big boys, market and stories

It is no secret that market perceptions play a significant role in valuing firms. It is, in fact, the discounting of future stories related to a business by the market that reflects its current valuation. I mean, market valuation, not intrinsic valuation. 

These future stories are told as perceived, not as they actually unfold. That is why it is dangerous to accept market's views in the short term. Invariably, the stories are going to turn different. You cannot tell the story in zest; this is not the place to display excitement or dejection; investment decisions are done with real cash. Therefore, one of the key requirements of a successful investment operation is control over emotions. Put another way, the story has to be told not as likely to be perceived, rather, as more likely to develop. The probability of the story to become a reality should be rather high for an investment to bear fruit.

As noted, market valuations do not reflect those odds; this is true in the short term. However, in the long term, as the story actually emerges, the market adjusts the valuation accordingly. It is better to play the long term game for satisfactory returns. As much as the long term is uncertain, the investment returns are more predictable at least for certain businesses. 

It is true that intrinsic value of a firm is the present value of its cash flows discounted at an appropriate rate. Accordingly, the value is affected by cash flows, their growth period and growth rate. Once we have estimates of these numbers, the value becomes a function of the expected rate of return. 

The following is a snapshot of 3 big boys in the world of business. We have the latest annual revenues, 5-year average operating margins and 5-year average free cash flows to firm for each of the firms. None of the numbers are based on the trailing months. 

Based on the above information only, how do we value each firm? All of them have been around for a fairly long period. The business model of each relies heavily on technology for its success. Each of them has disrupted its market in a significant way. They are all being managed by competent people. One is in the retail business, the other is into computer peripherals (and more) and the last one is in the advertising business. 

As much as we would like to estimate the value of these firms, market as already done the work and given us its offer. Now it is up to us whether to buy them at those prices or leave for another day when the market is in another mood. 

While its cash is building up at a very rapid pace, we would like to know the reinvestment plans of Apple; how long its story is going to continue like it did in the past and what it is going to do with its cash are what determine its value. 

While Google's story appears to be more stable and credible, advertising market is not unlimited. It has boundaries and Google will have to operate within that. 

It is Amazon that amazes me the most. How long it is going to be until it really starts generating cash flows? The market has been very patient and is playing a very long term game. 

If we accept that it is the buy price that determines our investment returns significantly, we should be careful about what we pay; and this applies to Amazon, Apple and Google. 

morality of business

I have always maintained that one should carry out in a way that is within the legal boundaries set by the regulation and the moral boundaries set by the society. It applies to both personal life in terms of behavior and professional life. While it is easy to know the legal boundaries, checking out morality is not so easy. What is moral to one, might as well appear to be immoral to another. So, where do we stand here?

Is advocating Coke consumption immoral or is it tobacco that is bad? What about fried, packaged and canned food? What about environmentally unfriendly business? I can give more, but the line is blur. Yet, people always like to talk, or preach is the right word. Do as what I say, not as what I do, seems to be the cliche. 

I have not been a fan of Coke, and although I have said in the past that I won't buy Coca-Cola stock, I might buy it if the price is right, but not tobacco. When you attach big names to stories, they become more interesting; and that's what is happening at the moment. Wall Street likes to make it interesting. Someone says buying Valeant stock is immoral and some other says buying Coke stock is immoral. I liked the thud of that counter attack. 

I don't think any of these accusations are new stuff though. When it is never easy to draw the line of morality, opinions become personal not pervasive. If image-bashing is what attracts attention, people think so be it, and more. Now, is that moral? 

I don't think Warren Buffett has crossed any legal boundaries; I also find him to be very honest and ethical. His advice on investment management is the best one can take. No one has ever let out secrets of investment as openly as he has, and it is all free of cost. Probably, that's why they are not taken sincerely by people. Perhaps he should have priced his advice appropriately for its value to appear. As a matter of fact, I thoroughly enjoy his mocking Wall Street and the academia. Why not, when they fail to understand the difference between price and value, responsibility towards owners and are obsessed with personal gain? Yet, it does not mean that he is free of faults. He is a businessman and an investor. When he deals with other people's cash, he has the responsibility to maximize their (and his) returns. His actions are always within law, and what he considers to be within morality is up to him.

