Wednesday, December 16, 2015

Apple: It's all about the valuation

       Apple is now priced as if it is projected to have negative growth.  Using a discount rate of 9%, which is probably high, if Apple can maintain its current earnings, the value per share comes to $102.  But that ignores net cash.  Apple has net cash of about $26 per share.  That brings the total value to $128.  Not an Ichan like number, but still a good deal more than the market price of $110.  This implies that the market is predicting significant negative growth for Apple.  Admittedly Apple faces some challenges, but with good management it should be able to at least maintain current earnings.  It looks like Apple is now cheap.

Tuesday, December 15, 2015

Carl Ichan and Apple

       Too often the investment business mimics the entertainment business.  An issue becomes hot, it dominates the press for a short time, and then it is gone and everyone forgets it.  While that may be a fine strategy for think about movies, it is not a good one for analyzing investments.  If you don't follow up on your predictions and reassess your analyses, what is the point of doing the valuation analysis in the first place?

       Here is one example.  On May 18, 2015 Carl Ichan penned an open letter to Tim Cook on the valuation of Apple.  Ichan concluded, "With Apple’s shares trading for just $128.77 per share versus our valuation of $240 per share, now is the time for a much larger buyback."  Well, Apple bought back a bunch of shares and now it is trading at $110.  The question is where is Mr. Ichan?  Is he buying shares like crazy at $110?  Has he changed his mind?  Who knows.  Those questions are no longer fashionable.

Friday, December 11, 2015


     Suppose your neighbors have a fire sale and put their furniture on the market at extraordinarily low prices?  What you should do is buy all you can – not match their low prices.  We have reached that point in the case of oil.  For whatever complicated strategic or political reasons, countries like Russia, Saudi Arabia, Iran and many others are intent on selling oil at bargain basement prices.  Perhaps they are struggling to maintain a fixed level of revenue.  Whatever the reason for their actions, the rational response is to buy as much as possible.  American companies should leave their shale oil in the ground.  The world stock of reserves, as measured by British Petroleum, is only 40 times the world’s annual usage.  This means that eventually, though it may be a decade out, having large oil stocks will be valuable both economically and from the standpoint of national defense.  In fact, if the major producers today dump their stocks at bargain prices while American firms leave their oil in the ground, the US may be a leader of “OPEC” in the future.  Seen in this context, removing legal restrictions on exports of oil is the right thing to do from the standpoint of fairness, but will have little economic impact.  Why would American producers want to export when the current OPEC is flooding the world with cheap oil?  The wise thing to do is to cash in on the bargain by buying cheap oil now and then win again as the commodity becomes more scarce and the US stock becomes more precious.

Friday, November 27, 2015

A Warning

       It is easy to lose perspective when things are going well and for stock things have been going well for quite some time.  The chart table below gives the total returns on the S&P 500 for the years 2008 through the current point in 2015.  Since the collapse in 2008, it has been up, up and away.  From the end of 2008 onward, the S&P 500 has average a compound return of over 15% in an environment of little inflation and with short-term interest rates close to zero.  But the continued rise stretches valuation thinner and thinner.  Stocks clearly cannot go on performing as they have relative to interest rates and inflation forever.  The question is when will stop, or even reverse.  If I had a good idea I would be trading rather than writing this blog.  (Well to be fair I am trading, but cautiously.)  Although I can't predict the future with any accuracy, in my view a warning is in order.

S&P 500 Total Return
2008 -37.00%
2009 26.46%
2010 15.06%
2011 2.11%
2012 16.00%
2013 32.39%
2014 13.69%
2015 2.65%

Friday, November 20, 2015

Don't Be Square

     I hate to be boring but here we go again.  Square has jumped to nearly $14 after its IPO.  To justify that valuation you have to assume significant future value creation (what financial economists call growth options).  Exploiting growth options requires barriers to entry and in the payments world the barriers may be less than in the wearable devices market discussed here earlier.  Apple and Samsung, among others, may use payments as a free feature to sell their devices.  Of course, Square may say that it is going to become some type of financial service provider for small business.  But at this point that is pie in the sky and that business is highly competitive too.  In short, buying Square for about $14 means bearing a great deal of risk for what appears to me to be little expected return at such a high valuation.  The good news is incorporated in the price but that market has not given enough weight to the down side.  Bottom line - keep you money elsewhere and don't be square.

