Icahn exits, Buffett enters, Whither Apple? Value and Price Effects of Big Name Investing

In my last post, I looked at Apple, arguing, with a Monte Carlo simulation, that the stock was a good investment at the prevailing market price ($93 at the time of the analysis). I appreciate the many comments that I got on the analysis, some taking issue with the distributions that I used for profit margins and revenue growth and some taking me to task for ignoring the fact that big name investors were either entering and exiting the stock. Those who felt that my valuation was optimistic pointed out that Carl Icahn, a long time and very vocal investor in Apple, had decided to sell his stake in the company on April 28. Some who concurred with my value judgment on Apple pointed out that Berkshire Hathaway (and by extension, Warren Buffett or his proxies) had invested in the company on May 16.  Should Carl Icahn’s decision to sell Apple or Berkshire Hathaway’s choice to buy it change my assessments of value or views on its price? More generally, should the decisions by "big name" investors to buy or sell a specific company affect your investment judgments about that company? 

Price versus Value: The Set Up

To set up the discussion of whether, and if so how, the actions of other investors, especially those with big names and reputations to match, affect your investing choices, I will fall back on a device that I have used before, where I contrast the value and pricing processes.

Put simply, the value process is driven by a company's fundamentals (cash flows, growth and risk) or at least your perception of those fundamentals, whereas  the pricing process is driven by demand and supply, with mood, momentum and liquidity all playing big roles in determining price. In an earlier post,  I argued that it these processes that separate investors from traders, with investors focused on the drivers of value and traders on the pricing process, and that the skills and tools that you need to be a successful trader are different from those that you need to be a successful investor. To understand how and why the entry of a big name investor may alter your assessments of value and price, I would suggest categorizing that investor into one of four types.

1. An Insider, who is either part of management or has privileged access to management.
2. An Activist, who plans to change the way the firm is run or financed.
3. A Trader, whose skill lies in playing the pricing game, with the power to either reinforce or reverse price momentum
4. A Value Investor, who has valued the company and is willing to take a position based upon that value, on the expectation that the pricing gap will close.

Each type of big name investor has the potential to change how you view the dynamics of price and value, though the place where the change occurs will depend on the investor type.

The entry (or exit) of a big name insider or big name activist can alter your estimate of value for a company, by either changing your perceptions of cash flows, growth and risk or by having the potential to change the company's operating and financing characteristics. As a trader, the entry or exit of a big name trader may cause you to move from one side of the pricing game to the other, i.e., shift you from being a buyer to a seller. Finally, as a long term value investor who believes that a stock is mis-priced but has little or no power to cause the pricing gap to close, the entry of a big name value investor can provide a catalyst for the correction.

The Value Effect 

If you asked a value purist whether the actions of other investors affect his or her value, the answer will almost always be "of course not". After all, the essence of intrinsic value is that it is determined not by what others think about the company but the company's capacity to generate cash flows  over time. That said, there are two ways that the investment action (to buy or sell) of a big name investor can change your assessment of value. 

1. The first is if the big name investor has private information or is perceived as knowing more about the firm than you do. While that may walk awfully close to the insider trading line in the United States, it is entirely possible that the investor's information is diffuse enough to not be in violation of the law. In this case, it is entirely rational for you, as an investor, to reassess your cash flows and risk, based upon the insiders' actions. That is perhaps why we are so fascinated by insider trading, where the perception is that insider buying is value increasing and insider selling is value selling. In some emerging markets, where possessing proprietary information is neither illegal nor unusual, and the decision by an investor who is perceived as having this information (an insider, manager or family member) to buy (or sell) is an indicator that your value should be increased (decreased). 
2. The other scenario is where the big name investor is an activist who plans to push for changes in the way the company operates, how it is financed or how much and how it returns cash to investors. The potential effects of these changes can be most easily seen using a financial balance sheet:

To the extent that you believe that the company will have to respond to activist pressure, your assessment of value will change. An asset restructuring can alter he cash flows and risk characteristics of a business, changing your estimate of value, though the direction of the value change and its magnitude will depend on how you see these operating changes playing out in cash flows and growth.  Adding debt to your financing mix can add value to a firm (because of the tilt in the tax code towards debt) or destroy value (because it exposes companies to bankruptcy risk). If you are valuing a company, the entry of a big name activist investor in the ranks with a history of pushing for more debt could lead you to reassess your value estimate as well. Returning more cash to stockholders in special dividends or buybacks can change value either upwards (if the market is discounting the cash on the presumption that the company would waste the cash on bad investments/acquisitions) or downwards (if returning the cash will expose the firm to default risk or substantial financing costs in the future).

The Pricing Effect

In some cases, the big name investing in the stock is a trader, doing so on the expectation that momentum will either continue, sustaining the pricing trend, or that momentum will reverse, causing the trend to reverse as well. Since this trade is not motivated by either new information or the desire to change how the company is run, there is no value effect, but there can be a price effect for two reasons. 