The accusations have been: He does not advocate use of derivatives, yet, he uses himself. He is an activist investor and uses his connections for profit. He advocates higher taxes, but pays the lowest tax rate. There are more. 

If he knows what he is doing, and his doing profits him, why not use derivatives? He is a businessman looking for profitable projects for his shareholders. His advice has been to avoid doing what you don't understand especially when it involves cash. Derivatives can be so complex that most don't understand the game, yet, play it, whereas, he is smart and plays it to his advantage; is that wrong? 

Activism and connections is a severe charge because it amounts to insider trading, which is illegal. Well, it is not proven as such. So people should be careful about what they talk. This one is ridiculous. If he found opportunities during the financial crisis when irresponsible firms were in trouble, why not profit from their folly? Did these reporters want him to look around and just feel sorry? It does not happen in business. 

He would be a bad businessman if he does not use prevailing tax laws to his advantage. He is in charge of shareholders' money where he has a fiduciary duty to make its best use. Did these characters want him to pay tax at say, 40% when as per rules it was only say, 20%? That math is crazy.

He is human too, and has his own shortcomings. Some may not find him to be the most adorable person due to stories regarding his family relationships. I too might have liked to advice him on a thing or two. We are all entitled to our opinions.

I would like to look at his positive side: He has taught people how they can lead a fulfilling life with lots of fun, and also make money by being honest, ethical and law abiding. Isn't that wonderful? 

His personal story may have been interesting for his biographer and others who enjoyed it, but I don't attach too much importance to it. I admire his simplicity, wit and wisdom. The guy is giving away almost all of his wealth. 

Charlie Munger can be the smartest guy we can find, and he is entitled to his views on morality of Valeant's business model. And so is Bill Ackman on Coke.

It is those storytellers who tend to attract attention with their so-called insights. They probably fail to look at the purpose of a business and decisions that maximize its value. To generate cash flows and growth, managers have to take good projects, finance them well and deal with excess cash appropriately. For personal charity, there is another platform.

precision castparts and berkshire hathaway

No due diligence, no advisors, no fees, no frills. That is how Berkshire Hathaway does acquisitions, and that's how it should be done as well. Of course, the due diligence part can remain a bit distinct. I like, however, the idea of not having any outside professional help; what do they do anyway other than making money for themselves? Berkshire has been an exception in an otherwise sticky framework for acquisitions. With its Chairman & CEO and Vice Chairman, it remains grounded on most of its business decisions. Warren Buffett and Charlie Munger can be as rational as we can expect in a corporate executive or a businessman. It is never that easy, but those men make it simple. Just look into eyes before dealing with people. It can't get better than that. One of the finest run firms in the world of business, Berkshire announced acquisition of Precision Castparts for $37 b including debt in August 2015 at a price of $235 per share in cash. Its has 137.59 m shares outstanding.

Interestingly, when it was announced the stock price of Precision jumped nearly 20%. So is this deal good for shareholders of both Precision and Berkshire? Precision managers consider that their stock is cheap at the price of $222.64, for that's what they paid when they bought back 7.21 m shares during the year that ended in March 2015. Later, they accepted the offer for the entire company at a premium of just over 5%. It appears that Berkshire got the better of Precision shareholders, unless, $222.64 a share was not cheap in terms of its intrinsic value, which then would mean their managers wasted $1.6 b in an expensive buyback. Knowing Berkshire's history, I am not surprised that they got a better deal; note that the price is 21 times its 2015 earnings. Precision's past performance and future prospects should tell us how good the deal is.

Precision's share price was as high as $275.09 in 2015 and as low as $47.08 in 2009. From its high market value of equity of $18 b in 2009, it has come a long way. Its revenues grew by 12.77% annually over the last five years; operating earnings increased by 12.86%, net earnings by 10.67% and earnings per share by 11.19%.

It did not have a particularly good year in 2015 though. $10 b revenues were not enough to show a good performance.