Wednesday, November 18, 2015

Market Sentiment

      For long-term fundamental investors the path to superior returns is via market sentiment - both when it is high and it is low.  Gpro has been a constant topic in this blog due to the fact that I long argued that it was vastly overvalued due to market sentiment.  Well things go both ways.  Now, at about $19 dollars per share, I actually think that Gpro is undervalued.  The sentiment has turned so dramatically that its P/E ratio is below the average for the S&P 500.  While it may not have the growth options implied by a $90 dollar price, it does have some.  Ironically, my models suggest a fair value around the IPO price of $24.  Stay tuned as the saga continues.

Monday, November 9, 2015

Google vs. Amazon: A Valuation Faceoff

            Google (now Alphabet) and Amazon are two of the giants of the internet.  As of the close on Friday, November 6, Google had a stock market capitalization of $541 billion while Amazon weighed in at $309 billion.  The two companies are often lumped together, but from a valuation perspective, at least to date, they could not be more distinct.  To see why we say this, remember that the source of all value is free cash flow and take a look at the Table below.  No surprise in the case of Google.  It generated $24 billion of free cash flow in 2014 even after deducting the company’s “other investments” that are not part of its core business.  Add back those other investments and the free cash flow for 2014 was $34 billion.

            In the case of Amazon, the free cash flow is, like the operating income, essentially zero.  At a minimum, this puts to rest the assertion that the market is short-sighted and focuses too heavily on quarterly earnings.  Amazon is one of the most valuable companies in the world and it has never had any quarterly earnings to speak of.  The market clearly believes that someday Mr. Bezos will pull the switch and earnings and free cash flow will start pouring in, but that day has yet to arrive.

            But the point here is not to analyze Amazon in isolation, but relative to Google.  Based on 2014 results, Google is winning the free cash flow race by more than $23 billion, more than $34 billion if you add back the other investments.  Amazon’s free cash flow is less than 4% of Google’s.

            To compare the operating values of the two companies, net cash (cash minus debt) must be deducted from the stock market values.  In the case of Google, net cash is almost $60 billion (the free cash flow has to go somewhere) while at Amazon it is less than $5 billion (because it has been generating much less free cash flow).  Therefore, the operating values are $482 billion for Google and $304 for Amazon.  For the operating values to be this similar, it must be case that the market expects Amazon’s free cash flow to “catch up” to Google’s in the not too distant future given the impact of discounting.

            To be more specific, assume that a fair discount rate for both companies is 9% and that Google’s free cash flow grows initially at 10% falling to 4% in the long run.  These assumptions are basically consistent with Google operating value.  To rationalize the relative valuations, it turns out the Amazon’s free cash flow must grow at about 175% per year for the next twenty years (at which point it catches Google) to rationalize the relative valuation!  Does that seem unlikely to you?  If so, you are effectively saying that Google is underpriced relative to Amazon.  If you were to buy one of the two stocks, Google would be the wiser choice.  More generally, relative valuation often provides useful investment insight because one company can serve as a benchmark for the other.

GOOGLE 2014 2013 2012 2011
Stock market capitalization    541,150
  - Net cash     (59,158)
Market enterprise value    481,992
Operating Income (EBIT)       49,505       40,116       32,505       26,273
  -  Corp Tax at 20%       (9,901)       (8,023)       (6,501)       (5,255)
  +  Depreciation         3,523         2,781         1,988         1,396
  + Amortization         1,456         1,158            974            455
  -  Increase in working cap            364            (31)            898            630
  -  Capital expenditures     (10,959)       (7,358)       (3,273)       (3,438)
  -  Other investments     (10,096)       (6,321)       (9,783)     (15,603)
Free Cash Flow       23,892       22,322       16,808         4,458
Stock market capitalization    309,090
  - Net cash       (4,927)
Market enterprise value    304,163
Operating Income (EBIT)            178            745            676            862
  -  Corp Tax at 20%            (36)          (149)          (135)          (172)
  +  Depreciation         4,746         3,253         2,159         1,083
  + Amortization               -                 -                 -                 -  
  -  Increase in working cap            974            767         1,523         1,464
  -  Capital expenditures       (4,893)       (3,444)       (3,785)       (1,811)
  -  Other investments          (172)          (832)            190          (119)
Free Cash Flow            797            340            628         1,307

