Control, Complexity and Politics: Deconstructing the Adani Affair!

The India Rising story hit some turbulence last week, as one of its biggest corporate success stories, the Adani Group, was hit with a report from Hindenburg Research, an investing group that specializes in targeting and shorting companies that it believes have dubious accounting and business practices. In response, people have fallen into two groups, with the Adani family and its supporters arguing that the short selling report is a hit job by a "foreign" entity to bring down not just the company, but also the country, and others noting that the report just reinforces what has troubled them about the company's meteoric rise in the last decade. I will confess that I know very little about the Adani Group, and I have nothing invested financially or emotionally in the company's fortunes. If you are looking for advice on whether you should buy or sell Adani shares, based upon my analysis, you will be disappointed. Instead, I will argue that the ingredients that led to the Adani stock price meltdown last week, which include an ambitious family group obsessed with control, a financial market where trading momentum trumps financial fundamentals and a capital market (debt and equity) where governments and regulators put their thumbs on the scale, are embedded in many Indian companies, and represent the weakest links in the India story.

The Lead In

    As noted in the introductory paragraph, I start from a position of ignorance about the Adani Group, and it thus made sense to fill in that gap. In doing so, I will undoubtedly bore those of you who have followed the company closely, and know far more than I do, and I apologize. 

The History

    The Adani Group, founded by Gautam Adani, started life as a commodity trading partnership business in Gujarat, and listed on stock markets in 1994, as Adani Exports, with a large chunk of its revenues coming from its operation of a local port in Mundra, with a subsequent entry into the edible oil business. The group's investments were regionally concentrated, but over time, they have expanded into other businesses and across India, and while I seldom draw on corporate presentations, I will make an exception and use a slide from Adani's January 2023 pitch to describe their business mix:

Link to Adani Corporate Presentation

With the exception of Adani Wilmar, a food processing business that has recently been bolstered by acquisition of leading brands, the rest of the Adani businesses share some common characteristics. First, they are infrastructure businesses, requiring large up-front investments and having long gestation periods, with regulatory and government oversight. Second, an increasing proportion of the company's investments are related to energy, in green energy and gas transmission/distribution, but the company's most significant investments are in logistics, especially in airports and ports . While each of these businesses is operated by a stand-alone Adani company, the businesses flow through a holding company, Adani Enterprises. The percentages of each company that is held by the Adani family is shown in brackets in the picture, and we will return to examine the implications later in this section.

The Rise to Market Prominence

    The Indian economy, in general, and Indian public markets, in specific, have always been dominated by family group companies, with many of the family groups tracing their history back a century or more. Given the historical roots of the biggest Indian family groups, the Adani Group has been a recent entrant, not making the top ten list (in terms of either operating metrics like revenues or market-based numbers like market capitalization or enterprise value) as recently as ten years ago, and barely making the top ten list five or six years ago. That has clearly changed, and at the start of 2023, four Adani companies were in the top twenty Indian companies, in terms of market capitalization, and the collective value of the seven publicly traded Adani companies was $220 billion (₹ 17,600 billion), greater than the market capitalization of Reliance, the Ambani family flagship, and India's largest company. In fact, for a brief period  at the start of 2023, Gautam Adani was the second richest man in the world, based upon his holdings in his group's companies:

The surge in market capitalization at the any company, by itself, is not surprising, especially after a decade where companies (like Tesla and Facebook) have added (and lost) hundreds of billions in market capitalization in individual years. The surprise, though, is that this dramatic boost in market capitalization happened at a family group built around infrastructure businesses, where investors have to wait for decades for payoffs, and often not driven to sudden changes in value assessment.

Adani's Operating History

    In an attempt to understand Adani's rise to market prominence, I started by looking at revenues and operating income at Adani Enterprises, the flagship company for the group:

Download data

I broke the 20-year history into three sub-periods, the 2002-2015 time period, where the company grew its revenues steadily and reported solid, albeit low, profitability, the 2016-2021 time period after a major restructuring in 2015 that spun off Adani Ports Adani Power and Adani Transmission, as separate companies, and the most recent year and a half (from March 2021 to September 2022), where the company reported a quantum leap in revenues. During that most recent period, the Adanis acquired a stake in the cement business, another capital-intensive and low profitability business, when they bought Hochim's stake in ACC and Ambuja Cements.

    While the revenue part of the story is one of almost unstoppable growth, it is worth noting that through its entire operating history, the Adani Group has had low operating margins, with the trend lines in the wrong direction. While some of the decline can be attributed to the revving up of reinvestment in new businesses, it is also worth emphasizing that even when these investments start paying off, they will remain low-margin businesses.

Adani's Investment Push

    It is rare to see infrastructure companies grow as quickly as Adani has, and the reason is that growth in this business requires large investments in capacity. Looking at the capital invested at Adani Enterprises provides us with a sense of how much capital this company has employed over the last twenty years to get to its current standing. 

Download data

Again,  the steep drop off in invested capital that you see in 2015 is just a reflection of the restructuring of the company that year, as the invested capital in Adani Ports and Power was removed from the mix. 

    Bringing in the operating income from the previous section, and adjusting for taxes, I scale those after-tax operating earnings to invested capital to estimate a return on invested capital at Adani Enterprises, and as you can see the Adani success story hits a roadblock. The company's return on invested capital has steadily declined, even as it has scaled up, hovering just over 3% in 2021-2022. Again, it is true that in infrastructure businesses, returns on capital improve as assets age, partly driven by higher operating income and partly by declining invested capital, but as with margins, the reality check is that these businesses will struggle to earn their costs of capital. 