1. The volume effect: If the big name trader has enough money to back his or her trade, there will be a liquidity effect, where a buy will push the price up higher and a sell will push it lower. 
2. The bandwagon effect: To the extent that there are some in the market who perceive the big name trader as better at perceiving momentum swings than the rest of us, they will follow the investor in buying or selling the stock. 

In contrast to a value effect, which is long term and sustained, the pricing effect will have a shorter half life. To the extent that the big name trader's time horizon may be even shorter, he or she can still make money from the bandwagon effect. To get a measure of the pricing effect of a big name trade, you have to look at both the resources commanded by the trader as well as the liquidity/trading volume in the stock. A trader with billions under his control investing in a lightly traded and lightly followed stock will have a much bigger pricing effect than in a very liquid, large market capitalization company. 

The Catalyst Effect

It is an undeniable and frustrating truth about value investing that for most of us, it is not just enough to be right in your assessment of value but you have to get the market to correct its mistakes to make money on your investments. If you are a small investor, there is little that you can do to close the pricing gap because you have neither the money or the megaphone to close the gap. A big name value investor, though, may be more successful for two reasons: he or she can take a larger position in the stock and as with the big name trader, create a bandwagon effect where other value investors will follow into the stock.  Again, the magnitude of the catalyst effect will vary across both investors and companies. The extent of the impact on the pricing gap will depend in large part on the history of success that the big name investor brings into the investment, with sustained success in the past going with a larger impact. 

Apple, Icahn and Buffett

It has taken me a while to get to the point of this post, which was ostensibly about Apple and how Icahn’s exit and Buffett’s entry into the stock affect my thinking. At first sight, this graph shows how the market reacted to their actions:

While it does look like Icahn's sale had a negative effect (albeit mild) and Berkshire's buy had a positive effect (almost as mild), I plan to use the framework of the last section to assess each of these investors and gauge how it should affect my thinking about the stock.

Icahn, the Activist Trader

Through much of his tenure, Carl Icahn has been labeled an activist investor but I will take issue with at least a portion of that label. It is true that Icahn is an activist, though he is much more active on the financing/dividend dimension (pushing companies to borrow money and return cash) than on the operating dimension. I do think that Icahn is more of a trader than an activist, more focused on momentum and pricing than on value and this is illustrated by the tools that brings to the assessment. When Icahn was asked why he invested in Lyft in 2015, his response was that it looked cheap relative to Uber, a classic pricing argument. With Apple, in his bullish days, Icahn argued that it was cheap, but consider how he justified his contention in May 2015, that Apple, then trading at $100, should really be trading at $240. In effect, he forecast out earnings per share in 2016 to be $12, applied a PE ratio of 18 and added the cash balance of $24.44/share. Not only is this definitely not an intrinsic valuation, it is at best "casual pricing", i.e., the type of pricing you would do on the back of an envelope after you have had a little too much to drink.

Before you point out to me that Icahn is worth billions and I am not, let me hasten to add that there is nothing ignoble about trading and that Icahn has been an incredibly successful trader over the last few decades, testimonial to his targeting and trading skills. It does color how I viewed Icahn’s investment in Apple in January 2014, his push at Apple for more dividends and more debt during his days as a Apple investor and his decision to sell his holdings on April 2016. I was already an investor in Apple in January 2014, when Icahn bought his shares, and while I did not view his decision to buy the shares as vindication of my valuation, I welcomed him to the shareholder ranks both because Apple was badly in need of a momentum shift and Icahn was playing both an activist and a catalyst role. I am glad that he put pressure on Apple to get over its unwillingness to borrow money and to return more cash in dividends and buybacks. His decision to depart does tells me two things. First, Icahn has recognized the limitations of financing and dividend policy changes in driving Apple’s value and is moving on to companies where the payoff is greater from financial reengineering. Second, it is possible that Icahn’s momentum detector is telling him that while Apple’s stock price may not be going lower, it has little room to go higher either, at least in the short term, and given his trading track record, I would take that signal seriously,

Buffett Buys In?

The decision by Berkshire Hathaway to invest in Apple about three weeks after Icahn’s departure mollified some worried Apple investors, since there is no more desirable endorsement in all of value investment than Warren Buffett’s buy order. I am not privy to the inner workings in Omaha, but I have a feeling that this decision was made more by Todd Combs and Ted Wechsler, the co-heads that Buffett hired as his successors, than by Buffett, but let’s assume that they are following the Buffett playbook. What does that tell you about Apple stock? The good news is that the greatest value investor of this generation now considers Apple to be a value stock. The bad news is that this investor's biggest investment in a technology company has been in IBM, a company that delivers solid dividends and cash flows but has been liquidating itself gradually over the last ten years. If my value judgment on Apple had required substantial growth for value to be delivered, Buffett’s investment could very well have adversely affected my view on the company. In this case, though, I agree with his assessment that Apple is a mature company, with enough cash flows to cover dividends for a generation. 