Thursday, October 22, 2015

Not so "fit" Fitbit

I know this blog is beginning to sound like a broken record but yet another example has emerged – Fitbit.  As the P/E multiple approached 50 on Monday, I could not resist writing call options.  Not only did the stock appear overpriced, for the reasons discussed below, but the implied volatility was over 90%.

The rationale behind my decision is familiar.  A P/E of 50 requires significant growth in free cash flow – not revenues.  Sustained growth in free cash flow requires meaningful, long-term barriers to entry.  When it comes to wearable fitness tracking devices, it is hard to imagine a more competitive business.  Not only is the space filled with big players like Apple, Samsung and Microsoft, but there are also a host of smaller companies like Pebble, Jawbone and Garmin jockeying for market share.  Where the “moats” around Fitbit’s products in such a situation?

Despite my overall belief in its efficiency, the stock market seems to periodically confuse growth in a sector (electronic watches and fitness trackers) with growth in the profitability of companies within the sector.  Unfortunately, it is quite possible for the sector to grow rapidly while competition prevents most (if not all) of the competitors from making a killing.  In my view, Fitbit will turn out to be another example.

Wednesday, October 14, 2015

Tesla Once Again and "Short-termism"

            To follow up on the previous post, let’s consider Tesla, the other stock that has been consistently discussed here as being overvalued.  Before getting to valuation, it is worth noting that Tesla is one example among many that contradict the view that the market is “short-term oriented.”  It is surprising how often this evidence is ignored in light of the fact that concern regarding "short-termism" has even spread to presidential candidates.  The fact is that all Tesla offers in the short-term are small profits or losses.  Nothing that can remotely justify its $30 billion (or so) valuation.  The only way to rationalize that valuation, particularly in light of the difficulty of growing rapidly in the automobile industry, is to conclude that the market is taking a very long view with respect to Tesla.  It sees big profits in the distant future.

            But then why does Tesla react, in some cases quite strongly, to short-term information?  To start, if what is meant by short-term is current information that is all there is.  Given that all new information is current, the relevant question is whether the current information has long-term implications, at least in the view of investors.  And that turns out to be an extremely difficult question to answer.

            A big reason for the difficulty is that information can accumulate and then suddenly have an impact on long-term views when a critical juncture is reached.  For instance, Tesla investors may largely ignore bad short-term news such as delays in the Model X for a while.  But if that news accumulates, at some point it will undermine their confidence in the company’s long-term growth.  At that point, the stock price will collapse.  However, there is no objective way to measure how information is accumulating in the minds of investors or what their thresholds are.  This is what makes shorting stocks such as Tesla so risky.  There is no way to predict how long it will take for investors to change their minds or what type of information will cause the change.  Eventually, of course, the stock price must drop if it becomes clear that the expected growth in future cash flows will not be realized.  But eventually can be a very long time.  As long as investors believe that future growth is coming, the stock price will not fall.

Monday, October 5, 2015

Go Pro "Went"

     A little over a year ago I posted an article calling GoPro wildly overvalued at a price of $75 per share.  I argued that the barriers to entry and the growth opportunities simply could not support a price-earnings ratio of over 250.  Suppose you agreed and decided to go short GoPro or write call options.  When do you make money?  Not until the market agrees with you.  And as Keynes noted nearly a century ago who knows when that will be.  The fact is that to make money, particularly on short positions, it is not enough to be right - the market has to accept your conclusion.

     What is odd that such agreement tends to arrive suddenly and for unclear reasons.  Since I posted my blog, Go Pro has done very well - sales and profits have both been growing sharply.  But not as sharply as investors apparently hoped.  In the last couple of months, the stock price has collapsed to less than 30, down more than 60%.  But the decline was hardly linear.  In fact, following the post the stock got as high as $90 per share.  I still believe that in the long run fundamental investing is the only way to make superior risk adjusted returns.  But waiting for the long run may be harrowing.