Adani's Debt Load

    The investment side of the Adani story is not complete without bringing in the financing part, since the money for these investments has to come from somewhere, either internally, residual cash flows from existing operations, or externally, from new debt or equity. Using the statement of cashflows from Adani Enterprises, I present a picture of how the company funded its investments:

Download data

As you can see from the percentages of financing that Adani Enterprises raised from debt and equity, it is incontestable that the company funded almost all of its growth with debt through this period. In fact, the company continued to pay a dividend to shareholders, even as it raised fresh debt to keep growing, in effect using debt to pay dividends during the 2016-2021 time period,. In the most recent period (2021-22), there does seem to be a push to raise fresh equity, and that may or may not be in response to pressures from investors and lenders to reduce the debt burden.

    The cumulated effects of adding to debt each year, as Adani Enterprises has grown, can be seen in three debt metrics that I report for the company in the graph below: debt as a percent of book capital (debt plus book equity), debt as a percent of market capital (debt plus market capitalization) and an interest coverage ratio, estimated by dividing operating income by the interest expenses:

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The debt to book capital ratio has stayed high through the period, but the rise in market capitalization in 2021 and 2022  lowered the debt to market capital ratio. The interest coverage ratio better captures the limited buffer that the company has on its debt load, since the operating income is barely higher than interest expenses.

    In defense of the Adanis, it is not uncommon for infrastructure companies to borrow money and carry heavy debt loads, especially as they make new investments, on the expectation that as their projects mature, this debt will be repaid as well. What sets Adani apart thought is it scale, since a failure on its part to make debt payments will create ripple effects that are vastly greater than a much smaller infrastructure company.

Adani's Ownership Structure

    It is no secret that family group companies are controlled by the families that run them, but the degree of ownership that the Adanis have in their companies is high, even by Indian family group companies. In fact, the slide that I drew from the company's own slide deck is open about the family's percentage ownership of each of the Adani companies. Consolidating across the Adani companies, it looks like the family owns about 73% of the outstanding equity in these companies:

(Afro Asia, Universal Trade, Worldwide Emerging and Flourishing Trade are counted as part of Adani holdings)

This not a secret and these details are available from an Adani SEBI filing, where the family also includes the holdings of four corporate bodies that they control, as extensions of their holdings. While a family controlling a significant portion of the equity in a family group may not surprise you, the fact that this ownership stake has hardly budged over a decade where the company has increased in scale more than ten-fold, with dependence on external capital for that growth, is striking. The reason, of course, lies in the earlier graph, where we looked at how dependent the Adani companies have been on debt for their funding, rather than equity. There is a control story here that needs to be told, and we will come back to it.

    Of the 27.5% that is not held by the family, a significant percentage is held by foreign institutional investors, with Vanguard and Blackrock making the list, largely through their index funds holdings. Among Indian institutions, LIC is the largest holder with just over 4% of the shares, but the retail investor presence in this company is small, largely because of the low float, though the surge in the company's price in the last two years has drawn some traders to it.

Adani's Market Capitalization

    In our final assessment, I look at how the market have priced Adani Enterprises over time, looking at the multiples that investors have been willing to pay for its operating numbers from earnings to revenues to EBITDA, as well as relative to its accounting value (book value):

Download data

With every pricing metric, the surge in the last two years is striking. The PE ratio for the stock has gone from a modest 15 times earnings in the 2016-21 time period to 214 times earnings in the most recent two years, and the enterprise value has jumped from about 12 times EBITDA during 2016-21 to 53 times EBITDA in the most recent two years. You see similar movements in the price to book, where the stock has gone from trading under book value to 6.7 times book value, and the enterprise value, which was less than revenue in 2016-21 to 2.71 times revenues in the most recent two years.

    By itself, the surge in pricing multiples is a feature of volatile markets, and it is a phenomenon that we saw with technology companies in the last decade. What makes it surprising at Adani is the fact that this is an infrastructure company, and the irrational exuberance that animates pricing in tech or software usually has little play in this sector. In addition, the question of which group of investors is leading the push to higher prices is a puzzle, since, unlike an Agatha Christie mystery, the list of suspects (see ownership structure) is short. One benign explanation is that foreign institutional investors  are using Adani listed shares to make a joint bet on Indian growth, infrastructure investment and Indian politics, and that the pricing is being pushed up because of the limited float, but as we will see when we get to the short sellers' thesis, there are more malignant explanations, as well.

The Shorts Speak up

    All of the information that I used in the last section came from publicly disclosed documents, and there are no secrets. In fact, it is common knowledge that the Adani Group has grown, with a disproportionate dependence on debt, and that the rise in stock prices in the last two years has worked to the family's advantage, as it considers selling some of its ownership stake to raise fresh capital. It is also widely known that one of the competitive advantages of the group is its closeness to political power, and arguing that the company is benefiting from its political connections is neither novel nor uncommon in Indian business setting.

    When the Hindenburg Research report targeting the Adani Group came out a couple of weeks ago, I was surprised for a simple reason. I have seen this group target companies before, using the game plan that they are using with Adani, but their typical target firms are usually much smaller, under-the-radar firms, where public market investors may have missed troubling aspects of operations. The Adani Group is a huge target, by the standards of any market, and it is one of most widely talked-about Indian firms. I must confess that I find the Hindenburg shock-and-awe approach of throwing up dozens, perhaps hundreds of accusations of wrong doings at a firm, hoping that something sticks,  off putting, since even if I am in agreement, I find myself spending time trying to separate the wheat from the chaff, the big wrongdoings from the minor distractions. I may be doing a disservice to Hindenburg and other Adani naysayers, but it seems to me that what they  call the "biggest con" in history has three legs to it, and everything in the report feeds into one of the legs:

Almost every contention in the Hindenburg report can be traced to one of these three groupings, and I will try to regroup them on that basis. 

