picture perspective on valuing/pricing, followed by intrinsic valuation (DCF), relative valuation (pricing and multiples), asset-based valuation (accounting, liquidation & sum of the parts) and it will end with real options. There will be two add-on sessions on acquisition valuation and value enhancement.

If you are one of the 300 registered in the class, I hope to see you in class. If not, the classes will be recorded and webcast, usually by the end of each session day, and there are three forums you can use to follow the class:
  1. My website: Everything I do in this class will be accessible on this page for the class. As you will notice on the page, you can not only access the webcasts for the lectures, but you can download the lecture notes, try your hand at the valuations of the week and even take quizzes/exams (though you have to grade them yourself). If you want, you can read the emails that I send to the class at this link
  2. iTunes U: This has become one of my favorite platforms for delivering my class and it works flawlessly, if you have an Apple device, with an iPad providing a much better experience than an iPhone. (You have to download the iTunes U app, but it is free and the learning curve is barely uphill.)  However, you can tweak it to work on an Android, with an add-on app. This semester's version will be available at this link.
  3. YouTube: This was my add-on platform last semester and while it was never intended for delivering full classes, it worked surprisingly well. The webcasts come naturally to it, though the 80 minutes is a stretch, but I will add on the presentation material and the post-class tests to the webcasts to supplement them. This semester, the lectures and supporting material will be found at this channel.
Alternate Pathways
This is not the first time that I have put my classes online and this may not be the first time that you have thought about taking this particular class. As with other online classes, I know that life gets in the way, with family and work commitments taking priority, as they should, over an online valuation class that provides no credit or certification. You can follow one of the following four paths, each requiring more time and brain commitment than the prior one:
  1. Watch an occasional lecture or lectures: Rather than watch all 26 lectures, you can pick and choose a few on the topics that interest you the most. This strategy works best for those who cannot commit the time and/or are already experienced enough in valuation that they need just a brushing up of skill sets. 
  2. Watch every lecture, do post class tests/solutions: You could watch every lecture, a significant time commitment at 80 minutes apiece, and do just the post-class tests (designed to take about 5-10 minutes). Remember that you don't have to take this in real time, since the course will stay online for at least a year.
  3. Watch lectures and take quizzes/exam: In addition to watching the lectures, you can put your knowledge to the test and take the quizzes and final exam. I will post my solutions with a grading template and you can grade yourself (My advice: Be an easy grader!). Since the exams are all open-book, open-notes all you have to do is honor the time constraint (30 minutes for quizzes, 2 hours for the final).
  4. Watch lectures, take quizzes exam & value a company: In addition to doing all of the tasks in the prior path, you also pick a company to value (just as everyone else in my class will be) and try to apply what you learn in the class in that valuation. Unfortunately, there is little chance that I can offer you the feedback that I offer to those in my class, but I will try to answer a question or two, if you are stuck, and will provide my feedback template, when the time comes due.
If all of these pathways all sound like too much work/time commitment and/or watching 80 minute videos of valuation lectures on your phone or tablet is not your idea of fun, I do have an alternative. Try my online valuation class, where the sessions are about 10-15 minutes apiece, on my website, YouTube or iTunes U
Pass on it or pass it on!
If you try the class and don't like it, I will not be offended and I am sure that you will find a better use for  your time. If you try the class and you like it, I would like something in return. Please pass on a bit of what you know or have learned to at least one other person, and perhaps more. Knowledge is one of the few things in life that we can share, without being left poorer for the sharing, and while the return on this investment will be not be financial, the emotional dividends will make it worthwhile. 

Attachments

Friday, August 21, 2015

Beijing Blunders: Bull in a China Shop!

I have generally steered from using my blog as a vehicle for rants, not because I don't have my share of targets, but because I know that while ranting makes me feel better, it almost always creates more costs than benefits. It is true that I have had tantrums (mini-rants) about the practice of adding back stock-based compensation to EBITDA or expensing R&D to get to earnings, but the targets of those tend to be harmless. After all, what can sell-side  equity research analysts or accountants collectively do to retaliate? Refuse to send me their buy and sell recommendations? Threaten me with gang-audits?