PS.  Currently, the P/E of GoPro has fallen to about 25.  In my view, the stock is now about fairly priced.

Friday, July 24, 2015

Amazon and Google Jump

               Remember the value of a company equals the present value of the market’s expectations of future cash flow.  For the value to jump overnight, it must be the case that the market’s expectations have been significantly altered.  (The discount rate is unlikely to change overnight except possibly in times of crisis.)  Recently, both Google and Amazon announced better than expected results and both stock prices jumped almost 20% overnight.  As an investor, the question you should ask is what news justifies that result?  Both companies stock prices, particularly Amazon’s, already incorporated expectations of rapid growth.  Prior to the jumps both company’s stock had also risen sharply relative to the market with Amazon up about 55% compared to the S&P 500 so the market was already incorporating ever more bullish expectations.  Was the news so much better than those expectations that it warranted at 20% upward valuation in the company overnight?  While that is not impossible, it does seem unlikely.  At any rate, at the new loftier valuations it raises the question of how future expected returns could possible justify the risk at such valuations.

Thursday, February 26, 2015

Opportunity and Diversity

           Recently concern has been expressed regarding the lack of diversity among the employees of major companies in Silicon Valley.  It is observed that the distribution of employees at these firms is markedly different, across ethnic, racial and gender dimensions, than the distribution of people in the population as a whole.  The implicit assumption is that the skewed distribution is result of unfair barriers, such as bias, prejudice, and cronyism that prevent there being equal access for all people.  The implication is that if those barriers are reduced, perhaps through political intervention, the distribution of employees will become more similar to the overall population.
           While such an assumption may be true in certain situations, as a general proposition it is clearly false.  Here is one example.
           In 1972, American Frank Shorter won the marathon at the Olympic Games.  In that year, Track and Field News ranked the world’s top marathoners.  The list was remarkably diverse.  In addition to Shorter and other Americans, it included Japanese, Mexicans, Europeans, Russians, Australians, a New Zealander and an African, among others.  But in 1972 there were barriers to entry in marathon running.  The lack of funding for marathon runners and the underdevelopment of the African continent prevented most Africans from competing at an elite level.  In the ensuing years, those barriers came down.  Elite marathons began offering prize and appearance money and African countries developed.
           When Track and Field News ranked the top marathoners in 2014 the list was dramatically different.  Diversity had disappeared.  Every one of the top forty runners was from Ethiopia or Kenya.  But even that overstates the diversity.  Ethiopia and Kenya are not homogenous societies.  With few exception, all the elite marathoners came from ethnic minorities than lived in the mountainous parts of the countries.
           In marathoning at least, the end result of removing barriers to opportunity did not result in increased diversity but in a remarkable degree of specialization.  In an activity open to virtually every human – running distance – all the elite men (and virtually all the elite women) now come from small ethnic minorities of two African countries.  Equality of opportunity, in this case, did not promote diversity, it destroyed it.  This example, though perhaps the most dramatic, is not unique.  There are many other instances throughout the world of sport, where performance can measured more objectively, in which opening doors to all people has led to increased specialization.
           Of course, the marathoning example is not a general rule either.  There are obvious instances in which removal of barriers increased diversity.  The entry of African Americans into professions from which they were previously barred is an example.  As the barriers were torn down, diversity increased.
           What the example does show is the removing barriers and increasing diversity are not the same thing.  Furthermore, in situations where barriers are removed and diversity decreases, attempting to enforce it is hazardous.  Doing so in marathoning would result in a bias against elite African runners and an increase in the mediocrity of marathon competitions.  Whether there is a similar risk in other professions is difficult to determine.  But one thing is certain.  Simply comparing the distribution of people in a given profession with the distribution of the overall population will not produce a meaningful assessment of the potential benefits and costs of attempting to enforce greater diversity.  Each situation will require its own fact intensive investigation.