• Use of Shell companies: The most damaging of the Hindenburg contentions is that Vinod Adani, Gautam Adani's oldest brother has created a large number (38, by Hindenburg's count) of shell companies, based in Mauritius, and used them specifically for  "(1) stock parking / stock manipulation (2) and laundering money through Adani’s private companies onto the listed companies’ balance sheets in order to maintain the appearance of financial health",
• Dubious intra-party transactions: Hindenburg contends that the Adani Group has used its shell companies, in conjunction with transactions among its holding companies, some of which are privately owned by the family, to "inflate revenues" and for "manipulate earnings" at their listed companies.
• Inexperienced (or worse) auditors: Hindenburg notes that the accounts at Adani Enterprises and Adani Total Gas are audited by a tiny and largely unknown auditing firm, Shah Dhandaria, with four partners and eleven employees, some young and inexperienced. Implicit in this statement is the contention that this auditing firm is either incapable of or unwilling to highlight the accounting irregularities at the Adani companies.
• Listing rules: Publicly traded companies are required to have at 25% of their shares be held by non-promoters to stay listed on exchanges. Hindenburg contends that there are some of the foreign funds that the Adani Group lists as non-promoter holding to pass the listing threshold are almost entirely invested in Adani companies, and controlled by the Adani family. In short, Adani is being accused of violating listing rules, and covering it up.
• Stock as collateral for debt: The motive for the stock price manipulation, at least according to Hindenburg, is that some of the debt in the Adani companies has been backed up or secured by shares in the company, with a higher market capitalization then allowing these companies to borrow more than they should.
• Guilt by association: Along the way, Hindenburg notes connections that the Adani Group has to a host of individuals, some within the family (Samir Vora, Vinod Adani and Rajesh Adani) and many outside, who have been accused of fraud and manipulation, or in some cases, been found found guilty and barred from trading.

Hindenburg should be complimented for their legwork, but their critique of the Adani Group rests on a mix of serious contentions, circumstantial evidence and questionable claims. On the first, I would include the Mauritius-based shell entities, with no real operating purpose, and their links to the Adani Group companies. In the second, I would list many of the stock price manipulation charges, since the primary evidence offered is that the Mauritius shell companies hold material stakes in the company, with secondary evidence on delivery volume. To be able to manipulate and move the market capitalization of a company by a hundred billion, roughly the increase in value in 2022, you would expect to see huge numbers of shares being traded by these entities, and I don't see that. On the questionable claims are the ones to do with earnings manipulation, since if Adani is manipulating earnings, it is not doing a very good job, reporting low margins and return.

    I am puzzled that Hindenburg's short thesis spends as much time as it does trying to convince us that the company is over levered. Even if you believe Hindenburg's contention that a low current ratio equates to higher default risk, being over levered is not a con game, but a risk, perhaps a poorly thought through one, but one that equity investors in many investments take to increase their returns. In fact, the infrastructure business is full of companies that borrow heavily, with little or no earnings buffer, and I am not sure that many of them will withstand the Hindenburg test for over leverage. 

My Adani Assessment

   In sum, I am willing to believe that the Adani Group has played fast and loose with exchange listing rules, that it has used intra-party transactions to make itself look more credit-worthy than it truly is and that even if it has not manipulated its stock price directly, it has used the surge in its market capitalization to its advantage, especially when raising fresh capital. As for the institutions involved, which include banks, regulatory authorities and LIC, I have learned not to attribute to venality or corruption that which can be attributed to inertia and indifference. 

  It is possible that Hindenburg was indulging in hyperbole when it described Adani to be  "the biggest con" in history. A con game to me has no substance at its core, and its only objective is to fool other people, and part them from their money. Adani, notwithstanding all of its flaws, is a competent player in a business (infrastructure), which, especially in India, is filled with frauds and incompetents,. A more nuanced version of the Adani story is that the family group has exploited the seams and weakest links in the India story, to its advantage, and that there are lessons  for the nation as a whole, as it looks towards what it hopes will be its decade of growth. 

• First, in spite of the broadening of India's economy, it remains dependent on family group businesses, some public and many private, for its sustenance and growth. While there is much that is good in family businesses, the desire for control, sometimes at all cost, can damage not just these businesses but operate as a drag on the economy. Family businesses, especially those that are growth-focused, need to be more willing to look outside the family for good management and executive talent.
• Second, Indian stock markets are still dominated by momentum traders, and while that is not unusual, there is a bias towards bullish momentum over its bearish counterpart. In short, when traders, with no good fundamental rationale, push up stock prices, they are lauded as heroes and winners, but when they, even with good reason, sell stocks, they are considered pariahs. The restrictions on naked short selling, contained in this SEBI addendum, capture that perspective, and it does mean that when companies or traders prop up stock prices, for good or bad reasons, the pushback is inadequate.
• Third, I believe that stock market regulators in India are driven by the best of intentions, but so much of what they do seems to be focused on protecting retail investors from their own mistakes. While I understand the urge, it is worth remembering that the retail investors in India who are most likely to be caught up in trading scams and squeezes are the ones who seek them out in the first place, and that the best lessons about risk are learnt by letting them lose their money, for over reaching.
• Fourth, Indian banks have always felt more comfortable lending to family businesses than stand alone enterprises for two reasons. The first is that the bankers and family group members often are members of the social networks, making it difficult for the former to be objective lenders. The second is the perception, perhaps misplaced, that a family's worries about reputation and societal standing will lead them to step in and pay of the loans of a family group business, even if that business is unable to. It is easy to inveigh against the crony relationships between banks and their borrowers, but it will take far more than a Central Banking edict or harshly worded journalistic pieces to change decades of learned behavior.

