Resources

Saturday, June 24, 2017

Musings: Cash on the Sidelines and the Illusion of Market Cap Calculations

Cash on the Sidelines


I read Zero Hedge regularly. It is not the most reputable publication, but once in a while it bring up interesting topics. Like this article: Destroying The Myth Of 'Cash On The Sidelines'.

Permabulls love to argue there are all these “cash on the sidelines” ready to buy stocks and jack up prices. The article disagrees with the very idea of it. It quotes Cliff Asness:

There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Asness is saying there are no sidelines because buy/sell transactions do not increase overall cash in the system, since for every buyer there’s a seller.

I used to think that, and it’s something clever to say. But it’s wrong.

We all know friends, relatives, or neighbors who, at one point or another, try to put their growing cash piles to work. These people clearly have cash and its growing. Where does that come from?

First, it’s called money creation. As people earn wages and deposit that in their bank account, their “cash on the sideline” grows. So you say, “but the employer who paid them now has less cash, so total cash level don’t change right??” Well, at least some of the employers borrowed money, the act of which is how our financial system expands money supply.

Second, there’s asset class rotation. Asness would be right in a world where it’s just cash and equities, (and no liquidity creation). But you know, there’s such a thing as fixed income and bonds and they get used as cash alternatives. You see all these balance sheets where companies list “cash and marketable securities”? That’s your T-bill/CP’s/notes/bonds…etc.

So to the extent bond prices start going down and people rotate into equities, that’s “cash (and marketable securities) on the sidelines” which can boost equity prices.



The Illusion of Market Caps


The big news last week was Amazon buying Wholefood. As CNBC reported here, Amazon is paying $13.7bn for Wholefood, yet AMZN’s market appreciated by $15.6bn when the news hit.

CNBC wrote: “So, you could argue, they are getting Whole Foods for free, and pocketing $1.9 billion as well.

How could this be? Are investors stupid? One explanation (which is the CNBC editor’s view) is that the market thinks Amazon will get so much synergy that it exceeds the entire cost of acquisition.

Maybe. But there’s another explanation - that the way we calculate market cap renders it a flawed concept.

The CNBC article wrote: “Amazon's stock was up $32 and change mid-morning. There are 478 million shares outstanding, so Amazon's market cap has appreciated by about $15.6 billion today.

The flaw is one of extrapolation. The deal was announced on June 16th, 2017. That day 11.47mm shares of AMZN traded.

That tells us the market was willing to pay $32 more for 11.47mm shares. That’s it. It does not mean the market was willing to pay $32 more for all 478mm shares outstanding. In fact, if all 478mm shares were for sale, I’m sure AMZN stock price would crash!

But that’s what our market cap calculation does. We take the increased price for 11.47mm shares, and then extrapolate that to say every single share, to the tune of 478mm shares, gets the increased valuation. We take one single point in the stock’s demand curve, which tells us there’s demand for x # of shares at y price, and extrapolate that to total shares outstanding.

And we do this all the time. We do this whenever we calculate market cap, which goes into enterprise value, EV/EBIT, EV/sales, and so on. 

It get's dangerous when we apply this false logic to value investing. How many times have you heard this type of argument: "This company had one little bad news, and its market capitalization declined by $7bn! How can the worth of the company change that much!?  It's irrational! Misunderstood! Buy buy buy!"

Again, it's extrapolation. We take one single point on the demand curve and assume all shares will clear at that price. Then we make claims about what the whole company is worth.  

This should make you think twice about using these metrics to make buy/sell decisions! Our “fundamental” valuation isn’t just subjective based on our view of the future - it is fundamentally and precisely wrong!

Sunday, June 11, 2017

Notes on Wachenheim’s “Common Stocks and Common Sense”

Ed Wachenheim runs Greenhaven Associates, a $6 billion value fund. He piled up an enviable track record over the past 20+ years, regularly making 20%+ a year. And he does this by investing in large caps like IBM and Lowe’s. I’ve been resorting to nanocaps to in my quest for returns, so I wanted to read his book and see how he did it.

The book, "Common Stocks & Common Sense" has an excellent format. It is a series of case studies, each about a particular company Wachenheim invested in.

He would typically start with some historical backgrounds for the industry and the company in question. Then he shows how he develops a thesis, problems the company was having (to the extent there were any), and how the idea played out the next couple years. Throughout these passages Wachenheim would sprinkle in bite sized philosophy about how to use sell-side research, his view toward interviewing management…etc.