This post is an exception, because the target of the rant is China, a much bigger and more powerful  adversary than those in my mini-rants, and it is only fair that I let you know my priors before you read this post. First, I am hopelessly biased against the Chinese government. I believe that its reputation for efficiency and economic stewardship is inflated and that its thirst for power and money is soft-pedaled. Second, I know very little about the Chinese economy or its markets, how they operate and what makes them tick. It it true that some of my ignorance stems from the absence of trustworthy information about the economy but a great deal of it comes from not spending any time on the ground in China. So, if you disagree with this post, you have good reason to dismiss it as the rant born of ignorance and bias. If you agree with it, you should be wary for the same reasons.

The Chinese Economic Miracle: Real or Fake?
For the last two decades, the China story has been front and center in global economics, and with good reason. In the graph below, you can see the explosive growth in Chinese GDP, measured in Chinese Yuan and US dollars:


The Chinese economy grew from being the eighth largest in the world in 1994 to the second largest in the world in 2014. It is true that many of the statistics that we use for China come from the Chinese government and there are is reason to question its reliability. In fact, there are some with conspiratorial inclinations who wonder whether the Chinese miracle is a Potemkin village, designed for show. Much as my bias would lead me down this path, there are some realities on the ground that are impossible to ignore:
  1. The China growth story is real: Any one who has visited China will tell you that the signs of real growth are around you, especially in urban China. It is not just the physical infrastructure of brand new airports, highways and high-speed trains, but the signs of prosperity among (at least some of) its people. I did my own experiment yesterday that confirmed the reality of Chinese growth. After I woke up to the alarm on my China-made iPhone, I put on my Nike exercise clothes, manufactured in China, slipped on my Asics running shoes, also from China. As I went through the day, it was easier for me to keep track of the things that were not made in China than those that were. Based just on that very unscientific sampling, I am willing to believe that China is the world's manufacturing hub.
  2. It has a Beijing puppet-master: To those who celebrate the growth of the Chinese economy as a triumph of free markets, I have to demur. The winners and losers in the Chinese economy are not always its best or most efficient players and investment choices are made by policy makers (or politicians) in Beijing, not by the market. There are those who distrust markets who would view this as good, since markets, at least in their view, are short term, but trusting a group of experts to determine how an economy should evolve can be even more dangerous.
  3. It is driven by infrastructure investment, not innovation: The Chinese economy is skilled at copying innovations in other parts of the world, but not particularly imaginative in coming up with its own. It is revealing that the current vision of innovation in China is to have a CEO dress up like Steve Jobs and make an Android phone that looks like the iPhone. Note that this should not be taken as a reflection of the Chinese capacity to be innovative but a direct consequence of centralized policy (see prior point). 
  4. The China story is now part of every business: In just the last month and a half, I have been in the US, Brazil and India, and can attest to the fact that the China story is now embedded in companies across the globe. In the US, I saw Apple report good earnings and lose $100 billion in market capitalization, with some attributing the drop to disappointing results from China. In Brazil, my Vale valuation rests heavily on how China does in the future, because China accounts for 37% of Vale's revenues and the surge in iron ore prices in the last decade came primarily from Chinese infrastructure investment. In India, I valued Tata Motors, whose acquisition of Jaguar , has made them more of a Chinese company than an Indian one, dependent on the Chinese buying oversized Land Rovers for a significant portion of their profits. 
  5. It is also a weapon of mass distraction: In a post from a few months ago, I talked about weapons of mass distraction, words that analysts use to induce you to pay premiums  for companies and to distract you from specifics. In that post, I highlighted "China" as the ultimate wild card, with mention of exposure to the country operating as an excuse for pushing up the stock price. The problems with wild cards though is that they are unpredictable, and it is entirely possible that the China card may soon become a reason to discount value, as the handwringing about earnings effects and corporate exposures of the China crisis begins.  
The Chinese Markets: All Pricing, all the time!
If you have been reading the news for the last few months, which have been about the epic collapse of Chinese stocks, I would not blame you for feeling sorry for investors in the Chinese market. I would suggest that you save your sympathy for more deserving causes, because as with everything else in markets, it depends on your time perspective. In the chart below, I look at three charts that look at the Shanghai Composite over time:
Shanghai Composite
It is undeniable that markets have been melting down since June, with the Shanghai Composite down 32% from its peak on June 12. However, if you had invested in Chinese stock at the start of this year, you have no reason to complain, with a return of 8.44% for the year to date, among the best-performing markets globally.  Stepping even further back, if you had invested in Chinese stocks in 2005, you would have earned close to 13$ as an annual return each year, with all the ups and downs in between.