I know that there are some of you who may view me as unpatriotic for pointing to these flaws, but I think that for the India story to unfold, it has to deal with these weaknesses. The short thesis against Adani can start that process, and I hope that the foreigner card does not get played on Hindenburg, dismissing its claims. There are plenty of Indians (analysts, investors, fund managers) who have been saying and thinking what is made explicit in the Hindenburg report, and the question that we should be asking is why they have not been given bigger platforms to air out their views.

    There is another seam or weakness in the global economic setting that Adani Enterprises exploited, and that is ESG, an acronym far more deserving of the "biggest con" label than Adani, since it is threatening to lay waster to trillions of dollars, not billions. If you review the Adani website and sales pitch, it is quite clear that the company learned to play the ESG game well, creating an entire ESG universe to underpin its companies, and exploiting the green bond market, presumably for its green energy business. The notion that a family group that build ports, airports and gas transmission lines qualifies for green bond issuance, tells you less about the group making the issuance, and more about the emptiness of the green bond promise. In fact, if Adani happens to default on its debt, I hope that it starts with the green bond holders, since I cannot think of a group that deserves default more.

Valuation and Investment Judgment

    I know that your intent in reading this thesis might be a more pragmatic one, where you wonder whether the Adani companies were over valued at the start of this year, when they hit their all time high, and whether they are a bargain, at half that price today. 

• On the first question, I don't think that there is much doubt that the market was over stretched when it valued the Adani companies collectively at $220 billion (₹ 17,600 billion) and Adani Enterprises at $53 billion (₹ 4,243 billion). In fact, a valuation of Adani Enterprises with upbeat assumptions on revenue growth and operating margins, and without factoring any of the Hindenburg accusations of fraud and malfeasance, yields a value of just about ₹ 945 per share, well below the stock price of ₹ 3,858 per share. 

  

  Download spreadsheet with valuation

• On the second question, even with the share price at 1,531 per share, I still think the company is priced too high, given its fundamentals (cash flows, growth and risk) and before factoring the damage that might have done to the company's reputation and long term value, by this short selling episode. 

Even with a further share drop, I am not tempted to buy shares in Adani companies, and it has little to do with the Hindenburg report. I have likened buying shares in a family group company to getting married, and then having all of your in-laws move into the bedroom with you. Investors in family group companies, no matter how honorable the family, are buying into cross holdings, opacity and the possibility of wealth transfers across family group companies. Those risks increase, if the family group companies are built around political connections, where you are one political election loss away your biggest competitive advantage. It is true that at the right price, I would be willing to expose myself to those risks, but it would require a significant discount on intrinsic value, and we are not even to close to that point yet. In short, I will watch this tussle between the Adani Group and Hindenburg from the sidelines, with less interest in the firm and more in what changes it may (or may not) bring to business, investing and regulatory practices in India.

YouTube Video

Datasets

1. Adani Enterprises- Historical Financial Data

Spreadsheets

1. Valuation of Adani Enterprises on February 4, 2023

Investing Whiplash: Looking for Closure with Apple and Amazon!

In September, I took a look, in a series of posts, at two companies that had crested the trillion dollar market cap mark, Apple and Amazon, and concluded that series with a post where I argued that both companies were over valued. I also mentioned that I was selling short on both stocks, Amazon for the first time in 22 years of tracking the company, and Apple at a limit price of $230. Two months later, both stocks have taken serious hits in the market, down almost 25% apiece, and one of my short sales has been covered and the other is still looking profitable. It is always nice to have happy endings to my investment stories, but rather than use this as vindication of my valuation or timing skills, I will argue that I just got lucky in terms of timing. That said, given how much these stocks have dropped over the last two months, it is an opportunity to not just revisit my valuations and investment judgments, but also to draw some general lessons about intrinsic valuation and pricing.

My September Valuations: A Look Back

In September, I valued Apple and Amazon and arrived at a value per share of roughly $200 for Apple and $1255 for Amazon, well below their prevailing stock prices of $220 (Apple) and $1950 (Amazon). I was also open about the fact that my valuations reflected my stories for the companies, and that my assumptions were open for debate. In fact, I estimated value distributions for both companies and noted that not only did I face more uncertainty in my Amazon valuation, but also that there was a significant probability in both companies that my assessment (that the stocks were over valued) was wrong. I summarized my results in a table that I reproduce below:

Apple Valuation & Amazon Valuation in September 2018

I did follow through on my judgments, albeit with some trepidation, selling short on Amazon at the prevailing market price (about $1950) and putting in a limit short sell at $230, which was fulfilled on October 3, as the stock opened above $230. With both stocks, I also put in open orders to cover my short sales at the 60th percentile of my value distributions, i.e., $205 at Apple and $1412 at Amazon, not expecting either to happen in the near term. (Why 60%? Read on...) Over the years, I have learned that investment stories and theses, no matter how well thought out and reasoned, don't always have happy endings, but this one did, and at a speed which I did not expect:

My Apple short sale which was initiated on October 3 was closed out on November 5 at $205, while Amazon got tantalizingly close to my trigger price for covering of $1412 (with a low of $1420 on November 20), before rebounding. 