Precision's growth has come mainly through acquisitions. In the last eight years, it spent $9.78 b in acquiring other businesses, and recorded a goodwill of $6.67 b as of March 2015. Its net reinvestment in the business during that period was $13.13 b. Because of this, it never paid large dividends, and its free cash flows are not that robust. Surely, both its managers and Berkshire must consider Precision as more of a growth company. 

Its return on equity (13.44% in 2015) and after-tax return on capital (11.96%) have been declining over the years. This is because its capital efficiency has come down significantly, requiring larger reinvestment for generating revenues. Perhaps, managers and Berkshire must consider that results of reinvestment would show up in the future years. 

Debt of $4.58 b is not too much compared to the market value of its equity, which was mainly raised for the purpose of a large acquisition in 2013. It also has a small amount of lease debt. As in any manufacturing company, a good amount of capital is tied up in working capital requirements. I reckon, there might be some discrepancy between discount rate and expected return assumptions used in its pension liabilities.

If Precision were to grow at 12% annually in the next five years, and then slow down a bit to become a mature business by its eleventh year; if it were to become efficient in capital utilization (i.e. lower reinvestment to bring revenues), say, as it was in 2009; if its return on capital were to reach 20% during its stable growth period; if its operating margins do not deteriorate anytime; then the value of the firm would be a function of expected rate return of the investor. 

As you can see, I have not used conservative assumptions regarding growth rate and reinvestment. Nevertheless, I am not going to argue with Berkshire on its acquisition price. Precision, surely, appears to be a good business to keep for Berkshire. As much as it has grown in size and as much as its free cash available for use, Berkshire cannot continue to buy common stocks from open market and make any meaningful contribution to its value. It has been correctly pursuing an acquisition policy that suits its size and cash flows. 

shareholders or customers

Can someone run a business and become a billionaire snubbing investors? May be the title of the article is incongruous, or may be there is a real snub out there what with 5.80% return on equity.

Whatever that is, Mr. Kazuo Inamori must be a great guy with motives towards welfare of his employees. As per the story in the article, he was able to amass huge wealth focusing on making staff happy, let's call it creating employee value. He must have also created shareholder value in the process; he let Japan Airlines come out of bankruptcy. His lines: If you want eggs, take care of the hen; At times company management has to say no to shareholders' selfish requests. And the response from the shareholders was, we are shareholders and not selfish shareholders. Mr. Inamori apparently acknowledges that the companies do belong to the shareholders, however, he is quick to extend that hundreds or thousands of employees are also involved, and then he says, the hen has to be healthy. 

What I am not clear though is, who is the hen here. I would like to argue that if Mr. Inamori's businesses are any successful in increasing their long term returns, the hen would be shareholders, not employees. Mr. Inamori must have focused on creating shareholder value through the means of making his employees happy. Never mind if there has been some mix-up over who the hen is.

This brings us to think about the purpose of a firm. Although arguments on this topic are unresolved, the favorite choices remain: shareholder value, customer value and society value creation.

Here's my take. Any business, small or big, private or public, listed or unlisted, national or multinational, is started by the owners, with a combination of their own and borrowed capital, in order that they make money out of it. If this was not true, they would not be spending their time, resources and efforts. In an owner-managed business, the owner would both supply capital and operate the business. In a professionally managed business, the owners employ outside managers to operate the business as per their mandate; the managers would get paid for the services and final profits would accrue to the owners. The owners' goal here is not to make anybody but themselves happy, and happy they would be, if only they make money; otherwise they would do something else, not start a business. Of course, they would have to operate their business within legal boundaries set by the regulation and moral boundaries set by the society. If making money for themselves requires anything to be done, they would willingly do it. For instance, if happy employees would make more money for the firm, the owners would like to take good care of their employees; if it requires making customers happy, so be it.

What is important is to know the final objective of a business. The end is to generate cash flows, more the better, and there could be several means - making employees, customers and society happy. Therefore, creating long term value for shareholders is the only objective of a business. 