In earlier posts, I have drawn a contrast between valuation and pricing and why a healthy market need both investors (who buy or sell businesses based on their perceptions of the values of these businesses) and traders (who buy and sell assets based on what they think others will pay for them). A market dominated mostly by investors will quickly become illiquid and boring, and ironically reduce the incentives to collect information and value companies. A market dominated by traders will be volatile, with price movements driven by mood, momentum and incremental information, and will be subject to booms and busts. I would characterize the Chinese stock market as a pricing market, where traders rule and investors have long since fled or have been pushed out. While there are some who will attribute this to China being a young financial market, and others to cultural factors, I believe that it is a direct consequence of self-inflicted wounds.
  1. Investor restrictions: There is perhaps no more complicated market to trade in than the Chinese markets, with most Chinese companies having multiple classes of shares: Class A shares,  and traded primarily on the mainland, denominated in Yuan, Class B shares, denominated in US $, traded on the mainland and Class H shares, traded in Hong Kong, denominated in HK$. The Chinese government imposes tight restrictions on both domestic investors (who can buy and sell class A shares and class B shares, but only if they have legal foreign currency accounts, but cannot trade in class H shares) and foreign investors (who can buy and sell only class B and class H shares). As a consequence of these restrictions, investors are forced into silos, where shares of different classes in the same company can trade at different prices and governments can keep a tight rein on where investors put their money. Note also that the highest profile technology companies in China, like Baidu and Alibaba, create shell entities (variable interest entities or VIEs) and list themselves on the NASDAQ, making them effectively off-limits to domestic investors.
  2. Opaque financials and poor corporate governance: While China has moved towards adopting international accounting standards, Chinese companies are not doyens of disclosure, often holding back key information from investors. It is therefore not surprising that almost 10% of all securities class action litigation in the US between 2009 and 2013 was against Chinese companies listed in the US, that variable interest entities hold back key information and that non-Chinese companies like Caterpillar and Lixil have had to write off significant portions of their Chinese investments, as a result of fraud. This non-disclosure problem is twinned with corporate governance concerns at Chinese companies, where shareholders are viewed more as suppliers of capital than as part-owners of the company.
  3. Markets as morality plays: The nature of markets is that they go up and down and it is that unpredictability that keeps the balance between investors and traders. In China, the response to up and down markets is asymmetric. Up markets are treated as virtuous and traders who push up stock prices (often based on rumor and greased with leverage) are viewed as "good" investors. Down markets are viewed as an affront to Chinese national interests and not only are there draconian restrictions on bearish investors (restrictions on short selling, trading stops) but investors who sell stock are called traitors, malicious market manipulators or worse. Thus, the same Chinese government that sat on its hands as stock prices surged 60% from January to June has suddenly discovered the dangers of volatility in the last few weeks as markets have given up much of that gain.   
The bottom line is that the Chinese government neither understands nor trusts markets, but it needs them and wants to control them. By restricting where investors can put their money, treating short sellers as criminals and market drops as calamities, the Chinese government has created a monster, perhaps the first one that does not respond to its dictates. The current attempt to stop the market collapse, including buying with sovereign funds, putting pressure on portfolio managers, name calling and sloganeering may very well succeed in stopping the bleeding, but the damage has been done.

Moneyball in China
The best cure for bias and ignorance is data and I decided that the first step in ridding myself of my China-phobia would be a look at how Chinese stocks are being priced in the market today. The essence of value investing is that at the right price, any company (including a Chinese company with opaque financials and non-existent corporate governance) can be a good investment and it is possible that the drop in stock prices in the last few months has made Chinese stocks attractive enough for the rest of us.

To make these comparisons, I used the market price data as of August 19, 2015, to estimate market capitalization and enterprise values. For the accounting data, I used the numbers from the trailing 12 months, generally the 12 months ending mid-year 2015, for most companies. The first comparison was on pricing multiples:

I compared China with India, Brazil and Russia, the three other countries that have been lumped together (awkwardly, in my view) as the BRIC,  as well as with the rest of the emerging markets. For comparisons, I also looked at the US and the rest of the developed markets (where I included Japan, Western Europe, Australia, Canada and New Zealand). In spite of the drop in stock prices in the last few months, Chinese stocks are collectively more expensive than stocks anywhere else in the world.