Intrinsic Value Lessons

Every investment, whether it is a winner or a loser, carries investment lessons, and here are mine from my AAPL/AMZN experiences, at least so far:

1. Auto pilot rules to fight behavioral minefields: If you are wondering why I put in limit orders on both my Apple short sale and my covering trades on both stocks, it is because I know my weaknesses and left to my own biases, the havoc that they can wreak on my investment actions. I have never hidden the fact that I love Apple as a company and I was worried that if I did not put in my limit short sell order at $230, and the stock rose to that level, I would find a way to justify not doing it. For the limit buys to cover my short sales, I used the 60th percentile of the value distribution, because my trigger for buying a stock is that it be at least at the 40th percentile of its value distribution and to be consistent, my trigger for selling is set at the 60th percentile. It is my version of margin of safety, with the caveat being that for stocks like Amazon, where uncertainty abounds, this rule can translate into a much bigger percentage price difference than for a stock like Apple, where there is less uncertainty. (The price difference between the 60th and 90th percentile for Apple was just over 10%, whereas the price difference between those same percentiles was 35% for Amazon, in September 2018.)
2. Intrinsic value changes over time: Among some value investors, there is a misplaced belief that intrinsic value is a timeless constant, and that it is the market that is subject to wild swings, driven by changes in mood and momentum. That is not true, since not only do the determinants of value (cash flows, growth and risk) change over time, but so does the price of risk (default spreads, equity risk premiums) in the market. The former occurs every time a company has a financial disclosure, which is one reason that I revalue companies just after earnings reports, or a major news story (acquisition, divestiture, new CEO),  and the latter is driven by macro forces. That sounds abstract, but I can use Apple and Amazon to illustrate my point. Since my September valuations for both companies occurred after their most recent earnings reports, there have been no new financial disclosures from either company. There have been a few news stories and we can argue about their consequentiality for future cash flows and growth, but the big change has been in the market. Since September 21, the date of my valuation, equity markets have been in turmoil, with the S&P 500 dropping about 5.5% (through November 30) and the US 10-year treasury bond rate have dropped slightly from 3.07%  to 3.01%, over the same period. If you are wondering why this should affect terminal value, it is worth remembering that the price of risk (risk premium) is set by the market, and the mechanism it has for adjusting this price is the level of stock prices, with a higher equity risk premium leading to lower stock prices. In my post at the end of a turbulent October, I traced the change in equity risk premiums, by day, through October and noted that equity risk premiums at the end of the month were up about 0.38% from the start of the month and almost 0.72% higher than they were at the start of September 2018. In contrast, November saw less change in the ERP, with the ERP adjusting to 5.68% at the end of the month.
   
   Plugging in the higher equity risk premium and the slightly lower risk free rate into my Apple valuation, leaving the rest of my inputs unchanged, yields a value of $197 for the company, about 1.5% less than my $200 estimate on September 21. With Amazon, the effect is slightly larger, with the value per share dropping from $1255 per share to $1212, about 3.5%. Those changes may seem trivial but if the market correction had been larger and the treasury rate had changed more, the value effect would have been larger.
3. But price changes even more: If the fact that value changes over time, even in the absence of company-specific information, makes you uncomfortable, keep in mind that the market price usually changes even more. In the case of Apple and Amazon, this is illustrated in the graph below, where I compare value to price on September 21 and November 30 for both companies:
   
   In just over two months, Apple's value has declined from $201 to $196, but the stock price has dropped from $220 to $179, shifting it from being overvalued by 9.54% to undervalued by 9.14%. Amazon has become less over valued over time, with the percentage over valuation dropping from  55.38% to 39.44%. I have watched Apple's value dance with its price for  much of this decade and the graph below provides the highlights:
   
   From my perspective, the story for Apple has remained largely the same for the last eight years, a slow-growth, cash machine that gets the bulk of its profits from one product: the iPhone. However, at regular intervals, usually around a new iPhone model, the market becomes either giddily optimistic about it becoming a growth company (and pushes up the price) or overly pessimistic about the end of the iPhone cash franchise (and pushes the price down too much). In the face of this market  bipolarity, this is my fourth round of holding Apple in the last seven years, and I have a feeling that it will not be the last one.
4. Act with no regrets:  I did cover my short sale, by buying back Apple at $205, but the stock continued to slide, dropping below $175 early last week. I almost covered my Amazon position at $1412, but since the price dropped only as low as $1420, my limit buy was not triggered, and the stock price is back up to almost $1700. Am I regretful that I closed too early with Apple and did not close out early enough with Amazon? I am not, because if there is one thing I have learned in my years as an investor, it is that you have stay true to your investment philosophy, even if it means that you leave profits on the table sometimes, and lose money at other times. I have faith in value, and that faith requires me to act consistently. I will continue to value Amazon at regular intervals, and it is entirely possible that I missed my moment to sell, but if so, it is a price that I am willing to pay.
5. And flexible time horizons: A contrast that is often drawn between investors and traders is that to be an investor, you need to have a long time horizon, whereas traders operate with windows measured in months, weeks, days or even hours. In fact, one widely quoted precept in value investing is that you should buy good companies and hold them forever. Buy and hold is not a bad strategy, since it minimizes transactions costs, taxes and impulsive actions, but I hope that my Apple analysis leads you to at least question its wisdom. My short sale on Apple was predicated on value, but it lasted only a month and four days, before being unwound. In fact, early last week, I bought Apple at $175, because I believe that it under valued today, giving me a serious case of investing whiplash. I am willing to wait a long time for Apple's price to adjust to value, but I am not required to do so. If the price adjusts quickly to value and then moves upwards, I have to be willing to sell, even if that is only a few weeks from today. In my version of value investing, investors have to be ready to hold for long periods, but also be willing to close out positions sooner, either because their theses have been vindicated (by the market price moving towards value) or because their theses have broken down (in which case they need to revisit their valuations).