The Apple End Game

In early May, when I analyzed Apple, I knew that Carl Icahn had already closed out his position and it had no impact on my value estimate or investment judgment. Icahn’s decision to sell was an indication to me that the price might not recover quickly and that momentum could work against me in the near term, but I was okay with that, since my time horizon was not constrained. Buffett’s decision (if it was his) to jump in, a couple of weeks later, may be an indication that the best days of Apple are behind it, but I had already made the same judgment in my valuation. If there is a silver lining, it is that Buffett's followers, with their large numbers and unquestioning, will imitate him and perhaps get the price gap to close. 

The Dark Side of Big Name Investing
While I am open to the possibility that the entry of a big name into a company has the potential to change the way I think about the company and perhaps my investment decisions, there are dangers embedded in doing so.

1. Confirmation bias: It is a well-established fact that investors look for evidence that confirms decisions that they have already made and ignore evidence that contradicts it and big name investors feed into this bias. Thus, if you have bought a stock, you are far more likely to focus in on those big name investors who agree with you (and are either bullish on the stock or buy it) and screen out big name investors who do no.
2. Mixed Motives: It is entirely possible that you (as an investor) may be misreading or misunderstanding the motives that caused the big name trade in the first place. In particular, the insider, who you assumed was trading because he or she had private information, may be selling the stock for tax or liquidity reasons. The activist, who you assumed was pushing for real changes in the company, may be more interested in collecting a payoff from the company to leave it alone. The trader, who you assumed had skills playing the momentum game, may himself be following the crowd rather than assessing momentum shifts. Finally, the value investor, who you assumed had valued the company and was pushing for the price/value gap to close, may be more trader than investor, quick to give up, if the stock moves in the wrong direction.

There are some investors, including many institutional investors, whose entire investment strategy seems to be built around watching what big name investors do and imitating them. While imitation may be the best form of flattery, it is inauthentic and a poor basis for an investment philosophy, no matter who the big name investor that you are imitating is and how successful he or she has been. We are too quick to attribute investment success to skill and wisdom and that much of what passes for "smart" money is really "lucky" money. My advice is that if you have an investment thesis that leads you to buy the stock, do so and stop worrying about what the talking heads on CNBC or Bloomberg tell you about it. If you have so little faith in your reasoning that you doubt it and are ready to abandon it the moment it is contested by a big name, you should consider investing in index funds instead.

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DCF Myth 3.1: The Margin of Safety - Tool for Action or Excuse for Inaction?

In my last post on dealing with uncertainty, I brought up the margin of safety, the tool that many value investors claim to use to protect themselves against uncertainty. While there are certainly some in the value investing community who have found a good way to incorporate MOS into their investing process, there are many more who seem to have misconceptions about what it does for them as well as the trade off from using it. 

The Margin of Safety: Definition and Rationale

While the margin of safety has always been around, in one form or another, in investing, it was Ben Graham who brought the term into value investing in The Intelligent Investor, when he argued that the secret of sound investment is to have a margin of safety, with the margin of safety defined as the difference between the value of an asset and its price. The definitive book on MOS was written by Seth Klarman, a value investing icon. Klarman’s book has acquired a cult following, partly because of its content and partly because it has been out of print now for years; a quick check of Amazon indicates a second-hand copy can be acquired for about $1600. Klarman’s take on margin of safety is similar in spirit to Graham’s measure, with an asset-based focus on value, which is captured in his argument that investors gain the margin of safety by “buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles”.

There are many reasons offered for maintaining a margin of safety. The first is that the value of an asset is always measured with error and investors, no matter how well versed they are in valuation techniques, have to recognize that they can be wrong in their judgments. The second is that the market price is determined by demand and supply and if it diverges from value, its pathway back is neither quick nor guaranteed. The proponents of margin of safety point to its benefits. By holding back on making investment decisions (buy or sell) until you feel that you have a margin of safety, they argue that you improve your odds of making successful investments. In addition, They also make the point that having a healthy margin of safety will reduce the potential downside on your investments and help protect and preserve your capital. 

The Margin of Safety: Divergence across Investors

As a concept, I not only understand the logic of the MOS, but also its allure, and I am sure that many investors adopt some variant of it in active investing, but there are differences in how it is employed:

1. Valuation Basis: While MOS is often defined it as the difference between value and price, the way in which investors estimate value varies widely. The first approach is intrinsic value, either in its dividend discount model format or a more expansive DCF version. The second approach estimates value from accounting balance sheets, using either unadjusted book value or variants thereof (tangible book value, for instance). The third approach is to use a pricing multiple (PE, EV to EBITDA), in conjunction with peer group pricing, to estimate “a fair price” for the company. While I would contest even calling this number a value, it is still used by many investors as their estimated value.
2. Magnitude and Variability: Among investors who use MOS in investing, there seems to be no consensus on what constitutes a sufficient margin. Even among investors who are explicit about their MOS, the follow up question becomes whether it should be a constant (say 15% for all investments) or whether it should be greater for some investments (say in risky sectors or growth stocks) than for others (utilities or MLPs).

The bottom line is that a room full of investors who all claim to use margin of safety can contain a group with vast disagreements on how the MOS is computed, how large it should be and whether it should vary across investments and time.