A business operates as a going concern, usually until perpetuity. It is clear therefore that the shareholders would look for long term profits and value creation rather than short term. It is true for a private business and also for a publicly listed business. For a listed firm, there are many distractions, the biggest one is the capital market. The market would like to grade the firm on a moment to moment basis, and at each quarter it is open to a harsh scrutiny. If managers and shareholders consider this as troublesome, they are not aligned with their thoughts. It really does not matter what happens in the short term, because there are always inefficiencies in that flawed process. What matters is the long term performance of the business. In the final analysis, stock prices follow earnings and cash flows. It is better for the business, managers and shareholders to focus on the long term than think about what would happen in the short term. 

In this respect, there is no need to reinvent the purpose of the firm as this report calls for. The article calls it the age of customer capitalism, as opposed to shareholder capitalism, and supplies a series of confused arguments. It gives example of four firms, Coca-Cola and GE as proponents of shareholder value, and Johnson & Johnson and Procter & Gamble as proponents of customer value. It argues that there is no sign that shareholders benefited more when their interests were put first and foremost.

My intention is not to disagree with the author personally, rather with everyone, who is from that school of thought. The article then goes on to say that to create shareholder value, you should instead aim to maximize customer satisfaction. Our response to that muddling is, who said no? Note that it starts the sentence with to create shareholder value, which means it implicitly accepts that the end is the creation of shareholder value, but fails to put it explicitly.

A CEO should do whatever it takes to ensure enhanced returns for the shareholders. If that takes making customers happy, the CEO should take it as a task.

Consider this: If happy customers do not translate into high return on the invested capital, why would shareholders continue to invest? It is called throwing good money after bad. Capital is not available free of cost. Let's take an example. Imagine that there is a business, which either due to being a monopoly or some other uniqueness has immense pricing power. Let's assume that because of this power, it is able to charge more than what its customers feel fair, and consequently it makes customers somewhat unhappy, and yet is able to make money. Would managers and shareholders think in these lines - this business is too good, makes a lot of money for us, but our customers are unhappy, we cannot see it, let's close the business or charge them less and earn less for ourselves - would they?

The article throws yet another argument: that the only sure way to increase shareholder value is to raise expectations about the future performance of the company. While it acknowledges that there is a behavioral aspect to this in the markets, it fails to bring forth the economic reasoning behind allocation of capital. The manager's role is to ensure that capital supplied by shareholders is suitably allocated to projects that earn more than their cost of capital. This is not an overnight's journey, but a long one. Those who are not tuned to this thinking, whether managers or shareholders, should rather stay away, and look somewhere else. 

I find the article's most flawed argument: Executives come to understand that shareholder value creation and destruction are cyclical, and more important, not under their control. How can we respond to this? If shareholder value creation is not in their hands, in whose hands are they? Why have shareholders picked these managers for? A CEO's job is to maximize the value of the firm, which requires obtaining a right mix of capital, allocating capital in the right projects, and paying out excess cash generated back to shareholders. These decisions are to be taken considering long term economic impact on the business and its value, not based on the dancing notes of speculators and traders. Short term gyrations are best to be ignored; when such alignment exists between executives and shareholders, shareholder value creation is warranted.

Value of a firm is the present value of its future cash flows. Managers can destroy value in several ways with short term tactics, which they often do - take projects that do not earn their cost of capital, pay too much for growth, take on excessive leverage - to manage quarterly earnings and increase immediate stock prices. This does not, however, change the objective of the business. 

Stock-based compensation is another aspect that is misunderstood. Stock options are given basically to align the thoughts of managers with that of shareholders. If managers are shareholder oriented and believe in long term economics of the business, they can buy stocks from open market themselves with their own cash. They need not rely on stock options for that. When we find top managers, who do not keep their stocks for long, it is safe to conclude that they are not shareholder oriented.

The article says that companies should seek to maximize customer satisfaction while ensuring that shareholders earn an acceptable risk-adjusted return on their equity. I would like to ask, what if companies are able to give an acceptable return on equity to shareholders despite making their customers slightly unhappy?