Bottom Line

As investors, we are often quick to claim credit for our successes and equally quick to blame others for our failures, and I am no exception. While I am sorely tempted to view what has happened at Apple and Amazon as vindication of my value judgments, I know better. I got lucky in terms of timing, catching a market correction and one targeted at tech stocks, and I am inclined to believe that  is the main reason why my Apple and Amazon positions have made me money in the last two months. With Amazon, in particular, there is little that has happened in the last two months that would represent the catalysts that I saw in my initial analysis, since it was government actions and regulatory pushback that I saw as the likely triggers for a correction. With Apple, I do have a longer history and a better basis for believing that this is market bipolarity at play, with the stock price over shooting its value, after good news, and over correcting after bad news, but nothing that has happened  to the company in the last two month would explain the correction. Needless to say, I will bank my profits, even if they are entirely fortuitous, but I will not delude myself into chalking this up to my investing skills. It is better to be lucky than good!

YouTube Video

Blog Posts

1. Apple and Amazon at a Trillion $: A Follow-up on Uncertainty and Catalysts (September 2018)
2. An October Surprise: Making Sense of Market Mayhem (October 2018)

Amazon and Apple at a Trillion $: A Follow-up on Uncertainty and Catalysts!

In my last post, I looked at Apple and Amazon, as their market caps exceeded a trillion dollars, tracing the journey that they took over the last two decades to get to that threshold and valuing them  given their current standing. While you can check out the stories that I told and the details of my valuation in that post, I valued Apple at $200, about 9% less than the market price, and Amazon at abut $1255, about 35% lower than its market price. I concluded the post with a teaser, promising to come back with my decisions on whether I would sell my existing Apple shareholding and/or sell short on Amazon, after reviewing two loose ends. The first is to lay bare the uncertainties inherent in both valuations, to see if there is something in those uncertainties that I can use to make a better decision. The second is to evaluate whether there are catalysts that will convert the gap that I see between value and price into actual profits.

Facing up to Uncertainty

One of the recurrent themes in this blog is that we (as human beings) are not good at dealing with uncertainty. We avoid, evade and deny its existence, and in the process end up making unhealthy choices. When valuing companies, uncertainty is a given, a feature and not a bug, and traditional valuation models often give it short shrift. In fact, looking at my valuations of Apple and Amazon, you can see that the only place that I explicitly deal with uncertainty is in the discount rate, and even that process is rendered opaque, because I use betas and equity risk premiums to get to my final numbers. My cash flows reflect my expectations, and even in my moments of greatest hubris, I don't believe that I know, with precision, what will happen to Apple's revenue growth over time or how Amazon's operating margin will evolve in the future. So, why bother? In investing, you have no choice but to make your best estimates and value companies, knowing fully well that you will be wrong, no matter how much information you have and how good your models are. 

That said, it is puzzling that we still stick with point estimates (single numbers for revenue growth and operating margins) in conventional valuation, when we have the tools to bring in uncertainty  into our valuation judgments. While our statistics classes in college are a distant (and often painful) memory for most of us, there are statistical tools that can help us. While these tools may have been impractical even a decade ago, they are now more accessible, and when coupled with the richer data that we now have, we have the pieces in place to go beyond single value judgments. It is with this objective in mind that I recently updated a paper that I have on using probabilistic and statistical techniques to enrich valuation online, and you can get the paper by going to this link. Consider it a companion to another paper that I wrote a while back, dealing more expansively with uncertainty and healthy ways of dealing with it in investing and valuation.

Summarizing the probabilistic techniques that may help in valuation, I suggest three: (1) Scenario Analysis, for valuing companies that may have different valuations depending upon specific and usually discrete scenarios unfolding (for example a change in regulatory regimes for a bank or telecommunications company), (2) Decision Trees, for valuing companies that face sequential risk, i.e., you have to get through one phase of risk to arrive at the next one, as is the case with young drug companies that have new drugs in the regulatory pipeline and (3) Monte Carlo Simulations, the most general technique that can accommodate continuous and even correlated risks that you face in valuation, as is the case when you forecast revenue growth and operating margins for Apple and Amazon, in pursuit of their values.

Simulated Values: Apple and Amazon
Before delving into the simulations for Apple and Amazon, it is important that we set up the structure of the simulations first by first deciding what variables to build distributions around. While you may be tempted by the power of the tool to make every input (from risk free rates to terminal growth rates) into a distribution, my suggestion is that you focus on the variables that not only matter the most, but where you feel most uncertain. With Apple, the three inputs that I will build distributions around are revenue growth, operating margins and cost of capital. With Amazon, I will add a fourth variable to the mix, in the sales to invested capital, measuring how efficiently Amazon can deliver its revenue growth.