Myths about Margin of Safety

When talking about value, I am often challenged by value investors on how I control for risk and asked why I don’t explicitly build in a MOS. Those are fair questions but I do think that some of the investors who are most enamored with the concept fundamentally misunderstand it. So, at the risk of provoking their wrath, here is my list of MOS misconceptions.

Myth 1: Having a MOS is costless

There are some investors who believe that their investment returns will always be improved by using a margin of safety on their investments and that using a larger margin of safety is costless. There are very few actions in investing that don’t create costs and benefits and MOS is not an exception. In fact, the best way to understand the trade off between costs and benefits is to think about type 1 and type 2 errors in statistical analysis. If type 1 errors refer to the fact that you have a false positive, type 2 errors reflect the opposite problem, where you have a false negative. Translating this proposition into investing, let’s categorize type 1 errors as buying an expensive stock, because you mistake it to be under valued, and type 2 errors as not buying a bargain-priced stock, because you perceive it wrongly to be over valued. Increasing your MOS will reduce your type 1 errors but will increase your type 2 errors. 

Many risk averse value investors would accept this trade off but there is a cost to being too conservative and  if that cost exceeds the benefits of being careful in your investment choice, it will show up as sub-par returns on your portfolio over extended periods. So, will using a MOS yield a positive or negative payoff? I cannot answer that question for you, because each investor has to make his or her own judgment on the question, but there are simple tests that you can run on your own portfolios that will lead you to the truth (though you may not want to see it). If you find yourself consistently holding more of your overall portfolio in cash than your natural risk aversion and liquidity needs would lead you to, and/or you don't generate enough returns on your portfolio to beat what you would have earned investing passively (in index funds, for instance), your investment process, no matter what its pedigree, is generating net costs for you. The problems may be in any of the three steps in the process: your valuations may be badly off, your judgment on market catalysts can be wrong or you may be using too large a MOS.

Myth 2: If you use a MOS, you can be sloppy in your valuations

Value investors who spend all of their time coming up with the right MOS and little on valuation are doing themselves a disservice. If your valuations are incomplete, badly done or biased, having a MOS on that value will provide little protection and can only hurt you in the investment process (since you are creating type 2 errors, without the benefit of reducing type 1 errors). Given a choice between an investor with high quality valuations and no/little MOS and one with poorly done valuations and a sophisticated MOS, I would take the former over the latter every single time.

I am also uncomfortable with investors who start with conservative estimates of value and then apply the MOS to that conservative value. In intrinsic valuation, conservative values will usually mean haircutting cash flows below expectations, using high discount rates and not counting in growth that is uncertain. In asset-based valuation, it can take the form of counting only some of the assets because they are tangible, liquid or both. Remember that you are already double counting risk, when you use MOS, even if your valuation is a fair value (and not a conservative estimate of value), because that value is computed on a risk-adjusted basis. If you are using a conservative value estimate, you may be triple or even quadruple counting the same risk when making investment decisions. If you are using this process, I am amazed that any investment manages to make it through your risk gauntlets to emerge as a good investment, and it does not surprise me that nothing in the market looks cheap to you.

Myth 3: The MOS should be the same across all investments 

I have always been puzzled by the notion that one MOS fits all investments. How can a 15% margin of safety be sufficient for both an investment in a regulated utility as well as a money-losing start-up? Perhaps, the defense that would be offered is that the investors who use MOS as their risk breakers would not look at companies like the latter, but I would still expect that even in the value investing spectrum, different investments would evoke different degrees of uncertainty (and different MOS).

Myth 4: The MOS on your portfolio = MOS on individual investments in the portfolio

I know that those who use MOS are skeptics when it comes to modern portfolio theory, but modern portfolio theory is built on the law of large numbers, and that law is robust. Put simply, you can aggregate a large number of risky investments to create a relatively safe portfolio, as long as the risks in the individual stocks are not perfectly correlated. In MOS terms, this would mean that an investor with a concentrated portfolio (who invests in three, four or five stocks) would need a much larger MOS on individual investments than one who spreads his or her bets across more investments, sectors and markets.

Expanding on this point, using a MOS will create biases in your portfolio. Using the MOS to pick investment will then lead you away from investments that are more exposed to firm-specific risks, which loom large on an individual company basis but fade in your portfolio. Thus, biotechnology firms (where the primary risk lies in an FDA approval process) will never make your MOS cut, but food processing firms will, for all the wrong reasons. In the same vein, Valeant and Volkswagen will not make your MOS cut, even though the risk you face on either stock will be lowered if they are parts of larger portfolios. 

Myth 5: The MOS is an alternative risk measure

I know that many investors abhor betas, and believe it or not, I understand. In fact, I have long argued that there are replacements available for portfolio theory-based risk measures and that not only is intrinsic value robust enough to work with these alternative risk measures but that the discount rate is not (and should not) be the ultimate driver of value in most companies. That said, there are some in the value investing community who like to use their dislike of betas as a bludgeon against all financial theory and after they have beaten that straw horse to death, they will offer MOS as their alternative risk measure. That suggests a fundamental misunderstanding of MOS. To use MOS, you need an estimate of value and I am not aware of any intrinsic value model that does not require a risk adjustment to get to value. In other words, MOS is not an alternative to any existing risk measure used in valuation but an add-on, a way in which risk averse investors can add a second layer of risk protection.