To measure the profitability of Chinese companies, I looked at three measures of margin (EBITDA, Operating Income and Net Income) and three measures of return (Return on Equity and Return on Invested Capital):

Chinese companies lag the rest of the world, when it comes to EBITDA and operating margins, but do better than other emerging market companies on net margins. On returns on equity and invested capital, Chinese companies are more profitable than Brazilian companies (reflecting the economic downturn in Brazil in the last year) but are pretty much on par with the rest of the world.

One reason for the superior net margins at Chinese companies is that they tend to borrow less than companies elsewhere in the world, perhaps the only bright light in these comparisons.


That may be at odds with some of what you may be reading about leverage in China, but it looks like the debt in China is either more in the hands of local governments or is off balance sheet.

Finally, if the straw that you are grasping for is higher growth in China, there is some backing for it when you compare growth rates across companies, but only in analyst expectations, rather than in growth delivered:

It is true that this market-level look at China may be missing bargains at the sector level and to remedy that, I looked at PE ratios and EV/EBITDA multiples regionally, by industry grouping. The industry-average values, classified by region, can be downloaded here, but across the ninety five industry groupings, Chinese companies have the highest PE ratios in the world in fifty and the highest EV/EBITDA multiples in fifty eight. You could dig even deeper and look at company-level data and you are welcome to do so, using the complete dataset here.

Overall, I am hard pressed to make a case for investing in Chinese stocks, if you have a choice of investing in other markets, even after the market drop of the last few months. If you are a domestic investor in China, your choices are more restricted, and you may very well be forced to stay in this market. It is interesting that India and China, two markets that restrict domestic investors from investing outside the country, are the two most richly priced.

Conclusion
As I confessed up front, I am not a China hand and don't claim any macro or market forecasting skills, but my experience with company valuation and pricing lead me to make the following predictions for China.
  1. Slower real growth: If I were a betting man, I would be willing to take a wager that the expected real growth rate in the Chinese economy will be closer to 5% a year for the next decade than to the double-digit growth that we have been programmed to expect. That may strike you as pessimistic, after the growth of the last two decades, but just as size eventually catches up with companies, the Chinese economy is getting too big to grow at the rates of yesteryear. The question, for me, is not whether this will happen but how the Chinese government will deal with the lower growth. While the sensible option is to accept reality and plan for lower real growth, I fear that the need to maintain appearances will lead to a cooking of the economic books, in which case we will have an number-fixing scandal of monumental proportions.
  2. More pricing ahead: I don't see much hope that investors will be welcomed back into Chinese markets any time soon. So, even if this market shakeup drives some of traders out of the game, investors motivated by value will be reluctant to step in, if the government continues to make markets into morality plays. As long as the market continues to be a pricing game, the price moves in the market will have little do with fundamentals. As a consequence, I would suggest that you ignore almost all attempts by market experts to explain what is happening in Chinese markets with economic stories. 
  3. Buyer beware: If you are drawn to Chinese markets (like moths to a flame), here is my advice for what it is worth. If you are an investor, you need to look past the hype and value companies, opacity and complexity notwithstanding, and be a realist when it comes to corporate governance. If you are a trader, this is a momentum game and if you can get ahead of momentum shifts, you will make money. If your bet is on the downside, just be ready to be maligned, abused or worse.
I understand why corporate chieftains and heads of government are unwilling to speak openly about the Chinese government, given how much of their own economic prosperity rests on maintaining good relations. Financial markets don't have such qualms and they are delivering their message to Beijing clearly and decisively. Let's hope someone is listening!
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Saturday, August 15, 2015

Storied Asset Sales: Valuing and Pricing "Trophy" Assets

Pearson PLC, the British publishing/education company, has been busy this summer, shedding itself of its ownership in two iconic media investments, the Financial Times and the Economist. On July 23, 2015, it sold its stake in the Financial Times for $1.3 billion to Nikkei, the Japanese media company, after flirting with Bloomberg, Reuters and Axel Springer. It followed up by selling its 50% stake in the Economist for $738 million, with 38% going to Exor, the investment vehicle for the Agnelli family, and the remaining 12% being purchased by the Economist Group itself. The motive for the divestitures seems to be a desire on the part of Pearson to stay focused on the education business but what caught my eye was the description of both the Financial Times and the Economist as “trophy” assets, a characterization that almost invariably accompanies an inability on the part of analysts to explain the prices paid by the acquirer, with conventional business metrics (earnings, cash flows, revenues etc.).