We need more books like this. This is a little like “Alchemy of Finance” where Soros documented his real time decision making. If anything, this book provides interesting snapshots of some industries from 1990's to now.

This book was helpful in confirming some of the ideas I have on how to approach research, on top of some great insights. I will first share my observations about Wachenheim’s style, then list out some general takeaways.


Observations of Wachenheim’s style


  • Buy large cap liquid securities. 15-25 stocks in the portfolio, try to be fully invested all the time. 
  • Targets 20% return. This means individual ideas need much higher upside (say 60%+), because there will be losers also.
  • Ignore broad market moves, focus on fundamentals.
  • Not a buy and hold forever type of guy. Willing to hold for 2-3 years and sell when the thesis is played out.
  • In general stay away from growth stocks with high multiples. But also try to stay away from severely distressed companies. 
  • Typical type of plays:
    • Turnarounds/ leadership changes: e.g. IBM, Interstate Bakeries
    • Cyclicals: e.g. U.S. Home Corp, Centex, Southwest, Lowes, Whirlpool
    • Good companies with temporary issues: Union Pacific, Lowes, Boeing, Goldman Sachs 

Miscellaneous Notes and Takeaways


1) Focus on the upside first. Creativity is key in target identification.

Before doing a big deep dive, do a simple model and project 2-5 years out to see if there's enough upside to justify further work. Try to be creative in generating thesis - what can make revenue and margins go up? Can management cut cost here and there? What happens if input cost goes down…etc.

A lot of people say “focus on the downside and the upside will take care of itself”. But at least in the idea generation/filtering stage, you have to demand the upside - else you’re just wasting your time. The focus on downside can come after an idea passes the initial filtering and you’re doing deep dives and running scenarios.


2) Know the long term history of the business and industry. This helps you appreciate the structural difficulties and what it takes to fix them. 

IBM was an example in the book. In the 1990’s the company’s business model of selling, leasing, and servicing mainframes became outdated due to emergence of the PC. That left IBM with a bloated cost structure which old management was not willing to address. The buying opportunity came when Lou Gerstner became the new CEO and showed “the courage to take tough steps”.

Knowing the long term history also helped Wachenheim invest in cyclical companies. He bought Southwest Airlines in 2012, understanding that the decade of 2000's were miserable for airlines and forced them to cut capacity.


3) True insight comes from understand the unit economics of the business well.

Knowing the economics of Union Pacific helped Wachenheim differentiate between a temporary problem and a structural one. In UNP's case, congestions led to train delays, which hurt margins because revenue is a function of volume, while much of the expenses like labor are a function of time. When congestions were fixed, UNP’s margins improved and stock went along with it.

Another example is when he talked about Southwest Airline's capacity utilization. 83.1% utilization might seem like there's some excess capacity. But that is the average. Since unpopular flights (bad hours, remote locations...etc) are going to have many empty seats, the more popular flights are probably operating at full capacity and having wait lists.


4) Historical average P/E of the market is a little less than 16x. When valuing companies Wachenheim would use the 16x as a benchmark and adjust up and down based on business quality.

This is a better approach than using comparable multiples, which may be the most over-rated valuation methodology of all. “Peer comps” is an easy way for unscrupulous bankers and analysts to justify over-valuation in bubbly markets (“hey Alibaba trades at 56x PE so let me value this other shitty e-commerce stock with 45x PE! Look I’m really conservative here!”)


5) Use sell side analysts mostly as a gauge of market consensus, and think “do I see an upside here that consensus is not pricing in?” 

That makes sense because sell side guys get their feedback from buy side community, so these analyst reports in some way reflects prevailing opinions.


6) In my humble opinion, Wachenheim can screen stocks more effectively. He seems to run a lot of screens based on low valuation ratios, which he himself admitted is rarely productive, since these “cheap” stocks are usually cheap for a reason. 

I think you’re better off screening with charts and basic technical analysis. For example if you're looking for out of favor stocks, don't screen for low P/Es, low EV/EBIT...etc. Rather, find some price charts that dropped like a rock more than a year ago, underwent heavy capitulation selling, and have since showed price stabilization along with low volume (a sign of investor disinterest). What I typically do is screen for some minimum quality (low debt, high ROIC...etc) then run them through charts.