The article then promptly highlights Johnson & Johnson's credo, which according to it, gives shareholders last priority compared to the doctors, nurses, patients, customers, employees and communities. As I read the last sentence of the credo which states that when we operate according to these principles, the stockholders should realize a fair return, I find that again the primary goal appears to be shareholder value, if it was not, J&J would price its products at cost or below so that customers and society were happy. Whether CEO James Burke's recall of every Tylenol capsules across America, or more recent recall of Volkswagen vehicles across the world or recall of Maggi noodles across India, yes, it is about doing the right thing, but not for customers, it is for shareholders. If not, the long term brand image would be hit severely impacting long term profits; in such situations, it is better to take lower profits or even losses in the short term. This is again a shareholder oriented policy, not customer oriented.

The article mistakenly thinks that companies such as J&J and P&G are customer focused rather than shareholder focused, and therefore they are able to deliver impressive returns to shareholders. It is a flawed thinking. At the cost of repetition, I note that if maximizing shareholder returns requires customer satisfaction, the CEO should work towards it. However, it is a mistake to assume that customer satisfaction is the primary focus and shareholder profits are incidental.

A good CEO is one who understands shareholder value well enough, and runs the business accordingly. This involves taking investing, financing and dividend decisions in the best interests of shareholders. It is not about increasing stock prices in the short term, thus making way for managers and traders. It is about increasing long term economic value of the firm, which when done increases the stock price eventually. Investing in stocks, as opposed to playing in the derivatives, is not a zero-sum game. Here, the stockholders are rewarded for supplying capital to a well run business. This business, operating under free market environment, will be doomed in the long run if it continues with the policy of ill treating employees or charging excessively to its customers. The competition will ensure destruction of its image, business and eventually, value. The decisions taken here are business decisions which are shareholder oriented.

In conclusion, while creating shareholder value is the single objective of a business, creating employee, customer and society satisfaction is only a means to that end. If the primary goal is creating value to customers and society, the capital providers should look towards charity, not business profits. They are noble thoughts, but not ethos of business.  

apple in a decade

Shareholders' pride, neighbors' envy
Apple's market cap is $ $676 b now. It peaked at $750 b in 2015. The returns given by the stock are phenomenal by any standards. 

As we can see, even if we had purchased the stock at the high price in any prior year, our investment return would have been more than satisfactory. For instance, if we had picked it in 2005 at its high price for that year, the annual return would be 31.29%; that is our investment growing by 15 times. At 2010 high price, it would be 20.25%. We would not make much if it was bought in 2012 and 2013. 

If someone was a superb market timer and was able to buy the stock at the low price in any prior year, the story would be extraordinary. 

The entire company was available at $15 b in 2005; but, who would have turned it into $676 b by now? Not any of us. As near as last year, Apple was available at $397 b and that is a 70% upside now.

As they say, we don't need many stock ideas in our life time to become rich. Yet, not many would have the foresight, wisdom and belief in management. It looks like everything has turned out well for Apple so far; this is despite our asking the right question: for how long this magic is going to continue? Is many shall fall that are now in honor going to be true for Apple ever? May be it will one day. In the meantime, it is not inappropriate to ask, what makes Apple as a business so special?

The story that has been
Apple's revenues increased by 27.86% to $233.71 b, operating earnings by 35.67% to $71.23 b, and its earnings per share increased by 42% in 2015. This EPS is slightly different from the one reported because I have not used the weighted average number of shares outstanding.

What I find striking is that Apple has been generating cash year after year. My unsolicited advice to Apple in October 2014 for effective use of its cash went, not surprisingly, unnoticed; my consolation is that I usually write for myself, not for others. 

If the story continues the way it has been, Apple is going to outgrow and it will always be in honor. That kind of perpetual model has not been witnessed in the history of business. So it is appropriate to consider that one day Apple will face the reality and slow down. But, when will that be?

In the last ten years, Apple generated free cash flows of $235 b, significantly through its own capital. It has started raising debt only recently. It spent $59 b on capital expenditure, including acquisitions. Yet, its net cash spend was only $9 b in the last ten years. This was possible primarily due to savings from working capital and depreciation. I look at the story like this: $235 b of cash was generated with the help of $9 b reinvestment. Granted, Apple also spent $30 b in research and development; I am not sure whether innovation in iPhones, iPads or Macs in the recent years reflect that. It is not surprising that Apple has been operating with negative capital in its business. Its current cash hoard is $205 b, of which a significant part is trapped outside of US and is liable for additional taxation. Still, free cash net of tax liability is massive.