What is a trophy asset?
My first task in this analysis was to find other cases where the term was used and I found that its use spreads across asset classes. For instance, it seems to be commonplace in real estate transactions like this one, where high-profile properties are being acquired. As in the stories about the Economist and the Financial times, it seems to also be used in the context of media properties that have a long and storied tradition, like the Washington Post and the Boston Globe. In the last few years, sports franchises have increasingly made the list as well, as billionaires bid up their prices for these franchises. I have seen it used in the context of natural resources, with some mines and reserves being categorized as trophy assets for mining companies. While this is a diverse list, here are some of what they share in common:
  1. They are unique or rare: The rarity can be the result of natural scarcity (mining resources or an island in Hawaii), history (a newspaper that has survived a hundred years) or regulation/restriction (professional sports leagues restrict the creation of new franchises). 
  2. They have name recognition: For the most part, trophy assets have name recognition that they acquire either because they have been around for a long time, are in the news or have wide following.
  3. They are cash flow generating businesses or investments: In contrast with collectibles and fine art, trophy assets are generally cash flow generating and can be valued as conventional assets/businesses.
There is undoubtedly both a subjective and a negative component to the “trophy asset” label. The subjective component lies in how “rare” is defined, since some seem to define it more stringently than others. The negative aspect of labeling an asset as a trophy asset is that the buyer is perceived as paying a premium for the asset. Thus, an asset is more likely to be labeled as a trophy asset, when the buyer is a wealthy individual, driven more by ego and less by business reasons in making that investment.

Valuing a trophy asset
Rather than take it as a given that buyers overpay for trophy assets, let us look at the possibility that these assets are being acquired for their value rather than their glamor. We have the full financial statements for the Economist but only partial estimates for the Financial Times, and I have used this information to estimate base values for the two assets:
Spreadsheet with valuation
Thus, based on the earnings power in the two assets and low growth rates, reflecting their recent static history, the estimated value for the Economist is about £800 million and the Financial Times is worth £410 million. I will label these values in this table as the status quo estimates, since they reflect the ways in these media names are managed currently. While you could take issue with some of my assumptions about both properties, it seems to me that Nikkei’s acquisition price (£844 million) for the Financial Times represents a much larger premium over value than Exor's acquisition of the Economist Group for £952 million.  Does that imply that Nikkei is paying a trophy asset premium for the Financial Times? Perhaps, but there are three other value possibilities that have to be considered.
  1. Inefficiently utilized: If a trophy asset is under utilized or inefficiently run, a buyer who can use the asset to its full potential will pay a premium over the value estimated using status quo numbers. That is difficult to see in the acquisition of the Economist stake, at least to the Agnellis, since the interest is a non-controlling one (with voting rights restricted to 20%), suggesting that the acquirer of the stake cannot change the way the Economist is run. With the Financial Times, the possibilities are greater, since there are some who believe that the Pearson Group has not invested as much as it could have to increase the paper's US presence. 
  2. Synergy benefits to another business: If the buyer of the trophy asset is another business, it is possible that the trophy asset can be utilized to increase cash flows and value at the acquiring business. The value of those incremental cash flows, which can be labeled synergy, can be the basis for a premium over the status quo value. With the Nikkei acquisition of the Financial Times, this is a possibility, especially if growth in Asia is being targeted. With the Agnelli acquisition of the Economist, it is difficult to see this as a rationale since Exor is an investment holding company, not an operating business.
  3. Optionality: There is a third possibility and it relates to other aspects of the business that currently may not be generating earnings but could, if technology or markets change. With both the Economist and the Financial Times, the digital versions of the publications in conjunction with large, rich and loyal reader bases offer tantalizing possibilities for future revenues. That option value may justify paying a premium over intrinsic value. In fact, at the risk of playing the pricing game, note that you are acquiring the Economist at roughly the same price that investors paid for Buzzfeed, a purely digital property with a fraction of its history and content. 
With the Financial Times, adding these factors into the equation reinforces the point that the price paid by Nikkei can be justified with conventional value measures. With the Economist, and especially with the Exor acquisition, it does look like the buyers are paying a premium over value.

Pricing a trophy asset
As many of you who read my blog know, I have a fetish when it comes to differentiating between the value of an asset and its price. If value is a function of the cash flows from, growth in and risk of a business (estimated using intrinsic valuation models), price is determined by demand and supply and driven often by mood and momentum. If “trophy assets” are sought after by buyers just because they are rare and have name recognition, it is entirely possible that the pricing process can yield a number (price) very different from that delivered by the value process. In particular, the more sought after the trophy asset, the greater will be the premium that buyers are willing to pay (price) over value.