There is one possible way in which the MOS may be your primary risk adjustment mechanism and that is if you use a constant discount rate when doing valuation (a cost of capital of 8% for all companies or even a risk free rate) and then apply a MOS to that valuation to capture risk. If that is your approach, you should definitely be using different MOS for different investments (see Myth 3), with a larger MOS being used on riskier investments. I would also be curious about how exactly you make this MOS adjustment for risk, including what risks you bring in and how you make the conversion.

Margin of Safety – Incorporating into a Strategy

I would not put myself in the MOS camp but I recognize its use in investing and believe that it can be incorporated into a good investing strategy. To do so, though, you would need to do the following:

1. Self examination: Even if you believe that MOS is a good way of picking investments, it is not for everyone. Before you adopt it, you have to assess not only your own standing (including how much you have to invest, how risk averse you are) but also your faith (in your valuation prowess and that markets correct their mistakes). Once you have adopted it, you still need the effects it has on your portfolio, including how often you choose not to invest (and hold cash instead) and whether it makes a material difference to the returns you generate on your portfolio.
2. Sound Value Judgments: As I noted in the last section, a MOS is useful only if it is an addendum to sound valuations. This may be a reflection of my biases but I believe that this requires intrinsic valuation, though I am willing to concede that there are multiple ways of doing it right. Accounting valuations seem to be built on the twin presumptions that book value is an approximation of liquidation value and that accounting fair value actually means what it says, and I have little faith in either. As for passing of pricing as value, it strikes me as inconsistent to use the market to get your pricing number (by using multiples and comparable firms) and then argue that the same market misprices the asset in question.
3. A Flexible MOS: Tailor the MOS to the investment that you are looking at: There are two reasons for using a MOS in the first place. The first is an acceptance that, no matter how hard you try, your estimate of value can be wrong and the second is that even if the value estimate is right, there is uncertainty about whether the market will correct its mistakes over your time horizon. If you buy into these two reasons, it follows that your MOS should vary across investments, with the following determinants.

• Valuation Uncertainty: The more uncertain you are about your estimated value for an asset, other things remaining equal, the larger the MOS should be. Thus, you should use a smaller MOS when investing in mature businesses and during stable markets, than when putting your money in young, riskier business or in markets in crises.
• Portfolio Tailoring: The MOS that you use should also be tailored to your portfolio choices. If you are a concentrated investor, who invests in a four or five companies, you should use a much higher MOS than an investor who has a more diversified portfolio, and if you the latter, perhaps even modify the MOS to be larger for companies that are exposed to macroeconomic risks (interest rates, inflation, commodity prices or economic cycles) than to company-specific risks (regulatory approval, legal jeopardy, management flux).
• Market Efficiency: I know that these are fighting words to an active investor, red flags that call forth intemperate responses. The truth, though, is that even the most rabid critics of market efficiency ultimately believe in their own versions of market efficiency, since if markets never corrected their mistakes, you would never make money of even your canniest investments. Consequently, you should settle for a smaller MOS when investing in stocks in markets that you perceive to be more liquid and efficient than in assets, where the corrections will presumably happen more quickly than in inefficient, illiquid markets where the wait can be longer.
• Pricing Catalysts: Since you make money from the price adjusting to value, the presence of catalysts that can lead to this adjustment will allow you to settle for a lower MOS. Thus, if you believe that a stock has been mispriced ahead of an earnings report, a regulatory finding or a legal judgment, you should demand a lower MOS than when you invest in a stock that you believe is misvalued but with no obvious pricing catalyst in sight. 

Finally, if MOS is good enough to use when you buy a stock, it should be good enough to use when you sell that stock. Thus, if you need a stock to be under valued by at least 15%, to buy it, should you also not wait until it is at least 15% over valued, to sell it? This will require you to abandon another nostrum of value investing, which is that once you buy a great company, you should hold it forever, but that is not just unwise but is inconsistent with true value investing.

Conclusion

Would I prefer to buy a stock at a 50% discount on value rather than at just below fair value? Of course, and I would be even happier if you made that a 75% discount. Would I feel even more comfortable if you estimated value very conservatively. Yes and I would be delighted if all you counted was liquid assets. That said, I don't live in a  world where I see too many of these investments and when I do, it is usually the front for a scam rather than a legitimate bargain.  That is the reason that  I have never formally used a MOS in investing. I did buy Valeant at $32, because my valuation of the stock yielded $45 for the company. Would I have still bought the stock, if my value estimate had been only $35 or if it was a big chunk of my portfolio? Perhaps not, but I have bought stocks that were priced at my estimated fair value and have held back on investments that I have found to be under valued by 25% or more. Why? That has to wait for my coming post on simulations, since this one has run its course.