Monday, February 16, 2015

Apple's Car and Barriers to Entry

               The rumor that Apple is considering entering the car business is one more example of a central issue this blog has addressed repeatedly regarding the valuation of Tesla (and other technology companies as well.)  There is a tendency to think that if a technology is fundamentally disruptive the companies that develop and exploit that technology will be huge creators of value.  Not necessarily so.
               One warning in this regard comes from Warren Buffett.  Consider one of the great disruptive technologies of the 20th century – the airplane.  Mr. Buffett notes that while the airplane dramatically changed the lives of most Americans, from an investment standpoint had it been at Kittyhawk he would have attempted to shoot the Wright Brothers down.  Mr. Buffett goes on to observe that despite all the benefits provided by air travel, investors in the airline industry (including Mr. Buffet) have almost uniformly under performed the market and frequently lost money outright.
               The problem is one that economists have recognized for centuries – competition.  Remember that in a perfectly competitive market producers create no new value.  They only earn their cost of capital.  Creating value requires keeping competition out.  Creating fortunes requires keeping competition out for a long time.  Technology is not a particularly good tool in this regard.  Yes, the innovations associated with it open doors, but those doors are opened to competitors as well.
               To return to Tesla, current competition and potential future entry are why Professor Damodaran and I have argued that Tesla’s current valuation is rich and that a valuation of Tesla comparable to Apple’s is ridiculous.  The automobile market is simply too competitive.  The entry of Apple, if it occurs, is just another example of that.  It is also worth adding that one should not assume that if Apple enters it will necessarily be a boon for the company for precisely the same reason.  Apple will not be immune from competition, including, ironically, competition from Tesla.  The bottom line is that the future of the automobile industry looks great from the standpoint of consumers, but not necessarily from the standpoint of investors.  Airlines 2?

Friday, February 13, 2015

Mr. Musk: Please Read Our Paper

              About six months ago, when Tesla was trading north for $250 per share, Aswath Damodaran and I published a paper arguing that a price of $250 per share was next to impossible to rationalize on a fundamental basis.  Even making optimistic assumptions, we arrived at a fundamental valuation on the order of $100 per share.  Since then, Tesla’s price has melted down to a less stratospheric $200.  Still high by our reckoning, but not ridiculous.  What is ridiculous is the recent statement by Mr. Musk that within 10 years Tesla’s valuation may approach Apple’s current $700 billion market capitalization.
              To see why, start with a simple calculation.  At $200 per share, the market capitalization of Tesla is $25 billion.  As a rough ballpark estimate, a fair risk adjusted rate of return on an investment in Tesla is about 10%.  Because Tesla does not pay a dividend, shareholders must earn all of this return in the form of stock price appreciation.  Assuming that Tesla appreciates at 10% per year for 10 years, the market capitalization will rise to $65 billion, less than 10% of Mr. Musk’s target of $700 billion.
              As a been stressed often on this blog, value creation on the order of that contemplated by Mr. Musk requires that a company earn returns far in excess of the cost of capital over extended periods of time.  That requires significant barriers to entry because every current and potential competitor will want to capture some of those excess returns.  In an industries as established as automobiles and batteries, it is hard to imagine that knowledgeable competitors, of which there are many, will sit back and allow Mr. Musk to earn extraordinary returns for decades at their expense.  If a new automotive design looks promising, they will adopt it.
              Of course, there is the example of Apple.  Apple’s market capitalization exceeds $700 billion because the company has been able to earn excess returns for more than a decade and the market expects it to continue for another decade.  But Apple is unique.  The company’s remarkable innovation, in conjunction with a strategy of coordinating software, hardware and design, has been brilliant.  Apple has also been benefited from a series of “butt fumbles” by its competitors that would make the New York Jets proud.  There is no evidence to date that Tesla is comparable to Apple in either respect.
              In short, for Tesla to be worth anything close to $700 billion in 10 years the company would have to move at “ludicrous speed.”  A potentiality that, from the point of view of any reasonable valuation model, is ludicrous.