In June 2014, when Steve Ballmer bid $2 billion to buy the Los Angeles Clippers, I tried first explaining his bid by valuing the Clippers as a business. Even my most optimistic estimates of earnings and cash flows at the franchise generated a value of $1.2 billion for the franchise, leading me to conclude that Ballmer was paying the excess amount ($800 million) for an expensive play toy. While it is possible that the same motivations may be driving John Elkann, the scion of the Agnelli family and chairs Exor, in his acquisition of the Economist, I hope that Nikkei, a privately held business, is not paying for an expensive toy.

I am not arguing that paying this price premium is irrational or foolish. Far from it! First, it is possible that the emotional dividends that you receive from owning a trophy asset make up for the higher price up front. After all, Steve Ballmer’s friends are likely to be much more excited about being invited to have a ring side view of a Clippers game than watch Microsoft introduce Windows 10. Second, paying a premium over value does not preclude you from generating nosebleed returns from your investment, if you can find other buyers who are willing to pay even bigger premiums to take these trophy assets of your hands. In fact, many sports franchise buyers in the last decade who were viewed as paying nosebleed prices for their acquisitions have been able to sell them to new buyers for even higher prices. 

Implications
I tend to be skeptical of when an assets is casually labeled as a trophy asset, since it the labeling allows us to categorize its buyers as driven by non-financial considerations, without having to back up that contention. While both the Economist and the Financial Times have been labeled trophy assets, I think we have to hold back on that judgment, especially with the latter, to see what Nikkei has in mind for its new addition. After all, people were quick to label the acquisition of the Washington Post by Jeff Bezos as a trophy buy, but news stories suggests that there have been major changes at the Post since the deal was completed, which may be laying the foundations for delivering value.

If an asset class becomes a repository for trophy assets, it will attract buyers who will pay for non-economic benefits and the pricing of assets will lose connection to fundamentals. At the MIT Sloan Sports Conference this year, I was on a panel about the “valuation” of sports franchises and I made the argument that wealthy buyers in search of glamorous toys were increasingly changing these markets into pricing markets. In fact, as long as the number of sports franchises is static and the number of billionaires keeps increasing, I see no reason for this trend to stop. So, if the New York Yankees or Real Madrid go on the auction block, be prepared for some jaw-dropping prices for these franchises.

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Wednesday, August 12, 2015

Narrative Resets: Revisiting a Tech Trio (Apple, Facebook and Twitter)

In a post in August 2014, I examined the importance of narratives in valuation and how shifts or changes in those narratives can affect value, using Apple, Twitter and Facebook to illustrate my point. Since all of these companies have reported earnings in the last few weeks, I revisited my valuations of these companies, with the specific intent of seeing whether there is a need to update the narratives (and values) for these companies and whether, as an investor, I need to act.

Apple
I have been valuing Apple every quarter on my blog for the last four years. While I admitted in my very first posted valuation of the company that I liked the company and its products too much to ever be unbiased in my valuations, I did reluctantly sell my Apple shares when they hit $600 in early April 2012, arguing that the traders were driving the stock in ways that I could not comprehend. That turned out to be a lucky break, because the momentum shifted (as it does in pricing games), causing the stock to go into a tailspin. In January 2013, I reentered the Apple investor sweepstakes, when the stock hit $440, using this post to explain my rationale and in April 2014, I looked at the sometimes divergent paths taken by price and value at the company.

My August 2014 narrative
My last blog post valuation of Apple was in August 2014, after the stock had a 7 for 1 stock split, and the value per share that I obtained was $96. Starting in 2011, my narrative for Apple has been that it is a mature company, with limited growth potential (revenue growth rates< 5%) and sustained profitability, albeit with downward pressure on margins, as its core businesses becomes more competitive, and only a small probability that the company would introduce another disruptive product to follow up its trifecta from the prior decade (the iPod, the iPhone and the iPad). I saw no reason to change this narrative significantly, and as the stock was hovering around $100 at the time of the analysis, I considered it fully priced.