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Uncertainty Posts

1. DCF Myth 3: You cannot do a valuation, when there is too much uncertainty
2. The Margin of Safety: Excuse for Inaction or Tool for Action?
3. Facing up to Uncertainty: Probabilities and Simulations

DCF Myth Posts

Introductory Post: DCF Valuations: Academic Exercise, Sales Pitch or Investor Tool

1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
2. A DCF is an exercise in modeling & number crunching. 
3. You cannot do a DCF when there is too much uncertainty.
4. It's all about D in the DCF (Myths 4.1, 4.2, 4.3, 4.4 & 4.5)
5. The Terminal Value: Elephant in the Room! (Myths 5.1, 5.2, 5.3, 5.4 & 5.5)
6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
7. A DCF cannot value brand name or other intangibles. 
8. A DCF yields a conservative estimate of value. 
9. If your DCF value changes significantly over time, there is something wrong with your valuation.
10. A DCF is an academic exercise.

Putting a Price Tag on Scandal: Sturm und Drang at Volkswagen!

My Vale missteps illuminated for me some of the risks of going where it is darkest, but I will not let them stop me from trying again. This time, my focus is Volkswagen, a company that has, over the course of a month, gone from being just another mature company in a bad business (automobiles) to one beset on all sides by governments, lawyers and investors. In this case, though, unlike Vale and Lukoil, much of the uncertainty comes from self-inflicted wounds and as its stock price drops, it is worth looking at whether the market reaction has been overdone.

The setting

For the last decade, Volkswagen has worked hard to make itself a global automobile giant. Last year, the company was the leading auto company in the world, in terms of revenues, and second only to Toyota in units sold. In the US, it has a much lower profile, with a market share in the low single digits.

The company has been able to weather the 2008 crisis well, and has seen revenues and earnings climb, albeit at the moderate levels that befit a mature automobile company.

Source: S&P Capital IQ, Data

The company's operating margin of 6.07% in the last twelve months (ending June 30, 2015) was higher than its historical average margin of 4.21%. During the period, the Volkswagen auto offerings have expanded to include not only Audi and Skoda but also luxury brands including Bentley, Lamborghini, Porsche and Bugatti.

The Scandal, The Stock Price and Knee Jerk Contrarianism

In the last few weeks, the wheels have come off the Volkswagen bus. The trigger was a revelation that VW had designed the computer software on its diesel automobiles to fool the EPA, when it was testing for emissions; this BBC story explains it well. Once the story became public, Volkswagen admitted that it had screwed up big time, its CEO resigned, a whole host of top managers lost their jobs and Volkswagen's stock price collapsed, losing almost 40% of its value in the last month.

While both the ordinary and preferred shares have collapsed, the preferred shares seem to have taken more of a beating; the ordinary shares that used to trade at par with the preferred now trade at a premium of about 8% (and I will take more about this later in this post)

There is no doubt that this is more than a tempest in a  teapot, and that that there will be consequences, but are the consequences dire enough to cause a loss of more than 30 billion Euros in market capitalization? That remains the key question, as investors who are attracted to beaten up stocks look at Volkswagen. A knee jerk contrarian strategy may argue that history and empirical evidence is on your side and push for investment in Volkswagen now, but I am wary of using average returns from past studies, often based upon large samples of companies, to justify investing in one company that meets the criteria. 

The Costs

In the aftermath of Volkwagen's revelations, the news media have turned their full attention to the company's foibles, real and made up, with a skew towards putting the worst possible spin on the company's actions. Thus, the fact that the company has close ties to German lawmakers is viewed as a sign of the company's moral turpitude, as if other auto makers do not have their own stables of legislators pushing for preferential treatment.  Thus, the first step in assessing the impact of this scandal on Volkswagen is separating the wheat from the chaff, or in Nate Silver's words, the signal from the noise. It is quite clear that this scandal is going to cost Volkswagen, in many different arenas, starting with penalties being imposed by governments and regulators for the deception, continuing with the costs of recalling and fixing the cars and expanding to cover lost sales, as potential customers switch to competing car companies.

1. The Legal Penalties: There is no question that there are legal penalties coming, with Volkswagen already setting aside $7.3 billion (6.5 billion Euros) to cover the costs (fines/penalties, recall costs and other legal costs) that it will face, and the EPA's potential fines could expand to $18 billion. There is talk in Europe of similar penalties being meted out by European governments, which will add to the cost. (Update: A reader sent me the link to this article that provides some perspective on the potential fine size being closer to $11 billion, rather than $18 billion.)
2. Auto Recall Costs/ Legal Costs: It is estimated that Volkswagen has about 11 million vehicles that it might have to recall and refit, and that will be costly. Not surprisingly, talk of lawsuits fill the air, with both European and American shareholders considering suing the company for damages; even if the company wins all of these suits, it will be paying hefty legal fees along the way.
3. Lost Sales/Operating Income: There is also talk of lost trust and tarnished brand names, but these remain PR buzzwords until they start showing up in lost sales/profits. Unlike the BP or GM scandals, where lives were lost, the impact of this scandal is more diffuse, though the New York Times segued into this argument (a little far fetched) that the cheating could have cost lives. 