Valuation
To value Apple, we need to estimate how much it would need to reinvest in the business to achieve the expected growth rate. We know that growth is not free. However, as evident from its past, Apple has been growing without much help from reinvestment. How do we estimate reinvestment? We could use the industry standards; but, Apple has been defying it all the time. We cannot assume past reinvestment rate either, which is ridiculously amazing. 

If we assume that Apple's free cash flows are going to grow at the rate of growth in the US economy forever and use the expected rate of return considering our opportunity cost, we should be able to get a value. Two problems though: We are not sure whether even this low perpetual growth rate will be valid for Apple, because at some stage it will have to put in capital for reinvestment. It cannot continue squeezing its suppliers forever. Again, our opportunity costs differ. We could also calculate its cost of capital, but I am not interested. This is because I am more interested in how much I can make than how much Apple is actually worth.

I also used my estimates of growth and reinvestment in the next decade and made Apple a stable firm thereafter. I know my estimates are going to be wrong.

The questions to ask are: How much Apple is going to grow in the future? How much capital it is going to require to be able to show that growth? When will it stop growing and start behaving like a normal, stable firm? What is our opportunity cost at the moment? What alternatives do we have to invest our capital - treasuries, bank rates, money markets, bonds, equity market rates - how about Apple stock? Will Apple managers ever mess up?

Is there anyone who can take on iPhone? Will Macs continue their fancy? Will iPads follow the PC markets? Is there any product - it can't be watch or TV - in pipeline for Apple to hold its fort? Tough questions, which only time will be able to answer.

I come back again to that unsolicited advice. 

strategic buzzwords

Earlier it was China, quantitative easing and demand for commodities, which made firms, analysts and every other to justify their actions, whatever that might be, acquisitions or high valuations. 

Now it is the same, but in the opposite direction. It is China slowing down, low commodity prices, and the Fed quitting the easing. I wonder how some things just don't change. While there are still acquisitions happening around the world, the cues are about slowing down. 

What I have seen and remain confident about is that economists never concur on anything. You put several of them in a room and they will diverge in their opinions. Again, it is evident from history that any economy moves in cycles; we witness growth and recessions all the time, one after the other. 

My take is that no federal policy would be able to permanently change the path of a cycle. We might want to attribute the change to the government, but it is more due to the spirited free markets that eventually push for the change. This is because in a democracy and free markets economy, the government's role is limited, and should be limited, only to put the system in place and oversee as a regulator, and not meddle much. 

As the economy, including the government, is made up of humans, what drives it is the change in the behavior of the individuals. We know that they are not rational beings; therefore at any point in time, the economy reflects their moods. Higher value is driven by meaningful growth, which is reflected by increase in future cash flows, and cash flows are generated through investments. When they are optimistic about future, good investments are made, projects are executed well, and there is growth. Opposite is true when people become depressed and consequently, reluctant to invest in projects. 

Just like firms, investing, financing and dividend decisions of the country are dependent upon the behavior of the people. It is up to the government, as a manager, to take these decisions in the best interests of the stakeholders; probably the key function of the government is to lift the mood. I don't know why China is slowing down now when it was growing in earlier years. May be people are scared of its past financing decisions, or may be something else. I don't know why commodity prices are low now. Isn't it all good for the firms to buy them cheap to use in their production, and drive growth? Quantitative easing has been the savior for the US economy, but how much credit is due to it is something we need to ponder. If it was not there, what would have happened? Would markets have remained on the brink until now? I don't have an answer to any hypothetical question. Of course, sometimes things don't really work out for a long time just like it is the case for Japan, where they are clueless about what should be the way forward. I find that ironic.

Mostly, though, we are responsible for our own actions. If we remain positive collectively, work hard enough towards what we want, use only reasonable, not excessive, debt and execute our tasks well enough, we should be able to move forward. If that sounds Utopian even for a capitalistic economy, my advocacy is to hope for this during longer cycles. Wait, hasn't this been happening already? We have had more positive years than negative years in the past as long as we can go back. From stone age to here, we have moved far enough. That is going to continue long enough into the future. I see this as the bright side.