Apple: A September 2018 Simulation
I build around my core story for Apple, which is that it will be a slow growth, cash machine, deriving the bulk of its revenues, profits and value from the iPhone, but allow for uncertainty in each of my key inputs:

1. Revenue growth: While my expected growth rate stays 3%, I allow for a range of growth rates from no growth (flat revenues) , if the iPhone's higher prices cost it signifiant market share) to 6% growth, which would require that Apple find a new growth source, perhaps from services or a new product.
2. Operating Margin: In my story, I assumed that operating margin would decline to 25% (from  the current 30%) over the next five years. While I still feel that this is the best estimate, I allow for the possibility that competition will be stronger than expected (with margins dropping to 20%), at one end, and that Apple will be able to use its brand name to keep margins at 30%, at the other. 
3. Cost of capital: My base case cost of capital is 8.20%, reflecting Apple's mix of businesses, but allowing for errors in my sector risk measures and changes in business mix, I build a distribution centered around 8.20% but with a small standard error (0.40%).  

Since I want to stay market neutral, taking no stand on either the level of interest rates or overall stock prices, I am leaving the ten-year bond rate and equity risk premium untouched. The results of the simulation are below:

Valuation & Simulation Output

Note that the median, mean and base case valuations are all bunched up at $200 and that the range in value, using the 10th and 90th percentiles, is tight ($176 to $229).

Amazon: A September 2018 Simulation
Moving from Apple to Amazon, my uncertainties multiply partly because my story is of a company that will move into any business where it believes its disruptive platform can deliver results, and there are very few businesses that are immune. Consequently, every input into the valuation is much more volatile, but I will focus on four:

1. Revenue Growth: I used an expected growth rate for Amazon of 15% a year for the next 5 years, tapering down to lower levels in the future, to push revenues to $626 billion, ten years from now. While that is an ambitious target, Amazon has proved itself capable of beating sky high expectations before and it is plausible that the growth rate could be as high as 25% (which would translate to revenues of $1.13 trillion, ten years out). There is also the possibility that regulators and anti-trust enforcers may step in and restrain Amazon's growth plans, which could cause the growth rate to drop significantly to 5% (resulting in revenues of $330 billion in year 10).
2. Operating Margin: While Amazon's margins have been on a slow, but steady, climb in the last few years, much of that improvement has come from the cloud services business, and the future course of margins will depend not only on how well Amazon can bring logistics costs under control but also on what new businesses it targets. I will stay with my base cash assumption of a target operating margin of 12.5%, but allow for the possibility that Amazon's margins will stay stagnant (close to today's margins of about 7%), at one extreme, and that there might be a new, very profitable business that Amazon can enter, pushing up the margins above 18%, at the other.
3. Sales to Invested Capital: Currently, Amazon is an efficient utilizer of capital, generating $5.95 in revenues for every dollar of capital invested. While this will remain my base case, there may be future businesses that Amazon is targeting that may be more or less capital intensive than its current ones, leading to a significant range (3.95 for the more capital intensive - 7.95 to the less  capital intensive).
4. Cost of Capital: I will stick with my base case cost of capital of 7.97%, with the possibility that that it could drop as Amazon's older businesses become profitable (but not by much, since the current cost of capital is close to the median for global companies) as well as the very real chance that it could go up significantly, if Amazon targets risky businesses in emerging markets for its growth.

Valuation & Simulation Output

The median value across the simulations is $1242, close to the base case valuation of $1,255. The range on value, using the 10th and 90th percentiles is $705 - $2,152, much wider than the range for Apple.

Lessons from Apple and Amazon Simulations
Simulations yield pretty pictures and if that is all you get out of them, it is time and energy wasted. There are lessons that we can eke out of the Apple and Amazon simulations that may help us in making more informed judgments:

1. This is not about getting better estimates of value: If you are running simulations because you think they will give you more precise or better estimates of value than point estimate valuations, you will be disappointed. Since my input distributions are centered around my base case assumptions, and they should be, the median values across 100,000 simulations are close to my base case valuations for both Apple and Amazon.
2. If it is a risk proxy, it is a very noisy and dangerous one: It is true that the spread of the distributions provides a measure of estimation uncertainty that you bring into your valuation. Using the Apple and Amazon simulations to illustrate, I face far greater uncertainty with my Amazon story than with my Apple story, and you can see it reflected in a larger range of value for the former. You may be puzzled that my cost of capital is lower for Amazon than for Apple, but that reflects the fact that much of the uncertainty that I face with Amazon is company-specific and should be buffered by other stocks in my portfolio. As a diversified investor, the variance in simulated values is a poor proxy for risk. However, if you are an investor who prefers concentrated portfolios, you can use the variance in simulated value as a measure of risk. 
3. There can be no one margin of safety for all companies: I have written about the margin of safety before, often with skepticism, and one of my critiques has been with the way it is used in practice, where it is set at a fixed number for all companies. Thus, you will find value investors who use a margin of safety of 15% or 20% for all stocks, and the Apple and Amazon simulations show the danger in this practice. A 15% margin of safety for Apple may be too large, given how tightly values are distributed for the company, whereas the same 15% margin of safety may be too small for Amazon, with its wider band of values.
4. Tails matter: Symmetry or the lack of it in distributions may seem like an inside statistics topic, but with simulated values, it has investment consequences. You can see that Apple's value distribution is  much more symmetric than Amazon's distribution, with the latter having a significant positive skew, reflecting a greater likelihood of big positive surprises in value, than negative ones. With companies with exposure to large and potentially catastrophic news stories (a large lawsuit or debt covenants), you can have value distributions that are negatively skewed.  In general, positive skewed distributions are better for (long) investors than negatively skewed ones, and the reverse is true for investors who are shorting a company.

I ran the simulations after my base case valuations suggested that Apple and Amazon were over valued, to see how they might affect my decision on whether to sell short on either company. The results are mixed.