At the moment, the magnitude of these costs is still murky, but waiting for them to be clearer, as some investors seem to be doing, is an investment cop out. The market is already imputing a cost , and investors who want to invest in Volkswagen have no choice but to make their own judgments on whether the market imputed cost is too high (in which case Volkswagen becomes a buy), just right or too low (Volkswagen will be over valued).

I know that the cases are dissimilar, but to get a measure of what a scandal can cost an auto company, I looked at Toyota's experiences in 2010 with faulty gas pedals, the press coverage and controversy and the subsequent costs to the company.

	Toyota	Volkswagen
The Scandal	Gas pedals stuck, causing acceleration & accidents.	Computer software fooled EPA on emissions tests, reporting emissions at lower than actual level.
Deaths/Fatalities	37* (NHSTA)	None
Number of cars affected	9 million	11 million
EPA fines/ Government Penalties	$1.2 billion	VW set aside $7.3 billion
		EPA maximum fine $18 billion
Auto Recall Costs & Car Owner lawsuits	$1.1 billion	If proportional to number of cars, $1.34 billion.
Shareholder lawsuits	$25.5 million	Lawsuits being considering in both US and Europe.
Effect on Revenues/Operations	Revenues dropped from $19.1 billion in 2009 to $17.8 billion in 2010 and stayed about that level through 2011 and 2012, before rebounding to $21 billion in 2013.	Not known yet
Effect on stock price	Market Cap dropped 20% between 2009 and 2012, but rebounded in 2013.	Market capitalization down 40% in month since story broke

The Valuation

To evaluate how this scandal affects Volkswagen's value as a company, I will adopt a two-step process. In the first, I will go back a month and value Volkswagen before the revelations, but to isolate the effect of the scandal, I will assume that the market capitalization a month ago (on August 31) was right and back out the operating income that the market was imputing in the stock price. In the second, I will make judgments on the extent of the costs, with a bias towards over estimating, rather than under estimating them, and revalue Volkswagen.

The Pre-Scandal Volkswagen
To value the company prior to the scandal, I drew on Volkwagen's financial history, which is summarized here. If you truly want to numb yourself, try reading Volkswagen's annual report, a model of opacity and bulk. Once I had those numbers and examined the landscape of the auto business, my initial narrative for Volkswagen was a boring one: it is a mature firm that I expect to grow barely (at the same rate as the economy), earn no excess returns and an established capital structure and regional exposure. Rather than try to value the company, I took the market capitalization of 82 billion Euros that the company was trading at then, and solved for the operating income that the firm would need to generate to be trading at the prevailing market value, arriving at 7,683 million Euros in operating income, well below the 12,886 million Euros that the company earned in the trailing 12 months, and about 25% below the average operating income generated over the last five years.

Spreadsheet

Update: I added a worksheet to the spreadsheet to explain how I came up with the net asset value for the financial services company. Put simply, rather than let its numbers drown out and distract me from valuing Volkswagen, I separate all of the assets and liabilities that VW reported for its financial services business and estimated a net book value. My estimate is significantly lower than VW's own book value of equity estimate for its financial service firm, reflecting what I chose to include in the financial service firm's assets and liabilities. I also fixed the post-scandal spreadsheet to let you change the operating income to any of the pre-specified choices and fixed an error in the total debt number.

The Post-Scandal Valuation
There have been no major financial reports from the company over the last month and the macro environment has changed little, with the German 10-year Euro bond rate stuck at 0.60%. In effect,  the only thing that has changed is that the company has revealed its deception and the costs are starting to be tallied. Using the structure that I described in the last section, I  brought in the effects of the scandal in three layers.

1. Government and Regulatory Fines/Penalties: In this layer, I look at the fines and penalties that Volkwagen has to pay, and it seems reasonable that the lower bound on this number would be the $7.3 billion that VW has already set aside, but the upper bound may be much higher, ranging to include the $18 billion (16.07 billion Euros) that would be the maximum fine (for the EPA) and other fines that may come from European governments that have also been deceived. In my assessment, I added 10 billion Euros, reflecting the tendency of governments to pile on, to the 16.07 billion Euros to arrive at a total penalty of 26.07 billion Euros.
2. Auto recalls & Lawsuits: To estimate the costs that Volkswagen might face, as a result of this scandal, note that 11 million vehicles may need to be recalled and "fixed" and the costs will be high. Scaling up the $1.1 billion that Toyota spent recalling 9 million cars to fix gas pedals, adjusting for inflation and adding a buffer, I estimate a recall cost of $1.6 billion. In addition, a big company in the midst of a self-inflicted scandal is a ripe target for lawsuits, from both shareholders and affected customers, and while the end judgment may not be huge, the legal costs will accumulate along the way. With Toyota, these lawsuits created more noise than consequences, with the final settlement being only $25.5 million, but I am sure that the legal costs to the company were a multiple of this number. With Volkswagen, I will take the conservative tack and estimate a cost of $2.4 billion, matching the largest judgment ever in a shareholder suit,
3. Reputation Loss: Will customers stop buying Volkswagen cars as a result of this fiasco? Again, using the Toyota gas-pedal problem as an illustrative example, the company saw its revenues drop by about 7% in 2010 and stay low until 2012, though other factors may have contributed to the decline as well. Volkswagen will lose sales, especially in its diesel car segment, because of this scandal, but the effect will fade over time, just as it has for Toyota, GM and Ford, each of whom has had a scandal (or two) in the past. In fact, the car business is full of fallen sinners and soon-to-be sinners, and it seems unlikely that any company will be tarred for life.  Again, in the interests of being conservative, I will assume that Volkswagen will lose 20% of its (imputed) operating income each year for the next 5 years; the present value of these lost profts amounts to $5.17 billion.