What’s happened since
The biggest news announcements from Apple came in September 2014, where they announced two new products, the Apple iWatch and Apple Pay. While I don’t see much in Apple iWatch to change my narrative in significant ways, Apple Pay offers the potential to provide a breakthrough, because the financial services business is a huge one and ripe for disruption. It is that shift that led me to hold Apple through the rest of 2014 and into 2015. In addition, Apple’s introduction of the iPhone 6 has allowed it to protect its margins much better than I had anticipated that they would. In a valuation that I did as part of my valuation class in March 2015, I revalued Apple at close to $118/share, about 10% below the stock price of $128 at that point in time, leading to a decision to sell the stock and count my blessings.

The August 2015 narrative
The last earnings report from Apple, which came out in late July, contains few surprises or twists, with perhaps the only surprising feature being the unexpectedly large jump in the cash balance to over $200 billion. That fact, while Apple continues to buy back billions in stock and pay large dividends, is a testimonial to the cash machine that Apple has created with its iPhones and iPads. In fact, just incorporating the higher cash balance and the lower share count into the valuation yields a value per share of close to $130. While you can download the valuation by clicking here, I also ran a simulation, where I allowed my assumptions on revenue growth, margins and cost of capital to vary to generate these numbers:

At the time of this post, the mood around Apple has darkened and the stock has dropped to less than $110. The purported reason for the stock price drop is the slow down in Apple sales in China, but that sounds to me like an attempt to fit a “good” reason to an old-fashioned sell off. Even allowing for a Chinese economic slowdown, Apple is starting to look like a bargain to me again but given the ebbs and flows in momentum in this stock, I would not be surprised if this round of selling leads the stock even lower, before good sense prevails. I think I will wait a few weeks before putting my buy order in but it looks like I will once more be an Apple stockholder.

Facebook
When Facebook filed for its initial public offering in February 2012, I described it as the most pre-priced IPO in history, as it had been actively traded in private markets before that offering. In my initial narrative for Facebook, I foresaw a company that would tread in Google’s path in terms of generating advertising revenues, while posting substantial profit margins. That “Google wannabe” narrative yielded a value of $71 billion for the company and a value per share of $28. Needless to say, I was not tempted to buy the stock at the offering price of $38 per share, but a few months later, I was extraordinarily lucky to get the stock at $18, as investors dumped the stock after its first earnings report. Since my narrative changed relatively little in the year following, my value changed little, but the stock price recovered to $45, leading to a decision on my part to sell.. The subsequent rise of the stock to $95/share meant that I left significant profits on the table by selling too early, but better than bailing on an investment philosophy that has worked for me.

My August 2014 narrative
In my August 2014 post on Facebook, following another blockbuster earnings report, where they reported more success in their mobile advertising efforts, I admitted that my original narrative was too cramped and that Facebook was perhaps on its way to outstripping Google not only in advertising but also in generating other ways of making money of its monstrously large (and involved) user base. The expanded narrative yielded a value per share of close to $63, still lower than the price at the time ($72) and I concluded that much as I liked the company, it looked over priced to me. 

What’s happened since
In its earnings reports in October 2014, January 2015 and April 2015  in Facebook continued to impress markets with its capacity to scale up revenues, while maintaining huge operating margins. In addition, other evidence accumulated that Facebook was moving forward briskly in its business model. In May 2015, Buzzfeed and the New York Times announced that they would be posting articles directly on Facebook, cementing its status as a news source. Facebook has also turned Instagram into a powerful tool for mobile advertising, with revenues of $600 million in 2015 and expected to rise to almost $3 billion in the next few years.

The August 2015 narrative
The last earnings report on July 29, 2015, continued this trend but it also included a note of caution from Mark Zuckerberg that investors should take to heart. He was explicit in his view, just as he was in the quarters before, that growth was getting more expensive and that investors should expect larger capital investments (and acquisitions) in the future. Looking at my August 2014 narrative, I see little need to make major changes to it, since I am already building in large reinvestment needs in the future. My updated valuation yields a value of $69/share and at its current price of $95, it is still too richly priced for my taste. Again, you can download the valuation by clicking here, but the simulation yields the following results:

At its current stock price of $94, I am not tempted yet, but I am all aware that this may be more a reflection of my narrative failure than a market mistake. In my August 2014 post, I described Facebook as a company where my valuations may chase the price for a long time and that is certainly turning out to be true.