• While the simulations confirm my over valuations (no surprise there), with both companies, the current stock price is well within the realm of possibilities. While my base case valuation suggested that Apple was far less over valued (10%) than Amazon (55%), there is roughly a 15-20% chance that both companies are under valued, not over valued.
• In addition, with Amazon, there is the added risk, if you are selling short, given the long positive tail on the distribution, that if I am wrong, the price I will pay will be much greater than if I am wrong with Apple.

The bottom line is that while Amazon seemed like a much better short selling target, after my base case valuations, because it was far more over valued than Apple, the simulations that I did on the two companies even out the scales, at least marginally. Apple is more over valued, but the probability of making money, assuming my valuations are on target is about the same with both stocks, and the downside of being wrong is far greater with Amazon than with Apple.

Value and Price: The Search for Catalysts
In the post that initiated this series, I looked at why crossing a trillion-dollar threshold may matter to investors, using the contrast between the value process and the pricing process. In effect, I argued that there can be a gap between value and price, and that even if you are right about your value judgment, you will make money only if the gap between the two closes:

Investment success thus rides not only on the quality of your value judgment, and how much faith you have in it, but on whether there are catalysts that can cause the gap to change. With companies, these catalysts can take different forms:

1. Earnings reports: In their earnings reports, in addition to the proverbial bottom line (earnings per share), companies provide information about operating details (growth, margins, capital invested). To the extent that the pricing reflects unrealistic expectations about the future, information that highlights this in an earnings report may cause investors to reassess price. 
2. Corporate news: News stories about a company's plans to expand, acquire or divest businesses  or to update or introduce new products can reset the pricing game and change the gap.
3. Management Change/Behavior: A change in the ranks of top management or a managerial misjudgment that is made public can cause investors to hit the pause button, and this is especially true for companies that are bound to a single personality (usually a powerful founder/CEO) or derive their value from a key person. 
4. Macro/ Government: A change in the macro environment or the regulatory overlay for a company can also cause a reassessment of the gap.

With all of these catalysts, there may be value effects (because the cash flows, growth and risk) as well, and it should also be noted that when the gap changes, it may not always close. In fact, these catalysts can sometime make a gap bigger, by feeding into pricing momentum.

As an investor, I look for catalysts when I invest, but I am even more intent on finding them, when I sell short than when I am long a stock. The reason for that divergence is that I am in far greater control of my time horizon, when I buy a stock, since, as long as I stay disciplined and retain faith in my value, only liquidity needs can cause me to sell. When I sell short, my time horizon is far less under my control, exposing me to timing risk. Put different, I can bet on a company being over valued, be right on my thesis, but still lose money on a short sale, because I am forced to close out my position, in the absence of a catalyst.

Going through the list of catalysts with Apple and Amazon, with both stocks approaching all-time highs, there is no obvious pricing trigger than I can point to, though my technical analyst friends will undoubtedly point to indicators that I did not even know existed. On the earnings front, the earnings reports for both companies are so heavily scripted to expectations that it would take a big surprise to reset stories, and I don't see that happening. In fact, I will predict that Amazon's earnings reports will continue to deliver double digit revenue growth and improving margins for the next few quarters, and investors will react positively, even though the growth may not be high enough or the margin improvement substantial enough to justify the market pricing. On the corporate news front, Apple's smart phone business model, with the pressure it puts on the company every year or two to reinvent itself, with the latest and the best, coupled with its big announcement events, creates catalyst moments. Looking back at Apple's ups and downs over the last few years, the triggers for substantial up and down movements on the stock have been new iPhone models doing better or worse than expected. In contrast, Amazon is remarkably low key in new product introductions, preferring to slip in under the radar. Both companies have well regarded and established CEOs, and neither company is personality-driven, making it unlikely that you will see management changes triggering big price changes. Finally, on the macro front, both companies face potential catalyst moments. For Apple, it is the possibility of a trade war with China, a huge market for its products and devices, and for Amazon, it is talk of regulatory restrictions and anti-trust actions that can constrain the company.  Since I cannot filibuster my way to a non-decision, I decided to compare my Apple and Amazon numbers/analysis, side by side:

I sold my Apple shares at $220, at the start of trading on Friday (9/21), but while I have not sold short any more shares. I have put in a limit (short) sell, if the price hits $230 (roughly my 90th percentile of value) in the near future. With Amazon, I sold short at $1950 at the start of trading on Friday (9/21).  the first time in twenty years that I have sold short on the company, and one reason that I am pulling the trigger is because I believe that the pushback from regulators and anti-trust enforcers will slow the company down in ways that no competitor ever could. I am doing so, with open eyes, since I believe that Amazon is in one of the best run companies in the world, adept at setting market expectations and beating them, and with a track record of taking short sellers to the graveyard. Time will tell, and I am sure that some of you reading this post will let me know, if my bet goes awry, but I don't plan to lose any sleep over this. 

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Trillion Dollar Posts

1. Trillion Dollar Toppers: Market Drivers, Pricing Triggers and Catalysts
2. Amazon and Apple at a Trillion $: Looking back and Looking forward
3. Amazon and Apple at a Trillion $: A Follow up on Uncertainty and Catalysts!

Spreadsheets

1. Apple valuation and simulation results
2. Amazon valuation and simulation results

(I use Crystal Ball, an add-on to Excel, for my simulations. If you don't have that extension (available only on the PC version), you cannot recreate my simulations, but you can download the program for a trial run on the Oracle website)

Papers/Reading

1. Facing up to Uncertainty: Using Probabilistic Approaches in Valuation
2. Living with Noise: Investing and Valuation in the Face of Uncertainty