Note that some of these costs will create tax savings, insofar as they are tax deductible. (Update: A reader notes that US tax law generally does not allow government fines to be tax deductible, but there is some give in the provision.)  In my assessment, in keeping with the conservative estimation, I will assume that only half of the costs on the first two items (fines and legal costs) are tax deductible. Finally, note that if Volkswagen pays the fines and incurs recall/legal costs, they will show up as expenses in the near years, and that you should expect to see reported losses in the mega-billions.

There is one more potential cost, which is that the management of Volkswagen will be focused on managing the scandal so much that they will not be able to direct their attention towards managing the company. If this were a creative company in a good business, I would be calculating the cost of lost investments and foregone growth and reducing my value. With Volkswagen, a not-that-imaginative company in a bad business (at least based on my narrative), I am less concerned, since an auto management's effort to grow faster (by acquiring other companies, expanding market share, entering new markets) is just as likely to destroy value, as it is to add value. In a perverse way, Volkswagen's stockholders may be better served by managers doing too little rather than trying to do too much.

With these conservative (almost worst-case numbers), I revalued Volkswagen's equity at 52.5 billion Euros, about 10% higher than the market capitalization of 48 billion Euros at the time of this assessment.  While that may not seem impressive, that is with an extremely conservative assessment of costs. Incorporating  the full tax benefit from the government penalties and auto recall increases the value to 56.7 billion Euros, and assuming a smaller penalty or less in legal costs will push the value up even further. (Negative numbers in the last column indicate under valued.)

	Assumptions	Value of Equity (billions of Euros)	% under or over valued
Worst Case	Maximum EPA Penalty + 10 billon in Other Government Fines, 4 bilion Euros in recall/legal costs, 20% loss in operating income forever, Fines and Legal costs not deductible.	32.04 €	59.47%
Base Case	Maximum EPA Penalty + 10 billon in Other Government Fines, 4 billion Euros in recall/legal costs, 20% loss in operating income for 5 years, Fines and Legal costs only 50% deductible	52.50 €	-8.05%
Better Case	Maximum EPA Penalty + 10 billon in Other Government Fines, 4 bilion Euros in recall/legal costs, 20% loss in operating income for 3 years, Fines and Legal costs 100% deductible	58.75 €	-17.95%
Likely Case	Half of maximum EPA Penalty + 5 billon in Other Government Fines, 2 bilion Euros in recall/legal costs, 20% loss in operating income for 3 years, Fines and Legal costs 50% deductible	65.91 €	-30.54%
Best Case	Penalties proportionate to Toyota, 20% loss in operating income for 3 years, Fines and Legal costs 100% deductible	73.60 €	-34.78%

Updated the likely case to make the costs only 50% deductible since readers who are much better versed than I on the tax law indicate that it is unlikely that VW will be able to deduce a large portion of their government fines. 
For the final question of whether to buy the ordinary or preferred shares, here is the trade off. The preferred shares have dropped by more than the ordinary shares and have historically been more liquid, but in times when you want a say in who runs the company and how it is run, it is better to own the ordinary shares. In fact, I would argue that the reason the common shares are trading at an 8% premium over the preferred shares now, as opposed to trading at par just a month ago, can be traced to the reawakening of interest in control and corporate governance that comes out of every scandal.

The End Game

This may be a reflection on my moral compass, but I find it difficult to muster the outrage that some people seem to feel about Volkswagen's deception. I think that the company's acts were stupid, short-sighted and greed-driven, but there have been far more appalling acts in corporate history, that are more deserving of my outrage. Volkswagen should be punished and the market has already meted out a hefty penalty, but looking at the possible costs of this scandal, I think that the market has over reacted. My market order for ordinary shares in Volkswagen went through yesterday, as my desire to have a say in management (with the ordinary shares) overwhelmed the bargain hunter in me (which was attracted to the preferred shares). I am investing in Volkswagen, but this will be a bumpy ride, for quite a while. This is the scandal du jour, of the moment, but there will be other news stories that draw the rubber necking crowd away. I have neither the desire, nor the inclination, to talk you into buying the stock. If you work through the numbers and come to the same conclusion that I did, I will be glad to have your company, but if your judgment leads you to a different assessment, I have no quarrels with you. To each, his (or her) own!

YouTube


Data

1. Volkswagen: Financial Data (History)
2. Volkswagen: Annual Report

Spreadsheets

1. Volkswagen: Pre-scandal valuation (to get imputed operating income)
2. Volkswagen: Post-scandal valuation

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