Twitter
I valued Twitter for the first time in early October 2013, when the company filed its prospectus as a precursor to its initial public offering. My initial valuation of $18/share of the company is contained in this post from late October was based on the promise of advertising revenues that its large user base provided. While the initial offer price for the stock was set at $22, it was moved up to $26 and the stock itself opened for trading at $46 on the offering date. In the months after, the stock moved above $70 per share, before investors started noticing its flaws.

My August 2014 narrative
In my post on Twitter in August 2014, I stuck with my narrative of it becoming a successful but not-dominant online advertising companies, capable of commanding healthy margins, but added the concern that its management did not seem to have any control of this narrative or act in a way to make it happen. I contrasted how Twitter’s business model was a static one, relative to Facebook’s, and my estimate of value was $22.53, higher than the IPO number, but not by much. 

What’s happened since
It has been a tumultuous year at Twitter. In the aftermath of their stock price drop last year, they held an analyst meet in San Francisco in December 2014, where the CFO, Anthony Noto, tried to lay out the vision that the company had for its future. I must admit that I was underwhelmed by both how cramped that vision was and how little thought had been given to making it happen, and I posted my reaction in this post, where I likened it a bar mitzvah moment. If what has happened at the company in the months since are any indication, it looks like Twitter has a lot of growing up to do. After another bad earnings report, Twitter’s CEO, Dick Costolo, lost his job. That might have qualified as good news, but he was replaced by Jack Dorsey, who heads another company (Square). Twitter needs more than a part-time CEO and one who will represent a clean break from the status quo.

The August 2015 narrative
The last earnings report confirmed the chaos at Twitter. While the news in the report was not bad, investors latched on to the slowing growth in users as an excuse for selling off the stock. While I was disappointed in Twitter’s inability to extend its user presence especially overseas, Twitter’s bigger problem is not being able to convert its existing user base into revenues. There must be a way to monetize a social media presence that causes governments to quake, politicians to fall and breaks news ahead of established news services. My narrative for Twitter therefore is very similar to what it was in 2014. I believe that it will eventually get a management team that finds a way to convert potential to profits, stops catering to equity research analysts and expands its international presence. My valuation reflects this narrative and yields a value per share close to $26/share, and you can download it by clicking here. The simulation delivers the following numbers:

Note that the distribution of values for Twitter is much less symmetric that the distributions for Facebook and Apple, and is skewed towards larger values. IThis is not uncommon for small, high growth companies and is part of the "option" story, where you buy these companies to take advantage of the potential for breakout values. While the stock is, at best, fairly valued (at least based on my value), the optionality tilts the scale for me, and my (limit) buy orders were executed on Friday at $27/share. I am now a Twitter shareholder, and needless to say, I will keep you posted on how this investment evolves.

The End Game
Apple, Facebook and Twitter are three companies that I will continue to value at regular intervals and I will use them to remind myself of three fundamental propositions about value-based investing.
  1. Never say never: I do not want to tar all value investing with the same brush, but a substantial proportion of "value" investors draw lines in the sand. You should never invest in stocks that operate in technology businesses, they tell you, and definitely not in social media companies. Not only do these rules make no sense, but they take larger and larger proportions of companies out of your investing universe. Much as I have taken issue with Twitter's management in the past, at its current price, it looks like a good value to me. Put more generally, at the right price, I would buy almost any company, even a risky one with bad corporate governance, and at the wrong price, I would not buy even the very best company.
  2. Don't just buy and hold: The other piece of advice you get from value investors is buy great companies and hold them forever. This advice does not hold up either, since the essence of investing for value is that you buy an asset for a price that is less than its value. A consistent version of value investing would push for you to buy a a stock when the price is below value (with perhaps a margin of safety built in) but you should sell the stock when the price exceeds value (perhaps, using the same margin of safety in the other direction), even if you have held it for only a short period. If Apple continues its drop below $100, I will be buying Apple for the third time in four years and if Facebook sees a dramatic drop off in price to $60 per share or lower, I will buy it for the second time.  
  3. PE Ratios are blunt instruments: Generations of investors have been brought up on the notion that you should screen stocks, using multiples of earnings (PE or EV/EBITDA) or book (price to book), and pick companies that trade at low multiples. Even if Twitter dropped to $20/share, it will not trade at a low PE, even if with forward earnings, but I think it will be a good value.

 Attachments
  1. Valuation of Apple (July 2015) and Simulation Results
  2. Valuation of Facebook (July 2015) and Simulation Results
  3. Valuation of Twitter  (July 2015) and Simulation Results