Wednesday, February 11, 2015

Value Creation and Technology

              In previous blogs, I have argued that Apple was undervalued.  No more.  My opinion now is that it is fully valued, if not over-valued.  But with one crucial caveat that deserves attention.
              The caveat is this.  Value arises from satisfying human wants.  Solving hard technical problems will not produce much value if it does not address human desires.  And we human are not getting any smarter nor are our desires changing all that much.  As a result, the key to valuation creation in technology is the machine to human interface.  That interface, furthermore, is not just the technological aspects, but all aspects including how a device looks, feels, responds, interacts with you and so forth.  After all, look how much we humans spend on fashion and appearance.
              The caveat is that Apple, in the tradition of Steve Jobs and Jony Ive, is acutely aware of this while competitors have been dropping the ball.  If the competitors do not respond quickly, Apple’s valuation could even go higher.  Exhibit A of this problem is Samsung’s failure to produce phones that feel good and look good.  Exhibit B is Google wasting time on Glass, which is a fashion disaster, rather than rapidly improving and constantly marketing the look and feel of Android.  Pick up an Android device and I’ll bet you have no idea what version it is running or how that version relates to the current one.  Furthermore, the device is likely to feel uncomfortable in your hand and look ugly.  Apple routinely upgrades their operating system in a highly public fashion that produces a consistent experience across users.  Jony Ive obsesses over how the devices feel in your hand.
              As intelligence moves into all aspects of our lives, the interface will become even more important.  I know from my own efforts to build a smart home that the companies are only beginning to address the interface problems in that area.  Even GPS devices in cars remain ridiculously complex.  The GPS system ought to talk to you like a well-trained assistant.  Given that the things you and your GPS will be discussing are limited, this problem could be solved today with proper focus.
              To conclude, value creation in the technology space in future years will come down to interface design, including the incorporation of artificial intelligence.  Apple is getting that right and as a result is worth more than $710 billion today.  If the competitors fail to meet them head on then the value could go even higher.

Wednesday, January 21, 2015

IBM Should Buy Blackberry

            Let me admit from the start I am a big fan of John Chen and what he has been doing at Blackberry.  My view is simple.  There is a difference between the way an executive or an attorney uses a handset and the way young people use them.  If you want to swap photos and videos, check Facebook, or surf the internet - Apple and Android are the way to go.  But if you want to exchange secure emails as quickly and efficiently as possible Blackberry has a far superior solution.  Even the handsets, with their external keyboards, are better.  The new Classic and Passport are the best email devices available today.

            This brings me to part two.  IBM should buy Blackberry.  Providing services to corporations and professionals is what IBM does best.  As such, it cannot afford to not be in the communications business.  Properly developed, hopefully with John Chen still on board, Blackberry can make them a leader in that field.  IBM has been struggling to grow.  Buying Blackberry, even at $15 per share, is a far more optimistic use of its cash than buying more IBM shares.

Monday, January 19, 2015

Fundamental Valuation and Investing

            It may seem like a time for crowing.  The position advocated in these posts, that GoPro and Tesla had reached values that were unsustainable, has been vindicated.  But it is a better time to take stock in the relation between fundamental valuation and investing, than for self-congratulation.

            Making money from fundamental valuation requires the confluence of three factors.  The first is that once the investor completes the fundamental valuation the estimated value differs significantly from the market price.  This is actually likely to be quite rare.  Assuming both the investor and the market are reasonably rational, the two valuations will typically be quite similar in which case there is no incentive to invest. 

            If the two valuations differ, then it must be the case that the investor is right and the market is wrong.  Think for a moment what this means.  It means that one investor is able to assess value more accurately than the weighted average of the valuations of millions of investors reflected in the market price.  How likely is that to be the case?

            But even if the investor is right and the market is wrong, the investor does not make money off the discrepancy until the market recognizes the error if it ways.  If the market gets even more wrong, the investor loses money.  This leads to the old Wall Street adage that, “The market can stay irrational longer than you can stay solvent.”

            So even in this moment of glory regarding Tesla and GoPro, the message is to be cautious and humble.  The circumstances under which any investor, even Warren Buffett, can identify meaningful market misvaluations are likely to be rare.  Over-weighting a portfolio to what you believe to be misvalued securities might lead to nothing more than bearing unnecessary risk.